Taxes in Businesses

Prof. Maydew - Spring 2012 1

Background: Fundamental Tax Concepts

The handout is designed to get you up and running with tax planning in short order. It is an

ultra-condensed, hit-the-big-points summary of some fundamental aspects of taxation and tax

planning. Beware of two things. One, there are exceptions to many of these rules. You are best

off not worrying about the exceptions but just recognize that they exist. Two, even though these

are just the basic rules there is a lot of information in this handout. It will take you a while to

absorb.

Four questions:

1. What are the basic types of taxes and how are they levied?

2. How is taxable income determined?

3. How are different types of organizations taxed?

4. What are the fundamental principles of tax planning?

Prof. Maydew - Spring 2012 2

What are the basic types of taxes and how are they levied?

Income taxes - levied on taxable income at both individual and corporate level. Accounts for

large sums of tax revenue mostly from upper income individuals because of progressive tax rates

and credits. Economists tend to like the income tax because if crafted carefully it should distort

behavior less than some other taxes. However, income is a tricky concept (just think of your

financial accounting courses) so there is a lot of potential for creative tax planning with income

taxes.

Payroll taxes - levied on payroll. Rivals income tax in terms of tax revenue. Funds are

earmarked for government pension and medical programs (Social Security and Medicare in the

US). Not as much planning opportunity as with income tax.

Estate and gift taxes - levied on the transfer of assets at death (estate tax) or during life (gift

tax). Distinct from the income tax. Minor source of tax revenue. Widely despised by the US

public even though less than 2% of estates subject to the tax. Lots of planning opportunities.

Tax law changes reduce rates and increase exemption amounts through 2009, with temporary

one-year repeal in 2010. In late 2010 Congress extended reduced rates and exemptions through

2012.

Sales taxes and VAT taxes - Large source of revenue at the state and local levels. Usually

levied on sales of goods and sometimes on services. Often items like medical care and groceries

are exempt. No national sales tax in US though its close cousin, the VAT tax, is common in

other countries.

Excise taxes - Gas taxes, telephone taxes, cigarette and alcohol taxes. Account for modest

amounts of revenue and often designed to discourage certain behavior.

Property taxes - Large source of revenue at the state and local level. Usually only levied on

real estate.

Prof. Maydew - Spring 2012 3

How is taxable income determined?

Taxable income vs. GAAP income

Firms pay taxes based on their taxable income. Think of taxable income as being similar to

GAAP income in that it represents some measure of revenues less some measure of expenses.

There are differences between GAAP and tax rules for measuring income, of course, but there

are also similarities.

Similarities include the fact that like GAAP income, taxable income for most corporations must

be computed on an accrual basis. That is, income is recognized as it is earned rather than when

the cash is collected, and expenses are recognized as they are incurred rather than when they are

paid.

Differences include things like municipal bond interest, which is tax-exempt at the federal level

but counts as income for GAAP purposes. There are different methods of computing

depreciation expense for GAAP and tax purposes. Purchase accounting goodwill amortization is

generally not tax-deductible (more on this later in the course). These book-tax differences are

reflected in financial statements in two places - temporary differences like depreciation are

reflected in the deferred tax liability or asset, while permanent differences like tax-exempt

interested are reflected in the effective tax rate reconciliation, which is part of the tax footnote to

the financial statements.

As stated, most corporations must use the accrual basis. There are some corporations that are

allowed to use the cash method to compute their non-inventory related taxable income, but this is

limited to corporations that have less than $5 million in revenue per year. Individuals can use the

cash method (and usually do), except to the extent they have inventory.

Gains and losses and tax basis

Tax gains and losses are computed in the same manner as in financial accounting. For example,

if a firm purchased a building for $100,000, then depreciated it by $40,000 over some period and

later sold it for $70,000, then the firm would report a $10,000 gain on the sale. The