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An Introduction to Taxation

An Introduction to Taxation

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An Introduction to Taxation

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  1. An Introductionto Taxation Chapter1

  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 and 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 2010 • $11,400 married filing a joint return • $5,700 married filing separately • $8,400 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 2010 • $3,650 per dependent (including taxpayer)

  22. Corporate Tax Rates • 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% over $18,333,333

  23. Tax Rates forMarried Filing a Joint Return • For married filing a joint return for 2010 • 10% on first $16,750 taxable income • 15% on $16,751 - $68,000 • 25% on $68,001 - $137,300 • 28% on $137,301 - $209,250 • 33% on $209,251 - $373,650 • 35% over $373,650

  24. Tax Rates forMarried Filing Separately • For married filing separately for 2010 • 10% on first $8,375 taxable income • 15% on $8,376 - $34,000 • 25% on $34,001 - $68,650 • 28% on $68,651 - $104,625 • 33% on $104,626 - $186,825 • 35% over $186,825

  25. Tax Rates forHead of Household • For head of household for 2010 • 10% on first $11,950 taxable income • 15% on $11,951 - $45,550 • 25% on $45,551 - $117,650 • 28% on $117,651 - $190,550 • 33% on $190,551 - $373,650 • 35% over $373,650

  26. Tax Rates for Single Individuals • For single individuals for 2010 • 10% on first $8,375 taxable income • 15% on $8,376 - $34,000 • 25% on $34,001 - $82,400 • 28% on $82,401 - $171,850 • 33% on $171,851 - $373,650 • 35% over $373,650

  27. Alternative Rate Schedulefor Single Individuals • If taxable income is not over $8,375, tax is 10% of taxable income • If taxable income is over $8,375 but not over $34,000, tax is $837.50 + (15% x excess over $8,375) • If taxable income is over $34,000 but not over $82,400, tax is $4,681.25 + (25% x excess over $34,000) • If taxable income is over $82,400 but not over $171,850, tax is $16,781.25 + (28% x excess over $82,400) • If taxable income is over $171,850 but not over $373,650, tax is $41,827.25 + (33% x excess over $171,850) • If taxable income is over $373,650, tax is $108,421.25 + (35% x excess over $373,650

  28. 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

  29. 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

  30. Tax Prepayments & Credits • Tax Prepayments • 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

  31. 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

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

  33. Fiduciary Income Tax Rates • 2010 Rates • 15% on $0 - $2,300 • 25% on $2,301 - $5,350 • 28% on $5,351 - $8,200 • 33% on $8,201 - $11,200 • 35% over $11,200 • When beneficiaries are in lower marginal tax brackets, distributing the income annually to beneficiaries usually results in lower overall taxes

  34. Choice of Business Entity • Sole Proprietorships • Partnerships • C Corporations • S Corporations

  35. 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)

  36. 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)

  37. 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

  38. 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

  39. 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)

  40. 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

  41. 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

  42. 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)

  43. S Corporations • “Small business corporation” • 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)

  44. 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

  45. 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

  46. 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

  47. 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

  48. Wealth Transfer Taxes • Gift tax assessed on the one making the gift • Lifetime credit equal to $1 million (fair market value) means most gifts are not subject to gift tax • $13,000 annual exclusion excludes the first $13,000 of gifts given to each recipient each year • When more than $13,000 is given to a person in a year, a gift tax return must be filed to notify the IRS that some of the lifetime credit has been used • Transfers to spouses and charities are not subject to tax (and do not use up any of the lifetime credit) • Recipient does not pay income tax on receipt of gift

  49. Wealth Transfer Taxes • In 2009 the estate tax was assessed on transfers at death in excess of $3.5 million (fair market value) at tax rates of 18% to 45% • Transfers to spouses & charities not subject to tax • Estate tax expired 1/1/10 but sunset provision will automatically reinstate it 1/1/11 (using a lower credit and higher tax rates than 2009) • Congress is expected to extend it retroactively to the beginning of 2010 with a credit and tax rates similar to 2009 • Recipient does not pay income tax on receipt of inheritance

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