Chapter 2

The Tax Environment

Organizational Form and Taxes

• Four basic forms of business ownership: 1. Sole proprietorship 2. Partnership 3. Corporation 4. Limited liability company

Organizational Form and Taxes

1. Sole Proprietorship – Owned and operated by a single individual – Formation is extremely simple – Owner is solely liable for all obligations of the business; this liability extends to personal assets –

Taxed at individual rate

Organizational Form and Taxes

2. Partnership – Two or more owners – All partners share equally in profits and losses – Decision-making process is complicated –

Taxed at individual rate

Organizational Form and Taxes

3. Corporation – Exists independently of its stockholders (owners) or stock sales – Personal assets of owners cannot be seized to settle claims – Capital can be raised in corporation’s name – Shares of stock are transferable among owners –

Advantage of limited liability

– Taxed at corporate rate, regardless of individual income of owners

Organizational Form and Taxes

4. Limited liability company (LLC) – Taxed at individual rate (no double taxation) – Advantage of limited liability upon members

Corporate Income Taxes

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EXHIBIT 2.1 FEDERAL CORPORATE INCOME TAX RATE TAXABLE INCOME

$1 – $50,000 50,001 – 75,000 75,001 – 100,000 100,001 – 335,000 335,001 – 10,000,000 10,000,001 – 15,000,000 15,000,001 – 18,333,333 over $18,333,333

TAX RATE

15% 25 34 39 34 35 38 35

Corporate Income Taxes

• • Marginal tax rate: tax on each additional dollar of income Average tax rate: total tax as a percentage of income • Federal corporate income tax rate provides tax break for small corporations – i.e. First $100,000 of income is taxed at an average rate of only 22.25%

Corporate Income Taxes

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EXHIBIT 2.2 MARGINAL AND AVERAGE CORPORATE TAX RATES

CORPORATE TAXABLE INCOME MARGINAL TAX RATE AVERAGE TAX RATE * DOLLARS OF TAX DUE* $1 – $50,000 50,001 – 75,000 75,001 – 100,000 100,001 – 335,000 15% 25% 34% 39% $7,500 13,750 22,250 113,900 15.00% 18.33% 22.25% 34.00% 335,001 – 1,000,000 34% 340,000 34.00% *Assuming corporate taxable income equals the upper limit of the taxable income range.

(See example following Exhibit 2.2)

Corporate Income Taxes

• • Indicated tax rate actually paid by corporation (“effective tax rate”) may be substantially less than normal corporate rate (“statutory rate”).

Discrepancies between the statutory rate and the effective tax rate are explained in footnotes to financial statements.

Corporate Income Taxes

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EXHIBIT 2.3 DIFFERENCES IN ACTUAL VERSUS STATUTORY TAX RATES

1. Income less than $75,000 is taxed at less than 35 percent.

2. Earnings of some subsidiaries and affiliates—for example, foreign subsidiaries—may be taxed at rates of less than 35 percent.

3. Between 70 and 100 percent of income received from dividends paid on stock owned in other corporations is not taxable to the receiving corporation.

4. Net losses from prior years may be carried forward.

5. Some income may be from tax-exempt bonds.

Corporate Income Taxes

• More discrepancies between actual and statutory tax rates: – Earnings from foreign affiliates – Corporate capital gains and losses – Operating Loss Carry-Back and Carry-Forward – Intercorporate Dividend Taxation – Corporate Taxes and Personal Taxes

Corporate Income Taxes

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Earnings from Foreign Affiliates

– Domestic international sales corporation (DISC): at least 95% of its gross receipts must be from exports – Foreign sales corporation (FSC) –

Tax Reform Act of 1984

• Limited tax benefits and imposed interest charge to tax deferred earnings of DISCs • Established new tax benefits for FSCs –

FSC Repeal and Extraterritorial Income Exclusion Act of 2001

• Corporations may not elect FSC status • Lower tax rate on foreign income than on domestic income

Corporate Income Taxes

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Corporate Capital Gains and Losses

– Corporate capital assets: assets not normally bought and sold in ordinary course of a corporation’s business (i.e. security investments) – Long-term capital gain: gains on assets held for more than one year –

Tax Reform Act of 1986

• Same tax rate applied to all sources of income (i.e. ordinary income, long-term capital gains)

Corporate Income Taxes

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Operating Loss Carry-Back and Carry-Forward

– Allows ordinary operating loss to be carried back three years and forward for up to fifteen years to offset taxable income in previous or future years

Intercorporate Dividend Taxation

– Eliminates possibility of triple taxation of a corporation’s income

Corporate Taxes and Personal Taxes

Personal Income Taxes

• • • Personal tax-rate starts lower than corporate tax rate in lowest brackets.

At higher income levels, highest personal rate never exceeds highest corporate rate.

LLCs combine the best of single level taxation with limited liability.

Personal Income Taxes

• • • • Sole owners or partners organized as a corporation draw a salary from the corporation and then pay their personal-tax rate on the salary.

Remaining corporate income is taxed at corporate rate.

Profits reinvested in the corporation are available to finance future growth or pay future dividends.

Corporate profits paid out as dividends are taxed twice (corporate rate and then recipient pays personal-tax rate)

Subchapter S Corporations

• • Some incorporated businesses can elect to be taxed as sole proprietorships or partnerships Requirements: 1. May not have more than 100 individual stockholders and may have only one class of stock.

2. Must be domestic and must not be affiliated with any group eligible to file consolidated tax returns.

3. May not derive over 20% of gross receipts from royalties, rents, dividends, interest, annuities, and gains on sale of securities.