Chapter 1
Federal Income Tax – An Overview
Murphy & Higgins
Concepts in Federal Taxation, 2014 edition
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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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What is the Purpose of a Tax?

Revenue

Social changes

Economic changes

Equity

Not a Penalty
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Standards of a Good Tax System
Adam Smith’s Four Criteria (slide 1 of 5)
 Equality
 Certainty
 Convenience
 Economy
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Adam Smith’s First Criterion
(slide 2 of 5)

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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Adam Smith’s Second Criterion
(slide 3 of 5)

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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Adam Smith’s Third Criterion
(slide 4 of 5)

Convenience

Tax should be levied when the taxpayer has
funds available to pay
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Adam Smith’s Fourth Criterion
(slide 5 of 5)

Economy

The costs of complying with the tax system
should be minimal
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Tax Computation
Tax = Tax Base × Tax Rate
the value subject to taxation
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Tax Rates for Income Tax

Marginal Tax Rate: The rate of tax on the
next dollar of taxable income

Average Tax Rate: The rate equal to the
total tax divided by the tax base

Effective Tax Rate: The rate equal to the
total tax divided by economic income
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Tax Structures: Proportional
(slide 1 of 3)
Average tax rate
remains the same
as tax base increases
tax rate
Proportional
average rate
tax base
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Tax Structures: Regressive
(slide 2 of 3)
Average tax rate
decreases as
tax base increases
tax rate
Regressive
tax base
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Tax Structures: Progressive
(slide 3 of 3)
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

Employment Tax

Sales Tax

Property Tax

Excise Tax

Wealth Transfer Tax

Health Care Related
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Income Taxes

Taxes are paid by individuals, corporations,
estates, and trusts

Tax base is total income less allowed
deductions
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Employment Taxes

Taxes are paid by employees, employers, and
self-employed taxpayer

Tax base is wages and salaries earned

Two major types
 Social Security Taxes
 Unemployment Taxes
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Sales Taxes

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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Property Taxes

Taxes are paid by owners of property

Real property is land and any structures that
are permanently attached to it (buildings)

All other types of property are personal
property

Tax base is the assessed value of real or
personal property (ad valorem)
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Excise Taxes
 Taxes
are paid by purchasers
 Tax
base is the quantity purchased
and not the value of the purchase
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Wealth Transfer Taxes
Taxes are paid by entity transferring property
 Tax base is the value of the property
transferred
 Transfers to spouses and charities are
excluded
 For 2013, Unified Credit excludes up to
$5.25M in property from gift and/or estate
tax otherwise excluded
 Donors may exclude annual gifts of
$14,000 per donee

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Health Care Related Taxes

For Higher Income Workers

0.9% Hospital Insurance applied to



Wages in excess of threshold amounts
Net self-employment income in excess of threshold
amounts
Surtax on Unearned Income


3.8% Medicare contribution tax on unearned income
of individual, estates and trusts
For individuals imposed on lesser of
 net investment income or
 Modified AGI in excess of threshold amount
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Sources of Federal Income Tax Law

Legislative
 Law (Internal Revenue Code)

Administrative
 Treasury Regulations
 IRS Pronouncements

Judicial
 Supreme Court
 Other courts
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Tax formula
Broadly defined income
Includes all forms of
income (Ch 3)
minus:
Exclusions
Income specifically
excluded from
income by legislative
grace (Ch 4)
equals:
Gross Income
Income to be reported
Deductions
Amounts specifically
allowed as
subtractions (Chs 5-7)
minus:
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Some Deduction Examples

Expenses (Chapters 5 & 6)


Losses (Chapter 7)



Current period expenditures incurred in order to earn
income
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 ($3,800 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: Tax Due
times:
equals:
minus:
equals:
Taxable Income
Tax Rate
Income Tax Liability
Prepayments & Credits
Tax or (Refund) due
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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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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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Audit and Appeals Process

Types of examinations

Correspondence examinations

Office examinations

Field examinations
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Audit and Appeals Process

Settlement Procedure

Report of outcome of audit

Waiver of assessment (Form 870)

30-day letter
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Audit and Appeals Process

Appeals

Meeting with IRS Appeals Division

90-day letter
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Tax Planning

Goal is to maximize after-tax wealth

Considers the Time Value of money



Defer income
Accelerate deductions
Considers Marginal tax rates



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 Avoidance v. 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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