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An Introductionto Taxation
Chapter 1
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What is a Tax?
A forced payment made to a governmental unit that is unrelated to the value of goods or services provided by
the government
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Brief History of U.S. Income Tax
1913 – 16th Amendment to U.S. Constitution 1939 – income tax laws codified as the Internal
Revenue Code 1954 – recodification of IRC 1986 – no recodification, but Code renamed
Internal Revenue Code of 1986
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Objectives of Taxation
Goals – raise revenue, redistribute wealth, stabilize prices, foster economic growth, and promote social goals
Horizontal equity – persons in similar circumstances should face similar tax burdens
Vertical equity – persons with higher incomes should pay not only more tax but also higher percentages of their income as tax
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Current Influences on Tax Law
The makeup of Congress Lobbyists Elected representatives attempts to satisfy
many constituencies The economy
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Taxing Units
Three types of “persons” subject to income tax in the U.S. Individual C corporation Fiduciary (estate and trust)
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Corporate Tax Model
Gross revenuesLess: Cost of goods soldEquals: Gross incomePlus: Other includible income itemsLess: DeductionsEquals: Taxable income (loss)
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Corporate Tax Model (continued)
Taxable incomeTimes: Tax ratesEquals: Gross income tax liabilityPlus: Additions to taxLess: Tax credits or prepaymentsEquals: Tax owed or refund due
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Individual Income Tax Model
Gross incomeLess: Deductions for adjusted gross incomeEquals: Adjusted Gross Income (AGI)Less: Deductions from AGI (greater of
itemized or standard deduction)Less: Exemptions (personal &
dependency)Equals: Taxable income (loss)
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Individual Model (continued)
Taxable incomeTimes: Tax ratesEquals: Gross income tax liabilityPlus: Additions to taxLess: Tax credits or prepaymentsEquals: Tax owed or refund due
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Gross Income
Gross income for services & sales of goods Taxable interest Dividends Tax refunds (except federal income tax refunds) Gains on capital assets (losses subject to limits) Gains & losses on other property transactions Income & losses from ownership interests in
partnerships Income & losses from rental real estate
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Gross Income
Additional Sources for Individuals Wages & salaries Income & losses from sole proprietorships and
ownership interests in S corporations Taxable pension plan distributions Unemployment compensation Alimony received Taxable portion of Social Security benefits
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Losses
Losses result when income is less than expenses or amount invested Business losses – deductible in full against
ordinary income Investment losses – subject to limits as capital
losses ($3,000 limit for individuals; C corporations can only offset against capital gains)
Personal losses – most are not deductible
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Exclusions from Gross Income (All Taxpayers)
Tax-exempt interest Nontaxable stock dividends Nontaxable stock rights Proceeds of life insurance policies Tax refunds to the extent no prior tax benefit
was received Disallowed and deferred gains and losses on
property transactions Unrealized gains and losses
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Exclusions from Gross Income (Individual Taxpayers Only)
Nontaxable portion of pension plan distributions
Nontaxable portion of Social Security benefits Damages awarded for physical injury Gifts and inheritances Welfare benefits (food stamps, workman’s
compensation and family aid) $250,000 gain on sale of personal residence Scholarships Qualified employee fringe benefits
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Property Transactions
Amount realized = cash + net fair market value of property received
Adjusted basis = cost – accumulated depreciation + capital improvements (similar to book value)
Realized gain or loss = amount realized – adjusted basis
Recognized gain or loss = gain included in or loss deducted from gross income
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Deductions
Corporations – all business expenses are deductible if ordinary, necessary, and reasonable (unless disallowed by law)
Individuals Deductions for AGI Deductions from AGI
• Greater of itemized deductions or standard deduction
• Personal & dependency exemptions
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Deductions For AGI
Contributions to pension and retirement plans Health savings account contributions Moving expenses One-half of self-employment taxes Self-employed health insurance premiums Penalty on early withdrawal of savings Tuition deduction ($4,000 limit) Qualified student loan interest ($2,500 limit) Alimony paid
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Itemized Deductions
Medical & dental (in excess of 7.5% AGI) Taxes (state, local, and foreign income and
property taxes) Interest (mortgage and investment) Charitable contributions (up to 50% AGI) Casualty & theft losses (in excess of 10% AGI) Miscellaneous including unreimbursed employee
business expenses, investment expenses and tax preparation fees (in excess of 2% AGI)
Gambling losses (up to gambling winnings)
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Standard Deductions & Exemptions
Standard Deductions $9,700 married filing a joint return $4,850 married filing separately $7,150 head of household $4,850 single (unmarried) individual
Personal and dependency exemptions $3,100
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Corporate Tax Rates
15% on first $50,000 25% on $50,001 - $75,000 34% on $75,001 - $100,000 39% (34% + 5% surtax) on $100,001 - $335,000 34% on $335,001 - $10,000,000 35% on $10,000,001 - $15,000,000 38% (35% + 3%) on $15,000,001 - $18,333,333 35% over $18,333,333
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Tax Rates forMarried Filing a Joint Return
For married filing a joint return for 2004 10% on first $14,300 taxable income 15% on $14,301 - $58,100 25% on $58,101 - $117,250 28% on $117,251 - $178,650 33% on $178,651 - $319,100 35% over $319,100
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Tax Rates forMarried Filing Separately
For married filing separately for 2004 10% on first $7,150 taxable income 15% on $7,151 - $29,050 25% on $29,051 - $58,625 28% on $58,626 - $89,325 33% on $89,326 - $159,550 35% over $159,551
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Tax Rates forHead of Household
For head of household for 2004 10% on first $10,200 taxable income 15% on $10,201 - $38,900 25% on $38,901 - $100,500 28% on $100,501 - $162,700 33% on $162,701 - $319,100 35% over $319,100
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Tax Rates for Single Individuals
For single individuals for 2004 10% on first $7,150 taxable income 15% on $7,151 - $29,050 25% on $29,051 - $70,350 28% on $70,351 - $146,750 33% on $146,751 - $319,100 35% over $319,100
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Tax Losses
A net operating loss (NOL) results when allowable deductions are greater than gross income from a trade or business NOLs can be carried back 2 years and forward
20 years Due to the time value of money, losses that
are carried forward do not provide the same tax relief as losses that are carried back
An individual’s NOL must be adjusted to reflect only business losses
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Additions to Tax
Corporate Alternative Minimum Tax (Corporate AMT rate is 20%)
Individual AMT (Individual AMT rates are 26% on first $175,000 of AMTI and 28% on excess above $175,000)
Self-employment taxes Penalty for premature withdrawal from pension
plans Employment taxes for household help
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Tax Prepayments & Credits
Tax Prepayments Taxes withheld Estimated tax payments
Credits are a direct reduction in the tax liability
Credits available to all taxpayers AMT credit Foreign tax credit General business credits
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Tax Credits
Credits available to individuals only Earned income credit Educations credits Child tax credit Dependent care credit Adoption credit Credit for the elderly and disabled
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Other Entities
Sole proprietorship Partnerships
Limited liability partnerships Limited liability companies
S corporation Fiduciaries
Trusts Estates
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Fiduciary Income Tax Rates
2004 Rates 15% on $0 - $1,950 25% on $1,951 - $4,600 28% on $4,601 - $7,000 33% on $7,000 - $9,550 35% over $9,550
Because beneficiaries are usually in lower marginal tax brackets, distributing the income annually to beneficiaries usually results in overall lower taxes
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Choice of Business Entity
Sole Proprietorships Partnerships C Corporations S Corporations
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Sole Proprietorships
A one-owner business (independent contractor) No formal filing required by state Owner is considered self-employed
Must pay self-employment tax on net profit of business
Not eligible for tax-free employee fringe benefits Income and expenses reported on owner’s
Schedule C of Form 1040 (no separate business tax return)
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Sole Proprietorships
Sole proprietor is taxed on net profits from the business regardless of how much was withdrawn
A business loss can offset the sole proprietor’s other income
Sole proprietor is liable for all debts of business (unlimited liability)
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Partnerships
Two or more persons (with no restrictions on who can be a partner) join together to form a business and share profits
A “conduit” that passes income, gains, losses, deductions, and credits through to the owners to be reported on the partners’ tax returns
Most items retain their character when passed through to partners
Form 1065 informational return due 3½ months after year end
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Partnerships
Partners are taxed on their share of profits regardless of whether they receive any distributions
Profits retained in the partnership can be distributed later tax-free
Partners can deduct losses passed-through to them to extent of each partner’s basis account
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Partner’s Basis Account
Measures a partner’s investment in the partnership at any given time
Basis = cash + adjusted basis of property contributed by the partner + income that flows through to the partner - losses - distributions
Basis can never be negative Is the upper limit on the amount a partner may
Receive as a tax-free distribution Deduct in losses (excess losses carried
forward)
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Corporations
Must file articles of incorporation with state Shareholders are only at risk for their capital
investment (limited liability) Centralized management Death of an owner or transfer of stock
ownership does not end the corporation’s legal existence (unlimited life)
Owners can be employees and receive tax-free employee fringe benefits
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Corporations
Form 1120 due 2½ months after year end Can use calendar year or fiscal year When the corporate rates are lower than the
individual tax rates, the owners have increased capital for reinvestment and business expansion
Disadvantages Double taxation (dividends are nondeductible) Corporate losses can only offset corporate profits
(no flow-through to shareholders)
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S Corporations
Formed the same as C corporations; revert to being taxed as C corporations if they cease to qualify for S status
Limited liability with no double taxation To elect S status:
Domestic corporation with no more than 75 shareholders (generally individuals who are not nonresident aliens)
One class of stock outstanding File Form 2553 election within first 2½ months
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S Corporations
Profits and losses flow through to owners each year
Shareholders are taxed on their share of profits even if they receive no distribution
Shareholders can be employees but cannot participate in tax-free employee fringe benefits if they own more than 2% of stock
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Comparison of Business Entities
Conduit entities are attractive in early years when operating losses are likely to occur C corporation losses do not provide a tax
benefit until the corporation becomes profitable
C corporation tax rates may be lower than tax rates for individual owners resulting in lower taxation for profits that remain in the business
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Comparison of Business Entities
Employee tax-free fringe benefits are available to employee-shareholders of C corporations
Self-employed individuals (including partners and greater than 2% shareholders in S corporations) are not eligible for most tax-free employee fringe benefits
Changing from one type of entity to another can be difficult and expensive
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Other Types of Taxes
Wealth taxes (real property tax) Wealth transfer taxes
Gift tax (assessed on lifetime gifts in excess of $1 million)
Estate tax (assessed on transfers at death in excess of $1.5 million)
Consumption taxes (sales and use taxes) Tariffs and duties
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Progressive Tax Rate System
Tax rates on income increase as income increases
In 1913 rates ranged from 1% to 7% To finance World War I the top rate increased
to 77% In 1985, 15 tax brackets ranged from 11% to
50% 2003 Tax Act reduced top rate from 38.6% to
35% (rates now 10%, 15%, 25%, 28%, 33%, and 35%)
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Capital Gains Rates
Net long-term capital gains are taxed at 15% for taxpayers in higher tax brackets 5% for taxpayers in the 10% or 15% tax
brackets Net short-term capital gains are taxed using
the same rates as ordinary income Corporations have no special rates for capital
gains
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Average vs. Marginal Rate
Average tax rate = tax liability divided by taxable income
Marginal tax rate is the tax rate to which the next dollar of taxable income is subject and is used for tax planning
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Other Tax Rate Systems
Proportional “Flat” Tax System – all income taxed at the same rate regardless of amount or type of income
Regressive Tax System – taxpayers pay a decreasing proportion of their income as income increases Social Security tax is 6.2% on first $87,900 in
wages (Medicare is 1.45% on all wages) FUTA is 6.2% on first $7,000 of wages
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Characteristics of a Good Tax
Adam Smith’s Canons of Taxation Equity Economy Certainty Convenience
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The End