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Chapter 1

Chapter 1. An Introduction to Taxation and Understanding the Federal Tax Law. 1. The Big Picture (slide 1 of 5). Travis and Betty Carter are married and have 2 children April (age 17), and Martin (age 18) Travis is a mining engineer; Betty is a registered nurse

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Chapter 1

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  1. Chapter 1 An Introduction to Taxation and Understanding the Federal Tax Law 1

  2. The Big Picture (slide 1 of 5) Travis and Betty Carter are married and have 2 children April (age 17), and Martin (age 18) Travis is a mining engineer; Betty is a registered nurse The Carters live only a few blocks from Ernest and Mary Walker, Betty Carter’s parents The Walkers are retired and live on interest, dividends, and Social Security benefits.

  3. The Big Picture (slide 2 of 5) Various developments occurred during the year with possible tax ramifications The ad valorem property taxes on the Carters’ residence are increased, while those on the Walkers’ residence are lowered When Travis registers an automobile purchased last year in another state, he is forced to pay a sales tax to his home state

  4. The Big Picture (slide 5 of 5) Various developments occurred during the year with possible tax ramifications (cont) The Walkers are audited by the IRS Unlike the Carters, they did not have to deal with an agent but settled the matter by mail Explain these developments and resolve the issues raised. Read the chapter and formulate your response.

  5. History of Taxation (slide 1 of 2) Prior to 1900s income tax financed wars 1861: First Federal individual income tax enacted Repealed after Civil War 1894: New Federal individual income tax enacted Tax found to be unconstitutional C1-7

  6. History of Taxation (slide 2 of 2) Other important events 1909: First Federal corporate income tax enacted 1913: 16th Amendment ratified Sanctioned both Federal individual and corporate income taxes C1-8

  7. Federal Budget Receipts—2011 Individual income taxes 44% Corporation income taxes 12 Social insurance taxes and contributions 36 Excise taxes 3 Other 5 Total 100% FIGURE 1.1 C1-9

  8. Criteria for Evaluating a Tax Structure (slide 1 of 2) Adam Smith identified the following canons of taxation which are still considered when evaluating tax structures: Equality Convenience Certainty Economy C1-10

  9. Criteria for Evaluating a Tax Structure (slide 2 of 2) In addition, the AICPA suggests that the tax system should be: Simple Neutral in terms of its effect on business Clear and readily understandable Structured to minimize noncompliance Should enable the IRS to predict the amount and timing of revenue, and Should not reduce economic growth and efficiency C1-11

  10. Tax Structure (slide 1 of 2) Tax base: amount to which the tax rate is applied e.g., For the Federal income tax, the tax base is taxable income Tax rates: applied to the tax base to determine the tax liability May be proportional or progressive Incidence of tax: degree to which the tax burden is shared by taxpayers C1-12

  11. Tax Structure (slide 2 of 2) Examples: Income $10 $20 $30 Proportional $3 (30%) $6 (30%) $ 9 (30%) Tax Progressive $3 (30%) $7 (35%) $12 (40%) Tax C1-13

  12. Major Types of Taxes Property Taxes Transaction Taxes Death Taxes Gift Taxes Income Taxes Employment Taxes Other U.S. Taxes C1-14

  13. Property (ad valorem) Taxes Based on the value of the asset Essentially, a tax on wealth, or capital Generally imposed on realty or personalty Exclusive jurisdiction of states and their local political subdivisions Deductible for Federal income tax purposes C1-15

  14. The Big Picture – Example 4Ad Valorem Property Taxes Return to the facts of The Big Picture on p. 1-2. Why did the Walkers’ taxes decrease while those of the Carters increased? A likely explanation is that one (or both) of the Walkers achieved senior citizen status. In the case of the Carters, the assessed value of their property probably increased. Perhaps they made significant home improvements (e.g., kitchen/bathroom renovation, addition of a sundeck).

  15. Transaction Taxes Excise taxes General sales taxes Severance taxes C1-17

  16. Excise Taxes Imposed at the Federal, state, and local levels Restricted to specific items Examples: gasoline, tobacco, liquor Declined in relative importance until recently Example-two types of excise taxes at the local level have recently become increasingly popular Hotel occupancy tax Rental car surcharge Tax is levied on visitors who cannot vote and often used to fund special projects C1-18

  17. General Sales Taxes Currently jurisdiction of states and localities States that impose sales taxes also charge a use tax on items purchased in other states but used in their jurisdiction States without sales or use taxes are Alaska, Delaware, Montana, New Hampshire, and Oregon C1-19

  18. The Big Picture – Example 5Use Tax Return to The Big Picture on p. 1-2 The payment Travis made when he registered the car is probably a use tax When the car was purchased in another state, likely no (or a lesser) sales tax was levied The current payment makes up for the amount of sales tax he would have paid had the car been purchased in his home state

  19. Severance Taxes Tax on natural resources extracted Important revenue source for states rich in natural resources C1-21

  20. Death Taxes (slide 1 of 2) Tax on the right to transfer property or to receive property upon the death of the owner If imposed on right to pass property at death Classified as an estate tax If imposed on right to receive property from a decedent Classified as an inheritance tax C1-22

  21. Death Taxes (slide 2 of 2) The value of the property transferred provides the base for determining the amount of the death tax The Federal government imposes only an estate tax Many state governments levy inheritance taxes, estate taxes, or both C1-23

  22. Federal Estate Tax(slide 1 of 2) Federal estate tax is on the right to pass property to heirs Gross estate includes FMV of property decedent owned at time of death Also includes property interests, such as life insurance proceeds paid to the estate or to a beneficiary other than the estate if the deceased-insured had any ownership rights in the policy C1-24

  23. Federal Estate Tax(slide 2 of 2) Property included in the gross estate is valued on either: Date of death, or If elected, the alternate valuation date Generally 6 months after date of death Certain deductions and credits allowed in arriving at the taxable estate Examples - marital deduction, funeral and admin. expenses, certain taxes, debts of decedent C1-25

  24. Unified Transfer Tax Credit Unified credit reduces or eliminates the estate tax liability for modest estates For 2010, credit is $1,455,800 Offsets tax on $3,500,000 of the tax base For 2011 and 2012, $5,000,000 per spouse tax base is exempt C1-26

  25. Phaseout of Estate Tax The estate tax has been criticized for the hardship it imposes on small businesses and family farms Tax Relief Reconciliation Act of 2001 included the phase out of the estate tax Phase out was accomplished by scheduled increases in the unified transfer credit over a 10 year period Estate tax was due to be eliminated in 2010 A “sunset provision” was scheduled to reinstate the estate tax as of January 1, 2011 Recent legislation made significant changes to the estate tax C1-27

  26. State Death Taxes State death taxes may be estate tax, inheritance tax, or both Inheritance tax is on the right to receive property from a decedent Tax is generally based on relationship of heir to decedent The more closely related, the lower the tax C1-28

  27. Federal Gift Tax (slide 1 of 3) Tax on the right to transfer assets during a person’s lifetime Applies only to transfers that are not supported by full and adequate consideration Taxable gift = FMV of gift less annual exclusion less marital deduction (if applicable) Federal gift tax provides an annual exclusion of $13,000 per donee (in 2011) Amount is adjusted for inflation C1-29

  28. Federal Gift Tax (slide 2 of 3) Married persons can make a special election to split gifts Allows 1/2 of a gift made by a donor-spouse to be treated as having been made by a nondonor-spouse (gift splitting) Effectively increases the number of annual exclusions available and allows the use of the nondonor-spouse’s unified transfer tax credit C1-30

  29. Federal Gift Tax (slide 3 of 3) The unified transfer tax credit is available for gifts (as well as the estate tax) Despite the proposed repeal of the estate tax, the gift tax has been retained with the unified transfer tax credit frozen at $345,800, covering $1,000,000 of taxable gifts for 2010 Recent legislation has significantly changed the gift tax essentially reunifying the estate and gift taxes for 2011 and 2012 C1-31

  30. Gift and Estate Unified Tax Schedule Gift and estate taxes are unified under a single tax rate schedule Since tax rates are progressive, prior years’ transfers must be considered when calculating the current year’s gift or estate tax C1-32

  31. The Big Picture – Example 11Gift Tax Return to The Big Picture on p. 1-2 The value of the RV is not stated, but probably exceeds the annual exclusion allowed—$52,000 for two donees (the Walkers) from two donors (the Carters). Thus, a taxable gift results, and a Form 709 (Gift Tax Return) must be filed. Whether any gift tax is due depends on Past taxable gifts the Carters have made, and Amount their unified transfer tax credit still available

  32. Income Taxes Imposed at the Federal, most state, and some local levels of government Income taxes generally are imposed on individuals, corporations, and certain fiduciaries (estates and trusts) Federal income tax base is taxable income (income less allowable exclusions and deductions) Most jurisdictions attempt to assure tax collection by requiring pay-as-you-go procedures, including Withholding requirements for employees, and Estimated tax prepayments for all taxpayers C1-34

  33. Formula for Federal Income Tax on Individuals Figure 1.2 C1-35

  34. Corporate Income Tax Corporate Taxable Income = Income – Deductions Does not require the computation of adjusted gross income Does not provide for the standard deduction or personal and dependency exemptions All allowable deductions are business expenses C1-36

  35. State Income Tax (slide 1 of 3) All but the following states impose an income tax on individuals: Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming C1-37

  36. State Income Tax (slide 2 of 3) Some characteristics of state income taxes include: With few exceptions, all states require some form of withholding procedures Most states use as the tax base the income determination made for Federal income tax purposes Some states apply a flat rate to Federal AGI Some states apply a rate to the Federal income tax liability Referred to as the “piggyback” approach to state income taxation C1-38

  37. State Income Tax (slide 3 of 3) Some states ‘‘decouple’’ from select tax legislation enacted by Congress State may not be able to afford the loss of revenue resulting from such legislation Because of tie-ins to the Federal return, states may be notified of changes made by the IRS upon audit of a Federal return In recent years, the exchange of information between the IRS and state taxing authorities has increased C1-39

  38. The Big Picture – Example 12State Income Tax-Double Taxation Return to The Big Picture on p. 1-2 Because the income earned by Travis on his Chicago trip is subject to tax in his home state, he probably will be able to claim an offsetting credit. Whether this negates the double taxation of the same income depends on the amount of credit allowed.

  39. Employment Taxes (slide 1 of 3) FICA taxes Paid by both an employee and employer The Social Security rate is 6.2% in 2010 and 4.2% in 2011 on a maximum of $106,800 of wages The Medicare rate is 1.45% on all wages for both years A spouse employed by another spouse is subject to FICA Children under the age of 18 who are employed in parent’s unincorporated trade or business are exempt from FICA C1-41

  40. Employment Taxes (slide 2 of 3) FICA taxes Sole proprietors and independent contractors may also be subject to Social Security taxes Known as the self-employment tax Rates are twice that applicable to an employee 12.4% for Social Security and 2.9% for Medicare in 2010 10.4% for Social Security and 2.9% for Medicare in 2011 The tax is imposed on net self-employment income up to a base amount of $106,800 for 2010 and 2011 C1-42

  41. Employment Taxes (slide 3 of 3) FUTA (unemployment) taxes Provides funds for state unemployment benefits In 2011, rate is 6.2% on first $7,000 of wages for each employee Administered jointly by states & Fed govt. Credit is allowed (up to 5.4%) for FUTA paid to the state Tax is paid by employer C1-43

  42. The Big Picture – Example 13Social Security Tax Return to The Big Picture on p. 1-2 Presuming April and Martin perform meaningful services for Travis, they are legitimate employees. April is not subject to Social Security tax because she is < age 18. However, Martin is age 18 and needs to be covered. Furthermore, Betty Carter is now working and will also be subject to Social Security tax. Travis, as an independent contractor, is subject to self-employment tax.

  43. Other Taxes Federal customs duties Tariffs on certain imported goods Franchise taxes Levied on the right to do business in the state Occupational taxes Applicable to various trades or businesses e.g., liquor store license, taxicab permit, fee to practice a profession C1-45

  44. The Big Picture – Example 14Occupational Fees Return to The Big Picture on p. 1-2 Although the facts do not mention the matter, both Travis and Betty will almost certainly pay occupational fees—Travis for engineering and Betty for nursing.

  45. Proposed Taxes Flat tax Would replace the current graduated income tax with a single rate Value added tax Taxes the increment in value as goods move through production & manufacturing stages to the market Paid by the producer and reflected in the sales price of goods National sales tax Levied on the final sale of goods and services Collected from consumer, not from businesses as with VAT C1-47

  46. Tax Administration (slide 1 of 4) Internal Revenue Service (IRS) Responsible for enforcing the Federal tax laws Audits small percentage of returns filed using mathematical formulas and statistical sampling To update selection criteria, the IRS selects a cross section of returns, which are subject to various degrees of inspection Results highlight areas of taxpayer noncompliance and enable the IRS to use its auditors more productively C1-48

  47. Tax Administration (slide 2 of 4) Types of audits: Correspondence audit Office audit Usually restricted in scope and conducted in facilities of IRS Field audit Involves examination of numerous items reported on the return and is conducted on premises of taxpayer or taxpayer's representative C1-49

  48. Tax Administration (slide 3 of 4) After the audit, a Revenue Agent’s Report (RAR) is issued summarizing the findings which can result in a: Refund (tax was overpaid) Deficiency (tax was underpaid), or No change (tax was correct) finding C1-50

  49. Tax Administration (slide 4 of 4) If an audit results in an assessment of additional tax Taxpayer may attempt to negotiate a settlement An appeal is available through the Appeals Division of the IRS Appeals Division is authorized to settle all disputes based on the hazard of litigation (i.e., probability of favorable resolution, if litigated) If a satisfactory settlement is not reached on administrative appeal, the taxpayer can litigate in: Tax Court Federal District Court, or Court of Federal Claims Litigation is recommended only as a last resort because of Legal costs involved Uncertainty of the final outcome C1-51

  50. The Big Picture - Example 19IRS Audit Return to The Big Picture on p. 1-2 The audit of the Walkers by the IRS obviously was a correspondence type. The reason for the audit was probably a minor oversight, such as the omission of some interest or dividend income. The audit of the Carters, however, was more serious—probably a field or office type. Since the Federal audit followed a state audit that was productive (i.e., led to the assessment of a deficiency), there may have been an exchange of information between the two taxing authorities.

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