Chapter 1 Federal Income Taxation - An Overview Federal Income Taxation - An Overview ©2008...

Chapter 1Chapter 1

Federal Income Taxation -An Overview

Federal Income Taxation -An Overview

©2008 South-Western©2008 South-Western©2008 South-Western©2008 South-Western

Kevin MurphyKevin MurphyMark HigginsMark Higgins

Kevin MurphyKevin MurphyMark HigginsMark Higgins

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What is the Definition of a Tax?

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

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Standards of a Good Tax System

Adam Smith’s Four Criteria

Standards of a Good Tax System

Adam 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

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Standards of a Good Tax System

Adam Smith’s Four Criteria

Standards of a Good Tax System

Adam Smith’s Four Criteria

EqualityCertainty

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

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Filing RequirementsFiling Requirements

Return must be filed annually Calendar-year individuals file and pay

on or before the 15th day of AprilMay receive an extension of time to file but

not time to pay

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Standards of a Good Tax System

Adam Smith’s Four Criteria

Standards of a Good Tax System

Adam Smith’s Four Criteria

EqualityCertaintyConvenience

Tax should be levied when the taxpayer has funds available to pay

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Standards of a Good Tax System

Adam Smith’s Four Criteria

Standards of a Good Tax System

Adam Smith’s Four Criteria

EqualityCertaintyConvenienceEconomy

The costs of complying with the tax system should be minimal

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Tax ComputationTax Computation

Tax = Tax Base X Tax Rate

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Tax ComputationTax Computation

Tax = Tax Base X Tax Rate

the value subject to taxation

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Tax Rates for Income TaxTax 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

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Tax StructuresTax Structures

Proportional

average tax rate remains the sameas tax base increases

average rate

tax base

tax

rate

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Tax StructuresTax Structures

Regressive

average tax rate decreases astax base increases

average rate

tax base

tax

rate

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Tax StructuresTax Structures

Progressive

average tax rate increases astax base increases average rate

tax base

tax

rate

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Major Types of U.S. TaxesMajor Types of U.S. Taxes

Individual Income

Sales

Total Taxes

Property

Employment

All Others

Corporate Income

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Types of U.S. TaxesTypes of U.S. Taxes

Income TaxTaxes are paid by individuals,

corporations, estates, and trustsTax base is total income less allowed

reductions

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Types of U.S. TaxesTypes of U.S. Taxes

Employment TaxTaxes are paid by employees, employers,

and self-employed taxpayerTax base is wages and salaries earnedTwo major types

Social Security Unemployment

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Types of U.S. TaxesTypes of U.S. Taxes

Sales TaxTaxes are paid by purchasers of goods

and servicesTax base is the selling price of a product or

a service

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Types of U.S. TaxesTypes of U.S. Taxes

Property TaxTaxes are paid by owners of propertyTax base is the assessed value of real or

personal property (ad valorem)

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Types of U.S. TaxesTypes of U.S. Taxes

Excise TaxTaxes are paid by purchasersTax base is the quantity purchased and not

the value of the purchase

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Types of U.S. TaxesTypes of U.S. Taxes

Wealth Transfer Tax Taxes are paid by entity transferring

propertyTax base is the value of the property

transferred Transfers to spouses and charities are

excluded Lifetime Unified Credit excludes up to $2M in

2007 Donors may exclude annual gifts of $12,000

per donee

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Tax FormulaTax Formula

Broadly defined income

Includes all forms ofincome(Chapter 3)

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Tax FormulaTax Formula

Broadly defined income

minus: Exclusions Income specificallyexcluded from income by legislative grace(Chapter 4)

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Tax FormulaTax Formula

Broadly defined incomeminus: Exclusions

Income to beReported

equals: Gross Income

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Tax FormulaTax Formula

Broadly defined incomeminus: Exclusionsequals: Gross Income

Amountsspecificallyallowed as subtractions (Chapters 5 - 7)

minus: Deductions

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Some Deduction ExamplesSome 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 ($3,400 each)

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Deduction TypesDeduction Types

Gross Income

minus: For Deductions not restricted based on taxpayer’s income generally trade, business, rent or royalty expenses

minus: From Deductionsrestricted based on Adjusted Gross Incomegenerally personal expenses

–Itemized, or–standard amount (changes with filing status)

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Tax FormulaAdjusted Gross Income

Tax FormulaAdjusted Gross Income

Gross Income

minus: For Deductions

equals: Adjusted Gross Income [AGI]

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Tax FormulaTaxable Income

Tax FormulaTaxable Income

Gross Income

minus: For Deductions

equals: Adjusted Gross Income [AGI]

minus: From Deductions and Exemptions

Taxable Income

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Tax FormulaThe Tax

Tax FormulaThe Tax

Taxable Incometimes: Tax Rateequals: Income Tax Liabilityminus: Prepayments & Creditsequals: Tax or (Refund) due

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Audit and Appeals ProcessStatute of Limitations

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

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Audit and Appeals ProcessSelection for Audit

Audit and Appeals ProcessSelection for Audit

Only about 2% of returns are audited

Procedures usedDiscriminant Function SystemTaxpayer Compliance Measurement

Program Document perfection & Information

matching

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Tax PlanningTax Planning

Goal is to maximize after-tax wealth

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Tax PlanningTiming

Tax PlanningTiming

Time Value of moneyDefer incomeAccelerate deductions

Marginal tax rateRecognize income in year of lower marginal rateRecognize deductions in year of higher marginal

rateShift income to taxpayer with lower marginal rate

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Tax PlanningTax Avoidance Vs. Tax

Evasion

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

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Ethics Ethics

Preparers are subject to penalties for negligence and fraud

Ethical StandardsIRS Circular 230AICPA’s Code of Professional ConductAICPA’s Statements on Standards for Tax

Services