Below you’ll find a rather detailed crash course on U.S. Federal Income Taxation and it’s written from the perspective of typical small business owners.
This paper was reviewed by a U.S. lawyer; however, it surely doesn’t replace a good accountant and his/her advice tailored to your situation. It should help, if you are new to tax law, to read it first before you approach your accountant as it will introduce you to a couple of important concepts and help you understand “accountant’s lingo”.
Individuals or partners who wish to set up their own business and undertake their own venture will sooner or later nee to acquaint themselves with the country’s tax system. Given the enormous complexity of tax systems today, this paper is limited to the U.S. federal income taxation principles and focuses exclusively on the needs of small business owners.
When setting up a business, tax matters are usually not the main focus of the proprietors, and as time passes, the focus remains on daily business matters. Due to its complexity and ever-changing nature, many managers overwhelmed with their daily business duties consider taxation a dreadful task and try to avoid and delegate it as much and as early as possible. Unfortunately, by doing so, managers fail to take advantage of many opportunities which can result from optimizing the company’s tax status. For example, managers might incorrectly assume that certain expenses are deductable, only to find out later that they were not. Conversely, for certain assets the tax system provides accelerated depreciation which can help the company write off the investment quickly. Managers unfamiliar with such basic tax regulations may not always be able to make the right decision for their organization; hence, a certain minimum of tax proficiency is necessary to avoid most common pitfalls.
Apart from federal tax, the U.S. states and local communities are free to impose their own tax. While the federal tax due each year is usually greater than the state and local taxes, business owners need to understand the local and state regulations because they require separate treatment from federal tax and might impose limitations to the business in question.
This research paper focuses primarily on the interests of business owners and excludes the intricacies of state and local taxation. Because business owners are in possession of the enterprise, they usually strive to maximize deductions and the business’ profits. Long lasting investments in machinery and other assets can not be written off within the same year but can generally be written off over a period of time. Knowing the nature of depreciation methods helps the business owner to decide which asset to buy and when to lease. Furthermore, there are many tax incentives directly relevant to the independent life style of self-employed people. Since self-employed people need to take care of their own insurances and career options, there are several tax incentives for health insurance, educational costs, and retirement plans available.
A certain level of tax proficiency can in addition help save a lot of tax money spent unnecessary. A tax proficient manager will generally benefit from a more rewarding communication experience when talking to tax experts and advisors. Managers will also benefit from having a deeper insight in the tax system because they are able to present their investment scenarios more clearly to accountants and tax advisors, who can then give better advice in return. As the income levels of business owners can fluctuate greatly and may exceed the year’s expectations, the help of tax experts can help minimize the overall tax burden greatly.
While all the details about federal income taxation are stipulated in the Internal Revenue Code (IRC), it can be a daunting task to look for quick answers; however, the basic concepts of tax rates, credits, deductions, and exclusions are relatively simple.
§1 in the IRC defines the progressive tax rates for several scenarios. For the year 2007, the tax imposed on married individuals filing jointly, for example, is 15% when at or below $36,900. If the couple earns more than that but less than $89,150, the tax due is $5,535 plus 28% of the excess over $36,900 (Dickinson, 2007). While some countries increase the rate as the total income increases, the federal income tax in the U.S. is split into income brackets. In the above example, the first $36,900 of income constitutes the first bracket at 15%. Then, another bracket applies at 28% for the amount earned above $36,900. Hence, for a couple who earned less than $89,150 but more than $36,900 the average tax rate will be lower than 28% because the first $36,900 where taxed at only 15% ($5,535). The marginal rate, however, is 28% because the couple is said to be in the 28% income bracket; therefore, the meaning of marginal rate only applies to each additional dollar earned above $36,900 (Schmalbeck & Zelenak, pp. 36-38, 2007). Overall, this progression of the tax brackets ensures low-income individuals pay less tax, while most of the tax burden is placed on wealthy people with higher income levels. While the bottom 50% of all U.S. taxpayers pays only 3.3% of total income taxes, the top 5% pay a whopping 57.1% (“Progressive Tax”, 2008).
Many rates, deductions, allowances, and other threshold values in the IRC are indexed for inflation. In other words, readers of the IRC need to pay attention to changing rates, tables, and numbers depending on the year of their return. Some regulations may be phased in while other regulations are gradually being phased out, which may reduce the benefits and tax relief under certain circumstances (Dickinson, 2007).
Credits, Exclusions, and Deductions
Credits, exclusions, and deductions are the basic building blocks of the individual income tax return, which is distributed as IRS Form 1040. Exclusions are subtracted from income before the income is stated on the tax return; therefore, they have low visibility and are preferred by taxpayers (Schmalbeck & Zelenak, pp. 16-18, 2007). Deductions reduce the income as well but are stated on the return; hence, exclusions and deductions have the same result but the tax savings are the results of a deduction that is dependent on the taxpayer’s marginal rate. For example, if a couple earned $40,000, its marginal tax rate in 2007 according to IRC §1 is 28%; hence, a $1,000 deduction will reduce the tax due by $280. For high income earners with a marginal tax rate of 35%, the same deduction would result in $350 savings; hence, the deductions work with the opposite strategy than the progressive tax model—deductions give more tax relief as income increases. In other words, a deduction is worth much more to higher income earners than to low-income workers.
Tax credits, such as the Child Tax Credit §24, are fundamentally different in that they reduce tax liability directly (Schmalbeck & Zelenak, p. 19, 2007). Therefore, a $1,000 tax credit reduces the income tax by $1,000, regardless of the taxpayer’s income level. Business owners should hence find out about all different tax credits, deductions, and exclusions that apply to their situation and maximize the gains from each of them by offsetting their income and tax burden. But what exactly constitutes income?
Gross income is defined in §61 as “income derived from any source whatever”, for example from compensation for services, fees, fringe benefits, business, gains derived from dealings in property, interest, rents, royalties, dividends, alimony, pensions, income from life insurance contracts, and discharge from indebtedness (Dickinson, p. 50, 2007).
Is gross income limited to cash transactions? Certainly not! In the case Rooney v. Commissioner, the clients of a business had difficulty paying off their debt so they repaid in services, such as plumbing work and cooking meals (Schmalbeck & Zelenak, pp. 116-118, 2007). The court found, however, that these benefits received were nevertheless income. These so-called in-kind receipts would otherwise result in a flight from cash, if §61 was limited to cash only.
Section 101(a) states that “amounts received…under a life insurance contract, if such amounts are paid by reason of the death of the insured” are not included in gross income (Schmalbeck & Zelenak, pp. 109, 2007). This form of preferred treatment by the tax is to encourage taxpayers to close life insurance contracts based on public policy. The employer’s payments of life insurance premiums will generally be treated as income to the employee; however, for policies up to $50,000 the payments will not be considered income (Posin & Tobin, p. 65, 2005). Independent of that, proceeds from life insurance in the form of annuities is income and taxable (p.96).
Fringe benefits are benefits provided by employers as compensation for services. Under §61, fringe benefits are assumed to be income unless excludible. According to §132(b), if a service is offered ordinarily by the employer to customers and the employer does not incur additional costs by offering it, then that so-called no-additional-cost service is excludible (Posin & Tobin, pp. 59-60, 2005). A qualified employee discount can also be excluded from the employee’s income if it’s not over 20% and the employee still pays the cost of the item (p 60). Qualified transportation fringes are allowed up to $105 per month and qualified parking fringes may cover expenses of up to $200 in 2005.
Damages from Injuries
According to §104(a)(2), when money is received as compensation for personal injuries or physical sickness then that amount is excluded from income (Posin & Tobin, p. 136, 2005). However, the recovery of these amounts is only tax free if based on a tort or a tort-type right and the injuries or sickness suffered must be physical and not mental of nature (p. 137).
Compensation for damages paid to a business, on the other hand, constitute income if the taxpayer is not able to prove the tax basis in case the payments are for the recovery of capital (Posin & Tobin, p. 141, 2005). This was decided in the case Raytheon Production Corp. v. Commissioner, where a taxpayer sued the company for antitrust violations. In absence of tax basis proof, the basis is assumed to be zero and the whole amount received represents income (pp. 140-141).
Imputed income is income derived from one’s own services or property and is exempt from taxation. For example, owning and residing in one’s own home provides economic value which is not taxed and preparing one’s own tax return similarly does not constitute income (Schmalbeck & Zelenak, pp. 121-125, 2007). However, a swapped service is taxable and occurs, for instance, when two neighbors agree to paint each other’s house.
Appreciation is an increase in value of an asset or property. For example, shares may grow in value from $1 to $10. As long as the shares are not sold back into the market, the increase in value has not been realized and is therefore not taxable (Schmalbeck & Zelenak, pp. 127-129, 2007). This so-called unrealized appreciation is a tool used to defer tax. For instance, an investor may defer from selling her stock in December because her marginal rate is relatively high. She assumes that her stocks will not change much in value until January 1st, so she defers selling her stocks until the following year. By doing so, the financial gain she derived (the stock price minus the tax base, which was the stock price when she bought the shares) will be included in the following year’s income instead. This deferral method is especially useful to even out irregular levels of income, or when tax rates are about to change in the near future.
Gift, Bequest, Devise, and Inheritance
According to §102(a), property obtained as gift, bequest, devise, or inheritance is not included in gross income, the rationale being that income tax has been already paid by the donor. However, §102(c)(1) considers employee gifts as income and is based on the case Commissioner v. Duberstein (Posin & Tobin, pp. 102-104, 2005). Similarly, tips are included in income (see §61(a)(1)) because of the expectation of in-kind service returned.
Health and Accident Benefits Paid by Employer
Section 104 provides that employers can deduct health and accident coverage for their employees (Posin & Tobin, p. 65, 2005). When certain conditions are met, these employer contributions may also be excluded from the employee’s income.
Scholarships and Fellowships
Scholarships are not included in gross income according to section 117(a). Certain limitations apply, such as that room and board are not excludable unless §119 or §132 apply. In addition, if the amount is received for teaching or research, then it is considered income, see §117(c)(1) (Dickinson, p. 96, 2007).
Illegal gains were found to be income in the case James v. United States and this came in congruence with §61 which requires all income to be taxed, regardless of origin (Posin & Tobin, pp. 144-145, 2005).
The Realization Doctrine
As mentioned in the previous section, realization is gain or loss derived by the “sale or other disposition of property” and this so-called fundamental realization provision is given in §1001(a) (Schmalbeck & Zelenak, pp. 251-276, 2007). Apart from the obvious realization event of a sale, the “other disposition of property” is termed “non-recognition”. Frequently non-recognition can result from a “like kind” exchange of properties (§ 1031) or an “involuntary conversion” (§ 1033) of the property, such as by physical destruction or condemnation (p.277). A “like kind” exchange of properties is deployed to essentially swap properties of equal value and bypass the realization event which would trigger the imposition of income tax on the gains realized. Section 1033 provides a refuge for taxpayers who have been the victim of a disaster and received reimbursement for their property. If the taxpayer decides to purchase replacement property (of equivalent value) within a statutory period, then no gains would result from the transaction (p.285).
Gain on the Sale of Principal Residence
Generally and within limits, §1034 provides that no gain is recognized when the primary residence is sold and a new one is bought and inhabited by the taxpayer within a certain period of time (Schmalbeck & Zelenak, p. 287, 2007). Limitations include the taxpayer’s income levels, the gain level realized, and the period of time of residence and the period between sale and purchase.
Gift Transactions Inter Vivo and at Death
If a donor makes a gift during her lifetime to another person, the tax basis is transferred to the donee; hence, the donor will not realize a gain at all but the donee will carry over the basis and upon realization, will need to income tax the whole gain (Schmalbeck & Zelenak, p. 298-300, 2007). For example, if shares were purchased for $10, appreciated in value to $50 and then donated to another person, then the property has been transferred tax free; however, as soon as the donee sells the shares, the realized gain will be based upon the difference to $10. Unfortunately §1015 forbids losses to be “donated” in this fashion, which would occur if a share below its original purchase price is “donated” to another taxpayer. Neither the donee nor the donor in that case would be able to claim a loss after donation took place (p. 299).
In case of inherited property, the basis is updated at the time of death. The basis is moved either up or down to reflect market value but according to §1014, the transaction is completely tax free with limitations applying.
In the year 2005, most itemized deductions were in the following categories: interest paid (82%), taxes paid (98%), charitable gifts (87%), and medical expenses (19%) (Schmalbeck & Zelenak, p. 368, 2007). In 2003, only 33.7% of all taxpayers chose to itemize their deductions, instead of opting for standard deduction and people with higher incomes tend towards itemizing their deductions (p. 369).
Under §170, taxpayers can support charitable organizations by donating money and deduct that amount. The contribution of services, however, is not allowed under section §170, as stated by Treas. Reg. §1.170A-1(g). The organizations to receive charitable contributions are subject to specific requirements under §170(c) and can be a government unit, corporation or other religious or education entity. Corporations may make such contributions as well but their contributions may not exceed 10% of their taxable income.
Interest expenses are generally not deductable (Schmalbeck & Zelenak, p. 378, 2007). There is range of interest payments, however, that is deductable, including home mortgage interest, educational loan interest, business interest, and investment interest.
The qualified residence interest applies to taxpayers who have a mortgage with their personal residence serving as collateral (Schmalbeck & Zelenak, p. 379, 2007). This deduction was primarily put in place to give new home owners relief on their interest payments. In spite of this, it is still possible to finance the purchase of another asset, such as a car, using a mortgage in the form of home equity indebtedness and have the right to deduct interest payments (p. 380).
According to §163, business debt may be deducted even if results in a loss from the activity (Schmalbeck & Zelenak, p. 383, 2007). As with all business expenses, the “trade or business” rules must apply for the debt to qualify as a business debt.
Educational Loan Interest
In 1997, Congress enacted §221 to permit a deduction of up to $2,500 of educational loan interests. Unfortunately, deductibility is phased out for higher income levels, beginning with $50,000 for single taxpayers and $105,000 for married taxpayers and completely denied above $65,000 and $135,000, respectively (Schmalbeck & Zelenak, p. 388, 2007).
State and Local Taxes
Deductions for state and local taxes are defined in §164 and were available since the Revenue Act of 1913 (Schmalbeck & Zelenak, pp. 388-395, 2007). These deductions include state and local income taxes, real property taxes, foreign income taxes, and personal property taxes. The deductibility of these taxes mostly serves to avoid a form of double taxation.
If a taxpayer experiences severe losses, for example due to theft and storms, which were not covered and reimbursed by her insurance, then she may be able to deduct portions of the total casualty loss (Posin & Tobin, pp. 500-501, 2005). First, there is a $100 floor limit on each loss, which needs to be subtracted. Then, the deductible may only be used to the extent it exceeds 10% of the taxpayer’s adjusted gross income (AGI) (p. 500). A taxpayer with an AGI of $50,000 and three casualty losses totaling $7,500 will thus only be able to deduct $2,200.
Medical expenses are deductible when they exceed a floor of 7.5% of the taxpayer’s adjusted gross income. People who are severely ill and have considerable medical expenses are advised to delay payment of medical bills to the following year if possible to maximize the amount deductible (Posin & Tobin, pp. 514-519, 2005). Unfortunately, costs incurred as a result of the illness are not always deductible. In the case Ochs v. Commisioner, a woman was ill with cancer and her doctor suggested sending her children to boarding school to prevent her cancer from remitting. The court found, however, that these costs were not deductible even though if [she] were sent away to a sanitarium, the expensive would be deductible” (p. 516).
Medical expenses need to exceed 7.5% of the taxpayer’s adjusted gross income and only the portion exceeding that amount is actually deductible (Schmalbeck & Zelenak, pp. 406-407, 2007). In addition, the medical expense needs to actually have been paid within the year in question. For married couples, it can be advantageous to file separately because of this rule if one spouse if seriously ill and incurs significant medical spending.
Reduction of Itemized Deduction for High Income Earners
As of 2006, married taxpayers earning more than $150,500 (or $75,250 if filing separately) are limited in their deduction allowance for itemized deductions. The maximum allowed must be reduced to the lesser of two amounts: either 3% of the excess of adjusted gross income over the ceiling amount, or 80% of itemized deductions otherwise allowable for the tax year. Given the mathematical relationship of correlation between higher income and greater itemized deductions, usually the first provision presents the limit that applies in most cases (Schmalbeck & Zelenak, p. 409, 2007). According to §68, this provision is being phased out, however, but may return in 2010 if Congress does not intervene in the meantime (p.410).
Business Expense Deductions
Understanding business expenses and their deductibility is by far one the essential information required to successfully run a business without overpaying tax. In fact, only 8% of business receipts are left on average and constitute income for the average business (Schmalbeck & Zelenak, p. 495, 2007).
Ordinary and Necessary Expenses
Section 162 allows the deduction of business expenses if they are “ordinary and necessary…in carrying on any trade or business”. The Code mentions salaries, compensation for services, traveling expenses, rentals, maintenance costs, and other costs as typical examples of business deductions. The Supreme Court decided in the case Welch v. Helvering that the word “necessary” does not necessarily carry such strong notion; rather, §162 usage of “necessary” is best substituted by “appropriate and helpful” (Schmalbeck & Zelenak, p. 497, 2007). It would have been impractical and too intrusive to have the Commissioner decide which business expense is absolutely necessary and which can be avoided.
The word “ordinary” has a more confusing meaning in that some court opinions use it interchangeably with “necessary” (p. 498). It is generally agreed upon, however, that the IRS will consider ordinary expenses as being a current expense rather than a investment; hence, the distinction is sought between currently deductible expenses and capital expenditures, which must be amortized over the life of the asset.
The meaning of ordinary and necessary business expenses is also well illustrated by the following cases. In Goedel v. Commissioner, the court denied the manager of an entertainer to deduct life insurance premiums on a policy on the entertainer’s life. Similarly, in Booney v. Commissioner, paying hush money to an accuser to protect one’s professional reputation was not held deductable either (Posin & Tobin, p. 364, 2005).
Definition: Trade or Business
Under §212, the deduction of business expenses is allowed “for the production or collection of income” and “for the management or maintenance of property held for the production of income”. By running a business, a taxpayer qualifies as trade or business and can deduct ordinary and necessary business expenses under §162(a). By engaging in “profit-seeking” and “investment” activities, a taxpayer investing in stocks and real estate, whose activities do not constitute trade or business, can deduct under §212 (Posin & Tobin, pp. 362-365, 2005).
Section 162 allows for the deduction of “reasonable compensation for salaries or other compensation for personal services actually rendered”. This provision is particularly burdensome for small subchapter C corporations, who, unlike subchapter S corporation that act as pass-through entities, are subject to corporation tax on the corporation’s income (Schmalbeck & Zelenak, p. 521, 2007). As §11 requires corporations to pay tax on their income, owner-managers of small C corporations try to minimize their corporation’s tax liability by paying out exorbitant salaries. Such high salaries can cause trouble, if it is found that they are unreasonably high. If a C corporation incurs a higher income than expected for a year, it needs to pay corporate tax on its income and owners may elect to pay out the proceeds to the shareholders. Shareholders need then to pay tax on their dividends received. Obviously for small C corporations where the owners are also managers, there will be a conflict of interest in that the owners will try to charge very high salaries to their corporation in order to avoid the double taxation of corporate dividends.
Section 162(a)(2) provides that traveling expenses are deductible including meals and lodging; however, many limitations and restrictions apply. First, the taxpayer needs to be away from his “tax home”, meaning the trip needs to extend beyond the vicinity of the taxpayer’s work place. In addition, the “overnight rule” needs to apply, requiring an overnight stay for the travel expenses to be deductible. Commuting and meal costs, on the other hand, are considered personal consumption costs and are thus exempt from travel expense deduction (Schmalbeck & Zelenak, p. 529, 2007).
Section 274 IRC generally rejects deductions for entertainment, amusement, or recreation costs, unless the taxpayer proves that the expense was directly related to the taxpayer’s trade or business (Posin & Tobin, p. 402, 2005). For example, entertainment immediately before or after a bona fide business discussion would be therefore deductible but is nevertheless severely limited. In many cases, such as business dinners, even if all tests for deductibility apply, only 50% of the expenses can be deducted.
Expenses incurred for activities not engaged in for profit are not deductible and the IRS is particularly sensitive about deductions made that appear to be made for personal gain (Posin & Tobin, p. 407, 2005). Section 183 defines such situations where taxpayers seek to deduct personally incurred costs and the courts generally will strike against the taxpayer unless some profits can be shown originating from the activity in question (Schmalbeck & Zelenak, p. 551, 2007). In the case Keanini v. Commissioner, for instance, the court allowed a couple to deduct costs for dog breeding because the couple eventually managed to produce a profit from its dog operations (Schmalbeck & Zelenak, p. 547-551, 2007).
For educational expenses to be deductible as business expenses they must satisfy several conditions. First, the educational program must improve the skills of the taxpayer or employees as required by the employer’s trade or business or the program must meet the express requirements of the employer or licensing regulations imposed by the government. Nevertheless, the taxpayer will not be able to deduct the expenses if the education meets the entry-level requirements of a new or unrelated trade or it is the entry-level degree for a particular profession (Schmalbeck & Zelenak, p. 559, 2007). Reg. §1.162-5 sets forth in detail with examples describing which educational programs would be deductible. An engineer would not be able to deduct the tuition for a law degree, even if his business required him to acquire these particular skills because a law degree would essentially allow the engineer to enter a new profession, trade, or business (Dickinson, p. 1110, 2007). On the other hand, a general practitioner of medicine can deduct a two-week course “reviewing new developments in several specialized fields of medicine”. The tax policy seems to create a dividing line between education used for further specialization and the general deduction of all educational programs. While engineers can always deduct their furthering engineering courses as business expenses, an attempt to deduct tuition for a university law program leading to a Juris Doctor degree is barred. If such deductions were allowed, taxpayers could set up a minimal quasi business based on a professional that is relatively easy to learn and then be able to write off huge losses originating from relatively high tuition costs, for example to pay medical or law school. On the other hand, many legitimate business reasons exist to horizontally diversify one’s own skill-set and thereby that of the company. For example a small business owner may want to acquire legal skills including the authorization to legally represent her own business as a J.D. Such investment is considered personal, unfortunately, because it entitles the small business owner to enter an entirely new profession even if the business owner does not actually take advantage of this option.
Section 280A regulates with stringent rules the situation where employees and self-employed people wish to deduct expenses for their home office as business expense. That part of the taxpayer’s residence needs to be used regularly and exclusively for business and one of three rules need to apply. First, it needs to be either the principal place of business for any trade or business. Second, it needs to be place of business to meet clients, patients, or customers. Third, it is used for trade or business but needs to be a separate structure, not physically connected to the taxpayer’s residence (Posin & Tobin, p. 412, 2005). If the home office is used by an employee, it must serve for the convenience of the employer. For taxpayers engaging only in profit-seeking activities but not owning a business, deductions are not possible under §280A.
For many small business owners §280A is good news because many small businesses operate from a home office and it would be unfair not be able to deduct costs, solely on the grounds that the taxpayer’s home office is located within the taxpayer’s residence. Curiously operating out of the home office not only saves gas and car maintenance costs, but it also allows the self-employed to deduct mileage when visiting clients. Transportation to a rented office outside the taxpayer’s residence would not qualify for deductions because it is considered personal commuting.
Capitalization and Cost Recovery
When businesses invest in machinery or other assets that help produce income, such as a company car, computers, tools, and other equipment, businesses want to “write off” the asset as quickly as possible. That is, businesses want to deduct from their income the money spent for obtaining the asset over the useful life of the asset. For example, if a car is bought for $10,000 it can be depreciated over five years according to §168(g)(2)(D).
Apart from a linear (straight line) depreciation where each year the same fraction of the asset’s value is deducted from the business income, §168 also provides the so-called accelerated cost recovery system, which helps businesses recover costs quicker than the real average expected lifetime of an asset. The recovery periods depend on the type of asset and accelerated schedules exist for certain assets that allow larger shares of the asset value to be deducted in earlier years (Schmalbeck & Zelenak, pp. 583-589, 2007). Instead of requiring exact purchase dates to be recorded, the tax office assumes for most assets that it was bought in mid-year, which allows only half the deductions in the first year and shifts the depreciation schedule by half a year. To speed up the calculations and to limit confusion, Rev. Proc. 87-57, 1987-2 C.B. 687 provides a range of depreciation tables where the values are stated as unadjusted basis percentages. By using these tables taxpayers can easily figure out the amount deductable per year because it only requires multiplication by the original purchase cost; hence, the overhead for computing depreciation is limited (p. 585).
Sections 167 and 168 provide the details for the types of depreciation and the asset lifetime to be assumed per asset. Those sections also define the accelerated cost recovery system per asset (Dickinson, 2007).
Not every asset is depreciable because not every asset is subject to loss of value or wear and tear. Land, for example, is a non-depreciable tangible property (Schmalbeck & Zelenak, p. 590, 2007). Antiquities and expensive paintings are also not depreciable because they are also not subject to wear and tear.
Some intangible assets can be deducted, such as purchased mailing lists and costs for goodwill when a business is purchased. Section 197 was enacted by the Congress to allow taxpayers to amortize intangibles using straight-line depreciation over 15 years (Schmalbeck & Zelenak, p. 591, 2007). With intangibles, cost recovery is referred to as amortization, whereas with tangible property the cost recovery method is termed depreciation.
Cost to be Capitalized
The tax system imposes a capitalization requirement, which determines how assets can be distinguished in their deductibility as business expense, investment expense, or as capital expenditure. While expenses are deductible in the tax year they occurred, capital items are deducted over several years via depreciation or amortization. Capital expenditures are subject to §263A Uniform Capitalization Rules and a series of expenses has to be capitalized (Schmalbeck & Zelenak, pp. 583-622, 2007). Among the costs that need to be capitalized are repairs and maintenance expenses, acquisition expenses (§263), and goodwill costs (§197) which need to be capitalized over several years.
Cash accounting is used when a business wants to deduct expenditures when they were actually paid. Similarly, gross income from property, cash, or services will be added to the tax year in which it was actually received.
In accrual accounting, as stated in Reg. §1.446-1(c)(1)(i), the difference is that gross income will be added to the year in which the event took place that “fix the right to receive the income”. Expenses are likewise to be included in the year in which they physically occurred.
While the accrual method is more accurate, most taxpayers prefer the cash method because it gives taxpayers a deferral advantage (Schmalbeck & Zelenak, p. 632, 2007). The accounting method can generally be freely chosen; however, if “the production, purchase, or sale of merchandise is an income-producing factor” in the business of the taxpayer, then the only accrual method can be applied. Taxpayers with less than $1 million gross receipts may elect to use either the cash method or to not account for inventories (p. 632). For a limited set of industries that limit has been elevated to $10 million.
For businesses that merchandise or manufacture goods, gross income equals the difference between total sales and the cost of goods sold. In case the business manufactures its own products, it must include the manufacturing costs including labor in the calculation of costs of goods. Businesses can further choose whether to use first-in-first-out (FIFO) and last-in-first-out flow rules (LIFO). In FIFO, the items acquired first are the ones that deducted first. LIFO allows for the deduction of the newly acquired items first. The rules can be used to defer tax liability and to give more relief in situations where the price of the inventory has changed substantially between the purchases of several product batches.
The Alternative Minimum Tax
The IRC spans over thousands of pages with hundreds of regulations. As many sections overlap, augment, and sometimes even cancel out each other, they seem impossible to keep track of. As regulations and threshold values change over time as some sections are phased in, others are phased out, and certain values are adjusted for inflation, it seems possible that certain taxpayer constellations can result in very low tax liabilities. Whether legitimate or not, Congress, too, is not able to predict all possible scenarios either and therefore enacted the Alternative Minimum Tax in §§55-59.
The Alternative Minimum Tax is a “catch-all” mechanism to provide a global floor limit, such that if foxy taxpayers find a way to massively deduct expenses, for example by using tax shelters, they will be still faced with a minimum tax burden. For 2006 joint returns the alternative minimum taxable income was $62,500 and $42,500 for singles (Schmalbeck & Zelenak, p. 700, 2007). After that amount, a fixed 26% tax rate applies for the first $175,000; thereafter, a 28% rate applies (2007).
While the Alternative Minimum Tax is primarily useful to catch unjust attempts to cut tax liability to minimum, it can also hit innocent taxpayers who legally and justifiably claim their deductions. In Klaassen v. Commissioner, the court demanded additional tax payments from the Klaassen family because they failed to provide Alternative Minimum Tax calculations on their tax return. The Klaassens had ten children and claimed 12 personal deductions totaling $29,400 with an adjusted gross income of $83,056. The Klaassens were taken by surprise that an additional $1,300 in income tax was eventually charged, given their situation (Schmalbeck & Zelenak, pp. 702-704, 2007).
Taxation of Families
Several sections in the tax system help relieve the tax burden on families by allowing deductions, giving credits, and allowing the distribution of income to both spouses to avoid unjust taxation with high marginal rates.
Child Care Credit
To help parents recover part of their child care expenses which were “incurred to enable the taxpayer to be gainfully employed”, §21 offers relieve of up to either $3,000 for one child or $6,000 for two or more children. Taxpayers earning an AGI of less than $15,000 may claim a credit of 35%. For higher income earners, the credit is capped at 20%. By enacting §21 and allowing working adults to get tax relief for raising children, Congress has effectively allowed child care as a business expense (Schmalbeck & Zelenak, p. 727, 2007). The child care credit of section 21 is, however, not the only child-related tax benefit available.
Dependent Care Assistance Exclusion
If the taxpayer’s employer participates in a dependent care assistance program (DCAP) of section 129, the employees can elect to be paid up to $5,000 less salary and submit invoices to their employer for up to that amount, which are then reimbursed by the employer. Unfortunately, §21 and §129 are mutually exclusive but taxpayers are free to choose which tax benefit is more beneficial to them (Schmalbeck & Zelenak, p. 728, 2007).
Exemptions for Dependents
Section 151 allows for the exemption of $3,300 per dependent as of the year 2006. This number is indexed for inflation and the amount stated can be deducted for each person in the household (Schmalbeck & Zelenak, p. 729, 2007). A dependent can be a “qualified child” or “qualified relative” and needs to be related to the taxpayer, such as a son, daughter, grandchild, brother, sister, nephew, stepbrother, etc. or a descendant of one of the above. According to §152, the age limits for qualified dependents are 19 or 24 in case the child is a student; however, the age limit is lifted for permanently or totally disabled dependants. Separated parents may decide to allocate the dependency exemption to the supporting parent, even if that parent earns a higher income (Posin & Tobin, pp. 530-532, 2005).
In addition to §151 and its dependency exemption, Congress allowed in 1997 the so-called Child Credit in section 24 which reduces taxpayers’ liability by $1,000 per child and is scheduled to remain at that level through the year 2010 (Posin & Tobin, p. 640, 2005). Unfortunately, higher income earners are disadvantaged again from a phase out beginning at $110,000 AGI for 2006 (Schmalbeck & Zelenak, p. 732, 2007).
Retirement Savings Accounts
Since small business owners are usually not part of an employer-based group plan, they generally need to take care themselves of their retirement. Apart from undertaking various investment activities for retirement, these individuals can open Individual Retirement Accounts (IRA) to ensure an additional source of income upon retirement. Section 219 permits a deduction of $5,000 per individual and year, subject to total AGI limitations on deductibility. Money paid into this account and interest earned is not considered income and therefore no income tax applies; however, upon retirement, the money withdrawn is subject to income tax (Schmalbeck & Zelenak, p. 833, 2007). For this reason, the IRAs are also called tax deferral devices.
Withdrawals before the age of 59.5 are subject to a penalty of 10%, unless the early withdrawal is carried out to finance education or to purchase a house for the first time (Posin & Tobin, p. 586, 2005). In the latter case, a withdrawal limit of $10,000 applies.
Another retirement option is the Roth IRA, which permits tax free interest on the retirement account as well; however, the money contributed to a Roth IRA is income taxed first. In that case, individuals pay no taxes for withdrawing money including the interest earned on the account if the account is at least five years old and the account holder is older than 59.5 years. The contribution limits are the same as for a standard IRA; hence, the strategic question for deciding on whether to opt for a standard or Roth IRA is whether one anticipates relatively lower or higher tax rates upon retirement compared to the taxpayer’s current situation (Schmalbeck & Zelenak, p. 836, 2007). The AGI limits for standard IRAs and unmarried taxpayers are $60,000, and for Roth IRAs $75,000. There is also an option for a nondeductible IRA for taxpayers with much higher income levels. The nondeductible IRA allows interest to grow tax-free as well, but earnings withdrawals need to be taxed. Withdrawing contributions, however, is tax free because no deductions were allowed on the contributions (Posin & Tobin, p. 586, 2005).
Health Savings Accounts
As it is essential for self-employed to prepare for the retirement in the future, it is also very important to ensure health care for the family. The government has enacted §223 to allow deductions for Health Savings Accounts (HSA) which function similar to IRAs. Instead of a deferred taxation, HSAs give immediate benefit for holders of a high-deductible health plan. There are no income limits; however, several numeric limitations apply. For the year 2007, the coverage, or minimum deductible, needs to exceed $1,100 for individuals or $2,200 for family coverage but out-of-pocket expenses may not exceed $5,500 for individuals or $11,000 for families (U.S. Treasury Department, 2007).
These accounts cannot be used to pay the monthly health insurance premium but are supposed to act as a cushion to protect the individual or family from sudden financial difficulties in meeting out-of-pocket expenses in case of a serious injury or illness. A family with a health plan out-of-pocket limit of $11,000 can therefore save within two years the money required to cover its total out-of-pocket risk for one year. Nevertheless, a family may currently contribute $5,800 for 2008 and continue to contribute to the account every year. Interest earned as well as the contributions are deductible and therefore tax free. As with IRAs, the famous 10% penalty tax will apply on top of income tax for distributions which were not used for qualified medical expenses (U.S. Treasury Department, 2007).
Capital Gains and Losses
Section 1221 defines capital assets by exclusion as property that is not stock or inventory of the business or trade; property that is otherwise depreciable or consumed by the business; copyrights or other intellectual property of the business; or, ordinary accounts receivable. Gains derived from “dealings in property” are gross income, according to §61(a)(3), and therefore gains derived from capital assets is to be considered income. Section 1223 describes the rules for determining the holding period of the properties dealt with which is needed to assign the capital gains and losses to one of four groups. Long-term gains (property held for more than a year) are netted against long-term losses and short-term gains are netted against short-term losses. If the netted results have the same sign they, too, can be netted; otherwise, more complicated treatment follows (Schmalbeck & Zelenak, p. 857, 2007).
Capital gains are taxed at different rates depending on property type and holding period. Collectibles gains are taxed at 28% and include rugs, works of art, alcoholic beverages, etc. Section 1202 gains are also taxed at 28% and include small-business corporate stock and the residual capital gains are taxed at 15% (Schmalbeck & Zelenak, p. 859, 2007).
Deductibility of Losses
Capital losses can deducted up to the amount of capital gains plus $3,000 for non-corporate taxpayers. Corporations do not receive the additional $3,000 allowance but §1212 entitles them to carry back losses and offset any prior gains experienced for up to three years in the past (Schmalbeck & Zelenak, p. 861, 2007). If that fails to absorb the losses, the loss can be carried up to five years into the future. Individuals, on the other hand, are able to carry losses forward indefinitely.
Taxation is an important field for a business owner or self-employed person in that there are many incentives hidden in the tax system from which the taxpayer can benefit. Conversely, not being adequately informed about tax issues constitutes an opportunity cost to all citizens and especially to business owners who engage in many more transactions than the regular taxpayer. Apart from overpaying tax unknowingly, taxpayers run also risk of not taking full advantage of tax incentives such as health savings and retirement accounts.
At the basic level, income tax is charged according to the total taxable income brackets defined in section 1 of the IRC. Several exclusions, deductions, and credits can be applied to either offset taxable income (exclusions and deductions), or to directly reduce tax liability (credits), depending on the taxpayer’s situation.
One of the central questions for taxpayers is what constitutes gross income or what does not. Interest received and compensation for services rendered are examples for taxable income, whereas unrealized appreciation and scholarships are examples for tax exempt cash receipts. The U.S. tax system uses the realization doctrine to determine the point in time when an individual is required to pay tax. Hence, when property gains market value that gain does not constitute taxable income until the property is sold and a gain has been realized. When gifts are transferred from taxpayer to taxpayer in vivo, the donor is not taxed but the donee becomes liable for the overall gains tax; however, inherited property tax basis is “stepped up” or “stepped down” to reflect market value, relieving the recipient’s tax burden.
A large field of interest to all taxpayers is the range of personal deductions available. Among those are deductions for charitable contributions, interest expenses, state and local taxes, casualty losses, and medical expenses. Deductions appear on the income tax return but are subtracted from income.
Business expenses form another group of tax regulations that small business owners need to focus on. The most important expenses for a business are wages and salaries, travel, office expenses, supplies, and educational expenses. Knowing the circumstances under which thee expenses are deductible is crucial to business owners and can affect the way business decisions are made.
When businesses invest in machinery it is essential to deduct the costs of maintenance and repairs as well as the asset’s funding as quickly as possible. The tax system provides several recovery options, including accelerated depreciation schedules, to give appropriate relief to businesses; however, there are rules regarding the standardized useful life of certain assets and limits regarding the deductibility of such expenses. For these reasons, business owners are urged to take all recovery options into account before investing in certain types of assets, and may want to consider leasing options instead if there are better alternatives available.
The taxation of families differs mainly in that spouses can file jointly, claim deductions for dependents, and receive child credits. High income earners, in particular, are not likely to gain as much from these provisions, however.
The alternative minimum tax is a form of catch-all minimum tax burden that applies to all taxpayers who manage to claim many deductions. It ensures a specific floor on individual tax burden.
Capital gains and losses receive special, yet complicated treatment by the tax law. Congress tried to find a fair way to tax these types of income given their unique nature, such as the taxpayer’s increased control over realization events.
While many taxpayers view taxation as a liability, it is an important form of social policy making. By imposing tax, the government can arrange subsidies for specific groups of taxpayers or geographic regions. Taxation can also be used an incentive for taxpayer’s to take specific action, whether positive or negative. Health savings accounts, for example, encourage taxpayers with deductible limits to create appropriate saving accounts and the Congress wants to reward this move by allowing certain deductions from income tax. Individual Retirement Accounts were also installed in order to achieve a similar goal.
Dickinson, M. B. (2007). Federal Income Tax Code and Regulations. Chicago, IL. CCH
Income Tax in the United States. (2008, June 17). In Wikipedia, the free encyclopedia. Retrieved June 17, 2008
Posin, D.Q., Tobin, D. T. (2005). Principles of Federal Income Taxation (7th ed.). New York, NY: Thomson West.
Progressive Tax. (2008, June 17). In Wikipedia, the free encyclopedia. Retrieved June 17, 2008
Schmalbeck, R., Zelenak, L. (2007). Federal Income Taxation. New York, NY: Aspen Publishers.
U.S. Treasury Department. (2007). All About HSAs. Retrieved June 21, 2008 from http://www.ustreas.gov/offices/public-affairs/hsa/pdf/all-about-HSAs_051807.pdf
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