Chapter 1

1. Chapter 1 Federal Income Taxation - An Overview Kevin Murphy Mark Higgins © 2009 South-Western, a part of Cengage Learning

2. What is the Definition of a Tax? • An enforced, involuntary contribution • Required and determined by law • Providing revenue for public and governmental purposes • For which no specific benefits or services are received

3. What is the Purpose of a Tax? • Revenue • Penalty • Social changes • Economic changes • Equity

4. Standards of a Good Tax SystemAdam Smith’s Four Criteria • Equality • Tax should be based on the taxpayer’s ability to pay • Horizontal Equity: Two similarly situated taxpayers are taxed the same • Vertical Equity: Differently situated taxpayers are taxed differently but fairly

5. Standards of a Good Tax SystemAdam Smith’s Four Criteria • Equality • Certainty • When and how a tax is to be paid should be known to the taxpayer • The taxpayer should be able to determine the amount of the tax

6. Standards of a Good Tax SystemAdam Smith’s Four Criteria • Equality • Certainty • Convenience • Tax should be levied when the taxpayer has funds available to pay

7. Standards of a Good Tax SystemAdam Smith’s Four Criteria • Equality • Certainty • Convenience • Economy • The costs of complying with the tax system should be minimal

8. Tax Computation Tax = Tax Base X Tax Rate

9. Tax Computation Tax = Tax Base X Tax Rate the value subject to taxation

10. Tax Rates for Income Tax • Marginal Tax Rate is the rate of tax on the next dollar of taxable income • Average Tax Rate is the rate equal to the total tax divided by the tax base • Effective Tax Rate is the rate equal to the total tax divided by economic income

11. Tax Structures Proportional average tax rate remains the same as tax base increases tax rate average rate tax base

12. Tax Structures Regressive average tax rate decreases as tax base increases tax rate average rate tax base

13. Tax Structures Progressive average tax rate increases as tax base increases tax rate average rate tax base

14. Major Types of U.S. Taxes Employment Corporate Income Individual Income Total Taxes Property Sales All Others

15. Types of U.S. Taxes • Income Tax • Taxes are paid by individuals, corporations, estates, and trusts • Tax base is total income less allowed reductions

16. Types of U.S. Taxes • Employment Tax • Taxes are paid by employees, employers, and self-employed taxpayer • Tax base is wages and salaries earned • Two major types • Social Security • Unemployment

17. Types of U.S. Taxes • Sales Tax • Taxes are paid by purchasers of goods and services • Tax base is the selling price of a product or a service

18. Types of U.S. Taxes • Property Tax • Taxes are paid by owners of property • Tax base is the assessed value of real or personal property (ad valorem)

19. Types of U.S. Taxes • Excise Tax • Taxes are paid by purchasers • Tax base is the quantity purchased and not the value of the purchase

20. Types of U.S. Taxes • Wealth Transfer Tax • Taxes are paid by entity transferring property • Tax base is the value of the property transferred • Transfers to spouses and charities are excluded • Lifetime Unified Credit excludes up to $2M in 2008 • Donors may exclude annual gifts of $12,000 per donee

21. Sources of Federal Income Tax Law • Legislative • Law (Internal Revenue Code) • Administrative • Treasury Regulations • IRS Pronouncements • Judicial • Supreme Court • Other courts

22. Tax Formula Broadly defined income Includes all forms of income (Chapter 3)

23. Tax Formula Broadly defined income minus: Exclusions Income specifically excluded from income by legislative grace (Chapter 4)

24. Tax Formula Broadly defined income minus: Exclusions Income to be Reported equals: Gross Income

25. Tax Formula Broadly defined income minus: Exclusions equals: Gross Income minus: Deductions Amounts specifically allowed as subtractions (Chapters 5 - 7)

26. Some Deduction Examples • Expenses (Chapters 5 & 6) • Current period expenditures incurred in order to earn income • Losses (Chapter 7) • Transaction losses result when an asset is disposed of at a price less than its tax cost • Annual losses result when allowed deductions exceed income • Exemptions (Chapter 8) • A minimum amount of income needed for basic living • Personal and dependency ($3,500 each)

27. Deduction Types Gross Income minus:For Deductions • not restricted based on taxpayer’s income • generally trade, business, rent or royalty expenses • minus: From Deductions • restricted based on Adjusted Gross Income • generally personal expenses • Itemized, or • standard amount (changes with filing status)

28. Tax Formula Adjusted Gross Income Gross Income minus:For Deductions equals: Adjusted Gross Income [AGI]

29. Tax FormulaTaxable Income Gross Income minus:For Deductions equals: Adjusted Gross Income [AGI] minus: From Deductions and Exemptions Taxable Income

30. Tax FormulaThe Tax Taxable Income times: Tax Rate equals: Income Tax Liability minus: Prepayments & Credits equals: Tax or (Refund) due

31. Filing Requirements • Return must be filed annually • Calendar-year individuals file and pay on or before the 15th day of April • May receive an extension of time to file but not time to pay

32. Audit and Appeals ProcessStatute of Limitations • Three years from filing date • Extends to six years if income is under-reported by 25% of gross income • No limitation for fraud or if no return is filed

33. Audit and Appeals ProcessSelection for Audit • Only about 2% of returns are audited • Procedures used • Discriminant Function System • Taxpayer Compliance Measurement Program • Document perfection & Information matching

34. Audit and Appeals ProcessTypes of Examinations • Correspondence examinations • Office examinations • Field examinations

35. Audit and Appeals Process • Settlement Procedure • Report of outcome of audit • Waiver of assessment (Form 870) • 30-day letter • Appeals • Meeting with IRS Appeals Division • 90-day letter

36. Tax Planning Goal is to maximize after-tax wealth

37. Tax PlanningTiming • Time Value of money • Defer income • Accelerate deductions • Marginal tax rate • Recognize income in year of lower marginal rate • Recognize deductions in year of higher marginal rate • Shift income to taxpayer with lower marginal rate

38. Tax PlanningTax Avoidance Vs. Tax Evasion • Tax Avoidance - Taxpayers have no obligation to pay more tax than the law requires • Tax Evasion - Taxpayers may not use fraudulent or deceptive behavior to hide tax liability

39. Ethics • Preparers are subject to penalties for negligence and fraud • Ethical Standards • IRS Circular 230 • AICPA’s Code of Professional Conduct • AICPA’s Statements on Standards for Tax Services