income tax exam 1

elements of a tax

• payment

• required by government

• not tied to any benefits received by taxpayer

tax calc formula

tax base x tax rate = tax

marginal tax rate measure

rate at which the next dollar of income will be taxed

change in tax/change in taxable income

average tax rate measure

average tax level on each dollar of taxable income

total tax/taxable income

effective tax rate measure

average rate of tax on each dollar of total income

total tax/total income

proportional tax rate (flat tax) structure

constant rate of tax impose throughout the tax base

progressive tax rate structure

increasing marginal rate as tax base increases

• what our individual system has

regressive tax rate structure

decreasing marginal rate as tax base increases

by jurisdiction type taxes

federal, state, and local taxes

by type taxes

income, employment, unemployment, excise, transfer, gift, estate, generation-skipping-transfer

implicit taxes

not direct taxes - changes in market conditions

ex: lower return on tax exempt bonds = implicit tax, the difference in return is the tax since it’s tax exempt you just get a lower return

income taxes

tax on income of taxpayer (business/individual), 60% of all tax revenue collected in US

levied on individuals, corporations, estates, trusts,..

employment/unemployment taxes

social security (OASDI) and medicare (MHI) taxes

unemployment taxes fund temp. unemployment benefits for individuals terminated from jobs without cause

excise taxes

assessed on quality/number of products sold, certain activities - sin taxes, user-fee excise taxes

estate, gift, generational-skipping-transfer taxes

imposed on FMV of transfers of property during one’s life (gift) or death (estate)

sales and use taxes

imposition of taxes on sale of goods/services

use tax for goods owned, possessed, used within a different state it was not purchased in

property salt taxes

tax base is FMV of property

real property taxes imposed on land and permanent structures (homes, buildings)

personal property taxes imposed on other types of property (tangible/intangible - cars, stock)

income salt taxes

similar to computation of fed. income tax - at different rates

excise salt taxes

similar to fed. excise tax

sufficiency tax system

need to generate enough revenue to cover total expenditures of government

• static revenue forecasting: ignores the change taxpayers have in behavior if tax law changes

• dynamic revenue forecasting: predicts possible behavioral responses to tax law changes

  • income effect - rates go up, people will work harder to maintain same after tax income

  • substitution effect - rates increase, people will engage in nontaxable activities

equity

tax system is equitable if based on taxpayers’ ability to pay

• horizontal equity - two similarly situated tax payers pay the same tax, same tax burden

  • vertical equity - taxpayers with greater ability to pay will pay more tax

certainty

do taxpayers know clearly when, how, and where to pay tax

convenience

tax shouldn’t be unduly burdensome to taxpayers or government

economy eval

cost of system should be at a minimum

when do corporations file?

always, regardless of any amount of taxable income - Form 1120

when do estates and trust file?

if they have a gross income of $600 - Form 1041

when do individuals file?

depends on filing status, age, and gross income - Form 1040

senior deduction

$6000 deduction per individual over 65, added by One Big Beautiful Bill

• available for itemized and standard deduction

• phases out as AGI exceeds 75k for single 150k for joint

• reduces taxable income only

tax return due date for individuals

15th day of 4th month after tax year end

tax return due date for C corporations

C corporations - pays corporate tax

15th day of 4th month after tax year end

june 30 year end = 15th day of 3rd month

partnerships and s corporation tax return due date

15th day of 3rd month after tax year end

extended due dates

due dates on weekends/holidays - next business day

auto extensions - add 5-6 months to due date

statute of limitations

so that tax returns aren’t vulnerable to tax law changes

• 3 years after

  • original due date

  • original filing date

  • refund claim - must be filed within 3 years of filing return or 2 of paying the tax, whichever is later

• 6 years after if >25% gross income omitted

audit selection reasons

• IRS suspects errors

• history of errors

• check voluntary compliance

• taxpayer asks

computerized scoring systems to select audit

• Discriminant Function (DIF) system - scoring system

• Document Perfecting program - checks match

• Information Matching programs - compares tax return data with IRS info

correspondence exams

by mail, most common, few issues at hand

office exam

at IRS office, covering an number of issues/issues that need more inquiry

field exam

at the business, large issues at hand, complex, teams of IRS staff

courts with jurisdiction over federal tax cases

• US tax court - 19 appointed judges, arguing at prepayment of tax

• Local US District Courts - generalist judges, jury present, tax paid and refund is denied

• US Court of Federal Claims - somewhat generalist judges, no jury, tax paid and refund is denied

source of tax law: primary authorities

official sources

• statutory sources - Internal Revenue Code (IRC), regulations/rulings

• judicial sources - the courts

• administrative sources - IRS pronouncements, notes, reports

sources of tax law: secondary authorities

• tax services

• tax articles

• tax research services

• newsletters

• law reviews

• journals

• commercial guides

IRC

internal revenue code, main statutory framework for federal taxes of all types

congress passes changes to IRC to president who passes the bill, accepting the change

16th amendment

congress can lay and collect taxes on income without dividing among the states or basing it on population

authority of the courts

• supreme court - highest authority, same authority as IRC

• courts of appeals - 13 circuit courts, next level of judicial authority

• trial level courts - US tax court, US district courts, US court of federal claims

stare decisis

courts will generally follow the ruling of past cases

Golsen rule

local rules have jurisdiction over taxpayer

authority of the treasury/IRS - regulations and forms

regulations - treasury departments official interpretation of the IRC

• three forms

  • final

  • temporary

  • proposed

• three purposes

  • legislative

  • interpretive

  • procedural

revenue rulings

less authoritative weight, provides detailed interpretation of code

revenue procedures

explains in great detail IRS practice and procedures in tax law

letter rulings

less authoritative but in great detail more than revenue rulings and regulations

tax research

1. understand facts

2. identify issues

3. locate relevant authorities

4. analyze tax authorities

5. document and communicate the results

1. understand the facts

• open facts - things not yet occurred, proposed transactions

• closed facts - things that have occurred

• interview clients, speak with third parties..

2. identify issues

• in expertise of tax professional

• facts with tax law to know issues

3. locate relevant authorities

• two types of tax services used in tax research

  • annotated - arranged by IRC section

  • topical - arranged by tax topic, “gross income”

  • keyword searches - relevant area of law and 1-2 facts describing the situation

4. analyze tax authorities

• question of fact or question of law

• answers to question lie in facts and circumstances, interpretation of law

• analyze hierarchy, jurisdiction, and age of conflicting views

5. document and communicate findings

• tax research memo format

  • facts

  • issues

  • authorities

  • conclusion

  • analysis

• client letter layout

  • salutations

  • research question and limitations

  • facts

  • analysis

  • closing

civil penalties

common, monetary penalties

• tax return preparers/taxpayer violates tax statutes without reasonable cause

criminal penalties

less common, jail time

taxpayer/tax return preparer exceptions

if substantial authority is backing them up OR there is a reasonable cause and it is disclosed

goal of effective tax planning

maximize taxpayer’s after tax income

achieving taxpayer’s nontax goals

three parties in a transaction

tax payer

other transacting party

government

timing strategy

when income is taxed / when expense deducted

• timing affects present value of taxes paid on income/tax savings on deductions

• tax cost and savings vary on tax rate changes

present value

one dollar today worth more than one dollar in the future

• cash inflow wants to be accelerated - higher PV

• cash outflow wants to be deferred - lower PV

future value formula

FV = PV + (1+r)^n

two tax related timing strategies

accelerating deductions - accelerating current cash inflow, higher PV and savings on deductions now

deferring income - deferring current cash outflow, lower PV and saving on tax paied

timing strategies when tax rates increase

• calculate if benefit of accelerating deductions > disadvantage of recognizing deductions at a lower rate year

• calculate if benefits of deferring income > disadvantage of recognizing income at a higher rate year

timing strategies when tax rates decrease

• accelerate tax deductions into earlier years

• defer taxable income to later years

timing strat limitations

• tax deduction acceleration also accelerate actual cash outflow

• tax law requires taxpayers to continue investment to defer income recognition

• deferral strategy isn’t good if there’s low returns/high risk

• constructive receipt doctrine

income shifting strategies

• exploits differences in tax rates across tax payers

  • shift income from high to low rate taxpayers

  • shift deductions from low to high rate taxpayers (more saving on each $)

income shifting - between family

children have lower marginal tax rates, shift to children

kiddie tax

income shifting - between business and owner

• individual to corporation - lower current tax on business income

• corporation to owner - avoids double taxing, if shifted based on compensation, interest, or rent, it won’t be taxed. if given as a dividend and income it’ll be taxed on dividends and income

income shifting - across jurisdictions

• income earned in different jurisdictions often taxed differently and different rates

• limits

income shifting strat limitations

• scrutiny over related party party transactions

• implicit taxes

• kiddie tax

• negative publicity

• judicial court limits income shifting

conversion strategy

tax rates vary on different activities

• ordinary income taxed at ordinary rates

• long term capital gain taxed at preferential rates (0, 15, 20)

• some income tax exempt - tax exempt bond income

to implement conversion strategy:

• understand differences in tax treatment across different types of income, expenses and activities

• have ability to alter the nature of income or expense

conversion strategy limitations

• IRC has provisions to prevent a taxpayer from changing nature

• implicit taxes to reduce or eliminate advantages

• judicia court doctrines

constructive receipt doctrine

recognize income when it is actually/constructively received

assignment of income doctrine

income to be taxed to taxpayer that actually earned the income

attributing a paycheck or dividend to another taxpayer doesn’t change liability

business purpose doctrine

IRS has power to disallow business expenses if they don’t have a business purpose

step-transaction doctrine

IRS has power to minimize a series of transactions into one to determine tax liability

substance over form doctrine

can be taxed on substance over form for tax liability - reclassify it

economic substance doctrine

transaction must meet two criteria

• transaction meaningfully changed taxpayer’s economic position

• taxpayer must have a substantial purpose, not tax avoidance

tax avoidance vs evasion

avoidance - legal and expected

evasion - willful attempt to defraud the government out of tax - outside of legal tax avoidance and criminal

taxable income formula

gross income

- for AGI (above the line) deductions

= adjusted gross income (AGI)

- from AGI (below the line) deductions:

• greater of standard deduction or itemized deduction +

• deductions for senior, qualifying car loan interest, tip income, overtime comp., business income

= taxable income

taxes due/refund formula

taxable income

* tax rate

= income tax liability

+ other taxes

= total tax

- credits

- prepayments

= taxes due/refund

all-inclusive income concept

realized income and recognized income reported on tax return

• realized income - transactions that have measurable change in property rights

excluded income

never included in gross income

• municipal bond interest

• gain on sale of a personal residence

deferred income

income included in next tax year

• installment sales

• like kind exchanges

character of income or loss

determines the rates applicable to income or loss in current year

• tax exempt - no tax

• tax deferred - no tax in current year

• ordinary - ordinary rates from tax rate schedule

• qualified dividends at 0, 15, 20 percent depending on income level of taxpayer

capital gain or loss

depends on short or long term

• from selling capital asset

• long term = asset held for longer than a year - day of disposition but day of acquisition

• net capital gains (long term gains in excess of short term losses) taxed at rates lower than ordinary

capital assets gain or loss included

all assets except

• account receivable

• inventory

• assets used in a trade or business

For AGI (above the line) deductions

• always reduce taxable income dollar for dollar

• ex: alimony, rental and royalty expenses, contributions to qualified retirement accounts

From AGI (below the line) deductions

deductions from AGI to get taxable income

• greater of standard or itemized deductions

• itemized deductions - mortgage interest, state income taxes, charitable contributions

items at preferential rates

net capital gains

qualified dividends

tax on items calculated separately from income taxed at ordinary rates

tax credits

reduce tax liability dollar for dollar

• child tax credit rules:

  • $2200 tax credit for qualifying children under 17 at year end

  • $500 credit for qualifying dependents who do not meet requirements of a higher credit amount

tax prepayments

payments already made toward tax liability

• income taxes withheld from wages by employer

• estimated tax payments made during the year

• taxes overpaid in prior year and applied toward current year’s liability

dependent status, why needed

determines

• filing status

• eligibility for tax benefits - child tax credit, american opportunity credit

dependency requirements

• citizen of US or resident of US, Canada, Mexico

• must not file joint return with spouse (except if their tax liability is 0 or separate return)

• must be qualifying child or qualifying relative of taxpayer

qualifying child

relationship test

age test

residence test

support test

qualifying child - relationship test

taxpayer’s child, stepchild, foster child, sibling, stepsibling, halfsibling, or descendant of any of these relatives