1-2 Introduction An income tax was first enacted in 1861 and repealed after the Civil War ended An income tax law was passed in 1894 and was rejected by the Supreme Court in Sixteenth Amendment to the Constitution was passed in 1913 –This is the basis of modern income tax law
1-3 Introduction About million individual income tax returns were filed in 2011 –Almost 83% were filed electronically Individual income tax collections were about $1.04 trillion in 2011.
1-4 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)
1-5 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
1-6 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
1-7 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 $35,000 th 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 #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
1-10 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
1-11 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
1-12 LO #3 Components of Form 1040EZ Unemployment compensation is taxable –Reported on Form 1099-G Permitted deductions are shown on line 5 –$10,000 for single, $20,000 for married Total income minus permitted deductions equals Taxable Income (line 6)
1-13 LO #4 Calculation of Tax For taxable income up to $100,000, use tax tables (printed in Appendix D) 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
1-14 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
1-15 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)
1-16 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
1-17 LO #5 Tax Authority Statutory sources of tax authority –16 th 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
1-18 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
1-19 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
1-20 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.
1-21 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.
1-22 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.
1-23 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.
1-24 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
1-25 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