1. An Introduction to Taxation
Chapter 1
An Introduction to Taxation

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
The economy

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 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; 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, workman’s 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 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 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
$9,700 married filing a joint return
$4,850 married filing separately
$7,150 head of household
$4,850 single (unmarried) individual
Personal and dependency exemptions
$3,100

21. 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

22. Tax Rates for Married Filing a Joint Return
For married filing a joint return for 2004
10% on first $14,300 taxable income
15% on $14,301 - $58,100
25% on $58,101 - $117,250
28% on $117,251 - $178,650
33% on $178,651 - $319,100
35% over $319,100

23. Tax Rates for Married Filing Separately
For married filing separately for 2004
10% on first $7,150 taxable income
15% on $7,151 - $29,050
25% on $29,051 - $58,625
28% on $58,626 - $89,325
33% on $89,326 - $159,550
35% over $159,551

24. Tax Rates for Head of Household
For head of household for 2004
10% on first $10,200 taxable income
15% on $10,201 - $38,900
25% on $38,901 - $100,500
28% on $100,501 - $162,700
33% on $162,701 - $319,100
35% over $319,100

25. Tax Rates for Single Individuals
For single individuals for 2004
10% on first $7,150 taxable income
15% on $7,151 - $29,050
25% on $29,051 - $70,350
28% on $70,351 - $146,750
33% on $146,751 - $319,100
35% over $319,100

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 individual’s 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
Taxes withheld
Estimated tax payments
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
Educations credits
Child tax credit
Dependent care credit
Adoption credit
Credit for the elderly and disabled

30. Other Entities Sole proprietorship Partnerships S corporation
Limited liability partnerships
Limited liability companies
S corporation
Fiduciaries
Trusts
Estates

31. Fiduciary Income Tax Rates
15% on $0 - $1,950
25% on $1,951 - $4,600
28% on $4,601 - $7,000
33% on $7,000 - $9,550
35% over $9,550
Because beneficiaries are usually in lower marginal tax brackets, distributing the income annually to beneficiaries usually results in overall lower 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 owner’s 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 proprietor’s 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” 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

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 partner’s basis account

37. 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)

38. 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 (unlimited life)
Owners can be employees and receive tax-free employee fringe benefits

39. Corporations Form 1120 due 2½ months after year end
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)

40. S Corporations
Formed the same as C corporations; 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

41. 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 tax-free employee fringe benefits if they own more than 2% of stock

42. 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

43. 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

44. 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

45. Progressive Tax Rate System
Tax rates on income increase as income increases
In 1913 rates ranged from 1% to 7%
To finance World War I 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%)

46. 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

47. 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

48. 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 $87,900 in wages (Medicare is 1.45% on all wages)
FUTA is 6.2% on first $7,000 of wages

49. Characteristics of a Good Tax
Adam Smith’s Canons of Taxation
Equity
Economy
Certainty
Convenience

50. The End