Chapter 01 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 Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 1

Introduction An income tax was first enacted in 1861 and repealed after the Civil War ended An income tax law was passed in 1894 and was rejected by the Supreme Court in 1895.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 The first income tax was enacted almost 150 years ago. It was not until a constitutional amendment was enacted in 1913 that the individual income tax became a reality. Much of the Internal Revenue Code has its legal foundation in the 16th Amendment. 2

Introduction About 142.5 million individual income tax returns are filed annually Almost 67% are filed electronically Individual income tax collections were about $1 trillion in 2008. Electronic filing has now grown to almost 67% of all tax returns. Tax collections from individuals make up the largest part of total tax collections. 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) Most taxes are calculated by multiplying a tax rate against a tax base. 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 One tax rate structure is a progressive tax structure where the rate increases as the base increases. The notion is that those with more can pay more. Our income tax system is based on this idea. Another structure is the proportional structure where the rate remains constant at all levels of tax base. Sales taxes are such a type. 5

LO #1 Progressive, proportional, and regressive tax structures The tax rate decreases as the tax base increases. Example is social security tax system A regressive rate structure is one in which the rate goes down as income goes up. It is regressive because those with less pay proportionally more. 6

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. It is important to clearly understand the difference between an average tax rate and a marginal tax rate. They are seldom the same. An average rate represents the arithmetic average. It is the total tax divided by the total taxable income. Some income may be taxed at a higher or lower rate, but this calculation determines the average over all the income. As tax rate changes or income changes, the average will change. The marginal rate is the rate that will be paid on the next dollar of income. Refer to Table 1-2. Because of our tax bracket system, the marginal rate stays constant and then makes a jump. For example, a married couple with taxable income of $90,000 has a marginal rate of 25%. If they earn $90,001 they will pay 25 cents on that additional dollar. The marginal rate is also 25% for the next dollar, and the next dollar, and the next dollar. In fact, the marginal rate remains the same until they get to $137,301. At that point, the very last dollar is taxed at 28%. 7

LO # 2 The Income Tax Formula − Permitted Deductions from Income -------------------------------- = Taxable Income × Appropriate Tax Rates = Tax Liability − Tax Payments and Tax Credits --------------------------------- = Tax Refund or Tax Due with Return This is the basic income tax formula. All individual income tax returns are based on this formula. As the complexity of the tax situation of an individual increases, this formula becomes more complicated, but the basic structure remains the same. We will show you a more complex formula in chapter 2. 8

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 There are three tax forms on which a taxpayer can report their income and deductions to the Internal Revenue Service. The most complex is a Form 1040, the least complex is a 1040EZ, and a 1040A is in the middle. All taxpayers can file a Form 1040. However, some taxpayers may be able to file using a simpler form. 9

LO #3 Components of Form 1040EZ To use a 1040EZ taxpayer must meet all: 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 EIC To be eligible to use a Form 1040EZ (the simplest form) the taxpayer must meet ALL of the criteria listed. 10

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 The first item on a 1040EZ is wages. Wages include salaries, tips, and other items. Taxpayers receive a Form W-2 from their employer at the end of the year. This document lists the amount of wages received as well as other items, such as income tax withholdings, that will enable the taxpayer to file their tax return. Interest income is another item that must be reported on an income tax return. 11

LO #3 Components of Form 1040EZ Unemployment compensation is taxable Reported on Form 1099-G Permitted deductions are shown on line 5 $9,500 for single, $19,000 for married Total income minus permitted deductions equal Taxable Income (line 6) Unemployment compensation is, in effect, a payment in lieu of wages. It is included as income on a tax return. Taxpayers are allowed a deduction on line 5 of a Form 1040EZ. Taxable income is the total of all income minus the deduction from line 5. 12

LO #4 Calculation of Tax For taxable income up to $100,000, use tax tables (printed in Appendix D) Tax rate schedules 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 Taxpayers who have taxable income up to $100,000 will use the tax tables to determine the amount of tax liability. These tables are easy to use and will reduce calculation errors. If the income is $100,000 or more, taxpayers use the tax rate schedules. 13

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 Individuals who receive income from wages pay some or all of their tax liability throughout the year with “withholding payments” that are deducted from their paycheck. These withholding amounts are sent to the IRS and credited to the account of the taxpayer. 14

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) In a way, a tax return is the document used to “settle up” with the IRS at the end of the year. A taxpayer has earned income. Most taxpayers have wage income so they have already paid much of their liability. When a taxpayer gets to the bottom of a 1040EZ, he or she will either owe the IRS some additional money or will receive a refund for excess payments. 15

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 Although the Internal Revenue Code is a large and complex document, it is not always totally clear, it does not answer each and every situation, and it is subject to interpretation. Tax authority is the body of law, regulation, court cases, and precedent that guide everyone in the practical application of the Internal Revenue Code. The three types of primary tax authority are statutory, administrative, and judicial. 16

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 Statutory authority is derived from the 16th amendment to the constitution, the Internal Revenue Code (the law), and the committee reports generated as part of the process of passing the law. 17

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 Administrative sources of tax authority are derived from IRS Regulations, and IRS pronouncements such as Revenue Rulings, Revenue Procedures and the like. 18

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 Courts also create tax authority when they rule on cases that are brought before them. Taxpayers or the IRS can begin a case in one of three courts. Cases can be appealed to higher courts. 19

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. Depending on where a case begins, the appeal process can take slightly different routes. Ultimately, the U.S. Supreme Court is the final court in any route. The Supreme Court hears very few tax cases during a year. 20