Chapter 1 An Overview of Federal Taxation

1. Chapter 1An Overview of Federal Taxation The purposes of this course are to: Introduce you to the Federal income taxation of individuals and To increase your tax awareness (ability to recognize tax problems, pitfalls and planning opportunities).

2. The Nature of a Tax The Supreme Court has defined a “tax” as “an exaction for the support of the Government.” A “tax”, therefore, provides a means through which the government derives a majority of the revenues necessary to keep it in operation. It also has become a powerful instrument that policymakers use to attain social as well as economic goals.

3. Characteristics of a Tax A “tax” has one or more of the following characteristics: There is no direct relationship between the exaction of revenue and any benefit to be received by the taxpayer Is levied on the basis of predetermined criteria. Is levied on a recurring or predictable basis May be distinguished from regulations or penalties

4. History of Income Taxation in USA 1789 – US Constitution gave Congress power to levy and collect taxes Tariff Act of 1789 promptly passed 1862 – First Federal Income Tax enacted Apportionment requirement ignored Applied uniformly Expired in 1872 1909 – First Federal corporate income tax successfully passed and upheld in Court February 16, 1913 – Sixteen Amendment passed and was upheld in Court which allowed Congress to pass an individual income tax (the Revenue Act of 1913 on October 3)

5. History of Income Taxation (cont’d) 1916 – First Federal law to impose a tax on the transfer of property (triggered by the death of an individual) was passed – known as an “Estate Tax” Measured on FMV of decedent’s estate 1939 – The Internal Revenue Code of 1939 was created by Congress Was the 1st systematic arrangement of all tax laws Was revised in 1954 and 1986 The Internal Revenue Code of 1986 Continues to be today’s governing Federal tax law Has been amended by significant tax changes since 1986

6. Key Tax Terms Tax Base: amount on which a tax is levied Ex. Taxable Income Ex. FMV of property transferred by gift or at death reduced by allowed exclusions, exemptions or deductions Income: any permanent increment to wealth Loans are not income Some increments are exempted from taxation Deduction: a reduction in the gross (total) amount that must be included in the taxable base. Ex. Medical expenses, interest on mortgages, property taxes, etc.

7. Key Tax Terms (continued) Exclusions: increments to wealth that are not included in a particular Federal tax base Ex. Graduation gift Tax Rates: some percentage applied to the tax base to determine a taxpayer’s liability Are usually proportional or progressive, but can be regressive Progressive tax rate structure is one in which an increasing percentage rate is applied

8. Key Tax Terms (continued) Marginal, Average , and Effective Tax Rates Marginal Tax Rate – is the percentage at which the next dollar added to the tax base will be taxed; is important in tax planning Average Tax Rate – total tax paid divided by the tax base Effective Tax Rate – tax divided by total economic income Tax Credits: a dollar-for-dollar offset against a tax liability A deduction simply reduces the base amount subject to the tax

9. Major Types of Taxes Income Taxes Wealth Transfer Taxes Employment Taxes Excise Taxes Franchise Tax Sales Tax Use Tax Doing-Business Penalty Real Property Tax Tangible Personal Property Tax Intangible Personal Property

10. Income Taxes An Income Tax is an extraction of some of the taxpayer’s economic gain, usually on a periodic basis Many states and some local governments also impose income taxes Income taxes are imposed on individuals, corporations, estates, and trusts To ensure tax collections are made, Congress created a pay-as-you-go requirement Application of Federal income tax on Individuals is discussed in Chapters 3 & 4 Partnerships & corporations in Ch. 19

11. Income Taxes (continued) Exhibit 1-2 (page 1-9) Tax Formula for Corporate Taxpayers Income less: exclusions from gross income Gross Income less: deductions Taxable Income less: applicable tax rates Gross Tax less: tax credits and prepayments Tax Due (or Refund)

12. Income Taxes (continued) Exhibit 1-3 (page 1-9) Tax Formula for Individual Taxpayers Income less: exclusions from gross income Gross Income less: deductions for adjusted gross income Adjusted Gross Income less: (1) the larger of the Standard Deduction or total itemized deductions (2) personal/dependency exemption amounts Taxable Income less: applicable tax rates Gross Tax less: tax credits and prepayments Tax Due (or Refund)

13. Wealth Transfer Taxes The Unified Transfer Tax Is a combination The Federal Estate Tax and the Federal Gift Tax (since 1976) Is Progressive in nature Is computed cumulatively on taxable gifts made during a donor’s lifetime and on taxable transfers made at the donor’s death I.e., is based on lifetime gifts since 1976 Exhibit 1-4 (Computation of Federal Estate Liability) on page 1-11 shows calculation

14. Wealth Transfer Taxes (continued) The Unified Transfer Tax (continued) Decedent’s gross estate includes the fair market value of all property owned at date of death (including any insurance policies decedent had any ownership rights in or to which the estate was beneficiary) The Taxable Estate is the Gross Estate reduced by funeral/administrative expenses, debts, taxes, losses, and charitable gifts from the estate There would be no taxable estate if everything was left to charity There is an unlimited marital deduction

15. Wealth Transfer Taxes (cont’d) The Unified Transfer Tax (continued) Unified Tax Credit Is the major credit available to reduce the Federal Estate Tax Is a lifetime credit available for all taxable transfers The Taxpayer Relief Act of 1997 increased amount of unified credit to $1MM It was further increased by the Economic Growth and Tax Relief Reconciliation Act of 2001 – by 2009 the exclusion amount will grow to $3.5MM and will be repealed (the Estate Tax) in 2010 (for one year); after that (2011) it could return in its current form In 2004, the unified credit is $555,800 (which offsets taxes on $1,500,000)

16. Wealth Transfer Taxes (cont’d) The Federal Gift Tax The purpose of the Federal Gift Tax is to prevent a taxpayer from avoiding Federal Estate Taxes by giving away his/her property prior to death Exhibit 1-5 (Computation of Federal Tax Liability) shows the gift tax calculation on gifts made in the current year – a donor allowed an annual exclusion of $11,000 per donor in 2004 The marital and charitable deductions for federal gift tax are unlimited If taxable gifts have been made for the current year, the cumulative computational procedure of the unified transfer tax must be applied

17. Wealth Transfer Taxes (cont’d) See Examples 15&16 on page 1-13 Note that the cumulative system of wealth transfer taxation AND the progressive rate schedule cause a higher tax on the 2004 gift than the 1995 gift. The tentative tax liability is reduced by the unified transfer tax credit The unified transfer tax credit is the only credit available to offset the Federal gift tax liability A “gift-splitting” election is available for married couples

18. Wealth Transfer Taxes (continued) State and Local Transfer Taxes Many states/local jurisdictions impose inheritance tax on the right to receive property at death (i.e., the recipient, not the decedent) In addition, many impose estate taxes on a decedent’s estate Nine states impose a state gift tax Assignment for next class: Does Texas have an estate tax?

19. Employment Taxes The Federal government and most states impose some kind of employment tax on either self-employed individuals, employees or employers The Federal government imposes two types of taxes on employment: A Social Security tax (FICA Taxes) Imposed on employees, employers and self-employed individuals An unemployment tax (FUTA Taxes) Only imposed on employers Self employed not eligible

20. Employment Taxes (cont’d) FICA Taxes (7.65%) Used to finance social security benefits and Medicare health benefits (MHI) In 2004, $87,900 of wages and self-employment income was subject to Social Security (6.2%) Social security benefits include old age, survivors’ and disability insurance All wages and self-employed income are subject to MHI payments (1.45%)

21. Employment Taxes (continued) FICA (continued) Employer is required to: match the amount of FICA the employee pays, withhold both Federal income taxes and FICA from employees wages during the year, and file Form 941 quarterly and pay the taxes

22. Employment Taxes (continued) FICA (continued) Self-employed taxpayers: Pay twice the amount of FICA as do employees (12.4% Social Security and 2.9% MHI) Are allowed an income tax deduction for one half the amount of FICA taxes actually paid In addition, are also allowed to reduce net earnings from self-employment by an amount equal to one-half the combined 15.3% tax rate (7.65%) times earnings from self-employment in arriving at each of the self-employment tax bases (see page 1-17) Are required to pay quarterly estimated Federal taxes if estimates are $1,000 or more

23. Employment Taxes (continued) FUTA Taxes A Federal unemployment tax is imposed on employers who pay wages of $1500 or more a calendar year, or who employ at least one employee on each of some 20 days during the calendar year or previous year Current rate is 6.2% of first $7000 in wages paid during the year on each covered employee (that is, a maximum of $434 per employee) Since most states also impose an unemployment tax on employers, a credit is allowed for any similar taxes paid up to 5.4% (the maximum normally paid is $56) Form 940 must be filed on or before 1/31 of following year Most states require quarterly payments of unemployment taxes

24. Excise Taxes The purpose of an excise tax is to tax certain privileges as well as manufacture, sale, or consumption of specified commodities Major types include: Occupational taxes: some businesses pay a fee before engaging in business (ex. Liquor stores) Facilities & services taxes: person who uses services/facilities pays taxes, and institution/ individual providing services/facilities collects taxes (ex. Air travel, hotels, phone service, etc.)

25. Types of excise taxes (cont’d): Manufacturers’ taxes: excise taxes on certain semi-luxurious or specialty manufactured goods to make collection easier (ex. Firearms, sporting goods) Retail sales of products and commodities taxes: applies to retail sale of diesel fuel, special motor fuels, and fuel used in non-commercial aviation Many states also have excise taxes. Excise Taxes (continued)

26. Additional Types of Taxes Franchise Tax – tax on privilege of doing business Sales Tax – imposed on retail sale of personal property and certain services Use Tax – imposed on the use of property in a state where a sales tax was not paid Doing-Business Penalty – imposed on businesses not authorized to do business in a state Real Property Tax – placed on realty owned by non-exempt individuals or organizations Tangible Personal Property Tax – tax on property not classified as realty (ex. office furniture, equipment, inventories, supplies, etc.) Intangible Personal Property – tax imposed on stocks, bonds, A/R, notes receivable, etc.

27. Goals of Taxation Objectives: Economic To provide resources to fund governmental expenditures Price stability Can be a major tool to attain satisfactory growth with full employment (i.e., to place more after-tax income in hands of taxpayers) Can be a major tool to stimulate investment spending (through ACRS)

28. Goals of Taxation (cont’d) Objectives (continued): Social Tax system is used to achieve social goals as well. Examples: To Fund charities Encourage home ownership Fight unemployment problems among certain disadvantaged groups of citizens Relieve tax burdens for citizens over 65 Encourage retirement savings

29. Five Qualities of a “Good” Tax A “good” tax satisfies the following conditions: Is equitable or fair Is economically efficient Is certain and not arbitrary Can be administered by the government and complied with by the taxpayer at a low cost Is convenient (i.e., administration and compliance can be carried out with utmost simplicity)