Fed Tax – Hoyt—Fall 2007
How to Read Statutes
o 101(a)(2)(A)(i)
§ 101 is section; (a) is subsection; (2) is a paragraph; (A) sub paragraph; (i) sub sub paragraph
· History of Taxation
o Type of taxes
§ Local/county
· Schools, sanitation, police and fire
· Largest source of revenue is property tax
· Income tax may only be about 1%, income tax can leave (move/shop somewhere else) so property can not be avoided
§ State
· Education, highways, prisons
· 50/50 between income and sales tax
o income tax lower in cities b/c easy to avoid
o retailers collect sales tax for the government
· national sales tax is disadvantageous (regressive) b/c disproportionately paid by poor b/c have to spend all money to live, where rich are able to save money
· NH does not have this system, they only have property tax
· 9 states without income tax at all
§ Federal
· Social security, military pensions, social service pensions, national defense, etc.
· 45% income tax of people
· 9% income tax of corporations
· 40% social security tax – the typical worker pays more then rich people
· 1% estate taxes
· power given by clause in constitution
o if taxes are leaved on the US population, must be proportional to the population
§ have to have a head tax—meaning if VA and NY had same number of people must collect the same from each person
· problem is that you can’t charge one person more then another
o income taxes were not allowed so government got revenue port taxes
o until about the 1900’s there was no income tax only tariffs
o during the civil war there was an income tax, this was probably illegal
o The constitution said tax (head tax) had to be the exact same for every person, in proportion to the population
o had to amend constitution to take out the head tax language (16th A in 1913)—only the rich were taxed
§ 1916 revenue act—estate taxes enacted (hit rich people)
§ 1921—1st gift tax
§ Pre WWII only 6% paid income taxes
§ Post WWII—75% of people were paying income taxes
o 1921—tax statutes somewhat organized but were located throughout code
o 1939—dedicated the 19th title of code to taxes Title 26 = The Tax Code
o 1954—during cold/Korean war—finally got a comprehensive code, however everything thereafter was the 1954 code amended for 1960
o 1985—Regan said code too complicated, so enacted code of 1986 and is amended every year
§ Tax Reform act of 1986 – amended every year and this is what we now use today
· How is tax law enacted
o It is different from any other law
o Constitution gives special rules for tax law
§ Constitution requires that every tax law has to start in house of representatives can not start in the Senate
· b/c the theory was since the representatives replaced every 2 years, you can vote out the people you didn’t like to change the tax law
· our legislature is based on the two part model of VA house and senate (Madison drafted this)
o CT which was small state objected, proposed 2 amendments that passed
§ Every state had 2 senators and House is proportionate to population
§ Must start in house
§ Committee in house that controls things (ways and means committee) very powerful committee
§ Senate finance committee
· Is the part of senate that takes the tax bill after it passes in the house
· They add all their ideas to the bill and take out some of the stuff from house
§ Joint Conferences committee – 5 House and 3 Senate and they hash it out, compromise to one package
· Committee made up of house and senate reps they find all things that are the same and then barter to get the disputed provisions in
· Then passes in both house and senate and then goes to President who has power to Veto (has never happened)
· What should a good tax system do?
· Policies
o Economic efficiency
§ Tax law should interfere as little as possible w/ the optimal allocation of resources in the economy
§ High tax rates effect peoples behavior
o Equity/Fairness—2 Types people will more likely follow if they think it is fair
§ Horizontal Equity
· Provides that 2 people in same economic circumstances should pay the same amount of income tax
· Important b/c paying same amount will perceive the tax system as fair
· Violated b/c you pay less taxes if you are married
§ Vertical Equity
· Concept that the rich people should pay more then the poor
· Best example is progressive tax rates (there is a handout)
o Simplicity
§ Is important that the tax law be able to be understood by people—is view of sales tax
§ If a tax code is not simple it leads to people feeling that it is unfair, which can cause people to cheat
§ If the IRS is giving refunds and charging people during an audit on a provision—shows that people are not understanding
o Achieving economic and social objectives
§ We use the tax code often to achieve things that could be achieved through social expenditures
· Example: have the federal government provide day care or give tax brakes to parents needing day care this is more efficient and the program would work better
· Good Example: homeowners exception
o In Canada, no deduction for homeownership—means more people rent
o In US, deduction for homeownership—means more people own
§ Equity and Simplicity often conflict w/ one another
INCOME – WHEN DO YOU FILE A RETURN?
· Must file if gross income is greater than standard deductions and exemptions
· Standard Deduction $5,350
· Personal Exemption $3,400
o $8,750
· After these two deductions (that you get right off the bat) you now have your TAXABLE INCOME
· You may also have a dependent (kid)
· Page 3-25 if your income is under this gross income amount, then you don’t have to file a return
· The second column is for inflation
· Page 3-26 for Dependents, they have to file if they are UNDER the gross amount
· For Dependents
o Earned Income – labor, employed (social security taxes)
§ If you are a dependent and your earned income is less then $5350, you don’t have to file
o Unearned Income- investments, savings account (no taxes withheld)
§ If $850 or more then you do have to file, if less then no filing tax return
· What if a child has both earned and unearned? Pg. 3-26 go through test above, if they are more or less
1040 – B-6, 7
Adjusted Gross Income
Single
· Pay highest tax rate
· Get to 35% faster if single then do if you are married
Married Filing Jointly
· Gets the lowest rates
· Means both spouses sign form and both are responsible legally
Married Filing Separately
· Pays highest tax rates
· Means file own separate return, are only liable for own return
· You might do this even if can file jointly if you do not trust the other spouse (cheat on taxes)
· Filing jointly makes you liable for the other one
· More the likely you will file jointly when can because you will save money
· He said there are only about two instances to file this way (overseas, lot of deductions for one, and the above situation)
Head of Household
· Generally single parent – this is the best way to think of it pg 3-30
· 2/3-1/2 of the way between married filing jointly and being single in terms of paying most v. least
· TEST:
· 1. Unmarried individual
· 2. Who pays more then ½ the cost of maintaining a household
· 3. Where they live w/ a dependent
o Exceptions
§ Child does not have to be your dependent
· Dad pays child support so he claims child as dependent, mom would claim head of household
· If mom who is unmarried, and daughter (age doesn’t matter) who is broken up w/ her husband and moves back in w/ mom, mom can claim head of household
· If the child is married then must be a dependent
§ Dependent parent does not have to live w/ you
· Often kids take care of elderly parents, could take mom as a dependent even though she doesn’t live w/ you as long pay ½ of moms living expenses—qualifies if mom is living in nursing home
o Abandoned Spouse—you are married w/ a child and your spouse had not been a member of the household for the last 6 months of the year (July-December)
§ Spouse walks out in May and can’t find to sign joint return—can file H of House
§ Spouse walks out in October and Can’t find to sign joint return—can’t file
§ Must have a child who is a dependent
Qualifying Widower
· Sometimes called surviving spouse—means that you qualify for the married filing jointly (lowest rates)
· If you have a married couple and there is a death, in the year of death you can file a joint return, (doesn’t matter if you have kids or not), the next year if you have no dependent children they you are single (unless remarried), special status qualifies if you have dependent child (2 tests: dependent and child)—then for 2 years qualify for joint rates
o Example:
§ In 2004 spouse dies: get to file joint return
§ In 2005 and 2006: get to file as qualifying widower as long as have dependent child
§ In 2007 and beyond: get head of household as long as have dependent child, then would go to single
Test for Filing Status
· TEST: what were you on the last day of the year
· If you get married on Dec. 31st, you were married all year
· If you get divorced on Dec. 31st, you were single all year
Defense of Marriage Act
· For federal law defined marriage as begin between one man and one woman—even if state has exception for homosexuals, doesn’t apply for federal purposes
· Deductions
o Can do standard deductions or itemize
§ Standard deductions
· Single $5,350
· Married Joint $10,700
· Over 65 get an extra $1,300
· Blind get an extra $1,300
§ Itemize (1/3 of people do this)
o Personal deductions and dependents
§ For yourself get $3,300
§ Get $3,300 for each dependent
o AGI—Standard deductions—personal exemptions—dependent exemptions = taxable income
o Dependents
§ Is either a qualifying child or a qualifying relative (Handout)
This new system for qualifying child/relative changed in 2004:
Test For Dependency Exemption
Test
Qualifying Child
(used for tax statutes too)
Qualifying Relative
(don’t have to apply to child under 18, but once turn 19 have to apply)
Relationship
1. Child (includes taxpayers brothers and sisters and their dependents)
2. Other blood relationship (cousins don’t count though)
3. Unrelated “member of household”
1. Yes
2. No
3. No
1. Yes
2. Yes (lineal ascendants, collateral ascendants, certain in-laws) (parents, grandparents, uncles, aunts, mother and father in law) (no cousins)
3. Yes
Age
1. Child under age 19?
1. Yes (test = under age 24 if FT student—FT student exception)
1. N/A (child over age 18 can be Qualifying relative if pass support and gross income tests)
Domicile – (Abode)
(>1/2 year; FT student exception)
1. Yes
1. N/A (except for household member)
Support
1. Pay > 1/2 of dependents support?
*(rich child pay > 1/2 of own support can’t be dependent)
1. N/A *(rich child) (scholarships do not matter in this test)
1. Yes**
**(“multiple support” agreement, if more than 1 relative combine support to make up 100% of parent support but one 1 of them pays more then 50% can rotate and everyone take turn each year as to who takes deduction)
Most important test for this (food, shelter, clothing, and medical care)
Gross Taxable Income Less Than $3,400?
nt
· Constructive Receipt Exception (§ 1.451-2)
o General Rule: income although not in taxpayers possession, is constructively received when it is “made available”
o Defense in this situation would be if there was a substantial restriction/limitation (possibly condition)
§ 60 mile round trip is enough
§ E.g. – IBM says if you stop now and meet these criteria we will give you a $20,000 bonus—not constructively received b/c there is a condition of quitting your job
o if at a new years eve party and client offer to pay you then and you say no wait till next year—must pay taxes b/c it was constructively received b/c it was made available
o if check bounces not constructively received b/c funds were not available
o when there is still a price to be paid not constructively received b/c have to work for it—Ex: negotiations (looks like this in contracts: “shall not be made or available until…”)
Agents
· Delivery to the agent is delivery the principle and income is recognized even if handed to agent
· Doesn’t matter when the principle deposits/cashes the payment just when received it
Deductions
· Only actual payment qualifies (461)
· When you write and deliver a check—it is a deduction
· Mailbox Rule: only time tax law favors cash method. For important checks use certified mail.
o Your client is a LL and T puts check in mail in Dec. and LL doesn’t get the rent till Jan. when does T deduct rent
§ T can deduct rent in Dec. when they wrote the check, the post office is deemed the agent of the LL
o When the check is large make sure send by certified mail b/c IRS could want to make sure it was mailed
o LL will not attribute it as income until it is received
· If pay by credit card—you deduct when you charge it
o Logic is that when you charge something you are essentially taking a loan from the bank
Prepaid Income
· If get income in advance, you owe taxes on when it is received—pay taxes on prepaid income. No exception.
· If client is LL and wants 1st and last month rent—has to pay taxes on both
· Not as complicated as prepaid expenses
Prepaid Expenses
· General Rule: you can’t deduct in year of actual payment, must allocate over the time period (can’t deduct in advance for expenses must allocate) He gave the example of paying rent years in advance, you can’t do this. You will be only allowed deductions from year to year, not all at once on one year.
o Exception where can deduct expenses in advance
§ One year Rule: Zaninovich – common law (only applies to business expenses)—as long as payments don’t extend beyond one year you can take the deduction in year of payment (doesn’t have to be calendar year)
· could be more than 1 actual year, just must not span more than 2 different years
o Ex: if you have an expense that you pay in July 2003 that is for 15 months, could take the deduction in 2003, as long as time frame doesn’t extend into 2005
o Example of magazine subscription and insurance, you have to pay up front
o Exception to 1 year rule: Can’t deduct prepaid interest 461(g)
§ Reason is b/c Congress passed a law saying can’t do that
o Exception to Exception: (points = only interest that can be deducted via the 1 year rule)
§ You can deduct points on mortgage for your principle place of residence in the year in which you took out the loan
§ Refinancing must be capitalized and amortized over the life of the new loan. Refinance does not quality for the full point deduction in one year.
§ If you are buying a vacation home or rental property, doesn’t count b/c not principal residence—must allocate points over life of loan
· Example: If you buy a house in 2003 can deduct all points in 2003, if you refinance in 2005 then you have to amortize the points for the life of the loan, if you refinance in 2007 you can take the remaining points from the 2005 refinance in 2007 but have to amortize the points from 2007 for the life of that loan
o This came from a private letter ruling which is something you get from IRS which is almost bullet proof and they are not supposed to be relied on
o When you have a client having a problem that is not explained by the regulations or by the statute then you can search these private letter rulings and when you find several of them going your way you can tell your client they likely can do this and then have them staple the rulings to their return when they mail it in
NOTE: if you can deduct the points, pay as many points as possible. If you can’t deduct the points in one year or if you are going to sell the property in a short time, then don’t pay any points.
