Chapter 1. Introduction to Taxation, the Income Tax Formula, and Form 1040EZ â€œTaxes, after all, are dues that we pay for the privileges of membership in an organized society.â€ -- Franklin D. Roosevelt. Introduction.
Introduction to Taxation, the Income Tax Formula, and Form 1040EZ
“Taxes, after all, are dues that we pay for the privileges of membership in an organized society.”
-- Franklin D. Roosevelt
An income tax was first enacted in 1861 and repealed after the Civil War ended
An income tax law was passed in 1894 and was rejected by the Supreme Court in 1895.
Sixteenth Amendment to the Constitution was passed in 1913
This is the basis of modern income tax law
About 145.6 million individual income tax returns were filed in 2011
Almost 83% were filed electronically
Individual income tax collections were about $1.04 trillion in 2011.
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
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
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 15% on their $35,000th dollar of income.
− Permitted Deductions from Income
= Taxable Income
× Appropriate Tax Rates
= Tax Liability
− Tax Payments and Tax Credits
= Tax Refund or Tax Due with Return
Taxpayers annually file a tax return using
All follow the basic income tax formula
Form 1040EZ is the simplest form
To use a 1040EZ taxpayer must meet all the following:
Single or married filing jointly
Under age 65 and not blind
Taxable income < $100,000
Income only from wages, unemployment compensation or interest ≤ $1,500
Claim no credits except Earned Income Credit
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
Unemployment compensation is taxable
Reported on Form 1099-G
Permitted deductions are shown on line 5
$10,000 for single, $20,000 for married
Total income minus permitted deductions equals Taxable Income (line 6)
For taxable income up to $100,000, use tax tables (printed in Appendix D)
Tax rate schedules are used for higher income (printed on inside front cover)
Tax tables calculate tax at the midpoint of the range on the table
Tax rate schedules calculate tax precisely
Tax liability is generally paid throughout the year through withholding tax payments deducted from wages
Also 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 IRS at the end of the year.
When filing a tax return, taxpayers will either
Owe the IRS (tax liability > payments)
Receive a refund (tax liability < payments)
Tax authority is the body of law, regulation, and precedent that guide taxpayers, the IRS, and the courts in the proper application of tax law.
Three types of primary tax authority:
Statutory sources of tax authority
16th amendment to the U.S. Constitution
Internal Revenue Code (IRC)
Passed by Congress and signed into law by the president
Committee reports from tax law process
Administrative sources of tax authority, in order of strength
Treasury Regulations (IRS Regulations)
Private Letter Rulings
Judicial sources of tax authority
Courts resolve disputes between taxpayers and the IRS.
Initial court of jurisdiction is either the
U.S. District Court
U.S. Court of Federal Claims
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.
Circular 230 sets forth rules which must be followed by all paid tax preparers
Includes CPA’s, attorneys, enrolled agents, and any other individual who receives compensation for preparing a tax return, providing tax advice, or practicing before the IRS
Circular 230 sets forth ethical standards and expectations.
Failure to comply with Circular 230 will subject the paid preparer to suspension or disbarment from IRS practice, public censure, fines, and civil or criminal penalty.
Rules are far reaching and complex.
Paid tax preparers must obtain a preparer tax identification number (PTIN).
Must be renewed annually.
Preparers who are not CPAs, attorneys, or enrolled agents must pass a competency exam and annually obtain continuing education.
CPAs, attorneys, and enrolled agents must also obtain continuing education.
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 nonfrivolous tax positions
Notify clients of errors on a client return
Provide information to the IRS
Inform a client if the client made an error
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 IRS
Cash an IRS check for a client
Represent a client if a conflict of interest exists
Make false or fraudulent statements