1 Unit 01.
Introduction to Taxation
The first chapter in PAK outlines the basic purposes and
principles of taxation. This is an overview chapter. Read it
with the goal of gaining a broad understanding of tax
purposes and principles. Although the history is interesting, for
our purposes, the sections on tax structure, types of tax, tax
administration, and understating the tax law will be relatively
more important.
For efficiency and space reasons textbook examples are not
copied to the slides. Instead, you are asked to study specific
examples in the textbook when you read through the slides at
various points. These example-study notes are highlighted in
RED.
Outline
2
History of taxation in the United States
Types of tax rate structures
Other type of taxes
Criteria for a tax structure
Objectives of the federal income tax law
Entities in the federal income tax system
Tax law sources
Enactment of tax law
Administration of the tax law and tax practice issues
Components of a tax practice
History of Taxation
Early Periods
3
First federal income tax levied in 1861 to fund Civil
war.
It was repealed after the war.
Federal income tax reinstated in 1894, but challenged
in court. In 1895, Supreme Court ruled income tax
unconstitutional!
Constitution amended in 1913; 16th amendment gives
Congress right to tax income.
The Congress shall have the power to lay and collect taxes on
incomes, from whatever source derived, without
apportionment among the several States and without regard to
any census or enumeration.
History of Taxation
Revenue Acts from 1913 to the Present
4
Early tax rates were relatively low and high
exemption levels effectively exempt most of the US
population from paying taxes.
In 1939, less than 6% of US population paid a
federal income tax.
Due to need for increased government revenue to
fund World War II, tax base was broadened so
that by 1945, 75% of the US population paid
federal income tax.
“Pay as go” withholding was added in 1943.
History of Taxation
Revenue Sources
5
History of Taxation
Revenue Sources
6
Individual income taxes comprise almost ½ of the
revenue received by the federal government.
This share has held fairly steady over time.
Social insurance taxes and contribution comprise
about another third. This share has increased 18
percentage points since 1960.
Corporate income taxes provide about 13% of
government revenue. This share has decreased 10
percentage points sine 1960.
Figure 1.1. Breakdown of Federal Revenues:
7
1960-2008
Two Basic Components of Tax
8
Structures
Tax base:
The amount to which tax rate is applied to determine
the tax due.
Example: taxable income
Tax rate:
The percentage rate applied to the tax base
Types of Tax Rate Structures
Individual Income Tax Rates
9
Possible tax rate structures are
Progressive: Rate increases as tax base increases, such as the
current U.S. income tax.
Study Example1-1 and 1-2 on Page 1-4
Proportional (flat tax): Rate is the same regardless of tax base, such as
sales tax
Study Example 1-3 on Page 1-4
Regressive: Rate decreases as tax base increases, such as the
current U.S. FICA tax (Social security and Medicare tax)
Study self-study question on Page 1-5
The current U.S. federal income tax system is mildly progressive
(10%-35%).
The benefits of personal and dependency exemptions are phased-
out for upper-income taxpayers.
Also, upper-income taxpayers will lose some benefit for certain
itemized deductions.
Types of Tax Rate Structures
Individual Income Tax Rates for 2009
10
For 2009 the
federal income tax
rate begins at 10%
to increase to 15%,
25%, 28%, 33%,
and 35%. For
details see the
inside front cover of
the PAK textbook, or
visit IRS website at
http://www.irs.gov/
pub/irs-
pdf/i1040tt.pdf
The two tables on
the right show the
tax rates for two
filing statuses as
examples.
11
Types of Tax Rate Structures
Corporate Tax Rates
12
The tax rates for regular corporations (C corporations) are
also mildly progressive (varying between 15% and 39%).
A surcharge is applicable to high corporate taxable income.
The stair-step pattern of progression tends to benefit small
corporations
Benefit of graduated tax rates phased out between $100K
and $335K, and $15M and $18.33M
Types of Tax Rate Structures
Marginal, Average, and Effective Tax Rates
13
Marginal tax rate – most useful rate in tax planning
Tax rate applied to incremental amount of taxable income that is
added to tax base.
Study Example 1-4 on Page 1-5
Average tax rate
Total tax liability divided by amount of taxable income
Study Example 1-5 on Page 1-6
Effective tax rate
Total tax liability divided by total economic income
Study Example 1-5 on Page 1-6
The marginal, average, and effective tax rates may
vary significantly from the nominal schedule rates.
For example, even though the nominal maximum individual
rate is 35%, the marginal rate will be increased by any
phase-out of exemptions or itemized deductions.
Types of Tax Rate Structures
Determination of Taxable Income and Tax Due
14
Taxable income for all types Gross Income
of taxpayers is calculated
by subtracting allowable - Deductions for AGI
exclusions, deductions, and = AGI
exemptions from total
income. - Deductions from AGI
The tax or refund due is = Taxable Income
calculated by subtracting x Individual Tax Rate
allowable credits and/or
prepayments from the gross = Gross Tax Due
tax liability resulting from - Credits & Payments
applying applicable tax
rates times taxable income. = Tax or Refund Due
Other Types of Taxes
15
State and local income taxes
State and local franchise taxes
Wealth transfer taxes
Estate tax – Covered in FCS 5540 Estate Tax Planning
Gift tax: Tax imposed on the donor for transfer of property
that is considered a taxable gift.
$13,000 annual exclusion per donee
Unlimited marital deduction for transfer between spouses
Charitable gifts are exempt – unlimited deduction
Study Example 1-6 on Page 1-8 and 1-9
Other types of taxes
Property, excise, sales, & employment taxes
Criteria for a Tax Structure
How to judge whether a tax structure is “good”?
16
Equity: How fair is the tax structure? Problem: Fairness is very subjective!
Vertical equity: Taxpayers who are not situated similarly should be treated
differently.
Horizontal equity: Similarly situated taxpayers should be treated the same.
Certainty
Stable source of government revenues
Amount of liability for taxpayers
Convenience - Easily assessed, collected, and administered
Economy
Minimal compliance and administration costs
Businesses spent $148B to comply with federal tax law and $80B to comply with state
and local taxes
Cost to individuals $111B
Simplicity - Should not be overly complex
Objectives of Federal Income Tax Law
17
Economic Objectives:
Raise Revenues for Government Operations
Stimulate Private Investment
Reduce Unemployment
Mitigate Effects on Inflation
Social Objectives:
Encouragement of certain activities and industries
Encourage corporate research activities by tax write-offs
Encourage charitable contributions (tax deductible)
Study Example 1-11 on Page 1-15
Income tax reform proposals (Advisory Panel Report in
2005)
Simplified Income Tax Plan (SITP)
Growth and Investment Tax Plan (GITP)
Entities in Federal Income Tax System
Taxpaying Entities
18
Various entities in the federal income tax system may be
classified into two general categories: taxpaying entities
and flow-through entities.
Taxpaying entities: Directly pay income tax
Individuals
Taxable income = Total income – Exclusions – Deductions for AGI –
Deductions from AGI
Study Example 1-13 on Page 1-18 to see how individual tax is
computed
“C” corporations (regular corporations)
Taxable income = Total income – Exclusions – Deductions
Study Example 1-14 on Page 1-19 to see how a C corporation tax is
calculated.
Double taxation on C Corporations
Study Example1-15 and Example 1-16 on Page 1-20 to understand
the issue of double taxation on C corporations.
Entities in Federal Income Tax System
Flow-Through Entities
19
Flow-through entities: Do no directly pay income tax
Sole proprietorship (Also known as a Schedule C business).
Business income earned by the proprietor is reported on Schedule C of
his/her individual income return.
Partnerships
Study Example1-17 and Example -18 on Page 1-21
S Corporations
Study Example 1-19 and Example 1-20 on Page 1-22
LLC (Limited Liability Company)
Study Example 1-21 on Page 1-23
LLP (Limited Liability Partnership)
Study Example 1-22 on Page 1-23
Trusts and estates to the extent the trust’s or estate’s income is distributed
(Example I: 1-23)
Entities in Federal Income Tax System
Flow-Through Entities
20
Flow-through entities: Do no directly pay income tax
Sole proprietorship (Also known as a Schedule C business).
Business income earned by the proprietor is reported on Schedule C of
his/her individual income return.
Partnerships
Study Example1-17 and Example -18 on Page 1-21
S Corporations
Study Example 1-19 and Example 1-20 on Page 1-22
LLC (Limited Liability Company)
Study Example 1-21 on Page 1-23
LLP (Limited Liability Partnership)
Study Example 1-22 on Page 1-23
Trusts and estates to the extent the trust’s or estate’s income is distributed
(Example I: 1-23)
Entities in Federal Income Tax System
Other Entities
21
Trusts and estates – hybrid entities
Ifincome is not distributed then they are taxpaying entities
To the extent the trust’s or estate’s income is distributed they
are flow-through entities
Study Example 1-23 on Page 1-23
Tax Law Sources
22
Legislative tax law sources include
Internal Revenue Code
Congressional Committee reports
Executive (administrative) tax law sources include
Income tax regulations
Revenue Rulings
Revenue Procedures
Private Letter Rulings
Judicial tax law sources include various levels of court
decisions
Trial
courts: District Court, Tax Court, U.S. Court of Federal Claims
Appeals courts: Circuit Courts
Supreme Court
Enactment of a Tax Law
23
The procedures for enactment of tax legislation are the same as those
for any other federal legislation, with the exception that all revenue
measures are constitutionally required to be introduced in the House of
Representatives.
These procedures include deliberations by the House Ways and Means
Committee, the Senate Finance Committee, and the Joint Conference
Committee.
The committee reports produced during these deliberations are valuable
sources of legislative intent used in governmental and taxpayer
interpretation of the enacted legislation.
The political process affects tax legislation as it proceeds through the
House of Representatives and the Senate towards the President's
signature. The economic, social, and revenue priorities of the
legislators (and their constituencies) affect the final product. Also,
efforts to reduce the budget deficit in recent years have had an impact
on annual tax legislation.
Enactment of a Tax Law
Steps
24
1. House of Representatives responsible for initiating new tax
legislation
President may make proposal to Congress with studies on needed
tax reform prepared by Treasury
2. Referred to the House Ways and Means Committee
(HW&MC)
3. Voted on by HW&MC
Forwarded to House of Representatives for a vote if approved by
HW&MC
4. Voted on by House of Reps
If approved, sent to Senate Finance Committee (SFC)
5. Voted on by SFC
If approved, sent to Senate for a vote
Bill may be different than House version
Enactment of a Tax Law
Steps Continued
25
6. Senate considers bill and may add amendments
7. Voted on by Senate
If approved, sent to Joint Conference Committee (JCC) to
reconcile bill
8. JCC produces final bill
Sent back to House and Senate to vote on final bill
9. If JCC bill approved, sent to President for approval or
veto
10. Presidential veto may be overturned by 2/3 vote in
both House & Senate
11. Committee reports prepared by staff of HW&MC,
SFC, and JCC
Administration of the Tax Law & Tax Practice
Organization of the IRS
26
Important personnel in the IRS (in descending authority)
are
The Commissioner of the Internal Revenue
Deputy and assistant commissioners
Regional commissioners
District directors
Tax litigation in Tax Court is handled by the office of
the Chief Counsel.
Tax litigation in a U.S. District Court and the U.S. Claims
Court is handled by attorneys in the Department of
Justice.
Administration of the Tax Law and Tax Practice
Enforcement procedures
27
The U.S. tax system is based on self assessment & voluntary
compliance. However, enforcement by the IRS is essential to
maintain the integrity of the tax system.
With the use of computer analysis and professional judgment,
taxpayer returns are selected for additional correspondence, office
audit, or field audit.
Mathematical errors and certain matching problems (i.e. the amount of
interest on a form 1099 received by the IRS does not match the amount
of interest reported by the taxpayer) can generally be resolved by
correspondence.
Study Example 1-24 on Page 1-27.
In an office audit, the taxpayer is asked to bring documentation to the
IRS office to substantiate income, deduction, and/or credit items on the
taxpayer's return.
Study Example 1-25 on Page 1-27
More complex audits are handled by a field audit where the IRS agent
goes to the taxpayer's place of business or to the office of the
taxpayer's tax professional.
Administration of the Tax Law and Tax Practice
Selection of Returns for Audit
28
Administration of the Tax Law and Tax Practice
Selection of Returns for Audit
29
The IRS uses both computers and experienced personnel
to select returns for examination.
Computer: Discriminant Function System (DIF)
DIF system generates “score” for return based on the potential for
the return to generate additional tax revenue
Returns manually screened by IRS
Decide which returns to examine further based on experience
Less than 1% of all individual returns are selected for
examination each year
While the overall individual audit rate is less than 1%, individuals
with relatively large amounts of income and deductions are
significantly more likely to be audited. If a return contains a
frequently disputed item (i.e. home office deduction), the
likelihood of audit also increases.
Administration of the Tax Law and Tax Practice
Selection of Returns for Audit
30
The IRS uses both computers and experienced personnel
to select returns for examination.
Computer: Discriminant Function System (DIF)
DIF system generates “score” for return based on the potential for
the return to generate additional tax revenue
Returns manually screened by IRS
Decide which returns to examine further based on experience
Less than 1% of all individual returns are selected for
examination each year
While the overall individual audit rate is less than 1%, individuals
with relatively large amounts of income and deductions are
significantly more likely to be audited. If a return contains a
frequently disputed item (i.e. home office deduction), the
likelihood of audit also increases.
Administration of the Tax Law and Tax
31
Practice Issues - Statute of limitations
Administration of the Tax Law and Tax Practice
Statute of limitations
32
General rule 3 years from later of the date tax return
was actually filed or due date
Six years if taxpayer omits items of gross income that in
total exceed 25%
Indefinite if fraudulent return filed or no return filed
The applicable statute of limitations may be extended
by mutual agreement between the taxpayer and the
government. Reticent taxpayers are encouraged to
extend the statute of limitations when the alternative is
an immediate unfavorable notice of deficiency. These
varying lengths of statutes of limitation can cause a
record keeping problem for taxpayers.
Study Example 1-26 on Page 1-28
Administration of the Tax Law and Tax Practice
Interest and Penalties
33
If IRS owes you a refund
The IRS has 45 days to issue a refund without paying any interest.
Interest and penalties may apply to tax due and other
taxpayer noncompliance.
Penalties are not tax deductible. Here are some examples of
these panalties:
A penalty of 5% per month subject to a 25% maximum for failure to
file a tax return.
A penalty of 0.5% per month up to a 25% maximum for failure to
pay the tax that is due.
A 75% penalty for fraud.
A penalty based on current interest rate for underpayment of
estimated taxes.
Administration of the Tax Law and Tax Practice
Administrative appeal procedures
34
Disputes
between IRS
agents and
taxpayers may
be resolved with
the IRS Appeals
Division.
Addition Things to Study
35
Answers to Selected Textbook Problems:
1-4, 1-5, 1-8, 1-19, 1-26, 1-42, 1-45, 1-46, 1-48, 1-49
http://www.fcs.utah.edu/~fan/fcs5530/Answers%20to%20Selected%20Problems/
AnswersSelectedUnit01.pdf
Self-study Quizzes on Publisher’s website:
http://wps.prenhall.com/bp_pope_fedtax_2010/120/30826/7891613.cw/index.
html
Homework Assignment for Unit01 (Graded)
PAK, Chapter 1 Problems: 1-39, 1-40, 1-41, 1-43, 1-44, 1-47.
Please go to the “Learning Modules” link on Blackboard/WebCT to submit your
assignment. You can also access it directly through the “Assignments” link.
Discussion Topic for Unit01(Graded)
Don’t forget to post your thoughts on the discussion topic of the week.
Go to the “Learning Modules” link on Blackboard/WebCT to post your thoughts. You
can also access it directly through the “Discussions” link.
