1 - 1 ©2005 Prentice Hall, Inc. An Introduction to Taxation Chapter 1.

1 - 1©2005 Prentice Hall, Inc.

An Introductionto 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 – 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

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

The makeup of Congress Lobbyists Elected representatives attempts to satisfy

many constituencies The economy


Taxing Units

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


Corporate Tax Model

Gross revenuesLess: Cost of goods sold

Equals: Gross income

Plus: Other includible income itemsLess: Deductions

Equals: Taxable income (loss)


Corporate Tax Model (continued)

Taxable incomeTimes: Tax rates

Equals: Gross income tax liabilityPlus: Additions to taxLess: Tax credits or prepayments

Equals: Tax owed or refund due


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)


Individual Model (continued)

Taxable incomeTimes: Tax rates

Equals: Gross income tax liabilityPlus: Additions to taxLess: Tax credits or prepayments

Equals: Tax owed or refund due


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 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 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)

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)

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

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

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

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

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 $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

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 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 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 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

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

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

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 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

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

Sole proprietorship Partnerships

Limited liability partnerships Limited liability companies

S corporation Fiduciaries

Trusts Estates


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

Sole Proprietorships Partnerships C Corporations S Corporations


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 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

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


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

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

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


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

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 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

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 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

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

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

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 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

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

Adam Smith’s Canons of Taxation Equity Economy Certainty Convenience


The End

1 - 1 ©2005 Prentice Hall, Inc. An Introduction to Taxation Chapter 1.

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