Donor's cost or adjusted basis h&r block

Taxation for Decision Makers

2020 EDITION

Shirley Dennis-Escoffier and

Karen A. Fortin

VP AND EDITORIAL DIRECTOR Michael McDonald ACQUISITIONS EDITOR Lise Johnson EDITORIAL MANAGER Judy Howarth CONTENT MANAGEMENT DIRECTOR Lisa Wojcik CONTENT MANAGER Nichole Urban SENIOR CONTENT SPECIALIST Nicole Repasky PRODUCTION EDITOR Bharathy Surya Prakash COVER PHOTO CREDIT © Manit Plangklang/EyeEm/Getty Images

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ISBN: 978-1-119-56210-8 (PBK) ISBN: 978-1-119-60171-5 (EVALC) Serial Record: ISSN 2006209815

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To the memory of Marty Escoffier who was always

ready with a willing hand to help, a word of

encouragement as deadlines neared, and a sense of

humor that never failed to make us laugh when we

needed it most. His presence has been missed as we

have worked on this revision.

Shirley Dennis-Escoffier and Karen A. Fortin

v

Preface xx About the Authors xxv

PART I INTRODUCTION TO TAXATION AND ITS ENVIRONMENT

1 An Introduction to Taxation 2

2 The Tax Practice Environment 47

PART II INCOME, EXPENSES, AND INDIVIDUAL TAXES

3 Determining Gross Income 110

4 Employee Compensation 155

5 Deductions for Individuals and Tax Determination 209

PART II I BUSINESS AND PROPERTY CONCEPTS

6 Business Expenses 274

7 Property Acquisitions and Cost Recovery Deductions 324

PART IV PROPERTY DISPOSITIONS

8 Property Dispositions 360

9 Tax-Deferred Exchanges 407

PART V BUSINESS TAXATION

10 Taxation of Corporations 458

11 Sole Proprietorships and Flow- Through Entities 507

PART VI WEALTH TAXATION

12 Estates, Gifts, and Trusts 566

Appendix Selected Tax Tables for 2019 and 2018 609

Index 619

Brief Table of Contents

vii

Preface xx About the Authors xxv

PART I Introduction to Taxation and Its Environment

1 An Introduction to Taxation 2

Setting the Stage—An Introductory Case, 3

1.1. An Introduction to Taxes, 3

1.1.1. What Is a Tax?, 3

1.1.2. Evolution of the Federal Income Tax, 4

1.1.3. State and Local Income Taxes, 5

1.1.4. Employment Taxes, 7

1.1.5. Wealth Taxes, 8

1.1.6. Wealth Transfer Taxes, 9

1.1.7. Consumption Taxes, 10

1.1.8. Tariffs and Duties, 12

1.2. Types of Tax Rate Systems, 13

1.2.1. The Progressive Tax Rate System, 13

1.2.2. Proportional “Flat” Tax Rate, 15

1.2.3. Regressive Taxes, 15

1.3. Characteristics of a Good Tax, 16

1.3.1. Equity, 16

1.3.2. Economy, 17

1.3.3. Certainty, 18

1.3.4. Convenience, 18

1.4. The Taxing Units and the Basic Income Tax Model, 19

1.4.1. The Basic Tax Model, 20

1.4.2. Trusts and Estates, 29

1.5. Choice of Business Entity, 30

1.5.1. Sole Proprietorships, 32

1.5.2. Partnerships, 33

1.5.3. C Corporations, 36

Table of Contents

viii Table of Contents

1.5.4. S Corporations, 37

1.5.5. Comparing Business Entity Attributes, 38

Revisiting the Introductory Case, 40

Summary, 40

Key Terms, 41

Test Yourself, 41

Problem Assignments, 42

Answers to Test Yourself, 46

2 The Tax Practice Environment 47

Setting the Stage—An Introductory Case, 48

2.1. Tax Compliance, 48

2.1.1. Filing a Tax Return, 48

2.1.2. Selecting Returns for Audit, 51

2.1.3. Types of Audits, 52

2.1.4. The Appeals Procedure, 53

2.1.5. Taxpayer Noncompliance Penalties, 54

2.1.6. Collection Procedures, 55

2.2. Professional Responsibil ities and Ethics, 56

2.2.1. Avoidance versus Evasion, 56

2.2.2. Tax Preparer Registration, 56

2.2.3. Tax Preparer Penalties, 56

2.2.4. Tax Professionals’ Dual Responsibilities, 57

2.2.5. Sources of Professional Guidance, 58

2.3. Tax Planning, 61

2.3.1. Cash Flows and Present Value, 62

2.3.2. Significance of the Marginal Tax Rate, 63

2.3.3. Timing Income and Deductions, 63

2.3.4. Income Shifting, 66

2.3.5. Changing the Character of Income, 67

2.3.6. Other Factors Affecting Tax Planning, 68

2.4. Tax Research, 71

2.4.1. Gather the Facts and Identify the Issues, 72

2.4.2. Locate Relevant Authority, 72

2.4.3. Evaluate the Sources of Authority, 79

2.4.4. Communicate the Recommendations, 86

2.4.5. Keeping Up-to-Date, 86

2.4.6. Sample Research Problem, 87

Revisiting the Introductory Case, 91

Summary, 91

Table of Contents ix

Key Terms, 92

Test Yourself, 92

Problem Assignments, 92

Answers to Test Yourself, 99

Appendix: Authorities for Sample Research Problem, 99

PART II Income, Expenses, and Individual Taxes

3 Determining Gross Income 110

Setting the Stage—An Introductory Case, 111

3.1. What Is Income?, 111

3.1.1. Taxable versus Gross Income, 112

3.1.2. Tax versus Financial Accounting, 112

3.1.3. Return of Capital Principle, 113

3.2. When Is Income Recognized?, 114

3.2.1. The Tax Year, 115

3.2.2. Accounting Methods, 116

3.3. Who Recognizes the Income?, 120

3.3.1. Assignment of Income Doctrine, 120

3.3.2. Community Property Laws, 120

3.4. Sources of Income, 121

3.4.1. Interest Income, 121

3.4.2. Dividend Income, 126

3.4.3. Annuity Income, 128

3.4.4. Transfers from Others, 129

3.4.5. Discharge of Indebtedness, 134

3.4.6. Tax Benefit Rule, 135

3.4.7. System for Reporting Income, 135

3.5. Exclusions, 136

3.5.1. Gifts and Inheritances, 136

3.5.2. Insurance Proceeds, 137

3.5.3. Scholarships, 139

3.5.4. Other Exclusions, 140

3.6. Expanded Topics—Jurisdictional Issues, 141

3.6.1. International Issues, 141

3.6.2. Taxpayers Subject to U.S. Taxation, 141

Revisiting the Introductory Case, 144

Summary, 144

Key Terms, 145

x Table of Contents

Test Yourself, 145

Problem Assignments, 146

Answers to Test Yourself, 154

4 Employee Compensation 155

Setting the Stage—An Introductory Case, 156

4.1. Employee Compensation, 156

4.1.1. Payroll Taxes, 156

4.1.2. Employee versus Independent Contractor, 158

4.1.3. Timing of Compensation Deduction, 161

4.1.4. Reasonable Compensation, 161

4.2. Employee Fringe Benefits, 163

4.2.1. Group Term Life Insurance Premiums, 165

4.2.2. Health and Accident Insurance Premiums, 166

4.2.3. Child and Dependent Care Programs, 167

4.2.4. Cafeteria Plans and Flexible Spending Arrangements, 167

4.2.5. No-Additional-Cost Services, 169

4.2.6. Employee Purchase Discounts, 169

4.2.7. Employee Achievement Awards, 170

4.2.8. De Minimis Fringe Benefits, 170

4.2.9. Working Condition Fringe Benefits, 171

4.2.10. Education Expenses, 173

4.2.11. Employee Relocation Expenses, 174

4.2.12. Substantiating Business Expenses, 175

4.3. Employee Stock and Stock Options, 176

4.3.1. Restricted Stock, 176

4.3.2. Stock Options, 179

4.3.3. Phantom Stock and Stock Appreciation Rights, 181

4.4. Deferred Compensation and Retirement Planning, 182

4.4.1. Qualified Retirement Plans, 182

4.4.2. Types of Retirement Plans, 183

4.4.3. Contribution Limits, 185

4.4.4. Nonqualified Deferred Compensation Plans, 186

4.4.5. Individual Retirement Accounts, 187

4.5. Self-Employed Individuals, 190

4.5.1. Employment Tax Consequences, 190

4.5.2. Fringe Benefits Limited, 192

4.5.3. Retirement Plans, 193

4.6. Expanded Topics—Foreign Assignments, 194

4.6.1. Foreign Earned Income Exclusion, 194

4.6.2. Excess Housing Cost Exclusion, 196

Table of Contents xi

4.6.3. Credit for Foreign Taxes, 196

4.6.4. Tax Reimbursement Plans, 197

4.6.5. Tax Treaties, 197

Revisiting the Introductory Case, 198

Summary, 198

Key Terms, 199

Test Yourself, 200

Problem Assignments, 201

Answers to Test Yourself, 208

5 Deductions for Individuals and Tax Determination 209

Setting the Stage—An Introductory Case, 210

5.1. The Individual Tax Model, 210

5.2. Adjustments to Income, 212

5.2.1. Student Loan Interest Deduction, 213

5.2.2. Educator Expenses, 214

5.2.3. Health Savings Accounts, 214

5.2.4. Penalty on Early Withdrawal of Savings, 215

5.2.5. Other Adjustments to Income, 215

5.3. Standard Deduction, 216

5.3.1. Standard Deduction Amounts, 216

5.3.2. Married Filing Jointly, 218

5.3.3. Surviving Spouse, 218

5.3.4. Married Filing Separately, 219

5.3.5. Head of Household, 220

5.3.6. Single (Unmarried) Individual, 221

5.4. Itemized Deductions, 221

5.4.1. Medical Expenses, 222

5.4.2. Taxes, 223

5.4.3. Interest Expense, 224

5.4.4. Charitable Contributions, 227

5.4.5. Casualty Losses, 230

5.4.6. Miscellaneous Itemized Deductions, 231

5.5. Qualified Business Income Deduction, 233

5.6. Dependents, 235

5.6.1. Qualifying Child, 235

5.6.2. Qualifying Relatives, 236

5.7. Tax Credits, 238

5.7.1. Credits versus Deductions, 238

5.7.2. Child Tax Credit, 238

5.7.3. Education Credits, 239

xii Table of Contents

5.7.4. Dependent Care Credit, 241

5.7.5. Earned Income Credit, 242

5.7.6. Excess Payroll Tax Withheld, 243

5.7.7. Other Credits, 243

5.8. Computing the Tax, 244

5.8.1. Medicare Surtaxes, 246

5.8.2. Alternative Minimum Tax, 248

5.8.3. Other Taxes, 252

5.9. Payment of Tax and Filing the Return, 252

5.9.1. Payment of Tax, 252

5.9.2. NOL, 253

5.9.3. Who Must File a Return?, 253

Revisiting the Introductory Case, 258

Summary, 259

Key Terms, 259

Test Yourself, 260

Problem Assignments, 261

Answers to Test Yourself, 271

PART III Business and Property Concepts

6 Business Expenses 274

Setting the Stage—An Introductory Case, 275

6.1. Criteria for Deductibility, 275

6.1.1. General Provisions for Trade or Business Expenses, 275

6.1.2. Ordinary and Necessary, 276

6.1.3. Contrary to Public Policy, 277

6.1.4. Related to Tax-Exempt Income, 278

6.1.5. Accrued to Related Party, 278

6.1.6. Obligation of Another Taxpayer, 278

6.1.7. Substantiation, 279

6.2. Timing of Deductions, 279

6.2.1. Accrual Method, 280

6.2.2. Cash Method, 280

6.2.3. Restrictions on Prepaid Expenses, 282

6.2.4. Disputed Liabilities, 283

6.3. Costs of Starting a Business, 283

6.3.1. Business Investigation and Start-Up Expenses, 283

6.3.2. Organization Costs, 284

Table of Contents xiii

6.4. Operating Expenses, 285

6.4.1. Business Meals and Entertainment, 285

6.4.2. Travel and Transportation Expenses, 286

6.4.3. Combining Business with Pleasure Travel, 289

6.4.4. Bad Debt Expenses, 291

6.4.5. Insurance Premiums, 292

6.4.6. Interest Expense, 292

6.4.7. Legal Expenses, 293

6.4.8. Taxes, 293

6.5. Limited Expense Deductions, 294

6.5.1. Residential Rental Property, 294

6.5.2. Home Office Expenses, 297

6.5.3. Hobby Expenses, 300

6.6. Expanded Topics—Book/Tax Differences, 300

6.6.1. Accounting for Income Tax Expense, 300

6.6.2. UNICAP Rules and Inventory, 307

Revisiting the Introductory Case, 309

Summary, 311

Key Terms, 312

Test Yourself, 312

Problem Assignments, 313

Answers to Test Yourself, 323

7 Property Acquisitions and Cost Recovery Deductions 324

Setting the Stage—An Introductory Case, 325

7.1. Capital Expenditures, 325

7.1.1. Capitalize or Expense, 326

7.1.2. Basis of Property, 327

7.2. MACRS, 330

7.2.1. Averaging Conventions, 331

7.2.2. Year of Disposition, 335

7.2.3. Alternative Depreciation System (ADS), 336

7.3. Special Expensing Provisions, 337

7.3.1. Section 179 Expensing Election, 337

7.3.2. Bonus Depreciation, 339

7.4. Provisions Limiting Depreciation, 341

7.4.1. Mixed-Use Assets, 341

7.4.2. Limits for Passenger Vehicles, 342

7.5. Depletion, 344

xiv Table of Contents

7.6. Amortization, 345

7.6.1. Research and Experimentation Expenditures, 346

7.6.2. Software, 347

Revisiting the Introductory Case, 347

Summary, 348

Key Terms, 348

Test Yourself, 348

Problem Assignments, 349

Answers to Test Yourself, 357

PART IV Property Dispositions

8 Property Dispositions 360

Setting the Stage—An Introductory Case, 361

8.1. Determining Gain or Loss on Dispositions, 362

8.1.1. Property Dispositions and Cash Flow, 362

8.1.2. Types of Dispositions, 363

8.1.3. Amount Realized, 364

8.1.4. Realized versus Recognized Gain or Loss, 365

8.1.5. Holding Period, 365

8.1.6. Character of Gains and Losses, 367

8.1.7. Mixed-Use Assets, 369

8.2. Disposition of Capital Assets, 369

8.2.1. The Capital Gain and Loss Netting Process, 369

8.2.2. Tax Treatment of Net Capital Gains and Losses, 371

8.3. Disposition of Section 1231 Property, 377

8.3.1. Depreciation Recapture, 378

8.3.2. Unrecaptured Section 1250 Gains for Individuals, 381

8.3.3. Section 1231 Look-Back Rules, 382

8.4. Mixed-Use Property, 384

8.5. Special Rules for Small Business Stock, 385

8.5.1. Losses on Section 1244 Stock, 385

8.5.2. Section 1202 Gains on Qualified Small Business Stock, 386

8.5.3. Comparison of Sections 1244 and 1202, 387

8.6. Sale of Principal Residence—Section 121, 388

8.6.1. Debt Reductions, Short Sales, and Foreclosures, 391

8.7. Navigating Individual Capital Gains Tax Rates, 391

8.7.1. Determining the Long-Term Capital Gains Tax Rate, 392

8.7.2. Planning with Multiple Tax Rates, 393

Table of Contents xv

Revisiting the Introductory Case, 394

Summary, 395

Key Terms, 396

Test Yourself, 396

Problem Assignments, 397

Answers to Test Yourself, 406

9 Tax-Deferred Exchanges 407

Setting the Stage—An Introductory Case, 408

9.1. Basics of Tax-Deferred Exchanges, 408

9.1.1. Basis Adjustments, 409

9.1.2. Holding Period, 410

9.2. Like-Kind Exchanges—Section 1031, 410

9.2.1. Qualifying Properties, 411

9.2.2. Determining Realized Gain or Loss and the Effect of Boot, 411

9.2.3. Basis and Holding Period of Like-Kind Property, 413

9.2.4. Indirect Exchanges, 414

9.3. Involuntary Conversions, 415

9.3.1. Casualty and Theft Losses, 415

9.3.2. Gains on Involuntary Conversions—Section 1033, 421

9.3.3. Involuntary Conversion of a Principal Residence, 424

9.4. Other Tax-Deferred Exchanges or Dispositions, 424

9.4.1. Wash Sales, 424

9.4.2. Installment Sales, 425

9.4.3. Related-Party Sales, 426

9.4.4. Other Deferrals, 428

9.5. Asset Transfers to Businesses, 428

9.5.1. Transfers to Sole Proprietorships, 428

9.5.2. Transfers to Controlled Corporations—Section 351, 429

9.5.3. Transfers of Property to a Partnership, 434

9.5.4. Formation of a Limited Liability Company, 437

9.6. An Introduction to Corporate Reorganizations, 437

Revisiting the Introductory Case, 438

Summary, 438

Key Terms, 439

Test Yourself, 439

Problem Assignments, 440

Answers to Test Yourself, 449

Appendix: Corporate Reorganizations, 450

xvi Table of Contents

PART V Business Taxation

10 Taxation of Corporations 458

Setting the Stage—An Introductory Case, 459

10.1. Introduction to Corporations, 459

10.1.1. Corporate Advantages, 460

10.1.2. Disadvantages of the Corporate Form, 461

10.1.3. Capital Structure, 461

10.2. Taxation of C Corporations, 463

10.2.1. Dividend Received Deduction, 463

10.2.2. Charitable Contribution Deduction, 464

10.2.3. Capital Gains and Losses, 465

10.2.4. Net Operating Losses, 466

10.2.5. Computing the Corporate Income Tax, 466

10.2.6. Reconciling Book and Taxable Income, 467

10.2.7. Tax Credits, 471

10.2.8. Filing and Payment Requirements, 472

10.3. Corporate Dividend Distributions, 472

10.3.1. Tax Effects of Dividend Distributions, 473

10.3.2. Calculating Earnings and Profits, 473

10.3.3. Applying E&P to Distributions, 474

10.3.4. Property Distributions, 477

10.3.5. Stock Dividends, 478

10.4. Corporate Redemptions and Liquidations, 479

10.4.1. Redemption Sale Requirements, 479

10.4.2. Partial Liquidation, 481

10.4.3. Liquidating Distributions, 482

10.4.4. Dividend and Redemption Planning Issues, 482

10.5. Issues for Closely Held Corporations, 484

10.5.1. Constructive Dividends, 484

10.5.2. Penalty Taxes to Encourage Dividend Payments, 485

10.5.3. Controlled Corporate Groups, 486

10.6. Consolidated Returns, 488

10.6.1. Consolidated Net Income, 489

Revisiting the Introductory Case, 490

Summary, 491

Key Terms, 491

Test Yourself, 492

Problem Assignments, 492

Table of Contents xvii

Answers to Test Yourself, 502

Appendix: Exempt Organizations, 502

11 Sole Proprietorships and Flow- Through Entities 507

Setting the Stage—An Introductory Case, 508

11.1. Intro duction to Flow-Through Business Entities, 508

11.2. The Sole Pro prietorship, 509

11.2.1. Forming the Sole Proprietorship, 509

11.2.2. Operating the Sole Proprietorship, 511

11.2.3. Limitation on Excess Losses, 513

11.2.4. Qualified Business Income Deduction, 514

11.2.5. Self-Employment Taxes, 515

11.3. Partnerships, 516

11.3.1. Types of Partnerships, 516

11.3.2. Advantages and Disadvantages of Partnerships and LLCs, 517

11.3.3. Entity versus Aggregate Concepts, 517

11.3.4. Partnership Operations, 518

11.3.5. Partner’s Basis Account, 523

11.3.6. Loss Limitation Rules, 525

11.3.7. Guaranteed and Nonguaranteed Payments, 527

11.3.8. Partnership Distributions, 528

11.3.9. Selling a Partnership Interest, 532

11.3.10. Qualified Business Income Deduction, 533

11.4. S Corpo ration Char acteristics, 534

11.4.1. Eligibility Requirements for S Status, 535

11.4.2. Making the S Election, 536

11.4.3. Terminating the S Election, 536

11.4.4. S Corporation Operations, 537

11.4.5. Loss Limitations, 541

11.4.6. Tracking Basis, 541

11.4.7. Property Distributions, 542

11.4.8. The S Corporation Schedules M-1, M-2, and M-3, 542

11.4.9. The Accumulated Adjustments Account, 543

11.4.10. S Corporation Taxes, 544

11.4.11. Redemptions and Liquidations by S Corporations, 545

11.5. Expanded Topics—The Passive Deduction Limitations, 546

11.5.1. Material Participation, 547

11.5.2. Real Property Business Exception, 548

Revisiting the Introductory Case, 549

Summary, 550

Key Terms, 551

xviii Table of Contents

Test Yourself, 551

Problem Assignments, 552

Answers to Test Yourself, 564

PART VI Wealth Taxation

12 Estates, Gifts, and Trusts 566

Setting the Stage—An Introductory Case, 567

12.1. Overview of Wealth Transfer Taxation, 567

12.1.1. The Unified Transfer Tax, 567

12.1.2. Features of the Unified Transfer Tax, 569

12.1.3. Major Exclusions, 569

12.2. The Federal Gift Tax, 572

12.2.1. Transfers Subject to Gift Taxes, 572

12.2.2. Transfers Excluded from Gift Taxes, 575

12.2.3. Valuation of Gift Property, 576

12.2.4. Special Rules Affecting the Annual Gift Tax Exclusion, 576

12.2.5. Gift Tax Deductions, 579

12.3. Tax Consequences for Donees, 580

12.3.1. Kiddie Tax, 581

12.3.2. Special Education Savings Plans, 582

12.4. The Taxable Estate, 583

12.4.1. Identifying the Gross Estate, 584

12.4.2. Valuation Issues, 586

12.4.3. Estate Deductions, 587

12.4.4. Generation-Skipping Transfer Taxes, 587

12.5. Transfer Tax Planning, 588

12.5.1. Selecting the Right Property to Give, 588

12.5.2. Advantages of Making Lifetime Gifts, 589

12.5.3. Disadvantages of Lifetime Gifts, 591

12.6. Fiduciary Income Tax Issues, 591

12.6.1. The Decedent’s Final Tax Return, 591

12.6.2. Income Tax Consequences of Inherited Property, 592

12.6.3. Income Taxation of Trusts and Estates, 593

12.7. Expanded Topics—The Tax Calculations, 594

12.7.1. Computing the Gift Tax, 594

12.7.2. Computing the Estate Tax, 595

12.7.3. Computing the Fiduciary Income Tax, 596

Revisiting the Introductory Case, 598

Table of Contents xix

Summary, 598

Key Terms, 599

Test Yourself, 599

Problem Assignments, 600

Answers to Test Yourself, 607

Appendix Selected Tax Tables for 2019 and 2018 609

Corporate Tax Rates for 2019 and 2018, 609

Individual Income Tax Rate Schedules for 2019 and 2018, 609

Social Security and Medicare Taxes for 2019 and 2018, 611

Standard Deductions for 2019 and 2018, 612

Tax Rates for Estates, Gifts, and Trusts for 2019 and 2018, 612

Depreciation Tables, 613

Present Value and Future Value Tables, 615

Index 619

xx

FOCUS

This text is designed for a one-semester introductory tax course at either the undergraduate or graduate level. It is ideal for an MBA course or any program emphasizing a decision-making approach. This text introduces all tax topics on the CPA exam in only 12 chapters.

COMPREHENSIVE YET CLEAR AND CONCISE

This text covers basic taxation of all taxable entities—individuals, corporations, S corporations, partnerships, and fiduciary entities, emphasizing a balance between concepts and details. Tax concepts and applications are presented in a clear, concise, student-friendly writing style with sufficient technical detail to provide a foundation for future practice in taxation and consulting while not overwhelming the student with seldom-encountered details.

WHAT’S NEW THIS EDITION

This text has been completely updated for all law changes and pronouncements issued through the first four months of 2019. In addition to updating all chapters for these changes, Chapter 1 was modified to better introduce the taxation of corporations and flow-through businesses including an introductory discussion of the qualified business income deduction. Additional details are provided in Chapter 5 regarding reporting on the individual tax return and in Chapter 11 on the returns for the flow-through businesses. Chapter 5 was rewritten and new sample filled-in tax forms have been introduced in this chapter as well as in other several chap- ters of the text.

TAX PLANNING

The importance of tax planning is emphasized throughout the text. Margin icons are woven into each chapter to highlight planning opportunities. Tax planning strategies are introduced early in Chapter 2 along with the impact of taxes on cash flow.

LEARNING OBJECTIVES

Each chapter begins with learning objectives for that specific chapter as well as a basic introduction to the included topics, emphasizing why decision makers need to understand these topics. Each chapter is organized by learning objective making is easy to identify rele- vant topics.

SETTING THE STAGE—AN INTRODUCTORY CASE

Each chapter opens with a case that focuses on one or more key issues within the chapter to promote critical analysis and decision-making skills. The case is then revisited at the end of the chapter with a suggested solution to stimulate further class discussion.

Preface

Preface xxi

EXAMPLES

Rigorous topics are tackled through numerous simple but realistic examples.

KEY CASES

Key Cases bring real world applications into the classroom.

KEY CASES In 2008, actor Wesley Snipes was sentenced to 3 years in prison for willfully failing to file tax returns for years 1999–2004, a period in which he earned more than $38 million. Follow- ing an unsuccessful appeal, he served his sentence in a medium-security prison in Pennsylvania.

In December 2014, Representative Michael Grimm, who had just been re-elected to his third term in Congress, resigned from Congress after agreeing to plead guilty to felony tax fraud. The indictment alleged that he kept two sets of records for a restaurant he previously owned con- cealing more than $1 million in gross receipts and underreporting his employees’ wages to avoid federal and state taxes. He served 7 months in prison.

EXPANDED TOPICS

The Expanded Topics section included at the end of Chapters 3, 4, 6, 11, and 12 contains more advanced topics for instructors who wish to challenge their students. These advanced discussions relate to the other material within the chapters, but which our adopters and reviewers have indi- cated could be omitted to allow more time for the more critical material.

SUMMARY

Each chapter closes with a Summary of the most important topics introduced in the chapter, rein- forcing important concepts for students.

KEY TERMS

A list of Key Terms is included at the end of each chapter. They appear in bold print and are keyed to the first page on which the term is discussed.

TEST YOURSELF

Each chapter includes a Test Yourself section of five multiple-choice questions for students to assess their understanding of topics covered in the chapter. Answers to these questions follow the end-of-chapter materials.

Example 1.1When Alex Rodriguez, the former Texas Rangers shortstop, lived in Texas (a state with no individual income tax), he owed more than $271,000 to California (which assesses a nonresident income tax) for games he played in that state during baseball season. It was estimated that if the Rangers had played all their games at home, A-Rod’s state tax bill could have been reduced by more than half a million dollars a year. When A-Rod switched to the New York Yankees, his state and local tax burden increased dramatically. On the $155 million that A-Rod was to be paid over his initial seven-year contract, he was expected to owe $3.57 million to New York City and an additional $6.19 million to the State of New York for income taxes.

xxii Preface

PROBLEM ASSIGNMENTS

More than 60 problems are included at the end of each chapter. Check Your Understanding includes a wide variety of noncomputational questions that review the topics included in the chapter. Crunch the Numbers presents quantitative problems covering the computational aspects of chapter materials. Comprehensive problems integrate topics covered in several different chapters.

DEVELOP PLANNING SKILLS

Develop Planning Skills problems give students the opportunity to test their knowledge in planning situations. The tax planning suggestions integrated throughout the text continually remind students of the importance of developing appropriate planning strategies.

THINK OUTSIDE THE TEXT

For instructors wishing to challenge their students, Think Outside the Text questions develop critical thinking skills by requiring students to expand their thinking beyond the material covered in the chapter.

IDENTIFY THE ISSUES

Identify the Issues includes short scenarios designed to challenge the students to identify issues and formulate research questions. These scenarios, however, do not provide enough information to enable students to develop definitive solutions but are designed to help students practice the issue- identification step in the research process, a step that many new tax students consider the most difficult.

DEVELOP RESEARCH SKILLS

Develop Research Skills requires students to research the relevant authorities and present possible solutions. These can be solved using a subscription-based tax service or free Internet sources. Citations to relevant Internal Revenue Code sections, cases, and rulings are included only in the Instructor’s Manual along with solutions to these research problems, allowing each instructor to decide what, if any, hints should be given to students when a problem is assigned.

FILL-IN THE FORMS

Most of the chapters have problems that require completion of one of more tax forms in a Fill-in the Forms section. Some of these are very basic and may simply require completion of forms for earlier problems—usually one or two forms—and will assist in familiarizing the student with basic tax forms. There are, however, several chapters that have more comprehensive problems that require completion of a number of forms. These will present a challenge to the student and lend themselves to completion in small groups. These include returns for individuals and the four types of business entities covered. All or parts of these problems may be assigned when the instructor feels the students are ready for additional challenges presented in translating tax knowledge to form completion. The solutions for these problems are only included in the Instructor’s Manual.

CHAPTER APPENDICES

End-of-chapter appendices introduce topics not typically covered in a first tax course including corporate reorganizations and taxation of nonprofit entities. These materials are placed in chapter appendices to allow instructors the flexibility to include or omit them as deemed appropriate.

Preface xxiii

UP-TO-DATE

This text has been completely updated for all recent legislation and for all IRS pronouncements available as of April 2019.

ORGANIZATION

This text is ideal for schools with only one required tax course. Its 12 chapters can be covered in one semester, with time for assessments, eliminating the need to omit chapters. The text empha- sizes tax planning to stimulate students’ thinking in terms of the effect taxation has on decisions for both individuals and entities.

There are two introductory chapters in Part I. The first chapter includes a brief introduction to the different types of taxes and introduces Adams Smith’s Canons of Taxation that can be used throughout the text to evaluate specific tax legislation. To emphasize to students the decision- making focus of this text, the first chapter introduces simple problems on the choice of business entity and provides an easily understood background for the more complex material to follow. The second chapter covers tax compliance issues, an introduction to tax planning, and the basics of tax research. A sample research problem (with sources included in an appendix) is included that can be used to guide students in performing basic tax research at any time during the course.

Part II has three chapters that cover income and expenses, as well as other topics needed for individual return preparation. Chapter 3 answers the question, “What is income?” by exploring the various facets of taxable and nontaxable income for entities as well as individuals. Chapter 4 introduces an example of a dual planning orientation (the two sides to any transaction) with the discussion of employee compensation, a subject often relegated to the end of a text where, unfor- tunately, many students are never introduced to it. This topic provides an opportunity for students to view transactions from an individual employee’s perspective (maximizing employee bene- fits while minimizing taxable income) and the employer’s perspective (designing an optimum compensation plans that combines salary and benefits to attract valuable employees). The chapter provides a broader view of income by including the perspective of the entity making the payments.

Chapter 5 includes deductions for individuals and the additional related information on credits and tax rates necessary to complete an individual tax return. This allows the assignment and completion of basic individual tax returns early in the term.

The focus in Parts III and IV turns primarily to business-related subjects covering general business expenses in Chapter 6 and then capital recovery through depreciation, depletion, and amortization in Chapter 7. Chapters 8 and 9 present discussions of taxable and nontaxable prop- erty dispositions, respectively.

With the completion of Chapters 6 through 9, the student is ready to apply the information to the basic business entities starting in Part V with the regular corporation in Chapter 10. The specifics of the sole proprietorship and the basic flow-through entities of partnerships and S cor- porations and their relationship to their owners are included in Chapter 11.

Part VI includes an introduction to wealth transfer taxes—estate and gift taxes. It also includes a discussion of income taxation of estates and trusts, the tax effects on beneficiaries, and the kiddie tax.

YOUR COURSE YOUR WAY

The organization of the text is designed primarily to respond to our adopters who have indicated that many students’ interest in taxation is delayed until they are introduced to the provisions affecting their own current or potential taxation. Chapters 3 through 5 now contain the primary information relevant to individual taxation (excluding property transactions) for instructors who prefer introducing individual taxation prior to taxation of entities. Alternatively, Chapter 3,

xxiv Preface

selected topics from Chapter 4, and Chapter 6 may be covered in sequence with topics unique to individuals tackled later in the term along with entity taxation. The flexibility of this text makes it easy to change the sequence of chapters as well as the topics within the chapters. Sections of the chapters are easily identifiable allowing instructors to pick and choose those they deem more important for classroom coverage. We have emphasized the readability of the text so that instruc- tors feel comfortable simply assigning sections to be read by students outside of the class while spending their limited classroom time on more complex topics. This text also works particularly well for instructors who use a flipped-classroom approach to their course.

SUPPLEMENTS

Supplements include an author-prepared Solutions Manual, a separate Instructor’s Manual with solutions to the Research and Tax Return Problems, an extensive Test Bank, and PowerPoint slides.

COMMENTS AND SUGGESTIONS

We realize that it is almost impossible for a text to be completely free of technical errors or to include every relevant topic. We welcome comments and suggestions on how we can improve the next edition. Please email your comments and suggestions to sdennis@miami.edu.

ACKNOWLEDGMENTS

We wish to acknowledge and thank Saira Fida at the University of Miami for her extensive help in this edition. We are grateful to the entire Wiley team for their assistance.

Shirley Dennis-Escoffier and Karen A. Fortin

xxv

Shirley Dennis-Escoffier is an associate professor at the University of Miami, where she teaches both graduate and undergraduate tax classes. She received her Ph.D. from the University of Miami and returned to UM after teaching at the University of Hawaii and California State University in Hayward. She is a Certified Public Accountant licensed to practice in Florida. She is a Past President of the American Taxation Association and remains actively involved in the association receiving the Outstanding Service Award. She is also involved with the American Institute of Certified Public Accountants. She has received several teaching awards including the University of Miami Excellence in Teaching Award and the Masters in Taxation Excellence in Teaching Award. She has published numerous articles in tax and accounting journals and is the recipient of an Ernst and Young Foundation tax research grant.

Karen A. Fortin retired from her position as Professor of Accounting and Taxation at the University of Baltimore, where she had been Department Chair and taught graduate and under- graduate tax classes in both the Business School and the Law School. She received her Ph.D. from the University of South Carolina and held teaching positions at the University of Wisconsin– Milwaukee and the University of Miami. She was a Wisconsin Certified Public Accountant and a recipient of a Sells Award. During her teaching years, she was active in the American Taxation Association and the American Accounting Association as an editor, reviewer, and chairperson for numerous events. As a member of the AICPA she served on several committees and task forces. She has published numerous articles in tax and accounting journals and has co-authored and edited a number of textbooks.

About the Authors

1

PART I

CHAPTER 1 An Introduction to Taxation

CHAPTER 2 The Tax Practice Environment

Introduction to Taxation and Its Environment

2

CHAPTER 1

CHAPTER OUTLINE

Setting the Stage—An Introductory Case 3

1.1 An Introduction to Taxes 3

1.2 Types of Tax Rate Systems 13

1.3 Characteristics of a Good Tax 16

1.4 The Taxing Units and the Basic Income Tax Model 19

1.5 Choice of Business Entity 30

Revisiting the Introductory Case 40

Summary 40

Key Terms 41

Test Yourself 41

Problem Assignments 42

Answers to Test Yourself 46

This chapter presents an overview of the types of taxation, key concepts to facilitate understanding taxation, and an introduction to business entities in the United States. The detailed provisions of income tax law follow in subsequent chapters. Similarly, detailed calculations are covered in subsequent chapters as these figures change with each tax year. The focus of this chapter is on developing a broad understanding of how the U.S. income tax system works.

The first section provides background information on the types of taxation (income, consumption, wealth, and wealth transfer taxes). It is followed by a discussion of the effects of various tax rate structures (progressive, proportional, and regressive), examples of each type, and their effects. It ends with a brief description of Adam Smith’s Canons of Taxation (equity, economy, certainty, and convenience), which provide the framework for assessing what constitutes a “good” tax.

An introductory discussion of federal income taxation follows and introduces the three types of taxable persons—individuals, C corporations, and fiduciaries—the ulti- mate payers of all income taxes. The basic tax model is introduced and the concepts of gross income, taxable income, tax rates, gross tax liability, and tax credits are presented in the context of the tax model.

The final section discusses business entities and how they are subject to federal income taxes (sole proprietorships, partnerships, C corporations, and S corporations). The individual owner of a sole proprietorship is taxed on the business’s income. Partner- ships and S corporations are conduit or flow-through entities that pass their income (and loss) items through to their owners for taxation at the owner level. A C corporation’s

LEARNING OBJECTIVES

After completing this chapter, you should be able to:

1.1 Explain the basic types of taxes and the bases on which they are levied by various governmental units.

1.2 Compare the effects of progressive, proportional, and regressive tax systems on taxpayers’ incomes.

1.3 Explain the characteristics of a good tax system using characteristics of equity, economy, certainty, and convenience.

1.4 Describe the components of the basic income tax model and understand how the tax due is calculated.

1.5 Identify the most common business entities recognized by the U.S. tax system and explain the basic differences in ownership and their effects on entity taxation.

An Introduction to Taxation

1.1 An Introduction to Taxes 3

income is subject to double taxation, first at the entity level by the corporate income tax and then a second time when distributed to shareholders as dividends. A table comparing the basic attrib- utes of each of these entities completes this chapter.

Wing Hue, an engineer from China with U.S. residency status, recently obtained permanent employment with a U.S. consulting firm. Before coming to the United States, Hue developed a totally new system of gears for bicycles. He obtained a patent on his gear design and plans to solicit several venture capitalists for funds to begin manufacturing and marketing the gears as a venture separate from his consulting work. He believes his gear design would be attractive to both bicycle manufacturers and repair shops as replacements for existing gears.

As a student in China, Hue never had sufficient income to pay taxes. He understands that as a U.S. resident, he is subject to a variety of taxes. He is particularly interested in how his gear manufacturing enterprise will be taxed. He asks you for a brief explanation of the potential taxes that he faces as an employee and as an entrepreneur. We will return to this case at the end of this chapter.

1.1.1 WHAT IS A TAX?

A tax is a forced payment (meaning required by the law and is not voluntary) to a governmental unit that is unrelated to the value of goods or services received. Failure to collect and remit taxes to the appropriate governmental unit, subjects the responsible persons to civil, or even criminal, penalties.

One tax that is familiar to most U.S. citizens is the federal income tax (for individuals, this includes filing Form 1040). The individual calculates his or her taxable income and tax liability to report in a specific tax year. The income taxes are then remitted to the federal government, and possibly state and/or local governments, by a date specified by the taxing authority.1

Two more familiar taxes are sales taxes and real property taxes. Many states (and other smaller governmental units) require the sellers of certain consumer goods or services to col- lect sales taxes on these purchases. The owners of real property are responsible for property taxes levied annually by the local government, based on the assessed value on that property. A bill is sent to the owner for these property taxes and, if unpaid, the government may seize the property.

There are hidden taxes as well. Hidden taxes are those taxes paid on a taxable purchase but not specifically itemized as part of the purchase price. For example, in the price of gasoline there are significant taxes imbedded in the pump price. This is also true for cigarettes and alcoholic beverages. Nevertheless, if we want that particular good (legally, that is), we pay the hidden tax.

Remember, taxes are often called forced extractions. You must pay them to the government, but you may have no direct benefit from them. This is in contrast to a garbage collection fee (where the payment is in exchange for the service). Although we may benefit from governmental activities paid for by taxes, they are not levied as a payment for the goods or services. For example, property taxes to support local schools are based on the value of the property owned. They are unrelated to the owner’s school-age children (if any) who benefit from free public education.

SETTING THE STAGE—AN INTRODUCTORY CASE

1.1 AN INTRODUCTION TO TAXES

1 Individuals are assessed federal income taxes only if their income exceeds their allowable deductions (including their standard or itemized deductions).

4 CHAPTER 1 An Introduction to Taxation

Our current income tax system is complex. Its primary goal is no longer to meet the revenue needs of the government’s basic functions, but has evolved into an engine that fosters the economic and social goals lawmakers deem appropriate. As our government has grown, so have the laws governing the determination of taxable income and taxes owed. Although there have been many calls for simplifying the tax system, it is necessary to have a basic understanding of the current tax system and its potential alternatives, before developing a new tax system to either replace or supplement the current federal system.

To begin this introductory study of the income tax system, certain basic tax concepts, alternative types of taxes, and the types of tax rates that can be applied to a taxable base are introduced. Adam Smith’s canons of taxation, developed many years ago, provide a foundation for assessing whether a tax is indeed a good tax. Once an understanding of these concepts is integrated with an understanding of the current income tax laws, one can intelligently participate in discussions about reforming our current tax system.

While embarking on this journey to understand taxation, remember to ask a few questions: (1) Which taxing authority is requiring the tax collection? (2) Which person or business entity is being subject to the taxation? (3) Which income is included as taxable (and when)? (4) Which expenses are deductible for tax purposes (and when)?

1.1.2 EVOLUTION OF THE FEDERAL INCOME TAX

The federal income tax is the most significant tax assessed by the U.S. government. The ini- tially simple concept of taxing income expanded over the years into an exceedingly complicated system. During the Civil War there was a federal income tax, however, the federal income tax system as we know it today began in 1913 when the 16th Amendment to the U.S. Constitution was ratified. The 16th Amendment gave Congress the power to lay and collect taxes “on income, from whatever source derived,” without the previous requirement that all direct taxes be imposed based on population. This first federal income tax law enacted in 1913 consisted of only 16 pages and required only a simple individual income tax return.

Each time the income tax statutes were revised between 1913 and 1939, an entire set of new provisions replaced the existing law. In 1939 this procedure changed, and the income tax laws were codified as the Internal Revenue Code. Amendments and revisions were then made to the specific sections of the Code, rather than replacing the old law with an entirely new set of statutes.

In 1954, there was another major overhaul of the tax laws. In this 1954 recodification, the income, estate, gift, and excise tax laws were incorporated into the Internal Revenue Code of 1954. There were many significant tax law changes between then and 1986, each amending the Internal Revenue Code of 1954. Because the Tax Reform Act of 1986 was so extensive, the Code was renamed the Internal Revenue Code of 1986. Any current changes to the tax laws are now amendments to the Internal Revenue Code of 1986.

A number of factors influence the federal tax laws, but similar to all law, probably the makeup of Congress is the most important. Democratic and Republican Parties disagree on how to best serve the public interest. Additional initiatives are from lobbyists trying to influence representatives and senators to sponsor or vote for legislation favorable to their particular industries. Accomplishing the particular interests of each elected representative leads to rather strange results. For example, the federal government successfully sued the tobacco industry for the harm done by cigarette smoking while maintaining subsidy programs for tobacco farmers.

This industry influence is generally manifested in two ways. First, industries contribute substantial monies to election campaigns, pouring the greatest amount of money into the cam- paigns of persons they believe will support their positions—incumbent or not. Second, many

1.1 An Introduction to Taxes 5

lobbyists and political action committees (PACs) have extremely large staffs available to research various technical issues. They can funnel this research, often slanted in their desired direction, to the various members of Congress. It is not unusual for a lobbyist to have provided the basic text of a tax law introduced in Congress.

The attempt to satisfy the many constituencies of our elected representatives has led to a collection of tax laws that have become more and more complex. This has significantly increased the compliance burden on taxpayers as well as Internal Revenue Service (IRS) administration. In spite of many calls for simplification, Congress continues to pass addi- tional tax provisions, adding complexity to the system, without revisiting or deleting existing provisions.

Both political parties provide tax breaks to their constituents referred to as tax expen- ditures. Tax expenditures can take the form of special exclusions, deductions, credits or pref- erential rates for specific activities. These tax expenditures result in a reduction in the revenue that would be collected under a more comprehensive income tax. Although many of these tax expenditures are viewed positively because they can stimulate the economy, the dispute among politicians is usually over how to pay for them. They can usually be paid for in one of three ways: (1) reducing spending, (2) adding to the budget deficit, or (3) raising other tax revenue to offset the cost of the tax expenditures. Although politicians say they want to cut spending, they have been very ineffective in doing so. They usually add to the budget def- icit or increase taxes. This dilemma has led to an alternative way to minimize the cost of tax expenditures by making them temporary rather than permanent. A tax expenditure expected to expire in only a few years, needs to raise far less revenue to pay for it than making the expen- diture permanent. Unfortunately, the uncertainly surrounding the extension of some of these provisions makes tax planning difficult so that much of any expected economic stimulus is negated by this uncertainly.

The elections in November 2016 gave the Republican Party control of the House of Repre- sentatives, the Senate, and the White House. This gave them their best opportunity in some time to enact change. In December 2017, Congress passed the Tax Cuts and Jobs Act which perma- nently reduced corporate tax rates from a high of 35 percent to a flat rate of 21 percent. Individual tax rates were also slightly reduced, but only temporarily. These cuts were paid for by placing new limits on some deductions, completely eliminating other deductions, and adding over $1.4 trillion to the budget deficit. The legislative process through which tax proposals become law is discussed in the next chapter.

Although this text is primarily about the federal income tax, a basic understanding of other taxes will be helpful before we begin exploring the federal income tax in more detail.

1.1.3 STATE AND LOCAL INCOME TAXES

While most students are aware of the federal income tax, not all are familiar with state and local income taxes. The increasing importance of these taxes is reflected in the growth of state and local tax (SALT) practices in public accounting. Most states (and some local governments) impose corporate and/or personal (individual) income taxes on both residents and nonresidents.2 States, however, normally tax nonresidents only on income from business activities or property located within that state.

2 States not imposing a corporate income tax or other form of business tax include Nevada, South Dakota, and Wyoming. States that do not impose individual incomes taxes are Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming. Additionally, some states only tax certain types of interest and dividend income.

6 CHAPTER 1 An Introduction to Taxation

The state in which a corporation is organized has the right to impose an income tax on that corporation under the residency principle. Alternatively, the source principle allows taxation of a business that has an economic connection to a state (derives income from assets or activities located within a state).

When a resident corporation of one state derives income from business activities in another state, double taxation could result. To minimize this, states that levy an income tax on its resident businesses usually allow them to claim a credit for some or all of the income taxes paid to other states. Historically, the type and degree of connection between a business and a state necessary for the state to impose a tax is referred to as nexus.

In place of the income tax, some states impose a franchise tax. A franchise tax is an excise tax based on the right to do business or own property in the state. Whether the tax is called an income tax or a franchise tax, the tax is usually determined based on corporate income.5

Most states piggyback their computation of state taxable income on the federal income tax system by beginning with individual or corporate federal taxable income. Piggybacking on the federal system is particularly problematical, however, when Congress amends the tax law result- ing in reduced taxable income (for example, by increasing or accelerating deductions). To mini- mize the potential impact on state tax revenues, many states adopt a fixed version of federal tax law by computing state taxable income as determined under the federal tax rules in effect as of a specific date. This allows state legislatures time to study the impact of changes on state revenue before adopting them. Although most states eventually adopt the federal changes, considerable delays are common.

When a corporation has nexus in several states, each state taxes only a percentage of the corporation’s income based on the business allocated to that state. Although computations differ from state to state, many states use a three-factor allocation formula based on sales, payroll costs, and tangible property. Some states place more weight on the sales factor, while others weigh these factors equally.6

Corian Corporation manufactures equipment for sale nationwide. Corian’s corporate headquar- ters and production facilities are located in Florida. Corian has regional sales offices in New York, Illinois, and California. Corian has nexus in Florida, New York, Illinois, and California due to the presence of employees and business property in those states.

Example 1.2

3 Mark Hyman, “Why the ‘Jock Tax’ Doesn’t Play Fair,” Business Week, July 7, 2003, p. 37. 4 Dan Kadison, “$10M is Ballpark for Taxman,” The New York Post, February 17, 2004, p. 4. 5 A few states impose their franchise tax on a corporation’s stock value or net worth, either in addition to or instead of a tax on corporate income if it results in a higher tax. 6 Because of the variation in allocation formulas between states, some corporations may have more than 100 percent of their total taxable income subject to state income taxes.

When Alex Rodriguez, the former Texas Rangers shortstop, lived in Texas (a state with no individual income tax), he owed more than $271,000 to California (for nonresident income tax) for games he played there during baseball season. It was estimated that if the Rangers had played all their games at home, A-Rod’s state tax bill would have been reduced by more than half a million dollars a year.3 When A-Rod became a New York Yankee, his state and local tax burden increased dramatically. On the $155 million that A-Rod was to be paid over his initial seven-year contract, he was expected to owe $3.57 million to New York City and an additional $6.19 million to the State of New York for income taxes.4

Example 1.1

1.1 An Introduction to Taxes 7

Nonbusiness income, such as interest, dividends, rent and royalties, is taxed in only one state—the state in which the corporation is domiciled or the state in which the underlying prop- erty is located or used.8

Income tax planning for multistate corporations usually involves shifting income from high-tax states to low-tax states by shifting assets from one state to another or by outsourcing some functions to eliminate or move nexus from a particular state. Businesses that are expanding or relocating facilities should measure the impact this will have on the amount of income appor- tioned to the state. For example, a corporation with plans to expand its facilities should avoid a high tax-rate state that uses an apportionment formula that weights property and payroll factors more heavily. The expansion of plant and the addition of employees can increase the percentage of total income subject to state tax.

1.1.4 EMPLOYMENT TAXES

Employment taxes include those specified under the Federal Insurance Contributions Act (FICA) along with federal and state unemployment taxes. The FICA tax has two components: Social Security and Medicare. Social Security pays monthly retirement benefits (also survivor and disability benefits) to qualified individuals. The 6.2 percent Social Security tax applies to salaries and wages up to an annual maximum of $132,900 for 2019 ($128,400 for 2018). The Medicare tax pays for medical insurance for individuals who are elderly or disabled. The 1.45 percent Med- icare portion of the FICA tax applies to all salary and wages without limit. Thus, an employer pays 7.65 percent FICA tax on each employee’s wages up to $132,900 and 1.45 percent on compensation above $132,900.

Example 1.3Southeastern Corporation does business and has nexus in States X and Y. Its sales, payroll costs, and tangible property located in each state are:

Sales Payroll Property

State X $800,000 $315,000 $540,000 State Y 800,000 135,000 360,000 Total $1,600,000 $450,000 $900,000

Based on these dollar figures, the percentages for the three factors are as follows:7

Sales Payroll Property Total

State X 50% 70% 60% 180% State Y 50% 30% 40% 120% Total 100% 100% 100%

If each factor is weighted equally, the apportionment formula computes the average of the three factors so that the apportionment percentage for State X is 60 percent (180%/3) and the apportionment percentage for State Y is 40 percent (120%/3). Southeastern Corporation allo- cates 60 percent of its income to State X and 40 percent to State Y.

7 The percentage for each factor is determined by dividing the dollar amount of the item attributable to that state by the total dollar amount for that factor. For example, payroll for State X is $315,000. Dividing $315,000 by the total payroll costs of $450,000 means 70 percent of all payroll costs were incurred in State X. 8 The corporation’s domicile is the principal place from which the business is managed or directed, not necessarily the state of incorporation.

8 CHAPTER 1 An Introduction to Taxation

In addition to the employer FICA tax, employees pay a matching FICA tax. Employers withhold the employee portion of the FICA tax from the employee’s salary or wages and forward it to the federal government (along with any income tax withheld).

Self-employed individuals (such as independent contractors, sole proprietors and partners) must pay the self-employment tax that includes both the employer and employee share of FICA tax, as discussed in detail in Chapter 4. Similarly, a deduction that is an adjustment to income will be discussed in detail which provides self-employed individuals a similar deduction to the corporate payroll tax expense deduction (i.e., Marlin Corporation’s deduction for payroll taxes paid for all employees in the example above).

In addition to FICA taxes, employers are also required to pay federal and state unemployment taxes. These taxes fund temporary unemployment benefits for employees terminated from their jobs without cause. The rate under the Federal Unemployment Tax Act (FUTA) is 6 percent on the first $7,000 of wages. The state rates vary widely but the federal government allows a credit of up to 5.4 percent for state unemployment taxes the employer pays. Unemployment taxes are usually only paid by the employer and not the employee. Self-employed individuals are not eligible to collect unemployment benefits so they do not pay unemployment taxes for themselves; they pay unemployment taxes only for their employees.

1.1.5 WEALTH TAXES

Wealth taxes are based on the taxable entity’s total wealth or the value of specific types of prop- erty. The most common wealth tax is the real property tax. This ad valorem tax is levied on individuals and businesses that own real property—land and buildings—and is assessed on the fair market value of the property. Local taxing jurisdictions rely heavily on the real property tax for the support of schools, police and fire protection, and other services furnished by the local municipality. The federal government generally does not levy any form of wealth tax, leaving the various forms of wealth taxes to the state or local governments.

To determine the rate at which the real property taxes will be levied, the municipality “works backward.” The total budget is determined along with the total assessed valuation for all property subject to the tax. A mill levy (a “mill” is one-tenth of one cent) is then determined based on the total assessed value of the property to raise the revenue required by the budget. The mill levy is applied to each individual property within the district to determine its separate property tax.

Maria is an employee of Marlin Corporation. In 2019, Maria received a salary of $135,000. Marlin Corporation paid a Social Security tax of $8,239.80 ($132,900 limit x 6.2%) plus a Med- icare tax of $1,957.50 ($135,000 × 1.45%) for a total FICA tax of $10,197.30. Marlin Corpo- ration withheld $8,239.80 from Maria’s pay for her share of Social Security tax and $1,957.50 for her Medicare tax. Marlin Corporation also withheld income tax based on Maria’s W-4 form that indicated her filing status (single). Marlin Corporation forwards both the employer’s and employee’s share of FICA tax to the federal government, as well as any income tax withheld for Maria.

Remember, payroll tax and federal income tax are two separate taxes. When Marlin Corpo- ration calculates its federal income tax liability, the corporation will deduct payroll taxes it paid for all employees (for Maria the amount is $10,197.30). This payroll tax expense is an ordinary and necessary business expense that reduces taxable income for the corporation when calculating its federal income tax liability.

Example 1.4

1.1 An Introduction to Taxes 9

Other forms of wealth taxes include the personal property tax, the tangible property tax, and the intangible property tax. These taxes are collected annually on property owned as of a certain date based on a predetermined fixed rate applied to the fair market value of the property. Personal property or tangible property taxes are more likely to be levied on the value of a busi- ness’s inventory and/or operating assets. Individuals may not always escape this tax, however, as a number of states base a part of the cost of obtaining automobile registrations or license plates on the value of the auto as an ad valorem tax.

Some states levy intangible taxes on the value of receivables, stocks, bonds, and other forms of investment instruments owned by businesses and individuals. Intangible taxes are based on a fixed tax rate times the fair market value of the intangible assets owned as of a specific date.

Two major problems related to wealth taxes have lessened government reliance on them as a source of revenue: the difficulty in establishing fair market value annually and the taxpayer’s ability to “hide” personal property. The market value of many types of personal property (tangible or intangible) is not verifiable, leading to significant undervaluation by taxpayers. Moreover, the government may not know who owns a specific asset unless there is a way to trace or detect own- ership. Thus, most local governments rely heavily on real property taxes rather than other types of personal property taxes, as real estate is much harder to hide. Through the assessment system, taxes are thought to be levied on a more uniform basis across the value of the properties.9

Based on ability to pay, wealth taxes would seem to be a sound source of tax revenue. Many items, however, such as a personal residence, do not produce direct income, and the owner may have little or no disposable income with which to pay the tax—a major problem for the elderly or others on fixed incomes when real property taxes increase.

1.1.6 WEALTH TRANSFER TAXES

Wealth transfer taxes are levied when all or part of an individual’s wealth is transferred to another person. Since 1916, the United States has had an estate tax, a wealth transfer tax that applies to transfers of property as a result of the owner’s death. A second wealth transfer tax, the gift tax, was enacted in 1932. The gift tax is imposed on a donor who makes a gratuitous lifetime transfer of property.10 To avoid double taxation on these transfers, the recipient is not subject to income tax on inherited property or property received as a gift.

Since 1976, the federal estate and gift taxes have been unified. Gift transfer taxes are levied based on a person’s transfers during his or her lifetime with the final estate tax based on transfers at death. The tax is assessed on the fair market value of the property transferred.

A tax liability may be avoided if the gift is less than the annual exclusion ($15,000 per recipient per year in 2019 and 2018) or if the taxpayer uses their lifetime credit to offset the tax liability (equivalent to the tax on $11.4 million in 2019). Additionally, unlimited transfers to a spouse and qualified charities (during lifetime and at death) escape taxation.

The purpose of the annual gift exclusion is to ease the administrative burden as it prevents smaller gifts from being subject to the transfer tax (and does not result in a gift tax return fil- ing requirement).11 The unified gift and estate lifetime credit assures that a certain base amount

Example 1.5A municipality’s budget is $1,000,000 and the total assessed value of all the property subject to the property tax is $200,000,000. To raise the required $1,000,000, a five-mill levy is required per $1 of assessed value ($1,000,000/$200,000,000 = $.005). When this mill levy is applied to a piece of property with an assessed value of $100,000, the owner would pay $500 ($.005 × $100,000) in real property taxes.

9 Ideally, there would be an annual valuation process, but in reality, property assessments may increase or decrease based on indices only, or are otherwise revised only when a property is sold. 10 Chapter 12 contains a more detailed discussion of wealth transfer taxes. 11 If a taxpayer’s annual gifts to an individual recipient do not exceed $15,000, the donor is not required to file a gift tax return.

10 CHAPTER 1 An Introduction to Taxation

of wealth can be transferred to others (including children, grandchildren, other relatives, and friends) through lifetime gifts or transfers at death free of a transfer tax.

With the integration of the gift and estate taxes, any unified credit not used for lifetime gifts can be used for transfers made by the decedent’s estate. Thus, the decedent’s estate escapes taxation unless his or her total lifetime taxable gifts plus taxable transfers at death exceed the lifetime exclusion.12

A number of states levy inheritance taxes rather than estate taxes. The inheritance tax is based on a person’s right to receive property upon the death of another. The tax rates and amount excluded from taxation vary with the relationship of the heir to the decedent and the value of the property received. The estate normally pays the inheritance tax, but the tax paid reduces the total value of the property transferred to the heir. In addition to an inheritance or estate tax, many states also levy a gift tax.

1.1.7 CONSUMPTION TAXES

Consumption taxes may take many forms, but the sales tax is the most common form in the United States. Most states levy sales taxes on some or all of the goods and services purchased, although certain items considered necessities may be exempt from tax. For example, food, clothing, prescriptions, and many services may be excluded from the sales tax while items not considered necessities such as restaurant meals, rental cars, and hotel rooms are taxed. Purchases of inventory for resale are usually exempt from sales tax because the inventory will be taxed when sold; however, purchases for use in a business are taxable as a final sale.

The retailer is responsible for collecting and remitting sales taxes to the appropriate state and local tax authority. Because the determination of items subject to sales tax varies greatly from state to state, multistate retailers must determine not only the appropriate sales tax rates (which may vary within a zip code due to local sales taxes) but also determine which items are subject to tax in each location.

The concept of nexus is also important in determining the sales tax, as it is for an income tax. The exact definition for sales tax nexus may differ from that of income tax nexus. A business may have nexus in a state for sales taxes but not for income taxes or vice versa. For example,

In 2019, Marleen gave $50,000 to a qualified charity. She also gave each of her five grandchildren 700 shares of stock valued at $10,000 on their birthdays. The charitable gift is not subject to the gift tax. The birthday gifts are also free of the gift tax (and Marleen does not have to file a gift tax return) as they do not exceed each grandchild’s $15,000 annual gift tax exclusion.

If Marleen gives an additional $10,000 to each grandchild this year, she now exceeds the annual gift exclusion ($10,000 + $10,000 − $15,000 = $5,000 taxable gift to each) and would have to file a gift tax return for 2019. This notifies the government that she is using some of her lifetime unified credit. However, assuming she has not exhausted her lifetime unified credit, no tax is due. Marleen’s gifts remain free of any gift tax until her total taxable gifts exhaust her unified credit that is equal to the tax on total taxable gifts over her lifetime of $11.4 million (the 2019 lifetime exclusion).

The grandchildren have no tax consequences on the receipt of the gifts because gifts are not subject to income taxes. They will, however, be subject to income tax on future dividends received or realized gains on any stock sales.

Example 1.6

12 The lifetime exclusion for taxable transfers is $11,400,000 for 2019 ($11,180,000 for 2018 and $5,490,000 for 2017). Chapter 12 has a more complete discussion of the annual and lifetime exclusions for taxable transfers.

1.1 An Introduction to Taxes 11

employees from out-of-state who solicit sales within a state may create sales tax nexus but not income tax nexus.

Historically, case law did not permit a state to collect sales tax unless it had a physical presence in the state (which generally meant the business had property or employees in the state). However, as businesses evolve so must the laws that regulate them.

KEY CASE Wayfair, Inc. recently challenged a new law in South Dakota based on the legal precedent from two prior cases. Under National Bellas Hess, Inc. v. Department of Revenue of Ill. (386 U. S. 753) and Quill Corp. v. North Dakota (504 U. S. 298) South Dakota may not require a business that has no physical presence in the state to collect its sales tax. Consumer compliance rates are notoriously low, however, and it is estimated that Bellas Hess and Quill cause South Dakota to lose between $48 and $58 million annually. Thus, South Dakota Legis- lature enacted a law requiring out-of-state sellers to collect and remit sales tax “as if the seller had a physical presence in the state.” The Act covers only sellers that, on an annual basis, deliver more than $100,000 of goods or services into the state or engage in 200 or more separate trans- actions for the delivery of goods or services into the state. Wayfair, Inc. challenged the new law and lost. In June 2018, the Supreme Court upheld the law with its decision in South Dakota v. Wayfair, Inc. (138 S. Ct. 2080), changing the e-commerce landscape. The precedent set by this decision is that a state may now require a business to collect sales tax even if that business does not have a physical presence in that state (overruling the physical presence requirement which generally meant the business had property or employees in the state).

Other states are now in the process of establishing new laws as a result of this decision to

generate tax revenues from online retailers that do not have a physical presence in their state, but do meet a requirement set by that state.

Each state that imposes a sales tax also imposes a companion use tax. A use tax is imposed on property to be used in one state but purchased in another state if no sales tax was paid in the state of purchase. A use tax is self-assessed and usually at the same rate as the sales tax. Without a use tax, there is an incentive to purchase from out-of-state businesses not required to collect a state sales tax to the detriment of in-state businesses.

Most states have difficulty collecting use taxes from individuals (except for automobiles that require registration with the state). Collection from businesses is much easier to enforce because most states regularly audit in-state businesses for compliance with sales and use tax laws.

One benefit of a consumption tax like the sales tax is that it encourages savings— considered a necessity for continued investment and economic growth. A person can avoid the sales tax by not purchasing certain goods for consumption; income that is not consumed is available for savings. The income tax not only taxes income whether consumed or saved, but taxes the income earned on savings, further discouraging savings.

Other types of consumption taxes include excise taxes, value-added taxes, and turnover taxes—although only the excise tax is in common use in this country. An excise tax is another form of sales tax and the only sales tax levied by the federal government. Excises are generally

Example 1.7JX Corporation operates in a state with a 6 percent sales and use tax. JX purchases office supplies over the Internet from an out-of-state supplier for $2,000. JX pays no sales tax. If JX purchased these supplies from the local office supply store, it would have to pay a sales tax of $120 ($2,000 × 6%). JX should file a use tax return and pay the $120 use tax to its state because the supplies will be used within the state.

12 CHAPTER 1 An Introduction to Taxation

levied on taxable goods for which there is a low elasticity of demand or on goods whose use the government wishes to discourage, such as tobacco products and alcoholic beverages. This latter group of excises is generally referred to as “sin” taxes.13 Other excises offset some of the costs incurred by the government for certain services, for example, the tax on airline tickets helps pay for the system of air traffic controllers.

The value-added tax (VAT), in use in most of the developed countries of the world, has not been adopted in the United States. It is a type of sales tax that is added to a product or service based on the value added at specific points in the production or service process. Although there are several methods for calculating the value-added tax, it basically works as described in the following example.

Some features of a VAT differentiate it from a sales tax. First, it is generally included directly in the selling price at the consumer level. Second, the VAT is not levied on goods exported to other countries. Businesses that export goods to other countries receive refunds of the VAT paid on exported goods. When the United States exports goods to a foreign country in competi- tion with another exporting country that levies a value-added tax (instead of a corporate income tax), the United States may be at a competitive disadvantage. All other costs being equal, the U.S. firm will have to charge more than the other exporter to make the same profit because it receives no rebate of income taxes while the foreign exporter receives a rebate of its value-added taxes.14

The turnover tax, another consumption tax, is a sales tax levied at each step of a business chain—both wholesale and retail—but with no rebates or credits for prior taxes paid. Thus, if one firm handles all the steps in a manufacturing process from raw materials to finished goods, the tax is levied only once, when the product is sold to the consumer. If, however, that same product’s manufacturing process is handled by two or three firms, the tax is levied and collected each time the items move from one manufacturer to the other—driving up its costs relative to the manufac- turer that is able to complete the various manufacturing steps.

1.1.8 TARIFFS AND DUTIES

Tariffs are taxes levied on goods and materials brought into a country, usually for one of two rea- sons: (1) A foreign business sells goods to the purchasers in the destination country at prices that may be below production costs in an attempt to capture a market and put the local operations out

A business buys parts to manufacture a widget. The parts cost $400, to which a 10 percent value-added tax is added by the seller—a total cost of $440. The business assembles the parts into a widget and sells the assembled widget for $800 plus a 10 percent value-added tax of $80—the purchaser’s total purchase price is $880. The business, however, remits only $40 of the tax to the government—the total $80 VAT less a credit for the $40 VAT paid to the supplier of the purchased parts. The government collects the other $40 from the parts supplier. The consumer pays the full tax on the product to the last business in the business chain. The tax collected at each step is based on the difference in the price paid for the goods coming in and the price received when leaving.

Example 1.8

13 The indirect costs incurred from the consumption of these products must be borne by the government; that is, treating persons for lung cancer and alcoholism is the justification for taxing these products at rates that are designed to discourage their use. 14 Foreign firms that sell goods within the United States may be subject to U.S. income taxes, but they may be levied at rates significantly different from those faced by comparable U.S. firms. Taxation of foreign corporations is discussed in Chapter 3.

1.2 Types of Tax Rate Systems 13

of business. (2) A local business’s operating costs are higher than those costs for the same product produced in the foreign jurisdiction.15

Import duties are similar to tariffs as they are taxes on goods brought into a country and levied by the destination country. When persons travel abroad, they are permitted to purchase a certain amount of goods and bring them back “duty free.” When the duty-free allowance is exceeded, the government levies a tax on the excess. This encourages the purchase of goods at home by making imported goods more expensive. Export duties are taxes levied on goods that are leaving the country of origin. These taxes discourage producers from selling their goods abroad by making them more expensive. In this way, they are available for purchase in the country of origin at lower prices.

1.2.1 THE PROGRESSIVE TAX RATE SYSTEM

The current federal income tax system is a progressive tax system—one in which the tax rates increase as income increases. The system is based on the belief that taxpayers with higher levels of income should pay a greater proportion of the taxes necessary to support the government. This is known as the “ability to pay” or the “wherewithal to pay” concept.

The U.S. income tax rate structure has always been progressive with initial rates in 1913 of 1 percent to 7 percent. In 1945, to fund the war, the top rate increased to 94 percent.16 In 1985, there were 15 tax brackets from a low of 11 percent to a high of 50 percent. In an attempt to sim- plify the tax system, the Tax Reform Act of 1986 drastically reduced the number of brackets as well as the rates. However, the top rate and the number of rates have continued to change either to raise revenue to balance the budget or to provide a tax cut when budget surpluses were predicted.

The current federal tax rates for individuals range from 10 percent to 37 percent. The range of income subject to a specific tax rate is known as a tax bracket. As the taxpayers’ income exceeds a specific bracket, income within that next bracket is subject to the increased percentage rate. This percentage is referred to as the marginal tax rate and is discussed in more detail later in this chapter.

Table 1.1 shows the tax rates on ordinary income for single individuals and married cou- ples filing a joint return for 2019. The brackets to which these rates apply are adjusted annually for inflation.

As an individual’s income increases through this progressive tax rate schedule, the lower tax rates continue to apply to the amount of income in each of the lower tax brackets. As a result,

1.2 TYPES OF TAX RATE SYSTEMS

Table 1.1 Ordinary Income Tax Rates for 2019

Tax rates Taxable income for single individuals Taxable income for married filing a joint return

10% $0–$9,700 $0–$19,400 12% $9,701–$39,475 $19,401–$78,950 22% $39,476–$84,200 $78,951–$168,400 24% $84,201–$160,725 $168,401–$321,450 32% $160,726–$204,100 $321,451–$408,200 35% $204,101–$510,300 $408,201–$612,350 37% Over $510,300 Over $612,350

15 The tariffs on foreign steel are examples of taxes levied because of the concern that foreign countries were “dumping” steel here at prices below their costs. 16 See www.taxpolicycenter.org/statistics/historical-top-tax-rate.

14 CHAPTER 1 An Introduction to Taxation

the first $9,700 of income of all single individuals is taxed at only the 10 percent rate—even indi- viduals whose total taxable income exceeds $1 million.

Two types of income are subject to lower tax rates: dividend income and long-term capital gains. Dividend income is taxed at a lower rate because a corporation pays tax on earned income but is not allowed a deduction for dividends paid to its shareholders. Shareholders’ dividend income is effectively subject to a second tax at the shareholder level. To minimize the impact of this double taxation, the dividend income of individual shareholders is taxed at lower tax rates as shown in Table 1.2.

To encourage long-term investment, individuals owning investments (such as stock) for more than 12 months are taxed at lower rates when sold. Table 1.2 provides the long-term capital gain tax rates which are the same rates that apply to dividend income. Short-term capital gains (those that do not meet the more-than-one-year holding period) are taxed at an individual’s ordi- nary income tax rate.

Prior to 2018, corporations also faced progressive tax rates consisting of four nominal tax rates of 15%, 25%, 34% and 35% and two surtaxes applied at different income levels. Corpora- tions also had no special long-term capital gains tax rates; their capital gains were taxed using the same rates as their ordinary income. Since 2018, corporations pay a flat tax rate of 21 percent on all taxable income.

There are several other important tax rate concepts in a progressive tax rate system. An average tax rate is determined by dividing the taxpayer’s tax liability by taxable income. For example, a single individual with $250,000 of taxable income and a tax liability of $62,694 pays a 35 percent tax rate on the last $45,900 of income above the $204,100 starting point for the 35 percent tax bracket but has an average tax rate of only 25.08 percent ($62,694/$250,000). In highlighting the tax effects on different groups of taxpayers, the average tax rate is often used to compare the percentage of taxes paid on taxable earned income.

The marginal tax rate is the tax rate that applies to the next dollar of taxable income (or deduction).

As a taxpayer moves from one tax bracket to another, the marginal tax rate moves from one rate to the next. For decision purposes, the marginal tax rate is the most relevant rate for tax planning. Basic tax planning strategies that use the marginal tax rate are discussed in Chapter 2.17

Sarah is single with taxable income of $120,000 that puts her in the 24 percent marginal tax bracket. If she earns an additional $10,000 in ordinary income, her taxable income increases to $130,000 and she will pay an additional $2,400 ($10,000 × 24% marginal tax rate) in income tax. If, instead, she has $10,000 of additional deductions, her taxable income decreases to $110,000, she will save $2,400 in income taxes.

Example 1.9

Table 1.2 2019 Tax Rates for Dividend Income and Long-term Capital Gains

Tax rates for dividend income and long-term capital gains

Taxable income for single individuals

Taxable income for married filing a joint return

0% $0–$39,375 $0–$78,750 15% $39,376–$434,550 $78,751–$488,850 20% Over $434,550 Over $488,850

17 A third tax rate, the effective tax rate, divides the taxes paid by an individual’s economic income (both taxable and nontaxable).

1.2 Types of Tax Rate Systems 15

In a progressive individual income tax system, the marginal tax rate is always higher than the average tax rate. The average rate may approach the highest marginal rate, but there is always some income that was taxed at a lower rate preventing the average rate from equaling the marginal rate for individuals.

1.2.2 PROPORTIONAL “FLAT” TAX RATE