ACTG-401 Principles of Federal Taxation – Individuals Chapter 4 Gross Income: Concepts and Inclusions LO.1 – Explain the differences between the economic, accounting, and tax concepts of gross income. LO.2 – Describe the taxable years and tax accounting methods generally available to taxpayers and other tax reporting entities. LO.3 – Identify the general sources of income and to whom they are taxable. LO.4 – Apply the tax rules on alimony, loans made at below-market interest rates, annuities, prizes and awards, unemployment compensation, Social Security benefits, and foreign bank accounts. LO.5 – Identify tax planning strategies for minimizing gross income and the present value of the related tax. Gross Income • Section 61(a) of the Internal Revenue Code defines the term gross income • Definition – Except as otherwise provided in this subtitle, gross income means all income from whatever source derived • Concept is interpreted broadly by the courts • Recovery of capital doctrine • Prevents income from being taxed more than once • Capital is the accumulation of previously taxed income • Supreme court has held that • Gross income is not synonymous with gross receipts • Rather, a taxpayer does not have income until recovering any amount of capital that might have been invested in the item sold • Economic and accounting concepts of income • Economists measure income as sum of • The value of goods and services consumed • Change in the value of net assets from the beginning to the end • Taxability of income follows the realization principle from accounting • Income is recognized (taxed) when realized • Mere appreciation in wealth (economic income) is not considered realized income • Income is recognized whether it is in the form of cash, or “in-kind” cash equivalents (that is, property or services) • The amount of income from “in-kind” receipts is equal to the FMV of the property or services • Taxable Year • The annual accounting period, or taxable year, is generally a 12-month period – Taxable year for most individual taxpayers is the calendar year – A fiscal year can be elected if taxpayer maintains adequate books and records • A fiscal year is a 12-month period ending on the last day of a month other than December 1 – Example: July 1 to June 30 • Income be recognized in the proper year for several reasons • Taxpayer’s rate may vary across years – Taxpayer’s marginal tax rate can change from year to year – Congress may change the tax rates – Change in the taxpayer’s status • Example: person may marry, or business may be incorporated Accounting Method • There are two primary methods of accounting for tax purposes: o Cash receipts and disbursements method o Accrual method • Other methods of accounting: o hybrid method – combination of cash and accrual method o Special accounting methods – example: installment method, percentage of completion method, completed contract method • Taxpayers can elect to use the installment method (a taxpayer may choose to spread the gain from an installment sale of eligible property) • Certain contractors may elect to use either the percentage of completion method or the completed contract method • Change in the accounting method requires the advance consent of the IRS Cash Receipts Method • Income is recognized in the year it is actually or constructively received in cash or cash equivalent • An amount is constructively received when it is set aside and made available to taxpayer without substantial restrictions • Example – Constructive receipt – An employer issued a bonus check to an employee on December 31 st but asked her to hold it for a few days until the company could make deposits to cover the check. • The income was not constructively received on December 31 since the issuer did not have sufficient funds in its account to pay the debt. Exceptions to Cash Receipts Method • Original issue discount (O I D) interest is taxable when earned rather than when interest is received • OID rules do not apply to obligations with a maturity date of one year or less from the date of issue • Series E and EE bonds are not subject to the O I D rules o However, a cash basis taxpayer may elect to recognize the interest when earned Accrual Method • Income is recognized in the year that it is earned regardless of when it is collected 2 • Income is earned when: o All events have occurred that fix taxpayer’s right to receive income and o The amount can be determined with reasonable accuracy • The accrual method is required for determining purchases and sales when inventory is an income-producing factor • If rights to income have accrued but are subject to refund, the income is reported in the year of sale and deduction is allowed in the year when actual claims accrue • Claim of right doctrine o If the payment is received before the dispute is settled, this right requires the taxpayer to recognize the income in the year of receipt o The taxpayer has the funds to pay tax. Therefore, the government should be allowed to collect tax rather than wait until the uncertainty is resolved Exceptions to the Accrual Method • Taxpayer can elect to defer recognition of income from advance payment for goods and services if same method of accounting is used for tax and financial reporting purposes • This special method will result in differences in the timing of the reporting of revenue when financial reporting rules requires it to be reported over 3 or more years • The special election is not available for unearned rent, interest, insurance premiums, and certain other advance payments which are taxed in the year of receipt Hybrid Method • A combination of cash and accrual methods • Generally, used when inventory is a material income-producing factor • For example: o Use accrual method to account for sale of goods and cost of goods sold o Use cash method for other income and expenses • Beginning in 2018, more types of businesses can use the cash method and not account for inventory o The hybrid method is not likely to be commonly used Income Sources • Income from personal services is taxable to the person who performs the services o Fruit and tree metaphor o Services performed by an employee for an employer’s customers are considered performed by the employer o Employer is taxed on the income from the services provided to the customer, and the employee is taxed on any compensation received from the employer • Income from property is taxable to the owner of the property o Assignment of income is not permitted • Interest income accrues daily 3 o If interest bearing instrument (for example, bonds) is transferred, interest income must be allocated between transferor and transferee based on the number of days during the period that each owned the property Dividends • Unlike interest, dividends do not accrue on a daily basis • Dividends are generally taxed to the party who is entitled to receive them o The shareholder of record as of the corporation’s record date • Dividends on stock transferred by gift after declaration date but before record date are generally taxed to the donor • Recent legislation has provided partial relief from double taxation of corporate dividends o Generally, dividends received are taxed at the same marginal rate that is applicable to a net capital gain • Depending on the individual’s taxable income, capital gain tax rates of 0%, 15%, and 20% apply • The following dividends are not eligible for the reduced tax rates o Dividends received by corporations • Corporations are permitted a dividend received deduction ranging from 50%-100% of dividend received from another domestic corporation o Dividends that do not satisfy the holding period requirement • Stock on which the dividend is paid must have been held for more than 60 days during the 121-day period beginning 60 days before the ex-dividend date to qualify for the reduced tax rates Income Received by an Agent • Income received by the taxpayer’s agent is considered to be received by the taxpayer – A cash basis principal must recognize the income at the time it is received by the agent Income from Partnerships • A partnership is not a separate taxable entity – Files an information return (Form 1065) • Provides data necessary for determining each partner’s distributive share of partnership’s income and deductions • Each partner reports distributive share of partnership income and deductions – Reported in year earned, even if not actually distributed • Because a partner pays tax on income as the partnership earns it, distributions are treated under the recovery of capital rules Income from S Corporations • A small business corporation may elect to be taxed similarly to a partnership – Referred to as an S corporation • The shareholders, rather than the corporation, pay the tax on the corporation’s income 4 • Generally, shareholders report their share of the corp’s income and deductions for the year, even if not actually distributed Income from Estates & Trusts • Beneficiaries of estates and trusts – Generally, taxed on the income earned by the estates or trusts that is actually distributed or required to be distributed to them – Any income not taxed to the beneficiaries is taxable to the estate or trust Income in Community Property States • All property is deemed either to be separately owned by one spouse or to belong to the marital community o Community income is allocable equally to each spouse o Separate income are allocable to owner-spouse in few states • Separate property may produce community income (example – Idaho, Texas) • Income from personal services is generally treated as if one-half is earned by each spouse • A spouse is taxed only on his or her actual earnings from personal services • Conditions to be satisfied: o The spouse lived apart for the entire year o They do not file a joint return with each other o No portion of the earned income is transferred between the individuals Alimony and Separate Maintenance Payments Alimony and separate maintenance payments made under an agreement entered into before December 31, 2018, are: – Deductible by payor – Includible in gross income of recipient – For payments related to pre-2019 agreements, income is shifted from the income earner to the income beneficiary – Has a legal right to the income and is better able to pay the tax on the amount received Payments may qualify as alimony if: – Payments are in cash – Agreement or decree does not specify that the payments are not alimony – Payor and payee are not members of the same household at the time the payments are made – There is no liability to make the payments for any period after the death of the payee • Property settlements – Transfer of property to former spouse – No deduction or recognized gain or loss for transferor – No gross income and carryover of transferor’s basis for transferee – Front-loading of alimony payments • Alimony recapture (gross income) for payor 5 • Deduction from gross income for recipient • Child support payments – Payments made to satisfy legal obligation to support the child of taxpayer – Nondeductible by payor and not taxed to recipient (or child) • May be difficult to determine whether an amount received is alimony or child support – If amount of payment would be reduced due to some future event related to the child (for example, child reaches age 21), such reduction is deemed child support Imputed Interest on Below-Market Loans • Interest is imputed, using Federal government rates, when a loan does not carry a market rate of interest o Imputed interest = the difference between the amount that would have been charged at the Federal rate and the amount actually charged • Applies to: ▪ Gift loans ▪ Compensation-related loans ▪ Corporation-shareholder loans The table below presents the effect of certain below-market loans on the lender and borrower • Gift loans o Exemption for loans of $10,000 or less between individuals ▪ If loan proceeds are used to purchase income-producing property, the exemption does not apply ▪ On loans of $100,000 or less between individuals o Imputed interest is limited to borrower’s net investment for year o No imputed interest if net investment income is $1,000 or less o This limitation for loans of $100,000 or less does not apply if a principal purpose of a loan is tax avoidance Imputed Interest on Below-Market Loans • $10,000 exemption also applies to compensation-related and corporation-shareholder loans o No exemption if principal purpose of loan is tax avoidance 6 ▪ Makes practically all loans of this type suspect • Interest expense imputed to borrower may be deductible Income from Annuities • Purchaser pays fixed amount for the right to receive a future stream of payments o Generally, early collections over the cost of the contract is included in gross income o Increase in the cash value of the contract is not immediately taxable as it is subject to substantial restrictions – For collections on and after the annuity starting date: – The exclusion ratio is applied to annuity payments received under contract to determine amount excludable – • Once investment is recovered, remaining payments are taxable in full • If the annuitant dies before recovering the investment, the unrecovered cost is deductible in the year the payments cease • Examples: • Taxpayer pays $10,000 for annuity that will pay $1,000 a year • A: For a term of 15 years • B: For lifetime (life expectancy = 15 years) – A: 15 years of annuity payments – Years 1-15: $333 taxable and $667 excludable – B: Lifetime payments and taxpayer lives 18 years • Years 1-15: $333 taxable and $667 excludable • Years 16-18: $1,000 taxable each year – B: Lifetime payments and taxpayer lives 10 years • Years 1-10: $333 taxable and $667 excludable, and $4,444 deduction on final return • The simplified method is required for allocating basis to the annuity payments received from a qualified retirement plan o Exclusion amount is employee’s investment in contract divided by number of anticipated monthly payments 7 Prizes and Awards • Gross income – F M V of any prizes and awards (other than exempted scholarships) • Exceptions: o The prize or award is received in recognition of religious, charitable, scientific, educational, artistic, literary, or civic achievement (e.g., Nobel Prize, Pulitzer Prize) o The recipient transfers the prize or award to a qualified governmental unit or nonprofit organization o The recipient was selected without any action on his or her part to enter the contest or proceeding o The recipient is not required to render substantial future services as a condition for receiving the prize • Exclusion of employment achievement awards made in the form of tangible personal property but not cash or cash equivalents o Award must be made in recognition of an employee’s length of service or safety achievement o The ceiling on the excludable amount for an employee is $400 per year o The ceiling on the excludable amount for an employee is $1,600 per year if the award is made as a part of tax qualified plan Group Term Life Insurance • Exclude premiums paid by employer on first $50,000 of coverage o Premiums on excess coverage are included in gross income ▪ Inclusion amount based on I R S provided tables • If plan discriminates in favor of key employees (example: Officers), key employees are not eligible for exclusion o In such a case, the key employees must include in gross income the greater of: ▪ The actual premiums paid by the employer ▪ The amount calculated from the Uniform Premiums table Unemployment Compensation • Unemployment compensation is taxable in full • It is sponsored and operated by the states and Federal government • It is to provide a source of income for people who have been employed and are temporarily out of work Social Security Benefits • Benefits included are based on 2 factors: o Taxpayer’s ability to pay o The amount of benefits considered to be a recovery of the taxpayer’s contributions, or a recovery capital • Up to 85% of benefits may be taxable • Taxability based on taxpayer’s modified adjusted gross income (M A G I) 8 o M A G I = A G I (excluding Social Security) + foreign earned income exclusion + tax exempt income • If M A G I plus 50% social security benefits (provisional income) does not exceed a threshold amount ($32,000 for married filing jointly or $25,000 for single taxpayers), the taxpayer need not include any social security benefits in gross income • If provisional income exceeds the threshold o The amount included in gross income is equal to 50% of the amount by which the provisional income exceeds the threshold, limited to 50% of the benefits themselves o If the taxpayer’s provisional income also exceeds a second threshold ($44,000 or $34,000), the amount included in gross income is equal to 85% of the amount that provisional income exceeds the higher threshold, plus the smaller of: • Amount determined in point 1, above, or • 50% of the difference between the 2 threshold amounts ($6,000 for married filing jointly or $4,500 for a single taxpayer) • The threshold amounts for married taxpayers filing separately is zero • Examples of Social Security income: o A: Married with A G I = $30,000; tax exempt interest income = $3,000; Social Security benefits = $10,000 • Portion of Social Security benefit to be included in gross income = 50% of ($30,000 + $3,000 + $5,000 – $32,000) i.e. $3,000 limited to 50% of $10,000 i.e. $5,000 = $3,000 o B: Married with A G I = $40,000; tax exempt interest income = $6,000; Social Security benefits = $10,000 • Portion of Social Security benefit to be included in gross income = 50% of ($40,000 + $6,000 + $5,000 – $32,000) i.e. $9,500 limited to 50% of $10,000 i.e. $5,000 = $3,000 FBAR • FinCEN Form 114, Report of Foreign Bank and Financial Accounts (F B A R) o Must be filed with Treasury Department if aggregate balance of all foreign bank, brokerage, and similar financial accounts exceeds $10,000 at any time during the year o Filed electronically o Filed separately from Form 10 40 ▪ Schedule B of Form 10 40 includes questions about foreign accounts o Due by April 15 with automatic extension to October 15 o Large penalty for non-filing – as much as 50 percent of the value of the foreign accounts 9 ACTG 401 Principles of Federal Taxation – Individuals Chapter 2: Working with the Tax Law LO.1- Distinguish between the statutory, administrative, and judicial sources of the tax law and understand the purpose of each source. LO.2 – Locate and work with the appropriate tax law sources. LO.3 – Develop an awareness of tax research tools. LO.4 – Describe the tax research process. LO.5 – Communicate the results of the tax research process in a client letter and a tax file memorandum. LO.6 – Apply tax research techniques and planning procedures. LO.7 – Be aware of taxation on the CPA examination Statutory Sources of Tax Law • Constitution (Article I, Sections 7, 8, and 10) • Tax treaties o Agreements between countries to mitigate the double taxation of taxpayers subject to the tax laws of those countries • Internal Revenue Code o Codification of the Federal tax law provisions in a logical sequence and placed them in a separate part of the Federal statutes o We have had three “codifications”: ▪ 19 39, 19 54, and 19 86 • Example of Code Citation: § 2(a)(1)(A) – § = Abbreviation for “Section” – 2 = section number – (a) = subsection – (1) = paragraph designation – (A) = subparagraph designation Legislative Process For Tax Bills 1 Administrative Sources of Tax Law • Treasury Department Regulations • Revenue Rulings • Revenue Procedures, and • Other administrative pronouncements 2 *Through 2008, the contents of Internal Revenue Bulletins were consolidated semiannually into a Cumulative Bulletin. Beginning in 2009, the I R S decided to stop producing a Cumulative Bulletin as all Internal Revenue Bulletins are available electronically on the I R S website **Thomson Reuters Checkpoint includes a wide variety of tax resources. The most significant are materials produced by the Research Institute of America (R I A), including the Federal Tax Coordinator 2d Regulations – Issued by U.S. Treasury Department – Provide general interpretations and guidance in applying the Code – Issued in – Proposed – Preview of final regulations – Do not have force and effect of law – Temporary – Issued when guidance needed quickly – Same authoritative value as final regulations and may be cited as precedents – Final – Issued as Treasury Decisions (T Ds) – Force and effect of law – Example of Regulation citation: – Reg. § 1.2 – Refers to Regulations under Code § 2 – Subparts may be added for further identification – The numbering patterns of these subparts often have no correlation with the Code subsections 3 – – – – Example of Proposed Regulation citation: Prop. Reg. § 1.2 Example of Temporary Regulation citation: Temp. Reg. § 1.956–2T(d)(2) Regulations also may be classified as Example of Proposed Regulation citation: – Legislative – Interpretive – Procedural Revenue Rulings • Revenue rulings o Official pronouncements of the National Office of the IRS ▪ Provide one or more examples of how the IRS would apply a law to specific fact situations ▪ Published weekly in the Internal Revenue Bulletin (I.R.B.) by the U.S. ▪ Provide guidance to IRS personnel and taxpayers in handling routine tax matters • Example of Revenue Ruling citation o Rev. Rul. 2019–13, 2019–20 I.R.B. 1179 ▪ Explanation: Revenue Ruling Number 13, appearing on page 1179 of the 20th weekly issue of the Internal Revenue Bulletin for 2019 Revenue Procedures o Deal with the internal management practices and procedures of the IRS ▪ Published weekly in the Internal Revenue Bulletin (I.R.B.) by the U.S. Government ▪ Provide guidance to IRS personnel and taxpayers in handling routine tax matters • Example of Revenue Procedure citation o Rev. Proc. 2020–1 (2020–1 I.R.B. 1) Letter Ruling • Offer guidance to taxpayer on how a transaction will be taxed before proceeding with it o Issued for a fee upon a taxpayer’s request by the National office of the I R S o Describe how the I R S will treat a proposed transaction for tax purposes • Apply only to the taxpayer who asks for and obtains the ruling o Post-1984 letter rulings may be substantial authority for purposes of the accuracyrelated penalty • Limited to restricted, preannounced areas of taxation • Example of Letter Ruling citation o Ltr.Rul. 201933005 o 5th ruling issued during the 33rd week of 2019 Other Administrative Announcements 4 • • • • • • Treasury Decisions (TDs) – Issued by the Treasury Department to: Announce new regulations Amend or change existing regulations Announce the position of the Government on selected court decisions TDs are published in the Internal Revenue Bulletin Determination Letters – Issued by an IRS Area Director at taxpayer’s request – Provide guidance on the application of the tax law – Usually involve completed transactions – Not published • Made known only to the party making the request Other Administrative Pronouncements • A variety of internal memoranda that constitute the working law of the IRS also are released but not officially published, such as o General Counsel Memoranda (GCMs) o Technical Advice Memoranda (TAMs) o Internal Legal Memoranda (ILMs) o Field Service Advice Memoranda (FSAs) • The IRS indicates that they may not be cited as precedents by taxpayers o However, these working documents do explain the IRS’s position on various issues. • Technical advice memoranda (TAMs) o resembles letter rulings that give the IRS’s determination of an issue o deal with completed (rather than proposed) transactions o is issued by the national office of the IRS o purpose is to expedite legal guidance to field agents Federal Judicial Systems 5 Judicial Sources • There are five federal courts that have jurisdiction over tax disputes between the IRS and taxpayers: o The U.S. Tax Court o The U.S. District Court o The U.S. Court of Federal Claims o The U.S. Court of Appeals o The U.S. Supreme Court • There are three courts of original jurisdiction (trial courts) o U.S. Tax Court ▪ Small Cases Division – only hears cases involving amounts of $50,000 or less o U.S. District Court o U.S. Court of Federal Claims • Important terms to understand o The plaintiff is the party requesting a hearing o The defendant is the party being challenged o Sometimes court uses the terms petitioner and respondent (rather than plaintiff and defendant) • Difference between various trial courts are by: o Number of courts 6 o o o o o o o o o Number of judges Location Jurisdiction of the Tax Court and District Courts Jurisdiction of the Court of Federal Claims Jury trial Payment of deficiency Appeals Bankruptcy Gray areas Issue U.S. Tax Court U.S. District Court Number of judges per court 19* Varies Payment of deficiency before trial No Yes Jury trial available No Yes Types of disputes Tax cases only Most criminal and civil issues Jurisdiction Nationwide Location of taxpayer I R S acquiescence policy Yes Yes Appeal route U.S. Court of Appeals U.S. Court of Appeals *Currently, there are only 15 regular judges. They are assisted by 11 senior judges (whose terms have ended, but return to hear cases as needed) and 4 special trial judges (who are appointed by the Senior Judge of the U.S. Tax Court, rather than by the President) (January 2020) • Appellate Courts o Trial court decision can be appealed to the appropriate Circuit Court of Appeals o A three-judge panel hears a Court of Appeals case, but occasionally the full court The Appellate Process • The role of the appellate court is limited to a review of whether the trial court applied the proper law in arriving at its decision 7 • Appeals from District Court or Tax Court go to the U.S. Court of Appeals for circuit where taxpayer resides • Appeals from Court of Federal Claims go to Court of Appeals for the Federal Circuit • Appeal to the Supreme Court is by Writ of Certiorari o Only granted for those cases the Supreme Court wants to hear; only a few every year Judicial Citations – The U.S. Tax Court Issues two types of decisions: Regular and Memorandum o Regular decisions involve novel issues not previously resolved by the tax court • Regular decisions are published by U.S. government, for example: • Summary opinions o Issued in small tax cases and may not be used as precedent in any other case • Tax Court Memorandum decisions o Memorandum decisions deal with cases that involve only the application of already established principles of law o Memorandum decisions are available on the U.S. tax court website • Memorandum decisions are published by both CCH and RIA o Consider, for example, the three different ways the Nick R. Hughes case can be cited: • Nick R. Hughes, T.C.Memo. 2009–94 • The 94th Memorandum decision issued by the Tax Court in 2009 • Nick R. Hughes, 97 T C M 1488 • Page 1488 of Vol. 97 of the C C H Tax Court Memorandum Decisions • Nick R. Hughes, 2009 R I A T.C.Memo. ¶2009,094 • Paragraph 2009,094 of the R I A T.C. Memorandum Decisions Judicial Citations – The U.S. District Court, Court of Federal Claims, and Court of Appeals • District Court, Court of Federal Claims, Court of Appeals, and Supreme Court decisions dealing with Federal tax matters are reported in both the CCH U.S. Tax cases (USTC) and the RIA American Federal Tax Reports (AFTR) series • U.S. District Court decisions, dealing with both tax and nontax issues, also are publishedby West in its Federal Supplement Second Series • Examples of District Court case citations • Turner v. U.S., 2004–1 USTC ¶60,478 (D.Ct. Tex., 2004) (CCH citation) 8 • Turner v. U.S., 93 AFTR 2d 2004–686 (D.Ct. Tex., 2004) (RIA citation) • Turner v. U.S., 306 F.Supp.2d 668 (D.Ct. Tex., 2004) (West citation) • • Examples of citations of Court of Federal Claims • Tax Treaties • The U.S. signs tax treaties with foreign countries to: o Avoid double taxation • When there is a direct conflict between the code and a treaty, the most recent item will take precedence Working with the Tax Law – Tax Research Tools • Tax law consist of a body of o Legislative (e.g., code sections and tax treaties) o Administrative (e.g., regulations and rulings) o Judicial (e.g., court cases) • Working with the tax law requires being able to locate and use these sources effectively • Unless the problem is simple (for example, the Code Section is known and there is a Regulation on point), the research process begins with a tax service • The research process begins with tax service • Commercial tax services • Electronic tax (online) services • Noncommercial electronic tax (online) services • Commercial tax services • Here is a partial list of the available commercial tax services: • Standard Federal Tax Reporter, Commerce Clearing House • CCH IntelliConnect, Commerce Clearing House online service • United States Tax Reporter, Research Institute of America, Thomson Reuters • Thomson Reuters Checkpoint, Research Institute of America • Practical Tax Expert, CCH/Wolters Kluwer • Tax Management Portfolios, Bloomberg BNA • Mertens Law of Federal Income Taxation, Thomson Reuters • Westlaw and WestlawNext, Thomson Reuters 9 • Tax Center, LexisNexis Electronic (online) tax services • Competent tax professional must become familiar and proficient with electronic research services • Certain general procedures • Carefully choose keywords for the research • Take advantage of connectors • Be selective in choosing the data to search • Use a table of contents, an index, or a citation when appropriate • Noncommercial electronic (online) tax services • Internet provides a wealth of tax information in many popular forms • Websites are provided by accounting and consulting firms etc., • Blogs and RSS sites provide a means by which information related to the tax law can be exchanged among taxpayers, tax professionals etc., • Tax Research Process 10 Working with Tax Law-Tax Research • Tax research is the process of finding a competent and professional conclusion to a tax problem • Tax research involves: o Identifying and refining the problem o Locating the appropriate tax law sources o Assessing the validity of the tax law sources o Arriving at the solution or at alternative solutions with due consideration given to nontax factors o Effectively communicating the solution to the taxpayer o Updating the solution (where appropriate) in light of new developments Assessing the Validity of Tax Law Sources • Treasury Regulations 11 • • • • • • o IRS agents must give the Code and the Regulations equal weight when dealing with taxpayers and their representatives o Proposed Regulations are not binding on IRS or taxpayer o Burden of proof is on taxpayer to show that a Regulation is incorrect o If the taxpayer loses the challenge, a 20% negligence penalty may be imposed Final Regulations tend to be of three types o Procedural – “Housekeeping-type” instructions o Interpretive – Rephrase or elaborate what is in Committee Reports and the Code • Hard to get overturned o Legislative – Allow the Treasury Department to determine the details of law • Congress has delegated its legislative powers and these cannot generally be overturned Revenue Rulings o Carry less weight than Treasury Department Regulations o Not substantial authority in court disputes Judicial sources o Consider the level of the court and the legal residence of the taxpayer o Tax Court Regular decisions carry more weight than Memorandum decisions • Tax Court does not consider Memorandum decisions to be binding precedents • Tax Court reviewed decisions carry even more weight o Circuit Court decisions where certiorari has been requested and denied by the U.S. Supreme Court carry more weight than a Circuit Court decision that was not appealed o Consider whether the decision has been overturned on appeal Primary sources of tax law include: o The Constitution o Legislative history materials o Statutes (for example, the Internal Revenue Code) o Treaties o Treasury Regulations o IRS pronouncements o Judicial decisions o In general, the IRS considers only primary sources to constitute substantial authority Secondary Sources include: o Legal periodicals o Treatises o Legal opinions o IRS publications o Other materials In general, secondary sources are not authority 12 Working with the Tax Law – Tax Planning • The primary purpose of effective tax planning is to maximize the taxpayer’s after-tax wealth o Must consider the legitimate business goals of taxpayer • A secondary objective of effective tax planning is to reduce, defer, or eliminate the tax • Tax avoidance versus tax evasion o Tax avoidance is the legal minimization of tax liabilities and one goal of tax planning o Tax evasion is the illegal minimization of tax liabilities • Suggests the use of subterfuge and fraud as a means to tax minimization • Can lead to fines and jail • This objective aims to accomplish: • Eliminating the tax entirely • Eliminating the tax in the current year • Deferring the receipt of income • Converting ordinary income into capital gains • Converting active income into passive active income • Converting passive activity expense to active expense • Increasing the number of taxpayers • Eluding double taxation • Avoiding ordinary income • Creating, increasing or accelerating deductions • Taxation on the C P A Examination • CPA exam test in the familiar four sections – Auditing and Attestations (AUD), Business Environment and Concepts (BEC), Financial Accounting and Reporting (FAR), and Regulation (REG) • Total testing time is 16 hours (4 hours per section) • Taxation is included in the 4-hour Regulation section • Knowledge is tested using both multiple-choice questions and task-based simulations 13 Chapter 1: An Introduction to Taxation and Understanding the Federal Tax Law LO.1 – Explain the importance of taxation and apply methods for studying this topic. LO.2 – Describe some of the history and trends of the Federal income tax. LO.3 – Describe and apply principles and terminology relevant to the design of a tax system. LO.4 – Identify the different taxes imposed in the United States at the Federal, state, and local levels. LO.5 – Explain the administration of the tax law, including the audit process utilized by the IRS. LO.6 – Evaluate some of the ethical guidelines involved in tax practice. LO.7 – Classify tax rules based on their possible economic, social, equity, and political reasons for inclusion in a particular tax system. LO.8 – Explain the role played by the IRS and the courts in the evolution of the Federal tax system. Approaching Study of Taxation • What is taxation? – Meaning from two famous quotes: • “Taxes are what we pay for civilized society.” • “Nothing is certain, except death and taxes.” – Taxes produce revenue for government operations. – Can also be used to modify behavior. – Affect many aspects of our lives – income, spending, savings, asset transfers at death, and more. – Can also be used to influence the behavior of individuals and businesses Tax Relevance to Accounting and Finance Professionals • Key tax functions – Compliance – Planning – Key tax functions – Financial reporting – Controversy – Cash management 1 – Data analysis – How to Study Taxation – Goal—Recognize issues or transactions that have tax implications – Find the outcome through research – Focus on understanding the rules – When applicable – Why designed in a particular way – When relevant – For business tax rules—How do they compare to financial reporting treatment. – Tax Relevance to Individuals Use this diagram to consider situations where taxes relevant to individuals and how. History of Taxation • Prior to 1900s income tax financed wars – 1861: First Federal individual income tax enacted » Repealed after Civil War – 1894: New Federal individual income tax enacted » Tax found to be unconstitutional 2 • Other important events – 1909: First Federal corporate income tax enacted – 1913: 16th Amendment ratified » Sanctioned both Federal individual and corporate income taxes Federal Budget Receipts 2019 Tax Revenue Sources Percentage Individual income taxes 51% Corporate income taxes 8 Payroll taxes 36 Excise taxes 3 Custom duties 1 Estate and gift taxes Total 1 100% • Legal foundation o U.S. Constitution ▪ Article I, Section 8—Gives taxing power to Congress ▪ Sixteenth Amendment—Allows for an income tax Criteria Used in the Selection of a Tax Structure • Adam Smith identified the following canons of taxation which are still considered when evaluating tax structures: – Equality – Convenience – Certainty – Economy 3 • AICPA Guiding Principles of Good Tax Policy • Equity and Fairness • Certainty • Convenience of Payment • Effective Tax Administration • Information Security • Simplicity • Neutrality • Economic Growth and Efficiency • Transparency and Visibility • Minimum Tax Gap • Accountability to Taxpayers • Appropriate Government Revenues • Tax Structure • Legal foundation – Constitution of the taxing jurisdiction – Example – US Constitution • Article I, Section 8 – gives taxing power to Congress • 16th Amendment – allows for an income tax • Tax base: amount to which the tax rate is applied • e.g., For the Federal income tax, the tax base is taxable income • Tax rates: applied to the tax base to determine the tax liability – May be proportional or progressive • Incidence of tax: degree to which the tax burden is shared by taxpayers A I C P A Guiding Principles of Good Tax Policy a) b) c) d) e) f) g) h) i) Equity and Fairness Certainty Convenience of Payment Effective Tax Administration Information Security Simplicity Neutrality Economic Growth and Efficiency Transparency and Visibility 4 j) Minimum Tax Gap k) Accountability to Taxpayers l) Appropriate Government Revenues Major Types of Taxes • • • • • • • • Property Taxes Transaction Taxes Death Taxes Gift Taxes Income Taxes Employment Taxes Other U.S. Taxes Proposed U.S. taxes Property (ad valorem) Taxes • Based on the value of the asset – Essentially, a tax on wealth, or capital • Generally on realty or personalty • Exclusive jurisdiction of states and their local political subdivisions • Deductible for Federal income tax purposes Transaction Taxes • • • • Federal excise taxes State and local excise taxes General sales taxes Severance taxes Federal Excise Taxes • • o o ▪ Imposed at the Federal level Restricted to specific items Examples: tobacco products, fuel and gasoline sales, air travel Other Federal taxes include: Manufacturer’s excise tax on trucks, trailers, tires, firearms, sporting equipment, and coal and gas guzzler tax on automobiles ▪ Alcohol taxes 5 ▪ Miscellaneous taxes (e.g., tax on wagering, tax on investment income of certain private colleges and universities) State and Local Excise • • o o ▪ ▪ o Imposed at the state and local levels Restricted to specific items Examples: tobacco products, gasoline sales, liquor Two types of excise taxes at the local level have recently become increasingly popular Hotel occupancy tax Rental car surcharge Tax is levied on visitors who cannot vote and often used to fund special projects that generate civic pride General Sales Taxes • Currently jurisdiction of states and localities • States that impose sales taxes also charge a use tax on items bought in other states but used in their jurisdiction • States without sales or use taxes are Alaska, Delaware, Montana, New Hampshire, and Oregon Severance Taxes • Tax on natural resources extracted o Important revenue source for states rich in natural resources – Example: oil, gas, iron ore, or coal etc. • • • • • Taxes on Transfers at Death • Tax on the right to transfer property or to receive property upon the death of the owner – If imposed on right to pass property at death • Classified as an estate tax – If imposed on right to receive property from a decedent • Classified as an inheritance tax The value of the property transferred provides the base for determining the amount of the death tax The Federal government imposes only an estate tax Some state governments levy inheritance taxes, estate taxes, or both Some state governments levy neither tax (for example, Florida and Texas) 6 Federal Estate Tax • – – • • – • Federal estate tax is on the right to pass property to heirs – Gross estate includes FMV of property decedent owned at time of death • Also includes property interests, such as life insurance proceeds paid to the estate or to a beneficiary other than the estate if the deceased-insured had any ownership rights in the policy Property included in the gross estate is valued on either: Date of death, or If elected, the alternate valuation date Generally 6 months after date of death Certain deductions and credits allowed in arriving at the taxable estate Examples—Marital deduction, funeral and administration expenses, certain taxes, debts of the decedent, casualty losses incurred during the administration of the estate, and transfers to charitable organizations • Marital deduction is available for amounts actually passing to a surviving spouse (a widow or widower) Unified Transfer Tax Credit • Unified transfer tax credit reduces or eliminates the estate tax liability for certain estates • For 2020, the credits exempt tax base up to $11,580,000 State Taxes on Transfers at Death • o o ▪ State taxes on transfers at death may be estate tax, inheritance tax, or both Inheritance tax is on the right to receive property from a decedent Tax is generally based on the relationship of the heir to the decedent The more closely related, the lower the rates imposed and/or the greater the exemption allowed Federal Gift Tax • Tax on the property transfers during the person’s life and not at death • Taxable gift = F M V of the gift less annual exclusion per donee less marital deduction (if applicable) 7 • In 2020, each donor is allowed an annual exclusion of $15,000 for each donee (the same as in 2019) • Married couple can make a special election to split gifts o Allows one-half of the gift made by the donor-spouse to a third party to be treated as being made by the non-donor-spouse (gift splitting) o Effectively allows the annual exclusion to double o The unified transfer tax credit is available for gifts (as well as the estate tax) o The credit for 20 20 is $4,577,800 o Covers taxable gifts up to $11,580,000 o The credit for 20 19 is $4,505,800 o Covers taxable gifts up to $11,400,000 o There is only one unified transfer tax credit o It applies to both taxable gifts and the Federal estate tax o Once the unified transfer tax credit has been used up for Federal gift tax purposes, any transfers at death will be subject to Federal estate tax Income Taxes • Imposed at the Federal, most state, and some local levels of government – Income taxes generally are imposed on individuals, corporations, and certain fiduciaries (estates and trusts) • Federal income tax base is taxable income (income less allowable exclusions and deductions) • Most jurisdictions attempt to assure tax collection by requiring pay-as-you-go procedures, including – Withholding requirements for employees, and – Estimated tax prepayments for all taxpayers Formula for Federal Income Tax on Individuals 8 *Exemption deductions are not allowed from 2018 through 2025 **Only applies from 2018 through 2025 Tie above to the 1040 in appendix B (what amounts above tie to what lines of the 1040) Corporate Income Tax (will be covered in greater detail in Chapter 17 next semester) Corporate Taxable Income = Income – Deductions o Uses a flat tax rate of 21 percent – Does not require the computation of adjusted gross income – Does not provide for the standard deduction or personal and dependency exemptions All allowable deductions are business expenses State Income Tax • All but the following states impose an income tax on individuals: – Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming – New Hampshire and Tennessee impose an individual income tax only on interest and dividends 9 Some characteristics of state income taxes include: With few exceptions, all states require some form of withholding procedures – Most states use as the tax base the income determination made for Federal income tax purposes • Some states apply a flat rate to Federal AGI • Some states apply a rate to the Federal income tax liability – Referred to as the piggyback approach to state income taxation – Some characteristics of state income taxes are: – Some states ‘‘decouple’’ from selected Federal tax legislation enacted by Congress – State may not be able to afford the loss of revenue resulting from such legislation – Because of tie-ins to the Federal return, states may be notified of changes made by the IRS upon audit of a Federal return (or vice versa) – Most states allow a deduction for personal and dependency exemptions – Some characteristics of state income taxes are: – Many state income tax returns provide checkoff boxes for donations to various cause – The objective of most states is to tax the income of residents and those who conduct business in the state – Most states allow their residents some form of credit for income taxes paid to other states – Some characteristics of state income taxes are: – The due date for filing generally is the same as for Federal income tax (usually April 15 for calendar year taxpayers) – Some states have occasionally instituted amnesty programs that allow taxpayers to pay back taxes (and interest) on unreported income with no (or reduced) penalty – In some states, state income tax returns include a separate line for reporting any use tax that is due Local Income Taxes • Cities imposing an income tax include Baltimore, Cincinnati, Cleveland, Detroit, Kansas City (Missouri), New York, Philadelphia, and St. Louis o The application of a city income tax is not limited to local residents Employment Taxes – Imposed on employers and employees – FICA taxes – Two components – The Social Security rate is 6.2% in 20 20 on a maximum of $137,700 of wages ($ 132,900 for 2019) – The Medicare rate is 1.45% on all wages – A spouse employed by another spouse is subject to FICA 10 – Children under the age of 18 who are employed in parent’s unincorporated trade or business are exempt from FICA – FICA taxes – The Affordable Care Act imposes an additional 0.9% tax on earned income above $200,000 (single filers) or $250,000 (married filing jointly) – An employer does not have to match the employees’ 0.9% – A 3.8% tax is imposed on net investment income (example – rents, taxable interest, dividends, and capital gains) – Applies when modified AGI exceeds $200,000 (single filers) or $250,000 (married filing jointly) – • Self-employment tax – Sole proprietors and independent contractors may also be subject to Social Security taxes • Rates are twice that applies to an employee • Generally, 12.4% for Social Security and 2.9% for Medicare • The social security tax is imposed on net self-employment income up to a base amount of $137,700 for 20 20 and $ 132,900 for 20 19 • The additional 0.9% Medicare tax also covers situations involving high net income from self-employment • FUTA (unemployment) taxes – Provide funds for state to administer unemployment benefits – In 20 20, rate is 6% on first $7,000 of wages paid to each employee – Administered jointly by Federal and state government • Credit is allowed (up to 5.4%) for F U T A paid to the state • Thus, the amount required to be paid to the Federal government could be as low as 0.6% (6.0% − 5.4%) – Tax is paid by employer • Few states, however, levy a special tax on employees to provide either disability benefits or supplement unemployment compensation or both Other Taxes • Federal customs duties o Tariffs on certain imported goods • Franchise taxes o Levied on corporation for the right to do business in the state • Occupational fees o Applicable to various trades or businesses • Example: liquor store license, taxicab permit, fee to practice a profession such as law, medicine or accounting Proposed Taxes • Flat tax o Is a form of consumption tax 11 o Flat 19% tax on all businesses (corporate or otherwise) o Flat 19% tax on wages and pension benefits above an exemption of $25,500 • National sales tax (Fair tax) o Levied on the final sale of goods and services (at approximately 23%) ▪ Provides monthly rebate to offset a portion of sales tax paid by individuals Value added tax ▪ Imposed on the value added by each party in a production cycle ▪ The system of credit results in VAT ultimately only being paid by the final consumer ▪ Most countries use this (in addition to income tax) ▪ Carbon tax ▪ Aims to help reduce carbon emissions (i.e., greenhouse gases) • Financial transaction tax o Can take many forms o Could be imposed on the value of financial instruments purchased (e.g., stocks and bonds) o Could be imposed on the value of bank assets Tax Administration • Internal Revenue Service (IRS) o Part of the Department of the Treasury and is responsible for enforcing the Federal tax laws o The Commissioner of Internal Revenue is appointed by the President with the advice and consent of the Senate o The Commissioner is responsible for establishing policy and supervising the activities of the IRS • The Audit Process o Only a small number of returns are audited each year using mathematical formulas and statistical sampling ▪ To update selection criteria, the I R S selects a cross section of returns, which are subject to various degrees of inspection o I R S pays rewards to persons who provide information leading to discovery of those who violate tax laws ▪ The rewards may not exceed 30% of taxes, fines, and penalties recovered • Types of audits: o Correspondence audit o Office audit ▪ Usually restricted in scope and conducted in I R S offices o Field audit ▪ Involves examination of numerous items reported on the return and is conducted at the taxpayer’s location or that of the taxpayer’s representative 12 • At the end of an audit, a Revenue Agent’s Report (R A R) is issued summarizing the findings that can result in a: o Refund (tax was overpaid) o Deficiency (tax was underpaid), or o No change (tax was correct) finding • During the course, if a special agent accompanies the regular auditor: o The I R S suspects fraud o The taxpayer should retain competent legal counsel • If an audit results in an assessment of additional tax o Taxpayer may request an appeal ▪ An appeal is available through the Appeals Division of the I R S • Appeals Division is authorized to settle all disputes based on the hazards of litigation (i.e., probability of favorable resolution, if litigated) o If a satisfactory settlement is not reached on administrative appeal, the taxpayer can litigate in: ▪ Tax Court ▪ Federal District Court, or ▪ Court of Federal Claims o Litigation is recommended only as a last resort because of: ▪ Legal costs involved ▪ Uncertainty of the final outcome Statute of Limitations • Statute of limitations is a provision that requires any lawsuit to be brought within a reasonable period of time o Found at the state and Federal levels, such statutes cover the multitude of both civil and criminal suits • For Federal income tax purposes, the two categories involved are: o The assessment of additional tax deficiencies by the I R S and o Claims for refunds by taxpayers • For a deficiency assessment by I R S o Generally 3 years from the later of the due date or the filing date of the return o For material (more than 25%) omissions of gross income, time period is 6 years o No statute if no return is filed or fraudulent return is filed • For a refund claim by taxpayer o Generally 3 years from date return was filed or 2 years from date tax was paid, whichever is later • Income tax returns filed early are deemed to have been filed on the date the return was due Interest and Penalties 13 • Interest accrues on the taxes due starting from the due date of the return, and interest is paid on refunds if not received within 45 days of when the return was filed o Rate for January 1 to March 31 of 2020 is 5% o I R S publishes rate quarterly • Tax law provides various penalties for lack of compliance including penalties for: o Failure to file a tax return by the due date • Penalty is 5% per month up to a max of 25% on the amount of tax shown as due on the return • Any fraction of a month counts as a full month o Failure to pay the tax • Penalty is 0.5% per month up to a max of 25% o Negligence penalty (up to 20%) may also apply to underpayment for disregard of rules without intend to defraud • Interest accrues on the taxes due starting from the due date of the return, and interest is paid on refunds if not received within 45 days of when the return was filed o Rate for January 1 to March 31 of 2020 is 5% o I R S publishes rate quarterly Tax Practice • Area of tax practice is largely unregulated – Members of professions must follow certain ethical standards (CPAs, Attorneys) – Various penalties may be imposed upon preparers of Federal tax returns who violate proscribed acts and procedures • Ethical guidelines issued by American Institute of C P As (A I C P A) – Do not take questionable positions on client’s tax return in hope of it not being audited by I R S – Client’s estimates may be used if reasonable under the circumstances – Try to answer every question on the tax return (even if disadvantageous to client) – Upon discovery of an error in prior year tax return, advise client to correct it • Do not inform the I R S of the error • Statutory penalties may be levied on tax return preparers for: – Procedural matters including failure to: • Provide copy of return to taxpayer • Endorsing a taxpayer’s refund check • Sign the return as a preparer • Furnish identification number • Keep copies of returns • Maintain a client list • Statutory penalties may be levied on tax return preparers for: – Understatement of tax liability based on a position that lacks substantial authority – Willful attempts to understate tax – Failure to exercise due diligence in determining eligibility for, or the amount of, the earned income tax credit, the child tax, or the American opportunity tax credit 14 Understanding the Federal Tax Law • The Federal tax law is the vehicle for accomplishing many objectives of the nation such as: – Raising revenue: the major objective of the tax system but not the sole objective – Economic: increasingly important objective is to regulate the economy and encourage certain behavior and businesses considered desirable • Federal tax objectives – Social: encourage socially desirable behavior that provides benefits that government might otherwise provide – Equity: equity within the tax laws (e.g., wherewithal to pay concept) and not necessarily equity across taxpayers • Federal tax objectives – Political considerations – a large segment of the tax law is created through a political process; thus, compromises and special interest dealings occur – Influence of I R S – many provisions are meant to aid the I R S in the collection of taxes – Influence of courts – influence tax law and sometimes cause it to change 15
