An Introduction To Taxation and Understanding The Federal Tax Law

C H AP T E R
1
An Introduction to Taxation and
Understanding the Federal Tax Law
Individual Income Taxes
2017 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
History of Taxation (slide 1 of 2)

Prior to 1900s income tax financed wars
1861:
First Federal individual income tax

enacted
Repealed after Civil War
1894:
New Federal individual income tax

enacted
Tax found to be unconstitutional
History of Taxation (slide 2 of 2)

Other important events
1909:
1913:
First Federal corporate income tax

enacted
16th Amendment ratified
Sanctioned both Federal individual and corporate income
taxes
Federal Budget Receipts2016

Individual income taxes
Corporation income taxes
Social insurance taxes and contributions
Excise taxes
Other
Total
100%
Exhibit 1.1
47%
13
32
3
5
Criteria for Evaluating

a Tax Structure (slide 1 of 2)
Adam Smith identified the following canons of
taxation which are still considered when
evaluating tax structures:
Equality
Convenience
Certainty
Economy
Criteria for Evaluating

a Tax Structure (slide 2 of 2)
In addition, the AICPA suggests that the tax
system should be:
Simple
Neutral in terms of its effect on business
Clear and readily understandable
Structured to minimize noncompliance
Should enable the IRS to predict the amount and
timing of revenue
Should not reduce economic growth and efficiency
Tax Structure (slide 1 of 2)

Tax base: amount to which the tax rate is applied
e.g., For the Federal income tax, the tax base is
taxable income
Tax rates: applied to the tax base to determine

the tax liability
May be proportional or progressive
Incidence of tax: degree to which the tax burden

is shared by taxpayers
Tax Structure (slide 2 of 2)

Examples:
Income
Proportional
Tax
Progressive
Tax
$10
$20
$30
$3 (30%)
$6 (30%)
$ 9 (30%)
$3 (30%)
$7 (35%)
$12 (40%)
Major Types of Taxes
Property Taxes
Transaction Taxes
Death Taxes
Gift Taxes
Income Taxes
Employment Taxes
Other U.S. Taxes
Property (ad valorem) Taxes

Based on the value of the asset
Essentially, a tax on wealth, or capital
Generally imposed on realty or personalty

Exclusive jurisdiction of states and their local
political subdivisions
Deductible for Federal income tax purposes
10
Transaction Taxes
Excise taxes
General sales taxes
Severance taxes
11
Excise Taxes
Imposed at the Federal, state, and local levels
Restricted to specific items
Examples: gasoline, tobacco, liquor
Declined in relative importance until recently

Example-two types of excise taxes at the local level
have recently become increasingly popular
Hotel occupancy tax
Rental car surcharge
Tax is levied on visitors who cannot vote and often

used to fund special projects
12
General Sales Taxes

Currently jurisdiction of states and localities
States that impose sales taxes also charge a
use tax on items purchased in other states but
used in their jurisdiction
States without sales or use taxes are Alaska,
Delaware, Montana, New Hampshire, and
Oregon
13
Severance Taxes
Tax on natural resources extracted
Important revenue source for states rich in natural
resources
14
Death Taxes (slide 1 of 2)

Tax on the right to transfer property or to receive
property upon the death of the owner
If imposed on right to pass property at death
Classified as an estate tax
If imposed on right to receive property from a

decedent
Classified as an inheritance tax
15
Death Taxes (slide 2 of 2)

The value of the property transferred provides
the base for determining the amount of the
death tax
The Federal government imposes only an estate
tax
Many state governments levy inheritance taxes,
estate taxes, or both
16
Federal Estate Tax

(slide 1 of 2)
Federal estate tax is on the right to pass

property to heirs
Gross estate includes FMV of property decedent
owned at time of death
Also includes property interests, such as life insurance
proceeds paid to the estate or to a beneficiary other than the
estate if the deceased-insured had any ownership rights in
the policy
17
Federal Estate Tax

(slide 2 of 2)
Property included in the gross estate is valued

on either:
Date of death, or
If elected, the alternate valuation date
Generally 6 months after date of death
Certain deductions and credits allowed in

arriving at the taxable estate
Examples - marital deduction, funeral and admin. expenses,
certain taxes, debts of decedent
18
Unified Transfer Tax Credit

Unified credit reduces or eliminates the estate
tax liability for certain estates
For 2016, credit is $2,125,800
Offsets tax on $5.45 million of the tax base
19
State Death Taxes

State death taxes may be estate tax, inheritance
tax, or both
Inheritance tax is on the right to receive property from
a decedent
Tax is generally based on relationship of heir to
decedent
The more closely related, the lower the tax
20
Federal Gift Tax

(slide 1 of 3)
Tax on the right to transfer assets during a

persons lifetime
Applies only to transfers that are not supported by full
and adequate consideration
Taxable gift = FMV of gift less annual exclusion

less marital deduction (if applicable)
Federal gift tax provides an annual exclusion of
$14,000 per donee (in 2016)
Amount is adjusted for inflation
21
Federal Gift Tax

(slide 2 of 3)
Married persons can make a special election to

split gifts
Allows 1/2 of a gift made by a donor-spouse to be
treated as having been made by a nondonor-spouse
(gift splitting)
Effectively increases the number of annual exclusions
available and allows the use of the nondonorspouses unified transfer tax credit
22
Federal Gift Tax

(slide 3 of 3)
The unified transfer tax credit is available for

gifts (as well as the estate tax)
The credit for 2016 is $2,125,800
Covers taxable gifts up to $5,450,000
There is only one unified transfer tax credit

It applies to both taxable gifts and the Federal estate
tax
23
Income Taxes
Imposed at the Federal, most state, and some local
levels of government
Income taxes generally are imposed on individuals,
corporations, and certain fiduciaries (estates and trusts)
Federal income tax base is taxable income (income less

allowable exclusions and deductions)
Most jurisdictions attempt to assure tax collection by
requiring pay-as-you-go procedures, including
Withholding requirements for employees
Estimated tax prepayments for all taxpayers
24
Formula for Federal Income

Tax on Individuals
Exhibit 1.2
25
Corporate Income Tax

Corporate Taxable Income
= Income Deductions
Does not require the computation of adjusted gross
income
Does not provide for the standard deduction or
personal and dependency exemptions
All allowable deductions are business expenses
26
State Income Tax (slide 1 of 3)

All but the following states impose an income tax
on individuals:
Alaska, Florida, Nevada, South Dakota, Texas,
Washington, and Wyoming
New Hampshire and Tennessee impose an individual
income tax only on interest and dividends
27

Some characteristics of state income taxes
include:
With few exceptions, all states require some form of
withholding procedures
Most states use as the tax base the income
determination made for Federal income tax purposes
Some states apply a flat rate to Federal AGI
Some states apply a rate to the Federal income tax liability
Referred to as the piggyback approach to state

income taxation
28

Some states decouple from select tax
legislation enacted by Congress
State may not be able to afford the loss of revenue
resulting from such legislation
Because of tie-ins to the Federal return, states

may be notified of changes made by the IRS
upon audit of a Federal return
In recent years, the exchange of information between
the IRS and state taxing authorities has increased
29
Employment Taxes (slide 1 of 4)

FICA taxes
Paid by both an employee and employer
The Social Security rate is 6.2% in 2016 on a
maximum of $118,500 of wages
The Medicare rate is 1.45% on all wages
A spouse employed by another spouse is subject to

FICA
Children under the age of 18 who are employed in
parents unincorporated trade or business are exempt
from FICA
30

Beginning in 2013,
An additional 0.9% tax is imposed on earned income
above $200,000 (single filers) or $250,000 (MFJ)
An employer does not have to match the
employees 0.9%
A 3.8% tax is imposed on investment income (e.g.,

taxable interest, dividends, and capital gains)
Applies when modified AGI exceeds $200,000 (single filers)
or $250,000 (MFJ)
31

FICA taxes
Sole proprietors and independent contractors may
also be subject to Social Security taxes
Known as the self-employment tax
Rates are twice that applicable to an employee
Generally, 12.4% for Social Security and 2.9% for Medicare
The tax is imposed on net self-employment income up to a

base amount of $118,500 for 2015 and 2016
The new 0.9% tax addition to Medicare also covers situations
involving high net income from self-employment
32

FUTA (unemployment) taxes
Provides funds for state unemployment benefits
In 2016, rate is 6% on first $7,000 of wages for each
employee
Administered jointly by states & Fed govt.
Credit is allowed (up to 5.4%) for FUTA paid to the state
Thus, the amount required to be paid to the IRS could be as
low as 0.6% (6.0% - 5.4%)
Tax is paid by employer
33
Other Taxes
Federal customs duties
Tariffs on certain imported goods
Franchise taxes
Levied on the right to do business in the state
Occupational fees
Applicable to various trades or businesses
e.g., liquor store license, taxicab permit, fee to practice a
profession
34
Proposed Taxes
Flat tax
Would replace the current graduated income tax with
a single rate
Value added tax

Taxes the increment in value as goods move through
production & manufacturing stages to the market
Paid by the producer and reflected in the sales price of goods
National sales tax

Levied on the final sale of goods and services
Collected from consumer, not from businesses as with VAT
35
Tax Administration (slide 1 of 4)

Internal Revenue Service (IRS)
Responsible for enforcing the Federal tax laws
Audits small percentage of returns filed using
mathematical formulas and statistical sampling
To update selection criteria, the IRS selects a cross section
of returns, which are subject to various degrees of inspection
Results highlight areas of taxpayer noncompliance and
enable the IRS to use its auditors more productively
36

Types of audits:
Correspondence audit
Office audit
Usually restricted in scope and conducted in facilities of IRS
Field audit
Involves examination of numerous items reported on the
return and is conducted on premises of taxpayer or
taxpayer's representative
37

After the audit, a Revenue Agents Report (RAR)
is issued summarizing the findings which can
result in a:
Refund (tax was overpaid)
Deficiency (tax was underpaid), or
No change (tax was correct) finding
38

If an audit results in an assessment of additional tax
Taxpayer may attempt to negotiate a settlement
An appeal is available through the Appeals Division of the IRS
Appeals Division is authorized to settle all disputes based on the
hazard of litigation (i.e., probability of favorable resolution, if litigated)
If a satisfactory settlement is not reached on administrative

appeal, the taxpayer can litigate in:
Tax Court
Federal District Court, or
Court of Federal Claims
Litigation is recommended only as a last resort because of

Legal costs involved
Uncertainty of the final outcome
39
Statute of Limitations (slide 1 of 3)

Statute of limitations offers a defense against a suit
brought by another party after the expiration of a
specified period of time
Purpose is to preclude parties from prosecuting stale claims
The passage of time makes defense of such claims difficult since
witnesses may no longer be available or evidence may have been
lost or destroyed
For Federal income tax purposes, the two categories

involved relate to the statute of limitations applicable to:
The assessment of additional tax deficiencies by the IRS, and
Claims for refunds by taxpayers
40

For a deficiency assessment by IRS
Generally 3 years from the later of the due date or the
filing date of the return
For material (more than 25%) omissions of gross
income, time period is 6 years
No statute if no return filed or fraudulent return filed
41

For a refund claim by taxpayer
Generally 3 years from date return filed or 2 years
from date tax paid, whichever is later
42
Interest and Penalties (slide 1 of 2)

Interest accrues on the taxes due starting from
the due date of the return and interest is paid on
refunds if not received within 45 days of when
the return was filed
43
Interest and Penalties (slide 2 of 2)

Tax law provides various penalties for lack of
compliance including penalties for:
Failure to file
Penalty is 5% per month up to a max of 25% on the amount
of tax shown as due on the return
Any fraction of a month counts as a full month
Failure to pay
Penalty is 0.5% per month up to a max of 25%
Penalties may also apply to underpayment of

estimated taxes, negligence, fraud, etc
44
Tax Practice (slide 1 of 4)

Area of tax practice is largely unregulated
Members of professions must follow certain ethical
standards (CPAs, Attorneys)
Various penalties may be imposed upon preparers of
Federal tax returns who violate proscribed acts and
procedures
45

Ethical guidelines issued by AICPA:
Do not take questionable position on clients tax
return in hope of it not being audited
Clients estimates may be used if reasonable
Try to answer every question on the tax return (even if
disadvantageous to client)
Upon discovery of an error in prior year tax return,
advise client to correct
46

Statutory penalties may be levied on tax return
preparers for:
Procedural Matters-Failure to:
Provide copy of return to taxpayer

Sign the return as preparer
Keep copies of returns
Maintain a client list
47

Statutory penalties may be levied on tax return
preparers for:
Understatement of tax liability based on a position
that lacks a realistic possibility of being sustained
Willful attempts to understate tax
Failure to exercise due diligence in determining
eligibility for, or the amount of, the earned income tax
credit
48
Understanding the Federal

Tax Law (slide 1 of 3)
The Federal tax law is the vehicle for
accomplishing many objectives of the nation
such as:
Raising revenue: the major objective of the tax
system but not the sole objective
Economic: increasingly important objective is to
regulate the economy and encourage certain behavior
and businesses considered desirable
49

Federal tax objectives
Social: encourage socially desirable behavior that
provides benefits that government might otherwise
provide
Equity: equity within the tax laws (e.g., wherewithal to
pay concept) and not necessarily equity across
taxpayers
50

Federal tax objectives
Political: a large segment of the tax law is created
through a political process; thus, compromises and
special interest dealings occur
Ease of administration: many provisions are meant to
aid the IRS in the collection of taxes
Courts: influence tax law and sometimes cause it to
change
51

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C H AP T E R

History of Taxation (slide 1 of 2)

First Federal individual income tax

New Federal individual income tax

History of Taxation (slide 2 of 2)

First Federal corporate income tax

Federal Budget Receipts2016

Criteria for Evaluating

Criteria for Evaluating

Tax Structure (slide 1 of 2)

Tax rates: applied to the tax base to determine

Incidence of tax: degree to which the tax burden

Tax Structure (slide 2 of 2)

Major Types of Taxes

Property (ad valorem) Taxes

Generally imposed on realty or personalty

Declined in relative importance until recently

Tax is levied on visitors who cannot vote and often

General Sales Taxes

Death Taxes (slide 1 of 2)

If imposed on right to receive property from a

Death Taxes (slide 2 of 2)

Federal Estate Tax

Federal estate tax is on the right to pass

Federal Estate Tax

Property included in the gross estate is valued

Certain deductions and credits allowed in

Unified Transfer Tax Credit

State Death Taxes

Federal Gift Tax

Tax on the right to transfer assets during a

Taxable gift = FMV of gift less annual exclusion

Federal Gift Tax

Married persons can make a special election to

Federal Gift Tax

The unified transfer tax credit is available for

There is only one unified transfer tax credit

Federal income tax base is taxable income (income less

Formula for Federal Income

Corporate Income Tax

State Income Tax (slide 1 of 3)

State Income Tax (slide 2 of 3)

Referred to as the piggyback approach to state

State Income Tax (slide 3 of 3)

Because of tie-ins to the Federal return, states

Employment Taxes (slide 1 of 4)

A spouse employed by another spouse is subject to

Employment Taxes (slide 2 of 4)

A 3.8% tax is imposed on investment income (e.g.,

Employment Taxes (slide 3 of 4)

The tax is imposed on net self-employment income up to a

Employment Taxes (slide 4 of 4)

Tax is paid by employer

Value added tax

National sales tax

Tax Administration (slide 1 of 4)

Tax Administration (slide 2 of 4)

Tax Administration (slide 3 of 4)

Tax Administration (slide 4 of 4)

If a satisfactory settlement is not reached on administrative

Litigation is recommended only as a last resort because of

Statute of Limitations (slide 1 of 3)

For Federal income tax purposes, the two categories