An Introduction to Taxation Chapter 1 An Introduction to Taxation

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

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 Sources for Corporations and Individuals Gross income from 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 Alimony received Taxable portion of unemployment compensation 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 per year; 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

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 deductible Gains from the exchange of business or investment property may be deferred

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 “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

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)

Standard Deductions & Exemptions Standard Deductions for 2009 $11,400 married filing a joint return $5,700 married filing separately $8,350 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 2009 $3,650 per dependent (including taxpayer)

Corporate Tax Rates 15% on first $50,000 25% on $50,001 - $75,000 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 for Married Filing a Joint Return For married filing a joint return for 2009 10% on first $16,700 taxable income 15% on $16,701 - $67,900 25% on $67,901 - $137,050 28% on $137,051 - $208,850 33% on $208,851 - $372,950 35% over $372,950

Tax Rates for Married Filing Separately For married filing separately for 2009 10% on first $8,350 taxable income 15% on $8,351 - $33,950 25% on $33,951 - $68,525 28% on $68,526 - $104,425 33% on $104,426 - $186,475 35% over $186,475

Tax Rates for Head of Household For head of household for 2009 10% on first $11,950 taxable income 15% on $11,951 - $45,500 25% on $45,501 - $117,450 28% on $117,451 - $190,200 33% on $190,201 - $372,950 35% over $372,950

Tax Rates for Single Individuals For single individuals for 2009 10% on first $8,350 taxable income 15% on $8,351 - $33,950 25% on $33,951 - $82,250 28% on $82,251 - $171,550 33% on $171,551 - $372,950 35% over $372,950

Tax Losses A net operating loss (NOL) results when allowable deductions are greater than gross income from a trade or business NOL’s 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 taxpayer’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 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 Alternative minimum tax credit Foreign tax credit Investment tax credit General business credits

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 Credit for excess payroll tax withheld First-time homebuyer credit

Other Entities Sole proprietorship Partnerships S corporations Limited liability partnerships (LLPs) Limited liability companies (LLCs) S corporations Fiduciaries Trusts Estates

Fiduciary Income Tax Rates 15% on $0 - $2,300 25% on $2,301 - $5,350 28% on $5,351 - $8,200 33% on $8,201 - $11,150 35% over $11,150 When beneficiaries are in lower marginal tax brackets, distributing the income annually to beneficiaries usually results in lower overall 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” (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

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 + 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 distribution Deduct in losses (excess losses carried forward)

Limited Liability Companies 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 corporation If owned by a single individual, the LLC would be taxed as a sole proprietorship if corporate tax treatment not elected

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

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)

S Corporations “Small business corporation” To qualify for S status Formed the same as a C corporation Reverts to being taxed as C corporation if it ceases to qualify for S status To qualify for S status Domestic corporation No more than 100 shareholders (who generally must be individuals who are not nonresident aliens) One class of stock outstanding File Form 2553 election (must be filed within first 2½ months of year to be retroactive)

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 Loss 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

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

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 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

Wealth Transfer Taxes Gift and estate taxes assessed on the one making the transfer Gift tax assessed on lifetime gifts in excess of $1 million (fair market value) First $13,000 of gifts to recipient each year are excluded so if gifts to an individual are no more than $13,000 then no gift tax return must be filed Estate tax assessed on transfers at death in excess of $3.5 million (fair market value) Transfers to spouses and charities are not subject to tax Recipient does not pay income tax on receipt of gift or inheritance

Other Types of Taxes Wealth taxes (real property tax) Consumption taxes (sales and use taxes) Tariffs and duties

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%

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

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 planning Marginal tax rate x income = tax paid on that additional income Marginal tax rate x deduction = tax savings from the deduction

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 $106,800 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

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