Income Tax Chapter 1 and 2

First Quiz

Current Tax Code

The Internal Revenue Code of 1986

• Current law with tax changes incorporated almost every year

History of Taxation

People were taxed before the 16th amendment was ratified in 1913

Mass taxation began after World War 2

Primary Purpose of Taxation

To raise revenue for government operations: defense, protection (police and fire), education, roads, the court system, social services, etc

Oftern used as a tool to influence the behavior of individuals and businesses

Tax base

The amount to which tax rate is applied

Ex) For income tax = taxable income, which gross income minus deductions

Tax rates

Rate is applied to the base to calculate the amount of tax liability

Progressive tax rate

Higher rates apply as the tax base increases

Ex) Income tax, estate tax

Proportional Tax Rate

Everyone pays the same rate regardless of income

Ex) Sales tax, gasoline excise tax

Incidence of tax

Ultimately, all taxes are paid by individuals

Property Taxes

Based on the value of the property

Ad valorem tax = based on value = it is a tax on wealth or capital

Taxes on real property

Used by state and local governments, including state, city, county and school districts

A major source of revenue for local governments

Real property = land, buildings, fixtures

Property Taxes Lowers When…

1. Lower taxes may apply to residence owned by taxpayers aged 65 or older

2. Property value lowers

Property Taxes Increases When…

1. Property value increases

2. Add ons to property

Taxes on Personal Property

Includes both tangible and intangible property

Anything other than land and buildings

Ex) Vehicles

Estate Tax

Commonly referred to as the death tax, this tax is collected when a decedent’s wealth exceeds the unified transfer credit

Tax imposed on the estate on the right to pass property at death

FICA Tax

This is payroll tax that is paid by the employee (through payroll withholdings) and the employer (as a business expense) in equal parts. It funds social security and medicare programs.

Real Property Tax

An ad valorem tax based upon the value of the real estate

Federal Income tax

Tax that is collected on the taxable income of individuals, corporations, and certain other entities

Pay as you go system of repayment

Date: April 15th

Self-employment Tax

Tax paid by someone who runs their own business. This tax is = to the taxes paid by employees and employers for social security and medicare

Excise Tax

Federal/State Tax included in the price of certain products/services

Restricted to particular transaction

Ex) Tobacco product or air travel

Sales Tax

Tax collected by state on most retail sales transactions within the state

Gift Tax

Tax that is imposed when property is tranferred in excess $19,000 per donee per year

Up to 15,000,000 than tax is imposed

Prior to death

Use Tax

Tax collected by the state retail purchases made outside the state when the purchases are brought back into the state

FUTA Tax

Payroll tax that is paid by the employer to cover the administrative cost of managing the unemployment compensation system

Social Security Tax Rate

6.2% for the first 184,500 for both employer and employee (total 12.4%)

Self-employed = 12.4%

Medicare Tax

1.45% for all wages paid for both employer and employee (total 2.9%)

Addition 0.9% for high income on employees, no match from employers, ObamaCare

Self-employed = 2.9%, with ObamaCare 3.8%

• Pay the full 15.3% (12.4+2.9) on the first $184,500 of self-employment wages and 2.9% on the remainder

FUTA Tax Rates

6% of the first $7,000 of wages paid/employee with a credit of up to 5.4% if the employer participates and funds the state unemployment fund, net effect = 0.6%

Federal Corporate Income Tax

Not progressive, flat rate of 21%

They have exclusions and deductions

Federal Individual Income Tax

10% to 35%

Progressive

Certain credits apply, example: kids

Higher taxpayer’s income, higher tax rate

Negligence

Intentional disregard of rules and regulations

20% penalty

Fraud

Intentional, specific intent to evade a tax

75% penalty

Wherewithal

Pay concept

The ability to pay tax

Audit - % of selection

0.2% of returns are selected for an audit each year

“Red-flags” that trigger audits

• Large gross incomes

• Self-employed individuals

• Taxpayers who have been audited in the past and have been found deficient

• Cash-based businesses

• When informational returns (W2s, 1099s, K-1s) do not match tax returns

• Itemized deductions are “out of whack” (too high) compared to similar incomes

• Information obtained from other sources (whistle blower, newspaper accounts of big windfalls)

Correspondence Audit

Minor matter, IRS sends a letter requesting additional monies (possible interest/penalties too)

Office Audit

Restricted in scope and conducted in IRS’s office

Field Audit

Examination of numerous items and conducted on the taxpayer’s premise or taxpayer’s representative (CPA or attorney)

Special Agent Audit

When a special agent is assigned to the audit = suspected fraud involved = taxpayers need an attorney

RAR

Revenue Agent’s Report summarizes the findings of the audit

Statue of Limitations

Lawsuits must be brought within a reasonable period of time

Assessment of IRS: 3 years form filing date or due date of the return (whichever is later)

Statue of Limitations - Excess of 25% Gross Income Omitted in Tax Return

6 years

Statue of Limitations - Tax Returned Not Filed or Fraudulent Return

No limit

Revenue Neutrality

Changes neither increase nor decrease the net revenues received by the government

Revenue needs = government needs to fund annual budget

Tax cuts then add tax, can’t cut the government’s revenue

Sunset Provision

Limit the tax law change to a certain number of years and reinstate the prior law when the time period expires

Unrealized gain and losses

Appreciation/depreciation in value but we still own it

Realized gain or loss

Sale or other depositions = $ received - $ what you paid (basis)

Recognized gain or loss

Portion of realized gain this is taxable; portion of loss that is deductible

Recognized is not bigger than realized

• You’re not going to be taxed more than realized

Where tax legislation originates and the legislative process for tax bills (Exhibit 2.1)

Federal tax legislation generally originates in the House of Representatives, where it is first considered by House of Ways and Mean Committee. House-passed tax bills are sent to the Senate, where they are considered by the Senate Finance Committee

Most Authoritative Source of Tax Law and Where Tax Treaties Fall

Upmost Authority: Constitution, Tax Treaties, and The Internal Revenue Code of 1986

After: Regulations

• New regulations carry little weight don’t rely

• Final Regulations have the force and effect of the law

• Temporary Regulations same authoritative value as final regulations

Tax Treaties are sign with foreign countries to avoid double taxation

Most recent Code/Treaty takes precedence

Tax avoidance

Tax minimization through legal techniques.

Tax evasion

While also aimed at the elimination or reduction of taxes, connotes the use of fraud as means to an end

Tax Research

Tax research and tax planning work hand in hand

Is the process of finding a professional conclusion to a tax problem. The problem might originate either from completed or proposed transactions

Components of Tax Research

• Identifying and refining the problem

• Locating the appropriate tax law sources

• Assess the validity of the tax law sources

• Arriving at the solution or alternative solution with due consideration given to nontax factors

• Effectively communicating the solution to the taxpayer of the taxpayer’s representative

• Updating the solution in light of new developments

Tax Planning

Primary purpose of effective tax planning is to reduce the taxpayer’s total tax bill, maximize the taxpayers after-tax wealth

Secondary objective is to reduce or defer the tax in the current tax year

Components of Tax Planning

• Avoid the recognition of income

• Defer the recognition of income (or accelerate deductions)

• Convert the classification of income to a more advantageous form

• Chose the business entity with desired tax attributes

• Preserve formalities by generating and maintaining supporting documentation

• Act in manner consistent with the intended objective

Tax Practice, CPA

CPA should not take a questionable stance on tax returns for clients; fully advice clients on possible penalties if position is unsucessful

A tax practitioner can use client’s estimates if they are reasonable; don’t audit

Every question on the return should be answered if possible

Advise clients to correct errors on past tax returns