Federal Income Tax Test 1

Average Tax Rate

(Tax Liability/Taxable Income)

Effective Tax Rate

(Tax Liability/Total Income)

State & Local Use Tax Imposed on

- Manufacturers that purchased items for their own use under their sales tax exemption - Consumers who purchased items for their own use in a state outside their home state (ex: car)

Adam Smith's Canons of a "Good Tax"

- Sufficiency - Equity (fairness) - Certainty - Convenience - Economy (efficiency)

Methods of selecting tax return for an audit

- document matching/information perfection system - discriminant function system - national research program

Statutory Notice of Deficiency

- gives the taxpayer 90 days to either agree to the assessment of additional tax liability with penalties and interest or file a petition in tax court - court gets involved in writing tax law when an audit cannot be resolved within the IRS - identifies one court that may be used to contest an assessment of an additional tax from an audit, but there are three courts of original jurisdiction for tax cases

Exceptions to three-year rule

- if taxpayer failed to report more than 25% of gross income, then it expands to 6 years from the filing date, or the due date if it was filed early - if tax payer fails to file a return then the statute of limitations never starts running and then time to select taxpayer for an audit is unlimited

Federal Unemployment Tax (employers only)

.8% (.008) average on the first $7,000 of wages/employee/year

Self-Employment Tax (additional medicare)

.9% (.009) in excess of $200,000 (unmarried) or $250,000 (married)

Employee FICA Tax (additional medicare)

.9% (.009) on wages in excess of $200,000 (unmarried) or $250,000 (married)

Failure to pay penalty

0.5% per month of unpaid tax liability up to 25%

Sources of Tax law issued by IRS

1. Regulations 2. Revenue Rulings 3. Revenue Procedures 4. Private Letter Rulings 5. Technical Advice Memoranda 6. Information Releases 7. Notices/Announcements

Employee FICA Tax (medicare)

1.45% on all wages

Employer FICA Tax (medicare)

1.45% on all wages

Self-Employment Tax (social security)

12.4% on the first $160,200 of net self-employment income

Self-Employment Tax (medicare)

2.9% on all net self-employment income

Failure to file penalty

5% per month of unpaid tax liability up to 25%

State Unemployment Tax (employers only)

5.4% average on the first $7,000 of wages/employee/year

State Income Taxes

50 different jurisdictions with 50 different variations

Employee FICA Tax (social security)

6.2% on the first $160,200 of wages

Employer FICA Tax (social security)

6.2% on the first $160,200 of wages

Explicit tax rate on municipal bond

ALWAYS 0

Announcements and Notices citation

Announcement or Notice year-number, year-(1 or 2) CB page number

After Tax Rate of Return

Before tax return * (1 - marginal tax rate(for municipal that is 0))

Basic Federal Estate Tax Formula

FMV All assets owned on date of death (Debts owed on date of death) (Unlimited Marital deduction) (Unlimited charitable deduction) = Net Taxable Estate (Must exceed unified credit amount for the estate to be taxable)

Information Releases Citation

I.R. 2 num year, # within yr

General IRC Citation

IRC §(section number) subsection (a,b,c) paragraph (1,2,3) subparagraph (A,B,C) clauses (i,ii,iii)

Information Releases

IRS uses information releases to disseminate information to the general public like a press release

Gift Tax (Federal Transfer Tax)

Inter vivos transfers, tax on the value of the property transferred from one to another

Explicit Tax on corporate bond

Investment amount(before tax rate of return) = earned earned (marginal tax rate) = explicit tax on corporate bond

Examples of Non-Taxable Income

Municipal Bond Interest and Gifts

Private Letter Rulings Citation

PLR YEAR,WEEK, 0 NUMBER WITHIN WEEK (no spaces), date on letter to taxpayer who requested - might start with Ltr. Rul.

Proposed Regulations citation

Prop. Reg. §1.(IRC section number)(a,b,c)

FInal Regulations Citation

Reg. §1.(IRC section number) (a,b,c)

Revenue Procedures Citation

Rev. Proc. (full year (last 2 num before 2000))-number, (full year)-(1 or 2) CB (page number)

Revenue Rulings Citation

Rev. Rul. (yr - full after 200)-(number within year), (year - full after 2000)-(1 or 2 for cumulative bulletin issue) (CB) (page number) - might say IRB and number instead of CB - IRB issued weekly

Technical Advice Memoranda Citation

TAM YEAR,WEEK, 0 NUMBER WITHIN WEEK (no spaces), date

Macro Level Efficiency Example

Tax laws

Estate Tax (Federal Transfer Tax)

Tax on the value of transfers of property upon the death of a taxpayer

Total Income

Taxable + Non-Taxable Income

Temporary Regulations Citation

Temp. Reg. §1.(section number) (a,b,c)

Judicial (Court)

adjudicates disputes between IRS and taxpayers in the application of the law

Federal Excise Taxes (Transaction Taxes)

alcohol, tobacco, firearms, gasoline, telephone, and tanning beds

IRS Audit

an examination of a taxpayer's tax return and supporting documentation - burden of proof is on taxpayer to prove they are right

Regressive Tax System

as the tax base increases, the tax rate decreases (ex: social security tax)

Progressive Tax System

as the tax base increases, the tax rate increases (ex: individual income tax)

Proportional Tax System

as the tax base increases, the tax rate remains constant (Flat Tax) (ex: sales tax)

Static forecasting (sufficiency)

assumes no change in taxpayer's behavior in response to a change in the tax rate

Dynamic forecasting (sufficiency)

assumes taxpayers will alter their behavior in one of two ways in response to a change in the tax rate

Executive (Treasury Dept/IRS)

carries out tax law

IRS Duties

collect taxes, conduct audits, criminal investigation division

Marginal Tax Rate of $1

determined from the rate in the tax table (UNLESS that one dollar pushes the person into the next bracket it is the same as the one applied)

Proposed Regulations

drafts issued for public comment; not authoritative

Income effect

dynamic forecasting behavioral response, taxpayers will increase their work/effort or other income-producing activities to overcome an increase in the tax rate

Substitution effect

dynamic forecasting behavioral response, taxpayers will seek out lower tax or non-tax alternatives to avoid an increase in the tax rate

Employee FICA Tax payment method

employer withholding

Legislative (congress)

empowered to write tax law

State Property Tax - Ad valorem (Personalty)

everything else

Regulation

explains/interprets the IRC (definition of terms, numerical example etc)

Field Exam

for large corporations, an IRS agent practically moves in with them for a period of time to complete their examination.

Temporary Regulations

have the full effect of law for a limited time period (ex: natural disaster, changing due date of return)

FInal Regulations

have the full effect of the law - the next best support to IRC code section in an audit with the IRS (IRS will accept because they wrote it)

Implicit Taxes

hidden costs created from tax preferences - measured using the difference between the before tax rates of return of the taxable and tax preferred options (ex: municipal taxes) (before tax rate of return for the taxable item - before tax rate of return on the tax preferred item)

National research program

how did you get it right, how did they get it wrong (ex: tip income)

Technical Advice Memoranda (TAM)

interpretive pronoucements issued by the IRS at the request of a revenue agent, tecnhical advice memoranda arise from audits when a revenue agent encounters an issue that requires guidance - can be used pre-audit to get an idea of what agent might do or if they are applying the law fairly

Revenue Procedures

interpretive pronouncements based on administrative or compliance issues, describes how the IRS will resolve the issue (authoritative if you have the issue) (ex: due dates of returns, how to file an election, how to revoke an election)

Private Letter Rulings (Letter Rulings)

interpretive pronouncements issued by the IRS at the request of a taxpayer, intially, these rulings were issued based on a proposed transaction, in recent years, IRS has expanded this program to include things like missed deadlines for elections or missed rollover dates for retirement funds - must be gray area of law, meaningful enough to pay application fee - by applying you are legally bound to following the ruling - used to avoid audit, weigh if its worth it - cannot apply someone else's PLR to your own situation

Revenue Rulings

interpretive pronouncements issued by the IRS based on a factual scenario, the revenue rulings describes the application of the law to a factual scenario - authoritative to taxpayers with the same factual circumstances

State Property Tax - Ad valorem (Realty)

land, buildings, and all permanent improvements to land

Title 26 (Internal Revenue Code)

laws dealing with tax passed by congress are codified, 26 is a volume number referring to a physical book

Statute of Limitations

length of time that the IRS has to select a tax return for audit - generally: three years from the filing date of the return or the due date of the return, if it was filed early (due date: April 15)

Micro Level Efficiency Example

manage IRS budget

Document matching/information perfection system

match docs from third party (like employer) (ex: form W-2, form 1099) answer required questions

Office/Desk Audit

might be international, too many records for correspondence or used as a strategy (don't give person time to get their story together), invite person to IRS office - only done when necessary

Economy (Efficiency)

minimize the administrative cost (minimize distortive tax behaviors and monitor the cost-benefit of tax administration)

Convenience

minimize the compliance cost for taxpayers

Criminal fraud

monetary penalties and could include incarceration

Correspondence Exam (audit)

never initiated by phone call or email, will come to an address on the tax return, under audit, must identify particular issue (95% of all audits)

Certainty

predictability with respect to how and when to file a tax return, calculating the amount of tax due

Self-Employment Tax Payment mechanism

quarterly estimated payments

Negligence

reckless disregard for the law - 20% of the unpaid tax liability attributable to negligence

Discriminant Function System (DIF)

returns put into peer groups, compare return to peers to detect under-reported income and over-reported expenses, decide who will be selected for an audit based on issues - IRS agents will not select returns in their own area

Self-Employment Tax (Self-employed/independent contractors)

social security, medicare, and additional medicare

Employees/Employers FICA Taxes

social security, medicare, and additional medicare (employees only)

Implicit tax on municipal or corporate bond

subtract the before tax rates (opportunity cost)

Revenue Agent Report (RAR)

summarizes the results of an audit, if the RAR denies deductions or includes income not reported on the originally filed tax return, the taxpayer will owe additional tax liability and penalties and interest accruing from the orginal due date of the return

Federal Employment Tax

tax on work/effort (two types of workers: employees and self-employed/independent contractors)

Explicit Taxes

taxes actually paid for by taxpayers

Who has to file a return?

taxpayers with a positive taxable income must file a tax return, however the penalty for not filing is not tied to taxable income but rather the unpaid tax liability

Vertical equity

taxpayers with dissimilar circumstances pay different amounts of tax

Horizontal equity

taxpayers with similar circumstances pay similar amounts of tax

Marginal Tax Rate

the rate that applies to the next dollar(s) of income or deduction (Change in tax liability/Change in taxable income)

US District Courts

there is a trial by jury, judge is a generalist, taxpayer must pay the disputed tax and then sue the IRS for a refund - must pay to start case (typically used for emotion based cases)

US Federal Claims

there is no jury, judge is a generalist, tax payer must pay disputed tax and then sue IRS for a refund (usually used for cases that aren't particularly technical or emotional)

Tax court

there is no jury, judge is a tax expert, taxpayer does not have to pay the disputed tax to start the case - regular decisions: the first hearing of an issue by the court - memo decisions: shorter opinions issued when the court has already ruled on an issue - if you lose, pay penalties and interest accrued (typically used for technical cases)

Announcements and Notices

these sources of tax law are similar to information releases except they are written for tax practitioners

State and Local Sales Tax (Transaction Tax)

transaction tax on the value of retail goods/services

Civil fraud

willful disregard for the law - 75% of the unpaid tax liability attributable to fraud