Chapter 1
Introduction to Taxation
Taxation of Business Entities
Copyright ©2010 Cengage Learning
Taxation of Business Entities
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Tax Structure (slide 1 of 2)
• Tax base: amount to which the tax rate is
applied
• Tax rates: applied to the tax base to
determine the tax liability
– May be proportional, progressive, or regressive
• Incidence of tax: degree to which the total
tax burden is shared by taxpayers
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Tax Structure (slide 2 of 2)
• Examples:
Income
$10
$20
$30
Proportional $3 (30%) $6 (30%) $ 9 (30%)
Tax
Progressive $3 (30%) $7 (35%) $12 (40%)
Tax
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Major Types of Taxes
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Transaction Taxes
Employment Taxes
Death Taxes
Gift Taxes
Property Taxes
Income Taxes
Other U.S. Taxes
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Excise Taxes
• Imposed at the Federal, state, and local levels
• Restricted to specific items
– Examples: gasoline, tobacco, liquor
• Declined in relative importance until recently
– Example-two types of excise taxes at the local level
have recently become increasingly popular
• Hotel occupancy tax
• Rental car surcharge
– Tax is levied on visitors who cannot vote and used to
fund special projects
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General Sales Taxes
• Currently jurisdiction of states and localities
• States that impose sales taxes also charge a
use tax on items bought in other states but
used in their jurisdiction
• States without sales or use taxes are Alaska,
Delaware, Montana, New Hampshire, and
Oregon
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Employment Taxes (slide 1 of 3)
• FICA taxes
– Paid by both an employee and employer
– In 2009, Social Security rate is 6.2% on a
maximum of $106,800 of wages, and Medicare
rate is 1.45% on all wages
• A spouse employed by another spouse is subject to
FICA
• Children under the age of 18 who are employed in
parent’s unincorporated trade or business are exempt
from FICA
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Employment Taxes (slide 2 of 3)
• FICA taxes
– Sole proprietors and independent contractors
may also be subject to Social Security taxes
• Known as the self-employment tax
• Rates are 12.4% for Social Security and 2.9% for
Medicare
– Twice the rates applicable to an employee
• The tax is imposed on net self-employment income
up to a base amount of $106,800 for 2009
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Employment Taxes (slide 3 of 3)
• FUTA (unemployment) taxes
– Provides funds for state unemployment benefits
– In 2009, rate is 6.2% on first $7,000 of wages
for each employee
– Administered jointly by states & Fed govt.
• Credit is allowed (up to 5.4%) for FUTA paid to the
state
– Tax is paid by employer
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Death Taxes (slide 1 of 2)
• Tax on the right to transfer property or to
receive property upon the death of the
owner
– If imposed on right to pass property at death
• Classified as an estate tax
– If imposed on right to receive property from a
decedent
• Classified as an inheritance tax
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Death Taxes (slide 2 of 2)
• The value of the property transferred
provides the base for determining the
amount of the death tax
• The Federal government imposes only an
estate tax
• Many state governments levy inheritance
taxes, estate taxes, or both
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Federal Estate Tax
(slide 1 of 2)
• Federal estate tax is on the right to pass
property to heirs
– Gross estate includes FMV of property
decedent owned at time of death
• Also includes property interests, such as life
insurance proceeds paid to the estate or to a
beneficiary other than the estate if the deceasedinsured had any ownership rights in the policy
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Federal Estate Tax
(slide 2 of 2)
• Property included in the gross estate is
valued at either:
– Date of death, or
– If elected, the alternate valuation date
• Generally 6 months after date of death
– Certain deductions and credits allowed
• Examples - marital deduction, funeral and admin.
expenses, certain taxes, debts of decedent
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Unified Transfer Tax Credit
• Unified credit reduces or eliminates the
estate tax liability for modest estates
• For 2009, credit is $1,455,800
– Offsets tax on $3,500,000 of the tax base
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Phaseout of Estate Tax
• The estate tax has been criticized for the hardship
it imposes on small businesses and family farms
• Tax Relief Reconciliation Act of 2001 included the
phase out of the estate tax
– Unified transfer credit is scheduled to increase over a
10 year period
– Estate tax is due to be eliminated in 2010
• Sunset provision reinstates estate tax as of
January 1, 2011
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State Death Taxes
• State death taxes may be estate tax,
inheritance tax, or both
– Inheritance tax is on the right to receive
property from a decedent
– Tax is generally based on relationship of heir to
decedent
• The more closely related, the lower the tax
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Federal Gift Tax
(slide 1 of 3)
• Tax on the right to transfer assets during a
person’s lifetime
– Applies only to transfers that are not supported by full
and adequate consideration
• Taxable gift = FMV of gift less annual exclusion
less marital deduction (if applicable)
• Federal gift tax provides an annual exclusion of
$13,000 per donee (in 2009)
– Amount is adjusted for inflation
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Federal Gift Tax
(slide 2 of 3)
• Married persons can make a special election
to split gifts
– Allows 1/2 of a gift made by a donor-spouse to
be treated as having been made by a nondonorspouse (gift splitting)
– Effectively increases the number of annual
exclusions available and allows the use of the
nondonor-spouse’s unified transfer tax credit
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Federal Gift Tax
(slide 3 of 3)
• The unified transfer tax credit is available
for gifts (as well as the estate tax)
• Despite the proposed repeal of the estate
tax, the gift tax has been retained with the
unified transfer tax credit frozen at
$345,800, covering $1,000,000 of taxable
gifts
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Gift and Estate Unified
Tax Schedule
• Gift and estate taxes are unified under a
single tax rate schedule
– Since tax rates are progressive, prior years’
transfers must be considered when calculating
the current year’s gift or estate tax
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Property (ad valorem) Taxes
• Based on the value of the asset
• Generally on realty or personalty
• Exclusive jurisdiction of states and their
local political subdivisions
• Deductible for Federal income tax purposes
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Other Taxes
• Federal customs duties
– Tariffs on imported goods
• Franchise taxes
– Levied on the right to do business in the state
• Occupational taxes
– Applicable to various trades or businesses
• e.g., liquor store license, taxicab permit, fee to
practice a profession
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Severance Taxes
• Tax on the value of natural resources
extracted
• Important revenue source for states rich in
natural resources
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Income Taxes
• Imposed at the Federal, most state, and some local
levels of government
– Income taxes generally are imposed on individuals,
corporations, and certain fiduciaries (estates and trusts)
• Federal income tax base is taxable income
(income less allowable exclusions and deductions)
• Most jurisdictions attempt to assure tax collection
by requiring pay-as-you-go procedures, including
– Withholding requirements for employees, and
– Estimated tax prepayments for all taxpayers
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Formula for Federal Income
Tax on Individuals (Slide 1 of 3)
Income (broadly conceived)
$xx,xxx
Less: Exclusions
(x,xxx)
Gross income
$xx,xxx
Less: Certain deductions for AGI (x,xxx)
Adjusted Gross Income
$xx,xxx
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Formula for Federal Income
Tax on Individuals (Slide 2 of 3)
Adjusted Gross Income
Less: The greater of:
Itemized deductions, or
The standard deduction
Less: Personal and
dependency exemptions
Taxable income
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$xx,xxx
(x,xxx)
(x,xxx)
$xx,xxx
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Formula for Federal Income
Tax on Individuals (Slide 3 of 3)
Tax on taxable income (see Tax Rate
Schedules in Appendix A)
$ x,xxx
Less: Tax credits (including
Federal income tax withheld and
other prepayments of Federal
income taxes)
(xxx)
Tax due (or refund)
$ xxx
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Individual Income Tax (Slide 1 of 2)
• For individuals, deductions are separated
into two categories
– Deductions for adjusted gross income (AGI)
• Generally, related to business activities
– Deductions from AGI
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Individual Income Tax (Slide 2 of 2)
– Deductions from AGI (cont’d)
• Often personal in nature
– e.g., medical expenses, mortgage interest and property
taxes on a personal residence, charitable contributions, and
personal casualty losses, or related to investment activities
• Generally, itemized deductions and personal and
dependency exemptions
– Individuals may take a standard deduction (a specified
amount based on filing status) rather than itemizing actual
deductions
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Corporate Income Tax
Corporate Taxable Income = Income Deductions
– Does not require the computation of adjusted
gross income
– Does not provide for the standard deduction or
personal and dependency exemptions
– All allowable deductions are business expenses
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State Income Tax (slide 1 of 3)
• All but the following states impose an
income tax on individuals:
– Alaska, Florida, Nevada, South Dakota, Texas,
Washington, and Wyoming
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State Income Tax (slide 2 of 3)
• Some characteristics of state income taxes
include:
– With few exceptions, all states require some form of
withholding procedures
– Most states use as the tax base the income
determination made for Federal income tax purposes
• Some states apply a flat rate to Federal AGI
• Some states apply a rate to the Federal income tax liability
– Referred to as the piggyback approach to state income
taxation
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State Income Tax (slide 3 of 3)
• Some states ‘‘decouple’’ from select tax legislation
enacted by Congress
– State may not be able to afford the loss of revenue
resulting from such legislation
• Because of tie-ins to the Federal return, states may
be notified of changes made by the IRS upon audit
of a Federal return
– In recent years, the exchange of information between
the IRS and state taxing authorities has increased
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Various Business Forms
• Sole proprietorships
• Regular corporations (also called C
corporations)
• Partnerships
• S corporations
• Limited liability companies
• Limited liability partnerships
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Sole Proprietorship
• Not a separate taxable entity
• Income reported on owner’s Sch. C
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C Corporation
• Separate tax-paying entity
– Reports income and expenses on Form 1120
– Income taxed at corporate level and again at
owner level when distributed as a dividend
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Partnership
• Separate entity, but does not pay tax
• Allocates partnership income to partners
– Partners report partnership income on personal
tax returns
• Files information return (Form 1065)
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S Corporation
• Separate entity, only pays special taxes
(e.g.,built-in gains)
• Allocates entity income to shareholders
– Shareholders report entity income on personal
tax return
• Files information return (Form 1120S)
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Limited Liability Companies and
Limited Liability Partnerships
• These organizations exist under state laws
– Specific rules vary somewhat from state to state
• Both forms have limited liability and some
(but not all) of the other nontax features of
corporations
• Both forms usually are treated as
partnerships for tax purposes
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Dealings Between Individuals
and Entities (slide 1 of 2)
• Many tax provisions deal with the relationship
between owners and their business entities,
including the following interactions:
– Owners put assets into a business when they establish a business
entity
– Owners take assets out of the business during its existence in the
form of:
• Salary, dividends, withdrawals, redemptions of stock, etc.
– Through their entities, owner-employees set up retirement plans for
themselves, including IRAs, Keogh plans, and qualified pension
plans
– Owners dispose of all or part of a business entity
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Dealings Between Individuals
and Entities (slide 2 of 2)
• Transactions between owner and business
entity have important tax ramifications, e.g.,
– How to avoid taxation at both owner and entity
levels (i.e., the multiple taxation problem)
– How to do the following with the least adverse
tax consequences:
• Get assets into the business
• Get assets out of the business
• Dispose of the business entity
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Tax Planning
(slide 1 of 3)
• Tax planning strategies may include:
– Avoiding income recognition
• Compensate employees with nontaxable fringe benefits
– Postponing recognition of income
• Postpone sale of assets to achieve tax deferral
– Maximizing deductible amounts
• Invest in stock of another corporation
– Accelerating recognition of deductions
• Elect to deduct charitable contribution in year of pledge rather
than in year of payment
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Tax Planning
(slide 2 of 3)
• Tax planning strategies may include (con't):
– Shifting net income from high to low-bracket years
• Postpone recognition of income to low-bracket year
• Postpone recognition of deductions to a high-bracket year
– Shifting net income from high to low-bracket
taxpayers
• Pay children to work in the family business
– Shifting net income from high to low-tax
jurisdictions
• Establish subsidiary operations in countries with low tax rates
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Tax Planning
(slide 3 of 3)
• Tax planning strategies may include (con't):
– Controlling the character of income and deductions
• Hold assets long enough to qualify for long-term capital gain rates
• Invest in small business stock to obtain ordinary loss treatment under
§ 1244
– Avoiding double taxation
• Operate as a flow-through entity rather than a C corporation
• Maximize deductible expenses paid by a C corporation to a
shareholder/employee
– Maximizing tax credits
• Hire employees who qualify the business for the work opportunity
tax credit
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Understanding the Federal
Tax Law (slide 1 of 3)
• The Federal tax law is the vehicle for
accomplishing many objectives of the
nation such as:
– Raising revenue: the major objective of the tax
system but not the sole objective
– Economic: increasingly important objective is
to regulate the economy and encourage certain
behavior and businesses considered desirable
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Understanding the Federal
Tax Law (slide 2 of 3)
• Federal tax objectives
– Social: encourage socially desirable behavior
that provides benefits that government might
otherwise provide
– Equity: equity within the tax laws (e.g.,
wherewithal to pay concept) and not necessarily
equity across taxpayers
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Understanding the Federal
Tax Law (slide 3 of 3)
• Federal tax objectives
– Political: a large segment of the tax law is
created through a political process; thus,
compromises and special interest dealings
occur
– Ease of administration: many provisions are
meant to aid the IRS in the collection of taxes
– Courts: influence tax law and sometimes cause
it to change
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If you have any comments or suggestions concerning this
PowerPoint Presentation for South-Western Federal
Taxation, please contact:
Dr. Donald R. Trippeer, CPA
trippedr@oneonta.edu
SUNY Oneonta
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