Multifaceted system of tax principles and concepts may seem bewildering at first. However, most tax systems have developed around fundamental concepts that do not change much and thus provide a deep structure to tax rules as I will discuss through this post. For example: a number of principles and concepts guide how tax laws are structured in the United States. While these tax principles and concepts cannot be used to provide guidance on all tax rules, they generally explain why many tax laws are structured the way they are throughout the world. For easier understanding, each principle [and concept] is illustrated with fairly light examples. Enjoy!
Under the ability-to-pay principle, the tax is based on what a taxpayer can afford to pay. One concept that results from this is that taxpayers are generally taxed on their net incomes.
X and Y corporations each have sales revenues of $500,000. Expenses for the two corporations are $100,000 and $300,000, respectively. Corporation X will pay more taxes, because it has greater net income and cash flows, and thus can afford to pay more.
This concept does not apply to every tax in every jurisdiction. Nor do the rest of the concepts presented in this post. Furthermore, those that do most often are understood rather than explicit. That is, they are unofficially applied administratively rather than mandated by primary sources of law.
These concepts are more likely to have developed in more industrialized societies where tax laws have become more complex, the foremost example being the United States. Nevertheless, by suggesting what the tax rules ought to be, these concepts can help people understand current rules and anticipate what the rules will most likely be in the future.
Under the entity principle, an entity (such as a corporation) and its owners (for a corporation, its shareholders) are separate legal entities. As such, the operations, record keeping, and taxable incomes of the entity and its owners (or affiliates) are separate.
An entrepreneur forms a corporation that develops and sells the entrepreneur’s software products. During the year, the corporation has $200,000 in revenue and $50,000 in expenses. The entrepreneur also has a salary of $100,000. The corporation will file a corporate tax return showing $50,000 in taxable income, and the entrepreneur will file an individual tax return showing $100,000 of income.
The Doctrine Principle [The Arm’s Length Transaction]
Closely related to the entity concept is the arm’s length doctrine. Doctrines are principles that, while often not officially appearing in the tax laws, carry the weight of law. In the United States, for example, doctrines are developed through a series of court cases. An arm’s length transaction is one in which all the parties in the transaction have bargained in good faith and for their individual benefit, not for A Framework for Understanding the benefit of the transaction group. Transactions that are not made at arm’s length will not be given their intended tax effect.
Assume that in Example-2 the corporation pays its entire $250,000 in net income to the entrepreneur as a salary for being president of the corporation. Suppose that a reasonable salary for a president of a small software company is $100,000. The effect of the salary is to reduce the corporation’s taxable income to zero, so that it does not have to pay any taxes. While salaries in such closely held corporations are deductible in general, in this case the arm’s length test is not met. As a result, only $100,000 (i.e., the reasonable portion) of the salary will be deductible by the corporation. The remaining $150,000 will be considered a dividend.
In determining whether the arm’s length rule is likely to be violated with regard to expenses and losses, tax authorities look to see if the transaction is between related taxpayers. Related taxpayers generally include individuals related by blood and marriage, and business entities owned more than 50% by a single entity or individual.
Assume that an entrepreneur sells an asset to his corporation and that the sale results in a loss. The entrepreneur owns 49% of the corporation’s stock; the other 51% is owned by a group of unrelated investors. Since the loss is not between related taxpayers, it may be considered arm’s length.
In applying the ownership test, constructive ownership is considered. That is, indirect ownership and chained ownership are considered.
Assume the same facts as Example-4, except that the other 51% of the stock is owned by Z Corporation, which is owned 100% by the entrepreneur. By the rules of attribution and constructive ownership, the entrepreneur is considered to own 100% of the stock: by direct ownership in the first corporation, plus the stock owned by the Z Corporation. Thus, the transaction is not arm’s length, and none of the loss would be deductible.
Related to the ability-to-pay concept is the pay-as-you-go concept. Taxpayers must pay part of their estimated annual tax liability throughout the year, or else they will be assessed penalties and interest. For individuals, the most common example is income tax withholding.
In the United States, for example, employers withhold estimated income taxes and payroll taxes from each employee’s paycheck and then remit the withholding to the government. These taxes, and the requirements for withholding, can be imposed by local governments (such as cities) as well as higher levels (such as state and national governments), but are more common of the higher levels.
In many countries, the withholding is the tax; in the United States, it is only a prepayment, which is reflected as a credit against further liability when the relevant tax return for the period is filed. If the taxpayer also has nonwage income (that is, income not subject to withholding), the taxpayer must remit one-fourth of the estimated annual tax due on this nonwage income every three months. This estimated tax requirement generally applies only to expected taxes A Framework for Understanding Taxes 45 over a minimum level, such as $1,000 for annual U.S. personal income tax.
Referring to Example-3, how should the entrepreneur pay U.S. income taxes on personal income derived from the corporation? The $100,000 salary portion must have taxes withheld by the employer (the entrepreneur’s own corporation). In addition, the entrepreneur is supposed to estimate the income taxes which will be caused by the $150,000 dividend, and pay the additional tax as part of his or her quarterly estimated taxes. If these estimated taxes are not paid in advance of the actual due date of the annual tax return, the taxpayer may be subject to penalties and interest.
Under the same pay-as-you-go principle, corporations in the United States (which typically do not have taxes withheld) must remit one-fourth of their estimated annual tax every three months by making estimated tax payments.
Suppose a corporation expects to owe $200,000 in taxes at the end of the year: $160,000 in U.S. federal income taxes, and $40,000 in state income taxes. It is required to prepay $40,000 and $10,000 to the federal and state governments, respectively, every three months, or else be subject to penalties and interest.
All-Inclusive Income Principle
This principle basically means that if some simple tests are met, then receipt of some economic benefit will be taxed as recognized income, unless there is a tax law specifically exempting it from taxation. The tests are (each test must be met if an item is considered to be income):
- Does it seem like income?
- Is there a transaction with another entity?
- Is there an increase in wealth?
The first is a commonsense test meant to eliminate things that cannot be income. For example, making an expenditure cannot generate income. The second test is the realization principle from accounting; that is, for income to be recognized, there must be a measurable transaction with another entity. Therefore, accretion in wealth cannot generate income.
A corporation owns two assets that have gone up in value. It owns common stock in another corporation, which it originally purchased for $100,000 and is now worth $500,000. It also owns raw land worth $1 million, which it originally purchased for $200,000. It sells the stock for its fair market value, but not the land. Income is recognized only on the stock; there has been no realization on the land.
The increase-in-wealth test means that unless there is a change in net wealth, no income will be recognized. This eliminates a number of transactions from taxation.
A corporation borrows $5 million from a bank, issues $1 million in common stock, and floats a bond issue for which it receives $10 million. Although each of these transactions involves cash inflows and transactions with other entities, there is no change in net wealth. This because of each of the three cash inflows, there is an offsetting increase in liabilities (or equity) payable.
Recovery Of Capital Concept
Closely related to the income-realization concept are the concepts of recovery of capital, claim of right, and constructive receipt:
- Under recovery of capital, a taxpayer does not usually recognize income on the sale of an asset until the taxpayer’s capital is first recovered.
- Under claim of right, income is recognized once the taxpayer has a legal right to the income.
- Under constructive receipt, income is recognized when it is available for the taxpayer’s use, even if the taxpayer does not collect the income.
Note that constructive receipt applies only to cash-basis taxpayers; accrual-basis taxpayers recognize income (if it is realized) regardless of whether it is received.
A corporation sells inventory for $100,000; its cost to manufacture is $10,000. The sale is for cash. It also receives $100,000 from a customer by mistake; it will eventually have to pay the money back. Finally, it makes another cash sale of inventory for $10,000, with a cost of goods sold of $2,000. The sale was at year-end. The corporation did not pick up the check from the client until the beginning of the next year, even though the money was available to it before year-end.
On the first inventory sale, the corporation is first allowed to recover its $10,000 inventory cost. Thus, only the remaining $90,000 is subject to tax.
On the second item, there is no income because there is no legal claim of right to the funds yet.
Finally, the disposition of the last item (constructive receipt) depends on the corporation’s method of accounting. If it is an accrual-basis taxpayer, when it receives the cash is irrelevant; income is recognized at the time of the sale. If it is a cash-method taxpayer, constructive receipt occurs this year because that is when the funds are available.
Note that the concept of recovery of capital also implies that if the taxpayer does not dispose of the asset, the taxpayer can recover the tax basis over time through depreciation. The extant depreciation used, for federal income tax purposes, is the modified cost recovery system (MACRS) referred to previously. Generally, a capital expenditure cannot be expensed but instead must be depreciated over time.
Closely related to the income concepts already described is the concept of legislative grace. Here income that would normally be taxed under the preceding rules is either exempt from tax or subject to a lower tax rate due to special rules. In the United States, for example, these can be provisions in the law, such as the Internal Revenue Code enacted by Congress or its equivalent at the state level. For all taxpayers, one example is the federal exclusion of interest income from state and local obligations. For corporations, federal income tax law has a number of exclusions, the most noteworthy being:
- Exclusion from U.S. taxation of the income of subsidiaries located overseas until the funds are repatriated. (This applies for most, but not all, subsidiaries.)
- Exclusion of up to 100% of dividend income received from another corporation.
For individuals, there are numerous exclusions related to employment (some fringe benefits, insurance, retirement fund contributions), illness or death (worker’s compensation benefits or life insurance proceeds), family transfers (receipt of gifts and inheritances), and education (scholarships, fellowships, and some employee tuition-assistance plans). Perhaps the most significant is the preferential tax rates given to long-term capital gains. As noted, the standard U.S. tax rate is 15% on long-term capital gains, a rate substantially below the maximum federal rate of 35%. This rate can be even lower: For individuals who are in the 15% bracket for ordinary income, a 5% rate applies to long-term capital gains. In many countries, gains from the sale of long-held assets are exempt from taxation.
An important aspect of the preferential capital gain tax rate as related to strategic tax planning is the owner’s or manager’s sale of ownership of the entity.
An entrepreneur sells the shares in his company to a larger firm. He sells the company for $10 million. His tax basis in the shares—what he put into the company in return for shares—is $1 million. After subtracting his basis (pursuant to the concept of recovery of capital), his capital gain is $9 million. The maximum tax rate on the gain is 15%.
The legislative grace concept applies to deductions as well (deductions are expenses that can be used to reduce taxable income). In the United States, no deduction is allowed under federal and most state income tax laws unless it is specifically authorized by the law.
For businesses and sole proprietors, the usual types of expenses are generally allowed for tax purposes. This is also true for certain types of expenses related to individuals’ investment incomes. However, other deductions for individuals exist purely by legislative grace. For example, as already noted, there is a fixed standard deduction. If greater, however, individuals are allowed itemized deductions (bounded by elaborate ceilings and floors) for medical expenses, charitable contributions, state taxes paid, home mortgage interest expense, casualty and theft losses, and certain miscellaneous types of expenses.
Business Purpose Concept
Business purpose is closely related to legislative grace as it relates to deductions. Here business expenses are deductible only if they have a business purpose, that is, the expenditure is made for some business or economic purpose, and not for tax-avoidance purposes. The test is applied to a bona fide trade or business, or to expenses for the production of income. The former is a sole proprietorship, corporation, or other business entity. The latter generally includes investment-type income of individual investors. This rule typically is enforced only when the business deduction also gives some economic benefit to the owner; thus, the owner is trying to get something of value in after-tax dollars, when the item is not otherwise deductible. The rule typically is enforced only in the case of a closely held business.
An entrepreneur owns 100% of the stock of her corporation. She has the corporation buy an aircraft to facilitate any out-of-town business trips she might make. The entrepreneur, who also happens to enjoy flying as a hobby, rarely makes out-of-town business trips. Since the plane will not really help the business, and there is a tax-avoidance motive (the plane would generate tax-depreciation deductions), there is no business purpose to the aircraft. Accordingly, any expenses related to the aircraft, including depreciation, are nondeductible.
The Accounting Methods
As noted, some general rules apply when a taxpaying entity wants to choose among cash, accrual, or hybrid (part cash, part accrual) methods of accounting:
- For individuals, the election is made on their first tax return. Virtually every individual elects the cash method.
- For businesses, two rules apply. The first is that when inventory is a substantial income-producing factor, inventory (including related sales and cost of goods sold) must be accounted for by the accrual method.
Note that this rule still permits the taxpayer to use the cash method for other items of income and expense. The second rule relates to entity type. If the business is a corporation and it has gross receipts in excess of $5 million, it must use the accrual method for all transactions. Aside from the inventory and the entity-type rules, a business is free to choose any method of accounting.
Under the tax-benefit rule, if a taxpayer receives a refund of an item for which it previously took a tax deduction (and received a tax benefit), the refund becomes taxable income in the year of receipt.
A U.S. corporation pays a consulting firm $100,000 for consulting services in one year. Because this is a normal business expense, the corporation takes a tax deduction for $100,000. Early the next year, the consulting firm realizes it has made a billing mistake and refunds $20,000 of the fees. The $20,000 is taxable income to the corporation in second year because it received a tax benefit in the prior year.
Note that the rule applies only to items for which the firm has received a tax benefit. Accordingly, if the firm was in an NOL status in the prior year, or the amount paid was nondeductible (say, a bribe to a lawmaker), the refund would not be taxable income the next year.
Substance Over Form
Under the doctrine of substance over form, even when the form of a transaction complies with a favorable tax treatment, if the substance of the transaction is the intent to avoid taxes, the form will be ignored and the transaction recast to reflect its real intent.
An entrepreneur is the sole stockholder of his corporation. The corporation never pays dividends to the entrepreneur, and, instead, each year it pays out 100% of the corporation’s net income as a salary to the entrepreneur (who also serves as company’s chief executive officer).
The doctrine of substance over form empowers tax authorities to tax at least part of the salary as if it were a dividend. In jurisdictions where substance over form applies, it has quite often been developed in a series of court decisions rather than by explicit legislative action.