Ch1 Book

Example 16 Information Leading to an IRS Audit

After 15 years of service, Rita is discharged by her employer, Dr. Smith. Shortly thereafter, the IRS receives an anonymous letter stating that Dr. Smith keeps two separate sets of books and that the one used for tax reporting substantially understates his cash receipts.

Example 25

Al and Fran are husband and wife, and their only income is the $80,000 annual salary Al receives. If they live in New Jersey (a common law state), the $80,000 salary belongs to Al. If, however, they live in Arizona (a community property state), the $80,000 is divided equally, in terms of ownership, between Al and Fran.

Income Taxes: State Income Taxes

All but the following states impose an income tax on individuals: Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming. New Hampshire and Tennessee impose an individual income tax only on interest and dividends. Some of the characteristics of state income taxes are summarized as follows: • 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. • A minority of states go even further and impose a flat rate on AGI as computed for Federal income tax purposes. Several apply a rate to the Federal income tax liability. This is often referred to as the piggyback approach to state income taxation. Although the term piggyback does not lend itself to a precise definition, in this context, it means making use, for state income tax purposes, of what was done for Federal income tax purposes. • Some states are somewhat eroding the piggyback approach by "decoupling" from selected recent tax reductions passed by Congress. The purpose of the decoupling is to retain state revenue that would otherwise be lost. In other words, the state cannot afford to allow its taxpayers the same deductions for state purposes that are allowed for Federal purposes. • Because of the tie-ins to the Federal return, a state may be notified of any 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. Lately, some states (e.g., California) are playing a major role in revealing tax shelter abuses to the IRS. • Most states allow a deduction for personal and dependency exemptions. Some states substitute a tax credit for a deduction. • A diminishing minority of states allow a deduction for Federal income taxes. • Virtually all state income tax returns provide checkoff boxes for donations to various causes. Many are dedicated to medical research and wildlife programs, but special projects are not uncommon. For example, Oklahoma had one to retire the debt incurred for its new capitol dome, while Wisconsin uses one for maintenance and operating costs of Lambeau Field (home of the Green Bay Packers). These checkoff boxes have been criticized as adding complexity to the returns and misleading taxpayers. • Most states allow their residents some form of tax credit for income taxes paid to other states. • The objective of most states is to tax the income of residents and those who regularly conduct business in the state (e.g., nonresidents who commute to work). These states also purport to tax the income of nonresidents who earn income in the state on an itinerant basis. Usually, however, the only visitors actually taxed are highly paid athletes and entertainers. This so-called jock tax has been much criticized as being discriminatory due to its selective imposition. • The due date for filing generally is the same as for the Federal income tax (the fifteenth day of the fourth month following the close of the tax year). • Some states have occasionally instituted amnesty programs that allow taxpayers to pay back taxes (and interest) on unreported income with no (or reduced) penalty. In many cases, the tax amnesty has generated enough revenue to warrant the authorization of follow-up programs covering future years. Amnesties usually include other taxes as well (e.g., sales, franchise, and severance). One major advantage of amnesty programs is that they uncover taxpayers who were previously unknown to the taxing authority. • Because many consumers do not pay state and local sales taxes on out-of-state purchases, state income tax returns often contain a separate line for the reporting of the use tax that is due. The instructions to the form may provide tables of suggested amounts based on income levels for those who lack records on the purchases not previously taxed. Thus, the income tax return serves as a means of collecting use taxes. Nearly all states have an income tax applicable to corporations. It is difficult to determine those that do not because a state franchise tax sometimes is based in part on the income earned by the corporation.

Early Periods

An income tax was first enacted in 1634 by the English colonists in the Massachusetts Bay Colony, but the Federal government did not adopt this form of taxation until 1861. In fact, both the Federal Union and the Confederate States of America used the income tax to raise funds to finance the Civil War. When the Civil War ended, the need for additional revenue disappeared and the income tax was repealed. Once again the Federal government was able to finance its operations almost exclusively from customs duties (tariffs). It is interesting to note that the courts held that the Civil War income tax was not contrary to the Constitution. When a new Federal income tax on individuals was enacted in 1894, its opponents were prepared and were able to successfully challenge its constitutionality. In Pollock v. Farmers' Loan and Trust Co., the U.S. Supreme Court found that taxes on the income of real and personal property were the legal equivalent of a tax on the property involved and, therefore, required apportionment. A Federal corporate income tax, enacted by Congress in 1909, fared better in the judicial system. The U.S. Supreme Court found this tax to be constitutional because it was treated as an excise tax. In essence, it was a tax on the right to do business in the corporate form. As such, it was likened to a form of the franchise tax. Since the corporate form of doing business had been developed in the late nineteenth century, it was an unfamiliar concept to the framers of the U.S. Constitution. Because a corporation is an entity created under law, jurisdictions possess the right to tax its creation and operation. Using this rationale, many states still impose franchise taxes on corporations. The ratification of the Sixteenth Amendment to the U.S. Constitution in 1913 sanctioned both the Federal individual and corporate income taxes and, as a consequence, neutralized the continuing effect of the Pollock decision.

Example 23

Assume the same facts as in Example 22, except that Ron reinvests only $140,000 of the award in new pasture land. Now Ron has a taxable gain of $10,000. Instead of ending up with only replacement property, Ron has $10,000 in cash.

Economic Considerations: Encouragement of Certain Industries

Because a sound agricultural base is necessary for a well-balanced national economy, farmers are accorded special treatment under the Federal tax system. Among the benefits are the election to expense rather than capitalize certain soil and water conservation expenditures and fertilizers and the election to defer the recognition of gain on the receipt of crop insurance proceeds. To stimulate the manufacturing industry, Congress enacted a domestic production activities deduction. The provision provides a tax benefit in the form of a deduction for profits derived from manufacturing activities conducted in the United States. By restricting the deduction to manufacturing income attributable to wages reportable to the IRS, new U.S. jobs will result and the outsourcing of labor is discouraged. Thus, the tax system is used to encourage both domestic manufacturing and job growth.

Equity Considerations: Coping with Inflation

Because of the progressive nature of the income tax, a wage adjustment to compensate for inflation can increase the income tax bracket of the recipient. Known as bracket creep, its overall impact is an erosion of purchasing power. Congress recognized this problem and began to adjust various income tax components, such as tax brackets, standard deduction amounts, and personal and dependency exemptions, through an indexation procedure. Indexation is based on the rise in the consumer price index over the prior year.

Example 1

Bill has $10,000 of taxable income and pays a tax of $3,000, or 30%. Bob's taxable income is $50,000, and the tax on this amount is $15,000, or 30%. If this constant rate is applied throughout the rate structure, the tax is proportional.

Example 9

Carl sells property worth $50,000 to his daughter for $1,000. Although property worth $50,000 has been transferred, only $49,000 represents a gift, because this is the portion not supported by full and adequate consideration.

Example 21

Cindy underpaid her taxes for 2013 in the amount of $20,000, of which $15,000 is attributable to negligence. Cindy's negligence penalty is $3,000 (20% × $15,000).

Income Taxes: Local Income Taxes

Cities imposing an income tax include, but are not limited to, Baltimore, Cincinnati, Cleveland, Detroit, Kansas City (Missouri), New York, Philadelphia, and St. Louis. The application of a city income tax is not limited to local residents.

Example 17

During a divorce proceeding, it is revealed that Leo, a public official, kept large amounts of cash in a shoe box at home. This information is widely disseminated by the news media and comes to the attention of the IRS. Needless to say, the IRS is interested in knowing whether these funds originated from a taxable source and, if so, whether they were reported on Leo's income tax returns.

Example 2

If Cora, a married individual filing jointly, has taxable income of $10,000, her tax for 2015 is $1,000 for an average tax rate of 10%. If, however, Cora's taxable income is $50,000, her tax will be $6,578 for an average tax rate of 13.2%. The tax is progressive because higher rates are applied to greater amounts of taxable income.

Example 14 The Big Picture

Return to the facts of The Big Picture. 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.

Political Considerations

A large segment of the Federal tax law is made up of statutory provisions. Because these statutes are enacted by Congress, is it any surprise that political considerations influence tax law? For purposes of discussion, the effect of political considerations on the tax law is divided into the following topics: special interest legislation, political expediency situations, and state and local government influences.

Proposed U.S. Taxes

Considerable dissatisfaction with the U.S. Federal income tax has led to several recent proposals that, to say the least, are rather drastic in nature. One proposal, the flat tax, would retain the income tax but with substantial change. Two other proposals, the value added tax and the national sales tax, would replace the Federal income tax with an entirely different system of taxation.

Property Taxes

Correctly referred to as ad valorem taxes because they are based on value, property taxes are a tax on wealth, or capital. In this regard, they have much in common with estate taxes and gift taxes discussed later in the chapter. Although property taxes do not tax income, the income actually derived (or the potential for any income) may be relevant insofar as it affects the value of the property being taxed. Property taxes fall into two categories: those imposed on realty and those imposed on personalty, or assets other than land and buildings. Both have added importance because they usually generate a deduction for Federal income tax purposes.

Tax Practice

If a practitioner is a member of a profession such as law or public accounting, he or she must abide by certain ethical standards. Furthermore, the Internal Revenue Code imposes penalties upon the preparers of Federal tax returns who violate proscribed acts and procedures.

Statute of Limitations: Limitations on Refunds

If a taxpayer believes that an overpayment of Federal income tax was made, a claim for refund should be filed with the IRS. A claim for refund, therefore, is a request to the IRS that it return to the taxpayer excessive income taxes paid. A claim for refund generally must be filed within three years from the date the return was filed or within two years from the date the tax was paid, whichever is later. Income tax returns that are filed early are deemed to have been filed on the date the return was due.

Example 19

For 2015, Mark, a calendar year taxpayer, reported gross income of $400,000 on a timely filed income tax return. If Mark omitted more than $100,000 (25% × $400,000), the six-year statute of limitations would apply to the 2015 tax year.

Tax Practice: Statutory Penalties Imposed on Tax Return Preparers

In addition to ethical constraints, a tax return preparer may be subject to certain statutorily sanctioned penalties, including the following: •Various penalties involving procedural matters. Examples include failing to furnish the taxpayer with a copy of the return, endorsing a taxpayer's refund check, failing to sign the return as a preparer, failing to furnish one's identification number, and failing to keep copies of returns or maintain a client list. •Penalty for understatement of a tax liability based on a position that lacks any realistic possibility of being sustained. If the position is not frivolous, the penalty can be avoided by disclosing it on the return. •Penalty for any willful attempt to understate taxes. This usually results when a preparer disregards or makes no effort to obtain pertinent information from a client. •Penalty for failure to exercise due diligence in determining eligibility for, or the amount of, an earned income tax credit.

Income Taxes

Income taxes are levied by the Federal government, most states, and some local governments. The trend in recent years has been to place greater reliance on this method of taxation. This trend is not consistent with what is happening in other countries, and in this sense, our system of taxation is somewhat different. Income taxes generally are imposed on individuals, corporations, and certain fiduciaries (estates and trusts). Most jurisdictions attempt to ensure the collection of income taxes by requiring pay-as-you-go procedures, including withholding requirements for employees and estimated tax prepayments for all taxpayers.

Exhibit 1.1 Federal Budget Receipts- 2015

Individual income taxes: 46% Corporate income taxes: 13% Social insurance taxes and contributions: 32% Excise taxes: 3% Other taxes: 6%

Criteria Used in the Selection of a Tax Structure

In the eighteenth century, Adam Smith identified the following canons of taxation, which are still considered when evaluating a particular tax structure: • Equality. Each taxpayer enjoys fair or equitable treatment by paying taxes in proportion to his or her income level. Ability to pay a tax is one of the measures of how equitably a tax is distributed among taxpayers. • Convenience. Administrative simplicity has long been valued in formulating tax policy. If a tax is easily assessed and collected and its administrative costs are low, it should be favored. An advantage of the existing withholding system (pay-as-you-go) is its convenience for taxpayers. • Certainty. A tax structure is good if the taxpayer can readily predict when, where, and how a tax will be levied. Individuals and businesses need to know the likely tax consequences of a particular type of transaction. • Economy. A good tax system involves only nominal collection costs by the government and minimal compliance costs on the part of the taxpayer. The American Institute of Certified Public Accountants (AICPA) has issued suggestions for Federal tax policy. Titled Guiding Principles of Good Tax Policy: A Framework for Evaluating Tax Proposals, the monograph sets forth 10 tax principles that are commonly used as indicators of desirable tax policy. The first four principles are adapted from Adam Smith's The Wealth of Nations. The other six are summarized as follows: • The tax system should be simple. • The tax should be neutral in terms of its effect on business decisions. • The tax system should not reduce economic growth and efficiency. • The tax should be clear and readily understood so that taxpayers know about it and know when it applies. • The tax should be structured so as to minimize noncompliance. • The tax system should enable the IRS to predict the amount and timing of revenue production. By these canons, the Federal income tax is a contentious product. Equality is present as long as one accepts ability to pay as an ingredient of this component. Convenience exists due to a heavy reliance on pay-as-you-go procedures. Certainty probably generates the greatest controversy. In one sense, certainty is present because a mass of administrative and judicial guidelines exists to aid in interpreting the tax law. In another sense, however, certainty does not exist because many questions remain unanswered and frequent changes in the tax law by Congress lessen stability. Particularly troublesome in this regard are tax provisions that are given a limited life (e.g., only one year). If not extended by Congress, the provisions expire. All too often, Congress does not give the necessary approval in time, and the extension has to be applied retroactively. Economy is present if only the collection procedure of the IRS is considered. Although the government's cost of collecting Federal taxes amounts to less than one-half of 1 percent of the revenue collected, the complexity of our current tax structure imposes substantial taxpayer compliance costs.

Transaction Taxes: Federal Excise Taxes

Long one of the mainstays of the Federal tax system, Federal excise taxes had declined in relative importance until recently. In recent years, Congress substantially increased the Federal excise taxes on items such as tobacco products, fuel and gasoline sales, and air travel. Other Federal excise taxes include the following: • Manufacturers' excise taxes on trucks, trailers, tires, firearms, sporting equipment, and coal and the gas guzzler tax on automobiles. • Alcohol taxes. • Miscellaneous taxes (e.g., the tax on wagering). The list of transactions covered, although seemingly impressive, has diminished over the years. At one time, for example, there was a Federal excise tax on admission to amusement facilities (e.g., theaters) and on the sale of items such as leather goods, jewelry, furs, and cosmetics. When reviewing the list of both Federal and state excise taxes, one should recognize the possibility that the tax laws may be trying to influence social behavior. For example, the gas guzzler tax is intended as an incentive for the automobile companies to build fuel-efficient cars.

Example 28

Nora leases unimproved real estate to Wade for 20 years. At a cost of $400,000, Wade erects a building on the land. The building is worth $150,000 when the lease terminates and Nora takes possession of the property. Does Nora have any income either when the improvements are made or when the lease terminates? In a landmark decision, a court held that Nora must recognize income of $150,000 upon the termination of the lease.

Example 6

Pete and Sam both live in a state that has a general sales tax of 3%. Sam, however, resides in a city that imposes an additional general sales tax of 2%. Even though Pete and Sam live in the same state, one is subject to a rate of 3%, while the other pays a tax of 5%.

Property Taxes: Ad Valorem Taxes on Realty

Property taxes on realty are used exclusively by states and their local political subdivisions, such as cities, counties, and school districts. They represent a major source of revenue for local governments, but their importance at the state level has waned over the past few years. Some states, for example, have imposed freezes on upward revaluations of residential housing. How realty is defined can have an important bearing on which assets are subject to tax. This is especially true in jurisdictions that do not impose ad valorem taxes on personalty. Primarily a question of state property law, realty generally includes real estate and any capital improvements that are classified as fixtures. Simply stated, a fixture is something so permanently attached to the real estate that its removal will cause irreparable damage. A built-in bookcase might well be a fixture, whereas a movable bookcase would not be a fixture. Certain items such as electrical wiring and plumbing cease to be personalty when installed in a building and become realty. The following are some of the characteristics of ad valorem taxes on realty: • Property owned by the Federal government is exempt from tax. Similar immunity usually is extended to property owned by state and local governments and by certain charitable organizations. • Some states provide for lower valuations on property dedicated to agricultural use or other special uses (e.g., wildlife sanctuaries). Reductions in appraised valuations may also be available when the property is subject to a conservation easement (e.g., a limitation on further development). • Some states partially exempt the homestead, or personal residence, portion of property from taxation. • Lower taxes may apply to a residence owned by a taxpayer aged 65 or older. • When non-income-producing property (e.g., a personal residence) is converted to income-producing property (e.g., a rental house), typically the appraised value increases. • Some jurisdictions extend immunity from tax for a specified period of time (a tax holiday) to new or relocated businesses. A tax holiday can backfire, however, and cause more harm than good. If it is too generous, it can damage the local infrastructure (e.g., less funding for public works and education). Unlike the ad valorem tax on personalty, the tax on realty is difficult to avoid. Because real estate is impossible to hide, a high degree of taxpayer compliance is not surprising. The only avoidance possibility that is generally available is associated with the assessed value of the property. For this reason, the assessed value of the property—particularly, a value that is reassessed upward—may be subject to controversy and litigation. The history of the ad valorem tax on realty has been marked by inconsistent application due to a lack of competent tax administration and definitive guidelines for assessment procedures. In recent years, however, some significant improvements have occurred. Some jurisdictions, for example, have computerized their reassessment procedures so that they immediately affect all property located within the jurisdiction. Several jurisdictions provide homeowners with a measure of protection from increased property taxes by "freezing" existing assessments and limiting future upward adjustments. Such restrictions on reassessments, however, do not carry over to the new owner when the property is sold. Thus, such measures tend to lock in ownership and restrict the mobility of those who might otherwise change residences.

Example 11 The Big Picture

Return to the facts of The Big Picture. Although the value of the RV is not stated, it is highly likely to exceed the annual exclusion allowed of $56,000 [$14,000 (annual exclusion) × two donees (the Walkers) × 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 what past taxable gifts the Carters have made and how much of their unified transfer tax credit.

Example 12 The Big Picture

Return to the facts of The Big Picture. Because the income earned by Travis on his Chicago trip will be subject to tax by his home state, he probably will be able to claim an offsetting tax credit. Whether this negates the double taxation of the same income depends on the amount of credit allowed.

Political Considerations: Special Interest Legislation

There is no doubt that certain provisions of the tax law can largely be explained by the political influence some pressure groups have had on Congress. Is there any other realistic reason that, for example, prepaid subscription and dues income is not taxed until earned while prepaid rents are taxed to the landlord in the year received? A recent provision, sponsored by a senator from Georgia, suspended the import duties on ceiling fans. The nation's largest seller of ceiling fans is Home Depot, which is based in Atlanta, Georgia. Another provision, sponsored by a congressman from Illinois, reduced the excise taxes on fishing tackle boxes. The representative's district includes Plano Molding, a major manufacturer of tackle boxes. The justification for this change was that it placed tackle boxes on a more level playing field with toolboxes (which are not subject to tax). Allegedly, fishermen had been buying and converting toolboxes to avoid the excise tax. Special interest legislation is not necessarily to be condemned if it can be justified on economic, social, or some other utilitarian grounds. In most cases, however, it is objectionable in that it adds further complexity to an already cluttered tax law. It is, however, an inevitable product of our political system.

Economic Considerations

Using the tax system in an effort to accomplish economic objectives has become increasingly popular in recent years. Generally, proponents of this goal use tax legislation to amend the Internal Revenue Code in ways designed to help control the economy or encourage certain activities and businesses.

Influence of the Courts: Judicial Concepts Relating to Tax

A leading tax concept developed by the courts deals with the interpretation of statutory tax provisions that operate to benefit taxpayers. The courts have established the rule that these relief provisions are to be narrowly construed if there is any doubt about their application. Important in this area is the arm's length concept. Particularly in dealings between related parties, transactions may be tested by looking to whether the taxpayers acted in an arm's length manner. The question to be asked is: Would unrelated parties have handled the transaction in the same way?

Proposed U.S. Taxes: National Sales Tax

A national sales tax differs from a VAT in that it would be collected on the final sale of goods and services. Consequently, it is collected from the consumer, not from businesses that add value to the product. Like the VAT, the national sales tax is intended to replace the Federal income tax. A current proposal for a national sales tax, called the "Fair Tax," would tax all purchases, including food and medicine, at approximately 23 percent. Exempt items include business expenses, used goods, and the costs of education. The "Fair Tax" would replace not only the income tax (both individual and corporate) but also payroll taxes (including the self-employment tax) and the gift and estate taxes. Critics contend that both forms of consumption taxes, a VAT and a national sales tax, are regressive. They impose more of a burden on low-income taxpayers who must spend larger proportions of their incomes on essential purchases. The proposals attempt to remedy this inequity by granting some sort of credit, rebate, or exemption to low-income taxpayers. In terms of taxpayer compliance, a VAT is preferable to a national sales tax. Without significant collection efforts, a national sales tax could easily be circumvented by resorting to a barter system of doing business. Its high rate would also encourage smuggling and black market activities.

Statute of Limitations

A statute of limitations is a provision in the law that offers a party a defense against a suit brought by another party after the expiration of a specified period of time. The purpose of a statute of limitations is to preclude parties from prosecuting stale claims. The passage of time makes the defense of such claims difficult because witnesses may no longer be available or evidence may have been lost or destroyed. Found at the state and Federal levels, such statutes cover a multitude of suits, both civil and criminal. For our purposes, the relevant statutes deal with the Federal income tax. The two categories involved cover both the period of limitations applicable to the assessment of additional tax deficiencies by the IRS and the period applicable to claims for refunds by taxpayers.

The Tax Structure: Tax Base

A tax base is the amount to which the tax rate is applied. In the case of the Federal income tax, the tax base is taxable income. As noted later in Exhibit 1.2, taxable income is gross income reduced by certain deductions (both business and personal).

Example 20

Adam files his tax return 18 days after the due date of the return. Along with the return, he remits a check for $1,000, which is the balance of the tax he owed. Disregarding the interest element, Adam's total penalties are as follows: Failure to pay penalty (.5% x $1,000) = $5 -- Plus: Failure to file penalty (5% x $1,000) = $45 Less failure to pay penalty for the same period (5) -- Failure to file penalty = $45 = Total penalties: $50 Note that the penalties for one full month are imposed even though Adam was delinquent by only 18 days. Unlike the method used to compute interest, any part of a month is treated as a whole month.

Taxes on Transfers at Death: State Taxes on Transfers at Death

As noted earlier, some states levy an inheritance tax, an estate tax, or both. The two forms of taxes on transfers at death differ according to whether the tax is imposed on the heirs or on the estate. Characteristically, an inheritance tax divides the heirs into classes based on their relationship to the decedent. The more closely related the heir, the lower the rates imposed and the greater the exemption allowed. Some states completely exempt from taxation amounts passing to a surviving spouse.

Employment Taxes

Classification as an employee usually leads to the imposition of employment taxes and to the requirement that the employer withhold specified amounts for income taxes. The material that follows concentrates on the two major employment taxes: FICA (Federal Insurance Contributions Act—commonly referred to as the Social Security tax) and FUTA (Federal Unemployment Tax Act). Both taxes can be justified by social and public welfare considerations: FICA offers some measure of retirement security, and FUTA provides a modest source of income in the event of loss of employment. Employment taxes come into play only if two conditions are satisfied. First, is the individual involved an employee (as opposed to self-employed). Second, if the individual involved is an employee, is he or she covered under FICA or FUTA or both.

Economic Considerations: Encouragement of Small Business

At least in the United States, a consensus exists that what is good for small business is good for the economy as a whole. Whether valid or not, this assumption has led to a definite bias in the tax law favoring small business. In the corporate tax area, several provisions can be explained by the desire to benefit small business. One provision permits the shareholders of a small business corporation to make a special election that generally avoids the imposition of the corporate income tax. Furthermore, such an election enables the corporation to pass through its operating losses to its shareholders.

Example 7

At the time of her death, Wilma lived in a state that imposes an inheritance tax but not an estate tax. Mary, one of Wilma's heirs, lives in the same state. Wilma's estate is subject to the Federal estate tax, and Mary is subject to the state inheritance tax.

Example 26

Tina, a cash basis taxpayer, owns and operates a pharmacy. All drugs and other items acquired for resale, such as cosmetics, are charged to the purchases account and written off (expensed) for tax purposes in the year of acquisition. As this procedure does not clearly reflect income, it would be appropriate for the IRS to require that Tina establish and maintain an ending inventory account.

Economic Considerations: Control of the Economy

Congress has used depreciation write-offs as a means of controlling the economy. Theoretically, shorter asset lives and accelerated methods should encourage additional investment in depreciable property acquired for business use. Conversely, longer asset lives and the required use of the straight-line method of depreciation dampen the tax incentive for capital outlays. Another approach that utilizes depreciation as a means of controlling capital investment is the amount of write-off allowed upon the acquisition of assets. This is the approach followed by the § 179 election to expense assets. A change in the tax rate structure has a more immediate impact on the economy. With lower tax rates, taxpayers are able to retain additional spendable funds. If lower tax rates are accompanied by the elimination of certain deductions, exclusions, and credits, however, the overall result may not be lower tax liabilities.

The Audit Process: Selection of Returns for Audit

Due to budgetary limitations, only a small number of tax returns are audited. The overall audit rate for individuals in 2013 dropped to .96 percent, the lowest percentage since 2005. Personnel cutbacks within the IRS can be expected to further reduce this rate for 2014. Keep in mind, however, that the chance for audit increases for higher-income taxpayers. The IRS utilizes mathematical formulas and statistical sampling techniques to select tax returns that are most likely to contain errors and to yield substantial amounts of additional tax revenues upon audit. The mathematical formula yields what is called a Discriminant Index Formula (DIF) score. It is the DIF score given to a particular return that may lead to its selection for audit. Periodically, the IRS updates the DIF components by auditing a cross section of returns to determine the most likely areas of taxpayer noncompliance. Although the IRS does not openly disclose all of its audit selection techniques, the following observations may be made concerning the probability of selection for audit: •Certain groups of taxpayers are subject to audit much more frequently than others. These groups include individuals with large amounts of gross income, self-employed individuals with substantial business income and deductions, and taxpayers with prior tax deficiencies. Also vulnerable are businesses that receive a large proportion of their receipts in cash (e.g., cafés and small service businesses) and thus have a high potential for tax avoidance. •If information returns (e.g., Form 1099 or Form W-2) are not in substantial agreement with reported income, an audit can be anticipated. •If an individual's itemized deductions are in excess of norms established for various income levels, the probability of an audit is increased. •Filing of a refund claim by the taxpayer may prompt an audit of the return. •Information obtained from other sources (e.g., informants and news items) may lead to an audit. Recently, for example, the IRS advised its agents to be on the alert for newspaper accounts of large civil court judgments. The advice was based on the assumption that many successful plaintiffs were not reporting as income the taxable punitive damages portion of awards. The tax law permits the IRS to pay rewards to persons who provide information that leads to the detection and punishment of those who violate the tax laws. The rewards may not exceed 30 percent of the taxes, fines, and penalties recovered as a result of such information.

Gift Taxes The Federal Gift Tax

First enacted in 1932, the Federal gift tax was intended to complement the estate tax. If lifetime transfers by gift were not taxed, it would be possible to avoid the estate tax and escape taxation entirely. Only taxable gifts are subject to the gift tax. For this purpose, a taxable gift is measured by the fair market value of the property on the date of transfer less the annual exclusion per donee and, in some cases, less the marital deduction, which allows tax-free transfers between spouses. In 2014 and 2015, each donor is allowed an annual exclusion of $14,000 for each donee. A married couple may make a special election that allows one-half of the gift made by the donor-spouse to a third party to be treated as being made by the nondonor-spouse. This gift splitting effectively allows the annual exclusion to double. Also, it allows the use of the nondonor-spouse's unified transfer tax credit and may lower the tax rates that will apply. The gift tax rate schedule is the same as that applicable to the estate tax. The schedule is commonly referred to as the unified transfer tax rate schedule. The Federal gift tax is cumulative in effect. What this means is that the tax base for current taxable gifts includes past taxable gifts. Although a credit is allowed for prior gift taxes, the result of adding past taxable gifts to current taxable gifts could be to force the donor into a higher tax bracket. Like the Federal estate tax rates, the Federal gift tax rates are progressive. The unified transfer tax credit is available for all taxable gifts. As was the case with the Federal estate tax, the credit for 2014 is $2,081,800 (which covers taxable gifts up to $5,340,000) and for 2015 is $2,117,800 (which covers taxable gifts up to $5,430,000). There is, however, only one unified transfer tax credit, and it applies to both taxable gifts and the Federal estate tax. In a manner of speaking, therefore, once the unified transfer tax credit has been exhausted for Federal gift tax purposes, it is no longer available to insulate a decedent's transfers from the Federal estate tax, except to the extent of the excess of the credit amount for estate tax purposes over that for gift tax purposes. Making lifetime gifts of property carries several tax advantages over passing the property at death. If income-producing property is involved (e.g., marketable securities and rental real estate), a gift may reduce income taxes for the family unit by shifting subsequent income to lower-bracket donees. If the gift involves property that is expected to appreciate in value (e.g., life insurance policies, real estate, and artwork), future increases in value will be assigned to the donee and will not be included in the donor's estate. Also important is that due to the annual exclusion ($14,000 per donee in 2015), some of the gift is not subject to any gift tax. Recall that the gift-splitting election enables married donors to double up on the annual exclusion. Neither the receipt of a gift nor an inheritance will cause income tax consequences to the donee or heir.

Revenue Acts

Following ratification of the Sixteenth Amendment, Congress enacted the Revenue Act of 1913. Under this Act, the first Form 1040 was due on March 1, 1914. The law allowed various deductions and personal exemptions of $3,000 for a single individual and $4,000 for married taxpayers. For those times, these were large exemptions that excluded all but the more wealthy taxpayers from the new income tax. Rates ranged from a low of 2 percent to a high of 6 percent. The 6 percent rate applied only to taxable income in excess of $500,000. Various revenue acts were passed between 1913 and 1939. In 1939, all of these revenue laws were codified into the Internal Revenue Code of 1939. In 1954, a similar codification of the revenue law took place. The current law is entitled the Internal Revenue Code of 1986, which largely carries over the provisions of the 1954 Code. To date, the Code has been amended numerous times since 1986.

The Audit Process: Settlement Procedures

If an audit results in an assessment of additional tax and no settlement is reached with the IRS agent, the taxpayer may attempt to negotiate a settlement with a higher level of the IRS. If an appeal is desired, an appropriate request must be made to the Appeals Division of the IRS. The Appeals Division is authorized to settle all disputes based on the hazard of litigation (the probability of favorable resolution of the disputed issue or issues if litigated). In some cases, a taxpayer may be able to obtain a percentage settlement or a favorable settlement of one or more disputed issues. If a satisfactory settlement is not reached in the administrative appeal process, the taxpayer can litigate the case in the Tax Court, a Federal District Court, or the Court of Federal Claims. However, litigation is recommended only as a last resort because of the legal costs involved and the uncertainty of the final outcome.

Equity Considerations: Mitigating the Effect of the Annual Accounting Period Concept

For purposes of effective administration of the tax law, all taxpayers must report to and settle with the Federal government at periodic intervals. Otherwise, taxpayers would remain uncertain as to their tax liabilities, and the government would have difficulty judging revenues and budgeting expenditures. The period selected for final settlement of most tax liabilities, in any event an arbitrary determination, is one year. At the close of each year, therefore, a taxpayer's position becomes complete for that particular year. Referred to as the annual accounting period concept, its effect is to divide each taxpayer's life, for tax purposes, into equal annual intervals. The finality of the annual accounting period concept could lead to dissimilar tax treatment for taxpayers who are, from a long-range standpoint, in the same economic position. The same reasoning used to support the deduction of net operating losses can explain the special treatment the tax law accords to excess capital losses and excess charitable contributions. Carryback and carryover procedures help mitigate the effect of limiting a loss or a deduction to the accounting period in which it was realized. With such procedures, a taxpayer may be able to salvage a loss or a deduction that might otherwise be wasted. The installment method of recognizing gain on the sale of property allows a taxpayer to spread tax consequences over the payout period. The harsh effect of taxing all of the gain in the year of sale is thereby avoided. The installment method can also be explained by the wherewithal to pay concept because recognition of gain is tied to the collection of the installment notes received from the sale of the property. Tax consequences, then, tend to correspond to the seller's ability to pay the tax.

Influence of the Courts

In addition to interpreting statutory provisions and the administrative pronouncements issued by the IRS, the Federal courts have influenced tax law in two other respects. First, the courts have formulated certain judicial concepts that serve as guides in the application of various tax provisions. Second, certain key decisions have led to changes in the Internal Revenue Code.

Summary

In addition to its necessary revenue-raising objective, the Federal tax law has developed in response to several other factors: •Economic considerations. The emphasis here is on tax provisions that help regulate the economy and encourage certain activities and types of businesses. •Social considerations. Some tax provisions are designed to encourage (or discourage) certain socially desirable (or undesirable) practices. •Equity considerations. Of principal concern in this area are tax provisions that alleviate the effect of multiple taxation, recognize the wherewithal to pay concept, mitigate the effect of the annual accounting period concept, and recognize the eroding effect of inflation. •Political considerations. Of significance in this regard are tax provisions that represent special interest legislation, reflect political expediency, and exhibit the effect of state and local law. •Influence of the IRS. Many tax provisions are intended to aid the IRS in the collection of revenue and the administration of the tax law. •Influence of the courts. Court decisions have established a body of judicial concepts relating to tax law and have, on occasion, led Congress to enact statutory provisions to either clarify or negate their effect. These factors explain various tax provisions and thereby help in understanding why the tax law developed to its present state.

Influence of the Internal Revenue Service: The IRS as Protector of the Revenue

Innumerable examples can be given of provisions in the tax law that stem from the direct influence of the IRS. Usually, such provisions are intended to prevent a loophole from being used to avoid the tax consequences intended by Congress. Working within the letter of existing law, ingenious taxpayers and their advisers devise techniques that accomplish indirectly what cannot be accomplished directly. As a consequence, legislation is enacted to close the loopholes that taxpayers have located and exploited. Some tax law can be explained in this fashion. In addition, the IRS has secured from Congress legislation of a more general nature that enables it to make adjustments based on the substance, rather than the formal construction, of what a taxpayer has done. For example, one such provision permits the IRS to make adjustments to a taxpayer's method of accounting when the method used by the taxpayer does not clearly reflect income.

Example 15

Jack owns and operates a liquor store on a cash-and-carry basis. Because all of Jack's sales are for cash, he might well be a prime candidate for an audit by the IRS. Cash transactions are easier to conceal than those made on credit.

Interest and Penalties

Interest rates are determined quarterly by the IRS based on the existing Federal short-term rate. Currently, the rates for tax refunds (overpayments) for individual taxpayers are the same as those applicable to assessments (underpayments). For the first quarter (January 1-March 31) of 2015, the rates are 3 percent for refunds and assessments. For assessments of additional taxes, the interest begins running on the unextended due date of the return. With refunds, however, no interest is allowed if the overpayment is refunded to the taxpayer within 45 days of the date the return is filed. For this purpose, returns filed early are deemed to have been filed on the due date. In addition to interest, the tax law provides various penalties for lack of compliance by taxpayers. Some of these penalties are summarized as follows: •For failure to file a tax return by the due date (including extension), a penalty of 5 percent per month up to a maximum of 25 percent is imposed on the amount of tax shown as due on the return. Any fraction of a month counts as a full month. •A penalty for failure to pay the tax due as shown on the return is imposed in the amount of .5 percent per month up to a maximum of 25 percent. Again, any fraction of a month counts as a full month. During any month in which both the failure to file penalty and the failure to pay penalty apply, the failure to file penalty is reduced by the amount of the failure to pay penalty. •A negligence penalty of 20 percent is imposed if any of the underpayment was for intentional disregard of rules and regulations without intent to defraud. The penalty applies to just that portion attributable to the negligence. •Various penalties may be imposed in the case of fraud. Fraud involves specific intent on the part of the taxpayer to evade a tax. In the case of civil fraud, the penalty is 75 percent of the underpayment attributable to fraud. In the case of criminal fraud, the penalties can include large fines as well as prison sentences. The difference between civil and criminal fraud is one of degree. Criminal fraud involves the presence of willfulness on the part of the taxpayer. Also, the burden of proof, which is on the IRS in both situations, is more stringent for criminal fraud than for civil fraud. The negligence penalty is not imposed when the fraud penalty applies.

Gift Taxes

Like taxes on transfers at death, a gift tax is an excise tax levied on the right to transfer property. In this case, however, the tax is imposed on transfers made during the owner's life and not at death. A gift tax applies only to transfers that are not offset by full and adequate consideration.

Transaction Taxes: State and Local Excise Taxes

Many state and local excise taxes parallel the Federal version. Thus, all states tax the sale of gasoline, liquor, and tobacco products; however, unlike the Federal version, the rates vary significantly. For gasoline products, for example, compare the 39.5 cents per gallon imposed by the state of California with the 4.0 cents per gallon levied by the state of Florida. For tobacco sales, contrast the 17 cents per pack of 20 cigarettes in effect in Missouri with the $4.35 per pack applicable in the state of New York. Given the latter situation, is it surprising that the smuggling of cigarettes for resale elsewhere is so widespread? Other excise taxes found at some state and local levels include those on admission to amusement facilities, on the sale of playing cards, and on prepared foods. Most states impose a transaction tax on the transfer of property that requires the recording of documents (e.g., real estate sales). Some extend the tax to the transfer of stocks and other securities. Over the last few years, two types of excise taxes imposed at the local level have become increasingly popular: the hotel occupancy tax and the rental car "surcharge." Because they tax the visitor who cannot vote, they are a political windfall and are often used to finance special projects that generate civic pride (e.g., convention centers and state-of-the-art sports arenas). These levies can be significant, as demonstrated by Houston's hotel tax of 17 percent [6 percent (state) + 7 percent (city) + 2 percent (county) + 2 percent (sports authority)].

Other U.S. Taxes: Miscellaneous State and Local Taxes

Most states impose a franchise tax on corporations. Basically, a franchise tax is levied on the right to do business in the state. The base used for the determination of the tax varies from state to state. Although corporate income considerations may come into play, this tax most often is based on the capitalization of the corporation (either with or without certain long-term indebtedness). Closely akin to the franchise tax are occupational fees applicable to various trades or businesses (e.g., a liquor store license; a taxicab permit; or a fee to practice a profession such as law, medicine, or accounting). Most of these are not significant revenue producers and fall more into the category of licenses than taxes. The revenue derived is used to defray the cost incurred by the jurisdiction in regulating the business or profession in the interest of the public good. Concept Summary 1.1 provides an overview of the major taxes existing in the United States and specifies which political jurisdiction imposes them.

Example 8

Ned made no taxable gifts before his death in 2015. If Ned's taxable estate amounts to $5.43 million or less, no Federal estate tax is due because of the application of the unified transfer tax credit. Under the tax law, the estate tax on a taxable estate of $5.43 million is $2,117,800.

Example 10

On December 31, 2014, Louise (a widow) gives $14,000 to each of her four married children, their spouses, and her eight grandchildren. On January 2, 2015, she repeats the procedure, again giving $14,000 to each recipient. Due to the annual exclusion, Louise has not made a taxable gift, although she transferred $224,000 [$14,000 (annual exclusion) × 16 (donees)] in 2014 and $224,000 [$14,000 (annual exclusion) × 16 (donees)] in 2015, for a total of $448,000 ($224,000 + $224,000).

The Audit Process: Types of Audits

Once a return is selected for audit, the taxpayer is notified. If the issue involved is minor, the matter often can be resolved simply by correspondence (a correspondence audit) between the IRS and the taxpayer. Other examinations are generally classified as either office audits or field audits. An office audit usually is restricted in scope and is conducted in the facilities of the IRS. In contrast, a field audit involves an examination of numerous items reported on the return and is conducted on the premises of the taxpayer or the taxpayer's representative. Upon the conclusion of the audit, the examining agent issues a Revenue Agent's Report (RAR) that summarizes the findings. The RAR will result in a refund (the tax was overpaid), a deficiency (the tax was underpaid), or a no change (the tax was correct) finding. If, during the course of an audit, a special agent accompanies (or takes over from) the regular auditor, this means the IRS suspects fraud. If the matter has progressed to an investigation for fraud, the taxpayer should retain competent counsel.

Example 13 The Big Picture

Return to the facts of The Big Picture. Presuming that April and Martin perform meaningful services for Travis (which the facts seem to imply), they are legitimate employees. April is not subject to Social Security tax because she is under the age of 18. However, Martin is 18 and needs to be covered. Furthermore, recall that Betty Carter is now working at a medical clinic and will likewise be subject to Social Security tax. Travis, as an independent contractor, is subject to self-employment tax.

Example 18 The Big Picture

Return to the facts of The Big Picture. 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. Because 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.

Proposed U.S. Taxes: The Flat Tax

One proposal is for a flat tax that would replace the current graduated income tax with a single rate of 17 percent. Large personal exemptions (e.g., approximately $30,000 for a family of four) would allow many low- and middle-income taxpayers to pay no tax. All other deductions would be eliminated, and no tax would be imposed on income from investments. Various other versions of the flat tax have been suggested that would retain selected deductions (e.g., interest on home mortgages and charitable contributions) and not exclude all investment income from taxation. The major advantage of the flat tax is its simplicity. Everyone agrees that the current Federal income tax is inappropriately complex. Consequently, compliance costs are disproportionately high. Proponents of the flat tax further believe that simplifying the income tax will significantly reduce the current "tax gap" (i.e., the difference between the amount of taxes that should be paid and what is actually paid). Political considerations are a major obstacle to the enactment of a flat tax in its pure form. Special interest groups, such as charitable organizations and mortgage companies, are likely to strongly oppose the elimination of a tax deduction that benefits their industry. In addition, there is uncertainty as to the economic effects of a flat tax.

Other U.S. Taxes: Federal Customs Duties

One tax that has not yet been mentioned is the tariff on certain imported goods. Generally referred to as customs duties or levies, this tax, together with selective excise taxes, provided most of the revenues needed by the Federal government during the nineteenth century. In view of present times, it is remarkable that tariffs and excise taxes alone paid off the national debt in 1835 and enabled the U.S. Treasury to pay a surplus of $28 million to the states. In recent years, tariffs have served the nation more as an instrument for carrying out protectionist policies than as a means of generating revenue. Thus, a particular U.S. industry might be saved from economic disaster, so the argument goes, by imposing customs duties on the importation of foreign goods that can be sold at lower prices. Protectionists contend that the tariff thereby neutralizes the competitive edge held by the producer of the foreign goods. History shows that tariffs often lead to retaliatory action on the part of the nation or nations affected.

Example 5 The Big Picture

Return to the facts of The Big Picture. 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.

Example 4 The Big Picture

Return to the facts of The Big Picture. Why did the Walkers' property 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 was probably increased (see the following discussion). Perhaps they made significant home improvements (e.g., kitchen/bathroom renovation or addition of a sundeck).

Property Taxes: Ad Valorem Taxes on Personalty

Personalty can be defined as all assets that are not realty. It may be helpful to distinguish between the classification of an asset (realty or personalty) and the use to which it is put. Both realty and personalty can be either business use or personal use property. Examples include a residence (realty that is personal use), an office building (realty that is business use), surgical instruments (personalty that is business use), and regular wearing apparel (personalty that is personal use). Personalty can also be classified as tangible property or intangible property. For ad valorem tax purposes, intangible personalty includes stocks, bonds, and various other securities (e.g., bank shares). The following generalizations may be made concerning the ad valorem taxes on personalty: • Particularly with personalty devoted to personal use (e.g., jewelry and household furnishings), taxpayer compliance ranges from poor to zero. Some jurisdictions do not even attempt to enforce the tax on these items. For automobiles devoted to personal use, many jurisdictions have converted from value as the tax base to arbitrary license fees based on the weight of the vehicle. Some jurisdictions also consider the vehicle's age (e.g., automobiles six years or older are not subject to the ad valorem tax because they are presumed to have little, if any, value). • For personalty devoted to business use (e.g., inventories, trucks, machinery, equipment), taxpayer compliance and enforcement procedures are measurably better. • Which jurisdiction possesses the authority to tax movable personalty (e.g., railroad rolling stock) always has been and continues to be a troublesome issue. • A few states levy an ad valorem tax on intangibles such as stocks and bonds. Taxpayer compliance may be negligible if the state lacks a means of verifying security transactions and ownership.

Political Considerations: State and Local Government Influences

Political considerations have played a major role in the nontaxability of interest received on state and local obligations. In view of the furor that state and local political figures have raised every time any modification of this tax provision has been proposed, one might well regard it as next to sacred. Somewhat less apparent has been the influence that state law has had in shaping our present Federal tax law. Such was the case with community property systems. The nine states with community property systems are Louisiana, Texas, New Mexico, Arizona, California, Washington, Idaho, Nevada, and Wisconsin. The rest of the states are classified as common law jurisdictions. The difference between common law and community property systems centers around the property rights possessed by married persons. In a common law system, each spouse owns whatever he or she earns. Under a community property system, one-half of the earnings of each spouse is considered owned by the other spouse. At one time, the tax position of the residents of community property states was so advantageous that many common law states adopted community property systems. Needless to say, the political pressure placed on Congress to correct the disparity in tax treatment was considerable. To a large extent, this was accomplished in the Revenue Act of 1948, which extended many of the community property tax advantages to residents of common law jurisdictions. The major advantage extended was the provision allowing married taxpayers to file joint returns and compute their tax liability as if one-half of the income had been earned by each spouse. This result is automatic in a community property state, because half of the income earned by one spouse belongs to the other spouse. The income-splitting benefits of a joint return are now incorporated as part of the tax rates applicable to married taxpayers.

The Tax Structure: Tax Rates

Tax rates are applied to the tax base to determine a taxpayer's liability. The tax rates may be proportional or progressive. A tax is proportional if the rate of tax remains constant for any given income level. Examples of proportional taxes include most excise taxes, general sales taxes, and employment taxes (FICA and FUTA). A tax is progressive if a higher rate of tax applies as the tax base increases. The Federal income tax, Federal gift and estate taxes, and most state income tax rate structures are progressive.

Example 27

Rex, the sole shareholder of Silver Corporation, leases property to the corporation for a yearly rent of $60,000. To test whether the corporation should be allowed a rent deduction for this amount, the IRS and the courts will apply the arm's length concept. Would Silver Corporation have paid $60,000 a year in rent if it had leased the same property from an unrelated party (rather than from Rex)? Suppose it is determined that an unrelated third party would have charged an annual rent for the property of only $50,000. Under these circumstances, Silver Corporation will be allowed a deduction of only $50,000. The other $10,000 it paid for the use of the property represents a nondeductible dividend. Accordingly, Rex will be treated as having received rent income of $50,000 and dividend income of $10,000.

Example 3

Rick is employed by Flamingo Corporation in San Antonio, Texas, at a salary of $74,000. Rick's employer offers him a chance to transfer to its New York City office at a salary of $94,000. A quick computation indicates that the additional taxes (Federal, state, and local) involve approximately $12,000. Although Rick must consider many nontax factors before he decides on a job change, he should also evaluate the tax climate. How do state and local taxes compare? For example, neither Texas nor San Antonio imposes an income tax, but New York State and New York City do. Consequently, what appears to be a $20,000 pay increase is only $8,000 when the additional taxes of $12,000 are taken into account.

Transaction Taxes: Severance Taxes

Severance taxes are transaction taxes that are based on the notion that the state has an interest in its natural resources (e.g., oil, gas, iron ore, or coal). Therefore, a tax is imposed when the natural resources are extracted. For some states, severance taxes can be a significant source of revenue. Due to the severance tax on oil production, Alaska has been able to avoid both a state income tax and a state general sales tax.

Influence of the Courts: Judicial Influence on Statutory Provisions

Some court decisions have been of such consequence that Congress has incorporated them into statutory tax law. For example, many years ago the courts found that stock dividends distributed to the shareholders of a corporation were not taxable as income. This result was largely accepted by Congress, and a provision in the tax statutes now covers the issue. On occasion, however, Congress has reacted negatively to judicial interpretations of the tax law. Congress believed that the result reached in Example 28 was inequitable in that it was not consistent with the wherewithal to pay concept. Consequently, the tax law was amended to provide that a landlord does not recognize any income either when the improvements are made (unless made in lieu of rent) or when the lease terminates.

Example 22

Some of the pasture land belonging to Ron, a rancher, is condemned by the state for use as a game preserve. The condemned pasture land cost Ron $120,000, but the state pays him $150,000 (its fair market value). Shortly thereafter, Ron buys more pasture land for $150,000. Ron has a realized gain of $30,000 [$150,000 (condemnation award) − $120,000 (cost of land)]. It would be inequitable to force Ron to pay a tax on this gain for two reasons. First, without disposing of the property acquired (the new land), Ron would be hard-pressed to pay the tax. Second, his economic position has not changed.

Social Considerations

Some provisions of the Federal tax law, particularly those dealing with the income tax of individuals, can be explained by social considerations. Some notable examples and their rationales include the following: •Certain benefits provided to employees through accident and health plans financed by employers are nontaxable to employees. Encouraging such plans is considered socially desirable because they provide medical benefits in the event of an employee's illness or injury. •Most premiums paid by an employer for group term insurance covering the life of the employee are nontaxable to the employee. These arrangements can be justified on social grounds in that they provide funds for the family unit to help it adjust to the loss of wages caused by the employee's death. •A contribution made by an employer to a qualified pension or profit sharing plan for an employee may receive special treatment. The contribution and any income it generates are not taxed to the employee until the funds are distributed. Such an arrangement also benefits the employer by allowing a tax deduction when the contribution is made to the qualified plan. Private retirement plans are encouraged to supplement the subsistence income level the employee otherwise would have under the Social Security system. •A deduction is allowed for contributions to qualified charitable organizations. The deduction attempts to shift some of the financial and administrative burden of socially desirable programs from the public (the government) to the private (the citizens) sector. •A tax credit is allowed for amounts spent to furnish care for certain minor or disabled dependents to enable the taxpayer to seek or maintain gainful employment. For those employees who do not choose home care for their children, employers are allowed a credit for child care provided at the workplace. Who could deny the social desirability of encouraging taxpayers to provide care for their children while they work? •To encourage taxpayers to join the workforce even though their wages may be marginal, an earned income tax credit can be claimed. The credit varies depending on the number of qualifying children being claimed and the level of wages earned. Because it stimulates employment, the earned income tax credit can also be justified on economic grounds. •Due to the usual impairment in earning potential, certain credits are made available to elderly and disabled persons. Credits also are allowed to businesses that incur expenditures to make their facilities more accessible to the disabled. •Various tax credits, deductions, and exclusions are designed to encourage taxpayers to obtain additional education. •A tax deduction is not allowed for certain expenditures deemed to be contrary to public policy. This disallowance extends to such items as fines, penalties, illegal kickbacks, bribes to government officials, and gambling losses in excess of gains. Social considerations dictate that the tax law should not encourage these activities by permitting a deduction. Although many other examples could be identified, these examples demonstrate that social considerations do explain a significant part of the Federal tax law.

Influence of the Internal Revenue Service: Administrative Feasibility

Some tax law is justified on the grounds that it simplifies the task of the IRS in collecting the revenue and administering the law. With regard to collecting the revenue, the IRS long ago realized the importance of placing taxpayers on a pay-as-you-go basis. Elaborate withholding procedures apply to wages, while the tax on other types of income may be paid at periodic intervals throughout the year. The IRS has been instrumental in convincing the courts that accrual basis taxpayers should, in most cases, pay taxes on prepaid income in the year received and not when earned. The approach may be contrary to generally accepted accounting principles, but it is consistent with the wherewithal to pay concept. Of considerable aid to the IRS in collecting revenue are the numerous provisions that impose interest and penalties on taxpayers for noncompliance with the tax law. Provisions such as the penalties for failure to pay a tax or to file a return that is due, the negligence penalty for intentional disregard of rules and regulations, and various penalties for civil and criminal fraud serve as deterrents to taxpayer noncompliance. One of the keys to an effective administration of our tax system is the audit process conducted by the IRS. To carry out this function, the IRS is aided by provisions that reduce the chance of taxpayer error or manipulation and therefore simplify the audit effort that is necessary. An increase in the amount of the standard deduction, for example, reduces the number of individual taxpayers who will choose the alternative of itemizing their personal deductions. With fewer deductions to check, the audit function is simplified.

Tax Practice: Ethical Guidelines

The American Institute of CPAs has issued numerous pronouncements, called the "Statements on Standards for Tax Services," dealing with CPAs engaged in tax practice. These pronouncements are enforceable as part of its Code of Professional Conduct. They include the following summarized provisions: •Do not take questionable positions on a client's tax return in the hope that the return will not be selected for audit by the IRS. Any positions taken should be supported by a good-faith belief that they have a realistic possibility of being sustained if challenged. The client should be fully advised of the risks involved and of the penalties that will result if the position taken is not successful. •A practitioner can use a client's estimates if they are reasonable under the circumstances. If the tax law requires receipts or other verification, the client should be so advised. In no event should an estimate be given the appearance of greater accuracy than is the case. For example, an estimate of $1,000 should not be deducted on a return as $999. •Every effort should be made to answer questions appearing on tax returns. A question need not be answered if the information requested is not readily available, the answer is voluminous, or the question's meaning is uncertain. The failure to answer a question on a return cannot be justified on the grounds that the answer could prove disadvantageous to the taxpayer. •Upon learning of an error on a past tax return, advise the client to correct it. Do not, however, inform the IRS of the error. If the error is material and the client refuses to correct it, consider withdrawing from the engagement. This will be necessary if the error has a carryover effect and prevents the current year's tax liability from being determined correctly.

Employment Taxes: FICA Taxes

The FICA tax rates and wage base have increased steadily over the years. It is difficult to imagine that the initial rate in 1937 was only 1 percent of the first $3,000 of covered wages. Thus, the maximum tax due was only $30. The FICA tax has two components: Social Security tax (old age, survivors, and disability insurance) and Medicare tax (hospital insurance). The Social Security tax rate is 6.2 percent for 2015 and generally does not change each year. The base amount does vary and is $118,500 for 2015 ($117,000 for 2014). The Medicare portion of FICA is applied at a rate of 1.45 percent and, unlike Social Security, is not subject to any dollar limitation. An additional .9 percent is imposed on earned income (including self-employment income) above $200,000 (single filers) or $250,000 (married filing jointly). Unlike the Social Security tax of 6.2 percent and the regular Medicare portion of 1.45 percent, an employer does not have to match the employees' .9 percent. A spouse employed by another spouse is subject to FICA. However, children under the age of 18 who are employed in a parent's unincorporated trade or business are exempted. Taxpayers who are not employees (e.g., sole proprietors and independent contractors) may also be subject to Social Security taxes. Known as the self-employment tax, the rates are 12.4 percent for Social Security and 2.9 percent for Medicare, or twice that applicable to an employee. The additional .9 percent Medicare tax also covers situations involving high net income from self-employment. The Social Security tax is imposed on net self-employment income up to a base amount of $118,500 for 2015. The Medicare portion of the self-employment tax is not subject to any dollar limitation. To defray the cost of extended medical care, Congress enacted a special tax on investment income. For this purpose, "investment income" is often referred to as "unearned income" because it is not generated by the performance of services. A tax of 3.8 percent is imposed on investment income when a taxpayer's modified adjusted gross income (MAGI) exceeds certain threshold amounts. The threshold amounts, which are not adjusted for inflation each year, are $250,000 for married taxpayers and $200,000 for single taxpayers. Investment income generally includes passive income (e.g., taxable interest, dividends, and capital gains). This tax was first assessed in 2013.

Income Taxes: Federal Income Taxes

The Federal income tax imposed on individuals follows the formula set forth in Exhibit 1.2. The formula for the individual income tax establishes the framework followed in the text. Like its individual counterpart, the Federal corporate income tax is progressive in nature. But its application does not require the computation of adjusted gross income (AGI) and does not provide for the standard deduction and personal and dependency exemptions. All allowable deductions of a corporation fall into the business-expense category. In effect, therefore, the taxable income of a corporation is the difference between gross income and deductions.

Understanding the Federal Tax Law

The Federal tax law is a mosaic of statutory provisions, administrative pronouncements, and court decisions. Anyone who has attempted to work with this body of knowledge would have to admit to its complexity. For the person who has to trudge through a mass of rules to find the solution to a tax problem, it may be of some consolation to know that the law's complexity can generally be explained. Whether sound or not, there is a reason for the formulation of every rule. Knowing these reasons, therefore, is a considerable step toward understanding the Federal tax law. The Federal tax law has as its major objective the raising of revenue. But although the fiscal needs of the government are important, other considerations explain certain portions of the law. Economic, social, equity, and political factors also play a significant role. Added to these factors is the marked impact the IRS and the courts have had and will continue to have on the evolution of Federal tax law.

Taxes on Transfers at Death: The Federal Estate Tax

The Revenue Act of 1916 incorporated the estate tax into the tax law. The tax was originally intended to prevent large concentrations of wealth from being kept in a family for many generations. Whether this objective has been accomplished is debatable. Like the income tax, estate taxes can be reduced through various planning procedures. The gross estate includes property the decedent owned at the time of death. It 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. Quite simply, the gross estate represents property interests subject to Federal estate taxation. All property included in the gross estate is valued as of the date of death or, if the alternate valuation date is elected, six months later. Deductions from the gross estate in arriving at the taxable estate include funeral and administration expenses; certain taxes; debts of the decedent; casualty losses incurred during the administration of the estate; transfers to charitable organizations; and, in some cases, the marital deduction. The marital deduction is available for amounts actually passing to a surviving spouse (a widow or widower). Once the taxable estate has been determined and certain taxable gifts made by the decedent during life have been added to it, the estate tax can be computed. From the amount derived from the appropriate tax rate schedules, various credits should be subtracted to arrive at the tax, if any, that is due. Although many other credits are also available, probably the most significant is the unified transfer tax credit. The main reason for this credit is to eliminate or reduce the estate tax liability for certain estates. For 2015, the amount of the credit is $2,117,800. Based on the estate tax rates, the credit exempts a tax base of up to $5.43 million.

Equity Considerations

The concept of equity is relative. Reasonable persons can, and often do, disagree about what is fair or unfair. In the tax area, moreover, equity is most often tied to a particular taxpayer's personal situation. To illustrate, compare the tax positions of those who rent their personal residences with those who own their homes. Renters receive no Federal income tax benefit from the rent they pay. For homeowners, however, a large portion of the house payments they make may qualify for the Federal interest and property tax deductions. Although renters may have difficulty understanding this difference in tax treatment, the encouragement of home ownership can be justified on both economic and social grounds. In the same vein, compare the tax treatment of a corporation with that of a partnership. Although the two businesses may be equal in size, similarly situated, and competitors in the production of goods or services, they are not treated comparably under the tax law. The corporation is subject to a separate Federal income tax; the partnership is not. Whether the differences in tax treatment can be justified logically in terms of equity is beside the point. The point is that the tax law can and does make a distinction between these business forms. Equity, then, is not what appears fair or unfair to any one taxpayer or group of taxpayers. Some recognition of equity does exist, however, and explains part of the law. The concept of equity appears in tax provisions that alleviate the effect of multiple taxation and postpone the recognition of gain when the taxpayer lacks the ability or wherewithal to pay the tax. Provisions that mitigate the effect of the application of the annual accounting period concept and help taxpayers cope with the eroding results of inflation also reflect equity considerations.

The Tax Structure: Incidence of Taxation

The degree to which various segments of society share the total tax burden is difficult to assess. Assumptions must be made concerning who absorbs the burden of paying the tax. For example, because dividend payments to shareholders are not deductible by a corporation and are generally taxable to shareholders, the same income is subject to a form of double taxation. Concern over double taxation is valid to the extent that corporations are not able to shift the corporate tax to the consumer through higher commodity prices. Many research studies have shown a high degree of shifting of the corporate income tax, converting it into a consumption tax that is borne by the ultimate purchasers of goods. The progressiveness of the Federal income tax rate structure for individuals has varied over the years. As late as 1986, for example, there were 15 rates, ranging from 0 to 50 percent. These later were reduced to two rates of 15 and 28 percent. Currently, there are seven rates ranging from 10 to 39.6 percent.

Transaction Taxes: General Sales Taxes

The distinction between an excise tax and a general sales tax is easy to make. One is restricted to a particular transaction (e.g., the 18.4 cents per gallon Federal excise tax on the sale of gasoline), while the other covers a multitude of transactions (e.g., a 5 percent tax on all retail sales). In actual practice, however, the distinction is not always that clear. Some state statutes exempt certain transactions from the application of the general sales taxes (e.g., sales of food to be consumed off the premises and sales of certain medicines and drugs). Also, it is not uncommon to find that rates vary depending on the commodity involved. Many states, for example, allow preferential rates for the sale of agricultural equipment or apply different rates (either higher or lower than the general rate) to the sale of automobiles. With many of these special exceptions and classifications of rates, a general sales tax can take on the appearance of a collection of individual excise taxes. A use tax is an ad valorem tax, usually at the same rate as the sales tax, on the use, consumption, or storage of tangible property purchased outside the state but used in the state. The purpose of a use tax is to prevent the avoidance of a sales tax. Every state that imposes a general sales tax levied on the consumer also has a use tax. Alaska, Delaware, Montana, New Hampshire, and Oregon have neither tax. There is no Federal general sales or use tax. The use tax is difficult to enforce for many purchases; therefore, the purchaser often does not pay it. In some cases, for example, it may be worthwhile to make purchases through an out-of-state mail-order business or the websites of certain vendors. In spite of shipping costs, the avoidance of the local sales tax that otherwise might be incurred can lower the cost of such products as computer components. Some states are taking steps to curtail this loss of revenue. For items such as automobiles (refer to Example 5), the use tax probably will be collected when the purchaser registers the item in his or her home state. Local general sales taxes, over and above those levied by the state, are common. It is not unusual to find taxpayers living in the same state but paying different general sales taxes due to the location of their residence. For various reasons, some jurisdictions will suspend the application of a general sales tax. Frequently, the "sales tax holiday" occurs in late summer when it applies to back-to-school clothing and supplies. Some states use sales tax holidays to encourage the purchase of energy-conserving appliances and hurricane preparedness items.

Revenue Needs

The foundation of any tax system has to be the raising of revenue to cover the cost of government operations. Ideally, annual outlays should not exceed anticipated revenues, thereby leading to a balanced budget with no resulting deficit. When enacting tax legislation, a deficit-conscious Congress often has been guided by the concept of revenue neutrality. Also referred to as "pay-as-you-go" ("paygo"), the concept means that every new tax law that lowers taxes must include a revenue offset that makes up for the loss. Revenue neutrality does not mean that any one taxpayer's tax liability will remain the same. Because the circumstances involved will differ, one taxpayer's increased tax liability could be another's tax savings. Although revenue-neutral tax reform does not reduce deficits, at least it does not aggravate the problem. In addition to making revenue-neutral changes in the tax law, several other procedures can be taken to mitigate any revenue loss. When tax reductions are involved, the full impact of the legislation can be phased in over a period of years. Or as an alternative, the tax reduction can be limited to a period of years. When the period expires, the prior law is reinstated through a sunset provision. Most of the major tax bills recently passed by Congress have contained numerous sunset provisions. They provide some semblance of revenue neutrality as some of the bills include tax cuts that were not offset by new sources of revenue. It remains to be seen, however, whether Congress will allow the sunset provisions to take effect and, thereby, kill the tax cuts that were enacted.

Equity Considerations: Alleviating the Effect of Multiple Taxation

The income earned by a taxpayer may be subject to taxes imposed by different taxing authorities. If, for example, the taxpayer is a resident of New York City, income might generate Federal, state of New York, and city of New York income taxes. To compensate for this apparent inequity, the Federal tax law allows a taxpayer to claim a deduction for state and local income taxes. The deduction does not, however, neutralize the effect of multiple taxation because the benefit derived depends on the taxpayer's Federal income tax rate. Only a tax credit, not a deduction, would eliminate the effects of multiple taxation on the same income. Equity considerations can explain the Federal tax treatment of certain income from foreign sources. Because double taxation results when the same income is subject to both foreign and U.S. income taxes, the tax law permits the taxpayer to choose between a credit and a deduction for the foreign taxes paid.

Historical Trends

The income tax has proved to be a major source of revenue for the Federal government. Exhibit 1.1, which contains a breakdown of the primary sources, demonstrates the importance of the income tax. Estimated income tax collections from individuals and corporations amount to 59 percent of the total receipts. The need for revenues to finance the war effort during World War II converted the income tax into a mass tax. For example, in 1939, less than 6 percent of the U.S. population was subject to the Federal income tax. In 1945, more than 74 percent of the population was subject to the Federal income tax. Certain changes in the income tax law are of particular significance in understanding the Federal income tax. In 1943, Congress passed the Current Tax Payment Act, which provided for the first pay-as-you-go tax system. A pay-as-you-go income tax system requires employers to withhold for taxes a specified portion of an employee's wages. Persons with income from other than wages may have to make quarterly payments to the IRS for estimated taxes due for the year. One trend that has caused considerable concern is the increasing complexity of the Federal income tax laws. In the name of tax reform, Congress has added to this complexity by frequently changing the tax laws. Most recent legislation continues this trend. Increasingly, this complexity forces many taxpayers to seek assistance. According to recent estimates, about 56 percent of individual taxpayers who file a return pay a preparer, and one-third purchase tax software. At this time, therefore, substantial support exists for tax law simplification.

Influence of the Internal Revenue Service

The influence of the IRS is apparent in many areas beyond its role in issuing the administrative pronouncements that make up a considerable portion of our tax law. In its capacity as the protector of the national revenue, the IRS has been instrumental in securing the passage of much legislation designed to curtail the most flagrant tax avoidance practices (to close tax loopholes). As the administrator of the tax law, the IRS has sought and obtained legislation to make its job easier (to attain administrative feasibility).

Equity Considerations: The Wherewithal to Pay Concept

The wherewithal to pay concept recognizes the inequity of taxing a transaction when the taxpayer lacks the means with which to pay the tax. It is particularly suited to situations in which the taxpayer's economic position has not changed significantly as a result of the transaction. An illustration of the wherewithal to pay concept is the provision of the tax law dealing with the treatment of gain resulting from an involuntary conversion. An involuntary conversion occurs when property is destroyed by a casualty or taken by a public authority through condemnation. If gain results from the conversion, it need not be recognized if the taxpayer replaces the property within a specified period of time. The replacement property must be similar or related in service or use to that involuntarily converted. A warning is in order regarding the application of the wherewithal to pay concept. If the taxpayer's economic position changes in any way, tax consequences may result.

Employment Taxes: FUTA Taxes

The purpose of the FUTA tax is to provide funds the states can use to administer unemployment benefits. This leads to the somewhat unusual situation of one tax being handled by both Federal and state governments. The end result of such joint administration is to compel the employer to observe two sets of rules. Thus, state and Federal returns must be filed and payments made to both governmental units. In 2015, FUTA is 6 percent on the first $7,000 of covered wages paid during the year to each employee. The Federal government allows a credit for FUTA paid (or allowed under a merit rating system) to the state. The credit cannot exceed 5.4 percent of the covered wages. Thus, the amount required to be paid to the IRS could be as low as .6 percent (6.0% − 5.4%). States follow a policy of reducing the unemployment tax on employers who experience stable employment. Thus, an employer with little or no employee turnover might find that the state rate drops to as low as .1 percent or, in some states, even to zero. The reason for the merit rating credit is that the state has to pay fewer unemployment benefits when employment is steady. FUTA, unlike FICA, is paid entirely by the employer. A few states, however, levy a special tax on employees to provide either disability benefits or supplemental unemployment compensation or both.

Internal Revenue Service

The responsibility for administering the Federal tax laws rests with the Treasury Department. The IRS is part of the Department of the Treasury and is responsible for enforcing the tax laws. The Commissioner of Internal Revenue is appointed by the President and is responsible for establishing policy and supervising the activities of the IRS.

Taxes on Transfers at Death

The right to transfer property or to receive property upon the death of the owner may be subject to estate and/or inheritance taxes. Consequently, such taxes fall into the category of excise taxes. If the tax is imposed on the right to pass property at death, it is classified as an estate tax. If it taxes the right to receive property from a decedent, it is termed an inheritance tax. As is typical of other types of excise taxes, the value of the property transferred provides the base for determining the amount of the tax. The Federal government imposes only an estate tax. Many state governments, however, levy inheritance taxes, estate taxes, or both. Some states (e.g., Florida and Texas) levy neither tax. An estate tax is levied on the estate of the decedent, whereas an inheritance tax is paid from the property received by the heir.

Learning and Coping with Taxation

The study of taxation is important because taxes permeate our society. Effectively coping with taxes often involves making decisions based on timing considerations. Timing considerations are paramount when it is deemed desirable to accelerate (or defer) income or accelerate (or defer) deductions for any one year. Taxation is anything but stagnant. As circumstances change, so does the tax result. One of the most common changes in circumstance that can affect the tax position of an individual is marital status. Getting married, although usually favorable, can sometimes have negative tax results. Even more diverse and pronounced, however, are the effects of a divorce. The study of taxation teaches us not to overlook the less obvious taxes that can block our intended objective. An attractive income tax result could be materially diminished by adverse property tax consequences. It is essential in working with taxation to maintain a balanced perspective. Tax considerations should not control decisions, but they remain one of many factors to be considered. The study of taxation involves reviewing a multitude of rules and exceptions and, when possible, trying to understand the justification for them. But the desired goal of this learning process is the ability to recognize issues that carry tax implications. The issue has been identified, and the outcome (i.e., when an exception applies) can easily be resolved by additional research.

Proposed U.S. Taxes: Value Added Tax

The value added tax (VAT) is one of two proposals that would replace the Federal income tax. Under the VAT, a business would pay the tax (approximately 17 percent) on all of the materials and services required to manufacture its product. In effect, the VAT taxes the increment in value as goods move through production and manufacturing stages to the marketplace. Moreover, the VAT paid by the producer will be reflected in the selling price of the goods. Thus, the VAT is a tax on consumption. In fact, the VAT has been described by some as a "layered sales tax." In spite of its extensive use by other countries (including Canada), the adoption of a VAT by the United States appears doubtful.

Transaction Taxes

Transaction taxes, which characteristically are imposed at the manufacturer's, wholesaler's, or retailer's level, cover a wide range of transfers. Like many other types of taxes (e.g., income taxes, estate taxes, and gift taxes), transaction taxes usually are not within the exclusive province of any one level of taxing authority (Federal, state, or local government). As the description implies, these levies place a tax on transfers of property and normally are determined by multiplying the value involved by a percentage rate.

Concept Summary 1.1 Overview of Taxes in the United States Imposed by Jurisdiction

Type of Tax: Federal | | State | | Local «Property taxes: •Ad valorem on realty: No, Yes, Yes •Ad valorem on personalty: No, Yes, Yes «Transaction taxes: •Excise: Yes, Yes, Few •General sales: No, Most, Some •Severance: Yes, Most, No •Estate: Yes, Some, No •Inheritance: No, Some, No •Gift: Yes, Few, No «Income taxes: •Corporations: Yes, Most, Few •Individuals: Yes, Most, Few «Employment taxes: •FICA: Yes, No, No •FUTA: Yes, Yes, No «Customs duties: Yes, No, No «Franchise taxes: No, Yes, No «Occupational taxes or fees: Yes, Yes, Yes

Statute of Limitations: Assessment by the IRS

Under the general rule, the IRS may assess an additional tax liability against a taxpayer within three years of the filing of the income tax return. If the return is filed early, the three-year period begins to run from the due date of the return (usually April 15 for a calendar year individual taxpayer). If the taxpayer files the return late (i.e., beyond the due date), the three-year period begins to run on the date filed. If a taxpayer omits an amount of gross income in excess of 25 percent of the gross income reported on the return, the statute of limitations is increased to six years. The six-year provision on assessments by the IRS applies only to the omission of income and does not cover other factors that might lead to an understatement of tax liability, such as overstatement of deductions and credits. There is no statute of limitations on assessments of tax if no return is filed or if a fraudulent return is filed.

Political Considerations: Political Expediency Situations

Various tax reform proposals rise and fall in favor with the shifting moods of the American public. That Congress is sensitive to popular feeling is an accepted fact. Therefore, certain provisions of the tax law can be explained by the political climate at the time they were enacted. Measures that deter more affluent taxpayers from obtaining so-called preferential tax treatment have always had popular appeal and, consequently, the support of Congress. A direct approach bars the benefit completely and explains such provisions as the imputed interest rules and the limitations on the deductibility of interest on investment indebtedness. More subtle are provisions that phase out tax breaks as income rises. Because taxpayers may be unaware of what is causing the shift to higher marginal tax rates, these phaseouts are often called "stealth taxes." The tax law contains several dozen such phaseout provisions. Examples include the earned income credit, the child tax credit, the lifetime learning credit, and the credit for first-time home purchases. At least for the immediate future, the use of these stealth taxes can be expected to increase. Other changes, explained at least partially by political expediency, include the lowering of individual income tax rates, the increase in the personal and dependency exemptions, and the increase in the amount of the earned income credit.

Economic Considerations: Encouragement of Certain Activities

Without passing judgment on the wisdom of any such choices, it is quite clear that the tax law encourages certain types of economic activity or segments of the economy. For example, providing favorable treatment for research and development expenditures can be explained by the desire to foster technological progress. Under the tax law, these expenditures can be either deducted in the year incurred or capitalized and amortized over a period of 60 months or more. Given the time value of money, the tax savings from a current deduction usually is preferable to capitalizing the cost with a write-off over the estimated useful life of the asset created. If the asset developed has an indefinite useful life, no write-off would be available without the two options allowed by the tax law. Part of the tax law addresses the energy crisis—in terms of both our reliance on foreign oil and the need to ease the problem of climate change. For example, a tax credit is allowed for installation of solar and small wind energy equipment. In addition, tax credits are available to those who purchase new plug-in electric drive motor vehicles. Residential energy credits are allowed for home improvements that conserve energy or make its use more efficient (e.g., solar hot water and geothermal heat pumps). Ecological considerations justify a tax provision that permits a more rapid expensing of the costs of installing pollution control facilities. Measures such as these that aid in maintaining a clean air environment and conserving energy resources can also be justified under social considerations. Is it wise to stimulate U.S. exports of services? Along this line, Congress has deemed it advisable to establish incentives for U.S. citizens who accept employment overseas. Such persons receive generous tax breaks through special treatment of their foreign-source income. Is saving desirable for the economy? Saving leads to capital formation and thereby makes funds available to finance home construction and industrial expansion. The tax law encourages saving by according preferential treatment to private retirement plans. Besides contributions to Keogh (H.R. 10) plans and certain IRAs being deductible, income from the contributions accumulates free of tax. The encouragement of private-sector pension plans can also be justified under social considerations.

Exhibit 1.2 Formula for Federal Income Tax on Individuals

•Income (broadly conceived) •Less: Exclusions (income that is not subject to tax) -- •Gross income (income that is subject to tax) •Less: Certain deductions (usually referred to as deductions for adjusted gross income) -- •Adjusted gross income •Less: The greater of certain personal and employee deductions (usually referred to as itemized deductions) OR The standard deduction (including any additional standard deduction) •Less: Personal and dependency exemptions -- •Taxable income = •Tax on taxable income (see the Tax Tables and Tax Rate Schedules in Appendix A) •Less: Tax credits (including Federal income tax withheld and other prepayments of Federal income taxes) -- •Tax due (or refund)