Federal Income Taxation

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Tax

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A payment required by a government that is unrelated to any specific benefit or service received from the government

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Sin taxes

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Taxes imposed on the purchase of goods (ie alcohol and tobacco) that are considered socially less desirable

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Earmarked tax

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A tax assessed for a specific purpose (ie education)

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To qualify as a tax, 3 criteria must be met. The payment must be:

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-required

-imposed by the government

-and not tied directly to the benefit received by the taxpayer

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Tax =

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Tax base × tax rate

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Tax base

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The item that is being taxed (ie purchase price of a good, taxable income, etc)

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Tax rate

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The level of taxes imposed on the tax base, usually expressed as a %

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Flat tax

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A tax in which a single tax rate is applied throughout the tax base

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Graduated taxes

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Taxes in which the tax base is divided into a series of monetary amounts, or brackets, where each successive bracket is taxed at a different (gradually higher or lower) % rate

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Bracket

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A subset (or portion) of the tax base subject to a specific tax rate. Brackets are common to graduated taxes.

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Marginal tax rate

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The tax rate that applies to the next additional increment of a taxpayer's taxable income (or to deductions).

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Marginal tax rate =

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🔺️ tax / 🔺️ taxable income

(New total tax - old total tax) / (New taxable income - old taxable income)

Where old refers to the current tax and new refers to the revised tax after incorporating the additional income in question

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Average tax rate

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A taxpayer's average level of taxation on each dollar of taxable income.

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Average tax rate =

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Total tax / taxable income

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Effective tax rate

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The taxpayer's average rate of taxation on each dollar of total income (taxable and nontaxable income)

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Effective tax rate =

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Total tax / total income

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Proportional tax rate structure

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Aka flat tax

This tax rate structure imposes a constant tax rate throughout the tax base. As the tax base increases, the taxes paid increase proportionally.

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Proportional tax rate =

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Tax base × tax rate

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Progressive tax rate structure

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A tax rate structure that imposes an increasing marginal tax rate as the base increases. As the tax base increases, both the marginal tax rate and the taxes paid increase.

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Regressive tax rate structure

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A tax rate that imposes a decreasing marginal tax rate as the tax base increases. As the tax base increases, the taxes paid increase, but the marginal tax rate decreases.

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Income tax

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A tax in which the tax base is income. Income taxes are imposed by the federal government and by most states.

The most significant tax assessed by the US govt.

Represents approx. 60% of all tax revenues collected in the US

Levied on individuals, corporations, estates, and trusts

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Employment and unemployment taxes

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-Second largest group of taxes imposed by the US govt

-Employment taxes consist of the social security tax and the Medicare tax

-unemployment taxes fund temporary unemployment benefits for individuals terminated from their jobs without cause

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Excise taxes

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-Third largest group of taxes imposed by US govt

-Levied on the quantity of products sold

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Transfer taxes

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Levied on the fair market values of wealth transfers upon death or by gift

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Excise taxes definition

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Taxes levied on the retail sale of particular products. They differ from other taxes in that the tax base for an excise tax typically depends on the quantity purchased rather than a monetary amount

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Excise taxes definition

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Taxes levied on the retail sale of particular products. They differ from other taxes in that the tax base for an excise tax typically depends on the quantity purchased rather than a monetary amount

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Sales and use taxes

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-The tax base for a sales tax is the retail sales of goods and some services.

-The tax base for the use tax is the retail price of goods owned, possessed, or consumed within a state that were not purchased within the state.

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Explicit taxes

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Taxes directly imposed by a government

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Implicit taxes

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Indirect taxes that result from a tax advantage the government grants to certain transactions to satisfy social, economic, or other objectives. They are defined as the reduced before-tax return that a tax-favored asset produces because of its tax advantaged status.

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Sufficiency

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A standard for evaluating a good tax system. Sufficiency is defined as assessing the aggregate size of the tax revenues that must be generated and ensuring that the tax system provides these revenues.

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Static forecasting

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The process of forecasting tax revenues based on the existing state of transactions while ignoring how taxpayers may alter their activities in response to a tax law change

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Dynamic forecasting

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The process of forecasting tax revenues that incorporates into the forecast how taxpayers may alter their activities in response to a tax law change

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Income effect

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One of the two basic responses that a taxpayer may have when taxes increase. The income effect predicts that when taxpayers are taxed more they will work harder to generate the same after-tax dollars.

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Substitution effect

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One of the two basic responses that a taxpayer may have when taxes increase. The substitution effect predicts that, when taxpayers are taxed more, rather than work more, they will substitute nontaxable activities (ie leisure pursuits) for taxable ones because the marginal value of taxable activities has decreased.

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Equity

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A tax system is considered fair or equitable if the tax is based on the taxpayer's ability to pay; taxpayers with a greater ability to pay tax, pay more tax.

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Horizontal equity

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Is achieved if taxpayers in similar situations pay the same tax

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Vertical equity

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Is achieved when taxpayers with greater ability to pay tax, pay more tax relative to taxpayers with a lesser ability to pay tax

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Certainty

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Taxpayers should be able to determine when, where, and how much tax to pay

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Convenience

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Means a tax system should be designed to facilitate the collection of tax revenues without undue hardship on the taxpayer or the government

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Economy

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Means a tax system should minimize its compliance and administration costs

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Assignment of income doctrine

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Requires income to be taxed to the taxpayer who actually earns it

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Conversion strategy

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Based on the understanding that the tax law does not treat all types of income or deductions the same.

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After-Tax return =

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Before-tax return × (1- marginal tax rate)

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Before-tax rate of return

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A taxpayer's rare if return on an investment before paying taxes on the income from the investment

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After tax rate of return on any investment =

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(FV/I)^(1/n)-1

I =investment

N = #of investment periods

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Business purpose doctrine

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Allows the IRS to challenge and disallow business expenses for transactions with no underlying business motivation

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Step-transaction doctrine

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Allows the IRS to collapse a series of related transactions into one transaction to determine the tax consequences of the transaction

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Substance-over-form doctrine

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Allows the IRS to consider the transaction's substance regardless of its form, and where appropriate, to reclassify the transaction according to its substance

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Economic substance doctrine

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Requires transactions to meet two criteria to obtain tax benefits. 1. A transaction must meaningfully change a taxpayer's economic position (excluding any federal income tax effects). 2. The taxpayer must have a substantial purpose (other than tax avoidance) for the transaction

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Tax avoidance

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The legal act of arranging one's transactions or affairs to reduce taxes paid

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Tax evasion

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The willful attempt to defraud the government

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Taxpayer filing requirements

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IRC Sec. 6012

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Tax professional responsibilities

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6694

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Tax professional responsibilities

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6694

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Taxpayer and tax practitioner penalties LO 7

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IRC Sec 6662

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Transactions between family members and limitations

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IRC Sec. 267

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Limitations to timing strategies

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IRC Sec 267

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After tax =

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Pretax - PV savings

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3 basic tax planning strategies

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Timing

Income shifting

Conversion

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Timing

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Deferring or accelerating taxable income and tax deductions

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Income shifting

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Shifting income from high to low tax rate taxpayers

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Conversion

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Converting income from high to low tax rate activities

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Present value =

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Future value/(1+r)^n

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When considering cash inflows, prefer ______ present values; when considering cash outflows, prefer ______ Present values

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Higher

Lower

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Tax deductions

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Accelerate tax deductions into earlier years (deduct in earlier period)

Maximizes the present value of tax savings from deductions. Ie tax savings received now have a higher PV than the same amount received a year from now.

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Taxable income

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Defer taxable income into later tax years (recognize in later period)

Minimizes the PV of taxes paid. Ie taxes paid a year from now have a lower PV than taxes paid today

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Tax deductions

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Requires calculation to determine optimal strategy

The taxpayer must calculate whether the benefit of accelerating deductions outweighs the disadvantage of recognizing deductions in a lower tax rate year

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Taxable income

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Requires calculation to determine optimal strategy

The taxpayer must calculate whether the benefit of differing income outweighs the disadvantage of recognizing income in a higher tax rate year

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Constructive receipt doctrine

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The judicial doctrine that provides that a taxpayer must recognize income when it is actually or constructively received. Constructive receipt is deemed to have occurred if the income has been credited to the taxpayer's account or if the income is unconditionally available to the taxpayer, the taxpayer is aware of the incomes availability and there are no restrictions on the taxpayer's control over the income.