c1 - 1 west federal taxation: an introduction to business entities chapter 1 introduction to...

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West Federal Taxation:An Introduction to Business Entities


Chapter 1

Introduction To Taxation

Chapter 1

Introduction To Taxation

Copyright ©2002 South-Western/Thomson Learning , Cincinnati, OhioCopyright ©2002 South-Western/Thomson Learning , Cincinnati, Ohio

James E. Smith, William A. James E. Smith, William A. Raabe, Raabe, and and David M. David M. MaloneyMaloney

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Learning Objective 1Learning Objective 1

Understand the components of a tax.Understand the components of a tax.

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The Structure of TaxesThe Structure of Taxes

• Components of a tax– Tax rate

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

• Types of tax rates– Progressive - rate increases as base increases

– Proportional - rate is constant despite size of base

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

• Components of a tax– Tax rate

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

• Types of tax rates– 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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Identify the various taxes

affecting business enterprises.

Identify the various taxes

affecting business enterprises.

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Types of Taxes(slide 1 of 2)

Types of Taxes(slide 1 of 2)

• Transaction taxes– Sales, use, excise, value added (VAT), gift,

estate, inheritance, employment taxes

• Property taxes– Real property tax, personal property tax

• Taxes on privileges and rights– Customs duties, franchise tax, occupational

taxes, severance tax

• Transaction taxes– Sales, use, excise, value added (VAT), gift,

estate, inheritance, employment taxes

• Property taxes– Real property tax, personal property tax

• Taxes on privileges and rights– Customs duties, franchise tax, occupational

taxes, severance tax

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Types of Taxes (slide 2 of 2)

Types of Taxes (slide 2 of 2)

• Income taxes– Federal income tax

• Individual

• Corporate

– State income taxes• Most states have some form of income tax

• State tax usually “piggybacks” on Federal

– Local income taxes• City taxes apply to anyone who earns income in the city, not

just residents of the city

• Income taxes– Federal income tax

• Individual

• Corporate

– State income taxes• Most states have some form of income tax

• State tax usually “piggybacks” on Federal

– Local income taxes• City taxes apply to anyone who earns income in the city, not

just residents of the city

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Understand some of the history

of the Federal income tax.

Understand some of the history

of the Federal income tax.

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A Brief History of the Income Tax (slide 1 of 2)


• 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

• 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

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

• 1913 - Sixteenth Amendment to the Constitution passed: – Provided that taxes did not have to be

apportioned among the states– Basis for the current income tax law

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

• 1913 - Sixteenth Amendment to the Constitution passed: – Provided that taxes did not have to be

apportioned among the states– Basis for the current income tax law

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Recall the basic tax formula for individuals and taxable business entities.

Recall the basic tax formula for individuals and taxable business entities.

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Basic Formula for the Federal Income Tax

Basic Formula for the Federal Income Tax

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)

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 (slide 1 of 2)


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 or itemized deductions

-Personal and dependency exemptions

=Taxable 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 or itemized deductions

-Personal and dependency exemptions

=Taxable income

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Federal income tax (from Tax Table or Rate Schedule)

-Tax credits and prepayments

=Tax owed (or refund if negative)

Federal income tax (from Tax Table or Rate Schedule)

-Tax credits and prepayments

=Tax owed (or refund if negative)

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Understand the relationship between business entities and their owners.

Understand the relationship between business entities and their owners.

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Income Taxation of Business Entities (slide 1 of 3)


• Proprietorships– Not a separate taxable entity– Income of a proprietorship is reported by the

proprietor

• Proprietorships– Not a separate taxable entity– Income of a proprietorship is reported by the

proprietor

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• 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

• 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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• Partnerships– Partnerships are not subject to the income tax;

partners report share of income; avoids double taxation

• LLCs and LLPs– 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

• Partnerships– Partnerships are not subject to the income tax;

partners report share of income; avoids double taxation

• LLCs and LLPs– 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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Relationships Between Individuals and Entities (slide 1 of 2)


• Owners transfer assets to an entity when they establish a business

• Owners take assets out of a business in the form of salary, profits, withdrawals, etc.

• Owners transfer assets to an entity when they establish a business

• Owners take assets out of a business in the form of salary, profits, withdrawals, etc.

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• Entities establish retirement plans for owner-employees

• Owners dispose of all or part of the business entity

• Entities establish retirement plans for owner-employees

• Owners dispose of all or part of the business entity

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Tax Issues Related to Individual/Entity Transactions

(slide 1 of 2)


(slide 1 of 2)

• Avoidance of taxation at both the owner and entity level (double taxation problem)

• How to get assets into the entity with no adverse tax consequences

• Avoidance of taxation at both the owner and entity level (double taxation problem)

• How to get assets into the entity with no adverse tax consequences

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(slide 2 of 2)


(slide 2 of 2)

• How to get assets out of the entity with the least adverse tax consequences

• How to dispose of the entity with the least adverse tax consequences

• How to get assets out of the entity with the least adverse tax consequences

• How to dispose of the entity with the least adverse tax consequences

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Recognize tax planning opportunities and apply a simplified model of tax planning.

Recognize tax planning opportunities and apply a simplified model of tax planning.

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Overview of Tax PlanningOverview of Tax Planning

• Minimizing taxes legally is referred to as tax avoidance.– Taxpayers have no duty to pay more than their

fair share of taxes.

• 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).

• Minimizing taxes legally is referred to as tax avoidance.– Taxpayers have no duty to pay more than their

fair share of taxes.

• 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).

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The Goal of Tax PlanningThe Goal of Tax Planning

• Design a transaction so as to minimize its tax costs while meeting the nontax objectives of the taxpayer.– Minimize overall tax costs to all parties to a

transaction (equilibrium tax planning)– Consider all nontax aspects of a transaction

• Design a transaction so as to minimize its tax costs while meeting the nontax objectives of the taxpayer.– Minimize overall tax costs to all parties to a

transaction (equilibrium tax planning)– Consider all nontax aspects of a transaction

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Determining the Tax BurdenDetermining the Tax Burden

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

• 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 currently payable and deferred tax expense divided by net income before tax

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

• 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 currently payable and deferred tax expense divided by net income before tax

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Explicit vs. Implicit TaxesExplicit vs. Implicit Taxes

• 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

• 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

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Tax Minimization Strategies (slide 1 of 2)


• Change the character of income and expenses from tax-disfavored to tax-favored– The law: long-term capital gain is taxed at a

lower rate than ordinary income• Strategy: hold assets for the long-term holding

period before selling them at a gain

• Change the character of income and expenses from tax-disfavored to tax-favored– The law: long-term capital gain is taxed at a

lower rate than ordinary income• Strategy: hold assets for the long-term holding

period before selling them at a gain

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• Change the character of income and expenses from tax-disfavored to tax-favored (Cont’d)– The law: corporations are allowed a dividends

received deduction (70%, 80%, or 100% of dividends received from another corporation)

• Strategy: invest in corporate stock instead of corporate bonds

• Change the character of income and expenses from tax-disfavored to tax-favored (Cont’d)– The law: corporations are allowed a dividends

received deduction (70%, 80%, or 100% of dividends received from another corporation)

• Strategy: invest in corporate stock instead of corporate bonds

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Shifting Tax Liability Across Time (slide 1 of 2)


• Defer taxable income to a future period by– Deferring income, and/or– Accelerating deductions

• Benefits of deferring taxable income– Allows taxpayer to take advantage of time

value of money– Saves taxes if future tax rates are lower

• Defer taxable income to a future period by– Deferring income, and/or– Accelerating deductions

• Benefits of deferring taxable income– Allows taxpayer to take advantage of time

value of money– Saves taxes if future tax rates are lower

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• Accelerate taxable income to an earlier tax year by– Accelerating income and/or– Deferring deductions

• Benefit of accelerating taxable income– Saves taxes if tax rates increase in future tax

years

• Accelerate taxable income to an earlier tax year by– Accelerating income and/or– Deferring deductions

• Benefit of accelerating taxable income– Saves taxes if tax rates increase in future tax

years

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Shifting Tax Liability Between Entities

Shifting Tax Liability Between Entities

• Goal: 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.

• Goal: 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 Across Jurisdictions

Shifting Tax Liability Across Jurisdictions

• Goal: 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)

• Goal: 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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Recognize the economic, social,

equity, and political considerations

that underlie the tax law.

Recognize the economic, social,

equity, and political considerations

that underlie the tax law.

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Understanding the Federal Tax Law

Understanding the Federal Tax Law

• The major objective of the Federal tax law is to raise revenues for the government

• Other considerations that affect the tax law:– Economic considerations– Social considerations– Equity considerations– Political considerations

• The major objective of the Federal tax law is to raise revenues for the government

• Other considerations that affect the tax law:– Economic considerations– Social considerations– Equity considerations– Political considerations

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Economic Considerations (slide 1 of 2)Economic Considerations (slide 1 of 2)

• Emphasize tax provisions that help regulate the economy and encourage certain activities and types of businesses

• Encouragement of certain activities– Research and development activities (research credit, deduction in

year incurred)– Investment in business activities (shorter depreciation lives and

accelerated depreciation)– Conservation of energy resources (tax credits for energy

conservation expenditures, gas guzzler tax on automobiles)– Stimulation of U.S. exports (favorable treatment of Foreign Sales

Corporations)

• Emphasize tax provisions that help regulate the economy and encourage certain activities and types of businesses

• Encouragement of certain activities– Research and development activities (research credit, deduction in

year incurred)– Investment in business activities (shorter depreciation lives and

accelerated depreciation)– Conservation of energy resources (tax credits for energy

conservation expenditures, gas guzzler tax on automobiles)– Stimulation of U.S. exports (favorable treatment of Foreign Sales

Corporations)

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Economic Considerations (slide 2 of 2)Economic Considerations (slide 2 of 2)

• Encouragement of certain industries– Support for a sound agricultural base (favorable

treatment of farmers)

• Encouragement of small business– S corporation provisions (permit S corporations

to avoid double taxation)– Immediate expensing of a limited amount of

capital expenditures

• Encouragement of certain industries– Support for a sound agricultural base (favorable

treatment of farmers)

• Encouragement of small business– S corporation provisions (permit S corporations

to avoid double taxation)– Immediate expensing of a limited amount of

capital expenditures

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Social ConsiderationsSocial Considerations

• 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– No deduction for expenditures deemed to be

contrary to public policy

• 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– No deduction for expenditures deemed to be

contrary to public policy

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Equity Considerations (slide 1 of 2)


• 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)

• 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)

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• Coping with inflation (indexing certain components of the income tax system to avoid pushing taxpayer into higher bracket when the increase in income may be attributable to inflation)

• Marginal tax rates– Standard deduction amounts– Personal and dependency exemptions

• Coping with inflation (indexing certain components of the income tax system to avoid pushing taxpayer into higher bracket when the increase in income may be attributable to inflation)

• Marginal tax rates– Standard deduction amounts– Personal and dependency exemptions

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Political Considerations (slide 1 of 2)


• Special interest legislation may benefit certain groups with political influence.– Prepaid subscription and dues income is not

taxed until earned, while other types of prepaid income are taxed when received.

• Political expediency may account for tax provisions that benefit low-income taxpayers and increase taxes on wealthy individuals.

• Special interest legislation may benefit certain groups with political influence.– Prepaid subscription and dues income is not

taxed until earned, while other types of prepaid income are taxed when received.

• Political expediency may account for tax provisions that benefit low-income taxpayers and increase taxes on wealthy individuals.

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• State and local government influences may account for some tax provisions.– Interest earned on most state and local bonds is

not taxable.– Joint return rates equalize the treatment of

taxpayers in common law and community property states.

• State and local government influences may account for some tax provisions.– Interest earned on most state and local bonds is

not taxable.– Joint return rates equalize the treatment of

taxpayers in common law and community property states.

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Describe the role played by the IRS and the courts in the evolution of the Federal tax

system.

Describe the role played by the IRS and the courts in the evolution of the Federal tax

system.

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Influence of the IRS (slide 1 of 2)


• The IRS acts as a protector of the revenue:– Pushes for provisions to close loopholes that

are used by taxpayers.– May make adjustments to a taxpayer’s method

of accounting if the method used does not clearly reflect income.

• The IRS acts as a protector of the revenue:– Pushes for provisions to close loopholes that

are used by taxpayers.– May make adjustments to a taxpayer’s method

of accounting if the method used does not clearly reflect income.

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• The IRS seeks laws that make administration of the tax law easier:– Withholding procedures applicable to wages– Interest and penalties for misreporting

• The IRS seeks laws that make administration of the tax law easier:– Withholding procedures applicable to wages– Interest and penalties for misreporting

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Influence of the Courts (slide 1 of 2)


• Federal courts have had an influence on the tax law through formulation of judicial concepts that serve as guides in application of various tax provisions.– Substance over form

– Arm’s length concept

– Business purpose test

• Federal courts have had an influence on the tax law through formulation of judicial concepts that serve as guides in application of various tax provisions.– Substance over form

– Arm’s length concept

– Business purpose test

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• Some court decisions have resulted in modification of the tax law by Congress.– Nontaxability of stock dividends– No income recognized by landlord when lease

terminates and landlord becomes owner of leasehold improvements

• Some court decisions have resulted in modification of the tax law by Congress.– Nontaxability of stock dividends– No income recognized by landlord when lease

terminates and landlord becomes owner of leasehold improvements

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If you have any comments or suggestions concerning this PowerPoint Presentation for West Federal Taxation, please contact:

Donald R. Trippeer, PhD, CPA

[email protected]

East Carolina University

If you have any comments or suggestions concerning this PowerPoint Presentation for West Federal Taxation, please contact:

Donald R. Trippeer, PhD, CPA

[email protected]

East Carolina University



c1 - 1 west federal taxation: an introduction to business entities chapter 1 introduction to...

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