1 - 1 ©2004 prentice hall, inc. an introduction to taxation chapter 1

1 - 1©2004 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 – Code renamed Internal Revenue Code of

1986


Objectives of Taxation

Goals include: raising revenue, wealth redistribution, price stability, economic growth, and 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 Need to find revenue offsets for pay for tax

reductions


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 Wages & salary Taxable interest Dividends Gains on capital assets (losses subject to limits) Gains & losses on other property transactions Income & losses from flow-through entities Income & losses from rental real estate


Losses

Losses are negative income 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

Tax-exempt interest Nontaxable stock dividends Nontaxable stock rights Proceeds of life insurance Tax refunds to the extent no prior tax benefit

was received Qualified employee fringe benefits Gifts and inheritances Scholarships


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 gross income or deductible loss


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


Deductions For AGI

Contributions to pension and retirement plans Medical savings account contributions Moving expenses One-half of self-employment taxes Self-employed health insurance premiums Penalty on early withdrawal of savings Tuition deduction ($3,000 limit) Qualified student loan interest ($2,500 limit)


Itemized Deductions

Medical & dental expenses (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 and theft losses (in excess of 10% AGI) Miscellaneous including unreimbursed employee

business expenses and investment expenses (in excess of 2% AGI)

Gambling losses (up to gambling winnings)


Standard Deductions & Exemptions

Standard Deductions (before 2003 Tax Act) $7,950 married filing a joint return $3,975 married filing separately $7,000 head of household $4,750 single (unmarried) individual

Personal and dependency exemptions $3,050


2003 Tax Act Changes

Standard deduction marriage penalty relief For 2003 and 2004 married filing jointly

deduction increases to double the deduction for single individuals (increases from $7,950 to $9,500 for 2003)

After 2004 returns to present law


Tax Rates for Single Individuals

Rates before 2003 Tax Act 10% on first $6,000 taxable income 15% on $6,001 - $28,400 27% on $28,401 - $68,800 30% on $68,801 - $143,500 35% on $143,501 - $311,950 38.6% over $311,950

Income levels at which rates apply vary with filing status



The rates above 15% drop to 25%, 28%, 33%, and 35%

The 10% bracket expands For 2003 and 2004 to the first $7,000 of

taxable income for single individuals ($14,000 for married filing joint return)

After 2004 the 10% bracket returns to $6,000 ($12,000) as under present law


2003 Tax Act New Rates

For single individuals for 2003 10% on first $7,000 taxable income 15% on $7,001 - $28,400 25% on $28,401 - $68,800 28% on $68,801 - $143,500 33% on $143,501 - $311,950 35% over $311,950


2003 Tax Act New Rates

For married filing joint return for 2003 10% on first $14,000 taxable income 15% on $14,001 - $56,800 25% on $56,801 - $114,650 28% on $114,651 - $174,700 33% on $174,701 - $311,950 35% over $311,950


Corporate Tax Rates

Corporate rates not affected by 2003 Tax Act 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% on over $18,333,333


Tax Losses

A net operating loss (NOL) results when deductions are greater than gross income 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


Additions to Tax

Corporate Alternative Minimum Tax rate is 20% Individual AMT rate is:

26% on first $175,000 of AMTI 28% on excess above $175,000

Other additions to tax include 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


Income Taxation of Fiduciaries

Fiduciaries (estates & trusts) reach top 35% tax rate in 2003 with income over $9,350

Income distributed to beneficiaries is taxed to beneficiaries instead of fiduciary


Choice of Business Entity

Sole ProprietorshipsPartnershipsC CorporationsS 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 partners with no restrictions on who can be a partner

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 Owners can be employees and receive tax-free

employee fringe benefits Form 1120 due 2½ months after year end Can use calendar year or fiscal year


Corporations

When the corporate rates are lower than the individual tax rates, the owners have increased capital for reinvestment and business expansion

Disadvantages Double taxation (no deduction for dividends) Corporate losses can only offset corporate

profits (no flow-through to shareholders)


S Corporations

Formed the same as C corporations and 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 employee tax-free fringe benefits if they own more than 2% of stock


Compare 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


Compare 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


Other Types of Taxes

Wealth taxes (real property tax) Wealth transfer taxes (estate and gift taxes) 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 II, 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 rates up to a maximum of 28% for individuals (20% was primary rate before the 2003 Tax Act)

Net short-term capital gains are taxed using the same rates as ordinary income

Corporations have no special rates for capital gains



For capital assets sold or exchanged after May 5, 2003 new rates apply for individuals 15% rate (instead of 20%) for LTCG 5% rate applies to taxpayers in 10% or

15% tax brackets Dividend income will be taxed using the new

capital gains rates


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)


Characteristics of a Good Tax

Adam Smith’s Canons of Taxation Equity Economy Certainty Convenience


The End

1 - 1 ©2004 prentice hall, inc. an introduction to taxation chapter 1

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