Tag Archives | capital gains

Passive Income

Passive Income Definition 

Tax law distinguishes between active income and passive income. Returns generated from investments or business activities that require the continued effort of the taxpayer are considered active income. Consider returns coming from investments or business activities that require little or no participation from the taxpayer passive income. Another type of income is portfolio income, which includes returns from investments. Some examples include both dividends and capital gains.

The key distinction is that passive losses cannot be deducted from active or portfolio income. Furthermore, passive losses can only be deducted from income that is passive. If passive losses are incurred when the taxpayer has no offsetting passive income, then these losses can be carried forward to a year when the taxpayer does have offsetting the income that is passive.

Examples

Examples include the following:

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Passive Income

See Also:
Economic Income
Remuneration
Pension Plans
Deferred Income Tax
Prepaid Income Tax

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Equity Interest Definition

See Also:
Brand Equity
Return on Common Equity (ROCE)
Return on Equity Analysis
Carried Interests

Equity Interest Definition

Equity interest, defined as the amount of equity a single person holds in a business, is a common concept to the small business world. For example, if an angel investor receives 25% ownership of a company, the investor has a 25% equity interest in that business. Equity interest accounting is simple: equity is worth nothing until it results in cash flows, either through disbursement of dividends or the sale of assets. At this point standard capital gains tax applies.

Equity Interest Explanation

Equity interest is the level of interest an owner has in the success of a company. It is also a basic business concept. The equity interest rate could be seen as the level of motivation a single owner has towards the outcome of the project. For example, a founder with 90% ownership will work harder for a successful outcome than a founder with 1% ownership. Due to the fact that owners have a difficult time leading a business to growth, their ownership in the business is an obvious factor of motivation while working.

To mitigate the risk of business a financial derivative known as an equity interest rate swap has been created. This is an agreement where future success of a business, measured in cash flows, is agreed to be shared between two businesses. If one business sees success, it pays a portion of this success to the other. In the event that the other business sees success, the other business would then pay the first company a portion of their cash flows. An equity interest rate correlation between the cash flows of the two businesses assures that none sees failure outright.

Equity Interest Example

Frank is an angel investor. He has worked hard to build and sell his first company. Since he has already achieved that, he now turns his focus on investing in other budding entrepreneurs. Frank loves to see businesses grow with the owners.

Frank is invested in multiple businesses. One, a green products manufacturer, has received $1,000,000 from Frank. For this he received 40% ownership. Another, a Web 2.0 company, has received $1,500,000 from Frank. In this business, Frank owns 25%. Yet another, a simple e-commerce store, has received only $750,000 from Frank. Frank owns 15% of this business.

The total value of Frank’s equity interest is $3,250,000. Phrased in terms of a percentage, Frank’s equity interest in all of the businesses is a combined 80%. Though Frank does not own a majority percentage of these businesses he has 80% ownership as a total of 3 businesses.

Frank knows that he, in the event of a disagreement, will not be able to argue control of any business that he does not have approximately 30% of ownership for. This is due to the fact that courts tend to rule in the favor of the majority owner. Unless they appear to have been neglecting the business, that is the case. Frank can accept this for 2 reasons. He trusts the majority shareholders and sees this as just a risk of doing business. If Frank could not accept this, he would be wise to only invest in a business with the end result of 30% or more of total shares of stock.

equity interest definition

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Dividends

See Also:
Dividend Yield
Capital Impairment Rule
Dividend Payout Ratio
Financial Ratios

Dividends Explained

Dividends are corporate profits distributed to shareholders. When a company makes a profit, the board of directors can decide whether to reinvest the profits in the company or to pay out a portion of the profits to shareholders as a dividend on shares. The board of directors determines the amount of the dividend on stocks, as well as the dividend payout dates.

Stockholders typically receive a certain amount of dividends per share for each share of stock they own. Tax rates on dividends, historically, have often differed from tax rates on capital gains from investments. If the dividend tax rate exceeds the capital gains tax rate, it may benefit the shareholders to avoid paying a dividend, and instead to carry out a stock repurchase.

Dividend Yield Definition

We define dividend yield as the dividend amount expressed as a percent of the current stock price. For example, if a stock will pay a $1 dividend at the end of this year, and today the stock price is $10, then that stock’s dividend yield is 10%.

10% = 1/10

Dividend yield equation

Dividend Yield = D1 / P0

D1 = Annual dividend per share amount (the dividend per share at time period one)
P0 = Current stock price (the price at time period zero)

Dividend Date Definitions

The process of distributing dividends to shareholders follows a set schedule. The board of directors announces the dividend on the dividend declaration date. Once the dividend has been declared, the company is legally obligated to pay the stated dividend to shareholders.

The next significant date is the ex dividend date. Investors who purchase the stock on or after the ex-dividend date will not receive the forthcoming dividend. Prior to the ex dividend date, the stock is considered cum dividend, or with dividend. This means that anyone buying the stock during this period will receive the forthcoming dividend.

The ex dividend day precedes the dividend record date, or the dividend date of record, by three days. Shareholders documented as owning the stock on the dividend record date will receive the dividend.

Last is the dividend payable date, or the dividend distribution date. This is the actual date on which the company pays out the dividends to its shareholders. The dividend payable date is typically about a month after the dividend date of record.

Dividend Payout Dates

• Dividend Declaration Date (stock is trading cum dividend)
• Ex-Dividend Date
• Dividend Record Date (three days after the ex-dividend date)
Payable Date for Dividend (one month after the dividend record date)

Dividend Signaling

Dividend signaling hypothesis refers to the idea that changes in a company’s dividend policy reflect management’s perceptions of the company’s future earnings outlook. Basically, it states that a change in a company’s dividend policy can be interpreted as a signal regarding future earnings. The problem is that a company can interpret the signals as contradictory messages.

Dividend Example

For example, if a company announces that it will increase its dividend yield, investors may interpret this as a positive signal. It could mean the company anticipates a profitable future and is allowing shareholders to benefit from these profits.

On the other hand, one can interpret an increase in the dividend payout rate as a negative signal. It could mean that the company has no good investment opportunities, and it has nothing better to do with its cash than to pay it out to shareholders as dividends.

Similarly, if a company announces that it will decrease its dividend payout rate, this can be interpreted as either a positive or negative signal. It could be interpreted as a positive signal because it could mean that the company has so many good investment opportunities that it needs all available cash for positive-NPV investments and projects. This could mean the company is growing and expanding.

On the other hand, if a company cuts its dividend rate, that could mean that the company anticipates lower earnings or even losses. This, of course, could be a bad sign. So as you can see, the logic behind the dividend signaling hypothesis makes sense, but because it can be interpreted in contradictory ways, the reading of the signals is not necessarily very meaningful.

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dividends

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Direct Tax Definition

See Also:
Indirect Labor
Direct Labor
Direct Cost vs. Indirect Cost
Unsecured Credit
Flat Tax Rates
Tax Abatement

Direct Tax Definition

Direct tax, defined as a tax directly on the amount of a taxable item, is the current tax method of the U.S.A. Currently in the U.S., this includes taxes wages, property, capital gains, or directly to the amount of some other valuable item. In some situations, direct tax credits are also given to those who need or would benefit from decreased tax income.

Direct Tax Explanation

Direct tax, explained as a tax on valuables, differs greatly from indirect tax. Where indirect tax taxes a factor which does not directly increase the wealth of the individual, like consumption, direct tax places a tax on the factors that increase wealth in a person’s life. This is the difference of direct tax vs indirect tax.

Direct Tax Advantages

Direct tax advantages are numerous. With a direct tax, the government closely knows the amount to be taxed and the amount applied. Direct tax cuts out a liaison, preventing corruption of lower level tax officials. Additionally, many argue that direct tax apportionment creates a civic sense; that people think in terms of the community rather than themselves.

Direct Tax Disadvantages

Direct tax disadvantages also exist. Under direct taxation, people are taxed based on their assumed ability to pay taxes. This means that the certain members of the population receive a disproportionately larger amount of taxation that others. Additionally, direct tax allows the tax rate of individuals to be decided by government rather than their actions. These two factors relate to the common opinion that direct tax can be demotivational. With an indirect tax, like a flat consumption tax, people are taxed based on their amount of consumption. With a direct tax, people are taxed based on the amount of wealth they build. Some argue that this causes the benefits of productivity to be decreased, thus providing a disincentive to produce as much as possible.

Direct Tax Example

For example, Nancy is a financial adviser. She helps others make investments which improve their wealth. Thus, Nancy believes she is helping others to live the best life they can.

Nancy deals with direct tax code often. First, her personal wages fall under direct taxation. Next, the property her clients invest in experiences a direct tax in the form of property tax. Additionally, the financial instruments, which hold the wealth of her clients, fall under direct taxation. When they receive capital gains, they pay a certain portion to the government as tax.

Nancy sometimes questions the government for the method of direct taxation. Despite this, she knows that direct taxation is here to stay. She also knows that the government engages in projects which are important to the people. Though she does not agree with all of the tax laws, she accepts it as a part of her life and still seeks to be the best financial adviser she can.

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Basis Definition

See Also:
Basis Points
Make or Buy Business Decision
Collateralized Debt Obligations
Carried Interests
Letter of Credit

Basis Definition

In accounting, the basis definition is the value of an asset for tax purposes. The basis of an asset is the cost of the asset reported to the Internal Revenue Service (IRS). It includes the original purchase price of the asset plus any acquisition expenses. The basis may increase by the value of any subsequent capital improvement in the asset. Or itt may decrease due to depreciation. Also, refer to basis as cost basis or tax basis.

The basis is also the amount used to calculate gains or losses if and when the asset is sold or scrapped.

Basis Examples

For example, if shares of common stock are purchased for $1,000 and sold three years later for $1,500, then the basis is still $1,000. As a result, the taxpayer would recordcapital gain of $500.

Likewise, if you purchase equipment for $1,000 with installation and shipping fees of $500, then the basis for that asset would be $1,500. If the equipment is depreciated down to $500 and then sell it for $300, then the taxpayer would record a loss of $200.

basis definition

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Capital Gains

See Also:
Tax Brackets
Marginal Tax Rate
Deferred Income Tax
Flat Tax Rates
Company Valuation

Capital Gains Definition

The capital gains definition is the proceeds from the sale of an asset. These gains can be realized from the sale of stocks, bonds, real estate, equipment, intangible assets, or other property. When the asset or property is sold, the capital gain is calculated by subtracting the asset’s book value from its selling price. If the selling price is higher than the book value, it is a capital gain.

It can also refer to an increase in the value of an asset. If the value of an asset increases while held, the increase in value above the asset’s purchase price is considered a capital gain. This gain is considered unrealized until the asset is sold.


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Capital Gains Equation

Capital Gains = Selling Price – Book Value

Losses

A capital loss is the loss incurred on the sale of an asset when the book value exceeds the selling price. Capital losses can occur from the sale of stocks, bonds, real estate, equipment, intangible assets, or other property. When the asset or property is sold, the capital loss is calculated by subtracting the asset’s book value from its selling price. If the book value is higher than the selling price, the company incurs a capital loss.

A capital loss can also refer to a decrease in the value of an asset. If the value of an asset decreases while held, the decrease in value below the asset’s purchase price is considered a capital loss. This loss is considered unrealized until the asset is sold.

Equation

Capital Loss = Selling Price – Book Value

Tax Rates

These gains are taxed according to a rate, called the capital gains tax rate, which may be different from the tax rate for regular income (depending on tax laws at the time). Long term capital gains are capital gains on assets held for more than one year. Short term capital gains are capital gains on assets held for less than one year.

Presently, in the U.S., long term capital gains tax rates are lower than regular income tax rates for individuals. Short term capital gains tax rates are the same as regular income tax rates for individuals. For companies, long term capital gains tax rates and short term capital gains tax rates are the same as regular income tax rates. In the U.S., the taxpayer may employ techniques to defer or reduce capital gains taxes.

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