Exam 1

Question 1

Define “Exclusions” and give some examples

Answer 1

• Items that are specifically removed from the tax base by law
• It reduces the amount that a tax filer reports as their total, or gross, income

Ex. Academic scholarships, portions of retirement income, combat zone

Question 2

Define “Deduction” and give some examples

Answer 2

• Items that are explicitly subtracted in deriving the tax base, reducing their tax liability
• Lowers a person’s tax liability by lowering his taxable income

Ex. Business expenses, charitable donations, contributions to pension accounts

Question 3

Define “Tax Base”

Answer 3

• The net quantity on which any particular tax is levied
• The remaining amount after considering both exclusions and deductions
• The total amount of assets or income that can be taxed
• Your taxable income/estate/gifts

Question 4

Define “Tax Rate”

Answer 4

• A specified percentage or series of percentages in the case of a progressive tax, which the law stipulates as the appropriate multiplier in the determination of the gross tax liability
• The percentage at which an individual or corporation is taxed

Question 5

Define “Tax Credits”

Answer 5

• Any specifically authorized reduction in gross tax liability
• An amount of money that taxpayers can subtract from taxes owed to their government
• Unlike deductions and exemptions, which reduce the amount of taxable income, tax credits reduce the actual amount of tax owed
• Used to incentivize, to protect the environment there’s a credit for the cost of purchasing solar panels for use in your home, credits for adopting children

Question 6

Define “Flat Tax”

Answer 6

• One single rate is applied to the entire tax base regardless of income bracket

Question 7

Define “Progressive Tax”

Answer 7

• The marginal rates get higher as the tax base increases in amount
• A tax that imposes a lower tax rate on low-income earners
• A tax based on the taxpayer’s ability to change

Question 8

Define “Property taxes” and name the two property tax categories

Answer 8

• Taxes imposed on the mere ownership of property.
• Typically based on the value of the property
• Two categories: realty and personalty

Question 9

Define “Real property taxes”

Answer 9

• All real property is subject to this tax which is imposed at the local level
• Easy to impose a property tax on real estate because it cannot be concealed and is immobile

Question 10

Define “Personal property taxes”

Answer 10

• Difficult tax to enforce because property is easily concealed and moved
• Only common personal property tax is imposed on vehicles and is easy to enforce because it is necessary to register them`

Question 11

Define “Sales tax”

Answer 11

• A tax typically applied by the state with an additional small amount imposed at the city level
• Imposed by the government on the sale of goods and services
• Only charged to the end user of a good or service, not manufactures

Question 12

Define “Use tax”

Answer 12

• Used to prevent the avoidance of a sales tax
• It’s a sales tax on purchases made outside one’s state of residence for taxable items that will be used, stored or consumed in one’s state of residence on which no tax was collected in the state of purchase
• Imposed at the same rate as a sales tax, on the use or consumption of personal property

Question 13

Define “Excise tax”

Answer 13

• Imposed as a result of the sale of goods, but it only applies to the sale of a specific good or service (tires, cigarettes, gasoline)
• An indirect tax, the IRS levies the tax on the producer or merchant who passes it onto the consumer by including it in the product’s price

Question 14

Define “Transfer tax” and give two categories of it

Answer 14

• Imposed on the right to transfer property either by gift or inheritance
• Imposed on the donor not the donee
• Two categories are gift tax and estate tax

Question 15

Define “Gift tax”

Answer 15

• Imposed on the intervivos (living) transfer of property
• Gifts are allowed a $15,000 ($30,000 if gifts are given jointly with spouse) per year per donee exclusion
• Unlimited marital deduction and contribution to charity

Question 16

Define “Estate tax”

Answer 16

• A tax levied on an heir’s inherited portion of an estate if the value of the state exceeds an exclusion limit of $11,200,000

Question 17

What are the two components of FICA taxes?

Answer 17

• Social security tax (old age, survivors, and disability insurance) and Medicare tax
• The employee pays a specified percentage of wage base and the employer matches it

Question 18

What are the rates on social security and Medicare?

Answer 18

• Social security: 6.2% up to $128,000
• Medicare: 1.45% for an unlimited wage base, .9% tax on earned income above $200,000 fir single people and $250,000 for married filing jointly

Question 19

What are the self-employment tax rates?

Answer 19

• Tax is the same as the FICA tax but applied to those who are self-employed
• 15.3% tax on income up to $128,400 and 2.9% on income in excess of $128,400

Question 20

Tax avoidance versus tax evasion

Answer 20

• Legitimate means of reducing taxes are known as tax avoidance
• Illegal means to the same end are called tax evasion
• Minimizing taxes vs. not paying taxes

Question 21

What are the three sources of tax law?

Answer 21

• Statutory
• Administrative
• Judicial

Sources may be classified as secondary or primary.

• Primary: issued by some branch of government in an official capacity
• Secondary: carry no official weight as far as the IRS is concerned (ex. textbooks)

Question 22

Statutory sources of tax law

Answer 22

• The Internal Revenue Code (IRC) is the statutory source of tax law
• The “Code” represents laws passed by Congress and signed into law by the President

Question 23

Administrative sources of tax law

Answer 23

• Issuances from the Department of the Treasury (The IRS)

- The most importance source here is Regulations, which clarify or elaborate on the Code sections passed by Congress

Question 24

Judicial authority sources of tax law

Answer 24

• Taxpayers who disagree with the IRS’s interpretation of the law may take their case to federal court-perhaps all the way to the Supreme Court
• The legal decisions handed down provide clarification and insight into the correct implementation of the tax law

Question 25

Describe the entity variable

Answer 25

• The entity variable is about which entity undertakes the transaction
• Individuals and regular corporations are the two primary taxpaying entities
• Partnerships (including LLCs and LLPs) and S-Corporations are not taxpaying entities

Question 26

Explain the Assignment of Income Doctrine

Answer 26

• The taxpayer cannot assign income to someone else
• If the taxpayer retains ownership of the property, then the taxpayer is taxed on the income derived from the property
• In place to avoid tax evasion

Question 27

Describe the time period variable

Answer 27

• The Time period variable is which tax year or years the transaction occurs
• The tax cost or savings depends on the year in which the transaction occurs
• Assuming equal marginal tax rates and costs across time periods, a dollar paid in tax in the current year costs more than a dollar paid in a later year
• A dollar saved in this year is worth more than a dollar of tax saved in some future period
• Examples are waiting several years before selling stock or investing in retirement plans

Question 28

Describe the Jurisdiction variable

Answer 28

• The jurisdiction variable is about which taxing jurisdiction the transaction occurs
• Tax costs decrease when income is generated in a jurisdiction with a low tax rate
• Common tax havens include Luxembourg, Caymen Islands, Isle of Man, Jersey, Ireland, Bermuda, and the Bahamas
• Populations are generally increasing in low tax states such as Texas and Florida (no income tax) and leaving high tax states such as NJ, New York, and Connecticut

Question 29

Describe the Character variable

Answer 29

• The character variable is about what the tax character of the income from the transaction is
• Every item of income is ultimately characterized for tax purposes as either ordinary income or capital gain

Question 30

When are you entitled to receive a long-term capital gain?

Answer 30

• Taxpayers with ordinary income tax rates of 10% or 12% have long term capital gain rates and qualified dividend rates of 0%
• The other two rates for long term capital gains and qualified dividends are 15% and 20%

Question 31

How do you decide between taxable or municipal bond interest?

Answer 31

Yt = Ym / (1-mtr)
Yt = Equivalent taxable yield
Ym = Current yield on municipal bonds
mtr = Marginal tax rate

If the investor’s equivalent yield (Yt) is greater than the yield currently available on taxable bonds of comparable risk, the municipal bonds should be purchased. If it’s less, then taxable bonds should be purchased.

Question 32

Define “Capital gain”

Answer 32

• A rise in the value of a capital asset (investment or real estate) that gives it a higher worth than the purchase price
• The gain is not realized until the asset is sold
• A capital gain may be short-term (one year or less) or long-term (more than one year) and must be claimed on income taxes

Question 33

Summary of the four basic tax planning maxims

Answer 33

1. Tax costs decrease when income is generated by an entity subject to a relatively low tax rate
2. Tax costs decrease when a tax liability is deferred until a later taxable year
3. Tax costs decrease when income is generated in a jurisdiction with a relatively low tax rate
4. Tax costs decrease when income is taxed at a preferential rate because of its character

Question 34

Define “Municipal bond”

Answer 34

• A debt security issued by a state, municipality or county to finance its capital expenditures (ex. highways, bridges, schools)
• Exempt from federal taxes and most state and local taxes making them especially attractive to people in high income tax brackets