Chapter 1 An Overview of Federal Taxation

1
Chapter 1An Overview of Federal Taxation

• The purposes of this course are to
• Introduce you to the Federal income taxation of
  individuals and
• To increase your tax awareness (ability to
  recognize tax problems, pitfalls and planning
  opportunities).

2
The Nature of a Tax

• The Supreme Court has defined a tax as an
  exaction for the support of the Government.
• A tax, therefore, provides a means through
  which the government derives a majority of the
  revenues necessary to keep it in operation.
• It also has become a powerful instrument that
  policymakers use to attain social as well as
  economic goals.

3
Characteristics of a Tax

• A tax has one or more of the following
  characteristics
• There is no direct relationship between the
  exaction of revenue and any benefit to be
  received by the taxpayer
• Is levied on the basis of predetermined criteria.
• Is levied on a recurring or predictable basis
• May be distinguished from regulations or penalties

4
History of Income Taxation in USA

• 1789 US Constitution gave Congress power to
  levy and collect taxes
• Tariff Act of 1789 promptly passed
• 1862 First Federal Income Tax enacted
• Apportionment requirement ignored
• Applied uniformly
• Expired in 1872
• 1909 First Federal corporate income tax
  successfully passed and upheld in Court
• February 16, 1913 Sixteen Amendment passed and
  was upheld in Court which allowed Congress to
  pass an individual income tax (the Revenue Act of
  1913 on October 3)

5
History of Income Taxation (contd)

• 1916 First Federal law to impose a tax on the
  transfer of property (triggered by the death of
  an individual) was passed known as an Estate
  Tax
• Measured on FMV of decedents estate
• 1939 The Internal Revenue Code of 1939 was
  created by Congress
• Was the 1st systematic arrangement of all tax
  laws
• Was revised in 1954 and 1986
• The Internal Revenue Code of 1986
• Continues to be todays governing Federal tax law
• Has been amended by significant tax changes since
  1986

6
Key Tax Terms

• Tax Base amount on which a tax is levied
• Ex. Taxable Income
• Ex. FMV of property transferred by gift or at
  death reduced by allowed exclusions, exemptions
  or deductions
• Income any permanent increment to wealth
• Loans are not income
• Some increments are exempted from taxation
• Deduction a reduction in the gross (total)
  amount that must be included in the taxable base.
• Ex. Medical expenses, interest on mortgages,
  property taxes, etc.

7
Key Tax Terms (continued)

• Exclusions increments to wealth that are not
  included in a particular Federal tax base
• Ex. Graduation gift
• Tax Rates some percentage applied to the tax
  base to determine a taxpayers liability
• Are usually proportional or progressive, but can
  be regressive
• Progressive tax rate structure is one in which an
  increasing percentage rate is applied

8
Key Tax Terms (continued)

• Marginal, Average , and Effective Tax Rates
• Marginal Tax Rate is the percentage at which
  the next dollar added to the tax base will be
  taxed is important in tax planning
• Average Tax Rate total tax paid divided by the
  tax base
• Effective Tax Rate tax divided by total
  economic income
• Tax Credits a dollar-for-dollar offset against a
  tax liability
• A deduction simply reduces the base amount
  subject to the tax

9
Major Types of Taxes

• Income Taxes
• Wealth Transfer Taxes
• Employment Taxes
• Excise Taxes
• Franchise Tax
• Sales Tax
• Use Tax
• Doing-Business Penalty
• Real Property Tax
• Tangible Personal Property Tax
• Intangible Personal Property

10
Income Taxes

• An Income Tax is an extraction of some of the
  taxpayers economic gain, usually on a periodic
  basis
• Many states and some local governments also
  impose income taxes
• Income taxes are imposed on individuals,
  corporations, estates, and trusts
• To ensure tax collections are made, Congress
  created a pay-as-you-go requirement
• Application of Federal income tax on
• Individuals is discussed in Chapters 3 4
• Partnerships corporations in Ch. 19

11
Income Taxes (continued)

• Exhibit 1-2 (page 1-10)
• Tax Formula for Corporate Taxpayers
• Income
• less exclusions from gross income
• Gross Income
• less deductions
• Taxable Income
• less applicable tax rates
• Gross Tax
• less tax credits and prepayments
• Tax Due (or Refund)

12
Income Taxes (continued)

• Exhibit 1-3 (page 1-10)
• Tax Formula for Individual Taxpayers
• Income
• less exclusions from gross income
• Gross Income
• less deductions for adjusted gross income
• Adjusted Gross Income
• less (1) the larger of the Standard Deduction
  or total itemized deductions
• (2) personal/dependency exemption amounts
• Taxable Income
• less applicable tax rates
• Gross Tax
• less tax credits and prepayments
• Tax Due (or Refund)

13
Wealth Transfer Taxes

• The Unified Transfer Tax
• Is a combination The Federal Estate Tax and the
  Federal Gift Tax (since 1976)
• Is Progressive in nature
• Is computed cumulatively on taxable gifts made
  during a donors lifetime and on taxable
  transfers made at the donors death
• I.e., is based on lifetime gifts since 1976
• Exhibit 1-4 (Computation of Federal Estate
  Liability) on page 1-12 shows calculation

14
Wealth Transfer Taxes (continued)

• The Unified Transfer Tax (continued)
• Decedents gross estate includes the fair market
  value of all property owned at date of death
  (including any insurance policies decedent had
  any ownership rights in or to which the estate
  was beneficiary)
• The Taxable Estate is the Gross Estate reduced by
  funeral/administrative expenses, debts, taxes,
  losses, and charitable gifts from the estate
• There would be no taxable estate if everything
  was left to charity
• There is an unlimited marital deduction

15
Wealth Transfer Taxes (contd)

• The Unified Transfer Tax (continued)
• Unified Tax Credit
• Is the major credit available to reduce the
  Federal Estate Tax
• Is a lifetime credit available for all taxable
  transfers
• The Taxpayer Relief Act of 1997 increased amount
  of unified credit to 1MM
• It was further increased by the Economic Growth
  and Tax Relief Reconciliation Act of 2001 by
  2009 the exclusion amount will grow to 3.5MM and
  will be repealed (the Estate Tax) in 2010 (for
  one year) after that (2011) it could return in
  its current form
• In 2005, the unified credit is 555,800 (which
  offsets taxes on 1,500,000)

16
Wealth Transfer Taxes (contd)

• The Federal Gift Tax
• The purpose of the Federal Gift Tax is to prevent
  a taxpayer from avoiding Federal Estate Taxes by
  giving away his/her property prior to death
• Exhibit 1-5 (Computation of Federal Tax
  Liability) shows the gift tax calculation on
  gifts made in the current year a donor allowed
  an annual exclusion of 11,000 per donor in 2005
• The marital and charitable deductions for federal
  gift tax are unlimited
• If taxable gifts have been made for the current
  year, the cumulative computational procedure of
  the unified transfer tax must be applied

17
Wealth Transfer Taxes (contd)

• See Ex. 15 16 on pages 1-1415
• Note that the cumulative system of wealth
  transfer taxation AND the progressive rate
  schedule cause a higher tax on the 2005 gift than
  the 1995 gift.
• The tentative tax liability is reduced by the
  unified transfer tax credit
• The unified transfer tax credit is the only
  credit available to offset the Federal gift tax
  liability
• A gift-splitting election is available for
  married couples

18
Wealth Transfer Taxes (continued)

• State and Local Transfer Taxes
• Many states/local jurisdictions impose
  inheritance tax on the right to receive property
  at death (i.e., the recipient, not the decedent)
• In addition, many impose estate taxes on a
  decedents estate
• Nine states impose a state gift tax
• Assignment for next class Does Texas have an
  estate tax?

19
Employment Taxes

• The Federal government and most states impose
  some kind of employment tax on either
  self-employed individuals, employees or employers
• The Federal government imposes two types of taxes
  on employment
• A Social Security tax (FICA Taxes)
• Imposed on employees, employers and self-employed
  individuals
• An unemployment tax (FUTA Taxes)
• Only imposed on employers
• Self employed not eligible

20
Employment Taxes (contd)

• FICA Taxes (7.65)
• Used to finance social security benefits and
  Medicare health benefits (MHI)
• In 2005, 90,000 of wages and self-employment
  income was subject to Social Security (6.2)
• Social security benefits include old age,
  survivors and disability insurance
• All wages and self-employed income are subject to
  MHI payments (1.45)

21
Employment Taxes (continued)

• FICA (continued)
• Employer is required to
• match the amount of FICA the employee pays,
• withhold both Federal income taxes and FICA from
  employees wages during the year, and
• file Form 941 quarterly and pay the taxes

22
Employment Taxes (continued)

• FICA (continued)
• Self-employed taxpayers
• Pay twice the amount of FICA as do employees
  (12.4 Social Security and 2.9 MHI)
• Are allowed an income tax deduction for one half
  the amount of FICA taxes actually paid
• In addition, are also allowed to reduce net
  earnings from self-employment by an amount equal
  to one-half the combined 15.3 tax rate (7.65)
  times earnings from self-employment in arriving
  at each of the self-employment tax bases (see
  page 1-18)
• Are required to pay quarterly estimated Federal
  taxes if estimates are 1,000 or more

23
Employment Taxes (continued)

• FUTA Taxes
• A Federal unemployment tax is imposed on
  employers who pay wages of 1500 or more a
  calendar year, or who employ at least one
  employee on each of some 20 days during the
  calendar year or previous year
• Current rate is 6.2 of first 7000 in wages paid
  during the year on each covered employee (that
  is, a maximum of 434 per employee)
• Since most states also impose an unemployment tax
  on employers, a credit is allowed for any similar
  taxes paid up to 5.4 (the maximum normally paid
  is 56)
• Form 940 must be filed on or before 1/31 of
  following year
• Most states require quarterly payments of
  unemployment taxes

24
Excise Taxes

• The purpose of an excise tax is to tax certain
  privileges as well as manufacture, sale, or
  consumption of specified commodities
• Major types include
• Occupational taxes some businesses pay a fee
  before engaging in business (ex. Liquor stores)
• Facilities services taxes person who uses
  services/facilities pays taxes, and institution/
  individual providing services/facilities collects
  taxes (ex. Air travel, hotels, phone service,
  etc.)

25
Excise Taxes (continued)

• Types of excise taxes (contd)
• Manufacturers taxes excise taxes on certain
  semi-luxurious or specialty manufactured goods to
  make collection easier (ex. Firearms, sporting
  goods)
• Retail sales of products and commodities taxes
  applies to retail sale of diesel fuel, special
  motor fuels, and fuel used in non-commercial
  aviation
• Many states also have excise taxes.

26
Additional Types of Taxes

• Franchise Tax tax on privilege of doing
  business
• Sales Tax imposed on retail sale of personal
  property and certain services
• Use Tax imposed on the use of property in a
  state where a sales tax was not paid
• Doing-Business Penalty imposed on businesses
  not authorized to do business in a state
• Real Property Tax placed on realty owned by
  non-exempt individuals or organizations
• Tangible Personal Property Tax tax on property
  not classified as realty (ex. office furniture,
  equipment, inventories, supplies, etc.)
• Intangible Personal Property tax imposed on
  stocks, bonds, A/R, notes receivable, etc.

27
Goals of Taxation

• Objectives
• Economic
• To provide resources to fund governmental
  expenditures
• Price stability
• Can be a major tool to attain satisfactory growth
  with full employment (i.e., to place more
  after-tax income in hands of taxpayers)
• Can be a major tool to stimulate investment
  spending (through ACRS)

28
Goals of Taxation (contd)

• Objectives (continued)
• Social
• Tax system is used to achieve social goals as
  well. Examples To
• Fund charities
• Encourage home ownership
• Fight unemployment problems among certain
  disadvantaged groups of citizens
• Relieve tax burdens for citizens over 65
• Encourage retirement savings

29
Five Qualities of a Good Tax

• A good tax satisfies the following conditions
• Is equitable or fair
• Is economically efficient
• Is certain and not arbitrary
• Can be administered by the government and
  complied with by the taxpayer at a low cost
• Is convenient (i.e., administration and
  compliance can be carried out with utmost
  simplicity)