Taxation Chapter1

LO1 A clear understanding of the role of taxes in everyday decisions will help you make an informed decision about the value of studying taxation or pursuing a career in taxation. One view of taxation is that it represents an inconvenience every April 15th (the annual due date for filing federal individual tax returns without extensions). However, the role of taxation is much more pervasive than this view suggests. Your study of this subject will provide you a unique opportunity to develop an informed opinion about taxation.

As a business student, you can overcome the mystery that pervades popular impressions of the tax system and perhaps, one day, share your expertise with friends or clients. What are some common decisions you face that taxes may influence? In this course, we alert you to situations in which you can increase your return on investments by up to one third! Even the best lessons in finance courses can’t approach the increase in risk-adjusted return that smart tax planning provides. Would you like to own your home someday?

Tax deductions for home mortgage interest and real estate taxes can reduce the after-tax costs of owning a home relative to renting. Thus, when you face the decision to buy or rent, you can make an informed choice if you understand the relative tax advantages of home ownership. Would you like to retire someday? Understanding the tax-advantaged methods of saving for retirement can increase the after-tax value of your retirement nest egg—and thus increase the likelihood that you can afford to retire, and do so in style.

Other common personal financial decisions that taxes influence include: choosing investments, evaluating alternative job offers, saving for education expenses, and doing gift or estate planning. Indeed, taxes are a part of everyday life and have a significant effect on many of the personal financial decisions all of us face. The role of taxes is not limited to personal finance. Taxes play an equally important role in fundamental business decisions such as the following: ¦ What organizational form should a business use? ¦ Where should the business locate?

¦ How should business acquisitions be structured? ¦ How should the business compensate employees? ¦ What is the appropriate mix of debt and equity for the business? ¦ Should the business rent or own its equipment and property? ¦ How should the business distribute profits to its owners? http://highered. mcgraw-hill. com/sites/0077420667/student_view0/ebook/chapter1/chbo... 2010/9/12 w ?? ,2/2(W) Savvy business decisions require owners and managers to consider all costs and benefits in order to evaluate the merits of a transaction.

Although taxes don’t necessarily dominate these decisions, they do represent large transaction costs that businesses should factor into the financial decision-making process. Taxes also play a major part in the political process. U. S. presidential candidates often distinguish themselves from their opponents based upon their tax rhetoric. Indeed, the major political parties generally have very diverse views of the appropriate way to tax the public. 1 Determining who is taxed, what is taxed, and how much is taxed are tough questions with nontrivial answers.

Voters must have a basic understanding of taxes to evaluate the merits of alternative tax proposals. Later in this chapter, we’ll introduce criteria you can use to evaluate alternative tax proposals. Taxes in the Real World No New Taxes George H. W. Bush famously stated in his 1988 presidential election campaign, “Read my lips, no new taxes. ” In 1990, he signed legislation increasing individual income tax rates. Political observers cite this as one reason he lost the 1992 presidential election to Bill Clinton.

In summary, taxes affect many aspects of personal, business, and political decisions. Developing a solid understanding of taxation should allow you to make informed decisions in these areas. Thus, Margaret can take comfort that her semester will likely prove useful to her personally. Who knows? Depending on her interest in business, investment, retirement planning, and the like, she may ultimately decide to pursue a career in taxation.

1 The U. S. Department of the Treasury provides a “history of taxation” on its Web site (www. treas. gov/education/fact-sheets/taxes/ustax.shtml). You may find it interesting to read this history in light of the various political parties in office at the time. 2011 McGraw-Hill Higher Education Any use is subject to the Terms of Use and Privacy Notice. McGraw-Hill Higher Education is one of the many fine businesses of The McGraw-Hill Companies. http://highered. mcgraw-hill. com/sites/0077420667/student_view0/ebook/chapter1/chbo... 2010/9/12 w ?? ,1/2(W) Taxation of Individuals and Business Entities 2011, eBook - 1st 2/e Content Chapter1: An Introduction to Tax What Qualifies as a Tax?

LO2 Taxes have been described in many terms, some positive, some negative, some printable, some not. Let’s go directly to a formal definition of a tax, which should prove useful in identifying alternative taxes and discussing alternative tax systems. A tax is a payment required by a government that is unrelated to any specific benefit or service received from the government. The general purpose of a tax is to fund the operations of the government (to raise revenue). Taxes differ from fines and penalties in that taxes are not intended to punish or prevent illegal behavior.

Nonetheless, by allowing deductions from income, our federal tax system does encourage certain behaviors like charitable contributions, retirement savings, and research and development, and we can view it as discouraging other legal behavior. For example, “sin taxes” impose relatively high surcharges on alcohol and tobacco products. 2 THE KEY FACTS What Qualifies as a Tax? ¦ The general purpose of taxes is to fund government agencies. ¦ Unlike fines or penalties, taxes are not meant to punish or prevent illegal behavior; but “sin taxes” are meant to discourage some behaviors.

¦ The three criteria necessary to be a tax are that the payment is ¦ required ¦ imposed by a government ¦ and not tied directly to the benefit received by the taxpayer. Key components of the definition of a tax are that ¦ the payment is required (it is not voluntary), ¦ the payment is imposed by a government agency (federal, state, or local), and ¦ the payment is not tied directly to the benefit received by the taxpayer. This last point is not to say that taxpayers receive no benefits from the taxes they pay.

They benefit from national defense, a judicial system, law enforcement, government-sponsored social programs, an interstate highway system, public schools, and many other government-provided programs and services. The distinction is that taxes paid are not directly related to any specific benefit received by the taxpayer. Can taxes be assessed for special purposes, such as a 1 percent sales tax for education? Yes. Why is an earmarked tax, a tax that is assessed for a specific purpose, still considered a tax? Because the payment made by the taxpayer does not directly relate to the specific benefit received by the taxpayer.

Example 1-1 Margaret travels to Birmingham, Alabama, where she rents a hotel room and dines at several restaurants. The price she pays for her hotel room and meals includes an additional 2 percent city surcharge to fund roadway construction in Birmingham. Is this a tax? Answer: Yes. The payment is required by a local government and does not directly relate to a specific benefit that Margaret receives. Example 1-2 Margaret’s parents, Bill and Mercedes, recently built a house and were assessed $1,000 by their county government to connect to the county sewer system.

Is this a tax? Answer: No. The assessment was mandatory and it was paid to a local government. However, the third criterion was not met since the payment directly relates to a specific benefit (sewer service) received by the payees. For the same reason, tolls, parking meter fees, and annual licensing fees are also not considered taxes. 2 Sin taxes represent an interesting confluence of incentives. On the one hand, demand for such products as alcohol, tobacco, and gambling is often relatively inelastic because of their addictive quality.

Thus, taxing such a product can raise substantial revenues. On the other hand, one of the arguments for sin taxes is frequently the social goal of reducing demand for such products. 2011 McGraw-Hill Higher Education http://highered. mcgraw-hill. com/sites/0077420667/student_view0/ebook/chapter1/chbo... 2010/9/12 w ?? ,1/2(W) Taxation of Individuals and Business Entities 2011, eBook - 1st 2/e Content Chapter1: An Introduction to Tax How to Calculate a Tax LO3 In its simplest form, the amount of tax equals the tax base multiplied by the tax rate: (Eq.1-1) THE KEY FACTS How to Calculate a Tax ¦ Tax = Tax Base ?

Tax Rate ¦ The tax base defines what is actually taxed and is usually expressed in monetary terms. ¦ The tax rate determines the level of taxes imposed on the tax base and is usually expressed as a percentage. ¦ Different portions of a tax base may be taxed at different rates. The tax base defines what is actually taxed and is usually expressed in monetary terms, whereas the tax rate determines the level of taxes imposed on the tax base and is usually expressed as a percentage.

For example, a sales tax rate of 6 percent on a purchase of $30 yields a tax of $1. 80 ($1. 80 = $30 ? .06). Federal, state, and local jurisdictions use a large variety of tax bases to collect tax. Some common tax bases (and related taxes) include taxable income (federal and state income taxes), purchases (sales tax), real estate values (real estate tax), and personal property values (personal property tax). Different portions of a tax base may be taxed at different rates. A single tax applied to an entire base constitutes a flat tax.

In the case of graduated taxes, the base is divided into a series of monetary amounts, or brackets, and each successive bracket is taxed at a different (gradually higher or gradually lower) percentage rate. Calculating some taxes—income taxes for individuals or corporations, for example—can be quite complex. Advocates of flat taxes argue that the process should be simpler. But as we’ll see throughout the text, most of the difficulty in calculating a tax rests in determining the tax base, not the tax rate.

Indeed, there are only three basic tax rate structures (proportional, progressive, and regressive), and each can be mastered without much difficulty. http://highered. mcgraw-hill. com/sites/0077420667/student_view0/ebook/chapter1/chbo... 2010/9/12 w ?? ,1/5(W) Taxation of Individuals and Business Entities 2011, eBook - 1st 2/e Content Chapter1: An Introduction to Tax Different Ways to Measure Tax Rates Before we discuss the alternative tax rate structures, let’s first define three different tax rates that will be useful in contrasting the different tax rate structures: the marginal, average, and effective tax rates.

The marginal tax rate is the tax rate that applies to the next additional increment of a taxpayer’s taxable income (or deductions). Specifically, (Eq. 1-2) where “old” refers to the current tax and “new” refers to the revised tax after incorporating the additional income (or deductions) in question. In graduated income tax systems, additional income (deductions) can push a taxpayer into a higher (lower) tax bracket, thus changing the marginal tax rate. Example 1-3 Margaret’s parents, Bill and Mercedes, file a joint tax return.

They have $140,000 of taxable income this year (after all tax deductions). Assuming the following federal tax rate schedule applies, how much federal income tax will they owe this year? 3 Answer: Bill and Mercedes will owe $27,443. 50 computed as follows: Note that in this graduated tax rate structure, the first $16,750 of taxable income is taxed at 10 percent, the next $51,250 of taxable income (between $16,750 and $68,000) is taxed at 15 http://highered. mcgraw-hill. com/sites/0077420667/student_view0/ebook/chapter1/chbo... 2010/9/12 w ?? ,2/5(W)percent, the next $69,300 of taxable income (between $68,000 and $137,300) is taxed at 25 percent. Bill and Mercedes’ last $2,700 of taxable income (between $137,300 and $140,000) is taxed at 28 percent.

Many taxpayers incorrectly believe that all their income is taxed at their marginal rate. This mistake leads people to say, “I don’t want to earn any additional money because it will put me in a higher tax bracket. ” Bill and Mercedes are currently in the 28 percent marginal tax rate bracket, but notice that not all their income is taxed at this rate. Their marginal tax rate is 28 percent.

This means that small increases in income will be taxed at 28 percent, and small increases in tax deductions will generate tax savings of 28 percent. If Bill and Mercedes receive a large increase in income (or in deductions) such that they would change tax rate brackets, we cannot identify their marginal tax rate by simply identifying their current tax bracket. Example 1-4 Bill, a well-known economics professor, signs a publishing contract with an $80,000 royalty advance. Using the rate schedule from Example 1-3, what would Bill and Mercedes’ marginal tax rate be on this additional $80,000 of taxable income?

Answer: 28. 67 percent, computed as follows: Note that Bill and Mercedes’ marginal tax rate on the $80,000 increase in taxable income rests between the 28 percent and 33 percent bracket rates because a portion of the additional income ($209,250–$140,000 = $69,250) is taxed at 28 percent with the remaining income ($220,000– $209,250 = 10,750) taxed at 33 percent. Example 1-5 Assume now that, instead of receiving a book advance, Bill and Mercedes start a new business that loses $80,000 this year (it results in $80,000 of additional tax deductions).

What would be their marginal tax rate for these deductions? Answer: 24. 10 percent, computed as follows: http://highered. mcgraw-hill. com/sites/0077420667/student_view0/ebook/chapter1/chbo... 2010/9/12 w ?? ,3/5(W) Bill and Mercedes’ marginal tax rate on $80,000 of additional deductions (24. 10 percent) differs from their marginal tax rate on $80,000 of additional taxable income (28. 67 percent) in these scenarios because of the relatively large increase in income and deductions. Taxpayers often will face the same marginal tax rates for small changes in income and deductions.

THE KEY FACTS Different Ways to Measure Tax Rates ¦ Marginal tax rate ¦ The tax that applies to next increment of income or deduction. ¦ ¦ Useful in tax planning. ¦ Average tax rate ¦ A taxpayer’s average level of taxation on each dollar of taxable income. ¦ ¦ Useful in budgeting tax expense. ¦ Effective tax rate ¦ A taxpayer’s average rate of taxation on each dollar of total income (taxable and nontaxable income). ¦ ¦ Useful in comparing the relative tax burdens of taxpayers. http://highered. mcgraw-hill. com/sites/0077420667/student_view0/ebook/chapter1/chbo...

2010/9/12 w ?? ,4/5(W) The marginal tax rate is particularly useful in tax planning because it represents the rate of taxation or savings that would apply to additional taxable income (or tax deductions). In Chapter 3, we discuss basic tax planning strategies that use the marginal tax rate. The average tax rate represents a taxpayer’s average level of taxation on each dollar of taxable income. Specifically, (Eq. 1-3) The average tax rate is often used in budgeting tax expense as a portion of income (what percent of taxable income earned is paid in tax).

The effective tax rate represents the taxpayer’s average rate of taxation on each dollar of total income, including taxable and nontaxable income. Specifically, (Eq. 1-4) Relative to the average tax rate, the effective tax rate provides a better depiction of a taxpayer’s tax burden because it depicts the taxpayer’s total tax paid as a ratio of the sum of both taxable and nontaxable income earned. Example 1-6 Assuming Bill and Mercedes have $140,000 of taxable income and $10,000 of nontaxable income, what is their average tax rate? Answer: 19.

60 percent, computed as follows: We should not be surprised that Bill and Mercedes’ average tax rate is lower than their marginal tax rate because although they are currently in the 28 percent tax rate bracket, not all of their taxable income is subject to tax at 28 percent. The first $16,750 of their taxable income is taxed at 10 percent, their next $51,250 is taxed at 15 percent, their next $69,300 is taxed at 25 percent, and only their last $2,700 of taxable income is taxed at 28 percent. Thus, their average tax rate is considerably lower than their marginal tax rate.

Example 1-7 Again, given the same income figures as in Example 1-6 ($140,000 of taxable income and $10,000 of nontaxable income), what is Bill and Mercedes’ effective tax rate? Answer: 18. 30 percent, computed as follows: http://highered. mcgraw-hill. com/sites/0077420667/student_view0/ebook/chapter1/chbo... 2010/9/12 w ?? ,5/5(W) Should we be surprised that the effective tax rate is lower than the average tax rate? No, because except when the taxpayer has more nondeductible expenses (such as fines or penalties) than nontaxable income (such as tax-exempt interest), the effective tax rate will be equal to or less than the average tax rate.

3 The tax rate schedules for single, married filing jointly, married filing separately, and head of household are included inside the front cover of the text. 2011 McGraw-Hill Higher Education Any use is subject to the Terms of Use and Privacy Notice. McGraw-Hill Higher Education is one of the many fine businesses of The McGraw-Hill Companies. http://highered. mcgraw-hill. com/sites/0077420667/student_view0/ebook/chapter1/chbo... 2010/9/12 w ?? ,1/4(W) Taxation of Individuals and Business Entities 2011, eBook - 1st 2/e Content Chapter1: An Introduction to Tax.

Tax Rate Structures There are three basic tax rate structures used to determine a tax: proportional, progressive, and regressive. Proportional Tax Rate Structure A proportional tax rate structure, also known as a flat tax, imposes a constant tax rate throughout the tax base. As the tax base increases, the taxes paid increase proportionally. Because this rate stays the same throughout all levels of the tax base, the marginal tax rate remains constant and, in fact, equals the average tax rate (see Exhibit 1-1). The most common example of a proportional tax is a sales tax.

To calculate the tax owed for a proportional tax, simply use Equation 1-1 to multiply the tax base by the tax rate. Example 1-8 Knowing her dad is a serious Bulldog fan, Margaret buys a $100 sweatshirt in downtown Athens. The city of Athens imposes a sales tax rate of 7 percent. How much tax does Margaret pay on the purchase? Answer: $100 purchase (tax base) ? 7% (tax rate) = $7 EXHIBIT 1. 1 Proportional Tax Rate http://highered. mcgraw-hill. com/sites/0077420667/student_view0/ebook/chapter1/chbo... 2010/9/12 w ?? ,2/4(W) Progressive Tax Rate Structure.

A progressive tax rate structure imposes an increasing marginal tax rate as the tax base increases. Thus as the tax base increases, both the marginal tax rate and the taxes paid increase. Common examples of progressive tax rate structures include federal and state income taxes. The tax rate schedule in Example 1-3 is a progressive tax rate structure. As illustrated in Exhibit 1-2, the average tax rate in a progressive tax rate structure will always be less than or equal to the marginal tax rate. EXHIBIT 1. 2 Progressive Tax Rate Regressive Tax Rate Structure.

A regressive tax rate structure imposes a decreasing marginal tax rate as the tax base increases (see Exhibit 1-3). As the tax base increases, the taxes paid increases, but the marginal tax rate decreases. Regressive tax rate structures are not common. In the United States, the Social Security tax and federal and state unemployment taxes employ a regressive tax rate structure. 4 However, some taxes are regressive when viewed in terms of effective tax rates. For example, a sales tax is a proportional tax by definition, because as taxable purchases increase, the sales tax rate remains constant.

Nonetheless, when you consider that the proportion of your total income spent on taxable purchases likely decreases as your total income increases, you can see the sales tax as a regressive tax. http://highered. mcgraw-hill. com/sites/0077420667/student_view0/ebook/chapter1/chbo... 2010/9/12 w ?? ,3/4(W) EXHIBIT 1. 3 Regressive Tax Rate Example 1-9 Bill and Mercedes have two single friends, Elizabeth and Marc, over for dinner. Elizabeth earns $300,000 as CFO of a company and spends $70,000 for purchases subject to the 7 percent sales tax.

Marc, who earns $75,000 as a real estate agent, spends $30,000 of his income for taxable purchases. Let’s compare their marginal, average, and effective tax rates for the sales tax with Bill and Mercedes, who spend $50,000 of their income for taxable purchases: Is the sales tax regressive? Answer: In terms of effective tax rates, the answer is yes. THE KEY FACTS Tax Rate Structures ¦ Proportional tax rate structure ¦ Imposes a constant tax rate throughout the tax base. ¦ As a taxpayer’s tax base increases, the taxpayer’s taxes increase proportionally. ¦ The marginal tax rate remains constant and always equals the average tax rate.

¦ Progressive tax rate structure ¦ Imposes an increasing marginal tax rate as the tax base increases. http://highered. mcgraw-hill. com/sites/0077420667/student_view0/ebook/chapter1/chbo... 2010/9/12 w ?? ,4/4(W) ¦ As a taxpayer’s tax base increases, both the marginal tax rate and the taxes paid increase. ¦ Regressive tax rate structure ¦ Imposes a decreasing marginal tax rate as the tax base increases. ¦ As a taxpayer’s tax base increases, the marginal tax rate decreases while the total taxes paid increases. When we consider the marginal and average tax rates in Example 1-9, the sales tax has a proportional tax rate structure.

But when we look at the effective tax rates, the sales tax is a regressive tax. Indeed, Marc, who has the smallest total income, bears the highest effective tax rate, despite all three taxpayers being subject to the same marginal and average tax rates. Why do we see such a different picture when considering the effective tax rate? Because unlike the marginal and average tax rates, the effective tax rate captures the incidence of taxation, which relates to the ultimate economic burden of a tax. Thus, a comparison of effective tax rates is more informative about taxpayers’ relative tax burdens.

4 Wages subject to the Social Security tax (6. 2 percent tax rate) are capped each year ($106,800 in 2010). Wages in excess of the cap are not subject to the tax. As might be expected, the maximum Social Security retirement benefit is capped as a function of the maximum wage base. Likewise, the federal and state unemployment tax bases and related unemployment benefits are capped. 2011 McGraw-Hill Higher Education Any use is subject to the Terms of Use and Privacy Notice. McGraw-Hill Higher Education is one of the many fine businesses of The McGraw-Hill Companies. http://highered.mcgraw-hill. com/sites/0077420667/student_view0/ebook/chapter1/chbo... 2010/9/12 w ?? ,1/5(W).

Taxation of Individuals and Business Entities 2011, eBook - 1st 2/e Content Chapter1: An Introduction to Tax Types of Taxes LO4 “You can’t live with ’em. You can’t live without ’em. ” This statement has often been used in reference to bosses, parents, spouses, and significant others. To some degree, it applies equally well to taxes. Although we all benefit in multiple ways from tax revenues, and all civilized nations impose them, it would be hard to find someone who enjoys paying them.

Most people don’t object to the idea of paying taxes. Instead, it’s the way they’re levied that many people, like Margaret’s friend Eddy, dislike. Hence, the search for the “perfect” tax. The following paragraphs describe the major types of taxes currently used by federal, state, and local governments. After this discussion, we describe the criteria for evaluating alternative tax systems. Federal Taxes The federal government imposes a variety of taxes to fund federal programs such as national defense, Social Security, an interstate highway system, educational programs, and Medicare.

Major federal taxes include the individual and corporate income taxes, employment taxes, estate and gift taxes, and excise taxes (each discussed in detail in the following paragraphs). Noticeably absent from this list are a sales tax (a common tax for most state and local governments) and a value-added tax (a type of sales tax). Value-added taxes are imposed on the producers of goods and services based on the value added to the goods and services at each stage of production.

They are quite common in Europe. Income Tax The most significant tax assessed by the U. S.government is the income tax, representing approximately 59 percent of all tax revenues collected in the United States in 2008. Despite the magnitude and importance of the federal income tax, its history is relatively short. Congress enacted the first U. S. personal income tax in 1861 to help fund the Civil War. This relatively minor tax (maximum tax rate of 5 percent) was allowed to expire in 1872. In 1892, Congress resurrected the income tax, but not without dissension among the states. In 1895, the income tax was challenged in Pollock v. Farmers’ Loan and Trust Company, 157 U. S. 429 (1895).

The U. S. Supreme Court ruled that the income tax was unconstitutional because direct taxes were prohibited by the Constitution unless the taxes were apportioned across states based upon their populations. This ruling, however, did not deter Congress. In July 1909, Congress sent a proposed constitutional amendment to the states to remove any doubt as to whether income taxes were allowed by the Constitution—and in February 1913, the 16th amendment was ratified. Congress then enacted the Revenue Act of 1913, which included a graduated income tax structure with a maximum rate of 7 percent.

The income tax has been an important source of tax revenues for the U. S. government ever since. Today, income taxes are levied on individuals (maximum rate of 35 percent), corporations (maximum rate of 39 percent), estates (maximum rate of 35 percent), and trusts (maximum rate of 35 percent). As Exhibit 1-4 illustrates, the individual income tax represents the largest source of federal tax revenues followed by employment taxes and the corporate income tax. We discuss each of these taxes in greater detail later in the text. EXHIBIT 1. 4 U. S. Federal Tax Revenues Source: Internal Revenue Service.

Employment and Unemployment Taxes Employment and unemployment taxes are the second largest group of taxes imposed by the U. S. government. Employment taxes consist of the Old Age, Survivors, and Disability Insurance (OASDI) tax, commonly called the Social Security tax, and the Medical Health Insurance (MHI) tax known as the Medicare tax. The Social Security tax pays the monthly retirement, survivor, and disability benefits for qualifying individuals, whereas the Medicare tax pays for medical insurance for individuals who are elderly or disabled. The tax base for the Social Security and Medicare taxes is wages or salary, and the rates are 12.

4 percent and 2. 9 percent, respectively. In 2010, the tax base for the Social Security tax is capped at $106,800. The tax base for the Medicare tax is not capped. Employers and employees split these taxes equally. Selfemployed individuals, however, must pay these taxes in their entirety. In this case, the tax is often referred to as the self-employment tax. We discuss these taxes in more depth later in the text. THE KEY FACTS Federal Taxes ¦ Income taxes http://highered. mcgraw-hill. com/sites/0077420667/student_view0/ebook/chapter1/chbo... 2010/9/12 w ?? ,2/5(W) ¦.

The most significant tax assessed by the U.S. government is the income tax, representing approximately 59 percent of all tax revenues collected in the United States. ¦ Levied on individuals, corporations, estates, and trusts. ¦ Employment and unemployment taxes ¦ Second largest group of taxes imposed by the U. S. government. ¦ Employment taxes consist of the Old Age, Survivors, and Disability Insurance (OASDI) tax, commonly called the Social Security tax, and the Medical Health Insurance (MHI) tax known as the Medicare tax. ¦ Unemployment taxes fund temporary unemployment benefits for individuals terminated from their jobs without cause.

¦ Excise taxes ¦ Third largest group of taxes imposed by the U. S. government. ¦ Levied on the quantity of products sold. ¦ Estate and gift taxes ¦ Levied on the fair market values of wealth transfers upon death or by gift. In addition to the Social Security and Medicare taxes, employers are also required to pay federal and state unemployment taxes, which fund temporary unemployment benefits for individuals terminated from their jobs without cause. As you might expect, the tax base for the unemployment taxes is also wages or salary. Currently, the Federal Unemployment Tax rate is 6. 2 percent on the first $7,000 of wages.

The U. S. government allows a credit for state unemployment taxes paid up to 5. 4 percent. Thus, the Federal Unemployment Tax rate may be as low as 0. 8 percent (6. 2%–5. 4% = 0. 8%). 5 Excise Taxes Excise taxes are taxes levied on the retail sale of particular products. They differ from other taxes in that the tax base for an excise tax typically depends on the quantity purchased, rather than a monetary amount. The federal government imposes a number of excise taxes on goods such as alcohol, diesel fuel, gasoline, and tobacco products and on services such as telephone use and air transportation.

In addition, states often impose excise taxes on these same items. Example 1-10 On the drive home from Athens, Georgia, Margaret stops at Gasup-n-Go. On each gallon of gasoline she buys, Margaret pays 18. 4 cents of federal excise tax and 7. 5 cents of state excise tax (plus 4 percent sales tax). Could Margaret have avoided paying excise tax had she stopped in Florida instead? Answer: No. Had she stopped in Florida instead, Margaret would have paid the same federal excise tax. Additionally, Florida imposes higher state taxes on gas.

Because the producer of the product pays the government the excise tax, many consumers are not even aware that businesses build these taxes into the prices consumers pay. Nonetheless, consumers bear the incidence of the taxes because of the higher price. Transfer Taxes Although they are a relatively minor tax compared to the income tax in terms of revenues collected, federal transfer taxes—estate and gift taxes—can be substantial for certain individual taxpayers and have been the subject of much debate in recent years.

The estate tax (labeled the “death tax” by its opponents) and gift taxes are based on the fair market values of wealth transfers upon death or by gift, respectively. The estate and gift tax rates have traditionally been high (maximum tax rate through 2009 was 45%) compared to income tax rates and can be burdensome without proper planning. In 2010, the maximum rate imposed on gifts is 45%, and the estate tax is scheduled to be repealed for one year only unless Congress enacts legislation to maintain the estate tax in 2010.

At the time of publication, no legislation had been enacted to preserve the estate tax in 2010, but we anticipate that the estate tax will be extended through 2010. Most taxpayers, however, are not subject to estate and gift taxation because of the annual gift exclusion and gift and estate unified tax credits. The annual gift exclusion allows a taxpayer to transfer $13,000 of gifts per donee (gift recipient) each year without gift taxation. The unified tax credit exempts from taxation up to $1,000,000 in lifetime gifts and in 2009, up to $3,500,000 in bequests (transfers upon death) and gifts.

6 Thus, only large transfers are subject to the gift and estate taxes. State and Local Taxes Like the federal government, state and local governments (such as counties, cities, and school districts) use a variety of taxes to generate revenues for their programs (such as education, highways, and police and fire departments). Some of the more common state and local taxes include income taxes, sales and use taxes, excise taxes, and property taxes. Typically, as shown in Exhibit 1-5, the largest state and local revenues are generated by state sales taxes and local property taxes. EXHIBIT 1. 5.

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