Regulation

Chapter 1 – Individual Taxation (abridged)

Individual Taxation: FILING STATUS

I. FILING
- Requirement for filing: must file if income is ≥ personal exemption + regular standard
deduction + addt’l standard deduction for age 65+ or blind
o Exceptions:
(1) Self-Employment earnings ≥ $400
(2) Indvd claimed as dependents, have unearned income, and gross
income ≥ $900
(3) Indvds who receive advance payments of earned income credit
- Tax return due Apr 15; paperwork has auto 6-mo extension (until Oct 15), payment still
due Apr 15
- Taxpayers outside of country have auto 2-mo extension to file, but not to pay
II. FILING STATUS
- Single/End of Year Test: On Dec 31, file single if: Single OR Legally Separated
- Joint Returns/End of Year Test: On Dec 31, file joint if: married at end of year or married
and living apart but not legally divorced
o Joint: Married at year end or spouse dies during the year
o Not Joint: Divorced during the year
- Married filing separately: can report even if only one spouse had income. In community
property state, everything split 50/50
- Qualifying widow(er) (surviving spouse): widow(er) may use join tax return for two years
following year of death of spouse, unless remarry.
o Requirement: must maintain household for WHOLE taxable year was principal
residence of (step)son, (step)daughter (whether by blood or adoption)
o Surviving spouse must also be entitled to dependency exemption for such
individual
- Head of Household: Pay lower taxes from larger standard deduction and “wider” tax
brackets
o Requirements:
 Not married, legally separated OR married and has lived apart from his/her
spouse for last 6 mos of year at close of taxable year.
 Maintains household that for MORE THAN HALF the year is principal
residence of:
• Son or daughter (also legally adopted children, stepchildren, g-
children)
• Working Families Act ~ child must either be qualifying child or
qualify as taxpayer’s dependent (Must live with); to protect Divorced
Mom
• Father or Mother (not required to live with)
• Dependent Relatives (Must live with)
• NOT kissing cousins, free-loading friends, or foster parents

Individual Taxation: EXEMPTIONS

I. PERSONAL EXEMPTIONS
a. If eligible to be claimed as dependent on another’s tax return, NOT allowed personal
exemption on own returns (if folks use it, you lose it)
b. Each spouse receives personal exemption
c. Married taxpayer who files separately may claim his/her spouse’s personal
exemption if:
i. Taxpayer’s spouse has no gross income
ii. Taxpayer’s spouse was not claimed as dependent of another taxpayer
 d. If person is born or dies during year, entitled to personal exemption for entire year.
Not prorated
II. DEPENDENCY EXEMPTIONS
a. Qualifying Child (CARE): Close relative, Age limit, Residency Requirements, Eliminate
Goss Income Test, Support Test Changes
b. Qualifying Relative (SUPORT): Support (over 50%) test, Under a specific amount of
taxable gross income test, Precludes dependent filing a joint tax return test, Only
citizens test (incl Mexico/Canada), Relative test OR Taxpayer lives with indvd for
whole year test (if not related)
c. No additional exemption for being old/blind. It is an increased standard deduction
III. PHASE-OUT OF PERSONAL AND DEPENDENCY EXEMPTIONS
a. Give to the poor and take away from the rich
b. Reduces exemptions by 2% of each $2500 or fraction thereof ($1,250 for married
filing separately)

Individual Taxation: GROSS INCOME

I. Gross Income in General
a. Basis
i. FMV: Taxable
ii. NBV: Non-taxable, no income
b. Realization = real world. Requires accrual or receipt of cash, property, or services
(sale/exchange)
c. Recognition = Realized gain included record/report on tax return
II. Specific Items of Income and Exclusions
a. Salaries and Wages
i. Property – FMV included in gross income; taxable
ii. Cancellation in Debt included in gross income
iii. If employer sells property to employee for < FMV, difference is income
iv. Partially Taxable Fringe Benefits
1. Premiums above first $50,000 are taxable income and included in W-2
wages
v. Non-taxable Fringe Benefits
1. Life Insurance Proceeds – unlimited. Interest income on deferred
payouts fully taxable
2. Employer payment of employee’s educational expenses (up to $5,250).
MBA is OK
vi. Employee discounts on employer-provided merchandise and service are
excludable limited to employer’s gross profit percentage
vii. Qualified pension, profit-sharing, and stock bonus plans
1. Payments made by employer are non-taxable (tax deferred until
withdraw)
2. Benefits received (taxable) – when withdraw benefits
b. Interest Income (GR: all interest taxable)
i. Taxable interest
1. Interest paid by FEDERAL or STATE gov’t for late payment of tax refund
2. Premiums received for opening savings acct (e.g. prizes and awards)
3. FEDERAL gov’t obligations are taxable!
ii. Tax Exempt Interest (reportable but not taxable)
1. Interest on STATE and LOCAL bonds/obligations is tax EXEMPT
2. Interest on U.S> obligation is tax exempt
3. Series EE (U.S> Savings Bond) – “educational expenses”
a. Used to pay for higher education, reduced by scholarships
b. If not used, must pay interest
c. Phaseout starts when modified AGI > indexed amount. Robin
Hood
iii. Unearned Income of Child < 18 (“Kiddie Tax”)
1. Taxed at parent’s higher rate of > $1800
 2. Taxed at child’s rate if $901-$1800; No tax if below $900
3. Net Unearned Income = Child’s total unearned inc – Child stand
deduction $900 - $900
c. Dividend Income
i. Four sources:
1. E&P / Current = By Year End
2. E&P / Accumulated = Dist Date
3. Return of Capital = No E&P (tax-free)
4. Cap Gain Dist = No E&P / no basis (favorable tax rate)
ii. Three categories of Dividends
1. Taxable Dividends
a. Cash = Amount received
b. Property = FMV
c. Qualified dividends holding period: stock must be held > 60 days
during 120-day period beginning 60 days before ex-dividend
dates
d. Special (lower) tax: 15% for most. 0% for those in 10% or 15%
income bracket
2. Tax-Free distributions – GR: non-taxable
a. Return of Capital
b. Stock Split
c. Stock Dividend (unless cash or other property option: taxable
FMV)
i. EXCPTION: if receive cash or other property: taxable at
FMV of dividend
d. Life insurance dividend (premium)
3. Capital Gain distribution – taxable gross income
d. State and Local tax refunds – not taxable if taxes paid did not result in tax benefit
i. Prior yr itemized = taxable state or local refund
ii. Prior yr used stand deduction (freebie) = nontaxable state or local refund (no
tax benefit)
1. 1040 EZ = standard deduction
e. Payments related to divorce
i. Alimony – deductible/get adjustment
1. Cannot extend beyond death of payee-spouse
2. Must be legally required pursuant to written divorce agreement
3. Must be Cash
ii. Child support – non-taxable
1. Payment applies first to child support rather than alimony (“deadbeat
dad”)
iii. Property settlements – non-taxable
f. Business Income or loss (Schedule C or C-EZ). Self Employed.
Gross Business Income
<Business Expenses>
Profit OR Loss
i. Gross Income
ii. Expenses – BOTH incurred AND paid
1. COGS (expensed when sold)
2. Salaries and commissions paid to others
3. Business meal and entertainment expenses at 50%
4. Interest expense on business loans (those paid in advance cannot be
deducted until tax year/period to which interest relates)
5. Bad debts actually written off for accrual basis taxpayer only (direct
write off method)
iii. Nondeductible Expenses
1. Salaries paid to sole proprietor (considered a “draw”)
2. Federal income tax
 3. Personal portion of business expenses (car, travel, meals,
entertainment, interest exp)
4. Bad debt expense of a cash basis taxpayer (who never reported
income)
5. Charitable contributions – Schedule A
iv. Net Business Income or Loss is taxable
1. Two taxes on net taxable income  profit
a. Income tax
b. Federal self-employed (SE) tax – social security
2. Business with loss may deduct loss against other income. (2 yrs
carryback, 20 forward)
v. Uniform Capitalization Rules
1. Capitalized as Inventory: direct materials, direct labor, factory overhead
2. Capitalized as Period Expense: SG&A, R&D
g. Gains and losses on disposition of property
Amount Realized
<Adj Basis of Assets Sold>
Gain or Loss Realized
h. IRA Income (GR: taxable when withdrawn at age 59 ½, otherwise 10% penalty)
i. Roth IRA – benefits are non-taxable
ii. Traditional IRA – principal is nontaxable, accum earnings taxable when
withdrawn
i. Annuities – treat like depreciation
i. Live longer than actuarial payout period – if live longer than 260 months,
further payments are fully taxable
ii. Death before full recovery – unrecovered portion of investment is
miscellaneous itemized deduction not subject to 2% of AGI Floor
j. Rental Income (passive activity, use Schedule E)
i. Rental of Vacation Home
1. Rented < 15 days: Rental income excluded. Mortgage and real estate
taxes are itemized deduction. Depreciation, utilities and repairs not
deductible
2. Rented > 15 days: Expenses pro-rated btwn personal and rental use.
Rental use expenses deductible only to extent of rental income
ii. Passive Activity Losses (PALs) – nondeductible. Includes rental, interests in
limited partnerships, S corporations, and most tax shelters
1. Carry forward losses indefinitely
a. When property disposed of, unused losses are fully tax
deductible
2. PAL (disallowed net loss) exceptions
a. Mom and Pop: may deduct up to $25k per year of net passive
losses attributable to rental estate annually if indvds are actively
participating/managing
b. Phaseout for poor: $25k allowance reduced by 50% of excess of
AGI. No allowance after $150,000 AGI
k. Unemployment Compensation – taxable
l. SSC Income –
i. Low income (single $25k, MFJ $32k) – no SSC taxable
ii. Upper income (single $34k, MFJ $44k) – 85% SSC taxable
m. Miscellaneous Income
i. Taxable
1. Gambling winnings in gross income. Losses may be deducted to extent
of winnings.
ii. Partially taxable
1. Scholarships and fellowships for degree-seeking student (nontaxable);
for nondegree-seeking student (taxable)
2. Room and board or services required are TAXABLE
 iii. Nontaxable
1. Life insurance proceeds (except deferred payouts)
2. Gifts and inheritances
3. Medicare
4. Workers’ Compensation (vs. unemployement comp taxable)
5. Personal (Physical) injury award
6. Accident insurance – premiums paid by taxpayer

Individual Taxation: CAPITAL GAINS AND LOSSES

I. Capital Assets – property (real and personal)
a. Stocks and securities of all types (except those held by dealers  inventory)
b. Personal property of taxpayer (not used in trade or business)
c. Real property (not used in trade or business)
II. Non-Capital Assets
a. Property normally included in inventory or held for sale to customers in ordinary
course of business
b. Depreciable personal property, equipment, and real estate used in trade or business
c. Copyrights held by original artist
d. GAAP Capital Asset = machinery, building, land, equipment = TAX Section 1231
e. Equipment used by business > 1 year  Section 1245 is ordinary income. If sold for
loss: Section 1231
III. Adjusted basis of asset sold
a. GR: FMV higher than donor’s basis  Gain = Selling Price – Basis
b. Sell higher than NBV (Donor Basis)  Gain = Selling Price – Basis
c. Sell below lower FMV at Date of Gift  Loss = Selling Price – FMV at Gift Date
d. Sell between donor basis and FMV  No gain or loss. Basis = selling price
IV. Nondeductible Losses
a. Wash Sale Loss: when security (stock/bond) sold for loss and repurchased w/in 30
days b4 or after sale
i. If taxpayer buys same stock 30 days before sale of stock that resulted in loss,
loss is disallowed
ii. If security is sold resulting in gain and repurchased w/in 30 days, must pay
capital gains tax and use new purchase price as the basis
V. C Corporation Capital Gain and Loss Rules
Excess
Offset Carryback Carryforward
Operating Losses Yes 2 years (can 20 years
forego)
Indvd Capital $3,000 No Forever
Losses
Corporate Capital No 3 years 5 years
Loses

Chapter 3 – Corporate Taxation and MACRS

C Corporations, Depreciation, and MACRS

I. FORMATION – issuance of common stock (formation), purchase of treasury stock
(reacquisition), sale of
treasury stock (resale)
 - Corporation Tax
o General rule: no gain/loss recognized
o Basis of property: The greater of adjusted NBV (basis) of the
transferor/shareholder + gain recognized or debt assumed by corporation
(transferor may recognize gain to prevent negative basis)
o Exception: If the aggregate adjusted basis of property contributed to corp by
transferor/shareholder exceeds FMV of property transferred, corp’s basis is limitd
to aggregate FMV of property (prevents transfer of property with “built in losses”
to corp)
- Shareholder Tax
o Shareholder contributing PROPERTY in exchange for corp’s common stock has no
gain or loss if:
 Transferors/shareholders own at least 80% of voting stock and at least 80%
of non-voting stock immediately after the transaction
 No Boot involved
o Gains are recognized if: Boot is involved (taxable)
(1) Cash withdrawn
(2) Cancellation of Debt (C.O.D.): Liabilities > NBV Assets transferred into corp,
generating gain
NBV Assets
<Liabilities>
C.O.D.  Boot
o Basis of common stock (to shareholder): Cash + NBV Property + FMV Services
o Cash = amount contributed
o Property = adjusted basis (NBV)
 Adjusted basis of property is reduced by any debt (C.O.D.)
 Add: taxable boot (excess liabilities) to bring stock basis to zero
o Services: shareholder receiving common stock for services rendered must
recognize FMV as ordinary income (taxable)
II. OPERATIONS
- Sched M-1 reconciles net book and taxable income. Does not distinguish btwn temp and
permanent
Corporate Taxable Items
- Gross Income
(1) Cash received in advance of accrual GAAP income is taxed when received (temp
diffs)
a. Interest income, Rental income, or Royalty income received in advance
(2) GAAP income items not in taxable income (perm diffs)
a. Interest income from municipal or state obligations/bonds
b. Proceeds from life insurance on officers’ lives where corporation is
beneficiary (“key person” policy)
- Trade or business deductions (ordinary and necessary are deductible)
o “ordinary and necessary” means expenses are common (or accepted in the
particular business or profession and they relate to producing current year’s
income)
o Domestic Production Deduction (to keep labor in U.S.)
 Deduction % phases in over a period of years
 Lesser of:
• Qualified Production Activities Income (QPAI)
• Taxable Income (w/o QPAI deduction)
 Calculating QPAI
Domestic Production Gross Receipts
<COGS>
<Other directly allocable expenses or losses>
<Proper share of other deductions>
 QPAI
• Domestic production gross receipts: gross receipts derived in significant
part w/in U.S. from any disposition of qualified production property that is
manuf, grown, etc.
o Cannot deduct compensation expenditures > $1M paid to CEO or four other most
highly compensated officers
o Bonuses deductible if paid out by 3/15 in tax year
o Bad debts – Specific charge-off method
(1) Accrual Basis: Direct write-off method. Write-off bad debts as become
worthless
(2) Cash Basis: not allowed tax deduction
o Business Interest Expense
(1) Interest paid or accrued during taxable yr for business purposes is
deductible
(2) Interest expense on loans for investment is taxed limited to “net
investment income”
(3) Prepaid interest expense must be allocated to the period it is incurred and
paid
o Charitable Contributions (Limited to 10% of Adjusted Taxable Income)
 Any disallowed contribution carried forward 5 years
o Business Losses or Casualty Losses Related to Business not compensated for by
insurance are deductible. May be ordinary or capital loss depending on asset.
 Differs from individual (personal) casualty in 2 ways:
 No $100 reduction
 No 10% of AGI reduction
 Partially destroyed: lesser of: (1) decline in value of property or (2)
adjusted basis of property before casualty
 Fully destroyed = adjusted basis NBV
o Organization Expenditures and Start-Up Costs
 Tax Rule - $5,000 expense max / 180 mos amortization of remainder
 Look for month business started on exam!!
 GAAP Rule – expense charged off in year incurred
 Excluded costs: raising $ (stock, underwriter’s fees, commissions) and
costs to transfer assets to corp
o Purchased goodwill
 Tax Rule – Amortized on straight-line basis over 15 years
 GAAP Rule – not amortized; test for impairment
o Life Insurance Premiums (expense)
 Corporation names beneficiary (key person) = NOT tax deductible
 Insured Employee names beneficiary (fringe benefit) = tax deductible
o Business gifts deductible up to $25/person
o Business meals and entertainment 50% tax deductible
o Penalties and Illegal Activities NOT deductible
o Federal income taxes NOT deductible; Foreign income taxes may be used as
credit
o Lobbying and Political Expenditures NOT deductible
o Capital Gains and Losses
 Corporation cannot deduct capital losses; can only offset capital gains
 Capital Loss Carryover 3 yrs back/5 yrs forward as short-term capital losses
 Capital Gains Tax Calculation = taxed like ordinary income; no max 15%
tax rate
o Net Operating Losses (NOL) carryover 2 yrs back /20 yrs forward (same as indvd)
 NO charitable contribution deductions
Offset other Carrybac Carryforwa
 income k rd
NOL N/A 2 20
Corporate Net Capital -0- 3 5
Loss
Indvd Net Capital Loss $3,000 max 0 Unlimited
 General Business Credit (investment, work opp, alcohol fuels, low-income
housing, etc)
o Net income tax minus greater of:
 25% of regular tax liability above $25K or
 Tentative min tax for the year
- Dividends Received Deduction (DRD): to prevent triple taxation of earnings. DRD
dependent upon % of investee corp. owned by investor corp. (70%, 80%, or 90%)
o Requirements: (1) 1st corp is taxed (2) owned 45 days before or after
o Dividend Income (DRD)
 100% (Own 80 - 100%)  consolidate
 80% (Own 20 - <80%)  large investment
 70% (Own < 20%)  “Unrelated” company
 Limited to % of B: whichever smaller
 Except: if taking full % of dividend income, it creates or adds to corp. loss
o Taxable Income Limitation: DRD = lesser of 70% (or 80%) of dividends
received OR 70% (or 80%) of taxable income (TI) computed without regard to the
DRD, any NOL deduction, or capital loss carryback
o Exception: if after taking into account full DRD, result is NOL, then can take
DRD instead of limit (% of TI)
o Entities for which DRD does not apply: personal service corps, personal
holding companies, and personally taxed S corporations (don’t take it
personally)
o Dividends from affiliated corporations (80% or more common ownership) that
file consolidated returns qualify for a 100% deduction
III. DEPRECIATION (MACRS)
o MACRS Depreciation Rules
a. For 3, 5, 7, and 10 year property, use 200% declining balance method
b. For 20 year property, use 150% declining balance method
o Machinery and Equipment
a. Salvage value ignored
b. Half-Year Convention: property placed in service or disposed of during a
taxable year is treated as placed in service or disposed of at mid-year
c. Mid-Quarter Convention: If more than 40% of depreciable property is placed in
service in last quarter of year, mid-quarter convention used
o Buildings/Real Estate
a. Salvage value ignored
b. Residential Rental Property (27.5-year Straight-Line) – apts, duplex homes
c. Non-Residential Real Property (39-year Straight-Line) – offices, warehouses
d. Mid-Month Convention: straight-line depreciation; ½ month taken in month
property placed in service. ½ month taken for month in which property disposed
i. Ex. If placed in service Jan 1 for 12 months, get 11.5/12
o Not Buildings – Expense deduction in lieu of depreciation
a. Taxpayer may deduct fixed amt of depreciable (mach&equip) property. Limit now
is $250,000 of new or used property acquired during year
b. Max amount is reduced dollar for dollar by amount of property placed in service
during taxable year that exceeds $800,000
c. Deduction is not permitted when net loss exists or if it would create net loss
d. SUVs: Section 179 limits cost of SUB that may be expensed to $25,000
IV. DEPLETION
e. Cost Depletion (GAAP)
 i. Unit depletion rate = remaining property basis/remaining # of recoverable
units
ii. Deduction for depletion = unit depletion rate x # units sold for year
f. Percentage Depletion (Non-GAAP)
i. Deduction limited to 50% of taxable income (excluding depletion) from the
well or mine; allowable 5-22% depending on mineral. May be taken even
after costs have been completely recovered and there is no basis
V. AMORTIZATION
a. Intangibles such as goodwill, licenses, franchises, and trademarks may be amortized
using straight-line basis over period of 15 years, starting with month of acquisition
b. Others
i. Business start-up expenses/organization costs permitted to expense $5000
and amortize remainder over 180 months (15 years)
1. VS. GAAP where you expense all
ii. Research expenses amortized over 60 months
iii. Pollution-control facilities amortized on straight-line basis
VI. SECTION 1231, 1245, AND 1250 ASSETS
a. Section 1231: depreciable personal and real property used in taxpayer’s trade or
business and held for over twelve months + trade/business property and capital
assets that have been involuntarily converted
i. Capital Gain treatment: tax rates of 5% or 15% on net Section 1231 gains
from sales, exchanges, or involuntary conversions
1. Ordinary Income = Gain to the extent of all accumulated depreciation
2. Section 1231 (capital) gain = Gain for sale in price in excess of orig
cost
ii. Ordinary Loss treatment: treat sale of mach/equip as ordinary loss
VII. TAXATION OF A C CORPORATION
a. File by March 15 if year end is 12/31; when due date falls on holiday or weekend, tax
return is due on next business day; extension of 6 mos by filing form 7004
b. Accrual basis method of accounting for tax purposes required for:
i. Accounting for purchases and sales of inventory, tax shelters, C corps with >
$5M avg annual gross receipts for 3-yr pd ending with tax yr
c. Estimated Payments of Corporate Tax
i. Corporations other than Large Corporations
1. Pay lesser of: 100% of tax shown on return for current year OR 100% of
tax shown on return for preceding year
2. Note: Preceding year cannot be used if corp owed no tax for preceding
yr or preceding tax yr was < 12 mos
ii. Large Corporations (taxable income > $1M)
1. Pay 100% of tax as shown on current yr return; not allowed to use last
year’s
d. Consolidated Tax Returns: An affiliated group of corporations may elect to be taxed
as a single unit, eliminating intercompany gains and losses (dividends)
i. Requirements: all corporations in group (i) must have been members of
affiliated group & (ii) each member of group must file consent; filing a
consolidated return by all affiliated corps will satisfy consent requirement.
ii. Affiliated Group means common parent owns:
1. 80% or more of voting power of all outstanding stock AND
2. 80% or more of value of all outstanding stock of each corporation
e. Corporate Alternative Minimum Tax (AMT): corps subject to AMT of 20% on AMT
income, less exemption amount. The objective is to ensure that every corp with
substantial economic income pays at least some min tax
i. Calculation (Adjustments vs. Preferences vs “ACE”)
1. Begin with regular taxable income or (loss) before NOL modified by adj,
pref, ACE
2. Adjustment (LIE)
 a. Long-term Contracts: adj is calculated for the difference btwn
competed contract revenue and % of completion revenue
b. Installment Sales – Dealer: difference btwn full accrual revenue
and installment sales revenue
c. Excess of depreciation of tangible property placed in service
after 1986 over:
i. Real property: Straight-line using 40-year life
ii. Personal property: 150% declining balance (switch to
straight-line)
3. Preferences (PPP)
a. Percentage Deletion
b. Private Activity Bonds
c. Pre-1987 ACRS Depreciation
4. Adjusted Current Earnings (MIND): ACE adjustments = 75% the diff (pos
or neg) btwn ACE and AMTI before this adj and the alt tax NOL
deduction
a. Municipal bond interest
b. Increase life insurance cash surrender value
c. Non-straight-line depreciation after 1989 vs. ADS
d. Dividends received deduction (less than 20% ownership/70%
deduction)  unrelated entity
5. Tax rate on AMTI is 20%
ii. Exemption Formula: $40,000 less 25% of AMTI in excess of $150,000.
Completely eliminated at AMTI in excess of $310,000
$40,000
<Disallowed>  (MTI – $150,000) x 25%
Allowed Exemption
iii. Foreign tax credit is the ONLY credit available to reduce AMT
iv. Minimum tax credit (MTC) carryforward – to credit reduce future regular tax
1. AMT system is an acceleration of the payment of a corporation’s
income taxes. A corp that pays AMT in one year may use AMT as credit
in future years against the corporation’s regular income tax liability.
2. MTC may be carried forward indefinitely but may not be carried back
f. Accumulated Earnings Tax –penalty for failure to pay dividends
i. Imposed on regular C corporation whose accumulated (retained) earnings >
$250K if improperly retained instead of being distributed as dividends to (high
tax bracket) shareholders
ii. Addt’l tax rate for accumulated earnings if flat 15%
iii. To avoid unreasonable accumulation of earnings, there should be:
1. Specific, definite, and feasible plan for use of accumulation (reasonable
needs) or
2. Need to redeem corporate stock included in deceased stockholder’s
gross estate
iv. Formula
Taxable Income
<All Charity>
<All Capital Losses>
<Taxes>
<Dividends Paid>
Accumulated Taxable Income
<Remained Credit  $250K for reg corp, $150K for service corp>
X 15%
Accumulated Earnings Tax
g. Personal Holding Company Tax – extra harsh
i. Really corps set up by rich people to channel investment income into corp and
shelter income by low normal tax (15%-25%) of corporation
 ii. Personal Holding Company: corporations > 50% owned by 5 or fewer indvds
and having 60% of adjusted ordinary gross income consisting of (passive
income):
1. Net Rent
2. Interest that is taxable
3. Royalties (but not mineral, oil, gas, or copyright royalties)
4. Dividends from an unrelated domestic corporation
iii. Corps deemed to be PHCs are taxed addt’l 15% on PHC net income not
distributed
1. Taxable income must be reduced by federal income taxes and net long-
term capital gain (net of tax) to determine undistributed PHC income
prior to divided paid deduction
2. No penalty if net income is distributed (ex. Dividends or consent
dividends)
h. Personal Service Corporations (PSC) are taxed at flat 35%
VIII. CORPORATE DISTRIBUTIONS – taxable if classified as dividends
a. Dividends: distribution of property by a corporation out of its earnings & profits (E&P)
i. Current E&P (By Y/E) = taxable dividend
ii. Accumulated E&P (dist. date) = taxable dividend
iii. Return of Capital (No E&P) = tax free and reduces basis of common stock
iv. Capital Gain Distribution (No E&P/No Basis) = taxable income as capital gain
b. Source of Distributions: distributions come first from E&P and then from
accumulated E&P.
i. Matching cash dividends to source when dividends > E&P:
1. Current earnings and profits are allocated on pro rata basis to each
distribution
a. Ex. Corp had E&P of $15K, paid four cash dividends of $7.5K
each for total of $30K. Half of each dividend will be treated as
made from current E&P, taxable to shareholder
2. Accumulated E&P are applied in chronological order, beginning with
earliest dist
c. Stock dividends generally not taxable unless shareholder has choice of receiving
cash or other property. Value is FMV on distribution date
d. Shareholder Taxable Amount
i. Individuals and Corporations
1. Cash dividends: amount received
2. Property dividends: FMV
e. Corporation Paying Dividend: payment of dividend is non-taxable. A dividend is
reduction of E&P (retained earnings)
i. Property dividends: corp recognizes gain as if the property had been sold
(FMV – adjusted basis) The gain increases E&P
FMV Property
<NBV>
Corp. Gain  E&P
- Chain of events for corps paying dividends:
(1) Corp has to E&P – dividend not taxable income
(2) Corp distributes appreciated property as dividend
(3) Corp has recognized gain (on property dividend)
(4) Corp gain increase/creates corporate E&P
(5) Dividend to shareholder is now taxable income (to extent of E&P)
f. Stock Redemption: when a corporation buys back stock from its shareholders
- If stock redemption qualifies for sale or exchange treatment, gain or loss is
recognized by shareholder. If not, gain/loss recognized by shareholder
- Proportional – taxable dividend income (to shareholder-ordinary income) 
disguised dividend
- Disproportional (substantially disproportionate) – sale by shareholder subject to
taxable capital gain/loss to shareholder.  Buyback
 IX. CORPORATE LIQUIDATION: subject to double taxation (corp and shareholder must recognize
gain or loss)
a. Corporation sells assets and distributes cash to shareholders
i. Corp recognizes gain/loss (as normal) on sale of assets: First tax at corporate
level
Sale Price
<Basis>
Taxable Gain/Loss
ii. Shareholders recognize gain/loss to extent cash exceeds adjusted basis of
stock: Second tax at shareholder level
Proceeds
<Stock Basis>
Taxable Gain/Loss
b. Corporation distributes (not sells) assets to shareholders directly
i. Corporation recognizes gain/loss as if it sold assets for the FMV (1st tax)
FMV
<Basis>
Taxable Gain/Loss
ii. Shareholders recognize gain/loss to extent FMV of assets received > adj basis
of stock (2nd tax)
FMV
<Stock Basis>
Taxable Gain/Loss
c. Tax-Free Reorganizations (No Tax)
i. Includes:
1. Mergers or consolidations (Type A)
2. Acquisition by one corp of another corp’s stock, stock for stock (Type B)
3. Acquisition by one corp of another crop’s assets, stock for assets (Type
C)
ii. Shareholder recognizes gain to the extent he/she receives boot (cash) in reorg
iii. Reorg is considered nontaxable b/c it results in continuation of business in
modified form. The acquiring corp must continue the business of the old entity
or use a significant portion of old corp’s assets
Taxpayer Event Income Basis Tax
Attributes
Corporation & Nontaxable N-O-N-E NBV No Change
Shareholder
d. Worthless stock (small business stock) – original stockholder can be treated as
having ordinary loss (fully tax deductible), instead of capital loss, up to $50K ($100K
if married filing joint). Any loss in excess of this amount would be capital loss, which
would offset capital gains and max of $3K/year would be deductible
i. Must be issued to indvd stockholder or partnership for money/property
ii. Must be cash/property paid to corp in exchange for first $1M of capital stock
e. A noncorporate shareholder who holds qualified small business stock for > 5 years
may exclude 50% of the gain on the sale or exchange of the stock
i. Limited to 50% of the greater of 10x taxpayer’s basis in stock or $10M
ii. C corporation ONLY, not S corp
Business Activity Corporation Shareholder
Consequence Consequence
Liquidation Completely ceases Taxable Taxable
Reorganizatio Continues Nontaxable Nontaxable
n

Small Business Corporations (S Corporations) – all profit/loss passed through to

shareholders; no corp-level tax
I. ELIGIBILITY
 a. Must be domestic corporation
b. Eligible shareholders
i. Indvd, estate, or certain types of trusts
ii. Qualified retirement plans, trusts, and 501 orgs
iii. Not a nonresident alien
iv. Neither corps nor partnerships
c. May not be > 100 shareholders; family members can be one shareholder
d. May not be more than one class of stock outstanding; diffs in common stock voting
rights are allowed. Preferred stock not permitted
II. ELECTING S CORPORATION STATUS
a. Election takes effect March 15 (retroactive for whole year)
b. After election is made, consent of new shareholder not required; S corp status
continues unless shareholder who owns > 50% of stock acts to terminate election
III. EFFECT OF S CORPORATION ON CORPORATION
a. Adopt calendar year. Dec 31 is year end. Tax return due by March 15.
b. GR: No tax on Corporation; earnings passed through to shareholders
c. GR Exception: Dist or sale of S corp’s assets may result in tax on unrealized “built-in
gain” when:
i. C corp elects S corp status
ii. FMV corp assets > adj basis of corp assets on election date
d. Exception to Exception: S corp exempt from tax on “built-in gains” when:
i. S corp was never a C corp
ii. Sale or transfer does not occur w/in 10 yrs of first day of first yr that S election
is made
iii. S corp can demonstrate that appreciation occurred after S election
IV. EFFECT OF S CORPORATION ELECTION ON SHAREHOLDERS
a. Pass-through of income and/or losses (to shareholder / K-1)
i. S corps report both separately and non-separately stated items of income
and/or loss (like partnerships)
ii. Allocations to shareholders are made on per-share, per-day basis
iii. Losses are limited to shareholder’s adjusted basis in S corp stock + direct
shareholder loans to corp. Shareholder guarantees do not increase basis
1. Partnership rules different (liabilities increase basis)
iv. KEY POINT: Similar to partnership, shareholders in S corp must include
on personal income tax return their distributive share of each
separate “pass-thru” item
1. Shareholders are taxed on these items, regardless of whether or not
items have been dist (w/d) to them during the yr
b. Computing shareholder basis in S corp stock (Base): like a bank account
Initial Basis
Income items
Addt’l shareholder investments in corp stock
<Distribution to shareholders>
<Loss of Expense Items>  basis + direct shareholder loans - distributions
Ending Basis
o S corp shareholder can deduct on personal income tax return their pro rata share
of S corp loss subject to limitation (basis + direct shareholder loans –
distributions)
c. Taxability of Distributions to Shareholders
S Corp with NO C Corp E&P
Distribution Tax Result Treatment
1st To extent of basis in No tax; reduce basis in Return of capital
stock stock
2nd Exceeds basis of stock L/T Cap gain if stock Capital gain dist
held > 1 year

S Corp WITH C Corp E&P

 Distribution Tax Result Treatment
1st To extent of AAA* Not subject to tax, reduces basis in S-Corp profits
stock
2n To extent of C corp Taxed as dividend, does not reduce Old C-Corp taxable
d
E&P basis in stock dividend
3r To extent of basis in Not subj to tax, reduces basis in stock Return of capital
d
stock
4t In excess of basis in Taxed as L/T Cap Gain Capital gain
h
stock distribution

V. TERMINATING THE ELECTION IF ANY OF FOLLOWING:

a. Holders of majority of corp’s stock (any combo of voting and non-votign) consent to
voluntary revocation
b. Corp fails to meet any or all eligibility requirements for S Corp stats
c. > 2% fo corp’s gross receipts come from passive investment income for 3
consecutive yrs and corp had C corp earning sand profits at end of year (3 strikes
and you’re out). Termination at beg of 4th yr
i. Ex. Was C corp, had lots of E&P, kept E&P in company. When become S, put
E&P into stocks and bonds – give passive income. If > 25% gross receipts, lose
S status
- Once S corp election is terminated or revoked, new election can’t be made for 5 yrs
unless IRS consents to earlier election.

Chapter 4 – Partnership Taxation, Estate & Trust Taxation, SOX, Ethics

Partnership Taxation
I. FORMATION OF PARTNERSHIP
a. Generally: no gain or loss is recognized on a contribution of property to a
partnership in return for a partnership interest
b. Exceptions to nonrecognition of gain (taxable events)
i. Capital/partnership interest acquired for services rendered is ordinary income
(FMV)
ii. Property subject to a (excess) liability
II. BASIS FOR PARTNERSHIP INTEREST ACQUIRED BY CONTRIBUTION
Cash
Property – adjusted basis (NBV) - nontaxable
Services (FMV) - taxable
<Liabilities> - incoming partner’s liabilities assumed by new partner
Liabilities – other partners’ liabilities assumed by incoming partner
- Partnership differs from corporation: when property is subject to liability where decrease
in partner’s indvd liability (assumed by new partner) > partnership basis (NBV), excess is
taxable boot (taxable gain to partner)
o In corporation: subject 100% of liability
o Partner’s capital account can never begin with negative balance
- Holding Period – includes holding period of property contributed if property was capital
asset or section 1231 asset in hands of the partner (always L/T even if only held for 1
week)
- Partner’s basis will increase by pro rate share of income and increase of partnership
liabilities
- Special Allocation: Built-in Loss (Contributed Appreciated) Property
 o When partner contributes property (which has FMV higher or lower than adjusted
basis, or NBV), the “built-in” gain or loss with respect to the contributed property
(when sold) must be allocated to the contributing partner
- Partnership takes contributor’s basis for any contributed property (plus any gain
recognized by incoming partner)  NBV
o Partnership’s holding period for contributed property includes time held by
partner if property were capital asset or Section 1231 asset in hands of partner
III. PARTNERSHIP OPERATIONS: PARTNER BASIS FORMULA
a. Partner's Basis = adj basis of assets contributed + gain recognized on the
contribution – debt relief
b. Increased by investment, pro-rata share of income, and liabilities for which
personally liable.
c. Decreased by distributions, pro-rata share of losses, and liabilities for which
personally relieved of
Beginning Capital Account
% All Income
<% All losses>
<Withdrawals>
Ending Capital Account
+ % Recourse Liabilities
Year-End Basis
IV. PARTNERSHIP TAX RETURNS – not subject to income taxes; files partnership tax return
(Form 1065), Schedule K & K-1 for each partner’s share of income, deductions, credits,
etc. ; Individual partners report net income/loss on Schedule E
a. Partnership terminates when
i. Operations cease
ii. 50% or more of total partnership interest in both capital and profits sold or
exchanged within any 12-month period
iii. There are less than two partners
b. Effects: like closing old account and open new account
i. Deemed distribution to remaining partners; hypothetical recontribution of
assets
c. Transactions between partnership and partner
i. Related Party Loss (WRaP) is Disallowed – Losses btwn controlling partner
(>50%) and controlled partnership from sale or exchange of property not
allowed
ii. Related Party Gain is Ordinary Income
d. Determination of Partner’s Share of Income, Credits, and Deductions
i. Taxable Income – must include his share of partnership income (even if not
received)
1. Income – taxable – increase basis
2. Withdrawals – nontaxable – decrease basis
ii. Tax Losses
1. Loss deduction limited to partner’s adjusted basis in partnership
(which is increased by liabilities he is personally liable for – “at risk”
provision)
2. Any unused loss can be carried forward indefinitely and used in
future yr when basis becomes available
iii. Guaranteed Payments – reasonable compensation for services rendered;
allowable tax deduction to partnership and taxable income to partner
Income
<Expenses>
<Guaranteed payment> (like salary>
Profits
 Captial Account: If you put in $500k and receive interest: expensed as
guaranteed payment
  Distributive deduction to partnership via K-1 and taxable income to partner
iv. Org Expenditures and Start-Up Costs
1. May elect to deduct up to $5,000 each of organizational expenditures
and start-up costs
2. Each $5,000 amount reduced by amount by which organizational
expenditures or start-up costs exceeds $50,000 respectively
3. Excess org expenditures/startup costs amortized over 180 months
4. Vs. GAAP rule: expense costs
v. Syndication Costs (e.g. offering materials, raising $) non-deductible
V. NONLIQUIDATING DISTRIBUTIONS – STOP AT ZERO, Basis = NBV Asset
a. Generally nontaxable
Beg Capital Acct
% Income < Loss> Up to Withdrawal
Partner’s Capital Account
% of Liabilities
Adjusted Basis @ Date of Withdrawal
<Cash Withdrawn>
Remaining Basis to be Allocated to Assets Withdrawn
b. Distributions of cash or property reduce basis by the cash or adjusted basis (NBV) of
property distributed
i. Property = NBV
c. Basis in the land is the lesser of the land's basis in the partnership's hands or
Partner’s remaining basis in his partnership interest in company
d. Do not ordinarily recognize income on nonliquidating distribution of property other
than money.
e. Reduction (for a withdrawal) limited to partnership basis – cannot be < 0
i. Assigned basis may not exceed basis in partnership
ii. Ex. Capital account $10k, w/d $2k  $8k left basis
1. Business car has $15k NBV, nontaxable
2. Take care out at $8k, not assets basis
iii. Basis > BV, no gain
iv. Basis < BV: basis in partnership = basis of asset (smaller of two)
VI. LIQUIDATING DISTRIBUTIONS – MUST “ZERO-OUT” ACCOUNT, Basis of property = Adjusted
basis of partnership interest
a. Three ways to liquidate (nontaxable):
i. Complete withdrawal
ii. Sale of partnership interest
iii. Retirement or death
b. Basis for the distributed property = adjusted basis of partnership interest (as the
partner is simply exchanging his partnership interest for the distributed assets)
MINUS monies received in same transaction
c. Recognize gain only to the extent that money received exceeds the partner's basis
in the partnership.
d. Complete Withdrawal (Liquidation)
i. General Rule: ZERO-OUT, GET OUT
ii. Recognize gain only to extent that money received exceeds partner’s basis in
partnership
iii. Recognize loss only if money, unrealized receivables, or inventory are
received and if basis of assets received < adjusted basis in partnership
iv. EX. Basis $100k
<Cash $40k>
$60k = Capital Account, Remaining Basis
If you take out another asset, take it out at remaining basis ($60k)
e. Sale of Partnership Interest (Liquidation)
 i. General Rule: Gain or loss measured by amount realized for sale – adjusted
basis of partnership interest. Liabilities transferred to buyer are part of amount
realized
Beg Capital Acct
% Income < Loss> Up to Sale
Capital Account @ Sale Date Adds to
% of Liabilities Zero
Adjusted Basis
<Amount Received> (Cash, C.O.D. <discharge of liabilities>, FMV
Property)
Gain or Loss
ii. “Hot Assets” treated as “ordinary income” as if cash were taken
1. Unrealized receivables (as if exchanged for cash)
2. Appreciated inventory (as if exchanged for cash)
f. Retirement or Death of Partner
i. Payments allocated btwn payment for an interest in partnership assets and
other payments
ii. Payment for interest result in capital gain or loss to deceased party

Estate, Trust, and Gift Taxation

I. OVERVIEW
a. Trusts and estates called fiduciaries in which assets transferred to entity so person
with fiduciary responsibility for entity can hold legal title for benefit of named
“beneficiaries”
b. Distributions deductible by entity but taxable to recipient. Gifts may also be subject
to taxable
c. Two separate taxes
i. Income tax on is based on income earned while estate in existence
ii. Estate tax is transfer tax based on value of decedent’s estate. Taxed to
estate before property is transferred
d. Transfer Tax = unified Estate AND Gift Tax. Unified credit allowed against this tax
i. Cumulative lifetime gifts ($345,800 credit and $1M exemption)
ii. Death time transfers ($780,000 credit and $2M exemption)
II. INCOME TAXATION RULES FOR ESTATES AND TRUSTS
Taxable Income (rental, taxable interest)
<Fees and expenses>
Distributable Net income (DNI)
<Exemption> ($600, $300, or $100)
<Income Distribution Deduction> (Lower of DNI or Distributions)
Taxable Income
a. Distributable Net Income (DNI) – potentially taxable
Estate (Trust) Gross Income – includes capital gains
<Estate (Trust) Deductions>
Adj Total Income
Tax Exempt Income
<Capital Gains> - attributable to corpus
DNI (If dist, whoever got it is taxed. If not dist, estate or trust is taxed)
b. Deductions are allowed for ordinary and necessary expenses in contributions to
charity (unlimited), carrying on trade or business, production of income,
determination, collection or refund of tax
c. Income dist. to beneficiaries has same character (e.g. tax exempt, portfolio, passive,
etc.) as it had at fiduciary level (same as partnership taxation)
d. Income Distribution Deduction is LESSER of Actual Distributions OR DNI (less tax-
exempt income)
e. Annual Estate Income tax - Estate is taxable entity (file Form 1041)
i. Exemption of $600, no standard deductions
 ii. May have either a calendar year (tax return due 4/15) OR Fiscal year
due on the 15th day of the fourth month after year-end. (ex. Die in Nov,
don’t finish estate until Mar so Nov-March = 1 fiscal yr). Can die anytime and
they let you start the fiscal yr.
iii. Exempted from making estimated tax payments for first 2 tax years
f. Annual Trust Income Tax (same Form 1041)
i. Must use calendar year (except tax-exempt trusts)
ii. May deduct amounts distributed to beneficiaries up to DNI
iii. Simple Trust: Exemption of $300, no deduction for charitable contribution;
Only makes distributions out of current income (none from trust corpus)
iv. Complex Trust: Exemption of $100, may deduct charitable contribution, may
accumulate current income, may distribute principal
III. THE ESTATE TAX (FORM 706)
a. File if gross estate exceeds $2M; file within 9 months after decedent’s death
(unless request extension)
FMV Assets
<Liabilities>
Net Worth
<Transfers> - charity, spouse, etc.
Remainder
x Tax Rate
Estate Tax
<Credits> - unified credit
<State Taxes>
Federal Estate Tax
b. Gross Estate – includes value of all decedent’s worldwide property
i. FMV of Property – Spouse Joint (split 50/50) or Other Joint (100% less other
owner’s contribution)
ii. Value at “death”
1. Date of death OR
2. Alternative Valuation Date is earlier of
a. Date property is distributed to heirs
b. Six months after date of death (max)
iii. File within 9 months after death (unless request extension) – same as estate
tax form
c. Estate Deductions
i. Nondiscretionary Expenses: medical expenses (not funeral exp) subject to
7.5% limitation, admin expenses, outstanding debts of decedent, claims
against estate, funeral costs, certain taxes (including state death taxes)
1. Medical and Admin Expenses EITHER
a. Expense on Income Tax Return OR
b. Liability on Estate/Property Tax Return (Form 1041)
ii. Discretionary expenses: unlimited charitable deduction, unlimited marital
deduction
d. Other credits that reduce gross estate tax: foreign death taxes, prior transfer taxes
(prior gift taxes paid)
IV. THE GIFT TAX – giving it away will go against lifetime transfers
a. Annual exclusion: may exclude first $12,000 of gifts made to single donee in a year;
$24,000 if married and elect gift splitting
i. To apply: must be a present interest, complete, under $12k/$24k per donee
(unless paid directly)
b. Unlimited exclusion: payments made directly to educational institution, payments
made directly to health care provider for medical care, charitable gifts, marital
deduction (must be terminable interest)
c. Gifts: Present vs. Future interest
 i. Future interest: Postponement of right to use, possess, or enjoy property
distinguishes (ex. Reversions – gift and get property back later, remainders,
trust income interests, present interest w/o ascertainable value)
ii. Future interest does not qualify for annual exclusion, will not be removed from
estate
iii. Present interest qualifies for annual exclusion, will be removed from estate
d. Gifts: Complete vs. Incomplete Gifts
i. Complete Gifts: qualify for annual exclusion and subject to gift tax; not part of
gross estate
ii. Incomplete Gifts: included in gross estate and is not subject to gift tax
1. Conditional gifts: precedent conditions (e.g. not get gift unless graduate
from college)
2. Revocable gifts: donor reserves right to revoke gift or change
beneficiaries
V. GENERATION-SKIPPING TRANSFER TAX (GSTT)
a. Designed to prevent indvd from escaping entire generation of gift and estate tax
b. Separate tax imposed in addition to federal estate and gift tax
c. Applies when indvds transfer property to person who is 2+ generations younger than
donor or transferor
d. Ex. If worth $100M, 50% goes to gov’t. Rest goes to kids. Maybe kids won’t live so
long, so why don’t pass on to grandchildren? You would get double taxed.

Tax Return Preparer Issues

I. PENALTIES
a. Failure to file by due date: 5%/month or fraction of month on tax due on return
b. Failure to pay tax due: 0.5%/month or fraction of month
c. Accuracy related: 20% penalty
d. Fraud: 65% of underpayment due to willful evasion
e. Earned Income Credit: may lose ability to claim credit for 2 yrs, or if fraudulently
claimed, up to 3 yrs
II. PREPARER RESPONSIBILITIES
a. Requirements:
i. Sign tax return
ii. Include ID # of preparer and employer
iii. Provide copy of return to taxpayer by or at time taxpayer signs original
iv. Preparer must keep: list of those for whom returns were filed OR copies of
returns for three years
b. Additional penalties for: disclosure to enable third party to solicit business and
knowing or reckless disclosure of information
c. Acceptable circumstances for disclosure: Computer processing, Peer review,
Administrative order
d. To avoid penalties, tax preparer should make reasonable inquiries of taxpayer’s info
is incomplete
e. Upon discovery of an error, CPA should notify the client (oral or written) of error and
advise the client of appropriate measures. If client does not rectify error, CPA should
consider withdrawing from engagement

The Sarbanes-Oxley Act of 2002

I. PCAOB - PUBLIC COMPANY ACCOUNTING OVERSIGHT BOARD
a. SOX provides for PCAOB with five members (2 CPAs, 3 non-CPAs)
b. Board subject to oversight by the SEC and has duty to:
i. Register public accounting firms that prepare audit reports for issuers
ii. Est rules relating to preparation of audit reports for issuers
iii. Conduct inspections, investigations, and disciplinary proceedings concerning
registered public accounting firms
c. Only a “registered public accounting firm” with PCAOB can prepare audit reports for
SEC issuer
 d. Auditing standards
i. Maintain audit workpapers and supporting documentation for seven years
ii. Provide concurring or second partner review of each audit report
iii. Describe in audit reports the scope of testing of issuer’s internal control
structure and procedures
II. AUDITOR INDEPENDENCE
a. Lead auditor or coordinating partner and reviewing partner must rotate off audit
every 5 years
b. Firm that provides audit services may not provide many other services to firm
III. CORPORATE RESPONSIBILITY
a. Audit committee:
i. Each audit committee member must be member of issuer’s board of directors
and must be independent (i.e. can only receive compensation for his position
on board)
ii. Audit committee must establish procedures for:
1. Treatment of complains regarding auditing matters
2. Confidential employee tips of questionable accounting procedures
b. Officers (CEO, CFO) must sign 10-K and 10-Q certifying that
i. Report is true, does not contain material deficiencies, and fairly represents
issuer’s financial position based on knowledge
ii. Signing officer responsible for establishing internal controls
iii. Fines up to $1M and 10 yrs imprisonment for knowingly making false
certification
c. SEC ensures no director/officer fraudulently influenced indep auditor to make F/S
materially misleading
d. SEC can prohibit any person from acting as officer or director of issuer if SEC finds
person unfit to serve
IV. FINANCIAL DISCLOSURES
a. Each issuer must disclose in 10K and 10Q whether or not they have code of ethics for
senior financial officers. If not, must state why.
b. 10K and 10Q must include internal control report saying
i. Management’s responsibility for est adequate internal control structure and
procedure for financial reporting
ii. Assessment of effectiveness of current years’ control structure
V. CORPORATE AND CRIMINAL FRAUD
a. Criminal penalty for auditors to fail to keep all workpapers related to audit for at least
7 years
b. Statute of limitations is later of 2 years after discovery of fraud or 5 years after action
occurred
c. Whistleblower Protection: Employees discharged b/c they lawfully provided info to
their supervisors or federal gov’t regarding conduct believed to be violation of
securities laws may sue employer
VI. SEC Authority to censure any person or deny privilege of practicing before SEC…

Ethics and Professional Responsibilities

I. CODE OF PROFESSIONAL CONDUCT
a. AICPA Code of Professional Conduct governs any service that a member of AICPA
performs
i. Code applicable to all members of AICPA, not just to those in public practice
ii. A professional code of conduct is a distinguishing mark of a profession that
accepts a high degree of responsibility toward the public
iii. AICPA code divided into 2 Sections: Principles and Rules
b. Principles
i. Article IV: Objectivity and Independence: “A member should maintain
objectivity and be free of conflicts of interest in discharging professional
responsibilities. A member in public practice should be independent in fact
and appearance when providing auditing and other attestation services.”
 ii. Article V: Due care – no negligence
iii. Article VI: Scope and nature of services
1. Have adequate internal quality control measures to ensure quality work
2. Determine whether, for audit clients, conflicts of interest arise due to
scope and nature of other services
3. Assess whether firm’s activities are consistent with professionalism
c. KEY POINT: objectivity applies to all services rendered, but independence applies to
attestation services ONLY (audits, special reports, and reviews…i.e. financial reports,
financial forecasts)
II. RULES – rules, interpretations, and rulings that govern the specific performance of members
a. Rule 101: Independence – Most heavily tested!!
i. Independence not required for nonattestation services (e.g. tax, consulting,
compilations)
ii. Independence impaired by direct financial interest (regardless of materiality)
or material indirect financial interest in attestation client
1. Stock ownership, even if owned in blind trust
2. Member is general partner in client
3. Financial interest in trust when member is trustee
4. Member owns shares in mutual fund that invests in attestation client
5. Member direct financial interest  Co. A  direct fi. int. in attestation
client
6. Independence is not impaired in financial institution client by ordinary
course of business
7. Fully collateralized car loans
8. Cash advance or credit card balances not exceeding $10,000
9. Bank account fully insured by gov’t
10. Passbook loan
iii. Business relationship activities that impair independence
1. Authorizing, executing or consummating transaction on behalf of client
2. Preparing source documents or originating data
3. Having custody of clients’ assets
4. Supervising client employees in performance of normal recurring
activities
5. Member previously employed by attest client
6. Member leaves audit form for position with the client
7. Member manages internal audit activities of client
8. Valuation and appraisal services performed are material to F/S and
subject to significant degree of subjectivity
9. Client more than 1 year overdue in payment of professional
fees. Cannot be independent if you are a creditor. Fees must be
paid before issuance of report
10. Actual or threatened litigation regardless of who plaintiff
and defendant are
iv. Independence not impaired by
1. Immediate family member’s employment w/ client if (s)he is not in key
position
2. If appointed honorary trustee for nonprofit, civic, or religious group
3. Suit for immaterial dollar amount for work unrelated to attestation
service
v. Firm cannot serve or appear to serve as member of client’s management (may
not make operational or financial decisions for clients, perform management
functions, or report to board on behalf of management)
b. Rule 102: Integrity and Objectivity
i. Conflict of interest may occur, but service may still be performed if
relationship is disclosed and consent of client is obtained
c. Rule 201: General Standards; must comply in ALL engagements
 i. Professional Competence – undertake only those professional
services that member/his firm can reasonably be expected to
complete with professional competence
ii. Due Professional Care of Member to:
1. Possess same degree of skill commonly possessed by others in
field
2. Act as a reasonably prudent accountant would
3. Critically review work done by those assisting in engagement at
every level of supervision
4. Adequately plan and supervise the performance of professional
services
5. Obtain sufficient (‘not all’) relevant data to afford a reasonable
basis for conclusions or recommendations in relation to any
professional services performed
d. Rule 202: Compliance with Standards – measures quality of performance
i. Standards promulgated by bodies designated by Council
1. Management Consulting Services Executive Committee
2. Accounting and Review Services Committee
3. Government Accounting Standards Board (GASB)
4. Tax Executive Committee
e. Rule 203: Accounting Principles (General Rule: GAAP followed)
i. Member shall not express opinion or state affirmatively or negatively that
financial statements are presented in conformity with GAAP if there is any
departure from accounting principle that has material effect on financial
statement
ii. EXCEPTION: unusual circumstances may justify departure from GAAP if
compliance would cause financial statements to be misleading
1. Interpretations of Code recognize new legislation and new forms of
business transactions as occasions that might justify departure from
GAAP
2. Justified departure must be described & explained in footnotes
3. Unusual degree of materiality or existence of conflicting industry
practices would not justify departure from GAAP
f. Rule 301: Confidential Client Information – no disclosure without specific consent of
client
i. EXCEPTIONS: (1) if subpoenaed or summoned (2) part of quality
review (3) in response to any inquiry either made by ethics division
or trial board of Institute or investigative or disciplinary body of state
CPA society. See Reg Ch 7.
g. Rule 302: Contingent Fees – established for performing services where:
i. No fee charged unless specific finding or result is obtained OR
ii. Fee amount is dependent upon finding or result obtained
iii. Contingent fees prohibited for audits and reviews of financial statements or
examinations of prospective financial information
iv. Contingent fees permitted for:
1. Tax/bankruptcy client
2. Not contingent when fixed by cours or other public authorities or in tax
matters, If based on results of court proceedings or findings of
governmental agencies
a. Oversight of gov’t so allowed to charge contingent fees
3. Permitted for compilations of F/S expected be used by 3rd parties if
member includes statement that member is not independent
h. Rule 501: Discreditable Acts
i. Member shall not commit discreditable acts:
1. Failure to return records to client after client makes demand
2. Solicitation or disclosure of CPA Examination questions and answers
3. Negligence in preparing F/S or records
 4. Failing to follow GAAS and other applicable standards of gov’t agencies
5. Failure to timely file a personal or firm tax return or to timely remit
payroll or other taxes collected on half of others
i. Rule 502: Shall not seek to obtain clients by advertising or other forms of solicitation
in manner that is false, misleading, or deceptive
j. Rule 503: Commissions and Referral Fees
i. Shall not for a commission recommend or refer to a client any product or
service when member or member’s firm also performs for that client:
1. Audit or review of F/S
2. Compilation of F/S expected to be used by 3rd parties
3. Examination of prospective financial info
ii. Member performing other services (tax/consulting) may receive commission,
but commission must be disclosed to client
iii. Member who receives referral fee for recommending another CPA or pays
referral fee to obtain client must disclose to client
k. Rule 505: Form of Practice and Name
i. Use of misleading firm names not allowed
1. I.e. sole proprietor – cannot imply a partnership
2. Can continue to use names of 1+ past owners if owner allowed before
death
ii. CPA Ownership “professional corporation”
1. Majority of ownership in financial interests & voting rights must belong
to CPAs
2. CPA must have ultimate responsibility for all services provided by firm
and by each business unit providing attest and compilation services
iii. Non-CPA owners can use titles: “principal,” “owner,” “officer,” “member,” or
“shareholder,” or any other title permitted by state law but not hold
themselves out to be CPAs
iv. Use of CPA Title in Private Industry
III. MANAGEMENT CONSULTING SERVICES
a. No public opinion as to the assertions of others
b. Objective advisor
c. In attest service (relied on by public), the practitioner expresses a conclusion about
reliability of written assertion that is responsibility of another party, the asserter
d. In consulting service, practitioner develops findings, conclusions, and
recommendations presented
i. Nature and scope of work determined by agreement btwn practitioner and
client
ii. Generally work for internal use only
e. Types of Consulting Services (CPA-SIT): Consultations, Product services, Advisory
services, Staff and other support services, Implementation services and Transaction
services
f. Standards: professional competence, due professional care, adequate planning and
supervision, sufficient relevant data for conclusions and recommendations
g. Additional standards
i. Serve client interest by seeking to accomplish objectives by understanding
client while maintaining integrity and objectivity
ii. Establish written or oral understanding with client about:
1. Responsibilities of parties
2. Nature, scope, and limitations of services to be performed
a. Do not do anything that would mislead or create unjustified
expectations
iii. Inform the client of
1. Conflicts of interest that may occur
2. Significant reservations concerning scope or benefits of engagement
3. Significant engagement findings or events
 h. Performance of consulting services for attest client does not impair independence,
however, should comply with independence standards, rules, and regs

Chapter 5 – Contract and Sales (abridged)

Contracts
I. TERMINOLOGY
a. Method of Formation
i. Express Contract: formed by language, oral or written
ii. Implied-in-Fact Contract: formed by conduct
iii. Implied-in-Law Contract or Quasi Contract: not a contract. Remedy that allows
plaintiff to recover benefit unjustly conferred upon defendant, to prevent
unjust enrichment
b. Unilateral and Bilateral Contracts
i. Unilateral: one promise, given in exchange for performance. Contract formed
when performance completed (e.g. give Barb $10 if Barb will wash Ann’s Car)
1. Accept with complete performance
ii. Bilateral: two promises, exchanged for promise. Contract formed when
promises exchanged (e.g. Barb promises to wash Ann’s car if Ann will promise
to pay Barb $10 upon completion)
1. Accept with promise
c. Stage of Performance
i. Executory Contract – if duties remain to be performed under control
ii. Executed Contract – if all duties under contract have been performed
d. STEP 1: What law applies. Sources of Contract Law – Common Law and UCC
i. Common Law: Judge made law, derived from courts. Involve real estate,
insurance, services and employment (R.I.S.E.); Non-sale of goods
ii. Uniform Commercial Code (UCC) Sales Article: Statutory law that governs
contracts for sale of goods (moveable, tangible things)
II. CREATION OF A CONTRACT
a. Three requirements of legally enforceable contract
i. Offer and acceptance
ii. Exchange of consideration (something of legal value)
iii. Lack of defenses on part of defendant
If all three met, there is enforceable contract and remedies available if one party
breaches
b. General rule: writing is not required. Only Statute of Frauds or a merchant’s firm
offer is writing required
c. Agreement (MUTUAL ASSENT) = Offer + Acceptance. One party make offer and
other will accept
i. Offer – express (oral or written) or implied (conduct)
ii. To be an offer, the communication must create a reasonable
expectation in the offeree that the offeror intends to make a contract
1. Manifestation of intent to contract
a. Obvious jokes are not offers – follow objective theory
b. Advertisements are not offers; only invitations seeking offers
c. Advertisement that limits scope of persons who can accept (e.g.
first five customers can buy coffeemaker for $1) is considered an
offer
2. Terms must be definite and certain
a. UCC General Rule: quantity only
b. Common Law
i. Identity of offeree and subject matter; parties
ii. Price to be paid
iii. Time of performance
iv. Quantity involved
v. Nature of work to be performed (type)
 3. Communication of the above to the offeree – no knowledge, no
acceptance
a. Ex. Lost dog, and put ad in newspaper offering $100 reward for
finding dog (unilateral contract), but if you don’t know about
reward, you cannot accept
iii. Termination of Offer – to create a contract an offer must be accepted
before It is terminated, otherwise it is merely a counteroffer
1. Method #1: Revocation
a. General Rule: offeror can revoke offer anytime before
acceptance by communicating revocation to offeree. Even when
he promises to keep offer open
i. May be direct or indirect
ii. Offers by publication can be revoked thru comparable
means
iii. Revocation is generally effective when received by offeree
b. Exception: Irrevocable offers
i. Option Contract: Consideration is paid to keep offer open
(UCC and/or Common Law)
ii. Merchant’s firm offers under UCC Sales
iii. Unilateral contract where offeree begins to perform (ex.
Once start searching for dog, must give reasonable time
to complete search)
2. Method #2: Rejection by offeree
a. Once offer is rejected, it cannot be accepted. Rejection effective
when received.
b. Express Rejection – say “no”
c. Counteroffer is considered to be both a rejection (terminating
original offer) and an offer (of which original offeror is now the
offeree who may accept or reject)
d. Mere Inquiry or “feeling the other party out” by questioning is
not counteroffer
e. Silence = rejection of offer
f. Offeree must accept offer within time period specified or within
reasonable time
3. Method #3: Operation of Law – automatically
a. Termination by death or insanity of parties (except option
contract)
b. Termination by destruction of subject matter (ex. Car crash
destroys car)
c. Termination by Illegality (ex. Sell drugs)
iv. Acceptance of Offer
1. Express – oral or written. Implied – conduct.
2. General Rule: only person to whom offer was made my accept.
a. Option contracts are assignable; purchased right to decide
whether to accept
3. Acceptance may be made in any manner reasonable under the
circumstances
a. However, if offeror specifies method of comm., that method
must be used, otherwise the acceptance using different method
is a counteroffer
4. Acceptance must follow mirror image rule (no change, deletion,
addition). Otherwise changes are a counteroffer
5. MAILBOX RULE!: Acceptances are generally effective when they are
dispatched if properly addressed. It is irrelevant if a properly addressed
acceptance is lost or delayed
a. If have until June 20th to accept, can mail on June 20.
 b. Offers, rejections, revocations, and counteroffers effective when
received. If revocation was effective first, the offer was
terminated; no contract.
c. Exception: Offerer can OPT-OUT of the mailbox rule by
stating in the offer that acceptances must be received to be
effective.
d. Consideration – when someone promises something not already obligated to do
i. Both sides of the contract must be supported by legally sufficient
consideration
ii. Two elements of Consideration
1. Something of legal value give to each party
a. If it constitutes either detriment to the promisee or benefit
to the promisor
i. Promise is supported by consideration only if promise
agrees to do something he/she is not already obligated to
do (detriment) or promisor will obtain some benefit
b. Need not have monetary value – ex. Stop smoking or getting B
avg in college
c. Fairness generally not required
d. Promise to perform or performance of an existing duty is not
sufficient consideration
i. Exception: if each party offers to give something different
from what was originally promised, the courts will usually
enforce the promise despite the preexisting legal duty
rule
ii. UCC – good faith only
2. Must be bargained for exchange
a. Not consideration unless an exchange: “your promise induced
my promise”
b. Promises to make gift are unenforceable b/c of lack of
consideration
c. If something had already been give or performed before promise
was made, it will not satisfy “bargain” requirement
i. Ex. If promise to pay $1k after you save someone, don’t
have to pay
d. Exceptions: promises enforceable without consideration
i. The promise must be reasonably relied upon and
detrimental (party relying on promise was substantially
harmed)
1. Ex. Quit job and sell house to move in w/ someone
for new house = consideration
e. Defenses – can make a contract enforceable
i. Fraud – “MAIDS” Can establish defense of fraud if (s)he can prove:
1. Misrepresentation of material fact
2. Actual and justifiable reliance by plaintiff on misrepresentation
3. Intent to induce plaintiff’s reliance on misrepresentation
4. Damages – compensatory and punitive damages available for fraud or
rescind contract
5. Scienter – an intent to deceive; made knowingly or intentionally. Make
misrepresentation with reckless disregard for the truth (i.e. saying car
has not been in accident but really don’t know)
ii. Fraud in the execution: when party is deceived into signing something that he
does not know is a contract
iii. Fraud in the inducement: voidable at option of defrauded party. Defrauded
party aware (s)he is making contract, but terms are materially misrepresented
 iv. Innocent misrepresentation/negligent misrepresentation: has all elements of
fraud except scienter (MAID). Unintentional.
v. Duress arises when a party’s free will to contract is overcome by an unlawful
use of a threat of harm. If it is physical force  contract void. If it is economic
or social  contact is voidable
1. Taking advantage of the other person’s economic condition to negotiate
a favorable contract (if not threat is involved) does not constitute
duress
vi. Undue influence – taking unfair advtg of a relationship (ex. Parent & child)
vii. Mutual mistake – if both parties to contract mistaken as to basic assumption of
contract, the adversely affected party can void contract
1. If subject matter of contract is not in existence (stolen or destroyed),
the contract is void
viii. Unilateral mistake – generally not a defense to contract
1. Exception: is a defense if the other party knew or should have
known of the mistake (ex. Obvious computational errors, like adding
zero). Bidder’s negligence is irrelevant.
ix. Illegality – contract generally void
1. Not having a license
2. Promises not to compete are illegal b/c they violate Antitrust law. Only
okay if:
a. Reasonably needed to protect a legitimate business interest
b. Reasonable in duration
c. Reasonable as to distance
x. Minors may generally disaffirm contracts or even within reasonable time after
becoming an adult
1. Minor will be bound on contracts for necessities of life (food, clothing,
shelter)
xi. Contract may be ratified by
1. Failing to disaffirm within reasonable time after reaching majority
2. Expressly ratifying entire contract orally or in writing
3. Retaining or accepting benefits
xii. Statute of Limitations: 4-6 years to sue (to commence lawsuit)
1. Actions for breach usually measured from time of breach
xiii. Statute of Frauds: Six Contracts Requiring a Writing (signed by
defendant only) – MY LEGS
1. Marriage consideration
2. Terms cannot be performed within a year
a. Ex. For next 18 mos, pay for lawn mowing. Not in writing – but
performed, so must pay
3. Contracts involving interests in land (includes all contracts for sale of
an interest in real property and leases of real property of > year)
a. Exception: lease for < year
b. Oral contracts involving land can be enforceable if party has fully
or partially performed
4. Contracts by executors or similar representatives to pay estate debts
5. Contracts for sale of goods for $500 or more
a. If a sales contract has been modified, It is the contract as it has
been modified that determined whether a writing is required
b. Writing does not need to be a “contract.” Only needs to have
quantity term and signature. Terms may be stated in more than
one document.
6. Contracts to act as surety
xiv. Novation: when new contract substitutes new party for an old party in
existing contract. All parties must agree to the release
 xv. Parol Evidence Rule: Parol (oral) evidence rule prohibits the admission of
oral or written evidence to contract terms of a written contract. For evidence
to be inadmissible under parol evidence rule:
1. Evidence must relate to prior or contemporaneous statements (either
oral or written)
III. REMEDIES
a. What to do when party fails to perform something he/she is contractually obligated to
do
b. At common law if there has been material or substantial breach, nonbreaching party
can be discharged from contract
c. Punitive damages available for fraud only, not for breach
d. Recission or cancellation cancels the contract and restores parties to former position
i. Doctirine of Substantial Performance: under common law, a party cannot
rescind or cancel if a contract has been substantially performed. Nonbreaching
party’s only remedy is monetary damages for the minor breach. However, this
doctrine is not available under UCC Sales article.
e. Quasi-contract damages – to prevent unjust enrichment. Ex. Guy in coma did not
verbally agree to any surgery or care. He is not forced to pay for services that were
given. Prevent unjust enrichment
IV. THIRD PARTY RIGHTS
a. Intended beneficiaries can enforce(sue promisor), but incidental beneficiaries cannot
enforce
b. Donee beneficiaries receive interest as a gift – cannot sue the promise.
c. Creditor beneficiaries receive interest b/c party owes them something – can sue the
promise for failure to fulfill original obligation of promise
d. General rule: any right may be assigned and any duty may be delegated.
i. Exception: when assignment will change the obligor’s risk or the delegated
duty involved specialized personal sieves or relies heavily on personal
attributes of person performing
e. After Delegation, both delegator and delegee are liable unless there is a novation
i. Assumed mortgage is an assignment
ii. If person takes subject to the mortgage, it is not an assignment. Upon default,
the mortgagee can foreclose on property and hold assignor/mortgagor liable
f. Generally an assignment needs no writing and does not need to be supported by
consideration (ex. Gift)
i. Exception: Notice must be given to the third party

Sales
V. INTRODUCTION
a. UCC Sales Article applies to sale of goods, which is all things moveable. Includes
most tangible personal property). Fixtures attached to land, personal services,
intangible property, & real estate are excluded
b. UCC is not limited to merchants
i. Merchants must observe reasonable common standards; generally held to
higher standards
c. UCC imposes obligation of good faith on both parties to sales contract
VI. CREATION OF A CONTRACT
d. Offer: Merchant’s firm offer
i. Under common law, consideration is needed to make an offer irrevolcable.
There is limited exception to this rule that only arises under UCC – merchant’s
firm offers
1. Certain offers by merchants are irrevocable without consideration
ii. To qualify as merchant’s firm offer:
1. Seller must be a merchant
2. Offer must be in writing and signed by the merchant – could be
a “rain check”
 3. Offer must give assurances it will be kept open for a certain
time
iii. If no time is stated, firm offers are irrevocable for reasonable time,
not longer than 3 months
e. Consideration
i. Output contract – buyer agrees to buy entire output of seller’s factory for
stated period of time
ii. Requirements contract – seller agrees to supply buyer with all reqs for a stated
period of time
1. Output and requirements contracts are enforceable if actual amounts
are reasonable with respect to normally expected amounts
iii. Under UCC, modification of contract is enforceable, even without
consideration, as long as modification is sought in good faith (for common law,
need consideration)
f. Defenses
i. Statue of Frauds – contracts for sale of goods for $500 or more must
be evidenced by writing signed by party being sued. Four exceptions
(SWAP)
1. Specifically manufactured goods (not generally suitable for sale to
others, such as embroidered clothing)
2. Merchant sends another merchant a written confirmation of a contract
that is sufficient to bind the sender
3. Contracts that the parties have admitted in court
4. Contracts that have been performed, to extent that performance has
been accepted
VII. DELIVERY, RISK OF LOSS, AND TITLE
g. General Rule: seller’s basic duty to hold conforming goods for buyer and give buyer
reasonable notice to enable buyer to take delivery
h. Step 1: parties determine who has risk of loss
i. Step 2: where there is no agreement, there are two categories: noncarrier cases and
carrier cases
i. Noncarrier cases – buyer usually picks up goods at seller’s place of business
1. Nonmerchant seller (garage sale) - risk of loss passes to buyer upon
seller’s tender of delivery of goods to buyer
2. Merchant seller – risk passes on actual delivery to buyer
ii. Carrier cases –parties contemplate a common carrier will be used to ship
goods
1. Shipment contract – risk passes on delivery to carrier
2. Destination contract – risk passes at destination
iii. F.A.S. (Free Along Side) and C.I.F. (Cost, Insurance, and Freight) - Buyer has
Risk of Loss
iv. F.O.B. Seller’s place is shipment contract. Seller must get goods to
carrier for R.O.L. to pass
v. F.O.B. Buyer’s place is destination contract. Seller retains risk of loss
until goods arrive at destination and there is tender delivery
VIII. WARRANTIES
j. In sales a seller must make a “perfect tender” (seller’s delivery must be perfect
without any defects)
i. To fulfill requirement of perfect tender, goods must conform to all warranties
k. Four warranties
i. Express warranties – oral or written
ii. Implied warranty of title
iii. Implied warranty of merchantability
iv. Implied warranty of fitness for particular purpose
l. Implied warranties (see R5-39)
i. Can be disclaimed, if correct words are used (even by merchants)
 ii. Do not need a writing. Automatically implied in sales contract
iii. Merchantability vs. fitness: warranty of merchantability can only be
made by merchants and is warranty only that the goods will be fit for
ordinary purposes. Warranty of fitness can be made by any seller, but
only if buyer is relying on seller to pick goods suitable for particular
purpose and is warranty that they will be fit for that purpose
iv. Warranties are independent from tort liability (negligence or strict
liability)
1. Common law – only party to a contract could sue for damages
(more lenient)
2. UCC – warranty liability not limited by privity. Extends to
member’s of buyer’s household. Also extends to those
expected to use, consume, or be affected by the product (ex.
Borrower of a car)
m. Tort Liability
i. Intentional = fraud; unintentional = negligence
ii. Negligence – Failure to use reasonable care. Must prove:
1. Seller owed them duty of care
2. Seller breached duty by failing to use due care
3. Damages – plaintiff suffered damages
4. Causation – damages were caused by seller’s negligence
 Any injured party would sue manuf, wholesaler, and retailer for breach of
warranty and commission of a tort
iii. Those injured by goods can sue in tort for strict products liability. Must prove:
1. Product was defective when it left seller’s hands
2. Defect caused plaintiff’s injury
3. Defect made product unreasonably dangerous
IX. REMEDIES
n. Seller’s remedies
i. Right to cancel and sue for damages
ii. Right to withhold delivery and stop goods in transit
iii. May sue buyer for any losses seller may have. This is the difference btwn
contract price and resale price + any addt’l or incidental damages
iv. Seller can collect full contract price + incidental damages if goods cannot be
resold
v. Liquidated damages must be reasonable. If buyer has made down payment
and breaches, seller may keep lesser of $500 or 20% of price
o. Buyer’s remedies
i. Buyer’s right to reject for ANY nonconformity
1. Under UCC, seller must make “perfect tender” – delivery free from
any defects
a. If goods do not conform to contract, buyer may reject all, reject
some, or reject none of goods
2. Rejection must be made in a reasonable time
3. To cancel under common law, must be large breach to cancel contract
X. ENTRUSTING AND VOIDABLE TITLE

Chapter 6 – Commercial Paper, Secured Transactions, and Real Property

(abridged)

Commercial Paper (Note/CD or Draft/Check)

I. IN GENERAL
a. A “note” is a two party commercial paper. It is a promise by one party (the “maker”)
to pay money to another party (the “payee” or to bearer)
b. CD – a bank promissory note.
 c. Drafts – an order for a third party to pay. A draft generally is a three party
commercial paper. It is an order by one person (the drawer) to another person (the
drawee) demanding that the drawee pay money to a third person (the payee)
II. To be a NEGOTIABLE INSTRUMENT within Article 3, the instrument must:
a. Be in writing.
b. Be signed by the maker (note) or drawer (draft). If you make mark, doesn’t
matter whose name you sign
i. A note singed by maker and draft signed by drawer
c. Contain an unconditional promise (note) or order (draft) to pay
i. Instrument generally NOT negotiable if it states that payment is conditional.
Basically freely transferable substitute for cash. (IOU not negotiable)
ii. Permissible conditions that do not destroy negotiability
1. States its consideration (instrument in exchange for car)
2. Refers to transaction (i.e. “memo” section of checks)
3. Limits payment to particular source or fund
d. Be for a fixed amount of money (only currency)
i. To be negotiable, must be payable in money and ONLY money.
e. Be payable on demand or at a definite time
i. Payable (i) on or before stated date (ii) at a fixed period after stated
date or (iii) at some time readily ascertainable at the time the
instrument is issued
ii. If certain to happen, but don’t know date (ex. Death), NOT OKAY
f. Be payable to order or to bearer; with exception of checks; AND
i. IF not or draft says “pay John Smith” without one of “magic words,” not
negotiable
g. Contain no additional undertaking or instruction not authorized by UCC
- If instrument not negotiable, there can be no holder in due course (HDC) and holder
in due course rule cannot apply. Thus, transferees of instrument will take instrument
subject to any defense against payment that a party might have. Nonnegotiable is
treated as ordinary contract.
o Look only at face of instrument: nothing on back can create or destroy
negotiability
III. NEGOTIATION – becoming a holder in due course
a. Process by which commercial paper is transferred is called “negotiation” and
person’s whom UCC seeks to protect are “holders in due course” (HDCs) and most
transferees of holders in due course
b. Becoming a Holder (first step in becoming HDC)
i. Holder is a person with good title to commercial paper. Become holder thru
proper negotiation
ii. Bearer paper negotiated by delivering instrument to transferee
iii. Order Paper negotiated by delivery to that person and subsequent transfer
requires specified payee’s endorsement (signature) plus delivery
iv. Last endorsement controls order vs. bearer. Look at last to determine what is
necessary
1. Three qualities of endorsement (i) special or blank, (ii) restrictive or
unrestrictive and (iii) qualified or unqualified
c. Types of endorsements
i. Blank = BEARER PAPER. Can be negotiated by delivery alone.
ii. Special – pay to specific person = ORDER PAPER. Further negotiation requires
signature of special endorsee plus delivery. Does not need to contain words
like “order” or “bearer”
iii. Restrictive – Only, or “for deposit” or “for collection” = ORDER. Specifies use
of instrument or conditions use of instrument. No effect on negotiability
because they appear on back.
1. Ex. Conditions (pay only if…), trust endorsements, and restricting
further negotiation (e.g. “for deposit only)
 iv. Qualified = “Without Recourse” = BEARER PAPER.
1. W/O Recourse means there is no guarantee of payment by the endorser
(no contract liability). “Without recourse” endorser still has warranty
liability.
d. Becoming a holder in due course (HDC)
i. Obtain the paper “in due course” (Second step in becoming HDC)
ii. Holder will take commercial paper in due course to the extent that he
takes the paper:
1. For value
a. Performance, acquisition of lien or security interest in
instrument, taking instrument as payment or security for debt
2. In good faith – honesty in fact
3. Without notice of any defenses or claims of ownership on the
instrument
a. Holder must purchase instrument w/o notice or knowledge that it
is overdue or has been dishonored, or of any defense or claim
against the instrument
o If any one of these reqs are not met, holder is mere assignee of transferor and
has no better rights than transferor
iii. The Shelter Doctrine – most subsequent transferees of an HDC can “succeed
to” or “take shelter in” the rights of the HDC. Even though transferee himself
might not qualify as HDC, he can claim rights of an HDC who held commercial
paper before him
iv. Ex. If don’t qualify as HDC, get rights of those who transferred to you. If
transferor was HDC, you get HDC also.
IV. CLAIMS AND DEFENSES ON THE INSTRUMENT
a. Holder in Due Course Rule: if negotiable instrument is negotiated to a
holder in due course, the HDC takes free from personal defenses and claims
and is subject only to real defenses. “FAIDS”
i. HDC always gets paid; maker/drawer loses
b. To be an HDC, must answer YES to these questions:
i. Was he holder of negotiable instrument? Must be holder, and instrument must
be negotiable. To be holder of bearer paper, need mere possession. To be
holder of order paper needs possession + proper endorsement
ii. Did holder give present value?
iii. Did holder take instrument in good faith?
iv. Did holder take instrument w/o notice of any defenses to or claims of
ownership?
c. Real Defenses – maker does not have to pay anyone, not even HDC. Does the
maker/drawer have a real or personal defense? “FAIDS”
i. Fraud in the execution
ii. Forgery of necessary signature
iii. Adjudicated insanity
iv. Material Alteration (partial real defense. Must pay $10)
v. Infancy
vi. Illegality
vii. Duress
viii. Discharge in bankruptcy and other discharges (e.g. release written on face of
instrument)
ix. Suretyship defenses
x. Statute of limitations has run (generally 3 yrs after dishonor or acceptance on
drafts and 6 yrs after demand or other due date)
d. Personal Defense If not part of FAIDS, then it is
i. Cannot be raised against one having rights of HDC or their “shelter doctrine”
V. LIABILITY OF THE PARTIES
a. Note/CD:
 i. Primary: maker
ii. Secondary: endorsers
b. Draft/Check:
i. Primary: drawee – if accept
ii. Secondary: drawer and endorsers
c. Liability of endorser (person who signs on back of check)
i. Type 1: Endorser’s Contract – endorser secondarily liable
1. By singing name on back, means endorser will pay subsequent holder
of instrument if:
a. Holder presents instrument to maker or primary drawee for
payment
b. Maker or drawee dishonors (refuses to pay) AND
c. Endorser given proper notice of dishonor
2. Must be presented w/in 30 days to preserve liability of endorser
3. Exception: Endorsement without recourse has no contract liability
ii. Type 2: Warranty liability – exists even if transferor does not sign or signs w/o
recourse
1. If transferor does not endorsee, warranties run only to immediate
transferee and not to subsequent holders
2. If transferor endorses, warranties run to all subsequent holders
3. Five Transfer Warranties of Those Transferring for
Consideration
a. Tansferor entitled to enforce instrument (ie has good
title) or is authorized to act for one who is entitled to
enforce
b. All signatures are genuine or authorized
c. Instrument has not been materially altered
d. No defense of any party is good against the transferor
e. Transferor has no knowledge of any insolvency
proceeding that has been instituted against eh maker,
acceptor, or drawer of an unaccepted instrument
VI. DISCHARGE
a. Instrument is never discharged, but parties can be discharged from liability
b. No one held liable on paper anymore b/c (1) paid/satisfied. Payee offered payment
(2) cancelled
c. Methods
i. Payment, satisfaction, or tender
ii. Cancellation
iii. Impairing recourse or collateral
iv. Delay in presentment or failure to give notice of dishonor
v. Acceptance or certification of draft by bank

Secured Transactions
I. INTRODUCTION
a. Secured transaction – debt secured by collateral
b. Security interest – right of creditor to repossess upon default
c. Effective btwn creditor and debtor upon attachment
i. Attachment: agreement btw, debtor and creditor that has been affected.
Creditor attaches hand to debtor’s property
d. Effective against third parties upon perfection
i. Perfection is form of notice that creditor has security interest in collateral,
and because of this notice, gives creditor rights in collateral superior to certain
third parties
e. Purchase Money Security Interests (PMSIs) – has priority over all other types of
security interests in the same collateral, if properly perfected
i. Creditor gives debtor money for buying collateral
 ii. PMSI arises when: (Did the debtor receive the collateral with the
creditor’s money or creditor’s credit?)
1. Creditor sells collateral to debtor on credit, retaining security
interest for purchase price
2. Creditor advances funds used by debtor to purchase collateral
(creditor need not sell)
II. STEP 1: CREATION (ATTACHMENT) OF THE SECURITY INTEREST
a. Three requisites for ATTACHMENT
i. Parties must have agreement creating security interests evidenced
by either
1. Authenticated record of security agreement OR
2. Creditor’s taking possession or control of collateral (“pledge”)
ii. Value must be given by secured party in exchange for security
interest (e.g. creditor gives debtor a loan in exchange for security
interest in debtor’s equipment; loan is value), AND
iii. Debtor must have rights in collateral
b. Since creditor must either take possession or control of collateral or obtain an
authenticated record of security agreement, neither is specifically required (either
one will do, but one or other must be present)
c. If there is record of security agreement, it must be authenticated by the debtor
not the creditor
d. The debtor must have rights in the collateral, but need not necessarily own the
collateral
e. A financing statement is not required. It is related to perfection, not attachment.
III. STEP 2: PERFECTION OF THE SECURITY INTEREST (creditor vs. third parties)
a. To acquire max priority in collateral over third parties, secured party must also
“perfect”
b. Cannot perfect until attach - Security interest not enforceable against any party until
it has attached to the collateral.
c. Five methods of perfection:
i. Filing
1. “Notice” filing of: name and mailing address of debtor AND secured
party, indication of collateral covered by financing statement, and
description of real property
2. Debtor must authorize filing of F/S in “authenticated record” (cannot be
oral)
ii. Taking possession of collateral (pledge) – oral agreement ok
1. Similar to when pawn shop takes item in exchange for loan of money
2. Intangible property cannot be pledged
iii. Control
1. Secured party or other purchaser) has control of an item of investment
property when secured party has taken whatever steps necessary to be
able to have investment property sold w/o further action from owner
iv. Automatic perfection – perfected by attachment to security interest
1. ONLY PMSI in Consumer goods - “personal use”
2. PMSI in inventory or equipment collateral must be filed to be valid
v. Temporary perfection
1. Security interest in proceeds from original collateral perfected for 20
days from debtor’s receipt of proceeds
2. Interstate shipments – perfection in first state valid for four months
after collateral brought to second state
IV. PRIORITIES – between conflicting interests in collateral. Priority ranking is:
a. Buyer in ordinary course (serves as collateral for security agreement
created by seller), HDCs of negotiable instruments, and holders of
possessory liens
i. Buyer who buys goods from merchant’s inventory
 ii. Holders of possessory liens (Mechanic’s liens) – repairer that keeps possession
of goods to ensure payment
b. Holder of properly perfected PMSI in collateral
i. PMSI in Consumer Goods automatically perfected
ii. Exception: “Garage sale rule” – 2nd hand consumer purchaser without notice
will take priority over automatically perfected PMSI.
iii. PMSI in Inventory – has priority over prior perfected security interests only if
(1) filing before inventory delivered) and secured party who has filed security
interest in same collateral is given notice of PMSI before debtor receives
inventory
iv. Noninventory PMSI (e.g. equipment, bank) – priority if filing within 20-days
after debtor in possession of collateral
c. Holder of perfected security interest in, or judicial lien that was attached to
the collateral
i. Two non-PMSIs: first to file or perfect gets priority
d. Holder of an unperfected security interest in the collateral – if 2 unperfected,
first to attach has priority
e. The debtor
- Generally look at filing or perfection dates. Attachment generally irrelevant
V. RIGHTS ON DEFAULT – right to take possession of and sell collateral
a. Effect of sale of collateral: all subordinate claims are wiped out and there is no right
of redemption by subordinate security interest holders or the debtor
i. Good faith purchaser of collateral at the sale takes priority of all subordinate
interests, but is subject to superior interests
b. Proceeds of sale are distributed in following order:
i. Sale and repossession expense
ii. Secured party – satisfaction of debt of creditor with highest priority
iii. Satisfaction of other creditors with security interests
iv. Debtor
c. After default, generally secured party may keep collateral in full or partial satisfaction
of debt
i. In consumer goods cases where debtor has paid at least 60% of loan, the
secured party must sell collateral w/in 90 days after repossession unless
debtor waives his right

Real Property
I. ESTATES IN LAND
a. Tangible land
i. Fee simple: absolute ownership
ii. Life estate – lasts as long as life of person
b. Intangible real property
i. Profit – allows profit holder to enter tract of land to take minerals, timber, soil,
etc.
ii. Easement – limited right to use land of another
iii. License - privilege to go upon land of another
II. CONCURRENT ESTATES
a. Joint tenancy – distinguished by joint survivorship. If one joint tenant dies, property
passes by operation of low to survivors
i. Four unities required to create joint tenancy: Unity of Time, Title, Interest,
Possession (TTIP)
ii. Severance – transferee becomes tenant in common
1. If joint tenant sells his interest, new person will be tenant in common
instead of joint tenant. Remaining joint tenants remain joint tenants
w.r.t. one another
2. While joint tenant is alive, he/she may transfer interest w/o permission
of other joint tenants
b. Tenancy in common – concurrent estate with no right of survivorship
 i. When tenant in common dies, her interest passes to heirs or persons named
to take in will
ii. In most state, multiple grantees are presumed to be tenants in common
(unless deed states joint tenants and/or right of survivorship – “TTIP”)
c. Tenancy by entirety – joint tenancy between spouses
i. Can be terminated only by: death, divorce, or mutual agreement
III. LANDLORD AND TENANT
a. Leasehold estate is possessory estate that entitles tenant, rather than owner, to
exclusive possession of land. Generally, leases have few formal requirements and
short-term leases need not be in writing
b. Types of activities in which tenant may engage on leased premises
i. W/o restrictions in lease, Tenant may engage in any lawful activity on
the premises (watch out for unlawful)
c. Assignments and subleases
i. Complete transfer of entire remaining term, is an assignment. If tenant retains
any part of remaining term, transfer is a sublease.
ii. Assignments by tenants – orig tenant trnfers all interest to new tenant
1. Original tenant is liable if rent is not paid
iii. Sublease - Sublessor (orig lessee) is liable to landlord for orig lease terms
iv. Unless lease provide otherwise, lease can be assigned or premises
sublet
d. Fixture- cannot be removed from property at end of lease term
e. Death of landlord or tenant does not generally end lease
f. Warranties
i. Warranty of possession – put tenant in possess at beginning of lease
ii. Warranty of quiet enjoyment – no eviction
iii. Implied warranty of habitability – reasonably suitable for occupation by
humans
IV. TRANSFER OF REAL PROPERTY (LAND/BLDG) – Conveyancing (transfer title – sale OR gift)
a. Statute of frauds: contract for sale of land must be in writing signed by party to be
charged. Writing must contain description of property, identity of parties, and price
and manner of payment
b. Deeds
i. Deed must identify the property, identify the parties, and show intention to
transfer realty
1. Price not required (i.e. gift)
ii. Deed not effective unless it has been delivered
iii. General warranty deed – best protection
iv. Special Warranty Deed – only two assurances against acts of grantor
v. Bargain and Sale Deed – only warrants grantor has title
vi. Quitclaim Deed – no warranties
c. Recording – similar to perfecting – protects buyer from subsequent 3rd parties
i. To give notice to world that interest in property has been conveyed
ii. Recordation not essential btwn grantor and grantee
1. Recording gives constructive notice to the world of the purchaser’s
interest
iii. Three types of recording acts:
1. Notice statues – BFP (bona fide purchaser) prevails over unrecorded
deal
a. Subsequent purchaser need not record in order to prevail
2. Race-Notice statutes – Recording BFP prevails
a. First in time prevails until a subsequent purchaser
records first
3. Race Statutes – First to record wins
V. MORTGAGES – debt secured by real property
a. Prerequisites
i. Delivered and in writing
 ii. Description of property
iii. Mortgagor’s signature ONLY
iv. Names of grantor/mortgagor and grantee/mortgagee
v. Mortgagor’s acknowledgment
vi. Words of grant or conveyance
b. Recordation – provides constructive notice of mortgage to 3rd parties
i. Just like a security agreement and deed
ii. GR: first mortgagee to obtain and record mortgage will have priority
iii. Mortgage is valid btwn parties even though not recorded
iv. Recording has effect is like filing security interest – gives priority
c. Rights of mortgagee on default of mortgagor
i. On default, mortgagee usually foreclose on property and sell it
ii. Debtor doesn’t pay any of banks
iii. If buyer assumes existing mortgage of seller, buyer has agreed to be liable for
mortgage. Seller (old mortgagor) is also liable
iv. Buying subject to an existing mortgage
1. <Good News> Buyer is not liable – buyer is not liable for existing
mortgage
2. <Bad News> Buyer runs risk of foreclosure if seller defaults. Not liable
for payments.
d. Key Points to Remember:
i. Prior recorded mortgage has priority over second mortgage. Thus,
upon default, first mortgagee must be paid in full before second
mortgagee can get anything
ii. Mortgagor has equitable right of redemption until foreclosure sale is
held and may have statutory right to redeem property after the sale
as well, if a state statute so provides
VI. ADVERSE POSSESSION – title by trespass
a. Person will be deemed owner of property if:
i. Possession is exclusive (cannot be along with the whole public)
ii. Possession is adverse and hostile (w/o permission of true owner)
iii. Possession is open and notorious (use as ordinary owner would)
iv. Possession is continuous

Chapter 7 – Agency, Bankruptcy, Securities regulation, CPA legal liability,

Property insurance

Agency
I. CREATION OF THE AGENCY RELATIONSHIP
a. Agency: legal relationship in which Principal appoints Agent to act on his behalf
b. Requirements for creation
i. Principal must have capacity (not a minor and not incompetent) and consent
of the parties (parties agree to act as principal and agent)
ii. Writing is not required, but many states require written agency agreement if
agent is to buy or sell interest in land for principal
1. Agency agreements that cannot be performed in 1 year evidenced by
writing
iii. Agent does not need to have capacity (minors or mentally incompetent ppl
can be agents)
c. Power of Attorney – Written Authorization of Agency
i. Only principal required to sign (agent no need)
ii. Agent’s authority limited to specific transactions
 iii. Agent referred to “attorney in fact” means he/she has power to act on behalf
of principal
d. Duties
i. Duties of Agent to Principal (“Fiduciary Duty”)
1. Duties stated in contract
2. Loyalty – act solely in principal’s interest
3. Obedience – obey all reasonable directions of principal; do not exceed
authority
4. Reasonable care – carry out w/o negligence; liable to both P and 3rd
party
5. Subagent has duty of care to agent AND principal
ii. 3 Common breaches of duty
1. No kickbacks/self-dealing
2. Avoid conflicts of interest
3. Do not disclose confidential information
iii. How principal can recover damages from agent if breached
1. Tort Damages – if agent negligently or intentionally breached duty
2. Contract Damages if agent was compensated or received consideration
3. Recovery of Secret Profits (kickbacks) – impose constructive trust if
agent obtained secret profits from another customer/client
iv. Duties of Principal to Agent
1. Reasonable Compensation
2. Reimbursement/Indemnification for all expenses incurred in carrying
out agency
v. Either party has the POWER but NOT RIGHT to terminate relationship at any
time (wrongful termination will be breach of contract)
1. Exception: Agency Coupled with Interest cannot be terminated by
principal, ONLY Agent
a. When agent has interest in subject matter of agency, like when
agent has paid for right to be appointed as agent, usually by
giving credit
i. Principal: debtor; Agent: Creditor
b. Death, incapacity, or bankruptcy of principal will not end ACwithI
II. AGENT’S POWER TO CONTRACTUALLY BIND PRINCIPAL (when true agency relationship does
not exist)
a. Agency power can arise through: Actual authority, Apparent authority or estoppels,
OR Ratification
b. Type I: Actual Authority (aka “real authority” or “authority”)
i. Definition: the authority the agent reasonably believes he possesses b/c of the
principal’s communications to the agent. Can be either express or implied.
ii. Express Actual Authority – oral/written instructions. Includes all powers that
principal expressly grants w/in “four corners” of agency agreement
iii. Implied Actual Authority – also includes other authority that agent could
reasonably believe is implied along with express grant
1. Includes authority to do things reasonably necessary to carry out
agency (e.g. managers usually have authority to hire employees, buy
merchandise, etc.), or things the principal has repeatedly allowed agent
to do, and emergencies
a. Subagents owe fiduciary duty to both Primary Agent and
Principal
2. Ex. Implied authority of business manager: No implied authority to sell
or mortgage business fixtures or other property of Principal (other than
inventory). Agent does not have implied authority to borrow money on
principal’s behalf (must be expressed)
iv. Termination of Actual Authority
1. Act of Parties – Agent quits or gets fired
 a. If termination violates parties’ contract, damages could be
available
b. Exception: Agency coupled with interest. A is creditor, P cannot
terminate
2. Accomplishment of objective OR Expiration of stated period/reasonable
time
3. Termination of Actual Authority automatically by “operation of
law” in events below:
a. Death of principal or agent
b. Incapacity of principal
c. Discharge in bankruptcy of principal
d. Failure to acquire necessary license
e. Destruction of subject matter of agency (car destroyed
before purchased)
f. Subsequent illegality (e.g. Hire agent to purchase
antique gun, but before purchase, a law is passed
prohibiting private ownership of guns)
c. Type II: Apparent Authority (power to bind the principal)
i. When principal’s conduct caused 3rd parties to reasonably believe agent had
authority or b/c principal was negligent, so estopped from denying that agent
had authority
1. Actual authority when agent reasonably believes he/she has power to
bind principal; Apparent authority when third party reasonably believes
agent has power to bind principal
ii. Ex. P grants A title/position
1. Requires holding out by principal or negligent inaction by principal
2. Agent cannot give him/herself title/apparent authority
3. Secret limiting instructions not effective to limit agent’s apparent
authority (e.g. Cannot buy dog over $200. Agent has apparent authority
to purchase dogs)
iii. Notice required to terminate Apparent Authority
1. Ex. Failure of P to give notice to 3rd parties after A quits/gets fired
2. Actual notice to old customers; Constructive notice to new customers
(ex. newspaper ad)
3. Exceptions: no notice required if following occur:
a. Death of principal or agent
b. Incapacity of principal
c. Principal receives discharge in bankruptcy
iv. General agent performs series of transactions with continuity of service vs.
Special agent NOT involving continuity.
d. Type III: Ratification – allows principal to choose to be bound by previously
unauthorized act of agent
i. Requirements
1. Agent must have disclosed he/she acting on behalf of principal to 3rd
party
2. Material facts disclosed to principal
3. Principal must ratify entire transaction
ii. Generally, any act may be ratified unless:
1. Performance illegal
2. 3rd party withdraws prior to ratification
3. Material change of circumstance so not fair to hold 3rd party liable
iii. Only disclosed and purported principal may ratify
e. Contractual liability
i. Disclosed principal liable if agent had actual / apparent authority or if principal
ratified (see above)
ii. If agent discloses principal, authorized agent not liable to 3rd party
 iii. If agent partially discloses principal, the agent is liable to 3rd party
1. Once 3rd party finds out identity of Principal, can hold EITHER Principal
OR Agent liable
2. Undisclosed Principal only liable if Agent had actual authority (cannot
be apparent auth)
3. Undisclosed Principal has no effect on agent’s actual authority
since actual authority arises from communications btwn
principal and agent
III. TORT LIABILITY – intentional or negligent wrongful act
a. General rule: Only agent, not principal, liable for torts committed by agent
i. Exception for employers under doctrine of respondeat superior:
employer can be liable for employee’s torts committed within scope of
employment
ii. Injured person may sue both employer under respondeat superior and the
agent
b. Step 1: Employer-Employee Relationship (employee or independent contractor)
i. Employer (master) generally only liable for torts of employee (servant), not
indep contractors
ii. Employee vs. Indep Cont: right of principal to control the manner in which
person performs
iii. Employee: one who works full time for the employer, uses the employer's tools,
is compensated on a time basis, and is subject to supervision of the employer in
the details of the work.
iv. Indep Cont: one who has a calling of his own, who uses his own tools, is hired for
a particular job, is paid a given amount for the job, and follows his own discretion.
c. Step 2: Scope of Employment
i. Injury must have occurred while employee was working for employer within
time and geographic area in which employee was to work
ii. Employer usually liable for employee’s negligence and not intentional torts
(seldom w/in scope)
iii. Where tort or use of force is authorized (ex. Bouncer), employer can be liable
d. Step 3: Whether employer liable for torts committed by independent
contractors
i. Only liable if employer authorized tortuous act or if work involved
ultrahazardous activity (i.e. blasting / bombing)

Bankruptcy
I. 5 TYPES OF BANKRUPTCY CASES: Chapter 9 is for municipal debt adjustment; Chapter 7
provides for liquidation of a debtor's estate; Chapter 11 is for debt reorganization an available
to family farmers with regular income; Chapter 13 is for adjustment of debts of individuals with
regular income; Chapter 12 – family farmers with reg income
a. Chapter 7 Liquidation (Indvd, Partnerships, Corp) – Trustee appointed
i. Trustee collects debtor’s assets, liquidates them, and uses proceeds to pay off
creditors to the extent possible
ii. Preferred by debtor b/c if debtor is indvd, the debts are discharged (debts
wiped)
iii. If debtor is artificial entity (e.g. corp), it is dissolved (debts wiped)
b. Chapter 13 Adjustments of Debts of Indvds with Regular Income – Trustee
oversees
i. Not preferred b/c debtor repays all or portion of debts over 3-5 years;
remaining debt discharged
c. Chapter 11 Reorganization (Indvd, Partnerships, Corps) – Trustee not required,
but court may appoint if needed
i. Debtor remains in possession of his/her assets and plan of reorg is adopted
ii. Creditors are paid to extent possible and business continues (not dissolved!!)
d. The Means Test – dismissal or conversion of Chapter 7 Case
 i. Indvd consumer debtor may be dismissed upon finding that relief under Chpt 7
would be abuse
ii. Calculation of Debtor’s Income: to determine whether debtor has sufficient
income to pay some or all debts under Chpt 13 plan
1. Step 1: Current Monthly Income (annual) compared to state
median income
a. Avg of 6 mos b4 filing x 12 + debtor’s spouse ≤ state
median income  Chapt 7
b. Avg of 6 mos b4 filing x 12 > state median income 
means test
2. Step 2: Means Test – to determine whether debtor has sufficient
income to repay debts using Chapter 13
a. (6-Month Avg Income – Allowed Expenses) x 60 < $6,575
 Chapt 7 permitted
b. (6-Month Avg Income – Allowed Expenses) x 60 ≥ $10,950
Chpt 13 or dismissed; abuse
c. $6,575 ≥ Current Avg 6-Month Average Income – Allowed
Expenses x 60 < $10,950  abuse or Chpt 13 only if
amount ≥ 25% of non-priority claims
3. Allowable deductions: living expenses, health and disability insurance
and health savings acts, care of elderly, disabled, and chronically ill,
expenses to keep debtor safe from family violence, actual expenses to
administer chpt 13, expenses for dependents’ education, 1/60 of
payments due to secured creditors, 1/60 of priority claim payments
4. Can rebut the assumption of abuse by showing special circumstances
(serious illness/call to military duty) that create addt’l expenses
5. General Abuse Test: Chpt 7 may still be denied if can show that debtor
acted in “bad faith” or that under “totality of circumstances” there is
abuse
a. If qualify for Chpt 7, can only be dismissed by general abuse
test, court, trustee, or bankruptcy administrator (not creditor)
iii. Who may be a debtor
1. Indvds, Partnerships, Corps
2. Chpt 7 NOT Railroads, Insurance companies, Banks, Savings
institutions, and Small business investment companies
3. Chpt 11 same except NOT brokers or commodity brokers
4. If Debtor is an individual
a. Counseling must occur no more than 180 days before filing
bankruptcy petition
b. Debtors must complete financial mngmt course before debts
discharged
II. COMMON FEATURES OF CHAPTER 7 (LIQUIDATION) AND CHAPTER 11 (REORGANIZATION)
CASES (I, P, C)
a. Automatic Stay – stops collection efforts when bankruptcy petition is filed
b. After petition filed, debtor must file schedule of assets and liabilities (at FMV), current
income & expenses, financial affairs, pay stubs, list of creditors, itemized statement
of monthly net income, disclosure of reasonably anticipated increase in
income/expenses for 12 mos after filing
i. If fail to file any of these items within 45 days of filing petition, case is auto
dismissed on 46th day
c. Chpt 7 and 11 may be voluntary OR involuntary
i. Voluntary Cases
1. Spouses may file jointly to avoid duplicative fees
2. Chpt 13: indvd and voluntary only!!
 3. Commenced when debtor files petition for relief; has debts of any amt
not capable of paying when due regardless of ability to pay; Debtor
need not be insolvent
ii. Involuntary Cases: unsecured creditors can petition debtor involuntarily into
bankruptcy proceedings under chpt 7 or 11, NOT 13
1. Who must join petition: only creditors who are owed at least
$13,475 in unsecured, undisputed debt pay petition debtor
involuntarily into bankruptcy
a. If debtor has < 12 creditors: ≥ 1 creditors owed at least
$13,475 in unsecured, undisputed debt may file
b. If debtor has ≥ 12 creditors: ≥ 3 creditors owed at least
#13,475 in aggregate, unsecured, undisputed debt must
join in involuntary petition
2. Farmers as nonprofit charitable orgs cannot be petitioned involuntarily
3. Creditors must show debtor is defaulting – not paying debts when due
iii. If creditors improperly filed involuntary petition, court may award debtor
compensatory damages, court costs, attorney’s fees, and even punitive
damages if bad faith can be shown
d. 20-40 days after order for relief, a Section 341 Meeting is held for all interested
parties; debtor must attend. Purpose is to provide creditors opportunity to examine
the debtor
e. Property of Bankruptcy Estate
i. Debtor’s estate subject to being seized and sold includes
1. All real and personal property at time of filing
2. Property debtor receives from divorce, inheritance, or
insurance within 180 days after filing of petition
ii. Property excluded from estate
1. Post-petition earnings, spendthrift trusts, educational IRAs, state tuition
programs
2. Generally things necessary to live: homestead, motor vehicle,
household goods, crops, and animals, unmatured life insurance
contracts, tools of a trade or professional books, gov’t benefits (soc sec,
veteran’s benefits, unemployment comp, disability benefits), alimony,
support, or maintenance
3. Exemptions do not apply if:
a. PMSI (Purchase Money Security Interests) – PMSIs in
noninventory collateral within 30 days after debtor receives
possession of collateral has priority over trustee
b. Mortgage
c. Tax Liens Creditor – priority over all creditors except creditors
with prior perfected security interests or prior statutory or
judicial liens
iii. Trustee can set aside fraudulent transfers made within 2 years of filing date
(concealing assets; “sell” below FMV/gift)
1. Fraudulent transfer: any transfer made with intent to hinder, delay,
or defraud creditors or any transfer where debtor received less than
equivalent value while debtor was insolvent (“Sell” but keep possibility
or equitable benefit)
iv. Trustee can set aside preferences: payment taken back from creditor and
becomes part of bankruptcy estate
1. Purpose: prevent one creditor from receiving unfairly large payment
relative to others
2. Preferential Payment is:
a. Made within 90 days prior to the filing of the petition (1 yr
if creditor is insider)
b. Results in creditor receiving more than creditor would
have received under Bankruptcy Code
 c. Transfer made to or for benefit of creditor
d. On account of antecedent debt of debtor
e. Made while debtor was insolvent
3. Exceptions: Transfers that cannot be set aside
a. Transfers in ordinary course of business
b. Domestic support obligations (spousal support or child support)
v. Claims against the state (“I want a piece”) – all rights to payment from
debtor’s estate
1. Unsecured creditors and security holders must file, otherwise cannot
take part in distribution of debtor’s estate
2. To have claim allowed, unsecured creditors must file proof of claim, and
shareholders must file proof of interest with bankruptcy court
3. Unless someone objects, filed claim or interest will automatically be
allowed by court
III. FEATURES OF A CHAPTER 7 LIQUIDATION: Indvd must satisfy income test or convert to
Chapter 13
a. Goal: give honest debtor a “fresh start” by discharging MOST debts owed by debtor
b. In liquidation, bankruptcy trustee appointed; trustee collects all debtor’s nonexempt
property, liquidates it, and pays off debtor’s creditors
c. Objections to discharge – destroys chapter 7 case. dishonest debtor (DRAWING)
i. Discharge within 8 years
ii. Records, failure to keep: unjustifiably concealed, falsified, or failed to keep
or preserve adequate books and records
iii. Assets, failure to explain whereabouts of or losses
iv. Willfully concealing assets
v. Individual, not one (corporations are dissolved, not discharged)
vi. Not obeying court orders
vii. Guilty of a bankruptcy crime
d. Not all debts discharged under Chpt 7 or 11 (WAFTED)
i. Willful and malicious injury, Alimony, Fraud, Education loans, Debts
e. Sometimes debtor does not want particular debt discharged (e.g. to maintain good
relations with particular creditor) May reaffirm debts only if:
i. Agreement to reaffirm made before granting of discharge
f. Distribution of debtor’s estate – priorities of payment
i. Three basic categories of claimants: security claimants, priority
claimants, general creditors who filed claims on time
ii. Payments are made in full to secured claimants up to the value of
collateral securing claims
iii. Whatever is left over used to pay 1st, 2nd, 3rd priority claimants followed by
general creditors
iv. If not sufficient money to pay all creditors at particular level, creditors share
pro rata
v. Priority (SAG - WEG - CTI)
1. Support obligations to spouse & children
2. Administrative expenses of bankruptcy proceeding
3. Gap creditors
4. Wages up to $10,950 for each employee if earned within 180 days prior
to filing
5. Employee benefit plan contributions up to $10,950 for each employee,
reduced by wage claims, if earned w/in 180 days prior to filing
6. Grain farmers’ and fishermen’s claims up to $5,400
7. Consumer deposits for goods paid for but not delivered up to $2,425
8. Taxes
9. Injury claims caused by Intoxicated driving
IV. FEATURES OF REORGANIZATION CASES UNDER CHAPTER 11
 a. Committee of unsecured creditors is appointed; consisting of willing persons holing
seven largest unsecured claims against debtor
b. Committees engaged with “approving the plan”
c. Trustee is not appointed in Chpt 11; Debtor usually remains in possession of estate’s
assets
i. Exception: trustee appointed on showing of fraud, dishonesty, incompetence,
or gross mismanagement on part of debtor’s estate
d. Debtor may file reorg plan under Chpt 11 at any time
i. Unless trustee appointed, debtor has exclusive right to file plan during first
120 days after order for relief is effective
ii. Other interested parties (creditors) may file plan if:
1. Trustee appointed OR debtor not filed plan w/in 120 days after order of
relief OR debtor filed plan but has not obtained acceptance of every
impaired class w/in 180 days
iii. Court will confirm plan if accepted by all impaired classes
1. Court can confirm plan even if not accepted by all impaired classes if:
a. At least 1 impaired class accepted
b. Plan not unfairly discriminatory and is fair and equitable with
respect to any dissenting impaired classes
iv. Effects of confirmation: binding on all parties regardless of whether they
accepted plan; debtor pays debts; discharges debtor from all pre-confirmation
debts

Securities Regulation
I. Intro
a. Securities Act of 1933 – regulates original issuances of securities
b. Securities Act of 1934 – regulates purchases and sales after initial issuance
c. Securities: If investor is passive – i.e. relies solely on management of others to
make money (i.e. limited partners/shareholders)
i. Stocks, bonds, debentures, stock options, collateral trust certificates, warrants
ii. NOT CDs or general partnership interests
II. SECURITIES ACT OF 1933 (IPO)
a. GOAL: assure investors have sufficient information on which to make informed
investment decision
i. Requires most issuers to register new issues of securities with SEC and
provide prospectuses before they sell to public
b. Those required to register (must file) with SEC:
i. Issuer – entity whose securities being sold
ii. Underwriter – intermediary who sells issuer’s securities to general public or
dealers
iii. Dealer – sells or trades securities
c. Registration Statement
i. Part I: Prospectus – any written, radio, or television offer to sell securities
1. Summarizes important info contained in Part II
ii. Part II: Info about securities being issued to include
1. Audited balance sheet and P&L statement certified by public accounting
firm registered with PCAOB
2. “Other material facts” requiring disclosure
a. Names, addresses of directors, officers, underwriters,
shareholders who own 10% or more of company’s shares
b. Principal purposes for which offering proceeds will be used
c. Anything that might affect value of securities being issued
iii. Shelf Registrations – One registration statement for all securities they will
offer in the future
 1. Generally prohibited; permitted if issuer has continuously filed under
1934 Act for 1 year (not first-time issuer) and info is continuously
updated
iv. SEC reviews registration statement to ensure both parts complete
v. Blue Sky Laws: state laws governing stock sales; most preempted by federal
law
d. Timetable of sales activity
i. Prefiling Period – 30 days before registration
1. No sales activity allowed, but issuer allowed to negotiate with
underwriter
ii. Waiting Period – 20 days between registration and filing; some sales activity
allowed:
1. Tombstone Ads – can be placed before a registration statement is
effective. Ad identifies the nature of the security, price, who will execute
orders, and the availability of a prospectus.
2. Red Herring (preliminary prospectus) – may be missing certain
information that is not yet available.
3. Oral but not written offers to sell
iii. Post-Effective Period – 20 days after filing or as SEC directs
1. All investors receive prospectus before or with sale
iv. Special Rules for some 1934 Act reporting companies (WKSIs)
1. Seasoned Issuers: continuously reporting under 1934 Act for at least 12
mos, not filed to pay dividend, not defaulted on material debt or L/T
rent obligation in current fiscal yr
2. Well Known seasoned issuers: seasoned issuers with at least $700M in
equity or issues that have issued at least $1B in nonconvertible
securities in last 3 years
e. Exemptions from Registration - All securities must be registered unless exempt
i. Securities of charitable organizations
ii. Bonds issued by municipalities for governmental purposes
iii. Transaction Exemptions
1. Intrastate sales
2. Regulation A (Partial Exception)
a. Exception from the full registration requirements; simplified
form of registration
b. An offering circular must be filed with the SEC
c. Sales may not exceed $5M in 12-month period
3. Regulation D (Exempts “Private Offerings”)
a. 3 private offering exemptions under Regulation D: Rules 504, 505,
406
b. May be made to both accredited and nonaccredited investors
c. General Conditions
i. No advertising; general solicitation prohibited
ii. Immediate resale (reoffers) to public prohibited
iii. SEC must be notified within 15 days after the first
sale of the offering
d. Requirements of Rule 504 – $1M limit on issuance of
securities in 12 mo period
i. No limit on number of or accredited/unaccredited
purchasers
ii. No specific disclosure to investors prior to sale
e. Requirements of Rule 505 - $5M limit on issuance of
securities in 12 mo period
i. Less than 35 unaccredited investors, unlimited accredited
ii. Accredited investor: institutional investor, bank, natural
person with at least $1M net worth or $200K annual income
 iii. If only accredited investors purchase, no disclosure
required
f. Requirements of Rule 506 – unlimited $ amount;
sophisticated investors ONLY
i. Less than 35 unaccredited but sophisticated investors,
unlimited accredited
ii. If only accredited investors purchase, no disclosure
required
f. Liability under the 1933 Act
i. Section 11 Liability – civil liability for misstatements, whether or not intentional
in registration statements
1. Section 11 Cause of Action – ANYONE who signs is liable for ALL
damages caused by any misstatement of material fact in registration
statement
a. Plaintiff acquired stock (not necessarily initial purchaser)
b. Plaintiff suffered loss (i.e. damages)
c. Registration statement contained material
misrepresentation or material omission of fact
d. Plaintiff need not prove intent to deceive or negligence on part of
defendant or reliance.
e. Damages is ONLY remedy; recission not available
2. Who may be liable: anyone who signs registration statement (officers,
directors, underwriters, lawyers, auditors)
a. Privity not required under federal law! Doesn’t matter if you
never met them
3. Due diligence defenses (“Affirmative defense”) – proving this makes
you not liable
a. Due diligence: defendant had reasonable grounds to believe
facts in registration/financial statement true and no material
facts omitted
b. GAAP/GAAS Defense: workpapers follow rules
c. Issuers may not use this defense
4. Misstatement did not cause plaintiff’s damages
a. Other defenses: misstatement was not material or when plaintiff
knew of truth or omission in statement at time she purchased
securities
ii. Section 12 – civil liability if required registration not made, if prospectus not
give, or if false statements were made in connection with sales or offers to sell
iii. Section 17 – criminal penalties against anyone who uses fraud in connection
w/ issuance
III. SECURITIES ACT OF 1934 –
a. Intro
i. Concerned with exchanges (sales, purchases, etc.) after they are issued
ii. Has reporting provisions that apply only to certain companies and anti-fraud
provisions that apply to all purchasers and sellers, regardless of registration
iii. SEC can seek suspension or revocation of a company’s registered securities
for violation of reg or reporting requirements
b. Registration Requirements
i. Two types of companies must register securities
1. Shares traded on national exchange
2. Companies that have at least 500 shareholders in any one class and
> $10M in assets
ii. National stock exchanges, brokers, and dealers
c. 1934 Act Reporting Requirements
i. Reporting Companies: all companies required to register under 1934 Act AND
any issuer that must register under 1933 Act
 ii. 10K (filed annually within 60 days of end of fiscal year; certified by
independent accountants), 10Q (filed within 35 days of end of first 3 quarters
of fiscal year; must contain reviews of interim financial info), 8K (filed w/in 4
days after major change in company)
iii. 5% or more owners must report to SEC, Issuer, and Exchange
1. Must include background about purchaser, source of funds, and
purpose in buying
iv. Tender offers – offer to all shareholders to purch stock for specific price for
specific amt of time
v. Insiders – officers, directors, > 10% shareholders, accountant, or attorneys of
company
1. Must file report with SEC disclosing holdings in reporting co. and make
monthly updates
2. Imposes absolute liability on any insider who makes profits on purchase
or sale of reporting company’s stock w/in 6-month period (called short
swing profits)
vi. Proxy Solicitations and Proxy Statements
1. Truthful, not misleading
vii. Under Section 18, person can be held liable for intentionally making false
and/or misleading statements in a registration statement or any report
required under 1934 Act
d. Antifraud provisions – RULE 10b-5
i. In General – Rule 10b applies even if registration is not required
1. Rule 10b-5 prohibits fraud in connection with purchase or sale of any
security
ii. Cause of Action – to recover damages for violation of 10b-5, plaintiff must
prove:
1. Plaintiff bought or sold securities
2. Purchaser suffered loss as result of fraud
3. Defendant made Material misrepresentation or material
omission of fact
4. Scienter (intent to deceive or reckless disregard for the truth) –
negligence insufficient
5. Reliance – relied on the defendant’s misrepresentation
6. Interstate Commerce – means of interstate commerce (federal law)
was involved. e.g. use of mail or phones or national securities exchange

Section 11 of 1933 Act Rule 10b-5 of 1934 Act

NO proof of scienter, reliance, or negligence
Plaintiff needs to show he acquired stock,
suffered loss, and there was material
misrepresentation or material omission of fact in
registration statement
Requires proof of scienter and reliance;
Fraud = must prove intent to deceive
Plaintiff needs to show he acquired stock,
suffered loss, and there was material
misrepresentation or material omission of fact in
registration statement
Proof of negligence is insufficient

CPA Legal Liability

I. CPA legal liability can arise in any of 3 ways: Breach of contract, Commission of tort, or
Violation of statute
II. Breach of Contract
a. If CPA does not fulfill terms of engagement
b. Requires privity, so only a party to contract can use under contract theory
c. Client OR third party entitled to recover compensatory damages
d. All defenses mentioned in contract outline apply (e.g. client’s failure to let CPA see
any accounting records) – “hinders performance”
III. Commission of Tort (wrongful act) - Three torts: negligence, constructive fraud (gross
negligence), and fraud)
a. Negligence - 4 elements: duty of care, breach (lack of due care), breach caused
plaintiff’s injury, damages
i. Ex. Failure to warn client about known internal control weakness
ii. Ex. Failure to have critical review at every level of supervision  negligence
iii. CPA Liability
1. Duty to clients, and under the majority rule to any person or
limited foreseeable class of persons whom CPA knows will be
relying on CPA’s work
2. Ultramares decision – limits CPA liability to persons in privity on
contract with the CPA (clients) and intended 3rd party
beneficiaries; parties merely "foreseen" cannot recover
iv. Breach – failure to act with due care (“reasonable care”) = ordinary
negligence
1. CPA must perform with same skill and care expected of ordinarily
prudent CPAs under the circumstances
2. Due diligence defense / GAAP & GAAS Defense: CPA followed applicable
standards (e.g. AAS in audit or GAAP in financial statements)
b. Actual Fraud (“Bad Faith”) – intentional misrepresentation; 5 elements:
i. Misrepresentation of material fact
ii. Intent to deceive (knowing the statement was false); Defendant acts
with gross negligence or recklessly.
iii. Actual and justifiable reliance by plaintiff on misrepresentation
iv. Intent to induce plaintiff’s reliance on misrepresentation
v. Damages
vi. Liable to all people who rely on F/S
c. Constructive Fraud (Gross Negligence)
i. Same elements as actual fraud, except instead of intentionally deceiving,
the defendant acts recklessly (i.e. makes a statement w/o knowing
whether it is true or false)
ii. CPA Liability
1. CPA can be held liable to anyone who proves these elements
2. Privity not a defense to fraud. Liability not limited to people in privity,
third party beneficiaries, or limited foreseeable class of persons
3. Liable to all people who rely on F/S
iii. Best defense for fraud: lack of scienter/good faith
IV. CPA Statutory Liability
a. Section 11 of 1933 Act (IPO) – Plaintiff need not prove intent, negligence, privity, or
reliance
i. CPA liable for misstatements in F/S to plaintiff who
1. Acquired the stock
2. Suffered a loss
3. F/S contained material misrepresentation or material omission
of fact
ii. Easier for plaintiff to win
b. Rule 10b-5 of the 1934 Act – “sue for fraud”
i. CPA criminally or civilly liable for misstatements in F/S to plaintiff who:
1. Same as Section 11 of 1933 Act AND…
2. Misrepresentation was made with scienter (intent to deceive or
reckless disregard for the truth). Negligence not enough
3. Plaintiff justifiably relied on misrepresentation
4. Used some means of interstate commerce
c. Private Securities Litigation Reform Act
i. Audit pursuant to 1934 Act must include
 1. Procedures to detect illegal acts that would have a direct and material
effect on F/S
2. Procedures to identify related party transacs that are material or
require disclosure
3. Procedures to eval whether there is doubt about ability of issuer to
continue as going concern
ii. Notification
1. Issuer’s board must report to SEC the receipt of notice within 1 day
after receiving and furnish accountant with copy of notice
2. If CPA fails to receive copy of notice w/in 1 day, CPA is to
furnish SEC with copy of report w/in 1 day
V. Communication Privileges and Workpapers
a. Info exchanged w/in scope of relationship may not be disclosed as evidence in court
w/o consent of privilege holder
b. Generally federal law does not recognize accountant-client privilege; CPA
can be forced to disclose client info if subpoenaed and relevant to federal
court case
i. When it does exist, state courts and agencies have no power to force CPA to
disclose confidential client information
c. Workpapers belong to accountant that prepares them, not the client
d. An accountant is prohibited from showing the workpapers to anyone without the client's
permission, EXCEPT:
i. Lawful subpoena.
ii. Surviving member of the firm; prospective purchaser of CPA’s practice as
long as purchaser does not disclose confidential information*
*CPA may not turn over workpapers to purchaser without client’s
permission
iii. Quality control panel.
iv. AICPA/State Trial Board.
v. Court proceedings.
vi. GAAP/GAAS requires disclosure.

Property Insurance
PARTIALLY DESTROYED
Recovery = Face value of policy x Loss
Coinsurance x FMV of Property
Accept lesser of face value of policy or recovery

MULTIPLE POLICIES ON SAME PROPERTY – pro-rata allocation of loss for each insurance payment

FULLY DESTROYED
Receive lesser of combined insurance or amount of damage

Chapter 2 – Individual Taxation: Adjustments, Itemized Deductions, Credits

Adjustments and Itemized Deductions

I. Overview
II. Adjustments (Deductions) to Gross Income to arrive at AGI
III. Deductions from Adjusted Gross Income (AGI)

Tax Calculations and Credits

I. Tax Calculation and Limitations
II. Tax Credits
Individual Taxation – Other Taxes
I. Alternative Minimum Tax (AMT)
II. Social Security / Medicare Tax – reported in same section as AMT. 50% of amount is adj. to
arrive at AGI

Individual Taxation – Other Items

I. Statute of Limitations
II. Estimated Tax and Inadequate Withholding