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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


The McGraw-Hill Companies, Inc. 2008

An income tax was first enacted in 1861 and repealed after the Civil War ended An an income tax law was passed in 1894 and was rejected by the Supreme Court in 1895.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

Over 132 million individual income tax returns are filed annually
Over 50% are filed electronically

Individual income tax collections exceed $830 billion.


LO #1 Understand 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)


LO #1 Understand progressive, proportional, and regressive tax structures

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


LO #1 Understand progressive, proportional, and regressive tax structures Regressive tax structure:
the tax rate decreases as the tax base increases. Example is social security tax system


LO # 2 Marginal and Average Tax Rates Average tax rates is the total tax paid for a certain amount of taxable income
Total 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 tables For example, a married couple will pay a marginal rate of 15% on their $35,000th dollar.


LO # 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


LO #3 Components of Form 1040EZ

Taxpayers annually file a tax return using either
Form 1040 Form 1040A Form 1040EZ

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


LO #3 Components of Form 1040EZ

To use a 1040EZ taxpayer must meet all:
Single or married Under age 65 and not blind No dependents Taxable income < $100,000 Income only from wages, unemployment compensation or interest less than $1,500 Claim no credits except EIC


LO #3 Components of Form 1040EZ

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 1099INT

LO #3 Components of Form 1040EZ

Unemployment compensation is taxable
Reported on Form 1099-G

Permitted deductions are shown on line 5

$8,750 for single, $17,500 for married

Total income minus permitted deductions equal Taxable Income (line 6)


LO #4 Calculation of Tax
For taxable income up to $100,000, use tax tables (printed in the back of the book) Tax rate schedules used for higher income Tax tables calculate tax at the midpoint of the range on the table Tax rate schedules calculated precisely

LO #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


LO #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)


LO #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


LO #5 Tax Authority
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


LO #5 Tax Authority
Administrative sources of tax authority, in order of strength
Treasury Regulations (IRS Regulations) Revenue Rulings Revenue Procedures Private Letter Rulings IRS Notice


LO #5 Tax Authority
Judicial sources of tax authority
Courts resolve disputes between taxpayers and IRS. Initial court of jurisdiction is either
Tax Court U.S. District Court U.S. Court of Federal Claims


LO #5 Tax Authority
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 and then to the Supreme Court.