Modern income tax laws also promote activities that help the government to achieve its social objectives. Income tax provisions such as those allowing deductions on charitable contributions to charitable organization are providing services such as education or healthcare to the lower income or unemployed, therefore serving the public good and taking over certain tasks from the government. In addition to encourage socially desirable practices, modern income tax law attempts to discourage the non-desirable ones such us deduction of penalties or bribes.
Modern income taxes with other tax laws are used to motivate business to conduct certain activities and restrain from others at the same time. An example, the tax breaks for environmental friendly practices, which coupled with excise taxes on oil products can encourage companies and the public to use “green” energy.
Comparison between generally accepted accounting principles and tax accounting
Generally accepted accounting principles (“GAAP”) and tax accounting rules can be differentiate based on their:
- Primary objectives
- Development and source
- Basic principles used to record transactions
GAAP is a set of accounting standards private or public companies use for financial statement preparation purposes. The principal purpose of these guidelines serves as single standard for companies presenting their financial positions and results of their operations. Consistent accounting practices will promote financial statements which are consistent, relevant and reliable, which in turn, provide the users of the financial statements with increased level of confidence in the integrity and quality of the information.
Since GAAP primarily serves the interest of the private sector the government did not codify the accounting guidelines rather let the accounting profession develop them. As several organizations developed standards, interpretations and technical bulletins a need for a clear hierarchy is emerged. The foundation of the GAAP hierarchy built on three pillars. The most prominent sources of GAAP are the statements and interpretations issued by Financial Accounting Standards Board (“FASB”), opinions issued by the Accounting Principles Board (“APB”) and research bulletins issued by the American Institute of Certified Public Accountants (“AICPA”). In addition, there are several, less prominent source of accounting rules.
Several sources of GAAP create a quilt work of standards, interpretations and rules. The accounting principles are fundamental to ensure basic consistency and quality of financial reporting. From the four key principles the revenue recognition principle and the matching principle serve as the basis of the accrual accounting concept.
The revenue recognition principle in GAAP requires revenue to be recognized when they are 1) realized or realizable and 2) earned that is services performed or products delivered irrespective of when the cash collected. The matching principle in GAAP further requires expenses to be recognized in the same period as the corresponding revenue. Expenses are recognized as they incurred as compared to cash accounting when they recognized when paid.
Tax accounting is a completely different set of accounting rules from GAAP with the primary purpose to set the taxable income of taxpayers. It serves the interest of federal and state governments. Tax accounting rules are governed by the applicable income tax law. . For tax purposes to determine the taxpayer’s taxable income the following accounting methods can be used: cash method, the accrual method or a hybrid of the previous two. The determination which of the three methods may be used by a taxpayer depends on the activities of the taxpayer. An example is using cash basis accounting by investment advisers which main source of revenue is the management fee and inventory does not contribute to their income.
As noted, the objectives of GAAP and tax accounting are different and it results in differences in the applied accounting rules. GAAP follows primarily accrual accounting where as tax accounting allows for cash based accounting or a hybrid of accrual and cash based accounting. This may result in differences in recording and reporting transactions. The differences are either temporary or permanent. APB Opinion No. 11, Accounting for Income Taxes, defines these differences and provides guidelines to distinguish these differences.
Permanent differences, as defined under APB Opinion No. 11, are differences between taxable income and pretax accounting income arising from transactions that are not considered taxable income or are not tax deductible. The treatment of these transactions for financial reporting purposes and for determination of taxable income will always differ, the differences are permanent. An example for transaction, which is not considered taxable income, is interest earned on municipal bonds are reported in GAAP financial statements as financial income, but excluded from taxable income. Another example for non tax deductible transactions are fines or penalties, which are recorded as expense but non deductable for the purpose of determining the taxable income.
APB Opinion No. 11, Accounting for Income Taxes, used the term timing differences for temporary differences and defined them as differences between the period in which transactions affect taxable income and the periods in which they enter into the determination of pretax financial income. An example is the difference arises from allowing accelerated depreciation of fixed assets for determination of taxable income and straight line depreciation for GAAP financial statement reporting purposes. The difference between the reduced balance method and straight line method results greater recognizable depreciation in the tax return for each period in the early stage of the fixed asset life, but this timing difference reverses in subsequent periods.
A single, comprehensive set of accounting standards would remove these permanent and temporary differences; on the other hand, it could not serve two distinct, but equally important objectives.
Differences between tax avoidance and tax evasion
Both tax avoidance and tax evasion aim to minimize a person’s or entity’s tax liability, The difference is how the person plans to minimize his tax and the legitimacy of his approach under applicable tax laws.
Tax avoidance is application of tax strategies to minimize tax liability by maximizing all legally permissible exemptions and deductions. Tax avoidance can be as simple as filing joint returns by married couples instead of separate tax returns, but often requires more careful tax planning. For more complex tax planning tax advisors and often accountants, financial planning consultants and attorneys are engaged. The tax planning involves various tax planning schemes such as establishing residency in other tax jurisdiction, use allowed tax shelters, change accounting methods or simply defer income. An example is U.S. tax exempt investors can avoid Unrelated Business Taxable Income by investing via offshore blocker corporations. Another example is structuring hedge funds as partnerships and utilizing performance allocation (carried interest) structure to compensate the general partners to allow the limited partners retain the characteristics of the funds income, therefore pay tax at preferential rate after long term capital gains.
Tax evasion is intentional application of unlawful means to minimize or completely avoid tax liabilities. Tax evasion involves misrepresenting facts and circumstances, intentionally omitting information and misleading tax authorities. Tax evasion is considered fraudulent activity and as such it is a crime. Tax payers should consult with subject matter experts in respect of complex transactions to avoid committing tax evasion.
Future trends
Recent events prove that the evolution of tax laws has not stopped. On May 11, 2008 Department of the Treasury has released its This publication is also known as the .
The Obama Administration’s proposals on tax reform are attracting lots of attention. Tax consultants are working with the broader business community to interpret the potential implication of these new proposals. The plan promotes small businesses and research activity to stimulate the economy. In addition, tax cuts provided to the middle class families will revitalize the consumption fueled economy. The Obama Administration, on the other hand, attempts to close down tax loopholes deemed unfair such as the check the box election or oil company tax breaks.
Limitations, Conclusions and Recommendations
The paper attempted to provide a brief overview on the principal objectives of current U.S. income tax statutes, comparison between GAAP and income tax accounting identifying the differences and the difference between legitimacy of tax avoidance and tax evasion. The modern income tax law’s impact on the entire society is significant. As the current events show the income tax laws are constantly evolving to address new economic and social challenges and the evolution of the tax statute and practice will continue to add to the complexity. Constant study, self education and research are critical to keep the knowledge up to date as the considerations discussed above will be impacted by the recent changes.
References
Thomas R. Pope, Kenneth E. Anderson, and John L. Kramer. Prentice Hall’s Federal Taxation 2008: Individuals, Twenty-First Edition, Prentice Hall.
Ephraim Smith, Philip J. Harmelink, and James R. Hasselback. CCH Federal Taxation – Comprehensive Topics, CCH Incorporated.
Tax avoidance vs. tax evasion. (1999, February 28). Austin American Statesman,p. K2. Retrieved May 15, 2009, from Business Dateline database. (Document ID: 39351680).
Avoidance and evasion are birds of different hues: K. Ramesh on the perpetual debate over what is permissible as tax avoidance. (2003, December 27). Businessline, 1.
Statement of Leon M. Metzger, Former Vice Chairman and Chief Administration Officer of Paloma Partners Management Company, Testimony Before the Full Committee
of the House Committee on Ways and Means
Emory University, Gouzieta Business School, Accounting – The House of GAAP
Accounting Principles Board Opinion No. 11, Accounting for Income Taxes
Planned Giving Design Center, LLC, Treasury Releases Obama Administration Budget Proposals Greenbook
http://www.pgdc.com/pgdc/treasury-releases-obama-administration-budget-proposals-greenbook
