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INCOME TAX OUTLINE CALCULATING TAX LIABILITY A. Steps to determining tax liability 1. Calculate gross income (§61) 2. Subtract “ above-the-line ” deductions (enumerated in §62) 3. The resulting figure is known as adjusted gross income (§62) 4. Subtract “below-the-line” deductions - the sum of personal exemptions (§§ 151, 152) and either a standard deduction (§63) or itemized deductions (start with §67) 5. The resulting figure is known as taxable income (§63) 6. Apply the tax rate schedules (§1) to taxable income to find tentative tax liability . 7. Subtract from tentative tax liability any available tax credits . 8. The remaining amount is final tax liability B. Tax Credits and Deductions 1. Tax Deductions a. Above-the-line deductions reduce your gross income. b. Below the line reductions reduce your taxable income. 2. Tax Credits a. Do not affect calculation of income. b. Reduce your tax liability directly. C. Tax Rates 1. Marginal Tax Rate – The tax rate you would on an additional dollar of income as determined by tax tables. a. Every dollar you earn is reduced by your marginal tax rate. This is the after- tax value of that dollar. b. A tax deduction is actually worth the amount of the deduction multiplied by the your marginal tax rate. 2. Average Tax Rate – Total tax liability divided by taxable income. a. Good measure of a taxpayers overall tax burden. 1
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WHAT IS INCOME A. Gross Income defined – Gross income means all income from whatever source derived. (§61) 1. Code enumerates items of gross income but that list is not exclusive. (§61) 2. Payment of income tax by an employer is income which is also taxed. ( Old Colony ) a. Form of payment makes no difference. b. Tax inclusive base – Federal income tax is imposed on a tax inclusive basis. i. The amount of federal tax is included in the amount of taxable income to which rates are applied. 3. Winnings – The IRS has always taken the position that game show winners must report their earnings and prizes. 4. Economic Definition of Income – Hague-Simons definition (Income = Consumption + Change in Wealth) 5. Income arising from an illegal activity is still income. ( Collins ) B. Compensation other than in cash – Form of compensation does not matter, still have to include it as income. (§1.61-2(d)) 1. If services are paid for in property, the Fair market value of the property is income 2. If services are paid for with other services, the fair market value of the services is income. C. Property as Payment – Where a taxpayer is permitted to purchase property or services at a price below fair market value because the seller is compensating the purchaser for services, the purchaser must include the amount of the discount as gross income. (§83) 1. Substantially vested - Such property is not taxable until it has been transferred and become substantially vested in the transferee. (§1.83-1(a)(1)) a. Until substantial vesting transferor is considered the owner.
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