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Legal Grind® presents

The Little Law Book

by Miriam Kurtzig Freedman, J.D
Illustrations by Daphne San Jose

CHAPTER 10

Individual Income Taxes

Income Tax drawing

Income-tax procedures are complex, even after Congressís revisions of the Internal Revenue Code in the name of 'tax simplification.' The least a taxpayer can do is learn the language! So, here goes...

For information on IRC please go to the United States Code, Internal Revenue Code (IRC):
The statutes dealing with federal tax law. These include income, estate, gift, excise, and stamp taxes. For the IRC, look in Title 26 of the United States Code (USC). Happy reading! Itís several thousand pages long - of very fine print!


Tax:
A compulsory assessment of a person, corporation, trust, or other taxable entity and property for money to support the government. It is not a voluntary contribution!

Income:
All the moneys you make, including salaries, tips, profits, interest and dividends, lottery prize winnings, commissions, royalties, alimony received, capital gains, rents, gains from the sale of real estate, and everything else! Itís all the money you make in your business, your work, and your investments.
You make it; the government gets a piece of it! But it wasnít always so. Before 1913 an income tax was unconstitutional. Then the Sixteenth Amendment was ratified, which gave Congress the right to tax income 'from whatever source derived.'

Tax return:
The document a taxpayer provides to the Internal Revenue Service, detailing his income and tax liability.

Internal Revenue Service (IRS):
The federal agency that administers the IRC. It is part of the Treasury Department.

1040 form:
This form, mailed to all taxpayers that filed in the past, provides forms and instructions.... It comes around January first of every year. Itís a New Yearís present we all get!

Here are the basic terms:

Gross income:
The total money you bring in from all sources. In divorce it includes alimony received but not lump-sum payments or child support. It includes valuables you find, but not gifts you get. (The donor may be taxed on gifts to an individual over ten thousand dollars per year. Gift tax is not dealt with here.) It does get complex! Gross income is the biggest sum that appears on your tax return. Luckily, everyone gets to subtract (deduct) from that - bit by bit - to get to the all-important bottom line, the actual taxable income. (Itís from your taxable income that you compute the taxes you owe, based on various formulae and charts.... But we have a long way to go before we get to that!) So, here we go...

Adjustments to income:
These are deductions you can take for various purposes, such as tax- deferred retirement accounts (IRAs), self-employment health insurance deductions (above a specified amount), reimbursed employee business expenses, and alimony (but not child support) you paid to your ex- spouse. (This list is not totally inclusive; there may be other adjustments.)

Total adjustments:
All the deductions you can take as adjustments to income.

Adjusted gross income:
Your gross income minus the adjustments.

Deductions:
Amounts you can deduct from your adjusted gross income. You can do this in two ways:

  1. Use the standard deduction: For 2002 taxes this amount was $for a joint return filed by a married couple with dependent child. Note, of course, that 2002 taxes are paid in 2003.
  2. Use itemized deductions: You can deduct various expenses. For example, certain expenses are deductible dollar for dollar: state and local income and real estate taxes, charitable gifts, mortgage interest, moving expenses, et cetera. Other expenses are deductible above a certain amount, such as medical and dental expenses, casualty losses and thefts, unreimbursed employee business expenses, tax preparation expenses, and so on. These lists are not all-inclusive; there may be other items. This is where you need all those stubs and careful notes you take all year. If you deduct an expense, you may have to be able to prove that you paid it. Obviously, in choosing between the standard or itemized deduction route, you use whichever gives you the larger deduction (that you can prove).

We move on...

Exemption:
An additional amount you can deduct, depending on the number of dependents you have. You get an exemption for yourself, for your spouse, and for each dependent. The value of an exemption has changed over the years. Itís now around two thousand dollars.

Taxable income (also called Net Income):
The amount of income left after figuring in adjustments and deductions.

Compute the tax:
Take your taxable income and decide how much tax you owe, based on your filing status: Are you single? married? filing a joint return with your spouse or married and filing separately? an individual return? as a head of household? These all lead to different tax rates, which appear in the tax tables. Most favorable is a married, joint return.

Credits:
An amount subtracted from the tax. Credits are now allowed for such items as child and dependent care, elderly and disabled care, and foreign tax credit. Again, this list is not all-inclusive.
Now, unfortunately, you may have to add to the tax owed.

Other taxes:
Taxes including self-employment taxes, Social Security taxes on tip income not reported, and others.

Total tax:
The Bottom Line, at last! This is the tax owed. You subtract what has been withheld by your employer (shown on the W-2 form) and what you paid during the year at this time. If you paid more than you owe, you get a refund. If you owe more than you paid, you owe the difference. ìI owe, I owe, itís off to work I go.î And the cycle begins anew!

OTHER TERMS

Income is divided into capital gains and ordinary income.

  • Ordinary income:
    All income that does not qualify as capital gains income
  • .
  • Capital gains income:
    Money made on the sale or exchange of capital assets. These include your home, stocks and bonds, et cetera. Anything you sell, excluding what you usually sell to your customers.
    Capital gains are further separated into short-term gains (or losses) and long-term capital gains (or losses). Long term is for something held for more than twelve months; short term is for something held less than twelve months. Over the years Congress has changed the way both of these are taxed. By doing that Congress is engaged in both revenue collection and social planning. Which of these gains gets favorable treatment? What policies are encouraged? Is it investments? savings? growth? In 2002????? long- and short-term gains were taxed at the same rate as ordinary income. In earlier years long-term gains were taxed at lower rates. Itís a fascinating process to watch!

Filing status:
Whether you file as a single person, married person with a joint return, married person filing separately, or head of household. Each status has its own reasons and advantages.

Head of household:
An unmarried taxpayer that maintains a household with at least one dependent and satisfies certain criteria established by the IRS. This, too, is an area of flux, as Congress grapples with the changing criteria in society.
Why does someone want to be considered a head of household instead of a single person? To qualify for the favorable tax rates, of course.

Graduated tax:
Tax system in which the tax rate increases with the taxpayer's income. The income tax system is a graduated tax. For example, in 2002?????, a married taxpayer filing jointly paid fifteen percent on the first $30,950 of taxable income; twenty-eight percent on income between $30,950 and $74,850; thirty-three percent on income between $74,850 and $155,320; a lower percentage, depending on circumstances, on taxable income over $155,320. Note how the percentages increase as income increases, up to $155,320.

Progressive tax:
Another term for the graduated tax. The social policy goal is to tax the wealthy proportionally more than the poor.

Regressive tax:
The opposite of a progressive tax. Here, the tax rate increases less than the income base. Thus, it falls more heavily on poorer taxpayers.

April fifteenth:
Midnight! Tax returns are due. Taxes are due. A good time to get a temporary job at the IRS!

Automatic extension:
Tax returns are normally due on April fifteenth. You are entitled to extend that time by four months (until August fifteenth) by filing a form and paying your taxes (as you estimate them) by April fifteenth. If your estimates are too low, you will pay the penalties discussed below. The automatic extension does not change the deadline for payment of taxes due.

There are several ways to get in trouble with the IRS. Including:

  • Failure to file a tax return:
    If you fail to file a return, you may be charged a penalty for not (or late) filing, the taxes owed plus interest, and a penalty for late payment of taxes.
  • Failure to pay taxes:
    If you file a return but fail to pay taxes, you may be charged a penalty, along with the taxes owed.
  • Underpayment of taxes:
    If you pay less tax than you owe, you may be charged interest, compounded daily, on all that you owe. The rate is adjusted twice a year and based on the prime rate. It used to be clever to ìborrowî from Uncle Sam because the back interest rates were low. Alas, they no longer are.
  • Underpayment of taxes because of overvaluation of property:
    If you pay less tax than you owe because you overvalued your property, you will pay a penalty depending on how much you overvalued the, property-for example, if you exaggerated a charitable deduction or the basis of (i.e., what you paid for) a capital asset.
  • Understatement of tax liability:
    If you substantially understate the tax you owe, you may be penalized.
  • Negligence penalties:
    If your underpayment is caused by negligence, you may pay a penalty.
  • Fraud penalties:
    If your underpayment is caused by fraud, you may pay a hefty penalty, and often criminal penalties.
  • Criminal penalties:
    If you 'willfully' evade or cheat the tax law, penalties include fines, imprisonment for up to five years, or both.
  • Tax avoidance and tax evasion:
    They are not the same things. Tax avoidance is legal. Itís the tax planning you may do to pay the minimum tax legally. Tax evasion is illegal. It is the intentional payment of less tax than is due, by use of fraud, false statements, false records, et cetera. Basically, it is filing a false tax return. It is a crime.

Statute of limitations:
The IRS is given three years from the time you file your return to audit you. If you don't file a return, they may come after you anytime, as the statute of limitation does not begin to run until you do so. If you file a return but omit items that amount to more than twenty-five percent of your gross income, the IRS has six years to come after you!
If you commit tax fraud, the IRS can come after you anytime. It has no time limits.

Audit:
An examination of a taxpayer's financial records by an IRS agent.

There are several levels:

  1. A correspondence audit is done through the mails. The IRS asks for information and the taxpayer mails it in.
  2. An office audit is conducted in the IRS agentís office.
  3. A field audit is conducted at the place of business or home of the taxpayer.

Appeal:
If you dispute the results of the audit, you may appeal them to the supervisor, the IRS administrative hearing, or Tax Court or other federal court.

Tax Court:
The Tax Court of the United States has jurisdiction over cases in which the IRS and taxpayers dispute the amount of taxes owed. To get into this court the IRS has to issue a statutory Notice of Deficiency (called ìthe ninety-day letterî) and the taxpayer has to file a petition for a hearing within the specified time.

OTHER TERMS ABOUT TAXES: NOT INCOME

Estate tax:
Tax on the transfer of property at death. Called a 'transfer tax' in some states.

Inheritance tax:
Tax on the right to receive property. This exists only in a few states.

Gift tax:
A federal tax on a donor's gift if it amounts to more than ten thousand dollars per year to any individual. Some states tax the done. There is also a lifetime exemption providing no taxes below the exempt amount.

Tax lien:
The government's claim on a property as security for taxes due. Yes, they can force you to sell your property to collect the taxes.

And there you have it. The key tax terms in seven pages or less!


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