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

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 Sources for Corporations and Individuals
Gross income from 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
Alimony received
Taxable portion of unemployment compensation
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 per year; 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. Property Transactions
The recognized gain (taxable gain) or recognized loss (deductible loss) may differ from the realized gain or loss because of limitation or deferral provisions
Deduction of losses from investment sales (capital losses) may be limited
Losses from the sale of personal-use assets are not deductible
Gains from the exchange of business or investment property may be deferred

18. 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

19. Deductions For AGI “Above-the-line” deductions
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
Qualified student loan interest
Alimony paid

20. Itemized Deductions “Below-the-line” 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)

21. Standard Deductions & Exemptions
Standard Deductions for 2009
$11,400 married filing a joint return
$5,700 married filing separately
$8,350 head of household
$5,700 single (unmarried) individual
Dependents limited to greater of (a) $950 or (b) earned income plus $300
Personal and dependency exemptions for 2009
$3,650 per dependent (including taxpayer)

22. 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

23. Tax Rates for Married Filing a Joint Return
For married filing a joint return for 2009
10% on first $16,700 taxable income
15% on $16,701 - $67,900
25% on $67,901 - $137,050
28% on $137,051 - $208,850
33% on $208,851 - $372,950
35% over $372,950

24. Tax Rates for Married Filing Separately
For married filing separately for 2009
10% on first $8,350 taxable income
15% on $8,351 - $33,950
25% on $33,951 - $68,525
28% on $68,526 - $104,425
33% on $104,426 - $186,475
35% over $186,475

25. Tax Rates for Head of Household
For head of household for 2009
10% on first $11,950 taxable income
15% on $11,951 - $45,500
25% on $45,501 - $117,450
28% on $117,451 - $190,200
33% on $190,201 - $372,950
35% over $372,950

26. Tax Rates for Single Individuals
For single individuals for 2009
10% on first $8,350 taxable income
15% on $8,351 - $33,950
25% on $33,951 - $82,250
28% on $82,251 - $171,550
33% on $171,551 - $372,950
35% over $372,950

27. Tax Losses
A net operating loss (NOL) results when allowable deductions are greater than gross income from a trade or business
NOL’s 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 taxpayer’s NOL must be adjusted to reflect only business losses

28. 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

29. Tax Prepayments & Credits
Taxes withheld (from salary & wages)
Estimated tax payments (corporations & self-employed individuals)
Credits are a direct reduction in the tax liability
Credits available to all taxpayers
Alternative minimum tax credit
Foreign tax credit
Investment tax credit
General business credits

30. Tax Credits Credits available to individuals only Earned income credit
Education credits
Child tax credit
Dependent care credit
Adoption credit
Credit for the elderly and disabled
Credit for excess payroll tax withheld
First-time homebuyer credit

31. Other Entities Sole proprietorship Partnerships S corporations
Limited liability partnerships (LLPs)
Limited liability companies (LLCs)
S corporations
Fiduciaries
Trusts
Estates

32. Fiduciary Income Tax Rates
15% on $0 - $2,300
25% on $2,301 - $5,350
28% on $5,351 - $8,200
33% on $8,201 - $11,150
35% over $11,150
When beneficiaries are in lower marginal tax brackets, distributing the income annually to beneficiaries usually results in lower overall taxes

33. Choice of Business Entity
Sole Proprietorships
Partnerships
C Corporations
S Corporations

34. 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)

35. 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)

36. 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” (or flow-through) entity
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

37. 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

38. 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 + partner’s share of partnership liabilities + income that flows through to the partner - distributions - losses
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)

39. Limited Liability Companies
Owners of an LLC are called members and they have limited liability protection
An LLC will be treated as a partnership for tax purposes unless the company elects to be taxed as a corporation
If owned by a single individual, the LLC would be taxed as a sole proprietorship if corporate tax treatment not elected

40. Corporations Must file articles of incorporation with state
Limited Liability - shareholders are only at risk for their capital investment
Centralized management
Unlimited Life - death of an owner or transfer of stock ownership does not end the corporation’s legal existence
Owners can be employees and receive tax-free employee fringe benefits

41. Corporations Form 1120 due 2½ months after year end
March 15th for calendar year taxpayer
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)

42. S Corporations “Small business corporation” To qualify for S status
Formed the same as a C corporation
Reverts to being taxed as C corporation if it ceases to qualify for S status
To qualify for S status
Domestic corporation
No more than 100 shareholders (who generally must be individuals who are not nonresident aliens)
One class of stock outstanding
File Form 2553 election (must be filed within first 2½ months of year to be retroactive)

43. S Corporations Limited liability with no double taxation
Profits and losses flow through to owners each year
Shareholders are taxed on their share of profits even if they receive no distribution
Loss deductions are limited to basis (unlike partners, shareholders do not increase their basis for liabilities of the business); excess losses are carried forward
Shareholders can be employees but cannot participate in tax-free employee fringe benefits if they own more than 2% of stock

44. 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

45. 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

46. 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
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

47. Wealth Transfer Taxes
Gift and estate taxes assessed on the one making the transfer
Gift tax assessed on lifetime gifts in excess of $1 million (fair market value)
First $13,000 of gifts to recipient each year are excluded so if gifts to an individual are no more than $13,000 then no gift tax return must be filed
Estate tax assessed on transfers at death in excess of $3.5 million (fair market value)
Transfers to spouses and charities are not subject to tax
Recipient does not pay income tax on receipt of gift or inheritance

48. Other Types of Taxes Wealth taxes (real property tax)
Consumption taxes (sales and use taxes)
Tariffs and duties

49. Progressive Tax Rate System
Tax rates increase as income increases
In 1913 rates ranged from 1% to 7%
To finance World War I, top rate was increased to 77%
In 1985, 15 tax brackets ranged from 11% to 50%
Current rates are 10%, 15%, 25%, 28%, 33%, and 35%

50. Capital Gains Rates
Most individual’s net long-term capital gains are now taxed at 15%
Zero rate for taxpayers in the 10% or 15% tax
brackets
Short-term (held one year or less) capital gains are taxed using the same rates as ordinary income
Corporations have no special rates for capital gains

51. 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
The marginal tax rate is used for tax planning
Marginal tax rate x income = tax paid on that additional income
Marginal tax rate x deduction = tax savings from the deduction

52. 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 $106,800 in wages (Medicare is 1.45% on all wages)
FUTA is 6.2% on first $7,000 of wages

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

54. The End