An Introduction to Taxation

1
An Introductionto Taxation

• Chapter 1

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 Code renamed Internal Revenue Code of 1986

4
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

5
Current Influences on Tax Law

• The makeup of Congress
• Lobbyists
• Need to find revenue offsets for pay for tax
  reductions

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
• 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

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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

13
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

14
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

15
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

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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)

17
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)

18
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

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2003 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

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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

21
2003 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

22
2003 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

23
2003 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

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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

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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

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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

27
Tax Prepayments Credits

• Tax Prepayments
• Taxes withheld
• Estimated tax payments
• Credits are a direct reduction in the tax
  liability

28
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

29
Choice of Business Entity

• Sole Proprietorships
• Partnerships
• C Corporations
• S Corporations

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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 owners Schedule
  C of Form 1040 (no separate business tax return)

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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 proprietors
  other income
• Sole proprietor is liable for all debts of
  business (unlimited liability)

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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

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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 partners basis account

34
Partners Basis Account

• Measures a partners 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)

35
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 corporations 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

36
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)

37
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

38
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

39
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

40
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

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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

42
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)

43
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

44
2003 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

45
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

46
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)

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Characteristics of a Good Tax

• Adam Smiths Canons of Taxation
• Equity
• Economy
• Certainty
• Convenience

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The End