Tax II Ch. 12, 13, 14 HW Concept
What is a "backdoor" Roth IRA contribution and when is it useful?
A "backdoor" IRA contribution is beneficial for taxpayers who would like to contribute to a Roth IRA but they have too much income to be allowed to contribute directly. Consequently, they can contribute to a traditional IRA (likely nondeductible contributions) and then convert the funds in the traditional IRA to a Roth IRA. The same strategy would work for a SEP IRA with higher contribution limits. Taxpayers can contribute to the SEP, get the deduction for the contribution, and then convert the contribution amount into a Roth IRA. The deduction from the SEP will offset the income from the conversion and the taxpayer will have indirectly contributed the funds to a Roth IRA through the backdoor (i.e., the SEP or traditional IRA).
Under what circumstances can a taxpayer meet the ownership and use requirements for a residence but still not be allowed to exclude all realized gain on the sale of the residence?
A taxpayer is limited to one exclusion on a sale of a principal residence every two years. That is, once the taxpayer sells a residence and uses the exclusion on the sale, the taxpayer will not be allowed a second exclusion until at least two years passes from the time of the first sale. Consequently, although a taxpayer may meet the use and ownership tests on two residences, the taxpayer cannot exclude gain from the sale of her second residence if the taxpayer has sold the first residence within the two preceding years. Also, if a taxpayer sells a home after December 31, 2008, and the taxpayer had nonqualified use of the property after December 31, 2008 (that is, the taxpayer used the property for a purpose other than as a principal residence such as vacation home or rental property) the taxpayer is not allowed to deduct a certain percentage of the otherwise excludable gain. Note, however, that nonqualified use does not include use during any portion of the five-year period that is after the last date the property was used as the principal residence of the taxpayer or the taxpayer's spouse. That is, this exception allows the taxpayer a five-year period to sell the principal residence after moving out of it without having to count the time the house is available for sale as nonqualified use. The percentage of the gain that is not excludable is the period of nonqualified use after December 31, 2008, divided by the period of time the taxpayer owned the home before selling.
Assume that your friend has accepted a position working as an accountant for a large automaker. As a signing bonus, the employer provides the traditional cash incentive but also provides the employee with a vehicle not to exceed a retail price of $25,000. Explain to your friend whether the value of the vehicle is included, excluded, or partially included in the employee's gross income.
An employer can exclude a qualified employee discount from an employee's taxable income because it is a nontaxable fringe benefit. A qualified employee discount is a discount not to exceed the cost of the good to the employer. As a result, the vehicle bonus should be partially taxable. The taxable portion would be the amount of the discount below the actual cost to manufacture the vehicle and will be included in gross income of the employee. The remaining value of the vehicle (fair market value less cost) can be received as a nontaxable fringe benefit.
How are defined benefit plans different from defined contribution plans? How are they similar?
As the name suggests, defined benefit plans spell out the specific benefit the employee will receive on retirement. In contrast, defined contribution plans specify the maximum annual contributions that employers and employees may contribute to the plan. Defined benefit plans are funded by the employer while defined contribution plans are funded by the employee. Both plans are generally classified as employer-provided qualified retirement plans and have similar rules for vesting (although the vesting rules are slightly more favorable for defined contribution plans than defined benefit plans) and required distributions.
Why do employers use stock options in addition to salary to compensate their employees? For employers, are stock options treated more favorably than salary for tax purposes? Explain.
Because stock options reward employees for making choices that increase the share price of the corporations where they are employed, this form of compensation is considered to be superior to salary in terms of motivating employees to behave more like owners—in short, stock options align the incentives of employees and owners. In addition, employers may use stock options to compensate their employees without a cash outlay. For tax purposes, NQOs are treated the same as salary and wages. The employer receives a deduction equal to the bargain element (FMV of shares on exercise date less the strike price). In certain situations, NQOs can potentially be treated more favorably than salary for tax purposes. For example, NQOs may allow employers to deduct executive compensation above $1 million, and NQOs can generate tax deductions without a corresponding cash outlay.
A taxpayer purchases and lives in a home for a year. The home appreciates in value by $50,000. The taxpayer sells the home and purchases a new home. What information do you need to obtain to determine whether the taxpayer is allowed to exclude the gain on the sale of the first home?
Because the taxpayer lived in the home for only a year, the taxpayer would not be able to meet the ownership and use tests. However, the taxpayer could potentially exclude all or a portion of the gain if the taxpayer were able to show that he or she sold the home due to unforeseen circumstances such as a change in employment, medical reasons, or other unusual/unforeseen circumstances. You would need to determine the reason for the move and whether that reason qualified as an unforeseen circumstance.
Under what circumstances would a taxpayer who generates a loss from renting a home that is not a residence be able to fully deduct the loss? What potential limitations apply?
By definition, a rental activity is considered to be a passive activity. Because they are passive losses, losses from rental property are generally not allowed to offset other ordinary or investment type income. However, the loss from a rental activity may be deductible under two circumstances. First, the taxpayer may offset the passive loss from the rental activity against other sources of passive income. Second, a taxpayer who is an active participant in the rental activity may be allowed to deduct up to $25,000 of the rental loss against other types of income (subject to phase-out beginning at $100,000 AGI).
Explain why Congress allows employees to receive certain fringe benefits tax-free but others are taxable.
Congress allows employees to receive certain benefits (e.g., health insurance) tax-free as a subsidy to encourage employers to provide these benefits. Many of these benefits are considered to be in the public's interest. For example, if employees have health insurance, they are less likely to fall under Medicaid. In addition, employers are allowed a deduction. Together these incentives should decrease the after-tax cost of health insurance and result in increased coverage by employers. However, benefits that are considered luxuries (e.g., country club memberships) are generally taxed as compensation. If all fringe benefits were nontaxable, Congress would have to increase income tax rates or broaden the taxable base in order to generate additional income to pay for the subsidy. Further, employers and employees might get very creative in their compensation arrangements such that most of what employees receive would be in fringe benefit form.
Describe how an employee's benefit under a defined contribution plan is determined.
Contributions are invested and accumulate earnings until they are distributed to the employee. Upon distribution the benefit is taxed as ordinary income. The ultimate benefit depends on the amount of employer contributions (and the employee's vesting in the employer contributions), employee contributions, and the earnings on the contributions.
From an employee perspective, how are ISOs treated differently from NQOs for tax purposes? In general, for a given number of options, which type of stock options should employees prefer?
Employees prefer ISOs. Unlike nonqualified stock options, the bargain element of incentive stock options is not included in the employee's regular taxable income on the exercise date. For incentive stock options, the taxation of the bargain element is deferred until the stock acquired from the exercise is sold, at which time it is included as long-term capital gain, assuming the holding periods are met. The employee must hold the options for at least 2 years after the grant date and the stock received for at least 1 year after the exercise date to obtain this treatment. For these reasons - deferral and capital gain treatment - employees generally prefer incentive stock options over an equivalent number of nonqualified stock options.
Explain why an employee might accept a lower salary to receive a nontaxable fringe benefit. Why might an employee not accept a lower salary to receive a nontaxable fringe benefit?
Employees prefer nontaxable benefits over an equivalent amount of salary or taxable benefits assuming that they need the benefits (e.g., health insurance) offered by the employer. This is because the government subsidizes the cost of qualified fringe benefits by allowing employees to receive them tax-free. Therefore, the after-tax costs of receiving lower salary and fringe benefits (non-qualified) are usually higher than receiving only salary and purchasing the needed benefits with after-tax dollars. An employee might be unwilling to accept a lower salary to receive a nontaxable benefit when the employee either doesn't value the benefit or values the benefit less than the reduction in salary.
From a nontax perspective, what issues does an employee need to consider in deciding whether to defer compensation under a nonqualified deferred compensation plan or to receive it immediately?
Employees should consider whether or not the benefits to be received from the nonqualified deferred compensation plan are adequate to meet their expected costs upon retirement. They should also consider whether they can afford to defer current salary and the expected rate of return of the deferred salary and the rate of return they would receive if they were to receive the salary now and invest it. Finally, employees should consider the financial stability of their employer because employers are not required to fund nonqualified plans.
Can employers match employee contributions to Roth 401(k) plans? Explain.
Employers are not allowed to contribute to an employee's Roth 401(k) plan. They may contribute to the employee's traditional 401(k) plan.
True or False. Both Sato and Kiran have worked for JBP Corp. and have participated in JBP's defined benefit plan for the past 20 years. Sato's annual salary over the prior three years was $800,000 and Kiran's annual salary over the prior three years was $500,000. Assuming both retire effective January 1 of the current year, Sato's annual retirement payment from the defined benefit plan will be higher than Kiran's annual retirement payment. Explain.
False. Both Sato's and Kiran's average compensation over the prior three consecutive years are greater than the annual compensation limits ($280,000 for 2019, $285,000 for 2020, and $290,000 for 2021). Therefore, for purposes of the calculating the retirement payment benefit, Sato's and Kiran's compensation will be the same (the annual limit in each year). Because they both have the same number of years working for JBP (20), if the annual defined benefit payment based on the formula including the compensation limits exceeds the annual defined benefit payment limitation ($245,000 in 2022), the annual defined benefit payment limit will apply to both taxpayers so they will receive the same retirement payment.
What is the limitation on a deductible IRA contribution for 2022?
For those not already participating in an employer-sponsored retirement plan, deductible contributions to an IRA are limited to $6,000 a year or earned income if it is less. Taxpayers who have reached the age of 50 by year end are able to contribute an additional $1,000. A taxpayer already participating in an employer-sponsored program may also make deductible contributions of the same amount if their AGI falls below a certain threshold. The $6,000 (or $7,000) deductible amount is phased out for taxpayers whose AGI exceeds the threshold amount.
Holding all else equal, does an employer with a higher marginal tax rate or lower marginal tax rate have a lower after-tax cost of paying a particular employee's salary? Explain.
Holding all else equal (including the amount of the employee's salary) an employer with a higher marginal tax rate will have a lower after-tax cost of paying an employee's salary. The reason is that the employer's after-tax cost of the salary is the before tax cost minus the tax savings from deducting the employee's salary. The tax savings from a deduction are greater the higher the marginal tax rate. Because the high marginal tax rate employer has greater tax savings from deducting the employee's salary, the high marginal tax rate employer has a lower after-tax cost of paying the employee's salary.
Matt just started work with Boom Zoom, Inc., a manufacturer of credit-card-sized devices for storing and playing back music. Due to the popularity of their devices, analysts expect Boom Zoom's stock price to increase dramatically. In addition to his salary, Matt received Boom Zoom restricted stock. How will Matt's restricted stock be treated for tax purposes? Should Matt consider making the 83(b) election? What are the factors he should consider in making this decision? From a tax perspective, would this election help or hurt Boom Zoom?
If Matt doesn't make the 83(b) election, the fair market value of the stock on the vesting date will be included in Matt's salary income in the year the stock vests and the restrictions lapse. Boom Zoom, Inc. will take a corresponding ordinary deduction in the same year Matt includes the value of the stock in his salary. If Matt makes an 83(b) election, he will include the fair market value of the stock on the grant date in his salary income in the year of grant and Boom Zoom will take a deduction of the same amount as compensation expense in the year of grant. Matt should consider making this election to accelerate income if the current stock price of Boom Zoom is small relative to his expectation of the future share price of Boom Zoom. Also, if Matt makes an 83(b) election and then leaves Boom Zoom prior to the restricted stock vesting, Matt will be precluded from claiming a loss on the basis he has in the stock that was forfeited. This inability to undo the 83(b) election in terms of acceleration income on an item that may eventually be forfeited should be considered. Under these conditions, the current tax Matt pays now will pale in comparison to the tax savings generated by converting the appreciation in share price from the grant date to the vesting date into capital gain. However, an 83(b) election under these conditions would be detrimental to Boom Zoom because its salary deduction, although accelerated, will be much smaller at the same before-tax cost.
Nicole and Braxton are each 50 percent shareholders of NB Corporation. Nicole is also an employee of the corporation. NB is a calendar-year taxpayer and uses the accrual method of accounting. The corporation pays its employees monthly on the first day of the month after the salary is earned by the employees. What issues must NB consider with respect to the deductibility of the wages it pays to Nicole if Nicole is Braxton's sister? What issues arise if Nicole and Braxton are unrelated?
If Nicole and Braxton are sister and brother, according to §267(b) of the Internal Revenue Code, Nicole and NB Corporation are considered to be "related persons." Nicole is treated as owning her 50 percent and her brother's 50 percent for a total of 100 percent ownership. Because NB and Nicole are related, NB is not allowed to deduct the salary expense it accrued for book purposes on the salary it owes to Nicole until the year in which Nicole recognizes income. This does not cause any issues until the last paycheck of the year. For book purposes, NB accrues and deducts Nicole's December salary but for tax purposes, NB is not able to deduct the salary until January 1 when Nicole receives her check. If Nicole and Braxton are unrelated, Nicole would own 50 percent of NB, and she would not be considered a related party to NB because she does not own more than 50 percent of NB. NB is allowed to deduct the compensation earned by Nicole in December of the prior year as long as it pays the compensation within 2 ½ months of year end (by March 15). In this case, NB pays the compensation at the beginning of January, so it would be allowed to deduct the compensation expense it accrued in December for Nicole.
Could a taxpayer contributing to a traditional 401(k) plan earn an after-tax return greater than the before-tax return? Explain.
If an individual contributes to a traditional 401(k) plan and later receives a distribution when they are paying tax at a lower marginal tax rate, they can earn an after-tax rate of return greater than the before-tax rate of return. This occurs because contributions are deductible and provide a tax benefit at a high tax rate and distributions are taxable but provide a tax cost at a low rate.
Lars and Leigha saved up for years before they purchased their dream home. They were considering (1) using all of their savings to make a large down payment on the home (90 percent of the value of the home) and barely scraping by without backup savings or (2) making a more modest down payment (50 percent of the value of the home) and holding some of the savings in reserve as needed if funds got tight. They decided to make a large down payment because they figured they could always refinance the home to pull some equity out of it if they needed cash. What advice would you give them about the tax consequences of their decision?
If the couple is forced to refinance their loan sometime in the future, the refinanced loan is treated as acquisition debt only to the extent that the principal amount of the refinancing does not exceed the amount of the acquisition debt immediately before the refinancing. That is, the refinancing cannot increase their acquisition indebtedness. Consequently, any amount borrowed in excess of the remaining principal on the original loan does not qualify as acquisition indebtedness (unless it is used to substantially improve the home).
Why might it be good advice from a tax perspective to think hard before deciding to quickly pay down mortgage debt?
If the taxpayer has a cash crunch in the future due to quickly paying down the mortgage debt, they may be forced to refinance the loan to get the necessary cash. However, when a taxpayer refinances their home, and the amount of the refinancing exceeds the amount of the acquisition indebtedness immediately before the refinancing (and the taxpayer doesn't use the proceeds to substantially improve the home), the excess cannot be classified as acquisition indebtedness, and thus is not deductible. Thus, the taxpayer may be in a situation where they will not be able to deduct as much interest due to the refinance as he would have been able to deduct if they had not quickly paid down the mortgage debt. That is, by decreasing the acquisition indebtedness by paying down the debt, the taxpayer may be unable to deduct a portion of their interest payments due to refinancing.
What risks are assumed by employees making an 83(b) election on a restricted stock grant?
If, after making an 83(b) election, the market value of the restricted shares stays flat (or declines), employees will have accelerated a tax payment without receiving the benefit of converting what would otherwise have been ordinary income into capital gain. Moreover, if the restricted stock subsequent to the 83(b) election is forfeited prior to the vesting date, employees will have reported income that they did not actually receive (phantom income).
From an employer perspective, how are ISOs treated differently from NQOs for tax purposes? In general, for a given number of options, which type of stock options should employers prefer?
In contrast to nonqualified options, employers never receive a tax deduction for incentive stock options. Thus, employers generally prefer to issue (unless the employer's marginal rate is 0 percent) nonqualified options over an equivalent number of incentive stock options.
Deductions for traditional IRAs and contributions to Roth IRAs are phased out based on modified AGI (MAGI). In general terms, how does MAGI for purposes of determining the traditional IRA deduction differ from AGI and how does it differ from MAGI for purposes of determining whether a taxpayer can contribute to a Roth IRA?
In general MAGI for purposes of determining the traditional IRA deduction is different from AGI because it is AGI disregarding the deduction for the IRA itself and certain other items. MAGI for Roth IRA purposes is the same as MAGI for traditional IRA purposes except that MAGI for Roth IRA purposes excludes income recognized on a traditional to Roth IRA conversion.
What is a "disqualifying disposition" of ISOs, and how does it affect employees who have exercised ISOs?
In order to receive the favorable tax treatment afforded incentive stock options, employees acquiring shares by exercising ISO's must hold the options for at least 2 years after the grant date and the stock for at least 1 year after the exercise date. Shares acquired with ISOs and sold prior to meeting these holding period requirements trigger a "disqualifying disposition." Because disqualifying dispositions cause incentive stock options to be treated as nonqualified options for tax purposes, the bargain element is taxed at the time of sale at ordinary rates.
For taxpayers qualifying for home office deductions, what are considered to be indirect expenses of maintaining the home? How are these expenses allocated to personal and home office use? Can taxpayers choose to calculate home office expenses without regard to actual expenses allocated to the home office? Explain.
Indirect expenses are expenses incurred in maintaining and using the entire home. Indirect expenses include insurance, utilities, interest, real property taxes, general repairs, and depreciation on the home as if it were used entirely for business purposes. Under the actual expense method for determining home office expenses, indirect expenses allocated to the home office space are deductible. If the rooms in the home are roughly of equal size, the taxpayer may allocate the indirect expenses to the business portion of the home based on the number of rooms. Alternatively, the taxpayer may allocate indirect expenses based on the amount of the space or square footage of the business-use room relative to the total square footage in the home. Each year, taxpayers can elect to use the simplified method of determining home office expenses or the actual method. Under the simplified method, taxpayers do not consider actual home office expenses. Rather, they multiply the square footage of the home office space (limited to 300 square feet) by a $5.00 application rate. Under this method, taxpayers deduct all property taxes (subject to limitation) and mortgage interest as itemized deductions on Schedule A (taxes and interest are not deductible as home office expenses). Further, under the simplified method, taxpayers do not claim depreciation expense. This has the additional tax benefit of not having to recognize a gain on the sale of the house, to the extent of post May 5, 1997 depreciation taken, when the house is sold.
Can both employees and self-employed taxpayers claim the home office deduction? Explain.
No. Self-employed taxpayers can claim the home office deduction if they meet the requirement of using the home office as either (1) the principal place of business for any of the taxpayer's trade or businesses or (2) as a place to meet with patients, clients, or customers in the normal course of business. Employees are not eligible to claim the home office deduction.
What nontax factor(s) should an employee consider when deciding whether and to what extent to participate in an employer's 401(k) plan?
Nontax factors to be considered in the decision to participate in an employer's 401(k) plan include any matching programs the employer may have in place, when an employee may need funds distributed, and how funds contributed to the 401(k) will be invested.
What are the ownership and use requirements a taxpayer must meet to qualify for the exclusion of gain on the sale of a residence?
Ownership test: The taxpayer must have owned the property for a total of two or more years during the five-year period ending on the date of the sale. Use test: The taxpayer must have used the property as the taxpayer's principal residence for a total of two or more years during the five-year period ending on the date of the sale. Married couples are eligible for the married filing jointly exclusion amount if at least one spouse meets the ownership test and both spouses meet the principal use test.
When determining whether a dwelling unit is treated as a residence or a nonresidence for tax purposes, what constitutes a day of personal use and what constitutes a day of rental use?
Personal use by a taxpayer includes days when (1) the taxpayer or other owner stays in the home, (2) a relative of an owner stays in the home, even if the relative pays full fair market value rent, except if the relative is renting the home as his or her principal residence, (3) a nonowner stays in the home under a vacation home exchange or swap arrangement, and (4) the taxpayer rents out the property for less than fair market value. Rental use includes days when the property is rented out at fair market value. Days spent repairing or maintaining the vacation home for rental use count as rental days, and days when the home is available for rent, but not actually rented out, do not count as personal days or as rental days.
What tax reasons explain why a corporation may choose to cap its executives' salaries at $1 million?
Publicly-traded corporations may cap their executives' salaries at $1 million to ensure that the company is able to deduct the compensation expense for the full amount of the compensation. This is important because the government no longer subsidizes salary for covered employees over $1 million. This means for a corporation with a 21 percent marginal tax rate the government would effectively be paying for or subsidizing $210,000 the first $1 million in salary. However, for publicly-traded corporations, the deductible compensation limit for covered employees is $1 million. The definition of covered employees is the CEO, CFO, and the other three highest compensated officers (plus all covered employees from prior years). Consequently, the government does not subsidize any salary above $1 million, which makes the salary above $1 million more expensive to provide, on an after-tax basis, than salary up to $1 million.
Explain the tax similarities and differences between qualified defined contribution plans and nonqualified deferred compensation plans from an employer's perspective.
Similarities Employers: Employers deduct amounts they pay for qualified and nonqualified plans. Both plans provide deferred compensation or benefits to the employee. Dissimilarities Employers: Nonqualified plans are not subject to the same restrictive requirements pertaining to qualified plans, so employers may discriminate in terms of who they allow to participate in the plan. In fact, employers generally restrict participation in nonqualified plans to more highly compensated employees. Also, employers are not required to "fund" nonqualified plans. That is, employers are not required to formally set aside and accumulate funds specifically to pay the deferred compensation obligation when it comes due. Rather, employers typically retain funds deferred by employees under the plan, use the funds for business operations, and pay the deferred compensation out of their general funds when it comes due.
Describe the annual limitation on employer and employee contributions to traditional 401(k) and Roth 401(k) plans.
The combined contributions made by an employer and employee to an employee's 401(k) plan (Roth or traditional) is limited to the lesser of $61,000 or 100% of the employee's compensation for the year. In 2022, the employee's contribution is limited to $20,500 ($27,000 if age 50 by the end of the year). Thus, if an employee contributes $20,500 to her 401(k) plan (Roth or traditional), the employer's contribution to the employee's traditional 401(k) plan is limited to $40,500, ($61,000 - $20,500). If the employee and employer make the maximum contributions, taxpayers under 50 years of age could have $61,000 contributed to their accounts and taxpayers 50 years of age or older could have $67,500 contributed to their accounts. Employers may not contribute to an employee's Roth 401(k).
Compare and contrast the annual limitations on deductible contributions to SEP IRAs and individual 401(k) accounts for self-employed taxpayers.
The contribution limitation on a SEP IRA for 2022 is the lesser of $61,000 or 20% of Schedule C net income minus the deduction for half of self-employment taxes paid. The contribution limitation on individual 401(k) accounts is the lesser of $61,000 or 20% of Schedule C net income minus the deduction for half of self-employment taxes paid plus $20,500 (the employee's contribution). Taxpayers 50 years old and older may contribute an additional $6,500 "catch up" contribution above and beyond these limitations (the catch up is not available for SEP IRAs). Thus, taxpayers who are at least 50 years of age at the end of the year can contribute up to $67,500 to their individual 401(k) accounts. In any event, taxpayers are not allowed to contribute more than their net Schedule C income minus the deduction for self-employment taxes no matter their age at year end.
Describe the maximum annual benefit that taxpayers may receive under defined benefit plans.
The maximum annual benefit an employee who retires in the year 2022 can receive from a defined benefit plan is the lesser of 100% of the average of the three highest years of compensation paid to the employee or $245,000.
What is the maximum saver's credit available to taxpayers? What taxpayer characteristics are relevant to the determination?
The maximum saver's credit available to taxpayers is $1,000. It is calculated by multiplying the taxpayer's contribution, up to a maximum of $2,000, by the applicable percentage depending on the taxpayer's filing status and AGI. Also, the credit is restricted to individuals who are 18 years of age or older and who are not full-time students or claimed as dependents on another taxpayer's return. The saver's credit is nonrefundable.
Compare and contrast the minimum vesting requirements for defined benefit plans and defined contribution plans.
The minimum vesting requirements for a defined benefit plan are a five-year cliff or a seven-year graded schedule. These enable the employee to fully vest in their benefits after five years or over the course of seven years, respectively. The minimum vesting requirements for a defined contribution plan are a three-year cliff or a six-year graded schedule. Under these schedules, an employee fully vests after three years of service or over the course of six years, respectively.
When an employer provides group-term life to an employee, what are the tax consequences to the employee? What are the tax consequences to the employer?
The premiums paid for group-term life insurance coverage of up to $50,000 by an employer on behalf of an employee is excluded from an employee's income. When an employee receives more than $50,000 of coverage, the taxpayer must recognize taxable income based on a formula determined by the regulations. A table requires a specified amount of income (which varies according to age) per $1,000 of life insurance coverage exceeding the threshold. The required income is likely to differ from the amount paid for the insurance by the employer. The cost of group-term life premiums is always deductible by the employer.
What is the saver's credit, and who is eligible to receive it?
The saver's credit is a credit provided for an individual's elective contributions of up to $2,000 to any qualified retirement plan multiplied by a percentage provided by the IRS and dependent upon AGI. The credit is in addition to any deduction the taxpayer may have been able to take as a result of the contribution. The credit is only available for taxpayers who are 18 years of age or older, not full-time students during the year (full-time student during five calendar months during taxpayer's tax year), and not claimed as dependents on another taxpayer's return.
Under what circumstances, if any, can a taxpayer fail to meet the ownership and use requirements but still be able to exclude all of the gain on the sale of a principal residence?
The taxpayer may be able to exclude the gain on the sale of a principal residence when the taxpayer sells the home due to unforeseen circumstances such as a change in employment, significant health issues, or other unforeseen financial difficulties. The maximum exclusion available to a taxpayer selling under these circumstances is the product of (1) the maximum exclusion had the taxpayer fully qualified for the exclusion (i.e., $250,000 for a single taxpayer or $500,000 for a taxpayer filing a joint return) and (2) the ratio of (a) the number of months the taxpayer met the ownership and use requirements to (b) 24 months. The taxpayer may use either days or months in the computation. Note that under these unforeseen circumstances provision, the maximum limitation is reduced, not necessarily the excludable gain. Consequently, if the taxpayer has a gain on the sale of the residence that is less than the reduced maximum exclusion, the full amount of the gain may be excluded.
Harry decides to finance his new home with a 30-year fixed mortgage. Because he figures he will be in this home for a long time, he decides to pay a fully deductible discount point on his mortgage to reduce the interest rate. Assume that Harry itemizes deductions and has a constant marginal tax rate over time. Will the time required to recover the cost of the discount point be shorter or longer if Harry makes extra principal payments starting in the first year (as opposed to not making any extra principal payments)? Explain.
The time required to recoup the cost of the discount point will be longer if Harry makes extra principal payments. If Harry makes extra principal payments on his mortgage during the first year, the balance of the loan is reduced and, as a result, Harry will pay less interest than he would have paid had he not made the extra loan payments (a smaller loan principal times the same interest rate equals a smaller amount of interest). Consequently, his after-tax savings from having the lower interest rate is reduced relative to what it would have been had he not made the extra payments. Because the interest expense is deductible for tax purposes, the after-tax savings from having the lower interest rate is calculated as follows: Interest saved = principal amount of loan × (original interest rate - lower interest rate) After-tax interest savings = interest saved - (interest saved × MTR) Because the after-tax cost of paying points remains constant, the reduction in after-tax savings from the lower interest rate increases the break-even point. Recall that the break-even point is calculated as follows: Break-even point = after-tax cost of paying points/after-tax savings of lower interest rate.
Mike is working his way through college and trying to make ends meet. Tara, a friend, is graduating soon and tells Mike about a really great job opportunity. She is the onsite manager for an apartment complex catering to students. The job entails working in the office for about 10 hours a week, collecting rent each month, and answering after-hours emergency calls. The owner of the apartment complex requires the manager to live onsite as a condition of employment. The pay is $20 per hour, plus a rent-free apartment (worth about $800 per month). Tara then tells him the best part: the rent-free apartment is tax-free as well. Knowing that you are a tax student, Mike asks you if the rent-free apartment is really tax-free or if Tara is mistaken. Explain to Mike whether the compensation for the apartment is really a nontaxable fringe benefit.
The value of an apartment or lodging to an employee may be excluded from taxable income if the benefit is provided for the convenience of the employer and is required as a condition of employment. Since Mike is required to live on the premises in order to be an "onsite" manager, and he does so to provide services to the other tenants, he may exclude the value of the apartment from his income as a nontaxable fringe benefit under §132.
Compare and contrast how employers record book and tax expense for stock options.
Under ASC 718, employers expense the economic value of option grants (determined on the grant date) ratably over the vesting period for book purposes for both incentive and nonqualified stock options. For tax purposes, employers expense the bargain element when nonqualified options are exercised by the employee. However, employers never receive a tax deduction for incentive stock options.
A taxpayer owns a home in Salt Lake City, Utah, and a second home in St. George, Utah. How does the taxpayer determine which home is their principal residence is for tax purposes?
When a taxpayer lives in more than one residence during the year, the determination of which residence is the principal residence depends on the facts and circumstances. Factors to consider in making this determination include the amount of time the taxpayer spends at each residence during the year, the proximity of each residence to the taxpayer's employment, the principal place of abode of the taxpayer's family, and the taxpayer's mailing address for bills and correspondence among other things.
For purposes of determining a taxpayer's deductible home mortgage interest, does it matter when the taxpayer incurred the debt to acquire the home? Explain.
Yes, it matters for taxpayers with acquisition debt over $750,000. Taxpayers can deduct mortgage interest on acquisition indebtedness up to $1,000,000 ($500,000 if married filing separately) if the debt was incurred before December 16, 2017. If taxpayers incur the debt before this date and then refinance the remaining debt after December 15, 2017 the $1,000,000 limit still applies. However, for acquisition indebtedness occurring after December 15, 2017, taxpayers may only deduct interest on up to $750,000 of acquisition indebtedness ($375,000 if married filing separately).
Is there a limit to how much an employer and/or employee may contribute to an employee's defined contribution account(s) for the year? If so, describe the limit.
Yes, there is a limit to how much an employer and/or employee may contribute to an employee's defined contribution account(s) for the year. For 2022, the combined contributions to an employee's defined contribution plan(s) made by both the employer and employee are limited to the lesser of $61,000 or 100% of the employee's compensation for the year ($67,500 for employees 50 years old by year end). The employee's contribution is limited to $20,500 for 401(k) and 403(b) plans ($27,000 for employees who are at least 50 years old at the end of the year).
Is it possible for a rental property to generate a positive annual cash flow and at the same time produce a loss for tax purposes? Explain.
Yes. A taxpayer is able to have a positive cash flow and at the same time produce a loss for tax purposes. This outcome is possible due to depreciation expense that is deductible for tax purposes but does not require an annual cash outflow. A rental property could provide a positive cash flow (gross receipts greater than cash expense for the year) but generate a tax loss when depreciation expense is deducted.
Is it possible for a taxpayer to have more than one loan that is treated as acquisition indebtedness for tax purposes, even if one of the loans is considered to be a "home equity loan" by the bank lending the money?
Yes. Acquisition indebtedness is defined as debt secured by the home that is incurred in acquiring, constructing, or substantially improving the home. A taxpayer could incur acquisition indebtedness by borrowing money to acquire a home and then incur additional acquisition indebtedness with a loan used to finish the basement, add onto the house, or some other substantial improvement - even if the loan were taken out long after the home was acquired or constructed. While a bank might call such a loan a "home equity loan" it would be considered to be acquisition indebtedness for tax purposes to the extent it is used to substantially improve the home. As long as the sum of the loans are under the acquisition debt limit, the taxpayer would be able to deduct all the interest on both loans.
Halle just acquired a vacation home. She plans on spending several months each year vacationing in the home and renting out the property for the rest of the year. She is projecting tax losses on the rental portion of the property for the year. She is not too concerned about the losses because she is confident she will be able to use the losses to offset her income from other sources. Is her confidence misplaced? Explain.
Yes. Because Halle will be living in the home for several months, the home will be considered a residence with significant rental use. Consequently, she may deduct expenses to obtain tenants (direct rental expenses such as advertising and realtor commissions) and, assuming she itemizes deductions, mortgage interest expense and real property taxes (to the extent her itemized deduction for taxes is less than $10,000) allocated to the rental use of the home. To the extent that these expenses exceed gross rental income she may deduct the loss (the passive loss rules do not apply). However, the remaining expenses allocated to the rental use of the home may only be deducted to the extent of the net rental income after deducting the direct rental expenses and rental mortgage interest and certain real property taxes allocated to the property. This limitation reduces her ability to deduct a rental loss from the home.
Explain the differences and similarities between fringe benefits and salary as forms of compensation.
`A fringe benefit is a non-cash form of compensation. In contrast, salary is cash compensation. They are similar in that both fringe benefits and salary are forms of compensation provided to an employee by an employer. Salary and taxable fringe benefits are income to the employee and deductible by the employer. Nontaxable fringe benefits provide benefits to employees without tax consequences to the employee, but still allow an employer a tax deduction and reducing the after-tax cost of these benefits.
Brady Corporation has a profit-sharing plan that allocates 10 percent of all after-tax income to employees. The profit sharing is allocated to individual employees based on relative employee compensation. The profit-sharing contributions vest to employees under a six-year graded plan. If an employee terminates their employment before fully vesting, the plan allocates the forfeited amounts among the remaining participants according to their account balances. Is this forfeiture allocation policy discriminatory, and will it cause the plan to lose its qualified status? (Hint: Use Rev. Rul. 81-10 to help formulate your answer).
§401(a)(4) dictates that a profit-sharing plan will not qualify if it discriminates in favor of officers, or highly compensated employees. The issue addressed is whether or not the above profit-sharing plan is discriminatory. Rev. Rul. 81-10 explains that a profit-sharing plan will not be disqualified "merely because it provides for the allocation of forfeitures arising from termination of service among the remaining participants on the basis of their account balances." It appears that this profit sharing will not cause the plan to lose its qualified status.
