CFP COURSE #4: TAX PLANNING

EDUCATION TAX BENEFITS: Tax-Free Scholarships

A scholarship or fellowship grant is tax free (excludable from gross income) only if you are a candidate for a degree at an eligible educational institution. The IRS states that a scholarship or fellowship grant is tax free only to the extent that it: -- doesn't exceed your qualified education expenses, -- isn't designated or earmarked for other purposes (e.g., room and board), -- doesn't prohibit its use for qualified education expenses; and -- doesn't represent payment for teaching, research, or other services required as a condition for receiving the scholarship.

SCHEDULE C

A sole proprietor will report net earnings from self-employment on IRS Form 1040, Schedule C.

PROFESSOR'S NOTE: BENEFITS & INCOME

Be aware that typically, most clients will have between 50% and 85% of their benefits included in income.

EXAMPLE: Mixed use rental property

Doug and Cathy own a house at the beach. The house was rented to unrelated parties for eight full weeks during the current year. Doug and Cathy used the house 16 days for their vacation during the year. After properly dividing the expenses between rental and personal use, it was determined that a rental loss was incurred as follows: Gross rental income ($800/Wk) $6,400 Less mort. interest & prop. taxes $5,000 Other allocated expenses 3,000. (8,000) -------------------- Net rental loss ($1,600) This is a mixed-use rental property. The deductible rental expenses are limited to the gross rental income of $6,400. They cannot take a net loss, just as if the hobby loss rule applied. The interest and taxes allocated to personal use may be deductible on Schedule A as itemized deductions. The excess can be carried forward to a future year.

Miscellaneous Fringe Benefits

Finally, there are a number of miscellaneous fringe benefits provided by an employer that may be nontaxable if certain conditions are met. These are referred to as Section 132 benefits, after the Internal Revenue Code section of the same number, and include: 1.) no-additional-cost services (e.g., free stand-by flights from airlines to their employees); 2.) qualified employee discounts (e.g., the discount on products is limited to the gross profit on the product, and the discount on services is limited to no more than 20% of the retail price sold by the employer to retail customers); 3.) working condition fringe benefits (e.g., the business use of a company car); 4.) qualified transportation fringes (e.g., a bus transit pass within limits and subsidized parking within limits); and 5.) de minimis fringes (e.g., an occasional theater or sporting event ticket).

GROSS INCOME

For federal income tax purposes, gross income is defined as all income from whatever source derived (see SECTION 61(a) of the TAX CODE) except for those items specifically excluded by the Tax Code. Gross income is similar to total income as reported on the 1040. The MOST IMPORTANT DIFFERENCE is that there are some DEDUCTIONS ALLOWED in computing the TOTAL INCOME on the 1040. COMMON DEDUCTIONS include: - UP TO $3,000 NET CAPITAL LOSS, - allowable RENTAL LOSSES, - and LOSSES from a SOLE PROPRIETORSHIP.

APPLICABLE FEDERAL RATE (AFR)

** It is the MINIMUM INTEREST RATE that the IRS ALLOWS FOR PRIVATE LOANS**. ** The rate used is the FEDERAL GOVERNMENT'S BORROWING RATE, compounded SEMIANNUALLY and ADJUSTED MONTHLY.

EXAMPLE: Tax law doctrines

Blake wishes to reduce his income and assist his friend, Paul, at the same time by assigning income he receives from a small commercial property. Blake is satisfied that the rents totaling $2,000 monthly will provide a financial safety net for Paul and reduce Blake's monthly taxable income. This is an example of the assignment-of-income doctrine. While Blake is free to assign the income to Paul, it is really a gift to Paul and remains taxable income to Blake

PROFESSOR'S NOTE: BOND PREMIUMS & DISCOUNTS NETTING

Bond premiums and discounts can be a very complex area of the tax law. The general rules are stated here, but different rules may apply to the election to amortize, or the method used to amortize premiums or discounts, depending on the year the bond was acquired or issued

The most important miscellaneous itemized deductions are:

1) gambling losses and transaction expenses, to the extent of gambling winnings; 2) impairment-related work expenses for handicapped taxpayers; 3) the unrecovered investment in an annuity contract when the annuity terminates because the taxpayer died (e.g., in a single life period annuity); and 4) a federal estate tax that is attributable to items included in the taxpayer's estate as income in respect of a decedent. These deductions may be taken if the taxpayer itemizes deductions, and they are not limited in amount.

A CORP IS A PERSONAL SERVICE CORP IF BOTH OF THESE TESTS ARE MET:

1). Substantially all of the corporation's activities involve the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting. 2). At least 95% of the corporation's stock, by value, is owned directly or indirectly by employees performing the services.

Income Taxation of Trusts and Estates: GENERAL

1. A trust is a legal arrangement whereby an individual transfers legal ownership of property to a trustee. 2. Trust income can be taxed to the following: a. Trust—if income is accumulated in the trust b. Beneficiary—if income is distributed from the trust c. Grantor—if the trust is a grantor trust (discussed in the following) 3. An estate is a legal entity that comes into existence upon the death of an individual and remains in existence until the decedent's assets pass to the heirs. a. The estate consists of the probate estate. b. The estate holds and protects the assets, collects income from those assets, and satisfies obligations of the estate until all the assets are distributed. 4. Persons or entities that are responsible for trusts and estates are called fiduciaries.

Tax Treatment of Distributions to Beneficiaries

1. The beneficiary is taxed on an amount equal to the distribution deduction. 2. The fiduciary receives a deduction for the distribution. 3. Income distributed to the beneficiary maintains its character (e.g., capital gain, ordinary income, etc.). 4. A beneficiary who receives a distribution from a fiduciary will receive a Schedule K-1 each year. a. K-1 summarizes the amounts and character of the various items of income that constitute the taxable portion of the distribution. b. A beneficiary who receives a distribution from a fiduciary with both taxable and nontaxable DNI will only be taxed on a portion of the distribution received.

IMPUTED INCOME AND THE ALTERNATIVE MINIMUM TAX: BELOW-MARKET LOANS (3)

3. Exceptions and limitations to the imputed interest rules include the following: a. No interest is imputed on total outstanding gift loans in the aggregate of $10,000 or less between individuals, unless the proceeds are used to purchase income-producing property. i. Also an exception for compensation-related or corporation-shareholder loans that are less than or equal to $10,000 b. On loans between individuals greater than $10,000 and less than or equal to $100,000, the imputed interest cannot exceed the borrower's investment income (from all sources) for the year. i. A further exception carved out by law states that if the borrower's investment income for the year does not exceed $1,000, no interest is imputed on loans of $100,000 or less. c. If the principal purpose of the loan is tax avoidance, none of the exceptions apply

ETHICAL CONSIDERATIONS, AUDITS, AND TAX PENALTIES: TAX AUDITS: Representing Clients Before the IRS (II)

3. Power of attorney a. A power of attorney is a written authorization for an individual to act on another's behalf. b. With a power of attorney, any recognized representative (other than an unenrolled preparer) may usually perform the following acts: 1.) Represent the client before the IRS 2.) Record the interview 3.) Sign on the client's behalf a.) Waiver of restriction on assessment or collection of a tax deficiency b.) Consent to extend the statutory period for assessment or collection of a tax c.) Closing agreement 4.) Receive (but not cash) a refund check c. A recognized representative generally cannot sign a client's income tax return, except as preparer.

PROFESSOR'S NOTE: EDUCATIONAL TAX BENEFITS: 529s

529 beneficiaries can apply up to $10,000 to pay for student loan debt. Previously, money could only be used to pay for tuition. Excess 529 money can be used to pay down student debt.

CAPITAL GAINS: 0% TAX RATE

A 0% rate applies to long-term capital gains if the taxpayer's taxable income is under $83,350 (for married couples filing jointly); a 15% rate applies for long-term capital gains if they fall between the taxable income breakpoints of $83,350 to $517,200 (for married couples filing jointly). A 20% rate applies to the long-term capital gain income above the $517,200 breakpoint (for married taxpayers filing jointly).

EXAMPLE: Depreciation period

A business purchases and places into service a machine and a warehouse on October 25, 2018. The machine has a useful life of seven years. Even though the depreciation deductions will end in 2028, the depreciable period ends in October 2027—10 years after the machine is placed into service. The warehouse has a useful life (depreciable life) of 39 years. Thus, the depreciation period (for the QBI deduction) will run through the end of 2056—the last day of the last year of the warehouse's 39-year depreciation schedule.

NETTING PROCESS: WASH SALE RULE (2)

A difference in maturity bond dates of the same issuer does not necessarily take them out of the substantially identical category. Courts have pointed out that six months, added to a maturity of one year, results in a significant difference, but when six months are added to a duration of 20 years, it does not result in a significant difference. Planners should exercise caution when advising clients on the appropriateness of a bond swap, for example. The wash sale rule applies to sales and investments in mutual funds as well. This is an area that has received very little attention, both in trade and technical journals, and from the IRS. It may be possible that due to the volume of mutual fund transactions, the IRS has not made an attempt to enforce the wash sale rule in this area. It seems clear, however, that a dividend reinvestment with a sale at a loss within the 61-day period would fall under the wash sale rules, and that a portion of the loss would be disallowed.

Tax planning for AMT: OVERVIEW

A fairly standard income tax planning technique involved prepayment of the next years' estimated state income tax and/or property tax liability. Keep in mind that many traditional tax planning strategies still work, even if the taxpayer is subject to the AMT. Reducing AGI and taxable income is still generally effective in reducing the overall tax liability. For example, contributing an additional $1,000 to the client's 401(k) account reduces taxable income by $1,000. It also reduces the AMT base (the amount on which the AMT is calculated) by $1,000. If the client is paying the 28% AMT rate, this $1,000 contribution saves $280 in alternative minimum tax.

CAPITAL GAINS: 28% TAX RATE

A maximum 28% rate applies to net capital gains on collectibles if they are held for more than one year. Collectibles include coins, artwork, et cetera.

PROFESSOR'S NOTE: SECTION 1245 PROPERTY

Arguably, the ordinary income tax consequence in this question (or full recapture) could also be categorized as Section 1245 gain. Such accounting subtleties will not be tested on the national exam.

EXAMPLE: Audits

Grayson has been summoned to the IRS office to discuss a previous year's income tax return. The IRS has asked him to bring his records regarding a specific deduction he made on his return. This is an example of an office audit.

PROFESSOR'S NOTE: TAX EVASION

IRS Revenue Agents and Field Agents handle normal tax inquiries and common audits. They deal regularly with the public regarding civil matters. A client may ask a CPA or EA to represent them before these agents. IRS Special Agents are duly sworn law enforcement officers trained to deal with tax evasion. When asked about the difference between tax avoidance and tax evasion, one observer quipped, "The bars." In the rare event a client is contacted by an IRS Special Agent, practitioners should be aware that he or she is conducting a criminal investigation. In such circumstances, the client should seek competent legal counsel.

Tax Law Compliance and Procedures: Citations For Regulations

Regulations are arranged in the same sequence as the Code sections they interpret. Regulations are prefixed by a number designating the type of tax or administrative, definitional, or procedural matter to which they relate. Treasury Regulation Section 1.614-3(f)(5) will serve as an illustration of how regulations are cited. Temporary regulations should not be confused with proposed regulations. The latter have no force or effect. Nevertheless, proposed regulations provide insight into how the IRS currently interprets a particular Code section. For this reason, they should not be ignored.

EXAMPLE: Adjusted basis calculation

Adam Smith purchased a computer for exclusive use in his consulting business. The computer cost $2,200, and Adam paid $45 for delivery and an additional $125 for setup charges. His adjusted basis is calculated as follows: Purchase price $2,200 Adjustments 170 -------- Adjusted basis $2,370 Assume that Adam took a first-year cost recovery (depreciation) deduction of $474. His adjusted basis in the computer after the first year would be $1,896, computed as follows: Adjusted basis $2,370 Minus: cost recovery 474 -------- Equals: adjusted basis $1,896

PROFESSOR'S NOTE: QUALIFIED DISASTER AREAS

Additional special rules exist for qualified disaster area losses. Qualified disaster areas are declared by the President under the provisions of the Stafford Act of 2016. Examples include Hurricane Harvey, the California wildfires, and other exceptional disasters described in the Taxpayer Certainty and Disaster Tax Relief Act of 2019. Taxpayers can deduct these special disaster losses without itemizing. Their standard deduction is increased accordingly. Moreover, the net loss doesn't need to exceed 10% of AGI. However, the $100 limit per casualty is increased to $500. To avoid confusion, students should be aware that the rules for this extraordinary type of loss are not tested in this course.

Alimony and Child Support: Alimony (and Separate Maintenance) Payments: 3 PAYMENT CATEGORIES

Alimony normally is an important issue debated during the divorce process. Alimony payments fall into three categories: 1. Payments under a support decree 2. Written separation agreement payments 3. Payments under a separate maintenance or divorce decree or under a written instrument incident to divorce/separation If the payments fall into any of the previous categories, they will be deductible by the payor spouse and includible in the payee spouse's income.

Tax Accounting Methods: Accounting Periods

All taxpayers may report taxable income on the basis of a calendar year (any 12-month period ending on December 31). In contrast, fiscal year reporting may only be adopted by taxpayers (such as a business) that maintain adequate financial records. A FISCAL YEAR is a 12-month period ending on the last day of any month OTHER THAN December. Many businesses use a fiscal year based on the natural receipt of most of their income and expenses (e.g., a business selling ski apparel may adopt a fiscal year ending in March or April to mirror the end of ski season). The ACCOUNTING PERIOD is initially ESTABLISHED when an individual or business FILES its INITIAL INCOME TAX RETURN. Like changes in the accounting method, once the accounting period has been established, the taxpayer can CHANGE it ONLY WITH IRS CONSENT. Finally, certain flow-through business entities (such as a partnership or S corporation) must generally use the same accounting period as that of their owners. If a partner or S corporation shareholder/owner has a different taxable year than that of the business entity, the owner must report their share of the entity's income in the same taxable year within which the entity's taxable or fiscal year ends.

PROFESSOR'S NOTE: NET INVESTMENT INCOME TAX (NIIT)

Although extremely similar in intent, the Additional Medicare Tax is an additional .9% imposed on wages and self-employment income. The NIIT is a 3.8% tax imposed on portfolio income.

ADDITIONAL MEDICARE TAX: OVERVIEW (1)

An Additional Medicare Tax is imposed on some taxpayers at a rate of 0.9%. An individual is liable for the Additional Medicare Tax if the individual taxpayer's wages, other compensation, or self-employment income (combined with a spouse if filing as MFJ) exceeds the thresholds listed in the following table for the taxpayer's filing status. Married filing jointly (MFJ): $250,000 Married filing separately (MFS): $125,000 Single: $200,000 Head of household (with qualifying person) $200,000 Qualifying widow(er) with dependent child. $200,000 Unlike the 2.9% Medicare tax, which is divided between an employer and a W-2 (statutory or regular) employee share, only the employee pays the full 0.9% tax. This tax is in addition to the 1.45% employee share of the regular Medicare tax. The 0.9% Additional Medicare Tax is applied to the amount of income that is in excess of the threshold for the taxpayer's filing status.

PROFESSOR'S NOTE: EDUCATION TAX BENEFITS: CARES ACT

Under the CARES Act, a business could also pay up to $5,250 of an employee's student loans in 2020. The business may make payments to the employee or lender directly, which can then be applied to principal and interest. The payment is tax free to the employee and tax deductible to the employer. The Consolidated Appropriations Act of 2021 then extended this provision through 2025, at which time it will sunset, barring further congressional action

TEST TIP: CHECK-THE-BOX REGULATIONS

Under the check-the-box regulations, an unincorporated entity, such as a sole proprietorship, partnership, or an association, may use Form 8832 to elect to be taxed as a corporation. On the national exam, students have to be told this election had been made if it is applicable to the question asked.

TEST TIP: FILING REQUIREMENTS

You need not memorize the standard deduction amounts because they will be provided on the national exam.

Tax Treatment of Business Property Gains: INVOLUNTARY CONVERSIONS

An involuntary conversion results from the destruction, theft, seizure, condemnation, sale, or exchange of the taxpayer's property under threat of condemnation. Section 1033 of the Internal Revenue Code allows a taxpayer who undergoes an involuntary conversion to postpone recognition of the gain. The taxpayer must reinvest in a similar property as a replacement property to defer or postpone the recognition of any gain that is inherent in the amount the taxpayer was paid for the involuntarily converted property. -- If the amount reinvested in the replacement property equals or exceeds the amount realized, the realized gain is not recognized. -- If the amount reinvested in the replacement property is less than the amount realized, the gain is recognized to the extent the proceeds are not reinvested. The recognized gain is gain that is recognized as taxable income for the taxpayer. Note that Section 1033 only applies to gains and not losses.

Tax Law Compliance and Procedures: Announcement

Announcements are issued on a regular basis. They have only immediate, short term value. They often summarize code sections in layman's terms or notify taxpayers of impending deadlines.

Passive Activity and At-Risk Rules: DIRECT PARTICIPATION PROGRAMS: Tax Credits

Another way direct participation programs have traditionally produced tax benefits for investors is via the pass-through of various tax credits, such as the low-income housing credit and the historic rehabilitation tax credit.

PROFESSOR'S NOTE: MEC

Any single premium whole life policy issued on or after June 21, 1988, is a MEC.

Tax Reduction and Management Techniques: Charitable Contributions by Businesses: FLOW-THROUGH ENTITIES

A charitable contribution made by an S corporation or a partnership (or entity treated as a partnership for income tax purposes, such as an LLC or LLP) is a "separately stated item" for the S corporation shareholder or partner. This means that the contribution is not deductible in computing the net income of the entity, but instead retains its character as it flows through to the individual from the S corporation or partnership on the K-1. S corporation shareholders or partners will claim the charitable contribution on their Schedule A, as an itemized deduction.

EXAMPLE: Accumulated earnings tax computation

Assume DEF Corporation is not a personal service corporation and cannot establish a business purpose for excess accumulations. In 2021, DEF has taxable income of $600,000, paid federal income tax of $200,000, and paid no dividends. The accumulated earnings at the beginning of the year were $200,000. The accumulated earnings tax would be computed as follows: Taxable income $600,000 Federal income tax - (200,000) Dividends paid - 0 Accumulated earnings credit - (50,000) ($250,000 - $200,000) -------------- Accumulated taxable income $350,000 Tax rate × 20% -------------- Accumulated earnings tax $70,000

EXAMPLE: Fixed Annuity Exclusion Ratio

Assume that Andrew purchased an annuity contract for $360,000 that provides for payments of $2,000 per month, and assume that his life expectancy is 20 years at the time the payments are to begin. The total expected return on the contract is $480,000 ($2,000 per month × 12 months × 20 years). For tax purposes, the exclusion ratio is the investment in the contract divided by the total expected return. Thus, Andrew's exclusion ratio is 75%, computed as follows: $360,000/$480,000 = 75% Of the $2,000 per month he received, Andrew may exclude from taxation 75% of that amount, or $1,500 as a return of capital. The remaining $500 is interest and is taxed as ordinary income.

S Corporations and Pass-Through Entities: S Corporation (II)

Because of the possibility of a disqualifying event as a planning technique, it is usually critical that an S corporation has previously executed a valid buy/sell agreement. In general, the IRS treats S corporation shareholders as general partners. Thus, shareholders are required to report the pro rata shares of corporate income (K-1 distributions) that pass through. However, it should be noted that, while general partnerships can implement special allocations of income and loss, this advantage is not available to S corporations. All items of income and loss are reported based on the ownership percentage of each shareholder. Moreover, the basis of an S corporation shareholder is calculated differently than that of a general partner. While general partners are permitted to include in their basis recourse and nonrecourse debt of the partnership, S corporation shareholders can count as basis only that which they have personally loaned to the corporation in addition to the shareholders' investment in the S corporation.

S Corporations and Pass-Through Entities: Qualified Business Income (Pass-Through Business) Deduction: Within Phaseout Range

Between $340,100 and $440,100 (married filing jointly) or $170,050 and $220,050 (all other taxpayers), the wage and property limit is phased in. However, the calculation is done differently depending on the type of business (SSTB or not). For a business that is not an SSTB, where the owner is within the phaseout range, the deduction is reduced by a pro rata portion of the excess of "a" over "b" below: a. 20% of the QBI b. The greater of 1. 50% of the taxpayer's allocable share of the W-2 wages paid by the business, or 2. 25% of the taxpayer's allocable share of the W-2 wages paid by the business, plus 2.5% of the taxpayer's allocable share of the unadjusted basis of all qualified property of the business

ETHICAL CONSIDERATIONS, AUDITS, AND TAX PENALTIES: Tax Avoidance and Tax Evasion: Preparer Penalties

Both clients and tax professionals alike may be held accountable for tax reporting errors. Financial planners should also be aware that a tax return preparer might be subject to certain penalties. These penalties include failure to provide a taxpayer with a copy of their return, failure to keep a copy of all returns prepared for at least the last three years or to maintain a list of returns prepared, and failure to sign a return as preparer and give their tax identification number on the return. Disclosing or otherwise using any client information given to a tax return preparer pursuant to the preparation of a tax return is a crime for which the preparer may be imprisoned for up to one year.

EXAMPLE: SE earnings are at or below the Social Security wage base

Catie has net earnings from self-employment of $40,000 in 2022. Her self-employment tax for the year is $5,652, calculated as follows. Self-employment income $40,000 Less $40,000 × 0.0765 $3,060 Equals net earnings $36,940 Multiplied by 0.1530 × 0.1530 ---------- Self-employment tax $5,652 **(also equal to $40,000 × 0.1413)

Tax Consequences of Property Transactions: COST RECOVERY METHODS: Amortization of Intangible Assets

Certain intangible assets (known as Section 197 assets) of a trade or business are amortizable over a period (useful life) of 15 years. Such assets include -- goodwill; -- trademarks; -- covenants not to compete; -- copyrights; and -- patents.

EXAMPLE: Tax implications of marriage

Cheryl and Liam were married this year, and both use a calendar year for income tax purposes. However, Liam was a nonresident alien until May 1 this year. Because of Liam's status, the couple may not file a joint income tax return this year.

EXAMPLE: Bargain sale to charity

Claudette sells a piece of modern art with an appraised FMV of $10,000 to a local museum of modern art. Claudette's basis is $6,000, and the sale price to the museum was $7,500. Claudette's allocated basis is $4,500 [$6,000 × ($7,500 ÷ $10,000)]. Her taxable gain on the sale is $3,000 ($7,500 sale price - $4,500 allocated basis). The gift to the museum has an FMV of $2,500 ($10,000 - $7,500) and a basis of $1,500 ($6,000 original basis - $4,500 allocated basis).

PROFESSOR'S NOTE: TAX LAW

Congress delegates rule-making authority to the U.S. Department of Treasury. Treasury Regulations are the Department's official interpretation of the Internal Revenue Code. Next to the Code itself, Treasury Regulations are the highest source of authority in matters of federal income tax law.

EXAMPLE: Installment sale calculation

Continuing the previous example, the down payment of $100,000 received by Mike is reported in the year of sale as $40,000 capital gain and $60,000 return of capital. The capital gain portion is determined by multiplying the down payment by the gross profit percentage, $100,000 × 0.40 = $40,000. The remaining $60,000 is considered a nontaxable return of capital.

Above-the-Line Deductions: Deductible IRA Contributions (1)

Contributions to a deductible traditional IRA are subject to AGI thresholds and other limitations. The maximum IRA contribution in 2022 is $6,000. The deduction for this contribution may be phased out or completely eliminated if the taxpayer is an active participant in an employer-sponsored qualified plan. 1) For single individuals who are active participants, the IRA deduction is phased out for MAGIs between $68,000 and $78,000 (2022). 2) For a married couple filing a joint return, if both spouses are active participants, the IRA deduction is phased out for MAGIs between $109,000 and $129,000 (2022). 3) For married taxpayers filing jointly, if only one spouse as an active participant, the active participant spouse is subject to the phaseout range of $100,000 to $120,000. The nonactive participant spouse is subject to a phaseout range of $204,000 to $214,000. These limitations are for the 2022 tax year, and the phaseout limits are indexed for inflation.

INCOME: DEDUCTIONS

DEDUCTIONS are TAKEN FROM ADJUSTED GROSS INCOME (AGI) TO DETERMINE TAXABLE INCOME. For the individual taxpayer, DEDUCTIONS can be STANDARD or ITEMIZED. ADJUSTMENTS, on the other hand, REDUCE TOTAL INCOME to arrive at AGI. Both ADJUSTMENTS & DEDUCTIONS ultimately have the effect of REDUCING TAXES owed.

EXAMPLE 2: Ordinary income property

Dale Hudson donates a painting to an art museum. The painting now has an FMV of $100,000, even though Dale purchased it for only $20,000 two years ago. Because the painting does, in fact, relate to the art museum's function, the current FMV of the painting ($100,000) may be deducted by Dale. If this painting were instead donated to a hospital and thus became use-unrelated property, Dale's allowable deduction would be limited to his basis (the purchase price of $20,000).

Supporting Elderly Parents or Special Needs Children: Caring for Elderly Parents or an Adult Child

Depending on the individual taxpayer, and the financial circumstances of a parent or adult child a taxpayer may be caring for, there may be tax implications for both the taxpayer and the person in their care. Understanding the income limitations and the specific rules involved may provide an opportunity for the client-taxpayer to reduce income tax liability and deduct specific expenses. The child and dependent care tax credit may also be available. The planner should review with the client the rules for claiming dependents to determine filing status when the taxpayer is supporting another person. The situation may arise where multiple adult children are contributing to the care of one aging parent. In this event, eligible taxpayers are generally free to agree among themselves who will claim an individual as a dependent for the purposes of filing status and tax credits.

EDUCATION TAX BENEFITS: Coverdell Education Savings Accounts (ESAs) (2)

Distributions up to the amount of qualified education expenses are made tax-free, even if the student is not a full-time student. Qualified education expenses include postsecondary tuition, fees, books, supplies, and basic room and board (or $2,500 per year for off-campus away-from-home students). However, the exemption does not apply to room and board if the student is enrolled on a less than a half-time basis. The definition of qualified education expenses for the Coverdell is very broad. These distributions may also be used to pay for K-12 expenses, for public or private schools, including tutoring, computer equipment, room and board, uniforms, and certain other expenses. Qualified education expenses also include amounts distributed for contributions to a 529 plan. For distributions that exceed education expenses, the excess is taxable once the basis is proportionately recovered from the entire distribution and the taxable portion is generally subject to a 10% penalty. Any remaining balance in a Coverdell account must be distributed when the beneficiary reaches the age of 30. However, the Coverdell account may be rolled over or transferred tax free to another Coverdell account, for the benefit of another family member of the original beneficiary. Contributions may be made to both a Coverdell account and a qualified state tuition program in the same year, for the same beneficiary. In any year that the exclusion for the distribution from a Coverdell account is claimed, neither the AOTC nor the Lifetime Learning Credit may be claimed with respect to the same expenses. Only education expenses in excess of those paid by Coverdell (or Section 529 plan) distributions may be used for the education credits.

Taxation of Cash Value Life Insurance

During the policyowner's lifetime, the accumulation of cash value within the policy is allowed to GROW TAX DEFERRED until it is surrendered. This is commonly referred to as the "INSIDE BUILDUP." AT the DEATH of the insured, the life insurance proceeds are typically EXCLUDED FROM GROSS INCOME of a beneficiary. An investment product does not share these tax advantages. Accordingly, under IRC SECTION 7702, there are two tests, ONLY ONE of which must be met for a product to be considered life insurance. These tests are known as: (1) the cash value accumulation test and (2) the cash guideline premium and corridor test. Presuming that the definitional provisions for life insurance have been met, income earned on money invested in insurance accumulates tax deferred. If one invests in securities, dividends and interest are currently taxable, as are any realized gains. Thus, because of the tax shelter nature of life insurance, what may appear to be a relatively low rate of return on a policy may be better than it seems. Proceeds payable before death (e.g., the surrender value) may be taxable if they exceed the insured's cost basis—the investment in the contract. In other words, to the extent that the cash surrender value exceeds the investment in the contract, there is taxable income at the surrender of the policy. If these proceeds are received in a lump-sum payout, the excess over the cost basis is taxable as ordinary income (interest income) in that year. If the proceeds are spread out in payments over a fixed period of years, the insured's cost is prorated over this period. These amounts received in excess of cost basis are taxed in the year of receipt, just like an annuity. A distribution from the life insurance contract is treated on a first-in, first-out (FIFO) basis. A taxable event occurs only to the extent that the distribution exceeds the investment in the insurance contract. On the insured's death, the proceeds, if paid in a lump sum to the beneficiary, are exempt from income tax under IRC Section 101. Payments made under other settlement options may be partially taxable. For example, interest on proceeds left with the insurance company are taxable to the beneficiary when paid or credited. Likewise, proceeds paid out in installments may be taxable to the beneficiary to the extent the anticipated installments exceed the exempt proceeds.

IMPUTED INCOME AND THE ALTERNATIVE MINIMUM TAX: AMT EXEMPTIONS

Each taxpayer is allowed a special AMT exemption before calculating the alternative minimum tax. These amounts are indexed for inflation. A tax rate of 26% applies to alternative minimum tax base amounts up to and including $206,100 (2022). A 28% rate applies to amounts in excess of $206,100. These AMT exemptions are subject to a phaseout. AMT Exemption Amounts and Phaseout Points Filing Status: Exemption: Phaseout Threshold Married, (MFJ) $118,100. $1,079,800 Married, (MFS*) $59,050 $539,900 Single $75,900 $539,900 Estates or trusts $26,500 $88,300 *For married taxpayers filing separately, there is an add-back to AMTI that is necessary to prevent married taxpayers subject to the AMT from filing separately to reduce the AMT liability. This add-back is beyond the scope of the materials. In 2022, the AMT exemption amount for a child subject to "kiddie tax" may not exceed $8,200 plus earned income.

PROFESSOR'S NOTE: PERSONAL SERVICE CORP TAX (PSC)

Easily remember this list with the mnemonic HALE for the first letter of each profession. -- Health; -- Accounting, architecture, and actuarial science; -- Law; or -- Engineering and consulting.

Tax Law Compliance and Procedures: Technical Advice Memoranda (TAMs)

Either a taxpayer or an IRS district's Appeals Division may request advice from the National Office of the IRS as to the Code, regulations, and statutes and their impact upon a specific set of facts. Generally, such requests take place during an audit or during the appeals process of the audit, and they give both the taxpayer and the revenue agent an opportunity to resolve a dispute over a technical question. If the National Office renders advice favorable to the taxpayer, normally it must be applied. However, if the advice is against the taxpayer, the taxpayer does not lose their right to further pursue the issue in question with the IRS.

EDUCATION TAX BENEFITS: U.S. Savings Bonds Redeemed for Education Expenses (1)

Eligible taxpayers are allowed a tax exemption for interest on qualified U.S. savings bonds redeemed to pay for qualified higher education expenses of the taxpayer, the taxpayer's spouse, or the taxpayer's dependents. Series EE and Series I savings bond interest is typically deferred until redemption of the bond. A taxpayer may make an election to treat the interest from these bonds as currently taxable. This education income tax exemption of the interest on the bonds (above and beyond mere deferral) is only available to certain taxpayers. In order to qualify, the bonds must be purchased by an individual age 24 or older, and must be held in that person's name, or jointly with a spouse. The bonds must then be redeemed to pay for the qualifying higher education expenses of the taxpayer, spouse, or dependent. Bonds purchased by a parent and titled in a child's name, as well as those purchased by a relative to pay a child's education expenses, will not qualify for the exemption. Thus, bonds placed into a custodial (Uniform Gift to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA)) account for the child are not eligible for the interest exclusion. Also, married taxpayers filing separately do not qualify for the exclusion. As a practical matter, putting ownership in the dependent child's name is disadvantageous for calculating the Expected Family Contribution (EFC) when filing the Free Application for Federal Student Aid (FAFSA).

PROFESSOR'S NOTE: CHILD CARE

Employees who use the dependent care FSA may not base a child and dependent care credit on those same expenses.

EXAMPLE: Types of expenditures

Everyday Equipment Company had to install a new starter on a bulldozer to keep it working. This repair is a current expense as the repair merely brought the bulldozer back to its original, useful condition. It did not add value, extend the useful life, or adapt the machine to another purpose.

PROFESSOR'S NOTE: FLPs

FLPs have the same treatment for general partners as general partnerships, and for limited partners the same treatment as limited partnerships.

SCHEDULE F

Farming income and expenses are reported on Schedule F of Form 1040 by individuals engaged in commercial fishing or farming as a business. It is also considered self-employment income and is subject to self-employment taxes. As a result, you should also be aware that a separate entry entitled self-employment taxes must be shown under the taxes section of cash outflows on the statement.

Tax Treatment of Business Property Gains: Related Party Transactions

Finally, if like-kind property is exchanged with a related party (defined in the previous module), the taxpayer and related party must not dispose of the like-kind property received until after two years following the exchange. If the related party transferee does dispose of the property within two years following the exchange, all previously deferred gain is recognized immediately. The only exceptions to this treatment are death of the recipient taxpayer, involuntary conversion, or both.

PROFESSOR'S NOTE: ALIMONY

For any divorce or separation agreement executed after December 31, 2018, alimony is no longer deductible by the payor spouse, nor included in income by the recipient spouse. Payments under decrees issued on December 31, 2018 or earlier will remain deductible by the payor spouse and taxable to the recipient spouse. As a practical matter, most payors can still deduct their alimony payments because the vast majority of divorces in effect during 2022 were finalized before 2019. Barring further action from Congress, it will take many years for the "new" rules to become the norm.

EXAMPLE: BOOT

For example, Property A has an FMV of $60,000 and a mortgage of $20,000 and is traded in a like-kind exchange for Property B with an FMV of $60,000 and a mortgage of $25,000. The exchange includes the assumption of the indebtedness by the new owner. The net reduction in indebtedness received by the owner of Property B is $5,000 and is the amount of boot received (assuming there was no other boot given or received in the transaction). If the mortgages were of equal amounts, there would be no reduction in indebtedness and no boot.

EDUCATION TAX BENEFITS: American Opportunity Tax Credit (AOTC) (2)

For 2022, the AOTC is phased out between $80,000 and $90,000 of AGI for single taxpayers and between $160,000 and $180,000 of AGI for married taxpayers filing jointly. For each eligible student, a taxpayer may elect the AOTC or the Lifetime Learning Credit. A taxpayer may also claim an exclusion from gross income for amounts distributed in the same year from a Coverdell ESA or Section 529 plan, provided that any excluded account distribution is not used to cover the same expenses for which the education credit is claimed. Election of a specific credit for one student does not preclude the use of a different credit for another eligible student. If parents pay the eligible expenses on behalf of a dependent, then the parents claim the credit. If the student pays the eligible expenses, the parents who treat the child (student) as a dependent are treated as having paid the expenses, and the parents must claim the credit. If the child is eligible to be treated as a dependent, but is not, only the child (student) may claim the credit. If the parents' AGI is high enough that they don't qualify for the AOTC, it may make sense to forgo treating the student as a dependent, in order to allow the student to claim the credit. Of course, the strategy only makes sense if the student has a tax liability to be offset by the AOTC. Note that 40% of the AOTC ($1,000) is refundable. When analyzing a tax return of a client, the planner may notice that $1,500 (or 60% of the total credit amount) is reported in the nonrefundable credit area of Form 1040, and $1,000 (or 40%) of the total credit is reported in the payments section of the 1040. The credit is not refundable for a student claiming the credit who is subject to the kiddie tax rules. The maximum $2,500 AOTC is allowed per student. However, the Lifetime Learning Credit (discussed in the following section) is allowed only per taxpayer. For example, a married couple filing jointly with three dependent children in the first four years of college may claim up to a $2,500 AOTC for each of the children, for a maximum $7,500 AOTC. However, a married couple filing jointly, with three dependent children in graduate school, may claim no more than a total $2,000 in Lifetime Learning Credit per tax year.

PROFESSOR'S NOTE: MUNI BONDS CAPITAL GAINS

If a taxpayer purchases a municipal bond at a market discount, the interest from this bond will remain tax free. However, the gain at redemption is considered a capital gain and is not exempt from federal tax.

EXCLUSIONS FROM INCOME: Items that are a return of capital.

For example, a taxpayer's adjusted tax basis in an investment constitutes a tax-free return of capital.

EXAMPLE: EQUIVALENT TAX BENEFIT

For example, assume a taxpayer in the 24% marginal income tax bracket qualifies for a $2,200 IRA deduction. The amount of tax credit that would provide a tax benefit equal to the deduction can be determined in the following manner: TC = $2,200 × 0.24 TC = $528 Alternatively, if one knows the amount of tax credit (or tax savings) and wishes to determine the amount of exclusions or deductions that would equal the credit, the following formula applies: d = TC/m For example, assume a taxpayer in the 32% marginal income tax bracket qualifies for a $600 child care credit. The amount of exclusions or deductions that would provide tax benefits equal to the child care credit can be determined in the following manner: d = $600/0.32 d = $1,875

Tax Reduction and Management Techniques: CHARITABLE CONTRIBUTIONS (3)

For example, if a donor who is a famous artist donates a painting to an art museum, the donor is entitled to a deduction for the basis of the painting. Thus, the deduction would be limited to the cost of the frames, canvas, and paints incorporated into the paintings, and not to the value of the time spent to produce them or the increase in value due to the artistic talent. Similarly, if a donor allows a qualified charity the rent-free use of his property (as opposed to giving title to the property to the charity), the donor will not be entitled to a charitable deduction because the right to use the property is not deductible. Generally, a charitable contribution of less than a donor's entire interest is nondeductible. There are four statutory exceptions to this rule: -- A gift of an undivided portion of the donor's entire interest (e.g., a right of ownership in a painting to an art museum for half of the year) -- A gift of a remainder interest in a personal residence or farm -- A gift to a public charity of a remainder interest in real property granted solely for conservation purposes -- A gift of a partial interest transferred through a qualifying form of trust (e.g., a charitable remainder annuity trust)

PROFESSOR'S NOTE: 50% ORGANIZATIONS

For gifts of cash only to a 50% organization, the maximum current year deduction is limited to 60% of AGI. This provision is designed to encourage greater cash contributions to public charities. Thus, it is possible to obtain a 60% AGI deduction from a "50% charity." For noncash gifts or ordinary income property to a public charity, the limit remains 50% of AGI. Furthermore, the limitation is reduced to 30% of AGI if donating long-term capital gain property if the deduction is based on the FMV of the property.

S Corporations and Pass-Through Entities: Qualified Business Income (Pass-Through Business) Deduction: OVER THRESHOLDS

For taxpayers over the phaseout threshold ($440,100 for married taxpayers filing jointly, or $220,050 for other taxpayers), there are additional restrictions, depending upon the type of business. Businesses may be divided into two categories: specified service businesses and other businesses. A specified service trade or business (SSTB) is one of the following: -- Any trade or business involving the performance of services in health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees. -- Any trade or business that involves the performance of services that consist of investing and investment management, trading, or dealing in securities, partnership interests, or commodities. Note that engineering and architecture are specifically excluded from the definition of SSTB. For SSTBs, once the taxable income exceeds the top of the phaseout range ($440,100 for married taxpayers filing jointly, or $220,050 for other taxpayers), there is no QBI deduction allowed. For businesses that are not SSTBs, the QBI deduction is the lesser of: -- 20% of the QBI; or -- the greater of + 50% of the taxpayer's allocable share of the W-2 wages paid by the business, or + 25% of the taxpayer's allocable share of the W-2 wages paid by the business, plus 2.5% of the taxpayer's allocable share of the unadjusted basis of all qualified property of the business. **The QBI DEDUCTION is STILL LIMITED BY 20% of the taxpayer's taxable income, reduced by any capital gains included in the taxable income.**

TEST TIP: SECTION 79

For the purposes of the CFP® exam, the Section 79 group term life insurance premium will be included in the question stem or case study facts.

EDUCATION TAX BENEFITS: Student Loan Cancellation

Generally, if a taxpayer is responsible for making loan payments, and the loan is canceled or repaid by someone else, the borrower must include the amount that was canceled or paid on their behalf in gross income for tax purposes. However, after December 31, 2017, the borrower may be able to exclude amounts from gross income if the cancellation is due to death or permanent and total disability.

EXAMPLE 1: AMT calculation

Gerald Parker is married and will file a joint return with his wife. They have four children. They have an AGI of $303,250. Gerald exercised an incentive stock option during the year. The option price was $10,000, while the FMV of the stock at the time it was exercised was $80,000. They also have $5,000 of tax-exempt interest from qualified private-activity municipal bonds issued in 2008. They have itemized deductions, as follows: Charitable contributions (cash) $6,000 State income taxes 17,000 Real estate taxes 5,000 Home mortgage interest 14,000 Their regular income tax calculation is listed in the following table. (WILLS: SEE SCREENSHOTS)

Tax Reduction and Management Techniques: CHARITABLE CONTRIBUTIONS (2)

Gifts that qualify for the charitable deduction generally are one of two types: 1). Perhaps the most common is a direct gift of cash or property to the charitable organization. 2). The second is an indirect gift that includes the provision of goods and services to the charity to make possible the achievement of the charitable purpose. Indirect gifts are said to be "to and for the use of charity" and are not considered to be made directly to the charity. The most common example of such a contribution is the use of the taxpayer's car for the organization's charitable purpose, for which the taxpayer is allowed to deduct 14 cents per mile. Also included in the category of indirect gifts is the cost of meals and lodging for the taxpayer on charitable business for which the taxpayer receives no reimbursement from the charitable organization. Although there is no deduction for the value of the services that the taxpayer renders to charity, the unreimbursed out-of-pocket expenses are deductible.

CAPITAL GAINS: STOCK DIVIDENDS AND RIGHTS (4)

If the distribution of either stock or stock rights is taxable, as discussed previously, the shareholder's basis in the old stock does not change. The basis in the new stock is equivalent to the amount of dividend income that the shareholder is required to include in their gross income. The holding period of any new stock or rights begins on the day after the distribution. If the shareholder exercises the stock rights, the holding period of the new stock acquired under the rights, begins on the date the new stock is acquired.

Tax Reduction and Management Techniques: EXCESS CONTRIBUTIONS CARRY FORWARD

If the taxpayer has made contributions in excess of the limits prescribed in the current year, the taxpayer is entitled to carry forward the excess deduction for up to five years. At the end of five years or upon the death of the taxpayer, the carry forward expires.

EXAMPLE: Personal service hours

If the taxpayer is a dentist with a full-time practice, it will be practically impossible to meet the personal service hours test. If the dental practice takes up 2,000 hours per year, the dentist would need to participate in a real estate rental activity for 2,001 hours per year (more than 50% of the taxpayer's personal service hours).

EDUCATION TAX BENEFITS: Self-Employed Work-Related Education Deduction

If you are self-employed, you can deduct your expenses for qualifying work-related education directly from your self-employment income. According to the IRS, this reduces the amount of your income subject to both income tax and self-employment tax. This deduction is only available to Schedule C filers.

EXAMPLE: Section 179 (I)

In 2022, Benes Corporation purchased and placed in service office machinery costing $20,000. However, the taxable income for Benes Corporation in 2022 (without regard to the Section 179 expense election and other exceptions) is $10,000. Therefore, the maximum Section 179 expense that may be taken by Benes Corporation in 2022 is only $10,000. While $20,000 of the expense is eligible, only $10,000 may be taken because the deductible amount is limited to business taxable income. The remaining $10,000 may be carried over for use in future years. Finally, the adjusted taxable basis of any qualifying property is reduced by the amount of the Section 179 deduction taken and is adjusted for the dollar limitation ($10,000), not for the taxable income limitation.

Taxation of Security Transactions: PROPERTY ACQUIRED BY GIFT

In a situation where the donee, the recipient of a gift, assumes the donor's adjusted basis, the donor's holding period is tacked. In other words, the donee's holding period begins on the date that the donor acquired the property. Thus, if the fair market value (FMV) on the date of the gift is greater than the donor's adjusted basis, the recipient of the gift is treated as holding the property, beginning with the date that the donor acquired the property. Alternatively, if the FMV on the date of the gift is used as the donee's basis, the holding period starts on the date of the gift. The following example will help to illustrate the rules.

Electing Section 179 Expense Treatment (IV):

In general, taxable income for this purpose is calculated by totaling the net income and losses from all trades or businesses a taxpayer actively conducted during the year. For taxpayers who file as MFJ, eligible taxable income from both spouses is used. Net income or loss from a trade or business includes the following items: -- Section 1231 gains (or losses) -- Interest from working capital of the taxpayer's trade or business -- Wages, salaries, tips, or other pay earned as an employee Taxable income is calculated without regard to any of the following: -- The Section 179 deduction -- The self-employment tax deduction -- Any net operating loss carryback or carryforward

Taxation of Annuity Contracts: PARTIAL ANNUITIZATION

In the past, if a taxpayer wanted to access a portion of the funds in an annuity contract, she had to take a nonperiodic distribution (discussed later). However, partial annuitization of an annuity contract is now allowed. If any amount is received as an annuity for a period of 10 years or more, or over one or more lives, under any portion of an annuity (endowment or life insurance) contract, that portion of the annuity will be treated as a separate contract for annuity taxation purposes. Thus, holders of nonqualified (commercial) annuities can elect to receive a portion of an annuity contract in the form of a stream of annuity payments. This leaves the remainder of the contract to accumulate income on a tax-deferred basis.

Tax Law Compliance and Procedures: INTRO

In the study of income tax planning, there are always two parts—substantive tax law (which was the focus of Modules 1-7) and tax procedure (the focus of this module). Tax procedure includes the sources and levels of federal tax law, tax law doctrines developed by the courts, and the operations of the IRS. Tax audits will also be discussed. The IRS imposes penalties for specific acts or failures to act by the taxpayer. Penalties are imposed for failure to file a return as well as to pay the proper amount of tax due at the prescribed time. This module considers all of these penalties, as well as the interest on underpayments (and overpayments) of tax. Also covered in this module is the issue of who can represent a taxpayer before the IRS in a taxpayer audit. A favorite question on the CFP® Certification Examination is whether a CFP® certificant is permitted to represent a taxpayer before the IRS in the event of an audit. The answer to this question is no, without evidence of certain additional credentials, such as the CPA designation or state licensing as an attorney.

SELF EMPLOYED: PARTNERSHIPS

Income from partnerships is TAXED TO THE GENERAL PARTNER at his own INDIVIDUAL RATE. The partnership files an INFORMATIONAL RETURN (IRS Form 1065) and provides each partner with a SCHEDULE K-1 form indicating his share of the partnership income. The partner then reports this K-1 amount as income on Form 1040, Schedule E and pays self-employment tax on the same.

SPOUSE RELIEF: INJURED SPOUSE

Injured spouse relief is similar to innocent spouse relief, but there are key differences. An injured spouse claim is filed when the refund on a jointly filed return has been frozen or seized to satisfy some past-due obligation. In most cases, this obligation preexisted the marriage. With this claim, the injured spouse may be able to recover their portion of the refund.

EDUCATION TAX BENEFITS: Student Loan Interest Deduction

Interest paid on qualified higher education loans is generally deductible to reach AGI. The MAXIMUM ALLOWABLE DEDUCTION is $2,500. However, the taxpayer may not be claimed as a dependent of another and deduct such interest. In addition, the deduction is phased out if the taxpayer's MAGI is above a certain amount (e.g., in 2022, for taxpayers filing as MFJ with a MAGI phaseout between $145,000-$175,000; and a MAGI phaseout between $70,000-$85,000 for single taxpayers). Several provisions in the IRC provide special treatment for education funding. For example, COVERDELL ESAs allow for the TAX-DEFERRED, and possibly TAX-FREE, ACCUMULATION of funds to help pay for higher education costs of certain individuals. SERIES EE U.S. SAVINGS BONDS may allow for the tax-free accumulation of funds in certain circumstances. In addition, the IRC provides for two tax credits for funds that are expended in the pursuit of higher education. Lastly, the state prepaid tuition plans allow for preferential income tax treatment.

Like-Kind Exchanges: OVERVIEW

Internal Revenue Code Section 1031 provides that no gain or loss is recognized where investment property or business property is exchanged solely for property of a like-kind. Thus, a like-kind exchange is a potentially nontaxable transaction involving the exchange of qualifying, like-kind property. The like-kind exchange is typically used when a taxpayer wishes to dispose of an asset (while minimizing potential taxation), and acquire another asset. Taxpayers involved in such transactions often have no recognized (taxable) gain at the time of the exchange. There are, however, certain situations in which the like-kind exchange may be taxable. If the taxpayer receives boot (i.e., any property that is not qualified or like-kind), then gain may be recognized (subject to tax) in the exchange. In the form of nontaxable exchanges, realized gains or losses are not recognized (taxed) in the year of the exchange. However, this nonrecognition is usually temporary because taxation of any gain is only deferred, and the allowance of any loss is merely postponed. The most common example of a nontaxable exchange is a Section 1031 like-kind exchange. Almost all real property will qualify for like-kind treatment. However, this applies only to realty. Personalty does not qualify for like-kind exchange treatment. Although the exchange of personalty for personalty is perfectly legitimate, it is no longer protected by Section 1031. Only realty for realty will qualify for these special tax-favored rules.

Passive Activity and At-Risk Rules: DIRECT PARTICIPATION PROGRAMS: Direct Ownership

Investors also have the option of directly owning tangible income-producing assets. For example, investors often own rental real estate in an individual capacity. Several investors may own a direct interest in a single property, as tenants in common or otherwise. However, the direct ownership form of owning property often involves personal liability, a lack of flexibility, and illiquidity.

TEST TIP: INCOME TAX

It is HIGHLY UNLIKELY that you will have to complete any of the IRS forms for the CFP® exam. You should, however, understand how the forms are structured, as well as what is included in each of the steps in the basic federal income tax formula.

TEST TIP: TAX IMPLICATIONS OF MARRIAGE

It is normal for spouses that are planning to divorce to the use the MFS status. Be aware that even if they file separately, their deductions must still be congruous. In other words, if one spouse itemizes, the other spouse must also itemize. Likewise, if one spouse takes the standard deduction, the other spouse must also take the standard deduction. The IRS does not allow one spouse to take "all" the itemized deductions while the other takes the standard deduction. Doing so would artificially reduce taxable income

TEST TIP: AMT

It is not crucial for students to understand the intricacies of the various depreciation adjustments. However, it is important to realize that depreciation will often cause a potential AMT problem.

TEST TIP: PHASEOUTS FOR EDUCATION PROVISIONS

It is not necessary to memorize the phaseouts for various education provisions. These phaseout amounts will be provided both on the College's final exam and on the CFP® exam.

Taxation of Cash Value Life Insurance: Life Insurance in Qualified Plans

It should be noted that the tax treatment is different when cash value life insurance is owned inside a qualified retirement plan. The purchase of life insurance must be incidental to providing a retirement benefit. The premiums paid are a taxable benefit to the employee, using IRS PS 58 tables. The CHIEF BENEFIT of this arrangement, to the EMPLOYER, is REDUCED ADMIN COSTS. The MAIN BENEFIT to the EMPLOYEE is in the event of their premature demise, their survivors will still RECEIVE AMPLE RETIREMENT BENEFITS. This is a TREMENDOUS ADVANTAGE if the plan is held in a DEFINED CONTRIBUTION plan. If the employee survives to retirement, the benefit can be annuitized. If the employee passes unexpectedly before retirement, the tax computation is complex. However, the net proceeds of the death benefit pass tax free to beneficiaries.

EXAMPLE: Ordinary assets versus capital assets

Jacob has acquired the following assets: -- A rental property that is held exclusively to be rented by others -- A sculpture bought from an art gallery -- Accounts receivable from his florist business -- A delivery van for his shop Of these, only the sculpture is a capital asset. Creative works are noncapital assets in the hands of the creator, not the buyer. The other acquisitions are noncapital assets.

EXAMPLE: Qualifying Dividends Example 1

Karl bought 5,000 shares of XYZ Corporation's common stock on July 1, 2022. XYZ Corp. paid a cash dividend of 10 cents per share. The ex-dividend date was July 9, 2022. Karl's Form 1099-DIV from XYZ Corp. shows $500 in box 1a (ordinary dividends) and in box 1b (qualified dividends). However, Karl sold 5,000 shares on August 4, 2022. Karl held his shares of XYZ Corp. for only 34 days of the 121-day period (from July 2, 2022, through August 4, 2022). The 121-day period began on May 10, 2022 (60 days before the ex-dividend date), and ended on September 7, 2022. Karl has no qualified dividends from XYZ Corp. because he held the XYZ stock for less than 61 days during the 121-day period.

EXAMPLE: Replacement property and time limitation (II)

Ken was notified by the city council on December 2, 2018, of its intention to acquire by condemnation his real property used in his business. On June 5, 2019, the city paid Ken for his property. The replacement period began on December 2, 2018, the date Ken was notified of the intention to condemn his property. Because Ken did not realize a gain on the disposition of the property until 2019, the replacement period ends on December 31, 2022, the last day of the third taxable year following the year in which the gain was first realized.

EXAMPLE: Accounting methods

Kim is a sole proprietor and may use the cash method of accounting for her business. If Kim's business maintains an inventory, gross receipts exceed $27 million dollars annually, and it is not a service business, she must use the accrual method of accounting. If Kim's business included both inventory and service components, she could use the hybrid method of accounting.

EXAMPLE: Netting capital gains and losses: Example 4

Last year, Jake had a $10,000 short-term capital loss carryforward. During the current tax year, he sold several securities that resulted in the following types of gains and losses: -- Long-term capital gain: $9,600 -- Short-term capital gain: $7,900 -- Long-term capital loss: $2,500 -- Short-term capital loss: $600 The result is as follows: LTCG $ 9,600. STCG $ 7,900 LTCL (2,500) STCL (10,600) LTCG $ 7,100 STCL (2,700) ** Net LTCG $4,400

TEST TIP: PUBLICALLY-TRADED-PARTNERSHIPS (PTP)

Losses from one non-publicly traded partnership can be used to offset income from another non-publicly traded partnership. Losses from a PTP cannot be used to offset income from other partnerships. Losses from a PTP may only be used to offset income from the same PTP in subsequent years. In essence, PTP income is treated as portfolio income.

EXAMPLE: Passive activities

Louise inherited a home at her parents' deaths earlier this year. She has been renting it to tenants since that time. It is her only rental property and she handles everything from the lease to the repairs. This does not interfere with her full-time employment as an insurance broker. When she reports her income and expenses for the rental, she will treat it as a passive activity and follow the passive activity loss and at-risk rules.

EDUCATION TAX BENEFITS: State Tuition Programs, 529 Plans, and Educational Provisions: State Tuition Programs (2)

Many, but not all, 529 plans will allow a rollover from an UGMA or UTMA. However, because these funds belong to the child under the custodial arrangement, withdrawals from the account must be for the benefit of that child only. Many plans also allow a rollover from a Coverdell account, or from qualified U.S. savings bonds, and these rollovers are generally tax free. Contributions to qualified state tuition programs are treated as completed gifts of a present interest, and are therefore excludible under the annual gift tax exclusion and under the generation-skipping transfer tax. To the extent the contributions exceed the annual gift tax exclusion amount, the contributor may elect to have the contribution treated ratably over five years. Contributions to a 529 account in a single year can be treated for gift tax purposes as if they were made over a five-year period. This allows contributions in the current year of up to five times the maximum annual exclusion ($80,000 using the 2022 exclusion amount, or if gift-splitting with spouse, up to $160,000). If this five-year averaging or frontloading election is made, the annual gift tax exclusion will not be available for other gifts to the beneficiary of the account for a period of five years. This is true unless the maximum annual exclusion amount increases. Premature death of the owner of the 529 plan could result in federal estate tax clawback.

EXAMPLE: CALCULATING STANDARD DEDUCTION

Mary Sue, age 16, has earned income of $15,400 and interest income of $800 in the year 2022. She is claimed as a dependent on her parents' income tax return. Mary Sue's standard deduction is $12,950. Because Mary Sue has both earned and unearned income, and she is claimed as a dependent, her standard deduction is the earned income plus $400, or $15,000 + $400 = $15,400. However, this exceeds the allowable limits. Thus, her deduction is capped at $12,950. She has taxable income of $3,250 ($16,200 income reduced by the standard deduction of $12,950). Because her unearned income is under $2,300, there is no application of the parental rate. The $3,250 is taxed at her marginal rate of 10%.

Meals and Lodging Furnished for the Convenience of the Employer

Meals furnished by the employer on its business premises and for its convenience to employees are not taxable. This also includes the benefit of an executive dining room. If lodging is provided for free as an employee benefit, the employee must accept it as a condition of employment for the benefit to be excludable from income. Beginning in 2021, Congress authorized a full 100% deduction for business meals provided by a restaurant. The expense must be paid after December 31, 2020, and before January 1, 2023 (Consolidated Appropriations Act 2021). The prior limit was 50%. This measure is intended to help revive the food service industry, which witnessed an unprecedented economic slowdown in 2020.

EXAMPLE: Recognized gain is equal to boot received

Mike exchanged investment land with an adjusted basis of $35,000, receiving another parcel of investment land in exchange. The land received by Mike had an FMV of $50,000, and Mike received $12,000 in cash from the other party. Because of this exchange, Mike (the recipient) must recognize a taxable gain of $12,000 (his realized gain was $27,000). FMV of property received by Mike $50,000 Cash (boot) received by Mike $12,000 -------- Amount realized by Mike $62,000 Less adjusted basis in property exchanged ($35,000) --------- Realized gain $27,000 Recognized gain $12,000

TEST TIP: SECTION 1245

Note that Section 1245 does not apply to losses. Rather, Section 1231 rules are used, resulting in ordinary loss treatment.

Tax Law Compliance and Procedures: Legislative Regulations

Occasionally, Congress will give specific authorization to the Secretary of the Treasury to issue regulations on a particular Code section. For example, under Section 1502, the secretary is charged with prescribing the regulations for the filing of a consolidated return by an affiliated group of corporations. There are virtually no Code sections governing consolidated returns, and the regulations in effect serve in lieu of the Code. In this case and others where it occurs, the regulation has the force and effect of a law, with the result that a court reviewing the regulation usually will not substitute its judgment for that of the Treasury Department unless the Treasury has clearly abused its discretion.

EXAMPLE: IMPUTED INTEREST RULES

On January 1 of the current year, Ken loaned his son, Mark, $95,000 to purchase a new personal residence. He did not charge Mark interest, although the federal interest rate was 6%. Ken had annual investment income of $105,000, whereas Mark had interest income of only $5,000. As a result, Ken must recognize imputed interest income equal to Mark's (the borrower's) NII of $5,000 even though the calculated interest would have been $5,700 ($95,000 × 0.06). In addition, Ken is considered to have made a gift to Mark of $5,000. Gift tax could also be levied on any forgiveness of debt by father to son. The gift, however, may be offset by any gift tax annual exclusion that is otherwise permitted under transfer tax law (covered in the FP516 Estate Planning course).

EXAMPLE: Imputed interest on a gift loan

On January 1, Richie loaned his daughter, Beth, $90,000 to purchase a new personal residence. There were no other loans outstanding between Richie and Beth. Beth's only income was $30,000 in salary and $3,300 in interest income. Richie had investment income of $200,000. Richie did not charge Beth interest. The relevant federal rate was 9%. Richie must recognize imputed interest income of $3,300. The $100,000 exemption applies, and thus Richie's imputed interest income (and Beth's imputed interest expense) is limited to Beth's investment income. In addition, Richie is deemed to have made a gift to Beth of $3,300. The gift is eligible for the annual exclusion.

CAPITAL GAINS: 25% TAX RATE

On the sale of Section 1250 property (primarily depreciable real estate), the portion of the capital gain attributable to depreciation is subject to a maximum 25% tax rate. This 25% gain is referred to as UNRECAPTURED Section 1250 income.

Standard and Itemized Deductions

Once AGI has been calculated, the taxpayer may choose to take additional below-the-line deductions. An individual's AGI is reduced by the greater of the specified standard deduction under law or allowable itemized deductions. Basic standard deduction amounts are based on filing status and the calendar year of filing. The standard deduction amounts for 2022 are given in the following table. A taxpayer who is age 65 or older or blind qualifies for an additional standard deduction amount depending on filing status. Two additional standard deductions are given for a taxpayer who is age 65 or older and blind. The next table lists the additional standard deduction amounts for 2022.

NETTING PROCESS: MUTUAL FUNDS

One of the most frequently overlooked aspects of investing in mutual funds is the tax consideration arising from the sale of mutual fund shares. If an investor sells shares of a mutual fund, there is a tax owed on any gain. This gain is measured by the difference between the sales proceeds and the investor's basis (i.e., adjusted cost) in the shares.

Passive Activity and At-Risk Rules: DIRECT PARTICIPATION PROGRAMS: Accelerated Deductions

One way a direct participation program produces tax benefits is by generating losses through accelerated deductions (such as accelerated cost recovery deductions) or noncash deductions (such as percentage or cost depletion in an oil and gas activity). While accelerated depreciation was allowed for real estate under old rules, the vast majority of real estate is now depreciated using straight-line depreciation. Personalty (machinery, equipment, etc.) is still depreciated using an accelerated method.

Tax Reduction and Management Techniques: Ordinary Income Property

Ordinary income property is property that, when sold, would result in recognition of ordinary income by the taxpayer. One of the most common examples is the charitable donation of a work of art created by the taxpayer. This category also includes business inventory, taxpayer-created artwork and manuscripts, letters and memoranda, and stock that has been held by the taxpayer for less than one year (short-term capital gain property). The following are ordinary income property: -- Cash -- Short-term capital gain property (property held less than one year) -- Works of art, books, or letters, when given by the person who produced them -- Inventory A taxpayer will usually receive greater benefits from gifts of appreciated long-term capital gain property than can be received from gifts of cash or other ordinary income property. This is because the taxpayer is allowed a deduction for the FMV of long-term capital gain property on the date of the gift. Thus, the income tax deduction includes the appreciation, which has never been recognized as income. Long-term capital gain property is property that would have produced a long-term capital gain on the date of the gift had it been sold rather than donated to charity.

Tax Planning for the Medicare Contribution Tax (2)

Other traditional tax planning techniques should still be explored. Income shifting, by transferring assets to family members (often children) in a lower marginal income tax bracket, is still appropriate. For 2022, a child subject to the kiddie tax may have $2,300 of unearned income before the fiduciary tax rate (i.e., trust rates) applies. Strategies that defer taxable income will remain popular. Funds within a Section 529 (or Coverdell) plan will grow tax deferred, and the distributions are excluded from income if the funds are used for qualified higher education expenses. It seems likely that the use of commercial annuities will continue to gain in popularity. The tax-deferred growth within the annuity contract is not subject to current taxation and thus avoids the Medicare contribution tax. Keep in mind that if the contract is annuitized, the taxable portion of the annuity distributions is treated as investment income. If nonperiodic or lump-sum distributions are taken from the contract, those distributions are subject to the tax as well. Certain taxpayers will have a high enough MAGI that reducing it to a point where the Medicare contribution tax will no longer apply is simply not possible. In those cases, it is beneficial to look at reducing the investment income.

PROVISIONAL INCOME

PROVISIONAL INCOME is the beneficiary's modified adjusted gross income (MAGI) + municipal bond interest + 1⁄2 of the Social Security (or tier 1 railroad) retirement benefits. For SINGLE taxpayers with PROVISIONAL INCOME of $25,000 OR LESS ($32,000 MFJ), NONE of the income is TAXABLE. For SINGLE taxpayers with PROVISIONAL INCOME between $25,000 and $34,000 ($32,000 to $44,000 MFJ), 50% of the benefits are TAXABLE. For SINGLE taxpayers with PROVISIONAL INCOME that is GREATER than $34,000 ($44,000 MFJ), 85% of the benefits are TAXABLE.

TEST TIP: "EVERY PIG NEEDS A PAL"

Passive losses may only be deducted against passive income. When a client has multiple passive activities in place, a helpful mnemonic device is "Every pig needs a pal." In order to achieve a tax deduction, a passive income generator (PIG) should be offset by a passive activity loss (PAL) if available. The absence of one or the other will result in either a taxable event or suspended losses.

EXAMPLE: Net Investment Income Tax calculations Example 2

Paul and Tina are married taxpayers filing a joint tax return. In 2022, their MAGI is $350,000, and their net investment income (included in the MAGI) is $80,000. They will pay the 3.8% Medicare contribution tax on $80,000. This is the lesser of the net investment income ($80,000) or the AGI in excess of the threshold amount ($350,000 - $250,000, or $100,000). In this situation, all $80,000 of the net investment income is subject to the Medicare contribution tax. Paul and Tina will pay a $3,040 Medicare contribution tax (3.8% of $80,000).

EXAMPLE: Closely held C corporations (I)

Paul is a shareholder in a closely held corporation. His accountant told him he could deduct the losses generated by the corporation against his active income. Passive activity loss (PAL) rules apply to individuals, estates, trusts, personal service corporations, and closely held C corporations. Closely held C corporations may offset passive losses against active income but not against portfolio income. In addition, an oil and gas activity that involves a working (not royalty) interest in any oil and gas property a taxpayer owns directly or through a general partnership is not a passive activity.

PROFESSOR'S NOTE: RECOMMENDING BUSINESS FORMS

Planners should exercise caution when recommending a specific business form over another because doing so could be construed as practicing law. Thus, it is always best for the client to consult a licensed attorney before making a final decision about business forms.

Tax Law Compliance and Procedures: Procedural Regulations

Procedural regulations cover such areas as the information a taxpayer must supply to the IRS and the internal management and conduct of the IRS in certain matters. Those regulations affecting vital interests of the taxpayers are generally binding upon the IRS, and those regulations stating the taxpayer's obligation to file particular forms or other types of information are given the effect of law.

CONTRASTING PASSIVE AND ACTIVE INCOME: PUBLICLY TRADED PARTNERSHIPS

Publicly traded partnerships trade over an established exchange. Privately traded partnerships do not and thus are usually acquired via private placement. It is important to understand the distinction between the two for tax purposes. After TRA'86, advisers and tax planners thought that the master limited partnership (MLP) was the panacea for the PAL rules. In late 1986 and early to mid-1987, many planners (brokers, etc.) were recommending MLPs as a way to generate the passive income that their clients needed to allow the use of their otherwise unused passive losses. In addition, the MLP seemed to offer advantages not normally associated with tax shelters and limited partnerships. Because they were traded on an established stock exchange, they offered liquidity and marketability, typically lacking in most limited partnership investments. The combination of passive income and investment advantages led to a tremendous surge in purchases of the MLP. Congress was not very pleased about taxpayers manipulating the PAL rules, and this led to further legislation dealing with passive activities. With the enactment of OBRA in 1987, Congress changed the treatment of income and losses from publicly traded partnerships, including the MLP. OBRA provides that the net income or net loss from each publicly traded partnership (PTP) is treated separately for purposes of the PAL rules. This means that the income from a publicly traded partnership may not be offset by passive losses from any other source. In essence, the income from a publicly traded partnership is treated as portfolio income. Because MLPs are publicly traded, the income and loss from them are subject to these rules. In addition, losses from publicly traded partnerships may not be used to offset passive income from any other source. Each publicly traded partnership is treated separately, and a net loss from a publicly traded partnership must be carried forward and used only against the future income from that same partnership. Note that publicly traded partnership is broadly defined. A partnership is publicly traded if the interests in such partnership are traded on an established securities market, or are readily tradable on a secondary market (or the substantial equivalent thereof).

EDUCATION TAX BENEFITS: U.S. Savings Bonds Redeemed for Education Expenses (2)

Qualified U.S. savings bonds are Series EE U.S. savings bonds issued after 1989, and Series I bonds. Qualified higher education expenses are tuition and fees, net of any scholarships, fellowships, or other tuition reduction amounts, paid to an institution of higher education. Also, the transfer of redemption proceeds to a qualified tuition program (529 plan) or to a Coverdell account for the taxpayer, spouse, or dependent is treated as a qualified higher education expense. Two provisions may limit the amount of interest for exemption. One limitation applies when the total redemption proceeds of the bonds, including principal and interest, exceed the amount of qualified higher education expense in a tax year. The other limitation phases out the exclusion when a taxpayer's modified adjusted gross income (MAGI) exceeds certain amounts when the bonds are redeemed. In 2022, this phaseout applies to single taxpayers with MAGI between $85,800 and $100,800, and to married taxpayers filing jointly with MAGI between $128,650 and $158,650. (MAGI figures are indexed for inflation.) If the bonds are purchased by an individual under 24 years of age; if the bonds are gifted to another individual; or if the bonds are redeemed to pay for the education of someone other than the taxpayer, the taxpayer's spouse, or a dependent of the taxpayer, the exclusion does not apply. Also, a married taxpayer must file jointly to qualify for the exclusion.

TYPES OF BUSINESS ENTITIES: C CORPORATIONS: ACCUMULATED EARNINGS TAX: REASONABLE BUSINESS NEEDS

Reasonable business needs of the corporation would include: -- a reasonable accumulation of working capital, -- expansion of the business, -- debt retirement, -- acquisition of another business, -- or replacement of plant or equipment.

Tax Law Compliance and Procedures: REVENUE PROCEDURES

Revenue procedures are statements reflecting the internal management practices of the IRS that affect the rights and duties of taxpayers. Occasionally they are also used to announce procedures to guide the public in dealing with the IRS or to make public something the IRS believes should be brought to the attention of taxpayers. The citation of revenue procedures is done with the prefix Rev. Proc

Tax Treatment of Business Property Gains: Section 1250 Property

Section 1250 applies to depreciable real property used in a trade or business or for the production of income, that is, real estate that is a Section 1231 asset. Upon sale, the gain attributable to straight-line depreciation is treated as long-term capital gain, subject to a special LTCG tax rate. This gain is referred to as unrecaptured Section 1250 gain and is taxed at the maximum 25% capital gain rate. If the taxpayer's marginal tax rate is less than 25%, the Section 1250 gain will be taxed at that lower marginal tax rate. For taxpayers whose marginal rate is 32% or higher, 25% is the maximum rate at which the unrecaptured Section 1250 gain will be taxed. Any gain not attributable to depreciation (gain attributable to actual appreciation of the asset) is subject to a LTCG rate. Like Section 1245, any losses on Section 1250 property do not have any depreciation recapture and are usually treated as Section 1231 (ordinary) losses.

SELF-EMPLOYED (1)

Self-employed individuals, such as a SOLE PROPRIETOR or GENERAL PARTNER in a partnership, generate self-employment income. In turn, such individuals MUST PAY BOTH PORTIONS of the Federal Insurance Contributions Act (FICA) PAYROLL TAX, which is 15.3%. This tax CONSISTS of TWO SEPARATE TAXES: 1.) an Old Age, Survivors, and Disability Insurance (OASDI)—also called SOCIAL SECURITY—tax that is levied on earnings UP TO the taxable wage base ($147,000 in 2022) of generally 12.4%, 2.) and a MEDICARE TAX of 2.9% that is LEVIED ON ALL EARNINGS on all earnings with NO INCOME LIMIT. **Collectively, this is REFERRED TO to as SE TAX**

Above-the-Line Deductions: Self-Employed Health Insurance Deduction

Self-employed taxpayers (sole proprietors and partners), as well as taxpayers who are more than 2% shareholders of an S corporation, can take a 100% deduction for amounts paid for health insurance coverage for themselves, their spouses, and eligible dependents. In contrast, unless their group health insurance premium is paid with after-tax dollars, employees may not deduct the health insurance premiums they pay through their employers. If they do pay for a health insurance policy with their after-tax dollars, the premiums paid are deductible, but subject to the 7.5% of AGI floor. These premium payments may be combined with other qualified medical expenses in order to reach and exceed that threshold.

Self-Employment Tax and Health Insurance Deduction: Self-Employment Income TAX: NOT INCLUDED

Self-employment income DOES NOT include: -- dividends or interest on investments; -- real estate rental income; -- the distributive share of income paid to a limited partner; -- wages or salary paid to an S corporation shareholder; or -- the distributive share of earnings to an S corporation shareholder (also known as K-1 income).

EXAMPLE: Shareholder basis

Shannon is one of two shareholders in an S corporation and contributes $100,000 in cash for her shareholder interest. If the corporation borrows $500,000 from a bank for ongoing operations, Shannon's shareholder basis remains unchanged because she did not directly loan the corporation the money. Alternatively, if Shannon had been a general partner in the business, her basis would have increased by $250,000 (half of the $500,000), making her new basis in the partnership $350,000.

TAXATION: S-CORPS

Similar to a partnership, the shareholders—rather than the corporation—pay taxes on an S corporation's income. An S corporation FILES FORM 1120S and also provides each shareholder with a Schedule K-1 form indicating that shareholder's share of the corporation's income. However, unlike the general partnership, these K-1 distributions are not treated as self-employment income. Instead, a different form of tax treatment applies to S corporation distributions. Typically, only the W-2 salary of S CORP OWNERS is subject to Social Security and Medicare taxes. Other S corp earnings pass to the shareholder(s) as dividends and capital gains. ** THIS REDUCTION IN SE TAX for small businesses is considered ONE OF THE CHIEF BENEFITS of the S CORP ENTITY.**

NETTING PROCESS: Original issue discount (OID)

Some new bonds are issued at a discount, deemed an original issue discount (OID). The annual accrual also increases the cost basis of the bond each year. The treatment of OID also applies to tax-exempt bonds. However, in the case of tax-exempt bonds, the OID is also tax-exempt. The accrued OID increases the basis in the bond for purposes of calculating capital gain or loss if the bond is sold prior to maturity. In many instances, the taxpayer, and the IRS, will receive a Form 1099-OID that reports the annual OID amount.

Passive Activity and At-Risk Rules: DIRECT PARTICIPATION PROGRAMS: SPECIAL ALLOCATIONS

Special Allocations The benefits that flow through from a partnership entity may be enhanced by the potential, under certain circumstances, for the special allocation of certain items of income, expense, gain, or loss. A special allocation is an allocation of one or more items of income, gain, losses, deductions, or credits that depart from the partner's general profit and loss sharing ratio. In other words, it may not be necessary to split all of these items pro rata among all of the owners. Certain deductions may be allocated to certain individuals, rather than dividing it among all participants. For example, if one partner voluntarily contributed a solely owned warehouse to a partnership, the depreciation deductions for the warehouse may be specially allocated to only that partner

EXAMPLE: Injured spouse relief

Steve is a highly successful bartender in an upscale nightclub. In his spare time, he is also a drummer in a band. His income is sporadic and most of it consists of cash tips. He recently married Stephanie, a CPA who earns $150,000 per year. They filed their first 1040 as MFJ. The couple was originally expecting a refund of $15,000. However, a letter arrived from the IRS explaining that their refund has been seized to satisfy a past-due obligation. After some conversations, Steve admitted to Stephanie that he has defaulted on several student loans. He dropped out of medical school to pursue his music career. Because she is not liable for this loan, Stephanie can file an injured spouse claim to recover her portion of the tax refund. Premarital agreements also have a variety of tax implications that should be discussed thoroughly with the drafter. Primary among these are gift and estate tax consequences that may occur. The income tax consequences of the premarital agreement depend in large part upon whether the transfer under the agreement is treated as a gift (where income tax is avoided) or as a transfer for consideration (which will probably result in the recognition of significant income by one party).

EXAMPLE: Active participation standard

Stewart, who is single and has an AGI of $110,000, owns two houses that he rents to tenants. This year he had a combined loss of $6,000 from the two rentals. Because his AGI exceeds $100,000, the deduction is reduced by 50% of Stewart's AGI in excess of $100,000. Thus, the allowance is reduced to $20,000 [$25,000 - (0.50 × $10,000)] and the full $6,000 loss is still deductible by Stewart.

EXAMPLE: Section 1250 property

Suppose Larry, a landlord, purchases a residential property for $100,000. Larry is in the 37% federal bracket. He leases the property to Theresa, a tenant. Larry takes $10,000 of depreciation deductions over the next few years. His adjusted basis at that point is $90,000. Larry then sells the property to Theresa for $115,000. Larry has $10,000 of 1250 gain, which is taxed at 25%. Larry also has $15,000 of 1231 gain, which is taxed at 20%. This topic will be discussed further later in the course. However, it is important to remember that unrecaptured Section 1250 gain is taxed at a maximum rate of 25%.

EXAMPLE: NETTING: IRA loss

Susan has made nondeductible IRA contributions of $45,000 to a single IRA. Due to poor investment performance, the account is now worth $25,000. She passes away in 2022. Her executor liquidates the IRA and withdraws the entire $25,000 in 2022. Susan's executor is allowed to claim a deduction for the $20,000 loss in 2022 on Susan's final 1040 tax return

ETHICAL CONSIDERATIONS, AUDITS, AND TAX PENALTIES: TAX AUDITS: ESTIMATED TAXES: SAFE HARBOR

Taxpayers generally will not be required to make estimated tax payments if the total amount of income tax withheld by their employers or at the source of the payment, combined with any credits they might have, is at least equal to the lesser of: -- 90% of their current year's tax liability, or -- 100% of their tax for the prior year, as long as a return showing a tax liability was filed for the prior year and the prior year was a period of 12 months. The preceding safe harbor applies to individuals with a previous-year AGI of $150,000 or less ($75,000 or less if married filing separately). For individuals with a previous-year AGI exceeding $150,000 ($75,000 if married filing separately), the total amount required to be withheld is the lesser of: -- 90% of the current year's (2022) tax liability or -- 110% of the prior year's (2021) tax. Taxpayers who will be liable for a federal tax payment of less than $1,000 when they file their tax return do not have to make estimated tax payments. The due date of each installment is listed as follows. The last installment does not have to be paid if the taxpayer's return is filed and the tax shown is paid by January 31.

Contributions of Clothing and Household Items

Taxpayers have been deducting contributions of clothing and household items to charities for years. "Household items" include furniture, furnishings, electronics, appliances, linens, and other similar items, but does not include food, paintings, antiques, or other objects of art, jewelry, gems, or collections. Such contributions should be deducted by the taxpayer at their current FMV as estimated by the taxpayer, not at their original retail value. Congress and the IRS have long suspected that the values of such items have been inflated on tax returns. The IRS can deny a deduction for the contribution of clothing / household item. However these deductions are not usually challenged if: -- a deduction of less than $500 is claimed, or -- the taxpayer includes a qualified appraisal.

Tax Consequences of Property Transactions: COST RECOVERY METHODS

Taxpayers may recover their original cost or investment in certain assets used in a trade or business through depreciation, amortization, or depletion. As we have seen, these allowances reduce the cost basis of the investor in reaching the adjusted basis in the asset. Property eligible for capital recovery includes real property, personal property, and intangibles used in a trade or business. The property must have a determinable useful life and be subject to a decline in FMV from natural wear and tear or obsolescence. Thus, the asset is capitalized; that is, instead of an expense, the asset is recorded as an asset that may also be subject to the depreciation, amortization, or depletion cost recovery methods. The taxpayer must be the legal or equitable owner of the asset to use cost recovery. Inventory, or property that is held for sale to customers in the ordinary course of business, is not depreciable property.

PROFESSOR'S NOTE: BONUS DEPRECIATION

The 100% first-year bonus depreciation deduction was part of the 2017 tax act. It generally applies to depreciable business assets with a depreciation period of 20 years or less and specified other property. Bonus depreciation has not always been so generous nor is it likely to remain so indefinitely. The 100% bonus depreciation provision is currently scheduled to sunset on January 1, 2027, absent any further Congressional action. In that event, Section 179 will likely become more relevant to taxpayers.

Tax Accounting Methods: Accrual Method of Accounting

The ACCRUAL METHOD is the conceptual opposite of the cash method and requires recognition of taxable income in the same tax year it is reported on the taxpayer's financial statements when the income is earned in any year and the expenses are reported as they are incurred. INCOME DOES NOT HAVE TO BE RECEIVED TO BE TAXABLE, NOR DO EXPENSES have to be paid to be tax deductible. Many businesses (including sole proprietorships that are not primarily service businesses) use the ACCRUAL METHOD to match expenses with income, but the method is MANDATORY for any business that MAINTAINS INVENTORY—an EXCEPTION applies if the average annual gross receipts are $27 MILLION OR LESS. As a result, whenever the sale of merchandise is an income-producing factor, the business MUST USE the ACCRUAL method of accounting when gross receipts EXCEED $27 MILLION (indexed for inflation) for the THREE PRIOR TAX YEARS.

PROFESSOR'S NOTE: ADVANCE CHILD TAX CREDIT

The Advance Child Tax credit of up to $3,600 was temporarily created by the American Rescue plan. This was originally intended to be a quasi-stimulus payment, limited to 2021. However as of this writing Congress is considering making the higher $3,600 limit permanent beginning in 2022.

The American Opportunity Tax Credit and the Lifetime Learning Credit

The American Opportunity Tax Credit and the Lifetime Learning Credit are typically discussed together because both were created to help families pay for some of the expenses of postsecondary education. The student must be pursuing a college or graduate degree or vocational training in an accredited postsecondary institution. Qualifying students are the taxpayer, taxpayer's spouse, taxpayer's dependent child(ren), and other dependents of the taxpayer.

PROFESSOR'S NOTE: DEDUCTION LIMITS: CARES ACT

The CARES Act of 2020 took the highly unusual step of raising the AGI limitation to 100% for cash donations only. (Note that donor advised funds do not qualify for the 100% AGI limit.) However as of this writing, the threshold is scheduled to revert to 60% in 2022 barring further congressional action.

Tax Accounting Methods: Hybrid Method of Accounting

The HYBRID method of accounting is a COMBINATION of the ACCRUAL method AND the CASH method of accounting. **Under this method, the taxpayer may account for some items of income using the ACCRUAL METHOD (e.g., the SALE of MERCHANDISE) and other items using the CASH METHOD (e.g., INCOME from SERVICES).** The MOST COMMON EXAMPLE of a business that would use the HYBRID method of accounting is an AUTO DEALERSHIP, where the ACCRUAL method would report income from car SALES and the CASH method would be used to recognize income from SERVICE-related transactions involving car repairs and maintenance.

QUALIFIED RESIDENCE INTEREST: HOME EQUITY LOAN INDEBTEDNESS

The INTEREST DEDUCTION IS NO LONGER ALLOWED IF the proceeds on the same loan are USED TO pay personal living expenses OR PAY OFF OTHER LOANS such as credit card debts, student loans, and others.

ETHICAL CONSIDERATIONS, AUDITS, AND TAX PENALTIES: TAX AUDITS: ESTIMATED TAXES: RETURN DUE DATE

The IRS Form 1040 must be filed with the IRS by the taxpayer no later than the 15th day of the fourth month after the end of the tax year (April 15 of the subsequent year). If this date falls on a weekend or holiday (e.g., Patriots' Day in Massachusetts), the return is due on the next business day. A six-month extension (generally to October 15 or six months after the required filing date if the taxpayer uses a fiscal year) of time to file (not to pay because the estimated amount of tax due must be paid on or before April 15) may be requested on IRS FORM 4868. This request for extension is usually GRANTED ABSENT IN EGREGIOUS CIRCUMSTANCE. Corporations, both C and S, must file by the 15th day of the third month following the end of the corporation's tax year. Extensions are also available to corporations. Partnerships must file Form 1065 by the first March 15 following the close of the partnership's tax year.

TYPES OF BUSINESS ENTITIES: C CORPORATIONS: Personal Holding Company (PHC) Tax: CALCULATION

The PHC tax is CALCULATED by MULTIPLYING the UNDISTRIBUTED PERSONAL HOLDING COMPANY INCOME by a flat rate of 20%. This tax is levied in addition to the regular corporate tax.

ADDITIONAL MEDICARE TAX: SUMMARY OF TYPES (2)

The Social Security wage base is adjusted annually for cost of living increases. The amount of wages a taxpayer receives during the year reduces the wage base because these have already been subject to Social Security withholding. If net self-employment earnings are less than $400, no self-employment tax is imposed. Net self-employment earnings include all business income less all business deductions allowed for income tax purposes. The income can be derived from the taxpayer's operation of a nonexempt trade, business, or profession as a sole proprietorship, general partnership, or independent contractor. Also, the flow-through of income to an operating member of an LLC or LLP is treated as self-employment income. Self-employment income may also include income from the rental of personalty (i.e., personal property), but not realty. Net earnings from self-employment must be determined under the same accounting methods used for income tax purposes.

Documenting the Charitable Deduction (2)

The Treasury regulations controlling the deduction of charitable gifts allow the IRS to require proof to verify the deduction. The deduction can be denied for failure to provide this documentation. The IRS currently requires the following for gifts of property valued at $500 or more: -- The name and address of the organization and the date of the gift -- A description of the property -- The date acquired by the taxpayer -- The fair market value of the property and how that value was obtained -- The taxpayer's adjusted basis in any appreciated property gift -- Any reduction in the value of appreciated property claimed by the taxpayer -- The terms of any agreement with the charitable organization -- The amount claimed as a deduction

NETTING PROCESS: Taxation of U.S. Treasury Securities

The U.S. government issues bills, notes, and bonds. Bills have maturities of 52 weeks or less, notes have maturities from no less than one year to 10 years, and bonds have maturities greater than 10 years.

Tax Reduction and Management Techniques: Alternative Minimum Tax (AMT) (1)

The alternative minimum tax (AMT) was originally enacted in 1969 TO TARGET FEWER THAN 200 TAXPAYERS. The AMT is essentially a second income tax system that parallels the regular federal income tax. The PURPOSE of the AMT is to ENSURE THAT TAXPAYERS who reduce their tax liability below a certain point by utilizing tax preference items (items that were afforded preferential treatment for regular income tax purposes) will be REQUIRED TO PAY AT LEAST A MINIMUM AMOUNT OF INCOME TAX.

TEST TIP: AT-RISK RULES

The at-risk rules are applied before the PAL rules due to IRS ordering rules. A partner may deduct losses only to the extent they of the amount they have at risk. This means that if a loss is not allowed because of the at-risk limitations, the loss is not a suspended loss eligible for deduction as a disposition of a passive activity. Rather, the loss continues to remain suspended under the at-risk rules.

Tax Consequences of Property Transactions: CAPITAL ASSETS AND DEPRECIATION: ESTABLISHING BASIS: GIFTS

The basis of an asset acquired by gift is generally the donor's basis. However, there is one situation where the fair market value on the date of the gift is used. If the fair market value on the date of the gift is less than the donor's basis in the asset, the donee's basis in the asset for purposes of determining a loss on the sale of the asset will be the asset's fair market value on the date of the gift. Furthermore, in the event that the donor gifts appreciated property and pays gift tax, only a portion of gift tax paid may be added to the basis. In other words, because the gifted property is not loss property, the following formula is used to define basis: donor's basis + (appreciation / FMV - gift tax exclusion) × gift tax paid = donee's basis

PROFESSOR'S NOTE: DIRECT PARTICIPATION PROGRAMS

The benefits of direct participation programs are many, but they are usually not suitable for inexperienced investors. In evaluating the suitability of a potential direct participation program for a particular client, the planner must consider the client's need for liquidity, their ability to bear the risks of the investment, and their need for and ability to utilize the tax benefit provided. Limited partnerships, for example, generally involve relatively high levels of risk and low levels of liquidity.

Employer-Provided Auto (Company Car)

The business use of such auto is excludable without limit from the employee's income. However, personal use of a company car is usually a taxable fringe benefit, with the actual taxable amount determined by the employer.

Annual Deductions Limits: DONOR ADVISED FUNDS (DAFs)

The donor advised fund may be thought of as a charitable savings account. With a DAF, a taxpayer may lump several years' worth of charitable contributions into a single DAF contribution, take the charitable contribution deduction in that year (possibly allowing the taxpayer to itemize deductions that year), and then direct that grants to their selected charities be paid from the DAF over the next few years.

IMPUTED INTEREST RULES: COMPENSATION-RELATED LOANS

The employer makes a below-market loan to an employee. As a result, the lender-employer has interest income and compensation expense for the amount of the imputed interest. The borrower-employee has compensation income and interest expense for the same amount. Like gift loans, there is also an exception for compensation-related loans that are less than or equal to $10,000. However, the exception for loans between $10,001 and $100,000 does not apply because all of the parties to compensation-related loans are not individuals.

EQUIVALENT TAX BENEFIT

The equivalent tax benefit of exclusions or deductions to tax credits can be determined by applying the following formula: TC = d × m where: TC = amount of tax credit (or tax savings) d = before-tax benefit (amount of exclusions or deductions) m = marginal income tax bracket

Tax Consequences of Property Transactions: INTRO

The general formula applied when calculating the gain or loss from a taxable property disposition is to subtract the taxpayer's basis in the property sold from the amount of the sale proceeds. This gain (if any) is then taxed at preferable capital gain rates or a taxpayer's marginal income tax rate, depending on (1) the holding period, and (2) whether the asset sold is a capital asset or an ordinary asset. In the ordinary course of business, property is normally depreciated or amortized over time. The fair market value of property tends to decline over its useful life, as is often the case with rental real estate or machinery. As a result, this type of asset may be depreciated for tax purposes. In effect, the cost of the taxpayer's investments in wasting assets is matched against the income stream generated by the asset over time, thus allowing for the taxpayer's cost recovery. In layman's terms, the depreciation of business property is an extremely valuable deduction that reduces taxable income. Therefore, planners should acquire a functional comprehension of depreciation.

TEST TIP: Child and Dependent Care Tax Credit

The important numbers to remember for exam purposes are the 20% and the $3,000 limit for one dependent or $6,000 for two or more dependents. Due to the considerable expenses associated with child care, most taxpayers quickly exceed these thresholds. As a practical matter, the vast majority of taxpayers receive either $600 for one qualifying individual or $1,200 for two or more qualifying individuals. Also note that if taxpayers incur over $6,000 in child care expenses and defer $5,000 to an employer-sponsored dependent care flexible spending account (FSA), they may claim the dependent care credit only on the remaining $1,000 of expenses in the same tax year. They may not use the first $5,000 of expenses already paid with an FSA to also claim the child and dependent care credit.

IMPUTED INCOME AND THE ALTERNATIVE MINIMUM TAX: BELOW-MARKET LOANS (1)

The imputed interest rules generally apply to the following types of below-market loans. 1. When a lender has issued a below-market-rate loan, the lender may be required to impute (recognize) interest income or the borrower may receive an interest expense deduction when, in fact, no interest has been received or paid. a. Imputed interest is calculated using the federal government's borrowing rate, compounded semiannually and adjusted monthly. b. If the interest charged on the loan is less than the federal rate, the imputed interest is the difference in interest determined using the federal rate and the interest determined using the actual rat

TRUST INCOME TAX RULES: OVERVIEW (2)

The income of the trust is taxable to the grantor if the grantor retains a significant reversionary interest in the corpus of the trust. Any income from property transferred to a trust in which the grantor (or grantor's spouse) has more than a 5% reversionary interest is taxed to the grantor. However, the trust income will not be taxable to the grantor if the grantor's reversion occurs because of the death before age 21 of a trust beneficiary who is a lineal descendant of the grantor. If the grantor retains control over the benefits of the trust, then the trust's taxable income is taxed to the grantor. For this purpose, the grantor has control over the benefits of the trust if the grantor can exercise a power of disposition over either the trust's income or corpus without the consent of an adverse party. An adverse party is a beneficiary whose economic interest in the trust may be diminished by the grantor's exercise of the power of disposition. However, a grantor will not be taxed as owner of a trust merely by retaining a power to allocate income or principal among charitable beneficiaries, or by retaining a power to allocate receipts and disbursements between income and principal. In addition, a grantor will not be taxed as owner of a trust merely by retaining a power to withhold income during the legal disability of a beneficiary, or to withhold income during the period that any income beneficiary is under age 21. Also, if a grantor merely retains a power to temporarily withhold income for ultimate distribution to a beneficiary, or to distribute principal limited by a reasonably definite standard, the trust is not a grantor trust.

PROFESSOR'S NOTE: INSTALLMENT SALE TREATMENT

The installment sale treatment is automatic for any sale in which a payment on the purchase price is received in a year later than the year of sale. It is possible for the taxpayer to affirmatively elect out of installment sale treatment by making such an election when filing the tax return for the year of sale. To elect out of installment sale treatment, the seller simply reports the entire gain in the year of disposition. Once the election out of installment reporting is made, the consent of the IRS is required to revoke the election.

S Corporations and Pass-Through Entities: Limited Liability Partnership

The limited liability partnership (LLP) exemplifies the characteristics of a general partnership with one major difference—in an LLP, the general partners are not liable for the acts of other partners. In addition, some states will protect the general partners from the claims that arise from obligations of the partnership, but this typically extends only to claims arising out of tort law, not contract law. LLPs (like LLCs to be subsequently discussed) are state-created entities and may be formed only in those states that allow the form. Typically, the form is available only to professionals, such as attorneys, accountants, and medical doctors. To date, the greatest users of this form have been the major public accounting firms, including each of the Big Four certified public accounting partnerships.

Tax Consequences of Property Transactions: CAPITAL ASSETS AND DEPRECIATION: Determining Gain or Loss

The realized gain or loss from a sale or other disposition of property is the difference between the amount realized and the property's adjusted basis. When the amount realized is more than the property's adjusted basis, there is a realized gain; when the property's adjusted basis is greater than the amount realized, there is a realized loss. Generally, the amount realized is the sum of any money received plus the fair market value of other property received in the transaction. If the buyer assumes any liability on the property, such as a mortgage, this amount is also included in the amount realized. The recovery of capital doctrine allows taxpayers to recover the cost or other original basis of property tax free. For example, the cost or other basis of depreciable property is recovered through annual depreciation deductions.

CALCULATING COMPLEX CAPITAL ASSET GAINS AND LOSSES: Capital Gains Netting Procedures (II)

The reporting of a taxpayer's capital gains and losses is done on Schedule D of IRS Form 1040. Under this schedule, the following rules for the capital gains netting procedure are implemented. -- STCG and short-term capital losses (STCL) are netted against each other. -- LTCG and long-term capital losses (LTCL) are netted against each other. -- If any gains and losses remain (whatever their character), they are again netted. -- If a capital loss remains after netting, only $3,000 ($1,500 for taxpayers filing as MFS) of the net loss may be used to offset ordinary income in any one year. Individuals may generally carry over a net capital loss to future tax years (indefinitely) until the loss is fully used. However, in some cases (e.g., the application of the related party rules), the loss may be disallowed entirely. When there are both unused STCL and LTCL, the short-term losses are used first and the remaining losses are carried forward. For example, if after netting all short-term gains and losses and all long-term gains and losses, the taxpayer has both a net STCL of $4,000 and an LTCL of $3,000, the taxpayer uses $3,000 (unless filed as MFS) of the STCL in the current tax year and carries forward a $1,000 STCL and a $3,000 LTCL.

Supporting Elderly Parents or Special Needs Children: Rules to Determine Dependent Status

The rules for claiming a dependent are complex. For purposes of this course, students should be aware of the income test and the support test. A dependent may not have more than $4,400 (2022) of gross income. Social Security income is excluded from the test if that is the elder's only source of income. The taxpayer must also provide over 50% of the dependent's support to claim them. Coincidentally, as long as all the tests are met, a person who dies during the year may still be identified as a dependent. A situation may arise where more than one person can claim a minor as a dependent. This is where the income and support tests become critical.

SPOUSE RELIEF

The situation may arise where one spouse was genuinely not aware that the other was underreporting their income. The law does provide for spouse relief, which excuses one spouse for the failure of the other spouse's tax obligation if certain conditions are met. If a married couple files jointly, both spouses are jointly and individually responsible for the tax and any interest or penalty due on the joint return. One spouse may be held responsible for all the tax due even if all the income was earned by the other spouse. However, a spouse may be relieved of the tax, interest, and penalties on a joint tax return in some cases. Types of relief available include the following.

S Corporations and Pass-Through Entities: SOLE PROPRIETORSHIP

The sole proprietorship is the first of the conduit or pass-through business entities and is the most common. No formal legal documents need to be filed to form a business as a sole proprietorship, and all income and losses pass directly through to the businessowner and are reported on the businessowner's income tax return. The taxable income or losses from the business on an annual basis are reported on Schedule C of IRS Form 1040, and the owner is also subject to self-employment tax on business net income. If the business losses exceed the allowable excess business loss limits, the owner may carry the excess loss forward indefinitely under the NOL provision of the Tax Code. The overwhelming disadvantage of a sole proprietorship is that the businessowner is personally liable for all debts and claims against the business. Other disadvantages of the sole proprietorship form include the following: -- The difficulty of raising capital (the owner is limited to personal funds plus whatever a bank will lend; further, if the bank chooses to lend any money, it almost always requires the personal guarantee of the owner) -- The lack of creditor protection (associated with the unlimited liability disadvantage). -- The fact that the business will die with the owner (unless a valid buy/sell agreement has previously been executed) Just as the ease of formation of a sole proprietorship is one of the attractive attributes of this form of business, so too is the ease in which a sole proprietorship business may be terminated. The owner may simply cease operations and pay off all vendors, and the sole proprietorship is terminated. The income or loss for the final operating year is reported on Schedule C.

NETTING PROCESS: SPECIFIC IDENTIFICATION

The specific identification method requires the seller of the shares to identify shares of the fund that are sold. Detailed records must be kept to enable proper identification of shares. To accomplish this method, the investor indicates to the mutual fund company which shares, based on purchase date, are being sold. The gain, if any, on these shares is then computed using the excess of the total sales price over the basis of the shares sold.

ETHICAL CONSIDERATIONS, AUDITS, AND TAX PENALTIES: TAX AUDITS: COMMON TAX TRAPS: Substance Over Form Doctrine

The substance of a transaction, rather than its mere form, will govern the tax consequences of a transaction. If, for example, A sells an asset to B at a loss, and B sells an identical asset to A, also at a loss, the transaction will be viewed, in substance, as a like-kind exchange and the losses will be disallowed.

Capital Gain Rates: Taxation of Capital Gains

The tax rate that applies to long-term capital gains is determined by the taxpayer's taxable income. For taxpayers with a combination of ordinary income (wages, interest, etc.) and long-term capital gains, the IRC provides for a very favorable approach to determining the tax rate applicable to the long-term capital gains. The taxpayer's deductions for the standard deduction or itemized deductions are applied first against ordinary income. **Most net long-term capital gains and qualified dividends are taxed at rates of 0%, 15%, or 20%.** The rate applicable to the long-term capital gains is determined by the taxpayer's taxable income, which includes the long-term capital gain income. The following table provides the breakpoints for various filing statuses, and for trusts and estates. You do not need to memorize this table. It will be provided on the exam.

Tax Reduction and Management Techniques: Charitable Contributions by Businesses

The tax rules for charitable contributions are different from those for individual taxpayers. For example, a sole proprietor may not claim a business charitable contribution on the Schedule C. Instead, the sole proprietor will claim the charitable contribution on their Schedule A as an itemized deduction. As an itemized deduction, the contribution is subject to all the individual contribution rules just discussed. In some cases, the charitable contribution by the sole proprietor may actually be properly treated as an advertising expense or a business expense.

REIMBURSED EMPLOYEE EXPENSES

The tax treatment of reimbursed employee business expenses depends on whether the reimbursements are made under an ACCOUNTABLE plan or a NONACCOUNTABLE plan. In an ACCOUNTABLE plan, employees must substantiate their expenditures, and employees who receive advances must return any amounts that exceed their substantiated expenses. All other plans are NONACCOUNTABLE plans (also known as allowance plans) that require all expense allowances to be included on an employee's W-2 as taxable income and do not require documentation from the employee. When employee business expenses are reimbursed under an accountable plan, the REIMBURSEMENTS are EXCLUDED FROM the employee's GROSS INCOME, and the expenses are NOT DEDUCTIBLE by the employee.

ETHICAL CONSIDERATIONS, AUDITS, AND TAX PENALTIES: TAX AUDITS: COMMON TAX TRAPS: Unreasonable Compensation Rules

The tendency in closely held corporations is to pay out all corporate distributions as salary or bonus (which are deductible to the corporation), therefore reducing corporate tax liability. However, the IRS may examine the reasonableness of these salary payments and, if they are deemed to be excessive, may reclassify the payments as nondeductible dividends. The dividends are still, of course, taxable to the recipient.

Social and Economic Federal Tax Law Assumptions: Revenue-Raising Objective

The three main sources of federal tax revenue are individual income taxes, corporate income taxes, and payroll taxes. Individual income tax accounts for approximately 40% of the total tax revenue collected by the federal government. The corporate income tax accounts for an additional 8% of the tax revenue. According to the Congressional Budget Office, the federal government collected $3.5 trillion in tax revenues in 2018, $2 trillion1 of which was composed of individual, estate, and trust income taxes. Separate payroll taxes are collected to fund Social Security and Medicare. Other exceptional taxes, such as the federal estate tax and gift tax, actually compose only a small percentage of annual tax revenues.

S Corporations and Pass-Through Entities: Qualified Business Income (Pass-Through Business) Deduction: UNADJUSTED BASIS OF QUALIFIED PROPERTY

The unadjusted basis of qualified, or qualifying, property is also taken into account in the formula. Qualified property is tangible property (equipment, real estate, etc.) subject to depreciation that is held by and available for use in the trade or business at the close of the tax year and is used at any point during the tax year in the production of qualified business income. Unadjusted basis is the property's basis not reduced by any depreciation deductions. In addition, the depreciable period for the property must not have ended before the close of the tax year. For this purpose only, the depreciable period begins on the date the property is placed into service, and ends on the later of 10 years or the last day of the last year of the asset's depreciation period.

Tax Planning for the Medicare Contribution Tax (3): MUNI BONDS

The use of municipal bonds, instead of investments that produce interest and dividends, would serve the dual purpose of reducing the investment income, and reducing the MAGI. It may make sense to look at assets and asset classes that produce little or no current income, such as certain real estate investments or tangible assets. Also, it is advisable to examine the tax-efficiency of any mutual funds in the taxable portfolio. Exchange-traded funds (ETFs) may be preferable to mutual funds from a tax standpoint, as they are often more tax-efficient than mutual funds. Keep in mind that in restructuring a portfolio, transaction costs may be incurred, and the sale of portfolio assets may incur capital gains that will also be subject to the Medicare contribution tax (if over the MAGI threshold). Make certain that any restructuring of an investment portfolio, to emphasize tax-free income, or to minimize current taxable income, is done with an eye toward the client's risk tolerance, overall goals, and objectives.

PROFESSOR'S NOTE: QBI

The variant QBI calculations can be quite complex, and most exceed the scope of this course. However, the qualified business income thresholds are important to understand because the QBI deduction depends heavily on the type of business. For specified service businesses, once the taxable income exceeds the top of the phaseout range, there is no QBI deduction allowed. However, non-specified service businesses may still be eligible for a QBI deduction if they are paying W-2 wages (e.g., creating jobs) or purchasing depreciable assets (e.g., otherwise stimulating the broader economy as a whole).

PROFESSOR'S NOTE: TAX AUDITS

The vast majority of IRS audits are correspondence audits. The IRS may also arrange an in-person interview, known as an office audit. Finally, the IRS may visit the taxpayer at their place of business to conduct a field audit. ** IRS audits are NOT CONDUCTED BY TELEPHONE**

Alimony and Child Support: Alimony and Separate Maintenance Payments

There are four separate tax issues to be considered upon divorce or dissolution of the taxpayer's marriage. They are the tax status of -- alimony payments (note TCJA change for 2019 and beyond); -- child support payments; -- property settlement agreements; and -- qualifying child for filing status.

Net Investment Income Tax (NIIT) (1)

There is a 3.8% tax, also known as the Medicare Contribution Tax, imposed on taxpayers with unearned income, such as interest, dividends, and net capital gains. This is deemed the Net Investment Income Tax (NIIT). Although extremely similar in purpose to the aforementioned Additional Medicare Tax, the NIIT is actually a separate tax on investment income. The key difference is that Additional Medicare Tax is an additional .9% imposed on wages and self-employment income. (Not coincidentally, when imposed, the total employer/employee Medicare contribution adds up to 3.8% of wages.) The NIIT is a 3.8% tax imposed on portfolio income. Portfolio income is not normally subject to any Medicare tax at all. It is possible for a taxpayer to be subject to both taxes if their wages and investment income exceed certain thresholds. The NIIT is 3.8% of the lesser of the: -- net investment income, or -- excess of the modified AGI (MAGI) over a specified threshold amount

ETHICAL CONSIDERATIONS, AUDITS, AND TAX PENALTIES: TAX AUDITS: Audit Triggers

There is a common misconception among taxpayers that the IRS audit process is a random one. Although approximately 55,000 returns had been randomly selected for audit every two years, these were the exception rather than the rule. The National Research Program is the only random audit program that the IRS utilizes. In fact, the IRS uses a highly selective process to determine which returns will be audited. There are essentially TWO PARTS to the IRS audit process. FIRST, all returns are screened by the Discriminant Functions System Program (DIF). The DIF screens all returns and ranks them in order of audit worthiness. SECOND, the IRS uses a targeted programs approach for approximately 25% of all returns audited. In addition to these two major audit selection tools, the IRS employs several minor programs that assist in the audit selection process.

TEST TIP: S-CORP DEDUCTIONS

There is a deduction for pass-through income of 20% allowed to a noncorporate taxpayer, including a trust or estate, who has QBI from a partnership, S corporation, or sole proprietorship. The full calculation is complex and not testable on the exam. Students need only be cognizant that the maximum deduction is 20%.

FURTHER EXAMPLES OF SELF EMPLOYED (SE)

Therefore, if you see the entry Schedule C income reported on the cash flow statement of any taxpayer, you know that the individual is self-employed. That is, if the self-employed taxpayer invests some of the net income from the business in securities and receives dividends, that income is not reported on SCHEDULE C but is reported as though the taxpayer was not self-employed.

IMPUTED INTEREST RULES: TAX-AVOIDANCE LOANS

These are below-market loans that significantly affect the borrower's or lender's federal income tax liability and are made primarily for the purpose of tax avoidance. If the principal purpose of the loan is for tax avoidance, none of the previous exceptions apply.

PROFESSOR'S NOTE: PARTIAL ANNUITIZATION

This provision applies only to nonqualified annuities, such as an individual would purchase from an insurance company. It does not apply to qualified annuities, as may be found in a qualified retirement plan.

EXAMPLE: Net Investment Income Tax calculations Example 3

Tim and Jennifer are married taxpayers filing a joint tax return. In 2022, their MAGI is $275,000, and their net investment income is $80,000. They will pay the 3.8% Medicare contribution tax on $25,000. This is the lesser of the net investment income ($80,000) or the MAGI in excess of the threshold amount ($275,000 - $250,000, or $25,000). In this situation, only $25,000 of the investment income is subject to the Medicare contribution tax. Tim and Jennifer will pay a $950 Medicare contribution tax (3.8% of $25,000).

Taxation of Annuity Contracts: FIXED ANNUITY

To find the amount excluded from taxation in a fixed annuity, it is necessary to determine the exclusion ratio. The exclusion ratio for annuities consists of the investment in the annuity contract divided by the total expected return. This ratio is multiplied by the annual return each year to determine the annual amount that is excluded. To get the total expected return, multiply the annual payments by a life expectancy factor supplied by the appropriate treasury table.

PROFESSOR'S NOTE: POSTPONING RECOGNITION OF GAIN

To postpone the recognition of gain from a casualty, theft, or condemnation, the replacement property must be purchased within a specified replacement period

Tax Accounting Methods: Cash Method of Accounting

Under the CASH method of accounting, a taxpayer generally reports income when any cash is collected (or the constructive receipt income tax doctrine applies) and reports expenses when any cash payment is made. The cash method may be used by taxpayers (other than tax shelters) whose annual average gross receipts DO NOT EXCEED $27 million for the THREE PRIOR TAX YEARS. This method may be used by -- individuals; -- sole proprietorships; -- partnerships that do not have C corporations as partners and whose average annual gross receipts for any three-year preceding period do not exceed $27 million; -- C corporations if average annual gross receipts for any three-year preceding period do not exceed $27 million; and -- qualified personal service corporations (to be subsequently discussed) in the fields of medicine (health), accounting, architecture, law, or engineering if the use of the method clearly reflects income.

Tax Treatment of Business Property Gains: Installment Sale Treatment (II)

Under the installment sale method, immediate recognition of remaining gain occurs: -- at the time an installment sale is canceled; -- when there is a gift of an installment sale to the obligor-debtor; -- when there is a sale of the installment note to another party; or -- when an installment note is pledged as collateral for a loan. Installment sale treatment is not available for: -- property held for sale in the ordinary course of business (inventory); and -- securities traded in a secondary market.

EDUCATION TAX BENEFITS: EDUCATION ASSISTANCE

Undergraduate and graduate education assistance is excluded from an employee's income in any one year period, up to a maximum of $5,250.

Education Assistance

Undergraduate and graduate education assistance is excluded from an employee's income in any one year, up to a maximum of $5,250 under Code Section 127.

WAGES

WAGES are the FIRST ITEM of income REPORTED ON the FORM 1040. Employers are required to provide information to their employees about the amount of income earned during the year. This is typically accomplished by the employer issuing a W-2 form to the employee. The AMOUNT REPORTED on Form 1040 is the amount shown in BOX 1 of the W-2. The BOX 1 AMOUNT is the amount of compensation earned by the taxpayer AFTER a REDUCTION FOR amounts contributed to a 401(k), 403(b), or other QUALIFIED retirement plan.

Self-Employment Tax and Health Insurance Deduction: Self-Employment Income TAX: CALCULATING NET EARNINGS FROM SELF-EMPLOYMENT

When calculating their net earnings from self-employment, businessowners are allowed to deduct self-employment taxes they paid for their employees but not the Social Security tax they paid for themselves. However, the law provides a substitute for this deduction. This amount is determined by multiplying net earnings from self-employment by 7.65%. The steps to calculate total self-employment tax for 2022 when net income from self-employment is at or below the Social Security wage base of $147,000 are as follows: 1. Calculate self-employment income. 2. Subtract 7.65% or multiply by 0.9235 (1 - 0.0765). 3. Multiply the resulting product by 15.3%. The shortcut method for SE income at or below the Social Security wage base is to simply multiply the amount of self-employment income by 0.1413 (0.9235 × 0.1530). The shortcut method for arriving at the deductible employer share of SE tax in 2022 is to multiply the income × 0.9235 × 0.0765. This method is valid up to the taxable wage base of $147,000 in 2022 (or simply divide the already calculated SE tax by 2). The steps to calculate self-employment tax in 2022 when net income from self-employment is above the taxable wage base are as follows: 1. Calculate self-employment income. 2. Subtract 7.65% or multiply by 0.9235 (1 - 0.0765). 3. From Step 2, subtract the wage base and multiply the excess by 2.9% (Medicare portion of the tax). 4. Multiply the wage base by 15.3%. 5. Add the results of Steps 3 and 4 to arrive at the total self-employment tax.

TEST TIP: INSTALMENT SALE CALCULATIONS

When doing installment sale calculations, students should be aware that the seller has no taxable interest income on the down payment. No time has yet passed when the down payment is rendered. Thus, interest income should only be calculated on the principal owed after subtracting the down payment.

NETTING PROCESS: AVERAGE COST METHOD

With the average cost method, the investor pools all purchased shares into one account and then divides the total cost ofall their shares by the number of shares held. Therefore, all mutual fund shares in this method have the same cost or basis. The gain is computed by subtracting the basis of the shares sold from the sales proceeds. The basis is the number of shares sold, multiplied by the average cost per share. Under the single-category method, the investor is allowed to group all shares together to determine the average cost. This method treats shares sold on a FIFO basis. So, shares that qualify for long-term capital gain or loss treatment are treated as sold before shares that would get short-term treatment. Note that the average cost method is available only for mutual fund shares. Stock sales must use the specific identification method or the IRS will assume FIFO for the basis of the shares sold.

IMPUTED INCOME AND THE ALTERNATIVE MINIMUM TAX: CORPORATE AMT

With the reduction in corporate income tax rates in December 2017, the structure of the corporate AMT was such that most corporations would have been subject to the AMT. Rather than reform the corporate AMT, Congress decided instead to simply repeal the corporate AMT, effective with the 2018 tax year and beyond.

PROFESSOR'S NOTE: NET INVESTMENT INCOME TAX (NII)

You should be aware that there is a possibility of a 3.8% Medicare surcharge in addition to the 15% and 20% long-term capital gain and qualified dividend rates, respectively. This 3.8% is deemed the Net Investment Income (NII) tax, which will be discussed later in this course. Therefore, it is conceivable that affluent taxpayers could pay combined rates of 18.8%, or perhaps even 23.8% on their capital gains.

ETHICAL CONSIDERATIONS, AUDITS, AND TAX PENALTIES: TAX AUDITS: ESTIMATED TAXES: FILING REQUIREMENTS

A U.S. citizen or resident uses the following three factors in determining whether an income tax return is required to be filed for the year: -- Gross income -- Filing status -- Age The following individuals are not required to file unless their income is equal to or exceeds their applicable standard deductions: -- Single individuals -- Heads of households -- Surviving spouses/qualifying widowers Taxpayers who file as married filing jointly (MFJ) are not required to file unless their combined gross income equals or exceeds the basic standard deduction amounts. Taxpayers who file as married filing separately (MFS) must file if income equals or exceeds the standard deduction amount.

DEPENDENCY: IRS PUBLICATION 501

NOTE: THE RULES FOR BEING A DEPENDENT ARE STILL VALID EVEN THOUGH THE DEPENDENCY EXEMPTION AMOUNT HAS BEEN REDUCED TO ZERO. THE INCOME TEST FOR A QUALIFYING RELATIVE MEANS THE INCOME OF THE DEPENDENT MUST BE LESS THAN $4,400 (FOR 2022)

FILING STATUS: HEAD OF HOUSEHOLD (HH)

Head of household (HH). Unmarried individuals who maintain a household for a qualifying child or relative under the tax law (usually a dependent child or a dependent parent) often use this status and pay tax according to a schedule with rates somewhere between that of MFJ and single filing status. The taxpayer must put the dependent's Social Security or taxpayer identification number on the return to use this status.

DEPENDENCY: QUALIFYING RELATIVE

A qualifying relative is an individual who is not a qualifying child and bears a specified relationship to the taxpayer such as a parent, in-law, niece, nephew, aunt, uncle, or is unrelated to the taxpayer but resided in the taxpayer's principal home during the tax year. The taxpayer must have provided more than half of the person's support for the tax year.

QUALIFIED RESIDENCE INTEREST: ACQUISITION INDEBTEDNESS

Acquisition indebtedness. This is interest incurred in acquiring, constructing, or substantially improving a qualified residence of the taxpayer and one other residence, such as a vacation home. The debt (on which the interest is paid) must be secured by the real property and is limited in amount to a total of $1 million ($500,000 for married filing separately) for property acquired before December 15, 2017. - For property acquired after that date, the limit is $750,000 ($375,000 for MFS). Regardless of how the loan is labeled (e.g., home equity loan, home equity line of credit, or second mortgage), if the proceeds are used to buy, build, or substantially improve the home of the taxpayer who secures the loan, the interest is still deductible, as long as the total indebtedness is under the threshold. - Note that a loan secured by the primary residence cannot be used to secure another residence and still have deductible interest. - If a taxpayer takes a loan to purchase a primary residence that is also secured by the primary residence, and also takes a loan on a vacation home secured by the vacation home, the interest on both loans is deductible as long as the total of the two loans does not exceed $750,000 ($375,000 for MFS). If the loan amounts exceed the threshold, only a corresponding percentage of the interest would be deductible.

Group Term Life Insurance

An employee CAN EXCLUDE the premiums paid by the employer ON THE FIRST $50,000 of group term life insurance coverage. If the plan is discriminatory, key employees lose the $50,000 coverage exclusion. For any amount of group term life insurance coverage greater than $50,000, the scheduled premium per $1,000 of coverage, per the SECTION 79 TABLE, is included in the employee's W-2 income.

Employer-Provided Child and Dependent Care Services

An employee can exclude up to $5,000 annually in child care expenses paid by an employer to enable the employee to work.

CAPITAL GAINS AND LOSSES

Capital gains are considered taxable income. For example, if a taxpayer buys 100 shares of ABC stock for $10 per share and later sells the shares for $20 each, she has a capital gain of $1,000 ($10 × 100 shares). Conversely, if the taxpayer purchases 100 shares of XYZ for $10 per share and later sells those shares for $5 per share, he will experience a capital loss of $500. Capital losses may be used to offset capital gains without limit. However, if these losses exceed the gains, they may offset ordinary income only up to $3,000 ($1,500 for MFS) per year. The excess loss may be carried forward to future years. The capital loss deduction is actually calculated and shown on Schedule D of Form 1040 and then transferred to Form 1040.

INCOME: EXCLUSIONS

Certain items of income receive special treatment and are not included as income, and thus, are not subject to taxation. These items are called exclusions and do not have to be included as gross income: -LIFE INSURANCE proceeds received by reason of death of the insured (excluding policies transferred-for-value or owned by a qualified retirement plan), -a gift or most INHERITANCES received, -interest received from MUNICIPAL bonds, -CHILD SUPPORT payments received, -WORKERS' COMP insurance proceeds and many EMPLOYEE FRINGE BENEFITS are common examples of items that are EXCLUDED from income. Some of these EXCLUDED FRINGE BENEFITS include: - EMPLOYER-PROVIDED HEALTH INSURANCE, - GROUP TERM life insurance coverage up to $50,000, - QUALIFIED employee DISCOUNTS, - and EMPLOYEE EDUCATIONAL ASSISTANCE -Gifts -Inheritances -Child support -Muni bond income -Workers' comp payments -Compensatory damages

IMPUTED INTEREST RULES: GIFT LOANS

Gift loans. A gift loan can only occur between individuals. The lender has interest income, and the borrower has interest expense to the extent of the imputed interest. In addition, a gift has been made to the borrower (subject to federal gift tax) in the amount of imputed interest. However, there are several EXCEPTIONS to the application of the rule. - No interest is imputed on total outstanding gift loans in the aggregate of $10,000 or less between individuals, unless the proceeds from the loan are used to purchase income-producing property. - For loans between individuals in an amount greater than $10,000 and less than or equal to $100,000, the imputed interest cannot exceed the borrower's NII for the year. - If the borrower's NII for the year does not exceed $1,000, no interest is imputed on loans of $100,000 or less.

CALCULATE TAXABLE INCOME

Having calculated adjusted gross income, reviewed deductions, and calculated the amount of itemized deductions, the taxpayer must now use this information to calculate taxable income. The taxpayer must return to the Form 1040. The income tax liability for an individual taxpayer is calculated under a rate schedule determined by the taxpayer's filing status. A taxpayer's marginal income tax rate is the percentage of tax applying to the next dollar of taxable income and is one of the keys to effective tax management. For example, if an individual is slightly above the cutoff for the 22% marginal rate, the financial planner should undertake tax avoidance, tax deferral, or tax conversion strategies to reduce taxable income to the point where it all falls into the 22% tax bracket. A taxpayer's marginal rate is that which is paid on the last taxable dollar. This is also often referred to as the taxpayer's income tax bracket. A single taxpayer whose taxable income is $25,000 is said to be in the 12% tax bracket. *** The taxpayer's EFFECTIVE RATE is determined by DIVIDING the TAX PAID BY the TAXABLE INCOME***. example, if the tax liability on $100,000 of taxable income of a single taxpayer is $17,836, the effective tax rate is 17.84%. However, the last taxable dollar is taxed at the 24% rate in the tax brackets for a single taxpayer. On the other hand, if the taxpayer owed $17,836 on $125,000 of total income, their average tax rate would be 14.27%. Note the subtle difference between effective and average rates. The former uses taxable income. The latter uses total income.

STRUCTURE SETTLEMENTS (2)

If the damages arising out of the personal injury lawsuit are considered only to make the injured party whole (i.e., restore the party back to where she was before the accident), they are referred to as COMPENSATORY DAMAGES. These types of damages are INCOME TAX-FREE to the injured party, with ONE EXCEPTION: damages received in age, sex, or racial discrimination cases (DEFAMATION OF CHARACTER) are GENERALLY TAXABLE. If the damages are only compensatory in nature, so also are the proceeds from the annuity or money used as part of a structured settlement on behalf of the victim. Conversely, if the damages arising out of a personal injury lawsuit are intended to punish the offender (tortfeasor) for his acts (i.e., PUNITIVE DAMAGES), these types of damages are generally TAXABLE. Again, there is ONE notable EXECPTION to this rule: - if the punitive damages are awarded as a result of a WRONGFUL DEATH death suit by the plaintiff, and if state law permits it, these damages are INCOME TAX FREE. As mentioned, if a lump-sum payment representing the present value of future compensatory damages is invested for the benefit of the victim/claimant, who CAN DIRECT how the lump sum is to be invested, ONLY the amount of the LUMP-SUM payment received in lieu of compensatory damages IS NONTAXABLE. None of the earnings generated from that lump-sum payment (e.g., interest on an annuity) are excludible from taxes. However, where the victim/claimant has NO CONTROL over the investment of the present-value lump-sum amount, ALL OF THE annuity PAYMENT is NONTAXABLE, including earnings on the fund.

PROGRESSIVE INCOME TAX SYSTEM

In a progressive income tax system, the more taxable income a taxpayer has, the higher the tax bracket in which the last dollar is taxed. Put another way, low income workers lose a smaller percentage of their earnings to taxes. The single taxpayer whose taxable income is $100,000 is taxed progressively through the tax brackets. For example: 10% × $10,275 (up to the first $10,275) = $1,028 12% × $31,500 ($41,775 - $10,275) = $3,780 22% × $47,300 ($89,075 - $41,775) = $10,406 24% × $10,925 ($100,000 - $89,075) = $2,622 Total tax= $17,836 Using the tax tables, the tax on the first $89,075 is $15,214. 24% × ($100,000 - $89,075) Total tax liability = $2,622 = $17,836 The example illustrates that the progressive tax rate is built into the tax tables, and the tax liability calculated with either method is the same. The U.S. progressive tax system differs from flat tax systems used by some states and other countries. Flat tax systems impose a uniform rate on all taxpayers, regardless of their income.

IMPUTED INTEREST RULES

In instances when a lender (e.g., an individual, employer, or institution) has engaged in a below-market-interest rate loan transaction, the lender may be REQUIRED TO IMPUTE (report) interest income even WITHOUT RECEIVING the INTEREST. Alternatively, the BORROWER may receive an interest expense DEDUCTION when, in fact, no interest to the extent of this imputed amount has ever been paid. ** The rate used is the FEDERAL GOVERNMENT'S BORROWING RATE, compounded SEMIANNUALLY and ADJUSTED MONTHLY. This is called the "APPLICABLE FEDERAL RATE". ** It is the MINIMUM INTEREST RATE that the IRS ALLOWS FOR PRIVATE LOANS**.

ORDINARY & NECESSARY BUSINESS EXPENSES

Many students tend to think of total income (reported on Form 1040) and gross income as being synonymous, though technically, they are not. The BIGGEST DIFFERENCE is that there are some SUBTRACTIONS ALLOWED in computing TOTAL INCOME on the tax return that are NOT DEDUCTED in COMPUTING GROSS INCOME. Some of these deductible items may include losses from certain unincorporated businesses (e.g., sole proprietorships or partnerships). EXPENSES related to carrying on a taxpayer's trade or business are a DEDUCTION in the CALCULATION of AGI. However, the deduction is NOT SHOWN on the FRONT PAGE of Form 1040 like most other deductions to reach AGI. Rather, the expenses, along with the income generated from the business, are reported on Schedule C of Form 1040. Most individual expenses that are deductible are only deductible as itemized and miscellaneous itemized deductions from AGI, subject to various limitations on some deductions. There are TWO CASES in which the taxpayer may DEDUCT some expenses from GROSS INCOME in arriving at AGI: 1.) When the expenses are incurred in carrying on a trade or business (Schedule C) 2.) When the expenses are incurred in connection with property held for the production of rents or royalties (Schedule E) The expenses for these activities are reported, along with the income generated by the activities, on the appropriate IRS tax schedule.

FILING STATUS: MARRIED FILING JOINTLY (MFJ)

Married filing jointly (MFJ). Spouses in a marriage legally recognized under federal law or in the state of domicile may file a joint return, even though one spouse has no income or deductions, if they are not legally separated or divorced on the last day of the tax year. It is usually advantageous for married persons to file a joint return because the combined amount of tax is usually LOWER. When a spouse dies during the tax year, the surviving spouse may file MFJ in that year. This election should be coordinated with the administrator or executor of the deceased spouse's estate

MORTGAGE INSURANCE PREMIUMS

Mortgage holders can deduct mortgage insurance premiums whether the coverage is provided by private insurers or by a federal agency, such as the Federal Housing Administration, the Department of Veterans Affairs, or the Department of Agriculture's Rural Housing Service. Taxpayers must itemize deductions to take advantage of this deduction. Congress extended this deduction through the end of 2021, subject to phaseout ($54,500 S or $109,000 MFJ). As of this writing, Congress is considering legislation that would make the deduction permanent beginning in 2022.

Taxation of Windfall and Other Fringe Benefits: Overview

Not all income fits neatly onto a W-2 or Form 1099. There are less common types of income that may be taxable regardless of whether the taxpayer actually receives a tax form at the end of the year. Generally, income is not recognized (taxable) unless it is actually physically received by the taxpayer. However, there are two primary exceptions to this rule: 1.) The imputed interest rules 2.) The constructive receipt income doctrine

Personal Casualty Losses

Pursuant to the TCJA, personal casualty losses are deductible only if incurred in a federally declared disaster. The event must result in property damage, and it must be sudden, unusual, and unexpected (such as a hurricane, tornado, or wildfire). For a loss to insured property, if an insurance claim is not filed in a timely manner or at all, the loss is not a casualty loss. If the event does qualify as a deductible casualty loss, the taxpayer is limited to the amount of casualty loss that may be deducted by using the following steps: 1. Take the lesser of the taxpayer's adjusted tax basis in the property or the difference between the fair market value (FMV) of the property before the loss and the FMV after the loss. 2. Subtract any insurance amounts reimbursing the taxpayer for the loss. 3. Subtract $100 (per claim). 4. Subtract 10% of the taxpayer's AGI (a 10% AGI floor). 5. The result equals the amount of deductible casualty loss.

QUALIFIED DIVIDENDS

Qualified dividends receive favorable income tax treatment. Qualified dividends are taxed at the rates applicable to long-term capital gains. A 0% RATE applies to qualified dividends if the taxpayer's taxable income is LESS THAN $83,350 (for married couples filing jointly); a 15% RATE applies for qualified dividends if they fall BETWEEN the taxable income BREAKPOINTS of $83,350-$517,200 (for married couples filing jointly). A 20% RATE applies to qualified dividends ABOVE the $517,200 BREAKPOINT (for married taxpayers filing jointly). There are different breakpoint figures for different filing statuses. These rates apply for both the regular tax and the alternative minimum tax (AMT). These figures are for 2022 and are INDEXED FOR INFLATION. Preferential rates are available only to eligible dividends from stock; INTEREST EARNED from CDs, BONDS, and SAVINGS accounts are NOT ELIGIBLE. Only certain dividends are eligible for this preferential rate. For example, dividends received from most foreign corporations, credit unions, mutual insurance companies, real estate investment trusts, farmers' cooperatives, and tax-exempt entities; deductible dividends from employer securities owned by an employee stock ownership plan (ESOP); and dividends from stock owned for LESS THAN 61 days in the 121-day period beginning 60 days before the ex-dividend date DO NOT QUALIFY. Qualified dividends are further discussed in Module 6 of this course.

Athletic Facility Provided to Employees

The value of an athletic facility or gym provided by the employer on its premises, if solely for the use of the employee and the employee's dependents, is nontaxable to the employee. If an employer pays the dues of an outside health club for the employee, the dues are taxable.

EXCLUSIONS FROM INCOME: Items or benefits provided by an employer.

This is the broad category of employer-provided fringe benefits. The majority of employer-provided fringe benefits are either NONTAXABLE in full or at least in part. Fringe benefits are a part of the compensation package given to an employee who is not salary but consists of valuable consideration such as employer-paid health insurance, life insurance, retirement plan contributions, and educational assistance. As a general rule, if these benefits discriminate in favor of HIGHLY COMPENSATED EMPLOYEES (HCEs) or key employees (e.g., in the case of nonqualified DEFERRED COMP plans established on behalf of a corporate executive), you should be aware that taxation may result and a SEPARATE SET OF TAX PROVISIONS APPLY.

Above-the-Line Deductions: Deductible Portion of Self-Employment Tax Paid

To lessen the burden of paying both halves of the FICA payroll tax (as discussed earlier), self-employed individuals are allowed a deduction for AGI of the employer share of the self-employment tax paid. The deduction is calculated based on the employer share (1⁄2) of the self-employment tax paid. For example, assume that a taxpayer's self-employment tax for 2022 is $5,000. On his 2022 tax return, the taxpayer is allowed to deduct $2,500 from total income in determining the AGI.

FILING STATUS: MARRIED FILING JOINTLY (MFS)

When filing separate returns, each spouse reports only the spouse's own income and applicable deductions and credits. In addition, each spouse must use the tax rates for married persons filing separately. Married couples may file in this manner if they are going through a divorce proceeding or simply do not want to assume the joint and several liability of MFJ status. ** It should be noted that some deductions and credits are limited or unavailable to taxpayers using this filing status. However, if married taxpayers file separate returns and live in a community property state, the taxpayer and the taxpayer's spouse must each report half of the combined community income and deductions, in addition to any separate income and deductions. This could drastically change any advantage that may exist in filing separate returns.

EXAMPLE: INVESTMENT INTEREST EXPENSE

Your client, Emma, is single and has $10,000 of investment interest expense from her margin account. She has also earned $3,000 of taxable bond interest, $4,000 of qualified dividends, and $5,000 of long-term capital gains. She has gross income of $138,000. If Emma elects not to apply the 15% capital gain rate to both the $4,000 of qualified dividends and $5,000 of long-term capital gain income, she can include the $9,000 total in the investment income necessary to help offset the $10,000 of investment interest expense. Otherwise, she is limited to a possible investment interest expense deduction of $3,000 (only the amount of bond interest and dividends constituting investment income).

DEPENDENCY STATUS: QUALIFYING CHILD

A qualifying child must be the taxpayer's: - child, - stepchild, - foster child, - brother, - stepbrother, - sister, - stepsister, - or a descendant of any of the previously listed and MUST HAVE LIVED with the taxpayer MORE THAN HALF OF THE TAX YEAR. The individual MUST PASS AN AGE TEST, meeting one of the following standards: 1) Under age 19 at the close of the tax year 2) A full-time student and under age 24 at the close of the tax year 3) Totally and permanently disabled at any time during the tax year To satisfy the support test, the individual must not have provided more than 50% of his own support (scholarships do not count), and the individual cannot claim any other individual as a dependent. The individual may not file a joint return for the tax year (unless the only reason a return was filed was to obtain a refund of tax withheld). The individual generally must also be a U.S. citizen, U.S. national, or resident of the United States, Canada, or Mexico.

STRUCTURED SETTLEMENTS (1)

A structured settlement is a method of compensating a victim for injuries arising, in most cases, as a result of a personal injury lawsuit. Historically, damages paid due to an injury lawsuit were paid in the form of a single lump sum. However, this settlement method burdened the injury victim with now having to manage a large lump sum of money, in addition to nursing himself back to health. The lump sum could also be squandered on nonmedical related spending, leaving the recipient of a court award with no funds to pay for medical costs. To address these issues, Congress passed the PERIODIC PAYMENT SETTLEMENT ACT in 1982. The act allows damages from a personal injury lawsuit to be PAID OUT PERIODICALLY, most often in an annuity form for the remainder of the injured party's lifetime.

MORTGAGE INTEREST DEDUCTION (4)

Generally, there are FIVE TYPES OF POSSIBLE INTEREST EXPENSES that may be incurred by a taxpayer. These were mentioned in a previous course and consist of: 1) CONSUMER INTEREST (never deductible); 2) QUALIFIED RESIDENCE INTEREST (to be discussed here); 3) INVESTMENT INTEREST EXPENSE (handled separately from other expenses incurred in connection with the production of investment income); 4) BUSINESS INTEREST (previously discussed as an allowable Schedule C business expense); and 5) PASSIVE INTEREST (to be discussed in Module 7 of this course).

Alimony and Child Support: Alimony (and Separate Maintenance) Payments: CHILD SUPPORT PAYMENTS

***CHILD SUPPORT PAYMENTS ARE NONTAXABLE TO THE PAYEE AND NONDEDUCTIBLE BY THE PAYOR*** However, it is sometimes difficult to distinguish child support from alimony. Therefore, if the payment is tied to a contingency related to the child (e.g., the child marries, dies, or reaches a certain age), the amount of this payment is presumed to be child support (with any remainder constituting alimony if the payment separately satisfies those requirements). For example, if the payor must provide life insurance for children until they achieve a certain age, marry, or die, then the payments for the life insurance are child support and not alimony to the spouse. In the past, much abuse has occurred in the area of child support. The general rule is that child support payments are nontaxable to the recipients and nondeductible by the payor. Payments resulting from a divorce decree should be clearly specified as either alimony or child support.

TYPES OF BUSINESS ENTITIES: C CORPORATIONS: Personal Holding Company (PHC) Tax

**PERSONAL HOLDING COMPANY (PHC) tax is INTENDED TO DISCOURAGE (primarily) CLOSELY-HELD CORPORATE OWNERS FROM USING THE SEPARATE CORP ENTITY AS INVESTMENT SHELL.** Specifically, the PHC tax applies if the corporation meets both of the following tests. 1.) An OWNERSHIP TEST—During the last half of the taxable year, more than 50% of the value of the outstanding stock of the corporation is owned by five or fewer individuals. 2.). A PASSIVE INCOME TEST—At least 60% of the CORP'S ADJUSTED ORDINARY INCOME consists of personal holding company income. PERSONAL HOLDING COMPANY INCOME is generally defined as INCOME FROM FROM SECURITIES AND OTHER INCOME-PRODUCING PROPERTY.

Tax Consequences of Property Transactions: CAPITAL ASSETS AND DEPRECIATION: ESTABLISHING BASIS: TYPES OF BASIS

-- Original or cost basis. This is where the calculation of basis begins and is the amount of the taxpayer's original funds used to make the investment, plus any improvements made to the investment, legal fees, and permits to build (e.g., real property). The original basis or cost basis of property received as compensation for services rendered is the FMV of the property at the time it was received and is the amount of income taxable because of the payment of compensation in the form of property. The taxpayer receiving the property will have a basis equal to the FMV of the property at the time it was received. -- Adjusted basis. The investment's cost basis (increased by any capitalized costs), reduced by any cost recovery deductions (in the case of tangible assets), amortization (in the case of Section 197 intangible assets), or depletion (in the case of natural resources) (upon disposition, fees incurred to dispose of the investment [commissions] will decrease the sales price). For financial intangibles (securities), commissions and other fees to acquire the security will increase the basis of the asset. -- Carryover basis. Basis that is transferred or carried over from one party to another; its most notable application is appreciated property gifted from the donor to the donee. -- Stepped-up basis. As previously stated, this is basis that is increased to some point in time, free of any intervening income taxation. Its most notable application is property that appreciates during a taxpayer's lifetime and is received by the heirs at time of death and, generally, receives a stepped-up basis to the FMV at the date of death for the property inherited by the heirs. -- Substituted basis. The property's FMV less any deferred gain or plus any postponed loss; its most notable application is a nontaxable exchange of qualifying real property (also known as a like-kind exchange). (Note: This will be discussed in Module 8 of this course when discussing nontaxable property transactions.)

OTHER DEDUCTIONS

1) Charitable contributions. If the taxpayer itemizes, these are often fully deductible in the current year. This topic is discussed at greater length in subsequent modules. 2) Legal and accounting fees. Legal and accounting fees incurred for personal purposes are not deductible. When legal and accounting fees are incurred in connection with a trade or business or for the production of rents and royalties, they are deductible in calculating AGI, as discussed in earlier in this module. 3) Worthless securities. Securities must be completely worthless to be deductible. Losses are considered to be capital losses occurring on the last day of the year in which the securities become worthless. These losses are treated as capital losses (discussed later). 4) Bad debts. A deduction is allowed for business debts that become partially or wholly worthless if the income from the debt was previously included in the taxpayer's income. Business bad debts are deductible as an ordinary loss. Some nonbusiness bad debts can be written off but only if they are completely worthless. Nonbusiness bad debts are always considered short-term capital losses.

Fiduciary Tax Rates and Filing Requirements

1. Fiduciaries file Form 1041 on or before the 15th day of the fourth month after the close of the tax year. Grantor trusts may also file a Form 1041. 2. A trust must adopt a calendar year 3. Estates may adopt either a calendar year or a fiscal year. The first taxable year begins on the day following the decedent's death. 4. Estates and trusts are subject to the following rate schedule (a highly progressive structure). 5. Any component of fiduciary taxable income consisting of long-term capital gain is taxed at the long-term capital gain rate. 6. Trusts may be subject to alternative minimum tax.

Income Taxation of Trusts and Estates: TYPES OF TRUSTS

1. Simple trust a. Trust is required to distribute all income to beneficiaries each year. b. Charitable donations are prohibited. c. Principal distributions are prohibited. 2. Complex trust a. A trust that can accumulate income. b. Principal can be distributed. c. The trust pays tax on accumulated income. 3. Grantor trust a. If a trust is a grantor trust, the grantor pays tax on all trust income. b. Trust is ignored for income tax purposes. c. A trust will be a grantor trust if the grantor retains the power to control enjoyment. These powers include the power to i. add or remove beneficiaries; ii. determine the timing of distributions; iii. alter the beneficiaries' share of principal or income; iv. retain a reversionary interest in either corpus or income; v. control the beneficial enjoyment (either the grantor, a nonadverse party, or both); vi. retain certain administrative powers; vii. revoke the trust; and viii. retain the ability to take income distributions, hold or accumulate income for future distributions to the owner or a nonadverse party, or apply income to the payment of life insurance policies on the life of the grantor or the grantor's spouse (e.g., a funded irrevocable life insurance trust [ILIT]).

Income Taxation of Trusts and Estates: Fiduciary Accounting Income

1. The accounting income of a fiduciary is determined by the decedent's will (in the case of an estate) or the trust instrument (in the case of a trust). 2. Every fiduciary may have its own unique set of rules for computing accounting income. 3. A common difference between fiduciary accounting income and fiduciary taxable income is the treatment of capital gains. a. For accounting purposes, capital gains generally represent an increase in the value of the principal and are not available for distribution to the income beneficiaries. b. For tax purposes, the capital gains represent taxable income. 4. Trustee fees are generally deductible for tax purposes but may be treated as either income or principal for trust accounting purposes.

Income Taxation of Trusts and Estates: Fiduciary Taxable Income and Distribution Deduction (1)

1. The taxable income of a trust is similar to the calculation of taxable income for an individual taxpayer. 2. Major differences between trust taxable income and individual taxable income include the following: a. A trust is entitled to a deduction for distributions made to beneficiaries. b. A trust is not entitled to a standard deduction. c. A trust is entitled to a personal exemption of $300 for a simple trust and $100 for a complex trust. 3. If an administrative expense is claimed as a deduction on the estate tax return of a decedent, it may not also be claimed as a deduction on the income tax return of the decedent's estate. a. The deduction may be prorated between the two returns.

IMPUTED INCOME AND THE ALTERNATIVE MINIMUM TAX: BELOW-MARKET LOANS (2)

2. The imputed interest rules apply to the following types of below-market-rate loans: a. Gift loans—The lender has interest income, and the borrower has interest expense to the extent of imputed interest. In addition, a gift has been made to the borrower in the amount of imputed interest. Gift loans may only occur between individuals. b. Compensation-related loans—The employer makes loans to employees. The corporation has interest income and compensation expense for the amount of the imputed interest. The borrower will have compensation income and interest expense, which may or may not be deductible, in the same amount. c. Corporation-shareholder loans—These are loans to a nonemployee shareholder by the corporation. The corporation will have interest income and a dividend distribution for the amount of the imputed interest. The shareholder-borrower will have dividend income and interest expense (may or may not be deductible) for the same amount. d. Tax avoidance loans—These loans significantly affect the borrower or the lender's federal tax liability.

Income Taxation of Trusts and Estates: Fiduciary Taxable Income and Distribution Deduction (2)

4. Medical expenses paid for the care of the decedent before death can be handled in these two ways. a. If paid within one year after death, medical expenses can be deducted either on the decedent's final income tax return (Form 1040) or the decedent's estate tax return (Form 706), but not both. Final medical expenses are typically best deducted on the 706 rather than on the final 1040 (Schedule A) because there is no 7.5% (2022) threshold requirement on the 706. b. If paid more than one year after death, expenses can only be deducted on the estate tax return. 5. Deductions for distributions made to beneficiaries are treated as follows: a. The fiduciary is allowed a deduction for the amount of distributions made to beneficiaries during the year. b. The amount deductible by the fiduciary is the same amount that is taxable to the beneficiaries. c. The distribution deduction is calculated as the lesser of distributable net income (DNI) or the amount actually distributed to the beneficiaries. d. Distributable net income (DNI) -- is similar to fiduciary accounting income; -- includes most normal income/expense items; -- excludes items relating to corpus, such as capital gains, stock splits, and depreciation of business assets.

CHILD TAX CREDIT

A $2,000 child tax credit (up to $1,500 refundable) is given for each qualifying child under the age of 17. A qualifying child includes the taxpayer's child, stepchild, grandchild, brother, sister, stepbrother, stepsister, niece, nephew, or eligible foster child, and in all cases, the child must be a dependent of the taxpayer. The Additional Child Tax Credit may be available to certain low-income taxpayers with at least three qualifying children. The amount of the credit is phased out (reduced) by $50 for each $1,000, or portion thereof, for married taxpayers filing jointly with MAGI exceeding $400,000 and taxpayers of other filing statuses with MAGI exceeding $200,000. For example, assume that a married couple filing jointly has an AGI of $408,010 and one qualifying child. The excess of the AGI over the threshold is $8,010. Divide the $8,010 excess by $1,000 to equal 8.01. Because the credit is reduced by $50 for each $1,000 or part thereof, we round up to nine. Nine multiples of $50 equals $450. The $2,000 potential child tax credit is reduced by the $450 phaseout to $1,550. In addition, the Code provides for a $500 credit for each dependent who is not a qualifying child (a qualifying relative, discussed previously). Thus, the taxpayer may claim the $500 credit for a dependent child who is 17 or older, a full-time student under the age of 24, or a dependent parent or other relative.

EXAMPLE 2: Charitable contributions by businesses

A sole proprietor made a $100,000 donation to a committee organized by the local chamber of commerce to bring a convention to her city, with the intent of increasing overall business activity, which would benefit her business as well. The payment is not a charitable contribution; however, the payment is deductible as a business expense.

Taxation of Security Transactions: CAPITAL ASSETS (1)

A capital gain or loss is the result of a sale or exchange of a capital asset. A capital asset is DEFINED to be any asset held by the taxpayer (whether or not connected with their trade or business) other than one that falls under one of the excluded classes. The five excluded classes include the following: -- Inventory or property held primarily for sale to customers in the ordinary course of business -- Property subject to depreciation and real property used in a trade or business -- A copyright; a literary or artistic composition, a letter, memorandum, or similar property held by the author or creator, or by the donee of the author or creator -- A patent, invention, model or design (whether or not patented); a secret formula or process which is held either by the creator, or by a taxpayer with a substituted or transferred basis from the taxpayer, who created the property (e.g., typically, a donee of the property) -- Accounts or notes receivable, acquired in the ordinary course of trade or business, for services rendered or from the sale of inventory -- United States government publications (received from the government without charge, or below the price sold to the public) -- Supplies regularly used or consumed by the taxpayer in the ordinary course of a trade or business

ETHICAL CONSIDERATIONS, AUDITS, AND TAX PENALTIES: TAX AUDITS: COMMON TAX TRAPS: Constructive Receipt Doctrine

A cash basis taxpayer must report income in the year it is constructively received, even if it is not actually received until a later year. Income is constructively received when the taxpayer could have it if they wanted. Taxpayers may not turn their backs on income to defer its recognition to a later year.

Estate Planning Techniques for the Newly Single: The Present Value of Divorce Settlement Payments

A common issue that arises in the settlement of divorce proceedings is how payments are best structured in resolution of marital obligations. Generally, it is usually in the best interest of the payor to spread the amount of payments over as many years as possible to take advantage of the time value of money. Alternately, the payee's best interests are served by immediately receiving as much money as possible rather than receiving payments over a longer period. Sometimes, the interests of both parties will be met when the payee agrees to settle in present value dollars for a current amount that is less than the amount resulting from the assumed discount rate used by the payor over time. Divorce can be a costly endeavor. As assets are distributed, practitioners need to be cognizant of the tax bracket of the client. Because the single brackets are somewhat more compressed than the MFJ brackets, it is common for the higher earning ex-spouse to suddenly find themselves in a higher tax bracket, even though their salary has not materially changed. It is also normal for divorcees to access their retirement accounts to pay attorney fees. During the financial transition, some clients may even need to make premature withdrawals simply to pay living expenses. It is paramount that clients are reminded that this money is fully taxable. Usually a 10% early withdrawal penalty will also apply.

MEDICAL EXPENSES

A deduction is available for any expense incurred with respect to the diagnosis, cure, treatment, or prevention of disease, as well as for transportation expenses related to this objective. The SECURE Act was passed by Congress in December 2019, which reduced the 10% threshold to 7.5% for 2019 and 2020. The Consolidated Appropriations Act of 2021 made this change to 7.5% permanent. Premiums paid directly by the W-2 taxpayer from after-tax income for accident and health insurance and disability insurance can be included in deductible medical expenses (subject to a 7.5% of AGI floor, which we'll discuss more in the next paragraph). Premiums paid by greater than 2% shareholders of an S corporation and by self-employed taxpayers are covered later in this course. Qualifying medical expenses include those expended for the W-2 taxpayer, the taxpayer's spouse, and any dependents. However, to be deductible, the expenses must not be reimbursed by any insurance coverage and must be paid on behalf of only the taxpayer, spouse, or dependent. In addition, all medical expenses are subject to a 7.5% of AGI floor (2022), which means no qualifying medical expense may be deducted until the total of all qualifying expenses exceeds 7.5% of a taxpayer's AGI (2022). Effectively, this limitation precludes the deduction of medical expenses for most taxpayers, except those who experience a catastrophic illness for which they do not have insurance coverage.

Passive Activity and At-Risk Rules: DIRECT PARTICIPATION PROGRAMS: PARTNERSHIP ENTITIES (I)

A direct participation program is a pooled entity that offers investors access to the cash flow and tax benefits of the business. Direct participation programs are not rigid investments. On the contrary, they are offered in many different forms. The most common form is the partnership, but passive income can originate from several different entities. Three main types of partnerships are available: -- Limited partnership -- General partnership -- Master limited partnership (presently the least common of the three) The LLC and LLP may be mentioned here as well, since both of these forms of business are, by default, treated as a partnership for income tax purposes. However, if the LLC or LLP has elected to be treated as a corporation for tax purposes, then those entities are no longer conduits and cannot function as direct participation programs. The LLC offers many of the benefits of the limited partnership. The LLC is a conduit. The members of the LLC enjoy limited liability, as with the limited partnership. An additional benefit is that the members may participate in management without losing their limited liability status, as would be the case with the limited partnership.

TEST TIP: CHARITABLE GIFTS PROPERTY

A distinction should be drawn between charitable gifts of so-called use-unrelated tangible personalty (for which the rules were just stated) and gifts to charity of use-related appreciated tangible personal property. In the latter case, a deduction is allowed for the full FMV of the property as of the date of the gift, as long as the property had been held for more than one year at such time. Remember, this provision does not apply to contributions of real estate (which is not personalty) or stocks, bonds, and mutual funds (which are intangibles). The charitable deduction allowed for gifts of appreciated tangible personal property is limited to the taxpayer's adjusted basis in such property, unless the donated property relates to the exempt purpose of the charity.

S Corporations and Pass-Through Entities: Family Limited Partnership (FLP)

A family limited partnership (FLP) is a type of limited partnership that is typically set up by a senior family member. The senior family member transfers business or investment assets to the FLP in exchange for a 1% general partnership interest and a 99% limited partnership interest. Then, over time, the senior family member makes tax-advantaged transfers of the limited partnership interests to younger members of the family. This technique is FREQUENTLY USED TO TRANSFER PRIVATELY OWNED FARMING OPERATIONS FROM ONE GENERATION TO THE NEXT. One of the MAJOR BENEFITS of an FLP is its ability to REDUCE the senior family member's GIFT and ESTATE TAX EXPOSURE.

TEST TIP: FULL-TIME STUDENTS

A full-time student is a student who is enrolled for the number of hours or courses that the school considers to be full-time attendance for at least five calendar months during the tax year. The five months do not have to be consecutive.

S Corporations and Pass-Through Entities: GENERAL PARTNERSHIP

A general partnership is treated as a separate entity from its members, but only for limited purposes. For example, the partnership entity may borrow money in its own name and sue or be sued in that capacity. The partnership is distinguished by three elements. -- There is a common ownership in the business by more than one owner. -- There is a sharing of profits and losses of the business; these are normally done in proportion to the partner's interest, but special allocations of profits and losses may be made. -- General partners (not limited partners) are afforded the right to participate in the management and operation of the business. They also have unlimited personal (or joint and several) liability for the acts of the partnership and other partners. Partnerships are pass-through entities for purposes of federal income taxation. While a tax return is filed for the partnership (IRS Form 1065), this return is for information purposes only. Items of income and deduction are not taxed at the partnership level but are reported (passed through) to the partners on Schedule K of Form 1065. Each partner then receives a Schedule K-1 that includes the allocation of each item of income or deduction. These amounts are subsequently reported on Schedule E of each partner's IRS Form 1040. The calculation of a partner's basis is an advantage of a general partnership. Specifically, a partner's basis in a partnership consists of the original cash or property contribution to the entity, which is then adjusted by earnings and losses. In addition, a partner's basis is increased by any direct loans to the partnership, plus the share of any money borrowed by the entity on either a recourse (personal liability) or nonrecourse (secured by collateral) basis. The addition to the partner's basis by recourse and nonrecourse financing is an advantage because losses in excess of the partner's actual cash (or property) contributed to the partnership may be deducted. Per the partnership agreement, special allocation of income, losses, or both is possible. Partners are self-employed for income tax purposes and pay self-employment taxes on net income from self-employment, half of which is a deductible expense by the taxpayer. However, employee wages and payroll taxes paid by the self-employed owner for those wages are a flow-through deductible expense on Schedule E. (Calculating the self-employment tax and the deductible portion of the tax is discussed later in this module.)

S Corporations and Pass-Through Entities: LIMITED PARTNERSHIP

A limited partnership is a type of partnership in which the partner is liable to the creditors of the partnership only to the extent of that partner's contributed or promised cash or property. In exchange for this limited liability, the limited partner does not have the authority to bind the partnership entity and cannot participate in the management of the entity. A limited partnership is formed very similarly to a general partnership, except that a written agreement must be drafted. There is at least one general partner, responsible for day-to-day operations, and at least one limited partner. Once this agreement is executed, an application must then be filed with the state giving notice to others of the limited partnership form. When the state authorities are satisfied that the forming partners have complied with all state statutes, they will issue the partnership a certificate of authority to operate. A limited partnership is taxed under the same principles applying to a general partnership, except that a limited partner is only a passive owner for income tax purposes. This means that the limited partner is subject to the passive activity rules, which will be discussed later in this course. The practical import of these rules is that it is extremely difficult for the limited partner to deduct any annual losses incurred from the operations of the partnership entity. Notable examples of these rules applying in practice are real estate syndications and oil and gas partnerships in which the limited partner is receiving a royalty.

CALCULATING COMPLEX CAPITAL ASSET GAINS AND LOSSES: Capital Gains Netting Procedures

A netting process applies to capital gains and losses. The netting process is pro-taxpayer. Initially, all gains and losses are grouped into several categories—short-term gains and losses in one group, and long-term gains and losses are grouped according to their respective groups or buckets. The long-term groups are collectibles, unrecaptured Section 1250 gains, and securities and other gains and losses (15/20% group). This final group—securities and other gains and losses—comprises gains and losses that don't fall into one of the other categories. Gains and losses are first netted within their own rate group (collectibles losses against collectibles gains, and so on) to arrive at a net figure for that group. A net short-term capital loss is applied first to reduce net long-term gain from the 28% group, then to reduce gain from the 25% group, and finally to reduce net gain from the 15/20% group. A net loss from the 28% group is used first to reduce gain from the 25% group, then to reduce net gain from the 15/20% group. A net loss from the 15/20% group is used first to reduce net gain from the 28% group, then to reduce gain from the 25% group. Any resulting net capital gain is taxed at that group's marginal tax rate. The common theme here is that the capital loss is generally deducted against the gain that would be taxed at the highest rate.

Tax Law Compliance and Procedures: Notice

A notice is a public pronouncement that contains official guidance about regulations or interpretations of the Code. The guidance is often substantial but again, ultimately it only points to higher regulations. Notices in and of themselves do not carry the weight of law.

Tax Reduction and Management Techniques: OVERVIEW (1)

A number of successful tax reduction strategies are at the disposal of high net worth clients. ** THESE PREDOMINANTLY INCLUDE: -- TRUSTS -- INCOME SHIFTING -- CHARITABLE GIVING A number of different types of trusts can be created. TRUSTS ARE USEFUL FOR: (1) administrative efficiency, (2) probate avoidance, (3) creditor protection, and (4) intergenerational gifting. In this module, we will confine ourselves primarily to a discussion of grantor trust rules. Some trusts are designed simply to avoid probate. The grantor retains control of the assets during his lifetime. Other trusts are created for more complex purposes. The legal labyrinth of trust design can only be navigated successfully with the assistance of a competent estate planning attorney. Trusts are often established to transfer assets from individual ownership to entity ownership, which achieves unique tax benefits. How the trust is taxed ultimately depends upon many factors. The IRS is aware of these strategies. Thus, estates and trusts are subject to their own unique and generally unfavorable income tax brackets.

TYPES OF BUSINESS ENTITIES: C CORPORATIONS: Section 1244 Stock

A particular type of stock that may be separately categorized for tax purposes upon the formation of a C corporation. This is Section 1244 stock, named after the Internal Revenue Code section of the same number. If, at the time of forming a regular or C corporation, the total capital contributions to the corporation do not exceed $1 million and stock is issued in exchange for investor money (not services), favorable tax consequences will result from the sale or disposition of such stock. Specifically, if a married investor sells such stock at a loss (or if the stock becomes worthless), up to $100,000 of the loss may be deducted as an ordinary loss. (This limit is $50,000 if the investor is a single taxpayer.) Section 1244 stock still maintains its character as a capital asset for gain purposes, meaning that gains from the stock are still eligible for long-term capital gain preference. A corporation does not have to make any special designation for Section 1244 stock treatment. It is important to note that any excess loss over the allowable maximum is a capital loss that may be netted against capital gains in the year the loss occurs or as a carryforward. In the year of loss, a capital loss of up to $3,000 may also be taken if a loss remains after netting against capital gains. As a planning technique, taxpayers with Section 1244 losses in excess of the annual limitations ($100,000 or $50,000) should consider selling the stock (if there is a market) over periods of more than one year to maximize the amount of losses that may be claimed as an ordinary loss deduction.

Passive Activity and At-Risk Rules: DIRECT PARTICIPATION PROGRAMS: PASSIVE ACTIVITIES (I)

A passive activity is in an income-producing program in which the participation of the investor is not regular, continuous, and substantial. Income-producing actions in which the taxpayer passively participates constitute passive income and loss. The passive activity rules limit the deductibility of these passive losses. Before passage of the landmark Tax Reform Act of 1986, investments made for primarily tax-motivated reasons (versus those with economic substance) were quite popular. These tax-shelter investments were intended to defer or eliminate taxes for the investor and, sometimes, generate tax losses considerably in excess of taxpayer income.

NETTING PROCESS: SHORT SALES

A short sale occurs when an investor borrows a security from a broker and then sells it, with the understanding that the security must later be bought back (hopefully at a lower price) and returned to the broker. This transaction is still governed by the capital gain and loss rules, so long as the short sale property constitutes a capital asset in the hands of the taxpayer. Generally, the gain or loss is not recognized until the short sale is closed. A capital gain from a short sale generally will be considered short term (unless the investor closes the short sale with securities held for the long-term holding period). A loss generally will be treated as a short-term capital loss. The loss may be treated as a long-term capital loss if the investor closes the sale, with substantially identical securities held for the long-term holding period prior, to the sale date.

NETTING PROCESS: Other Investment Losses (2)

A similar rule applies to losses from Roth IRAs. While no losses from the sale of assets within the Roth IRA may be deducted, if the taxpayer liquidates all of his Roth IRAs, a loss is recognized (deducted) if the amounts distributed are less than the remaining unrecovered basis in the Roth IRAs. For purposes of this rule, all Roth IRAs are aggregated; they are not combined with traditional or Coverdell IRAs. A loss also may be allowed upon the surrender of a refund annuity policy. If the taxpayer surrenders an annuity policy, and receives less than the adjusted basis in the contract, the annuitant has sustained a deductible loss. The basis in the contract is the premiums paid reduced by any amounts previously received from the annuity contract that were excludible from gross income (e.g., excludible dividends, excludible portions of any nonperiodic distributions, and prior annuity payments). In order to qualify for this deduction, the taxpayer must be an annuitant on the policy. If the taxpayer owns a policy that has another individual as the annuitant, there is no presumption of a profit motive for purchasing the contract, and any ensuing loss is not deductible. It should be noted that none of these losses are capital losses. They are treated as ordinary losses. Thus, they are not part of the capital gain and loss netting process, nor are they subject to the $3,000 annual net capital loss limitation

Self-Employed Health Insurance Deduction

A sole proprietor may deduct 100% of the amount paid for health insurance and qualified long-term care insurance for the sole proprietor and their spouse, dependents, and any child of the taxpayer until age 26 at the close of the tax year. This deduction also applies to a partner, or to a greater than 2% shareholder in an S corporation, with wages from the S corporation reported on Form W-2. The insurance plan generally must be established under the taxpayer's business. However, health insurance that is purchased in the self-employed individual's name, rather than in the business name, can qualify for the deduction. A sole proprietor who purchases health insurance in their individual name is treated as having established a plan providing medical care coverage with respect to their trade or business, and therefore qualifies for the deduction. Medicare Part B premiums may also be included as part of the deduction, as well as premiums for qualified long-term care insurance, subject to IRS limits. There are special rules related to the greater than 2% shareholder in an S corporation. As was previously discussed, the plan providing health insurance for the taxpayer must be established by the S corporation. Insurance law in some states does not allow a corporation to purchase group health insurance if the corporation has a single employee. Thus, the IRS will treat the plan as established by the S corporation if; (1) the S corporation makes the premium payments, or (2) the greater than 2% shareholder makes premium payments and is then reimbursed by the S corporation for them. In addition, the S corporation must report the premiums paid (or reimbursed) as wages on the greater than 2% shareholder's W-2 form in that same year. Thus, the premiums are treated as income, subject to income tax. The amount reported as wages is generally not, however, subject to FICA (Social Security withholding).

EXAMPLE 1: Charitable contributions by businesses

A sole proprietor paid $415 to a local church for a quarter-page ad in a program for a concert the church is sponsoring. The purpose of the ad was to encourage readers to buy the proprietor's products. The payment is not a charitable contribution; however, it may be deducted as an advertising expense.

EXAMPLE: Failure-to-pay (FTP) and failure-to-file (FTF) penalties

A taxpayer files her tax return 39 days after the due date. Along with the filing of the return, she remits a check for $6,000, which is the balance of the tax owed. Therefore, the total FTF and FTP penalties are $600, computed as follows: FTP penalty (0.5% × $6,000 × 2) $60 FTF penalty (5% × $6,000 × 2) + $600 $60 + $600 FTP penalty (penalties run concurrently) - $60 --------- Total penalties (FTF and FTP). $600 The FTF penalty of $600 is reduced by the FTP penalty of $60, making the adjusted FTF penalty $540. Then, adding the FTP penalty of $60 (still due even though it reduces the FTF penalty) makes up total assessed penalties of $600 ($540 + $60).

RESIDENTIAL ENERGY CREDITS

A taxpayer may be able to take residential energy credits for certain expenses to have qualified energy-saving items installed on his home. In general, an individual is allowed an annual credit for buying residential energy-efficient property equal to the sum of 30% of the amounts paid. Fuel-cell equipment only qualifies if it is installed in the taxpayer's principal residence and is limited. There is no upper limit on the amount of credit for installation of the following items: 1) Qualified solar electric property 2) Qualified solar water heating property 3) Qualified small wind energy property 4) Qualified geothermal heat pump property This credit is available through the end of 2022 although it seems likely that it will be extended.

Tax Consequences of Property Transactions: CAPITAL ASSETS AND DEPRECIATION: ESTABLISHING BASIS: Acquisition Costs

A taxpayer must capitalize (include in basis rather than deduct as an expense) certain costs associated with the acquisition of an asset. For example, sales taxes, freight costs, setup and installation costs, and legal or other professional fees incurred with respect to the acquisition of an asset must be included in the basis of the asset and recovered through depreciation, if the asset is depreciable.

Tax Consequences of Property Transactions: CAPITAL ASSETS AND DEPRECIATION: ESTABLISHING BASIS

A taxpayer's basis in an asset generally will be tied to the cost of the asset if the asset was purchased (cost basis). When an asset is received as a gift, the taxpayer's basis generally will be tied to the basis that the donor had in the asset before the gift (carryover basis). When an asset is received as an inheritance, the heir's basis in the asset generally will be its fair market value on the date of death (stepped-up basis). Several adjustments may be necessary to arrive at a taxpayer's basis in an asset. The adjustments vary with the type of acquisition.

Estate Planning Techniques for the Newly Single: PROPERTY SETTLEMENTS

A transfer of property between spouses incident to a divorce is always income tax free. This property settlement is part of the nontaxable exchange provisions of the Tax Code. In addition, the transferor spouse's basis in the property is carried over to the transferee spouse for taxation of future property dispositions. Finally, it is important to note that the transfer-for-value income tax rule does not apply in situations when a life insurance policy is transferred from one spouse to another because of a property settlement. Thus, the death proceeds from a life insurance policy transferred during a divorce proceeding retain their income tax-free status.

Tax Consequences of Property Transactions: COST RECOVERY METHODS: Depreciation/Modified Accelerated Cost Recovery System (MACRS)

A wasting asset is one that decreases in value over time, due to exhaustion, wear and tear, or obsolescence. Methods of depreciation available under the broad heading of the Modified Accelerated Cost Recovery System (MACRS) include bonus depreciation, accelerated depreciation, straight-line depreciation, and Section 179 expensing. The following chart illustrates various types of property and their useful lives under MACRS to recover taxpayer cost. There are 10 recovery periods/useful lives under MACRS to which assets are assigned, but students will likely only need to know these four periods and applicable properties for the exam. Under MACRS, each type of property (assigned to a recovery period) is given a depreciation percentage. The percentage is based on a 200% declining balance for 10-year and less property and 150% declining balance for 15-year and 20-year property. For residential and commercial rental property (271⁄2-year and 39-year useful life), the cost recovery percentages are calculated using a straight-line method. IRS tables provide the statutory MACRS percentages.

EXCLUSIONS FROM INCOME: Items characterized by love, affection, or assistance.

An example of this is a gift, bequest, or inheritance. Life insurance proceeds paid by reason of death also fall into this category.

EXAMPLE: Taxation of distributable net income from a trust

ABC Trust has DNI of $100,000, of which $40,000 is nontaxable. The beneficiary received a distribution of $20,000 during the year. The distribution received will be taxable in the amount of $12,000 [$20,000 distribution × ($60,000 taxable DNI ÷ $100,000 total DNI)] and nontaxable for the remaining $8,000. Because a simple trust is required to distribute all trust income to its beneficiaries, the entire amount of taxable DNI will be taxed to the beneficiaries each year.

MEC/: MATERIAL CHANGES: OVERVIEW

ANY LIFE INSURANCE POLICY, regardless of when it is issued, is also SUBJECT to MEC TESTING. This is true EVEN AFTER ITS FIRST SEVEN YEARS if there is a MATERIAL CHANGE to the benefits provided by the policy. Once a material change occurs, a new seven-year testing period is started and a new seven-year MEC limit is calculated. The material change stipulation typically refers to universal life contracts. It is often seen when an additional death benefit, typically in excess of $150,000, is added to the pre-June 22, 1988, contract without medical underwriting.

EXAMPLE: Mixed-use vacation home rental home

Aaron and Julia own a vacation home located on the beach. They rent the home for eight full weeks during the year at a rate of $800 per week. Aaron and Julia also use the home personally for 16 days for their vacation each year. Their allocable rental expenses are $8,000 ($5,000 for mortgage interest and property taxes and $3,000 for other expenses). Under the mixed-use rules, they incur a loss of $1,600 each year, calculated as follows: Gross rental income ($800/wk × 8 wks) $6,400 Less allocable interest and taxes - $5,000 Less other allocated expenses - $3,000 ($8,000) --------- Net loss ($1,600) Aaron and Julia are prohibited from claiming this loss and report deductible rental expenses (up to the gross rental income) on Schedule E of IRS Form 1040. The allocable mortgage interest and property taxes are deductible on Schedule A of Aaron and Julia's Form 1040. The couple may carry forward the excess allocable expenses ($1,600) to future years. However, unless the rental income increases, they may never be able to deduct the excess expenses carried forward each year. Note: The calculation for allocating expenses in a mixed-use rental has been the subject of dispute by the IRS and the courts. Clients should be advised to seek qualified tax advice before determining which method they will use.

Taxation of Cash Value Life Insurance: MODIFIED ENDOWMENT CONTRACT (MEC) (1)

After the reformation of the tax shelter industry, as a result of TAX REFORM ACT OF 1986, the insurance industry began touting single premium whole life as the last remaining tax shelter. Some insurance companies had quarter-page ads in the Wall Street Journal extolling the investment benefits of the single premium whole life policies. The ideas made sense: dump a large premium into a single premium product, wait until the cash value accumulated to a large amount, and then borrow from the policy that is free of income taxes and/or tax penalties. At the death of the insured, the face amount of the policy, reduced by the borrowings, would be paid to the beneficiary tax free as well. Despite their differing views, in 1988 the U.S. House and U.S. Senate reached a compromise on the tax treatment of certain single premium life insurance contracts, now defined as modified endowment contracts (MECs). A modified endowment contract is a life insurance contract that meets both the state law definition and the IRC definition of a life insurance contract, and FAILS the seven-pay test, which is discussed later. Single premium contracts enjoy tax-deferred accumulation inside the contract just like any other cash value life insurance product. If a policyholder wishes to make a withdrawal (or loan) from a MEC before age 591⁄2, then that withdrawal (or loan) will be treated just like a withdrawal from an annuity contract (post-August 1982 last-in, first-out (LIFO) withdrawal rules).

ETHICAL CONSIDERATIONS, AUDITS, AND TAX PENALTIES: TAX AUDITS: Discriminant Functions System Program (DIF)

After the returns have been fed into a computer program, the information is screened by the DIF. This program compares the information on each return to a precomputed set of norms, or averages. These norms are computed from the TAXPAYER COMPLIANCE MEASUREMENT PROGRAM (TCMP). The TCMP had been conducted approximately every two years on about 55,000 individual returns. These TCMP AUDITS ARE THE MOST DETAILED AUDITS THAT THE IRS CONDUCTS, with every single item on the return likely to be examined for accuracy. The auditors verify each item of income and deduction. The auditors also have been known to verify age and Social Security numbers through birth certificates and drivers licenses. They may request marriage certificates and may go so far as requesting to see the taxpayer's children who have been claimed as dependents. By verifying the accuracy of every item on these returns, the IRS accomplishes two things. FIRST, voluntary compliance with income tax laws supposedly is increased by the fear that these random audits instill in taxpayers. SECOND, the IRS develops a set of norms that shows what an average taxpayer in a particular class earns and deducts on the return. These may be classified by geographic location, occupation, and earnings range. The TCMP also ascertains how and where taxpayers are most likely to cheat on their returns.

ALIMONY RECEIVED

Alimony payments arising as a result of divorce or separation decrees executed prior to 2019 are typically taxable to the recipient, as they are deductible by the payor. If the divorce decree or separation instrument is executed after December 31, 2018, the alimony payments are not includible as income, nor are they deductible by the payor. Therefore, practitioners should take note of the date the divorce was finalized

PROFESSOR'S NOTE: CHARITABLE CONTRIBUTIONS PAYMENT METHODS

All charitable contributions should be made by check and not in cash. For contributions of cash, in any amount, the taxpayer must maintain a bank record or receipt from the charity showing the name of the charity, the date of contribution, and the amount of the contribution. This change eliminates the old "collection plate" rule that allowed the deduction of cash contributions up to $250 without substantiation.

NETTING PROCESS: WASH SALE RULE (3)

Although the IRS has not ruled on the issue, many experts agree that the sale of an index fund, and subsequent purchase of a different fund investing in the same index, is subject to the wash sale rule. Experts are divided on the issue of the sale of an index fund and the subsequent repurchase of an exchange traded fund (ETF) in the same index. Some feel that this is a wash sale, and some feel that the wash sale rules will not apply here, because mutual funds and the ETF trade differently. There is some consensus that the sale of an index fund and subsequent purchase of a narrower or broader index fund is not subject to the wash sale rules. For example, a sale of an S&P 500 index fund and purchase of a total stock market index fund or a New York Stock Exchange (NYSE) composite ETF may not be subject to the wash sale rule. The basis and holding period of the newly acquired (and substantially identical) security are impacted by the wash sale. The basis of the new security is increased by the amount of loss that was disallowed on the wash sale. This basis adjustment essentially postpones the deduction for the loss until the sale of the new security. In addition, the holding period for the new securities includes the holding period of the old security.

TYPES OF BUSINESS ENTITIES: C CORPORATIONS: ACCUMULATED EARNINGS TAX: COMPUTATION

Although the full computation is somewhat complex, we can greatly simplify it for our purposes, as seen below: Taxable income $xxx Federal income tax - $xxx Dividends paid - $xxx Accumulated earnings credit* - $xxx -------- Accumulated taxable income $xxx Tax rate × 20% -------- Accumulated earnings tax $xxxx *$250,000 (or $150,000) reduced by prior accumulations The deduction for dividends paid includes dividends paid during the applicable tax year plus those paid during the first 21⁄2 months of the following tax year.

S Corporations and Pass-Through Entities: S Corporation (I)

An S corporation is a type of regular corporation that has made a special election to be taxed as a general partnership (to obtain pass-through tax treatment). The entity must be organized under state law, and the shareholders must be U.S. citizens or residents, estates, certain trusts, or certain tax-exempt organizations. A partnership or regular corporation may not be a shareholder. An S corporation may only have one class of outstanding stock (no preferred stock is allowed) and, currently, the entity may have no more than 100 shareholders. S corporation status is elected by obtaining the consent of all of the shareholders and filing an IRS Form 2553 by the 15th day of the third month (generally March 15) of the taxable year in which the shareholders intend the election to take effect. (Like C corporations, an S corporation must file its annual income tax return, IRS Form 1120S, by the 15th day of the third month following the end of its tax year.) The election is terminated either by the majority agreement of all shareholders or by some automatic event, such as a nonqualifying individual or entity becoming a shareholder.

EXCLUSIONS FROM INCOME: Items that are socially desirable or a matter of legislative grace.

An example of this is workers' compensation payments and the partial exclusion of the taxation of Social Security benefits. Interest on state and local government obligations (such as municipal bonds) encourages such investments and fall into this category. Some items related to educational incentives are excluded from gross income, as well. For example, distributions from a Coverdell Education Savings Account or a qualified tuition (Section 529) plan are excluded from gross income of the student if the distributions are used to pay qualified education expenses of an eligible student. Education funding is covered in Module 2 of this course.

Taxation of Cash Value Life Insurance: Transfer of Value (1)

An exception to the general rule, excluding life insurance death proceeds from income, is the transfer for value rule. This rule can render a portion of the death benefit of a life insurance policy as includible in income. This rule applies when a life insurance contract is transferred for valuable consideration (i.e., a sale transfer as opposed to a gift transfer or swap transfer). A calculation is necessary to determine the amount of proceeds excludible from income. The amount of the death benefit that is excludible is the actual value of consideration paid by the transferee to acquire the contract (or the interest in the contract), plus any premiums, or other amounts paid by the transferee subsequent to the transfer.

Passive Activity and At-Risk Rules: Excess Business Loss Provision

Another factor that may limit passive loss deductions is the excess business loss provision. The Tax Cut and Jobs Act (TCJA) includes this provision that restricts the deductibility of business losses to a maximum of $270,000 (2022) for single taxpayers, and $540,000 for married taxpayers filing jointly. These amounts are indexed for inflation. This provision applies after application of the PAL rules. It is possible that, upon disposition of a passive business activity, that this provision may come into play.

Tax Reduction and Management Techniques: KIDDIE TAX: STRATEGIES: Employment of Family Members

Another method of transfer involves the employment of a family member (normally a child) in the family business. This allows a portion of the business profits to be paid to the employed family member as salary or wages, which are, in turn, deductible as a business expense by the owner. This has the effect of shifting income from the owner's high bracket to the employed family member's lower bracket, and it may allow the latter to establish an individual retirement account (IRA) to shelter this income further. Employing family members, however, is not without its problems and abuses. An attempt to employ a family member who is a minor or away at school may result in serious problems. While there is no set age limit in terms of an employment relationship with family members, employment of a very young child may result in disallowance of the deductions and possible imposition of tax penalties. The child may use his own standard deduction amount ($12,950 in 2022) to offset earned income. However, in the event of an audit by tax authorities, a valid business purpose behind the child's employment must be proved to avoid construing that the income was a gift by the parent. Another consideration involves the payment of the Federal Insurance Contributions Act (FICA) and federal unemployment taxes. Wages paid to an employer's child under age 18 are not subject to the FICA or the federal unemployment taxes. For this rule to apply, the parent's business must be unincorporated. When a dependent has a combination of both earned and unearned income, it is important to remember that the ratio of earned income to unearned income may also impact the tax calculation. As a result of TCJA, the child's net unearned income was taxed at the fiduciary (trust and estate) rates for 2018 and 2019 only. However, as a result of the SECURE Act, the kiddie tax rate reverted to the parent's marginal rate. Taxpayers even have the option of amending their 2018 and 2019 returns to use the parent's marginal rate, if it is advantageous to do so.

EXAMPLE: Employer-provided fringe benefits

As a fringe benefit, Miranda has both a group health insurance plan and a group disability insurance plan through her employer. For both plans, Miranda pays 45% of the premium. Because Miranda's employer pays 55% of her disability insurance premium, Miranda must include 55% of any benefit she receives from the disability plan in her income. Premiums paid by the employer for accident, health, and disability income insurance plans (group plans) are deductible by the employer and generally excludable from the employee's income. Benefits paid under employer-sponsored accident and health (medical) plans are also not included in the taxpayer's income.

Tax Treatment of Business Property Gains: Basis and Holding Period of Property Received

As mentioned, in a like-kind exchange, substituted basis rules apply. Notably, this basis is equal to the FMV of the property received in the exchange, less any deferred gain or plus any postponed loss. Another method is available to calculate the basis in the new property: adjusted basis in property surrendered + boot given (if property, it is the property's FMV) + gain recognized - FMV of boot received - loss recognized ---------------------- recipient's basis in new property The holding period of the property surrendered in an exchange carries over and adds to the holding period of the like-kind property received.

CONTRASTING PASSIVE AND ACTIVE INCOME: Active Participation Standard (I)

As mentioned, rental real estate activities are inherently passive (for purposes of the passive activity loss rules). However, there is an exception to the disallowance of passive losses for certain rental real estate professionals and non-real-estate professionals (otherwise referred to as the small real estate investor). Losses are not considered passive for a real estate professional if real estate activities are more than 50% of her personal services for the year and she puts in more than 750 hours of work in the real estate activity. This exception covers the part-time real estate broker who invests in real estate properties and permits her to fully deduct losses from those real estate activities against active income, portfolio income, or both. The second (and more common) exception is for those small investors who dabble in real estate rental activities. For example, a homeowner who converts his home into a rental (perhaps after not being able to obtain a desired price for the home) is covered by this exception. Specifically, in meeting several tests, such investors may deduct up to $25,000 of rental real estate losses against active and portfolio income in any one year. These tests are as follows. -- The small investor must actively participate in the activity; note that active participation is a lesser standard than that of material participation and requires only that the investor participate in management decisions with respect to the real property. -- The small investor must own at least 10% in value of all interests in the activity during the taxable year.

ETHICAL CONSIDERATIONS, AUDITS, AND TAX PENALTIES: TAX AUDITS: ESTIMATED TAXES: UNDERPAYMENT PENALTIES

As mentioned, there are also underpayment penalties owing to some fault of the taxpayer. The least severe of these is the 90%/100% payment criteria to avoid the estimated tax penalty. However, there are also the following penalties, listed in order of their severity. -- CRIMINAL FRAUD —This is simply tax evasion, which is illegal. If convicted of this penalty, the taxpayer will be subject to heavy (court-determined) fines, imprisonment, or both. -- CIVIL FRAUD —This is essentially taxpayer fraud that does not rise to the level of criminal fraud. If imposed, the penalty is 75% of the portion of tax underpayment attributable to fraud. -- NEGLIGENCE PENALTY—This accuracy-related penalty is imposed if any part of the underpayment of tax is due to taxpayer neglect or to disregard of the tax rules and regulations, without the intent to defraud. The penalty is 20% of the portion of the underpayment attributable to negligence. -- FRIVOLOUS RETURN —A frivolous return is one that omits certain information necessary to determine the taxpayer's tax liability, such as her Social Security number. Usually, such a return is filed by a tax protester who is attempting to pester the IRS and make its job more difficult. The penalty is $5,000 for each frivolous return filed.

Tax Consequences of Property Transactions: CAPITAL ASSETS AND DEPRECIATION: Holding Period Exceptions and Other Special Issues

As noted, property generally must be owned longer than one year (one year plus one day) to qualify for LTCG tax rates. There are some exceptions to this rule, however: -- Gift property. If the donor's basis carries over to the donee, the donor's holding period is added to the donee's holding period. -- Inherited property. Property inherited from a decedent is treated as long term regardless of the actual original holding period. -- Section 1031 (like-kind) nontaxable exchanges (discussed later in this module). The holding period of the property surrendered in the exchange carries over and adds to the holding period of the like-kind property received. -- Mark-to-market rules. Regulated futures contracts and certain other contracts are treated as though they were sold on the last day of the taxable year; capital gains or losses are treated as 40% short term and 60% long term. -- Worthless securities. If securities that are capital assets become worthless, they are treated as though they were sold or disposed of on the last day of the tax year.

PROFESSOR'S NOTE: REPORTED INCOME

As of 2018, income must be recognized for income tax purposes in the same tax year it is reported on the taxpayer's financial statements.

EXAMPLE: Child support payments

As part of their divorce agreement executed in 2018, Jay must pay Sharon $4,000 per month. In five years, when their son turns 18, these payments are reduced to $2,800 per month. Therefore, the reduction of $1,200 ($4,000 - $2,800) in the total payment is considered child support and is not deductible by Jay.

Tax Planning for the Medicare Contribution Tax (5): PASSIVE INCOME

As previously discussed, the definition of investment income includes passive income from a trade or business. A passive activity is the conduct of a trade or business, in which the taxpayer does not materially participate. To the extent that the taxpayer can increase involvement in the activity to a material participation level, the business activity will no longer be treated as a passive activity. The income from the nonpassive business is not included in the definition of investment income (as discussed earlier). While there are seven possible tests for determining material participation under the Treasury Regulations to Section 469, the bottom line is whether there is regular, continuous, and substantial involvement in the activity. A thorough explanation of the passive activity loss rules may be found in Module 7. An excellent discussion of these rules, in the context of the Medicare contribution tax, may be found in the article "Preparing for the 2013 Medicare Contribution Tax" in the September 2011 issue of The CPA Journal.

Alimony and Child Support: Alimony (and Separate Maintenance) Payments: OVERVIEW

As we have learned, pre-TCJA alimony and separate maintenance payments are deductible for AGI for the payor and are includable in the gross income of the payee. However, to avoid confusing (deductible) alimony payments with those of (nondeductible) property settlements, Congress developed the following criteria that must be met for a payment to an ex-spouse to be considered alimony. -- The payment must be made in cash. + Cash payments, checks, or money orders to a third party on behalf of a spouse under the terms of a divorce or separation instrument can be alimony, if the expenses otherwise qualify. + These include payments for the spouse's medical expenses, life insurance premium on the life of the spouse, housing costs (e.g., rent, utilities), taxes, tuition, and so on. The payments are treated as received by the spouse and then paid to the third party. The spouse receiving these items must include in income these other amounts paid as alimony. -- The agreement or decree does not specify that the payments are not alimony for federal income tax purposes. -- The payee and payor are not members of the same household at the time the payments are made. -- There is no liability to make the payments for any period after the death of the payee. -- Payments are made directly to the payee spouse or to a third party for direct benefit of the payee spouse (e.g., making the mortgage payment).

HOME OFFICE DEDUCTION: EXPENSES

As with several other deductions, whether a taxpayer may take a deduction for home office expenses depends on the current employment status. A self-employed individual may deduct qualifying home office expenses to reach AGI. The deduction for expenses is taken as a line item on Schedule C of the IRS Form 1040. Under current law, only the self-employed qualify for the home office deduction for tax years 2018 through 2025. A taxpayer may use either method in any tax year by using the selected method on the federal income tax return for that year (must be filed timely). The taxpayer may not later change the method for that same tax year. When using the regular method, home office expenses are deducted in the following order. (The excess may be carried forward.) From gross income, the taxpayer first deducts expenses directly related to the business before considering any home office expenses. After determining the percentage of the home used as a home office, the taxpayer deducts allocable mortgage interest and property taxes, utilities and other expenses, and depreciation.

TYPES OF BUSINESS ENTITIES: C CORPORATIONS (II)

As with the individual taxpayer, all corporate income is taxable unless Congress has specifically exempted the income from taxation. THERE ARE FEWER RESTRICTIONS ON CORPORATE DEDUCTIONS because all business expenses are generally deductible in arriving at net income for a business (except for those specifically limited or disallowed by law, such as bribes or other illegal activities). There are also special taxes applicable only to the regular or C corporation form: Accumulated earnings tax Personal holding company (PHC) tax

EXAMPLE: QBI deduction

Assume that Andy and Amy are married taxpayers filing jointly, with taxable income of $450,000 (not including the QBI deduction). Included in the taxable income is $40,000 of net long-term capital gain from a securities sale. Andy is a shareholder in an engineering firm (not an SSTB) organized as an S corporation. His K-1 from the S corporation shows that his allocable share of the: -- net income is $350,000; -- W-2 wages paid is $125,000; and -- qualified property is $60,000. Andy's QBI deduction is the lesser of: -- 20% of the QBI (20% of $350,000 = $70,000); or -- the greater of: + 50% of his allocable share of the W-2 wages paid by the business (50% of $125,000 = $62,500), or + 25% of his allocable share of the W-2 wages paid by the business, plus 2.5% of his allocable share of the unadjusted basis of all qualified property of the business (25% × $125,000 wages = $31,250 + 2.5% of $60,000 = $1,500; total $32,750). In this situation, the QBI deduction is the lesser of $70,000, or the greater of (1) $62,500 or (2) $32,750. The $70,000 is compared to $62,500, and the lesser of these two is the potential QBI deduction ($62,500). This deduction is still potentially limited by 20% of the taxpayer's taxable income, not including any capital gains income. The taxable income limit does not come into play here, however, as 20% of the taxable income reduced by the capital gain income is $82,000.

EXAMPLE 2: KIDDIE TAX: Unearned income rules

Assume that Billy, age 17, is properly treated as a dependent on his parents' tax return. Billy has income from a part-time summer job of $4,600 and has interest income of $425. Billy's standard deduction is $5,000: the amount of earned income ($4,600) plus $400. Thus, Billy's tax return would show taxable income of $25 ($5,025 total income - $5,000 standard deduction).

EXAMPLE 1: Kiddie tax

Assume that Fred and Linda, married taxpayers filing jointly, have taxable income of $350,000 and are therefore in a 32% marginal income tax bracket (2022). Their dependent daughter Sarah, age 15, has $5,000 of interest and short-term capital gain income only. On Sarah's tax return, the first $1,150 is sheltered by her limited standard deduction. The next $1,150 is taxed to her at her own tax rate, in this case 10%, for a tax of $115. The remaining $2,700 is taxed to Sarah at the parental tax rates. The tax on the $2,700 at 32% is $864. Thus, Sarah has a total tax liability of $979. Sarah's tax on $2,700 is calculated as follows: $5,000 (1,150) limited standard deduction (1,150) taxed at child's rate of 10%: $1,150 × 10% = $115 $2,700 @ parent rate of 32%: $2,700 × 32% = $864 ------ $979 If the child has long-term capital gains and/or qualified dividends, the child still receives the advantage of the preferential long-term capital gain rates. Normally, $1,150 is taxed to the child at the child's rate—typically 10%. As discussed in Module 2, long-term capital gain rates are determined by the taxpayer's taxable income. If the child has taxable income under $41,675, the LTCG and qualified dividends are subject to a 0% long-term capital gain rate. The long-term capital gain or qualified dividend income that is taxed at the parents' marginal tax rates is subject to the 0/15/20% long-term capital gain rates, depending upon the parents' taxable income.

EXAMPLE: Excess business loss provisions

Assume that John Baker, a single taxpayer, sells his passive business activity in the current year. John has accumulated $360,000 of suspended passive losses over the years. The $360,000 of suspended losses are freed up due to the taxable disposition of his entire interest in the activity. Only the first $270,000 of losses would be deductible in the current year, and the remaining $90,000 of losses are carried forward to the subsequent tax year.

EXAMPLE: Taxation of property acquired by gift

Assume that Juan bought stock for $10 per share on January 1, 2011. He gifted the stock to his daughter, Sarah, on March 15, 2022, when the FMV was $5 per share. Donor's adjusted basis: $10 FMV on date of gift: $5 The sale at $3 generates a $2 loss using the FMV on date of gift—Sarah's holding period begins on March 15, 2022. The sale at $14 generates a $4 gain using donor's basis—Sarah's holding period begins on January 1, 2011. Sale at $6, $7, $8, or $9 generates no gain or loss—the basis of the property is equal to the sales price of that security.

EXAMPLE 2: Kiddie tax

Assume that Luigi and Marianne, married taxpayers filing jointly, have taxable income of $350,000 and are therefore in a 32% marginal income tax bracket (2022). Their dependent daughter Maria, age 15, has $5,000 of long-term capital gain and qualified dividend income only. On Maria's tax return, the first $1,150 is sheltered by her limited standard deduction. The next $1,150 is taxed to her at her own tax rate—in this case, 0%. The remaining $2,700 is taxed to Maria at her parents' marginal tax rates. The parents' rate on long-term capital gains and qualified dividends is 15%, based on a taxable income of $350,000. The tax on the $2,700, at 15%, is $405. Thus, Maria has a total tax liability of $405. Maria's tax is calculated as follows: $5,000 (1,150) limited standard deduction (1,150) taxed at child's rate of 0%* 1,150 X 0% = 0 ------- $2,700 @ parents' LTCG rate @ 15%** 2,700 X 15%= 405 ----- $405 *The 0% LTCG rate applie to taxable income under $41,675. **The long-term capital gain rate is 15% for married couples filing jointly with taxable income between $83,350 and $517,200.

EXAMPLE: QBI deduction

Assume that Steve and Joann are married taxpayers filing jointly, with taxable income of $300,000 (not including the QBI deduction). Included in the taxable income is $40,000 of net long-term capital gain from a securities sale. Steve is a partner in a manufacturing partnership. His QBI is $290,000. Steve's QBI deduction is the lesser of: -- 20% of the qualified business income (20% of $290,000 = $58,000); or -- 20% of the taxable income in excess of net capital gains (20% of $260,000 = $52,000). Thus, the QBI deduction is restricted by the taxable income limitation, and Steve and Joann may deduct $52,000 as the QBI deduction.

EXAMPLE: Qualified dividend income

Assume that a 12-year-old has qualified dividend income of $3,300. Her parent has taxable income of $190,000 and is in the 32% marginal tax bracket. The first $1,150 of income received is sheltered by the limited standard deduction. The next $1,150 of qualified dividends received is eligible for the child's preferential rate of 0%. The remaining $1,000 of qualified dividend income is taxed at 15%. You may recall that the 15% long-term capital gain rate applies between $41,675 and $459,750 (for single taxpayers). Thus, the parental rate on the qualified dividends is 15%. The child's tax liability on $3,300 of qualified dividends is only $150.

EXAMPLE: Self-employment tax

Assume that a single taxpayer has self-employment income of $230,000 for 2022. Because the net self-employment income is over the wage base, the full 15.3% up to the wage base, and the 2.9% Medicare tax on the excess over the wage base must be used for the calculation. It is necessary to compute the Additional Medicare Tax of 0.9% on the excess over $200,000. The self-employment tax and self-employment tax deduction are calculated in the following table. Self-Employment Tax Calculation Actual earnings $230,000 Less 7.65% (17,595) ---------- Net earnings from self-employment $212,405 Less wage base (147,000) ---------- $65,405 Medicare rate X 2.9% --------- $1,897 Add 15.3% of $147,000 22,491 -------- $24,388 Additional Medicare Tax 0.9% ($212,405 - $200,000) 112 -------- Total tax $212,405 A taxpayer is allowed to deduct one-half of their self-employment tax liability as an adjustment to income. Note that the adjustment is computed without regard to the Additional Medicare Tax. Thus, in this example, the deductible portion is $12,194, one-half of $24,388 (i.e., the self-employment tax without the additional 0.9% Additional Medicare Tax).

EXAMPLE 1: AGI (50% ELECTION)

Assume that a taxpayer has an AGI of $100,000. She owns stock with an FMV of $55,000 and a basis of $52,000. She will contribute the stock to her church. Without the election, she would use the FMV of the stock and be limited to a deduction of 30% of AGI, or $30,000, with a carryforward of $25,000. If the 50% election were made, she would use the basis of the stock but would be limited to 50% of AGI, (or $50,000), with a $2,000 carryforward.

EXAMPLE 1: KIDDIE TAX: Unearned income rules

Assume that a taxpayer, Frank, provides over 50% of the support for his elderly father, Don, who has $3,150 of unearned income only. Frank treats Don as a dependent. Don is entitled to a limited standard deduction of $1,150. The limited standard deduction would shelter $1,150 of Don's unearned income, and the remaining $2,000 of taxable income would be taxed at Don's tax bracket rate of 10%. Thus, Don's tax liability would be $200. Note that the result would be the same for a dependent child who is not subject to the kiddie tax.

EXAMPLE: Netting capital gains and losses: Example 3

Assume that during the current tax year Andy has a $10,000 long-term capital loss and a $10,000 long-term capital gain, both from the sales of securities. Andy also has a $15,000 long-term capital gain from the sale of collectibles. Andy is in a 35% marginal income tax bracket. Because there is a long-term capital loss and a long-term capital gain within the same basket, those must offset each other. That leaves the long-term collectibles gain of $15,000 to be taxed at 28%.

EXAMPLE: Netting capital gains and losses: Example 1

Assume that during the current tax year Jeannette has a short-term capital loss of $5,000 from the sale of securities. She also has a long-term capital gain from the sale of a stamp collection of $2,200 and has unrecaptured Section 1250 income of $10,000. Her short-term capital loss is first used to offset the collectibles gain (with a potential 28% rate) of $2,200. This leaves a short-term capital loss of $2,800. This is next used to offset the 25% gain. The $10,000 is offset by the $2,800 remaining capital loss. This leaves $7,200 of unrecaptured Section 1250 income, which is taxed at a maximum 25% rate.

EXAMPLE: Netting capital gains and losses: Example 2

Assume that during the current tax year Riley has a $10,000 short-term capital loss and a $10,000 long-term capital gain, both from the sales of securities. Riley also has a $15,000 long-term capital gain from the sale of collectibles. Riley is in a 35% marginal income tax bracket. The $10,000 short-term capital loss is first used against the collectibles gain, which is the gain that would be taxed at the highest rate. This leaves $5,000 of collectibles gain, taxed at 28%, and $10,000 of long-term capital gain from the sale of securities, taxed at 15%

EXAMPLE: Long-term capital gains: Example 3

Assume that for 2022, Bob and Nora are married taxpayers filing jointly. They have $200,000 of ordinary income (after all deductions) and $100,000 of net long-term capital gains from the sale of securities. This gives them taxable income of $300,000. Since all of the capital gain income falls between the $83,350 breakpoint and the $517,200 breakpoint, all of the capital gain income is taxed at the 15% long-term capital gain rate.

EXAMPLE: Long-term capital gains: Example 1

Assume that for 2022, Jim and Patty are married taxpayers filing jointly. They have $44,800 of ordinary income and $30,000 of net long-term capital gains from the sale of securities. They claim the standard deduction. This deduction equals $25,900, leaving $18,900 of ordinary income and $30,000 of LTCG. Therefore, their taxable income is $48,900. This is under the breakpoint of $83,850. As a result, the entire $30,000 is subject to the 0% tax rate.

EXAMPLE: Long-term capital gains: Example 4

Assume that for 2022, Roberto and Barb are married taxpayers filing jointly. They have $200,000 of ordinary income (after all deductions) and $400,000 of net long-term capital gains from the sale of securities, resulting in a $600,000 taxable income. The capital gain income that is above the $517,200 breakpoint is taxed at the 20% rate. Thus, $82,800 of long-term capital gain income is taxed at 20%, and the remaining long-term capital gain ($317,200) is taxed at 15%, as it falls between the $83,350 breakpoint and the $517,200 breakpoint.

EXAMPLE: Long-term capital gains: Example 2

Assume that for 2022, Sam and Sally are married taxpayers filing jointly. They have $50,000 of ordinary income and $60,000 of net long-term capital gains from the sale of securities. They claim the standard deduction of $25,900. This leaves $24,100 of ordinary income and $60,000 of long-term capital gains, giving them taxable income of $84,100. The top of the 0% long-term capital gains rate is $83,850 of taxable income. Thus, only $750 of the long-term capital gain income is taxed at the 15% long-term capital gain rate. The remaining $59,250 of long-term capital gain is taxed at the 0% rate.

Investment Interest Expense Deduction

Assume that in the current tax year, Joe had investment income, which includes interest and short-term capital gains of $15,000, and adjusted gross income (AGI) of $65,000. He incurred investment adviser fees of $2,000 and paid investment interest of $20,000 on a debt. The proceeds were then used to purchase stock, mutual funds, and bonds. Joe's investment interest expense is deductible up to $15,000—the amount of Joe's interest and capital gain income. The excess investment interest expense of $5,000 can be carried forward to the following year and may be allowed as a deduction in that year.

EXAMPLE: Qualifying Dividends Example 2

Assume the same facts as in the previous example, except that Karl bought the stock on July 8, 2022 (the day before the ex-dividend date), and sold the stock on September 9, 2022. Karl held the stock for 63 days (from July 9, 2022, through September 9, 2022). The $500 of qualified dividends shown in box 1b of Karl's Form 1099-DIV are all qualified dividends because he held the stock for 61 days of the 121-day period (from July 9, 2022, through September 7, 2022).

EXAMPLE 2: AMT calculation

Assume you have a client who has a regular income tax liability after credits of $30,000 but an AMT liability of $34,000. The difference between the AMT liability ($34,000) and the regular income tax liability ($30,000) results in an AMT payable of $4,000. In order to calculate the individual AMT payable, first determine the amount of the taxpayer's alternative minimum taxable income (AMTI). The formula for determining AMTI is as follows. regular taxable income (from IRS Form 1040) + positive AMT adjustments - negative AMT adjustments + AMT preference items = AMTI Once AMTI is determined, then calculate the amount of individual AMT payable, as follows. AMTI - applicable AMT exemption (based on filing status) = alternative minimum tax base AMT base × AMT rate [either a flat 26% (for the first $206,100 (2022) of AMTI and $103,050 for married taxpayers filing separately) or 28% rate (for AMTI in excess of $206,100 and $103,050 for MFS) based on alternative minimum tax base in 2022] = tentative AMT - regular income tax on taxable income = individual AMT payable

KIDDIE TAX: UNEARNED INCOME RULES

Before 1987, any unearned income received by a child was taxed to the child at the child's own marginal tax rate. Today, special rules are in place for dependents with unearned income. A limited standard deduction amount of $1,150 (for 2022) may be used by the taxpayer against unearned income (interest, dividends, etc.). For this purpose, unearned income is defined as income other than earned income, (i.e., income from wages, salaries, summer jobs, etc.) For any taxpayer eligible to be treated as a dependent, with earned income or a combination of earned and unearned income, the rules are slightly more complex. The allowable standard deduction for the dependent is the greater of (1) $1,150 or (2) the amount of earned income plus $400, not to exceed the full standard deduction amount ($12,950 in 2022). These rules apply to all taxpayers eligible to be treated as a dependent on another taxpayer's return. Certain children are subject to even more restrictive rules: the kiddie tax rules. The kiddie tax rules provide for a limited standard deduction of $1,150 (2022) against unearned income on the child's income tax return. The next $1,150 is taxed to the child at the child's marginal tax rate. Any net unearned income over $2,300 is taxed to the child at the parent's or parents' marginal income tax rate (if higher than the child's marginal rate). The standard deduction rules applicable to earned income, or a combination of earned and unearned income, are the same as those previously discussed. The kiddie tax applies to a child -- under 19 years of age (at the close of the tax year), or -- under 24 years of age if a full-time student.

Passive Activity and At-Risk Rules: DIRECT PARTICIPATION PROGRAMS: PASSIVE ACTIVITIES (II)

Before Congress restricted the practice, paper losses in excess of the amount of capital invested in an activity (particularly by limited partner investors) allowed a considerable benefit to taxpayers who were otherwise not liable if the investment failed to perform. Included in the legislation were two major provisions that have significantly reduced the benefit of tax-shelter investments. These provisions are: -- the at-risk rules; and -- the passive activity loss rules limits. The Tax Code lists the following two kinds of passive activities: -- Trade or business activities in which the taxpayer does not materially participate -- Rental activities, even if the taxpayer is a material participant, unless the taxpayer is also a real estate professional

Tax Treatment of Business Property Gains: Personal Residence Exclusion

Before enactment of Section 121 of the Internal Revenue Code (the exclusion of taxable gain provision), the sale of a personal residence was part of the nontaxable exchange provisions. Currently, Section 121 allows for a gain exclusion of up to $250,000 ($500,000 for married filing jointly) to any taxpayer who satisfies certain tests, known as the ownership test and the use test. -- OWNERSHIP TEST. The home must have been owned and used as a principal residence for at least two of the five years preceding the date of sale. (Note: These years do not have to be consecutive; they only have to add up to at least two years.) -- Use test. Either spouse can meet the ownership test, but both must meet the use (two-out-of-five- year) test. This is likely not difficult for most married couples, but it can be burdensome for individuals who are divorced or in the process of a divorce. If the taxpayer fails to meet either test because of a change in employment or health, the taxpayer may be entitled to a partial exclusion based on the shorter of the taxpayer's use or ownership.

EXAMPLE: Recognized gain is equal to realized gain

Bill exchanged investment land with an adjusted basis of $55,000, receiving another parcel of land from Jack with an FMV of $50,000. In addition, Bill's land was subject to a $15,000 mortgage, which was assumed by Jack as part of the exchange. As a result, Bill has a recognized taxable gain of $10,000 (the amount of realized gain) even though he received boot (equal to the liabilities assumed by Jack) of $15,000. FMV of property received by Bill $50,000 Liabilities assumed (boot) received by Bill $15,000 -------- Amount realized by Bill $65,000 Less adj. basis in property surrendered ($55,000) -------- Realized gain $10,000 --------- Recognized gain $10,000

EXAMPLE 1: Ordinary income property

Bill, a sole proprietor, makes the following charitable donations this year. Type of Property Inventory in Bill's business. Basis: $8,000 FMV: $6,000 Stock ABC Corp. (acquired 2 yrs ago) $10,000 $40,000 Coin collection (acquired 10 years ago) $1,000 $7,000 Assume Bill's AGI is $200,000. The inventory was given to a local public school. The ABC stock was given to Bill's church, and the coin collection was given to a museum. Accordingly, Bill's income tax charitable contribution for this year is $47,000, calculated as follows. -- The inventory is ordinary income property for purposes of the rules. Therefore, Bill is limited to the lesser of FMV ($6,000) or his basis ($8,000). -- The ABC stock is appreciated long-term capital gain property. Therefore, assuming he elects FMV as a total deduction, his maximum deduction for this year is $40,000. -- The coin collection is appreciated tangible personal property, and the amount of Bill's deduction, therefore, depends on the use to which the museum put the property. If it is an unrelated use, then Bill must use the basis of $1,000.

EXAMPLE: Kiddie tax with earned income

Billy is 16 and may be claimed as a dependent by his parents, who are married filing jointly. Billy's parents have taxable income of $350,000, placing them in the 32% marginal income tax bracket. Billy earned $13,950 from a part-time job and had $3,000 of interest income. Billy's total income is $16,950. This is reduced by his standard deduction of $12,950 (the amount of earned income plus $400, not to exceed the full standard deduction of $12,950). Billy has taxable income of $4,000. His net unearned income is $700 (interest income of $3,000, reduced by $2,300). This is taxed at a parental rate of 32%. The remaining taxable income (earned income) of $3,300 is taxed at Billy's marginal income tax bracket of 10%.

SPOUSE RELIEF: INNOCENT SPOUSE RELIEF

By requesting innocent spouse relief, an individual can be relieved of responsibility for paying tax, interest, and penalties if their current or former spouse improperly reported (or omitted) items from the joint tax return. An individual must meet all of the following conditions to qualify for innocent spouse relief: -- An individual filed a joint return that has an understatement of tax due because of erroneous items (e.g., unreported income and erroneous deductions) of the individual's current or former spouse. -- The individual can establish that, at the time the joint return was signed, the individual did not know and had no reason to know of the understatement of tax. -- After taking into account all the facts and circumstances, it would be unfair to hold the individual liable for the understatement of tax

Tax Consequences of Property Transactions: CAPITAL ASSETS AND DEPRECIATION: Ordinary Assets Versus Capital Assets (I)

Capital assets are personal use assets (e.g., a personal residence) and most investment assets. While losses from personal use assets are generally not deductible, losses from investment assets are deductible as capital losses. Section 1221 defines capital assets by exclusion. The following is a list of the primary noncapital assets or ordinary income assets that generate ordinary income and losses (think of the mnemonic device ACID): -- Accounts receivable or notes receivable of a trade or business -- Copyrights and creative works held by the creator -- Inventory or property held for sale to customers in a taxpayer's trade or business -- Depreciable personal and real property used by a business (Section 1231 property). Section 1231 assets also specifically include timber, coal, and iron ore; livestock; unharvested crops; and goodwill and intangibles. Depreciated assets that are sold for more than the original cost basis may generate capital gain. This occurs most often in the case of real property used in a business that can appreciate over time. The length of time a taxpayer has owned an asset of any type is called the holding period. Capital assets owned by the taxpayer for more than a year (one year and one day) are considered long-term assets and qualify for a preferential long-term capital gain (LTCG) tax rate.

EXAMPLE: Related party transactions

Carl entered into a like-kind exchange with his father 18 months ago. His father just died. Carl is free to sell the property he received in the exchange because death is an exception the two-year rule for related party like-kind exchanges.

Passive Activity and At-Risk Rules: DIRECT PARTICIPATION PROGRAMS: OVERVIEW (I)

Certain investments have historically been designed to generate tax benefits (subject to certain restrictions) for the investor in the form of losses or credits. These investments are able to provide these benefits because they are structured to allow investors to participate directly in the income, deductions, and credits of the business. In other words, they are conduit entities. Thus, the phrase direct participation program often is used to describe these investments. Quite simply, any flow-through entity (limited or general partnership, S corporation, LLC, or LLP) may be referred to as a direct participation program. To understand the potential tax advantages provided by direct participation programs, one must: -- FIRST understand the nature and sources of the tax advantages. -- SECOND, one must understand the possible structures of the investments that provide these advantages.

ADDITIONAL MEDICARE TAX: SUMMARY OF TYPES (3)

Certain types of income are not subject to the self-employment tax. The flow-through of portfolio income is not treated as self-employment income. For example, if the taxpayer receives a K-1 from a partnership or S corporation that reflects both operating income and portfolio income, the operating income is subject to the self-employment tax, but the portfolio income (e.g., interest, dividends, net capital gains) retains its character as it flows through to the taxpayer. The portfolio income is not subject to the self-employment tax. Qualified dividends and net capital gains that flow-through from a partnership or S corporation are separately reported on the taxpayer's tax return, where they are subject to the preferential tax rates. The flow-through of net income from an S corporation specifically is not subject to the self-employment tax. Remember that the shareholder or employee of the S corporation must receive a reasonable salary. It is not acceptable to the IRS for the shareholder or employee to draw a nominal salary, and allow the remaining net income to flow-through to the shareholders free of the self-employment tax. If the shareholder or employee does not draw a reasonable salary, the IRS may reclassify a portion of the flow-through as salary and impose payroll taxes, penalties, and interest.

ETHICAL CONSIDERATIONS, AUDITS, AND TAX PENALTIES: TAX AUDITS: COMMON TAX TRAPS: The Tax Benefit Rule

Certain types of income generally are not taxable. However, the tax benefit rule may convert nontaxable receipts into taxable income. For example, suppose that a taxpayer incurred, and deducted, certain medical expenses that they also paid personally during a particular year. In the following year, the taxpayer is reimbursed for these medical expenses. While medical expense reimbursements generally are not taxable, the tax benefit rule would make them taxable in this situation, but only to the extent that the taxpayer derived tax benefit from the deduction of the expenses in the year they were incurred. The other most common example involves state income taxes. For example, assume that John Jones deducts $6,000 of state income taxes as an itemized deduction on his 2021 federal tax return. His actual state liability turns out to be $5,200, so he receives a state refund of $800 in 2022 due to overpaid 2021 taxes. The $800 will then be taxable in 2022 because he received a federal tax benefit from the previous deduction. If the taxpayer did not itemize deductions in the prior year, the state tax refund is not taxable, because there was no previous tax benefit.

Tax Reduction and Management Techniques: Charitable Contributions by Businesses: C-CORPS

Charitable contributions by corporations are also subject to special rules. A corporation may normally only deduct, in a given tax year, up to 10% of its taxable income. The CARES Act of 2020 temporarily raised this limit to 25% for 2020 and 2021. In-kind donations of food are normally limited to 15%. That also has been raised to 25%. At press time, it was unclear if Congress intended to extend this 25% limit into 2022.

Tax Reduction and Management Techniques: CHARITABLE CONTRIBUTIONS (1)

Charitable contributions, or charitable gifts, are an important tax planning technique. Assuming the taxpayer itemizes, she can make contributions to assist a favorite charity while producing significant tax benefits for herself. Please note that only an estimated 5%-7% of all taxpayers will itemize. Most taxpayers will take the significantly elevated standard deduction, thereby foregoing any charitable deductions. Charitable contributions are granted preferential treatment under federal income, gift, and estate tax laws. Thus, careful planning of charitable contributions can serve to reduce the size of the taxpayer's taxable estate. Charitable gifts also serve to reduce current income taxes by producing a deduction for taxpayers. The focus of this section will be on the income tax deductions available from charitable contributions.

EXAMPLE: QBI deduction (III)

Charlotte now has a legal practice, operated as a single-member LLC, treated as a sole proprietorship for tax purposes. She has QBI from the practice of $250,000 and the business paid $30,000 of wages. Her taxable income is $200,050. Her QBI deduction is computed as follows: Excess of taxable income over threshold/phaseout range = $30,000/$50,000 = 60% This again tells us that Charlotte is 60% of the way through the phaseout range. The specified percentage is 40% (calculated as 1 - 60%, the percentage of the way through the phaseout range). Multiply the business income and the wages by the 40%. QBI $250,000 × 40% = $100,000 Wages $30,000 × 40% = $12,000 Next, determine the difference between the QBI limit and the wage/ property limit based on the reduced amounts: -- 20% of the reduced QBI ($20,000) -- 50% of the reduced W-2 wages paid by the business ($6,000) The difference between the two limits is $14,000. This is multiplied by 60% to equal $8,400. The $8,400 is subtracted from 20% of the QBI ($20,000) to equal a deduction of $11,600.

EXAMPLE: QBI deduction (II)

Charlotte owns a restaurant as a single-member LLC, treated as a sole proprietorship for tax purposes. She has net income from the business of $250,000 and the business paid $30,000 of wages. Her taxable income is $200,050. Her QBI deduction is computed as follows: excess of taxable income over threshold/phaseout range = $30,000/$50,000 = 60% This tells us that Charlotte is 60% of the way through the phaseout range. Then, we determine the difference between the QBI limit and the wage/ property limit. -- 20% of the QBI ($250,000 × 20% = $50,000) -- 50% of the W-2 wages paid by the business ($30,000 × 50% = $15,000) The difference between the two limits is $35,000. This is multiplied by 60% to equal $21,000. The $21,000 is subtracted from 20% of the QBI ($50,000) to equal a deduction of $29,000. Note: if the business paid no wages (and had no qualifying property), then the deduction would be reduced to $20,000, as shown below: -- 20% of the QBI ($50,000) -- 50% of the W-2 wages paid by the business ($0) The difference between the two limits is $50,000. This is multiplied by 60% to equal $30,000. The $30,000 is subtracted from 20% of the QBI ($50,000) to equal a deduction of $20,000.

EXAMPLE: MACRs and straight-line depreciation

Joe buys a light-duty truck costing $20,000 for use in his delivery business. In the first year of service, using straight-line depreciation, he can recover $2,000 of the truck's cost ($20,000 × 10%). Alternatively, using MACRS, he can recover $4,000 of the truck's cost ($20,000 × 20%).

EXAMPLE: Home office deduction

Chaz uses 200 square feet of his home for his business. The business use of the space satisfies the criteria for a deductible home office. Chaz has $5,000 of expenses directly related to his business before considering any home office expenses. His gross income from the business was $13,000. He had the following expenses this year for his home: -- Mortgage interest $11,000 -- Property taxes 2,500 -- Homeowners insurance 1,300 -- Utilities 2,700 -- Roof repairs 600 ------ -- Total home expenses $18,100 Chaz elects the simplified method for calculating his home office deduction, 200 SF × $5.00 = $1,000. He also deducts his full amount of mortgage interest and real estate property taxes on Schedule A of IRS Form 1040 ($13,500). Because Chaz's gross income of $13,000 reduced by his business expenses of $5,000 equals $8,000, he may take the $1,000 home office expense deduction as it does not exceed his net income from the business before the home office deduction. Even using the simplified method, the home office deduction cannot create a loss from the business for the taxpayer.

Hobby Income

Classification of an activity as a trade, business, or hobby is important because it affects the deductibility of losses. Specifically, if an activity is a trade or business, the losses are usually fully deductible (an ordinary loss) and can offset other taxpayer income. If an activity is considered by the IRS to be only a hobby of the taxpayer, the hobby rules are used. Under hobby rules, the only expenses that are generally permitted are cost of goods sold. All of the gross hobby income is reported as other income on IRS Form 1040. To avoid hobby income restrictions, the taxpayer must show a clear profit motive. The tax authorities have some discretion, but generally speaking, an activity is presumed not to be a hobby if there have been profits from the activity in any three of the previous five consecutive tax years, ending with the tax year in question (unless the IRS proves otherwise).

Estate Planning Techniques for the Newly Single: Property Settlements

Code Section 1041 states that any transfer of property between spouses incident to a divorce is tax free. No gain or loss is recognized, and for income tax purposes, such transfers are treated as if acquired by gift, with the transferor's basis in such property carried over to the transferee. A transfer of property is considered incident to a divorce if such transfer occurs within one year after the date on which the marriage ceases. The situation may arise where a former spouse is the beneficiary of an irrevocable trust. As part of the divorce proceedings, this spouse may be asked to disclaim their interest in the trust. Practitioners and clients alike need to be aware that this may create unintended gift tax consequences to the other beneficiaries. Some trust documents do not allow the beneficiary to be removed. In this case, the original grantor may be able to create a new trust. The trustee of the old trust could then decant the assets to the new trust. However, this arrangement presupposes the agreement of the disinherited spouse. Finally, it is common for a spouse that owes alimony to purchase a life insurance policy on themselves. In fact, some jurisdictions require this. Statistics indicate that divorce has a surprising impact on longevity. If the life insurance policy is court ordered, premiums paid to the policy can be used to satisfy an alimony obligation.

ETHICAL CONSIDERATIONS, AUDITS, AND TAX PENALTIES: TAX AUDITS: COMMON TAX TRAPS: Reallocation of Income Doctrine

Code sections 482 and 269A, along with the tax accounting principle of clear reflection of income, allow the court to reallocate income between related taxpayers. Thus, in certain circumstances where a personal service corporation is formed to avoid taxes and secure tax benefits for an employee-owner (which would not otherwise be available), the court may reallocate income between the personal service corporation and its employee-owner to clearly reflect the income of each, if BOTH (1) the personal service corporation was formed or availed of for the principal purpose of the avoidance or evasion of federal income tax by reducing the income of—or securing the benefit of any expense, deduction, credit, exclusion, or other allowance for—any employee-owner that would not otherwise be available; and (2) the personal service corporation performs substantially all its services for or on behalf of one other corporation, partnership, or other entity.

EDUCATION TAX BENEFITS:OVERVIEW

Congress considers it desirable to encourage people to attend college. A more educated, highly trained, competitive workforce is good for the economy and the country as a whole. Thus a myriad of tax benefits are offered under the law to support higher education. Most notable among these are the state sponsored Section 529 traditional and pre-paid tuition plans. However, most students may also benefit from the American Opportunity Tax Credit (AOTC), the Lifetime Learning Credit and the Student Loan Interest deduction. There are other rules parents need to be aware of. Withdrawals from an IRA to support higher education expenses are exempt from the 10% penalty. This is not true of 401(k)s. ***EDUCATIONAL ASSISTANCE offered by an employer and SCHOLARSHIPS ARE TAX-EXEMPT***. Coverdell Education Savings Accounts (ESAs) can be useful both for college and college prep schools.

Tax Law Compliance and Procedures: OVERVIEW

Congress has authorized the Secretary of the Treasury to prescribe and issue all rules and regulations needed for enforcement of the Code. The primary purpose of the regulations is to explain and interpret particular Code sections. Although regulations have not been issued for all Code sections, they have been issued for the great majority. In those cases where regulations exist, they are an important authoritative source on which one can usually rely. Regulations can be classified into three groups: (1) legislative, (2) interpretive, and (3) procedural.

CAPITAL GAINS: Property Dividend (1)

Corporate dividends may also be paid in property, other than the company's own stock, instead of cash. The types of property typically distributed in lieu of cash include bonds, promissory notes, accounts receivable, equipment, and real estate. Generally, for the recipient, the tax consequences of a property dividend are the same as for a cash dividend. The amount of the distribution for an individual shareholder is usually the fair market value (FMV) of the property at the time of the distribution, plus any cash received. In this case, the amount of the distribution is decreased by any liabilities on the property that the shareholder assumes. As with the cash distribution, the property distribution is a dividend only to the extent of corporate E&P. To the extent the FMV exceeds corporate E&P, the distribution is a return of capital and reduces the shareholder's basis in their shares. If the FMV exceeds both E&P and basis, then the excess is treated as a capital gain.

ALTERNATIVE MINIMUM TAX (AMT)

Created by Congress to make it more difficult for wealthy individuals to avoid paying taxes through the use of various deductions. The financial planner must be aware that although some items are not taxable for regular income tax purposes, they may still be taxable for individual AMT purposes. An EXAMPLE of this IS INTEREST from some PRIVATE-activity MUNI BONDS that, although nontaxable for regular income tax purposes, is INCLUDED as an AMT PREFERENCE ITEM.

Net Investment Income Tax (NIIT) (2)

Currently, these thresholds are not indexed for inflation. So, over time, this provision will impact more and more taxpayers. Net investment income is the investment income in excess of the deductions allowed that are properly allocable to the investment income or net gain. The definition of "net investment income" used for purposes of the Medicare contribution tax is different from the definition used for purposes of investment interest expense. The penalty on early withdrawal of savings is allowed as a deduction for computing the net investment income. Investment interest expense is also allowed as a deduction (to the extent allowed for regular income tax purposes). The deduction for an amortizable bond premium on a taxable bond is also an allowable deduction. A portion of a taxpayer's state, local, and/or foreign income taxes may be deducted in computing the net investment income as well. An allocation of this deduction must be made using any reasonable method. An allocation based on the ratio of the investment income (e.g., interest, dividends, net capital gains, etc.) to the taxpayer's gross income is an example of a reasonable method.

EXAMPLE: Limited partnership income and loss

Dan purchased an interest in a non-publicly traded partnership that had income of $15,000 in the current year. He also purchased an interest in a PTP that had $20,000 of loss. Because losses from a PTP cannot offset income from a non-publicly traded partnership, the income of $15,000 from the non-publicly traded partnership is fully taxable to Dan in the current year. In addition, the $20,000 of losses from the PTP is disallowed this year and must be carried forward.

EXAMPLE: AMT CREDIT

Darrell, a single taxpayer, recently filed his income tax return for 2021. With the return, Darrell had to pay $35,000 of AMT, resulting from the exercise of incentive stock options (ISOs), a deferral item for purposes of AMT, and tax-exempt interest from private activity bonds that were issued in 2016 (an exclusion item). If Darrell would have taken into account only the tax-exempt interest, his AMT liability would have been $15,000. Therefore, Darrell's individual AMT credit is $20,000. This is calculated as follows: $35,000 (actual AMT paid) - $15,000 (AMT based on exclusion items only). Stated another way, Darrell's AMT based on deferral items only is $20,000.

Documenting the Charitable Deduction (1)

Delivery of the gift to the charitable organization determines the date of the gift. When a taxpayer mails a contribution on the last day of the year, the post office is considered to be the agent of the recipient; thus, the charitable contribution is considered to be made on the last day of the year. Charitable contributions made by credit cards are considered to be made on the date charged or the date paid, depending on the wishes of the taxpayer. As a practical matter, taxpayers generally desire the deduction at the earlier time. A donor's promissory note made payable to a charitable organization is not deductible until it is paid. The contribution of a promissory note by a third party is deductible as of the date of delivery to the charitable organization. Stocks, bonds, and other securities are deductible on the date of delivery to the charitable organization. If the taxpayer were to instruct a broker to reissue the security in the charity's name, there would be no delivery until the charity actually receives the security. If time were a problem, the taxpayer could immediately deliver the properly assigned security to the charitable organization's broker. Gifts of real estate are deductible at the time the deed to the property is delivered or at the time there is a transfer of equitable title. Any gift of a future interest in tangible personal property is not entitled to an income tax deduction until all intervening interests expire. No deduction is allowed for a donation of services.

Taxation of Disability Insurance

Disability payments may or may not be taxable. The taxability of benefit payments from disability income is dependent on how the premiums were paid. Benefit payments from individually owned and paid for policies generally are not taxable because the premiums were paid with after-tax dollars. Benefit payments from group policies, where premiums have been paid by the employer, generally are taxable to the employee. When policy premiums are paid partly by the employer and partly by the employee, a portion of the benefit payments will be taxable to the employee (the percentage of premium paid by the employer), and a portion will not be taxable to the employee (the percentage of premium paid by the employee). The employee may also have the option of reimbursing the employer for premiums paid (prior to any disability). In this case, benefit payments will be received tax free, as long as the employee has previously reimbursed the employer for the premiums. If the disability insurance premiums were paid by the employer, the benefit payments are subject to Social Security (FICA) and federal unemployment tax (FUTA) for the first six months. If the employee paid the premiums, then the proceeds are exempt from both FICA and FUTA.

EXAMPLE: Involuntary conversion

Drew had property condemned by the State of Louisiana. The property had an adjusted basis of $26,000. Drew received $31,000 from the state for the property. Therefore, Drew realizes a gain of $5,000 ($31,000 - $26,000) and, assuming he now buys a property similar in use to his old property for $29,000, he must recognize a gain of $2,000 ($31,000 - $29,000). This is the amount of proceeds realized ($5,000) minus the amount of proceeds reinvested ($3,000). Drew's basis in the new property is $26,000, or $29,000 less the $3,000 amount of deferred gain/proceeds reinvested.

Taxation of Annuity Contracts: Nonperiodic Distribution (Lump Sum)

During the accumulation period of a deferred annuity, earnings grow on a tax-deferred basis, which translate into a higher return. A nonperiodic distribution (i.e., lump-sum withdrawal) is also referred to as an amount not received as an annuity. The tax treatment of a nonperiodic distribution depends on whether the payment is made before or after the annuity starting date. The annuity starting date is either the date at which the taxpayer receives an annuity payment under the contract, or the date on which the obligation under the contract becomes fixed, whichever is later.

EXAMPLE: Netting process

During the current tax year, Kristen sold several securities that resulted in the following types of gains and losses: -- Long-term capital gain: $7,600 -- Short-term capital gain: $8,100 -- Long-term capital loss: $2,100 -- Short-term capital loss: $9,600 The result is as follows: LTCG $7,600 STCG 8,100 LTCL (2,100) STCL (9,600) ------------- -------------- LTCG 5,500 STCL 1,500 **Net LTCG $4,000 To calculate the net capital gain or loss, short-term items are netted, leaving a short-term capital loss of $1,500. The long-term items are netted, leaving a long-term capital gain of $5,500. The short-term capital loss is netted with the long-term capital gain to result in a net long-term capital gain of $4,000. This net long-term capital gain is subject to a preferential tax rate of 15% or 20%, assuming that the taxpayer's capital gains are part of taxable income above the $41,675 breakpoint (for a single taxpayer 2022)

Social and Economic Federal Tax Law Assumptions: SOCIAL Objectives

During the last 35 to 40 years, we have seen a trend toward using the tax system as a means of accomplishing social objectives. Many social objectives are, of course, closely related to economic objectives and can be encouraged through the use of economic incentives. Other provisions, known as relief provisions, are more strictly related to social goals. Economic incentives to achieve socially desirable goals are abundant in the Internal Revenue Code. For example, it is socially desirable to support charitable organizations. Thus, Section 170 of the Code provides for the deductibility of charitable contributions (within certain limitations) for individuals and corporations. It also has been decided that the renovation and preservation of our nation's historic buildings is desirable. Thus, the Code provides for special tax credits for expenditures related to the preservation and renovation of those buildings. The low-income housing credit is another example of an incentive provision. JGTRRA and TCJA significantly increased the Section 179 expense limit and the amount of depreciation deductions (bonus depreciation) that may be claimed in the first year in an attempt to stimulate purchases of business assets. Other provisions may be considered relief provisions. These provisions are designed to provide relief from income taxes, either by an exclusion or a specific deduction or credit. For example, the Code specifically excludes life insurance proceeds (received by reason of death) from taxation. Another example is the additional standard deduction for blind or elderly taxpayers or the credit for certain child care expenses.

Passive Activity and At-Risk Rules: AT-RISK RULES (I)

Each of the doctrines, or rules, that provide for certain tax advantages have corresponding limitations or restrictions on them. The usefulness of tax shelters has been reduced significantly primarily by the passive activity loss rules. Other changes that affected tax shelters involve the at-risk rules. The passive activity loss rules state that passive losses may only be deducted against passive income. As a result, investors are prohibited from deducting passive losses against either active income (wages, salaries, and other employee compensation) or portfolio income (dividends, interest, and capital gains). Because active and portfolio income likely constitute the majority, if not all, of an investor's income in any one year, the passive loss restrictions have effectively curtailed all tax-shelter investment activity conducted in the limited partnership form. The passive activity loss rules apply to the following taxpayers: -- Individuals -- Estates -- Trusts -- Personal service corporations (PSCs) -- Closely held C corporations (however, note that closely held C corporations may offset passive losses against active income but not against portfolio income)

ETHICAL CONSIDERATIONS, AUDITS, AND TAX PENALTIES: Tax Avoidance and Tax Evasion: Willful Failure to Collect or Account for and Pay Over a Tax

Employers are expected to withhold income taxes on behalf of employees and tender the proceeds to the government. If an employer fails to tender revenues in a timely manner, the responsible persons will be held accountable. Responsible persons who are required to collect, account for, and pay over taxes, but who fail to do so, are subject to a 100% penalty. The character of this penalty can be somewhat misleading. Responsible persons who are subject to this penalty simply have to pay 100% of the amount they should have collected, accounted for, and paid over; they are not subject to any additional penalty. Employers are required to withhold amounts from an employee's paycheck for Social Security taxes and federal income taxes. If the employer fails to do so or fails to pay such amounts to the IRS, they or any other responsible person will be subject to the 100% penalty. The determination of whether someone is a responsible person is a test of facts and circumstances. Some of the questions the IRS usually asks in determining responsibility are as follows: -- Was the individual an officer or director? -- Was the individual a shareholder? -- Was the individual a member of a board of directors? -- Did the individual have the authority to sign checks? -- Was the individual responsible for hiring and firing employees? -- Did the individual have actual authority or merely an impressive title?

ADDITIONAL MEDICARE TAX: OVERVIEW (2)

Employers are required to begin collecting Additional Medicare Tax from employees in the first payroll period from the employee's compensation when wages exceed $200,000. Only the amount in excess of $200,000 is subject to the payroll tax deduction. The employer does not match the employee contribution of the Additional Medicare Tax. If an employee who files as MFJ does not have income exceeding $250,000 when the spouses combine their income and file their income tax return, or when spousal incomes are combined and the amount of Additional Medicare Tax that should have been paid is less than what was deducted, any excess payments can be refunded to the taxpayer when the income tax return is filed. Additionally, if a taxpayer expects to have income above the threshold for the taxpayer's filing status, when combined with a spouse's income, and any self-employment income, the taxpayers may ask for additional federal income tax withheld by the employers. This is true even though neither taxpayer's compensation will reach the $200,000 threshold. A self-employed taxpayer may make additional estimated tax payments to cover this contingency as well. It must be emphasized that this is in addition to the 2.9% that is assessed on all compensation and net self-employment income.

Calculating the Tax Payable After Applying Tax Credits

Estimated taxes (paid by self-employed individuals), taxes previously withheld (paid by salaried individuals), and tax credits are subtracted from an individual's annual income tax liability to reduce any potential balance due. If the total of all of these is more than the individual's tax liability, the taxpayer is entitled to a refund. If the total of all of these is less than the individual's tax liability, the taxpayer must pay additional taxes. An underpayment penalty of 20% may be assessed for an accuracy-related penalty due to negligence or a substantial understatement of tax. After calculating the regular income tax due based on taxable income, the next step is to deduct the nonrefundable credits previously discussed. To the remaining balance of regular tax liability payable, other taxes are added, such as the self-employment tax and the tax on early withdrawals from qualified plans, IRAs, and other tax-advantaged accounts. Finally, subtract the refundable credits and payments, including federal income tax withheld on wages; estimated tax payments made for the tax year; the earned income credit; excess Social Security tax withheld due to working for more than one employer during the year; any amounts paid with a request for an extension to file; and other lesser known refundable tax credits. The resulting amount calculated is the tax overpaid (and therefore, refundable in cash or applied to the next year's estimated tax) or the balance due on the tax liability, which is payable to the U.S. Treasury.

EXAMPLE: Qualifying Dividends Example 3

Eva bought 10,000 shares of ABC Mutual Fund on July 1, 2022. ABC Mutual Fund paid a cash dividend of 10 cents a share. The ex-dividend date was July 9, 2022. ABC Mutual Fund advises Eva that the portion of the dividend eligible to be treated as qualified dividends equals 2 cents per share. Her Form 1099-DIV from ABC Mutual Fund shows total ordinary dividends of $1,000 and qualified dividends of $200. However, Eva sold the 10,000 shares on August 4, 2022. She has no qualified dividends from ABC Mutual Fund because she held the ABC Mutual Fund stock for less than 61 days.

Tax Reduction and Management Techniques: OVERVIEW (3)

Even the average taxpayer is vaguely aware that charitable contributions may qualify for an itemized deduction. When gifting anything other than cash, the rules can quickly become complex. In order to maximize the client's deduction, it is important for the planner to have a working knowledge of charitable giving rules. For instance, there may also be situations where parents "loan" money to their children at below-market interest rates. Both borrowers and lenders need to be aware that this may trigger gift tax consequences. More succinctly, IRS may impute interest income to the lender, even if no interest has actually been paid. Finally, we will examine the alternative minimum tax (AMT). The AMT has been highly controversial since at least the Tax Equity and Fiscal Responsibility Act (TEFRA) of 1986 and was subject to significant modifications by the Tax Cuts and Jobs Act of 2017 (TCJA). AMT was a relatively high burden for affluent middle class taxpayers (those with $400,000 to $1 million of adjusted gross income (AGI), accompanied by a Schedule A with relatively large deductions). Historically speaking, high net worth clients have both the financial means and the incentive to hire sophisticated tax advisers. Needless to say, these advisers earn their compensation by helping clients deftly and legally avoid paying income tax. This is accomplished by taking advantage of the opportunities legitimately available in the Internal Revenue Code (IRC). In response, Congress created the AMT. The purpose of AMT is to ensure that every taxpayer, no matter how savvy, pays at least something to tax authorities. Students will not be asked to perform a full AMT calculation on the exam, but they should have a working knowledge of the AMT. High net worth clients can save significant amounts of money by taking advantage of tax reduction strategies described herein.

Taxation of Annuity Contracts: EXCLUSION RATIO FOR ANNUITIES

Even though many annuity contracts are never annuitized, it is important to be able to determine the tax consequences upon annuitization. Annuity payments or periodic payments from a commercial annuity are partially a return of capital and partially interest income. Upon annuitized payments, the return of capital is nontaxable, and the interest is treated as ordinary income.

EXCLUSIONS FROM INCOME: Items that, per the Tax Code, make the taxpayer whole again.

Examples include compensatory damages, injury or sickness payments, and amounts received under property and casualty insurance contracts for certain living expenses.

TRUST INCOME TAX RULES: OVERVIEW (4)

Finally, a person other than the grantor may be taxed on the trust's income. This occurs when another person has a power exercisable solely by that person to receive either the corpus or the income of the trust. This person is deemed a grantor because of the power to appropriate corpus or income to herself. Individuals deemed to be grantors often arise from a Section 2503(c) trust. The 2503(c) trust allows a donor who wants to make a gift to a minor to use the annual gift exclusion and defer giving control over the gift until the minor reaches age 21. Frequently, such trusts require the minor to notify the trustee of the minor's intent to terminate the trust at age 21. If the minor fails to notify the trustee, then the trust will continue. If the trust continues past the minor's 21st birthday, the minor is deemed to be the grantor and is taxed on the trust's income as a result. The 2503(c) trust is a "complex" trust that rolls up income, must have an employer identification number (EIN), and files a 1041 income tax return (fiduciary return). Gifts to this type of "juvenile education trust" are safe-harbored as gifts of a present interest and eligible for the annual gift tax exclusion. The 2503(b) trust, by contrast, is a "simple" trust, pays out all of its income, does not need an EIN, and does not file a tax return. Gift transfers in are gifts of a future interest and not eligible for the annual gift exclusion.

S Corporations and Pass-Through Entities: S Corporation: SPECIAL TAXES

Finally, like a regular or C corporation, there are also special taxes assessed at the entity level of an S corporation. Although S corporations are pass-through entities, the corporation may be required to pay one of the following taxes. 1. Built-in gains tax. This tax applies when the S corporation disposes of an asset, held at the time of conversion to S status, in a taxable disposition within five years after conversion. The tax applies to any unrealized gain attributable to appreciation in the value of an asset while held by the C corporation. In this situation, the highest corporate tax rate applies to the lesser of -- the recognized built-in gains of the S corporation for the taxable year; or -- the amount of "taxable income" of the corporation if it were a C corporation. 2. LIFO recapture tax. If a C corporation used the LIFO method of inventory valuation for its last year before making an S corporation election, it must include in income the amount of excess found when comparing the inventory's value under FIFO with the LIFO value. This LIFO recapture tax is payable in four installments, with the first payment due on or before the due date for the final C corporation return. 3. Net passive income penalty tax. For this tax to apply, the S corporation must have accumulated earnings and profits as a C corporation from prior periods, and more than 25% of the S corporation's gross receipts must be from passive investment income. If the corporation meets both requirements, then the tax is applied to the lesser of the net passive income, or the entire taxable income of the corporation, at the corporate marginal rate of 21%. Passive investment income is gross income derived from rents, royalties, dividends, interest, annuities, and sales of securities. The most important of these is the built-in gains tax that applies to S corporations that used to be C corporations

CONTRASTING PASSIVE AND ACTIVE INCOME: Active Participation Standard (II)

Finally, this $25,000 offset allowance (deduction) is reduced by 50% of the small investor's AGI in excess of $100,000 annually for single filers and for married taxpayers who file jointly (MFJ). The deduction is lost at the rate of $1 for every $2 of AGI greater than $100,000. Thus, the $25,000 offset allowance is phased out completely when the small investor's AGI reaches $150,000 annually. Note that the exception is up to $25,000 and is not allowed for married taxpayers filing separately who have lived together at any time during the tax year. If the married taxpayers file separately yet live apart for the entire tax year, the special allowance is $12,500, subject to an AGI phaseout threshold that begins at $50,000. The applicable allowance of $12,500 is reduced by 50% of the amount of the taxpayer's modified AGI that exceeds the $50,000 threshold amount. In summary: 1. If the taxpayer's adjusted gross income is $100,000 or less, the taxpayer may deduct up to $25,000 of losses on an annual basis. 2. If the taxpayer's adjusted gross income is greater than $100,000 but less than $150,000, the $25,000 loss limitation is phased out (eliminated) on a 2-for-1 basis. 3. For the taxpayer with greater than $150,000 of AGI, the active participation losses are simply treated as passive losses. Note that the $100,000 to $150,000 phaseout numbers are not indexed for inflat

Estate Planning Techniques for the Newly Single: Life Insurance Policy Review

Financial planners should not assume that their clients will automatically change their primary life insurance beneficiary to someone other than their former spouses. In the event that divorce occurs and the insurance company is not notified of a change of beneficiary, the company's contractual obligation will likely require payment to the designated beneficiary, even if that beneficiary is now the client's ex-spouse. In any event, even if clients are going to retain their ex-spouses as beneficiaries, they should be encouraged to update their policies to confirm this. In this way, the beneficiary designation is less likely to create hard feelings or legal disputes with other family members in the event of the client's death. These disputes often arise when family members assume that the client neglected to update the beneficiary designation but meant to do so.

EMPLOYEE BONUSES: EXAMPLE

For example, suppose Jack is paid a bonus of $100,000 in 2021, contingent upon working for the ABC Corporation for five years. If Jack instead retires in 2023, he would be obligated to repay ABC Corporation the full $100,000. To recover the taxes he previously paid on that $100,000 in 2021, Jack would have to claim the amount as a credit when he files his 2023 tax return. Jack WOULD NOT AMEND his 2021 return.

Annual Deductions Limits: Public Charities (50% Organizations)

For gifts of ordinary income property, taxpayers generally may not deduct more than 50% of their AGI for donations to public charities. These public charities are often referred to as 50% organizations. These 50% organizations include churches, schools, hospitals and medical research organizations, and governmental units. Other organizations that allow charitable deductions of up to 60% of AGI include: -- operating, -- conduit, -- pass-through, -- distributing, -- community, and -- pooled-fund foundations. Again, these are nonetheless commonly referred to as 50% organizations.

Tax Consequences of Property Transactions: CAPITAL ASSETS AND DEPRECIATION: ESTABLISHING BASIS: DETERMINING BASIS IN PROPERTY

For purposes of determining a taxpayer's basis in property: -- improvements increase original basis (known as capitalizing the cost of the improvements over the useful life of the property); and -- repairs do not add to or impact original basis (they are always deducted annually as expenses, also known as expensing the cost). Basis is increased by legal fees, commissions, sales tax, and transportation charges. However, ongoing property expenses, such as utilities and taxes, are expensed annually and do not impact basis. When property is acquired that is subject to a mortgage, the mortgage does not reduce the basis of the property. For example, a building is acquired for $100,000 (FMV), but the property is also subject to a mortgage of $30,000 ($100,000 property purchase, $30,000 of which is financed). The basis of $100,000 is not affected by the $30,000 mortgage and is the original amount of the investment for the original or cost basis for the property.

ADDITIONAL MEDICARE TAX: INVESTMENT INCOME (1)

For purposes of the Medicare contribution tax, net investment income includes investment income, such as the taxable income from interest, dividends, annuities, net royalties, and net rental income. Also included in the definition is net gain (when taken into account in computing taxable income) attributable to the disposition of property. Gross income from annuities, referenced earlier, includes both the gross income from amounts received as an annuity (e.g., the includible portion of an annuitized payment), and amounts not received as an annuity (e.g., nonperiodic, lump-sum distributions, and surrenders). Just as dividends and interest are included in investment income, substitute dividends, or substitute interest, received are subject to the tax. A substitute dividend, or substitute interest, is received by an individual who has loaned a security to another in a short sale.

CONTRASTING PASSIVE AND ACTIVE INCOME: PUBLICALLY-TRADED-PARTNERSHIPS (PTP)

For purposes of the PAL rules, there are two types of limited partnerships: 1). Publicly traded partnership (PTP), which includes the master limited partnership (MLP) 2) Non-publicly traded or privately offered limited partnership A PTP, as previously discussed, is a partnership that is traded on an established securities exchange. Losses from such a partnership: -- cannot be used to offset income from a non-publicly traded partnership; and -- cannot be used to offset income from other publicly traded partnerships (i.e., losses from a PTP may only be used to offset income from the same PTP). Losses from a PTP that are disallowed in any one year (because of the PAL rules) may be carried forward and allowed as a deduction in a year when the same PTP has net income or the taxpayer's interest in the activity is sold. Losses from a non-publicly traded limited partnership, which are typically real estate limited partnerships (RELPs), may only be used to offset income from another non-publicly traded limited partnership. However, this income does not have to be generated from the same non-publicly traded limited partnership. Any RELP that generates passive income (also referred to as a passive income generator) will suffice. In summary, a passive income loss generated from a RELP may offset income from a PIG, if indeed such an investment activity is available for purchase by the investor.

Tax Consequences of Property Transactions: CAPITAL ASSETS AND DEPRECIATION: Ordinary Assets Versus Capital Assets (II)

Gain on capital assets owned one year or less is considered short-term capital gain (STCG) and is taxed at the ordinary income (marginal) tax rates. The day of disposition (sale date) is included in the determination of a taxpayer's holding period, although the date of acquisition is not included. For gifts, the donee's holding period begins on the day after the gift and includes the date of disposition. Capitalizing an asset, generally an asset used in a trade or business, occurs when the asset is recorded as a long-term asset on the balance sheet and expensed over its useful life through the depreciation, amortization, or depletion expense methods. It should be noted that the capital gain tax rate is progressive in nature. If a married taxpayer has $60,000 in taxable ordinary income, a portion will be taxed at the 10% rate and a portion will be taxed at the 12% ordinary income tax rate. If the taxpayer also has $40,000 in LTCG, a portion of the capital gains is taxed at the 0% capital gain rate and a portion will be taxed at the 15% tax rate. The reason for this is that the combined taxable income of $100,000 will force the taxpayer to cross the capital gain breakpoint of $83,350, which makes that portion of the capital gain taxable at the 15% capital gain rate. There are also several special capital gains rules and rates: -- Collectibles that are held more than one year before sale or disposition are subject up to a 28% tax rate. This means that if the taxpayer's ordinary income tax rate is 24% or less, the ordinary income tax rate will apply to the collectible sale. Unrecaptured Section 1250 gain on depreciable real property (discussed later in this module) held more than one year is subject up to a 25% maximum capital gain tax rate. Qualified dividend income is taxed at individual capital gains rates.

Tax Treatment of Business Property Gains: Installment Sale Recapture

Gain recaptured under Section 1245 (depreciable personal property used in a trade or business) is taxed as ordinary income and is not eligible for installment sale treatment. These amounts are fully recognized (taxable) as ordinary income in the year of sale. The ordinary income recognized in the year of sale is added to the property's basis, and this adjusted tax basis is used in determining gross profit in the sale. If a portion of the gain on an installment sale is attributable to 25% gain (straight-line depreciation on real property) and another consists of 20%/15%/0% gain, the taxpayer must recognize the 25% gain before the 20%/15%/0% gain when reporting gain received from installment sale payments. As a planning technique, it may not be advisable to sell some types of depreciable property used in a trade or business using the installment method.

EXAMPLE: Nondeductible Property Donations

Gary made the following donations: -- $500 to his friend Joe to assist him in a financial crisis -- $100 for 10 raffle tickets sold by his church -- $150 to United Way Of the three donations, only the donation to United Way is deductible. Donations to individuals or made to purchase raffle tickets are nondeductible

IMPUTED INCOME AND THE ALTERNATIVE MINIMUM TAX: OVERVIEW

Generally, income is not recognized (taxable) unless it is actually physically received by the taxpayer. However, there are two primary exceptions to this rule: -- The imputed interest rules -- The constructive receipt income doctrine Income that is constructively received is taxed to a taxpayer as though it had actually been received. As a result, if there is no substantial limitation or restriction on a taxpayer's right to bring the funds under personal control, the constructive receipt income tax rule or doctrine will apply. For example, a payroll check issued December 31 by an employer that is available to be picked up by the employee on that date is income for that year. Delaying the check retrieval from the employer until January of the next year does not change the fact that the taxpayer had the right to it (constructive receipt) in the prior year. In instances when a lender (an individual, employer, or an institution) has engaged in a below-market-interest rate loan transaction, the lender may be required to impute (report) interest income even without actually receiving this interest. Alternatively, the borrower may receive an interest expense deduction when in fact no interest to the extent of this imputed amount has ever been paid. **THE RATE USED IS THE FEDERAL GOVERNMENT'S BORROWING RATE (called the "Federal Interest Rate"), COMPOUNDED SEMIANNUALLY & ADJUSTED MONTHLY.

INCOME TAX CREDITS

Generally, tax credits are a means of implementing social or economic objectives by providing more equitable benefits for taxpayers in various marginal income tax brackets than can be achieved through allowed exclusions or deductions. Exclusions or deductions serve to reduce total income, but they do not reduce the tax liability directly; thus, they are less beneficial than tax credits and provide less equitable benefits for taxpayers in the lower marginal income tax brackets. It is important for the financial planner to be able to differentiate among exclusions, deductions, and tax credits and also to be able to calculate the equivalent tax benefit of exclusions or deductions to tax credits. Armed with this ability, the planner can readily compare the tax impact of alternatives the client may be considering that involve exclusions, deductions, or tax credits.

FILING STATUS: SINGLE

Generally, this is an unmarried, legally separated, or divorced individual who does not qualify for any other filing status. Note that married individuals who live apart from their spouses, as of the last day of the tax year, and maintain a household for a dependent child may be able to use the more advantageous head of household filing status.

Tax Reduction and Management Techniques: KIDDIE TAX: STRATEGIES: GIFTS TO MINORS

Gifts to minors are of particular interest to most tax planners. Outright gifts to minors may pose problems because they can require a legal guardianship. Remember that income from outright gifts made to a child subject to the kiddie tax is taxed at the parental tax rate to the extent that the unearned income exceeds $2,300 in any year. The most popular technique of gifting to minors is use of a Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA) custodial account. This technique allows a donor to create an investment account for the minor without having to set up a trust. The general rule for taxation of UGMA/UTMA accounts is that income from the custodial property will be taxed to the minor, whether distributed or not, except to the extent it is used to discharge a legal obligation of the parent. However, should this income exceed $2,300, it may be subject to the kiddie tax. UGMA and UTMA accounts are a relatively simple and effective way to gift property to a minor. For a child not subject to the kiddie tax, proper planning with long-term capital gains or qualified dividends may yield tremendous tax savings.

EXAMPLE: Material participation rules

Glenn has owned two small businesses for the past seven years. In Business 1, Glenn has consistently completed 600 hours of participation each year. In Business 2, Glenn has participated in 150 hours annually, as he is the sole owner and participant. His bookkeeping is handled externally. Because he participates in Business 1 more than 500 hours, he is a material participant. Because his participation in Business 2 constitutes all of the participation in the activity, he is also a material participant in Business 2. Glenn is considered a material participant in both activities and he is not subject to the PAL rules for these businesses.

TAX PLANNING FOR AMT: 3 GENERAL STRATEGIES

Here are three general strategies that may be used to plan for the possible imposition of the individual AMT: -- Move income into an AMT year: Such strategy works best for a taxpayer when the AMT is primarily due to the add-back of exclusion-type adjustments or preferences. In addition, accelerating income into an AMT year will prove beneficial when the taxpayer's marginal tax bracket in future years will exceed 28%, the top tax bracket under the current AMT system. -- Move deductions into a non-AMT year: If itemized deductions such as medical expenses and taxes increase a taxpayer's exposure to AMT, it is likely prudent to pay these expenses in a year in which the AMT does not apply. -- Time the recognition of certain AMT adjustments and tax preference items: A taxpayer with a substantial number of incentive stock options, for example, may defer the exercise of these options until a later year. Similarly, a taxpayer should avoid the purchase of private activity bonds (other than those issued in 2009 and 2010) and, instead, purchase only public purpose municipal bonds.

Passive Activity and At-Risk Rules: INTRODUCTION

Historically, one major tool used to reduce tax liability was investing in certain tax-advantaged investment products. However, the use of these tax-advantaged investments was significantly altered by the Tax Reform Act of 1986 (TRA '86), with the passage of the passive activity loss rules. In brief, during the 1970s, federal marginal tax brackets could climb as high as 70%. In this regulatory environment, Americans had strong incentive to seek out tax-advantaged investments, also known as tax shelters. Under the old rules, a taxpayer could, for example, receive as much as $10 or $12 in tax deductions for every $1 invested. Not surprisingly, this state of affairs did not last indefinitely. Voters began clamoring for tax relief in the early 1980s. As a precondition for rate cuts, tax authorities insisted abusive tax shelters be curtailed. The result of these discussions is also the focus of this module, namely the passive activity and at-risk rules. Congress, in a conscious effort to stimulate certain key sectors of the economy, established a wide variety of tax incentives designed to promote investment in key sectors. These tax incentives formed the basis for a variety of the tax-advantaged investments that we enjoy today. Currently income is classified into three basic categories: active income (wages), passive income (conduit entities), and portfolio income (investments). Each has its own specific set of rules. This module is devoted exclusively the study of passive income. It will discuss the unique tax benefits and limitations of direct participation programs. The module will also explore the material participation standard and review common exceptions that are applied to rental real estate.

Passive Activity and At-Risk Rules: DIRECT PARTICIPATION PROGRAMS: Borrowing (Debt)

Historically, tax shelters have used debt to magnify tax advantages. By borrowing the funds needed to incur deductible expenses, the program could provide an owner with deductions in excess of the owner's cash investment. For example, the deductions attributable to a $1 million building are substantially greater than the deductions attributable to a $100,000 building. If the business can raise $100,000 and borrow the other $900,000, the owners have substantially increased the deductions available from the program. In addition, the interest paid on the debt is generally a deductible expense. However, the at-risk rules, discussed later, may limit the advantages that may be gained through the use of leverage.

CAPITAL GAINS: Tax Treatment of Dividends (1)

How a nonliquidating distribution, from a corporation to its shareholders, is taxed depends on whether it is a dividend, return of capital, or capital gain. A dividend is the most common type of distribution resulting from the ownership of corporate stock. It is a distribution to the shareholder of either cash or property out of the corporation's current earnings and profits, or earnings and profits accumulated after February 28, 1913. A dividend distribution is not deductible by the corporation. The dividend distribution is subject to preferential treatment by the taxpayer. Preferential rates are applicable to qualified dividends received. As discussed earlier, these qualified dividends are subject to long-term capital gain rates. Thus, a 0% rate applies to qualified dividends if the taxpayer's taxable income is under $83,350 (for married couples filing jointly); a 15% rate applies for qualified dividends if they fall between the taxable income breakpoints of $83,350 to $517,200 (for married couples filing jointly). A 20% rate applies to qualified dividends falling above the $517,200 breakpoint (for married taxpayers filing jointly). As with long-term capital gains, these rates apply for both the regular tax and the AMT. Note that the preferential rates are available only to eligible dividends from stock. ***INTEREST EARNED FROM CDs, BONDS, and SAVINGS ACCOUNTS IS **NOT** ELIGIBLE.

Tax Reduction and Management Techniques: KIDDIE TAX: STRATEGIES

How can a client take maximum advantage of parent-to-child transfers? Probably the first and most important planning technique is to transfer only certain types of income-producing assets to the child. Note: There is an election available to include the child's net unearned income on the parents' tax return, but it is unlikely to be used. The unearned income reported on the parents' return actually increases the AGI and the taxable income on that return. This increased AGI can result in reduced deductions where AGI phaseouts are in play. In addition, the net unearned income may be subject to the net investment income tax.

CAPITAL GAINS: STOCK DIVIDENDS AND RIGHTS (2)

However, there are exceptions to this rule. In any of the following five situations, the stock or rights dividend is taxed as a regular (taxable) dividend: -- One situation occurs when any shareholder has the option between cash and stock. -- A second situation occurs when the stock is distributed in a disproportionate manner, that does not reflect the ownership percentages of the shareholders' interest, or when a distribution increases some shareholders' ownership interests in the E&P of the corporation while decreasing other shareholders' ownership. This occurs commonly when a corporation has more than one class of common stock. If one class receives stock while the other receives cash or property, the distribution is disproportionate. -- A third situation occurs when a distribution, or series of distributions, disburses common stock to some shareholders and preferred stock to others. Essentially, this type of distribution increases the ownership percentage of the shareholders who received the common stock. It should be noted that the distribution is a taxable dividend for all shareholders, regardless of which type of stock they received. -- A fourth situation occurs in any case of distribution of a corporation's preferred stock. -- A fifth situation occurs if the distribution consists of stock that may be converted into common stock.

ETHICAL CONSIDERATIONS, AUDITS, AND TAX PENALTIES: TAX AUDITS: ESTIMATED TAXES: Interest and Penalties

INTEREST: Interest on underpayments (or overpayments) runs from the unextended due date of the tax return (i.e., April 15 of any given year). The rate of interest is set by statute and is the same rate that will be paid by the IRS on overpayments (refunds) to noncorporate taxpayers. Interest assessments cannot be waived by the IRS if the taxpayer is audited and a tax deficiency results. PENALTIES: Penalties may be generally categorized as three types: -- FAILURE TO FILE or FAILURE-TO-PAY penalties (which are automatically assessed by the IRS) or UNDERPAYMENT penalties that are related to some negligence or intentional fault of the taxpayer. ** The FAILURE-TO-FILE (FTF) PENALTY is assessed by the IRS at a RATE OF 5% PER MONTH (or partial month) up to a 25% MAXUMUM.** If the return is filed more than 60 days after the due date or extended due date, the minimum penalty is the smaller of $450 or 100% of the unpaid tax. A failure-to-file penalty will not be assessed if the taxpayer can show there was reasonable cause for the failure to file on time. ** The FAILURE-TO-PAY (FTP) penalty is assessed by the IRS at a RATE OF 0.5% PER MOTNH (or partial month) up to a 25% MAXIMUM.** If both the FTF and FTP penalties are assessed, the FTF penalty is reduced by the FTP penalty.

EXAMPLE: SE earnings are above the Social Security wage base

If Catie's net earnings from self-employment were $170,000, her self-employment tax would be as follows. Self-employment income $170,000 Less $170,000 × 0.0765 - 13,005 Equals net earnings $156,995 Less 2022 wage base -147,000 Equals excess over wage 9,995 base multiplied by 0.029 × 0.029 ----------- = excess Medicare part of SE tax 290 Multiply the wage base ($147,000 in 2022) by 0.153 and add to the Medicare tax on the excess over the wage base + 22,491 Equals total self-employment tax $22,781 The above-the-line deduction for the employer share of the SE tax for 2022 = 1⁄2 × self-employment tax of $22,781 = $11,390.

CAPITAL GAINS: Stock Redemption

If a corporation purchases its shares back from its shareholders in a stock redemption, the transaction is treated as a payment for the stock, and qualifies for capital gain treatment. There are several different transactions that qualify as a stock redemption. The most common transaction that qualifies as a redemption is a complete redemption, in which all stock owned by the shareholder is redeemed. The rules related to the other types of transactions may be quite complex, and are beyond the scope of this course.

PROFESSOR'S NOTE: TAXATION OF DISABILITY INSURANCE

If an S corporation sponsors a group long-term disability plan and pays 100% of the group insurance premiums, the taxation of claims to a greater than 2% shareholder of the S corporation is unique. Essentially, the cost of the long-term disability insurance to the shareholder is imputed into the W-2 income of this taxpayer. Because he has effectively paid tax on this imputation, any future disability claims would be tax free, like an individually owned policy.

PROFESSOR'S NOTE: QDRO

If an ex-spouse is awarded a QDRO distribution, this distribution is not subject to the 10% early withdrawal penalty. However, if the recipient spouse does not roll the proceeds into another qualified plan or IRA within 60 days (or via trustee to trustee transfer), the distribution will be fully taxable to the payee in the year received as ordinary income.

SPOUSE RELIEF: EQUITABLE RELIEF

If an individual does not qualify for innocent spouse relief or relief by separation of liability, the individual can still be relieved of responsibility for tax, interest, and penalties through equitable relief. An individual must meet all of the following conditions to qualify for equitable relief: -- The individual does not qualify for innocent spouse relief or relief by separation of liability. -- The individual and the spouse (or former spouse) did not transfer assets to each other as a part of a fraudulent conveyance. -- The individual did not file the return with the intent to commit fraud. -- After taking into account all the facts and circumstances, it would be unfair to hold the individual liable for the understatement of tax. -- The income tax liability from which the individual seeks relief must generally be attributable to an item of the spouse (or former spouse) with whom the individual filed the joint return.

TEST TIP: PROPERTY RENTAL USE

If it is not used for personal use more than the greater of 14 days per year or 10% of rental days, a property is classified as primarily rental use, at which point, a taxpayer is eligible for the $25,000 material participation deduction.

NETTING PROCESS: MORE OR LESS STOCK BOUGHT THAN SOLD

If the number of shares of substantially identical stock or securities purchased within 30 days, before or after the wash sale, is either more or less than the number of shares sold, then taxpayers must determine the particular shares to which the wash sale rules apply. This is accomplished by matching the shares bought with an equal number of the shares sold. Match the shares purchased in the same order they were purchased, beginning with the first shares bought. The shares or securities matched are subject to the wash sale rules. One investment strategy that may be explored is known as doubling up. An investor may buy additional securities equal in number to those already held, wait at least 31 days, and then sell the original securities. In this manner, the investor can maintain their position but may take advantage of the loss on the sale of the original securities. At one time, it was thought that an investor could use an IRA to get around the wash sale rules. However, the IRS has now officially ruled that it is not possible. If an investor sells an investment at a loss, and has her IRA buy a substantially identical security within 30 days before, or 30 days after the date of the sale, the wash sale rule applies and the loss is disallowed. According to Revenue Ruling 2008-5, the basis of the security within the IRA is not increased by the disallowed loss. Note that the wash sale rule does not apply to dealers. Dealers are those engaged in the business of buying and selling securities

Tax Reduction and Management Techniques: Depreciated or Loss Property

If the property to be donated is property with a current value that is less than its original basis, such as depreciated property or property whose current FMV is less than its original basis, only the current lower value may be deducted as a charitable contribution. Any capital loss inherent to the loss of value on the property is not deductible if the loss property is donated. If possible, the donor should sell the property in an arm's-length transaction to a third person that would allow the donor to recognize the capital loss (as long as the loss is otherwise deductible under the capital loss rules) and then donate the cash received to the charity separately.

PROFESSOR'S NOTE: Caring for Elderly Parents or an Adult Child

If the qualifying relative is a parent of the taxpayer, the parent does not have to reside in the same home as the taxpayer. The parent may reside in their own home or possibly an assisted living facility and still be an eligible dependent. This is true if the assisted living facility is located in the United States, Mexico, or Canada.

FILING A TAX RETURN

If the taxpayer's total income is equal to or less than its applicable standard deduction, no return will be required. Regardless of the general rule, a taxpayer will be required to file a tax return under any one of the following circumstances: 1) The had net earnings of $400 or more from self-employment income . 2) He had wages of approximately $110 or more from a church that is exempt from paying the employer portion of Social Security taxes. 3) He is subject to one of the special taxes (e.g., self-employment tax or alternative minimum tax). After credits have been subtracted from the tax liability, as determined in the tax computation section of Form 1040, other types of taxes may need to be added to the balance. They include additional taxes such as the self-employment tax and the alternative minimum tax. The total tax due from the taxpayer is the amount determined after adding in these other taxes. This amount is then offset by any payments already made, such as federal income taxes withheld from wages or salaries or estimated tax payments. The bottom line on the back of the taxpayer's Form 1040 will be either a refund amount or an amount owed that equals the total tax due.

PROFESSOR'S NOTE: TAX IMPLICATIONS OF MARRIAGE

If they earned U.S. income during the year, nonresident aliens must file Form 1040NR. However, if married to a U.S. citizen or resident alien, the nonresident alien can elect to be treated as a resident alien for tax purposes only. Tax status does not necessarily reflect immigration status. If this election is made, the couple must pay U.S. taxes on their worldwide income. In this situation, the nonresident alien spouse should obtain an Individual Tax Identification Number (ITIN). Depending on their individual situation and intentions, they may apply for a social security number with the Social Security Administration.

ETHICAL CONSIDERATIONS, AUDITS, AND TAX PENALTIES: TAX AUDITS: COMMON TAX TRAPS: Forgiveness of Debt

If, for whatever reason, a creditor of a solvent debtor excuses the debtor from their obligation to repay the debt, the debtor may realize taxable income as a result of this relief from indebtedness. However, forgiveness of debt in bankruptcy is not taxable. If the debtor is insolvent, the debt relief is not taxable

EXAMPLE: Section 179 (II)

In 2022, Constanzo Corporation purchased and placed in service office machinery costing $2,900,000. If the taxable income of Constanzo Corporation in 2022 is $1,080,000, the cost of the machinery that the corporation can expense using the Section 179 election is $880,000 [$1,080,000 - ($2,900,000 - $2,700,000)]. As a result, the adjusted basis of the property (ignoring any potential additional allowable MACRS depreciation) is $2,020,000 ($2,900,000 - $880,000).

EXAMPLE: HOME EQUITY LOAN

In January 2022, Brittany incurs a $400,000 mortgage to purchase a main home with a fair market value of $800,000. In February 2022, she takes out a $250,000 home equity loan to put an addition on the main home. Both loans are secured by the main home, and the total does not exceed the cost of the home. Because the total amount of both loans does not exceed $750,000, all of the interest paid on the loans is deductible. However, if Brittany used the home equity loan proceeds for personal expenses, such as paying off student loans and credit cards, then the interest on the home equity loan would not be deductible. The taxpayer's points for a principal mortgage are deductible in the year incurred on the mortgage

EXAMPLE: Replacement property and time limitation (I)

In June 2022, Caitlin discovered that her safe had been stolen. In September of the same year, she received a reimbursement check from her insurance company. Caitlin has until December 31, 2024, to purchase replacement property (the last day of the second taxable year following the year in which the gain was first realized)

CAPITAL GAINS: STOCK DIVIDENDS AND RIGHTS (3)

In addition to these five situations, transactions that have the effect of increasing any shareholder's proportionate interest in the company do not qualify for tax-exempt treatment. These transactions are referred to as deemed distributions and are addressed in-depth in the Treasury Regulations Section 305. If a stock dividend or right receives tax-exempt treatment, the shareholder's basis in their old shares is allocated between the old and new shares. The general rule for stock rights, providing the FMV of the rights is 15% or more of the FMV of the old stock, is to allocate the basis between the stock and the stock rights in proportion to their relative fair market values at the time of the distribution. If the shareholder exercises the stock rights, their basis in the new shares is equivalent to the basis in the stock rights plus the purchase price of the new shares. The holding period of stock, or rights acquired in a nontaxable transaction, is added to the holding period of the old stock. The shareholder is treated as if they possessed the stock for as long as they held the old stock. If they have kept it more than one year, it is considered long-term property; if held less than a year, it is short-term property.

PROFESSOR'S NOTE: premature distributions from a deferred annuity

In addition, premature distributions from a deferred annuity (but not an immediate annuity) may be subject to a premature distribution penalty of 10% on the taxable amount of the withdrawal. A premature withdrawal is a withdrawal or distribution prior to the annuitant reaching age 591⁄2. No penalty is imposed if the distribution is taken after age 591⁄2, in the event of disability or death, or as a part of a series of substantially equal periodic payments taken over the annuitant's life expectancy. (For more information on substantially equal periodic payments (SEPPs), see IRC 72(t) for qualified annuities or IRC 72(q) for nonqualified annuities.).

Documenting the Charitable Deduction (3)

In addition, qualified appraisals are required for donated property when the claimed value is over $5,000, or in the case of closely held stock, when the claimed value is over $10,000. The information regarding the appraisal (but not the appraisal itself) must be attached to the return. It is common for a charitable deduction to be denied if the required information is not furnished. There are special requirements for a donation to a charity of a "qualified vehicle." A qualified vehicle is an automobile, boat, or airplane (other than inventory). The deduction is generally limited to the amount that the charity receives from the sale of the vehicle. However, if the organization intends to use (rather than sell) the vehicle, the taxpayer may value the donation at the time of the contribution, using a reasonable method. In either case, the taxpayer must receive contemporaneous acknowledgment from the charity in order for the contribution to be deductible.

S Corporations and Pass-Through Entities: Qualified Business Income (Pass-Through Business) Deduction (III)

In addition, the QBI is reduced by the following deductions attributable to the trade or business: -- 1⁄2 of the self-employment tax -- The self-employed health insurance deduction -- The Keogh deduction (contributions to qualified retirement plans by owners of unincorporated businesses) This deduction reduces taxable income, rather than adjusted gross income, and is available to taxpayers who take the standard deduction. The deduction is taken after AGI and is not an itemized deduction. The deduction is limited to 20% of the client's taxable income, after reduction for any net capital gain income. Thus, the basic rule is that the deduction is equal to the lesser of: -- 20% of the qualified business income; or -- 20% of the taxable income in excess of net capital gains. There is also a phaseout range to consider. For married taxpayers within the phaseout range of $340,100 to $440,100 for 2022 (or single taxpayers between $170,050 and $220,050), the rules are a bit more complex. For taxpayers over the top of the phaseout range, the availability of the deduction will depend upon the type of the business.

ADDITIONAL MEDICARE TAX: SUMMARY OF TYPES (1)

In order to completely understand Additional Medicare Tax, it is necessary to briefly examine the self-employment tax. The SE tax will be discussed in-depth later in the course. A taxpayer is also allowed to deduct one-half of their self-employment tax liability as an adjustment to income. However, the Additional Medicare Tax of .9% is not included in this deductible amount. Since self-employed taxpayers are not subject to employer withholding, they must pay their own Social Security and Medicare taxes. The Self-Employed Contributions Act (SECA) tax is comprised of two components. 1) The first component is a Social Security component: Old Age, Survivors and Disability Insurance (OASDI). 2) The second component is a Medicare Part A. OASDI is 12.4% of SE earnings up to the maximum wage base of $147,000 for 2022. The Medicare A (covering future hospitalization) component is 2.9% of the self-employment earnings, with no wage base or ceiling. Thus, the full 15.3% applies to net earnings from self-employment up to $147,000, with only the additional 2.9% applying to amounts over $147,000. As mentioned before, there is also an additional Medicare surcharge tax of 0.9% on combined self-employment income and wages over $200,000 for single taxpayers, or $250,000 combined self-employment income and wages for joint returns.

DEPENDENCY STATUS: OVERVIEW

In order to use either the qualifying widow(er)/surviving spouse status after the year of a spouse's death or the head of household filing status, the taxpayer must have a qualifying child or qualifying relative as a dependent. They also apply to whether or not a taxpayer may use the child tax credit or the child and dependent care credit. In all cases, the dependent's Social Security number or taxpayer identification number must be on the return.

Documenting the Charitable Deduction (5)

In other words, the amount of taxpayer deduction that may be taken for donations of appreciated property to charity depends on the purpose for which the recipient charity uses (or does not use) the property. Accordingly, the terms use-related property and use-unrelated property apply in this area. -- If the recipient charity does not have a related use for the gifted tangible personal property (use-unrelated property), the maximum deduction allowed is generally limited to the lesser of the fair market value (FMV) of the property or the donor's tax basis in the property, limited to 50% or 20% of AGI annually, depending on the type of charity. -- If it is use-related property, and the donor-taxpayer chooses to deduct the tangible personal property's FMV, then the taxpayer is limited to 30% or 20% of AGI annually, depending on the identity of the recipient charity. If the taxpayer chooses to deduct the basis in the property, the limits are 50% and 20%, respectively.

Electing Section 179 Expense Treatment (II):

In other words, the use of this section permits the taxpayer to deduct the cost of the tangible personal property dollar-for-dollar without reference to any depreciation percentage or MACRS table. To be eligible for this election, the property must be used at least 50% for business in the first year that it is placed in service (with only the actual business percentage eligible for the election). The maximum deduction under Section 179 for qualifying personal property (other than sport utility vehicles and luxury autos) is $1,080,000 for 2022. For taxpayers who file as MFS, the deduction may be allocated between the spouses if both have eligible deductible property, but the $1,080,000 maximum allocated deduction remains. Qualifying personal property (personalty) eligible for the election includes: -- office equipment (copiers, fax machines, and so on); -- computers; -- off-the-shelf computer software; -- automobiles and trucks; -- office machinery; and -- sport utility vehicles.

PROFESSOR'S NOTE: Purposes of the Federal Tax Law

In recent decades, federal tax law has evolved to serve the three-fold purpose of raising revenue for the federal government, redistributing wealth to achieve social objectives, and managing economic growth.

Tax Law Compliance and Procedures: Interpretive Regulations

Interpretative regulations explain the meaning of a Code section and commit the Treasury and the Internal Revenue Service to a particular position relative to the Code section in question. This type of regulation is binding upon the IRS but is not controlling on a court, although courts do look to it as "a body of experience and informed judgment to which courts and litigants may properly resort for guidance" (Skidmore v. Swift and Co.). Interpretive regulations have great weight and normally are invalidated only if they are inconsistent with the Code or are unreasonable.

Passive Activity and At-Risk Rules: AT-RISK RULES (II)

In the Tax Code, the at-risk rules are defined as the maximum deductible loss for an investment limited to the amount that the taxpayer-investor has at risk at the end of the current year (i.e., the amount of potential economic loss). A partner may deduct losses only to the extent of the amount that they have at risk. The amount at risk equals the sum of: -- the money invested (except to the extent the money invested was borrowed and was secured only by the investment); -- the adjusted basis of other property contributed to the partnership; -- amounts borrowed for use in the activity, but only to the extent that the partners are personally liable for repayment of the debt (recourse indebtedness); -- the partner's share of income, less the partner's share of losses or withdrawals from the partnership; and -- the proportionate share of qualified nonrecourse financing in a real estate activity only. Essentially, the only difference between the amount at risk and the basis in a partnership interest is the treatment of nonrecourse financing. A partner's share of nonrecourse financing established basis in the partnership, but is not treated as an amount at risk. Remember that nonrecourse financing is debt that is secured by the property, but for which no individual has personal liability. In the event of default, the lender may seize the property, but that is the lender's only recourse. This amount is adjusted annually (like basis) by the taxpayer-investor's share of profit or loss from the activity. A tax loss disallowed because of the at-risk rules is a suspended loss. That suspended loss may be used in either the first year in which the at-risk amount is sufficient to absorb the loss, or the year that investment is subsequently sold. If the investment is sold, the loss is allowed only to the extent of an increase in the at-risk amount. Otherwise, all suspended at-risk losses are lost on the complete disposition of the property.

ETHICAL CONSIDERATIONS, AUDITS, AND TAX PENALTIES: TAX AUDITS: ESTIMATED TAXES

In the United States, taxpayers are expected to withhold sufficient taxes as they earn the income. Taxpayers do not merely send in payment once every April 15. Doing so would incur an underpayment penalty. Most employers withhold this for their employees. Taxpayers who have income that is not subject to withholding generally must pay estimated taxes. This includes income derived from self-employment, interest, dividends, alimony, rent, and gain from the sale of assets, prizes, and awards. Also, although it does not usually happen, if the amount withheld from a taxpayer's wages is insufficient, estimated tax payments will be required.

PROFESSOR'S NOTE: OID

In the case of OID bonds issued after May 27, 1969, the amount of the discount must be treated annually as income for tax purposes, even if the taxpayer is on a cash method basis of reporting. In other words, the bondholder may owe tax on this phantom income even if no cash is received.

EXAMPLE: Application of at-risk rules

In the current year, Tyler invested $60,000 for a 20% interest in a partnership in which he was a material participant. The partnership entity incurred a loss, and Tyler's proportional share was $95,000. However, Tyler has only $60,000 of capital at risk, so he cannot deduct more than $60,000 against his other income. Tyler's nondeductible loss of $35,000 may be carried over and used later when either Tyler has $35,000 of income from the partnership in a future tax year (and he has no other transactions that would affect his at-risk amount) or he invests $35,000 more into the partnership.

ETHICAL CONSIDERATIONS, AUDITS, AND TAX PENALTIES: TAX AUDITS: Representing Clients Before the IRS (I)

In the event a client is audited by the tax authorities, the client can and should seek professional counsel. It is important for CFP® practitioners to understand that they CANNOT represent clients before the IRS without additional credentials. 1. In general a. Only a recognized representative can represent a client before the IRS. b. A representative can act on the client's behalf at conferences, hearings, or meetings with the IRS. c. The representative must be granted authority to act on behalf of the client. Authority is granted through a power of attorney. 2. Recognized representative a. A recognized representative must file a written declaration with the IRS that states he is qualified and authorized to represent the client. b. Recognized representatives can include the following: 1.) Attorneys 2.) Certified public accountants 3.) Enrolled agents or enrolled actuaries 4.) Certain unenrolled individuals, such as an unenrolled tax return preparer a.) Unenrolled individuals typically have limited authority to represent the client. b.) Unenrolled individuals must present satisfactory identification and proof of authority to represent the client. c. Recognized representatives do not include the following: 1.) Individuals convicted of a criminal offense 2.) Individuals under disbarment or suspension from practicing as attorneys, certified public accountants, or actuaries 3.) Individuals who are suspended from practicing before the IRS 4.) Officers or employees of the U.S. government or District of Columbia 5.) Members of Congress, if receiving compensation regarding the IRS issue 6.) CFP® practitioners (without additional credentials)

Constructive Receipt Income Rule or Doctrine

Income that is constructively received is taxed to a taxpayer as though it had actually been received. As a result, if there is no substantial limitation or restriction on a taxpayer's right to bring the funds under personal control, the constructive receipt doctrine will apply. For example, a payroll check issued on December 31 by an employer that is available to be picked up by the employee on that date is income for that year. Delaying the check retrieval from the employer until January of the next year does not change the fact that the taxpayer had the right to it (constructive receipt) in the prior year. Common examples of constructive receipt include matured and payable bond interest coupons, interest credited on savings bank deposits, and dividends on stock made payable at the shareholder's demand or personal request. Taxpayers are usually notified of the amounts of earned income from these kinds of financial instruments by Form 1099, usually by January 31 of the following year.

INVESTMENT INTEREST EXPENSE

Investment interest expense is interest paid on indebtedness used to acquire investment assets. The MOST COMMON EXAMPLE of such expense is MARGIN ACCOUNT INTEREST. *This form of interest is DEDUCTIBLE UP TO THE AMOUNT OF the taxpayer's INVESTMENT INCOME.* If, however, the interest is not taxable (such as municipal bond interest), then the investment interest is not deductible because there is no interest income to offset. However, qualified dividends and long-term capital gains taxed at the favorable long-term capital gain rates (since 2003) are not included in investment income, which, in turn, can offset investment interest expense unless the taxpayer elects out of these rates. This result also holds if the taxpayer does not elect out of the preferential rates for long-term capital gains. In other words, unless the taxpayer elects out of the long-term capital gain rates for long-term capital assets sold at a gain, the long-term gains cannot be included in investment income.

NET INVESTMENT INCOME: INVESTMENT INTEREST EXPENSE: OVERVIEW

Investment interest is interest paid or accrued on a debt that was incurred to purchase property held for investment. In this context, property held for investment is any property that produces portfolio-type income, such as interest from annuities, stocks, bonds, CDs or savings accounts, etc. The capital gains that may be included here must be gains from these types of assets. In this context, property held for investment does not include rental properties. Investment interest does not include interest incurred to purchase tax-exempt securities. There is no deduction allowed for the interest on funds borrowed to purchase tax-exempt securities. For individual taxpayers, an investment interest expense deduction is allowed to the extent of the taxpayer's net investment income. The investment interest expense is an itemized deduction and is reported on Schedule A. Investment income is the sum of the gross income from property held for investment. This includes interest income, short-term capital gains, and nonqualified dividends. Net long-term capital gain and qualified dividend income may be included in investment income, but only if the taxpayer elects to forgo preferential treatment on these long-term capital gains and qualified dividends.

TRUST INCOME TAX RULES: OVERVIEW (1)

It is a common misconception that the creation of a trust always results in a separate taxpaying entity. In fact, for the trust to qualify as a taxpayer separate from the grantor, the grantor (the person who creates the trust) will have to give up virtually all rights in and to the property. A properly structured irrevocable trust does, however, offer significant benefits for the grantor and the beneficiary. When applicable, the grantor trust rules require that the trust's income be taxed to the grantor. The rationale for these rules is that a trust's income should be taxable to the grantor if the grantor retains too much power over, or interest in, the assets transferred into the trust. The grantor is treated as holding any power or interest that is held by the grantor's spouse. In fact, through a series of IRS Code sections (671-679), an irrevocable trust can be structured to violate certain guidelines and become an "intentionally defective" grantor trust, with a division of trust characteristics such that contributions to the trust (gift, sale, or swap transfers) are deemed "completed" while the income tax liability associated with trust income is retained by the grantor.

PROFESSOR'S NOTE: LIKE-KIND EXCHANGE

It is imperative that clients understand that like-kind exchanges must be transacted through a qualified intermediary. Failure to procure the services of such an intermediary will disqualify the exchange for tax purposes. In other words, if improperly handled, the client will lose the tax deferral. Section 1031 is for business properties, while Section 121 is reserved for disposition of personal residences.

Tax Law Compliance and Procedures: Judicial Interpretations

It is important for a student of tax, as well as the tax practitioner, to have a grasp of the judicial system of the United States and how tax cases move through this system. Congress passes the tax law and the executive branch of the federal government enforces and interprets it, but under the American system of checks and balances, it is the judicial branch that ultimately determines whether the executive branch's interpretation is correct. This provides yet another source of tax law: court decisions. Before litigating a case in court, the taxpayer must have exhausted the administrative remedies available to him or her within the IRS. If the taxpayer has not exhausted their administrative remedies, a court will deny a hearing because the claim filed in the court is premature. All litigation begins in what are referred to as courts of original jurisdiction, or trial courts, which try the case. There are three trial courts: (1) the tax court, (2) the U.S. District Court, and (3) the U.S. Claims Court. Note that the taxpayer may select any one (and only one) of these three courts to hear the case. If the taxpayer or IRS disagrees with the decision by the trial court, it has the right to appeal to either the U.S. Court of Appeals or the U.S. Court of Appeals for the Federal Circuit, whichever is appropriate in the particular case. If a litigating party is dissatisfied with the decision by the appellate court, it may ask for review by the Supreme Court, but this is rarely granted.

CAPITAL GAINS: Tax Treatment of Dividends (4)

It is important to note that as of 2003, when these rules were enacted, approximately 65% of corporate dividends were paid to institutional owners or individuals owning stock in tax-deferred vehicles such as pension plans, IRAs, college savings plans, or 401(k)s. Dividends paid to such tax-deferred vehicles receive no preferential treatment. For purposes of the investment interest expense deduction, a dividend will qualify as investment income only if the taxpayer elects not to use the preferential rates for the dividend. To the extent a distribution exceeds the current and accumulated earnings and profits (E&P), the distribution is treated as a return of capital, or return of the shareholder's basis. The taxpayer's basis in their shares is reduced by the amount of the distribution treated as return of capital, but it cannot be reduced below zero. Return of capital distributions are not considered taxable income to the shareholder. If the distribution is not a dividend, and the amount exceeds the shareholder's basis, the excess is treated generally as capital gain.

CAPITAL GAINS: Tax Treatment of Dividends (3)

It is important to note that securities on loan, from a broker, and in connection with a short sale, often generate substitute payments in lieu of a dividend. These substitute payments, specifically, are not considered qualified dividends and will not qualify for preferential rates. Payments in lieu of dividends are generally paid with respect to stock that has been lent in connection with a short sale, on which dividends are declared before the short sale is closed. The dividends are paid to the short sale buyer. The payments in lieu of dividends are paid to the lender of the stock, by the borrower, to compensate the lender for not receiving the actual dividends. Dividends from a qualified foreign corporation qualify for the reduced rate. A qualified foreign corporation is an entity incorporated within a U.S. possession or one that is eligible for the benefits of a comprehensive satisfactory treaty that provides for the exchange of tax information. Dividends from foreign stocks, if they are readily tradable on an established U.S. securities market (i.e., an ADR), are also eligible.

Tax Planning for the Medicare Contribution Tax (1)

It is important to note that traditional tax planning still works. The taxpayer can use exclusions and above-the-line deductions (i.e., deductions on the front page of Form 1040, thus reducing AGI) to the extent the Medicare contribution tax may be reduced. Contributions to 401(k)s, 403(b)s, or health savings accounts (HSAs) and medical savings accounts (MSAs), for example, will reduce the current year's AGI. This may help reduce, or even eliminate, the Medicare contribution tax (but will not affect the 0.9% Additional Medicare Tax, discussed earlier). While the previous example uses 401(k) contributions to reduce the AGI, the same result is possible by deducting a Section 1231 loss from the sale of a rental property, for example. Similarly, taking full advantage of legitimate deductions in a taxpayer's sole proprietorship (reported on Schedule C) or rental property (reported on Schedule E) may reduce the income, or generate or increase a loss, from the activity and will serve to reduce the AGI.

CONTRASTING PASSIVE AND ACTIVE INCOME: MATERIAL PARTICIPATION

It is important to understand that the passive loss rules limit deductions from a trade or business activity only when a taxpayer does not materially participate in the activity. To the extent that an investor is willing and able to meet the standards for material participation, they still may use the losses and credits to offset other active income. The material participation rules are statutorily created and may be found in the Treasury Regulations. If the answer to any of the following is yes, the taxpayer is a material participant, and the activity is not classified as passive. -- Does the taxpayer complete more than 500 hours of participation during the year? -- Does the individual's participation in the activity constitute substantially all of the participation in the activity of all individuals who participate in the activity (including individuals who are not owners) for the year? -- Does the taxpayer participate for more than 100 hours, and is this amount equal to or more than any other participant in the activity? -- Is the activity a significant participation activity (i.e., more than 100 hours of participation), and does total participation in all such activities exceed 500 hours? -- Did the taxpayer materially participate in the activity in at least five of the past 10 years? -- Is the activity a personal service activity, and did the taxpayer materially participate in the activity in any of the three previous years? -- Using the existing facts and circumstances, did the taxpayer participate on a regular, continuous, and substantial basis during the year? These requirements effectively preclude limited partners from meeting the material participation. Limited partners are passive investors and are subject to the PAL rules.

Supporting Elderly Parents or Special Needs Children: Elder Care Credits, Deductions, and Exclusions

It is normal for a client to financially support an elderly parent in need of assisted living. Common tax benefits of this arrangement include the following: -- If the client provides over 50% of the elder's support, the client may claim their elderly parent as a qualifying relative on their tax return. As a tax benefit, the client receives a $500 credit. -- If the qualifying relative is incapable of self-care, the child and dependent care credit (also sometimes referred to as the aging parent tax credit) may also be claimed, which is generally $600. -- Assuming the elderly parent is an eligible dependent, any medical expenses paid on their behalf can be taken as an itemized deduction subject to AGI thresholds. Finally, in extreme cases, a client may have to provide full-time care to a parent in their own home. In this special case, a client may receive wages from a qualified Medicaid facility to do so. ***THIS IS DEEMED "DIFFICULTY OF CARE INCOME"***. Congress recognizes that this arrangement may be more cost-effective than placing some individuals in a nursing home. Thus, per IRS Notice 2014-7, these Medicaid wages may be excluded from taxable income. Under the SECURE Act, difficulty-of-care payments also qualify as earned income for IRA purposes. Thus, these payments are excluded from taxable income yet still treated as earned income for IRA contributions. The overall tax savings can be powerful when these wages are combined with a Roth IRA strategy. This is a tremendous benefit to self-employed caregivers that ordinarily are not offered a retirement plan. A qualifying relative may also be a special needs child who, although over age 18, is likely to need lifetime support. Again, many of the aforementioned expenses incurred may be deductible.

EXAMPLE: Net Investment Income Tax calculations Example 4

Joe and Robin are married taxpayers filing a joint tax return. In 2022, their AGI is $290,000, and their net investment income is $0. They will not pay the 3.8% Medicare contribution tax. This is because the lesser of the net investment income ($0) or the AGI in excess of the threshold amount ($290,000-$250,000, or $40,000) is zero.

Like-Kind Exchanges: BOOT (I)

It is very difficult to find qualifying real property to generate an even exchange or trade. Typically, cash or other property is involved in the exchange to benefit one party and equalize the exchange. This cash, including an assumption of liabilities or receipt of other property, is known in the tax law as "BOOT". In some transactions, the real property exchanged is subject to a liability that is to be assumed by the other party. This most often occurs in real estate exchanges where there is a mortgage on one or both of the properties involved. ** The PARTY ASSUMING THE DEBT has "GIVEN BOOT", and the PARTY RELIEVED of the debt has "RECEIVED BOOT" in the amount of the liability.** If the property is exchanged for property that is also subject to a liability, then the boot given and received is the net reduction of the liability on the property.

PROFESSOR'S NOTE: NONREFUNDABLE CREDIT

It should be noted that if a nonrefundable credit does, in fact, reduce the taxes owed in the applicable year to zero, the taxpayer may still receive a refund of any taxes he has already prepaid that year in the form of payroll deductions, estimated taxes, or other withholdings. Nonrefundable credits can reduce the tax liability—not the refund itself—to zero.

PROFESSOR'S NOTE: Section 1250

It should be noted that if the taxpayer's marginal ordinary income tax rate is less than 22% (the 10% or 12% brackets), the unrecaptured Section 1250 gain will be taxed at the taxpayer's lower, ordinary income tax rate. This tax is also progressive in the same manner as the regular capital gain tax rates. It is possible for a portion of the gain to be taxed at the 0% rate, with any remaining balance of the unrecaptured Section 1250 gain then taxed at the 25% rate.

Tax Consequences of Property Transactions: CAPITAL ASSETS AND DEPRECIATION: Ordinary Assets Versus Capital Assets (III)

It should be noted that the capital gain tax rate is progressive in nature. If a married taxpayer has $60,000 in taxable ordinary income, a portion will be taxed at the 10% rate and a portion will be taxed at the 12% ordinary income tax rate. If the taxpayer also has $40,000 in LTCG, a portion of the capital gains is taxed at the 0% capital gain rate and a portion will be taxed at the 15% tax rate. The reason for this is that the combined taxable income of $100,000 will force the taxpayer to cross the capital gain breakpoint of $83,350, which makes that portion of the capital gain taxable at the 15% capital gain rate. There are also several special capital gains rules and rates: -- Collectibles that are held more than one year before sale or disposition are subject up to a 28% tax rate. This means that if the taxpayer's ordinary income tax rate is 24% or less, the ordinary income tax rate will apply to the collectible sale. -- Unrecaptured Section 1250 gain on depreciable real property (discussed later in this module) held more than one year is subject up to a 25% maximum capital gain tax rate. Qualified dividend income is taxed at individual capital gains rates

ITEMIZED DEDUCTIONS

Itemized deductions are reported on Schedule A of Form 1040. The major item or activity that will permit a taxpayer to itemize deductions is the ownership of a personal residence with the corresponding mortgage interest deduction. Often, the size of this interest amount will exceed that of the specified standard deduction for an individual's filing status and will allow itemization of deductions. Qualifying to itemize is important for a number of reasons, among them, the possibility to deduct charitable contributions, which cannot be deducted separately if the standard deduction amount is elected. There are some itemized deductions that, as a category, are subject to limitations as a percentage of AGI in order for the amount to qualify. The charitable deduction, medical expense deduction, and miscellaneous deduction are just a few that have qualifications based on AGI.

EXAMPLE: Material participation in real estate provision

Jeff Thompson is a full-time real estate broker employed by a corporation in which he owns a 50% interest. He devotes about 2,000 hours a year to this employment. He has no other employment or profession except the ownership of an apartment building, which generates a $100,000 loss during 2022. Jeff devotes 600 hours of his time to the management of the building in 2022, thus meeting the material participation standard. Since he has performed more than half of his personal services in the real property trades or businesses in which he materially participates and has met the more-than-750-hours test, he is entitled to deduct the $100,000 loss against whatever non-passive income he may have. This other income might be his salary and commissions as a broker or any interest or dividends he may have received.

EXAMPLE: Married filing separately

Jimmy is a delivery driver for YPS and earns $80,000 per year. His wife, Deanna, recently began selling makeup to her friends and family online via Mary Jay Cosmetics. Deanna's business has been wildly successful. Their garage is stacked full of cosmetics ready to be shipped. She has been too busy to hire a bookkeeper. However, Jimmy is aware Deanna has not been withholding any money to pay her taxes. He does not have sufficient cash flow to pay her taxes for her. Jimmy chooses the MFS status. Thus, he will not be held liable by the IRS for Deanna's income tax liability on her business.

EXAMPLE 2: AGI (CARRY FORWARD)

John Williamson has an AGI of $100,000 in 2022 and contributes $65,000 in cash to a public (50%) charity. John can deduct $60,000 in 2022 (60% of $100,000) and carry over $5,000. In 2023, John's AGI is also $100,000, and he contributes $59,000 to the charity. John can deduct $60,000 (60% of $100,000) in 2023. So, in addition to deducting the $59,000 contribution, John may deduct $1,000 of the carryover from 2022 and carry over the other $4,000 to 2024.

EXAMPLE: Mortgage interest deduction

John and Cheryl, married taxpayers filing jointly, bought a residence in 2016 by financing $900,000 of acquisition debt. Several years later, when the principal amount of the loan is $780,000, they refinance in order to obtain a better interest rate. They also want to pull some cash out to pay off an auto note and credit card debt. The new loan has a principal amount of $850,000. Only the interest on the first $780,000 of debt will continue to be treated as acquisition debt. Because they still fall under the old debt rules, the interest on the full $780,000 is deductible, but the remaining loan principal amount of $70,000 (the amount above the refinanced principal) is not treated as acquisition debt, and interest associated with this debt is not deductible.

EXAMPLE: Gifts to minors

John and Mary have been in the top marginal income tax bracket for many years. Over the years, they have transferred numerous securities, via a Uniform Transfers to Minors Act account (UTMA), to their son, Kevin. Kevin, now 19, has decided to take a year off before he goes to college. Kevin is not subject to the kiddie tax. Kevin liquidates a large portion of the portfolio that has built up in the UTMA account, and has $46,950 of net long-term capital gains and qualified dividends during the year. Because Kevin's income is too high to be treated as a dependent, he can utilize his full standard deduction. The standard deduction amount is $12,950 for 2022. This leaves $34,000 of taxable income, all attributable to net long-term capital gains and qualified dividends. Because $34,000 of taxable income is under the $41,675 breakpoint for the 15% LTCG rate, he will pay a 0% rate on these income items. If the assets had remained with John and Mary instead of the UTMA, they would pay a 20% rate on this income, because they are in the 37% bracket (over the $517,200 breakpoint for the 20% LTCG rate). They could have paid over $9,000 on this income had the assets remained in their control.

TAX IMPLICATIONS OF MARRIAGE

Legally, married spouses may file a joint return (even though one spouse has no income or deductions) if -- their tax years begin on the same date; -- they are not legally separated under a decree of divorce or separate maintenance on the last day of the calendar year; and -- neither is a nonresident alien at any time during the year. Spouses who file a joint return as married filing jointly (MFJ) have joint and several liability for the payment of any tax due. In other words, each spouse is responsible for the entire tax liability and not just half of the tax liability due. This is the case even if one spouse cannot locate the other spouse. Tax filing status is determined on the last day of the tax year. For example, if a couple marries on December 31, 2022, they are considered married for all of 2022 for tax purposes. Likewise, if the couple divorces one year later on December 31, 2023, they are considered divorced for the entire 2023 tax year. As an alternative to filing jointly, married individuals may file separate returns. This is called married filing separately (MFS) and, in a few cases, the individuals may derive some tax benefit. However, the filing of returns MFS is usually not advantageous for married individuals.

EXAMPLE: When a hobby becomes a Schedule C business

Liam has been selling decorative posters online for six years. It is not his primary employment, but it has been doing very well. While Liam will be itemizing his deductions this year, he believes he can report his income and expenses on Schedule C. His gross sales from the poster business this year are $56,500. His expenses include: Cost of goods sold $28,000 Supplies $2,000 Web-related costs $4,300 Magazine and web advertising $1,100 Postage/delivery costs $2,200 Allocated mortgage interest: For home office $900 Allocated property taxes: For home office: $500 Liam has kept detailed records from the beginning and can track his profit and loss from each year. In Year 1, he had a loss of $5,000; Year 2 was a loss of $2,000; Year 3 showed a profit of $9,000; Year 4 had another loss of only $500; and Year 5 was a good year with a profit of $12,000. Because Liam had a profit in Years 3, 5, and 6, the hobby rules do not apply, and he can use Schedule C to report income and expenses from his business. ACCOUNTING FOR A HOBBY LOSS ***If Liam's business had not been profitable in THREE OF LAST 5 YEARS and had instead generated INCOME OF ONLY $25,000 from his online poster business this year, he WOULD NOT BE ALLOWED TO CLAIM BUSINESS LOSSES on Schedule C.***

Tax Law Compliance and Procedures: REVENUE RULINGS

Like regulations, revenue rulings are official interpretations of the federal tax laws. They are official pronouncements of the National Office of the Internal Revenue Service. Revenue rulings do not have quite the authority of regulations, however. Regulations are a direct extension of the lawmaking powers of Congress, whereas revenue rulings are an application of the administrative powers of the Internal Revenue Service. In contrast to rulings, regulations are usually issued only after public hearings and must be approved by the Secretary of the Treasury. Unlike the regulations, revenue rulings are limited to a given set of facts. Taxpayers may rely on revenue rulings in determining the tax consequences of their transactions; however, the taxpayers must determine for themselves if the facts of their cases are substantially the same as those set forth in the revenue ruling. Revenue rulings are published in the weekly issues of the Internal Revenue Bulletin. Revenue rulings are cited as Rev. Rul.

S Corporations and Pass-Through Entities: LIMITED LIABILITY COMPANY (LLC)

Limited Liability Company The limited liability company (LLC) is a relatively new form of business entity but one that is now permitted in all 50 states and the District of Columbia. IT IS A HYBRID BUSINESS ENTITY that combines the limited liability normally associated with either a C or S corporation and the pass-through tax treatment (and other tax advantages) associated with a general partnership. ** The MAJOR ADVANTAGE of this form is that an LLC LIMITS THE LIABILITY of the one-owner business to only the business (and not personal) obligations.** However, an LLC accomplishes these benefits without having to comply with the 100-shareholder restriction of an S corporation (thus allowing for additional capital infusion possibilities). To form a new LLC, the owners (known as members) must file an article of organization with the state. While the initial costs of forming an LLC may be higher than that of a regular corporation, the flexibility is also greater. For example, an LLC may generally be liquidated without the adverse tax consequences of a regular corporation. In addition, if state law permits, a one-member LLC may be implemented in lieu of a sole proprietorship.

EXAMPLE: Net Investment Income Tax calculations Example 1

Manny and Carol are married taxpayers filing a joint tax return. In 2022, their MAGI is $245,000, and their net investment income is $80,000. They will not pay a Medicare contribution tax. This is because the lesser of the net investment income ($80,000) or the AGI in excess of the threshold amount ($250,000) is zero.

TAXATION: SOCIAL SECURITY BENEFITS

Many recipients of Social Security are surprised to learn their benefits may be taxable. The taxability of Social Security benefits is a function of two amounts: 1.) the amount of Social Security benefits received 2.) and the amount of the taxpayer's other income, including tax-exempt interest. The computation necessary to determine the amount of benefits included in income is covered in the Retirement Planning course. ** TAXATION IS BASED ON PROVISIONAL INCOME**

EXAMPLE: WASH SALE 1

Marcy has owned 100 shares of ABC stock since January 5, 2014. Her basis in the 100 shares is $10,000. She sold these shares on January 5, 2022, for $9,000. After hearing an upbeat prediction for the ABC stock, she purchases 100 shares on January 27, 2022, for $9,500. The $1,000 loss from the sale of the original shares is not currently deductible due to the wash sale rules. Her basis in the new shares is $10,500 (the $9,500 purchase price increased by the disallowed loss of $1,000). Her holding period for the 100 shares of ABC begins on January 5, 2014. This is because the holding period for the new stock includes the holding period of the stock sold.

EXAMPLE: Filing requirements

Margo and Bruce, both age 33, are married. If the couple decides to file their income tax return as married filing jointly (MFJ), the minimum gross income which requires the couple to file an income tax return is $25,900 in 2022. However, if the couple files separately as MFS, then each will be required to file a return when their individual gross income is $5 in 2022

EXAMPLE: Tax planning for AMT

Maria knows she will be subject to an AMT liability next year that is not an issue this year. Accordingly, she decides to pay certain deductible expenses this year instead of next year. The effect of this reduces the itemized deduction add-back in the calculation of AMTI in the year she will be subject to the AMT.

EXAMPLE: Capital gains and losses

Marie, a single taxpayer, completed several security transactions in the year 2020, generating the following capital gains and losses: -- LTCG of $6,000 -- LTCL of $5,000 -- STCG of $3,000 -- STCL of $8,000 Therefore, Marie has a $1,000 LTCG and a $5,000 STCL, which are combined for a STCL of $4,000. A maximum loss of $3,000 may be taken against Marie's ordinary income in the year 2020 and her remaining loss of $1,000 is carried forward to future tax years until fully used.

EXAMPLE: Character of gain

Mark sold a building used in his business in 2021 for $100,000. He originally acquired the building in 2009 for $75,000. Straight-line depreciation taken was $30,000. Mark is in the 32% marginal income tax bracket. However, because the property is Section 1250 property, the character of his gain is: -- $30,000 at a 25% rate (equal to amount of straight-line depreciation taken); and -- $25,000 at a 15% or 20% capital gain rate depending on Mark's total income.

EXAMPLE: Amortization of intangible assets

Mary acquired a business on July 1 of the current year. Included in the purchase price was a copyright valued at $30,000. Therefore, Mary can amortize (deduct) $1,000 in the current year. The annual total amount of amortization is $2,000, or $30,000 ÷ 15, but Mary owned the business for only six months during the current year.

EXAMPLE: Sale of personal residence gain exclusion

Mary and Ben, both middle-aged, get married, and Ben moves into the house that Mary has been using as her principal residence for seven years. The home is retitled into both of their names immediately. Nine months later, Ben gets a job promotion, and the newlyweds move to a new city. They realized a gain of $700,000 on their (Mary's) residence. Mary has met both the ownership and use tests, but Ben has not. Therefore, Mary gets a full exclusion of $250,000 of taxable gain. However, because Ben has been in the house only nine months, he is eligible for an exclusion of only $93,750 (9 ÷ 24, or 0.3750, × $250,000). Their total exclusion is $343,750 ($250,000 + $93,750), and they must pay tax on the remaining gain of $356,250 ($700,000 - $343,750) at capital gains rates. Finally, the gain exclusion may be used once every two years and, as with any other personal asset, losses from the sale of a personal residence are not deductible.

MEC/: MATERIAL CHANGES INCLUDE:

Material changes include the following: - The exchange of one policy for another - An exchange of insured - The increase or addition of certain riders - The conversion of a term policy for a whole life contract . - An increase in future benefits (unless the increase is due to the payment of premiums to fund the lowest death benefit or due to the crediting of interest to those premiums) - An increase of more than $150,000 over the death benefit payable as of October 20, 1988, (unless the contract would have met the seven-pay test on June 21, 1988) ***A material change DOES NOT RESULT FROM: -- A decrease in future benefits -- An increase in death benefits because of dividends -- A cost of living adjustment (COLA) to the death benefit

EXAMPLE: Recognized gain when boot given is appreciated other property

Mike exchanged investment land with an adjusted basis of $35,000 and an FMV of $50,000, receiving another parcel of investment land in exchange with an FMV of $80,000. Mike gave as boot other property, a machine, with an FMV of $30,000 and an adjusted basis of $15,000. Because the boot given was not cash but appreciated other property, the other property is treated as though it had been sold, and the gain of $15,000 must be recognized by Mike. The character of the gain, capital or ordinary, depends on the rules that governed the sale had it not been part of a like-kind exchange.

EXAMPLE: Installment sale calculation

Mike sold some land via an installment sale for a total contract price of $500,000 on January 1 of Year 0. His adjusted basis in the land was $300,000 at the time of sale. The agreement specified a down payment of $100,000 with the remaining $400,000 sales price paid over a five-year term at 10% interest in annual installments beginning January 1, Year 1. The buyer signed an installment note agreeing to those terms. Mike's profit from the sale is $200,000 ($500,000 sales price - $300,000 adjusted basis), and the gross profit percentage is 40% ($200,000 profit ÷ $500,000 contract price). Mike will report gain each year on 40% of the principal reduction as capital gain and the remaining 60% of principal reduction as a recovery of capital. The interest received from the buyer each year is ordinary income.

ETHICAL CONSIDERATIONS, AUDITS, AND TAX PENALTIES: TAX AUDITS: PENALTIES

Most U.S. citizens with income are expected to file a tax return in a timely manner. However some citizens may not be required to file at all because they are below certain thresholds. If a taxpayer is required to file but does not, they are subject to severe penalties. Late filings may be accepted but also incur uncomfortable penalties. Thus taxpayers need to be aware of their respective filing requirements and deadlines. It is important for taxpayers and practitioners alike to be able to determine who is, and who is not, required to file a tax return and when.

Tax Consequences of Property Transactions: COST RECOVERY METHODS: Depletion

Natural resources (e.g., oil and gas wells) are subject to depletion. The owner is entitled to a deduction for AGI (an above-the-line deduction) to recover the costs of exhausting the natural resource. There are two depletion methods: -- Cost depletion. The asset basis is divided by the total number of recoverable units of the asset and then multiplied by the number of units sold (not produced) to determine the amount of the deduction for the year. -- Percentage depletion. A statutory percentage is applied to the gross income from the property (limited to 50% of the gross income); this method is unrelated to the cost basis of the asset. Percentage depletion is the more aggressive of the two depletion methods. Therefore, the portion of percentage depletion that is more than the adjusted basis of the property owned by the taxpayer is a tax preference item for purposes of the individual AMT.

MORTGAGE INTEREST DEDUCTION (3)

New debt is mortgage debt incurred after December 15, 2017. The deductibility of the interest on this debt is limited to $750,000 of acquisition indebtedness. In addition, the interest on a home equity loan (a loan secured by the residence that is used for purposes other than acquiring, constructing, or substantially improving any qualified residence of the taxpayer) is no longer deductible after 2017. Note that the focus is on the use of the loan proceeds, not what the loan is called. If the proceeds of a home equity line of credit (HELOC), for example, is used to remodel the taxpayer's residence, that debt is treated as acquisition debt. Generally, points paid on a loan must be capitalized and amortized over the life of the loan since they are nothing more than prepayments of interest. If, however, points are incurred on a loan, the proceeds of which are used to buy or improve a principal residence, the amount paid as points generally may be deducted in the year paid. The points paid on a refinance must be deducted ratably over the life of the loan (amortized). If there is a second refinance, the unamortized (not deducted) points from the first refinance are deductible in full when the first refinance loan is paid off.

NETTING PROCESS: Related Party Sales of Loss Property—IRC Section 267

No loss deduction is allowed from a sale or exchange between certain related taxpayers. Related taxpayers include the following: -- Members of the seller's family including brothers, sisters, parents, grandparents, children, etc. (in-laws are not included) -- Controlled corporations (if more than 50% ownership is by taxpayer) -- Certain business organizations, if one person owns more than 50% of each -- An estate and beneficiary -- Certain trustees, grantors, and beneficiaries The disallowed loss generally increases the basis of the acquired property, such that a later resale (to an unrelated party) of the property results in a smaller gain.

ETHICAL CONSIDERATIONS, AUDITS, AND TAX PENALTIES: TAX AUDITS: COMMON TAX TRAPS: Step Transaction Doctrine

Not every transaction has a clear beginning and end, such that it falls clearly within a particular Code section. Often, a series of transactions are involved. If each transaction is viewed separately, there is one tax result. But if the transactions are viewed together, there is a different tax result. This has led to the judicial formulation of the step transaction doctrine. Under the step transaction doctrine, a court may ignore the separate, individual transactions, choosing instead to impose tax based upon the ultimate economic reality of the entire series of transactions.

PROFESSOR'S NOTE: LONG TERM CAPITAL GAINS

Note that the short-term capital loss carryforward is combined with the current year short-term capital loss. The calculation is then handled in the same manner as in the previous example. To calculate the net capital gain or loss, the long-term items are netted, leaving a long-term capital gain of $7,100. The short-term items are netted, leaving a short-term capital loss of $2,700. The long-term capital gain is netted with the short-term capital loss to result in a net long-term capital gain of $4,400. This net long-term capital gain is subject to a preferential tax rate of 15% or 20%, assuming that the taxpayer has a taxable income of greater than $41,675 (single) or $83,350 (married filing jointly 2022). Excess losses, to the extent that they exceed capital gains in any one year, can be deducted only against up to $3,000 of ordinary income. In other words, net capital losses are only deductible up to the lesser of the net capital loss or $3,000. If the taxpayer has net short-term and net long-term losses in the same year, the short-term losses are used first. Net capital losses that cannot be deducted against the current year's ordinary income may be carried forward to later years. Any amounts carried forward to the following tax year retain their original character (short-term or long-term) and are involved in the netting process as if they had occurred in such tax year.

ETHICAL CONSIDERATIONS, AUDITS, AND TAX PENALTIES: TAX AUDITS: COMMON TAX TRAPS: Ownership Attribution Rules

Oftentimes the tax effects of a particular transaction depend upon the percentage ownership of stock before and after the transaction. For example, whether an amount received in redemption of stock is treated as proceeds from the sale of the stock or as a dividend payment will depend on the percentage of stock ownership before and after the redemption. In determining the percentage of stock owned, both actual and constructive ownership are considered. The ownership attribution rules may provide that an individual is deemed to constructively own stock that is actually owned by certain other related individuals. Thus, if a father and son each own 50% of the stock of a corporation, and all of the father's stock is redeemed by the corporation, the father is deemed to own 100% of the stock both before and after the redemption. He owned 50% directly and 50% constructively before the redemption, and 100% constructively through his son after the redemption.

MORTGAGE INTEREST DEDUCTION (2)

Old debt is mortgage debt, or qualified residence interest, incurred on or before December 15, 2017. The deductible qualified residence interest is limited to interest on acquisition indebtedness secured by a principal or secondary residence up to a maximum debt of $1 million ($500,000 for married taxpayers filing separately). As mentioned earlier, acquisition debt is debt that is incurred in acquiring, constructing, or substantially improving any qualified residence of the taxpayer. ACQUISITION DEBT also includes debt from the refinancing of other acquisition indebtedness, but only to the extent of the amount (and term) of the refinanced indebtedness. When a taxpayer refinances, the refinanced indebtedness is treated—for purposes of the special rule just mentioned for debt incurred on or before December 15, 2017 (limiting acquisition indebtedness to $1 million/$500,000)—as incurred on the date the original indebtedness was incurred, to the extent the amount of the indebtedness resulting from the refinancing doesn't exceed the amount of the refinanced indebtedness.

Tax Accounting Methods: Change in Accounting Method

Once an accounting method (e.g., the cash method) has been adopted by either an individual or business, it CAN NOT BE CHANGED (e.g., to the accrual method) WITHOUT APPROVAL FROM IRS. Changes in accounting methods include changes in inventory methods and REQUIRE IRS APPROVAL. A change in accounting method is different, however, from a correction of an error on an individual's or business's tax returns. ERRORS may be corrected by filing an amended return (IRS Form 1040X) with the IRS WITHOUT PRIOR APPROVAL. **Contrary to popular opinion, the FILINING of an AMENDED RETURN will NOT automatically TRIGGER an AUDIT of the original return. However, if the correction results in an additional tax liability, interest and possible tax penalties may apply.

Estate Planning Techniques for the Newly Single: RETIREMENT BENEFITS

One of the most difficult problems in the settlement of a divorce occurs in determining how retirement plan benefits of the participating employee spouse are to be allocated to the other spouse. In a community property state, half of a participating employee's interest, when it is accrued under a retirement plan during marriage, belongs to the spouse. This is true regardless of whether the rights of the participating employee have vested as of the divorce date. In common law or noncommunity property states, the employee's interest in a retirement plan is considered marital property to be shared with the other spouse, although not all states have recognized this principle to date. Therefore, the planner should consult individual state law when faced with such an issue. Qualified domestic relations orders (QDRO) should be used to divide qualified retirement plan assets among spouses at the time of divorce. If a QDRO is valid and approved by the court, retirement plan assets may be transferred from one spouse to the other spouse without any immediate income tax consequences. Benefits from a qualified retirement plan generally may not be assigned or alienated. However, all divorce decrees dealing with the division of retirement plan benefits among spouses must be qualified (in the form of a QDRO) to avoid the problem of improperly assigned benefits. The benefit amounts awarded a spouse under a QDRO may be paid to the alternate payee at the time that the participant reaches their earliest retirement age, which is the earlier of (1) the earliest date that benefits are payable to the participant under the plan, or (2) the later of the date when the participant reaches age 50 or the date on which the participant could start receiving benefits if separating from service. A defined contribution plan can usually be settled with a QDRO. With traditional defined benefit pension plans, a lien must be filed against the accrued benefit. This requires a court order signed by a matrimonial judge and recognized by pension authorities across state borders.

CAPITAL GAINS: Tax Treatment of Dividends (2)

Only certain dividends are eligible for this preferential rate. Dividends received from credit unions, mutual insurance companies, real estate investment trusts, farmers' cooperatives, tax-exempt entities, deductible dividends from employer securities owned by an employee stock ownership plan (ESOP), and dividends on stock owned for less than 61 days in the 121-day period surrounding the ex-dividend date do not qualify. Dividends received on any share of stock that is held for less than 61 days during the 121-day period that began 60 days before the ex-dividend date do not qualify for preferential treatment. The ex-dividend date is the first date following the declaration of a dividend. On this date, the purchaser of a stock is not entitled to receive the next dividend payment. When counting the number of days the stock is held, include the day the stock was disposed of, but not the day it was acquired (the general rule for determining a holding period). Consider the following examples.

PROFESSOR'S NOTE:

Only the calculations for the first three years are shown here. At the optimal point (after three years in the case of five-year property), there is a switch to the straight-line method. This switch is beyond the scope of this text, and beyond the scope of what the planner should ever have to do

ACCIDENT & HEALTH PLANS

PREMIUMS PAID BY THE EMPLOYER for accident, health, and disability income insurance plans (group plans) ARE DEDUCTIBLE BY THE EMPLOYER and generally EXCLUDABLE FROM EMPLOYEE'S INCOME. Benefits paid under employer-sponsored accident and health (medical) plans are also not included in the taxpayer's income. However, if the employer pays all or part of the premiums on a GROUP DISABILITY PLAN, the benefits are TAXABLE to the employee WHEN RECEIVED. If the EMPLOYEE PAYS a PORTION of or the ENTIRE PREMIUM for a disability plan, the BENEFITS received are NOT TAXABLE to the employee, to the extent of the PROPORTION of employee-paid premiums. For example, an employer pays 60% of the premium for disability insurance, and the employee pays 40%. Only 60% of the disability insurance benefits received by the employee under the plan is taxable to the employee. The other 40% is not includable in the employee's income and is tax free.

Alimony and Child Support: Alimony (and Separate Maintenance) Payments: Payments to Third Parties

Payment made by the payor spouse to a third party because of a divorce or separation instrument can be alimony. Cash payment of the payee spouse's mortgage, rent, tuition, or tax liability made by the payor spouse as required by the divorce or separation instrument may qualify as alimony. Payments to maintain property used by the payee spouse, but owned by the payor spouse, do not qualify as alimony, even if required under the instrument. Payments made with respect to jointly owned property are considered half alimony. These property-related expenditures may include mortgage payments, real estate taxes, and homeowners insurance.

Taxation of Cash Value Life Insurance: MEC: POLICY DISTRIBUTIONS

Policy distributions are withdrawals, loans taken as cash or used to pay premiums, and dividends received as cash or used to pay a loan. Policy distributions do not include dividends retained by the insurer to pay premiums or to purchase paid-up insurance or other benefits. Assignments, or pledges, of any part of the modified endowment contract, if they are used to cover burial expenses or prearranged funeral expenses if the maximum death benefit does not exceed $25,000, are also not treated as distributions.

Taxation of Security Transactions: OVERVIEW

Preferential rates apply to long-term capital gains, whereas short-term capital gains are taxed at the taxpayer's marginal income tax bracket. Thus, the holding period of the capital asset makes a tremendous difference in the taxation of that asset. The long-term holding period is more than 12 months, and the short-term holding period is 12 months or less. When computing a taxpayer's holding period, the day of acquisition is not counted but the day of disposition is. The holding period is computed based on calendar months, not days. Thus, if a capital asset is acquired on March 15, it must be held until March 16 of the following year to meet the long-term holding period. Note that the trade date, not the settlement date, is used when determining the holding period of publicly traded securities.

S Corporations and Pass-Through Entities: Qualified Business Income (Pass-Through Business) Deduction (II)

QBI IS DEFINED AS "THE NET AMOUNT OF INCOME, GAIN, AND LOSS WITH RESPECT TO THE TRADE OR BUSINESS." Rental activities may allow for the deduction as long as the rental activity rises to the level of a Section 162 trade or business. However, it's also not entirely clear which rental activities will qualify for the QBI deduction. It is doubtful that owning and managing a single residential rental activity will qualify, but it's possible that ownership and rental of a single commercial building may. A rental real estate activity may also qualify for the deduction if it meets the 250-hour safe harbor test released by the Treasury. The deduction is generally 20% of a taxpayer's QBI from a partnership, LLC, S corporation, or sole proprietorship. Most investment income is not included as part of the QBI. Specifically, the QBI DOES NOT INCLUDE: -- short-or long-term capital gain or loss; -- any dividends or substitute payments in lieu of a dividend; -- any interest income other than interest income that is properly allocable to the trade or business (interest income earned by a lending company, for example, would be directly related to the trade or business); -- any amount received from an annuity that is not received in connection with the trade or business; and -- gains and losses from commodity transactions or foreign currency transactions.

EDUCATION TAX BENEFITS: State Tuition Programs, 529 Plans, and Educational Provisions: State Tuition Programs (3)

Qualified distributions—that is, distributions up to the amount of qualified higher education expenses—are excluded from income. Qualified higher education expenses are tuition, books, fees, and equipment for enrollment at an eligible educational institution; expenses for special needs services for a special needs student; and room and board costs for students who are at least half-time. In addition, expenses for the purchase of computer or peripheral equipment (printer, modem, etc.), computer software, internet access, and related services may be treated as qualifying expenses if the equipment, software, or services are to be used primarily by the beneficiary during any of the years the beneficiary is enrolled at an eligible educational institution. 529 plans may distribute up to $10,000 per year for tuition incurred by the designated beneficiary at a public, private, religious elementary, or secondary school. Qualified higher education expenses are reduced by excludible scholarships or education assistance, and any amounts used for the AOTC, or Lifetime Learning Credits. Any distribution in excess of the allowable amounts excluded from qualified state tuition programs are treated under the Section 72 annuity rules. In other words, the excess distribution is partly a return of capital and partly a distribution of investment income.

Tax Consequences of Property Transactions: CAPITAL ASSETS AND DEPRECIATION: Qualified Dividend Income

Qualified dividend income is a distribution to the shareholder of either cash or property out of the corporation's current or accumulated earnings and profits. A dividend distribution is considered ordinary income to the investor-taxpayer and is not deductible by the distributing corporation. Qualified dividend distributions are eligible for the same 20%/15%/0% rate as are LTCGs, and most dividends declared by a corporate board of directors of a domestic corporation are considered qualified dividends and are permitted the preferential rate. Dividends from a qualified foreign corporation also qualify for preferential treatment. Qualified dividend income may be treated at favorable LTCG rates (0% or 15%/20%) if it meets the following criteria: -- The dividend is declared and paid by a domestic or qualified foreign corporation. -- The stock is held for more than 61 days during the 121-day period beginning 60 days before the ex-dividend date. -- The dividend must generally be paid from a stock or regulated investment company.

FILING STATUS: SURVIVING SPOUSE (SS)

Qualifying widow(er) with dependent child [also called surviving spouse (SS)]. A taxpayer with a dependent child and whose spouse has died within the past three years may use this filing status. For example, an individual whose spouse died in 2022 and has a dependent child may file as a qualifying widow(er) for taxable years 2023 and 2024. During 2022, the widow(er) may file as MFJ because the deceased spouse was alive at some time during that year. The taxpayer must put the dependent's Social Security or taxpayer identification number on the return to use this status. The filing of a joint return in the year of death by a surviving spouse should be coordinated with the administrator or executor of the deceased spouse's estate. Qualifying widow(er) status entitles the taxpayer to use joint income tax return rates.

EXAMPLE: At-risk rules and passive activity loss rules

Reggie is a high-income wage earner currently earning $180,000 annually. Recently, he invested $30,000 for a 15% interest in a RELP as a limited partner. Operations of the activity resulted in a loss of $300,000, of which Reggie's share is $45,000. Reggie does not have any passive income in the current year. As a result, $15,000 of Reggie's loss is suspended under the at-risk rules ($45,000 loss—$30,000 basis), which leaves a potential remaining deduction of $30,000. This $30,000 loss is suspended under the PAL rules because Reggie does not have any passive income with which to offset the loss, and he has not disposed of his entire interest in the passive activity in the current year.

EXAMPLE: Wash sale 2

Roy purchased 100 shares of XYZ stock on September 30, 2021, for $5,000. On December 20, 2021, Roy bought another 75 shares of XYZ stock for $3,300. On January 10, 2022, Roy sold the 100 shares purchased in September for $4,000. Roy has a $1,000 loss on the sale. Because Roy purchased 75 shares of substantially identical stock within 30 days before the sale, he cannot deduct the loss ($750) on 75 shares. He can deduct the loss ($250) on the other 25 shares. The basis of the 75 shares purchased on December 20 is increased by the $750 disallowed loss. The new basis of those shares is $4,050 ($3,300 + $750). The holding period of the remaining 75 shares begins on September 30, 2021, because the holding period is determined by reference to the shares sold in the wash sale.

Passive Activity and At-Risk Rules: DIRECT PARTICIPATION PROGRAMS: S CORPORATIONS

S Corporations are also sometimes used as direct participation vehicles, but their use is somewhat limited by the technical requirements for making and maintaining an S election. These technical requirements include the following: -- maximum 100 shareholders -- limits on who may be a shareholder -- only one class of stock permitted -- limits on the interest, dividend, and rental income that the S corporation may receive Nonetheless, if the shareholder does not materially participate in the operation of the S corporation that shareholder's interest will be a passive activity interest

Taxation of Cash Value Life Insurance: EXCHANGES

SECTION 1035 of the IRC governs the tax treatment on the exchange of one insurance product for another. **SECTION 1035 specifically STATES that NO GAIN OR LOSS SHALL BE RECOGNIZED ON THE EXCHANGE OF ONE LIFE INSURANCE CONTRACT FOR ANOTHER LIFE INSURANCE CONTRACT, ANNUITY, OR ENDOWMENT CONTRACT.** Tax-free exchange treatment ALSO APPLIES to the exchange of an endowment contract for an ANNUITY or another ENDOWMENT CONTRACT providing for payments that start no later than the beginning date under the old contract. This rule also applies to the exchange of an annuity contract for another annuity contract. **Note that AN EXCHANGE from an ANNUITY contract to a LIFE INSURANCE contract CANNOT BE DONE.** Among other considerations, life insurance contracts require medical and financial underwriting, while annuity contracts are more typically non-health related and have greater similarity to investment vehicles.

Tax Treatment of Business Property Gains: Section 1231 Property

Section 1231 property is any depreciable real property or personal property used in a trade or business or for the production of income. As such, it encompasses both Section 1250 property (real property used in a trade or business) and Section 1245 property (tangible personal property used in a trade or business). This does not include inventory or cost of goods sold, which is not depreciable. Section 1231 is a business-friendly section of Tax Code that is designed to encourage businesses to invest in property and thus stimulate the larger economy. There are special tax rules associated with the sale or disposition of Section 1231 property. -- Any such property sold at a gain above the purchase price may be afforded capital gain tax treatment. Nevertheless, take caution—if previous depreciation has been taken exceeding any recognized gain, this portion is ordinary income to the extent of the previous depreciation taken. -- Any such property sold at a loss is afforded ordinary loss tax treatment (rather than capital loss tax treatment with the $3,000 limit or $1,500 for MFS). -- A taxpayer who has a net Section 1231 gain for the current year must report the gain as ordinary income to the extent of any Section 1231 losses reported within the past five taxable years (the lookback rule).

Tax Treatment of Business Property Gains: Section 1245 Property

Section 1245 property is depreciable tangible personal property used in a trade or business. Section 1245 recapture requires any recognized gain on the sale of Section 1245 property to be treated as ordinary income to the extent of any depreciation taken. As a result, the application of Section 1245 is also termed as full recapture. Any remaining gain over and above the Section 1245 recapture amount is considered Section 1231 (capital) gain.

Taxation of Cash Value Life Insurance: SINGLE PREMIUM LIFE INSURANCE

Single premium life insurance begins with one payment, typically of at least $5,000 and usually not more than $1 million. Under the terms of most policies, there are no further payments. The payment may be applied to whole life, universal, or variable life policy. For POLICIES PURCHASED PRIOR TO JUNE 21, 1988, the INTEREST on a single premium life policy is COMPOUNDED on a TAX-DEFERRED BASIS. ** This means the permitted policyholder CAN RECEIVE THIS INTEREST INCOME TAX-FREE BY TAKING OUT COST-FREE LOANS.** When the insured dies, the death benefit and the remainder of the policy (additional paid-up insurance, retained dividends plus interest, etc.) is paid to the beneficiary, free of income taxes. This death benefit is, of course, reduced by loans and any interest owed. A disadvantage to the policy is that, upon its premature lifetime surrender, (due to either lapse or intentional termination) the policyholder is taxed on all the income borrowed over the years plus any other earnings that had previously built up in the account. Holding the policy until the insured's death is, therefore, necessary to avoid potentially adverse tax consequences.

Above-the-Line Deductions: Payments to Keogh (Self-Employed) Plans, Self-Employed SEPs, or SIMPLEs

Small business have several options for retirement plans. Plans designed specifically for small businesses include the Keogh (self-employed) retirement plan, simplified employee pension (SEP), or savings incentive match plan for employees (SIMPLE). A deduction for contributions the owner-employee made to such plans is allowed, but not in the same amount as plan contributions for other employees of the business.

Taxation of Security Transactions: CAPITAL ASSETS (2)

Stocks and bonds, including municipal bonds, held for investment are common examples of capital assets. Personal-use assets (e.g., jewelry, boats, and automobiles) are capital assets. A principal residence is also a capital asset. Even though depreciable property and real estate used in a trade or business are not capital assets, they are IRC Section 1231 assets. Thus, those assets may be entitled to long-term capital gain treatment under Section 1231. The fact that a taxpayer incurs a loss on a capital asset does not make that loss deductible. Generally, a capital loss is allowed only on the sale of an asset held for investment purposes. For example, if a taxpayer sells a personal-use automobile for a gain, that gain is treated as a taxable capital gain. However, the same automobile sold at a loss does not generate a deductible capital loss. Note that the loss on the personal-use asset is simply nondeductible—the capital loss does not enter into the capital gain and loss netting process. Taxpayers who are in the trade or business of dealing in stocks or real property usually do not receive capital asset treatment.

TEST TIP: Capital Gains Netting Procedures

Students are strongly encouraged to first sort gains and losses into their respective buckets before calculating. Pair short term with short term and long term with long term (28%, 25%, 20%, and 15% respectively). Then, if applicable, net them against each other to calculate tax liability.

PROFESSOR'S NOTE: KIDDIE TAX: LTCG

Students should note that qualified dividends and long-term capital gains still receive preferential tax treatment even when the kiddie tax is applied. As you recall from Module 2, the rates on qualified dividends and long-term capital gains are 0%, 15%, and 20%, respectively. These preferential rates apply to the long-term capital gains and qualified dividends that are taxed at the parental tax rates.

PROFESSOR'S NOTE: Active participation standard

Students should note that when AGI limitations apply, the phaseout range is reduced, not the actual loss. If the overall loss is less than the reduced phaseout range, the loss is still fully deductible.

NETTING PROCESS: T-BILLS

T-bills are short-term versions of zero coupon bonds—that is, they make no interest payments per se but are sold at a discounted face value. An investor might buy a T-bill for $9,530 and receive $10,000 six months later at maturity. The difference between the holder's tax basis and the face value is the total return, which is treated as ordinary income. That income recognition falls into the year in which the face value is paid over to the investor, not when the T-bill is purchased. State and local governments do not impose their own taxes on U.S. Treasury securities.

ETHICAL CONSIDERATIONS, AUDITS, AND TAX PENALTIES: TAX AUDITS: Targeted Programs

TARGETED PROGRAMS audits make up approximately 25% of each year's TOTAL OF RETURNS AUDITED. Targeted program audits are not so much a revenue-raising device as a voluntary compliance device. These targeted programs may vary from year to year. A number of years ago, the IRS targeted waiters, waitresses, bartenders, and others who are likely to underreport their tip income. Also targeted were students with unearned income. In the past several years, returns reflecting potential hobby losses and home sale exclusions under Section 121 were being scrutinized. Attorneys and partnerships are now targeted for closer scrutiny. The effect of the targeted program audits is clear. When a particular problem area is singled out, the word quickly spreads, and voluntary compliance is greatly increased.

TYPES OF BUSINESS ENTITIES: C CORPORATIONS: Personal Service Corporation (PSC)

Tax Personal service corporations (PSCs) are regular corporations operating in the professional fields of -- health; -- accounting, architecture, and actuarial science; -- law; or -- engineering and consulting. **An S CORP is a flow-through entity. Income is taxed at the shareholder level. The PSC IS TAXED AT THE ENTITY LEVEL.** Historically, if a business's principal activity was providing services in any of these professional fields, the business may be at a disadvantage if operated as a regular corporation, because the net income of the corporation was taxed at the highest marginal corporate rate. However, under current law all corporate net income is taxed at a flat rate of 21%. During the 1970s, many small-business owners chose to be taxed as corporations. At the time, the IRS felt this entity choice gave them too many unintended tax breaks. After many court challenges, a sort of compromise was reached and the personal service corporation (PSC) was created. Although a PSC may resemble an S corporation to a casual observer, there are major tax differences.

Self-Employment Tax and Health Insurance Deduction: Self-Employment Income TAX(I)

Tax Self-employed individuals (sole proprietors and partners) must pay a self-employment tax. In 2022, the rate is 12.4% (6.2% is paid by the employer and 6.2% is paid by the employee) for Social Security (OASDI) up to the Social Security taxable wage base (TWB), and 2.9% (1.45% is paid by both the employer and the employee) for Medicare, for a total self-employment tax rate of 15.3%. This tax is based on self-employment (SE) income, which is defined as net earnings from self-employment. (If net earnings from self-employment are less than $400 in any one year, no self-employment tax is payable.) There is a taxable wage base amount (cap) applied to the Social Security tax ($147,000 for 2022), whereas there is no cap for the Medicare portion. Finally, an above-the-line deduction is afforded to the self-employed individual for the deductible share of the self-employment tax due. Note that the deductible amount of self-employment tax (the employer share) has not changed for 2022 [7.65%: 6.2% Social Security (OASDI) plus 1.45% Medicare]. The deductible portion is simply half of the self-employment tax.

Tax Planning for the Medicare Contribution Tax (4): TAX LOSS HARVESTING

Tax loss harvesting is a typical approach to tax planning, and will only gain in importance since the additional 3.8% tax applies to the taxpayer's capital gains (if over the threshold). Tax loss harvesting involves selling a security at a loss in order to offset the capital gain from the sale of other securities. If the taxpayer incurs a net capital loss, up to $3,000 annually may be used to offset ordinary income. The final regulations provide that the net capital loss deduction is allowed for purposes of computing the NIIT, as well. If the taxpayer wishes to maintain his position in the same or similar security, then consideration must be given to the wash sale rules. Remember that the wash sale rule disallows (i.e., postpones) the recognition of loss from the sale or other disposition of stock or securities if within a period beginning 30 days before the date of the sale or disposition, and ending 30 days after that date, the taxpayer acquires substantially identical stock or securities

NETTING PROCESS: Treasury Notes and Bonds

Tax treatment of treasury notes and bonds is the same as it is for corporate bonds. In the cases of treasury notes and bonds, that interest is exempt from state and local income taxation.

NETTING PROCESS: Bond Premium and Discount

Taxable and tax-exempt bonds are commonly purchased at a price other than the face value of the bond. A purchase for a price greater than the face value of the bond generates a bond premium. Conversely, if the purchaser pays a price less than the face value of the bond, then the result is a market discount.

EDUCATION TAX BENEFITS: Coverdell Education Savings Accounts (ESAs) (1)

Taxpayers (including corporations, tax-exempt organizations, and other entities) may make annual NONDEDUCTIBLE CONTRIBUTIONS UP TO $2,000, PER BENEFICIARY under age 18, TO A COVERDELL ESA. The beneficiary may be over age 18 if they have special needs as determined by the Treasury Regulations. Contributions are not considered to be a taxable gift. Taxpayers generally have until the due date of the return (not including extensions) to make a contribution. Thus, a taxpayer would have until April 15, 2023, to make a 2022 contribution. However, the contribution may not be made after the beneficiary of the account reaches age 18. For example, if the beneficiary turns age 18 on March 15, 2023, the taxpayer could not make a 2022 contribution after March 15, 2023. The allowed contribution limit begins phasing out ratably for married taxpayers when their modified AGI reaches $190,000 ($95,000 for single taxpayers). The contribution is completely phased out at a modified AGI of $220,000 for married couples ($110,000 for single taxpayers). MAGI is defined as AGI increased by any amounts excluded, due to foreign earned income, or by income earned from sources within the U.S. territories or possessions. These modified AGI limits are not indexed for inflation. A corporation may make contributions to a Coverdell account that has an employee's child as the beneficiary. The contribution would not, however, be considered a gift. It would instead be considered additional compensation to the employee, and would be subject to taxation and withholding.

ETHICAL CONSIDERATIONS, AUDITS, AND TAX PENALTIES: TAX AUDITS: Statute of Limitations

Taxpayers have rights. After the statute of limitations has passed, except in cases of fraud, the IRS cannot audit a return. The statutes to be aware of are as follows: -- Three years from the filing date of the return or due date if later -- Six years if 25% of gross income is unreported -- No statute of limitations for failure to file or if a fraudulent return is filed

EDUCATION TAX BENEFITS: State Tuition Programs, 529 Plans, and Educational Provisions: State Tuition Programs (1)

Taxpayers may make nondeductible contributions to a qualified state tuition program without regard to AGI. There are no federal tax law limitations on the amount that may be contributed, but each state's plan will vary as to the maximum contribution. For example, CollegeInvest, the Colorado 529 plan, allows lifetime contributions of $400,000 per beneficiary. Generally, any accredited public, nonprofit, or proprietary postsecondary institution that accepts a student's use of federal financial aid, is treated as a qualified institution. Eligible institutions include community colleges, public and private four-year colleges and universities, graduate and postgraduate programs, and vocational and trade schools. Also, public or private institutions may sponsor a Section 529 plan. The contributor or beneficiary may not control the investment of contributions or earnings. Typically, there are a limited number of investment options (usually a combination of mutual funds) available to choose from. The contributor may change the investment option only twice per calendar year. The contributor may roll over the account to a different state's plan only once every 12 months. The account beneficiary can be changed to another qualifying family member at any time. Changing the beneficiary to a nonqualifying family member could result in a tax penalty. Age-based investment options are popular. As the beneficiary grows older and enrollment nears, the asset allocation gradually grows more conservative, much like a target-date retirement fund

Tax Consequences of Property Transactions: COST RECOVERY METHODS: Alternative Depreciation System (ADS)

Taxpayers must use the alternative depreciation system (ADS) for listed property that is used 50% or less in business. Listed property includes passenger automobiles, entertainment assets, computers, and phones. ADS must also be used for purposes of making certain alternative minimum tax (AMT) adjustments, assets used outside the United States, tax-exempt bond financed assets, and assets imported from certain countries that maintain discriminating trade restrictions. Taxpayers may voluntarily elect to use ADS for any other type of depreciable assets. Depreciation under ADS is based on the straight-line method.

TYPES OF BUSINESS ENTITIES: C CORPORATIONS: Section 1202 Stock

Taxpayers other than C corporations who hold qualified small business stock (QSBS, or Section 1202 stock) for more than five years may exclude a portion (or all) of the gain on the sale of the stock. For stock acquired after September 27, 2010, the maximum exclusion is 100%. The maximum amount of gain eligible for the exclusion is limited to the greater of: -- 10 times the taxpayer's basis in the stock; or -- $10 million of gain from the stock in that corporation. The qualified small business corporation must be a C corporation and must not have aggregate gross assets in excess of $50 million when the stock is issued. Also, 80% or more of the value of corporate assets must be used in the active conduct of one or more qualified trades or businesses. Qualified trades or businesses are businesses other than those performing services in a personal service field; in the areas of finance, banking, real estate, leasing, mineral extraction, and farming; or hotels, motels, restaurants, or similar businesses. The amount of gain that may be excluded depends upon when the qualified small business stock was acquired. As discussed previously, if the stock was acquired after September 27, 2010, the maximum exclusion is 100%. If the QSBS was acquired between February 17, 2009, and September 27, 2010, the exclusion was 75% of the gain. For QSBS acquired before that, the maximum exclusion was 50%. It is not necessary to memorize all the changes that have taken place to the exclusion percentage over the years. The stock must be original issue stock acquired after August 10, 1993. It must be acquired for money or property other than stock, or it must be acquired as compensation for services other than underwriting. The amount of gain not excluded (when the exclusion was 50% or 75%) under this provision is subject to a maximum capital gain rate of 28%. If the QSBS sale exclusion is 100%, then there is no AMT preference generated. In all other cases, 7% of the amount of gain excluded under this provision is treated as a preference item for purposes of the alternative minimum tax.

Tax Reduction and Management Techniques: Qualified Charitable Distributions

Taxpayers over age 701⁄2 can make qualified charitable distributions (QCDs) of up to $100,000 per year. Briefly, if the withdrawal goes directly to a qualified charity, the proceeds are tax free. A QCD also satisfies required minimum distribution rules. How do contributions to traditional IRAs after age 701⁄2 affect QCDs? Can someone make a post-701⁄2 contribution to a traditional IRA and then make a QCD? No. The SECURE Act of 2019 has an anti-abuse rule to prevent this sort of "double-dipping." Any QCD will be reduced, but not below $0, by the cumulative post-701⁄2 IRA contributions.

Tax Law Compliance and Procedures: Private Letter Rulings (PLRs)

Taxpayers who are in doubt about the particular tax consequences of a contemplated transaction may ask the National Office of the IRS for a ruling on the tax question involved. Generally, the IRS has discretion about whether to rule or not and has issued guidelines describing the circumstances under which it will issue a ruling on a question posed by a taxpayer. Unlike revenue rulings, letter rulings (or private letter rulings) apply only to the particular taxpayers asking for the ruling and are not applicable to all taxpayers. For those requesting a ruling, the response might be insurance against surprises because, as a practical matter, a favorable ruling should preclude any controversies with the IRS on a subsequent audit. Citations for letter rulings and technical advice memoranda follow a multi-digit file number system. IRS Letter Ruling 8745016 may serve as an example: 87 is the year the ruling was issued, 45 is the week of issuance, and 016 is the number out of the rulings issued that week.

Tax Treatment of Business Property Gains: Installment Sale Treatment (I)

The general rule of taxation regarding most property dispositions is that all gains are recognized (taxable) in the year of sale. However, an exception to this rule applies to the installment sale method of accounting. An installment sale is any sale of property (with the exception of certain property that may not be sold using the installment method) in which the seller receives at least one payment after the year of sale. As such, the installment method permits the taxpayer to spread out the taxable gain as payments are received using the following formula: profit/total contract price = gross profit percentage The profit is calculated by subtracting the seller's adjusted basis in the property sold from the total contract price.

EXCESS SOCIA SECURITY TAXES

Taxpayers who have more than one job may be entitled to a refundable credit with respect to the old age, survivors, and disability insurance (OASDI) portion of the Social Security taxes they have paid. The 2022 wage base for the OASDI tax is $147,000; for the Medicare tax, the wage base is unlimited. The result is that W-2 employees are required to pay 7.65% of the first $147,000 of wages paid to them in 2022, and 1.45% on any wages above the Social Security wage base. Note that the employer is required to match these amounts by paying 7.65% of the first $147,000 and 1.45% on any wages above the wage base. This is not an employer-by-employer limit; it is for total wages received from all employers during the year. Each employer, however, is required to withhold OASDI on the first $147,000 of wages paid to an employee. Consequently, taxpayers working for more than one employer may have excess amounts of OASDI tax withheld from their wages. In such cases, the taxpayer is entitled to a refundable credit for the Social Security tax that was withheld on wages in excess of the OASDI wage base

IMPUTED INCOME AND THE ALTERNATIVE MINIMUM TAX: CALCULATION OF AMT

Technically, the alternative minimum tax is calculated from adjusted taxable income. However, for simplicity's sake the logical starting point for calculating the AMT is adjusted gross income, as opposed to taxable income. The AMT may be calculated as follows: Step 1. Adjusted gross income (AGI) is increased by any tax preference items and increased or decreased by the appropriate adjustments. Step 2. That figure is reduced by the allowable itemized deductions. The resulting figure is the alternative minimum taxable income (AMTI). Step 3. The AMTI is then reduced by the appropriate AMT exemption amount to arrive at the AMT base. Step 4. A tax rate of 26% applies to AMT base amounts up to and including $206,100 (2022). A 28% rate applies to amounts in excess of $206,100. The 15% or 20% rate applicable to long-term capital gains and qualified dividends also applies for AMT purposes. Step 5. The AMT amount is compared to the regular tax. -- If the regular tax after credits equals or exceeds the AMT amount, then no AMT payment is required. -- If the regular tax is less than the AMT amount, then the difference is the AMT payment required. Step 6. The AMT payment required is then reduced by any refundable credits, and the allowable AMT foreign tax credit, and the low-income housing credit for low-income housing property placed in service after 2007. For 2013 and beyond, the personal nonrefundable credits are allowed against the AMT, as well as being used against the regular income tax liability. Among those allowed are the adoption credit, the child and dependent care credit, the child tax credit, and the Lifetime Learning and American Opportunity Tax Credits.

SELF-EMPLOYED (2)

The ADDITIONAL MEDICARE TAX of 0.9% also applies to self-employed individuals who have a COMBINED INCOME GREATER THAN $200,000 if SINGLE and $250,000 if MFJ. The tax is LEVIED ON the NET EARNINGS from self-employment of the sole proprietor or partner and CONSISTS OF the GROSS INCOME derived from any trade or business, LESS allowable DEDUCTIONS attributable to this trade or business (generally Schedule C); or the TAXPAYER'S distributive SHARE of the ORDINARY INCOME or LOSS of a PARTNERSHIP (NOT an S CORP) engaged in a trade or business (Schedule K -1). For WAGE EARNERS (taxpayers employed by another), the EMPLOYER PAYS 6.2% OASDI share that is levied on earnings up to the taxable wage base, and the EMPLOYEE-TAXPAYER ALSO PAYS 6.2% on the same amount of compensation. The EMPLOYER will PAY 1.45% of the Medicare tax (half of the 2.9% due) ON TOTAL AMOUNT OF COMP. earned by the employee, AND the EMPLOYEE WILL ALSO PAY 1.45%. The ADDITIONAL MEDICARE TAX of 0.9% APPLIES TO WAGE EARNERS as well, but it is NOT MATCHED BY EMPLOYER. The FICA PAID BY THE EMPLOYEE is NOT DEDUCTIBLE deductible, but the SHARE PAID BY EMPLOYER in fact IS DEDUCTIBLE on the employer income tax return as an ORDINARY and NECESSARY business EXPENSE.

EDUCATION TAX BENEFITS: American Opportunity Tax Credit (AOTC) (1)

The American Opportunity Tax Credit (AOTC) provides a maximum tax credit of $2,500 per student for qualified tuition and related expenses incurred by the taxpayer, the taxpayer's spouse, or a dependent of the taxpayer. This credit is offered during the first four years of postsecondary education, during which the student is required to attend school at least half-time for at least one academic period during the year (i.e., greater than 5 months). The credit is calculated as 100% on the first $2,000 of qualified expenses and 25% on the next $2,000. Thus, it takes $4,000 of qualifying expenses to reach the maximum credit amount of $2,500 (100% of 2,000 = $2,000; 25% of 2,000 = $500; $2,000 + $500 = $2,500 maximum credit). Qualified higher education expenses include tuition, books, supplies, and equipment needed for a course of study. Qualified expenses do not include room, board, nonacademic fees (e.g., student activity, athletic, or insurance fees), or student health fees. Also, noncredit courses or courses involving sports, games, or hobbies do not qualify for the AOTC, unless those courses are a part of the student's degree program. Generally, any accredited public, nonprofit, or proprietary postsecondary institution that is eligible to participate in the federal student loan program (considered a Title IV institution) is treated as a qualified institution. The AOTC may be elected for a student's expenses for only four tax years, and only for students who have not completed the first four years of postsecondary education as of the beginning of the tax year. An eligible student cannot include individuals convicted of any federal or state or felony drug offenses for possession or distribution.

TEST TIP: CARRY FORWARD

The CFP® exam often tests the largest deduction in the first year rather than the largest deduction over six years (i.e., the initial year plus the carry forward). Students are advised to read such question carefully. Also, with a carry forward, if there is some question about the taxpayer's projected ability to generate enough AGI in future years, maximizing the first year deduction may be advisable.

Child and Dependent Care Tax Credit

The Child and Dependent Care Tax Credit is a nonrefundable tax credit and is permitted for a portion of dependent care expenses paid for the purpose of allowing the taxpayer to be gainfully employed. To be eligible to take the credit, the taxpayer must: 1) have earned income 2) be paying the dependent care expenses in order to work (or be looking for work) and 3) keep a home for a qualifying individual. A qualifying individual is 1) a qualifying child younger than the age of 13 or permanently and totally disabled 2) the taxpayer's spouse who is physically or mentally incapable of self-care or 3) any other person who is physically or mentally incapable of self-care (and is eligible to be a qualifying relative). The credit is decreased depending on the taxpayer's AGI. Eligible expenses are capped at $3,000 for a single eligible dependent and $6,000 for two or more eligible dependents. A sliding-scale credit percentage of 20%-35% of the taxpayer's work-related expenses applies. The highest credit percentage (35%) applies to taxpayers with AGI of $15,000 or less. The lowest credit percentage (20%) applies to taxpayers with AGI of more than $43,000.

CARES Relief and Tax Credits

The Coronavirus Aid Relief and Economic Security (CARES) Act was passed by Congress and signed on March 27, 2020. The $2 trillion stimulus legislation was a direct response to the highly unusual economic downturn that resulted from the COVID-19 pandemic and the stay-at-home orders that many state governors issued to slow the spread of the virus. Barring further action from Congress, the majority of the provisions contained within the CARES act appear to be limited to 2020. Some, however, will remain in place until at least 2022.

NETTING PROCESS: FIFO

The FIFO method is the default method used by the IRS, in the event that the investor does not prove specific identification or chooses the average cost method. FIFO is generally the LEAST ADVANTAGEOUS method to the investor in calculating the cost of mutual fund shares and and the gain that may result from their sale. This is the case if the shares in the fund purchased later were more expensive than earlier purchases. Under this method, the IRS uses the first-purchased mutual fund shares (i.e., presumably lower costs) to determine which shares are sold for purposes of computing a gain or loss.

ADDITIONAL MEDICARE TAX: SUMMARY OF TYPES: COMPUTING SELF EMPLOYMENT TAX

The FIRST STEP when computing the self-employment tax is to reduce the self-employment income by 7.65%. THIS IS ALWAYS THE FIRST STEP. This 7.65% reduction applies whether the self-employment income is above or below the wage base. Thus, if the taxpayer has self-employment income of $100,000, we reduce that amount by 7.65% and pay self-employment tax on the remaining $92,350. (The subtraction of 7.65% is the same as multiplying by .9235. In the previous example, $100,000 × 0.9235 = $92,350.) If there are no wages involved, or if the sum of the wages and the net earnings from self-employment do not exceed the wage base, the computation is straightforward. For example, assume that a taxpayer has self-employment income of $30,000. Simply reduce the $30,000 by 7.65% and multiply the result by 15.3%. Note that the full $30,000 is included as income for regular tax purposes. The 7.65% adjustment applies only to the computation of the self-employment tax. $30,000 - (7.65% × $30,000) = $27,705 of net earnings from self-employment $27,705 × 15.3% = $4,238.87 of self-employment tax If the net earnings from self-employment exceed the wage base of $147,000 but are below the level where Additional Medicare A Tax applies, the full 15.3% is calculated on $147,000, and the additional 2.9% is calculated on the excess. If the taxpayer has self-employment income over $200,000 for single taxpayers, or $250,000 combined self-employment income for joint returns, then the Additional Medicare Tax of 0.9% must be accounted for.

PROFESSOR'S NOTE: TAX PRISON

The IRS does not have the direct authority to send a taxpayer to prison. The IRS may conduct a criminal investigation, but ultimately only the courts are able sentence a taxpayer to imprisonment.

ETHICAL CONSIDERATIONS, AUDITS, AND TAX PENALTIES: TAX AUDITS: Document Matching Programs

The IRS has developed several programs designed to match information documents (e.g., W-2 forms and 1099 forms) with the individual taxpayer's return. Other information documents, such as those that indicate the amount of mortgage interest paid, also are matched with taxpayers' returns. This matching is done when the returns enter the audit process. A separate program also matches the information documents with the returns that are not in the audit process. Thus, the IRS is able to detect discrepancies in taxpayer return filings and substantially increase its efficiency in checking for compliance.

Documenting the Charitable Deduction (4)

The IRS has stated that, for contributions through payroll deductions, employer-furnished documents (pay stub, Form W-2) and pledge cards from the donee organization will be treated as "written communications from donee" that meet substantiation requirements. There are special rules that apply to contributions of tangible personal property which depend on intended use. For example, unless the donor has actual knowledge that the charity plans to sell the gift, the donation of a painting to an art museum could be treated as use related, since the museum can use the painting to further its charitable purpose of promoting the display, knowledge, and appreciation of works of art. This result is true even if the museum subsequently does sell the painting.

TYPES OF BUSINESS ENTITIES: C CORPORATIONS: ACCUMULATED EARNINGS TAX

The OBJECTIVE OF the ACCUMULATED EARNINGS TAX is TO COERCE the regular CORP into PAYING DIVIDENDS to its shareholders. The tax generally applies whenever a corporation accumulates earnings beyond its reasonable business needs (as established by a preponderance of the evidence in the judgment of the IRS). However, EVERY REGUAR CORP can ACCUMULATE UP TO $250,000 in RETAINED EARNINGS WITHOUT having to PROVE a REASONABLE BUSINESS NEED. If the accumulated earnings tax does apply, it is ASSESSED AT A RATE of 20% of ACCUMULATED TAXABLE INCOME for the year (beyond the $250,000 floor) and is in addition to the regular corporate tax. The accumulated earnings tax IMPOSES A PENALTY TAX OF 20% ON THE EARNINGS OF A C CORP that are accumulated beyond the reasonable needs of the business. A CORP that is NOT a PERSONAL SERVICE CORPORATION (PSC) may accumulate up to $250,000 without having to prove a valid business purpose. A PSC has an accumulation limit of $150,000 before a valid business purpose must be shown. **If a corporation accumulates earnings IN EXCESS of the accumulation limits, or beyond the reasonable needs of the business, the ONUS IS ON THE CORPORATION to prove that no tax avoidance purpose exists.**

Social and Economic Federal Tax Law Assumptions: Tax Law Doctrines

The IRS is well aware of tax management techniques in use today by tax and financial planning practitioners. They also have an opinion as to what constitutes proper tax management and what constitutes abusive tax planning practices. Accordingly, tax law doctrines have been developed by the IRS and courts to guide practitioners with what is proper (versus abusive) tax management. The following are three of the doctrines. -- BUSINESS PURPOSE DOCTRINE - This doctrine stipulates that a transaction will not be effective for income tax purposes unless it is intended to achieve a genuine business purpose other than tax avoidance. An example is a high tax bracket individual taxpayer forming a regular corporation simply to take advantage of the lower rates afforded to the corporation on the sale or disposition of assets. In this case, the corporate entity will be ignored because it lacks a valid business purpose. -- ASSIGNMENT-OF-INCOME DOCTRINE —This doctrine is generally well-known under the colloquial term the fruit of the tree. A taxpayer who earns income and is the source of that income (i.e., the tree) cannot assign that income (i.e., the fruit) to someone else for income tax purposes (i.e., separate the fruit from the tree). As a result, the taxpayer who actually earns the income will be taxed on that income. -- TAX BENEFIT RULE OR DOCTRINE —This rule converts otherwise nontaxable receipts into taxable income. The most common example is when a taxpayer is reimbursed in a subsequent year for medical expenses paid and deducted in a previous year. Because the taxpayer received a tax benefit (via the previous year's medical deduction) the application of the rule results in the taxability of subsequent medical reimbursements (an otherwise nontaxable item)

PROFESSOR'S NOTE: DEPRECIATION DEDUCTIONS

The IRS will impute depreciation allowed or allowable. In other words, for capital gain tax purposes, the tax authorities will presume depreciation was taken whether it was in fact or not. Taxpayers are thus all but compelled to take depreciation deductions whenever they are available.

EDUCATION TAX BENEFITS: Lifetime Learning Credit

The Lifetime Learning Credit is a nonrefundable credit of up to $2,000; it is equal to 20% of up to $10,000 of qualified tuition expenses. The Lifetime Learning Credit is phased out between $80,000 and $90,000 of AGI for single taxpayers, and between $160,000 and $180,000 of AGI for married taxpayers filing jointly. The Consolidated Appropriations Act of 2021 aligned these phaseout limits with the AOTC intentionally. There are several important differences between the AOTC and the Lifetime Learning Credit. The Lifetime Learning Credit is available annually for an unlimited number of years. It is available for expenses related to acquiring or improving job skills (such as continuing professional education through qualifying institutions), and it is available for undergraduate, graduate, or professional degree expenses. Qualified education expenses generally include tuition only. However, amounts paid for books, supplies, and equipment may be included if required to be paid to the institution as a condition of enrollment or attendance. Noncredit courses or courses involving sports, games, or hobbies do not qualify for the Lifetime Learning Credit, unless the course helps the student acquire or improve job skills. Generally, any accredited public, nonprofit, or proprietary postsecondary institution that is eligible to participate in the federal student loan program (via a Title IV institution) is treated as a qualified institution. Expenses, for a student who qualifies for the AOTC credit, do not qualify for the Lifetime Learning Credit.

Tax Consequences of Property Transactions: COST RECOVERY METHODS: 200% Declining-Balance Method

The MACRS table is based on the 200% declining-balance method, with the half-year convention. Unlike other depreciation methods (such as straight line), when using the 200% declining-balance method, we must reduce the basis before computing next year's depreciation. Assume a client purchased machinery for $75,000. The annual depreciation deductions for the first three years, using the double-declining-balance (MACRS) method, is computed by doubling the straight-line rate of 20% to get 200% of the straight-line rate, which is 40%. We then must account for the half-year convention. This brings the first-year percentage down to 20%. This is multiplied by the basis of $75,000 to give us a $15,000 first-year deduction. Straight-line rate for five-year property = 20% Twice the straight-line rate = 40% 40% × $75,000 × 1⁄2 = $15,000 first-year deduction When computing the second-year depreciation, start with the basis of $75,000 and reduce that amount by the first-year depreciation deduction of $15,000. Thus, the second-year depreciation deduction is calculated based on the balance of $60,000. $75,000 - $15,000 = $60,000 × 40% = $24,000 second-year deduction When computing the third-year depreciation, start with the reduced basis of $60,000 and reduce that by the second-year depreciation deduction of $24,000. Thus, the third-year depreciation deduction is calculated based on the balance of $36,000. $60,000 - $24,000 = $36,000 × 40% = $14,400 third-year deduction The double-declining-balance method is shown in the following table so that the practitioner understands how to quickly calculate the deductions for the first couple of years without referring to the MACRS table. Students do not need to memorize this table. It is intended as a study aid.

Tax Planning for the Medicare Contribution Tax (6): TRUSTS & ESTATES

The Medicare contribution tax also applies to certain trusts and estates. In this case, the 3.8% tax applies to the lesser of (1) the undistributed net investment income for the taxable year, or (2) the excess of the AGI (as defined in IRC Section 67(e)), over the dollar amount at which the highest income tax bracket for an estate or trust begins. For 2022, the highest marginal bracket applicable to trusts or estates begins at $13,450. The tax does not apply to a trust in which all of the unexpired interests are devoted to charitable purposes, to trusts that are exempt from taxation under Section 501, or to charitable remainder trusts exempt under Section 664. Based on the statutory language, the Medicare contribution tax should not apply to simple trusts, as all of the income is required to be distributed currently. Thus, there should be no undistributed net investment income for the taxable year. Also, the tax should not apply to a grantor trust, as the grantor is treated as the owner of the trust, and the trust income is reported on the grantor's income tax return.

Passive Activity and At-Risk Rules: Disposition of Passive Activities/Suspended Losses and Carryovers

The PAL limitation is not a permanent disallowance rule. When a taxpayer disposes of his entire interest in a fully taxable transaction to an unrelated purchaser (not a related party), his suspended losses from that activity, including any losses incurred in the year of disposition, are generally deductible in full. What constitutes disposition of a taxpayer's entire interest in a passive activity? It is a disposition of his interest in all entities that are engaged in the passive activity and, to the extent that the activity is owned in the sole proprietorship form, all of the assets used or created in that activity. In a taxable disposition of a passive activity property, suspended losses from the activity are first offset against any gain on the sale of the activity, then against current year passive income from other passive activities. Any remaining unused losses are then classified as non-passive and may be used to offset income from non-passive activities (such as salary and interest). Finally, when determining the amount of suspended loss that may be used against income, the at-risk rules are applied before the PAL rules. This means that if a loss is not allowed because of the at-risk limitations, the loss is not a suspended loss eligible for deduction as a disposition of a passive activity. Rather, the loss continues to remain suspended under the at-risk rules.

Taxation of Cash Value Life Insurance: MODIFIED ENDOWMENT CONTRACT (MEC) (2)

The SEVEN-PAY TEST (IRC 7702A) assumes a step process over the first seven years of the cash value life insurance contract. Putting too much premium in the life insurance contract, either each year or cumulatively, will trigger MEC status. Essentially, the IRS is asserting that cash value life insurance is simply too good of a tax shelter and it is necessary to curb or regulate its use. Significantly, there is no explicit penalty for a policy simply being a MEC. If withdrawals or loans are taken from the policy, they are given unfavorable LIFO treatment. For MECs, taxation, like an annuity, is only relevant if the internal cash value is withdrawn or loaned from the policy. In fact, single pay or limited pay life insurance contracts utilized for estate planning may be intentionally structured as MECs. Normally dividends are treated as a tax-free return of excess premiums paid in a participating whole life contract. **However, in a MEC, TAKING the DIVIDENDS IN CASH is considered a TAXABLE EVENT, as is electing to use whole life dividends to offset an outstanding loan.** Electing to use dividends to buy paid-up additions could defer taxation on the MEC dividends, and could even eliminate the tax liability upon the death of the insured. In other words, the withdrawal is considered earnings first (taxed as ordinary income) and then on a LIFO basis, and there is a potential 10% PREMATURE DISTRIBUTIONS PENALTY on the taxable portion of the distribution. This means that distributions, primarily withdrawals or loans, will be treated on a LIFO basis; therefore, proceeds from distributions will be taxed first as ordinary income to the extent that the cash surrender value exceeds the investment in the contract. Further, if the policyholder withdraws more than the earnings within the contract, then the distribution begins eating into the basis, and the basis in the contract will be reduced. This will affect the taxation of future withdrawals or loans, if any. This rule will also apply if a distribution is kept by the insurance company to pay premiums. Further, all MECs issued by the same company, to the same policyholder, during a calendar year will be treated as one contract. An early withdrawal penalty of 10% will typically be imposed on the taxable portion of a distribution made before the policyholder is age 591⁄2. The penalty will not apply if the policyholder meets one of the exceptions to the premature distribution penalty. For example, if the policyholder becomes disabled, the distribution is annuitized over the life of the policyholder, or the joint lives of the policyholder and a beneficiary. During the first seven years of the contract, the rules will apply only to those distributions that occur during the year the contract fails to meet the seven-pay test and all subsequent years.

PROFESSOR'S NOTE: ANNUITY "START DATE"

The START DATE refers to the date that the contract is annuitized. In other words, it is when the periodic payments begin under the annuity contract. For annuity contracts that annuitized prior to 1987, the exclusion ratio generally is applied to all future payments, even if the annuitant outlives their life expectancy. However, for annuities that started after 1986, the entire annuity payment is taxable once the investment in the contract has been recovered.

Electing Section 179 Expense Treatment (I): OVERVIEW

The Section 179 expense election has been an important part of the planning related to the acquisition of property. This election allowed for a much larger deduction than would otherwise have been available in the year the property is acquired. Given the 100% immediate expensing allowed by the bonus depreciation provision, the necessity of Section 179 is greatly diminished. It appears that the primary use of Section 179 will be in activities that are generally prohibited from utilizing the bonus depreciation provision. In writing off (expensing) the cost of tangible personal property used in a trade or business, an accelerated or faster method of cost recovery is permitted. The Section 179 expense election allows an annual expensing of the cost of tangible personal property (such as business computers or business trucks) in any one year up to a certain amount.

Above-the-Line Deductions: Deductible IRA Contributions (2)

The Setting Every Community Up for Retirement Enhancement (SECURE) Act was signed December 19, 2019. The goal is to: (1) increase the number of people participating in retirement plans and (2) increase the length of time they invest in the plan. The act makes it easier to save for retirement. It also makes retirement plans more accessible to more people. Most changes based on the new law took effect January 1, 2020. In theory, these changes will relieve pressure on the Social Security system. Long-term part-time workers, such as students or primary family caregivers, will have easier access to 401(k) plans. Previously, an employee must have worked at least 1,000 hours per year for three consecutive years to be admitted to the plan. Now employees who work at least 500 hours per year for three consecutive years can make elective deferrals. Employers, however, are not required to make matching contributions for part-time employees. Note, therefore, that the full-time employer matching requirements still apply. Prior to 2020, the age limit to contribute to an IRA was 701⁄2. Starting in 2020, workers of any age can make retirement contributions, provided they have earned income. The previous RMD rule was that the withdrawal must have been made no later than April 1 of the year after the account holder turned age 701⁄2. The new rule is that the RMD must be taken by April 1 in the calendar year after the participant reaches age 72. The SECURE Act also broadened the definition of earned income for IRA purposes. For instance, fellowships and stipends among graduate students are now considered earned income and are eligible for IRA contributions.

TOTAL INCOME: OVERVIEW

The Starting point for reading and analyzing the U.S. Individual Income Tax Return is the income section of the return on the front of IRS FORM 1040. GROSS INCOME for tax purposes is "ALL INCOME FROM WHATEVER SOURCE DERIVED," unless specifically excluded. This terminology is TAKEN DIRECTLY FROMT THE 16TH AMENDMENT and encompasses all items that constitutionally can be considered income, except for certain items that are specifically excluded by another provision of the Internal Revenue Code. Items such as WAGES, COMMISSIONS, TIPS, PRIZES & AWARDS, UNEMPLOYMENT compensation, HONORARIUMS, INTEREST, DIVIDENDS, SOLE PROPRIETORSHIP income, RENTS, ROYALTIES, GAMBLING income, JURY DUTY FEES received, and PARTNERSHIP INCOME all must be recognized (treated as income) and included as TOTAL INCOME for tax purposes.

Tax Consequences of Property Transactions: COST RECOVERY METHODS: Bonus Depreciation

The Tax Cuts and Jobs Act of 2017 (TCJA) liberalized and extended the provision that provides for additional first-year depreciation, or bonus depreciation. This provision allows taxpayers to claim 100% first-year depreciation, or bonus depreciation of 100% of the basis of the asset purchased. As an example, a taxpayer may purchase $200,000 of equipment for their manufacturing business, and immediately depreciate (deduct) all $200,000 of the cost. There is no dollar limit on the bonus depreciation that is allowed. The TCJA allows 100% first-year bonus depreciation for qualifying assets placed in service between September 28, 2017 and December 31, 2022. The bonus depreciation percentage will begin to phase out in 2026. The law includes used property, subject to restrictions. Previously, only new property was eligible. The inclusion of used property represents a major, business-friendly policy shift from previous bonus depreciation rules. Broadly speaking, the property will qualify if the taxpayer didn't use the property at any time before acquiring it and did not acquire the property from a related party or from a controlled corporation or business.

S Corporations and Pass-Through Entities: Qualified Business Income (Pass-Through Business) Deduction (I)

The Tax Cuts and Jobs Act of 2017 (TCJA) reduced the corporate tax rates from a high of 35% to a flat 21% for tax years after 2017. As the tax rate on C corporations was reduced, Congress felt it appropriate to reduce (potentially) the rates at which other (non-C corporation) businesses are taxed. To accomplish this, Congress provided a potential deduction equal to 20% of the QBI that owners of pass-through business may deduct in calculating their personal income tax. In other words, taxpayers who qualify for the full deduction may only pay income tax on 80% of the business income that flows through to them. The deduction is available to all taxpayers other than C corporations. This section focuses on the rules as they apply to the deduction for individual taxpayers. Keep in mind that there are various aspects of this provision that will need clarification from the Treasury in the form of Regulations, and that there are numerous intricacies that are beyond the scope of this discussion. To qualify for the deduction, the income must be from a qualified trade or business. A qualified trade or business, as defined by the Regulations, is a Section 162 trade or business. This concept is not well-defined in either the Code or the Regulations; there is no bright-line test to determine if an activity meets the Section 162 trade or business requirement. Under case law, we know that the taxpayer must enter into and carry on the activity with a good-faith intention to earn a profit, and the taxpayer must also participate in the activity on a regular and continuous basis.

Social and Economic Federal Tax Law Assumptions: Purposes of the Federal Tax Law

The United States was not always the wealthy nation it is today. In fact, early in its existence the federal government was often strapped for cash. In 1909, Congress passed the Sixteenth Amendment, which states, "The Congress shall have the power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several states, and without regard to any census or enumeration." In 1913, the required number of states ratified the Sixteenth Amendment, and taxation of income began on March 1 of that year. Since that time, the federal income tax system has played an important role in an individual's investment decisions. There are three primary objectives served by the federal tax law. The most obvious objective is to raise revenue. Perhaps as important as the revenue-raising objective are both the economic and social objectives of taxation. This section focuses on the purposes of federal tax law, which include 1) raising revenue, 2) economic growth and development, and 3) price stability. It is important for the financial planner to understand these purposes in order to correctly anticipate a change in the tax law and to minimize the adverse effects on clients' financial plans.

PROFESSOR'S NOTE: ACTIVE PARTICIPATION RENTAL REAL ESTATE EXCEPTION

The active participation rental real estate exception does not apply to mixed use rentals. Unlike a pure rental, if expenses exceed income on a mixed use property, they are treated as nondeductible personal expenses, not business expenses. In other words, total deductions are limited to rental income.

Adoption Credit and the Adoption Expense Exclusion

The adoption credit is a nonrefundable tax credit for qualified adoption expenses that is generally taken in the year the adoption becomes final. Qualified adoption expenses include adoption costs, court costs, and attorney fees, but do not include costs of a surrogate parenting arrangement or any costs incurred for adopting a spouse's child (i.e., a second family). The credit may be allowed for the adoption of a child with special needs, even if the taxpayer does not have any qualified expenses. The maximum credit (in 2022) is $14,890 per child, including children with special needs. The credit is phased out ratably for taxpayers with MAGIs of $223,410-$263,410 (2022). The credit is limited to the taxpayer's tax liability and may not reduce the tax liability below zero. Any unused credit may be carried forward for up to five years. Employees may exclude from gross income adoption assistance payments received from an employer for the adoption of a child under a written adoption assistance program. In 2022, the adoption exclusion amount is $14,890. For 2022, the amount excludable from an employee's gross income will be phased out ratably for taxpayers with MAGIs of $223,410-$263,410.

Annual Deductions Limits: The 50% Election

The amount of charitable deduction that may be taken in a given year historically has been restricted by the limitation that deductions for long-term capital gain property (and appreciated, use-related, tangible personalty held more than one year) may not exceed 30% of a taxpayer's AGI if the contribution is made to a 50% organization. However, a taxpayer may make a so-called 50% election (reduced deduction election). In this event, the taxpayer elects a deduction of up to 50% of AGI in a given year, but they are limited to the adjusted basis of the property as the total allowable amount of deduction. This election only applies to contributions of long-term capital gain property made to 50% organizations. The 50% election makes the most sense if the difference between the FMV and the basis is relatively small, as in the following example. Another situation where the 50% election should be considered is when the taxpayer is in a higher marginal income tax bracket in the current year than in future carryforward years. Maximizing the deduction in the current year by using the 50% election may result in the greatest tax savings.

PROFESSOR'S NOTE: AT-RISK RULES

The at-risk rules are applied before the limits of the passive activity loss rules. They operate together such that, even if the taxpayer can avoid the restrictions of the at-risk rules, the passive activity loss rules will likely still preclude an income tax loss on an annual basis.

NETTING PROCESS: BASIS

The calculation of basis can be complicated particularly if the investor has bought a number of shares at different times over a period of years. In this situation, there are three methods the investor may use in calculating basis: (1) specific identification, (2) average cost, and (3) FIFO.

PROFESSOR'S NOTE: PORTFOLIO INCOME

The capital gain or loss resulting from various security transactions is categorized as PORTFOLIO INCOME. Remember that losses from passive activities generally can offset only passive income and cannot shelter portfolio investment income until the individual disposes of their interest in the passive activity.

TEST TIP: CHARITABLE CONTRIBUTION PROPERTY

The charitable contribution deduction is a function of two things: 1). the type of property contributed and 2). the type of organization to which the property is contributed. The amount of the charitable deduction allowed for qualifying contributions is generally the FMV of the property on the date of the contribution. However, for gifts of ordinary income property, the deduction is based on the adjusted basis of the property.

PROFESSOR'S NOTE: CHARIABLE CONTRIBUTIONS

The charitable contribution deduction is allowed for contributions of cash or property only. Time and talent donated to charitable causes are not deductible.

ETHICAL CONSIDERATIONS, AUDITS, AND TAX PENALTIES: TAX AUDITS: COMMON TAX TRAPS: Assignment of Income Doctrine

The classic statement of the assignment of income doctrine is that ANY ARRANGEMENT BY WHICH THE FUNDS ARE ATTRIBUTED TO A DIFFERENT TREE FROM THAT ON WHICH THEY GREW WILL NOT BE RECOGNIZED FOR TAX PURPOSES. As long as a taxpayer retains control over the tree, they will be taxed on its fruit, even though they have assigned all of the rights to the fruit to another. Thus, even though a taxpayer effectively and irrevocably assigns the rights to receive income to another, and the other person in fact collects the income directly, the original taxpayer/assignor is liable for the tax on the income if control over the source of the income is retained.

PROFESSOR'S NOTE: NETTING PROCESS

The common theme here is that a capital loss is generally deducted against the gain that would be taxed at the highest rate.

Interaction of Kiddie Tax With Earned Income

The computation of the child's tax when there is a combination of earned and unearned income is more complex. We must reduce the AGI by the standard deduction, which is the amount of earned income plus $400, not to exceed the full standard deduction of $12,950 (2022). This gives us the taxable income. The unearned income is reduced by $2,300, resulting in net unearned income (the amount subject to the parental rate). The remaining taxable income is attributable to the earned income and will be subject to the child's tax rate schedule.

PROFESSOR'S NOTE: PRIVATE LETTER RULINGS (PLRs)

The cost of a private letter ruling (PLR) can range anywhere from $250 to $50,000, depending on the complexity of the tax matter at hand. Depending on the client's situation and net worth, a PLR may well be worth the expense to avoid any potential controversy with the IRS or the tax courts.

ADDITIONAL MEDICARE TAX: INVESTMENT INCOME (3)

The definition of net investment income includes the net gain attributable to the disposition of property. Certainly, this includes both short-and long-term capital gains. The gain attributable to the disposition of property also includes taxable gain from the sale or surrender of a life insurance contract. Investment income does not include distributions from qualified plans, or most other retirement plans. The IRC specifically exempts distributions from Section 401(a), 403(a), 403(b), 408, 408A, or 457(b) plans. Therefore, distributions from 401(k)s, qualified annuity plans, annuities for employees of tax-exempt organizations or public schools, individual retirement accounts, Roth IRAs, and governmental 457 plans, respectively, are all excluded from the definition of net investment income. Keep in mind, however, that the taxable portion of these qualified plan distributions will increase the AGI, possibly to a point where Medicare contribution tax will apply to the taxpayer's investment income. Tax-exempt income is generally not subject to the Medicare contribution tax. Thus, veteran's benefits and tax-exempt interest from municipal bonds escape the tax. In addition, life insurance proceeds received by reason of the death of an insured (excluded under Section 101) will not be included. Any gain from the sale of a principal residence that is excluded under the IRC's Section 121, is likewise exempted. Note that on the sale of a principal residence, any gain that exceeds the $250,000 exclusion ($500,000 for taxpayers filing jointly) allowed under Section 121 is included in computing the Medicare contribution tax. The net gain on the sale of a vacation home or other second residence will be included in the calculation.

Social and Economic Federal Tax Law Assumptions: Economic Objectives

The federal tax system is used to achieve several economic goals. The first, and perhaps most important, of these is price stability. With the public and private sectors competing for goods and services in the marketplace, the excess demand will generate inflationary pressure. Thus, a policy to restrict the spending of either one, or both, of these sectors is necessary. The policy that restricts spending by the private sector is, of course, taxation. Conversely, during periods of recession or depression, it seems sensible to decrease the amount of taxes paid by individuals and corporations. This should allow people to spend more money, thus increasing demand, creating more jobs, and stimulating the economy. Keep in mind that the tax system is not the only way to control price stability. Monetary policy, as controlled by the Federal Reserve System, also is used to promote price stability. The second major goal is economic growth, and with it full employment. The premise here is that when taxes are reduced, private spending increases demand and stimulates the economy

FILING STATUS: OVERVIEW

The filing status used by a taxpayer when filing an individual tax return (as opposed to a tax return for a business entity) greatly impacts the ultimate income tax liability on the income tax return. Filing status affects phaseout limitations for certain items that can provide deductions to reduce taxable income and determines the tax table used.

ETHICAL CONSIDERATIONS, AUDITS, AND TAX PENALTIES: TAX AUDITS: COMMON TAX TRAPS

The financial planner should be aware of the most common tax traps. By studying the discussions presented in this module, the financial planner will be able to help their clients avoid falling into the more common tax traps. These basic tax traps may be broken into three broad categories. First are tax traps that tax a transaction based upon "economic reality" as well as formality. Second are tax traps that result in the unexpected recognition of income. Finally, there are tax traps of particular concern to the owners of closely held corporations.

TYPES OF BUSINESS ENTITIES: C CORPORATIONS (I)

The first type of business entity discussed is also the one LEAST LIKELY TO BE USED BY most SELF-EMPLOYED individuals (at least those starting a business): the "REGULAR" or C corporation. ** A C CORP IS REGARDED AS A PERSON (entity) SEPARATE FROM ITS SHAREHOLDERS/OWNERS for INCOME TAX PURPOSES.** The MAJOR DISADVANTAGE of the corporate form is the DOUBLE TAXATION of these profits. The MAJOR ADVANTAGE of the form is the LIMITED LIABILITY accorded to the shareholders for corporate obligations. The corporation is TAXED ON its INCOME and PAYS DIVIDENDS FROM its AFTER-TAX income to shareholders. The SHAREHOLDER is then TAXED ON THE DIVIDEND. While this has been alleviated at times by preferable income tax rates on qualified dividends at the shareholder level, the disadvantage of the form still exists. In addition, the earnings of or profits from the business are TAXED TO THE REGULAR CORPORATION at special corporate income tax rates. Distributions of these PROFITS, in the form of DIVIDENDS, are then TAXED AGAIN as taxable income to the recipients. QUALIFIED DIVIDENDS at the shareholder level are taxed at PREFERABLE RATES, and NON-QUAL DIVIDENDS are taxed as ORDINARY INCOME. MOST DIVIDENDS a taxpayer receives are QUALIFIED dividends.

FOREIGN TAX CREDIT

The foreign tax credit is a means of avoiding double taxation by granting a tax credit for taxes paid or accrued to a foreign country or U.S. possession. However, a taxpayer may not take advantage of both the foreign tax credit and foreign earned income exclusion permitted under U.S. tax law. If the tax in the foreign jurisdiction is more than the U.S. tax (which is typically the case), it is generally more advantageous to take the foreign tax credit, which cannot create a refund (nonrefundable). The average U.S. investor usually pays at least some foreign tax unwittingly via mutual funds. Global mutual funds typically own international stocks and pay nominal taxes to those foreign governments.

Tax Treatment of Business Property Gains: Replacement Property and Time Limitation (I)

The general requirement to apply Section 1033 is that the replacement property must be similar in service or use to the involuntarily converted property. For an owner-user, a functional-use test applies, whereas for an owner-investor, a taxpayer-use test applies. -- FUNCTIONAL-USE TEST. The taxpayer's use of the replacement property and of the involuntarily converted property must be the same. -- TAXPAYER-USE TEST. The owner-investor's properties must be used in similar endeavors as the previously held properties. Thus, there is more flexibility with this test than with the functional-use test. For example, the proceeds from a condemned office building may be used to acquire any investment real property (and not just another office building). Normally, the taxpayer has a two-year period from the end of the taxable year in which any gain is realized from an involuntary conversion (e.g., fire) to replace the property. However, if a condemnation of real property by a governmental authority is the reason for the conversion, this period is extended to three years from the end of the taxable year in which any gain is realized.

CAPITAL GAINS: Life Insurance Dividends

The general rule is that life insurance dividends are nontaxable as a refund of unused premium or excess premium paid. However, the dividends are taxable to the extent the dividends received exceed the investment in the life insurance contract. A dividend from a MEC is taxable as a distribution unless the dividend is retained by the insurer to pay premiums, or purchase additional paid-up insurance. These dividends are not subject to the preferential treatment brought about by Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA). The taxable life insurance dividend is treated as ordinary income.

WINDFALLS

The general rule is that the receipt of a monetary windfall, such as winning the lottery, is taxable. In addition, under the tax doctrine of constructive receipt, the winner of a lottery who is given the option of receiving either a lump sum or an annuity must include the full value of the annuity in income immediately, even if she takes the proceeds over time. The QUALIFIED PRIZE OPTION is the one exception to this rule. The QUALIFIED PRIZE OPTION must be permitted by the state sponsoring the lottery that awarded the prize. Under this option, if the lottery winner has the choice of either cash or an annuity and takes an annuity payout, the PAYOUTS are TAXABLE AS RECEIVED RATHER THAN ALL AT ONCE.

ETHICAL CONSIDERATIONS, AUDITS, AND TAX PENALTIES: Tax Avoidance and Tax Evasion: OVERVIEW

The goal of tax planning is to minimize tax liability for a client. However this goal should be pursued with the utmost good faith. TAX AVOIDANCE is correctly using the tools and rules provided by Congress to minimize taxes due. Tax avoidance should not be confused with tax evasion. An example of lawful tax avoidance is the purchase of municipal bonds. Generally speaking, no tax will be owed to the federal government on interest paid by municipal bonds. TAX EVASION, on the contrary, is the willful underreporting of taxable income. Concealing or understating taxable income is a matter that is taken very seriously by the tax authorities.

PROFESSOR'S NOTE: TRUST TAXATION

The grantor is taxed on the income of the trust if the grantor reserves the right to revoke the trust

TRUST INCOME TAX RULES: OVERVIEW (3)

The grantor will be taxed on the trust's income if the grantor directly or indirectly retains certain administrative powers that can be exercised for the benefit of the grantor. Such powers would include a right of the grantor to purchase, exchange, borrow, or deal with trust assets without adequate interest or security. The grantor is allowed to exercise only clerical and administrative functions. The grantor is taxed on the income of the trust if the income is or may be used for the benefit of the grantor or the grantor's spouse. Thus, the grantor trust rules apply if income is distributed or may be distributed at any time to the grantor or the grantor's spouse or is used to pay premiums on life insurance policies on the grantor or grantor's spouse. On the other hand, only trust income that actually is used to discharge a legal support obligation of the grantor or the grantor's spouse will cause grantor taxation on trust income.

NETTING PROCESS: MARKET DISCOUNT BONDS

The holder of a bond purchased in the market at a discount may elect to treat the difference between the purchase price and the face value—that is, the discount—being taxed as current income annually over the remaining term of the bond. It may also be taken in total as ordinary income upon the maturity of the bond. If the taxpayer does not include the market discount in income, the gain realized on disposition of the market discount bond is treated as ordinary income to the extent of the accrued market discount on the bond. The election to include market discount in income is revocable only with consent of the IRS, and applies to all market discount bonds acquired during and after the year of election. The previous rules dealing with bond discount do not apply to U.S. savings bonds or tax-exempt bonds.

Taxation of Security Transactions: Property Acquired from a Decedent

The holding period of most property, inherited from a decedent, is deemed to be long term. Assume that Susan inherits 100 shares of stock from Aunt Martha on April 15, 2022. The FMV of the stock on the date of Martha's death was $30,000. If Susan sells the stock three months later for $31,200, she has a long-term capital gain of $1,200. These rules do not apply to property that constitutes income in respect of a decedent. Inherited IRAs, colloquially known as stretch IRAs, were discontinued as a result of the SECURE Act. Previously, IRAs inherited by non-spouses could be liquidated over the beneficiary's lifetime. IRAs must now must be completely liquidated within 10 years of date of death. In short, take the date of death and add 10 years. The beneficiary can wait until the tenth year to meet this requirement. As a planning strategy, if they have other earned income in the budget, they could contribute money to an IRA in their own name. It is important to note that a spouse can still take out withdrawals over their life expectancy. If the beneficiary is not 10 years younger than the deceased, they can still take RMDs over their expected lifetime. A minor child who has inherited an IRA is not subject to the 10-year rule until they turn 18. Note that inherited IRAs do not qualify for a step-up in basis adjustment.

Tax Treatment of Business Property Gains: NONQUALIFIED USE

The home sale exclusion is not available for periods of nonqualified use even though the two-out-of-five-year ownership and use tests are otherwise satisfied. This restriction is meant to prevent taxpayers from converting rental property or a vacation home into a principal residence and using the exclusion again within two years after the sale of the principal residence. Nonqualified use is ANY PERIOD FOR WHICH PROPERTY IS NOT USED AS A PRINCIPAL RESIDENCE during which the taxpayer does not live in the home. Also included are periods of rental and vacation home usage of the residenc

Tax Law Compliance and Procedures: Secondary Sources

The importance of understanding the sources discussed thus far stems from their role in the taxation process. As mentioned earlier, the statutory law and its official interpretations constitute the legal authorities that set forth the tax consequences for a particular set of facts. These legal authorities, sometimes referred to as primary authorities, must be distinguished from secondary sources or secondary authorities. The secondary sources of tax information consist mainly of books, periodicals, articles, newsletters, and editorial judgments published by tax services. When working with the tax law, it must be recognized that secondary sources are unofficial interpretations—mere opinions—which have no legal authority. Although secondary sources should not be cited as an authority, they are an indispensable aid when seeking an understanding of the tax law

ADDITIONAL MEDICARE TAX: INVESTMENT INCOME (2)

The income from most active trades or businesses, along with taxable gains attributable to the disposition of property used in an active trade or business, is not treated as net investment income. In fact, net investment income does not include any item taken into account in determining self-employment income. As a result, the flow-through of operating income from S corporations, partnerships (or entities treated as a partnership for federal income tax purposes), and sole proprietorships is not included in the definition of investment income. However, the income from businesses that are passive activities, under Section 469 of the IRC, or the income from certain businesses involved in trading financial instruments or commodities, is treated as investment income. Note that rent received in the ordinary course of a trade or business is not included in investment income. For example, the rental income from an automobile rental business conducted through an S corporation would not be included in the calculation of the Medicare contribution tax. Special rules apply in the case of a taxpayer who sells an interest in a partnership or sells the stock in an S corporation. Essentially, only gain attributable to property held by the partnership or S corporation that is not properly attributable to the active trade or business will be taken into account. However, the income derived from the investment of working capital within an active trade or business is treated as investment income for purposes of the tax.

Tax Reduction and Management Techniques: Alternative Minimum Tax (AMT) (2)

The individual AMT is based on the tax preference items and adjustments listed here: Accelerated cost recovery deductions on real property in excess of the straight-line method (no longer common, because all real estate placed in service after 1986 is depreciated using straight-line) -- Accelerated cost recovery deductions on leased property in excess of the straight-line method -- Accelerated cost recovery deductions for personalty placed in service after 1986, to the extent the deductions exceed the 150% declining-balance method amount calculated over the ADR midpoint life of the asset -- Percentage depletion in excess of adjusted basis (but not for independent oil and gas producers and royalty owners) -- Excess intangible drilling costs (IDC) are the excess of the amount allowable over the amount deductible had the cost been capitalized and amortized over a 10-year period. The rules related to the treatment as a preference item vary depending upon whether or not the taxpayer is considered an integrated oil company. -- Bargain element on the exercise of an incentive stock option (bargain element is the excess of the FMV at the exercise date over the option price). If the stock is sold in the same tax year that the option is exercised, there is no AMT adjustment required. -- Research and experimental costs, circulation expenses, and mining exploration and development costs deducted, to the extent the deduction exceeds the amount that would have been deductible had the costs been capitalized and amortized over a 10-year period (a 3-year period for circulation expenses) -- Rapid amortization of a certified pollution control facility in excess of amortization under the alternative depreciation method -- The completed-contract method for long-term contracts entered into after February 28, 1986, is not allowed for AMT purposes; the percentage-of-completion method must be used in computing alternative minimum taxable income (AMTI). -- Tax-exempt interest on qualified private-activity municipal bonds, but not for bonds issued in 2009 and 2010 -- Passive farm losses are treated as a preference item. -- Seven percent of the excluded gain from qualified small business stock (if the QSBS was acquired after September 27, 2010, there is no AMT preference)

CAPITAL GAINS: Property Dividend (2)

The individual shareholder's basis in the property is the equivalent of the FMV of the property at the time of distribution, and it is not adjusted for any liabilities that the shareholder assumes. The holding period for determining long-or short-term gain or loss on the sale, or exchange of the property, begins on the date of the distribution. For the corporation that distributes a property dividend, the income tax rules are considerably different than for a cash dividend. A distribution of appreciated property is treated as if the corporation had sold the property to the shareholder for the property's FMV. A corporation may recognize gain, but not loss, on the distribution of property to a shareholder. For example, if a corporation distributes equipment with a basis of $12,000 and a FMV of $25,000, the corporation will recognize a gain of $13,000. Alternatively, if a corporation distributes equipment with a basis of $20,000 and a FMV of $8,000, the corporation is not allowed to recognize the loss.

Taxation of Annuity Contracts: Distribution Prior to the Annuity Start Date

The individual who holds a contract issued before August 14, 1982, retains the right of tax-free early withdrawal of their investment. In other words, the nonperiodic payment is treated on a FIFO basis. As an example, assume that a taxpayer purchased a deferred annuity in 1981 for $300,000, and the cash surrender value is now $500,000. The contract has not reached its start date. A nonperiodic distribution of up to $300,000 would be tax free, as the taxpayer is withdrawing their investment first. However, nonperiodic withdrawals from an annuity contract issued after August 13, 1982, are treated on a LIFO basis. In other words, the withdrawals consist of fully-taxable interest, and second, tax-free principal to the extent that interest payments are fully exhausted. This rule applies to the extent that the cash surrender value of the contract exceeds the investment in the contract. Using the same facts as in the preceding example, any distribution up to $200,000 (the earnings in the contract) would be fully-taxable as interest income. Consider nonperiodic distribution after the annuity start date. A nonperiodic payment from an annuity contract received on or after the annuity start date is generally fully-taxable to the extent that the withdrawal exceeds the investment cost remaining in the contract.

NETTING PROCESS: TELEPHONE TRANSFER

The investor should be aware that the occurrence of a taxable event, in mutual fund transactions, is not limited just to sales of the shares. Sometimes a mutual fund sponsor, particularly a sponsor of funds that are part of a mutual fund family, allows the investor to switch from one type of fund to another without paying a fee. This is often referred to as a telephone transfer. However, the investor should note that this transfer between funds is a taxable event—even if the transfer is only from one growth or one income fund to another. If a gain is shown on the shares transferred between funds, it must be reported on the investor's tax return. This rule presupposes that the mutual funds are not held within a tax-advantaged account such as an individual retirement account (IRA).

Tax Law Compliance and Procedures: Tax Treaties

The laws contained in tax treaties represent another component of the statutory law. Tax treaties are agreements between the United States and the governments of other countries that provide the rules governing the taxation of residents of one country by another. For example, the tax treaty between the United States and France indicates how the French government taxes U.S. citizens residing in France and vice versa. Tax treaties, as law, have the same authority as those laws contained in the Code. In fact, treaty provisions normally take precedence over those contained in the Code. For this reason, practitioners should do their due diligence when involved with an international clients such as U.S. citizens working abroad, foreign exchange students, dual citizens and/or U.S. resident aliens. Per the Code a client may be a resident alien for tax purposes, regardless of their visa status.

EMPLOYEE BONUSES

Typically bonuses are taxed as W-2 wages in the year received. A situation may arise where an employee is paid a bonus contingent upon the performance of certain services. If the employee does not live up to the original agreement, the employer has the right to demand repayment of the bonus. This is often referred to as a clawback. This presents a tax problem for the employee if the clawback occurs in a different tax year. In that instance, the employee would PAY BACK the full bonus, then FILE A RIGHT OF CLAIM under Code SECTION 1341 to receive credit for taxes already paid. **The EMPLOYEE WOULD NOT FILE AN AMENDMENT.**

Passive Activity and At-Risk Rules: DIRECT PARTICIPATION PROGRAMS: PARTNERSHIP ENTITIES (II)

The limited partnership traditionally has been the form most often selected for direct participation investments. It offers the advantage of limited liability for a limited partner (investor). Limited partnerships may be quite large or quite small, with the number of limited partners restricted only by securities registration requirements. The disadvantages of this form include the lack of liquidity that most limited partnership interests have and the fact that a limited partner/investor has no voice in management. This is the type of investment historically referred to as a tax shelter. The general partnership form is seldom selected today because of the unlimited personal liability of each general partner. When this form is used, the partnership generally is small. The advantages of this form are that it is relatively simple to organize and each owner/investor may have a significant voice in management. Master limited partnerships (MLPs) enjoyed a brief period of increased popularity after the Tax Reform Act of 1986. A MLP is a limited partnership in which units are publicly traded on an established stock exchange. The MLP thus offers the advantage of high liquidity. MLPs are almost always very large. The Omnibus Budget Reconciliation Act of 1987 (OBRA) imposed special rules on the income and losses from publicly traded partnerships. Since 1998, many MLPs have not been treated as a conduit entity. Instead, they have been taxed as corporations.

MORTGAGE INTEREST DEDUCTION (1)

The mortgage interest deduction is a significant itemized deduction for many taxpayers. Given the new limitation on the overall deductibility of state and local income, sales, and property taxes, most taxpayers are not likely to be able to itemize deductions unless they have home mortgage interest. There are limits on the amount of acquisition debt that may be taken into account when computing the mortgage interest deduction. Acquisition debt is debt that is incurred in acquiring, constructing, or substantially improving any qualified residence of the taxpayer. Acquisition debt also includes debts from the refinancing of other acquisition indebtedness, but only to the extent of the amount (and term) of the refinanced indebtedness. These limits changed due to the Tax Cuts and Jobs Act (TCJA); thus, there are two sets of rules that will come into play with the mortgage interest deduction. Mortgage debt incurred on or before December 15, 2017 (old debt), is subject to the old rule, which is less restrictive than the newer rule that applies for mortgage debt incurred after December 15, 2017 (new debt)

TEST TIP: 1031

The phrase "BOOT IS WHAT CAUSES TAX TO KICK IN" will help students remember that only recognized gain is currently taxable. (The tax basis in the new property will normally be the adjusted basis of the property relinquished plus any boot paid.) Gain realized but not recognized is tax deferred. Capital gain tax deferral is the very purpose of a 1031 exchange. The presence of boot in a 1031 calculation invariably poses a major challenge to students. There are simply too many variables to account for mentally. Further, a calculator is of limited value without adequate structure. Therefore, when students encounter a 1031 question, they are best served to set up the equation first. The FMV is what the property is worth at the time of the exchange. The adjusted basis is cost minus any prior depreciation taken. Boot is cash (or debt relief) paid by the seller. Briefly list each value in the table. After the table is set up, students should then turn to their calculator. Such a question will normally ask, "What is Seller 1's gain realized and gain recognized?" Realized gain is FMV of the property received minus adjusted basis of the property relinquished. Recognized gain is the lesser of gain realized or boot received (not boot paid).

Like-Kind Exchanges: BOOT (II)

The presence of boot does not disqualify the entire transaction for like-kind treatment; however, the receipt of boot will -- result in the recognition (taxability) of gain if there is a realized gain; or -- result in no recognition (disallowance) if there is a realized loss. When there is boot received, the actual amount of recognized (taxable) gain is equal to the lesser of the realized gain or the boot received. When boot paid is in the form of appreciated property, gain or loss is recognized as if the property had been sold. The planner, especially when aware of a like-kind exchange before it takes place, should ascertain the impact of the proposed exchange on the client's finances. A transaction that does not contain boot received allows the client to defer any gain realized on the transaction until the property received is disposed of if the transaction is real estate (realty) not held primarily for sale. The impact of boot received is a recognition of income (unless the boot received and given are the same as in an exchange of mortgages) that the planner must incorporate into the client's financial plan. If the planner learns of the like-kind exchange after the fact, in addition to acquiring all documentation on the transaction from the client, the planner should educate the client on the possible tax consequences of these transactions and ask the client to allow the planner to advise the client of the impact of a future exchange before it takes place.

Annual Deductions Limits: OVERVIEW

The previous discussion has focused on the total amount of charitable deduction that is available to the taxpayer for a given type of property. However, all of this deduction amount may not be deductible in a given tax year. The second important factor is the type of organization to which the property is contributed. The limitation on per-year charitable deductions depends primarily upon the identity of the donee.

IMPORTANCE OF ADJUSTED GROSS INCOME (AGI) (1)

There are several functions served by the taxpayer's AGI: ***AGI IS USED TO SET THE LIMIT (THE FLOOR) ON ALLOWABLE MEDICAL EXPENSE DEDUCTIONS. The deductible floor for medical expenses is 7.5% of the taxpayer's AGI. AGI is used to set limits on allowable casualty loss deductions. After subtracting a $100 floor per loss, casualty losses are deductible only to the extent they exceed 10% of the taxpayer's AGI. Personal casualty losses are only deductible if they occur in a federally declared disaster area. AGI is used to set maximum annual deduction limits (ceilings) on charitable contribution deductions. AGI is one of the factors used to determine whether contributions to a traditional individual retirement account (IRA) will be deductible. The AGI also limits the ability to contribute to a Roth IRA.

Tax Accounting Methods: Net Operating Losses

The purpose of allowing a NET OPERATING LOSS (NOL) for a business is to level the playing field. **Generally, NOLs CAN BE CARRIED FORWARD INDEFINITELY.** The LOSS IS LIMITED to 80% of the TOTAL TAXABLE INCOME REPORTED FOR THE CARRYFORWARD YEARS. That is, a cyclical business that might otherwise lose money without receiving any benefit (given its accounting period) is the primary beneficiary of the NOL tax provision. ** NOLs are ALLOWED FOR SELF-EMPLOYED INDIVIDUALS, regular CORPORATIONS, and ESTATE and TRUST entities. The benefit is NOT ALLOWED for PARTNERSHIPS or S CORP FLOW-THROUGH entities (the benefit is only permitted at the taxpayer-shareholder self-employed owner level). Once the taxpayer makes the election to claim an NOL, the election is irrevocable. The election generates a tax advantage if the taxpayer was in a low tax bracket in earlier years and expects to be in a higher tax bracket in the carryforward years associated with the provision.

Tax Treatment of Business Property Gains: Replacement Property and Time Limitation (II)

The replacement period for a casualty or theft begins on the date the property was damaged, destroyed, or stolen, and ends on the last day of the second taxable year after the year in which the taxpayer realizes a gain with respect to the property. The replacement period for a condemnation begins on the earlier of -- the date on which the condemned property was disposed of; or -- the date on which the threat of condemnation first occurred. The replacement period ends on the last day of the second taxable year following the year in which any part of the gain on the condemnation is realized. If the condemned property is real property held for use in a trade or business or for investment (not including property held primarily for sale), the replacement period ends on the last day of the third taxable year following the year in which any part of the gain on the condemnation is realized. Taxpayers may get an extension of the replacement period if they apply to the district director of the IRS for their area. The application should state why an extension is needed and should be filed before the end of the replacement period. The request will usually be granted if the taxpayer can show reasonable cause as to why the replacement property has not been purchased within the allotted replacement period

TRUST INCOME TAX RULES: OVERVIEW (5)

The requirement that trust income be taxed to the grantor in the foregoing situations can be avoided if the grantor irrevocably transfers property to the trust and retains none of the prohibited powers or beneficial interests. For a trust to qualify as irrevocable, the grantor cannot retain any right to alter, amend, revoke, or terminate. As long as such a trust does not contain any of the prohibited grantor trust powers, all income from the trust property will be taxed to the trust as a separate entity or to the trust beneficiaries, and not to the grantor. This relieves the grantor of the tax burden, shifting taxation to the potentially lower-bracket trust entity or beneficiary. A full explanation of estate and trust law is beyond the scope of this text. Both trusts and estates file annual income taxes with IRS Form 1041. Income distributed to the beneficiaries is taxed to the beneficiaries, not to the trust itself. Again, this process should not be confused with the separate, end-of-life estate tax, which uses Form 706. For purposes of the CFP® exam, the following summary establishes key points for income tax planning students to remember.

Tax Consequences of Property Transactions: COST RECOVERY METHODS: Straight-Line Depreciation Method

The simplest form of depreciation is straight-line depreciation. Straight-line depreciation assumes that depreciation is uniform throughout the useful life of the asset. The cost or adjusted basis of the asset is deducted in relatively equal annual installments over the asset's useful life. SL = cost basis ÷ useful life. -- This method can be used under the MACRS depreciation method. -- Taxpayers must use the half-year convention. For example, assume a five-year property with a cost of $75,000 was placed in service during January of the current year. Under the straight-line method (with no bonus depreciation), the first-year depreciation deduction equals $7,500 (20% × $75,000 × 1⁄2). During each of the next four years, the annual deduction will equal $15,000 ($75,000 × 20%). The deduction in the sixth year will equal $7,500. The straight-line method is an option in lieu of MACRS for all property where cost recovery is possible. However, when using the straight-line method, a half-year convention is assumed or built into the applicable percentage. This convention means that whenever the depreciable asset is placed into service in the year of acquisition, only a half year of depreciation is permitted. This is also the case in the year of the asset's disposition.

Passive Activity and At-Risk Rules: DIRECT PARTICIPATION PROGRAMS: OVERVIEW (II)

The tax advantages provided by direct participation programs are founded upon the principle that most types of business organizations function as tax conduits. That is, while these organizations may function as business entities separate from their owners, they are not separate taxable entities. Rather, items of taxable income, deductible expenses, tax credits, gains, and losses "flow through" the organization to be reported by the individual owners. Direct participation investments generally are structured in one of three ways: 1). Partnerships 2) S corporations 3) Fractional interest of direct ownership Examples of a fractional interest include joint tenancy, tenancy in common, and tenancy by the entirety. Other business forms also may be used, such as the LLC or LLP, which typically are treated as partnerships for income tax purposes.

Passive Activity and At-Risk Rules: DIRECT PARTICIPATION PROGRAMS: Creation of Tax Benefits

There are several rules, or doctrines, that may allow direct participation programs to generate specific tax advantages.

TYPES OF BUSINESS ENTITIES: C CORPORATIONS: DIVIDENDS-RECEIVED DEDUCTION

There are some deductions that are specific to corporations. An important deduction is the DIVIDENDS-RECEIVED DEDUCTION. ** If the RECEIVING CORP owns LESS THAN 20% of DISTRIBUTING CORP, the RECEIVING CORP MAY DEDUCT 50% of the DIVIDENDS.** **If the RECEIVING CORP owns 20% OR MORE of the DISTRIBUTING CORP'S STOCK, it CAN then DEDUCT 65% of the DIVIDENDS received.** THE AMOUNT of the dividends-received deduction is BASED ON the PERCENTAGE OWNED OF the dividend-paying CORPORATION by the CORPORATION RECEIVING THE DIVIDEND.

Tax Treatment of Business Property Gains: NONQUALIFIED USE: VACATION HOME/RENTAL PROPERTY

The tax laws include restrictions intended to prevent taxpayers from using vacation homes to generate deductible rental losses. The tax consequences of vacation home use depend on the relative time the home is rented (for income purposes) versus the amount of time the home is used personally. There are three categories of use. -- PRIMARY PERSONAL USE If the property is rented for fewer than 15 days a year, it is considered a personal residence only, and all rent (without limit) generated during this time is excluded from the taxpayer's income. -- PRIMARY RENTAL USE. If the residence test is not met (i.e., the rental property is rented at least 15 days a year and is not used for personal use more than the greater of 14 days per year or 10% of the rental days), it is classified as primarily rental use. This treatment permits the taxpayer to deduct expenses associated with the rental (not personal) use on Schedule E of IRS Form 1040 and allows for a possible deduction of rental losses up to $25,000. (Note: Rental property and the passive income activity rules will be discussed in Module 9 of this course.) -- MIXED (personal and rental) USE. If the vacation home meets the residence test (i.e., the property is rented for at least 15 days a year and it is also used for personal use more than the greater of 14 days per year or 10% of the rental days), then the rental expenses can be deducted only to the extent of rental income; no loss may be generated. Thus, there is no possibility of a $25,000 ordinary loss against income (as in the primarily rental use category). The rental income and expenses are reported on Schedule E of IRS Form 1040, including mortgage interest and expenses, and the mortgage interest and property taxes allocable to the personal use of the vacation home are deductible on Schedule A of Form 1040 as itemized deductions. Even though the deductions are taken on separate places on the IRS Form 1040, the effect on the taxpayer's income is an above-the-line deduction because the total deduction is allowed to the extent of the reported income. Any allocable expenses incurred that are in excess of the income in the year incurred may be carried forward by the taxpayer and deducted from the rental income in future years.

SCHEDULE A TAXES

The types of taxes that are deductible on Schedule A of Form 1040 (as an itemized deduction) may be summarized as: 1) state, local, and foreign real estate taxes; 2) state and local sales taxes; 3) state and local personal property taxes (e.g., personal automobiles); and 4) state, local, and foreign income taxes. These are colloquially referred to as SALT taxes, or state and local taxes. The deduction for these taxes is capped at $10,000 aggregately. If a taxpayer receives a state or local income tax refund for taxes that were deducted in a prior year, then to the extent the taxpayer deducted the taxes previously, the refund must be included in the taxpayer's income in the year it is received/refunded. If the taxpayer did not itemize deductions and did not deduct the tax in the prior year, then the refund is not includable in the taxpayer's income in the year it is received.

The Premarital Agreement: OVERVIEW

The typical marriage, particularly a first marriage, is not likely to involve a lot of premarital financial planning. However, in certain cases, a premarital agreement plays a part in the marriage contract and, by implication, any divorce proceeding that may occur. Such an agreement is common in the case of a second marriage between individuals with children from either or both spouses' prior marriages. The purpose of the premarital agreement is to limit the presumed effect of the marriage on property acquired before, or during, the marriage. Property acquired by one spouse before marriage (or property brought to the marriage) often remains the separate property of that spouse and is not subject to division upon dissolution of the marriage. In its most common form, the premarital agreement involves a transfer of property from the more affluent spouse to the other spouse in exchange for a release of all rights and claims the other may have for support or may have against the transferor's property. Considerable legal care must be taken in some states for a premarital agreement to be legally binding. W

Tax Planning for the Medicare Contribution Tax (5): ROTH IRAS

The use of Roth IRAs appears to be very beneficial under the new tax. Qualified distributions from a Roth are not taxable, so the distributions do not increase potential exposure to the Medicare contribution tax, because the distributions do not increase the MAGI. In addition, the distribution is not subject to the Medicare contribution tax, because it is not included in the net investment income. Unfortunately, taxpayers subject to the Medicare contribution tax already have an AGI too high to allow for contributions to a Roth account. For married taxpayers filing a joint return, the threshold for the Medicare contribution tax is $250,000. The 2022 AGI phaseout limit for contributing to a Roth IRA is $204,000 to $214,000. For single taxpayers, the threshold for the Medicare contribution tax is $200,000, while the 2022 AGI phaseout limit for contributing to a Roth IRA is $129,000 to $144,000. In years when the taxpayer's AGI dips into the range where contributions are permitted, contributions to the Roth would certainly be advised if the taxpayer has sufficient cash flow to allow for the contribution. If the taxpayer has a traditional IRA, a conversion to a Roth may be explored. The conversion analysis is further complicated by the fact that the taxable portion of the distribution will increase the AGI, therefore increasing exposure to the Medicare contribution tax. Again, in years when the AGI dips, it may be advisable to explore a conversion to a Roth.

ETHICAL CONSIDERATIONS, AUDITS, AND TAX PENALTIES: TAX AUDITS: Audits

There are three types of tax audits performed by the IRS: 1). A CORRESPONDENCE AUDIT, which is usually performed through the mail because the disputed tax issue is minor 2) An OFFICE AUDIT, which is usually restricted in scope to a specific item or items and is performed at the IRS office by an office auditor 3) A field audit, which is an examination of numerous items and is usually performed on the premises of the taxpayer (such as a business office) by a revenue agent IRS procedures for conducting audits and assessing taxes have been subject to reforms in recent years to help assure the protection of taxpayer rights. For example, these reforms require the IRS to disclose the criteria it uses in selecting returns for audit and to take steps to protect the confidentiality of personal and financial information. The IRS must also follow due process when imposing tax levies and provide clear explanations in any tax notices or inquiries.

Tax Accounting Methods: Inventory Methods

There are THREE commonly used methods to establish the cost of business inventory—first in, first out (FIFO); last in, first out (LIFO); and SPECIFIC IDENTIFICATION. While there is no general rule regarding which of these methods is preferable, the choice a business will make has a significant impact on the amount of taxable income that is reported. For example, if a business uses the FIFO method in an environment of RISING PRICES, the COST OF GOOD SOLD will be LOWER, and the amount of business TAXABLE INCOME will be HIGHER. CONVERSELY, if LIFO is used, the cost of goods sold will be higher, and the amount of business taxable income will be lower. However, converting from FIFO to LIFO (or vice versa) will also impact the amount of the company's earnings; accordingly, companies will issue earnings notices to the market whenever a change in inventory costing method is imminent. Taxpayers that meet the $27 million gross receipts test are not required to account for inventories using LIFO or FIFO methods, but may use an accounting method for inventories that either treats inventories as nonincidental materials and supplies or conforms to the taxpayer's financial accounting treatment of inventories. The SPECIFIC IDENTIFICATION method of INVENTORY accounting requires the owner of a small business to keep track of the cost of EACH SPECIFIC ITEM in inventory, and to take the cost of each specific item into cost of goods sold as each specific item is sold. **This method is FEASIBLE ONLY IN SMALL BUSINESSES that have a relatively SMALL NUMBER of relatively HIGH-VALUE items in inventory. Thus, it might be used by the owner of an ART GALLERY (assuming that the gallery owned the artwork rather than simply showing it on consignment) or a CAR DEALER.

IMPUTED INCOME AND THE ALTERNATIVE MINIMUM TAX: ITEMIZED DEDUCTIONS

There are certain itemized deductions allowed against the alternative minimum taxable income. Note that the standard deduction is not allowed for AMT purposes. Those allowable itemized deductions include -- medical expenses in excess of 7.5% of adjusted gross income; -- casualty losses in excess of 10% of adjusted gross income and the $100 floor, if from a federally declared disaster zone; -- gambling losses to the extent of gambling winnings; -- qualified housing interest; -- investment interest expense to the extent of qualified net investment income; -- estate taxes paid on a decedent's income; and -- charitable contribution deductions. In summary, a positive adjustment is made when the deduction or exemption allowed for regular income tax purposes exceeds the deduction or exemption allowed for AMT purposes. A negative adjustment is made when the deduction allowed for AMT purposes exceeds that for regular income tax purposes as illustrated in the following figure.

5 SAFE-HARBOR EXCEPTIONS TO THE "TRANSFER OF VALUE" RULE

There are five safe-harbor EXCEPTIONS to the transfer for value rule. None of the proceeds will be includible as income if the following occur: 1) Sale of the policy is to the insured, insured's spouse, or insured's ex-spouse if incident to a divorce under SEC. 1041 2) Sale to a business partner of the insured 3) Sale to a partnership in which the insured is a partner 4) Sale to a corporation in which the insured is a shareholder or officer 5) Sale to anyone whose basis is determined by reference to the original transferor's basis (i.e. a gift or swap) Transfer for value examples are commonly seen in both buy-sell arrangements between business partners (or co-shareholders), as well as disposition of CORPORATE-OWNED LIFE INSURANCE (COLI) key man policies when a senior executive of a firm retires.

Overview & Priority of Credits

There are generally TWO CATEGORIES OF INCOME TAX CREDITS. Refundable tax credits are paid to the taxpayer even if the amount exceeds the taxpayer's tax liability. In other words, a refundable credit can create a refund. Nonrefundable tax credits cannot be used to create a refund, per se. At most, they will reduce a taxpayer's tax liability to zero. When a taxpayer is entitled to multiple nonrefundable tax credits, the credits must be applied using the priority list defined in the Tax Code. Although NONREFUNDABLE CREDITS DO NOT CREATE A REFUND, some credits, such as the ADOPTION credit and the FOREIGN TAX credit, may be CARRIED FORWARD to later years. Some personal credits may reduce not only the taxpayer's regular income tax liability, but also the taxpayer's alternative minimum tax (AMT) liability. A tax credit (in contrast to a tax deduction) is a dollar-for-dollar reduction against an individual's income tax liability and, therefore, is not affected by the marginal tax rate of the taxpayer. There are numerous tax credits for both the business and personal activities of the taxpayer, but the most important are: 1) excess Social Security taxes 2) the child and dependent care credit 3) the child tax credit 4) the adoption expense credit 5) the foreign tax credit 6) the American Opportunity Tax Credit 7) the Lifetime Learning Credit 8) residential energy credits

NETTING PROCESS: Other Investment Losses (1)

There are other investment losses that may be deducted by an individual taxpayer. While no losses from the sale of assets within an IRA may be deducted, certain losses may still be deductible. If the taxpayer has made nondeductible traditional IRA contributions and liquidates all of her traditional IRAs, then a loss is recognized only if the amounts distributed are less than the remaining unrecovered basis in the traditional IRAs. If the taxpayer has made only deductible contributions to the IRAs, no loss may be recognized because the taxpayer has no basis in the deductible IRAs. However, if the taxpayer has made deductible and nondeductible traditional IRA contributions, and liquidates all of her traditional IRAs, a loss is recognized if the amounts distributed are less than her remaining unrecovered basis in the traditional IRAs. For purposes of this rule, all traditional IRAs are aggregated; they are not combined with Roth or Coverdell IRAs. Note that currently this rule only applies in the year of death.

Annual Deductions Limits: Private Charities (30% Organizations)

There are other types of charities to which a 30% of AGI limitation applies. These organizations include: -- certain private nonoperating foundations, -- veterans' groups, -- fraternal associations, and -- other not-for-profit associations. These are called 30% organizations. For gifts of cash and other ordinary income property to these 30% organizations, the law limits the amount that a taxpayer may deduct in a given year to 30% of the taxpayer's AGI. Again, this 30% limitation applies to gifts of ordinary income property. For gifts of long-term capital gain property to 30% organizations, the deduction is limited to 20% of the taxpayer's AGI.

Electing Section 179 Expense Treatment (III):

There are two annual limitations associated with use of the Section 179 expense election: -- If the total amount of qualifying property placed in service for a given year is more than $2,700,000 (for 2022), the allowance is reduced dollar-for-dollar for any amount more than $2.7 million. No carryover is allowed. For taxpayers who file as MFS, the allowance may be allocated between the spouses if both have eligible deductible property, but the total may not exceed $2.7 million. -- The amount of the deduction cannot exceed the taxable income from the trade or business of the taxpayer (although a carryover is allowed here). Therefore, a loss cannot be created using the election.

Taxation of Annuity Contracts: OVERVIEW

There is NO MAX ANNUAL CONTRIBUTION. If the annuity holder DIES DURING ACCUMULATION PERIOD, the beneficiary is GUARANTEED no less than the AMOUNT INVESTED. The variable annuity has historically outperformed the fixed annuity while providing a hedge against inflationary pressures. The overwhelming majority of annuity contracts written today are deferred annuities. Historically, immediate annuities hedged the risk of "SUPERANNUATION" or the RISK OF OUTLIVING ONE'S RETIREMENT FUNDS. DEFERRED ANNUITIES attempt to hedge this same risk by creating greater earning potential and the introduction of guaranteed income riders, which may or may not require annuitization.

EDUCATION TAX BENEFITS: State Tuition Programs, 529 Plans, and Educational Provisions: State Tuition Programs (4)

There is a 10% penalty on the account earnings for nonqualified distributions, and these earnings are treated as ordinary income on the tax return. The penalty does not apply if the account is terminated due to the death or disability of the beneficiary. The penalty does not apply if the withdrawal occurred because the beneficiary has received a scholarship or fellowship grant, veteran's educational assistance, or employer-provided educational assistance so other funds are not needed for college. The tax-free distribution cannot be used for the same qualified expenses for which the AOTC or Lifetime Learning Credit is claimed. Tuition credits or other amounts may be transferred from one Section 529 plan to another for the same beneficiary on a tax-free basis. As mentioned earlier, contributions to Section 529 plans are not tax deductible at the federal level. However, many states allow for a limited deduction for contributions to that state's 529 plan. For example, Massachusetts allows a state tax deduction for contributions made to their 529 plan. Some states allow for an unlimited state deduction, and a few states allow a limited deduction for contributions to any their state's 529 plan.

Capital Gain Rates: Collectibles and Section 1250 Property

There is a maximum 28% rate that is applicable to certain long-term capital gains. This rate applies to net gains on collectibles, if held for more than one year. Collectibles may include coins, works of art, among many others. Gold and silver exchange-traded funds (ETFs) are generally not taxed as securities, but as collectibles. This means long-term capital gains on the funds are taxed at a maximum rate of 28% rather than the lower 15% or 20% rates that would apply to long-term capital gains on the sale of most securities. This 28% rate is a ceiling on the rate the taxpayer must pay on the gain from collectibles held long term. In other words, if the taxpayer is in a marginal income tax bracket higher than 28%, the long-term collectibles gain will be taxed at 28%. If the taxpayer is in a marginal income tax bracket lower than 28%, the gain will be taxed at the marginal rate. In Section 1250 of the IRC, 1250 property is defined as revenue generating real estate used in a trade or business. Taxpayers are allowed to depreciate such property annually, which reduces their cost basis. If the property is later sold at gain, any applicable deprecation previously deducted must be repaid. For capital gains created by the depreciation deductions, the tax rate is 25%. This rate is a ceiling. In other words, if the taxpayer is in a marginal income tax bracket higher than 25%, the gain will be taxed at 25%. If the taxpayer is in a marginal income tax bracket lower than 25%, the gain will be taxed at the marginal rate. After 1250 gain is repaid any additional gain is taxed as 1231 gain. This gain is eligible for normal long-term capital gains rates. To distinguish 1250 gain due to depreciation from 1231 gain, the IRS uses the term "unrecaptured Section 1250 gain."

Tax Consequences of Property Transactions: COST RECOVERY METHODS: Mid-Quarter Convention

There is a mid-quarter convention used to reduce the benefits of the half-year convention for personal property (not real property) placed in service late in the year of acquisition. If, during the tax year, the total basis of depreciable personalty placed in service during the last three months of the year exceeds 40% of the total basis of all depreciable personalty placed in service during that year, the taxpayer must use a mid-quarter convention. A quarter of a year consists of three months. To illustrate the use of these tables, assume that a taxpayer places the following assets in service during 2021, and opts out of bonus depreciation.

Capital Gain Rates: NETTING PROCESS

There is a netting process that applies to capital gains and losses. Initially, all gains and losses are grouped into several categories. The process is as follows: Short-term gains and losses are grouped in one, and then the long-term gains and losses are grouped according to their respective buckets. The long-term groups include collectibles, unrecaptured Section 1250 gains, securities, and other gains and losses (the 15/20% group). This final group is comprised of gains and losses that do not fall into one of the other categories. Gains and losses are first netted within their own rate group (collectible losses against collectible gains, etc.) to arrive at a net figure for that group. Finally, the buckets are netted against each other to produce the lowest tax possible for the taxpayer. A net short-term capital loss is applied first to reduce net long-term gain from the 28% group, then to reduce gain from the 25% group, and finally to reduce net gain from the 15/20% group. A net loss from the 28% group is used first to reduce gain from the 25% group, then to reduce net gain from the 15/20% group. A net loss from the 15/20% group is used first to reduce net gain from the 28% group, then to reduce gain from the 25% group. Any resulting net capital gain is taxed at that group's marginal tax rate. As mentioned earlier, a net short-term capital loss is first used against any gain from the 28% group, then from the 25% group, and finally against the 15% (or 20%) group. A net loss from the 28% group is first used to reduce gain from the 25% group, then the 15% (or 20%) group. A net loss from the 15% (or 20%) group is first used against gain from the 28% group, and then the 25% group. The following examples will help to illustrate these concepts.

IMPUTED INCOME AND THE ALTERNATIVE MINIMUM TAX: AMT CREDIT

There is an AMT credit available for years after an AMT liability has occurred. The credit is generated based on deferral, but not exclusion preferences and adjustments. The deferral preferences and adjustments are those other than the standard deduction and personal exemptions, disallowed itemized deductions, depletion adjustments, private-activity municipal bond interest, and small business stock exclusion. The credit is allowed against regular income tax only, and only to the extent that the regular income tax exceeds the tentative minimum tax. Stated another way, the individual AMT credit is available only to the extent the AMT was attributable to deferral items.

PROFESSOR'S NOTE: EARLY WITHDRAWALS FOR EDUCATION

There is an exception to the 10% early withdrawal penalty for higher education expenses. It is possible to withdraw funds from a traditional IRA or a Roth IRA without incurring a 10% early withdrawal penalty if the proceeds are used for higher education expenses. Students should be aware this exception does not extend to qualified plans, such as 401(k)s. Funds withdrawn from a 401(k) before age 591⁄2 will still be subject to a 10% early withdrawal penalty, even if the proceeds are used for higher education. For this reason, many parents with a 401(k) opt to borrow in the form of a loan if college funding is an issue.

NETTING PROCESS: Treasury Inflation-Indexed Securities

These Treasury securities combine a fixed interest rate with the principal amount of the securities, adjusted for inflation. The interest payments are taxed when received. The inflation adjustments to the principal are taxable in the year in which such adjustments occur, even though the inflation adjustments are not paid until maturity. The interest is exempt from state and local income taxation.

Tax Reduction and Management Techniques: CHARITABLE CONTRIBUTIONS (4)

These exceptions are nonetheless subject to the same deductible percentage limitations discussed later as are outright gifts of property to the charity. For a charitable contribution to be deductible, the taxpayer must ensure that the contributions are made to a qualifying organization, which includes governmental units if the gift is used for exclusively public purposes. Other charitable organizations are groups organized and operated exclusively for religious, scientific, literary, or educational purposes, or for the promotion of international or national sports. Groups that aid in the prevention of cruelty to children or animals are also considered charitable. For a charity to be considered as a qualifying organization, no part of the corporation's earnings can benefit any private shareholder or similar individual.

Above-the-Line Deductions: Contributions to Health Savings Accounts (HSAs) and Archer Medical Savings Accounts (Archer MSAs)

These plans allow qualifying individuals with high-deductible health insurance plans to make tax-deductible cash contributions. In addition, the HSA funds may be used to reimburse the individual tax free for qualifying medical expenses. In 2022, the maximum contribution limits are $3,650 for singles and $7,300 for families. Additional catch-up contributions of $1,000 are permitted for taxpayers age 55 and older. If the individual makes HSA withdrawals for expenses other than qualifying medical expenses, the amount withdrawn will be subject to income tax and a 20% penalty (unless they are made after the individual reaches age 65, dies, or becomes disabled). Archer Medical Savings Accounts (Archer MSAs) were first authorized by federal legislation in 1996. After December 31, 2003, no new Archer MSA plans may be established (existing Archer MSAs can be maintained). Archer MSAs have been effectively replaced by HSAs.

Tax Reduction and Management Techniques: OVERVIEW (2)

These should be approached with caution because, by design, these brackets increase much more rapidly than individual rates. For example, irrevocable and complex trusts are excellent for gift and estate strategies, but inefficient from an income tax standpoint. As a reminder, estate and trust annual income tax rates should not be confused with estate tax, which is covered in the estate planning course. To save on both income taxes and potential estate taxes, clients are prone to gift large amounts of assets to their children. This is a legitimate strategy known as income shifting. It removes current income from the parents, which reduces their income tax liability. It also removes future appreciation, which reduces gift and estate tax liability. However, there are guidelines that need to be observed. The most important among these for exam purposes are the kiddie tax rules. Practitioners need to be aware that if the minor's unearned income surpasses certain thresholds, it will be taxed at the estate and trust (a.k.a., fiduciary) income tax rates.

S Corporations and Pass-Through Entities: Qualified Business Income (Pass-Through Business) Deduction: UNDER THRESHOLD

This basic rule applies for taxpayers with taxable income (without the QBI deduction) under $340,100 (married filing jointly) or $170,050 (all other taxpayers). These threshold amounts are indexed for inflation, and are tied to the top of the 24% marginal income tax bracket. The phaseout ranges in 2022 are $340,100 to $440,100 (MFJ) or $170,050 to $220,050 (S) respectively.

EXAMPLE: ADOPTION CREDIT

Tim and Robert are married and have adopted a child from a local adoption agency. They paid $6,050 in adoption expenses last year and $9,000 in the current year (2022). Their MAGI is $198,000. The adoption credit is available in the year the adoption is final. The couple may take an adoption credit in 2022 of $14,890. Because the adoption credit is a nonrefundable tax credit, it cannot reduce the couple's tax liability below zero. If their tax liability is less than $14,890, they may carry the balance of the unused credit forward for five years to use against a future tax liability. Similarly, under the SECURE Act, it is now possible to take withdrawals of up to $5,000 from IRAs to pay for birth and adoption expenses. These withdrawals are exempt from the 10% early withdrawal penalty. A married couple may take two distributions for a total of $10,000.

ETHICAL CONSIDERATIONS, AUDITS, AND TAX PENALTIES: TAX AUDITS: COMMON TAX TRAPS: Hobby Loss Rules

To be eligible to deduct losses generated by a trade or business carried on as a proprietorship, a partnership (for tax purposes), or S corporation, the taxpayer must prove that they had a profit motive for engaging in the activity. Unless the taxpayer can prove that they were engaged in the activity for the purpose of earning a profit, losses will be deemed nondeductible hobby losses. There is a rebuttable presumption that a profit motive exists if the activity shows net income for at least three of the past five years. In the case of an activity that consists in major part of the breeding, training, showing, or racing of horses, then the presumption of a profit motive exists if the activity shows net income for at least two of the past seven years. In these cases, the IRS bears the burden of proving that the activity is not engaged in for profit. It is fairly common for a taxpayer to have income associated with a hobby. The income is treated as gross income, reported on the other income line on the Form 1040. Current IRS guidance states that cost of goods sold can be deducted from gross receipts to arrive at the gross income from the hobby. Taxpayers must clearly understand that they cannot deduct hobby losses.

ETHICAL CONSIDERATIONS, AUDITS, AND TAX PENALTIES: TAX AUDITS: COMMON TAX TRAPS: Sham Transaction Doctrine

To be given effect for tax purposes, a purported transaction must be real and bona fide—not mere paper fiction that completely lacks substance. A transaction so lacking in substance that the court considers it a sham will be disregarded for tax purposes. For example, suppose there is a sale of property by one entity to another, both of which are controlled by the same persons. There is no business purpose for the sale, and the only motive for the sale was to recognize a tax gain or loss on the sale in a particular year. This sale will be viewed as a sham transaction, and no gain or loss will be recognized.

Self-Employment Tax and Health Insurance Deduction: Self-Employment Income TAX: CALCULATION

To calculate the self-employment tax, you must first determine what constitutes self-employment income. Self-employment income includes -- net Schedule C income; -- the distributive share of income paid to a general partner (K-1 income from the tax form reporting such income); -- part-time earnings of an individual (e.g., a professional); and -- board of directors fees.

NETTING PROCESS: WASH SALE RULE (1)

Toward the end of the tax year, taxpayers often have incentive to engage in a practice that is referred to as tax loss harvesting. Their broker will deliberately sell select securities at a loss to reduce the client's overall tax liability. This is a legitimate tax strategy, provided certain IRS rules are followed. For example, the taxpayer cannot sell a security on Monday to create paper loss and then buy the same security back Tuesday morning. Such losses are disallowed under the wash sale rule. The taxpayer's only motivation is to create a loss near year-end for tax reporting purposes without actually risking their overall position in the security. The IRS, via the wash sale rule, is attempting to curb this type of behavior. The wash sale rule disallows a loss on the sale or disposition of stock or other securities (including options or contracts to sell or acquire) if the taxpayer purchases substantially identical stock or securities within either 30 days before or 30 days after the date of the sale or disposition. The definition of substantially identical is not precise. A stock or security is substantially identical if it is not different in any material, or essential, way. Factors to be considered include interest rates, dividend rights, maturity dates, and conditions of retirement. Stocks or securities are not substantially identical if they have a different issuer or obligor.

Tax Law Compliance and Procedures: Authoritative Sources of Tax Law

Ultimately all federal tax authority begins with the Constitution and Congress. The U.S .Department of Treasury is responsible for enforcing the Internal Revenue Code, often referred to simply as the Code. The Internal Revenue Service itself reports to the Secretary of the Treasury. To comply with current tax laws, taxpayers and practitioners alike often find it necessary to research complex tax questions. Normally this is done simply to prepare the annual return. However research may also be conducted in response to an IRS audit or perhaps even a tax court hearing. The Internal Revenue Code is vast and complex. Tax related information is available from various sources, both primary and secondary. Practitioners need to be aware that not all sources carry the same weight under the law. After the Code itself, the hierarchy of authoritative sources published by the IRS is as follows: -- Regulations -- Revenue Rulings -- Revenue Procedures -- Private Letter Rulings -- Technical Advice Memorandums -- Notices -- Announcements Just as not all investment advice is of equal quality, not all tax advice is of equal quality either. For example if a taxpayer finds themselves in tax court, citing a Treasury Regulation will carry much more weight than citing an IRS publication. In fact, there have been cases where taxpayers correctly and accurately cited an IRS publication, but still lost their case. This serves to illustrate an important point. Some documents are published merely for informational purposes while others carry the effect of law. It is important to know the difference when dealing with the tax authorities.

S Corporations and Pass-Through Entities: LIMITED LIABILITY COMPANY (LLC): MAY ELECT TO BE TAXED AS...

Under the check-the-box Treasury Regulation, an LLC must declare how it wishes to be taxed. In other words, an LLC is a disregarded entity for federal tax purposes. Specifically, an LLC can elect be taxed as any of the following. -- Sole proprietorship—While this is only permitted for one-member LLCs, the owner simply files a Schedule C with IRS Form 1040 to report the income and losses incurred while operating as an LLC. -- Partnership—This is available for LLCs with two or more members and follows the tax treatment accorded to general partners, including the basis advantages. If an LLC has two or more members, it will automatically be taxed as a partnership unless a corporate election is made. -- Regular or C corporation—This is available for any LLC and, just like a regular corporation, the entity will have two levels of taxation. -- S corporation—This is available for those LLCs that elect to be treated as S corporations. As with S corporation shareholders, members report income on their individual Forms 1040 based on the Schedule K-1 they receive from the S corporation.

Passive Activity and At-Risk Rules: Real Estate Professionals

Under this provision, taxpayers who materially participate (specially defined) in a real property trade or business now are allowed to deduct losses attributable to that activity. In order to deduct losses from these real property trades or businesses, the individual taxpayer (or closely held C corporation) must satisfy certain eligibility requirements. These requirements are met in the following circumstances: 1. More than 50% of the individual's personal services during the tax year are performed in the real property trades or businesses in which the individual materially participates a. If the individual's personal services are performed as an employee, the individual must be at least a 5% owner of the employer organization 2. The individual performs more than 750 hours of service in the real property trades or businesses in which the individual materially participates A real property trade or business means any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business. Modified adjusted gross income for other PAL purposes will not be affected by a deduction allowed under this provision. The following example illustrates the material participation in real estate provision.

Passive Activity and At-Risk Rules: Mixed Use and Vacation Homes

Vacation home rentals restrictions are designed to prevent taxpayers from using a vacation home as an abusive tax shelter. Tax treatment thus depends on the relative time rented versus personal use. Most rental activities are deemed passive. However, vacation home rentals fall into a somewhat ambiguous area. For this reason, majority of these rules were covered in the previous module. Nonetheless, Section 280A of the Internal Revenue Code provides special rules that limit the deductibility of expenses incurred in connection with the rental of a residence or vacation home. The owner's personal use of the rental property for even one day during the tax year will cause application of the vacation home rules. The key point to remember is the aforementioned active participation rental real estate exception does not apply to mixed use rentals. The regulations define a dwelling unit as a "house, apartment, condominium, mobile home, boat, or similar property which provides basic living accommodations such as sleeping space, toilet, and cooking facilities." Excluded from the definition are units used exclusively as a hotel, motel, inn, or similar establishment. The allocation of expenses is based on the number of days that the property is rented at fair rental value compared to the total number of days that the property is used during the year. The position of the IRS is that all expenses are allocated in this manner

ETHICAL CONSIDERATIONS, AUDITS, AND TAX PENALTIES: TAX AUDITS: ESTIMATED TAXES: Wage and Other Withholding

WAGE WITHHOLDING IS TREATED AS A PAYMENT OF ESTIMATED TAX, and the total amount withheld is applied equally to each installment. Withholding from IRAs, qualified plans, and other income sources is also treated as having been made evenly throughout the year, even if the actual withholding is a lump sum at year-end, for example. Thus, it is possible for the taxpayer to catch up by having extra federal income tax withheld toward the end of the year, either from wages or other sources where taxes may be withheld, in order to avoid the underpayment penalty. If the taxpayer can establish the actual date on which the amount was withheld, the actual date will control to which installment it is applied. Taxpayers who do not receive their income evenly throughout the year may choose to make their estimated tax payments based on the annualized income installment method. The payments to be made under this method are calculated by following a lengthy procedure outlined in IRS Publication 505.

CAPITAL GAINS: STOCK DIVIDENDS AND RIGHTS (1)

When a corporation distributes shares of its own stock as a dividend, the distribution is referred to as a stock dividend. A stock right gives the holder the right to purchase a stated amount of shares of a corporate stock. These should be distinguished from stock splits. Essentially, after the stock split, the shareholder has a greater number of shares to spread across the same basis. A stock split is not considered a distribution of corporate E&P; therefore, there are no tax consequences. A stock dividend is not taxable as long as the dividend, or rights, are issued pro rata stock-to-stock.

Tax Reduction and Management Techniques: BARGAIN SALE TO CHARITY

When a donor-seller transfers property to a charity (or other tax-exempt organization) in exchange for a sum that is less than the FMV of the property, a bargain sale to the charity occurs. This transaction is considered part sale and part charitable contribution, for which the donor's basis in the property and any appreciation are allocated on a pro rata basis to both the sale and gift portions. The donor must recognize the taxable gain on the sale portion to the extent it exceeds the allocated basis of the donor-seller.

NETTING PROCESS: DISTRIBUTIONS

When a mutual fund earns dividends from stock and passes them on to the investor, whether in cash or in the form of an additional purchase of shares, the distribution is taxed and potentially subject to preferential rates as discussed later. The distribution of long-term capital gains from security sales within the fund is treated as long-term capital gains to the shareholder. The distribution of short-term capital gains from within the fund is treated as ordinary income to the shareholder. The investor should note that reinvested distributions (i.e., those used to purchase additional mutual fund shares) increase the number of shares and the aggregate basis in an individual's holdings in the fund. When buying mutual fund shares, an investor generally should not buy into the fund immediately prior to a distribution. In such a case, the investor is in effect buying a tax liability, since income tax will be due on the distribution even if the value of the shares drops after the distribution. Rather, the investor should generally wait until after the distribution is made. In fact, it is a good idea to analyze if the fund expects to make a distribution in the very near future before buying any of its shares.

EXAMPLE: Closely held C corporations (II)

When a taxpayer is invested in multiple passive activities, it is possible for there to be both income and losses in a given year. If that occurs, then the passive income is allocated among the passive losses in proportion to the total loss. For example: First activity ($40,000) Second activity ($20,000) Third activity $15,000 Net passive loss ($45,000) The passive income is allocated and the net passive loss is as follows: ($40,000 ÷ $60,000) × $45,000 = $30,000 to activity 1 ($20,000 ÷ $60,000) × $45,000 = $15,000 to activity 2 Losses are allocated on their percentage of the total loss.

NETTING PROCESS: BOND PREMIUM

When a taxpayer purchases a bond at a premium, the interest return on the bond, in essence, is reduced. The IRC allows the taxpayer to amortize (i.e., deduct) the bond premium on taxable bonds over the life of the bond. This deduction is taken as an offset to the interest income as a negative entry on Schedule B. The deduction reduces the basis of the bond. The election to amortize bond premiums on taxable bonds applies to all future bonds acquired by the taxpayer, and may not be revoked without IRS consent. In the case of a tax-exempt bond issued at a premium, the bondholder must amortize the premium to reduce the basis of the bond. The premium amortization is not deductible in this situation.

Tax Consequences of Property Transactions: CAPITAL ASSETS AND DEPRECIATION: ESTABLISHING BASIS: EXPENSING POLICIES

When a taxpayer purchases, or holds, an asset, three corresponding expenses are generally involved. These three types of expenditures are closely connected with the activity for which the property is used. The types of expenditures, summarized in the following table, are (1) expenditures that are not currently deductible, (2) expenditures that are currently deductible, and (3) expenditures that are not currently deductible but can be recovered over a specified period. Property eligible for capital recovery, or depreciation, includes personalty, realty, and intangibles. The property must have a determinable useful life and be subject to wear and tear, decay or decline from natural causes, or obsolescence. Expense incurred for the maintenance and general repairs for depreciable assets are current period expenses and are not depreciated. If a repair adds to the value or the useful life of the asset, or adapts the asset to another purpose, the expense can be depreciated. Expenses that keep the asset in an ordinary working condition do not add value and are considered a current expense. For example, making minor general repairs to a building or part of it, repairing roof leaks, or repairing a broken window are all ordinary maintenance. Installing a new roof is a capital expenditure and is depreciable.

Tax Treatment of Business Property Gains: OVERVIEW

When a taxpayer-businessowner purchases real or personal property for use in a business and takes cost recovery (depreciation) deductions, these deductions offset the businessowner's ordinary income. When selling the property for a gain, the businessowner must look back and recapture all or part of those previous cost recovery deductions. The amount of cost recovery deduction that must be recaptured as ordinary income depends on the type of business property that is sold at a gain. There are three types of business property that are relevant for purposes of these recapture calculations: 1231, 1245, and 1250.

Tax Consequences of Property Transactions: CAPITAL ASSETS AND DEPRECIATION: ESTABLISHING BASIS: INHERITANCE

When an asset is received as an inheritance, the heir's basis in the asset is generally the fair market value on the date of death. This is commonly referred to as a stepped-up basis. Realize, however, that the basis may also be stepped-down to fair market value in the case of an asset that has lost value since purchase. Adjusted basis refers to the original basis in the property, increased by any adjustments such as acquisition expenditures or improvements, and reduced by any adjustments to basis, such as depreciation deductions taken and the Section 179 deduction (discussed later in this module).

SPOUSE RELIEF: BY SEPARATION OF LIABILITY

When requesting relief by separation of liability, an individual can allocate any understatement of tax between the individual and their spouse. The individual is only responsible for their own portion of any underpayment. An individual must meet both of the following conditions to qualify for relief by separation of liability: -- The individual must have filed a joint return. -- The individual must meet one of the following requirements: + The individual is no longer married to (or is separated from) the spouse with whom the joint return was filed. + The individual was not a member of the same household as the spouse with whom the joint return was filed.

PROFESSOR'S NOTE: LONG-TERM CAPITAL GAINS

When taxpayers have long-term capital gains, and/or qualified dividends, the income tax is computed on a qualified dividends and capital gains tax worksheet. Remember that the capital gains and qualified dividends are included in the total income, the adjusted gross income (AGI), and the taxable income. The worksheet is where the preferential rates are calculated for these income items. On the worksheet, the capital gains and qualified dividends are subtracted from taxable income. The tax is first computed on the income that is not subject to the preferential rates, then the tax is computed on the income that is subject to the preferential rates, and the two amounts are added.

The Premarital Agreement: ENFORCEABLE FACTORS

Whether the premarital agreement will be enforceable in a court of law depends upon a number of factors. 1. The premarital agreement must be in writing and signed by both parties affected. In addition, some states have other formal requirements regarding the agreement, such as having two witnesses, notarizing signatures, or executing the agreement at least 10 days before the celebration of the marriage. 2. The premarital agreement must include a full and complete disclosure of each party's net worth. Specifically, the provision for one spouse cannot be clearly disproportionate to the wealth of the other spouse, such that a presumption of designed concealment arises. In such a case, the burden of proof is on the wealthier party to show that the agreement is, in fact, fair and enforceable. As a practical matter, this is not easily done. 3. Premarital agreements must not be intended to facilitate or promote the procurement of a divorce. This results in the agreement being declared invalid as contrary to public policy. For example, a premarital agreement that attempts to regulate the disposition of property or an award of alimony on divorce would probably be held invalid. This is in contrast to those agreements by which the parties agree upon and fix the property rights that either spouse will have in the case of the other's death. Such contracts have been recognized as valid and not contrary to public policy. 4. It must be shown that the agreement was executed willingly by both parties without duress or coercion. Accordingly, if one party alleges duress or coercion at the time of the agreement's implementation, it is likely that the agreement will not be binding.

Tax Reduction and Management Techniques: Nondeductible Property

While a taxpayer may donate money or property, not all contributions are tax deductible. Nondeductible property is money or property given to the following: -- Foreign organizations (except certain Canadian, Israeli, and Mexican charities) -- Individuals -- Political groups or candidates for public office, political campaigns, or political parties Money or property paid for the following is also nondeductible: -- Cost of raffle, bingo, or lottery tickets -- Tuition -- Value of a person's time or services donated to the charity

Taxation of Annuity Contracts: VARIABLE ANNUITY

With a variable annuity, the exclusion amount is determined by dividing the investment in the contract by the number of expected payments. For example, assume that Carol purchased a variable annuity for $240,000 and has a life expectancy of 20 years at the time the payments are to begin. Annuity payments are to be made monthly. The number of anticipated payments is 240 (12 months × 20 years). Thus, $1,000 of each payment is excluded from taxation as a return of capital ($240,000 investment ÷ 240 anticipated payments). For both the fixed and variable annuity calculations, the investment in the contract is the net cost of the contract as of the annuity start date. This is the total amount of premiums paid reduced by any distributions that were excluded from income. For example, assume that John had invested $200,000 in a pre-August 14, 1982, annuity contract. In 1999, he took a nonperiodic distribution of $25,000. When the annuity payments began in 2005, the investment in the contract was $175,000.

IMPORTANCE OF ADJUSTED GROSS INCOME (AGI) (2)

You may occasionally encounter the term modified adjusted gross income, or MAGI. AGI and MAGI are calculated similarly. The exact Internal Revenue Code definition of MAGI is complex and beyond the scope of this text. As a practical matter, ***MAGI IS SIMPLY AGI BEFORE DEDUCTING IRA CONTRIBUTIONS***. Thus, for most taxpayers, there is no difference between AGI and MAGI. For purposes of this course, THE FOLLOWING DEDUCTIONS AND EXCLUSIONS ARE NOT PERMITTED WHEN CALCULATING MAGI: - IRA deduction - Student loan interest deduction - Foreign earned income exclusion and foreign housing exclusion - Exclusion of qualified savings bond interest from Series EE bonds - Exclusion of Qualified Adoption Expenses The key point to remember is that MAGI is USED TO CALCULATE MANY PHASEOUT LIMITS. In other words, MAGI DETERMINES taxpayer ELIGIBILITY for other CREDITS and DEDUCTIONS such as the aforementioned student loan interest deduction and the child tax credit.