TAX PLANNING AND CONSULTING
TAX PLANNING AND CONSULTING TAX 6845
University of Central Florida
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TAX 6845 Tax Planning amp Consulting September 22 Topic Operating a business Business expenses inventory and the manufacturer s deduction updated September 14 2009 l Deductible expenses to be deductible in the current period an expense must be A ordinary normal usual or customary in the type of business run by taxpayer NOT capital in nature based on common and accepted business practice an expense need not be recurring to be deductible B necessary a prudent businessperson would incur the same expense the expense is expected to be appropriate and helpful in the business not synonymous with indispensable C reasonable in amount 9 while the Code refers solely to salary amp other compensation the Courts have expanded the scope to include all other business expenses not excessive in the speci c circumstances expenses in excess of reasonable amounts are NOT deductible the taxpayer has the burden of proof for substantiating expenses and must retain adequate records othenNise IRS can disallow any deductions especially with respect to travel meals amp entertainment business gifts and transportation car expenses n addition the expense must be incurred in connection with either a trade or business or with the production of income in one sense this is a business purpose test incurred by the taxpayer eg a father cannot deduct his son39s interest possess substance E A current deduction is not allowed for capital expenditures adds to the value or useful life ofthe property or adapts property to new or different use for most personal expenditures food clothing or hobby expenses related to the production of tax exempt income expenses contrary to public policy for expenses covered by some speci c rule political contributions related party wash sale atrisk passive loss vacation home etc Note Some deductions are speci cally allowed and hence do not have to pass all ofthe tests Examples include alimony medical and casualty losses etc Some deductions are exempt from some of criteria Thus home mortgage interest expense is not a trade or business expense and de nitely is a personal expense Similarly a swimming pool may be a capital expenditure but still can qualify as a medical expense but not necessarily all ofthe expenditure is deductible II The domestic production activities deduction DPAD Sec 199 A The DPAD was created by the American Jobs Creation Act of 2004 The DPAD replaced a number of export subsidies that were deemed by the World Trade Organization VVTO and the European community to be illegal export subsidies The battle between us and them has lasted for several decades Here is a look at how we go to the DPAD 1 First it was through the use of domestic international sales corporations DISC The DISC was able to defer the tax on foreign source income until it was repatriated to US 2 This was followed by the use of foreign sales corporations FSC V th a FSC a certain percentage of foreignsource income was exempt from taxation 3 Then it was the extraterritorial income ETI exclusion Basically a FSC under a new name The ETl was phased out over 2004 2006 Note All were intended to improve the balance of trade de cit and mitigate relatively high corporate tax rates in the US B Now certain domestic manufacturers can claim a deduction equal to 9 of qualified production activities income QPAI It is phased in as follows Years Percent 20052006 3 20072009 6 2010 9 C Some oddities about the DPAD 1 It does not require exporting or any activity outside the United States therefore it is no longer an international tax issue 2 It provides bene ts to more businesses than just those considered manufacturers For example it includes the following manufacturing activities 0 cultivating the soil 0 raising livestock 0 shing 0 mining and 0 storage handling and processing of agricultural products 3 It is a deduction based on net income from certain activities therefore it does not require an additional cash out ow its effect is similar to a tax rate reduction or tax credit see handout on web page Note It is becoming a very costly complex calculation with cumbersome recordkeeping requirements and with many unanswered questions In fact there is a reverse de minimus safe harbor rule lfa taxpayer s qualified activities are less than 5 oftheir total activities they can avoid the application of Sec 199 D The deduction is available to individuals partnerships S corporations C corporations estates and trusts For passthrough entities all of the information necessary to compute the deduction quali ed production activities income and employer s W 2 wages is passed through to the individual owners partners and shareholders as a separately stated item The individual owners must compute their DPADS separately aggregating their share of items from all pass through entities and individually owned businesses E In the end the purpose of the deduction is to preserve US manufacturing jobs and to discourage their outsourcing lll Components of the domestic production activities deduction A The quali ed production activities deduction DPAD is computed by multiplying 369 times the lesser of 1 quali ed production activities income QPAI or 2 taxable income without regard to the DPAD but adjusted for any NOL carryfonNard 3 However the DPAD is subject to an overall W 2 wage limitation 50 of employer s W 2 wages This includes only wages properly allocable to domestic production gross receipts DPGR This allocation may be made using any reasonable method There are now two safe harbor methods for computing the W 2 amount 0 V th a wageexpense method W 2 wages are multiplied by the ratio ofwage expense used to determine QPAI to the total wage expenses used to determine taxable income for the year 0 Under the small business simplified overall method W 2 wages are charged against DPGR in the same proportion as DPGR bears to total gross receipts Originally the wage limitation included all wages paid to all workers for the rst two years 20052006 Note1 The W 2 wage limit could be a problem for smaller sole proprietorships and partnerships because the ownerpartners are not considered employees Note2 For passthrough entities each partner or shareholder is treated as having W 2 wages for the tax year equal to his allocable share ofthe partnership s or S corporation s W 2 wages Note3 lfthe deduction cannot be used in the current year because ofthe taxable income or W 2 wage limitation it is lost forever B Quali ed production activities income QPAI domestic production gross receipts DPGR less allocable expenses QPAI is determined on an itemby item basis no grouping is permitted 1 domestic production gross receipts DPGR includes but is not limited to gross receipts from a lease license sale or other disposition ofqualified production property QPP that was manufactured produced grown or extracted MPGE by the taxpayer in whole or significant part within the US b qualified lms largely created in the US 0 production ofelectricity natural gas or potable water Cl construction projects real property located in the US but not selfconstruction e engineering amp architectural services for domestic construction Note1 DPGR does not include gross receipts from the sale of food and beverages prepared at a retail business services or sales between related parties ie between controlled business and af liated groups Note2 Must apportion gross receipts that qualify from those that don t qualify Must use a reasonable method that is satisfactory to the IRS For example from products produced in the US from those produced outside the US Also must apportion gross receipts for products with an embedded service component eg a product warranty training or maintenance agreement Note3 There are several de minimis safe harbortests 1 No apportionment necessary if less than 5 of total gross receipts are from nonquali ed activities 2 No apportionment necessary if embedded service element in a contract is less than 5 of the selling price 2 less allocable expenses a cost of goods sold in accordance with the general principals of Section 263A In a typical scenario this would include direct materials direct labor factory overhead and a portion of its mixed service costs b other deductions expenses and losses directly allocable to those receipts selling amp marketing expenses c a ratable portion of other deductions expenses and losses not directly allocable to those receipts general amp administrative expenses Note1 The second and third categories may be allocated by one of three methods see item V page 9 IV More on the term quali ed production property QPP that was manufactured produced grown or extracted MPGE by the taxpayer in whole or signi cant part within the USquot A Quali ed production property QPP 1 includes tangible personal property computer software and sound recordings 2 does not include land buildings other structural components of buildings or intangible property B Manufactured produced grown or extracted includes 1 activities relating to manufacturing producing growing extracting installing developing improving and creating QPP 2 making QPP out of scrap salvage orjunk material as well as from new or raw materials 3 combining or assembling two or more articles 4 cultivating soil raising livestock shing and mining minerals C By the taxpayer in whole or significant part two tests 1 a broad substantial in nature test based on all facts amp circumstances 2 a cost safe harbor taxpayer incurs conversion cost direct labor amp factory overhead gt 20 of the property s cost of goods sold 3 two categories of costs are excluded packaging repackaging labeling and minor assembly activities will probably be subject of controversy design amp development costs associated with the creation or licensing of intangible property with respect to the production of tangible QPP the manufactured product must be broken down into its tangible amp intangible portion components V Three methods are speci ed to allocate amp apportion direct amp indirect costs A The Sec 861 Regulations 1 may be used by all taxpayers but must be used by taxpayers with average annual gross receipts gt 100M 2 timeconsuming mechanical and accurate rules used by US taxpayers to allocate amp apportion income between foreign sources amp domestic sources 3 will now be used to allocate amp apportion income between qualified amp nonquali ed production activities will require signi cant work for entities without international operations B Simpli ed deduction method 1 for taxpayers with average annual gross receipts over the three prior years lt 1 00M or total assets at the end of the taxable year lt 10M 2 most deductions are apportioned to DPGR in the same proportions as DPGR bears to total gross receipts exception cost of goods sold C Smallbusiness simpli ed overall method 1 for taxpayers with average annual gross receipts over the three prior years lt 5M 2 all deductions including cost of goods sold are apportioned to DPGR in the same proportions as DPGR bears to total gross receipts Note Government officials believe more that 99 of C corporations will qualify as small taxpayers D QPAI is computed as follows Domestic production gross receipts DPGR Cost of goods sold CGS Direct costs Allocable indirect costs Quali ed production activities income QPAI Vl Tax planning opportunities A Identify what activities qualify for the DPAD B Put in place processes for gathering the data to calculate QPAI C Develop methods for data analysis D Accumulate appropriate information to substantiate amount deducted Vll Inventories in general A Manufacturing amp merchandising companies are required to use the accrual method for purchases amp sales of goods B The method used 1 must conform to generally accepted accounting principles from similar businesses amp must be considered the best practice for the industry and 2 must clearly re ect income C Once adopted the method cannot normally be changed without approval consent ofthe IRS D ltems included in inventory 1 merchandise 2 raw materials 3 work in process 4 nished products 5 supplies that physically become part of the item intended for sale Note The Uniform Capitalization Rules UNICAP Sec 263A de ne what amounts must be included in inventory and what amounts must be capitalized in the cost of longterm contracts However the UNICAP rules 0 Do not apply to merchandising businesses if gross receipts for the preceding three years do not exceed lt 10M 0 There are no size exceptions for manufacturing businesses E Valuing inventory four methods 1 speci c identi cation method 2 rstin rstout method FIFO two methods 0 cost method 0 Iowerofcostormarket method 3 lastin rstout LIFO if LIFO is adopted fortax purposes it must be used for nancial reporting purposes Sec 472c the LIFO conformity rule Note Internationally there is little support for LIFO If LIFO was eliminated in the US the revenue pickup from the LIFO reserves is estimated to be 100 billion 4 retail method VIII Cost method A For merchandising companies cost includes 1 invoice price 2 minus trade discount based on volume or quantity purchases 3 plus transportation and other handling charges 4 plus offsite storage warehousing purchasing salary of purchasing agent and handling processing assembling and repackaging cost must be included in inventory but only if average gross receipts during the previous three years exceed 10 million Note1 The items in 4 are capitalized and allocated between inventory and cost of goods sold because ofthe uniform capitalization rules UNICAP rules of Sec 263A These amounts are expensed under GAAP creating another booktax difference Note2 Any cash discount may be deducted from inventory cost or included in gross income but it must be treated in the same manner from yearto year B Sec 263A For manufacturing companies and for measuring longterm contracts cost includes all direct amp indirect costs that have to be capitalized under the UNICAP rules Previously many businesses included only factory overhead costs in inventory omitting service costs such as personnel purchasing payroll legal departments and data processing Now such costs must be included in inventory to the extent they are associated with production 1 Direct costs required to be capitalized l direct labor direct materials lndirect costs required to be capitalized indirect labor costs of cers compensation pension and other related cost employee bene t expenses indirect material costs purchasing costs handling costs storage costs cost recovery allowances on equipment including depreciation and amortization depletion rent taxes insurance utilities repairs and maintenance engineering and design costs spoilage tools and equipment quality control costs bidding costs licensing and franchise costs interest capitalizable service costs A selling and distribution costs research and experimental expenditures Sec 179 costs expensing election Sec 165 costs capital losses and CampT losses Indirect costs not required to be capitalized cost recovery allowances on temporarily idle equipment and facilities taxes assessed on the basis of income strike expenses warranty and product liability costs onsite storage costs unsuccessful bidding expenses deductible service costs C Comparison between GAAP and tax Capitalization period of direct and indirect costs Method PreProduction Production 0232 Sale Costs to be Expensed Costs to be Capitalized Costs to be Expensed Expensed Selling Costs Design Costs Due matenals Storage Distribution Costs Full Absorption Direct Labor Bidding Expense Handling Income Taxes ie GAAP Purchasin Direct Production Costs Warrant Costs 9 Indirect Production Costs1 y Method PreProduction Production 0232 Sale Costs to be Capitalized Costs to be Capitalized Costs to be Expensed Capitalzed Selling Costs Design Costs Due matenals Storage Distribution Costs UNICAP Biddin Ex ense DlreCt Labor Handlin Income Taxes 263A 9 P Direct Production Costs 9 Purchasmg Indirect Production Costs1 Warranty Costs Note1 Bottom line an expanded list of overhead costs are included in inventory under the tax code s UNICAP rules compared to GAAP D Depreciation and interest 1 When determining the amount to include in inventory tax depreciation not nancial depreciation is used 2 Interest must be included in inventory in the case of property with either a long production period or a long useful life A long production period is 2 years or longer one year or longer in the case of property costing more than 1 million Property has a long useful life ifit is real estate or if the class life is 20 years or longer E Allocation of indirect costs to ending inventory under Sec 263A using the preferred direct to total labor hours burden rate method under Regulation 1 263A1f3i See Sec 263A worksheet on web page E There is also a simpli ed method These additional costs may be allocated to inventory in a manner similar to an overhead application rate For example if these costs are equal to 20 of other manufacturing costs then the inventory value can simply be increased by 20 In the case of LIFO users the adjustment is made only to the current LIFO layer which means no addition is made in years when the ending inventory is lower than the beginning inventory IX Lowerof costormarket method A Compare the market value replacement cost of each item on hand on the inventory date with its cost and use the lower value as its inventory value This method applies to the following 1 goods purchased and on hand 2 the basic elements of cost direct materials direct labor and an allocable share of indirect costs of goods being manufactured and nished goods on hand B Market value replacement cost the usual bid price on the date of inventory based on the volume of merchandise you usually buy it is not selling price C FortaX purposes the LCM method must be applied to each separate inventory item GAAP allows an aggregate or group approach D Cannot be used in conjunction with the LIFO inventory E Obsolete or other slow moving inventory cannot be written down below replacement cost unless based on the Thor Power Tool case 1 the selling price is also reduced or 2 the inventory is destroyed or othenNise disposed of X LIFO pools or dollarvalue LIFO A Two problems with LIFO 1 recordkeeping under LIFO can often be cumbersome even with computer software amp bar codes most systems track units and sales revenue not old base layer costs The method is applied to individual units of inventory 2 LIFO liquidation may occur ifthe number of units on hand decreases during the year The oldoutof date costs imbedded in the existing LIFO layers often referred to as LIFO reserves are charged to cost of goods sold in the current period and the paper pro ts deferred from prior years are recognized in the current period and the related tax is due B The solution Dollarvalue LIFO inventory pools DVL 1 DVL keeps track of inventories by grouping inventory units into pools based on the same cost change pressures not necessarily physical similarity 2 tax requires you to have more than one pool 3 inventory is viewed as a quantity ofvalue instead ofa physical quantity ofgoods 4 the focus is on inventory value not inventory units 5 the new replacement units must be substantially identical to the units sold 6 price indices either a government index or an internally generated index are used to determine if any increasedecrease in inventory is due to a an increasedecrease in the quantity ofinventory or b an increasedecrease in prices C The mechanics of doarvalue LIFO inventory 1 Step 1 Determine the current year s ending inventory at yearend cost 2 Step 2 Convert ending inventory valued at yearend cost to base year cost ending inventory at yearend cost X base year cost index from step 1 current year cost index This re ects ending inventory de ated to base year cost 3 Step 3 Identify the layers of ending inventory and the years the layers were created Compare ending inventory de ated to base year cost with beginning inventory in baseyear dollars to determine whether the inventory quantity increased or decreased during the year 4 Step 4 Convert each layer s baseyear cost to layeryear cost using the cost index for the year it was acquired Multiply each layer by cost index when layer added base year cost index D Tax requires more than one pool Many companies use two pools Exception taxpayers with average annual gross receipts lt 2M may use the simpli ed LIFO method or one pool XI The retail inventory method A The retail inventory method is used by many highvolume retailers selling many different items at low unit prices B It can be used for both GAAP and tax purposes C It does not require a physical count ofinventory D The mechanics of the retail inventory method 1 Step1 compute ending inventory at retail cost of goods available at retail less sales at retail 2 Step 2 convert ending inventory at retail to ending inventory at cost using the current costtoretail percentage the markup percentage 3 the current costtoretail percentage is based on beginning inventory purchases goods available for sale TAX 6845 Tax Planning amp Consulting September 8 Topic Investment issues amp the loss limiters updated August 13 2009 I Abusive tax shelters vs legitimate investment opportunities A What is an abusive tax shelter 1 Abusive tax shelters are transactions promoted with the promise oftax bene ts with no meaningful change in a taxpayer s income or assets 2 These transactions typically have no economic purpose other than reducing taxes with predictable tax losses or tax consequences 3 Most abusive tax shelters involve the use of multiple layers of domestic and foreign passthrough entities such as trusts partnerships s corporations and limited liability companies B Abusive tax schemes became increasingly popular in the 1990 s among both individuals and businesses because 1 The penalties associated with participating in abusive tax schemes were too small to have a deterrent affect 2 Promoters increased the marketing ofabusive tax schemes as legally defensible ways to minimize tax burdens 3 There was no ef cient disclosure and reporting system for abusive tax schemes C What did the IRS do to combat abusive tax shelters and transactions 1 The IRS maintains a list of certain tax avoidance transactions that are considered abusive 2 Taxpayers are required to disclose their participation in these listed transactions 3 Material advisors promoters must register the transactions with the IRS and they must maintain investor lists and provide the list to the IRS upon request ll Current efforts to further combat the abusive tax shelter problem A After years of failed attempts Congress is trying to raise the legal hurdle that determines whether a tax shelter is legitimate or abusive Their efforts are aimed at reining in questionable tax shelters that have deprived the government of hundreds of billions of dollars in tax revenues in recent years B The hurdle in question is the doctrine of economic substance The economic substance doctrine holds that a transaction must have genuine economic substance as well as a legitimate business purpose other than tax savings in orderto reap a legitimate tax bene t C In other words ifa tax shelter does fancy footwork to follow or appear to follow the letter of the tax code but violates its spirit by existing mainly to generate tax deductions then it is an abusive tax shelter in the eyes of the Internal Revenue Service D Opposing viewpoints 1 Senate and House proponents argue that making the doctrine into a law ratherthan keeping it a common sense principle and leaving its interpretation up to the courts will make it easier to crack down on abusive tax shelters l Critics argue that the doctrine has worked well enough as it is as evidenced by a string of highpro le IRS victories in tax and federal courts Codifying the doctrine into law creates rigidity that will cause promoters to look to the words and letters rather than underlying substance of the transaction Tax lawyers have no limits in their imagination and once there s a rigid statement of itquot they will seek ways to get around it and there will be a way to get around it Note The move to write the economic substance doctrine into law is not supported by the IRS and the Treasury Department lll Why were the passive activity limits and the at risk rules added to the tax code A A brief history of the tax shelter problem prevalent in the 1970 s and early 1980 s Abusive tax shelters allowed taxpayers to invest in activities that generated huge losses tax deductions and credits without the taxpayer participating in the activity How 1 Two sources of capital a lnvestors some money was invested by taxpayers b Creditors most of the money was raised through nonrecourse borrowings A type of loan that is secured by collateral which is usually the property being acquired lfthe borrower defaults the creditor recovers the collateral but cannot seek out the borrower for any further repayment even ifthe collateral does not cover the full value of the defaulted amount the borrower does not have personal liability for the loan 2 Operations a The activity generated large losses in the early years much from accelerated depreciation amp depletion deductions and other tax elections b Most were organized as limited partnerships with the taxpayersinvestors as the limited partners with limited liability 3 Tax treatment a In the early years the entity usually a limited partnership although some elected Scorporation status produced large ordinary losses that were then passed thru to the investors Taxpayers could use these losses to offset other types of income salary interest and dividends and other businesses b In fact the promoters often promised multiple writeoffs for your investment in the first few years c lfthe activity was successful the subsequent sale of the investment often resulted in a recognized gain subject to favorable longterm capital gain rates 4 Why were these types of investments attractive to highly successful taxpayers a From 19651980 individual taxpayers faced a top marginal tax rate of 70 on portfolio earnings a top marginal tax rate of 50 on earned income and a longterm capital gains rate of 28 technically the tax law excluded 60 of longterm capital gains from tax therefore 40 x 70 28 b The atrisk limits and the passive activity limits did not exist 0 Savings and loan associations were still making nonrecourse loans to fund these types ofentities limited partnership and s corporations based on in ated asset prices Eventually this lead to the SampL crisis ofthe 1980s and 1990s which cost US taxpayers an estimated 160 billion Note See the link to Historical highest marginal income tax rates on my web page B Congress enacted a twostep solution to the abusive tax shelter problem 1 The atrisk limitations enacted in 1976 limit a taxpayer s ability to deduct losses to the amount they could lose ifthe business failed the amount that they are economically invested in the business a an investor s at risk amount uctuates over time b the amount at risk their investment in the business any amounts borrowed that the taxpayer is personally liable recourse loans income loss from the activity 2 The passive activity limits enacted in 1986 limit a taxpayer s ability to deduct losses from passive activities against income from nonpassive sources such as salary active income interest and dividends portfolio income a The passive activity rules separate income and losses into three buckets according to their source active income portfolio income and passive income b Tax treatment in general passive losses may only offset income from other passive activities passive losses may not offset active income or portfolio income 3 Today the atrisk limits and the passive loss limits work together to limit defer loss deductions a passive loss rules are applied after application ofthe atrisk rules b a loss that is allowed under the atrisk rules may be suspended under the passive loss rules IV More on the atrisk limitations A The amount atrisk in a partnership adjusted basis minus nonrecourse debt Recall the partner s adjusted basis in the partnership interest is computed as follows cash and adjusted basis of property contributed to the partnership increased by subsequent investments partner s share of any increase in partnership debts both recourse amp nonrecourse partner s share of taxable or nontaxable income and gains ordinary partnership income and separately stated items decreased by distributions amp withdrawals partner s share of any decrease in partnership debts both recourse amp nonrecourse partner s share of deductions nondeductible expenses and losses ordinary partnership loss and separately stated items B The amount atrisk in an Scorporation adjusted basis plus loans from the corporation to the shareholder Recall the shareholder s adjusted basis in the Scorporation stock is computed as follows cash and adjusted basis of property contributed to the partnership increased by subsequent investments shareholder s share of taxable or nontaxable income and gains ordinary Scorporation income and separately stated items decreased by distributions amp withdrawals shareholder s share of deductions nondeductible expenses and losses Note For both partnerships and Scorporations the atrisk amount can t be negative C Disallowed loss are suspended and carried forward for an unlimited period Suspended losses can be deducted in future tax years to the extent that the taxpayer restores their atrisk amount In general the taxpayer has three ways to restore their atrisk amount 1 the partnership or scorporation reports taxable or nontaxable income and gains ie the entity becomes profitable 2 the partner or shareholder makes an additional investment 3 the partnership borrows money on a recourse basis D The disposal ofan investment in a taxable transaction usually triggers the deduction of all suspended losses Why Because debt relief from the nonrecourse debt is added to the amount realized to compute the realized gain E Quali ed nonrecourse financing QNRF an exception to the general rule A taxpayer is considered at risk for qualified mrecourse nancing QNRF de ned is nancing for which no one is personally liable for repayments and that is borrowed by you in connection with the activity of holding real property secured by the real property used in the activity not convertible from a debt obligation to an ownership interest and loaned or guaranteed by any federal state or local government or borrowed by you from a quali ed person a person who actively and regularly engages in the borrowing of money Le a bank V More on the passive activity limits A The passive loss rules separate income and losses into three buckets active income portfolio income and passive income 1 Active income includes wages salaries bonuses exchanged for services rendered pro tloss from an active trade or business in which the taxpayer is a material participant 2 Portfolio investment income includes dividends interest annuities royalties not derived from a trade or business gainslosses from the sale of investment property 3 Passive income pro tloss from tradebusiness or investment activity in which taxpayer is NOT a material participant most rental activities See also the information on the two real estate exceptions B Passive losses may only offset income from passive activities C Passive losses cannot offset income from active or portfolio activities D Excess passive loss is suspended carried fonNard if more than one activity generates a passive loss the suspended loss must be allocated between the activities loss from activityXsum of losses from all activitiesxy reporting losses loss from activityysum of losses from all activitiesxy reporting losses E Suspended losses are carried forward to subsequent years the carryover is unlimited in amount and duration 1 The suspended loss is used to offset future passive activity income 2 Any remaining suspended loss is deducted when you dispose ofyour entire interest in the activity in a taxable transaction to an unrelated entity the suspended loss is used to offset in order a any gain on the sale of the passive activity b other passive income from other sources for the current year c and nally any active or portfolio income for the current year F The passive loss rules apply to 1 individual taxpayers 2 passthrough entities at the owner level a partners not the partnership b shareholders not the S Corporation 3 personal service corporations PSC PSC de ned a its principal activity is performing personal services1 b its employeeowners substantially perform the services c its employeeowners own more than 10 of the fair market value of its outstanding stock Note1 Personal services include any activity performed in the elds of accounting actuarial science architecture consulting engineering health including veterinary services law and the performing arts 4 closely held Ccorporations de ned more than 50 ofthe value of the outstanding stock is owned by not more than 5 individuals 5 estates and trusts other than grantor trusts G The labels passive or active are based on a set of materia participation tests Some look at current levels of participation while others look at prior participation Material participation means that the owner is involved in the business on a regular continuous and substantial basis in operations A taxpayer can have a signi cant nancial interest in a business and yet not materially participate Vl Identifying passive activities what is material participation in an activity A Passive activities defined Any trade or business or incomeproducing activity in which the taxpayer does not materially participate Note Rental activities are generally passive whether or not the taxpayer materially participates By de nition limited partners in a limited partnership are passive Working interests in oil and gas activities are exempt from the passive loss limitations B Material participation is a year by year determination Consequently it is conceivable that a taxpayer could be passive in one year and nonpassive in other words materially participating in the subsequent year C The taxpayer must consider two elements 1 What is an activity lfthe taxpayer is involved in multiple related businesses they must rst consider the appropriate grouping of the activities The taxpayer must determine the appropriate economic unit based on all ofthe relevant facts and circumstances The grouping must be applied in a reasonable and consistent manner Factors to consider include a similaritiesdifferences in types oftradebusiness b extent of common controlownership c the geographical location d interdependency among activities Note An activity is not constrained by entity lines It is also possible that several different activities may exist within a single entity or two unrelated businesses Note Rental activities may not be grouped with other activities unless one is insubstantial Tax planning opportunity By grouping related businesses as a single activity the taxpayer can more easily meet the hour tests for material participation discussed on the next page 2 What is material participation The taxpayer materially participates if and only if he or she meets one of the following seven tests provided in Treasury Reg 14695Ta a The taxpayer works 500 hours or more during the year in the activity b The taxpayer does substantially all the work in the activity 0 The taxpayer works more than 100 hours in the activity during the year w no one else works more than the taxpayer d The activity is a signi cant participation activity SPA and the sum of SPAs in which the taxpayer works 100500 hours exceeds 500 hours for the year f The taxpayer materially participated in the activity in any 5 of the prior 10 years g The activity is a personal service activity and the taxpayer materially participated in that activity in any 3 prior years h Based on all of the facts and circumstances the taxpayer participates in the activity on a regular continuous and substantial basis during such year However this test only applies if the taxpayer works at least 100 hours in the activity no one else works more hours than the taxpayer in the activity and no one else receives compensation for managing the activity Note The rst four tests look to a set number of hours of participation in the current tax year The next two tests look to material participation in prior tax years The nal test looks to the facts and circumstances but is highly restrictive Note Participation of spouse counts even if your spouse did not own any interest in the activity and you do not le a joint return D Some indicators that the taxpayer did not materially participate in the activity 1 l O The taxpayer was not compensated for services Most individuals do not work signi cant hours without expecting wage or commissions The taxpayer39s residence is hundreds of miles from the activity The taxpayer has a W 2 wage job requiring 40 hours a week for which he or she receives signi cant compensation The taxpayer has numerous other investments rentals business activities or hobbies that absorb signi cant amounts oftime There is paid onsite managementforemansupervisor andor employees who provide daytoday oversight and care ofthe operations The taxpayer is elderly or has health issues The majority of the hours claimed are for work that does not materially impact operations Business operations would continue uninterrupted if the taxpayer did not perform the services claimed Vll Exceptions to the passive loss limitations for rental real estate activities A A rental activity is any activity where payments are received principally for the use oftangible real or personal property B In general rental activities are automatically treated as passive activities even if the taxpayer would meet the material participation tests C The passive loss rules contain two exceptions related to real estate 1 real estate professionals may qualify for nonpassive treatment under a slightly different set of material participation rules 2 small landlords may deduct up to 25000 of losses from rental activities against active or portfolio income D To qualify for the real estate professional exception the taxpayer must satisfy both ofthe following requirements 1 more than half ofthe personal services that the taxpayer performs are performed in a real estate trade or business in which the taxpayer materially participates 2 taxpayer performs more than 750 hours of services in these real property trades or businesses as a material participant Note If both conditions are met the rental real estate activity is treated as an active trade or business and the loss is fully deductible against other income Note What is a real estate trade or business A real estate trade or business is de ned as ANY real estate development redevelopment construction reconstruction acquisition conversion rental operation management leasing or brokerage trade or business E To qualify for the 25000 small landlord exception the taxpayer must 1 3 actively participate in the real estate rental activity a slightly less rigorous test active participation requires participation in making management decisions in a signi cant and bona de sense own 10 percent or more in value of all interests in the activity during the entire taxable year or shorter period during which the taxpayer held an interest in the activity limits on the deduction the potential 25000 deduction against active or portfolio income is reduced by 50 of the amount by which the taxpayer s modi ed AGI exceeds 100000 so if modified AGI gt 150000 no small landlord loss is allowed for the year if there isn t any nonpassive income to offset the 25000 allowance the othenNise allowable rental real estate losses will give rise to a net operating loss NOL that may be carried fonNard and back in accordance with the NOL rules F More on modi ed adjusted gross income MAGI for computing the small landlord exception MAGI equals adjusted gross income AGI without any passive loss or passive income or any rental losses IRA taxable social security or onehalf of selfemployment tax exclusion under Sec 137 for adoption expenses student loan interest exclusion for income from US savings bonds used to pay higher education tuition and fees qualified tuition expenses tax years 2002 and later tuition and fees deduction any overall loss from a PTP publicly traded partnership G Minimum level of rental activity The activity is not a rental activity ifthe rental activity is incidental to a nonrental activity there is a materiality threshold The rental of property is incidental to an activity of holding property for investment if the main purpose of holding the property is to realize a gain from its appreciation and the gross rental income from the property is less than 2 ofthe smaller of the property s unadjusted basis or fair market value The unadjusted basis of property is its cost not reduced by depreciation or any other basis adjustment H Tax credit vs tax deduction the 25000 offset amount is actually an aggregate of both tax deductions amp tax credits in equivalent amounts The deduction equivalent ofa passive activity credit is the amount of deduction that reduces the tax liability by an amount equal to the credit Example Taxpayer has a 5000 tax credit associated with a passive activity and is in the 25 marginal tax rate The taxpayer would be entitled to a deduction equivalent of 20000 500025 VIII Investment interest expense limitation the amount of investment interest expense is limited to the amount of net investmentincome earned during the year A Net investment income the limiter Investment income includes gross income from property held for investment such as interest dividends annuities and royalties Quali ed dividends if the taxpayer elects to have the dividends taxed at their regular marginal tax rate Net longterm capital gains ifthe taxpayer elects to have their LTCG taxed at their regular marginal tax rate Investmentrelated expenses other then investment interest expense after applying the 2 oor that applies to miscellaneous itemized deductions B The disallowed amount of investment interest expense is suspended and is carried fonNard to offset future net investment income C Tax planning opportunity the taxpayer can elect to have all or part of their qualified dividends andor longterm capital gain included in net investment income 1 The taxpayer must reduce the amount ofquali ed dividends eligible for the lower capital gains tax rate by the same amount I The taxpayer must reduce the amount ofthe longterm capital gain eligible forthe lower capital gains tax rate by the same amount A The taxpayer must consider the tradeoff between the additional current year interest deduction vs the additional taxes paid on the qualified dividendsLTCG at the higher marginal rate and the timing of the carry fonNard The big question iswhen does the taxpayer expect to deduct the suspended investment interest expense A Once made the election for the current year can only be revoked with IRS consent IX Rental activities and vacation homes A Vacation homes or a taxpayer s second home may have both personal and pro tmotivated attributes B Sec 280A may disallow or limit deductions for expenses related to the rental ofa vacation home that is also used as a residence by the taxpayer The objective of Sec 280A is to prevent a taxpayer from 1 deducting othenNise nondeductible personal expenses and 2 claiming a rental loss on Schedule E a FOR AGI deduction C A vacation or second home can be classified one ofthree ways in the tax code 1 a residence 2 rental property or 3 a combination of the two 1 Taxpayer s residence it has only minimal rental use a it is rented for less than 15 days per year b all rental income is excluded from income 0 no rental expenses may be deducted d Some personaluse expenses mortgage interest and property taxes may still be deductible as itemized deductions Schedule A 2 Rental property it has minimal personal use a it is not used by the taxpayer for personal use for more than the greater of 14 days 10 of the total days rented at fair rental value b all expenses must be allocated between personal use and rental use the rental portion total expense x rental days rental days personal days 0 The Sec 280A rules and limitations do not apply d If a net loss results rental expenses gt rent income then the loss may be deductible subject to the passive loss rules e The remaining personaluse expenses are not deductible except for property taxes which may be deducted as an itemized deduction The mortgage interest related to personaluse days becomes nondeductible personal interest similar to interest paid on credit cards and car loans 3 mixed personalrental use a used by the taxpayer for personal use for more than the greater of 14 days 10 ofthe total days rented at fair rental b all expenses must be allocated between personal use and rental use the rental portion total expense x rental da s rental days personal days 0 Rental expenses are deductible to the extent of rent income a net loss is not deductible in current year disallowed portion is carried fonNard d The remaining personaluse expenses mortgage interest and property taxes may still be deductible as itemized deductions Schedule A e Ordering of deductions o categom expenses that may be deducted even if not incurred in a trade or business mortgage interest and property taxes 0 categom 2 businessrelated expenses that do not reduce the tax basis of an asset repairs amp maintenance insurance advertising utilities etc o categom 3 businessrelated expense that reduce the tax basis ofan asset depreciation Note Even ifyou have strong positive cash flow from your rental real estate chances are you still have a loss for tax purposes due to the depreciation deduction f Tax planning opportunity the IRS and some Courts disagree on how mortgage interest and property taxes should be allocated the lRS s position taxpayer must use the total number of days used in the denominator rental days personal days some Courts position use 365 in the denominator for mortgage interest and property taxes tier 1 expenses This method allocates less interest and property taxes to the rental use allowing more of the other expenses from tiers 2 and 3 to be deducted against the rental income See Sec 280Ae amp Bolton case handout on my web page Summary of major loss quot Listed below are three rules intended to prevent taxpayers from investing in quottax sheltersquot designed to generate losses that offset other Income Investment Interest Limitation AtRisk Rule Passive Loss Limitation Purpose The investment interest expense The atrisk rule prevents taxpayers The passive loss limitation limitation prevents taxpayers from deducting depreciation prevents taxpayers from from using interest deductions to amortization depletion and other deducting losses from activities offset current ordinary income expenses that do not require that involve limited amounts of from activities other than the current cash flow in situations personal participation investments where basis is generated by loans for which that taxpayer is not personally liable ie most nonrecourse debt What is limited The 39 39 quot for39 39 quot for 39 39 quot and Net passive loss cannot be interest expense is limited to net investment income Investment income includes taxable interest income Longterm capital gains and qualified dividend income are included if taxed at the taxpayer s marginal rate an election made by the taxpayer amortization are limited to basis of investment reduced by nonrecourse debt and any net income generated from the activity offset against other income until investment is sold An exception permits investors to deduct up to 25000 of losses from rental real estate if MAGI is 100000 or less If MAGI exceeds 100000 the 25000 limitation is reduced by 1 for each 2 of excess MAGI Order of application Investment interest deduction is exempt from the L if the PLL applies Applies before AR Applied before PLL after llL Applied after AR Covered activities Portfolio investments and quotpure All activities Passive activities investmentsquot Aggregate or per Aggregate Each activity Aggregate activity limitation Carryover Indefinite Must offset against future investment income Indefinite Can deduct as amount atrisk increases Indefinite Offset against future passive income orfinally upon sale of 39 Applicable to credits No Yes Yes TAX 6845 Tax Planning and Consulting Case Part 8 Tax sheltered investments due date December 1 2009 Steve and Julie sold a portion of their BHN stock for 1200000 early in 2009 The stock was acquired under a company stock option plan This sale resulted in a 500000 gain onehalf of which will be treated as longterm capital gain and onehalfwill be treated as ordinary income This type of gain can occur with stock acquired via employee stock options Their salaries total 150000 but they plan to retire in a few years They enter your of ce with the check for 1200000 and ask you what they should do with the money You resist the urge to lecture them on the tax problems that they have created In an attempt to reduce the problem you investigate various possibilities and arrive at the following options 1 Invest in a residential duplex Cost is 200000 land 40000 building 160000 Rental revenue is expected to be 22000 per year and cash expenses other than interest are expected to average 10000 per year Other similar properties are available Appreciation is expected to be 5 per year 2 Invest in a residential duplex that quali es as lowincome housing Cost is 200000 land 40000 building 160000 Rental income is expected to be 10000 per year and cash expenses other than interest are expected to average 10000 per year Appreciation is expected to be 3 and the lowincome credit is expected to be 8000 per year 3 Invest 100000 in an oilproducing property Steve and Julie can invest in any amount they want in a quotprovenquot area That is there is almost no chance they will end up with a dry hole A typical investment would include Exploration costs 0 Lease acquisition costs 50000 Intangible drilling costs lDCs 50000 Annual production costs 20000 Gross revenue from sale of oil per year for ve years beginning in 2010 50000 4 Invest 600000 in stocks and bonds Available stocks and bonds are listed below Bond B is tax exempt Dividend or Growth Interest Rate Rate Stock A 3 2 Stock B 1 6 Bond A 8 0 Bond B 5 0 Steve and Julie39s living expenses total 160000 per year including 20000 of mortgage interest and property taxes 12000 of state and local taxes and 8000 of charitable contributions In addition to the 12 million proceeds from the sale Steve and Julie will borrow 100000 with interest payable annually at 8 The amount borrowed would be repaid in 10 equal annual installments Assume Steve and Julie purchase one residential duplex one lowincome housing unit and that they invest in one oil amp gas property with just the drilling taking place this year Finally assume 600000 cash is invested in stocks and bonds ofyour choice All investments are completed by the end of January 2009 Note This will also leave Steve and Julie holding some cash in orderto remain liquid Steve and Julie will have 9000 of interest income and 21000 of quali ed dividend income from other investments each year in addition to the income from investing the additional 600000 Their current portfolio is worth 700000 and its value is expected to remain stable Required 1 Explain to Steve and Julie the short and longrun advantages and disadvantages risks and benefits of investments 1 4 2 Determine the impact ofthe hypothetical investment portfolio on the Stumbergs current tax liability 2009 and estimated future tax liabilities 2010 and 2011 Note lgnore AMT 3 Prepare a cash flow projection and a balance sheet to estimate their net worth for the periods ending December 31 2009 2010 and 2011 TAX 6845 Tax Planning and Consulting Case Part 5 Employee compensation 20 points due date October 27 2009 Black Hammock Nursery is continuing to grow and now employs several thousand workers The corporation is in the process of reviewing its employee fringe bene t package The company is concerned that fringe bene ts are becoming too expensive and they want you to review bene ts from scratch They currently offer health insurance groupterm life insurance a exible spending account and a de ned contribution retirement plan For purposes of simplicity you may base your computations on two employees only They are Steve Stumberg and Joe Worker Steve is a key employee while Joe is typical of many other workers Employee BNH Joe Steve Corporation Current age 35 55 Current salary 40000 225000 Current tax rates ordinary income 15 33 35 capital gains 0 15 Groupterm life insurance 20000 200000 Retirement tax rates ordinary income 15 33 Rate of return 10 forthe retirement plan low risk 4 4 moderate risk 8 6 high risk 11 10 Years to retirement 30 10 Obviously this may require you to make several additional assumptions However given that many different forms of fringe bene ts and providers are out there it is not unrealistic to begin a process with limited information The company pays 3000 per employee for health insurance coverage The company allows an employee to establish a exible spending account FSA through a salary reduction agreement to pay for quali ed medical expenses Groupterm life insurance rates vary based on the age of employees Joe s premiums are 200 per year per 1000 of coverage and he has 20000 of coverage Steve s premiums are 500 per year per 1000 of coverage and he has 200000 of coverage This year the company contributes 5 of each employee39s salary to a de ned contribution retirement plan Required Calculate the costbenefit ratio if any for Joe and for Steve for each ofthe following fringe bene ts 1 BHN pays each employee a 1000 cash bonus 2 BHN pays the 3000 premium for each employee s health insurance coverage employees perceive bene t to be 3000 3 BHN allows employees to contribute 2500 oftheir salary to a exible spending account employees perceive bene t to be 2500 4 BHN pays for employee s life insurance coverage prepare a separate computation for rst 50000 of coverage and Steve additional coverage 5 BHN contributes 5 of salary to a de ned contribution retirement plan Employees are taxed on distributions at retirement use various discount rates to model low moderate and high risk taxpayers 6 What recommendations would you make to BHN regarding their current fringe bene t program 7 Are there any other fringe bene ts that you might suggest that BHN offer to their employees TAX 6845 Tax Planning amp Consulting Oct 27 Topic Alternative minimum tax AMT updated October 19 2009 l The alternative minimum tax a general overview A What is the AMT The AMT is a separate and parallel federal income tax system with different tax rates different de nitions of income deductions and credits designed to measure the taxpayer s economic income The AMT applies to individuals corporations estates and trusts It is an alternative tax because the AMT rules constitute a complete alternative set of rules amp minimum tax because taxpayer must pay the larger of its AMT or its regular income tax liabilities B Why do we have the AMT The AMT was put into place to make sure that highincome taxpayers paid their fair share oftax Over the years Congress has used the income tax law for a variety of reasons other than just raising revenue to fund government operations and programs such as enacting provisions to promote economic and social goals As the number of special tax provisions increased many taxpayers were able to carefully plan their nancial affairs to substantially reduce or eliminate their entire income tax liability A study released in 1986 reported that 130 ofthe 250 largest corporations in the US paid no federal tax or received refunds between 1981 and 1985 The AMT grew out of the minimum tax that was enacted in 1969 It was intended to target 155 highincome individual households that had been eligible for so many tax benefits that they owed little or no income tax under the tax code of the time C The minimum tax enacted in 1969 The original addon minimum tax was 10 x the taxpayer s tax preference items in excess of 30000 It was referred to as an addon tax because it was added to the taxpayer s regular income tax liability The present AMT system evolved from this in 1978 D Calculation of the AMT 1 Taxpayers are rst required to compute their regular income tax liability and then compute their tax under the AMT system The AMT system requires taxpayers to adjust their regular taxable by a number of adjustments and preferences and then subtract an exemption amount to arrive at the AMT base 2 The AMT base is multiplied by the special AMT rate 26 or 28 for individuals and 20 for corporations to compute their tentative minimum tax TMT 3 Taxpayers are required to pay the greater of1 the regular income tax or 2 the TMT 4 Even though the highest tax rate under the AMT 28 is lower than that in the regular tax system AMT victims are paying more because they are taxed on a greater amount of income Under the AMT rules many deductions and exemptions are disallowed 1 E Typical AMT modifications 1 tax preference items TPIs always increase AMTI TPls subject otherwise nontaxable income to the AMT Many tax preferences items TPIs are permanent differences between taxable income and AMTI alternative minimum taxable income 2 AMT adjustments may either increase or decrease AMTI Are mainly timing adjustments usually postpone deductions and accelerate income Adjustments are required to eliminate time value of moneyquot tax savings F The growing problem Unlike most tax laws the AMT is not adjusted for inflation and has gone largely unchanged for 30 years Consequently it applies to more individuals each year Only 19000 households paid the AMT in 1970 36 million paid in 2005 out of131 million individual tax returns and it could affect 33 million by 2010 ifnothing is done Who paid the AMT in 2005 amp who is schedule to pay the tax in 2010 Percent of tax payers earning projected by today between 2010 17 75000100000 37 39 1000002000000 73 78 200000500000 93 Table LPErtEnt ufTax Fliers Affezted by theAMT by Cash lntomea furwm law Tmall wmhiMi39uquvi H mer w m M hm G The adjusted current earnings ACE Athird separate tax system parallel to both AMT and the regular income tax applies to corporations This w another attempt by Congress to make sure that large corporations pay their fair sharequot of Federal income taxes Which leads to the question Do corporations pay tax ll Size limit for corporations a small corporation is exempt from the AMT if it meets the following tests A Initial test the corporation must report average annual gross receipts of no more than 5 million for the threeyear period beginning after December 1993 a small business exception enacted by Congress in 1997 B Ongoing test if the initial test is passed the corporation is exempt from the AMT as long as its average annual gross receipts for the threeyear period preceding the tax year and any intervening threeyear periods do not exceed 75 million Note A corporation is automatically classi ed as a small corporation in its first year of its existence lfthe ongoing test is failed the taxpayer is subject to AMT for that year and all subsequent years Ill The basic AMT formula for corporations Taxable income before NOL deduction Plusminus AMT adjustments except ACE adjustments Plus Tax preference items Equals AMTl before AMT NOL deduction and ACE adjustment Plusminus ACE adjustment Equals AMTl before AMT NOL Minus AMT NOL limited to 90 Equals Alternative minimum taxable income AMTl Minus Statutory exemption Equals AMT tax base Times AMT corporate tax rate 20 Equals Tentative AMT before AMT foreign tax credit Minus AMT foreign tax credit Equals Tentative minimum tax Minus Regular gross income tax liability before credits minus regular foreIgn tax credIt Equals Alternative minimum tax AMT if positive IV Some common AMT tax preference items TPls TPl s are always positive adjustments A percentage depletion related to the exploration of natural resources not a tax preference for independent oil and gas producers depletion is computed by using the statutory percentage rate for the type of resource ranges from 522 the rate is multiplied by the gross receipts from the property percentage depletion reduces the basis in property however total percentage depletion may exceed the total cost of the property example property with zero basis but still generating income will record depletion AMT preference excess of percentage depletion regular income tax deduction over the adjusted basis ofthe property at the end ofthe year B for large integrated oil companies ExxonMobil Chevron the excess of intangible drilling costs over 10year amortization in excess of 65 of net oil and gas income Intangible drilling costs include costs for making the property ready for drilling costs ofdrilling the hole tax treatment of IDC expense in the year incurred or capitalize and write off through depletion It is generally advantageous to write off IDC immediately Note Again this is not a tax preference for independent oil amp gas producers C taxexempt interest on private activity bonds issued after August 8 1986 issued by state and local governmental entities but more than 10 of the proceeds are used to benefit a private business That is the funds are not used for an essential function of the government AMT preference taxexempt interest less any related expenses to carry the bonds Note Taxexempt interest on private activity bonds issued between December 31 2008 and January 1 2011 isn t a tax preference item under the American Recovery and Reinvestment Act of 2009 In addition tax exempt interest on private activity bonds issued between December 31 2008 and January 12011 is not included in the corporate ACE adjustment D for property acquired before 1987 the excess of accelerated depreciation ACRS over straightline depreciation computed on an itembyitem basis this includes real property leased personal property lowincome housing property certi ed pollution control facilities amortization Note A recovery period of 19 years was used for most real property acquired between May 8 1985 and before 1987 so this adjustment goes away for current tax returns V Some common AMT adjustments may be positive or negative adjustments A depreciation of post1986 personal property amp before January 1 1999 the difference between the MACRS deduction 200 declining balance method and the amount determined by using the alternative deprecation system ADS 150 declining balance method over a longer class life B depreciation of post1998 personal property the difference between the MACRS deduction 200 declining balance method and the amount determined by using the alternative deprecation system ADS 150 declining balance method over the same class life C depreciation of post1986 real property amp before January 1 1999 the difference between the MACRS deduction straightline over 275 or 39 years and the amount determined by using the alternative depreciation system ADS straightline over 40 years D depreciation of post1998 real property there is no difference since 1999 because ofthe AMT recovery period conformity rule the same recovery period is used for regular income tax and AMT E the difference in the gain or loss on the disposal of the property caused by different depreciation methods and the different corresponding adjusted bases F pollution control facilities the difference in the amortization of certain pollution control facilities the costs are amortized over 60 months for regular income tax purposes versus depreciated using the ADS over the longer class life for AMT G longterm contracts the difference between the completed contract method usually limited to real estate construction contracts and the percentage of completion method which must be used for AMT purposes H domestic production activities deduction for AMT purposes the DPAD is equal to 6 in 20072009 of the smaller of 1 quali ed production activities income QPAI or 2 alternative minimum taxable income AMTl before the DPAD I adjusted current earnings the ACE adjustment is equal to 75 ofthe difference between ACE and AMTl before this adjustment and the NOL deduction J AMT NOL a negative adjustment but must be recomputed for AMT purposes The NOL deduction if any is recomputed using AMT rules and is limited to 90 ofAMTl before the NOL deduction VI Adjusted current earnings ACE amp the ACE adjustment the starting point is alternative minimum taxable income AMTI ACE is similar to a corporation s EampP with a bunch of twists Some common ACE adjustments include A depreciation of pre1994 property the difference between the MACRS deduction 200 declining balance method and the amount determined by using the alternative deprecation system ADS 150 declining balance method over a longer class life B depreciation of post1993 property no ACE adjustment is necessary ACE and AMT use same deprecation method C the difference in the gain or loss on the disposal of property caused by different depreciation methods and adjusted bases D taxexempt income interest and life insurance proceeds is included in ACE Any related expenses are deducted for ACE E increase in the cash surrender value of life insurance F installment sales method is not allowed must recognize 100 of the gain in the year of the sale G the 70 dividend received deduction is disallowed but the 80 and 100 dividend received deductions are allowed H organizational costs can not be deducted for ACE I LIFO is not allowed for ACE The ACE adjustment increasedecrease in LIFO recapture FIFO in excess of LIFO J cost depletion must be used except for independent oil and gas producers K the limitation for the charitable contribution deduction is recomputed using ACE income Note The ACE adjustment does not apply to individuals S corporations regulated investment companies and real estate investment trusts REITs Note Any negative ACE adjustment can not exceed prior net positive adjustments For this reason the corporation may want to keep track of its ACE adjustment each year even though it is not subject to AMT Vll Other pieces of the AMT A The AMT exemption 1 corporations are entitled to an exemption of 40000 2 however the exemption is reduced by 25 of AMTl over 150000 resulting in the elimination of the exemption when AMTl is over 310000 Note Corporations with gross receipts over 5000000 may still have relatively small AMTl and still bene t from the AMT exemption B The minimum tax credit MTC 1 corporate taxpayers are allowed to carryover any minimum tax they pay the difference between AMT and the regular income tax and subtract it from any regular income tax in the future as long as it does not reduce that tax below that year39s AMT 2 the minimum tax credit may not be carried back and may not be offset against any future AMT liability Note While this may seem unusual at rst the underlying reasoning for the AMT credit is as follows since AMT is caused primarily by timing adjustments that will reverse in the future and the taxpayer will actually pay a higher regular tax in these future years the imposition ofthe prior year AMT and the current year regular tax essentially would constitute double taxation C AMT and ow through entities partnerships and S corporations Many of the AMT adjustments and tax preference items pass through to the individual partners and S shareholders in order to compute their individual AMT VIII AMT and depreciation summary A The depreciation rules for the AMT are much simpler today than they have been in the past Nevertheless previous rules still apply to assets acquired when the rules were in effect B In the past separate rules applied to depreciation computed fortaxable income purposes alternative minimum tax purposes adjusted current earnings purposes In addition to book depreciation under GAAP rules and depreciation using ADS for EampP purposes C In computing taxable income MACRS depreciation rules are used to determine depreciation on recently acquired assets That is most personal property is depreciated using 200 declining balance over 5 or 7 years In computing alternative minimum taxable income and adjusted current earning personal property is depreciated over MACRS recovery periods using 150 declining balance using the same class life D Straight line depreciation is used for real property and the recovery period is 275 years for residential and 39 years for nonresidential property In computing alternative minimum taxable income and adjusted current earning real property is depreciated over the same MACRS recovery periods MACRS straight line over 275 or 39 years so it is the same as regular taxable income depreciation E Although the rules for earlier acquisition are very complex the fact is that in most cases there is no difference between taxable income depreciation and either AMT or ACE depreciation because ofthe passage of time Note See also the handout on my web page Summary oftax depreciation rules IX Taxexempt and private activity bonds summary Taxexempt bonds Private act ivity bonds Issued by a government entity Issued by a government entity Issued by a government entity proceeds are used by a government entity proceeds are used by a private business entity proceeds are used by a private business entity to fund a government activity to fund a qualified activity to fund an unqualified activity build schools roads government buildings court house fire station police station and many of the facilities to the right 9 build airports docks and certain other transportationrelated facilities water sewer and certain other local utility facilities solid and hazardous waste disposal facilities certain residential rental projects redevelopment purposes by a governmental entity in designated blighted areas provide student loans low income housing veteran s mortgages and facilities to be used by 501c3 organizations build arena provide loans to 39 sses Exempt from income tax Exempt from income tax Included in taxable income Not a preference Included as a preference Not a preference as already in taxable income Included in ACE Included in ACE Included in ACE Note Taxexempt interest on private activity bonds issued between December 31 2008 and January 1 2011 isn t a tax preference item under the American Recovery and Reinvestment Act of 2009 In addition taxexempt interest on private activity bonds issued between December 31 2008 and January 1 2011 is not included in the corporate ACE adjustment gtlt The basic AMT formula for individuals Taxable income before NOL deduction Plusminus AMT adjustments except ACE adjustments Plus Tax preference items Plus Personal and dependency exemptions Plus Standard deduction if taxpayer doesn t itemize Equals Alternative minimum taxable income AMTl Minus Statutory exemption Equals AMT tax base Times AMT individual tax rate 26 of rst 175000 28 of excess Equals Tentative AMT before tax credits Minus AMT foreign tax credit Minus Nonrefundable personal tax credits Equals Tentative minimum tax Minus Regular gross income tax liability before credits minus regular foreign tax credit Equals Alternative minimum tax AMT if positive XI Differences between the AMT for individuals and corporations include A w U quot39 n 0 I personaldependency exemptions are disallowed and added back to taxable income standard deduction is disallowed and added back to taxable income some itemized deductions are disallowed and added back to taxable income property taxes state income taxes home equity loan interest for purposes other than home improvements and most 2 miscellaneous itemized deductions medical deduction is allowed but only to the extent that medical expenses exceed 10 of AGI ratherthen 75 ofAGl the bargain element of incentive stock options the difference between the value of the stock and the option price is included in AMTl in the year the options are exercised except in cases where the stock itself is sold during the same year A compensating adjustment is made in the year the stock is sold no ACE adjustment the individual AMT rates are slightly progressive 26 on the rst 175000 ofincome and 28 ofthe amount in excess of 1 75000 longterm capital gains and quali ed dividends are taxed at their usual rates 15 or 0 the exemption amount is different but is still subject to phaseout the AMT exemption is reduced by 025 for each 1 of AMTl in excess of the phase out amount The exemption amount depends on the taxpayer s ling status Filing status 2000 2007 2008 2009 MFJ amp SS 45000 66250 69950 70950 Single amp HH 33750 44350 46200 46700 For example for married couples filing jointly and surviving spouse the exemption is 70950 in 2009 but is reduced by 25 of AMTl over 150000 which means the full amount ofthe exemption is phasedout at AMTI of 433800 Note The AMT exemption has been scheduled to revert back to 2000 levels In both 2007 and 2008 Congress passed latesession oneyear patches to avoid major problems The 2009 patch was passed in February 2009 as part ofthe stimulus bill 13 J AMT credit not allowed for tax caused by permanent differences eg private activity bond interest personal exemptions disallowed standard amp itemized deductions and some depletion allowances Credit is allowed for AMT attributed to timing differences eg depreciation and the accounting long term construction contracts etc Xll Top ten things that cause individual AMT liability Here are some items that can cause or contribute to the AMT tax liability The list isn39t complete there are other items that can contribute to AMT liability A Exemptions The exemptions you claim for yourself your spouse and your dependents are not allowed when calculating alternative minimum tax It39s pretty rare though not impossible to see a tax return where someone had to pay AMT solely because of their exemptions but the more exemptions you claim the more likely it is that you39ll have AMT liability when all is said and done B Standard deduction Some 7075 ofAmerican taxpayers claim the standard deduction rather than itemizing The standard deduction isn39t allowed under the AMT Usually this isn39t a problem because the AMT generally hits people with higher incomes and these people are more likely to claim itemized deductions Yet it39s worth noting that a deduction that39s so widely used can contribute to AMT liability C State and local taxes lfyou itemize there39s a good chance you claim a deduction for state and local tax including property tax and state income tax For 20042007 you could claim a deduction for sales tax ifyou didn39t claim a deduction for state or local income tax this provision has been extended two years through 2009 These deductions are not allowed underthe AMT lfyou live in a place where state and local taxes are high you39re more likely to be subject to the alternative minimum tax D Interest on second mortgages The AMT allows a deduction for interest on mortgage borrowings used to buy build or improve your home lfyou borrowed against your home for some other purpose the interest deduction isn39t allowed under the alternative minimum tax E Medical expenses The AMT allows a medical expense deduction but it39s more limited than the deduction under the regular income tax 10 vs 75 AGI oor lfyou claim an itemized deduction for medical expenses part or all ofit will be disallowed when you calculate your alternative minimum tax F Miscellaneous itemized deductions Certain itemized deductions are available if your total in this general category is more than 2 ofyour adjusted gross income Among the items here are unreimbursed employee expenses tax preparation fees and many investment expenses You can39t deduct these items under the AMT though If you claim a large number in this area you could end up paying alternative minimum tax G Various credits Many ofthe credits that are allowed when you calculate your regular income tax aren39t allowed when you calculate your AMT The more credits you claim the more likely it is that you39ll end up paying alternative minimum tax Fortunately Congress has extended relief for the quotpersonal creditsquot in recent years H Incentive stock options Generally you don39t report anything on your regular income tax at the time you exercise an incentive stock option But you have to report income for purposes ofthe AMT Exercising a large incentive stock option is almost certain to cause you to pay alternative minimum tax I Longterm capital gains Longterm capital gains receive the same preferential rate underthe AMT as they do underthe regular income tax In theory they shouldn39t cause you to pay alternative minimum tax In practice it39s possible to be stuck with AMT liability because of a large capital gain The reasons are a little complicated but mainly have to do with the fact that a large capital gain reduces or eliminates the AMT exemption amount which is designed to protect lowincome taxpayers from having to pay alternative minimum tax J Taxexempt interest Interest that39s exempt from the regular income tax may or may not be exempt from the AMT It depends on complicated rules that are fully understood only by bond lawyers Bonds that aren39t exempt from AMT pay a slightly higher rate of interest to compensate for the fact that they aren39t fully tax exempt If you invest in bonds that aren39t exempt underthe alternative minimum tax you39re a candidate for AMT liability Note Many mutual funds that provide exempt interest invest at least some of their money in bonds that aren39t exempt under the AMT to get a higher rate of interest Their annual statement tells you how much of the exempt interest you received during the year is taxable under the alternative minimum tax K Tax shelters The Tax Reform Act of 1986 severely curtailed the ability to reduce income tax through tax shelters Yet there are still some legitimate ways of reducing tax liability through investments in certain types of partnership or limited liability company arrangements involving such activities as oil and gas drilling The AMT provides reduced tax bene ts for these activities You should always explore the alternative minimum tax consequences among other things before investing in a tax shelter XIII Some issues associated with the AMT myths complexity fairness and incentives A The AMT reduces the number of highincome filers who pay no income tax In 2001 an estimated 100 tax filers with income over 1 million avoided all income tax but at least 700 would have if not for the AMT Even so this goal could be accomplished more simply in the regular income tax B The AMT is notoriously and pointlesst complex The Internal Revenue Service and the Taxpayer Advocate have agged the AMT as one ofthe most complicated tax provisions to comply with and administer Most people required to ll out the AMT forms end up owing no additional taxes The AMT also creates complicated interactions with the regular income tax C The AMT raises marginal tax rates By 2010 the AMT will impose higher marginal tax rates than the regular income tax does for 93 percent ofAMT taxpayers High marginal tax rates encourage tax avoidance and penalize work and saving D The AMT is poorly targeted Although originally intended to curb tax sheltering the AMT raises less than 5 percent of its revenue from antisheltering provisions such as accelerated deprecation or oil depletion allowances In 2010 only about 1 percent of AMT taxpayers will be subject to the tax due to anti sheltering rules A key reason why the AMT does not target shelters very well is that the preferential treatment for capital gains the Iynchpin of most individual tax shelters is not curtailed by the AMT E The AMT imposes penalties on marriage and having children Couples will be more than 20 times as likely as singles to face the AMT in 2010 Because the AMT prohibits deductions for dependents 85 percent of married couples with two or more children will face the AMT 97 percent among such couples with income between 75000 and 100000 About 6 million taxpayers will face the AMT in 2010 simply because they have children XIV Changing or fixing the individual AMT A Repeal the AMT The simplest way to deal with the growth of the AMT would be to eliminate the alternative tax entirely Repeal would reduce tax revenues by roughly 800 billion over the next decade under current law Eliminating the AMT would free many taxpayers from having to make a second set of tax calculations and would lower taxes for nearly everyone now subject to the AMT B Index AMT parameters for inflation The AMT39s reach will grow primarily because its parameters are xed in nominal terms while parameters in the regular income tax are adjusted annually to take account of in ation lndexation under current law prevents regular tax liabilities from growing simply because incomes keep pace with price in ation but AMT liabilities have no such brake As nominal incomes rise over time more taxpayers become liable for the AMT For 2009 the AMT exemption is 70950 for married couples ling jointly and 46700 for unmarried lers In comparison in 1982 the AMT exemption for married couples ling joint was 40000 Adjusted for inflation 3 that would be around 88000 today C Allow dependent exemptions for the AMT The AMT currently has a disproportionate impact on large families by denying them the dependent exemptions allowed in the regular income tax Permitting the same personal and dependent exemptions in the AMT as in the regular tax would eliminate the AMT impact for about 6 million tax households in 2010 D Allow the deduction of state and local taxes for the AMT Taxpayers cannot deduct state and local income and property taxes in calculating their taxable income for the AMT As a result people in hightax jurisdictions are more likely to have AMT liability than their counterparts in lowtax areas Allowing taxpayers to deduct state and local taxes for AMT purposes would eliminate the AMT impact for about 10 million tax households in 2010 E Allow many of the tax cuts passed in 2001 amp 2003 to expire lfthe 20012003 tax cuts were made permanent a projected 44 million taxpayers would face the AMT in 2014 In contrast ifthe tax cuts are allowed to expire as scheduled in 2010 only 26 million would face the AMT in 2014 However this would mean that most taxpayers would end up paying more regular tax rather than AMT F Modest increase in the regular income tax rates G Eliminate the favorable rate 15 on capital gains amp qualified dividends This would retarget the AMT toward highincome households This would also make the AMT more effective in combating tax shelters since most attempt to have income reclassi ed as long term capital gain H Eliminate the AMT exemption phaseout XV Challenges associated with changing or xing the individual AMT A Repeal would be expensive and regressive Repealing the AMT would reduce revenues by 872 billion through 2017 if the 20012003 Bush tax cuts expire as scheduled in 2010 The cost would increase to about 15 trillion if the tax cuts are extended We are getting to the point where it will cost more to repeal the AMT than to zero out the regular income tax More than 75 percent of the bene ts of repeal would go to households with income above 100000 in 2010 And over 50 of the bene ts from repeal would go to households making over 200000 B Paying for reform is a key issue Congress is looking at a number of options under their current PAYGO budgeting system payasyougo C The AMT should be retargeted at highincome tax avoiders By combining the reforms above and treating the lower rates on capital gains and dividends as a quotpreference itemquot as capital gains were treated before 1987 This pays for most of the cost of the reforms mentioned above reduces sheltering and exempts most middle income households from the tax I Employee compensation Stock options The Horgan Company s common stock is worth 100 per share today and is appreciating at a rate of 10 per year The company is thinking about adding a stock option component to their fringe bene t packages They are considering the pros and cons of both ISOs and NSOs to compensate their key executives In addition they are looking into ESPPOs to offer stock to their rankand le workers ISOs and NSOs are set at current market value 100 and must be exercised within ve years They expect that employees will exercise the option just before they expire when the stock will be worth 161 and they will sell the stock two years later when it will be worth 195 Employees are not liable for any AMT ESPPO are set at 085 and must be exercised within two years They expect that employees will exercise the option just before they expire when the stock will be worth 121 and they will sell the stock ve years later when it will be worth 195 Both the company s and the employee s discount rates are 10 The Horgan Company is in the 35 tax bracket Their typical key executive is in the 33 ordinary income tax bracket while their typical rankand le worker is in the 25 tax bracket The ESPPO example is not directly comparable to the other examples because the ESPPO rules limit the option period As noted the lRS39s position is that the N80 is subject to payroll taxes which are not incorporated into this example The computation as illustrated below suggests that stock options may not always be an ef cient form of compensation They have been touted because they may both help retain and motivate employees and in the past at least could be used without having to show the cost as an expense on nancial statements Here is the time line indicating the stock price today and at the end ofyears 2 5 and 7 fairvalue 1oo 11ol 121I 133l 146I 161I 177l 195 19x1 19x2 19x3 19x4 19x5 19x6 19x7 Time value of money factors i10 n PV of 1 factor 2 0826 5 0621 7 0513 Required Compute the costbene t ratio assuming the stock options are considered 1 incentive stock options lSOs 2 nonquali ed stock options NSOs with no readily determinable fair value 3 nonquali ed stock options NSOs with a readily determinable fair value 020 4 employee stock purchase plan options ESPPOs Also note the tax consequences to the corporation and the employee of each type of option Incentive stock option E0 Company cost Fair value of stock when option exercised 1610 Less Option price 1000 Discount 610 x PV of 1 i10n5 x 0621 Company cost 0379 Employee benefit Selling price 1950 Less Taxes paid 195 100 X 15 0143 181 xPV of 1 i10n7 x0513 PV of cash received year 7 0927 0927 Cash paid for stock year 5 option price 1000 x PV of 1 i10n5 x 0621 PV of cash paid for stock year 5 0621 0621 Employee benefit 0306 Cost benefit ratio costbenefit Nonqualified stock option NSO no readily 39 39 39 fair market value Company cost Fair value of stock when option exercised 1610 Less Option price 1000 Discount expense 610 Less Tax benefit 0610 x 35 0214 0396 x PV of 1 i10n5 x 0621 Company cost 0246 Employee benefit Selling price 1950 Less Taxes paid 195 161 x 15 161 100 cash paid 061 ord inc recognized 0051 1899 xPV of 1 i10n7 x0513 PV of cash received year 7 0974 0974 Cash paid for stock year 5 option price 1000 Plus Tax paid 161 100 x 33 061 ord inc recognized 0201 1201 x PV of 1 i10n5 x 0621 PV of cash paid for stock year 5 0746 0746 Employee benefit 0228 Cost benefit ratio costbenefit 1079 Nonqualified stock option N30 with a readil ascertainable fair market value 020 Company cost Fair value of stock when option exercised 1610 Less Option price 1000 Discount 610 X PV of 1 i10n5 X 0621 379 Less Tax benefit 020 X 35 007 Company cost 0309 309 Employee benefit Selling price 1950 Less Taxes paid 195 120 X 15 161 100 cash paid 020 ord inc recognized 0113 1837 XPV of 1 i10n7 X0513 PV of cash received year 7 0942 0942 Cash paid for stock year 5 option price 1000 X PV of 1 i10n5 X 0621 0621 Plus Tax paid 020 X 33 ord inc recognized when granted 0066 0687 0687 Employee benefit 0255 Cost benefit ratio costbenefit 121 ESPPO Company cost Fair value of stock when option exercised 1210 Less ESPPO option price 0850 Discount but no compensation cost 0360 X PV of 1 i10n2 X 0826 Company cost 0297 Employee benefit Selling price 1950 Less Taxes paid 195 100 X 15 on capital gain 0143 Less Taxes paid 100 085 X 25 on ordinary income 0038 1769 XPV of 1 i10n7 X0513 PV of cash received year 7 0907 0907 Cash paid for stock year 2 option price 0850 X PV of 1 i10n2 X 0826 0702 0702 Employee benefit 0205 Cost benefit ratio costbenefit 145 General business credit Solution I Part 1 Talon Corporation s general business credit for the current year is 70000 Talon s net income tax is 150000 tentative minimum tax is 130000 and net regular tax liability is 150000 Talon has no other tax credits Required Compute Talon s general business credit for the current tax year Talon s general business credit for the year is limited to 20000 determined as follows Net income tax 150000 Less The greater of 130000 tentative minimum tax 31250 25 x 150000 25000 130 000 Amount of general business credit allowed 20 000 Note Talon then has 50000 70000 20000 of unused general business credits that may be carried back or forward Part 2 Falcon Corporation s general business credit for the current year is 85000 Falcon s net regular tax liability is 107000 and its tentative minimum tax is 88000 Required Compute Falcon s general business credit for the current tax year Falcon s general business credit for the year is limited to 19000 determined as follows Net income tax 107000 Less The greater of 88000 tentative minimum tax 20500 25 x 107000 25000 88 000 Amount of general business credit allowed 19 000 Note Falcon then has 660000 85000 19000 of unused general business credits that may be carried back or fonNard
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