Chapter 1

Introduction to Taxation

• Define the tax: Tax is a fiscal tool (compulsory payment) used to support cost of the
government.
• A tax differs from a fine or penalty (‫ )الغرامة‬imposed by a government, because a tax is not
intended to deter or punish unacceptable behavior.

Tax liability is generally determined by multiplying a tax base by a tax rate. Tax systems vary with
respect to the structure of their rates and the base to which the rate is applied.

Tax Bases: The tax base is the amount to which the tax rate is applied.
a. Examples:
i. The base for a sales tax is the amount of a sale
ii. The base for a real estate tax is assessed value
b. For the Federal income tax, the tax base is taxable income.

c. Most taxes are levied on one of four kinds of tax bases.

1-Transactions [including sales or purchases of goods and services, and transfers of wealth
(e.g., by gift or at death)]. The tax is triggered only when an event occurs or transaction takes
place.
2-Property or wealth (including ownership of specific kinds of property)
3-Privileges and rights)‫( (االمتيازات والحقوق‬including the ability to do business as a corporation,
the right to work in a certain profession, and the ability to move goods between countries).
4-Income on a gross or net-of-expenses basis.

Tax rates: applied to the tax base to determine the tax liability
– May be proportional or progressive
 A tax rate is progressive if it increases as the tax base increases. The Federal income tax
is structured so as to be progressive. For example, the Federal income tax rates for
corporations range from 15 to 39 percent. These rates increase with increases in taxable
income.

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 • Refer to the corporate tax rate schedule inside the front cover of this text. If Abel
Corporation records taxable income of $5,000, its income tax is $750 and its average tax
rate is 15% ($750/ $5,000, or the ratio of tax liability to the tax base). If, however, Abel’s
taxable income is $200,000, its income tax is $61,250 and its average tax rate is 30.63%
($61,250/$200,000).
50,000*15%=7,500
25,000*25%=6,250
25,000*34%=8,500
100,000*39%=39,000
Total =61,250
 A tax is proportional if the rate of tax is constant, regardless of the size of the tax base.
State retail sales taxes are proportional. Proportional tax rates also underlie the various
“flat tax” proposals recently in the news.1
Example 2: Bob purchases an automobile for $6,000. If the sales tax on automobiles is
7% in Bob’s state, he will pay a $420 tax. Alternatively, if Bob pays $20,000 for a car,
his sales tax will be $1,400 (still 7% of the sales price). Because the average tax rate
does not change with the tax base (sales price), the sales tax is proportional.
 Regressive tax rates decrease as the tax base increases. Federal employment taxes, such
as FICA and FUTA, are regressive. When the tax base and the taxpayer’s ability to pay
generally are positively correlated.

Incidence of tax: Incidence = ultimate economic burden of a tax (On whom the tax is located) May
not fall on the person or organization who pays tax
• Example: Mr. Blair owns an eight- unit apartment building. Currently, the tenants living in
each unit pay a $6000 annual rent. The local government notifies Mr. Blair that this property
tax on the apartment building will increase by $2400 for the next year. Mr. Blair reacts by
informing his tenants that their rent for the next year will increase by $300. Consequently, Mr.
Blair total revenues will increase by $2400. Although Mr. Blair is the tax payer who must remit
the property tax to the government, the incidence of the tax increase is on the tenants who will
indirectly pay the tax through higher rent.

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 The Federal tax law is the vehicle for accomplishing many objectives of the nation such
as :( The objectives of Tax)
1-Raising revenue: the major objective of the tax system but not the sole objective. Leading to a
balanced budget with no resulting deficit
2-Economic: increasingly important objective is to regulate the economy and encourage certain
behavior and businesses considered desirable:
– Encouragement of Certain Activities( R&D)
– Encouragement of Certain Industries
– Encouragement of Small Business
3-Social: encourage socially desirable behavior that provides benefits that government might
otherwise provide:
1. Certain benefits provided to employees through accident and health insurance
plans financed by employers are nontaxable to employees.
2. A contribution made by an employer to a qualified pension or profit sharing plan
for an employee may receive special treatment.
3. A deduction is allowed for contributions to qualified charitable organizations.
4. Various tax credits, deductions, and exclusions are designed to encourage
taxpayers to obtain or extend their level of education.
5. A tax credit is allowed for amounts spent to furnish care for certain minor or
disabled dependents
6. A tax deduction is denied for certain expenditures deemed to be contrary to
public policy. This disallowance extends to items such as fines, penalties, illegal
kickbacks, bribes to government officials
4-Equity: The concept of equity is relative
Equity is most often tied to a particular taxpayer’s personal situation.
Alleviating ‫تخفيف‬the Effect of Multiple Taxation
The income earned by a taxpayer may be subject to taxes imposed by different taxing
authorities. If, for example, the taxpayer is a resident of New York City, income might be subject
to Federal, state of New York, and city of New York income taxes. To compensate for this
apparent inequity, the Federal tax law allows a taxpayer to claim a deduction for state and local
income taxes.

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The Wherewithal to Pay Concept
Mitigating the Effect of the Annual Accounting Period Concept
Federal income tax returns are due for every tax year of the taxpayer. The application of this
annual accounting period concept can lead to dissimilar tax treatment for taxpayers who are,
from along-range standpoint, in the same economic position.

5-Political: a large segment of the tax law is created through a political process; thus,
compromises and special interest dealings occur
– Special Interest Legislation(Political opportunism)
– State and Local Government Influence
6-Influence of the Internal Revenue Service:
1. Closing Perceived Tax Loopholes
Certain tax provisions are intended to prevent a loophole from being used to avoid the tax
consequences intended by Congress. Legislation is enacted to close the loopholes that taxpayers
have located and exploited.
2. Administrative Feasibility
Some tax law is justified on the grounds that it simplifies the task of the IRS in collecting the
revenue and administering the law.

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-Withholding procedures apply to wages,
-accrual basis taxpayers often must pay taxes on prepaid income in the year received and not
when earned.
7- Influence of the Courts:
The Federal courts have influenced tax law in two other respects:
1. Judicial Concepts Relating to Tax:
The courts have formulated certain judicial concepts that serve as guides in the application of
various tax provisions.
2. Judicial Decision influence on Statutory Provisions:
Some court decisions have been of such consequence that Congress has incorporated them into
statutory tax law

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 Major Types of Taxes:-

1-Transaction Taxes 2-Employment Taxes

3-Death Taxes 4-Gift Taxes

5-Property Taxes 6-Income Taxes

7-Other U.S. Taxes

1-Transaction Taxes

• Excise taxes
• General sales taxes
Sales taxes Excise taxes
(indirect and transaction taxes) (indirect and transaction taxes) Federal Excise Taxes
Is typically based on the retail sales of Are taxes paid when purchases Together with customs duties, excise
tangible personality, it’s based and are made on a specific good, such taxes served as the principal source
apply to most types of consumer goods , as gasoline. Excise taxes are often of revenue for the United States
and may take the form of consumption included in the price of the during its first 150 years of
tax levied on the purchaser. product. existence.
The seller is responsible for collecting The seller is responsible for State Excise Taxes
the tax at point of sales and remit it to collecting and remitting the excise Many states levy excise taxes on the
government. tax . Excise taxes can be extremely same items taxed by the Federal
heavy. government.
Local Excise Taxes
Tax is levied on visitors who cannot
Broad-based (e.g., it might be levied on limited to a specific kind of good vote and often used to fund special
all retail sales). or service projects.
These are: 1- hotel occupancy tax
2-rental car .
 The sales tax: While specific rules vary from state to state
One obvious approach to avoiding state and local sales taxes is to purchase goods in a state that
has little or no sales tax and then transport the goods back to one’s home state.
Use taxes exist to prevent this tax reduction ploy. The use tax is a value-based.
The use tax applies only if the owner of the goods did not pay the state sales tax when the goods
were purchased, it is a complementary tax.
The use tax is difficult to enforce for many purchases; therefore, the purchaser often does not
pay it.

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  The value added tax (VAT) is a variation of a sales tax; it is levied at each stage of
production on the value added by the producer. VAT is in widespread use in many countries
around the world .
The tax typically serves as a major source of revenue for governments that use it.
For example: Farmer Brown sells wheat to a flour mill for $100. If the wheat cost $65 for Brown
to produce and if the VAT rate 10%, then Brown will owe a VAT of $3:50 [.10($100-$65)]. If the
mill sells the flour for $200 to a baker, and if it cost the mill $120 to make the flour (including
the cost of Brown’s wheat), then it will pay a VAT of $8 [.10($200-120)]. If the baker sells the
200 loaves of bread he makes from the flour for $400,and if it cost the baker $280 to make the
bread, then the baker pays a VAT of $12[.10($400-$280)].
The consumers who buy the bread will not pay any VAT directly. It is likely, however, that some
or all of the total VAT paid of $23:50 ($3:50 + $8 + $12) will be paid by the consumers in the
form of higher prices for the bread.

2-Employment taxes represent a major source of funds. Second only to the income tax in its
contribution. The Federal government imposes two kinds of employment tax:
a) The Federal Insurance Contributions Act (FICA) imposes a tax on self-employed
individuals, employees, and employers. The proceeds of the tax are used to finance Social
Security and Medicare benefits.
Sole proprietors and independent contractors may also be subject to Social Security taxes
(Known as the self-employment tax), Rates are twice that applicable to an employee.
b) The Federal Unemployment Tax Act (FUTA) imposes a tax on employers only. The FUTA
tax provides funds to state unemployment benefit programs. Administered jointly by states
& Fed govt.

3-Death Taxes Tax on the right to transfer property or to receive property upon the death of
the owner.
If imposed on right to pass property at death (Classified as an estate tax).
If imposed on right to receive property from a decedent (Classified as an inheritance tax). The
value of the property transferred provides the base for determining the amount of the death tax
• The Federal government imposes only an estate tax
• Many state governments levy inheritance taxes, estate taxes, or both
Deduction: Certain deductions and credits allowed in arriving at the taxable estate
Examples - marital deduction, funeral and admin. Expenses, certain taxes, debts of decedent

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 4-Federal Gift Tax: Tax on the right to transfer assets during a person’s lifetime
• Applies only to transfers that are not supported by full and adequate consideration
• The Federal gift tax and the Federal estate tax are unified. The transfer of assets by a
decedent at death effectively is treated as a final gift under the tax law.
Taxable gift = FMV of gift less annual exclusion less marital deduction (if applicable).

5-Property (ad valorem) Taxes:

Local government depend heavily on real property taxes They represent a major source of revenue
for local governments
Most property taxes in the United States are taxes on wealth; they use value as a base. These
value-based property taxes are known as ad valorem taxes.
Property taxes generally are administered by state and local governments, where they serve as a
significant source of revenue
Realty: is defined as land and anything permanently attached to land
Personality: consists of all assets that are not realty
Both realty and personality can be either business use or personal use
The following are some of the characteristics of ad valorem taxes on realty:
1- Property owned by the Federal government is exempt from tax.
2-Some states provide for lower valuations on property dedicated to agricultural use or other
special uses (e.g., wildlife sanctuaries)
3-Some states partially exempt)‫ (معفى‬the homestead, or personal residence, portion of property
from taxation.
4- Lower taxes may apply to a residence owned by a taxpayer age 65 or older.
5-Some jurisdictions)‫ (السلطة القضائية‬extend immunity )‫ (حصانة‬from tax for a specified period of
time (a tax holiday) to new or relocated businesses.
a- Taxes on Personality
Personality includes all assets that are not realty.
Realty and personality can be either business-use or personal-use property. Examples include a
residence (personal-use realty), an office building (business-use realty),
Personality can also be classified as tangible property or intangible property
The following generalizations may be made concerning the property taxes on personality

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. • Particularly with personality devoted to personal use (e.g., jewelry, household furnishings),
taxpayer compliance ranges from poor to zero. Some jurisdictions do not even attempt to enforce
the tax on these items.
For personality devoted to business use (e.g., inventories, trucks, machinery, equipment), taxpayer
compliance and enforcement procedures are notably better.
• Some jurisdictions impose an ad valorem property tax on intangibles (refers to marketable
securities: stocks and bonds)
b- Taxes on Privileges and Rights
Taxes on privileges and rights are usually considered excise taxes. The most important of these
taxes are reviewed here.
Federal Customs Duties
Customs duties or tariffs can be characterized as a tax on the right to move goods across national
borders. Customs duties account for only 1 percent of revenues in the Federal budget. In recent
years, tariffs have acted more as an instrument for carrying out protectionist policies than as a
means of generating revenue. The argument)‫ (حجة‬goes, by placing customs duties on the
importation of foreign goods that can be sold at lower prices
c- Franchise Taxes and Occupational Taxes
Franchise taxes Levied on the right to do business in the state.
Typically, the tax is imposed by states on corporations, but the tax base varies from state to state
Severance Taxes Severance taxes are based on the extraction of natural resources (e.g., oil, gas,
iron ore, and coal). They are an important source of revenue for many states; Alaska does not levy
either a state-level income or sales/use tax, because the collections from its severance taxes are so
large.

6-Income Taxes
Imposed at the Federal, most state, and some local levels of government
Income taxes generally are imposed on individuals, corporations, and certain fiduciaries
(estates and trusts)
Federal income tax base is taxable income (income less allowable exclusions and deductions)
Most jurisdictions attempt to assure tax collection by requiring pay-as-you-go procedures,
including:-Withholding )‫ (حجب‬requirements (withholding at the source) for employees, and
estimated tax prepayments for all taxpayers.

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The income tax is based on the known as legislative grace: all income is subject to tax and no
deductions are allowed unless specifically provided for in the law.
Some types of income are excluded on the basis of various economic, social, equity, and political
considerations.
All entities are allowed to deduct business expenses from gross income

Adjusted gross income

Less: The greater of certain personal and employee deductions (usually referred to as itemized
deductions) or The standard deduction (including any additional standard deduction)
Less: Personal and dependency exemptions
 For individuals, deductions are separated into two categories )Deductions for adjusted
gross income (AGI)(
Generally, related to business activities
Often personal in nature. e.g., medical expenses, mortgage interest and property taxes on a personal
residence, charitable contributions, and personal casualty losses, or related to investment activities
Generally, itemized deductions and personal and dependency exemptions
Individuals may take a standard deduction (a specified amount based on filing status).
 Corporate Income Tax
Does not require the computation of adjusted gross income
Does not provide for the standard deduction or personal and dependency exemptions
All allowable deductions are business expenses.

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State Income Tax
Most states also impose either a corporate income tax or a franchise tax based in part on corporate
income
Some characteristics of state income taxes include:
1. With few exceptions, all states require some form of withholding procedures
2. Most states use as the tax base the income determination made for Federal income tax purposes
Some states apply a flat rate to Federal AGI
Some states apply a rate to the Federal income tax liability
3. Most states also require withholding of state income tax from salaries and wages and estimated
payments by corporations and self-employed individuals.
4. Most states have their own set of rates, exemptions, and credits.
5. Many states also allow a credit for taxes paid to other states.
6. Virtually all state income tax returns provide checkoff boxes for donations to various causes.
Many are dedicated to medical research and wildlife programs, but special projects are not
uncommon.

Many tax provisions deal with the relationship between owners and their business entities,
including the following interactions:
– Owners put assets into a business when they establish a business
entity
– Owners take assets out of the business during its existence in the form
of:
• Salary, dividends, withdrawals, redemptions of stock, etc.
–
Through their entities, owner-employees set up retirement plans for
themselves, including IRAs, Keogh plans, and qualified pension plans
– Owners dispose of all or part of a business entity
Transactions between owner and business entity have important tax ramifications,
e.g., How to avoid taxation at both owner and entity levels (i.e., the multiple taxation problem)
How to do the following with the least adverse tax consequences:
• Get assets into the business
• Get assets out of the business
• Dispose of the business entity
A common set of tax planning tools can be applied. These tax planning fundamentals are
introduced in the next section

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 INCOME TAXATION OF BUSINESS ENTITIES
Limited liability
Regular corporations companies (LLCs)
Sole proprietorships Partnerships S corporations
(C corporations) and limited liability
partnerships (LLPs)
Like a C corp. for all
nontax purposes
Corporations that are
Corporations that meet
Not a separate taxable Separate tax-paying
certain requirements
entity, the proprietor entity
and pay no tax at the
reports the net profit A C corporation is
A partnership is not a corporate level are
of the business on his required to file a tax
separate taxable referred to as S
or her own individual return and is subject to
entity. The partnership corporations, because
tax return. the Federal income Offer limited liability
is required to file a tax they are governed by
A proprietorship itself tax and some (but not all)
return (Form 1065) on Subchapter S of the
is not a taxpaying The shareholders then of the other nontax
which it summarizes Code.
entity. The owner of pay income tax on the features of corporation.
the financial results of Tax treatment of an S
the proprietorship dividends they receive These organizations
the business. Each corp. is more like a
reports the income and when the corporation exist under state laws.
partner then reports partnership
deductions of the distributes its profits. Both forms usually
his or her share of the The S corp. is not
business on a Schedule the profits of the are treated as
net income or loss and subject to Federal
Net profit (or loss) of corporation can be seen partnerships for tax
other special items that income tax
the proprietorship is as subject to double purposes
were reported on the Like a partnership, it
then reported on his taxation, Income taxed
partnership return. does file a tax return
or her Form 1040 at corporate level and
(Form 1120S), but
(U.S. Individual again at owner level
Shareholders report
Income Tax Return) when distributed as a
their share of net
dividend
income or loss and
other special items on
their own tax returns.
Tax Planning
Minimizing taxes legally is referred to as tax avoidance. On the other hand, some taxpayers
attempt to evade income taxes through illegal actions.
There is a major distinction between tax avoidance and tax evasion ‫التهرب الضريبي‬
Clients expect tax practitioners to provide advice to help them minimize their tax costs. This
part of the tax practitioner’s practice is referred to as tax planning.
Tax planning skill is based on knowledge of tax saving provisions in the tax law.
• The primary goal of tax planning is to design a transaction so as to minimize its tax
costs, while meeting the other nontax objectives of the client.
• The main goal of tax planning is to maximize the present value of its after-tax
income and assets, not to minimize tax cost.
Effective tax planning requires careful consideration of the nontax issues involved in
addition to the tax consequences.

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 The Ethics of Tax Planning
Tax planning (avoidance) is a fully ethical activity by the taxpayer and the tax professional, but
tax evasion (fraud) is no.
Other formal restrictions and directives concerning the conduct of the tax professional can be
found in two broad forms:
1. Penalties‫ عقوبات‬and interest may apply to the taxpayer when a tax liability is
understated. Examples include penalties for filing a tax return after its due date,
understating gross income amounts, and underpaying withholding or estimated taxes
that are due.
2. Sanctions ‫عقوبات‬are used for tax preparers who disregard the tax law.

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Determining the Tax Burden ‫العبء الضريبي‬
There are at least three kinds of tax rates to consider in making a financial decision.
1- Marginal tax rate is a tax rate paid on an additional dollar of taxable income.
2-The average tax rate is the ratio of taxes paid to the tax base= tax expense ÷ Taxable income
3- The effective tax rate = tax expense ÷ total revenue
Example: 34
Azure Corporation reports taxable income of $80,000. Azure also received $10,000 of tax-free
interest income from municipal bonds. Using the corporate tax rate schedule on the inside
front cover of this text, one can determine that the company’s tax liability is $15,450. If Azure
were to earn an additional dollar in taxable income, it would pay an extra $.34 in tax. Thus, the
company’s marginal tax rate is 34%. Azure’s average tax rate is the ratio of taxes paid to book
income, or 19.3% ($15,450/$80,000). Finally, the company has an effective rate of tax of 17.2%
($15,450/$90,000), the ratio of taxes paid to book net income before tax (here, the sum of
taxable income and tax-free income).

Example: 35
Magenta Corporation is a publishing company that specializes in electronic media. It is a new
corporation that was formed on January 1, 2015. During that year, it generated a net operating
loss (NOL) of $300,000. The NOL can be carried forward to offset future years’ taxable income
and thereby reduce Magenta’s future tax liabilities. Magenta expects to earn $100,000 of
income each year over the next four years. The NOL should completely offset the company’s
taxable income for the first three of these years. At the beginning of 2016, Magenta must decide
whether to invest in a project that will earn an additional $40,000 of taxable income during
2016 or in a project that will generate $36,000 of tax free income.

The tax cost of the $40,000 project equals the discounted value of the tax due for 2018.
Assuming a 10% after-tax internal rate of return and a 15% corporate tax rate, the present
value of taxes deferred for three years is $4,508 and the discounted tax rate is 11.27%. Thus, the
after-tax proceeds on the taxable project are $35,492, or $508 less than the $36,000 earnings
on the tax-free project. The president’s decision is incorrect

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