Introduction to Taxation

Introduction to Taxation1-1

CHAPTER 1

INTRODUCTION TO TAXATION

SOLUTIONS TO PROBLEM MATERIALS

Status: Q/P

Question/Presentin Prior

Problem Topic EditionEdition

1Effect of state and local taxes on decision makingUnchanged1
2History of Federal income taxUnchanged2

3Tax structureNew

4Use taxesUnchanged4
5Inheritance and estate taxes comparedUnchanged5

6Cumulative nature of the Federal gift taxUnchanged6

7Federal gift tax and use of annual exclusionsUnchanged7

8Advantage of Federal gift tax election for spouses toUnchanged8

split gifts

9Ethics problemUnchanged9

10Issue recognitionUnchanged 10
11Issue recognitionUnchanged11

12Issue recognitionNew

13Issue recognitionNew

14Proportional versus progressive taxUnchanged12
15FICA and FUTA comparedUnchanged16

16Issue recognitionNew
17Issue recognitionNew
18Flat-tax definedUnchanged17
19Income tax computationModified19
20Entity choiceUnchanged20

21Entity choiceUnchanged21

22Implicit tax Unchanged22

23Tax rate determinationUnchanged23

24Tax rate determinationUnchanged24

25Justification for several tax provisionsUnchanged25

26Common objective of retirement plansUnchanged26

and charitable contributions

27Economic and social considerations: home ownership Unchanged27

28Wherewithal to payUnchanged28

29Mitigating the effect of the annual accountingUnchanged29

period concept

30Coping with inflation: indexation procedure Unchanged 30

1-1

PROBLEM MATERIAL

1.Some tax considerations Aqua should investigate include the following:

• State and local income taxes.

• State and local sales taxes.

• State and local property taxes.

Many such taxes could affect any cost-of-living differential. pp. 1-5, 1-10 to 1-12, and 1-16

2.This is not the case. During the Civil War, both the Federal Union and the Confederate States of America had an income tax. Furthermore, an income tax was reenacted in 1894. It was this tax that was held to be unconstitutional by the U. S. Supreme Court and ultimately led to the passage of the Sixteenth Amendment. pp. 1-13 and 1-14

3.Except for the Federal estate and gift taxes, all excise taxes are proportional. This is also the case with ad valorem property taxes. Besides the Federal estate and gift taxes, income taxes are progressive. p. 1-15

4.Jim probably will be required to pay the Washington use tax if, and when, he applies for Washington license plates. In this case, the use tax probably is the same amount as the Washington sales tax. p. 1-5 and Example 5

5.An inheritance tax is a tax on the right to receive property due to the death of another. As such it is a tax on the heir. An estate tax is a tax on the right to pass property by death. As such, it is a tax on the decedent. The Federal government levies an estate tax. States levy inheritance or estate taxes or both. pp. 1-8 and 1-9

1. Since the gift tax is cumulative in effect, the 1998 taxable gift must be added to the 2000 taxable gift. As the tax rates are progressive, the tax on $500,000 is $155,800. From this amount is subtracted the amount paid on the 1998 gift. Thus, $85,000 ($155,800 - $70,800) is the amount of tax due on the 2000 gift. p. 1-9 and Example 12

7.16 (donees) X $10,000 (annual exclusion) X 10 years = $1,600,000. p. 1-9 and Example 14

8.The special election allows one-half of the gifts made by the donor-spouse to be treated as being made by the nondonor-spouse. The effect of this election to split gifts of property made to third persons is to increase the number of annual exclusions available and to allow the use of the nondonor-spouse’s unified transfer tax credit. p. 1-10

9.In all probability, the residence was not on the property tax rolls when it was owned by a tax-exempt organization (i.e., St. Matthew's Catholic Church)—see p. 1-10 in the text. Also clear is the fact that the taxing authority is not aware that the residence is no longer owned by a tax-exempt organization.

Since it is only a question of time before the omission is noticed by the taxing authority, it would be advisable for the Toth's to get the matter cleared up. In many cases, further delay can lead to additional interest and penalties. pp. 1-10 and 1-11

10.Gull Company is trying to minimize the value of the real estate. This can be done by keeping personalty from becoming a “fixture.” The jurisdiction where the building is situated probably imposes an ad valorem tax on realty that is higher than that imposed on personalty. pp. 1-10 and 1-11

11.Probably John has no desire to experience the trouble and expense of paying the income taxes imposed by other states and many cities. By limiting his performances to Las Vegas, he avoids state and local income taxes. pp. 1-16 and 1-17

12.The replacement of an army base with an industrial park will increase the amount of property that is included in the property tax base of Madison County. Keep in mind that property owned by various government units is not subject to the ad valorem tax. p. 1-10

13.Since property owned by the state is exempt from ad valorem property taxes, a prison farm would lower the tax base. The ultimate effect is to reduce the revenue the county receives from the ad valorem tax on realty. p. 1-10

14.As the Medicare tax component of the FICA tax rate is constant, the tax is proportional. pp. 1-3, 1-7, and Example 2

15.a.The FICA tax burden is shared by both employer and employee, while the incidence of FUTA falls entirely on the employer. pp. 1-7 and 1-8

b. The justification for FICA is to provide retirement and disability security. FUTA, on the other hand, is designed to provide modest unemployment benefits. p. 1-7 and 1-8

c.For 2000, the FICA tax rate on employees and employers is 6.2 percent of wages up to a maximum base amount of $76,200 and 1.45 percent on all wages (no limit). FUTA applies at a maximum rate of 6.2 percent on the first $7,000 of covered wages. p. 1-7 and 1-8

16.In some states, countries (and cities) are given the option to impose additional sales tax levies. It is possible that this is the situation with Wilson Country. If so, this would explain why Velma does her shopping in Grimes County. p. 1-5 and Example 4

17.Earl probably purchased his computer out-of-state by use of a catalog or through the Internet. In such cases, state collection of the sales (use) tax is improbable without taxpayer compliance. p. 1-5

18.A flat tax is an income tax imposed at a single rate. Under a pure flat tax, no deductions are allowed and certain types of investment income may be exempt. To preclude hardship, low-income and some middle-income taxpayers are exempted from the tax. The major advantage of the flat tax is its simplicity. p. 1-15

19.a.Using the individual income tax formula in Figure 1-2, Jill’s taxable income is computed as follows:

Income broadly conceived $175,000

Less: exclusions (30,000)

Gross income $145,000

Less: deductions for AGI (40,000)

AGI $105,000

Less: greater of

Itemized deductions 20,000

Standard deduction 4,400 (20,000)

Less: personal exemption (2,800)

Taxable income $ 82,200

Using the Tax Rate Schedule X inside the front cover of the textbook, Jill’s total tax liability for 2000 would be $20,163 ($14,381.50 + 0.31 [$82,200 – $63,550]).

This tax liability of $20,163 would then be reduced by the tax credits of $18,000 to $2,163. The $837 excess of estimated tax payments of $3,000 over the $2,163 could be refunded or applied to the next year's tax liability.

b.If Jill were a corporation, her taxable income would be computed using the formula in Figure 1-1, as follows:

Income broadly conceived $175,000

Less: exclusions (30,000)

Gross income $145,000

Less: deductions (60,000)

Taxable income $ 85,000

Note that the corporation receives no personal exemption and that no distinction is made between deductions for and from AGI. Using the corporate tax rate schedule inside the front cover of the textbook, Jill’s total tax liability for 2000 is $17,150.

$50,000 X 15% = $ 7,500

25,000 X 25% = 6,250

10,000 X 34% = 3,400

$17,150

This tax liability would then be reduced by the tax credits of $18,000. Assuming the credits are nonrefundable, Jill would have a tax credit carryover of $850 ($18,000 - $17,150). The $3,000 of estimated tax payments could be refunded or applied to next year's tax liability.

pp. 1-16 and 1-17

20.Smith, Raabe, and Maloney, CPAs

5101 Madison Road.

Cincinnati, Ohio 45227

Cynthia Clay

1206 Seventh Avenue

Fort Worth, TX 76101

Dear Cynthia:

I am writing this letter to help you decide on what form of entity to choose for your new sandwich delivery business. In our phone conversation, you indicated that you expect to have losses for the first two years in this business and then make substantial profits in subsequent years. You and Cory also indicated that you are concerned about potential personal liability.

While I can’t make a conclusive recommendation based on the information you have given me, I can provide you with some general guidelines that should simplify your decision. First, given your concern about personal liability, a partnership does not appear to be a desirable option (you would both be personally liable for any injuries to customers). Similarly, given your expectation of losses in the first two years, it does not appear that a regular “C” corporation would be a desirable choice, at least initially. This is because any losses in the corporation could only be used to offset future corporate profits—you could not use the losses to immediately offset your personal tax liability.

Thus, two choices exist which provide limited liability and deductibility of losses on your personal income tax return. These are the “S” corporation and the limited liability company. If you choose an “S” corporation, we would probably convert the entity to a “C” corporation when the business becomes profitable. At that point, profits would be taxed at the regular “C” corporation rates. A second tax would be levied on your personal income tax return for any dividends paid by the corporation once it achieves “C” status. In contrast, limited liability companies are taxed like partnerships—all income would be taxed on your personal income tax return in profitable years. The relative desirability of each of these two forms depends on a number of factors. One of the most important factors in your situation is the relationship between your personal tax rate and the tax rate of a regular “C” corporation. If you are in a high tax bracket and if the income in the the business is sufficiently low, you might be best off choosing the “S” corporation. Alternatively, if you expect the business to generate a sufficiently large profit each year, it might be best to choose the limited liability company.

If you would like me to give you a clearer recommendation, we should meet at your earliest convenience. If you have any additional questions, please call me.

Best regards,

Julian Jackson, CPA

pp. 1-17 to 1-19

21.a.

2000 / 2001 / 2002
Corporate Tax Liability
Sales Revenue / $150,000 / $320,000 / $600,000
Cash Expenses / (30,000) / (58,000) / (95,000)
Depreciation / (25,000) / (20,000) / (40,000)
Taxable Income / $95,000 / $242,000 / $465,000
Corporate Tax Liability / $20,550 / $ 77,630 / $158,100
Cash Available for Dividends
Sales Revenue / $150,000 / $320,000 / $600,000
Tax-Free Interest Income / 5,000 / 8,000 / 15,000
Cash Expenses / (30,000) / (58,000) / (95,000)
Corporate Tax Liability / (20,550) / (77,630) / (158,100)
Cash Available for Dividends / $104,450 / $192,370 / $361,900
Ashley's After-Tax Cash Flow
Dividend Received / $104,450 / $192,370 / $361,900
Tax on Dividend / (41,362) / (76,179) / (143,312)
After-Tax Cash Flow / $ 63,088 / $116,191 / $218,588
PV of Cash Flow / $ 57,353 / $ 96,026 / $164,228
Present Value / $317,607

b.

2000 / 2001 / 2002
Individual Tax Liability
Sales Revenue / $150,000 / $320,000 / $600,000
Cash Expenses / (30,000) / (58,000) / (95,000)
Depreciation / (25,000) / (20,000) / (40,000)
Taxable Income / $ 95,000 / $242,000 / $465,000
Individual Tax Liability / $ 37,620 / $ 95,832 / $184,140
Ashley's After-Tax Cash Flow
Sales Revenue / $150,000 / $320,000 / $600,000
Tax-Free Interest Income / 5,000 / 8,000 / 15,000
Cash Expenses / (30,000) / (58,000) / (95,000)
Individual Tax Liability / (37,620) / (95,832) / (184,140)
After-Tax Cash Flow / $ 87,380 / $174,168 / $335,860
PV of Cash Flow / $ 79,436 / $143,940 / $252,337
Present Value / $475,713

c.If Ashley wants to have access to all available cash from the business, then she will have to pay out dividends annually. As seen in the answers to a and b above, the present value of future cash flows is substantially greater if she does not incorporate under this assumption. Alternatively, if she does not need to pay out dividends, then she may be better off by incorporating, since only the corporate tax will be incurred, which is less than her individual tax. The value of her stock will increase and she can then sell the stock at a later date at favorable capital gains rates.

pp. 1-17 to 1-19

22.a.The implicit tax rate on the Kiowa County bonds is (8% - 5%) / 8%, or 37.5%. Implicit tax can be thought of as the tax rate that would generate the tax-free return if it were applied to the taxable bond.

b.Given that Sienna only faces a 25% marginal tax rate, the tax-free bonds would not be a good investment because the implicit tax rate is too high.

p. 1-22 and Example 23

23.Without the new product line, Chartreuse would offset all of its 2000 and 2001 income with the NOL carryforward and would have no regular tax liability until 2002. With the new product line, Chartreuse would have taxable income of $20,000 ($50,000 income - $30,000 NOL carryforward) in 2001. That is, all $70,000 of 2000 income would be offset by the NOL carryforward and $30,000 of the 2001 income would be offset. Assuming no changes in corporate tax rates, Chartreuse would face a 0% tax rate in 2000 and a 15% tax rate in 2001 if the new product line were chosen versus a 0% tax rate if the line were not chosen. The tax rate faced in 2001 in the new product line would be the discounted value of the 15% rate over one year. For example, assuming a 10% discount rate, the tax rate would be 13.6% (15% / 1.1). pp. 1-20 and 1-21 and Example 22

24.Using the corporate tax rate schedule inside the cover of the textbook, Mauve’s tax liability (on $105,000) is $24,200. Since Mauve would pay $0.39 on the next dollar of taxable income earned, its marginal tax rate is 39%. Its average tax rate is the ratio of tax liability to taxable income or approximately 23% ($24,200 / $105,000). Its effective tax rate is the ratio of tax liability to total income or approximately 20% ($24,200 / $120,000). p. 1-21 and Example 21

25.a.Known as the “S election” (see Chapter 12), the election permits certain small business corporations to generally avoid the imposition of the corporate income tax. One important justification for this provision of the tax law is that it may encourage the formation of such small business corporations. pp. 1-25 and 1-26

b.Congress felt that it was socially desirable to encourage employer-sponsored accident and health plans. As such, §§ 105 and 106 make the benefits and coverage of these plans generally nontaxable to the employees and their beneficiaries. Furthermore, § 162 allows the employer a deduction for the cost of coverage or any benefits that it pays directly. p. 1-26

26.The encouragement of private retirement plans and contributions to charitable organizations have the common objective of shifting some of the financial and administrative burden of desirable programs from the public (government) to the private (citizen) sector. p. 1-26

27.The encouragement of home ownership is largely a social consideration. However, the equitable aspects of providing the home owner a tax benefit that is not available to one who rents is subject to criticism. pp. 1-26 and 1-27

1. Under the involuntary conversion provision, Wilma can avoid recognizing $50,000 of her $70,000 realized gain. She must recognize $20,000 of gain because $20,000 of the condemnation proceeds were not reinvested in property that is similar or related in service or use. p. 1-27

29.The installment method of recognizing gain on the sale of property allows a taxpayer to spread the tax consequences over the payout period. The harsh effect of taxing all of the gain in the year of sale is thereby avoided. p. 1-28

30.Indexation is provided for various components of the Federal income tax structure (e.g., tax rates and personal exemptions). p. 1-29