Chapter 1

An Introduction
to Taxation

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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

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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

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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

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Current Influences on Tax Law

The

makeup of Congress
Lobbyists
Elected representatives attempts to satisfy
many constituencies
The economy

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Taxing Units
Three

types of persons subject to income

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

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Corporate Tax Model

Less:

Gross revenues
Cost of goods sold

Equals: Gross income

Plus:
Other includible income items
Less: Deductions
Equals: Taxable income (loss)

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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

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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)

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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

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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
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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

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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

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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
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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, workmans
compensation and family aid)
$250,000 gain on sale of personal residence
Scholarships
Qualified employee fringe benefits
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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
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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

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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

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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)

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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

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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

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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

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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

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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

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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

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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

individuals NOL must be adjusted to

reflect only business losses

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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

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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

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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

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Other Entities
Sole

proprietorship
Partnerships

Limited liability partnerships

Limited liability companies

corporation
Fiduciaries
Trusts
Estates

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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

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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 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 3
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

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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)

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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 (unlimited life)
Owners can be employees and receive tax-free
employee fringe benefits
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Corporations
Form

1120 due 2 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)

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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 2 months

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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

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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

corporation tax rates may be lower than

tax rates for individual owners resulting in
lower taxation for profits that remain in the
business

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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
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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

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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%)
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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

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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

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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

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Characteristics of a Good Tax

Adam

Smiths Canons of Taxation

Equity
Economy
Certainty
Convenience

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The End

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