The Individual Tax Model
Taxable Income Computation
 Calculate gross income totaling Line 22 on 1040 –
based on filing status (S,MFJ, MFS,HH).
 Calculate Adjusted Gross Income (AGI)
 Subtract the greater of:
itemized deductions or
 the standard deduction (based on filing status)
Subtract total personal/dependency exemptions
Result is Taxable Income
Individual Tax Model – Gross Income / Exclusions
General Rule: Gross Income is “Broadly Conceived”: Includes all income
subject to taxation unless specifically indicated as not taxable by law.
Exclusions include:
 unrealized gains, gifts, inheritances, welfare type payments, many fringe
benefits, returns of capital, Municipal Interest, some US Govt for higher
education, life insurance proceeds.
Scholarships - excludible if
recipient is candidate for degree, amount received is not a payment
for services, and is used to pay tuition, books, and other similar
educational expenses
Foreign earned Income (Sec. 911) - build U.S. Economy
Exclude up to $95,100 of foreign earned income annually plus a
housing allowance (exclusion cannot exceed earned income
Individual must be a bona fide resident of the foreign country for an
entire tax year or be in the foreign country for 11 mos in any 12 month
period.
Individual Tax Model: Special Income Inclusions
Annuities: Amount not taxed: Inv. / Expected Return *
Pymts Rec
Deferred Compensation Plans: Defined Contribution
Plans, Defined Benefit Plans - Qualified Retirement Plans
Prizes and Awards - include FMV
Social Security Benefits - up 85% may be taxed
Unemployment compensation is taxable
Alimony received is taxable / Child support is not
includible but is not deductible either.
Special Rules
Dividends (cash and noncash) - FMV of prop
received (subject to E& P provisions)
Stock dividends generally not taxable
Damages - personal (special rules) business
damages not excludible.
Discharge of indebtedness - generally includible.
Business versus Investment
Business activity
Time and talent on regular basis
Profit partially attributable to personal involvement
Income is considered earned income
Hobby losses only deductible to extent of hobby income –
not a business activity
Investment activity
Passive role as owner of income-producing property
Income is considered unearned income
Losses on personal use assets are not deductible – gains
from sale are treated as capital assets.
Gains/Losses on Securities
Realization requires a sale or exchange
Gain/loss = Proceeds - adjusted basis
Character is capital - time period matters
Basis issues
reinvested dividends increase basis.
Sale of stock uses either specific ID or FIFO method of
matching basis with sales.
Mutual fund shares sold typically use an average basis.
What to do with Capital Gains and Losses
SHORT TERM asset held for <= 1 year – gains taxed as
ordinary income
LONG TERM asset held for > 1 year
L/T Gains taxed at lower capital gains tax rate of 15%
Net the gains and losses in each class (net ST, net LT, net
28%LT).
Special rule for sale of principal residence
Exclude only one gain every 2 years.
Limits $500,000 MFJ, $250,000 other
Deductions for Adjusted Gross Income and AGI
Deductions for Adjusted Gross Income
 Trade/Business Exp from a Sole Proprietorship are reported on Schedule C /
or for a rental property are recorded on schedule E
 Student Loan interest up to $2500 (Income limits apply)
 Self Employed Expenses: 50% of SE tax, percentage of health insurance
premiums, Keogh and Simple retirement plans
 IRAs, Moving Expenses, Contributions to MSAs
 Penalty for early withdrawal of savings
Result of Income less deductions for Adjusted Gross
Income –is AGI (very key concept) - many deductions are a
function of AGI (e.g., IRA deductions, medical expenses,
charitable contributions)
Many items of gross income are also a function of AGI
Social Security Benefits, Passive Activity Losses
Itemized Deductions / Personal Losses Itemized deductions
a special class of deductions that allow taxpayers to derive tax
benefits from certain personal & investment expenditures
Medical, Interest (Mortgage/Investment), Taxes (ad
valorem/Sales/State Income Tax), Charity, Miscellaneous
(Unreimbursed Employee Bus expenses, Investment Expenses, Tax
Prep, Casualty losses)
Individuals deduct the greater of the standard deduction for
his/her filing status or the total of his/her itemized
deductions.
About 1/3 of all TPs claim itemized deductions
Itemized deductions are shown on Form 1040 Schedule A.
Exemptions
Personal exemption for the taxpayer (2 for MFJ).
If you are a dependent on someone else’s return, can you
still claim yourself?
Exemption = $3,900 in 2013 for each personal or
dependency exemption.
5 Tests for Dependency?
Rich People
Phase-out of itemized deductions –
see handout. Haircut 3% of AGI
over $300,000
Phase-out of exemptions – see
handouts, in 2013, MFJ
exemptions disallowed if AGI
>$425,000 – if less assume fully
allowed.
Tax Credits
A credit is a dollar for dollar reduction in the tax liability. A
deduction only reduces the tax by the marginal tax rate
associated with that deduction.
Child Credit = $1,000 per child in 2013. Phases out for rich.
Dependent care credit (child < 13 years old). Credit amount
between 30% and 20% of child care costs depending on
income range.
Earned income credit. This is refundable - a transfer
payment to working poor. Increases progressivity of tax
rates. Credit is higher for taxpayers with children and phases
out as income increases.
Excess FICA withholding is refunded through a tax return
claim.
Payment and Filing Requirements
Taxes on wages are withheld each pay
period.
Estimated taxes are due on April 15, June
15, September 15, and January 15.
Pay 90% of current year tax, 100% of prior
year (or 110% of prior year AGI>$150,000).
Tax return due 4/15, but may be extended to
8/15 then 10/15 (LAST DATE).
Taxable Income from
Business Operations
Taxable Income
Taxable income = gross income less allowable
deductions
Gross income “means all income from whatever source
derived.” AKA Broadly Conceived.
Deductions are allowed through legislative grace, and include
all ordinary and necessary expenses … in carrying on any
trade or business.”
Good rule of thumb: receipts are taxable UNLESS you
can find a law that says it is excluded. Expenses are
deductible ONLY if you can find a law that says it is
deductible.
Taxable Year
12-month period which generally
corresponds to its fiscal year.
Individual taxpayers must generally choose
a calendar year.
Firms generally choose a year = end of an
annual operating cycle.
Changing tax years requires permission - most
common reason is merger of firms with different
year-ends.
Accounting Methods
Overall method by which taxpayers determine their
income, deductions and credits, as well as the time
realized and recognized. Section 482 grants IRS
broad powers to “distribute, apportion, or allocate
income” among businesses to CLEARLY REFLECT
income of each.
CONSISTENTLY APPLIED
Establish a method by using it in the first tax return.
Requires IRS permission to change.
Cash Method
Under the cash method, gross income includes cash or
property actually RECEIVED during the tax year.
Deductions are usually taken in the year cash or property is
PAID.
Cash method income includes receipt of noncash goods
Anti-abuse provision: Constructive receipt doctrine.
Occurs when taxpayer has unrestricted access to and control of the
income.
NO constructive receipt if the amount is available only on surrender of
a valuable right, or if there are substantial limits on the right to receive
it.
Exceptions - Cash Method
Cash method - deduct expenses when PAY. A
check is payment when mailed.
An asset must be capitalized. The cost of the
asset may be recovered over the asset life (e.g.
depreciation, cost of goods sold). Major repairs may
result in IRS dispute regarding expense versus
capitalization.
Inventory must be accounted for on the accrual
method, even for cash basis taxpayers. This is
called a HYBRID method of accounting.
Cash Method Deductions - Prepaid Expenses
Where an expense (e.g., rent or an insurance
premium) covers more than the following tax year,
the deduction must be spread over the period to
which the expense applies.
However, prepaid interest must be capitalized and
deducted over the period for which interest is
actually charged even if prepayment < next tax
year.
Exception - deduct prepaid interest (points) on the
purchase of a home. Does not apply to refinancing.
Accrual Method of Accounting
Under the accrual method, report income when the
right to the income and the amount of the income
can be determined with reasonable accuracy.
(REALIZATION)
MATCH expenses against revenues. Deduct when
ALL EVENTS have occurred that determine the
existence of the liability and the amount of the
liability can be determined with reasonable
accuracy.
Book-Tax Differences
Contrasting principles of conservatism.
GAAP - protect shareholders and creditors: don’t
overstate book income.
Tax - protect government revenues: Don’t
understate taxable income. (Contrasting result may
arise due to economic incentives - e.g. accelerated
depreciation.)
Book-Tax Permanent Differences
Permanent differences do not reverse; Temporary
differences reverse over the life of the firm.
Examples of permanent differences
50% meals and entertainment
political contributions
fines and penalties
interest expense to generate tax-exempt municipal bond
income
premiums on life insurance
Tax-exempt municipal bond income
Life insurance proceeds
Temporary Book-Tax Differences
Examples of temporary differences:
Depreciation
Timing of accruals
Capital losses
Bad debts (allowance vs. writeoff)
Cash versus accrual accounting
Accrual Expenses Exceptions
Related Party Accruals – Sec. 267
The paying party cannot deduct an expense until the year
that a receiving party deducts the expense.
Prevents accrual basis taxpayers from accruing an
expense but delaying payment.
Sole Proprietorship
Business income and expenses are reported on
Schedule C, filed with the individual form 1040.
Net income or loss on Schedule C is ordinary
income or loss; combine this net with other items of
gross income.
If the Schedule C business loss > other sources of
income, the NOL (net operating loss) can be carried
back 2 years and forward 20 years.
Employment Taxes
FICA = 6.2%/6.2% Social Security tax (on wages up to
$113,700 in 2013) + 1.45% Medicare tax on all wages. Both
employer and employee must pay this tax.
Employers withhold income taxes and the employee’s share
of FICA.
Employers must remit the withheld taxes to the federal (and
state if applicable) governments.
Self-employed taxpayers must pay SE (self-employment)
tax, equal to 2 x FICA, or 15.3% of net earnings from selfemployment. (See footnote 20 for details). 1/2 of SE tax is
deductible on Form 1040.
Property Acquisitions and
Cost Recovery Deductions
Expense vs. Capitalize
Deduction permitted for all “ORDINARY
AND NECESSARY” business expenses
Deduction prohibited for “PERMANENT
improvements to increase the value of
property”
Some types of capitalized costs can be
recovered through amortization or
depreciation
Tax Basis
Tax basis = unrecovered cost (cost - depreciation).
Starting basis generally equals COST basis:
original purchase price regardless of whether acquired by
debt, or
FMV of asset if cost more difficult to measure.
Cost recovery of
Inventory = cost of goods sold
Tangible assets = depreciation
Intangible assets = amortization
Natural resources = depletion
Depreciation
Depreciation applies to tangible assets (things you
can touch versus intangibles like patents, goodwill)
that:
Lose value over time due to wear and tear, obsolescence
Buildings depreciate even though real estate often increases
in value.
Have a reasonably ascertainable useful life
Artwork is not generally depreciable.
Depreciation
MACRS - Modified Accelerated Cost
Recovery System
Personalty:
DDB: 3, 5, 7, 10
150% DB:15, 20
General rule is half year convention
Realty: SL method: 27.5 years residential, 39
years non-residential (specialty realty 20, 25, 50)
Mid Month convention
Depreciation Conventions - Personalty
Normal is half year convention
Anti-Abuse provision Mid-quarter convention
: IF > 40% personalty is acquired during the last quarter
of the year, THEN
Compute depreciation separately for EACH quarter’s
acquisition using mid-quarter tables in appendix of
chapter 6
Automobiles
Maximum annual depreciation limit per
vehicle, indexed for inflation. ––, 2013 bonus
depreciation 50%
Compute depreciation per MACRS, then
limit above.
Expensing Election – Section 179
Applies to tangible personalty. May expense
$500,000 of assets purchased in 13 – also
50% bonus depreciation for 2013.
Expense cannot create a business loss.
Expense reduced $ for $ by purchases >
$2,000,000.
Reduces recordkeeping, benefit for small
businesses
Planning - if buy a 3-year, 5-year and 7-year asset,
which one should you expense?
Amortization of Intangibles
Generally requires a determinable useful life.
Organizational costs are amortizable straight
line method over 180 months – first 5K
generally deductible immediately.
Start-up costs are also amortizable straight
line method over 180 months - some
exceptions.
Expansion costs may be currently
deductible.
Leasehold Costs and Improvements
Cost of acquiring lease is amortized
over the period of lease.
Improvements to leased property are
capitalized and depreciated according to
type of property.
Purchased Intangibles
Allocate lump-sum price to assets by
relative FMVs.
Residual = goodwill.
Tax = 15 years SL
GAAP = 40 years pre-2002. No GAAP
amortization post-2001 - evaluate for
impairment annually. Book-tax difference
is permanent post-2001.
Chapter
7
Property Dispositions
Realized Gain or Loss
Amount realized on disposition
MINUS adjusted basis of property (e.g. cost accumulated tax depreciation = “NBV”)
= Realized gain or loss.
GENERALLY, realized (economic) gains and
losses on disposition are recognized (result in
taxable income or deductions) unless there is a
specific exception. See Chapter 8.
Unrealized (mere appreciation or decline in value)
gains and losses are neither realized nor
recognized.
Amount Realized
Cash received
FMV of any property received, including buyer’s
note
Relief of debt. AP3.
Reduce the amount realized by selling costs such
as sales commissions, broker fees.
No adjustment for “inflationary gains.”
Installment Sale Method
Permits deferral of gain recognition until cash is
received on the sale.
Gain recognized this year = (cash this year) x (total
gain / total sales price).
Not allowed for sales of publicly traded stock or for
inventory, or to delay recognition of depreciation
recapture.
Financial accounting uses accrual accounting, so
installment sales method for tax creates a
temporary book-tax difference.
Related Party Losses
Relative:
family = spouse, sibling, ancestors, lineal descendants
Q10
50% controlled corporations
Losses realized on sale of property between
related parties are NONdeductible.
Future gain (but NOT loss) by relative can be offset
by disallowed loss.
Character of Gain or Loss - Overview
Tax or deduct
at ordinary rates
Ordinary
Section1231
net gain
Capital
Net capital gains and
losses: Individual may
deduct $3000 net loss.
Net LT gain taxed at
lower rates.
Section 1231 Assets
Real or depreciable property used in a trade or
business. Q1
GENERAL rule.
Net Section 1231 gains and losses
IF NET GAIN => add to capital gains and losses. Result
is possible lower tax rate on 1231 net gains.
IF NET LOSS => add to ordinary gains and losses. Can
also offset salary, interest, dividends, etc. Result is
ordinary rate benefit of 1231 net losses.
Depreciation Recapture
Gain on each separate asset may be subject to
depreciation recapture.
Depreciation recapture does NOT apply if the asset
is sold at a loss, nor can it increase the amount of
the gain.
For sales of depreciable personalty and
amortizable intangibles, the gain is characterized as
ordinary up to the amount of accumulated
depreciation.
Why? because depreciation has resulted in prior
deductions at ordinary rates.
Depreciation Recapture
REALTY:
Special rules apply to pre-1986 depreciation on
accelerated methods: most of this property is
fully depreciated, so rules seldom apply.
Corporations must recapture 20% of amount
that would have been ordinary had it been
personalty (lesser of gain or depreciation).
Individuals treat lesser of gain or depreciation
as a capital gain subject to a special 25% tax
rate - see chapter 15.
Section 1231 Netting
After all depreciation recapture, NET the remaining
Section1231 gains with Section 1231 losses.
If a net loss, treat as an ordinary loss and combine
with other ordinary income and losses.
If a net gain, then the net gain is treated as a
capital gain UNLESS:
Section 1231 Look Back Rule
The net 1231 gain is treated as ordinary income
recapture to the extent of unrecaptured Section
1231 losses during the prior five years.
EXAMPLE: Start business in 1990. Section 1231
gains and losses.
1998 net gain $10 treated as capital.
1999 net loss ($15) treated as ordinary.
2000 net gain $23 treated as $15 ordinary
(recapture 1991) and $8 capital.
2001 net loss ($40) treated as ordinary.
2002 net gain $6 treated as ordinary. Still have
$34 unrecaptured loss from 1993.
2003 net gain $50 treated as $34 ordinary, $16
capital.
At Risk (Sec. 465) and Passive Activities (Sec. 469)
Losses in business entities only allowed to the
extent that you have sufficient at-risk basis.
Disallowed losses under Sec 465 are suspended
until sufficient basis exists to take the losses.
Once a loss is allowed under Sec. 465, it may
further be limited by Sec. 469 if the entity is a
passive activity. - general rule for PALS?
There are special rules for office-in-home and for
rental properties with mixed use (personal v. rental)
be sure to check the rules.