Glossary of Tax Terms
If the IRS or some other taxing authority says you owe more than you think you do or you are seeking to pay what you owe and no more, this tax law keyword glossary is for you. After all, you need to have some idea of the lingo to understand how to work with a tax attorney to save you the big bucks (and, perhaps, avoid jail time).
Tax Law Keyword Glossary
Abusive Tax Scheme
It’s okay to pay the least amount of taxes legitimately owed, but it’s not okay to avoid paying what is actually owed by using illegal transactions. Qualified tax attorneys will help you to work within the law to minimize your taxes. Abusive tax schemes are a “no no” and will land you in hot water (aka jail).
For example, Craig and Sami set up an offshore trust to avoid paying income taxes on their earnings. This is an abusive tax scheme because while offshore trusts may help you protect your assets from future creditors, they can’t be used to avoid tax liabilities. Americans owe taxes to the U.S. government no matter where they live and no matter where assets are situated.
Adjusted Gross Income (AGI)
Your “gross income” is your income from all sources.
Your “Adjusted gross income” is your income minus appropriate adjustments for personal exemptions and itemized deductions.
For example, Jeff, a writer and actor, figured out his adjusted gross income by taking his gross income and subtracting his business expenses such as traveling costs, a NYC apartment, software, computer hardware, continuing education, books, agent, and manager expenses.
Annual Exclusion Amount
The amount that you can gift each calendar year to an unlimited number of people, without incurring any gift tax, is referred to the “annual exclusion amount”. In 2013, that amount is $14,000 for individuals and $28,000 for married couples (whose marriage is recognized by the federal government).
For example, Joe won $55 million in the lottery and wanted to do nice things for the people in his life. He already had paid high income taxes on that money and didn’t want to incur gift taxes on the transfers.
Upon the advice of his tax attorney, Joe decided to give $14,000 gifts to each of his children, his grandchildren, friendly neighbors, the paperboy, the mailman, each of his coworkers, etc.
Joe could actually give away every dollar he won in $14,000 allotments and never pay gift taxes on any of the gifts. Plus, he could put 5 years worth of annual exclusion amounts in 529 Plans for all of those people (to the tune of $70,000 each and still not incur any gift tax).
Capital Gains Tax
Capital gains tax is a type of income tax, usually taxed at a much lower rate than ordinary income. In addition, although it’s not normally defined as such, the capital gains tax is technically a transfer tax as we’ll.
- A capital gain is the difference between the amount you paid for an investment and the amount you sold that investment for.
- The capital gains tax, taxes that difference.
- The capital gains tax rate is:
- 10% – 20% for investments owned for more than a year. The actual rate depends upon your overall income.
- Taxed at your ordinary income tax rate for investments owned for a year or less.
For example, Jane bought stock for $10 a share. Five years later, she sold the stock for $15 a share. Thus, Jane realized a capital gain of $5 per share. Here’s the math: $15 selling price – $10 purchase price = $5 capital gains per share.
Jane had 100 shares, so she owed a capital gain tax of $75. Here’s the math: 100 shares x $5 gains x 15% tax rate =
WARNING: Ask your tax lawyer whether it’s in your best interests to transfer your investments, including your house, during your lifetime or at your death. Although it’s natural to want to take care of things during your lifetime, your assets get a step up in basis at your death, which may save thousands of dollars in capital gains taxes.
Credit – Tax Credit
A tax credit lowers the actual amount you owe in taxes, dollar for dollar.
- A credit is more valuable than a tax deduction because a deduction only lowers your taxable income.
- Both credits and deductions are used to encourage certain behaviors.
For example, Ken and Barbie adopted a child in 2012 so they received a $5,000 tax credit to cover their adoption expenses. The taxes Ken and Barbie pay are actually reduced by $5,000.
On the other hand, Ken and Barbie donated $5,000 to the Animal Rescue League. They will be able to deduct $5,000 from their income thus saving the taxes on that income, which are about $1,400.
A correspondence audit refers to an IRS demand for documentation of some statement you’ve made on your tax return. However, instead of having to appear before an IRS agent in person, you are able to mail in the documentation requested.
For example, Becca and Dan received a letter from the IRS asking for documentation of the $5,000 they donated to their library. They mailed in the letter from the library thanking them for their $5,000 donation.
Currently Not Collectible
If you really can’t pay your tax debt, the IRS may add you to the “currently not collectible” list. Your status on this list will be reviewed from time to time.
For example, the IRS determined that Gabriel owed $40,000 in back taxes and they garnished his wages. In an unrelated case, Gabriel was convicted and sent to jail for theft by deception. He had no wages or assets, so the IRS put him on the “currently not collectible” list.
Deduction – Tax Deduction
A tax deduction reduces your taxable income and, therefore, eliminates the taxes you would have paid on that income.
- So, if you’re in the 28% tax bracket, each dollar in deductions saves you 28 cents.
- If you have $10,000 in tax deductions, you’ll actually save $2,800 in taxes.
- On the other hand, a tax credit lowers the amount you owe in taxes, dollar for dollar. So, if you have a $10,000 tax credit, you’ll actually save $10,000 in tax dollars.
- Both tax credits and tax deductions are used to encourage certain behaviors.
For example, Elizabeth and Stan added solar panels to their home and received a tax credit of $10,000. That $10,000 credit repaid them for $10,000 worth of solar panels.
In addition, Elizabeth and Stan paid $10,000 in mortgage interest and were able to deduct that amount on their taxes. The mortgage interest deduction saved them $2,500 because they are in the 25% tax bracket. (The math is $10,000 x 25% = $2,500.)
An enrolled agent is an IRS employee who has passed a test covering all aspects of federal taxation.
For example, Alex and his tax attorney met with an enrolled agent to discuss his mother’s estate and applicable taxes due.
Estate Tax Exemption – Gift Tax Exemption
Each individual has a large tax exemption that she can use during her lifetime or at her death. In 2013, that exemption amount is $5.12 million – that’s $5,120,000.
- This means that you can give away, during your lifetime or leave to your loved ones at your death, up to $5.12 million without incurring either gift or federal estate taxes.
- If you’re married – and the federal government recognizes that marriage – this amount is doubled to $10.24 between the two of you.
If you do have more money than the exemption protects, any funds you transfer will be taxed at a whopping 40% – meaning for each $1 you transfer, 40 cents in taxes will be paid. Fortunately, tax attorneys know how to legally minimize the taxes paid on transfers.
For example, Ben died with a net worth of $10.12 million, which he left to his friend, Josh. He had no tax planning. $2 million was due in federal estate taxes.
Had Ben done proper estate planning, perhaps with a life insurance trust and a charitable trust, $0 would have been due in federal estate tax.
Federal Estate Tax
The tax levied by the federal government on the transfer of wealth at an individual’s death is called the “federal estate tax”. If your estate owes federal estate tax, about 40 cents on each and every dollar will go to taxes, not your loved ones.
- Fortunately, there is a federal estate tax exemption, which in 2013 is the unused portion of your $5.12 million exemption. This exemption can be used during your lifetime or at your death.
- There’s more good news. Tax attorneys consider the federal estate tax to be a voluntary tax in that if you don’t plan, you volunteer to pay it.
- What does this mean? It means that you won’t pay the federal estate tax if you do good planning.
- While tax planning has to be balanced with other goals, the federal estate tax can be minimized or eliminated entirely.
- The tax rate for assets going to a spouse or a charity is 0%.
For example, Craig and Richard were married in the eyes of Connecticut law, but not the federal government. They had been together for 26 years when Craig died. He left everything he owned to Richard.
If Craig had been married to a woman, $0 in federal estate taxes would have been due. Instead, $2 million in federal estate taxes were due.
Couples, whose marriage is not yet recognized by the federal government, need to do an extra layer of planning to get the benefits heterosexual couples enjoy automatically.
If the IRS garnishes your wages, you’ll be motivated to call a tax attorney fast. Why? A garnishment means that you don’t get the money you’ve earned.
- If the IRS says you owe them money, they have the legal authority to garnish your wages, meaning that they have the power to order your employer to send them your earnings, minus a small amount.
- The garnishment will continue until the tax debt is paid off.
For example, Leslie was overwhelmed with her divorce and trouble with her children and job. When she received an audit notice from the IRS, she threw the letter away. The IRS garnished her wages to pay off the debt and she didn’t have enough money to pay her rent and utility bills.
WARNING: Do not ignore correspondence or telephone calls from the IRS or any other taxing authority. Your inaction may result in a taxing authority taking your earnings or levying against your bank account, house, car, boat, and other property. Your tax attorney needs to review any correspondence you receive from the IRS or any other taxing authority.
Generation Skipping Tax (GST)
Most folks havent heard of the generation skipping tax, but it’s real and demands big money. There’s a huge deduction ($5.12 million in 2013) so the GST doesnt affect most families, but if it does, it’s serious.
- The federal government uses taxes such as the gift tax, federal estate tax, and generation skipping tax to tax wealth as it is transferred from one generation to the next.
- If you try to skip a generation (e.g. give wealth to your grandchildren, instead of your children), the generation skipping tax is triggered, resulting in a tax bill.
However, we have GREAT news. The generation skipping tax is a voluntary tax. You only pay it if you don’t plan. Yes, you heard it here. The generation skipping tax can be totally avoided with good tax planning.
For example, Paula and Michael have 4 financially successful children, so they want to pass the majority of their wealth directly to their grandchildren. They meet with a tax attorney to formulate a plan to carry out their goal.
Their tax attorney explains:
- If they name their grandchildren as outright beneficiaries in their wills, their estates will be hit with a $2 million federal estate tax and a $2 million generation skipping tax bill.
- If they do tax planning, both the federal estate tax and the generation skipping tax can be avoided, saving $4 million in taxes.
You can give lots of money and assets away without paying any gift taxes. In fact most folks can give everything they own away without ever incurring the bite of gift tax. However, for the wealthy, the gift tax is very real and takes a 40% bite out of their pockets.
You can avoid the gift tax by:
- Giving an unlimited amount to an American citizen spouse (or to charity).
- Giving up to $14,000 per year to an unlimited number of individuals. This is called your “annual exclusion amount”.
- If you’re married, and the federal government recognizes your marriage, you can double this amount to $28,000 per year to an unlimited number of individuals.
- If youd like to fund 529 Plans, you can do so for any number of individuals and use 5 years worth of the annual exclusion amount at one time.
- This means an individual can fund 529 Plans with $70,000 all at once.
- A married couple can fund each 529 Plan with $140,000.
- Paying unlimited amounts of tuition and medical expenses for as many people as youd like, but be sure to make payments directly to the education provider or medical provider.
- Use your exemption of $5.12 million (2013).
If you give away more money than this, you may owe gift taxes, meaning that you’ll owe about 40 cents on each dollar you give away.
For example, Ben and Jerri owned a successful business and they wished to start passing the value of their business to their children. They passed $10.24 million ($5.12 x 2) in limited partnership interests to trusts for their 3 children in 2013. In 2014, they are considering passing another $10 million in business interests to their children. If they choose to do so, they will owe $4 million in gift taxes ($10 million x 40% gift tax rate).
WARNING: Don’t pay gift taxes without consulting with a tax attorney. In many circumstances, good planning permits transfers to be made without incurring gift tax.
You don’t have to pay off your past tax debts all at once. Instead, you can pay the debt off over time through an installment agreement; however, just like a credit card, you’ll have to pay interest in addition to the principal amount due.
For example, Noel and Susan owed the IRS $28,000. Through negotiations, that amount was reduced to $7,000, but they still didn’t have the money to pay off the tax debt in one fell swoop. They set up an installment agreement with the IRS and they paid their debt (plus interest) over the next year.
Internal Revenue Service (IRS)
The IRS is part of the US Treasury Department that collects taxes from US residents, citizens, businesses, and entities. You can review more information on federal taxes, download tax forms, and find contact information for the IRS at www.irs.gov.
- The IRS gets it’s authority to collect tax revenue from Congress.
- Congress gets it’s taxing authority from the U.S. Constitution in Article 1, Section 8, Clause 1.
Levy – Tax Levy
Just as the IRS can garnish (aka “levy”) your wages to meet your tax debts, they can levy your property. This means that they can seize your property and sell it to pay your tax debt. Bank accounts, wages, boats, cars, and houses can be levied.
For example, James owed $50,000 in back taxes. After proper notices and procedures, the IRS seized Jamess house and sold it to pay his tax debt.
Marginal Tax Rate
Under the U.S. tax code, most of us pay income tax based on a graduated rate, starting at 10% and increasing through 15%, 25%, 28%, 33%, 35%, and 39.6%, depending on income.
Your marginal tax rate is the rate at which you pay tax on your last dollar of income.
- So, if you are one of the highest income earners in the U.S., your marginal rate would likely be 39.6%.
- If you are a middle-income earner, your marginal rate may be 28% or 33%.
For example, Kelly just graduated from college and is waitressing until she can find a “real job”. Her marginal tax rate is 15%. On the other hand, her parents, both financially successful professionals have a marginal tax rate of 35%.
Offer in Compromise
The IRS may accept less than you actually owe in taxes if you have limited income, limited resources, and significant expenses. You must make an offer of compromise to apply for this leniency.
For example, Leo was seriously injured in a one-car accident and is unable to work. He and his tax attorney decided to make an offer in compromise to the IRS to deal with the previous years tax debt.
Penalty Abatement – Penalty Abatement Petition
You have the right to ask the IRS for a penalty abatement, meaning that you can ask the IRS to waive the penalties that they have a right to assess against you for not filing and paying your taxes in a timely manner. You must show “reasonable cause” to have your penalty waived.
For example, Karena called the IRS for help with a tax issue. She received advice and relied on it. It turns out that she was given incorrect information. She filed a penalty abatement petition to have the penalties dropped, explaining that she relied on IRS advice to her detriment.
The goal of a sham transaction is to avoid paying appropriate taxes. If the courts determine that a business transaction had only the goal avoiding an individuals or entities fair share of taxes, it can be reversed. The courts may deem taxes to be due and award penalties – in addition, criminal charges may be filed.
For example, Noah listed made up business losses on his tax returns so he could reduce his taxes.
Stay of Collections
Once a bankruptcy petition is accepted by the court, an automatic “stay of collections” is issued which prevents creditors, including the IRS, from trying to collect on a debt.
In certain and very limited circumstances, back taxes are discharged in bankruptcy – although this is not usually the case. It’s important to consult with an attorney to determine your best strategy to getting rid of tax debt.
For example, Autumn filed for bankruptcy protection under Chapter 7 of the Bankruptcy Code. Upon acceptance of her application, the court issued an automatic stay notifying her creditors that they could no longer try to collect on Autumns debt. Both the IRS and credit card companies had to stop sending letters, calling, and filing lawsuits against Autumn.
If you have a dispute with the IRS or any other taxing authority, you may be able to avoid litigation (i.e. court) through arbitration. Arbitration is much like a court in that a neutral party imposes a decision on you, but it’s faster and less expensive than tax court.
Your tax attorney can represent you during arbitration or tax court – or she can negotiate directly with the IRS to work out a settlement.
For example, Ronald was not able to reach a mutually agreeable settlement with the IRS, so his attorney suggested arbitration as a cost effective method of getting the case resolved in a timely manner.
Remember the introduction when we pointed out that while were all required to pay some tax, we have no moral or legal obligation to pay more than we owe. Tax avoidance is strategizing, within the law, to pay the least amount of taxes possible.
For example, Gerald and Mina hired a tax attorney to develop a life insurance trust to avoid paying federal estate and generation skipping taxes as their wealth was transferred to generation after generation.
Tax Evasion – Tax Fraud
There are a myriad of ways to legally minimize taxes paid; however, if you break the law to avoid paying taxes, that’s a crime called “tax evasion” and you’ll go to jail and be subject to still penalties.
For example, Helena cooked the books, so to speak, and failed to pay taxes on her income from her new restaurant. She filed tax returns showing losses that were never experienced. Helena was arrested for tax evasion and spent several years in jail.
Tax planning is perfectly legitimate and legal so long as it falls within the legal boundaries. Millions of Americans meet with their tax attorney each year to plan to minimize income taxes as we’ll as transfer taxes such as gift taxes and federal estate taxes.
For example, Bob met with his tax attorney annually to prepare for the next year. They determined exactly how much he should take out of his IRA to offset his mortgage interest deduction. This strategy helped Bob get money out of his IRA without paying ordinary income tax on the withdrawals.
The term, “transfer taxes”, refers to the taxes incurred when property passes from one individual or entity to another. Examples of transfer taxes would include gift, federal estate, generation skipping, state inheritance, state estate, and real estate taxes. Even sales taxes and capital gains taxes are a form of transfer tax.
For example, Carolyn met with an attorney who ascertained that her estate would pay $4 million in transfer (federal estate taxes and state inheritance taxes) taxes if she didn’t do proper estate planning. Fortunately, all of the federal estate taxes could be avoided with careful planning.