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Chapter 1

Chapter 1. Introduction to Taxation. Tax Structure (slide 1 of 2). Tax base: amount to which the tax rate is applied Tax rates: applied to the tax base to determine the tax liability May be proportional, progressive, or regressive

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Chapter 1

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  1. Chapter 1 Introduction to Taxation

  2. Tax Structure (slide 1 of 2) • Tax base: amount to which the tax rate is applied • Tax rates: applied to the tax base to determine the tax liability • May be proportional, progressive, or regressive • Incidence of tax: degree to which the total tax burden is shared by taxpayers C1-2

  3. Tax Structure (slide 2 of 2) C1-3

  4. Major Types of Taxes • Transaction Taxes • Employment Taxes • Death Taxes • Gift Taxes • Property Taxes • Income Taxes • Other U.S. Taxes C1-4

  5. 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 used to fund special projects C1-5

  6. General Sales Taxes • Currently jurisdiction of states and localities • States that impose sales taxes also charge a use tax on items bought in other states but used in their jurisdiction • States without sales or use taxes are Alaska, Delaware, Montana, New Hampshire, and Oregon C1-6

  7. Employment Taxes (slide 1 of 3) • FICA taxes • Paid by both an employee and employer • In 2009, Social Security rate is 6.2% on a maximum of $106,800 of wages, and 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 C1-7

  8. Employment Taxes (slide 2 of 3) • FICA taxes • Sole proprietors and independent contractors may also be subject to Social Security taxes • Known as the self-employment tax • Rates are 12.4% for Social Security and 2.9% for Medicare • Twice the rates applicable to an employee • The tax is imposed on net self-employment income up to a base amount of $106,800 for 2009 C1-8

  9. Employment Taxes (slide 3 of 3) • FUTA (unemployment) taxes • Provides funds for state unemployment benefits • In 2009, rate is 6.2% 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 C1-9

  10. 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 C1-10

  11. 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 C1-11

  12. 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 C1-12

  13. Federal Estate Tax(slide 2 of 2) • Property included in the gross estate is valued at either: • Date of death, or • If elected, the alternate valuation date • Generally 6 months after date of death • Certain deductions and credits allowed • Examples - marital deduction, funeral and admin. expenses, certain taxes, debts of decedent C1-13

  14. Unified Transfer Tax Credit • Unified credit reduces or eliminates the estate tax liability for modest estates • For 2009, credit is $1,455,800 • Offsets tax on $3,500,000 of the tax base C1-14

  15. Phaseout of Estate Tax • The estate tax has been criticized for the hardship it imposes on small businesses and family farms • Tax Relief Reconciliation Act of 2001 included the phase out of the estate tax • Unified transfer credit is scheduled to increase over a 10 year period • Estate tax is due to be eliminated in 2010 • Sunset provision reinstates estate tax as of January 1, 2011 C1-15

  16. 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, the lower the tax C1-16

  17. 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 $13,000 per donee (in 2009) • Amount is adjusted for inflation C1-17

  18. 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 C1-18

  19. Federal Gift Tax (slide 3 of 3) • The unified transfer tax credit is available for gifts (as well as the estate tax) • Despite the proposed repeal of the estate tax, the gift tax has been retained with the unified transfer tax credit frozen at $345,800, covering $1,000,000 of taxable gifts C1-19

  20. Gift and Estate Unified Tax Schedule • Gift and estate taxes are unified under a single tax rate schedule • Since tax rates are progressive, prior years’ transfers must be considered when calculating the current year’s gift or estate tax C1-20

  21. Property (ad valorem) Taxes • Based on the value of the asset • Generally on realty or personalty • Exclusive jurisdiction of states and their local political subdivisions • Deductible for Federal income tax purposes C1-21

  22. Other Taxes • Federal customs duties • Tariffs on 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 C1-22

  23. Severance Taxes • Tax on the value of natural resources extracted • Important revenue source for states rich in natural resources C1-23

  24. 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 C1-24

  25. Formula for Federal Income Tax on Individuals (Slide 1 of 3) Income (broadly conceived) $xx,xxx Less: Exclusions (x,xxx) Gross income $xx,xxx Less: Certain deductions for AGI (x,xxx) Adjusted Gross Income $xx,xxx C1-25

  26. Adjusted Gross Income $xx,xxx Less: The greater of: Itemized deductions, or The standard deduction (x,xxx) Less: Personal and dependency exemptions (x,xxx) Taxable income $xx,xxx Formula for Federal Income Tax on Individuals (Slide 2 of 3) C1-26

  27. Tax on taxable income (see Tax Rate Schedules in Appendix A) $ x,xxx Less: Tax credits (including Federal income tax withheld and other prepayments of Federal income taxes) (xxx) Tax due (or refund) $ xxx Formula for Federal IncomeTax on Individuals (Slide 3 of 3) C1-27

  28. 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 C1-28

  29. 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 C1-29

  30. 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 C1-30

  31. 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 C1-31

  32. 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 C1-32

  33. 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 C1-33

  34. Various Business Forms • Sole proprietorships • Regular corporations (also called C corporations) • Partnerships • S corporations • Limited liability companies • Limited liability partnerships C1-34

  35. Sole Proprietorship • Not a separate taxable entity • Income reported on owner’s Sch. C C1-35

  36. 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 C1-36

  37. Partnership • Separate entity, but does not pay tax • Allocates partnership income to partners • Partners report partnership income on personal tax returns • Files information return (Form 1065) C1-37

  38. S Corporation • Separate entity, only pays special taxes (e.g.,built-in gains) • Allocates entity income to shareholders • Shareholders report entity income on personal tax return • Files information return (Form 1120S) C1-38

  39. Limited Liability Companies and Limited Liability Partnerships • These organizations exist under state laws • Specific rules vary somewhat from state to state • Both forms have limited liability and some (but not all) of the other nontax features of corporations • Both forms usually are treated as partnerships for tax purposes C1-39

  40. Dealings Between Individuals and Entities (slide 1 of 2) • Many tax provisions deal with the relationship between owners and their business entities, including the following interactions: • Owners put assets into a business when they establish a business entity • Owners take assets out of the business during its existence in the form of: • Salary, dividends, withdrawals, redemptions of stock, etc. • Through their entities, owner-employees set up retirement plans for themselves, including IRAs, Keogh plans, and qualified pension plans • Owners dispose of all or part of a business entity C1-40

  41. Dealings Between Individuals and Entities (slide 2 of 2) • Transactions between owner and business entity have important tax ramifications, e.g., • How to avoid taxation at both owner and entity levels (i.e., the multiple taxation problem) • How to do the following with the least adverse tax consequences: • Get assets into the business • Get assets out of the business • Dispose of the business entity C1-41

  42. Tax Planning(slide 1 of 3) • Tax planning strategies may include: • Avoiding income recognition • Compensate employees with nontaxable fringe benefits • Postponing recognition of income • Postpone sale of assets to achieve tax deferral • Maximizing deductible amounts • Invest in stock of another corporation • Accelerating recognition of deductions • Elect to deduct charitable contribution in year of pledge rather than in year of payment C1-42

  43. Tax Planning(slide 2 of 3) • Tax planning strategies may include (con't): • Shifting net income from high to low-bracket years • Postpone recognition of income to low-bracket year • Postpone recognition of deductions to a high-bracket year • Shifting net income from high to low-bracket taxpayers • Pay children to work in the family business • Shifting net income from high to low-tax jurisdictions • Establish subsidiary operations in countries with low tax rates C1-43

  44. Tax Planning(slide 3 of 3) • Tax planning strategies may include (con't): • Controlling the character of income and deductions • Hold assets long enough to qualify for long-term capital gain rates • Invest in small business stock to obtain ordinary loss treatment under § 1244 • Avoiding double taxation • Operate as a flow-through entity rather than a C corporation • Maximize deductible expenses paid by a C corporation to a shareholder/employee • Maximizing tax credits • Hire employees who qualify the business for the work opportunity tax credit C1-44

  45. Understanding the Federal Tax Law (slide 1 of 3) • The Federal tax law is the vehicle for accomplishing many objectives of the nation such as: • Raising revenue: the major objective of the tax system but not the sole objective • Economic: increasingly important objective is to regulate the economy and encourage certain behavior and businesses considered desirable C1-45

  46. Understanding the Federal Tax Law (slide 2 of 3) • Federal tax objectives • Social: encourage socially desirable behavior that provides benefits that government might otherwise provide • Equity: equity within the tax laws (e.g., wherewithal to pay concept) and not necessarily equity across taxpayers C1-46

  47. Understanding the Federal Tax Law (slide 3 of 3) • Federal tax objectives • Political: a large segment of the tax law is created through a political process; thus, compromises and special interest dealings occur • Ease of administration: many provisions are meant to aid the IRS in the collection of taxes • Courts: influence tax law and sometimes cause it to change C1-47

  48. If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact: • Dr. Donald R. Trippeer, CPA • trippedr@oneonta.edu • SUNY Oneonta C1-48

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