ch01 an introduction to taxation

 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 interes

the government

1 - 3

©2005 Prentice Hall, Inc.

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

1 - 4

©2005 Prentice Hall, Inc.

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

1 - 5

©2005 Prentice Hall, Inc.

Current Influences on Tax Law

 The makeup of Congress

 Lobbyists

 Elected representatives attempts to satisfy

many constituencies

 The economy

1 - 6

©2005 Prentice Hall, Inc.

Taxing Units

 Three types of “persons” subject to income

tax in the U.S

 Individual

 C corporation

 Fiduciary (estate and trust)

Less: Cost of goods sold

Equals: Gross income Plus: Other includible income items

Less: Deductions

Equals: Taxable income (loss)

Times: Tax rates

Equals: Gross income tax liability

Plus: Additions to tax

Less: Tax credits or prepayments

Equals: Tax owed or refund due

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)

Times: Tax rates

Equals: Gross income tax liability

Plus: Additions to tax

Less: Tax credits or prepayments

Equals: Tax owed or refund due

 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

1 - 12

©2005 Prentice Hall, Inc.

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

1 - 13

©2005 Prentice Hall, Inc.

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

 Nontaxable stock dividends

 Nontaxable stock rights

 Proceeds of life insurance policies

 Tax refunds to the extent no prior tax benefit

1 - 15

©2005 Prentice Hall, Inc.

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

1 - 16

©2005 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 or

loss deducted from gross income

1 - 17

©2005 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

1 - 18

©2005 Prentice Hall, Inc.

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

1 - 19

©2005 Prentice Hall, Inc.

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)

 $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

 For married filing a joint return for 2004

 10% on first $14,300 taxable income

 For married filing separately for 2004

 10% on first $7,150 taxable income

 For head of household for 2004

 10% on first $10,200 taxable income

 For single individuals for 2004

 10% on first $7,150 taxable income

1 - 26

©2005 Prentice Hall, Inc.

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

 Individual AMT (Individual AMT rates are 26%

on first $175,000 of AMTI and 28% on excess

 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

1 - 29

©2005 Prentice Hall, Inc.

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

 Limited liability partnerships

 Limited liability companies

 S corporation

 Fiduciaries

 Trusts

 Estates

 Because beneficiaries are usually in lower

marginal tax brackets, distributing the income

annually to beneficiaries usually results in overall

lower taxes

1 - 33

©2005 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)

1 - 34

©2005 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)

1 - 35

©2005 Prentice Hall, Inc.

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

1 - 36

©2005 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

1 - 37

©2005 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)

1 - 38

©2005 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 (unlimited life)

 Owners can be employees and receive tax-free

employee fringe benefits

1 - 39

©2005 Prentice Hall, Inc.

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)

1 - 40

©2005 Prentice Hall, Inc.

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

 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

1 - 42

©2005 Prentice Hall, Inc.

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

1 - 43

©2005 Prentice Hall, Inc.

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

1 - 44

©2005 Prentice Hall, Inc.

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

1 - 45

©2005 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 I the top rate increased

1 - 46

©2005 Prentice Hall, Inc.

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

1 - 47

©2005 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

1 - 48

©2005 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

1 - 49

©2005 Prentice Hall, Inc.

Characteristics of a Good Tax

 Adam Smith’s Canons of Taxation

 Equity

 Economy

 Certainty

 Convenience

1 - 50

©2005 Prentice Hall, Inc.

The End