Fundamentals of Taxation

2020 Edition
Cruz, Deschamps, Niswander, Prendergast, Schisler

Chapter 1
Introduction to
Taxation, the
Income Tax
Formula, and
Form 1040
© 2020 McGraw-Hill. All rights reserved. Authorized only for instructor use in the classroom.
No reproduction or further distribution permitted without the prior written consent of McGraw-Hill.
 Introduction

An income tax was first enacted in 1861 and repealed

after the Civil War ended.
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 153 million individual income tax returns were
filed in 2017 (most recent year available).
• Almost 136 million (89%) were filed electronically.
Individual income tax collections were about $1.59
trillion in 2017.
©McGraw-Hill 1-2
 Learning Objective #1: Progressive,
Proportional, and Regressive Tax
Structures 1

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 for married taxpayers).

Progressive tax structure:

• The tax rate increases as the tax base increases.
• Example is the U.S. income tax system.

©McGraw-Hill 1-3
 Learning Objective #1: Progressive,
Proportional, and Regressive Tax
Structures 2

Proportional tax structure:

• The tax rate remains the same regardless of the
tax base.
• Example is state or local sales taxes.
Regressive tax structure:
• The tax rate decreases as the tax base increases.
• Example is social security tax system.

©McGraw-Hill 1-4
 Learning Objective #1: Progressive,
Proportional, and Regressive Tax
Structures Concept Check 1-1
1. The three types of tax rate structures are

Progressive, proportional, and regressive

2. The tax rate structure for which the tax rate remains the same
for all levels of the tax base is the rate structure.

Proportional
3. The federal income tax system is an example of a
tax structure.

Progressive
©McGraw-Hill 1-5
 Learning Objective #2: Marginal and
Average Tax Rates
Average tax rate is the total tax paid on 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 rate
schedule.
• For example, a married couple will pay a
marginal rate of 22% on their $78,951st dollar
of income.
©McGraw-Hill 1-6
 Learning Objective #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

©McGraw-Hill 1-7
 Learning Objective #2: The Income
Tax Formula Concept Check 1-2 1

1. The marginal tax rate is the rate of tax

imposed on the next dollar of taxable income.
True or false?
True

2. What is the marginal tax rate for a married

couple with taxable income of $97,350?

22%

©McGraw-Hill 1-8
 Learning Objective #2: The Income
Tax Formula Concept Check 1-2 2

3. Average tax rate and marginal tax rate mean

the same thing. True or false?

False

4. Complex tax returns do not follow the basic (or

simplified) income tax formula. True or false?

False

©McGraw-Hill 1-9
Learning Objective #3: Components of
Form 1040 1

Taxpayers annually file a tax return using

• Form 1040.
• Plus: zero to three of Schedules 1-3. Some
taxpayers will not use any schedules, some will
use three, and others will use something in
between.

The forms and schedules all follow the basic

income tax formula.
• One or more schedules are used as the tax
return becomes more complex.
©McGraw-Hill 1-10
Learning Objective #3: Components of
Form 1040 2

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 1099-INT.

©McGraw-Hill 1-11
Learning Objective #3: Components of
Form 1040 3

Unemployment compensation is taxable.

• Reported on Form 1099-G.

The Standard Deduction is shown on line 9.

• $12,200 for single, $24,400 for married.

Total income minus permitted deductions

equals Taxable Income (line 11b).

©McGraw-Hill 1-12
Learning Objective #3: Components of
Form 1040 Concept Check 1-3

1. Only certain types of income are reported on

the face of page 2, Form 1040EZ. They are

Wages, interest

2. Unemployment compensation is reported to

the taxpayer on a Form
1099-G

©McGraw-Hill 1-13
 Learning Objective #4: Calculation of
Tax

For taxable income up to $100,000, use tax

tables (printed in Appendix D and in the
instructions to Form 1040, available on the I RS
website).
Tax rate schedules are used for higher income
(printed in Appendix F).
Tax tables calculate tax at the midpoint of the
income range on the table.
Tax rate schedules calculate tax precisely.

©McGraw-Hill 1-14
 Learning Objective #4: Calculation of
Tax Concept Check 1-4 1

1. Taxpayers with taxable income under

$100,000 must calculate their tax liability
using the tax tables. True or false?
True

2. Refer to the tax tables. What is the tax

liability of a married couple with taxable
income of $91,262?
$11,798

©McGraw-Hill 1-15
 Learning Objective #4: Calculation of
Tax Concept Check 1-4 2

3. Using the tax rate schedule in Table 1-2, determine

the tax liability (to the nearest penny) for a married
couple with taxable income of $91,262.

$11,794.64

©McGraw-Hill 1-16
 Learning Objective #3: Tax Payments
Tax liability is generally paid throughout the year through
withholding tax payments deducted from wages.
• Withholding payments are reported on W-2.

Low income taxpayers may be eligible for the Earned

Income Credit.
• Discussed in chapter 9 with other credits.

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).
©McGraw-Hill 1-17
 Learning Objective #3: Tax Payments
Concept Check 1-5
1. Taxpayers pay all of their tax liability when they file
their tax returns. True or false?
False

2. Bret’s tax liability is $15,759. His employer withheld

$15,367 from his wages. When Bret files his tax return,
will he be required to pay or will he get a refund? What
will be the amount of payment or refund?
Required to pay, $392

3. An Earned Income Credit will increase the amount of

tax liability. True or false?
False
©McGraw-Hill 1-18
 Learning Objective #5: Tax Authority 1

Tax authority is the body of law, regulation, and

precedent that guide taxpayers, the I RS, and
the courts in the proper application of tax law.
Three types of primary tax authority:
• Statutory sources.
• Administrative sources.
• Judicial sources.

©McGraw-Hill 1-19
 Learning Objective #5: Tax Authority 2

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.

©McGraw-Hill 1-20
 Learning Objective #5: Tax Authority 3

Administrative sources of tax authority, in

order of strength:
• Treasury Regulations (IRS Regulations).
• Revenue Rulings.
• Revenue Procedures.
• Private Letter Rulings.
• IRS Notices.

©McGraw-Hill 1-21
 Learning Objective #5: Tax Authority 4

Judicial sources of tax authority.

Courts resolve disputes between taxpayers and
the IRS.
Initial court of jurisdiction is either the
• Tax Court.
• U.S. District Court.
• U.S. Court of Federal Claims.

©McGraw-Hill 1-22
 Learning Objective #5: Tax Authority 5

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 −
Federal Claims and then to the Supreme Court.

©McGraw-Hill 1-23
 Learning Objective #5: Tax Authority
Concept Check
1. The committee charged with considering tax
legislation in the House of Representatives is
called the Committee.
Ways and Means
2. The most commonly relied-on statutory authority is

The Internal Revenue Code

3. All tax legislation must pass both the House of
Representatives and the Senate and be signed by
the president of the United States in order to
become law. True or false?
True
©McGraw-Hill 1-24
 Learning Objective #5: Tax Authority
Concept Check 1-7
1. Administrative tax authority takes precedence
over statutory tax authority. True or false?
False

2. IRS Revenue Procedures are applicable only to the

taxpayer to whom issued. True or false?
False

3. The administrative tax authority with the most

strength of authority is
IRS Treasury Regulations
©McGraw-Hill 1-25
 Learning Objective #5: Tax Authority
Concept Check 1-8
1. The U.S. Supreme Court does not accept
appeals of tax cases. True or false?
False
2. A taxpayer who does not agree with an
assessment of tax by the IRS has no recourse.
True or false?
False
3. A taxpayer who does not want to pay the tax
assessed by the IRS prior to filing a legal
proceeding must use the Court.
Tax
©McGraw-Hill 1-26
 Learning Objective #6: Circular 230 1

Circular 230 sets forth rules which must be

followed by all paid tax preparers.
• Includes CPAs, attorneys, enrolled agents,
and any other individual who receives
compensation for preparing a tax return,
providing tax advice, or practicing before the
IRS.

Circular 230 sets forth ethical standards and

expectations.

©McGraw-Hill 1-27
 Learning Objective #6: Circular 230 2

Failure to comply with Circular 230 will subject

the paid preparer to suspension or disbarment
from IRS practice, public censure, fines, and
civil or criminal penalty.
Rules are far reaching and complex.

©McGraw-Hill 1-28
 Learning Objective #6: Circular 230 3

Paid tax preparers must obtain a preparer tax

identification number (P TIN).
• Must be renewed annually.
Preparers who are not C PAs, attorneys, or
enrolled agents must pass a competency exam
and annually obtain continuing education.
• CPAs, attorneys, and enrolled agents must
also obtain continuing education.

©McGraw-Hill 1-29
 Learning Objective #6: Circular 230 4

Paid preparers must:

• Sign all tax returns they prepare.
• Provide a copy to clients.
• Return records to clients.
• Exercise due diligence and best practices.
• Disclose non-frivolous tax positions.
• Notify clients of errors on a client return.
• Provide information to the I RS.
• Inform a client if the client made an error.

©McGraw-Hill 1-30
 Learning Objective #6: Circular 230 5

Paid preparers must NOT:

• Take a position unless it has a “realistic
possibility” of being sustained.
• Charge a contingent fee.
• Charge an unconscionable fee.
• Unreasonably delay matters with I RS.
• Cash an IRS check for a client.
• Represent a client if a conflict of interest exists.
• Make false or fraudulent statements.

©McGraw-Hill 1-31