Essentials of taxation 2016 cengage chapter 01

Tax Structure slide 1 of 2applied – e.g., For the Federal income tax, the tax base is taxable income the tax liability – May be proportional or progressive... Tax Structure slide 1 of 2

Chapter 1

Introduction to Taxation

The Big Picture (slide 1 of 5)

• Travis and Betty Carter are married and have 2

• The Carters live only a few blocks from Ernest and

Mary Walker, Betty Carter’s parents

– The Walkers are retired and live on interest, dividends, and

Social Security benefits.

The Big Picture (slide 2 of 5)

year with possible tax ramifications

– The ad valorem property taxes on the Carters’

residence are increased, while those on the

Walkers’ residence are lowered

– When Travis registers an automobile purchased

last year in another state, he is forced to pay a sales tax to his home state

The Big Picture (slide 3 of 5)

• Various developments occurred during the year

with possible tax ramifications (cont’d)

– As an anniversary present, the Carters gave the

Walkers a recreational vehicle (RV)

– When Travis made a consulting trip to Chicago,

the client withheld Illinois state income tax

from the payment made to Travis for his

services

The Big Picture (slide 4 of 5)

• Various developments occurred during the year with possible tax

ramifications (cont’d)

– Travis employs his children to draft blueprints and

prepare scale models for use in his work

• Both April and Martin have had training in drafting and

topography.

– Early in the year the Carters are audited by the state on

an income tax return filed several years ago

• Later in the year, they are audited by the IRS on a Form 1040

The Big Picture (slide 5 of 5)

• Various developments occurred during the year with

possible tax ramifications (cont’d)

– The Walkers are audited by the IRS

• Unlike the Carters, they did not have to deal with an

agent but settled the matter by mail

issues raised

response.

Tax Structure (slide 1 of 2)

applied

– e.g., For the Federal income tax, the tax base is

taxable income

the tax liability

– May be proportional or progressive

Tax Structure (slide 1 of 2)

applied

– e.g., For the Federal income tax, the tax base is

taxable income

the tax liability

– May be proportional or progressive

burden is shared by taxpayers

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Tax Structure (slide 2 of 2)

Major Types of Taxes

Transaction Taxes

Excise Taxes

• Imposed at the Federal, state, and local levels

• Restricted to specific items

– Examples: gasoline, tobacco, liquor

• Declined in relative importance until recently

– Example-two types of excise taxes at the local level have

recently become increasingly popular

• Hotel occupancy tax

• Rental car surcharge

– Tax is levied on visitors who cannot vote and often used to

fund special projects

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Excise Taxes

• Imposed at the Federal, state, and local levels

• Restricted to specific items

– Examples: gasoline, tobacco, liquor

• Declined in relative importance until recently

– Example-two types of excise taxes at the local level have

recently become increasingly popular

• Hotel occupancy tax

• Rental car surcharge

Excise Taxes

• Imposed at the Federal, state, and local levels

• Restricted to specific items

– Examples: gasoline, tobacco, liquor

• Declined in relative importance until recently

– Example-two types of excise taxes at the local level have

recently become increasingly popular

• Hotel occupancy tax

• Rental car surcharge

– Tax is levied on visitors who cannot vote and often used to

fund special projects

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General Sales Taxes

tax on items purchased in other states but used

in their jurisdiction

Delaware, Montana, New Hampshire, and

Oregon

The Big Picture – Example 4

Use Tax

– The payment Travis made when he registered the

car is probably a use tax

• When the car was purchased in another state, likely no

(or a lesser) sales tax was levied

• The current payment makes up for the amount of sales

tax he would have paid had the car been purchased in his home state

Employment Taxes (slide 1 of 5)

– Paid by both an employee and employer

– The Social Security rate is 6.2% in 2015 on a

maximum of $118,500 of wages

• The Medicare rate is 1.45% on all wages

– A spouse employed by another spouse is subject to

FICA

– Children under the age of 18 who are employed in

Employment Taxes (slide 2 of 5)

earned income above $200,000 (single filers)

or $250,000 (MFJ)

• An employer does not have to match the

employees’ 9%

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Employment Taxes (slide 3 of 5)

assessed on the investment income of

individuals whose modified adjusted gross

income exceeds $200,000 or $250,000, as

above

• For this purpose, investment income includes interest,

dividends, net capital gains, and income for similar portfolio items.

Employment Taxes (slide 4 of 5)

– Sole proprietors and independent contractors may

also be subject to Social Security taxes

• Known as the self-employment tax

• Rates are twice that applicable to an employee

– Generally, 12.4% for Social Security and 2.9% for Medicare

• The tax is imposed on net self-employment income up

to a base amount of $118,500 for 2015

• The new 9% tax addition to Medicare also covers

situations involving high net income from employment.

self-C1-20

Employment Taxes (slide 5 of 5)

– Provides funds for state unemployment benefits

– In 2015, rate is 6% on first $7,000 of wages for

each employee

– Administered jointly by states & Fed govt

• Credit is allowed (up to 5.4%) for FUTA paid to the

state– Tax is paid by employer

The Big Picture – Example 7

Social Security Tax

• Return to The Big Picture on p 1-1

• The combined income of Travis and Betty Carter may

be large enough to trigger one or both of the

additional Medicare taxes

– The marginal tax rate of “upper income” taxpayers like the

Carters is higher than that of other individuals because of these taxes

– Congress has designated these taxes as part of the payment

for Federal health care costs

– The application of these taxes may affect Betty’s decision

to re-enter the work force.

Death Taxes (slide 1 of 2)

receive property upon the death of the owner

– If imposed on right to pass property at death

• Classified as an estate tax

– If imposed on right to receive property from a

decedent

• Classified as an inheritance tax

Death Taxes (slide 2 of 2)

the base for determining the amount of the

death tax

estate tax

taxes, estate taxes, or both

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Federal Estate Tax

(slide 1 of 2)

property to heirs

– Gross estate includes FMV of property decedent

owned at time of death

• Also includes property interests, such as life insurance

proceeds paid to the estate or to a beneficiary other than the estate if the deceased-insured had any ownership rights in the policy

Federal Estate Tax

(slide 2 of 2)

on either:

– Date of death, or

– If elected, the alternate valuation date

• Generally 6 months after date of death

arriving at the taxable estate

• Examples - marital deduction, funeral and admin

expenses, certain taxes, debts of decedent

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Unified Transfer Tax Credit

tax liability for certain estates

million of taxable estate

State Death Taxes

Federal Gift Tax

(slide 1 of 3)

person’s lifetime

– Applies only to transfers that are not supported by

full and adequate consideration

exclusion less marital deduction (if applicable)

of $14,000 per donee (in 2015)

Federal Gift Tax

(slide 2 of 3)

split gifts

– Allows 1/2 of a gift made by a donor-spouse to be

treated as having been made by a nondonor-spouse

(gift splitting)

– Effectively increases the number of annual

exclusions available and allows the use of the

nondonor-spouse’s unified transfer tax credit

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Federal Gift Tax

(slide 3 of 3)

gifts (as well as the estate tax)

to $5,430,000

– It applies to both taxable gifts and the Federal

estate tax

Property (ad valorem) Taxes

• Based on the value of the asset

– Essentially, a tax on wealth, or capital

• Generally imposed on realty or personalty

• Exclusive jurisdiction of states and their local

political subdivisions

• Deductible for Federal income tax purposes

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Property (ad valorem) Taxes

• Based on the value of the asset

– Essentially, a tax on wealth, or capital

• Generally imposed on realty or personalty

• Exclusive jurisdiction of states and their local

political subdivisions

• Deductible for Federal income tax purposes

The Big Picture – Example 14

Ad Valorem Property Taxes

• Return to the facts of The Big Picture on p 1-1.

– Why did the Walkers’ taxes decrease while

those of the Carters increased?

• A likely explanation is that one (or both) of the

Walkers achieved senior citizen status

• In the case of the Carters, the assessed value of their

property probably increased

– Perhaps they made significant home improvements (e.g.,

kitchen/bathroom renovation, addition of a sundeck).

Other Taxes

– Tariffs on certain imported goods

– Levied on the right to do business in the state

– Applicable to various trades or businesses

• e.g., liquor store license, taxicab permit, fee to practice

The Big Picture – Example 15

Occupational Fees

– Although the facts do not mention the matter, both

Travis and Betty will almost certainly pay

occupational fees—Travis for engineering and

Betty for nursing

Severance Taxes

– Important revenue source for states rich in natural

resources

Income Taxes

• Imposed at the Federal, most state, and some local

levels of government

– Income taxes generally are imposed on individuals,

corporations, and certain fiduciaries (estates and trusts)

• Federal income tax base is taxable income (income

less allowable exclusions and deductions)

• Most jurisdictions attempt to assure tax collection by

requiring pay-as-you-go procedures, including

– Withholding requirements for employees, and

– Estimated tax prepayments for all taxpayers

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Formula for Federal Income

Tax on Individuals

Individual Income Tax (Slide 1 of 2)

two categories

– Deductions for adjusted gross income (AGI)

• Generally, related to business activities

– Deductions from AGI

Individual Income Tax (Slide 2 of 2)

– Deductions from AGI (cont’d)

• Often personal in nature

– e.g., medical expenses, mortgage interest and property taxes

on a personal residence, charitable contributions, and personal casualty losses, or related to investment activities

• Generally, itemized deductions and personal and

dependency exemptions

– Individuals may take a standard deduction (a specified amount

based on filing status) rather than itemizing actual deductions

Corporate Income Tax

= Income – Deductions

– Does not require the computation of adjusted gross

income

– Does not provide for the standard deduction or

personal and dependency exemptions

– All allowable deductions are business expenses

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State Income Tax (slide 1 of 3)

• All but the following states impose an income

tax on individuals:

Washington, and Wyoming

dividend and interest income

• Most states also impose either a corporate

State Income Tax (slide 2 of 3)

• Some characteristics of state income taxes include:

– With few exceptions, all states require some form of

withholding procedures

– Most states use as the tax base the income determination

made for Federal income tax purposes

• Some states apply a flat rate to Federal AGI

• Some states apply a rate to the Federal income tax liability

– Referred to as the “piggyback” approach to state income

taxation

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State Income Tax (slide 3 of 3)

• Some states ‘‘decouple’’ from select tax

legislation enacted by Congress

resulting from such legislation

• Because of tie-ins to the Federal return, states

may be notified of changes made by the IRS

upon audit of a Federal return

Various Business Forms

Sole Proprietorship

are reported on Schedule C (Profit or Loss

from Business), and

reported on his or her Form 1040 (U.S

Individual Income Tax Return)

C Corporation

– Reports income and expenses on Form 1120

– Income taxed at corporate level and again at owner

level when distributed as a dividend

– Files information return (Form 1065)

– Partners report partnership income on personal tax

returns

S Corporation

• Like a C corp for all nontax purposes

– Shareholders have limited liability,

– Shares are freely transferable,

– Has centralized management (vested in board of directors),– Has continuity of life (i.e., the corp continues to exist after

withdrawal or death of a shareholder)

• Tax treatment of an S corp is more like a partnership

– The S corp is not subject to Federal income tax

• Like a partnership, it does file a tax return (Form 1120S), but

• Shareholders report their share of net income or loss and other

special items on their own tax returns

Limited Liability Companies and Limited

Liability Partnerships

– Specific rules vary somewhat from state to state

(but not all) of the other nontax features of

corporations

for tax purposes

Dealings Between Individuals

and Entities (slide 1 of 2)

• Many tax provisions deal with the relationship

between owners and their business entities, including the following interactions:

– Owners put assets into a business when they establish a

business entity

– Owners take assets out of the business during its existence

in the form of:

• Salary, dividends, withdrawals, redemptions of stock, etc.

– Through their entities, owner-employees set up retirement

plans for themselves, including IRAs, Keogh plans, and qualified pension plans

– Owners dispose of all or part of a business entity

Dealings Between Individuals

and Entities (slide 2 of 2)

entity have important tax ramifications, e.g.,

– How to avoid taxation at both owner and entity

levels (i.e., the multiple taxation problem)

– How to do the following with the least adverse tax

consequences:

• Get assets into the business

• Get assets out of the business

Dealings Between Individuals

and Entities (slide 2 of 2)

entity have important tax ramifications, e.g.,

– How to avoid taxation at both owner and entity

levels (i.e., the multiple taxation problem)

– How to do the following with the least adverse tax

consequences:

• Get assets into the business

• Get assets out of the business

• Dispose of the business entity

Tax Planning

(slide 1 of 3)

– Avoiding income recognition

• Compensate employees with nontaxable fringe benefits

– Postponing recognition of income

• Postpone sale of assets to achieve tax deferral

– Maximizing deductible amounts

• Invest in stock of another corporation

– Accelerating recognition of deductions

Tax Planning

(slide 1 of 3)

– Avoiding income recognition

• Compensate employees with nontaxable fringe benefits

– Postponing recognition of income

• Postpone sale of assets to achieve tax deferral

– Maximizing deductible amounts

• Invest in stock of another corporation

– Accelerating recognition of deductions

• Elect to deduct charitable contribution in year of pledge

rather than in year of payment

Tax Planning

(slide 1 of 3)

– Avoiding income recognition

• Compensate employees with nontaxable fringe benefits

– Postponing recognition of income

• Postpone sale of assets to achieve tax deferral

– Maximizing deductible amounts

• Invest in stock of another corporation

– Accelerating recognition of deductions

Tax Planning

(slide 2 of 3)

• Tax planning strategies may include (con't):

– Shifting net income from high to low-bracket years

• Postpone recognition of income to low-bracket year

• Postpone recognition of deductions to a high-bracket

year – Shifting net income from high to low-bracket

taxpayers

• Pay children to work in the family business

– Shifting net income from high to low-tax

jurisdictions

• Establish subsidiary operations in countries with low

tax rates