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
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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
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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
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The makeup of Congress
Lobbyists
Elected representatives attempts to satisfy
many constituencies
The economy
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Taxing Units
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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
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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
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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
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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)
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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)
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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
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Property Transactions
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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
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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
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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
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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
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Standard Deductions
 $9,700 married filing a joint return
 $4,850 married filing separately
 $7,150 head of household
 $4,850 single (unmarried) individual
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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
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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
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An individual’s NOL must be adjusted to
reflect only business losses
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Additions to Tax
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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
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Tax Prepayments
Taxes withheld
Estimated tax payments
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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
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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
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Sole proprietorship
Partnerships
 Limited liability partnerships
 Limited liability companies
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S corporation
Fiduciaries
Trusts
Estates
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Fiduciary Income Tax Rates
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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
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Sole Proprietorships
Partnerships
C Corporations
S Corporations
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Sole Proprietorships
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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
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Income and expenses reported on owner’s
Schedule C of Form 1040 (no separate
business tax return)
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Sole Proprietorships
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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)
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Partnerships
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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
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Partnerships
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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
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Partner’s Basis Account
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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)
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Corporations
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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
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Corporations
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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)
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S Corporations
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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
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S Corporations
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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
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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
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C 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
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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
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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)
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Consumption taxes (sales and use taxes)
Tariffs and duties
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Progressive Tax Rate System
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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
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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
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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
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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
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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
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Adam Smith’s Canons of Taxation
Equity
Economy
Certainty
Convenience
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The End
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