Tax Midterm Outline- Schenk- Fall 2014
Intro to Federal Taxation
A. Pillars of establishing a tax system (what makes a tax system good or bad):
1. Equity- requires a determination of what are “similar economic circumstances”
§ Horizontal equity- satisfied if those with equal incomes are taxed equally.
§ Vertical equity- satisfied if taxpayers with unequal incomes are taxed unequally.
o This concept supports progressive taxes- those with higher incomes should pay a higher percentage of tax.
o Those with greater ability should pay more
2. Efficiency- in economic terms, as little interference as possible in peoples’ market behaviors. Business people should not be making decisions based on tax law.
§ Another view is whether it affects economic growth (if yes, then it is efficient).
3. Simplicity- the tax laws should be as simple as possible so that taxpayers can calculate their taxes, understand them and comply with them.
§ This is nearly impossible today and won’t be accomplished with a flat tax.
B. Current Taxes in the United States
· Income Tax: Imposed on individuals/entities and varies with income/profit of taxpayer
· Flat Tax à Flat Tax with a consumption base: tax system with marginal rate applied to individual/corp.
· Head Tax: Fixed amount applied to individual
· Progressive Tax: Tax Rate increases as taxable base amount increases
· Payroll Tax: Tax imposed on employers for employee salary
· Excise Tax: Tax for production
· Sales Tax: Tax for Sale
C. Basic structure of the Internal Revenue Code:
· § 1 Individual income tax is imposed on taxable income (TI). Provides the rates for various categories of tax payers.
· Top is 39.6%
· § 63 Defines taxable income: except otherwise provided, it is gross income less some deductions. Types of deductions allowed depend on whether or not you itemize.
· Gross Income – Deductions
· Itemize- claim deductions for items that are allowed under the code.
· The taxpayer must elect to itemize.
· 2/3-3/4 of taxpayers do not itemize.
· § 61 Defines Gross Income- all income from whatever source derived.
· The list is illustrative, not exhaustive.
· § 62 Defines Adjusted Gross Income- gross income minus the following deductions.
· Any item that is deductible when arriving at adjusted gross income is deductible, whether or not you itemize.
· All deductions that individuals can take are either itemized deductions or personal or dependency exemptions, unless they are listed in § 62 and deductible when arriving at adjusted gross income.
· List of Itemized items: p. 22
*** Adjusted gross income: only a definition; section 62(a)(1) is ONLY A DEFINITION does not allow you to take any deductions!!!!!–> does not allow you to deduct anything: it tells you that arriving at adj. GI if you have a provision that is provided by another part of code and is listed in section 62—but it has to be an operative provision of code that authorizes the deduction; even if you take the standard deduction, you can take the deduction that are listed in section 62!
D. Tax Terminology:
· Tax Basis (§§ 1011, 1012, 1013, 1016)- tax investment in an asset/piece of property that is used, generally, in order to calculate gain or loss on the disposition of an asset.
· WHAT YOU INITIALLY PAID
· Ex. Buy Ford stock for $8 a share and sell it for $11.75 a share. The gain is only the amount that exceeds the investment. The profit is $3.75 a share for tax purposes. The $8 per share originally paid is the tax basis- you don’t have to pay tax on that amount again when you sell it.
· Adjusted Basis- Basis increased by capital improvements and decreased by depreciation deductions.
· Ex. Buy a machine for business at $50,000 and take dep. on it for $4000. $4000 is an a depreciation expense that can be deducted thus Adjusted Basis is $46,000
· ANYTIME THERE IS A TRANSACTION INVOLVING PROPERTY, YOU MUST DEAL WITH BASIS AND ADJUSTED BASIS
· i.e. home improvements, § 1016.
· Realization- General principle is that you don’t report gains/losses until they’re realized; conversion of non-cash assets into cash assets. An event or transaction, such as the sale of property, that substantially changes a taxpayer’s economic position so that income tax may be imposed or a tax allowance granted.
· Ex. If one buys stock for $5 per share and it increases in value to $9 per share, you do not have to report that increase in value until it is realized (generally when you sell it).
· Capitalization- An asset that will be useful for many years cannot be taken as a deduction all at once- it must be capitalized. The cost is recovered through a depreciation or amortization (both are interchangeable) charge over a number of years.
· Under § 1012: purchase price becomes basis value
· Deduction- Revenue losses attributable to provisions of the Federal tax laws which allow a special exclusion, exemption or deduction from Gross Income or which provide a special credit, a preferential rate of tax, or a deferral of tax liability.
· Deduction vs. credit: a deduction is taken away from gross income, so the value of the deduction is the amount times the percentage tax bracket the tax payer is in (i.e. $10,000 deduction, top tax bracket [35%], the taxpayer saves $3,500 in taxes). A credit, on the other hand, is a uniform amount, no matter what tax bracket the taxpayer is in ($10,000 credit saves any tax payer $10,000 in taxes).
· Tax expenditure budget- Mechanism to alert Congress to the amount of revenue that the government has been losing because of this special legislation, because of the exclusions.
· Basic methods of accounting:
· Cash method- Generally includes items in income in the year in which they are received and allows items as deductions in the year in which they are paid.
· Accrual method- includes items in income when earned, regardless of when they are actually received and allows items as deductions in the year in which they are incurred, regardless of when they are paid. (this method is typically used by manufacturing, wholesale and retail.)
E. Constitutional Limitations on Taxation
· Originally the government’s ability to tax was limited; states were taxed based on population.
· Pollack v. Farmers Loan (1895)- the Supreme Court ruled that the income tax imposed on rent from real estate was unconstitutional because it was a direct tax and it wasn’t apportioned among the states in accordance with population.
· Flint v. Stone Tracy (1911) The Supreme Court held constitutional the corporate tax as an excise tax.
· 1913- the 16th Amendment took effect (“Congress shall have the power to lay and collect taxes on incomes from whatever source derived…”)
· This is now the language in § 61 of the Code
· The Supreme Court sustained this amendment in Brushaber v. Union Pacific R.R. Co.
F. The Legislative Process [p.54] · Th
peal would belong to that circuit.
§ If there’s a tax court that’s been appealed to your circuit and the circuit has ruled on that issue, we will follow that decision, even if we disagree, and as long as within that circuit, then we’re sticking to it
Standing [p. 77] · It is very difficult to obtain standing to challenge a tax provision. Harm to a group or harm to society is not sufficient.
o For example, challenge to tax-exempt status of university. Jones- no standing.
Ethics (of being a tax lawyer)
· A taxpayer has a responsibility to file an accurate, non-frivolous tax return.
· § 6694 imposes penalties on preparers of tax returns that take “unreasonable positions”
· § 7206 Any person who willfully [INTENT] makes or returns a document which he does not believe to be true and correct…
o A lawyer may run into trouble if he guarantees a refund without seeing any of the taxpayer’s information.
o It doesn’t matter if the taxpayer is unaware that the preparer is inserting false information- the tax preparer could go to jail even if the taxpayer does not know of the fraud.
Statutes of Limitations
· Ordinarily, the statute of limitations on a tax return is 3 years.
o If an agent is investigating a tax return and is getting close to the end of the statute of limitations, he can send a request to the taxpayer for an extension. The taxpayer can say no, but if he does the IRS will likely file a jeopardy assessment (this is what we think you owe, so we are determining it today).
· After three years, it closes unless more than 25% of the taxpayer’s gross income has been omitted from the return, in which case the statute of limitations is 6 years.
· If there is evasion, fraud, etc. the statute of limitations is unlimited for criminal prosecution
Tax Calculation [p. 25] – Computation of Tax Liability
Calculate Gross Income (§ 61)
– Certain Deductions (above the line)(enumerated in §62)
Adjusted Gross Income (§ 62)
– Standard Deduction OR Miscellaneous Itemized Deduction (§ 63 & § 67)
– Personal Exemption (§ 151)
Taxable Income (§ 63)
x Tax Rate (§ 1)
Tentative Tax Liability
– Tax Credits
Tax Due or Refund
The Tax Map:
Tax Liability = [Ordinary Income – “Above the Line” Deductions – Personal Exemptions – Standard or Itemized Deductions] x Taxpayer’s Ordinary Rate + [Net Capital Gain x Capital Gains Rate] – credits.
Gross Income: Wages, commissions, dividends, alimony payments, lottery winnings, discharge from indebtedness, and so forth. (Does NOT include: certain fringe benefits such as health insurance). In addition, it is not only cash receipts but also receipts in the form of services, property, or payments to third parties on the taxpayer’s behalf. Also, Gains derived from the sales of securities, real estate, works of art, and other tangible and intangible property.