Chapter

Chapter 1: An Introduction to TaxationPrentice Halls Federal Taxation 2016: Individuals

Copyright 2016 Pearson Education, Inc. 1History of U.S. Taxation Early PeriodsGovernment relied on customs duties and excise taxes until 1913.Briefly had an income tax in 1861-65 to fund the Civil War.Sixteenth Amendment was passed in 1913 to make federal taxation of individuals constitutional.Copyright 2016 Pearson Education, Inc. 1-2History of U.S. Taxation CurrentTax laws were codified into Internal Revenue Code of 1939, 1954, and 1986.1939 less than 6% of US citizens taxed.1974 more than 74% taxed.Tax revenues are used to fund government operations.Copyright 2016 Pearson Education, Inc. 1-3Revenue SourcesCopyright 2016 Pearson Education, Inc. 1-4Types of Tax Rate StructuresCopyright 2016 Pearson Education, Inc. 1-5Types of Tax Rate Structures (contd)Copyright 2016 Pearson Education, Inc. 1-6Determination of Taxable Income and Tax DueTotal incomeMinus: ExclusionsGross IncomeMinus: DeductionsExemptionsTaxable IncomeTimes: Tax RateIncome Tax Before CreditsMinus: Tax CreditsTotal Tax LiabilityMinus:PrepaymentsBalance Due or Refunds

Copyright 2016 Pearson Education, Inc. 1-7Other Types of TaxesCopyright 2016 Pearson Education, Inc. 1-8Criteria for a Tax StructureCopyright 2016 Pearson Education, Inc. 1-9Objectives of the Federal Income Tax LawCopyright 2016 Pearson Education, Inc. 1-10Entities in Federal Tax SystemCopyright 2016 Pearson Education, Inc. 1-11Taxpaying Entities IndividualsCopyright 2016 Pearson Education, Inc. 1-12Tax Calculation for IndividualsCopyright 2016 Pearson Education, Inc. 1-13Components of Gross IncomeCopyright 2016 Pearson Education, Inc. 1-14For vs. From AGICopyright 2016 Pearson Education, Inc. AGI = THE LINE1-15Taxpaying Entities CorporationsAccounts for only 10% of US tax revenues.C Corporations cause double taxation on same income.First level of tax on C Corporation taxable income.Second level of tax imposed when dividends are distributed to shareholders, and taxed at the shareholder level.Copyright 2016 Pearson Education, Inc. 1-16Taxpaying Entities Corporations (contd) First level of tax may be mitigated by paying shareholder-employees salaries and bonuses. Can be subject to IRS attack.Second level of tax may be mitigated with DRD (corporate s/h) or reduced rate for dividends received (individual s/h).Copyright 2016 Pearson Education, Inc. 1-17Tax Calculation for CorporationsCopyright 2016 Pearson Education, Inc. 1-18Taxpaying Entities Flow-throughsCopyright 2016 Pearson Education, Inc. 1-19Taxpaying Entities Flow-throughs (contd)Flow-through entities are not taxed on an entity level. Income is allocated to shareholder/partner/member and taxed on that level. To prevent double taxation of same income, TPs basis in entity must be maintained.Copyright 2016 Pearson Education, Inc. 1-20Calculating Basis in Flow-through EntityCopyright 2016 Pearson Education, Inc. 1-21Taxpaying Entities PartnershipsPartnership = two or more parties that carry on a business.Partners can be individuals, corporations, trusts, or estates.Partnerships need to file an annual return (Form 1065).Entity income and deductions flow through to the partners (Form K-1). Net income is not taxed at the partnership level, only at the partner level.Copyright 2016 Pearson Education, Inc. 1-22PARTNERSHIP ENTITYForming a Partnership

PARTNERAPARTNERBPROPERTY50%PARTNERSHIPINTEREST$50%PARTNERSHIPINTERESTCopyright 2016 Pearson Education, Inc. 1-23Taxpaying Entities S CorporationsS Corporation = corporation that is treated as a flow-through entity.S Corporations can only have limited number of shareholders, and there are limits to the allocation of income and losses.S Corp reports income and deductions on Form 1120S. Allocation of income and deductions reported to shareholders on Form K-1.

Copyright 2016 Pearson Education, Inc. 1-24Taxpaying Entities S Corporations (contd)Shareholders basis in S Corporation stock is calculated similar to partnership interests.Flow-through nature of income/deductions and basis calculations ensure the single layer of taxation.Copyright 2016 Pearson Education, Inc. 1-25Taxpaying Entities LLCsLLC can be treated like a partnership for tax purposes but offers liability protection of a corporation.LLC owners (members) elect whether LLC is to be taxed as a partnership or a corporation.Partnership treatment is usually selected since there will only be one layer of tax on the income.Copyright 2016 Pearson Education, Inc. 1-26Taxpaying Entities LLCs (contd)LLCs that elect partnership treatment file Form 1065.If elect tax treatment as a corporation, then it must file Form 1120.Single member LLCs are disregarded for tax purposes. Income/deductions flow through to individuals Schedule C.Copyright 2016 Pearson Education, Inc. 1-27Taxpaying Entities LLPsLLP is similar to LLC except partners are not liable for bad acts of the other partners.Copyright 2016 Pearson Education, Inc. 1-28Taxpaying Entities TrustsCan be taxed either on an entity level or as a flow-through.Generally, trusts are taxed on income NOT distributed to beneficiaries.Files on Form 1041.Trust marginal tax rates go to the highest levels far more quickly than on an individual level.Copyright 2016 Pearson Education, Inc. 1-29Tax Law SourcesCopyright 2016 Pearson Education, Inc. 1-30TAX BILLHOUSE WAYS & MEANS COMMITTEE HOLDS HEARINGS WITH PUBLIC, TREASURY SECRETARY, & IRS COMMISSIONER. APPROVEDBILL DIESLegislative Process REJECTEDDEBATED BY HOUSE

REJECTEDCopyright 2016 Pearson Education, Inc. 1-31Legislative Process (contd) APPROVEDSenate Finance Committee Holds HearingsBILL DIESREJECTEDDEBATED BY SENATEAPPROVEDAPPROVEDDIFFERENCES BETWEEN HOUSE AND SENATE VERSIONS RESOLVED BY THE CONFERENCE COMMITTEEREJECTEDREJECTEDCopyright 2016 Pearson Education, Inc. 1-32Legislative Process (contd)RECONCILED REVSION SENT TO THE HOUSE AND SENATEAPPROVEDPRESIDENTBILL DIESREJECTEDAPPROVEDBILL BECOMES LAWSIGNEDVOTED ON BY HOUSE AND SENATEVETOSDOES NOT RECEIVE 2/3 VOTEDOES RECEIVE2/3 VOTECopyright 2016 Pearson Education, Inc. 1-33Organization of the IRSCopyright 2016 Pearson Education, Inc. 1-34AuditsCorrespondence or Letter audits Automated letter is sent to taxpayer if reporting documents (e.g., 1099s, W-2s) do not match up with tax return. IRS requests money or explanation from taxpayer.1% of tax returns are selected for audit based on DIF score.

Copyright 2016 Pearson Education, Inc. 1-35Audits (contd)In-person audits Taxpayers will work with IRS agents either at IRS office or at taxpayers place of business.Statute of Limitations Absent fraud, IRS can audit return for the later of 3 years from the date the return was filed or the due date.Longer SOL if fraud or understatement of more than 25% gross income.Copyright 2016 Pearson Education, Inc. 1-36PenaltiesCopyright 2016 Pearson Education, Inc. 1-37Interest and PenaltiesInterest and penalties are assessed on tax liabilities that were not timely paid.Failure to File penalty 5% per month up to a maximum of 25%.Failure to Pay penalty of 1% per month up to 25% of unpaid liability.Interest accrues on unpaid liability AND the penalties.Copyright 2016 Pearson Education, Inc. 1-3838Interest and Penalties (contd)20% accuracy-related penalty.75% penalty for fraud.Taxpayer can appeal to the IRS if the field or office audit results in an unsatisfactory conclusion.Copyright 2016 Pearson Education, Inc. 1-39Components of Tax PracticeCopyright 2016 Pearson Education, Inc. 1-40