Course Notes to accompany by liwenting


									Course Notes to accompany
        ACCT 3307

Concepts in Federal Taxation
    Murphy & Higgins
       2008 Edition

       Spring 2008

                                      Chapter 1
                         Federal Income Taxation -
                              An Overview

                                Definition of a Tax
–   An enforced, involuntary contribution
–   Required and determined by law
–   Providing revenue for public and governmental purposes
–   For which no specific benefits or services are received

                     Standards of a Good Tax System
                             Adam Smith’s Four Criteria

– Equality
  – Tax should be based on the taxpayer’s ability to pay
      • Horizontal Equity: Two similarly situated taxpayers are taxed the same

      • Vertical Equity: Differently situated taxpayers are taxed differently but fairly

        Explicit vs. Implicit Taxes

– Certainty
  – When and how a tax is to be paid should be known to the taxpayer
  – The taxpayer should be able to determine the amount of the tax

– Convenience
  – Tax should be levied when the taxpayer has funds available to pay

– Economy
  – The costs of complying with the tax system should be minimal

                               Tax Rates

                     Tax = Tax Base X Tax Rate

                     Tax Rates for Income Tax
– Marginal Tax Rate is the rate of tax on the next dollar of taxable

• Average Tax Rate is the rate equal to the total tax divided by the
  tax base.

                            Tax Structures

Proportional – the average tax rate remains the same as the tax
               base increases

Regressive – the average tax rate decreases as the tax base

Progressive – the average tax rate increases as the tax base

                          Types of U.S. Taxes
– Income Tax

  – Taxes are paid by individuals, corporations, estates, and trusts

  – Tax base is total income less allowed reductions

– Employment Tax

  – Taxes are paid by employees, employers, and self-employed taxpayer

  – Tax base is wages and salaries earned

  – Two major types
    • Social SecurityUnemployment

– Sales Tax

  – Taxes are paid by purchasers of goods and services
  – Tax base is the selling price of a product or a service

– Property Tax

  – Taxes are paid by owners of property
  – Tax base is the assessed value of real or personal property (ad

– Excise Tax

  – Taxes are paid by purchasers
  – Tax base is the quantity purchased and not the value of the purchase

– Wealth Transfer Tax

  – Taxes are paid by entity transferring property
  – Tax base is the value of the property transferred
     • Transfers to spouses and charities are excluded
     • Lifetime Unified Credit excludes up to ($           ) of transfers
     • Donor’s may exclude annual gifts of ($        ) per donee

                                  Tax Formula
Broadly Defined

 Income includes all forms of income


- Exclusions (Income specifically excluded from income)

= Gross Income (Income to be reported)

- Deductions (amounts specifically allowed as subtractions)

= Taxable Income
- Broadly defined income

– Expenses (Chapters 5 & 6)
  – Current period expenditures incurred in order to earn income

   -Transaction losses result when an asset is disposed of at a price less
    than its tax cost.

   -Annual losses result when allowed deductions exceed income.

  -A minimum amount of income needed for basic living.

                 Tax Formula - Adjusted Gross Income
          Gross Income

minus:    For Deductions
         • not restricted based on taxpayer’s income
         • generally trade, business, rent or royalty expenses

equals: Adjusted     Gross Income (AGI)

minus: From      Deductions
       restricted based on AGI
       generally personal expenses
         -Itemized, or
         -Standard Deduction amount ($   Single, $             MFJ)
minus: Personal and Dependency exemptions ($                 pp)
equals: Taxable     Income
times:    Tax Rate
equals:   Income Tax Liability

minus: Prepayments     & Credits

equals: Tax   or (Refund) Due

                         Filing Requirements
– Return must be filed annually
– Calendar-year individuals file and pay on or before the 15 day of
  – May receive an extension of time to file but not time to pay

                    Audit and Appeals Process
                      Statute of Limitations
– Three years from filing date
– Extends to six years if income is under-reported by 25% of gross
– No limitation for fraud or if no return is filed

                    Audit and Appeals Process
                       Selection for Audit
• Only about 2% of returns are audited
• Procedures used
  – Discriminant Function System
  – Taxpayer Compliance Measurement Program
  – Document perfection
  – Information matching
  – Special audit programs

                   Audit and Appeals Process
                    Types of Examinations
– Correspondence examinations

– Office examinations

– Field examinations

                   Audit and Appeals Process
– Settlement Procedure
  – Report of outcome of audit
  – Waiver of assessment (Form 870)
  – 30-day letter
– Appeals
  – Meeting with IRS Appeals Division
  – 90-day letter

                            Tax Planning

Goal is to maximize after-tax wealth


– Time Value of money

  – Defer income

  – Accelerate deductions

                       Marginal Tax Rate

   Recognize income in year of lower marginal tax rate.

   Recognize deductions in year of higher marginal tax rate.

   Shift income to taxpayer with lower marginal rate.

                Tax Avoidance vs. Tax Evasion

– Tax Avoidance – Taxpayers have no obligation to pay more tax
 than the law requires

– Tax Evasion – Taxpayers may not use fraudulent or deceptive
 behavior to hide tax liability

                                Chapter 2
                      Income Tax Concepts
• Based on a system of rules

• Rules are developed around general concepts and specific exceptions

– A concept is a broad principle

– A construct is a means to implement a concept

– A doctrine is a construct developed by the courts

                            General Concepts

                               Ability to Pay
  Tax should be based on an amount that a taxpayer can afford to

– Constructs used

  – Deductions

  – Exclusions

  – Credits

  – Progressive tax rates

                       General Concepts
                   Administrative Convenience
  The benefit derived from a concept, construct or doctrine should
  always exceed the cost of implementation.

– Constructs used
  – Standard deduction amounts

  – Fringe benefit exclusions

               Arms-Length Transaction Concept
  A transaction between related parties must reflect economic

– Constructs used
  – Related party provisions

  – Constructive ownership rules

                      Pay As You Go Concept
  Taxpayers are required to pay tax as they generate income.

– Constructs used
  – Withholding

  – Estimated tax payments

                           Entity Concept
  Each tax entity must keep separate records and report
  operations separately.

• Doctrine used
  – Assignment of Income

  Assignment of Income Doctrine: All income earned from services
  provided by an entity or property owned by an entity is to be
  taxed to that entity.

                  Annual Accounting Period Concept
– Each taxpayer must select

  – A tax year
     • Calendar

     • Fiscal

  – An accounting method
     • cash

     • accrual

     • hybrid

  Tax Benefit Rule: If a tax benefit is derived from a deduction in
  one year, any refund received in a subsequent year must be
  reported as income.

  Substance-Over-Form Doctrine: A transaction must be realistic
  in an ordinary sense and not contrived merely to avoid tax.

                         Income Concepts
                   All-inclusive Income Concept
  All income received is taxable unless a provision of the law
  specifically excludes it.

                     Legislative Grace Concept
  Any tax relief provided is the result of specific acts of Congress
  which are applied and interpreted strictly.

– Constructs used
  – Exclusions, deductions and credits

  – Special classifications such as capital assets

                     Capital Recovery Concept
  A taxpayer may recover all invested capital before income is

– Constructs used
  – Basis

  – Gains and Losses

                         Realization Concept
  No income is recognized as taxable income until it has been
  realized by the taxpayer.

– Doctrines used
  – Claim of Right Doctrine

  – Constructive Receipt Doctrine

  Claim of Right Doctrine: Realization does not occur until an
  amount has been received without restriction.

  Constructive Receipt Doctrine: Realization is deemed to have
  occurred if

  – a taxpayer is aware an amount is available,

  – the amount is unconditionally available (even without physical
    possession), and

  – receipt of the amount is within the taxpayer’s control.

                  Wherewithal-to-Pay Concept
 Tax should be recognized and paid when the taxpayer has the
 resources to pay.

– Constructs used
  – Deferrals

  – Accrual basis recognition of unearned income

                      Deduction Concepts
                    Legislative Grace Concept
 Any deduction allowed is the result of specific acts of Congress
 which are applied and interpreted strictly.

                    Business Purpose Concept
 Only expenditures made in order to generate income and for a
 purpose other than tax avoidance will be deductible.

– Examples:
  – Trade or business expenses

  – Investment expenses

                    Capital Recovery Concept
 A taxpayer may deduct the amount of capital invested before
 income is reported.

– Constructs used
  – Basis

  – Capital expenditures

                                 Chapter 3
                             Income Sources
                             What is Income?
FYI – Capital gains and losses will be covered in chapter 11!!

– All-inclusive Income Concept
  – Defined by exception: “Except as otherwise provided…”

– Judicial findings
   – Income is the gain derived from labor and capital

   – Any increase in wealth that has been realized is income

                             What is Income?
– Current View
  – A change in the form and/or substance of the taxpayer’s property, and

   – The involvement of a second party in the income process

                              Earned Income
    Derived from labor

   1. Compensation

   2. income from active conduct of trade or business

  3. income from services rendered

  4. income from performing illegal activities.

– Two problems that may arise when determining taxability of
 earned income
  – Assignment of income

  – Cash-equivalent approach

                           Unearned Income
 The earnings from investments and gains from the sale,
 exchange or disposition of investment assets is unearned

– Examples of unearned income are:
  – Interest and Dividend Income

  – Rental and Royalty Income

  – Annuities

– An annuity is a series of equal payments received at set time
 intervals for a determinable period

– Capital Recovery Concept excludes the amount of original
  investment from taxable income

                         Annuity Exclusions
– If the payment term and amount are fixed:

Exclusion Ratio =      Cost of the contract
                         # of payments
                      total expected return

– If the payment term depends on the life of the taxpayer
   – Must estimate the number of payments
   – If payments began before 11/19/96, use life expectancy at the date of
      the first payment

    Annuity payments beginning after November 18, 1996
       Must use “simplified method” for determining capital recovery
       Use Tables 3-1 or 3-2 to determine the number of payments

       Excluded Portion =         Contract Cost
                                  # of Payments

Ex: Annuity – Purchased for $25,000
              Will pay $5,000/year
              Current age – 62, life expectancy – 77

How is each pmt taxed?

What happens if live longer than 77?

What happens if die before receives all payments?

                 Income from Conduit Entities
– Income from a conduit entity is reported by the owners and taxed
 on the owners’ returns

– Distributions from conduit entities to the owners are treated as a
 recovery of capital

                          Transfer Income
 Some amounts of income are neither earned nor unearned.
  – Prizes and Awards
  – Unemployment Compensation
  – Social Security Benefits
  – Alimony Received

                       Prizes and Awards
 Amounts received as prizes and awards are generally taxable.

  – Exceptions exist for:
    • Scientific and literary achievements
      – must be given by recipient to a qualified charity or government unit

    • Employee achievements
      – must be given to employee for length of service or safety
      – amount is limited to $400 (or $1,600)

                     Unemployment Compensation
 Amounts received from unemployment compensation plans are
 considered substitutes for earned income and are always

                            Social Security Benefits
 A portion of Social Security benefits received may be taxable if
 provisional income exceeds certain limits.

         Adjusted gross income
   plus: ½ social security benefits
   plus: tax exempt income
   plus: foreign earned income exclusions
         Provisional income

                   Social Security Benefits: Tier One
– Unmarried individuals with provisional income between $25,000
  and $34,000, and
– MFJ individuals with provisional income between $32,000 and

                                Tier One Calculation
The taxable portion of Social Security is equal to the lesser of:
     1. ½ Social Security received,
OR 2. ½ of the amount by which provisional income exceeds the
        base amount.

Where the base amounts are $25,000 for unmarried individuals, $32,000 for MFJ,
and $0 for others
                                Tier Two Calculation
The taxable portion of Social Security is equal to the lesser of:
      1. 85% of Social Security received,
OR 2. 85% of the amount by which provisional income exceeds the base

PLUS the smaller of
     a. the amount of SS benefits included under the 50% formula, or
     b. $4,500 for unmarried individuals, or $6,000 for MFJ

where the base amounts are $34,000 for unmarried individuals, $44,000 for MFJ, and $0 for others

                                  Alimony Received
  Amounts received for alimony payments are taxable income if:
   – the payments are made in cash
   – there is a written agreement
   – the payments are not disguised child support
   – the payments cannot be made to payee’s estate
   – the payer and payee do not live in the same household

                                   Imputed Income
– The value of the goods and services produced by individuals for
  personal consumption generally are not taxable

  – Realization concept

  – Administrative Convenience concept
                      Imputed Income
                 Payment of Expense by Others
 A taxpayer whose expenses are paid by another has realized an
 increase in wealth.

– Payments made by family members may be considered
 nontaxable gifts

– Payments made by employers are taxable income

                        Bargain Purchases
 When a bargain purchase price does not result from an arms-
 length transaction, the bargain amount is taxable income.

                    When is Income Reported?
 The Accounting Method chosen by a taxpayer dictates when
 income is reported.
  – Cash Method taxpayers report income when cash is actually or
    constructively received

  – Accrual Method taxpayers report income when it is earned

                           Accounting Method
  Cash method taxpayers must follow the Constructive Receipt
  – Exceptions to the cash method:
     • Taxpayers who sell inventory may not use the cash method
  Under tax law, income is accrued when
– All events have occurred that fix the right to receive the income,

– The amount of income earned can be determined

– Exceptions to the accrual method:
  – The Wherewithal-to-Pay concept requires income to be reported in the
    year pre-payment is received for rents, interest and royalties

  – Pre-payments for services may be accrued if the service will be
    performed within one tax-year of receipt

  – Pre-payments for goods may be accrued if the payment is less than the
    Cost of Goods Sold.

- Exceptions to all methods

Installment Sales Method: Any time one payment is received after the year
of sale, taxpayers must recognize income proportionately as the selling
price is received unless they elect to report in the year of sale.

 Taxpayers may mix the cash and accrual methods, using accrual
 for sales of inventories and cash for other revenues and

                            Chapter 4
                       Income Exclusions
                        Concept Review
 The All-inclusive income concept considers all income taxable
 unless a specific provision can be found that exempts it from

 Under the legislative grace concept, only Congress can provide
 income exclusion.

                          Major Reasons
 The major reasons income items are excluded

– To increase equity through relief provisions

– To provide incentives for taxpayers to engage in an activity

                       Income Exclusions
 There are four major categories of exclusions:

  – Donative items
  – Employment-related
  – Returns of human capital
  – Investment related

                          Donative Items
                       Gifts and Inheritances
 Donative items are increases in wealth that are not earned or the
 result of investment.

– Gifts are excluded to relieve double taxation caused by the gift

– Inheritances are excluded to relieve double taxation caused by
 the estate tax

                      Life Insurance Proceeds
– Life Insurance Proceeds are excluded to provide equity with
 other types of inheritances
  – Proceeds from policies purchased for consideration are not excluded

  – Interest income earned from the proceeds due to electing receipt as an
    annuity are not excluded

– Scholarships are excluded to provide incentive for education. To
 qualify, the scholarship
  – Must not require the performance of future services

  – Must be used for direct costs of education such as tuition, fees, books,
    and supplies

                          Employment Related

                         Foreign Earned Income
 Foreign Earned Income may be excluded to relieve double

                      Payments Made by Employer
 Payments made on behalf of an employee are excluded as an
 incentive to employers to provide these benefits.
 Examples of excluded payments are:
 – Contributions to qualified pension plans

  – Premiums for group term life insurance

  – Premiums for health and accident insurance

  – Meals and lodging

  – Fringe benefits

                      Payments Made by Employer
                       To Qualified Pension Plan
  Payments made by employers to qualified pension plans
– are not included in income in the year of payment

– are included in income in the year of withdrawal

                  Payments Made by Employer
                   Group Term Life Insurance
 Premiums paid for $50,000 of group term life insurance are
 excluded from income.

– Plan may not discriminate in favor of highly paid employees
– Premiums for insurance in excess of $50,000 are included in
 taxable income

                 Payments Made by Employer
                 Health and Accident Insurance
 Premiums paid for health and accident insurance are excluded
 from income to encourage employers to provide insurance.

                  Payments Made by Employer
                     For Meals and Lodging
– The value of meals provided by the employer are excluded from
 income if the meals are provided
  – on the employer’s premises
  – for the employer’s convenience

– The value of lodging provided must meet these conditions and
 also be a condition of employment

                    Payments Made by Employer
                      General Fringe Benefits
 The following types of fringe benefits are excludable from income
 if they are provided on a nondiscriminatory basis:
  – No additional cost services

  – Employee discounts
    • on goods, are limited to the gross profit %
    • on services, are limited to 20%

  – Child and dependent care services

  – Educational assistance programs

  – Employer’s athletic facility

                         General Fringe Benefits
 Other types of fringe benefits are excludable from income even if
 they are provided on a discriminatory basis:
  – Working condition

  – De minimus

                         Employer Benefit Plans
– Cafeteria Plans allow employees to choose from a menu of
 benefits and are excludable unless an employee elects to take
 cash in lieu of benefits

                      Employer Benefit Plans
– Flexible Benefit (Salary Reduction) Plans allow employees to use
    pre-tax compensation dollars to cover medical or child-care

                   Payments Made by Employer
                     Employer Benefit Plans
–   Health Savings Accounts are excluded to encourage employers
    and employees to purchase adequate medical coverage
          May be established for individuals covered only by high-
            deductible plans

        Employer contributions are excluded from income and
         individual contributions are deductible for AGI

                    Returns of Human Capital
    Payments received that are intended to reimburse an individual
    for injuries are excluded under the capital recovery concept
    because they merely restore the individual to a previous

    Payments that are intended to replace lost income are not

                      Worker’s Compensation
    Worker’s compensation payments related to an injury suffered on
    the job are excluded because they help restore individuals to
    their previous condition and do not add to their wealth.

               Personal Physical Injury or Sickness
• Compensatory damage payments received for a personal physical injury
  or sickness and medical payments for emotional distress are excluded to
  provide a return to equity

• Loss of income damage payments are only excluded if they are related to
  personal physical injury or sickness

• Punitive damage payments are never excluded

                  Health and Accident Insurance
– Payments or reimbursements for medical or health costs are
  excluded to provide an individual a return to equity

– Disability payments are excluded if the policy was purchased by
  the employee but not excluded if the policy was purchased by the

                       Investment Related
                      Municipal Bond Interest
– Interest income received from investment in municipal bonds is
  excluded to allow state and local municipalities to sell bonds for a
  lower interest rate

                         Investment Related
                           Stock Dividends
– Stock dividends are excluded from income because their receipt
  does not qualify as income under the realization concept

– If the shareholder has the option to receive cash instead of stock,
  realization has occurred and the value of the dividend is included
  in income

                          Investment Related
                       Discharge of Indebtedness
– An amount received as a loan is generally excluded from income
  under the realization concept because it must be returned

– If a lender discharges all or a portion of the debt, realization
  occurs and the forgiven portion is income
     • Discharge due to insolvency or bankruptcy is excluded from income

                         Investment Related
                       Leasehold Improvements
– The value of improvements to property made by a lessee are
  excluded under the wherewithal-to-pay concept

                                    Chapter 5
               Introduction to Business Expenses
   All tax deductions are a matter of Legislative Grace

 Deductions are part of Congress’ approach to implementation of
    Remember - expenses due to legislative grace implements ability to pay concept
    Deductions are only permitted if all requirements are met

                           Reporting Deductions
 There are two primary types of deductions allowed individuals:

– Deductions for adjusted gross income
  – generally have a business purpose

– Deductions from adjusted gross income
  – generally have a personal purpose

    Remember Tax Formula - Deductions For & From AGI

           For AGI:
            Trade or business expenses/losses
            Rent & Royalty expenses
            Capital loss deductions ($3,000 max)
            Other specifically allowed deductions (alimony, IRA, moving expenses)

           From AGI:
           Standard deduction or itemized deductions
                  itemized deductions include: medical exp, mtg interest, investment
                   interest, property taxes, state income taxes, charitable
                   contributions, personal casualty losses,

                  Subject to income limits

                  miscellaneous itemized deduction include: investment expenses,
                  tax return preparation fees, unreimbursed employee expenses

                         2% Floor

                      Reporting Deductions
                 Conduit Entities (Ptrshps & SCorps)
  Conduit entities are not subject to tax, but results of operations
  flow-through to owner’s returns.

– Items subject to special tax treatment are kept separate

– Items not subject to special tax treatment are netted to arrive at
  ordinary net income or net loss

     Conduit Entity Reporting - report items separately that receive special treatment -
     charitable contributions, investment interest expense, capital gains(loss), net income(loss),
     expenses that are subject to 2% AGI limitations, etc. Then individuals AGI can be

                        Classification of Deductions
  All expenditures fall into two categories:

– Profit-motivated
  – Trade or business expenses
  – Expenses for the production of income (Investment)

– Personal
  – Specifically allowed itemized deductions
  – Nondeductible personal expenses

                      Profit-Motivated Expenditures
  To be deductible, an expenditure must have a business purpose
  unrelated to its tax effect. Profit must be dominant motive.

– Show that the expense is related to a profit-motivated transaction

– Show that the business purpose is the primary or dominant

                                 Trade or Business
  Requirements to qualify as a trade or business:
– Primary purpose is to earn income or a profit
– Involvement is regular and continuous
– Activity is not merely a hobby

     These classifications apply to all entities except “C” corporations

            Classification depends on facts & circumstances

            Trade or business - no definition in code/regs, courts state that trade or
            business should have (1) profit motive [earn a living], (2) high taxpayer
            involvement [continuous and regular activity], (3) not sporadic, hobby, or
            for amusement.

            Production of Income Expenses - not related to trade or business. They
            are called nonbusiness or investment expenses.

            Expenses must bear reasonable and close relationship to earnings of

            Investment expenses - generally miscellaneous deductions subject to 2%

                                   Rental Activity
– Rental activities may be either trade or business or for the
 production of income
  – Expenses are always deducted for AGI
  – Classification matters when property is sold

– Classification is determined by the scope of the taxpayer’s
      Rental Activity - facts & circumstances determine treatment - in past, generally
              considered a trade or business, look at scope of rental activities &
             taxpayer involvement. Makes no difference on year to year tax return or if
             sell property at a gain, but it does make a difference if sold at a loss - if
             investment, capital loss limited to $3,000/year.

                    Mixed Business and Personal Use
– Mixed-Use Assets
  – Used both to earn income and for personal purposes

  – Treat as two separate assets by allocating amount of use

– Mixed-Use Expenditures

  – Incurred both for profit and personal reasons

  – Allocate between business and personal use and deduct as allowed

    Personal expenses not deductible unless itemized deductions.

  To be deductible, expenses must profit-motivated or specifically
  allowed and also must have business purpose beyond tax

– Ordinary commonly incurred

   Normal, common, generally accepted

   They do not have to be recurring expenses

   The determination of what is usual or customary is based on nature
    of the business.

   Also means that expense must be assignable to current accounting
      period - i.e., can’t benefit more than current period

– Necessary not essential to business but necessary
  – Appropriate, helpful, prudent

– Reasonable in amount
  – Arm’s length

To be deductible, expenses must not be
– Personal
   – Business purpose is not primary motive
   – Not specifically allowed
   i..e., motivation for incurring expense is primarily personal, a significant business motive is not

– Capital
  – Expenditures that should be capitalized as assets
  – Useful life extends beyond a year
  – Start-up costs
Not a capital expenditure - don’t get immediate deduction because useful life extends beyond
year. Land is not depreciable (permanent life).

       Certain exceptions: (legislative grace) research and
        experimentation expenditures, soil and water conservation expenses, certain depreciable
       assets, fertilizer for farms, etc.

Repair & Maintenance - currently deductible - keeps assets in normal operating condition [don’t
appreciably extend the life of assets or materially add to its value]

Betterments, improvements, replacements - extend life, add value - capitalize & depreciate

Start-up Costs -investigating or creating new trade or business. Costs are capitalized before
activities begin.

       Capitalize & amortize over => 60 months beginning in month operations begin.

               If not elect to amortize, recovered when you sell the business

           1) Investigate starting new or unrelated business –
              Open business – deduct first $5,000 of expenses. Remainder is amortized over 180
                                 months beginning in the month the business begins operations.
                                 The $5,000 deduction is phased out dollar for dollar when start-up
                                costs exceed $50,000

               Do not open business – personal expenses, no deduction.

           2) Investigate expanding an existing business. If already in same line of business - you
              can get current deduction regardless of whether you decide to open. Investigation
              expenses are considered to have a business purpose.

Organization costs - costs incurred to organize a corporation or partnership. These also must be
capitalized & amortized over => 180 months.

– Against Public Policy
  – Resulting from violation of a law - fines, penalties, kickbacks, bribes
  – Resulting from an illegal business
      • Cost of goods sold are always deductible under the capital recovery concept even for illegal
      • Ordinary, necessary and reasonable business expenses are deductible for all illegal businesses
        except sale of drugs – so rent, utilities, wages are deductible
               Not Frustrate public policy - fines, bribes, etc., lobbying or political activities

               drug sales - only get cost of goods sold

   – For lobbying and political activities
      • Costs to influence local legislation are deductible – not state or federal legislation
      • Costs to monitor any legislation are deductible

– Related to Tax-Exempt Income – not deductible
  – Incurred to generate tax-exempt income – didn’t include in income so can’t

– Another Person’s Obligation
  – Cannot recover another’s capital
     Expenditure must be for Taxpayer’s benefit - payment of another’s expense does not
      result in a deduction for either party

       Exception: medical expenses of a dependent

                               Timing of Deductions
  The taxpayer’s accounting method is used to determine the
  timing of deductions.

                                      Cash Method
– Cash Method claim a deduction in the year an expense is paid

   – Date of mailing for checks - if NSF, the date the check is made good
   – Date of charge for credit cards
   – Prepaid expenses are deductible if used within one tax year (prepaid
     interest does not qualify)

1 Prepaid expense needs to be required by creditor
2 payment does not distort income.

                                   Accrual Method
– Accrual Method claim a deduction in the year two tests are met
  – All-events test is met when a liability exists and the amount can be
    determined – can’t just assume a liability will exist sometime in the future
           ex. Warranty expense

   – Economic performance test is met when services or property are
     provided – when warranty work is actually performed or money refunded.

                           Timing of Deductions
                      Related Party Accrued Expenses
  Deductions for accrued expenses payable to a cash basis related
  party are limited.

• Related parties include family members and businesses owned or
  controlled by the taxpayer

• Unless both parties are accrual basis, both report using the cash method;
  until income is reported no expense may be deducted

              Related Party Expenses - limits timing of the deduction of accrued expenses
              payable to a related cash basis taxpayer. Related parties - family, 50% owned
              businesses. Expense is not deductible until paid & included in related cash basis
              taxpayer’s income.

         Financial Accounting Income vs. Taxable Income
– Matching and Conservatism are not tax concepts

– Estimates of expenses are not permitted for tax purposes
       1. Use specific write-off for bad debts - Tax (specific write-off), Book (allowance
       2. Vacation Pay - accrual if paid within 2.5 months

       3. Warranty - book (accrual), tax (when paid/services performed)

   – Do not estimate warranty expense

                                Mixed-Use Expenses
There are 3 areas deemed greatest potential for abuse in Mixed-use expenses. 1) Hobby
expenses 2) vacation homes 3) home office

                                 Hobby vs. Business
  An income-earning activity without a predominant profit motive is
  a hobby.

– Factors considered in determining profit-motive are
Look at following facts and circumstances:
   – Manner of conducting activity
   – Expertise or reliance on expert advice
   – Time and effort spent on activity
   – History of income and loss
   – Amount of occasional profit
   – Elements of personal pleasure
   – Success in similar activities
Presumed for profit if gross income>expenses in 3 of last 5 years

– Losses from a hobby are not deductible
   – Expenses allowed up to amount of income generated
               Excess expenses do not carryover, considered personal expense.

Rules for Deductions – Take 1st tier, then 2nd, then 3rd. They can’t exceed Gross income

   – Deductions taken using three tier system:
       1 Expenses also allowed as personal itemized deductions rest, real estate taxes]
       2 Expenses that qualify as business expenses – misc itemized ded subject to 2% floor
       3 Depreciation on assets used

   – Allowable expenses are deducted from AGI

                                  Mixed-Use Expenses
                                    Vacation Home
  A residence used for personal vacations and also rented to unrelated
  people is a mixed-use asset and is classified as:

   – Personal residence if rented
       • less than 15 days in a year

   – Vacation home if used personally
       • More than 14 days, or
       • More than 10% of the number of days rented

   – Rental property if used personally
       • less than 15 days, or
       • Less than or equal to 10% of the days rented

                                       Tax Treatment
Treatment depends on usage

Personal Residence
       If rental period<=14 days, don’t report income, don’t deduct expenses. But you
       can deduct mortgage interest and real estate taxes as itemized deductions.

Vacation Home
     If rent>14 days but you personally use it for greater of (a) 14 days or (b) 10% of
      days rented at FMV - it is considered a vacation home.

            1.   Report income
            2.   Deduct allocated expenses
            3.   Expenses limited to gross income
            4.   Same order as hobby
            5.   You Can Carryforward Losses

     IRS says use the following to allocate all expenses,

            Personal Use % = Personal use days / [Personal use days + Rent days]

Rental Propety
     If rent>14 days but you do not use it greater than 14 days and 10% of days rented,
      then the property is considered rental property.

            You can deduct business portion of expenses

                              Mixed-Use Expenses
                                 Home Office
  A taxpayer who operates a trade or business from home may
  deduct a portion of the home’s expenses.

– Expenses of the home are allocated between business and
  personal use

– A specific portion of the home must be used
  – Exclusively and regularly,
  – As the principal place of business or as a place to meet clients, but
     • If taxpayer has no other available location to do administrative and management
       work, this requirement will not disqualify the deduction

• Employees must also show that the use

  – Is for the convenience of their employer
  – Required as a condition of employment

• Allowed expenses are deducted using the three tier system

• Deduction is limited to the amount of net income from the business
  – Home-office deduction may not create a loss
  – Excess may be carried-forward

                                   Chapter 6
                            Business Expenses
All deductions are a matter of Legislative Grace. Just
because GAAP allows a deduction, don’t assume tax law
will too.

                             Business Expenses
All expenses must first meet the basic tests for deductibility -
– Have a business purpose
– Be ordinary, necessary and reasonable
– Be allowed under the Legislative Grace Concept

                          Business Expenses
                     Substantiation Requirements
– Expenses related to Meals, Entertainment, Automobile Usage,
  Travel and Business Gifts are deductible subject to limitations
  and strict documentation requirements
  – Amount of the expense
  – Time and place of travel or entertainment
  – Date and description of the gift
  – Business purpose of the expense
  – Business relationship of person entertained

                        Meals and Entertainment
  Meals and entertainment expenses must be directly related to or
  associated with the active conduct of a business activity.

                     Meals and Entertainment
                      Directly Related Test
– The “directly related to” test is met if
  – There is more than a general expectation of business benefit
  – A bona fide business activity takes place during the meal or
  – The principal reason for the meal or entertainment is business
  – The expenses are related to the taxpayer and people involved in the
    business activity

                     Meals and Entertainment
                      Associated With Test
– The “associated with” test is met if

  – There is a clear business purpose for the meal or entertainment
  – The meal or entertainment directly precedes or directly follows a
    substantial business discussion

                     Meals and Entertainment
– Meal costs include food, beverage, tax, and tips

– Entertainment costs include expenses for clubs, theaters, and
  sporting events
  – Only the face amount of a ticket is allowed
  – Club dues do not qualify

                     Meals and Entertainment
                        Cost Limitations

– Only 50% of the costs may be deducted

– Exceptions to the 50% limitation
  – Reimbursed expenses
  – Expenses that are taxable income to a non-employee recipient (awards,
  – Expenses for recreational or social activities which benefit employees

                               Auto Expenses
                            General Requirements
– The cost of using an automobile for business is deductible
  – Use of the automobile must be for travel
     •   Out of town
     •   From home to a temporary workplace
     •   From the regular to a temporary workplace
     •   From the workplace to a second job

  – The cost of commuting is never deductible.

                                 Auto Expenses
– Auto expenses may be computed using one of two methods:
  – Actual Cost

  – Standard Mileage Rate

                           Auto Expenses
                         Actual Cost Method
– The actual cost of using the automobile may be deducted
  – The business percentage of depreciation, gas and oil, repairs,
    insurance, interest, license fees, etc. is deductible

  – Deduction amount is often larger than the standard rate

                         Auto Expenses
                  Standard Mileage Rate Method
– The administrative convenience concept allows a deduction
  based on the number of business miles driven during the year
  – Rate is $     per mile
  – Tolls, parking, interest (for self-employed) and property taxes are added

– Standard rate method is not allowed if multiple cars are used

                           Travel Expenses
– Travel expenses incurred while on business away from the tax
  home overnight are deductible
  – Tax home is the principal area in which business is conducted

  – Overnight means longer than a regular workday

– Over 50% of the activity requiring travel must have a business
  – Personal activity costs on a business trip are not deductible
  – Incidental business expenses on a personal trip are deductible
  – Travel for general educational purposes is not deductible
  – Travel for investment related meetings is not deductible

                             Business Gifts
– The cost of a gift given to a business customer may not be fully
  – There is an overall limitation of $25 per person, per year
  – Gifts are not subject to the 50% entertainment limits
  – Delivery, gift wrap, engraving, etc. do not count toward the $25

                   Compensation of Employees
– Wages, salaries, bonuses and other compensation paid to
 employees is deductible if two basic tests are met:
  – Employees must perform actual service

  – Payment must be reasonable in amount

                   Compensation of Employees
                    Reasonable Compensation
– Some factors considered when determining if compensation is
 reasonable are
  – Duties, responsibilities and pay history of the employee

  – Volume and complexity of the business
  – Time required to do the work
  – Ability and accomplishments of the employee
  – Company pay policy

– Payments to a related party may be examined closely for
  – Lack of a business purpose
  – An arms-length transaction
  – Reality of compensation in a closely-held business

– Size of deduction for salary paid to a covered employee is limited
  – CEO and the four highest paid officers are covered employees
  – The is a $1,000,000 limit on compensation deduction per employee
  – Some amounts are exempt from the limit
     • commissions and performance based payments
     • pension plan contributions
     • fringe benefits

                                     Bad Debts
 Bad debts are generally deductible under the capital recovery

– Business bad debts are deductible only under the accrual
– Nonbusiness (Investment) bad debts are deductible if the debt is
  bona fide
  – Report as a short-term capital loss
  – No deduction is allowed if the debt is voluntarily forgiven

          Domestic Production Activities Deduction

Qualified Production Activities Deduction
Amount Of Deduction

   6% of the lesser of:

Qualified Production Activities Income OR

Taxable Income before Qualified Production Activities Deduction

     Cannot Exceed 50% of W-2 wages paid by Taxpayer

Qualified Production Activities Income equals:

Domestic Gross Production Receipts
Less the allocable:
                 Cost of Goods Sold
                 Direct Expenses and Losses
                 Indirect Expenses and Losses
Qualified Production Activities Deduction

Domestic    Gross Production Receipts arise from

Sale, exchange, lease, rental or other disposition of:

     Qualifying property manufactured, produced, grown, or extracted in the

     Qualified films produced

     Electricity, natural gas, or potable water produced in the U.S.

       Construction activities performed in the U.S.

       Engineering or architectural services performed in the U.S

Qualified production property (QPP) includes tangible personal property,
computer software, and sound recordings

Tangible personal property does not include the leasing or renting of land,
buildings, structural components of buildings, or intangible property.

                                Safe Harbor
(1) An overall de minimis safe-harbor test applies to taxpayers having less
than 5 percent of total gross receipts from non-DPGR. The taxpayers may
treat all gross receipts as DPGR.

Gross receipts derived from the performance of services, receipts from the
sale of food and beverages at retail establishments, and gross receipts
derived from property leased, licensed, or rented to a related person do not
qualify as DPGR.

Example – If a retailer sells roasted coffee to a number of unrelated
vendors and sells the brewed coffee to customers, the sale of the roasted
coffee beans is DPGR and the sale of the brewed coffee is not DPGR.
MPGE Safe Harbor

                               Safe Harbor II

Safe harbor exists when an employer incurs conversion costs related to
MPGE of the property within the United States and the costs account for 20
percent or more of the property’s cost of goods sold.

                             Other Expenses
  Insurance premiums paid to protect a business from the following
  losses are deductible.

  – Fire, theft, casualty or liability
  – Group medical, term-life and worker’s compensation
  – Performance and fidelity bonds
  – Business interruption

  Most business related taxes are deductible except those paid to
  the federal government.
• Sales taxes related to long-lived assets must be capitalized

• Property taxes related to real estate bought or sold during the year must
  be allocated between buyer and seller

• Taxes related to assessments for local benefits are added to the property’s

                                Legal Fees
  Legal fees are deductible if they were paid to defend business
  income, reputation or goodwill
  – If fees are related to property ownership, they are capitalized with the
    cost of the property

                       Individual Deductions
                     For Adjusted Gross Income
  Expenses paid by individuals
– for a business purpose, or
– specifically allowed by Congress to create equity in tax treatment
  are allowed as deductions for AGI.
                        Reimbursed Employee
                          Business Expenses
– Reimbursements received from an accountable plan are
  deductible for AGI

– Reimbursements received from a nonaccountable plan are
  deductible from AGI

             Reimbursed Employee Business Expenses
                       Accountable Plan
  Employees are required to make an adequate accounting of their
• Reimbursements = expenses
  – nothing is reported

• Reimbursements < expenses
  – reimbursement is reported as income
  – expenses = reimbursement income are deducted for AGI
  – excess expenses are deducted from AGI

• Reimbursements > expenses
  – excess reimbursement is reported as income

            Reimbursed Employee Business Expenses -
                     Nonaccountable Plan
  Employees are not required to make an adequate accounting of
  their expenses.

• All reimbursements are included in income
• All expenses are deducted from AGI

              Deductions for Self-Employed Taxpayers
  To provide self-employed taxpayers equity with the tax treatment
  of employees, they are allowed to deduct:

– 100% of the cost of health insurance premiums paid for
  themselves. Remainder is personal medical expense deducted
  from AGI.

– 50% of the amount of self-employment tax paid

                               Education Expenses

Costs of education are deductible if
      Required by law (or employer) to maintain employment, or
      Maintains or improves current job skills

Costs of education are not deductible if,
      Necessary to meet minimum job requirements, or
      Qualifies taxpayer for new trade or business

Unreimbursed allowable costs are deductible as miscellaneous itemized deduction.

Employee may exclude up to ($            ) of reimbursed expenses from a qualified plan.

              Retirement Plan Contribution Deductions
  Taxpayers who do not have access to an employer sponsored
  pension plan are allowed several options:

– Keogh or H.R.10 plans (for self-employed taxpayers only)
– Individual Retirement Accounts (for all taxpayers)

                     Individual Retirement Accounts
– All taxpayers may contribute up to $    of their earned income to
  a Deductible or a Roth IRA. A married couple may contribute

– $       in total, but not more than $     to any one account.A
  married couple may contribute $6,000 in total, but not more than
  $3,000 to any one account. If 50 years old or older

                                  Deductible IRA
– Contributions limited to lesser of $ ($      for married
  taxpayers) or amount of earned income. If 50 years old or older
  catch-up provision allows $   (    MFJ)

  – Fully deductible if not covered by an employer’s plan
      • Not linked to spouse’s coverage

  – If covered, maximum deduction equals:
                  a) Single starts at ($     to $         )
                  b) MFJ (both covered by a plan) ($          to $    )
                  c) MFJ (one spouse covered by plan)
                     i. Spouse with plan starts at ($       to $      )
                     ii. Spouse without plan starts at ($      to $       )
                                        Roth IRA
– Contributions are not deductible

– Earnings distributions are tax-free if
  – IRA has existed for 5 years, and
  – Taxpayer is >59 1/2 years old
  – No age limit to begin distributions

– Contributions are phased-out
  – Married, between ($   to $                      )
  – Single, between ($   to $                   )

                                Education IRA
– Set up as a trust for the benefit of any person under age 18

– ($      ) annual nondeductible contribution
   – Maximum contribution to one trust cannot exceed ($               )

– Tax-free growth in the IRA

– No tax at time of withdrawal if used for qualified expenses
  – Tuition and fees of student

      Taxpayer may use up to $2,500 to pay expenses of room and board.

– Taxpayers cannot use income exclusion in the same year they
  use HOPE Scholarship Credit or Lifetime Learning Credit.

                  Higher Education Expense Deduction

May deduct up to ($              ) of qualifying higher education
expenses FOR AGI.

       Qualifying = tuition and fees
       Must have AGI < $65,000 if single ($130,000 if MFJ)
       Cannot claim if claiming HOPE or Lifetime Learning
        Credits but can take a tax-free distribution from an
        education IRA if for different expenses.

                       Other Education Incentives
– Education Loan Interest
  – May deduct up to ($   ) for interest paid on education loans

  – Taken as a “for” deduction

  – Deduction phased-out when AGI exceeds

                          Moving Expenses
                           Distance Test
  Moving expenses are deductible if they meet two tests.
– Distance test – Commuting distance from old residence to the
  new job must be 50 miles farther than the commuting distance
  was to the old job.

                                 Time Test
– Time Test
  – Employee taxpayers must be employed in the new area for 39 weeks of
    the 12 months after moving

  – Self-employed taxpayers must be employed in the new area for 78
    weeks of the 24 months after moving

                        Qualifying Expenses
  Only two types of expenses are deductible:
– Costs of moving household goods and personal items to the new

– Transportation and lodging costs of moving the taxpayer’s family
  to the new location
  – Mileage is allowed at     cents per mile
  – None of the cost of meals is deductible

– Any reimbursement of moving expenses received from an
 employer is included as income

                            Chapter 7
            Losses - Deductions and Limitations
                         Concept Review

The deductibility of losses is a matter of legislative grace and is
 based on the ability-to-pay concept.

                     Definition of Losses
• Annual (Activity) Losses result when an entity’s
  deductions for the period exceed its income

• Transaction Losses result from the disposition of an asset

           General Scheme for Treatment of Losses

              Annual Losses-Net Operating Loss

• Incurred in trade or business operations
  – Caused by business expenses

  – May not be caused by investment or personal expenses

                          Annual Losses
                        Net Operating Loss
• Treatment
  – No tax in year NOL occurs

  – Carry-back 2 years

  – Carry-forward unused NOL 20 years
    • May elect to forego carry-back

                          Annual Losses
                         Tax Shelter Losses
 Tax shelters are activities designed to minimize the effect of tax
 on wealth accumulation.

– Dominant business purpose is lacking

– Primary motivation is tax reduction

– Are often vehicles for tax law abuse

                                  Tax Shelter Losses
                                    At-Risk Rules
– At-Risk Rules disallow the deduction of artificial losses

– Loss deduction limited to amounts actually at-risk

  Amount at risk = Cash or adj. basis of other assets contributed
                    Debt for which t/p is responsible
              +(-) share of income (loss) from activity
                (-) withdrawals

                                Tax Shelter Losses
                               Passive Activity Loss
  A passive activity is any trade or business in which the taxpayer
  does not materially participate.
Definition – material participant
          3) involvement on a regular and continuous and substantial basis
          4) for > 500 hours per year, or
          5) > 100 hours/year and > any other individual

– Passive Activity Loss Rules disallow the deduction of passive
  activity losses from other forms of income

                      Passive Activity Losses
                         Types of Income
  Three classifications for activities:
• Portfolio income: unearned income derived from holding investments

• Active income: earned income

• Passive income: earned or unearned income from a trade or business in
  which a taxpayer does not materially participate

                      Passive Activity Losses
Taxpayers subject to the limitations:
– All non-corporate taxable entities

– Conduit entity passive losses flow-through to owners

Taxpayers not subject to the limitations:
– Publicly held corporations

– Closely held corporations

                    Passive Activity Losses
                  General Rules for Limitations

• Passive activity losses must be netted against passive
  activity income
   – Net passive losses are not deductible

   – Net passive gains are reported with other income

                       Passive Activity Losses
            Exception for Rental Real Estate Professionals
– By definition, all rental activities and limited partnership interests
  are passive

– Taxpayers who materially participate in rental real estate
  business are allowed to offset any losses against other active or
  portfolio income
Definition – Material participant for real estate professional.
  1) Material Participant (500 hours/ yr. working or meet 100 hour test)
  2) > 750 hours in real property trade or business
  3) > 50% of working hours in real property trade or business
  4) Does t/p own > 5% interest in a real property trade or business?

If so, activity is active. Loss deductions are allowed.

– Active Participation Exception permits up to $25,000 of rental real
  estate loss to be deducted annually
   – Deduction amount is reduced by $0.50 for each dollar of AGI over

   – For AGI over $150,000, no allowed loss deduction remains.

    Significant service rentals like hotels, car rentals, video rentals, golf course
     fees …are not passive as long as owner meets material participation rules.

    Working interest in oil and gas deposit is always an active business. Royalty
     interests in the property by individuals who are not active are not considered
     active interests.

    Low-income housing interests are active.

                        Passive Activity Losses
                    Disposition of Passive Activities
Disposition by Sale

– Excess (suspended) losses must be accounted for in the year of

– Disposition by sale frees the suspended loss to offset income of any other

 Gain or loss generally capital gain or loss

Disposition by Death

– Disposition upon death leaves the passive activity in the
  decedent’s estate

   – Passive activity with unrealized gain
      • Beneficiary takes passive activity with stepped-up basis
      • Released excess loss is deductible against other income, but

    • Any unrealized gain on activity decreases amount of suspended loss to release

  – Passive activity with unrealized loss
    • No suspended loss is released

                           Transaction Losses
 Transaction losses result from the disposition of business,
 investment or personal-use assets.

                       Trade or Business Losses
 Business casualty and theft losses result from damage caused
 by a sudden, unexpected and/or unusual event

  – For property fully destroyed, deduct the adjusted basis less insurance

  – For property partially destroyed, deduct the lesser of the property’s
    adjusted basis, or the decline in the property’s value

                      Investment-Related Losses
– Net capital losses result from netting short-term and long-term
 capital gains and losses
  – Individual taxpayers may deduct only $3,000 annually

  – Corporate taxpayers may not deduct any net capital loss

   Losses on Small Business Stock may be deducted up to
 $50,000 per person ($100,000 per married couple) per year
  – Small business = a corporation with capitalization of less than $1 million

  – Stock must be bought directly from corporation

  – Excess over $50,000 ($100,000 MFJ) is netted with other capital gains
    and losses
                          Transaction Losses
                      Investment-Related Losses
– Losses on Related Party Sales are disallowed because they
 generally fail the arm’s length transaction concept
  – Loss is carried forward with the property
    • Gain from later sale may be offset by deferred loss

    • Loss cannot be created or increased by using the deferred loss

– Wash Sale losses are disallowed because the sale violates the
 substance-over-form doctrine
  – A wash sale occurs when a security is sold at a loss, and during +/- 30
    days of the sale the seller buys substantially identical securities

  – Disallowed loss amount is added to the basis of the replacement

                           Transaction Losses
                           Personal Use Losses

– Losses from the disposition of personal use assets are generally
  not deductible

– Exception exists for personal casualty and theft losses

Loss is the lesser of
 Property’s adjusted basis
 The decline in value of the property

Loss is reduced by
 Insurance proceeds received
 $100 per event
 10% of AGI per year
                                         Chapter 8
                             Taxation of Individuals
                             Review of Tax Formula
– The formula for calculating taxable income generally is gross
  income minus allowable deductions.

– For individuals, deductions are split into two classes
  – Deductions for adjusted gross income

   – Deductions from adjusted gross income

                            Individual Tax Formula
         Gross Income
minus:   For Deductions
      • not restricted based on taxpayer’s income
      • generally trade, business, rent or royalty expenses
  =     Adjusted Gross Income (AGI)
minus: From Deductions
         The greater of –
             Total itemized deductions
             Or Standard Deduction

     Personal and Dependency Exemptions
  = Taxable Income

            Personal and Dependency Exemptions
– Each individual taxpayer is allowed one personal exemption

– May also claim one exemption for each dependent

  – Only one exemption may be taken per person per year

                         Two types of dependents
       Qualifying child
             Must pass five tests: age, non-support, relationship, principal
             residence, and citizenship

       Qualifying relative
             Must also pass five tests: gross income, support, relationship,
             citizenship, and joint-return

  1. Age Test – Must be

        younger than 19, or

        a full-time student younger than 24, or

        Permanently and totally disabled

  2. Non-Support Test – Child may not

        Supply more than 50% of their own support
            Scholarships don’t count

         Note: the taxpayer who claims the child does not have to
          provided more than 50% of the support

¸ 3. Relationship Test – Child must be taxpayer’s:
        Foster child
        Decedent of any of the above

  4. Principal Residence Test

        Child must live with taxpayer more than 50% of the year
             Absence due to illness, vacation, education, or military
             service does not count

  5. Citizen or Resident Test

        Child must be a U.S. citizen, or

        Resident of the U.S., Canada, or Mexico

                       Qualifying Relative Tests
– 1) Gross Income Test - A dependent’s gross income must be
  less than the personal and dependency exemption amount.

– 2)Support Test -The taxpayer must provide more than 50% of a
  dependent’s support for the year

   – Two exceptions apply
      • Custodial parent may always claim a child

     • Multiple Support Agreement

                    Multiple Support Agreement
– When two or more people together provide over half of another’s
  support, any one who contributes over 10% of the support may
  claim the exemption
   – Group must sign a support agreement

   – May rotate the exemption among the group

– 3)Relationship Test- A dependent must be related to or reside
  with the taxpayer
   – Relatives are ancestors, descendants, and other blood or in-law
     relations such as siblings, aunts, uncles, nieces and nephews (cousins
     don’t count, but adopted children do)

   – Non-relatives must reside in the taxpayer’s home for the entire year

– 4)Citizenship or Residency Test A dependent must be a U.S.
  citizen or a resident of a country adjacent to the U.S.

– 5)Joint Return Test A dependent must not file a joint return
   – A joint return may be filed simply to claim a refund of all withheld tax

                                Filing Status

 Tax law recognizes the difference in ability-to-pay by basing
 exemptions, standard deductions and tax rates on an individual’s
 filing status.

                             Married, Filing Jointly
– Taxpayers must be legally married on the last day of their tax

– A Surviving Spouse may continue to use Married, Filing Jointly
  – For two subsequent years
  – If at least 1 dependent child lives at home
  – And the surviving spouse has not remarried

                          Married, Filing Separately
– Taxpayers married as of the last day of the year may choose to
 file separately

                               Head of Household
 Unmarried taxpayers qualify if they
  – are legally unmarried or an “abandoned spouse” at end of tax year, and

  – provide over 50% of the cost of a home for
     • A qualified dependent, or
     • An unmarried child who does not qualify as a dependent but resides with the
       taxpayer, or
     • A parent

 Abandoned Spouse
     Dependent child lives in the home for more than ½ of the year
     t/p’s spouse doesn’t live in the home during the last ½ of the tax year.

 Taxpayers who are not legally married on the last day of the year
 and do not qualify as Head of Household must file Single

                          Deductions From AGI
 Individual taxpayer’s may deduct the larger of either a standard
 deduction or total itemized deductions.

                          Standard Deductions
   Based on filing status of t/p

   Additional standard deductions are available for blind t/p’s or those who have
    attained age 65 by the end of the tax year.

                          Itemized Deductions
 Through legislative grace, there are 6 categories of personal
 expenses individual taxpayers may deduct, instead of the
 standard deduction.

                            Medical Expenses
– Unreimbursed medical expenses of the taxpayer(s) and medical
 dependents are deductible
  – Medical dependents may violate the gross income and the joint return

  – Costs include premiums for health and accident insurance and
    transportation at    cents per mile

  – Deduction is limited to the excess of total costs over 7.5% of AGI

– Amounts paid for state and local income, real estate and other
  personal property taxes are deductible
  – No payments for federal taxes are allowed

  – Property taxes must be based on value

  – The tax benefit rule may require including refunds of previously
    deducted taxes as income

– Qualified home mortgage interest is deductible
  – Debt must be secured by a principal residence or one other residence
  – 2nd residence must qualify as a vacation home.

  – Qualified interest is interest paid for
     • Acquisition debt up to $1 million
     • Home equity debt up to $100,000

– Points on a qualified mortgage are deductible if paid to acquire
  – Must be stated as a % of the loan value

  – Deductible currently if paid on acquisition debt

  – If not, amortize over the life of the loan

– The deduction for investment interest is limited to the amount of
 net investment income
  Investment income
- Investment expenses (other than interest)
= Net investment income

                          Charitable Contributions
– Contributions made to qualifying charitable organizations are
  – Organizations established for religious, educational, charitable, scientific
    or literary purposes qualify

  – Deductible amount includes cash paid and the value of property given
    and cents per mile driven

  – Three major limitations exist

  – Contributions in excess of limitations may be carried forward for five

                          Charitable Contributions
– Deduction amount for property depends of the type of property
  – Ordinary income property or short-term capital gain property
     • Deduction is the lesser of the property’s
       – FMV, or
       – adjusted basis

  – Deduction amount for long-term capital gain property is FMV

– The overall deduction cannot exceed 50% of AGI

– Deduction for long-term capital gain property cannot exceed 30%
 of AGI
  – If the taxpayer elects to deduct the adjusted basis rather than FMV, the
    50% limit is used. To make this election, the FMV of the property must
    be greater than the basis of the property.

 Other various expenses are combined as miscellaneous itemized
 deductions and are either fully deductible or partially deductible

                           Fully Deductible
  Fully Deductible expenses include:
– Gambling losses to the extent of gambling winnings,
– Impairment-related-work expenses of disabled taxpayers, and
– Unrecovered capital from a terminated annuity

                         Partially Deductible
– Other miscellaneous expenses are partially deductible to the
 extent their total exceeds 2% of AGI
  – Unreimbursed employee expenses

  – Investment expenses other than interest

  – Hobby-related expenses

     Fully Deductible Miscellaneous Itemized Deductions

   Gambling losses to the extent of gambling winnings

   Impairment related work expenses of disabled taxpayers, and

   Unrecovered capital from a terminated annuity

            Reductions for High-Income Taxpayers
  Taxpayers whose AGI exceeds set threshold amounts must
  reduce their itemized deductions and personal & dependency
                               Tax Credits
  A tax credit is a direct reduction of tax liability.
  The purposes of tax credits are
  – to provide incentives for taxpayers to engage in specific activities
  – to provide equity among taxpayers
  – to provide tax relief for low-income taxpayers

                            Child Tax Credit
– Non-refundable $           credit for each qualifying dependent
  – Under age 17, and
  – U.S. citizen or resident

                        Earned Income Credit

– The earned income credit provides tax relief to low-income

– Credit is refundable
  – The taxpayer may receive a refund if the credit exceeds the tax liability

– Eligibility requirements are
  – Taxpayer must live more than half the year in the U.S.
  – Taxpayer or spouse must be older than 25 and younger than 65
  – Taxpayer or spouse cannot be a dependent of another
  – Married taxpayers must file jointly
  – Taxpayer may not have portfolio or passive income in excess of $2,700

– Amount of the credit depends on
  – The taxpayer’s earned income
     • Phased-out after maximum limit is reached

  – The number of qualifying children living in the taxpayer’s home
     • Child must be less than 19 years old (24 if full-time student)
     • Must be a natural, step, or foster child and reside with taxpayer more than half of
       the year

– Amount is determined using an IRS table

                  Child and Dependent Care Credit
– The child and dependent care credit provides tax relief to
  taxpayers so that they can be employed

– Two qualifying conditions must be met
  – Expenses must be incurred so that taxpayer can be employed
  – Expenses must be for the care of qualified individuals

– Qualified individuals are

  – Dependents younger than 13 years old or
  – A dependent or spouse who is physically or mentally incapacitated

– The credit amount may not exceed $              (     ) if more than
 one qualified individual.

                     Higher Education Credits
  – HOPE Scholarship Credit

  – Lifetime Learning Credit

    For Either Credit:

  - May only claim one of the two credits for each student.
  – Must be enrolled at least one semester

  - Cannot claim education credit if you claim the For AGI Higher Education
    Expense deduction.

  – Must be enrolled at least half-time

                         Qualifying Expenses
– Expenses must be for higher education of taxpayer, spouse, or

– Tuition and related fees are reduced by the amount of any
 scholarship or fellowship received

                     HOPE Scholarship Credit

– Non-refundable $1,650 credit
  – 100% of the first $1,100, plus 50% of the second $1,100

– Student or qualifying taxpayer may claim

– Separate Hope Credit for each student

– Available only for first two years of post-secondary education

                         Lifetime Learning Credit
– Non-refundable $            credit
  – 20% of the first $         of qualifying expenses

– Only one credit per return (regardless of number of students in

– Expense can be for any course work to acquire or improve job

           Overall Limitation on Education Incentives
– May only use one incentive per return per year

– If t/p claims a deduction for AGI for higher education expenses,
  can’t claim HOPE or LLC.
  Can claim an education tax credit and receive a tax-free distribution from
   an Education IRA.

                           Filing Requirements
– Individuals must file a return when
   – Gross income exceeds (standard deduction + additional deductions for
     age + personal exemption)

3 major exceptions:

   – Self-employment income exceeds $400

   – They can be claimed as a dependent on another’s return and their
     unearned income exceeds $700

   – Married t/p’s filing separate returns are required to file if their gross income
     exceeds the personal exemption amount.

                                    Chapter 9
                         Acquisitions of Property
                Tax Definition of Property
   The term property refers to long-lived assets owned by a

    The amount invested in an asset is the property’s basis.

                              Classes of Property
     Property is classified by both its use and its type.

                                Use of Property
– All property may be classified by use as either personal use or
  trade or business use.

                              Types of Property
All property may be classified by type as either tangible or

– Tangible property may be classified as personal property or real

– Intangible property lacks physical substance and has only an
 economic existence.

                            Classes of Property
– Tangible property has physical substance

  – Tangible real property (real estate) consists of land and structures
    permanently attached to land

  – Tangible personal property (personalty) is all other tangible property
                      Property Investment Cycle
                          Increases in Basis
– There are two broad categories of increases

  Additional capital investments
    • Capital expenditures
    • Costs of defending ownership
    • Special assessments

  Reinvestment of income from the property
    • Taxable income from conduit entities

                             Decreases in Basis
– There are three broad categories of decreases

  Annual tax deductions for cost recovery
    • Depreciation, depletion or amortization
    • Losses from conduit entities

  Disposition of all or part of the property

  Capital recovery due to income exclusion

                        Basis in Conduit Entities

– Basis in a conduit entity is adjusted yearly for items passed
 through to owners
  – Increased for additional capital invested, taxable and nontaxable
    income, and owner’s share of entity liabilities

  – Decreased for deductible or nondeductible expenses, cash or property
    distributed to the owner, and owner’s share of liability reductions

                       Property Dispositions

                              Initial Basis
Amount invested =
– Cash paid +
– FMV of property or services given +
– Increases in liabilities related to the purchase +
– Any cost incurred to get the asset ready for its intended use

                     Basis in Bargain Purchase
– The all-inclusive income concept requires income recognition
 equal to the difference between an asset’s FMV and its sales

– The asset’s basis = amount paid + the amount of income

                      Purchase of Multiple Assets
– Total basis is allocated between assets based on the relative
  FMV of each

                   Purchase of Assets of a Business
– Purchase price is allocated to individual assets by their FMVs or
  through specific agreement

– Excess of purchase price over FMV of assets is considered

– Purchase of corporate stock does not confer ownership of the
  business’ assets

                       Basis in Constructed Assets
  Basis includes

– Direct construction costs
  – Actual costs of physical construction

– Indirect construction costs
   – General costs of the business that support the construction
     • For example: interest, taxes, equipment depreciation, general admin., etc.

                               Basis of Property
                               Acquired by Gift
  On the date of gift, compare FMV of property to the donor’s

– FMV > donor’s basis

  – Basis in the property is the donor’s basis plus any gift tax paid on net

Donor’s basis > FMV
– Basis is determined when property is eventually sold

  – If sold for more than donor’s basis, use donor’s basis (gain)

  – If sold for less than FMV, use FMV as basis (loss)

  – If sold for an amount between the two, use sales price as basis (no gain
    or loss)
                    Holding Period for Property
                         Acquired by Gift
– If donor’s basis is used, holding period begins on the donor’s
 acquisition date

– If FMV is used, holding period begins on the date of gift

                         Basis of Property
                      Acquired by Inheritance
– Three dates are important

  – Primary valuation date is the date of death

  – Alternate valuation date is six months after the date of death

  – Distribution date is the date a beneficiary receives the property

– Basis is generally the FMV of the property on the primary
 valuation date

– If the estate is valued on the alternate valuation date
   – Basis is the FMV of the property on the earliest date received, either
     • Date of distribution, or
     • Alternate valuation date

                       Holding Period of Property
                        Acquired by Inheritance

  The holding period for property acquired by inheritance is
  automatically considered to be held long-term.
– Property owned by spouses as joint-tenants with right of
  – Treated as owned one-half by each person

  – When one dies, the survivor’s basis is
     • Survivor’s adjusted basis for one-half +
     • FMV of the inherited half

                            Basis in Property
                         Acquired From a Spouse
– The realization concept does not apply to a transaction between
  spouses because of the arm’s length transaction concept
  – Basis and holding period in property is carried over from one spouse to
    the other

  – The same result occurs for property transfers created by a divorce

                              Basis for Securities
                               Stock Dividends
  Stock dividends are generally non-taxable dividends.

                          Basis for Securities
                             Wash Sales
  A wash sale occurs when a security sold at a loss is replaced
  with a substantially similar security +/- 30 days from the sale.

– Loss is not deductible under the substance-over-form doctrine

– Nondeductible loss amount is added to the basis of the
  replacement security

                             Chapter 10
  Cost Recovery on Property: Depreciation, Depletion,
                   and Amortization

                           Concept Review
– The capital recovery concept allows a taxpayer to recover all
  invested capital before income is taxed

– An asset’s basis is the maximum investment that qualifies as
  capital for recovery

– Legislative grace allows the capital to be recovered
  systematically over the life of the asset

                         Methods of Recovery
– Depreciation: used for tangible assets that
  – Are used for a business or production of income purpose

  – Have a determinable life

– Depletion: used for wasting assets

– Amortization: used for intangible assets

                       History of Depreciation
                        Section 179 Election
  A taxpayer may elect to expense rather than capitalize qualifying
             property placed in service during the year.

– Promotes administrative convenience

– Treated as a depreciation deduction

                          Section 179 Election
                          Qualifying Property
– Tangible, personal property
  – Real estate does not qualify

– Used in a trade or business
  – Investment property does not qualify

                         Section 179 Election
                        Deduction Limitations
– Limitations apply to each entity

– Cannot exceed $

– Cannot exceed taxable income from the business
  – Excess may be carried over

– Deduction decreased if total cost of qualifying property placed in service
  exceeds ($               )
   – by $1 for every $1 of value over ($  )

                           Qualifying Property
– MACRS applies to
  – New and used tangible, depreciable property

  – Used in a trade or business or for the production of income

– Depreciable basis is
  – The asset’s original basis for depreciation (discussed in chapter 9)

  – Reduced by any Section 179 deduction.

– Adjusted basis is
  – The remaining unrecovered capital of an asset
     • Asset basis minus accumulated depreciation

                            Recovery Period
– Each asset must be placed in a MACRS class according to its
 class life

  – Most personal property is in a 3, 5, or 7 year class

  – Most land improvements and specialized property are in a 10, 15, or 20
    year class

  – Real estate is in a 27.5, 31.5, or 39 year class

– For administrative convenience, three assumptions are made
 about the time property was placed in service during the year
  – Mid-year convention applies to all property except real estate

  – Mid-month convention applies to real estate only

  – Mid-quarter convention applies to personal property

                        Mid-Year Convention
– Assumes property is placed in service and will be disposed of at
 the mid-point of the year
  – One-half year depreciation allowed in the first year of service

  – One-half year depreciation allowed in the last year of service

– IRS tables reflect the mid-year adjustment for the first year and
 only for the last year if the property is kept until the final year of
 depreciation schedule.

                      Mid-Month Convention
– Assumes property is placed in service and will be disposed of at
 the mid-point of a month
  – One-half month allowed at the beginning

  – One-half month allowed at disposition

– IRS tables reflect the adjustment for the acquisition year and only
 for the last year if the property is kept until the final year of
 depreciation schedule.

                      Mid-Quarter Convention
 If > 40% of the depreciable basis of all personal property is
 placed in service during the 4th quarter of the year:

– Assume property is placed in service and will be disposed of at
 the mid-point of a quarter rather than at mid-year
   Determine the 40% after taking the Section 179 expense

                Depreciation Method Alternatives
– Regular MACRS with Section 179

– Straight-line MACRS

– Straight-line Alternative Depreciation System (ADS)

                           Regular MACRS
– Method is double declining balance

  – IRS tables provide the depreciation rate
    • Designed to permit full recovery of depreciable basis

    • Incorporate the conventions

– Maximum acquisition year deduction when used with the Section
 179 election.

                          Straight-Line MACRS
– Taxpayers may elect to use the slower straight-line method

– Election is made each year

– MACRS recovery periods are used
  – mid-year convention applies

                  Alternative Depreciation System
– Taxpayers may elect to use ADS

– Use is mandatory for alternative minimum taxable income

– Uses a longer recovery period than MACRS

– Election is made on a class-by-class, year-by-year basis

                   Limitations on Listed Property
– Most mixed-use property is considered listed property and
 subject to special limitations

  – Examples: automobiles, computers, cellular phones, etc.

                   Limitations on Listed Property
– Treatment depends on the percentage of business usage
  – if >50% business use, treated like other depreciable assets

  – if < 50% business use, deductions are limited to ADS without Section

– In either case, only the business portion of the asset’s basis is

                   Limitation on Passenger Autos
– The total amount of depreciation and Section 179 expense that
  can be deducted is limited
  – Annual maximum limit set and linked to the year the car was placed in

  – Annual limit is further reduced by the business use %

  – First year limit for cars placed in service $

                      Adequate Record Keeping
– Listed property is subject to strict record keeping requirements
– No deduction is allowed without proof of

  – Why? The business purpose of the use What? The amount
  – Where? The reality of the use When? The dates of use

– The basis of intangible assets is recovered using the straight-line
  method over the life of the asset

– Intangible assets acquired through purchase of substantially all of
 the assets of a business generally use a 15 year life.

– Created assets and individually purchased assets are amortized
 over their legal life

                                      Chapter 11
                             Property Dispositions
                                   Concept Review

                                  Amount Realized
 Amount realized is gross sales price less selling expenses.
  – Gross sales price is the amount received by the seller from the buyer
    and includes
    • Cash and FMV of property or services received

    • Seller’s debt assumed by the buyer

    • Seller’s expenses paid by the buyer

  – Gross sales price is decreased by amounts given to the buyer by the
    • Buyer’s expenses paid by the seller

    • Buyer’s debt assumed by the seller

                          Effect of Debt Assumption
– Assumption of debt is treated as a realization of income similar to
 paying or receiving cash
  – Assumption of the seller’s debt increases sales price

  – Assumption of debt by the seller decreases the sales price

                        Capital Gains and Losses
 A capital asset is any asset other than inventory, receivables,
 copyrights, assets created by the taxpayer and depreciable or
 real property used in a trade or business.

                        Capital Gains and Losses
                            Holding Period
 The holding period for capital assets is how long the taxpayer
 owned the asset.

 Determining holding period is the first step in determining tax

                       Capital Gains - Exceptions
– Maximum rate remains at 28% for
  – Collectibles

                 Capital Gains and Losses
                      Tax Treatment
• Net Capital Gain
  – Net long-term capital gain is taxed at various rates
  – Net short-term capital gain is taxed as ordinary income

• Net Capital Loss
  – Individuals may use only $3,000 to offset other income
    • Excess loss is carried forward indefinitely

  – Corporations cannot deduct a net capital loss
    • Excess loss carried back 3 then forward 5 years to offset capital gains

                         Planning Strategies
– Net Capital Gain position
  – Sell assets with unrealized losses

– Net Capital Loss position
  – Sell assets with unrealized gains

                         Planning Strategies
– Worthless Securities
  – Worthlessness deemed to occur on the last day of the year

  – Realized loss = basis in the worthless security

                              Section 1231
  A Section 1231 asset is an asset
– Used in a trade or business
  – not for investment

– Held long term

                              Section 1231
Net Section 1231 gains may be allowed capital gain treatment
 even though they arise from “ordinary” assets.

                               Netting Results
– Net Section 1231 gain is classified as long-term capital gain

  – Lookback rule may reclaim some gains as ordinary
    • to the extent of Section 1231 loss reported in the previous 5 years

– Net Section 1231 loss is classified as ordinary loss

                            Section 1231
                   Disposition of Rental Activities
– Disposition of rental property held for the production of income
 (investment) yields capital gain or loss

– Disposition of rental property used in a trade or business yields
 Section 1231 gain or loss

                         Depreciation Recapture
 Prevents taxpayers from receiving the dual benefits of a
 depreciation deduction and special Section 1231 gain treatment

                         Depreciation Recapture
– Applies to Section 1231 gain property only

– Requires gains to be treated as ordinary to the extent of prior
 depreciation deductions

                       Depreciation Recapture
                            Section 1245
– Requires full recapture of all depreciation
  – Gains are treated as ordinary income to the extent of any depreciation

– Any gain in excess of depreciation is netted under Section 1231

                       Depreciation Recapture
                            Section 1245
– Applies to
  – Depreciable personal property

                       Depreciation Recapture
                            Section 1250
– Requires partial recapture of depreciation
  – Gains are treated as ordinary income to the extent of depreciation taken
    over straight-line amount (accelerated portion of depreciation)

– Next, any gain up to amount of straight line depreciation is netted
  under Section 1231as unrecaptured 1250 gain taxed at a
  maximum of 25%.

– Any remaining gain is 1231 gain subject to netting

                       Depreciation Recapture
                            Section 1250
– Applies to depreciable real property
  – Not covered by Section 1245 and
  – Not depreciated using the straight-line method


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