Tax-1 HANDOUT Federal Income Taxes Corporations and Individuals Tax-2 Income 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. Tax-3 Income Taxes Tax-4 Income Taxes 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. Tax-5 Income Taxes The tax handout gives a broad 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) Tax-6 Income Taxes Tax law vs. GAAP Who makes tax law? a. IRS b. Congress c. Supreme Court d. FASB Tax-7 Income Taxes Tax law vs. GAAP Who makes tax law? Who makes GAAP? Two sets of books CPAs and taxes We are all experts in this field - NOT! Tax avoidance vs. tax evasion Which is illegal? Where do you get copies of tax forms? Tax-8 Who Pays And Who Does Not 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 Tax-9 Corporate 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. Tax-10 Corporate 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. Tax-11 Corporate Taxes 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 results in a tax refund in the current year for taxes paid in past year(s). A loss carryforward is applied against taxable income in future years. 3 15 Tax-12 Corporate Taxes Depreciation Methods Depreciate me 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 to the actual useful life of the asset; thus, no attempt is made to match revenues and expenses.” Tax-13 Corporate Taxes 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 Tax-14 Corporate Taxes 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 Income (from tax return) and “Book” Income (from income statement) Income Permanent differences Statement Temporary (or timing) differences Tax-15 Corporate Taxes Permanent 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 Tax-16 Corporate Taxes Permanent 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 Tax-17 Corporate Taxes Temporary Differences These are differences between taxable income and book income caused by items that affect both, but in different periods. Therefore, they are also called timing differences. Tax-18 Corporate Taxes Temporary Differences Temporary/timing differences include: Revenues reported earlier on the tax return than on the books e.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. Tax-19 Corporate Taxes Temporary Differences A reconciliation must be used to explain why book and taxable income differ. Reconciliation of Book Income to Taxable Income (p. 22) per tax return Tax-20 Corporate Taxes Temporary Differences All temporary differences require the use of interperiod income tax 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.) Tax-21 Corporate Taxes Temporary Differences Page 23 [Per Tax Return] * 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. [Per Income Statement * Tax-22 Personal Income Tax . . . . . . Joe P. Taxpayer 123 45 6789 . Sally L. Taxpayer 987 65 4321 123 Main Street Anywhere, USA 55555-5555 X X 2 X Kenny Taxpayer Son Posh Taxpayer Daughter Tinkie Winky Taxpayer ??? 5 Tax-23 Personal Income Tax 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. Tax-24 Personal Income Tax 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. Tax-25 Personal Income Tax Taxable Income Examples of Excluded Income Gifts, inheritances, interest on state of Taxable Flow Chart for Determination bonds, certain Social Security benefits. for These items are not deducted! Income(NOTE:Individual Taxpayer (p. 25) They are just never included.) Also includes illegal gambling income and other illegal income. 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. Less Tax-26 Personal Income Tax Taxable Income Examples: Individual Retirement Accounts (IRA) Less and Keogh plans. Deductions From Gross Income Consists of business expenses, payments to an individual retirement arrangement, and a few other minor items. Equals Adjusted Gross Income Less Tax-27 Personal Income Tax Taxable Income Standard Deduction - A specified amount that is permitted by Less tax law to be deducted in lieu of itemized deductions. It each year because it is Personal inflation. changesStandard or Itemized indexed to 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. Less Tax-28 Personal Income Tax Taxable Income Less 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. Equals Taxable Income Tax-29 Personal Income Tax Subtractions Types of Itemized Deductions Certain taxes including real estate and state income tax Interest on principal residence and any second residence No longer deductible on consumer loans Charitable contributions to approved educational, religious and other not-for- profit organizations Tax-30 Personal Income Tax Subtractions 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 Tax-31 Personal Income Tax Subtractions 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 Tax-32 Personal Income Tax Subtractions Your taxable income is understated. You cannot claim Babe as an exemption! Tax-33 Personal Income Tax Rates 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! Tax-34 Personal Income Tax Rates Effective Tax Rate - The average rate of taxation on a given amount of taxable income. Effective = Total Taxes Paid Tax Rate Total Taxable Income Tax-35 Personal Income Tax Rates 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 $11,158 Tax on income above $49,300 (31% x $13,700 [$63,000 - $49,300]) 4,247 Tax Liability $15,405 Marginal tax rate = 31% Average tax rate = $15,405/$63,000 = 24.5% Tax-36 Tax-37 .
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