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Chapter 2
The Tax Environment
Organizational Form and Taxes
• Four basic forms of business ownership:
1.
2.
3.
4.
Sole proprietorship
Partnership
Corporation
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
• 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
• 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
15%
$7,500
15.00%
50,001 – 75,000
25%
13,750
18.33%
75,001 – 100,000
34%
22,250
22.25%
100,001 – 335,000
39%
113,900
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
• 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
• 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 taxdeferred 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
• 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
• 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 corporatetax 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.