Chapter 1
Federal Income Taxation An Overview
Kevin Murphy
Mark Higgins
©2008 South-Western
What is the Definition of a Tax?
 An enforced, involuntary contribution
 Required and determined by law
 Providing revenue for public and
governmental purposes
 For which no specific benefits or
services are received
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Standards of a Good Tax System
Adam Smith’s Four Criteria
Equality
Tax should be based on the taxpayer’s
ability to pay
Horizontal Equity: Two similarly situated
taxpayers are taxed the same
Vertical Equity: Differently situated taxpayers
are taxed differently but fairly
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Standards of a Good Tax System
Adam Smith’s Four Criteria
Equality
Certainty
When and how a tax is to be paid should
be known to the taxpayer
The taxpayer should be able to determine
the amount of the tax
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Filing Requirements
 Return must be filed annually
 Calendar-year individuals file and pay
on or before the 15th day of April
May receive an extension of time to file but
not time to pay
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Standards of a Good Tax System
Adam Smith’s Four Criteria
Equality
Certainty
Convenience
Tax should be levied when the taxpayer
has funds available to pay
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Standards of a Good Tax System
Adam Smith’s Four Criteria
Equality
Certainty
Convenience
Economy
The costs of complying with the tax system
should be minimal
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Tax Computation
Tax = Tax Base X Tax Rate
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Tax Computation
Tax = Tax Base X Tax Rate
the value subject to taxation
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Tax Rates for Income Tax
• Marginal Tax Rate is the rate of tax on
the next dollar of taxable income
• Average Tax Rate is the rate equal to
the total tax divided by the tax base
• Effective Tax Rate is the rate equal to
the total tax divided by economic
income
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Tax Structures
average tax rate
remains the same
as tax base increases
tax rate
Proportional
average rate
tax base
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Tax Structures
average tax rate
decreases as
tax base increases
tax rate
Regressive
tax base
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Tax Structures
average tax rate
increases as
tax base increases
tax rate
Progressive
tax base
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Major Types of U.S. Taxes
Employment
Corporate
Income
Individual
Income
Total Taxes
Property
Sales
All Others
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Types of U.S. Taxes
 Income Tax
Taxes are paid by individuals, corporations,
estates, and trusts
Tax base is total income less allowed
reductions
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Types of U.S. Taxes
 Employment Tax
Taxes are paid by employees, employers,
and self-employed taxpayer
Tax base is wages and salaries earned
Two major types
Social Security
Unemployment
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Types of U.S. Taxes
 Sales Tax
Taxes are paid by purchasers of goods and
services
Tax base is the selling price of a product or
a service
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Types of U.S. Taxes
 Property Tax
Taxes are paid by owners of property
Tax base is the assessed value of real or
personal property (ad valorem)
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Types of U.S. Taxes
 Excise Tax
Taxes are paid by purchasers
Tax base is the quantity purchased and not
the value of the purchase
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Types of U.S. Taxes
 Wealth Transfer Tax
Taxes are paid by entity transferring
property
Tax base is the value of the property
transferred
Transfers to spouses and charities are
excluded
Lifetime Unified Credit excludes up to $2M in
2007
Donors may exclude annual gifts of $12,000
per donee
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Tax Formula
Broadly defined income
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Includes
all forms of
income
(Chapter 3)
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Tax Formula
Broadly defined income
minus:
Exclusions
Income
specifically
excluded from
income by
legislative grace
(Chapter 4)
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Tax Formula
minus:
equals:
Broadly defined income
Exclusions
Gross Income
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Income to be
Reported
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Tax Formula
minus:
equals:
minus:
Broadly defined income
Exclusions
Gross Income
Deductions
Amounts
specifically
allowed as
subtractions
(Chapters 5 - 7)
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Some Deduction Examples
 Expenses (Chapters 5 & 6)
 Current period expenditures incurred in order to earn income
 Losses (Chapter 7)
 Transaction losses result when an asset is disposed of at a
price less than its tax cost
 Annual losses result when allowed deductions exceed
income
 Exemptions (Chapter 8)
 A minimum amount of income needed for basic living
 Personal and dependency ($3,400 each)
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Deduction Types
minus:
Gross Income
For Deductions
 not restricted based on taxpayer’s income
 generally trade, business, rent or royalty expenses
minus:
From Deductions
restricted based on Adjusted Gross Income
generally personal expenses
–Itemized, or
–standard amount (changes with filing status)
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Tax Formula
Adjusted Gross Income
Gross Income
minus: For Deductions
equals: Adjusted Gross Income [AGI]
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Tax Formula
Taxable Income
Gross Income
minus: For Deductions
equals: Adjusted Gross Income [AGI]
minus: From Deductions and Exemptions
Taxable Income
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Tax Formula
The Tax
times:
equals:
minus:
equals:
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Taxable Income
Tax Rate
Income Tax Liability
Prepayments & Credits
Tax or (Refund) due
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Audit and Appeals Process
Statute of Limitations
 Three years from filing date
 Extends to six years if income is underreported by 25% of gross income
 No limitation for fraud or if no return is
filed
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Audit and Appeals Process
Selection for Audit
 Only about 2% of returns are
audited
 Procedures used
Discriminant Function System
Taxpayer Compliance Measurement
Program
Document perfection & Information
matching
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Tax Planning
Goal is to maximize after-tax wealth
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Tax Planning
Timing
 Time Value of money
 Defer income
 Accelerate deductions
 Marginal tax rate
 Recognize income in year of lower marginal rate
 Recognize deductions in year of higher marginal
rate
 Shift income to taxpayer with lower marginal rate
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Tax Planning
Tax Avoidance Vs. Tax Evasion
 Tax Avoidance - Taxpayers have no
obligation to pay more tax than the law
requires
 Tax Evasion - Taxpayers may not use
fraudulent or deceptive behavior to hide
tax liability
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Ethics
 Preparers are subject to penalties for
negligence and fraud
 Ethical Standards
IRS Circular 230
AICPA’s Code of Professional Conduct
AICPA’s Statements on Standards for Tax
Services
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