1. Chapter 1 An Introduction to Taxation and Understanding the Federal Tax Law Copyright ©2005 South-Western/Thomson Learning Eugene Willis, William H. Hoffman, Jr., David M. Maloney, and William A. Raabe

2. C1 - 2 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of Taxation (slide 1 of 2) Prior to 1900s income tax financed wars –1861: First Federal individual income tax enacted Repealed after Civil War –1894: New Federal individual income tax enacted Tax found to be unconstitutional because no capitation or other direct tax shall be laid unless in proportion to the census. Prior to 1900s income tax financed wars –1861: First Federal individual income tax enacted Repealed after Civil War –1894: New Federal individual income tax enacted Tax found to be unconstitutional because no capitation or other direct tax shall be laid unless in proportion to the census.

3. C1 - 3 History of Taxation (slide 2 of 2) Other important events –1909: First Federal corporate income tax enacted, ruled constitutional because it was treated as an exercise tax. –1913: 16th Amendment ratified Sanctioned both Federal individual and corporate income taxes  Question #2 Other important events –1909: First Federal corporate income tax enacted, ruled constitutional because it was treated as an exercise tax. –1913: 16th Amendment ratified Sanctioned both Federal individual and corporate income taxes  Question #2

4. C1 - 4 Federal Budget Receipts-2004 Individual income taxes 44% Corporation income taxes 9 Social insurance taxes 40 Excise taxes 3 Other 4 100% Individual income taxes 44% Corporation income taxes 9 Social insurance taxes 40 Excise taxes 3 Other 4 100%

5. C1 - 5 Criteria for Evaluating a Tax Structure (slide 1 of 2) Adam Smith identified the following criteria for evaluating tax structures: –Equality: fair and equitable –Convenience: simple to administrate –Certainty: easy to predict tax liability –Economy: cost little to collect Adam Smith identified the following criteria for evaluating tax structures: –Equality: fair and equitable –Convenience: simple to administrate –Certainty: easy to predict tax liability –Economy: cost little to collect

6. C1 - 6 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 not reduce economic growth and efficiency, and –Should enable the IRS to predict the amount and timing of revenue 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 not reduce economic growth and efficiency, and –Should enable the IRS to predict the amount and timing of revenue

7. C1 - 7 Tax Structure (slide 1 of 2) Tax base: amount to which the tax rate is applied (What amount is taxable?) Tax rates: applied to the tax base to determine the tax liability –May be proportional, progressive, or regressive Incidence of tax: degree to which the total tax burden is shared by taxpayers (Who bears how much of the tax burden?) Tax base: amount to which the tax rate is applied (What amount is taxable?) Tax rates: applied to the tax base to determine the tax liability –May be proportional, progressive, or regressive Incidence of tax: degree to which the total tax burden is shared by taxpayers (Who bears how much of the tax burden?)

8. C1 - 8 Possible Tax Rate Structures (slide 2 of 2) Examples:

9. C1 - 9 Major Types of Taxes Property Taxes Transaction Taxes Death Taxes Gift Taxes Income Taxes Employment Taxes Other U.S. Taxes Property Taxes Transaction Taxes Death Taxes Gift Taxes Income Taxes Employment Taxes Other U.S. Taxes

10. C1 - 10 Property (ad valorem) Taxes Based on the value of the asset Generally on realty or personalty Exclusive jurisdiction of states and their localities Deductible for Federal income tax purposes **Question: What is the rate for real property in San Bernardino county?  Question #12 Based on the value of the asset Generally on realty or personalty Exclusive jurisdiction of states and their localities Deductible for Federal income tax purposes **Question: What is the rate for real property in San Bernardino county?  Question #12

11. C1 - 11 Transaction Taxes Excise taxes General sales taxes Severance taxes Excise taxes General sales taxes Severance taxes

12. C1 - 12 Excise Taxes Imposed at the federal, state, and local levels Restricted to specific items –Examples: gasoline, tobacco, liquor, firearms Declined in relative importance until recently –Example: two types of excise taxes at the local level have recently become increasingly popular Hotel occupancy tax (17% in Houston) Rental car surcharge (28.7% in Boston) Tax is levied on visitors who cannot vote and used to fund special projects that generate civic pride Imposed at the federal, state, and local levels Restricted to specific items –Examples: gasoline, tobacco, liquor, firearms Declined in relative importance until recently –Example: two types of excise taxes at the local level have recently become increasingly popular Hotel occupancy tax (17% in Houston) Rental car surcharge (28.7% in Boston) Tax is levied on visitors who cannot vote and used to fund special projects that generate civic pride

13. C1 - 13 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  Question #19 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  Question #19

14. C1 - 14 Severance Taxes Tax on the value of natural resources extracted Important revenue source for states rich in natural resources Tax on the value of natural resources extracted Important revenue source for states rich in natural resources

15. C1 - 15 Death Taxes (slide 1 of 2) Federal estate tax is on the right to pass property to heirs –Gross estate includes: FMV of the property transferred at the date of death If elected, the alternate valuation date (generally 6 months after date of death) –Certain deductions and credits allowed Example - marital deduction, funeral and admin. expenses, certain taxes, debts of decedent  Question #26 Federal estate tax is on the right to pass property to heirs –Gross estate includes: FMV of the property transferred at the date of death If elected, the alternate valuation date (generally 6 months after date of death) –Certain deductions and credits allowed Example - marital deduction, funeral and admin. expenses, certain taxes, debts of decedent  Question #26

16. C1 - 16 Death Taxes (slide 2 of 2) 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 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

17. C1 - 17 Unified Credit For Estate and Gift Taxes Unified credit reduces or eliminates the estate tax liability for modest estates Unified credit for estate tax purposes is $555,800 for 2004 which offsets tax on $1,500,000 of the tax base (i.e., you can pass $1,500,000 to heirs without paying any estate taxes) Unified credit reduces or eliminates the estate tax liability for modest estates Unified credit for estate tax purposes is $555,800 for 2004 which offsets tax on $1,500,000 of the tax base (i.e., you can pass $1,500,000 to heirs without paying any estate taxes)

18. C1 - 18 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 –Due to be eliminated in 2010 Sunset provision reinstates estate tax as of January 1, 2011 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 –Due to be eliminated in 2010 Sunset provision reinstates estate tax as of January 1, 2011

19. C1 - 19 Gift Tax (slide 1 of 3) Tax on the right to transfer assets during a person’s lifetime Taxable gift = FMV of gift less annual exclusion less marital deduction (if applicable) Federal gift tax provides an annual exclusion of $11,000 per donee (adjusted for inflation) Tax on the right to transfer assets during a person’s lifetime Taxable gift = FMV of gift less annual exclusion less marital deduction (if applicable) Federal gift tax provides an annual exclusion of $11,000 per donee (adjusted for inflation)

20. C1 - 20 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 nondonor- spouse –Effectively increases the number of annual exclusions available and allows the use of the nondonor-spouse’s unified transfer tax credit  Question #23 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 nondonor- spouse –Effectively increases the number of annual exclusions available and allows the use of the nondonor-spouse’s unified transfer tax credit  Question #23

21. C1 - 21 Gift Tax (slide 3 of 3) The unified transfer tax credit is available for gifts (as well as the estate tax) Despite the eventual repeal of the estate tax, the gift tax has been retained with the unified transfer tax credit frozen at its current level ($345,800, covering $1,000,000 of taxable gifts)  Question #22 The unified transfer tax credit is available for gifts (as well as the estate tax) Despite the eventual repeal of the estate tax, the gift tax has been retained with the unified transfer tax credit frozen at its current level ($345,800, covering $1,000,000 of taxable gifts)  Question #22

22. C1 - 22 Tax Smart? Since Uncle Sam taxes both gift and bequest, I am going to be tax smart by giving all my assets to my beloved heirs before I die. Will this work? The answer is ______. Since Uncle Sam taxes both gift and bequest, I am going to be tax smart by giving all my assets to my beloved heirs before I die. Will this work? The answer is ______.

23. C1 - 23 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’ gift transfers must be considered when calculating the current year’s gift or estate tax Gift and estate taxes are unified under a single tax rate schedule –Since tax rates are progressive, prior years’ gift transfers must be considered when calculating the current year’s gift or estate tax

24. C1 - 24 Income Taxes Imposed at the Federal, state, and local levels of government Federal tax base is taxable income (income less allowable exclusions and deductions) States not having a resident individual income tax: Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming  Question #29 Imposed at the Federal, state, and local levels of government Federal tax base is taxable income (income less allowable exclusions and deductions) States not having a resident individual income tax: Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming  Question #29

25. C1 - 25 Formula for Federal Individuals Income Tax (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 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

26. C1 - 26 Formula for Federal Income Tax on Individuals (Slide 2 of 3) Adjusted Gross Income $xx,xxx Less: The greater of: Itemized deductions, or The standard deduction (x,xxx) Less: Personal and dependency exemptions (x,xxx) Taxable income $xx,xxx Adjusted Gross Income $xx,xxx Less: The greater of: Itemized deductions, or The standard deduction (x,xxx) Less: Personal and dependency exemptions (x,xxx) Taxable income $xx,xxx

27. C1 - 27 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 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

28. C1 - 28 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 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

29. C1 - 29 Employment Taxes (slide 1 of 2) FICA taxes (Social Security Taxes) –Paid by both an employee and employer –In 2004, Social Security rate is 6.2% on a maximum of $87,900 of wages, and Medicare rate is 1.45% on all wages  Question #33 FICA taxes (Social Security Taxes) –Paid by both an employee and employer –In 2004, Social Security rate is 6.2% on a maximum of $87,900 of wages, and Medicare rate is 1.45% on all wages  Question #33

30. C1 - 30 Tax Smart? Since I have to pay social security taxes if I am employed, How about I employ myself so that I do not have to pay social security taxes? Will this work? Self-employment tax serves as FICA tax for self- employed taxpayers –Rate is 15.3%, base is net self-employment income, and deduction (FOR AGI) is allowed for 1/2 of self- employment tax Since I have to pay social security taxes if I am employed, How about I employ myself so that I do not have to pay social security taxes? Will this work? Self-employment tax serves as FICA tax for self- employed taxpayers –Rate is 15.3%, base is net self-employment income, and deduction (FOR AGI) is allowed for 1/2 of self- employment tax

31. C1 - 31 Employment Taxes (slide 2 of 2) FUTA (unemployment) taxes –Provides funds for state unemployment benefits for individuals that are laid-off or fired –In 2004, rate is 6.2% on first $7,000 of wages for each employee –Administered jointly by states & Fed govt. Credit is allowed (up to 5.2%) for FUTA paid to the state –Tax is paid by employer  Question #32 & #35 FUTA (unemployment) taxes –Provides funds for state unemployment benefits for individuals that are laid-off or fired –In 2004, rate is 6.2% on first $7,000 of wages for each employee –Administered jointly by states & Fed govt. Credit is allowed (up to 5.2%) for FUTA paid to the state –Tax is paid by employer  Question #32 & #35

32. C1 - 32 Other Taxes Federal customs duties –Tariffs on 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 Federal customs duties –Tariffs on 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

33. C1 - 33 Proposed Alternatives Flat tax: 17% for all income after $30,000 proposed by Dick Armey (R, Texas) Value added tax: 17% on all values added (materials and service added) by a business National sales tax: imposed on consumers rather than producers, proposed by Bill Archer (R, Texas)  Question 36 & 37 Flat tax: 17% for all income after $30,000 proposed by Dick Armey (R, Texas) Value added tax: 17% on all values added (materials and service added) by a business National sales tax: imposed on consumers rather than producers, proposed by Bill Archer (R, Texas)  Question 36 & 37

34. C1 - 34 Tax Administration (slide 1 of 2) Internal Revenue Service (IRS) –Responsible for enforcing the Federal tax laws –Audits small percentage of returns filed using mathematical formulas and statistical sampling techniques for selection IRS is instituting a National Research Program –Selected a cross section of 47,000 returns subject to various degrees of inspection to: Highlight areas of taxpayer noncompliance, and Enable the IRS to use its auditors more productively Internal Revenue Service (IRS) –Responsible for enforcing the Federal tax laws –Audits small percentage of returns filed using mathematical formulas and statistical sampling techniques for selection IRS is instituting a National Research Program –Selected a cross section of 47,000 returns subject to various degrees of inspection to: Highlight areas of taxpayer noncompliance, and Enable the IRS to use its auditors more productively

35. C1 - 35 Tax Administration (slide 2 of 2) 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  Question 38 & 39 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  Question 38 & 39

36. C1 - 36 Statute of Limitations (slide 1 of 2) 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 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

37. C1 - 37 Statute of Limitations (slide 2 of 2) For a refund claim by taxpayer –Generally 3 years from date return filed or 2 years from date tax paid, whichever is later For a refund claim by taxpayer –Generally 3 years from date return filed or 2 years from date tax paid, whichever is later

38. C1 - 38 Tax Smart? Since it is always advantageous to me to pay tax later, I will pay my tax later if my money can earn a higher return than the interest IRS would charge me. Would this work? Since it is always advantageous to me to pay tax later, I will pay my tax later if my money can earn a higher return than the interest IRS would charge me. Would this work?

39. C1 - 39 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 is 4% (determined quarterly by the IRS)  Question #5 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 is 4% (determined quarterly by the IRS)  Question #5

40. C1 - 40 Interest and Penalties (slide 2 of 2) Penalties apply for failure to file, failure to pay, underpayment of estimated taxes, negligence, etc. Tax return preparer penalties also exist Penalties apply for failure to file, failure to pay, underpayment of estimated taxes, negligence, etc. Tax return preparer penalties also exist

41. C1 - 41 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 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

42. C1 - 42 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 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

43. C1 - 43 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 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

44. C1 - 44 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 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

45. C1 - 45 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 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

46. C1 - 46 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 alleviating the effect of multiple taxation) and not necessarily equity across taxpayers 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 alleviating the effect of multiple taxation) and not necessarily equity across taxpayers

47. C1 - 47 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  Question 47 & 48 & 53 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  Question 47 & 48 & 53

48. C1 - 48 That’s it for today. Hope you become tax smarter! Have a good evening! That’s it for today. Hope you become tax smarter! Have a good evening!