chapter 1

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Chapter 1 Chapter 1

Introduction to Taxation, the Income

Tax Formula, and Form 1040EZ

“Taxes, after all, are dues that we pay for the privileges of membership in an organized

society.” -- Franklin D. Roosevelt

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IntroductionIntroduction

• An income tax was first enacted in 1861 and repealed after the Civil War ended

• An income tax law was passed in 1894 and was rejected by the Supreme Court in 1895.

• Sixteenth Amendment to the Constitution was passed in 1913– This is the basis of modern income tax law

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IntroductionIntroduction

• About 145.6 million individual income tax returns were filed in 2011– Almost 83% were filed electronically

• Individual income tax collections were about $1.04 trillion in 2011.

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LO #1 Progressive, proportional, and regressive tax structures


• Taxes are levied by multiplying a tax rate (the rate of tax) by a tax base (the amount taxed).– May be multiple rates on multiple bases

(see Table 1-2 for married taxpayers)

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• Progressive tax structure: – The tax rate increases as the tax base

increases.– Example is the U.S. income tax system

• Proportional tax structure: – The tax rate remains the same regardless

of the tax base.– Example is state or local sales taxes

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• Regressive tax structure: – The tax rate decreases as the tax base

increases.– Example is social security tax system

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LO # 2 Marginal and Average Tax Rates

LO # 2 Marginal and Average Tax Rates

• Average tax rate is the total tax paid on a certain amount of taxable incomeTotal tax / taxable income = average tax rate

• Marginal tax rates are the rate of tax that will be paid on the next dollar of income.– Determined with reference to tax rate

schedule– For example, a married couple will pay a

marginal rate of 15% on their $35,000th dollar of income.

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LO # 2 The Income Tax FormulaLO # 2 The Income Tax Formula

Income − Permitted Deductions from Income -------------------------------- = Taxable Income × Appropriate Tax Rates--------------------------------= Tax Liability− Tax Payments and Tax Credits---------------------------------= Tax Refund or Tax Due with Return

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LO #3 Components of Form 1040EZLO #3 Components of Form 1040EZ

• Taxpayers annually file a tax return using – Form 1040– Form 1040A– Form 1040EZ

• All follow the basic income tax formula• Form 1040EZ is the simplest form

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• To use a 1040EZ taxpayer must meet all the following:– Single or married filing jointly – Under age 65 and not blind– No dependents– Taxable income < $100,000– Income only from wages, unemployment

compensation or interest ≤ $1,500– Claim no credits except Earned Income

Credit

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• Wages include salaries, tips, commissions, bonuses, severance pay, sick pay, meals and lodging, fringe benefits, etc.– Employees receive a Form W-2 indicating

total wage income in box 1• Interest income is taxable unless

specifically exempt – Interest income reported on Form 1099-INT

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• Unemployment compensation is taxable– Reported on Form 1099-G

• Permitted deductions are shown on line 5– $10,000 for single, $20,000 for married

• Total income minus permitted deductions equals Taxable Income (line 6)

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LO #4 Calculation of TaxLO #4 Calculation of Tax

• For taxable income up to $100,000, use tax tables (printed in Appendix D)

• Tax rate schedules are used for higher income (printed on inside front cover)

• Tax tables calculate tax at the midpoint of the range on the table

• Tax rate schedules calculate tax precisely

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LO #3 Tax PaymentsLO #3 Tax Payments

• Tax liability is generally paid throughout the year through withholding tax payments deducted from wages– Also reported on W-2

• Low income taxpayers may be eligible for the Earned Income Credit– Discussed in chapter 9 with other credits

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LO #3 Tax PaymentsLO #3 Tax Payments

• A tax return is also used to “settle up” with the IRS at the end of the year.

• When filing a tax return, taxpayers will either – Owe the IRS (tax liability > payments)– Receive a refund (tax liability < payments)

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LO #5 Tax AuthorityLO #5 Tax Authority

• Tax authority is the body of law, regulation, and precedent that guide taxpayers, the IRS, and the courts in the proper application of tax law.

• Three types of primary tax authority:– Statutory sources– Administrative sources– Judicial sources

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• Statutory sources of tax authority– 16th amendment to the U.S. Constitution– Internal Revenue Code (IRC)

• Passed by Congress and signed into law by the president

– Committee reports from tax law process

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• Administrative sources of tax authority, in order of strength– Treasury Regulations (IRS Regulations)– Revenue Rulings– Revenue Procedures– Private Letter Rulings– IRS Notices

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• Judicial sources of tax authority– Courts resolve disputes between taxpayers

and the IRS.– Initial court of jurisdiction is either the

• Tax Court• U.S. District Court• U.S. Court of Federal Claims

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• Tax Court and District Court rulings can be appealed to the U.S. Court of Appeals and then to the Supreme Court

• U.S. Court of Federal Claims rulings can be appealed to the U.S. Court of Appeals – Federal Claims and then to the Supreme Court.

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LO #6 Circular 230LO #6 Circular 230

• Circular 230 sets forth rules which must be followed by all paid tax preparers– Includes CPA’s, attorneys, enrolled agents,

and any other individual who receives compensation for preparing a tax return, providing tax advice, or practicing before the IRS

• Circular 230 sets forth ethical standards and expectations.

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• Failure to comply with Circular 230 will subject the paid preparer to suspension or disbarment from IRS practice, public censure, fines, and civil or criminal penalty.

• Rules are far reaching and complex.

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• Paid tax preparers must obtain a preparer tax identification number (PTIN).– Must be renewed annually.

• Preparers who are not CPAs, attorneys, or enrolled agents must pass a competency exam and annually obtain continuing education.– CPAs, attorneys, and enrolled agents must

also obtain continuing education.

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• Paid preparers must:– Sign all tax returns they prepare– Provide a copy to clients– Return records to clients– Exercise due diligence and best practices– Disclose nonfrivolous tax positions– Notify clients of errors on a client return– Provide information to the IRS– Inform a client if the client made an error

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• Paid preparers must NOT:– Take a position unless it has a “realistic

possibility” of being sustained– Charge a contingent fee– Charge an unconscionable fee– Unreasonably delay matters with IRS– Cash an IRS check for a client– Represent a client if a conflict of interest

exists– Make false or fraudulent statements

chapter 1

Documents

rate of tax

tax rate structure

tax rate decreases

income tax formula

introductionan income

tax base increases

levels of tax base

total tax collections