1 Income Taxes Description Income in the U.S. is taxed by the Federal government to provide revenue to run the government and provide services to the citizens. Each year businesses and individuals must file a set of forms outlining income and expenses and compute the tax owed. Many turn this task over to accountants who are specialists. In the simplest situations, the IRS will calculate the tax for a filled-in form or by telephone. It is not difficult to file your own tax forms if you have some understanding of the principles, can read IRS instructions, and are willing to ask questions when confused. In most cases the forms and figures for each year are very similar to the previous year. As discussed in the labor section, income taxes actually are paid throughout the year through tax withholding or quarterly estimated payments for both businesses and individuals, except for farms. Therefore, the tax forms often just verify the final official computation and show whether the citizen is entitled to a refund or owes more money in taxes. The most important forms are described below. All are supporting forms, making calculations for the main form Schedule F (Profit or Loss from Farming) lists farm receipts and expenses, including total depreciation for the year. That net farm income then appears in the income section of the Main Federal Tax Forms 1040 Main individual return Sched A Itemized deductions Sched B Interest and Dividends Sched F Farm Profit/Loss Sched C Business Profit/Loss 4562 Depreciation 4797 Sales of Business Property Sched SE Self Employment Tax Sched D Capital Gains/Losses Sched J Farm Income Averaging IRS forms can be obtained on the web (http://www.irs.gov ) in PDF format for laser printing. Fill-in forms are also available.
2 1040 Form - Individual Income Tax Return Gross Income (Salary, wages, tips, net farm, net business, interest, dividends) +/- Adjustments (Half SE tax, alimony, retirement plans) Adjusted Gross Income - Deductions (subtractions for qualifying "family expenses") - Exemptions (subtractions for family size or disabilities) Taxable Income (pay tax on this amount) Tax (lookup/computed) - Tax Credits (child care, elderly, foreign, special programs) Tax Liability (what is actually owed) - Withheld/Prepaid Owed/Refund (net from previously paid tax) 1040 Example Married Single Salaries, Wages 40,000 Farm Profit/Loss 40,000 40,000 Adjusted Gross Income 80,000 40,000 Deductions (standard) 7,850 4,700 Exemptions (2 and 1) 6,000 3,000 Taxable Income 66,150 32,300 Tax 11,658 5,068 Tax Credit 1,000 1,000 Tax Liability 10,658 4,068 Computation of Income Taxes Income tax is calculated on the taxable income. Up to roughly $27,000 per person ($45,000 if married), the tax is 15% of taxable income. For approximately the next $39,000 per person, 28% is owed in taxes, and so on. The key concept is that as more money is earned, a larger percentage of it is paid in taxes. If the taxable income is about $60,000 per person, the total percentage would be an average of 15% and 27.5%, or about 21% owed in tax. The common term for discussing taxes, however, is the marginal tax rate (MTR or tax bracket). The MTR is the rate at which the next dollar earned will be taxed. This is the important rate for making decisions. For $40,000 of taxable income this would be a MTR of 27.5%. The next $100 earned would cost $27.5 in Federal income tax. This rate will increase as larger amounts are earned. It will go up to 30.5% if $136,750 or more is earned. The tax calculation can be taken from a tax table or calculated from a formula as described below. The Federal Internal Revenue Service publishes the rates by income category as determined by Congress.
3 Standard Deductions: Married = 7,850 Single = 4,700 Everyone gets at least the standard deduction. If itemized deductions exceed the standard deduction, then the itemized deduction is used. Deductions reduce taxable income. Exemptions: 3,000 each An exemption is deducted for each person supported by the family. This reduces taxable income. Marginal Tax Rate Formulas Married Example for $66,150 taxable income: 6, *(66,150 46,700) 6, *(19,150) = $11,658 Single Example for $32,550 taxable income: 3, *(32,300-27,950) 3, *(4,350) = $5,068 Other Taxes State Income Tax Adjusted Gross Income - Deductions ($1,640 single; $3,280 married) - Exemptions (145 each) Taxable Income Tax [ *(Taxable Income 12,500)] (OR) Self Employment Tax - Social Security (FICA and Medicare) for people with no employer to deduct it or pay half of it. The income tax system is the most logical and easiest place to collect it. o Rate: 8.2% up to Taxable Income of $84,900 plus 2.9% Medicare over $84,900 (no ceiling on Medicare portion) o Half is tax deductible on Form 1040 (about line 29) as adjustment to income. Summary At 27% marginal tax rate, this should prove that the effects of income taxes on management decisions are significant. Legal minimization of tax liabilities is a critical issue for businesses. 27% Federal 9% State 18.2% Self Employment 54.2% Total (up to 2.5% less due to deduction for SE).
4 Profit or Loss from Farming (Schedule F) This form looks very similar to a Profit-Loss Statement. It is used to report cash receipts and expenses, and non-cash depreciation. It does not include debt or loan principal paid, nor change in capital items (except through depreciation), nor change in inventory unless reporting on an accrual basis (what has been used). All figures must be documentable. Schedule F - Profit or Loss from Farming Farm Income - Cash Sale of Milk 270,000 Sale of Culls & Calves 34,000 Gross Income 304,000 Farm Expenses Operating Expenses 238,200 Depreciation ,000 Interest 19,800 Total Expenses 284,000 Net Farm Profit (Loss) 20,000 Depreciation Depreciation for tax purposes is a scheduled loss in value of an item for each year. We have used the concept in calculating annual cost. It also has appeared on the Profit- Loss or Income Statement. The government gives a business tax deduction for depreciation of qualified capital assets. To receive this tax benefit, however, specific rules must be followed. There is some choice of depreciation method, but the rate of depreciation for each method is fixed by law. If it turns out that the official depreciation schedule depreciates the item too quickly or too slowly as indicated by actual or sale value, the taxes will be adjusted at the time of sale. Ultimately, then, the appropriate amount of depreciation is given tax credit, achieving a measure of fairness. Rules for defining Depreciable Property: 1. Used in a business to produce income 2. Useful life exceeding one year 3. Wears out, becomes obsolete, or loses value from natural causes Buildings? Land? Machinery? Purchased Cattle? Raised Cattle? Milk Base? Silos? Parlors? Trucks? Feeder Cattle? MACRS - Modified Accelerated Cost Recovery System 1. GDS General Depreciation - 1.5X Declining Balance 2. ADS Alternative Depreciation - Straight Line
5 MACRS Classes Class Property 3 Yr, 1.5/3 Breeding Hogs, breeding horses > 12 yrs old 5 Yr, 1.5/5 Cattle, Goats, Sheep, Autos, Trucks, Computers 7 Yr, 1.5/7 Machinery, Fences, Grain Bins, Horses<12, Furniture 10 Yr, 1.5/10 Single Purpose Structures, Silos, Fruit Trees 20 Yr, 1.5/20 Farm Buildings (Multipurpose) 27.5 Yr, SL Residential Rental Property 39 Yr, SL Non-Residential Real Property First Year Depreciation (special handling required for year 1) 1. Mid-Year Convention - 1/2 deprec. 1st year (finish it in year n+1) 2. Mid-Quarter Convention - varies (invoked if >40% of new items purchased in 4th quarter) Section Expensing Each year, $24,000 immediately deductible, but then not depreciated. This was originally intended for smaller depreciable items for which depreciation schedules would be a nuisance. Schedule: 24,000 (2001-2), and 25,000 (2003). MACRS Depreciation - Percent of Original Price 150% Declining Balance switching to Straight Line when Beneficial Depreciation Class Year 3-YR 5-YR 7-YR 20-YR MACRS Depreciation Example $30,000 Tractor 7-Year Class 1.5/7 per year Mid-Year convention Switch to straight-line in year 4
6 6% MARR 28% MTR Notes Depreciation each year is (1.5/7)=21.4% of the prior-year balance. Depreciation in year 1 is only half. In year 4 it can be switched to straight line because (1/4.5) is more than (1.5/7). Straight line is figured on the remaining 4.5 years and is a constant dollars yrs 4-8. The switch to straight line yields about $1,400 more depreciation ($1,000 pv). In year 8 the half year lost in year 1 is claimed, but at the straight line amount. Depreciation benefits = 6,656/30,000 = 22.2% of purchase price Must own the item on midnight December 31 to claim the year's depreciation. Year Depreciation Balance MTR Tax Saved 6% PV 1 3,214 26, ,740 21, ,607 1, ,510 16, ,263 1, ,675 12, , ,675 9, , ,675 5, , ,675 1, , ,837 (0) Totals 30,000 8,400 6,656 Selling an Asset Depreciation gives a tax deduction for the declining value of an asset. When that asset is sold then the selling price is the actual value. If its depreciated book value does not match the sale value, then too much or too little depreciation has been taken and a tax adjustment must be made. Basically you give back the extra depreciation deductions which, in retrospect, you did not deserve, or you are allowed to take more deduction. The following table shows the value of the $30,000 tractor after 3 years of depreciation to be $16,536. Original Basis 30,000 (Price) - Depreciation - 13,464 (Sum 3 yrs) + Cost of Selling 0 Adjusted Basis 16,536 (End of 3 yrs)
7 30,000 Profit Capital Gain (long term > 12 mo) Depreciation Ordinary Tax 16,536 (Recoup Depreciation) Value Capital Loss 0 (adjusted basis) (long term capital loss > 12 mo) Note: If sell for depreciated value, no tax is owed. If sell for less than depreciated value, did not depreciate enough, hence a loss, and a deduction. If sell for more than depreciated value, depreciated too much, must give back in tax. If sell for more than purchase price, must give back all depreciation, and pay tax on Capital Gain, but only 10% and 20% on Long Term Gain, instead of 15% and 27% as for ordinary income and Short Term Capital Gain. Rules for Depreciating Cattle Raised Cattle: Basis is zero. Deducted the cost of raising as cash expenses. Price received is taxable. If over 2 yrs old, the whole price is a long term capital gain. Purchased Cattle: Begin depreciating when placed in service. Depreciate in 5-year class. Long term capital gain requires holding > 2 yrs from purchase. (Other assets > 1 yrs) Capital Gain: Capital Loss: Reduced tax rate for long term. Tax rate on long term capital gain is 10% for the 15% MTR and 20% for the 28% MTR. Implication: Keep a profitable animal for 2 years or more if possible. Why? Losses must be used first to offset gains. Long term capital gains are offset by short term capital losses. Same rules, except losses are deductions. Therefore, get rid of a loss before 2 years. Why?
8 Purchasing and Selling a Cow Purchase her as a heifer for $2,000 on 6/98 She calves on 9/00 Sell her for $1,500 on 7/02 0 (1-99) 1 (1-00) 2 (1-01) 3 (1-02) 4 (1-03) 5 (1-04) 2,000 1,500?? Buy In Service Sell Depreciate (1/2) Depreciate Year Depreciation Balance , , Tax Work on Purchased Cow Original Basis 2,000 (Price) - Depreciation (Sum 2 yrs) Adjusted Basis 1,190 (End of 2 yrs) Scenarios Sell Price Capital Gain/Loss Ordinary Gain $2, x (2,500 2,000) 0.27 x (2,000 1,190) $1, x (1,500 1,190) $1,190 $ x (1, ) Tax Liability = (1,500-1,190)*0.27 = 310*0.27 = 83.70
9 Major Effects of Income Taxes 1. Additional expenses Reduce tax by (MTR x Expense) 2. Additional receipts Increase tax by (MTR x Receipt) 3. Interest on loans Reduce tax by (MTR x Interest) 4. Depreciation of purchased assets Reduce tax by (MTR x Depreciation) 5. Tax on sale of capital assets Reduce tax if depreciation has been too little Increase tax if depreciation has been excessive 6. Long Term Capital Gains/Losses Reduced tax on "profits" (would apply to all raised cattle, including culls) Year-End Tax Planning Assume a tax will be owed, otherwise reverse the suggested plan. 1. Look for additional deductions to reduce tax Pre-purchase supplies, feed, fertilizer by Dec. 31 Take care of needed repairs and maintenance Make new capital purchases (begin depreciating) 2. Look for opportunities to defer income Postpone sale of crops and raised cattle to January 1 3. Examine potential capital gains and losses Hold capital items for gains (1 yr machinery, 2 yrs cattle), but cut losses early Capital losses can be used to offset capital gains 4. Contribute to tax-deferred IRA's or Roths up to April 15 (tax deductible (deferred)) The Big Tax Myths 1. All income is taxed. 2. All taxable income is taxed at the MTR. 3. The Federal MTR is the whole story. 4. It's always better to depreciate as fast as possible. 5. If I work, it will put us into a higher tax bracket, and the additional taxes will exceed 6. my take-home pay. 7. It's better to buy something (anything?) than to pay taxes. 8. It won't cost you anything to take the trip, it's tax deductible.
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