Chapter 1: Introduction Flashcards
Marginal tax rate
Rate applied to an incremental amount of taxable income that is added to the tax base.
Can be used to measure the tax effect of a given transaction
Average tax rate
Total tax liability / taxable income
Average tax rate for each $ of income
Effective tax rate
Total tax liability / by total economic income (not just taxable)
A broad measure of a taxpayer’s ability to paybtaxes
Taxable income
Total income Minus exclusions = Gross income Minus deductions = Taxable income (AGI)
Calculation of tax due
Taxable income x applicable tax rate = Income tax before credits Minus tax credits = Total tax liability Minus prepayments = Balance due or refund
Total tax liability
Taxable income x rate
Less tax credits
Gross income
Total income less exclusions (non taxable items)
Franchise tax
Another name for state corporate income tax. Generally based on weighted average formula of: net worth, income and sales (x modified federal taxable income)
Gift tax
Excise tax imposed on the donor for transfer of property considered to be a taxable gift.
Annual exclusion allowed per donee
Unlimited marital deductions between spouses
Cumulative over the taxpayer’s lifetime
Gift tax calculaton
FMV all gifts in current year
Minus: annual exclusions, marital deductions, charitable contribution deduction
= Taxable gifts for current year
Plus: taxable gifts for all prior years
= Cumulative taxable gifts (tax base)
Times: unified transfer tax rates
= Tentative tax on gift tax base
Minus: unified transfer taxes pd in prior years and unified credit
= Unified transfer tax (gift tax) due for current year
Donee liability for gift tax
Contingent liability in event of nonpayment by donor
Gift tax: charitable contributiona
Unlimited deduction allowed (essentially exempt from gift tax)
Federal estate tax
Part of the unified transfer tax system
Based on the total property transfers an individual makes during their lifetime and at death
Aka unified transfer tax
Federal estate tax structure
Tax base is estate (less death expenses/ charitable contributions/ transfers to spouse) plus taxable gifts prior to death
Tax base x tax rate less tax credits and gift taxes already paid = estate tax
Unified tax credit
As of 2021: $4,625,800
From $345,800 + .40 ($11,700,000 - $1,000,000)
Alternative valuation date for decedent’s property value
Six months after date of death
May be elected if the aggregate value of the gross estate decreases in that six months and election results in lower liability
Ad valorem tax
Taxes according to value (property tax)
Value added tax
Essentially a sales tax levied at each state of production on the value added
Sales tax
Varies by state
Not deductable on personal federal income tax, but may be deductable if incurred for trade or business
Also taxpayer may elect to deduct state and local sales tax INSTEAD of state and local income tax
OASDI
Old-age survivors and disability insurance
Part of FICA
6.2% on the first $142,800 of wages
HI
Hospital insurance (medicare)
Part of FICA
1.45% on wages up to $200,000
Additional 0.9% on wages over $200,000 ($250,000 for married filing jointly)
No ceiling
Self employed OASDI and HI
OASDI 12.4% (income up to $142,800)
HI 2.9% income up to $200,000 and 3.8% anything over that
Unemployment tax
Paid to federal and state
Federal rate 6% on first $7000 of wages, with 5.4% credit for taxes paid to state government
May be adjusted by employer circumstance
Adam Smith’s four canons of taxation
Equity
Certainty
Convenience
Economy
(Additional 5th: simplicity)
Horizontal equity
Similarly situation taxpayers treated equally
Vertical equity
Taxpayers who are not similarly situated should be treated differently
Basis of a progressive rate structure
Certainty in taxation
1) ensures a stable source of government operating revenues
2) provides taxpayers with some certainty concerning amount of annual tax liability
IRS advanced rulings
May be requested by a taxpayer for a proposed transaction. Taxpayers then may rely on ruling if transaction is completed in affordable with the proposal
Economical tax structure
Requires only minimal compliance and administrative costs
Tax gap
The difference between reported tax liability and true tax liability (tax avoidance and evasion)
Objectives of the federal income tax law
- raise government revenue
- economic objectives (as fiscal policy tool)
- encouragement of certain activities and industries
- social objectives
Taxpaying entities
Individuals
C corporations
Flow through entities
Generally do not pay income taxes but rather pass income on to taxpaying entities (still file tax returns - income allocated to owners proportionally)
Sole proprietorships Partnerships S corporations LLCs and LLPs (limited liability partnerships) Truste
AGI
Adjusted gross income
Total income (earned + investment + flow-through) Less exclusions = Gross income Less: deductions for AGI = AGI
Exclusions
Items the law exempts from taxation
Deductions FOR AGI
- expenses connected with a taxpayer’s business or rental property
- specified deductions (IRA contributions
)
Deductions FROM AGI
Either itemized or the standard deduction
Maximum tax rates
Certain types of income may be subject to a maximum tax rat
Taxable income for C corps
No AGI.
Total income
Minus exclusions
= Gross income
Minus deductions= taxable income
C corp annual tax form
Form 1120
Qualified business income
Net income from business activities not including investment income
Most Flow through entities may deduct 20% of QBI
Adjusted basis
An owner’s ownership interest basis from a flow through entity
Starts with interest in formation or purchase
Increased for additional contributions, Share of income
Decreased for share of losses, liabilities, and distributions
Outside basis
Owner’s adjusted basis
Inside basis
An entity’s basis in it’s assets
Partnership return of income
Form 1065
Information return
Accompanied by Schedule K-1
Schedule K-1
Reports the income, deductions, losses and credits that flow through a flow-through entity to it’s owners
Supporting document for individual income return
Return of capital
Distributions to owners of partnership. Not taxable (changes adjusted basis)
S corporation
Entities incorporated under state law that have elected to be treated as flow-through entities for tax purposes
Includes some limitations on structure and financial operations
Allocations of basis on a per-share per - day basis
Still limited liability
S corp vs partnership basis adjustment
Partners: Increase basis for all partnership liabilities
S corp shareholders: increase basis for direct loans to Corp. Debt basis separate from stock basia
LLC
Treated as a partnership for tax purposes but with the limited liability protection of a corp
Entity makes an election to be taxed as partnership or corp (if does not elect = partnership)
Uses partnership return if taxed as partnership. Corporation return (1120) if taxed as Corp
Can be an LLC for state law and an S Corp for tax
Single member LLC = sole proprietorship
LLP
Limited liability partnership
LLC but partners not liable for liability arising from acts of negligence or misconduct of another partner of the LLP (gen partnership all partners liable for all liabilities)
Trusts
May be a taxpaying entity or a flow through entity
Generally subject to taxation on net income not distributed to beneficiaries
Tend to have high progressive taxes
Tax law sources
Legislative: internal revenue code & congressional committed reports
Executive (administrative): Income tax regulations, revenue rulings, revenue procedures, letter rulings
Judicial: court decisions
Weight of source importance varies
IRC
Internal revenue code
Tax law passed by Congress
Most authoritative source of tax law
Legislative process for new tax law
1) bill introduced in the House and referred to ways and means committee
2) ways and means committee considers bill (hearings)
3) ways and means committee votes. If approved bill forwarded to full house
4) House votes. If approved bill forwarded to Senate
5) Senate finance committee amends house bill into Senate bill
6) senate bill considered by full Senate
7) if Senate bill approved Senate and house bills go to joint conference committee
8) joint conference committee issues a bill based on a reconciliation of Senate and house bills. Reconciled bill sent to house and Senate for approval
9) president approves or vetos proposed legislation (2/3 majority of house AND Senate can overturn veto).
10) new law and amendments incorporated into tax code
Organization of the IRS
On a type-of- taxpayer basis (allows for specialization)
Chief officer of the IRS
Commissioner of internal revenue
Appointed by president
Supported by chief counsel’s office
Responsibilities of Chief counsel’s office
Preparing government’s case for litigation of tax disputes
Responsibility of the IRs national office
Process ruling requests
Prepare revenue procedures that assist taxpayers with compliance
IRS operating divisions
Wage and investment income
Small business and self employed
Large business and international
Tax exempt and government entities
Correspondence audit
If differences are noted between tax return and supporting docs, IRS sends taxpayer a bill for corrected tax and a statement of differences
Issues make be solved via correspondance
Discriminant function system
DIF
Computer system used to select returns for audit
Generates a score for the return based on its likelihood of generating addition tax revenue
Scored returns are manually screened to determine which require further examination
Office audit procedure
Audit procedure generally used for individual return audits. Does not generally involve a complete audit. Just confirmation of an item in question
Field audit
Generally used for corps and individuals in trade/ business
Wider scope than office audit procedure
Statute of limitations
Period where taxpayer or IRS may make corrections to a return
Generally three years from filing date or due date (whichever is later)
(Six years for omissions of over 25% of gross income. Indefinite in cases of fraud or a return not filed)
Interest on tax assessments or refunds
Interest accrues on both assessments and refunds due.
No interest on refund if refunded by IRS within 45 days of due date of return (or if filed late within 45 days of filing)
Penalties for
- Failure to file (5% per month, max 25%)
- failure to pay tax due (0.5% per month, max 25%)
- penalty for inaccuracies resulting in underpayments (20% specific circumstances)
- fraud (75%)
- underpayment of estimated taxes (based on interesting rate)
- on tax return prepares for positions on tax returns where there is a “realistic possibility” that the position would not be upheld by a court (no penalty if position is disclosed in the return)
Hazards of litigation
The probability of winning or losing a case
Used by appeals division to negotiate compromise settlement
Components of a tax practice
- compliance and procedure (compliance: preparation of returns. Also, assisting client with IRS negotiations)
- research
- planning and consulting
- personal finance planning
Optimal tax planning
To maximize after-tax cash flows (not just to minimize tax)
Tax planning principles
- keep sufficient records
- forecast effect of future events
- support plans with sound business purpose
- bad plan on legal authorities
- do not carry a plan too far
- plan should be flexible
- integrate the plan with other decision making factors
- research plan for precedents
- consider maximum risk exposure
- consider effect of timing
- customize plan to client
Internet tax research services
RIA’s Checkpoint
CCH’s Tax Research Network
IRS.gov
