CHAPTER 1

1. CHAPTER 1 Introduction to Federal Income Taxation

2. Function of Tax System • Main function of tax system: • Raise revenues to operate the government • Secondary functions include: • Through progressive structure, allocate cost of public goods and services on ability-to-pay basis • Implement desirable social and economic policies

3. Milestones in U.S. Federal Tax History • Eisner v. Macomber1920

4. The Wealth of Nations • Adam Smith’s canons of taxation (from Wealth of Nations, Book V, Chapter II, Part II) • Equality – taxes paid “in proportion to their respective abilities” – taxpayers should pay what they are able to pay. • Certainty – “uncertainty of taxation encourages insolence and favors corruption” – the time, place, and amount of taxation should be certain. • Convenience – “tax ought to be levied…most likely to be convenient for the contributor to pay it” • Economy – “Every tax ought to be so contrived as both to take out and keep out of the pockets as little as possible, over and above what it brings into the public treasury of the state” – the system should waste as little money as possible.

5. Original Constitutional Status Congress has power “To lay and collect Taxes, Duties, Imposts and Excises, to pay the Debts and provide for the common Defence and general Welfare of the United States; but all Duties, Imposts and Excises shall be uniform throughout the United States”; and “To make all Laws which shall be necessary and proper for carrying into Execution the foregoing Powers.”

6. Early Tax Policy Civil War Tax – 1861 Wilson-Gorman Tariff Act – 1894

7. Pollock v. Farmers’ Loan & Trust Co. Legal challenge was a direct result of WG Tariff Act Pollock sued FL&TC when they promised to withhold and pay tax for customers The Act was found to be unconstitutional

8. Federal Tax of 1909 In 1909, a Federal corporate income tax was enacted and held to be constitutional because it was created as an excise tax (currently known as a franchise tax - a tax for doing business).

9. The 16th Amendment The 16th Amendment, passed in 1913, made all prior decisions on taxation irrelevant. It stated that: “The Congress shall have the power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.” BACK

10. Eisner vs. Macomber - 1920 • Eisner v. Macomberwasthe last of the early formative decisions on the constitutional status of federal income taxation. • The Court found that a stock dividend was not income • The Court stated that “Income may be defined as the gain derived from capital, from labor, or from both combined.” • More importantly, the Court implied that unrealized appreciation in property is not taxable income.

11. Questions to be Answered Our tax law should answer five questions: • What items are included in gross income? • What items are allowable as deductions? • When is an amount includible in income? When is a taxpayer entitled to a deduction for an amount? • Who is the taxpayer? • What is the character of the items of income or the deductions?

12. Income Tax Base Statutory Base  Taxable Income Gross Income § 61(a) Minus: Deductions allowed by § 62 Equals: Adjusted Gross Income (AGI) Minus: Greater of (a) itemized deductions or (b) standard deduction Minus: Personal and dependency exemptions Equals: Taxable income x Rate = Tax Liability - Tax Credits - Tax Payments Tax Due or Refund

13. Gross Income “Except as otherwise provided in this subtitle, gross income means all income from whatever source derived, including (but not limited to) the following items:…” (§ 61(a)) What items are missing from the list in Section 61?

14. Adjusted Gross Income Gross Income minus Deductions specified by § 62 • Expenses incurred in a trade or business • ½ self employment tax • Unreimbursed moving expenses (§ 217) • Contributions to IRAs and other specified retirement plans • Fees for college tuition and related expenses • Contributions to HSAs • Penalty for early withdrawal from savings • Interest on student loans • Excess capital losses • Alimony payments

15. Taxable Income The base to which the statutory rates are applied.

16. Progression in the Rate Schedules Pre-2001 marginal tax brackets: 15%, 28%, 31%, 36%, 39.6% The Economic Growth and Tax Relief Reconciliation Act of 2001 (2001 Act) amended rate schedules: • Added a 10% marginal tax bracket • Reduces pre-2001 rates each year until 2006 • Absent further legislation, pre-2001 rates would return in 2011

17. 2001 Act – Marginal Rate Brackets

18. Jobs and Growth Tax Relief Reconciliation Act of 2003 Accelerated the tax rate reduction scheduled for January 1, 2006 retroactive to January 1, 2003. 10%, 15%, 25%, 28%, 33%, 35%

19. Tax Rates Marginal Tax Rate (MTR) – tax rate on next dollar of taxable income • used for tax planning Average Tax Rate (ATR) – tax rate on each dollar of taxable income • used for purposes of distributive justice • tax liability / taxable income Effective Tax Rate (ETR) – the taxpayer’s average rate of taxation on each dollar of income • both taxable and non-taxable income

20. Tax Rates Example Bill and Mercedes have $140,000 of taxable income and an additional $10,000 of nontaxable income. Using the 2009 married-joint tax rates, what is their average tax rate and effective tax rate? If they receive an additional $80,000 of taxable income, what is their marginal tax rate on this income?

21. Tax Rates Solution

22. Taxable Entities Individual • unmarried • married filing joint and surviving spouse • married filing separate • head of household Partnership (conduit) • income passes through to the partners (whether distributedor not) Corporation LimitedLiability Company (LLC) – state law • treated as a corporation (if elected), otherwise as a partnership (2 or more owners) or disregarded (sole owner) Trust • distributed income taxed to beneficiaries • accumulated income taxed to trust

23. Taxpayer Filing Requirements Corporations: all must file regardless of taxable income Estates and Trusts: required to file if gross income exceeds $600 Individuals: filing is determined by taxpayer’s filing status, age, and gross income 2-23

24. 2011 Gross Income Thresholds by Filing Status Table 1.2011 Filing Requirements Chart for Most Taxpayers 2-24

25. Tax Return Due Date • Individuals: 15th day of 4th month following end of tax year. • Usually April 15th because individuals are usually on a calendar year. • Corporations: 15th day of the 3rd month following end of tax year. • Due dates on a Saturday, Sunday, or holiday are extended to next business day • Individuals and corporations are allowed to apply for an automatic 6 month extensions 2-25

26. Statute of Limitations • Often tax returns are filed with incorrect amounts reported either in the taxpayer’s favor or the government’s favor. • Statute of limitations: the time in which the taxpayer can file an amended return or the IRS can assess a tax deficiency. • Generally ends 3 years from the later of (1) the date the tax return was actually filed, or (2) the tax return’s original due date. 2-26

27. IRS Audit Selection • In general a taxpayer’s return is selected for audit because the IRS believes the tax return has a high probability of being incorrect. • IRS uses computer programs to identify tax returns which might have an understated liability. • Discriminant Function (DIF) system (scoring system) • Document perfection (checks for math errors, etc.) • Information matching programs (compares tax return data with other IRS information) 2-27

28. Types of Audits • Correspondence examinations: • Most common audit • Conducted by mail and are generally limited to 1 or 2 items on the return • Office examinations: • Second most common audit • Conducted in the local IRS office and tends to be broader in scope • Field examinations: • Least common audit • Held at the taxpayer’s place of business and can last months to years. 2-28

29. IRS Appeals/Litigation Process 2-29

30. Trial Level Courts • Tax Court • National court; Tax experts; Do not pay tax 1st • U.S. District Court • Local court; Possible jury trial; Generalists; Pay tax 1st • Cases are low on technical merit, high on emotion. • U.S. Court of Federal Claims • National court; Generalists; Pay tax 1st; Appeals to U.S. Circuit Court of Appeals for the Federal Circuit 2-30

31. Appendix 1 Researching the Tax Law

32. Tax Law Sources • Primary Authorities: Official sources of tax law • Statutory sources (e.g., Internal Revenue Code) • Judicial sources (the courts) • Administrative sources (IRS pronouncements) • Secondary Authorities: Unofficial tax authorities • Tax services • Tax articles 2-32

33. Tax Sources • Are the following primary or secondary sources? • Internal Revenue Code • (Primary) • Tax Article in USA Today • (Secondary) • Article on Supreme Court Opinion • (Secondary) • Supreme Court Opinion • (Primary) • RIA Federal Tax Coordinator • (Secondary) • Treasury Regulations • (Primary) 2-33

34. Primary Tax Authorities: The Hierarchy 2-34

35. Statutory Authorities • U.S. Constitution • The 16th Amendment provides Congress the ability to tax income directly, from whatever source derived, without apportionment across the states • Tax Treaties • agreements negotiated between countries that describe the tax treatment of entities subject to tax in both countries 2-35

36. Statutory Authority: Internal Revenue Code • The main statutory authority • Changes enacted by Congress • Organization of Internal Revenue Code: Subtitle A – Income Taxes Chapter 1 – Income Taxes Subchapter A – Determination of Tax Liability Part I – Definition of Gross Income, Adjusted Gross Income, Taxable Income, etc. (Sec. 61 – 68) Sec. 61 – Gross Income Defined Sec. 62 – Adjusted Gross Income Defined Sec. 63 – Taxable Income Defined Subsection 63(c) – Standard Deduction Paragraph 63(c)(2) – Basic Standard Deduction Subparagraph 63(c)(2) - … Clause 63(c)(2)(i) - … 2-36

37. Tax Legislation Process 2-37

38. Judicial Sources: The Courts 2-38

39. Administrative Sources: The US Treasury 2-39

40. Tax Research Step 1: Understand the facts Step 2: Identify issues Step 3: Locate relevant authorities Step 4: Analyze tax authorities Step 5: Communicate the results 2-40

41. Tax Research • Two types of tax services used in tax research • Annotated • Topical • Research questions often consist of questions of fact or questions of law • The answer to a question of fact hinges upon the facts and circumstances of the taxpayer’s transaction • The answer to a question of law hinges upon the interpretation of the law, such as, interpreting a particular phrase in a code section 2-41

42. Tax Professional Responsibilities • Tax professionals are subject to various statutes, rules and codes of conduct: • AICPA Code of Professional Conduct • AICPA Statement on Standards for Tax Services • IRS Circular 230 • State Board of Accountancy Statutes • Failure to comply with statutes can result in being admonished, suspended, or barred from practicing 2-42

43. Taxpayer and Tax Practitioner Penalties • Civil Penalties: most common type of penalties • Generally in monetary penalties • Imposed when tax practitioners or taxpayers violate tax statutes without reasonable cause • Criminal Penalties: much less common than civil penalties • Penalties are much higher and can include prison sentences 2-43

44. Taxpayer and Tax Practitioner Penalties • A taxpayer and tax practitioner will not be subject to an underpayment penalty if: • there is substantial authority that supports the tax return position or • if there is a reasonable basis for the position and it is disclosed on the taxpayer’s tax return 2-44