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An Introduction to Taxation

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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An Introduction to Taxation

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  1. An Introductionto Taxation Chapter1

  2. 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

  3. 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

  4. 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

  5. Current Influences on Tax Law • The makeup of Congress • Lobbyists • Elected representatives attempts to satisfy many constituencies

  6. Taxing Units • Three types of “persons” subject to income tax in the U.S. • Individual • C corporation • Fiduciary (estate and trust)

  7. Corporate Tax Model Gross revenues Less: Cost of goods sold Equals: Gross income Plus: Other includible income items Less: Deductions Equals: Taxable income (loss)

  8. 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

  9. 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)

  10. 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

  11. Gross Income • Sources for Corporations and Individuals • Gross income from 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

  12. Gross Income • Additional Sources for Individuals • Wages & salaries • Income & losses from sole proprietorships and ownership interests in S corporations • Taxable pension plan distributions • Alimony received • Taxable portion of unemployment compensation • Taxable portion of Social Security benefits

  13. 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 per year; C corporations can only offset against capital gains) • Personal losses – most are not deductible

  14. 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

  15. 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

  16. 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

  17. Property Transactions • The recognized gain (taxable gain) or recognized loss (deductible loss) may differ from the realized gain or loss because of limitation or deferral provisions • Deduction of losses from investment sales (capital losses) may be limited • Losses from the sale of personal-use assets are not deductible • Gains from the exchange of business or investment property may be deferred

  18. 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

  19. Deductions For AGI • “Above-the-line” deductions • 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 • Qualified student loan interest • Alimony paid

  20. Itemized Deductions • “Below-the-line” 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)

  21. Standard Deductions & Exemptions • Standard Deductions for 2009 • $11,400 married filing a joint return • $5,700 married filing separately • $8,350 head of household • $5,700 single (unmarried) individual • Dependents limited to greater of (a) $950 or (b) earned income plus $300 • Personal and dependency exemptions for 2009 • $3,650 per dependent (including taxpayer)

  22. 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

  23. Tax Rates forMarried Filing a Joint Return • For married filing a joint return for 2009 • 10% on first $16,700 taxable income • 15% on $16,701 - $67,900 • 25% on $67,901 - $137,050 • 28% on $137,051 - $208,850 • 33% on $208,851 - $372,950 • 35% over $372,950

  24. Tax Rates forMarried Filing Separately • For married filing separately for 2009 • 10% on first $8,350 taxable income • 15% on $8,351 - $33,950 • 25% on $33,951 - $68,525 • 28% on $68,526 - $104,425 • 33% on $104,426 - $186,475 • 35% over $186,475

  25. Tax Rates forHead of Household • For head of household for 2009 • 10% on first $11,950 taxable income • 15% on $11,951 - $45,500 • 25% on $45,501 - $117,450 • 28% on $117,451 - $190,200 • 33% on $190,201 - $372,950 • 35% over $372,950

  26. Tax Rates for Single Individuals • For single individuals for 2009 • 10% on first $8,350 taxable income • 15% on $8,351 - $33,950 • 25% on $33,951 - $82,250 • 28% on $82,251 - $171,550 • 33% on $171,551 - $372,950 • 35% over $372,950

  27. Tax Losses • A net operating loss (NOL) results when allowable deductions are greater than gross income from a trade or business • NOL’s 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 taxpayer’s NOL must be adjusted to reflect only business losses

  28. 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

  29. Tax Prepayments & Credits • Tax Prepayments • Taxes withheld (from salary & wages) • Estimated tax payments (corporations & self-employed individuals) • Credits are a direct reduction in the tax liability • Credits available to all taxpayers • Alternative minimum tax credit • Foreign tax credit • Investment tax credit • General business credits

  30. Tax Credits • Credits available to individuals only • Earned income credit • Education credits • Child tax credit • Dependent care credit • Adoption credit • Credit for the elderly and disabled • Credit for excess payroll tax withheld • First-time homebuyer credit

  31. Other Entities • Sole proprietorship • Partnerships • Limited liability partnerships (LLPs) • Limited liability companies (LLCs) • S corporations • Fiduciaries • Trusts • Estates

  32. Fiduciary Income Tax Rates • 2009 Rates • 15% on $0 - $2,300 • 25% on $2,301 - $5,350 • 28% on $5,351 - $8,200 • 33% on $8,201 - $11,150 • 35% over $11,150 • When beneficiaries are in lower marginal tax brackets, distributing the income annually to beneficiaries usually results in lower overall taxes

  33. Choice of Business Entity • Sole Proprietorships • Partnerships • C Corporations • S Corporations

  34. 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)

  35. 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)

  36. 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” (or flow-through) entity • 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

  37. 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

  38. 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 + partner’s share of partnership liabilities + income that flows through to the partner - distributions - losses • 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)

  39. Limited Liability Companies • Owners of an LLC are called members and they have limited liability protection • An LLC will be treated as a partnership for tax purposes unless the company elects to be taxed as a corporation • If owned by a single individual, the LLC would be taxed as a sole proprietorship if corporate tax treatment not elected

  40. Corporations • Must file articles of incorporation with state • Limited Liability - shareholders are only at risk for their capital investment • Centralized management • Unlimited Life - death of an owner or transfer of stock ownership does not end the corporation’s legal existence • Owners can be employees and receive tax-free employee fringe benefits

  41. Corporations • Form 1120 due 2½ months after year end • March 15th for calendar year taxpayer • 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)

  42. S Corporations • “Small business corporation” • Formed the same as a C corporation • Reverts to being taxed as C corporation if it ceases to qualify for S status • To qualify for S status • Domestic corporation • No more than 100 shareholders (who generally must be individuals who are not nonresident aliens) • One class of stock outstanding • File Form 2553 election (must be filed within first 2½ months of year to be retroactive)

  43. S Corporations • Limited liability with no double taxation • Profits and losses flow through to owners each year • Shareholders are taxed on their share of profits even if they receive no distribution • Loss deductions are limited to basis (unlike partners, shareholders do not increase their basis for liabilities of the business); excess losses are carried forward • Shareholders can be employees but cannot participate in tax-free employee fringe benefits if they own more than 2% of stock

  44. 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

  45. 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

  46. 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 • 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

  47. Wealth Transfer Taxes • Gift and estate taxes assessed on the one making the transfer • Gift tax assessed on lifetime gifts in excess of $1 million (fair market value) • First $13,000 of gifts to recipient each year are excluded so if gifts to an individual are no more than $13,000 then no gift tax return must be filed • Estate tax assessed on transfers at death in excess of $3.5 million (fair market value) • Transfers to spouses and charities are not subject to tax • Recipient does not pay income tax on receipt of gift or inheritance

  48. Other Types of Taxes • Wealth taxes (real property tax) • Consumption taxes (sales and use taxes) • Tariffs and duties

  49. Progressive Tax Rate System • Tax rates increase as income increases • In 1913 rates ranged from 1% to 7% • To finance World War I, top rate was increased to 77% • In 1985, 15 tax brackets ranged from 11% to 50% • Current rates are 10%, 15%, 25%, 28%, 33%, and 35%

  50. Capital Gains Rates • Most individual’s net long-term capital gains are now taxed at 15% • Zero rate for taxpayers in the 10% or 15% tax brackets • Short-term (held one year or less) capital gains are taxed using the same rates as ordinary income • Corporations have no special rates for capital gains

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