Hamilton, pp. 161-175: Federal Income Taxation: Basic Principles


There can’t be a business without individuals who own it and run it.  Any talk of the taxation of businesses must therefore include a word or two about the taxation of individuals.  We’ll just do the fundamentals now.  Businesses compute income for tax purposes about the same way.  But then how the business is treated for tax purposes varies based on what form it uses.  The Internal Revenue Service has two different taxation methods described as “corporate” and “partnership” taxation.  Corporate income taxation is described in Subchapters C and S, while partnership income taxation is found in Subchapter K.


(a)   Corporate Tax Rates


Corporations are subject to a progressive tax with the highest marginal rate starting at about $18 million in income.  That top rate is 35%.  Er, the highest rate is 39%...hootie what?  It’s not purely progressive, and it’s not purely regressive either.  What’s the deal?


(b)   Individual Tax Rates


These tax rates are more complex!  There are lots of different tables to look at and different deductions that can be applied.  Marginal tax rates went super high around World War II and leading right up to the 1980’s.  Now the top marginal tax rate is lower, but it’s been tending to rise over the years.


(c)   The Taxation of Capital Gains or Losses


The capital gains tax rate is much lower than the top marginal tax rate!  So there’s a big incentive to convert income into long-term capital gains.  But your capital gains must be long-term.  If they’re short-term, they’ll just get taxed at regular income tax rates!


(d)   Estate Taxes


When a business owner dies, they have to pay taxes that are assessed based on the value of the business.  This can make succession plans difficult.  It provides an incentive to sell a business while you’re alive rather than leave it to your heirs.  There has been reductions in the estate tax in the last couple of years.  However, they may cause an unforeseen consequence: the Alternative Minimum Tax may kick in for more middle and upper-middle class people.


Here are some vocabulary words.  It would be hard to get the definitions shorter for the purposes of these notes.  Basis, adjusted basis, amount realized, and gain…


(e)   The Taxation of Partnerships and Corporations

(1)    Proprietorships


If someone wholly owns a business in their own name, their profit or loss is simply reported on their own tax return.  They have to file the long-form 1040 and Schedule C.  They must pay an extra self-employment tax.


(2)    Unincorporated Business Forms


These will usually fall under Subchapter K of the Internal Revenue Code unless the entity chooses to be treated as a corporation.  Partnerships don’t pay tax themselves, but rather pass through income to the partners, who then pay regular old personal income tax.  This seems simple, but it might not be as simple as it sounds.


(3)    C Corporations


These corporations have their own tax schedule.  And they get double-taxed!  The corporation gets taxed on income, and then the dividends get taxed when they’re distributed!


(4)    S Corporations


This form was created to provide relief from double taxation.  A corporation must elect to use this form.  An S corporation is like a C corporation in all respects except for tax differences.  An S corporation must not have more than 75 shareholders.  There are some other requirements as well.  Most S corporations are small and only have one shareholder.


(f)     Business tax planning strategies


When you set up a corporation, you have to think about both taxation and tort liability.  Not everyone will be sued, but everyone has to pay taxes.  So tax planning may be of more importance than liability concerns.  You are allowed to try to reduce your tax liability as much as possible legally, but you can’t illegally evade taxes.  You need to focus on the marginal tax rate rather than the average rate.  Most people have enough income to already be in the higher tax brackets.


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