South-Western Federal Taxation 2024, Essentials of Taxation,
Individuals and, Business Entities, 27th Edition
CHAPTER 1: INTRODUCTION TO TAXATION
TABLE OF CONTENTS
Problems ..............................................................................................................................1
Bridge Discipline Problems ................................................................................................ 6
Research Problems ............................................................................................................. 7
PROBLEMS
1. (LO 1) Various answers are possible, including using the Key Terms at the end of each
chapter, referring to the Glossary (Appendix C), looking up the footnote resources to
the Internal Revenue Code in Appendix D, using chapter features (e.g., Global Tax
Issues, Ethics & Equity, Tax Planning, and Digging Deeper), examining the tax forms
used in the chapters, and completing additional end-of-chapter assignments. All of
these resources will help students engage more deeply with the materials and help
their understanding.
2. (LO 3, 5, 6) Some tax and nontax considerations James should investigate include the
following:
• State and local income taxes.
• State and local sales taxes.
• State and local property taxes.
• Employee implications of the move (Will James lose current employees? Is the
labor market better in the new location? Is cost of living lower or higher in new
location?).
• Logistics/transportation of products to customers (specifically document lower
costs).
• State infrastructure (better in new location?).
3. (LO 2) A tax is regressive if it represents a larger percentage of the income of a low-
income taxpayer relative to the income of a high-income taxpayer. Examples of
regressive taxes include sales and excise taxes. A tax is progressive if it represents a
larger percentage of the income of a high-income taxpayer relative to the income of a
low-income taxpayer. The Federal income tax is an example of a progressive tax.
,4. (LO 3)
a. The parsonage probably was not listed on the property tax rolls because it was
owned by a tax-exempt church. Apparently the taxing authorities are not aware
that ownership has changed.
b. Ethan should notify the authorities of his purchase. This will force him to pay back
taxes but may eliminate future interest and penalties.
5. (LO 1, 2, 6) (See Digging Deeper 1.) As to Adam Smith’s canon on economy, the Federal
income tax yields a mixed result. From the standpoint of the IRS, economy exists as
collection costs are nominal (when compared with revenue generated). The
government’s cost of collecting Federal taxes amounts to less than one-half of 1
percent of the revenue collected. Economy is not present, however, if one looks to the
compliance effort and costs expended by taxpayers. According to recent estimates,
about 56% of individual taxpayers who file a return pay a preparer, and one-third
purchase tax software.
6. (LO 3) Jang probably will be required to pay the Washington use tax if, and when, he
applies for Washington license plates. In this case, the use tax probably is the same
amount as the Washington sales tax. See the discussion in connection with Example 4
in the textbook.
7. (LO 3) Although the Baker Motors bid is the lowest from a long-term financial
standpoint, it is the best. The proposed use of the property by the state and the
church probably will make it exempt from the school district’s ad valorem tax. This
would hardly be the case with a car dealership. In fact, commercial properties (e.g., car
dealerships) often are subject to higher tax rates.
8. (LO 3) A possible explanation is that Sophia made capital improvements (e.g., added a
swimming pool) to her residence and her parents became retirees (e.g., reached age 65).
9. (LO 5, 6) SWFT, LLP
5191 Natorp Boulevard
Mason, OH 45040
December 5, 2023
Cynthia Clay
1206 Seventh Avenue
Fort Worth, TX 76101
Dear Cynthia:
I am writing this letter to help you decide on what form of entity to choose for your
new food delivery business. In our phone conversation, you indicated that you expect
to have losses for the first two years in this business and then make substantial
profits in subsequent years. You and Marco also indicated that you are concerned
about potential personal liability.
While I can’t make a conclusive recommendation based on the information you have
given me, I can provide you with some general guidelines that should simplify your
decision. First, given your concern about personal liability, a partnership does not
appear to be a desirable option (you would both be personally liable for any injuries to
customers). Similarly, given your expectation of losses in the first two years, it does
, not appear that a C corporation would be a desirable choice, at least initially. This is
because any losses in the corporation could only be used to offset future corporate
profits—you could not use the losses to immediately offset your personal tax liability.
Thus, two choices exist which provide limited liability and deductibility of losses on
your personal income tax return. These are the S corporation and the limited liability
company. If you choose an S corporation, we would probably convert the entity to a
C corporation when the business becomes profitable. At that point, profits would be
taxed at the C corporation rate. A second tax would be levied on your personal income
tax return for any dividends paid by the corporation once it achieves C status. In
contrast, limited liability companies are taxed like partnerships—all income would be
taxed on your personal income tax return in profitable years. The relative desirability
of each of these two forms depends on a number of factors. One of the most
important factors in your situation is the relationship between your personal tax rate
and the tax rate of a C corporation. If you are in a high tax bracket and if the income in
the business is sufficiently low, you might be best off choosing the S corporation.
Alternatively, if you expect the business to generate a sufficiently large profit each
year, it might be best to choose the limited liability company. The qualified business
income deduction for income from flow-through entities along with the flat tax rate of
21% that applies to corporations also must be taken into consideration.
If you would like me to give you a clearer recommendation, we should meet at your
earliest convenience. If you have any additional questions, please call me.
Best regards,
Julian Jackson, CPA
10. (LO 5, 6)
a. Year 1 Year 2 Year 3
Corporate Tax Liability
Sales revenue $150,000 $320,000 $600,000
Cash expenses (30,000) (58,000) (95,000)
Depreciation (25,000) (20,000) (40,000)
Taxable income $ 95,000 $242,000 $465,000
Corporate tax liability $ 19,950 $ 50,820 $ 97,650
Cash Available for Dividends
Sales revenue $150,000 $320,000 $600,000
Tax-free interest income 5,000 8,000 1 5,000
Cash expenses (30,000) (58,000) (95,000)
Corporate tax liability (19,950) (50,820) (97,650)
Cash available for dividends $105,050 $219,180 $422,350
Ashley’s After-Tax Cash Flow
Dividend received $105,050 $219,180 $422,350
Tax on dividend at 15% rounded (1 5,758) (32,877) (63,353)
After-tax cash flow $ 89,292 $186,303 $358,997
PV of cash flow* $ 79,729 $148,521 $255,534
Total present value $483,784
*Present value factors (.8929, .7972, .7118) from Appendix E.
, b. Year 1 Year 2 Year 3
Individual Tax Liability
Sales revenue $150 , 000 $320,000 $600,000
Cash expenses (30,000) (58,000) (95,000)
Depreciation (25,000) (20,000) (40,000)
Taxable income $ 95,000 $242,000 $465,000
Individual tax liability** $ 23,750 $ 60,500 $1 1 6,2 50
**Rate = 25%
Ashley’s After-Tax Cash Flow
Sales revenue $1 50 ,000 $320,000 $600,000
Tax-free interest income 5,000 8,000 1 5,000
Cash expenses (30,000) (58,000) (95,000)
Individual tax liability (23,750) (60,500) (116,250)
After-tax cash flow $1 0 1 ,250 $209,500 $403,750
PV of cash flow* $ 90,406 $16 7,0 1 3 $287,389
Total present value $544,808
*Present value factors (.8929, .7972, .7118) from Appendix E.
c. If Ashley wants to have access to all available cash from the business, then she
will have to pay out dividends annually. As seen in the answers to parts a. and b.
above, the present value of future cash flows is substantially greater if she does
not incorporate under this assumption. Alternatively, if she does not need to pay
out dividends, then she may be better off by incorporating, since only the
corporate tax will be incurred, which is less than her individual tax. The value of
her stock will increase and she then can sell the stock at a later date at favorable
capital gains rates.
11. (LO 1) PowerPoint presentations will vary. In favor of high progressivity:
• Ability to pay.
• Fairness of result.
• Benefits of government skew toward those at upper-income levels.
Contrary to high progressivity:
• Discouragement of work and innovation.
• Unfairness of result.
• Civic engagement by those at lower-income levels requires “skin in the game.”
12. (LO 3)
a. In terms of taxpayer compliance, an ad valorem tax on personalty is less desirable
than one on realty. However, a tax on business personalty, such as inventory, is to
be preferred over one on personal use (i.e., nonbusiness) personalty.
b. A tax on stock and bonds would be too easily avoided. The taxing authority would
have no means of ascertaining ownership of these assets.
Individuals and, Business Entities, 27th Edition
CHAPTER 1: INTRODUCTION TO TAXATION
TABLE OF CONTENTS
Problems ..............................................................................................................................1
Bridge Discipline Problems ................................................................................................ 6
Research Problems ............................................................................................................. 7
PROBLEMS
1. (LO 1) Various answers are possible, including using the Key Terms at the end of each
chapter, referring to the Glossary (Appendix C), looking up the footnote resources to
the Internal Revenue Code in Appendix D, using chapter features (e.g., Global Tax
Issues, Ethics & Equity, Tax Planning, and Digging Deeper), examining the tax forms
used in the chapters, and completing additional end-of-chapter assignments. All of
these resources will help students engage more deeply with the materials and help
their understanding.
2. (LO 3, 5, 6) Some tax and nontax considerations James should investigate include the
following:
• State and local income taxes.
• State and local sales taxes.
• State and local property taxes.
• Employee implications of the move (Will James lose current employees? Is the
labor market better in the new location? Is cost of living lower or higher in new
location?).
• Logistics/transportation of products to customers (specifically document lower
costs).
• State infrastructure (better in new location?).
3. (LO 2) A tax is regressive if it represents a larger percentage of the income of a low-
income taxpayer relative to the income of a high-income taxpayer. Examples of
regressive taxes include sales and excise taxes. A tax is progressive if it represents a
larger percentage of the income of a high-income taxpayer relative to the income of a
low-income taxpayer. The Federal income tax is an example of a progressive tax.
,4. (LO 3)
a. The parsonage probably was not listed on the property tax rolls because it was
owned by a tax-exempt church. Apparently the taxing authorities are not aware
that ownership has changed.
b. Ethan should notify the authorities of his purchase. This will force him to pay back
taxes but may eliminate future interest and penalties.
5. (LO 1, 2, 6) (See Digging Deeper 1.) As to Adam Smith’s canon on economy, the Federal
income tax yields a mixed result. From the standpoint of the IRS, economy exists as
collection costs are nominal (when compared with revenue generated). The
government’s cost of collecting Federal taxes amounts to less than one-half of 1
percent of the revenue collected. Economy is not present, however, if one looks to the
compliance effort and costs expended by taxpayers. According to recent estimates,
about 56% of individual taxpayers who file a return pay a preparer, and one-third
purchase tax software.
6. (LO 3) Jang probably will be required to pay the Washington use tax if, and when, he
applies for Washington license plates. In this case, the use tax probably is the same
amount as the Washington sales tax. See the discussion in connection with Example 4
in the textbook.
7. (LO 3) Although the Baker Motors bid is the lowest from a long-term financial
standpoint, it is the best. The proposed use of the property by the state and the
church probably will make it exempt from the school district’s ad valorem tax. This
would hardly be the case with a car dealership. In fact, commercial properties (e.g., car
dealerships) often are subject to higher tax rates.
8. (LO 3) A possible explanation is that Sophia made capital improvements (e.g., added a
swimming pool) to her residence and her parents became retirees (e.g., reached age 65).
9. (LO 5, 6) SWFT, LLP
5191 Natorp Boulevard
Mason, OH 45040
December 5, 2023
Cynthia Clay
1206 Seventh Avenue
Fort Worth, TX 76101
Dear Cynthia:
I am writing this letter to help you decide on what form of entity to choose for your
new food delivery business. In our phone conversation, you indicated that you expect
to have losses for the first two years in this business and then make substantial
profits in subsequent years. You and Marco also indicated that you are concerned
about potential personal liability.
While I can’t make a conclusive recommendation based on the information you have
given me, I can provide you with some general guidelines that should simplify your
decision. First, given your concern about personal liability, a partnership does not
appear to be a desirable option (you would both be personally liable for any injuries to
customers). Similarly, given your expectation of losses in the first two years, it does
, not appear that a C corporation would be a desirable choice, at least initially. This is
because any losses in the corporation could only be used to offset future corporate
profits—you could not use the losses to immediately offset your personal tax liability.
Thus, two choices exist which provide limited liability and deductibility of losses on
your personal income tax return. These are the S corporation and the limited liability
company. If you choose an S corporation, we would probably convert the entity to a
C corporation when the business becomes profitable. At that point, profits would be
taxed at the C corporation rate. A second tax would be levied on your personal income
tax return for any dividends paid by the corporation once it achieves C status. In
contrast, limited liability companies are taxed like partnerships—all income would be
taxed on your personal income tax return in profitable years. The relative desirability
of each of these two forms depends on a number of factors. One of the most
important factors in your situation is the relationship between your personal tax rate
and the tax rate of a C corporation. If you are in a high tax bracket and if the income in
the business is sufficiently low, you might be best off choosing the S corporation.
Alternatively, if you expect the business to generate a sufficiently large profit each
year, it might be best to choose the limited liability company. The qualified business
income deduction for income from flow-through entities along with the flat tax rate of
21% that applies to corporations also must be taken into consideration.
If you would like me to give you a clearer recommendation, we should meet at your
earliest convenience. If you have any additional questions, please call me.
Best regards,
Julian Jackson, CPA
10. (LO 5, 6)
a. Year 1 Year 2 Year 3
Corporate Tax Liability
Sales revenue $150,000 $320,000 $600,000
Cash expenses (30,000) (58,000) (95,000)
Depreciation (25,000) (20,000) (40,000)
Taxable income $ 95,000 $242,000 $465,000
Corporate tax liability $ 19,950 $ 50,820 $ 97,650
Cash Available for Dividends
Sales revenue $150,000 $320,000 $600,000
Tax-free interest income 5,000 8,000 1 5,000
Cash expenses (30,000) (58,000) (95,000)
Corporate tax liability (19,950) (50,820) (97,650)
Cash available for dividends $105,050 $219,180 $422,350
Ashley’s After-Tax Cash Flow
Dividend received $105,050 $219,180 $422,350
Tax on dividend at 15% rounded (1 5,758) (32,877) (63,353)
After-tax cash flow $ 89,292 $186,303 $358,997
PV of cash flow* $ 79,729 $148,521 $255,534
Total present value $483,784
*Present value factors (.8929, .7972, .7118) from Appendix E.
, b. Year 1 Year 2 Year 3
Individual Tax Liability
Sales revenue $150 , 000 $320,000 $600,000
Cash expenses (30,000) (58,000) (95,000)
Depreciation (25,000) (20,000) (40,000)
Taxable income $ 95,000 $242,000 $465,000
Individual tax liability** $ 23,750 $ 60,500 $1 1 6,2 50
**Rate = 25%
Ashley’s After-Tax Cash Flow
Sales revenue $1 50 ,000 $320,000 $600,000
Tax-free interest income 5,000 8,000 1 5,000
Cash expenses (30,000) (58,000) (95,000)
Individual tax liability (23,750) (60,500) (116,250)
After-tax cash flow $1 0 1 ,250 $209,500 $403,750
PV of cash flow* $ 90,406 $16 7,0 1 3 $287,389
Total present value $544,808
*Present value factors (.8929, .7972, .7118) from Appendix E.
c. If Ashley wants to have access to all available cash from the business, then she
will have to pay out dividends annually. As seen in the answers to parts a. and b.
above, the present value of future cash flows is substantially greater if she does
not incorporate under this assumption. Alternatively, if she does not need to pay
out dividends, then she may be better off by incorporating, since only the
corporate tax will be incurred, which is less than her individual tax. The value of
her stock will increase and she then can sell the stock at a later date at favorable
capital gains rates.
11. (LO 1) PowerPoint presentations will vary. In favor of high progressivity:
• Ability to pay.
• Fairness of result.
• Benefits of government skew toward those at upper-income levels.
Contrary to high progressivity:
• Discouragement of work and innovation.
• Unfairness of result.
• Civic engagement by those at lower-income levels requires “skin in the game.”
12. (LO 3)
a. In terms of taxpayer compliance, an ad valorem tax on personalty is less desirable
than one on realty. However, a tax on business personalty, such as inventory, is to
be preferred over one on personal use (i.e., nonbusiness) personalty.
b. A tax on stock and bonds would be too easily avoided. The taxing authority would
have no means of ascertaining ownership of these assets.
