Fed Tax Chapter 1
components of a tax practice
tax compliance and procedure tax research tax planning and consulting financial planning
1-14 simplicity
taxpayers should be able to understand and comply with any tax system within reasonable boundaries. sales tax is simple. federal income tax system is not. simplicity and fairness are impossible to achieve together.
1-29 penalties
-penalty of 5% per month subject to a maximum amount of 25% for failure to file a tax return -penalty of 0.5% per month up to 25% for failure to pay the tax that is due -an accuracy related penalty of 20% of the underpayment for items such as negligence or disregard of rules or regulations, any substantial understatement of income tax, or any substantial misstatement of valuation -75% penalty for fraud -penalty based on the current interest rate for underpayment of estimated taxes -new penalties on tax return preparers have been enacted by Congress for position on a tax return where there is a realistic possibility that the position would not be upheld in a court of law. the penalty is not assessed if the position is disclosed in the return
1-13 certainty
1. ensures a stable source of government operating revenues 2. provides taxpayers with some degree of certainty concerning the amount of their annual tax liability. a tax that is simple to understand and administer provides certainty for taxpayers. to try and provide certainty for taxpayers, the IRS issues advance rulings to taxpayers to provide assurance
wealth transfer taxes
US citizens are subject to taxation on certain transfer of property to another person. the tax law provides a unified transfer tax system that imposes a single tax on transfers of property taking place during an individual's lifetime (gifts) and at death (estates). formerly, the gift and estate tax laws were separate and distinct. the federal estate tax was initially enacted in 1916. the original gift tax law dates back to 1932. the gift tax was originally imposed to prevent widespread avoidance of the estate tax (taxpayers could make tax-free gifts of property before their death). both the gift and estate taxes are wealth transfer taxes levied on the transfer of property and are based on the fair market value of the transferred property on the date of the transfer.
marginal, average, & effective tax rates for taxpayers
a taxpayer's marginal tax rate is the tax rate applied to an incremental amount of taxable income that is added to the tax base. the marginal tax rate concept is useful for planning because it measures the tax effect of a proposed transaction. while the marginal tax rate measures the tax rate applicable to the next $1 of income or deduction for a taxpayer, there are two other tax rates that are used primarily by tax policy makers: average tax rate and effective tax rate. the average tax rate is computed by dividing the total tax liability by the amount of taxable income. this represents the average rate of tax for each dollar of taxable income.
special objectives
attempts to encourage or discourage certain socially desirable or understandable activities. -special tax-favored pension and profit-sharing plans have been created for employees and self-employed individuals to supplement the social security retirement system -charitable contributions are deductible to encourage individuals to contribute to charitable organizations -the claiming of a deduction for illegal bribes, fines, and penalties has been prhibited to discourage activities that are contrary to public policy.
1-15 encouragement of certain activities and industries
attempts to stimulate and encourage certain activities, specialized industries, and small businesses. an example is permitting write-off expenses and a special tax credit for increasing research and experimental costs. special incentives are also provided to the oil and gas industry through % depletion allowances and an election to deduct intangible drilling costs. some tax provisions for small businesses are reduced corporate tax rates of 15% on the first $50,000 of taxable income and 25% for the next $25,000 of taxable income. favorable ordinary loss deductions are granted to individual investors who sell their small business corporation stock at a loss, provided that certain requirements are met. in addition, non-corporate investors may exclude up to 50% of the gain realized from the disposition of qualified small business stock if the stock is held for more than 5 years.
why is the marginal tax rate much more important in the tax planning process than the average tax rate?
because tax planning is done at the margin. it'll have a higher % thus, decreasing their tax liability amount
1-28 statute of limitations
both the IRS and the taxpayers can make corrections to a return after is has been originally filed. this prevents either the taxpayer or the IRS from changing a filed tax return after the time period has expired. it is 3 years from the later date the tax return was actually filed or its due date. however, a 6 year statute of limitations applies if the taxpayer omits items of gross income that in total exceed 25% of the gross income reported on the return. but it remains ope if a fraudulent return is filed or if no return is filed
1-5 the structure of corporate tax rates
corporations are separate entities and are subject to income tax. the federal corporate income tax reflects a stair-step pattern of progression that tends to benefit small corporations
regressive tax rate
decreases with an increase in the tax base (income). regressive taxes, while not consistent with the fairness of the income tax, are found in the US. the social security (fica) tax is regressive because a fixed rate of tax of 6.20% for OASDI for both the employer and employee is levied up to a ceiling amount of $113,700 for 2013. the sales tax, which is levied by many states, is also regressive when measured against the income base.
gift tax rules and concepts
gift tax is cumulative over the taxpayer's lifetime. -gifts between spouses are exempted from the gift tax due to the operation of an unlimited martial deduction -the primary liability for payment of the gift tax is imposed on the donor. the donee is contingently liable for payment of the gift tax in the event of nonpayment by the donor. -a donor is permitted a $14,000 annual exclusion for gifts of a present interest to donee -charitable contributions are effectively exempted for the gift tax because an unlimited deduction is allowed -the tax basis of the property to the donee is generally the donor's cost and the property's fair market value on the date of the gift is the property is sold by the donee at a loss -a unified tax credit equivalent to a $5,000,000 deduction (adjusted for inflation, the amount is $5,250,000) is available to offset any gift tax on taxable gifts that exceed the $14,000 annual exclusion
1-3 revenue acts from 1913 to the present
had 16 pages, it imposed a flat 1% tax (with no exemptions) on a corporation's net income. the rate varied from 1% to 7% for individuals, depending on the individual's income level. however very few individuals paid federal income taxes because a $3,000 personal exemption (4,000 for married individuals) was permitted as an offset to taxable income. these amounts were greater than the incomes of most individuals in 1913. various amendments to the original law were passed between 1913 and 1939 as separate revenue acts. for example, a deduction for dependency exemptions was provided in 1917. In 1939, the separate revenue acts were codified into the internal revenue code of 1939. a similar codification was accomplished in 1954. the 1954 codification, which was known as the internal revenue code of 1954, included the elimination of many "deadwood" provisions, a rearrangement and clarification of numerous code sections, and the addition of major tax law changes. whenever changes to the internal revenue code are made, the old language is deleted and the new language added. thus, the statutes are organized as a single document, and a tax advisor does not have to read through the applicable parts of all previous tax bills to find the most current law. in 1986, major changes were made to the tax law, and the basic tax law was redesigned as the internal revenue code of 1986. the federal income tax became a mass tax in the early 1940's. this change was deemed necessary to finance the revenue needs of the federal government during WW2. in 1939, less than 6% of the US population was subject to the federal income tax; by 1945, 74% of the population was taxed.
interest
interest accrues on both assessments of additional tax due and on refunds that the taxpayer receives from the government. no interest is paid on a tax refund if the amount os refunded by the IRS within 45 days of the day prescribed for filing the return determined without regard to extensions. if a return is filed after the filing date, no interest is paid if the refund is made within 45 days of the date the return was filed.
federal gift tax
is an excise tax that is impose on the donor for transfers of property that are considered to be a taxable gift. a gift, generally speaking, is a transfer made gratuitously and with donative intent. however, the gift tax law has expanded the definition to include transfers that are not supported by full and adequate consideration. $14,000 annual exclusion is allowed per donee. also, an unlimited marital deduction is allowed for transfers between spouses. the formula is: fair market value of all gifts made in the current year - annual donee exclusions (14,000 per donee), marital deductions, charitable contribution deduction + taxable gifts for all prior years = cumulative taxable gifts (tax base) X unified transfer tax rates = tentative tax on gift tax base - unified transfer taxes paid in prior years - unified credit = unified transfer tax (gift tax) due in the current year
1-6 effective tax rate
is the total tax liability divided by total economic income. total economic income includes all types of economic income that a taxpayer has for the year. EI is much broader than taxable income and includes most types of excludible income, such as tax-exempt bond interest, and generally permits business deductions but not personal type deductions. it should be pointed out that economic income is not statutorily defined and experts may disagree on a precise calculation. the basic purpose of calculating the effective tax rate is to provide a broad measure of taxpayers' ability to pay taxes. it is mainly used by tax policy makers to determine the fairness of the income tax system.
objectives of the federal income tax law
is to raise revenues for government operations
convenience
it should be easily assessed, collected, and administered. taxpayers should not be overly burdened with the maintenance of records and compliance considerations. one of the reasons that the sales tax is such a popular form of tax for state and local governments is that it is convenient for taxpayers to pay and for the government to collect. the consumer need not complete a tax return or keep detailed records.
1-12 criteria for a tax structure: equity
lists types of taxes and tax structure. it needs to be equitable or fair to taxpayers. however, equity or fairness is elusive because of the subjectivity of the concept. what one person might call fair, another might not. fairness is relative in nature and is extremely difficult to measure. for example, the deductibility of mortgage interest on a taxpayer's home certainly seems to be a fair provision for taxpayers. however, for taxpayers who do not own a home but live in a rental apartment, the deductibility of mortgage interest may not be considered as fair because the renter cannot deduct any portion of the rent paid. two common aspect of equity are commonly discussed in the tax policy literature, horizontal and vertical equity. horizontal refers to the notion that similarly situated taxpayers should be treated equally. vertical implies that taxpayers who are not similarly situated should be treated differently. vertical provides that the incidence of taxation should be borne by those who have the ability to pay the tax, based on income or wealth. the progressive rate structure is founded on the vertical equity premise.
1-7 state and local income and franchise taxes
many states and local jurisdictions impose income taxes on individuals and businesses. these state and local taxes have gradually increased over the years and currently represent a significant source of revenue for state and local governments but also represent a significant tax burden on taxpayers. only 7 states do not impose an individual income tax. in most instances, state income tax rates are mildly progressive and are based on an individual's federal adjusted gross income, with minor adjustments. some states also allow a deduction for federal income taxes in the computation of taxable income for state income tax purposes. states imposing a state income tax generally require the withholding of state income taxes and have established mandatory estimated tax payment procedures. the due date for filing state income tax returns generally coincides with the due date for the federal income tax returns(15th day of the 4th month following the close of the tax year for individuals). most states impose a corporate income tax, although in some instances the tax is called a franchise tax. franchise taxes usually are based on a weighted-average formula consisting of net worth, income, an sales
1-16
objectives of the tax law
economy
should require only minimal compliance and administrative costs. one indicator of total compliance costs for taxpayers is the demand for tax professionals. the IRS collection costs are less than 0.5% of revenues. complying with the tax laws is enormously expensive for both businesses and individuals in the US.
major characteristics of the federal income tax
since its inception to today is the manner in which the tax law is changed or modified. the federal income tax is changed on an incremental basis rather than a complete revision basis. under so-called incrementalism, when a change in the tax law is deemed necessary by congress, the entire law is not changed, but specific provisions of the tax law are added, changed, or deleted on an incremental basis. thus, the federal income tax has been referred to as a quilt work of tax laws, referring to the patchwork nature of the law. without question, one of the principal reasons for the complexity of the federal income tax today is the incremental nature of tax legislation
proportional tax rate
sometimes called a flat tax, is one where the rate of tax is the same for all taxpayers, regardless of the level of their tax base. the type of tax rate is generally used for real estate taxes, state and local sales taxes, personal property taxes, customs duties, and excise taxes. a flat tax has been the subject of considerable discussion over the past 20 years and promises to be a controversial topic as the debate on federal income tax reform continues into the future. it is proportional if the tax rate applies to both taxpayers without regard to their income level. and it results in lower taxes for higher income taxpayers.
1-2 history of the federal income tax
the federal income tax is the dominant form of taxation in the US. In addition, most states and some cities and counties also impose an income tax. Both corporations and individuals are subject to such taxes. prior to the 1913 (the date of enactment of the modern-day federal income tax), the federal government relied predominantly on customs duties and excise taxes to finance its operations. The first federal income tax on individuals was enacted in 1861 to finance the Civil War but was repealed after the war. The federal income tax was reinstated in 1894 however, that tax was challenged in the courts because the US constitution required that an income tax be apportioned among the states in proportion to their populations. This type of tax system, which would be both impractical and difficult to administer, would mean that different tax rates would apply to individual taxpayers depending on their states of residence. In 1895, the supreme court ruled that the tax was in violation of the US constitution. Therefore, it was necessary to amend the US constitution to permit the passage of a federal income tax law. This was accomplished by the 16th amendment, which was ratified in 1913, and it consists of one sentence.
determination of taxable income and tax due
the federal income taxes imposed on all taxpayers are based on the determination of taxable income. it is calculated by: total income - exclusions= gross income- deductions and exemptions= taxable income X applicable tax rate = income tax before credits - tax credits = total tax liability - prepayments = balance due or refund
revenue sources
the largest source of federal revenues is individual income taxes. other ones include, social security (FICA) taxes and corporate income taxes
economic objectives
used as a fiscal policy tool to stimulate private investment, reduce employment, and mitigate the effects of inflation on the economy. many are adjusted for inflation by using the consumer price index, including tax brackets, personal and dependency exemptions, and standard deduction amounts. these adjustments will provide relief for individual taxpayers who would otherwise be subject to increased taxes due to the effects of inflation
1-4 the structure of individual income tax rates
virtually all tax structures are comprised of two basic parts: the tax base and the tax rate. the tax base is the amount to which the tax rate is applied to determine the tax due. for example, an individual's tax base for the federal income tax is taxable income, as defined and determined by the income tax law. similarly, the tax base for the property tax is generally the fair market value of property subject to the tax. the tax rate is merely the percentage rate applied to the tax base. tax rates may be progressive, proportional, or regressive. a progressive rate structure is one where the rate of tax increases as the tax base increases. the most notable tax that incorporates a progressive rate structure is the federal income tax. thus, as a taxpayer's taxable income increases, a progressively higher rate of tax is applied. income increases, tax rates increase.
