TOC_Concepts_in_Federal_Taxation_MurphyHiggins16SM_Combined - CHAPTER 1 FEDERAL INCOME TAXATION AN OVERVIEW 2016 Edition Questions 1 Topic Status Adam

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Unformatted text preview: CHAPTER 1 FEDERAL INCOME TAXATION - AN OVERVIEW 2016 Edition Questions 1 Topic Status Adam Smith's system requirements Unchanged 2 How well income tax and employment taxes meet Adam Smith's requirements Unchanged 3 Proportional, regressive, or proportional tax Unchanged 4 Proportional, regressive, or proportional tax Unchanged 5 Federal income tax as a revenue producer Unchanged 6 Collection of income taxes Unchanged 7 Sales tax versus excise tax Unchanged 8 Collection of sales and excise taxes Unchanged 9 Real property versus personal property taxes Unchanged 10 Gift tax Unchanged 11 Estate tax Unchanged 12 Valuation of gift and estate assets Unchanged 13 Payment of gift and estate taxes Unchanged 14 Primary sources of tax law Unchanged 15 Supreme Court cases Unchanged 16 Federal income tax base Unchanged 17 Exclusion Unchanged 18 Deferral versus exclusion Unchanged 19 Gross income versus income Unchanged 20 Deductibility of expenses Unchanged 21 Expense versus loss Unchanged 22 Transaction loss versus annual loss Unchanged 23 Legislative grace concept Unchanged 1-1 1-2 Topic Status 24 Exemptions Unchanged 25 Inflation effects on taxes Unchanged 26 Pay-as-you-go collection of taxes Unchanged 27 Tax credits Unchanged 28 Tax credit versus deduction Unchanged 29 Tax credit versus deduction Unchanged 30 Statute of limitations Unchanged 31 Auditing returns Unchanged 32 IRS examinations Unchanged 33 30-day letters Unchanged 34 90-day letters Unchanged 35 Individual versus corporate taxable income Unchanged 36 Deductions for and from AGI Unchanged 37 Standard deduction Unchanged 38 Why study taxes? Unchanged 39 Goal of tax planning Unchanged 40 Tax planning-who benefits Unchanged What is a tax? Unchanged 2016 Edition Problems 41 42 Definition of a tax - five scenarios Unchanged 43 Calculation of tax and tax rates (marginal, average, effective) Unchanged 44 Calculation of tax - comparing entities Unchanged 45 Social Security calculation/tax rate (marginal, average, effective) Unchanged 46 Progressive, proportional, regressive taxes Unchanged 47-CT Progressive, proportional, regressive taxes Unchanged 1-3 2016 Edition Status 48 Social Security tax calculation Unchanged 49 Social Security tax calculation Unchanged 50 Social Security tax calculation/payment by employer Unchanged 51 Self-employment tax calculation Unchanged 52 Social security/self-employment tax Unchanged 53 Classification of income items Unchanged 54 Classification of income items Unchanged 55 What is deductible? Unchanged 56 Classification of deduction items Unchanged 57 Calculation of taxable income/tax liability Unchanged 58 Calculation of taxable income/tax liability Unchanged 59-COMM Effect of deduction FOR/FROM adjusted gross income Unchanged 60-COMM Tax planning Unchanged Gift versus Income Unchanged 62-CT Tax planning Unchanged 63 Tax planning Unchanged 64 Tax planning Unchanged 65-CT Tax planning - income splitting Unchanged 66-CT Tax planning - income splitting Unchanged 67 Evasion versus avoidance Unchanged 68 Evasion versus avoidance Unchanged 69-IID Prepaid taxes Unchanged 70-IID Student loan interest Unchanged 71-IID Gift versus sale of stock Unchanged 72-IID Income splitting 61 Topic Modified 1-4 2016 Edition Topic 73 INTERNET Unchanged 74 INTERNET Unchanged 75 Research Problem Unchanged 76 Research Problem Unchanged 77 Spreadsheet Problem Unchanged 78-DC-CT Value-added Tax Unchanged 79-DC-CT How inflation adjustments preserve after tax income Unchanged 80-TPC-COMM Actions an owner can take to reduce taxes 81-TPC 82-EDC-CT Status Unchanged Tax effects of financing options Unchanged Statements on Standards for Tax Services (SSTS) to situations in problem 67 Unchanged CHAPTER 1 FEDERAL INCOME TAXATION - AN OVERVIEW DISCUSSION QUESTIONS 1. 2. Briefly state Adam Smith's four requirements for a good tax system. a. Equality - A tax should be imposed based on the taxpayer's ability to pay. b. Certainty - The taxpayer should be able to determine the amount of tax and how to make the required payment. c. Convenience - The tax should be levied as close as possible to the time the taxpayer receives the amount subject to tax. d. Economy - The cost of taxpayer compliance and administering the tax system should be small in relation to the revenue generated. Based on the discussion in the chapter, evaluate how well each of these taxes meets Adam Smith's four requirements: a. Income tax Adam Smith's four criteria for evaluating a tax are Equality, Certainty, Convenience, and Economy. The aspects of the income tax that promote each of the individual criteria are: Equality - Progressive tax rates; the use of a standard deduction and exemption amounts have the effect of exempting low-income taxpayers from the tax; indexing of tax rates, standard deduction and exemption amounts are adjusted for inflation. Certainty - The use of an annual accounting period and the consistent use of the same tax return due date. Convenience - The use of a pay as you go system of collecting taxes is more convenient than collecting all taxes at one date. Taxpayer's determine their own tax due in privacy. Economy - The cost of running the IRS is a small percentage of the total tax collected. 1-5 1-6 Chapter 1: Federal Income Taxation - An Overview Factors in the tax system that dilute Adam Smith's requirements: Equality - Income exclusions and special deductions allow taxpayers with high incomes to pay taxes equivalent to those with lower incomes. The use of tax planning by higher income taxpayers also negates some of the equality of the system. Certainty - The complexity of many of the tax law provisions and numerous changes in the tax law from year to year make proper calculation of the tax less certain. Convenience - Some would contend that determining the amount of tax to be withheld is difficult for many people, making the pay as you go system less convenient. Economy - There are significant costs of record-keeping and compliance that borne by the taxpayers, making the tax less economical. are b. Employment taxes The aspects of employment taxes that promote compliance with each of the four requirements: Certainty - The taxes are due as income is earned. The amount of tax is known with little uncertainty in its calculation. Convenience - Taxes are collected by employers and paid by the employer to the government. Economy - No annual reporting is required by the individual; however, the employer must incur the reporting costs. Costs of compliance are minimal. Aspects that dilute the requirements: Equality - The tax is not progressive; the tax consumes more of low income taxpayer's income than a higher income taxpayer's income. Economy - The cost of reporting is proportionately higher for smaller businesses. 3. Based solely on the definitions in the chapter, is the Social Security tax a proportional, regressive, or progressive tax? Explain, and state how the tax might be viewed differently. Strictly speaking, the Social Security tax is a proportional tax because it is applied at a constant rate (6.20 % up to $118,500 and 1.45% on all wages and salaries) to all levels of the tax base. Using the tax base, salaries and wages, the marginal cost is always equal to the average cost, which is indicative of a proportional tax. When viewed as a percentage of the taxpayer's total income, the Social Security tax is a regressive tax. That is, if you compare marginal and average tax rates for taxpayers whose income is greater than the OASDI base amount, the marginal tax rate is 1.45% and the average tax rate decreases as income increases. Thus, higher income taxpayers (those whose income exceeds the base amount subject to tax) pay lower marginal and average rates of tax than those whose income does not exceed the base. Chapter 1: Federal Income Taxation - An Overview 4. 1-7 Based solely on the definitions in the chapter, is the sales tax a proportional, regressive, or progressive tax? Explain and state how the tax might be viewed differently. Strictly speaking, the sales tax is a proportional tax because it is applied at a constant rate to all levels of the tax base. Using the tax base, goods and services purchased, the marginal tax rate is always equal to the average tax rate, which is indicative of a proportional tax. When another base is used to calculate marginal and average tax rates, the tax appears to be regressive. For example, if total economic income is used as the base, lower income taxpayers will spend a higher percentage of their income on items subject to the sales tax when compared to higher income taxpayers. Thus, the marginal tax rate will be less than the average tax rate, which is indicative of a regressive tax. 5. As stated in the text, the federal income tax is the largest revenue-producing tax in use in the United States. Why do you think the income tax produces more revenue than any other tax? There are two main reasons why the income tax is the largest revenue producer. They evolve around the calculation of a tax as the TAX BASE x TAX RATE. First, the tax rates are generally higher than other most other taxes (10% to 39.6% versus say, a 7% sales tax). Second, the tax base, taxable income, is larger than most other bases. For example, most individuals taxable income is greater than the amount they would spend on items subject to a sales or excise tax. Those taxes with higher rate schedules than the income tax (gift tax, estate tax) have relatively small tax bases. That is, not very many gifts and/or estates are subject to the tax in a given year. 6. How are federal, state, and local income taxes collected by the government? Consider the cases of an employee and a self-employed taxpayer. Employers are required to withhold income taxes on the wages and salaries of their employees. Employers are then responsible for depositing the taxes withheld to the appropriate governmental unit. Self-employed taxpayers are required to estimate their taxes and make quarterly payments to the appropriate governmental unit. 7. How is a sales tax different from an excise tax? Both are taxes on goods and/or services purchased. A sales tax is a percentage of the value of the sales price of the goods or services. It is paid when the goods and/or services are sold. An excise tax is based on either a quantity or volume of the product being sold, such as a gallon of gasoline or per tire. Although it is technically paid when the goods are sold, the excise tax is generally included in the sales price and is typically not shown separately as a tax. 8. Who is responsible for collecting sales and excise taxes? Who actually pays the tax? The seller of the goods and/or services subject to sales and excise taxes are responsible for the collection and payment of the tax. Sales taxes are paid directly by the purchaser as an addition to the sales price of the goods and/or services. The purchaser also pays excise taxes, but they generally are included in the price of the goods and, thus, are not shown as a separate payment by the buyer. 1-8 9. Chapter 1: Federal Income Taxation - An Overview Why is a tax on real property used more often than a tax on personal property? A tax on real property is more commonly used because real property is not mobile and is difficult to conceal. Thus, the tax base is more certain and the collection of the tax is easier. Personal property is mobile and easily concealed. Thus, it is more difficult to ascertain the value of personal property owned, making the tax base uncertain and the collection of the tax potentially difficult. 10. The gift tax is supposed to tax the transfer of wealth from one taxpayer to another. However, the payment of gift tax on a transfer of property is relatively rare. Why is gift tax not paid on most gifts? Gift tax payments are rare due to the exclusions from the tax. The basic exclusion is $14,000 per donee per year. This would allow a married couple to make tax-free gifts of up to $28,000 per donee per year. Gifts in excess of the annual exclusion can be taxfree if the donor elects to use part of the unified gift and estate tax credit. Under this credit, the equivalent of $5,430,000 of property transfers may be excluded from gift taxes. 11. The estate tax is a tax on the value of property transferred at death. Why is payment of the estate tax not a common event? Although many people die every year, most pay little or no estate tax. This is due to two factors: the unlimited marital deduction for property passing to a spouse and the unified gift and estate tax credit. The marital deduction exempts from estate tax any property passing to the decedent's spouse. The unified gift and estate tax credit allows up to $5,430,000 (2015) of tax-free property transfers. Because the majority of people do not have estates exceeding the $5,430,000 tax-free limit, their estates are not taxed. Proper tax planning for larger estates should result in paying no tax on the death of the first spouse through use of the marital deduction. 12. What is the basis for valuing assets transferred by gift and at death? Gift and estate taxes are based on the fair market value of the property at the date of the gift or at the date of death of the taxpayer. 13. Who is responsible for reporting and paying gift taxes? estate taxes? Gift taxes are assessed on the donor of the gift. It is the donor's obligation to properly report and pay taxes on gifts. Estate taxes are reported and paid by the executor of the estate. The person receiving the property has no obligation to pay either gift or estate taxes. 14. Identify three primary sources of tax law. 1. Legislative - The Internal Revenue Code of 1986. 2. Administrative - The income tax regulations and other IRS documents. 3. Judicial - Trial and appellate court decisions. Chapter 1: Federal Income Taxation - An Overview 15. 1-9 Explain why the following statement is not necessarily true: "If the IRS disagrees, I'll take my case all the way to the Supreme Court." This statement is false because the Supreme Court chooses the cases it will review. Thus, the court may deny the taxpayer a hearing of his case (a writ of certiorari). Generally, the Supreme Court only considers a few tax cases in a given year. 16. What is the federal income tax base? A tax base is the value that is subject to tax. The federal income tax base is a prescriptive net income amount called federal taxable income. The base is computed by reducing income from all sources by exclusions, deductions, losses, and exemptions. 17. What is an exclusion? An exclusion is an increase in the taxpayer's wealth that Congress has determined should not be subject to tax or it is a recovery of the taxpayer's capital (i.e., investment in an asset). 18. How is a deferral different from an exclusion? An exclusion is income that is never subject to tax. A deferral is income that is not taxed in the current period, but will be taxed in a future period. The future period tax may result from inclusion of the income through either lower depreciation/amortization deductions and/or by the inclusion of a larger gain than would have occurred without the deferral. 19. How does gross income differ from income? Income (broadly defined) includes both taxable and tax-exempt income. This definition of income is closer to an economist's definition of income than is gross income. Gross income is a more restrictive term. Gross income is income (broadly defined) less income not subject to tax (exclusions). Gross income items are the starting point for reporting on a tax return. 20. What are the three basic tests that an expense must satisfy to be deductible? 1. The expense must be ordinary, 2. The expense must be necessary, and 3. The expense must be reasonable in amount. 1-10 21. Chapter 1: Federal Income Taxation - An Overview What is the difference between an expense and a loss? Expenses are the ordinary, necessary and reasonable expenditures incurred during a taxable year to earn income. Expenses are normally items that recur each year and whose usefulness does not extend substantially beyond the end of the current year. A loss normally means that an asset has been disposed of (sold, abandoned, etc.) for a price that is less than its tax cost (basis). A loss generally results from a specific transaction as compared to expenses that are usually incurred throughout the year. 22. How is a transaction loss different from an annual loss? A transaction loss results when an asset is sold or otherwise disposed of at a price less than its tax cost (basis). An annual loss results from an excess of total deductions over total income for the year. Thus, a transaction loss is the result of a single event, while an annual loss is the cumulative effect of events for an entire year. 23. How does the legislative grace concept help identify amounts that qualify for deduction? According to the legislative grace concept, an expenditure is not deductible unless a specific provision of the tax law allows the item as a deduction. If an expenditure is identified as an allowable type of deduction by the tax law, it can be subtracted in the taxable income calculation. 24. What is the purpose of the exemption deduction? The exemption deduction is a predetermined amount that certain taxpayers may deduct to compute taxable income. The exemption is an example of the legislative grace concept. Congress has recognized that a certain amount of income is required to pay basic living costs. As a result, an individual is entitled to reduce income by the predetermined basic living cost amount (the exemption) for themselves and those who rely on the taxpayer for support. Estates and trusts are also allowed exemption deductions. However, other tax entities (e.g., corporations) are not allowed exemption deductions. 25. Based on the example in Exhibit 1--2, explain how inflation can have two effects that result in a hidden tax. The hidden tax from inflation can result from two effects: 1. As inflation increases the taxpayer's income, additional tax will be paid even though there is no change in the tax rates or increase in the taxpayer's real income, and 2. In some instances, the increase in income due to inflation may push the taxpayer into a higher marginal tax rate bracket. Thus, the taxpayer will be subject to a higher rate of tax without a corresponding change in real income. The problem of creeping into higher marginal tax brackets is partially cured by indexing the tax rates for inflation. Chapter 1: Federal Income Taxation - An Overview 26. 1-11 Explain the pay-as-you-go system. Income taxes are paid on income as close to the time it is received by the taxpayer as possible. This is accomplished through income tax withholding on wages and other types of income (e.g., gambling winnings) and through quarterly estimated tax payments on income that is not subject to withholding (e.g., self-employment income, investment income). 27. What is a tax credit? A tax credit is an incentive put into the tax law by Congress to encourage taxpayers to enter into specific types of transactions or to provide relief from double taxation. A tax credit is treated like a prepayment of tax because it reduces the amount due by the full amount of the credit (dollar for dollar reduction in tax liability). 28. How is a tax credit different from a tax deduction? A tax deduction results in a reduction of taxable income (the tax base). Therefore, the tax savings from a deduction are equal to the taxpayer's marginal tax rate multiplied by the amount of the deduction. In contrast, a tax credit is a direct dollar for dollar reduction in the tax liability. Therefore, one dollar of tax credit is worth more than one dollar of tax deduction. 29. If you were in the 28% marginal tax bracket and you could choose either a $1,000 tax credit or a $3,000 tax deduction, which would give you the most tax savings? Why? The tax credit is a better choice in this case. The tax credit wil...
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