An Introduction to Taxation

An Introductionto Taxation Chapter1

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 revenues Less: Cost of goods sold Equals: Gross income Plus: Other includible income items Less: Deductions Equals: Taxable income (loss)

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 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) 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 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

An Introduction to Taxation