Income Tax Exam #1

purpose of tax systems

to raise revenue for government functions and services, and encourage or discourage specific behaviors

tax equation

tax base x tax rate

progressive tax rate

tax rate increases as base increases, taxable income

proportional tax rate

tax rate is the same no matter the tax base

regressive tax rate

tax rate decreases as base increases

average tax rate

tax paid/tax base, only taxable income, assesses if it is a progressive/regressive system, doesn't explain ho tax burden is distributed

marginal tax rate

tax paid per incremental dollar of income (tax base), decision making

effective tax rate

tax paid/total economic income (pretax), measures incident of taxation across different economic sectors

incidence of taxation

how the economic burden of tax is distributed, who bears the tax burden, depends on elasticity (sensitivity to change), inelastic bears the burden, falls to individuals normally even if they aren't directly paying the tax not corporations

good tax system

sufficient, equitable, certain, convenient, efficient

sufficient

if the purpose of a tax is to provide government services, the revenue raised will be enough to pay for the services

equitable

similar taxpayers in similar situations pay similar taxes (horizontal equity) and taxpayers with greater ability to pay pay more (vertical equity)

certain

taxpayers and determine with confidence how much they owe and how to pay

convenient

the collection of taxes shouldn't impose undue burden or excessive cost to the taxpayer or government

efficient

minimizing economic distortions caused by taxes

tax law sources

3 branches of government, tax laws are written by Congress, regulations and pronouncements by the Treasury, court rulings

legislative law

Constitution gave congress the power to impose and collect taxes, tax law found in the IRR (Title 26 of the US code), committee reports contain the intent of Congress

Legislative process for tax bills

house ways/means committee, consideration from the house, senate finance committee, consideration from the senate, (joint conference committee, consideration from congress), approval/veto of president, incorporation into the code

treasury department

IRS, implements tax laws

treasury regulations

Treasury's official interpretation of tax law, legislative/procedural/interpretive, proposed/temporary/final

legislative regulations

congress gives the treasury the authority to write the law with authority of the law

procedural regulations

regulations that explain Treasury Department procedures in administering Code

interpretive regulations

treasury's official interpretation of the law, carries weight but courts can disagree

proposed regulations

haven't been through the public comment process, don't carry the same weight as temporary or final regulation

temporary regulations

regulations valid for 3 years, carry the same weight has final regulations while in effect

final regulations

regulations that have been issued in final form, and thus, until revoked, they represent the Treasury's interpretation of the Code.

IRS rulings

revenue rulings, revenue procedures, private letter rulings, determination letters, publications

revenue rulings

IRS interpretation of specific fact pattern and can be broadly applied

revenue procedures

issued like revenue rulings but for specific procedures the IRS will follow

private letter rulings

rulings issued by the IRS to specific taxpayers or organizations that request an interpretation of the law, can't be used by other people

IRS publications

explain application of particular Code provisions, not viewed as official IRS pronouncements, can not be relied upon

taxpayer disagreement options

tax dispute about additional taxes being paid, pay the tax and sue the IRS for a refund in district court of claims or federal courts of claims OR don't pay the tax and petition the tax court to hear the case, decision on where to file depends on different factors, district cases are heard by juries but others are only heard by judges

trial courts of general jurisdiction

small case division- US tax court, us district court, court of federal claims

appellate courts

US court of appeals- regional circuit, US court of appeals- federal circuit, supreme court

appeals

decisions by lower courts (except small case division of the US tax court) can be appealed to court of appeal, court of appeal only bound by precedent in own circuit, supreme court is the final authority

tax formula

Gross Income

-Deductions/Exemptions

=Taxable Income

Tax owed

-tax credits/tax payments

=Refund or Balance Due

gross income

all income from whatever source derived, doesn't include specifically stated exemptions or returns of capital

income realization

supplying goods or services, control income, or transfer ownership, realized=taxable

income measurement methods

accrual, cash, hybrid

accrual method

recognized in period activity occurred

cash method

income is taxable when cash or property is received, deduction when cash/property is paid

hybrid method

used by smaller businesses, income/deductions use cash method, inventory uses accrual method

noncash exchanges

transactions don't have to exchange cash to realize inocme

ownership of income

person performing the service owns the income, received by agent is also considered to be received by principal

legislative grace

all income is subject to tax and no deductions are allowed unless specifically provided for in the law

exclusions

specific items exempt from tax, never counted as taxable, gifts/inheritance, life insurance, state/local bond interest, implicit taxes, damages/injuries, debt forgiveness, imputed interest

deductions

amounts subtracted from taxable income after income is recognized

gifts (inheritance)

biggest exclusion, property acquired by gift, it is not a gift if an employers gives something to employee

life insurance

exclusion, also excludes transfers if insured is chronically/terminally ill, if cash out value is exercised then exclusion does not apply

state and local bond interest

exclusion, state/local bond is an obligation of a state/political subdivision, have lower yields than taxable interest

implicit taxes

exclusion, indirect taxes that result from a tax advantage the government grants to certain transactions

damages and injuries

exclusion, money received from workers comp, damages received for injury or sickness

debt forgiveness

exclusion of debts distinguished in bankruptcy proceeding, debt of insolvent payers, gifts by creditors, some student loans, seller cancelled debt

imputed interest

something lent below market interest rate, difference between the amount that would have been charged at the Federal rate and the amount actually charged, not excluded if: loan less than $10000 buys income income producing assets, loans between people of 100000 or less=imputed interest limited to borrower net investment if over 1000,

business expense general requirements

ordinary and necessary, must be reasonable

cash basis timing

deduct expenses when paid, cash/credit card/loan, some deduction are deferred even if paid (ex: substantial benefit beyond tax year)

accrual basis timing

expense deducted as incurred, ALL EVENTS have occurred to establish legal liability, amount can be determined with reasonable accuracy, ECONOMIC PERFORMANCE- obligated party satisfies liabilities, expense incurred to related parties can't be deducted before the related party recognizes income

business expense deduction requirements

related to actual business, origin of the expense is the business, regularly conducted business with intent to earn profit, profit 3 of 5 years

start up costs

costs incurred before business is operating can't be deducted because there is no business, start up costs are capitalized and deducted using straight line over 180 months, if already in a line of business the expenses are immediately deductible, if business begins operations $5000 of start up are deductible immediately (limit reduced dollar for dollar if suc exceed $50000), if not in a line of business and do not pursue business opportunity any costs are not deductible

disallowed deductions

expenses that can't be deducted from taxable income, bribes/kickbacks, penalties, political contributions, executive comp over $1000000, expenses incurred to earn tax exempt interest, capital expenses, losses on sales to related parties

business interest expense

deductible for large business but limited to 30% of adjusted taxable income, prevents income stripping

meals and entertainment

entertainment is not deductible, business meals are deductible if there is a business purpose and the cost is not extravagant, expense is reduced by 50% to calculate the deduction

macrs

modified accelerated cost recovery system, tangible asset cost recovery, personal property-modified declining balance dep, real property- straight line dep- only property subject to wear and tear, dep starts when asset begins service, deduction reduces adjusted basis of asset

personal property

business property other than real estate, divided into classes with set lives

macrs for personal property

choose straight line or modified declining year by year class by class, no estimating useful life, 5/7 year classes

5 year classes

automobiles, computers, electronics

7 year classes

furniture, fixtures, equipment, equipment not specifically included in another class

personal property conventions

half year and mid quarter, assumed to be put in service in the middle of the year, cost recovery in first year is 50% of normal declining balance dep

mid quarter convention

depreciation convention for tangible personal property, allows for one-half of a quarter's worth of depreciation in the quarter of purchase and in the quarter of disposition, used when more than 40% of tangible personal property is placed into service in the 4th quarter of the tax year

half year convention

depreciation convention for tangible personal property to take one-half of a year's worth of depreciation in the year of purchase and in the year of disposition regardless of when the asset was actually placed in service or sold

macrs for real property

residential building cost (at least 80% of revenue is from residential units) is recovered over 27.5 years, non-residential buildings are recovered over 39 years, using straight line and mid month convention

section 179 depreciation

allow immediate deduction of tangible personal property when used in business, limits: 2560000 ceiling, phase out beginning at 4090000 when property put in place during yr exceeds po threshold, can't exceed business income for the year, cost recovery reduces basis of asset

bonus depreciation

additional depreciation allowed in first yr asset is in service, can deduct 100% of cost of qualified property under 168k, no limit or phase out, optional if future marginal tax rates are higher or if there is a loss

qualified property

Any tangible personal property with a recovery period of 20 years or less

listed property

automobiles, trucks, planes, property used for entertainment, if used for 50+ yrs no bonus dep only straight line

amortization

intangibles recovered over 180 months beginning when acquired, straight line, self created intangibles don't qualify

ordinary losses

losses from regular business operations, deducted in year occurred

individual capital losses

can offset capital gains and deduct $3000 per year of capital losses as ordinary losses, remaining losses carried forward and deducted in the future indefinitely

corporate capital losses

c corp only use capital losses to offset capital gains, carried 3 years back and 5 years forward, remaining capital loss after 5 years is lost, partnerships/sole proprietors/s corporations pass on income/deductions/loss to owners to report on personal tax return

bad debts cash basis

bad debts from accounts receivable aren't deductible bc they never recorded income

bad debts accrual basis

deducted in whole/part as soon as the debt is partially worthless, subtract from ordinary income

non business bad debts

Debt not related to the conduct of a trade or business

Deduct as a short-term capital loss in year the debt becomes totally worthless

No deduction for partial worthlessness

Net with other capital gains/losses

casuality

specific event is identifiable, damaging to property, sudden and unexpected/unusual in nature, deducted in yr occurred, theft losses deducted in year discovered, deductions reduced by expected insurance recovery, federally declared disaster=can claim loss in year preceding loss

property used to produce income that is completely destroyed/stolen

loss=insurance proceeds=adjusted basis of asset

partially damaged loss

insurance proceeds - lesser of adjusted basis of property or decline in fmv

personal use casualty loss

not deductible unless federal disaster area, $100 floor, reduced to 10% of agi, only deductible as itemized deduction, insurance reduces deduction, casualty gains- net gains are ordinary income, losses- itemized deduction

net operating losses

losses from business operations, can offset 80% of taxable income in future years when business is profitable until loss is used up

tax shelters

sheltering income from tax by artificially generating losses

at risk limitation

Congress limits deductible loss to investment by taxpayer, disallowed losses carried forward until at risk amount incr in future yr, at risk limit calc separately for each activity, separate from passive limits, if at risk falls below 0 any previous losses are recaptured as income

active income

wages, salaries, taxpayer is a material participant

portfolio income

income from interest, dividends, royalties, not earned in ordinary business

passive income

business activities where the taxpayer doesn't materially participate (rentals), losses from passive can only be offset by other passive income

material participation

the individual is involved in day-to-day operations on a regular, continual, and substantial basis