Tax Effects of Business Decisions Semester Of Notes
Tax Effects of Business Decisions Semester Of Notes ACCTG 215
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Reviews for Tax Effects of Business Decisions Semester Of Notes
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ACCTG321 Notes 110 Ch3 Subdivided in terms of its uses Income used for current consumption vs income saved for future consumption Income might be classified according to its sources Income derived from the rendering of personal services vs income derived from the ownership of property 302 Uses Consumption vs Savings Tax on income will reduce the future consumption 302b Sources Interest vs Wages Tax only the wages e same result as consumption tax Legal Concept of Income 303 Legal Concept of Income The statutory concept of Income Gross income all income from whatever source derived pg 36 Realization necessary condition for an increase in wealth to constitute income Realization process of converting noncash resources and rights into money and is most precisely used in acctg and financial reporting to refer to sales of assets for cash or claims to cash No realization is necessary for a purely economic concept of income only for acctg and judicial concept 303c A Judicial Concept of Income Courts when an exchange transaction has occurred the item received in the exchange need not necessarily be liquid to cause income to be considered realized Summary of income for tax purposes 1 If a taxpayer has no asset at the beginning of a period but receives one say by finding it realization occurs and the increase in wealth is taxable If the taxpayer receives the asset by exchanging his labor for it realization has occurred and the increase in wealth is taxable 2 If a taxpayer is holding an asset at the beginning of a period and this asset increases in value during the period but is not exchanged no realization occurs and such increase in wealth is not taxable 3 If a taxpayer is holding an asset at the beginning of a period and exchanges this asset during the period such exchange is a realization event Any gain on the exchange is counted as income The taxpayer does not need to receive cash or near cash for the event to be taxable The receipt of any other asset or even release from a liability is sufficient to cause income realization for tax purposes 34 n Kind Income 2 types of unrecognized income 1 n kind income from personal labor 2 n kind income on property used for consumption purposes 304b n kind Income from Property The net rental value on the owner occupied home is not taxable while the interest received on the bonds is taxable The basic inconsistency in tax law arises from the fact that implicit income is excluded not from the allowance of the interest deduction 35 Statutory Exclusions of Income Annuities returns of original investment are not included in gross income cost recovery doctrine recovery of capital doctrine Exclusion ratio Original investment expected return 305b Death benefits Amounts received by a beneficiary under a life insurance contract bc of the death of the insured are generally excluded from the gross income of the beneficiary 305c Interest income Interest received on investments in bonds issued by states political subdivisions of states or US possessions are exemption of tax However interest on US government obligations is still taxable 305d Employee Fringe Benefits Categories of excludable employee benefits no additional cost services qualified employee discounts working condition fringes de minimis fringes qualified transportation fringes and qualified moving expense reimbursements No Additional Cost services ex free standby flights offered to airline employees 1 Employer must not incur any significant additional cost in providing the service to the employee 2 The service must be one that is offered to sale to customers in the same line of business in which the employee works 3 Service must be offered to employees on a nondiscriminatory basis Qualified employee discounts 1 Discounts must be available to employees on a nondiscriminatory basis 2 Discounts must relate to qualified property or services offered for sale to customers in the same line of business in which the employee works 3 Discount can be excluded only up to a limit a Employer39s gross profit percentage for property b 20 of the price offered to customers for service Working condition fringe benefits possible even when made available to employees on a discriminatory basis De minimis Fringe Benefits if the value of any property or service provided to employees is so minimal that acctg for it would be administratively impracticable it is excluded from the employee39s gross income Subsidized employee dining room also de minimis fringe benefit if 1 Located on or near the employer s business premises and 2 The revenue from facility at least equals its direct operating costs BUT has to be nondiscrimination rules applied Qualified transportation fringes transportation in a van that 1 Has a seating capacity of 8 adults driver and 2 Is used at least 80 for the purpose of transporting employees between their home and places of work Transit pass provided by the employer and free parking can be excluded for amts up to 230 month Qualified moving expense reimbursements if paid by the employee Employer contributions to group termlife insurance plans accident and health insurance programs educational assistance plans certain dependent care assistance payments and even meals and lodging when provided under certain conditions are excludable Employer provided group term life insurance up to 50000 if whole life rather than group term zb entire amt of employer paid premiums for any amt of coverage must be included in the gross income of the employee Group accident and health insurance plans premiums paid by an employer on group accident and health insurance policies are not taxable to the employees nor must the employees include benefits collected under such insurance programs in their gross incomes Employer provided educational assistance up to 5250 Certain Dependent Care Assistance Plans under a written nondiscriminatory plan meeting certain requirements such amts are excluded from the employees gross incomes Limitation of 5000 2500 for a separate return filed by a married individual Employer provided meals and lodging 1 The meals must have been furnished for the convenience of the employer 2 Meals must have been furnished on the employer s business premises Value of employer provided lodging also excluded if in addition to the 2 preceding conditions the employee is required to accept the lodging as a condition of employment Incidental or Indirect benefits provided by Employer 305e Gifts and Inheritances Exempt from the federal income tax Must be genuinely gratuitous donor must receive nothing in terms of moneymoney s worth Contest prizes bonuses for past services found property and scholarships do not qualify as gifts Any income earned on the property after the recipient becomes the owner is taxable to the recipient If gift gt 10000 donor may be liable for a tax levied under the gift tax laws 305f scholarships and fellowships fellowships are now fully taxable See pg 324 305g social security benefits Depends on how much income a taxpayer has Starting point modified adjusted gross income 305h Unemployment Compensation unemployment compensation amounts received are fully taxable 305i property transfers between spouses Property transfers between divorced spouses are to be treated as gifts 36 capital gain income congress repealed the 60 deduction for long term capital gains in the Tax Reform Act of 1986 Currently net capital gains of individuals are subject to tax rates that are below the rates that apply to ordinary income Allowed to deduct capital losses in excess of capital gains to the extent of 3000 in any one yean ACCTG321 Notes 14 Tax Entities and Rates Average tax dividing the total tax liability by the total taxable income Represents the tax rate that would have applied to each SEGMENT of income if each segment had been taxed at the same rate Marginal tax rate rate that would apply to the next dollar of income Entities subject to income taxes individuals estates and corporations Entities not subject to income taxes partnerships and S corporations owners are responsible for paying the tax passthrough entities Trust cross between a taxpaying entity and a passthrough entity if trust retains all its income then the trust is taxed but if it distributes its income to its bene ciaries the bene ciaries are taxed Tax shall be imposed on the taxable income of every individual Tax law does not distinguish between a person and an unincorporated business sole proprietorship Subject to tax on respective income does not mean taxed at the same rate for 2 reasons 1 Tax rates rate generally higher for higher levels of income 2 Even at the same level of income tax rates vary depending on an individual s ling status function of family responsibilities 6 categories of an individual taxpayer s ling status and 4 corresponding tax rate schedules 1 Schedule X Single 2 Schedule YS Married ling separately 3 Schedule YJ Married ling jointly surviving spouse 4 Schedule Z Head of household certain married individuals living apart 203b Estates Individual alive income on hisher property is taxed to that individual Individual dies 39 future income on that property will be taxed to those who inherit the property However it is taxable to the heirs only after they receive the property between this 2 Estates get taxed What about the time lag Estates legal entities that exist for the purpose of managing and distributing the deceased person s property to the heirs 203c Corporations Corporations afforded separate legal existence under the law taxpaying entities separate and apart from their owners Corporate shareholders double taxation Dividend income taxed at special capital gain rates which are lower than the rate on ordinary income corporations are treated as distinct Double taxation can be reduced considerably by retaining current income within the corporation if delayed Can be completely avoided if some way can be found to distribute the earnings of the corporation in such a way that the corporation receives a current deduction Ex Shareholder is also an employee of the corporation could claim deduction for compensation expense avoiding the tax at the corporate level Ex corporation make the distribution to the shareholder in the form of rent or in the form of interest 203d Nontaxpaying Entities Partnerships do not pay federal income taxes All partnership income is taxed currently to the partners without regard to whether the partners withdraw any of that income from the partnership Basis tax term for what accountants call book value S Corporations shareholders must include on their tax returns their share of corporate income without regard to whether cash is withdrawn from the business 203e Trusts Trust legal arrangement of transfer of the property to a trustee in order to have the trustee manage the property for the bene t of the son or daughter Bene ciaries sonsdaughter Pretax income retained by the trust income is taxed to the trust itself Income distributed trust is allowed a deduction in determining its taxable income and the bene ciary must include the receipt of the distribution as taxable income at the individual level Throwback rules to tax bene ciaries in the year they receive distributions of previously taxed trust income but to limit this tax to the amount of previous tax savings that resulted from taxing the trust instead of the bene ciary Throwback rules repealed in 1997 bc income tax rate brackets applying to trusts have become more compressed 4 no necessity of having complex rule 25 Statutory vs Effective Tax Rates Effective tax rate determined by dividing the total tax owed by the taxpayer s economic income Effective tax rates are much less progressive than the stated rates of the of cial rate schedules Property income receives preferential treatment in tax Many ppl might get impression that wealthier ppl pay more tax but wealthy ppl know that effective tax rates are really much less political interests 26 Progressive Taxation Critical point is to distinguish between one s expectation of diminishing marginal utility and its eventual realization indexation income brackets of the various rate schedules would increase according to some measure of general in ation 208 Implications for decision making 2 ways to lower tax 1 Considering which taxpaying entity should recognize an item of income 2 When the income should be recognized Natural resources Acquisition costs exploration costs development cost and restoration costs Acquisition costs amounts paid to aquire the rights to explore for undiscovered natural resources or to extract proven natural resources Exploration costs expenditures such as drilling a well or excavating a mine or any other costs of searching for natural resources Development costs incurred after the resource has been discovered but before production begins tunnels wells and shafts etc Restoration costs to restore land or other property to its original condition after extraction of the natural resource ends ACCTG321 Notes 115 Ch4 General Criteria for Deductions 401 Nature of Deductions8 criteria for the deducibility of expenditures Expenditure must 1 be profit motivated occurring either in a trade or business or other income producing activity 2 be ordinary 3 be necessary 4 not be a capital expenditure 5 be reasonable in amount 6 not be contrary to public policy 7 have a business purpose other than just saving taxes 8 not be directly relate to the production of tax exempt income Exclusion receipts eg interest received on state bonds that are omitted from gross income bc of specific statutory or administrative provisions Deductions expenditures eg payment of ad expenses by a business made by taxpayers and certain statutory amounts dividends received deduction allowed to corporations that are subtracted in determining taxable income 402 statutory authorities In general personal living costs are not deductible EXCEPT alimony casualty losses charitable contributions certain interest paid medical expenses and certain taxes paid other than the federal income tax 403 Judicial Concepts 403a Motive Deductibility is often an all or nothing proposition xw what is the Primary motive Sometimes a single cost is allocated between 2 purposes Example 43 Deductions for meals and entertainment 50 Hobby If a person realizes revenue in excess of expenses on an activity that was entered into for predominately personal reasons the profit is taxable just as it would be taxable on a profit intended venture Deduction of most realized losses only if the taxpayers original motivation for the activity was to seek an economic profit Legal expenses Backward view examine the nature of past events that caused the taxpayer to incur the expense Forward view look at the nature of future events occasioned or avoided by incurring the expense Gilmore decision firmly established the benchmark that the deductibility of legal fees depends on the origin of the litigated claim and not on the potential consequence to the taxpayer39s income status One of the criteria for determining the deductibility of a given expense is whether or not the expense was incurred in a profit intended activity but categorizing activity solely can lead to argument final determination might have to be made by a court 403b Trade or Business Rental Real Estate Exception rental of real estate even if the taxpayer rents out only one piece of real estate is a trade or business regardless of the level of personal effort The personal security investing exception personal security investing is never treated as a trade or business Personal security trading always a T or B The costs of preparation to enter a business personal in nature and therefore nondeductible Taxpayers may elect to amortize business start up costs over a 60 month period if 3 conditions are met 1 cost must related to creating or investigating the creation or purchase of an active trade or business 2 the cost must be one that would have been deductible in the year incurred if it had been incurred in connection with the expansion of an existing trade or business in the same field as that entered into by the taxpayer 3 Trade or business must be commenced before amortization begins 403c Ordinary and Necessary Ordinary 1 Concept of ordinary is held to be a variable affected by time place and circumstance it is not a matter of mere frequency Necessary profit intended in an expected sense not in a realized sense 403d Capital Expenditures Issue is not whether the cost of business or income producing assets will be deductible but when such deductions will be allowed 403e Reasonable in Amount Real purpose of the reasonable amount rule is not to impose wage and price ceilings but to prevent income shifting between related tax payers whose economic interests are essentially iden caL Whether a given amount is reasonable is a question of fact not law IRS can adjust the owners reported shares of income to reflect reasonable amounts of salary if 1 where the low salary is paid by a family partnership to a family member or 2 where the low salary is paid by a family owned S corporation to a family member 403f Public Policy Considerations 1 Deductions not allowed for illegal payments such as bribes and kickbacks 2 fines and other penalties paid to governmental units for law violations Deductions are now allowed for grease payments made to foreign government officials to facilitate routine administrative actions 403g Business Purpose Business purpose doctrine not a matter of statutory law but is a particularly pervasive judicial concept Taxpayer must be able to show that the transaction in question had some business purpose and was not contrived solely for the purpose of generating a tax reduction substance over form doctrine 403h Expenses Related to Tax Exempt Income 3 aspects of section 265 deserve emphasis 1 if the tax exempt income is from investment income only section 212 investment expenses are disallowed 2 If the expenses consist of interest expense on borrowed funds the disallowance of deductions for the interest expense applies only if the taxpayer39s purpose for such borrowing was to generate tax exempt income With regard to interest expense that does NOT relate to the production of tax exempt income the following rules apply a Deductions for personal interest expense are not allowed unless the interest relates to a home mortgage b Deductions for interest payments related to investments other than tax exempt investments can be deducted only to the extent of net taxable investment income c Interest payments that are part of a trade or business are fully deductible Only expenses that related to exempt income are prohibited from deduction Expenses that relate to income that is tax favored but not exempt may be deductible Ex Investment adviser fees on IRA ACCTG321 Notes 15 Ch 7 Deductions for AGI gt Deductions from AGI Adjusted gross income gross income less certain speci ed deductions explicitly naming all the deductions that are deductions for AGI No logical classi cation between d fors and d froms one must simply know which deductions are named in section 62 as deductions for AGI all others are from AGI 703 deductions from adjusted gross income 2 types 1 Itemized deductions 2 Exemptions Itemized deductions Medical expenses Certain taxes paid Certain interest expenses Charitable contributions Casualty or theft losses Miscellaneous itemized deductions Deductions not subject to the 3 reduction rule include deductible medical expenses investment interest expense casualty losses theft losses and gambling losses OU1I bJgt t 703c Exemptions Generally 1 personal exemption allowed 2 personal exemptions in the case of joint return BUT if taxpayer can be claimed as a dependent on someone else s tax return that taxpayer cannot claim a personal exemption for herself Dependent qualifying child or a qualifying relative Child must meet 1 Relationship test be the taxpayer s child or stepchild foster child sibling or stepsibling or a descendant of one of these Residence test child has the same principal residence as the taxpayer for more than 12 a year Age test the child is either under 19 at year end or a full time student under age 24 at year end Support test child did not provide more than 12 of his own support Joint return test Citizenship test quot39gtquot Relative must meet the following 5 tests 1 Gross income test potential dependent must have gross income that is less than the exemption amount for the particular tax year in question 2 Support test over 50 of the potential dependent s support for the year in question must have been provided by the taxpayer However an exception is allowed in situations in which 2 or more taxpayers collectively provide over 50 of another person s support V agreement 3 Relationship test potential dependent must be a member of the taxpayer s household for the entire year or fall within certain family relationships as shown in the diagram Above relationships may exist w respect to either spouse amp relationship once established will not multiple support terminate by divorce or death of a spouse 4 Joint return test the potential dependent if married must not have led a joint return With his spouse for the year in question Exception if separate returns were led and the joint return is being led solely to claim a refund of all taxes Withheld 5 Citizenship or residency test potential dependent must be either a citizen of the US or a resident of the US or Canada or Mexico Alien children adopted by and living With US citizens in a foreign country can qualify under this test 703d The Phaseout Rule for Exemptions Taxpayers Whose adjusted gross income in 2009 exceeds a certain threshold amt must reduce the amount of each exemption claimed 704 Limits on the standard deduction Teenager s standard deduction Would be limited to the greater of 1 The sum of earned income plus 300 up to the statutory amount of the standard deduction or 2 950 Standard deduction disallows it entirely for the following tax payers 1 A married individual ling a separate return Where either spouse itemizes deductions 2 A nonresident alien individual 3 An individual ling a return for a period of less than 12 months bc of a change in his accounting period 4 An estate or trust common trust fund or partnership Marginal tax rate extra tax divided by the extra income 705b Taxes on Children s Income Kiddie tax rules apply if a the child is under age 18 regardless of Whether his earned income equal more than 12 of his support or b the child turns 18 or if a full time students turns 1923 before the end of the applicable year and the child s earned income for the tax year does not exceed 12 of his support 706 Tax Credits The only difference between the gross tax and the regular income tax of an individual is the amount if any of applicable tax credits 709 Implications for Decision Making ACCTG321 Notes 116 Ch5 Tax Accountin g Concepts 5 01 Role of Accounting in Taxation Travel and entertainment expenses can be substantiated by 1Adequate contemporaneous records or 2 Suf cient evidence corroborating a taxpayer s own statement Written or oral statement by the taxpayer containing the speci c information in detail and testimony from a disinterested unrelated party Other issues 1 Timing issues questions concerning when a given taxpayer must recognize taxable income 2 Attribution issues questions concerning which of several taxpayers is deemed to have taxable income 502 Timing of Income and Deductions IRC requires that a taxpayer use the same method of accounting for tax purposes that he uses for nancial accounting purposes as long as that method clearly re ects income 502a The So Called Cash Method of Accounting Exceptions to the Cash Receipt Rule 1 Return of capital doctrine all cash receipts are taxable as income is that receipts that include the return of an assets basis are not taxable Ex sale of securities 2 Borrowing does not produce taxable income to the borrower 3 Income includes not only receipts of cash but also receipts of cash equivalents form of receipt doctrine form of receipt is irrelevant Excepetion AR 4 Sales of a taxpayer s inventory must be accounted for under the accrual method Hybrid method of accounting account for inventories on the accrual method while all other aspects of the business are accounted for under the cash method 5 Notion of cash receipt is interpreted broadly to include amounts that are constructively received Constructive receipt doctrine three steps 1 The payee must have control of the amount in question wout substantial limitations or restrictions and 2 The payor must have credited the account of the payee or set aside funds for the payee s bene t and 3 The payor must have the ability to pay that is funds must be currently available Exceptions to the Cash Disbursement Rule 1 repayments of borrowed amounts are not deductible by the borrower nor taxable to the lender 2 Inventory purchases must be on the accrual method cash paid for inventory is not deductible until the inventory is sold 3 Cash payments for long lived assets are not deductible but must be capitalized and amortized or depreciated over more than one accounting period Cash method is not available to all taxpayers 1 Regular corporations 2 Partnerships with a regular corporation as a partner 3 Tax shelters entities whose principal purpose is tax avoidance or evasion Certain exceptions engaged in farming avg annual gross receipts for the most recent 3 yr period are 5000000 or less personal service corporation corporation that performs services in the elds of health law engineering architecture accounting actuarial science performing arts or consulting 502b The So called Accrual method of Accounting General exception to accrual accounting that requires amounts received in advance to be included as income even though not earned yet Exception to exception advance receipts for services to be rendered before the end of the very next taxable year can be allocated between the 2 years If the services will not be completely rendered only one until the 2nd taxable yr after the end of the year when advance receipts was collected z year deferral will be allowed Other examples of items still eligible for deferred tax purposes are 1 Subscription receipts received in advance may be allocated over the life of the subscription and 2 Dues received in advance can be allocated over the membership period unless the dues are nonrefundable Exceptions to accrual rules for expenses An accrual basis taxpayer is allowed a deduction only when all the events have occurred which determine the fact of the liability and the amount thereof can be determined with reasonable accuracy all events test result cannot take deductions for estimated expenses such as property maintenance and service guarantees estimated refunds and various other accruals that most accountants would regard as expenses related to the production of current revenues Economic performance test otherwise deductible accrued liabilities shall not be deductible any earlier than the time economic performance occurs and economic performance is to be determined under the following principles 1 If a liability of a taxpayer requires payment to another for providing goods or services to the taxpayer EP occurs when those goods or services are provided to the taxpayer 2 If a liability of a taxpayer requires the taxpayer to provide goods or services to another EP occurs as the taxpayer provides the goods or services 3 If a liability of a taxpayer requires the taxpayer to pay another person due to the taxpayer s tort or due to workers compensation laws EP occurs as the payments are made 4 When EP for a particular item occurs after year end but the all events test was met before year end the recurring item exception applies to normal recurring expenses that are treated consistently each year by the taxpayer 502c Other items Affecting the Timing of Income Recognition for Both Cash and Accrual Basis Taxpayers Claim of right doctrine money received not borrowed p GI fact that there was a dispute about the taxpayer s right to the money did not prevent the money from being taxable when received Taxpayer allowed to adjust his tax in the repayment yr to equalize tax cost and tax savings but don t have to taxpayer can bene t if his marginal tax rate is higher for the repayment year Right Doctrine Tax bene t rule recovery must be included in GI only to the extent that its prior deduction produced a tax bene t for the tax payer No tax bene t recovery not taxable Ex When you couldn t deduct tax payments since you used standard deduction 3 points about tax bene t rule 1 In only part of an earlier expense generated a tax bene t a deduction then only that portion of the recovery is included in income 2 Amount of GI from the recovery is based on the amount of the original deduction not on the market value of recovered property at the time of its return to the taxpayer 3 Section 1341 applies only to claim of right restorations Cancellation of Indebtedness whenever the borrower s indebtedness is decreased wout pmt Being made by the borrower the borrower s net worth is increased and as a general rule taxable income is deemed to have been realized by the taxpayer whose debt is reduced or cancelled Ex Repurchase of bonds 520 pmt of income tax liability Cancellation of debt as a gift not taxable must be reflected as reductions in lower depreciation higher gain Income from debt cancellation that is not positive insolvency 0f the basis of the taxpayer s assets Tax shelter losses Active income salary biz income portfolio income dividends interest capital gain and loss passive activity income income from an activity in which the taxpayer does not materially participate Material participation you are involved in operations on a regular continuous and substantial basis 1 The activity is your principal business 2 You are present where the operations are conducted 3 You have knowledge or experience in the business 4 You provide services that are integral to the activity legal tax acting services not Interest in Limited Partnership and rental activity 2 passive Losses from passive activities cannot be used to shelter income from the other 2 categories BUT when the entire interest in the passive activity is sold any accumulated loss can be used to offset any type of income Accrued Liabilities payable to related parties Timing of the accrual basis corporation deduction be matched to the timing of the cash basis taxpayer s recognition of gross income Related parties would include 1 2 members of the same family or 2 An individual and a corporation in which the individual owns more than a 50 interest in the corporation Accounting periods Taxpayer must use the calendar year If adequate books and records are kept taxpayer may elect to use a scal year 53 Attribution of Income and Deductions 503e Personal Service Income Assignment of income doctrine income attributable to one taxpayer cannot be assigned to another taxpayer 503b property income 2 problems gt 1 Distinguishing between property and income and 2 Ascertaining the owner of a given property Property vs Income you can transfer the ownership of the property to another taxpayer but complication arise when the property is created by your own efforts Ascertaining Property Ownership ex land giving land to son but with interest H taxable If it is a complete gift son is taxable 503c Losses Between Related taxpayers Deduction of losses on sales between members of certain groups of related taxpayers prohibited only to losses not to gains No readjustment if the related buyer later resells the property at a loss Check example 530 504 Role of Asset Basis in Tax Accounting Return of original investment no income or return on that investment income Ex liquidation of dividend not taxable Gain from selling taxable Depreciationdeduction of machine tax free 504a Wash Sales Wash sale taxpayer both sells and purchases substantially identical stocks or bonds within 30 days Disallows deductions for losses on wash sales Whenever a realized loss on an asset is to be deferred adjust the basis of the asset upwards Holding period for securities bought in connection with a wash sale includes the period for which the original securities were held A longterm gain or loss results when the holding period is longer than the holding period speci ed in the Code generally 12 months for securities Short term gain or loss results when the holding period is equal or less than this holding period 5 O4b Transfers to Controlled Corporations Realization criteria of the law would result in taxable income being recognized upon a transfer of assets between legally distinct entities even though effective control of the assets remained with the mother is same individual Exception shareholder receive only stock not cash or other property in exchange for property given to the corporation Very complicating P look at example 536 54 Implications for Decision Making Issue of taxation may concern any one of 3 different aspects of taxation 1 Whether a given amount is to be taxed at all 2 When it is to be taxed and 3 To whom it is to be taxed 505a Avoiding Income Recognition Borrowers are taxfavored over lenders during in ationary economic conditions Looka t example 537 Tangible assets more like an income deferment bc of difference in gain when u sell it However when borrowed funds used to nance immediate consumption differences in current income recognition would never be reversed 505b Shifting Income Recognition Trust Gift and leaseback z example 538 505c Delaying Income Recognition Ex borrowing against rather than selling appreciated property and making use of various elections available under the Code for the acceleration of certain deductions 505d Tax Shelter Strategies Tax shelter considered passive now can only offset income from other sources Ch1404 Limits on Passive Activity Losses Taxpayer s income categorized to p 1Active 2 Portfolio and 3 Passive activities Active activities salary and incomeloss from TB in which taxpayer materially participates Portfolio activities activities that produce dividends interest capital gainloss annuities royalties not derived in the ordinary course of TB Passive activities any TB in which the taxpayer does not materially participate Include 1 Ownership of an interest in any limited partnership and 2 The activity of renting out property Passive activity losses PALS can only be used to offset income from other passive activities Suspended losses can be carried forward inde nitely until 1 There is some passive income to offset or 2 Until the activity that generated the suspended loss is completely sold once sold A can use to offset any type of income 1404a Which Taxpayers are affected by Section 469 1 Individuals estates and trusts 2 Personal service corporations PSCs 3 closely held C corporations that are not PSCs but PALs occurring in these C corporations are less restricted than PALs in the other entities Personal service corporation any C corp where a the principal activity is the performance of personal services b such services are substantially performed by owner employees ie employees who own stock and c the owner employees considered together own directly or indirectly more than 10 of the stock PAL cannot be used to offset income produced from personal services portfolio Closely held C corporation C corp other than a PSC in which at any time during the last half of the year more than 50 of the stock is owned directly or indirectly by 5 or fewer individuals PALs could be used to offset active income of corp What is material participation 7 tests on pg 1416 1 The individual participates in the activity for more than 500 hrs during the year 2 The individual is the sole participant in the activity 3 The individual participates in the activity for more than 100 hours during the year and no one else spends more time than this individual 4 The activity is an activity in Which the individual participates for more than 100 hours during the year and his aggregate participation in all activities in Which he spent more than 100 hours is greater than 500 hours 5 The activity is an activity in Which the individual has materially participated for any 5 not necessarily consecutive taxable yrs during the immediately preceding 10 taxable years 6 The activity is a personal service activity and the individual materially participated in the activity for any 3 not necessarily consecutive taxable years preceding the current taxable year 7 Based on all the facts and circumstances the individual participated in the activity on a regular continuous and substantial basis during the year Estatetrust is treated as materially participating in an activity if the executor or trustee meets lof the 7 tests above PSC or closely held C corp is treated as materially participating in an activity if 1 or more of its shareholders owning in the aggregate more than 50 of the stock materially participate according to the 1 of the 7 tests Passive activity 1 TB in Which the taxpayer does not materially participate 2 A limited partnership interest or 3 Most rental activity Loss of rental activity deducted against active a property being rented out is a real estate b that the taxpayer in question is an individual and c that the individual actively participates in the rental activity loses from rental real estate activity up to a max of 25000 can be deducted against active and portfolio income Active participation test can be satis ed Wout regular continuous and substantial involvement in operations so long as the taxpayer participates in the making of management decisions or arranging for others to provide services such as repairs in a signi cant bona de sense l404d Certain Rental Real Estate Treated as Active Applies When 1 More than 50 of the individual s personal services during the tax year is performed in real property trades or businesses in Which the individual materially participates and 2 The individual performs more than 750 hrs of service in the real property trades or businesses in which the individual materially participates A closely held C Corp Will satisfy if more than 50 of gross receipts of the corporation were derived from real property trades or businesses in Which the corporation materially participatd A real property trade or business includes any property development redevelopment construction reconstruction acquisition conversion rental operation management leasing or brokerage trade or business 1404e Interaction of the At Risk Rules and Passive Activity Loss Limitations At risk rules must be applied before applying the passive activity loss rules bc at risk rules limit the recognition of losses from all types of activities Whether passive or not ACCTG321 Notes 120 Ch 8 Special Items 801 Opportunities for Tax Avoidance Ex 8 1 To be deductible as interest the person who pays it must be legally liable to do so Father pay straight to the bank 2 form over substance If father and son were jointly liable on the note then either could have taken a deduction for any interest that he actually paid 802 Deductions for AGI 802a Alimony Payments Only alimony not voluntary gifts property settlement distributions or child support payments Property settlement dividing of property previously accumulated during the marriage whereas alimony provides support Alimony test The payments must be in cash The payments must be required by a divorce or separation agreement so not gift The payments must not continue beyond the death of the payment The payments must not be made to a person who resides in the same household as the payor The payments do not relate child support xcess front loading prohibited pay 500000 upfront 1 later years U1I bJgt t 66 must be contained in the Qualify for treatment as alimony NOT mean must be treated as alimony written divorce or separation instrument and is binding on both parties Ex 8 2 Save tax by not being an alimony If any alimony amt speci ed in alimony in the divorce agreement will be reduced in the event of a contingency relating to the child the amt of reduction child support 802b Retirement Savings 2 advantages for quali ed retirement plans corporate retirement plans for employees pensions pro t sharing plans employee stock ownership plans retirement plans for self employed HR 10 Keogh plans and IRA 1 Contributions by the taxpayer to these plans are immediately deductible 2 The income earned on the contributed funds is not taxed until the funds are withdrawn IRA withdrawal as a general rule are taxable both the withdrawal of the original investment and the withdrawal of accumulated interest Advantages restricted for taxpayers who are 1 Active participants in other employer sponsored quali ed plans and 2 Have AGI gt certain levels 56000 for single and 89000 for joint lers For those not subject to the restrictions I limits on annual deductible contribution to an IRA may not claim a deduction for a contribution to an IRA unless that taxpayer has earned income at least equal to the amount contributed not dividends interest or other investments 0 unmarried individual can deduct up to 5000 Nonworking spouse married to a working spouse allowed to have up to 5000 deductible contribution to an IRA provided the couple les a joint return and their combined compensation is at least equal to the contributed amount Contributions made to an IRA in excess of these limits 6 excise tax Deductions are also allowed for contributions made by the normal due date of the tax return Single taxpayer who is active participant in other quali ed plan 3 5 000 deduciton is phased out as AGI moves from 56000 to 66000 joint ler 89000 to 109000 calculation on Ex 8 7 Funds withdrawn from IRAordinary income Must withdraw from 595 before 10 penalty tax unless exception medical expense excess of 75 AGI education expenses up to 10000 of rst home 705 trigger 50 tax Rollover tax free swap p amount received from IRA reinvested in another IRA w in 6 days 802c Moving Expenses 1 employment related 2 distance test taxpayer s new place of work must be at least 50 miles farther form his old residence than the old residence was from his former place of work No place of work NM whether the new work site is at least 50 miles from his old residence Distance between old and new residence NOT relevant 3 Time test 77 Employee employee must be employed on a full time bais for at least 39 weeks during the 12 month period following the move f Self employed 1 To work full time for at least 39 wks in the rst 12 months period following the move and 2 To work full time for at least 78 weeks in the rst 24 month period following the move Most expenses of cash basis taxpayer deductible only in the tax year when the expenses are paid 1 The taxpayer may wait until the time test has been satis ed and then le an amended return for the earlier year in which the moving expense was paid 2 Taxpayer may claim the deduction when rst ling a tax return for the year in which the expenses were paid If assumption is false previously claimed deduction recaptured Exception to a time test 1 The taxpayer is transferred or laid off from the new job for reasons other than willful misconduct 2 The taxpayer is a member of the armed forces and the move was due to a permanent change of station 3 The taxpayer moves from a foreign country to the US bc of retirement or bc of the death of a related person whose job location had been outside of the US 4 The taxpayer becomes disabled after the move 5 The taxpayer dies after the move Deductible costs and limitations 1 Cost of moving household goods and personal affects ex packing loading storage insurance transporting and unloading of personal possessions 2 Cost of travel to the new residence transporation and loding for taxpayer and family members Automobile Related cash expense OK but NOT depreciation Alternatively a standard mileage rate of 165cmileautomobile may be deducted 803 Deductions from AGI 803a Casualty and Theft Losses Any loss sustained in TB or an investment activity 2 deductible Personal loss 1 Must be related to property and 2 Must arise from theft or re storm shipwreck or other casualty Casualties and thefts loss to property caused by some external force in an event that was due to some sudden unexpected or unusual cause auto accident airplane crash earthquake ood lightning sonic boom vandalism and many other events NOT dry rot not sudden collision in an auto race not unusual and death of an animal from old age not unexpected Suddenness test applies to period over which the property damage occurred not to the timing of its discovery Ex8 13 Accidents can be deducted but not willful act Only losses related to a taxpayer s own property constitute casualties for tax purposes neither liabilities to others nor medical expenses are included Theft larceny robbery embezzlement and any other unlawful taking of money or other property ex fraud kidnapping for ransom blackmail Misplaced or lost property NOT casualty or theft loss deduction Measuring the Deduction 100 floor for each casualty or theft of personal use property rst 100 is not deductible Partial damage tentative amount of loss 2 lower of the adjusted basis or the decline in the fair market value Completely destroyed a Personal same as partial damage b Business Tentative loss measured by the adjusted basis regardless of the amount of decline in FMV losses on personal use asset are only deductible to the extent they are due to a casualty or theft Loss must be reduced by any potential reimbursement as well as by actual reimbursement Congress felt that the govt should not subsidize the taxpayer s decision to avoid submitting a claim Costs of repairing replacing and cleaning up property after a casualty not deductible Cost of appraisal deductible as MIDs Timing the Deduction generally can be deducted only in the year in which the casualty occurs theft loss deducted only in the year in which the theft is discovered a Insurance claim for reimbursement may force a delay in claiming the reduction P K loss cannot be deducted as long as a reimbursement claim is outstanding if there is a reasonable prospect of recovery under the insurance claim Disaster loss casualty losses occurring in an area of cially designated by the President of the US as a disaster area area entitled to federal assistance 803b Charitable Contributions 2 requirements 1 Payment must be a gift must be made with a donative intent The purchase at FMV of a good service from a charitable organization would not result in a charitable contribution 2 Payment must be made to a quali ed organization to an organization of the type described in the tax law Gifts made directly to needy individuals are not deductible Quali ed charitable organizations 1 National state and local govts units of the US 2 Corporations trusts and other organizations operated exclusively for 1 or more of the following purposes religious charitable scienti c literary educational purposes or the prevention of cruelty to children or animals 3 Veteran s organizations 4 Fraternal organizations but only if the gift is used for 1 or more of the purposes named in 2 5 Nonpro t cemetery companies Measuring the amount contributed charitable contribution must be in cash or other property No deduction allowed for contribution of personal services Capital gain property frequently used as charitable contributions securities paintings and other art objects and land Ordinary income property deductible amount property s Market Value income that would have been recognized if the property had been sold No deduction is allowed for the unrealized loss on the contributed property Ordinary property that has declined in value sell the property rst and deduct the loss then contribute the proceeds Contribution of a long term capital gain property gives rise to a deduction equal to the current FMV of the property given 2 give it directly rather than selling it rst Exception to the general rule of measuring long term capital gain property contributions at their current FMV 1 When any long term capital gain property is contributed to a private nonoperating foundation 2 When any long term capital gain property contributed to a public charity meets all of the following conditions 77 The property is tangible securities 2 intangible f Not real estate 397 Is used by the charity in a Way that is unrelated to the charity s purpose ex if painting is sold even if cash is used for educational purpose Limitations on the Deduction for Charitable Contributions 1 Contributions of long term capital gain property to private charities cannot exceed 20 of the taxpayer s AGI 2 Contributions of all types of property to private charities cannot exceed 30 fo the taxpayer s AGI 3 Contributions of long term capital gain property to public charities cannot exceed 30 of AGI 4 Total contributions of all types cannot exceed 50 of AGI 803c Interest Expenses Deductible interest 1 TB interest 2 Investment interest 3 Quali ed residence interest 4 Personal interest TB interest d for Other 3 itemized deductions interest payments must relate to a debt of the taxpayer making the payments Interest compensation for the use of money Valid debt necessary for an interest to be deducted Also pmts for services rather than for the use of money are not classi ed as interest Some examples 1 Interest on money borrowed to nance the purchase of assets held for investment investment interest 2 Interest on home mortgage quali ed residence interest 3 Points paid by a home buyer When obtaining a mortgage quali ed residence interest if the points are related to obtaining money but not if related to obtaining services such as title search and administrative costs If points are paid by the seller of the property they will be treated as if rst paid to the buyer decreasing the purchase price of the home and then paid by the buyer to the lender giving the buyer a deduction 4 Interest on income tax de ciencies personal interest Finance charges on credit cards and charge accounts personal interest 6 Penalties for the late payment of utility bills personal interest U1 Not interest 1 Payments on a legal debt to a related party when the creditor does not intend to collect the debt in full 2 Credit investigation fees 3 Bank service charges Investment Interest 3 only deductible to the extent of the taxpayer s net investment income Excess carried forward Investment income dividends interest income net short term capital gains on sales of investment assets Congress provided a special election that allows a taxpayer to choose to include net long term capital gain but the price of this election 2 net long term capital gain is taxed at regular ordinary income rates Quali ed residence test 2 categories 1 Interest on acquisition indebtedness 2 Interest on home equity indebtedness Acquisition indebtedness any debt that is incurred in acquiring constructing or substantially improving any quali ed residence of the taxpayer a Quali ed residence taxpayer s principal residence plus one other residence of the taxpayer if that 2nd residence is used signi cantly by the taxpayer personal use of more than 14 daysyr or for more than 10 of the days that the second residence is rented to others b Aggregate amount treated as acquisition indebtedness cannot exceed 1M for any taxable year Home equity indebtedness other than acquisition indebtedness that is secured by a quali ed residence Cannot exceed 100000 Personal Interest interest expense that does not fall under the categories of TB interest investment interest or quali ed residence interest Not deductible EXCEPT up to 2500 on interest paid on loans used to nance the taxpayer s spouse s or dependent s education a Allowed for interest paid during the rst 60 months in which interest payments are required on each education loan b Deduction is phased out for taxpayers w AGI between 50000 and 65000 single lers or between 105000 and 135000 joint lers Other restrictions on Interest Deductions 1 The disallowance of prepaid interest deductions for cash basis taxpayers m over the term of the loan unless for purchase of personal residence 2 The disallowance of interest on debt incurred for the purpose of producing tax exempt income 3 The requirement to capitalize construction period interest 803d Medical Expenses Permitted to deduct unreimbursed medical and dental expenses to the extent such expenses exceed 75 of AGI for medicaldental for taxpayer spouse dependents No dependency gross income test test needed The medical expense deduction is allowed only for expenses both paid and incurred during the tax yean must be amortized Medical care means amounts paid A For the diagnosis cure mitigation treatment or prevention of disease or for the purpose of affecting any structure or function of the body B For transportation primarily for and essential to medical care referred to in subparagraph A C For insurance covering medical care referred to in subparagraphs A and B Capital expenditure incurred for medical purposes not need be capitalized and depreciated expensed in the year of acquisition eyeglasses a seeing eye dog arti cial teeth wheelchair clutches incubator Capital expenditure for medically related improvement to nonmedical property Zo deductible to extent that expenditure exceeds the increase in the market value of the property Ex elevator to a house Meals and lodging deductible as long as it is in patient hospital care or at nursing home if primary reason is medical attention For family consideration 1 Cost of medical care deductible as medical expense 2 The cost of meals lodging and other personal services not deductible as medical expense Medicine and drugs deductible if both legally procured and prescribed by a physician a Exemption Insulin Transportation and lodging up to 50night away from home for the purpose of receiving medical care are deductible Premiums paid for medical insurance are deductible If no designation stated in insurance contract that provides multiple coverage none is deductible 803e Taxes paid Only deductible state and local taxes are 1 State and local real property taxes 2 State and local personal property taxes 3 Either state and local income taxes or state and local general sales taxes Other taxes nor following federal taxes deductible federal income taxes social security taxes excise taxes gift taxes or estate taxes Real Property Taxes generally deductible only if paid by the person assessed property owner When sold annual real estate taxes must be apportioned between the buyer and the seller on the basis of the time during the year the property was owned by each Special tax assessments for local improvements streets curbing sidewalks must be added to the adjusted basis of the property Personal property taxes 3 tests for a state or local tax to qualify as a deductible personal property tax 1 The tax must be based on the value of the property 2 Tax must be charged on personal property other than real estate 3 Tax must be charged on a yearly basis State and local income taxes and the tax bene t rule Cash basis individual deductions are allowed in the year of payment not in the year of accrual not deductible but Refunds received in year following the tax year must be included in GI of following year not needed if it was not deducted from original payments General Sales tax Taxpayers could elect to deduct the state and local general sales taxes they paid instead of state and local income taxes 803f MID 1 unreimbursed employee business expenses 2 automobile expenses if used in the taxpayer s capacity as an employee or if used in an investment activity such as travel to visit an investment advisor actual cost or 50cmile 3 portion of divorce costs associated w the determining the TAX consequences of the divorce 4 employee s education expenses if related to maintaining or improving job skills for the employee s current job education costs that qualify for new job 2 personal expenses 2 not deductible if self employed any quali ed education expenses dfor 5 employment agency fees if paid by an employee seeking a job in the same eld 6 Home of ce expenses of an employee if the home of ce is used exclusively and regularly for the convenience of the employer 7 professional journal subscriptions paid by employees 8 tax return preparation fees if self employed and part of the fee is related to determine tax related to the business D For 9 tools that relate to job purchased by employees 10 transportation costs between jobs 11 Uniforms if not suitable for general wear 12 union dues 803g Tax Credits Tax credits reduce the tax directly 804a Child and Dependent Care Credit Tax credit allowed for percentage of quali ed child care expenses paid for the purpose of being gainfully employed Base for computing credit has 2 limits Earned income limit and overall limit Earned a Married couple ling jointly limit based on the income of the lower earning spouse b One spouse Works and other is full time studentdisabled T nonworking spouse is assumed to earn 200month if 1 dependent or 400 for 2 or more Overall limit a 3000 for 1 qualifying child or dependent and 6000 for 2 or more Credit 35 of the base for taxpayers W AGI of 15 000 or less gt15000 rate of credit is reduced by 1 for each 2000 of AGI over 15000 but not below 20 804b Credit for the Elderly and Disabled Social security retirement bene ts partially excluded from GI 1 Rate of credit is 15 of a base amount Base subject determined by Initial amount is identi ed depending on the taxpayer s ling status Initial base amounts Single individual age 65 or over 5000 Joint return one spouse age 65 or over 5000 Joint return both spouses age 65 or over 7500 Married individual age 65 or over separate return 3750 2 Initial base amount reduced by nontaxable portion of Social Security bene ts and certain other nontaxable pensions and annuities received 3 Any remaining base is further reduced by 12 of the excess of the taxpayer s AGI over a modest amount Modest amount Single taxpayer 7500 Joint return 10000 Married taxpayer ling separately 5 000 4 Residual base amount if any is multiplied by 15 to determine the credit for the elderly limited to the amount of taxpayer s precredit liability Can never create a negative tax 804c Earned Income Credit Eligibility earn some income and have a qualifying child Individuals Wout children may also claim if 1 The individual has a principal residence in the US for more than 12 of the tax year 2 The individual or if married either the individual or individual s spouse has attained age 25 years but has not attained age 65 before year end and 3 The individual cannot be claimed as a dependent Amount of credit based on earned income of taxpayer a Earned income Wages salaries tips and net earnings from self employment b Does not include nontaxable forms of earned income unemployment compensation social security bene ts pensions alimony received income from investments dividends interest capital gains c Its for aiding Working poor 2 no earned income P v 2010 credit is a 34 for taxpayer W 1 qualifying child max income 8970 b 40 With 2 or more max income 12590 c 765 With no qualifying child 5980 804d Foreign Tax Credit Can elect either an itemized deduction or credit for foreign income taxes paid Limit 2 Foreign Taxable Income Total Taxable Income US Tax Before Credit or Deduction a Total Taxable Income before any deductions for personal exemptions 805 Implications for Decision Making 805a Examples demonstrating the importance of structuring transactions to meet technical tax requirements Charitable contribution credit 0 Charitable lead trust exists when the taxpayer transfers property to a trust and gives instructions to the trustee to pay to a charity all the income from the trust for a certain period of time Interest Expenses points on home mtge Medical expenses when taxpayer makes capital improvement to someone else s property no deduction is allowed to either taxpayer making improvement or to the property owner for medical reasons 805b Examples demonstrating the Importance of Combination Tax Effects Medical expenses medical expenses paid for the care of someone other than the taxpayer s spouse often qualify as a deduction only if related to a dependent pass support test same cash outlay could produce 2 deductions medical expense and dependency deduction Child and dependent care unit limited credit allowed for child care costs but does not apply to pmts made for support costs food clothing and education BUT full amount of expense quali es for child care credit where manner of providing care provides other bene ts that are inseparable from the care by selecting activities that combine both employment related child care services and other bene ts parents may be able to increase their child care credits or reduce the nondeductible costs of supporting their children or both 806 Appendix A brief discussion of some tax provisions Roth IRA contributions not deductible but neither the original contributions nor the earnings on those contributions are taxed when withdrawals are taken a Only true if taxpayer owned Roth IRA for 5 yrs and has attained required age 59 12 Education Savings Account earnings build up inside ESA tax free and all withdrawals are tax free to the extent that they do not exceed the quali ed education expenses incurred by the bene ciary during the year the withdrawal is made Child tax credit 1000 for 2010 Reduced in 50 steps for each 1000 of AGI in excess of 110000 forjoint lers American Opportunity Credit entitled to credit equal to 100 of the rst 2000 of tuition and related expenses and 25 of the next 2000 for each student for each of the 131 4 yrs of post secondary education Lifetime learning credit 20 of tuition and fees incurred during the tax year on behalfof the taxpayer spouse dependents Up to 10000 of tuition and fees tax return are eligible for the credit ie the maximum credit is 2000 ACCTG321 Notes 125 Ch7 Alternative Minimum Tax AMT equal to the excess of the tentative minimum tax over the individual s regular tax AMT can never apply to low income taxpayers Exemption amts are phased out as AMTI exceeds certain levels Exemption amts are reduced by 25 of the excess of AMTI over 1 150000 for joint returns 2 112500 for single and head of household returns 3 75000 for taxpayers who are married ling separate returns 707a Some of the more common tax preference items 1 Excess depletion does not allow depletion in excess of the basis of the property 2 Certain tax exempt interest income Private activity bonds 3 Exclusions for gains on sale of certain small business stock 77 12 of the gain can be excluded from GI in regular TI be added to regular TI for AMT 4 Excess depreciation on real property and on leased personal property if the real or leased personal property was placed in service prior to 1987 Excess depreciation added back to regular TI in calculating AMTI 7 of the excluded amount must 707b Other Adjustments to Regular Taxable Income Might either have to be addedsubtracted depending on the situation Depreciation on real property placed in service after 1986 Depreciation on personal property placed in service after 1986 Income recognized under long term construction contracts Adjusted basis Bargain element in incentive stock options Itemized deductions 77 Medical expenses are only deductible for AMTI to the extent they exceed 10 of AGI 75 for regular TI f Interest on home equity indebtedness not allowed in calculating AMTI 7 State and local taxes paid state income taxes real estate taxes personal property taxes not deductible J1 MIDs hobby losses unreimbursed employee business expenses uniforms tax return preparation fees etc not deductible at all 7j SIDs no phaseout rule for AMT system 7 Standard Deduction not allowed 8 Personal and dependency exemptions not allowed 9 Other adjustments AMT simply a more conservative tax system that does not allow as many income deferrals or exclusions or as much acceleration of deductions as the regular tax system does OU1I bJgt t 707c The AMT Credit Exclusion adjustments items that result in some income being permanently excluded from regular TI but not excluded from AMTI Tax exempt interest income Itemized deduction for state income taxes 1 Excess percentage depletion 2 Tax exempt interest income on private activity bonds 3 Any itemized deductions standard deduction personal and dependency exemptions that are denied for AMTI purposes 4 50 of exclusions for gains on the sale of certain small business stock Deferral adjustments reduce regular TI relative to AMTI in one period but this effect reverses in a later period accelerated depreciation Credit amount amount by Which the portion of the TMT arising from deferral adjustments exceeds the regular tax for the year 708 Net Operating Losses NOL a Carried to another year b can be carried back 2 yrs and applied 1 to the earliest of the 2 yrs preceding the loss year If all the positive T1 for prior taxable years is reduced to O and there is some NOL remaining carried forward to rst 20 yrs after the loss yr Negative taxable income exists in a year in which deductions and exemptions exceed GI Net operating loss negative taxable income after certain adjustments NOL deduction occurs When that NOL is carried over to a different year Only economic losses can produce NOLs personal exemption Wont count ACCTG321 Notes 22 Ch10 Assets Buy and Sell 1001 Tax Planning for Property Acquisitions Tax on total income not consumption properties tends to discourage investments in income producing Code contains several incentive provisions 1002 Basis Determination Procedure depends on whether property was acquired by purchase self construction gift or inheritance 1002a Properties purchased from outsiders Cost Determination includes but is not limited to cash paid any other properties or services rendered in the exchange Ascertaining the cost of a property requires distinguishing between 1 Items making up the property 2 Ordinary business expense of the current year Mortgage liability is secured by an asset Mortgage or other liability becomes part of a taxpayer s basis when 1 The taxpayer accepts personal liability for a previously existing mortgage on the property or 2 The taxpayer promises to pay a portion of the purchase price in the future whether or not this promise is secured by the property or 3 The taxpayer purchases the property subject to the debt of someone else so that the taxpayer could lose the property in the event the debt is not paid even though the taxpayer is not personally liable to pay this debt or 4 The taxpayer agrees to pay someone else s debt as part of the purchase agreement even though the debt is not connected with the property Amts paid for Interest on a property mortgage do not increase the basis of the property Unstated interest must be imputed Cost allocation based on the relative market values of the various properties at the date of acquisition Use for both TB and personal z only the portion of the asset used for business puposes 1 May be depreciated 2 May be counted for purposes of taking any available credit or 3 May give rise to a deductible loss upon later sale 1002b SelfConstructed Properties Basis of a property 2 cost Depreciable machinery and equipment are used depreciation on the machinery and equipment is not deducted currently but becomes part of the basis of the recently constructed property which in turn will be depreciated over its depreciable life 1002c Conversion of Personal Use Properties to Business Use Gain basis property s adjusted basis as of the date of conversion Loss basis lower of 1 The property s adjusted basis as the date of conversion or 2 The property s fair market value on that date Loss basis used for calculating depreciation IIF the selling price were anywhere in the range from Gain Basis and Loss Basis recognize no gain or loss Not have to report any gain unless she sells at a market value that exceeds the original 40000 ignoring any depreciation she took ex p10 9 1002d Gift Properties required to Not recognized as taxable gain or loss to the donor Gain basis donor s adjusted basis as the date of the gift Loss basis lower of 1 The donor s adjusted basis as of the date of the gift or 2 The property s fair market value on that date Similar to conversion of Personal Use to Business use Pg 1010 The donor s potential gains are shifted to the donee Unlike when property converted from personal to business use g when depreciable property is acquired by gift the recipient s basis for depreciation purposes is the gain basis pg 1012 1002e Inherited Properties Heir takes the fair market value of the property at the property s basis I result in no gainloss Rather than market value the basis of inherited property to such an heir decedent s adjusted basis immediately prior to the death if 1 Decedent previously acquired the property as a gift from the same person currently inheriting it 2 The gift occurred win one year of the decedent s death and 3 The market value exceeded the basis of the property at the date of gift gift and inherit back transaction 1002f Properties Purchased from Related Parties Related party sales 2 gain P gain recognized for tax purposes Related party sales 2 loss prohibits the seller from recognizing loss Gain on the second sale recognized only to the extent that it exceeds the loss that was disallowed on the rst sale loss on the second sale would be recognized in full 1003 Investment Tax Credit Overview immediate sale would 1006 Special Rules for Investments in Bonds Investors buying 1 Promise to pay a stated amt of interest every period and 2 The promise to pay the maturity value par Value face value at a speci ed date in the future Compare stated rate with the market rate Same When redeemed no gainloss 1006a Bonds purchased at premium Tax treatment differ whether 1 The interest received is taxable 2 The interest received is not taxable or 3 Zero interest is received US savings bond Premium reduction of the interest income he earned Tax laws allow you to elect to reduce the amt of interest income that you report by amortizing the premium using the Effective interest method Election to amortize 2 generally advantageous bc the taxpayer gets to reduce his taxable income earlier than when the election is not made each period s amortization is an offset against ordinary income rather than being a capital loss Treatment of premium When interest received is not taxable premium must be amortized no election available basis is reduced Treatment of Premium when zero interest is received series E and Series EE US savings bonds these bonds will never sell at premium 1006b Bonds purchased at a Discount Original issue discount discount that exists bc the investor bought the bond for less than 1000 when the bond was originally issued Market discount exists bc the investor bought the bond in the open market for less than 1000 at sometime after the bond was originally issued Treatment of OID When interest received is taxable required to increase the amount of interest income by amortizing the OID Treatment of Market Discount when Interest Received is Taxable increase in taxable interest income BUT does not have to be recognized each period Treatment of OID When Interest Received is not taxable OID must be amortized but increased interest income is not taxable 9B bond s basis to be increased to prevent any gain recognition upon redemption Treatment of Market Discount when interest received is not taxable if not amortized t taxable ordinary income upon redemption or if amortize it is taxable each period 2 tax disadvantage to investing in tax exempt bonds at discount Treatment of OID when zero interest is received may elect to amortize the OID period Treatment of market discount when zero interest is received not applicable to US savings bond if there is market discount it is not amortized the basis of the bond stays low and the investor has a capital gain upon redemption 10060 Summary of Premiums and Discounts Pg 1029 1006d complication when bonds originally issued at a premium or discount are later purchased in the open market p X total amount f amortization allocated between the rst holder and the second holder Discount determined at the original issue date of the bond is the amount that will eventually increase the aggregate taxable income of any holders of the bond 1007 Implications for decision making Identifying Speci c properties Shifting losses with gifts Avoiding recapture of the rehabilitation credit Making appropriate elections for bond investments taxable each ACCTG321 Notes 25 1201 Opportunities for Tax Savings LTCG highly favored a Able to deduct 60 of such gains b Ccorp 28 1203 De ning Pure Capital GL Pure Capital Gains and Losses GL on the sale or exchange of a capital asset if and ot the extent such a GL is recognized 1203 A matter of classi cation only Rules for capital GL control only the classi cation of income already recognized by some other tax authority 1203b Sale or Exchange GL must be triggered by a sale or exchange if it is to be treated as a capital transaction Ex Abandonment 2 Ordinary loss not capital loss 1203c De nition of a Capital Asset Capital asset property held by the taxpayer Whether or not connected W his TB but does not include Pg 124 If no property is deemed to exist Capital GL treatment Will not apply Ex 123 Property used in the taxpayer s TB not capital asset A Authors composers and artists ordinary gain on the sale of their Work B You sell letter received from the president of the US you Will have ordinary income C Gift if used FMV as a basis capital No exemption for patents or musical Works from the capital assets category even when such an asset is held by its creator 4 Excludes from the de nition of capital assets all receivables that result from providing services in the ordinary course of a TB or form selling inventory on credit Other types of receivables are not exempted from capital asset de nition 5 stops elected of cials and others from claiming charitable contribution deductions on the donation of govt publications to libraries when such publications are obtained t not cost to the donor so u can only take the basis Which is O Futures played an integral role in taxpayer s TB and it could not be considered capital assets ex 125 vs 126 stock Was not considered as ordinary assets Entire interest in the asset must be sold to be capital asset 1204 classifying pure Capital GL as LT or ST Long term over one year 1205 Section 1231 GL 1 Gains gt any depreciation recapture amount and losses from the saleexchange of real or depreciable property used in TB 2 Gains gt any depreciation recapture amount and losses from condemnations or seizures of a property use in a TB or b capital assets held in TB or c capital assets held in an income producing investment activity involuntary y conversions from other than casualties or thefts 3 Gains gtany depreciation recapture amount and losses from casualties and thefts of a property used in TB or b capital assets heldin a TB or c capital assets heldin an income producing investment activity involuntary conversions from casualties or thefts Holding period gt 1 yr steps A Casualty and theft GL from category 3 are netted together Net loss PD ordinary loss Net gain wI net gain combined With items from categories 1amp2 B GL from categories 1amp2 as Well as neg gain from step A are netted together Net loss 0 ordinary loss Net Gain LTCG to the extent that the net gain exceeds any unrecaptured net Section 1231 losses To the extent that net gaindoes not exceed Section 1231 losses form this 5 yr lookback period net gain 2 ordinary income 1205a Recapture of Net Section 1231 Losses from the Lookback Period Past losses go to ordinary income Ex 1212 1205b SaleExchange of Property Used in a TB Land used in a TB if held fro more than the long term holding period Depreciable real estate used in a TB if held for more than the long term holding period Depreciable personal property used in a TB if held for more than the long term holding period Certain timber coal and domestic iron ore Unharvested crops on land used in a TB for more than the long term holding period if the unharvested crops and the land are sold to the same person at the same time Cattle and horses held for draft breeding dairy or sporting purposes if held for more than 24 months Livestock other than cattle and horses held for draft breeding dairy or sporting purposes if held for more than 12 months Such livestock can never include poultry however 1205c Involuntary Conversions from Other Than Casualties and Thefts a property use din TB b capital assets held in a TB capital assets held in an investment activity must be held for the long term holding period 1205d Involuntary conversions from casualties and thefts If an involuntary conversion from a casualty or theft occurs such as insurance proceeds or other reiumbursement suffers a casualty or theft might realize either GL on a property use din TB b capital assets held in a TB capital assets held in an investment activity must be held for the long term holding period 1206 Depreciation Recapture Limitation on the LTCG treatment afforded gains realized on the disposition of depreciable assets Section 1245 any tentative Section 1231 gain or tentative LTCG be reclassi ed as ordinary income to the extent of all depreciation taken on the asset Applies to all depreciable personalty and depreciable nonresidential realty if an accelerated method of depreciation has been used Section 1250 any tentative Section 1231 gain or tentative LTCG be reclassi ed as ordinary income to the extent of excess depreciation taken on the asset 2 amount by Which actual depreciation taken exceeds the amount that Would have been taken if the straight line method of depreciation had been used Applies only to residential realty Corporation add back 20 of relative advantage Ex 1220 1207 Casualties and Thefts of Personal Use Properties GL from casualties and thefts of personal use properties are not subject to the netting procedure of section 1231 Separate netting procedure for personal casualty and theft GL 1 Each casualty or theft loss is reduced by 100 2 All GL are netted 3 Net gain gy all GL are treated as capital GL LT or ST depending on holding length 4 Net loss ordinary itemized deduction after rst reducing it by 10 of AGI 1208 Review of Netting Procedures 1 Section 1231 transactions 2 Capital transactions 3 Ordinary transactions 4 Personal casualties and thefts Steps are on Pg 1228 1209 Taxation of Capital GL of Individuals Capital losses can be deducted wout limit against capital gains but if there is any capital loss that exceeds capital gain the excess can only be deducted against ordinary income to the extent of 3 000 Excess Carried forward NCG excess of the net LTCG for the taxable year over the net STCL for such year 1210 Taxation of Capital Gains and Losses of Corporations No special capital gain rate for corporations as there is for individuals 1 Corporation cannot deduct any portion of its current net capital loss against ordinary income 2 Net capital loss the corporation can carry the loss back 3 yrs and forward 5 yrs to match against capital gains in those years Always classi ed as short term No capital gains in those yrs the loss expires and cannot be deducted at all Ex 1227 pg 1238 1211 Special Provisions 1211a Non Business Bad Debts Receivable created in the ordinary course of business are NOT capital assets HOWEVER a receivable that is created when a taxpayer makes a personal loan to someone is a capital asset Congress all nonbusiness bad debt losses be treated as STCL Losses on loans of an investment nature are also included only as STCL not ordinary losses 1211b Losses on Small Business Stock In the event of business failure investors in regular corporations must generally bear a greate rafter tax loss than do investors in partnerships and S corps Section 1244 allows investors in regular corporations to claim an ordinary loss deduction rather than a capital loss for losses realized on what is known as small business stock when the corporation goes bankrupt or when the investor sells the stock Limited to 50000 in any one year for a single individual or 100000 for a married taxpayer ling a joint return Stock must meet all the requirements set forth in Section 1244 for a small business corporation a Must largely be an operating company rather than deriving most of its gross income from unearned sources Stock must have been issued for property or cash not services c Entire amount o fpaidin capital received by the corporation on issuance of the stock cannot have exceeded 1000000 1211c Gains on Quali ed Small Business Stock Any noncorporate shareholder who holds this stock for more than 5 yrs may exclude 50 of the gain from GI certain small business stock purchased after August 101993 Shareholder must be the original holder of the stock and must have received the stock in exchange for money or property or as compensation for services performed for the corporation Corporation must have actively conducted a TB other than a service business banking farming extracting natural resources or operating hotels or restaurants For purposes of section 1202 small corporation has under 50000000 in assets 1212 Implications for Decision Making Besides being subject to taxation at a lower rate than ordinary income capital gains are advantageous if the taxpayer has capital losses 1212a Structuring Transactions Generally capital gains arise only on the saleexchange of capital assets Generally ordinary losses are preferable to capital losses bc of the limits that apply to the deductibility of capital losses Also better than Section 1231 loss bc it Will cause any net section 1231 gains in the following 5 yrs to be treated as ordinary income instead of LTCG Selling capital asset or abandonment For taxpayers owning depreciable real estate that has a low basis relative to this current market value it is sometimes advantageous to engage in a sale and leaseback transaction Sale and leaseback should be conducted W an independent party LTCG treatment never applies to gain realized on sales of depreciable property to related taxpayers 1212b Controlling Asset Classi caiton What it counts is the actual purpose for Which an asset is held at the time of disposition 1212c Measuring GL Excise tax as an itemized deduction offset ordinary income 1212d Allocating Total Price on Sale of a Business Covenant not to compete not a capital asset recognized as ordinary income When received Goodwill capital asset 1213 Capital Gain Rates NCG a Gain from collectibles held over 1 yr max rate 28 77 Includes Works of art antiques gems stamps coins and the like b Unrecaptured section 1250 gain max rate 25 77 Even more of the gain be reclassi ed but the gain is not reclassi ed as ordinary income f Reclassi ed as a special category of capital gain and taxed a 25 c The excluded gain from the sale of small business stock max rate 0 77 bc 50 of the gain is excluded this portion is not subject to any tax The remaining 50 is taxed at 28 rate gain Effective tax rate on the entire gain is 14 d The remainder equals adjusted net capital gain ANCG max 15 7 0 for the portion of the gain that Would be taxed at 10 and 15 if it Were ordinary income f A maximum rate of 15 for the rest of the gain 397 Dividend income While not classi ed as capital gain is generally taxed as if it were in this ANCG category ACCTG321 Notes 222 Ch 9 903 Determining Gross Income G1 a unrealized appreciation in the value of taxpayer s property is not GI b most of the exclusions from realized income not G1 904 Deductions for Corp 904a Charitable Contributions Deduction for contribution in any given year limited to 10 of its current year taxable income before certain deductions Only deductible items not subtracted in computing the base for 10 limit 1 the contribution deduction itself 2 deduction for dividends received 3 the deduction for NOL carrybacks 4 deduction for CL carrybacks amts that cannot be deducted due to 10 limit CF for 5 yrs 904b NOL NOL carryover from some other year cannot be used to create an NOL of the current year 2 alternatives 1 NOLs may be carried back 2 yrs and forward 20 yrs 2 Carryback may be omitted with the carryforward period remaining at 20 years 904c Capital Losses CL can be deducted against all CG but cannot be deducted at all against Ordinary Income If there is still some capital loss remaining after all capital gains have been offset this net capital loss cannot be used to reduce ordinary income 904d Dividends Received Deduction Parent corp receiving dividends from a subsidiary corp parent corp allowed 100 dividends received deduction when separate corporation tax returns are led by the parent and the subsidiary parent must own 80 or more of the subsidiary company If own 20 or more of the payor corp P 80 dividends received deduction Own less than 20 Recipient corp allowed 70 dividends received deduction Taxable income is determined prior to 1 The dividends received deduction 2 The deduction for any NOL carryovers 3 The deduction for any capital loss carrybacks The limit does not apply if the deduction of the full 80or 70 of dividends received results in a NOL for the current year Arrange by 1 Have their business operating income exceed their business operating expenses in which case the limitation rule will produce a limitation amount grater than the tentative deduction 2 Have their business operating expenses exceed their business operating income by amount greater than 20 of the amount of their dividend income in which case the limitation will not apply bc of the creation of a NOL 909b Shifting Dividend Income to Corporations The special dividends received deduction available to corporate shareholders makes it particularly attractive to shift investments in stocks to corporate ownership Corporate penalty tax can be avoided by a Having the corporation produce enough earned income b Or by making dividend payments to the shareholder ACCTG321 Notes 210 Ch13 Tax Deferred Transactions 1301 opportunities for Tax postponement Installment Method Exchange of property held for productive use or investment Involuntary conversions Exclusion of Gain from Sale of Principal Residence 1302 Conceptual Overview Realized When an exchange transaction occurs receipt of either cashother property Realized gain might or might not be recognized for tax purposes included in the computation of taxable income I Deferred or excluded Basis of a property received 2 basis of the property given up any recognized gain or any recognized loss 1303 Installment Sales The amt of cash received dictates how much gain is recognized in any particular year collections in current year contract pricetotal cash to be collected total gain realized Only applies to gains 1303a Recapture of Depreciation in Installment Sales First recognized income recaptured as ordinary income Only after all relevant depreciation recapture section 1245 and 1250 can any capital gain be recognized Installment sales after June 6 1984 X all depreciation recapture must be recognized as ordinary income in the year of sale depends on when the sale occurred not when the payment is received by the seller 13 O3b Installment Sales De ned a disposition of property Where at least one payment is to be received after the close of the taxable year in Which the disposition occurs Not allowed to dealers 1 Taxpayer Who regularly sells personal property under deferred payments contracts 2 One Who disposes of real property that had been held for sale to customers in the ordinary course of business 1303c Payments vs Installment Obligations Obligation an installment receivable stating that the buyer promises to pay a certain amount for the seller s property Payment either a collection on the installment receivable or it is something that the buyer gives to the seller in addition to the installment receivable Evidence of indebtedness 1 Payable on demand 2 Readily tradable is treated as a payment received 1303d Installment Sales of Mortgaged Properties Debt relief not part of the contract price BUT Whenever the amount of debt relief to the seller gt adjusted basis of asset being sold 2 excess treated as a collection in the year of sale 1303e Interest on Installment Sales 2 elements of income U 1 Gain realized on the sale 2 Interest income ordinary income 1303f Dispositions of Installment Obligations Gain realized but not yet recognized on the original sale shall be reported as income by the seller in the year the seller disposes of the installment obligation 1303g Related Party Sales Sale of property other than marketable securities Seller is required to recognize gain based on the larger of a The cumulative amount of cash received by the seller from the buyer or b The cumulative amount of cash received by the buyer up the amount of but not exceeding the contract price on the original sale on subsequent dispositions Sale of Property other than Marketable Securities 2 yr time limit on the resell rule Depreciable property all realized gain must be recognized in the year of sale 1304 LikeKind Exchanges Prohibit the recognition of losses as Well as gains is mandatory 1304a LikeKind Exchanges De ned Property held for productive use in a TB or for investment if such property is exchanged solely for property of a like kind to be held either for productive use in a TB or for investment Exceptions securities interests in partnership certi cates of trust or bene cial interests or choses in action Like kind property 1 Only direct exchanges are included 2 Like kind property traded must have been held either for business use or an investment Receiving party must intend to hold the property for business or investment purposes 3 Neither the property given nor the property received in Section 1031 exchange can be 1 Inventory 2 A security investment 3 A note or AR 4 An interest in a partnership 4 Assets exchanged must be of like kind 5 Personal properties are considered to be a like kind if they are of a like class 1304b Tax Impact of Boot Neither GL on boot property is deferred by the provisions of Section 1031 Receiving boot any realized GL on boot property given up be recognized EXCEPTION if the taxpayer received any boot property in the exchange 0 like kind property given up Will be recognized ot the extent of the FMV of the boot property received 1304c Basis Adjustments 1304d Exchanging Mortgaged Properties Debt relief treated as boot received by the taxpayer Who is giving up the property subject to a mortgage realized gain on the 13 05 Involuntary Conversions Government condemnation casualty insurance settlement in excess of a property s adjusted basis Section 1033 never prohibits the recognition of losses and is elective With respect to gains If elected no gain recognized if the taxpayer acquires quali ed replacement property costing at least as much as the net proceeds received from the conversion Any proceeds left over after buying replacement property gain must be recognized If converted property 2 condemned real estate replacement property must meet the like kind test 1306 Sales of Personal Residences Section 121 exclude up to 250000 500000 if joint of gain realized on the sale of the individual s home Must have both owned and used the property as hisher principal residence for at least 2 years during the 5 yr period preceding the date of the sale 1307 Implications for decision making 1307 a Installment Sales If a seller of property gets cash from a lender instead of from the buyer of the property the cash received will not be taxable 1307 b LikeKind Exchanges Realized gain is recognized only to the extent that boot is received taxpayer who is receiving boot should try to negotiate the terms of the exchange so that the amount of boot received is reduced 1307 c Involuntary Conversions Have govt condemn rst so that you qualify for deferral 1307 d Sales of Personal Residences Control classi cation ofa residential property as of the date of its sale 1308 Appendix Multiple LikeKind Property Exchanges Exchange group surplus exists when the aggregate FMV of the assets received in that group exceeds the aggregate FMV of the assets given up in that group Exchange group de ciency when the aggregate FMV of the assets given up in that group exceeds the aggregate FMV of the assets received in that group If aggregate realized gain gain recognized to the extent of the lesser of the gain realized or the amount of the exchange group de ciency
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