Are 457 plan withdrawals taxable?A:
All contributions to 457 plans grow tax-deferred until retirement, when they are either rolled over or withdrawn. All withdrawals are taxable, regardless of the participant's age. Similar to 401(k)s and 403(b)s, all contributions into 457 plans grow tax free, but early withdrawals are not penalized.
Differences Between 457 Plans and 401(k) and 403(b) Plans
457 plans are not classified as qualified plans, and they are not bound by the same rollover and distribution rules as 401(k) and 403(b) plans. Originally, 457 plans were only available to state and local government employees, entities and 501(c)3 organizations. Looser restrictions now allow more employers to offer 457 plans in addition to other retirement plans.
Unlike 401(k) and 403(b) accounts, participants can take regular withdrawals from 457 plans as soon as they retire, regardless of whether they have reached age 59.5. These distributions are taxed as regular income, but the 10% early withdrawal penalty is never applied. Rather than withdrawing funds, participants may also roll their 457 plans into other qualified plans.
457 Plans Are Unique and Complicated
As the only non-qualified group plans available in the United States, 457 plans are unique and complex, offering several advantages over more popular deferred compensation plans. While more employers are offering 457 plans every year, they are not common. There are many different types of 457 plans, all with different characteristics; they are categorized as governmental or nongovernmental, and eligible or ineligible. Eligible plans are categorized as 457(b); non-eligible plans are categorized as 457(f), and they lack many of the benefits of eligible plans.
Are estate distributions taxable?A:
In general, most estate distributions are not subject to income tax. In some cases, however, a distribution from an estate may include income that can be taxed, but this is a rare occurrence.
The U.S. government does not have any form of inheritance tax. Thus, an estate distribution than an heir receives as a beneficiary is inherited tax-free. A limited number of states require payment of inheritance tax. Also, in instances where the estate has failed to pay income tax prior to distribution, the U.S. government may attach limited beneficiary taxes to distributions. As is true for an individual, an estate must use an income tax return to report an income. Though estates can generate income in several ways, the most common income is earned in the form of interest on the accounts that it owns.
Though an estate must report this income, it may also distribute the taxable income to heirs. The estate may distribute this income along with the inheritance. For example, if an estate makes a distribution of $10,000 to an heir, it is likely that $2,000 to $3,000 of the distribution is taxable income, while the remaining $7,000 to $8,000 is the actual inheritance.
In the end, this saves the heir money. An estate is subject to the top tier of tax rates significantly quicker than an individual. The heir who must put $2,000 or $3,000 on a personal tax return ultimately receives more of than money, as less tax is deducted from it than if it were taxed as part of the estate's income. The heir then receives a Schedule K-1 form from the IRS and has to report the taxable income on his own income tax return.
Are gross sales and taxable gross sales the same thing?A:
The terms gross sales and taxable gross sales are not the same thing, and the difference can mean a huge difference in the profits of a company. Gross sales is a raw figure that includes all sales that occurred during a particular time frame. The gross sales figure does not take into account numerous categories of expenses such as items returned, the cost of any retail items that are purchased to be resold, taxes, licenses and business fees, rent, electric, payroll or any other costs that a business can expect to incur to operate.
Taxable gross sales is a term that describes the amount of income that a company is liable for paying taxes on. A company is able to take a tax deduction on many, if not all, of the aforementioned expenses, and is not liable to pay taxes on those amounts. What remains after all the liabilities are deducted from the gross sales is the taxable gross income. A company generally attempts to deduct as many individual expenses as it can to make the taxable gross sales as low as possible, thus lowering the company's tax liability. A company may choose to take a standard deduction amount, or individually deduct expenses, and it also chooses whichever figure helps it arrive at the lowest taxable gross income.
These same terms apply to individual taxing liabilities as well. An individual's gross income, minus allowed deductions and expenses, leave the taxable gross income for the individual. This figure is what an individual's tax liability is based on.
Are qualified dividends included in gross income?A:
Qualified dividends are included in a taxpayer's adjusted gross income. However, these are taxed at a lower rate than ordinary dividends.
Ordinary Dividends vs. Qualified Dividends
According to the Internal Revenue Service (IRS), ordinary dividends are paid out of a corporation or mutual fund's earnings and taxed at the same rate as ordinary income. These payouts are shown in box 1a of Form 1099-DIV, which is sent to investors.
Qualified dividends are similar to ordinary dividends but are subject to the maximum tax rate that applies to the investor's capital gains. This figure is shown in box 1b of Form 1099-DIV. As of 2015, the maximum rates for qualified dividends are 0% if ordinary income is taxed at the 10% or 15% rate, and 15% if the ordinary income tax bracket is greater than 15% and less than 39.6%. The tax rate is capped at 20% for those whose ordinary income is taxed at the 39.6% rate.
To meet the requirements for a qualified dividend, the dividend must have been paid by a U.S. corporation or a qualified foreign corporation and meet the holding period, which is more than 60 days during a 121-day period, which starts 60 days prior to the ex-dividend date. The holding period is different for preferred stock.
Company ABC declares 25-cent dividends per share. If an investor owns 10,000 shares of ABC Corporation common stock, the dividend payment received is $2,500. If the ex-dividend date is July 1, the investor needs to have owned the stock for more than 60 days from May 2 through Oct. 30, or the 121-day period, for the payout to be considered a qualified dividend.
Are student loans dischargeable after bankruptcy?A:
In limited circumstances, you can discharge student loans in bankruptcy, although many people drowning in student loan debt do not know this is a possibility, according to the study An Empirical Assessment of Student Loan Discharges and the Undue Hardship Standard, by Jason Iuliano, published in the American Bankruptcy Law Journal.
What Are the Chances?
Among bankruptcy filers daring enough to ask the courts to discharge their student loans, 40% received some sort of remedy, either full or partial discharge, noted Iuliano much to the surprise of industry observers. The courts granted 25% of the filers a complete discharge of all student loan debt. The takeaway from Iuliano’s study is that it is worth the effort to at least request student loans be discharged in bankruptcy, because even if the courts say "no" in most cases, they say "yes" in some.
Passing the Brunner Test
Most bankruptcy courts use the three-part Brunner test to determine whether bankruptcy filers qualify for a discharge of student loan debt. The test is named after Marie Brunner, a bankruptcy filer in the state of New York, who in the 1980s attempted to have her student loan debt discharged. The case, ultimately unsuccessful, established the three-part test. Filers must prove that repaying the loans would cause them to live in poverty. They must show their financial situation is not likely to change. They must also show they made a good-faith effort to repay the loans.
Student Loan Debt Forgiveness
Consumers with high student loan debt should explore forgiveness and repayment assistance programs to manage the debt. For example, people who pursue careers in public service, such as teaching, medicine and law, and meet certain criteria may be eligible for partial or full-loan forgiveness. The U.S. Department of Education and state departments of education post information regarding student loan forgiveness on their websites.
Are tax brackets adjusted for inflation?A:
Each year, the U.S. Internal Revenue Service (IRS) adjusts tax brackets for changes in the cost of living to calculate federal tax liability. Because the U.S. economy typically faces inflation each year, the IRS adjusts tax brackets upward.
Tax brackets represent the dollar amount that stratifies taxable income. Tax rates change in the U.S. progressive tax system; tax brackets provide limit values with which the tax rate changes. For instance, if a single individual earned taxable income of $9,075 in 2014, he faces a 10% tax rate for federal income purposes, resulting in a total tax of $907.50. However, if an individual earned $36,900, he pays 10% on $9,075 and 15% on the remaining $27,825, resulting in a federal tax liability of $5,081.25.
Every year, the IRS makes adjustments to personal exemption, standard deduction, tax brackets and other tax credits to account for changes in the cost of living. Even through U.S. tax rates may remain the same, changing tax brackets, deductions and credits affects the effective tax rate faced by individuals and corporations.
In 2014, the IRS changed all tax brackets across all filing statuses, thus changing the effective tax rate. For example, from 2013 to 2014 for single filing status, the IRS adjusted the 10% tax bracket cutoff value from $8,925 to $9,075; the 15% tax bracket cutoff value from $36,250 to $36,900; and the 25% tax bracket cutoff value from $87,850 to $89,350. For a single filing status, these changes represent an average increase of approximately 1.7% for tax brackets, which was close to the U.S. inflation rate of 1.6% in 2014.
Are taxes calculated in operating cash flow?A:
Yes, taxes are included in the calculations for the operating cash flow. Cash flow from operating activities is calculated by adding depreciation to the earnings before income and taxes, and then subtracting the taxes. The operating cash flow indicates the cash a company brings in from ongoing, regular business activities. The operating cash flow can be found on a company's cash flow statement in the financial reporting done annually and quarterly.
The operating cash flow is important when considering whether the company can generate enough positive funds to maintain and grow its operations. If not, the company may require external financing. Shorter turnover rates in inventory and shorter times for receiving funds increase the operational cash flow. Items such as depreciation and taxes are included to adjust the net income, rendering a more accurate financial pictures. Higher taxes and lower depreciation methods adversely impact the operational cash flow.
Investors find it important to look at the cash flow after taxes, which indicates a corporation's ability to pay dividends. The higher the cash flow, the better the company is financially and the better positioned it is to make distributions. Income the company has from outside of its operations is not included in the operational cash flow. Any dividends paid and infrequent long-term expenses are often excluded from this calculation as well.
One-time asset sales are also noted, as they inflate the cash flow numbers during the relevant time period. Investors look at the balance and income statements to gain better knowledge of the overall health of a company.
Can a corporation deduct dividend payments before its taxes are calculated?A:
Corporations may not legally deduct the dividend payments before taxes but there is another approach: a corporate structure called an income trust. Income trusts allow a firm to deduct dividends, or trust payments, before taxes are calculated. The essence of an income trust is to pay all of the earnings after all business expenses to the unit holders, who are the owners of the income trust.
An income trust is essentially a corporation with a different classification under tax law. Income trusts are not permissible in most countries, but there are a few (Canada, for example) that still allow them, or a variation thereof. Because trust payments are paid out to unit holders in a cash-distributions-per-unit format before taxes are calculated, the corporation will have no income against which to calculate income taxes, virtually eliminating its tax liability.
If you want to learn more about dividends, please read "How and Why Do Companies Pay Dividends?"
Can the IRS audit you after a refund?A:
The U.S. Internal Revenue Service (IRS) can audit tax returns even after it has issued a tax refund to a taxpayer. According to the statute of limitations, the IRS can audit tax returns filed within the previous three years. In certain instances when a significant error is identified, the IRS can audit returns filed even further back than that but typically no more than the previous six calendar years.
Every year, the IRS selects numerous tax returns for audits. Tax returns can be selected regardless of whether a taxpayer has been issued a refund or has a tax liability, as long as the IRS identifies a tax mistake or fraud. Tax returns for audits are typically chosen based on random selection and comparison of a return to a similar "norm" group of returns using a statistical formula.
Other methodologies the IRS uses to select returns for audits include related examination and matching documents. The IRS conducts its tax audits by email or through personal interviews at a local IRS office. Tax audits can result in no corrections, or corrections with a taxpayer owing more or being entitled to a larger refund; the latter is typically rare.
Statute of Limitations
While the IRS tries to audit tax returns as soon as they are filed, it is not unusual to receive an audit notice about tax issues going back a few years. The statute of limitations limits the time given to the IRS to impose additional taxes, and it is typically three years after a return is due or was filed, depending on which is later. If a tax issue is not resolved within the time permitted by the statute of limitations, the IRS may ask a taxpayer to extend the statute for additional time. A taxpayer can decline such a request, forcing the IRS to make its tax determination based on available information only.
Can you calculate the marginal tax rate in Excel?A:
Marginal tax rates are higher for higher-income individuals. Accurate information about current tax brackets is needed to complete the table. American tax information is available from the Internal Revenue Service (IRS) and will be necessary to create a tax table that appropriately calculates U.S. marginal tax rates. To create an Excel spreadsheet that calculates the marginal tax rate, begin by opening a spreadsheet and creating columns entitled "Taxable Income", "Marginal Tax Rate" and "Base Tax". Under the first column, place the year's income maximums for each marginal tax rate. The column should start at the lowest tax bracket and end at the highest bracket. Under the second column, list each tax rate, starting with the lowest. The final column should have minimum tax values for each tax bracket. After filling in the values, a formula to calculate the appropriate values is needed.
To create the formula, choose an income value to apply the calculation to and enter it in cell A11. Under the second column and in the same row as the value that was just entered, type "=VLOOKUP(A11,A3:C8,2)" in cell C11, and save your spreadsheet. This calculation will now apply to values entered in the first two columns in row 11, 12, 13 and so on through your spreadsheet. Note that these calculations only provide a marginal tax rate applied to income and do not factor in individual tax circumstances, such as deductions and taxable income limits. These values result in an approximate tax rate that provide a starting point for personal tax estimates.
Dangers of Electronic Federal Tax Payment System (EFTPS)A:
The Electronic Federal Tax Payment System (EFTPS) is a free tax payment service offered by the U.S. Department of the Treasury to help individual and business taxpayers pay their federal taxes electronically. To use the service, you must first enroll online by entering your Taxpayer Identification Number (your Employer Identification Number if you're enrolling as a business, or your Social Security Number if you're enrolling as an individual), your banking account information, and your name and address as they appear on your IRS tax documents. Approximately one week after you enroll online, you will receive a PIN (Personal Identification Number) in the mail, and you can complete your online registration and begin making payments.
Phishing scams are one of the potential dangers of using the EFTPS system. These scams occur outside of the EFTPS website. In 2010, for example, fraudulent emails targeting EFTPS users were circulated with the subject line: Your Federal Tax Payment ID: 010363124 has been rejected. A link in the email prompted recipients to update their information, but instead installed malware used to intercept their online banking transaction data.
The IRS website warns, "The IRS does not initiate contact with taxpayers by email to request personal or financial information. This includes any type of electronic communication, such as text messages and social media channels. The IRS also does not ask for PINs, passwords or similar confidential access information for credit card, bank or other financial accounts. Recipients should not open any attachments or click on any links contained in the message. Instead, forward the e-mail to email@example.com."
The EFTPS website protects sensitive tax payment data by using firewalls and internal security policies to ensure that you and only you can make, cancel, and inquire about your tax payments. According to the EFTPS website, "Every secure interaction involving EFTPS online requires identification and authentication of each user. EFTPS online identifies and authenticated each taxpayer using his or her Taxpayer Identification Number, Personal Identification Number and Internet password. Without these key pieces of information, you may not use many of the functions of EFTPS online."
Do all taxes create deadweight loss?A:
Taxes create deadweight loss because they prevent people from buying a product that costs more after taxing than it would before the tax was applied. Deadweight loss is the loss of something good economically that occurs because of the tax imposed. Tax on a product alone is not the only contributor to deadweight loss. People are less likely to desire and seek work when the tax imposed on them is more than what would be possible if they did not seek work or higher-paying work. They must also make changes in their spending habits to avoid taxes, further placing a burden on them and lessening their overall economic quality of life.
While taxes create deadweight loss, varies based on several factors. Two of the most important factors are whether a consumer is willing to spend on a product and how much, as well as how well a supplier can get the desired product to the consumer. This is one example of the law of supply and demand in economics. When supply and demand are not equal, more deadweight loss occurs.
Deadweight loss of taxation is looked at as time and money that could be spent in other areas of an individual's life, especially in areas that result in better spending and greater contribution to the economy. Governments can reduce their spending on tax collection if different tax policies were in place. Those people who spend hours looking for ways to avoid taxes could spend that time doing other activities that could contribute to the economy more, especially if those activities include spending in ways that put money back into the economy.
Do beneficiaries of a trust pay taxes?A:
Beneficiaries of a trust typically pay taxes on distributions they receive from the trust's income. However, they are not subject to taxes on distributions from the trust's principal. When a trust makes a distribution, it deducts the income distributed on its own tax return and issues the beneficiary a tax form called a K-1. The K-1 indicates how much of the beneficiary's distribution is interest income versus principal and, thus, how much the beneficiary is required to claim as taxable income when filing taxes.
Interest Versus Principal Distributions
When a trust beneficiary receives a distribution from the trust's principal balance, he does not have to pay taxes on it: The Internal Revenue Service (IRS) assumes this money was already taxed before it was placed into the trust. Once money is placed into the trust, the interest it accumulates is taxable as income, either to the beneficiary or the trust itself. The trust must pay taxes on any interest income it holds and does not distribute past year-end. Interest income the trust distributes is taxable to the beneficiary who receives it.
The two most important tax forms for trusts are the 1041 and the K-1. Form 1041 is similar to Form 1040. On this form, the trust deducts from its own taxable income any interest it distributes to beneficiaries. At the same time, the trust issues a K-1, which breaks down the distribution, or how much of the distributed money came from principal versus interest. The K-1 is the form that lets the beneficiary know his tax liability from trust distributions.
For additional info, see "Designating a Trust as Retirement Beneficiary" and "Pros/Cons of Naming a Trust as Beneficiary."
Do I pay capital gains taxes on a house that my company sells back to myself?
The answer to this question really depends on the type of legal entity your business is operated through. Businesses may be operated as any of the following:
- Traditional "C" Corporation
- S Corporation
- Single-Member Limited Liability Company, taxed as a sole proprietorship
- Limited Liability Company with multiple owners, taxed as a corporation or partnership
- General Partnership
- Sole Proprietorship
Each legal entity has unique tax advantages and disadvantages, depending upon the nature of the business. Let's answer this question, legal entity by legal entity.
There would be no long-term capital gains tax on the sale, but there would be regular corporate income tax if a profit is realized on the house. The reason: C corporations do not have any preferential capital gains tax rates available to them. Generally, all of the income recognized by a business operating through a traditional C corporation is taxed at the corporate income tax rate – a flat 21%, as of 2018. Any asset sale by a corporation to a shareholder would be taxed if there were a gain on the sale, including a house.
Furthermore, the sales price must represent what is called an arm's length price, meaning it represents what an independent third party would pay for the home. No charging yourself $100 for a 25,000 square-foot residence with swimming pool and three-car garage, in other words If the sales price of the home was determined to be not at arm's length by the IRS, then there are a host of distribution-related issues that could apply.
The sale of a house by an S corporation to one of its shareholders would be treated as a long-term capital gain (if the corporation owned the house for more than one year). An S corporation generally does not pay any income tax; all items of income and loss are passed through to the individual shareholders. So, this gain would be passed through to the respective shareholder and who must report it on his or her individual income tax return. here are other issues, such as depreciation recapture if the house were used for a business purpose.
Single-Member LLC and Sole Proprietorship
Single-member LLCs and sole proprietorships are taxed the same way at the federal level. If the house were used for business purposes and was owned by an LLC (that is, the title was in the name of the LLC) then the gain on the sale would have to be reported by the owner of the LLC on his or her individual income tax return. If the house were owned more than one year by the LLC, then the owner would treat the gain as a long-term capital gain.
With respect to a sole proprietorship, the house can only be titled in the name of the individual who operated the sole proprietorship. Since title does not change, there is no sale and no capital gains issue until the individual sells the house to an independent third party. Depreciation recapture rules would apply if the house were used by the business whether an LLC or sole proprietorship.
LLC with Multiple Owners, Taxed as a Corporation
The rules that apply to a corporation would be identical in this scenario, meaning any long-term capital gain would be taxed only within the LLC.
LLC with Multiple Owners, Taxed as a Partnership and General Partnership
Partnerships are similar to S corporations in that the individual items of income and loss are not taxed within the partnership, but are passed through to the individual partners and taxed on their individual income tax returns. Thus, any sale of a house by the partnership would be taxable to the individual partners, and not the partnership. If the partnership owned the house for more than one year, then the gain would be eligible for the long-term capital gains tax rate, which is currently 15%.
The Bottom Line
The real troublesome issue with respect to a house owned by a business is the loss of the home sale exclusion. This provision allows homeowners who sell their primary residence to exclude much the gain from taxation ($250,000 if single; $500,000 if married filing jointly). When the house is owned by a business this home sale exclusion is lost, as in any tax transaction, it goes without saying that individuals need to seek the advice of a CPA or tax attorney.
See also: "Should You Incorporate Your Business?"
- Traditional "C" Corporation
Do non-U.S. citizens living outside the U.S. pay taxes on money earned through a U.S. internet broker?A:
The tax implications for a foreign investor will depend on whether that person is classified as a resident alien or a non-resident alien. To be considered a non-resident alien, a person must meet several guidelines. First of all, the person cannot have had a green card at any time during the relevant tax reporting period and cannot have resided in the U.S. for more than 183 days in the past three years, including the current reporting period.
However, non-U.S. citizens who hold green cards and have been in the U.S. for at least 31 days during the current year and more than 183 days in the past three years are classified as resident aliens for tax purposes and are subject to different guidelines than non-resident aliens.
If you fall under the non-resident alien category and the only business you have in the U.S. is in investments (stocks, mutual funds, commodities, etc.) held with a U.S. dollar-denominated brokerage firm or other agent, you are subject to the following tax guidelines.
In terms of capital gains, non-resident aliens are subject to no U.S. capital gains tax, and no money will be withheld by the brokerage firm. This does not mean, however, that you can trade tax free – you will likely need to pay capital gains tax in your country of origin.
In terms of dividends, non-resident aliens face a dividend tax rate of 30% on dividends paid out by U.S. companies. However, they are excluded from this tax if the dividends are paid by foreign companies or are interest-related dividends or short-term capital gain dividends. This 30% rate can also be lower depending on the treaty between your home country and the U.S., so it is important that you contact your brokerage firm to verify the rate.
If you are a resident alien and hold a green card or satisfy the resident rules (183 days), you are subject to the same tax rules as any U.S. citizen.
For more information, see "IRS Publication 515: Withholding of Tax on Nonresident Aliens and Foreign Entities."
Do nonprofit organizations pay taxes?A:
Section 501 of the Internal Revenue Service (IRS) tax code exempts qualified nonprofit organizations from federal taxes. A nonprofit organization is an organization that engages in activities for both public and private interest without pursuing the goal of commercial or monetary profit. To be exempted from federal taxes, nonprofit organizations have to meet certain rules. Some of these rules include:
- Being organized and operated exclusively for charitable, scientific, religious or public safety purposes.
- Collecting income and turning over entire amount less expenses to organizations or individuals who are lawfully recognized as legitimate charities.
If a nonprofit organization engages in activities that are unrelated to their basic purpose, they are required to pay income taxes on that money. For example, if nonprofit organization ABC was formed to provide shelter for the homeless and it makes some money selling bicycles, that income may be eligible for income tax purposes.
Nonprofits are also exempt from paying sales tax and property taxes. While the income of a nonprofit organization may not be subject to federal taxes, nonprofit organizations do pay employee taxes (Social Security and Medicare) just like any for-profit company. To learn more about tax issues for nonprofit organizations, go to the IRS website. (Learn more about nonprofit financial statements in "Navigating Government And Nonprofit Financial Statements.")
- Being organized and operated exclusively for charitable, scientific, religious or public safety purposes.
Do tax liabilities appear in the financial statements?A:
Taxes appear in some form in all three of the major financial statements: the balance sheet, the income statement and the cash flow statement. Deferred income tax liabilities can be included in the long-term liabilities section of the balance sheet. A deferred tax liability is a liability that is due in the future. Specifically, the company has already earned the income, but it will not pay taxes on that income until the end of the tax year. Long-term liabilities are payable in more than 12 months.
Sales tax and use tax are usually listed on the balance sheet as current liabilities. They are both paid directly to the government and depend on the amount of product or services sold because the tax is a percentage of total sales. The sales tax and use tax depend on the jurisdiction and the type of product sold. These taxes are generally accrued on a monthly basis. Any expense that is payable in less than 12 months is a current liability.
The income statement, or profit and loss statement, also lists expenses related to taxes. The statement will determine pre-tax income and subtract any tax payments to determine the net income after taxes. Using this method also allows companies to estimate their income tax liabilities.
The cash flow statement also includes information on tax expenses. It is listed as "taxes payable" and includes both long-term and short-term tax liabilities. When taxes are paid during the cash flow period reflected in the statement, then this change is shown as a decrease in taxes payable.
Does QVC charge sales tax?A:
QVC, an American TV network, is registered with states to collect sales or use tax on taxable items. QVC is also required by most states to tax shipping and handling costs. After collecting sales taxes from a customer, QVC remits them to the tax authority in the state where the customer resides.
QVC is a wholly owned subsidiary of Liberty Interactive Corporation. QVC was founded in 1986 as a TV network that to this day specializes in providing a home shopping experience over cable, satellite and broadcast TV networks. Currently, QVC broadcasts its televised shopping shows to six countries and over 235 million households. QVC shopping shows are led in an entertaining way by over 20 hosts from diverse backgrounds. In 2009, QVC began offering a high-definition feed of its channels.
Purchases on QVC
QVC offers its customers an easy and convenient ordering process. Customers can place their orders through the QVC website, automated ordering, mobile services or a customer service representative.
Customers can view and purchase all items shown over QVC's TV network through QVC.com. Also, QVC offers 24/7 automated ordering, where customers can call a specific phone number and order their items using known item numbers. Customers can also place their orders using their mobile devices through QVC applications available on iPad, iPhone, BlackBerry or Android. Finally, customers can call and speak with a customer service representative, who can assist them in placing orders. Like any other merchant that ships goods ordered online or over the phone, QVC must collect state sales tax from its customers.
Does the tradeoff model or the pecking order play a greater role in capital budgeting?A:
The static trade-off theory and the pecking order theory are two financial principles that help a company choose its capital structure. Both play an equal role in the decision-making process depending on the type of capital structure the company wishes to achieve. The pecking order theory, however, has been empirically observed to be most used in determining a company's capital structure.
The static trade-off theory is a financial theory based on the work of economists Modigliani and Miller. With the static trade-off theory, and since a company's debt payments are tax deductible and there is less risk involved in taking out debt over equity, debt financing is initially cheaper than equity financing. This means a company can lower its weighted average cost of capital (WACC) through a capital structure with debt over equity. However, increasing the amount of debt also increases the risk to a company, somewhat offsetting the decrease in the WACC. Therefore, the static trade-off theory identifies a mix of debt and equity where the decreasing WACC offsets the increasing financial risk to a company.
The pecking order theory states that a company should prefer to finance itself first internally through retained earnings. If this source of financing is unavailable, a company should then finance itself through debt. Finally, and as a last resort, a company should finance itself through the issuing of new equity. This pecking order is important because it signals to the public how the company is performing. If a company finances itself internally, it means it is strong. If a company finances itself through debt, it is a signal that management is confident the company can meet its monthly obligations. If a company finances itself through issuing new stock, it is normally a negative signal, as the company thinks its stock is overvalued and it seeks to make money prior to its share price falling.
How and where is revenue recognized from barter transactions?
Not all transactions of goods or services involve a monetary medium, such as dollars. Sometimes, companies exchange saleable goods for each other, an act that is considered a barter trade. This type of transaction presents a problem to accountants: Should the revenue be recorded based on the fair market value of the good traded? What forms are you required to fill out for tax purposes?
The Internal Revenue Service has ruled that companies and individuals must include the fair market value of all received goods and services exchanged for all provided goods and services – in short, you need to keep track of the value of barter transactions.
Example: Internet Advertising Space
One common contemporary example of barter transaction involves two different Internet companies that exchange ad space on each other's websites.
Both ad spaces have a market value, though they are not necessarily the same. Moreover, the value of ad space fluctuates rapidly, which can sometimes lead to difficult estimations for their value. In 1999, an FASB task force ruled that revenue needs to be reported only if the fair market value of the ad space given up is determinable based on the company's history of receiving cash (or a good readily convertible to cash) for similar ad space.
If your company usually received $100 for an ad space and then barters away a similar ad space, the IRS wants to see that transaction recognized as earning $100 in revenue.
Recording Barter Revenue
Barter revenue is accounted for, in dollars, on IRS Form 1040, Schedule C, Profit or Loss from Business. In some cases, it could also be recorded in Schedule C-EZ, Net Profit from Business (also in IRS Form 1040).
In a standard journal entry, a barter exchange account is treated as an asset account, and the bartering revenues are treated as income items. In the example given above, the barter exchange account would be debited $100 and barter revenues would be credited $100.
If a company fails to record a bartering expense properly, it can correct its return by filing a Form 1040X with the IRS.
Barter Exchange vs. Trading Services
The IRS differentiates between trading services between two parties on a non-commercial basis and the act of using a saleable business goods or services in an barter exchange, as described above.
If a company or person simply trades services, the IRS sometimes requires a Form 1099-MISC.
If a company or person engages in barter exchange, a Proceeds From Broker and Barter Exchange Transactions, also known as a Form 1099-B, must be filed.
A comprehensive resource for the tax treatment of barter transactions and revenue accounting can be found in IRS Publication 525, Taxable and Nontaxable Income.
How are an employee's fringe benefits taxed?A:
Common fringe benefits provide employees total compensation above and beyond stated wages or salaries, and a wide range of fringe benefits are offered from employers. To take advantage of an employer’s fringe benefits in the most effective way, it is important for employees to understand how common fringe benefits are considered for taxation purposes.
Taxable Fringe Benefits
Any fringe benefit offered as a bonus to an employee from an employer is considered taxable income, unless it falls under a specific list of excluded benefits as determined by the IRS. Taxable fringe benefits must be included on an employee’s W-2 each year, and the fair market value of the bonus is subject to withholding.
The most common fringe benefits considered a taxable part of total compensation include reimbursement for mileage expenses that exceed the limitations provided by IRS guidelines, relocation expenses for an employee who moves for employment that is less than 50 miles away, and reimbursement of education or tuition expenses that are not directly related to job performance or are in excess of stated IRS limits. In addition, a bonus that falls under the category of a working conditions benefit, such as a mobile phone or company car, is considered taxable if used outside of business.
Fringe Benefits Excluded From Taxation
Although some fringe benefits are considered a part of taxable income for employees, a lengthy list of common fringe benefits are excluded from an employee’s taxable compensation. First, fringe benefits that fall under the definition of de minimis benefits are not taken into consideration when determining taxable income. De minimis benefits are those that hold such a minimal amount of value that employers would have a difficult time accounting for them. For instance, a gift card given to an employee for a holiday or birthday is considered a de minimis benefit, as are refreshments or snacks provided during a business meeting.Typically meals are not considered a taxable fringe benefit for employees, although certain qualifications must be met. Employers buying lunch or dinner for employees must provide the meal on business grounds, and it must be offered to the benefit of the employee. This means a meal could be a tax-free benefit to employees when offered during a lengthy meeting or during required overtime.Other fringe benefits not considered taxable to employees include health insurance up to a maximum dollar amount; dependent care; group term life insurance; qualified benefits plans such as profit sharing or stock bonus plans; commuting or transportation benefits; employee discounts; and working condition benefits only used for business purposes.
Employers offer a wide range of fringe benefits as a recruitment or retention strategy, and these benefits can make up a substantial portion of an employee’s total compensation. To fully compare benefits packages between employers, however, it is important to understand how common fringe benefits are taxed.
How are capital gains and dividends taxed differently?A:
Dividends are income earned by investing in stocks, mutual funds or exchange-traded funds, and they are included in your tax return on Schedule B, Form 1040. Capital gains are the amount an asset increases in value between when it is purchased and when it is sold. The U.S. tax code gives similar treatment to dividends and short-term capital gains, and qualified dividends and long-term capital gains, respectively.
Ordinary dividends and short-term capital gains, those on assets held less than a year, are subject to one's income tax rate. However, qualified dividends and long-term capital gains benefit from a lower rate. Qualified dividends are those paid by domestic or qualifying foreign companies that have been held for at least 61 days out of the 121-day period beginning 60 days prior to the ex-dividend date.
In the case of qualified dividends and long-term capital gains, as of 2018, individuals in the 10% to 15% tax bracket are still exempt from any tax. Investors who fall in the middle brackets—25%, 28%, 33%, or 35%—pay 15% at most in capital gains. The highest earners, in the 39.6% bracket pay 20% in capital gains (plus 3.8% net investment income tax, per the Patient Protection and Affordable Care Act.)
So, although dividends and capital gains are different types of investment income, they receive similar treatment at tax time. (For related reading, see: Investment Tax Basics for All Investors.)
How are effective tax rates calculated from income statements?A:
Income statements offer a quick overview of the financial performance of a given company over a specified period of time, usually annually or quarterly. On an income statement, you can view revenues, gross margins, after-tax earnings and overhead costs, which is a litany of useful information.
A company does not provide its actual percentage rate of taxation on the income statement. Expense from taxes is usually the last line item before net income calculation, and you can figure out the effective tax rate using the rest of the information on the statement.
Calculating Effective Tax Rate
The effective tax rate is the average tax rate paid by the company on its earned income. Locate net income on the company's income statement (this line may sometimes read "earnings"). Net income shows how much revenue a company is able to keep after deducting taxes, and the two preceding line items should identify both revenue and taxes paid.
The most straightforward way to calculate effective tax rate is to divide the income tax expenses by the earnings (or income earned) before taxes. For example, if a company earned $100,000 and paid $25,000 in taxes, the effective tax rate is equal to 25,000 ÷ 100,000 or 0.25. In this case, you can clearly see that the company paid an average rate of 25% in taxes on income.
Significance of Effective Tax Rate
Effective tax rate is one ratio that investors use as a profitability indicator for a company. This amount can fluctuate, sometimes dramatically, from year to year. However, it can be difficult to immediately identify why an effective tax rate jumps or drops. For instance, it could be that a company is engaging in asset accounting manipulation to reduce a tax burden, rather than a change reflecting operational improvements.
Also, keep in mind that companies often prepare two different financial statements; one is used for reporting, such as the income statement, and the other is used for tax purposes. Actual tax expenses may vary in these two documents.
How are trust fund earnings taxed?A:
Trust funds are taxed differently, depending on the type of fund they are.
A trust that distributes all its income is considered to be a simple trust; otherwise the trust is said to be complex. A tax deduction is made for income that is distributed to beneficiaries. In this case, the beneficiary pays the income tax on the taxable amount, rather than the trust.
The amount distributed to the beneficiary is considered to be from the current-year income first, then from the accumulated principal. This is usually the original contribution plus subsequent ones and is income in excess of the amount distributed. Capital gains from this amount may be taxable to either the trust or the beneficiary. All the amount distributed to and for the benefit of the beneficiary are taxable to him or her to the extent of the distribution deduction of the trust.
If the income or deduction is part of change in the principal or part of the estate's distributable income, then income tax is paid by the trust and not passed on to the beneficiary. An irrevocable trust that has discretion in distribution of amounts and retains earnings pays trust tax that is 35% of annual income over $12,700.
The K-1 schedule for taxing distributed amounts is generated by the trust and handed over to the IRS. The IRS, in turn, delivers the document to the beneficiary to pay the tax. The trust then completes Form 1041 to determine the income distribution deduction that is accorded on the distributed amount.
How are yields taxed on a certificate of deposit (CD)?A:
Certificates of deposit (CDs) are popular savings vehicles for investors who are seeking a steady return that is not tied to stock market performance. A CD is typically issued by a bank or credit union and pays interest on deposited funds in return for leaving that money in the account for a specific term, ranging from a few months to several years (one, three or five years are the most common). CDs often pay higher interest rates than those paid offered by checking, savings or money market accounts.
But there is a price to pay for that higher Interest. Regardless of how it's paid out to the investor – usually, it goes into another account or is reinvested back into the certificate – the money is considered taxable on both state and federal levels. And that amount is taxed as interest income, not at the (usually) more favorable capital gains rate. In, 2018, for example, if an investor is in the 24% tax bracket and has earned $300 in CD interest for the year, he or she owes $72 in taxes.
The bank or credit union that issued the CD provides the owner of the account with a 1099-INT statement detailing how much interest was earned annually. On CDs purchased that mature in the same year, all credited interest is taxable for that year. For multiyear CDs, only the interest credited each year is taxable. For example, if a three-year CD pays accrued interest on the last day of each year, the account holder pays taxes only on the interest earned for each tax year.
There's no getting around paying tax on the interest – unless the CD is purchased in a tax-advantaged account such as an individual retirement account (IRA) or 401(k) plan. In this case, the same rules of tax deferral that apply to an IRA are applied to the CD. Although interest is being earned, no 1099-INT is issued until distributions are taken from the account, presumably during retirement when the investor is in a lower tax bracket.
In addition to earned interest, penalties for early withdrawals (that is, prior to the CD's maturity) are included on Form 1099-INT. In the event of this type of penalty, CD holders can deduct the amount charged from earned interest to reduce their tax obligation.
A CD is considered a low-risk investment. But while they're safe from loss, individuals need to be aware of how taxes may impact the total return they realize on the certificate.
How can a trust lower federal transfer tax liability?A:
A trust is an arrangement in which an individual or entity controls property or funds on behalf of someone else without actually owning them. This can be done for tax purposes or to ensure the depositor's wishes are carried out. For example, a deceased grandparent can give a gift to a favorite grandchild when the grandchild turns 18. This can be done by placing $10,000 into a trust, which is managed by a third individual with the age stipulation included in the agreement. (To learn more about these trusts, see Pick The Perfect Trust and Establishing A Revocable Living Trust.)
Trusts can be used in this way to reduce taxes when transferring property or funds. In an estate transfer to a surviving spouse, there are unlimited deductions, so taxes are not an issue. However, if the second spouse dies several years later and the combined estate that is transfered to the children turns out to be larger than the current exemption level, then a trust can help reduce federal estate taxes. By placing the first spouse's estate into a trust in which the manager is the second spouse, the estate of the first spouse is never actually transferred. Because there is no transfer, the second spouse's estate is separate from the trust when given to the children after death. If both the trust and the estate are under the exemption level, then there are federal tax savings.
For example, let's assume Joe and Beth are married and each holds an estate value of $3 million. Let's also assume the estate transfer exemption amount is $3.5 million where they live. Without a trust, if Joe dies and transfers his estate to his wife, then Beth is left with an estate worth $6 million. If Beth dies, the $6 million transfer will exceed the exemption level and taxes will be levied. If, on the other hand, Joe places his estate into a trust for his children, the trust would be independent of Beth's estate. As such, Beth could live off the funds in the trust until she died, then transfer her $3 million estate and the $3 million trust to the children, thus eliminating the tax burden. (For more on estate planning, check out Six Estate Planning Must-Haves and The Importance Of Estate And Contingency Planning.)
How do externalities affect equilibrium and create market failure?A:
Externalities, or consequences of an economic activity, lead to market failure because a product or service's price equilibrium does not accurately reflect the true costs and benefits of that product or service. Equilibrium, which represents the ideal balance between buyers' benefits and producers' costs, is supposed to result in the optimal level of production. However, the equilibrium level is flawed when there are significant externalities, creating incentives that drive individual actors to make decisions which end up making the group worse off. This is known as a market failure.
When negative externalities are present, it means that the producer does not bear all costs, resulting in excess production. With positive externalities, the buyer does not get all the benefits of the good, resulting in decreased production. An example of a negative externality is a factory that produces widgets but pollutes the environment in the process. The cost of the pollution is not borne by the factory, but instead shared by society.
If the negative externality is taken into account, then the cost of the widget would be higher. This would result in decreased production and a more efficient equilibrium. In this case, the market failure would be too much production and a price that didn't match the true cost of production, as well as high levels of pollution.
An example of a positive externality would be education. Obviously, the person being educated benefits and pays for this cost. However, there are positive externalities beyond the person being educated, such as a more intelligent and knowledgeable citizenry, increased tax revenues (from better-paying jobs), less crime and more stability. All of these factors positively correlate with education levels. These benefits to society are not accounted for when the consumer is considering the benefits of education.
Therefore, education would be underconsumed relative to its equilibrium level if these benefits are taken into account. Clearly, public policymakers should look to subsidize those markets with positive externalities and punish those with negative externalities.
One obstacle for policymakers, though, is the difficulty of quantifying externalities to increase or decrease consumption or production. In the case of pollution, policymakers have tried tools, including mandates, incentives, penalties and taxes, that would result in increased costs of production for companies that pollute. For education, policymakers have looked to increase consumption with subsidies, access to credit and public education.
In addition to positive and negative externalities, some other reasons for market failure include a lack of public goods, underprovision of goods, overly harsh penalties and monopolies (see also "How Does a Monopoly Contribute to Market Failure?"). Markets are the most efficient way to allocate resources with the assumption that all costs and benefits are accounted into price. When this is not the case, significant costs are inflicted upon society, as there will be underproduction or overproduction.
Being cognizant of externalities is one important step in combating market failure. While price discovery and resource allocation mechanisms of markets need to be respected, market equilibrium is a balance between costs and benefits to the producer and consumer. It does not take third parties into effect. Thus, it is the policymakers' responsibility to adjust costs and benefits in an optimal way.
How do I calculate my effective tax rate using Excel?A:
Your effective tax rate can be calculated using Microsoft Excel through a few standard functions and an accurate breakdown of your income by tax bracket. Most of the legwork actually involves looking up the Internal Revenue Service, or IRS, tax brackets and segregating your taxable income into the correct cells.
IRS Tax Brackets
Every year, the IRS announces its tax brackets, standard deduction amounts and cost-of-living adjustments. Any announced changes are effective the following Jan. 1.
If you are preparing your 2015 tax returns in March 2016, you do not apply the announced 2016 rates. You will still apply the prior year's (2015) rates; those should have been announced in 2014.
Segregating Earned Income
For simplicity's sake, imagine that the tax brackets were divided into 10% increments every $25,000 of earned income. You made $80,000 during the year. The following tax rates would apply: 10% for the first $25,000, 20% for $25,001 to $50,000; 30% for $50,001 to $75,000 and 40% for $75,001 to $80,000.
Create a different cell for each income tax rate and multiply it by the amount of income you have in each bracket: $25,000 times 10% for the first, $5,000 times 40% for the last, and so on. This is your lost income per bracket.
Finding Your Effective Rate
In the above scenario, your marginal tax rate would be 40%. This is because the government will confiscate 40 cents out of every dollar that you earn above $80,000.
Your effective tax rate is different. It averages the amount of taxes you paid on all of your income. To calculate this rate, take the sum of all your lost income and divide that number by your earned income.
In the above case, the government has taken a total of $17,000 ($2,500 + $5,000 + $7,500 + $2,000). With an income of $80,000, your effective rate would be 21.25% ($17,000 / $80,000).
How do you file IRS Form 709?A:
The Internal Revenue Service (IRS) Form 709 is used to report gifts and transfers subject to the federal gift tax and some generation-skipping transfer taxes. The following is a description of how to file IRS Form 709.
When the Form Is Required and Who Needs to File
Technically, whenever a person gives a gift to another person, such as a birthday gift, the rules of gift taxes must be followed. If the person giving the gift is a U.S. citizen, he or she must file Form 709 if the gifts given total $14,000, or more, as of 2016. This does not apply if the gifts are given to a spouse. This also does not apply for gifts given to charities and deducted as such.
Three types of transfers are not subject to the gift tax and do not require Form 709. These are transfers to political institutions, payments that qualify for the education exclusion and payments that qualify for the medical exclusion.
Spouses are not allowed to file a joint Form 709. Each individual required to file Form 709 must file his or her own. Nonresident noncitizens may also be required to file Form 709 under certain circumstances. There are other details regarding who must file, but the above are the general cases. Full details are available on the IRS website. Also, the donor of the gift is responsible for paying the tax, not the receiver of the gift.
How to File Form 709
There are 10 basic steps required for filling out Form 709. It is highly recommended to go on the IRS website for the latest up-to-date details on each of these steps.
Step One: Determine if filing Form 709 is required. The above statements provide a good idea if the form should be filed, but confirm that on the IRS website.
Step Two: Determine what gifts need to be reported on Form 709 if filing is necessary.
Step Three: If the person giving the gifts has a spouse, determine if the two people would prefer to split the gifts and filing requirements. It is best to seek out a tax professional or Certified Public Accountant (CPA) for the answer to this question.
Step Four: Complete the general information part of the form, which is located in part one.
Step Five: Detail the gifts line by line on Schedule A "Computation of Taxable Gifts" for parts one, two and three of the form.
Step Six: If applicable, complete Schedule B "Gifts from Prior Periods," Schedule C "Deceased Spousal Unused Exclusion Amount" and Schedule D "Computation of Generation-Skipping Transfer Tax."
Step Seven: If the gift is listed on part two or three of Schedule A, complete Schedule D.
Step Eight: Complete Schedule A, part four, "Taxable Gift Reconciliation."
Step Nine: Complete part two of the first page of Form 709, "Tax Computation."
Step 10: Sign and date the form.
How does an entrepreneur pay taxes?A:
In the United States, tax policy neither officially defines nor makes special rules for entrepreneurs. Certain types of entrepreneurial activities carry tax benefits, such as subsidies or write-offs, but these do not uniformly apply to all entrepreneurs in the economy. An entrepreneur only pays taxes in accordance with his business activity. All other aspects of tax payment – from filing to withholding to receiving a refund – are the same for those considered entrepreneurs as those who are not.
Entrepreneurial Activity and Taxes
Economists at the National Bureau of Economic Research published a paper in 2002 titled "Taxes and Entrepreneurial Activity: Theory and Evidence in the U.S." The paper provided a theoretical proof that taxes affect economic activity and change the incentive structure for existing and potential entrepreneurs. Their research focused on the differences in tax rates between business income and wage income, and how profits and losses are treated. It concluded by reinforcing the intuitive notion that tax laws change human behavior in meaningful ways.
This type of research shows that taxes change the scope of entrepreneurial activity in the U.S., even though entrepreneurs are not taxed differently. Ostensibly, tax laws inform where entrepreneurs attempt to make changes in the economy and alter the types of external benefits or costs that entrepreneurs produce.
Entrepreneurs and Business Taxes
The notion of an entrepreneur is normally associated with new startup businesses. The tax rules for businesses are very different than the tax laws for individuals. However all taxpayers, entrepreneurs or not, are incentivized to pay as few taxes as possible to maximize their economic gains, whether they file income through businesses or as individuals.
To that extent, it is a misnomer to suggest that entrepreneurs are faced with different tax consequences than non-entrepreneurs. The same goes for individuals and businesses. It may very well be that entrepreneurs are more likely (on average) to pursue a minimum-tax strategy, but the underlying principles and methods are no different.
How does the marginal tax rate system work?A:
The marginal tax rate is the rate of tax income earners incur on each additional dollar of income. As the marginal tax rate increases, the taxpayer ends up with less money per dollar earned than he or she had retained on previous earned dollars. Tax systems employing marginal tax rates apply different tax rates to different levels of income; as income rises, it is taxed at a higher rate. It is important to note, however, the income is not all taxed at one rate but at many rates as it moves across the marginal tax rate schedule.
The goal of the marginal rate is to place the burden of supporting government on the shoulders of taxpayers more financially able to do so, versus spreading the burden evenly to the detriment of taxpayers not able to afford any more, while attempting to balance the problems of a straight progressive rate.
Flat Tax System
The other tax system used in modern economics is flat taxes. With flat taxes, the rate does not change, regardless of the individual's income. No matter how much a person makes, he or she will be taxed at the same percentage. Supporters of flat taxes argue that this system is fair because it taxes all individuals and businesses at the same rate, rather than taking into account the levels of their income. Flat tax systems usually do not allow deductions. This form of taxation is often associated with countries that have a rising economy, but there is little evidence to support flat tax as the sole cause of growth.
Marginal Tax Rate Example
The above is a simple example of a marginal tax rate schedule. It illustrates the rate at which various levels of income are taxed. As income rises, each dollar of income above the previous level is taxed at a higher rate. If a taxpayer earns more money and moves into a higher income level, marginal tax rates can significantly diminish the benefit of the additional income because it will be taxed at a higher rate. As a result, some believe marginal tax rates are harmful to the economy because they discourage people from working harder to earn more money. Although earning more money may increase the income tax rate, a larger income will still be taxed at more than one level. The chart below illustrates how marginal tax rate works.
As the graph shows, it may be best to think of the example in terms of income growing from $0 to $120,000. As it moves toward $120,000 it incurs different tax rates. Therefore, income between $0 and $20,000 is taxed at 10%, so the tax owed is $2,000 ($20.000 x 10%). Then income moves into a new marginal tax rate (20%). As it grows above $20,000, the $120,000 income earner owes $4,000 in tax ($20,000 x 20%) for this portion of income in addition to the $2,000 of tax incurred on the first $20,000. This is done at each income level up to the taxpayer's total income, in this case, $120,000. Based on the tax rate schedule above, the $120,000 income earner pays a total of $38,000 in taxes based on the marginal tax rate system.
This example also illustrates not all of this taxpayer's income is taxed at the same rate. Therefore, only $2,000 of tax is owed at the lowest income level, while $6,000 of tax is incurred at the third level on the same amount of money ($20,000). Many people are confused by marginal tax rates, believing the rate at which they will be taxed is a flat rate based on the income level into which they fall. According to this incorrect assumption, a $120,000 income would be taxed at a 50% rate, making the amount of tax owed $60,000.
(For additional reading, see: Tax Tips For The Individual Investor.)
How important are contingent liabilities in an audit?A:
Contingent liabilities, when present, are very important audit items because they normally represent risks that are easily misunderstood or dismissed. For companies in the United States, the Financial Accounting Standards Board, or FASB, sets specific criteria for how contingent liabilities are to be assessed, disclosed and audited. Auditors are expected to apply recognition, measurement and disclosure criteria per FASB accounting standards codification.
Importance of Proper Contingent Liability Disclosure
Contingent liabilities are those future expenses that might occur. Common examples include lawsuits, warranties on company products and unsettled taxes. Because of the risks they impose and the increased frequency with which they occur in contemporary finance, contingent liabilities should be carefully considered by every private and government auditor. Credit rating agencies, creditors and investors rely on audits to expose hidden risks to counterparties. The opposite risk is also present. A company might overstate its contingent liabilities and scare away investors, pay too much interest on its credit or fail to expand sufficiently for fear of loss.
Importance of Audits
Audits protect the integrity of financial information. Trust, reputation and fair dealings are crucial elements in any business transaction, but they are even more important when dealing with securities and large loans among parties without working relationships. The auditor keeps an eye on undisclosed contingent liabilities. If the company's claims are confirmed and shown to be reasonable, the auditor can then validate the information presented to the public. If, for whatever reason, some liabilities were listed incorrectly or left out or if taxes were not properly disclosed, the auditor is responsible for correcting those errors and alerting the proper authorities.
Reviewing Contingent Liabilities in an Audit
An auditor should never assume company management has always disclosed all contingent liabilities. This is particularly true with legal expenses and unsettled taxes. Auditors have the authority to review all Internal Revenue Service, or IRS, reports for possible undisclosed tax liabilities. All legal expenses are to be accompanied by supporting documents.
An auditor may not always be a sufficient legal authority on a specific topic to understand the likelihood of the expense. Also, the legalese may be written to be intentionally obtuse. In such cases, the auditor can review precedent or consult with an expert before making a ruling on possible contingencies.
Materiality and Likelihood
For contingent liabilities, a possible expense is only material if it represents a significant impact on the company's finances. For example, a $1,000 liability is not material for Berkshire Hathaway even if it had a 95% chance of occurring. Once materiality is determined, it is up to the company, first, and the auditor, second, to determine if the contingent liability's realization is remote, reasonably possible or probable.
The FASB allows auditors to use their best judgment when deciding between the three levels of likelihood. Large contingent liabilities can dramatically affect the expected future profitability of a company, so this judgment should be wielded carefully. All important footnotes need to be added to the balance sheet.
How is residual value of assets taxed?A:
Residual value has several meanings, each with its own potential tax consequences. Tax laws vary between jurisdictions, so taxes on residual values vary as well. Generally speaking, residual value is taxable whenever it represents a net gain in an economic transaction. For example, residual value is taxable if a company sells an asset for a profit or if a car lessee purchases a vehicle at the end of the lease.
Meanings of Residual Value
The most common accounting usage of residual value is the asset's cost less any allowable depreciation. Though sometimes conflated, this residual value is not identical to scrap value, or salvage value, which equals an asset's proceeds minus any disposal costs.
Another possible meaning of residual value involves leased assets, such as a car. In these cases, residual value represents the leased object's fair market value after the term expires. Leased value can be guaranteed or nonguaranteed.
Taxation of Residual Values
Residual value and salvage value are both taxable in some cases. This occurs whenever these values have not been considered for depreciation. In this case, the assets eventually have a book value of zero at the end of their useful life. If a company sells an asset with a residual value greater than its book value, the company has to pay taxes on the profits of the sale. For a leased asset, residual value often forms the tax base if the lessee decides to purchase it after the lease terms end. Sales tax laws vary from state to state, but it is not uncommon for the sales tax to be assessed based on residual value.
How is taxation treated for both the parent and subsidiary company during a spinoff?A:
A common separation strategy used by corporations includes divestiture activities that segment a portion of a company's operations, resulting in a new corporate entity. Also known as a spinoff, a business has the ability to create a new company that conducts separate operations from the parent company, which may prove to be more beneficial to its shareholders in terms of long-term profitability. Spinoffs may also take place in an effort to reduce potential regulatory issues with the parent company, to enhance the company's competitive advantage or to diversify the corporation's investment portfolio. The new entity established during a spinoff is known as the subsidiary company and in most cases it is still owned by the shareholders of the parent business. Corporations implement a spinoff of the business in lieu of selling a portion of operations in an effort to avoid debilitating corporate taxation on the transaction.
Taxation of the Parent Company
Under the Internal Revenue Code Section 355, most parent companies can avoid taxation on spinoff activity because no funds are provided in exchange for ownership. Instead, a spinoff involves the distribution of company stock of the subsidiary entity from the parent company on a pro rata basis to shareholders, making the same shareholders of the parent company owners of the subsidiary. No cash is exchanged when the subsidiary is formed in a spinoff, and as such, no ordinary income or capital gains taxes are assessed.
Taxation of the Subsidiary
Similar to the parent company tax benefits experienced in a spinoff, the subsidiary company can also avoid taxation during the transaction. Because the shareholders of the subsidiary company receive stock on a pro rata basis from the parent company in lieu of cash for sale of the company, ordinary income and capital gains taxes are not applicable. Instead, the owners of the parent company become the owners of the subsidiary through the transfer of shares as a more cost-effective alternative than receiving compensation for the new company through a stock dividend.
IRC Section 355 requires that the parent company and the subsidiary must meet stringent requirements to maintain the tax-free benefits of a spinoff, however. A spinoff remains a non-taxable event when the parent company retains control over at least 80% of the newly formed entity's voting shares and nonvoting stock classes. Additionally, both the parent and subsidiary companies are required to maintain engagement in the trade or business of the companies that had been conducted during the five years prior to the spinoff taking place. A spinoff may not be used solely as a mechanism for distributing profits or earnings of the parent or subsidiary companies, and the parent company may not have taken control of the subsidiary in a similar manner in the past five years of operations. If the parent or subsidiary does not meet the requirements set out in IRC Section 355, a spinoff is considered taxable to both parties at the applicable corporate tax rates.
How Much Does a Dependent Reduce Your Taxes?A:
Each qualified dependent you claim on your federal income tax form can reduce your taxable income by $4,050 for the tax year 2017. In addition to providing a means of reducing your total taxable income by thousands of dollars, having qualified dependent children may also allow you to claim significant tax credits, including the earned income credit (EIC) and child tax credit.
The EIC and child tax credits combined can reduce your tax liability by almost $10,000 if you have three dependent children. The child tax credit is $1,000 per qualifying child, and the EIC as of 2017 ranges from $3,400 for one qualifying child, up to a maximum of $6,444 for three or more children. The EIC is adjusted annually for inflation. It is based on your income, whether you are filing jointly or individually, and how many qualifying children you are claiming. The highest adjusted gross income you can have is $48,340 if you file individually, or $53,930 if you file jointly, with three children.
To get an idea of how much dependent children can reduce tax liability, consider a married couple filing jointly, with a total annual income of $50,000, who have two qualifying children. Claiming the two children as dependents reduces their taxable income to $41,900. The EIC then provides a tax credit of $5,616, and the child tax credit provides an additional $2,000 credit, bringing their taxable income down to $34,284.
A qualified dependent for tax purposes can be either a qualifying child or another qualifying relative (the child tax credit and EIC may not apply to other qualifying relatives). A qualified dependent must either be a citizen or resident of the United States, or a resident of Canada or Mexico. In addition, you cannot claim someone as a dependent if he files his own tax form on which he takes a personal exemption for himself or on which he claims dependents. Anyone who is married and filing a joint return may not be claimed as a dependent. (For related reading, see: How to Claim a Dependent on Your Tax Return.)
How much will it cost to hire an accountant to do my taxes?A:
Tax accounting generally costs less than $100 for simple tax returns, and it takes only a few hours to prepare and complete a tax return. Certified public accountants generally charge at least twice that amount, since CPAs have the necessary skills to tackle the core of problematic business and investment issues. However, the cost of tax accounting differs if parts of the tax filings are under special cases and take longer for the accountant to complete the tax returns. In these circumstances, accountants charge more due to consultation fees and overtime work.
Although doing taxes independently using tax software saves money over hiring an accountant, the costs of hiring an accountant is also beneficial to the individual. Accountants prepare tax returns with much more sophisticated software, compared to software sold to consumers. These programs have high data rates that scan financial information quickly and organize data accurately. The computerized organization in the software will decrease unnecessary errors in tax returns.
The cost of tax accounting also includes numerous services, including accounting, record-keeping, tax consultation and auditing. Accountants provide assistance in building up an effective accounting system to accurately and conveniently assess profitability, monitor prices and expenses, control budgets and forecast future speculation trends. Accountants can also consult their clients with tax-related problems, such as tax compliance and regulations and methods of tax reduction. Moreover, accountants can come up with accurate audit reports, financial statements and other accounting documentation required by government regulation and lending institutions.
Overall, hiring an accountant also means the start of a relationship with a financial consultant. The accountant will understand your family or business's financial records and goals, and he or she can give valuable and personal tax reduction suggestions and answers to critical questions at any time of the year.
How will bankruptcy affect my ability to get credit in the future?A:
Bankruptcy can impact your credit score more severely than any other single financial event. While not all bankruptcies actually cause a big credit drop (in fact, it is possible your credit score could rise following a bankruptcy), any negative effect makes it more challenging to acquire credit in the future. A bankruptcy also appears on your credit report for years after you file, providing a big warning sign to potential lenders about a troubled payment history. Some creditors immediately deny an application when a bankruptcy is listed on a credit report.
Bankruptcy and Your Credit Rating
Your FICO credit score is often the most important determinant in whether you receive credit, how much and at what interest rate. The higher your credit rating means that you can borrow more and at a lower interest rate. Filing bankruptcy can cause your credit score to drop dramatically. If a lender is willing to accept your credit application, it is likely to be on less favorable terms.
FICO states that your payment history makes up 35% of your total credit score. It is possible that a bankruptcy filing will not cause a major drop if you already have an inconsistent payment history. Another 30% of your score is the total amount of debt that you owe, which bankruptcy discharge can actually help. However, it is rare that a bankruptcy does not damage your credit rating.
Bankruptcy and Your Credit Report
The type of bankruptcy you choose to file will determine how long it is listed on your consumer credit report. Chapter 7 and Chapter 11 bankruptcies stay on your credit report for 10 years after you file. Chapter 13 bankruptcies remain on a credit report for seven years after the bankruptcy is completed, but Chapter 13 proceedings can take up to three to five years to finish.
In many cases, it is not your damaged credit score that makes it hard to obtain credit. Some lenders do not grant credit to anyone with a bankruptcy, regardless of their FICO score. If you are having difficulty obtaining credit following a bankruptcy, it may be a good idea to open up a secured credit card.
Applying for Credit After Bankruptcy
Since it can be difficult to get credit after filing bankruptcy, your personal relationship with a lender can be crucial. Having employees or management at a bank, credit union or auto lender that know, trust and like you makes it easier to get an application accepted.
You rebuild credit after bankruptcy the same way that you build credit before one: with time and a consistent repayment history. If you believe you can continue to repay a pre-existing debt during and after a bankruptcy, consider a reaffirmation agreement with one of your creditors to help the process of rebuilding your credit score.
If a LEAP option is purchased and held for more than 12 months, is the tax treatment long term?A:
A LEAP (long-term equity anticipation security) is a call or put option that allows the holder to buy or sell shares of stock at a set strike price. Expiration dates on LEAPs can range from nine months to three years, which is longer than the holding period for a traditional call or put option. Because of their long-term nature, LEAPs are often sold by the same investor who originally purchased the contracts. When LEAPs are sold at a profit, the gain is taxable. The seller of the LEAP is taxed at the long-term capital gain rate if they held the contract for at least a year and a day. If they held the contract for a shorter period, they would be subject to short-term capital gains rates.
Selling a LEAP option contract is not the only way that an investor can incur tax consequences with this instrument. An investor who exercises a LEAP call option and then sells the stock purchased immediately would be subject to short-term capital gains rates even if he or she had held the LEAP contract for more than 12 months. Once a LEAP call option is exercised, the investor must hold the stock purchased for more than 12 months from the exercise date in order to qualify for the long-term capital gains tax rate. For a put, the investor who sells the stock at the LEAP's strike price and subsequently makes a profit would pay capital gains tax based on the amount of time he owned the actual shares, without regard to the length of time he held the contract.
In what types of economies are regressive taxes common?A:
Regressive taxation systems are more likely to be found in developing countries or emerging market economies than in the economies of developed countries. The predominance of regressive taxation in less-developed countries is mainly due to the fact that regressive tax systems are generally simpler tax systems. Countries with less-developed economies overall are also countries likely to have simpler, less-complex tax systems, if for no other reason than the fact less-developed governments have less ability to administer and collect more complex tax policies. Also, in less-developed economies, there is commonly less widespread disparity in income. That is to say, a much larger percentage of the population, as compared to that of developed countries, probably has roughly the same level of income. The net effect of such a situation is to make a regressive tax system less regressive since the vast majority of the population suffers essentially the same impact from the tax system. It can be argued that this common equality of tax burden renders a regressive taxation system more properly referred to as a proportionate tax system.
There are three main types of taxes or tax systems: regressive, proportionate or progressive. The differences between the three types of taxes are shown in the effect on the tax that results from changes in the base of the tax, such as income. For example, changes in income have little effect in terms of tax rates and amounts paid with a regressive income tax but have substantial effect where the income tax system, as in the United States, is highly progressive. Regressive taxes result in lower-income individuals or entities paying a higher percentage of their incomes in taxes than higher-income individuals or entities. Typical regressive taxes are the taxes known as "sin taxes," such as taxes on cigarettes and alcohol, since such taxes take a much higher percentage of income from low-income people than high-income people.
Proportional taxes, also referred to as flat taxes, are taxes that take the same proportion or percentage of income from everyone subject to the tax. A flat tax is one of the popular proposed alternatives to the current, very progressive U.S. income tax system. Some economists argue that proportionate taxes are the fairest tax system because the tax is applied, in percentage terms, equally across the board to everyone who is part of the system.
Progressive tax systems place a proportionately higher burden on upper-income individuals or entities as compared to lower-income individuals or entities. This is the tax system most commonly found in developed nations such as the U.S. or Canada. In a progressive tax system, the marginal tax rate, the tax rate resulting from increases in income, is higher than the average tax rate.
NOI (net operating income) versus EBIT (earnings before interest and taxes): What's the difference?A:
Net operating income (NOI) determines an entity's or property's revenue less all necessary operating expenses. NOI does not take into account interest, taxes, capital expenditures, depreciation and amortization expenses. Conversely, earnings before interest and taxes (EBIT) consists of revenues less expenses, excluding tax and interest, but takes into account depreciation and amortization expenses. It determines a company's profitability.
EBIT is calculated by subtracting a company's cost of goods sold (COGS) and operating expenses from its revenue. EBIT can also be calculated as operating revenue and non-operating income less operating expenses.
For example, assume company ABC generated $50 million in revenue, and had COGS of $20 million, depreciation expenses of $3 million, non-operating income of $1 million and maintenance expenses of $10 million during the last fiscal year. Its resulting EBIT for last year was $21 million ($50 million + $1 million - $10 million - $20 million).
NOI is generally used to analyze the real estate market and a house's or building's ability to generate income. Real estate property can generate revenue from rent, parking fees, servicing and maintenance fees. A property may have operating expenses of insurance, property management fees, utility expenses, property taxes and janitorial fees. Income taxes do not impact a company's or real estate investment's NOI. However, property taxes are included in the operating expenses of a real estate investment's operating expenses.
For example, assume an investor purchases an apartment building in an all-cash deal. The property generates $20 million dollars in rents and servicing fees. The apartment building has operating expenses that amounts to $5 million and depreciation expenses of $100,000 for its laundry machines.
The resulting NOI generated by the apartment building is $15 million ($20 million - $5 million). But its EBIT is different. Remember, EBIT takes into account the depreciation expense, so the resulting EBIT generated by the apartment building is $14.9 million ($20 million - $5 million - $100,000).
NOI also determines a property's capitalization rate, or rate of return. A property's capitalization is calculated by dividing its annual NOI by the potential total sale price. Assume our building has a sale price of $120 million. Its capitalization rate is 12.5%.
Using QDRO money from a divorce to pay for a new homeA:
There are several issues to consider:
- The early distribution penalty: Assets distributed from a qualified plan in accordance with a qualified domestic relations order (QDRO) are exempted from the usual 10% early-withdrawal penalty. So if you are under age 59½ and want to use any portion of the assets immediately, it may be practical not to roll over that portion of the assets to an IRA. Funds rolled over to a Traditional IRA and then distributed from that IRA will be subject to the 10% to the penalty, unless you meet an exception.
You could have a portion of the amount processed as a direct rollover to your Traditional IRA and the balance paid to you. The amount that is processed as a direct rollover to your IRA will not be subject to tax withholding.
Tax Withholding: Because the qualified plan assets you receive pursuant to a QDRO are rollover-eligible, amounts that are paid directly to you instead of to an eligible retirement plan will be subject to mandatory withholding. This withholding is 20% for federal taxes and, depending on your state of residence, the payer may also withhold amounts for state taxes. Therefore, you may need to increase the distribution amount to ensure that the net amount you receive is sufficient to meet your financial needs for that home.
Distributions may be taken over a certain period: Unless you need some of the money immediately, you may choose to roll over the assets to your Traditional IRA and have the distributions paid to you over time (from the IRA). Amounts paid to you for at least five years or until you are age 59½ (whichever is longer) are exempted from the 10% early-distribution penalty, provided the payments meet certain requirements. This is commonly referred to as substantially equal periodic payments or 72(t) distributions. If you decide to consider this option, you'll need to know the amount you would receive each year and decide whether this amount meets your requirements.
Converting the asset to a Roth IRA: If you want to convert the assets to a Roth IRA, you must first roll the amount to a Traditional IRA. The amount may then be converted from the Traditional IRA to the Roth IRA. You will owe taxes on the converted amount for the year the conversion occurs.
- Caution: Some qualified plans will not distribute assets pursuant to a QDRO until the plan participant, in this case your former spouse, experiences a triggering event, such as reaching retirement age or being separated from service with an employer. Other plans consider a QDRO a triggering event. Check with the plan regarding its rules for processing distributions due to a QDRO.
What are examples of products and companies that rely on protective tariffs to survive?A:
Examples of U.S. products that rely on protective tariffs to survive include paper clips, canned tuna, tobacco and sneakers.
A single paper clip manufactured and sold in the United States retails for less than a penny. Most paper clips sold in the U.S. are manufactured domestically and are priced favorably, due in large part to tariffs as high as 126.94% on Chinese-manufactured paper clips.
Canned tuna manufactured and sold in the U.S. has been protected by a 35% tariff against Ecuador's cannery imports since 2002. Rising wages in the U.S. have caused canned tuna manufacturers to outsource the cleaning of their fish to countries with cheap labor, and then have domestic operations in California and Georgia package the final product. This takes advantage of a loophole where cheap labor can still be realized, and no tariff is paid due to the fact that the final product is packaged and sold domestically.
Tobacco is quite possibly one of the most well-known domestic products protected by tariffs. The import rate on foreign tobacco products has reached as high as 350%, stemming from high tariffs passed during the Great Depression.
Sneakers produced by New Balance, the last large shoemaker to have its entire production process in the U.S., is protected by a 48% tariff on foreign shoe imports. This is part of the reason why popular brands of shoes such as Nike and Adidas have higher prices. Since they create many of their final products outside the U.S., they are faced with paying the tariff that protects domestic suppliers such as New Balance, and they pass those costs through to the customer.
What are some common examples of demand shock?A:
Common examples of demand shocks are interest rate cuts, tax cuts, government stimulus programs, natural disasters, terrorist attacks, wars or stock market crashes. Demand shocks are surprise events that lead to increased or decreased demand for goods or services. They can lead to surging or falling prices as supply tends to be inelastic in the short-term. Over time, the shock fades and supply responds to find a new, sustainable equilibrium.
Positive Demand Shocks
Examples of positive demand shocks are interest rate cuts, tax cuts or a government stimulus. They have the effect of increasing aggregate demand in the economy, leading to increased consumption. Companies anticipating increased revenues may respond by hiring more workers or expanding operations. This increase in hiring and economic activity feeds back to lead to even more consumption. One drawback of a positive demand shock is it can lead to higher prices if the economy is near full capacity, which heightens inflation risks.
Negative Demand Shocks
Terrorist attacks, natural disasters or stock market crashes are negative economic shocks as they create fear. In this mindset, people are more inclined to save rather than consume. Further, they are less inclined to take risks to start a business or pursue an education, which are activities integral to economic growth. Although these decisions may be rational on an individual basis, on an aggregate basis, it can lead to crippling economic losses. To balance such a negative demand shock, governments may be inclined to lower interest rates, cut taxes or increase spending to reverse a self-reinforcing negative spiral. This is essentially introducing a positive demand shock to counteract a negative shock.
What are some examples of a value-added tax?A:
A value-added tax (VAT) is a consumption tax levied on products at every point of sale where value has been added, starting from raw materials and going all the way to final retail purchase. Ultimately, the consumer pays the VAT; buyers at earlier stages of production receive reimbursements for the previous VAT they've paid.
VAT is commonly expressed as a percentage of total cost. For example, if a product costs $100 and there is a 15% VAT, the consumer pays $115 to the merchant. The merchant keeps $100 and remits $15 to the government.
A VAT system is often confused with a national sales tax. With a sales tax, the tax is only collected once – at the final point of purchase by a consumer – and so only the retail customer ever pays it. The VAT system is invoice-based and collected at several points throughout an item's production, each time value is added and a sale is made. Every seller in the production chain charges a VAT tax to the buyer, which it then remits to the government. The amount of tax levied at each sale along the chain is based on the value added by the latest seller.
Example of Value-Added Taxation
To calculate the amount of VAT a consumer or business must pay, take the cost of the goods or service, and subtract any material costs previously taxed. An example of a 10% VAT in sequence through a chain of production can occur as follows:
A manufacturer of electronic components purchases raw materials made out of various metals from a dealer. The metals dealer – the seller at this point in the production chain – charges the manufacturer $1 plus a 10-cent VAT, and then pays the 10% VAT to the government.
The manufacturer adds value through its manufacturing process of creating the electronic components, which it then sells to a cell phone manufacturing company for $2 plus a 20-cent VAT. The manufacturer remits 10 cents of the 20-cent VAT it collected to the government, the other 10 cents reimbursing it for the VAT it previously paid to the metals dealer.
The cell phone manufacturer adds value by making its mobiles, which it then sells to a cellphone retailer for $3 plus a 30-cent VAT. It pays 10 cents of this VAT is paid to the government; the other 20 cents reimburse the cell phone manufacturer for the previous VAT it has paid to electronic component company.
Finally, the retailer sells a phone to a consumer for $5 plus a 50-cent VAT, 20 cents of which is paid to the government.
The VAT paid at each sale point along the way represents 10% of the value added by the seller.
Value Added Tax Arguments
In Favor of VAT
Those who favor value-added taxation make the argument that a VAT system encourages payment of taxes and discourages attempts to avoid them. The fact that VAT is charged at each stage of production rewards tax compliance and and acts as a disincentive from operating in the black market: For manufacturers and suppliers to be credited for paying VAT on their inputs, they are responsible for collecting VAT on their outgo – the goods they create or sell. Retail businesses have incentives to collect the tax from consumers, since that is the only way for them to obtain credit for the VAT they have paid in buying their goods wholesale. A VAT is also supported as a better alternative to so-called hidden taxes.
Because it is typically levied at the same percentage on different products and services, a VAT tends to have less of an impact on economic decisions than an income tax. Still, it can register on a country's economy. Along with improving the efficiency of tax collection, a VAT is considered an effective way to improve growth of a nation's gross domestic product (GDP), raise tax revenues and eliminate government budget deficits.
Opponents of VAT claim that it unfairly burdens people with lower incomes. Unlike a progressive tax (like the U.S. income tax system, in which higher-income individuals pay a higher percentage of tax), a VAT is like a flat tax where all consumers of all income levels pay the same percentage, regardless of earnings: Whether your annual income is $50,000 or $500,000, you are levied the identical 15% VAT on products and services. Obviously, that 15% cuts deeper into the budget of the $10,000 individual than the $500,000 person. If the former paid $1,000 in VAT taxes, that comes out to 2% of his annual income. If the latter pays the same $1,000 in VAT, it's only .02% of his income.
To combat this income inequality argument, most countries that have VAT (including Canada and the United Kingdom) offer numerous exemptions, usually on necessities such as children’s clothing, child care and groceries.
The United States holds the distinction of being the only member of the Organization for Economic Co-operation and Development (OECD) without a VAT.
What are some examples of different taxable events?A:
A taxable event is any event or occurrence that results in a tax liability. All investors or parties that pay taxes experience taxable events. Two examples of taxable events are if an investor receives dividends or realizes capital gains.
Although a party should focus on generating profits, it should also focus on limiting its tax liabilities. For example, suppose an investor owns a stock that pays dividends of 60 cents per share on a quarterly basis. The investor owns 1,000 shares of the stock and will receive $2,400 for the year and will be taxed on the dividends she receives.
Another taxable event is a capital gain. A capital gain occurs when there is an increase in the value of an investment in capital or real estate asset above a party's purchase price. A capital gain is unrealized until the asset is sold for a profit.
For example, suppose an investor owns a mutual fund and it has accumulated $200,000. The investor's initial investment in the mutual fund was $50,000. If the investor sells all of his holdings in the mutual fund, it will be considered a taxable event.
Suppose the investor wants to sell $150,000 worth of his shares in his mutual fund to buy a house. Since the shares of the mutual fund have appreciated in value, it would result in a taxable event. The investor calculates that he would owe a capital gains tax of $15,000 if he sells his shares and decides to hold off on buying a house. He is not taxed because the sale of his shares of the mutual fund did not occur.
What are the advantages and disadvantages of capitalizing interest for tax purposes?A:
The advantages and disadvantages of capitalizing interest for tax purposes lie in a company's ability to manage or manipulate both the period in which the capitalized interest is recognized as an expense on the income statement and by the way in which the capitalized interest is recognized on the income statement.
What Is Capitalized Interest?
Capitalized interest refers to the cost of the funds used to finance the construction of a long-term asset that a company constructs. This treatment of interest is a requirement under the accrual basis of accounting and increases the amount of the fixed asset on a company's balance sheet.
When a company capitalizes interest, the cost of the interest is added to the book value of the long-term asset and is recognized as periodic depreciation expense on the income statement rather than as interest expense.
Tax Advantages of Capitalizing Interest
Depreciation expense is a pretax cost that reduces the profit of a company without reducing its cash flow.
When a company capitalizes its interest and adds the cost to its long-term asset, it effectively defers the interest expenses to a later accounting period. When it comes to taxes, the company can recognize the interest expense in the form of depreciation expense in a later period when its tax bill is higher. This reduces the amount of taxes that the company owes.
Tax Disadvantages of Capitalizing Interest
When a company is required to capitalize its interest on the loan used to construct a long-term asset, it cannot reduce its tax bill in the current period because the interest expense is deferred to a later period. It is unable to realize the tax benefits in the period for which the loan was taken out.
What are the benefits of R&D (research and development)?A:
Research and development (R&D) refers to the part of a company's operations that seeks knowledge to develop, design and enhance that company's products, services, technologies or processes. Along with creating new and innovative products and adding features to old ones, R&D connects various parts of a company's strategy and business plan, such as marketing and cost reduction.
Some advantages of research and development are clear, such as the possibility for increased productivity or new product lines. The Internal Revenue Service offers an R&D tax credit for businesses. Some kinds of investors look for firms with aggressive R&D efforts. It's also not uncommon for small business owners to make a lot of money by being bought out by a larger firm in the industry that wants to use their R&D.
Defining Research and Development
Research and development consists of the investigative activities that a person or business chooses to do with the desired result of a discovery that will either create an entirely new product, product line or service, or strengthen an existing product or service with additional features.
Research refers to any new science or thinking that will result in a new product or new features for an existing product. Research can be broken down into either basic research or applied research. Basic research seeks to delve into scientific principles from an academic standpoint, while applied research seeks to use that basic research in a real-world setting.
The development portion refers to the actual application of the new science or thinking so that a new or increasingly better product or service can begin to take shape.
Research and development is essentially the first step in developing a new product, but product development is not exclusively research and development. An offshoot of R&D, it can refer to the entire product life cycle, from conception to sale to renovation to retirement.
Productivity and Product Differentiation
Firms gain a competitive advantage by performing in some way that their rivals cannot easily replicate. If R&D efforts lead to an improved type of business process – cutting marginal costs or increasing marginal productivity – it is easier to outpace competitors.
R&D often leads to a new type of product or service. According to the Small Business Administration, this is most common in sectors such as industrial machinery, trucks and tractors, semiconductors, computing technology and pharmaceuticals (see "How Much of a Drug Company's Spending Is Allocated to Research and Development on Average?")
The R&D Tax Credit
In 1981, the IRS started offering tax breaks for companies to spend money and hire employees for the purpose of research and development.
Qualifying companies include startups and other small ventures with qualified research expenses. Such expenses can be used to offset tax liabilities, along with an impressive 20-year carry-forward provision for the credit.
Buyouts and Mergers
Many entrepreneurs and small businesses have made a large sum of money in a short time by selling good ideas to established firms with many resources. Buyouts are particularly common with internet companies, but they can be seen wherever there is a lot of incentive to innovate.
Advertising and Marketing
Advertising is full of claims about revolutionary new techniques or never-before-seen products and technologies. Consumers demand new and improved products, sometimes simply because they are new. R&D departments can act as advertising wings in the right market.
R&D strategies let companies create highly effective marketing strategies around releasing a new product or an existing product with new features. A company can create innovative marketing campaigns that match the inventive products and increase market participation. Innovative new products or features can increase market share by giving customers something they've never seen before.
The Bottom Line
Increased market participation, cost management benefits, advancements in marketing abilities and trend-matching – these are all reasons companies invest in R&D. R&D can help a company follow or stay ahead of market trends and keep the company relevant. Although resources must be allocated to R&D, the innovations gained through this research can actually work to reduce costs through more efficient production processes or more efficient products. R&D efforts can also reduce corporate income tax, thanks to the deductions and credits they generate.
What are the differences between Chapter 7 and Chapter 13 bankruptcy?A:
In the United States, the most common kinds of personal bankruptcy filings are under Chapter 7 or Chapter 13 proceedings. The first kind, Chapter 7, is commonly referred to as a personal liquidation and allows the filing party to wipe out significant chunks of personal debt. Chapter 13 bankruptcies are known as personal reorganizations, whereby the terms of the debtor's obligations are changed and a new repayment plan is created over a three- to five-year period.
Chapter 7 bankruptcies are supposed to be reserved for those individuals who are in very dire financial straits. If there is a prospect of repayment, even under slightly reduced terms, Chapter 13 is considered the more appropriate route.
In many states, individuals with high incomes are unlikely to qualify for a Chapter 7 bankruptcy. Eligibility requirements vary from place to place, but all filers are subject to a financial interview process, known as means testing, whereby their ability to make payments is assessed.
Chapter 7 Bankruptcy
Under a Chapter 7 bankruptcy, the individual debtor declares all of his financial obligations and assets, pays off what he can afford, and is subsequently forgiven the remaining debt – although certain kinds of debt are exempt. It is possible that the bankruptcy court will force the filing individual to sell certain assets for repayment, but many important assets, such as a home and primary vehicle, are exempted.
There are three important terms to understand with regards to a Chapter 7 bankruptcy: automatic stay, reaffirmation and discharge.
Once an asset or debt is listed under the bankruptcy, is goes under the protection of automatic stay. Creditors may no longer attempt to collect on the debt or repossess an item. Some debts can be reaffirmed by the debtor, which means he releases them from stay and will make a good-faith effort to repay to the creditor. Finally, all discharged debts in a bankruptcy are wiped out, and the filer is no longer considered responsible for them.
Unless under special circumstances, nobody may declare Chapter 7 on two separate occasions within six years.
Chapter 13 Bankruptcy
When an individual files for Chapter 13 bankruptcy, he agrees to pay a specified amount of disposable earnings to the bankrupcty trustee over a three- to five-year period. The trustee collects and distributes those funds on behalf of creditors. Once this reorganization period ends, all remaining debts are discharged.
The trustee plays a very large role in Chapter 13 bankruptcies. Filers are not allowed to sell assets without consulting and receiving permission from their trustees during the repayment plan. Filers must report any changes in income to the trustees. Creditors speak to the trustees during this process, not the filers.
Certain debts are only dischargeable through a Chapter 13 filing. These include certain kinds of child support owed to collection agencies, non-exempt income taxes, old liabilities from divorce proceedings, court fees, homeowners association fees and loans from retirement plans.
What are the differences between regressive, proportional, and progressive taxes?A:
Tax systems fall into three main categories within the tax code: regressive, proportional and progressive taxes. Regressive taxes are those that have a greater impact on low-income individuals than high-income earners. A proportional tax, also referred to as a flat tax, impacts low-, middle- and high-income earners relatively equally. A progressive tax has more of a financial impact on higher-income individuals and businesses, and less on low-income earners. The U.S. federal tax system and local and state tax systems use all three types to collect tax revenue.
Under a regressive tax system, individuals and entities with low incomes pay a higher amount of that income in taxes compared to high-income earners. Rather than basing the tax on the individual or entity's earnings or income level, the government assesses tax as a percentage of the asset that the taxpayer purchases or owns.
For example, a sales tax on the purchase of everyday products or services, such as food and clothing, is assessed as a percentage of the item bought, and is the same for every individual or entity. Shoppers pay, say, a 6% sales tax on their groceries, whether they earn $30,000 or $130,000 annually. Because the buyer's wealth (and hence, ability to pay) is not taken into consideration, this sales tax – while nominally the same for all shoppers – effectively places a greater burden on lower-income earners than it does on the wealthy: The former end up paying a greater portion of total income than the latter. For instance, if a person makes $20,000 a year and pays $1,000 in sales taxes on clothing and other consumer goods, then 5% of his annual income goes to sales tax. If a person makes $100,000 a year and pays the same $1,000 in sales taxes, then only 1% of his income goes to sales tax.
Aside from state and local sales taxes, regressive taxes include real estate property taxes and excise taxes (a fixed tax included in the price of the product or service) on consumables such as gasoline or airfare. Sin taxes, a subset of excise taxes, are imposed on certain commodities or activities perceived to be unhealthy or have a negative effect on society, such as cigarettes, gambling and alcohol (in an effort to deter individuals from purchasing those products). Sin-tax critics argue that these disproportionately affect the less well-off not just because of economics, but because these lower-income groups tend to indulge more in these items or activities.
Many also consider Social Security a regressive tax. Social security tax obligations are capped at a certain level of income. This means that once an individual reaches that income threshold ($128,700 in 2018), any wages he earns above that are not subject to the 6.2% FICA bite. In other words, the annual maximum that one pays in Social Security tax is "capped" at $7,979 (in 2018) – whether one earns $128,701 or $300,00 or $1 million. Because of this cap, higher-income employees effectively pay a lower proportion of their overall income into the Social Security system than lower-income employees do.
Under a progressive tax system, the taxes assessed – say, on income or business profits – are based on the taxable amount, and follow an accelerating schedule. High-income earners pay more than low-income earners, and the tax rate, along with tax liability, increases as an individual or entity's wealth increases. The overall outcome is that higher earners pay a higher percentage of taxes and more money in taxes than do lower-income earners.This sort of system is meant to affect upper-class people more low- or middle-class individuals – to reflect the fact that they can afford to pay more.
The current U.S. federal income tax is a progressive tax system. Its schedule of marginal tax rates imposes a higher income tax rate on people with higher incomes, and a lower income tax rate on people with lower incomes. As taxable income increases, the percentage rate increases at each interval as the income level moves across the schedule. With a marginal tax rate, each dollar the individual earns places him into a bracket or category, resulting in a higher tax rate once the dollar amount enters a new category.
To understand the marginal tax rate system, consider the following schedule: a first tax rate of 10% for taxable income less than $10,000, a second rate of 15% for taxable income between $10,000 and $30,000 and a third rate of 25% for taxable income between $30,000 and $60,000.
According to the schedule, if a taxpayer's income is $50,000, the third rate of 25% does not apply to the full $50,000 of income. Instead, the taxpayer owes 10% for the first $10,000 of income, 15% for $20,000 of income at the second rate amount between $10,000 and $30,000, and 25% for the remaining $20,000 that falls into the third tax rate. The taxpayer in this example owes a total of $9,000, because the 10% rate on the first $10,000 is $1,000, the 15% rate on the next $20,000 is $3,000, and the 25% rate on the remaining $20,000 is $5,000.
Part of what makes the U.S. federal income tax progressive is the personal exemption, a feature that has been available since the first taxes were collected in 1915. The personal exemption means individuals do not pay taxes on the first bit of income they earn each year, and this amount changes from year to year. Due to personal exemptions, deductions and tax credits, many low-income Americans pay no federal income tax at all. When the economy is stable and unemployment is low, as many as 40% of U.S. citizens don't pay income taxes because their earnings are too small to reach the lowest tax rate.
Estate taxes are another example of progressive taxes, as they mainly affect on high net worth individuals, and rise with the size of the estate.
As with any government policy, progressive tax rates have critics. Some say progressive taxation is a form of inequality and amounts to a redistribution of wealth, as higher earners pay more to a nation that supports more lower-income earners. Those who oppose progressive taxes often point to a flat tax rate as the most appropriate alternative. (See "What are the pros and cons of a progressive tax policy and who benefits the most from it?")
A proportional tax system, also referred to as a flat tax system, assesses the same tax rate regardless of income or wealth. It is meant to create equality between marginal tax rate and average tax rate paid.
For example, under a proportional income-tax system, individual taxpayers would pay a set percentage of their annual income, regardless of the size of that income. Say the fixed rate is 10%. Since it does not increase or decrease as income rises or falls, an individual who earns $20,000 annually pays $2,000, while someone who earns $200,000 each year pays $20,000 in taxes.
Some other specific examples of proportional taxes include per capita taxes, gross receipts taxes, and occupational taxes.
Proponents of proportional taxes believe they stimulate the economy more by encouraging people to work more, as well as spend more. They also believe businesses are likely to spend and invest more as well under a flat tax system, putting more dollars into the economy.
The Bottom Line
A progressive tax is one that increases along with an individual's means, while a regressive tax doesn't consider the individual's means (and thus often penalizes those with less). Proportional taxes are applied equally to all income groups.
What are the pros and cons of a progressive tax policy and who benefits the most from it?A:
Those who oppose a progressive tax hierarchy are likely to be those who pay more taxes when such a policy is in place. A progressive tax policy requires individuals with higher incomes and wealth to pay taxes at a rate that is higher than those with lower incomes. It is fair to say that those who are wealthier and with higher incomes oppose such a policy, but this is not always the case.
There are many arguments against such a policy. One is that it divides people into categories that make them unequal. It is also looked at as an unequal way to represent a nation's citizens. Very few people are extremely wealthy, and the majority of people who have power to put representatives in government are in middle class or lower economic positions. The wealthy pay much in terms of money that goes to run the government, but they have very little say because there are so few of them putting representatives into Congress, or the body of government that sets policy in their respective country.
A progressive tax hierarchy sounds as if it may save the poorer money at first since they are not paying nearly as much in taxes; however, opponents argue the opposite is often true and progressive taxes lead to individuals saving less money. Like any policy in government that influences fiscal policy, taxes are complicated and never black and white. Wealthier individuals find ways to avoid paying more than the government intended, which can lead to less money going toward projects to improve the country.