Tax Law and Accounting
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Recent decades, and especially recent years, have witnessed a phenomenon of great economic significance, a phenomenon that is having and will continue to have major implications for taxation. Income tax revenues have consistently risen as a percent of gross domestic product (GDP), now totaling 1.8 percent. The current federal income tax is a complex hybrid between an income and consumption tax, with some features that violate the principles of either system. This work has two objectives: to illustrate tax law and accounting in the United States, and to compare and contrast GAAP and tax accounting.
Taxes are levied in the USA by the federal, state, and local governments. Each government imposes its own taxes. There are no shared taxes, although more than one government may exploit the major revenue sources. In addition, there is considerable shifting of money through shared expenditure programs from higher to lower levels of government. The federal government, most state governments, and some local governments impose income taxes. The most important revenue sources are income and payroll taxes at the federal level, sales and income taxes at the state level, and property taxes at the local level.
In the USA, income tax applies to every individual and entity having taxable income. Taxpayers are classified by the type of return they are required to file. The base of the income tax falls far short of a comprehensive notion of income. The starting point is ‘gross income’, defined broadly as ‘all income from whatever source derived’ (Tanzi 23). Taxable income is determined for both individuals and corporations by subtracting allowable exclusions, exemptions, and deductions from gross income. For individuals, gross income includes wages and salaries, taxable interest, dividends, capital gains, rents, royalties, pension income including distributions of individual retirement accounts (IRAs), business income from sole proprietorships, income from partnerships, income from estates and trusts, farm income, refunds of state and local income taxes (if they were previously deducted), alimony received, unemployment benefits, social security benefits over certain dollar limits, and other income. US residents are in general taxed on worldwide income, although they may receive credit for taxes paid to foreign countries.
Taxpayers are allowed to deduct certain amounts, termed ‘adjustments’, from gross income to arrive at adjusted gross income (AGI). The most important of these adjustments are one-half of self-employment taxes paid by the self-employed, qualified contributions to certain tax-deferred retirement accounts (IRAs and Keogh retirement plans), and alimony paid.
After computing tax on taxable income, the individual taxpayer is allowed to claim certain tax credits. The most important of these are the earnedincome credit (a variable, vanishing credit targeted to low-income tilers who work), credit for care of child or dependant, the credit for the elderly or disabled, the foreign tax credit, and the low-income housing tax credit. Of these, only the earned-income credit is refundable (the excess of the credit over the tax liability is returned to the taxpayer). Many low-income households are not liable to tax (if their AGI is less than the total of their deductions and personal exemptions) but may still receive a tax credit refund through the earned-income credit.
Individuals are also subject to the alternative minimum tax. The tax is computed by taking AGI, making adjustments and additions for tax preferences, and then subtracting certain itemized deductions and the personal exemption. The rate is 26 and 28 per cent for individuals. Taxpayers pay the alternative minimum tax if it exceeds their regular tax.
The main form of tax collection is based on withholding of employee earnings, instituted in 1943 with the dramatic expansion of the income tax to finance the Second World War. There is only very limited withholding of capital income. However, individuals with significant income outside the withholding system must estimate their tax liability and pay it in quarterly instalments during the year. On their final tax return, taxpayers reconcile their final tax liability with amounts already paid.
Corporations can claim certain tax credits, including the foreign tax credit and the general business credit. The latter credit is an umbrella covering eight separate tax credits for investment, targeted jobs (for individuals in certain groups with high unemployment rates), alcohol used as fuel, research and development, and so forth.
Corporations pay tax on income from the sale of capital assets at the same rate as other income. Certain tax benefits, such as depreciation, are subject to recapture at ordinary income tax rates. Unlike individuals, corporations can only offset capital losses against capital gains. The remaining losses may be carried back three years and carried forward five years against capital gains.
Certain non-profit organizations, including charitable, religious, educational, and medical organizations, trade associations, labor unions, and fraternal organizations, are exempt from corporate income taxes. These organizations are, however, subject to tax on business income derived from activities unrelated to their exempt purposes.
Corporations are also subject to an alternative minimum tax (AMT), which was designed to ensure that all corporations pay tax, even those benefiting from extensive tax preferences. The base of this tax is computed by recalculating taxable income, making adjustments, and adding back certain tax preference items. The rate of tax is 20 per cent for corporations.
The primary focus of GAAP is financial accounting and reporting rather than tax accounting and reporting. There are different accounting methods for financial and tax accounting (i.e., the proverbial “two sets of books”) (Hopwood 58). The use of different accounting methods should be expected, given the contrasting objectives of financial and tax accounting. The primary objective of GAAP is to provide information useful in making rational economic decisions. On the other hand, the objectives of tax accounting are:
- To raise revenues;
- To achieve stated economic objectives (for example, tax credits are granted to stimulate investment in research and development activities);
- To achieve stated social objectives (for example, tax credits are granted for the rehabilitation of certain nonresidential, real property) (Zodrow 110).
From the financial accounting standpoint, taxes are only considered to the extent that they impact published financial information. However, the manner in which the accountant reflects the impact of taxation is usually different from the information presented on the entity’s income tax returns. Regardless of the accountant’s treatment of income taxes, the analyst must be able to utilize the information provided in the annual report to assess the present and potential future cash flow consequences of the firm’s tax information reported in the financial statements.
To oversimplify somewhat, it may be said that if a determination of income meets the standards of GAAP, it is likely to be accepted for income tax purposes as well. That obviously gives great significance to GAAP in the process of computing taxable income. It is true, though, that the rules of accounting, as expressed in GAAP, have a different purpose than the rules of taxation and that GAAP does not comprise a fixed set of simple rules. Proper accounting practice may change over time and may also vary from one line of business to another. Hence, it is only natural that one cannot always combine the two sets of rules. The GAAP depreciation methods can be used for most state and local taxes. U.S. GAAP require deferred tax allocation on all significant timing differences, including the allocations to untaxed reserves.
Hopwood, Anthony. (2004). The Economics and Politics of Accounting: International Perspectives on Research Trends, Policy, and Practice. Oxford University Press: Oxford.
Tanzi, Vito. (1995). Taxation in an Integrating World. Brookings Institution: Washington, DC.
Zodrow, George R. (1999). State Sales and Income Taxes: An Economic Analysis. Texas A&M University Press: College Station, TX.