1. © 2010 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 Chapter 1 Federal Income Tax – An Overview Murphy & Higgins, Concepts in Federal Taxation, 2010 edition

2. 1-2 © 2010 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 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

3. 1-3 © 2010 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 What is the Purpose of a Tax? Revenue Penalty Social changes Economic changes Equity

4. 1-4 © 2010 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 Standards of a Good Tax System Adam Smith’s Four Criteria 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

5. 1-5 © 2010 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 Equality 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 Standards of a Good Tax System Adam Smith’s Four Criteria

6. 1-6 © 2010 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 Equality Certainty Convenience Tax should be levied when the taxpayer has funds available to pay Standards of a Good Tax System Adam Smith’s Four Criteria

7. 1-7 © 2010 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 Equality Certainty Convenience Economy The costs of complying with the tax system should be minimal Standards of a Good Tax System Adam Smith’s Four Criteria

8. 1-8 © 2010 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 Tax = Tax Base × Tax Rate Tax Computation

9. 1-9 © 2010 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 Tax = Tax Base × Tax Rate the value subject to taxation Tax Computation

10. 1-10 © 2010 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 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 © 2010 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 Tax Structures Proportional Average tax rate remains the same as tax base increases average rate tax base tax rate

12. 1-12 © 2010 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 Tax Structures Regressive Average tax rate decreases as tax base increases average rate tax base tax rate

13. 1-13 © 2010 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 Tax Structures Progressive Average tax rate increases as tax base increases average rate tax base tax rate

14. 1-14 © 2010 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 Major Types of U.S. Taxes Individual Income Sales Total Taxes Property Employment All Others Corporate Income

15. 1-15 © 2010 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 Types of U.S. Taxes Income Tax Taxes are paid by individuals, corporations, estates, and trusts Tax base is total income less allowed deductions

16. 1-16 © 2010 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 Types of U.S. Taxes Employment Tax 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

17. 1-17 © 2010 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 Types of U.S. Taxes Sales Tax Taxes are paid by purchasers of goods and services Tax base is the selling price of a product or a service

18. 1-18 © 2010 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 Types of U.S. Taxes Property Tax Taxes are paid by owners of property Real property is land and any structures that are permanently attached to it, such as buildings All other types of property are personal property Tax base is the assessed value of real or personal property (ad valorem)

19. 1-19 © 2010 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 Types of U.S. Taxes Excise Tax Taxes are paid by purchasers Tax base is the quantity purchased and not the value of the purchase

20. 1-20 © 2010 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 Types of U.S. Taxes Wealth Transfer Tax Taxes are paid by entity transferring property Tax base is the value of the property transferred Transfers to spouses and charities are excluded Lifetime Unified Credit excludes up to $3.5M in 2009 Donors may exclude annual gifts of $13,000 per donee

21. 1-21 © 2010 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 Sources of Federal Income Tax Law Legislative Law (Internal Revenue Code) Administrative Treasury Regulations IRS Pronouncements Judicial Supreme Court Other courts

22. 1-22 © 2010 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 Tax Formula Broadly defined income Includes all forms of income (Chapter 3)

23. 1-23 © 2010 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 Tax Formula Broadly defined income minus: Exclusions Income specifically excluded from income by legislative grace (Chapter 4)

24. 1-24 © 2010 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 Broadly defined income minus: Exclusions Income to be Reported equals: Gross Income Tax Formula

25. 1-25 © 2010 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 Broadly defined income minus: Exclusions equals: Gross Income Amounts specifically allowed as subtractions (Chapters 5 - 7) minus: Deductions Tax Formula

26. 1-26 © 2010 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 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

27. 1-27 © 2010 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 Some Deduction Examples Exemptions (Chapter 8) A minimum amount of income needed for basic living Personal and dependency ($3,500 each)

28. 1-28 © 2010 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 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)

29. 1-29 © 2010 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 Tax Formula Adjusted Gross Income Gross Income minus: For Deductions equals: Adjusted Gross Income [AGI]

30. 1-30 © 2010 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 Tax Formula Taxable Income Gross Income minus: For Deductions equals: Adjusted Gross Income [AGI] minus: From Deductions and Exemptions Taxable Income

31. 1-31 © 2010 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 Taxable Income times: Tax Rate equals: Income Tax Liability minus: Prepayments & Credits equals: Tax or (Refund) due Tax Formula Taxable Income

32. 1-32 © 2010 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 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

33. 1-33 © 2010 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 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

34. 1-34 © 2010 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 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

35. 1-35 © 2010 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 Audit and Appeals Process Types of Examinations Correspondence examinations Office examinations Field examinations

36. 1-36 © 2010 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 Audit and Appeals Process Settlement Procedure Report of outcome of audit Waiver of assessment (Form 870) 30-day letter Appeals Meeting with IRS Appeals Division 90-day letter

37. 1-37 © 2010 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 Tax Planning Goal is to maximize after-tax wealth

38. 1-38 © 2010 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 Tax Planning Timing Time Value of money Defer income Accelerate deductions Marginal tax rate Recognize income in year of lower marginal rate Recognize deductions in year of higher marginal rate Shift income to taxpayer with lower marginal rate

39. 1-39 © 2010 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 Tax Planning Tax Avoidance Vs. 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

40. 1-40 © 2010 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 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