Definition of Income tax
Income tax
A government tax on the income earned by an individual or corporation.
INCOME TAX
What the business paid to the IRS.
Related Terms:
A measure of profit that
equals sales revenue for the period minus cost-of-goods-sold expense
and all operating expenses—but before deducting interest and income
tax expenses. It is a measure of the operating profit of a business before
considering the cost of its debt capital and income tax.
That portion of the total income tax provision that is based on
taxable income.
That portion of the total income tax provision that is the result
of current-period originations and reversals of temporary differences.
See income tax provision.
The expense deduction from pretax book income reported on the
income statement. It consists of both current income tax expense and deferred income tax
expense. The terms income tax expense and income tax provision are used interchangeably.
Gross income less a set of deductions.
current compensation that is taxed at a future date
current compensation that is never taxed
tax incentives for labor and business to induce them to conform to wage/price guidelines.
income subject to income tax as reported on the tax return.
Earnings before interest and income taxes plus one-third rental charges, divided
by interest expense plus one-third rental charges plus the quantity of principal repayments divided by one
minus the tax rate.
A financial measure defined as revenues less cost of goods sold
and selling, general, and administrative expenses. In other words, operating and non-operating profit before
the deduction of interest and income taxes.
The practice of reporting to shareholders using straight-line depreciation and
accelerated depreciation for tax purposes and "flowing through" the lower income taxes actually paid to the
financial statement prepared for shareholders.
Home country credit against domestic income tax for foreign taxes paid on foreign
derived earnings.
The reduction in income taxes that results from the tax-deductibility of interest payments.
Municipal bond
State or local governments offer muni bonds or municipals, as they are called, to pay for
special projects such as highways or sewers. The interest that investors receive is exempt from some income taxes.
Normalizing method
The practice of making a charge in the income account equivalent to the tax savings
realized through the use of different depreciation methods for shareholder and income tax purposes, thus
washing out the benefits of the tax savings reported as final net income to shareholders.
Sole proprietorship
A business owned by a single individual. The sole proprietorship pays no corporate
income tax but has unlimited liability for business debts and obligations.
Tax anticipation bills (TABs)
Special bills that the Treasury occasionally issues that mature on corporate
quarterly income tax dates and can be used at face value by corporations to pay their tax liabilities.
Tax-exempt sector
The municipal bond market where state and local governments raise funds. Bonds issued
in this sector are exempt from federal income taxes.
Tax shield
The reduction in income taxes that results from taking an allowable deduction from taxable income.
Dividend
A payment a company makes to stockholders. Earnings before income tax. The profit a company made
before income taxes.
INCOME STATEMENT
An accounting statement that summarizes information about a company in the following format:
Net Sales
– Cost of goods sold
--------------------
Gross profit
– Operating expenses
--------------------
Earnings before income tax
– income tax
--------------------
= Net income or (Net loss)
Formally called a “consolidated earnings statement,” it covers a period of time such as a quarter or a year.
accrual-basis accounting
Well, frankly, accrual is not a good descriptive
term. Perhaps the best way to begin is to mention that accrual-basis
accounting is much more than cash-basis accounting. Recording only the
cash receipts and cash disbursement of a business would be grossly
inadequate. A business has many assets other than cash, as well as
many liabilities, that must be recorded. Measuring profit for a period as
the difference between cash inflows from sales and cash outflows for
expenses would be wrong, and in fact is not allowed for most businesses
by the income tax law. For management, income tax, and financial
reporting purposes, a business needs a comprehensive record-keeping
system—one that recognizes, records, and reports all the assets and liabilities
of a business. This all-inclusive scope of financial record keeping
is referred to as accrual-basis accounting. Accrual-basis accounting
records sales revenue when sales are made (though cash is received
before or after the sales) and records expenses when costs are incurred
(though cash is paid before or after expenses are recorded). Established
financial reporting standards require that profit for a period
must be recorded using accrual-basis accounting methods. Also, these
authoritative standards require that in reporting its financial condition a
business must use accrual-basis accounting.
contribution margin
An intermediate measure of profit equal to sales revenue
minus cost-of-goods-sold expense and minus variable operating
expenses—but before fixed operating expenses are deducted. Profit at
this point contributes toward covering fixed operating expenses and
toward interest and income tax expenses. The breakeven point is the
sales volume at which contribution margin just equals total fixed
expenses.
current liabilities
Current means that these liabilities require payment in
the near term. Generally, these include accounts payable, accrued
expenses payable, income tax payable, short-term notes payable, and
the portion of long-term debt that will come due during the coming year.
Keep in mind that a business may roll over its debt; the old, maturing
debt may be replaced in part or in whole by new borrowing.
depreciation
Refers to the generally accepted accounting principle of allocating
the cost of a long-term operating asset over the estimated useful
life of the asset. Each year of use is allocated a part of the original cost of
the asset. Generally speaking, either the accelerated method or the
straight-line method of depreciation is used. (There are other methods,
but they are relatively rare.) Useful life estimates are heavily influenced
by the schedules allowed in the federal income tax law. Depreciation is
not a cash outlay in the period in which the expense is recorded—just
the opposite. The cash inflow from sales revenue during the period
includes an amount to reimburse the business for the use of its fixed
assets. In this respect, depreciation is a source of cash. So depreciation is
added back to net income in the statement of cash flows to arrive at cash
flow from operating activities.
extraordinary gains and losses
No pun intended, but these types of gains
and losses are extraordinarily important to understand. These are nonrecurring,
onetime, unusual, nonoperating gains or losses that are
recorded by a business during the period. The amount of each of these
gains or losses, net of the income tax effect, is reported separately in the
income statement. Net income is reported before and after these gains
and losses. These gains and losses should not be recorded very often, but
in fact many businesses record them every other year or so, causing
much consternation to investors. In addition to evaluating the regular
stream of sales and expenses that produce operating profit, investors
also have to factor into their profit performance analysis the perturbations
of these irregular gains and losses reported by a business.
financial leverage
The equity (ownership) capital of a business can serve
as the basis for securing debt capital (borrowing money). In this way, a
business increases the total capital available to invest in its assets and
can make more sales and more profit. The strategy is to earn operating
profit, or earnings before interest and income tax (EBIT), on the capital
supplied from debt that is more than the interest paid on the debt capital.
A financial leverage gain equals the EBIT earned on debt capital
minus the interest on the debt. A financial leverage gain augments earnings
on equity capital. A business must earn a rate of return on its assets
(ROA) that is greater than the interest rate on its debt to make a financial
leverage gain. If the spread between its ROA and interest rate is unfavorable,
a business suffers a financial leverage loss.
gross margin, or gross profit
This first-line measure of profit
equals sales revenue less cost of goods sold. This is profit before operating
expenses and interest and income tax expenses are deducted. Financial
reporting standards require that gross margin be reported in
external income statements. Gross margin is a key variable in management
profit reports for decision making and control. Gross margin
doesn’t apply to service businesses that don’t sell products.
operating leverage
A relatively small percent increase or decrease in
sales volume that causes a much larger percent increase or decrease in
profit because fixed expenses do not change with small changes in sales
volume. Sales volume changes have a lever effect on profit. This effect
should be called sales volume leverage, but in practice it is called operating
leverage.
operating liabilities
The short-term liabilities generated by the operating
(profit-making) activities of a business. Most businesses have three types
of operating liabilities: accounts payable from inventory purchases and
from incurring expenses, accrued expenses payable for unpaid expenses,
and income tax payable. These short-term liabilities of a business are
non-interest-bearing, although if not paid on time a business may be
assessed a late-payment penalty that is in the nature of an interest
charge.
operating profit
See earnings before interest and income tax (EBIT).
profit
The general term profit is not precisely defined; it may refer to net
gains over a period of time, or cash inflows less cash outflows for an
investment, or earnings before or after certain costs and expenses are
deducted from income or revenue. In the world of business, profit is
measured by the application of generally accepted accounting principles
(GAAP). In the income statement, the final, bottom-line profit is generally
labeled net income and equals revenue (plus any extraordinary gains)
less all expenses (and less any extraordinary losses) for the period. Inter-
nal management profit reports include several profit lines: gross margin,
contribution margin, operating profit (earnings before interest and
income tax), and earnings before income tax. External income statements
report gross margin (also called gross profit) and often report one
or more other profit lines, although practice varies from business to
business in this regard.
profit module
This concept refers to a separate source of revenue and
profit within a business organization, which should be identified for
management analysis and control. A profit module may focus on one
product or a cluster of products. Profit in this context is not the final, bottom-
line net income of the business as a whole. Rather, other measures
of profit are used for management analysis and decision-making purposes—
such as gross margin, contribution margin, or operating profit
(earnings before interest and income tax).
return on assets (ROA)
Although there is no single uniform practice for
calculating this ratio, generally it equals operating profit (before interest
and income tax) for a year divided by the total assets that are used to
generate the profit. ROA is the key ratio to test whether a business is
earning enough on its assets to cover its cost of capital. ROA is used for
determining financial leverage gain (or loss).
straight-line depreciation
This depreciation method allocates a uniform
amount of the cost of long-lived operating assets (fixed assets) to each
year of use. It is the basic alternative to the accelerated depreciation
method. When using the straight-line method, a business may estimate a
longer life for a fixed asset than when using the accelerated method
(though not necessarily in every case). Both methods are allowed for
income tax and under generally accepted accounting principles (GAAP).
sunk cost
A cost that has been paid and cannot be undone or reversed.
Once the cost has been paid, it is irretrievable, like water over the dam
or spilled milk. Usually, the term refers to the recorded value of an asset
that has lost its value in the operating activities of a business. Examples
are the costs of products in inventory that cannot be sold and fixed
assets that are no longer usable. The book value of these assets should
be written off to expense. These costs should be disregarded in making
decisions about what to do with the assets (except that the income tax
effects of disposing of the assets should be taken into account).
times interest earned
A ratio that tests the ability of a business to make
interest payments on its debt, which is calculated by dividing annual
earnings before interest and income tax by the interest expense for the
year. There is no particular rule for this ratio, such as 3 or 4 times, but
obviously the ratio should be higher than 1.
unit margin
The profit per unit sold of a product after deducting product
cost and variable expenses of selling the product from the sales price of
the product. Unit margin equals profit before fixed operating expenses
are considered and before interest and income tax are deducted. Unit
margin is one of the key variables in a profit model for decision-making
analysis.
tax exemption
a tax treatment where income is never subject to income taxation
Net income
The excess of revenues over expenses, including the impact of income taxes.
Disposable Income
income less income tax.
Current Tax Payment Act of 1943
A federal Act requiring employers to withhold income taxes from employee pay.
Section 83(b) Election
The decision by an employee to recognize taxable income
on the purchase price of an incentive stock option within 30 days following
the date when an option is exercised and withhold taxes at the ordinary
income tax rate at that time.
Adjusted Cash Flow Provided by Continuing Operations
Cash flow provided by operating
activities adjusted to provide a more recurring, sustainable measure. Adjustments to reported cash
provided by operating activities are made to remove such nonrecurring cash items as: the operating
component of discontinued operations, income taxes on items classified as investing or financing activities, income tax benefits from nonqualified employee stock options, the cash effects of purchases and sales of trading securities for nonfinancial firms, capitalized expenditures, and other nonrecurring cash inflows and outflows.
Statutory Tax Rate
The income tax rate that is stated in income tax law. It is applied to taxable
income reported in income tax returns. The U.S. Federal statutory corporate income tax rate
starts out at 15% for taxable income up to $50,000 and rises quickly to 35%.
Beneficiary
This is the person who benefits from the terms of a trust, a will, an RRSP, a RRIF, a LIF, an annuity or a life insurance policy. In relation to RRSP's, RRIF's, LIF's, Annuities and of course life insurance, if the beneficiary is a spouse, parent, offspring or grand-child, they are considered to be a preferred beneficiary. If the insured has named a preferred beneficiary, the death benefit is invariably protected from creditors. There have been some court challenges of this right of protection but so far they have been unsuccessful. See "Creditor Protection" below. A beneficiary under the age of 18 must be represented by an individual guardian over the age of 18 or a public official who represents minors generally. A policy owner may, in the designation of a beneficiary, appoint someone to act as trustee for a minor. Death benefits are not subject to income taxes. If you make your beneficiary your estate, the death benefit will be included in your assets for probate. Probate filing fees are currently $14 per thousand of estate value in British Columbia and $15 per thousand of estate value in Ontario.
Another way to avoid probate fees or creditor claims against life insurance proceeds is for the insured person to designate and register with his/her insurance company's head office an irrevocable beneficiary. By making such a designation, the insured gives up the right to make any changes to his/her policy without the consent of the irrevocable beneficiary. Because of the seriousness of the implications, an irrevocable designation should only be made for good reason and where the insured fully understands the consequences.
NoteA successful challenge of the rules relating to beneficiaries was concluded in an Ontario court in 1996. The Insurance Act says its provisions relating to beneficiaries are made "notwithstanding the Succession Law Reform Act." There are two relevent provisions of the Succession Law Reform Act. One section of the act gives a judge the power to make any order concerning an estate if the deceased person has failed to provide for a dependant. Another section says money from a life insurance policy can be considered part of the estate if an order is made to support a dependant. In the case in question, the deceased had attempted to deceive his lawful dependents by making his common-law-spouse the beneficiary of an insurance policy which by court order was supposed to name his ex-spouse and children as beneficiaries.
Endowment
Life insurance payable to the policyholder, if living on the maturity date stated in the policy, or to a beneficiary if the insured dies before that date. For example, some Term to age 100 policies offer the option of taking the face amount of the policy as a cash payout at age 100 if the policyholder is still alive and paying all required income taxes on the amount received or leaving the policy to pay out upon death whereupon the payout is tax free.
Registered Pension Plan
Commonly referred to as an RPP this is a tax sheltered employee group plan approved by Federal and Provincial governments allowing employees to have deductions made directly from their wages by their employer with a resulting reduction of income taxes at source. These plans are easy to implement but difficult to dissolve should the group have a change of heart. Employer contributions are usually a percentage of the employee's salary, typically from 3% to 5%, with a maximum of the lessor of 20% or $3,500 per annum. The employee has the same right of contribution. Vesting is generally set at 2 years, which means that the employee has right of ownership of both his/her and his/her employers contributions to the plan after 2 years. It also means that all contributions are locked in after 2 years and cannot be cashed in for use by the employee in a low income year. Should the employee change jobs, these funds can only be transferred to the RPP of a new employer or the funds can be transferred to an individual RRSP (or any number of RRSPs) but in either scenario, the funds are locked in and cannot be accessed until at least age 60. The only choices available to access locked in RPP funds after age 60 are the conversion to a Life income Fund or a Unisex Annuity.
To further define an RPP, Registered Pension Plans take two forms; Defined Benefit or Defined Contribution (also known as money purchase plans). The Defined Benefit plan establishes the amount of money in advance that is to be paid out at retirement based usually on number of years of employee service and various formulae involving percentages of average employee earnings. The Defined Benefit plan is subject to constant government scrutiny to make certain that sufficient contributions are being made to provide for the predetermined pension payout. On the other hand, the Defined Contribution plan is considerably easier to manage. The employer simply determines the percentage to be contributed within the prescribed limits. Whatever amount has grown in the employee's reserve by retirement determines how much the pension payout will be by virtue of the amount of LIF or Annuity payout it will purchase.
The most simple group RRSP plan is a group billed RRSP. This means that each employee has his own RRSP plan and the employer deducts the contributions directly from the employee's wages and sends them directly to the RRSP plan administrator. Regular RRSP rules apply in that maximum contribution in the current year is the lessor of 18% or $13,500. Generally, to encourage this kind of plan, the employer also agrees to make a regular contribution to the employee's plans, knowing full well that any contributions made immediately belong to the employee. Should the employee change jobs, he/she can take their plan with them and continue making contributions or cash it in and pay tax in the year in which the money is taken into income.
Capital Cost Allowance (CCA)
The annual depreciation expense allowed by the Canadian income tax Act.
Earnings
In general, refers to a company's total sales less cost of sales and operating expenses, including interest and income tax.
annual return
The fund return, for any 12-month period, including changes in unit value and the reinvestment of distributions, but not taking into account sales, redemption, distribution or other optional charges or income taxes payable by any unitholder that would reduce returns.
After-tax profit margin
The ratio of net income to net sales.
After-tax real rate of return
Money after-tax rate of return minus the inflation rate.
Asymmetric taxes
A situation wherein participants in a transaction have different net tax rates.
Average tax rate
taxes as a fraction of income; total taxes divided by total taxable income.
Before-tax profit margin
The ratio of net income before taxes to net sales.
Break-even tax rate
The tax rate at which a party to a prospective transaction is indifferent between entering
into and not entering into the transaction.
Cash flow after interest and taxes
Net income plus depreciation.
Corporate tax view
The argument that double (corporate and individual) taxation of equity returns makes
debt a cheaper financing method.
Corporate taxable equivalent
Rate of return required on a par bond to produce the same after-tax yield to
maturity that the premium or discount bond quoted would.
Deferred taxes
A non-cash expense that provides a source of free cash flow. Amount allocated during the
period to cover tax liabilities that have not yet been paid.
Depreciation tax shield
The value of the tax write-off on depreciation of plant and equipment.
Double-tax agreement
Agreement between two countries that taxes paid abroad can be offset against
domestic taxes levied on foreign dividends.
Economic income
Cash flow plus change in present value.
Equivalent taxable yield
The yield that must be offered on a taxable bond issue to give the same after-tax
yield as a tax-exempt issue.
Fixed-income equivalent
Also called a busted convertible, a convertible security that is trading like a straight
security because the optioned common stock is trading low.
Fixed-income instruments
Assets that pay a fixed-dollar amount, such as bonds and preferred stock.
Fixed-income market
The market for trading bonds and preferred stock.
Imputation tax system
Arrangement by which investors who receive a dividend also receive a tax credit for
corporate taxes that the firm has paid.
Income beneficiary
One who receives income from a trust.
Income bond
A bond on which the payment of interest is contingent on sufficient earnings. These bonds are
commonly used during the reorganization of a failed or failing business.
Income fund
A mutual fund providing for liberal current income from investments.
Income statement (statement of operations)
A statement showing the revenues, expenses, and income (the
difference between revenues and expenses) of a corporation over some period of time.
Income stock
Common stock with a high dividend yield and few profitable investment opportunities.
Interest equalization tax
tax on foreign investment by residents of the U.S. which was abolished in 1974.
Investment income
The revenue from a portfolio of invested assets.
Investment management Also called portfolio management and money management, the process of
managing money.
Investment tax credit
Proportion of new capital investment that can be used to reduce a company's tax bill
(abolished in 1986).
Limited-tax general obligation bond
A general obligation bond that is limited as to revenue sources.
Marginal tax rate
The tax rate that would have to be paid on any additional dollars of taxable income earned.
Monthly income preferred security (MIP)
Preferred stock issued by a subsidiary located in a tax haven.
The subsidiary relends the money to the parent.
Net income
The company's total earnings, reflecting revenues adjusted for costs of doing business,
depreciation, interest, taxes and other expenses.
Personal tax view (of capital structure)
The argument that the difference in personal tax rates between
income from debt and income from equity eliminates the disadvantage from the double taxation (corporate
and personal) of income from equity.
Progressive tax system
A tax system wherein the average tax rate increases for some increases in income but
never decreases with an increase in income.
Short-term tax exempts
Short-term securities issued by states, municipalities, local housing agencies, and
urban renewal agencies.
Split-rate tax system
A tax system that taxes retained earnings at a higher rate than earnings that are
distributed as dividends.
Spread income
Also called margin income, the difference between income and cost. For a depository
institution, the difference between the assets it invests in (loans and securities) and the cost of its funds
(deposits and other sources).
TANs (tax anticipation notes)
tax anticipation notes issued by states or municipalities to finance current
operations in anticipation of future tax receipts.
Tax books
Set of books kept by a firm's management for the IRS that follows IRS rules. The stockholder's
books follow Financial Accounting Standards Board rules.
Tax clawback agreement
An agreement to contribute as equity to a project the value of all previously
realized project-related tax benefits not already clawed back to the extent required to cover any cash
deficiency of the project.
Tax differential view ( of dividend policy)
The view that shareholders prefer capital gains over dividends,
and hence low payout ratios, because capital gains are effectively taxed at lower rates than dividends.
Tax free acquisition
A merger or consolidation in which 1) the acquirer's tax basis in each asset whose
ownership is transferred in the transaction is generally the same as the acquiree's, and 2) each seller who
receives only stock does not have to pay any tax on the gain he realizes until the shares are sold.
Tax haven
A nation with a moderate level of taxation and/or liberal tax incentives for undertaking specific
activities such as exporting or investing.
Tax Reform Act of 1986
A 1986 law involving a major overhaul of the U.S. tax code.
Tax swap
Swapping two similar bonds to receive a tax benefit.
Tax deferral option
The feature of the U.S. Internal Revenue Code that the capital gains tax on an asset is
payable only when the gain is realized by selling the asset.
Tax-deferred retirement plans
Employer-sponsored and other plans that allow contributions and earnings to
be made and accumulate tax-free until they are paid out as benefits.
Tax-timing option
The option to sell an asset and claim a loss for tax purposes or not to sell the asset and
defer the capital gains tax.
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