Week 1 Writing Project
Fundamentals of Taxation 2020 Edition Cruz, Deschamps, Niswander, Prendergast, Schisler
Chapter 1
Introduction to Taxation, the Income Tax Formula, and Form 1040
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No reproduction or further distribution permitted without the prior written consent of McGraw-Hill.
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Introduction
An income tax was first enacted in 18 61 and repealed after the Civil War ended.
An income tax law was passed in 18 94 and was rejected by the Supreme Court in 18 95.
Sixteenth Amendment to the Constitution was passed in 19 13.
This is the basis of modern income tax law.
Over 153 million individual income tax returns were filed in 2017 (most recent year available).
Almost 136 million (89%) were filed electronically.
Individual income tax collections were about $1.59 trillion in 2017.
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The first income tax was enacted almost 150 years ago. It was not until a constitutional amendment was enacted in 1913 that the individual income tax became a reality. Much of the Internal Revenue Code has its legal foundation in the 16th Amendment.
Electronic filing has now grown to 89% of all tax returns.
Tax collections from individuals make up the largest part of total tax collections.
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Learning Objective #1: Progressive, Proportional, and Regressive Tax Structures 1
Taxes are levied by multiplying a tax rate (the rate of tax) by a tax base (the amount taxed).
May be multiple rates on multiple bases (see Table 1-2 for married taxpayers).
Progressive tax structure:
The tax rate increases as the tax base increases.
Example is the U.S. income tax system.
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Most taxes are calculated by multiplying a tax rate against a tax base.
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Learning Objective #1: Progressive, Proportional, and Regressive Tax Structures 2
Proportional tax structure:
The tax rate remains the same regardless of the tax base.
Example is state or local sales taxes.
Regressive tax structure:
The tax rate decreases as the tax base increases.
Example is social security tax system.
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One tax rate structure is a progressive tax structure where the rate increases as the base increases. The notion is that those with more can pay more. Our income tax system is based on this idea.
Another structure is the proportional structure where the rate remains constant at all levels of tax base. Sales taxes are such a type.
A regressive rate structure is one in which the rate goes down as income goes up. It is regressive because those with less income pay proportionally more.
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Learning Objective #1: Progressive, Proportional, and Regressive Tax Structures Concept Check 1-1
The three types of tax rate structures are
Progressive, proportional, and regressive
The tax rate structure for which the tax rate remains the same for all levels of the tax base is the
rate structure.
Proportional
The federal income tax system is an example of a
tax structure.
Progressive
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Learning Objective #2: Marginal and Average Tax Rates
Average tax rate is the total tax paid on a certain amount of taxable income
Total tax / taxable income = average tax rate.
Marginal tax rates are the rate of tax that will be paid on the next dollar of income.
Determined with reference to tax rate schedule.
For example, a married couple will pay a marginal rate of 22% on their $78,951st dollar of income.
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It is important to clearly understand the difference between an average tax rate and a marginal tax rate. They are seldom the same.
An average rate represents the arithmetic average. It is the total tax divided by the total taxable income. Some income may be taxed at a higher or lower rate, but this calculation determines the average over all the income. As tax rate changes or income changes, the average will change.
The marginal rate is the rate that will be paid on the next dollar of income. Refer to Table 1-2. Because of our tax bracket system, the marginal rate stays constant and then makes a jump. For example, a married couple with taxable income of $90,000 has a marginal rate of 22%. If they earn $90,001 they will pay 22 cents on that additional dollar. The marginal rate is also 22% for the next dollar, and the next dollar, and the next dollar. In fact, the marginal rate remains the same until they get to $168,401. At that point, the very last dollar is taxed at 24%.
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Learning Objective #2: The Income Tax Formula
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This is the basic income tax formula. All individual income tax returns are based on this formula. As the complexity of the tax situation of an individual increases, this formula becomes more complicated, but the basic structure remains the same. We will show you a more complex formula in chapter 2.
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Learning Objective #2: The Income Tax Formula Concept Check 1-2 1
The marginal tax rate is the rate of tax imposed on the next dollar of taxable income. True or false?
True
What is the marginal tax rate for a married couple with taxable income of $97,350?
22%
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Learning Objective #2: The Income Tax Formula Concept Check 1-2 2
Average tax rate and marginal tax rate mean the same thing. True or false?
False
Complex tax returns do not follow the basic (or simplified) income tax formula. True or false?
False
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Learning Objective #3: Components of Form 1040 1
Taxpayers annually file a tax return using
Form 1040.
Plus: zero to three of Schedules 1-3. Some taxpayers will not use any schedules, some will use three, and others will use something in between.
The forms and schedules all follow the basic income tax formula.
One or more schedules are used as the tax return becomes more complex.
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There is one tax forms on which a taxpayer can report their income and deductions to the Internal Revenue Service – Form 1040. There are also three schedules that apply to a Form 1040. Taxpayers will use between zero and three of the schedules, depending on the complexity of their tax return.
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Learning Objective #3: Components of Form 1040 2
Wages include salaries, tips, commissions, bonuses, severance pay, sick pay, meals and lodging, fringe benefits, etc.
Employees receive a Form W-2 indicating total wage income in box 1.
Interest income is taxable unless specifically exempt.
Interest income reported on Form 1099-INT.
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The first item on a Form 1040 is wages. Wages include salaries, tips, and other items. Taxpayers receive a Form W-2 from their employer at the end of the year. This document lists the amount of wages received as well as other items, such as income tax withholdings, that will enable the taxpayer to file their tax return.
Interest income is another item that must be reported on an income tax return.
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Learning Objective #3: Components of Form 1040 3
Unemployment compensation is taxable.
Reported on Form 1099-G.
The Standard Deduction is shown on line 9.
$12,200 for single, $24,400 for married.
Total income minus permitted deductions equals Taxable Income (line 11b).
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Unemployment compensation is, in effect, a payment in lieu of wages. It is included as income on a tax return.
Taxpayers are allowed a deduction on line 9 of a Form 1040.
Taxable income (line 11b) is the total of all income minus the deduction from line 9.
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Learning Objective #3: Components of Form 1040 Concept Check 1-3
Only certain types of income are reported on the face of page 2, Form 1040EZ. They are
Wages, interest
Unemployment compensation is reported to the taxpayer on a Form
1099-G
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Learning Objective #4: Calculation of Tax
For taxable income up to $100,000, use tax tables (printed in Appendix D and in the instructions to Form 1040, available on the I R S website).
Tax rate schedules are used for higher income (printed in Appendix F).
Tax tables calculate tax at the midpoint of the income range on the table.
Tax rate schedules calculate tax precisely.
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Taxpayers who have taxable income up to $100,000 will use the tax tables to determine the amount of tax liability. These tables are easy to use and will reduce calculation errors.
If the taxable income is $100,000 or more, taxpayers use the tax rate schedules.
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Learning Objective #4: Calculation of Tax Concept Check 1-4 1
Taxpayers with taxable income under $100,000 must calculate their tax liability using the tax tables. True or false?
True
Refer to the tax tables. What is the tax liability of a married couple with taxable income of $91,262?
$11,798
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Learning Objective #4: Calculation of Tax Concept Check 1-4 2
Using the tax rate schedule in Table 1-2, determine the tax liability (to the nearest penny) for a married couple with taxable income of $91,262.
$11,794.64
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Learning Objective #3: Tax Payments
Tax liability is generally paid throughout the year through withholding tax payments deducted from wages.
Withholding payments are reported on W-2.
Low income taxpayers may be eligible for the Earned Income Credit.
Discussed in chapter 9 with other credits.
A tax return is also used to “settle up” with the I R S at the end of the year.
When filing a tax return, taxpayers will either
Owe the I R S (tax liability > payments).
Receive a refund (tax liability < payments).
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Individuals who receive income from wages pay some or all of their tax liability throughout the year with “withholding payments” that are deducted from their paycheck. These withholding amounts are sent to the IRS and credited to the account of the taxpayer.
In a way, a tax return is the document used to “settle up” with the IRS at the end of the year.
A taxpayer has earned income. Most taxpayers have wage income so they have already paid much of their liability. When a taxpayer gets to the bottom of a 1040, he or she will either owe the IRS some additional money or will receive a refund for excess payments.
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Learning Objective #3: Tax Payments Concept Check 1-5
Taxpayers pay all of their tax liability when they file their tax returns. True or false?
False
Bret’s tax liability is $15,759. His employer withheld $15,367 from his wages. When Bret files his tax return, will he be required to pay or will he get a refund? What will be the amount of payment or refund?
Required to pay, $392
An Earned Income Credit will increase the amount of tax liability. True or false?
False
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Learning Objective #5: Tax Authority 1
Tax authority is the body of law, regulation, and precedent that guide taxpayers, the I R S, and the courts in the proper application of tax law.
Three types of primary tax authority:
Statutory sources.
Administrative sources.
Judicial sources.
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Although the Internal Revenue Code is a large and complex document, it is not always totally clear, it does not answer each and every situation, and it is subject to interpretation. Tax authority is the body of law, regulation, court cases, and precedent that guide everyone in the practical application of the Internal Revenue Code.
The three types of primary tax authority are statutory, administrative, and judicial.
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Learning Objective #5: Tax Authority 2
Statutory sources of tax authority.
16th amendment to the U.S. Constitution.
Internal Revenue Code (I R C).
Passed by Congress and signed into law by the president.
Committee reports from tax law process.
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Statutory authority is derived from the 16th amendment to the constitution, the Internal Revenue Code (the law), and the committee reports generated as part of the process of passing the law.
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Learning Objective #5: Tax Authority 3
Administrative sources of tax authority, in order of strength:
Treasury Regulations (I R S Regulations).
Revenue Rulings.
Revenue Procedures.
Private Letter Rulings.
I R S Notices.
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Administrative sources of tax authority are derived from IRS Regulations, and IRS pronouncements such as Revenue Rulings, Revenue Procedures and the like.
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Learning Objective #5: Tax Authority 4
Judicial sources of tax authority.
Courts resolve disputes between taxpayers and the I R S.
Initial court of jurisdiction is either the
Tax Court.
U.S. District Court.
U.S. Court of Federal Claims.
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Courts also create tax authority when they rule on cases that are brought before them. Taxpayers or the IRS can begin a case in one of three courts. Cases can be appealed to higher courts.
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Learning Objective #5: Tax Authority 5
Tax Court and District Court rulings can be appealed to the U.S. Court of Appeals and then to the Supreme Court.
U.S. Court of Federal Claims rulings can be appealed to the U.S. Court of Appeals − Federal Claims and then to the Supreme Court.
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Depending on where a case begins, the appeal process can take slightly different routes. Ultimately, the U.S. Supreme Court is the final court in any route. The Supreme Court hears very few tax cases during a year.
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Learning Objective #5: Tax Authority Concept Check
The committee charged with considering tax legislation in the House of Representatives is called the
Committee.
Ways and Means
The most commonly relied-on statutory authority is
The Internal Revenue Code
All tax legislation must pass both the House of Representatives and the Senate and be signed by the president of the United States in order to become law. True or false?
True
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Learning Objective #5: Tax Authority Concept Check 1-7
Administrative tax authority takes precedence over statutory tax authority. True or false?
False
I R S Revenue Procedures are applicable only to the taxpayer to whom issued. True or false?
False
The administrative tax authority with the most strength of authority is
I R S Treasury Regulations
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Learning Objective #5: Tax Authority Concept Check 1-8
The U.S. Supreme Court does not accept appeals of tax cases. True or false?
False
A taxpayer who does not agree with an assessment of tax by the I R S has no recourse. True or false?
False
A taxpayer who does not want to pay the tax assessed by the I R S prior to filing a legal proceeding must use the
Court.
Tax
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Learning Objective #6: Circular 230 1
Circular 230 sets forth rules which must be followed by all paid tax preparers.
Includes C P A s, attorneys, enrolled agents, and any other individual who receives compensation for preparing a tax return, providing tax advice, or practicing before the I R S.
Circular 230 sets forth ethical standards and expectations.
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Circular 230 provides for standards of practice for all paid tax preparers.
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Learning Objective #6: Circular 230 2
Failure to comply with Circular 230 will subject the paid preparer to suspension or disbarment from I R S practice, public censure, fines, and civil or criminal penalty.
Rules are far reaching and complex.
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Failure to comply with Circular 230 will subject the paid preparer to numerous sanctions.
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Learning Objective #6: Circular 230 3
Paid tax preparers must obtain a preparer tax identification number (P T I N).
Must be renewed annually.
Preparers who are not C P A s, attorneys, or enrolled agents must pass a competency exam and annually obtain continuing education.
C P A s, attorneys, and enrolled agents must also obtain continuing education.
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Circular 230 requires registration and establishes continuing education requirements.
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Learning Objective #6: Circular 230 4
Paid preparers must:
Sign all tax returns they prepare.
Provide a copy to clients.
Return records to clients.
Exercise due diligence and best practices.
Disclose non-frivolous tax positions.
Notify clients of errors on a client return.
Provide information to the I R S.
Inform a client if the client made an error.
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Circular 230 sets forth actions which a paid preparer must do.
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Learning Objective #6: Circular 230 5
Paid preparers must NOT:
Take a position unless it has a “realistic possibility” of being sustained.
Charge a contingent fee.
Charge an unconscionable fee.
Unreasonably delay matters with I R S.
Cash an I R S check for a client.
Represent a client if a conflict of interest exists.
Make false or fraudulent statements.
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Circular 230 sets forth actions which a paid preparer must NOT do.
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Income
Permitted Deductions from Income
Taxable Income
Appropriate Tax Rates
Tax Liability
Tax Payments and Tax Credits
Tax Refund or Tax Due with Return
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