1 - 1 ©2004 Prentice Hall, Inc. An Introduction to Taxation Chapter 1

1 - 2 ©2004 Prentice Hall, Inc. 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

1 - 3 ©2004 Prentice Hall, Inc. Brief History of U.S. Income Tax 1913 – 16 th Amendment to U.S. Constitution 1939 – income tax laws codified as the Internal Revenue Code 1954 – recodification of IRC 1986 – Code renamed Internal Revenue Code of 1986

1 - 4 ©2004 Prentice Hall, Inc. Objectives of Taxation Goals include: raising revenue, wealth redistribution, price stability, economic growth, and 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

1 - 5 ©2004 Prentice Hall, Inc. Current Influences on Tax Law The makeup of Congress Lobbyists Need to find revenue offsets for pay for tax reductions

1 - 6 ©2004 Prentice Hall, Inc. Taxing Units Three types of “persons” subject to income tax in the U.S.  Individual  C corporation  Fiduciary (estate and trust)

1 - 7 ©2004 Prentice Hall, Inc. Corporate Tax Model Gross revenues Less: Cost of goods sold Equals: Gross income Plus: Other includible income items Less: Deductions Equals: Taxable income (loss)

1 - 8 ©2004 Prentice Hall, Inc. 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

1 - 9 ©2004 Prentice Hall, Inc. 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)

©2004 Prentice Hall, Inc. 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

©2004 Prentice Hall, Inc. Gross Income Gross income for services & sales of goods Wages & salary Taxable interest Dividends Gains on capital assets (losses subject to limits) Gains & losses on other property transactions Income & losses from flow-through entities Income & losses from rental real estate

©2004 Prentice Hall, Inc. Losses Losses are negative income  Business losses – deductible in full against ordinary income  Investment losses – subject to limits as capital losses ($3,000 limit for individuals; C corporations can only offset against capital gains)  Personal losses – most are not deductible

©2004 Prentice Hall, Inc. Exclusions from Gross Income Tax-exempt interest Nontaxable stock dividends Nontaxable stock rights Proceeds of life insurance Tax refunds to the extent no prior tax benefit was received Qualified employee fringe benefits Gifts and inheritances Scholarships

©2004 Prentice Hall, Inc. 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 gross income or deductible loss

©2004 Prentice Hall, Inc. 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

©2004 Prentice Hall, Inc. Deductions For AGI Contributions to pension and retirement plans Medical savings account contributions Moving expenses One-half of self-employment taxes Self-employed health insurance premiums Penalty on early withdrawal of savings Tuition deduction ($3,000 limit) Qualified student loan interest ($2,500 limit)

©2004 Prentice Hall, Inc. Itemized Deductions Medical & dental expenses (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 and theft losses (in excess of 10% AGI) Miscellaneous including unreimbursed employee business expenses and investment expenses (in excess of 2% AGI) Gambling losses (up to gambling winnings)

©2004 Prentice Hall, Inc. Standard Deductions & Exemptions Standard Deductions (before 2003 Tax Act)  $7,950 married filing a joint return  $3,975 married filing separately  $7,000 head of household  $4,750 single (unmarried) individual Personal and dependency exemptions  $3,050

©2004 Prentice Hall, Inc Tax Act Changes Standard deduction marriage penalty relief  For 2003 and 2004 married filing jointly deduction increases to double the deduction for single individuals (increases from $7,950 to $9,500 for 2003)  After 2004 returns to present law

©2004 Prentice Hall, Inc. Tax Rates for Single Individuals  Rates before 2003 Tax Act  10% on first $6,000 taxable income  15% on $6,001 - $28,400  27% on $28,401 - $68,800  30% on $68,801 - $143,500  35% on $143,501 - $311,950  38.6% over $311,950  Income levels at which rates apply vary with filing status

©2004 Prentice Hall, Inc Tax Act Changes The rates above 15% drop to 25%, 28%, 33%, and 35% The 10% bracket expands  For 2003 and 2004 to the first $7,000 of taxable income for single individuals ($14,000 for married filing joint return)  After 2004 the 10% bracket returns to $6,000 ($12,000) as under present law

©2004 Prentice Hall, Inc Tax Act New Rates  For single individuals for 2003  10% on first $7,000 taxable income  15% on $7,001 - $28,400  25% on $28,401 - $68,800  28% on $68,801 - $143,500  33% on $143,501 - $311,950  35% over $311,950

©2004 Prentice Hall, Inc Tax Act New Rates  For married filing joint return for 2003  10% on first $14,000 taxable income  15% on $14,001 - $56,800  25% on $56,801 - $114,650  28% on $114,651 - $174,700  33% on $174,701 - $311,950  35% over $311,950

©2004 Prentice Hall, Inc. Corporate Tax Rates  Corporate rates not affected by 2003 Tax Act  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% on over $18,333,333

©2004 Prentice Hall, Inc. Tax Losses A net operating loss (NOL) results when deductions are greater than gross income  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

©2004 Prentice Hall, Inc. Additions to Tax Corporate Alternative Minimum Tax rate is 20% Individual AMT rate is:  26% on first $175,000 of AMTI  28% on excess above $175,000 Other additions to tax include  Self-employment taxes  Penalty for premature withdrawal from pension plans  Employment taxes for household help

©2004 Prentice Hall, Inc. Tax Prepayments & Credits Tax Prepayments  Taxes withheld  Estimated tax payments Credits are a direct reduction in the tax liability

©2004 Prentice Hall, Inc. Income Taxation of Fiduciaries Fiduciaries (estates & trusts) reach top 35% tax rate in 2003 with income over $9,350 Income distributed to beneficiaries is taxed to beneficiaries instead of fiduciary

©2004 Prentice Hall, Inc. Choice of Business Entity Sole Proprietorships Partnerships C Corporations S Corporations

©2004 Prentice Hall, Inc. 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)

©2004 Prentice Hall, Inc. 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)

©2004 Prentice Hall, Inc. Partnerships Two or more partners with no restrictions on who can be a partner A “conduit” that 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

©2004 Prentice Hall, Inc. 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

©2004 Prentice Hall, Inc. 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 + income that flows through to the partner - losses - distributions 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)

©2004 Prentice Hall, Inc. Corporations Must file articles of incorporation with state Shareholders are only at risk for their capital investment (limited liability) Centralized management 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 Form 1120 due 2½ months after year end Can use calendar year or fiscal year

©2004 Prentice Hall, Inc. Corporations When the corporate rates are lower than the individual tax rates, the owners have increased capital for reinvestment and business expansion Disadvantages  Double taxation (no deduction for dividends)  Corporate losses can only offset corporate profits (no flow-through to shareholders)

©2004 Prentice Hall, Inc. S Corporations Formed the same as C corporations and revert to being taxed as C corporations if they cease to qualify for S status Limited liability with no double taxation To elect S status:  Domestic corporation with no more than 75 shareholders (generally individuals who are not nonresident aliens)  One class of stock outstanding  File Form 2553 election within first 2½ months

©2004 Prentice Hall, Inc. S Corporations 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 employee tax-free fringe benefits if they own more than 2% of stock

©2004 Prentice Hall, Inc. Compare 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

©2004 Prentice Hall, Inc. Compare 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

©2004 Prentice Hall, Inc. Other Types of Taxes Wealth taxes (real property tax) Wealth transfer taxes (estate and gift taxes) Consumption taxes (sales and use taxes) Tariffs and duties

©2004 Prentice Hall, Inc. Progressive Tax Rate System Tax rates on income increase as income increases In 1913 rates ranged from 1% to 7% To finance World War II, the top rate 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%)

©2004 Prentice Hall, Inc. Capital Gains Rates Net long-term capital gains are taxed at rates up to a maximum of 28% for individuals (20% was primary rate before the 2003 Tax Act) Net short-term capital gains are taxed using the same rates as ordinary income Corporations have no special rates for capital gains

©2004 Prentice Hall, Inc Tax Act Changes For capital assets sold or exchanged after May 5, 2003 new rates apply for individuals  15% rate (instead of 20%) for LTCG  5% rate applies to taxpayers in 10% or 15% tax brackets Dividend income will be taxed using the new capital gains rates

©2004 Prentice Hall, Inc. 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

©2004 Prentice Hall, Inc. 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)

©2004 Prentice Hall, Inc. Characteristics of a Good Tax Adam Smith’s Canons of Taxation  Equity  Economy  Certainty  Convenience

©2004 Prentice Hall, Inc. The End