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TAX 4001 Taxation of Business Entities. Introduction To Taxation Text: Chapter 1. Learning Objectives. Understand the components of a tax Identify the various taxes affecting business enterprises Briefly review history of the Federal income tax

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TAX 4001Taxation of Business Entities

Introduction To Taxation

Text: Chapter 1


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Learning Objectives

  • Understand the components of a tax

  • Identify the various taxes affecting business enterprises

  • Briefly review history of the Federal income tax

  • Identify the basic tax formula for individuals and taxable business entities

  • Recognize tax planning opportunities and distinguish between implicit and explicit taxes

  • Recognize the economic, social, equity, and political considerations that underlie the tax law


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The Structure of Taxes

  • Components of a tax

    • Tax rate

    • Tax base (e.g., income, property, sales)

  • Types of tax rate schedules

    • Progressive - rate increases as base increases

    • Proportional - rate is constant despite size of base

    • Regressive - rate of tax decreases as the tax base increases


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Types of Taxes

  • Transaction taxes - e.g. sales, use, excise, gift, estate, employment taxes

    • Sales Tax represents 46% of states’ tax collections

  • Property taxes - real estate, personal property (e.g. cars), intangible property

    • Property taxes represent 72% of local government tax collections

  • Taxes on privileges andrights - custom duties, franchise tax, occupational taxes

    • Small percentage of taxes


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Types of Taxes

  • Income taxes

    • Federal income tax

      • Individual

      • Corporate

    • State income taxes

      • Most states have some form of income tax

      • State tax system usually “piggybacks” on Federal

    • Local income taxes

      • City taxes usually apply to anyone who earns income in the city, not just residents of the city


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A Brief History of the Income Tax

  • 1634 - First income tax in U.S. introduced in the Massachusetts Bay Colony.

  • 1861-1872 - U.S. government introduced income tax to finance the Civil War; tax was repealed after the war.

  • 1893 – Government reinstated the individual income tax to address a deficit; found unconstitutional in Pollock.

  • 1909 - Four percent corporate income tax was enacted; unsuccessfully challenged in Flint vs. Stone Tracy Co.

  • 1913 - Sixteenth Amendment to the Constitution passed.


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Constitutional Issues

  • Prior to 16th amendment, the constitutional impediment to the income tax lay in the following passage:

    • …No Capitation, or other direct, Tax shall be laid, unless in Proportion to the Census …

  • The 16th amendment’s full text is as follows:

    • The Congress shall have the 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.


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    A Brief History of the Income Tax – cont

    • In 1939, less than 6% of U.S. Citizens paid income tax.

    • 1942-1943 – income tax rates rose dramatically in order to finance WWII and income tax withholding began.

    • By 1945 - 74% of citizens paid income tax

    • 1986 -TRA of 1986 made comprehensive changes including base broadening and dramatic decrease in rates.

    • Post 1986 – added complexity.

    • 2010 and forward  ???


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    Basic Formula for the Federal Income Tax – Corporate Income

    Income (broadly conceived)

    -Exclusions (income that is not subject to tax)

    =Gross income

    -Certain business deductions

    =Taxable income

    Federal income tax (from Rate Schedule)

    -Tax credits and prepayments

    =Tax owed (or refund if negative)


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    Federal Income Tax Formula for Individuals Income

    Income (broadly conceived)

    -Exclusions (income that is not subject to tax)

    =Gross income

    -Certain deductions (deductions for AGI)

    =Adjusted gross income (AGI)

    -The greater of standard deduction oritemized deductions

    -Personal and dependency exemptions

    =Taxable income

    Federal income tax (from Tax Table or Rate Schedule)

    -Tax credits and prepayments

    =Tax owed (or refund if negative)


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    Income Taxation of Business Entities Income

    • Proprietorships

      • Not a separate taxable entity

      • Income of a proprietorship is reported by the proprietor – Schedule C of Form 1040

    • Corporations

      • C (regular) corporations are taxable entities; shareholders also pay tax on dividend income (the “double taxation” problem)

      • S shareholders (not S corporations) pay tax on entity’s income; avoids double taxation


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    Income Taxation of Business Entities Income

    • Partnerships (general, limited, LLP)

      • Partnerships are not subject to the income tax; partners report their share of pship income on their tax return; avoids double taxation.

    • LLCs

      • Have limited liability and some (but not all) of the other nontax features of corporations.

      • Can elect under the “check-the-box” regulations to be taxed as a partnership.


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    Determining the Tax Burden Income

    • Marginal tax rate- the rate that would be paid on an additional dollar of income

      • This is usually the rate used for tax planning purposes

    • Average tax rate - the ratio of taxes to the tax base

    • Effective tax rate - may be defined as

      • The ratio of taxes paid to financial net income before tax, OR

      • The sum of current and deferred tax expense divided by net income before tax


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    Determining the Tax Burden Income

    • Example - C Corporation with:

      • Financial net income (before taxes) = $120,000, and

      • Taxable income = $110,000.

      • Assume the only book-tax difference is $10,000 of municipal bond income.

    • What is the C corporation’s marginal, average, and effective tax rate?


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    Explicit vs. Implicit Taxes Income

    • Explicit taxes are those paid directly to the government

    • Implicit taxes are those paid through higher prices or lower returns on tax-favored investments

      • Example: Lower return on tax-favored municipal bonds

    • Implicit Tax Rate = (Fully-Taxed Return – Tax-Free Return)/ Fully-Taxed Return


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    Explicit vs. Implicit Taxes Income

    • Example: Muni bonds pay 7% (equivalent taxable bonds are paying 10%)

      • What is implicit tax rate?

      • Who should invest in muni bonds instead of taxable bonds?


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    Overview of Tax Planning Income

    • Minimizing taxes legally is referred to as tax avoidance.

      • Taxpayers have no duty to pay more than their legal obligation .

    • Reducing or eliminating taxes through illegal means is referred to as tax evasion.

      • Tax evaders may be subject to civil or criminal penalties (including imprisonment).

    • Objective of Tax Planning

      • Design a transaction to (legally) minimize its tax costs while meeting the non-tax objectives of the taxpayer.


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    Overview of Tax Planning Income

    • CPAs are bound by professional standards

      • AICPA Statements on Standards for Tax Services Nos. 1-8, 2000

    • and IRS Regulations

      • Circular 230

    • Tax advice:

      • Tax professionals should rely on substantial authority (e.g. Internal Revenue Code, IRS Treasury Regulations and Rulings) .

      • Tax professional should NOT consider the likelihood of audit.


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    Tax Planning Strategies – IncomeExamples

    • Change the character of income and expenses from tax-disfavored to tax-favored

      • Long-term capital gains are taxed at a lower rate than ordinary income (for individuals)

      • C Corporations are allowed a dividends received deduction (70%, 80%, or 100% of dividends received from another corporation)


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    Shifting Tax Liability IncomeAcross Time

    • Defer taxable income to a future period by

      • Deferring income, and/or

      • Accelerating deductions

    • What are the benefits of deferring taxable income?

    • Accelerate taxable income to an earlier tax year by

      • Accelerating income and/or deferring deductions

    • What are the benefits of accelerating taxable income?


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    Shifting Tax Liability IncomeBetween Entities

    • Shift taxable income from higher-bracket to lower-bracket taxpayers

    • Restrictions on shifting tax liability

      • Income must be reported by entity (or individual) that earned it.

      • Expense may be deducted only by entity (or individual) that incurred it.

    • Income from property can be shifted by transferring ownership of the property.


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    Shifting Tax Liability IncomeAcross Jurisdictions

    • Shift income from high-tax jurisdictions to low-tax jurisdictions

      • Strategy: shift income from a high-tax state (or country) to a low-tax state (or country)

      • Strategy: shift deductions from a low-tax state (or country) to a high-tax state (or country)


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    Understanding the IncomeFederal Tax Law

    • The major objective of the Federal tax law is to raise revenuesfor the government.

    • Other considerations that affect the tax law:

      • Economic considerations

      • Social considerations

      • Equity considerations

      • Political considerations


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    Understanding the IncomeFederal Tax Law

    • What is the Tax Law?

      • Legislative (Internal Revenue Code)

      • Administrative (e.g., Treasury Regulations, IRS Rulings)

      • Judicial (e.g., Supreme Court Doctrine, tax court or appeals court interpretations)


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    Economic Considerations Income

    • Some tax provisions are designed to stimulate economic growth and/or encourage certain activities and types of businesses

      • Encouragement of certain activities

        • Examples include R&D, U.S. Exports, Domestic Manufacturing

      • Encouragement of certain industries

        • Examples include Agriculture, Energy

      • Encouragement of small business

        • Examples include S Corporations, direct write-off for investment in business equipment


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    Social Considerations Income

    • Encourage (or discourage) socially desirable (or undesirable) practices

      • Favorable treatment of employer-sponsored health and accident coverage for employees

      • Tax-deferred pension plans for employees (with an immediate deduction for employers)

      • Deductions for charitable contributions

      • Homeowners favored by tax code

      • No deduction for expenditures deemed to be contrary to public policy (e.g., bribes/fines)


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    Equity Considerations Income

    • Alleviating the effect of multiple taxation (e.g., credit for foreign taxes paid)

    • Possible gain deferral on transaction when the taxpayer lacks the wherewithal to pay

    • Mitigating the effect of the annual accounting period concept (net operating loss deduction, carryover of disallowed charitable contributions, installment sales provisions)

    • Indexing for Inflation

    • Consideration of ability to pay (e.g., through progressive tax rates)


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    Political Considerations Income

    • Special interest legislation may benefit certain groups with political influence

    • Political expediency may account for tax provisions that have popular appeal

    • Influence of the IRS particularly regarding enforcement issues


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