Taxes

“The art of taxation consists in so plucking the goose as to obtain the largest possible amount of feathers with the

least possible amount of hissing.”

Jean Baptiste Colbert

Definitions• Tax = required payment to support government

– contrast with fine/penalty or user fee

• Taxpayer = person or organization that pays tax (includes individuals and corporations)

• Incidence refers to ultimate economic burden of a tax – may not be person who pays tax

• Jurisdiction is the right of a government to tax

Tax Formula

• Tax revenue = rate x base

• Rate can be flat or graduated (usually progressive)

Federal Taxes

• Income taxes (individual and corporation)

• Employment and unemployment taxes

• Transfer taxes (gift, estate, generation skipping)

• Excise taxes (luxury, sin, transportation, communication)

State Taxes

• Real property tax– Abatements often granted to entice new business

• Personal property tax– Household tangibles (vehicles), business tangibles,

intangibles (securities)

• Sales/use, excise tax• Income tax (personal or corporation)• Estate or gift tax• Fees and other

Tax Policy Issues• Tax Rate Structure

– Average Tax Rate = The tax rate on income determined by dividing tax paid by an income measure. Income measures selected are usually adjusted gross income or taxable income.

– Marginal Tax Rate = The rate of tax applied to the next dollar of taxable income. In a progressive rate structure this rate increases as income levels increase. In a proportionate rate structure average and marginal rates are the same.

– Effective Tax Rate = The taxpayer’s average rate of taxation on each dollar of total income (both taxable and non-taxable).

Marginal and Average Rate Example

• Tax rate structure• 10% of the first $100,000; 12% of the second $500,000;

15% of income in excess of $600,000

• Taxpayer has $1 million income and pays a $130,000 tax

10% x $100,000 = $10,00012% x $500,000 = 60,00015% x $400,000 = 60,000

$130,000• What is the taxpayer’s marginal rate?

• 15%• What is the taxpayer’s average rate?

• 13% (130,000/1,000,000)

Tax Rate Structures• Proportional Tax Rate (Flat Tax): imposes

a constant tax rate throughout the tax base.

• Progressive Tax Rate: imposes an increasing marginal tax rate as the tax base increases.

• Regressive Tax Rate: imposes a decreasing marginal tax rate as the tax base increases.

Implicit Taxes• The reduction in rate of return that a

taxpayer receives because the market has bid up the price of a tax-favored asset.– Easiest example is municipal bonds: If

taxable bonds are yielding 10%, and if the top tax bracket is 40%, then municipal bonds will yield about 6%, because rich taxpayers will buy municipals as long as the interest rate is at least 6%. If not enough rich taxpayers demand municipal bonds, the rates may be slightly higher.

How to evaluate different tax systems

• Sufficiency: involves assessing the aggregate size of the tax revenues that must be generated and making sure that the tax system provides these revenues.

• Equity: how the tax burden should be distributed across taxpayers.

• Certainty: means that taxpayers should be able to determine when to pay the tax, where to pay the tax, and how to determine the tax.

• Convenience: tax system should be designed to be collected without undue hardship to the taxpayer.

• Economy: should minimize the compliance and administration costs associated with the tax system.

Effects

• Income versus Substitution Effects– Taxpayers often modify their behavior in

reaction to increased tax rates. These behavioral changes result in either an income effect or substitution effect.

• Remember tax = rate * base

• What effect on behavior does a change in either rate or base have?

Effects

• Income Effect: – Work to keep after-tax income the same.

Effects

• Substitution Effect:– Substitute between labor and leisure.

• Theoretically, the income effect is more powerful for lower-income taxpayers and the substitution effect is more compelling to higher-income taxpayers.

Forecasting• Types of revenue forecasting:

– Static: Forecasting revenue ignores how taxpayers might alter their activities in response to a tax law change and to base projected tax revenues on the existing state of transactions.

– Dynamic: Forecasting which tries to predict possible responses by taxpayers to new tax laws.

• Income Effect: as tax rates go up, people will work harder to maintain same after-tax income.

• Substitution Effect: as tax rates go up, people will substitute non-taxable activities because the marginal value of taxable ones has decreased.

Tax Planning

• …”there is nothing sinister in so arranging affairs to keep taxes as low as possible.” --Judge Learned Hand

• Tax avoidance versus tax evasion• Tax planning variables

– Entity– Time Period– Jurisdiction– Character of Income

Choice of Business Entity

• Sole Proprietorships

• Partnerships

• C Corporations

• S Corporations

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)

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)

Partnerships

• Two or more partners with no restrictions on who can be a partner

• 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

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

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)

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• Owners can be employees and receive tax-free

employee fringe benefits• Form 1120 due 2½ months after year end• Can use calendar year or fiscal year

Corporations

• When the corporate rates are lower than the individual tax rates, the owners have increased capital for reinvestment and business expansion

• Disadvantages– Double taxation (no deduction for dividends)– Corporate losses can only offset corporate

profits (no flow-through to shareholders)

S Corporations

• Formed the same as C corporations and 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

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

Comparing 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

Comparing 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

• Double Taxation– Income generated by flow-through entities is taxed

only once while that of C corporations is taxed twice– Flow-through entity owners pay tax on their share of

income as if they had earned it themselves– Corporations pay first level of tax on their taxable

income at the corporate marginal tax rate– Current marginal tax rate

• Lowest - 15 percent and highest - 35 percent• Most profitable corporations - 35 percent

– Shareholders are subject to double taxation when second level of tax is paid

Entity Tax Characteristics

Book-Tax Adjustments

• Financial income typically starting point for computing taxable income– Reconcile to taxable income– Book-tax adjustments for differences between

financial accounting rules and tax rules– Companies preparing financial statements

with tax accounting methods won’t have book-tax adjustments

End of Taxes