Introduction to Taxation: Understanding Tax Structure and Types

1. Chapter 1 Introduction to Taxation 1

2. The Big Picture (slide 1 of 5) Travis and Betty Carter are married and have 2 children April (age 17), and Martin (age 18) Travis is a mining engineer; Betty is a registered nurse The Carters live only a few blocks from Ernest and Mary Walker, Betty Carter’s parents The Walkers are retired and live on interest, dividends, and Social Security benefits.

3. The Big Picture (slide 2 of 5) Various developments occurred during the year with possible tax ramifications The ad valorem property taxes on the Carters’ residence are increased, while those on the Walkers’ residence are lowered When Travis registers an automobile purchased last year in another state, he is forced to pay a sales tax to his home state

4. The Big Picture (slide 3 of 5) Various developments occurred during the year with possible tax ramifications (cont’d) As an anniversary present, the Carters gave the Walkers a recreational vehicle (RV) When Travis made a consulting trip to Chicago, the client withheld Illinois state income tax from the payment made to Travis for his services

5. The Big Picture (slide 4 of 5) Various developments occurred during the year with possible tax ramifications (cont’d) Travis employs his children to draft blueprints and prepare scale models for use in his work Both April and Martin have had training in drafting and topography. Early in the year the Carters are audited by the state on an income tax return filed several years ago Later in the year, they are audited by the IRS on a Form 1040 they filed for the same year In each case, a tax deficiency and interest were assessed.

6. The Big Picture (slide 5 of 5) Various developments occurred during the year with possible tax ramifications (cont’d) The Walkers are audited by the IRS Unlike the Carters, they did not have to deal with an agent but settled the matter by mail Explain these developments and resolve the issues raised. Read the chapter and formulate your response.

7. Tax Structure (slide 1 of 2) Tax base: amount to which the tax rate is applied e.g., For the Federal income tax, the tax base is taxable income Tax rates: applied to the tax base to determine the tax liability May be proportional or progressive Incidence of tax: degree to which the tax burden is shared by taxpayers C1-7

8. Tax Structure (slide 1 of 2) Tax base: amount to which the tax rate is applied e.g., For the Federal income tax, the tax base is taxable income Tax rates: applied to the tax base to determine the tax liability May be proportional or progressive Incidence of tax: degree to which the tax burden is shared by taxpayers C1-8

9. Tax Structure (slide 2 of 2) Examples: Income $10 $20 $30 Proportional $3 (30%) $6 (30%) $ 9 (30%) Tax Progressive $3 (30%) $7 (35%) $12 (40%) Tax C1-9

10. Major Types of Taxes Transaction Taxes Employment Taxes Death Taxes Gift Taxes Property Taxes Income Taxes Other U.S. Taxes C1-10

11. Transaction Taxes Excise taxes General sales taxes Taxes on the transfer of wealth C1-11

12. Excise Taxes Imposed at the Federal, state, and local levels Restricted to specific items Examples: gasoline, tobacco, liquor Declined in relative importance until recently Example-two types of excise taxes at the local level have recently become increasingly popular Hotel occupancy tax Rental car surcharge Tax is levied on visitors who cannot vote and often used to fund special projects C1-12

13. Excise Taxes Imposed at the Federal, state, and local levels Restricted to specific items Examples: gasoline, tobacco, liquor Declined in relative importance until recently Example-two types of excise taxes at the local level have recently become increasingly popular Hotel occupancy tax Rental car surcharge Tax is levied on visitors who cannot vote and often used to fund special projects C1-13

14. Excise Taxes Imposed at the Federal, state, and local levels Restricted to specific items Examples: gasoline, tobacco, liquor Declined in relative importance until recently Example-two types of excise taxes at the local level have recently become increasingly popular Hotel occupancy tax Rental car surcharge Tax is levied on visitors who cannot vote and often used to fund special projects C1-14

15. General Sales Taxes Currently jurisdiction of states and localities States that impose sales taxes also charge a use tax on items purchased in other states but used in their jurisdiction States without sales or use taxes are Alaska, Delaware, Montana, New Hampshire, and Oregon C1-15

16. The Big Picture – Example 4Use Tax Return to The Big Picture on p. 1-1 The payment Travis made when he registered the car is probably a use tax When the car was purchased in another state, likely no (or a lesser) sales tax was levied The current payment makes up for the amount of sales tax he would have paid had the car been purchased in his home state

17. Employment Taxes (slide 1 of 5) FICA taxes Paid by both an employee and employer The Social Security rate is 6.2% in 2015 on a maximum of $118,500 of wages The Medicare rate is 1.45% on all wages A spouse employed by another spouse is subject to FICA Children under the age of 18 who are employed in parent’s unincorporated trade or business are exempt from FICA C1-17

18. Employment Taxes (slide 2 of 5) An additional .9% Medicare tax is imposed on earned income above $200,000 (single filers) or $250,000 (MFJ) An employer does not have to match the employees’ .9% C1-18

19. Employment Taxes (slide 3 of 5) Similarly, an additional 3.8% Medicare tax is assessed on the investment income of individuals whose modified adjusted gross income exceeds $200,000 or $250,000, as above. For this purpose, investment income includes interest, dividends, net capital gains, and income for similar portfolio items. C1-19

20. Employment Taxes (slide 4 of 5) FICA taxes Sole proprietors and independent contractors may also be subject to Social Security taxes Known as the self-employment tax Rates are twice that applicable to an employee Generally, 12.4% for Social Security and 2.9% for Medicare The tax is imposed on net self-employment income up to a base amount of $118,500 for 2015 The new .9% tax addition to Medicare also covers situations involving high net income from self-employment. C1-20

21. Employment Taxes (slide 5 of 5) FUTA (unemployment) taxes Provides funds for state unemployment benefits In 2015, rate is 6% on first $7,000 of wages for each employee Administered jointly by states & Fed govt. Credit is allowed (up to 5.4%) for FUTA paid to the state Tax is paid by employer C1-21

22. The Big Picture – Example 7Social Security Tax Return to The Big Picture on p. 1-1 The combined income of Travis and Betty Carter may be large enough to trigger one or both of the additional Medicare taxes. The marginal tax rate of “upper income” taxpayers like the Carters is higher than that of other individuals because of these taxes. Congress has designated these taxes as part of the payment for Federal health care costs. The application of these taxes may affect Betty’s decision to re-enter the work force.

23. Death Taxes (slide 1 of 2) Tax on the right to transfer property or to receive property upon the death of the owner If imposed on right to pass property at death Classified as an estate tax If imposed on right to receive property from a decedent Classified as an inheritance tax C1-23

24. Death Taxes (slide 2 of 2) The value of the property transferred provides the base for determining the amount of the death tax The Federal government imposes only an estate tax Many state governments levy inheritance taxes, estate taxes, or both C1-24

25. Federal Estate Tax(slide 1 of 2) Federal estate tax is on the right to pass property to heirs Gross estate includes FMV of property decedent owned at time of death Also includes property interests, such as life insurance proceeds paid to the estate or to a beneficiary other than the estate if the deceased-insured had any ownership rights in the policy C1-25

26. Federal Estate Tax(slide 2 of 2) Property included in the gross estate is valued on either: Date of death, or If elected, the alternate valuation date Generally 6 months after date of death Certain deductions and credits allowed in arriving at the taxable estate Examples - marital deduction, funeral and admin. expenses, certain taxes, debts of decedent C1-26

27. Unified Transfer Tax Credit Unified credit reduces or eliminates the estate tax liability for certain estates For 2015, the credit offsets the tax on $5.43 million of taxable estate C1-27

28. State Death Taxes State death taxes may be estate tax, inheritance tax, or both Inheritance tax is on the right to receive property from a decedent Tax is generally based on relationship of heir to decedent The more closely related to the deceased, the lower the tax C1-28

29. Federal Gift Tax (slide 1 of 3) Tax on the right to transfer assets during a person’s lifetime Applies only to transfers that are not supported by full and adequate consideration Taxable gift = FMV of gift less annual exclusion less marital deduction (if applicable) Federal gift tax provides an annual exclusion of $14,000 per donee (in 2015) Amount is adjusted for inflation C1-29

30. Federal Gift Tax (slide 2 of 3) Married persons can make a special election to split gifts Allows 1/2 of a gift made by a donor-spouse to be treated as having been made by a nondonor-spouse (gift splitting) Effectively increases the number of annual exclusions available and allows the use of the nondonor-spouse’s unified transfer tax credit C1-30

31. Federal Gift Tax (slide 3 of 3) The unified transfer tax credit is available for gifts (as well as the estate tax) The credit for 2015 covers the tax on gifts up to $5,430,000 There is only one unified transfer tax credit It applies to both taxable gifts and the Federal estate tax C1-31

32. Property (ad valorem) Taxes Based on the value of the asset Essentially, a tax on wealth, or capital Generally imposed on realty or personalty Exclusive jurisdiction of states and their local political subdivisions Deductible for Federal income tax purposes C1-32

33. Property (ad valorem) Taxes Based on the value of the asset Essentially, a tax on wealth, or capital Generally imposed on realty or personalty Exclusive jurisdiction of states and their local political subdivisions Deductible for Federal income tax purposes C1-33

34. The Big Picture – Example 14Ad Valorem Property Taxes Return to the facts of The Big Picture on p. 1-1. Why did the Walkers’ taxes decrease while those of the Carters increased? A likely explanation is that one (or both) of the Walkers achieved senior citizen status. In the case of the Carters, the assessed value of their property probably increased. Perhaps they made significant home improvements (e.g., kitchen/bathroom renovation, addition of a sundeck).

35. Other Taxes Federal customs duties Tariffs on certain imported goods Franchise taxes Levied on the right to do business in the state Occupational taxes Applicable to various trades or businesses e.g., liquor store license, taxicab permit, fee to practice a profession C1-35

36. The Big Picture – Example 15Occupational Fees Return to The Big Picture on p. 1-1 Although the facts do not mention the matter, both Travis and Betty will almost certainly pay occupational fees—Travis for engineering and Betty for nursing.

37. Severance Taxes Tax on natural resources extracted Important revenue source for states rich in natural resources C1-37

38. Income Taxes Imposed at the Federal, most state, and some local levels of government Income taxes generally are imposed on individuals, corporations, and certain fiduciaries (estates and trusts) Federal income tax base is taxable income (income less allowable exclusions and deductions) Most jurisdictions attempt to assure tax collection by requiring pay-as-you-go procedures, including Withholding requirements for employees, and Estimated tax prepayments for all taxpayers C1-38

39. Formula for Federal Income Tax on Individuals C1-39

40. Individual Income Tax (Slide 1 of 2) For individuals, deductions are separated into two categories Deductions for adjusted gross income (AGI) Generally, related to business activities Deductions from AGI

41. Individual Income Tax (Slide 2 of 2) Deductions from AGI (cont’d) Often personal in nature e.g., medical expenses, mortgage interest and property taxes on a personal residence, charitable contributions, and personal casualty losses, or related to investment activities Generally, itemized deductions and personal and dependency exemptions Individuals may take a standard deduction (a specified amount based on filing status) rather than itemizing actual deductions

42. Corporate Income Tax Corporate Taxable Income = Income – Deductions Does not require the computation of adjusted gross income Does not provide for the standard deduction or personal and dependency exemptions All allowable deductions are business expenses C1-42

43. State Income Tax (slide 1 of 3) All but the following states impose an income tax on individuals: Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming Tennessee and New Hampshire tax only certain dividend and interest income Most states also impose either a corporate income tax or a franchise tax based in part on corporate income C1-43

44. State Income Tax (slide 2 of 3) Some characteristics of state income taxes include: With few exceptions, all states require some form of withholding procedures Most states use as the tax base the income determination made for Federal income tax purposes Some states apply a flat rate to Federal AGI Some states apply a rate to the Federal income tax liability Referred to as the “piggyback” approach to state income taxation C1-44

45. State Income Tax (slide 3 of 3) Some states ‘‘decouple’’ from select tax legislation enacted by Congress State may not be able to afford the loss of revenue resulting from such legislation Because of tie-ins to the Federal return, states may be notified of changes made by the IRS upon audit of a Federal return In recent years, the exchange of information between the IRS and state taxing authorities has increased C1-45

46. Various Business Forms Sole proprietorships Regular corporations (also called C corporations) Partnerships S corporations Limited liability companies Limited liability partnerships

47. Sole Proprietorship Not a separate taxable entity Income and deductions of the proprietorship are reported on Schedule C (Profit or Loss from Business), and Net profit (or loss) of the proprietorship is then reported on his or her Form 1040 (U.S. Individual Income Tax Return)

48. C Corporation Separate tax-paying entity Reports income and expenses on Form 1120 Income taxed at corporate level and again at owner level when distributed as a dividend

49. Partnership Separate entity, but does not pay tax Files information return (Form 1065) Allocates partnership income to partners Partners report partnership income on personal tax returns

50. S Corporation Like a C corp. for all nontax purposes Shareholders have limited liability, Shares are freely transferable, Has centralized management (vested in board of directors), Has continuity of life (i.e., the corp. continues to exist after withdrawal or death of a shareholder) Tax treatment of an S corp. is more like a partnership The S corp. is not subject to Federal income tax Like a partnership, it does file a tax return (Form 1120S), but Shareholders report their share of net income or loss and other special items on their own tax returns