Bad Business Debt Deduction for Federal Taxes

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Bad Business Debt Deduction for Federal Taxes Powered By Docstoc
					Chapters 7-13
Bad Debts
   Review Concept Summary 7-2, Page 7-7
   Accounting for Bad Debts
       For most taxpayers, use the specific charge off
   Non business bad debts
       A debt unrelated to the taxpayer’s trade or
        business either when it was created or when it
        became worthless; treated as a STCL
   Business bad debts
       Provides an ordinary loss deduction
       Deduction is available for partial worthlessness.
§ 1244 (Small Business) Stock
   Ordinary loss deduction arising from the sale
    of the stock or its becoming worthless
   Only individuals who acquired the stock from
    the corporation are eligible
   Limited to $ 50,000 ($ 100,000 MFJ), any
    remainder is capital.
   $ 1 million limit to contribution to capital.
    Test is applied at the time the corporation is
   § 1244 applies to losses, gains are capital.
Casualty and Theft Losses

   Casualty Definition—”an identifiable
    event that is sudden, unexpected and
   Theft Definition—”larceny,
    embezzlement and robbery.”
Deductible Amount of Loss
   When losses are deductible
       Normally in the year when the casualty occurred.
        However, the loss may be deductible in a
        subsequent year if:
            It is a theft loss. Must deduct loss in the year the theft is
            Reimbursements are reasonably expected in a
             subsequent year.
            It is a disaster area loss. Taxpayer can elect the year
             the loss occurred or the previous year.
       Business and rental property net casualty
        losses are 100% deductible for AGI.
Deductible Amount of the Loss
   Measuring the amount of the loss
        FMV before and after the casualty
       For partial destruction rule is
        <  FMV or adjusted basis of the property
       For total destruction of business or
        investment property use adjusted basis
       For total destruction of personal use
        property use the < of  FMV or adjusted
Deductible Amount of the Loss
   Measuring the Amount of the Loss
       Generally  FMV determined by appraisal
       If appraisal is difficult or impossible to obtain use
        the cost of repairs.
   Limitations on Personal-Use Property
       Two limitations:
            Each separate casualty reduced by $ 100
            Total amount of all personal-use casualties reduced by
             10% of AGI
       Review Concept Summary 7-3 on Page 7-15,
Deductible Amount of Loss
   Netting Casualty Gains and Losses on
    Personal-Use Property
       Net personal use casualty gains and losses for the
        year are netted. Losses should be reduced by
        insurance reimbursements and $ 100 floor.
        If gains exceed losses result is a capital gain.
       If losses exceed gains, net loss is reduced by 10%
        of AGI. The loss is reported on Form 4684 and
        then on Schedule A.
        Research & Experimental
   § 274 “Costs incident to the development of an
    experimental or pilot model, a plant, process, a
    product, a formula, an invention or similar property,
    and the improvement of existing property of the type
   Three Approaches
       Expense in Year Incurred. Election in first year R & E
        expenses occur; must continue to expense in future years.
       Deferral—Amortize over 60 months. Must elected in the
        year the first benefit occurs.
       Capitalization—Deduction not available until project is
        abandoned or deemed worthless
   20% Credit also available see Ch 13
Net Operating Losses
   General Rule is carry-back two years and
    carry-forward twenty years.
       Tax payer may elect to carry forward twenty years
   Rules for individuals, trusts and estates are
    much more complex than for C corporations.
   For corporations: NOL is generally the excess
    of deductions (including the dividends
    received deduction) for the year over
Net Operating Losses
   Measuring the NOL for Individuals—A Conceptual
       Step 1 Accumulate all operating loss amounts:
            Net proprietorship losses
            Net ordinary losses from partnerships and
             S corporations.
            § 1244 stock ordinary loss deduction
            § 1231 losses
            Ordinary bad debt losses
            Business casualties and personal casualty losses (net of
             $ 100 floor) taken as an itemized deduction
       Step 2
            Offset total loss from step 1 by income items from
             business sources—salaries and wages, § 1245 gains, §
             1231 gains
Net Operating Losses--Continued
     Step 3
          Offset total non-business income (interest,
           dividends, and capital gains) against itemized
           deductions (excluding personal casualties) or
           the standard deduction, if result is positive,
           reduce the amount computed in step 2.
     This approach ignores (correctly) personal
      and dependency exemptions, the standard
      deduction or the $ 3,000 capital loss offset
      against ordinary income.
Computation of Tax Liability for
year to which NOL is carried
     Taxable income and income tax for the
      carry-back year must be recomputed by
      including the NOL as a deduction for

     All deductions except charitable
      contributions are taken from new AGI
      after the NOL has been applied
    Calculation of the remaining NOL
   Amount of the carryover loss is the excess of the NOL
    over the taxable income of the year to which the loss is
    being applied

   Taxable income must be determined with the following
       No deduction for excess capital losses over capital gains
       No deduction for NOL that is being carried back
       Any deductions based on or limited by AGI must be determined
        after making preceding adjustments
       No deduction is allowed for personal and dependency exemptions
Depreciation and Cost Recovery
   Types of Property
       Tangible property—property that has physical
        substance (land, buildings, improvements)
            Real property—land and structures attached to the land.
            Personal property [personalty]—tangible property that is
             not real. (equipment, vehicles, furniture)
       Intangible property—property that does not have
        physical substance (goodwill, patents, stocks and
       Personal use property—generally capital assets;
        may be real or personal, or an intangible. These
        assets are not depreciable or amortizable.
Depreciation and Cost Recovery
   General Considerations:
       Methods used depend on when the property was placed in
            Prior to 1981 § 167 (financial accounting)
            1981 – 1986 § 168 (ACRS)
            After 12/31/86 § 168 (MACRS)
       Common Rules
            Depreciation must be claimed on property used in a
             trade or business or for the production of income.
            No depreciation for land or other assets with an
             indefinite life.
            Depreciation for the first year the asset is placed in
            Method must be consistent
            Basis of property reduced by allowable depreciation.
Depreciation Methods
   MACRS Cost Recovery System:
       Ignore salvage value
       Specific asset classes based on life of asset
       For personalty use either SL or DDB  SL;
        real property—SL
       For tangible personal property generally use the
        half year convention for acquisitions and
       For depreciable real property; use the mid month
       Depreciation tables are based on cost.
Calculation of Depreciation
   Tangible personal property
       Classifications:
            3 yr. Tractor units and special tools
            5 yr. Automobiles, trucks, computers, research
             and experimental equipment equipment.
            7 yr. Office furniture and equipment, machinery,
             property with no class life.
            10 yr. Barges, vessels, petroleum and food processing
            15 yr. Billboards, service station buildings, land
            20 yr. Utilities and sewers
Calculation of Depreciation
   Bonus Depreciation
       Qualified property acquired after 9/11/01 and before
        9/11/04 and placed in service before 1/01/05.
       Qualified Property includes MACRS property with a recovery
        period of 20 years or less,”canned” computer software,
        qualified leasehold improvement property
       Bonus depreciation is 50% of adjusted basis for both
        regular and AMT purposes.
       Order for deduction is § 179 depreciation, bonus
        depreciation, MACRS
       Taxpayer must elect out of bonus depreciation.
Calculation of Depreciation
   Real Property
       Classification and Recovery Rates
            Residential rental property (dwelling units, houses,
             apartments and manufactured homes)—27.5 years
            Non-residential rental property—39 years
   Straight line election under MACRS
   Alternative Depreciations System (ADS)
       Used for E & P and AMT purposes
       Required for tangible personal property used outside the
       Use SL method with mid year, quarter, month conventions
       Elective on a year by year basis, but permanent for the
        specific property
Calculation of Depreciation
   Tangible Personal Property
       § 179 Election
            For 2004 taxpayers can elect to expense up to
             $102,000 of the acquisition cost as an ordinary
             deduction in the year of acquisition.
            MACRS rules apply to the residual cost.
            Must be purchased for use in an active trade or business.
            If the total cost of assets placed in service is more than $
             410,000 the ceiling is reduced on the excess amount.
            The § 179 deduction cannot exceed the taxpayer’s
             taxable income (before deducting the § 179 expense)
             from the trade or business.
Calculation of Depreciation
   MACRS Restrictions
       Personal Use Assets—no depreciation deduction
       Listed Property Rules > 50% use MACRS take
        bonus depreciation; otherwise use ADS, no bonus
        depreciation. Must be able to document usage.
       Recapture of excess depreciation for MACRS
        property if use decreases to 50% or less.
       Limits luxury automobiles:
            Consider first § 179 and bonus depreciation
            Limit is $ 7,650 for year 1, $ 4,900 year 2, reduced for
             % of business use. ($ 14,800 is total cost of auto)
            Special rules for leased automobiles.
   All intangibles are amortized on the straight
    line basis. Convention is to take a full month’s
    amortization in the month the intangible is
   Major intangible assets
       § 197 Assets
       Research and Experimental § 174
       Computer Software § 167 (f)(1)
       Start-Up Expenses § 195
       Organization Costs § 248
       Pollution Control Facilities § 169
§ 197 Intangibles
   Amortization deducted ratably over a 15 year period.
   § 197 applies only to intangible assets that are
    acquired in connection with the conduct of a trade or
    business or the production of income.
   § 197 does not apply to internally created
   §1231 treatment for assets held more than one year.
    Recapture of gain under § 1245 and postponement
    of losses on partial disposals.
§ 197 Assets--Continued
   Definition of a § 197 Asset
       Goodwill and going concern value
       Intangible assets related to the workforce,
        information base, patents, copyrights, formulas,
        processes, customers and suppliers.
       Licenses, permits and other rights granted by a
        governmental unit or agency.
       Covenants not to compete
       Franchises, trademarks and trade names
Research and Experimental
Expenditures § 174
   Include experimental and laboratory costs
    incidental to the development of a product.
       20% credit available for certain R & E expenses
   Items that qualify:
       Costs incidental to the development of an
        experimental or pilot model, a plant process, a
        product, a formula, an invention
       Costs associated with product improvements
       Costs of obtaining a patent, such as attorney fees
       Research contracted to others
       Depreciable or cost recovery amounts attributable
        to capitalized R & E items
Research and Experimental
   Items that do not qualify.
       Expenditures for ordinary testing or inspection of materials
        or products for quality control purposes
       Efficiency surveys and management studies
       Marketing research
       Costs of acquiring another person’s patent, model,
        production or process.
       Research incurred in connection with literary and historical
   Three alternatives for the treatment of R & E
       Expense in the year paid or incurred
       Defer and amortize or a period of at least 60 months
       Capitalize and write-off only when the project is
        abandoned or worthless
Computer Software
   Developed computer software
       Can be considered R & D costs under § 174
       If it does not qualify under § 174 amortize over 36
        months beginning with the month the software is
        placed in service § 167 (f)(1)
   Acquired Computer Software
       Depreciated in one of two ways:
            Included in the cost of the hardware use MACRS 5 yr.
            Purchased separately, use SL over 36 months.
   Leased or Licensed Computer Software
       Deductible in full in the year paid.
Depletion—The Two Methods
   Cost Depletion § 611 (a)
       Can be used on any wasting asset
       Calculate depletion under both the cost and %
        approach (if available) and select the larger
        deduction. [an annual election]
       Determined using the following formulae:
              Adjusted Basis of Asset     = Depletion per
             Estimated Recoverable Units        Unit
            Depletion per Unit x Units Sold = Cost Depletion Allowed
       If estimates are inaccurate revise future
Percentage Depletion § 613(a)
   Based for a mineral on a specific percentage
    provided in the IRC
   Rate is applied to the gross income from the
    property but cannot exceed 50% of the
    taxable income from the property before the
    allowance for depletion.
   Depletion may produce negative basis, AMT
Intangible Drilling and Development
Costs (IDC)
   Two options Available to the Taxpayer
       Charged off as an expense in the year
       Capitalized and written off through
            Cost depletion may limit the usefulness of using
             percentage depletion approach.
       Excess intangible drilling costs are a
        preference for AMT purposes.
Employee Expenses
   Importance of Proper Classification
       Self-employed Individuals (Independent
        Contractors) pay both shares of the Social
        Security tax on Schedule SE. ½ of the SE
        taxes paid are deductible for AGI.
       Employers pay their share of their share of
        Social Security tax and in addition deposit
        the share withheld from the employee.
        Employers also pay unemployment tax.
Travel Expenses
   Definitions:
       Travel “includes transportation, meals, lodging, and other
        reasonable and necessary expenses while “away from home”
        in the pursuit of a trade or business or an employment
        related activity.” A deduction for travel expenses is available
        only if the taxpayer is away from his or her tax home.
       Transportation include only the cost of transporting the
        employee from one place to another in the course of
        employment when the employee is not away from the home
        on travel status. Such costs include taxi fares, automobile
        expenses, tolls, and parking. Commuting expenses are non-
        deductible, but travel between work stations is deductible.
Travel Expense--Continued
   Transportation Expenses—Automobiles
       Two methods to deduct allowable expenses:
            Actual expenses: gas, oil, repairs, depreciation, interest,
             property taxes, license fees and insurance. Deduction is
                   Total expenses x Business miles
                                         Total Miles
            Standard mileage rate
                37.5¢ per mile for 2004

                Additional deduction for parking and tolls, auto
                 interest and personal property taxes.
                Cannot be use if two or more autos are used
                 simultaneously for business purposes.
Moving Expenses § 217
   Limited deduction available to employer and
   Two Conditions:
       New job location must be at least 50 miles farther from
        taxpayer’s old residence than old residence was from
        former place of employment.
       Time requirement: employed full time at new location for
        at least 39 weeks in a twelve month period.
   Deduction for AGI for un-reimbursed amount.
   Deductible expenses:
       Cost of moving household goods and personal effects.
       Cost of traveling (including lodging but excluding meals)
        from former residence to new residence Mileage rate is 14¢
        per mile.
Education Expenses
   For AGI for trade or business (self-employed)
   From AGI for un-reimbursed employee
    expenses (2% miscellaneous)
   General Requirements:
       Incurred to maintain or improve skills required for
        employment or
       Meet requirements imposed by law or by the
        employer for retention of employment, rank, or
        compensation rank.
       Not deductible if required to meet minimum
        educational requirements or qualifies for a new
        trade or business.
Meals and Entertainment Expenses
   The cutback adjustment—50% of meals and
    entertainment expenses allowed as a deduction.
    Includes M & E, taxes, tips, cover charges, M & E
    room rental fees, parking fees at the location. Also
    includes face value of tickets and non-luxury box
   Business meals are deductible only:
      If they are directly related to or associated with the active
       conduct of a trade or business
      The expense is not lavish or extravagant.

      The taxpayer (or an employee) is present at the meal

   No deduction for entertainment facilities, club dues
Expenses of Office in the Home
   Deductibility Based on the Following Criteria:
       Principal place of business for any trade or business of the
            The office is used by the taxpayer to conduct
             administrative or management activities of a trade or
            There must be no other fixed location of the trade or
             business where the taxpayer conducts these activities.
       Allowable home office expenses cannot exceed the gross
        income from the business less all other business expenses
        attributable to that activity.
       Deduction for AGI for self employed individuals, Schedule A,
        Miscellaneous Itemized Deductions for employees.
       Deductible amount computed on Form 8829
Expenses of Office in the Home--

   Ordering rules for deducting the

       1. Mortgage interest and real estate taxes
       2. Operating expenses of the residence
       3. Depreciation

   Expenses cannot generate a loss
Employee Expenses
   Two classifications
       Reimbursed--§ 62(a)(2) are a deduction for AGI
       Un-reimbursed are a 2% miscellaneous itemized
        deduction § 67
   Nature of employment relationship
       Self-employed individuals—§162 all expenses
        related to the proprietorship are deductible
        for AGI on schedule C.
       For employees the tax treatment depends on
        whether the expenses are reimbursed or un-
Reimbursed Employee Business
   Accountable Plans
       Return any excess reimbursement or allowance. An
        ―excess reimbursement or allowance‖ is any amount
        that the employee does not adequately account for
        as an ordinary and necessary business expense.‖
   Deemed Substantiation
       Employees reimbursed a per diem allowance.
        Deemed substantiated if the amount is  Federal rate
   Non Accountable Plans
       All reimbursements reported on Form W-2 and
        reported as income, also 2% Misc. Itemized
        Deductions on Schedule A.
Reimbursed Employee Business
   Reporting Requirements
       Not reported by employee (accountable plans
        meeting all requirements)
       Form 2106
            Reimbursed employee expenses under an accountable
             plan are deductible for AGI.
            Reimbursement is apportioned between Meals and
             Entertainment and Other Expenses based on the relation
             of each to total expenses.
            Un-reimbursed expenses are deductible from AGI.
                 Total from Form 2106  Schedule A, 2% Misc.
    2% Miscellaneous Itemized
   An accumulation of various personal expenditures.
       Un-reimbursed employee business expenses
            Travel, entertainment, business gifts ($ 25 per gift
       Investment expenses § 212
            Investment advice, custodial fees, safe deposit box
             rental, publications
       Other expenses
            Tax return preparation expenses
            Special clothing
            Job-hunting expenses
            Professional journals, professional dues, union dues,
             small tools and supplies.
            Office in the home
2% Miscellaneous Itemized

   The tax benefit of these deduction is
    limited in several ways:
       The total expense is reduced by the 2%
       3% scale down (§ 68) for high income
        individuals applies
       2% miscellaneous items are a positive
        adjustment for AMT purposes.
Itemized Deductions—Medical Expenses

   Qualified Individuals

       Taxpayer and spouse
       Taxpayer’s dependent (includes those who
        could be dependents except for the gross
        income or joint return tests
       Child of divorced taxpayer (as a
Itemized Deductions—Medical Expenses
   Qualified Medical Expenses
       Diagnosis, cure, mitigation, treatment or prevention of
       The purpose of affecting any structure of function of the
       Transportation primarily for and essential to medical care.
       Qualified long-term care services
       Health Insurance
   Limitation on the Amount Deductible—7½% of AGI
   Medical Insurance Reimbursements
       Reimbursements in & for the current year offset the
       Reimbursement in a subsequent year for the current year
        may result in gross income in the year received under the
        tax benefit rule § 111
Itemized Deductions—Taxes § 164
   Definition of a tax—a mandatory assessment
    under the authority of a political entity for the
    purpose of raising revenue to be used for
    public or governmental purposes. These do
    not include:
       Vehicle registration and inspection fees
       Registration tags for pets
       Toll charges
       Parking meter charges
       Charges for water, sewer and other services
       Special assessments against real estate
Itemized Deductions—Taxes

   Deductible taxes:

       State, local and foreign real property taxes
       State and local personal property taxes if
        based on value
       State, local and foreign income taxes
Itemized Deductions--Taxes
   Non-Deductible Taxes
      Federal income Taxes

      Federal estate and gift taxes

      Federal import and tariff duties

      Employee’s portion of Social Security and other
       payroll taxes
      State and local sales taxes, estate, inheritance and
       gift taxes.
      Foreign income taxes, if taxpayer elects to take
       the credit
      Property taxes on real estate to the extent the
       taxes are treated as imposed on another taxpayer.
Itemized Deductions--Interest
   Supreme court defines interest as “compensation for
    the use or forbearance of money” Old Colony
    Railroad 52 S. Ct. 211 (USSC, 1932)
   Allowed and Disallowed Items
       Interest on qualified education loans. A deduction for
        AGI. Maximum deduction is $ 2,500, phase-out rules apply
       Investment interest—an itemized deduction, limited to net
        investment income (interest, dividends, annuities, royalties,
        and if elected, capital gains). Investment expenses are
        those deductible expenses related to investment income.
        Note that some of these expenses may be eliminated by the
        2% miscellaneous itemized deduction floor.
Itemized Deductions—Interest
   Allowed and Disallowed Items—Continued
       Qualified Residence Interest
            Qualified residence interest is interest paid or accrued
             during the taxable year on indebtedness (subject to
             limitations) secured by any property that is a qualified
             residence of the taxpayer
       Qualified Residence Interest—Acquisition Indebtedness
            Qualified residence includes the taxpayer’s residence
             and one other residence of the taxpayer or spouse.
            Interest paid or accrued during the tax year limited to
             acquisition indebtedness of $ 1 million or less.
            Acquisition indebtedness refers to amounts incurred in
             acquiring, constructing, or substantially improving a
             qualified residence of the taxpayer.
Itemized Deductions--Interest
     Qualified Residence Interest—Home Equity Loans
          Funds from loan can be used for personal purposes
          Interest is deductible only on the portion of a home
           equity that does not exceed the lesser of:
                The fair market value of the residence, reduced by
                 the acquisition indebtedness or
                $ 100,000
     Prepayment Penalty
          Occurs when the loan is paid off early.
          Considered interest in the year paid.
          Subject to the general rules related to deductibility
Itemized Deductions--Interest
     Related Parties
          If the debtor uses the accrual basis and the
           creditor uses the cash basis, accrued but
           unpaid interest is not deductible until the
           payment is made.
     Personal (Consumer) Interest
          Non-deductible
          Examples are credit card loans, auto loans
Itemized Deductions--Interest
   Restrictions on Deductibility and Timing
       Taxpayer’s Obligation
            Debt must represent a bona fide obligation of the
            Taxpayer may not deduct interest paid on behalf of
             another individual
       Time of Deduction
            Cash basis—deductible when paid
            Accrual basis—over the life of the loan
       Prepaid Interest
            Accrual method reporting is imposed on cash basis
             taxpayers for interest prepayments that extent beyond
             the end of the taxable year.
Classification of Interest Expense
   General Rule:
       Whether interest is deductible for AGI or as an
        itemized deduction (from) depends on whether
        the indebtedness has a business investment or
        personal purpose.
            Business purpose or for the production of rent or royalty
             income: Deduction for AGI.
            Investment purpose not related to rents or royalties:
             Deduction from AGI
            Personal purpose (qualified residence interest):
             Deduction from AGI
       Exceptions: Early withdrawal penalty/qualified
        student loan interest are deductions for AGI
Itemized Deductions—Charitable
   § 170 (c) Charitable Contribution is a gift
    made to a qualified organization. The
    taxpayer has the burden of establishing that
    the transfer was made from motives of
    disinterested generosity.
       Benefit Received Rule—When a donor derives a
        tangible benefit from the contribution, he or she
        cannot deduct the value of the benefit.
       Contribution of services—No deduction is allowed
        for a contribution of one’s services to a qualified
        charitable organization.
Itemized Deductions—Charitable
     Examples of non-deductible items
          Rental value of property used by a qualified
          Gifts to individuals
          Dues paid to fraternal organizations
          Cost of tuition
Itemized Deductions—Charitable
   Qualified Organizations §§ 170(c), 501
       A state or possession of the United States or any
        subdivisions thereof § 501 (a)
       A corporation, trust, or community chest, fund or
        foundation that is situated in the United States
        and is organized exclusively for religious,
        charitable, scientific, literary or educational
        purposes or for the prevention of cruelty to
        children or animals § 501 (c)(3)
       Veterans’ and fraternal (lodge) organizations,
        cemetery companies § 501
Itemized Deductions—Charitable
   Timing of Deduction
       For both cash and accrual taxpayers generally in
        the year payment is made.
       For property, the date of delivery
       For credit cards, the date of the charge
   Record-keeping Requirements
       No deduction for contributions of $ 250 or more
        without written substantiation.
       Additional information required if the value of the
        donated property is > $500 but < $5,000.
       Appraisal required for non-cash contributions over
        $ 5,000
Itemized Deductions—Charitable
   Valuation Requirements
       Property donated to a charity is valued at the FMV
        at the date of the gift.
       Taxpayer must maintain reliable written evidence
            FMV and how it was determined.
            Reduction in value for certain appreciate property
            Terms of any agreement with the charitable organization
             dealing with use and potential sale.
            Signed copy of appraisal
Itemized Deductions—Charitable
   Ordinary Income Property
       Includes any property that if sold will result in the
        recognition of ordinary income.
       Examples are ordinary assets such as (1)
        inventory & (2) depreciable property used in a
        trade or business for 1 year or less and also
        capital assets held for 1 year or less.
       Deduction is usually limited to the adjusted
Itemized Deductions—Charitable
   Capital Gain Property
       Any property that would have resulted in the
        recognition of long-term capital gain or § 1231
        gain if the property had been sold by the donor.
       Deduction is equal to the fair market value
        of the property.
       Exceptions on the deductibility of the
            Donations to certain private non-operating foundations.
            For tangible personal property, no deduction for the
             appreciation if the property is put to an unrelated use.
Itemized Deductions—Charitable

   General Rule:
       Overall limit for individuals is 50% of AGI
       Applies to public charities
       Applies to private operating foundations
       Applies to certain private non-operating
Itemized Deductions—Charitable
   Special Rules
       Thirty percent ceiling
            Applies to cash and ordinary income contributions to
             certain private non-operating foundations
            Applies to contributions of appreciated capital gain
             property by 50% organizations.
            In the event that contributions for any one tax year
             include both 50% and 30% property, the allowable
             deduction comes first from the 50% property
            Special election permits the taxpayer to take a 50%
             deduction for capital gain property if he/she forgoes
             the appreciation.
       Twenty percent ceiling
            Applies to contributions of appreciated long term
             capital gain property to certain private non-operating
Itemized Deductions—Charitable

   Contributions Carryovers
       Can be carried forward for 5 years.
       Contributions retain their character (30%,
       Consider current year contributions first
        before applying carryover provisions.
Overall Limitation on Certain
Itemized Deductions
   The cutback adjustment § 68
       Applies to taxpayers whose AGI exceeds $ 142,700 for 2004.
       Relates to the following itemized deductions:
          Taxes

          Home mortgage interest

          Charitable contributions

          Un-reimbursed employee expenses subject to 2% of AGI

          All other 2% miscellaneous itemized deductions.

       Not Subject to the cutback adjustment
          Medical and dental expenses

          Investment interest expenses

          Non business casualty thefts and losses

          Gambling losses
Overall Limitation on Certain
Itemized Deductions
   The cutback adjustment—continued
       Taxpayers subject to the limitation must
        reduce itemized deductions by the lesser
            3 % of the amount by which AGI exceeds
            80% of itemized deductions that are affected
             by the limit.
       Overall limit is applied after all other
    Passive Activities §469

   Any trade or business or income-
    producing activity in which the taxpayer
    does not materially participate

   Subject to certain exceptions, all rental
Material Participation
   Must participate on a regular,
    continuous, and substantial basis to be
   Tests:
       Based on current participation
       Based on prior participation
       Based on facts and circumstances
Passive Activity Losses
   Designed to discourage taxpayer from
    investing in tax shelters for tax avoidance
   Congress have developed two methods to
    reduce or eliminate loss deductions from
    business and income-producing activities.
       The at-risk limitations
       The passive activity loss rules
Passive Activity Losses
   The at-risk limits § 465
       Apply to individuals and closely-held
       Designed to prevent taxpayers from
        deducting losses in excess of their
        economic investment in the activity.
       Deductible amount for the year is limited to
        the amount the taxpayer has at risk at the
        end of the taxable year.
Passive Activity Losses
   At-risk limits, calculation of at-risk amount
       Increases to a taxpayer’s at-risk amount
            Cash and the adjusted basis of contributed property
            Amounts borrowed for use in the activity for which the
             taxpayer is personally liable or has pledged security.
            Taxpayer’s share of increases in non-recourse financing
            Taxpayer’s share of the activity’s income.
       Decreases to a taxpayer’s at-risk amount:
            Withdrawals from the activity
            Taxpayer’s share of the activity’s loss.
            Taxpayer’s share of reductions in (a) personal recourse
             debt and (b) qualified non recourse financing.
Passive Activity Losses
   At-risk limits, an illustration
       In year 1, Sue invests $ 40,000 in an oil partnership that, by
        the use of non-recourse loans, spends $ 60,000 on
        deductible intangible drilling costs applicable to her interest.
        Assume Sue’s interest is not subject to the passive activity
       Result is that Sue has a $ 40,000 deductible loss and a $
        20,000 suspended loss under the at-risk rules.
       If in year 2 Sue has taxable income of $ 15,000 from the oil
        partnership and invests $ 10,000 during the year, she can
        offset the $ 15,000 of income and has $ 5,000 at risk.
PAL Limits
   Three Categories of Income and Losses
       Active Income
            Wages, salaries, commissions, bonuses
            Profit from a trade or business in which the taxpayer is a
             material participant.
            Gain on sale or other disposition of assets used in an
             active trade or business
            Income from intangible property is the taxpayer’s
             personal efforts significantly contributed to the creation
             of the property.
       Portfolio Income
            Interest, dividends, royalties
            Gain or loss on disposition of property that produces
             portfolio income or was used for investment purposes/
PAL Limits--Continued
     § 469 Passive (Activity) Income
         Any trade or business or income-producing
          activity in which the taxpayer does not
          materially participate.
         Any rental activity except for:
              § 469 (c)(7) losses associated with real estate
              $ 25,000 of losses can offset against active
               income by individuals who actively participate in a
               real estate activity. (phase-out for AGI > $ 100,000)
PAL Limits--Continued
   General Impact
       Losses or expenses generated by passive
        activities can be deducted only to the extent
        of income from all of the taxpayer’s passive
       Suspended losses can be carried forward
        indefinitely and used to offset passive
       Suspended losses can also be used when the
        taxpayer disposes of the activity.
PAL Limits--Continued
   Carryover of Suspended Losses
       Taxpayers often own more than one passive
        activity. In that case any suspended losses must
        be allocated among the activities in which the
        taxpayer has an interest
       The allocation:
            Disallowed PAL X       Loss from activity
             (all activities)  losses from all activities having
Passive Activity Losses

   Taxpayers subject to the Passive Loss Rules
       Personal service corporations (PSC’s)
       Closely held C corporations
            Definition—”If at any time during the year > 50% of the
             value of the outstanding stock is owned (directly or
             indirectly) by five or fewer individuals.
       Individuals
       Estates
       Trusts
       Investments in partnerships and S
Interaction of the At-risk and Passive
Activity Limits

   The determination of whether a loss is
    suspended under the passive loss rules
    is made after the application of the at-
    risk rules.
   A loss that is not allowed because the
    taxpayer is not at risk is suspended
    under the at-risk provisions and not the
    passive activity provisions.
Interaction of the At-risk and Passive
Activity Limits—An Illustration
   Jack’s adjusted basis in a a passive activity is $
    10,000 at the beginning of 2003. His loss from the
    activity in 2003 is $ 4000
       Jack has an adjusted basis and at risk amount of $ 6,000 in
        the activity.
       The suspended passive loss is $ 4,000.
   Jack has a loss of $ 9,000 for 2004
       A $ 3,000 loss is suspended under the at risk rules.
       $10.000 is suspended under the passive activity rules.
       An adjusted basis and an at-risk amount in the activity of
Interaction of the At-risk and Passive
Activity Limits—An Illustration
   Jack realizes $ 1,000 of passive income
    from the activity in 2005.
       No taxable passive income
       $ 2,000 of losses suspended under the at-
        risk rules
       $ 10,000 remains suspended under the
        passive activity rules
       An adjusted basis and an at-risk amount in
        the activity of zero.
Dispositions of Passive Interests
     Taxpayer disposes of an entire interest in a
      passive activity, any suspended losses may
      be utilized when calculating the final
      economic gain or loss on the investment
     Other situations with specific treatment
         Disposition at death
         Disposition by gift
         Installment sale
         Nontaxable exchange
Individual Alternative Minimum Tax
   The AMT Formula:
       Regular Taxable Income
            +/- Adjustments
            + Preferences
       = AMTI
            - Exemption
       = Alternative Minimum Tax Base
            X 26% or 28% rate
       = Tentative Minimum Tax before FTC
            - AMT Foreign Tax Credit
       = Tentative Minimum Tax
            - Regular Tax Liability (Net of Regular FTC)
       = AMT (If the amount is positive)
AMT Components--Continued
   Exemption Amount
       Initial Exemption Amounts
            $ 58,000 MFJ
            $ 40,250 S, HH
       Phase Out of 25¢ per $ 1 when AMTI exceeds:
            $ 112,500 S, HH
            $ 150,000 MFJ
   AMT Rate Schedule
       26% of first $ 175,000 and 28 % on excess
AMT Components
   Adjustments
       Two types: Those that result from (1) timing differences
        (separate regular and AMT treatments that will eventually
        reverse) and from (2) permanent differences (disallowed
        itemized deductions)
       Timing Differences
            Circulation Expenditures
            Depreciation of Post-1986 Real Property (applies only to
             property placed in service between 1/1/87 and 12/31/98)
            Depreciation on Post-1986 Personal Property (applies only to
             property placed in service between 1/1/87 and 12/31/98)
            Pollution Control Facilities
            Expenditures Requiring 10 year write off for AMT purposes, (1) mining
             exploration and development costs and (2) research and experimental
AMT Components--Continued
   Adjustments
       Timing Differences
            Use of Completed Contract Accounting for Regular Tax
             Purposes (% Completion for AMT)
            Incentive Stock Options
            Adjusted Gain or Loss
                 When a property is sold during the year or a
                  casualty occurs to business or income-producing
                  property, gain or loss reported for regular income
                  tax may be different than gain or loss determined
                  for AMT. This difference occurs because the
                  adjusted basis of the property for AMT purposes
                  must reflect any current and prior AMT
                  adjustments. (e.g. depreciation, research and
                  experimental expenditures.
AMT Components--Continued
   Adjustments
       Timing Differences
            Passive Activity Losses—A separate calculation of PAL
             for AMT purposes.
            NOL deductions—A separate calculation of NOL for AMT
       Permanent Differences—Positive Adjustments for
        Certain Itemized Deductions
            Taxes
            2% Miscellaneous Itemized Deductions
            Disallowed Interest (For AMT only mortgage interest on
             principal residence + AMT investment interest is
            Medical Expenses (AMT threshold is 10% not 7 ½%)
            Personal and Dependency Exemptions
            Standard Deduction
AMT Components--Continued
   Adjustments—
       Negative Permanent Differences
            The 3% cutback adjustment (§ 68) that applies to
             regular income tax itemized deductions does not apply
             in computing AMT.
            Tax benefit rule for state income tax refund
   Preferences—All Positive
       % Depletion in excess of basis
       Intangible Drilling Costs
       Private Activity Bond Interest (> 10% of state and municipal
        bond proceeds used for private business purposes
       Depreciation for real property and leased personal property
        placed in service before 1987
       50% exclusion for certain small business stock.
AMT Components--Continued
   AMT Credit
       Reduces regular tax liability in a subsequent year.
       May be carried forward indefinitely
       Applicable only to timing differences.
       Not available in connection with AMT permanent
        differences (exclusions).
            Itemized Deductions
            Standard Deduction
            Personal & Dependency Exemptions
            Excess % Depletion
            Private Activity Bond Interest
Tax Credits--Priority of Credits
   Refundable versus Non-refundable credits
       Refundable credits are paid to the taxpayer even if
        the amount of the credit (or credits) exceeds the
        taxpayer’s tax liability.
       Refundable credits include:
            Taxes withheld on wages, estimated income tax
            Earned income credit.
       Non-refundable credits include:
            Personal credits
            Miscellaneous credits
            Business credits
General Business Credit
   The sum of the following:
       Rehabilitation Expenses § 47
       Business Energy Credits § 48(a)(2)
       Work Opportunity Credit § 51
       Welfare to Work Credit § 51A
       Research Activities § 41
       Low Income Housing § 42
       Disabled Access § 44
       Small Employer Pension Start Up Costs § 45E
       Employer Provided Child Care § 45F
General Business Credit--Continued

   Carried Back 1 year and Carried
    Forward 20 years, Use FIFO approach
   Limited to the Taxpayer’s net income
    tax (Regular + AMT) reduced by >
       The tentative minimum tax
       25 % of the net regular tax liability >
        $ 25,000
Tax Credit for Rehabilitation
Expenditures § 47
   When taking the credit the basis of a rehabilitated
    building must be reduced by the full rehabilitation credit
   To qualify the building must be substantially rehabilitated.
    Qualified rehabilitation expense must exceed >
       $ 5,000
       The adjusted basis of the property before rehabilitation
   The credit is 10% of rehabilitation expenses for non-
    residential buildings and residential rental property
    (other than certified historic structures) placed in
    service before 1936.
   Recapture (< 5 years) if disposed of or is not qualifying
Work Opportunity Credit § 51
   Includes the following qualified groups:
       AFDC
       Veterans
       Ex-Felons
       High-risk youths
       Vocational Rehabilitation
       Summer Youth
       Local Food Stamp Recipient
       Qualified SSI
   Schedule to expire (12/31/03)
Work Opportunity Credit--Continued
   Credit is 40% of the first $ 6,000 of wages.
    Minimum employment levels apply (180 days,
    400 hours of service for full time employees)
   Credit reduced to 25 % for employees not
    reaching minimum levels but working at least
    120 hours.
   Employer must obtain certificate for each
    qualified employee.
Welfare to Work Credit § 51A
   Credit is 35% of the qualified first-year wages
    plus 50% of the qualified second year wages
    for “long term family assistance recipients” up
    to a maximum of $ 10,000 of wages.
   Credit expires 12/31/03
   Reduce deductible wages by the amount of
    the credit taken.
   Employer cannot take both the work
    opportunity credit and the welfare to work
Credit for Increasing Research
Activities § 41
   Two types of activities
       Credit is 20% of the excess of qualified research
        expenses for the taxable year over a base amount
       20% of basic research payments made to qualified
   Research deduction must be reduced by the
    amount of the research credit taken.
   Credit expires 6/30/04
Low Income Housing Credit §42

   Amount of the Credit based on the qualified basis of
    the property (# units rented to low-income tenants)
   Credits are issued based on a nationwide allocation.
   Credit = qualified basis X applicable %
   Applicable % is determined by the IRS each month
    (e.g. 7.95%)
   Credit is allowed over a 10 year period if conditions
    are met.
   Recapture required for termination, early disposal, or
    inadequate low income units or amounts at risk.
Employer Provided Child Care § 45F
   The credit is the sum of the following two amounts:
       25 % of qualified child care expenses (amounts paid to
        acquire, construct, rehabilitate, expand and operate a
        qualified child care facility)
       10 % of qualified care resources and referral expenditures.
   Total credit cannot exceed $ 150,000
   Employers must reduce deductible expenses by the
    amount of the credit taken.
   If within 10 years the employer cease to operate the
    facility, all or part of the credit is recaptured.
Refundable Credits
   Earned Income Credit
       A Negative Income Tax
       Determined by multiplying a maximum amount of earned
        income by the appropriate percentage. If the taxpayer has
        children the percentage used in the calculation depends on
        the number of qualifying children.
       Phase-outs apply--for MFJ with qualifying children begins
        at $ 15,040 AGI or earned income.
       Tables are available to simplify the calculation.
       Eligibility requirements
            Taxpayers with children or certain workers without children
            Relationship test—a ―child‖ of the taxpayer
            Residency test—share same abode, US
            Age test– 19 to 64, child < 19, 24 (full-time student)
Personal Tax Credits
   Offset the Income Tax Liability, before the
    Miscellaneous Credits and the General Credits.
   These Credits are Non-Refundable
   Include:
       §   21 Child and dependent care credit
       §   22 Credit for elderly and disabled
       §   23 Adoption credit
       §   24 Child tax credit
       §   25 Residential mortgage credit
       §   25A HOPE scholarship credit (covered in tax project)
       §   25A Lifetime learning credit (covered in tax project)
       §   25B Qualified retirement savings contribution credit
The Foreign Tax Credit § 904
   Taxpayer may elect to take the credit (more frequent choice)
    or to take a deduction.

   Credit is the the lesser of the actual taxes paid or the credit

   Foreign tax                           Foreign source
      credit       =    Pre-credit   X    taxable income
     limitation         U.S. tax         Total taxable income

   Unused FTC: Carry-back and Carry-forward
                2 years         5 years
Personal Tax Credits--Continued
   § 23 Adoption Credit
       For Qualified Adoption Expenses—adoption fees,
        court costs, attorney fees, and other expenses
        directly related to legal adoption.
       Not eligible until the year the adoption is finalized
       If adoption expenses are paid during or after the
        year the adoption is finalized, credit is allowable
        in the year paid or incurred.
       Phase-out 2004 AGI--$ 155,860$ 195,860
       Maximum Credit ($ 10,390—maximum for child
        with special needs)
Personal Tax Credits--Continued
   Child Tax Credit § 24
       Taxpayers are presently allowed a credit of $
        1,000 for each qualifying child under the age of
       Qualifying child must be a dependent of the
        taxpayer and a son or daughter (or lineal
        descendent), step-child, foster child and a US
        citizen, national or resident).
       Phase-out for MAGI of $ 110,000 ($75,000 S,HH)
       Partially refundable
Personal Tax Credits--Continued
   § 21 Child and Dependent Care Credit
       Individual must meet two requirements:
            Eligible child or dependent care expenses must be
             incurred to enable the taxpayer to be gainfully
            The taxpayer must maintain a household for a
             dependent under age 13 or an incapacitated dependent
             or spouse.
       Eligible expenses include amounts spent for housekeeping,
        nursing, cooking, babysitting in the taxpayer’s home; an
        outside the home at a qualified dependent care facility.
       Maximum amount that qualifies is $ 3,000 for one qualifying
        individual and $ 6,000 for two or more
       Maximum expenses cannot exceed the individuals earned
        income. Use smaller earned income level for MFJ
       Credit ranges 20% to 35%
Withholding of Taxes
   Employer must withhold Federal (State and
    local) income taxes and FICA taxes from an
    employee’s wages.
       Persons responsible for depositing these
        taxes are personally liable for failure to pay.
       Salaries, fees, bonuses, dismissal payments,
        commissions, vacation pay, and taxable fringe
        benefits are subject to withholding.
       Exemptions for certain employment activities.
Withholding Allowances and Methods
   Form W-4
       Each employee must file a Form W-4 which lists the
        employee’s marital status and number of allowances.
            $ 500 civil penalty for filing false statements.
            Employee may claim exempt status if he or she has no
             income tax liability and anticipates none in the current
            An individual may request that additional amounts be
            Each withholding allowance reduces the amount
   Computation of Federal Income Tax Withheld.
      Wage Bracket Tables

      Optional Percentage Method
Estimated Tax Payments
   Certain types of income frequently are not
    subject to withholding
       Investment Income
       Rents
       SE Income
       Capital Gains
   Taxpayer files quarterly estimated payments
    on Form 1040 ES.
       Payments are normally due 4/15, 6/15, 9/15, and
Estimated Tax Payments
   To avoid an underpayment penalty the
    payments must be the lesser of:
       90% of the tax liability shown on the return for
        the current year.
       100% of the liability for the prior year if AGI is $
        150,000 or less; 110% for AGI > $150,000
       No penalty is imposed if the liability is < $ 500 or
        the individual had no liability for the prior year.
   Complete Form 2210 to determine the amount of
    liability. Interest rate is approximately Federal short
    term prime rate + 3%.
Self Employment Tax § 6017
   Net Earnings from Self-Employment
    (Schedule C)
       Gross Income from a trade or business less
        allowable trade or business deductions
       Distributive share of any partnership
        income or loss derived from a trade or
        business activity
       Net income from rendering personal
        services as an independent contractor.
Self-Employment Tax
   Individuals with net earnings of $ 400 or more
    from self-employment are subject to SE tax.
   Calculation of the Tax (Schedule SE)
       For 2004 15.3% of SE income up to $ 87,900 and 2.9% on
        income in excess of $ 87, 900
       Deduction for AGI for ½ SE tax paid.
       Net earnings from self-employment are determined by
        multiplying SE income X .9235
       If an individual is an employee and also has income from
        self-employment, the tax base for computing the self
        employment tax is reduced by the wages that are subject to
        FICA tax.
       All of the self employment earnings are subject to Medicare

Description: Bad Business Debt Deduction for Federal Taxes document sample