Category: taxes

Fair Tax/ National Sales Tax

Taxation is basically taking a cut from the earning of the taxpayers. From taxpayers’ point of view, taxation of any kind can never be not fair to them. Taxpayers always seek reasonableness and not fairness in any taxation system. The proposal to replace income tax with national sales tax may contain certain attributes of reasonableness but it can never be fair to taxpayers.

When 5% sales tax is levied on purchases of $100, the cost to consumers is $105. The consumer feels a tax burden up to 5% of tax on purchases. But when the goods or services are sold for a price of $105 that is inclusive of taxation of $5, the consumer may feel that the rate of taxation is only 4.8% of its purchase price of $105. That means fairness or reasonableness of tax system from the point of view of taxpayers depends upon the feeling that the taxation system generates. Otherwise, all taxation systems are unfair from taxpayers’ point of view. Therefore replacing federal Income tax with National sales tax can only be an effort to change the feeling of taxpayers about the impact of taxation.

The advantage of National sales tax is that it is not a direct tax and accordingly the taxpayers may not feel that as a cut from their income is being made directly. Instead, it will generate a feeling that consumers are paying the purchase price of the product or services being enjoyed by them. This advantage may be called fair or reasonable because of its psychological impact, but the real effect is the same as a direct cut on taxpayers’ income.

‘The proponents of fair tax points out that the prices on consumer goods contain what are called “hidden taxes”. Under current laws, the corporations have to pay taxes on their earnings. Moreover, businesses have to pay social security taxes for each employee. The money to pay taxes has to come from somewhere, and the Fair Tax supporters argue that the cost is passed on to the consumer.'(Joe Miller, 2007).

Whatever may be the arguments of fair tax supporters, the net effect of taxes is always on the income of taxpayers. Therefore under the American system of taxation replacing Federal Income Tax with National Sales tax may not be called the introduction of a fair taxation system. However, there is likelihood of making a psychological impact on taxpayers that their income is not subject to a direct cut and nothing more than that.

Flat Tax

Flat tax implies that tax is being levied at single rate at all levels of taxable income. There are no slabs where under-tax rates rise gradually. This is a simple method of taxation; and supporters of flat tax believe that ‘simple tax will influence the American economy profoundly: improved incentives for work, entrepreneurial activity, and capital formation will substantially raise national output and standard of living.’(Robert Earnest Hall and Alvin Rabushka,1995).

According to Daniel J. Mitchell (2005) ‘a flat tax treats all taxpayers equally…. …. And unlike the current system, which punishes people for contributing to the nation’s wealth, a flat tax would lower marginal tax rates and eliminates the tax bias against savings and investment, thus ensuring better economic performance in a competitive global economy.’

Assuming flat rate is fixed somewhere at say half of the rate at present higher slab, it will be seen that most of the taxpayers will be freed from the liabilities to pay taxes. Those paying taxes at middle rates will have to pay taxes at a higher rate; higher rate taxpayer will gain by paying a lower rate than earlier. But is also a fact that those who are paying taxes at higher rates fall under the group having fluctuating income in any economy. That means the real brunt of taxes under flat rate shall only be borne by middle taxpayers who are actually the backbone of any economy. Thus in a way flat tax will work against those who are actually responsible for sustaining the development of economy that has already been achieved. This is certainly a big limitation of flat-rate tax system.

Douglas Dunn (2006) states that flat tax has three flaws:

• it seeks to improve something that is already completely equal;
• it force middle-class taxpayers to subsidize the wealthy;
• it confuses much-needed tax reform and tax simplification in defining taxable income with unrelated issue of whether the rate applied to the income is flat or graduated.

He further argues that ‘graduated progressive taxes are fair because of three reasons:

1. they treat all taxpayers exactly the same;
2. they treat dollars with an appropriate difference based on differing levels of marginal utility;
3. those who receive most benefit should pay for the disproportionate benefit derived from the system.

Evaluating both sides of flat tax system it is clear that simplicity is not the answer to tax reforms. Flat tax system will create more problems in the American economy than providing the real benefits.

Value Added Tax

Value-added tax is being followed in many countries. The modus operendi is that tax is levied at multi-stages in the chain that make value additions at every stage of the chain while determining the final price for the consumer. VAT normally contains provisions for adjustment of input taxes against output tax before remitting the net tax. One of the benefits of VAT is that it eliminates the distortions in tax structure that carve up the nation into small markets instead of big markets.

But the problem with VAT is that with value additions at multi-levels, the ultimate price of products gets affected and may be counterproductive from consumers’ point of view unless checked effectively by the authorities. Another limitation is that VAT is based on multiple rates as per priority of products in the economy and varieties of factors are considered before settling tax rates under VAT. This multiple rate system distorts the choices of both consumers as well as manufacturers.

The point that goes against VAT is that it is an indirect tax and is mostly used to replace or modify taxes on sales of goods and services. Therefore such a tax cannot be a replacement to income tax and the American economy cannot introduce VAT for taxing income of its citizens.

References

Joe Miller, Unspinning the Fair Tax, Fact Check.org, 2007. Web.

Robert Earnest Hall and Alvin Rabushka, The Flat Tax, page 83, Hoovers Press, 1995.

Daniel J. Mitchell, A Brief Guide to the Flat Tax, 2005. Web.

Douglas Dunn, Flat Tax Fiasco, 2006. Web.

Introduction

Companies incorporated in Australian are taxed on any income they get from any business operation. Foreign companies situated in Australia are only taxed on the income they derive from Australia. The rate on the income for the tax period 2009/2010 is 30%. The Australia tax period is from 1^st July to 30^th July the following year. According to the Australian tax law, the companies are supposed to assess their tax liability (CCH Editors 2009, p.1065).

Each company is supposed to fill a tax return individually. The taxable income is from the sources like the rental income, business income, capital gains on some assets like motor vehicle and dividend interests. Companies are supposed to pay their corporate tax on a quarterly manner for each year. But if a company has an income of less than AUD $ 8000 or the company is not to be filling a report of its tax on a monthly basis, the company is allowed by the Australian taxation commission to pay the tax annually on every 21^st October. Quarterly tax payments are made before the end of the twenty first day after the end of every year quarter.

Two methods are use to pay the quarterly tax. One is the instalment income option and the second is the GDP adjustment notional tax option. Both the foreign and resident Australian companies have the same tax rate (CCH Editors 2009, p.1067)..

Capital gain is taxed according to the marginal rate of the item in question. Before capital gains are taxed, the business is allowed some of the items that are deducted from the taxable amount. The items deducted are referred as the allowable expenses. The allowable deductions include those business expenses that are incurred in the course of obtaining business income. Capital and personal expenses are not allowed since they are not regularly occurring expenses or they are not incurred in the income generation for the company (Woellner, Barkoczy & Murphy 2009, p 83).

Taxable profit

Eastside printing Pty ltd. Trading profit and loss account. As at the year ended 30^th June 2011.

Notes

• Note 1. Total sales are found by subtracting the stock returned from the total closing debtors and then adding the balance of the debtors to the total cash sales
• Note 2. Total purchases are found by adding the total trading stock acquired within the period with the total closing creditors
• Note 3. The value of closing stock to be taken is the cost which is $24000. According to the principle of historical cost, the closing stock should be valued using the cost price if it is lees than the market selling price. The closing stock takes the value that is lower between the cost and the market value. Replacement value is the price to be paid in future for the stock. It is not usually used since it has some variation from different suppliers (CCH Editors 2009, p.1065).
• Note 4. To find the total value of the print papers used, we subtract the balance at the end. Also the obsolescence value or the stock that is still available but cannot be used because it is outdated is subtracted from the total print supplies.
• Note 5. Some amount of the wage expense has realized but the company have not paid it as by the end of the accounting period. To get the total expense incurred, the outstanding value is added to the total amount of wages.
• Note 6. The Mazda van is used partly for business and partly for personal use. Since 50% is business use then the expense incurred will be divided according to the uses.
• Note 7. The lease paid by for business incentive every year is 10000.

Plant and machinery tax allowances

Introduction

Capital allowance is a tax deduction that is usually given on plant and machinery. The plant and machineries that are allowed are motor vehicles tools, furniture, computers, machinery and equipment. Also some building fixtures are allowed some portion of their value (Cassidy 2007, p.164).

For any plant or machinery to qualify for tax allowances, it must have the following feature. Firstly the asset must have been used in the business for some time and capital expenditure for the asset should have occurred. Secondly, the purpose of acquiring the asset is not to resale it but to use it for income generation activity of the business. Lastly the asset should have been acquired to be used for a period that exceeds two years (Woellner, Barkoczy & Murphy 2009, p 83).

To determine the asset deprecation, the prime cost method has been used. This method is seen as the flat rate way of measuring the loss of value for the assets used in the business. The formula of the method is asset value × (number of days used÷ 365) × (100% ÷ asset effective life). The asset effective life is number of years the asset is expected to be useful. If not calculated by the company itself the commissioner of tax provides the effective years for both the intangible and tangible assets (Cassidy 2007, p.164).

Determining taxable value for eastside printing ltd

Calculating the taxable value for printing equipment.

New printers as at 15.07.2010 $400000

Add licence cost $20000

New printer as at 15.09.2010 is 9.5/12 × 18500 giving $14645

Total value of printers as at 30^th June 2011 is 434645

Depreciation is tax allowable therefore it is subtracted from the asset value. Using prime cost method to calculate depreciation, then old printer’s depreciation is Asset’s cost x (days held/365) x (100%/asset’s effective life). That is 400000 x (365/365) x (1/5). Depreciation is 80000. New printer is 18500 x (9.5/12) x (1/5) giving 4642. Total depreciation is 84642. Taxable value is 434645-84642= 350003

AIA annual allowance gives on printer is 20% of 350003 giving 70000. Taxable value is 280003.

The effective life for a printer is five years. The period for which the new printer was used is nine and a half month, from 15^th September 2010 to 30^th June 2011. Investment allowance is only applied to new depreciating assets and expenditure. A new asset is the one that has never be in operation anywhere within Australia and abroad before 13.12.2008. Although Eastside printing Pty ltd acquired second hand printing equipment from the previous owner, they will receive the tax allowance because the asset had been in business use before (Cassidy 2007, p.167)

Computer tax allowance

Value to be taxed is 10 /12 × 10500 which is 8750. According to the tax commission, the effective year for the computer is five years. Therefore computer depreciation using prime cost method is 10500 x (10/12) x (1/5) which give 1750. Allowance is 20% of (8750-1750) giving 1400. Total taxable income is 7350.

The value to be taxed is for the period used, which in this case is nine months from 1^st September 2010 to 30^th June 2011.

Taxable value of furniture

Opening balance as at 15^th July 2010 is 100000

Added shelves value is 9/12 × 4500 giving 3375

The effective life for the furniture is ten years. Depreciation for opening furniture is 100000 × (12/12) × (1/10) = 10000. The new furniture is 4500× (9/12) × (1/10) = 338. Total depreciation is 10338. Taxable value is 103375 -10338 which is 93307. Tax allowance is 20% of 93307 which gives 18607. Taxable income is 74700.

Taxable value for motor vehicle

Mazda is 11/12 × 50/100 × 24000 giving 11000

Audio station wagon is 4/12 × 72000 giving 24000.Depreciation for Mazda is 24000 x (11/12) x (1/8) = 2760. Since is used half time for business and half for personal use, the business depreciation expense is 50/100 × 2760, giving 1380..the effective life for general motor vehicle is eight years. Audio wagon depreciation is 72000 x (4/12) x (1/8) which give 3000. Total depreciation is 1380 +3000= 4380.

Taxable amount is 35000-4380 = 30620. Allowance is 12% of 30620 which is 3674. Taxable income is 26946.

Mazda car had been used for eleven months from 1^st August 2010 to 30^th June 2011. Since 50 percent of its use was for the business use, then the amount to be taxed is half of its cost. Audio station wagon had been in use for only four months since 1^st march to 30^th June 2011.

Tax allowance for air conditioner

The allowance is 10% for special rate pool. Air condition has an effective life of fifteen years. It has been use since Feb 2011 for five months till 30 June 2011.

Depreciation is 60000 x (5/12) x (1/15) = 1667. Taxable value is 58333.

Therefore allowable tax is 10% x 5/12 x 58333 giving 2431. Total taxable income is 58333-2431 which is 55902.

The business investment is at the start 650000 and AIA exempts 100% tax on investments for the first year.

Total taxable income for eastside printing company is

Income tax is 280003 +7350 + 74700 + 26946 + 55902 + 993050 = 1363251

Australian corporate tax is 30% for the year 2011. Therefore corporate tax to be paid is 30% of 1363251 which is 408975.

Eastside printing. Balance sheet. As at the year ended 30^th June 2011.

Notes

1. The capital is found by the equation assets is equal to capital added to liabilities.
2. The stock used is the closing stock
3. Depreciation is subtracted from the assets value to keep the amount to date.
4. The value of the Mazda car put in the balance sheet is the one that is used for the business purposes which is half of the price.

References

Cassidy, J. (2007). Concise Income Tax. Sydney: Federation Press.

CCH Editors. (2009). Australian master tax guide. Australia: CCH Australia Limited.

Woellner, R., Barkoczy, S and Murphy, M. (2009). Australian taxation law 2009. Australia: CCH Australia Limited.

Global Compensation Challenges in Emerging Market

As multinational corporation expands to new markets, all the aspects become increasingly complex for them to compete globally. They face many challenges in their bid to compensate for their diverse workforce. The challenge can also be attributed to the human resource management practices, which are also scrambling to fit in the global trend of using both the local and global nationals in a firm, which has become a critical factor for a company’s global success. MNCs operating in emerging markets find it difficult to determine a standard rate to compensate different employees.

MNCs expand their operations across borders to emerging markets to foster global economic growth through activities such as talent mobility, which has greatly influenced their general success. Human resource management is struggling to find the best fit for the company in terms of talent. The challenge arises because most organizations have not yet implemented practices that can create a strong alignment between employee mobility and the company’s goals in managing talent. Setting the right salary for the right market, which targets compensating local talents and other international talents, has become a daunting task and a major concern to multinational corporations. These firms find it difficult to develop a compensation strategy that they can use to ensure that employees of different ranks are compensated to a given limit due to the trends in the new market (Toolkits. SHRM, 2022). Some MNCs use a standard compensation rate, while others depend on the market forces of the host country to determine the compensation of the employees. Different countries across the globe have different policies and regulations apart from the market and industry factors making the payment of the workforce vary.

General Characteristics of India as an Emerging Market

India is characterized by less mature financial and regulatory policies than a more advanced economy. The country also has a low per capita income but enjoys enormous growth due to its huge population, which acts as a source of labor for MNCs. India’s growth is huge in the manufacturing sector and other sectors. This growth is also attributed to policy reforms, infrastructural development, and political stability. These factors make the country most preferred by investors compared to other emerging economies.

According to the International Monetary Fund Economic Outlook, India is among the top countries which experience exponential growth, thus, placing fourth globally. In 2017 the organization projected India would experience 7.2 percent and 7.7 percent in 2018. In 2017 the country experienced 3.3 dollars in the form of investment, which explains how stable the Indian economy is among the emerging markets (Financier Worldwide, 2017). Despite the growth and stability of the Indian market, it experiences challenges when it comes to compensating the employees of the MNCs due to tax policies and other regulatory challenges.

Influence of Tax Policy in Selecting and Recruiting International Assignees

Multinational companies that operate in India range from various sectors of the economy. They dominate the consulting and construction industries, among other segments of the Indian economy. These economy segments require highly qualified professionals, including experts and executive managers, to which the MNCs assign international duties to manage and implement temporary projects. The organization considers the employees’ productivity regarding the importance of the projects in deciding to assign them responsibility.

However, a country-specific factor can also affect the selection of the employees to be assigned international duties. The factors influencing the selection and recruitment process of employees to be assigned the international assignment may include the risk-incentive-trade-offs and tax and remuneration policies within a country. Taxation policies and regulations within a country can influence the decision of a company to assign duties to expatriates. If an organization aims to send employees abroad, it must consider international tax laws. They also have to consider wage taxation at the agent level and corporate taxation at the principal level. For the MNCs to succeed in assigning an individual an international assignment, the countries where the assignee is sent to the organization must ensure that they keep the national tax policies in mind to avoid double taxation and offer fair compensation to their employees abroad.

Influence of Tax and Remuneration Policies on Global Compensation

Influence of Tax Policies on Compensation of Expatriates

India is one of the countries which top the global emerging markets as it is in the transition phase towards the developed market. The Indian economy is growing at an unprecedented rate, even though the economy is associated with low per capita income (Dhasmana, 2017). This high growth rate makes India a lucrative market for most MNCs worldwide. Compensation is an important aspect of any organization; it provides the organization and the employee with the point where their priorities can meet. It ensures that individual goals meet and encourage the contentment of both parties. Compensation is vital for any organization as it helps the company acquire and retain talent and acts as a source for encouraging talents to ensure continuous performance.

Policy differences always dictate the compensation of various employees within a country. Global taxation on the income of the international assignee always influences the compensation of the expatriates. Apart from the requirement by most host countries that require expatriates to pay taxes on their global income, there may be a range of additional taxes on their global income levied by the host country (Mansaray, 2022). These additional taxes may include the tax on shipments made by expatriates and excise duty on imported goods that often have the potential to be high. Taxation and retirement welfare policies vary across countries, forming part of national policy. National policies determine the relationship between employees, employers, and the government, influencing the compensation and reward system globally.

India’s existing Exchange Control Regulation policy allows expatriates to receive up to 75 percent of their salaries from outside the country. This is only possible when the expatriate receives their payment from a foreign company; however, the remaining 25 percent of the salary is then paid to the individual in India (Directorate of Income Tax, 2018). The income tax of the amount earned by the expatriate is discharged in India. This regulation also influences the compensation in many ways as it requires foreign employees who are not permanent residents of India but resides within the country. In an event that these expatriates receive their salaries while outside India, the law requires that they first bring their salaries into the country. After that, it will be the sole responsibility of the expatriate to find a solution by meeting expenses, and they need to transfer their salary abroad.

The Indian Foreign Exchange Management Act of 1999 is considered less draconian, but it still has some challenges that make it difficult for expatriates’ compensation. It is less draconian because it allows the expatriates within the country to receive and transfer their net earnings to support their families abroad. However, it becomes challenging for the employees who live with their families in India to do the same but still want to meet their responsibilities abroad. This influences the compensation system as these expatriates have a limited option as their net earnings can only be transferred abroad if they permanently relocate to their home country. The Act gives the employees obligations in India to pay their individual income tax.

The salaries earned by expatriates for any work done in India are subject to income, irrespective of where the employee receives their salaries. The Indian national policy also helps the government obtain income tax from foreign national global income after a given duration stay where the expatriate is considered a resident of India. This policy varies between India and other countries to avoid double taxation issues. The MNCs often cover much of these additional taxes burden. This element of expatriate compensation is commonly known as tax equalization. The company may offer to pay these extra taxes to relieve the expatriate of extra charges.

Influence of Remuneration Policies on Expatriates

Apart from taxation, the MNCs are faced with the challenge of formulating compensation strategies that meet a country’s regulations that they can use to compensate their expatriates. The strategy formulated by the MNCs must be in line with the host country’s remuneration policies. The organization needs to understand the remuneration policies for employees in India and how they are applied. According to the Indian remuneration policies, workers, including expatriates, are eligible for various benefits such as provident funds, tips, compensation due to injury, and statutory bonuses. The Indian company act defines remuneration as any form of payment in terms of money or its equivalent given or passed to an individual for their work (ClearTax, 2021). For the MNCs registered as public companies, the Company Act prescribes how they can pay remuneration to employees in managerial positions.

The Act requires that the amount of money payable to managers in any financial year shall not exceed 11 percent of the company’s net profit. In addition to that, the remuneration payable to the managers and the directors of MNCs listed as the public company shall not exceed 5 percent of the company’s net profit, and in a place where the company pays renumeration to more than one person, such payment shall not exceed 10 percent of the company net profit (ClearTax, 2021). The MNCs are also obligated to comply with the need to ensure employees’ safety by providing a safer workplace and preventing sexual harassment, among other vices. The MNCs intending to send their employees to India can overcome this challenge by replicating their global employment agreements and employment policies to ensure uniformity with the Indian regulation and standards that apply to their expatriates to ensure they compensate their employees accordingly without violating the law. The MNCs can also revise their policies to align with the applicable laws and reflect India’s industry practice.

Summary

India is considered an emerging market because it has less mature financial and regulatory policies. The country has a low per capita income but enjoys enormous economic growth due to its huge population, which acts as a source of cheap labor for MNCs, prompting most companies to invest in the country. India’s growth is huge in manufacturing, construction, medical and other sectors. Foreign companies expand their operations in India and other countries to promote their global economic growth. India is one of the countries which top the global emerging markets as it is in the transition phase towards the developed market. Tax and remuneration policies play a critical role in the company’s global compensation system and selection of international assignees. Tax policies can influence how people will view the compensation system. Multinational companies which intend to send their employees to India are challenged by India’s tax policies and remuneration regulations on determining compensation.

The Indian income tax influences compensation in many ways. It requires foreign employees who are not permanent residents of India but reside within the country first to bring their salaries into the country and find out how to remit the remaining to their own country. Apart from taxation, multinational companies are faced with the challenges of developing remuneration strategies that meet India’s regulations. The organization needs to understand the remuneration policies within the country to reward its employees in India and how they are applied. This is very important as it helps the company motivate its employees without breaking the laws within the country.

References

ClearTax. (2021). Managerial remuneration under the Companies Act, 2013. Under the Companies Act, 2013.

Dhasmana, I. (2017).IMF retains India’s growth projections at 7.2%, UPS China’s. Business Standard.

Directorate of Income Tax. (2018). Tax treatment of foreign income of persons resident in India.

India – a front runner among emerging markets. Financier Worldwide. (2017).

Jha, L. K. (2018). IMF sees India GDP growth at 7.4% in 2018, China’s at 6.8%. mint.

Mansaray, H.E. (2022). The impact of multinationals on labor relations in developing countries: A literature review. Konfrontasi: Jurnal Kultural, Ekonomi Dan Perubahan Sosial, 9(1), 70–80.

Toolkits. SHRM. (2022).

Case #1

Facts

Tracey is employed as a salesperson by a renowned company that supplies pharmaceuticals. The region she handles is very vast and thus she uses the company automobile to reach out to the customers. It takes her over 16-19 hours every day and sometimes it is required to be done a couple of times a week. While on such trips, she usually pulls over to a selected area like a rest point to take a brief nap in her automobile.

Issue

The issue which arises from this fact is the cost of meals Tracy purchased while on her usual rounds deductible?

Conclusion

No, the cost of meals Tracy purchased while on her usual rounds is not deductible.

Analysis

According to Section 162, (2) of the Internal Revenue Code, any traveling expense incurred while an employee is away from home is subjected to taxation (Davis, 2011). As per the facts on the table, there is no provision by the company which requires that Tracey rests while executing her duties. This implies that the overnight rule is not applicable in this particular case. In addition to this fact, according to the situation issued, Tracey was not away from her home as Sec. 162(a) (2) fully provides. The Supreme Court seems to have constricted the issue to business trips that only require a brief moment of rest, just like in Tracey’s case. Based on this assumption, this should not be the case.

Case #2

Facts

Mark is a captain of a certain boat that ferries tourists on their trip from Seattle to Victoria and back. Every round takes 15-17 hours, with a provision of 6-7 layover hours on arrival in Victoria. It is within this layover moment that Mark takes a 4-hour nap in the ferryboat

Issue

Is the cost of meals Mark purchased while on his usual rounds deductible?

Conclusion

Yes, the cost of meals Mark purchased while on his usual rounds is deductible.

Analysis

Code 162(a) (2) provides rest and sleep as a standard rule which gauges if a taxpayer is “away from home” (Davis, 2011). When applying this to Mark’s case, we come to a conclusion that he is not warranted by his work/employer to be absent from his home overnight. Secondly, Mark’s nature of work requires that he get some sleep when he is far away from his home and when he is released. This rest is necessary for him to be able to properly dispense his duties. This is as per the stipulation that all expenditures by the employee which comprise expenses that are incidental like tips for sleep or rest taking purposes are deductible. Mark can hence deduct his meals expenses that he claimed are between every trip.

Case #3

Facts

According to the issue of Ralph and Cindy who own TidyCo. Inc, as per my records, they have a negative accumulated and current E&P, as well as a substantial basis of the stock which amounts to $300,000 (Anonymous, 2009). The Internal Revenue Service (IRS) has revealed that the two have $200,000 of income that is unaccounted for both by the company and IRS. This amount is said to have been hidden in shoe boxes and taken to their home instead of being deposited to the bank account of the company’s rules. Therefore, the Internal Revenue Service is planning to take them to court and make criminal charges against them for allegedly defrauding the government (Anonymous, 2009).

Issue

Do these facts have any dire consequences related to the fraudulent activities, as well as evasion charges the Internal Revenue Service is seeking to file in court against the two?

Conclusion

Yes, this issue has dire consequences related to fraudulent activities. However, this issue appears to be hanging on the fence, as sources below reveal, two separate but very similar scenarios yielded two quite different conclusions.

Analysis

In reality, Internal Revenue Service has not substantially proved the diversion of TidyCo. Inc.’s $200,000 by the Edmonds is against the law, as Section 7201 of the Internal Revenue Code stipulates. The company, in both its current E&P and accumulated accounts, has a negative E&P that was not reported as a constructive dividend (Davis, 2011). The IRS thus can not allege that the two have intentions to evade payment of taxes. Besides, the same exercise of tax payment is not yet due.

As per the authorities, however, there is a disparity in whether these affidavits are substantial to stir up an argument against tax evasion charges that are pursuant to Sec. 7201 (Anonymous, 2009). Therefore, such income is only taxable to the extent that the company has E&P. In addition, because no tax was due and no given income subjective to taxation was reported, then no tax evasion charges should be held (Anonymous, 2009). The court argued that there must be some evidence that proves beyond reasonable doubt that there willingness and incident was affirming indeed there was an attempt to evade taxes. As opposed to this, in the William’s case, the U.S. court of appeal purported that the government ought not to prove that the company’s distributions as per the issue were subject to taxation. The idea that the shareholder has a control over the company’s funds is sufficient to give the way for the tax evasion charges to hold. What is a controversy?

In the current economic climate of the United States, publicly traded companies normally pay dividends on a regular basis and in a fixed manner, but they always declare availability of dividends for members at any given time. Such abrupt dividends are referred to as special dividends, so called to differentiate them from the regular dividends (Dividends explained, 2013). On the other hand, closely held corporations issue and align dividends based on the activities undertaken by each member. This makes such dividends to be considered as expenses that are pre-taxed.

No matter what the type of corporation is, dividends are paid in various forms. The most common ones are:

• Cash dividends; it is the most preferred form of dividend payment. The shareholders receive them to inform of currency and hence they are considered as income to the recipient. As such, the shareholders are taxed during the year in which such payments are made. The approach is simple: a given amount is allocated to every shareholder by a member. This means that the more shares a shareholder owns, the more s/he earns.
• Stock dividends; in this case, extra shares of the stock are distributed to shareholders (Dividends explained, 2013). As a result, the total share a member owns increases.
• Interim dividends; when using this method, shareholders receive their dividends just before the Annual General Meeting of the company. In most cases, such dividends come together with financial statements of the corporation or company.

In most cases, closely held corporations are managed by family members. These entities have a nature whereby only few persons are both crucial employees and stakeholders and thus, providing keen scrutiny by IRS as far as compensating members reasonably is concerned (Englebrecht, Mitchell, & Martinson, 1998). This makes them consider the business as a family property. Dividend payment in such cases becomes rare as all members have a sense of belonging and thus work towards strengthening the family’s financial base (Merino, 1981).

When it comes to taxation, closely held corporations do the following to ensure that IRS does not reclassify the compensation they do to their members: all members’ salaries are within the bracket of provisions of the industry standards, the compensation of members is based on a fraction of employee’s gross income, and finally, ensure that overall salaries are not too large to do away with taxable income. There is generally no specific formula used in order to determine the amount of compensation awarded to employees (Theisen & Kleiman, 1991). On the other hand, dividends in publicly-traded companies are solely announced by the board of directors. Resolutions by shareholders concerning dividends are highly forbidden.

To minimize double or over taxation in publicly-held companies, most of the dividends are ploughed back to the business.

References

Anonymous. (2009). Internal Revenue Service. Standard Federal Tax Reports, 96(12), 7.

Davis, G.T. (2011). S Corporation Reasonable Compensation. The Tax Adviser, 42(5), 308.

Dividends explained (2013). Money City Direct. Web.

Englebrecht, T.D., Mitchell, C., & Martinson, O. (1998). What is reasonable compensation in closely held corporations? Management Accounting, 79(9), 38.

Merino, B.D. (1981). United States Government Internal Revenue Service Field Agents’ Income Tax Auditing Manual. Journal of Accountancy (pre-1986), 151(6), 114.

Theisen, B.A., & Kleiman, R.T. (1991). Employee Stock Ownership Plans: The Right Choice for Closely Held Corporations? The Tax Adviser, 22(1), 40.

Tax evasion is one of the major concerns that affect the country’s economy as well as the living standard of citizens. The revenue authority has therefore, instituted measure to curb this affect by reducing the magnitude of undisclosed income from fraudulent citizens. Strict tax compliance would mean improved economy, better living standards because the government will be having a wider tax base. A good method of detecting the undisclosed income is the indirect method. The approach is relevant for determining the undisclosed income since it involves assessing the tax accountability by examining the financial performance of a taxpayer from assortment of sources outside the declaration of the taxpayer and the official books of accounts kept. The examination is majorly based on incidental proof indicating a rational estimate of the taxpayer accurate tax responsibility in that year of income.

Indirect Method

Net worth approach.

This method is considered superior because, it tracks all the business deal for a given period in which an individual performed business or personal transaction. A detail analysis of receipts as well as disbursement is analysed and the net effect would be the funds from unknown source. There is no shortcoming and consequently, the reasonableness test is reliable in assessing the undisclosed income. The circumstance that will facilitate use of indirect method is where a practitioner is convinced with the integrity of the taxpayer in filing all the returns, however, where the books of account are found to contain malicious entries and the records do not portray the actual financial affairs of the business, a substantial understatement of income might be suspected and as a results, practitioner should appreciate using the indirect method in ascertaining all source of income to detect any fraudulent entries.

Key signs to undisclosed income are: failure to maintain proper books of account and to file statement, mysterious declared income is not directly proportion to taxpayer living standard or the declared income does not reflect the business activities and the taxpayers’ constantly announces losses for an extended period with cash as the method of handling transaction

Source and Application of Funds Approach.

This method is considered less effective in relation to the net worth approach since a detail study of individual transactions is not analysed. Lack of internal control will be observed because fraudulent citizen will not disclose all their source of income for tax purposes. With this approach, care should be taken on transaction between an individual and the contractor because there is no audit trail review on cash disbursement. It therefore signifies that the adequacy of this approach should not be fully relied upon as the method will not disclose all income which is subject to tax hence making it a good haven for tax evasion.

Bank Deposits Method.

This approach appreciates Bank account records to ascertain the understatement of taxable income if any. Where there is Presence of limited or direct evidence on income and expense, the government might as well execute an examination indirectly by use of situational proof. This method of determining an understatement of income does not have any legal condition; the approach is principally based upon the Supreme Court verdict. Lack of delegation of obligation and lines of accountability are frequently a key cause for worry when appraising the internal control. It implies therefore, that the reasonableness of the evidence provided would not be relied upon fully for tax purpose and taxing authority would opt for net worth approach because of the detailed analysis on an individual transaction both for personal reason as well as for business the net worth approach would mandate for examination.

Introduction

The Unites States’ tax system has often been the subject of economic debates. Several stakeholders have called for an overhaul of the United States’ tax regime. Currently, the United States has what is often considered as an ‘odd’ tax system. The main distinction between the United States’ tax system and that of most countries is the manner in which the earnings that are made in foreign countries are handled when they are repatriated back to their parent countries. Most countries do not tax money that is earned in other countries or outside their territories of interest. This mode of taxation is known as the territorial tax system and it is commonly used by countries around the world. On the other hand, the taxation system that taxes earnings that are made in foreign countries is known as the worldwide tax system. The worldwide tax system is only used in a few countries around the world including the United States. There are big differences between territorial and worldwide tax systems. Most of these differences apply to the taxation of corporations and other multi-national companies. One of the countries that recently made the switch from worldwide to territorial tax is the United Kingdom. The fundamental differences between the United Kingdom and the United States’ tax regimes have far-reaching impacts. This paper compares the United States’ worldwide tax system with the United Kingdom’s territorial tax system.

The Worldwide Tax System

The worldwide tax system stipulates that all income from domestically headquartered entities has to be subjected to taxation even though it comes from foreign countries. However, most of the countries that use the worldwide tax system offer tax credits in order to avoid instances of double taxation. These tax breaks cover the amount of money that is paid as taxes to foreign governments. The main logic behind worldwide tax systems is to ensure that all citizens are equally taxed irrespective of their global location. Consequently, individuals and companies cannot move to destinations that offer lower tax options irrationally. For example, a company that has its headquarters in the United States is obligated to pay taxes on all its income whether it is earned in the country or through its subsidiaries in other countries.

The Territorial Tax System

The territorial tax system stipulates that countries can only collect revenue from money that is earned within their borders. Therefore, during taxation, all the income and dividends that are earned from foreign subsidiaries are exempted from domestic taxation. The main purpose of the territorial tax system is to ensure that all entities are offered a level playing field when investing. In addition, the territorial tax system ensures that individuals and companies are at liberty to invest their capital where the return on investment is best. For example, a company that is headquartered in the United Kingdom does not have to pay taxes on most or all of its income from foreign subsidiaries.

Overview of Tax Different Systems

The United States’ tax system is worldwide but no money can be taxed until it is repatriated back to the country. Taxation for non-repatriated money only occurs in special circumstances within worldwide tax systems. Taxation on foreign earnings is one of the pillars of the Unites States’ economy because it maintains a stable business environment within the country. For instance, countries cannot use profits from more conducive business environments to compete with local companies unfairly. Therefore, most countries are faced with the option of retaining their earnings in foreign countries or repatriating them to the United States where they are taxed. Companies in the United States are partially cautioned from foreign-based business instabilities through the worldwide tax system.

Most developed economies employ the territorial tax system because of its ability to foster good international business environments. Previously, worldwide tax systems were popular with most developed countries. For instance, in the year 2000, a majority of the countries under the OECD (Organization for Economic Co-operation and Development) umbrella utilized the worldwide tax system. However, the situation has rapidly changed within the last decade as only seven out of the thirty-four OECD countries are currently using the worldwide tax system. Interestingly, the United States has constantly been urged to shift to the territorial tax system by several advisory committees on the country’s taxation issues.

Comparison of the United States and the United Kingdom

A comparison of the United States and the United Kingdom’s tax systems involves exploring their effects on the respective economies. Furthermore, statistics such as foreign direct investments, unemployment rates, and tax revenues amounts are part of the comparison. About five years ago, the tax systems of both the United States and the United Kingdom were almost similar. The United Kingdom’s decision to shift from worldwide to territorial was motivated by the need to ensure that the country’s companies were competitive in the global arena. The United Kingdom’s decision was preceded by rigorous efforts to come up with a more competitive and global tax system. The efforts were prompted by a massive emigration of individuals and companies in the years before 2009. In addition, the shift involved consultations by both politicians and business leaders. In the United States, the previous and the current administrations have turned down calls to shift from the worldwide to the territorial tax system. For instance, President Obama has ignored recommendations from several commissions that have called for the shift in the tax system.

The United Kingdom’s tax system incorporates tax-exemptions on foreign-sourced dividends. In addition, the United Kingdom’s tax regime accounts for domestic-tax deductions on foreign-based expenses. This tax system is structured in a manner that caters to tax avoidance by instituting limits on deductible interests especially for entities that operate in areas with low taxes. For example, the United Kingdom’s tax regime stipulates that only entities that operate in territories whose tax rates are three quarters less than that of the home country can be taxed. The United Kingdom’s tax regime uses a ‘patent box’ or low taxes on any revenue from home-based patents. The United Kingdom’s tax system is largely territorial but the country’s taxation stakeholders have proposed a regime that exempts all foreign-earned income except the one that is artificially diverted from the country.

The United States’ tax system has three prominent features including tax credits, taxation on repatriated revenue, and deferral of foreign earnings. Under the United States’ tax system, entities are required to pay taxes on all their earnings once they are brought back to the country. Deferral refers to the practice of delaying taxation on foreign-earned revenue until it has been repatriated back to the United States. Moreover, when earnings are repatriated in the United States they are subject to a tax credit in accordance with the source country’s taxation rates. For example, the United States’ highest corporate tax rate currently stands at 39.2%. Therefore, if a company repatriates $1 million from a country with a 20% taxation rate, it will end up paying $392,000 less the $200,000 that has already been paid to the original country ($192,000). In rare instances, the United States passively taxes foreign earnings on some types of investments such as earnings on foreign bonds.

The United States’ tax system seeks to reduce foreign direct investments because they tend to displace jobs and revenue away from the country. On the other hand, the United Kingdom shifted from the worldwide to the territorial system with the view of enhancing the country’s competitive edge as a viable destination for starting, financing, and growing a business. The effects of the two tax systems on employment rates are valid. In the United Kingdom, a slight increase in unemployment rates was recorded after the shift to the territorial tax system. However, the United States recorded lower rates of unemployment as compared to other OECD countries. The United Kingdom’s tax revenues have increased since 2009 mostly because of the fact that the country’s GDP improved after the shift to a territorial system. On the other hand, the United States has recorded lower tax revenues than most of the OECD countries that use the territorial tax system including the United Kingdom.

Conclusion

The United Kingdom’s tax system used to be similar to that of the United States but economic circumstances contributed to its shift. The main defense for the United States’ tax system is that it prevents losses in investments and jobs. On the other hand, the United Kingdom’s tax regime is meant to give the country a competitive edge in the global business arena. Eventually, the United States might yield to pressure and shift to the territorial tax system.

Defensible strategy for the client

The defensible strategy for the client is based on the six steps in the tax research process namely establishment of facts, identification of issues, location of the authority, evaluation of the authority, development of conclusions and recommendations, as well as communication of the recommendations (Sawyers, Raabe, Whittenburg & Gill, 2014). The strategy intends to help the client solve the tax problem. Just as the case is with the conventional research process, the tax research would comply with the steps stated above to make the process methodical and cover all aspects of the tax problem to have an effective defense against the internal revenue service (IRS) (Sebastian, 2002). Two points are critical in the strategy. First, I will use various mechanisms in identifying and finding tax authorities associated with the current tax issues. The second point is the application of creativity and reasoning based on professional qualification to solve the problem and defend the client (Rupert, Pope & Anderson, 2014).

Using the six steps, the first one will help in identifying the major issues and clarifying facts to the IRS. Having identified the issues, the second step would facilitate the process of identifying the applicable law and possible areas of reference to provide solutions and respond to counterarguments. Having identified the law information applicable to the current tax problem, a thorough examination assists in identifying potential areas to support the defense argument. Through the fourth step in the research process, the defender is able to develop conclusions focusing on the research on every tax issue affecting the client based on the facts identified in previous steps (Rupert, Pope & Anderson, 2014). From the conclusions, it is possible to develop arguments that are correct according to the law about the tax implications of the facts specified. The facts and conclusions form the results of the research process. Using the fifth step of the tax research process and the results obtained from the fourth step, the defender develops a set of recommendations to the client for the most appropriate course of action. The final step involves the communication of conclusions and outcomes, which form the basis for future prevention of problem occurrence (Sawyers, Raabe, Whittenburg & Gill, 2014).

Fact-based argument to defend client’s position with IRS

The defense of the client is based on five major factual points. First, the defense argument is based on the high-net-worthiness of the client, which drives naturally to venture into new businesses, which accounts for the profit motives of the client. Second, from history, the client had learned that businesses can be profitable or result in losses and this is established after a considerable amount of time, which in this case is insufficient to have an adequate understanding of the business. Third, occasional profits should be a major part of the defense as they form the basis for sustainable profitability for any business and may not necessarily imply tax problems (Rupert, Pope & Anderson, 2014). Fourth, the long haul consideration is a vital point for defense because, with the availability of resources, clients can be involved in non-performing businesses with the long haul in mind. Finally, the defense is based on much involvement of the client in the business, which indicates something more than the profit motivation behind the conduction of the business (Schwartz & Catanach, 2009).

Counter argument by the IRS to validate its position

Considering the case was about schedule C and F of tax shelters, IRs could develop counterarguments that could result in the client flossing the case (Rupert, Pope & Anderson, 2014). Indeed, using schedule C in real estate enables offsetting of maintenance and carrying of the real estate to the time of sale for profit or loss. The counterargument is based on the fact that for real estate to be regarded as business, and not an investment, there should be proof of continuous and regular sales. This may result in an expensive audit and bearing of costs by the client in case of losses. In the counterargument, the IRS may use various legal provisions to separate other activities taking place in the property to validate its position. This results in disallowing losses from activities taking place in real estate. In response to IRS’s counterargument, the defense focuses on the actual intention of the client in the development of the tax problem (Rupert, Pope & Anderson, 2014). The intention is clear and the client intends to use the property for different activities to maximize the profit. This position limits the IRS counterargument and provides the client with time to make corrections and avoid such occurrences again (Sebastian, 2002).

Letter on behalf of the client

Having examined the tax problems raised by the Internal Revenue Service, I wish to clarify to you a few points for your consideration in addressing the problem. It is important to consider the long-term worthiness of the business rather than consider the present only. As history shows, profits rise over time which indicates possible profitability in the future. Furthermore, the business has occasional profits, which is a clear indication of positive times ahead. This is clear with my desire to the business succeed for the long-term benefits.

References

Rupert, T. J., Pope, T. R. & Anderson, K. E. (2014). Prentice Hall’s Federal Taxation 2014 Comprehensive (27^th ed.). Upper Saddle River, NJ: Pearson.

Sawyers, R., Raabe, W., Whittenburg, G., & Gill, S. (2014). Federal tax research (10th ed.). Stamford, CT: Cengage Learning.

Schwartz, B. N., & Catanach, A. H. (2009). Advances in accounting education teaching and curriculum innovations. Bingley, UK: Emerald.

Sebastian, S. J. (2002). Internal revenue service: Status of Recommendations From Financial Audits and Related Financial Management Reports. Ft. Belvoir: Defence Technical Information Centre.

Overview of the Research

This research will investigate factors that determine the capital financing structure of firms within a tax-exempt country, Kuwait. I am informed by my passion to progress my career in the field to expand my knowledge base while contributing to the development of literature, theory, and practice.

This research will add interesting insights to the existing literature on how tax-exempt companies, regardless of the lack of debt incentives, continue to prefer debt financing to internal sources of capital. The research attempts to fill the literature gaps, using theories of capital structure, and provide significant reasons why firms in tax-exempt countries, especially the GCC countries, tend to use debt and equity financing.

Although several studies have focused on this topic, there are still no tangible or conclusive findings that can be used to generalize this scenario.

The reason why I have chosen this research topic is that the paper will be instrumental in contributing toward the development of literature and providing insights to future researchers in the field of business finance. Since the MBS focuses on issues that expand the knowledge base of scholars and answer some of the questions that remain unanswered, my research fits well in this endeavor since it seeks to investigate the decision models of firms operating in GCC countries. Since little research has been compiled to examine these companies, my paper will be significant in this respect.

The findings of this research will help company executives and stakeholders in companies to understand the decision models that inform a firm’s capital structure financing decision. The paper will also confirm the findings of previous studies while finding gaps in some of the studies that have been completed. Therefore, I intend to have a coherent analysis of the firm-specific and sector factors that influence debt financing decisions in GCC countries, especially Kuwait.

Positioning of the Research

While the capital structure has been a popular topic on which many studies have focused, there is no consensus on absolute factors that drive capital structure decisions among companies. Following many studies on the subject, a large theoretical literature has evolved, leading to the development of numerous theories, to explain how decisions on capital structure are made. These theories have pointed to several factors to explain the capital structure of tax-exempt organizations.

The controversy that has emerged concerning the testability and validity of these theoretical models and how they can be used to determine companies’ capital structure. Since some of these theories are difficult to test, it remains difficult to arrive at firm conclusions. Some studies have found that the trade-off theory fails to address the key issues surrounding this topic, concluding that the pecking order theory could offer a more affirmative and explanatory insight.

Some researchers have found no reasons to reject or contend with both the pecking order model and the trade-off theory¹. These studies uphold that while both theories offer informative knowledge about the behavior of corporations in terms of formulating capital structure decisions, they do not lend themselves to explaining the determinants of this endeavor. While there is a consensus on previous literature, which indicates that companies tend to set target levels of their debts, there is no clear agreement on which determinants help companies to reach their optimal targets.

The other gap in the current literature is that many studies that have sought to delve into this line of research have focused on developed or advanced economies. This means that the test results obtained cannot help to explain the capital structure of companies in tax-exempt countries that still developing.

Another focus of the research is that the study will seek to explain trends in GCC countries that are tax-exempt. This research will not focus on capital structure decisions of companies in countries other than GCC (especially Kuwait). Previous studies have indicated that capital structure decisions of companies from developed countries are based on institutional factors, firm-specific and, corporate governance, tax regimes, and market-wide factors. Since the test results from these studies cannot be used to explain what happens in completely tax-exempt countries, it is difficult to make meaningful inferences to help readers and researchers understand GCC countries.

Many companies are operating in tax-exempt economies, which continue to spur the economic growth of these economies, including Kuwait. Although a lot of research has been focused on studying the financing structure of such firms, little research has been conducted to provide theoretical and empirical explanations underlying the use of debt financing to finance their activities². There is a growing need to establish research that will explore the underlying determinants of the capital structure of companies operating in Kuwait, which is a tax-exempt country.

There are several merits of studying the capital structure and decision model for tax-exempt companies. Since debt ratios of non-taxable companies do not influence corporate taxes, tax-exempt firms are good sources of information that can be used to understand the theory of capital structure³.

One thing that makes it difficult to study and compare the capital structure of taxable organizations is the challenge of estimating the marginal tax rates, as well as the endogeneity of these companies.

In their study, Wurgler & Baker (2002) and Leary & Roberts (2005) observed that complexity noted makes it difficult to identify absolute reasons why companies may opt for debt instead of own financing⁴.

Some studies have shown that companies in a tax-exempt country behave as though they competed for debt accumulation, or have target levels of accumulating tax-exempt debts. They also indicate that tax-exempt companies design strategies for obtaining tax-exempt debts under the constraints of capital projects in which to invest. This is to means that as debt increases, organizations show an increase in the level of their tangible assets. However, similar studies demonstrate that service companies registered low profitability with increases with the amount of debt held.

The study makes significant contributions to the existing body of knowledge about capital structure. This will also allow the researcher to control the size of the firm and other industry-specific effects that have not been factored in past studies. This research will go beyond the usual leverage and simple ratio of debts to include various elements relevant to explaining the underlying phenomenon. These include tax-exempt, taxable debt, and financial debt ratios.

While abundant literature examines the significance of firm-specific factors in determining the financing decisions, the effect of tax-free economies in determining the choice of capital structure is limited⁵. According to the studies conducted by Baker and Wurgler, the effect of debt ratios, asset tangibility are relevant in explaining the capital structure decisions of firms⁶. Other studies such as those conducted show that macroeconomic factors such as asset growth, inflation, and firm-specific factors play a significant role in determining the capital and financial structure of a firm⁷.

Although variations are eminent, all the studies arrive at similar conclusions concerning the role of firm-specific factors in controlling the mode of financing. However, there is a need to formulate a holistic approach that can explain other factors that have not been researched by the preceding studies. Because companies in tax-exempt countries enjoy the benefits of accessing non-taxable debt, it is important to study industry-specific factors that may explain similarities and differences in the capital structure and financial structure of companies in Kuwait, which is the focus of the study.

Both studies arrive at similar conclusions about the relationship between debt financing and firm-specific factors. For example, studies have shown a negative relationship between debt financing and profitability. However, it is worth noting that this relationship is constrained by the quality of the management of the debt portfolio. Developments in the stock market cause replacement of debt financing with debt-equity, especially in the developing economies⁸.

Although these studies provide important insights on the effect of market-specific factors in determining capital structure decisions, these studies base their results and findings on mixed data from developed and emerging economies. For this reason, this research offers unique insights on how companies from a selected country with its heterogeneous characteristics. This will allow the researcher to use uniform data, collection procedures, and similar variables⁹.

The results of this paper will seek to address the literature gaps in several ways. The existence of limited literature on the capital structure of firms in GCC and tax-exempt countries forms the basis of this paper.

There are limited explanations that can qualify contributions of theories of capital structure of firms as applies to GCC countries. Therefore, this research will add relevant information and insight about distinct features of firms operating in tax-free markets in GCC countries.

The market within the GCC countries is unique to the extent that the capital markets are relatively young and that companies in these markets have low risks associated with debts. In addition, these markets are dominated by the private sector, and the economies are exclusively dependent on the world economy.

The study setting affords to provide the field with literature about the capital structure of corporations in a non-tax economy. The paper will extend the current literature by re-evaluating the concept of capital structure decisions of countries with and without taxation policies. The recognition of the lack of studies that relate industry-specific factors would have a far-reaching contribution to the body of knowledge in the field.

This study will be a cross-sectional analysis of firms from various industries. This shall make facilitate comparisons, generalizations and avoid biasness of associated with past studies.

The model that is adopted by this research is the dynamic model, which is relevant in studying corporations in emerging markets experiencing market dynamics. The rest of the paper is organized as follows. The section that follows discusses the methodology and framework of the study.

Research Design & Methodology

This research will utilize a theoretical framework involving three broad approaches that will explore the subject of the study. These theories include the static trade-off, pecking order theory, and agency cost theory. Previous studies have confirmed that these theories provide meaningful insights into some of the key firm-specific factors that influence an organization’s capital structure. This section will deal with a discussion of the three theories of capital structure to help in understanding the empirical design of the research.

Pecking Order Theory

The pecking order theory developed by Myers and Majluf (1984), suggests that external capital sources are affected by adverse selection because of asymmetry of information. In simple terms, they found that since internal management has more information than outsiders do, company executives tend to cash on the ignorance of the outsiders who are in demand of a premium on top of their investments¹⁰. Companies that have a monopoly of information tend to read the behavior of investors and use it to increase their capital investments. For tax-exempt organizations, the adverse selection does not only include interest expense, but also other factors such as bond covenants, including other factors that may be decided by the executives of a firm.

This theory relies on the concept of asymmetry of information¹¹. This theory postulates that firms are unable to design or achieve optimal leverage, but can set targets, which are used as pointers for future capital capacities. This theory focuses on the costs of information and other signaling effects¹². In their studies, Myers and Majluf showed that firms prefer to finance their investments through internal finances rather than outside sources¹³.

They use such sources as depreciation expenses and retained earnings. Upon exhausting these sources, these firms move to debts to finance their activities. In cases where the debt is not sufficient, a company may move to fill its financing needs through additional equity. The theorem postulates that companies rank their sources of capital in the order of the costs of financing and the number of benefits that can be derived from such sources. In essence, they use the hierarchy order, which is justified by the financing costs. The issuance of additional equity by a company is considered the most expensive source of investment capital.

This is because equity capital is a source of capital that is affected by the informational asymmetry between a company’s existing shareholders, company executives, and prospective shareholders. However, since debts tend to have fixed returns and payments, it is least sensitive to the effects of asymmetry of information. On the other hand, internally generated finances are not affected since they have no issuing costs.

Contrary to the trade-off theory, the pecking order theory argues that there can never be a definite optimal capital that a company can use to navigate its long-term investments. The key component of this theorem revolves around how a firm chooses between external sources and internal sources of capital to finance its operations. Therefore, the pecking order theory concludes that there exists a hierarchy of choice of financing options where a firm descends from internal sources then debts, and finally equity funding.

Static Trade-Off Theory

The static trade-off theory proposes that there is no existence of an optimal capital structure and that what companies do is to set their levels of debt and formulate strategies toward achieving these targets. The model observes that a capital structure of a firm is a static trade-off that relates the cost and benefits of a firm’s equity and debt. The theory anticipates that a firm seeks to increase its debt holding to offset the marginal tax advantages by the increased cost of financial distress and bankruptcy¹⁴. In essence, the theory of static trade-off of capital structure implies assumes that since the interests are subject to tax deductions, increasing the level of debt raises the tax benefits¹⁵. On the same line of thinking, increasing the amount of debt capital stimulates default and this raises chances of bankruptcy.

Modigliani and Miller (1963) found that firms seek to reach optimal capital structure using debts because of deductibility of interest expense¹⁶. Other studies have expanded this theory to include other the probability of financial distress costs as some of the firm-specific factors that may affect the capital structure of a firm. The trade-off theory suggests that firms are always on the mission to balance the cost and returns of debt¹⁷. Companies operating a tax-exempt economy must strive to strike a balance between the costs of financing through equity and debts and minimizing financial distress arising from debt-equity.

Agency cost theory

The last theory that the research will consider is the agency cost theory, which suggests that a firm seeks to achieve an optimal level of capital by balancing between returns and costs that accompany conflicting interests. According to Meckling and Jensen (1976), agency costs refer to the cumulative costs of monitoring expenses by the bond agent, the principal, and the residential loss from such a relationship¹⁸. Meckling and Jensen argue that agency costs influence the cost financing decisions citing the role of secured debts in downsizing the costs of acquisition of debts.¹⁹.

In their studies, they suggest that using short-term financing may mitigate and solve problems of agency relationships. This is because the motivation of the shareholders to reap from debt holders tends to narrow a firm’s access to short-term debts rather than long-term debts. This helps to solve agency problems.

Because of such costs arising from agency relations, a firm is motivated to focus on a targeted debt level to lower agency costs.

If there are no effects or costs of floatation, similar adjustments are deemed continuous in all firms. In practical terms, the fact that floatation costs exist implies that there shall be a fluctuation in the debt and leverage ratios on the target debt levels. Because of this, there is a need to establish a company’s debt targets and find out how this level may change as a result of external factors. However, it is difficult to unveil this given that the target levels are difficult to tell. It means that we can only use historical information to study the behavior of companies’ target levels. In this respect, the research will use the dynamic panel approach to provide a basis to investigate a firm’s target leverage ratio.

Berger, Ofek, and Yermack (1997) found that executives who have worked in a company for a long tend to tend evading debts²⁰. In their studies, Galai and Masulis (1976)²¹, Jensen and Meckling (1976), and Stulz (1990) indicated that acquisition of debt encourages a firm’s decision-making body to engage in riskier capital investments since losses are burdens to the bondholders, while gains are channeled to shareholders²².

For tax-exempt firms, the agency cost theory anticipates that a mix of personal risk aversion, experience (entrenchment), and career concerns influences decision making on the type and amount of debt²³. The effects arising out of these factors could be more in a tax-exempt economy, or sector because of the non-existence of corporate control²⁴.

Bibliography

Baker, M & J Wurgler, ‘Market timing and capital structure’, Journal of Finance, vol. 57, no. 1, 2002, pp. 1-32.

Berger PG, E Ofek &DL Yermack, ‘Managerial entrenchment and capital structure decisions’, Journal of Finance, vol. 52, no. 4, 1997, pp. 1411-1438.

Booth, L, V Aivazian, A Demirguc-Kunt & V Maksimovic, ‘Capital structures in developing countries’, Journal of Finance, vol. 56, no.1, 2001, pp.87-130. Finance, vol. 60, no. 6, 2005, pp. 2575-2619.

Galai, D &RW Masulis, ‘The option-pricing model and the risk factor of stock’, Journal of Financial Economics, vol. 3, 1976, pp. 53-81.

Jensen, MC & WH Meckling, ‘Theory of the firm: Managerial behavior, agency costs and ownership structure’, Journal of Financial Economics, vol. 3, 1976, pp. 305-360.

Leary, MT & M R Roberts, ‘Do firms rebalance their capital structures?’, Journal of Finance, vol. 60, no. 6, 2005, pp. 2575-2619.

Modigliani F & MH Miller, ‘Corporate income taxes and the cost of capital: A correction’, American Economic Review, vol. 53, no. 3, 1963, pp. 433-443.

Myers, SC & NS Majluf, ‘Corporate financing and investment decisions when firms have information that investors do not have’, Journal of Financial Economics, vol. 13, 1984, pp.187-221.

Pandey L, ‘Capital Structure and the Firm Characteristics: Evidence from an Emerging Market’, IIMA Working Paper, 2001.

Shyam-Sunder L & SC Myers, ‘Testing Static Trade-off against Pecking order Models of Capital Structure’, Journal of Financial Economics, vol. 51, 1999, pp. 219-244.

Stulz, RM, ‘Managerial discretion and optimal financing policies. Journal of Financial Economics, 26:3-27, 1990.

Footnotes

1. L Pandey, ‘Capital Structure and the Firm Characteristics: Evidence from an Emerging Market’, IIMA Working Paper, 2001.
2. L Pandey, ‘Capital Structure and the Firm Characteristics: Evidence from an Emerging Market’, IIMA Working Paper, 2001.
3. M Baker & J Wurgler, ‘Market timing and capital structure’, Journal of Finance, vol. 57, no. 1, 2002, pp. 1-32.
4. L Pandey, ‘Capital Structure and the Firm Characteristics: Evidence from an Emerging Market’, IIMA Working Paper, 2001.
5. L Pandey, ‘Capital Structure and the Firm Characteristics: Evidence from an Emerging Market’, IIMA Working Paper, 2001.
6. M Baker & J Wurgler, ‘Market timing and capital structure’, Journal of Finance, vol. 57, no. 1, 2002, pp. 1-32.
7. M Baker & J Wurgler, ‘Market timing and capital structure’, Journal of Finance, vol. 57, no. 1, 2002, pp. 1-32.
8. L Booth, V Aivazian, A Demirguc-Kunt & V Maksimovic, ‘Capital structures in developing countries’, Journal of Finance, vol. 56, no.1, 2001, pp.87-130.
9. L Pandey, ‘Capital Structure and the Firm Characteristics: Evidence from an Emerging Market’, IIMA Working Paper, 2001.
10. CM Myers & NS Majluf, ‘Corporate financing and investment decisions when firms have information that investors do not have’, Journal of Financial Economics, vol. 13, 1984, pp. 187-221.
11. MT Leary & MR Roberts, ‘Do firms rebalance their capital structures?’, Journal of Finance, vol. 60, no. 6, 2005, pp. 2575-2619.
12. CM Stewart & NS Majluf, ‘Corporate financing and investment decisions when firms have information that investors do not have’, Journal of Financial Economics, vol. 13, 1984, pp. 187-221.
13. CM Myers & NS Majluf, ‘Corporate financing and investment decisions when firms have information that investors do not have’, Journal of Financial Economics, vol. 13, 1984, pp. 187-221.
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The passion for information and communication has been the driving factor towards the start up of Einstein Web Solutions. Einstein Web Solutions is an ICT firm specializing in the Search Engine Optimization business. EWS is a firm based in the United States and enjoys a capital base of more than $100, 000. This organization is intended to offer SEO services to a wide array of customers. These include personal websites, small scale organizations to large companies with the interest of increasing their web presence. This firm will provide affordable and customized internet market solutions to a myriad range of clients. The market includes small and large businesses as well as individual website services.

The minds behind this initiative as we will see later, are professionals in web designing and marketing hence making the firm to run a URL of itself. Its services will cover as already mentioned earlier an extensive range of activities including on-site and off-site SEO services. This will be geared towards organizations interested in optimizing their web rankings. During the first year of operations, focus will be on marketing aimed at building a strong client base. Other than convectional market practices, quality services to existing clients will form the basis of our services marketing initiative (Steenburgh, & Avery, 2010). The business is then projected to expand to attain regional status and eventually global over time.

It is expectant that in the initial three years, the business will direct lots of resources towards marketing. A large portion of the content will be done in-house during these three years. This will however not be a problem considering that the stakeholders are experts in the field of the business. The main source of income / revenue in this business will be offering of SEO services to website owners. Another source of revenue will be through advertisements and affiliate programs. This firm is yet to be officially opened later during the year.

Products and Services

Products on offer at Einstein Web Solutions will provide website owners with high impact e-marketing strategies. These services are meant to help organizations increase their web presence and hence allowing them to reach out to a greater target audience. Unlike similar firms, Einstein Web Solution does not just attract traffic to the respective websites but rather attracts the right traffic with a potential of turning them into sales remember sales is the prime objective of a site. Our services are aimed at having client’s websites ranked high on search engines based on specific keywords. The organization applies both convectional and technical skills to achieve this, including the use of specific algorithms for appropriate content. Einstein Web Solutions will further offer marketing management service to clients to help clients’ websites to move up the rank in their respective website categories (Rupert, Pope, & Anderson, 2014).

Essentially, Einstein Web Solutions offer white-hat SEO techniques to help website get better ranking on search engines, enjoy increased web presence, and attract relevant traffic.

Financing

The business aims to raise a loan of £100,000 from a bank. The interest to be accrued on the loan is set at 10% fixed interest for the 10 year loan.

Einstein Web Solutions’ Mission Statement

The organization’s mission is provision of an integrated SEO menu to clients. Einstein Web Solutions is committed to provision of SEO services that will raise the online presence of customer’s. This will be achieved through ongoing and relevant approaches towards integration of online advertisement in service’s menu.

Management Team

The company brings together a team of experts who enjoy over 5 years of experience in SEO industry. The business will tap into its management’s expertise to consolidate business operations and generate profit without compromising quality service delivery to the clients. The team is expected to steer the business to profitability in its first year of operation.

Sales Forecast

Einstein Web Solutions is a company eyeing to run profitably. To further express this motive, are our projected figures below. The company expects a steady strong growth over the first three years.

Extension Plans

The management will put in place an intensified marketing campaign in its first three years in order to see a steep rise in small and medium sized business websites which will be the hub of the SEO business.

Organization and its Financing Summary

Registered Name and Corporate Structure

Einstein Web Solutions is a registered company in Ireland offering SEO services to business interested in increasing their web presence.

Funding required

Presently, Einstein Web Solutions will acquire £100,000 for its operations funding.

Detailed description of products and services

The services offered by the business will primarily be SEO services and pay-per-click marketing.

SEO Services

This is the main service to be offered by the business. It will involve application of relevant keywords to attract traffic to a customer’s website. In essence, it uses white hat SEO techniques to improve a client’s online presence.

Pay-per-Click Marketing

This is a subsidiary income source and will involve an ongoing pay-per-click advertising service. Each click is charged by the company.

Strategic and Market Analysis

Economic Analysis

This part of this report discusses the business’s economic environment. It will also look at the accounting methods that would be available for this type of business and discuss the customer profile, as well as competitive forces within the market. Currently, Ireland is in the post-recession period and the economy is beginning to pick up. Sales are on a steep rise as business focus on going online. Many economists project that the Eurozone economy will continue to rise and business will continuously seek to boost their online presence, implying increased market (Anderson, 2005).

Industry Analysis

SEO as an industry has largely expanded over the recent years. This has largely been facilitated by the steep rise in computer technology and e-readiness of the general population. Many people now rely on computers for literally everything. In response, more and more companies are seeking a stake in the booming online market. In Ireland, and larger Europe, internet remains a major avenue through which clients interact with manufacturers and service providers. Nonetheless, despite the ever growing client base for SEO services, business offering these services is also growing at a very fast pace. In 2012, the economic census revealed that more than 20000 service providers offer similar or identical services in Ireland, not to mention the larger Europe (Hill & Westbrook, 2006).

In general, this segment is expected to continue to rapidly grow as more corporations, large and small realize the importance of hiring professional SEO services if they are to successfully compete (Menon et al., 2010). Thesis best illustrated by sky-rocketing need for these services over the last two years, more especially after most directories disallowed special placement. Additionally, introduction of pay-per-click advertisement services has made it possible for many smaller businesses to find a place in the large web platform. The company will capitalize on the increased need for SEO services by smaller and medium sized companies. These businesses will offer a continuous Einstein Web Solutions.

Consumer Profile

Every single business organization keen on expanding its online presence is a prospective client of Einstein Web Solutions. Consequently, its target client demographics is extensive and include many businesses keen on e-commerce and hence in need of strong business presence.

Competitive Analysis

Research on SEO services in Ireland and the large EU zone reveal existence of hundreds of thousands of providers. In essence, this implies high levels of competition underlying the importance of strong market and enhanced quality service delivery to ensure retention of clients. Considering that SEO optimization does not require physical presence of the SEO provider at the company offices, Einstein Web Solutions finds itself pitted against leading SEO service providers from across the world. In essence, Einstein Web Solutions operates in an environment where the risk of losing a client is so high. Pricing and quality service delivery are therefore of extreme importance given the high number of SEO providers popping daily and the cheap prices offered by new entrants into the market, who are by no means lesser than those already in the market. This is a market where barriers to entry are so limited, exposing it to competition from new entrants each day. However, other than quality service delivery and affordable prices, the pay-per-click service acts as customer retention plan.

Marketing Plan

Einstein Web Solutions seeks to persistently engage in an elaborate and continuous marketing plan that will see it get from clients not just from Ireland but also from other parts of the globe. Its marketing objectives and strategies are outlined below:

Marketing Objectives

Einstein Web Solutions has set a number of objectives reviewable after every financial year to ensure its continued success. The objectives are listed below:

• Increase client base by 25% at the end of every financial year.
• Expand operations to international level by the end of the first three years of operation.
• Lower operational costs by 10% by the end of the first 3 years.
• Expand the affiliate program by 20% at the end of the first 3 years.

Marketing strategies

The management intends to employ multiple marketing strategies to ensure the aforementioned objectives are accomplished.

• Aggressive internal SEO campaigns to ensure increased online presence of Einstein Web Solutions.
• A continuous referral relationship with other internet marketing organizations and web programming entities. It is expected that such organizations can outsource SEO services from Einstein Web Solutions at a discounted rate for purposes of resale to their clients.
• Face to face interaction with companies in Ireland.
• Use of email marketing on basis of existing directories.
• Offering quality services.
• Offering discount coupons to new customers.
• Availing after-sale services and discounts to returning customers.

Pricing

Pricing has been identified as a very important factor in a market crawling with competitors from all corners of the world (Armstrong, 2006). However, the costs incurred by the organization and the need for delivery of quality services must be factored in during pricing. While low prices are customer winners, the organization cannot compromise its service provision at the expense of offering consumers low prices. A balance must therefore be struck between the two.

Financial Plan

Underlying Assumptions

• Einstein Web Solutions enjoy a yearly revenue stream growth rate of 15% annually.
• A funding of £100,000 will be acquired to fund business operations.
• The acquired loan will accrue an interest rate of 10% on a 10 year term.

Accounting year

The chosen tax year will affect the amount of taxable income. Income, whether received or accrued with the year is reported on the tax returns for that particular year, alongside all other paid/accrued expenses. The business has an option to choose from 4 tax year options. These include:

1. A calendar year.
2. An elected tax year as per IRC Sec. 444.
3. A 52 to 53 week tax-year that ends with reference to calendar year or a tax year elected as per IRC Sec. 444.
4. Other tax-year established for business purposes.

However, it is important to emphasize that given that the business has opted for tax year other than the calendar year, IRS approval will be sought through Form 2553, rather than use Form 1128.

The chosen tax year has been aligned with accuracy of the business’s income and expenditure cycles. In this case, the business was viewed as seasonal and hence the chosen accounting period was such that it reflected the entire season constituting the period when expenses where expenses incurred and income generated as a result of the expenses were included. In the business, a majority of expenses/income for the business’s operating cycle will occur in two different years. The fiscal year will therefore start in July and end in September.

Changing Accounting Method

After filing our initial tax return in the first year, we opt to change the accounting period / method. Currently we are using the tax year. To change it we need to get permission from the IRS. The reason being this accounting period will soon be a limiting factor on how we operate our business. This request can be achieved by filling in the form 1128.

In addition the accounting method that will be used is the cash accounting method. “The cash method allows us as the taxpayer to recognize income and expenses at the point in time that the money is received or paid” (Steenburgh, & Avery, 2010, p.76). This method is advantageous because it is easy to use and very little record keeping is required.

Looking at the tax method from another perspective, there might be a need to change with time, because as the business grows the management, will need to provide documented evidence of their tax returns. The other tax method that can be used is the accrual method.

Unlike the cash method, the accrual method is more based on the performance of the economy performance. “In this method one is able to recognize an item of expense when you become liable for it, whether or not you pay for it in the same year” (Steenburgh, & Avery, 2010, p.76). This allows for flexibility. Accrual method is also the most appropriate when it comes our type of business. The firm will have several transactions to carry out and most importantly we will have to use an inventory. “Most importantly with the accrual method, it will be more difficult to minimize taxes by shifting income generating items and expenses from one year to another” (Steenburgh, & Avery, 2010, p.76).

Letter to the IRS

The following is how our letter to the IRS would read.

This is to justify the change of Einstein Web Solution’s change of accounting method from cash accounting method to accrual accounting method. The change has been motivated by the need to carry our business flawlessly. Over the one year we have been in operation, our firm has undergone numerous expansions that have come with complexities. It is therefore most reasonable that we changed from the cash accounting system to the accrual accounting system to be able to keep pace with our ever growing business.

Amongst the main reasons for this change it may enable us carry our activities in well documented manner which is provided by the accrual accounting method. Einstein Web Services also requires working with the flexibility that comes with accrual accounting method”.

Sensitivity Analysis

Considering the changing economic fortunes in target market, the company’s revenues are sensitive to the economy just like companies would want to minimize their expenditure as economy slumps and spend more as economy grows strong. However, as more and more businesses seek to enhance their web presence, demand is bound to record a steep increase. The demand of traffic is continuously on the rise irrespective of economic changes.

References

Anderson, G. (2005). Framework for marketing planning. Michigan: Michigan Business school.

Armstrong, M. (2006). A handbook of Human Resource Management Practice. London: Kogan Page.

Hill, T., & Westbrook, R. (2006). Business Analysis: It’s Time for a Product Recall. Long Range Planning, 30 (1), 46–52.

Menon, A. et al. (2010). Consequences of Marketing Strategy Making. Journal of Marketing (American Marketing Association), 63 (2), 18–40.

Rupert, T. J., Pope, T. R., & Anderson, K. E. (2014). Prentice Hallâ EURO ™s Federal Taxation 2014 Comprehensive (27th ed.). Upper Saddle River, NJ: Pearson.

Steenburgh, T., & Avery, J. (2010). Marketing Analysis Toolkit: Situation Analysis. Case Harvard Business Review, 12 (5), 76 – 81.

Introduction

Every state has a systematic way of collecting taxes from its citizens. The tax system in the United States has undergone various transformations to respond to the needs of citizens in the evolving world (Rupert, Pope, & Anderson, 2014). Indeed, daily expenses are overburdening citizens in the contemporary world, and the citizens are in desperate need of a state that would relieve them from some tax burdens. Fortunately, the United States has a tax system that considers taxpayers who have encountered certain losses that have reduced their taxable income. Taxpayers who incur losses during sudden and unexpected events are entitled to tax deductions for all the losses incurred during the taxable year. It is noteworthy that losses that have insurance covers do not qualify for tax deductions. This paper will give an outlay of the manner in which tax-deductible losses came to be part of the U.S. tax code. It will also discuss a significant tax-deductible and non-deductible loss, and it will give an outline of the IRS audit activities.

Origin of tax-deductible losses

During colonial times, the United States obtained its tax revenues from excise taxes, customs duties, and tariffs. Since the government had a limited need for revenue, citizens did not have to pay taxes directly to the government. However, the post-revolutionary era acted as a revelation, and the federal government realized that there was a need to raise taxes to pay debts, develop the nation, and offer defense for the citizens. That revolutionary era marked the beginning of taxation, and within no time, taxation was imposed on all legal documents. The federal government began imposing direct taxes on the owners of land and property. The situation became worse when the federal government had to finance the civil war. The government obligated the employers to withhold the income taxes of their employees to enable timely collection of taxes. Fortunately, the income tax law of 1862 was reformed to cater to the taxpayers who lost their property in unexpected events.

After the end of the civil war, the need for federal revenue declined considerably, and the government officials thought that abolishing the income taxes would be a fair approach to relieve the citizens. However, later on, the first and second world Wars played a significant role in facilitating the hiking of income tax charges. The entire issues of wars, depressions, and economic booms affected the taxpayers considerably. Indeed, there was a need to find a permanent solution that would relieve the taxpayers from shocks and all unforeseen events. The policymakers felt that it was time to find a tool to stabilize the macroeconomic activities in the nation. After several deliberations, the income tax law was reviewed, and since the 1960s, the tax-deductable losses became part of the U.S. Tax Code.

Indeed, taxpayers who lose property during sudden or unpredictable events lose part of their taxable income. If the government continues charging them taxes on items that are no longer present, the taxes may be higher than the income on the taxpayer, and the tax burden would be overwhelming. Moreover, high marginal tax rates cause inflation, and the taxpayers may have a high regulatory burden. The scenario is devastating since the general economy would underperform. Therefore, although tax-deductible losses offer a small relief to individual taxpayers, the entire exercise has significant positive effects on the economy. In fact, the 2001 tax cut strengthened the economy, as the tax cut insured investors against economic downturns. The economy of the United States is undergoing a robust recovery, and this is attributed to the 2001 tax cut and the various tax-deductible losses.

Significant tax-deductible loss

Casualty losses are some of the most significant tax-deductible losses. Damage or destruction of property during sudden and unusual events like earthquakes, fires, floods, and terrorist attacks are deductable causality losses. As long as the property loss does not have an insurance cover, the owner of the property is entitled to a deduction of the taxable income. Moreover, if the insurance does not cover certain losses, the property owner can also claim a tax deduction of the losses incurred. In the case of partially destroyed property, the federal-state will calculate the deductable loss by subtracting the salvage value and the insurance proceeds from the net value of the property. The value of improvements is added to the original value of the property, whereas the depreciation value is subtracted to determine the net value of the property.

From the discussions, it is evident that casualty losses are inclined towards the property owners. Very little consideration is given to the multiple damages that occur in the case of casualty damages. Taxpayers who may happen to be tenants of the destroyed property may lose their valuables in the case of damage. Moreover, in case many disastrous incidences occur and the property owners claim for tax-deductible losses, the unaffected taxpayers will have to encounter a heavier tax burden than before. The tax rates may increase, inflation may occur, and the overall living expenses may increase. It would be worthwhile if the lawmakers considered the claims made by all the affected people in the case of a casualty loss. The tenants should have an opportunity to produce proof of their lost property, while the workers who lose their jobs should be compensated for their losses before they can secure other employment opportunities. Moreover, the government should use revenue reserves to run their errands during disastrous moments instead of raising tax levels.

Non-deductable loss

The sale or exchange of property between relatives is a nondeductible loss that affects the involved parties considerably. Two people who have a blood or ancestral relationship may decide to trade some property; however, in case they incur some loss in the course of the transactions, the federal-state cannot offer some tax-deductible losses. The state clearly indicates that people cannot have their losses deducted if prearrangements are made to sell an item to a relative through a broker. In case the relative resells the item at a profit, the recognized profit is the amount above the original price of the item. The entire rule applies to both direct and indirect transactions; therefore, the government discourages the trading of property or any tangible items between relatives, as it takes no responsibility in case of disputes or losses.

From a critical point of view, the state is somewhat unfair in dealing with the mentioned issue. This is because the state obligates the traders to figure the gains or losses separately, where, the gains are taxable, whereas the losses are non-deductible. Moreover, the gains from the trading activities cannot offset the losses incurred during the trading period. The government is acting in a selfish manner in handling trading activities between relatives. If it does not offer tax-deductible losses, then it should not tax the gains that are obtained during the trading activities between relatives. To make the entire procedure impartial, the federal government should allow tax-deductable losses for transactions between related family members.

Alternative to loss deductions

From the discussions, it is evident that some taxpayers are highly disadvantaged from the tax-deductable losses. The provisions for deductions are advantageous to the wealthy people who can afford to own large properties and large businesses. When such privileged people encounter losses, the poor taxpayers have to incur the expenses through increased taxes. The best alternative to loss deductions is adopting the Fair Tax Act. The act would replace all the practices of collecting revenue by the Internal Revenue Act with a retail sales tax. Essentially, the taxpayers will only have to pay tax when purchasing goods and services. The employers will not have to pay for medical taxes, capital gain taxes, estate taxes, or payroll taxes. Since the Fair Tax Act will not consider taxing people according to their income, the tax-deductible losses will be irrelevant (McCaffery, 2002). Investors will have to look for alternative ways to ensure their properties instead of burdening the taxpayers every time they incur losses. The federal government will be able to tax every citizen through the consumption tax. All citizens will contribute to the taxes needed regardless of their nationality. This approach will capture the immigrants and those citizens doing illegal activities within the nation. Everybody will pay taxes through the consumption tax to support the financial needs of the federal government. Indeed, the Fair Tax Act will achieve fairness to all taxpayers, as people will have to carry their own burdens. The property owners will not frustrate the United States Treasury, and neither will they impose tax burdens on the taxpayers. Citizens will be encouraged to save and invest, and there will be general economic growth.

IRS audit activities

The Internal Revenue Service (IRS) auditors double-check the reported figures of the taxpayers to ensure that they are free from discrepancies. From one time to another, people who claim tax-deductible losses cheat the system to avoid paying taxes. The IRS audit activities with regard to loss deductions scrutinize the tax gap. The main aim is to minimize the difference between what the IRS receives and what the taxpayers own the federal government (Keenan & Hoshall, 2014). Research indicates that the most recent IRS audit activities related to charitable donations and home office deductions. Since the IRS allowed deductions on charitable donations, taxpayers have abused the deduction. While charitable donations are a great show of selflessness, privileged people and big organizations have had a tendency of making false claims of offering charitable donations. Since the IRS can estimate the average charitable donation for a particular person or organization depending on the income bracket, exaggerated figures may raise eyebrows and trigger an IRS audit. Moreover, most people who work at home overstate their legitimate deductions, and the IRS is often triggered to audit the figures of people with home offices. Depending on the person’s profession and the prior tax filings, the auditors can identify fraud cases (Ungerman & Fowler Jr., 2011). The best strategy to defend a client facing an IRS challenge is providing all the supporting documents that indicate that indeed, the client underwent the losses that ought to be deductible.

Conclusion

From the discussions, it is evident that tax deductibles are social incentives that play a great role in relieving the taxpayers from tax burdens. However, some cunning people are taking advantage of the tax-deductible losses to trouble the federal government and the feeble taxpayers. It is upon the government to impose ways to establish alternatives to lose deductions that would be fair to all taxpayers. In this case, the Fair Tax Act would play a significant role in ensuring justice to all taxpayers who will collectively pay consumption taxes to support the financial needs of the federal government.

References

Keenan, J., & Hoshall, D. (2014). IRS watch. Journal of Tax Practice & Procedure, 16(1), 9-65.

McCaffery, E. J. (2002). Fair not flat: How to make the tax system better and simpler. Chicago, IL: University Of Chicago Press.

Rupert, T. J., Pope, T. R., & Anderson, K. E. (2014). Prentice Hall’s federal taxation 2014 comprehensive. Upper Saddle River, NJ: Pearson.

Ungerman, J. O., & Fowler Jr., C. E. (2011). The new gift tax audits A look at the recent IRS initiative to identify non-filers using state property records. Journal of Tax Practice & Procedure, 13(4), 29-47.