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Concepts Underlying the U.S. Tax Code.
The U.S. federal income tax is one of the most complex pieces of legislation ever written. People build high-paying careers based on trying to unravel and interpret the tax code. I’ve spoken to IRS agents that directly admit that even they don’t always know exactly what the code intends. This helps explain why, in addition to the Internal Revenue Code of 1986, there are Treasury Regulations, revenue rulings, private letter rulings, tax memorandum, as well as Tax Court rulings that all try to shed light on this convoluted piece of writing. It seems strange that something so basic to good government should be so very complex and today there are hundreds of thousands of people who all claim to have a better solution. Why so complicated though? The code is built around some broad general concepts that set the tone for the tax rules. If you do your own taxes, or are just interested in tax research, you these concepts are the place to start building your knowledge.
The first important concept to understand is the ability-to-pay. It sounds simple: the tax code is structured so that taxes levied on a taxpayer should be based on the amount a taxpayer can actually pay. The effect of this concept is that you don’t pay taxes based on just income, but rather on net income, total income less deductions. Losses suffered from casualty or business reduces your income and thus your ability to pay. Similarly, the more children you have, the less you can afford to pay.
A second effect of this is the progressive tax system. Now, I know there are a number of complaints with the progressive tax system. Many argue that citizens that make more money shouldn’t have to shoulder a greater portion of the burden. (I would point out that these comments are usually NOT attributed to the top 1% richest people who pay 85% of the nation’s taxes. It’s usually the upper-middle class.) The progressive tax rate reflects the fact that those who make more money can afford to pay more tax.
Administrative Convenience Concept
Do you keep track of every penny you make when you do your budget? Of course not, there are some things you spend money on that don’t really impact your financial situation, for instance change for gumballs. Keeping track of your gumball spending probably isn’t worth the money you might save. The federal government feels the same way. For instance, any benefit you receive from your employer is considered to be income, right? What about the free coffee you get in the break room? Technically, this is a benefit and should be considered part of your annual income. But how do either you or the company keep track of how many cups of coffee you drink annually? More importantly, is the revenue generated by tracking your coffee benefit going to out-weigh the cost of keeping track of it. When you drink as much coffee as I do, the answer is maybe, but for most of us, probably not. So there are some items that, for the sake of administrative convenience, the IRS doesn’t require you to keep track of.
It’s this same concept that the standard deduction for individuals was developed. For many of us who don’t spend a lot on medical expenses or who don’t own a home or don’t drive, it isn’t worth the time and expense to try and keep track of what little we spend for tax purposes. And so, in order to allow taxpayers to include these small amounts against their income, the standard deduction was implemented.
Arm’s-Length Transaction Concept
The federal government has no objection to its citizens trying to minimize the amount of tax due at the end of the year. What they object to is either breaking the law to avoid taxes or manipulating transactions in ways that fail to reflect the economic reality of the transaction. The arms-length transaction concept is based on the idea that transactions are completed in a way such that bargaining is done in good faith and for their individual benefit, not for the benefit of the whole group. Failure to abide by this concept can result in failing to gain any tax effect or not gaining the intended effect. An example might help clarify this.
Let’s say that John is a sole proprietor of the Feats of Strength Shoe Company. He has a piece of equipment that he bought for $10,000 and is currently worth $12,000. He sells the equipment to the company for $500 and puts the $11,500 loss on his Form 1040, schedule C. Six months later he gets a letter from the IRS saying that the loss is disallowed and they are going to be stopping by to visit soon. In essence, what he did was to sell the piece of equipment to himself, since he is the sole owner of the business. What if he had sold it to his grandmother? Still a related party transaction, disallowed.
What are the guidelines you need to know? Who’s considered to be a related party?
- Family members: Self, spouse, siblings, descendants (children and grandchildren), and ancestors (parents and grandparents).
- Sales between an individual and a corporation or partnership if the individual owns more than 50% of the business. Why 50%? Generally a partner who owns 50% of a business is considered to be in control of the business.
- Transactions between a corporation and a partnership, if an individual owns more than 50% of both businesses.
What if our friend John only owns 20% of the business while his wife and best friend both control 40%? Under constructive ownership rules, John and his wife are essentially one entity who therefore control 60% of the company.
There is a fundamental truth that the government doesn’t want you to know! Much like law enforcement the income tax system works by voluntary compliance. And the majority of Americans comply with it. They understand the value they receive from their taxes, like highways and national defense. In order to aid this compliance, taxes are collected periodically throughout the year through withholding and quarterly estimated tax payments. For people receiving salaries from an employer, regular deductions for withholding help implement this concept. For the self-employed, contract employees or Social Security beneficiaries, this may not be as easy. Instead, the IRS requires estimated quarterly payments for those whose tax liability is at least $1,000.
So these are the four general concepts that guide our tax laws. In theory, law makers use these as they build amendments to the IRC. As you can no doubt guess, too often these concepts are thrown out in favor of short sighted changes that are intended to benefit special interest groups. At least now you know what the underlying concepts are and if you find yourself discussing tax issues with your state’s Representative, or doing some research on a tax issue, you’ll know what to look for as you build your case.