Chapter 1

An Introduction
to Taxation

©2005 Prentice Hall, Inc. 1-

 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

©2005 Prentice Hall, Inc. 1-

 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

©2005 Prentice Hall, Inc. 1-

 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

©2005 Prentice Hall, Inc. 1-

 Current Influences on Tax Law

 The makeup of Congress

 Lobbyists
 Elected representatives attempts to satisfy
many constituencies
 The economy

©2005 Prentice Hall, Inc. 1-

 Taxing Units

 Three types of “persons” subject to income

tax in the U.S.
 Individual
 C corporation
 Fiduciary (estate and trust)

©2005 Prentice Hall, Inc. 1-

 Corporate Tax Model

Gross revenues
Less: Cost of goods sold
Equals: Gross income
Plus: Other includible income items
Less: Deductions
Equals: Taxable income (loss)

©2005 Prentice Hall, Inc. 1-

 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

©2005 Prentice Hall, Inc. 1-

 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)

©2005 Prentice Hall, Inc. 1-

 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

©2005 Prentice Hall, Inc. 1-1

 Gross Income

 Gross income for 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

©2005 Prentice Hall, Inc. 1-1

 Gross Income

 Additional Sources for Individuals

 Wages & salaries
 Income & losses from sole proprietorships and
ownership interests in S corporations
 Taxable pension plan distributions
 Unemployment compensation
 Alimony received
 Taxable portion of Social Security benefits

©2005 Prentice Hall, Inc. 1-1

 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; C
corporations can only offset against capital
gains)
 Personal losses – most are not deductible

©2005 Prentice Hall, Inc. 1-1

 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

©2005 Prentice Hall, Inc. 1-1

 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
©2005 Prentice Hall, Inc. 1-1
 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

©2005 Prentice Hall, Inc. 1-1

 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

©2005 Prentice Hall, Inc. 1-1

 Deductions For AGI
 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
 Tuition deduction ($4,000 limit)
 Qualified student loan interest ($2,500 limit)
 Alimony paid

©2005 Prentice Hall, Inc. 1-1

 Itemized 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)

©2005 Prentice Hall, Inc. 1-1

 Standard Deductions & Exemptions

 Standard Deductions
 $9,700 married filing a joint return
 $4,850 married filing separately
 $7,150 head of household
 $4,850 single (unmarried) individual
 Personal and dependency exemptions
 $3,100

©2005 Prentice Hall, Inc. 1-2

 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

©2005 Prentice Hall, Inc. 1-2

 Tax Rates for
Married Filing a Joint Return
 For married filing a joint return for 2004
 10% on first $14,300 taxable income
 15% on $14,301 - $58,100
 25% on $58,101 - $117,250
 28% on $117,251 - $178,650
 33% on $178,651 - $319,100
 35% over $319,100

©2005 Prentice Hall, Inc. 1-2

 Tax Rates for
Married Filing Separately
 For married filing separately for 2004
 10% on first $7,150 taxable income
 15% on $7,151 - $29,050
 25% on $29,051 - $58,625
 28% on $58,626 - $89,325
 33% on $89,326 - $159,550
 35% over $159,551

©2005 Prentice Hall, Inc. 1-2

 Tax Rates for
Head of Household
 For head of household for 2004
 10% on first $10,200 taxable income
 15% on $10,201 - $38,900
 25% on $38,901 - $100,500
 28% on $100,501 - $162,700
 33% on $162,701 - $319,100
 35% over $319,100

©2005 Prentice Hall, Inc. 1-2

 Tax Rates for
Single Individuals
 For single individuals for 2004
 10% on first $7,150 taxable income
 15% on $7,151 - $29,050
 25% on $29,051 - $70,350
 28% on $70,351 - $146,750
 33% on $146,751 - $319,100
 35% over $319,100

©2005 Prentice Hall, Inc. 1-2

 Tax Losses

 A net operating loss (NOL) results when

allowable deductions are greater than gross
income from a trade or business
 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
 An individual’s NOL must be adjusted to
reflect only business losses

©2005 Prentice Hall, Inc. 1-2

 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
©2005 Prentice Hall, Inc. 1-2
 Tax Prepayments & Credits

 Tax Prepayments
 Taxes withheld
 Estimated tax payments
 Credits are a direct reduction in the tax
liability
 Credits available to all taxpayers
 AMT credit
 Foreign tax credit
 General business credits

©2005 Prentice Hall, Inc. 1-2

 Tax Credits

 Credits available to individuals only

 Earned income credit
 Educations credits
 Child tax credit
 Dependent care credit
 Adoption credit
 Credit for the elderly and disabled

©2005 Prentice Hall, Inc. 1-2

 Other Entities

 Sole proprietorship
 Partnerships
 Limited liability partnerships
 Limited liability companies
 S corporation
 Fiduciaries
 Trusts
 Estates

©2005 Prentice Hall, Inc. 1-3

 Fiduciary Income Tax Rates

 2004 Rates
 15% on $0 - $1,950
 25% on $1,951 - $4,600
 28% on $4,601 - $7,000
 33% on $7,000 - $9,550
 35% over $9,550
 Because beneficiaries are usually in lower
marginal tax brackets, distributing the income
annually to beneficiaries usually results in overall
lower taxes

©2005 Prentice Hall, Inc. 1-3

 Choice of Business Entity

 Sole Proprietorships
 Partnerships
 C Corporations
 S Corporations

©2005 Prentice Hall, Inc. 1-3

 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)

©2005 Prentice Hall, Inc. 1-3

 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)

©2005 Prentice Hall, Inc. 1-3

 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” 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
©2005 Prentice Hall, Inc. 1-3
 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

©2005 Prentice Hall, Inc. 1-3

 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 + 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)

©2005 Prentice Hall, Inc. 1-3

 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 corporation’s legal
existence (unlimited life)
 Owners can be employees and receive tax-free
employee fringe benefits
©2005 Prentice Hall, Inc. 1-3
 Corporations

 Form 1120 due 2½ months after year end

 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)

©2005 Prentice Hall, Inc. 1-3

 S Corporations
 Formed the same as C corporations; 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

©2005 Prentice Hall, Inc. 1-4

 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 tax-free employee fringe
benefits if they own more than 2% of stock

©2005 Prentice Hall, Inc. 1-4

 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

©2005 Prentice Hall, Inc. 1-4

 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

©2005 Prentice Hall, Inc. 1-4

 Other Types of Taxes

 Wealth taxes (real property tax)

 Wealth transfer taxes
 Gift tax (assessed on lifetime gifts in excess
of $1 million)
 Estate tax (assessed on transfers at death
in excess of $1.5 million)
 Consumption taxes (sales and use taxes)
 Tariffs and duties

©2005 Prentice Hall, Inc. 1-4

 Progressive Tax Rate System
 Tax rates on income increase as income
increases
 In 1913 rates ranged from 1% to 7%
 To finance World War I 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%)
©2005 Prentice Hall, Inc. 1-4
 Capital Gains Rates
 Net long-term capital gains are taxed at
 15% for taxpayers in higher tax brackets
 5% for taxpayers in the 10% or 15% tax

brackets
 Net short-term capital gains are taxed using
the same rates as ordinary income
 Corporations have no special rates for capital
gains

©2005 Prentice Hall, Inc. 1-4

 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

©2005 Prentice Hall, Inc. 1-4

 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 $87,900 in
wages (Medicare is 1.45% on all wages)
 FUTA is 6.2% on first $7,000 of wages

©2005 Prentice Hall, Inc. 1-4

 Characteristics of a Good Tax

 Adam Smith’s Canons of Taxation

 Equity
 Economy
 Certainty
 Convenience

©2005 Prentice Hall, Inc. 1-4

 The End

©2005 Prentice Hall, Inc. 1-5