Tax Final
Business Deductions
Deductions must be directly connected to business activity Business expenditures must be ordinary, necessary, and reasonable in amount to be deductible Ordinary and necessary means conducive to profit generation - Need not be essential or indispensable (e.g., legal fees; special tools that may be used occasionally) Reasonable in amount means not extravagant - Compare to market price or arm's length amount - If extravagant, the courts presume the excess amount is spent for personal rather than business reasons - Watch out for related-party transactions
Refundable Personal Credit
Earned income credit - Help offset employment taxes paid by lower-income taxpayers and encourage them to seek employment - Also called "negative income tax" - Must have earned income - Must have at least one qualifying child or satisfy age requirements (at least 25 years old and less than 65) and not a dependent of another
•Expenses associated with the production of tax-exempt Income
Expenses that do not help businesses generate taxable income are not allowed to offset taxable income - Interest expense on loans where proceeds are invested in municipal bonds - Key employee insurance premiums - no deduction if business is the beneficiary of life insurance (recall from chapter 5 that death benefit from the life insurance policy is not taxable to the beneficiary)
Cash Method - Prepaid Expenses
Generally cannot deduct prepaid expenses that create future benefits (i.e., capital expenditure) 12-month rule - Can immediately deduct prepaid business expense if (1) the contract period does not last more than a year and (2) the contract period does not extend beyond the end of next tax year (ex. 9-15) - Otherwise, capitalize prepaid amount and amortize over the length of the contract - Does not apply to interest expense (can only deduct the portion accrued for the current year)
MACRS Problem At the beginning of the year, Poplock began a calendar-year dog boarding business called Griff's Palace. Poplock bought and placed in service the following assets during the year Asset; Date Acquired; Cost Basis Computer equipment; 3/23; $5,000 Dog grooming furniture; 5/12; $7,000 Pickup truck; 9/17; $10,000 Commercial building; 10/11; $270,000 Land (one acre); 10/11; $80,000 Assume Poplock does not elect §179 expensing or bonus depreciation. a. What is Poplock's year 1 depreciation expense for each tangible personal property? b. What is Poplock's year 2 depreciation expense for each tangible personal property?
Half-Year convention because no tangible personal property was acquired in Q4. Furniture is a 7-year recovery period while computer and truck are a 5-year recovery period. A)Furniture: $7,000 * .1429 = $1,000.3 Comp & Truck: $15,000 * .2 = $3,000 Total: 4,000.3 B)Furniture: $7,000 * .2449 = $1,714.3 Comp & Truck: $15,000 * .32 = $4,800 Total: 6,514.3
Way Corporation disposed of the following tangible personal property in 2020. Calculate Way Corporation's 2020 depreciation deduction (Ignore §179 expense & bonus depreciation and assume the delivery truck is not a luxury auto). Asset; Date acquired; Date sold; Convention; Original Basis Furniture (7 year); 5/12/16; 7/15/20; HY; $55,000 Machinery (7 year); 3/23/17; 3/15/20; MQ; $72,000 Delivery truck* (5 year); 9/17/18; 3/13/20; HY; $20,000 Machinery (7 year); 10/11/19; 8/11/20; MQ; $270,000 Computer (5 year); 10/11/20; 12/15/20; HY; $80,00
If you acquire and sell a tangible property in the same year, then you do not depreciate. Furniture: $55,000 * 8.93% * 50% = $3,069.69 Machinery: $72,000 * 10.93% * .5/4 = $983.7 Delivery Truck: $20,000 * 19.2% * 50% = $480 Machinery2: $270,000 * 38% * 2.5/4 = $64,125 Computer: No Depreciation If HY you deduct 50% on the last year, not by quarter.
Accounting Methods
Permissible "overall" methods - Cash - recognize income when received - Accrual - recognize income when earned or received (whichever is first generally) - Hybrid -mix of accrual and cash depending upon accounts (e.g., sales on accrual) Large C corporations and large partnerships with C corporation partners must use accrual method - Taxpayers that satisfy the gross receipts test can elect cash method
Basis Problem Meg O'Brien received a gift of some small-scale jewelry manufacturing equipment that her father had used for personal purposes for many years. Her father originally purchased the equipment for $1,500. Because the equipment is out of production and no longer available, the property is currently worth $4,000. Meg has decided to begin a new jewelry manufacturing trade or business. What is her depreciable basis for depreciating the equipment?
Property received as a gift -> $1500 depreciable basis
Gross Receipts Test for Determining Small Businesses
Qualified small businesses are exempt from certain complex tax law provisions Gross receipts cannot exceed $27 million for the 3-year period preceding the current year - Businesses without 3 years of data use the period for which gross receipts are available - Gross receipts for short years must be annualized
Accrual Method - Accrual Income
Recognize income when earned or received - all events test - recognize income when all the events have occurred that fix the right to receive income and - the amount can be determined with reasonable accuracy Business meet the all-events requirement on the earliest of three dates: - Complete services or sale - Payment is due - Payment is received Note: All-events test is deemed to be satisfied when income is recognized for financial reporting purposes
Reduced Standard Deduction for Dependents
Reduced standard deduction for a taxpayer claimed as a dependent by another •Greater of $1,150 or ($400 + earned income) •Ceiling is regular standard deduction
Formula for Computing the Alternative Minimum Tax
Regular Taxable Income Plus: Standard deduction if taxpayer deducted the standard deduction in computing regular taxable income Plus or Minus: Other adjustments* Equals: Alternative minimum taxable income Minus: AMT exemption amount (if any) Equals: Tax base for AMT Times: AMT rate Equals: Tentative minimum tax Minus: Regular tax Equals: Alternative minimum tax
Reasonableness Example Rick hired his brother, Tom, on a part-time basis. Tom performed the same duties as other part-time employees, but Rick paid Tom an extra $5 per hour to provide support for Tom's education. At year-end, Tom had worked a total of 100 hours and received $2,500 from Rick. What amount can Rick deduct for the compensation he paid to his part-time employees?
Rick can deduct $2,000, with $500 being treated as a gift
Self-Employment (SE) Taxes
Self-employed taxpayers - Responsible for entire FICA tax (employee and employer share and additional Medicare tax for employee portion) - Tax base is net earnings from self-employment (generally, net Schedule C income and multiple by 92.35%) - MEMORIZE If net earnings from SE < $400, no SE tax - Same $147,000 limit applies to Social Security tax
Depreciation
Since 1986, businesses calculate their tax depreciation using the Modified Accelerated Cost Recovery System (MACRS) To compute MACRS depreciation, the following need to be known: ØAsset's initial basis ØDate it was placed in service ØApplicable depreciation method ØAsset's recovery period (or depreciable "life") ØApplicable depreciation convention (depreciation deductible in the year of acquisition and the year of disposition)
Inventory Cost-Flow Methods
Specific identification First-in, first-out (FIFO) Last-in, first-out (LIFO) - Generates lower taxable income than FIFO in time of inflation - "Book-tax conformity" requirement: same method for financial and tax records
Tax Credits
Tax credits reduce tax liability dollar for dollar - In contrast, deductions have an income-level bias: Deductions × Marginal Tax Rate = Tax savings •Consist of three categories - Nonrefundable personal - Refundable personal - Business
Progressive tax rates
Tax tables (Required if taxable income < $100,000) Tax rate schedules (Use if taxable income ≥ $100,000)
Prepayments Requirements
Taxes must be paid as you go through •withholdings •Treated as made equally throughout the year •estimated tax payments •Due on 4/15, 6/15, 9/15 of the current year and 1/15 of the following year
AMT & TMT Calculations
Tentative minimum tax (TMT) = AMT tax base × AMT tax rates - 26% on the first $206,100 (indexed for inflation annually) of AMT base (half for MFS) - 28% for AMT base in excess of the threshold - Long-term capital gains and qualifying dividends taxed at the same preferential rate as for regular tax purposes AMT = TMT ̶ regular tax liability (if positive); zero otherwise
Limitation of Income Shifting from Parents to Children
The tax laws mitigate a parent's ability to shift unearned income to a child in two ways: 1) Reduced standard deduction for dependents 2) Kiddie Tax
Bad Debt Expense
Under accrual method - Financial reporting: allowance method - Tax: direct write-off method, i.e., deduct bad debt expense only when the debt actually becomes worthless Businesses using cash method are not allowed to deduct bad debt expenses, why?
Gross Receipts Question Blue Corp began business on July 1 last year and reports gross receipts of $12.5 million. Can Blue use the cash method this year? Why?
Yes, gross receipts total less than $27 million on an annualized basis (12.5*12/6)
Underpayment Penalties Example Problem. This year Lloyd, a single taxpayer, estimates that his tax liability will be $10,000. Last year, his total tax liability was $15,000. He estimates that his tax withholding from his employer will be $7,800. a.Is Lloyd required to increase his withholding or make estimated tax payments this year to avoid the underpayment penalty? If so, how much? a.Assuming Lloyd does not make any additional payments, what is the amount of his underpayment penalty? Assume the federal short-term rate is 5%.
a) .90*10,000 = 9,000 or 15,000*100% = 15,000 9,000 - 7,800 = 1,200
Limitation on Business Interest Deductions
lDoes not apply to taxpayers with average annual gross receipts of $27 million or less for the prior 3 taxable years lBusiness interest expense deduction is limited to: Øbusiness interest income plus 30% of adjusted taxable income Øadjusted taxable income is taxable income allocable to the business computed by: lSubtracting interest income lAdding interest expense lAdding depreciation, amortization, and depletion lAdding net operating loss deduction and 199A deductions
Organizational Expenditures & Start-up Costs
•Organizational expenditures include expenditures to form and organize a business in the form of a corporation or a partnership and are incurred prior to the starting of business (Ex. 10-22) •Start-up costs are costs businesses incur to start up a business •Recovery period: 180 months •May immediately expense up to $5,000 of organizational expenditures AND $5,000 of startup costs - $ for $ phase-out begins at $50,000 for organizational expenditures & $50,000 for startup costs (separately) •Amount not expensed is amortized over 15 years
Business Credits
•Promote certain behaviors, e.g., hiring unemployed individuals, expending funds to develop new technology •If credit exceeds gross tax, carry back one year and carry forward 20 years (but nonrefundable) •Foreign tax credit •Hybrid business and personal—nonrefundable; carry back one year and carry forward up to 10 years
Underpayments Penalties Continued
•Safe-harbor provisions are applied on a quarterly basis - 90%/4 = 22.5% of current year liability must be paid by each deadline or - 100%/4 = 25% of previous year's liability must be paid by each deadline (110%/4 = 27.5% for taxpayers with AGI > $150,000) •Penalty based on amount of underpayment at each quarter × (federal short-term rate + 3%)/4 - No penalty if no tax liability in the previous year or if tax payable (after withholdings) is < $1,000
Real Property Depreciation
•Straight line method •Mid-month Convention: deduct one-half of a month's depreciation for the month in which the real property was placed in service or sold
Underpayments Penalties
•Subject to underpayment penalty if fall behind on tax prepayments •Safe-harbor provisions help taxpayers who may not be able to predict their earnings for the year and to provide some margin of error (only need one) (1) 90% of current year's tax liability or (2) 100% of previous year's tax liability (110% if AGI > $150,000)
Special Rules: Immediate Expensing
•This incentive is commonly referred to as §179 expense or immediate expensing election •Businesses may immediately expense up to $1,080,000 of tangible personal property placed in service in 2022 - May elect to expense less than the maximum - May expense all or a portion of an asset's basis or several assets' bases - Must reduce the basis of the asset(s) by the §179 expense before computing MACRS depreciation
Depreciation Method
•Three acceptable methods for depreciating personal property Ø200% (double) declining balance (Default method) Ø150% declining balance ØStraight-line •The same method must be used for all similar assets acquired during the tax year ØDepreciation methods may differ for assets acquired in different tax years
Bonus Depreciation
•To stimulate the economy, policy makers occasionally implement bonus depreciation •Percentage is 100% for assets placed in service between 9/27/2017 and 12/31/2022 •Bonus depreciation will be the primary way to depreciate qualified assets for most businesses •Businesses may elect out of bonus depreciation on a property class basis •Bonus depreciation is calculated after the §179 expense but before regular MACRS depreciation
Travel and Transportation (1 of 2)
•Transportation expenses includes the direct cost of transporting the taxpayer to and from business sites - However, the cost of commuting between taxpayer's home & regular place of business is personal and NOT deductible •When using a vehicle for business, taxpayer may choose to deduct - cost of operating the vehicle plus depreciation expense or - a standard amount for each business mile driven, 58.5 cents per mile for 2022 (increased to 62.5 on 7/1/2022) •Travel expenses are only deductible if taxpayer is away from home overnight - Meals (50%), lodging, and incidental expenses are limited to the business portion - Transportation to arrive at the location (e.g., domestic airfare) - fully deductible only if the primary purpose of the trip is for business (zero otherwise)
§197 Intangibles
•When intangible assets are purchased together with other assets of another business for a single price, they are referred to as §197 Intangibles - E.g., goodwill, customer list - Each acquired asset takes a basis equal to its fair market value •Recovery period is 180 months (15 years), regardless of their actual life - A covenant not to compete for 5 years is amortized over 180 months, not 60 months (Ex. 10-21)
Listed Property Example Assume that Teton also purchased in 20x3 a new digital camera for $4,000 that its employees use for business on weekdays. On weekends, Steve uses the camera for his photography hobby. Assume that Teton determined the business-use percentage to be 75%, what is Teton's depreciation deduction on the camera for the year (ignoring bonus depreciation and §179 expensing)? Teton uses half-year convention.
$4,000 * 20% * 75% = $600 depreciation
Late Filing Example Example. Courtney filed her tax return on April 10 and included a check with the return for $4,073 made payable to the United States Treasury. The $4,073 consisted of her underpaid tax liability of $4,000 and her $73 underpayment penalty. If Courtney had waited until May 1 to file her return and pay her taxes, what late filing and late payment penalties would she owe?
$4,000 * 5% = 200
Business Casualty Loss Example Example. Rick acquired business equipment several years ago for $9,000 and had deducted $4,000 of depreciation expense against the asset. Hence, the equipment's adjusted tax basis was $5,000. Suppose further that a fire destroyed the asset, and at the time the asset was worth $1,000 and insured for $250. What would be the amount of his business casualty loss?
$4,750 computed as: $250 - $5,000 = $4,750
CPA Exam Question Nare, an accrual-basis taxpayer, owns a building which was rented to Mott under a ten-year lease expiring August 31, Year 8. On January 2, Year 2, Mott paid $30,000 as consideration for cancelling the lease. On November 1, Year 2, Nare leased the building to Pine under a five-year lease. Pine paid Nare $10,000 rent for the two months of November and December, and an additional $5,000 for the last month's rent. What amount of rental income should Nare report in its Year 2 income tax return?
$45,000
Marriage penalty or benefit - Who is likely to have marriage penalty? - Who is likely to have marriage benefit?
1. Both spouses receive high income 2. One spouse receives income
Credit Application Sequence
1. Nonrefundable personal credits. 2. Business credits 3. Refundable credits.
Summary - Calculating Depreciation for Personal Property
1.Determine the appropriate convention (half-year or mid-quarter) 2.Locate the applicable table provided in Rev. Proc. 87-57 3.Select the column that corresponds with the asset's recovery period 4.Find the row identifying the year of the asset recovery period 5.If the asset is disposed of before fully depreciated, apply half-year or mid-quarter convention for year of disposition
Limits on Immediate Expensing
1.The maximum amount of §179 expense is subject to a phase-out limitation - Reduce the $1,080,000 maximum $ for $ for tangible personal property purchased and placed in service during 2022 over $2,700,000 threshold - The phased-out portion disappears and does not carry over to another year 2.Deductible §179 expense is limited to the taxpayer's business income after deducting all expenses (including regular and bonus depreciation) except the §179 expense - §179 expense cannot create or extend net operating loss - Excess amount carries forward indefinitely
Self-Employment Taxes Problem Rasheed, single, works for Company A, earning $350,000 in salary during 2022. Assuming he has no other sources of income, what amount of FICA tax will Rasheed pay for the year?
147,000 * .062 = 9,114 350,000 * .0145 = 5,075 (350,000-200,000) * .009 = 1,350 Total = $15,539
Assume that Courtney received $100,000 of taxable compensation from EWD in 2022, and she received $180,000 in self-employment income from her consulting activities. Assume that Courtney's employer correctly withheld $6,200 of Social Security tax, $1,450 of Medicare tax, and $0 of additional Medicare tax. What amount of self-employment taxes and additional Medicare tax is Courtney required to pay on her $180,000 of business income?
180,000*92.35 = 166,230 (Net Earning From SE) SS Tax: (147,000-100,000)*.062*2 = 5,828 Medicare Tax: 166,230*1.45%*2 = 4,821 (100,000 + 166,230-200k)*.09%= 596 4,821 + 596 = 5,417
Business Interest Example This year MH Inc. reported $200,000 of taxable income on $30 million of revenue. The revenue included $20,000 of interest income. In calculating the taxable income, MH deducted: $340,000 of depreciation $210,000 of interest expense What is MH's maximum business interest deduction this year?
20,000 + (200,000+340,000 + 210,000- 20,000)*.3 = 239,000
Bad Debt Expense Example Example. At year-end, Rick estimates that about $900 of the receivables from his landscaping services will be uncollectible, but he has identified only one client, Jared, who will definitely not pay his bill. Jared, who has skipped town, owes Rick $280 for landscaping this fall. What amount of bad debt expense may Rick deduct for the year?
280
Immediate Expensing Example Assume TDW Corporation's (calendar year end) has 2022 taxable income of $650,000 for purposes of computing the §179 expense. The company acquired the following assets during 2022: Asset; Placed in Service; Basis Machinery; Sep 12; $2,270,000 Computer Equipment; Feb 10; 263,000 Furniture; April 2; 880,000 Total; ; $3,413,000 A) What is the maximum amount of §179 expense TDW may deduct for 2022?
3,413,000 - 2,700,000 = 713,000 1,080,000 - 713,000 = 367,000
Net Investment Income Tax
3.8% tax imposed on lesser of: - Net investment income (e.g., interest, dividends, annuities, royalties, rents, passive activity income, net gains from disposing of property, less related allowed deductions) or - Excess of modified AGI over $250,000 (MFJ), $125,000 (MFS), and $200,000 (all others)
Business Credit Application Example Example. Gram's gross tax liability is $369. She is entitled to an $800 nonrefundable personal tax credit, a $700 business tax credit, and a $600 refundable personal tax credit. What is the amount of Gram's refund or taxes due?
$600
Income Recognition Example Ben provides consulting services and bills Ace for $12,000. Ace disputes the amount claiming that $8,000 is the proper amount. How much income should Ben recognize under the accrual method this year?
$8,000
Statutory Limits on Business Expense Deductions (Summary)
- Expenditures against Public Policy - Political contributions & lobbying costs - Capital Expenditures - Expenses Relating to Tax-Exempt Income - Personal Expenditures - Mixed-motive Expenditures - Limitation on Business Interest Deductions - Losses on Disposition of Business Property
Choosing an Accounting Period
- Sole proprietorships use calendar year-end, because individual proprietors must report business income on individual returns - Flow-through entities (Partnerships & S corporations) must match to the owners' tax years - C corporations: can choose any option, consistent with book accounting period; choice is made on the first tax return - Need IRS permission to change tax year
Business Credit Application Example This year Luke has calculated his gross tax liability at $1,800. Luke is entitled to a $2,400 nonrefundable personal tax credit, a $1,500 business tax credit, and a $600 refundable personal tax credit. In addition, Luke has had $2,300 of income taxes withheld from his salary. What is Luke's net tax due or refund?
-$1,800 + $2,400 = $600 (loss of nonrefundable credit) + $1,500*0(carry forward or back) + $600 +$2,300 = $2,900 $2,900
Business casualty losses
-If asset is completely destroyed or stolen, loss is adjusted tax basis - If asset is damaged but not completely destroyed, loss is the lesser of decline in value (repair cost) or adjusted tax basis - Insurance proceeds and other cost recovery must be subtracted from casualty loss deductions
Basis Example •Scrap-Happy Inc., a scrapbooking retail chain, purchased an old office building for $175,000 for use in expanding its current operations. An additional $15,000 was spent painting and remodeling the building in preparation for its opening •Two years later, a Scrap-Happy employee discovered that several leaks in the roof were causing serious water damage to the store's inventory; the company spent $50,000 to re-roof the building •Every six months, Scrap-Happy pays $500 to have the carpet professionally cleaned A) What is the original basis of the building? B) What effects do the other two transactions have on the original basis?
A) $175,000, Initial Cost, +15,000, Painting and remodeling $190,000, Original basis B) - $50,000 re-roofing expense: Added to basis
Immediate Expensing Example Assume that Teton is eligible for and elects to immediately deduct $800,000 of §179 expense against the basis of the machinery acquired in 2022 (Note Teton could have elected to deduct up to $1,080,000). The cost basis of the machinery is $1,200,000. A) What is the amount of Teton's current year depreciation expense, including regular MACRS depreciation and the §179 expense on its machinery (assuming half-year convention applies)? B) Assume Teton was eligible and elected to claim the maximum amount of §179 expense. What is the total current year depreciation expense, including MACRS depreciation and §179 expense?
A) New Basis: $1,200,000 - $800,000 = $400,000 Use Half Year Convention 400,000 * 14.29% = 57,160 14.29% is year 1 depreciation rate for HY 7-year period 57,160 + 800,000 = 857,160 total depreciation for the first year. B) 1,200,000 - 1,080,000 = 120,000 120,000 * 14.29% = 17,148 17,148 + 1,080,000 = 1,097,148 total deduction
Personal Expenses Problem Michelle operates several food trucks. Indicate the amount (if any) that she can deduct as an ordinary and necessary business deductions in each of the following situations and explain your solution. a) Michelle moves her food truck between various locations on a daily rotation. Last week, Michelle was stopped for speeding. She paid a fine of $125 for speeding including $80 for legal advice in connection with the ticket. b) Michelle paid $750 to reserve a parking place for her food truck for the fall football season outside the local football arena. Michelle also paid $95 for tickets to a game for her children. c) Michelle provided a candidate with free advertising painted on her truck during the candidate's campaign for city council. Michelle paid $500 to have the ad prepared and an additional $200 to have the ad removed from the truck after the candidate lost the election.
A) Only the $80 can be deducted B) Only the $750 can be deducted C) None is deductible as it's essentially a contribution to the campaign.
Real Property Depreciation Example On July 12, Scrap-Happy purchases and places in service a warehouse and the land it resides on for $170,000 ($120,000 is allocated to the building and $50,000 to the land). A) What is the amount of depreciation on the property for the first year? B) What is the amount of depreciation if the property was sold in May of the 2nd year? C) What is the amount of depreciation in the last year if the property was retired at the end of its life (i.e., July of year 40)?
A) Table 5, Column 7, 1.77% * 120,000 = 1,412 B) 120,000 * 2.564% * 4.5/12 = 1,153.8 C) 120,000 * 1.391% = 1,669.2
Alternative Minimum Tax
AMT is a tax based on an alternative more inclusive tax base than regular taxable income - Meant to ensure that taxpayers are paying some minimum level of tax
Accrual Method - Unearned (Prepaid) Income
Advance payments for goods and services - Allowed to defer recognition until the next tax year unless income is earned or recognized for financial reporting purposes by end of year - The one-year deferral method does not apply to payments related to rent or interest income - This is an accounting method election that cannot be changed without the permission of the IRS
Nonrefundable Personal Credit continued
American opportunity credit (AOTC; formerly Hope scholarship credit) •For first four years of post-secondary education •For eligible expenses and institutions only •Applied per student •Taxpayer, taxpayer's dependents, third parties on behalf of taxpayer's dependents •Amounts paid by dependents treated as paid by taxpayer •100% of first $2,000 of eligible expenses and 25% of next $2,000 (maximum credit is $2,500) •Phase-out based on AGI •40% of credit is refundable (subject to restrictions)
Business Gross Income
Business income (Schedule C income) includes - gross profit from inventory sales (sales minus cost of goods sold) - income from services provided - income from renting property to customers A business is allowed to exclude or defer certain types of realized income
Self-Employment Taxes Problem Alice is single and self-employed in 2022. Her net business profit on her Schedule C for the year is $160,000. What are her self-employment tax liability and additional Medicare tax liability for 2022?
$160,000*.9235 = 147,760 Net Earnings from Self-Employment Social Security Tax: $147,000*.062*2 (employer & employee portion) = 18,228 Medicare Tax: $147,760 * .0145*2 (employer & employee portion) = 4,285 Total: $22,513
American Opportunity Credit Example Courtney paid $2,000 of tuition and $300 for books for Ellen to attend the University of Missouri-Kansas City during the summer following the end of her first year. What is the maximum American opportunity tax credit (AOTC) (before phase-out) Courtney may claim for these expenses?
$2,000 * 100% + ($300 *25%) = $2,075
12-month Rule Example Ben, a cash basis taxpayer, makes the following payments on June 30 of this year: - $10,000 for the next 10 months of utilities. - $12,000 for insurance over the next 24 months. - $9,600 for the next 8 months of interest on a business loan. What amounts are deductible this year?
$10,000 + ($12,000/24)*6 + ($9,600/8)*6 = $20,200
Alternative Minimum Taxable Income Example Problem. Sylvester files as a single taxpayer. He itemizes deductions for regular tax purposes. He paid charitable contributions of $7,000, real estate taxes of $1,000, state income taxes of $4,000 and mortgage interest of $2,000 on $30,000 of acquisition indebtedness on his home. Sylvester's regular taxable income is $100,000. What is Sylvester's AMTI?
$100,000 + 1,000 + 4,000 = $105,000
Personal Expenses Problem Indicate the amount (if any) that Josh can deduct as ordinary and necessary business deduction in each of the following situations and explain your solution. a. Josh borrowed $50,000 from the First State Bank using his business assets as collateral. He used the money to buy City of Blanksville bonds. Over the course of a year, Josh paid interest of $4,200 on the borrowed funds, but he received $3,500 of interest on the bonds. b. Josh purchased a piece of land for $45,000 in order to get a location to expand his business. He also paid $3,200 to construct a new driveway for access to the property. c. This year Josh paid $15,000 to employ the mayor's son in the business. Josh would typically pay an employee with these responsibilities about $10,000 but the mayor assured Josh that after his son was hired, some city business would be coming his way. d. Josh paid his brother, a mechanic, $3,000 to install a robotic machine for Josh's business. The amount he paid to his brother is comparable to what he would have paid to an unrelated party to do the same work. Once the installation was completed by his brother, Josh began calibrating the machine for operation. However, by the end of the year, he had not started using the machine in his business.
A) $0. The interest expense is not deductible (expense associated with tax-exempt income) B) $0. Capital expenditures are not deductible. C) Only $10,000 is deductible. The remaining $5,000 is unreasonable. D) $0. The cost to install the machine should be capitalized as part of the cost of the machine. It is a cost necessary to operate the machine.
Reduced Standard Deduction for Dependents Example Stephanie is 10 years old and often assists neighbors on weekends by babysitting their children. Calculate the 2022 standard deduction Stephanie will claim under the following independent circumstances (assume that Stephanie's parents will claim her as a dependent). a. Stephanie reported $600 of earnings from her babysitting. b. Stephanie reported $1,500 of earnings from her babysitting. c.Stephanie reported $18,000 of earnings from her babysitting.
A) $1,150 B) $1,900 ($1,500 + $400) C) $12,950 (standard deduction for single)
Kiddie Tax Example Suppose that during 2022, Deron received $5,300 in interest from an IBM bond, and he received another $2,100 in interest income from a money market account that his parents have been contributing to over the years. Deron is 10 years old at the end of 2022 and is claimed as a dependent by his parents on their tax return for 2022. Deron's parents' marginal tax rate is 24%. a) Is Deron subject to kiddie tax? What are Deron's taxable income and corresponding tax liability? b) What if Deron's only source of income is qualified dividends of $5,300.
A) $1,339 Tax Liability B) $450 Tax Liability
Qualifying Dividend Example Assume that Courtney's taxable income is $145,070 including $700 of qualifying dividends from GE. What is her tax liability on her taxable income assuming that she qualifies to file as head of household? What if her taxable income is $498,500 including $15,000 of qualifying dividends taxed at preferential rate?
A) $27,089.8 B) 144,228.1
Immediate Expensing Example Assume that during 2022, Teton placed into service $2,400,000 of machinery, $920,000 of computers, and $80,000 of delivery truck for a total of $3,400,000 tangible personal property for the year. A) What is Teton's maximum §179 expense after applying the phase-out limitation? B) Assume further that on November 13, Teton acquired and placed in service a warehouse costing $400,000. Taking the warehouse into account, what is Teton's maximum §179 expense after phase-out? C) Assume that Teton elects to claim the entire $380,000 expense and chooses to apply it against the machinery. Further assume that Teton reports $400,000 of taxable income before deducting any §179 expense and depreciation. What amount of total depreciation (including §179 expense) is Teton able to deduct on the machinery for the year assuming half-year convention applies? What is the amount of Teton's excess §179 expense and what does Teton do with it for tax purposes?
A) 1,080,000 - (3,400,000 - 2,700,000) = 380,000 Maximum §179 expense B) The same as above because the warehouse is not tangible personal property and therefore does not influence the deduction expense. C) 2,400,000 - 380,000 = 2,020,000 2,020,000 * 14.29% = 288,658 MACRS depreciation 400,000 - 288,658 = 112,342 (2 restriction)
AMT Example Problem. In 2022, Juanita is married and files a joint tax return with her husband. Her AMT base is $250,000, all ordinary income. A) What is her tentative minimum tax (TMT)? B) Is this the amount of AMT that she needs to pay?
A) 206,100 * .26 + 41,900 * .28 = $65,318 B) No, regular tax liability isn't given therefore you don't know the exact AMT
Calculate Depreciation of Computer for 20x1-20x3 (Half-year Convention, DB) Asset; Cost; Date placed in service Di-Cut Machine; $3,500; February 2 (1st Qtr.) Computer; $1,200; October 25 (4th Qtr.) A) Computer Depreciation:? B)•How much depreciation for 20x3 if the computer was sold in 20x3? C) Now assume the same facts, except that the computer was purchased in February and the machine in October. What convention should be used in computing depreciation for the year?
A) 20x1: 1,200*.2 = 240 20x2: 1,200 * .32 = 384 20x3: 1,200 * .192 = 230.4 B) 1,200 * .192 * .5 = 115.2 C) Mid-Quarter Convention because (3500)/(1200+3500) = 74.4% > 40%
Depreciation Example In 20x1, Scrap-Happy purchased and placed in service the following assets: Asset Cost Date placed in service Di-Cut Machine;$3,500; February 2 (1st Qtr.) Computer; $1,200; October 25 (4th Qtr.) What is the recovery period for each of the assets? 5 years for each Which convention should Scrap-Happy use to determine depreciation for 20x1?
A) 5 years for each B) (1200)/(1200+3500) = .25 < 40% therefore Half Year Convention
AMT Example Problem. Steve's tentative minimum tax (TMT) is $245,000. What is his AMT? a. if his regular tax is $230,000 b. if his regular tax is $250,000
A) AMT = TMT - RTL = 245,000 - 230,000 = 15,000 B) AMT = TMT - RTL = 245,000 - 250,000 = -5,000 Since RTL > TMT then AMT = 0
Accrual Method Example A) In late November 2022, Rick received a $7,200 payment in advance from a client for monthly landscaping services from December 1, 2022, through November 30, 2024 ($300/month for 24 months). When must Rick recognize the income from the advance payment for services? B) Suppose that rather than receiving payment in advance for services, Rick's client paid $7,200 in 2022 for landscaping supplies that Rick purchased and provided in 2023. When must Rick recognize the income from the advance payment for goods?
A) Cash Method: In November of 2022 Accrual: Recognize income $300 in current year and the rest ($3300) to next year B) Cash Method: Recognize in 2022 Accrual Method: Recognize in 2023
Timing Example Example. In early fall, Rick contracted with a dozen homeowners to landscape their yards. Rick agreed to do the work for an aggregate of $11,000. Rick and his crew started in the fall and completed the jobs in December of this year. However, he didn't mail the bills until after the holidays and didn't receive any payments until the following January. When must Rick recognize the income from this work?
Cash Method: Next Year (January) Accrual Method: Current Year (December)
Nonrefundable Personal Credit
Child tax credit - $2,000 for each qualifying child under age 17 at end of year who is claimed as taxpayer's dependent Partially refundable - $500 for each other qualifying dependent - Subject to phased out when AGI exceeds applicable threshold
Basis for Cost Recovery
•Once the use of purchased assets is started, recouping the cost of assets also starts (no cost recovery before the asset is used) •Initial basis decreases when cost is recovered through cost recovery deductions, which is called asset's adjusted basis or tax basis •Assets' adjusted basis = asset's initial basis minus accumulated depreciation (amortization or depletion)
Inventories
Inventories must generally be accounted for under the accrual method if sales of goods is an income-producing activity - Sales and purchases must be recorded using the accrual method - This requirement applies even if taxpayer uses the cash method (thus hybrid method applies)
AMT Adjustments
Items commonly added back to regular taxable income in computing alternative minimum taxable income (AMTI): •Standard deduction if used •If used itemized deduction - State income or sales taxes; real property and personal property taxes deducted as itemized deductions (subject to $10,000 limitation for state and local tax deductions) •Minus adjustments: state income tax refunds included in regular taxable income, why?
Late Filing and Late Payment Penalty
Late Filing Penalty - 5% of tax owed per month up to 25% if not fraudulent - 15% of tax owed per month up to 75% if fraudulent - No penalty if no tax is owed as of the due date •Late Payment Penalty - If don't pay entire tax owed by original due date of return - 0.5% of the tax owed for each month (or fraction of a month) that the tax is not paid up to 25% •If the late filing penalty and late payment penalty both apply in the same month, the late filing penalty for the month (and its corresponding maximum penalty) is reduced by the .5% late payment penalty for the month
Business Expenses with Personal Benefits
Mixed motive? - For some expenditures, deduction is determined by taxpayer's primary motive (all or nothing) - E.g., domestic airfare for business travel - Otherwise, allocate deduction to business portion Basis for allocation (mileage or time) Arbitrary percentage (50% for meals for the business portion) Record keeping - Document business purpose
Depreciation Convention - Half-year Convention
•One-half of a full year's depreciation is allowed in the first and last year of an asset's life •IRS depreciation tables automatically account for this convention in year of purchase and disposition (assuming the asset is held till the end of its life) •If an asset is disposed of before it is fully depreciated, only one-half of the table's applicable depreciation percentage is allowed in the year of disposition •The convention remains the same for the entire recovery period of an asset •If an asset is acquired and disposed of in the same year, no depreciation is allowed
Meals
•50% can be deducted if meet ALL of the following conditions (Ex. 9-7) - Amount is reasonable - Taxpayer (or an employee) is present when the meal is furnished - The meal must be directly associated with the active conduct of business: e.g., discussed business before, during or after the meal •100% for 2022 (and 2021) if provided by a restaurant
Other Refundable Personal Credits
•A portion of the child tax credit •A portion of the AOTC •Excess FICA withholdings •Tax withheld on wages and estimated tax payments
Depreciation Convention ̶ Mid-Quarter (MQ) Convention
•Applicable when > 40% of tangible personal property is placed in service in the last quarter of the business's tax year •If MQ convention applies, it must be used on all tangible personal property placed in service during the current year •In the year of acquisition (disposition), the asset is treated as though it was placed in service (disposed of) in the middle of the quarter in which it was actually placed into service (disposed of) •Becomes largely irrelevant post-TCJA due to §179 immediate expensing and bonus depreciation
Cost Recovery
•Businesses must capitalize the cost of assets with a useful life of more than one year on the balance sheet rather than expense the cost immediately •Businesses are allowed to allocate the cost of these assets to expense over time due to wear, tear and obsolescence of assets The method of cost recovery depends on the nature of the underlying asset •Depreciation - Deducting the cost of tangible personal and real property (other than land) over a specific period of time •Amortization - Deducting the cost of intangible property over a specific period of time •Depletion - Deducting the cost of natural resources over time
Amortization
•Businesses recover cost of intangible assets through amortization •Four general categories of intangible assets: -§197 Intangibles -Start-up expenditures and organizational costs -Research and experimentation costs -Patents and copyrights •Straight-line method: for both book & tax •Full-month convention: deduct an entire month's worth of amortization for the month of purchase and all subsequent months including the month of sale/disposition
Issues with Half-year Convention
•By purposely acquiring assets at the end of the year rather than at the beginning of the next tax year, businesses received one-half of a full year's depreciation deduction for assets that were used only for a small portion of the year •To prevent businesses from abusing the half-year convention, Congress introduced mid-quarter convention
Major itemized deductions that are deductible for both regular tax and AMT purposes (no adjustment is needed in computing AMTI)
•Charitable contributions •Home mortgage interest expenses •Gambling losses
Listed Property
•Defined: assets that tend to be used for both business and personal purposes • •Depreciation is limited to business use (Ex. 10-16) - If business use > 50%, use normal depreciation methods - If business use ≤ 50%, use straight-line depreciation
Employment & Self-Employment (FICA) Taxes
•Employee Must pay FICA taxes on compensation from employer - 6.2% Social Security tax rate; capped at $147,000 earnings (2022) - each spouse subject to separate limit - 1.45% Medicare tax rate, additional 0.9% on wages over $200,000 ($250,000 MFJ, $125,000 MFS) •Employer - Pays FICA tax on employee's compensation (6.2% Social Security tax rate; 1.45% Medicare tax rate - not subject to 0.9% additional Medicare tax) - Withholds FICA tax from employee's paycheck
Depreciation Recovery Period
•For financial accounting purposes, an asset's recovery period (depreciable life) is based on its taxpayer-determined estimated useful life •For tax purposes, an asset's recovery period is predetermined by the IRS in Rev. Proc. 87-56, which helps taxpayers categorize each of their assets based upon the property's description
Personal Property Depreciation
•Includes all tangible property such as computers, automobiles, furniture, machinery and equipment, other than real property •Personal property (not real property) and personal use property (used for personal purposes) are NOT the same
Filing Requirements
•Individual taxpayers must file a tax return if their gross income exceeds certain thresholds, which vary based on the taxpayers' filing status and age •Lower thresholds for those claimed as dependent on another's tax return •Due dates •April 15 •Extend filing up to six months •Does not extend due date for paying taxes
Employment and Self-Employment Taxes Continued
•Multiple employers during the year ØEach employer is required to withhold social security tax until the wage base limit is reached with the employer ØTaxpayer receives refund for excess social security tax paid (schedule 3, line 11) Ø •How does the $147,000 Social Security earnings limit apply when receiving both wages and SE earnings in the same year? ØWages use up limit first - taxpayer favorable or unfavorable? Why?
Kiddie Tax
•Net unearned income taxed at parents' marginal rate (preferential tax rate applies to LTCG and qualifying dividends) •Net unearned income is the lesser of 1.Child's gross unearned income minus $2,300 2.Child's taxable income Applies if 1.Child is under age 18 at year end 2.Child is 18 at year end but earned income not greater than half of child's support, or 3.Child is over age 18 but under age 24 at year-end, is a full-time student during the year, and child's earned income not greater than half of child's support (excluding scholarships)
