Regulation

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This publication is intended for the study and preparation of the CPA Exam, and is not intended to offer any legal, accounting, or professional advice. The guidance, opinions, and strategies contained herein make no representations or warranties with respect the accuracy or completeness of the content. The publisher specifically disclaims any express or implied warranties for a particular business, legal, or accounting purpose.
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About the Exam

The Uniform Certified Public Accountant Examination is the examination administered to people who wish to become U.S. Certified Public Accountants. The CPA Exam is used by the regulatory bodies of all fifty states plus the District of Columbia. The CPA Exam is developed, maintained and scored by the American Institute of Certified Public Accountants (AICPA) and administered at Prometric test centers in partnership with the National Association of State Boards of Accountancy (NASBA).

About Regulation
The Regulation section tests knowledge and understanding of ethics, professional and legal responsibilities, business law, and federal taxation. Ethics, Professional and Legal Responsibilities and Business Law These topics test knowledge and understanding of professional and legal responsibilities of certified public accountants. Professional ethics questions relate to tax practice issues and are based on the AICPA Code of Professional Conduct, Treasury Department Circular 230, and rules and regulations for tax return preparers. Business law topics test knowledge and understanding of the legal implications of business transactions, particularly as they relate to accounting, auditing, and financial reporting. This section deals with federal and widely adopted uniform state laws or references identified in this CSO. In addition to demonstrating knowledge and understanding of these topics, candidates are required to demonstrate the skills required to apply that knowledge in performing their responsibilities as certified public accountants. To demonstrate such knowledge and skills, candidates will be expected to perform the following tasks: Identify situations that might be unethical or a violation of professional standards, perform research and consultations as appropriate, and determine the appropriate action. Recognize potentially unethical behavior of clients and determine the impact on the tax services being performed.

 Demonstrate the importance of identifying and adhering to requirements, rules, and standards that are established by licensing boards within their state, and which may place additional professional requirements specific to their state of practice. Apply business law concepts in evaluating the economic substance of client transactions, including purchase agreements, loans and promissory notes, sales contracts, leases, side agreements, commitments, contingencies, and assumption of liabilities. Evaluate the legal structure of an entity to determine the implications of applicable laws and regulations on how a business is organized, governed, and operates. Federal Taxation These topics test knowledge and understanding of concepts and laws relating to federal taxation (income, gift, and estate). The areas of testing include federal tax process, procedures, accounting, and planning, as well as federal taxation of property transactions, individuals, and entities (which include sole proprietorships, partnerships, limited liability entities, C corporations, S corporations, joint ventures, trusts, estates, and tax-exempt organizations). In addition to demonstrating knowledge and understanding of these topics, candidates are required to demonstrate the skills required to apply that knowledge in providing tax preparation and advisory services and performing other responsibilities as certified public accountants. To demonstrate such knowledge and skills, candidates will be expected to perform the following tasks: Evaluate the tax implications of different legal structures for business entities. Apply analytical reasoning tools to assess how taxes affect economic decisions related to the timing of income/expense recognition and property transactions. Consider the impact of multijurisdictional tax issues on federal taxes. Identify the differences between tax and financial accounting. Analyze information and identify data relevant for tax purposes. Identify issues, elections, and alternative tax treatments. Research issues and alternative tax treatments. Formulate conclusions. Prepare documentation to support conclusions and tax positions. Research relevant professional literature.

AICPA, American Institute of Certified Public Accountants, Inc.

Content Specification Outline

This book is organized in conjunction with the AICPAs Content Specification Outline of the CPA Examination. The outline below specifies the knowledge in which candidates are required to demonstrate proficiency:
I. Ethics, Professional, and Legal Responsibilities (15% -19%) A. Ethics and Responsibilities in Tax Practice 1. Treasury Department Circular 230 2. AICPA Statements on Standards for Tax Services 3. Internal Revenue Code of 1986, as amended, and Regulations related to tax return preparers B. Licensing and Disciplinary Systems 1. Role of state boards of accountancy 2. Requirements of regulatory agencies C. Legal Duties and Responsibilities 1. Common law duties and liability to clients and third parties 2. Federal statutory liability 3. Privileged communications, confidentiality, and privacy acts

II. Business Law (17% - 21%) A. Agency 1. Formation and termination 2. Authority of agents and principals 3. Duties and liabilities of agents and principals B. Contracts 1. Formation 2. Performance 3. Third party assignments 4. Discharge, breach, and remedies C. Uniform Commercial Code 1. Sales contracts 2. Negotiable instruments 3. Secured transactions 4. Documents of title and title transfer D. Debtor-Creditor Relationships 1. Rights, duties, and liabilities of debtors, creditors, and guarantors 2. Bankruptcy and insolvency E. Government Regulation of Business 1. Federal securities regulation 2. Other federal laws and regulations (antitrust, copyright, patents, money-laundering, labor, employment, and ERISA) F. Business Structure (Selection of a Business Entity) 1. Advantages, disadvantages, implications, and constraints 2. Formation, operation, and termination 3. Financial structure, capitalization, profit and loss allocation, and distributions 4. Rights, duties, legal obligations, and authority of owners and management III. Federal Tax Process, Procedures, Accounting, and Planning (11% - 15%) A. Federal Tax Legislative Process B. Federal Tax Procedures 1. Due dates and related extensions of time 2. Internal Revenue Service (IRS) audit and appeals process 3. Judicial process 4. Required disclosure of tax return positions 5. Substantiation requirements 6. Penalties 7. Statute of limitations C. Accounting Periods D. Accounting Methods 1. Recognition of revenues and expenses under cash, accrual, or other permitted methods 2. Inventory valuation methods, including uniform capitalization rules 3. Accounting for long-term contracts 4. Installment sales E. Tax Return Elections, Including Federal Status Elections, Alternative Treatment Elections, or Other Types of Elections Applicable to an Individual or Entitys Tax Return F. Tax Planning 1. Alternative treatments 2. Projections of tax consequences 3. Implications of different business entities 4. Impact of proposed tax audit adjustments 5. Impact of estimated tax payment rules on planning 6. Role of taxes in decision-making G. Impact of Multijurisdictional Tax Issues on Federal Taxation (Including Consideration of Local, State, and Multinational Tax Issues) H. Tax Research and Communication

1. Authoritative hierarchy 2. Communications with or on behalf of clients IV. Federal Taxation of Property Transactions (12% - 16%) A. Types of Assets B. Basis and Holding Periods of Assets C. Cost Recovery (Depreciation, Depletion, and Amortization) D. Taxable and Nontaxable Sales and Exchanges E. Amount and Character of Gains and Losses, and Netting Process F. Related Party Transactions G. Estate and Gift Taxation 1. Transfers subject to the gift tax 2. Annual exclusion and gift tax deductions 3. Determination of taxable estate 4. Marital deduction 5. Unified credit V. Federal Taxation of Individuals (13% - 19%) A. Gross Income 1. Inclusions and exclusions 2. Characterization of income B. Reporting of Items from Pass-Through Entities C. Adjustments and Deductions to Arrive at Taxable Income D. Passive Activity Losses E. Loss Limitations F. Taxation of Retirement Plan Benefits G. Filing Status and Exemptions H. Tax Computations and Credits I. Alternative Minimum Tax VI. Federal Taxation of Entities (18% - 24%) A. Similarities and Distinctions in Tax Treatment Among Business Entities 1. Formation 2. Operation 3. Distributions 4. Liquidation B. Differences Between Tax and Financial Accounting 1. Reconciliation of book income to taxable income 2. Disclosures under Schedule M-3 C. C Corporations 1. Determination of taxable income/loss 2. Tax computations and credits, including alternative minimum tax 3. Net operating losses 4. Entity/owner transactions, including contributions and distributions 5. Earnings and profits 6. Consolidated returns D. S Corporations 1. Eligibility and election 2. Determination of ordinary income/loss and separately stated items 3. Basis of shareholders interest 4. Entity/owner transactions, including contributions and distributions 5. Built-in gains tax E. Partnerships 1. Determination of ordinary income/loss and separately stated items 2. Basis of partners/members interest and basis of assets contributed to the partnership 3. Partnership and partner elections

4. Transactions between a partner and the partnership 5. Treatment of partnership liabilities 6. Distribution of partnership assets 7. Ownership changes and liquidation and termination of partnership F. Trusts and Estates 1. Types of trusts 2. Income and deductions 3. Determination of beneficiarys share of taxable income G. Tax-Exempt Organizations 1. Types of organizations 2. Obtaining and maintaining tax-exempt status 3. Unrelated business income

AICPA, American Institute of Certified Public Accountants, Inc.

Regulation 1: Ethics, Professional, and Legal Responsibilities Role of state boards of accountancy
Generally each state operates their own board of accountancy to protect consumers by ensuring only qualified licensees practice public accountancy in accordance with established professional standards. To become a CPA, a candidate must first apply to their state's board.

National Association of State Boards of Accountancy

The National Association of State Boards of Accountancy (NASBA) is an association dedicated to serving the 55 state boards of accountancy. These are the boards that regulate the accountancy profession in the United States of America. There is one board for each of the 50 states, plus the District of Columbia, Puerto Rico, U.S. Virgin Islands, Guam and the Northern Mariana Islands. Structure of the U.S. accounting profession In the United States, the designation of Certified Public Accountant (CPA) is granted at state level. Individual CPAs are not required to belong to the American Institute of Certified Public Accountants (AICPA), although many do. NASBA acts primarily as a forum for the state boards themselves, as opposed to AICPA which represents CPAs as individuals. Role of NASBA NASBA's primary role is to:

Act as a forum for state boards to discuss issues of common concern Encourage reciprocal recognition of the CPA qualification between states Enable state boards to speak with one voice in dealing with AICPA, the Federal Government, and other stakeholders

NASBA is a member of the International Federation of Accountants. Uniform CPA Examination Responsibility for the Uniform Certified Public Accountant Examination is shared between state boards of accountancy, the AICPA and NASBA:

State boards of accountancy are responsible for assessing eligibility of candidates to sit for the CPA examination. Boards are also the final authority on communicating exam results received from NASBA to candidates. The AICPA is responsible for setting and scoring the examination, and transmitting scores to NASBA. NASBA maintains the National Candidate Database and matches score data received from the AICPA with candidate details. Most states offer online score reporting on NASBA's website at www.nasba.org [2]. NASBA also maintains records for those who have passed the exam.

The AICPA and NASBA also coordinate and maintain mutual recognition agreements with foreign accountancy institutes. Disciplinary Actions State boards have the authority to define proffessional misconduct within their state sufficient to require disciplinary action. Generally, misconduct can be defined as misconduct during the performance of accounting services, misconduct outside of accounting services, or criminal conviction. After an investigation, the board can hold a formal hearing, subject to judicial review. If the member is found to have committed professional misconduct, the board can impose five different types of penalties: suspension or revocation of license, monetary fine, reprimand or censure, probation, and requirement for Continuing Professional Education (CPE) courses. Licensing The licensing of Certified Public Accountants can only done through state boards of accountancy. Additionally, only the states have the right to revoke or suspend a license. Each state has its own requirements for licensure beyond passing the CPA examination. These requirements could relate to experience, education, and residence.

American Institute of Certified Public Accountants

Founded in 1887, the American Institute of Certified Public Accountants (AICPA) is the national professional organization of Certified Public Accountants (CPAs) in the United States, with nearly 377,000 CPA members in 128 countries in business and industry, public practice, government, education, student affiliates and international associates. It sets ethical standards for the profession and U.S. auditing standards for audits of private companies, non-profit organizations, federal, state and local governments. It also develops and grades the Uniform CPA Examination. The AICPAs founding established accountancy as a profession distinguished by rigorous educational

requirements, high professional standards, a strict code of professional ethics, and a commitment to serving the public interest. Mission The AICPA's mission is to provide members with the resources, information and leadership that enable them to provide valuable services in the highest professional manner to benefit the public, employers and clients. In fulfilling its mission, the AICPA works with state CPA organizations and gives priority to those areas where public reliance on CPA skills is most significant. Professional standards setting The AICPA sets generally accepted professional and technical standards for CPAs in multiple areas. Until the 1970s, the AICPA held a virtual monopoly in this field. In the 1970s, however, it transferred its responsibility for setting generally accepted accounting principles (GAAP) to the newly formed Financial Accounting Standards Board (FASB). Following this, it retained its standards setting function in areas such as financial statement auditing, professional ethics, attest services, CPA firm quality control, CPA tax practice, business valuation, and financial planning practice. Before passage of the SarbanesOxley law, AICPA standards in these areas were considered "generally accepted" for all CPA practitioners. In the early 2000s, federal public policy makers concluded that where independent financial statement audits of public companies regulated by the U.S. Securities and Exchange Commission are concerned, that the AICPA's standards setting and related enforcement roles should be transferred to a government empowered body with more enforcement authority than a non-governmental professional association, such as the AICPA could provide. As a result, the Sarbanes-Oxley law created the Public Company Accounting Oversight Board (PCAOB) which has jurisdiction over virtually every area of CPA practice in relation to public companies. However, the AICPA retains its considerable standards setting, ethics enforcement and firm practice quality monitoring roles for the majority of practicing CPAs, who serve privately held business and individuals. Credentialing The AICPA offers credentialing programs in certain subject areas for its members. The credentials are similar to state board certification for attorneys, which also recognize subject matter specific expertise. The AICPA credential for expertise in business valuation is the Accredited in Business Valuation (ABV) designation. For financial planning, it is the Personal Financial Specialist (PFS) designation and for forensic accounting, Certified in Financial Forensics (CFF). The AICPA also offers an information technology credential, Certified Information Technology Profession (CITP). Beginning January 31, 2012, the AICPA in a joint venture with the Chartered Institute of Management Accountants (CIMA) began issuing the Chartered Global Management Accountant (CGMA) credential.

Treasury Department Circular 230

Circular 230 prescribes the rules governing practice before the U.S. Internal Revenue Service (IRS). These rules also require attorneys, Certified Public Accountants (CPAs), Enrolled Agents, and others preparing tax returns and giving tax advice to do certain things, and prohibit certain things. Penalties may be applied for noncompliance. Applicability Anyone can prepare a tax return or give tax advice. U.S. rules currently do not impose educational, experience, or licensure requirements on tax advisers. However, IRS rules published as Circular 230 impose certain standards of professional conduct on all persons preparing returns or giving tax advice for compensation. The rules prohibit certain actions and require certain other actions for each such person with respect to return preparation and tax advice. Representing clients In general, only attorneys, CPAs, enrolled agents, or enrolled actuaries or enrolled retirement plan agents may represent clients in proceedings before the IRS. Representing clients includes all communication with the IRS in regarding client matters without the client present. Exceptions permit family members to represent each other, employees to represent their employer, officers to represent corporations, and certain other representation. Key prohibited actions Circular 230 contains rules of conduct in preparing tax returns. Persons preparing tax returns must not:

Take a position on a tax return unless there is a realistic possibility of the position being sustained on its merits. Frivolous tax return positions are prohibited. Unreasonably delay prompt disposition of any matter before the IRS. Charge a fee for preparing an original return contingent on the outcome of any position. (However, contingent fees are allowed for amended returns and positions under examination or judicial proceeding.) Charge the client an "unconscionable fee" for representation. Represent clients with conflicting interests. Represent clients with conflicting interests. Solicit business using false statements. Cash IRS checks to a client for whom the return was prepared.

Key required actions for preparers Persons preparing returns or giving tax advice must:

Disclose on returns all nonfrivolous tax positions whose disclosure is required to avoid penalties. Return records to clients. Sign all tax returns they prepare. Provide clients a copy of tax returns. Provide clients a copy of tax returns. Advise clients promptly of errors or omissions of the preparer or client in any tax matter with respect to which the preparer is retained. Submit records, etc., requested by the IRS in a timely manner. Exercise due diligence and use best practices of the profession.

Requirements for tax advice In addition to the above, those giving tax advice must follow certain procedural rules in giving the advice. Tax advice may consist of a "covered opinion," other written tax advice, or oral advice. No standards are provided for oral advice. Written tax advice must not be based on unreasonable factual or legal assumptions or unreasonably rely upon representations of the client or others. It must consider all relevant facts and law. Covered opinion A taxpayer may rely on a covered opinion by a licensed or enrolled tax adviser to avoid certain penalties. A covered opinion includes any written tax advice not otherwise disclaimed in the advice, with certain exceptions. The disclaimer must prominently state that the advice was not "intended or written by the practitioner to be used, and that it cannot be used by the taxpayer, for the purpose of avoiding penalties that may be imposed on the taxpayer." Specific standards apply to a covered opinion. These standards include:

The extent to which a practitioner must gather facts and to which facts and assumptions may be relied upon, and The depth of legal analysis required, a requirement to apply the law to the facts, a requirement to consider all applicable law, a requirement to conclude as to each significant Federal tax issue, and required disclosures.

Sanctions Tax preparers and advisers who violate Circular 230 may be subject to penalties. These include monetary penalties as well as potential suspension from practice before the IRS. The rules also provide procedures for disciplinary proceedings.

Ethics and Responsibilities in Tax Practice

As a CPA, you will have various ethical responsibilities as a tax practitioner. You must understand the ethical rules that apply to you as a tax practitioner practicing before the IRS and as an AICPA member. This section covers these ethical rules.

AICPA Statements on Standards for Tax Services

Members of the American Institute of Certified Public Accountants (AICPA) are held accountable to the Statements on Standards for Tax Services (SSTS), no matter where they practice, or which area of tax they practice. These standards were written to accompany and enhance the standards in the Internal Revenue Code and the Treasury Department Circular 230. Additionally, they are intended work alongside the rules of the different state boards of accountancy. The SSTSs began as Statements on Responsibilities in Tax Practice (SRTPs) and were originally meant to define the professional standards of conduct expected of accountants in a good tax practice. When the courts began relying on the SRTPs to define acceptable professional conduct, they became enforceable de facto. Eventually, the AICPA wrote the SSTSs to take the place of the SRTPs and the relating Interpretation No. 1-1. The first SSTSs were enforceable December 31, 2000. These original SSTSs have only once been updated. The updated SSTSs were enforceable January 1, 2010. These standards are codified in section TS. SSTS No. 1: Tax Return Positions SSTS No. 2: Answers to Questions on Returns SSTS No. 3: Certain Procedural Aspects of Preparing Returns SSTS No. 4: Use of Estimates SSTS No. 5: Departure from a Position Previously Concluded in an Administrative Proceeding or Court Decision SSTS No. 6: Knowledge of Error: Return Preparation and Administrative Proceedings SSTS No. 7: Form and Content of Advice to Taxpayers
[SSTS Interpretation No. 1-1, Realistic Possibility Standard (2000)] [SSTS Interpretation No. 1-2, Tax Planning (2003)]

SSTS No. 1: Tax Return Positions

A member can only recommend a position or prepare or sign a return if, under good faith, the position will be upheld by the taxing authority or in court. The following exceptions apply: 1. Recommended Position- must have a reasonable basis for the position and advise disclosure of the position with the tax return 2. Position on a return prepared or signed by the member- must have a reasonable basis for the position and disclose the position Potential penalties relating to a tax position should be related to the taxpayer, as well as disclosures that could provide an opportunity to avoid the penalties. A member can never recommend a position that exploits the taxing authority or is solely for negotiating. A member of the AICPA not only has the right to be an advocate for a taxpayer, but also has a responsibility to do so for any tax position that meets the requirements of this standard.

SSTS No. 2: Answers to Questions on Returns

This statement requires a member to have as many of the questions on a return answered before signing as possible. While the questions each have different importance, the member should attempt to have enough information to answer each question. Some questions are important in determining taxable income, and providing a complete return, and others might require disclosure. However, there are some reasonable grounds for not answering questions. These include the unavailability of information and insignificance of answer to the return, uncertainty as to what the question is asking regarding a particular return, or the answer is too much to include with the return, but could be provided if the return is further investigated, among others. It is never acceptable to omit a question if that provides an undue advantage to the taxpayer.

SSTS No. 3: Certain Procedural Aspects of Preparing Returns

This statement refers to the information given by the client and supporting their tax return.

A member can rely on information provided by a client or third party when preparing or signing tax returns. However, if the information provided seems to be incorrect, incomplete or doesnt fit with other known facts about the client, the member should strive to reasonably clarify the information. Additionally, if the return from prior year(s) is available, the member should refer to them if feasible. If the client is required by law to keep books updated, document the support for a deduction or certain tax treatment, or any other condition, the member should make sure that the client is satisfying those conditions. If there is relevant information relating to a clients return that is known through another taxpayer, this information should be considered by the member when preparing the return. However, the member should be aware of any confidentiality laws or limitations on using the information.

SSTS No. 4: Use of Estimates

A member can use estimates provided by the taxpayer as long as that is the most reasonable way to obtain the needed information. Disclosure of all estimated items calculated by the taxpayer is not necessary, unless there is an unusual circumstance, like the death of the taxpayer, pending litigation, data files are destroyed, or K-1s haven't been received yet.

SSTS No. 5: Departure from a Position Previously Concluded in an Administrative Proceeding or Court Decision
If a taxpayer was a part of a prior administrative proceeding or court decision concerning a particular item's treatment, a member can advise a different position in a future year, as long as the prior treatment was not required in later years. However, the member should make sure that the requirements of SSTS No. 1 are met with the new position.

SSTS No. 6: Knowledge of Error: Return Preparation and Administrative Proceedings

There are a few different types of errors that a member is responsible to inform a client of. These are (1) errors on previous returns, (2) errors on returns that are currently in an administrative proceeding, and (3) the error of failing to file a return. When a member is informed of any of these errors, they are responsible to the client to inform them of the error. This can be done orally and does not have to be done in writing. The member can't inform a taxing authority unless they are required by law or have permission from the

taxpayer. A member should take into consideration errors that have not been corrected when deciding to continue preparing a future return for a client. If they choose to prepare the return, they should make reasonably sure that the error is not repeated in the future. If the error is one that is a part of an administrative proceeding, the member should get the client's permission to disclose the error to the taxing authority. If they do not get permission, the member should reconsider representing the client in the administrative proceeding. Any errors that a client is not willing to fix or disclose should raise the question of whether the member continues working professionally for the client.

Internal Revenue Code Introduction

The Internal Revenue Code (or IRC; more formally, the Internal Revenue Code of 1986) is the domestic portion of Federal statutory tax law in the United States, published in various volumes of the United States Statutes at Large, and separately as Title 26 of the United States Code (USC). It is organized topically, into subtitles and sections, covering income tax, payroll taxes, estate taxes, gift taxes and excise taxes; as well as procedure and administration. Its implementing agency is the Internal Revenue Service. Organization Since the IRC is a duplicate of the USC Title 26, the organization of the IRC is identical. As an example, section 162(e)(2)(B)(ii) (26 U.S.C. 162(e)(2)(B)(ii)) would be as follows: Title 26: Internal Revenue Code Subtitle A: Income Taxes Chapter 1: Normal Taxes and Surtaxes Subchapter B: Computation of Taxable Income Part VI: Itemized Deductions for Individuals and Corporations Section 162: Trade or business expenses Subsection (e): Denial of deduction for certain lobbying and political expenditures Paragraph (2) Exception for local legislation Sub-paragraph (B) Clause (ii) The Internal Revenue Code is topically organized and generally referred to by section number (sections 1 through 9834). Some topics are short (e.g., tax rates) and some quite long (e.g., pension & benefit plans). The following describes the key topics, by section number: Subtitles A. Income Taxes (sections 1 through 1564)

As a further example, here are the chapters of this subtitle: Chapter 1NORMAL TAXES AND SURTAXES (sections 1 through 1400U3) Chapter 2TAX ON SELF-EMPLOYMENT INCOME (sections 1401 through 1403) Chapter 3WITHHOLDING OF TAX ON NONRESIDENT ALIENS AND FOREIGN CORPORATIONS (sections 1441 through 1464) Chapter 4Repealed Chapter 5Repealed Chapter 6CONSOLIDATED RETURNS (sections 1501 through 1564) B. Estate and Gift Taxes (sections 2001 through 2801) C. Employment Taxes (sections 3101 through 3510) D. Miscellaneous Excise Taxes (sections 4001 through 5000) E. Alcohol, Tobacco, and Certain Other Excise Taxes (sections 5001 through 5891) F. Procedure and Administration (sections 6001 through 7874) G. The Joint Committee on Taxation (sections 8001 through 8023) H. Financing of Presidential Election Campaigns (sections 9001 through 9042) I. Trust Fund Code (sections 9500 through 9602) J. Coal Industry Health Benefits (sections 9701 through 9722) K. Group Health Plan Requirements (sections 9801 through 9834) Treasury Regulations are the tax regulations issued by the United States Internal Revenue Service (IRS), a bureau of the United States Department of the Treasury. These regulations are the Treasury Departments official interpretations of the Internal Revenue Code and are one source of U.S. Federal income tax law. Authority and citations Section 7805 of the Internal Revenue Code gives the United States Secretary of the Treasury the power to create the necessary rules and regulations for enforcing the Internal Revenue Code. These regulations, also known as the Income Tax Regulations, are located in Title 26 of the Code of Federal Regulations, or C.F.R. The regulations are organized according to the Internal Revenue Code section that a regulation interprets. Citations to the Treasury Regulations may appear in different formats. For instance, the definition of gross income in the regulations may be cited to as 26 C.F.R. 1.61-1 or as Treas. Reg. 1.61-1. Both citations refer to the same regulation, which interprets Internal Revenue Code Section 61, "Gross income defined." Final and Interpretive Regulations Under this authority, the Secretary of the Treasury can promulgate final regulations that become a kind of proliferation of the statute. In the process of enacting final regulations, the Treasury enacts proposed or temporary regulations. Proposed regulations do not become effective until after comments and testimony are received ("notice and comment"), and a final regulation is issued. Proposed Regulations may offer guidance for a specific section of the Code and help in determining a taxpayer's liability for the given year, although they have limited precedential value. Interpretive Regulations may be dismissed if they

are determined to be at variance with the statute, however it is not unknown for courts to accorded interpretive regulations with "force of law" status. Temporary regulations are effective upon publication in the Federal Register and may be valid for no more than three years from their date of issuance. Because the notice and comment process can take several months or even years, if the Treasury wants a regulation to become effective more quickly, it will often issue a proposed regulation simultaneously as a temporary regulation. Publication Proposed Treasury Regulations are drafted by the Internal Revenue Service and published in the Federal Register. Proposed Treasury Regulations are published so that taxpayers may submit written comments or speak at hearings before final regulations are published. After the notice and comment period, the Final Treasury Regulations are then published first in the Federal Register before final publication in the Code of Federal Regulations. Temporary regulations are effective immediately upon publication in the Federal Register. Temporary and final regulations are initially published as Treasury Decisions (TD). TD's include an explanatory preamble, which can be a helpful source for legal research.

Internal Revenue Code of 1986, as amended, and Regulations related to tax return preparers
Internal Revenue Code Introduction The Internal Revenue Code (or IRC; more formally, the Internal Revenue Code of 1986) is the domestic portion of Federal statutory tax law in the United States, published in various volumes of the United States Statutes at Large, and separately as Title 26 of the United States Code (USC). It is organized topically, into subtitles and sections, covering income tax, payroll taxes, estate taxes, gift taxes and excise taxes; as well as procedure and administration. Its implementing agency is the Internal Revenue Service. Organization Since the IRC is a duplicate of the USC Title 26, the organization of the IRC is identical. As an example, section 162(e)(2)(B)(ii) (26 U.S.C. 162(e)(2)(B)(ii)) would be as follows: Title 26: Internal Revenue Code Subtitle A: Income Taxes Chapter 1: Normal Taxes and Surtaxes Subchapter B: Computation of Taxable Income Part VI: Itemized Deductions for Individuals and Corporations Section 162: Trade or business expenses Subsection (e): Denial of deduction for certain lobbying and political expenditures Paragraph (2) Exception for local legislation Sub-paragraph (B)

Clause (ii) The Internal Revenue Code is topically organized and generally referred to by section number (sections 1 through 9834). Some topics are short (e.g., tax rates) and some quite long (e.g., pension & benefit plans). The following describes the key topics, by section number: Subtitles A. Income Taxes (sections 1 through 1564) As a further example, here are the chapters of this subtitle: Chapter 1NORMAL TAXES AND SURTAXES (sections 1 through 1400U3) Chapter 2TAX ON SELF-EMPLOYMENT INCOME (sections 1401 through 1403) Chapter 3WITHHOLDING OF TAX ON NONRESIDENT ALIENS AND FOREIGN CORPORATIONS (sections 1441 through 1464) Chapter 4Repealed Chapter 5Repealed Chapter 6CONSOLIDATED RETURNS (sections 1501 through 1564) B. Estate and Gift Taxes (sections 2001 through 2801) C. Employment Taxes (sections 3101 through 3510) D. Miscellaneous Excise Taxes (sections 4001 through 5000) E. Alcohol, Tobacco, and Certain Other Excise Taxes (sections 5001 through 5891) F. Procedure and Administration (sections 6001 through 7874) G. The Joint Committee on Taxation (sections 8001 through 8023) H. Financing of Presidential Election Campaigns (sections 9001 through 9042) I. Trust Fund Code (sections 9500 through 9602) J. Coal Industry Health Benefits (sections 9701 through 9722) K. Group Health Plan Requirements (sections 9801 through 9834) Treasury Regulations are the tax regulations issued by the United States Internal Revenue Service (IRS), a bureau of the United States Department of the Treasury. These regulations are the Treasury Departments official interpretations of the Internal Revenue Code and are one source of U.S. Federal income tax law. Authority and citations Section 7805 of the Internal Revenue Code gives the United States Secretary of the Treasury the power to create the necessary rules and regulations for enforcing the Internal Revenue Code. These regulations, also known as the Income Tax Regulations, are located in Title 26 of the Code of Federal Regulations, or C.F.R. The regulations are organized according to the Internal Revenue Code section that a regulation interprets. Citations to the Treasury Regulations may appear in different formats. For instance, the definition of gross income in the regulations may be cited to as 26 C.F.R. 1.61-1 or as Treas. Reg. 1.61-1. Both citations refer to the same regulation, which interprets Internal Revenue Code Section 61, "Gross income defined."

Final and Interpretive Regulations Under this authority, the Secretary of the Treasury can promulgate final regulations that become a kind of proliferation of the statute. In the process of enacting final regulations, the Treasury enacts proposed or temporary regulations. Proposed regulations do not become effective until after comments and testimony are received ("notice and comment"), and a final regulation is issued. Proposed Regulations may offer guidance for a specific section of the Code and help in determining a taxpayer's liability for the given year, although they have limited precedential value. Interpretive Regulations may be dismissed if they are determined to be at variance with the statute, however it is not unknown for courts to accorded interpretive regulations with "force of law" status. Temporary regulations are effective upon publication in the Federal Register and may be valid for no more than three years from their date of issuance. Because the notice and comment process can take several months or even years, if the Treasury wants a regulation to become effective more quickly, it will often issue a proposed regulation simultaneously as a temporary regulation. Publication Proposed Treasury Regulations are drafted by the Internal Revenue Service and published in the Federal Register. Proposed Treasury Regulations are published so that taxpayers may submit written comments or speak at hearings before final regulations are published. After the notice and comment period, the Final Treasury Regulations are then published first in the Federal Register before final publication in the Code of Federal Regulations. Temporary regulations are effective immediately upon publication in the Federal Register. Temporary and final regulations are initially published as Treasury Decisions (TD). TD's include an explanatory preamble, which can be a helpful source for legal research.

Legal Duties and Responsibilities

1. Common law duties and liability to clients and third parties Overview of Auditors Legal Liability Liability to Clients-Common Law An auditor is in a contractual relationship with a client. If the auditor does not perform his or her side of the bargain according to contract terms the client can sue for breach of contract. A client may seek these remedies for breach of contract: (1) specific performance; (2) general monetary damages for losses incurred as a result of the breach; and (3) consequential damages that occur indirectly as a result of the breach. An accountant may also be sued by a client under tort law. A tort is a wrong committed which injures another persons property, body, or reputation. A tort suit by a client is usually based on negligence or

fraud. The elements of a tort action for negligence are as follows: A client may also sue an accountant for fraud. This tort is harder to prove than negligence because fraud requires scienter or an intent to deceive. Fraud contains these elements: A material fact is one that a reasonable person would consider important in deciding whether to act. Also, an accountant may be held liable for gross negligence by a client. Gross negligence does not require scienter but necessitates proof of reckless disregard of the truth or ones duties. Gross negligence is referred to by some as constructive fraud. No legal question arises about a clients right to sue (i.e., standing to sue) because the client and accountant are in privity. Privity refers to the existence of a direct connection or contractual relationship between parties. A client may sue an accountant for breach of fiduciary duty. A fiduciary relationship is usually considered to exist between two persons when one of them is under a duty to act or give advice for the benefit of another upon matters within the scope of the relation. It is well settled that in most engagements except an audit, a CPA is a fiduciary. Any non-audit services are quite likely to result in a finding of a fiduciary relationship. The burden is on the fiduciary to prove there was no violation of a fiduciary obligation. 2. Federal statutory liability 3. Privileged communications, confidentiality, and privacy acts Accountantclient privilege Accountantclient privilege is a confidentiality privilege, or more precisely, a group of privileges, available in American federal and state law. Accountantclient privileges may be classified in two categories: evidentiary privileges and non-evidentiary privileges. An evidentiary privilege is one that may as a general rule be successfully asserted in a court of law. A non-evidentiary privilege is (A) one that may not be maintained in a court of law, or (B) one which is, according to the terms of the statute granting the privilege, not applicable in the face of an order from the court compelling disclosure of the communication for which the privilege is claimed. The evidentiary and non-evidentiary versions of the accountant-client privilege are, as a general rule, creations of Federal or state statute. Under English common law, on which American law is based, there was generally no accountantclient privilege. In the United Kingdom in particular the Proceeds of Crime Act 2002 actually requires accountants (and solicitors, insolvency practitioners, etc.) who suspect their clients of tax evasion to report them to the authorities without telling the clients they have done so, subject to a maximum punishment of 14 years in jail. This affects even accountants who uncover a possibly inadvertent claim for expenses. Non-evidentiary accountantclient privileges Some states have enacted a non-evidentiary accountantclient privilege. For example, Texas has a privilege rule that requires that a certified public accountant (CPA) not voluntarily disclose information communicated to the CPA by a client in connection with the engagement without the client's permission. The privilege generally does not apply, however, in the case of an administrative summons by the Internal Revenue Service under 26 U.S.C. 7602, in the case of a summons under the Securities Exchange Act of 1934, or in the case of a court order.

The federally authorized tax practitioner privilege The federally authorized tax practitioner privilege, is a limited evidentiary privilege available in American federal tax law. The privilege is defined in an amendment to the Internal Revenue Code made by the Internal Revenue Service Restructuring and Reform Act of 1998: With respect to tax advice, the same common law protections of confidentiality which apply to a communication between a taxpayer and an attorney shall also apply to a communication between a taxpayer and any federally authorized tax practitioner to the extent the communication would be considered a privileged communication if it were between a taxpayer and an attorney. Under the law, the term "federally authorized tax practitioner" (or FATP) means an individual authorized under Federal law to practice before the Internal Revenue Service where the practice is subject to Federal regulation under 31 U.S.C. 330. The term 'tax advice' means advice given by an individual with respect to a matter that is within the scope of the individual's authority to practice. There are, however, some significant limitations on the FATP privilege. Not applicable in criminal proceedings or state law matters Unlike the attorneyclient privilege, the FATP privilege does not apply in criminal matters, and does not apply in state tax proceedings. The privilege may be asserted only in a "noncriminal tax matter before the Internal Revenue Service" and a "noncriminal tax proceeding in Federal court brought by or against the United States." Effect of date of the communication on availability of the FATP privilege The FATP privilege applies only to communications made on or after July 22, 1998. The privilege does not apply to any written communication before October 22, 2004, between a federally authorized tax practitioner and a director, shareholder, officer, employee, agent, or representative of a corporation in connection with the promotion of the direct or indirect participation of such corporation in any tax shelter. Section 7525 was amended by the American Jobs Creation Act of 2004, so that the privilege does not apply to written communications made on or after October 22, 2004, involving a federally authorized tax practitioner with respect to the participation of any person (not just a corporation) in a tax shelter. This is a further limitation of the privilege. The practitioner The term FATP includes an attorney, a CPA, an enrolled agent, or an enrolled actuary. The FATP privilege does not apply to accountants who are not CPAs (unless the accountant qualifies as an enrolled agent, etc.). The FATP privilege might not apply to certified public accountants who are not licensed to practice in the state in which the client lives (for example, in a situation where the client lives in New Jersey but works in New York, where he consults a CPA who is licensed in New York but not in New Jersey). Because the CPA is not licensed to practice in the state where the client resides, the communication might not qualify for the privilege.

Tax advice versus business advice The FATP privilege applies only to tax advice. The advice must be treated as confidential by both the accountant and the client to be covered by the privilege. If the communication is divulged to third parties, then it is not confidential. The privilege does not cover general business consultations or personal financial planning advice. Tax return preparation With respect to communications involved in the preparation of tax returns, there is a split of authority. Much of the relevant case law was rendered prior to the creation of the FATP privilege in 1998, and relates to the attorneyclient privilege. Most of the case law indicates that a communication in connection with tax return preparation is not covered. Under the argument accepted by the U.S. Court of Appeals for the Ninth Circuit, communication pertinent merely to preparing a tax return does not involve giving or receiving legal advice (see e.g., United States v. Gurtner). The United States Court of Appeals for the Eighth Circuit, meanwhile, has held that tax returns are not privileged. This holding is based on the rationale that tax returns are intended for disclosure to a third party, i.e., the Internal Revenue Service, so there can be no expectation of confidentiality, which defeats a claim that the return or pertinent communication is privileged. One minority view finds the privilege might apply to a communication about what to claim on a return. Another minority view is that such communications could be considered "legal" advice. On balance, however, the weight of authority is that communication in connection with tax return preparation is probably not protected by the privilege.

Requirements of regulatory agencies

American Institute of Certified Public Accountants Founded in 1887, the American Institute of Certified Public Accountants (AICPA) is the national professional organization of Certified Public Accountants (CPAs) in the United States, with nearly 377,000 CPA members in 128 countries in business and industry, public practice, government, education, student affiliates and international associates. It sets ethical standards for the profession and U.S. auditing standards for audits of private companies, non-profit organizations, federal, state and local governments. It also develops and grades the Uniform CPA Examination. The AICPAs founding established accountancy as a profession distinguished by rigorous educational requirements, high professional standards, a strict code of professional ethics, and a commitment to serving the public interest. Mission The AICPA's mission is to provide members with the resources, information and leadership that enable them to provide valuable services in the highest professional manner to benefit the public, employers and

clients. In fulfilling its mission, the AICPA works with state CPA organizations and gives priority to those areas where public reliance on CPA skills is most significant. Professional standards setting The AICPA sets generally accepted professional and technical standards for CPAs in multiple areas. Until the 1970s, the AICPA held a virtual monopoly in this field. In the 1970s, however, it transferred its responsibility for setting generally accepted accounting principles (GAAP) to the newly formed Financial Accounting Standards Board (FASB). Following this, it retained its standards setting function in areas such as financial statement auditing, professional ethics, attest services, CPA firm quality control, CPA tax practice, business valuation, and financial planning practice. Before passage of the SarbanesOxley law, AICPA standards in these areas were considered "generally accepted" for all CPA practitioners. In the early 2000s, federal public policy makers concluded that where independent financial statement audits of public companies regulated by the U.S. Securities and Exchange Commission are concerned, that the AICPA's standards setting and related enforcement roles should be transferred to a government empowered body with more enforcement authority than a non-governmental professional association, such as the AICPA could provide. As a result, the Sarbanes-Oxley law created the Public Company Accounting Oversight Board (PCAOB) which has jurisdiction over virtually every area of CPA practice in relation to public companies. However, the AICPA retains its considerable standards setting, ethics enforcement and firm practice quality monitoring roles for the majority of practicing CPAs, who serve privately held business and individuals. Credentialing The AICPA offers credentialing programs in certain subject areas for its members. The credentials are similar to state board certification for attorneys, which also recognize subject matter specific expertise. The AICPA credential for expertise in business valuation is the Accredited in Business Valuation (ABV) designation. For financial planning, it is the Personal Financial Specialist (PFS) designation and for forensic accounting, Certified in Financial Forensics (CFF). The AICPA also offers an information technology credential, Certified Information Technology Profession (CITP). Beginning January 31, 2012, the AICPA in a joint venture with the Chartered Institute of Management Accountants (CIMA) began issuing the Chartered Global Management Accountant (CGMA) credential. AICPA Code of Conduct Internal Revenue Service (IRS) The Internal Revenue Code (IRC) imposes criminal penalties for fraudulence concerning a material item on a tax return. If someone is found guilting of said faudulence, they are guilty of a felony and can be imprisoned for up to three years and/or fined for up to $100,000, $500,000 if it is a corporation. Additionally, the IRS can impose civil penalties, such as prohibiting an accountant to practice before the IRS and imposing fines.

Securities and Exchange Commission (SEC) An accountant can lose the right to practice before the SEC through censure, suspension, or permanent revocation. Additionally, the SEC may impose fines and issue cease and desist orders. The reasons for doing so are if the accountant lacks qualifications or character, acts unethically or unprofessionally, willfully violates security laws or regulations, is a convicted felon, or the accountant's license is suspended or revoked. The SEC also imposes the Sarbanes-Oxley Act of 2002 on registered companies. Sarbanes-Oxley Act of 2002 The SarbanesOxley Act of 2002, also known as the 'Public Company Accounting Reform and Investor Protection Act' (in the Senate) and 'Corporate and Auditing Accountability and Responsibility Act' (in the House) and more commonly called SarbanesOxley, Sarbox or SOX, is a United States federal law that set new or enhanced standards for all U.S. public company boards, management and public accounting firms. In summary, the act imposed the following:

Public Company Accounting Oversight Board (PCAOB) Title I consists of nine sections and establishes the Public Company Accounting Oversight Board, to provide independent oversight of public accounting firms providing audit services ("auditors"). It also creates a central oversight board tasked with registering auditors, defining the specific processes and procedures for compliance audits, inspecting and policing conduct and quality control, and enforcing compliance with the specific mandates of SOX.

Auditor Independence Title II consists of nine sections and establishes standards for external auditor independence, to limit conflicts of interest. It also addresses new auditor approval requirements, audit partner rotation, and auditor reporting requirements. It restricts auditing companies from providing nonaudit services (e.g., consulting) for the same clients.

Corporate Responsibility Title III consists of eight sections and mandates that senior executives take individual responsibility for the accuracy and completeness of corporate financial reports. It defines the interaction of external auditors and corporate audit committees, and specifies the responsibility of corporate officers for the accuracy and validity of corporate financial reports. It enumerates specific limits on the behaviors of corporate officers and describes specific forfeitures of benefits and civil penalties for non-compliance. For example, Section 302 requires that the company's "principal officers" (typically the Chief Executive Officer and Chief Financial Officer) certify and approve the integrity of their company financial reports quarterly.

Enhanced Financial Disclosures Title IV consists of nine sections. It describes enhanced reporting requirements for financial transactions, including off-balance-sheettransactions, pro-forma figures and stock transactions of corporate officers. It requires internal controls for assuring the accuracy of financial reports and disclosures, and mandates both audits and reports on those controls. It also requires timely reporting of material changes in financial condition and specific enhanced reviews by the SEC or its agents of corporate reports.

Analyst Conflicts of Interest Title V consists of only one section, which includes measures designed to help restore investor confidence in the reporting of securities analysts. It defines the codes of conduct for securities analysts and requires disclosure of knowable conflicts of interest.

Commission Resources and Authority Title VI consists of four sections and defines practices to restore investor confidence in securities analysts. It also defines the SEC's authority to censure or bar securities professionals from practice and defines conditions under which a person can be barred from practicing as a broker, advisor, or dealer.

Studies and Reports Title VII consists of five sections and requires the Comptroller General and the SEC to perform various studies and report their findings. Studies and reports include the effects of consolidation of public accounting firms, the role of credit rating agencies in the operation of securities markets, securities violations and enforcement actions, and whether investment banks assisted Enron, Global Crossing and others to manipulate earnings and obfuscate true financial conditions.

Corporate and Criminal Fraud Accountability Title VIII consists of seven sections and is also referred to as the "Corporate and Criminal Fraud Accountability Act of 2002". It describes specific criminal penalties for manipulation, destruction or alteration of financial records or other interference with investigations, while providing certain protections for whistle-blowers.

White Collar Crime Penalty Enhancement Title IX consists of six sections. This section is also called the "White Collar Crime Penalty Enhancement Act of 2002." This section increases the criminal penalties associated with white-

collar crimes and conspiracies. It recommends stronger sentencing guidelines and specifically adds failure to certify corporate financial reports as a criminal offense.

Corporate Tax Returns Title X consists of one section. Section 1001 states that the Chief Executive Officer should sign the company tax return.

Corporate Fraud Accountability Title XI consists of seven sections. Section 1101 recommends a name for this title as "Corporate Fraud Accountability Act of 2002". It identifies corporate fraud and records tampering as criminal offenses and joins those offenses to specific penalties. It also revises sentencing guidelines and strengthens their penalties. This enables the SEC to resort to temporarily freezing transactions or payments that have been deemed "large" or "unusual".

REG 1 (Ethics, Professional, and Legal Responsibilities) Questions

1) According to the AICPA Code of Professional Conduct, in which of the following circumstances may a CPA serve on a company's board of directors? A. The CPA audits a bank to which the company has applied for financing, and board approval is required for said financing to occur. B. The CPA does not audit the company and has no other business connection with the company. C.The CPA is asked by the company to test the internal controls of the company and offers compensation to the CPA for said services. D. The CPA performs attestation services for a nonpublic company.

2) How many audits of public companies per year does a CPA firm that is registered with the Public Company Accounting Oversight Board (PCAOB) have to perform before it receives an annual inspection from the PCAOB? A. One audit.

B. More than 10 audits. C. More than 50 audits. D. More than 100 audits.

3) What defense must an accountant establish to be absolved from civil liability under Section 18 of the Securities Exchange Act of 1934 for false or misleading statements made in reports or documents filed under the Act? A. Lack of gross negligence. B. Exercise of due care. C. Good faith and lack of knowledge of the statements falsity. D. Lack of privity with an injured party.

4) In which of the following situations is there a violation of client confidentiality under the AICPA Code of Professional Conduct? A. A member discloses confidential client information to a court in connection with arbitration proceedings relating to the client. B. A member discloses confidential client information to a professional liability insurance carrier after learning of a potential claim against the member. C. A member whose practice is primarily bankruptcy discloses a client's name. D. A member uses a records retention agency to store clients' records that contain confidential client information.

5) Smith, CPA, is a partner of Johnson Accounting Firm. Johnson audited the books of Hometown Bank. Smiths independence would be impaired under which of the following circumstances? A. Smith is a director of Hometown Bank.

B. Smith has a collateralized automobile loan with Hometown Bank. C. Smith had an account with Hometown Bank two years ago. D. Smith and a Hometown Bank board member belong to the same church.

6) Which of the following is a correct statement about the circumstances under which a CPA firm may or may not disclose the names of its clients without the clients' express permission? A. A CPA firm may disclose this information if the practice is limited to bankruptcy matters, so that prospective clients with similar concerns will be able to contact current clients. B. A CPA firm may disclose this information if the practice is limited to performing asset valuations in anticipation of mergers and acquisitions. C. A CPA firm may not disclose this information because the identity of its clients is confidential information. D. A CPA firm may disclose this information unless disclosure would suggest that the client may be experiencing financial difficulties. 7) Lawson, a CPA, discovers material noncompliance with a specific Internal Revenue Code (IRC) requirement in the prior-year return of a new client. Which of the following actions should Lawson take? A. Wait for the statute of limitations to expire. B. Discuss the requirements of the IRC with the client and recommend that client amend the return. C. Contact the IRS and discuss courses of action. D. Contact the prior CPA and discuss the client's exposure.

8) Able, CPA, was engaged by Wedge Corp. to audit Wedge's financial statements. Wedge intended to use the audit report to obtain a $10 million loan from Care Bank. Able and Wedge's president agreed that Able would give an unqualified opinion on Wedge's financial statements in the audit report even though there were material misstatements in the financial statements. Care refused to make the loan. Wedge then gave the audit report to Ranch to encourage Ranch to purchase $10 million worth of Wedge common stock. Ranch reviewed the audit report and relied on it to purchase the stock. After the purchase, Able's

agreement with Wedge's president was revealed. As a result, Wedge stock lost half its value and Ranch sued Able for fraud. What will be the result of Ranch's suit? A. Ranch will win because Able intentionally gave an unqualified opinion on Wedge's materially misstated financial statements. B. Ranch will win because Able is strictly liable for errors made in auditing Wedge's financial statements. C. Ranch will lose because Ranch is not a foreseen user of Able's audit report. D. Ranch will lose because Ranch is not in privity with Able.

9) Under the position taken by a majority of the courts, to which third parties will an accountant who negligently prepares a clients financial report be liable? A. Only those third parties in privity of contract with the accountant. B. All third parties who relied on the report and sustained injury. C. Any foreseen or known third party who relied on the report. D. Any third party whose reliance on the report was reasonably foreseeable.

10) A company engaged a CPA to perform the annual audit of its financial statements. The audit failed to reveal an embezzlement scheme by one of the employees. Which of the following statements best describes the CPA's potential liability for this failure? A. The CPA's adherence to generally accepted auditing standards (GAAS) may prevent liability. B. The CPA will not be liable if care and skill of an ordinary reasonable person was exercised. C. The CPA may be liable for punitive damages if due care was not exercised. D. The CPA is liable for any embezzlement losses that occurred before the scheme should have been detected.

11) In which of the following types of action, brought against a CPA who issues an audit report containing an unqualified opinion on materially misstated financial statements, may a plaintiff prevail without proving reliance on the audit report? A. An action for common law fraud. B. An action for common law breach of contract. C. An action brought under Section 11 of the Securities Act of 1933. D. An action brought under Rule 10b-5 of the Securities Exchange Act of 1934.

12) Pursuant to Treasury Circular 230, which of the following statements about the return of a client's records is correct? A. The client's records are to be destroyed upon submission of a tax return. B. The practitioner may retain copies of the client's records. C. The existence of a dispute over fees generally relieves the practitioner of responsibility to return the client's records. D. The practitioner does not need to return any client records that are necessary for the client to comply with the client's federal tax obligations.

13) According to the AICPA Statements on Standards for Tax Services, which of the following factors should a CPA consider in choosing whether to provide oral or written advice to a client? A. Whether the client will seek a second opinion. B. The tax sophistication of the client. C. The likelihood that current tax litigation will impact the advice. D. The client's business acumen.

14) Louis, the volunteer treasurer of a nonprofit organization and a member of its board of directors, compiles the data and fills out its annual Form 990, Return of Organization Exempt From Income Tax. Under the Internal Revenue Code, Louis is not considered a tax return preparer because A. He is a member of the board of directors. B. The return does not contain a claim for a tax refund. C. Returns for nonprofit organizations are exempt from the preparer rules. D. He is not compensated.

15) Which of the following areas of professional responsibility should be observed by a CPA not in public practice? Objectivity A. B. C. D. Yes Yes No No Independence Yes No Yes No

16) Under the ethical standards of the profession, which of the following investments by a CPA in a corporate client is an indirect financial interest? A. An investment held in a retirement plan. B. An investment held in a blind trust. C. An investment held through a regulated mutual fund. D. An investment held through participation in an investment club.

17) Rules issued under the Sarbanes-Oxley Act of 2002 restrict former members of an audit engagement team from accepting employment as a chief executive, chief financial or chief accounting officer, or controller of an audit client that files reports with the Securities and Exchange Commission. How many annual audit period(s) must be completed before such employment can be accepted? A. One. B. Two. C. Three. D. Four.

18) Under the Code of Professional Conduct of the AICPA, which of the following is required to be independent in fact and appearance when discharging professional responsibilities? A. A CPA in public practice providing tax and management advisory services. B. All CPAs. C. A CPA not in public practice. D. A CPA in public practice providing auditing and other attestation services. 19) Which of the following professional bodies has the authority to revoke a CPA's license to practice public accounting? A. National Association of State Boards of Accountancy. B. State board of accountancy. C. State CPA Society Ethics Committee. D. Professional Ethics Division of AICPA.

20) Which of the following acts by a CPA is a violation of professional standards regarding the confidentiality of client information?

A. Releasing financial information to a local bank with the approval of the client's mail clerk. B. Allowing a review of professional practice without client authorization. C. Responding to an enforceable subpoena. D. Faxing a tax return to a loan officer at the request of the client. 21) Which of the following statements best describes the ethical standard of the profession pertaining to advertising and solicitation? A. All forms of advertising and solicitation are prohibited B. There are no prohibitions regarding the manner in which CPAs may solicit new business. C. A CPA may advertise in any manner that is not false, misleading, or deceptive. D. A CPA may only solicit new clients through mass mailings.

22) Under the ethical standards of the profession, which of the following situations involving nondependent members of an auditors family is most likely to impair the auditors independence? A. A parents immaterial investment in a client. B. A first cousins loan from a client. C. A spouses employment with a client. D. A siblings loan to a director of a client.

23) Under the ethical standards of the profession, which of the following investments in a client is not considered to be a direct financial interest? A. An investment held through a nonclient regulated mutual fund. B. An investment held through a nonclient investment club. C. An investment held in a blind trust.

D. An investment held by the trustee of a trust.

24) Burrow & Co., CPAs, have provided annual audit and tax compliance services to Mare Corp. for several years. Mare has been unable to pay Burrow in full for services Burrow rendered 19 months ago. Burrow is ready to begin fieldwork for the current years audit. Under the ethical standards of the profession, which of the following arrangements will permit Burrow to begin the fieldwork on Mares audit? A. Mare sets up a two-year payment plan with Burrow to settle the unpaid fee balance. B. Mare commits to pay the past due fee in full before the audit report is issued. C. Mare gives Burrow an 18-month note payable for the full amount of the past due fees before Burrow begins the audit. D. Mare engages another firm to perform the fieldwork, and Burrow is limited to reviewing the workpapers and issuing the audit report.

25) Tork purchased restricted securities that were issued pursuant to Regulation D of the Securities Act of 1933. Which of the following statements is correct regarding Torks ability to resell the securities? A. Tork may resell the securities so long as the sale does involve interstate commerce. B. Tork may resell the securities as part of another transaction exempt from registration. C. Tork may not resell the securities if the certificates contain a legend indicating that they are unregistered securities. D. Tork may not resell the securities unless Tork obtains a written SEC exemption.

26) The prospectus for the sale of securities of a not-for-profit corporation contained material misrepresentations due to the negligence of the person who prepared the financial statements. As a result of the misrepresentations, purchasers of the shares lost their investment. Do the anti-fraud provisions of the Securities Act of 1933 apply in this situation? A. Yes, because the securities are required to be registered.

B. Yes, because the misrepresentations were material. C. No, because the securities are exempt from registration. D. No, because only the issuer was negligent.

27) An original issue of transaction exempt securities was sold to the public based on a prospectus containing intentional omissions of material facts. Under which of the following federal securities laws would the issuer be liable to a purchaser of the securitieS. I. II. The anti-fraud provisions of the Securities Act of 1933. The anti-fraud provisions of the Securities Exchange Act of 1934.

A. Neither I nor II. B. II only. C. Both I and II. D. I only.

28) Under the liability provisions of Section 18 of the Securities Exchange Act of 1934, for which of the following actions would an accountant generally be liable? A. Negligently approving a reporting corporation's incorrect internal financial forecasts. B. Negligently filing a reporting corporation's tax return with the IRS. C. Intentionally preparing and filing with the SEC a reporting corporation's incorrect quarterly report. D. Intentionally failing to notify a reporting corporation's audit committee of defects in the verification of accounts receivable.

29) According to the ethical standards of the profession, which of the following acts generally is prohibited?

A. Accepting a contingent fee for representing a client in connection with obtaining a private letter ruling from the Internal Revenue Service. B. Retaining client records after the client has demanded their return. C. Revealing client tax returns to a prospective purchaser of the CPA's practice. D. Issuing a modified report explaining the CPA's failure to follow a governmental regulatory agency's standards when conducting an attest service for a client.

30) In preparing a clients current-year individual income tax return, a tax practitioner discovers an error in the prior years return. Under the rules of practice prescribed in Treasury Circular 230, the tax practitioner A. Is barred from preparing the current years return until the prior-year error is rectified. B. Must file an amended return to correct the error. C. Is required to notify the IRS of the error. D. Must advise the client of the error.

31) An auditor's independence is considered impaired if the auditor has A. An immaterial, indirect financial interest in a client. B. An automobile loan from a client bank, collateralized by the automobile. C. A joint, closely-held business investment with the client that is material to the auditor's net worth. D. A mortgage loan, executed with a financial institution client on March 1,1990, that is material to the auditor's net worth.

32) Which of the following is(are) a correct definition of professional standards? I. Procedures used by an auditor to gather evidence on which to base an opinion.

II.

Measures of the quality of the auditor's performance.

A. I only. B. II only. C. Both I and II. D. Neither I nor II.

33) Under the Securities Act of 1933, which of the following acts by an accountant may subject the accountant to criminal penalties? A. Willfully including materially misstated financial statements in a registration statement. B. Giving an unqualified opinion on negligently prepared financial statements in an audit report included in a registration statement. C. Negligently making a false entry in financial statements included in a registration statement. D. Failing to use due diligence in the preparation of financial statements included in a registration statement.

34) Which of the following fee arrangements generally would not be permitted under the ethical standards of the profession? A. A referral fee paid by a CPA to obtain a client. B. A commission for compiling a client's internal-use financial statements. C. A contingent fee for preparing a client's income tax return. D. A contingent fee for representing a client in tax court.

35) A client suing a CPA for negligence must prove each of the following factors except A. Reliance.

B. Proximate cause. C. Breach of duty of care. D. Injury.

36) Under the ethical standards of the profession, which of the following positions would be considered a position of significant influence in an audit client? A. A marketing position related to the client's primary products. B. A policy-making position in the client's finance division. C. A staff position in the client's research and development division. D. A senior position in the client's human resources division.

37) A member would be in violation of the Standards for Tax Services if the member recommends a return position under which of the following circumstances? A. It does not meet the realistic possibility standard but is not frivolous and is disclosed on the return. B. It might result in penalties and the member advises the taxpayer and discusses avoiding such penalties through disclosing the position. C. It does not meet the realistic possibility standard but the member feels the return has a minimal likelihood for examination by the IRS. D. It meets the realistic possibility standard based on the well-reasoned opinion of the taxpayer's attorney.

38) A CPA who is not in public practice is obligated to follow which of the following rules of conduct? A. Independence. B. Integrity and objectivity. C. Contingent fees.

D. Commissions.

39) A client suing a CPA for negligence must prove each of the following factors except A. Breach of duty of care. B. Proximate cause. C. Injury. D. Reliance.

40) Under the ethical standards of the profession, which of the following positions would be considered a position of significant influence in an audit client? A. A marketing position related to the client's primary products. B. A policy-making position in the client's finance division. C. A staff position in the client's research and development division. D. A senior position in the client's human resources division.

41) A member would be in violation of the Standards for Tax Services if the member recommends a return position under which of the following circumstances? A. It does not meet the realistic possibility standard but the member feels the return has a minimal likelihood for examination by the IRS. B. It might result in penalties and the member advises the taxpayer and discusses avoiding such penalties through disclosing the position. C.IIt does not meet the realistic possibility standard but is not frivolous and is disclosed on the return. D. It meets the realistic possibility standard based on the well-reasoned opinion of the taxpayer's attorney.

42) A CPA who is not in public practice is obligated to follow which of the following rules of conduct? A. Independence. B. Integrity and objectivity. C. Contingent fees. D. Commissions.

43) Under the ethical standards of the profession, which of the following business relationships would generally not impair an auditor's independence? A. Promoter of a client's securities. B. Member of a client's board of directors. C. Client's general counsel. D. Advisor to a client's board of trustees.

44) Under the Securities Exchange Act of 1934, which of the following penalties could be assessed against a CPA who intentionally violated the provisions of Section 10(b), Rule 10b-5 of the Act? Civil liability of monetary damages A. B. C. D. Yes Yes No No Criminal liability of a fine Yes No Yes No

45) An accounting firm was hired by a company to perform an audit. The company needed the audit report in order to obtain a loan from a bank. The bank lent $500,000 to the company based on the auditor's report. Fifteen months later, the company declared bankruptcy and was unable to repay the loan. The bank discovered that the accounting firm failed to discover a material overstatement of assets of the company. Which of the following statements is correct regarding a suit by the bank against the accounting firm? The bank A. Cannot sue the accounting firm because of the statute of limitations. B. Can sue the accounting firm for the loss of the loan because of negligence. C. Cannot sue the accounting firm because there was no privity of contact. D. Can sue the accounting firm for the loss of the loan because of the rule of privilege.

46) At a confidential meeting, an audit client informed a CPA about the client's illegal insider-trading actions. A year later, the CPA was subpoenaed to appear in federal court to testify in a criminal trial against the client. The CPA was asked to testify to the meeting between the CPA and the client. After receiving immunity, the CPA should do which of the following? A. Take the Fifth Amendment and not discuss the meeting. B. Site the privileged communications aspect of being a CPA. C. Discuss the entire conversation including the illegal acts. D. Discuss only the items that have a direct connection to those items the CPA worked on for the client in the past.

47) Page, CPA, has T Corp. and W Corp. as audit clients. T Corp. is a significant supplier of raw materials to W Corp. Page also prepares individual tax returns for Time, the owner of T Corp. and West, the owner of W Corp. When preparing West's return, Page finds information that raises going-concern issues with respect to W Corp. May Page disclose this information to Time? A. No, because the information is confidential and may not be disclosed without West's consent. B. Yes, because there is no accountant-client privilege between Page and West. C. Yes, because Page has a fiduciary relationship with Time.

D. No, because the information should only be disclosed in Page's audit report on W Corp.'s financial statements.

48) The quarterly data required by SEC Regulation S-K have been omitted. Which of the following statements must be included in the auditors report? A. The auditor was unable to review the data. B. The companys internal control provides an adequate basis to complete the review. C. The auditor will review the selected data during the review of the subsequent quarterly financial data. D. The company has not presented the selected quarterly financial data.

49) The quarterly data required by SEC Regulation S-K have been omitted. Which of the following statements must be included in the auditors report? A. The auditor was unable to review the data. B. The companys internal control provides an adequate basis to complete the review. C. The company has not presented the selected quarterly financial data. D. The auditor will review the selected data during the review of the subsequent quarterly financial data.

50) Which of the following circumstances is a defense to an accountants liability under Section 11 of the Securities Act of 1933 for misstatements and omissions of material facts contained in a registration statement? A. The absence of scienter on the part of the accountant. B. The absence of privity between purchasers and the accountant. C. Due diligence on the part of the accountant. D. Nonreliance by purchasers on the misstatements.

51) Under which of the following circumstances may a CPA charge fees that are contingent upon finding a specific result? A. For an examination of prospective financial statements. B. For a compilation if a third party will use the financial statement and disclosure is not made in the report. C. For an audit or a review if agreed upon by both the CPA and the client. D. If fixed by courts, other public authorities, or in tax matters if based on the results of judicial proceedings.

51) According to the ethical standards of the profession, a CPA's independence would most likely be impaired if the CPA A. Accepted any gift from a client. B. Became a member of a trade association that is a client. C. Contracted with a client to supervise the client's office personnel. D. Served, with a client bank, as a cofiduciary of an estate or trust.

53) Professional rules and ethics for CPA tax practitioners that are merely advisory, rather than having formal administrative authority, include which of the following sources? A. AICPA Code of Professional Conduct. B. AICPA Statements on Responsibilities in Tax Practice. C. Internal Revenue Code. D. Treasury Department Practice Rules (Circular 230).

54) A CPA firm must do which of the following before it can participate in the preparation of an audit report of a company registered with the Securities and Exchange Commission (SEC)? A. Register with the Public Company Accounting Oversight Board. B. Join the SEC Practice Section of the AICPA. C. Register with the Financial Accounting Standards Board (FASB). D. Register with the SEC pursuant to the Securities Exchange Act of 1934.

55) Which of the following penalties is usually imposed against an accountant who, in the course of performing professional services, breaches contract duties owed to a client? A. Specific performance. B. Punitive damages. C. Money damages. D. Rescission.

Answers: 1)B 2)D 3)C 4)C 5)A 6)D 7)B 8)A 9)C 10)A 11)C 12)B 13)B 14)D 15)B 16)C 17)A 18)D 19)B 20)A 21)C 22)C 23)A 24)B 25)B 26)B 27)A 28)C 29)B 30)D 31)C 32)B 33)A 34)C 35)A 36)B 37)C 38)B 39)D 40)B 41)A 42)B 43)D 44)A 45)B 46)C 47)A 48)D 49)A 50)B 51)D 52)C 53)B 54)A 55)C

Regulation 2: Business Law Business Law Introduction

Commercial law (also known as business law, which covers also corporate law) is the body of law that governs business and commercial transactions. It is often considered to be a branch of civil law and deals with issues of both private law and public law. Commercial law includes within its compass such titles as principal and agent; carriage by land and sea; merchant shipping; guarantee; marine, fire, life, and accident insurance; bills of exchange and partnership. It can also be understood to regulate corporate contracts, hiring practices, and the manufacture and sales of consumer goods. Many countries have adopted civil codes that contain comprehensive statements of their commercial law. In the United States, commercial law is the province of both the United States Congress, under its power to regulate interstate commerce, and the states, under their police power. Efforts have been made to create a unified body of commercial law in the United States; the most successful of these attempts has resulted in the general adoption of the Uniform Commercial Code, which has been adopted in all 50 states (with some modification by state legislatures), the District of Columbia, and the U.S. territories. Various regulatory schemes control how commerce is conducted, particularly vis-a-vis employees and customers. Privacy laws, safety laws (e.g., the Occupational Safety and Health Act in the United States), and food and drug laws are some examples.

Agency
Agency Introduction The law of agency is an area of commercial law dealing with a set of contractual, quasi-contractual and non-contractual relationships that involve a person, called the agent, that is authorized to act on behalf of another (called the principal) to create a legal relationship with a third party. Succinctly, it may be referred to as the relationship between a principal and an agent whereby the principal, expressly or implicitly, authorizes the agent to work under his control and on his behalf. The agent is, thus, required to negotiate on behalf of the principal or bring him and third parties into contractual relationship. This branch of law separates and regulates the relationships between:

Agents and principals; Agents and the third parties with whom they deal on their principals' behalf; and Principals and the third parties when the agents purport to deal on their behalf.

The common law principle in operation is usually represented in the Latin [3] phrase, qui facit per alium, facit per se, i.e. the one who acts through another, acts in his or her own interests and it is a parallel concept to vicarious liability and strict liability in which one person is held liable in criminal law or tort for the acts or omissions of another.

In India, section 182 of the Contract Act 1872 defines Agent as a person employed to do any act for another or to represent another in dealings with third persons. The concepts The reciprocal rights and liabilities between a principal and an agent reflect commercial and legal realities. A business owner often relies on an employee or another person to conduct a business. In the case of a corporation, since a corporation is a fictitious legal person, it can only act through human agents. The principal is bound by the contract entered into by the agent, so long as the agent performs within the scope of the agency. A third party may rely in good faith on the representation by a person who identifies himself as an agent for another. It is not always cost effective to check whether someone who is represented as having the authority to act for another actually has such authority. If it is subsequently found that the alleged agent was acting without necessary authority, the agent will generally be held liable. Brief statement of legal principles There are three broad classes of agent 1. Universal agents hold broad authority to act on behalf of the principal, e.g. they may hold a power of attorney (also known as a mandate in civil law jurisdictions) or have a professional relationship, say, as lawyer[4] and client. 2. General agents hold a more limited authority to conduct a series of transactions over a continuous period of time; and 3. Special agents are authorized to conduct either only a single transaction or a specified series of transactions over a limited period of time. Authority An agent who acts within the scope of authority conferred by his or her principal binds the principal in the obligations he or she creates against third parties. There are essentially three kinds of authority recognized in the law: actual authority (whether express or implied), apparent authority, and ratified authority. Actual authority Actual authority can be of two kinds. Either the principal may have expressly conferred authority on the agent, or authority may be implied. Authority arises by consensual agreement, and whether it exists is a question of fact. An agent, as a general rule, is only entitled to indemnity from the principal if he or she has acted within the scope of her actual authority, and may be in breach of contract, and liable to a third party for breach of the implied warranty of authority. In tort, a claimant may not recover from the principal unless the agent is acting within the scope of employment. Express actual authority Express actual authority means an agent has been expressly told he or she may act on behalf of a principal.

Ireland v Livingstone (1872) LR 5 HL 395

Implied actual authority Implied actual authority, also called "usual authority", is authority an agent has by virtue of being reasonably necessary to carry out his express authority. As such, it can be inferred by virtue of a position held by an agent. For example, partners have authority to bind the other partners in the firm, their liability being joint and several, and in a corporation, all executives and senior employees with decision-making authority by virtue of their position have authority to bind the corporation.

Hely-Hutchinson v Brayhead Ltd [1968] 1 QB 549

Apparent authority Apparent authority (also called "ostensible authority") exists where the principal's words or conduct would lead a reasonable person in the third party's position to believe that the agent was authorized to act, even if the principal and the purported agent had never discussed such a relationship. For example, where one person appoints a person to a position which carries with it agency-like powers, those who know of the appointment are entitled to assume that there is apparent authority to do the things ordinarily entrusted to one occupying such a position. If a principal creates the impression that an agent is authorized but there is no actual authority, third parties are protected so long as they have acted reasonably. This is sometimes termed "agency by estoppel" or the "doctrine of holding out", where the principal will be estopped from denying the grant of authority if third parties have changed their positions to their detriment in reliance on the representations made.

Rama Corporation Ltd v Proved Tin and General Investments Ltd [1952] 2 QB 147, Slade J, "Ostensible or apparent authority... is merely a form of estoppel, indeed, it has been termed agency by estoppel and you cannot call in aid an estoppel unless you have three ingredients: (i) a representation, (ii) reliance on the representation, and (iii) an alteration of your position resulting from such reliance." Freeman & Lockyer v Buckhurst Park Properties (Mangal) Ltd [1964] 2 QB 480 The Raffaella or Egyptian International Foreign Trade Co v Soplex Wholesale Supplies Ltd and PS Refson & Co Ltd [1985] 2 Lloyd's Rep 36.

Watteau v Fenwick In the case of Watteau v Fenwick, Lord Coleridge CJ on the Queen's Bench concurred with an opinion by Wills J that a third party could hold personally liable a principal who he did not know about when he sold cigars to an agent that was acting outside of its authority. Wills J held that "the principal is liable for all the acts of the agent which are within the authority usually confided to an agent of that character, notwithstanding limitations, as between the principal and the agent, put upon that authority." This decision is heavily criticised and doubted, though not entirely overruled in the UK. It is sometimes referred to as "usual authority" (though not in the sense used by Lord Denning MR in Hely-Hutchinson, where it is

synonymous with "implied actual authority"). It has been explained as a form of apparent authority, or "inherent agency power.

Authority by virtue of a position held to deter: fraud and other harms that may befall individuals dealing with agents, there is a concept of Inherent Agency power, which is power derived solely by virtue of the agency relation. For example, partners have apparent authority to bind the other partners in the firm, their liability being joint and several, and in a corporation, all executives and senior employees with decisionmaking authority by virtue of their declared position have apparent authority to bind the corporation.

Even if the agent does act without authority, the principal may ratify the transaction and accept liability on the transactions as negotiated. This may be express or implied from the principal's behavior, e.g. if the agent has purported to act in a number of situations and the principal has knowingly acquiesced, the failure to notify all concerned of the agent's lack of authority is an implied ratification to those transactions and an implied grant of authority for future transactions of a similar nature. Liability of agent to third party If the agent has actual or apparent authority, the agent will not be liable for acts performed within the scope of such authority, so long as the relationship of the agency and the identity of the principal have been disclosed. When the agency is undisclosed or partially disclosed, however, both the agent and the principal are liable. Where the principal is not bound because the agent has no actual or apparent authority, the purported agent is liable to the third party for breach of the implied warranty of authority. Liability of agent to principal If the agent has acted without actual authority, but the principal is nevertheless bound because the agent had apparent authority, the agent is liable to indemnify the principal for any resulting loss or damage. Liability of principal to agent If the agent has acted within the scope of the actual authority given, the principal must indemnify the agent for payments made during the course of the relationship whether the expenditure was expressly authorized or merely necessary in promoting the principal's business. Duties An agent owes the principal a number of duties. These include:

a duty to undertake the task or tasks specified by the terms of the agency (that is, the agent must not do things that he has not been authorized by the principal to do); a duty to discharge his duties with care and due diligence; and

a duty to avoid conflict of interest between the interests of the principal and his own (that is, the agent cannot engage in conduct where stands to gain a benefit for himself to the detriment of the principal).

An agent must not accept any new obligations that are inconsistent with the duties owed to the principal. An agent can represent the interests of more than one principal, conflicting or potentially conflicting, only after full disclosure and consent of the principal. An agent also must not engage in self-dealing, or otherwise unduly enrich himself from the agency. An agent must not usurp an opportunity from the principal by taking it for himself or passing it on to a third party. In return, the principal must make a full disclosure of all information relevant to the transactions that the agent is authorized to negotiate and pay the agent either a prearranged commission, or a reasonable fee established after the fact. Termination An agent's authority can be terminated at any time. If the trust between the agent and principal has broken down, it is not reasonable to allow the principal to remain at risk in any transactions that the agent might conclude during a period of notice. As per sections 201 to 210 of the Indian Contract Act 1872, an agency may come to an end in a variety of ways: 1. Withdrawal by the agent however, the principal cannot revoke an agency coupled with interest to the prejudice of such interest. An agency is coupled with interest when the agent himself has an interest in the subject-matter of the agency, e.g., where the goods are consigned by an upcountry constituent to a commission agent for sale, with poor to recoup himself from the sale proceeds, the advances made by him to the principal against the security of the goods; in such a case, the principal cannot revoke the agents authority till the goods are actually sold, nor is the agency terminated by death or insanity (illustrations to section 201); 2. By the agent renouncing the business of agency; 3. By the business of agency being completed; 4. By the principal being adjudicated insolvent (section 201). The principal also cannot revoke the agents authority after it has been partly exercised, so as to bind the principal (section 204), though he can always do so, before such authority has been so exercised (section 203). Further, as per section 205, if the agency is for a fixed period, the principal cannot terminate the agency before the time expired, except for sufficient cause. If he does, he is liable to compensate the agent for the loss caused to him thereby. The same rules apply where the agent, renounces an agency for a fixed period. Notice in this connection that want of skill, continuous disobedience of lawful orders, and rude or insulting behavior has been held to be sufficient cause for dismissal of an agent. Further, reasonable notice has to be given by one party to the other; otherwise, damage resulting from want of such notice, will have to be paid (section 206). As per section 207, the revocation or renunciation of an agency may be made

expressly or impliedly by conduct. The termination does not take effect as regards the agent, till it becomes known to him and as regards third party, till the termination is known to them (section 208). When an agents authority is terminated, it operates as a termination of subagent also (section 210). This has become a more difficult area as states are not consistent on the nature of a partnership. Some states opt for the partnership as no more than an aggregate of the natural persons who have joined the firm. Others treat the partnership as a business entity and, like a corporation, vest the partnership with a separate legal personality. Hence, for example, in English law, a partner is the agent of the other partners whereas, in Scots law where there is a separate personality, a partner is the agent of the partnership. This form of agency is inherent in the status of a partner and does not arise out of a contract of agency with a principal. The English Partnership Act 1890 provides that a partner who acts within the scope of his actual authority (express or implied) will bind the partnership when he does anything in the ordinary course of carrying on partnership business. Even if that implied authority has been revoked or limited, the partner will have apparent authority unless the third party knows that the authority has been compromised. Hence, if the partnership wishes to limit any partner's authority, it must give express notice of the limitation to the world. However, there would be little substantive difference if English law was amended: partners will bind the partnership rather than their fellow partners individually. For these purposes, the knowledge of the partner acting will be imputed to the other partners or the firm if a separate personality. The other partners or the firm are the principal and third parties are entitled to assume that the principal has been informed of all relevant information. This causes problems when one partner acts fraudulently or negligently and causes loss to clients of the firm. In most states, a distinction is drawn between knowledge of the firm's general business activities and the confidential affairs as they affect one client. Thus, there is no imputation if the partner is acting against the interests of the firm as a fraud. There is more likely to be liability in tort if the partnership benefited by receiving fee income for the work negligently performed, even if only as an aspect of the standard provisions of vicarious liability. Whether the injured party wishes to sue the partnership or the individual partners is usually a matter for the plaintiff since, in most jurisdictions, their liability is joint and several. Agency relationships Agency relationships are common in many professional areas.

employment. real estate transactions (real estate brokerage, mortgage brokerage). In real estate brokerage, the buyers or sellers are the principals themselves and the broker or his salesperson who represents each principal is his agent. financial advice (insurance agency, stock brokerage, accountancy) contract negotiation and promotion (business management) such as for publishing, fashion model, music, movies, theatre, show business, and sport.

An agent in commercial law (also referred to as a manager) is a person who is authorised to act on behalf of another (called the principal or client) to create a legal relationship with a third party. 1. Formation and termination

2. Authority of agents and principals 3. Duties and liabilities of agents and principals

Bankruptcy and insolvency

Bankruptcy Introduction Bankruptcy in the United States is governed under the United States Constitution (Article 1, Section 8, Clause 4) which authorizes Congress to enact "uniform Laws on the subject of Bankruptcies throughout the United States." Congress has exercised this authority several times since 1801, most recently by adopting the Bankruptcy Reform Act of 1978, as amended, codified in Title 11 of the United States Code and commonly referred to as the Bankruptcy Code ("Code"). The Code has been amended several times since, with the most significant recent changes enacted in 2005 through the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA). Some law relevant to bankruptcy is found in other parts of the United States Code. For example, bankruptcy crimes are found in Title 18 of the United States Code (Crimes). Tax implications of bankruptcy are found in Title 26 of the United States Code (Internal Revenue Code), and the creation and jurisdiction of bankruptcy courts are found in Title 28 of the United States Code (Judiciary and Judicial procedure). While bankruptcy cases are filed in United States Bankruptcy Court (units of the United States District Courts), and federal law governs procedure in bankruptcy cases, state laws are often applied when determining property rights. For example, law governing the validity of liens or rules protecting certain property from creditors (known as exemptions), may derive from state law or federal law. Because state law plays a major role in many bankruptcy cases, it is often unwise to generalize some bankruptcy issues across state lines. Chapters of the Bankruptcy Code Entities seeking relief under the Bankruptcy Code may file a petition for relief under a number of different chapters of the Code, depending on circumstances. Title 11 contains nine chapters, six of which provide for the filing of a petition. The other three chapters provide rules governing bankruptcy cases in general. A case is typically referred to by the chapter under which the petition is filed. These chapters are described below. Chapter 7: Liquidation Liquidation under a Chapter 7 filing is the most common form of bankruptcy. Liquidation involves the appointment of a trustee who collects the non-exempt property of the debtor, sells it and distributes the proceeds to the creditors. Because each state allows for debtors to keep essential property, most Chapter 7 cases are "no asset" cases, meaning that there are not sufficient non-exempt assets to fund a distribution to

creditors. U.S. Bankruptcy law changed dramatically in 2005 with the passage of BAPCPA, which made it more difficult for consumer debtors to file bankruptcy in general and Chapter 7 in particular. Advocates of BAPCPA claimed that its passage would reduce losses to creditors such as credit card companies, and that those creditors would then pass on the savings to other borrowers in the form of lower interest rates. Critics assert that these claims turned out to be false, observing that although credit card company losses decreased after passage of the Act, prices charged to customers increased, and credit card company profits soared. Chapter 9: Reorganization for municipalities A Chapter 9 bankruptcy is available only to municipalities. Chapter 9 is a form of reorganization, not liquidation. A famous example of a municipal bankruptcy was in Orange County, California. Chapters 11, 12, and 13: Reorganization Bankruptcy under Chapter 11, Chapter 12, or Chapter 13 is more complex reorganization and involves allowing the debtor to keep some or all of his or her property and to use future earnings to pay off creditors. Consumers usually file chapter 7 or chapter 13. Chapter 11 filings by individuals are allowed, but are rare. Chapter 12 is similar to Chapter 13 but is available only to "family farmers" and "family fisherman" in certain situations. Chapter 12 generally has more generous terms for debtors than a comparable Chapter 13 case would have available. As recently as mid-2004 Chapter 12 was scheduled to expire, but in late 2004 it was renewed and made permanent. Chapter 15: Cross-border insolvency The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 added Chapter 15 [11] (as a replacement for section 304) and deals with cross-border insolvency: foreign companies with U.S. debts. Features of U.S. bankruptcy law Voluntary versus involuntary bankruptcy As a threshold matter, bankruptcy cases are either voluntary or involuntary. In voluntary bankruptcy cases, which account for the overwhelming majority of cases, debtors petition the bankruptcy court. With involuntary bankruptcy, creditors, rather than the debtor, file the petition in bankruptcy. Involuntary petitions are rare, however, and are occasionally used in business settings to force a company into bankruptcy so that creditors can enforce their rights. The estate Commencement of a bankruptcy case creates an "estate." It is against this estate to which the debtor's creditors must look. The estate consists of all property interests of the debtor at the time of case commencement, subject to certain exclusions and exemptions. In the case of a married person in a community property state, the estate may include certain community property interests of the debtor's spouse even if the spouse has not filed bankruptcy. The estate may also include other items, including but not limited to property acquired by will or inheritance within 180 days after case commencement.

For federal income tax purposes, the bankruptcy estate of an individual in a Chapter 7 or 11 case is a separate taxable entity from the debtor. The bankruptcy estate of a corporation, partnership, or other collective entity, or the estate of an individual in Chapters 12 or 13, is not a separate taxable entity from the debtor. Bankruptcy court In Northern Pipeline Co. v. Marathon Pipe Line Co., the United States Supreme Court held that certain provisions of the law relating to Article I bankruptcy judges (who are not life-tenured "Article III" judges) are unconstitutional. Congress responded in 1984 with changes to remedy constitutional defects. Under the revised law, bankruptcy judges in each judicial district constitute a "unit" of the applicable United States District Court. The judge is appointed for a term of 14 years by the United States Court of Appeals for the circuit in which the applicable district is located. The United States District Courts have subject-matter jurisdiction over bankruptcy matters. However, each such district court may, by order, "refer" bankruptcy matters to the Bankruptcy Court, and most district courts have a standing "reference" order to that effect, so that all bankruptcy cases are handled by the Bankruptcy Court. In unusual circumstances, a district court may "withdraw the reference" (i.e. [12], taking a particular case or proceeding within the case away from the bankruptcy court) and decide the matter itself. Decisions of the bankruptcy court are generally appealable to the district court, and then to the Court of Appeals. However, in a few jurisdictions a separate court called a Bankruptcy Appellate Panel (composed of bankruptcy judges) hears certain appeals from bankruptcy courts. United States Trustee The United States Attorney General appoints a separate United States Trustee for each of twenty-one geographical regions for a five year term. Each Trustee is removable from office by and works under the general supervision of the Attorney General. The U.S. Trustees maintain regional offices that correspond with federal judicial districts and are administratively overseen by the Executive Office for United States Trustees in Washington, D.C. Each United States Trustee, an officer of the U.S. Department of Justice, is responsible for maintaining and supervising a panel of private trustees for chapter 7 bankruptcy cases. The Trustee has other duties including the administration of most bankruptcy cases and trustees. Under section 307 of title 11, a U.S. Trustee "may raise and may appear and be heard on any issue in any case or proceeding" in bankruptcy except for filing a plan of reorganization in a chapter 11 case. The Automatic stay Bankruptcy Code 362 imposes the automatic stay at the moment a bankruptcy petition is filed. The automatic stay generally prohibits the commencement, enforcement or appeal of actions and judgments, judicial or administrative, against a debtor for the collection of a claim that arose prior to the filing of the bankruptcy petition. The automatic stay also prohibits collection actions and proceedings directed toward property of the bankruptcy estate itself. In some courts violations of the stay are treated as void ab initio as a matter of law, although the court may annul the stay to give effect to otherwise void acts. Other courts treat violations as voidable (not necessarily void ab initio). Any violation of the stay may give rise to damages being assessed against the

violating party. Non-willful violations of the stay are often excused without penalty, but willful violators are liable for punitive damages and may also be found to be in contempt of court. A secured creditor may be allowed to take the applicable collateral if the creditor first obtains permission from the court. Permission is requested by a creditor by filing a motion for relief from the automatic stay. The court must either grant the motion or provide adequate protection to the secured creditor that the value of their collateral will not decrease during the stay. Without the bankruptcy protection of the automatic stay creditors might race to the courthouse to improve their positions against a debtor. If the debtor's business were facing a temporary crunch, but were nevertheless viable in the long term, it might not survive a "run" by creditors. A run could also result in waste and unfairness among similarly situated creditors. Bankruptcy Code 362(d) gives 4 ways that a creditor can get the automatic stay removed. Avoidance actions Debtors, or the trustees that represent them, gain the ability to reject, or avoid actions taken with respect to the debtor's property for a specified time prior to the filing of the bankruptcy. While the details of avoidance actions are nuanced, there are three general categories of avoidance actions:

Preferences - 11 U.S.C. 547 [13] Federal fraudulent transfer - 11 U.S.C. 548 [14] Non-bankruptcy law creditor - 11 U.S.C. 544 [15]

All avoidance actions attempt to limit the risk of the legal system accelerating the financial demise of a financially unstable debtor who has not yet declared bankruptcy. The bankruptcy system generally endeavors to reward creditors who continue to extend financing to debtors and discourage creditors from accelerating their debt collection efforts. Avoidance actions are some of the most obvious of the mechanisms to encourage this goal. Despite the apparent simplicity of these rules, a number of exceptions exist in the context of each category of avoidance action. Preferences Preference actions generally permit the trustee to avoid (that is, to void an otherwise legally binding transaction) certain transfers of the debtor's property that benefit creditors where the transfers occur on or within 90 days of the date of filing of the bankruptcy petition. For example, if a debtor has a debt to a friendly creditor and a debt to an unfriendly creditor, and pays the friendly creditor, and then declares bankruptcy one week later, the trustee may be able to recover the money paid to the friendly creditor under 11 U.S.C. 547. While this "reach back" period typically extends 90 days backwards from the date of the bankruptcy, the amount of time is longer in the case of "insiders" -- typically one year. Insiders include family and close business contacts of the debtor. Fraudulent transfer Bankruptcy fraudulent transfer law is similar in practice to non-bankruptcy fraudulent transfer law. Some terms, however, are more generous in bankruptcy than they are otherwise. For instance, the statute of

limitations within bankruptcy is two years as opposed to a shorter time frame in some non-bankruptcy contexts. Generally a fraudulent transfer action operates in much the same way as a preference avoidance. Fraudulent transfer actions, however, sometimes require a showing of intent to shelter the property from a creditor. Generally, conversion of nonexempt assets into exempt assets on the eve of bankruptcy would not be indicia of fraud per se. However, depending on the amount of the exemption and the circumstances surrounding the conversion, a court may find the conversion to be a fraudulent transfer. This is especially true when the conversion amounts to nothing more than a temporary arrangement. The cases that held a conversion of nonexempt into exempt assets to be a fraudulent transfer tend to focus on the existence of an independent reason for the conversion. For example, if a debtor purchased a residence protected by a homestead exemption with the intent to reside in such residence that would be an allowable conversion into nonexempt property. But where the debtor purchased the residence with all of their available funds, leaving no money to live off, that presumed that the conversion was temporary, indicating a fraudulent transfer. The courts look at the timing of the transfer as the most important factor. Non-Bankruptcy law creditor - "Strong Arm" The strong arm avoidance power stems from 11 U.S.C. 544 and permits the trustee to exercise the rights that a debtor in the same situation would have under the relevant state law. Specifically, 544(a) grants the trustee the rights of avoidance of (1) a judicial lien creditor, (2) an unsatisfied lien creditor, and (3) a bona fide purchaser of real property. In practice these avoidance powers often overlap with preference and fraudulent transfer avoidance powers. The creditors Secured creditors whose security interests survive the commencement of the case may look to the property that is the subject of their security interests, after obtaining permission from the court (in the form of relief from the automatic stay). Security interests, created by what are called secured transactions, are liens on the property of a debtor. Unsecured creditors are generally divided into two classes: unsecured priority creditors and general unsecured creditors. Unsecured priority creditors are further subdivided into classes as described in the law. In some cases the assets of the estate are insufficient to pay all priority unsecured creditors in full; in such cases the general unsecured creditors receive nothing. Because of the priority and rank ordering feature of bankruptcy law, debtors sometimes improperly collude with others (who may be related to the debtor) to prefer them, by for example granting them a security interest in otherwised unpledged assets. For this reason, the bankruptcy trustee is permitted to reverse certain transactions of the debtor within period of time prior to the date of bankruptcy filing. The time period varies depending on the relationship of the parties to the debtor and the nature of the transaction. Executory contracts The bankruptcy trustee may reject certain executory contracts and unexpired leases. For bankruptcy purposes, a contract is generally considered executory when both parties to the contract have not yet fully performed a material obligation of the contract.

If the Trustee (or debtor in possession, in many chapter 11 cases) rejects a contract, the debtor's bankruptcy estate is subject to ordinary breach of contract damages, but the damages amount is an obligation and is generally treated as an unsecured claim. Committees Under some chapters, notably chapters 7, 9 and 11, committees of various stakeholders are appointed by the bankruptcy court. In Chapter 11 and 9, these committees consist of entities that hold the seven largest claims of the kinds represented by the committee. Other committees may also be appointed by the court. Committees have daily communications with the debtor and the debtor's advisers and have access to a wide variety of documents as part of their functions and responsibilities. Exempt property Although in theory all property of the debtor that is not excluded from the estate under the Bankruptcy Code becomes property of the estate (i.e., is automatically transferred from the debtor to the estate) at the time of commencement of a case, an individual debtor (not a partnership, corporation, etc.) may claim certain items of property as "exempt" and thereby keep those items (subject, however, to any valid liens or other encumbrances). An individual debtor may choose between a "federal" list of exemptions and the list of exemptions provided by the law of the state in which the debtor files the bankruptcy case unless the state in which the debtor files the bankruptcy case has enacted legislation prohibiting the debtor from choosing the exemptions on the federal list. Almost 40 states have done so. In states where the debtor is allowed to choose between the federal and state exemptions, the debtor has the opportunity to choose the exemptions that most fully benefit him or her and, in many cases, may convert at least some of his or her property from non-exempt form (e.g. cash) to exempt form (e.g. increased equity in a home created by using the cash to pay down a mortgage) prior to filing the bankruptcy case. The exemption laws vary greatly from state to state. In some states, exempt property includes equity in a home or car, tools of the trade, and some personal effects. In other states an asset class such as tools of trade will not be exempt by virtue of its class except to the extent it is claimed under a more general exemption for personal property. One major purpose of bankruptcy is to ensure orderly and reasonable management of debt. Thus, exemptions for personal effects are thought to prevent punitive seizures of items of little or no economic value (personal effects, personal care items, ordinary clothing), since this does not promote any desirable economic result. Similarly, tools of the trade may, depending on the available exemptions, be a permitted exemption as their continued possession allows the insolvent debtor to move forward into productive work as soon as possible. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 placed pension plans not subject to the Employee Retirement Income Security Act of 1974 (ERISA), like 457 and 403(b) plans, in the same status as ERISA qualified plans with respect to having exemption status akin to spendthrift trusts. SEP-IRAs and SIMPLEs still are outside federal protection and must rely on state law. Spendthrift trusts Most states have property laws that allow a trust agreement to contain a legally enforceable restriction on the transfer of a beneficial interest in the trust (sometimes known as an "anti-alienation provision"). The

anti-alienation provision generally prevents creditors of a beneficiary from acquiring the beneficiary's share of the trust. Such a trust is sometimes called a spendthrift trust. To prevent fraud, most states allow this protection only to the extent that the beneficiary did not transfer property to the trust. Also, such provisions do not protect cash or other property once it has been transferred from the trust to the beneficiary. Under the U.S. Bankruptcy Code, an anti-alienation provision in a spendthrift trust is recognized. This means that the beneficiary's share of the trust generally does not become property of the bankruptcy estate. Redemption In a Chapter 7 liquidation case, an individual debtor may redeem certain "tangible personal property intended primarily for personal, family, or household use" that is encumbered by a lien. To qualify, the property generally either (A) must be exempt under section 522 of the Bankruptcy Code, or (B) must have been abandoned by the trustee under section 554 of the Bankruptcy Code. To redeem the property, the debtor must pay the lienholder the full amount of the applicable allowed secured claim against the property. Debtor's discharge Key concepts in bankruptcy include the debtor's discharge and the related "fresh start." Discharge is available in some but not all cases. For example, in a Chapter 7 case only an individual debtor (not a corporation, partnership, etc.) can receive a discharge. Discharge is also believed to play an important role in credit markets by encouraging lenders, who may be more sophisticated and have better information than debtors, to monitor debtors and limit risk-taking. The effect of a bankruptcy discharge is to eliminate only the debtor's personal liability, not the in rem liability for a secured debt to the extent of the value of collateral. The term "in rem" essentially means "with respect to the thing itself" (i.e., the collateral). For example, if a debt in the amount of $100,000 is secured by property having a value of only $80,000, the $20,000 deficiency is treated, in bankruptcy, as an unsecured claim (even though it's part of a "secured" debt). The $80,000 portion of the debt is treated as a secured claim. Assuming a discharge is granted and none of the $20,000 deficiency is paid (e.g., due to insufficiency of funds), the $20,000 deficiencythe debtor's personal liabilityis discharged (assuming the debt is not non-dischargeable under another Bankruptcy Code provision). The $80,000 portion of the debt is the in rem liability, and it is not discharged by the court's discharge order. This liability can presumably be satisfied by the creditor taking the asset itself. An essential concept is that when commentators say that a debt is "dischargeable," they are referring only to the debtor's personal liability on the debt. To the extent that a liability is covered by the value of collateral, the debt is not discharged. This analysis assumes, however, that the collateral does not increase in value after commencement of the case. If the collateral increases in value and the debtor (rather than the estate) keeps the collateral (e.g., where the asset is exempt or is abandoned by the trustee back to the debtor), the amount of the creditor's security interest may or may not increase. In situations where the debtor (rather than the creditor) is allowed to benefit from the increase in collateral value, the effect is called "lien stripping" or "paring down." Lien stripping is allowed only in certain cases depending on the kind of collateral and the

particular chapter of the Code under which the discharge is granted. The discharge also does not eliminate certain rights of a creditor to setoff (or "offset") certain mutual debts owed by the creditor to the debtor against certain claims of that creditor against the debtor, where both the debt owed by the creditor and the claim against the debtor arose prior to the commencement of the case. Not every debt may be discharged under every chapter of the Code. Certain taxes owed to Federal, state or local government, student loans, and child support obligations are not dischargeable. (Guaranteed student loans are potentially dischargeable, however, if debtor prevails in a difficult-to-win adversary proceeding against the lender commenced by a complaint to determine dischargeability. Also, the debtor can petition the court for a "financial hardship" discharge, but the grant of such discharges is rare.) The debtor's liability on a secured debt, such as a mortgage or mechanic's lien on a home, may be discharged. The effects of the mortgage or mechanic's lien, however, cannot be discharged in most cases if the lien affixed prior to filing. Therefore, if the debtor wishes to retain the property, the debt must usually be paid for as agreed. (See also lien avoidance, reaffirmation agreement) (Note: there may be additional flexibility available in Chapter 13 for debtors dealing with oversecured collateral such as a financed auto, so long as the oversecured property is not the debtor's primary residence.) Any debt tainted by one of a variety of wrongful acts recognized by the Bankruptcy Code, including defalcation, or consumer purchases or cash advances above a certain amount incurred a short time before filing, cannot be discharged. However, certain kinds of debt, such as debts incurred by way of fraud, may be dischargeable through the Chapter 13 super discharge. All in all, as of 2005, there are 19 general categories of debt that cannot be discharged in a Chapter 7 bankruptcy, and fewer debts that cannot be discharged under Chapter 13. Entities that cannot be debtors The section of the Bankruptcy code that governs which entities are permitted to file a bankruptcy petition is 11 U.S.C. 109. Banks and other deposit institutions, insurance companies, railroads, and certain other financial institutions and entities regulated by the federal and state governments cannot be a debtor under the Bankruptcy Code. Instead, special state and federal laws govern the liquidation or reorganization of these companies. In the U.S. context at least, it is incorrect to refer to a bank or insurer as being "bankrupt". The terms "insolvent", "in liquidation", or "in receivership" would be appropriate under some circumstances. Status of certain defined benefit pension plan liabilities in bankruptcy The Pension Benefit Guaranty Corporation (PBGC), a U.S. government corporation that insures certain defined benefit pension plan obligations, may assert liens in bankruptcy under either of two separate statutory provisions. The first is found in the Internal Revenue Code, at 26 U.S.C. 412(n), which provides that liens held by the PBGC have the status of a tax lien. Under this provision, the unpaid mandatory pension contributions must exceed one million dollars for the lien to arise. The second statute is 29 U.S.C. 1368, under which a PBGC lien has the status of a tax lien in bankruptcy. Under this provision, the lien may not exceed 30% of the net worth of all persons liable under a separate provision, 29 U.S.C. 1362(a).

In bankruptcy, PBGC liens (like Federal tax liens) generally are not valid against certain competing liens that were perfected before a notice of the PBGC lien was filed. Insolvency Insolvency is the inability of a debtor to pay their debt. Cash flow insolvency involves a lack of liquidity to pay debts as they fall due. Balance sheet insolvency involves having negative net assets where liabilities exceed assets. Insolvency is not a synonym for bankruptcy, which is a determination of insolvency made by a court of law with resulting legal orders intended to resolve the insolvency. A business may be cash-flow insolvent but balance-sheet solvent if it holds illiquid assets, particularly against short term debt that it cannot immediately realize if called upon to do so. Conversely, a business can have negative net assets showing on its balance sheet but still be cash-flow solvent if ongoing revenue is able to meet debt obligations, and thus avoid default: for instance, if it holds long term debt. Many large companies operate permanently in this state. Definition Insolvency is defined both in terms of cash flow and in terms of balance sheet in the UK Insolvency Act 1986, Section 123, which reads in part: 123. Definition of inability to pay debts (1) A company is deemed unable to pay its debts - [...] (e) if it is proved to the satisfaction of the court that the company is unable to pay its debts as they fall due. This is known as cash flow insolvency. (2) A company is also deemed unable to pay its debts if it is proved to the satisfaction of the court that the value of the company's assets is less than the amount of its liabilities, taking into account its contingent and prospective liabilities. This is known as balance sheet insolvency. Consequences of insolvency The principal focus of modern insolvency legislation and business debt restructuring practices no longer rests on the liquidation and elimination of insolvent entities but on the remodeling of the financial and organizational structure of debtors experiencing financial distress so as to permit the rehabilitation and continuation of their business. This is known as Business Turnaround orBusiness Recovery. In some jurisdictions, it is an offence under the insolvency laws for a corporation to continue in business while insolvent. In others (like the United States with its Chapter 11 provisions), the business may continue under a declared protective arrangement while alternative options to achieve recovery are worked out. Increasingly, legislatures have favored alternatives to winding up companies for good. It can be grounds for a civil action, or even an offence, to continue to pay some creditors in preference to other creditors once a state of insolvency is reached. Debt restructuring Debt restructurings are typically handled by professional insolvency and restructuring practitioners, and are usually less expensive and a preferable alternative to bankruptcy. Debt restructuring is a process that allows a private or public company - or a sovereign entity - facing cash

flow problems and financial distress, to reduce and renegotiate its delinquent debts in order to improve or restore liquidity and rehabilitate so that it can continue its operations. Government debt Although the terms bankrupt and insolvent are often used in reference to governments or government obligations, a government cannot be insolvent in the normal sense of the word. Generally, a government's debt is not secured by the assets of the government, but by its ability to levy taxes. By the standard definition, all governments would be in a state of insolvency unless they had assets equal to the debt they owed. If, for any reason, a government cannot meet its interest obligation, it is technically not insolvent but is "in default". As governments are sovereign entities, persons who hold debt of the government cannot seize the assets of the government to re-pay the debt. However, in most cases, debt in default is refinanced by further borrowing or monetized by issuing more currency (which typically results in inflation and may result in hyperinflation). United States Under the Uniform Commercial Code, a person is considered to be insolvent when the party has ceased to pay its debts in the ordinary course of business, or cannot pay its debts as they become due, or is insolvent within the meaning of the Bankruptcy Code. This is important because certain rights under the code may be invoked against an insolvent party which are otherwise unavailable. The United States has established insolvency regimes which aim to protect the insolvent individual or company from the creditors, and balance their respective interests. For example, see Chapter 11, Title 11, United States Code. However, some state courts have begun to find individual corporate officers and directors liable for driving a company deeper into bankruptcy, under the legal theory of "deepening insolvency." In determining whether a gift or a payment to a creditor is an unlawful preference, the date of the insolvency, rather than the date of the legally-declared bankruptcy, will usually be the primary consideration.

Contracts
1. Formation

Contract Law Introduction A contract is an agreement entered into voluntarily by two parties or more with the intention of creating a legal obligation, which may have elements in writing, though contracts can be made orally. The remedy for breach of contract can be "damages" or compensation of money. In equity, the remedy can be specific performance of the contract or an injunction. Both of these remedies award the party at loss the "benefit of the bargain" or expectation damages, which are greater than mere reliance damages, as in promissory estoppel. The parties may be natural persons or juristic persons. A contract is a legally enforceable promise or undertaking that something will or will not occur. The word promise can be used as a legal synonym for contract., although care is required as a promise may not have the full standing of a contract, as when it is an agreement without consideration. Origin and scope Contract law is based on the principle expressed in the Latin phrase pacta sunt servanda, which is usually translated "agreements must be kept" but more literally means "pacts must be kept". Contract law can be classified, as is habitual in civil law systems, as part of a general law of obligations, along with tort, unjust enrichment, and restitution. As a means of economic ordering, contract relies on the notion of consensual exchange and has been extensively discussed in broader economic, sociological, and anthropological terms (see "Contractual theory" below). In American English, the term extends beyond the legal meaning to encompass a broader category of agreements. This article mainly concerns the common law. Such jurisdictions usually retain a high degree of freedom of contract, with parties largely at liberty to set their own terms. This is in contrast to the civil law, which typically applies certain overarching principles to disputes arising out of contract, as in the French Civil Code. However, contract is a form of economic ordering common throughout the world, and different rules apply in jurisdictions applying civil law (derived from Roman law principles), Islamic law, socialist legal systems, and customary or local law. Elements At common law, the elements of a contract are offer, acceptance, intention to create legal relations, and consideration. Mutual assent At common law, mutual assent is typically reached through offer and acceptance, that is, when an offer is met with an acceptance that is unqualified and that does not vary the offer's terms. The latter requirement is known as the "mirror image" rule. If a purported acceptance does vary the terms of an offer, it is not an acceptance but a counteroffer and, therefore, simultaneously a rejection of the original offer. The Uniform Commercial Code notably disposes of the mirror image rule in 2-207, although the UCC only governs transactions in goods in the USA. Offer and acceptance The most important feature of a contract is that one party makes an offer for an arrangement that

another accepts. This can be called a concurrence of wills or consensus ad idem (meeting of the minds) of two or more parties. The concept is somewhat contested. The obvious objection is that a court cannot read minds and the existence or otherwise of agreement is judged objectively, with only limited room for questioning subjective intention: see Smith v. Hughes. Richard Austen-Baker has suggested that the perpetuation of the idea of 'meeting of minds' may come from a misunderstanding of the Latin term 'consensus ad idem', which actually means 'agreement to the [same] thing'. There must be evidence that the parties had each, from an objective perspective, engaged in conduct manifesting their assent, and a contract will be formed when the parties have met such a requirement. An objective perspective means that it is only necessary that somebody gives the impression of offering or accepting contractual terms in the eyes of a reasonable person, not that they actually did want to form a contract. The case of Carlill v Carbolic Smoke Ball Company is an example of a 'unilateral contract'. The term unilateral contract is used in contract law although ultimately there is an offerer and an offeree and a consideration (which may be an act), and in Australian Mills v The Commonwealth, the High Court of Australia considered the term "unscientific and misleading". Obligations are only imposed upon one party upon acceptance by performance of a condition [5]. In the United States, the general rule is that in "case of doubt, an offer is interpreted as inviting the offeree to accepteither by promising to perform what the offer requests or by rendering the performance, as the offeree chooses." Offer and acceptance does not always need to be expressed orally or in writing. An implied contract is one in which some of the terms are not expressed in words. This can take two forms. A contract which is implied in fact is one in which the circumstances imply that parties have reached an agreement even though they have not done so expressly. For example, by going to a doctor for a checkup, a patient agrees that he will pay a fair price for the service. If one refuses to pay after being examined, the patient has breached a contract implied in fact. A contract which is implied in law is also called a quasi-contract, because it is not in fact a contract; rather, it is a means for the courts to remedy situations in which one party would be unjustly enriched were he or she not required to compensate the other. For example, a plumber accidentally installs a sprinkler system in the lawn of the wrong house. The owner of the house had learned the previous day that his neighbor was getting new sprinklers. That morning, he sees the plumber installing them in his lawn. Pleased at the mistake, he says nothing, and then refuses to pay when the plumber delivers the bill. Will the man be held liable for payment? Yes, if it could be proven that the man knew that the sprinklers were being installed mistakenly, the court would make him pay because of a quasi-contract. If that knowledge could not be proven, he would not be liable. Such a claim is also referred to as "quantum meruit". Consideration Consideration is something of value given by a promissor to a promisee in exchange for something of value given by a promisee to a promissor. Typically, the thing of value is a payment, although it may be an act, or forbearance to act, when one is privileged to do so, such as an adult refraining from smoking. Consideration consists of a legal detriment and a bargain. A legal detriment is a promise to do something or refrain from doing something that you have the legal right to do, or voluntarily doing or refraining from doing something, in the context of an agreement. A bargain is something the promisor (the party making promise or offer) wants, usually being one of the legal detriments. The legal detriment and bargain

principles come together in consideration and create an exchange relationship, where both parties agree to exchange something that the other wishes to have. The purpose of consideration is to ensure that there is a present bargain, that the promises of the parties are reciprocally induced. The classic theory of consideration required that a promise be of detriment to the promissor or benefit to the promisee. This is no longer the case in the USA; typically, courts will look to a bargained-for exchange, rather than making inquiries into whether an individual was subject to a detriment or not. The emphasis is on the bargaining process, not an inquiry into the relative value of consideration. This principle was articulated in Hamer v. Sidway. Yet in cases of ambiguity, courts will occasionally turn to the common law benefit/detriment analysis to aid in the determination of the enforceability of a contract. Sufficiency Consideration must be sufficient, but courts will not weigh the adequacy of consideration. For instance, agreeing to sell a car for a penny may constitute a binding contract. All that must be shown is that the seller actually wanted the penny. This is known as the peppercorn rule. Otherwise, the penny would constitute nominal consideration, which is insufficient. Parties may do this for tax purposes, attempting to disguise gift transactions as contracts. Transfer of money is typically recognized as an example of sufficient consideration, but in some cases it will not suffice, for example, when one party agrees to make partial payment of a debt in exchange for being released from the full amount. Past consideration is not sufficient. Indeed, it is an oxymoron. For instance, in Eastwood v. Kenyon, the guardian of a young girl obtained a loan to educate the girl and to improve her marriage prospects. After her marriage, her husband promised to pay off the loan. It was held that the guardian could not enforce the promise because taking out the loan to raise and educate the girl was past considerationit was completed before the husband promised to repay it. The insufficiency of past consideration is related to the preexisting duty rule. The classic instance is Stilk v. Myrick, in which a captain's promise to divide the wages of two deserters among the remaining crew if they would sail home from the Baltic short-handed, was found unenforceable on the grounds that the crew were already contracted to sail the ship through all perils of the sea. The preexisting duty rule also extends beyond an underlying contract. It would not constitute sufficient consideration for a party to promise to refrain from committing a tort or crime, for example. However, a promise from A to do something for B if B will perform a contractual obligation B owes to C, will be enforceable - B is suffering a legal detriment by making his performance of his contract with A effectively enforceable by C as well as by A. Consideration must move from the promisee. For instance, it is good consideration for person A to pay person C in return for services rendered by person B. If there are joint promisees, then consideration need only to move from one of the promisees. Formation In addition to the elements of a contract:

a party must have capacity to contract;

the purpose of the contract must be lawful; the form of the contract must be legal; the parties must intend to create a legal relationship; and the parties must consent.

As a result, there are a variety of affirmative defenses that a party may assert to avoid his obligation. Affirmative defenses Vitiating factors constituting defences to purported contract formation include:

mistake; incapacity, including mental incompetence and infancy/minority; duress; undue influence; unconscionability; misrepresentation/fraud; and frustration of purpose.

Such defenses operate to determine whether a purported contract is either (1) void or (2) voidable. Void contracts cannot be ratified by either party. Voidable contracts can be ratified. Consideration Consideration is the concept of legal value in connection with contracts [6]. It is anything of value promised to another when making a contract. It can take the form of money, physical objects, services, promised actions, abstinence from a future action, and much more. Under the notion of "pre-existing duties", if either the promisor or the promisee already had a legal obligation to render such payment, it cannot be seen as consideration in the legal sense. In common law it is a prerequisite that both parties offer some consideration before a contract can be thought of as binding. However, even if a court decides there is no contract, there might be a possible recovery under quantum meruit (sometimes referred to as a quasi-contract) or promissory estoppel. Consideration and formation of a contract Consideration as defined is the interest, profit, and benefit accruing to one party involved as a payment for the consideration. 1. Consideration move at the desire of the promisor: In order to constitute consideration the act or abstinence forming the consideration for the promise must be done at the desire or request of the promise. Thus an act does or services rendered voluntarily, or at the desire of the third partly, will not amount to valid consideration so as to support a contract. The logic for this may be found in the worry and expense to which every one might be subjected, if he were obliged to pay for services which he did not request.

2. Consideration move from promisee or any other person: Consideration need not move from the promisee alone but may proceed from third person. Thus as long as there is a consideration for a promise, it is immaterial who has furnished it. It may move from the promise or from any other person. This means that even a stranger to the consideration can construct a contract, provided he is a party to the contract. This is sometimes called as doctrine of constructive consideration. 3. Consideration cannot be past: The words, has done or abstained from doing or does or has abstained from doing or promises to do or to abstained from doing or promises to do or to abstain from doing. 4. Consideration need to be adequate: It means that consideration is that it must be something to which the law attaches a value. The consideration need not to be adequate to the promise for the validity of an agreement. The law only consists on the presence of consideration and not on the adequacy of it. It leaves the people free to make their own bargains. If A signs a contract to buy a car from B for $5,000, A's consideration is the $5,000, and B's consideration is the car. Additionally, if A signs a contract with B such that A will paint B's house for $500, A's consideration is the service of painting B's house, and B's consideration is $500 paid to A. Further, if A signs a contract with B such that A will not repaint his own house in any other color than white, and B will pay A $500 per year to keep this deal up, there is also consideration. Although A did not promise to affirmatively do anything, A did promise not to do something that he was allowed to do, and so A did pass consideration. A's consideration to B is the forbearance in painting his own house in a color other than white, and B's consideration to A is $500 per year. Conversely, if A signs a contract to buy a car from B for $0, B's consideration is still the car, but A is giving no consideration, and so there is no valid contract. However, if B still gives the title to the car to A, then B cannot take the car back, since, while it may not be a valid contract, it is a valid gift [7]. There are a number of common issues as to whether consideration exists in a contract. Monetary value of consideration Generally, courts do not inquire whether the deal between two parties was monetarily fairmerely that each party passed some legal obligation or duty to the other party. The dispositive issue is presence of consideration, not adequacy of the consideration. The values between consideration passed by each party to a contract need not be comparable. For instance, if A offers B $200 to buy B's mansion, luxury sports car, and private jet, there is still consideration on both sides. A's consideration is $200, and B's consideration is the mansion, car, and jet. Courts in the United States generally leave parties to their own contracts, and do not intervene. The old English rule of consideration questioned whether a party gave the value of apeppercorn to the other party. As a result, contracts in the United States have sometimes have had one party pass nominal amounts of consideration, typically citing $1. Thus, licensing contracts that do not involve any money at all will often cite as consideration, "for the sum of $1 and other good and valuable consideration". However, some courts in the United States may take issue with nominal consideration, or consideration with virtually no value. Some courts have since thought this was a sham. Since contract disputes are

typically resolved in state court, some state courts have found that merely providing $1 to another is not a sufficiently legal duty, and therefore no legal consideration passes in these kinds of deals, and consequently, no contract is formed. However, this is a minority position. Pre-existing legal duties A party which already has a legal duty to provide money, an object, a service, or a forbearance, does not provide consideration when promising merely to uphold that duty. That legal duty can arise from law, or obligation under a previous contract. The prime example of this sub-issue is where an uncle gives his seven year old nephew (a resident of the US) the following offer: "if you do not smoke cigarettes or marijuana until your 18th birthday, then I will pay you $500" (assuming it is a criminal offense in the US for people under the age of 18 to smoke cigarettes, and for people of any age to smoke marijuana). On the nephew's 18th birthday, he tells the uncle to pay up, and the uncle says no. In the subsequent lawsuit, the uncle will win, because the nephew, by U.S. law, already had a duty to refrain from smoking cigarettes or marijuana. The same applies if the consideration is a performance for which the parties had previously contracted. For example, A agrees to paint B's house for $500, but halfway through the job A tells B that he will not finish unless B increases the payment to $750. If B agrees, and A then finishes the job, B still only needs to pay A the $500 originally agreed to, because A was already contractually obligated to paint the house for that amount. An exception to this rule holds for settlements, such as an accord and satisfaction. If a creditor has a credit against a debtor for $10,000, and offers to settle it for $5,000, it is still binding, if accepted, even though the debtor had a legal duty to repay the entire $10,000. Pre-existing duties relating to at-will employment depend largely on state law. Generally, at-will employment allows the employer to terminate the employee for good or even no reason, and allows the employee to resign for any reason. There are no duties of continued employment in the future. Therefore, when an employee demands a raise, there is no issue with consideration because the employee has no legal duty to continue working. Similarly, when an employer demands a pay-cut, there is also no contractual issue with consideration, because the employer has no legal duty to continue employing the worker. However, certain states require additional consideration other than the prospect of continued employment, to enforce terms demanded later by the employer, in particular, non-competition clauses. Bundled terms Contracts where a legally valueless term is bundled with a term that does have legal value are still generally enforceable. Consider the uncle's situation above. If the same uncle had instead told his 17 year old nephew the following offer: "if you do not smoke cigarettes and do not engage females before your 18th birthday, then I will pay you $500". On the nephew's 18th birthday, he asks the uncle to pay up, and this time, in the subsequent lawsuit, the nephew may win. Although the promise of not smoking was not valuable consideration (it was already legally prohibited), virtually all states allow some sort of engagement by minors. Even though the engagement by minors is legally restricted, there are circumstances where it is legal, and thus the promise to forbear from it entirely has legal value. However, the uncle would still be

relieved from the liability if his nephew smoked a cigarette, even though that consideration is valueless, because it was paired with something of legal value; therefore, adherence to the entire, collective agreement is necessary. Past consideration Generally, past consideration is not a valid consideration and has no legal value. Past consideration therefore cannot be used as a basis when claiming damages. Roscorla v Thomas. there are two exceptions to this rule they include; 1. Where it was paid at the request of the offeror. 2. where both parties had earlier on contemplated payment. Option contracts and conditional consideration Generally, conditional consideration is valid consideration. Suppose A is a movie script writer and B runs a movie production company. A says to B, "buy my script." Instead, B says "How about this I will pay you $5,000 so that you do not let anyone else produce your movie until one year from now. If I do produce your movie in that year, then I will give you another $50,000, and no one else can produce it. If I do not produce your movie in that year, then you're free to go." If the two subsequently get into a dispute, the issue of whether a contract exists is answered. B had an option contracthe could decide to produce the script, or not. B's consideration passed was the $5,000 down, and the possibility of $50,000. A's consideration passed was the exclusive rights to the movie script for at least one year. In settlements B committed a tort against A, causing $5,000 in compensatory damages and $3,000 in punitive damages. Since there is no guarantee that A would win against B if it went to court, A will agree to drop the case if B pays the $5,000 compensatory damages. This is sufficient consideration, since B's consideration is a guaranteed recovery, and A's consideration is that B only has to pay $5,000, instead of $8,000. 2. Performance Warranty In business and legal transactions, a warranty is an assurance by one party to the other party that specific facts or conditions are true or will happen; the other party is permitted to rely on that assurance and seek some type of remedy if it is not true or followed. In real estate transactions, a general warranty deed is an agreement that the buyer's title to a parcel of land will be defended. A limited warranty deed, on the other hand, is a promise that the title will be defended against a limited set of claims which is usually claims arising from incumberances executed by the grantor. Thus, a general warranty deed binds the grantor to defend the title against all claims even those arising from previous owners; whereas, a limited warranty deed typically only binds the grantor to defend the title against claims arising from when the grantor held title to the property. A limited warranty deed is

the deed of choice for banks when selling foreclosed properties. A warranty may be express or implied, depending on the product. Implied warranty An implied warranty is one that arises from the nature of the transaction, and the inherent understanding by the buyer, rather than from the express representations of the seller. The warranty of merchantability is implied, unless expressly disclaimed by name, or the sale is identified with the phrase "as is" or "with all faults." To be "merchantable", the goods must reasonably conform to an ordinary buyer's expectations, i.e., they are what they say they are. For example, a fruit that looks and smells good but has hidden defects would violate the implied warranty of merchantability if its quality does not meet the standards for such fruit "as passes ordinarily in the trade". The warranty of fitness for a particular purpose is implied when a buyer relies upon the seller to select the goods to fit a specific request. For example, this warranty is violated when a buyer asks a mechanic to provide snow tires and receives tires that are unsafe to use in snow. This implied warranty can also be expressly disclaimed by name, thereby shifting the risk of unfitness back to the buyer. Lifetime warranty A lifetime warranty is usually a guarantee on the lifetime of the product on the market rather than the lifetime of the consumer (the exact meaning should be defined in the actual warranty documentation). If a product has been discontinued and is no longer available, the warranty may last a limited period longer. For example:

the Cisco Limited Lifetime Warranty currently lasts for five years after the product has been discontinued. HP Networking products lifetime warranties for as long as you own the product.

Second-hand Product Warranty The importance of the used/second-hand product market as a fraction of the total market (new + secondhand) has been growing significantly since the beginning of the twenty-first century. Second-hand products include products that have previously been used by an end user/consumer. Users change their products even if they are still in good condition. Some products such as computers and mobile phones have a short lifetime and technologies of these products are released to the market every day. As a result, the sale of new products is often tied to a trade-in, resulting in a market for second-hand products. For instance, in France, used car unit sales increased from 4.7 million to 5.4 million between 1990 and 2005, at the same time as new car sales declined from 2.3 million to 2.07 million units. Breach of warranty A warranty is violated when the promise is broken; when goods are not as should be expected, at the time the sale occurs, whether or not the defect is apparent. The seller should honor the warranty by making a timely refund or a replacement. The date of delivery starts the time under the statute of limitations for starting a court complaint for breach of warranty if the seller refuses to honor the warranty. This period is

often overlooked where there is an "extended warranty" in which a seller or manufacturer contracts to provide the additional service of replacing or repairing goods that fail within the extended period. However, if the goods were defective at the time of sale, and the relevant statute of limitations has not expired, then existence or duration of any "extended warranty" is secondary: there was a breach of a primary warranty for which the seller may be liable. It could be an unfair and deceptive business practice (a statutory type of fraud) to attempt to avoid liability for breach of a primary warranty by claiming expiration of the irrelevant extended warranty. A statute of limitations on a contract claim may be shorter (or longer) than that of a tort claim, and some breach of warranty cases are filed late and are characterized as a fraud or other related tort. For example, a consumer buys an item that was discovered to be broken or missing pieces before it was even taken out of the package. This is a defective product and can be returned to the seller for refund or replacement, regardless of what the seller's "returns policy" might state (with limited exceptions for second-hand or "as is" sales), even if the problem wasn't discovered until after the "extended warranty" expired. Similarly, if the product fails prematurely, it may have been defective when it was sold and could then be returned for a refund or replacement. If the seller dishonors the warranty, then a contract claim can be started in court. 3. Third party assignments 4. Discharge, breach, and remedies Breach of Contract Breach of contract is a legal cause of action in which a binding agreement or bargained-for exchange is not honored by one or more of the parties to the contract by non-performance or interference with the other party's performance. If the party does not fulfill his contractual promise, or has given information to the other party that he will not perform his duty as mentioned in the contract or if by his action and conduct he seems to be unable to perform the contract, he is said to breach the contract. Breach of contract is a type of civil wrong. Minor breaches In a "minor" breach (a partial breach or immaterial breach or where there has been substantial performance), the non-breaching party cannot sue for specific performance, and can only sue for actual damages. Suppose a homeowner hires a contractor to install new plumbing and insists that the pipes, which will ultimately be hidden behind the walls, must be red. The contractor instead uses blue pipes that function just as well. Although the contractor breached the literal terms of the contract, the homeowner cannot ask a court to order the contractor to replace the blue pipes with red pipes. The homeowner can only recover the amount of his or her actual damages. In this instance, this is the difference in value between red pipe and blue pipe. Since the color of a pipe does not affect its function, the difference in value is zero. Therefore, no damages have been incurred and the homeowner would receive nothing. However, had the pipe colour been specified in the agreement as a condition, a breach of that condition would constitute a "major" breach. For example, when a contract specifies time is of the essence and one

party to the contract fails to meet a contractual obligation in a timely fashion, the other party could sue for damages for a major breach. Material breach A material breach is any failure to perform that permits the other party to the contract to either compel performance, or collect damages because of the breach. If the contractor in the above example had been instructed to use copper pipes, and instead used iron pipes that would not last as long as the copper pipes would have lasted, the homeowner can recover the cost of actually correcting the breach - taking out the iron pipes and replacing them with copper pipes. There are exceptions to this. Legal scholars and courts often state that the owner of a house whose pipes are not the specified grade or quality (a typical hypothetical example) cannot recover the cost of replacing the pipes for the following reasons: 1. Economic waste. The law does not favor tearing down or destroying something that is valuable (almost anything with value is "valuable"). In this case, significant destruction of the house would be required to completely replace the pipes, and so the law is hesitant to enforce damages of that nature[3] [8] . 2. Pricing in. In most cases of breach, a party to the contract simply fails to perform one or more terms. In those cases, the breaching party should have already considered the cost to perform those terms and thus "keeps" that cost when they do not perform. That party should not be entitled to keep that savings. However, in the pipe example the contractor never considered the cost of tearing down a house to fix the pipes, and so it is not reasonable to expect them to pay damages of that nature. Most homeowners would be unable to collect damages that compensate them for replacing the pipes, but rather would be awarded damages that compensate them for the loss of value in the house. For example, say the house is worth $125,000 with copper and $120,000 with iron pipes. The homeowner would be able to collect the $5,000 difference, and nothing more. The Restatement (Second) of Contracts lists the following criteria can be used to determine whether a specific failure constitutes a breach: In determining whether a failure to render or to offer performance is material, the following circumstances are significant: (a) the extent to which the injured party will be deprived of the benefit which he reasonably expected; (b) the extent to which the injured party can be adequately compensated for the part of that benefit of which he will be deprived; (c) the extent to which the party failing to perform or to offer to perform will suffer forfeiture; (d) the likelihood that the party failing to perform or to offer to perform will cure his failure, taking account of all the circumstances including any reasonable assurances; (e) the extent to which the behavior of the party failing to perform or to offer to perform comports with standards of good faith and fair dealing. American Law Institute, Restatement (Second) of Contracts 241 (1981) Fundamental breach A fundamental breach (or repudiatory breach) is a breach so fundamental that it permits the aggrieved party to terminate performance of the contract. In addition that party is entitled to sue for damages.

Anticipatory breach A breach by anticipatory repudiation (or simply anticipatory breach) is an unequivocal indication that the party will not perform when performance is due, or a situation in which future non-performance is inevitable. An anticipatory breach gives the non-breaching party the option to treat such a breach as immediate, and, if repudiatory, to terminate the contract and sue for damages (without waiting for the breach to actually take place). For example, A contracts with B on January 1st to sell 500 quintals of wheat and to deliver it on May 1st. Subsequently, on April 15th A writes to B and says that he will not deliver the wheat. B may immediately consider the breach to have occurred and file a suit for damages without waiting until after May 1st for the scheduled performance, even though A has until May 1st to perform. Example: if Company A refuses to pay substantial interim payments to Company B, Company B can begin legal action due to anticipatory breach. Company B could also stop performing its contractual obligation, potentially saving time and or money. Duress In jurisprudence, duress or coercion refers to a situation whereby a person performs an act as a result of violence, threat or other pressure against the person. Black's Law Dictionary (6th ed.) defines duress as "any unlawful threat or coercion used... to induce another to act [or not act] in a manner [they] otherwise would not [or would]". Duress is pressure exerted upon a person to coerce that person to perform an act that he or she ordinarily would not perform. The notion of duress must be distinguished both from undue influence in the civil law and from necessity. Duress has two aspects. One is that it negates the person's consent to an act, such as sexual activity or the entering into a contract; or, secondly, as a possible legal defense or justification to an otherwise unlawful act. A defendant utilizing the duress defense admits to breaking the law, but claims that he/she is not liable because, even though the act broke the law, it was only performed because of extreme unlawful pressure. In criminal law, a duress defense is similar to a plea of guilty, admitting partial culpability, so that if the defense is not accepted then the criminal act is admitted. Duress or coercion can also be raised in an allegation of rape or sexual assault to negate a defense of consent on the part of the person making the allegation. Discussion A defendant who raises a defense of duress has actually done everything to constitute the actus reus of the crime and has the mens rea because he or she intended to do it in order to avoid some threatened or actual harm. Thus, some degree of culpability already attaches to the defendant for what was done. In criminal law, the defendant's motive for breaking the law is usually irrelevant although, if the reason for acting was a form of justification, this may reduce the sentence. The basis of the defense is that the duress actually overwhelmed the defendant's will and would also have overwhelmed the will of a person of ordinary courage (a hybrid test requiring both subjective evidence of the accused's state of mind, and an objective confirmation that the failure to resist the threats was reasonable), thus rendering the entire behavior involuntary. Thus, the liability should be reduced or discharged, making the defense one of exculpation. The extent to which this defense should be allowed, if at all, is a matter of public policy. A state may say

that no threat should force a person to deliberately break the law, particularly if this breach will cause significant loss or damage to a third person. Alternatively, a state may take the view that even though people may have ordinary levels of courage, they may nevertheless be coerced into agreeing to break the law and this human weakness should have some recognition in the law. A variant of duress involves hostage taking, where a person is forced to commit a criminal act under the threat, say, that their family member or close associate will be immediately killed should they refuse. This has been raised in some cases of ransom where a person commits theft or embezzlement under orders from a kidnapper in order to secure their family member's life and freedom. Requirements For duress to qualify as a defense, four requirements must be met: 1. 2. 3. 4. The threat must be of serious bodily harm or death The threatened harm must be greater than the harm caused by the crime The threat must be immediate and inescapable The defendant must have become involved in the situation through no fault of his or her own

A person may also raise a duress defense when force or violence is used to compel him to enter into a contract, or to discharge In contract law Duress in the context of contract law is a common law defense, and if one is successful in proving that the contract is vitiated by duress, the contract may be rescinded, since it is then voidable. Duress has been defined as a "threat of harm made to compel a person to do something against his or her will or judgment; esp., a wrongful threat made by one person to compel a manifestation of seeming assent by another person to a transaction without real volition". - Black's Law Dictionary (8th ed. 2004) Duress in contract law falls into two broad categories:

Physical duress, and Economic duress

Business Structure (Selection of a Business Entity)

1. Advantages, disadvantages, implications, and constraints Business Entity A business entity is an organization that is formed in accordance with the law in order to engage

in business activities, usually the sale of a product or a service. There are many types of business entities defined in the legal systems of various countries. These include corporations, cooperatives, partnerships, sole traders, limited liability company and other specialized types of organization. In the United States, the individual states incorporate most businesses. Very few special types are incorporated by the federal government. For federal tax purposes, the Internal Revenue Service has separate entity classification rules. Under the rules, an entity may be classified as a corporation, a partnership or disregarded entity. As a corporation, it may be further classified as either an S corporation or a C corporation. Federally incorporated The key word for a bank is "national". A bank chartered by the OCC must have the word "national" in its name. A bank chartered by a state is forbidden to have the word "national" in its name. For a savings bank or credit union, the key word is "federal," and the same rules apply; a federally chartered savings bank or credit union must have the word "federal" in its name, while a state chartered savings bank or credit union cannot have "federal" in its name.

NA (National Association), a designation used by national banks chartered by the Office of the Comptroller of the Currency (OCC) NT&SA (National Trust and Savings Association), a less common designation used by national banks Federal Credit Union, chartered by the National Credit Union Association (NCUA) Federal Savings Bank, formerly called federal savings and loan association

Many federal governmental units are specially formed public corporations, while some private organizations have received a charter from Congress. State, Territory or Commonwealth incorporated The following are the main business designations and types (corporations and non-corporations):

Corp., Inc. (Corporation, Incorporated): used to denote corporations (public or otherwise). These are the only terms universally accepted by all 51 corporation chartering jurisdictions in the United States. However in some states other suffixes may be used to identify a corporation, such as Ltd., Co./Company. Some states that allow the use of "Company" prohibit the use of "and Company", "and Co.", "& Company" or "& Co.". In most states sole proprietorships and partnerships may register a fictitious "doing business as" name with the word "Company" in it. For a full list of allowed designations by state, see the table below. Doing Business As (DBA): denotes a business name used by a person or entity that is different from the person's or entity's true name. Filing requiments vary and are not permitted for some types of businesses or professional practices. DBAs can be sole proprietorships, or can be used by corporate entities to reserve "brand names", such as those of chain stores owned and operated by a holding company or other "umbrella".

General partnership is a partnership in which all the partners are jointly liable for the debts of the partnership. It is typically created by agreement rather than being created by a public filing. LLC [24], LC, Ltd. Co. (limited liability company): a form of business whose owners enjoy limited liability, but which is not a corporation. Allowable abbreviations vary by state. Note that Ltd. by itself is not a valid abbreviation for an LLC, because in some states (e.g. Texas), it may denote a corporation instead. See also Series LLC. For U.S. federal tax purposes, an LLC with two or more members is treated as a partnership, and an LLC with one member is treated as a sole proprietorship. LLLP (limited liability limited partnership): a combination of LP and LLP, available in some states LLP (limited liability partnership): a partnership where a partner's liability for the debts of the partnership is limited except in the case of liability for acts of professional negligence or malpractice. In some states LLPs may only be formed for purposes of practicing a licensed profession, typically attorneys, accountants and architects. This is often the only form of limited partnership allowed for law firms (as opposed to general partnerships). LP (limited partnership): a partnership where at least one partner has unlimited liability and one or more partners have limited liability PLLC (professional limited liability company): Some states do not allow certain professionals to form an LLC that would limit the liability that results from the services the professionals provide such as doctors, medical care; lawyers, legal advice; and accountants, accounting services, when the company formed offers the services of the professionals. Instead states allow a PLLC or in the LLC statutes, the liability limitation only applies to the business side, such as creditors of the company, as opposed to the service side, the level of medical care, legal services, or accounting provided to clients. This is meant to maintain the higher ethical standards that these professionals have committed themselves to by becoming licensed in their profession and not immune to malpractice suits. Professional corporations (abbreviated as PC or P.C.) are those corporate entities for which many corporation statutes make special provision, regulating the use of the corporate form by licensed professionals such as attorneys, architects, accountants, and doctors. Sole proprietorship: a business consisting of a single owner, not in a separately recognized business form

2. Formation, operation, and termination 3. Financial structure, capitalization, profit and loss allocation, and distributions 4. Rights, duties, legal obligations, and authority of owners and management

Debtor-Creditor Relationships

1. Rights, duties, and liabilities of debtors, creditors, and guarantors Collateral In lending agreements, collateral is a borrower's pledge of specific property to a lender, to secure repayment of a loan. The collateral serves as protection for a lender against a borrower's default - that is, any borrower failing to pay the principal and interest under the terms of a loan obligation. If a borrower does default on a loan (due to insolvency or other event), that borrower forfeits (gives up) the property pledged as collateral - and the lender then becomes the owner of the collateral. In a typical mortgage loan transaction, for instance, the real estate being acquired with the help of the loan serves as collateral. Should the buyer fail to pay the loan under the mortgage loan agreement, the ownership of the real estate is transferred to the bank. The bank uses a legal process called foreclosure to obtain real estate from a borrower who defaults on a mortgage loan obligation. Concept of collateral Collateral, especially within banking, traditionally refers to secured lending (also known as asset-based lending). More recently, complex collateralization arrangements are used to secure trade transactions (also known as capital market collateralization). The former often presents unilateral obligations, secured in the form of property, surety, guarantee or other as collateral (originally denoted by the term security), whereas the latter often presents bilateral obligations secured by more liquid assets such as cash or securities, often known for margin. Another example might be to ask for collateral in exchange for holding something of value until it is returned. Some forms of lending are solely based on the strength of the collateral such as gold, jewelry and property. Certain non-conservative lending practices such as lending against antique items or art works are also known to exist. In many developing countries, the use of collateral is the main way to secure bank financing. The ease of acquiring a loan depends on the ability to use assets such as real estate as collateral. Security Interest A security interest is a property interest created by agreement or by operation of law over assets to secure the performance of an obligation, usually the payment of a debt. It gives the beneficiary of the security interest certain preferential rights in the disposition of secured assets. Such rights vary according to the type of security interest, but in most cases, a holder of the security interest is entitled to seize, and usually sell, the property to discharge the debt that the security interest secures. Rationale A secured creditor takes a security interest to enforce its rights against collateral in case the debtor defaults on the obligation. If the debtor goes bankrupt, a secured creditor takes precedence over unsecured creditor in the distribution. There are other reasons that people sometimes take security over assets. In shareholders' agreements involving two parties (such as a joint venture), sometimes the shareholders will each charge their shares in favor of the other as security for the performance of their obligations under the agreement to prevent the

other shareholder selling their shares to a third party. It is sometimes suggested that banks may take floating charges over companies by way of security - not so much for the security for payment of their own debts, but because this ensures that no other bank will, ordinarily, lend to the company, thereby almost granting a monopoly in favour of the bank holding the floating charge on lending to the company. Some economists question the utility of security interests and secured lending generally. Proponents argue that secured interests lower the risk for the lender, and in turn allows the lender to charge lower interest, thereby lower the cost of capital for the borrower. Compare, for example, interest rates for a mortgage loan and for a credit card debt. Detractors argue that creditors with security interests can destroy companies that are in financial difficulty, but which might still recover and be profitable. The secured lenders might get nervous and enforce the security early, repossessing key assets and forcing the company into bankruptcy. Further, the general principle of most insolvency regimes is that creditors should be treated equally (or pari passu), and allowing secured creditors a preference to certain assets upsets the conceptual basis of an insolvency. More sophisticated criticisms of security point out that although unsecured creditors will receive less on insolvency, they should be able to compensate by charging a higher interest rate. However, since many unsecured creditors are unable to adjust their "interest rates" upwards (tort claimants, employees), the company benefits from a cheaper rate of credit, to the detriment of these non-adjusting creditors. There is thus a transfer of value from these parties to secured borrowers. Most insolvency law allows mutual debts to be set-off, allowing certain creditors (those who also owe money to the insolvent debtor) a pre-preferential position. In some countries, "involuntary" creditors (such as tort victims) also have preferential status, and in others environmental claims have special preferred rights for cleanup costs. The most frequently used criticism of secured lending is that, if secured creditors are allowed to seize and sell key assets, a liquidator or bankruptcy trustee loses the ability to sell off the business as a going concern, and may be forced to sell the business on a break-up basis. This may mean realising a much smaller return for the unsecured creditors, and will invariably mean that all the employees will be made redundant. For this reason, many jurisdictions restrict the ability of secured creditors to enforce their rights in a bankruptcy. In the U.S., the Chapter 11 creditor protection, which completely prevents enforcement of security interests, aims at keeping enterprises running at the expense of creditors' rights, and is often heavily criticised for that reason. The most draconian jurisdictions in favour of creditor's rights tend to be in offshore financial centres, who hope that, by having a legal system heavily biased towards secured creditors, they will encourage banks to lend at cheaper rates to offshore structures, and thus in turn encourage business to use them to obtain cheaper funds. Security Under English law and in most common law jurisdictions derived from English law (the United States is the exception as explained below), there are eight types of proprietary security interests: (1) 'true' legal mortgage; (2) equitable mortgage; (3) statutory mortgage; (4) fixed equitable charge, or bill of sale; (5) floating equitable charge; (6) pledge, or pawn; (7) legal lien; (8) equitable lien; and (9) hypothecation, or trust receipt.

Security interests at common law are either possessory or non-possessory, depending upon whether the secured party actually needs to take possession of the collateral). Alternatively, they arise by agreement between the parties (usually by executing a security agreement), or by operation of law. The following discussion of the types of security interest principally concerns English law. English law on security interests has been followed in most common law countries, and most common law countries have similar property statutes regulating the common law rules. Types Security interests may be taken on any type of property. The law divides property into two classes: personal property and real property. Real property is the land, the buildings affixed to it and the rights that go with the land. Personal property is defined as any property other than real property. "True" legal mortgage A legal mortgage arises when the assets are conveyed to the secured party as security for the obligations, but subject to a right to have the assets reconveyed when the obligations are performed. This right is referred to as the "equity of redemption". The law has historically taken a dim view of provisions which might impede this right to have the assets reconveyed (referred to as being a "clog" on the equity of redemption), although the position has become more relaxed in recent years in relation to sophisticated financial transactions. References to "true" legal mortgages mean mortgages by the traditional common law method of transfer subject to a proviso in this manner, and references are usually made in contradistinction to either equitable mortgages or statutory mortgages. True legal mortgages are relatively rare in modern commerce, outside of occasionally with respect to shares in companies. In England, true legal mortgages of land have been abolished in favour of statutory mortgages. To complete a legal mortgage it is normally necessary that title to the assets is conveyed into the name of the secured party such that the secured party (or its nominee) becomes the legal titleholder to the asset. If a legal mortgage is not completed in this manner it will normally take effect as an equitable mortgage. Because of the requirement to transfer title, it is not possible to take a legal mortgage over future property, or to take more than one legal mortgage over the same assets. However, mortgages (legal and equitable) are non-possessory security interests. Normally the party granting the mortgage (the mortgagor) will remain in possession of the mortgaged asset. The holder of a legal mortgage has three primary remedies in the event that there is a default on the secured obligations: they can foreclose on the assets, they can sell the assets or they can appoint a receiver over the assets. The holder of a mortgage can also usually sue upon the covenant to pay which appears in most mortgage instruments. There are a range of other remedies available to the holder of a mortgage, but they relate predominantly to land, and accordingly have been superseded by statute, and they are rarely exercised in practice in relation to other assets. The beneficiary of a mortgage (the mortgagee) is entitled to pursue all of its remedies concurrently or consecutively. Foreclosure is rarely exercised as a remedy. To execute foreclosure, the secured party needs to petition the court, and the order is made in two stages (nisi and absolut), making the process slow and cumbersome. Courts are historically reluctant to grant orders for foreclosure, and will often instead order a judicial sale.

If the asset is worth more than the secured obligations, the secured party will normally have to account for the surplus. Even if a court makes a decree absolut and orders foreclosure, the court retains an absolute discretion to reopen the foreclosure after the making of the order, although this would not affect the title of any third party purchaser. The holder of a legal mortgage also has a power of sale over the assets. Every mortgage contains an implied power of sale. This implied power exists even if the mortgage is not under seal. All mortgages which are made by way of deed also ordinarily contain a power of sale implied by statute, but the exercise of the statutory power is limited by the terms of the statute. Neither implied power of sale requires a court order, although the court can usually also order a judicial sale. The secured party has a duty to get the best price reasonably obtainable, however, this does not require the sale to be conducted in any particular fashion (i.e. by auction or sealed bids). What the best price reasonably obtainable will be will depend upon the market available for the assets and related considerations. The sale must be a true sale - a mortgagee cannot sell to himself, either alone or with others, even for fair value; such a sale may be restrained or set aside or ignored. However, if the court orders a sale pursuant to statute, the mortgagee may be expressly permitted to buy. The third remedy is to appoint a receiver. Technically the right to appoint a receiver can arise two different ways - under the terms of the mortgage instrument, and (where the mortgage instrument is executed as a deed) by statute. In England, a third remedy, "appropriation" may exist under The Financial Collateral Arrangements (No.2) Regulations 2003 where the assets subject to the mortgage are 'financial collateral' and the mortgage instrument provides that the regulations apply. Appropriation is a means whereby the mortgagee can take title to the assets, but must account to the mortgagor for their fair market value (which must be specified in the mortgage instrument), but without the need to obtain any court order. If the mortgagee takes possession then under the common law they owe strict duties to the mortgagor to safeguard the value of the property (although the terms of the mortgage instrument will usually limit this obligation). However, the common law rules relate principally to physical property, and there is a shortage of authority as to how they might apply to taking "possession" of rights, such as shares. Nonetheless, a mortgagee is well advised to remain respectful of their duty to preserve the value of the mortgaged property both for their own interests and under their potential liability to the mortgagor. Equitable mortgage An equitable mortgage can arise in two different ways either as a legal mortgage which was never perfected by conveying the underlying assets, or by specifically creating a mortgage as an equitable mortgage. A mortgage over equitable rights (such as a beneficiary's interests under a trust) will necessarily exist in equity only in any event. Under the laws of some jurisdictions, a mere deposit of title documents can give rise to an equitable mortgage. With respect to land this has now been abolished in England, although in many jurisdictions company shares can still be mortgaged by deposit of share certificates in this manner. Generally speaking, an equitable mortgage has the same effect as a perfected legal mortgage except in two respects. Firstly, being an equitable right, it will be extinguished by a bona fide purchaser for value who did not have notice of the mortgage. Secondly, because the legal title to the mortgaged property is not

actually vested in the secured party, it means that a necessary additional step is imposed in relation to the exercise of remedies such as foreclosure, it was held that an equitable mortgagee could enforce security over financial collateral (in this case shares) by informing the interested mortgagor and other interested parties of the fact without first taking possession of shares or having his ownership interest recorded in the register. Statutory mortgage Many jurisdictions permit specific assets to be mortgaged without transferring title to the assets to the mortgagee. Principally, statutory mortgages relate to land, registered aircraft and registered ships. Generally speaking, the mortgagee will have the same rights as they would have had under a traditional true legal mortgage, but the manner of enforcement is usually regulated by the statute. Equitable charge A fixed equitable charge confers a right on the secured party to look to (or appropriate) a particular asset in the event of the debtor's default, which is enforceable by either power of sale or appointment of a receiver. It is probably the most common form of security taken over assets. Technically, a charge (or a "mere" charge) cannot include the power to enforce without judicial intervention, as it does not include the transfer of a property proprietary interest in the charged asset. If a charge includes this right (such as private sale by a receiver), it is really an equitable mortgage (sometimes called charge by way of mortgage). Since little turns on this distinction, the term "charge" is often used to include an equitable mortgage. An equitable charge is also a non-possessory form of security, and the beneficiary of the charge (the chargee) does not need to retain possession of the charged property. Where security equivalent to a charge is given by a natural person (as opposed to a corporate entity) it is usually expressed to be a bill of sale, and is regulated under applicable bills of sale legislation. Difficulties with the Bills of Sale Acts in Ireland, England and Wales have made it virtually impossible for individuals to create floating charges. Floating charge Floating charges are similar in effect to fixed equitable charges once they crystallise (usually upon the commencement of liquidation proceedings against the chargor), but prior to that they "float" and do not attach to any of the chargor's assets, and the chargor remains free to deal with or dispose of them. Pledge A pledge (also sometimes called a pawn) is a form of possessory security, and accordingly, the assets which are being pledged need to be physically delivered to the beneficiary of the pledge (the pledgee). Pledges are in commercial contexts used in trading companies (especially, physically, commodity trading), and are still used by pawnbrokers [10], which, contrary to their old world image, remain a regulated credit industry. The pledgee has a common law power of sale in the event of a default on the secured obligations which arises if the secured obligations are not satisfied by the agreed time (or, in default of agreement, within a reasonable period of time). If the power of sale is exercised, then the holder of the pledge must account to

the pledgor for any surplus after payment of the secured obligations. A pledge does not confer a right to appoint a receiver or foreclose. If the holder of pledge sells or disposes of the pledged assets when not entitled to do so, they may be liable in conversion to the pledgor. Legal lien A legal lien, in most common law systems, is a right to retain physical possession of tangible assets as security for the underlying obligations. In some jurisdictions it is a form of possessory security, and possession of the assets must be transferred to (and maintained by) the secured party. The right is purely passive; the secured party (the lienee) has no right to sell the assets - merely a right to refuse to return them until paid. In the United States, a lien can be a non-possessory security interest. See the main article: lien for a discussion of the differences between the United States and other common law countries. Most legal liens arise as a matter of law (mostly by common law, but also by statute), however, it is possible to create a legal lien by contract. The courts have confirmed that it is possible to also give the secured party a power of sale in such a contract, but case law on such a power is limited and it is difficult to know what limitations and duties would be imposed on the exercise of such a power. Equitable lien Equitable liens are slightly amorphous forms of security interest that only arise by operation of law in certain circumstances. Academically it has been noted that there seems to be no real unifying principle behind the circumstances that give rise to them. An equitable lien takes effect essentially as an equitable charge, and they arise only in specified situations, (e.g. an unpaid vendor's lien in relation to property is an equitable lien; a maritime lien is sometimes thought to be an equitable lien). It is sometimes argued that where the constitutional documents of a company provide that the company has a lien over its own shares, this take effect as an equitable lien, and if that analysis is correct, then it is probably the one exception to the rule that equitable liens arise by operation of law rather than by agreement. Hypothecation Hypothecation, or "trust receipts" are relatively uncommon forms of security interest whereby the underlying assets are pledged, not by delivery of the assets as in a conventional pledge, but by delivery of a document or other evidence of title. Hypothecation is usually seen in relation to bottomry (cf. bills of lading), whereby the bill of lading is endorsed by the secured party, who, unless the security is redeemed, can claim the property by delivery of the bill. Security interest vs. general obligation Some obligations are backed only by a security interest against specific designated property, and liability for repayment of the debt is limited to the property itself, with no further claim against the obligor. These are referred to as "nonrecourse obligations". Other obligations (i.e., recourse obligations) are backed by the full credit of the borrower. If the borrower defaults, then the creditor can force the obligor into bankruptcy and the creditors will divide all assets of the obligor.

Depending on the relative credit of the obligor, the quality of the asset, and the availability of a structure to separate the obligations of the asset from the obligations of the obligor, the interest rate charged on one may be higher or lower than the other. Perfection Perfection of security interests means different things to lawyers in different jurisdictions.

In American law, perfection is generally taken to refer to any steps required to ensure that the security interest remains enforceable on the debtor's bankruptcy.

With the Americanization of the world's legal profession, the second definition is becoming more frequently used commercially, and arguably is to be preferred, as the traditional English legal usage has little purpose except in relation to the comparatively rare true legal mortgage (very few other security interests require additional steps to attach to the asset, but security interests frequently require some form of registration to be enforceable on the chargor's insolvency). "Quasi-security" There are a number of other arrangements which parties can put in place which have the effect of conferring security in a commercial sense, but do not actually create a proprietary security interest in the assets. For example, it is possible to grant a power of attorney or conditional option in favour of the secured party relating to the subject matter, or to utilise a retention of title arrangement, or execute undated transfer instruments. Whilst these techniques may provide protection for the secured party, they do not confer a proprietary interest in the assets which the arrangements relate to, and their effectiveness may be limited if the debtor goes into bankruptcy. It is also possible to replicate the effect of security by making an outright transfer of the asset, with a provision that the asset is re-transferred once the secured obligations are repaid. In some jurisdictions, these arrangements may be recharacterised as the grant of a mortgage, but most jurisdictions tend to allow the parties freedom to characterise their transactions as they see fit. Common examples of this are financings using a stock loan or repo agreement to collateralise the cash advance, and title transfer arrangements (for example, under the "Transfer" form English Law credit support annex to an ISDA Master Agreement (as distinguished from the other forms of CSA, which grant security)). United States (the Uniform Commercial Code) In the late 1940s, the United States legal community arrived at a consensus that the traditional common law distinctions were obsolete and served no useful purpose. They tended to generate too much unnecessary litigation about whether the creditor had selected the correct type of security interest. The result was Article 9 of the Uniform Commercial Code, which regulates security interests in personal property (as opposed to real property) and establishes a unified concept of a security interest as a right in a debtor's property that secures payment or performance of an obligation. Article 9 was subsequently enacted in all 50 U.S. states as well as all U.S. territories. Many parts of Article 9, especially the idea that the traditional distinctions were hopelessly obsolete, were influential elsewhere and resulted in the enactment of Personal Property Security Acts throughout Canada.

Under Article 9, a security interest is created by a security agreement, under which the debtor grants a security interest in the debtor's property as collateral for a loan or other obligation. A security interest grants the holder a right to take a remedial action with respect to the property, upon occurrence of certain events, such as the non-payment of a loan. The creditor may take possession of such property in satisfaction of the underlying obligation. The holder will sell such property at a public auction or through a private sale, and apply the proceeds to satisfy the underlying obligation. If the proceeds exceed the amount of the underlying obligation, the debtor is entitled to the excess. If the proceeds fall short, the holder of the security interest is entitled to a deficiency judgment whereby the holder can institute additional legal proceedings to recover the full amount unless it is a non-recourse debt like many mortgage loans in the United States. In the U.S. the term "security interest" is often used interchangeably with "lien". However, the term "lien" is more often associated with the collateral of real property than with of personal property. A security interest is typically granted by a "security agreement". The security interest is established with respect to the property, if the debtor has an ownership interest in the property and the holder of the security interest conferred value to the debtor, such as giving a loan. The holder may "perfect" the security interest to put third parties on notice thereof. Perfection is typically achieved by filing a financing statement with government, often the secretary of state located at a jurisdiction where a corporate debtor is incorporated. Perfection can also be obtained by possession of the collateral, if the collateral is tangible property. Absent perfection, the holder of the security interest may have difficulty enforcing his rights in the collateral with regard to third parties, including a trustee in bankruptcy and other creditors who claim a security interest in the same collateral. Article 9 is limited in scope to personal property and fixtures (i.e., personal property attached to real property). Security interests in real property continue to be governed by non-uniform laws (in the form of statutory law or case law or both) which vary dramatically from state to state. In a slight majority of states, the deed of trust is the primary instrument for taking a security interest in real property, while the mortgage is used in the remainder.

Credit Risk
Credit risk refers to the risk that a borrower will default on any type of debt by failing to make payments which it is obligated to do. The risk is primarily that of the lender and include lost principal and interest, disruption to cash flows, and increased collection costs. The loss may be complete or partial and can arise in a number of circumstances. For example:

A consumer may fail to make a payment due on a mortgage loan, credit card, line of credit, or other loan

A company is unable to repay amounts secured by a fixed or floating charge over the assets of the company A business or consumer does not pay a trade invoice when due A business does not pay an employee's earned wages when due A business or government bond issuer does not make a payment on a coupon or principal payment when due An insolvent insurance company does not pay a policy obligation An insolvent bank won't return funds to a depositor A government grants bankruptcy protection to an insolvent consumer or business

To reduce the lender's credit risk, the lender may perform a credit check on the prospective borrower, may require the borrower to take out appropriate insurance, such as mortgage insurance or seek security or guarantees of third parties, besides other possible strategies. In general, the higher the risk, the higher will be the interest rate that the debtor will be asked to pay on the debt. Types of credit risk Credit risk can be classified in the following way:

Credit default risk - The risk of loss arising from a debtor being unlikely to pay its loan obligations in full or the debtor is more than 90 days past due on any material credit obligation; default risk may impact all credit-sensitive transactions, including loans, securities and derivatives. Concentration risk - The risk associated with any single exposure or group of exposures with the potential to produce large enough losses to threaten a bank's core operations. It may arise in the form of single name concentration or industry concentration. Country risk - The risk of loss arising from a sovereign state freezing foreign currency payments (transfer/conversion risk) or when it defaults on its obligations (sovereign risk).

Assessing credit risk Significant resources and sophisticated programs are used to analyze and manage risk. Some companies run a credit risk department whose job is to assess the financial health of their customers, and extend credit (or not) accordingly. They may use in house programs to advise on avoiding, reducing and transferring risk. They also use third party provided intelligence. Companies like Standard & Poor's, Moody's Analytics, Fitch Ratings, and Dun and Bradstreet provide such information for a fee. Most lenders employ their own models (credit scorecards) to rank potential and existing customers according to risk, and then apply appropriate strategies. With products such as unsecured personal loans or mortgages, lenders charge a higher price for higher risk customers and vice versa. With revolving products such as credit cards and overdrafts, risk is controlled through the setting of credit limits. Some products also require security, most commonly in the form of property. Credit scoring models also form part of the framework used by banks or lending institutions grant credit to clients. For corporate and commercial borrowers, these models generally have qualitative and quantitative sections outlining various aspects of the risk including, but not limited to, operating experience, management expertise, asset quality, and leverage and liquidity ratios, respectively. Once this

information has been fully reviewed by credit officers and credit committees, the lender provides the funds subject to the terms and conditions presented within the contract (as outlined above). Credit risk has been shown to be particularly large and particularly damaging for very large investment projects, so-called megaprojects. This is because such projects are especially prone to end up in what has been called the "debt trap," i.e., a situation where due to cost overruns, schedule delays, etc. the costs of servicing debt becomes larger than the revenues available to pay interest on and bring down the debt.

Documents of title and title transfer

Chain of title A chain of title is the sequence of historical transfers of title to a property. The "chain" runs from the present owner back to the original owner of the property. In situations where documentation of ownership is important, it is often necessary to reconstruct the chain of title. To facilitate this, a record of title documents may be maintained by a registry office or civil law notary. Chain of title for real property Real estate is one field where the chain of title has considerable significance. Various registration systems, such as the Torrens title system, have been developed to track the ownership of individual pieces of real property. In real estate transactions in the United States, insurance companies issue title insurance based upon the chain of title to the property when it is transferred. Title insurance companies sometimes maintain private title plants that track real estate titles in addition to the official records. In other cases, the chain of title is established by an abstract of title, sometimes, although not always, certified by an attorney. In the United States, some holders of mortgage debt may be unable to establish chain of title, despite the fact that clear chain of title can be required by the mortgage holder before foreclosure can proceed. Widespread lack of clarity in chain of title results from a 1995 decision by many lenders to rely on a third entity--often, a specific company, Mortgage Electronic Registration Systems (MERS)--to hold title nominally, in an effort to enable the buying and selling of mortgage liabilities without registration of changes of ownership with local governments. US states have objected and even sued over this practice. Chain of title for copyrights, trademarks, and rights of publicity In the motion picture industry, the chain of title involves the series of documentation which establishes proprietary rights in a film. The chain also applies to compilations in other fields, where many people have contributed to the project, thus acquiring authorship rights, or where materials were culled from many sources. Chain of title is extremely important to film purchasers and to film distributors, as it establishes the veracity of the owner's proprietary rights (or rights under license) in the intellectual property in a film, book or encyclopedia. Chain of title documentation can include:

copyright clearances on music from the regional collecting society, and to a less common extent, footage of other films; trademark clearances; talent agreements, which should incorporate a legal release from the talent, be they actors (including crowds), directors, cinematographers, choreographers, or others, to use their works, images, likeness and other personality rights in the film; proof of errors and omission insurance (a special form of insurance for motion picture producers which covers omissions in obtaining adequate chain of title).

Specialist organizations engage in the production of copyright property reports for motion picture studios, which cover original or unexploited works, and include the results of United States Copyright Office screening searches, author claimant searches, registration renewal searches and assignment searches. This involves reviewing US Copyright Office records from 1870 to present and numerous trade publications and databases, and Library of Congress records. Title (property) Title is a legal term for a bundle of rights in a piece of property in which a party may own either a legal interest or an equitable interest. The rights in the bundle may be separated and held by different parties. It may also refer to a formal document that serves as evidence of ownership. Conveyance of the document may be required in order to transfer ownership in the property to another person. Title is distinct from possession, a right that often accompanies ownership but is not necessarily sufficient to prove it. In many cases, both possession and title may be transferred independently of each other. Elements The main rights in the title bundle are usually:

Exclusive possession Exclusive use and enclosure Acquisition Conveyance, including by bequest Access easement Hypothecation Partition

The rights in real property may be separated further, examples including:

Water rights, including riparian rights and runoff rights In some U.S. states, water rights are completely separate from landsee prior appropriation water rights Mineral rights Easement to neighboring property, for utility lines, etc. Tenancy or tenure in improvements

Timber rights Farming rights Grazing rights Hunting rights Air rights Development rights to erect improvements under various restrictions Appearance rights, often subjected to local zoning ordinances and deed restrictions

Possession is the actual holding of a thing, whether or not one has any right to do so. The right of possession is the legitimacy of possession (with or without actual possession), the evidence for which is such that the law will uphold it unless a better claim is proven. The right of property is that right which, if all relevant facts were known (and allowed), would defeat all other claims. Each of these may be in a different person. For example, suppose A steals from B, what B had previously bought in good faith from C, which C had earlier stolen from D, which had been an heirloom of D's family for generations, but had originally been stolen centuries earlier (though this fact is now forgotten by all) from E. Here A has the possession, B has an apparent right of possession (as evidenced by the purchase), D has the absolute right of possession (being the best claim that can be proven), and the heirs of E, if they knew it, have the right of property, which they cannot prove. Good title consists in uniting these three (possession, right of possession, and right of property) in the same person(s). The extinguishing of ancient, forgotten, or unasserted claims, such as E's in the example above, was the original purpose of statutes of limitations. Otherwise, title to property would always be uncertain. Equitable versus legal title The equitable title is the right to obtain full ownership of property property, where another maintains legal title to the property. legal title is actual ownership of the property. When a contract for the sale of land is executed, equitable title passes to the buyer. When the conditions on the sale contract have been met, legal title passes to the buyer in what is known as closing. Legal and equitable title also arises in trust. In a trust, one person may own the legal title, such as the trustees. Another may own the equitable title such as the beneficiary. Another example is a land contract (also known as a contract for deed) whereby a seller transfers equitable title to a buyer and promises to transfer legal title upon the buyer's full payment. Similarly, mortgage servicers that sell REO (foreclosures) in bulk transfer equitable title to their buyers with the promise of delivering a trailing deed upon receipt of a foreclosure deed. Applications In countries with a sophisticated private property system, such as the United States, documents of title are commonly used for real estate, motor vehicles, and some types of intangible property. When such documents are used, they are often part of a registration system whereby ownership of such property can be verified. In some cases, a title can also serve as a permanent legal record of condemnation of property, such as in the case of an automobile junk or salvage title. In the case of real estate, the legal instrument used to transfer title is the deed. A famous rule is that a thief cannot convey good title, so title searches are

routine (or highly recommended) for purchases of many types of expensive property (especially real estate). In several counties and municipalities in the U.S. a standard title search (generally accompanied by title insurance) is required under the law as a part of ownership transfer. Paramount title is the best title in Fee simple available for the true owner. The person who is owner of real property with paramount title has the higher (or better, or "superior") right in an action toQuiet title. The concept is inherently a relative one. Technically, paramount title is not always the best (or highest) title, since it is necessarily based on some other person's title. A Quiet title action is a lawsuit to settle competing claims or rights to real property, for example, missing heirs, tenants, reverters, remainders and lien holders all competing to get ownership to the house or land. Each of the United States have different procedures for a quiet title action. However, most personal property items do not have a formal document of title. For such items, possession is the simplest indication of title, unless the circumstances give rise to suspicion about the possessor's ownership of the item. Proof of legal acquisition, such as a bill of sale or purchase receipt, is contributory. Transfer of possession to a good faith purchaser will normally convey title if no document is required.

Government Regulation of Business

1. Federal securities regulation Securities regulation in the United States Securities regulation in the United States is the field of U.S. law that covers various aspects of transactions and other dealings with securities. The term is usually understood to include both federal- and state-level regulation by purely governmental regulatory agencies, but sometimes may also encompass listing requirements of exchanges like the New York Stock Exchange and rules of self-regulatory organizations like the Financial Industry Regulatory Authority (FINRA). On the Federal level, the primary securities regulator is the Securities and Exchange Commission(SEC). However, Futures and some aspects of derivatives are regulated by the Federal Commodity Futures Trading Commission (CFTC). FINRA is a self-regulatory organization that promulgates rules that govern brokers and dealers and certain other kinds of professionals in the securities industry. It was formed by the merger of the enforcement divisions of the National Association of Securities Dealers (NASD) and the New York Stock Exchange. FINRA, like the exchanges, is overseen by the SEC, and FINRA's rules are generally subject to SEC approval. The federal securities laws were largely created as part of the New Deal. There are 5 particularly prominent federal securities laws: 1. Securities Act of 1933 - regulating distribution of new securities

2. 3. 4. 5.

Securities Exchange Act of 1934 - regulating trading securities, brokers and exchanges Trust Indenture Act of 1939 - regulating debt securities Investment Company Act of 1940 - regulating mutual funds Investment Advisers Act of 1940 - regulating investment advisers

Since these laws were originally enacted, Congress has amended them many times. The Holding Company Act and the Trust Indenture Act in particular have changed significantly since then. The titles listed above, including the year of original enactment, are the so-called "popular names" of these laws, and practitioners in this area reference these statutes using these popular names (e.g., "Section 10(b) of the Exchange Act" or "Section 5 of the Securities Act"). When they do so, they do not generally mean the original provisions of the original acts, they mean as amended to date. When Congress amends the securities laws, those amendments have their own popular names (a few prominent examples include Securities Investor Protection Act of 1970, the Insider Trading Sanctions Act of 1984, the Insider Trading and Securities Fraud Enforcement Act of 1988 and the Dodd-Frank Act). These acts often include provisions that state that they are amending one of the primary 5 laws. Although practitioners in this area use these popular names to reference the federal securities laws, like all U.S. statutes they are generally all codified in the U.S. Code, which is the official codification of U.S. statutory law. They are contained in Title 15. Thus, the official code citation for Section 5 of the Securities Act of 1933 is actually 15 U.S.C. section 77e. Not every law adopted by Congress is codified, because some of them just aren't appropriate for codification. E.g., appropriations are not codified. There are also fairly extensive regulations under these laws, largely made by the SEC. One of the most famous and often used SEC rules is Rule 10b-5, which prohibits fraud in securities transactions as well as insider trading. Because interpretations under rule 10b-5 often deem silence to be fraudulent in certain circumstances, efforts to comply with Rule 10b-5 and avoid lawsuits under 10b-5 have been responsible for a very large amount of corporate disclosure. The federal securities laws govern not only the offer and sale of securities, but also trading of securities, activities of certain professionals in the industry, investment companies like mutual funds, tender offers, proxy statements, and generally the regulation of public companies. Public company regulation is largely a disclosure-driven regime, but it has grown in recent years to the point that it begins to dictate certain issues of corporate governance. State laws governing issuance and trading of securities are commonly referred to as blue sky laws. Securities Act of 1933 Congress enacted the Securities Act of 1933 (the 1933 Act, the Securities Act, the Truth in Securities Act, the Federal Securities Act, or the '33 Act, 48 Stat. 74, enacted 1933-05-27, codified at 15 U.S.C. 77a et seq.), in the aftermath of the stock market crash of 1929 and during the ensuing Great Depression. Legislated pursuant to the interstate commerce clause of the Constitution, it requires that any offer or sale of securities using the means and instrumentalities of interstate commerce be registered with the SEC pursuant to the 1933 Act, unless an exemption from registration exists under the law. "Means and instrumentalities of interstate commerce" is extremely broad, and it is virtually impossible to avoid the operation of this statute by attempting to offer or sell a security without using an "instrumentality" of

interestate commerce. Any use of a telephone, for example, or the mails, would probably be enough to subject the transaction to the statute. The 1933 Act was the first major federal legislation to regulate the offer and sale of securities. Prior to the Act, regulation of securities was chiefly governed by state laws, commonly referred to as blue sky laws. When Congress enacted the 1933 Act, it left existing state securities laws ("blue sky laws") in place. The '33 Act is based upon a philosophy of disclosure, meaning that the goal of the law is to require issuers to fully disclose all material information that a reasonable shareholder would require in order to make up his or her mind about the potential investment. This is very different from the philosophy of the blue sky laws, which generally impose so-called "merit reviews." Blue sky laws often impose very specific, qualitative requirements on offerings, and if a company does not meet the requirements in that state then it simply will not be allowed to do a registered offering there, no matter how fully its faults are disclosed in the prospectus. Recently, however, NSMIA added a new Section 18 to the '33 Act which preempts blue sky law merit review of certain kinds of offerings. Purpose The primary purpose of the '33 Act is to ensure that buyers of securities receive complete and accurate information before they invest. Unlike state blue sky law, which imposes merit reviews, the '33 Act embraces a disclosure philosophy, meaning that in theory, it is not illegal to sell a bad investment, as long as all the facts are accurately disclosed. A company that is required to register under the '33 act must create a registration statement, which includes a prospectus, with copious information about the security, the company, the business, including audited financial statements. The company, the underwriter and other individuals signing the registration statement are strictly liable for any inaccurate statements in the document. This extremely high level of liability exposure drives an enormous effort, known as "due diligence," to ensure that the document is complete and accurate. The law is intended to in this way help bolster and maintain investor confidence in order to support the market. Registration process Unless they qualify for an exemption, securities offered or sold to the public in the U.S. must be registered by filing a registration statement with the SEC. Although the law is written to require registration of securities, it is more useful as a practical matter to consider the requirement to be that of registering offers and sales. If person A registers a sale of securities to person B, and then person B seeks to resell those securities, person B must still either file a registration statement or find an available exemption. The prospectus, which is the document through which an issuers securities are marketed to a potential investor, is included as part of the registration statement. The SEC prescribes the relevant forms on which an issuer's securities must be registered. Among other things, registration forms call for:

a description of the securities to be offered for sale; information about the management of the issuer; information about the securities (if other than common stock); and financial statements certified by independent accountants.

Registration statements and the incorporated prospectuses become public shortly after they are filed with the SEC. The statements can be obtained from the SEC's website using EDGAR. Registration statements are subject to SEC examination for compliance with disclosure requirements. It is illegal for an issuer to lie in, or to omit material facts from, a registration statement or prospectus. Not all offerings of securities must be registered with the SEC. Some exemptions from the registration requirements include:

private offerings to a specific type or limited number of persons or institutions; offerings of limited size; intrastate offerings; and securities of municipal, state, and federal governments.

One of the key exceptions to the registration requirement, Rule 144, is discussed in greater detail below. Regardless of whether securities must be registered, the 1933 Act makes it illegal to commit fraud in conjunction with the offer or sale of securities. A defrauded investor can sue for recovery under the 1933 Act. Rule 144 Rule 144, promulgated by the SEC under the 1933 Act, permits, under limited circumstances, the sale of restricted and controlled securities without registration. In addition to restrictions on the minimum length of time for which such securities must be held and the maximum volume permitted to be sold, the issuer must agree to the sale. If certain requirements are met, Form 144 [16] must be filed with the SEC. Often, the issuer requires that a legal opinion be given indicating that the resale complies with the rule. The amount of securities sold during any subsequent 3-month period generally does not exceed any of the following limitations:

1% of the stock outstanding the average weekly reported volume of trading in the securities on all national securities exchanges for the preceding 4 weeks the average weekly volume of trading of the securities reported through the consolidated transactions reporting system (NASDAQ)

Notice of resale is provided to the SEC if the amount of securities sold in reliance on Rule 144 in any 3month period exceeds 5,000 shares or if they have an aggregate sales price in excess of $50,000. After one year, Rule 144(k) allows for the permanent removal of the restriction except as to 'insiders'. In cases of mergers, buyouts or takeovers, owners of securities who had previously filed Form 144 and still wish to sell restricted and controlled securities must refile Form 144 once the merger, buyout, or takeover has been completed. Rule 144 is not to be confused with Rule 144A that provides a safe harbor from the registration requirements of the Securities Act of 1933 for certain private resales of restricted securities to qualified institutional buyers. Rule 144A has become the principal safe harbor on which non-U.S. companies rely when accessing the U.S. capital markets.

Regulation S Regulation S is a "safe harbor" that defines when an offering of securities is deemed to be executed in another country and therefore not be subject to the registration requirement under section 5 of the 1933 Act. The regulation includes two safe harbor provisions: an issuer safe harbor and a resale safe harbor. In each case, the regulation demands that offers and sales of the securities be made outside the United States and that no offering participant (which includes the issuer, the banks assisting with the offer and their respective affiliates) engage in "directed selling efforts". In the case of issuers for whose securities there is substantial U.S. market interest, the regulation also requires that no offers and sales be made to U.S. persons (including U.S. persons physically located outside the United States). Section 5 of the 1933 Act is meant primarily as protection for United States investors [17]. As such, the U.S. Securities and Exchange Commission had only weakly enforced regulation of foreign transactions, and had only limited constitutional authority to regulate foreign transactions. Civil liability Violation of the registration requirements can lead to civil liability for the issuer and underwriters sections 11, 12(a)(1) or 12(a)(2) of the Act. Additional liability may be imposed under the Securities Exchange Act of 1934 (Rule 10b-5). Securities Exchange Act of 1934 The Securities Exchange Act of 1934 (also called the Exchange Act, '34 Act, or Act of '34) (Pub.L. 73291, 48 Stat. 881, enacted June 6, 1934, codified at 15 U.S.C. 78a et seq.) is a law governing the secondary trading of securities (stocks, bonds, and debentures) in the United States of America. It was a sweeping piece of legislation. The Act and related statutes form the basis of regulation of the financial markets and their participants in the United States. The 1934 Act also established the Securities and Exchange Commission (SEC), the agency primarily responsible for enforcement of United States federal securities law. Companies raise billions of dollars by issuing securities in what is known as the primary market. Contrasted with the Securities Act of 1933, which regulates these original issues, the Securities Exchange Act of 1934 regulates the secondary trading of those securities between persons often unrelated to the issuer, frequently through brokers or dealers. Trillions of dollars are made and lost each year through trading in the secondary market. Securities exchanges One area subject to 34 Act regulation is the actual securities exchange -- the physical place where people purchase and sell securities (stocks, bonds, notes of debenture). Some of the more well known exchanges include the New York Stock Exchange, the American Stock Exchange, and regional exchanges like the Cincinnati Stock Exchange, Philadelphia Stock Exchange and Pacific Stock Exchange. At those places, agents of the exchange, or specialists, act as middlemen for the competing interests to buy and sell securities. An important function of the specialist is to inject liquidity and price continuity into the market. Given that people come to the exchange to easily acquire securities or to easily dispose of a portfolio of securities, the specialist's role is important to the exchange.

Securities associations The '34 Act also regulates broker-dealers without a status for trading securities. A telecommunications infrastructure has developed to provide for trading without a physical location. Previously these brokers would find stock prices through newspaper printings and conduct trades verbally by telephone. Today, a digital information network connects these brokers. This system is called NASDAQ, standing for the National Association of Securities Dealers Automated Quotation System. Self-regulatory organizations (SRO) In 1938 the Exchange Act was amended by the Maloney Act, which authorized the formation and registration of national securities associations, which would supervise the conduct of their members subject to the oversight of the SEC. That amendment led to the creation of the National Association of Securities Dealers, Inc. - the NASD, which is a Self-Regulatory Organization (or SRO). The NASD had primary responsibility for oversight of brokers and brokerage firms, and later, the NASDAQ stock market. In 1996 the SEC criticized the NASD for putting its interests as the operator of Nasdaq ahead of its responsibilities as the regulator, and the organization was split in two, one entity regulating the brokers and firms, the other regulating the NASDAQ market. In 2007 the NASD merged with the NYSE (which had already taken over the AMEX) and the Financial Industry Regulatory Authority (FINRA) was created, which is now the only SRO. Other trading platforms In the last 30 years, brokers have created two additional systems for trading securities. The alternative trading system, or ATS, is a quasi exchange where stocks are commonly purchased and sold through a smaller, private network of brokers, dealers, and other market participants. The ATS is distinguished from exchanges and associations in that the volumes for ATS trades are comparatively low, and the trades tend to be controlled by a small number of brokers or dealers. ATS acts as a niche market, a private pool of liquidity. Reg ATS, an SEC regulation issued in the late 1990s, requires these small markets to 1) register as a broker with the NASD, 2) register as an exchange, or 3) operate as an unregulated ATS, staying under low trading caps. A specialized form of ATS, the Electronic Communications Network (or ECN), has been described as the "black box" of securities trading. The ECN is a completely automated network, anonymously matching buy and sell orders. Many traders use one or more trading mechanisms (the exchanges, NASDAQ, and an ECN or ATS) to effect large buy or sell orders -- conscious of the fact that overreliance on one market for a large trade is likely to unfavorably alter the trading price of the target security. Issuers While the '33 Act recognizes that timely information about the issuer is vital to effective pricing of securities, the '33 Act's disclosure requirement (the registration statement and prospectus) is a one-time affair. The '34 Act extends this requirement to securities traded in the secondary market. Provided that the company has more than a certain number of shareholders and has a certain amount of assets (500 shareholders, above $10 million in assets, per Act sections 12, 13, and 15), the '34 Act requires that issuers regularly file company information with the SEC on certain forms (the annual 10-K [18] filing and the quarterly 10-Q filing). The filed reports are available to the public via EDGAR. If something material

happens with the company (change of CEO, change of auditing firm, destruction of a significant number of company assets), the SEC requires that the company soon issue an 8-K [19] filing that reflects these changed conditions (see Regulation FD). With these regularly required filings, buyers are better able to assess the worth of the company, and buy and sell the stock according to that information. Antifraud provisions While the '33 Act contains an antifraud provision (Section 17), when the '34 Act was enacted, questions remained about the reach of that antifraud provision and whether a private right of actionthat is, the right of an individual private citizen to sue [20] an issuer of stock or related market actor, as opposed to government suitsexisted for purchasers. As it developed, section 10(b) of the 1934 Act and corresponding SEC Rule 10b-5[21] have sweeping antifraud language. Section 10(b) of the Act (as amended) provides (in pertinent part): It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce or of the mails, or of any facility of any national securities exchange [. . .] (b) To use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered, or any securities-based swap agreement (as defined in section 206B of the Gramm-Leach-Bliley Act [22]), any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors. Section 10(b) is codified at 15 U.S.C. 78j(b) [23]. The breadth and utility of section 10(b) and Rule 10b-5 in the pursuit of securities litigation are significant. Rule 10b-5 has been employed to cover insider trading cases, but has also been used against companies for price fixing (artificially inflating or depressing stock prices through stock manipulation), bogus company sales to increase stock price, and even a company's failure to communicate relevant information to investors. Many plaintiffs in the securities litigation field plead violations of section 10(b) and Rule 10b-5 as a "catch-all" allegation, in addition to violations of the more specific antifraud provisions in the '34 Act. Exemptions from reporting because of national security Section 13(b)(3)(A) of the Securities Exchange Act of 1934 provides that "with respect to matters concerning the national security of the United States," the President or the head of an Executive Branch agency may exempt companies from certain critical legal obligations. These obligations include keeping accurate "books, records, and accounts" and maintaining "a system of internal accounting controls sufficient" to ensure the propriety of financial transactions and the preparation of financial statements in compliance with "generally accepted accounting principles." On May 5, 2006, in a notice in the Federal Register, President Bush delegated authority under this section to John Negroponte, the Director of National Intelligence. Administration officials toldBusiness Week that they believe this is the first time a President has ever delegated the authority to someone outside the Oval Office.

2. Other federal laws and regulations (antitrust, copyright, patents, money-laundering, labor, employment, and ERISA) Antitrust law Introduction The United States antitrust law is a body of laws that prohibits anti-competitive behavior (monopoly) and unfair business practices. Antitrust laws are intended to encourage competition in the marketplace. These competition laws make illegal certain practices deemed to hurt businesses or consumers or both, or generally to violate standards of ethical behavior. Government agencies known as competition regulators, along with private litigants, apply the antitrust and consumer protection laws in hopes of preventing market failure. The term antitrust was originally formulated to combat "corporate trusts," which were big businesses. Other countries use the term "competition law". Many countries including most of the Western world have antitrust laws of some form; for example the European Union has provisions under the Treaty of Rome to maintain fair competition, as does Australia under its Trade Practices Act 1974. Prohibited anti-competitive behavior A distinction between single-firm and multi-firm conduct is fundamental to the structure of U.S. antitrust law, which, as noted antitrust scholar Phillip Areeda has pointed out, "contains a 'basic distinction between concerted and independent action.'" Multi-firm conduct tends to be seen as more likely than single-firm conduct to have an unambiguously negative effect and "is judged more sternly." European competition law also includes a fundamental distinction between single-firm and multi-firm conduct, but a different analytical structure is applied. In U.S. antitrust law, the Sherman Act addresses single-firm conduct by providing a remedy against "[e]very person who shall monopolize, or attempt to monopolize...any part of the trade or commerce among the several States." This prohibition does not condemn monopoly per se but only monopoly that has been acquired or maintained through prohibited conduct. With regard to multi-firm conduct, the Sherman Act addresses this by prohibiting "[e]very contract, combination in the form of trust or otherwise, or conspiracy, in restraint of trade or commerce." Conduct falls within the scope of this prohibition only if some form of agreement or concerted action can be proven. In considering multi-firm conduct, another distinction is also fundamental: the distinction between conduct that is deemed anticompetitive per se and conduct that may be found to be anticompetitive after a reasoned analysis. There does not appear to be a precedent for per se condemnation of single-firm conduct. Monopoly power alone, without some act of wrongful exclusion or other legally cognizable anticompetitive conduct, is not prohibited. To the contrary, as the judge Learned Hand noted, "[t]he successful competitor, having been urged to compete, must not be turned on when he wins." U.S. antitrust law thus does not attack monopoly power obtained through "superior skill, foresight and industry." While the prohibition against multi-firm anticompetitive goes against agreements "in restraint of trade", it is not enough to show that an agreement in some technical way restrains trade. Under U.S. law, at least, the scope of the prohibition is limited to those agreements where the restraint of trade is unreasonable:

Every agreement concerning trade, every regulation of trade, restrains. To bind, to restrain, is of their very essence. The true test of legality is whether the restraint imposed is such as merely regulates and perhaps thereby promotes competition or whether it is such as may suppress or even destroy competition. One such obviously anticompetitive conduct as overt price fixing, for example, is placed into this per se category of conduct so clearly detrimental to competition that detailed analysis is unnecessary. Otherwise, antitrust plaintiffs are required to demonstrate, by "the facts peculiar to the business to which the restraint is applied", the nature of the challenged conduct and why it is harmful to competition. The following types of activity are often subject to antitrust scrutiny.

Price fixing: An agreement between business competitors selling the same product or service regarding its pricing Bid rigging: A form of price fixing and market allocation that involves an agreement in which one party of a group of bidders will be designated to win the bid Geographic market allocation: An agreement between competitors not to compete within each other's geographic territories. Walker Process fraud: Illegal monopolization through the maintenance and enforcement of a patent obtained via fraud on the Patent Office (the term comes from the Supreme Court case Walker Process Equipment, Inc. v. Food Machinery & Chemical Corp., 382 U.S. 172 (1965)).

Consumer protection Consumer protection laws seek to regulate certain aspects of the commercial relationship between consumers and business, such as by requiring minimum standards of product quality, requiring the disclosure of certain details about a product or service (e.g., with regard to cost, or implied warranty), prohibiting misleading advertising, or prescribing financial compensation for product liability. Consumer protection laws are distinct from anti-trust. Some consumer protection laws are enforced by the U.S. Federal Trade Commission, which also has anti-trust responsibilities. However, many competition agencies including the Justice Department antitrust division and the European Commission Directorate General for competition lack authority over consumer protection. Proponents of the Chicago school of economics are generally suspicious (and critical) of government intervention in the economy, including anti-trust laws and competition policies. Judge Robert Bork's writings on anti-trust law, along with those of Richard Posner and other law and economics thinkers, were heavily influential in causing a shift in the U.S. Supreme Court's approach to antitrust laws since the 1970s, to be focused solely on what is best for the consumer rather than the company's practices. Rationale Efficiency-oriented economists reject the goal of competition and instead argue that antitrust legislation should be changed to primarily benefit consumers. No Congress or administration has supported this position. These economists largely ignore the political issues that motivated the laws in the first place.Anti-trust laws prohibit agreements in restraint of trade, monopolization and attempted monopolization, anticompetitive mergers and tie-in schemes, and, in some circumstances, price

discrimination in the sale of commodities. Anti-competitive agreements among competitors, such as price fixing and customer and market allocation agreements, are typical types of restraints of trade proscribed by the antitrust laws. These type of conspiracies are considered pernicious to competition and are generally proscribed outright by the antitrust laws. Resale price maintenance by manufacturers is another form of agreement in restraint of people working together. Other agreements that may have an impact on competition are generally evaluated using a balancing test, under which legality depends on the overall effect of the agreement. Monopolization and attempted monopolization are offenses that may be committed by an individual firm, even without an agreement with any other enterprise. Unreasonable exclusionary practices that serve to entrench or create monopoly power can therefore be unlawful. Allegations of predatory pricing by large companies can be the basis for a monopolization claim, but it is difficult to establish the required elements of proof. Large companies with huge cash reserves and large lines of credit can stifle competition by engaging in predatory pricing; that is, by selling their products and services at a loss for a time, in order to force their smaller competitors out of business. With no competition, they are then free to consolidate control of the industry and charge whatever prices they wish. At this point, there is also little motivation for investing in further technological research, since there are no competitors left to gain an advantage over. High barriers to entry such as large upfront investment, notably named sunk costs, requirements in infrastructure and exclusive agreements with distributors, customers, and wholesalers ensure that it will be difficult for any new competitors to enter the market, and that if any do, the trust will have ample advance warning and time in which to either buy the competitor out, or engage in its own research and return to predatory pricing long enough to force the competitor out of business. From an economics perspective, the relatively recent industrial organization research has focused on construction of microeconomic models that predict and/or explain the prevalence of imperfectly competitive markets and deviations from competitive behavior, partly as a response to the criticisms of antitrust laws and policies by the Chicago School and by members of the law and economics school of thought. Enforcement Federal government The federal government, via both the Antitrust Division of the United States Department of Justice and the Federal Trade Commission, can bringcivil lawsuits enforcing the laws. The United States Department of Justice alone may bring criminal antitrust suits under federal antitrust laws. Perhaps the most famous antitrust enforcement actions brought by the federal government were the break-up of AT&T's local telephone service monopoly in the early 1980s and its actions against Microsoft in the late 1990s. Additionally, the federal government also reviews potential mergers to attempt to prevent market concentration. As outlined by the Hart-Scott-Rodino Antitrust Improvements Act, larger companies attempting to merge must first notify the Federal Trade Commission and the Department of Justice's Antitrust Division prior to consummating a merger. These agencies then review the proposed merger first by defining what the market is and then determining the market concentration using the Herfindahl-

Hirschman Index (HHI) and each company's market share. The government looks to avoid allowing a company to develop market power, which if left unchecked could lead to monopoly power. State governments State attorneys general may file suits to enforce both state and federal antitrust laws. Private suits Private civil suits may be brought, in both state and federal court, against violators of state and federal antitrust law. Federal antitrust laws, as well as most state laws, provide for triple damages against antitrust violators in order to encourage private lawsuit enforcement of antitrust law. Thus, if a company is sued for monopolizing a market and the jury concludes the conduct resulted in consumers' being overcharged $200,000, that amount will automatically be tripled, so the injured consumers will receive $600,000. The United States Supreme Court summarized why Congress authorized private antitrust lawsuits in the case Hawaii v. Standard Oil Co. of Cal., 405 U.S. 251, 262 (1972): Every violation of the antitrust laws is a blow to the free-enterprise system envisaged by Congress. This system depends on strong competition for its health and vigor, and strong competition depends, in turn, on compliance with antitrust legislation. In enacting these laws, Congress had many means at its disposal to penalize violators. It could have, for example, required violators to compensate federal, state, and local governments for the estimated damage to their respective economies caused by the violations. But, this remedy was not selected. Instead, Congress chose to permit all persons to sue to recover three times their actual damages every time they were injured in their business or property by an antitrust violation. By offering potential litigants the prospect of a recovery in three times the amount of their damages, Congress encouraged these persons to serve as "private attorneys general."

Secured transactions
Generally, a secured transaction is a loan or a credit transaction in which the lender acquires a security interest in collateral owned by the borrower and is entitled to foreclose on or repossess the collateral in the event of the borrower's default. The terms of the relationship are governed by a contract, or security agreement. A common example would be a consumer who purchases a car on credit. If the consumer fails to make the payments on time, the lender will take the car and resell it, applying the proceeds of the sale toward the loan. Mortgages and deeds of trust are another example. In the United States, secured transactions in personal property (that is, anything other than real property) are governed by Article 9 of the Uniform Commercial Code (U.C.C.). The law treats differently those creditors who are secured (i.e. have an authenticated, perfected security

interest) from those creditors who are unsecured. An unsecured creditor is simply a person who is owed money and has not received payment according to the terms of the agreed upon transaction. Upon default of a debtor who has multiple creditors, the distinction between being a secured creditor and an unsecured creditor is huge in the eyes of the law. The secured creditor will generally always have priority to getting his money before the unsecured creditors do. In other words, the unsecured creditor is at the back of the line of priority - his only remedy is to obtain a judgment from the court for the amount of the defaulted loan. The following example is given: A debtor borrows $10,000 from a car dealership to purchase an automobile, using the automobile itself as collateral for the loan (in other words the dealership retains a right to repossess the automobile in the event the debtor defaults on the loan). The dealership makes this loan using an authenticated security agreement - a signed agreement giving the dealership the secured right to repossess the car in the event of default of the debtor. The debtor also has two unsecured creditors who have made loans of $1000 each to the debtor. Neither of these creditors has a security agreement - their only method of recovering their money in the event that the debtor defaults on the loan is through the judicial system, whereas the secured creditor can simply repossess the car at his option (This is called self-help repossession and is completely legal provided the secured creditor does not breach the peace in doing so). The debtor is in debt $10K to the secured creditor and $2000 to the unsecured creditors. Assume the debtor defaults and his only asset is the automobile. The dealership can repossess the auto and sell it to satisfy its debt. Two things can happen here: 1) The dealership sells the collateral (car) for more than the amount of the debt (let's say $15K). In this case, the debtor would receive the excess $5K (surplus) which he would use to satisfy the debts of his unsecured creditors (and then would have $3K left over). 2) The dealership repossess the car and sells it for less than the amount of the debt, let's say $9K (more likely scenario). In this case, the secured creditor dealership keeps the $9K, and the remaining $1K (deficiency) that the dealership is owed becomes unsecured - it is on the same level of priority as the other two unsecured loans. Those three unsecured claims of $1K each will be paid off equally. Thus, if the debtor has $1500 to satisfy its debts - each unsecured creditor would get $500 (1/2 of amount each). The remaining debt will probably never be repaid because, in cases such as these with the debtor having multiple loans on default, the debtor has most likely filed for Ch. 7 Bankruptcy. It is crucial, if you are a lender, to have a security agreement in collateral that you are confident is worth at least as much as the amount of the loan you made to the debtor. If not, your deficiency in that amount is unsecured. In the previous example - the dealership loaned $10K on a car that had a fair market value of only $9K. Thus, they were deficient $1K which becomes unsecured.

Uniform Commercial Code

Uniform Commercial Code The Uniform Commercial Code (UCC or the Code), first published in 1952, is one of a number

of uniform acts that have been promulgated in conjunction with efforts to harmonize the law of sales and other commercial transactions in all 50 states within the United States of America. Goals The goal of harmonizing state law is important because of the prevalence of commercial transactions that extend beyond one state. For example, goods may be manufactured in State A, warehoused in State B, sold from State C and delivered in State D. The UCC therefore achieved the goal of substantial uniformity in commercial laws and, at the same time, allowed the states the flexibility to meet local circumstances by modifying the UCC's text as enacted in each state. The UCC deals primarily with transactions involving personal property (movable property), not real property (immovable property). Other goals of the UCC were to modernize contract law and to allow for exceptions from the common law in contracts between merchants. History The UCC is the longest and most elaborate of the uniform acts. The Code has been a long-term, joint project of the National Conference of Commissioners on Uniform State Laws (NCCUSL) and the American Law Institute (ALI), who began drafting its first version in 1942. Judge Herbert F. Goodrich was the Chairman of the Editorial Board of the original 1952 edition, and the Code itself was drafted by some of the top legal scholars in the United States, including Karl N. Llewellyn, William A. Schnader, Soia Mentschikoff, and Grant Gilmore. The Code, as the product of private organizations, is not itself the law, but only a recommendation of the laws that should be adopted in the states. Once enacted by a state, the UCC is codified into the states code of statutes. A state may adopt the UCC verbatim as written by ALI and NCCUSL, or a state may adopt the UCC with specific changes. Unless such changes are minor, they can seriously obstruct the Code's express objective of promoting uniformity of law among the various states. Thus persons doing business in different states must check local law. The ALI and NCCUSL have established a permanent editorial board for the Code. This board has issued a number of official comments and other published papers. Although these commentaries do not have the force of law, courts interpreting the Code often cite them as persuasive authority in determining the effect of one or more provisions. Courts interpreting the Code generally seek to harmonize their interpretations with those of other states that have adopted the same or a similar provision. UCC Articles The 1952 Uniform Commercial Code was released after ten years of development, and revisions were made to the Code from 1952 to 1999. The Uniform Commercial Code deals with the following subjects under consecutively numbered Articles: In 1989, the National Conference of Commissioners on Uniform State Laws recommended that Article 6 of the UCC, dealing with bulk sales, be repealed as obsolete. Approximately 45 states have done so. Two others have followed the alternative recommendation of revising Article 6.In 2003, amendments to Article 2 modernizing many aspects (as well as changes to Article 2A and Article 7) were proposed by the NCCUSL and the ALI. Because no states adopted the amendments and, due to industry opposition, none

were likely to, in 2011 the sponsors withdrew the amendments. As a result, the official text of the UCC now corresponds to the law that most states have enacted. A major revision of Article 9, dealing primarily with transactions in which personal property is used as security for a loan or extension of credit, was enacted in all states. The revision had a uniform effective date of July 1, 2001 although in a few states it went into effect shortly after that date. In 2010, NCCUSL and the ALI proposed modest amendments to Article 9. Several states have already enacted these amendments, which have a uniform effective date of July 1, 2013. The overriding philosophy of the Uniform Commercial Code is to allow people to make the contracts they want, but to fill in any missing provisions where the agreements they make are silent. The law also seeks to impose uniformity and streamlining of routine transactions like the processing of checks, notes, and other routine commercial paper. The law frequently distinguishes between merchants, who customarily deal in a commodity and are presumed to know well the business they are in, and consumers, who are not. The UCC also seeks to discourage the use of legal formalities in making business contracts, in order to allow business to move forward without the iintervention of lawyers or the preparation of elaborate documents. This last point is perhaps the most questionable part of its underlying philosophy; many in the legal profession have argued that legal formalities discourage litigation by requiring some kind of ritual that provides a clear dividing line that tells people when they have made a final deal over which they could be sued. Article 2 Article 2, dealing with sales, and Article 2A, dealing with leases, have not been adopted by Louisiana, as its provisions are inconsistent with the Louisiana Civil Code, which is based on civil law as opposed to common law. Contract formation

Firm offers (offers by a merchant to buy or sell goods and promising to keep the offer open for a period of time) are valid without consideration if signed by the offeror, and are irrevocable for the time stated (but no longer than 3 months), or, if no time is stated, for a reasonable time. Offer to buy goods for prompt shipment invites acceptance by either prompt shipment or a prompt promise to ship. Therefore, this offer is not strictly unilateral. However, this acceptance by performance does not even have to be by conforming goods 2-206(1) Consideration -- modifications without consideration may be acceptable in a contract for the sale of goods. 2-209(1) Failure to state priceIn a contract for the sale of goods, the failure to state a price will not prevent the formation of a contract if the parties' original intent was to form a contract. A reasonable price will be determined by the court. [2-305] Assignments -- a requirements contract can be assigned, provided the quantity required by the assignee is not unreasonably disproportionate to original quantity. 2-306

Contract repudiation and breach

Nonconforming goodsIf non-conforming goods are sent with a note of accommodation, such tender is construed as a counteroffer, and if accepted, forms a new contract and binds buyer at previous contract price. If seller refuses to conform and buyer does not accept, the buyer can sell the goods at public or private auction and credit the proceeds to amount owed. Perfect tenderThe buyer however does have a right of perfect tender and can accept all, reject all, or accept conforming goods and reject the rest, within a reasonable time after delivery but before acceptance, he must notify the seller of the rejection. If the buyer does not give a specific reason (defect), he cannot rely on the reason later, in legal proceedings. (akin to the cure before cover rationale). Also, the contract is not breached per se if the seller delivered the non-conforming goods, however offensive, before the date of performance has hit. Reasonable time/good faith standardSuch standard is required from a party to a contract indefinite as to time, or made indefinite by waiver of original provisions. Requirements/Output contractsThe UCC provides protection against disproportionate demands, but must meet the good faith requirement. Reasonable grounds for insecurityIn a situation with a threat of non-performance, the other part may suspend its own performance and demand assurances in writing. If assurance not provided within a reasonable time not exceeding 30 days, the contract is repudiated. [2-609] Battle of formsNew terms will be incorporated into the agreement unless 1) offer limited to its own terms, 2) materially alter original terms (limit liability etc.), 3) first party objects to new terms in a timely manner, or first party has already objected to new terms. Look at what the item is to determine whether the new terms materially alter the original offer. (delay in delivery of nails not the same as for fish). Battle of formsA written confirmation of an offer sent within a reasonable time operates as an acceptance even though it states terms additional terms to or different from those offered, unless acceptance is expressly made conditional to the additions. Statute of frauds as applicable to the sale of goodsThe actual contract does not need to be in writing. Just some note or memo must be in writing and signed. However, the UCC exception to the signature requirement is where written confirmation is received and not objected to within 10 days [2-201(2)] Cure/coverBuyer must give seller time to cure the defective shipment before seeking cover FOB place of businessThe seller assumes risk of loss until goods are placed on a carrier. FOB destination: seller risks loss until shipment arrives at destination. If the contract leaves out the delivery place, it is the sellers place of business. Risk of lossEquitable conversion does not apply. In sale of specific goods, the risk of loss lies with the seller until tender. Generally, the seller bears risk of loss until the buyer takes physical possession of the goods (the opposite of realty) Crop failureCrop failures resulting from an unexpected cause excuses a farmers obligation to deliver the full amount as long as he makes a fair and reasonable allocation among his buyers. The buyer may accept the proposed modification or terminate the contract.

ReclamationSuccessful reclamation of goods excludes all other remedies with respect to the goods [2-702(3)]. A seller can reclaim goods upon demand within 20 days after buyer receives them if the seller discovers that the buyer received the goods while insolvent. Rightfully rejected goodsA merchant buyer may follow reasonable instructions of the seller to reject the goods. If no such instructions are given, the buyer make a reasonable effort to sell them, and the buyer/bailee entitled to 10% of the gross proceeds. InsolvencyIf a buyer is insolvent, the seller may refuse to deliver the goods except for cash, including goods already delivered under the contract [2-702] Implied warranty of fitnessImplied warranty of fitness arises when the seller knows the buyer is relying upon his expertise in choosing goods. Implied warranty of merchantability: every sale of goods fit for ordinary purposes. Express warranties: arise from any statement of fact of promise. UCC damages for repudiating/breaching sellerDifference between 1) the market price when the buyer learned of breach and the 2) contract price 3) plus incidental damages. An aggrieved seller simply suing for the contract price is economically inefficient. [2-713] Specially manufactured goodsSpecially manufactured goods are exempt from statute of frauds where manufacturer has made a substantial beginning or commitments for the procurement of supplies.

Section 2-207: Battle of the forms One of the most confusing and fiercely litigated sections of the UCC is Section 2-207, which Professor Grant Gilmore called "arguably the greatest statutory mess of all time." It governs a "battle of the forms" as to whose boilerplate terms, those of the offeror or the offeree, will survive a commercial transaction where multiple forms with varying terms are exchanged. This problem frequently arises when parties to a commercial transaction exchange routine documents like requests for proposals, invoices, purchase orders, and order confirmations, all of which may contain conflicting boilerplate provisions. The first step in the analysis is to determine whether the UCC or the common law governs the transaction. If the UCC governs, courts will usually try to find which form constitutes the offer. Next, offeree's acceptance forms bearing the different terms is examined. One should note whether the acceptance is expressly conditional on its own terms. If it is expressly conditional, it is a counteroffer, not an acceptance. If performance is accepted after the counteroffer, even without express acceptance, under 2207(3), a contract will exist under only those terms on which the parties agree, together with UCC gapfillers. If the acceptance form does not expressly limit acceptance to its own terms, and both parties are merchants, offeror's acceptance of offeree's performance, though offeree's forms contain additional or different terms, forms a contract. At this point, if offeree's terms cannot coexist with offeror's terms, both terms are "knocked out" and UCC gap-fillers step in. If offeree's terms are simply additional, they will be considered part of the contract unless (a) the offeror expressly limits acceptance to the terms of the original offer, (b) the new terms materially alter the original offer or (c) notification of objection to the new terms has already been given or is given within a reasonable time after they are promulgated by the offeree.

Because of the massive confusion engendered by Section 2-207, a revised version was promulgated in 2003, but the revision has not yet been adopted as law by any state. Article 8 The ownership of securities is governed by Article 8 of the Uniform Commercial Code (UCC). This Article 8, a text of about thirty pages, underwent important recasting in 1994. That update of the UCC treats the majority of the transfers of dematerialized securities as mere reflections of their respective initial issue registered by the two American central securities depositories, respectively the Depository Trust Company (DTC) for the securities issued by corporations and the Federal reserve for the securities issued by the Treasury Department. In this centralised system, the title transfer of the securities does not take place at the time of the registration on the account of the investor, but within the systems managed by the DTC or by the Federal reserve. This centralization is not accompanied by a centralized register of the investors/owners of the securities, such as the systems established in Sweden and in Finland (so-called "transparent systems"). Neither the DTC nor the Federal Reserve hold an individual register of the transfers of property. The consequence for an investor is that proving ownership of its securities relies entirely on the accurate replication of the transfer recorded by the DTC and FED at the lower tiers of the holding chain of the securities. Each one of these links is composed respectively of an account provider (or intermediary) and of an account holder. The rights created through these links, are purely contractual claims: these rights are of two kinds: 1) For the links where the account holder is itself an account provider at a lower tier, the right on the security during the time where it is credited there is characterized as a "securities entitlement", which is an "ad hoc" concept invented in 1994: i.e. designating a claim that will enable the account holder to take part to a prorate distribution in the event of bankruptcy of its account provider. 2) For the last link of the chain, in which the account holder is at the same time the final investor, its "security entitlement" is enriched by the "substantial" rights defined by the issuer: the right to receive dividends or interests and, possibly, the right to take part in the general meetings, when that was laid down in the account agreement concluded with the account provider. The combination of these reduced material rights and of these variable substantial rights is characterised by article 8 of the UCC as a "beneficial interest". This decomposition of the rights organized by Article 8 of the UCC results in preventing the investor to revindicate the security in case of bankruptcy of the account provider, that is to say the possibility to claim the security as its own asset, without being obliged to share it at its prorate value with the other creditors of the account provider. As a consequence, it also prevents the investor from asserting its securities at the upper level of the holding chain, either up to the DTC or up to a sub-custodian. Such a "security entitlement," unlike a normal ownership right, is no longer enforceable "erga omnes" to any person supposed to have the security in its custody. The "security entitlement" is a mere relative right, therefore a contractual right. This re-characterization of the proprietary right into a simple contractual right may enable the account provider, to "re-use" the security without having to ask for the authorization of the investor. This is especially possible within the framework of temporary operations such as security lending, option to

repurchase, buy to sell back or repurchase agreement. This system the distinction between the downward holding chain which traces the way in which the security was subscribed by the investor and the horizontal and/or ascending chains which trace the way in which the security has been transferred or subdeposited. Contrary to claims suggesting that Article 8 denies American investors their security rights held through intermediaries such as banks, Article 8 has also helped US negotiators during the negotiations of the Geneva Securities Convention, also known as the Unidroit convention on substantive rules for intermediated securities. Article 9 Article 9 governs how security interests may be obtained in personal property to secure a debt. In Article 9 the owner of the collateral is referred to as the debtor and the creditor is referred to as the secured party. Fundamental concepts under Article 9 include how a security interest is created in property (attachment); how security interests are made generally effective against third parties with a claim to the collateral (perfection); which among multiple security interests or other claims to the collateral is best ("priority"); and what remedies are available to the secured party if the debtor defaults in payment or performance of the secured obligation. In general, Article 9 does not govern real property security interests, except for fixtures to real property. Mortgages, deeds of trust, and installment land contracts, which are the principal forms of real property security interests, remain governed by non-uniform state laws. 1. Sales contracts 2. Negotiable instruments Negotiable Instrument A negotiable instrument is a document guaranteeing the payment of a specific amount of money, either on demand, or at a set time. Negotiable instruments are often defined in legislation. For example, according to the Section 13 of the Negotiable Instruments Act, 1881 in India, a negotiable instrument means a promissory note, bill of exchange or cheque payable either to order or to bearer. So, in India, there are just three types of negotiable instruments such as promissory note, bill of exchange and cheque. Cheque also includes Demand Draft [Section 85A]. More specifically, it is a document contemplated by a contract, which (1) warrants the payment of money, the promise of or order for conveyance of which is unconditional; (2) specifies or describes the payee, who is designated on and memorialized by the instrument; and (3) is capable of change through transfer by valid negotiation of the instrument. As a negotiable instrument is a promise of a payment of money, the instrument itself can be used by the holder in due course as a store of value; although, instruments can be transferred for amounts in contractual exchange that are less than the instruments face value (known as discounting). Under United States law, Article 3 of the Uniform Commercial Code as enacted in the applicable State

law governs the use of negotiable instruments, except banknotes (Federal Reserve Notes, aka "paper dollars"). Negotiable instruments distinguished from other types of contracts A negotiable instrument can serve to convey value constituting at least part of the performance of a contract, albeit perhaps not obvious in contract formation, in terms inherent in and arising from the requisite offer and acceptance and conveyance of consideration. The underlying contract contemplates the right to hold the instrument as, and to negotiate the instrument to, a holder in due course, the payment on which is at least part of the performance of the contract to which the negotiable instrument is linked. The instrument, memorializing (1) the power to demand payment; and, (2) the right to be paid, can move, for example, in the instance of a 'bearer instrument', wherein the possession of the document itself attributes and ascribes the right to payment. Certain exceptions exist, such as instances of loss or theft of the instrument, wherein the possessor of the note may be a holder, but not necessarily a holder in due course. Negotiation requires a validendorsement of the negotiable instrument. The consideration constituted by a negotiable instrument is cognizable as the value given up to acquire it (benefit) and the consequent loss of value (detriment) to the prior holder; thus, no separate consideration is required to support an accompanying contract assignment. The instrument itself is understood as memorializing the right for, and power to demand, payment, and an obligation for payment evidenced by the instrument itself with possession as a holder in due course being the touchstone for the right to, and power to demand, payment. In some instances, the negotiable instrument can serve as the writing memorializing a contract, thus satisfying any applicable Statute of Frauds as to that contract. The holder in due course The rights of a holder in due course of a negotiable instrument are qualitatively, as matters of law, superior to those provided by ordinary species of contracts:

The rights to payment are not subject to set-off, and do not rely on the validity of the underlying contract giving rise to the debt (for example if a cheque was drawn for payment for goods delivered but defective, the drawer is still liable on the cheque) No notice need be given to any party liable on the instrument for transfer of the rights under the instrument by negotiation. However, payment by the party liable to the person previously entitled to enforce the instrument "counts" as payment on the note until adequate notice has been received by the liable party that a different party is to receive payments from then on. [U.C.C. 3-602(b)] Transfer free of equitiesthe holder in due course can hold better title than the party he obtains it from (as in the instance of negotiation of the instrument from a mere holder to a holder in due course)

Negotiation often enables the transferee to become the party to the contract through a contract assignment (provided for explicitly or by operation of law) and to enforce the contract in the transferee-assignees

own name. Negotiation can be effected by endorsement and delivery (order instruments [9]), or by delivery alone (bearer instruments). Classes Promissory notes and bills of exchange are two primary types of negotiable instruments. Promissory note A promissory note is an unconditional promise in writing made by one person to another, signed by the maker, engaging to pay on demand to the payee, or at fixed or determinable future time, certain in money, to order or to bearer. (see Sec.194) Bank note is frequently referred to as a promissory note, a promissory note made by a bank and payable to bearer on demand. Bill of exchange A bill of exchange or "draft" is a written order by the drawer to the drawee to pay money to the payee. A common type of bill of exchange is the cheque, defined as a bill of exchange drawn on a banker and payable on demand. Bills of exchange are used primarily in international trade, and are written orders by one person to his bank to pay the bearer a specific sum on a specific date. Prior to the advent of paper currency, bills of exchange were a common means of exchange. They are not used as often today. A bill of exchange is essentially an order made by one person to another to pay money to a third person. A bill of exchange requires in its inception three partiesthe drawer, the drawee, and the payee. The person who draws the bill is called the drawer. He gives the order to pay money to the third party. The party upon whom the bill is drawn is called the drawee. He is the person to whom the bill is addressed and who is ordered to pay. He becomes an acceptor when he indicates his willingness to pay the bill. The party in whose favor the bill is drawn or is payable is called the payee. The parties need not all be distinct persons. Thus, the drawer may draw on himself payable to his own order. A bill of exchange may be endorsed by the payee in favour of a third party, who may in turn endorse it to a fourth, and so on indefinitely. The "holder in due course" may claim the amount of the bill against the drawee and all previous endorsers, regardless of any counterclaims that may have disabled the previous payee or endorser from doing so. This is what is meant by saying that a bill is negotiable. In some cases a bill is marked "not negotiable" see crossing of cheques. In that case it can still be transferred to a third party, but the third party can have no better right than the transferor. In the United States In the United States, Article 3 and Article 4 of the Uniform Commercial Code govern the issuance and transfer of negotiable instruments. The various State law enactments of Uniform Commercial Code 3104(a) through (d) set forth the legal definition of what is and what is not a negotiable instrument: 3-104. NEGOTIABLE INSTRUMENT. (a) Except as provided in subsections (c) and (d), "negotiable instrument" means an unconditional promise or order to pay a fixed amount of money, with or without interest or other charges described in the

promise or order, if it: (1) is payable to bearer or to order at the time it is issued or first comes into possession of a holder; (2) is payable on demand or at a definite time; and (3) does not state any other undertaking or instruction by the person promising or ordering payment to do any act in addition to the payment of money, but the promise or order may contain (i) an undertaking or power to give, maintain, or protect collateral to secure payment, (ii) an authorization or power to the holder to confess judgment or realize on or dispose of collateral, or (iii) a waiver of the benefit of any law intended for the advantage or protection of an obligor. (b) "Instrument" means a negotiable instrument. (c) An order that meets all of the requirements of subsection (a), except paragraph (1), and otherwise falls within the definition of "check" in subsection (f) is a negotiable instrument and a check. (d) A promise or order other than a check is not an instrument if, at the time it is issued or first comes into possession of a holder, it contains a conspicuous statement, however expressed, to the effect that the promise or order is not negotiable or is not an instrument governed by this Article. Thus, for a writing to be a negotiable instrument under Article 3, the following requirements must be met: 1. 2. 3. 4. The promise or order to pay must be unconditional; The payment must be a specific sum of money, although interest may be added to the sum; The payment must be made on demand or at a definite time; The instrument must not require the person promising payment to perform any act other than paying the money specified; 5. The instrument must be payable to bearer or to order. The latter requirement is referred to as the "words of negotiability": a writing which does not contain the words "to the order of" (within the four corners of the instrument or in endorsement on the note or in allonge) or indicate that it is payable to the individual holding the contract document (analogous to the holder in due course) is not a negotiable instrument and is not governed by Article 3, even if it appears to have all of the other features of negotiability. The only exception is that if an instrument meets the definition of a cheque (a bill of exchange payable on demand and drawn on a bank) and is not payable to order (i.e. if it just reads "pay John Doe") then it is treated as a negotiable instrument. Negotiation and endorsement Persons other than the original obligor and obligee can become parties to a negotiable instrument. The most common manner in which this is done is by placing one's signature on the instrument (endorsement): if the person who signs does so with the intention of obtaining payment of the instrument or acquiring or transferring rights to the instrument, the signature is called anendorsement. There are five types of endorsements contemplated by the Code, covered in UCC Article 3, Sections 204 206:

An endorsement which purports to transfer the instrument to a specified person is a special endorsement for example, "Pay to the order of Amy"; An endorsement by the payee or holder which does not contain any additional notation (thus purporting to make the instrument payable to bearer) is an endorsement in blank or blank endorsement; An endorsement which purports to require that the funds be applied in a certain manner (e.g. "for deposit only", "for collection") is a restrictive endorsement; and, An endorsement purporting to disclaim retroactive liability is called a qualified endorsement (through the inscription of the words "without recourse" as part of the endorsement on the instrument or in allonge to the instrument). An endorsement purporting to add terms and conditions is called a conditional endorsement for example, "Pay to the order of Amy, if she rakes my lawn next Thursday November 11th, 2007". The UCC states that these conditions may be disregarded.

If a note or draft is negotiated to a person who acquires the instrument 1. in good faith; 2. for value; 3. without notice of any defenses to payment, the transferee is a holder in due course and can enforce the instrument without being subject to defenses which the maker of the instrument would be able to assert against the original payee, except for certain real defenses. These real defenses include (1) forgery of the instrument; (2) fraud as to the nature of the instrument being signed; (3) alteration of the instrument; (4) incapacity of the signer to contract; (5) infancy of the signer; (6) duress; (7) discharge in bankruptcy; and, (8) the running of a statute of limitations as to the validity of the instrument. The holder-in-due-course rule is a rebuttable presumption that makes the free transfer of negotiable instruments feasible in the modern economy. A person or entity purchasing an instrument in the ordinary course of business can reasonably expect that it will be paid when presented to, and not subject to dishonor by, the maker, without involving itself in a dispute between the maker and the person to whom the instrument was first issued (this can be contrasted to the lesser rights and obligations accruing to mere holders). Article 3 of the Uniform Commercial Code as enacted in a particular State's law contemplate real defenses available to purported holders in due course. The foregoing is the theory and application presuming compliance with the relevant law. Practically, the obligor-payor on an instrument who feels he has been defrauded or otherwise unfairly dealt with by the payee may nonetheless refuse to pay even a holder in due course, requiring the latter to resort to litigation to recover on the instrument. Usage While bearer instruments are rarely created as such, a holder of commercial paper with the holder designated as payee can change the instrument to a bearer instrument by an endorsement. The proper holder simply signs the back of the instrument and the instrument becomes bearer paper, although in

recent years, third party checks are not being honored by most banks unless the original payee has signed a notarized document stating such. Alternatively, an individual or company may write a check payable to "Cash" or "Bearer" and create a bearer instrument. Great care should be taken with the security of the instrument, as it is legally almost as good as cash. Exceptions Under the Code, the following are not negotiable instruments, although the law governing obligations with respect to such items may be similar to or derived from the law applicable to negotiable instruments:

Bills of lading and other documents of title, which are governed by Article 7 of the Code. However, under admiralty law, a bill of lading may either be a negotiable or 'order' bill of lading or a nonnegotiable or 'straight' bill of lading. Deeds and other documents conveying interests in real estate, although a mortgage may secure a promissory note which is governed by Article 3 IOUs Letters of credit, which are governed by Article 5 of the Code

REG 2 (Business Law) Questions

1. On December 1, Gem orally contracted with Mason for Mason to manage Gem's restaurant for one year starting the following January 1. They agreed that Gem would pay Mason $40,000 and that Mason would be allowed to continue to work for Gem if "everything worked out." On June 1, Mason quit to take a better paying job, alleging that the contract violated the statute of frauds. What will be the outcome of a suit by Gem for breach of contract? A. Gem will win because the contract was executory. B. Gem will win because the contract was for services not goods. C. Gem will lose because the contract could not be performed within one year. D. Gem will lose because the contract required payment of more than $500. 2. Which of the following bonds is an obligation of a surety? A. Convertible bonds. B. Debenture bonds. C. Municipal bonds. D. Official bonds. 3. According to the Securities Act of 1933, which of the following statements is correct regarding an issuer of securities?

A. If an issuer sells a security and fails to meet certain disclosure requirements, the purchaser may sell it back to the issuer and recover the price paid. B. An issuer is permitted to advertise an initial offering of securities only through distribution of the prospectus. C. All securities issuers must register the securities offering with the Securities and Exchange Commission (SEC) D. All securities issuers must provide potential investors with a prospectus containing specified information. 4. Which of the following circumstances best describes a landlord's constructive eviction of a tenant who has a written lease for the property? A. The landlord refuses to provide utilities to the tenant. B. The landlord starts a legal proceeding against the tenant for failure to pay rent. C. The landlord sues the tenant because the tenant complained to a government agency about the condition of the premises. D. The landlord changes the lock and refuses to give the tenant a new key. 5. Which of the following terms best describes the relationship between a corporation and the CPA it hires to audit corporate books? A. Employer and employee. B. Employer and independent contractor. C. Master and servant. D. Employer and principal. 6. Card communicated an offer to sell Card's stereo to Bend for $250. Which of the following statements is correct regarding the effect of the communication of the offer? A. Bend should immediately accept or reject the offer to avoid liability to Card. B. Card is not obligated to sell the stereo to Bend until Bend accepts the offer. C. Card is required to mitigate any loss Card would sustain in the event Bend rejects the offer. D. Bend may not reject the offer for a reasonable period of time. 7. Workers compensation benefits are available to which of the following parties? A. Only those employees injured while working on workplace premises. B. All agents injured while commuting to and from work. C. Only those employees injured while working within the scope of employment. D. All agents injured while using the employers automobile for personal use. 8. Under the Negotiable Instruments Article of the UCC, which of the following statements is correct regarding a check? A. A check is a promise to pay money. B. A check is an order to pay money.

C. A check does not need to be payable on demand. D. A check does not need to be drawn on a bank. 9. Under the Negotiable Instruments Article of the UCC, the proper party to whom a check is presented for payment is A. The drawer. B. The maker. C. The holder. D. The drawee 10. Under the Secured Transactions Article of the UCC, which of the following statements is correct regarding a security interest that has not attached? A. It is not effective against either the debtor or third parties. B. It is effective against both the debtor and third parties. C. It is effective against third parties with unsecured claims. D. It is effective against the debtor, but not against third parties. 11. Which of the following interests in real property gives the holder of that interest the greatest possessory interest in the property? A. Easement. B. Restrictive covenant. C. Fee simple. D. License. 12. Which of the following transactions is subject to registration requirements of the Securities Act of 1933? A. The public sale of stock of a trucking company regulated by the Interstate Commerce Commission. B. A public sale of municipal bonds issued by a city government. C. The issuance of stock by a publicly-traded corporation to its existing shareholders because of a stock split. D. The public sale by a corporation of its negotiable 10-year notes. 13. Under agency law, which of the following statements best describes ratification? A. A principal's affirmation of an agent's authorized act. B. A principal's affirmation of an agent's unauthorized act. C. A principal's approval in advance of an agent's acts. D. A principal's disavowal of an agent's unauthorized act. 14. Pierce owed Duke $3,000. Pierce contracted with Lodge to paint Lodge's house and Lodge agreed to pay Duke $3,000 to satisfy Pierce's debt. Pierce painted Lodge's house but Lodge did not pay Duke the $3,000. In a lawsuit by Duke against Pierce and Lodge, who will be liable to Duke?

A. Pierce only. B. Lodge only. C. Both Pierce and Lodge. D. Neither Pierce nor Lodge. 15. Under the Sales Article of the UCC, which of the following statements is correct regarding the creation of express warranties? A. Express warranties must contain formal words such as warranty or guarantee. B. Express warranties must be part of the basis of the bargain between buyer and seller. C. Express warranties are not enforceable if made orally. D. Express warranties cannot be based on statements made in the seller's promotional materials. 16. Lamont signed a promissory note in favor of Roth as part of Lamont's purchase of supplies from Roth. The note required that the $10,000 be repaid 90 days from the date of the note. There were no conditions attached to repayment. Roth endorsed the note in blank and sold it to the bank. Lamont defaulted on the promissory note. The bank sought a judgment ordering Lamont to pay the bank. Under the Negotiable Instruments Article of the UCC, how will the court most likely rule? A. The court will direct Lamont to pay the bank because the promissory note was a negotiable instrument negotiated to the bank in due course. B. The court will direct Lamont to pay the bank because the note was part of a transaction between merchants. C. The court will not direct Lamont to pay the bank because the promissory note was a negotiable instrument negotiated with Roth. D. The court will not direct Lamont to pay the bank because the promissory note was not a negotiable instrument. 17. What is the standard that must be established to prove a violation of the anti-fraud provisions of Rule 10b-5 of the Securities Exchange Act of 1934? A. Negligence. B. Intentional misconduct. C. Criminal intent. D. Strict liability. 18. In June, Mullin, a general contractor, contracted with a town to renovate the town square. The town council wanted the project done quickly and the parties placed a clause in the contract that for each day the project extended beyond 90 working days, Mullin would forfeit $100 of the contract price. In August, Mullin took a three-week vacation. The project was completed in October, 120 working days after it was begun. What type of damages may the town recover from Mullin? A. Punitive damages because taking a vacation in the middle of the project was irresponsible. B. Compensatory damages because of the delay in completing the project. C. Liquidated damages because of the clause in the contract.

D. No damages because Mullin completed performance. 19. Under the Negotiable Instruments Article of the UCC, which of the following defenses generally may be used against all holders of negotiable instruments? A. Breach of warranty. B. Fraud in the inducement. C. Lack of consideration. D. Minority of the maker. 20. Under the Documents of Title Article of the UCC, which of the following correctly describes the standard of liability that must be established to hold a warehouser liable for loss or damage to stored property? A. Strict liability. B. Ordinary negligence. C. Gross negligence. D. Deliberate destruction or theft. 21. Under the Negotiable Instruments Article of the UCC, a holder in due course in a nonconsumer transaction takes a negotiable instrument free from which of the following defenses that may be asserted by a party with whom the holder in due course had not dealt? A. Fraud in the execution. B. Discharge in an insolvency proceeding. C. Breach of contract. D. Infancy, to the extent that it is a simple contract defense. 22. Curator contracted to sell Train's painting. Train issued a $10,000 note to Curator that was payable within 10 days after Curator sold Train's painting. Curator sold the painting on May 1. Train, alleging that the note was not a negotiable instrument, refused to pay the note. Under the Negotiable Instruments Article of the UCC, which of the following statements is correct regarding the status of the note? A. The note was negotiable because it was conditioned on an event that took place. B. The note was not negotiable because it was subject to another writing. C. The note was negotiable because it was for a sum certain. D. The note was not a negotiable instrument because it was not payable at a definite time. 23. Which of the following is a prerequisite for the creation of an agency relationship? A. Consideration must be given. B. The agent must have capacity. C. The principal must have capacity. D. The consideration must be in writing. 24. Which of the following transactions is subject to registration requirements of the Securities Act of

1933? A. The public sale by a corporation of its negotiable 10-year notes. B. The public sale by a charitable organization of 10-year bearer bonds. C. The sale across state lines of municipal bonds issued by a city. D. Issuance of stock by a publicly-traded corporation to its shareholders because of a stock split. 25. Under Chapter 7 of the federal Bankruptcy Code, what affect does a bankruptcy discharge have on a judgment creditor when there is no bankruptcy estate? A. The judgment creditors claim is nondischargeable. B. The judgment creditor retains a statutory lien against the debtor. C. The debtor is relieved of any personal liability to the judgment creditor. D. The debtor is required to pay a liquidated amount to vacate the judgment. 26. A family farmer with regular annual income may file a voluntary petition for bankruptcy under any of the following Chapters of the federal Bankruptcy Code except A. 7 B. 9 C. 11 D. 13 27. Under the Sales Article of the UCC, which of the following statements is correct regarding risk of loss and title to the goods under a sale or return contract? A. Title and risk of loss are shared equally between the buyer and the seller. B. Title remains with the seller until the buyer approves or accepts the goods, but risk of loss passes to the buyer immediately following delivery of the goods to the buyer. C. Title and risk of loss remain with the seller until the buyer pays for the goods. D. Title and risk of loss rest with the buyer until the goods are returned to the seller. 28. Under the Negotiable Instruments Article of the UCC, which of the endorsers liabilities are disclaimed by a without recourse indorsement? A. Contract liability only. B. Warranty liability only. C. Both contract and warranty liability. D. Neither contract nor warranty liability. 29. Under the Negotiable Instruments Article of the UCC, which of the following provisions satisfies the requirement that an instrument, to be negotiable, must be payable at a definite time? A. The instrument is dated and payable 15 days after sight. B. The instrument is dated and payable in six months but the payor may extend this period indefinitely. C. The instrument is undated and payable 30 days after date. D. The instrument is undated and payable when the payee dies.

30. An appliance seller promised a restaurant owner that a home dishwasher would fulfill the dishwashing requirements of a large restaurant. The dishwasher was purchased but it was not powerful enough for the restaurant. Under the Sales Article of the UCC, what warranty was violated? A. The implied warranty of marketability. B. The implied warranty of merchantability. C. The express warranty that the goods conform to the sellers promise. D. The express warranty against infringement. 31. Under the Sales Article of the UCC, which of the following circumstances will relieve a buyer from the obligation of accepting a tender or delivery of goods? I. If the goods do not meet the buyers needs at the time of the tender or delivery. II. If the goods at the time of the tender or delivery do not exactly conform to the requirements of the contract. A. I only. B. II only. C. Both I and II. D. Neither I nor II. 32. Under the Sales Article of the UCC, which of the following statements is correct regarding a good faith requirement that must be met by a merchant? A. The merchant must adhere to all written and oral terms of the sales contract. B. The merchant must provide more extensive warranties than the minimum required by law. C. The merchant must charge the lowest available price for the product in the geographic market. D. The merchant must observe the reasonable commercial standards of fair dealing in the trade. 33. Under the Sales Article of the UCC, which of the following statements is correct regarding a sellers obligation under a F.O.B. destination contract? A. The seller is required to arrange for the buyer to pick up the conforming goods at a specified destination. B. The seller is required to tender delivery of conforming goods at the buyers place of business. C. The seller is required to tender delivery of conforming goods at a specified destination. D. The seller is required to tender delivery of conforming goods to a carrier who delivers to a destination specified by the buyer. 34. Under the Sales Article of the UCC, in an auction announced in explicit terms to be without reserve, when may an auctioneer withdraw the goods put up for sale? I. At any time until the auctioneer announces completion of the sale. II. If no bid is made within a reasonable time. A. I only. B. II only.

C. Either I or II. D. Neither I nor II. 35. When the original tenant of real property subleases the property to a third party (sublessee), who is responsible for the payment of the rent to the owner of the property? A. The sublessee only. B. The original tenant only. C. Either the original tenant or the sublessee. D. Both the sublessee and the original tenant. 36. Which of the following actions would most likely be an infringement of the exclusive rights of the owner of a copyrighted work? A. Using the copyrighted work for research. B. Writing a book review of the copyrighted work that includes excerpts from the work. C. Making multiple copies of extracts from the copyrighted work for classroom use. D. Preparing a foreign language translation of the copyrighted work. 37. Kemp created and patented a new process to convert liquid gas to powder. Two years later, Mill independently, and without knowledge of the Kemp patent, developed the identical process. Mill only wanted to use the process for Mills own business and did not attempt to patent the process. Kemp learned about Mills process and sued for patent infringement. Will Kemp prevail? A. Yes, because Kemp was the first to patent the process. B. Yes, because Mill should have known about Kemps patent. C. No, because Mill came up with the process independently. D. No, because Mill only used the process for Mills own business. 38. MNC Corp. bought a building for $300,000. At the same time, MNC purchased a $200,000 fire insurance policy from Building Insurance Co. and a $100,000 fire insurance policy from Property Insurance Co. Each policy contained a standard 80% coinsurance clause. Three years later, when the building had a fair market value of $400,000, the building was totally destroyed in a fire. What amount would MNC recover from the two insurance companies? A. $240,000 B. $300,000 C. $320,000 D. $400,000 39. Hall, CPA, is an unsecured creditor of Tree Co. for $15,000. Tree has a total of 10 creditors, all of whom are unsecured. Tree has not paid any of the creditors for three months. Under Chapter 11 of the federal Bankruptcy Code, which of the following statements is correct? A. Hall and two other unsecured creditors must join in the involuntary petition in bankruptcy. B. Tree may not be petitioned involuntarily into bankruptcy under the provisions of Chapter 11.

C. Hall may file an involuntary petition in bankruptcy against Tree. D. Tree may not be petitioned involuntarily into bankruptcy because there are less than 12 unsecured creditors. 40. Teller, Kerr, and Ace are co-sureties on a $120,000 loan with maximum liabilities of $20,000, $40,000, and $60,000, respectively. The debtor defaulted on the loan when the loan balance was $60,000. Ace paid the lender $48,000 in full settlement of all claims against Teller, Kerr, and Ace. What amount may Ace collect from Kerr? A. $0 B. $16,000 C. $20,000 D. $28,000 41. Miner Corp. wants to make a $5 million public stock offering under the exempt transaction limited offering provisions of the Securities Act of 1933. What must Miner do to comply with the Act? A. File a registration statement. B. Advertise the offering. C. Issue a "red herring" prospectus. D. Limit sales of the offering to no more than 35 unaccredited investors. 42. Third Corp. agreed to purchase goods from Silk Corp. Third could not pay for the goods immediately. A draft was then drawn by Silk ordering Third to pay Silk the price of the goods at a specified future date. Third signed the draft and returned it to Silk. Under the Negotiable Instruments Article of the UCC, what type of draft was created? A. A trade acceptance. B. A letter of credit. C. A bank draft. D. A check. 43. Kram sent Fargo, a real estate broker, a signed offer to sell a specified parcel of land to Fargo for $250,000. Kram, an engineer, had inherited the land. On the same day that Kram's letter was received, Fargo telephoned Kram and accepted the offer. Which of the following statements is correct under the common law statute of frauds? A. No contract could be formed because Fargo's acceptance was oral. B. No contract could be formed because Kram's letter was signed only by Kram. C. A contract was formed and would be enforceable against both Kram and Fargo. D. A contract was formed but would be enforceable only against Kram. 44. Under the Secured Transactions Article of the UCC, a secured party generally must comply with each of the following duties except A. Filing or sending the debtor a termination statement when the debt is paid.

B. Confirming, at the debtors request, the unpaid amount of the debt. C. Using reasonable care in preserving any collateral in the secured partys possession. D. Assigning the security interest to another party at the debtors request. 45. Under the federal Bankruptcy Code, which of the following rights or powers does a trustee in bankruptcy not have? A. The power to prevail against a creditor with an unperfected security interest. B. The right to avoid any statutory liens against the debtor's property that were effective before the bankruptcy petition was filed. C. The right to use any grounds available to the debtor to obtain the return of the debtor's property. D. The power to require persons holding the debtor's property at the time the bankruptcy petition is filed to deliver the property to the trustee. 46. On May 25, Fresno sold Bronson, a minor, a used computer. On June 1, Bronson reached the age of majority. On June 10, Fresno wanted to rescind the sale. Fresno offered to return Bronson's money and demanded that Bronson return the computer. Bronson refused, claiming that a binding contract existed. Bronson's refusal is A. Not justified, because Fresno is not bound by the contract unless Bronson specifically ratifies the contract after reaching the age of majority. B. Not justified, because Fresno does not have to perform under the contract if Bronson has a right to disaffirm the contract. C. Justified, because Bronson and Fresno are bound by the contract as of the date Bronson reached the age of majority. D. Justified, because Fresno must perform under the contract regardless of Bronson's minority. 47. Which of the following acts, if committed by an agent, will cause a principal to be liable to a third party? A. A negligent act committed by an independent contractor, in performance of the contract, which results in injury to a third party. B. An intentional tort committed by an employee outside the scope of employment, which results in injury to a third party. C. An employee's failure to notify the employer of a dangerous condition that results in injury to a third party. D. A negligent act committed by an employee outside the scope of employment that results in injury to a third party. 48. Under the Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA), if land is found to be contaminated, which of the following parties would be least likely to be liable for cleanup costs? A. A minority stockholder of the public corporation that owned the land. B. A parent corporation of the corporation that owned the land.

C. A bank that foreclosed a mortgage on the land and purchased the land at the foreclosure sale. D. A trustee appointed by the owner of the land to manage the land. 49. Trees were cut down and made into lumber. The lumber was used to build a house. Which of the following statements best describes the property aspect of these events? A. The trees were and remained tangible personal property. B. The trees were and remained real property. C. The trees were real property, then became and remained personal property. D. The trees were real property, became personal property, then reverted to being real property. 50. West, Inc. and Barton entered into a contract. After receiving valuable consideration from Egan, West assigned its rights under the Barton contract to Egan. In which of the following circumstances would West not be liable to Egan? A. West released Barton. B. West breached the contract. C. Egan released Barton. D. Barton paid West. 51. The federal Fair Debt Collection Practices Act prohibits a debt collector from engaging in unfair practices. Under the Act, a debt collector generally can be prevented from A. Contacting a third party to ascertain a debtor's location. B. Continuing to collect a debt. C. Communicating with a debtor who is represented by an attorney. D. Commencing a lawsuit to collect a debt. 52. Under the provisions of the Employee Retirement Income Security Act of 1974 (ERISA), which of the following statements is(are) correct regarding employee rights? I. Employers are required to establish either a contributory or noncontributory employee pension plan. II. Employers are required to include employees as pension-plan managers. A. I only. B. II only. C. Both I and II. D. Neither I nor II. 53. Under the Negotiable Instruments Article of the UCC, an instrument will be precluded from being negotiable if the instrument A. Fails to state the place of payment. B. Is made subject to another agreement. C. Fails to state the underlying consideration. D. Is undated.

54. All of the following statements regarding compliance with the statute of frauds are correct except A. Any necessary writing must be signed by all parties against whom enforcement is sought. B. Contracts involving the sale of goods in an amount greater than $500 must be in writing. C. Contract terms must be contained in only one document. D. Contracts for which it is improbable to assume that performance will be completed within one year must be in writing. 55. Which of the following types of mistake will generally make a contract unenforceable and allow it to be rescinded? A. A unilateral mistake of fact. B. A mutual mistake of fact. C. A unilateral mistake of value. D. A mutual mistake of value. 56. Ball borrowed $10,000 from Link. Ball, unable to repay the debt on its due date, fraudulently induced Park to purchase a piece of worthless costume jewelry for $10,000. Ball had Park write a check for that amount naming Link as the payee. Ball gave the check to Link in satisfaction of the debt Ball owed Link. Unaware of Ball's fraud, Link cashed the check. When Park discovered Ball's fraud, Park demanded that Link repay the $10,000. Under the Negotiable Instruments Article of the UCC, will Link be required to repay Park? A. No, because Link is a holder in due course of the check. B. No, because Link is the payee of the check and had no obligation on the check once it is cashed. C. Yes, because Link is subject to Park's defense of fraud in the inducement. D. Yes, because Link, as the payee of the check, takes it subject to all claims. 57. Which of the following securities is exempt from registration under the Securities Act of 1933? A. Municipal bonds. B. Securities sold by a discount broker. C. Pre-incorporation stock subscriptions. D. One-year notes issued to raise working capital. 58. Which of the following statements is the best definition of real property? A. Real property is only land. B. Real property is all tangible property including land. C. Real property is land and intangible property in realized form. D. Real property is land and everything permanently attached to it. 59. Which of the following contract rights can generally be assigned? A. The right to receive personal services. B. The right to receive a sum of money.

C. The right of an insured to coverage under a fire insurance policy. D. A right whose assignment is prohibited by statute. 60.Which of the following requirements must be met, by any type of deed, in order for title to real property to be transferred? A. The deed must be delivered to the purchaser of the property. B. The deed must be recorded by the seller of the property. C. The deed must include a statement of the property's value. D. The deed must include a general warranty of title. 61. Thorn purchased a used entertainment system from Sound Corp. The sales contract stated that the entertainment system was being sold "as is." Under the Sales Article of the UCC, which of the following statements is(are) correct regarding the seller's warranty of title and against infringement? I. Including the term "as is" in the sales contract is adequate communication that the seller is conveying the entertainment system without warranty of title and against infringement. II. The seller's warranty of title and against infringement may be disclaimed at any time after the contract is formed. A. I only. B. II only. C. Both I and II. D. Neither I nor II. 62. Under the Negotiable Instruments Article of the UCC, which of the following instruments meets the negotiability requirement of being payable on demand or at a definite time? A. A promissory note payable one year after a person's marriage. B. A promissory note payable June 30, year 1, whose holder can extend the time of payment until the following June 30 if the holder wishes. C. A promissory note payable June 30, year 1, whose maturity can be extended by the maker for a reasonable time. D. An undated promissory note payable one month after date. 63. Which of the following promises is supported by legally sufficient consideration and will be enforceable? A. A person's promise to pay a real estate agent $1,000 in return for the real estate agent's earlier act of not charging commission for selling the person's house. B. A parent's promise to pay one child $500 because that child is not as wealthy as the child's sibling. C. A promise to pay the police $250 to catch a thief. D. A promise to pay a minor $500 to paint a garage. 64. Grill deals in the repair and sale of new and used clocks. West brought a clock to Grill to be repaired. One of Grill's clerks mistakenly sold West's clock to Hone, another customer. Under the Sales Article of

the UCC, will West win a suit against Hone for the return of the clock? A. No, because the clerk was not aware that the clock belonged to West. B. No, because Grill is a merchant to whom goods had been entrusted. C. Yes, because Grill could not convey good title to the clock. D. Yes, because the clerk was negligent in selling the clock. 65. On April 1, Roe borrowed $100,000 from Jet to pay Roe's business expenses. On June 15, Roe gave Jet a signed security agreement and financing statement covering Roe's inventory. Jet immediately filed the financing statement. On July 1, Roe filed for bankruptcy. Under the federal Bankruptcy Code, can Roe's trustee in bankruptcy set aside Jet's security interest in Roe's inventory? A. Yes, because a security agreement may only cover goods actually purchased with the borrowed funds. B. Yes, because Roe giving the security interest to Jet created a voidable preference. C. No, because the security interest was perfected before Roe filed for bankruptcy. D. No, because the loan proceeds were used for Roe's business. 66. For which of the following contracts will a court generally grant the remedy of specific performance? A. A contract for the sale of a patent. B. A contract of employment. C. A contract for the sale of fungible goods. D. A contract for the sale of stock that is traded on a national stock exchange. 67. Under the Secured Transactions Article of the UCC, which of the following statements is(are) correct regarding the filing of a financing statement? I. A financing statement must be filed before attachment of the security interest can occur. II. Once filed, a financing statement is effective for an indefinite period of time provided continuation statements are timely filed. A. I only. B. II only. C. Both I and II. D. Neither I nor II. 68. Under Section 12 of the Securities Exchange Act of 1934, in addition to companies whose securities are traded on a national exchange, what class of companies is subject to the SEC's continuous disclosure system? A. Companies with annual revenues in excess of $5 million and 300 or more shareholders. B. Companies with annual revenues in excess of $10 million and 500 or more shareholders. C. Companies with assets in excess of $5 million and 300 or more shareholders. D. Companies with assets in excess of $10 million and 500 or more shareholders. Answers: 1)C 2)D 3)A 4)A 5)B 6)B 7)C 8)B 9)D 10)A 11)C 12)D 13)B 14)C 15)B 16)A 17)B 18)C 19)D 20)B 21)C 22)D 23)C 24)A 25)C 26)B 27)D 28)A 29)A 30)C 31)B 32)D 33)C 34)B 35)B 36)D 37)A 38)

B 39)C 40)B 41)D 42)A 43)D 44)D 45)B 46)D 47)C 48)A 49)D 50)C 51)C 52)D 53)B 54)C 55)B 56)A 5 7)A 58)D 59)B 60)A 61)D 62)B 63)D 64)B 65)B 66)A 67)B 68)D

Regulation 3: Federal Tax Process, Procedures, Accounting, and Planning Federal Tax Legislative Process
United States Congress Joint Committee on Taxation The Joint Committee on Taxation is a Committee of the U.S. Congress established under the Internal Revenue Code at 26 U.S.C. 8001. Duties The duties of the Joint Committee are: 1. 2. 3. 4. Investigating the operation, effects, and administration of internal revenue taxes Investigate measures and methods for the simplification of taxes Make reports on the results of those investigations and studies and make recommendations Review any proposed refund or credit of taxes in excess of $2,000,000.

With respect to the estimation of revenues for Congress, the Joint Committee serves a purpose parallel to that of the Congressional Budget Office for the estimation of spending for Congress, the Department of the Treasury for the estimation of revenues for the executive branch, and the Office of Management of Budget for the estimation of spending for the executive branch.

Federal Tax Procedures

1. Due dates and related extensions of time

General Federal Tax Calendar (IRS) Note for Fiscal-year taxpayers: If you file your income tax return for a fiscal year rather than the calendar year, you must change some of the dates in this calendar. These changes are described under Fiscal-Year Taxpayers at the end of this calendar. First Quarter: The first quarter of a calendar year is made up of January, February, and March. Second Quarter: The second quarter of a calendar year is made up of April, May, and June. Third Quarter: The third quarter of a calendar year is made up of July, August, and September. Fourth Quarter: The fourth quarter of a calendar year is made up of October, November, and December. Individuals Form 1040. This form is due on the 15th day of the 4th month after the end of your tax year. Estimated tax payments (Form 1040-ES). Payments are due on the 15th day of the 4th, 6th, and 9th months of your tax year and on the 15th day of the 1st month after your tax year ends. Partnerships Form 1065. This form is due on the 15th day of the 4th month after the end of the partnership's tax year. Provide each partner with a copy of Schedule K-1 (Form 1065) or a substitute Schedule K-1. Form 1065-B (electing large partnerships). This form is due on the 15th day of the 4th month after the end of the partnership's tax year. Provide each partner with a copy of Schedule K-1 (Form 1065-B) or a substitute Schedule K-1 by the first March 15 following the close of the partnership's tax year. Corporations and S Corporations Form 1120 and Form 1120S (or Form 7004). These forms are due on the 15th day of the 3rd month after the end of the corporation's tax year. S corporations must provide each shareholder with a copy of Schedule K-1 (Form 1120S) or a substitute Schedule K-1. Estimated tax payments. Payments are due on the 15th day of the 4th, 6th, 9th, and 12th months of the corporation's tax year. Form 2553. This form is used to choose S corporation treatment. It is due no more than two months and 15 days after the beginning of the tax year the election is to take effect or at any time during the preceding tax year.

2. Internal Revenue Service (IRS) audit and appeals process The IRS Appeals Process The Appeal System Because people sometimes disagree on tax matters, the Service has an appeal system. Most differences can be settled within this system without going to court. Reasons for disagreeing must come within the scope of tax laws, however. For example, an appeal of a case cannot be based only on moral, religious, political, constitutional, conscientious, or similar grounds. A case may be taken directly to tax court if the taxpayer does not want to appeal within the IRS. Appeal Within the IRS The tax decision reached by the examiner may be appealed to a local appeals office, which is separate and independent of the IRS Office that conducted the examination. An appeals office is the only level of appeal within the IRS. Conferences with appeals office personnel may be conducted in person, through correspondence, or by telephone with the taxpayer or its authorized representative Instructions for requesting a conference with an appeals officer are provided in the letter of proposed tax adjustment. In FSLG, the Letter 950 is generally used to propose adjustments to employment taxes. It states that to request a conference with an appeals officer, the taxpayer will need to file either a small case request or a formal written protest with the contact person named in the letter. Whether you file a small case request or a formal written protest depends on several factors. If a conference is requested the examiner will send the conference request letter to the appeals office to arrange for a conference at a convenient time and place. The taxpayer or its qualified representative should be prepared to discuss all disputed issues at the conference. Most differences are settled at this level. Only attorneys, certified public accountants or enrolled agents are allowed to represent a taxpayer before Appeals. An unenrolled preparer may be a witness at the conference, but not a representative. Making a Small Case Request A small case request is appropriate if the total amount of tax, penalties, and interest for each tax period involved is $25,000 or less. If more than one tax period is involved and any tax period exceeds the $25,000 threshold, a formal written protest for all periods involved must be filed. The total amount includes the proposed increase or decrease in tax and penalties or claimed refund. To make a small case request, the instructions in the letter of proposed tax adjustment provide that the taxpayer should send a brief written statement requesting an appeals conference and indicate the changes with which it does not agree with and the reasons it does not agree with them. Be sure to send the protest within the time limit specified in the letter you received, which is generally 30 days. Filing a Formal Protest When a formal protest is required, it should be sent within the time limit specified in the letter. The following should be provided in the protest:

Taxpayers name and address, and a daytime telephone number. A statement that taxpayer wants to appeal the IRS findings to the Appeals Office.

A copy of the letter proposed tax adjustment. The tax periods or years involved. A list of the changes that the taxpayer does not agree with, and reason for disagreement. The facts supporting the taxpayers position on any issue that it does not agree with. The law or authority, if any, on which the taxpayer is relying. The taxpayer must sign the written protest, stating that it is true, under the penalties of perjury as follows: Under the penalties of perjury, I declare that I examined the facts stated in this protest, including any accompanying documents, and, to the best of my knowledge and belief, they are true, correct, and complete.

If the taxpayers representative prepares and signs the protest for the taxpayer, he or she must substitute a declaration stating:

That he or she submitted the protest and accompanying documents and; Whether he or she knows personally that the facts stated in the protest and accompanying documents are true and correct.

Additional information about the Appeals process may be found in Publication 5, Your Appeals Rights and How to Prepare a Protest if you Dont Agree. The IRS Examination (Audit) Process The IRS examines (audits) tax returns to verify that the tax reported is correct. Selecting a return for examination does not always suggest that the taxpayer has either made an error or been dishonest. In fact, some examinations result in a refund to the taxpayer or acceptance of the return without change. The overwhelming majority of taxpayers files returns and make payments timely and accurately. Taxpayers have a right to expect fair and efficient tax administration from the IRS, including verification that taxes are correctly reported and paid with enforcement actions against those who fail to comply voluntarily. Taxpayer Rights The IRS trains its employees to explain and protect taxpayers rights throughout their contacts with taxpayers. These rights include:

A right to professional and courteous treatment by IRS employees. A right to privacy and confidentiality about tax matters. A right to know why the IRS is asking for information, how the IRS will use it and what will happen if the requested information is not provided. A right to representation, by oneself or an authorized representative. A right to appeal disagreements, both within the IRS and before the courts.

How Returns Are Selected for Examination The IRS selects returns using a variety of methods, including:

Potential participants in abusive tax avoidance transactions Some returns are selected based on information obtained by the IRS through efforts to identify promoters and participants of abusive tax avoidance transactions. Examples include information received from John Doe summonses issued to credit card companies and businesses and participant lists from promoters ordered by the courts to be turned over to the IRS. Computer Scoring Some returns are selected for examination on the basis of computer scoring. Computer programs give each return numeric scores. The Discriminant Function System (DIF) score rates the potential for change, based on past IRS experience with similar returns. The Unreported Income DIF (UIDIF) score rates the return for the potential of unreported income. IRS personnel screen the highest-scoring returns, selecting some for audit and identifying the items on these returns that are most likely to need review. Large Corporations The IRS examines many large corporate returns annually. Information Matching Some returns are examined because payer reports, such as Forms W-2 from employers or Form 1099 interest statements from banks, do not match the income reported on the tax return. Related Examinations Returns may be selected for audit when they involve issues or transactions with other taxpayers, such as business partners or investors, whose returns were selected for examination. Other Area offices may identify returns for examination in connection with local compliance projects. These projects require higher level management approval and deal with areas such as local compliance initiatives, return preparers or specific market segments.

Examination Methods An examination may be conducted by mail or through an in-person interview and review of the taxpayer's records. The interview may be at an IRS office (office audit) or at the taxpayer's home, place of business, or accountant's office (field audit). Taxpayers may make audio recordings of interviews, provided they give the IRS advance notice. If the time, place, or method that the IRS schedules is not convenient, the taxpayer may request a change, including a change to another IRS office if the taxpayer has moved or business records are there. The audit notification letter tells which records will be needed. Taxpayers may act on their own behalf or have someone represent or accompany them. If the taxpayer is not present, the representative must have proper written authorization. The auditor will explain the reason for any proposed changes. Most taxpayers agree to the changes and the audits end at that level.

Appeal Rights Appeal Rights are explained by the examiner at the beginning of each audit. Taxpayers who do not agree with the proposed changes may appeal by having a supervisory conference with the examiners manager or appeal their case administratively within the IRS, to the U.S. Tax Court, U.S. Claims Court or the local U.S. District Court. If there is no agreement at the closing conference with the examiner or the examiners manager, the taxpayer has 30 days to consider the proposed adjustments and their next course of action. If the taxpayer does not respond within 30 days, the IRS issues a statutory notice of deficiency, which gives the taxpayer 90 days to file a petition to the Tax Court. The Claims Court and District Court generally do not hear tax cases until after the tax is paid and administrative refund claims have been denied by the IRS. The tax does not have to be paid to appeal within the IRS or to the Tax Court. A case may be further appealed to the U.S. Court of Appeals or to the Supreme Court, if those courts accept the case. 3. Judicial process United States Tax Court The United States Tax Court is a federal trial court of record established by Congress under Article I of the U.S. Constitution, section 8 of which provides (in part) that the Congress has the power to "constitute Tribunals inferior to the supreme Court". The Tax Court specializes in adjudicating disputes over federal income tax, generally prior to the time at which formal tax assessments are made by the Internal Revenue Service. Though taxpayers may choose to litigate tax matters in a variety of legal settings, outside of bankruptcy, the Tax Court is the only forum in which taxpayers may do so without having first paid the disputed tax in full. Parties who contest the imposition of a tax may also bring an action in any United States District Court, or in the United States Court of Federal Claims; however these venues require that the tax be paid first, and that the party then file a lawsuit to recover the contested amount paid (the "full payment rule" of Flora v. United States). Tax Court judges are appointed for a term of 15 years, subject to removal for cause. Jurisdiction of the Tax Court The Tax Court provides a judicial forum in which affected persons can dispute tax deficiencies determined by the Commissioner of Internal Revenue prior to payment of the disputed amounts. The jurisdiction of the Tax Court includes, but is not limited to the authority to hear: 1. 2. 3. 4. 5. 6. 7. 8. 9. tax disputes concerning notices of deficiency notices of transferee liability certain types of declaratory judgment readjustment and adjustment of partnership items review of the failure to abate interest administrative costs worker classification relief from joint and several liability on a joint return review of certain collection actions

Congress amended the Internal Revenue Code, now codified in Internal Revenue Code section 7482, providing that decisions of the Tax Court may be reviewed by the applicable geographical United States Court of Appeals other than the Court of Appeals for the Federal Circuit. "Small Tax Cases" are conducted under Internal Revenue Code section 7463, and generally involve only amounts in controversy of $50,000 or less for any one tax year. The "Small Tax Case" procedure is available "at the option of the taxpayer." These cases are neither appealable nor precedential. At times there have been efforts in the Congress and the Tax Bar to create a single national Court of Appeals for tax cases (or make Tax Court decisions appealable to a single existing Court of Appeals), to maintain uniformity in the application of the nation's tax laws (the very reason underlying the creation of the Tax Court and the grant of national jurisdiction to the Tax Court), but efforts to avoid "hometown results" or inconsistent results due to a lack of expertise have failed. An important reason for the movements to create a single national Court of Appeals for tax cases is that the United States Tax Court does not have exclusive jurisdiction over tax cases. In addition to the Tax Court, federal tax matters can be heard and decided in three other categories of courts: U.S. District Courts, the Court of Federal Claims, and the Bankruptcy Court. In the first two instances, the taxpayer bringing the claim generally must have first paid the deficiency determined by the IRS. For the Bankruptcy Court, the tax matter must, of course, arise as an issue in a bankruptcy proceeding. Bankruptcy Court appeals are initially to the U.S. District Court. Appeals beyond the U.S. District Courts and the Court of Federal Claims follow the same path as those from the U.S. Tax Court as described above. With this number of courts involved in making legal determinations on federal tax matters including all 13 United States Courts of Appeals exercising appellate jurisdiction (the 11 numbered Circuits, the Federal Circuit (for appeals from the U.S. Court of Federal Claims), and the D.C. Circuit), some observers express concern that the tax laws can be interpreted differently for like cases. Thus arises the movement on the part of some for a U.S. Court of Federal Tax Appeals, though the merits of this are a matter of much discussion. 4. Required disclosure of tax return positions The IRS requires certain taxpayers to disclose uncertain tax positions, also known as UTP's in their federal income tax returns, including those positions for which the taxpayer may have reserved in the audited financial statements prepared under U.S. GAAP, International Financial Reporting Standards, or other country-specific financial accounting standards, or tax positions where a reserve has not been recorded due to a reasonable expectation be adjusted by an examionation or to litigate. 5. Substantiation requirements

What Are Adequate Records? You should keep the proof you need in an account book, diary, log, statement of expense, trip sheets, or similar record. You should also keep documentary evidence that, together with your record, will support each element of an expense.

Documentary evidence. You generally must have documentary evidence, such as receipts, canceled checks, or bills, to support your expenses. Exception. Documentary evidence is not needed if any of the following conditions apply.

You have meals or lodging expenses while traveling away from home for which you account to your employer under an accountable plan, and you use a per diem allowance method that includes meals and/or lodging. (Accountable plans[25] and per diem allowances [26]are discussed in chapter 6.) Your expense, other than lodging, is less than $75. You have a transportation expense for which a receipt is not readily available.

Adequate evidence. Documentary evidence ordinarily will be considered adequate if it shows the amount, date, place, and essential character of the expense. For example, a hotel receipt is enough to support expenses for business travel if it has all of the following information.

The name and location of the hotel. The dates you stayed there. Separate amounts for charges such as lodging, meals, and telephone calls.

A restaurant receipt is enough to prove an expense for a business meal if it has all of the following information.

The name and location of the restaurant. The number of people served. The date and amount of the expense.

If a charge is made for items other than food and beverages, the receipt must show that this is the case. Canceled check. A canceled check, together with a bill from the payee, ordinarily establishes the cost. However, a canceled check by itself does not prove a business expense without other evidence to show that it was for a business purpose. Duplicate information. You do not have to record information in your account book or other record that duplicates information shown on a receipt as long as your records and receipts complement each other in an orderly manner. You do not have to record amounts your employer pays directly for any ticket or other travel item. However, if you charge these items to your employer, through a credit card or otherwise, you must keep a record of the amounts you spend. Timely-kept records. You should record the elements of an expense or of a business use at or near the time of the expense or use and support it with sufficient documentary evidence. A timely-kept record has more value than a statement prepared later when generally there is a lack of accurate recall. You do not need to write down the elements of every expense on the day of the expense. If you maintain a log on a weekly basis that accounts for use during the week, the log is considered a timely-kept record.

If you give your employer, client, or customer an expense account statement, it can also be considered a timely-kept record. This is true if you copy it from your account book, diary, log, statement of expense, trip sheets, or similar record. Proving business purpose. You must generally provide a written statement of the business purpose of an expense. However, the degree of proof varies according to the circumstances in each case. If the business purpose of an expense is clear from the surrounding circumstances, then you do not need to give a written explanation. Example. If you are a sales representative who calls on customers on an established sales route, you do not have to give a written explanation of the business purpose for traveling that route. You can satisfy the requirements by recording the length of the delivery route once, the date of each trip at or near the time of the trips, and the total miles you drove the car during the tax year. You could also establish the date of each trip with a receipt, record of delivery, or other documentary evidence. Confidential information. You do not need to put confidential information relating to an element of a deductible expense (such as the place, business purpose, or business relationship) in your account book, diary, or other record. However, you do have to record the information elsewhere at or near the time of the expense and have it available to fully prove that element of the expense. What If I Have Incomplete Records? If you do not have complete records to prove an element of an expense, then you must prove the element with:

Your own written or oral statement containing specific information about the element, and Other supporting evidence that is sufficient to establish the element.

If the element is the description of a gift, or the cost, time, place, or date of an expense, the supporting evidence must be either direct evidence or documentary evidence. Direct evidence can be written statements or the oral testimony of your guests or other witnesses setting forth detailed information about the element. Documentary evidence can be receipts, paid bills, or similar evidence. If the element is either the business relationship of your guests or the business purpose of the amount spent, the supporting evidence can be circumstantial rather than direct. For example, the nature of your work, such as making deliveries, provides circumstantial evidence of the use of your car for business purposes. Invoices of deliveries establish when you used the car for business. Sampling. You can keep an adequate record for parts of a tax year and use that record to prove the amount of business or investment use for the entire year. You must demonstrate by other evidence that the periods for which an adequate record is kept are representative of the use throughout the tax year. Example. You use your car to visit the offices of clients, meet with suppliers and other subcontractors, and pick up and deliver items to clients. There is no other business use of the car, but you and your family use the car for personal purposes. You keep adequate records during the first week of each month that show that 75% of the use of the car is for business. Invoices and bills show that your business use continues at the same rate during the later weeks of each month. Your weekly records are representative of the use of the car

each month and are sufficient evidence to support the percentage of business use for the year. Exceptional circumstances. You can satisfy the substantiation requirements with other evidence if, because of the nature of the situation in which an expense is made, you cannot get a receipt. This applies if all the following are true.

You were unable to obtain evidence for an element of the expense or use that completely satisfies the requirements explained earlier under What Are Adequate Records [27]. You are unable to obtain evidence for an element that completely satisfies the two rules listed earlier under What If I Have Incomplete Records [28]. You have presented other evidence for the element that is the best proof possible under the circumstances.

Destroyed records. If you cannot produce a receipt because of reasons beyond your control, you can prove a deduction by reconstructing your records or expenses. Reasons beyond your control include fire, flood, and other casualty. Separating and Combining Expenses This section explains when expenses must be kept separate and when expenses can be combined. Separating expenses. Each separate payment is generally considered a separate expense. For example, if you entertain a customer or client at dinner and then go to the theater, the dinner expense and the cost of the theater tickets are two separate expenses. You must record them separately in your records. Season or series tickets. If you buy season or series tickets for business use, you must treat each ticket in the series as a separate item. To determine the cost of individual tickets, divide the total cost (but not more than face value) by the number of games or performances in the series. You must keep records to show whether you use each ticket as a gift or entertainment. Also, you must be able to prove the cost of nonluxury box seat tickets if you rent a skybox or other private luxury box for more than one event. See Entertainment tickets [29]in chapter 2. Combining items. You can make one daily entry in your record for reasonable categories of expenses. Examples are taxi fares, telephone calls, or other incidental travel costs. Meals should be in a separate category. You can include tips for meal-related services with the costs of the meals. Expenses of a similar nature occurring during the course of a single event are considered a single expense. For example, if during entertainment at a cocktail lounge, you pay separately for each serving of refreshments, the total expense for the refreshments is treated as a single expense. Car expenses. You can account for several uses of your car that can be considered part of a single use, such as a round trip or uninterrupted business use, with a single record. Minimal personal use, such as a stop for lunch on the way between two business stops, is not an interruption of business use. Example. You make deliveries at several different locations on a route that begins and ends at your employer's business premises and that includes a stop at the business premises between two deliveries. You can account for these using a single record of miles driven. Gift expenses. You do not always have to record the name of each recipient of a gift. A general listing will be enough if it is evident that you are not trying to avoid the $25 annual limit on the amount you can

deduct for gifts to any one person. For example, if you buy a large number of tickets to local high school basketball games and give one or two tickets to each of many customers, it is usually enough to record a general description of the recipients. Allocating total cost. If you can prove the total cost of travel or entertainment but you cannot prove how much it cost for each person who participated in the event, you may have to allocate the total cost among you and your guests on a pro rata basis. To do so, you must establish the number of persons who participated in the event. An allocation would be needed, for example, if you did not have a business relationship with all of your guests. See Allocating between business and nonbusiness [30]in chapter 2. If your return is examined. If your return is examined, you may have to provide additional information to the IRS. This information could be needed to clarify or to establish the accuracy or reliability of information contained in your records, statements, testimony, or documentary evidence before a deduction is allowed. How Long To Keep Records and Receipts You must keep records as long as they may be needed for the administration of any provision of the Internal Revenue Code. Generally, this means you must keep records that support your deduction (or an item of income) for 3 years from the date you file the income tax return on which the deduction is claimed. A return filed early is considered filed on the due date. For a more complete explanation of how long to keep records, see Publication 583, Starting a Business and Keeping Records. 6. Penalties IRS penalties Taxpayers in the United States may face various penalties for failures related to Federal, state, and local tax matters. The Internal Revenue Service (IRS) is primarily responsible for initiating these penalties at the Federal level. The IRS can impose only those penalties specified in Federal tax law. State and local rules vary widely, are administered by state and local authorities, and are not discussed herein. Penalties may be monetary, may involve forfeiture of property, or may even include jail time. Most monetary penalties are based on the amount of tax not properly paid. Penalties may increase with the period of nonpayment. Some penalties are fixed dollar amounts or fixed percentages of some measure required to be reported. Some penalties may be waived or abated where the taxpayer shows reasonable cause for the failure. Penalties apply for failures to file income tax or information returns or filing incorrect returns. Some penalties may be very minor. Penalties apply for certain types of errors on tax returns, and may be substantial. Some penalties are imposed as excise taxes on particular transactions. Certain other penalties apply for other types of failures. Willful failures generally carry much higher penalty, which may include jail. In addition, certain criminal acts may result in forfeiture of property of the taxpayer. Underestimate and late payment penalties Taxpayers are required to have withholding of tax or make quarterly estimated tax payments before the end of the tax year. Since accurate estimation requires accurate prediction of the future, taxpayers may underestimate the amount due. The penalty for paying too little estimated tax or having too little tax

withheld is computed like interest on the amount that should have been but was not paid. For 2009, this interest rate was 4%. Where a taxpayer has filed an income or excise tax return that shows a balance due but does not pay that balance by the due date of the return (without extensions), a different charge applies. This charge has two components, first an interest charge, computed as described above, and second a penalty of 0.5% per month applied to the unpaid balance of tax and interest. The 0.5% penalty is capped at 25% of the total unpaid tax. The underestimate penalty and interest on late payment are automatically assessed. No reasonable cause exception applies for these penalties. Late income tax return penalties If a taxpayer is required to file an income or excise tax return and fails to timely do so, an alternate penalty may be assessed. The penalty is 5% of the amount of unpaid tax per month the return is late, up to a maximum of 25%. The 25% cap above applies to the 5% late filing penalty and the 0.5% late payment penalty together. The late filing penalty may be waived or abated on showing of reasonable cause for failure. A minimum penalty of $135 may apply for late filing of an income tax return. Accuracy related penalties If amounts reported on an income tax return are later adjusted by the IRS and a tax increase results, an additional penalty may apply. This penalty of 20% or 40% of the increase in tax is due in the case of substantial understatement of tax, substantial valuation misstatements, transfer pricing [31] adjustments, or negligence or disregard of rules or regulations. Special rules apply for each of these types of errors under which the penalty may be waived. Late information return penalties Certain types of returns do not require payment of tax. These include forms filed by employers to report wages (Form W-2) and businesses to report certain payments (Form 1099 series instructions). The penalty for failures related to these forms is a small dollar amount per form not timely filed, and the amount of penalty increases with the degree of lateness. The current maximum penalty for these forms is $50. Many of the forms must be filed electronically, and filing on paper is considered non-filing. Late filing of partnership returns can result in penalties of $195 per month per partner. Similar penalties may apply to S corporation returns. 100% penalty on unpaid withholding taxes Employers are required to withhold income and social security taxes from wages paid to employees, and pay these amounts promptly to the government. A penalty of 100% of the amount not paid over (plus liability for paying the withheld amounts) may be collected without judicial proceedings from each and every person who had custody and control of the funds and did not make the payment to the government. This applies to company employees and officers as individuals, as well as to companies themselves. There have been reported cases of the IRS seizing houses of those failing to pay over employee taxes.

Penalties for failure to provide foreign information Taxpayers who are shareholders of controlled foreign corporations must file Form 5471 with respect to each such controlled foreign corporation. Penalties for failure to timely file are $10,000 to $50,000 per form, plus possible loss of foreign tax credits. U.S. corporations more than 25% owned, directly or indirectly, by foreign persons must file Form 5472 to report such ownership and all transactions with related parties. Failure to timely file carries a $10,000 penalty per required form. This penalty may be increased by $10,000 per month per form for continued failure to file. In addition, taxpayers who fail to report changes in foreign taxes used as credits against Federal income tax may be subject to penalties. U.S. citizen or resident taxpayers (including entities) who are beneficiaries of a foreign trust or make transfers of property to a foreign trust must report information about the transfer and the trust or corporation. Failure to timely report on Form 3520 or Form 3520-A may result in penalties of up to 35%. Similar transferors to foreign corporations failing to file Form 926 may face penalties of 10% of the value of the transfer, up to $100,000. Penalties up to $500,000 plus jail time may apply for failure to file Treasury Department Form TD F 90-22.1 each year by owners of or signatories to foreign bank or securities accounts. Excise taxes as penalties Federal excise taxes are imposed on a variety of goods and services. Some of these taxes require purchase of tax stamps or other evidence of advance payment of tax. Some require collection of the tax by retailers. An assortment of penalties apply to manufacturers and retailers not complying with the particular rules. In addition, certain penalties are imposed in the form of an excise tax. Pension and benefit plans must pay a tax for a variety of failures. Charities and Private foundations must pay an excise tax on prohibited transactions and other failures. Tax fraud penalties Intentional filing of materially false tax returns is considered tax fraud, and is a criminal offence. Any person convicted of committing tax fraud, or aiding and abetting another in committing tax fraud, may be subject to forfeiture of property and/or jail time. Conviction and sentencing is through the court system. Responsibility for prosecution falls to the U.S. Department of Justice not the Internal Revenue Service. Penalties may be assessed against tax protesters who raise arguments that income tax laws are not valid or for filing frivolous returns or court petitions. Tax adviser penalties Penalties also apply to persons who promote tax shelters or who fail to maintain and disclose lists of reportable transactions their customers or clients for those transactions. These monetary penalties can be severe. Judicial appeal of penalties Most penalties are subject to judicial review. However, the courts rarely modify assessment of the penalties and interest for underestimate or late payment. No criminal penalties may be imposed by the IRS or Department of Justice except by order of a court upon conviction at trial. Convictions may be appealed within the court system. Prosecution for tax crimes is undertaken in the U.S. District Court having

jurisdiction over the taxpayer. Appeal of other tax penalties may be in that district court, in the United States Tax Court, or in the Court of Claims. 7. Statute of limitations A statute of limitation is a time period established by law to review, analyze and resolve taxpayer and/or IRS tax related issues. The Internal Revenue Code (IRC) requires that the Internal Revenue Service (IRS) will assess, refund, credit, and collect taxes within specific time limits. These limits are known as the Statutes of Limitations . When they expire, the IRS can no longer assess additional tax, allow a claim for refund by the taxpayer, or take collection action. The determination of Statute expiration differs forAssessment, Refund, and Collection. The Statute of Limitations Project identifies statute imminent/expired returns and payments, and determines the Assessment Statute Expiration Date (ASED), Refund Statute Expiration Date (RSED), and Collection Statute Expiration Date (CSED).

Tax Research and Communication

1. Authoritative hierarchy Generally, the Internal Revenue Code (passed by congress) is the source for all tax law administration of the law, and at the top of the hierarchy. Second are court case decisions, and Federal Tax Regulations which are considered second. Below is a hierarchy of authority for tax matters listed In descending order of precedence: 1. Internal Revenue Code (abbreviated IRC), Title 26 of the United States Code. 2. Treasury Regulations (abbreviated Treas. Reg) also known as Federal Tax Regulations 3. U.S. Supreme Court decisions (abbreviated L.Ed. or S.Ct.) 4. U.S. Circuit Courts of Appeals (abbreviated F. or F.2d., etc..). 5. Federal courts of original jurisdiction (decisions may be appealed to a Circuit Court of Appeals). A. U.S. District Courts (cited as F. Supp.) Federal District Court decisions will vary on a particular topic since each court decision is rendered by a separate, geographically-bound court. 94 districts nationwide. B. U.S. Tax Court The tax court is a national court and will only follow the decision of the Circuit Court in which the taxpayer is domiciled. As a result, Tax Court decisions are not necessarily consistent on a particular topic. Tax court decisions are classified as follows: C. U.S. Court of Federal Claims (cited as FedCl since 1992; ClCt from 1982-1992; CtCl before 1982)

National court that handles all types of claims against the U.S. government, including those in the tax area. 7. Revenue Rulings (abbreviated as Rev. Rul.) Issued by the IRS, establishing official IRS interpretation of the tax law for specific types of transactions. Binding for the IRS for future tax treatment of such transactions. 8. Private Letter Rulings (abbreviated as PLR or LtrRul) Issued by the IRS upon request to an individual taxpayer regarding tax treatment for a specific transaction being considered. The IRS may also submit letter rulings based on a pressing tax matter. 2. Communications with or on behalf of clients A taxpayer has the right to represent themselves or have another party represent before the IRS in connection with a federal tax matter. Their representative must be an individual authorized to practice before the IRS. A taxpayer must submit a power of attorney with the IRS office where you want your representative to act for them (Form 2848). The taxpayers signature on Form 2848 allows the individual or individuals named to represent them before the IRS and to receive your tax information for the matter(s) and tax year(s)/period(s) specified on the Form 2848.

Tax Planning
Tax planning is a strategy to reduce a tax liability and encompasses many different aspects, including the timing of income and purchases and other expenditures. Analysis of a financial situation or plan from a tax perspective, is to align financial goals with tax efficiency planning over a period of time. The purpose of tax planning is to plan and execute a reduced tax liability over time based on current tax law. Unlike Tax Planning (A strategy to implement tax law in a legal way), tax evasion is the general term for efforts by individuals, corporations, trusts and other entities to evade taxes by illegal means. 1. Alternative treatments 2. Projections of tax consequences 3. Implications of different business entities 4. Impact of proposed tax audit adjustments 5. Impact of estimated tax payment rules on planning 6. Role of taxes in decision-making

Accounting Methods
Accounting Methods An accounting method is a set of rules used to determine when and how income and expenses are reported. Your accounting method includes not only the overall method of accounting you use, but also the accounting treatment you use for any material item. You choose an accounting method for your business when you file your first income tax return that includes a Schedule C for the business. After that, if you want to change your accounting method, you must generally get IRS approval. Kinds of methods. Generally, you can use any of the following accounting methods.

Cash method. An accrual method. Special methods of accounting for certain items of income and expenses. Combination method using elements of two or more of the above.

You must use the same accounting method to figure your taxable income and to keep your books. Also, you must use an accounting method that clearly shows your income. Business and personal items. You can account for business and personal items under different accounting methods. For example, you can figure your business income under an accrual method, even if you use the cash method to figure personal items. Two or more businesses. If you have two or more separate and distinct businesses, you can use a different accounting method for each if the method clearly reflects the income of each business. They are separate and distinct only if you maintain complete and separate books and records for each business. Cash Method Most individuals and many sole proprietors with no inventory use the cash method because they find it easier to keep cash method records. However, if an inventory is necessary to account for your income, you must generally use an accrual method of accounting for sales and purchases. Income Under the cash method, include in your gross income all items of income you actually or constructively receive during your tax year. If you receive property or services, you must include their fair market value in income.

Example. On December 30, 2011, Mrs. Sycamore sent you a check for interior decorating services you provided to her. You received the check on January 2, 2012. You must include the amount of the check in income for 2012. Constructive receipt. You have constructive receipt of income when an amount is credited to your account or made available to you without restriction. You do not need to have possession of it. If you authorize someone to be your agent and receive income for you, you are treated as having received it when your agent received it. Example. Interest is credited to your bank account in December 2012. You do not withdraw it or enter it into your passbook until 2013. You must include it in your gross income for 2012. Delaying receipt of income. You cannot hold checks or postpone taking possession of similar property from one tax year to another to avoid paying tax on the income. You must report the income in the year the property is received or made available to you without restriction. Example. Frances Jones, a service contractor, was entitled to receive a $10,000 payment on a contract in December 2012. She was told in December that her payment was available. At her request, she was not paid until January 2013. She must include this payment in her 2012 income because it was constructively received in 2012. Checks. Receipt of a valid check by the end of the tax year is constructive receipt of income in that year, even if you cannot cash or deposit the check until the following year. Example. Dr. Redd received a check for $500 on December 31, 2012, from a patient. She could not deposit the check in her business account until January 2, 2013. She must include this fee in her income for 2012. Debts paid by another person or canceled. If your debts are paid by another person or are canceled by your creditors, you may have to report part or all of this debt relief as income. If you receive income in this way, you constructively receive the income when the debt is canceled or paid. Repayment of income. If you include an amount in income and in a later year you have to repay all or part of it, you can usually deduct the repayment in the year in which you make it. If the amount you repay is over $3,000, a special rule applies. For details about the special rule, see Repayments in chapter 11 of Publication 535, Business Expenses. Expenses

Under the cash method, you generally deduct expenses in the tax year in which you actually pay them. This includes business expenses for which you contest liability. However, you may not be able to deduct an expense paid in advance or you may be required to capitalize certain costs, as explained later under Uniform Capitalization Rules. Expenses paid in advance. You can deduct an expense you pay in advance only in the year to which it applies. Example. You are a calendar year taxpayer and you pay $1,000 in 2012 for a business insurance policy effective for one year, beginning July 1. You can deduct $500 in 2012 and $500 in 2013. Accrual Method

Under an accrual method of accounting, you generally report income in the year earned and deduct or capitalize expenses in the year incurred. The purpose of an accrual method of accounting is to match income and expenses in the correct year. IncomeGeneral Rule

Under an accrual method, you generally include an amount in your gross income for the tax year in which all events that fix your right to receive the income have occurred and you can determine the amount with reasonable accuracy. Example. You are a calendar year accrual method taxpayer. You sold a computer on December 28, 2012. You billed the customer in the first week of January 2013, but you did not receive payment until February 2013. You must include the amount received for the computer in your 2012 income. IncomeSpecial Rules

The following are special rules that apply to advance payments, estimating income, and changing a payment schedule for services. Estimated income. If you include a reasonably estimated amount in gross income, and later determine the exact amount is different, take the difference into account in the tax year in which you make the determination.

Change in payment schedule for services. If you perform services for a basic rate specified in a contract, you must accrue the income at the basic rate, even if you agree to receive payments at a lower rate until you complete the services and then receive the difference. Advance payments for services. Generally, you report an advance payment for services to be performed in a later tax year as income in the year you receive the payment. However, if you receive an advance payment for services you agree to perform by the end of the next tax year, you can elect to postpone including the advance payment in income until the next tax year. However, you cannot postpone including any payment beyond that tax year. For more information, see Advance Payment for Services under Accrual Method in Publication 538. That publication also explains special rules for reporting the following types of income.

Advance payments for service agreements. Prepaid rent.

Advance payments for sales. Special rules apply to including income from advance payments on agreements for future sales or other dispositions of goods you hold primarily for sale to your customers in the ordinary course of your business. If the advance payments are for contracts involving both the sale and service of goods, it may be necessary to treat them as two agreements. An agreement includes a gift certificate that can be redeemed for goods. Treat amounts that are due and payable as amounts you received. You generally include an advance payment in income for the tax year in which you receive it. However, you can use an alternative method. For information about the alternative method, see Publication 538. Expenses

Under an accrual method of accounting, you generally deduct or capitalize a business expense when both the following apply. 1. The all-events test has been met. The test has been met when: a. All events have occurred that fix the fact of liability, and b. The liability can be determined with reasonable accuracy. 2. Economic performance has occurred. Economic performance. You generally cannot deduct or capitalize a business expense until economic performance occurs. If your expense is for property or services provided to you, or for your use of

property, economic performance occurs as the property or services are provided or as the property is used. If your expense is for property or services you provide to others, economic performance occurs as you provide the property or services. An exception allows certain recurring items to be treated as incurred during a tax year even though economic performance has not occurred. For more information on economic performance, see Economic Performance under Accrual Method in Publication 538. Example. You are a calendar year taxpayer and use an accrual method of accounting. You buy office supplies in December 2012. You receive the supplies and the bill in December, but you pay the bill in January 2013. You can deduct the expense in 2012 because all events that fix the fact of liability have occurred, the amount of the liability could be reasonably determined, and economic performance occurred in that year. Your office supplies may qualify as a recurring expense. In that case, you can deduct them in 2012 even if the supplies are not delivered until 2013 (when economic performance occurs). Keeping inventories. When the production, purchase, or sale of merchandise is an income-producing factor in your business, you must generally take inventories into account at the beginning and the end of your tax year. If you must account for an inventory, you must generally use an accrual method of accounting for your purchases and sales. Special rule for related persons. You cannot deduct business expenses and interest owed to a related person who uses the cash method of accounting until you make the payment and the corresponding amount is includible in the related person's gross income. Determine the relationship, for this rule, as of the end of the tax year for which the expense or interest would otherwise be deductible. If a deduction is not allowed under this rule, the rule will continue to apply even if your relationship with the person ends before the expense or interest is includible in the gross income of that person. Related persons include members of your immediate family, including only brothers and sisters (either whole or half), your spouse, ancestors, and lineal descendants. For a list of other related persons, see section 267 of the Internal Revenue Code. Combination Method You can generally use any combination of cash, accrual, and special methods of accounting if the combination clearly shows your income and expenses and you use it consistently. However, the following restrictions apply.

If an inventory is necessary to account for your income, you must generally use an accrual method for purchases and sales. You can use the cash method for all other items of income and expenses. If you use the cash method for figuring your income, you must use the cash method for reporting your expenses. If you use an accrual method for reporting your expenses, you must use an accrual method for figuring your income.

If you use a combination method that includes the cash method, treat that combination method as the cash method.

Inventories Generally, if you produce, purchase, or sell merchandise in your business, you must keep an inventory and use the accrual method for purchases and sales of merchandise. However, the following taxpayers can use the cash method of accounting even if they produce, purchase, or sell merchandise. These taxpayers can also account for inventoriable items as materials and supplies that are not incidental (discussed later). 1. A qualifying taxpayer under Revenue Procedure 2001-10 in Internal Revenue Bulletin 2001-2. 2. A qualifying small business taxpayer under Revenue Procedure 2002-28 in Internal Revenue Bulletin 2002-18. Qualifying taxpayer. You are a qualifying taxpayer if:

Your average annual gross receipts for each prior tax year ending on or after December 17, 1998, is $1 million or less. (Your average annual gross receipts for a tax year is figured by adding the gross receipts for that tax year and the 2 preceding tax years and dividing by 3.) Your business is not a tax shelter, as defined under section 448(d)(3) of the Internal Revenue Code.

Qualifying small business taxpayer. You are a qualifying small business taxpayer if:

Your average annual gross receipts for each prior tax year ending on or after December 31, 2000, is more than $1 million but not more than $10 million. (Your average annual gross receipts for a tax year is figured by adding the gross receipts for that tax year and the 2 preceding tax years and dividing the total by 3.) You are not prohibited from using the cash method under section 448 of the Internal Revenue Code. Your principal business activity is an eligible business (described in Publication 538 and Revenue Procedure 2002-28).

Business not owned or not in existence for 3 years. If you did not own your business for all of the 3-taxyear period used in figuring your average annual gross receipts, include the period of any predecessor. If your business has not been in existence for the 3-tax-year period, base your average on the period it has existed including any short tax years, annualizing the short tax year's gross receipts. Materials and supplies that are not incidental. If you account for inventoriable items as materials and supplies that are not incidental, you will deduct the cost of the items you would otherwise include in inventory in the year you sell the items, or the year you pay for them, whichever is later. If you are a

producer, you can use any reasonable method to estimate the raw material in your work in process and finished goods on hand at the end of the year to determine the raw material used to produce finished goods that were sold during the year. Changing accounting method. If you are a qualifying taxpayer or qualifying small business taxpayer and want to change to the cash method or to account for inventoriable items as non-incidental materials and supplies, you must file Form 3115, Application for Change in Accounting Method. See Change in Accounting Method, later. More information. For more information about the qualifying taxpayer exception, see Revenue Procedure 2001-10 in Internal Revenue Bulletin 2001-2. For more information about the qualifying small business taxpayer exception, see Revenue Procedure 2002-28 in Internal Revenue Bulletin 2002-18. Items included in inventory. If you are required to account for inventories, include the following items when accounting for your inventory.

Merchandise or stock in trade. Raw materials. Work in process. Finished products. Supplies that physically become a part of the item intended for sale.

Valuing inventory. You must value your inventory at the beginning and end of each tax year to determine your cost of goods sold (Schedule C, line 42). To determine the value of your inventory, you need a method for identifying the items in your inventory and a method for valuing these items. Inventory valuation rules cannot be the same for all kinds of businesses. The method you use to value your inventory must conform to generally accepted accounting principles for similar businesses and must clearly reflect income. Your inventory practices must be consistent from year to year. More information. For more information about inventories, see Publication 538. Uniform Capitalization Rules

Under the uniform capitalization rules, you must capitalize the direct costs and part of the indirect costs for production or resale activities. Include these costs in the basis of property you produce or acquire for resale, rather than claiming them as a current deduction. You recover the costs through depreciation, amortization, or cost of goods sold when you use, sell, or otherwise dispose of the property.

Activities subject to the uniform capitalization rules. You may be subject to the uniform capitalization rules if you do any of the following, unless the property is produced for your use other than in a business or an activity carried on for profit.

Produce real or tangible personal property. For this purpose, tangible personal property includes a film, sound recording, video tape, book, or similar property. Acquire property for resale.

Exceptions. These rules do not apply to the following property. 1. Personal property you acquire for resale if your average annual gross receipts are $10 million or less. 2. Property you produce if you meet either of the following conditions. a. Your indirect costs of producing the property are $200,000 or less. b. You use the cash method of accounting and do not account for inventories. Special Methods There are special methods of accounting for certain items of income or expense. These include the following.

Amortization, discussed in chapter 8 of Publication 535, Business Expenses. Bad debts, discussed in chapter 10 of Publication 535. Depletion, discussed in chapter 9 of Publication 535. Depreciation, discussed in Publication 946, How To Depreciate Property. Installment sales, discussed in Publication 537, Installment Sales.

Change in Accounting Method Once you have set up your accounting method, you must generally get IRS approval before you can change to another method. A change in your accounting method includes a change in: 1. Your overall method, such as from cash to an accrual method, and 2. Your treatment of any material item. To get approval, you must file Form 3115, Application for Change in Accounting Method. You can get IRS approval to change an accounting method under either the automatic change procedures or the advance consent request procedures. You may have to pay a user fee. For more information, see the form instructions. Automatic change procedures. Certain taxpayers can presume to have IRS approval to change their method of accounting. The approval is granted for the tax year for which the taxpayer requests a change (year of change), if the taxpayer complies with the provisions of the automatic change procedures. No

user fee is required for an application filed under an automatic change procedure generally covered in Revenue Procedure 2002-9. Generally, you must use Form 3115 to request an automatic change. For more information, see the Instructions for Form 3115. Tax accounting in the United States U.S. tax accounting refers to accounting for tax purposes in the United States. Unlike most countries, the United States has a comprehensive set of accounting principles for tax purposes, prescribed by tax law, which are separate and distinct from Generally Accepted Accounting Principles. Basic rules The Internal Revenue Code governs the application of tax accounting. Section 446 sets the basic rules for tax accounting. Tax accounting under section 446(a) emphasizes consistency for a tax accounting method with references to the applied financial accounting to determine the proper method. So the taxpayer must choose a tax accounting method using their financial accounting method as a reference point. Types of tax accounting methods Proper accounting methods are found in section 446(c)(1) to (4) which permits cash, accrual, and other methods approved by the IRS including combinations. After choosing a tax accounting method, under section 446(b) the Secretary of the Treasury has wide discretion to re-compute the taxable income of the taxpayer by changing the accounting method to be used by the taxpayer in order to clearly reflect the taxpayer's income. If the taxpayer engages in more than one business then it may use a different method for each business according to section 446(d). Tax accounting method changes If the taxpayer wants to change their tax accounting method, section 446(e) requires the taxpayer to acquire the consent of the Secretary of the Treasury. There are two kinds of changes, one where you must receive a letter of approval from the Secretary of the Treasury. Another type of change comes from a series of more routine changes each of which is an automatic change. To get the automatic change the taxpayer must fill out a form and return it to the Secretary of the Treasury. The taxpayer can adopt another method if the taxpayer files a tax return using that method for two consecutive years. This is different from changing a tax accounting method under the release of the Secretary of the Treasury because in the case of adopting another method the IRS may assess fines and reallocate taxable income. If the taxpayer wants to return to the previous method the taxpayer must ask for permission from the Secretary following the 446(e) procedure. If the taxpayer fails to request a change of method of accounting then according to section 446(f) the taxpayer does so at their own peril by exposure to penalties. Comparison with other countries In many other countries, the profit for tax purposes is the accounting profit defined by GAAP (coined the term "book profit" by the 18th century scholar Sean Freidel), with such additional adjustments to book profit as are prescribed by tax law. In other words, GAAP determines the taxable profits except where a

tax rule determines otherwise. Such adjustments typically include depreciation and expenses which for policy reasons are not deductible for tax purposes, such as entertaining costs and fines. But the U.S. is not the only jurisdiction in which there is a wide divergence between tax and financial accounting. Hugh Ault and Brian Arnold, in their book "Comparative Income Taxation," have observed that in The Netherlands, where financial accounting is known as "commercial accounting," there is a substantial divergence between those and the tax books. "[D]ifferences between tax and commercial accounting rules arise where the tax instrument is employed to pursue economic, social and cultural purposes," write Ault and Arnold. 1. Recognition of revenues and expenses under cash, accrual, or other permitted methods What is Taxable and Nontaxable Income? You can receive income in the form of money, property, or services. This section discusses many kinds of income that are taxable or nontaxable. It includes discussions on employee wages and fringe benefits, and income from bartering, partnerships, S corporations, and royalties. The information on this page should not be construed as all-inclusive. Other steps may be appropriate for your specific type of business. Constructively-received income. You are generally taxed on income that is available to you, regardless of whether it is actually in your possession. A valid check that you received or that was made available to you before the end of the tax year is considered income constructively received in that year, even if you do not cash the check or deposit it to your account until the next year. For example, if the postal service tries to deliver a check to you on the last day of the tax year but you are not at home to receive it, you must include the amount in your income for that tax year. If the check was mailed so that it could not possibly reach you until after the end of the tax year, and you could not otherwise get the funds before the end of the year, you include the amount in your income for the next year. Assignment of income. Income received by an agent for you is income you constructively received in the year the agent received it. If you agree by contract that a third party is to receive income for you, you must include the amount in your income when the party receives it. Example. You and your employer agree that part of your salary is to be paid directly to your former spouse. You must include that amount in your income when your former spouse receives it. Prepaid income. Prepaid income, such as compensation for future services, is generally included in your income in the year you receive it. However, if you use an accrual method of accounting, you can defer prepaid income you receive for services to be performed before the end of the next tax year. In this case, you include the payment in your income as you earn it by performing the services. 2. Inventory valuation methods, including uniform capitalization rules 3. Accounting for long-term contracts

4. Installment sales An installment sale is a sale of property where at least one payment is to be received after the tax year in which the sale occurs. You are required to report gain on an installment sale under the installment method unless you elect out on or before the due date for filing your tax return (including extensions) for the year of the sale. You may elect out by reporting all the gain as income in the year of the sale on Form 4797or on Form 1040, Schedule D and Form 8949. Installment method rules do not apply to sales that result in a loss. You cannot use the installment method to report gain from the sale of inventory or stocks and securities traded on an established securities market. Any portion of the gain from the sale of depreciable assets that must be reported as ordinary income under the depreciation recapture rules must be reported in the year of the sale. Your total gain on an installment method is generally the amount by which the selling price of the property you sold exceeds your adjusted basis in that property. The selling price includes the money and the fair market value of property you received for the sale of the property, any selling expenses, and existing debt encumbering the property that the buyer assumes or takes subject to. Under the installment method, you include in income each year only part of the gain you receive, or are considered to have received. Use Form 6252, Installment Sale Income, to report an installment sale in the year the sale occurs and for each year you receive an installment payment. You will need to file Form 1040, and may need to attach Form 4797 and Form 1040, Schedule D. You report interest on an installment sale as ordinary income in the same manner as any other interest income. If the installment sales contract does not provide for adequate stated interest, part of the stated principal may be recharacterized as imputed interest, or as interest under the original issue discount rules, even if you have a loss. You must use the applicable federal rate (AFR) to figure the unstated interest on the sale.

Accounting Periods
Accounting Periods You must use a tax year to figure your taxable income. A tax year is an annual accounting period for keeping records and reporting income and expenses. An annual accounting period does not include a short tax year (discussed later). You can use the following tax years:

A calendar year; or A fiscal year (including a 52-53-week tax year).

Unless you have a required tax year, you adopt a tax year by filing your first income tax return using that tax year. A required tax year is a tax year required under the Internal Revenue Code or the Income Tax Regulations. You cannot adopt a tax year by merely:

Filing an application for an extension of time to file an income tax return; Filing an application for an employer identification number (Form SS-4); or Paying estimated taxes.

This section discusses:

A calendar year. A fiscal year (including a period of 52 or 53 weeks). A short tax year. An improper tax year. A change in tax year. Special situations that apply to individuals. Restrictions that apply to the accounting period of a partnership, S corporation, or personal service corporation. Special situations that apply to corporations.

Calendar Year A calendar year is 12 consecutive months beginning on January 1st and ending on December 31st. If you adopt the calendar year, you must maintain your books and records and report your income and expenses from January 1st through December 31st of each year. If you file your first tax return using the calendar tax year and you later begin business as a sole proprietor, become a partner in a partnership, or become a shareholder in an S corporation, you must continue to use the calendar year unless you obtain approval from the IRS to change it, or are otherwise allowed to change it without IRS approval. See Change in Tax Year, later. Generally, anyone can adopt the calendar year. However, you must adopt the calendar year if:

You keep no books or records; You have no annual accounting period; Your present tax year does not qualify as a fiscal year; or You are required to use a calendar year by a provision in the Internal Revenue Code or the Income Tax Regulations.

Fiscal Year A fiscal year is 12 consecutive months ending on the last day of any month except December 31st. If you are allowed to adopt a fiscal year, you must consistently maintain your books and records and report your income and expenses using the time period adopted. 52-53-Week Tax Year

You can elect to use a 52-53-week tax year if you keep your books and records and report your income and expenses on that basis. If you make this election, your 52-53-week tax year must always end on the same day of the week. Your 52-53-week tax year must always end on:

Whatever date this same day of the week last occurs in a calendar month, or Whatever date this same day of the week falls that is nearest to the last day of the calendar month.

For example, if you elect a tax year that always ends on the last Monday in March, your 2012 tax year will end on March 25, 2013. Election. To make the election for the 52-53-week tax year, attach a statement with the following information to your tax return. 1. The month in which the new 52-53-week tax year ends. 2. The day of the week on which the tax year always ends. 3. The date the tax year ends. It can be either of the following dates on which the chosen day: a. Last occurs in the month in (1), above, or b. Occurs nearest to the last day of the month in (1), above. When you figure depreciation or amortization, a 52-53-week tax year is generally considered a year of 12 calendar months. To determine an effective date (or apply provisions of any law) expressed in terms of tax years beginning, including, or ending on the first or last day of a specified calendar month, a 52-53-week tax year is considered to:

Begin on the first day of the calendar month beginning nearest to the first day of the 52-53-week tax year, and End on the last day of the calendar month ending nearest to the last day of the 52-53-week tax year.

Example. Assume a tax provision applies to tax years beginning on or after July 1, 2012, which happens to be a Sunday. For this purpose, a 52-53-week tax year that begins on the last Tuesday of June, which falls on June 26, 2012, is treated as beginning on July 1, 2012. Short Tax Year

A short tax year is a tax year of less than 12 months. A short period tax return may be required when you (as a taxable entity):

Are not in existence for an entire tax year, or

Change your accounting period.

Tax on a short period tax return is figured differently for each situation. Not in Existence Entire Year Even if a taxable entity was not in existence for the entire year, a tax return is required for the time it was in existence. Requirements for filing the return and figuring the tax are generally the same as the requirements for a return for a full tax year (12 months) ending on the last day of the short tax year. Example 1. XYZ Corporation was organized on July 1, 2012. It elected the calendar year as its tax year. Therefore, its first tax return was due March 15, 2013. This short period return will cover the period from July 1, 2012, through December 31, 2012. Example 2. A calendar year corporation dissolved on July 23, 2012. Its final return is due by October 15, 2012. It will cover the short period from January 1, 2012, through July 23, 2012. Death of individual. When an individual dies, a tax return must be filed for the decedent by the 15th day of the 4th month after the close of the individual's regular tax year. The decedent's final return will be a short period tax return that begins on January 1st, and ends on the date of death. In the case of a decedent who dies on December 31st, the last day of the regular tax year, a full calendar-year tax return is required. Example. Agnes Green was a single, calendar year taxpayer. She died on March 6, 2012. Her final income tax return must be filed by April 15, 2013. It will cover the short period from January 1, 2012, to March 6, 2012. Figuring Tax for Short Year If the IRS approves a change in your tax year or you are required to change your tax year, you must figure the tax and file your return for the short tax period. The short tax period begins on the first day after the close of your old tax year and ends on the day before the first day of your new tax year. Figure tax for a short year under the general rule, explained below. You may then be able to use a relief procedure, explained later, and claim a refund of part of the tax you paid. General rule. Income tax for a short tax year must be annualized. However, self-employment tax is figured on the actual self-employment income for the short period. Individuals. An individual must figure income tax for the short tax year as follows.

1. Determine your adjusted gross income (AGI) for the short tax year and then subtract your actual itemized deductions for the short tax year. You must itemize deductions when you file a short period tax return. 2. Multiply the dollar amount of your exemptions by the number of months in the short tax year and divide the result by 12. 3. Subtract the amount in (2) from the amount in (1). The result is your modified taxable income. 4. Multiply the modified taxable income in (3) by 12, then divide the result by the number of months in the short tax year. The result is your annualized income. 5. Figure the total tax on your annualized income using the appropriate tax rate schedule. 6. Multiply the total tax by the number of months in the short tax year and divide the result by 12. The result is your tax for the short tax year. Relief procedure. Individuals and corporations can use a relief procedure to figure the tax for the short tax year. It may result in less tax. Under this procedure, the tax is figured by two separate methods. If the tax figured under both methods is less than the tax figured under the general rule, you can file a claim for a refund of part of the tax you paid. For more information, see section 443(b)(2) of the Internal Revenue Code. Tax withheld from wages. You can claim a credit against your income tax liability for federal income tax withheld from your wages. Federal income tax is withheld on a calendar year basis. The amount withheld in any calendar year is allowed as a credit for the tax year beginning in the calendar year. Improper Tax Year Taxpayers that have adopted an improper tax year must change to a proper tax year. For example, if a taxpayer began business on March 15 and adopted a tax year ending on March 14 (a period of exactly 12 months), this would be an improper tax year. See Accounting Periods, earlier, for a description of permissible tax years. To change to a proper tax year, you must do one of the following.

If you are requesting a change to a calendar tax year, file an amended income tax return based on a calendar tax year that corrects the most recently filed tax return that was filed on the basis of an improper tax year. Attach a completed Form 1128 to the amended tax return. Write FILED UNDER REV. PROC. 85-15 at the top of Form 1128 and file the forms with the Internal Revenue Service Center where you filed your original return. If you are requesting a change to a fiscal tax year, file Form 1128 in accordance with the form instructions to request IRS approval for the change.

Change in Tax Year Generally, you must file Form 1128 to request IRS approval to change your tax year. See the Instructions for Form 1128 for exceptions. If you qualify for an automatic approval request, a user fee is not required.

Individuals Generally, individuals must adopt the calendar year as their tax year. An individual can adopt a fiscal year provided that the individual maintains his or her books and records on the basis of the adopted fiscal year. Partnerships, S Corporations, and Personal Service Corporations (PSCs) Generally, partnerships, S corporations (including electing S corporations), and PSCs must use a required tax year. A required tax year is a tax year that is required under the Internal Revenue Code and Income Tax Regulations. The entity does not have to use the required tax year if it receives IRS approval to use another permitted tax year or makes an election under section 444 of the Internal Revenue Code (discussed later). The following discussions provide the rules for partnerships, S corporations, and PSCs. Partnership A partnership must conform its tax year to its partners' tax years unless any of the following apply.

The partnership makes an election under section 444 of the Internal Revenue Code to have a tax year other than a required tax year by filing Form 8716. The partnership elects to use a 52-53-week tax year that ends with reference to either its required tax year or a tax year elected under section 444. The partnership can establish a business purpose for a different tax year.

The rules for the required tax year for partnerships are as follows.

If one or more partners having the same tax year own a majority interest (more than 50%) in partnership profits and capital, the partnership must use the tax year of those partners. If there is no majority interest tax year, the partnership must use the tax year of all its principal partners. A principal partner is one who has a 5% or more interest in the profits or capital of the partnership. If there is no majority interest tax year and the principal partners do not have the same tax year, the partnership generally must use a tax year that results in the least aggregate deferral of income to the partners.

Impact of Multijurisdictional Tax Issues on Federal Taxation (Including Consideration of Local, State, and Multinational Tax Issues)

Generally, taxes paid to another jurisdiction are deducible on a Federal tax return, if all qualifications are met. For individuals, State and Local taxes are deducted on Schedule A, and foreign taxes may be deductible as a Foreign Tax Credit.

REG 3 (Federal Tax Process, Procedures, Accounting, and Planning) Questions

1. A calendar-year individual filed an income tax return on April 1. This return can be amended no later than A. Four months and 15 days after the end of the calendar year. B. Ten months and 15 days after the end of the calendar year. C. Three years, three months, and 15 days after the end of the calendar year. D. Three years after the return was filed. 2. In the absence of an election to adopt an annual accounting period, the required tax year for a partnership is A. A tax year that results in the greatest aggregate deferral of income. B. A calendar year. C. A tax year of one or more partners with a more than 50% interest in profits and capital. D. A tax year of a principal partner having a 10% or greater interest. 3. A tax preparer has advised a company to take a position on its tax return. The tax preparer believes that there is a 75% possibility that the position will be sustained if audited by the IRS. If the position is not sustained, an accuracy-related penalty and a late-payment penalty would apply. What is the tax preparer's responsibility regarding disclosure of the penalty to the company? A. The tax preparer is responsible for disclosing both penalties to the company. B. The tax preparer is responsible for disclosing only the accuracy-related penalty to the company. C. The tax preparer is responsible for disclosing only the late-payment penalty to the company. D. The tax preparer has no responsibility for disclosing any potential penalties to the company, because the position will probably be sustained on audit. 4. In the current year, Essex sold land with a basis of $80,000 to Yarrow for $100,000. Yarrow paid $25,000 down and agreed to pay $15,000 per year, plus interest, for the next five years, beginning in the second year. Under the installment method, what gain should Essex include in gross income for the year of sale? A. $25,000 B. $20,000 C. $15,000 D. $ 5,000

5. Sam's year 2 taxable income was $175,000 with a corresponding tax liability of $30,000. For year 3, Sam expects taxable income of $250,000 and a tax liability of $50,000. In order to avoid a penalty for underpayment of estimated tax, what is the minimum amount of year 3 estimated tax payments that Sam can make? A. $30,000 B. $33,000 C. $45,000 D. $50,000 6. An individual taxpayer agreed to a finding of fraud on an income tax return filed two years ago. What is the maximum time limitation, if any, after which the IRS may not assess any additional taxes against the taxpayer for this tax return? A. One year. B. Two years. C. Three years. D. There is no time limitation. 7. In calculating the tax of a corporation for a short period, which of the following processes is correct? A. Divide current-year income by prior-year income, then multiply the result by prior-year tax. B. Compute tax on short-period income, then multiply the result by 12 divided by the number of months in the short period. C. Determine the average taxable income for the past three years, then multiply the result by the number of months in the short period divided by 12. D. Annualize income and calculate the tax on annualized income, then multiply the computed tax by the number of months in the short period divided by 12. 8. Which of the following costs are subject to the Uniform Capitalization Rules of Code Sec. 263A for manufactured tangible personal property? A. Off-site storage. B. Advertising. C. Research. D. Marketing. 9. Martin filed a timely return on April 15. Martin inadvertently omitted income that amounted to 30% of his gross income stated on the return. The statute of limitations for Martin's return would end after how many years? A. 3 years. B. 6 years. C. 7 years. D. Unlimited.

10. One of the elections a new corporation must make is its choice of an accounting period. Which of the following entities has the most flexibility in choosing an accounting period? A. C corporation. B. S corporation. C. Partnership. D. Personal service corporation. 11. Nare, an accrual-basis, calendar-year taxpayer, owns a building that was rented to Mott under a 10year lease expiring August 31, year 3. On January 2, year 1, Mott paid $30,000 as consideration for canceling the lease. On November 1, year 1, Nare leased the building to Pine under a five-year lease. Pine paid Nare $5,000 rent for each of the two months of November and December, and an additional $5,000 for the last months rent. What amount of rental income should Nare report in its year 1 income tax return? A. $10,000 B. $15,000 C. $40,000 D. $45,000 12. U Co. had cash purchases and payments on account during the current year totaling $455,000. U's beginning and ending accounts payable balances for the year were $64,000 and $50,000, respectively. What amount represents U's accrual basis purchases for the year? A. $441,000 B. $469,000 C. $505,000 D. $519,000 13. Which of the following costs is includible in inventory under the uniform capitalization rules for merchandise manufactured by a company for sale to its customers? A. Advertising. B. General legal fees. C. Engineering. D. Selling expenses. 14. Chrisp, a freelance photographer, uses the cash method for business. The tax year ends on December 31. Which of the following should not be included in the determination of Chrisps gross income for the following year? A. Chrisp owns controlling shares of a closely-held corporation and is planning to delay the bonus payment from the corporation until January of the next year. Bonus was authorized on December 15, of the current year and may be drawn at any time. B. Chrisp received a check from a client on December 28 of the current year for a family portrait

produced on December 22 of the current year. The check was dated December 23 of the current year but was notdeposited until January 4 of the following year. C. A client notified Chrisp on December 27 of the current year that a check was ready. The check was not picked up until January 4 of the following year. D. Chrisp received a dividend check on January 4 of the following year. The dividends were declared payable on December 30 of the current year. 15. Mosh, a sole proprietor, uses the cash basis of accounting. At the beginning of the current year, accounts receivable were $25,000. During the year, Mosh collected $100,000 from customers. At the end of the year, accounts receivable were $15,000. What was Mosh's gross taxable income for the current year? A. $ 75,000 B. $ 90,000 C. $100,000 D. $110,000 16. In evaluating the hierarchy of authority in tax law, which of the following carries the greatest authoritative value for tax planning of transactions? A. Internal Revenue Code. B. IRS regulations. C. Tax court decisions. D. IRS agents' reports. 17. Which one of the following will result in an accruable expense for an accrual-basis taxpayer? A. An invoice dated prior to year end but the repair completed after year end. B. A repair completed prior to year end but not invoiced. C. A repair completed prior to year end and paid upon completion. D. A signed contract for repair work to be done and the work is to be completed at a later date. 18. Which of the following is correct concerning the LIFO method (as compared to the FIFO method) in a period when prices are rising? A. Deferred tax and cost of goods sold are lower. B. Current tax liability and ending inventory are higher. C. Current tax liability is lower and ending inventory is higher. D. Current tax liability is lower and cost of goods sold is higher. 19. Which of the following entities may adopt any tax year end? A. C corporation. B. S corporation. C. Limited liability company. D. Trust.

20. A C corporation must use the accrual method of accounting in which of the following circumstances? A. The business had average sales for the past three years of less than $1 million. B. The business is a service company and has over $1 million in sales. C. The business is a personal service business with over $15 million in sales. D. The business has more than $10 million in average sales. 21. Martinsen, a calendar-year individual, files a year 1 tax return on March 31, year 2. Martinsen reports $20,000 of gross income. Martinsen inadvertently omits $500 interest income. The IRS may assess additional tax up until which of the following dates? A. March 31, year 5. B. April 15, year 5. C. March 31, year 8. D. April 15, year 8. 22. Which of the following is subject to the Uniform Capitalization Rules of Code Sec. 263A? A. Editorial costs incurred by a freelance writer. B. Research and experimental expenditures. C. Mine development and exploration costs. D. Warehousing costs incurred by a manufacturing company with $12 million in annual gross receipts. Answers: 1)C 2)C 3)A 4)D 5)B 6)D 7)D 8)A 9)B 10)A 11)D 12)A 13)C 14)D 15)C 16)A 17)B 18)D 19)A 20)D 21)B 22)D

Regulation 4: Federal Taxation of Property Transactions Cost Recovery (Depreciation, Depletion, and Amortization)
A Brief Overview of Depreciation Depreciation is an income tax deduction that allows a taxpayer to recover the cost or other basis of certain property. It is an annual allowance for the wear and tear, deterioration, or obsolescence of the property. Most types of tangible property (except, land), such as buildings, machinery, vehicles, furniture, and equipment are depreciable. Likewise, certain intangible property, such as patents, copyrights, and computer software is depreciable.

In order for a taxpayer to be allowed a depreciation deduction for a property, the property must meet all the following requirements:

The taxpayer must own the property. Taxpayers may also depreciate any capital improvements for property the taxpayer leases. A taxpayer must use the property in business or in an income-producing activity. If a taxpayer uses a property for business and for personal purposes, the taxpayer can only deduct depreciation based only on the business use of that property. The property must have a determinable useful life of more than one year.

Even if a taxpayer meets the preceding requirements for a property, a taxpayer cannot depreciate the following property:

Property placed in service and disposed of in same year. Equipment used to build capital improvements. A taxpayer must add otherwise allowable depreciation on the equipment during the period of construction to the basis of the improvements. Certain term interests.

Depreciation begins when a taxpayer places property in service for use in a trade or business or for the production of income. The property ceases to be depreciable when the taxpayer has fully recovered the propertys cost or other basis or when the taxpayer retires it from service, whichever happens first. A taxpayer must identify several items to ensure the proper depreciation of a property, including:

The depreciation method for the property The class life of the asset Whether the property is Listed Property Whether the taxpayer elects to expense any portion of the asset Whether the taxpayer qualifies for any bonus first year depreciation The depreciable basis of the property

The Modified Accelerated Cost Recovery System (MACRS) is the proper depreciation method for most property. Additional information about MACRS, and the other components of depreciation are in Publication 946, How to Depreciate Property. A taxpayer must use Form 4562, Depreciation and Amortization, to report depreciation on a tax return. Form 4562 is divided into six sections and the Instructions for Form 4562 contain information on how, and when to fill out each section. Amortization In tax law, amortization refers to the cost recovery system for intangible property. Although the theory behind cost recovery deductions of amortization is to deduct from basis in a systematic manner over an asset's estimated useful economic life so as to reflect its consumption, expiration, obsolescence or other

decline in value as a result of use or the passage of time, many times a perfect match of income and deductions does not occur for policy reasons. Intangible property Intangible property which is subject to amortization is described in 26 U.S.C. 197(c)(1) and 197(d) and must be property held either for use in a trade, business, or for the production of income. Before 1993, the United States Tax Code did not contain provisions for cost recovery of intangible assets; rather, the intangible assets were depreciated under the current provisions for depreciation of tangible assets, 26 U.S.C. 167 and 168. However, the problem before 1993 was that many intangible assets did not meet the burdensome requirements of 167 and 168 because intangible assets can not necessarily be subject to wear and tear. This led to taxpayers having the incentive to ignore any basis in the intangible asset until it was sold. Under 197 most acquired intangible assets are to be amortized ratably over a fifteen-year period. This is not the best treatment of an intangible whose actual life is much shorter than fifteen years. Furthermore, if an intangible is not eligible for amortization under 197, the taxpayer can depreciate the asset if there is a showing of the assets useful life. Start-up expenditure For amortization as it relates to start-up expenses for a new business or activity. Start-up expenditures are defined as investigatory expenses incurred prior to commencing a trade or business activity which would have been deducted had it been paid or incurred when the taxpayer was already engaged in the trade or business activity. Unlike other sections in the tax code which lack in allowing current deductions for most start-up expenses, section 195 allows a taxpayer prorate start-up expenditures over a 180-month period. The policy behind this provision is to encourage taxpayers to explore new business ventures.

Estate and Gift Taxation

Estate Tax Introduction The Estate Tax is a tax on your right to transfer property at your death. It consists of an accounting of everything you own or have certain interests in at the date of death (Refer to Form 706 [32]). The fair market value of these items is used, not necessarily what you paid for them or what their values were when you acquired them. The total of all of these items is your "Gross Estate." The includible property may consist of cash and securities, real estate, insurance, trusts, annuities, business interests and other assets. Once you have accounted for the Gross Estate, certain deductions (and in special circumstances, reductions to value) are allowed in arriving at your "Taxable Estate." These deductions may include mortgages and other debts, estate administration expenses, property that passes to surviving spouses and qualified charities. The value of some operating business interests or farms may be reduced for estates that

qualify. After the net amount is computed, the value of lifetime taxable gifts (beginning with gifts made in 1977) is added to this number and the tax is computed. The tax is then reduced by the available unified credit. Most relatively simple estates (cash, publicly traded securities, small amounts of other easily valued assets, and no special deductions or elections, or jointly held property) do not require the filing of an estate tax return. A filing is required for estates with combined gross assets and prior taxable gifts exceeding $1,500,000 in 2004 - 2005; $2,000,000 in 2006 - 2008; $3,500,000 for decedents dying in 2009; and $5,000,000 or more for decedent's dying in 2010 or later (note: there are special rules for decedents dying in 2010.) Gift Tax Introduction The gift tax is a tax on the transfer of property by one individual to another while receiving nothing, or less than full value, in return. The tax applies whether the donor intends the transfer to be a gift or not. The gift tax applies to the transfer by gift of any property. You make a gift if you give property (including money), or the use of or income from property, without expecting to receive something of at least equal value in return. If you sell something at less than its full value or if you make an interest-free or reducedinterest loan, you may be making a gift. 1. Transfers subject to the gift tax Transfers subject to the gift tax A gift tax is a tax imposed on the transfer of ownership of property. The United States Internal Revenue Service says a gift is "Any transfer to an individual, either directly or indirectly, where full consideration (measured in money or money's worth) is not received in return." When a taxable gift in the form of cash, stocks, real estate, or other tangible or intangible property is made the tax is usually imposed on the donor (the giver) unless there is a retention of an interest which delays completion of the gift. A transfer is completely gratuitous where the donor receives nothing of value in exchange for the gifted property. A transfer is gratuitous in part where the donor receives some value but the value of the property received by the donor is substantially less than the value of the property given by the donor. In this case, the amount of the gift is the difference. In the United States, the gift tax is governed by Chapter 12, Subtitle B of the Internal Revenue Code. The tax is imposed by section 2501 of the Code. For the purposes of taxable income, courts have defined a "gift" as the proceeds from a "detached and disinterested generosity." Gifts are often given out of "affection, respect, admiration, charity or like impulses. Generally, if an interest in property is transferred during the giver's lifetime (often called an inter vivos gift) then the gift or transfer would not be subject to the estate tax. In 1976, Congress unified the gift and estate taxes limiting the givers ability to circumvent the estate tax by gifting during his or her lifetime. Notwithstanding, there remain differences between estate and gift taxes such as the effective tax rate, the amount of the credit available against tax, and the basis of the received property. There are also types of gifts which will be included in a person's estate such as certain gifts made within the three year window before death and gifts in which the donor retains an interest, such as gifts of

remainder interests that are not either qualified remainder trusts or charitable remainder trusts. The remainder interest gift tax rules apply the gift tax on the entire value of the trust by assigning a zero value to the interest retained by the donor. Nontaxable gifts Generally, the following gifts are not taxable gifts:

Gifts that are not more than the annual exclusion for the calendar year ($13,000 per recipient in 2009-2012, and $14,000 for 2013) Gifts to a political organization for its use Gifts to charities Gifts to one's (US Citizen) spouse Tuition or medical expenses one pays directly to a medical or educational institution for someone. Donor must pay the expense directly. If donor writes a check to donee and donee then pays the expense, the gift may be subject to tax.

2. Annual exclusion and gift tax deductions Annual exclusion There are two levels of exemption from the gift tax. First, gifts of up to the annual exclusion ($13,000 per recipient in 2009-2012) incur no tax or filing requirement. By splitting their gifts, married couples can give up to twice this amount tax-free (although they must file a gift return). Note that each giver and recipient pair has their own unique annual exclusion; a giver can give to any number of recipients and the exclusion is not affected by other gifts that recipient may have received from others. Second, gifts in excess of the annual exclusion may still be tax-free up to the lifetime estate basic exclusion amount ($5,120,000 in 2012), although for estates over that amount such gifts might increase estate taxes. Taxpayers that expect to have a taxable estate may sometimes prefer to pay gift taxes as they occur, rather than saving them up as part of the estate. Furthermore, transfers (whether by bequest, gift, or inheritance) in excess of $1 million may be subject to a generation-skipping transfer tax if certain other criteria are met. 3. Determination of taxable estate Gross Estate The "gross estate" for federal estate tax purposes often includes more property than that included in the "probate estate" under the property laws of the state in which the decedent lived at the time of death. The gross estate (before the modifications) may be considered to be the value of all the property interests of the decedent at the time of death. To these interests are added the following property interests generally not owned by the decedent at the time of death:

the value of property to the extent of an interest held by the surviving spouse as a "dower or curtesy"; the value of certain items of property in which the decedent had, at any time, made a transfer during the three years immediately preceding the date of death (i.e., even if the property was no longer owned by the decedent on the date of death), other than certain gifts, and other than property sold for full value; the value of certain property transferred by the decedent before death for which the decedent retained a "life estate [33]", or retained certain "powers"; the value of certain property in which the recipient could, through ownership, have possession or enjoyment only by surviving the decedent; the value of certain property in which the decedent retained a "reversionary interest", the value of which exceeded five percent of the value of the property; the value of certain property transferred by the decedent before death where the transfer was revocable; the value of certain annuities; the value of certain jointly owned property, such as assets passing by operation of law or survivorship, i.e. joint tenants with rights of survivorship or tenants by the entirety, with special rules for assets owned jointly by spouses.; the value of certain "powers of appointment"; the amount of proceeds of certain life insurance policies.

The above list of modifications is not comprehensive. As noted above, life insurance benefits may be included in the gross estate (even though the proceeds arguably were not "owned" by the decedent and were never received by the decedent). Life insurance proceeds are generally included in the gross estate if the benefits are payable to the estate, or if the decedent was the owner of the life insurance policy or had any "incidents of ownership" over the life insurance policy (such as the power to change the beneficiary designation). Similarly, bank accounts or other financial instruments which are "payable on death" or "transfer on death" are usually included in the taxable estate, even though such assets are not subject to the probate process under state law. Deductions Once the value of the "gross estate" is determined, the law provides for various "deductions" (in Part IV of Subchapter A of Chapter 11 of Subtitle B of the Internal Revenue Code) in arriving at the value of the "taxable estate." Deductions include but are not limited to:

Funeral expenses, administration expenses, and claims against the estate; Certain charitable contributions; Certain items of property left to the surviving spouse. Beginning in 2005, inheritance or estate taxes paid to states or the District of Columbia.

4. Marital deduction

Marital deduction Of the deductions, the most important is the deduction for property passing to (or in certain kinds of trust, for) the surviving spouse, because it can eliminate any federal estate tax for a married decedent. However, this unlimited deduction does not apply if the surviving spouse (not the decedent) is not a U.S. citizen. A special trust called a Qualified Domestic Trust or QDOT must be used to obtain an unlimited marital deduction for otherwise disqualified spouses. 5. Unified credit

REG 4 (Federal Taxation of Property Transactions) Questions

1. In the current year Tatum exchanged farmland for an office building. The farmland had a basis of $250,000, a fair market value (FMV) of $400,000, and was encumbered by a $120,000 mortgage. The office building had an FMV of $350,000 and was encumbered by a $70,000 mortgage. Each party assumed the other's mortgage. What is the amount of Tatum's recognized gain? A. $0 B. $ 50,000 C. $100,000 D. $150,000 2. Danielson invested $2,000,000 in DEC, a qualified small business corporation. Six years later, Danielson sold all of the DEC stock for $16,000,000, and purchased an office building with the proceeds. Danielson had not previously excluded any gain on the sale of small business stock. What is Danielson's taxable gain after the exclusion? A. $0 B. $6,000,000 C. $7,000,000 D. $9,000,000 3. Terry, a taxpayer, purchased stock for $12,000. Later, Terry sold the stock to a relative for $8,000. What amount is the relative's gain or loss? A. $2,000 loss. B. $0 C. $2,000 gain. D. $4,000 gain.

4. Winkler, a CPA, provided accounting services to a client, Thompson. On December 15 of the same year, Thompson gave Winkler 100 shares of Foster Corp. as compensation for services. The adjusted basis of the stock was $4,000, and its fair market value at the time of transfer was $5,000. Two months later, Winkler sold the stock on February 15 for $7,500. What is the amount that Winkler should recognize as gain on the sale of stock? A. $0 B. $1,000 C. $2,500 D. $5,000 5. On January 1, Fast, Inc. entered into a covenant not to compete with Swift, Inc. for a period of five years, with an option by Swift to extend it to seven years. What is the amortization period of the covenant for tax purposes? A. 5 years. B. 7 years. C. 15 years. D. 17 years. 6. Decker sold equipment for $200,000. The equipment was purchased for $160,000 and had accumulated depreciation of $60,000. What amount is reported as ordinary income under Code Sec. 1245? A. $0 B. $ 40,000 C. $ 60,000 D. $100,000 7. A taxpayer purchased five acres of land for $20,000 and placed in service other tangible business assets that cost $100,000. Disregarding business income limitations and assuming that the annual Section 179 (Election to Expense Certain Depreciable Business Assets) limit is $108,000, what maximum amount of cost recovery can the taxpayer claim this year? A. $120,000 B. $108,000 C. $100,000 D. $20,000 8. Hogan exchanged a business-use machine having an original cost of $100,000 and accumulated depreciation of $30,000 for business-use equipment owned by Baker having a fair market value of $80,000 plus $1,000 cash. Baker assumed a $2,000 outstanding debt on the machine. What taxable gain should Hogan recognize? A. $0 B. $3,000 C. $10,000

D. $11,000 9. A married couple purchased their principal residence for $300,000. They spent $40,000 on improvements. After living in it for 10 years, the couple sold the home for $650,000 and paid $36,000 in real estate commissions. What gain should the couple recognize on their joint return? A. $0 B. $ 60,000 C. $274,000 D. $310,000 10. A taxpayer sold for $200,000 equipment that had an adjusted basis of $180,000. Through the date of the sale, the taxpayer had deducted $30,000 of depreciation. Of this amount, $17,000 was in excess of straight-line depreciation. What amount of gain would be recaptured under Section 1245 (Gain from Dispositions of Certain Depreciable Property)? A. $13,000 B. $17,000 C. $20,000 D. $30,000 11. Four years ago, a self-employed taxpayer purchased office furniture for $30,000. During the current tax year, the taxpayer sold the furniture for $37,000. At the time of the sale, the taxpayer's depreciation deductions totaled $20,700. What part of the gain is taxed as long-term capital gain? A. $0 B. $7,000 C. $20,700 D. $27,700 12. Dunn received 100 shares of stock as a gift from Dunns grandparent. The stock cost Dunns grandparent $32,000 and it was worth $27,000 at the time of the transfer to Dunn. Dunn sold the stock for $29,000. What amount of gain or loss should Dunn report from the sale of the stock? A. $0 B. $2,000 gain. C. $3,000 gain. D. $3,000 loss. 13. Which of the following items is a capital asset? A. An automobile for personal use. B. Depreciable business property. C. Accounts receivable for inventory sold. D. Real property used in a trade or business.

14. When the original tenant of real property subleases the property to a third party (sublessee), who is responsible for the payment of the rent to the owner of the property? A. The sublessee only. B. The original tenant only. C. Either the original tenant or the sublessee. D. Both the sublessee and the original tenant. 15. Smith made a gift of property to Thompson. Smiths basis in the property was $1,200. The fair market value at the time of the gift was $1,400. Thompson sold the property for $2,500. What was the amount of Thompsons gain on the disposition? A. $0 B. $1,100 C. $1,300 D. $2,500 16. In 2001, Bach sold a painting for $50,000 purchased for his personal use in 1998 at a cost of $20,000. In Bachs 2001 income tax return, the sale of the painting should be treated as a transaction resulting in A. No taxable gain. B. Section 1231 (capital gainordinary loss rule) gain. C. Long-term capital gain. D. Ordinary income. 17. A taxpayer purchased and placed in service during the year a $100,000 piece of equipment. The equipment is 7-year property. The first-year depreciation for 7-year property is 14.29%. There is an allowable Section 179 limit in the current year of $25,000. What amount is the maximum allowable depreciation? A. $14,290 B. $25,000 C. $35,718 D. $39,290 18. Greller owns 100 shares of Arden Corp., a publicly-traded company, which Greller purchased on January 1, 2001, for $10,000. On January 1, 2003, Arden declared a 2-for-1 stock split when the fair market value (FMV) of the stock was $120 per share. Immediately following the split, the FMV of Arden stock was $62 per share. On February 1, 2003, Greller had his broker specifically sell the 100 shares of Arden stock received in the split when the FMV of the stock was $65 per share. What is the basis of the 100 shares of Arden sold? A. $5,000 B. $6,000 C. $6,200 D. $6,500

19. Farr made a gift of stock to her child, Pat. At the date of gift, Farr's stock basis was $10,000 and the stock's fair market value was $15,000. No gift taxes were paid. What is Pat's basis in the stock for computing gain? A. $0 B. $ 5,000 C. $10,000 D. $15,000 20. Allen owns 100 shares of Prime Corp., a publicly-traded company, which Allen purchased on January 1, 2001, for $10,000. On January 1, 2003, Prime declared a 2-for-1 stock split when the fair market value (FMV) of the stock was $120 per share. Immediately following the split, the FMV of Prime stock was $62 per share. On February 1, 2003, Allen had his broker specifically sell the 100 shares of Prime stock received in the split when the FMV of the stock was $65 per share. What amount should Allen recognize as long-term capital gain income on his Form 1040, U.S. Individual Income Tax Return, for 2003? A. $300 B. $750 C. $1,500 D. $2,000 21. Dove Corp. began operating a hardware store in the current year after constructing a building at a total cost of $100,000 on land previously acquired for $50,000. In the current year, the land had a fair market value of $60,000. Dove paid real estate taxes of $5,000 in the current year. What is the total depreciable basis of Dove's business property? A. $100,000 B. $150,000 C. $155,000 D. $160,000 22. Wallace purchased 500 shares of Kingpin, Inc., 15 years ago for $25,000. Wallace has worked as an owner/employee and owned 40% of the company throughout this time. This year, Kingpin, which is not an S corporation, redeemed 100% of Wallaces stock for $200,000. What is the treatment and amount of income or gain that Wallace should report? A. $0 B. $175,000 long-term capital gain. C. $175,000 ordinary income. D. $200,000 long-term capital gain. 23. Carter purchased 100 shares of stock for $50 per share. Ten years later, Carter died on February 1 and bequeathed the 100 shares of stock to a relative, Boone, when the stock had a market price of $100 per share. One year later, on April 1, the stock split 2 for 1. Boone gave 100 shares of the stock to another of

Carters relatives, Dixon, on June 1 that same year, when the market value of the stock was $150 per share. What was Dixons basis in the 100 shares of stock when acquired on June 1? A. $5,000 B. $5,100 C. $10,000 D. $15,000 24. Which of the following sales should be reported as a capital gain? A. Sale of equipment. B. Real property subdivided and sold by a dealer. C. Sale of inventory. D. Government bonds sold by an individual investor. 25. Taylor owns 1,000 shares of Media Corporation common stock with a basis of $22,000 and a fair market value of $33,000. Media paid a nontaxable 10% common stock dividend. What is the basis for each share of Media common stock owned by Taylor after receipt of the dividend? A. $20 B. $22 C. $30 D. $33 26. Gibson purchased stock with a fair market value of $14,000 from Gibson's adult child for $12,000. The child's cost basis in the stock at the date of sale was $16,000. Gibson sold the same stock to an unrelated party for $18,000. What is Gibson's recognized gain from the sale? A. $ 0 B. $ 2,000 C. $ 4,000 D. $ 6,000 Answers: 1)B 2)C 3)B 4)C 5)C 6)C 7)C 8)B 9)A 10)C 11)B 12)A 13)A 14)B 15)C 16)C 17)C 18)A 19)C 20)C 21)A 22)B 23)A 24)D 25)A 26)B

Regulation 5: Federal Taxation of Individuals Form 1040

The Form 1040, U.S. Individual Income Tax Return, is the starting form for personal (individual) federal income tax returns filed with the IRS. The first Form 1040 was published for use for the tax years 1913, 1914, and 1915. Beginning with the tax year 1916, Form 1040 was converted to an annual form (i.e., updated each tax year with the new year printed on the form).[1] [34] The IRS used to mail tax booklets (Form 1040, instructions, and most common attachments) to all households prior to 2009. Income tax returns for individual calendar year taxpayers are due by April 15 of the next year. Should April 15 fall on a Saturday, Sunday, or a legal holiday in Washington D.C. or in the state to which the return is required to be filed, the returns are due on the next business day. For example, in 2011, April 16 is a legal holiday, Emancipation Day, in Washington D.C. April 16, 2011, is a Saturday, so the holiday is observed on Friday, April 15, 2011. Because Friday, April 15, 2011 is a legal holiday in Washington D.C., Form 1040 income tax returns filed on Monday, April 18, 2011, will be treated as timely filed on Friday, April 15, 2011. Form 1040 consists of two full pages not counting attachments. The first page collects information about the taxpayer(s), dependents, income items, and adjustments to income. The second page calculates the allowable deductions and credits, tax due given the income figure, and applies funds already withheld from wages or estimated payments made towards the tax liability. At the top of the first page is the Presidential election campaign fund checkoff, which allows you to designate that the federal government give $3 of the tax it receives to the Presidential election campaign fund. Form 1040 has 11 attachments, called "schedules", which may need to be filed depending on the taxpayer. For 2009 and 2010 there is an additional form, Schedule M, due to the "Making Work Pay" provision of the American Recovery and Reinvestment Act of 2009 ("the stimulus"):

Schedule A itemizes allowable deductions against income; instead of filling out Schedule A, taxpayers may choose to take a standard deduction of between $5,700 and $15,800 (for tax year 2010), depending on age, filing status, and whether the taxpayer and/or spouse is blind. Schedule B enumerates interest and/or dividend income, and is required if either interest or dividends received during the tax year exceed $1,500 from all sources or if the filer had certain foreign accounts. Schedule C lists income and expenses related to self-employment, and is used by sole proprietors. Schedule D is used to compute capital gains and losses incurred during the tax year. Schedule E is used to report income and expenses arising from the rental of real property, royalties, or from pass-through entities (like trusts, estates, partnerships, or S corporations). Schedule EIC is used to document a taxpayer's eligibility for the Earned Income Credit. Schedule F is used to report income and expenses related to farming. Schedule H is used to report taxes owed due to the employment of household help. Schedule J is used when averaging farm income over a period of three years. Schedule L is used to figure an increased standard deduction in certain cases. Schedule M (2009 and 2010) is used to claim the Making Work Pay tax credit (6.2% earned income credit, up to $400). Schedule R is used to calculate the Credit for the Elderly or the Disabled.

Schedule SE is used to calculate the self-employment tax owed on income from self-employment (such as on a Schedule C or Schedule F, or in a partnership).

In most situations, other Internal Revenue Service or Social Security Administration forms such as Form W-2 must be attached to the Form 1040, in addition to the Form 1040 schedules. There are over 100 other, specialized forms that may need to be completed along with Schedules and the Form 1040. Short forms Over the years, other "Short Forms" were used for short periods of time. One was an IBM Card on which a few lines could be written which would be transcribed into another card which looked the same but which had holes in it which a computer or "unit record" machine could read. As with the other forms there was always a place for a signature. This was back in the 1960s. The Form 1040A ("short form"), U.S. individual income tax return, is a shorter version of the Form 1040. Use of Form 1040A is limited to taxpayers with taxable income below $100,000 who take the standard deduction instead of itemizing deductions. The Form 1040EZ ("easy form"), Income Tax Return for Single and Joint Filers With No Dependents, is the simplest, six-section Federal income tax return, introduced in 1982. Its use is limited to taxpayers with taxable income below $100,000 (as of tax year 2011) who take the standard deduction instead of itemizing deductions.

Form 1040 Filing Status

Filing status is an important factor when computing taxable income under the federal income tax in the United States. The federal tax filing status defines the type of tax return form an individual will use. Filing status is based on marital status and family situation. A taxpayer will fall into one of five possible filing status categories: single individual, married person filing jointly or surviving spouse, married person filing separately, head of household and a qualifying widow(er) with dependent children. A taxpayer who qualifies for more than one filing status may choose the most advantageous status. Determining filing status Generally, the marital status on the last day of the year determines the status for the entire year. Single Generally, if someone is unmarried, divorced, a registered domestic partner, or legally separated according to state law on December 31, that person must file as a single person for that year because the marital status at year-end applies for the entire tax year. There are some exceptions, such as qualifying as a head of household or as a surviving spouse, that do not require one to file as a single taxpayer.

Married filing jointly Marital status is decided based on a person's marital status on December 31. If a couple is married on December 31 of the taxable year, the couple may file a joint return for the year. However, even if the first day of legal separation or divorce from the spouse is December 31, one cannot file a joint return for any portion of that year. Certain married individuals, not legally separated or divorced, may still be considered single for purposes of filing tax returns if they are living apart. A married couple is not required to file jointly. If one lived apart from one's spouse for the last six months of the year, one may also qualify for head of household status. If a spouse dies during the year, the surviving spouse may generally still file a joint return with the deceased spouse for that year because the taxpayer's marital status at the time of the spouse's death applies to the entire taxable year. Married filing separately Although the joint return often produces lower taxes, the opposite is sometimes the case. To accommodate for such circumstances, married couples may decide to file separately for a taxable year. Married couples filing separately does not create an identical situation to the two parties filing as single. There are different brackets for unmarried taxpayers from the ones for married taxpayers who file separately. Unmarried taxpayers enjoy wider tax brackets and so pay less tax on the same amount of income. The rationale behind this differentiation may be in part due to the economy of scale that married couples enjoy by sharing certain expenses. Certain taxpayers, who would otherwise be considered married but file separately, maintain a household for a child and have a spouse not a member of the household for the last six months of the taxable year shall be considered unmarried. Head of Household To qualify for the head of household filing status, one must be unmarried and pay more than half the cost of maintaining a home for oneself and another relative who lives with that person for over half the year and can be claimed as the dependent. A "dependent" for these purpose includes grandchild and stepgrandchildren, not just children and stepchildren. Filing as a head of household can have substantial financial benefits over filing as a single status taxpayer. As a head of household, one may obtain a more generous tax brackets and largerstandard deductions. There are many special rules and exceptions applicable to head of household filing status. Qualifying widow(er) with dependent child Certain taxpayers, who maintain their homes as principal residences of qualifying dependents and whose spouses died during either of the last two preceding taxable years, may be considered surviving spouses as long as they have not remarried. If the two-year time period has run out following the spouse's death, one may still qualify for head of household status. There are many special rules and exceptions that apply to the surviving spouse filing status. Importance of choosing correct status An individual's tax liability depends upon two variables: the individual's filing status and the taxable income. The status can be determinative of the correct amount of tax, whether one can take certain tax

deductions or exemptions that could lower the final tax bill, and even whether one must file a return at all. One must file the status honestly, or it will be considered fraudulent and penalties will be assessed. As a taxpayer, one must withhold at least 90% of the tax burden for the year and should make sure to withhold enough to avoid penalties.

Rules for exemptions on Form 1040

Each exemption decreases your taxable income by $3,800. The two main types of exemptions are 1) personal exemptions for filers and their spouse and 2) dependency exemptions. On Form 1040, these exemptions can be found by completing lines 6a through 6d, with the total exemptions also recorded in line 42. In order to qualify for exemptions, you must be a U.S. citizen, resident alien, or resident of Canada or Mexico. If you are a nonresident alien, usually you only qualify for a single personal exemption and cannot claim a spouse or dependents for exemptions. 1) Personal Exemptions- You can usually take one exemption for yourself and an additional exemption for your spouse if you are married. a. Joint return - can claim an exemption for both yourself and your spouse b. Separate return - can only claim an exemption for your spouse if he or she did not have gross income, is not filling a return, and does not qualify as a dependent for another taxpayer. c. Special cases: i. If someone can claim you as a dependent for an exemption, than you cannot claim a personal exemption on your own return. ii. A spouse cannot be considered a dependent. iii. If your spouse died, you are still able to claim them as an exemption, unless you remarried. iv. If you become divorced or separated, you are not able to take your prior spouses exemption. 2)Dependency Exemptionsa. You can claim an exemption for a qualifying child or qualifying relative only if these three tests are met. i.Dependent taxpayer test- you (and your spouse if applicable) cannot be claimed by anyone else as a dependent ii. Joint return test- you cannot claim someone as a dependent if they filed a joint return unless their joint return was only for a refund of income tax withheld or estimated tax paid iii.Citizen or resident test- the person you are claiming as an exemption must be a U.S. citizen, U.S. resident alien, U.S. national, a resident of Canada or Mexico, or have been adopted. b.Tests to be a Qualifying Child: i. Must be your son, daughter, stepchild, foster child, sibling, step or half sibling, or a descendant of one of these relatives. ii. Must be under age 19 at end of year, younger than you (and spouse of filing jointly), under age 24 if a student, or any age if permanently and totally disabled iii. Must have lived with you more than half the year iv. Must not have provided more than half of their own support

v. Must not be filing a joint return (unless that joint return is filed only to claim a refund of withheld income tax or estimated tax paid) c.Tests to be a Qualifying Relative: i. Cannot be your or anothers qualifying child ii.Must live with you all year as a member of your household or meet requirements listed under Relatives who do not have to live with you iii.Their gross income cannot exceed $3,800 iv.You must provide at least half of their yearly total support d.For Separated/Divorced Parents- usually a child will be claimed by the custodial parent, but can be claimed by the noncustodial parent if: i. Parents are divorced or legally separated and lived apart for the last 6 months of the year ii. More than half of the childs support came from the parents iii.The child is in the parents custody for more than half the year. iv.Either the custodial parent signed a written declaration allowing the noncustodial parent to claim the child as an exemption or a pre-1985 divorce or separation agreement that was not changed to disallow the noncustodial from claiming the child as an exemption at the noncustodial parent provides at least $600 yearly for the childs support Links: http://www.irs.gov/publications/p501/ar02.html#en_US_2012_publink1000220844

Form 1040 Gross Income

Gross income in United States tax law is receipts and gains from all sources less cost of goods sold. Gross income is the starting point for determining Federal and state income tax of individuals, corporations, estates and trusts, whether resident or nonresident. "Except as otherwise provided" by law, Gross income means "all income from whatever source," and is not limited to cash received. However, tax regulations expand on this and say "all income from whatever source derived, unless excluded by law." The amount of income recognized is generally the value received or which the taxpayer has a right to receive. Certain types of income are specifically excluded from gross income. The time at which gross income becomes taxable is determined under Federal tax rules, which differ in some cases from financial accounting rules. What is income Individuals, corporations, members of partnerships, estates, trusts, and their beneficiaries ("taxpayers") are subject to Income tax in the United States. The amount on which tax is computed, taxable income, equals gross income less allowable tax deductions. The Internal Revenue Code states that "gross income means all income from whatever source derived," and gives specific examples. The examples are not all inclusive. The term "income" is not defined in the law or regulations. However, a very early Supreme Court case stated, "Income may be defined as the gain

derived from capital, from labor, or from both combined, provided it is understood to include profit gained through a sale or conversion of capital assets." The Court also held that the amount of gross income on disposition of property is the proceeds less the capital value (cost basis) of the property. Gross income is not limited to cash received. "It includes income realized in any form, whether money, property, or services." Following are some of the things that are included in income:

Wages, fees for services, tips, and similar income. It is well established that income from personal services must be included in the gross income of the person who performs the services. Mere assignment of the income does not shift the liability for the tax. Interest received, as well as imputed interest on below market and gift loans. Dividends, including capital gain distributions, from corporations. Gross profit from sale of inventory. The sales price, net of discounts, less cost of goods sold is included in income. Gains on disposition of other property. Gain is measured as the excess of proceeds over the taxpayer's adjusted basis in the property. Losses from property may be allowed as tax deductions. Rents and royalties from use of tangible or intangible property. The full amount of rent or royalty is included in income, and expenses incurred to produce this income may be allowed as tax deductions. Alimony and separate maintenance payments. Pensions, annuities, and income from life insurance or endowment contracts. Distributive share of partnership income or pro rata share of income of an S corporation. State and local income tax refunds, to the extent previously deducted. Note that these are generally excluded from gross income for state and local income tax purposes. Any other income from whatever source. Even income from crimes is taxable and must be reported, as failure to do so is a crime in itself.

Gifts and inheritances are not considered income to the recipient under U.S. law. However, gift or estate tax may be imposed on the donor or the estate of the decedent. Year of inclusion A taxpayer must include income as part of taxable income in the year recognized under the taxpayer's method of accounting. Generally, a taxpayer using the cash method of accounting (cash basis taxpayer) recognizes income when received. A taxpayer using the accrual method (accrual basis taxpayer) recognizes income when earned. Income is generally considered earned:

on sales of property when title to the property passes to the customer, and on performance of services when the services are performed.

Amount of income For a cash basis taxpayer, the measure of income is generally the amount of money or fair market value of

property received. For an accrual basis taxpayer, it is the amount the taxpayer has a right to receive. Certain specific rules apply, including:

Constructive receipt, Deferral of income from advance payment for goods or services (with exceptions), Determination what portion of an annuity is income and what is return of capital,

The value of goods or services received is included in income in barter [35] transactions. Exclusions from gross income Gross income includes "all income from whatever source derived." The courts have consistently given very broad meaning to this phrase, interpreting it to include all income unless a specific exclusion applies. Certain types of income are specifically excluded from gross income. These may be referred to as exempt income, exclusions, or tax exemptions. Among the more common excluded items are the following:

Tax exempt interest. For Federal income tax, interest on state and municipal bonds is excluded from gross income. Some states provide an exemption from state income tax for certain bond interest. Social Security benefits. The amount exempt has varied by year. The exemption is phased out for individuals with gross income above certain amounts. Gifts and inheritances. However, a "gift" from an employer to an employee is considered compensation, and is generally included in gross income. Life insurance proceeds. Compensation for personal physical injury or physical sickness, including: o Amounts received under workers compensation acts for personal physical injuries or physical sickness, o Amounts received as damages (other than punitive damages) in a suit or settlement for personal physical injuries or physical sickness, o Amounts received through insurance for personal physical injuries or physical sickness, and o Amounts received as a pension, annuity, or similar allowance for personal physical injuries or physical sickness resulting from active service in the armed forces. Scholarships. However, amounts in the nature of compensation, such as for teaching, are included in gross income. Certain employee benefits. Non-taxable benefits include group health insurance, group life insurance for policies up to $50,000, and certain fringe benefits, including those under a flexible spending or cafeteria plan. Certain elective deferrals of salary (contributions to "401(k)" plans). Meals and lodging provided to employees on employer premises for the convenience of the employer. Foreign earned income exclusion for U.S. citizens or residents for income earned outside the U.S. when the individual met qualifying tests.

Income from discharge of indebtedness for insolvent taxpayers or in certain other cases. Contributions to capital received by a corporation. Gain up to $250,000 ($500,000 on a married joint tax return) on the sale of a personal residence.

There are numerous other specific exclusions. Restrictions and specific definitions apply. Some state rules provide for different inclusions and exclusions. Source of income United States persons (including citizens, residents, and U.S. corporations) are generally subject to U.S. federal income tax on their worldwide income. Foreign persons (i.e., persons who are not U.S. persons) are subject to U.S. federal income tax only on income from a U.S. business and certain income from United States sources. Source of income is determined based on the type of income. The source of compensation income is the place where the services giving rise to the income were performed. The source of certain income, such as dividends and interest, is based on location of the residence of the payor. The source of income from property is based on the location where the property is used. Significant additional rules apply. Taxation of foreign persons Foreign persons are subject to regular income tax on income from a U.S. business or for services performed in the U.S. Foreign persons are subject to a flat rate of U.S. income tax on certain enumerated types of U.S. source income, generally collected as a withholding tax. The rate of tax is 30% of the gross income, unless reduced by a tax treaty. Foreign persons are not subject to U.S. tax on capital gains. Wages may be treated as effectively connected income, or may be subject to the flat 30% tax, depending on the facts and circumstances.

Adjustments and Deductions to Arrive at Taxable Income

Schedule A - Medical and Dental Expenses If, for a taxable year, you itemize your deductions on Form 1040, Schedule A, you may be able to deduct expenses you paid that year for medical and dental care for yourself, your spouse, and your dependents. You may deduct only the amount by which your total medical care expenses for the year exceed 7.5% of your adjusted gross income. For years beginning after December 31, 2012, you may deduct only the amount by which your total medical expenses exceed 10% of your adjusted gross income. You figure the amount you are allowed to deduct on Form 1040, Schedule A. IRS Publication 502, Medical and Dental Expenses, contains additional information on medical expenses including who will qualify as your dependent for purposes of the deduction and how you figure and report the deduction on your return.

Medical care expenses include payments for the diagnosis, cure, mitigation, treatment, or prevention of disease, or payments for treatments affecting any structure or function of the body. Medical care expenses include the insurance premiums you paid for policies that cover medical care or for a qualified long-term care insurance policy covering qualified long-term care services. If you are an employee, medical expenses do not include that portion of your premiums paid by your employer under its sponsored group accident or health policy or qualified long-term care insurance policy. Further, medical expenses do not include the premiums that you paid under your employer-sponsored policy under a premium conversion policy; for example, a federal employee, participating in the premium conversion program of the Federal Employee Health Benefits (FEHB) program, may not include the premiums paid for the policy as a medical expense. If you are self-employed and have a net profit for the year, you may be able to deduct (as an adjustment to income) the premiums you paid on a health insurance policy covering medical care including a qualified long-term care insurance policy covering medical care including a qualified long-term care insurance policy for yourself and your spouse and dependents. You cannot take this deduction for any month in which you were eligible to participate in any subsidized health plan maintained by your employer, your former employer, your spouse's employer, or your former spouse's employer. If you do not claim 100% of you self-employed health insurance deduction, you can include the remaining premiums with your other medical expenses as an itemized deduction on Form 1040, Schedule A. You may not deduct insurance premiums paid by an employer-sponsored health insurance plan (cafeteria plan) unless the premiums are included in Box 1 of your Form W-2. Deductible medical expenses may include but are not limited to:

Payments of fees to doctors, dentists, surgeons, chiropractors, psychiatrists, psychologists, and nontraditional medical practitioners Payments for in-patient hospital care or nursing home services, including the cost of meals and lodging charged by the hospital or nursing home Payments for acupuncture treatments or inpatient treatment at a center for alcohol or drug addiction, for participation in a smoking-cessation program and for drugs to alleviate nicotine withdrawal that require a prescription Payments to participate in a weight-loss program for a specific disease or diseases, including obesity, diagnosed by a physician but not ordinarily, payments for diet food items or the payment of health club dues Payments for insulin and payments for drugs that require a prescription Payments for admission and transportation to a medical conference relating to a chronic disease that you, your spouse, or your dependents have (if the costs are primarily for and essential to medical care necessitated medical care). However, you may not deduct the costs for meals and lodging while attending the medical conference Payments for false teeth, reading or prescription eyeglasses or contact lenses, hearing aids, crutches, wheelchairs, and for guide dogs for the blind or deaf Payments for transportation primarily for and essential to medical care that qualify as medical expenses, such as, payments of the actual fare for a taxi, bus, train, or ambulance or for medical

transportation by personal car, the amount of your actual out-of-pocket expenses such as for gas and oil, or the amount of the standard mileage rate for medical expenses, plus the cost of tolls and parking fees You may not deduct funeral or burial expenses, over-the-counter medicines, toothpaste, toiletries, cosmetics, a trip or program for the general improvement of your health, or most cosmetic surgery. You may not deduct amounts paid for nicotine gum and nicotine patches, which do not require a prescription You can only include the medical expenses you paid during the year. Your total deductible medical expenses for the year must be reduced by any reimbursement of deductible medical expenses. It makes no difference if you receive the reimbursement or if it is paid directly to the doctor, hospital, or other medical provider.

Alternative Minimum Tax

Alternative Minimum Tax The Alternative Minimum Tax (AMT) is an income tax imposed by the United States federal government on individuals, corporations, estates, and trusts. AMT is imposed at a nearly flat rate on an adjusted amount of taxable income above a certain threshold (also known as exemption). This exemption is substantially higher than the exemption from regular income tax. Regular taxable income is adjusted for certain items computed differently for AMT, such as depreciation and medical expenses. No deduction is allowed for state income taxes or miscellaneous itemized deductions in computing AMT income. Taxpayers with incomes above the exemption whose regular Federal income tax is below the amount of AMT must pay the higher AMT amount. A predecessor Minimum Tax, enacted in 1969, imposed an additional tax on certain tax benefits for certain taxpayers. The present AMT was enacted in 1982 and limits tax benefits from a variety of deductions. The thresholds at which AMT begins to apply are not automatically adjusted for inflation, as are regular tax thresholds, but Congress has made frequent legislative adjustments. AMT basics Each year a taxpayer must pay the greater of an Alternative Minimum Tax (AMT) or regular tax. The AMT is a nearly flat tax on taxable income as modified for AMT. As with regular Federal income tax, rates and exemptions vary by filing status. The lower rate and the exemption are phased out above certain income levels at 25% of AMT income. A lower rate applies (through 2012) on capital gains (and qualifying dividends). In addition, corporations with average annual gross receipts less than $7,500,000 for the prior three years are exempt from AMT, but only so long as they continue to meet this test. Further, a corporation is exempt from AMT during its first year as a corporation. Affiliated corporations are treated as if they were a single corporation for all three exemptions ($40,000, $7.5 million, and first year).

To the extent AMT exceeds regular Federal income tax, a future credit is provided which can offset future regular tax to the extent AMT does not apply in a future year. However, this credit is limited: see further details in the "AMT credit against regular tax" section. Regular tax used as a basis for computing AMT is found on the following lines of tax return forms: individual Form 1040 Line 44, or corporate Form 1120 Schedule J line 2 less foreign tax credit. Under the AMT, no deduction is allowed for personal exemptions, nor is the standard deduction. State, local, and foreign taxes are not deductible. However, most other itemized deductionsapply at least in part. Significant other adjustments to income and deductions apply. Individuals must file IRS Form 6251 and corporations must file Form 4626 if they have any net AMT due. The form is also filed to claim the credit for prior year AMT. Other individual adjustments in computing AMT include:

Miscellaneous itemized deductions are not allowed. These include all items subject to the 2% "floor", such as employee business expenses, tax preparation fees, etc. The home mortgage interest deduction is limited to interest on purchase money mortgages for a first and second residence. Medical expenses may be deducted only if they exceed 10% of Adjusted Gross Income, as compared to 7.5% for regular tax. Inclusion of the bargain element of an Incentive Stock Option when exercised, regardless of whether the stock can immediately be sold.

Many AMT adjustments apply to businesses operated by individuals or corporations. The adjustments tend to have the effect of deferring certain deductions or recognizing income sooner. These adjustments include:

Depreciation deductions must be computed using the straight line method and longer lives than may be used for regular tax. (See MACRS) Deductions for certain "preferences" are limited. These include deductions related to: o circulation costs, o mining costs, o research and experimentation costs, o intangible drilling costs, and o certain amortization. Certain income must be recognized earlier, including: o long term contracts and o installment sales.

Certain other adjustments apply. Corporations are also subject to an adjustment (up or down) for adjusted current earnings. In addition, a partner or shareholder's share of AMT income and adjustments flow through to the partner or shareholder from the partnership or S corporation. AMT is reduced by a foreign tax credit, limited based on AMT income rather than regular taxable income. Certain specified business tax credits are allowed.

AMT Details Alternative minimum tax (AMT) is imposed on an alternative, more comprehensive measure of income than regular federal income tax. Conceptually, it is imposed instead of, rather than in addition to, regular tax. AMT is imposed if the tentative minimum tax exceeds the regular tax. Tentative minimum tax is the AMT rate of tax times alternative minimum taxable income less the AMT foreign tax credit. Regular tax is the regular income tax reduced only by the foreign and possessions tax credits.[5] [36] In any year in which regular tax exceeds tentative minimum tax, a credit (AMT Credit) is allowed against regular tax to the extent the taxpayer has paid AMT in any prior year. This credit may not reduce regular tax below the tentative minimum tax. Alternative minimum taxable income is regular taxable income, plus or minus certain adjustments, plus tax preference items, less the allowable exemption (as phased out). Taxpayers and rates Individuals, regular C corporations, estates, and trusts are subject to AMT. Partnerships and S corporations are not taxable themselves, but the items related to computing AMT are "passed through" to their members. Foreign persons are subject to AMT only on their income effectively connected with a U.S. trade or business. The rate of AMT varies by type of taxpayer. Through 2012, individuals, estates, and trusts are subject to the same rate of tax on long term capital gains for regular tax and AMT. Exemptions The deduction for personal exemptions is not allowed. Instead, all taxpayers are granted an exemption that is phased out at higher income levels.[30] [37] See above for amounts of this exemption and phase out points. Due to the phase-out of exemptions, the actual marginal tax rate (1.25*26% = 32.5%) is higher for the income above the phase out point. The Married Filing Separately (MFS) phase-out does not stop when the exemption reaches zero, either in 2009 or 2010. This is because the MFS exemption is half of the joint exemption, but the phase-out is the full amount, so for MFS filers the phase-out amount can be up to twice the exemption amount, resulting in a 'negative exemption'. For example, using 2009 figures, a filer with $358,800 of income not only gets zero exemption, but is also taxed on an additional $35,475 that they never actually earned (see "Line 29 Alternative Minimum Taxable Income" in 2009 Instructions for Form 6251 or "Line 28 Alternative Minimum Taxable Income" in 2010 Instructions for Form 6251). This prevents a married couple with dissimilar incomes from benefiting by filing separate returns so that the lower earner gets the benefit of some exemption amount that would be phased out if they filed jointly. When filing separately, each spouse in effect not only has their own exemption phased out, but is also taxed on a second exemption too, on the presumption that the other spouse could be claiming that on their own separate MFS return. Small corporations are exempt from AMT. A small corporation is one with average gross receipts for the prior three years of $7.5 million or less. Once a corporation ceases to be a small corporation for AMT, it is never again a small corporation. This limit is applied to all members of an affiliated group as if they were a single corporation.

Depreciation and other adjustments All taxpayers claiming deductions for depreciation must adjust those deductions in computing AMT income to the amount of deduction allowed for AMT. For AMT purposes, depreciation is computed on most assets under the straight line method using the class life of the asset. When a taxpayer is required to recognize gain or loss on disposal of a depreciable asset (or pollution control facility), the gain or loss must be adjusted to reflect the AMT depreciation amount rather than regular depreciation amounts. This adjustment also applies to additional amounts deducted in the year of acquisition of the assets. For more details on these calculations, see MACRS. In addition, corporate taxpayers may be required to make adjustments to depreciation deductions in computing the adjusted current earnings (ACE) adjustment. Such adjustments only apply to assets acquired before 1989. Adjustments are also required for the following:

Long term contracts: taxpayers must use the percentage of completion method for AMT. Mine exploration and development costs must be capitalized and amortized over 10 years, rather than expensed. Certain accelerated deductions related to pollution controls facilities are not allowed. The credit allowed for alcohol and biodiesel fuels is included in income.

Adjustments for individuals Individuals are not allowed certain deductions in computing AMT that are allowed for regular tax. No deduction is allowed for personal exemptions or for the standard deduction. The phase out of itemized deductions does not apply. No deduction is allowed for state, local, or foreign income or property taxes. A recovery of such taxes is excluded from AMTI. No deduction is allowed for most miscellaneous itemized deductions. Medical expenses are deductible for AMT only to the extent they exceed 10% of adjusted gross income (as compared to 7.5% for regular tax). Interest expense deductions for individuals may be adjusted. Generally, interest paid on debt used to acquire, construct, or improve the individual's principal or second residence is unaffected. This includes interest resulting from refinancing such debt. In addition, investment interest expense is deductible for AMT only to the extent of adjusted net investment income. Other non-business interest is generally not deductible for AMT. An adjustment is also made for qualified incentive stock options and stock received under employee stock purchase plans. In both cases, the employee must recognize income for AMT purposes on the bargain or compensation element, the employer is granted a deduction for this, and the employee has basis in the shares received. Circulation and research expenses must be capitalized and amortized. Adjusted current earnings for corporations Corporations are required to make an adjustment based on adjusted current earnings (ACE). The adjustment increases or decreases AMTI for 75% of the difference between ACE and AMTI. ACE is AMTI further adjusted for certain items. These include further depreciation adjustments for most assets,

adjustments to more closely reflect earnings and profits, cost rather than percentage depletion, LIFO, charitable contributions, and certain other items. Losses The deduction for net operating losses is adjusted to be based on losses for AMTI. Farm losses are limited for AMT purposes. Passive activity losses are recomputed for AMT purposes based on income and deductions as recomputed for AMT. Certain adjustments apply with respect to farm and passive activity loss rules for insolvent taxpayers. Tax preferences All taxpayers must add back tax preference deductions in computing AMTI. Tax preferences include the following amounts of deduction:

percentage depletion in excess of basis, the deduction for intangible drilling costs in excess of the amount that would have been allowed if the costs were capitalized and amortized, with adjustments, otherwise tax exempt interest on bonds used to finance certain private activities, including mutual fund dividends from such interest, certain depreciation on pre-1987 assets, 7% of excluded gain on certain small business stock.

Taxpayers may elect an optional 10-year write-off of certain tax preference items in lieu of the preference add-back. Note that in prior years there were certain other tax preference items relating to provisions now repealed. Credits Credits are allowed against AMT for foreign taxes and certain specified business credits. The AMT foreign tax credit limitation is redetermined based on AMTI rather than regular taxable income. Thus, all adjustments and tax preference items above must be applied in computing the AMT foreign tax credit limitation. AMT credit against regular tax After a taxpayer has paid AMT, a credit is allowed against regular tax in future years for the amount of AMT. The credit for individuals is generally limited to the amount of AMT generated by deferral items (e.g. exercise of incentive stock options), as opposed to exclusion items (e.g. state and local taxes). This credit is limited so that regular tax is not reduced below AMT for the year. Taxpayers may use a simplified method under which the AMT foreign tax credit limit is computed proportionately to the regular tax foreign tax credit limit. Form 8801 is used to claim this credit. Stock options The Alternative Minimum Tax may apply to individuals exercising stock options. Under AMT rules, for incentive stock options at the time of exercise, the "bargain element" or "spread

price" (the difference between the strike price and fair market value) is treated as an AMT adjustment, and therefore needs to be added to the AMT calculation even though no ordinary income tax is due at the time of exercise. In contrast, under the regular tax rules capital gains taxesare not paid until the actual shares of stock are sold. For example, if someone exercised a 10,000 share Nortel stock option at $7 when the stock price was at $87, the bargain element was $80 per share or $800,000. Without selling the stock, the stock price dropped to $7. Although the real gain is $0, the $800,000 bargain element still becomes an AMT adjustment, and the taxpayer owes around $200,000 in AMT. The AMT was designed to prevent people from using loopholes in the tax law to avoid tax. However, the inclusion of unrealized gain on incentive stock options imposes difficulties for people who cannot come up with cash to pay tax on gains that they have not realized yet. As a result, Congress has taken action to modify the AMT regarding incentive stock options. In 2000 and 2001, people exercised incentive stock options and held onto the shares, hoping to pay long-term capital gains taxes instead of short-term capital gains taxes. Many of these people were forced to pay the AMT on this income, and by the end of the year, the stock was no longer worth the amount of AMT tax owed, forcing some individuals into bankruptcy. In the Nortel example given above, the individual would receive a credit for the AMT paid when the individual did eventually sell the Nortel shares. However, given the way AMT carryover amounts are recalculated each year, the eventual credit received is in many cases less than originally paid. Stock options in non-public companies In the Nortel example above, the taxpayer could have avoided problems by selling sufficient stock to cover the AMT liability immediately upon exercising the stock options. However, AMT also applies to stock options in pre-IPO or privately-held companies: in such cases the IRS calculates the "fair market value" of the stock on the basis of information supplied by the company, and therefore may treat the stock as having significant value even though the employee may be unable to sell it (either because there is no market, or because of legal restrictions such as lock-up periods). In such a case, it may be effectively impossible for the employee to exercise the option unless he or she has enough cash with which to pay the AMT. Growth of the AMT Although the AMT was originally enacted to target 155 high-income households, it now affects millions of families each year. The number of households that pay the tax has increased significantly in the last decade: In 1997, for example, 605,000 taxpayers paid the AMT; by 2008, the number of affected taxpayers jumped to 3.9 million, or about 4% of individual taxpayers. A total of 27% of households that paid the AMT in 2008 had adjusted gross income of $200,000 or less. The primary reason for AMT growth is the fact that the AMT exemption, unlike regular income tax items, is not indexed to inflation. This means that income thresholds do not keep pace with the cost of living. As a result, the tax affects an increasing number of households each year, as workers incomes adjust to inflation and surpass AMT eligibility levels. While not indexed for inflation, Congress has often passed short term increases in exemption amounts. The Tax Policy Center (a research group) estimated that if the AMT had been indexed to inflation in 1985, and if the Bush tax cuts had not gone into effect, only

300,000 taxpayersinstead of their projected 27 millionwould be subject to the tax in 2010. President Barack Obama included indexing the AMT to inflation in his FY2011 budget proposal, which did not pass. AMT raised $26 Billion of $1,031 Billion total individual income tax in 2008. Another important reason for the recent expansion of the AMT is the effect of the 20012006 Bush tax cuts. The tax cuts decreased marginal tax rates for all income tax brackets without making corresponding changes to AMT rates. The lower tax liabilities triggered AMT eligibility for many households. Economists often refer to this as the take-back effect of the Bush tax cuts. As the AMT has expanded, the inequalities created by the structure of the tax have become more apparent. Taxpayers are not allowed to deduct state and local taxes in calculating their AMT liability; as a result, taxpayers who live in states with high income tax rates are up to 7 times more likely to pay the AMT than those who live in states with lower income tax taxes. Similarly, taxpayers are not allowed to deduct personal exemptions in calculating their AMT liability; as a result, taxpayers with large families and specifically families with 3 or more childrenare more likely to pay the AMT than smaller families.

Passive Activity Losses

Passive Activity Losses - Real Estate Tax Tips Generally, a passive activity is any rental activity OR any business in which the taxpayer does not materially participate. Nonpassive activities are businesses in which the taxpayer works on a regular, continuous, and substantial basis. In addition, passive income does not include salaries, portfolio, or investment income. As a general rule, the passive activity loss rules are applied at the individual level. Although Internal Revenue Code Section 469 was enacted to discourage abusive tax shelters, its impact extends far beyond shelters to virtually every business or rental activity whether reported on Schedules C, F, or E, as well as to flow through income and losses from partnerships, S- Corporations, and trusts. Generally, the law does not apply to regular C-Corporations although it does have limited application to closely held corporations. There Are Two Kinds of Passive Activities:

Rentals, including both equipment and rental real estate, regardless of the level of participation Businesses in which the taxpayer does not materially participate on a regular, continuous, and substantial basis

Types of Income and Losses Income and losses on a tax return are divided into two categories:

Passive: Rentals and businesses without material participation. A limited partner is generally passive due to more restrictive tests for material participation. As a result, limited partners will generally have passive income or losses from the partnership

Nonpassive: Businesses in which the taxpayer materially participates. Also, salaries, guaranteed payments, 1099 commission income and portfolio or investment income are deemed to be nonpassive. Portfolio income includes interest income, dividends, royalties, gains and losses on stocks, pensions, lottery winnings, and any other property held for investment

Passive Activities Income and losses from the following activities would generally be passive:

Equipment leasing Rental real estate (with some exceptions) Sole proprietorship or farm in which the taxpayer does not materially participate Limited partnerships with some exceptions Partnerships, S-Corporations, and limited liability companies in which the taxpayer does not materially participate

Nonpassive Activities Income and losses from the following activities would generally be nonpassive:

Salaries, wages, and 1099 commission income Guaranteed payments Interest and dividends Stocks and bonds Sale of undeveloped land or other investment property Royalties derived in the ordinary course of business Sole proprietorship or farm in which the taxpayer materially participates Partnerships, S-Corporations, and limited liability companies in which the taxpayer materially participates Trusts in which the fiduciary materially participates

Income From Self-Rented Property It has been common tax practice for shareholders in closely held corporations to personally own the building (and sometimes equipment and vehicles as well) and rent it to their corporation.

REG 5 (Federal Taxation of Individuals) Questions

1. Robbe, a cash basis single taxpayer, reported $50,000 of adjusted gross income last year and claimed itemized deductions of $5,500, consisting solely of $5,500 of state income taxes paid last year. Robbe's itemized deduction amount, which exceeded the standard deduction available to single taxpayers for last year by $1,150, was fully deductible and it was not subject to any limitations or phase-outs. In the current year, Robbe received a $1,500 state tax refund relating to the prior year. What is the proper treatment of

the state tax refund? A. Include none of the refund in income in the current year. B. Include $1,150 in income in the current year. C. Include $1,500 in income in the current year. D. Amend the prior-year's return and reduce the claimed itemized deductions for that year. 2. Lane, a single taxpayer, received $160,000 in salary, $15,000 in income from an S Corporation in which Lane does not materially participate, and a $35,000 passive loss from a real estate rental activity in which Lane materially participated. Lane's modified adjusted gross income was $165,000. What amount of the real estate rental activity loss was deductible? A. $0 B. $15,000 C. $25,000 D. $35,000 3. Which of the following disqualifies an individual from the earned income credit? A. The taxpayers qualifying child is a 17-year-old grandchild. B. The taxpayer has earned income of $5,000. C. The taxpayer's five-year-old child lived in the taxpayer's home for only eight months. D. The taxpayer has a filing status of married filing separately. 4. Which of the following should be included when determining adjusted gross income? A. Alimony received. B. Compensation for injuries or sickness. C. Rental value of parsonages. D. Tuition scholarship. 5. An individual starts paying student loan interest in the current year. How many years may the individual deduct a portion of the student loan interest? A. Current year only. B. Five years. C. Ten years. D. Duration of time that interest is paid. 6. A taxpayer's spouse dies in August of the current year. Which of the following is the taxpayer's filing status for the current year? A. Single. B. Qualified widow(er). C. Head of household. D. Married filing jointly.

7. Stone owns 100% of an S corporation and materially participates in its operations. The stock basis at the beginning of the year is $5,000. During the year, the corporation makes a distribution of $3,500 and passes through a loss from operations of $2,000 for the year. What loss can Stone deduct on Stone's personal tax return? A. $0 B. $1,500 C. $2,000 D. $5,500 8. Carter incurred the following expenses in the current year: $500 for the preparation of a personal income tax return, $100 for custodial fees on an IRA, $150 for professional publications, and $2,000 for union dues. Carter's current year adjusted gross income is $75,000. Carter, who is not self-employed, itemizes deductions. What will Carter's deduction be for miscellaneous itemized deductions after any limitations in the current year? A. $0 B. $ 750 C. $1,250 D. $2,750 9. Cole earned $3,000 in wages, incurred $1,000 in unreimbursed employee business expenses, paid $400 as interest on a student loan, and contributed $100 to a charity. What is Cole's adjusted gross income? A. $3,000 B. $2,600 C. $2,500 D. $1,600 10. Doyle has gambling losses totaling $7,000 during the current year. Doyles adjusted gross income is $60,000, including $3,000 in gambling winnings. Doyle can itemize the deductions. What amount of gambling losses is deductible? A. $0 B. $3,000 C. $5,800 D. $7,000 11. A couple filed a joint return in prior tax years. During the current tax year, one spouse died. The couple has no dependent children. What is the filing status available to the surviving spouse for the first subsequent tax year? A. Surviving spouse. B. Married filing separately. C. Single. C. Head of household.

12. Chris, age five, has $3,000 of interest income and no earned income this year. Assume the current applicable standard deduction is $800, how much of Chris's income will be taxed at Chriss parents' maximum tax rate? A. $0 B. $1,400 C. $2,200 D. $3,000 13. Which of the following statements about the child and dependent care credit is correct? A. The credit is nonrefundable. B. The child must be under the age of 18 years. C. The child must be a direct descendant of the taxpayer. D. The maximum credit is $600. 14. Taylor, an unmarried taxpayer, had $90,000 in adjusted gross income for year 13. During year 13, Taylor donated land to a church and made no other contributions. Taylor purchased the land in year 1 as an investment for $14,000. The land's fair market value was $25,000 on the day of the donation. What is the maximum amount of charitable contribution that Taylor may deduct as an itemized deduction for the land donation for year 13? A. $25,000 B. $14,000 C. $11,000 D. $0 15. A self-employed taxpayer had gross income of $57,000. The taxpayer paid self-employment tax of $8,000, health insurance of $6,000, and $5,000 of alimony. The taxpayer also contributed $2,000 to a traditional IRA. What is the taxpayer's adjusted gross income? A. $55,000 B. $50,000 C. $46,000 D. $40,000 16. Which of the following is a miscellaneous itemized deduction subject to the 2% of adjusted gross income floor? A. Gambling losses up to the amount of gambling winnings. B. Medical expenses. C. Real estate tax. D. Employee business expenses. 17. Jackson, a single individual, inherited Bean Corp. common stock from Jacksons parents. Bean is a

qualified small business corporation under Code Sec. 1244. The stock cost Jacksons parents $20,000 and had a fair market value of $25,000 at the parents date of death. During the year, Bean declared bankruptcy and Jackson was informed that the stock was worthless. What amount may Jackson deduct as an ordinary loss in the current year? A. $0 B. $03,000 C. $20,000 D. $25,000 18. Smith, a single individual, made the following charitable contributions during the current year. Smiths adjusted gross income is $60,000. Donation TO Smiths church $5,000 Art work donated to the local art museum. Smith purchased it for $2,000 four months ago. A local art dealer appraised it for 3,000 Contribution to a needy family 1,000 What amount should Smith deduct as a charitable contribution? A. $5,000 B. $7,000 C. $8,000 D. $9,000 19. Fuller was the owner and beneficiary of a $200,000 life insurance policy on a parent. Fuller sold the policy to Decker, for $25,000. Decker paid a total of $40,000 in premiums. Upon the death of the parent, what amount must Decker include in gross income? A. $0 B. $135,000 C. $160,000 D. $200,000 20. Stahl, an individual, owns 100% of Talon, an S corporation. At the beginning of the year, Stahls basis in Talon was $65,000. Talon reported the following items from operations during the current year: Ordinary loss $10,000 Municipal interest income 6,000 Long-term capital gain 4,000 Short-term capital loss 9,000 What was Stahls basis in Talon at year end?

A. $50,000 B. $55,000 C. $56,000 D. $61,000 21. Thompsons basis in Starlight Partnership was $60,000 at the beginning of the year. Thompson materially participates in the partnerships business. Thompson received $20,000 in cash distributions during the year. Thompsons share of Starlights current operations was a $65,000 ordinary loss and a $15,000 net long-term capital gain. What is the amount of Thompsons deductible loss for the period? A. $15,000 B. $40,000 C. $55,000 D. $65,000 22. Stone and Frazier decided to terminate the Woodwest Partnership as of December 31. On that date, Woodwest's balance sheet was as follows: Cash $2,000 Equipment(adjusted basis) 2,000 Capital Stone $3,000 Capital - Frazier 1,000 The fair market value of the equipment was $3,000. Frazier's outside basis in the partnership was $1,200. Upon liquidation, Frazier received $1,500 in cash. What gain should Frazier recognize? A. $0 B. $250 C. $300 D. $500 23. Daven inherited property from a parent. The property had an adjusted basis to the parent of $1,600,000. It was valued at $2,000,000 at the date of death and valued at $1,800,000 six months after the date of death. The executor elected the alternative valuation date. What is Daven's basis in the property? A. $ 0 B. $1,600,000 C. $1,800,000 D. $2,000,000 24. Don and Linda Grant, U.S. citizens, were married for the entire 2003 calendar year. In 2003, Don gave a $60,000 cash gift to his sister. The Grants made no other gifts in 2003. They each signed a timely election to treat the $60,000 gift as one made by each spouse. Disregarding the unified credit and estate tax consequences, what amount of the 2003 gift is taxable to the Grants for gift tax purposes?

A. $0 B. $38,000 C. $49,000 D. $60,000 25. DAC Foundation awarded Kent $75,000 in recognition of lifelong literary achievement. Kent was not required to render future services as a condition to receive the $75,000. What condition(s) must have been met for the award to be excluded from Kent's gross income? I. Kent was selected for the award by DAC without any action on Kent's part. II. Pursuant to Kent's designation, DAC paid the amount of the award either to a governmental unit or to a charitable organization. A. I only. B. II only. C. Both I and II. D. Neither I nor II. 26. Smith paid the following unreimbursed medical expenses: Dentist and eye doctor fees $ 5,000 Contact lenses 500 Facial cosmetic surgery to improve Smiths personal appearance surgery is unrelated to personal injury or congenital deformity) 10,000 Premium on disability insurance policy to pay him if he is injured and unable to work 2,000 What is the total amount of Smiths tax-deductible medical expenses before the adjusted gross income limitation? A. $17,500 B. $15,500 C. $7,500 D. $5,500 27. Parker, whose spouse died during the preceding year, has not remarried. Parker maintains a home for a dependent child. What is Parkers most advantageous filing status? A. Single. B. Head of household. C. Married filing separately. D. Qualifying widow(er) with dependent child. 28. Porter was unemployed for part of the year. Porter received $35,000 of wages, $4,000 from a state unemployment compensation plan, and $2,000 from his former employer's company-paid supplemental unemployment benefit plan. What is the amount of Porter's gross income? A. $35,000

B. $37,000 C. $39,000 D. $41,000 29. In which of the following situations may taxpayers file as married filing jointly? A. Taxpayers who were married but lived apart during the year. B. Taxpayers who were married but lived under a legal separation agreement at the end of the year. C. Taxpayers who were divorced during the year. D. Taxpayers who were legally separated but lived together for the entire year. 30. In the current year, an unmarried individual with modified adjusted gross income of $25,000 paid $1,000 interest on a qualified education loan entered into on July 1. How may the individual treat the interest for income tax purposes? A. As a $500 deduction to arrive at AGI for the year. B. As a $1,000 deduction to arrive at AGI for the year. C. As a $1,000 itemized deduction. D. As a nondeductible item of personal interest. 31. Tanas divorce decree requires Tana to make the following transfers to Tanas former spouse during the current year: Alimony payments of $3,000. Child support of $2,000. Property division of stock with a basis of $4,000 and a fair market value of $6,500. What is the amount of Tanas alimony deduction? A. $ 3,000 B. $ 7,000 C. $ 9,500 D. $11,500 32. A calendar-year individual is eligible to contribute to a deductible IRA. The taxpayer obtained a fourmonth extension to file until August 15 but did not file the return until November 1. What is the latest date that an IRA contribution can be made in order to qualify as a deduction on the prior year's return? A. October 15. B. April 15. C. August 15. D. November 1. 33. Wilson, CPA, uses a commercial tax software package to prepare clients' individual income tax returns. Upon reviewing a client's computer-generated year 1 itemized deductions, Wilson discovers that the schedule's deductible investment interest expense is less than the amount paid by the taxpayer and the

amount that Wilson entered into the computer. After analyzing the entire tax return, Wilson determines that the computer-generated investment interest expense deduction is correct. Why is the computergenerated investment interest expense deduction correct? I. The client's investment interest expense exceeds net investment income. II. The client's qualified residence interest expense reduces the deductible amount of investment interest expense. A. I only. B. II only. C. Both I and II. D. Neither I nor II. 34. How may taxes paid by an individual to a foreign country be treated? A. As an itemized deduction subject to the 2% floor. B. As a credit against federal income taxes due. C. As an adjustment to gross income. D. As a nondeductible. 35. Evan, an individual, has a 40% interest in EF, an S corporation. At the beginning of the year, Evan's basis in EF was $2,000. During the year, EF distributed $100,000 and reported operating income of $200,000. What amount should Evan include in gross income? A. $38,000 B. $40,000 C. $80,000 D. $118,000 Answers: 1)B 2)B 3)D 4)A 5)D 6)D 7)B 8)C 9)B 10)B 11)C 12)B 13)A 14)A 15)D 16)D 17)A 18)B 19)B 20)C 21)C 22)C 23)C 24)B 25)C 26)D 27)D 28)D 29)A 30)B 31)A 32)B 33)A 34)B 35)C

Regulation 6: Federal Taxation of Entities

C corporations
C corporation C corporation refers to any corporation that, under United States federal income tax law, is taxed separately from its owners. A C corporation is distinguished from an S corporation, which generally is not taxed separately. Most major companies (and many smaller companies) are treated as C corporations for U.S. federal income tax purposes. C corporation vs. S corporation Shareholders of a corporation may elect to treat the corporation as a flow-through entity known as an S corporation. An S corporation is not itself subject to income tax; rather, shareholders of the S corporation are subject to tax on their pro rata shares of income based on their shareholdings. To qualify to make the S corporation election, the corporation's shares must be held by resident or citizen individuals or certain qualifying trusts. A corporation may qualify as a C corporation without regard to any limit on the number of shareholders, foreign or domestic. Forming a corporation In the United States, corporations are formed under laws of a state or the District of Columbia. Procedures vary widely by state. Some states allow formation of corporations through electronic filing on the state's web site or very quickly. All states require payment of a fee (often under USD200) upon incorporation. Corporations are issued a "certificate of incorporation" by most states upon formation. Most state corporate laws require that the basic governing instrument be either the certificate of incorporation or formal articles of incorporation. Many corporations also adopt additional governing rules knows as bylaws. Most state laws require at least one director and at least two officers, all of whom may be the same person. Generally there are no residency requirements for officers or directors. Financial statements Corporations are not required to issue financial statements in the United States. Financial statements may be presented on any comprehensive basis, including an income tax basis. There is no requirement for appointment of auditors, unless the corporation is publicly traded and thus subject to the requirements of the Sarbanes-Oxley Act. Distributions Any distribution from the earnings and profits of a C corporation is treated as a dividend for U.S. income tax purposes. "Earnings and profits" is a tax law concept similar to the financial accounting concept of retained earnings. Exceptions apply to treat certain distributions as made in exchange for stock rather than as dividends. Such exceptions include distributions in complete termination of a shareholder's interest and distributions in liquidation of the corporation.

S Corporations
S Corporation An S corporation, for United States federal income tax purposes, is a corporation [38] that makes a valid election to be taxed under Subchapter S of Chapter 1 of the Internal Revenue Code. In general, S corporations do not pay any federal income taxes. Instead, the corporation's income or losses are divided among and passed through to its shareholders. The shareholders must then report the income or loss on their own individual income tax returns. An overview of S corporations S corporations are merely corporations that elect to pass corporate income, losses, deductions, and credit through to their shareholders for federal tax purposes. The S corporation rules are contained in Subchapter S of Chapter 1 of the Internal Revenue Code (sections 1361 through 1379). S status combines the legal environment of C corporations with U.S. federal income taxation similar to that of partnerships. Like a C corporation, an S corporation is generally a corporation under the law of the state in which the entity is organized. For Federal income tax purposes, however, taxation of S corporations resembles that of partnerships. As with partnerships, the income, deductions, and tax credits of an S corporation flow through to shareholders annually, regardless of whether distributions are made. Thus, income is taxed at the shareholder level and not at the corporate level. Payments to S shareholders by the corporation are distributed tax-free to the extent that the distributed earnings were not previously taxed. Also, certain corporate penalty taxes (e.g., accumulated earnings tax, personal holding company tax) and the alternative minimum tax do not apply to an S corporation. Unlike a C corporation, an S corporation is not eligible for a dividends received deduction. Unlike a C corporation, an S corporation is not subject to the 10 percent of taxable income limitation applicable to charitable contribution deductions. Qualification for S corporation status In order to make an election to be treated as an S corporation, the following requirements must be met:

Must be an eligible entity (a domestic corporation, or a limited liability company which has elected to be taxed as a corporation). Must have only one class of stock. Must not have more than 100 shareholders. o Spouses are automatically treated as a single shareholder. Families, defined as individuals descended from a common ancestor, plus spouses and former spouses of either the common ancestor or anyone lineally descended from that person, are considered a single shareholder as long as any family member elects such treatment.

Shareholders must be U.S. citizens or residents, and must be natural persons, so corporate shareholders and partnerships are generally excluded. However, certain trusts, estates, and taxexempt corporations, notably 501(c)(3) corporations, are permitted to be shareholders. Profits and losses must be allocated to shareholders proportionately to each one's interest in the business.

If a corporation meets the foregoing requirements and wishes to be taxed under Subchapter S, its shareholders may file Form 2553: "Election by a Small Business Corporation" with the Internal Revenue Service (IRS). The Form 2553 must be signed by all of the corporation's shareholders. If a shareholder resides in a community property state, the shareholder's spouse generally must also sign the 2553. The S corporation election must typically be made by the fifteenth day of the third month of the tax year for which the election is intended to be effective, or at any time during the year immediately preceding the tax year. Congress has directed the IRS to show leniency with regard to late S elections. Accordingly, often, the IRS will accept a late S election. Some states such as New York and New Jersey require a separate state-level S election in order for the corporation to be treated, for state tax purposes, as an S corporation. If a corporation that has elected to be treated as an S corporation ceases to meet the requirements (for example, if as a result of stock transfers, the number of shareholders exceeds 100 or an ineligible shareholder such as a nonresident alien acquires a share), the corporation will lose its S corporation status and revert to being a regular C corporation. Furthermore, if more than 25% of a S-corporation's gross receipts consists of passive income for three consecutive years when the corporation has accumulated earnings and profits, the S corporation will automatically lose its subchapter S status and revert to being a regular C corporation. Taxation issues The S election affects the treatment of the corporation for Federal income tax purposes. The election does not change the requirements for that corporation for other Federal taxes such as FICA and Federal unemployment taxes. FICA As is the case for any other corporation, the FICA tax is imposed only with respect to employee wages and not on distributive shares of shareholders. Although FICA tax is not owed on distributive shares, the IRS and equivalent state revenue agencies may recategorize distributions paid to shareholder-employees as wages if shareholder-employees are not paid a reasonable wage for the services they perform in their positions within the company. Distributions Actual distributions of funds, as opposed to distributive shares, typically have no effect on shareholder tax liability. The term "pass through" refers not to assets distributed by the corporation to the shareholder, but instead to the portion of the corporation's income, losses, deductions or credits that are reported to the shareholder on Schedule K-1 and are shown by the shareholder on his or her own income tax return.

However, a distribution to a shareholder that is in excess of the shareholder's basis in his or her stock is taxed to the shareholder as capital gain. Conversion from C corporation S corporations that have previously been C corporations may also, in certain circumstances, pay income taxes on untaxed profits that were generated when the corporation operated as a C corporation. This is very common with uncollected accounts receivable or appreciated real estate. For example, if an S corporation that was formerly a C corporation sells an appreciated asset (such as real estate) and the appreciation occurred during the time the corporation was a C corporation, the S corporation will probably pay C corporation taxes on the appreciation--even though the corporation is now an S corporation. This Built In Gain (BIG) tax rate is 35% on the appreciated property, but is only realized if the BIG property is sold within 10 years (starting from the first day of the first tax year of conversion to S-Corp status.) The American Recovery and Reinvestment Act of 2009 reduced that 10year recognition period to 7 years (if that 7th year precedes either 2009 or 2010.) The Small Business Jobs Act of 2010 further reduced the recognition period to 5 years. Taxation of S corporation Distributive Share While an S corporation is not taxed on its profits, the owners of an S corporation are taxed on their proportional shares of the S corporation's profits. Example: Widgets Inc, an S-Corp, makes $10,000,000 in net income (before payroll) in 2006 and is owned 51% by Bob and 49% by John. Keeping it simple, Bob and John both draw salaries of $94,200 (which is the Social Security Wage Base for 2006, after which no further Social Security tax is owed). Employee salaries are subject to FICA tax (Social Security & Medicare tax) --currently 13.3 percent-(4.2% Social Security paid by the employee; 6.2% Social Security paid by the employer; 1.45% employee medicare and 1.45% employer medicare). The distribution of the additional profits from the S corporation will be done without any further FICA tax liability. If for some reason, Bob (as the majority owner) was to decide not to distribute the money, both Bob and John would still owe taxes on their pro-rata [39] allocation of business income, even though neither received any cash distribution. To avoid this "phantom income" scenario, S corporations commonly use shareholder agreements that stipulate at least enough distribution must be made for shareholders to pay the taxes on their distributive shares. Quarterly estimated taxes must be paid by the individual to avoid tax penalties, even if this income is "phantom income". IRS study of S corporation reporting compliance In 2005, the IRS launched a study to assess the reporting compliance of S corporations The study began in late 2005 and examined 5,000 randomly selected S corporation returns from tax years 2003 and 2004. The IRS intends to use the results to measure compliance in recording of income, deductions and credits from S corporations, and to formulate future audit criteria to better target likely non-compliant returns. This is part of a larger IRS effort to improve tax compliance and reduce the estimated $300 billion gap in gross reported figures each year. A large portion of that gap is thought to come from small businesses, and

particularly S corporations, which are now the most common corporate entity, numbering over 3 million in 2002, up from about 750,000 in 1985. Filing Form 1120S Form 1120S generally must be filed by March 15th of the year immediately following the calendar year covered by the return or, if a fiscal year (a year ending on the last day of a month other than December) is used, by the 15th day of the third month immediately following the last day of the fiscal year. The corporation must complete a Schedule K-1 for each person who was a shareholder at any time during the tax year and file it with the IRS along with Form 1120S. The second copy of the Schedule K-1 must be mailed to the shareholder. Some but not all states recognize a state tax law equivalent to an S corporation, so that the S corporation in certain states may be treated the same way for state income tax purposes as it is treated for Federal purposes. A state taxing authority may require that a copy of the Form 1120S return be submitted to the state with the state income tax return. 1. Eligibility and election 2. Determination of ordinary income/loss and separately stated items 3. Basis of shareholders interest 4. Entity/owner transactions, including contributions and distributions 5. Built-in gains tax

REG 6 (Federal Taxation of Entities) Questions

1. Which of the following can be an advantage of a limited liability company over an S corporation? A. Double taxation of profits is avoided. B. Owners receive limited liability protection. C. Appreciated property can be distributed tax-free to an owner. D. Incentive stock options can be used to compensate owners. 2. Mackenzie is the grantor of a trust over which Mackenzie has retained a discretionary power to receive income. Kelly, Mackenzie's child, receives all taxable income from the trust unless Mackenzie exercises the discretionary power. To whom is the income earned by the trust taxable? A. To the trust to the extent it remains in the trust. B. To Mackenzie because he has retained a discretionary power.

C. To Kelly as the beneficiary of the trust. D. To Kelly and Mackenzie in proportion to the distributions paid to them from the trust. 3. Which of the following entities must pay taxes for federal income tax purposes? A. General partnership. B. Limited partnership. C. Joint venture. D. C corporation. 4. Quail, Inc. manufactures consumer products and sells them to distributors. Quail advertises its products to increase sales and enhance the value of its trade name. What is the appropriate tax treatment for the advertising costs? A. Amortize the costs over 15 years. B. Amortize the costs over 36 months. C. Amortize the costs over 60 months. D. Deduct the costs currently as ordinary and necessary business expenses. 5. On June 30, Gold and Silver are calendar-year C corporations. The corporations have merged, with Gold as a subsidiary of Silver. Silver owns 85% of Gold's voting stock and fair market value (FMV). Which of the following tax return filings would be appropriate for the two companies? A. Two separate returns, because Silver owns at least 80% of both the voting stock and FMV of Gold. B. Two separate returns, because the merger took place before the close of the second quarter. C. A consolidated return, because Silver owns at least 80% of both the voting stock and FMV of Gold. D. A consolidated return, because the merger took place before the close of the second quarter. 6. Stone Corp. has been an S corporation since inception. In each of year 1, year 2, and year 3, Stone made distributions in excess of each shareholder's basis. Which of the following statements is correct concerning these three years? A. In year 1 and year 2 only, the excess distributions are taxed as capital gain. B. In year 1 only, the excess distributions are tax free. C. In year 3 only, the excess distributions are taxed as capital gain. D. In all three years, the excess distributions are taxed as capital gains. 7. Brown, a 50% partner in Brown & White, received a distribution of $12,500 in the current year. The partnerships income for the year was $25,000. What is the character of the payment that Brown received? A. Partial liquidation. B. Liquidating distribution. C. Disproportionate distribution. D. Current distribution. 8. Robin, a C corporation, had revenues of $200,000 and operating expenses of $75,000. Robin also

received a $20,000 dividend from a domestic corporation and is entitled to a $14,000 dividend-received deduction. Robin donated $15,000 to a qualified charitable organization in the current year. What is Robin's contribution deduction? A. $15,000 B. $14,500 C. $13,900 D. $13,100 9. Hot assets of a partnership would include which of the following? A. Cash. B. Unrealized receivables. C. Section 1231 assets. D. Capital assets. 10. As a general partner in Greenland Associates, an individual's share of partnership income for the current tax year is $25,000 ordinary business income and a $10,000 guaranteed payment. The individual also received $5,000 in cash distributions from the partnership. What income should the individual report from the interest in Greenland? A. $5,000 B. $25,000 C. $35,000 D. $40,000 11. Which of the following statements about qualifying shareholders of an S corporation is correct? A. A general partnership may be a shareholder. B. Only individuals may be shareholders. C. Individuals, estates, and certain trusts may be shareholders. D. Nonresident aliens may be shareholders. 12. Absent an election to close the books, the allocation of nonseparately stated income or loss for an S corporation shareholder that changed his ownership interest during the year is computed based on which of the following ownership percentages? A. Ownership percentage at the end of the S corporation year. B. Ownership percentage computed on a per-share per-day basis. C. Ownership percentage at the beginning of the S corporation year. D. Ownership percentage determined as an average of the beginning and ending ownership percentages. 13. Simon, a C corporation, had a deficit in accumulated earnings and profits of $50,000 at the beginning of the year and had current earnings and profits of $10,000. At year end, Simon paid a dividend of $15,000 to its sole shareholder. What amount of the dividend is reported as income? A. $0

B. $ 5,000 C. $10,000 D. $15,000 14. Campbell acquired a 10% interest in Vogue Partnership by contributing a building with an adjusted basis of $40,000 and a fair market value of $90,000. The building was subject to a $60,000 mortgage that was assumed by Vogue. The other partners contributed cash only. The basis of Campbell's partnership interest in Vogue is A. $84,000 B. $34,000 C. $30,000 D. $0 15. Baker is a partner in BDT with a partnership basis of $60,000. BDT made a liquidating distribution of land with an adjusted basis of $75,000 and a fair market value of $40,000 to Baker. What amount of gain or loss should Baker report? A. $35,000 loss. B. $20,000 loss. C. $0 D. $15,000 gain. 16. Nolan designed Timber Partnership's new building. Nolan received an interest in the partnership for the services. Nolan's normal billing for these services would be $80,000 and the fair market value of the partnership interest Nolan received is $120,000. What amount of income should Nolan report? A. $ 0 B. $ 40,000 C. $ 80,000 D. $120,000 17. The CSU partnership distributed to each partner cash of $4,000, inventory with a basis of $4,000 and a fair market value (FMV) of $6,000, and land with an adjusted basis of $5,000 and an FMV of $3,000 in a liquidating distribution. Partner Chang had an outside basis in Chang's partnership interest of $12,000. In the second year after receiving the liquidating distribution, Chang sold the inventory for $5,000 and the land for $3,000. What income must Chang report upon the sale of these assets? A. $0 gain or loss. B. $0 ordinary gain and $1,000 capital loss. C. $1,000 ordinary gain and $1,000 capital loss. D. $1,000 ordinary gain and $0 capital loss. 18. Commerce Corp. elects S corporation status as of the beginning of year 2000. At the time of Commerces election, it held a machine with a basis of $20,000 and a fair market value of $30,000. In

March of 2000, Commerce sells the machine for $35,000. What would be the amount subject to the builtin gains tax. A. $0 B. $ 5,000 C. $10,000 D. $15,000 19. Which of the following is allowed in the calculation of the taxable income of a simple trust? A. Exemption. B. Standard deduction. C. Brokerage commission for purchase of tax-exempt bonds. D. Charitable contribution. 20. The individual partner rather than the partnership makes which of the following elections? A. Election to amortize organizational costs. B. Nonrecognition treatment for involuntary conversion gains. C. Code section 179 deductions for tangible personal property. D. Whether to take a deduction or credit for taxes paid to foreign countries. 21. Forrest Corp. owned 100% of both the voting stock and total value of Diamond Corp. Both corporations were C corporations. Forrest's basis in the Diamond stock was $200,000 when it received a lump sumliquidating distribution of property as a result of the redemption of all of Diamond stock. The property had an adjusted basis of $270,000 and a fair market value of $500,000. What amount of gain did Forrest recognize on the distribution? A. $0 B. $ 70,000 C. $270,000 D. $500,000 22. Molloy contributed $40,000 in cash in exchange for a one-third interest in the RST Partnership. In the first year of partnership operations, RST had taxable income of $60,000. In addition, Molloy received a $5,000 distribution of cash and, at the end of the partnership year, Molloy had a one-third share in the $18,000 of partnership recourse liabilities. What was Molloy's basis in RST at year end? A. $ 55,000 B. $ 61,000 C. $ 71,000 D. $101,000 23. Fern received $30,000 in cash and an automobile with an adjusted basis and market value of $20,000 in a proportionate liquidating distribution from EF Partnership. Fern's basis in the partnership interest was $60,000 before the distribution. What is Fern's basis in the automobile received in the liquidation?

A. $0 B. $10,000 C. $20,000 D. $30,000 24. Pope, a C corporation, owns 15% of Arden Corporation. Arden paid a $3,000 cash dividend to Pope. What is the amount of Popes dividend-received deduction? A. $3,000 B. $2,400 C. $2,100 D. $0 25. A C corporation has gross receipts of $150,000, $35,000 of other income, and deductible expenses of $95,000. In addition, the corporation incurred a net long-term capital loss of $25,000 in the current year. What is the corporation's taxable income? A. $ 65,000 B. $ 87,000 C. $ 90,000 D. $115,000 26. Jagdon Corp.'s book income was $150,000 for the current year, including interest income from municipal bonds of $5,000 and excess capital losses over capital gains of $10,000. Federal income tax expense of $50,000 was also included in Jagdon's books. What amount represents Jagdon's taxable income for the current year? A. $185,000 B. $195,000 C. $205,000 D. $215,000 27. At the beginning of the year, Westwind, a C corporation, had a deficit of $45,000 in accumulated earnings and profits. For the current year, Westwind reported earnings and profits of $15,000. Westwind distributed $12,000 during the year. What was the amount of Westwinds accumulated earnings and profits at year-end? A. $30,000 B. $42,000 C. $45,000 D. $57,000 28. Baker, an individual, owned 100% of Alpha, an S corporation. At the beginning of the year, Bakers basis in Alpha Corp. was $25,000. Alpha realized ordinary income during the year in the amount of $1,000 and a long-term capital loss in the amount of $3,000 for this year. Alpha distributed $30,000 in

cash to Baker during the year. What amount of the $30,000 cash distribution is taxable to Baker? A. $0 B. $05,000 C. $07,000 D. $30,000 29. At the beginning of the year, Cable, a C corporation, had accumulated earnings and profits of $100,000. Cable reported the following items on its current-year tax return: Taxable income Federal income taxes paid Charitable contributions carry forward Capital loss carry forward $50,000 5,000 1,000 2,000

What is Cables accumulated earnings and profits at the end of the year? A. $145,000 B. $146,000 C. $148,000 D. $150,000 30. Oz, a nongovernmental not-for-profit organization, received $50,000 from Ame Company to sponsor a play given by Oz at the local theater. Oz gave Ame 25 tickets, which generally cost $100 each. Ame received no other benefits. What amount of ticket sales revenue should Oz record? A. $0 B. $2,500 C. $47,500 D. $50,000 31. State University received two contributions during the year that must be used to provide scholarships. Contribution A for $10,000 was collected during the year, and $8,000 was spent on scholarships. Contribution B is a pledge for $30,000 to be received next fiscal year. What amount of contribution revenue should the university report in its statement of activities? A. $ 8,000 B. $10,000 C. $38,000 D. $40,000 32. Tree City reported a $1,500 net increase in fund balance for governmental funds. During the year, Tree purchased general capital assets of $9,000 and recorded depreciation expense of $3,000. What amount should Tree report as the change in net assets for governmental activities? A. ($4,500)

B. $ 1,500 C. $ 7,500 D. $10,500 33. Chase City imposes a 2% tax on hotel charges. Revenues from this tax will be used to promote tourism in the city. Chase should record this tax as what type of nonexchange transaction? A. Derived tax revenue. B. Imposed nonexchange revenue. C. Government-mandated transaction. D. Voluntary nonexchange transaction. 34. Pica, a nongovernmental not-for-profit organization, received unconditional promises of $100,000 expected to be collected within one year. Pica received $10,000 prior to year end. Pica anticipates collecting 90% of the contributions and has a June 30 fiscal year end. What amount should Pica record as contribution revenue as of June 30? A. $ 10,000 B. $ 80,000 C. $ 90,000 D. $100,000 35. Forkin Manor, a nongovernmental not-for-profit organization, is interested in having its financial statements reformatted using terminology that is more readily associated with for-profit entities. The director believes that the term operating profit and the practice of segregating recurring and nonrecurring items more accurately depict the organizations activities. Under what condition will Forkin be allowed to use operating profit and to segregate its recurring items from its nonrecurring items in its statement of activities? A. The organization reports the change in unrestricted net assets for the period. B. A parenthetical disclosure in the notes implies that the not-for-profit organization is seeking for-profit entity status. C. Forkin receives special authorization from the Internal Revenue Service that this wording is appropriate. D. At a minimum, the organization reports the change in permanently restricted net assets for the period. 36. Nox City reported a $25,000 net increase in the fund balances for total governmental funds. Nox also reported an increase in net assets for the following funds: Motor pool internal service fund $ 9,000 Water enterprise fund 12,000 Employee pension fund 7,000 The motor pool internal service fund provides service to the general fund departments. What amount

should Nox report as the change in net assets for governmental activities? A. $25,000 B. $34,000 C. $41,000 D. $46,000 37. A not-for-profit voluntary health and welfare organization received a $500,000 permanent endowment. The donor stipulated that the income must be used for a mental health program. The endowment fund reported $60,000 net decrease in market value and $30,000 investment income. The organization spent $45,000 on the mental health program during the year. What amount of change in temporarily restricted net assets should the organization report? A. $75,000 decrease. B. $15,000 decrease. C. $0 D. $425,000 increase. 38. The statement of activities of the government-wide financial statements is designed primarily to provide information to assess which of the following? A. Operational accountability. B. Financial accountability. C. Fiscal accountability. D. Functional accountability. 39. According to GASB 34, Basic Financial Statements-and Managements Discussion and Analysis-for State and Local Governments, certain budgetary schedules are required supplementary information. What is the minimum budgetary information required to be reported in those schedules? A. A schedule of unfavorable variances at the functional level. B. A schedule showing the final appropriations budget and actual expenditures on a budgetary basis. C. A schedule showing the original budget, the final appropriations budget, and actual inflows, outflows, and balances on a budgetary basis. D. A schedule showing the proposed budget, the approved budget, the final amended budget, actual inflows and outflows on a budgetary basis, and variances between budget and actual. 40. Smith, a partner in Ridge Partnership, had a basis in the partnership interest of $100,000 at the time Smith received a nonliquidating distribution of land with an adjusted basis of $75,000 to Ridge and a fair market value of $135,000. Ridge had no unrealized receivables, appreciated inventory, or properties that had been contributed by its partners. Which of the following statements is(are) correct regarding the distribution? I. Ridge recognized a $60,000 capital gain from the distribution. II. Smith's holding period for the land includes the time it was owned by Ridge.

A. I only. B. II only. C. Both I and II. D. Neither I nor II. 41. Packer Corp., an accrual-basis, calendar-year S corporation, has been an S corporation since its inception. Starr was a 50% shareholder in Packer throughout the current year and had a $10,000 tax basis in Packer stock on January 1. During the current year, Packer had a $1,000 net business loss and made an $8,000 cash distribution to each shareholder. What amount of the distribution was includible in Starr's gross income? A. $8,000 B. $7,500 C. $4,000 D. $0 42. Gardner, a U.S. citizen and the sole income beneficiary of a simple trust, is entitled to receive current distributions of the trust income. During the year, the trust reported: Interest income from corporate bonds $5,000 Fiduciary fees allocable to income 750 Net long-term capital gain allocable to corpus 2,000 What amount of the trust income is includible in Gardner's gross income? A. $7,000 B. $5,000 C. $4,250 D. $0 43. A corporation was completely liquidated and dissolved during the current year. The filing fees, professional fees, and other expenditures incurred in connection with the liquidation and dissolution are A. Deductible in full by the dissolved corporation. B. Deductible by the shareholders and not by the corporation. C. Treated as capital losses by the corporation. D. Not deductible by either the corporation or the shareholders. 44. Anderson's basis in the SBF Partnership is $80,000. Anderson received a nonliquidating distribution of $50,000 cash, and land with an adjusted basis of $40,000 and a fair market value of $50,000. What is Anderson's basis in the land? A. $50,000 B. $40,000 C. $30,000 D. $20,000

45. Acme and Buck are equal members in Dear, an LLC. Dear has elected not to be treated as an LLC. Dear has not elected to be taxed as a corporation. Acme contributed $7,000 cash and Buck contributed a machine with an adjusted basis of $5,000 and a fair market value of $10,000, subject to a liability of $3,000. What is Acme's basis in Dear? A. $ 4,000 B. $ 7,000 C. $ 8,500 D. $10,000 46. Bridge, a C corporation, had $15,000 in accumulated earnings and profits at the beginning of the current year. During the current year, Bridge reported earnings and profits of $10,000 and paid $20,000 in cash distributions to its shareholders in both March and July. What amount of the July distribution should be classified as dividend income to Bridge's shareholders? A. $20,000 B. $15,000 C. $10,000 D. $ 5,000 47. Owen's tax basis in Regal Partnership was $18,000 at the time Owen received a nonliquidating distribution of $3,000 cash and land with an adjusted basis of $7,000 to Regal and a fair market value of $9,000. Regal did not have unrealized receivables, appreciated inventory, or properties that had been contributed by its partners. Disregarding any income, loss, or any other partnership distribution for the year, what was Owen's tax basis in Regal after the distribution? A. $9,000 B. $8,000 C. $7,000 D. $6,000 48. Dole, the sole owner of Enson Corp., transferred a building to Enson. The building had an adjusted tax basis of $35,000 and a fair market value of $100,000. In exchange for the building, Dole received $40,000 cash and Enson common stock with a fair market value of $60,000. What amount of gain did Dole recognize? A. $ 0 B. $ 5,000 C. $40,000 D. $65,000 49. Bailey contributed land with a fair market value of $75,000 and an adjusted basis of $25,000 to the ABC Partnership in exchange for a 30% interest. The partnership assumed Bailey's $10,000 recourse mortgage on the land. What is Bailey's basis for his partnership interest?

A. $15,000 B. $18,000 C. $65,000 D. $75,000 50. Aztec, a C corporation, distributed an asset to Burn, a shareholder. The asset had a fair market value of $30,000 and was subject to a $40,000 liability, assumed by Burn. The asset had an adjusted basis of $25,000. What amount of gain must Aztec recognize? A. $0 B. $5,000 C. $10,000 D. $15,000 51. A partnership had four partners. Each partner contributed $100,000 cash. The partnership reported income for the year of $80,000 and distributed $10,000 to each partner. What was each partner's basis in the partnership at the end of the current year? A. $170,000 B. $120,000 C. $117,500 D. $110,000 52. Which of the following items should be included on the Schedule M-1, Reconciliation of Income (Loss) per Books With Income per Return, of Form 1120, U.S. Corporation Income Tax Return to reconcile book income to taxable income? A. Cash distributions to shareholders. B. Premiums paid on key-person life insurance policy. C. Corporate bond interest. D. Ending balance of retained earnings. 53. Which of the following types of entities is entitled to the net operating loss deduction? A. Partnerships. B. S corporations. C. Trusts and estates. D. Not-for-profit organizations. 54. In the current year, Brown, a C corporation has gross income (before dividends) of $900,000 and deductions of $1,100,000 (excluding the dividends-received deduction). Brown received dividends of $100,000 from a Fortune 500 corporation during the current year. What is Brown's net operating loss? A. $100,000 B. $130,000 C. $170,000

D. $200,000 55. Kerr and Marcus form KM Partnership with a cash contribution of $80,000 from Kerr and a property contribution of land from Marcus. The land has a fair market value of $80,000 and an adjusted basis of $50,000 at the date of the contribution. Kerr and Marcus are equal partners. What is Marcuss basis immediately after formation? A. $0 B. $50,000 C. $65,000 D. $80,000 56. Smith received a one-third interest of a partnership by contributing $3,000 in cash, stock with a fair market value of $5,000 and a basis of $2,000, and a new computer that cost Smith $2,500. Which of the following amounts represents Smith's basis in the partnership? A. $10,500 B. $ 7,500 C. $ 5,500 D. $ 3,000 57. Which of the following is an advantage of forming a limited liability company (LLC) as opposed to a partnership? A. The entity may avoid taxation. B. The entity may have any number of owners. C. The owner may participate in management while limiting personal liability. D. The entity may make disproportionate allocations and distributions to members. 58. Walker transferred property used in a sole proprietorship to the WXYZ partnership in exchange for a one-fourth interest. The property had an original cost of $75,000, an adjusted tax basis to Walker of $20,000, and fair market value of $50,000. The partnership has no liabilities. What is Walker's basis in the partnership interest? A. $0 B. $20,000 C. $50,000 D. $75,000 59. Olson, Wayne, and Hogan are equal partners in the OWH partnership. Olson's basis in the partnership interest is $70,000. Olson receives a liquidating distribution of $10,000 cash and land with a fair market value of $63,000, and a basis of $58,000. What is Olson's basis in the land? A. $58,000 B. $60,000 C. $63,000

D. $70,000 60. Which of the following is an attribute of a complex trust? A. It distributes income to more than one beneficiary. B. It has a grantor that is not an individual. C. It has a beneficiary that is not an individual. D. It distributes corpus. 61. A corporation that has both preferred and common stock has a deficit in accumulated earnings and profits at the beginning of the year. The current earnings and profits are $25,000. The corporation makes a dividend distribution of $20,000 to the preferred shareholders and $10,000 to the common shareholders. How will the preferred and common shareholders report these distributions? A. Preferred - $20,000 dividend income; common - $10,000 dividend income. B. Preferred - $20,000 dividend income; common - $5,000 dividend income, $5,000 return of capital. C. Preferred - $15,000 dividend income; common - $10,000 dividend income. D. Preferred - $20,000 return of capital; common - $10,000 return of capital. 62. The at-risk limitation provisions of the Internal Revenue Code may limit I. A partner's deduction for his or her distributive share of partnership losses. II. A partnership's net operating loss carryover. A. I only. B. II only. C. Both I and II. D. Neither I nor II. 63. On December 31, after receipt of his share of partnership income, Clark sold his interest in a limited partnership for $30,000 cash and relief of all liabilities. On that date, the adjusted basis of Clark's partnership interest was $40,000, consisting of his capital account of $15,000 and his share of the partnership liabilities of $25,000. The partnership has no unrealized receivables or substantially appreciated inventory. What is Clark's gain or loss on the sale of his partnership interest? A. Ordinary loss of $10,000. B. Ordinary gain of $15,000. C. Capital loss of $10,000. D. Capital gain of $15,000. 64. Reid, Welsh, and May are equal partners in the RWM partnership. Reid's basis in the partnership interest is $60,000. Reid receives a liquidating distribution of $61,000 cash and land with a fair market value of $14,000 and an adjusted basis of $12,000. What gain must Reid recognize upon the liquidation of his partnership interest? A. $0 B. $ 1,000

C. $13,000 D. $15,000 65. Brown transfers property to a trust. A local bank was named trustee. Brown retained no powers over the trust. The trust instrument provides that current income and $6,000 of principal must be distributed annually to the beneficiary. What type of trust was created? A. Simple. B. Grantor. C. Complex. D. Revocable. 66. Magic Corp., a regular C corporation, elected S corporation status at the beginning of the current calendar year. It had an asset with a basis of $40,000 and a fair market value (FMV) of $85,000 on January 1. The asset was sold during the year for $95,000. Magics corporate tax rate was 35%. What was Magics tax liability as a result of the sale? A. $0 B. $ 3,500 C. $15,750 D. $19,250 Answers: 1)C 2)B 3)D 4)D 5)C 6)D 7)D 8)B 9)B 10)C 11)C 12)B 13)C 14)D 15)C 16)D 17)C 18)C 19)A 20)D 21)A 22)B 23)D 24)C 25)C 26)C 27)B 28)C 29)B 30)B 31)D 32)C 33)A 34)C 35)A 36)B 37)C 38)A 39)C 40)B 41)D 42)C 43)A 44)C 45)C 46)D 47)B 48)C 49)B 50)D 51)D 52)B 53)C 54)C 55)B 56)B 57)C 58)B 59)B 60)D 61)B 62)A 63)D 64)B 65)C 66)C