An Introduction to Taxation

1
An Introductionto Taxation

• Chapter 1

2
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

3
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

4
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

5
Current Influences on Tax Law

• The makeup of Congress
• Lobbyists
• Elected representatives attempts to satisfy many
  constituencies

6
Taxing Units

• Three types of persons subject to income tax in
  the U.S.
• Individual
• C corporation
• Fiduciary (estate and trust)

7
Corporate Tax Model

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

8
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

9
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)

10
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

11
Gross Income

• Sources for Corporations
• 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

12
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

13
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 per year C
  corporations can only offset against capital
  gains)
• Personal losses most are not deductible

14
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

15
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, workmans
  compensation and family aid)
• 250,000 gain on sale of personal residence
• Scholarships
• Qualified employee fringe benefits

16
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

17
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

18
Deductions For AGI

• Above-the-line deductions
• 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

19
Itemized Deductions

• Below-the-line 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)

20
Standard Deductions Exemptions

• Standard Deductions
• 10,000 married filing a joint return
• 5,000 married filing separately
• 7,300 head of household
• 5,000 single (unmarried) individual
• Personal and dependency exemptions
• 3,200 per dependent (including taxpayer)

21
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

22
Tax Rates forMarried Filing a Joint Return

• For married filing a joint return for 2005
• 10 on first 14,600 taxable income
• 15 on 14,601 - 59,400
• 25 on 59,401 - 119,950
• 28 on 119,951 - 182,800
• 33 on 182,801 - 326,450
• 35 over 326,450

23
Tax Rates forMarried Filing Separately

• For married filing separately for 2005
• 10 on first 7,300 taxable income
• 15 on 7,301 - 29,700
• 25 on 29,701 - 59,975
• 28 on 59,976 - 91,400
• 33 on 91,401 - 163,225
• 35 over 163,225

24
Tax Rates forHead of Household

• For head of household for 2005
• 10 on first 10,450 taxable income
• 15 on 10,451 - 39,800
• 25 on 39,801 - 102,800
• 28 on 102,801 - 166,450
• 33 on 166,451 - 326,450
• 35 over 326,450

25
Tax Rates for Single Individuals

• For single individuals for 2005
• 10 on first 7,300 taxable income
• 15 on 7,301 - 29,700
• 25 on 29,701 - 71,950
• 28 on 71,951 - 150,150
• 33 on 150,151 - 326,450
• 35 over 326,450

26
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 individuals NOL must be adjusted to reflect
  only business losses

27
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

28
Tax Prepayments Credits

• Tax Prepayments
• Taxes withheld (from salary wages)
• Estimated tax payments (corporations
  self-employed individuals)
• Credits are a direct reduction in the tax
  liability
• Credits available to all taxpayers
• AMT credit
• Foreign tax credit
• General business credits

29
Tax Credits

• Credits available to individuals only
• Earned income credit
• Education credits
• Child tax credit
• Dependent care credit
• Adoption credit
• Credit for the elderly and disabled

30
Other Entities

• Sole proprietorship
• Partnerships
• Limited liability partnerships
• Limited liability companies
• S corporation
• Fiduciaries
• Trusts
• Estates

31
Fiduciary Income Tax Rates

• 2005 Rates
• 15 on 0 - 2,000
• 25 on 2,001 - 4,700
• 28 on 4,701 - 7,150
• 33 on 7,151 - 9,750
• 35 over 9,750
• Because beneficiaries are usually in lower
  marginal tax brackets, distributing the income
  annually to beneficiaries usually results in
  lower overall taxes

32
Choice of Business Entity

• Sole Proprietorships
• Partnerships
• C Corporations
• S Corporations

33
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 owners Schedule
  C of Form 1040 (no separate business tax return)

34
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 proprietors
  other income
• Sole proprietor is liable for all debts of
  business (unlimited liability)

35
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 (or flow-through) entity
• 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

36
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 partners basis account

37
Partners Basis Account

• Measures a partners 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

38
Partners Basis Account

• 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)

39
Corporations

• Must file articles of incorporation with state
• Limited Liability - Shareholders are only at risk
  for their capital investment
• Centralized management
• Unlimited Life - Death of an owner or transfer of
  stock ownership does not end the corporations
  legal existence
• Owners can be employees and receive tax-free
  employee fringe benefits

40
Corporations

• Form 1120 due 2½ months after year end
• March 15th for calendar year taxpayer
• 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)

41
S Corporations

• Small business corporation
• Formed the same as C corporations revert to
  being taxed as C corporations if they cease to
  qualify for S status
• To elect S status
• Domestic corporation with no more than 100
  shareholders (generally individuals who are not
  nonresident aliens)
• Family members counted as one shareholder for
  purposes of determining the maximum number of
  shareholders
• One class of stock outstanding
• File Form 2553 election within first 2½ months

42
S Corporations

• Limited liability with no double taxation
• 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

43
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

44
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

45
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

46
Progressive Tax Rate System

• Tax rates increase as income increases
• In 1913 rates ranged from 1 to 7
• To finance World War I, top rate was 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)

47
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

48
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

49
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 90,000 in
  wages (Medicare is 1.45 on all wages)
• FUTA is 6.2 on first 7,000 of wages

50
Characteristics of a Good Tax

• Adam Smiths Canons of Taxation
• Equity
• Economy
• Certainty
• Convenience

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The End