1 topic 32: income tax fundamentals primary: internal revenue code treasury regulations revenue...

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Topic 32: Income Tax Fundamentals

Primary: Internal Revenue Code Treasury Regulations Revenue Rulings and PLRs (can’t rely on) Court cases

Secondary Guides: not law

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Determination of Income Tax Liability Gross Income - “Above the Line Deductions” = AGI (Adjusted Gross Income) - > Standard or Itemized Deductions -Personal and Dependency Exemptions = Taxable Income Tax Based on Filing Status -Credits = Tax Due

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Topic 33: Tax Compliance Filing requirements

Income > Standard deduction + personal exemptions Dependents: Unearned income > $1,000 All U.S. citizens; no matter where reside

Tax return due dates Individual: 4/15; six month extension Partnerships: same as individual; only five month extension Corporations: 3/15 for calendar corp; six month extend

IRS audits Statute: three years from due date of return

Longer if fraud (never) or substantial underpayment (6 years)

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Topic 33: Tax Compliance Burden of proof

On IRS if taxpayer keeps adequate records Privileged communication between CPAs and client if no

criminal act committed Audits

Random sample, scoring, matching 1099s, W-2s Target high income taxpayers, businesses generating cash

Taxpayer penalties substantial underpayment: 20% penalty

“substantial”: > 10% tax or $5,000 failure to pay: ½% per month up to 25% failure to file: 5% per month up to 25%

Minimum: $100/100% tax due if > 60 days past due

fraud: 75% penalty

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Topic 33: Tax Compliance Assessment: send 30 day letter Have 90 days to appeal to Tax Court

Not required to pay tax before hearing Other court venues (District Court) require payment of

tax and then filing suit for refund

Only lawyers and CPAs can represent taxpayer in Tax Court

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Topic 34: Income Tax Calculation

Gross Income - “Above the Line Deductions” = AGI (Adjusted Gross Income) - > Standard or Itemized Deductions -Personal and Dependency Exemptions = Taxable Income Tax Based on Filing Status

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Filing Status MFJ: 12/31 or widow for two years Head of household: single; majority of cost of home for

child/dependent

Gross Income Exclusions

Life insurance Muni bonds interest (not capital gains) Gifts/inheritances Personal injury damages

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Topic 34: Income Tax Calculation Imputed Income

Below market rate loans > $10,000 Zero coupon bonds

AGI = Gross Income – SE health insurance 50% SE tax $2,500 student loan interest $5,500 Traditional IRA (under age 50) Alimony Moving expenses Contributions to Health Savings Accounts

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Standard Deduction MFJ $12,400 Single $6,200 Additional standard deduction

Over 65 Blind

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Itemized Deductions: Schedule A Medical expenses > 10% AGI

Hospital, doctor, drugs, health insurance, mileage Property taxes: real estate and personal property State and local taxes: > of income or sales taxes Mortgage interest: on two homes; < $1 million

Also points if buying home Home equity loans: interest on loans up to $100,000

Use this instead of car loans; credit card interest, etc.

Gambling losses to extent of gambling income

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Itemized deductions Investment interest: to extent of investment interest

income If included in investment income; can’t use capital

gains tax rates. Generally better to not include long-term capital gains and dividends

Contributions Public charity

Cash: 50% of AGI Capital gains property: 30% of AGI

Deduct FMV, not cost

Five year carryover for gifts over AGI limit Receipts for gifts over $250

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Topic 34: Income Tax Calculation Itemized deductions

Casualty losses: Loss - $100 - 10% of AGI

Miscellaneous > 2% of AGI Unreimbursed employee business expenses Tax prep fees:

Phase Out For MFJ > $305,050

Itemized deductions reduced by three percent of (AGI - $305,050)

Maximum reduction is 80% of itemized deductions

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Personal exemptions: $3,950 Dependent:

Child < 19 or < 24 and full time student Relatives/household members earning <

$3,950 Provide most support

Divorced parents Generally custodial parent

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Personal exemptions: $3,950 in 2013 Phase Out: MFJ AGI > $305,050

Lose two percent of $3,900 for each $2,500 AGI > $305,050

Couple MFJ with kids and AGI of $500,003

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Topic 34: Income Tax Calculation Calculating income tax

Rate schedules Capital gains tax rates

15%; 0% for those with <15% ordinary tax rate 20%; for those with income MFJ > $450,000 AGI 3.8% Medicare tax on unearned income > $250,000 AGI

Kiddie tax: child under 19; student under 24 (increased in 2007) Unearned income

First $1,000 no tax; next $1,000 10% tax Above that, taxed at parent’s rates

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Topic 34: Income Tax Calculation Self-employment tax

Social security: 12.4% of $117,000 s-e income Technically, 92.35% of s-e income

Medicare: 2.9% of all s-e income Medicare tax of 3.8% on unearned income above $250,000 MFJ

Medicare tax of 3.8% on wages above $250,000 MFJ

Self-employment income Business (Schedule C) Farming (Schedule F) Partnership (Schedule E): guaranteed payments; doesn’t matter if

distributed Not self-employment income

S corporation earnings (Schedule E) Dividends and interest (Schedule B) Rental income (Schedule E)

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Topic 34: Income Tax Calculation Tax credits

Education See Education Planning Topic

Child Tax $1,000 for dependent child under 17 Reduced by $50 for each $1,000 AGI exceeds $110,000

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Dependent Care Under age 13 $3,000 one child; $6,000 more than one Each spouse must earn more than babysitter Credit is 20% of expenses for AGI > $43,000

Adoption Up to $13,190 in 2014 per child

Excludes child of spouse Non-refundable Must have expenses of this amount unless special

needs child

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Retirement Savings tax credit Credit for employee contributions to:

401(k) or other qualified plan IRAs (including Roth)

MFJ AGI up to $36,000 in 2014 Get credit for 50% of contributions up to $2,000 for maximum of $1,000

credit MFJ AGI $36,000 - $60,000 in 2014

Get credit for 10% of contributions up to $2,000 for maximum of $200 credit

Can’t be a full-time student for five calendar months Foreign tax credit

Withholding on dividends Credit is limited to amount of U.S. tax would have paid on dividend Can carry back excess two years and then forward five years

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Topic 34: Income Tax Calculation Payment of tax

Estimated payments Four payments each year =

90% of current year tax 100% of prior year tax

AGI > $150,000: pay 110% of prior year

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Topic 34: Tax Accounting Accounting periods

Calendar year generally Accounting methods

Cash Individuals

Constructive receipt Accrual

Retailers unless sales < $1 million FIFO vs LIFO

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Topic 34: Tax Accounting Net Operating Losses

Back 2 years; forward 20 years Installment sale

Recapture all in year of sale Capital gain Return of basis Interest

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Topic 35: Business Entities Sole Proprietorship: Schedule C

Taxed once; unlimited liability Book: transfer personal expenses to Sched C???

General Partnership: Schedule E Taxed once; unlimited liability Distribute partnership assets: carryover basis

Limited Partnership: Schedule E Taxed once; unlimited liability for general partners

Limited partners have limited liability but no say Requires filing with state

LLP: Schedule E Taxed once; no liability for other partners torts

LLC Taxed once; limited liability

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Topic 35: Business Entities Personal holding companies

>60% income from royalties, rents, dividends Majority owned by five or fewer owners Pays 15% penalty tax on undistributed earnings

C Corporation Ability to raise capital; limited liability Double taxation of dividends

C corp best if plan to retain earnings to grow business

Liquidating dividends treated as sale of stock Redemption: own < 80% of stock owned previously

Capital gains taxed at ordinary rates

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Topic 35: Business Entities S Corporation

Taxed once; limited liability <100 shareholders; one class of stock Basis for shareholder loans Appropriate if:

income from business will be distributed Otherwise, pay tax on earnings but no cash to pay it Earnings of S corp not subject to S-E tax but salaries paid

to owners subject to social security taxes Or if anticipate losses initially

Can’t deduct C corporation losses on stockholder’s 1040

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Topic 36: Income Taxation Trusts/Estates

Rates Generally higher than individual tax rates

Grantor: retains rights making him owner All income taxed to grantor

Simple: must distribute all income (generally not capital gains) Income taxed to beneficiaries Exemption amount: $300

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Topic 36: Income Taxation Trusts/Estates

Complex: can accumulate income Income distributed to beneficiaries taxed to them DNI: limit on amount of income taxable to beneficiary

Generally does not include capital gains

Estate Income Tax Income earned during estate administration

Same rules as complex trust Administration expenses

Can deduct either on estate or income tax return

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Topic 37: Basis Basis: initially cost of asset

Reduced by depreciation (whether taken or not) Increased by improvements

New roof versus painting building

Gift Generally carryover basis if asset increased in value Double basis if asset decreased in value

Inherited FMV at date of death

Exception if gifted property to decedent within year of death Separate property versus community property

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Topic 37: Depreciation MACRS: Cost of asset x percent

Tables provided Useful life:

7 year: equipment 27 ½: residential real estate 39: nonresidential real estate

Listed property Autos: limits on annual depreciation

Section 179: expense up to $500,000 in 2013; $25,000 in 2014 Assets used in business

Limited to amount of business income SUV limited to $25,000 Not available for real estate Bonus depreciation: 50% in 2013 for new property; $0 in 2014

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Topic 37: Depreciation Amortization: intangible assets

Can amortize $5,000 of business start-up expenses

Depletion: natural resources Oil, gravel

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Topic 38: Like Kind (1031) Exchanges

Qualifying transactions Like kind property

Real estate: broad definition Property used in business or for investment

Personal property must be like kind Excludes securities and inventory

If no cash received/liabilities assumed Carryover basis

Cash received/liabilities assumed Gain recognized equals lesser of:

Cash received/liabilities assumed Mortgage relieved like receiving cash

Gain realized Basis = Carryover – Cash Received + Gain Recognized

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Topic 38: Like Kind (1031) Exchanges

Related parties: must hold properties two years Deferred exchange

Identify replacement in 45 days; close in 180 days

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Topic 38: Disposition of Property

Capital assets: held more than one year for capital gains tax rates Collectibles: 28% Real estate (to extent of depreciation): 25% Muni bonds capital gains are taxed

Netting gains Net short and long gains/losses Then net short against long if one gain/one loss Can use capital losses up to $3,000 to offset other

income Excess carries over

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Topic 38: Disposition of Property Sale of principal residence

Live in home 2 of last 5 years Can exclude up to $500,000 gain MFJ

Depreciation recapture Gain attributable to depreciation deduction is ordinary

income 1231 gain: long-term capital gain to extent not from

depreciation If no 1231 loss in last five years

1231 loss: ordinary loss Section 1244 stock

Can deduct up to $100,000 MFJ (versus $3,000)

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Topic 38: Disposition of Property

Installment sale Include portion of payment representing profit in

income each year Depreciation recapture (section 1245) reported

all in year of sale

Involuntary conversions Postpone recognizing gain from insurance if replace

within two years

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Topic 38: Disposition of Property Capital gains tax rates

Long-term: 15% If in 10/15% ordinary rate, 0%

Home office expenses Can’t create a loss on Schedule C Interest/property taxes vs. insurance Depreciation will be recaptured on sale of home

Related parties Gain recognized on sale Loss not recognized until sold to non-related party

Wash sales Buy “substantially identical” securities within prohibited period

30 days prior/after loss sale Not identical securities Disallowed loss added to basis

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Topic 39: AMT Designed to ensure taxpayers with

substantial amounts of income pay income tax

If alternative minimum tax exceeds regular tax liability, then pay AMT Essentially a second income tax system

Even “not so rich” taxpayers are increasingly paying AMT

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Topic 39: AMT

AMT Taxable Income (AMTI) Starts with regular taxable income Plus/minus adjustments Plus tax preferences Minus AMTI exemption Equals AMTI

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Topic 39: AMT

Adjustments Depreciation

Separate calculation of AMT depreciation In general, less depreciation in initial years

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Topic 39: AMT

Preferences No standard deduction or personal

exemptions allowed These amounts have increased in recent

years

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Topic 39: AMT

Preferences Itemized deductions for AMTI

Medical expenses allowed only to the extent they exceed 10%, not 7.5%

State income taxes aren’t deductible Real estate and other property taxes aren’t

deductible No reduction of itemized deductions by 3%

when AGI exceeds allowable amount

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Topic 39: AMT Preferences

Incentive stock options (ISOs) Income tax implications ( regular, AMT, basis)

Upon grant Option price must be equal to stock price

(110% of stock price for > 10% owner) FMV stock thru option exercise must be <

$100,000 per year Expiration: 10 years from date of grant Typically a portion vests each year

(maybe 20% each year) Can only be transferred on death of employee

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Incentive stock options (ISOs) Upon exercise

Basis is equal to option price Difference between option price and the

value of stock on date of exercise is an AMT preference item

Exercising option before stock price increases reduces preference item but does subject employee to risk associated with ownership of the stock

AMT basis is equal to stock price on date of exercise; not option price

Higher basis for AMT if price has increased

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Incentive stock options (ISOs) Upon sale

If stock has increased in price between date option was vested and date option was exercised, AMT basis will exceed tax basis. Consequently, on sale of stock AMT gain will be smaller than capital gain

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Topic 39: AMT AMTI Exemption

MFJ $82,100 less 25% of AMTI over $150,000

AMT Tax Rate: All other than MFS 26% of first $175,000 28% of all amounts over $175,000

Minimum Tax Credit: Available if AMT due to timing differences

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Topic 39: AMT Corporations and trusts are subject to

AMT Corporate owned life insurance increases

AMTI

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Topic 40: Tax Reduction Techniques

Education credits Only available for amounts paid “out of

pocket” High income clients

Have children pay education expense due to phaseouts for exemptions/education credits

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Topic 40: Tax Reduction Techniques Intrafamily transfers

Not as effective due to extension of kiddie tax to older children

Accelerate deductions State income taxes Charitable contributions Section 179 Farm/business expenses year-end

Defer income Contribute to retirement plans

Remember your banker!!! Future tax rates???

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Topic 41: Hobby Losses

Substantial outside income Engaged in for profit Had profit three of last five years Fun?

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Topic 41: Passive Activity and At-Risk

At-Risk Generally deductible losses are limited to

amount invested in business, i.e., basis Calculating basis=

Amount invested Recourse and nonrecourse loans

Nonrecourse: not personally liable + Income from business - Losses from business - Distributions from business

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At-Risk Losses are also limited to amount at risk

Amount at risk generally does not include nonrecourse loans

Rules apply to individuals And corporations with < five owners

Losses can be carried forward Losses can not offset income from other

activities

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Topic 41: Passive Activity and At-Risk Passive Activity

Trade or business in which taxpayer does not materially participate Material participation: involved in activity on a regular

and continuous basis 500 hours per year Do all the work Personal services (attorney, doctor, etc.) Material participation in five of last 10 years or 100 hours per year if more than anyone else’s

participation Limited partners generally also passive

Can’t use limited partnership losses to offset other passive income

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Passive Activity Rental activities (not short term rentals – hotels)

Doesn’t matter if you materially participate However, can deduct up to a $25,000 loss MFJ if

“actively” participate in real estate Active: approve tenants, decide rental terms, approve

repairs and improvements Must also have at least 10% ownership

$25,000 allowance is phased out if AGI is above $100,000 for MFJ Can’t take $1 of loss for every $2 AGI > $100,000

Also, real estate professionals (more than 750 hours per year) can avoid passive activity loss rules if materially participate

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Vacation homes Rented > 14 days and personal use < 14 days or 10%

days rented Business: all income and expenses included on

Schedule E Rented > 14 days and personal use > 14 days or 10%

days rented Income included Allocation of expenses between business and

personal has been litigated Rented < 14 days

No income or expenses reported Home on Bagelfest parade route in Mattoon

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Losses can only be used to offset passive activity income Can’t offset active or portfolio income

Losses can be carried forward but retain their character

Losses not previously allowed from a passive activity are allowed in year passive activity is sold Grouping of passive activities

Must group in first year; more group, harder to dispose of entire interest

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Topic 42: Special Circumstances Filing status: only December 31st matters

Joint liability Innocent spouse

Alimony Payor: Deductible, child support is not

Can’t front load alimony ($15,000 more than later years)

Paying ex-spouse’s mortgage, etc. also considered alimony

Recipient: Taxable, child support is not

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Topic 42: Special Circumstances Property settlement is not taxable Exemption: generally goes to custodial parent QDRO: division of retirement assets

Defined contribution/IRAs/Defined benefit Death: still get personal exemption and can file MFJ

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Topic 43: Charitable Contributions Qualified organizations

Public charity: charitable, religious, education, government Not: your neighbor who lost his job; not Republicans

Private charity: foundation Must give property

Not value of time Must reduce contribution by value of benefit received

Raffle tickets Paid before end of year

Credit cards

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Topic 43: Charitable Contributions

Cash 50%: public charity Carryover for five years

Capital gain property: deduct FMV 30%: public charity Carryover for five years Elect 50% limit if use cost instead of FMV

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Topic 43: Charitable Contributions

Substantiation Must have:

a bank record (check) for contribution or documentation from charity

No deduction for: Cash contributions to

Salvation Army Church?

They generally will provide documentation

1 topic 32: income tax fundamentals primary: internal revenue code treasury regulations revenue...

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