Introduction to Taxation 1-5
CHAPTER 1
INTRODUCTION TO TAXATION
SOLUTIONS TO PROBLEM MATERIALS
Status: Q/P
Question/ Present in Prior
Problem Topic Edition Edition
1 Effect of state and local taxes on decision making Unchanged 1
2 History of Federal income tax Unchanged 2
3 Tax structure Unchanged 3
4 Use taxes Unchanged 4
5 Inheritance and estate taxes compared Unchanged 5
6 Cumulative nature of the Federal gift tax Unchanged 6
7 Federal gift tax and use of annual exclusions Unchanged 7
8 Advantage of Federal gift tax election for spouses to Unchanged 8
split gifts
9 Ethics problem Unchanged 9
10 Issue recognition Unchanged 10
11 Issue recognition Unchanged 11
12 Issue recognition New
13 Ad-valorem on realty: effect of tax holiday New
14 Proportional versus progressive tax Unchanged 14
15 FICA and FUTA compared Unchanged 15
16 Issue recognition Unchanged 16
17 Issue recognition Unchanged 17
18 General sales tax: excluded items Modified 18
19 Income tax computation Modified 19
20 Entity choice Unchanged 20
21 Entity choice Unchanged 21
22 Implicit tax Unchanged 22
23 Tax rate determination Unchanged 23
24 Tax rate determination Unchanged 24
25 Justification for annual exclusion New
26 Justification for several tax provisions Unchanged
27 Economic and social considerations: home ownership Unchanged 27
28 Wherewithal to pay Modified 28
29 Mitigating the effect of the annual accounting Unchanged 29
period concept
30 Coping with inflation: indexation procedure Unchanged 30
1-1
Status: Q/P
Question/ Present in Prior
Problem Topic Edition Edition
31 Internet activity New
32 VAT versus national sales tax: expected taxpayer Unchanged 32
compliance compared
Bridge Discipline
Problem
1 Bridge to Economics Unchanged 1
PROBLEM MATERIAL
1. Some tax considerations Aqua should investigate include the following:
· State and local income taxes.
· State and local sales taxes.
· State and local property taxes.
Many such taxes could affect any cost-of-living differential. pp. 1-5, 1-12, 1-13, and 1-18
2. This is not the case. During the Civil War, both the Federal Union and the Confederate States of America had an income tax. Furthermore, an income tax was reenacted in 1894. It was this tax that was held to be unconstitutional by the U. S. Supreme Court and ultimately led to the passage of the Sixteenth Amendment. pp. 1-15 to 1-18
3. Except for the Federal estate and gift taxes, all excise taxes are proportional. This is also the case with ad valorem property taxes. Besides the Federal estate and gift taxes, income taxes are progressive. pp. 1-4 and 1-17
4. Jim probably will be required to pay the Washington use tax if, and when, he applies for Washington license plates. In this case, the use tax probably is the same amount as the Washington sales tax. p. 1-5 and Example 5
5. An inheritance tax is a tax on the right to receive property due to the death of another. As such it is a tax on the heir. An estate tax is a tax on the right to pass property by death. As such, it is a tax on the decedent. The Federal government levies an estate tax. States levy inheritance or estate taxes or both. pp. 1-9 and 1-10
6. Since the gift tax is cumulative in effect, the 2000 taxable gift must be added to the 2002 taxable gift. As the tax rates are progressive, the tax on $500,000 is $155,800. From this amount is subtracted the amount paid on the 2000 gift. Thus, $85,000 ($155,800 - $70,800) is the amount of tax due on the 2002 gift. p. 1-11 and Example 12
7. 16 (donees) X $11,000 (annual exclusion) X 10 years = $1,760,000. p. 1-11 and Example 14
8. The special election allows one-half of the gifts made by the donor-spouse to be treated as being made by the nondonor-spouse. The effect of this election to split gifts of property made to third persons is to increase the number of annual exclusions available and to allow the use of the nondonor-spouse’s unified transfer tax credit. p. 1-11
9. In all probability, the residence was not on the property tax rolls when it was owned by a tax-exempt organization (i.e., St. Matthew's Catholic Church)—see p. 1-12 in the text. Also clear is the fact that the taxing authority is not aware that the residence is no longer owned by a tax-exempt organization.
Since it is only a question of time before the omission is noticed by the taxing authority, it would be advisable for the Toth's to get the matter cleared up. In many cases, further delay can lead to additional interest and penalties. pp. 1-12 and 1-13
10. Gull Company is trying to minimize the value of the real estate. This can be done by keeping personalty from becoming a “fixture.” The jurisdiction where the building is situated probably imposes an ad valorem tax on realty that is higher than that imposed on personalty. pp. 1-12 and 1-13
11. Probably John has no desire to experience the trouble and expense of paying the income taxes imposed by other states and many cities. By limiting his performances to Las Vegas, he avoids state and local income taxes. pp. 1-17 and 1-18
12. Property owned by churches and various other charitable organizations often are not included on the tax roll and are, therefore, not subject to ad valorem taxes. This probably was the case of the parsonage. Furthermore, it appears that the taxing authorities are not aware that the property is no longer entitled to a charitable exemption. Once this is discovered, Curtis can expect to be assessed for back taxes and, perhaps, interest and penalties. pp. 1-12 and 1-13
13. One way to resolve an anticipated power shortage would be to offer generous tax holidays to those who build and operate power generating facilities within the taxing jurisdiction. p. 1-12
14. As the Medicare tax component of the FICA tax rate is constant, the tax is proportional. pp. 1-3, 1-8, and Example 3
15. a. The FICA tax burden is shared by both employer and employee, while the incidence of FUTA falls entirely on the employer. pp. 1-8 and 1-9
b. The justification for FICA is to provide retirement and disability security. FUTA, on the other hand, is designed to provide modest unemployment benefits. p. 1-8 and 1-9
c. For 2002, the FICA tax rate on employees and employers is 6.2 percent of wages up to a maximum base amount of $84,900 and 1.45 percent on all wages (no limit). FUTA applies at a maximum rate of 6.2 percent on the first $7,000 of covered wages. p. 1-8 and 1-9
16. In some states, counties (and cities) are given the option to impose additional sales tax levies. It is possible that this is the situation with Wilson County. If so, this would explain why Velma does her shopping in Grimes County. p. 1-5 and Example 4
17. Earl probably purchased his computer out-of-state by use of a catalog or through the Internet. In such cases, state collection of the sales (use) tax is improbable without taxpayer compliance. p. 1-5
18. Paul undoubtedly purchased some items (e.g., drugs) that are excluded from the purview of the applicable general sales tax. p. 1-5
19. a. Using the individual income tax formula in Figure 1-2, Jill’s taxable income is computed as follows:
Income broadly conceived $220,000
Less: exclusions (30,000)
Gross income $190,000
Less: deductions for AGI (38,000)
AGI $152,000
Less: greater of
Itemized deductions 20,000
Standard deduction 4,700 (24,700)
Less: personal exemption (3,000)
Taxable income $124,300
Using the Tax Rate Schedule X inside the front cover of the textbook, Jill’s total tax liability for 2002 would be $31,605 ($14,625 + 0.30 [$124,300 – $67,700]).
This tax liability of $31,605 would then be reduced by the tax credits of $19,000 to $12,605. The $30,395 excess of estimated tax payments of $43,000 over the $12,605 could be refunded or applied to the next year's tax liability.
b. If Jill were a corporation, her taxable income would be computed using the formula in Figure 1-1, as follows:
Income broadly conceived $220,000
Less: exclusions (30,000)
Gross income $190,000
Less: deductions (58,000)
Taxable income $132,000
Note that the corporation receives no personal exemption and that no distinction is made between deductions for and from AGI. Using the corporate tax rate schedule inside the front cover of the textbook, Jill’s total tax liability for 2002 is $34,730.
$50,000 X 15% = $ 7,500
25,000 X 25% = 6,250
25,000 X 34% = 8,500
32,000 X 39% = 12,480
$34,730
This tax liability would then be reduced by the tax credits of $19,000 to $15,730 ($34,730 - $19,000). The $27,270 excess of estimated tax payments of $43,000 over the $15,730 could be refunded or applied to next year’s tax liability.
pp. 1-16 and 1-17
20. Smith, Raabe, and Maloney, CPAs
5191Natorp Boulevard
Mason,OH45040
February 25, 2002
Cynthia Clay
1206 Seventh Avenue
Fort Worth, TX 76101
Dear Cynthia:
I am writing this letter to help you decide on what form of entity to choose for your new sandwich delivery business. In our phone conversation, you indicated that you expect to have losses for the first two years in this business and then make substantial profits in subsequent years. You and Cory also indicated that you are concerned about potential personal liability.
While I can’t make a conclusive recommendation based on the information you have given me, I can provide you with some general guidelines that should simplify your decision. First, given your concern about personal liability, a partnership does not appear to be a desirable option (you would both be personally liable for any injuries to customers). Similarly, given your expectation of losses in the first two years, it does not appear that a regular “C” corporation would be a desirable choice, at least initially. This is because any losses in the corporation could only be used to offset future corporate profits—you could not use the losses to immediately offset your personal tax liability.
Thus, two choices exist which provide limited liability and deductibility of losses on your personal income tax return. These are the “S” corporation and the limited liability company. If you choose an “S” corporation, we would probably convert the entity to a “C” corporation when the business becomes profitable. At that point, profits would be taxed at the regular “C” corporation rates. A second tax would be levied on your personal income tax return for any dividends paid by the corporation once it achieves “C” status. In contrast, limited liability companies are taxed like partnerships—all income would be taxed on your personal income tax return in profitable years. The relative desirability of each of these two forms depends on a number of factors. One of the most important factors in your situation is the relationship between your personal tax rate and the tax rate of a regular “C” corporation. If you are in a high tax bracket and if the income in the business is sufficiently low, you might be best off choosing the “S” corporation. Alternatively, if you expect the business to generate a sufficiently large profit each year, it might be best to choose the limited liability company.
If you would like me to give you a clearer recommendation, we should meet at your earliest convenience. If you have any additional questions, please call me.
Best regards,
Julian Jackson, CPA
pp. 1-18 to 1-21
21. a.
2002 / 2003 / 2004Corporate Tax Liability
Sales Revenue / $150,000 / $320,000 / $600,000
Cash Expenses / (30,000) / (58,000) / (95,000)
Depreciation / (25,000) / (20,000) / (40,000)
Taxable Income / $95,000 / $242,000 / $465,000
Corporate Tax Liability / $20,550 / $ 77,630 / $158,100
Cash Available for Dividends
Sales Revenue / $150,000 / $320,000 / $600,000
Tax-Free Interest Income / 5,000 / 8,000 / 15,000
Cash Expenses / (30,000) / (58,000) / (95,000)
Corporate Tax Liability / (20,550) / (77,630) / (158,100)
Cash Available for Dividends / $104,450 / $192,370 / $361,900
Ashley's After-Tax Cash Flow
Dividend Received / $104,450 / $192,370 / $361,900
Tax on Dividend / (36,558) / (67,330) / (126,665)
After-Tax Cash Flow / $ 67,892 / $125,040 / $235,235
PV of Cash Flow / $ 61,721 / $103,333 / $176,732
Present Value / $341,786
b.
2002 / 2003 / 2004Individual Tax Liability
Sales Revenue / $150,000 / $320,000 / $600,000
Cash Expenses / (30,000) / (58,000) / (95,000)
Depreciation / (25,000) / (20,000) / (40,000)
Taxable Income / $ 95,000 / $242,000 / $465,000
Individual Tax Liability / $ 33,250 / $ 84,700 / $162,750
Ashley's After-Tax Cash Flow
Sales Revenue / $150,000 / $320,000 / $600,000
Tax-Free Interest Income / 5,000 / 8,000 / 15,000
Cash Expenses / (30,000) / (58,000) / (95,000)
Individual Tax Liability / (33,250) / (84,700) / (162,750)
After-Tax Cash Flow / $ 91,750 / $185,300 / $357,250
PV of Cash Flow / $ 83,410 / $153,132 / $268,402
Present Value / $504,944
c. If Ashley wants to have access to all available cash from the business, then she will have to pay out dividends annually. As seen in the answers to a and b above, the present value of future cash flows is substantially greater if she does not incorporate under this assumption. Alternatively, if she does not need to pay out dividends, then she may be better off by incorporating, since only the corporate tax will be incurred, which is less than her individual tax. The value of her stock will increase and she can then sell the stock at a later date at favorable capital gains rates.