1. Chapter 1 Federal Income Taxation - An Overview Federal Income Taxation - An Overview © 2009 South-Western, a part of Cengage Learning Kevin Murphy Mark Higgins Kevin Murphy Mark Higgins

2. 1-2 © 2009 South-Western, a part of Cengage Learning What is the Definition of a Tax? wAn enforced, involuntary contribution wRequired and determined by law wProviding revenue for public and governmental purposes wFor which no specific benefits or services are received

3. 1-3 © 2009 South-Western, a part of Cengage Learning What is the Purpose of a Tax? wRevenue wPenalty wSocial changes wEconomic changes wEquity

4. 1-4 © 2009 South-Western, a part of Cengage Learning Standards of a Good Tax System Adam Smith’s Four Criteria ¶Equality FTax should be based on the taxpayer’s ability to pay VHorizontal Equity: Two similarly situated taxpayers are taxed the same VVertical Equity: Differently situated taxpayers are taxed differently but fairly

5. 1-5 © 2009 South-Western, a part of Cengage Learning Standards of a Good Tax System Adam Smith’s Four Criteria ¬Equality ·Certainty FWhen and how a tax is to be paid should be known to the taxpayer FThe taxpayer should be able to determine the amount of the tax

6. 1-6 © 2009 South-Western, a part of Cengage Learning Standards of a Good Tax System Adam Smith’s Four Criteria ¬Equality ­Certainty ¸Convenience FTax should be levied when the taxpayer has funds available to pay

7. 1-7 © 2009 South-Western, a part of Cengage Learning Standards of a Good Tax System Adam Smith’s Four Criteria ¬Equality ­Certainty ®Convenience ¹Economy FThe costs of complying with the tax system should be minimal

8. 1-8 © 2009 South-Western, a part of Cengage Learning Tax Computation Tax = Tax Base X Tax Rate

9. 1-9 © 2009 South-Western, a part of Cengage Learning Tax Computation Tax = Tax Base X Tax Rate the value subject to taxation

10. 1-10 © 2009 South-Western, a part of Cengage Learning Tax Rates for Income Tax Marginal Tax Rate is the rate of tax on the next dollar of taxable income Average Tax Rate is the rate equal to the total tax divided by the tax base Effective Tax Rate is the rate equal to the total tax divided by economic income

11. 1-11 © 2009 South-Western, a part of Cengage Learning Tax Structures Proportional average tax rate remains the same as tax base increases average rate tax base tax rate

12. 1-12 © 2009 South-Western, a part of Cengage Learning Tax Structures Regressive average tax rate decreases as tax base increases average rate tax base tax rate

13. 1-13 © 2009 South-Western, a part of Cengage Learning Tax Structures Progressive average tax rate increases as tax base increases average rate tax base tax rate

14. 1-14 © 2009 South-Western, a part of Cengage Learning Major Types of U.S. Taxes Individual Income Sales Total Taxes Property Employment All Others Corporate Income

15. 1-15 © 2009 South-Western, a part of Cengage Learning Types of U.S. Taxes wIncome Tax FTaxes are paid by individuals, corporations, estates, and trusts FTax base is total income less allowed reductions

16. 1-16 © 2009 South-Western, a part of Cengage Learning Types of U.S. Taxes wEmployment Tax FTaxes are paid by employees, employers, and self-employed taxpayer FTax base is wages and salaries earned FTwo major types VSocial Security VUnemployment

17. 1-17 © 2009 South-Western, a part of Cengage Learning Types of U.S. Taxes wSales Tax FTaxes are paid by purchasers of goods and services FTax base is the selling price of a product or a service

18. 1-18 © 2009 South-Western, a part of Cengage Learning Types of U.S. Taxes wProperty Tax FTaxes are paid by owners of property FTax base is the assessed value of real or personal property (ad valorem)

19. 1-19 © 2009 South-Western, a part of Cengage Learning Types of U.S. Taxes wExcise Tax FTaxes are paid by purchasers FTax base is the quantity purchased and not the value of the purchase

20. 1-20 © 2009 South-Western, a part of Cengage Learning Types of U.S. Taxes wWealth Transfer Tax FTaxes are paid by entity transferring property FTax base is the value of the property transferred VTransfers to spouses and charities are excluded VLifetime Unified Credit excludes up to $2M in 2008 VDonors may exclude annual gifts of $12,000 per donee

21. 1-21 © 2009 South-Western, a part of Cengage Learning Sources of Federal Income Tax Law wLegislative F Law (Internal Revenue Code) wAdministrative FTreasury Regulations FIRS Pronouncements wJudicial FSupreme Court FOther courts

22. 1-22 © 2009 South-Western, a part of Cengage Learning Tax Formula Broadly defined income Includes all forms of income (Chapter 3)

23. 1-23 © 2009 South-Western, a part of Cengage Learning Tax Formula Broadly defined income minus: Exclusions Income specifically excluded from income by legislative grace (Chapter 4)

24. 1-24 © 2009 South-Western, a part of Cengage Learning Tax Formula Broadly defined income minus: Exclusions Income to be Reported equals: Gross Income

25. 1-25 © 2009 South-Western, a part of Cengage Learning Tax Formula Broadly defined income minus: Exclusions equals: Gross Income Amounts specifically allowed as subtractions (Chapters 5 - 7) minus: Deductions

26. 1-26 © 2009 South-Western, a part of Cengage Learning Some Deduction Examples wExpenses (Chapters 5 & 6) FCurrent period expenditures incurred in order to earn income wLosses (Chapter 7) FTransaction losses result when an asset is disposed of at a price less than its tax cost FAnnual losses result when allowed deductions exceed income wExemptions (Chapter 8) FA minimum amount of income needed for basic living FPersonal and dependency ($3,500 each)

27. 1-27 © 2009 South-Western, a part of Cengage Learning Deduction Types Gross Income minus: For Deductions Vnot restricted based on taxpayer’s income Vgenerally trade, business, rent or royalty expenses minus: From Deductions Vrestricted based on Adjusted Gross Income Vgenerally personal expenses –Itemized, or –standard amount (changes with filing status)

28. 1-28 © 2009 South-Western, a part of Cengage Learning Tax Formula Adjusted Gross Income Tax Formula Adjusted Gross Income Gross Income minus: For Deductions equals: Adjusted Gross Income [AGI]

29. 1-29 © 2009 South-Western, a part of Cengage Learning Tax Formula Taxable Income Gross Income minus: For Deductions equals: Adjusted Gross Income [AGI] minus: From Deductions and Exemptions Taxable Income

30. 1-30 © 2009 South-Western, a part of Cengage Learning Tax Formula The Tax Taxable Income times: Tax Rate equals: Income Tax Liability minus: Prepayments & Credits equals: Tax or (Refund) due

31. 1-31 © 2009 South-Western, a part of Cengage Learning Filing Requirements wReturn must be filed annually wCalendar-year individuals file and pay on or before the 15th day of April FMay receive an extension of time to file but not time to pay

32. 1-32 © 2009 South-Western, a part of Cengage Learning Audit and Appeals Process Statute of Limitations wThree years from filing date wExtends to six years if income is under- reported by 25% of gross income wNo limitation for fraud or if no return is filed

33. 1-33 © 2009 South-Western, a part of Cengage Learning Audit and Appeals Process Selection for Audit wOnly about 2% of returns are audited wProcedures used FDiscriminant Function System FTaxpayer Compliance Measurement Program FDocument perfection & Information matching

34. 1-34 © 2009 South-Western, a part of Cengage Learning Audit and Appeals Process Types of Examinations wCorrespondence examinations wOffice examinations wField examinations

35. 1-35 © 2009 South-Western, a part of Cengage Learning Audit and Appeals Process wSettlement Procedure FReport of outcome of audit FWaiver of assessment (Form 870) F30-day letter wAppeals FMeeting with IRS Appeals Division F90-day letter

36. 1-36 © 2009 South-Western, a part of Cengage Learning Tax Planning Goal is to maximize after-tax wealth

37. 1-37 © 2009 South-Western, a part of Cengage Learning Tax Planning Timing wTime Value of money FDefer income FAccelerate deductions wMarginal tax rate FRecognize income in year of lower marginal rate FRecognize deductions in year of higher marginal rate FShift income to taxpayer with lower marginal rate

38. 1-38 © 2009 South-Western, a part of Cengage Learning Tax Planning Tax Avoidance Vs. Tax Evasion wTax Avoidance - Taxpayers have no obligation to pay more tax than the law requires wTax Evasion - Taxpayers may not use fraudulent or deceptive behavior to hide tax liability

39. 1-39 © 2009 South-Western, a part of Cengage Learning Ethics wPreparers are subject to penalties for negligence and fraud wEthical Standards FIRS Circular 230 FAICPA’s Code of Professional Conduct FAICPA’s Statements on Standards for Tax Services