Acct 440
Welcome to Taxation of Business Entities
Dr. Efrat
rafi.efrat@csun.edu
JH 3224
(818) 677-3967
Office Hours: Tuesdays and Thursdays 12:302:00 p.m.
Course Objectives
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Tax Knowledge
Critical Thinking
Written Communication
Research Skills
Professional Responsibility & Ethics
Grading
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Attendance (3%)
Participation (7%)
Midterm (30%)
Final (40%)
Homework (10%)
Communication Problems (6%)
Tax Return (4%)
CHAPTER ONE
Introduction to Taxation
Pervasive Impact
of Taxation
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Tax freedom day
Tax to income ratio
Tax code provisions
Time & costs to comply
Tax Freedom Day 1971-2010
Tax Freedom Day by State
Tax Freedom Day- International
Comparison
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India- March 14
Australia- April 21
United Kingdom- June 3
Czech Republic- June 7
Canada- June 19
Poland- June 26
Days to Pay Taxes Compared to
Other Expenditures
Tax Burden
Tax Burden
Tax Burden
Tax Rates
• Progressive
• Proportional
• Regressive
Progressive Tax Rates
Earners Percentage Share of
Federal Taxes
Top 1% 1990: 25%
2010: 38%
Top 5% 1990: 44%
2010: 35%
Bottom
50%
2010: 3%
Percentage
Share of Total
Income
1990: 14%
2010: 20%
1990: 27%
2010: 35%
2010: 13%
Average Tax Rates
Progressive Tax Rates
• Alice, who is single, has $38,000 taxable
income in 2011. How much federal
income taxes would she have to pay?
•
10% X $8,500+
15% X ($34,500-$8,500)+
25% X ($38,000-$34,500)=$5,625
Types of Taxes
• Transactional Tax
• Property Tax
• Taxes on Privileges and Rights
• Income Tax
Transactional Taxes
• Sales Taxes
– Excise vs. Sales Tax
– Use Tax
• Employment Taxes
– FICA
– FUTA
Wealth Transfer
Taxes
• Estate Tax
– Estate vs. inheritance tax
– Computation
• FMV of decedent’s property, less
• Funeral expenses
• Debts
• Charitable donations
• Marital deduction to a surviving spouse
• United transfer tax credit
Wealth Transfer Taxes
• Gift Tax
– Original goal
– Donor is taxed
– Annual Exclusion
– Computation
Gift Tax
Antonio makes the following gifts in the
current year: (1) gift of a personal
automobile valued at $25,000 to his
adult son; (2) gift of a personal
computer valued at $4,000 to a friend.
Are any of these transfers taxable?
Property Taxes
• Assessed on personal or/and real
property
• Difference between real and personal
property
Taxes on Privileges &
Rights
• Custom Duties
• Franchise Tax
• Occupational Tax
Income Tax
• Main Source of Revenues for the
Federal Government
• Progressive in Nature
• Income Tax Computation
U.S. Federal Tax Revenues
Individual Income
Tax
9.94%
2.70%
1.17%
Employment Taxes
Corporate Income
Tax
Excise Taxes
Estate & Gift Taxes
35.64%
50.55%
Top Income Tax Rates
1980
2010
Australia
63%
45%
Canada
60
29
France
60
40
Germany
65
45
Ireland
60
41
Italy
72
43
Japan
75
50
Korea
89
40
Spain
66
43
Sweden
87
57
Switzerland
31
26
U.K.
83
40
United States
70
35
Average
67
43
Formula for Federal Income Tax
on Individuals Income (Slide 1 of 3)
Income (broadly conceived)
Less: Exclusions
Gross income
Less: Certain deductions for AGI
Adjusted Gross Income
$xx,xxx)
(x,xxx)
$xx,xxx)
(x,xxx)
$xx,xxx
Formula for Federal Income Tax
on Individuals Income (Slide 2 of 3)
Adjusted Gross Income
Less: The greater of:
Itemized deductions, or
The standard deduction
Less: Personal and
dependency exemptions
Taxable income
$xx,xxx)
(x,xxx)
(x,xxx)
$xx,xxx)
Formula for Federal Income Tax
on Individuals Income (Slide 3 of 3)
Tax on taxable income (see Tax Rate
Schedules in Appendix A)
$ x,xxx
Less: Tax credits
Less: Federal income tax withheld and
other prepayments of Federal
income taxes)
$(xxx)
Tax due (or refund)
$ xxx
Alternatives to Income Tax
• Value Added Tax
• Networth Tax
• Flat Tax
Business
Entities
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Sole proprietorships
Partnerships
C corporations
S corporations
Limited liability Company (LLC)
Types of Tax Rates
• Marginal Tax Rate
Sandra, who is single, is considering the purchase
of a personal residence that will provide a $10,000
tax deduction. Her current AGI is $95,000. What is
the tax effect of this transaction?
• Average Tax Rate
Sam, who is single, has $29,700 of taxable income
in 2011. Based on applicable tax rates, Sam’s total
tax is $4,030. What is the average tax rate?
Ethics & Professional
Responsibilities
•
http://www.pbs.org/wgbh/pages/frontline/shows/tax/view/4_hi.html?rp
• AICPA Code of Conduct
• AICPA Statements on Standards of
Tax Service
• Internal Revenue Code
• IRS Circular 230
Due Diligence
Rebecca, an accountant, fails to include
dividend income on a tax return she
completed for a client. The omitted dividend
income was from a new stock purchased by
the client this year from a new investment
banking firm and therefore had not been
reported in prior years. The taxpayer did not
mention the new stock investment to
Rebecca in any communication with her.
Has Rebecca exercised due diligence?
Advocating Positions on
Behalf of Client
• Circular 230
– Substantial authority for the position
taken
– Reasonable Basis and fully disclosed
• Penalties
Advocating Positions on Behalf of
Client
Clara Li owns 80% of the Li Corporation. The other 20%
of the stock is held by her husband, Kevin Li. While
working on the return, you note that Li Corporation
pays rent to Clara at least four times the normal rate
for rentals of similar property in that area of town. You
recall that under the code, in order for a business
expense to be deductible, it must be reasonable in
amount. You report this observation to the partner.
She tells you that it is all right to deduct the payments
because the corporation has been doing it for several
years. She asks you to sign the return. Should you sign
this tax return?
Advocating Positions on Behalf of
Client
• Burger, Inc. has been engaged in unique
lending practices for many years. Congress
has recently adopted a new Code provision
that prevents recognition of expenses
associated with such lending practices.
Burger Inc. and its tax advisor believe that
the new Code provision is unfair to the
taxpayer. However, the Code provision is
clear and constitutional. May Burger Inc.
claim the expense deduction nonetheless?
Advocating Positions on Behalf of
Client
• Assume the same facts as above, except
that Burger Inc. insists on taking the tax
return position (even though the CPA
concluded that it is frivolous) because
the company did not believe that the
position would be detected by the IRS
on an audit. May the tax preparer sign
the tax return?
Reliance on Client’s
Information
Is the information supplied
by client appear correct,
complete and consistent?
If yes, may rely
without verification
If no, must verify
information
Use of Estimates
• Estimates are allowed as long as:
– It is impractical to obtain exact data
– The estimated amount appears to be
reasonable
• Estimates are not allowed for certain
expenditures such as travel and
entertainment
Use of Estimates
Which of the following situations would provide an
acceptable case for using a taxpayer’s estimated
figures in the preparation of a federal income tax
return?
a. The taxpayer has the necessary data available,
but is busy with a pressing criminal prosecution.
b. The data are not available at the time of filing
the return, and the estimated amounts appear
reasonable to the accountant.
c. The taxpayer desires to use an estimate to
determine the amount of his deduction for
entertainment expenses.
Knowledge of an Error
• Advise client
• Include recommendation for corrective
action
• No disclosure to IRS, without client’s
permission
Knowledge of an Error
David Raskoff was hired as an accountant by Pipe &
Supply Inc. to prepare its tax returns. In preparing the
tax return David learns that his client has not complied
with an IRS regulation addressing the depreciation of
new machinery acquired by the business. David is
required to:
a. do nothing until advised by client or by previous
accountant to take corrective action.
b. advise the client of the noncompliance.
c. immediately notify the IRS
d. advise the client and notify the IRS, unless the
client wants to contact the IRS
directly.
CHAPTER TWO
Working with the Tax Law
Sources of Tax Law
• Legislative branch
– Statutory law
• Executive branch
– Administrative law
• Judicial branch
– Case law
Legislative Process
for Tax Bills
Statutory Sources
of Tax Law
• Internal Revenue Code
– Have had three codes:
• 1939, 1954, 1986
• Example of Code Citation: IRC§ 2(a)(1)(A)
2 = section number
(a) = subsection
(1) = paragraph designation
(A) = subparagraph designation
Administrative Sources
of Tax Law- Regulations
• Issued by IRS
• Provide general interpretations and guidance in
applying the Code
• Example of Regulation citation:
Reg. § 1.117-4(c)(1)
1 = income tax regulation
117 = code section to which regulation
pertains
-4 = fourth regulation on section 117 issued
Administrative Sources of Tax LawRevenue Rulings
• Officially issued by National Office of IRS
• Provide specific interpretations and guidance in
applying the Code
• Less legal force than Regulations
• Published in the Cumulative Bulletins
• Example of Revenue Ruling citation:
– Rev. Rul. 2004–18, 2004–1 C.B. 509
• Revenue Ruling Number 18, appearing on
page 509 of Volume 1 of the Cumulative
Bulletin for 2004
Administrative Sources of Tax LawPrivate Letter Rulings
• Provide guidance on how a transaction will
be taxed before proceeding with it
• Issued for a fee & describes how the IRS
will treat a proposed transaction
• Apply only to the taxpayer who asks for and
obtains the ruling
• Example of Letter Ruling citation
– Ltr.Rul. 200414039 (39th ruling issued in
the 14th week of 2004)
Administrative Sources of Tax
Law-Determination Letters
• Issued by Area Director at taxpayer’s
request
• Usually involve completed transactions
• Not published, but made known only
to party making the request
Federal Judicial
System
Circuits of the United States
Courts of Appeal
Forum Comparison
Issue
U.S. Tax Court
U.S. District Court
U.S. Court of
Federal Claims
Payment
of Deficiency
No
Yes
Yes
Jury trial
No
Yes
No
Types of
disputes
Appeal
Tax cases only
U.S. Court of
Appeals
Most criminal
& civil issues
U.S. Court of
Appeals
Claims against the
U.S. Gov
U.S. Court of
Appeals for the
Federal Circuit
Tax Research Process
Case Brief
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Facts
Issue/s
Rule/s
Holding/s
Reasoning/s
Formulating an Issue
• Whether/Does
• Key Facts
• Tax Provision
–Whether payments under a life
insurance must be reported as
income under section 61 of the
Internal Revenue Code.
Drafting a Memo
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Brief Answer
Facts
Issue
Rule
Discussion
Income vs. Gift
Donlad Bauta, who is homeless, listed in his tax return
in 2011 his occupation as a beggar. During the year at
issue, Mr. Bauta did not otherwise earn any income
working for anyone. Nonetheless, Mr. Bauta reported
income from begging in the amount of $3,000 in his
2011 Federal income tax return and claimed an
earned income credit, in the amount of $550. Based
on that credit, Mr. Bauta claimed a refund in the
amount of $550. The IRS denied his claim arguing
that the funds he collected while begging are not
earned income, and since the credit is available only
to individuals with earned income Mr. Bauta is
ineligible for the earned income credit. Is he entitled
to receive a refund?
CHAPTER FOUR
Gross Income
Income Defined
- Except otherwise provided, gross income
means all income from whatever source
- Economic Benefit Test:
-Compensation for services
-Business income
-Gains from the disposition of property
-Interest and dividends
-Rents and royalties
-Income arising out of debt forgiveness
-Income from partnerships
Form of Income
• King Corporation transfers 1,000 shares
of its stock to its president. The stock has
no restrictions and is part of the
president’s compensation. Must the
president include the value of the stock in
gross income?
• Ali, an attorney, performs legal services
for Paul, a painter, in exchange for Paul’s
promise to paint Ali’s residence. Must Ali
& Paul report income for this transaction?
When is Income
Taxable?
• Depends on Accounting Method
Selected
• Who Selects Accounting Method
• Cash Method
– actual or constructive receipt of
income
– Cash equivalency is required
Constructive Receipt
• Cathy, a cash basis taxpayer, has
received a paycheck from her employer
but has been told to hold the check
until the employer has sufficient funds
to cover the payroll. When does Cathy
need to report the amount of the check
as income?
When is Income Taxable?
Accrual Method
• All Events Test
– All events have occurred that fix the right
to receive income
– Amount can be determined with
reasonable degree of certainty
• Prepaid Income Exception
• Prepaid payment for goods
• Prepaid payment for services
Prepaid Payment for
Services
Bear Corporation, an accrual basis taxpayer
that uses the calendar year as its tax year,
sells computer courses under contracts
ranging from three months to two years.
Assume Bear Corporation sold and received
full payments for three contracts in July
2011: one for three months costing $90, one
for one year costing $300, and one for two
years costing $500. How much income must
it recognize in 2011 and in 2012?
Income Sources
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Personal Services
Dividends
Income from Property
Imputed Interest on Below Market Loans
Tax Benefit Rule
Interest on Municipal Bonds
Leasehold Improvements
Life Insurance Proceeds
Income from Discharge of Debts
Gains and Losses from Property Transactions
Imputed Interest
Type of Loan
Gift Loan
Compensationrelated loans
Corporation Loan to
a Shareholder
Shareholder loan to a
corporation
Imputed Transfer
to Borrower
Gift from lender to
the borrower
Compensation
income to the
employee;
compensation
expense for the
employer
Dividend income to
the shareholder;
nondeductible
dividend payment by
the corporation
Paid in capital
recorded by the
corporation; capital
contribution by the
shareholder
Imputed Transfer
to Lender
Interest income to
the lender; interest
expense to the
borrower
Interest income to
the employer; interest
expense to the
employee
Interest income to
the corporation;
interest expense to
the shareholder
Interest income to
the shareholder;
interest expense to
the corporation
Tax Benefit Rule
In 2010, Jack’s employer withheld $1,200
from his wages for state income tax.
Jack claimed the $1,200 as an itemized
deduction on his 2010 federal income
tax return. Because of a variety of losses
incurred by Jack, he reported a negative
taxable income of $32,000 during 2010.
The state refunded the $1,200 during
2011.
Leasehold
Improvements
Denver Investments, Inc. rents a retail space
to KFC, Inc. The space normally would rent
for $5,500 per month, but Denver
Investment Inc. agrees to accept $5,000 per
month for the first year if KFC builds a
patio outside the premises. This would
cause the building to appreciate in the
amount of $10,000. Are there any tax
consequences?
Discharge
of Debt
Indy Coal Company has seen its business decline
during the past two years. The Company has a
significant amount of bank debt that was incurred
over the years to fund its coal operations. In
order to maintain its operations, Indy entered
into an agreement with the bank whereby the
bank agreed to cancel 20% of Indy’s $500,000
debt. Assume Indy was solvent at the time of the
cancellation. Does Indy have to recognize any
income arising out of this transaction?
Discharge of DebtCreditors’ gift exception
• Farouk loaned his daughter $4,000 to
help her purchase a car. Several months
after she purchased the car, but before
she repaid the $4,000, Farouk’s
daughter got married. Farouk told his
daughter that he was “tearing up” the
$4,000 note as a wedding present.
Discharge of Debt: Insolvency
and bankruptcy exception
In year one, Donald borrows $100,000 from a bank.
The 10% interest on the loan is payable annually
and the principal is to be repaid 10 years later. In
year ten, Donald notifies the bank that he cannot
repay the full $100,000 of principal. After some
negotiations, the bank agrees to discharge the debt
for $85,000. Immediately before the discharge,
Donald has $300,000 of debt and $290,000 of
assets; after discharge, he has $200,000 of debt and
$205,000 of assets. What are the tax consequences
to Donald in year 10?
Discharge of Debt: Student
loan exception
Lee borrowed $160,000 from the federal
government to attend medical school.
Under the terms of the loan, $20,000 of
debt is forgiven for each year she practices
medicine in designated low-income
neighborhoods.
Discharge of Debts: Seller’s
cancellation exception
Clay purchased a used automobile from a dealer for
$6,000. He paid $2,000 down and agreed to pay the
balance of $4,000 over three years. After Clay
purchased the automobile, he determined that it
was defective. Clay tried to return the car, but the
auto dealer refused. Clay threatened to sue the
dealer. To resolve the problem, the dealer offered
to reduce the balance due on the debt from $4,000
to $2,500. Clay agreed.
Discharge of Debt:
Insolvency
• General Rule
• Exceptions
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Creditors’ gift
Insolvency and bankruptcy
Student loan
Seller cancellation
Shareholder’s cancellation
Taxpayer’s principal residence
Gains and Losses from
Property Transactions
• How Gain/Loss is Calculated
• Capital vs. Ordinary Gain/Loss
– Capital Asset Defined
– Treatment by individuals
– Treatment by Corporations
Chapter Five
Business Deductions
Business Deductions
• Ordinary- normal, customary, or usual
• Necessary• Reasonable
Business deduction:
Ordinary expense
For several years, Donna has been engaged in the
business of making and selling false teeth. Most of
the advertisements, orders and deliveries of the
teeth are done through the mail. During the
current year, the post office judged that some of
the advertisements were misleading. As a result, a
fraud order is issued under which the post office
stamps “Fraudulent” on all letters addressed to
Donna, and then returns them to the senders. In
an unsuccessful suit to prevent the post office from
continuing this practice, Donna expends $25,000 in
lawyer’s fees. Are these fees deductible?
Business deduction:
Necessary expense
Ronald owns a chain of 10 donut shops.
During the past three years the profits of the
shops have declined sharply. Ronald consults a
psychic to determine what to do about his reduced
profits. On the advice of his psychic he pays $10,000
for 10 custom made doormats, which he places in
front of the entrance to each of his stores. The
psychic tells him that the doormats will bring luck to
his business for the rest of the year. Is the cost
deductible?
Business deduction:
Reasonable amount
Brian, the controlling shareholder and an
employee of Central Corporation, receives
an annual salary of $250,000 from the
corporation. Based on several factors, such
as the size of Central Corporation’s total
operations and a comparison of salary
received by officers of comparably sized
corporations, the IRS contends that Brian’s
salary should be no higher than $150,000.
What is deductible?
Business Deductions:
Cash Method
– Timing of Deduction:
Deductible when paid with cash or
other property
Business Deduction:
Cash Method
Peter, a calendar year taxpayer, is the sole owner of a
plumbing repair business. The business uses the cash
method of accounting. Under an arrangement with one
of his suppliers, Peter and his employees can pick up
supplies at any time during the month by merely
signing for them. At the end of the month, the supplier
sends Peter a bill for the charges. Peter always pays the
bill in full during the following month. In December of
the current year, Peter charges on the open account
$1,500 for supplies. During the same month Peter
purchases a plumbing fixture for $250 from another
supplier. Peter uses his charge card at the time of the
purchase. How much may Peter deduct?
Business Deduction:
Capital Expenditures
On November 1 of the current year, Jack,
a cash basis taxpayer, enters into a lease
arrangement with Raul to rent Raul’s
office space for the following 36
months. By prepaying the rent for the
entire 36 month period, Jack is able to
obtain a favorable monthly lease
payment of $800 /month. How much
may Jack deduct in the current year?
Business Deduction: Accrual
Method
– All Events Test
• Liability is established
• Accuracy
– Economic Performance Test
• Recurring liability exception
Business Deduction: Accrual
Method
• During the current year, Phil provides
services to Gary. Gary uses the accrual
method of accounting. Phil claims that
Gary owes $10,000 for the services.
Gary admits owing Phil $6,000, but
contests the remaining $4,000. How
much can Gary deduct?
Business Deduction:
Accrual Method
• Best Corporation uses the accrual method of
accounting and is engaged in the business of
painting automobiles. Best Corporation
provides a five year warranty for new vehicles
and a two year warranty for used vehicles. Best
Corporation’s financial accounting reports
include a reserve (i.e., liability) for estimated
warranty expense and deduct an amount as an
expense on an annual basis. Is the warranty
expense deductible for tax purposes before the
warranty claim is actually made?
Business Deduction:
Accrual Method
• On December 20 of the current year, Chris, an
accrual method taxpayer, enters into a binding
contract with Pat to have Pat clean and paint
the exterior of Chris’ business building. Under
the terms of the contract, the work is to be
done in March of the following year. The total
cost of the job is $4,000. Chris pays 10% down
at the time the contract is signed. How much
may Chris deduct in the current year?
Business Deduction:
Accrual Method
• Dawn is a calendar year, accrual method
taxpayer. Every year at the end of October,
Dawn enters into a contract with Sam to
provide snow removal services for the
parking lots at Dawn’s business. This
contract extends for five months through
the end of March of the following year.
How much may Dawn deduct in the current
year?
Non Deductible Business
Expenses: Fines & Penalties
The delivery truck of Pizza Shack often
has to park illegally to deliver their
pizza on time. As a consequence, Pizza
Shack pays approximately $7,000 per
year in parking fines. Is the expense
deductible?
Expenses Relating to an
Illegal Activity
Tom runs an illegal bookie operation for an
organized crime ring. Last year he spent
$14,500 on rent and utilities for his gambling
operation and an additional $20,000 to hire a
thug to break the legs of customers who did
not pay their gambling debts. Are these
expenses deductible?
Political Contributions &
Lobbying Activities
Kate is a senior partner of a large New York
law firm. During the year, she flies to
Washington, D.C., to testify before a
Congressional subcommittee with regard to
proposed changes in the Social Security
taxes imposed on employers. Such changes
directly affect her business because they
affect the amount of taxes she must pay on
behalf of her employees. Are Kate’s
expenses deductible?
Executive Compensation
Capital Expenditures
• Acquiring or constructing a property that
has a useful life that extends substantially
beyond the end of the tax year.
• Permanent improvements made to:
– increase the value of the property;
– substantially prolong the useful life of the
property; or
– adapt the property to a new use.
Capital Expenditures
Determine whether any of the following
expenditures may be deducted currently or must
be capitalized:
a. Purchase of the copyright to the song “Stormy
Weather”
b. Purchase of a copying machine that will be used
in an accounting firm.
c. Purchase of paper used in the copying machine.
d. Repair and maintenance of the copying machine.
e. Legal fees incurred in purchasing the property on
which the taxpayer’ business is located.
Capital Expenditures
Pete’s Big Business, Inc. outgrows the office
building it has occupied for the last several
years. Rather than buy or lease an existing
structure, Pete commissions an architect to
design a new office building. The architect’s
fees are $120,000. The building costs $15
million to construct. The office furniture
and fixtures cost an additional $1.2 million.
How much of these expenditures are
currently deductible?
Investigation of a
New Business
• Taxpayer is in a business the same as or
similar to that being investigated
– Business acquired
– Business not acquired
• Taxpayer is not in a business the same as
or similar to that being investigated
– Business acquired
– Business not acquired
Related Party
Transactions
• Losses from property transactions
between related parties
– What is related party?
• Unpaid expense arising out of a
transaction between related parties
Transactions between
Related Parties
Alice, Craig (Alice’s husband) and Beth
each own a third of the outstanding
shares of First Corporation. Alice sells a
building she owns with a basis of
$250,000 to First Corporation for
$200,000. Is she able to deduct the
$50,000 loss?
Transactions between
Related Parties
Assume two separate scenarios in which Sam
sells a tract of land during the current year
(scenario one for $17,000; scenario two for
$8,000). In each case assume that Sam
purchased the land from his father, Frank,
for $10,000. Frank’s basis at the time of the
original sale was $15,000 in each case. Was
Frank able to deduct his loss at the time of
the original sale to Sam? What is Sam’s
recognized loss/gain at each of the two
scenarios of the subsequent sale?
Expenses Related
to Exempt Income
Chuck borrows $100,000 at 5% rate of
interest and invests the $100,000 in a
municipal bond yielding 8%. Is the
interest expense on his loan deductible?
Charitable
Contribution
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Qualified donees:
Donative intent:
Time of recognition:
Valuation of contribution:
Limits on deduction
Charitable contribution carryover
Research & Experimental
Activities
• What is it?
– Costs for the development of an product,
invention, and improvement of such
existing property
• Deduction method:
– Expense in year paid or incurred,
– Defer and amortize over period of 60
months
Cost Recovery
- Capitalization vs. Expensing
- Goal of Cost Recovery Allowance
- Types of Cost Recovery Allowance
- Depreciation
- Amortization
- Depletion
Modified Accelerated
Cost Recovery System
• Coverage
• Real vs. Personal Property
• Eligible Property:
– Property is used in business or is income
producing activity; and
– Property has determinable useful life; or
– Property declines in value due to
exhaustion, wear & tear, or obsolescence
Cost Recovery
A cost recovery allowance may be taken for
which, if any, of the following assets:
-Copyright
-An office building
-Land on which an office building sits
-A valuable original painting placed in the
office building lobby
-An owner occupied residence
Cost Recovery Allowance
• Cost recovery formula:
– Adjusted Basis X Percentage
• Adjusted Basis
– Computation:
• Purchase Price Less Depreciation Plus Capital
Improvements
– Failure to take deduction
– Conversion of personal use property to business
use
Cost Recovery Allowance
• Depreciation formula:
– Adjusted Basis times a Percentage
– Percentage Determination
• Applicable recovery period
• Applicable convention
• Applicable depreciation method
Cost Recovery for
Real Property
• Applicable Depreciation Method:
– Straight line
• Applicable Convention:
– Mid month convention
• Applicable Recovery Period:
– Residential real property- 27.5 years
– Non Residential real property- 39
years
Cost Recovery for
Personal Property
• Applicable Recovery period:
• Applicable Convention:
– Mid year convention
– Mid quarter convention
• Applicable Depreciation Method
– Double Declining or
– Straight line
179 Election
• Expense of acquisition in lieu of
capitalization
– Tangible personal business property
– Placed in service during the year of election
– MACRS applies for unused portion of cost
• Large scale property acquisition limitation
• Taxable income limitation
179 Election
Pam owns an unincorporated manufacturing
business. In 2011, she purchases and places
in service $2,050,000 of qualifying
equipment for use in her business. Pam’s
taxable income from the business (before
deducting any Sec. 179 amount) is $40,000.
How much can Pam expense under Section
179?
Mixed Used Personal
Property
• What is mixed use personal property?
– Listed property
• Predominant use test
– Predominant business use
– Predominant personal use
• Luxury automobiles restrictions
CHAPTER SIX
LOSSES AND LOSS
LIMITATIONS
Bona Fide DebtorCreditor Relationship
• Intent test
– Does a note or other written instrument
exist which evidences an obligation to
repay?
– Is a reasonable rate of interest stated?
– Would a person who is unrelated to the
debtor make the loan?
– Have the parties established a definite
schedule of repayment?
Bona fide Debt
• Sherrill loaned her sister Penny $5,000 three
years ago. No written agreement was ever
entered into. Penny had never made any
payments to Sherrill, and Sherrill never tried
to collect from Penny. This year, Penny filed
for bankruptcy and told Sherrill that she
would not be able to repay any of the $5,000
loan. Determine Sherrill’s tax treatment for
the loan for the current year.
Bad Debts
• Charge off method is utilized
• Type of debt
– Loan or debt instrument
– Account receivable
• Cash Method
• Accrual Method
–tax benefit rule
Bad Debt Loss
Ted, who uses the accrual method of
accounting, sells inventory on account
for $2,000. Buyer pays $200 down and
makes no further payments. How much
bad debt deduction, if any, does Ted
get? Will your answer change if he
follows a cash method of accounting?
Business Bad Debt
• When does a business bad debt arise?
– Creditor is in the business of lending
money; or
– Proximate relationship between creation
of the debt and taxpayer’s business
• What type of loss is recognized?
• Complete & partial loss are recognized
Non Business Bad Debt
• When does a non-business bad debt
arise?
• What type of loss is recognized?
• Partial loss cannot be recognized
Bad Debt
Lisa is engaged in the advertising
business. If clients occasionally need
additional funds to meet their cash-flow
obligations, Lisa lends them money so
that she can retain those clients. If any
of these loans become worthless, can
Lisa deduct them as bad debt losses?
Worthless Securities
• Complete loss is required
• Capital loss is recognized
Worthless Securities
On November 1, 2011, Y Corporation
purchased stock for $100,000. The
stock became worthless on March 1,
2012. Is there a deduction? If so, when,
how much and what type?
Worthless Securities
– Small business stock exception
• Direct purchase by taxpayer
• Small investment
• Limited corporate equity
Worthless
Securities
Tony, a single taxpayer, incorporated Waffle,
Inc. three years ago by contributing $70,000
in exchange for the stock. Waffle, Inc. owns
and operates a small restaurant.
Unfortunately, Waffle, Inc.’s business never
really became profitable. In February of the
current year, Waffle, Inc. has filed for
bankruptcy. Tony did not receive anything
for his stock. What deductions can Tony
claim in his personal tax return?
Casualty and Theft
Loss
– Identifiable event
– Damaging to the property
– Sudden- swift
– Unexpected- Ordinarily
unanticipated
– Unusual- Not a day to day
occurrence
Casualty Loss
– Fire, storm floods, vandalism
– Damage to building due to unusual jet
sonic boom
– Damage to automobile due to an accident
that is not the fault of the taxpayer
– Steady weakening of a building caused by
normal wind
– Damage to carpet caused by moths
When to Deduct the
Loss
• Casualty
• Theft
• Reasonable prospect of recovery
limitation
• Treatment of reimbursement
Measuring the Loss
• Complete loss of business or
investment property
• Partial loss of business or investment
property
• Complete or partial loss of personal use
property
– Per incident limitation
– Total amount limitation
Casualty Loss
Troy purchased a home for $25,000 several
years ago. Through the years, the value of
the home appreciated until it was appraised
at $125,000 in the current year. Shortly after
the appraisal, a flood sweeps through the
area, severely damaging Troy’s home and
reducing its value to $90,000. Troy does not
have any flood insurance. Before addressing
AGI limitation and per incident limitation,
what is Troy’s casualty loss deduction?
Casualty Loss
A machine that Beth uses in her
business is completely destroyed by
fire. At the time of the fire, the adjusted
basis of the machine is $5,000 and its
FMV is $3,000. How much could Beth
deduct?
Net Operating Losses
• Definition of net operating loss
Business losses from any one year can offset
past or future income
• Carryover period
– Must carryback to 2 prior years, then
carryforward to 20 future years
• May make an irrevocable election to just
carryforward
• When there are NOLs from two or more
years, use on a FIFO basis
Net Operating Losses
Warren Corp. has a NOL for 2011 in
the amount of $60,000. How must
Warren use the NOL?
Limitations on Loss
Deductions
• At risk limitation
• Passive loss limitation
At-Risk Limits
– The amount of a taxpayer’s economic
investment in an activity
– Can deduct losses from activity only
to extent taxpayer is at-risk
– Any losses disallowed due to at-risk
limitation are carried forward until atrisk amount is increased
– At-risk limitations must be computed
for each activity of the taxpayer
At Risk LimitationsAt Risk Amount
• Cash contributed
• Basis of property contributed
• Debt for which the taxpayer is personally
liable
• Adjusted basis of property pledged as
security for a debt, where the property is not
used in the activity
• Taxpayer’s share of annual income relating
to the activity less, share of annual losses or
withdrawals
At Risk Limitation
Siskel Ebert, a prominent movie critic,
buys a motion picture for $500,000. He
puts up $50,000 of his own money and
$450,000 from a nonrecourse loan. In
the first year of distribution, the movie
loses $80,000. What are the tax
consequences?
Limitations on passive losses
– Generally, passive losses can only offset
passive income, i.e., they cannot reduce
active or portfolio income
– Disallowed losses are suspended and
carried forward
• Suspended losses must be allocated to
specific activities
• Suspended losses are deductible in year
related activity is disposed of in a fully taxable
transaction
Passive Loss Limits:
Active Income
– Wages, salary, and other payments for
services rendered
– Income/losses from self-employed trade
or business activity in which taxpayer
materially participates
– Gain from sale or disposition of assets
used in an active trade or business
– Income from intangible property created
by taxpayer
Passive Loss Limits:
Portfolio income
– Interest, dividends, annuities, and
certain royalties not derived in the
ordinary course of business
– Gains/losses from disposition of
assets that produce portfolio income
or held for investment
Passive Loss Limits:
Passive Income
• Passive losses defined
– Losses from trade or business
activities in which taxpayer does not
materially participate, and
– Rental activities
Passive Loss Limitation
During the year, Kasi, a CPA, reports
$100,000 of active business income from
his CPA practice. He also owns two
passive activities, from which he earned
$10,000 of income from Activity A, and
incurred a $15,000 loss from activity B.
Can Kasi offset his losses from activity B
against any of the other income he earned?
Material Participation
• Definition: Participation that is regular,
continuous, and substantial
• What is regular, continuous and substantial:
– Taxpayer participated for more than 500 hours
– Taxpayer participated for more than 100 hours
and no one else had greater participation
– Taxpayer’s participation constituted substantially
all of the participation in activity
Material Participation
Roger’s auto repair shop shows a taxable
loss of $25,000 in year one. Year one is
the first taxable year for the repair
shop. The shop has five full time
employees. Roger, however, works at
the shop for only 600 hours per year.
State the amount of loss, if any, that
would be deductible?
Rental Activities
• General Rule:
• Exceptions
– Real Estate Professionals
• Half of services test
• Minimum hours test
– Rental Real Estate Deduction
• Active participation test
• Minimum ownership test
Rental Activities
On January 1, year one, Juan purchases an
apartment building. The apartment building
shows a net loss for the year of $30,000.
Juan has full time employee manage the
building; however, Juan interviews all
prospective tenants and makes the final
decision on major repairs. Juan spends about
110 hours a year on the building and has no
other investments. His adjusted gross
income is $110,000. How much of the loss
may Juan use to offset his salary income?
CHAPTER SEVEN
PROPERTY TRANSACTIONSBASIS, GAIN, LOSSES AND
NONTAXABLE EXCHANGES
Questions
• Is there a realized gain or loss?
• Is the gain or loss recognized?
• Is the gain or loss ordinary or
capital?
• What is the basis of the acquired
replacement property?
Determination of Gain or Loss
• Realized gain or loss
– Difference between amount realized
from sale or other disposition of the
asset and its adjusted basis
– Sale or other disposition
• Includes trade-ins, casualties,
condemnations, thefts
Determination of
Gain or Loss
Alice owns land that is held for
investment and has a basis of $20,000.
The land is taken by the city by right of
eminent domain, and she receives a
payment of $30,000 for the land. Is this
condemnation treated as a sale or
disposition? Has Alice realized a gain?
If so, how much?
Determination of
Gain or Loss
• Amount realized from disposition:
– Total consideration receivedcash, FMV of property received,
loans assumed by buyer
– Reduced by any selling expenses
Determination of
Gain or Loss
Anna exchanges land subject to a liability
of $20,000 and an adjusted basis of
$42,000 for $35,000 of stock owned by
Mario. Mario takes the land subject to
the liability. What is the realized
amount on this sale transaction? What
is the realized gain?
Determination of
Gain or Loss
Doug sells stock of Laser
Corporation, which has a cost basis
of $10,000, for $17,000. Doug pays
a sales commission of $300 to sell
the stock. What is the amount
realized and the gain realized?
Adjusted Basis
• = Original cost + capital additions capital recoveries
• Capital additions:
– Cost of improvements to the
property that are capital in nature
• Capital recoveries:
– Depreciation or cost recovery
allowances
– Casualty and theft losses
Basis Consideration
• Original basis of an asset is generally its
cost
• Bargain purchase assets have a basis
equal to their FMV
– Bargain amount may be income to
purchaser (e.g., employee =
compensation; shareholder = dividend)
Bargain Purchase
Ramona is an employee of S&S
Development Company. The company
recently subdivided and offered lots for
sale in the Porter Ranch area at a price
of $200,000. S&S sells Ramona a lot for
$150,000. How much gross income
does Ramona have from the purchase
of the property? What is her basis in
the property?
Bargain Purchase
Allegra wishes to purchase a Lamborghini. She
knows that such cars generally sell for about
$75,000. However, she searches on E-Bay
and locates an owner of such a car, who
purchased it three months ago and is now
having difficulties making monthly
payments. Allegra buys the property from
him for only $45,000. Does Allegra have
gross income from the purchase and what is
her basis in the property?
Basket Purchase
• Relative Value Allocation:
Must allocate basis to each asset obtained based on
relative FMV of assets
• Going Concern Purchase:
– Assign purchase price to assets (excluding
goodwill) to extent of their total FMV
– Residual amount is goodwill
Gift Basis
• FMV> Donor’s Basis:
– The donee’s basis is the donor’s basis
• FMV< Donor’s Basis:
– The donee has a dual basis:
• Loss Basis: FMV at the time of gift
• Gain Basis: same as donor’s
adjusted basis
Gift Basis
Kevin makes a gift of property with a
basis of $350 to Janet when it has a
$425 FMV. What would be Janet’s
realized loss/gain if she sells the
property for $450? for $330?
Property Acquired from a
Decedent
• Inherited property is always treated as longterm property
• Generally, beneficiary’s basis in inherited
assets will be the FMV of the asset at
decedent’s date of death
– Exception: If the executor/administrator
of estate elects alternate valuation date,
basis is FMV on such date
Property Acquired from a
Decedent
Dianna inherits property having a
$60,000 FMV at the date of the
decedent’s death. The decedent’s basis
in the property is $72,000. The alternate
valuation date is not elected. What is
Dianna’s basis in the property?
Personal Use Property Converted
to Business Use
• Gain basis
• Loss basis
• Depreciation basis
Personal Use Property
Converted to Business Use
Craig owns a personal use asset with a
basis of $80,000 and a $50,000 FMV.
How much losses may Craig deduct if
he sells it for its FMV? If Craig
converts the asset to business use and
then immediately sells it, how much
loss may be recognized?
Property Converted to
Business Use
Olga owns a boat that cost $2,000 and is
used for personal enjoyment. At a time
when the boat has a $1,400 FMV, Olga
transfers the boat to her business of
operating a marina. What is the basis of
the boat in Olga’s business for purpose
of determining depreciation?
Disallowed Losses from
Disposition of Property
• Personal Use Property
• Related Party Transaction
• Wash Sales
Disposition of Personal
Use Property
Bruce Evans owns a personal use car that
has an adjusted basis of $40,000. The
fair market value of the car is $35,000.
Calculate the realized and recognized
loss if Bruce sells the car for $35,000.
Disallowed Losses- Related
Parties
• Losses on sale of assets between related
parties are disallowed
• Right to offset
• Only available to original transferee
• Not available for sales of personal
use assets
Wash Sales
• Loss on sale of security
• Purchase of substantially identical
security
• Purchase done within close time
proximity sale of security
• Basis of new acquired security
Wash Sales
Leslie realizes $10,000 in short term capital gains
through dealings in the stock market during the
current year. To generate capital losses as a way of
offsetting the capital gains, she sells her Edison
Corporation stock for only $8,000, even though
she originally purchased it for $16,000.
Nonetheless, Leslie feels that Edison Corporation
is still a good investment and wants to retain the
stock. Can Leslie deduct the $8,000 loss if she sells
the stock she owns and repurchases a similar
number of shares of Edison stock two weeks later?
Non Tax Recognition of
Property Disposition
• Like Kind Exchange
• Involuntary Conversions
• Sale of Principal Residence
Like-Kind Exchanges
• §1031 requires nontaxable treatment
for gains and losses when:
–Asset exchanged must be likekind in nature
–Exchange of qualified assets
–Exchange is simultaneous
Like Kind Exchange
• Real Estate
• Improved for unimproved realty qualifies
• Commercial for residential realty qualifies
• Personal Property
• Office furniture & equipment
• Computers and peripheral equipment
• Airplanes
• Automobiles and taxis
• Buses
• Light general purpose truck
• Heavy general purpose truck
Like Exchange
Gail exchanges an office building
with a $400,000 adjusted basis
for an airplane with a $580,000
FMV to be used in business. Is
this a like-kind exchange?
Like Exchange
• Bob transfers a personal
computer used in his trade for a
printer to be used in his trade. Is
this a like kind exchange?
Like Exchange
• Renee transfers an airplane that
she uses in her business for a
heavy general purpose truck in
use in her business. Is this a like
kind exchange?
Exchange of Qualified Assets
• Assets involved are used in trade
or business or held for production
of income
•inventory, securities, and
partnership interests do not
qualify
The Exchange
Requirement
Dawn’s automobile is held only for
personal use. She exchanges the
automobile, which has a $10,000
basis, for stock of AT&T with a
$12,000 FMV. The stock will be
held for investment. Is the gain
recognized?
Simultaneous Exchange
• The exchange of the two like-kind
properties must be simultaneous
– Deferred exchange exception
Boot
• What is it:
– Any property involved in the exchange that is
not like-kind property is “boot”
• What is its Impact:
– The receipt of boot causes gain recognition
equal to the lesser of boot received (FMV) or
gain realized
• Gain Recognition Only:
– No loss is recognized even when boot is
received
Receipt of Boot
Mario exchanges business equipment
with a $50,000 adjusted basis for
$10,000 cash and business
equipment with a $65,000 FMV.
What is the realized and recognized
gain?
Receipt of Boot
Mary exchanges business equipment
with a $70,000 adjusted basis for
$20,000 cash and business
equipment with a $65,000 FMV.
What is her realized and recognized
gain, if any?
Basis of Property Received as Part
of an Exchange
• Basis in like-kind asset received:
FMV of new asset
– Gain not recognized
+ Loss not recognized
• Basis in boot received is FMV of
property
Involuntary Conversion
• May defer gain recognition if:
– Involuntary conversion
• The destruction, theft, seizure,
condemnation
– Reinvestment of the conversion amount
• Amount of reinvestment >= amount
realized
– Reinvestment in similar property
– Reinvestment within specified time
Involuntary Conversion
• Business or Personal Use Property
• Basis of New Property:
– Cost less deferred gain
• Partial Reinvestment
– Amount recognized is lesser of realized
gain or non-reinvested amount
• Inapplicable to Losses
• Permissive in Nature
CHAPTER EIGHT
PROPERTY TRANSACTIONS:
CAPITAL GAINS AND LOSSES,
SECTION 1231, AND
RECAPTURE PROVISIONS
Questions
• Is there a realized gain or loss?
• Is the gain or loss recognized?
• Is the gain or loss ordinary or
capital?
• What is the basis of the acquired
replacement property?
Capital Gain Tax Cut Windfall
Year
Realizations
Revenues
2002
$269
$49
2003
323
51
2004
499
74
2005
690
101
2006
798
117
2007
863
127
Source: Congressional Budget Office, January 2008
Total Federal Revenues
Why Separate Capital Gains/Losses
from Ordinary Gains/Losses?
Lower Tax Rate:
Long-term capital gains may be taxed
at a lower rate than ordinary gains
Limitation on Deduction:
The deduction of a net capital loss
may be limited
Proper Classification of
Gains and Losses
• Depends on three factors
– The tax character of the property
• Must be capital asset, not ordinary asset
– The manner of the property’s disposition
• By sale or exchange only
– The holding period of the property
• Must be long term
Capital Assets
• Assets held for Investment
• Personal Use Assets
Non Capital Assets
– Inventory
– Notes and accounts receivables
• Accrual Method
• Cash Method
– Real property & depreciable personal
property used in trade or business (§1231
assets)
– Creative works created by taxpayer
Inventory
• Define:
Property must be held primarily for sale
to customers in the ordinary course of
taxpayer’s business
• Automobiles as Inventory
• Securities as Inventory
• Real property as Inventory
Manner of Disposition
- Sale or Exchange is Required to
recognize capital gain/loss
- Are the following transactions
considered a “sale or an exchange”?
– Worthless securities
– Option transfer
– Patent transfer
Sale or Exchange- Worthless
Securities
Charles purchased $40,000 of bonds
issued by the Jet Corporation in March
2011. In February 2012, Jet is declared
bankrupt, and its bonds are worthless.
Can Charles recognize a capital loss?
Sale or Exchange: Options
On March 2, 2011, Dina pays $270 for an
option to acquire 100 shares of Arkansas
Corporation stock for $30 per share at any
time before December 11, 2011. As a result
of an increase in the market value of the
Arkansas stock, the market price of the
option increases and Dina sells the option
for $600 on August 2, 2011. What type of
gain must Dina recognize?
Sale or Exchange: Patent
• Transfer all substantial rights to a
patent is the equivalent of a sale
• Treated as a long term capital gain
• Individual ownership: the
transferor must be the individual
creator
Sale or Exchange: Patent
Clay invents a small utensil used to peel
shrimp. He has a patent on the utensil
and transfers all rights to the patent to a
manufacturing company. Clay receives
$100,000 plus 40 cents per utensil sold.
Clay’s cost basis in the patent is
$45,000. What type of gain must Clay
recognize?
Holding Period
• Short-term
– Asset held for 1 year or less
• Long-term
– Asset held for more than 1 year
• Holding period starts on the day after
the property is acquired and includes
the day of disposition
Holding Period
On June 1, 2011, Alfred sells stock held
as an investment and recognizes a gain.
If the stock was purchased on May 31,
2010, what type of a gain should Alfred
recognize in his tax return?
Holding Period
• Non Taxable Exchanges
• Disallowed Loss Transactions
• Property Received as Gift
– Carryover basis
– FMV basis
• Property Received from a Decedent
Holding Period
Cindy receives a capital asset as a gift
from Marc on July 4, 2011, when the
asset has a $4,000 FMV. Marc acquired
the property on April 1, 2011, for
$3,400. If Cindy sells the asset on April
14, 2012 for $3,800, how would any
gain/loss is classified?
Holding Period
The executor of Paul’s estate sells certain
securities for $41,000 on September 2,
2011, which are valued in the estate at
their FMV of $40,000 on June 5, 2011,
the date of Paul’s death. Paul purchased
these securities six months before his
death for $30,000. What type of gain
does the estate have?
Tax Treatment of Capital Gains and
Losses of Non-Corporate Taxpayers
• Short Term Capital Gains (STCG)
– No preferential tax rate available
• Long Term Capital Gains (LTCG)
– Regular LTCG- preferential tax rate available
– Exceptions:
• 28% Property
– Collectibles
– Small Business Stock
• 25% Property
– Unrecaptured Section 1250 gain
Offsetting Against Capital Gains
• Group All Gains & All Losses for Each Category
• Net Each Category
• In the Long Term Capital Categories, Net LTCL
Against Highest Taxed Capital Gain First
• Netting any STCL Against Highest Taxed Capital
Gain First
• Netting Against Ordinary Income
Netting
Sandy has a salary of $100,000. If she
sells a non-personal use asset
during the year and has a $40,000
loss, why is it important that the
asset not be a capital asset?
Netting
Bob has gross income of $60,000 before
considering capital gains and losses. If
Bob has Net Long Term Capital Gain
(NLTCG) of $10,000 and Net Short
Term Capital Loss (NSTCL) of
$15,000, how much, if any, could Bob
deduct against his ordinary income?
Netting
Last year, Milt had a NSTCL of $8,000
and a NLTCG of $2,600. During the
current year he sells a capital asset and
generates a STCG of $800. How much
capital losses could Milt deduct from
his ordinary income during last year and
this year?
Netting
In the current year, Beth has NSTCL of
$2,800 and NLTCL of $2,000. Does
Beth have any loss carryover for next
year? How much? Is it short term or
long term carryover loss?
Netting
Leroy, whose tax rate is 35%, has NSTCL
of $20,000, a $25,000 LTCG from the
sale of a rare stamp held for 16 months
and an $18,000 LTCG from the sale of
stock held for three years. What is the
effect of these gains and losses on his
total tax liability?
Netting
Elizabeth, whose tax rate is 35%, has
NSTCG of $40,000, a $30,000 LTCG
from the sale of an antique, a $10,000
LTCG in the 25% property group, and
a $22,000 LTCL from the sale of stock
held for four years. What is the effect
of these gains and losses on her total
tax liability?
Capital Gains & Losses of
Corporate Taxpayer
• No preferential tax rate
• No offsetting against ordinary income
• Carryback and carryforward period
Capital Gains & Losses of
Corporate Taxpayer
The Peach Corporation has income
from operations of $200,000, a
NSTCG of $40,000, and NLTCL
of $56,000 during the current year.
How much of the loss can Peach
Corporation offset against its
income from operations?
Section 1231 Asset
– Depreciable personal property used in
business
– Real property used in a business
– purchased intangibles
– Property held greater than 1 year
– Net §1231 loss = ordinary loss
– Net §1231 gain = long-term capital gain
Capital Gains & Losses of
Corporate Taxpayer
Dawn sold a machinery for $20,000 gain.
In the same year, she also sold land for
$12,000 loss. Both properties were used
in her business and were owned by
Dawn for three years. What kind of
gain/loss must Dawn recognize?
Depreciation Recapture
• Why §1231 gain is recaptured sometimes?
• The impact of recapture
– Gain recapture characterizes gains that would
otherwise be capital as ordinary income
• Properties subject to recapture:
– §1231 assets subject to depreciation are subject
to depreciation recapture when disposed of at a
gain
• The recapture provisions:
– §1245
– §1250
§1245 Recapture
• §1245 property:
– Depreciable personal property
– Purchased intangibles
• Applies to gain only
• Recapture amount:
– Total accumulated depreciation will be
recaptured as ordinary income
– The gain in excess of depreciation
recapture will be §1231 gain
Section 1245 Recapture
Buckeye Corporation owns the
following assets acquired in 2010: a
truck, a purchased patent, an office
building and a land, all of which are
used in business. Which one of
these properties are Section 1245
property?
Section 1245 Recapture
Adobe Corporation sells equipment used
in its trade for $95,000. The equipment
was acquired several years ago for
$110,000. The equipment’s adjusted
basis is $60,000 because of $50,000 of
depreciation was deducted. Will Adobe
have to recognize 1231 gain? What if
the equipment is sold for $117,000?
§1250 Recapture
• §1250 property: Depreciable real property sold at a
gain
• Recapture amount:
– Recapture potential is limited to excess of
accelerated depreciation taken on asset over
depreciation that would have been deductible if
straight-line depreciation had been used
• Tax rate:
– Recaptured gain: ordinary income
– Nonrecaptured gain: LTCG 25% Property
– Section 1231 gain: excess of sale prices over
original purchase price
Long Term Capital GainPartial Analysis
Sale or
Exchange?
NO
End of analysis
YES
Is this a
ordinary or
capital
property?
Ordinary
Capital
Property
reclassified as
Section 1231
Asset?
Long term
Short Term
YES
NO
Gains and losses
offset ordinary
income
Is there a gain
or a loss?
28%
25%
Regular
Need to
net gains
and losses
Need to
net gains
and losses
Need to
net gains
and losses
Gain
Loss
Does recapture
provision apply?
Need to net
gains and
losses
Deduct against
ordinary income
YES
Yes
NO
Gain taxed at
preferred rate of
long term capital
gain
Does Section
1250 recapture
apply?
Does Section
1245 Recapture
apply?
Yes
Yes
Taxed as
ordinary
income
Calculate net gain
or losses
No
No
Taxed as
regular
LTCG
Taxed as
ordinary
gain
Taxed as long
term capital
gain as 25%
category
property
Loss
Individual
Is there a net
loss or gain?
Is the taxpayer an
individual or a
corporation?
Gain
What type of
gain is it?
Corporate
Individual taxpayer
may offset up to
$3,000 against
ordinary income and
balance is carried
forward until used up
by taxpayer
Corporate taxpayer
may carry back for
three years and
forward for five year
Short term
capital gain is
taxed as
ordinary income
28%
property is
taxed at
28%
Regular long
term capital, is
taxed at 5% or
15%
Unrecaptured
gain of 25%
property is
taxed at 25%
CHAPTER SIXTEEN
TAXATION OF INDIVIDUALS
Tax Formula
Income (broadly conceived)
Less: Exclusions
Gross Income
Less: Deductions for AGI
AGI
Less: The greater ofTotal itemized deductions
or the standard deduction
Personal & dependency exemptions
Taxable Income
$x,xxx
(x,xxx)
$x,xxx
(x,xxx)
$x,xxx
(x,xxx)
(x,xxx)
$x,xxx
Exclusions from Gross Income
•
•
•
•
Child Support
Gifts & Inheritances
Scholarships
Damages
–
–
–
–
Loss of Income
Expenses Incurred
Property Damage
Personal Injury
• Compensatory Damages
• Punitive Damages
Scholarships
Becky is awarded a $7,000 per year scholarship
by State University. Becky spends $5,000 of
the scholarship for tuition, books and
supplies, and $2,000 is for room and board.
In addition, Becky is a graduate student
assistant and the University grants her a
waiver of half of her $6,000 annual tuition.
How much is Becky taxed on?
Items Included in Gross
Income
•
•
•
•
•
•
•
Compensation
Business Income
Interest
Rents & Royalties
Alimony
Unemployment Compensation
Prizes and Awards
Alimony
Helen earned $500,000 and, as a
result of her divorce, she was
required to pay William $250,000.
Is this payment included in
William’s gross income?
Alimony
As a result of a divorce, Dawn receives stock
that she has purchased with her former
husband during their marriage. They had
purchased the stock for $12,000. At the time
of the divorce, the stock was worth $14,000.
Assume the transfer is not considered as
alimony. How will this transfer affect the
parties’ taxable income? What if Dawn
subsequently sells the stock for $15,000?
Prizes and Awards
• General rule: FMV of item is included in income
• Exception One:
– Non commercial achievement
– No substantial services are due
– Redirected to non for profit
– Not self nominated income
• Exception Two:
– Employee achievement awards (up to $400) of
tangible personal property made in recognition
of length of service or safety achievement
Deductions for AGI
• Ordinary and necessary business
expense
• One half of self employment tax paid
• Moving expenses
• Capital loss deduction
• Alimony paid
• IRA contribution
Standard Deduction
• The basic standard deduction (BSD)
amount depends on filing status of
taxpayer
Filing status
2011
Single
$5,800
MFJ, SS
$11,600
HH
$8,500
MFS
$5,800
Standard Deduction
• Additional standard deduction (ASD)
– For taxpayers age 65 or older and/or
legally blind
Filing Status
2011 .
Single
$1,450
MFJ, SS
1,150
HH
1,450
MFS
1,150
SD Limit for Person
Claimed as Dependent
• In 2011, individual claimed as
dependent has a BSD limited to the
greater of:
– $950 or
– $300 plus earned income (but not
exceeding normal BSD)
• ASD amount(s) still available
Itemized Deductions
• Medical Expenses
• Taxes
– Personal & Real Property Taxes
– State, Local & Foreign Taxes
• Interest
– Business Interest- For AGI
– Personal Interest- Not deductible
– Interest on Student Loan-For AGI
– Investment Interest- For AGI
– Qualified Residence Interest- Itemized
• Charitable Contributions
Medical Expenses
During the current year, Kelly incurs
qualified medical expenditures of
$3,000. Her adjusted gross income for
the year is $30,000. What is the
itemized deduction for medical
expense?
Investment Interest Expense
Skip borrows $100,000 from a bank at 10%
interest, interest only for three years, to buy
Pork Belly common stock. In year one the
stock pays dividends of $8,000. In year two
the Pork Belly stock pays no dividends but
Skip receives $3,000 in dividends from some
Growth Company stock that he inherited. In
year three the Pork Belly stock pays $25,000
in dividends. How much of the $10,000 of
annual interest can Skip deduct each year?
Qualified Residence Interest
• Loans covered: acquisition or equity
loans on qualified residence
• Qualified Residence
• Acquisition Indebtedness
• Home Equity Loan
• Points
• Prepayment Penalty
Charitable Contributions
• Contributions must be made to domestic
organizations
• Contributor must have donative intent and
expect nothing in return
• No deduction is allowed for the contribution
of services (except for unreimbursed
expenses)
• Valuation
• Substantiation requirement
• Limit on deduction
Charitable Contribution
Cindy, a gym teacher, volunteered to work for
a week with handicapped children as part of
an athletic event sponsored by a charitable
organization. Cindy spent $40 on
transportation and $200 on lodging in
connection with the event. If Cindy had
been paid her normal fee for her services,
she would have received $500. What amount
can Cindy deduct as a charitable
contribution?
Charitable Contribution
Mona says: “It costs a low income
taxpayer more to make a donation
to charity than it costs a high
income taxpayer.” Is Mona correct?
Explain.
Miscellaneous Itemized Deductions
• Professional dues to membership
organizations
• Uniforms
• Fees incurred for the preparation of one’s
tax return for tax litigation before the IRS
• Job hunting costs
• Hobby losses
• Unreimbursed employee expenses
Exemptions
•
•
•
•
Amount
One Exemption Per Person
Personal Exemptions
Dependency Exemptions
– Qualifying Child
– Qualifying Relative
Qualifying Child
•
•
•
•
•
Relationship
Domicile
Age
Joint return
Citizen or residency
Qualifying Relative
A dependency exemption may be claimed
for each individual that meets all of the
following tests:
– Support
– Gross income
– Relationship (or household member)
– Joint return
– Citizen or residency
Qualifying Relative- Support
• Taxpayer must provide more than 50%
of the dependent’s support
– Only amounts expended are
considered in the support test
– Scholarships of children are not
considered in the support test
Qualifying Relative- Gross
Income
• Dependent’s gross income cannot be greater
than amount allowed for an exemption
– Exception: No gross income limitation if
dependent is child of taxpayer AND
either:
• i) Less than age 19, OR
• ii) Less than age 24 and a full-time
student
Taxable Income
• General Rule:
Tax return must be filed if gross
income is ≥ the sum of the standard
deduction and exemption amount
Filing Status
• There are 5 filing statuses
– Single
– Married, filing jointly
– Surviving spouse (qualifying widow/er)
– Head of household
– Married, filing separately
• Filing status affects tax rate brackets,
standard deduction, and other amounts
Kiddie Tax
• Limitations on Shifting Income to
Dependents:
– No Personal Exemption
– Lower Standard Deduction
– Parent’s Tax Rate on Net Unearned
Income (NUI)
-Child must be under age 19 (or under age 24
if full time student) at end of year
-NUI generally equals unearned income
less $1,900
Credits
•
•
•
•
Adoption Expense Credit
Child Tax Credit
Child Care Credit
Education Tax Credit
– American Opportunity Credit
– Life Time Learning Credit
• Earned Income Credit
Adoption Expenses Credit
• Credit for qualified adoption expenses
incurred in adoption of eligible child (fees,
court costs, attorney fees)
• Maximum credit in 2010 is $12,170
• Eligible child is one that is
– Less than 18 years of age, or
– Physically or mentally handicapped
• Nonrefundable credit
– Excess may be carried forward for five
years
Child Tax Credit
• Credit amount is $1,000 per child
• Eligible children are:
– Under age 17,
– US citizen, and
– Claimed as dependent on taxpayer’s tax
return
Child & Dependent Care Credit
• General qualifications for credit
– Must have employment related care costs for a
• Dependent under age 13, or Handicapped
dependent or spouse
• Credit amount
– Eligible care costs x 20% to 35% depending on
AGI
– Amount of costs that qualify is the lesser of
actual costs or $3,000 for one qualified
individual, and $6,000 for two or more qualified
individuals
– Amount of eligible care costs cannot exceed
lower of taxpayer’s or spouse’s earned income
Education Tax Credit
• 2 education tax credits are available
– American Opportunity Credit credit
– Lifetime learning credit
• Both nonrefundable credits are available for
qualifying tuition and related expenses
– Room, board, and book costs are ineligible for the
credits
– Undergraduate degrees, graduate degrees, or vocational
training.
Educational Tax CreditMaximum Credit
– American Opportunity Tax Credit
maximum per eligible student is $2,500 per
year for first 4 years of postsecondary
education
• 100% of first $2,000 of qualifying expenses
plus 25% of next $2,000 of qualifying
expenses
– Lifetime learning credit maximum per
taxpayer is 20% of qualifying expenses up
to $10,000 per year
• Cannot be claimed in same year the
American Opportunity Tax Credit is claimed
CHAPTER SEVENTEEN
INDIVIDUALS AS
EMPLOYEES AND
PROPRIETORS
Employee vs. Independent Contractor
• Why Proper Classification is Important?
– Expense Deductions
– Payment of Taxes and Benefits
– Liability
• How to Distinguish?
–
–
–
–
–
Degree of Control
Tools of Work
Method of Payment
Skills Required
Permanency
Employee vs. Independent Contractor
Truck drivers, who are owner operated,
are engaged under a contract with an
interstate trucking company. The truck
drivers selected their own routes and
were paid a percentage of the
company’s receipts for shipments. Are
the truck drivers considered employees
or independent contractors?
Exclusions from Gross Income
Available to Employees
• Accident & Health Insurance Plans
– Premiums
– Payment of Medical Care Benefits
• Long Term Care Benefits
• Meals & Lodging
• Life Insurance
• Tuition Reduction Plans
Meals & Lodging
• Meals:
– Furnished by Employer
– Employer’s Convenience
– Business Premises
• Lodging
– All of the Above
– Condition of Employment
Life Insurance
David receives $50,000 of group term life
insurance from his employer. He names
his long-time companion Fred as
beneficiary. Is David subject to tax on
the premiums paid by his employer for
the life insurance policy? If David dies,
is Fred taxed on the $50,000 death
benefits?
Other Fringe Benefits
• Dependent care
– Up to $5,000 of care costs paid for by
employer can be excluded
• Athletic facilities
– Value of use of athletic facilities located
on employer premises can be excluded
• Educational assistance programs
– Up to $5,250 for undergraduate and
graduate education is excludible
Other Fringe Benefits
• Adoption assistance programs
• Exclusion limited to $10,630
• Qualified transportation expenses
– Parking
– Commuter pass
• No additional costs services:
– No additional cost to employer
– Ordinary course of employer’s business
No Additional Cost Service
Dean, an airline reservation clerk for
Friendly Airlines, is allowed to fly free
of charge on Friendly Airlines flights.
Dean is required to fly on a stand by
basis and is permitted to board only
when there otherwise would be
unoccupied seats. Is the flight taxable
to Dean?
Other Fringe Benefits
• Qualified employee discounts
– Goods
– Services
• Working condition fringe benefit
• De minimis fringe benefit
Employee Discount
Mary is an accountant for the Eastside cleaning
Service. The business pays house cleaners $5 an
hour to clean customers’ homes. The gross
receipts of the business for the year were
$500,000 and its total expenses were $450,000.
Employees of Eastside are permitted to
purchase cleaning services at a 20% discount.
Mary hires the service to clean her apartment
once a week for $40. The ordinary price for
such cleaning would have been $50. Is Mary
subject to tax on the $10 discount?
Working Condition Fringe
Mark is a professional hockey player for the
Boston Brawlers. During the off-season
Mark lives in Mystic, Connecticut. The
Brawlers purchase a membership for Mark
in a Mystic health club at a cost of $500 and
hire a private trainer at a cost of $1,000 to
supervise Mark’s workouts. Is Mark taxed on
the cost of the club membership and trainer?