(Solution Manual) Concepts in Federal Taxation 2022

Murphy, Higgins, Skalberg, 29

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Author(s): Murphy, Higgins, Skalberg

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CHAPTER 1 FEDERAL INCOME TAXATION - AN OVERVIEW 1-1 © 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or i n part. 2022 Edition Topic Status Questions 1 Adam Smith's system requirements Unchanged 2 How well income tax and employment taxes meet Adam Smith's requirements Unchanged 3 Proportional, regressive, or proportional tax Unchanged 4 Proportional, regressive, or proportional tax Unchanged 5 Federal income tax as a revenue producer Unchanged 6 Collection of income taxes Unchanged 7 Sales tax versus excise tax Unchanged 8 Collection of sales and excise taxes Unchanged 9 Real property versus personal property taxes Unchanged 10 Gift tax Unchanged 11 Estate tax Unchanged 12 Valuation of gift and estate assets Unchanged 13 Payment of gift and estate taxes Unchanged 14 Primary sources of tax law Unchanged 15 Supreme Court cases Unchanged 16 Federal income tax base Unchanged 17 Exclusion Unchanged 18 Deferral versus exclusion Unchanged 19 Gross income versus income Unchanged 20 Deductibility of expenses Unchanged 21 Expense versus loss Unchanged 1-2 © 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 2022 Edition Topic Status 22 Transaction loss versus annual loss Unchanged 23 Legislative grace concept Unchanged 24 Inflation effects on taxes Unchanged 25 Pay-as-you-go collection of taxes Unchanged 26 Tax credits Unchanged 27 Tax credit versus deduction Unchanged 28 Tax credit versus deduction Unchanged 29 Statute of limitations Unchanged 30 Auditing returns Unchanged 31 IRS examinations Unchanged 32 30-day letters Unchanged 33 90-day letters Unchanged 34 Individual versus corporate taxable income Unchanged 35 Deductions for and from AGI Unchanged 36 Standard deduction Unchanged 37 Why study taxes? Unchanged 38 Goal of tax planning Unchanged 39 Tax planning -who benefits Unchanged Problems 40 What is a tax? Unchanged 41 Definition of a tax - five scenarios Unchanged 42 Calculation of tax and tax rates (marginal, average, effective) Unchanged 43 Calculation of tax - comparing entities Unchanged 1-3 © 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publ icly accessible website, in whole or in part. 2022 Edition Topic Status 44 Social Security calculation/tax rate (marginal, average, effective) Unchanged 45 Progressive, proportional, regressive taxes Unchanged 46-CT Progressive, proportional, regressive taxes Unchanged 47 Social Security tax calculation Unchanged 48 Social Security tax calculation Unchanged 49 Social Security tax calculation/payment by employer Unchanged 50 Self-employment tax calculation Unchanged 51 Social security/self -employment tax Unchanged 52 Classification of income items Unchanged 53 Classification of income items Unchanged 54 What is deductible? Unchanged 55 Classification of deduction items Unchanged 56 Calculation of taxable income/tax liability Unchanged 57 Calculation of taxable income/tax liability Unchanged 58-COMM Effect of deduction FOR/FROM adjusted gross income Unchanged 59-COMM Tax planning Unchanged 60 Gift versus Income Unchanged 61-CT Tax planning Date updates only 62 Tax planning Date updates only 63 Tax planning Date updates only 64-CT Tax planning - income splitting Unchanged 1-4 © 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 2022 Edition Topic Status 65 Evasion versus avoidance Date updates only 66 Evasion versus avoidance Date updates only 67-IID Prepaid taxes Date updates only 68-IID Student loan interest Unchanged 69-IID Gift versus sale of stock Unchanged 70-IID Income splitting Unchanged 71 INTERNET Unchanged 72 INTERNET Unchanged 73 Research Problem Unchanged 74 Research Problem Unchanged 75 Spreadsheet Problem Unchanged 76-DC-CT Value -added Tax Unchanged 77-DC-CT How inflation adjustments preserve after tax income Date updates only 78-TPC- COMM Actions an owner can take to reduce taxes Unchanged 79-EDC -CT Statements on Standards for Tax Services (SSTS) to situations in problem 67 Unchanged 1-5 © 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. CHAPTER 1 FEDERAL INCOME TAXATION - AN OVERVIEW DISCUSSION QUESTIONS 1. Briefly state Adam Smith's four requirements for a good tax system. a. Equality - A tax should be imposed based on the taxpayer's ability to pay. b. Certainty - The taxpayer should be able to determine the amount of tax and how to make the required payment. c. Convenience - The tax should be levied as close as possible to the time the taxpayer receives the amount subject to tax. d. Economy - The cost of taxpayer compliance and administering the tax system should be small in relation to the revenue generated. 2. Based on the discussion in the chapter, evaluate how well each of these taxes meets Adam Smith's four requirements: a. Income tax Adam Smith's four criteria for evaluating a tax are Equality, Certainty, Convenience, and Economy. The aspects of the income tax that promote each of the individual criteria are: Equality - Progressive tax rates; the use of a standard deduc tion and exemption amounts have the effect of exempting low -income taxpayers from the tax; indexing of tax rates, and standard deduction and exemption amounts that are adjusted for inflation. Certainty - The use of an annual accounting period and the con sistent use of the same tax return due date. Convenience - The use of a pay as you go system of collecting taxes is more convenient than collecting all taxes at one date. Taxpayers determine their own tax due in privacy. Economy - The cost of running the IRS is a small percentage of the total tax collected. 1-6 Chapter 1: Federal Income Taxation - An Overview © 2022 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Factors in the tax system that dilute Adam Smith's requirements: Equality - Income exclusions and special deductions allow taxpayers with high incomes to pay taxes equivalent to those with lower incomes. The use of tax planning by higher income taxpayers also negates some of the equality of the system. Certainty - The complexity of many of the tax law provisions and numerous changes in the tax law from year to year make an accurate calculation of tax liability less certain. Convenience - Some would contend that determining the amount of tax to be withheld is difficult for many peo ple, making the pay as you go system less convenient. Economy - There are significant costs of record -keeping and compliance that are borne by the taxpayers, making the tax less economical. b. Employment taxes The aspects of employment taxes that pro mote compliance with each of the four requirements: Certainty - The taxe s are due as income is earned. Since total income to be earned by the employee is unknown during the year, the total tax will only be known once the year is complete. Convenience - Taxes are collected by employers and paid by the employer to the government. Economy - No annual reporting is required by the individual; however, the employer must incur the reporting costs. Costs of compliance are minimal. Aspects tha t dilute the requirements: Equality - The tax is not progressive; the tax consumes more of low-income taxpayer's income than a higher income taxpayer's income. Economy - The cost of reporting is proportionately higher for smaller businesses. Chapter 1: Federal Income Taxation - An Overview 1-7 © 2022 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 3. Based solely on the definitions in the chapter, is the Social Security tax a proportional, regressive, or progressive tax? Explain, and state how the tax might be viewed differently. Strictly speaking, the Social Security tax is a proportional tax because it is applied at a constant rate (6.20 % up to $1 42,800 and 1.45% on all wages and salaries) to all levels of the tax base. Using the tax base, salaries and wages, the marginal cost is always equal to the average cost, which is indicative of a proportional tax. When viewed as a percentage of the taxpayer's total income, the Social Security tax is a regressive tax. That is, if you compare marginal and average tax rates for taxpayers whose income is greater than the OASDI base amount, the marginal tax rate is 1.45% and the average tax rate decreases as income increases. Thus, higher income taxpayers (those whose income exceeds the base amount subject to tax) pay lower marginal and average rates of tax than those whose income does not exceed the base. 1-8 Chapter 1: Federal Income Taxation - An Overview © 2022 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 4. Based solely on the definitions in the chapter, is the sales tax a proportional, regressive, or progressive tax? Explain and state how the tax might be viewed differently. Strictly speaking, the sales tax is a proportional tax because it is applied at a constant rate to all levels of the ta x base. Using the tax base, goods and services purchased, the marginal tax rate is always equal to the average tax rate, which is indicative of a proportional tax. When another base is used to calculate marginal and average tax rates, the tax appears to be regressive. For example, if total economic income is used as the base, lower income taxpayers will spend a higher percentage of their income on items subject to the sales tax when compared to higher income taxpayers. Thus, the marginal tax rate will b e less than the average tax rate, which is indicative of a regressive tax. 5. As stated in the text, the federal income tax is the largest revenue -producing tax in use in the United States. Why do you think the income tax produces more revenue than any other tax? There are two main reasons why the income tax is the largest revenue producer. They evolve around the calculation of a tax as the TAX BASE x TAX RATE. First, the tax rates are generally higher than other most other taxes (10% to 37% versus say, a 7% sales tax). Second, the tax base, taxable income, is larger than most other bases. For example, most individuals ’ taxable income is greater than the amount they would spend on items subject to a sales or excise tax. Those taxes with higher rate schedules than the income tax (gift tax, estate tax) have relatively small tax bases. That is, not very many gifts and/or estates are subject to the tax in a given year. 6. How are federal, state, and local income taxes collected by the government? Con sider the cases of an employee and a self -employed taxpayer. Employers are required to withhold income taxes on the wages and salaries of their employees. Employers are then responsible for depositing the taxes withheld to the appropriate governmental u nit. Self -employed taxpayers are required to estimate their taxes and make quarterly payments to the appropriate governmental unit. 7. How is a sales tax different from an excise tax? Both are taxes on goods and/or services purchased. A sales tax is a percentage of the value of the sales price of the goods or services. It is paid when the goods and/or services are sold. An excise tax is based on either a quantity or volume of the product being sold, such as a gallon of gasoline or per tire. Althoug h it is technically paid when the goods are sold, the excise tax is generally included in the sales price and is typically not shown separately as a tax. 8. Who is responsible for collecting sales and excise taxes? Who actually pays the tax? Chapter 1: Federal Income Taxation - An Overview 1-9 © 2022 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. The sel ler of the goods and/or services subject to sales and excise taxes are responsible for the collection and payment of the tax. Sales taxes are paid directly by the purchaser as an addition to the sales price of the goods and/or services. The purchaser als o pays excise taxes, but they generally are included in the price of the goods and, thus, are not shown as a separate payment by the buyer. 9. Why is a tax on real property used more often than a tax on personal property? A tax on real property is more commonly used because real property is not mobile and is difficult to conceal. Thus, the tax base is more certain, and the collection of the tax is easier. Personal property is mobile and easily concealed. Thus, it is more difficult to ascertain the value of personal property owned, making the tax base uncertain and the collection of the tax potentially difficult. 10. The gift tax is supposed to tax the transfer of wealth from one taxpayer to another. However, the payment of gift tax on a transfer of property is relatively rare. Why is gift tax not paid on most gifts? Gift tax payments are rare due to the exclusions from the tax. The basic exclusion is $1 5,000 per donee per year. This would allow a married couple to make tax -free gifts of up to $ 30,000 per donee per year. Gifts in excess of the annual exclusion can be tax -free if the donor elects to use part of the unified gift and estate tax credit. Under this credit, the equivalent of $11,700,000 of property transfe rs may be excluded from gift taxes. 11. The estate tax is a tax on the value of property transferred at death. Why is payment of the estate tax not a common event? Although many people die every year, most pay little or no estate tax. This is due to tw o factors: the unlimited marital deduction for property passing to a spouse and the unified gift and estate tax credit. The marital deduction exempts from estate tax any property passing to the decedent's spouse. The unified gift and estate tax credit al lows up to $11,700,000 ( 2021 ) of tax -free property transfers. Because the majority of people do not have estates exceeding the $11,700,000 tax-free limit, their estates are not taxed. Proper tax planning for larger estates should result in paying no tax on the death of the first spouse through use of the marital deduction. 12. What is the basis for valuing assets transferred by gift and at death? Gift and estate taxes are based on the fair market value of the property at the date of the gift or at the date of death of the taxpayer. 13. Who is responsible for reporting and paying gift taxes? Estate taxes? Gift taxes are assessed on the donor of the gift. It is the donor's obligation to properly report and pay taxes on gifts. Estate taxes ar e reported and paid by the executor of the estate. The person receiving the property has no obligation to pay either gift or estate taxes. 1-10 Chapter 1: Federal Income Taxation - An Overview © 2022 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 14. Identify three primary sources of tax law. 1. Legislative - The Internal Revenue Code of 1986. 2. Administrative - The income tax regulations and other IRS documents. 3. Judicial - Trial and appellate court decisions. 15. Explain why the following statement is not necessarily true: "If the IRS disagrees, I'll take my case all the way to the Supreme Court." This statement is false because the Supreme Court chooses the cases it will review. Thus, the court may deny the taxpayer a hearing of his case (a writ of certiorari). Generally, the Supreme Court only considers a few tax cases in a given year. 16. What is the federal income tax base? A tax base is the value that is subject to tax. The federal income tax base is a prescriptive net income amount called federal taxable income. The base is computed by reducing income from all sources by exclu sions, deductions, and losses . 17. What is an exclusion? An exclusion is an increase in the taxpayer's wealth that Congress has determined should not be subject to tax or it is a recovery of the taxpayer's capital (i.e., investment in an asset). 18. How is a deferral different from an exclusion? An exclusion is income that is never subject to tax. A deferral is income that is not taxed in the current period but will be taxed in a future period. The future period tax may result from inclusion of th e income through either lower depreciation/amortization deductions and/or by the inclusion of a larger gain than would have occurred without the deferral. 19. How does gross income differ from income? Income (broadly defined) includes both taxable and tax-exempt income. This definition of income is closer to an economist's definition of income than is gross income. Gross income is a more restrictive term. Gross income is income (broadly defined) less income not subject to tax (exclusions). Gross inc ome items are the starting point for reporting on a tax return. Chapter 1: Federal Income Taxation - An Overview 1-11 © 2022 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 20. What are the three basic tests that an expense must satisfy to be deductible? 1. The expense must be ordinary, 2. The expense must be necessary, and 3. The expense must be reasonable in amount. 21. What is the difference between an expense and a loss? Expenses are the ordinary, necessary and reasonable expenditures incurred during a taxable year to earn income. Expenses are normally items that recur each year and whose usefulness does not extend substantially beyond the end of the current year. A loss normally means that an asset has been disposed of (sold, abandoned, etc.) for a price that is less than its tax cost (basis). A loss generally results from a speci fic transaction as compared to expenses that are usually incurred throughout the year. 22. How is a transaction loss different from an annual loss? A transaction loss results when an asset is sold or otherwise disposed of at a price less than its tax c ost (basis). An annual loss results from an excess of total deductions over total income for the year. Thus, a transaction loss is the result of a single event, while an annual loss is the cumulative effect of events for an entire year. 23. How does th e legislative grace concept help identify amounts that qualify for deduction? According to the legislative grace concept, an expenditure is not deductible unless a specific provision of the tax law allows the item as a deduction. If an expenditure is id entified as an allowable type of deduction by the tax law, it can be subtracted in the taxable income calculation. 24. Based on the example in Exhibit 1 --2, explain how inflation can have two effects that result in a hidden tax. The hidden tax from inflation can result from two effects: 1. As inflation increases the taxpayer's income, additional tax will be paid even though there is no change in the tax rates or increase in the taxpayer's real income, and 2. In some instances, the increase in income due to inflation may push the taxpayer into a higher marginal tax rate bracket. Thus, the taxpayer will be subject to a higher rate of tax without a corresponding change in real income. The problem of creeping into higher marginal tax brackets is partially cured by indexing the tax rates for inflation. 1-12 Chapter 1: Federal Income Taxation - An Overview © 2022 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 25. Explain the pay -as-you-go system. Income taxes are paid on income as close to the time it is received by the taxpayer as possible. This is accomplished through income tax withholding on wage s and other types of income (e.g., gambling winnings) and through quarterly estimated tax payments on income that is not subject to withholding (e.g., self - employment income, investment income). 26. What is a tax credit? A tax credit is an incentive pu t into the tax law by Congress to encourage taxpayers to enter into specific types of transactions or to provide relief from double taxation. A tax credit is treated like a prepayment of tax because it reduces the amount due by the full amount of the cred it (dollar for dollar reduction in tax liability). 27. How is a tax credit different from a tax deduction? A tax deduction results in a reduction of taxable income (the tax base). Therefore, the tax savings from a deduction are equal to the taxpayer's marginal tax rate multiplied by the amount of the deduction. In contrast, a tax credit is a direct dollar for dollar reduction in the tax liability. Therefore, one dollar of tax credit is worth more than one dollar of tax deduction. 28. If you were in the 2 4% marginal tax bracket and you could choose either a $1,000 tax credit or a $3,000 tax deduction, which would give you the most tax savings? Why? The tax credit is a better choice in this case. The tax credit will reduce the tax due by $1,000 (i.e., tax credits directly reduce the amount of tax due). The tax deduction will reduce taxable income by $3,000, resulting in a reduction of the tax due of $ 720 ($3,000 x 24%). The tax credit gives a $ 280 ($1,000 - $720) tax advantage to a 2 4% marginal tax rate payer. The $1,000 tax credit is the equivalent of a $ 4,167 tax deduction ($ 1,000 ÷ 24%). 29. What is the statute of limitations, and what role does it play in the filing of tax returns? The statute of limitations is the period of time that the IRS and/or the taxpayer has to correct an error on a return. The general statute of limitations period is three years from the due date of the return. This gives both the IRS and taxpayers time to correct errors on previously filed returns. If a ta xpayer discovers an error in a previously filed return, the error is corrected by filing an amended return before the end of the statute of limitations. Thus, the statute of limitations provide s an upper end on the amount of time that the taxpayer and the IRS have to correct a return. Chapter 1: Federal Income Taxation - An Overview 1-13 © 2022 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 30. Briefly describe the types of programs used by the IRS to select a return for audit. The two basic audit programs are the document perfection program and the information matching program. Document perfection involve s checking all returns for mathematical, clerical, and tax calculation errors. Information matching uses documents filed by third parties that report various income items to verify that they were properly claimed on the taxpayer's return. These two types of programs do not generate audits per se; rather, taxpayers are notified when errors are found, and the tax is recalculated based on the errors. Selection of returns for audit is done using either the Discriminant Function System (DIF) or through spe cial audit programs. The DIF is a computerized return selection program that selects those returns with the highest probability of containing errors. This is done by comparing items on returns with pre - determined standards. The standards are developed b ased on the audit results of the Taxpayer Compliance Measurement Program (TCMP). The TCMP randomly selects returns from various income levels and each item on the return is comprehensively audited. Special audit programs are designed to select returns ba sed on various parameters that the IRS believes may indicate that the returns are likely to contain errors. Factors that have been used in such audit programs are size of refund and the size of certain deductions in relation to income. 31. What are the three types of IRS examinations? The three types of IRS examinations are correspondence examinations, office examinations, and field examinations. Correspondence examinations are done through the mail and usually involve requests for written documentati on of various items on the tax return. Office examinations are conducted at local IRS offices and consist of a meeting between the taxpayer and an IRS representative to resolve factual issues regarding the taxpayers return. Field examinations are done at the taxpayer's place of business and can involve any item on the taxpayer's return. As such, they are the most in -depth type of examination. 32. What is included in the 30 -day letter, and what options does the taxpayer have after receiving one? A 30-day letter includes the revenue agent's report of the results of an IRS examination and a Form 870. If the taxpayer agrees with the results of the examination, the Form 870 is signed. A taxpayer who does not agree with the report may request a meeting with the IRS Appeals Division within 30 days of receiving the revenue agent’s report. The appeals division is the last opportunity for the IRS and the taxpayer to work out an agreement on the issues under examination. 1-14 Chapter 1: Federal Income Taxation - An Overview © 2022 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 33. What does the 90 -day let ter represent, and what are the choices the taxpayer has after receiving one? The 90 -day letter is the formal statutory notice of deficiency that the IRS sends to taxpayers that are unable to reach agreement in the appeals division. After receiving the 90-day letter, taxpayers that do not wish to go to court can wait 90 days and have the IRS formally assess the deficiency and then pay the amount due. Taxpayers who want to litigate must file their litigation action within 90 days of the date of the lette r. 34. How is the calculation of taxable income for an individual different from the calculation of a corporation's taxable income? The main difference is in the classification of deductions. Because a corporation is deemed to be in a trade or business , all of its expense is deductible (i.e., a corporation does not engage in personal transactions and, therefore, does not incur nondeductible personal expenditures). Corporations are not allowed standard deduction amounts in the calculation of taxable income. Deductions of individuals are limited. An individual's deductions must be classified as being either FOR or FROM adjusted gross income. Deductions FOR adjusted gross income are for business related expens es, rental and royalty expenses, self -employment taxes paid, and other specified expenses. Only certain personal expenditures are allowed as deductions. Many of these deductions are subject to a limit based on the taxpayer's adjusted gross income. Allowa ble personal expenditures are deductible FROM adjusted gross income. An individual has a choice of deducting actual allowable personal expenditures or taking a pre -determined amount as a deduction, called the standard deduction. 35. How do deductions for adjusted gross income and deductions from adjusted gross income of an individual differ? Deductions for adjusted gross income are limited to those related to a trade or business, reimbursed employee expenses, rental and royalty expenses, alimony paid, one -half of self -employment tax paid, contributions to individual retirement accounts, and other specified expenses. Deductions for adjusted gross income are always deductible - there is no minimum allowable amount. In addition, they generally are not limited by the taxpayer's income. Deductions from adjusted gross income are for certain personal expenditures (medical, interest, taxes, charitable contributions, personal casualty losses) and investment related expenses. Many of these deductions are su bject to limitations based on the taxpayer's adjusted gross income. In addition, if the taxpayer's adjusted gross income exceeds a pre -specified amount, total itemized deductions are reduced. A minimum deduction from adjusted gross income is allowed to a ll taxpayers, called the standard deduction. Chapter 1: Federal Income Taxation - An Overview 1-15 © 2022 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 36. What is the purpose of the standard deduction for individuals? The purpose of the standard deduction is to ensure that all individuals get some minimum deduction for personal expenditures. The provision of the standard deduction also promotes administrative convenience because taxpayers who have very small amounts of the allowable personal deductions do not have to keep records necessary to substantiate deductions and fill out tax forms for very small deduction amounts. In addition, the government does not have to incur costs to audit standard deduction amounts. 37. Haru is studying finance at State University. To complete the finance major, he has to take a basic income tax course. Because Haru does not intend to be a tax expert, he considers the course a waste of his time. Explain to Haru how he can benefit from the tax course. The student's answers may vary, but should contain some of the following points: 1. When a p erson enters into an economic transaction there will usually be a related income tax effect. 2. Income taxes represent a major expenditure of time and money for most taxpayers. An understanding of basic tax concepts is necessary to avoid overpayment of ta xes. • Tax planning helps conserve wealth. • The taxpayer has the primary responsibility for recognizing planning opportunities. 3. Daily business decisions have a tax effect. The taxpayer needs to be familiar with these tax effects to choose between al ternative courses of action. 4. The taxpayer is responsible for complying with the tax law even when a tax adviser is hired to prepare returns. Thus, for self -protection, the taxpayer should understand basic tax concepts to be able to identify possible tax related situations. 38. Evaluate the following statement: "The goal of good tax planning is to pay the minimum amount of tax." This statement is partially correct. However, a better statement would be that "good tax planning maximizes the real after -tax return on income." To see why this is correct, consider the decision to recognize income in the current year or defer it to nex t year. If minimization of tax is the sole criteria, then the income is always deferred. However, deferral is not always the optimal choice. Determining the optimal choice requires the calculation of the real after -tax return from recognizing the income currently versus deferring it to the next year. This involves considering the relative marginal tax rates and the time -value of money. 1-16 Chapter 1: Federal Income Taxation - An Overview © 2022 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 39. It has often been said that only the rich can benefit from professional tax planning. Based on the informa tion presented in this chapter, why is this statement at least partially true? To take advantage of the two main tax planning techniques - timing income and deductions and income splitting, taxpayers must have income and deductions that can be manipulate d to achieve the best tax effect. Taxpayers whose main source of income is from wages and salaries have a very limited set of options available to them for reduction of their taxes. However, such taxpayers can still obtain a limited amount of benefit fro m tax planning by actions such as purchasing a home to secure an interest deduction (rather than paying non - deductible rent) and investing savings in tax -exempt securities. In addition, taxpayers with higher incomes have more incentive to spend the time, effort, and money necessary to engage in tax planning because the returns from this type of investment are higher (i.e., they are paying higher marginal tax rates). Therefore, each dollar reduction in taxable income is worth more to high income than to low-income taxpayers. Chapter 1: Federal Income Taxation - An Overview 1-17 © 2022 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. PROBLEMS 40. State whether each of the following payments is a tax. Explain your answers. a. To incorporate his business, Alex pays the state of Texas a $2,000 incorporation fee. The incorporation fee is not a tax. Alex receives a direct benefit from the payment of the fee - the privilege of operating his business as a corporation b. The city paves a road and assesses each property owner on the road $4,000 for his or her share of the cost. The payment of the assessment is not a tax. The assessment is a property improvement. Only the owners of the property benefit from the assessment. The assessment is a charge to reimburse the county government for the cost of paving the road that provides a direct benefit to each owner’s pr operty. Such assessments are added to the basis of the property and are not allowed as a property tax deduction. c. The city of Asheville charges each residence in the city $10 per month to pick up the trash. The fee to collect the trash is not a tax. The $10 payment provides a specific benefit - the picking up of trash. d. Rory pays $450 of income tax to the state of California. State income taxes meet the definition of a tax. They are required to be paid by law and result from the state’s legislative power to tax. State income taxes are general purpose revenues, and the payment of the tax does not provide any specific benefits, se rvices, or privileges to the payor. e. Lanny is fined $45 for exceeding the speed limit. Fines are not taxes. They are penalties to discourage behavior and are not designed to produce revenues. 1-18 Chapter 1: Federal Income Taxation - An Overview © 2022 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 41. Explain why each of the following payments does or d oes not meet the IRS definition of a tax: a. Jack is a licensed beautician. He pays the state $45 each year to renew his license to practice as a beautician. Not a tax. Jack receives a direct benefit from the payment of the licensing fee - he is allow ed to practice as a beautician. b. Polly Corporation pays state income taxes of $40,000 on its $500,000 of taxable income. State income taxes are a tax under the IRS definition. The taxes are paid to a governmental authority, are paid pursuant to the state's power to tax, are used to provide revenue for the state, and no specific benefit is derived from paying the tax. c. Winona pays $15 annually for a safety inspection of her automobile that is required by the state. Safety inspection fees are not taxes. By paying the fee, Winona is allowed to drive her automobile - a specific benefit is received. d. The Judd Partnership owns land that is valued by the county assessor at $30,000. Based on this valuation, the partner ship pays county property taxes of $800. Ad valorem property taxes meet the IRS definition of a tax. The taxes are paid to a governmental authority, are paid pursuant to the county's power to tax, are used to provide revenue for the county, and no speci fic benefit is derived from paying the tax. e. Andrea fails to file her income tax return on time. She files the return late, and the IRS assesses her $25 for the late filing and $5 for interest on the tax due from the due date of the return until the filing date. The late filing fee and interest charge are not taxes. They are penalties for failing to file a timely tax return. As such, they are used to discourage behavior, not produce revenue. Chapter 1: Federal Income Taxation - An Overview 1-19 © 2022 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 42. Aliyah is single with a gross income of $120,000 and a taxable income of $98,000. In calculating taxable income, she properly excluded $10,000 of tax -exempt interest income. Using the tax rate schedules in the chapter, calculate Aliyah's a. Total tax c. Average tax rate b. Marginal tax rate. d. Effective tax rate a. The total tax is $17, 541 Tax computation: single taxpayer rate schedule for 2021 : Taxable Income $ 98,000 Tax on 86,375 $14,751.00 Excess $ 11,625 Taxed at Marginal Rate x 24 % 2,790.00 Total Tax $17,541.00 b. The marginal tax rate is 24%. The marginal tax rate is the rate of tax that would be paid on an additional dollar of income. At a taxable income of $98,000, a single taxpayer would be in the 2 4% marginal tax rate bracket (from the calculation above). c. The average tax rate is 17. 90%. The average tax rate is the rate of tax paid on the total tax base; the total tax divided by taxable income. In this case, the total tax is $ 17,541 on a taxable income of $98,000, which gives an av erage tax rate of 17.90%: 17.90% = ($17,541 tax  $98,000 taxable income) d. The effective tax rate is 16. 24%. The effective tax rate is the rate of tax paid on all income (taxable and nontaxable). The total tax paid is divided by the taxpayer's eco nomic income (taxable income + nontaxable income). In this case, Aliyah has $10,000 of tax - exempt income that increases her economic income to $108,000 ($98,000 taxable + $10,000 nontaxable). This results in an effective tax rate of 16.24%: 16.24% = ($17,541 tax  $108,000 economic income) 1-20 Chapter 1: Federal Income Taxation - An Overview © 2022 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 43. A taxpayer has $95,000 of taxable income for the current year. Determine the total tax, the marginal tax rate, and the average tax rate if the taxpayer is a a. Single individual b. Married couple c. Corporation a. The total tax is $16, 821.00. The margina l tax rate is 24%. The average tax rate is 17. 71%. Total tax on $95,000 for a single individual: 2021 single rate schedule Taxable Income $ 95,000 Tax on 86,375 $ 14, 751.00 Excess $ 8,625 Taxed at Marginal tax rate x 24 % 2,070.00 Total Tax $ 16,821.00 average tax rate = 17. 71% = $16,821 tax  $95,000 taxable income b. The total tax is $12, 397.00. The marginal tax rate is 22%. The average tax rate is 12.95%. Total tax on $95,000 for a married couple: 2021 married, filing jointly rate schedule Taxable Income $ 95,000 Tax on 81,050 $ 9.328.00 Excess $ 13,950 Taxed at Marginal tax rate x 22 % 3,069.00 Total Tax $ 12, 397.00 average tax rate = 13.05 % = $12,397.00 tax  $95,000 taxable income c. Total tax on $95,000 for a corporation: 2021 corporate rate schedule Taxable Income $ 95,000 Taxed at tax rate x 21% Total Tax $19,950 average tax rate = 21.00 % = $19,950 tax  $95,000 taxable income Chapter 1: Federal Income Taxation - An Overview 1-21 © 2022 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 44. Rory earns $70,000 per year as a college professor. Latesia is a marketing executive with a salary of $ 140,000. With respect to FICA taxes, what are Rory’s and Latesia’s . a. Total FICA taxes? Rory’s total FICA taxes: $5,355.00 Latesia’s total FICA taxes: $ 10,710.00 Rory's salary is under the OASDI Social Security base limit. Therefore, he pays the combined 7.65% rate on his full salary, resulting in a tax of $5,355: $70,000 x 7.65 % = $5,355 Latesia's salary is under the OASDI Social Security base limit. Therefore, she pays the combined 7.65% rate on h er full salary, resulting in a tax of $ 10,710: $140,000 x 7.65% = $10,710 b. Marginal FICA tax rates? Rory’s marginal FICA tax rate: 7.65% Latesia’s marginal FICA tax rate: 7.65% The marginal tax rate is the rate of tax that is paid on the next dollar of income subject to the tax. Because Rory is under the base amount, any subsequent income earned up to the $ 142,800 OASDI base amount is subject to tax at 7.65%. Therefore, his marginal tax rate is 7.65%. Latesia is also under the base amount, any subsequent income earned up to the $142,800 OASDI base amount is subject to tax at 7.65%. Therefore, h er marginal tax rate is 7.65%. c. Average FICA tax rates? Rory's average FICA tax rate is 7.65%. Latesia's average FICA tax rate is 7.65%. The average tax rate is the total tax divided by the tax base. Rory's average tax rate is 7.65% ($5,355 tax  $70,000 tax base). Latesia's average tax rate is 7.65% ($10,710 tax  $140,000 tax base ) 1-22 Chapter 1: Federal Income Taxation - An Overview © 2022 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. d. Effective FICA tax rates? Rory’s effective tax rate: 7.65% Latesia’s effective tax rate: 7.65% The effective tax rate is the total tax divided by the taxpayer's economic income (tax base + income not subject to the tax base). The effective tax rates based only on their salaries are: Rory - 7.65% ($5,355 tax  $ 70,000 salary) Latesia - 7.65% ($10,710 tax  $140,000 salary) Chapter 1: Federal Income Taxation - An Overview 1-23 © 2022 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 45. For each of the following, explain whether the rate structure is progressive, proportional, or regressive: a. Plymouth County imposes a 5% tax on all retail sales in the county. Taxpayers with incomes less than $12,000 receive a refund of the tax they pay. Sales taxes are proportional as defined in the text. The average tax rate is equal to the marginal tax rate on all items subject to the tax. When evaluated using income as the tax base, sales taxes are generally regressive - low-income taxpayers spend a higher proportion of their income on goods subject to sales tax (their average tax rates are higher). The refund of the sales tax to taxpayers with lower incomes reduces the regressivity of the tax for those taxpayers. b. The country of Zambonia imposes a 10% tax on the taxable income of all individuals. The income tax is proportional. The average tax rate is equal to the marginal tax rate at all levels of taxable income. However, the tax becomes regressive if higher income taxpayers have a greater ability to lower their taxable income through exclusions and deductions. This lowers the effective rate of tax for high income taxpayers and induces regressivity into the tax structure. c. Regan County imposes a property tax using the following schedule: Assessed Value Tax $ -0- to $10,000 $ 40 $10,001 to $40,000 $ 40 + 1% of the v alue in excess of $10,000 $40,001 to $80,000 $ 340 + 2% of the value in excess of $40,000 $80,001 and above $1,140 + 3% of the value in excess of $80,000 The property tax is progressive. The marginal tax rates are increasing (1%, 2%, 3%) through t he rate structure and are higher than the average tax rate. d. The city of Thomasville bases its dog licensing fee on the weight of the dog per the following schedule: Weight (in pounds) Tax Rate 0 to 40 $ 2 + 50% of weight 41 to 80 $22 + 40% of weight in excess of 40 lbs. 81 and above $36 + 30% of weight in excess of 80 lbs. The dog licensing fee is regressive - marginal tax rates are increasing as the tax base increases. The marginal tax rate is le ss than the average tax rate. For example, the tax on a 20-pound dog is $12 [2 + (50 % x 20)]. The average rate is $.60, and the marginal rate is $.50. The tax on a 50 -pound dog is $42 [$ 22 + (40% x 50)], an average rate of $.84 and a marginal rate of $.40. Average tax rates are increasing with levels of the tax base while marginal tax rates are decreasing. 1-24 Chapter 1: Federal Income Taxation - An Overview © 2022 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 46. The country of Boodang is the leading producer of sausage. Boodang imposes three taxes on its residents and companies to encourage production of sausage and discourage its consumption. Each applies as follows: • Income tax: Rates apply to each taxpayer's total income: $ 0 - $ 50,000 5% of total income $ 50,001 - $ 200,000 $ 2,500 + 10% of income in excess of $50 ,000 $200,001 - $ 500,000 $17,500 + 20% of income in excess of $200,000 $500, 001 or more 40% of total income In calculating total income, sausage workers are allowed to deduct 25% of their salaries. Companies that produce sausage are allowe d to deduct 50% of their sales. No other deductions are allowed. • Sausage tax: All sausage purchases are subject to a 100% of purchase price tax. Residents who consume less than 10 pounds of sausage per year are given a 50% rebate of the sausage tax t hey paid. • Property tax: Taxes are based on the distance of a taxpayer's residence from state - owned sausage shops per the following schedule: 0 - 2 miles $ 15,000 per mile 2 miles - 5 miles $ 5,000 per mile 5 miles or more $ 2,000 per mile Given the definitions in the chapter, are Boodang's taxes progressive, proportional, or regressive? Evaluate and discuss each tax and the aspect(s) of the tax that you considered in making your evaluation. Income tax : The rate schedule is progre ssive - the marginal tax rate is greater than the average tax rate at all levels. However, the overall tax may be viewed as being regressive due to the deductions allowed to sausage workers and their employers. Because these deductions lower these entiti es tax base versus non - sausage related entities, their marginal and average tax rates will be lower than comparably paid workers and companies with similar revenues in other businesses. Sausage tax: By definition, the tax rate is proportional - the same tax is paid at all levels of purchases, making the marginal tax rate equal to the average tax rate. The allowance of a credit for small sausage purchasers adds an element of progressivity to the tax. That is, individuals who purchase less than 10 pounds of sausage will have a lower marginal and average tax rate than those who purchase 10 pounds or more. Thus, as the tax base (sausage purchases) increases to 10 pounds, the marginal and average tax rates increase. However, the tax remains proportional fo r all taxpayers whose purchases are less than 10 pounds, as it does for all taxpayers whose purchases equal or exceed 10 pounds. Property tax: The rate schedule is regressive - as the tax base (miles from a sausage shop) increases, the marginal and average tax rates increase. However, there is an element of proportionality to the tax because it is not cumulative through the base. That is, a di fferent per mile tax is levied at each base level, but the per mile tax does not accumulate as you move through the base. Thus, the marginal and average tax rates are equal through each level - a characteristic of a proportional tax. Chapter 1: Federal Income Taxation - An Overview 1-25 © 2022 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 47. Joe Bob is an em ployee of Rollo Corporation who receives a salary of $ 14,000 per month. How much Social Security tax will be withheld from Joe Bob's salary in a. March? Joe Bob's salary is under the OASDI Social Security base amount and his entire salary in March will be subject to the 7.65% Social Security tax. Therefore, he will pay $ 1,071 ($14,000 x 7.65%) of Social Security tax in March. b. November? By November, Joe Bob will have earned $ 140,000 ($ 14,000 x 10 months) which is $2,800 under the OASDI Social Security base limit of $142,800. Therefore, he will only pay the full 7.65% tax on $2,800 ($142,800 - $140,00) and will pay the 1.45% MHI component on the remaining $11,200 in November, resulting in a tax of $376.60 [($2,800 x 7.65% ) + (11,200 x 1.45%) ]. 48. Return to the facts of problem 47. Assume that each month, Joe Bob has $2,800 in federal income tax and $900 of state income tax withheld from his salary. What is Joe Bob's take -home pay in a. March? Joe Bob's gross salary will be reduc ed by amounts withheld for federal, state, and local taxes. His March take home pay will be $ 9,229 ($14,000 - $2,800 - $900 - $1,071). b. November? Joe Bob's take home pay is $ 9,923.40 ($14,000 - $2,800 - $900 - $376.60 ) and reflects the lower amount of Social Security withheld due to exceeding the OASDI base amount.