Tax-1 HANDOUT Federal Income Taxes Corporations and Individuals

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HANDOUTHANDOUT

Federal Income TaxesCorporations and Individuals

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Income TaxesIncome Taxes Cliche - “There are only two things

certain in life - death and taxes.” This is one of most written about and

discussed topics in American life. There are many thousands of books,

articles, jokes and cartoons on the subject.

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Income TaxesIncome Taxes

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The difference between the short and long income tax forms is simple. If you use the short form, the government gets your money. If you use the long form, the accountant gets your money.

A nervous taxpayer was unhappily conversing with the IRS auditor who had come to review his records. At one point the auditor exclaimed, Mr. Carr, we feel it is a great privilege to be allowed to live and work in the USA. As a citizen you have an obligation to pay taxes, and we expect you to eagerly pay them with a smile. Thank God, returned Mr. Carr. I thought you were going to want cash.

Even worse accounting jokes are available on the Web.

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The tax handout gives a broadbroad overview of corporate and individual taxes.

Loyola offers three tax courses One at undergraduate level Two in MBA program

Masters in Taxation is available in Business Schools (MS) Law Schools (LLM)

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Tax law vs. GAAP Who makes tax law?


b.

a.

d.

c.

IRS

Congress

Supreme Court

FASB

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Tax law vs. GAAP Who makes tax law?


Who makes GAAP? Two sets of books

CPAs and taxesWe are all experts in this field - NOT!NOT!

Tax avoidance vs. tax evasionWhich is illegal?

Where do you get copies of tax forms?

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Who Pays And Who Does Not Who Pays And Who Does Not Pay Income Taxes?Pay Income Taxes?

Pays Corporations Individuals

Does not pay Not-for-profit organizations

e.g., Loyola College Proprietorships and Partnerships

• They file informational returns only.• Then, how is the income taxed?

On the owners’ personal returns

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Corporate TaxesCorporate Taxes “Income Before Taxes” is a line on an

Income Statement prepared using GAAP. “Taxable Income” is a line on a tax return.

i.e., the amount on which the corp. pays tax. Reasons why above amounts may differ

Certain corporate revenues and expenses are excluded in computing taxable income.

These are known as “permanent” differences. Timing of recognition of revenues and

expenses may differ.

Known as “temporary” differences.

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Corporate TaxesCorporate Taxes

Tax Rates Technically, corporate tax rates are not a

flat rate; they are graduated as with individual’s rates.

However, for corporations with taxable incomes exceeding a relatively small amount ($335,000 in 1991), the tax is flat.

Therefore, the effect is a flat tax for most corporations.

Tax rates will be provided on the test if needed.

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Loss Carrybacks and Carryforwards Current year tax losses can be carried

back 3 years and forward 15 years. If the loss is not “used up” by the end of

the 15th year, what happens? A loss carryback carryback results in a tax refund

in the current year for taxes paid in past year(s).

A loss carryforwardcarryforward is applied against taxable income in future years.

3 15


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Depreciation Methods Methods used for tax

purposes are quite different from those used for financial statement purposes

Therein lies a major reason for most corporations keeping “two sets of books”

Key to understanding tax depreciation“The depreciable period or useful life used

for tax purposes is based on law and has no relationship no relationship to the actual useful life of the asset; thus, no attempt is made to no attempt is made to match revenues and expensesmatch revenues and expenses.”

Corporate TaxesCorporate TaxesDepreciate me

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Tax depreciation is based on MACRS Modified Accelerated Cost Recovery System It is an accelerated method similar to the

double-declining-balance and sum-of-the-years digits methods.

Straight-line depreciation can also be used for tax purposes.

You are not responsible for any depreciation calculations


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Income Tax Allocation (pp. 21-24) This is how to account for taxes under

GAAP, not how to calculate taxes owed. Congress vs. FASB

Two reasons for differences in Taxable Taxable Income Income (from tax return) and “Book” Book” Income Income (from income statement) Permanent differences Temporary (or timing) differences


Tax ReturnTax Return

Income Statement

Income Statement

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Corporate TaxesCorporate TaxesPermanent DifferencesPermanent Differences

As previously mentioned, certain corporate revenues and expenses are excluded in computing taxable income.

i.e., they are never shown on the tax return

Permanent differences include Nontaxable revenues Nondeductible expenses

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Corporate TaxesCorporate TaxesPermanent DifferencesPermanent Differences

Nontaxable revenue examples Life insurance proceeds on death of

key employee Interest received from state and local

bonds Nondeductible expense examples

Premiums paid on life insurance policies for key-employees

Lobbying expenses

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Corporate TaxesCorporate TaxesTemporary DifferencesTemporary Differences

These are differences between taxable income taxable income and book book

income income caused by items that affect both, but in different

periods. Therefore, they are also called

timing differences.

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Temporary/timing differences include: Revenues reported earlier on the tax

return than on the bookse.g., Revenue received in advance

Expenses reported later on the tax return than on the books

e.g., Expenses based on estimates such as uncollectible accounts expense

Expenses reported earlier on the tax return than on the books

e.g., when different depreciation methods are used for book and tax purposes.

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A reconciliation must be used to explain why book and taxable income differ.


per tax return

Reconciliation of Book Income to Taxable Income (p. 22)

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All temporary differences require the use of interperiod income tax interperiod income tax

allocation. allocation. Tax on the item causing the difference

will be reported in the period in which the item is reported for accounting purposes, regardless of when it is reported for tax purposes. (i.e., there must be a “normal”

relationship between Pretax Income and Income Tax Expense on the

Income Statement.)


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Page 23[Per Tax Return]

[Per Income Statement

*

* Note normal 15% relationship each year. This would not be the case if the amount of tax paid (i.e., amount on tax return) were reported as the income tax expense on the income statement.

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.

. ..

. .

.

Personal Income Tax Personal Income Tax

Joe P. Taxpayer 123 45 6789

Sally L. Taxpayer 987 65 4321

123 Main Street

Anywhere, USA 55555-5555

X

X

X

2

Kenny Taxpayer SonPosh Taxpayer DaughterTinkie Winky Taxpayer ???

5

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Whether an individual needs to file a tax return depends on whether their

income exceeds the sum of: Their standard deduction amount, plus Their exemption amount

e.g., using 1998 rates, a single person would not file unless their gross income were greater than $6,950.

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Four Filing Statuses Single Married filing jointly Married filing separately Head of household

Congress in it’s wisdom has seen fit to set different tax rates for each.

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Less

Personal Income TaxPersonal Income TaxTaxable IncomeTaxable Income

Flow Chart for Determination of Taxable Income for Individual Taxpayer (p. 25)

Know the model!

Gross (Total) Income

Includes all income from whatever source derived except for a few specifically excluded items. Includes such items as wages, dividends, interest, proprietorship earnings, taxpayer’s share of partnership earnings, net rents.

Examples of Excluded IncomeGifts, inheritances, interest on state bonds,

certain Social Security benefits. (NOTE: These items are not deducted!

They are just never included.) Also includes illegal gambling income and other illegal income.

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Equals

Deductions From Gross Income

Consists of business expenses, payments to an individual retirement arrangement, and a few other minor items.


Adjusted Gross Income

Less

Less

Examples: Individual Retirement Accounts (IRA) and Keogh plans.

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Less

Standard or Itemized Personal Deductions

Deduct the higher of the standard deduction or itemized personal deductions. Itemized deductions consist of contributions, mortgage interest, certain taxes levied directly against the taxpayer, limited casualty and theft losses, limited medical expenses and certain “nonbusiness” expenses. The standard deduction for a single taxpayer for 1998 was $4,250.


LessStandard Deduction - A specified amount that is permitted by tax law to be deducted in lieu of itemized deductions. It changes each year because it is indexed to inflation.

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Exemptions

One fixed amount (e.g., $2,700 for 1998)for taxpayer, one for spouse and one for each dependent. At certain levels of Adjusted Gross Income, personal exemptions are phased out.


Less

Equals

Taxable Income

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Types of Itemized Deductions Certain taxes including real estate and

state income tax Interest on principal residence and any

second residenceNo longer deductible on consumer loans

Charitable contributions to approved educational, religious and other not-for-profit organizations

Personal Income TaxPersonal Income TaxSubtractionsSubtractions

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Types of Itemized Deductions Medical expenses to the extent they

exceed 7.5% of Adjusted Gross Income


Casualty losses subject to certain complicated guidelines

(Which you do not need to know) Certain other deductions to the extent that

they exceed 2% of Adjusted Gross Income e.g., professional journals, union dues, tax

return preparation, business entertainment

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Exemption - A reduction in taxable income because you “are” (i.e., you be).

Exemptions are also available for dependents.

Dependents must meet 4 criteria. Close relative or effectively a family member Had income < $2,150

The law makes exceptions for children under age 19 or full-time college students under age 24.

Got > half of support from taxpayer Did not file a joint return with a spouse


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Your taxable income is understated. You cannot

claim Babe as an exemption!

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Personal Income TaxPersonal Income TaxRatesRates

Marginal Tax Rate - The rate applied to the next dollar of taxable income. This relates to the fact that personal tax rates are

graduated. It means that while a single taxpayer with taxable

income of $50,000 is in the “31% bracket”, he or she is taxed at that rate on only $700. (See Rate Schedule on p. 29)

It also means that the person who says “I don’t want more income this year because it will throw me into a higher tax bracket” doesn’t have a clue!

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Personal Income TaxPersonal Income TaxRatesRates

Effective Tax Rate - The average rate of taxation on a given amount of taxable income.

EffectiveTax Rate

= Total Taxes Paid Total Taxable Income

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Personal Income TaxPersonal Income TaxRates ExampleRates Example

Assume that a Tom (a single taxpayer) has taxable income of $63,000. Using the rate schedule in the handout, his tax liability,

marginal tax rate and average tax rate would be determined as follows:

Tax on income up to $49,300 $11,158Tax on income above $49,300 (31% x $13,700 [$63,000 - $49,300]) 4,247Tax Liability $15,405

Marginal tax rate = 31%

Average tax rate = $15,405/$63,000 = 24.5%

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35% 35%

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Taxes suck

.

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Tax-1 HANDOUT Federal Income Taxes Corporations and Individuals