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Chapter 1. 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. Introduction.

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chapter 1

Chapter 1

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

introduction
Introduction

An income tax was first enacted in 1861 and repealed after the Civil War ended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

introduction1
Introduction

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.

lo 1 progressive proportional and regressive tax structures
LO #1 Progressive, proportional, and regressive tax structures

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)

lo 1 progressive proportional and regressive tax structures1
LO #1 Progressive, proportional, and regressive tax structures

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

lo 1 progressive proportional and regressive tax structures2
LO #1 Progressive, proportional, and regressive tax structures

Regressive tax structure:

The tax rate decreases as the tax base increases.

Example is social security tax system

lo 2 marginal and average tax rates
LO # 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 15% on their $35,000th dollar of income.

lo 2 the income tax formula
LO # 2 The Income Tax Formula

Income

− Permitted Deductions from Income

--------------------------------

= Taxable Income

× Appropriate Tax Rates

--------------------------------

= Tax Liability

− Tax Payments and Tax Credits

---------------------------------

= Tax Refund or Tax Due with Return

lo 3 components of form 1040ez
LO #3 Components of Form 1040EZ

Taxpayers annually file a tax return using

Form 1040

Form 1040A

Form 1040EZ

All follow the basic income tax formula

Form 1040EZ is the simplest form

lo 3 components of form 1040ez1
LO #3 Components of Form 1040EZ

To use a 1040EZ taxpayer must meet all the following:

Single or married filing jointly

Under age 65 and not blind

No dependents

Taxable income < $100,000

Income only from wages, unemployment compensation or interest ≤ $1,500

Claim no credits except Earned Income Credit

lo 3 components of form 1040ez2
LO #3 Components of Form 1040EZ

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

lo 3 components of form 1040ez3
LO #3 Components of Form 1040EZ

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)

lo 4 calculation of tax
LO #4 Calculation of Tax

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

lo 3 tax payments
LO #3 Tax Payments

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

lo 3 tax payments1
LO #3 Tax Payments

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)

lo 5 tax authority
LO #5 Tax Authority

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

Administrative sources

Judicial sources

lo 5 tax authority1
LO #5 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

lo 5 tax authority2
LO #5 Tax Authority

Administrative sources of tax authority, in order of strength

Treasury Regulations (IRS Regulations)

Revenue Rulings

Revenue Procedures

Private Letter Rulings

IRS Notices

lo 5 tax authority3
LO #5 Tax Authority

Judicial sources of tax authority

Courts resolve disputes between taxpayers and the IRS.

Initial court of jurisdiction is either the

Tax Court

U.S. District Court

U.S. Court of Federal Claims

lo 5 tax authority4
LO #5 Tax Authority

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.

lo 6 circular 230
LO #6 Circular 230

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.

lo 6 circular 2301
LO #6 Circular 230

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.

lo 6 circular 2302
LO #6 Circular 230

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.

lo 6 circular 2303
LO #6 Circular 230

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

lo 6 circular 2304
LO #6 Circular 230

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