© 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Essentials of Taxation 1 Chapter 1 Introduction to Taxation

The Big Picture (slide 1 of 5) Travis and Betty Carter are married and have 2 children –April (age 17), and –Martin (age 18) Travis is a mining engineer; Betty is a registered nurse 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) Various developments occurred during the 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 they filed for the same year In each case, a tax deficiency and interest were assessed.

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

Tax Structure (slide 1 of 2) Tax base: amount to which the tax rate is applied –e.g., For the Federal income tax, the tax base is taxable income Tax rates: applied to the tax base to determine the tax liability –May be proportional or progressive Incidence of tax: degree to which the tax burden is shared by taxpayers C1-7

Tax Structure (slide 1 of 2) Tax base: amount to which the tax rate is applied –e.g., For the Federal income tax, the tax base is taxable income Tax rates: applied to the tax base to determine the tax liability –May be proportional or progressive Incidence of tax: degree to which the tax burden is shared by taxpayers C1-8

Major Types of Taxes Transaction Taxes Employment Taxes Death Taxes Gift Taxes Property Taxes Income Taxes Other U.S. Taxes C1-9

Transaction Taxes Excise taxes General sales taxes Taxes on the transfer of wealth C1-10

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 C1-11

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 C1-12

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 C1-13

General Sales Taxes Currently jurisdiction of states and localities States that impose sales taxes also charge a use tax on items purchased in other states but used in their jurisdiction States without sales or use taxes are Alaska, Delaware, Montana, New Hampshire, and Oregon C1-14

Employment Taxes (slide 1 of 5) FICA taxes –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 parent’s unincorporated trade or business are exempt from FICA C1-15

Employment Taxes (slide 2 of 5) An additional.9% Medicare tax is imposed on earned income above $200,000 (single filers) or $250,000 (MFJ) An employer does not have to match the employees’.9% C1-16

Employment Taxes (slide 3 of 5) Similarly, an additional 3.8% Medicare tax is 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. C1-17

Employment Taxes (slide 4 of 5) FICA taxes –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 self- employment. C1-18

Employment Taxes (slide 5 of 5) FUTA (unemployment) taxes –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 C1-19

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) Tax on the right to transfer property or to 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 C1-21

Death Taxes (slide 2 of 2) The value of the property transferred provides the base for determining the amount of the death tax The Federal government imposes only an estate tax Many state governments levy inheritance taxes, estate taxes, or both C1-22

Federal Estate Tax (slide 1 of 2) Federal estate tax is on the right to pass 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 C1-23

Federal Estate Tax (slide 2 of 2) Property included in the gross estate is valued on either: –Date of death, or –If elected, the alternate valuation date Generally 6 months after date of death Certain deductions and credits allowed in arriving at the taxable estate Examples - marital deduction, funeral and admin. expenses, certain taxes, debts of decedent C1-24

Unified Transfer Tax Credit Unified credit reduces or eliminates the estate tax liability for certain estates For 2015, the credit offsets the tax on $5.43 million of taxable estate C1-25

State Death Taxes State death taxes may be estate tax, inheritance tax, or both –Inheritance tax is on the right to receive property from a decedent –Tax is generally based on relationship of heir to decedent The more closely related to the deceased, the lower the tax C1-26

Federal Gift Tax (slide 1 of 3) Tax on the right to transfer assets during a person’s lifetime –Applies only to transfers that are not supported by full and adequate consideration Taxable gift = FMV of gift less annual exclusion less marital deduction (if applicable) Federal gift tax provides an annual exclusion of $14,000 per donee (in 2015) –Amount is adjusted for inflation C1-27

Federal Gift Tax (slide 2 of 3) Married persons can make a special election to 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 C1-28

Federal Gift Tax (slide 3 of 3) The unified transfer tax credit is available for gifts (as well as the estate tax) The credit for 2015 covers the tax on gifts up to $5,430,000 There is only one unified transfer tax credit –It applies to both taxable gifts and the Federal estate tax C1-29

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 C1-30

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 C1-31

The Big Picture – Example 14 Ad Valorem Property Taxes Return to the facts of The Big Picture on p –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 Federal customs duties –Tariffs on certain imported goods Franchise taxes –Levied on the right to do business in the state Occupational taxes –Applicable to various trades or businesses e.g., liquor store license, taxicab permit, fee to practice a profession C1-33

The Big Picture – Example 15 Occupational Fees Return to The Big Picture on p. 1-1 –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 Tax on natural resources extracted –Important revenue source for states rich in natural resources C1-35

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 C1-36

Formula for Federal Income Tax on Individuals C1-37

Individual Income Tax (Slide 1 of 2) For individuals, deductions are separated into 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 Corporate Taxable Income = 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 C1-40

State Income Tax (slide 1 of 3) All but the following states impose an income tax on individuals: –Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming –Tennessee and New Hampshire tax only certain dividend and interest income Most states also impose either a corporate income tax or a franchise tax based in part on corporate income C1-41

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 C1-42

State Income Tax (slide 3 of 3) Some states ‘‘decouple’’ from select tax legislation enacted by Congress –State may not be able to afford the loss of revenue 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 –In recent years, the exchange of information between the IRS and state taxing authorities has increased C1-43

Various Business Forms Sole proprietorships Regular corporations (also called C corporations) Partnerships S corporations Limited liability companies Limited liability partnerships

Sole Proprietorship Not a separate taxable entity Income and deductions of the proprietorship are reported on Schedule C (Profit or Loss from Business), and Net profit (or loss) of the proprietorship is then reported on his or her Form 1040 (U.S. Individual Income Tax Return)

C Corporation Separate tax-paying entity –Reports income and expenses on Form 1120 –Income taxed at corporate level and again at owner level when distributed as a dividend

Partnership Separate entity, but does not pay tax –Files information return (Form 1065) Allocates partnership income to partners –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 These organizations exist under state laws –Specific rules vary somewhat from state to state Both forms have limited liability and some (but not all) of the other nontax features of corporations Both forms usually are treated as partnerships 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) Transactions between owner and business 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

Dealings Between Individuals and Entities (slide 2 of 2) Transactions between owner and business 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) Tax planning strategies may include: –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) Tax planning strategies may include: –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) Tax planning strategies may include: –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 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

Tax Planning (slide 3 of 3) Tax planning strategies may include (con't): –Controlling the character of income & deductions Hold assets long enough to qualify for long-term capital gain rates Invest in small business stock to obtain ordinary loss treatment under § 1244 –Avoiding double taxation Operate as a flow-through entity rather than a C corp. Maximize deductible expenses paid by a C corp. to a shareholder/employee –Maximizing tax credits Hire employees who qualify the business for the work opportunity tax credit

Understanding the Federal Tax Law (slide 1 of 3) The Federal tax law is the vehicle for accomplishing many objectives of the nation such as: –Raising revenue: the major objective of the tax system but not the sole objective –Economic: increasingly important objective is to regulate the economy and encourage certain behavior and businesses considered desirable C1-58

Understanding the Federal Tax Law (slide 1 of 3) The Federal tax law is the vehicle for accomplishing many objectives of the nation such as: –Raising revenue: the major objective of the tax system but not the sole objective –Economic: increasingly important objective is to regulate the economy and encourage certain behavior and businesses considered desirable C1-59

Understanding the Federal Tax Law (slide 1 of 3) The Federal tax law is the vehicle for accomplishing many objectives of the nation such as: –Raising revenue: the major objective of the tax system but not the sole objective –Economic: increasingly important objective is to regulate the economy and encourage certain behavior and businesses considered desirable C1-60

Understanding the Federal Tax Law (slide 2 of 3) Federal tax objectives –Social: encourage socially desirable behavior that provides benefits that government might otherwise provide –Equity: equity within the tax laws (e.g., wherewithal to pay concept) and not necessarily equity across taxpayers C1-61

Understanding the Federal Tax Law (slide 2 of 3) Federal tax objectives –Social: encourage socially desirable behavior that provides benefits that government might otherwise provide –Equity: equity within the tax laws (e.g., wherewithal to pay concept) and not necessarily equity across taxpayers C1-62

Understanding the Federal Tax Law (slide 2 of 3) Federal tax objectives –Social: encourage socially desirable behavior that provides benefits that government might otherwise provide –Equity: equity within the tax laws (e.g., wherewithal to pay concept) and not necessarily equity across taxpayers C1-63

Understanding the Federal Tax Law (slide 2 of 3) Federal tax objectives –Social: encourage socially desirable behavior that provides benefits that government might otherwise provide –Equity: equity within the tax laws (e.g., wherewithal to pay concept) and not necessarily equity across taxpayers C1-64

Understanding the Federal Tax Law (slide 2 of 3) Federal tax objectives –Social: encourage socially desirable behavior that provides benefits that government might otherwise provide –Equity: equity within the tax laws (e.g., wherewithal to pay concept) and not necessarily equity across taxpayers C1-65

Understanding the Federal Tax Law (slide 3 of 3) Federal tax objectives –Political: a large segment of the tax law is created through a political process; thus, compromises and special interest dealings occur –Ease of administration: many provisions are meant to aid the IRS in the collection of taxes –Courts: influence tax law and sometimes cause it to change C1-66

Understanding the Federal Tax Law (slide 3 of 3) Federal tax objectives –Political: a large segment of the tax law is created through a political process; thus, compromises and special interest dealings occur –Ease of administration: many provisions are meant to aid the IRS in the collection of taxes –Courts: influence tax law and sometimes cause it to change C1-67

Refocus On The Big Picture (slide 1 of 4) The explanation given for the difference in the ad valorem taxes—the Carters’ increase and the Walker’s decrease—seems reasonable. –It is not likely that the Carters’ increase was due to a general upward assessment in valuation, as the Walkers’ taxes on their residence (located nearby) dropped. –More business use of the Carters’ residence (presuming Travis conducts his consulting practice from his home) might be responsible for the increase, but capital improvements appear to be a more likely cause.

Refocus On The Big Picture (slide 2 of 4) Imposition of the use tax when Travis registered the new car is one way a state can preclude the avoidance of its sales tax (see Ex. 4). When gifts between family members are material (e.g., an RV) and exceed the annual exclusion, a gift tax return needs to be filed. –Even though no gift tax is due because of the unified transfer tax credit, filing a return starts the running of the statute of limitations.

Refocus On The Big Picture (slide 3 of 4) Imposition of the ‘‘jock tax’’ on nonathletes is unusual but not improper. –The Carters must recognize that some of their income is subject to income taxes in two states and take advantage of whatever relief is available to mitigate the result.

Refocus On The Big Picture (slide 4 of 4) What if? Because of the double audit (i.e., both state and Federal) and the deficiency assessed, the Carters need to make sure that future returns do not contain similar errors. –Taxpayers with prior deficiencies are among those whose returns may be selected for audit.

© 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact: Dr. Donald R. Trippeer, CPA SUNY Oneonta C1-72