Chapter 1
Introduction to
Taxation, the Income
Tax Formula, and Form
1040EZ
“Taxes, after all, are dues that we pay for
the privileges of membership in an
organized society.”
-- Franklin D. Roosevelt
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Introduction
• An income tax was first enacted in 1861
and repealed after the Civil War ended
• An income tax law was passed in 1894
and was rejected by the Supreme Court
in 1895.
• Sixteenth Amendment to the
Constitution was passed in 1913
– This is the basis of modern income tax law
1-2
Introduction
• Almost 145 million individual income tax
returns were filed in 2012
– 122 million (over 84%) were filed
electronically
• Individual income tax collections were
about $1.2 trillion in 2012.
1-3
LO #1 Progressive, proportional, and
regressive tax structures
• Taxes are levied by multiplying a tax
rate (the rate of tax) by a tax base (the
amount taxed).
– May be multiple rates on multiple bases
(see Table 1-2 for married taxpayers)
1-4
LO #1 Progressive, proportional, and
regressive tax structures
• Progressive tax structure:
– The tax rate increases as the tax base
increases.
– Example is the U.S. income tax system
• Proportional tax structure:
– The tax rate remains the same regardless
of the tax base.
– Example is state or local sales taxes
1-5
LO #1 Progressive, proportional, and
regressive tax structures
• Regressive tax structure:
– The tax rate decreases as the tax base
increases.
– Example is social security tax system
1-6
LO #1 Progressive, proportional, and
regressive tax structures – Concept Check 1-1
1. The three types of tax rate structures are ________,
_________, and _________.
Progressive, proportional, and regressive
2. The tax rate structure for which the tax rate remains
the same for all levels of the tax base is the
__________ rate structure.
Proportional
3. The federal income tax system is an example of a
________ tax structure.
Progressive
1-7
LO # 2 Marginal and Average Tax
Rates
• Average tax rate is the total tax paid on
a certain amount of taxable income
Total tax / taxable income = average tax rate
• Marginal tax rates are the rate of tax that
will be paid on the next dollar of income.
– Determined with reference to tax rate
schedule
– For example, a married couple will pay a
marginal rate of 15% on their $35,000th
dollar of income.
1-8
LO # 2 The Income Tax Formula
Income
− Permitted Deductions from Income
-------------------------------= Taxable Income
× Appropriate Tax Rates
-------------------------------= Tax Liability
− Tax Payments and Tax Credits
--------------------------------= Tax Refund or Tax Due with Return
1-9
LO # 2 The Income Tax Formula
Concept Check 1-2
1. The marginal tax rate is the rate of tax
imposed on the next dollar of taxable
income.
True
2. What is the marginal tax rate for a
married couple with taxable income of
$75,350?
25%
1-10
LO # 2 The Income Tax Formula
Concept Check 1-2
3. Average tax rate and marginal tax rate
mean the same thing.
False
4. Complex tax returns do not follow the
basic (or simplified) income tax formula.
False
1-11
LO #3 Components of Form 1040EZ
• Taxpayers annually file a tax return
using
– Form 1040
– Form 1040A
– Form 1040EZ
• All follow the basic income tax formula
• Form 1040EZ is the simplest form
1-12
LO #3 Components of Form 1040EZ
• To use a 1040EZ taxpayer must meet all
the following:
– Single or married filing jointly
– Under age 65 and not blind
– No dependents
– Taxable income < $100,000
– Income only from wages, unemployment
compensation or interest ≤ $1,500
– Claim no credits except Earned Income
Credit
1-13
LO #3 Components of Form 1040EZ
Concept Check 1-3
1. Almost all taxpayers can file a Form 1040EZ.
False
2. Max, who is 74 years old and single, is
eligible to file Form 1040EZ if his taxable
income is under $100,000.
False
3. Erma, a 28-year-old single taxpayer with no
dependents, has wage income of $40,000.
She is eligible to file a Form 1040EZ.
True
1-14
LO #3 Components of Form 1040EZ
• Wages include salaries, tips,
commissions, bonuses, severance pay,
sick pay, meals and lodging, fringe
benefits, etc.
– Employees receive a Form W-2 indicating
total wage income in box 1
• Interest income is taxable unless
specifically exempt
– Interest income reported on Form 1099-INT
1-15
LO #3 Components of Form 1040EZ
• Unemployment compensation is taxable
– Reported on Form 1099-G
• Permitted deductions are shown on line
5
– $10,150 for single, $20,300 for married
• Total income minus permitted
deductions equals Taxable Income (line
6)
1-16
LO #3 Components of Form 1040EZ
Concept Check 1-4
1. Only certain types of income can be reported
on a Form 1040EZ. They are ________.
Wages, unemployment compensation, interest
2. Unemployment compensation is reported to
the taxpayer on a Form ______.
Form 1099-G
3. To be able to use a Form 1040EZ, a
taxpayer must either be filing status
_______ or filing status __________.
Married filing jointly or single
1-17
LO #4 Calculation of Tax
• For taxable income up to $100,000, use
tax tables (printed in Appendix D and in
the instructions to Form 1040, available
on the IRS website)
• Tax rate schedules are used for higher
income (printed on inside front cover)
• Tax tables calculate tax at the midpoint
of the range on the table
• Tax rate schedules calculate tax
precisely
1-18
LO #4 Calculation of Tax
Concept Check 1-5
1. Taxpayers eligible to use Form 1040EZ must
calculate their tax liability using the tax tables.
True
2. Refer to the tax tables. What is the tax liability of a
married couple with taxable income of $89,262?
$14,031
3. Using the tax rate schedule in Table 1-2, determine
the tax liability (to the nearest penny) for a married
couple with taxable income of $89,262.
$14,028.00
1-19
LO #3 Tax Payments
• Tax liability is generally paid throughout
the year through withholding tax
payments deducted from wages
– Also reported on W-2
• Low income taxpayers may be eligible
for the Earned Income Credit
– Discussed in chapter 9 with other credits
1-20
LO #3 Tax Payments
• A tax return is also used to “settle up”
with the IRS at the end of the year.
• When filing a tax return, taxpayers will
either
– Owe the IRS (tax liability > payments)
– Receive a refund (tax liability < payments)
1-21
LO #3 Tax Payments
Concept Check 1-6
1. Taxpayers pay all of their tax liability when they file
their tax returns.
False
2. Bret’s tax liability is $15,759. His employer withheld
$16,367 from his wages. When Bret files his tax
return, will he be required to pay or will he get a
refund? What will be the amount of payment or
refund?
Refund, $608
3. An Earned Income Credit will increase the amount of
tax liability.
False
1-22
LO #5 Tax Authority
• Tax authority is the body of law,
regulation, and precedent that guide
taxpayers, the IRS, and the courts in the
proper application of tax law.
• Three types of primary tax authority:
– Statutory sources
– Administrative sources
– Judicial sources
1-23
LO #5 Tax Authority
• Statutory sources of tax authority
– 16th amendment to the U.S. Constitution
– Internal Revenue Code (IRC)
• Passed by Congress and signed into law by the
president
– Committee reports from tax law process
1-24
LO #5 Tax Authority
Concept Check 1-7
1. The committee charged with
considering tax legislation in the House
of Representatives is called the
________________ Committee.
Ways and Means
2. The most commonly relied-on statutory
authority is _________________.
The Internal Revenue Code
1-25
LO #5 Tax Authority
Concept Check 1-7
3. All tax legislation must pass both the
House of Representatives and the
Senate and be signed by the president
of the United States in order to become
law.
True
1-26
LO #5 Tax Authority
• Administrative sources of tax authority,
in order of strength
– Treasury Regulations (IRS Regulations)
– Revenue Rulings
– Revenue Procedures
– Private Letter Rulings
– IRS Notices
1-27
LO #5 Tax Authority
Concept Check 1-8
1. Administrative tax authority takes precedence
over statutory tax authority.
False
2. IRS Revenue Procedures are applicable only
to the taxpayer to whom issued.
False
3. The administrative tax authority with the most
strength of authority is_______.
IRS Treasury Regulations
1-28
LO #5 Tax Authority
• Judicial sources of tax authority
– Courts resolve disputes between taxpayers
and the IRS.
– Initial court of jurisdiction is either the
• Tax Court
• U.S. District Court
• U.S. Court of Federal Claims
1-29
LO #5 Tax Authority
• Tax Court and District Court rulings can
be appealed to the U.S. Court of
Appeals and then to the Supreme Court
• U.S. Court of Federal Claims rulings can
be appealed to the U.S. Court of
Appeals – Federal Claims and then to
the Supreme Court.
1-30
LO #5 Tax Authority
Concept Check 1-9
1. The U.S. Supreme Court does not accept
appeals of tax cases.
False
2. A taxpayer who does not agree with an
assessment of tax by the IRS has no
recourse.
False
3. A taxpayer who does not want to pay the tax
assessed by the IRS prior to filing a legal
proceeding must use the ___________ Court.
Tax
1-31
LO #6 Circular 230
• Circular 230 sets forth rules which must
be followed by all paid tax preparers
– Includes CPA’s, attorneys, enrolled agents,
and any other individual who receives
compensation for preparing a tax return,
providing tax advice, or practicing before
the IRS
• Circular 230 sets forth ethical standards
and expectations.
1-32
LO #6 Circular 230
• Failure to comply with Circular 230 will
subject the paid preparer to suspension
or disbarment from IRS practice, public
censure, fines, and civil or criminal
penalty.
• Rules are far reaching and complex.
1-33
LO #6 Circular 230
• Paid tax preparers must obtain a
preparer tax identification number
(PTIN).
– Must be renewed annually.
• Preparers who are not CPAs, attorneys,
or enrolled agents must pass a
competency exam and annually obtain
continuing education.
– CPAs, attorneys, and enrolled agents must
also obtain continuing education.
1-34
LO #6 Circular 230
• Paid preparers must:
– Sign all tax returns they prepare
– Provide a copy to clients
– Return records to clients
– Exercise due diligence and best practices
– Disclose nonfrivolous tax positions
– Notify clients of errors on a client return
– Provide information to the IRS
– Inform a client if the client made an error
1-35
LO #6 Circular 230
• Paid preparers must NOT:
– Take a position unless it has a “realistic
possibility” of being sustained
– Charge a contingent fee
– Charge an unconscionable fee
– Unreasonably delay matters with IRS
– Cash an IRS check for a client
– Represent a client if a conflict of interest
exists
– Make false or fraudulent statements
1-36