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by: Jeffery Rohan


Jeffery Rohan
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This 27 page Class Notes was uploaded by Jeffery Rohan on Saturday September 12, 2015. The Class Notes belongs to HACE 3250 at University of Georgia taught by Goetz in Fall. Since its upload, it has received 70 views. For similar materials see /class/202278/hace-3250-university-of-georgia in Housing And Consumer Economics at University of Georgia.

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Date Created: 09/12/15
Amelie Turcotte HACE 3250 4 l 7 l 1 Chapter 13 Notes Estate Planning In large measure estate planning is about the transfer of property either during life or at death the methods of effecting those transfers and the risks associated with those transfers Estate planning 7financial planning in anticipation of client s inevitable death may be broadly defined as the process of accumulation management conservation and transfer of wealth considering legal tax and personal objectives Effective transfer 7 occurs when a person s assets are transferred to the person or institution intended by that person Ef cient transfer 7 occurs when transfer costs are minimized consistent with the greatest assurance of effectiveness Heir 7 person who inherits under state law Legatee 7 person named in a will Estate planning goals and objectives 0 Fulfill client s property transfer wishes o Minimize transfer taxes income gift estate state inheritance generation skipping Minimize transfer costs Maximize net assets to heirs OOO Provide needed liquidity at death 0 Fulfill client s healthcare decisions Risks in failing to plan an estate 0 Client s property transfer wishes go unfulfilled 0 Transfer taxes are excessive 0 Transfer costs are excessive o Client s family not properly provided for financially 0 Insufficient liquidity to cover client s debts taxes and costs at death Six Basic Steps to Estate Planning 0 Establish the clientplanner relationship 0 Gather client information including the client s current financial statements and establish the client s transfer objectives including family and charitable objectives 0 Determine the client s financial status 0 Develop a comprehensive plan of transfers consistent with all information and objectives 0 Implement the estate plan 0 Review the estate plan periodically and update the plan when necessary especially for changes in family situations Page 1 Amelie Turcotte HACE 3250 4 l 7 l l 0 To begin estate planning process planner should collect 0 000 0000 0 Current nancial statements Balance sheet and income statement Family information ages and health Copies of medical disability and longterm care insurance policies Copies of all current life insurance policies identifying the owner of each policy the named insured and the designated bene ciaries Copies of annuity contracts Copies of wills and trusts Identi cation of powers of attorney and general powers of appointment Copies of all previously led income taX gift taX and estate taX returns Identi cation of assets previously transferred to loved ones 0 Common transfer objectives 000000 0 0 Transfer property as desired and minimized estate and transfer taxes to maximize the assets received by heirs Avoid the probate process Use lifetime transfers 7 gifts Meet liquidity needs at death Plan for children Plan for the incapacity of the transferor Provide for the needs of the transferor s surviving spouse Ful ll the transferor s charitable intentions 0 Basic documents used in estate planning 0 Wills 7 legal document that gives the testator willmaker the opportunity to control the distribution of his property at death and thus avoid his state s intestacy laws 1 Requirements 0 Must be in writing 0 Must be signed at it logical end by testator 2 Types Statutory 7 generally witnessed and attested typically includes a selfproving af davit which aids in the institution of probate proceedings when testator dies Holographic 7 handwritten by testator Nuncupative 7 oral dying declarations made before a suf cient number of witnesses in some states nuncupative will may only be effective to pass personal property not real property and the dollar amount transferred by this method may be limited in states where this will type is permitted witnesses must generally submit an af davit declaring the testator s nal wishes Page 2 Amelie Turcotte ACE 325 4 17 l l 0 Side letters of instructions 7 details the testator s Wishes regarding the disposition of speci c tangible possessions household goods as Well as ineml and burial wishes I In many states burial is required before probate can begin and the side letter of instruction gives speci c instruc1ions to the heirs 2 May contain information regarding the location of nancial information that the executor will use to administer the decedent s estate While the letter has no legal standing executor will genemlly carry out the Wishes of decedent 0 Powers of attorney for property ilegal document that authorizes a trusted person to act on one s e f 1 Grants aright to one person attomeyinfact to act in the place of the other person princip Principal must have reached the age of maj ority de ned in most states as 18 and be legally competent in order to grant the power All powers are revocable by the principal and all powers gmnted cease at the principal s death Generali essentially the geneml power of attorney gives the agent the power to do anything that the principal could do geneml power of attorney may be revoked by the principal by giving notice usually with a revocation form to the agent and is automatically revoked at the principal s death should only be given to a spouse Limited 7 gives the agent very special power of attorney may be extremely narrow only authorizing the agent to act on a speci c matter 5 N E 4 U39 Pawns otAuomey SpecialLimited Powers General Powers hold quotAnything I 41 do who exitprionquot ramtin should uul cu m spumu 1th in39 1 m P dxc puwur in re ugt ur39s gmss mum in me agent39s gm Aral m Um mm Llquot 413cm digs harm the principal o Durable powers of attorney for health care 7 legal document that appoints an agent someone with authority to act on behalf of another to make health care decisions on behalf of a principal who is unable to make those decisions for himherself Page 3 Amelie Turcotte ACE 3 250 41711 1 Note that in some states a power of attorney for health care may provide the right to withhold or end lifesustaining treatment 0 Power of appointm ent ipower to appoint the assets of one person to another and may either be general or limited sometimes included in a power of attorney 1 Generalrif the agent dies before the principal and is holding a general power of appointment over assets of the principal the agent s gross estate will include the fair market value of the principal s assets over which the agent held the power of appointment regardless ofwhether the power has been invoked 2 Limited7 the power to affect the beneficial enjoyment of property 0 According to the Internal Revenue Code apower is limited by such a stande if the extent of the holder s duty to exercise and not to exercise the power is reasonably measurable in terms of his needs for health education maintenance or support If a power of appointment is limited by an ascertainable standard then the property subject to the power will not be includible in the gross estate ofthe power holder The use of an ascertainable standard allows the principal to give the power holder the ability to appoint assets to himselfwithout creating a general power of appointment poms oprpoinuumI SpecialLimited Powers Narmn 13mm 0 x mm mm bdllyullllc pu r huldcrio 1pmme mmu valmumlnab39 2rd L umcvcx1inir 39 ucduuuor Health Eduardme Maimcnsncc dlo Support lec a k n Um pom i an agent s gm uxuu General Powers m ch ago wuss csLuu in 11 guu Jib mm um pijuupzal Power of Attorney er of Annnimmpm A standalone document that allows an agent to act for the principal and may include the power to appoint assets Power to ac Ends at the death ofthe principal May be general or limited May be revoked at any time by the principal w A power usually included in a trust or power of attorney allowing the power holder to direct assets to another Power to transfer assets May survive the death of the grantor May be general or limited May be revoked by the principal during life or at death via last will Page 4 Amelie Turcotte HACE 3250 4 l 7 l l 0 Living wills or advance medical directives 7 legal document expressing an individual s last wishes regarding sustainment of life under speci c circumstances not a will 1 Establishes the medical situations and circumstances in which the individual no longer desires lifesustaining treatment in the event he is no longer capable of making those decisions 2 Usually limited to decisions concerning administering arti cial life support treatments when there is no reasonable expectation of recovery from extreme physical or mental disability 3 Almost every state has legislation in place that disregards the living will if the patient is pregnant 4 Also used to avoid expense of sustaining life arti cially and thus to preserve assets for the decedent s heirs 0 Do not resuscitate orders 7 these documents declare the principals wish to avoid having cardiopulmonary resuscitation CPR performed in the event their heart stops beating 1 These types of orders are usually prepared once an individual has already been admitted to the hospital and is near death and are commonly used by patients with advanced cancer or kidney damage or patients suffering from signi cant ailments relating to old age 2 Generally executed on a form provided by the state and may be led with the patient s medical records 3 ONLY apply to CPR 4 Not sufficient to avoid another life sustaining treatment Types of properties 0 Real property 7 realty includes land and anything permanently attached to the land buildings trees and xtures which are permanently attached to the buildings 0 Tangible personal property 7 all property that is not realty not af xed to land or buildings and generally movable that has physical substance 0 Intangible personal property 7 not real property and is without physical substance stocks bonds patents copyrights 0 Some types of property require a state title as proof of ownership real estate car stocks bonds bank accounts retirement accounts Fee simplesole ownership 7 the complete ownership of property by one individual who possesses all ownership rights associated with the property including the right to use sell gift alienate convey or bequeath the property Page 5 Amehe Tureotte ACE 3250 41711 Owner has unfettered nght to transfer hrs ownershrp rnterest m the property dunng hfehrne grft sale or at death W111 Most eornrn o n way to oWn property rnterest today abate Esme Yes 100 unre1ated pers 0 Most eornrnon type ofjolnt ownershtp between nonspouses 0 property 0 Eaeh corowner does not own a desrgnated porhon ofthe property but rnstead owns rnterest m the enhre pro e o Transfers at death ma W111 or rntestaey laws Number of Owners 2 Q1110 Trausf freely imam the mnsem nfnther wtenams m m e y the HIVDfownershp perpennge Pankiumable 39 39esl 3911 17 orrnthnuteonsent nfjointowner orrnore re1ated or unre1atedpersons calledjomttenants o Ea pe son ho1ds an undyrded equal rnterestrn the who1e property 0 1 t t tenants outsrde ofthe probate proeess accordmgto state trthng 1aw Tenancy by the Entirety TE 7 four key eornponents 1 Page 6 Arnehe Tureotte ACE 3250 41711 spouse on dea h 4 1t rnay mvolve the ownershrp rnterest of ertherrea1 or persona1 property gth ofthe marnage and or wrfe wrshes to transfer therr share of rnterest m the property to a thrrd party through sa1e or grft both pames mustjom or eonsent m a rnutua1 transfer ofproperty nets sun1y bf Lb e Yes cransfers at death tn rtLher speuse Yes always 50 nf mv methontcmsent ufspuuse Jointmmer Cnmmunity prnp erty e eryu 1aw ongna ng statutory regrrne under whr eh rnarned rna age 0 Property aequrred before mamage or property obtarned by 9ft or rnherrtanee dunng the rnarn e retarns rts status as separate proper o y separat property 15 eo mmgled wrth eornrnunrty property rtrs often assumed to be eornrnunrty property 0 States fouowrngthrs regrrne are Cahfornra Anzona Loursrana Texas New Mexxco Nevada Idaho Washrngton and Wrseonsrn 0 states mcludmg Texas and Ca11forn1ahave a suryryorshrp opuon herrs 0 Legal proceedmg that seryes to prove the vahddty of an exxstmg W111 superyrse reeerye e1eartrt1e and proteet eredtors bymsunng that yahd debts ofthe estate e p dpnorto dstnbuuon of assets to herrs o who does notyahd1y transfer assets by wru eontraet1aw state uthng1aw or trust 1aw Page 7 Amelie Turcotte HACE 3250 4 l 7 l l o A person who dies with a valid Will is said to die testate whereas a person who dies without a valid will is said to die intestate o A person who receives property under state intestacy laws is called an heir 1 Advantages of Probate l Implements disposition objectives of testator Provides for an orderly administration of assets Provides clean title to heirs or legatees 59 Increases the chance that parties of interest have notice of proceedings and therefore a right to be heard 5 Protects creditors by insuring that debts of the decedent are paid 2 Disadvantages of Probate 1 Can be complex and excruciatingly slow 7 Delays 2 Can result in substantial monetary costs Costs 3 The process is open to public scrutiny7 Publicity 0 Property that passes outside of the probate process includes property that passes by state contract law state property titling law and state trust law 1 All of these transfers reduce the probate estate and therefore reduce probate transaction costs and may improve liquidity for the named heirs and legatees 0 Trust 7 structure that vests legal title to assets in one party the trustee who manages those assets for the benefit of others the bene ciaries of the trust 0 To form a trust a grantor of a trust transfers retitles money or other property to the trustee This money is referred to as the trust principal corpus res or fund Grantor 7 person who creates and initially funds the trust Trustee 7 individual or entity responsible for managing the trust assets and ca1rying out the directions of the grantor that are formally expressed in the trust instrument 0 Bene ciary 7 persons who holds the beneficial title to the trust assets A trust can be used to provide professional management of assets for individuals who are not suited by training or experience to manage assets for themselves If an outright transfer without using atrust of assets is made the creditors of the O recipient Qudgment creditors or otherwise will have access to those funds to satisfy outstanding obligations 0 If property is placed in a trust with appropriate spendthrift protection provisions instead of being transferred outright the creditors of the beneficiary will not be able to access the funds in the trust to satisfy outstanding creditor claims 0 Spendthrift clause 7 states that the beneficiary may not anticipate distributions from the trust and may not assign pledge hypothecate or otherwise promise to Page 8 Amelie Turcotte HACE 3250 4 l 7 l 1 give distributions from the trust to anyone and is such a promise is made it is void and may not be enforced against the trust In some states claims for spousal or child support can be obtained from a trust despite the presence of a spendthrift clause 0 Gift tax 7 excise tax on the right to transfer assets gratuitously to another person during life 0 O O O Donor 7 person who makes the gift Donee 7 person who receives the gift Gift 7 voluntary transfer for less than full consideration of property from one person to another person or entity Elements of a gift 1 Donor must have intent to make a voluntary transfer Donor must be competent to make the gift Donee must be capable of receiving the gift Donee must take delivery Donor must actually part with dominion and control over the gifted property The value of a gift for gift tax purposes is equal to the fair market value of the gifted property on the date of the gift 959 1 Real estate 7 appraisal necessary for fair market value determination 2 Publicly traded securities 7 valued at average of the high and low trading prices for the day Annual exclusion 7 all individuals may gift transfertaxfree up to 13000 2009 per donee per year to a related or unrelated party In addition to annual exclusion each person has a 1000000 lifetime applicable gift tax exclusion 0 Estate tax 7 imposed on the decedent s right to transfer property to hisher heirs O O O O Generationskipping transfer tax system taxes transfers made during life or at death to skip persons The estate tax applies to all transfers at death of property owned by the decedent or property over which the decedent had a sufficient interest to require inclusion in the gross estate Estate tax is coordinated with the gift tax by including taxable gifts at fair market value on day of gift in the estate tax calculation For US citizens and residents estate taxes are imposed on worldwide assets For nonUS citizens and nonUS residents only pay estate tax on assets located within the United States Page 9 Amelie Turcotte HACE 32 50 4 17 1 1 2011 Update for Estate Gifts and GST Tax 9 lasiale m Exemph39on a 55000000 c edit E quotalency e 507304200 i Mamum Esme Tax kale a 35 Gift Tax Exemption 7 Synaa aoa a Credit Equivalency a 330300 Mamum Gi Tax ka 7 39 uemian skipping Transfer Tax Exemption 7 55000000 e Geumhnn slapping Tax kale Flatr 35 Annual Exduslon per llouee per nbubp 513000 11 7nno 39 39 39 l 39 quot 39 a o mnm EGTRAZOOI dying in 2010 Thebasis omie property will be treated as a transfer by gi Where llie i i i ei a ban 0i equal to fair market value 2 0 17 7 r spouse 3 Up to 1300000 ofadjustments to basis is available fonlie olliei heirs 4 Imie adjusted basis is less Lhanthe fair market value underwater lieu lieie is an addiu39oual adjustment available AssetA O y I r 17 7 spouse 0 0 a llie adjustment in basis includes 0 Outright transfen39ed property and 0 Quali e terminable interest property Oveai i u i basis Page 10 Amelie Turcotte HACE 3250 32211 Chapter 10 Notes Retirement Planning accumulations and Distributions Work Life Expectancy W LE 7 the period of time a person is expected to be in the work force the period during which one saves and accumulates for retirement 0 The United States has seen substantial decline in the overall WLE in the last several years primarily due to individuals pursuing advanced education delaying entry into the workforce and those taking early retirement which hastens their exit from the workforce o 93 ofUS residents retire between ages 6265 Remaining Work Life Expectancy RWLE 7the work period that remains at a given point in time before retirement Retirement Life Expectancy RLE 7 the time period beginning at retirement and extending until death 0 Currently many retirees live as long as 20 to 40 years in retirement 0 Savings and Investment issues 0 If people were saving adequately for retirement beginning at an early age 25 to 35 they would need to save about 10 to 13 percent of their gross annual income and invest in a broad portfolio of growth investments over their work life to adequately fund the retirement goal 0 Benchmarks for Investment Assets as a Percentage of Gross Pay 25 0201 0 Investment Decisions 0 After in ation real economic returns are extremely low for xedincome securities and Treasuries and these returns are further reduced by the effects of real investment growth in an investment portfolio over a long term is to invest at least some portion of the portfolio in common stocks Common stocks also provide the best hedge against in ation the loss of purchasing power 0 When investors are young their investment portfolio should be dominated by common stocks because due to long time horizons young investors an generally afford the risk Page 1 Amelie Turcotte HACE 3250 32211 0 As investors near retirement their asset allocation generally shifts so that it becomes less risky while still maintaining some growth component to mitigate O 0 against the risk of in ation Equities are a critical component in an investor s portfolio because they provide for growth over longer time horizons The asset allocation decision has as its intent either an expected return for a given level of risk or the lowest risk for a given expected return 0 Managing Retirement Distribution The risk include taking too large of a distribution in early years either due to underestimating needs lack of discipline poor investment performance or O O unexpected and increasing in ation Three different approaches to calculating retirement distributions 4 per year approach 7 limit withdrawals from the capital accumulation to four percent per year 0 Achieves probability of not outliving retirement capital at about 90 if retirement accumulation is invested in a balanced portfolio 60 stocks and 40 fixed instruments and the withdrawal rate is approximately 4 of capital A 4 level of withdrawal initially indicates an account balance that is 25 times the income needed and implies a needed earning rate of only 1219 to pay out a 4 rate for 30 years assuming no in ation with a 4 in ation adjusted withdrawal in ation assumed at 3 would require 43 earnings rate for 30 years 0 4 withdrawal rate combined with a balanced portfolio is supported by Monte Carlo analysis Money for life approach 7 divide the capital into 6 unequal strata with each representing five years of retirement Invest each strata in varying asset classes expected to produce in ation adjusted retirement income of about 5 to 5 12 percent per year of initial capital 0 Goal of this approach is to replenish the first fiveyear increment every five years 0 Overall portfolio standard deviation of such an approach is roughly 810 Intragenerational neutrality approach 7 sometimes used by endowments that have a perpetual life This method creates a perpetual capital base that is adjusted for in ation on an annual basis 0 Smoothing model is used to determine the portion of eamings to spend each year after contributing the amount of in ation to the capital base Page 2 Amelie Turcotte HACE 3250 32211 0 This approach has more appeal if additional monies are brought into the portfolio Implicitly there is a transfer objective from generation to generation equal to in ation adjustment capital balance at the beginning of the retirement period I Retirees in general should have investment portfolios with standard deviations of 510 producing returns of 59 annually Wage Replacement Ratio W RR 7 an estimate of the percent of annual income needed during retirement compared to income earned prior to retirement 0 Calculating WRR I Top Down Approach 7 frequently used with younger clients where income and expenditure patterns are unlikely to remain constant over time It estimates the wage replacement ratio using common sense and percentages Bottom Up Budgeting Approach 7 often used with older clients because as a person nears retirement age it is possible to examine the actual current expenditure patterns of the person and to more accurately forecast the retirement expenditure patterns Planner can determine which costs preretirement will change 0 Many expert financial planners conclude that most clients need approximately 70 80 of their preretirement current income to retire and maintain their pre retirement lifestyle Personal Assets and Savings 0 The median income of those retirees with asset income is more than twice as large as the income retirees with no asset income Qualitative Factors in Retirement 7 Advising Clients 0 Qualitative factors include involuntary versus voluntary retirement emotional and psychological factors such as loss of esteem with loss of j ob and boredom in retirement and the decision to relocate or to do things that were postponed during the work life like travel or pursue another vocation Page 3 Amelie Turcotte HACE 3250 32211 Factors that Negatively Affect Retirement Planning and Their Impact on the Planning Process to meet to meet 0 Capital needs analysis ithe process of calculating the amount of investment capital needed at retirement to maintain the preretirement lifestyle and mitigate the impact of in ation during the retirement years I Uses both objective and subjective criteria to determine retirement income needs I Accurate assumptions are made for the WRR WLE RLE in ation eamings Social Security and any other bene ts I Three methods for calculating the capital needs analysis 0 Capital Needs AnalysisAnnuity Method ibasic generally prepared on pretax basis assumes the individual saves for a period of time begins taking distributions at retirement and dies at a zero accumulation balance on the projected life expectancy date 0 Steps 1 Calculate WRR in today s dollars 2 Determine gross dollar needs 3 Determine the net dollar needs reduce gross dollar needs by expected Social Security bene ts in today s dollars or other bene ts that are indexed to in ation 4 Calculate in ated preretirement dollar needs in ate net dollar needs to the retirement age at the CPI rate to determine rst annual retirement payment 5 Calculate capital needed at retirement age calculate present value at retirement of an annuity due for an Page 4 Amelie Turcotte HACE 3250 32211 annual payment equal to the calculated in ated pre retirement dollar needs over the full retirement life expectancy 9093 and use in atedadjusted eamings rate 0 Capital Preservation Model CP 7 advanced assumes that at life expectancy as estimated in the annuity model the client has exactly the same account balance as heshe started with at retirement Purchasing Power Model PP 7 assumes that the client will have a capital balance of equal purchasing power at life expectancy as he did at retirement I One of the problems with traditional capital needs analysis is that nancial planners use deterministic estimates estimate is predetermined as oppose to a probability estimate for each of the variables needs in ation portfolio returns life expectancies etc A plan that only uses deterministic assumptions is likely to produce results that may range far from the original forecast Using range estimates allows the planner to project what outcome will occur if we use range of assumptions eg 25 to 35 in ation rate for a variable as opposed to a single mean expectation 3 in ation o A range estimate approach produces multiple outcomes that allow us to gain insight into the impact of change in one variable or changes in a set of variables 0 Simulations and Monte Carlo Analysis I Monte Carlo Analysis a mathematical tool that can be used to illustrate the unpredictability of the real world and its effects on the retirement plan 0 Uses random number generator for inputs into a software package that will provide an output with specific probabilities of outcomes 0 Problems with Monte Carlo Analysis 0 Assumes normal distributions serial independence and linear relationships for investment returns none of which are true 0 Stock returns are not normally distributed 7 kurtosis is higher than expected stock returns are actually lepto kurtic meaning that they do not have a normal distribution 0 Means and standard deviations for stock returns vary over time rather than remain static 0 Many MCA ignore income tax consequences Page 5 Amelie Turcotte HACE 3250 4 06 l 1 Chapter 11 Notes Income Tax 0 The three tax systems 0 In the US there are three separate and distinct tax systems that are relevant to financial planning I Income tax system I Estate and gift tax system I Generating skipping transfer tax system 0 It is possible for one single transaction to be treated as a gift for income tax purposes and as a sale for estate and gift tax purposes 0 Three types of income 0 In the US income tax system there are three types of income I Active ordinary income 7 derived from labor and income connected with the active conduct of a trade or business 0 Subject to ordinary income tax rates which are the highest tax rates in our system Portfolio income 7 income derived from investments such as interest dividends and capital gains 0 Some types of portfolio income are subject to favorable income tax rates such as the 15 rate that applies to longterm capital gains and qualified dividends Passive income 7 income derived from dealings in real estate and from the conduct of a trade or business in which the taxpayer does not participate 0 Passive income is subject to a host of antiabuse rules and therefore constitutes a separate category of income 0 Categorization of income is important for two reasons I Different tax consequences apply to each type of income I The bucket rule limits a taxpayer s ability to write off loses in one income bucket only to the gains in that same bucket 0 As in all other areas of tax laws there are exceptions to this rule 0 Three types of tax accounting 0 There are three methods of accounting that are used for federal income tax purposes I Cash method 7 used by most individuals and small businesses income is taxed when it is received and allowable deductions are claimed when they are paid Page 1 Amelie Turcotte HACE 3250 4 06 l l I Accrual method 7 used by large businesses income is taxed when it is eamed whether or not it has been received and deductions are claimed when they are incurred whether or not they have been paid I Hybrid method 7 combination of cash and accrual methods used by some businesses to better re ect their income on their income tax returns Three key tax principles 0 O O The doctrine of constructive receipt 7 states that if income is permanently set aside in an account for the bene t of the taxpayer or if a taxpayer is given the choice to receive income now or defer it to the future that income will be taxed to the taxpayer currently even if he does not receive it until some time in the future I At the cornerstone of retirement planning and must be avoided if a taxpayer wishes to defer income and taxes into the future to fund hisher retirement The economic bene t doctrine 7 states that if the taxpayer receives economic benefit as income the value of that benefit will be subject to tax The doctrine of the fruit and the tree 7 income taxed to the person who earns it or the person who owns the asset that produced the income Three sources of tax law 0 O 0 US Constitution did not give the federal government the ability to collect tax on income At the founding of our nation there was a great deal of suspicion surrounding the new federal centralized government and the states did not want the power of the federal government to get out of hand They imposed limitations on the federal govemment s ability to impose taxes As time went on the federal government began to take on a more active governance role and a source of revenue was needed to fund the cost of these activities I Constitutional amendment would be needed to grant Congress the power to lay and collect taxes on income 163911 amendment I Two clauses are especially important 0 The power to law and collect taxes on income 0 The clause from whatever source derived Statutory 7 Congressionally derived law through legislative power provided by the 16111 amendment to Constitution Administrative I Treasury Dept 7 executive authority of law enforcement delegated to the Treasury department I Internal Revenue Services 7tax collection authority delegated by Treasury Dept to the Internal Revenue Service Page 2 Amelie Turcotte HACE 3250 4 06 l l 0 Judicial 7 authority determined if tax laws enacted by Congress and enforced by the President are constitutional Also decides whether a regulation or IRS position follows the intent of Congree 0 Interest and penalties for noncompliance 0 Failure to le 0 Failure to pay 0 Accruedrelated penalty 7 le incorrectly as a result of l a failure to make a good faith effort to comply with the tax law 2 a substantial understatement of tax liability generally more than 10 of correct tax liability and at least 5000 de ciency 3 a substantial valuation understatement or 4 a substantial estate or gift tax valuation understatement o Ifa frivolous or incomplete tax return has been led a 500 penalty may be imposed o Intentional actions constituting fraud or a willful failure to le or pay the tax liability when due 0 Ifa tax preparer tax an unrealistic position on atax return and the preparer knew or reasonably should have known of the position then the penalty is greater than 1000 or 50 of the income derived by the preparer for preparing the return 0 If the understatement is due to willful or reckless conduct the penalty is the greater of 5000 or 50 of income derived by the preparer for the return 0 Other penalties may also be assessed like failure to sign a return prepared by a tax preparer failure to provide copy of the tax return to the taxpayer failure to keep copy of the return and a client list and failure to comply with due diligence requirements when claiming the eamed income credit Failure to to 25 max to to max to 0 Tax Formulas Taxable Income Income 7 Deductions Tax Liability Taxable income X Tax rate 0 The more complete tax formula includes exclusions from income different types 0 O of deductions and tax credits In addition there are intermediate calculations such as adjusted gross income that can be important considerations in tax planning 0 Page 3 Amelie Turcotte HACE 3250 4 06 1 1 0 Form 1040EZ 7 used by single or married taxpayers ling jointly who do not have any dependents and whose taxable income is less than 100000 for 2010 I May not be used by individuals claiming head of household or married ling separately Form 1040A 7 used by taxpayers of any ling status but taxable income must be less than 100000 for 2010 must not itemize deductions and must only take certain tax credits 0 0 Form 1040 7 used by any taxpayer 0 Income 7 gross amount of money and the fair market value of property services and other accretion to wealth received but does not include borrowed money or return on invested dollars 0 Gross income 7 includes all income items that must be reported on federal income tax return and that are subject to federal income tax I Gains from the sale of asset I Distributions from retirement plans I Rental income I Unemployment compensation bene ts I Royalty income I Compensation salaries and wages etc I Interest income I Dividend income I Alimony received I Gross income from selfemployment o Exclusions 7 income items that are not subject to income tax I Interest income from municipal bonds I Child support payments received from a former spouse I Cash or property received by inheritance I Speci ed employee fringe bene ts I Qualifying distributions from a Roth IRA during retirement I Cash or property received by gift I Deferral contributions to certain retirement plans I Gain on the sale of a principal residence I Scholarship or fellowship I Life insurance proceeds received because of the death of the insured o Deductions 7 subtracted from gross income in arriving at taxable income I For individual taxpayers deductions are divided into two categories 0 Above the line deductions Deduction for before adjusted gross income 0 Alimony paid Page 4 000000 0 Amelie Turcotte HACE 3250 4 06 l 1 Contributions to traditional IRAs Tuition for higher education Interest paid on student loans Business expenses Rental or royalty income expenses Losses from the sale of business property Moving expenses Below the line deductions Deduction from after adjusted gross income 0 0 0000000000 Miscellaneous expenses that exceed 2 of AGI Charitable contributions Tax return preparation fees Home mortgage interest Unreimbursed employee expenses Investment interest expense Medical and dental expenses in excess of 75 of AGI State and local income taxes Real property taxes on home Property taxes based on the value of a car Certain investment expenses Casualty losses in excess of 10 of AGI Gross Income Exclusions Adjustments abovetheline deductions Adjusted Gross Income The greater of the Standard Deduction or Itemized deductions belowtheline Personal and dependency exemptions Taxable Income Deductions for AGI Above 0 Adjustments reduce ataxpayer s adjusted gross income 0 Most of these deductions relate to expenses for business and production of income activities but some are allowed for individuals as well IRA deductions student loan interest etc 0 Can be claimed even if taxpayer did not itemize deductions o If expense is associated with business then it is above the line Itemized deductions Below 0 Deductions that are allowed for personal expenses and losses that are not typically associated with the conduct of business or with production of income activities Page 5 Amelie Turcotte HACE 3250 4 06 l l o Itemized are sometimes more important when planning for individual taxpayer o Taxpayer may take greater of itemized deductions or standard deduction 0 To achieve bene t taxpayer will need total itemized deductions to be greater than standard deduction o In three situations taxpayer MUST take itemized deductions I A married individual who les a separate return when person s spouse uses itemized deductions Nonresident alien and dualstatus alien Individual who les tax return for less than 12 months because of change in annual accounting period 0 Above the line deductions are usually more favorable to individual taxpayers on dollarfordollar basis 0 AGI 7 gross income reduced by above the line deductions 0 Standard deduction 7 standard amount used to offset AGI that is speci ed by Congress 0 Total includes basic standard deduction depends on ling status plus additional standard deduction amounts for ages 65 or older and for the blind Status 2010 Standard 2010 Additional 0 Calculation of Standard Deduction for Dependent 0 Basic standard deduction for someone who can be claimed as a dependent by another taxpayer is determined using a threeset process I Minimum basic standard deduction is 950 I If larger the basic deduction is equal to the earned income wages salary selfemployment income or taxable scholarshipfellowships of the taxpayer plus 300 Maximum basic standard deduction is equal to the normal basic standard deduction for the taxpayer s ling status Any additional standard deductions for age or blindness are added to basic 0 Personal and dependency exemptions 0 Personal exemption 7 allowed for the taxpayer and the taxpayer s spouse on a tax return Dependency exemption 7 allowed for each person who quali es as a dependent of O the taxpayer Page 6 Amelie Turcotte HACE 3250 4 06 l l o In ationadjusted amount allowed as a deduction for each personal and dependency exemption is 3650 for 2010 0 Filing Status 0 Malried Status I Malried Filing Jointly o If they do not itemize deductions the basic standard when ling jointly is double the size of the basic standard deduction for a married taxpayer ling separately A married couple is required to le jointly in order to be eligible for certain bene ts such as the earned income credit I Malried Filing Separate o It may also be used for tax minimization purposes by permitting one spouse to deduct more of his unusually large medical expenses or employee business expenses for the tax year I Abandoned Spouse 0 The head of household status is more favorable than ling as married ling separately and when an individual cannot locate spouse and does not want to le tax with himher it may be available 0 Requirements 0 Taxpayer must be married 0 Must le a separate tax return from spouse 0 Must maintain at hisher home or household which for more than onehalf of the taxable year is the principal place of abode of a child who can be claimed as a dependent 0 Must furnish over onehalf of the cost of maintaining household 0 Spouse must not be a member of household during last six 0 Unma1ried Status months of the tax year I Surviving Spouse 0 Afford basic standard deduction and tax rates as the married ling jointly status 0 Requirements 0 O Taxpayer s spouse must have died during either of the two preceding tax years Taxpayer must maintain pay more than half the cost of a household as hisher home Which is also the principal place of residence of a dependent child Page 7 Amelie Turcotte HACE 3250 4 06 l l o Taxpayer has not rema1ried o Taxpayer and spouse were eligible to le a joint return for the spouse s year of death 0 Head of Household 0 Can be used by an unmarried taxpayer who is not a surviving spouse 0 Requirements I Taxpayer must maintain a household as hisher home which is also the principal place of residence for more than half the year for o Qualifying child of taxpayer who is claimed as dependent of taxpayer Unma1ried qualifying child who lives in taxpayer s household but is claimed as dependent of another person Qualifying relative who is I claimed as dependent of taxpayer and 2actually related to taxpayer o If married child of taxpayer lives with taxpayer but cannot be claimed as dependent either because child 1 files a joint return or 2 fails to meet a citizenship or residency test the taxpayer is not allowed to use this status 0 Special rule for mother and father of taxpayer in order to use the head of household status a qualifying child or relative mist normally live with taxpayer However a taxpayer may also qualify by maintaining a separate household for the father and mother of the taxpayer who qualifies as a taxpayer s dependents 0 m 0 Tax credit 7 when an amount if subtracted from a tax 0 FICA 7 Federal Insurance Contributions Act provides oldage survivors disability and hospital insurance Social Security tax has a wage base limit of 106800 for 2010 and 2011 and a rate of 602 to an employee and is matched by a tax of 62 paid by the employer Required Medicare tax is collected from employee at a rate of 145 of salaries and wages with a matching tax of 145 from employer Medicare is not subject to wage base Page 8 Amelie Turcotte HACE 3250 4 06 1 1 Employers who require to withhold income tax and FICA tax must le a federal return each quarter 0 FUTA 7 Federal Unemployment Tax Act exists in concert with state unemployment systems to pay unemployment compensation to employees who have become unemployed Paid by employer only and is taxed a rate of 62 in 2009 on first 7000 that an employer pays in each employee s wages state wages may differ Reported annually Credit is allowed for unemployment taxes paid to states Net FUTA rate is normally 08 o Selfemployment Tax Credits Pays income tax as well as selfemployment FICAtax 153 on hisher eamings up to wage base of 106800 for 2010 and 2011 and 29 percent beyond the wage base for Medicare Not required to pay FUTA tax on himself Can take FICA deduction for adjusted gross income on his own tax return in the amount of onehalf of his total FICA taxes paid 0 Tax credit 7 an amount that is subtracted from calculated tax Come in two forms nonrefundable and refundable o Nonrefundable credit may only apply to the current year or in some cases they may be carried back to an earlier year carried forward to future years or both Cannot generate tax refund Foreign tax credit Credit for child and dependent care Credit for the elderly or disabled Education credits 0000 I Lifetime learning I American Opportunity Tax Credit Retirement savings contribution credit Child tax credit Qualified adoption expenses credit Residential energy efficient property credit Nonbusiness alternative motor vehicle credit OOOOOO Nonbusiness alternative fuel vehicle refueling property credit 0 General business credit 0 Refundable tax credits can be used to reduce or eliminate the current year s taxes but can also generate fund Page 9 Amelie Turcotte HACE 3250 4 06 l 1 American opportunity tax credit Federal income tax withheld from forms W2 and 1099 First time homebuyers tax credit Estimated tax payments Federal income tax refunds applied from prior years Excess social security taxes withheld Earned income credit OOOOOOOO Credit for tax on undistributed capital gain from a mutual fund and or a real estate investment trust 0 Health coverage tax credit 0 Credit for excise taxes on gasoline and special funds 0 With some credits the excess can be ca1ried 0 Tax on Taxable Income 7 Nonrefundable Credits 7 Refundable Credits Tax Due 01 Refund Due 0 Federal Income tax purposes nonrefundable credits are used before refundable credits 0 Tax Credits vs Tax Refunds I The benefit received by taxpayer from a tax credit is not dependent on the taxpayer s marginal tax rate I On the other hand the tax reduction received by deduction is entirely dependent on the marginal tax rate of taxpayer Basis 7 represents capital or aftertax income that ataxpayer uses to purchase an investment 0 Uses include 1 used to determine gain or loss on an investment when it is sold 2 used to determine amount an investor has at risk which limits loss deductions for income tax purposes under the at risk and passive activity loss rules and 3 used to determine the amount an investor has at risk which limits loss deductions for income tax purposes under the at risk and passive activity loss rules 0 Cost basis 7 initial basis an investor acquires in an asset by using capital to purchase an investment I Represents the amount of aftertax dollars that the investor has dedicated to purchasing an investment I Initial basis in an investment is the cost basis for most investments 0 Items included on basis I Purchase price I Sales tax I Freight I Installation and testing costs Page 10 Amelie Turcotte HACE 3250 4 06 l l I All costs to get the asset into operations 0 Basis determination I Purchase 7 basis is price paid for asset and all other associated cost with making asset operational I Gift 7 basis is donor s basis plus any gift tax the donor has paid I Inheritance 7 basis is asset s fair market value at decedent s date of death 0 Increase in basis I If additional capital is added to investment so that investor receives all of hisher capital back income taxfree I Examples include subsequent investments in same vehicle additions to investment or changes to investment 0 Decrease in basis I When capital is removed from investment I Two most common ways are distributions from business entities that have passthrough tax treatment partnerships LLCs and S corporations and claiming depreciation deductions o Realization and recognition I Unlike ordinary income which is subject to income tax when earned gains on capital assets are subject to tax only when there has been both realization implying that the asset has been sold or exchanged and recognition when a realized gain is required to be included on taxpayer s income tax return for federal tax purposes 0 Holding periods 0 Holding period 7 can be either shortterm or longterm for asset I Longterm is greater than one year I Shortterm is less than or equal to one year 0 Property acquired by inheritanc 7 deemed to have longterm holding period regardless of when asset was acquired by decedent 0 Gift Property 7 when gifted property has a fair market value in excess of donor s basis in property on the date of the gift donee s holding period will tack on to the donor s holding period donee s holding period begins on date the donor acquired property 0 Capital Gains Tax Rates 0 Capital gains tax rate that applies to a particular transaction is a function of the holding period of the asset o Shortterm gains and losses are subject to tax at the taxpayer s ordinary marginal income tax rate 0 There is no tax benefit afforded to assets held for a shortterm holding period Page 11 O O O O Amelie Turcotte HACE 3250 4 06 l l Ifthe asset sold was held for a longterm holding period the gain or loss will be subject to longterm capital gains tax rates which are lower than taxpayer s ordinary marginal income tax rate If transaction results in gain this is a good result since the taxpayer will pay less tax on gain If transaction results in loss taxpayer will receive less of a tax bene t Maximum longterm capital gains tax rate is 15 applies for anyone in 25 or higher ordinary marginal income tax brackets 0 for taxpayers in 1015 tax bracket 0 Sale of Personal Residence O O Excludes up to 500000 for ma1ried couples lingjointly and 250000 for all other individuals of the gain from the sale of a principal residence from income tax if certain requirements are met Qualify for the exclusion of gain if I Taxpayer has owned and used home as hisher principal residence for two out of the last ve years the ownership and use test Taxpayer must not have excluded gain on the sale of a principal residence within the last two years Malried couples who want to qualify for full 500000 exclusion must also ful ll extra requirements 0 Both spouses must have used the residence for two out of the previous ve years as a principal residence use test Only one spouse must have owned the residence for two out of the previous ve years ownership test If either spouse claimed section 121 exclusion within the previous two years gain cannot be excluded from income taxation If couple is getting divorced and are ling separate returns and a principal residence is sold both spouses can exclude up to 250000 of gain from the sale if the ownership and use tests are otherwise met I Probation of the Exclusion If a principal residence is sold before the twoyear ownership and use test is met or if the exclusion was used during the last two years it may be possible to qualify for a reduced exclusion A reduced exclusion will be available when the sale of the principal residence is caused by a change of employment a change of health or an unforeseen circumstance If this applies amount is determined by the following Page 12


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