Chapter 1
An Introduction to Taxation and
Understanding the Federal Tax Law
Individual Income Taxes
Copyright ©2010 Cengage Learning
Individual Income Taxes
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History of Taxation (slide 1 of 2)
• Prior to 1900s income tax financed wars
– 1861: First Federal individual income tax
enacted
• Repealed after Civil War
– 1894: New Federal individual income tax
enacted
• Tax found to be unconstitutional
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History of Taxation
(slide 2 of 2)
• Other important events
– 1909: First Federal corporate income tax
enacted
– 1913: 16th Amendment ratified
• Sanctioned both Federal individual and
corporate income taxes
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Federal Budget Receipts—2009
Individual income taxes
Corporation income taxes
Social insurance taxes and contributions
Excise taxes
Other
Total
46%
12
35
3
4
100%
FIGURE 1–1
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Criteria for Evaluating
a Tax Structure (slide 1 of 2)
• Adam Smith identified the following
canons of taxation to consider when
evaluating tax structures:
–
–
–
–
Equality
Convenience
Certainty
Economy
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Criteria for Evaluating
a Tax Structure (slide 2 of 2)
• In addition, the AICPA suggests that the tax
system should be:
–
–
–
–
–
Simple
Neutral in terms of its effect on business
Clear and readily understandable
Structured to minimize noncompliance
Should enable the IRS to predict the amount and timing
of revenue, and
– Should not reduce economic growth and efficiency
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Tax Structure (slide 1 of 2)
• Tax base: amount to which the tax rate is
applied
• Tax rates: applied to the tax base to
determine the tax liability
– May be proportional or progressive
• Incidence of tax: degree to which the tax
burden is shared by taxpayers
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Tax Structure (slide 2 of 2)
• Examples:
Income
$10
$20
$30
Proportional $3 (30%) $6 (30%) $ 9 (30%)
Tax
Progressive $3 (30%) $7 (35%) $12 (40%)
Tax
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Major Types of Taxes
•
•
•
•
•
•
•
Property Taxes
Transaction Taxes
Death Taxes
Gift Taxes
Income Taxes
Employment Taxes
Other U.S. Taxes
Individual Income Taxes
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Property (ad valorem) Taxes
• Based on the value of the asset
• Generally on realty or personalty
• Exclusive jurisdiction of states and their
local political subdivisions
• Deductible for Federal income tax purposes
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Transaction Taxes
• Excise taxes
• General sales taxes
• Severance taxes
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Excise Taxes
•
•
Imposed at the Federal, state, and local levels
Restricted to specific items
–
•
Examples: gasoline, tobacco, liquor
Declined in relative importance until recently
–
Example-two types of excise taxes at the local level
have recently become increasingly popular
•
•
–
Hotel occupancy tax
Rental car surcharge
Tax is levied on visitors who cannot vote and often
used to fund special projects
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General Sales Taxes
• Currently jurisdiction of states and localities
• States that impose sales taxes also charge a
use tax on items bought in other states but
used in their jurisdiction
• States without sales or use taxes are Alaska,
Delaware, Montana, New Hampshire, and
Oregon
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Severance Taxes
• Tax on natural resources extracted
– Important revenue source for states rich in
natural resources
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Death Taxes (slide 1 of 2)
• Tax on the right to transfer property or to
receive property upon the death of the
owner
– If imposed on right to pass property at death
• Classified as an estate tax
– If imposed on right to receive property from a
decedent
• Classified as an inheritance tax
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Death Taxes (slide 2 of 2)
• The value of the property transferred
provides the base for determining the
amount of the death tax
• The Federal government imposes only an
estate tax
• Many state governments levy inheritance
taxes, estate taxes, or both
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Federal Estate Tax
(slide 1 of 2)
• Federal estate tax is on the right to pass
property to heirs
– Gross estate includes FMV of property
decedent owned at time of death
• Also includes property interests, such as life
insurance proceeds paid to the estate or to a
beneficiary other than the estate if the deceasedinsured had any ownership rights in the policy
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Federal Estate Tax
(slide 2 of 2)
• Property included in the gross estate is
valued at either:
– Date of death, or
– If elected, the alternate valuation date
• Generally 6 months after date of death
– Certain deductions and credits allowed
• Examples - marital deduction, funeral and admin.
expenses, certain taxes, debts of decedent
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Unified Transfer Tax Credit
• Unified credit reduces or eliminates the
estate tax liability for modest estates
• For 2009, credit is $1,455,800
– Offsets tax on $3,500,000 of the tax base
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Phaseout of Estate Tax
• The estate tax has been criticized for the hardship
it imposes on small businesses and family farms
• Tax Relief Reconciliation Act of 2001 included the
phase out of the estate tax
– Unified transfer credit is scheduled to increase over a
10 year period
– Estate tax is due to be eliminated in 2010
• Sunset provision reinstates estate tax as of
January 1, 2011
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State Death Taxes
• State death taxes may be estate tax,
inheritance tax, or both
– Inheritance tax is on the right to receive
property from a decedent
– Tax is generally based on relationship of heir to
decedent
• The more closely related, the lower the tax
Individual Income Taxes
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Federal Gift Tax
(slide 1 of 3)
• Tax on the right to transfer assets during a
person’s lifetime
– Applies only to transfers that are not supported by full
and adequate consideration
• Taxable gift = FMV of gift less annual exclusion
less marital deduction (if applicable)
• Federal gift tax provides an annual exclusion of
$13,000 per donee (in 2009)
– Amount is adjusted for inflation
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Federal Gift Tax
(slide 2 of 3)
• Married persons can make a special election
to split gifts
– Allows 1/2 of a gift made by a donor-spouse to
be treated as having been made by a nondonorspouse (gift splitting)
– Effectively increases the number of annual
exclusions available and allows the use of the
nondonor-spouse’s unified transfer tax credit
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Federal Gift Tax
(slide 3 of 3)
• The unified transfer tax credit is available
for gifts (as well as the estate tax)
• Despite the proposed repeal of the estate
tax, the gift tax has been retained with the
unified transfer tax credit frozen at
$345,800, covering $1,000,000 of taxable
gifts
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Gift and Estate Unified
Tax Schedule
• Gift and estate taxes are unified under a
single tax rate schedule
– Since tax rates are progressive, prior years’
transfers must be considered when calculating
the current year’s gift or estate tax
Individual Income Taxes
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Income Taxes
• Imposed at the Federal, most state, and some local
levels of government
– Income taxes generally are imposed on individuals,
corporations, and certain fiduciaries (estates and trusts)
• Federal income tax base is taxable income
(income less allowable exclusions and deductions)
• Most jurisdictions attempt to assure tax collection
by requiring pay-as-you-go procedures, including
– Withholding requirements for employees, and
– Estimated tax prepayments for all taxpayers
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Formula for Federal Income
Tax on Individuals (Slide 1 of 3)
Income (broadly conceived)
$xx,xxx
Less: Exclusions
(x,xxx)
Gross income
$xx,xxx
Less: Certain deductions for AGI (x,xxx)
Adjusted Gross Income
$xx,xxx
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Formula for Federal Income
Tax on Individuals (Slide 2 of 3)
Adjusted Gross Income
Less: The greater of:
Itemized deductions, or
The standard deduction
Less: Personal and
dependency exemptions
Taxable income
Individual Income Taxes
$xx,xxx
(x,xxx)
(x,xxx)
$xx,xxx
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Formula for Federal Income
Tax on Individuals (Slide 3 of 3)
Tax on taxable income (see Tax Rate
Schedules in Appendix A)
$ x,xxx
Less: Tax credits (including
Federal income tax withheld and
other prepayments of Federal
income taxes)
(xxx)
Tax due (or refund)
$ xxx
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Corporate Income Tax
Corporate Taxable Income = Income Deductions
– Does not require the computation of adjusted
gross income
– Does not provide for the standard deduction or
personal and dependency exemptions
– All allowable deductions are business expenses
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State Income Tax (slide 1 of 3)
• All but the following states impose an
income tax on individuals:
– Alaska, Florida, Nevada, South Dakota, Texas,
Washington, and Wyoming
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State Income Tax (slide 2 of 3)
• Some characteristics of state income taxes
include:
– With few exceptions, all states require some form of
withholding procedures
– Most states use as the tax base the income
determination made for Federal income tax purposes
• Some states apply a flat rate to Federal AGI
• Some states apply a rate to the Federal income tax liability
– Referred to as the piggyback approach to state income
taxation
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State Income Tax (slide 3 of 3)
• Some states ‘‘decouple’’ from select tax legislation
enacted by Congress
– State may not be able to afford the loss of revenue
resulting from such legislation
• Because of tie-ins to the Federal return, states may
be notified of changes made by the IRS upon audit
of a Federal return
– In recent years, the exchange of information between
the IRS and state taxing authorities has increased
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Employment Taxes (slide 1 of 3)
• FICA taxes
– Paid by both an employee and employer
– In 2009, Social Security rate is 6.2% on a
maximum of $106,800 of wages, and Medicare
rate is 1.45% on all wages
• A spouse employed by another spouse is subject to
FICA
• Children under the age of 18 who are employed in
parent’s unincorporated trade or business are exempt
from FICA
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Employment Taxes (slide 2 of 3)
• FICA taxes
– Sole proprietors and independent contractors
may also be subject to Social Security taxes
• Known as the self-employment tax
• Rates are 12.4% for Social Security and 2.9% for
Medicare
– Twice the rates applicable to an employee
• The tax is imposed on net self-employment income
up to a base amount of $106,800 for 2009
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Employment Taxes (slide 3 of 3)
• FUTA (unemployment) taxes
– Provides funds for state unemployment benefits
– In 2009, rate is 6.2% on first $7,000 of wages
for each employee
– Administered jointly by states & Fed govt.
• Credit is allowed (up to 5.4%) for FUTA paid to the
state
– Tax is paid by employer
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Other Taxes
• Federal customs duties
– Tariffs on certain imported goods
• Franchise taxes
– Levied on the right to do business in the state
• Occupational taxes
– Applicable to various trades or businesses
• e.g., liquor store license, taxicab permit, fee to
practice a profession
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Proposed Taxes
• Flat tax
– Would replace the current graduated income tax with a
single rate
• Value added tax
– Taxes the increment in value as goods move through
production & manufacturing stages to the market
• Paid by the producer and reflected in the sales price of goods
• National sales tax
– Levied on the final sale of goods and services
• Collected from consumer, not from businesses as with VAT
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Tax Administration (slide 1 of 4)
• Internal Revenue Service (IRS)
– Responsible for enforcing the Federal tax laws
– Audits small percentage of returns filed using
mathematical formulas and statistical sampling
• To update selection criteria, the IRS selects a cross
section of returns, which are subject to various
degrees of inspection
• Results highlight areas of taxpayer noncompliance
and enable the IRS to use its auditors more
productively
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Tax Administration (slide 2 of 4)
• Types of audits:
– Correspondence audit
– Office audit
• Usually restricted in scope and conducted in
facilities of IRS
– Field audit
• Involves examination of numerous items reported on
the return and is conducted on premises of taxpayer
or taxpayer's representative
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Tax Administration (slide 3 of 4)
• After the audit, a Revenue Agent’s Report
(RAR) is issued summarizing the findings
which can result in a:
– Refund (tax was overpaid)
– Deficiency (tax was underpaid), or
– No change (tax was correct) finding
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Tax Administration (slide 4 of 4)
• If an audit results in an assessment of additional tax
– Taxpayer may attempt to negotiate a settlement
• An appeal is available through the Appeals Division of the IRS
– Appeals Division is authorized to settle all disputes based on the hazard
of litigation (i.e., probability of favorable resolution, if litigated)
– If a satisfactory settlement is not reached on administrative appeal,
the taxpayer can litigate in:
• Tax Court
• Federal District Court, or
• Court of Federal Claims
– Litigation is recommended only as a last resort because of
• Legal costs involved
• Uncertainty of the final outcome
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Statute of Limitations (slide 1 of 3)
• Statute of limitations offers a defense against a suit brought
by another party after the expiration of a specified period
of time
– Purpose is to preclude parties from prosecuting stale claims
• The passage of time makes defense of such claims difficult since
witnesses may no longer be available or evidence may have been lost
or destroyed
• For Federal income tax purposes, the two categories
involved relate to the statute of limitations applicable to:
– The assessment of additional tax deficiencies by the IRS, and
– The period that deals with claims for refunds by taxpayers
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Statute of Limitations (slide 2 of 3)
• For a deficiency assessment by IRS
– Generally 3 years from the later of the due date
or the filing date of the return
– For material (more than 25%) omissions of
gross income, time period is 6 years
– No statute if no return filed or fraudulent return
filed
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Statute of Limitations (slide 3 of 3)
• For a refund claim by taxpayer
– Generally 3 years from date return filed or 2
years from date tax paid, whichever is later
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Interest and Penalties (slide 1 of 2)
• Interest accrues on the taxes due starting
from the due date of the return and interest
is paid on refunds if not received within 45
days of when the return was filed
– Current rate for January 1–March 31 of 2009 is
6% (determined quarterly by the IRS)
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Interest and Penalties (slide 2 of 2)
• Tax law provides various penalties for lack
of compliance including penalties for:
– Failure to file
• Penalty is 5% per month up to a max of 25% on the
amount of tax shown as due on the return
– Any fraction of a month counts as a full month
– Failure to pay
• Penalty is 0.5% per month up to a max of 25%
– Penalties may also apply to underpayment of
estimated taxes, negligence, etc.
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Tax Practice (slide 1 of 4)
• Area of tax practice is largely unregulated
– Members of professions must follow certain
ethical standards (CPAs, Attorneys)
– Various penalties may be imposed upon
preparers of Federal tax returns who violate
proscribed acts and procedures
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Tax Practice (slide 2 of 4)
• Ethical guidelines issued by AICPA:
– Do not take questionable position on client’s tax
return in hope of it not being audited
– Client’s estimates may be used if reasonable
– Try to answer every question on the tax return
(even if disadvantageous to client)
– Upon discovery of an error in prior year tax
return, advise client to correct
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Tax Practice (slide 3 of 4)
• Statutory penalties may be levied on tax
return preparers for:
– Procedural Matters-Failure to:
•
•
•
•
Provide copy of return to taxpayer
Sign the return as preparer
Keep copies of returns
Maintain a client list
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Tax Practice (slide 4 of 4)
• Statutory penalties may be levied on tax
return preparers for:
– Understatement of tax liability based on a
position that lacks a realistic possibility of
being sustained
– Willful attempts to understate tax
– Failure to exercise due diligence in determining
eligibility for, or the amount of, the earned
income tax credit
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Understanding the Federal
Tax Law (slide 1 of 3)
• The Federal tax law is the vehicle for
accomplishing many objectives of the
nation such as:
– Raising revenue: the major objective of the tax
system but not the sole objective
– Economic: increasingly important objective is
to regulate the economy and encourage certain
behavior and businesses considered desirable
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Understanding the Federal
Tax Law (slide 2 of 3)
• Federal tax objectives
– Social: encourage socially desirable behavior
that provides benefits that government might
otherwise provide
– Equity: equity within the tax laws (e.g.,
wherewithal to pay concept) and not necessarily
equity across taxpayers
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Understanding the Federal
Tax Law (slide 3 of 3)
• Federal tax objectives
– Political: a large segment of the tax law is
created through a political process; thus,
compromises and special interest dealings
occur
– Ease of administration: many provisions are
meant to aid the IRS in the collection of taxes
– Courts: influence tax law and sometimes cause
it to change
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If you have any comments or suggestions concerning this
PowerPoint Presentation for South-Western Federal
Taxation, please contact:
Dr. Donald R. Trippeer, CPA
trippedr@oneonta.edu
SUNY Oneonta
Individual Income Taxes
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