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An Introduction to Taxation. Chapter 1. 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. Brief History of U.S. Income Tax. 1913 – 16 th Amendment to U.S. Constitution

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what is a tax
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

brief history of u s income tax
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
objectives of taxation
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
current influences on tax law
Current Influences on Tax Law
  • The makeup of Congress
  • Lobbyists
  • Elected representatives attempts to satisfy many constituencies
  • The economy
taxing units
Taxing Units
  • Three types of “persons” subject to income tax in the U.S.
    • Individual
    • C corporation
    • Fiduciary (estate and trust)
corporate tax model
Corporate Tax Model

Gross revenues

Less: Cost of goods sold

Equals: Gross income

Plus: Other includible income items

Less: Deductions

Equals: Taxable income (loss)

corporate tax model continued
Corporate Tax Model (continued)

Taxable income

Times: Tax rates

Equals: Gross income tax liability

Plus: Additions to tax

Less: Tax credits or prepayments

Equals: Tax owed or refund due

individual income tax model
Individual Income Tax Model

Gross income

Less: Deductions for adjusted gross income

Equals:Adjusted Gross Income (AGI)

Less: Deductions from AGI (greater of itemized or standard deduction)

Less: Exemptions (personal & dependency)

Equals: Taxable income (loss)

individual model continued
Individual Model (continued)

Taxable income

Times: Tax rates

Equals: Gross income tax liability

Plus: Additions to tax

Less: Tax credits or prepayments

Equals: Tax owed or refund due

gross income
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
gross income12
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
losses
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
exclusions from gross income all taxpayers
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
exclusions from gross income individual taxpayers only
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
property transactions
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
deductions
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
deductions for agi
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
itemized deductions
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)
standard deductions exemptions
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
corporate tax rates
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
tax rates for married filing a joint return
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
tax rates for married filing separately
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
tax rates for head of household
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
tax rates for single individuals
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
tax losses
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
additions to tax
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
tax prepayments credits
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
tax credits
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
other entities
Other Entities
  • Sole proprietorship
  • Partnerships
    • Limited liability partnerships
    • Limited liability companies
  • S corporation
  • Fiduciaries
    • Trusts
    • Estates
fiduciary income tax rates
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
choice of business entity
Choice of Business Entity
  • Sole Proprietorships
  • Partnerships
  • C Corporations
  • S Corporations
sole proprietorships
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)
sole proprietorships34
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)
partnerships
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
partnerships36
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
partner s basis account
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)
corporations
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
corporations39
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)
s corporations
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
s corporations41
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
comparison of business entities
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
comparison of business entities43
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
other types of taxes
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
progressive tax rate system
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%)
capital gains rates
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
average vs marginal rate
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
other tax rate systems
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
characteristics of a good tax
Characteristics of a Good Tax
  • Adam Smith’s Canons of Taxation
    • Equity
    • Economy
    • Certainty
    • Convenience