An Introduction to Taxation
I1-1 The Supreme Court held the income tax to be unconstitutional in 1895, because the income tax was considered to be a direct tax. At that time, the U.S. Constitution required that an income tax be apportioned among the states in proportion to their populations. This type of tax system would be extremely difficult to administer because different rates of tax would apply to individual tax payers depending on their states of residence. p. I1 2.
I1-2 The pay as you go withholding was needed in 1943 to avoid significant tax collection problems as the tax base broadened from 6% of the population in 1939 to 74% in 1945. Pay as you go permitted the federal government to deduct taxes directly out of an employee's wages. p. I1-3.
I1-3 Under a progressive tax rate structure, the tax rate increases as the taxpayer's income increases. Currently, tax rates of 15%, 28%, 31%, 36% or 39.6% apply depending upon the taxpayer's filing status and taxable income levels. Under a proportional tax rate or "flat tax" structure, the same tax rate applies to all taxpayers regardless of their income levels. Under a regressive tax rate structure, the tax rate decreases with an increase in income level. The concept of vertical equity holds that taxpayers with higher income levels should pay a higher proportion of tax and that the tax should be borne by those who have the "ability to pay." Thus, Congressman Patrick's opposition to the flat tax is theoretically correct, all taxpayers will pay taxes at the same rate, regardless of the ability to pay. pp. I1 4 and I1-5.
I1-4 It is possible for the government to raise taxes without raising tax rates. Because there are two components in computing a taxpayer's tax, the tax base and the tax rate, taxes can be raised by increasing either the rate or the base. Thus, even though the Governor proclaimed that tax rates have remained at the same level, adjustments to the tax base, such as the elimination of deductions, result in tax increases as much as increases in tax rates. p. I1-4.
I1-5 The marginal tax rate is of greater significance in measuring the tax effect for Carmen's decision. The marginal tax rate is the percentage that is applied to an incremental amount of taxable income that is added to or subtracted from the tax base. Through the marginal tax rate, the taxpayer may measure the tax effect of the charitable contribution to her church. The average tax rate is simply the total tax liability divided by taxable income. p. I1-5.
I1-6 Gift and estate taxes are levied when a transfer of wealth (property) takes place and are both part of the unified transfer tax system. The tax base for computing the gift tax is the fair market value of all gifts made in the current year minus an annual donee exclusion of $10,000 per donee, minus a marital deduction for gifts to spouse and a charitable contributions deduction if applicable, plus the value of all taxable gifts in prior years. The tax base for the estate tax is the decedent's gross estate, minus deductions for expenses, and a marital or charitable deduction if applicable, plus taxable gifts made after 1976. pp. I1-7 through I1-10.
I1-7 a. Cathy, the donor, is primarily liable for the gift tax on the two gifts. The children are contingently liable for payment of the gift tax in the event the donor fails to pay.
b. Before considering the unitary tax credit of $192,800 (or the $600,000 tax credit equivalent deduction), a gift tax is due on the two gifts computed as follows:
Total gifts $30,000
Minus: Annual gift tax exclusion ($10,000 x 2 donees) (20,000)
Gift tax base $10,000
Note: Cathy is permitted a $10,000 annual exclusion for gifts of a present interest to each donee. Since Cathy has never made gifts in prior years, no gift tax will be due because of the $192,800 unitary tax credit that is available. pp. I1 8 and I1-9.
I1-8 Carlos' tax basis for the stock is $10,000, the fair market value on the date of death. p. I1 10.
I1-9 a. Most estates are not subject to the federal estate tax because of generous credit and deduction provisions, such as the unified tax credit and the unlimited marital deduction. The unified tax credit of $192,800 is equivalent to a deduction of $600,000. This means that, at a minimum, no estate of $600,000 or less will be subject to the federal estate tax.
b. This is a controversial question that has proponents on both sides of the issue. Those that believe the estate tax should be reduced or eliminated basically argue that the estate tax is a double tax, that is, the property of the decedent has already been subject to income taxation and should not be subjected to further taxation at death. On the other hand, proponents of retaining or increasing the estate tax believe in the ability to pay principle. p. I1-10.
I1-10 a. Progressive.
e. Regressive. pp. I1-4 and I1-5 and I1-12.
Increase. While Carolyn is self employed, a self employment tax is imposed at a 15.3% rate on her income with a ceiling on the non hospital insurance (OASDI) portion of the tax base of $62,700 in 1996. Carolyn is also entitled to an income tax deduction equal to 50% of the self-employment tax payments if she is self-employed. If incorporated, however, FICA tax is imposed at the employee level at a rate of 7.65% on wages up to $62,700 in 1996 with an equal amount of tax imposed on the employer. The hospital insurance portion of the FICA premium continues to apply with no ceiling amount for both employees
, employers, and self-employed individuals. The rate is 2.9% for self-employed individuals and 1.45% each for employees and employers. p. I1-11.
a. Property taxes are primarily used by local governments and include both real property taxes (real estate) and personal property taxes (tangible and intangible property).
b. Excise taxes are primarily used by the federal government and are imposed on items such as alcohol, tobacco, telephone usage, and many other goods. While not as extensive as the federal government, many state and local governments impose similar types of taxes.
c. Sales taxes are primarily used by state governments and constitute a major revenue source for many states. Local governments are increasingly using sales taxes as well as states. The local governments frequently tack-on 1¢ or 2¢ to the existing state sales tax rather than imposing a separate sales tax.
d. Income taxes are the primary domain of the federal government and constitutes its major source of revenue. Clearly, however, both state and local governments now use the income tax in their revenue structures.
e. Employment taxes are primarily used by the federal government. Social security (FICA) taxes are a major source of federal revenue. Unemployment taxes are used by states as a compliment to the federal unemployment compensation tax. pp. I1-10 and I1-11.
I1-13 a. The four characteristics of a "good" tax are equity, certainty, convenience, and economy. Equity refers to the fairness of the tax to the taxpayers. A certain tax is one that ensures a stable source of government revenue and provides taxpayers with some degree of certainty concerning the amount of their annual tax liability. Convenience refers to the case of assessment, collectibility, and administration for the government and reasonable compliance requirements for taxpayers. An economical tax requires minimal compliance costs for taxpayers and minimal administration costs for the government.
b. 1. The federal income tax meets the four criteria reasonably well, even though many critics would suggest otherwise. The tax is reasonably fair in that the high income taxpayers pay the most tax, the low income taxpayers the least tax. While tax laws are constantly changing, most taxpayers have a pretty good idea of what their taxes are going to be for the tax year and the federal income tax does provide the government with a stable source of revenue. The tax is convenient to pay although compliance requirements for taxpayers has risen steadily over the years. The tax is economical for the government to collect, however, the cost of compliance for taxpayers is much too high as over 50% of all taxpayers pay a tax preparer to prepare their tax returns.
2. The state sales tax meets the criteria of certainty, convenience, and economy quite well. However, the sales tax is criticized as not being equitable as it tends to fall more heavily on lower and middle income taxpayers.
3. Property taxes do not fare well according to the characteristics of a "good" tax. From equity standpoint, the property tax is imposed on property owners without regard to their income situation. Thus, a farmer may have substantial property but little income to pay the property tax. Property taxes are certain but clearly not convenient in the sense that they are normally assessed in a lump-sum amount once a year. Property taxes do not meet the economy criteria.
pp. I1-11 through I1-14.
a. Horizontal equity refers to the concept that similarly situated taxpayers should pay approximately the same amount of tax. Vertical equity, on the other hand, refers to the concept that higher income taxpayers should not only pay a higher amount of tax but should pay a higher percentage of tax. Vertical equity is based on the notion that taxpayers who have the "ability to pay" (e.g., higher income taxpayers) should pay more tax than lower income taxpayers.
b. Fairness is an elusive term. Because of widely divergent opinions as to what constitutes fairness, it logically follows that there are also many different and divergent opinions as to what constitutes a "fair" tax structure. p. I1-11 through I1-13.
The carryback and carryover of net operating losses mitigate the effects of our progressive tax rate structure by allowing certain losses to offset taxable income for a three year carryback period or a fifteen year carryover period. p. I1 11.
Secondary objectives include the following:
a. Economic objectives such as stimulating private investment, reducing unemployment, and mitigating the effects of inflation.
b. Encouraging certain activities such as research and development and small business investment.
c. Social and public policy objectives, (e.g. encouraging charitable contributions and discouraging illegal bribes). pp. I1-14 and I1-15.
No, it is probably not possible to achieve a simplified tax system and also provide incentives to certain industries as well as achieve social objectives. To achieve a simplified tax system would require the elimination of special purpose provisions, such as with the several flat tax proposals being forwarded. pp. I1-14 and I1-15.
Because of the vast volume of tax law sources, it is impossible for any person to have recall knowledge of the tax law. Thus, the ability to understand what the relevant sources of tax law are
, their relative weight (importance), and where to find the sources are vital to a person working in the tax area. p. I1-16.
Even though the Code is the highest authority of tax law sources, the Code contains general language and does not address the many specific situations and transactions that occur. To resolve tax questions concerning specific situations, administrative rulings and court decisions are an integral part of the income tax law. p. I1-16.
I1-20 a. Ways and Means Committee (House of Representatives), Senate Finance Committee (U.S. Senate) and the Joint Conference Committee.
b. Committee reports are helpful for two major purposes: (1) to explain the new law before the Treasury Department drafts regulations on the tax law changes, and (2) to explain the intent of Congress for passing the new law. p. I1-18.
I1-21 The National Office of the IRS processes ruling requests and prepares Revenue Procedures that assist taxpayers with compliance matters. p. I1 18.
I1-22 Individuals most likely to be audited include those that may be involved in any of the following situations:
· Individuals who incur trade or business and/or investment losses.
· Itemized deductions in excess of an average amount for the person's income level.
· Filing of a refund claim by a taxpayer who has been previously audited and the audit resulted in a substantial tax deficiency.
· Individuals who are self employed with substantial business income or income from a profession such as a medical doctor. p. I1-19.
I1-23 a. The IRS may review each line item of Anya's return if it is selected by the Taxpayer Compliance Measurement Program (TCMP). Under this program a small number of taxpayers selected by a random sample are audited on a line by line basis. Currently, the IRS has announced that it's abandoning TCMP audits.
b. Generally not all items on a return will be audited. All tax returns are initially checked for mathematical accuracy and items that may be considered clearly erroneous. If differences are noted the IRS sends the taxpayer a bill for the corrected amount. Upon an audit of Anya's return, the IRS generally only examines selected items on the return. These items are those that the IRS believes there is a possibility of error. p. I1 19.
I1-24 a. The term "hazards of litigation" refers to the probability of winning or losing a case if it goes to court.
b. Because of the possibility that a case may be lost and the cost of litigation, both the IRS and taxpayers frequently settle a case to avoid such possibilities. The IRS may also decide to settle a case because it does not want to establish an unfavorable precedent of cases in a specific area. p. I1-21.
I1-25 No, the IRS may still audit a taxpayer even though he/she may have received a refund. p. I1 20.
a. The statute of limitations remains open indefinitely if a fraudulent return is filed or if no return is filed at all.
b. The general rule for the disallowance of tax deduction items is that an assessment may be made against the taxpayer within three years from the later of the date the tax return was filed or its due date.
c. A six year statute of limitations applies if the taxpayer omits an item of gross income that is in excess of 25 percent of the gross income that is reported on the return. p. I1-20.
I1-27 The best possible defensibly correct solution is one that is advantageous to the client but is based upon substantial authoritative support (e.g., favorable court cases) even though the position may be challenged upon audit by the IRS. p. I1-22.
I1-28 The four principal areas of activity for the profession of tax practice are; tax compliance and procedure, tax research, tax planning and financial planning. Tax compliance and procedure essentially consists of tax return preparation and assisting the taxpayer in dealing with the IRS. Tax research is the process of developing the most defensibly correct solution to a tax problem. Tax planning involves the process of reducing taxes so as to maximize a taxpayer's after-tax return. Financial planning, while not exclusively related to tax, is a relatively new area for tax professionals to assist clients with planning for their entire financial affairs. pp. I1-21 through I1-23.
I1-29 a. Because income taxes may approach 50% of a taxpayer's income (including federal and state income taxes), taxes are an extremely important part of the financial planning process. Any financial plan that does not carefully consider taxes is a flawed plan.
b. Because tax professionals see their clients at least once a year (preparation of their income tax returns), this represents a prefect opportunity to perform financial planning.
No, the principal goal of tax planning is to maximize a taxpayer's after-tax cash flow, not just the minimization of taxes due. p. I1-22.
Microcomputers, along with certain software programs, assist tax practitioners when determining if a corporation has an accumulated earnings tax problem and making basis adjustments for real estate partnerships and so on. In addition, computerized systems may help researchers update and/or back up their research through the use of computerized information retrieval systems such as ACCESS and LEXIS. pp. I1 25 and I1-26.
b. Marginal rate = 31% (From tax rate schedule)
Average rate = 23.0% ($14,176/$62,300)
Effective rate = 21.1% ($14,176/$62,300 + 5,000)
c. From a tax planning point of view, the marginal rate is the most important rate because it measures the tax saving from each additional $1 of deduction (or additional tax from each additional $1 of taxable income). pp. I1-4 through I1-7.
I1-33 a. Their marginal tax rate with $350,000 of taxable income is 39.6%. However, with an additional $80,000 of deductions, their taxable income would drop to $270,000 which would drop their marginal tax rate to 36% (for 1998, the 39.6% rate begins when taxable income exceeds $278,450).
b. Their tax savings using the 1998 Tax Rate Schedules would be $31,376, computed as follows:
Tax on $350,000 112,204
Tax on $270,000 80,828
Tax savings $31,376
pp. I1-4 through I1-7.
I1-34 a. Chuck's taxable gift for the current year is $20,000 computed as follows:
Gift to daughter $30,000
Minus: Gift tax exclusion (10,000)
Taxable gift $20,000
Note: Charitable contributions are not subject to a gift tax and gifts between spouses are eliminated by the unlimited marital deduction. pp. I1-8 and I1-9.
b. Chuck's taxable gift for the current year is $10,000 Computed as follows:
Gift to daughter
Minus: Gift tax exclusion, Chuck
Gift tax exclusion, spouse
Note: Gift splitting allows Chuck to split the gifts with his wife thus allowing her to take advantage of the $10,000 annual gift tax exclusion. pp. I1-8 and I1-9.
a. The amount of Clay's taxable estate is $250,000. This amount is computed as follows:
Gross estate $800,000
Minus: Marital deduction (350,000)
Funeral and Admin. Expenses (125,000)
Debts ( 75,000)
Taxable Estate $250,000
b. The tax base for computing Clay's estate tax is $250,000, computed as follows:
Taxable estate $ 250,000
Gifts after 1976 0
Tax base $ 250,000
c. If the tentative estate tax is $70,800, zero estate tax is due. Computed as follows:
Estate tax $ 70,800
Minus: Unified tax credit (1998) (202,050)
Estate tax due $ 0
d. Yes, because the aggregate value of the estate decreased during the six-month period following the date of death, the alternate valuation date may be selected by the administrator. The important factors in deciding whether to use the alternate valuation date are (1) the amount of estate taxes to be saved, and (2) the impact on the beneficiaries income tax situation.
Note: There can never be a tax refund even if the unified credit is greater than the tax liability. pp. I1 8 and I1 9.
Since Paul's return is filed late and the final balance due on the return is paid late (both due on or before April 15, 1998), Paul is subject to further interest and penalties on this 1997 income tax return. Both interest and penalties are computed on the net tax due or, in this case, $7,863 ($25,863 minus $18,000). The interest and penalties are computed as follows (assuming a 9% interest rate on underpayments on tax and the return is 229 days late):
Interest: $7,863 x 9% x 229/365 = $444.
There are two penalties to which Paul would be subject, a failure to file (timely) penalty and a failure to pay the tax (timely) penalty. The late payment penalty is .5% per month to a maximum of 25%; the late filing penalty is 5% per month to a maximum of 25%. However, both penalties are not assessed together. If both penalties apply, the failure to file penalty is reduced by .5%.
Penalties: Late filing penalty (5% per month to a maximum 25%) $7,863 x 25%* = $1,966.
*Because the late payment penalty below is assessed
, the penalty is 4.5% per
month; however, the return was filed 7½ months late, the maximum penalty of
Late payment penalty (.5% per month to a maximum 25%) $7,863 x 4%** =
**Eight months times .5% = 4%.
Thus, Paul must pay an additional $444 of interest and $2,281 of penalties for filing his return late. Obviously, Paul would be prudent to file his return in a timely manner. pp. I1-20 and I1-21.
a. Connie would most likely be audited. Individuals who have unincorporated businesses that produce significant tax losses are likely to get audited by the IRS.
b. Craig is not likely to be audited.
c. Dale is not likely to be audited. However, it is likely that the Form 1099 will be checked against the reported amount and the IRS Center will send Dale a bill for the corrected amount of tax. p. I1-19.
The statute of limitations will not prevent the IRS from issuing a deficiency assessment for 1993, 1994, or 1996. Dan's taxes from 1993 will be assessed because the statute of limitations remains open indefinitely if no return is filed.
The $40,000 of unreported gross income from 1994 is taxable. A six year statute of limitations applies if the taxpayer omits an item of gross income that is in excess of 25% of the reported gross income. In this case reported gross income was $60,000. $40,000 is greater than $15,000 (0.25 x $60,000).
The $600 unsubstantiated business travel and entertainment deduction are disallowed in 1996 and gross income will be increased in 1996 because an assessment may be made against the taxpayer within three years from the later of the due date or the date the tax return was filed. In this case the omission occurred in 1996. p. I1-20.
Case Study Problem
I1-39 (See Instructor's Guide)
Tax Research Problem
I1-40 (See Instructor's Guide)