Basic Federal Income Tax Outline – Ward
A. The Constitution and the Income Tax
1. About 65% of federal revenue comes from the income tax.
a. Makes up about 27% of the GNP.
2. Purpose of the income tax:
a. Raise revenue
b. Sops consumer purchasing power out of the system in order to keep inflation in check
c. Repository of relief for favored groups
d. Redistribution of wealth
1) Achieved by imposing high taxes on those with high incomes and redistributing money to those of low income through federal subsidies, etc.
3. Design limitations on the income tax
a) Are two people in substantially the same situation treated in the same way?
(1) Can be very difficult to determine when people are in substantially the same situation.
a) If there an appropriate differential between people of different income scales?
b) Progressive tax? Proportional? Regressive?
b. Tax system should promote economic efficiency
1) Should distort the marketplace as little as possible.
2) Tax law should let people make economic decisions for market reasons, not for tax reasons.
3) Should promote normal, economic incentives.
c. Tax system should be capable of fair & efficient administration.
1) Administration costs
2) Compliance costs (currently ~ $125 billion a year)
B. Income-Tax Legislation and Regulations
1. History & development of the income tax
a. 1913: Passage of the 16th Amendment made the income tax possible
1) The first income tax was passed
2) Until 1939, the tax laws were reenacted every year.
b. 1939: Passed the first Internal Revenue Code
c. 1954: Passed the Internal Revenue Code of 1954
1) Numbering system used today was adopted
d. 1986: Enacted the Tax Reform Act of 1986.
1) Code was renamed the Internal Revenue Code of 1986.
a) Rates were highly progressive
b) Tax base was extremely narrow
3) 1986 revisions:
a) Rates were drastically lowered
b) Broadened tax base
e. June 2001: Economic Growth Reconciliation Tax Act (EGRTA) was passed
1) Brought rates down again
2) But, didn’t broaden the base
a) Not fully phased in until 2010
b) On Jan. 1, 2011, the tax law reverts back to pre-2001.
2. Administrative Sources:
1) Empower the Commissioner to promulgate regulations of the IRC.
2) Types of regulations:
a) Interpretive regulations
b) Legislative regulations
(1) Issued in cases that are very complex, so that legislative power is delegated to the Treasury Department.
c) Temporary regulations
(1) Must be treated as a proposed regulation
(2) Expire after 3 years, but can be extended
3) Regulations are reviewable, but are rarely overturned, and legislative regulations are never overturned.
C. The Internal Revenue Service
a. Determinations letter
1) e.g. find out if you’re tax exempt
b. Letter rulings (PLR)
1) Find out tax consequences of a particular transaction.
2) May be a prerequisite to a corporate transaction.
3) Can only be relied upon by the taxpayer who requested it.
4) All rulings are published by private publishers
5) Cannot cite as authority, but in practice, they are read by everyone, and often cited.
c. Revenue rulings
1) Most important rulings
2) Officially published by the government
3) Can be cited as authority
4) Receive some significant amount of deference
d. Revenue procedure
1) Similar to revenue rulings, but deal with the IRS’ approach to certain problems.
2) Set up general guidelines.
e. Limitations on rulings:
1) Must be legal issues.
a. If the government loses the case in the Tax Court and disagrees with the results, the Commissioner may decide not to appeal because of facts, etc.
1) Rather, to show disagreement and that they will litigate in future cases, the Commissioner will issue a non-acquiescence.
2) An acquiescence shows that the Commissioner agrees with the outcome.
D. Tax Controversies
1. “Self-assessment system”
a. Taxpayers file returns and pay the taxes due.
b. The Service checks for mathematical and other routine errors.
c. Return goes through a matching process.
d. About 1% of returns are selected for audit.
1) When there is a controversy at the audit level, it usually is settled.
2) When it’s not settled, the Service will issue a 30-day letter.
a) Says the taxpayer has 30 days after the issues of the letter to appeal the decision of the Service.
3) If taxpayer takes no action, Service issues a 90-day letter (deficiency notice).
a) Says the taxpayer has 90 days to file an appeal with the Tax Court.
b) After 90 days, if no appeal is filed, the IRS will assess a deficiency and collect the tax.
2. Statute of limitations:
a. For filing a refund claim:
1) Three years from date return was filed.
2) Three years from the due date for the return.
3) Two years from the date the tax was paid.
3. Three possible forums:
a. U.S. Tax Court
1) No jury trial – case is heard by the judge.
2) Tax Court cases are appealable to the Court of Appeals for the circuit that has jurisdiction over the site of the dispute.
3) The Tax Court must follow the precedent of the appeals court to which the case is appealable.
a) There are differing precedents in the various circuits.
4) Tax Court has only “deficiency” jurisdiction – means that cannot be availed if the taxpayer has paid the tax in full.
b. Court of Claims
1) No jury trial.
c. U.S. District Court
1) Jury trial if desired.
4. Burden of proof:
a. IRS Restructuring and Reform Act of 1998 purported to shift the burden to the government in a narrow range of cases.
1) Burden of production – still on the taxpayer.
2) Burden of persuasion – now on the government.
a) Change had little practical outcome.
E. Taxpayers and Tax Rates
1. The Progressive Rate System
a. Focus is on the marginal rate.
1) Anything above a certain amount is taxed at the marginal rate.
2) For 2002-2003, the top tax rate is 38.6%.
b. Tax-rate schedules in § 1 apply only to taxable income.
1) Computed by subtracting from TP’s gross income any allowable deductions.
a) Code phases out certain deductions as the TP’s income increases.
c. The average tax rat
e the deduction is allowed.
b) This is a definition of adjusted gross income.
c) Reduces gross income by the cost of generating gross income.
d) AGI serves to limit other deductions (certain deductions are computed in reference to AGI).
e) AGI gets everyone on the same footing – e.g. salary-earner v. self-employed.
d. § 63 defines taxable income.
1) GI – all deds = TI
a) Leaves out the AGI intermediate step.
(1) GI – § 62 deds = AGI
(2) AGI – Itemized deds – Personal exemption = TI
2) Have choice between itemized deductions and the standard deduction.
a) Standard deductions are set out at § 63(c).
e. Tax rates are applied to get the tax before credits.
1) Examples of credits:
a) Pre-payment credit – credit for what you’ve already paid through employer-withholding.
b) Child care credit
2) Subtract the credits to get the tax due.
a. P. 42
1) GI = 40,000
§ 62 deds = (4,000)
AGI = 36,000
2) Possibilities for deductions:
a) Itemized deduction:
1,000 (allowed by § 164 – property taxes)
2,650 (allowed by § 164 – state income taxes)
3,650 total itemized deductions
b) Standard deduction: Basic Standard Ded + Additional Stand. Ded.
Basic Stand. Ded. = 3,000 (§ 63(c))
Add. Stand. Ded. = $750 (§ 63 (f)(3))
Total Stand. Ded. = 3,750
c) Use the Standard Deduction
3) Personal Exemption
a) Allowed by § 151
b) PE = 2,000 (§ 151(d)(1))
4) AGI = 36,000
Stand. Ded. = (3,750)
Pers. Exem. = (2,000)
TI = 30,250
B. Accessions to Wealth
a. Commissioner v. Glenshaw Glass Co., 348 U.S. 426 (1955)
1) Facts: Glenshaw Glass sued Hartford-Empire Company demanding, among other claims, exemplary damages for fraud and treble damages for violation of the federal antitrust laws. The suit was settled for $800,000. The Tax Court determined that $324,529.94 of the total settlement represented punitive damages for fraud and antitrust violations. Glenshaw did not report these damages as income.
2) Holding: Punitive damages are income.
3) No one challenged whether the compensatory damages are income.
a) Damages are taxed just like that which they were meant to replace.
4) The only precedent was Highland Farms, a Tax Court decision.
a) Held that punitive damages were not taxed.
b) Commissioner filed a non-acquiescence.
c) Congress reenacted § 61 without any change after Highland Farms.
(1) Could conclude that Highland Farms was the interpretations that Congress intended.
BUT, there was no evidence that Congress even knew the decision