CHAPTER 1
INTRODUCTION TO TAXATION
I.
What Constitutes a Tax
A. IRS Definition
1. Payment to a government authority that is required by law.
2. Payment is required pursuant to a legislative power to tax.
3. Purpose of the payment is to provide revenue for public
purposes.
4. No specific special benefits, services, or privileges are
received from paying the tax.
B. Examples of payments that are not taxes:
1. Licensing fees, tolls, fines, penalties, city charges for
water/sewer/garbage, special property assessments
C. Evaluating a Tax (is it "good" or "bad")
1. Equality - A taxed should be based on a Taxpayer’s ability to
pay the tax.
a. Horizontal Equity - Similarly situated taxpayers pay the
same amount of tax.
b. Vertical Equity - Taxpayers of different means are
treated differently, but fairly according to ability to pay.
Income Tax: Equality is attempted throughout many provisions of the
tax law. Low income taxpayers don't pay tax, various tax credits are
provided to low income taxpayers, and tax rates are progressive –
10%, 15%, 25%, 28%, 33%, 35%, and 39.6% as examples of attempts to
create equality.
Note: There are numerous provisions in the tax law that exclude items
from income or provide special treatment for deductions. These
provisions diminish equality in the system.
2. Certainty - Knowledge of when and how to pay the tax as well
ability to determine the amount to be paid.
Income Tax: Individual tax returns are due on April 15 every year. The
question of the ability to determine the amount of tax to pay is the
subject of much debate - most people think the tax is too complex.
3. Convenience - A tax should be levied as close to the time the
taxpayer receives the money to pay the tax as possible.
Income Tax: The income tax is based on a Pay-As-You-Go system
which requires employers to withheld estimates of tax owed to the
government. Taxpayers not subject to withholding are required to
make quarterly payments of estimated taxes.
4. Economy - compliance and administrative costs should be as
small as possible relative to the income generated.
Income Tax: IRS budget is 1/2 of 1% of revenue generated. The
question is: Is this the real cost of the income tax system?
II.
Structure of a Tax
A. Tax Liability = Tax Base X Tax Rate (schedule)
1. Tax Base - the value to be taxed
a. Some familiar bases - Sales Tax = Selling Price;
Property Tax = Assessed value of the property;
c. Federal Income Tax Base = TAXABLE INCOME
2. Tax Rates - Terminology
a. Marginal Tax Rate - The Tax Rate paid on the next dollar
to be taxed.
b. Average Tax Rate - The Total Tax Paid divided by the
Tax Base
c. Effective Tax Rate - The Total Tax Paid divided by the
sum of the Tax Base plus items exempted from the tax
base (economic income).
2014 Individual Tax Rate Schedules: See front cover of text
3. Rate Structures - Focus on how MR changes with respect to AR
a. Proportional - One rate is applied to all base levels
MTR = ATR > ETR
1. Sales Taxes, Excise Taxes, Property Taxes, Social
Security Taxes, Unemployment Taxes are Proportional
b. Regressive - The tax rate decreases as the tax base increases
MTR < ATR < ETR
1. There are no regressive taxes in the United States as defined.
However, if the comparison is changed from the tax base to
the taxpayer's income, then most proportional taxes are
regressive - i.e. low income taxpayers pay a higher proportion
of their income in sales taxes, social security taxes, etc.
c. Progressive - The tax rate increases as the tax base increases
MTR > ATR > ETR
1. The federal income tax is progressive (as defined), see Tax
Rate Schedules
III.
Taxes in the United States
A. Income Taxes
1. Federal
2. State
3. Local
B. Sales Tax
C. Property Tax
1. Real Property
2. Personal Property
D. Employment Taxes (SEE TABLE 1-1 on Page 13)
1. Social Security - The employee pays a tax on wages and
salaries earned which is matched by the employer. One part
of the tax (OASDI) is paid up to a pre-determined base
amount. MHI Paid on all wages.
2. Self-Employment Tax - Individuals who are not employees
pay the equivalent of the employee and employer rate (i.e.,
they pay twice the Social Security rate: 12.4% and 2.9%) on
the same pre-determined base on self-employment earnings.
i.e. a self-employed individual is considered to be both an
employee and an employer with regard to Social Security
Taxes.
E. Excise Taxes
F. Transfer Taxes
1. Gift Tax - A Tax is paid (by the donor) on the value of gifts
made.
a. $14,000 per person per year exclusion
b. Lifetime Unified Estate and Gift Tax Credit - Allows the
exclusion of $5,340,000 of gifts and property subject to
estate tax.
2. Estate Tax - A Tax paid on the value of assets held at death
a. Unlimited Marital Exclusion
b. Lifetime Unified Estate and Gift Tax Credit
IV. What is the "Tax Law"?
A. Three Primary Sources
1. Statutory/Legislative - Congress/President
a. Constitution - 16th Amendment
b. Internal Revenue Code of 1986*
2. Administrative - Treasury Dept/Internal Revenue Service
a. Regulations*
b. Revenue Rulings
c. Letter Rulings
d. Various Other Official/ Unofficial Informational Publications
3. Judicial - Courts
a. Trial Courts - District Court; Tax Court; Claims Court
b. Appellate Courts - By Circuit of the taxpayer
c. Supreme Court*
B. Why does the Tax Law Change?
1. Economic Reasons
2. Social Reasons
3. Political Reasons
IV. Income Tax Terminology
A. Tax Formula
Less:
Equals
Less:
Equals
X
Equals
Less:
Equals
Less:
Equals
All Income - Broadly defined
Exclusions
Gross Income
Deductions
Exemptions
Taxable Income
Tax Rate Schedule
Income Tax on Taxable Income
Tax Credits
Income Tax Liability
Tax Prepayments - Withholding/Estimated Tax
Tax Due (Refund)
B. Components of Tax Formula
1. Income - Any amounts received during the period
a. Ordinary Income
b. Capital Gains
2. Exclusions - Amounts of income received that are specifically
excluded from taxation. Amounts excluded are never subject
to tax.
a. Deferrals - Amounts received in the current period are
not taxed in the current period, but are to be taxed at
some point in the future. i.e. the income is excluded
from current taxation, but not permanently as
exclusions are.
3. Deductions - Amounts that the tax law specifically allows as a
reduction in taxable income.
a. Expenses
b. Losses
4. Exemptions - a pre-determined amount which an income tax
entity is always allowed to deduct. The most common exemption
is for individual taxpayers and their dependents. However,
estates and trusts also are allowed exemption deductions.
5. Income Tax Rates - See Rate Schedules - Appendix B
a. The federal income tax is a 7 rate structure – 10%, 15%,
25%, 28%, 33%, 35%, 39.6%. However, note that the
structure is adjusted by the filing status of the taxpayer.
6. Tax Credits - Direct reductions in the tax liability for entering
into certain types of transactions.
a. Value of a Tax Credit v. Deduction (Exclusion)
7. Filing Returns - All tax entities must file an annual return.
a. Due Dates - 15th day of 4th month following close of the
entity's tax year (Corporations - 15th day of 3rd month).
1. Can apply for automatic extensions (6 months for
individuals, 6 months for corporations).
2. Estimate of tax due must be paid with extension.
b. Statute of limitations - time period during which taxpayers &
IRS can correct errors on returns. General limit is 3 years. Period
is for 6 years when omission of gross income is greater than
25%. No statute of limitations for returns with criminal fraud.
c. Taxpayers correct errors by filing amended returns. Not used
to adjust items - only used when income or deduction was
improperly treated on a filed return.
VI. Individual Tax Formula: See Exhibit 1-3 on page 26 of the text
STANDARD DEDUCTION:
SINGLE
MARRIED
2013
$6,100
$12,200
2014
$ 6,200
$12,400
EXEMPTION AMOUNT:
$3,900
$ 3,950
VII. Tax Planning
A. Shifting income/deductions to provide the greatest after-tax
return.
1. Main considerations
a. Marginal Tax Rates - What rate of tax will be paid
on the income (saved on the deduction)
b. Time Value of Money - a dollar today is worth more
than a dollar one year (or more) from today
2. Some Rules of Thumb
a. Defer recognition of Income
b. Accelerate recognition of Deductions
c. Put income into the year with the lowest MTR
d. Put deductions into the year with the highest MTR
e. If there is a conflict between 1/2 and 3/4, then
calculate to determine the best course of action
B. Income Splitting
1. Taking advantage of the progressive nature of the tax
rate structure by allocating income into other tax entities to
achieve lower overall marginal and effective tax rates on
the same amount of income
VIII. Tax Avoidance v. Tax Evasion
A. Avoidance - Using legal means to reduce your income tax (i.e.
tax planning is tax avoidance)
B. Evasion - Using illegal means (fraudulent or deceptive
behavior) to reduce your tax
1. Willfulness to enter into the evasion - the taxpayer
knows (or should know) that what they are doing is illegal
2. A resulting underpayment of tax
3. An affirmative action to evade
a Unintentional mistakes & math errors are not evasion