© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Chapter 1 Federal Income Tax – An Overview Murphy & Higgins Concepts in Federal Taxation, 2014 edition

© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. What is the Definition of a Tax?  An enforced, involuntary contribution  Required and determined by law  Providing revenue for public and governmental purposes  For which no specific benefits or services are received

© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. What is the Purpose of a Tax?  Revenue  Social changes  Economic changes  Equity  Not a Penalty

Standards of a Good Tax System Adam Smith’s Four Criteria (slide 1 of 5)  Equality  Certainty  Convenience  Economy © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Adam Smith’s First Criterion (slide 2 of 5)  Equality Tax should be based on the taxpayer’s ability to pay  Horizontal Equity: Two similarly situated taxpayers are taxed the same  Vertical Equity: Differently situated taxpayers are taxed differently but fairly © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Adam Smith’s Second Criterion (slide 3 of 5)  Certainty When and how a tax is to be paid should be known to the taxpayer The taxpayer should be able to determine the amount of the tax © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Adam Smith’s Third Criterion (slide 4 of 5)  Convenience Tax should be levied when the taxpayer has funds available to pay © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Adam Smith’s Fourth Criterion (slide 5 of 5)  Economy The costs of complying with the tax system should be minimal © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Tax Computation Tax = Tax Base × Tax Rate the value subject to taxation

© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Tax Rates for Income Tax  Marginal Tax Rate: The rate of tax on the next dollar of taxable income  Average Tax Rate: The rate equal to the total tax divided by the tax base  Effective Tax Rate: The rate equal to the total tax divided by economic income

© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Proportional Average tax rate remains the same as tax base increases average rate tax base tax rate Tax Structures: Proportional (slide 1 of 3)

© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Regressive Average tax rate decreases as tax base increases average rate tax base tax rate Tax Structures: Regressive (slide 2 of 3)

© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Progressive Average tax rate increases as tax base increases average rate tax base tax rate Tax Structures: Progressive (slide 3 of 3)

© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Major Types of U.S. Taxes Individual Income Sales Total Taxes Property Employment All Others Corporate Income

Types of U. S. Taxes  Income Tax  Employment Tax  Sales Tax  Property Tax  Excise Tax  Wealth Transfer Tax  Health Care Related © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Income Taxes Taxes are paid by individuals, corporations, estates, and trusts Tax base is total income less allowed deductions © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Employment Taxes Taxes are paid by employees, employers, and self-employed taxpayer Tax base is wages and salaries earned Two major types  Social Security Taxes  Unemployment Taxes © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Sales Taxes Taxes are paid by purchasers of goods and services Tax base is the selling price of a product or a service © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Property Taxes Taxes are paid by owners of property Real property is land and any structures that are permanently attached to it (buildings) All other types of property are personal property Tax base is the assessed value of real or personal property (ad valorem) © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Excise Taxes Taxes are paid by purchasers Tax base is the quantity purchased and not the value of the purchase © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Wealth Transfer Taxes Taxes are paid by entity transferring property Tax base is the value of the property transferred  Transfers to spouses and charities are excluded  For 2013, Unified Credit excludes up to $5.25M in property from gift and/or estate tax otherwise excluded  Donors may exclude annual gifts of $14,000 per donee © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Health Care Related Taxes  For Higher Income Workers 0.9% Hospital Insurance applied to  Wages in excess of threshold amounts  Net self-employment income in excess of threshold amounts Surtax on Unearned Income  3.8% Medicare contribution tax on unearned income of individual, estates and trusts  For individuals imposed on lesser of  net investment income or  Modified AGI in excess of threshold amount © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Sources of Federal Income Tax Law  Legislative Law (Internal Revenue Code)  Administrative Treasury Regulations IRS Pronouncements  Judicial Supreme Court Other courts

© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Tax formula Broadly defined income minus: Exclusions equals: Gross Income minus: Deductions Includes all forms of income (Ch 3) Income specifically excluded from income by legislative grace (Ch 4) Income to be reported Amounts specifically allowed as subtractions (Chs 5-7)

© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Some Deduction Examples  Expenses (Chapters 5 & 6) Current period expenditures incurred in order to earn income  Losses (Chapter 7) Transaction losses result when an asset is disposed of at a price less than its tax cost Annual losses result when allowed deductions exceed income  Exemptions (Chapter 8) A minimum amount of income needed for basic living Personal and dependency ($3,800 each)

© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Deduction Types Gross Income minus : For Deductions  Not restricted based on taxpayer’s income  Generally trade, business, rent or royalty expenses minus: From Deductions  Restricted based on Adjusted Gross Income  Generally personal expenses  Itemized, or  Standard amount (changes with filing status)

© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Gross Income minus: For Deductions equals: Adjusted Gross Income [AGI] Tax Formula: Adjusted Gross Income

© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Gross Income minus: For Deductions equals: Adjusted Gross Income [AGI] minus: From Deductions and Exemptions Taxable Income Tax Formula: Taxable Income

© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Taxable Income times: Tax Rate equals: Income Tax Liability minus: Prepayments & Credits equals: Tax or (Refund) due Tax Formula: Tax Due

© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Filing Requirements  Return must be filed annually  Calendar-year individuals file and pay on or before the 15th day of April May receive an extension of time to file but not time to pay

Audit and Appeals Process  Statute of limitations Three years from filing date Extends to six years if income is under- reported by 25% of gross income No limitation for fraud or if no return is filed © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Audit and Appeals Process  Selection for audit Only about 2% of returns are audited Procedures used  Discriminant Function System  Taxpayer Compliance Measurement Program  Document perfection & Information matching © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Audit and Appeals Process  Types of examinations Correspondence examinations Office examinations Field examinations © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Audit and Appeals Process  Settlement Procedure Report of outcome of audit Waiver of assessment (Form 870) 30-day letter © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Audit and Appeals Process  Appeals Meeting with IRS Appeals Division 90-day letter © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Tax Planning  Goal is to maximize after-tax wealth  Considers the Time Value of money Defer income Accelerate deductions  Considers Marginal tax rates Recognize income in year of lower marginal rate Recognize deductions in year of higher marginal rate Shift income to taxpayer with lower marginal rate

Tax Avoidance v. Tax Evasion  Tax Avoidance: Taxpayers have no obligation to pay more tax than the law requires  Tax Evasion: Taxpayers may not use fraudulent or deceptive behavior to hide tax liability © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Ethics  Preparers are subject to penalties for negligence and fraud  Ethical Standards IRS Circular 230 AICPA’s Code of Professional Conduct AICPA’s Statements on Standards for Tax Services