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An Introductionto Taxation

Chapter 1

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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

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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

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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

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Current Influences on Tax Law

The makeup of Congress Lobbyists Elected representatives’ attempts to satisfy

many constituencies

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Taxing Units

Three types of “persons” subject to income tax in the U.S.IndividualC corporationFiduciary (estate and trust)

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Corporate Tax Model

Gross revenuesLess: Cost of goods soldEquals: Gross incomePlus: Other includible income itemsLess: DeductionsEquals: Taxable income (loss)

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Corporate Tax Model (continued)

Taxable incomeTimes: Tax ratesEquals: Gross income tax liabilityPlus: Additions to taxLess: Tax credits or prepaymentsEquals: Tax owed or refund due

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Individual Income Tax Model

Gross incomeLess: Deductions for adjusted gross incomeEquals: Adjusted Gross Income (AGI)Less: Deductions from AGI (greater of

itemized or standard deduction)Less: Exemptions (personal &

dependency)Equals: Taxable income (loss)

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Individual Model (continued)

Taxable incomeTimes: Tax ratesEquals: Gross income tax liabilityPlus: Additions to taxLess: Tax credits and prepaymentsEquals: Tax owed or refund due

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Gross Income

Sources for Corporations and IndividualsGross income from services & sales of goodsTaxable interestDividendsTax 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

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Gross Income

Additional Sources for IndividualsWages & salariesIncome & losses from sole proprietorships and

ownership interests in S corporationsTaxable pension plan distributionsAlimony receivedTaxable portion of unemployment compensationTaxable portion of Social Security benefits

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Losses

Losses result when income is less than expenses or amount invested Business losses – deductible in full against

ordinary incomeInvestment 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

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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

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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

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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

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Property Transactions

The recognized gain (taxable gain) or recognized loss (deductible loss) may differ from the realized gain or loss because of limitation or deferral provisions Deduction of losses from investment sales (capital

losses) may be limited Losses from the sale of personal-use assets are

not deductibleGains from the exchange of business or

investment property may be deferred

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Deductions

Corporations – all business expenses are deductible if ordinary, necessary, and reasonable (unless disallowed by law)

IndividualsDeductions for AGIDeductions from AGI

• Greater of itemized deductions or standard deduction

• Personal & dependency exemptions

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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 Qualified student loan interest Alimony paid

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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)

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Standard Deductions & Exemptions

Standard Deductions for 2010 $11,400 married filing a joint return $5,700 married filing separately $8,400 head of household $5,700 single (unmarried) individual

Dependents limited to greater of (a) $950 or (b) earned income plus $300

Personal and dependency exemptions for 2010 $3,650 per dependent (including taxpayer)

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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

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Tax Rates forMarried Filing a Joint Return

For married filing a joint return for 2010• 10% on first $16,750 taxable income• 15% on $16,751 - $68,000• 25% on $68,001 - $137,300• 28% on $137,301 - $209,250• 33% on $209,251 - $373,650• 35% over $373,650

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Tax Rates forMarried Filing Separately

For married filing separately for 2010• 10% on first $8,375 taxable income• 15% on $8,376 - $34,000• 25% on $34,001 - $68,650• 28% on $68,651 - $104,625• 33% on $104,626 - $186,825• 35% over $186,825

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Tax Rates forHead of Household

For head of household for 2010• 10% on first $11,950 taxable income• 15% on $11,951 - $45,550• 25% on $45,551 - $117,650• 28% on $117,651 - $190,550• 33% on $190,551 - $373,650• 35% over $373,650

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Tax Rates for Single Individuals

For single individuals for 2010• 10% on first $8,375 taxable income• 15% on $8,376 - $34,000• 25% on $34,001 - $82,400• 28% on $82,401 - $171,850• 33% on $171,851 - $373,650• 35% over $373,650

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Alternative Rate Schedulefor Single Individuals

• If taxable income is not over $8,375, tax is 10% of taxable income

• If taxable income is over $8,375 but not over $34,000, tax is $837.50 + (15% x excess over $8,375)

• If taxable income is over $34,000 but not over $82,400, tax is $4,681.25 + (25% x excess over $34,000)

• If taxable income is over $82,400 but not over $171,850, tax is $16,781.25 + (28% x excess over $82,400)

• If taxable income is over $171,850 but not over $373,650, tax is $41,827.25 + (33% x excess over $171,850)

• If taxable income is over $373,650, tax is $108,421.25 + (35% x excess over $373,650

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Tax Losses

A net operating loss (NOL) results when allowable deductions are greater than gross income from a trade or businessNOL’s can be carried back 2 years and

forward 20 yearsDue 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 taxpayer’s NOL must be adjusted to reflect only business losses

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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

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Tax Prepayments & Credits

Tax PrepaymentsTaxes 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

Alternative minimum tax creditForeign tax creditInvestment tax creditGeneral business credits

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Tax Credits

Credits available to individuals onlyEarned income creditEducation creditsChild tax creditDependent care creditAdoption creditCredit for the elderly and disabledCredit for excess payroll tax withheldFirst-time homebuyer credit

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Other Entities

Sole proprietorship Partnerships

Limited liability partnerships (LLPs) Limited liability companies (LLCs)

S corporations Fiduciaries

TrustsEstates

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Fiduciary Income Tax Rates

2010 Rates15% on $0 - $2,30025% on $2,301 - $5,35028% on $5,351 - $8,20033% on $8,201 - $11,20035% over $11,200

When beneficiaries are in lower marginal tax brackets, distributing the income annually to beneficiaries usually results in lower overall taxes

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Choice of Business Entity

Sole Proprietorships Partnerships C Corporations S Corporations

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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)

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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)

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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) entityPasses 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

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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

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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 + partner’s share of partnership liabilities + income that flows through to the partner - distributions - losses

Basis can never be negative Is the upper limit on the amount a partner may

Receive as a tax-free distributionDeduct in losses (excess losses carried forward)

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Owners of an LLC are called members and they have limited liability protection

An LLC will be treated as a partnership for tax purposes unless the company elects to be taxed as a corporationIf owned by a single individual, the LLC would

be taxed as a sole proprietorship if corporate tax treatment not elected

Limited Liability Companies

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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 corporation’s legal existence

Owners can be employees and receive tax-free employee fringe benefits

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Corporations

Form 1120 due 2½ months after year endMarch 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

DisadvantagesDouble taxation (dividends are nondeductible)Corporate losses can only offset corporate profits (no

flow-through to shareholders)

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S Corporations

“Small business corporation”Formed the same as a C corporationReverts to being taxed as C corporation if it ceases

to qualify for S status To qualify for S status

Domestic corporationNo more than 100 shareholders (who generally

must be individuals who are not nonresident aliens)One class of stock outstandingFile Form 2553 election (must be filed within first

2½ months of year to be retroactive)

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S Corporations

Limited liability with no double taxation Profits and losses flow through to owners

each yearShareholders are taxed on their share of profits

even if they receive no distributionLoss deductions are limited to basis (unlike

partners, shareholders do not increase their basis for liabilities of the business); excess losses are carried forward

Shareholders can be employees but cannot participate in tax-free employee fringe benefits if they own more than 2% of stock

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Comparison of Business Entities

Conduit entities are attractive in early years when operating losses are likely to occurC 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

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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

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Comparison of Business Entities

Conduit entities are attractive in early years when operating losses are likely to occurC corporation losses do not provide a tax benefit

until the corporation becomes profitable 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

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Wealth Transfer Taxes

Gift tax assessed on the one making the giftLifetime credit equal to $1 million (fair market value)

means most gifts are not subject to gift tax$13,000 annual exclusion excludes the first $13,000 of

gifts given to each recipient each year When more than $13,000 is given to a person in a

year, a gift tax return must be filed to notify the IRS that some of the lifetime credit has been used

Transfers to spouses and charities are not subject to tax (and do not use up any of the lifetime credit)

Recipient does not pay income tax on receipt of gift

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Wealth Transfer Taxes

In 2009 the estate tax was assessed on transfers at death in excess of $3.5 million (fair market value) at tax rates of 18% to 45%Transfers to spouses & charities not subject to tax

Estate tax expired 1/1/10 but sunset provision will automatically reinstate it 1/1/11 (using a lower credit and higher tax rates than 2009)Congress is expected to extend it retroactively to the

beginning of 2010 with a credit and tax rates similar to 2009

Recipient does not pay income tax on receipt of inheritance

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Other Types of Taxes

Wealth taxes (real property tax) Consumption taxes (sales and use taxes) Tariffs and duties

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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% Current rates are 10%, 15%, 25%, 28%, 33%,

and 35%

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Capital Gains Rates

Most individual’s net long-term capital gains are now taxed at 15%Zero rate for taxpayers in the 10% or 15% tax

brackets Short-term (held one year or less) capital

gains are taxed using the same rates as ordinary income

Corporations have no special rates for capital gains

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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

The marginal tax rate is used for tax planningMarginal tax rate x income = tax paid on that

additional incomeMarginal tax rate x deduction = tax savings

from the deduction

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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 increasesSocial Security tax is 6.2% on first $106,800 in

wages (Medicare is 1.45% on all wages)FUTA is 6.2% on first $7,000 of wages

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Characteristics of a Good Tax

Adam Smith’s Canons of TaxationEquityEconomyCertaintyConvenience

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The End