Volume. THE TAX COLLEGE Educational Series. Federal Income Tax Course 2015

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1 Volume 1 THE TAX COLLEGE Educational Series Federal Income Tax Course 2015

2 E D U C A T I O N A L S E R I E S - V O L U M E 1 Federal Income Tax Course 2015 WorldWideWeb Tax, Inc West McNab Rd. Pompano Beach, FL The Tax College is a Division of WorldWideWeb Tax, Inc. Copyright Notice and Warning: This publication is protected by U.S. Copyright Law and International Treaties. It is a violation of US federal copyright law to reproduce all or any part of this publication or any of its contents by any means. The Copyright Act imposes liability of up to $150,000 for such infringement. WorldWideWeb Tax, Inc. does not license or authorize reproduction of this publication without specific written permission. Unauthorized reproduction, distribution, or use of this publication, or any portion it, may result in severe civil and criminal penalties, and will be prosecuted to the maximum extent possible under the law. Any information concerning illicit duplication or reproduction is greatly appreciated. As an enrolled student of The Tax College you are hereby authorized to print one (1) copy of our Federal Income Tax Course for your personal use in your studies and as reference material. Redistribution is strictly prohibited. About Copyscape: This document is protected by Copyscape. Copyscape is a plagiarism detection service. Copyscape periodically retrieves and parses an original author s pages and queries Google s servers to find any illegal instances of the phrases, sentences, and paragraphs it has parsed. Copyscape then notifies the original author of any copyright infringement. i

3 H OW TO U S E O U R I N C O M E TA X C O U R S E Q U ESTIONS, COMMEN TS, AND NOTES: Our course is intentionally designed with a wide left margin to allow space for your questions, comments, and notes. I CO N AN D CO LOR KEY : The following icon and color coding is used in our Side Bars and Tips: I C O N T Y P E D E S C R I P T I O N T A X Q U O T E Tax Quotes appear in boxes with a lavender background. S I D E B A R Side Bars appear in boxes with a light yellow background. T A X T I P Tax Tips appear in boxes with a light blue background. T A X P L A N N I N G Tax & Financial Planning Tips appear in boxes with a light T I P green background. T A X P R A C T I C E Tax Practice Tips appear in boxes with a light grey T I P background. HOW TO CO MPLET E YOUR ST UDIES QUI CK LY If you are taking our course because you need to obtain your IRS Continuing Education hours quickly to renew your PTIN; or you are starting a job at a tax preparation office and you need to learn the material quickly before the tax season starts; you can skip reading the Tax Quotes, Sidebars, Tax Tips, Tax Planning Tips and Tax Practice Tips. The information discussed in them is not covered on the quizzes or final exam. You can return next summer when you have more time and read them at that time. However, if you are not in a hurry we strongly recommend that you read all of the above as they will enhance your knowledge of the tax laws and expand your understanding of the topics covered in this course. ii

4 K E Y T A X N U M B E R S Adoption Credit Child with special needs $13,190 Other adoptions, qualified expenses Up to $13,190 Alternative Minimum Tax Exemptions Married Filing Jointly $82,100 Married Filing Separately $41,050 Single or Head of Household $52,800 Tax Rates First $182,500 ($91,250 MFS) of AMTI 26% Over $182,500 of AMTI 28% Capital Gains (Long Term) and Qualifying Dividends Tax Rates 10% or 15% Tax Bracket 0% More Than 15% But Less Than 39.6% Tax Bracket 15% 39.6% Tax Bracket 20% Un-recaptured Section 1250 Gains 25% Capital Gains on Collectibles 28% Domestic Production Activities Deduction 9% Earned Income Tax Credit Single, Head of Household, Qualifying Widow Maximum Earnings Maximum EITC No Children $14,590 $496 One Child $38,511 $3,305 Two Children $43,756 $5,460 Three Children $46,997 $6,143 Married Filing Jointly No Children $20,020 $496 One Child $43,941 $3,305 Two Children $49,186 $5,460 Three Children $52,427 $6,143 Education American Opportunity Credit $2,500 Coverdell ESA $2,000 Lifetime Learning Credit $2,000 Student Loan Interest Deduction $2,500 Tuition and Fees Deduction Tier 1 $4,000 iii

5 Tuition and Fees Deduction Tier 2 $2,000 Elective Deferrals Limits 401(k), 403(b), 457 plans $17,500 Salary Reduction SEP $17,500 Additional Contribution Age 50 or Older $5,500 SIMPLE IRA $12,000 Additional Contribution Age 50 or Older $2,500 Employer Provided Transportation Exclusion Transit Passes and Commuter Vehicles $250 per month Qualified Parking $250 per month Qualified Bicycle Commuting $20 per month Exemptions Personal and Dependent $3,950 Estate $600 Simple Trust $300 Complex Trust $100 Exemption and Itemized Deduction Phase-out's (beginning at) Single $254,200 Married Filing Jointly or Qualifying Widow(er) $305,050 Married Filing Separately $152,525 Head of Household $279,650 Filing Requirements IF you're filing status is iv AND at the end of 2014 you were THEN you should file a return if your gross income was at least Single Under 65 $10, or older $11,700 Under 65 (both spouses) $20,300 Married Filing Jointly 65 or older (one spouse) $21, or older (both $22,700 spouses) Married Filing Separately Any age $3,950 Head of Household Under 65 $13, or older $14,600 Qualifying Widow(er) Under 65 $16, or older $17,550

6 Foreign Earned Income Exclusion $99,200 Gift Tax Exclusion $14,000 Spouse Unlimited Non-U.S. Citizen Spouse $145,000 Health Savings Accounts (HSA s) Maximum Annual Contribution Limits Self-Only Coverage $3,300 Family Coverage $6,550 Additional Over Age 55 $1,000 Minimum Deductible Self-Only Coverage $1,250 Family Coverage $2,500 Maximum Out of Pocket Self-Only Coverage $6,350 Family Coverage $12,700 IRA Contributions Traditional $5,500 Age 50 or Older $6,500 Roth $5,500 Age 50 or Older $6,500 Kiddie Tax Age Limit 18 Unearned Income Limitation $2,000 Long Term Care Premiums (deductible) Age 40 or Under $370 Age 41 to 50 $700 Age 51 to 60 $1,400 Age 61 to 70 $3,720 Age 71 and Over $4,660 Medical Savings Accounts (MSA s) Premium for High Deductible Self Coverage $2,200-$3,250 Family Coverage $4,350-$6,550 Maximum Out of Pocket Self Coverage $4,350 Family Coverage $8,000 Mileage Rates v

7 Business $0.56 Medical and Moving $0.235 Charitable $0.14 Section 179 Expense $500,000 Social Security Payback At full retirement age or older No limit on earnings Under full retirement age $1 of benefits will be deducted for each $2 earned above $15,480 In the year full retirement is reached $1 of benefits will be deducted for each $3 earned above $41,400 Social Security Wage Base Social Security Wage Base $117,000 Maximum Social Security Tax $7,254 Standard Deductions Base Amount Add for Blind or > 65 Single $6,200 $1,550 Married Filing Jointly $12,400 $1,200 Married Filing Separately $6,200 $1,200 Head of Household $9,100 $1,550 Qualifying Widow(er) $12,400 $1,200 Dependent of Another $1,000 or Earned Income + $350 $1,200 or $1,550 if Single or HOH vi

8 Lesson 1 Lesson 1 - Our Federal Tax System In this lesson you'll learn about the history of our federal tax system and how it works today. The following topics are discussed in this lesson: The Revolutionary War Period The Post-Revolutionary War Period The Civil War Period The Post-Civil War Period The 16th Amendment The 1920 s The 1930 s The Social Security Act The World War II Period The Post-World War II Period The 1960 s Medicare The Economic Recovery Tax Act of 1981 The Tax Reform Act of 1986 IRSRRA of 1998 EGTRRA of 2001 JGTRRA of 2003 The Modern Income Tax What are the different types of taxes? T he federal tax system in the United States has been marked by significant changes over the years in response to the ever changing role of the government. While the law itself is complex, the concept is relatively simple. Income from all sources is taxed, unless specifically exempted by the law. The types and amounts of tax collected are completely different than they were 200 years ago. Some of these changes are traceable to specific events, such as a war, or the passage of the 16th Amendment which gave Congress 1

9 the power to levy a tax on personal income. Other changes were more gradual, responding to changes in society, the economy, and in the role of the federal government. For most of our country's history, individuals rarely had any contact with the federal government as most of the government's tax revenues were derived from excise taxes, tariffs, and customs duties. In 1765, the English Parliament needing funds to pay for its war against France, passed the Stamp Act, the first tax imposed directly on the American colonies. Colonists lacked representation in the English Parliament. This led to the rallying cry of the American Revolution "taxation without representation is tyranny" and established a persistent wariness regarding taxation. On December 16, 1773 a group of Americans disguised as Indians board a ship and throw 342 chests filled with tea into Boston Harbor to protest England s tax on tea. The Boston Tea Party is perhaps the most famous event in U.S. tax history. Before the Revolutionary War, the federal government had only a limited need for revenue, while each of the colonies had greater responsibilities and revenue needs, which were met with different types of taxes. The south taxed primarily imports and exports, the middle colonies imposed a property tax and a "head" or poll tax levied on each adult male, and the northern colonies taxed real estate, had excises taxes, and taxes based on occupation. The Revolutionary War Period To pay the debts of the Revolutionary War, Congress levied excise taxes on distilled spirits, tobacco and snuff, refined sugar, carriages, property sold at auctions, and various legal documents. The Articles of Confederation of 1781 reflected the American fear of a strong federal government. The federal government had few responsibilities and no tax. It relied solely on donations from the States. When the Constitution was passed in 1789, it was recognized that no government could function if it relied entirely on other governments for its resources. Therefore, the federal government was granted the authority to raise taxes. Article I, Section 8, Clause 1 of the U.S. Constitution states Congress shall have the power to impose "Taxes, Duties, Imposts and Excises,". However 2

10 Article I, Section 9 requires that, "No Capitation, or other direct, tax shall be laid, unless in Proportion to the Census or enumeration herein before directed to be taken." Therefore, any taxes imposed had to be uniform throughout the United States. The Constitution limited Congress' ability to impose direct taxes, by requiring it to distribute taxes in proportion to each state's population. The table below shows how long it took the average American to prepare his or her tax return last year. Major Form Filed or Type of Taxpayer Percentage of Returns All Taxpayers 100% $200 Major forms filed: Total Time % $ A 19% $ EZ 12% $40 Type of Taxpayer: Nonbusiness * 68% $110 Business * 32% $410 * Taxpayers are considered business filers if they file one or more of the following with Form 1040: Schedule C, C-EZ, E, F, Form 2106 or 2106-EZ. Taxpayers are considered nonbusiness filers if they did not file any of those schedules or forms with Form 1040 or if they file Form 1040A or 1040EZ. Source: Internal Revenue Service Table: Time it takes to prepare return Record Keeping Average Time Burden (Hours) Tax Planning Form Completion & Submission All Other Average Cost T a x Q u o t e "It would be thought a hard government that should tax its people one tenth part." Benjamin Franklin ( ) Founding Father of the United States 3

11 The Post-Revolutionary War Period After the Revolutionary War the citizens had representation, but many still opposed taxes. From 1791 to 1802, the federal government was supported by taxes on distilled spirits, carriages, refined sugar, tobacco and snuff, property sold at auction, corporate bonds, and slaves. In 1794, farmers in Pennsylvania opposed the tax on whiskey, forcing President Washington to send federal troops to suppress the Whiskey Rebellion, and establishing the important precedent that the federal government was determined to enforce its revenue laws. On the other hand, The Whiskey Rebellion also established that the resistance to taxes that led to the Declaration of Independence and the Revolutionary War did not evaporate with the new federal government. To raise money for the War of 1812, Congress imposed additional excise taxes, sales taxes on gold, silverware, jewelry, and watches, and raised certain customs duties. Congress also raised money by issuing Treasury notes. In 1817 Congress did away with those taxes, relying solely on tariffs on imported goods, and for the next 44 years the federal government collected no taxes. T a x Q u o t e "Our Constitution is in actual operation; everything appears to promise that it will last; but in this world nothing is certain but death and taxes." Benjamin Franklin ( ) Founding Father of the United States The Civil War Period The Revenue Act of 1861, the first U.S. personal income tax, was imposed on August 5, This tax on personal income was a new direction for a federal tax system. It was amended on July 1, It taxed 3% of all incomes from $600 to $10,000 per year. The standard deduction was $600. Individuals with an annual income of more than $10,000 paid a 5% tax rate. This tax was the forerunner of our modern personal income tax as it was based on the concepts of graduated taxation and "withholding at the source" by employers. An "inheritance" tax also made its debut. The Act of 1862 established the office of Commissioner of Internal Revenue. The Commissioner was given the power to assess, levy, and collect taxes, 4

12 and the right to enforce the tax laws through seizure of property and through prosecution. By 1866, tax collections had reached their highest point in history. The federal government collected more than $310 million. In 1867, heeding public opposition to the income tax, Congress cut the tax rate. The need for federal revenue declined sharply after the war and the personal income tax was abolished in The Post-Civil War Period With the passage of The Wilson Tariff Act in 1894 Congress revived the flat rate federal income tax at a rate of 2%. The Bureau of Internal Revenue was created with an income tax division. However, the Supreme Court ruled the law unconstitutional in Pollock v. Farmers' Loan & Trust Co. the following year. The Supreme Court ruled that taxes on rents from real estate, interest income, dividend income, and from personal property were direct taxes on property, and therefore had to be apportioned according to the population of each state. Under the Constitution, Congress could impose direct taxes only if they were levied in proportion to each State's population. Thus, a federal income tax was impractical from the time of the Pollock decision until ratification of the Sixteenth Amendment in What seemed to be a straightforward limitation in the Constitution on the power of the Congress proved inexact and unclear when applied to an income tax. The Bureau of Internal Revenue s income tax division was closed. From 1896 until 1910 the Federal government relied heavily on high tariffs for its revenues. The War Revenue Act of 1899 raised funds for the Spanish- American War through the sale of bonds, taxes on recreational facilities, and it doubled the tax on beer and tobacco. The War Revenue Act expired in From 1868 to 1913, 90% of all revenue was collected from excise taxes on liquor, beer, wine and tobacco. In 1909 the Payne-Aldrich Tariff Act enacted an income tax on the privilege of conducting business as a corporation. It was affirmed by the Supreme Court in Flint v. Stone Tracy Co. Sometuimes referred to as the Corporate Income Tax Act of 1909, it was the United States's first corporate income tax law. It layed the ground work for the 16th Ammendment - the individual income tax. 5

13 The table below shows how long Americans work each year to pay their taxes: Number of Days Per Year Year Spent Working to Pay Taxes All Taxes as a Percentage of Income % % % % % % % % % % % % % % % % % % % % % % % % % % Source: Table: Total Effective Tax Rates 6

14 The 16th Amendment In 1909 President Taft recommended that Congress propose a constitutional amendment that would give the government the power to tax incomes without apportioning the burden among the states populations. The 16th amendment was ratified by Wyoming on February 3, 1913, providing the three-quarter majority of states necessary to amend the Constitution. It allowed the Federal government to tax the income of individuals without regard to the population of each State. The 16th Amendment states "The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration". It made the income tax a permanent fixture in the U.S. tax system and resulted in a revenue law that taxed incomes of both individuals and corporations. On October 3, 1913 President Woodrow Wilson signed into law the Revenue Act of 1913, also known as the Tariff Act of Congress levied a 1% tax on net personal incomes above $3,000 - rising to 6% on incomes of more than $500,000. Less than 1% of the population was subject to the income tax in At that time the average annual wage for a worker in the U.S. was under $1,300, so only the wealthy had to file a tax return. The $3,000 filing threshold in 1913, when adjusted for inflation, is the equivalent of about $69,573 in today s dollars. The income tax only applied to 358,000 highincome taxpayers. By 1944 that number grew to 47.1 million, and today it stands at nearly 150 million. The Revenue Act of 1913 also lowered basic tariff rates from 40% to 25%, the lowest rates since the Walker Tariff of In 1913 the first Form 1040 appeared as the standard tax reporting form, and March 1st was the date specified as the filing deadline. The 1 page of instructions for Form 1040 has since grown to 189 pages. Payment was not sent with the first Form(s) The return was verified by a field agent who then sent out tax bills on June 1st with payment due by June 30th. See the top of the first Form 1040 below. 7

15 Figure 1-0: Form 1040 page 1, circa To view the entire 1913 Form 1040 see Appendix A or click here. Before the income tax most citizens were able to pursue their financial affairs without any knowledge by the federal government. Individuals 8

16 earned their money and wealth was accumulated and dispensed with little or no interaction with the federal government. S i d e B a r How does a Bill become a Tax Law? The U.S. Constitution specifically spells out how Congress must consider and adopt tax legislation. Most tax legislation begins with the president who consults with his financial advisors and Treasury Department officials before sending a plan to Congress. He can do this at any time, but he usually does it shortly after the State of the Union address. All tax legislation must originate in the House Committee on Ways and Means. The panel which consists of the most senior and powerful members of the House, holds hearings, makes changes, and forwards the bill to the full House. The bill that the House of Representatives gets from the Committee on Ways and Means is then drafted into legislation and is accompanied by a detailed report that gives the Committee's reasons for recommending the bill. The IRS and the courts may later use this Committee report as an interpretation of the legislation. If the House approves the bill it is sent to the Senate Finance Committee. The Senate Finance Committee is responsible for all Senate legislation dealing with tax matters. They hold hearings and usually make changes before sending the bill to the full Senate. The Senate debates the bill and usually makes additional changes before holding a vote before the full Senate. If the Senate approves an unchanged version of the bill it received from the House, the bill goes to the White House for the president's signature. If the Senate makes changes in the bill it received from the House, it goes to a conference committee whose members are appointed by the Speaker of the House and the President of the Senate. This committee combines the two versions into compromise legislation. The compromise bill goes back to the full House and the full Senate, which each must 9

17 approve the same version of the bill. Once Congress votes, the bill goes to the President for his signature. 10

18 11

19 S I D E B A R What is the Federal Reserve and what does it do? In 1791 the U.S. Government chartered the first Bank of the United States to act as the U.S. central bank for 20 years. In 1811 Congress declined to renew its charter as it was believed to be unnecessary. In 1816 the second Bank of the United States was chartered for 20 years. In 1836 Congress declined to renew its charter as it was also believed to be unnecessary. The Panic of 1907 was started by a failed attempt to corner the stock of United Copper. Subsequent bank and brokerage failures only halted when J.P. Morgan convinced other trust company presidents to provide backing to the Trust Company of America. The Federal Reserve System (Federal Reserve) is the central bank of the United States. It was created in 1913 with the enactment of the Federal Reserve Act in response to a series of financial panics, especially the financial Panic of In the Federal Reserve Act Congress established three key objectives for monetary policy - maximum employment, stable prices, and moderate longterm interest rates. The first two objectives are sometimes referred to as the Federal Reserve's dual mandate. The Federal Reserve s duties include administering the nation's monetary policy, supervising and regulating banks, maintaining a stable financial system and providing banking and monetary services to depository institutions, the U.S. government, and foreign institutions. The United States entry into World War I greatly increased the need for revenue. One problem with the income tax law was how to define "lawful" income. Congress responded by passing the 1916 Revenue Act. It deleted the word "lawful" from the definition of income. Consequently, all income, regardless of how it was obtained, became subject to tax. The Supreme Court would subsequently rule the Fifth Amendment could not be used by bootleggers and others who earned income through illegal activities to avoid paying income taxes. As a result, many who broke various laws and were able to escape prosecution for those crimes were convicted on tax evasion charges. 12

20 The 1916 Act raised the lowest tax rate from 1% to 2% and raised the top rate to 15% on taxpayers with incomes in excess of $1.5 million. The 1916 Act also imposed taxes on estates and excess business profits. The income tax fundamentally changed the relationship between the citizens and the federal government by giving the federal government the right and the need to know all about an individual s or business's financial life. Consequently, in 1916 Congress required that information from income tax returns be kept confidential. Needing still more tax revenue, the War Revenue Act of 1917 lowered exemptions and greatly increased income tax rates. Tax revenues increased from $809 million in 1917 to $3.6 billion in The Revenue Act of 1918, passed to raise even greater sums for the World War I effort, increased income tax rates once again, this time raising the lowest rate to 6%. The top rate of income tax rose to 77%. The Revenue Act of 1918 codified all existing tax laws and pushed the filing deadline forward to March 15th where it remained until 1954 when it was moved ahead to April 15th. In 1918, 5% of the U.S. population paid income taxes, as compared to just 1% five years earlier. By 1939 that number would rise to 6%, and six years later by the end of World War II it would stand at 75%. Today the federal income tax affects 90% of all Americans. The 1920 s The Prohibition Unit was established to enforce the National Prohibition Act of 1919, commonly known as the Volstead Act, which, under the 18th Amendment to the Constitution prohibited the manufacture, sale, and transportation of alcoholic beverages. When it was first established in 1920, the Prohibition Unit was a division of the Bureau of Internal Revenue. On April 1, 1927 it became an independent entity within the Department of the Treasury, changing its name from the Prohibition Unit to the Bureau of Prohibition. The tax rates dropped sharply after World War I. During the 1920s, with a booming economy, Congress cut taxes five times returning the lowest tax rate to 1% and lowering the highest rate to 25%. As tax rates and tax collections declined, the economy got even stronger. 13

21 On a cold wintry morning in February, 1929 two cars; a Cadillac sedan and a Peerless, both outfitted to look like Chicago Police detective sedans, pulled up to the SMC Cartage Company garage at 2122 North Clark Street in the Lincoln Park neighborhood on Chicago's North Side that served as the headquarters of Bugs Moran s North Side Gang. Four gunmen, two disguised as police officers and toting Thompson submachine guns, killed seven men in a storm of seventy machine-gun bullets and two shotgun shells. Figure 1-1: George "Bugs" Moran To show by-standers that everything was under control, the two men in street clothes were "arrested" and came out with their hands up, led by the two phony uniformed cops. Al Capone, the Chicago gangster, had orchestrated the most notorious gangland killing of the 20th century - the St. Valentine's Day Massacre. The massacre was Capone's effort to dispose of Bugs Moran, who, as it turned out, wasn t in the garage at the time. Moran, spotting the police cars outside, had decided to keep walking. No one was ever arrested for the crime. The economy grew steadily during most of the 1920 s. It was a golden age as innovations such as radio, automobiles, aviation, and the telephone became popular. On August 24, 1921, the Dow Jones Industrial Average stood at By September 3, 1929 it had risen more than six fold to During the summer of 1929 it became clear that the economy was contracting and that the stock market would soon go through a series of unsettling price declines. When the New York Stock Exchange opened on the morning of October 24, 1929, nervous traders sensed something was wrong. By 11:00 AM the market was plunging. At noon a group of powerful bankers met secretly at J.P. Morgan & Co., next door to the New York Stock Exchange, and agreed to spend $240 million of their own funds to stabilize the stock market. 14

22 This strategy worked for a few days but the panic broke out again the following Tuesday, October 29, 1929, and there was no stopping it. The stock market crashed. Within three months the stock market lost 40% of its value. $26 billion of wealth disappeared. AT&T lost one-third of its value. General Electric lost one-half of its value. RCA's stock fell by three-quarters within a matter of months. It would take 25 years for the stock market to return to its pre-crash level. The Great Depression began and over the next few years: Unemployment exceeded 25% 10,000 banks failed The Gross National Product declined from $105 billion in 1929 to $55 billion in 1933 Compared to 1920's levels, net new business investment was minus $5.8 billion in 1932 Wages paid to workers declined from $50 billion in 1929 to $30 billion in 1932 Figure 1-2: Chart of the US Gross National Product from 1926 to As the economy shrank, government tax receipts also fell dramatically. S i d e B a r How do taxes affect the economy? Seventy-two percent of our economy is based on consumer spending. Raising taxes takes money from consumers and dampens the economy, because consumers have less money to spend. This results in less retail and home sales and lower investment and savings rates. However, raising taxes can increase public-sector jobs, provided the increased revenues are spent that way. It also helps decrease government debts which dampen the economy. During wartime government spending is much higher and it boosts all phases of the economy. Lowering taxes puts extra money in consumers' pockets. Consumers can then spend this money, boosting retail and home sales and investment and savings rates. However, the extent of this boost depends on how large the tax cut is, and which taxes are cut. Cuts for middle-income and 15

23 low-income people tend to put more money into the economy because these taxpayers are more likely to spend their extra cash right away, on purchases or renovations they have been putting off. Cuts for highincome taxpayers tend not to have the same effect, because this group already has enough money to buy everything they need. High-income taxpayers tend to save their extra money, so cuts for these taxpayers end up being used for investments and savings. Cuts for high-income taxpayers improve the outlook on Wall Street. Cuts in corporate and business taxes give businesses more money to spend, often creating jobs and boosting the bottom line. In 1932, the federal government collected only $1.9 billion in taxes, compared to $6.6 billion in taxes in In the face of rising budget deficits which reached $2.7 billion in 1931, Congress followed the prevailing economic wisdom of the time and passed the Tax Act of 1932 which dramatically increased tax rates. This further improved the government's finances while further weakening the economy. In retrospect, Congress should have lowered tax rates instead of raising them. By 1936 the lowest personal income tax rate had risen to 4% and the highest tax rate had risen to 79%. S i d e B a r How does the federal budget process work? On or before the first Monday in February of each year, the President is required by law to submit to the Congress a budget proposal for the fiscal year that begins the following October. The budget plan sets forth the President s proposed receipts, spending, and the surplus or deficit for the Federal Government. The plan includes recommendations for new legislation as well as recommendations to change, eliminate, and add programs. After receiving the President s proposal, the Congress reviews it and makes changes. It first passes a budget resolution setting its own targets for receipts, outlays, and the surplus or deficit. Next, individual spending and revenue bills that are consistent with the goals of the budget resolution are enacted. 16

24 Flowchart: Federal Income and Expenses 17

25 S i d e B a r Herbert Hoover Presidential Library and Museum Further information about The Great Depression is available in Gallery Six of the Herbert Hoover Presidential Library and Museum. The 1930 s Figure 1-3: Alphonse Gabriel Capone a.k.a. "Scarface Al" During a routine warehouse raid in Chicago in 1931 by the Treasury Department s Bureau of Prohibition, agents Eliot Ness and The Untouchables discovered what was clearly a crudely coded set of accounts in a desk drawer. They, and Frank Wilson, an undercover agent in the Bureau of Internal Revenue s Intelligence Unit, then concentrated on gathering evidence and pursuing Public Enemy No. 1, Al Capone, for his failure to pay income tax on this substantial illegal income. Capone had always done his business through front men and it was previously believed he had no books or accounting records in his own name. Even his mansion was in his wife's name. Capone was tried in federal court in Capone was found guilty on five of 22 counts of tax evasion for the years 1925, 1926, and 1927, and willful failure to file tax returns for 1928 and Capone's legal team offered to pay all outstanding income taxes plus interest and told their client to expect a severe fine. On October 17, 1931 the judge sentenced Capone to eleven years in a federal prison and one year in the county jail, as well as an earlier six-month contempt of court sentence. He ultimately served only six and a half years because of time off for good behavior. He also had to pay fines and court costs totaling $80,000. Capone s isolation from his associates and the repeal of Prohibition ended his criminal career. 18

26 Other notable tax evaders: On October 10, 1973, Spiro T. Agnew, the 39th Vice President of the United States, resigned and then pleaded nolo contendere (no contest) to criminal charges of tax evasion and money laundering; Soviet spy Aldrich Ames earned more than $2 million for his espionage and was also charged with tax evasion as none of the money was reported on his income tax returns. Ames attempted to have the tax evasion charge dismissed on the grounds his espionage profits were illegal, but the charges stood. The $2 million remains to this day in an undisclosed bank account. Russian intelligence has refused to disclose this bank account information in order for the United States to seize it, arguing that that money was rightfully earned by Ames; Leona Helmsley the billionaire New York City hotel operator and real estate investor nicknamed "The Queen of Mean." She was convicted of federal income tax evasion in 1989 and served 19 months in prison, after receiving an initial sentence of 16 years; Irwin A. Schiff, a prominent member of the group which refers to itself as the tax honesty movement, and which has been referred to by the Internal Revenue Service and other government agencies as the tax protester movement. Schiff is known for writing and promoting literature that claims the United States income tax is applied incorrectly. He has lost several civil cases against the federal government and has a record of multiple convictions for various federal tax crimes. Schiff is serving a 13-plus year sentence for tax crimes as Inmate # at the Federal Correctional Institution at Fort Worth, Texas. His projected release date is July 26, S i d e B a r Who was J.K. Lasser? Jacob Kay Lasser was born in Newark, NJ in He took night classes in accounting at New York University from and became a Certified Public Accountant practicing in New York City in In 1938 the publishing house Simon & Schuster commissioned him to author an 19

27 income tax guide. Its first publication in 1939 sold 23,000 copies and hit the best sellers list. Mr. Lasser became an adjunct professor at New York University in 1942 and served as the Institute on Taxation s chairman until his death. Mr. Lasser revised the tax guide each year and by 1946 seven million copies were sold. His books on taxation were used as texts in more than 160 colleges and universities. He died from a heart attack at the age of 57 in His best selling tax guide, J.K. Lasser s Your Income Tax is in its 76th year of continuous publication and today is published by John Wiley & Sons, Inc. We strongly recommend that you purchase a copy of J.K. Lasser s Your Income Tax each year. You can do so from Lesson 30 on the Homework Page. The Tax College is not affiliated with the J.K. Lasser Institute. T a x Q u o t e "Anyone may arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which best pays the treasury. There is not even a patriotic duty to increase one's taxes. Over and over again the Courts have said that there is nothing sinister in so arranging affairs as to keep taxes as low as possible. Everyone does it, rich and poor alike and all do right, for nobody owes any public duty to pay more than the law demands." Judge Learned Hand - ( ), Judge, U. S. Court of Appeals for the 2nd Circuit Gregory v. Helvering 69 F.2d 809, 810 (2d Cir. 1934), aff'd, 293 U.S. 465, 55 S.Ct. 266, 79 L.Ed. 596 (1935) The Social Security Act In 1935 Congress passed the Social Security Act. President Franklin D. Roosevelt signed the program into law on Aug. 14, This law provides payments to the aged, the needy, the handicapped, and to certain minors. These programs were initially financed by a 2% tax, one-half of which was withheld directly from an employee's paycheck and one-half of which was collected from employers. The tax was levied on the first $3,000 of the 20

28 employee's salary or wages. Figure 1-4: Ernest Ackerman Under the original 1935 law, monthly benefits were to start in 1942 (which was subsequently changed to 1940). From 1937 until 1940, Social Security paid benefits to retirees in the form of a single, lump-sum refund payment. The earliest reported applicant for a lump-sum refund was a retired Cleveland motorman named Ernest Ackerman, who retired one day after the Social Security program began. During his one day of participation in the program, a nickel was withheld from Mr. Ackerman s pay for Social Security, and, upon retiring, he received a lump-sum payment of 17 cents. The average lump-sum payment during this period was $ The smallest payment ever made was for 5 cents. Ida May Fuller of Ludlow, Vermont filed her retirement claim on November 4, While running an errand she dropped by the Rutland, VT Social Security office to ask about possible benefits. She would later say: "It wasn't that I expected anything, mind you, but I knew I'd been paying for something called Social Security and I wanted to ask the people in Rutland about it." Her claim was taken by Claims Clerk Elizabeth Corcoran Burke and transmitted to the Claims Division in Washington, D.C. for adjudication. The case was reviewed and sent to the Treasury Department for payment. In those days claims were grouped in batches of 1,000 and a Certification List for each batch was sent to the Treasury Department. Miss Fuller's claim was the first one on the first Certification List. 21

29 On January 31, 1940, Ida May Fuller popped open her mailbox and found Social Security check number payable to her in the amount of $ Though hardly a fortune, the check was nonetheless a milestone: it was the first monthly retirement payment made under the Social Security Act. Ida May Fuller had worked for three years under the Social Security program. Figure 1-5: Ida May Fuller The accumulated taxes on her salary during those three years were a total of $ Her initial monthly check was $ She didn t do too badly under Social Security - during her remaining thirty-five years she collected a total of $22, in Social Security benefits nearly 1,000 times more than she contributed. Miss Fuller lived to be 100 years old, dying in Soon after it was passed in 1935, Social Security morphed from a fully funded pension system into a pay-as-you-go system where every generation (except for Ernest s and Ida May s) pays into the system to support the currently-retired generation and relies on the next generation to pay its Social Security benefits. When Ida May Fuller retired, 40 workers were paying taxes to support each Social Security recipient. In 1960, there were 4.9 workers paying Social Security taxes for each person receiving benefits. Today, there are 2.8 workers for each beneficiary, a ratio that will drop to 1.9 workers by 2035, according to projections by the Congressional Budget Office. In 1940, when the Social Security Administration mailed Ida May Fuller the first monthly retirement payment, the retirement age was 65. At that time, workers who survived to age 65 had a remaining life expectancy of 12.7 years for men and 14.7 years for women. By 2011, life expectancy at age 65 was 18.7 years for men and 20.7 years for women, an increase of six full years for both. In 20 more years, life expectancy at age 65 for men is expected to be more than 20 years and more than 22 years for women. In 1940, 220,000 people received Social Security benefits, out of a total population of 132 million. At that time,.1666 percent of the total population 22

30 received benefits. In 2012, 57 million people received Social Security benefits, out of a total population of 315 million. Today, about 18 percent of the total population receive benefits. These figures don t include some 8.3 million people who receive payments under Supplemental Security Income, a program aimed primarily at the blind and disabled that launched in the 1970s. S i d e B a r Fast Facts & Figures About Social Security Fast Facts & Figures About Social Security answers the most frequently asked questions about the programs the Social Security Administration administers. To get your copy click here. In 1939, Congress again codified the income tax laws and all subsequent tax legislation until 1954 amended the 1939 tax code. The World War II Period The Revenue Act of 1942 was hailed by President Franklin Roosevelt as "the greatest tax bill in American history". It increased taxes and the number of Americans subject to the income tax, created deductions for medical expenses and investment expenses, and reduced the personal exemption amount from $1,500 to $1,200 for married couples. The exemption amount for each dependent was reduced from $400 to $350 and a 5% Victory tax on all individuals with incomes over $624 was created, with postwar credit. The top tax rate reached 94% during the World War II and remained at 91% until In 1943 Congress re-introduced payroll withholding, as had been done during the Civil War, with the Current Tax Payment Act. This greatly eased the collection of the tax for the Bureau of Internal Revenue. It also greatly reduced the taxpayer's awareness of the income tax by increasing its transparency, which made it easier to raise taxes in the future. 23

31 Figure 1-6: Form W-2 - Statement of Income Tax Withheld on Wages, circa Payroll withholdings are reported to the employee and the IRS on Form W-2. Tax withholding was also introduced in the Tariff Act of 1913, but repealed by the Income Tax Act of The Current Tax Payment Act required employers to withhold taxes from employees' wages and pay them directly to the government on the workers' behalf quarterly. In 1944 Congress passed the Individual Income Tax Act, which created the standard deductions on Form 1040, raised individual income tax rates, and repealed the Victory Tax. It standardized the value of personal exemptions at $500 per person. There were about 60 million taxpayers. The Post-World War II Period President Eisenhower reorganized the Bureau of Internal Revenue in 1953 and replaced its patronage system with career, professional employees. The IRS commissioner and chief counsel are selected by the president and confirmed by the Senate. The Bureau s name was changed to the Internal Revenue Service to stress the "service" aspect of its work. On August 16, 1954 the Internal Revenue Code of 1954 was enacted by Congress, succeeding the Internal Revenue Code of The Code temporarily extended the Revenue Act of 1951's 5% increase in corporate tax rates through March 31, 1955, increased depreciation deductions by providing additional depreciation schedules, and created a 4% dividend tax credit for individuals. References to the Internal Revenue Code subsequent to 1954 generally mean Title 26 of the United States Code, as amended. The basic structure of Title 26 remained the same until the enactment of the 24

32 comprehensive revisions contained in Tax Reform Act of 1986, although individual provisions of the law were changed regularly. The Social Security system remained basically unchanged until In 1956 Social Security began an evolution and more and more benefits were added, beginning with Disability Insurance benefits. In 1958, benefits were extended to dependents of disabled workers. In 1967, disability benefits were extended to widows and widowers. By 1959, the IRS had become the world's largest accounting, collection, and forms processing organization. Computers were introduced to automate and streamline its work and to improve service to taxpayers. In 1961, Congress passed a law requiring individual taxpayers to use their Social Security numbers on tax forms. The 1960 s The Revenue Act of 1964 was signed by President Lyndon Johnson on February 26th, It reduced individual income tax rates from 91% to 70%, and reduced the top corporate rate from 52% to 48%. A minimum standard deduction of $300 plus $100 per exemption was created. S i d e B a r Does raising income tax rates increase revenues to the federal government? Although conventional wisdom holds that increasing income tax rates or eliminating deductions for wealthier Americans will generate greater revenue for the U.S. Treasury, history shows otherwise. The Dow Jones Industrial Average dropped by about half, from 119 in November 1919 to 64 in August Double digit unemployment ensued. The federal government made it clear it would not intervene except to raise interest rates, cut taxes and reduce the size of the government. The economy recovered so quickly that the stock market crash of of 1919 is largely forgotten. During the 1920's Presidents Warren Harding and Calvin Coolidge cut the top marginal income tax rates from 77% to 25% only to see federal revenues rise dramatically as the economy grew increasingly stronger. 25

33 The rich, who at that time were earning more than $50,000 per year, went from paying 44% of total income tax revenues to paying 78.4%. On December 14, 1962 the 35th President of the United States, John F. Kennedy delivered a speech to the Economic Club of New York in which he stated: It is increasingly clear that... an economy hampered by restrictive tax rates will never produce enough revenues to balance our budget just as it will never produce enough jobs or enough profits... In short, it is a paradoxical truth that tax rates are too high today and tax revenues are too low and the soundest way to raise the revenues in the long run is to cut the rates now. After Presidents Kennedy and Lyndon Johnson slashed the capital gains tax and cut the top marginal tax rate from 91% to 70% federal tax revenues rose from $91 billion in 1960 to $153 billion in During those years the rich saw their total share of revenues increase by 57% while the poor's share increased by just 11%. During President Ronald Reagan's term in office ( ) he cut taxes but doubled revenue, and decreased unemployment from 7% to 5.4% and inflation from 13.5% to 4.1%. In the Reagan years, the top 1% of earners paid 57.2% of taxes, up from 48%. 26

34 The table below shows how much money the federal government collects each year in taxes: Total Individual Individual Year Total Tax Collections % Increase Income Tax Collections % Increase Tax % of Total 1960 $91,774,803,000 $44,945,711, % 1970 $195,722,096, % $103,651,585, % 52.96% 1980 $519,375,273, % $287,547,782, % 55.36% 1990 $1,056,365,652, % $540,228,408,000 88% 51.14% 2000 $2,096,916,925,000 99% $1,137,077,702, % 54.23% 2001 $2,128,831,182,000 2% $1,178,209,880,000 4% 55.35% 2002 $2,016,627,269,000-5% $1,037,733,908,000-12% 51.46% 2003 $1,952,928,045,000-3% $987,208,878,000-5% 50.55% 2004 $2,018,502,103,000 3% $990,248,760,000 0% 49.06% 2005 $2,268,895,122,000 12% $1,107,500,994,000 12% 48.81% 2006 $2,518,680,230,000 11% $1,236,259,371,000 12% 49.08% 2007 $2,691,537,557,000 7% $1,366,241,437,000 11% 50.76% 2008 $2,745,035,410,000 2% $1,425,990,183,000 4% 51.95% 2009 $2,345,337,177,000-15% $1,190,382,757,000-17% 50.76% 2010 $2,345,055,978,000 0% $1,175,989,528,000-1% 50.15% 2011 $2,414,952,112,000 3% $1,346,182,227,000 14% 55.74% 2012 $2,524,320,134,000 5% $2,172,233,368,000 61% 86.05% 2013 $2,855,059,420,000 13% $2,462,201,645,000 13% 86.24% 2014 $3,064,301,358,000 7% $2,575,871,018,000 5% 84.06% Table: Internal Revenue Gross Collections Medicare In 1965 Congress enacted the Medicare program which provides for the medical needs of persons aged 65 or older. Social Security Amendments created the Medicaid program which provides medical assistance for people with low incomes and resources. The expansions of Social Security and the creation of Medicare and Medicaid required additional tax revenues. In 1972 benefits were indexed for the cost of living. In 1949 the FICA payroll tax rate was 2%. The expansions in 1965 led to further rate increases, with the combined payroll tax rate climbing to 15.3 % by The maximum Social Security tax burden rose from $60 in 1949 to $7,849 by

35 The Economic Recovery Tax Act of 1981 In the late 1960s and through the 1970s there was persistent and rising inflation, ultimately reaching 13.3% in During this time, the income tax was not indexed for inflation. Despite repeated tax cuts, the tax burden of the citizens rose. The Economic Recovery Tax Act of 1981, which enjoyed strong bi-partisan support in Congress, was passed on August 4, 1981 and was signed into law by President Ronald Regan on August 13, It was the largest tax cut in U.S. history. It amended the Internal Revenue Code of 1954 to encourage economic growth through reductions in individual income tax rates, first year expensing of depreciable property, incentives for small businesses, and incentives for savings. The Accelerated Cost Recovery System was implemented for depreciation. The Act reduced the income tax rates by approximately 25% over three years with the top rate falling from 70% to 50% and the bottom rate falling to 11%. The rates were indexed for inflation, although indexing was delayed until 1985, and a 10% Investment Tax Credit was implemented to spur capital formation. The tax cuts resulted in deficits in the federal budget in the 1980s and early 1990s, but also created an economic expansion. The Tax Reform Act of 1984 tries to plug loopholes and ensure that all taxpayers pay a fair share of the tax burden. It also reforms taxation of international income, and tries to improve the administration and efficiency of the tax system. The Tax Reform Act of 1986 The Congress passed the Tax Reform Act of 1986 on October 22, President Reagan signed the most significant piece of tax legislation in 30 years. It contained 300 provisions and took three years to implement. The Act codified the federal tax laws for the third time since the Revenue Act of It simplified the income tax code, broadened the tax base and eliminated many tax shelters and other preferences. The top tax rate was lowered from 50% to 28%, the lowest it had been since 1916, while the bottom rate was raised from 11% to 15% - the only time in history that the top rate was reduced and the bottom rate increased concurrently. 15% and 28% became the only two income tax brackets. The capital gains tax rate was the same as for ordinary income. Interest on consumer loans and state and local sales tax were no longer deductible. Income averaging, which reduced taxes for those only recently making a much higher income than before, was eliminated. The Act increased the personal exemption and the 28

36 standard deduction. Deductions for passive activities were limited to remove the tax benefits of many tax shelters, especially for real estate investments. Also in 1986, limited electronic filing began. Flowchart: Number of Days Worked T a x Q u o t e "Government is saying to the average citizen every January 1: 'For the next five months you ll be working for us, for goals we shall determine. Is that clear? After May 5 you may look after your own needs and ambitions, but report back to us next January. Now move along.' If nearly half of what you make is spent by someone else, that means that half your work time is spent working for someone else. Call me a radical, but I think that comes dangerously close to being a form of indentured servitude." Richard "Dick" Armey ( ) House Majority Leader ( ) 29

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