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    Average vs Marginal Tax, LLCs and GAAP

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    Question 1

    a) Carmen has computed that her average tax rate is 16% and her marginal tax rate is 25% for the current year. She is considering whether to make a charitable contribution to her church before the end of the tax year. Which tax rate is of greater significance in measuring the tax effect for her decision? Explain.

    b) Limited liability companies (LLCs) are very popular today as a form of organization. Assume a client asks you to explain what this type of organization is all about. Prepare a brief description of the federal income tax aspects of LLCs.

    Question 2

    The auditor's report states in part, "...in conformity with generally accepted accounting principles".
    a) Explain the meaning of the term "accounting principles" as used in the audit report.
    b) How is it determined if an accounting principle is "generally accepted". Discuss the sources of evidence for determining whether an accounting principle has substantial authoritative support. Do not merely list the titles of publications.

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    Solution Preview

    Question 1

    In part A of the first question given you have been ask to explain which tax rate is of greater significance in measuring the tax effect of Carmen's decision. In order to answer this question, the first thing you may want to note is the definitions of marginal tax rate and average tax rate. After which, you may look at how either rate affects how an individual tax liability is calculated, especially as it relates to charitable contributions (which for taxation purposes are considered as tax deductions which can be subtracted from taxable income before calculating an individual's tax liability). Then you can tell which is of more significant to Carmen's decision.

    The marginal tax rate in any country may be defined as, "the tax you pay on your last dollar of income; and more importantly for tax planning, what you'll likely pay on your next dollar earned." Put simply, with marginal tax rates, as income rise, so does the tax rate. In the United States and Canada, tax brackets are used and these define the rates and income levels at which individuals should be taxed. For example, you may find that for an individual who earns $0 to $10,000.00, a Marginal Tax Rate of 20% will apply, whereas for an individual who earns $10,001.00 to $20,000.00 a marginal tax rate of 25% will apply. Hence, the more you earn the more taxes you will pay. Marginal tax rate is usually calculated as follows:

    Marginal Tax Rate = Change in Tax Liability / Change in Taxable Income

    Marginal tax rate should not be confused though with average tax rate - which is simply the amount of tax you pay divided by your income. It may also be defined as the total amount of income tax a person has paid as a proportion of their total income. Average tax rate is calculated by dividing total tax liability by taxable income. For example, if an individual pays $10,000 in taxes on an income of $100,000, this will result in an average tax rate of $10,000/$100,000, or 10%.

    Having looked at the definitions for each, you now need to understand how either rate affects how an individual's tax liability is calculated. To help you with this you may note the following excerpt:

    "Everyone wants to find ways to reduce their Federal tax liability. Some people will hire tax professionals and others will spend endless numbers of hours on-line, ...

    Solution Summary

    This solution provides responses to a host of questions. The first part of the response gives an overview of what is marginal tax rate and what is the average tax rate; then it tells which tax rate is of greater significance in measuring the tax effect on a person giving charitable contributions to a church and why. It also describes limited liability companies and the income tax aspect of such companies. The second part of the response explains the meaning of "accounting principles and gives information as to how it is determined as to whether or not an accounting principle has substantial authoritative support. Note, the solution is adequately referenced.