Lesson 1: Fact and Legal Issues
As the home page notes, the second step in conducting tax research involves identifying issues, which come in two varieties:
Generally, you must reach conclusions about factual issues before related legal issues. Stated differently, legal issues cannot be resolved until the researcher knows all relevant facts. To distinguish between these two types of questions, simply ask where you must look to reach a conclusion. If you consult only the law (steps 3 and 4 in the tax research process), the question is legal in nature. Otherwise, it is a factual issue that must be resolved through gathering additional information (step 1).
The following issues consist of some questions of fact and some questions of law:
- Is the taxpayer’s total compensation reasonable in amount?
- Must the taxpayer include bonuses she receives in gross income?
- Is entertainment the taxpayer purchases related to his business?
- Can the taxpayer deduct entertainment expenses?
The odd issues are questions of fact. You cannot determine whether compensation is reasonable or whether entertainment relates to business only from consulting tax law. Instead, a comparison of total compensation with industry averages or the activities and effort required to earn the income might reveal the reasonableness of the receipt. Similarly, determining if entertainment relates to business might depend on who enjoys it, where it occurs, and its nature. In contrast, the even issues represent questions of law since knowing whether a receipt is gross income or whether a payment is deductible requires knowledge of tax law.
Some researchers view many issues as hybrid in nature (i.e., partly questions of fact and partly questions of law). Specifically, you might consult the law to determine important factors in resolving an issue but then consult non-legal sources to determine what such factors suggest.
Determining whether a taxpayer’s activity constitutes a business or hobby requires examination of nine relevant factors in Reg. §1.183-2(b). The following list summarizes questions of fact that the regulation raises:
- Does the taxpayer carry on the activity in a businesslike manner and maintain complete and accurate books and records?
- Before starting the activity, did the taxpayer engage in extensive study of accepted business, economic, or scientific practices related to the activity or consult with experts?
- Does the taxpayer devote substantial time and effort to the activity?
- Does the taxpayer expect to derive profit from appreciating assets used in the activity?
- Has the taxpayer taken unprofitable activities in the past and made them profitable?
- Are the activity’s losses beyond the start-up period due to customary business risks (or reverses) or unforeseen circumstances such as casualties, thefts, involuntary conversions, or depressed markets?
- Over time, what is the taxpayer’s profit from the activity in relation to losses and investment?
- Does the taxpayer have substantial income or capital from other activities that provide a livelihood?
- Does the activity provide the taxpayer with recreational benefits or personal pleasure?
In effect, you consult the regulation to determine relevant factors and then look outside the law to determine whether the factors support a finding that the activity is a business or hobby.
An alternative to the hybrid view recognizes that some factual issues are just broader than others. Returning to the example above, whether an activity is a business or hobby constitutes a broad factual issue that itself consists of narrower factual issues derived from Reg. §1.183-2(b). The mere fact that the regulation (or law) identifies relevant factors does not cause any question to become partly legal in nature. Consistent with Lessons 2 through 4 that emphasize the need for questions of law to contain explicit tax concepts, the related legal question is whether the taxpayer can deduct expenses exceeding gross income from the activity or, stated differently, whether the taxpayer can deduct net loss from the activity in the current year. Since the issue of whether an activity constitutes a business or hobby does not explicitly ask whether a net loss from such activity is deductible, the issue is entirely factual in nature. Similarly, under this alternative view, the nine issues listed above are questions of fact.
This website does not embrace the view that some issues are partly questions of fact and partly questions of law. Taken to an extreme, most legal issues could be characterized as “hybrid” simply because the law almost always conditions legal rules on the existence of some facts. For instance, the Internal Revenue Code does not allow taxpayers to deduct everything given to charity; conditions must be satisfied under §170 before the Code permits charitable deductions. Nonetheless, the deductibility issue is clearly legal in nature.This lesson explains how to distinguish between questions of fact and law. Knowing the difference helps researchers to order procedures since factual issues must be resolved (step 1 in the tax research process) before related legal issues (steps 3 through 5). Further, distinguishing between types of tax issues assists in writing clear legal issues. Lessons 2 through 4 emphasize the importance of legal issues drawing on explicit tax concepts. When such concepts do not appear in a tax question, either the researcher expressed a legal issue unclearly or the issue is factual in nature. Please complete the one-minute exit questionnaire before leaving the site.