I. Why have taxes? 3
II. Basic Tax Computation (Page B-8 of West book) 4
III. Status 4
IV. 1040 A Form 4
V. Who is a dependent? 5
VI. Basic Adjusted Gross Income (AGI) Calculation 7
VII. Transfers to children 7
VIII. Who is the Taxpayer? 8
IX. “When” is income? 10
X. Taxation & Accounting Table 12
XIII. What is income? 13
XIV. Important Definitions for “Income” 15
XV. Items Specifically Included in Gross Income 15
XVI. Issues of Life Insurance, Gifts, Inheritances 16
XVII. Fringe Benefits (General) 20
XVIII. Other Fringe Benefit Issues 21
XIX. Tax Benefit Rule 22
XX. Income from Discharge of Indebtedness 22
XXI. Other Income Exclusion Issues 23
XXII. Expense vs. Capital Expenditure 26
XXIII. New Business Start-Up 27
XXIV. Travel & Entertainment Expenses 28
XXV. Education Expenses 30
XXVI. Moving Expenses 30
XXVII. Employee Expenses 31
XXVIII. Deferred Compensation 33
XXIX. Divorce 33
XXX. Income Shifting and Divorce 36
XXXI. Bad Debts 37
XXXII. Losses 39
XXXIII. Depreciation and MACRS 41
XXXIV. Depreciation 42
XXXV. Intangible Assets (Amortization) 44
XXXIX. Non-Business Deductions 47
XL. Charitable Deductions 50
XLI. Passive Loss Rule 52
XLII. Tax Credits 55
XLIII. Property Transactions 57
XLIV. Technical Aspects of Gain and Loss 59
XLV. Basis for Calculating Gain or Loss 60
XLVI. Deferred Gains 63
XLVII. Like-Kind Exchanges (§ 1031) 64
XLVIII. Involuntary Conversions (§ 1033) 66
XLIX. § 121 – Sale of Principal Residence 68
L. Installment Sales 70
LI. Dealing with an IRS Audit 72
Why have taxes?
Taxes raise revenue for government expenditures
County – education
State – education, transportation (roads)
Federal – Social Security, transportation, defense
Sources of Revenue
Cities – primary tax income is property tax, because property can’t move around. High sales taxes will cause people to shop elsewhere. Downside: Discourages improvement
States – primary income from income tax (harder to move around income tax on a statewide level). Some also use sales tax (though this varies).
Federal Govt. – Income Tax (46%); Corporate Income Tax (11%); some Excise Taxes (4%); Estate Tax (1%); Social Security Taxes (34%).
History of Taxation in America
Federal Income Tax required a Constitutional Amendment. Framers placed in Const. provision that any taxes be levied as a “head tax” (highly regressive).
1916 Amendment created a Graduated Income Tax. Income Tax exploded after WWII.
1939 – Federal Income Tax Code created (instead of being scattered)
1954 – Tax law was really “organized”
1986 – Huge revisions treated as a recodification
How sausage is made (Tax Law Enactment Procedure)
U.S. Const. says tax laws must be enacted in a particular procedure. Every tax law MUST begin in the House of Reps. Reps. are more quickly answerable to the votes due to their 2-year terms.
Begins in Ways & Means (Chair: Bill Archer)
(Avg. Ways & Means ctte. member’s campaign fund is more than twice others)
Ways & Means sends bill to full House
House votes
Senate Finance Ctte. amends (1 out of 5 Senators is on Finance – Chair is William Roth)
Ways & Means and Senate Finance send delegates to a conference ctte.
Conf. ctte. works out the differences, and sends bill back to the House for approval, then to Senate for approval, then to President.
Executive Branch (Sec. of Treasury – Larry Summers) administers the law through the IRS.
Guiding Principles to Tax Law
Economic Efficiency – the tax law should interfere as little as possible with the optimal allocation of resources.
Equity/Fairness
Horizontal – 2 people in the same situation should pay the same amount of tax. (Same income ought to equal same tax bill).
Vertical – Rich people should pay proportionately more than poor people. Manifest in progressive tax rates (from 15% – 40%).
Simplicity – Income tax is a voluntary system, we self-report our income. The more complicated the system, the more encouragement to lie and dodge the system.
Promote Specific Economic & Social Objectives – this is what makes the IRS Code so thick.
Tax Credits
Focused exclusions (Home mortgage deductions)
Basic Tax Computation (Page B-8 of West book)
AGI, then subtract
Standard Deduction (Itemize?)
Personal Exemption
=Taxable Income (Tax rate applies to this figure)
Status
Categories
Single (High)
Married – Joint (Lowest)
Married – Separate (Highest)
Head of Household (Lower)
Qualifying Widow – Determined by status on the last day of the year.
Example
Man
Woman
Married
Income
32,300
32,300
64,600
Std. Deduction
-4250
-4250
-7100
Exemption
-2700
-2700
-5400
Taxable Income
25,350
25,350
52,100
Tax Owed
3802
3802
8991
$1,400 in additional taxes owed every year, solely based on the fact that they are married.
1040 A Form
Label – fill in your name
Filing Status
Based on status on the last day of the year
Single (High)
Married – Joint (Lowest)
Married – Separate (Highest)
Can save if one spouse has lots of medical expenses
Can save if one spouse lives/works overseas
Why then file separate? One spouse is a crook.
Head of Household (Middle – between single and married – joint)
Basically a single parent
Requirements
Unmarried
Pay > 50% of the cost of maintaining a household for a dependent who lives with you.
Exceptions to Dependent Requirement
If the Child is living with you the child need not be a dependent. (Deals with divorce situations where non-custodial parent claims child as dependent). Also gets used when a child moves back home as an adult. (Doesn’t work if child is married).
If we’re dealing with a Parent, the parent needs only be a dependent, does not have to live with you.
Exceptions to “Unmarried” Requirement
If you’re an “Abandoned Spouse” you can use Head of Household status.
Absentee must be gone for last 6 months of the year.
Must have a child who is a dependent
Qualified Widow (Joint Rates)
Can get joint rate if spouse dies any time during the year.
Can continue to use the joint rate for two years thereafter if you have a dependent child in the household. (If the dependent child is still in the household at Year 3, then use “Head of Household”).
Otherwise, must file as Single thereafter.
Exemptions
Personal exemption for self
Joint return = 2 exemptions
1 for each dependent
Worth $2700 for each exemption
Who is a dependent?
Five Prong Test
Support test – provides > 50% of that person’s support
Food
Clothing
Medical Care
Relationship (Member of the Household) test
Blood relative (decendent/ancestor)
In-Laws (once an in-law, always an in-law)
Anyone you’ve taken into your household for the entire year.
Gross Income test (if dep. has too much money, they can’t be dep.)
Must have taxable income of less than $2,750 (amt. of the personal exemption)
Exception: Child under the age of 19 does not have to clear this hurdle
Exception: Child under the age of 24 who is a full-time student also does not need to clear this hurdle
Joint Return test
Dependent cannot file a joint return
Exception: If you would have no liability filing separately, you are OK filing a joint return.
Citizen or Resident test – for the preceeding year (check time frame)
U.S. Citizen
U.S. Resident
Resident of Canada or Mexico (NAFTA)
Phase-out of exemptions
Rich folks don’t get to take exemptions for their kids
Comes into play in divorces among wealthy folks
Status & Dependents Homework Problems
2-35, #21 – If Fran has a child, she could be filing as Head of Household. If there’s no kid, she’s been doing the right thing.
2-35, #47
Head of Household – only need one dependent
H of H – child exemption
Probably can’t be H of H, because the child is married
H of H – Abandoned spouse + Parent as dependent
2-35, #48
Married, Joint – Year of Death
H of H – traditional def. of H of H
H of H – child exception
Single
2-35, #49
1997 – Married, Joint (Year of Death)
1998
Mike is dependent (full-time student exception)
Qualifying Widower
1999
Mike is no longer dependent (not full-time student)
Still H
on Date – BOD says that there will be a dividend to everyone who owns stock on Date X
Record Date – Date X (if you own the stock on this date, you receive the dividend – regardless of subsequent sale).
Payment Date – Date when the check is actually cut
Sale
Gus has a capital gain
Purchaser has a dividend (at regular tax rate)
Transfer to Son
Gifts to Family Members – if you make a gift between the declaration date and the record date, parent is taxed on the dividend.
Same rule applied to accrued interest on a bond. Parent taxed on all of the interest accrued up until the time of the gift.
Problem #59
Part (b) – Donna’s benefits are taxable as income (unless she’s poor enough for them to be tax free)
Part (c) – She still earned the money (she’d be taxed on the interest), because she still owns the property.
Imputed Interest
Combination of Income tax and Estate tax
Rich parents would shift income by loaning money to son (famous case is Crown family case)
Mom loaned $54 million to son at 0% interest, who earned interest on that money (to avoid estate tax on that interest).
New Law – Imputed Interest – must state minimum interest rate (the Fed Rate). If you state less than that, it’s OK, but on the tax return you have to “pretend” that interest was charged at the fed rate (“imputed interest”). Figure the correct interest, parents pay tax on that interest, the remainder is treated as a gift to the child.
Only applies when there’s a gift over $100,000
Simplest thing is to actually go ahead and charge the Fed Rate and have the kid pay on the loan.
“When” is income?
Tax Deferral is Good
IRS tries to push income to an earlier year. You try to push income to a later year (so that you can collect interest on that income in the interim.
The reverse is true as to deductions. You want to deduct expenses NOW, IRS wants to push deductions to later years.
Accounting Methods (the Timing of Income)
Accrual Method
Cash Method
What event causes the recognition of income?
order date
shipping date
payment date
must choose one, and stick to it.
Individuals use the cash method, businesses use the accrual method
Accrual is more accurate, but too burdensome for individuals
Code § 451 (a)
“year in which received, unless”
you use the accrual method
Regulations
Interpretive – No direct instruction from Congress to write this reg, but IRS does it to clarify.
Legislative – Courts give these more respect
IRS gives regulations LOTS of weight. You have to be able to show actual conflict with the law.
Reg. Codes
1 = Income
20. = Gift, etc.
IRS Regulation 1.451-1
Received = actual OR constructive receipt
Actual = the day the payment physically lands in your hands (problems come up with year-end receipts)
Constructive = the day income is “made available.” (Defense: substantial restriction associated with taking that money). [no money in the account, price to pay for acceptance, negotiations]
Receipt by an agent – Delivery to the agent is delivery to the principal, even if the agent doesn’t deliver the payment until the next year.
Recognizes accrual method as alternative method of accounting
What about prepaid income? (i.e. last month’s rent in advance). Under CASH METHOD, must pay tax on prepaid income upon actual receipt.
What about deductions? (Can you say actual or constructive deductions)?
Normal Cash Method Rule – you get the deduction when you make actual payment
NO CONSTRUCTIVE PAYMENT for deductions.
Mailbox rule applies. Post Office is deemed the agent for whomever you intent to receive the payment.
Note: If it’s a big check, send it certified mail. Your postal meter date is NOT proof of date of mailing.
