Taxes and Decision Making

What 3 elements define a tax? (NEED ALL 3 for it to be a tax!)

1. A payment required

2. By a government

3. That is related to any specific benefit or service that is received from the government.

Tax Liability Equation

Tax Base x Tax Rate

Tax Liability

Represents the amount owed.

Tax Base

Represents the substantive item taxed (normally measured in dollars).

In the USA, our federal individual income tax IS NOT as simple as a flat rate; instead it is

a graduated, progressive tax system where the tax base is divided into “buckets.” Each bucket is taxed at a different rate, increasing with higher income levels.

Marginal Tax Rate

The tax rate that applies to the next additional increment of a taxpayer’s taxable income.

Average Tax Rate

Represents a taxpayer’s average level of taxation on each dollar of taxable income.

Effective Tax Rate

Represents a taxpayer’s average level of taxation on each dollar of total income.

Municipal Bond Interest Income

The income earned from municipal bonds, which is generally exempt from federal income tax and often from state and local taxes, making it attractive for investors. NON TAXABLE INCOME.

Non-Taxable Income

Income not subject to taxation, such as certain gifts, inheritances, and interest on municipal bonds.

Marginal Tax Rate Formula

Average Tax Rate Formula

Average Tax Rate Formula

Flat Tax Rate

When a single tax rate is applied to an entire tax base.

Graduated Tax Rate

When the tax base is divided into parts, with each successive part of the base being taxed at a different rate (higher or lower).

Proportional Tax Rate

Imposes a constant tax rate throughout the tax base (sales tax).

Progressive Tax Rate

Imposes an increasing marginal tax rate as the tax base increases (income taxes).

Regressive Tax Rate

Imposes a decreasing marginal tax rate as the tax base increases (FICA or SE tax, tarrifs).

Taxing Authorities: Federal Government

Helps to fund the national defense, Social Security, and Medicare, infrastructure, healthcare, research.

Taxing Authorities: State Government

Helps to fund public education, Medicaid, transportation, public safety, and social services.

Taxing Authorities: Local Government

Helps to fund local schools, police and fire departments, public infrastructure, and municipal services.

Income tax represents…

over half of all federal revenue; originally unconstitutional until 16th Amendment.

Employment Tax (payroll taxes)

FICA tax, if employee.

SE (self employment tax) if self-employed.

FUTA/SUTA (Federal/State Unemployment Tax Act.

Sales Tax and Use Tax (Consumption Taxes)

Sales Tax is applied to goods and some services and is added at the final point of sale (POS). There is no federal sales tax in the USA.

Use tax applies to goods purchased out of state but used in the state of residence. It ensures that sales tax is collected on products not subject to local sales tax.

Property Tax

Distinguish real property versus personal property. Both ad valorem taxes, meaning the tax base is the fair market value of the property.

Estate and Gift Tax (transfer taxes)

Taxes imposed on the transfer of wealth, either during an individual's lifetime (gift tax) or after death (estate tax). They are based on the value of the transferred assets.

SALT: State and local taxes

Imposed by states and local jurisdictions.

Excise Tax

A type of tax levied on specific goods or services, often included in the price, such as fuel, tobacco, or alcohol. These taxes are intended to discourage certain behaviors while generating revenue for the government.

Tariffs

Taxes on imports and exports that are used to regulate trade and generate revenue.

Types of Taxpayers: Individual taxpayers

Included personal income taxes, property taxes, excise taxes, and estate and gift taxes.

Types of Taxpayers: Business taxpayers

Sole proprietorships, partnerships, S and C corporations, and LLCs subject to different tax obligations.

Types of Taxpayers: Not for profit organizations

Organizations that operate without the intention of earning profits, often exempt from federal income taxes and may include charities and educational institutions.

Analyzing a tax

(1)Taxing Authority (2) Taxpayer Type (3) Type of Tax

Explicit taxes

Taxes directly imposed by a government that are easily quantified.

Implicit taxes

Arise because of a tax advantage the government applies to a certain type of transaction or event. (can affect investment decisions by reducing the effective tax rate on income or gains. Implicit taxes represent hidden costs associated with tax preferences that lower effective tax rates, influencing investor choices.

To compare investments, we need to compare ATROR with ATROR for each investment.

Evaluating Tax Systems: Sufficiency

A tax system must evaluate the ends it hopes to accomplish (eg. Social Services) and estimates the expenses and forecast the revenue necessary to support such expenses.

Evaluating Tax Systems: Forecasting

Static Forecasting: Estimating future tax revenues and expenditures based on current data without considering changes in behavior or policy.

Dynamic Forecasting: Assessment of future tax revenues by accounting for how changes in tax policy, economic conditions, and individual behavior impact revenue generation.

Horizontal Equity

Taxpayers in same situation (same income) should pay the same amount of tax; not always the case cause of tax preferences (eg. capital gains).

Vertical Equity

Taxpayers with greater ability to pay should contribute more in taxes than those with less ability, reflecting a fair distribution of tax burdens.

Certainty

A tax system should instruct taxpayer how to determine their tax liability, when taxes are due and where payment for tax can be made.

Convenience

A tax system should be designed to fairly collect taxes without imposing undue hardship.

Economy

A tax system should minimize compliance/administration costs of code enforcement.

Form 1040 (Standard form)

is the standard IRS form used by individual taxpayers to file their annual income tax returns. It reports income, deductions, and credits to calculate tax liability.

Form 1040 SR

is a simplified version of the Form 1040 designed specifically for seniors aged 65 and older. It allows for a straightforward filing process and includes features such as larger print and a simplified layout.

Form 1040 NR

is a variant of Form 1040 designed specifically for nonresident aliens to report their U.S. income and calculate their tax obligations.

Form 1040 X

A tax form used to amend a previously filed Form 1040 or 1040-SR. It allows taxpayers to correct errors or make changes to their tax returns.

Schedule 1

Additional Income and Adjustments

Schedule 1-A

Additional Income and Adjustments to Income form for non-resident aliens.

Schedule 2

A supplementary tax form used to report additional tax owed, such as self-employment tax or taxes on unreported income.

Schedule 3

A form used to report additional income or adjustments, such as tax-exempt interest and other sources not included in the main tax form.

Schedule A

A form used by taxpayers to report itemized deductions on their income tax returns, allowing them to potentially reduce their taxable income by detailing specific expenses such as medical costs, mortgage interest, and charitable contributions.

Schedule B

A tax form used for reporting interest and dividend income, typically filed by individuals.

Schedule C

A form used by sole proprietors to report income and expenses from their business activities.

Schedule E

Form used to report rental income and losses.

Schedule F

Used to report farm income and expenses on a federal tax return.

Schedule SE

A form used by self-employed individuals to calculate and report their Social Security and Medicare tax obligations.

Form 4562

Form used to claim depreciation on assets and amortization of costs for tax purposes.

Form 8949

A tax form used to report sales and exchanges of capital assets, including stocks and bonds, for individuals and businesses.

Form 8812

Used to claim the Additional Child Tax Credit for qualifying children.

Form 1116

A tax form used to claim a foreign tax credit for taxes paid to a foreign government. This helps prevent double taxation on income earned abroad.

Form 8938

A form used to report specified foreign financial assets and comply with the Foreign Account Tax Compliance Act (FATCA), required for certain U.S. taxpayers.

FBAR (FINCEN Form 114)

A form required to report foreign bank accounts and financial assets to the Financial Crimes Enforcement Network (FinCEN) by U.S. citizens and residents.

Form I-9

Employment authorization

Form W-2

Employee Wage Statement

Form W-4

Employee Withholding

Form W-9

Independent Contractor Information form

Corrected W-2

A form issued to correct errors on a previously issued Form W-2, providing accurate wage and tax information.

Form W-2G

Tax form for reporting gambling winnings

1099-MISC

A tax form used to report various types of income other than wages, salaries, and tips, typically for independent contractors or freelancers.

1099-DIV

A form used to report dividends and distributions to taxpayers. It indicates the amount of dividend income received during the tax year.

1099-INT

Interest Income:A form used to report interest payments made to individuals by banks or other financial institutions. It details the amount of interest earned during the tax year.

1099-B

A tax form used to report proceeds from broker and barter exchange transactions.

1099-OID

Form used to report original issue discount income.

1099 Consolidated

A tax form that combines various 1099 forms, summarizing income from multiple sources such as interest, dividends, and capital gains.

1099-G

A tax form used to report state or local tax refunds, credits, or offsets made to the taxpayer during the year.

1099-R

A form used to report distributions from pensions, retirement plans, IRAs, and other similar financial accounts.

1099-S

Form used for reporting proceeds from real estate transactions by the IRS.

SSA-1099

Form used to report Social Security benefits received during the year.

1099-K

A tax form used to report payments received via third-party network transactions, such as credit cards and PayPal.

1099-C

A tax form used to report cancellation of debt. It is issued by lenders to borrowers when a debt of $600 or more is forgiven.

1099-SA

A tax form used to report distributions from a health savings account (HSA), Archer medical savings account (MSA), or Medicare Advantage MSA.

Schedule K-1

A tax document used to report income, deductions, and credits from partnerships, S corporations, estates, and trusts to the IRS and recipients.

Form 1098

Used to report mortgage interest paid by a borrower to the lender. It is typically provided by the lender to the borrower for tax purposes.

Form 1098-E

Form used to report interest payments on student loans.

Form 1098-T

This tax form is used by eligible educational institutions to report information about qualified tuition and related expenses. It helps students and their families claim education-related tax benefits.

Tax Identification Numbers (TIN)

A unique identifier assigned to individuals and businesses for tax purposes, used by the IRS to track tax obligations and payments.

SSC number -US citizens/residents

Individual Taxpayer Identification Number (TIN) - Nonresident Aliens/spouses/dependents

Employer Identification Number (EIN) - businesses and other entities

Tax Professional Credentials: CPA

A Certified Public Accountant who has passed the CPA exam and met other state requirements. They provide accounting services, including auditing, tax preparation, and consulting.

Tax Professional Credentials: Enrolled Agent

A tax professional who is authorized by the IRS to represent taxpayers before the agency. Enrolled Agents have passed a comprehensive examination on tax-related matters and are required to maintain their knowledge through continuing education.

Tax Professional Identification Terms: Preparer Tax Identification Number (TIN)

A unique number issued by the IRS to tax preparers, allowing them to prepare tax returns for clients. This number helps identify preparers and track their activities with the IRS.

Tax Professional Identification Terms: Centralized Authorization File Number (CAF)

A number assigned by the IRS to identify taxpayers and their representatives who are authorized to act on their behalf, facilitating communication between the IRS and tax professionals.

Other Entity Tax Forms

Tax Year vs Calendar Year

Tax Year refers to a 12-month period for which tax returns are filed, while Calendar Year aligns with the January to December timeframe. The choice affects when income is reported and tax liabilities are calculated.

Who must file?: Corporations

Must file a tax return regardless of their income!

Who must file?: Estates and Trusts

Must file income tax return if their gross income exceeds 600$

Who must file?: Individuals

Generally not required to file if the standard deduction exceeds gross income.

However, the lack of requirement to file DOES NOT mean a taxpayer should not file a return.

The taxpayer could be due a refund for their withholdings and/or for refundable tax credits!

Alternatively, a taxpayer may want to file to start the SOL (Statute of Limitations, which is the legal time limit the government has to audit your return, collect back taxes, or let you claim a refund) to eventually close that tax year from being audited.

Non-tax matters that rely on filed tax returns

Student loan payments, mortgage or loan payments, applications for government assistance programs (Think: “Must file vs should file.”).

Tax Return Due Dates: Individuals

Return due on the 15th of the 4th month following the tax year end.

Tips/alternative: if tax year ends 5/30 and not 12/30, then the filing date is going to be 9/15.

If the filing date is on a Saturday, Sunday, or holiday…the due date is extended to the next day!

Automatic six-month extension to file

A provision that allows taxpayers to submit their tax returns six months after the original due date (4/15) without facing penalties, though any owed taxes must still be paid by the original due date.

Tax Return Due Dates: C Corporations

Return due on the 15th day of the 4th month following the close of the corporation's tax year; if the tax year ends on June 30, for example, the due date would be October 15. They also have a 6-month filing extension (not pay though!).