Business Taxation

by

Revision Date 7-17-2014

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Copyright Information

Copyright 2014 by

NetCBT, Inc.

The author is not engaged by this text or any accompanying lecture or electronic media in the rendering of legal, tax, accounting, or similar professional services. While the legal, tax, and accounting issues discussed in this material have been reviewed with sources believed to be reliable, concepts discussed can be affected by changes in the law or in the interpretation of such laws since this text was printed. For that reason, the accuracy and completeness of this information and the author's opinions based thereon cannot be guaranteed. In addition, state or local tax laws and procedural rules may have a material impact on the general discussion. As a result, the strategies suggested may not be suitable for every individual. Before taking any action, all references and citations should be checked and updated accordingly.

This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert advice is required, the services of a competent professional person should be sought.

—-From a Declaration of Principles jointly adopted by a

committee of the American Bar Association and a Committee of Publishers and Associations.

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TABLE OF CONTENTS

CHAPTER 1 - Structure, Reporting & Accounting .......... 1-1 Introduction .................................................................................................1-1 Types of Business Organizations .....................................................................1-2

Sole Proprietorships ...................................................................................1-2 Schedules C & C-EZ ..............................................................................1-3 Self-Employment Taxes ........................................................................1-4 Estimated Tax Payments .......................................................................1-4 Advantages .........................................................................................1-5 Disadvantages .....................................................................................1-5

Partnerships .............................................................................................1-5 Agreement ..........................................................................................1-5 General Tax Aspects .............................................................................1-6

Form 1065 ......................................................................................1-7 Limited Partnerships .............................................................................1-7

Passive Presumption .........................................................................1-7 At Risk Rules - §465 .............................................................................1-8

Financing ........................................................................................1-8 Passive Loss Limitations - §469 ..............................................................1-9

Active/Passive Determination .............................................................1-9 Triggering Suspended Losses .............................................................1-9

Regular Corporations .................................................................................1-10 Electronic Federal Tax Payment System (EFTPS) ......................................1-11 Form 1120 - Corporate Income Tax Return..............................................1-12

Which Form To File ...........................................................................1-12 Penalty for Late Filing of Return .........................................................1-12 Penalty for Late Payment of Tax .........................................................1-13 Limit on Deduction for Dividends ........................................................1-13 Effect of Net Operating Loss ..............................................................1-13 At-Risk Rules for Closely Held Corporations .........................................1-13 Tax Rate Schedule............................................................................1-14

Advantages .........................................................................................1-15 Disadvantages .....................................................................................1-15

Qualified Personal Service Corporation .........................................................1-16 S Corporations ..........................................................................................1-16

Advantages .........................................................................................1-17 Disadvantages .....................................................................................1-18

Limited Liability Company ..........................................................................1-19 Advantages .........................................................................................1-21 Disadvantages .....................................................................................1-21

Record keeping .............................................................................................1-22 Why Keep Records? ...................................................................................1-22

Monitor the Progress of a Business .........................................................1-22 Prepare Financial Statements .................................................................1-22 Identify Source of Receipts ....................................................................1-23

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Keep Track Of Deductible Expenses ........................................................1-23 Prepare Tax Returns .............................................................................1-23 Support Items Reported On Tax Returns .................................................1-23

Kinds of Records to Keep ...........................................................................1-23 Supporting Documents..........................................................................1-23 Gross Receipts .....................................................................................1-24 Purchases ...........................................................................................1-24 Expenses ............................................................................................1-24 Assets.................................................................................................1-25

Business Transactions ................................................................................1-26 Basic Record keeping ............................................................................1-27

Business Checkbook .........................................................................1-27 Reconciling the Checking Account .......................................................1-27

Bookkeeping Systems ................................................................................1-29 Single-Entry ........................................................................................1-29 Double-Entry .......................................................................................1-30 Computerized System ...........................................................................1-30 Microfilm .............................................................................................1-31 Electronic Storage System .....................................................................1-31

How Long To Keep Records ........................................................................1-31 Employment Taxes ...............................................................................1-32 Assets.................................................................................................1-32 Records for Nontax Purposes .................................................................1-33

Accounting Periods & Methods ....................................................................1-33 Tax Year .............................................................................................1-33

Section 444 Election .........................................................................1-34 Business Purpose .............................................................................1-34 Changes in Accounting Periods ...........................................................1-34

Accounting Method ...............................................................................1-35 Changing a Business‘s Method of Accounting .......................................1-36

Inventories ...............................................................................................1-36 Identification Methods...........................................................................1-36

Specific Identification Method ............................................................1-36 FIFO Method ....................................................................................1-37 LIFO Method ....................................................................................1-37

Valuation Methods ................................................................................1-37 Cost Method ....................................................................................1-38

Uniform Capitalization Rules - §263A ...............................................1-38 Lower of Cost or Market Method .........................................................1-39

CHAPTER 2 - Business Income, Credits & Assets .......... 2-1 Business Income ...........................................................................................2-1

Overview..................................................................................................2-1 Types of Income .......................................................................................2-1

Barter .................................................................................................2-2 Information Returns .........................................................................2-2

Rental Income .....................................................................................2-3 Individual Lessors ............................................................................2-3 Advance Rent ..................................................................................2-3 Lease Bonus ....................................................................................2-3

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Security Deposits .............................................................................2-3 Payment for Canceling a Lease ..........................................................2-4 Payments to Third Parties..................................................................2-4 Settlement Payments........................................................................2-4

Interest ..............................................................................................2-4 Uncollectible Loans ...........................................................................2-4 Below-Market Loans .........................................................................2-5 Installment Sales .............................................................................2-5 Interest on Insurance Dividends .........................................................2-5

Discharge of Debt Income .....................................................................2-5 Exceptions from Income Inclusion ......................................................2-5 Reduction of Tax Attributes ...............................................................2-6

Order of Reductions .......................................................................2-6 Sale of Products or Services ..................................................................2-7 Dividends ............................................................................................2-7

Ordinary Dividends ...........................................................................2-7 Money Market Funds ......................................................................2-7 Dividends on Capital Stock .............................................................2-7 Dividends Used to Buy More Stock ..................................................2-8

Qualified Dividends ...........................................................................2-8 Tax on Net Investment Income - §1411 ..................................................2-8 Recoveries ..........................................................................................2-9

Itemized Deduction Recoveries ..........................................................2-10 Recovery Limited to Deduction ........................................................2-11 Recoveries Included in Income ........................................................2-11

Non-Itemized Deduction Recoveries ...................................................2-11 Amounts Recovered for Credits ..........................................................2-11 Tax Benefit Rule ...............................................................................2-12

Recapture of Depreciation .....................................................................2-12 Sale Or Exchange Of Depreciable Property ..........................................2-12 Listed Property ................................................................................2-12 Section 179 Property ........................................................................2-12

Sole Proprietorship Income .........................................................................2-12 Partnership Income ...................................................................................2-13

Partnership Agreement .....................................................................2-13 Partnership Return ...........................................................................2-14 Partner‘s Return ...............................................................................2-14

Corporate Income ................................................................................2-14 S Corporation Income ...........................................................................2-14

S Corporation Return ........................................................................2-15 Shareholder‘s Return ........................................................................2-15 Distributions ....................................................................................2-15

Alternative Minimum Tax Income ...........................................................2-16 Small Business Corporation ...............................................................2-16

Business & Investment Credits ........................................................................2-16 Business Credit Carryback & Carryforward Rules - §39(a) ..............................2-17

NOL Comparison ..................................................................................2-18 Disposition of Business Assets ........................................................................2-18

Amount Realized .......................................................................................2-19 Basis of Assets ..........................................................................................2-19

Unstated Interest .................................................................................2-19

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Allocation of Purchase Price ...................................................................2-19 Asset Types ..............................................................................................2-20

Section 1231 Assets .............................................................................2-20 Character of Gain or Loss ..................................................................2-21 5 Year Averaging ..............................................................................2-21

Like-Kind Exchanges ..................................................................................2-21 Qualified Property Requirement ..............................................................2-22 Like-Kind Requirement ..........................................................................2-22

Goodwill Prohibition ..........................................................................2-22

CHAPTER 3 - Selected Business Expenses .................... 3-1 Section 162 ..................................................................................................3-1

Cost of Goods Sold ....................................................................................3-2 Capital Expenses .......................................................................................3-3

Cost Recovery Depreciation ...................................................................3-3 Personal vs. Business Expenses ..................................................................3-3 At-Risk Amounts - §465 .............................................................................3-3 Passive Losses - §469 ................................................................................3-4 Net Operating Loss - §172 ..........................................................................3-4

Creation of a NOL .................................................................................3-4 Individual NOLs ....................................................................................3-4

Carrybacks & Carryovers ...................................................................3-5 Further Limitations ...............................................................................3-5 Corporate NOLs ...................................................................................3-6

Timing of Expense Deduction - §447................................................................3-6 Economic Performance - §461 ....................................................................3-6 Prepayment of Expenses ............................................................................3-7 Contested Liability .....................................................................................3-7 Related Person ..........................................................................................3-8

Expenses of Not-for-Profit Activities - §183 ......................................................3-8 Presumption of Profit .................................................................................3-9

Using The Presumption Later .................................................................3-9 Limit on Deductions ...................................................................................3-10

Partnerships & S Corporations ...............................................................3-12 More Than One Activity ..............................................................................3-12

Rent Expenses ..............................................................................................3-12 Rent Paid In Advance .................................................................................3-13 Lease vs. Sale...........................................................................................3-13

Leveraged Leases .................................................................................3-14 Leveraged Leases Of Limited-Use Property ..........................................3-15

Leases over $250,000 - §467 .....................................................................3-15 Taxes on Leased Property ..........................................................................3-15 Cost of Getting a Lease ..............................................................................3-16

Options To Renew ................................................................................3-16 Cost Of A Modification Agreement ..........................................................3-17 Commissions, Bonuses, & Fees ..............................................................3-17 Loss On Merchandise & Fixtures .............................................................3-18

Leasehold Improvement & Restaurant Property - §168 ..................................3-18 Qualified 15-Year Leasehold Improvement Property - §168(e)(3)(E)(iv) ......3-18

Qualified Leasehold Improvement Property ..........................................3-19

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Subsequent Owner ...........................................................................3-19 Qualified 15-Year Retail Improvement Property - §168(e)(E)(ix) ................3-19 Qualified Retail Improvement Property ....................................................3-19

15-Year Restaurant Improvements - §168(e)(7) ..................................3-20 Assignment of a Lease ...............................................................................3-20 Capitalizing Rent Expenses .........................................................................3-21

Interest Expense - §163 .................................................................................3-21 Business Interest ......................................................................................3-21

Interest Paid In Advance .......................................................................3-22 Mortgage Interest .....................................................................................3-22

Prepayment Penalty..............................................................................3-22 Points .................................................................................................3-22 Expenses to Obtain a Mortgage ..............................................................3-23

Interest on Installment Purchases ...............................................................3-23 Investment Interest...................................................................................3-23

Investment Property .............................................................................3-24 Limit on Deduction ...............................................................................3-24

Net Investment Income ....................................................................3-25 Investment Income .......................................................................3-25

Capital Gain Inclusion Election .....................................................3-25 Investment Expenses ....................................................................3-26

Losses from Passive Activities ......................................................3-26 Carryover ........................................................................................3-26

When to Deduct Investment Interest ......................................................3-26 Form 4952 ......................................................................................3-26

Interest on Margin Accounts ..................................................................3-27 Interest on a Market Discount Bond ........................................................3-27

Nondeductible Interest ...............................................................................3-27 Interest on Income Tax Owed ................................................................3-28

Penalties ......................................................................................3-28 Commitment Fees & Service Charges .....................................................3-28 Capitalized Interest ..............................................................................3-28

Production Period .............................................................................3-29 Traced Debt.....................................................................................3-29 Avoided Cost Debt ............................................................................3-29 When Interest Is Paid or Incurred ......................................................3-30 Partnerships & S Corporations ...........................................................3-30

Interest Related To Tax-Exempt Income - §265 .......................................3-30 Interest on Insurance Policy Loans - §264 ...............................................3-31

Single Premium Life Insurance ...........................................................3-31 Systematic Plan of Borrowing ............................................................3-31

Key Person Insurance ...........................................................................3-31 Deductibility of Premiums & Interest on Life Insurance .........................3-32

Existing Interest on Purchase .................................................................3-32 Corporate Acquisition Interest ................................................................3-32

Interest Allocation Rules for Multi-Purpose Loans ..........................................3-32 Allocation period ..................................................................................3-33 Proceeds Not Disbursed To Borrower ......................................................3-33 Proceeds Deposited In Borrower's Account ..............................................3-34 Order Of Funds Spent ...........................................................................3-34 Payments From Checking Accounts .........................................................3-34

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Amounts Paid Within 30 Days ................................................................3-35 Optional Method For Determining Date Of Reallocation .............................3-35 Interest On A Separate Account .............................................................3-36 Accrued Interest ..................................................................................3-36

Accrued Interest Before Debt Proceeds Are Received ............................3-37 Loan Repayment ..................................................................................3-37 Continuous Borrowings .........................................................................3-37 Loan Refinancing ..................................................................................3-38 Special Rules for Partnerships & S Corporations .......................................3-38

Debt-Financed Acquisitions ................................................................3-38 Reallocation ..................................................................................3-39 How to Report ..............................................................................3-39

Debt-Financed Distributions ...................................................................3-39 Optional Method ............................................................................3-39 How to Report ..............................................................................3-40

Deductible Taxes - §164 ................................................................................3-40 Tax Refunds .............................................................................................3-40 Change in Date of Tax Accrual ....................................................................3-40 Real Estate Taxes ......................................................................................3-41

Local Benefits ......................................................................................3-41 Real Estate Taxes on Purchase Or Sale ...................................................3-42

Choosing To Ratably Accrue ...............................................................3-43 Separate Choices ..........................................................................3-43 Making the Choice .........................................................................3-43 Form 3115 ...................................................................................3-44

State & Local Income Taxes ........................................................................3-44 Foreign Income Taxes ...........................................................................3-44

States & Local Sales Tax for Individuals .......................................................3-44 Temporary Sales Tax Deduction for Qualified Vehicles (Expired).................3-44

Employment Taxes ....................................................................................3-45 Unemployment Fund Taxes ...................................................................3-45 Self-employment Tax ............................................................................3-45

Other Taxes ..............................................................................................3-45 Casualty & Theft Losses - §165 .......................................................................3-46

Proof of Loss .............................................................................................3-46 Amount of Loss .........................................................................................3-46 Insurance & Other Reimbursements ............................................................3-47 Limitations ...............................................................................................3-47

Dividends Received Deduction - §243 ..............................................................3-47 Dividends from Domestic Corporations .........................................................3-48

80% Exception ....................................................................................3-48 Ownership ................................................................................................3-48 Limitation .................................................................................................3-48

Other Selected Deductible Costs .....................................................................3-49 Home-Office Deduction - §280A ..................................................................3-49

Requirements - §280A ..........................................................................3-49 Non-Exclusive Use Exceptions ................................................................3-49 Income Limitation ................................................................................3-50 Home Office Deduction After 1998 ..........................................................3-50

Research & Experimental Costs - §174 .........................................................3-50 Definitions ...........................................................................................3-51

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Product ...........................................................................................3-51 Costs Not Included ...............................................................................3-51 When & How To Choose ........................................................................3-52

Business Start-Up & Organizational Costs - §195 ..........................................3-52 How To Make The Choice ......................................................................3-53

Carrying Charges ......................................................................................3-53 Intangible Drilling Costs .............................................................................3-53 Exploration Costs ......................................................................................3-53

Partnerships ........................................................................................3-54 Reduced Corporate Deductions For Exploration Costs ................................3-54 Recapture Of Exploration Expenses ........................................................3-54

Mine Development Costs ............................................................................3-54 Circulation Costs .......................................................................................3-55 Reforestation Costs ...................................................................................3-55 Retired Asset Removal Costs ......................................................................3-55 Barrier Removal Costs ...............................................................................3-55

Deduction Limit ....................................................................................3-56 Partners & Partnerships.........................................................................3-56 Qualification Standards .........................................................................3-56 Other Barrier Removals .........................................................................3-57

How To Make The Choice ..................................................................3-57 Amortization .................................................................................................3-57

Deducting Amortization ..............................................................................3-57 Start-Up Costs - §195 ................................................................................3-58

Amortization Period ..............................................................................3-58 Qualifying Costs ...................................................................................3-58 Purchasing An Active Trade Or Business ..................................................3-58

Corporate Organizational Costs - §248 .........................................................3-59 Qualifying Costs ...................................................................................3-59 Nonqualifying Costs ..............................................................................3-60

Partnership Organizational Costs - §709 .......................................................3-60 Qualifying Costs ...................................................................................3-60 Nonqualifying Costs ..............................................................................3-61 Partnership Liquidation .........................................................................3-61

Costs of Obtaining a Lease .........................................................................3-61 Section 197 Intangibles .............................................................................3-62

Cost Attributable To Other Property ........................................................3-62 Section 197 Intangibles Defined .............................................................3-63

Goodwill ..........................................................................................3-63 Going Concern Value ........................................................................3-63 Workforce In Place, Etc. ....................................................................3-63 Business Books And Records, Etc. ......................................................3-63 Patents, Copyrights, Etc. ...................................................................3-64 Customer-Based Intangible ...............................................................3-64 Supplier-Based Intangible .................................................................3-64 Government-Granted License, Permit, Etc. ..........................................3-64 Covenant Not To Compete .................................................................3-65 Franchise, Trademark, Or Trade Name ................................................3-65

Professional Sports Franchise ..........................................................3-65 Contract For The Use Of, Or A Term Interest In, A §197 Intangible ........3-65

Assets That Are Not §197 Intangibles .....................................................3-65

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Computer Software ..............................................................................3-66 Computer Software Defined ...............................................................3-67

Rights Of Fixed Duration Or Amount .......................................................3-67 Safe Harbor for Creative Property Costs ..................................................3-67 Anti-Churning Rules ..............................................................................3-68 Disposition of §197 Intangibles ..............................................................3-68

Nondeductible Loss ...........................................................................3-68 Covenant Not To Compete .................................................................3-68 Nonrecognition Transfers ..................................................................3-69

Research & Experimental Costs ...................................................................3-69 Optional write-off method .....................................................................3-70 Amortizable Costs ................................................................................3-70 Election ...............................................................................................3-70

Pollution Control Facilities ...........................................................................3-70 Certified Pollution Control Facility ...........................................................3-70

Reforestation Costs ...................................................................................3-71 Depletion - §613 ...........................................................................................3-72

Cost Depletion ..........................................................................................3-72 Basis For Depletion ...............................................................................3-72 Total Recoverable Units.........................................................................3-73 Number Of Units Sold ...........................................................................3-73 Determining The Cost Depletion Deduction ..............................................3-73

Percentage Depletion .................................................................................3-74 Gross Income ......................................................................................3-74 Taxable Income Limit ...........................................................................3-74

Partnerships & S Corporations ....................................................................3-75 Partner‘s or Shareholder‘s Adjusted Basis ................................................3-75 Records ..............................................................................................3-75 Reporting the Deduction .......................................................................3-75

Mines & Geothermal Deposits .....................................................................3-76 Gross Income From The Property ...........................................................3-76 Excise Tax ...........................................................................................3-77 Extraction ...........................................................................................3-77 Treatment Processes ............................................................................3-77 Transportation Of More Than 50 Miles .....................................................3-77

Lessor‘s Gross Income ...............................................................................3-77 Bonuses & Advanced Royalties ...............................................................3-78

Timber .....................................................................................................3-78 Business Bad Debts - §166 .............................................................................3-78

Credit Transactions ....................................................................................3-79 Income Inclusion ..................................................................................3-79

Accrual Method Taxpayers .................................................................3-80 Cash Method Taxpayers ....................................................................3-80

Former Business .......................................................................................3-80 Debt Acquired from a Decedent .............................................................3-80

Political Debts ...........................................................................................3-81 Insolvency of Partner .................................................................................3-81 Business Loan Guarantees ..........................................................................3-81 Reporting .................................................................................................3-82 Methods of Treating Bad Debts ...................................................................3-82

Specific Charge-Off Method ...................................................................3-82

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Partly Worthless Debts ......................................................................3-82 Deduction Disallowed .....................................................................3-83

Totally Worthless Debts ....................................................................3-83 Recovery of Bad Debt .......................................................................3-83 Property Received for a Debt .............................................................3-84 Bankruptcy Claim .............................................................................3-84 Sale of Mortgaged Property ...............................................................3-84 Net operating Loss ...........................................................................3-84

Nonaccrual-Experience Accounting Method ..............................................3-85 Performing Services..........................................................................3-85 Interest & Late Charges ....................................................................3-85

Refueling Property & Electric Vehicles ..............................................................3-86 Alternative Fuel Refueling Property - §30C ...................................................3-86 Plug-In Electric Drive Motor Vehicle Credit - §30 ...........................................3-87

2- & 3-Wheeled Plug-In Electric Vehicles .................................................3-87 Advanced Energy Investment Credit - §48C..................................................3-87

Depreciation - §168 .......................................................................................3-87 Personal Property ......................................................................................3-88

ACRS - §168 ........................................................................................3-88 Applicable Percentage .......................................................................3-88 Straight-line Election ........................................................................3-89

MACRS................................................................................................3-89 Elections .........................................................................................3-90 Bonus (or Additional First-year) Depreciation - §168(k) ........................3-90

Qualifying Property ........................................................................3-91 Coordination with §179 ..................................................................3-91

MACRS Conventions .........................................................................3-91 Mid-quarter Convention Exception ...................................................3-91

Recapture - §1245 ...............................................................................3-92 Real Property ............................................................................................3-92

ACRS ..................................................................................................3-92 MACRS................................................................................................3-93

Recapture - §1250 & §1245 ........................................................................3-93 Section 1245 .......................................................................................3-93

Full Recapture ..................................................................................3-94 Section 1250 .......................................................................................3-94

Partial Recapture ..............................................................................3-94 MACRS Recapture Exception for Real Property .........................................3-94

Alternative Depreciation System - §168(g) ...................................................3-94 Mandatory Application ..........................................................................3-94 Method ...............................................................................................3-95

CHAPTER 4 - Employee Compensation & Benefits ........ 4-1 Wages, Salary & Pay .....................................................................................4-1

Employee vs. Contractor Status ..................................................................4-1 Factors ...............................................................................................4-2

Tests for Deducting Pay to Employees ..........................................................4-4 Test #1 - Reasonableness .....................................................................4-4

Overall Limitation .............................................................................4-5 Allowance of Deduction ..................................................................4-5

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Limitation on Accrual Deduction ......................................................4-5 Employment Contracts ...................................................................4-5

Scope of Examination .......................................................................4-6 Officer‘s Compensation ..................................................................4-6

Factors ...........................................................................................4-6 Employee‘s Qualifications ...............................................................4-6 Size of the Business ......................................................................4-6 Employee‘s Compensation History ...................................................4-7

Unreasonably Low Salaries ..........................................................4-7 Past Service .................................................................................4-7 Reasonable Dividends ....................................................................4-7

Bonuses as Constituting Dividends ...............................................4-8 Payback Agreements .....................................................................4-8 Miscellaneous Factors ....................................................................4-8

Test #2 - For Services Performed ...........................................................4-9 Employee-Shareholder Salaries ..........................................................4-9

Selected Types of Compensation .................................................................4-9 Awards ...............................................................................................4-9 Bonuses ..............................................................................................4-9

Employee Gifts of Nominal Value ........................................................4-9 Education Expenses ..............................................................................4-10 Fringe Benefits .....................................................................................4-10 Life Insurance Coverage ........................................................................4-10 Welfare Benefit Funds ...........................................................................4-10 Loans or Advances ...............................................................................4-11 Property ..............................................................................................4-11

Restricted Property ...........................................................................4-11 Sick & Vacation Pay ..............................................................................4-12

Payroll Taxes ............................................................................................4-12 Form 941 ............................................................................................4-12

Deposit Rules ..................................................................................4-13 Lookback Period ............................................................................4-13

Monthly Depositor ......................................................................4-13 Semi-Weekly Depositor ...............................................................4-14 One-Day Rule ............................................................................4-14 De Minimis Rule .........................................................................4-14

Form W-4 ............................................................................................4-14 Whistle-Blowing ...............................................................................4-15

Form W-2 ............................................................................................4-15 Form W-3 ............................................................................................4-16

Social Security‘s Payroll Tax or FICA - §3111 & §3121 ...................................4-16 Rates ..................................................................................................4-17 Deduction ...........................................................................................4-18

Federal Unemployment (FUTA) Tax - §3302 .................................................4-18 Form 940 ............................................................................................4-18

Selected Fringe Benefits .................................................................................4-19 Old Dichotomy - Statutory v. Nonstatutory ...................................................4-19

Fringe Benefit Provisions .......................................................................4-20 TRA ‗84 - §132 ................................................................................4-20 Discrimination ..................................................................................4-20 Only Statutory Benefits .....................................................................4-20

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No-Additional-Cost Services - §132(b) .........................................................4-20 Covered Employees ..............................................................................4-21 Line of Business Requirement ................................................................4-21

Definition ........................................................................................4-21 Qualified Employee Discounts - §132(c) .......................................................4-21

Manner of Discount ..............................................................................4-22 Real Estate & Investment Property Exclusion .......................................4-22

Amount of Discount ..............................................................................4-22 Working Condition Fringes - §132(d) ...........................................................4-22

Covered Employees ..............................................................................4-23 Exceptions ...........................................................................................4-23 Substantiation .....................................................................................4-23

De Minimis Fringes - §132(e) ......................................................................4-23 Subsidized Eating Facilities ....................................................................4-24

Employee Achievement Awards - §74(c) & §274(j) ........................................4-24 Exclusion ............................................................................................4-24 Definition of Employee Achievement Awards ............................................4-24 Qualified Plan Award .............................................................................4-25 Employer Deduction Limits ....................................................................4-25

Aggregation Limit .............................................................................4-25 Special Partnership Rule ....................................................................4-26 Employee Impact .............................................................................4-26

Group Term Life Insurance - §79.................................................................4-26 Dependent Care Assistance - §129 ..............................................................4-26

Amount of Assistance ...........................................................................4-26 Requirements ......................................................................................4-27 Conflict with Dependent Care .................................................................4-27

Cafeteria Plans - §125 ...............................................................................4-27 Definition ............................................................................................4-27 Qualified Benefits .................................................................................4-28

Non-Qualified Benefits ......................................................................4-28 Controlled Group Rules .........................................................................4-28 Salary Reduction Plans ..........................................................................4-28 Nondiscrimination ................................................................................4-29

Meals & Lodging - §119 .............................................................................4-29 Income Exclusion .................................................................................4-29

Convenience of Employer ..................................................................4-29 Self-Insured Medical Reimbursement Plans - §105 ........................................4-30

Allowable Expenses ..............................................................................4-30 Requirements ......................................................................................4-30 Benefits ..............................................................................................4-30 Exposure .............................................................................................4-30

Employee Educational Assistance Programs - §127 ........................................4-31 Employer Provided Automobile - §61 & §132 ................................................4-31

General Valuation Method .....................................................................4-31 Annual Lease Value Method ...................................................................4-31

Computation ....................................................................................4-33 Cents Per Mile Method ..........................................................................4-33 Commuting Value Method .....................................................................4-33

Interest Free & Below-Market Loans - §7872 ................................................4-33 Permissible Discrimination .................................................................4-34

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Employee Needs ..............................................................................4-34 Imputed Interest ..................................................................................4-34 Types of Loans .....................................................................................4-35

Demand Loans .................................................................................4-35 Term Loans .....................................................................................4-35

Application of §7872 and Rate Determinations .........................................4-35 Summary ............................................................................................4-36

Moving Expenses - §217 ............................................................................4-36 Employer-Provided Retirement Advice & Planning - §132 ...............................4-36 Financial Planning - §67 & §212 ..................................................................4-37

Popularity ............................................................................................4-37 Taxation..............................................................................................4-37

Tax Planning - §67 & §212 .........................................................................4-37 Taxation..............................................................................................4-38

Estate Planning - §67 & §212 .....................................................................4-38 Physical Fitness Programs - §132(h)(5)........................................................4-38 ERISA Compliance .....................................................................................4-39

Welfare Plans .......................................................................................4-39 Additional Requirements ...................................................................4-39

Equity Participation .......................................................................................4-40 Stock Sales or Unrestricted Stock Plan .........................................................4-40 Stock Plans ..............................................................................................4-40

Stock Bonus ........................................................................................4-41 ESOT ..................................................................................................4-41 Phantom Stock ....................................................................................4-41

Advantages .....................................................................................4-42 Comparison with Profit Sharing Plans ..................................................4-42

Repurchase or Restricted Stock Agreement .............................................4-42 Stock Options ...........................................................................................4-43

Section 83 ...........................................................................................4-43 Risk of Forfeiture ..............................................................................4-43 Election ...........................................................................................4-44

Stock Appreciation Rights Plans .............................................................4-44 Tandem Plans ..................................................................................4-44

Qualified Incentive Stock Option .................................................................4-45 Requirements ......................................................................................4-45

Nonqualified Deferred Compensation ...............................................................4-46 Postponement of Income............................................................................4-46 Advantages ..............................................................................................4-46

IRS Scrutiny & Approval ........................................................................4-47 Nondiscrimination ................................................................................4-47

ERISA .............................................................................................4-47 Funding ..............................................................................................4-47

No Immediate Cash Outlay ................................................................4-47 Annual Report ......................................................................................4-47

Notice Requirement ..........................................................................4-47 Purposes ..................................................................................................4-48 Benefit Formula ........................................................................................4-48

Incentive .............................................................................................4-48 Deferred Bonuses .................................................................................4-48

Tax Status ................................................................................................4-49

x i i i

Service‘s Position .................................................................................4-49 Rationale.........................................................................................4-49

Constructive Receipt ..................................................................................4-49 Beyond Actual Receipt ..........................................................................4-49

Simple Set Asides Are Not Possible .....................................................4-50 Revenue Ruling 60-31 ...................................................................4-50 Regulations ..................................................................................4-50

Time & Control Concept ........................................................................4-51 Control ...........................................................................................4-51 Timing ............................................................................................4-51

Economic Benefit ......................................................................................4-51 Has Something of Value Been Transferred? .............................................4-52

Insurance Coverage Has a Calculable Value .........................................4-52 Segregated Funds Have Immediate Economic Value .............................4-52

General Principles.................................................................................4-52 Unfunded Bare Contractual Promise Plan - Type I ..........................................4-53

Risk ....................................................................................................4-53 Funded Company Account Plan - Type II ......................................................4-53

Ownership & Segregation ......................................................................4-54 Bookkeeping Reserve or Separate Account ..............................................4-54 Employee Bears Economic Risk ..............................................................4-54

Limited Protection ............................................................................4-54 Investment of Deferred Amounts ....................................................4-54 Life Insurance ...............................................................................4-55 Premiums .....................................................................................4-55 Third Party Guarantees ..................................................................4-56

Segregated Asset Plan - Type III .................................................................4-56 Section 83 Approach .............................................................................4-56 Tight Rope Format ................................................................................4-57 Transferable or Not Subject To A Risk of Substantial Forfeiture ..................4-57

Substantial Restrictions .....................................................................4-57 Redemption or Forfeiture ...............................................................4-57 Condition Related to a Purpose of the Transfer ..................................4-58 Noncompetition .............................................................................4-58 Consultation .................................................................................4-58 Time Alone is Not Enough ..............................................................4-58

Realization & Taxation ..........................................................................4-58 30-Day Election Period ..........................................................................4-59 Deduction Allowed ................................................................................4-59 Timing ................................................................................................4-59

Withholding .....................................................................................4-59 Tax Consequences .....................................................................................4-59

Reciprocal Taxation/Deduction Rule ........................................................4-60 No Difference for Cash or Accrual .......................................................4-60

Separate Accounts for Two or More Participants .......................................4-60 Income Tax on Employer Held Assets .....................................................4-60 Inclusion in Income Under §409A ...........................................................4-61

CHAPTER 5 - Automobiles ............................................ 5-1 Apportionment of Personal & Business Use .......................................................5-1

x i v

Car Pool ...................................................................................................5-2 Fines .......................................................................................................5-2 Parking Fees .............................................................................................5-2 Interest Deduction Limit for Individuals ........................................................5-2

Self-Employed Exception .......................................................................5-2 Property Taxes ..........................................................................................5-3 Sales Taxes ..............................................................................................5-3

2009 Sales Tax Deduction for Qualified Vehicles (Expired) - §164 ..............5-3 Actual Cost Method........................................................................................5-4

Deduction Limitations ................................................................................5-5 Definition of Car ...................................................................................5-5 Depreciation and Expensing ...................................................................5-5

Basis ..............................................................................................5-6 Trade-In of Old Car for New............................................................5-6

Placed in Service ..............................................................................5-7 Conversion to Business Use - ―Lesser of‖ Rule ...................................5-7

MACRS - 5 (Actually 6) Years .............................................................5-7 200%Double Declining Balance Method ............................................5-7

150% Declining Balance Method Election.......................................5-9 Straight-Line Method Election ......................................................5-9 Bonus (or Additional First-year) Depreciation - §168(k) ..................5-10

Half-Year Convention .....................................................................5-10 Mid-Quarter Convention .................................................................5-11

Depreciation ―Caps‖ ..........................................................................5-13 Separate Depreciation Caps for Trucks & Vans ..................................5-13 Post-Recovery Period Depreciation - Max Reduction Rule ....................5-14 Partial Business Use ......................................................................5-15 Improvements ..............................................................................5-15

Expensing - §179 ......................................................................................5-16 Cost of Car ..........................................................................................5-16 Basis Reduction ...................................................................................5-16 Making the §179 Election ......................................................................5-17 Business Use Reduction ........................................................................5-17 SUV Limitation .....................................................................................5-17

Predominate Business (More Than 50%) Use Rule .........................................5-18 Qualified Business Use ..........................................................................5-19

Exclusions .......................................................................................5-20 Change From Personal to Business Use ...............................................5-21 Employee Use of Their Own Car .........................................................5-22

Failure to Meet Predominate Business Use Rule ........................................5-22 Later Reduction in Qualified Use .............................................................5-23

ITC Recapture - Highly Unlikely ..........................................................5-23 Straight-line Depreciation ..................................................................5-23 Excess Depreciation Recapture ..........................................................5-24

Short Tax Year Depreciation Reduction ...................................................5-24 Auto Leasing .............................................................................................5-24

Pros & Cons .........................................................................................5-25 Leasing Terminology .............................................................................5-26 Closed-End vs. Open-End Lease .............................................................5-29 Formula for Monthly Payments ...............................................................5-29 Leasing Deduction Restrictions ...............................................................5-30

x v

Income Inclusion Amount ..................................................................5-31 Separate Lease Inclusion Table for Trucks & Vans .............................5-31

Cars Leased For 30 Days or More After 1986 .......................................5-31 Computation of Inclusion ..................................................................5-32

Nine-Month Following Year Rule ......................................................5-36 Buying v. Leasing .............................................................................5-36

Standard Mileage Method ...............................................................................5-37 Limitations on Standard Mileage Method ......................................................5-39

Use, Ownership & Prior Depreciation .......................................................5-39 Switching Methods ....................................................................................5-39 Charitable Transportation ...........................................................................5-40 Medical Transportation ...............................................................................5-41

Auto Trade-In vs. Sale ...................................................................................5-41 Working Condition Fringe Benefits ...................................................................5-42

Qualified Transportation - §132(f) ...............................................................5-43 Exclusion Limits ...................................................................................5-44

Employer-Provided Automobile ...................................................................5-44 General Hypothetical Valuation Method ...................................................5-45 Special Method #1 - Lease Value ...........................................................5-45

Annual Lease Value - For Entire Calendar Year .....................................5-46 Fair Market Value ..........................................................................5-48

Safe Harbor Value ......................................................................5-48 Items Included in Annual Lease Value Table .....................................5-48

Prorated Annual Lease Value - For 30 Days or More ..............................5-49 Daily Lease Value - For Less Than 30 Days ..........................................5-49

Special Method #2 - Cents per Mile ........................................................5-50 Regular Use - 50% Business ..............................................................5-51 Mileage Rule - 10,000 Miles ...............................................................5-51 Items Included In Cents-Per-Mile Rate ................................................5-51

Special Method #3 - Commuting Value ...................................................5-52 Control Employee .............................................................................5-53 Employer-Provided Transportation in Unsafe Areas ...............................5-53

Qualified Employee ........................................................................5-54 Nonpersonal Use Vehicles - 100% Excludable ..........................................5-55

Clearly Marked Police or Fire Vehicles .................................................5-55 Unmarked Law Enforcement Vehicles ..................................................5-56

Law Enforcement Officer ................................................................5-56 Trucks & Vans ..................................................................................5-56

Pickup Truck Guidelines .................................................................5-56 Van Guidelines ..............................................................................5-57

Qualified Automobile Demonstration Use .................................................5-57 Full-time Automobile Salesperson .......................................................5-58 Restrictions on Personal Use ..............................................................5-58

Reporting by Employer..........................................................................5-59 Election Not to Withhold for Income Taxes ..........................................5-59 Value Reported ................................................................................5-59 Accounting Period.............................................................................5-59

Special Accounting Period - Pour Over Method ..................................5-60

CHAPTER 6 - Business Travel & Entertainment............. 6-1

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Business Travel .............................................................................................6-1 Transportation & Travel Distinguished ..........................................................6-1

Travel Expenses ...................................................................................6-1 Transportation Expenses .......................................................................6-2

Definition of ―Tax Home‖ ............................................................................6-2 Circuit Court Test .................................................................................6-2 IRS Test ..............................................................................................6-3

Employment Area .............................................................................6-3 No Tax Home .......................................................................................6-3

Itinerant Worker ..............................................................................6-3 Two Work Locations..............................................................................6-4

Temporary & Indefinite Assignments ...........................................................6-4 Temporary Assignment .........................................................................6-4 Indefinite Assignment ...........................................................................6-4 Time ...................................................................................................6-5

Prior Law Presumptions .....................................................................6-5 One-Year IRS Presumption .............................................................6-5 Less than Two-Year Exception.........................................................6-5

Regular Home ............................................................................6-6 Temporary Job That Became Permanent ..........................................6-6

Current Law - One-Year Rigid Time Rule .............................................6-7 Away From Home Requirement ...................................................................6-7

Sleep & Rest Rule .................................................................................6-7 Correll Case .....................................................................................6-8

Business Purpose Requirement ...................................................................6-8 All or Nothing ......................................................................................6-8 Primarily for Business Test ....................................................................6-9

Time ...............................................................................................6-9 Other Factors ................................................................................6-9

Existing Trade or Business .................................................................6-9 51/49 Percent Test ...........................................................................6-9

Domestic Business Travel ......................................................................6-9 Foreign Business Travel ........................................................................6-10

Personal Pleasure .............................................................................6-10 Primarily Business ............................................................................6-10 Full Deduction ..................................................................................6-10 Definition of Business Day .................................................................6-11

Meals & Lodging ........................................................................................6-11 50% Deduction Limitation .....................................................................6-12

Conventions & Meetings .............................................................................6-12 Agenda Test ........................................................................................6-12 Foreign Conventions .............................................................................6-12

Factors ...........................................................................................6-13 North American Area ........................................................................6-13

Allowable Expenses ..............................................................................6-13 Cruises ....................................................................................................6-14

Deduction Limitation .............................................................................6-14 Reporting Statements ...........................................................................6-14

Luxury Water Travel ..................................................................................6-15 Exceptions ...........................................................................................6-15

Family Member Travel Expenses .................................................................6-15

x v i i

Definition .................................................................................................6-16 Lavish or Extravagant Restriction ................................................................6-16 Ordinary & Necessary Requirement .............................................................6-17

Directly Related Test ............................................................................6-17 Clear Business Setting Presumption ....................................................6-17

Associated Test ....................................................................................6-18 Substantial Business Discussion .........................................................6-18 Timing ............................................................................................6-18 Conventions ....................................................................................6-19

Statutory Exceptions ............................................................................6-19 Food and Beverages for Employees ....................................................6-19 Expenses Treated as Compensation ....................................................6-19 Reimbursed Expenses .......................................................................6-19 Recreational Expenses for Employees .................................................6-20 Employee, Stockholder and Business Meetings .....................................6-20 Trade Association Meetings................................................................6-20 Items Available to Public ...................................................................6-20 Entertainment Sold to Customers .......................................................6-20 Expenses Includible in Income of Non-employees .................................6-20

Quiet Business Meals & Drinks ...............................................................6-21 Taxpayer's (or Employee) Presence ....................................................6-21 Section 212 Meals Not Deductible .......................................................6-21

Home Entertainment ............................................................................6-21 Ticket Purchases .......................................................................................6-21

Exception for Charitable Sports Events ....................................................6-22 Special Limitation for Skyboxes ..............................................................6-22

Percentage Reduction for Meals & Entertainment ...........................................6-22 Related Expenses .................................................................................6-22 Application of Reduction Rule .................................................................6-23 Exceptions ...........................................................................................6-23

2% Floor on Employee Business Expenses ....................................................6-24 Miscellaneous Itemized Deductions .........................................................6-24

Entertainment Facilities ..............................................................................6-25 Exceptions ...........................................................................................6-25 Covered Expenses ................................................................................6-25 Club Dues ...........................................................................................6-26

OBRA '93 ........................................................................................6-27 Sales Incentive Awards .........................................................................6-27

Substantiation & Record Keeping.................................................................6-27 Documentation ....................................................................................6-27 Contemporaneous Records ....................................................................6-28

Payback Agreements ........................................................................6-28 Employee Expense Reimbursement & Reporting ............................................6-28

Family Support Act of 1988 ...................................................................6-29 Remaining Above-The-Line Deductions ...................................................6-29

Accountable Plans ............................................................................6-29 Reasonable Period of Time .............................................................6-30

Fixed Date Safe Harbor ...............................................................6-30 Period Statement Safe Harbor ......................................................6-30

Adequate Accounting .....................................................................6-31 Per Diem Allowance Arrangements ...............................................6-31

x v i i i

Reporting Per Diem Allowances .......................................................6-38 Reimbursement Not More Than Federal Rate .................................6-38 Reimbursement More Than Federal Rate .......................................6-38

Nonaccountable Plans ....................................................................6-41 Non-Reimbursed Employee Expenses...........................................................6-42

When an Employee Needs to File Form 2106 ...........................................6-42 Self-Employed Persons ..............................................................................6-42

Expenses Related to Taxpayer's Business ................................................6-42 Expenses Incurred on Behalf of a Client & Reimbursed ..............................6-43

Meal & Entertainment Expenses .........................................................6-43 With Adequate Accounting ..............................................................6-43 Without Adequate Accounting .........................................................6-43

Non-Entertainment Expense Deduction ...............................................6-44 Employers ................................................................................................6-45

When Can an Expense Be Deducted? ......................................................6-45 Economic Performance Rule ...............................................................6-45

Corporation .........................................................................................6-45 Nondeductible Meals .............................................................................6-45 Employer Provided Auto ........................................................................6-45

CHAPTER 7 - Retirement Plans ..................................... 7-1 Deferred Compensation .................................................................................7-1

Qualified Deferred Compensation ................................................................7-1 Qualified v. Nonqualified Plans ...............................................................7-1 Major Benefit .......................................................................................7-1

Current Deduction ............................................................................7-2 Timing of Deductions ........................................................................7-2 Part of Total Compensation ...............................................................7-2

Compensation Base ..............................................................................7-2 Salary Reduction Amounts .................................................................7-3

Benefit Planning ...................................................................................7-3 Corporate Plans ...................................................................................7-4

Advantages .....................................................................................7-4 Current ........................................................................................7-4 Deferred ......................................................................................7-4

Disadvantages .................................................................................7-5 Employee Costs ............................................................................7-5 Comparison with IRAs & Keoghs .....................................................7-5

Basic ERISA Provisions ..........................................................................7-5 ERISA Reporting Requirements ..........................................................7-6 Fiduciary Responsibilities ...................................................................7-6

Bonding Requirement ....................................................................7-7 Prohibited Transactions .....................................................................7-7

Additional Restrictions ...................................................................7-7 Fiduciary Exceptions ......................................................................7-8 Loans ..........................................................................................7-8

Employer Securities ..........................................................................7-9 Excise Penalty Tax ............................................................................7-10 PBGC Insurance ...............................................................................7-10

Sixty-Month Requirement ...............................................................7-10

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Recovery Against Employer ............................................................7-10 Termination Proceedings ...................................................................7-10 Plans Exempt from PBGC Coverage ....................................................7-11

Basic Requirements of a Qualified Pension Plan .............................................7-12 Written Plan ........................................................................................7-12

Communication ................................................................................7-12 Trust ..................................................................................................7-13

Requirements ..................................................................................7-13 Permanency ........................................................................................7-13 Exclusive Benefit of Employees ..............................................................7-14

Highly Compensated Employees .........................................................7-14 Reversion of Trust Assets to Employer ................................................7-14

Participation & Coverage .......................................................................7-14 Age & Service ..................................................................................7-15 Coverage ........................................................................................7-15

Percentage Test ............................................................................7-16 Ratio Test ....................................................................................7-16 Average Benefits Test ....................................................................7-16 Numerical Coverage ......................................................................7-17 Related Employers ........................................................................7-17

Vesting ...............................................................................................7-18 Full & Immediate Vesting ..................................................................7-18 Minimum Vesting .............................................................................7-18 Nondiscrimination Compliance ...........................................................7-20

Contribution & Benefit Limits .................................................................7-20 Defined Benefit Plans (Annual Benefits Limitation) - §415 .....................7-21 Defined Contribution Plans (Annual Addition Limitation) - §415 ..............7-21 Limits on Deductible Contributions - §404 ...........................................7-22

Assignment & Alienation .......................................................................7-22 Miscellaneous Requirements ..................................................................7-23

Basic Types of Corporate Plans ...................................................................7-24 Defined Benefit ....................................................................................7-24

Mechanics .......................................................................................7-24 Defined Benefit Pension ....................................................................7-25

Defined Contribution .............................................................................7-25 Mechanics .......................................................................................7-25 Discretion ........................................................................................7-25 Favorable Circumstances ...................................................................7-26

Types of Defined Contribution Plans ........................................................7-26 Profit Sharing ..................................................................................7-26

Requirements for a Qualified Profit Sharing Plan................................7-26 Written Plan ..............................................................................7-27 Eligibility ...................................................................................7-27 Deductible Contribution Limit .......................................................7-27 Substantial & Recurrent Rule .......................................................7-27

Money Purchase Pension ...................................................................7-28 Cafeteria Compensation Plan .............................................................7-30 Thrift Plan .......................................................................................7-30 Section 401(k) Plans ........................................................................7-31

Death Benefits .....................................................................................7-33 Defined Benefit Plans ........................................................................7-33

x x

Money Purchase Pension & Target Benefit Plans ...................................7-33 Employee Contributions ........................................................................7-33

Non-Deductible ................................................................................7-34 Life Insurance in the Qualified Plan .........................................................7-34

Return ............................................................................................7-34 Universal Life ...................................................................................7-34 Compare .........................................................................................7-35

Plan Terminations & Corporate Liquidations .............................................7-35 10-Year Rule ...................................................................................7-35 Lump-Sum Distributions ....................................................................7-35 Asset Dispositions ............................................................................7-36 IRA Limitations ................................................................................7-36

Self-Employed Plans - Keogh ......................................................................7-36 Contribution Timing ..............................................................................7-37 Controlled Business ..............................................................................7-37

General Limitations ..........................................................................7-38 Effect of Incorporation ..........................................................................7-38

Mechanics .......................................................................................7-39 Parity with Corporate Plans.............................................................7-40 Figuring Retirement Plan Deductions For Self-Employed .....................7-40

Self-Employed Rate ....................................................................7-40 Determining the Deduction .........................................................................7-41 Individual Plans - IRA‘s ..............................................................................7-42

Deemed IRA ........................................................................................7-42 Mechanics ...........................................................................................7-42

Phase-out........................................................................................7-43 Special Spousal Participation Rule - §219(g)(1) ...................................7-43 Spousal IRA .....................................................................................7-45

Eligibility .............................................................................................7-45 Contributions & Deductions ...................................................................7-45

Employer Contributions .....................................................................7-46 Retirement Vehicles ..............................................................................7-46 Distribution & Settlement Options ..........................................................7-47

Life Annuity Exemption .....................................................................7-47 Minimum Distributions ......................................................................7-47

Required Minimum Distribution .......................................................7-48 2009 Waiver of Required Minimum Distribution Rules .....................7-48 Definitions .................................................................................7-48 Distributions during Owner‘s Lifetime & Year of Death after RBD ......7-49 Sole Beneficiary Spouse Who Is More Than 10 Years Younger ..........7-51 Distributions after Owner‘s Death .................................................7-51

Inherited IRAs .................................................................................7-54 Estate Tax Deduction .....................................................................7-55 Charitable Distributions from an IRA ................................................7-55

Post-Retirement Tax Treatment of IRA Distributions .................................7-55 Income In Respect of a Decedent .......................................................7-56 Estate Tax Consequences ..................................................................7-56 Losses on IRA Investments ...............................................................7-56

Prohibited Transactions .........................................................................7-57 Effect of Disqualification ....................................................................7-57 Penalties .........................................................................................7-57

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Borrowing on an Annuity Contract ..........................................................7-57 Tax-Free Rollovers ...............................................................................7-58

Rollover from One IRA to Another ......................................................7-59 Waiting Period between Rollovers ....................................................7-59 Partial Rollovers ............................................................................7-59

Rollovers from Traditional IRAs into Qualified Plans ..............................7-59 Rollovers of Distributions from Employer Plans .....................................7-59

Withholding Requirement ...............................................................7-60 Waiting Period between Rollovers ....................................................7-60 Conduit IRAs ................................................................................7-60 Keogh Rollovers ............................................................................7-60 Direct Rollovers From Retirement Plans to Roth IRAs .........................7-61

Rollovers of §457 Plans into Traditional IRAs .......................................7-61 Rollovers of Traditional IRAs into §457 Plans .......................................7-61 Rollovers of Traditional IRAs into §403(B) Plans ...................................7-62 Rollovers from SIMPLE IRAs ..............................................................7-62

Roth IRA - §408A .................................................................................7-63 Eligibility .........................................................................................7-64 Contribution Limitation .....................................................................7-64

Roth IRAs Only .............................................................................7-64 Roth IRAs & Traditional IRAs ..........................................................7-64

Conversions .....................................................................................7-66 Recharacterizations ..........................................................................7-67 Reconversions .................................................................................7-67 Taxation of Distributions ...................................................................7-67

No Required Minimum Distributions .................................................7-68 Simplified Employee Pension Plans (SEPs) ....................................................7-68

Contribution Limits & Taxation ...........................................................7-71 SIMPLE Plans ............................................................................................7-71

SIMPLE IRA Plan ..................................................................................7-72 Employee Limit ................................................................................7-72 Other Qualified Plan ..........................................................................7-72 Set up ............................................................................................7-73 Contribution Limits ...........................................................................7-73

Salary Reduction Contributions .......................................................7-73 Employer Matching Contributions ....................................................7-74

Deduction of Contributions ................................................................7-74 Distributions ....................................................................................7-74

SIMPLE §401(k) Plan ............................................................................7-74

CHAPTER 8 - Insurance ................................................ 8-1 Company Paid Insurance ................................................................................8-1

Popularity .................................................................................................8-1 Types of Life Insurance ..................................................................................8-2

Group Term Life - §79 ...............................................................................8-2 Requirements ......................................................................................8-2 Cost Of Group-term Life Insurance .........................................................8-2 ―Key Employee‖ Defined........................................................................8-3

Retired Lives Reserve ................................................................................8-3 Revenue Ruling 68-577 .........................................................................8-4

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Taxation..............................................................................................8-4 Split Dollar Life .........................................................................................8-4

Low Cost Term Insurance ......................................................................8-5 Regulatory Requirements ......................................................................8-5 Taxation..............................................................................................8-5

Death Benefit Only Plan - Repealed .............................................................8-5 Business Travel Accident Insurance .............................................................8-6 Medical & Dental Insurance ........................................................................8-6

Premiums ............................................................................................8-6 Disability Income Insurance........................................................................8-6

Repeal of Exclusion ..............................................................................8-7 Tax Credit for Disabled .........................................................................8-7

Interest Limitation on Policy Loans - §264 ........................................................8-7 Deductibility of Premiums & Interest on Life Insurance ..................................8-7

Exclusion Of Inside Buildup & Amounts Received ......................................8-7 Premium Deduction Limitation ...............................................................8-7 Interest Deduction Disallowance With Respect To Life Insurance ................8-8

Prorata Disallowance of Interest on Debt to Fund Life Insurance ............8-9 Interest Limitation for Tax-Exempt Interest Income ...........................................8-12 Other Selected Insurances .............................................................................8-13

Self-Employed Health Insurance Deduction ..................................................8-13 Long-Term Care Premiums .........................................................................8-13 Capitalized Insurance ................................................................................8-14 Health Savings Accounts ............................................................................8-14 Small Business Health Insurance Expense Tax Credit - §45R ..........................8-14

CHAPTER 9 - Estate Planning ....................................... 9-1 Unlimited Marital Deduction ........................................................................9-2

Outright To Spouse ..............................................................................9-3 Marital Deduction Trust .........................................................................9-3 Qualified Terminable Interest Property Trust ............................................9-3

Applicable Exclusion Amount ......................................................................9-4 Spousal Portability of Unused Exemption Amount - §2010(c)(2) .................9-5

Stepped-up Basis & Modified Carryover Basis ...............................................9-6 Modified Carryover Basis - §1022 ...........................................................9-7 Limited Basis Increase for Certain Property .............................................9-8

2010 Special Election ........................................................................9-8 Basic Estate Planning Goals ........................................................................9-9 Primary Dispositive Plans ...........................................................................9-9

Simple Will ..........................................................................................9-9 Danger for Larger Estates .................................................................9-10 Probate ...........................................................................................9-10 Assets Not Subject to a Will ...............................................................9-10 Assets Subject to a Will .....................................................................9-11

Trusts ......................................................................................................9-11 Types of Trusts ....................................................................................9-12

Living Trusts ....................................................................................9-12 Testamentary Trusts .........................................................................9-12 Revocable & Irrevocable ....................................................................9-12

Living ―A-B‖ Revocable Trust .................................................................9-12

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Living ―A-B-C‖ (QTIP) Trust ...................................................................9-14 Impact of Spousal Portability on Trust B under TUIRJCA ............................9-15

Charitable Trusts .......................................................................................9-15 Charitable Remainder Trusts ..................................................................9-15 Charitable Income Trusts ......................................................................9-16

Insurance Trusts .......................................................................................9-16 Family Documents .....................................................................................9-17

Living Will ...........................................................................................9-18 Property Agreement & Inventory ............................................................9-18 Durable Power Of Attorney ....................................................................9-19

Power of Attorney for Health Care ......................................................9-19 Conservatorship ...................................................................................9-19 Funeral Arrangements ..........................................................................9-20 Anatomical Gifts ...................................................................................9-20

Private Annuity .........................................................................................9-20 Advantages to the Transferor .................................................................9-21 Disadvantages to the Transferor ............................................................9-21 Advantages to the Transferee ................................................................9-21 Disadvantages to the Transferee ............................................................9-21

Business Valuation ....................................................................................9-22 Relevant Facts .....................................................................................9-23 Revenue Ruling 59-60 ..........................................................................9-23 Tangible Assets ....................................................................................9-25

Special Real Estate Election - §2032A .................................................9-25 Limitations ...................................................................................9-26 Related Party Cash Lease ...............................................................9-27

Intangible Assets & Goodwill ..................................................................9-27 R.R. 68-609 .....................................................................................9-27

Land Subject To Conservation Easement - §2032A(c)(8) ...........................9-28 Family Member ................................................................................9-29 Indirect Ownership of Land ................................................................9-29 Qualified Conservation Easement .......................................................9-29

Qualified Real Property Interest ......................................................9-29 Qualified Organization ....................................................................9-30 Conservation Purpose ....................................................................9-30

No Additional Income Tax Deduction...................................................9-30 Valuation Discounts ..............................................................................9-31

Minority Interests .............................................................................9-31 Special Valuation plus Minority Discount ...........................................9-33

Fractional Interests ..........................................................................9-34 Lack of Marketability .........................................................................9-34 Swing Vote Premium ........................................................................9-35

Buy-Sell Agreements ............................................................................9-35 Redemptions Under §303 ...........................................................................9-36

Requirements ......................................................................................9-37 Corporate Accumulation For §303 Redemption .........................................9-38 Accumulation in Anticipation of Shareholder‘s Death .................................9-38

Death of a Spouse .....................................................................................9-39 Bypass Trust........................................................................................9-40

Lifetime Dispositions ..................................................................................9-40 Gifts ...................................................................................................9-41

x x i v

Stock Redemptions Under §302 .............................................................9-41 Substantially Disproportionate Redemption - 80/50 Rule .......................9-41 Redemptions Not Essentially Equivalent to a Dividend ...........................9-42 Complete Redemptions .....................................................................9-42 Constructive Ownership - §318 ..........................................................9-42

Double Attribution .........................................................................9-43 Stock Attribution in Complete Redemptions ......................................9-43

Stock Recapitalization ...........................................................................9-44 Section 306 Taint .............................................................................9-45

Deferred Compensation Agreements .......................................................9-45 Installment Payment of Federal Estate Taxes - §6166 ....................................9-46

Computation ........................................................................................9-47 Eligibility & Court Supervision ................................................................9-47 Closely Held Business ...........................................................................9-48 Acceleration of Payment ........................................................................9-48

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CHAPTER 1

Structure, Reporting &

Accounting

Introduction

The entrepreneurial spirit runs deep in America. The country is filled

with people who want to be their own bosses, but no business is entirely a one-man or one-woman show. Every businessperson has

a powerful uncle - Uncle Sam - who plays a role in the enterprise.

Often he is a rich, benevolent uncle, bestowing benefits on the

business. The nation‘s tax laws are intended to encourage people to start new businesses and are chock full of incentives and tax

breaks, and in the current political climate Washington seems to

want to offer even more encouragement to business.

But Uncle Sam can also be tough, not only requiring that Americans

render unto Caesar but also that they do it properly, keeping an eye on every jot and title of the tax code. This means not only

paying taxes on time but also meeting what can be onerous reporting requirements, and following tough provisions that are

intended to make sure all employees are treated equitably. Business owners who want to take advantage of certain tax breaks

or benefits for themselves – retirement and health plans, for example - may also have to make those benefits available to

employees. Whether that is financially feasible or desirable may depend on the type of business, the type of workforce employed,

and what competitors off their employees.

The purpose of this book is to help tax professionals help their

clients take advantage of the opportunities offered by the tax code

and, at the same time, avoid its pitfalls. Because of the laws‘ complexities, the best way to accomplish these goals will have to be

mapped out individually, business by business. This book will

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examine the choices and considerations needed to put together a

tax-smart individual business plan.

Types of Business Organizations

When organizing a new business, one of the most important

decisions to be made is choosing the structure of the business. The simplest structure is a sole proprietorship. That is for the one-man

band. When more than one person is involved in a business, the owners need to decide whether a partnership or corporation - either

an S corporation or a regular C corporation - or a limited liability company is most appropriate.

Factors to consider in deciding upon the structure for a particular business organization include:

(1) Legal restrictions,

(2) Liabilities assumed,

(3) Type of business operation,

(4) Earnings distribution,

(5) Capital needs,

(6) Number of employees,

(7) Tax advantages or disadvantages, and

(8) Length of business operation.

Many alternatives are available to the new business regarding the

legal form it should take. Likewise, an existing business may find it desirable to change forms. There are advantages and

disadvantages to any business form that are too numerous to become the subject of a single book.

Following are selected advantages and disadvantages of setting up a business as a sole proprietorship, partnership, or corporation.

Sole Proprietorships

A sole proprietorship is an unincorporated business that is owned by one individual. It is the simplest form of business organization to

start and maintain. Some sole proprietorships are full-time businesses in almost any field of endeavor. Others are sideline

activities, like an executive who does a bit of private consulting work or an employed person who longs to get into the arts and

manages to sell a painting, say, or a short story. Such a person may not think of herself as a business owner, but the IRS does if

her net earnings from self employment are $400 or more in a year.

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(On the other hand, if she reports a loss year after year, it may

decide she is a hobbyist, not a businessperson at all, and deny those losses.)

The business has no existence apart from its owner. Its liabilities are the owner‘s personal liabilities, and the owner undertakes the

risks of the business for all assets owned, whether or not used in the business. The artist‘s risks may not be great, but a business

involved in manufacturing or construction, for example, may entail risk, and therefore, owners of such businesses may want to

consider another form for business structure.

Schedules C & C-EZ

The owner of a sole proprietorship reports the income and expenses of the business on Schedule C of his or her personal

tax return, even if filing jointly. If a husband and wife jointly own and operate an unincorporated business and share in the profits

and losses, they are partners in a partnership, whether or not they have a formal partnership agreement. They cannot use

Schedule C or C-EZ, but must file Form 1065 instead. However, if two spouses own two separate businesses, they may include

two forms C or C-EZ on their return. Or, if one spouse owns a business, he or she may employ the other and still be eligible to

file as a sole proprietor.

A relatively simple small business may be eligible to use the abbreviated Schedule C-EZ instead of the longer Schedule C

when reporting a business profit or loss. The deductible business expense threshold for filing Schedule C-EZ of the Form 1040 for

the tax year is $5,000. This change allows an additional 500,000 small businesses to file the C-EZ rather than Schedule C,

according to the IRS.

Schedule C-EZ, Net Profit from Business (Sole Proprietorship), is

the simplified version of Schedule C, Profit or Loss from Business (Sole Proprietorship). It consists of an instruction page and a

one-page form with three short parts - General Information, Figure Your Net Profit, and Information on Your Vehicle. The

instruction page includes a worksheet for figuring the amount of deductible expenses. If that amount does not exceed $5,000, a

taxpayer should be able to use the C-EZ instead of Schedule C.

The more complex Schedule C is two pages long and is divided into five parts - Income, Expenses, Cost of Goods Sold,

Information on Your Vehicle, and Other Expenses - and a section for general information. It requests more detailed information

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than does the C-EZ. The instruction package is nine pages long.

Schedule C must be used when deductible business expenses exceed $5,000.

Self-Employment Taxes

In addition to being liable for income taxes, self-employed people are liable for self-employment tax (SECA) to cover Social

Security and Medicare. In fact, they are liable for both the

employer‘s and employee‘s shares of these taxes, which normally means a combined rate of 15.3% on income up to the

annually adjusted base ($117,000 in 2014). This 15.3% rate is a total of 12.4% for social security (old-age, survivors, and

disability insurance or OASDI) and 2.9% for Medicare (hospital insurance or MHI). All net earnings of at least $400 are subject

to the Medicare part, so that earnings above $117,000 (in 2014) are taxed for Medicare.

Note: TRUIRJCA temporarily reduced the OASDI tax rate under

the SECA tax by two percentage points to 10.4% for 2012,

resulting in a total rate of 13.3% (10.4% for OASDI and 2.9%

for HI).

The net cost to the taxpayer is not as high as those numbers

would indicate. The reason is that self-employed people then get to deduct half their self-employment tax as an above-the-line

deduction on the Form 1040. That is intended to put them on a par with other employers, who are allowed to deduct the Social

Security and Medicare taxes they pay on behalf of their employees. If a sole proprietorship employs other people, the

owner must also pay employment taxes for them.

Estimated Tax Payments

Self employed persons are also subject to estimated tax payments, which must reflect self-employment taxes as well as

federal income taxes. These estimated payments are made

quarterly and must equal the lesser of 100% (for some years it has been higher where the taxpayer‘s AGI is greater than

$150,000) of the prior year‘s tax liability or 90% of the current year‘s liability in order to avoid the penalties for under payment

of estimated tax by individuals.

Special Rule for 2009: Effective February 17, 2009, the

American Recovery & Reinvestment Act provided that the

required annual estimated tax payments of a qualified individual

for taxable years beginning in 2009 could not be greater than

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90% of the tax liability shown on the tax return for the

preceding taxable year.

The federal tax payment must be made with Form 1040-ES by the 15th day of April, June, September, and January of the

following year. Any remaining tax due (or refund) is reported on Form 1040, individual income tax return, on the following April

15th.

Advantages

The advantages of a sole proprietorship are:

(1) Organizational costs should be low;

(2) Legal, accounting, and administrative fees are lower;

(3) State and federal income taxes may be lower; and

(4) Administration is less complicated.

Disadvantages

The disadvantages of a sole proprietorship are:

(1) Personal liability,

(2) Inability to income split,

(3) Limited fringe benefits, and

(4) Self-employment tax.

Partnerships

A partnership is the relationship existing between two or more

persons who join to carry on a trade or business. Each person contributes money, property, labor, or skill, and expects to share in

the profits and losses of the business.

There are several types of partnerships. The two most common

types are general and limited partnerships. A general partnership can be formed simply by an oral agreement between two or more

persons, but a legal partnership agreement drawn up by an

attorney is highly recommended. Legal fees for drawing up a partnership agreement are higher than those for a sole

proprietorship, but may be lower than incorporating. A partnership agreement could be helpful in solving any disputes. However,

partners are responsible for the other partner‘s business actions, as well as their own.

Agreement

A Partnership Agreement should include the following:

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(1) Type of business,

(2) Amount of equity invested by each partner,

(3) Division of profit or loss,

(4) Partners‘ compensation,

(5) Distribution of assets on dissolution,

(6) Duration of partnership,

(7) Provisions for changes or dissolving the partnership,

(8) Dispute settlement clause,

(9) Restrictions of authority and expenditures, and

(10) Settlement in case of death or incapacitation.

General Tax Aspects

The tax particulars of partnerships are outlined in subchapter K of the Internal Revenue Code (§701 through §761, inclusive).

Partnership profits (and other income and gains) are not taxed to the partnership. Except for certain items that must be stated

separately, a partnership determines its income in basically the same way that an individual does (§701; §703(a)).

The partnership, not the partners, makes most choices about how to compute income. These include choices for accounting

methods, depreciation methods, accounting for specific items

such as depletion, amortization of certain organization fees, amortization of business start-up costs of the partnership, and

reforestation expenditures, installment sales, and nonrecognition of gain on involuntary conversions of property.

In determining a partner‘s income tax for the year (on their own income tax return), a partner must take into account their

distributive share (whether or not it is distributed) of partnership items. These items are furnished to the partner on Schedule K-1

(Form 1065).

Partners must treat partnership items in the same way on their

individual tax returns as the items are treated on the partnership return. If a partner treats an item differently on their individual

return, the IRS can automatically assess and collect any tax and penalties that result from adjusting the item to make its

treatment consistent with the treatment on the partnership

return. However, this does not apply if a partner files Form 8082 with their return identifying the different treatment (§6222).

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Form 1065

A partnership must file an annual information return, Form

1065 – U.S. Partnership Return of Income, to report the income, deductions, gains, losses, etc., from its operations,

but it does not pay income tax. Rather, it ―passes through‖ any profits or losses to its partners. Partners must include

partnership items on their tax returns. Because partners are not employees of the partnership, no withholding is taken out

of their distributions to pay the income and self-employment taxes on their Forms 1040. The partners may need to pay

Estimated Tax Payments using Form 1040-ES.

Except as provided in the instructions, every domestic partnership must file Form 1065, unless it neither receives

income nor incurs any expenditure treated as deductions or credits for Federal income tax purposes.

Entities formed as LLC‘s that are classified as partnerships for Federal income tax purposes must file Form 1065. Special

rules apply for a religious or apostolic organization exempt from income tax under section 501(d) that must file Form

1065 to report its taxable income.

Limited Partnerships

There are two basic types of partnerships. These are limited partnerships and general partnerships.

Under prior law it really didn‘t matter which one provided income or losses to the individual. However, since TRA ‗86, passive and

active items of income deduction, credit, gain, and loss are effectively segregated for tax purposes (§469).

Investing in a limited partnership could best be described as ―buying stock‖ in the partnership. As with a stockholder, the

limited partner is essentially just along for the ride. They generally do not participate in the management of the

partnership and in return are afforded limited liability.

Passive Presumption

All income, loss, and other items received by the limited partner from the partnership are presumed to be of a passive

character.

Prior to TRA ‗86, an important reason to invest in limited partnerships was the generation and pass through of losses

that could then be used by the limited partner to shelter other

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income. The effect of TRA ‗86 was to eliminate such sheltering

tactics for non-corporate taxpayers, personal service corporations, partnerships, and S corporations. The effective

use of these shelters was also reduced for closely held corporations and made it substantially more difficult for larger

corporations as well. The AMT, passive loss limitations and at risk rules combine to make this quite a formidable nut to

crack.

At Risk Rules - §465

At-risk rules apply to most trade or business activities, including activities conducted through a partnership, or activities for the

production of income. The at-risk rules limit the amount of loss a partner can deduct to the amounts for which that partner is

considered at risk in the activity (§465(a); §465(c)).

Financing

A partner is considered at risk for the amount of money and the adjusted basis of any property he or she contributed to

the activity, income retained by the partnership, and certain amounts borrowed by the partnership for use in the activity.

However, a partner generally is not considered at risk for amounts borrowed unless that partner is personally liable for

the repayment or the amounts borrowed are secured by the partner‘s property other than property used in the activity

(§465(b); §752).

Note: If real estate financing is provided by someone who is

regularly and actively engaged in the business of lending money

(provided that such person is neither the seller nor promoter of

the property), or by a federal, state or local government, the

investment is considered to be at risk and the losses are

permitted.

A partner is not considered at risk for amounts that are

protected against loss through guarantees, stop-loss

agreements, or other similar arrangements. The partner is also not at risk for amounts borrowed if the lender has an

interest in the activity (other than as a creditor) or if the lender is related to a person (other than the partner) having

an interest (§465(b)(3)(A); §465(b)(4)).

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Passive Loss Limitations - §469

A partner‘s loss deduction from a limited partnership interest

may also be disallowed under §469 (passive loss limitation rules). The IRS is now using the old ―divide and conquer‖ theory

and it would appear that they have been rather successful at it. Section 469 now requires taxpayers to divide their activities into

three ―buckets:‖

Passive: Income or loss from a trade or business in which

the taxpayer does not materially participate (including non-business activities under §212), are passive items;

Portfolio: Annuity income, interest, dividends, guaranteed

payments for return on capital, royalties not derived in the ordinary course of a trade or business, gains and losses from

the disposal of related assets, etc., are portfolio items; and,

Material Participation: All earned income such as salaries,

wages, self employment income or loss from a business or trade in which the taxpayer materially participates,

guaranteed payments for services rendered, etc., are all active items.

Active/Passive Determination

Participation in an activity is determined annually, and limited

partnership income is conclusively presumed to be passive income to the recipient limited partner. As a general rule,

passive activity losses may only offset passive activity income. In determining net passive activity income for a

given year, all items of income and loss from passive sources are aggregated. All suspended deductions are carried forward

indefinitely.

Triggering Suspended Losses

Only one reasonably high quality ―out‖ was left for us. That is, upon final disposition (disposition must be total) of a passive

activity interest, all suspended loss deductions are triggered and become available in that year.

These suspended loss deductions must be applied against income or gain in the following order (§469(g)(1)):

(1) First, gain from the disposition of the passive activity

interest that was terminated;

(2) Second, net income or gain from all other passive

activities; and

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(3) Third, any other income items, from whatever source.

The above rules apply only when the passive activity interest is disposed of in a taxable transaction (i.e. an outright sale).

If the interest is disposed of in a non-taxable manner (such as a §1031 exchange), the suspended losses are deductible only

to the extent of recognized gains. The remaining suspended loss deductions will be recognized upon the sale of the asset

acquired in the non-taxable transaction.

Regular Corporations

In forming a corporation, prospective shareholders transfer money,

property, or both, for the corporation‘s capital stock. A corporation generally takes the same deductions as a sole proprietorship to

figure its taxable income. A corporation can also take special deductions.

The corporate structure is usually the most complex and more costly to organize than the other two business formations. Control

depends on stock ownership. Persons with the largest stock ownership, not the total number of shareholders, control the

corporation. With control of stock shares or 51 percent of stock, a person or group is able to make policy decisions. Control is

exercised through regular board of directors' meetings and annual stockholders‘ meetings. Records must be kept to document

decisions made by the board of directors.

Small, closely held corporations can operate more informally, but record-keeping cannot be eliminated entirely. Officers of a

corporation can be liable to stockholders for improper actions. Liability is generally limited to stock ownership, except where fraud

is involved. Business owners can choose whether to incorporate as a ―C‖ or an ―S‖ corporation.

The profit of a regular, or C, corporation is taxed to the corporation when earned, and then is taxed to the shareholders when

distributed as dividends. However, shareholders cannot deduct any loss of the corporation.

The owners of a corporation may also be employees of the corporation and receive salaries and benefits from it. In that case,

the corporation will issue Forms W2 to them, and they will report that income on their personal Forms 1040, just as any employee

would.

A corporation generally must make estimated tax payments as it earns or receives income during its tax year. After the end of the

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year, the corporation must file an income tax return. Generally, a

corporation must make installment payments if it expects its estimated tax for the year to be $500 or more. Installment

payments are due by the 15th day of the 4th, 6th, 9th, and 12th months of the corporation‘s tax year.

Electronic Federal Tax Payment System (EFTPS)

A corporation may have to deposit taxes using EFTPS. It must

use EFTPS to make deposits of all depository tax liabilities (including social security, Medicare, withheld income, excise, and

corporate income taxes) it incurred in 2014 if it deposited more than $200,000 in federal depository taxes in 2012 or had to

make electronic deposits in 2013. If a corporation first met the $200,000 threshold in 2010, it must begin depositing using

EFTPS in 2014. Once it meets the $200,000 threshold, it must continue to make deposits using EFTPS in later years even if

subsequent deposits are less than the $200,000 threshold.

If a corporation must use EFTPS but fails to do so, it may be

subject to a 10 percent penalty.

Even if a corporation is not required to use EFTPS because it did

not meet the $200,000 threshold, it may voluntarily make deposits using EFTPS. Those that use EFTPS voluntarily will not

be subject to the 10 percent penalty if they make deposits using

a paper coupon.

A corporation that has overpaid its estimated tax for the tax year

may be able to apply for a quick refund. Use Form 4466 to apply for a quick refund of an overpayment of estimated tax. A

corporation can apply for a quick refund if the overpayment is:

(1) At least 10 percent of its expected tax liability, and

(2) At least $500.

Use Form 4466 to figure the corporation‘s expected tax liability

and the overpayment of estimated tax.

File Form 4466 before the 16th day of the 3rd month after the

end of the tax year, but before the corporation files its income tax return. Do not file Form 4466 before the end of the

corporation's tax year. An extension of time to file the corporation's income tax return will not extend the time for filing

Form 4466. The IRS will act on the form within 45 days from the

date it is filed.

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Form 1120 - Corporate Income Tax Return

Unless exempt under section 501 of the Internal Revenue Code,

all domestic corporations in existence for any part of a taxable year (including corporations in bankruptcy) must file an income

tax return whether or not they have taxable income.

Which Form To File

A corporation must generally file Form 1120 to report its income, gains, losses, deductions, credits, and to figure its

income tax liability. However, a corporation may file Form 1120–A if its gross receipts, total income, and total assets are

each under $500,000 and it meets certain other requirements. Also, certain organizations must file special

returns.

When to file. Generally, a corporation must file its income tax

return by the 15th day of the 3rd month after the end of its tax year. A new corporation filing a short-period return must

generally file by the 15th day of the 3rd month after the short

period ends. A corporation that has dissolved must generally file by the 15th day of the 3rd month after the date it

dissolved.

To request a six-month extension of time to file a corporation

income tax return file Form 7004. The IRS will grant the extension to those who complete the form properly, file it,

and pay any tax due by the original due date for the return.

Form 7004 does not extend the time for paying the tax due

on the return. Interest, and possibly penalties, will be charged on any part of the final tax due not shown as a balance due

on Form 7004. The interest is figured from the original due date of the return to the date of payment.

Penalty for Late Filing of Return

A corporation that does not file its tax return by the due date,

including extensions, may be penalized 5 percent of the unpaid tax for each month or part of a month the return is

late, up to a maximum of 25 percent of the unpaid tax. If the corporation is charged a penalty for late payment of tax

(discussed next) for the same period of time, the penalty for

late filing is reduced by the amount of the penalty for late payment. The minimum penalty for a return that is over 60

days late is the smaller of the tax due or $100. The penalty

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will not be imposed if the corporation can show the failure to

file on time was due to a reasonable cause. A corporation that has a reasonable cause to file late must attach a statement to

its tax return explaining the reasonable cause.

Penalty for Late Payment of Tax

A corporation that does not pay the tax when due may be

penalized ½ of 1 percent of the unpaid tax for each month or

part of a month the tax is not paid, up to a maximum of 25 percent of the unpaid tax. The penalty will not be imposed if

the corporation can show that the failure to pay on time was due to a reasonable cause.

Limit on Deduction for Dividends

The total deduction for dividends received or accrued is

generally limited (in the following order) to:

(1) 80 percent of the difference between taxable income

and the 100 percent deduction allowed for dividends received from affiliated corporations, or by a small business

investment company, for dividends received or accrued from 20 percent-owned corporations, then

(2) 70 percent of the difference between taxable income and the 100 percent deduction allowed for dividends

received from affiliated corporations, or by a small business investment company, for dividends received or accrued

from less-than-20 percent-owned corporations (reducing taxable income by the total dividends received from 20

percent-owned corporations).

For exceptions, see Schedule C on Form 1120 and the instructions for Forms 1120 and 1120–A.

Effect of Net Operating Loss

If a corporation has a net operating loss (NOL) for a tax year, the limit of 80 percent (or 70 percent) of taxable income does

not apply. To determine whether a corporation has an NOL,

figure the dividends-received deduction without the 80 percent (or 70 percent) of taxable income limit.

At-Risk Rules for Closely Held Corporations

For the at-risk rules, a corporation is a closely held

corporation if, at any time during the last half of the tax year, more than 50 percent in value of its outstanding stock is

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owned directly or indirectly by, or for, five or fewer

individuals.

To figure if more than 50 percent in value of the stock is

owned by five or fewer individuals, apply the following rules:

1. Stock owned, directly or indirectly, by or for a

corporation, partnership, estate, or trust is considered owned proportionately by its shareholders, partners, or

beneficiaries.

2. An individual is considered to own the stock owned,

directly or indirectly, by or for his or her family. Family includes only brothers and sisters (including half brothers

and half sisters), a spouse, ancestors, and lineal descendants.

3. If a person holds an option to buy stock, he or she is considered to be the owner of that stock.

4. When applying rule (1) or (2), stock considered owned

by a person under rule (1) or (3) is treated as actually owned by that person. Stock considered owned by an

individual under rule (2) is not treated as owned by the individual for again applying rule (2) to consider another

the owner of that stock.

5. Stock that may be considered owned by an individual

under either rule (2) or (3) is considered owned by the individual under rule (3).

Tax Rate Schedule

Most corporations figure their tax by using the following tax

rate schedule. This section discusses an exception to that rule for qualified personal service corporations. Other exceptions

are discussed in the instructions for Schedule J (Form 1120) or Part I (Form 1120–A).

Corporate Tax Rate Schedule

Taxable Income Tax Rate

Less than $50,000 15%

$50,001 to $75,000 25%

$75,001 to $100,000 34%

$100,001 to $335,000 39%

$335,001 to $10,000,000 34%

$10,000,001 to $15,000,000 35%

$15,000,001 to $18,333,333 38%

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$18,333,334 to Infinity 35%

Advantages

A ―C‖ corporation can have several tax advantages over S corporations and unincorporated businesses:

(1) As a separate taxpayer, it can be used to split income between itself and its owner(s), with potentially lower overall

tax rates as a result;

Note: In certain tax brackets, corporate rates are lower than

individual income tax rates.

(2) A ―C‖ corporation can deduct amounts paid for fringe

benefits for its employee/owners, such as medical insurance or medical reimbursement plans, disability insurance, or

group term life insurance;

Note: An S corporation cannot deduct any such expenses paid

on behalf of employees who are 2% (or larger) shareholders,

and unincorporated businesses cannot deduct such payments on

behalf of the owners.

(3) ―C‖ corporations can elect a fiscal tax year; and

Note: ―S‖ corporations and partnerships must generally be on a

calendar year, except for those that were already on a fiscal

year and elected on a timely basis to retain such fiscal year or

new S corporations or partnerships which may be allowed to

elect a year ending in September, October, or November,

instead of the calendar year.

(4) ―C‖ corporations are able to deduct up to 80% of the

dividends (70% of the dividends received if the corporation receiving the dividend owns less than 20% of the distributing

corporation) they receive from investments in other domestic corporations (§243(a)(1)).

Note: The deduction is 100% if the shareholder is a small

business investment company (§243(a)(2)). The dividends

received deduction is not available on dividends received by an

S corporation or an unincorporated business.

Disadvantages

Disadvantages of a ―C‖ corporation include:

(1) Required use of the accrual method of accounting (except

in the case of certain personal service corporations);

Note: ―S‖ corporations and unincorporated businesses can use

the cash method of tax accounting, unless they have inventories

of goods they sell.

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(2) ―C‖ corporations are subject to double taxation where

income is paid out as dividends;

Note: In actual fact, few closely held corporations go through

the formality of paying a dividend.

(3)―C‖ corporations with certain types of income such as interest, dividends, rents and royalties are potentially subject

to the personal holding company tax on such income; and

(4) The difference between a ―C‖ corporation‘s adjusted current earnings and its taxable income is mostly (75%) a tax

preference item for purposes of the alternative minimum tax.

Qualified Personal Service Corporation

A qualified personal service corporation is taxed at a flat rate of 35 percent on taxable income. A corporation is a qualified personal

service corporation if it meets both of the following tests:

1. Substantially all the corporation's activities involve the performance of personal services (as defined earlier under

Personal services).

2. At least 95 percent of the corporation's stock, by value, is

owned, directly or indirectly, by any of the following:

(a) employees performing the personal services,

(b) retired employees who had performed the personal services,

(c) an estate of the employee or retiree described above, or

(d) any person who acquired the stock of the corporation as

a result of the death of an employee or retiree (but only for the 2-year period beginning on the date of the employee's or

retiree's death).

S Corporations

An eligible domestic corporation can avoid double taxation (once to

the corporation and again to the shareholders) by electing to be treated as an S corporation. An S corporation generally is exempt

from federal income tax other than tax on certain capital gains and passive income. Its shareholders include on their tax returns their

share of the corporation‘s separately stated items of income, deduction, loss, and credit, and their share of nonseparately stated

income or loss.

A corporation may not carry a capital loss from, or to, a year for which it is an S corporation.

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Advantages

There are many advantages to an S corporation:

1. An S corporation can distribute its profits to shareholders with only a single tax, whereas a C corporation incurs a

double tax because dividends are not deductible.

Note: Distributions of profits to shareholders, whether or not

the shareholders are active in the business, are not subject to

self-employment tax.

2. The losses of an S corporation are currently deductible by

shareholders; shareholders cannot deduct the losses of a C

corporation. Thus, S corporations provide an opportunity for the owners of a new business who are anticipating initial

losses in the early years to take advantage of both the corporate limited liability and the flow through of losses. If a

C corporation were used, losses could only be used as net operating losses by the C corporation.

3. A new corporation may elect S corporation in its initial year in order for its shareholders to utilize initial losses of the

corporation, even though the shareholders may ultimately want to have the corporation taxed as a regular C

corporation.

4. An S corporation is specifically exempted from the accrual

method rules and can continue use of cash method of accounting, if such method is otherwise available because of

nature of business.

5. If an S corporation stockholder does not actively participate in management of the corporation any income

received will be passive and can be used to offset passive losses.

6. An S corporation provides a corporate shield for liability purposes for those taxpayers who want income and losses

taxed to them, but who do not want the potential liability problems of a partnership.

7. A subchapter S corporation may adopt tax deductible and non-deductible fringe benefit plans. However, there are

special rules and limits applicable to such plans.

8. An interest expense deduction is allowed for funds

borrowed by a shareholder to purchase stock in an S corporation. Such interest constitutes business interest when

the shareholder materially participates in the business.

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9. Also, many difficult problems of C corporations are not

problems for S corporations. For example:

(i) An S corporation is not subject to the alternative

minimum tax; and

(ii) The personal holding company tax under §541 and the

accumulated earnings tax of §531 do not apply to S corporations.

Disadvantages

A subchapter S election has quite a few disadvantages (or

potential disadvantages) that receive remarkably little press. It is important for you to consider these factors before electing S

corporation status:

1. Since there is no corporate tax rate, nonqualified deferred

compensation plans are an impracticality.

2. There is no opportunity to accumulate corporate earnings

in a lower corporate tax bracket. It is difficult for an S corporation to reinvest its profits in the business since current

profits are taxed to shareholders whether they are distributed or not.

3. Split-dollar and other non-deductible fringe benefits for the shareholders cannot be paid for by lower taxed corporate

funds.

4. The 80% dividends received deduction is lost (§243 and §1373(c)-(d)).

5. The state tax laws may not provide for anything like a subchapter S election. Often states that have enacted a

corporate income tax have not adopted a similar provision to the federal Subchapter S. Thus, in some states a Subchapter

S election will not avoid the corporate double tax.

6. A new or dissident shareholder can cause the termination

of the subchapter S election through a disqualified transfer of stock.

7. Neither an S corporation nor a C corporation has the flexibility that partners and partnerships do under §754 to

equalize the outside basis of the owner‘s interest with the inside basis of the entity‘s assets on certain acquisitions of

these interests or on property distributions from the entity to

the owners.

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8. Subchapter S corporations do not enjoy the special

allocation of deductions and basis that are afforded partnerships under §704(b) and (c).

9. All income, except long term capital gains, received by the corporation are taxable to the shareholders whether or not

they are currently distributed.

10. Use of an S corporation results in a loss of lower tax

bracket at the corporate level on the first $75,000 of taxable income.

11. There are restrictions on borrowings by S corporation shareholders from their qualified retirement plans (§4975(d)).

12. If an S corporation shareholder is not a material participant, S corporation losses may only be deducted

against passive profits.

13. More record keeping may be required by an S corporation

because of the need to maintain accurate records for basis in

shareholders stock, to maintain the accumulated adjustments account, and to determine the taxability of distributions.

Limited Liability Company

A limited liability company (LLC) is an entity formed under state law

by filing articles of organization as an LLC. Unlike a partnership, none of the members of an LLC are personally liable for its debts.

An LLC may be classified for Federal income tax purposes as if it

were a sole proprietorship (referred to as an entity to be disregarded as separate from its owner by applying the rules in

regulations §301.7701-3. If the LLC has only one owner, it will automatically be treated as if it were a sole proprietorship (referred

to as an entity to be disregarded as separate from its owner), unless an election is made to be treated as a corporation.

If the LLC has two or more owners, it will automatically be considered to be a partnership unless an election is made to be

treated as a corporation. If the LLC does not elect its classification, a default classification of partnership (multi-member LLC) or

disregarded entity (taxed as if it were a sole proprietorship) will apply. The election referred to is made using the Form 8832, Entity

Classification Election. If a taxpayer does not file Form 8832, a default classification will apply.

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Reporting Summary Chart

IF you are a -

THEN you may be liable for -

Use Form -

Sole proprietor

Income tax 1040 and Schedule C1 or

C-EZ (Schedule

F1 for farm business)

Self-employment tax 1040 and Schedule SE

Estimated tax 1040-ES

Employment taxes:

· Social security and

Medicare taxes and income tax withholding

941 (943 for

farm employees)

· Federal unemployment

(FUTA) tax

940 or 940-EZ

· Depositing employment

taxes

81092

Excise taxes See Excise Taxes

Partnership Annual return of income 1065

Employment taxes Same as sole proprietor

Excise taxes See Excise Taxes

Partner in a

partnership (individual)

Income tax 1040 and

Schedule E3

Self-employment tax 1040 and

Schedule SE

Estimated tax 1040-ES

Corporation

or S corporation

Income tax 1120 or 1120-A

(corporation)3 1120S (S

corporation) 3

Estimated tax 1120-W

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(corporation

only) and 81092

Employment taxes Same as sole

proprietor

Excise taxes See Excise Taxes

S corporation

shareholder

Income tax 1040 and Schedule E3

Estimated tax 1040-ES

1 File a separate schedule for each business.

2 Do not use if you deposit taxes electronically. 3 Various other schedules may be needed

Advantages

The advantages of a partnership include:

(1) Income is taxed to the partners rather than to the partnership;

(2) Distributed income is not subject to double taxation;

(3) Losses and credits generally pass through to partners;

(4) The liability of limited partners is normally limited as in a

corporation;

(5) There can be more than one class of partnership

interests;

(6) Partners can obtain basis for partnership liabilities;

(7) Special allocations are permitted; and

(8) A partnership can be used to transfer value and income

within a family group by making family members partners.

Disadvantages

The disadvantages of a partnership include:

(1) The liability of general partners is not limited;

(2) Partners are taxed currently on earnings even if the earnings are not distributed;

(3) Partners cannot exclude certain tax favored fringe benefits from their taxable income;

(4) Partners may be required to file numerous state individual income tax returns for a multistate partnership

business;

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(5) Built-in gain or loss on property is tagged to contributing

partner; and

(6) In the absence of a business purpose, a partnership must

use either a calendar year or the same year as the partners who own a majority of the interests in the partnership.

Record keeping

Except in a few cases, the law does not require any special kind of records. Taxpayers may choose any suitable record keeping system

that clearly shows income and expenses.

The business one is in affects the type of records needed for federal

tax purposes. A record keeping system should use an accounting method that clearly shows the income of the business for the tax

year. People who are in more than one business should keep a complete and separate set of records for each business.

The record keeping system should include a summary of business transactions. This summary is ordinarily made in accounting

journals and ledgers. These books must show gross income, as well as deductions and credits. For most small businesses, the business

checkbook is the main source for entries in the business books. In

addition, businesses must keep supporting documents.

Why Keep Records?

Everyone in business must keep records. Good records will help do the following:

Monitor the Progress of a Business

Records can show whether a business is improving, which items

are selling, or what changes are needed. Good records can increase the likelihood of business success.

Prepare Financial Statements

Good records are needed to prepare accurate financial

statements. These include income (profit and loss) statements and balance sheets. These statements can help in dealing with a

bank or creditors and help in managing a business.

An income statement shows the income and expenses of the

business for a given period of time. A balance sheet shows the

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assets, liabilities, and your equity in the business on a given

date.

Identify Source of Receipts

A business may receive money or property from many sources.

Records can identify the source of these receipts. It is essential to separate business from nonbusiness receipts and taxable from

nontaxable income.

Keep Track Of Deductible Expenses

People may forget expenses when it is time to prepare a tax return unless they have recorded them as they occur.

Prepare Tax Returns

Records are needed to support the income, expenses, and

credits reported on a return. Generally, these are the same records used to monitor a business and prepare its financial

statements.

Support Items Reported On Tax Returns

Business records need to be filed so they will be available at any time for inspection by the IRS. If the IRS examines a tax return,

it may ask the taxpayer to explain the items reported. A complete set of records will speed up the examination.

Kinds of Records to Keep

Except in a few cases, the law does not require any specific kind of records. That is up to the business, as long as it clearly shows

income and expenses.

The business you are in affects the type of records you need to

keep for federal tax purposes. For example, a corporation should keep minutes of board of directors' meetings, as well as financial

records.

Supporting Documents

A business‘s purchases, sales, payroll, and other transactions generate supporting documents. These documents, including

sales slips, paid bills, invoices, receipts, deposit slips, and canceled checks, contain information that should be recorded in

the business‘s books.

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It is important to keep these documents because they support

the entries in the books and on the business‘s tax return. Keep them in an orderly fashion and in a safe place. For instance,

organize them by year and type of income or expense.

Gross Receipts

Gross receipts are the total income a business receives. It should

keep supporting documents that show the amounts and sources

of its gross receipts. Documents that show gross receipts include the following:

(1) Cash register tapes,

(2) Bank deposit slips,

(3) Receipt books,

(4) Invoices,

(5) Credit card charge slips, and

(6) Form 1099-MISC.

Purchases

Purchases include the items a business buys and resells to

customers. For manufacturers or producers, this includes the cost of all raw materials or parts purchased for manufacture into

finished products. Supporting documents should show the amount paid and that the amount was for purchases. Documents

for purchases include the following:

(1) Canceled checks,

(2) Cash register tape receipts,

(3) Credit card sales slips, and

(4) Invoices.

These records will help determine the value of a business‘s inventory at the end of the year.

Expenses

Expenses are the costs a business incurs (other than purchases)

to carry on its activities. Supporting documents should show the amount paid and that the amount was for a business expense.

Documents for expenses include the following:

(1) Canceled checks,

(2) Cash register tapes,

(3) Account statements,

(4) Credit card sales slips,

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(5) Invoices, and

(6) Petty cash slips for small cash payments.

A petty cash fund allows a business to make small payments

without having to write checks for small amounts. Each time a payment is made from this fund, the person making the

payment should make out a petty cash slip and attach it to the receipt as proof of payment.

Assets

Assets are the property, such as machinery and furniture that a

business owns and uses, and it must keep records to verify certain information about its assets, as well as to figure the

annual depreciation and the gain or loss when assets are sold. Records should show the following information:

(1) When and how the asset was acquired,

(2) Purchase price,

(3) Cost of any improvements,

(4) Section 179 deduction taken,

(5) Deductions taken for depreciation,

(6) Deductions taken for casualty losses, such as losses

resulting from fires or storms,

(7) How the asset was used,

(8) When and how an asset was disposed of,

(9) Selling price, and

(10) Expenses of sale.

The following documents may show this information.

(1) Purchase and sales invoices,

(2) Real estate closing statements, and

(3) Canceled checks.

Note: If there is no canceled check, a taxpayer may be able to

prove payment with certain financial account statements

prepared by financial institutions. These include account

statements prepared for the financial institution by a third party.

These account statements must be highly legible. The following

table lists acceptable account statements.

Substantiation

IF payment is by...

THEN the statement must show the...

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Check Check number.

Amount.

Payee's name

Date the check amount was posted to the account by the financial

institution.

Electronic funds transfer

Amount transferred.

Payee's name.

Date the transfer was posted to the account by the financial institution.

Credit card Amount charged.

Payee's name.

Transaction date.

Proof of payment of an amount, by itself, does not establish that

the taxpayer is entitled to a tax deduction. Taxpayers should

also keep other documents, such as credit card sales slips and invoices, to show that they also incurred the cost.

Business Transactions

A good record keeping system includes a summary of business

transactions, which are shown on the supporting documents just discussed. Business transactions are ordinarily summarized in

books (or a computer program) called journals and ledgers, which

are available at office supply or software stores.

A journal is a book (or a computer program) where each business

transaction shown on the supporting documents is recorded. A business may have to keep separate journals for transactions that

occur frequently.

A ledger is a book (or a computer program) that contains the totals

from all of the journals. It is organized into different accounts.

Whether a business keeps journals and ledgers and how it keeps

them depends on the type of business. For example, a record keeping system for a small business might include the following

items:

(1) Business checkbook,

(2) Daily summary of cash receipts,

(3) Monthly summary of cash receipts,

(4) Check disbursements journal,

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(5) Depreciation worksheet, and

(6) Employee compensation record.

Basic Record keeping

The system used to record business transactions will be more

effective if the bookkeeper follows good record keeping practices, for example, recording expenses when they occur, and

identifying the source of recorded receipts. Generally, it is best

to record transactions on a daily basis.

Business Checkbook

One of the first things a new business should do is to open a

business checking account. The business account should be

separate from the owner‘s personal checking account.

The business checkbook is the basic source of information for

recording the business‘s expenses. All daily receipts should be deposited in the business checking account. The bookkeeper

should check the account for errors by reconciling it.

Consider using a checkbook that allows enough space to

identify the source of deposits as business income, personal funds, or loans. Businesses should also note on the deposit

slip the source of the deposit, and they ought to keep copies of all slips.

Businesses should make all payments by check to document business expenses. A business owner should write checks

payable to himself only when making withdrawals from the business for personal use. Business owners should avoid

writing checks payable to cash. If a check must be written for

cash to pay a business expense, the business ought to include the receipt for the cash payment in its records. If it is not

possible to get a receipt for a cash payment, the business should make an adequate explanation in its records at the

time of payment.

The business account should be used for business purposes

only. Indicate the source of deposits and the type of expense in the checkbook.

Reconciling the Checking Account

When the bookkeeper receives a bank statement, they should

make sure the statement, the checkbook, and the business‘s

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books agree. The statement balance may not agree with the

balance in the checkbook and books if the statement:

(a) Includes bank charges that have not been entered in

the books and subtracted from the checkbook balance, or

(b) Does not include deposits made after the statement

date or checks that did not clear the account before the statement date.

By reconciling the checking account, the business will:

(a) Verify how much money is in the account,

(b) Make sure that the checkbook and books reflect all bank charges and the correct balance in the checking

account, and

(c) Correct any errors in the bank statement, checkbook,

and books.

The checking account should be reconciled each month.

Before reconciling the monthly bank statement, the

bookkeeper should check his own figures, beginning with the balance shown in the checkbook at the end of the previous

month. To this balance, he must add the total cash deposited during the month and subtract the total cash disbursements.

After checking these figures, the result should agree with the checkbook balance at the end of the month. If the result does

not agree, there may have been an error in recording a check or deposit. One can find the error by doing the following:

(a) Adding the amounts on the check stubs and comparing that total with the total in the amount of check column in

the check disbursements journal; and

Note: If the totals do not agree, check the individual

amounts to see if an error was made in the check stub

record or in the related entry in the check disbursements

journal.

(b) Adding the deposit amounts in the checkbook.

Note: Compare that total with the monthly total in the cash

receipt book. If the totals do not agree, check the individual

amounts to find any errors.

If the checkbook and journal entries still disagree, then refigure the running balance in the checkbook to make sure

additions and subtractions are correct.

When your checkbook balance agrees with the balance

figured from the journal entries, one may begin reconciling

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the checkbook with the bank statement. Many banks print a

reconciliation worksheet on the back of the statement.

To reconcile the account, follow these steps.

1. Compare the deposits listed on the bank statement with the deposits shown in the checkbook. Note all differences in

the dollar amounts.

2. Compare each canceled check, including both check

number and dollar amount, with the entry in the checkbook. Note all differences in the dollar amounts. Mark

the check number in the checkbook as having cleared the bank. After accounting for all checks returned by the bank,

those not marked in your checkbook are your outstanding checks.

3. Prepare a bank reconciliation.

4. Update the checkbook and journals for items shown on

the reconciliation as not recorded (such as service charges)

or recorded incorrectly.

At this point, the adjusted bank statement balance should

equal your adjusted checkbook balance. If there are still differences, check the previous steps to find the errors.

Note: Using a computerized system like QuickBooks can

eliminate many errors and save a business owner a great deal of

time.

Bookkeeping Systems

Businesses may use either a single-entry or a double-entry

bookkeeping system. The single-entry system of bookkeeping is the

simplest to maintain, but accounting experts consider the double-entry system better because it has built-in checks and balances to

assure accuracy and control.

Single-Entry

A single-entry system is based on the income statement (profit

or loss statement). It can be a simple and practical system for a

small business just getting started by one person. The system records the flow of income and expenses through the use of:

(1) A daily summary of cash receipts, and

(2) Monthly summaries of cash receipts and disbursements.

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Double-Entry

A double-entry bookkeeping system uses journals and ledgers.

Transactions are first entered in a journal and then posted to ledger accounts. These accounts show income, expenses, assets

(property a business owns), liabilities (debts of a business), and net worth (excess of assets over liabilities). Income and expense

accounts are closed at the end of each tax year. Asset, liability, and net worth accounts are kept open on a permanent basis.

In the double-entry system, each account has a left side for debits and a right side for credits. It is self-balancing because

you record every transaction as a debit entry in one account and

as a credit entry in another.

Under this system, the total debits must equal the total credits

after the journal entries are posted to the ledger accounts. If the amounts do not balance, there is an error and the bookkeeper

must find and correct it.

An example of a journal entry exhibiting a payment of rent in

October is shown next.

General Journal

Date Description of Entry Debit Credit

Oct. 5 Rent expense 780.00

Cash 780.00

Computerized System

There are computer software packages businesses can use for

record keeping. They can be purchased in many retail stores.

These packages are very helpful and relatively easy to use; they require very little knowledge of bookkeeping and accounting.

Businesses that use a computerized system must be able to produce sufficient legible records to support and verify entries

made on their tax returns to determine correct tax liability. To meet this qualification, the machine-sensible records must

reconcile with your books and return. These records must provide enough detail to identify the underlying source

documents.

Businesses must also keep all machine-sensible records and a

complete description of the computerized portion of the record

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keeping system. This documentation must be sufficiently

detailed to show all of the following items:

(1) Functions being performed as the data flows through the

system,

(2) Controls used to ensure accurate and reliable processing,

(3) Controls used to prevent the unauthorized addition, alteration, or deletion of retained records, and

(4) Charts of accounts and detailed account descriptions.

Microfilm

Microfilm and microfiche reproductions of general books of accounts, such as cash books, journals, voucher registers, and

ledgers, are accepted by the IRS for record keeping purposes if they comply with Revenue Procedure 81-46 in Cumulative

Bulletin 1981-2.

Electronic Storage System

Records maintained in an electronic storage system are accepted for record keeping purposes if the system complies with Revenue

Procedure 97-22 in Cumulative Bulletin 1997-1.

An electronic storage system is one that either images hardcopy

(paper) books and records or transfers computerized books and records to an electronic storage media, such as an optical disk.

How Long To Keep Records

Records must be kept as long as they may be needed for the administration of any provision of the Internal Revenue Code.

Generally, this means taxpayers must keep records that support an item of income or deduction on a return until the period of

limitations for that return runs out.

The period of limitations is the period of time in which a taxpayer

can amend a return to claim a credit or refund, or the IRS can assess additional tax. The IRS table below contains the periods of

limitations that apply to income tax returns. Unless otherwise stated, the years refer to the period after the return was filed.

Returns filed before the due date are treated as filed on the due

date.

Period of Limitations

If you... THEN the period

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is...

1. Owe additional tax and situations

(2), (3), and (4), below, do not apply to you

3 years

2. Do not report income that you should report and it is more than

25% of the gross income shown on the return

6 years

3. File a fraudulent return Not limited

4. Do not file a return Not limited

5. File a claim for credit or refund after you filed your return

Later of: 3 years or 2 years after tax

was paid

6. File a claim for a loss from worthless securities or a bad debt

deduction

7 years

Businesses ought to keep copies of all filed tax returns. They help in

preparing future tax returns and making computations if there is a need to file an amended return.

Employment Taxes

If a business has employees, it must keep all employment tax

records for at least four years after the date the tax becomes due or is paid, whichever is later.

Assets

Keep records relating to property until the period of limitations

expires for the year in which a taxable disposition of the property is made. A business must keep these records to figure

any depreciation, amortization, or depletion deduction, and to figure the basis for computing gain or loss when it sells or

otherwise disposes of the property.

Generally, if a business received property in a nontaxable

exchange, its basis in that property is the same as the basis of the property it gave up, increased by any money paid. It must

keep the records on the old property, as well as on the new property, until the period of limitations expires for the year in

which it disposes of the new property in a taxable disposition.

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Records for Nontax Purposes

When business records are no longer needed for tax purposes,

the business ought not to discard them until its principals have checked to see if they have to keep them longer for other

purposes. For example, an insurance company or creditors may require that records be kept longer than the IRS does.

Accounting Periods & Methods

A business must figure taxable income and file a tax return on the basis of an annual accounting period called a ―tax year.‖ Also, it

must consistently use an accounting method that clearly shows its income and expenses for the tax year.

Generally, partnerships, S corporations, and personal service corporations must use ―required tax years.‖ The required tax year

does not have to be used if the partnership, S corporation, or personal service corporation establishes a business purpose for a

different period, or makes a §444 election (§441(i); §706(b); §1378).

Tax Year

A business‘s ―tax year‖ is the annual accounting period it uses to

keep records and report income and expenses on its income tax return. It can use one of the following tax years:

(1) A calendar tax year, or

(2) A fiscal tax year.

Note: A regular fiscal tax year is 12 consecutive months ending

on the last day of any month except December. A 52-53 week

year is a fiscal tax year that varies from 52 to 53 weeks

(§441(a)).

Unless a business has a required tax year, it adopts a tax year

when it files its first income tax return.

A business has not adopted a tax year if it merely did any of the following:

(1) Filed an application for an extension of time to file an income tax return;

(2) Filed an application for an employer identification number; or

(3) Paid estimated taxes for that tax year.

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Section 444 Election

Partnerships, S corporations, and personal service

corporations may elect to use a tax year that is different from the required tax year under §444. This election does not

apply to any partnership, S corporation, or personal service corporation that establishes a business purpose for a different

period.

A partnership, S corporation, or personal service corporation

may make a §444 election if it:

(a) Is not a member of a tiered structure,

(b) Has not previously had a section 444 election in effect,

and

(c) Elects a year that meets the deferral period

requirement (Reg. §1.444-1T(b); Reg. §1.444-2T).

An election to change a tax year will be allowed only if the

deferral period of the elected tax year is not longer than the shorter of:

(a) Three months, or

(b) The deferral period of the tax year being changed

(§444(b); Reg. §1.444-1T(b)(2)).

Business Purpose

A business purpose for a tax year is an accounting period that has a substantial business purpose for its existence. Both tax

and nontax factors must be considered in determining if there is a substantial business purpose for a requested tax year.

A nontax factor that may be sufficient to establish a business purpose for a tax year is the annual cycle of business activity,

called a ―natural business year.‖ The accounting period of a natural business year includes all related income and

expenses. A natural business year exists when a business has a peak period and a non-peak period. The natural business

year is considered to end at or soon after the end of the peak

period. A business whose income is steady from month to month, year-round, would not have a natural business year

as such (Reg. §1.7061(b)(4)(iii); R.P. 74-33).

Changes in Accounting Periods

Generally, one must file Form 1128 to request IRS approval to change the tax year. See the instructions for Form 1128 for

exceptions.

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If a taxpayer qualifies for an automatic approval request, a

user fee is not required. File Form 1128 by the due date (including extensions) for filing the tax return for the short

period required to effect such change. (The short period begins on the first day after the end of the present tax year

and ends on the day before the first day of the new tax year.)

If a taxpayer does not qualify for automatic approval, a ruling

must be requested. See the instructions for Form 1128 for information about user fees when requesting a ruling. File a

current Form 1128 with the IRS national office no earlier than the day following the end of the short period and no later

than the due date (not including extensions) of the tax return for the short period.

Accounting Method

An accounting method is a set of rules used to determine when

and how income and expenses are reported. A business chooses an accounting method when it files its first income tax return.

There are two basic accounting methods.

Cash method. Under the cash method, income is reported in

the tax year in which it is received. Expenses are usually deducted or capitalized in the tax year for which they are

paid.

Accrual method. Under an accrual method, income is generally reported in the tax year in which it is earned, even

though payments may be received in a later year. Expenses are deducted or capitalized in the tax year in which they are

incurred, whether or not the business pays them that year.

If a business needs inventories to show income correctly, it must

generally use an accrual method of accounting for purchases and sales. Inventories include goods held for sale in the normal

course of business. They also include raw materials and supplies that will physically become a part of merchandise intended for

sale.

Certain small business taxpayers can use the cash method of

accounting and can also account for inventoriable items as materials and supplies that are not incidental.

A business must use the same accounting method to figure its

taxable income and to keep its books. Also, it must use an accounting method that clearly shows its income. In general, any

accounting method that consistently uses accounting principles

1- 3 6

suitable for the trade or business clearly shows income. An

accounting method clearly shows income only if it treats all items of gross income and expense the same from year to year.

Note: When an owner has more than one business, they can

use a different accounting method for each business if the

method used for each clearly shows income. They must keep a

complete and separate set of books and records for each

business.

Changing a Business‟s Method of Accounting

Once a business has set up an accounting method, it must generally get IRS approval before it can change to another

method. A change in accounting method not only includes a change in the overall system of accounting, but also a change

in the treatment of any material item.

Inventories

Inventories are necessary to clearly show income when the

production, purchase, or sale of merchandise is an income-producing factor. If a business must account for inventories, it must

use the accrual method of accounting for purchases and sales (Reg. §1.471-1; Reg. §1.446-1(c)(2)(i)).

The value of inventories at the beginning and end of each tax year is required to determine taxable income. To determine the value of

inventory, both a method for identifying the items in inventory and a method for valuing these items is needed.

Identification Methods

There are three methods of identifying items in inventory -

specific identification, first-in first-out (FIFO), and last-in first-out (LIFO).

Specific Identification Method

The specific identification method is used to identify the cost

of each inventoried item by matching the item with its cost of acquisition in addition to other allocable costs, such as labor

and transportation. Under the specific identification method goods are matched with their invoices (less appropriate

discounts) to find the cost of each item.

If there is no specific identification of items with their costs,

an assumption must be made to decide which items were sold and which remain in inventory. Normally, this identification is

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made by either the first-in first-out method, or the last-in

first-out method.

FIFO Method

The first-in first-out (FIFO) method assumes that the items

purchased or produced first are the first items sold, consumed, or otherwise disposed of (Reg. §1.471-2(d)).

The items in inventory at the end of the tax year are valued

as the items most recently purchased or produced. If there is intermingling of the same type of goods in the inventory so

that they cannot be identified with specific invoices, the FIFO method must be used to value these items, unless the last-in

first-out (LIFO) method is elected (see below). Thus, the cost of inventory under the FIFO method is the cost of goods most

recently purchased.

LIFO Method

The last-in first-out (LIFO) method assumes that the items of inventory purchased or produced last are sold or removed

from inventory first. Thus, items included in the closing inventory are considered to be those from the opening

inventory plus those items acquired in the current year in the LIFO order (Reg. §1.472-1a).

The FIFO method and the LIFO method produce different results in income depending on the trend of price levels of the

goods included in those inventories. In times of inflation, when prices are rising, LIFO will produce a larger cost of

goods sold and a lower closing inventory. Under FIFO, the

cost of goods sold will be lower and the closing inventory will be higher. However, in times of falling prices, LIFO will

produce a smaller cost of goods sold and a higher closing inventory. Under FIFO the reverse will be true (Reg. §1.472-

1(b)).

Note: The ‗86 Act adopted tough uniform capitalization rules

that require all manner of indirect expenses to be capitalized

and included in the cost of inventory (for both FIFO and LIFO

taxpayers). Fortunately, small retailers and wholesalers (with

$10 million or less of average annual sales) are exempted.

Valuation Methods

Since valuing the items in inventory is a major factor in figuring

taxable income, the way inventory is valued is very important.

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Several pricing methods, which may be use to figure the correct

cost basis of inventory, are recognized for tax purposes. The dollar value that results is the cost basis of the inventory.

The two common ways to value inventory are:

(1) The cost method (Reg. §1.471-3), and

(2) The lower of cost or market method (Reg. §1.471-4).

The same method must be used to value the entire inventory,

and taxpayers may not change to another method without consent from the IRS.

Cost Method

The cost method is the foundation of inventory valuation and

may be used under any inventory identification method. Under §471, regulations defining ―cost‖ have been issued by

specific industry.

Note: For example, retailers can value each item of

merchandise in stock at the end of the year at its retail selling

price but adjusted to approximate cost by eliminating the

average percent of markup (Reg. §1.471-8(a)). Likewise,

miners and manufacturers who use a single process, and derive

a product of two or more kinds with a unit cost substantially

alike, may allocate a share of total cost to each kind as a basis

for pricing inventories (Reg. 1.471-7).

Generally, however, the cost of merchandise purchased during the year is the cost of acquisition in addition to costs

allocable to the merchandise. Thus, the cost of the goods purchased ordinarily is the invoice price reduced by trade or

other discounts. To this net invoice price should be added

transportation or other necessary charges incurred in acquiring possession of the goods (Reg. 1.471-3(b)).

The costs of goods produced by the taxpayer include the cost of raw materials and supplies entering into or consumed in

manufacture, regular and overtime direct labor costs, and the indirect costs (Reg. 1.471-3(c)).

Uniform Capitalization Rules - §263A

Under the uniform capitalization rules, businesses are

required to capitalize direct costs and an allocable portion of most indirect costs that benefit or are incurred because

of production or resale activities. This means that certain expenses incurred during the year will be included in the

basis of property produced or in inventory costs, rather

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than claimed as a current deduction. These costs will

eventually be recovered through depreciation, amortization, or cost of goods sold when the property is used, sold, or

otherwise disposed of.

Businesses are subject to the uniform capitalization rules if

they:

(i) Produce real or tangible personal property for use in a

trade or business or an activity engaged in for profit,

(ii) Produce real or tangible personal property for sale to

customers, or

(iii) Acquire property for resale, but not personal

property if the average annual gross receipts are not more than $10,000,000 (Reg. §1.263A-IT(a)(1); Reg.

§1.263A-IT(a)(6)(i)).

Lower of Cost or Market Method

Except for businesses using the LIFO method, inventories may be valued at the lower of cost or market. Businesses

using the LIFO method must value inventory at cost.

Lower of cost or market means that the market value of each

item on hand at the inventory date is compared with its cost and the lower value is used as its inventory value (Reg.

§1.471-4(a)).

Under ordinary circumstances and for normal goods, market value means the usual bid price at the date of the inventory.

This price is based on the volume of merchandise usually purchased (Reg. §1.471-4(a)). The courts have uniformly

interpreted ―bid price‖ to mean replacement cost - that is, the price that a taxpayer would have to pay on the open market

to purchase or reproduce the inventory items.

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CHAPTER 2

Business Income, Credits &

Assets

Business Income

If there is a connection between the income a business owner

receives and his or her business, the income is potentially business income. A connection exists if it is clear that the payment of income

would not have been made if the business did not exist.

Overview

A person can have business income even without being involved in

the activity on a regular, full-time basis. Some people do work on the side in addition to being employed in a regular job, and that

sideline work can produce business income.

Typically people who do work for a company but are not employees

of the company are considered outside contractors, and companies report amounts they pay on Form 1099-MISC. This includes

amounts reported as nonemployee compensation in box 7 of the form, and people who receive Form 1099 are expected to report the

income thus reported on their tax returns. This is true regardless of

whether the business is a full-time or sideline activity.

Types of Income

In fact, business owners are required to report on their tax returns all income received from a business unless it is excluded by law,

regardless of whether a form 1099 was received. In most cases, business income will be in the form of cash, checks, and credit card

charges. However, business income can be in other forms, such as

property or services.

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Note: If a U.S. citizen has business income from sources

outside the United States (foreign income), they must report

that income unless it is exempt from tax under U.S. law. If a

U.S. citizen lives outside the United States, they may be able to

exclude part or all of their foreign-source business income.

Barter

Bartering is an exchange of property or services. People who barter are required by law to include in their gross receipts, at

the time received, the fair market value of property or services received in bartering.

If two people exchange services and both have agreed ahead of time on the value of the services, that value will be accepted as

the fair market value unless the value can be shown to be otherwise. Income from bartering is subject to social security

and Medicare taxes (FICA), federal unemployment taxes (FUTA),

and income tax withholding.

Example 1

A self-employed lawyer performs legal services for a

client, a small corporation. In payment for her

services, she receives shares of stock in the

corporation. She must include the fair market value

of the shares in income.

Example 2

An artist creates a work of art to compensate his

landlord for the rent-free use of an apartment. He

must include the fair rental value of the apartment in

his gross receipts. The landlord must include the fair

market value of the work of art in his rental income.

Information Returns

If a taxpayer is involved in a barter transaction, they may have to file either of the following forms:

(1) Form 1099-B, Proceeds From Broker and Barter Exchange Transactions, and

(2) Form 1099-MISC, Miscellaneous Income.

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Rental Income

Rental income is any payment received for the use or occupation

of property. Taxpayers must include in gross income all amounts received as rent. In addition to amounts received as normal rent

payments, there are other amounts that may be rental income.

Individual Lessors

Real estate dealers who receives income from renting real property and owners of hotels, motels, etc., who provides

substantial services (maid services, etc.) for guests, report the rental income and expenses on Schedule C or C-EZ. If

taxpayers are not a real estate dealer or such owners, they report the rental income and expenses on Schedule E, instead

of on Schedule C or C-EZ.

When an individual taxpayer is in the business of renting

personal property (equipment, vehicles, formal wear, etc.), they must include the rent received in gross receipts on

Schedule C or C-EZ.

Advance Rent

Advance rent is any amount received before the period that it covers. Advance rent is included in income in the year

received regardless of the period covered or the method of

accounting used.

Example

Dan signs a 10-year lease to rent Ron’s property. In

the first year, Ron receives $5,000 for the first year’s

rent and $5,000 as rent for the last year of the lease.

Ron must include $10,000 in his income in the first

year.

Lease Bonus

A bonus received from a lessee for granting a lease is an

addition to the rent. Such payments are included in gross receipts in the year it is received.

Security Deposits

A security deposit is not included in income if the taxpayer

plans to return it to the tenant at the end of the lease.

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However, if during any year, the taxpayer keeps part or all of

the security deposit because their tenant does not live up to the terms of the lease, the amount kept is included in income

for that year.

Note: If an amount called a security deposit is to be used as a

final payment of rent, it is advance rent and includible in income

when received.

Payment for Canceling a Lease

If a tenant pays a taxpayer to cancel a lease, the amount

received is rent. The payment is included in income for the

year received regardless of the taxpayer‘s method of accounting.

Payments to Third Parties

If a lessee makes payments to someone else under an

agreement to pay a taxpayer's debts or obligations, the taxpayer must include the payments in their gross receipts

when the lessee makes the payments. A common example of this kind of income is a lessee's payment of the taxpayer's

property taxes on leased real property.

Settlement Payments

Payments received in settlement of a lessee's obligation to restore the leased property to its original condition are

income in the amount that the payments exceed the adjusted basis of the leasehold improvements destroyed, damaged,

removed, or disconnected by the lessee.

Interest

Taxable interest includes interest received from bank accounts, loans made to others, and interest from most other sources.

Interest received on notes receivable that a business owner has accepted in the ordinary course of business is business income.

Interest received on loans is business income if he is in the business of lending money.

Uncollectible Loans

If a loan payable to a business owner becomes uncollectible

during the tax year and he uses an accrual method of accounting, he must include in gross income interest accrued

up to the time the loan became uncollectible. If the accrued

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interest later becomes uncollectible, he may be able to take a

bad-debt deduction.

Below-Market Loans

When a taxpayer makes a below-market loan, they must

report as interest income any foregone interest arising from that loan. If a taxpayer receives a below-market loan, they

may be able to deduct interest expense that is more than any

interest actually paid (§7872).

Installment Sales

Certain deferred payments received under a contract for the

sale or exchange of property provide for interest that is

taxable. If little or no interest is provided for in certain contracts with payments due more than one year after the

date of sale, each payment due more than 6 months after the date of sale will be treated as containing interest. These

unstated interest rules apply to certain payments received on account of a seller-financed sale or exchange of property

(§483; §1274).

Interest on Insurance Dividends

Interest on insurance dividends that are left on deposit with an insurance company, that is credited annually, and that can

be withdrawn annually, is taxable when the interest is credited to a taxpayer‘s account. However, if it is

withdrawable only on the anniversary date of the policy (or other specified date), the interest is taxable in the year in

which that date occurs (Reg. §1.61-7(d)).

Discharge of Debt Income

If a taxpayer‘s debt is canceled or forgiven, other than as a gift, the taxpayer must include the canceled amount in their gross

income (§61(a)(12). A debt includes any indebtedness for which the taxpayer is liable or which attaches to property held by the

taxpayer (§108(d)(1); §108(e)(1); §61(a)(12)).

Exceptions from Income Inclusion

Despite the general rule requiring inclusion of a canceled debt in gross income, taxpayers do not include a canceled debt in

gross income if any of the following situations apply:

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1. The cancellation takes place in a bankruptcy case under

title 11 of the United States Code (§108(a)(1)(A)).

2. The cancellation takes place when the taxpayer is

insolvent. Here, the amount excluded is not more than the amount by which the taxpayer is insolvent at the moment

immediately prior to discharge (§108(a)(1)(B)).

3. The cancellation is a qualified farm debt discharged by

an unrelated lender (§108(a)(1)(C)).

4. The cancellation is real property business debt

(§108(a)(1)(D)).

5. The debt arises from certain student loans (§108(f)).

6. Other circumstances enumerated in §108(e) such as purchase-money debt reduction and cancellation of

deductible debt.

Reduction of Tax Attributes

The amount of canceled debt that does not create income must reduce tax attributes by the amount of such canceled

debt. Tax attributes include ―basis‖ of certain assets, net operating losses, general business credit carryovers,

minimum tax credits, capital losses, passive activity losses and credits, and foreign tax credit carryovers. Reducing the

tax attributes effectively defers the realization of the canceled

debt instead of excluding it.

Note: A bankrupt taxpayer may exclude the amount of

discharge of indebtedness income that exceeds their tax

attributes.

Order of Reductions

Generally, the order for reducing tax attributes is:

(1) Net operating losses,

(2) General business credit carryover,

(3) Alternative minimum tax credits,

(4) Capital losses,

(5) Property basis,

(6) Passive activity loss and credit carryovers, and then

(7) Foreign tax credit carryovers.

The taxpayer may elect to reduce the basis of depreciable property before reducing other tax attributes.

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Sale of Products or Services

Business income is income received for products or services sold.

For example, fees paid to a professional person are considered business income. Rents paid to a person in the real estate

business are business income. Payments received in the form of property or services must be included in income at their fair

market value.

Dividends

Dividends are distributions of money, stock, or other property by a corporation. Dividends may also be received through a

partnership, an estate, a trust, or an association that is taxed as a corporation. However, some amounts that are called dividends

are actually interest income.

Most distributions are paid in cash or by check. However,

distributions may be received as additional stock, stock rights, other property, or services.

Ordinary Dividends

Ordinary (taxable) dividends are the most common type of

distribution from a corporation. They are paid out of the earnings and profits of a corporation and are ordinary income

to the recipient. Most dividends, whether on common or

preferred stock, are ordinary dividends unless the paying corporation states otherwise (§316; Reg. §1.316-1(a);

§61(a)(7); Reg. §1.61-9).

Note: Since 2003, corporate dividends (defined as "qualified

dividends") paid to an individual are no longer taxed at ordinary

income rates; rather, they are taxed at the top rates for capital

gains.

Money Market Funds

Amounts received from money market funds are reported as dividend income. These amounts generally are not

interest income and should not be reported as interest.

Dividends on Capital Stock

Dividends on the capital stock of organizations, such as savings and loan associations, are ordinary dividends. They

are not interest (Reg. §1.116-(d)(1)).

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Dividends Used to Buy More Stock

A corporation may have a dividend reinvestment plan. Such

a plan permits the use of dividends to buy more shares of stock in the corporation instead of receiving the dividends

in cash. Members of this type of plan, who use their dividends to buy additional stock at a price equal to its fair

market value, must report dividends as income (R.R. 77-149).

Qualified Dividends

Qualified dividends receive special favorable tax treatment.

Qualified dividend income received by an individual is taxed at rates substantially lower than ordinary income.

Note: Dividends passed through to investors by a mutual fund

or other regulated investment company (RIC), partnership, real

estate investment trust (REIT), or held by a common trust fund

are also eligible for the reduced rate assuming the distribution

would otherwise be qualified dividend income

The rate for such dividends is 15% (or 20% for high income taxpayers), or 5% for those individuals whose incomes fall in

the 10% or 15% rate brackets (§1(h)(11)). Since 2008, a zero-percent rate applies to taxpayers in the 10% or 15%

income tax brackets.

Note: Under ATRA, for taxpayers with incomes below the 39.6%

income tax bracket, the rates on long-term capital gains and

qualified dividends (0% to 15%) were made permanent.

However, for taxpayers in the 39.6% bracket, the rate on such

items permanently rose to 20% (up from 15%) in 2014

(§1(h)(1)).

"Qualified dividend income" is dividends received from a:

(1) domestic corporation, or

(2) qualified foreign corporation.

In the alternative, taxpayers may elect to treat qualified dividend income as investment income under §163(d)(4) (B).

A taxpayer makes this election on Form 4952, Investment Interest Expense Deduction.

Tax on Net Investment Income - §1411

Since 2013, because of the 2010 health care legislation, a tax is

imposed on net investment income in the case of an individual, estate, or trust. In the case of an individual, the tax is 3.8% of

the lesser of net investment income or the excess of modified

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adjusted gross income over the threshold amount (§1411). The

threshold amount is $250,000 in the case of a joint return or surviving spouse, $125,000 in the case of a married individual

filing a separate return, and $200,000 in any other case. These thresholds are not indexed for inflation.

Note: This provision is treated as a "tax" for purposes of

computing the penalty for underpayment of estimated tax. As a

result, individuals are required to calculate their estimated taxes

according.

Net investment income (NII) is the excess of:

(1) the sum of:

(a) gross income from interest, dividends, annuities,

royalties, and rents, other than such income which is derived in the ordinary course of a trade or business that is

not a passive activity with respect to the taxpayer or a trade or business of trading in financial instruments or

commodities, and

(b) net gain (to the extent taken into account in computing

taxable income) attributable to the disposition of property other than property held in the active conduct of a trade or

business that is not in the trade or business of trading in

financial instruments or commodities, over

(2) deductions properly allocable to such gross income or net

gain.

Recoveries

A recovery is a return of an amount the taxpayer deducted or

took a credit for in an earlier year. Generally, part or all of the

recovered amounts must be included in income in the year the recovery is received.

The most common recoveries are refunds, reimbursements, and rebates of deductions itemized on Schedule A (Form 1040). Non-

itemized deduction recoveries include such items as payments received on previously deducted bad debts, and recoveries on

items previously claimed as a tax credit.

Note: If an individual business owner recovers a bad debt or

any other item deducted in a previous year, include the recovery

in income on Schedule C or C-EZ.

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Example

Joe Smith, a sole proprietor, had gross income of

$8,000, a bad debt deduction of $300, and other

allowable deductions of $7,700. He also had 2

personal exemptions for a total of $6,200. He would

not pay income tax even if he did not deduct the bad

debt. Therefore, he will not report as income any part

of the $300 he may recover in any future year.

If amounts are recovered which were deducted in a previous

year that are attributable to itemized deductions and to non-itemized deductions, recompute taxable income first as shown in

the section below on Non-Itemized Deduction Recoveries before determining the amount to include in income as shown in the

section below on Itemized Deduction Recoveries.

Note: Interest on any of the amounts recovered must be

reported as interest income in the year received.

Recovery & Expense—Same Year: If the refund or other recovery

and the deductible expense occur in the same year, the recovery reduces the deduction and is not reported as income.

Note: Refunds of federal income taxes are not included in

income because they are never allowed as a deduction from

income.

Recovery Attributable to 2 or More Years: If a refund or other

recovery is for amounts paid in 2 or more separate years, the taxpayer must allocate, on a pro rata basis, the recovered

amount between the years in which it was paid.

This allocation is necessary to determine the amount of recovery

attributable to any earlier years and to determine the amount, if any, of allowable deduction for this item for the current year.

Itemized Deduction Recoveries

If any amount is recovered that was deducted in an earlier

year on Schedule A (Form 1040), the taxpayer must determine how much, if any, of the recovery to include in

income. To determine if amounts deducted in 2013 and recovered in 2014 must be included in income, the taxpayer

must know the standard deduction for their filing status in 2013.

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Note: If a state or local income tax refund (or credit or offset) is

received in 2014, the taxpayer may receive Form 1099-G from

the payer of the refund by January 31, 2015. The IRS will

receive a copy of Form 1099-G.

Recovery Limited to Deduction

The amount included in income is limited to the lesser of:

(i) The amount deducted on Schedule A (Form 1040), or

(ii) The amount recovered.

Thus, any recovery amount that exceeds the amount

deducted in the earlier year is not included in income.

Recoveries Included in Income

Amounts deducted will be included in income if:

(i) The recoveries are equal to or less than the amount

by which itemized deductions exceeded the standard deduction for the filing status in the earlier year, and

(ii) Taxable income in the earlier year was zero or more.

However, under the tax benefit rule, recoveries included in

income will not be more than the amount deducted.

Non-Itemized Deduction Recoveries

If amounts recovered are due to both itemized deductions and non-itemized deductions taken in the same year, the

taxpayer must determine the amounts to include in income as follows:

(a) Figure the non-itemized recoveries,

(b) Add the non-itemized recoveries to taxable income,

and then

(c) Figure itemized recoveries.

This order is required because taxable income will change and the taxpayer must use taxable income to figure their itemized

recoveries.

Amounts Recovered for Credits

If a recovery is received in the current tax year for an item claimed as a tax credit in an earlier year, the current tax

year‘s tax must be increased to the extent the credit reduced tax in the earlier year. There is a recovery if there is a

downward price adjustment or similar adjustment on the item

for which a credit was claimed.

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Tax Benefit Rule

If an amount is recovered that the taxpayer deducted or took

a credit for in an earlier year, include the recovery in income only to the extent the deduction or credit reduced tax in the

earlier year.

If a deduction reduced taxable income, but did not reduce tax

because the taxpayer either was subject to the alternative minimum tax or had tax credits that reduced tax to zero, they

will need to recompute the earlier year‘s tax to determine whether they can exclude the recovery amount from income.

Recapture of Depreciation

In the following situations, businesses have to recapture the

depreciation deduction. This means in income part or all of the depreciation deducted in previous years is included in income.

Sale Or Exchange Of Depreciable Property

If depreciable property sold or exchanged at a gain, all or part

of the gain due to depreciation may have to be treated as ordinary income.

Listed Property

If business use of listed property falls to 50% or less in a tax

year after the tax year placed the property in service, a taxpayer may have to recapture part of the depreciation

deduction. Individual business owners do this by including in income on Schedule C part of the depreciation deducted in

previous years.

Section 179 Property

If a §179 deduction is taken for an asset and before the end of the asset's recovery period the percentage of business use

drops to 50% or less, part of the §179 deduction must be recapture . Individual business owners do this by including in

income on Schedule C part of the deduction taken.

Sole Proprietorship Income

A sole proprietorship is the simplest form of business

organization. It has no existence apart from its owner. For example, business debts are personal debts of the owner.

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Sole proprietors must file Form 1040 Schedule C , or Form 1040

Schedule C-EZ , with Form 1040, to report the profit or loss from their business. Also, sole proprietors must file Form 1040

Schedule SE if they had net earnings (from Schedule C or C–EZ) of $400 or more. Schedule SE is used to figure self-employment

tax, which is the combined social security and Medicare tax on self-employment income.

Partnership Income

A partnership generally is not a taxable entity. The income, gains, losses, deductions, and credits of a partnership are

passed through to the partners based on each partner‘s distributive share of these items.

A partnership is an unincorporated business organization that is the result of two or more persons joining together to carry on a

trade or business. Each person contributes a combination of money, property, labor, or skills, and each expects to share in

the profits and losses.

Note: A limited liability company with more than one owner is

generally treated as a partnership for tax purposes.

A partnership‘s income and expenses are generally reported on

Form 1065, an annual information return. No income tax is paid by the partnership itself. Each partner receives a Form 1065

Schedule K-1, which generally allocates the income and expenses among the partners according to the terms of the

partnership agreement.

Partnership Agreement

A partner‘s distributive share of partnership income, gains, losses, deductions, or credits is generally based on the

partnership agreement. A partner must report his distributive share of these items on his tax return whether or not they are

actually distributed to him. However, his distributive share of the partnership losses is limited to the adjusted basis of his

partnership interest at the end of the partnership year in

which the losses took place.

The partnership agreement usually covers the distribution of

profits, losses, and other items. However, if the agreement does not state how a specific item of gain or loss will be

shared, or the allocation stated in the agreement does not

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have substantial economic effect, each partner‘s distributive

share is figured according to his interest in the partnership.

Partnership Return

Although a partnership generally pays no tax, it must file an

information return on Form 1065, U.S. Return of Partnership Income. This shows the result of the partnership‘s operations

for its tax year and the items that must be passed through to

the partners.

Partner‟s Return

Each partner should receive from a partnership a copy of

Schedule K-1 (Form 1065), Partner‘s Share of Income,

Deductions, Credits, etc., showing his or her share of income, deductions, credits, and tax preference items of the

partnership for the tax year. Recipients should retain Schedule K-1 for their records. It is not to be attached attach

to their Forms 1040.

Partners generally must report partnership items on their

individual returns the same way they are reported on the partnership return. That is, if the partnership had a capital

gain, partners report their shares on their Schedules D (Form 1040). Partners report their share of partnership ordinary

income on Schedule E (Form 1040).

Generally, Schedule K-1 (Form 1065) will tell where to report

each item of income on an individual tax return.

Corporate Income

A corporation, for Federal income tax purposes, generally includes a business formed under Federal or state laws that refer

to it as a corporation, body corporate, or body politic. It also includes certain businesses that elect to be taxed as a

corporation by filing Form 8832. The owners of a corporation are the shareholders. The tax on a corporation‘s income is figured on

Form 1120 or Form 1120A.

S Corporation Income

Corporations that meet certain requirements may elect to become S corporations, which are treated in a manner similar to

partnerships. An S corporation files Form 1120S, and generally

does not pay tax on its income. Most income and expenses are ―passed through‖ to the shareholders on Form 1120S Schedule

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K-1. These amounts are to be included on the shareholders‘

individual returns.

In general, an S corporation does not pay tax on its income.

Instead, the income, losses, deductions, and credits of the corporation are passed through to the shareholders based on

each shareholder‘s pro rata share. Shareholders must report their share of these items on their own returns. Generally, the

items passed through will increase or decrease the basis of a shareholder‘s S corporation stock as appropriate.

S Corporation Return

An S corporation must file a return on Form 1120S, U.S.

Income Tax Return for an S Corporation. This shows the results of the corporation‘s operations for its tax year and the

items of income, losses, deductions, or credits that affect the shareholders‘ individual income tax returns.

Shareholder‟s Return

Shareholders should receive from the S corporation a copy of

Schedule K-1 (Form 1120S), Shareholder‘s Share of Income, Deductions, Credits, etc., showing the holder‘s share of

income, losses, deductions, and credits, of the S corporation for the tax year. Shareholders should retain Schedule K-1 for

their own records; it should not be attached to their Forms 1040.

A shareholder‘s distributive share of the items of income, losses, deductions, or credits of the S corporation must be

shown separately on his or her Form 1040. The character of

these items generally is the same as if they had been realized or incurred personally.

Generally, Schedule K-1 (Form 1120S) will tell where to report each item of income on an individual return.

Distributions

Generally, S corporation distributions are a nontaxable return

of shareholders‘ bases in the corporation stock. However, in certain cases, part of the distributions may be taxable as a

dividend, or as a long-term or short-term capital gain, or as both. The corporation‘s distributions may be in the form of

cash or property.

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Alternative Minimum Tax Income

Tax law imposes a minimum tax on an individual or a

corporation to the extent the taxpayer‘s minimum tax liability exceeds its regular tax liability. The individual minimum tax is

imposed at rates of 26% and 28% on alternative minimum taxable income in excess of a phased-out exemption amount;

the corporate minimum tax is imposed at a rate of 20% on alternative minimum taxable income in excess of a phased-out

$40,000 exemption amount. Alternative minimum taxable income (‗‗AMTI‘‘) is the taxpayer‘s taxable income increased by

certain preference items and adjusted by determining the tax

treatment of certain items in a manner that negates the deferral of income resulting from the regular tax treatment of those

items. In the case of a corporation, in addition to the regular set of adjustments and preferences, there is a second set of

adjustments known as the ‗‗adjusted current earnings‘‘ adjustment. However, for taxable years beginning after 1997,

the TRA ‗97 repealed the corporate alternative minimum tax for "small business corporations.‖

Small Business Corporation

A corporation is a small business corporation for its first

taxable years beginning after 1997 when it has average gross receipts of no greater than $5 million for three consecutive

taxable years beginning with the taxable year beginning after Dec. 31, 1994. A corporation that meets the $5 million test

continues as a small business corporation so long as its average gross receipts do not exceed $7.5 million.

A corporation that subsequently earns more than $7.5 million of gross receipts becomes subject to the corporate alternative

minimum tax, but only for adjustments and references on transactions and investments entered into after the

corporation loses its status as a small business corporation.

Business & Investment Credits

The Code provides for certain credits against tax with respect to business activities and investments. These credits cannot exceed

the amount of the tax. All of these credits are scheduled to expire, but Congress habitually extends the termination dates.

(1) Testing for rare diseases (§28; §280C(b)),

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(2) Producing nonconventional fuels (§29),

(3) Credit for federal tax on fuels (§34), and

(4) General business credit (§38).

The credits comprising the general business credit include (for a complete list see the instructions to Form 3800), but are not limited

to:

(1) Alcohol used as fuel (§40),

(2) Research credit (§41; §280C(c)),

Note: A taxpayer can claim a tax credit of 20% of the amount

of qualified research expenses that exceeds the average amount

of the research expenses in a base period.

(3) Low-income housing credit (§42),

(4) Rehabilitation credit (§46; §48(g) and (q)(1) & (3)),

(5) Energy investment tax credits (§46; §48(l) & (q)(1)),

Note: A business energy credit is available for:

(a) Solar energy property - 10%, and

(b) Geothermal property - 10%.

(6) Work opportunity tax credit (§51 & §280(a)), and

(7) Small business health insurance expense tax credit (§45R).

Note: Congress periodically allows certain of these credits to

expire only to later retroactively reinstate them.

The aggregate of the above credits cannot exceed the excess of the

taxpayer's net income tax over the greater of:

(1) 25% times the excess of the net income tax over $25,000, or

(2) the tentative AMT (§38; §39).

Business Credit Carryback & Carryforward Rules -

§39(a)

If in any taxable year the general business credit (the sum of the business credit carryforwards to the current year plus the current

year business credit) exceeds tax liability, the excess business credit may be carried back and carried forward until it is exhausted

(§39(a)). For credits after December 31, 1997, the carryback period is one year and the carryforward period is 20 years.

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NOL Comparison

For a net operating loss (NOL) arising after August 5, 1997, the

NOL is generally carried back two years. Any loss remaining after the two-year carryback period is then carried forward 20 years,

starting with the year after the loss year and then to each succeeding year for 19 more years or until the loss is completely

used up. Any portion of a net operating loss remaining after the 20-year carryover period is nondeductible (§172(b)(1)(A)).

Note: The American Recovery & Reinvestment Act, as expanded

by the Worker, Homeownership, and Business Assistance Act,

temporarily provided an eligible small business with an election

to increase the carryback period for an applicable 2008 & 2009

NOLs from two years to any whole number of years elected by

the taxpayer that is more than two and less than six. As a

result, qualified businesses had the choice to carryback such

NOLs three, four, or five years. The this provision applied only

to NOLs for any tax year beginning or ending in 2008 or 2009.

The regular two year NOL carryback period returned in 2010 and

thereafter.

Disposition of Business Assets

Business assets include property used in the conduct of a trade or

business, such as business machinery and office furniture. In addition to such tangible property, there are also intangible assets,

such as goodwill, patents, copyrights, trademarks, trade names, and franchises. The basis of an intangible asset is usually the cost

of buying or creating it.

If a business disposes of its propery, gain or loss may have to be

reported report. The sale of a business usually is not a sale of one asset. Instead, all the assets of the business are sold. Generally,

when this occurs, each asset is treated as being sold separately for determining the treatment of gain or loss. However, in some cases

there may be a gain that is not taxable or a loss that is not

deductible.

Note: A disposition includes a sale or an exchange. A sale is a

transfer of property for money or a mortgage, note, or other

promise to pay money. An exchange is a transfer of property for

other property or services.

Generally, gain is occurs when the amount realized exceeds the

basis of the business property. Likewise, loss occurs when the

amount realized is less than the basis of the business property.

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This gain or loss may or may not be recognized for tax purposes. If

recognized, its tax treatment will depend on the type of asset, how it was held, and for how long. Recognized gains and losses can be

ordinary or capital.

Amount Realized

The amount realized from a disposition of business assets is the total of all money received plus the fair market value of all property

or services received.

Note: Fair market value is the price at which the property would

change hands between a buyer and a seller, neither having to

buy or sell, and both having reasonable knowledge of all

necessary facts.

The amount realized also includes any of liabilities that were assumed by the buyer and any liabilities to which the property

transferred is subject, such as real estate taxes or a mortgage.

Basis of Assets

The cost or purchase price of property is usually the basis for

figuring gain or loss from its sale or other disposition. The cost is the amount paid in cash, debt obligations, other property, or

services. The cost also includes the amounts paid for the following items: sales tax, freight, installation and testing, excise taxes, legal

and accounting fees (when they must be capitalized) revenue

stamps, recording fees and real estate taxes (if assume for the seller).

Note: A business may have to capitalize certain other costs

related to buying or producing property.

Unstated Interest

If property is bought on a time-payment plans that charges little or no interest, the basis for the property is the stated purchase

price, minus the amount considered to be unstated interest. Purchasers are generally considered to have unstated interest if

the interest rate is less than the applicable federal rate.

Allocation of Purchase Price

When a trade or business is purchased, generally all the assets used in the business operations, such as land, buildings and

machinery are included in the purchase. The price must be

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allocated among the various assets, including any §197

intangibles.

Section 1060 requires that in an "applicable asset acquisition"

the consideration paid by buyer must be allocated to the different category of assets in the manner provided in

§338(b)(5). An "applicable asset acquisition" is any direct or indirect transfer of assets constituting a trade or business and

with respect to which the buyer's basis in the acquired assets is determined solely by reference to how much the buyer has paid

for such assets. §1060(c).

Both the buyer and seller involved in the sale of a business must

report to the IRS the allocation of the sales price among the business assets. Use Form 8594, Asset Acquisition Statement

Under Section 1060, to provide this information. The buyer and seller should each attach Form 8594 to their federal income tax

return for the year in which the sale occurred.

Asset Types

Obviously, whenever gain or loss is recognized as a result of an

asset disposition, the character of the gain or loss will depend upon the nature of the asset so disposed of. There are basically three

types of business property, these are:

1. Section 1231 assets are tangible non-inventory assets that

are used in a trade or business and have been held for more

than 12 months. The character of the property as being real or personal is immaterial for purposes of § 1231.

2. Capital assets are assets held for investment, whether tangible or intangible. Gains and losses from certain dispositions

of capital assets are treated as gains or losses from the disposition of either §1231 assets or ordinary assets.

3. Ordinary assets are assets that are held for sale in the ordinary course of the corporation‘s trade or business and all

other assets that do not qualify as being either capital assets or §1231 assets.

Section 1231 Assets

All gains from the dispositions of §1231 assets that are not

recaptured, must be netted with all losses from §1231 asset dispositions. The netting of §1231 gains and losses is to

determine whether they will be treated as long-term capital gains and losses or as ordinary gains and losses.

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Character of Gain or Loss

In general, if gains from the disposition of §1231 assets

exceed the losses from §1231 assets, the net gain is recognized as a long-term capital gain. However, if the losses

exceed the gains, then the net loss is treated as an ordinary loss.

5 Year Averaging

It is easy to see why this ―best of both worlds‖ phenomenon

caused a great many people to begin bunching their transactions to yield losses only in one year, and all gains in

the next. Congress did not agree that this was a terrific rule. As a result, TRA ‗84 introduced the five-year averaging rule.

In effect, net §1231 gain is treated as ordinary income to the extent that it does not exceed all §1231 losses for the

preceding five taxable years. Net §1231 losses that are used in this manner to recapture §1231 gains as ordinary income

in one year cannot be used again to recharacterize additional

§1231 gains from a subsequent year.

Like-Kind Exchanges

The ability to defer tax has risen in importance over the years. The depreciation allowances reduce basis and create paper gains that

become taxable upon sale. Thus, if property has been depreciated for several years, the owner‘s equity will be substantially reduced

by tax on the difference between the adjusted basis and the sale

price. However, in a properly structured exchange, the entire proceeds can be reinvested in other property that might later be

refinanced to take out non-taxable cash.

Based upon §1031 of the Internal Revenue Code, exchanging has

only three basic requirements:

(1) The properties must actually be exchanged and not sold

(exchange requirement);

(2) Both the property exchanged and the property received

must be held for productive use in trade or business or for investment (qualified property requirement); and

(3) The properties must be of a ―like-kind‖ with one another (like-kind requirement).

Under §1031, there must be a reciprocal transfer of property, as distinguished from a transfer of property solely for money. In short,

there must be a trade and not a sale.

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Qualified Property Requirement

Only qualified property can be traded under §1031. There are

three basic types of qualified property:

(1) Property used in your business (other than inventory);

(2) Rental property; and

(3) Investment property.

Tax-free exchange treatment is specifically denied to stocks, bonds, notes, interests in partnerships, certificates of trust, or

beneficial interests. In addition, property held primarily for sale to customers (i.e., dealer property) and a taxpayer's primary

personal residence do not qualify.

Like-Kind Requirement

The property given must be like-kind with the property received. The term ―like-kind‖ is the subject of much confusion but is best

understood as a simple distinction between real and personal property. Real estate is like-kind to other real estate. Personal

property is like-kind to other personal property. However, real

estate is not like-kind to personal property and vice versa. Thus, the ―like-kind‖ language does not apply to the grade or quality of

the property exchanged or whether it is improved or unimproved. As a result, the types of property that qualify as

like-kind are very broad.

Goodwill Prohibition

In the final regulations, the Service determined that goodwill and going concern value of one business can never be of a

like kind to that of another business (Reg. §1.1031(a)-2(c)(2)).

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CHAPTER 3

Selected Business Expenses

Business expenses are the costs of carrying on a trade or business,

and they are usually deductible if the business is operated to make a profit.

Section 162

To be deductible under §162, a business expense must be ordinary and necessary expenses for the carrying on of a trade or business,

or for the production or collection of income (§274(a), 274(e); Reg. §1.162-1(a), Reg. §1.212-1, Reg. §1.274-1). Unfortunately, the

words ―ordinary and necessary‖ are not defined in the Code or regulations, however, certain courts have attempted broad

definitions. Nevertheless, some elements of the requirement can be

identified:

1. The expenses must be incurred in an existing (i.e., on going)

trade or business. Start-up or investigatory expenses for a new business are not deductible under §162 but must be amortized

over 180 months under §195.

2. The expense must be normal, usual, or customary to the

business involved and appropriate and helpful to the business activity when incurred (Deputy v. DuPont, 308 U.S. 488; Welch

v. Helvering, 3 USTC 1164).

Note: An expense does not have to be indispensable to be

considered necessary (§162(a)).

3. The expense must actually be paid or incurred under the

taxpayer‘s accounting method (Reg. §1.466-(c)(1)(ii); Reg.§1.461-1(a)(2)).

4. Lavish or extravagant entertainment expenses are not deductible. However, entertainment expenses are not disallowed

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merely because they exceed a fixed dollar amount or are

incurred in deluxe restaurants, hotels, nightclubs, and resort establishments. An expense is not lavish or extravagant if

considering the facts and circumstances it is reasonable (Reg. §1.274-1; R.R. 63-144, 1963-2 CB 129, Q & A 42).

Exception: The lavish or extravagant limitation does not apply

to any expenses that are excepted from the 50% meal limitation

(See later discussion and §274(k)(2)).

Business expenses, which typically are currently deductible, must be distinguished from:

(1) Expenses used to figure cost of goods sold,

(2) Capital expenses,

(3) Personal expenses

(4) At-risk amounts, and

(5) Passive losses.

These items are either disallowed or receive special tax treatment.

Cost of Goods Sold

If a business manufactures products or purchases them for resale, it must value inventory at the beginning and end of each tax year

to determine the cost of goods sold. Some of a business‘s expenses may be included in figuring the cost of goods sold. The cost of

goods sold is deducted from the business‘s gross receipts to figure

the gross profit for the year. If a business includes an expense in the cost of goods sold, it cannot deduct it again as a business

expense.

The following are types of expenses that go into figuring cost of

goods sold.

(1) The cost of products or raw materials, including freight,

(2) Storage,

(3) Direct labor (including contributions to pension or annuity

plans) for workers who produce the products, and

(4) Factory overhead.

Under the uniform capitalization rules, businesses must capitalize the direct costs and part of the indirect costs for certain production

or resale activities. Indirect costs include rent, interest, taxes, storage, purchasing, processing, repackaging, handling, and

administrative costs.

This rule does not apply to personal property acquired for resale if a business‘s average annual gross receipts (or those of its

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predecessor) for the preceding three tax years are not more than

$10 million.

Capital Expenses

Businesses must capitalize, rather than deduct, some costs. These costs are a part of the investment in the business and are called

―capital expenses.‖ Capital expenses are considered assets of a business. There are, in general, three types of costs that must be

capitalized:

(1) Business start-up costs,

(2) Business assets, and

(3) Improvements.

A business can elect to deduct up to $5,000 of start-up costs that

are paid or incurred. The remaining costs can be amortized over 180 months (§195).

Note: For 2010 only, a taxpayer could elect to deduct up to

$10,000 reduced by expenditures that exceeded $60,000.

Cost Recovery Depreciation

Although businesses generally cannot take a current deduction for a capital expense, they may be able to recover the amount

spent through depreciation, amortization, or depletion. These recovery methods allow a business to deduct part of its cost

each year, gradually recovering its capital expense.

Personal vs. Business Expenses

Generally, a business owner cannot deduct personal, living, or

family expenses. However, if there is an expense for something that is used partly for business and partly for personal purposes, the

total cost can be divided between the business and personal parts, and the business part may be deducted.

For example, if a business owner borrows money and uses 70 percent of it for business and the other 30 percent for a family

vacation, then 70 percent of the interest is deductible as a business

expense. The remaining 30 percent is personal interest and is not deductible.

At-Risk Amounts - §465

Generally, a deductible loss from a trade or business or other

income-producing activity is limited to the investment the taxpayer

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has ―at risk‖ in the activity. He or she is at risk in any activity for

the following.

1. The money and adjusted basis of property he or she

contributed to the activity.

2. Amounts he or she borrowed for use in the activity if:

(a) He or she is personally liable for repayment, or

(b) He or she pledges property (other than property used in

the activity) as security for the loan.

Passive Losses - §469

Generally, a taxpayer is in a passive activity if he or she has a trade

or business activity in which he or she does not materially participate, or a rental activity. In general, deductions for losses

from passive activities offset income only from passive activities. Any excess deductions cannot be used to offset other income. In

addition, passive activity credits can offset the tax only on net passive income. Any excess loss or credits are carried over to later

years. Suspended passive losses are fully deductible in the year one completely disposes of the activity.

Net Operating Loss - §172

If a taxpayer‘s deductions are more than the income for the year, a ―net operating loss‖ results. However, certain deductions are not

considered in computing an NOL. A net operating loss can be used to lower taxes in other years. There are different limits for

individuals and corporations.

Creation of a NOL

A net operating loss can be created by any of the following:

(1) A loss from operating a sole proprietorship;

(2) A casualty or theft loss on business or personal use property;

(3) A partnership loss; and

(4) An ―S‖ corporation loss.

Individual NOLs

An NOL is basically a business deduction (except for personal

casualty and theft losses). However, most individuals claim some nonbusiness deductions in arriving at negative taxable income.

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As a result, these items (plus several others) must be added

back to total negative income to arrive at the NOL deduction.

Carrybacks & Carryovers

A net operating loss is a deduction in search of a tax return

on which to be used. The current year‘s return can‘t be used since an excess of losses in that year generated the NOL.

However, the NOL can be carried back 2 and forward 20 years

until it finds a year in which tax was paid. When more than one NOL is carried to a given year, the earliest NOL is used

first.

The American Recovery & Reinvestment Act, as expanded by

the Worker, Homeownership, and Business Assistance Act, provided an eligible small business with an election to

increase the carryback period for an applicable 2008 & 2009 NOLs from two years to any whole number of years elected

by the taxpayer that is more than two and less than six. As a result, qualified businesses had the choice to carryback such

NOLs three, four, or five years.

Note: The this provision applied only to NOLs for any tax year

beginning or ending in 2008 or 2009. The regular two year NOL

carryback period returned in 2010 and thereafter.

Eligible losses and farming losses qualify for longer carryback periods. The carryback period for eligible losses is 3 years. An

eligible loss is any part of an NOL that:

(a) Is from a casualty or theft, or

(b) Is attributable to a Presidentially declared disaster for a sole proprietorship or a partnership that has average

annual gross receipts (reduced by returns and allowances) of $5 million or less during the 3-year period ending with

the tax year of the NOL.

The carryback period for a farming loss is 5 years. A farming

loss is the smaller of:

(a) The amount which would be the NOL for the tax year if

only income and deductions attributable to farming

businesses were taken into account, or

(b) The NOL for the tax year.

Further Limitations

Before your loss can be deducted as an NOL, it can be limited by other rules. It may be limited by the at-risk rules. For example,

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it could also be limited by the passive activity rules. The loss

may even be considered a loss from a not for profit activity and therefore nondeductible.

Corporate NOLs

A corporation generally figures and deducts a net operating loss (NOL) the same way an individual, estate, or trust does. The

same carryback and carryforward periods apply, and the same

sequence applies when the corporation carries two or more NOLs to the same year.

A corporation's NOL generally differs from individual, estate, and trust NOLs in the following ways:

(1) A corporation can take different deductions when figuring an NOL; and

(2) A corporation must make different modifications to its taxable income in the carryback or carryforward year when

figuring how much of the NOL is used and how much is carried forward to the next year.

Timing of Expense Deduction - §447

When an expense can be deducted depends on the accounting method used. An accounting method is a set of rules used to

determine when and how income and expenses are reported. The two basic methods are the cash and the accrual methods.

Cash method. Under the cash method of accounting, business

expenses are generally deducted in the tax year they are paid.

Accrual method. Under an accrual method of accounting,

business expenses are generally deducted when both of the following apply.

1. The all-events test has been met. The test is met when:

a. All events have occurred that fix the fact of liability, and

b. The liability can be determined with reasonable accuracy.

2. Economic performance has occurred.

Economic Performance - §461

Generally a business cannot deduct or capitalize a business expense

until economic performance occurs. If the expense is for property or services provided to the business, or for its use of property,

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economic performance occurs as the property or services are

provided, or the property is used. If the expense is for property or services provided to others, economic performance occurs as the

property or service is provided.

Example

The tax year is the calendar year. In December 2013,

the Field Plumbing Company did some repair work at

a business and sent the business a bill for $600. The

business paid the bill by check in January 2014. If the

business uses the accrual method of accounting, it

may deduct the $600 on its tax return for 2013

because all events have occurred to ―fix‖ the fact of

liability (in this case the work was completed), the

liability can be determined, and economic

performance occurred in that year. If it uses the cash

method of accounting, it cannot deduct the expense

until it files its 2014 return.

Prepayment of Expenses

Generally taxpayers cannot deduct expenses in advance, even if they pay them in advance. This rule applies to both the cash and

accrual methods. It applies to prepaid interest, prepaid insurance

premiums, and any other expense paid far enough in advance to, in effect, create an asset with a useful life extending substantially

beyond the end of the current tax year.

Example

In 2014, a business signed a 10-year lease and

immediately paid its rent for the first three years,

2014, 2015, and 2016. However, it can deduct the

rent only for 2014 on its 2014 tax return. The rents

for 2015 and 2016 can be deducted on its tax returns

for those years.

Contested Liability

Under the cash method, a contested liability can be deducted only

in the year the liability is paid. Under the accrual method, contested liabilities such as taxes (except foreign or U.S. possession income,

war profits, and excess profits taxes) can be deducted either in the tax year the liability is paid (or money or other property is

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transferred to satisfy the obligation) or in the tax year the contest

is settled. However, to take the deduction in the year of payment or transfer, certain conditions must be met.

Related Person

Under an accrual method of accounting, a business generally

deducts expenses when it incurs them, even if it has not yet paid them. However, if the business owner and the person to whom he

or she owes money are related and that person uses the cash

method of accounting, the business owner must pay the expense before deducting it. The deduction is allowed when the amount is

includible in income by the related cash method payee.

Expenses of Not-for-Profit Activities - §183

Activities pursued as a hobby, or mainly for sport or recreation, are

not generally entered into for profit, but it is not unusual for a hobbyist to decide to turn her hobby into a business. If the hobby

turned business does not turn a profit, however, it can lead to tax

problems. That is because if a business or investment activity is not carried on to make a profit, the taxpayer cannot use a loss from the

activity to offset other income.

The limit on not-for-profit losses applies to individuals,

partnerships, estates, trusts, and S corporations. It does not apply to corporations other than S corporations.

Since hobby expenses are deductible only to the extent of hobby income, it is important to distinguish hobby expenses from

expenses incurred in an activity engaged in for profit. In making this distinction, all facts and circumstances with respect to the

activity are taken into account and no one factor is determinative. Among the factors that are normally taken into account are the

following:

(1) Whether the activity is conducted in a businesslike manner,

(2) Whether the time and effort put into the activity indicate the

taxpayer intends to make it profitable,

(3) Whether the taxpayer depends on income from the activity

for his or her livelihood,

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(4) Whether the business‘s losses are due to circumstances

beyond the owner‘s control (or are normal in the startup phase of a particular type of business),

(5) Whether the owner changes methods of operation in an attempt to improve profitability,

(6) Whether the business owner, or his or her advisors, have the knowledge needed to carry on the activity as a successful

business,

(7) Whether the business owner was successful in making a

profit in similar activities in the past,

(8) Whether the activity makes a profit in some years, and how

much profit it makes, and

(9) Whether the business owner can expect to make a future

profit from the appreciation of the assets used in the activity.

Presumption of Profit

An activity is presumed to be carried on for profit if it produced a

profit in at least three of the last five tax years, including the current year. Activities that consist primarily of breeding, training,

showing, or racing horses are presumed to be carried on for profit if they produced a profit in at least two of the last seven tax years,

including the current year. The activity must be substantially the same for each year within this period.

If a taxpayer dies before the end of the five-year (or seven-year)

period, the ―test‖ period ends on the date of the taxpayer‘s death.

If a business or investment activity passes this three - (or two-)

years-of-profit test, the IRS will presume it is carried on for profit. This means the limits discussed here will not apply. A business can

take all its deductions from the activity, even for the years that it has a loss. The business can rely on this presumption unless the

IRS later shows it to be invalid.

Using The Presumption Later

If a business owner is starting an activity and does not have three (or two) years showing a profit, he or she may want to

elect to have the presumption made after getting the five (or seven) years of experience allowed by the test.

The business owner can choose to do this by filing Form 5213. Filing this form postpones any determination that the activity is

not carried on for profit until five (or seven) years have passed since the activity was started.

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The benefit gained by making this choice is that the IRS will not

immediately question whether the activity is engaged in for profit. Accordingly, it will not restrict the business‘s deductions.

Rather, the business will gain time to earn a profit in the required number of years. If it shows three (or two) years of

profit at the end of this period, its deductions are not limited under these rules. If it does not have three (or two) years of

profit, the limit can be applied retroactively to any year with a loss in the five-year (or seven-year) period.

Filing Form 5213 automatically extends the period of limitations on any year in the five-year (or seven-year) period to two years

after the due date of the return for the last year of the period. The period is extended only for deductions of the activity and

any related deductions that might be affected.

The business must file Form 5213 within three years after the

due date of its return for the year in which it first carried on the

activity, or, if earlier, within 60 days after receiving written notice from the Internal Revenue Service proposing to disallow

deductions attributable to the activity.

Limit on Deductions

If an activity is not carried on for profit, a taxpayer may take deductions in the following order and only to the extent stated in

the three categories. For individuals, these deductions may be

taken only if by those who itemize. These deductions may be taken on Schedule A (Form 1040).

Category 1. Deductions that can be taken for personal as well as for business activities are allowed in full. For individuals, this

includes all nonbusiness deductions, such as those for homes mortgage interest, taxes, and casualty losses. They may be

deducted on the appropriate lines of Schedule A (Form 1040). A casualty loss on property owned for personal use is deductible

only to the extent it is more than $100 and exceeds 10 percent of the taxpayer‘s adjusted gross income.

Category 2. Deductions that do not result in an adjustment to the basis of property are allowed next, but only to the extent

that gross income from the activity is more than deductions under the first category. Most business deductions, such as

those for advertising, insurance premiums, interest, utilities, and

wages, belong in this category.

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Category 3. Business deductions that decrease the basis of

property are allowed last, but only to the extent the gross income from the activity exceeds the deductions taken under the

first two categories. Deductions for depreciation, amortization, and the part of a casualty loss an individual could not deduct in

category (1) belong in this category. Where more than one asset is involved, depreciation and these other deductions must be

allocated proportionally.

Individuals must claim the amounts in categories (2) and (3) as

miscellaneous deductions on Schedule A (Form 1040). They are deductible only to the extent they exceed 2 percent of adjusted

gross income.

Example

Ida is engaged in a not-for-profit activity. The

income and expenses of the activity are as follows.

Gross income $3,200

Subtract:

Real estate taxes $700

Home mortgage interest $900

Insurance $400

Utilities $700

Maintenance $200

Depreciation on

an automobile $600

Depreciation on

a machine $200 $3,700

Loss $(500)

Ida must limit her deductions to $3,200, the gross

income she earned from the activity. The limit is

reached in category (3), as follows.

Limit on deduction $3,200

Category 1: Taxes and interest $1,600

Category 2: Insurance, utilities,

and maintenance $1,300 $2,900

Available for Category 3 $300

The $800 of depreciation is allocated between the

automobile and machine as follows.

$600/$800 x $300 = $225 depreciation

for the automobile

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$200/$800 x $300 = $75 depreciation

for the machine

The basis of each asset is reduced accordingly.

The $1,600 for category (1) is deductible in full on

the appropriate lines for taxes and interest on

Schedule A (Form 1040). Ida deducts the remaining

$1,600 ($1,300 for category (2) and $300 for

category (3)) as other miscellaneous deductions on

Schedule A (Form 1040) subject to the 2 percent-of-

adjusted-gross-income limit.

Partnerships & S Corporations

If a partnership or S corporation carries on a not-for-profit

activity, these limits apply at the partnership or S corporation level. They are reflected in the individual shareholder‘s or

partner‘s distributive shares.

More Than One Activity

If a taxpayer has several undertakings, each may be a separate

activity or several undertakings may be combined. The following are the most significant facts and circumstances in making this

determination:

(1) The degree of organizational and economic interrelationship

of various undertakings,

(2) The business purpose that is (or might be) served by

carrying on the various undertakings separately or together in a business or investment setting, and

(3) The similarity of the undertakings.

The IRS will generally accept a taxpayer‘s characterization if it is

supported by facts and circumstances.

A taxpayer who is carrying on two or more different activities

should keep the deductions and income from each one separate and

figure separately whether each is a not-for-profit activity. If so, he or she should then figure the limit on deductions and losses

separately for each activity that is not for profit.

Rent Expenses

Rent or lease payments for business property and related expenses

like those for taxes on the property, improvements to the property, and getting a lease are generally deductible.

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In general, taxpayers can deduct rent as an expense only if the rent

is for property used in a trade or business. If the taxpayer has or will receive equity in or title to the property, the rent is not

deductible.

A rental deduction cannot be taken for unreasonable rent.

Ordinarily, the issue of reasonableness arises only if the lessee and the lessor are related. Rent paid to a related person is reasonable if

it is the same amount that would be paid to a stranger for use of the same property.

People who have a home office in a rented home may be able to deduct part of their rent.

Rent Paid In Advance

Generally, rent paid in a trade or business is deductible in the year paid or accrued. If rent is paid in advance, only the amount that

applies to the current tax year may be immediately deductible with the rest deductible in future years, as applicable.

Example

A calendar-year taxpayer who signed a five-year

lease on July 1 and paid the first year’s lease of

$12,000 could take half that, or $6,000, in the

current year and the other half the next year.

Generally an amount paid to cancel a business lease is deductible

as rent.

Lease vs. Sale

There may be instances in which determination must be made as to

whether payments are for rent or for the purchase of property. Taxpayers must first determine whether their agreement is a lease

or a conditional sales contract.

Payments made under a conditional sales contract are not

deductible as rent expense. Whether an agreement is a conditional sales contract depends on the intent of the parties. No single test or

special combination of tests applies. Nevertheless, an agreement may be considered a conditional sales contract rather than a lease if

any of the following is true.

1. The agreement applies part of each payment toward an equity

interest taxpayer will receive.

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2. Taxpayer gets title to the property after they make a stated

amount of required payments.

3. The amount taxpayer must pay to use the property for a short

time is a large part of the amount they would pay to get title to the property.

4. Taxpayer pays much more than the current fair rental value of the property.

5. Taxpayer has an option to buy the property at a nominal price compared to the value of the property when they may exercise

the option.

6. Taxpayer has an option to buy the property at a nominal price

compared to the total amount they have to pay under the agreement.

7. The agreement designates part of the payments as interest, or that part is easy to recognize as interest (R.R. 55-144).

Leveraged Leases

Leveraged lease transactions may not be considered leases.

Leveraged leases generally involve three parties: a lessor, a lessee, and a lender to the lessor. Usually the lease term covers

a large part of the useful life of the leased property, and the lessee's payments to the lessor are enough to cover the lessor's

payments to the lender.

R.P. 2001-28 provides that, for advance ruling purposes only, the IRS will consider the lessor in a leveraged lease transaction

to be the owner of the property and the transaction to be a valid lease if all the factors in the revenue procedure are met,

including the following:

(1) The lessor must maintain a minimum unconditional ―at

risk‖ equity investment in the property (at least 20% of the cost of the property) during the entire lease term;

(2) The lessee may not have a contractual right to buy the property from the lessor at less than fair market value when

the right is exercised;

(3) The lessee may not invest in the property, except as

provided by R.P. 2001-28;

(4) The lessee may not lend any money to the lessor to buy

the property or guarantee the loan used by the lessor to buy

the property; and

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(5) The lessor must show that it expects to receive a profit

apart from the tax deductions, allowances, credits, and other tax attributes.

Leveraged Leases Of Limited-Use Property

The IRS will not issue advance rulings on leveraged leases of so-called limited-use property. Limited-use property is

property not expected to be either useful to or usable by a

lessor at the end of the lease term except for continued leasing or transfer to a lessee (R.P. 2001-28).

Leases over $250,000 - §467

Special rules are provided for certain leases of tangible property.

Under §467, the rules apply if the lease calls for total payments of more than $250,000 and any of the following apply:

(1) Rents increase during the lease,

(2) Rents decrease during the lease,

(3) Rents are deferred (rent is payable after the end of the

calendar year following the calendar year in which the use occurs and the rent is allocated), or

(4) Rents are prepaid (rent is payable before the end of the calendar year preceding the calendar year in which the use

occurs and the rent is allocated).

These rules do not apply if the lease specifies equal amounts of rent

for each month in the lease term and all rent payments are due in the calendar year to which the rent relates (or in the preceding or

following calendar year).

Generally, if the special rules apply, taxpayers must use an accrual

method of accounting (and time value of money principles) for their rental expenses, regardless of their overall method of accounting.

In addition, in certain cases in which the IRS has determined that a

lease was designed to achieve tax avoidance, taxpayers must take rent and stated or imputed interest into account under a constant

rental accrual method in which the rent is treated as accruing ratably over the entire lease term.

Taxes on Leased Property

Businesses that lease business property can deduct as additional

rent any taxes they must pay to or for the lessor. When taxpayers

can deduct these taxes as additional rent depends on their accounting method.

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Cash method. If taxpayers use the cash method of accounting,

they can deduct the taxes as additional rent only for the tax year in which they pay them.

Accrual method. If taxpayers use an accrual method of accounting, they can deduct taxes as additional rent for the tax

year in which they can determine all the following.

(1) That taxpayer has a liability for taxes on the leased

property,

(2) How much the liability is, and

(3) That economic performance occurred.

The liability and amount of taxes are determined by state or local

law and the lease agreement. Economic performance occurs as taxpayer uses the property.

Cost of Getting a Lease

Very often if a business takes over an existing lease from another lessee, it must pay the previous lessee money to get the lease,

besides having to pay the rent on the lease. If so, it must generally amortize any amount paid for that lease over the remaining term of

the lease. For example, if it paid $10,000 to get a lease and there are 10 years remaining on the lease with no option to renew, it can

deduct $1,000 each year.

Note: If a business sells at a loss merchandise and fixtures that

it bought solely to get a lease, the loss is a cost of getting the

lease and must be capitalized and amortized over the remaining

term of the lease.

Options To Renew

The term of the lease for amortization includes all renewal

options plus any other period for which you and the lessor reasonably expect the lease to be renewed. However, this

applies only if less than 75% of the cost of getting the lease is for the term remaining on the purchase date (not including any

period for which the taxpayer may choose to renew, extend, or continue the lease). Allocate the lease cost to the original term

and any option term based on the facts and circumstances. In some cases, it may be appropriate to make the allocation using a

present value computation (Reg. §1.178-1(b)(5)).

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Example

Dan paid $10,000 to get a lease with 20 years

remaining on it and two options to renew for 5 years

each. Of this cost, Dan paid $7,000 for the original

lease and $3,000 for the renewal options. Because

$7,000 is less than 75% of the total $10,000 cost of

the lease (or $7,500), Dan must amortize the

$10,000 over 30 years. That is the remaining life of

Dan's present lease plus the periods for renewal.

Cost Of A Modification Agreement

A taxpayer may have to pay an additional ―rent‖ amount over part of the lease period to change certain provisions in a lease.

Taxpayers must capitalize these payments and amortize them over the remaining period of the lease. The taxpayer cannot

deduct the payments as additional rent, even if they are described as rent in the agreement.

Example

Dan is a calendar year taxpayer and signs a 20-year

lease to rent part of a building starting on January 1.

However, before Dam occupies it, he decides that he

really need less space. The lessor agrees to reduce

the rent from $7,000 to $6,000 per year and to

release the excess space from the original lease. In

exchange, Dan agrees to pay an additional rent

amount of $3,000, payable in 60 monthly

installments of $50 each.

Dan must capitalize the $3,000 and amortize it over

the 20-year term of the lease. Dan's amortization

deduction each year will be $150 ($3,000 ÷ 20). He

cannot deduct the $600 (12 × $50) that Dan will pay

during each of the first 5 years as rent.

Commissions, Bonuses, & Fees

Commissions, bonuses, fees, and other amounts taxpayer pays to get a lease on property they use in their business are capital

costs. The taxpayer must amortize these costs over the term of the lease.

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Loss On Merchandise & Fixtures

If taxpayer sells at a loss merchandise and fixtures that they

bought solely to get a lease, the loss is a cost of getting the lease. The taxpayer must capitalize the loss and amortize it over

the remaining term of the lease.

Leasehold Improvement & Restaurant Property -

§168

Generally, leasehold and other improvements must be depreciated over the life of the property using the modified accelerated cost

recovery system (MACRS) method and not over the life of the lease

(§168(i)(6)).

Note: A lessee is no longer allowed to amortize the cost over

the remaining term of the lease. If a lessee does not keep the

improvements when the lease is terminated, their gain or loss is

based on their adjusted basis in the improvements at that time.

However, a statutory 15 year straight line recovery period for

qualified leasehold improvement property placed in service after

October 22, 2004 and before January 1, 2014 was available.

In addition, starting for the first time in 2009, a qualified interior

improvement to an over-3-year-old building used for a retail business was depreciable over 15 years straight line method.

This 15-year life rule was not elective, but the improvements did not lose their §1250 real property status, and therefore, the

improvements did not qualify for 50% bonus depreciation or the §179 expensing allowance.

For 2010 and 2011, Congress expanded the coverage of §179 to qualified real property, defined as qualified leasehold improvement

property, qualified restaurant property and qualified retail improvement property (§179(f)(1)). However, this expensing was

limited to $250,000 of the total cost of such properties. ATRA extended this coverage to property placed in service before January

1, 2014.

As of this writing, Congress has not reinstated any of these provisions under §168(e) for 2014.

Qualified 15-Year Leasehold Improvement Property - §168(e)(3)(E)(iv)

Qualified leasehold improvement property placed in service after October 22, 2004, and before January 1, 2014, was 15-year

property under MACRS. Owners had to use the straight-line

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method over a 15-year recovery period (39 years if the

alternative depreciation system (ADS) is elected or otherwise applied).

Qualified Leasehold Improvement Property

A qualified leasehold improvement property was defined as any improvement to an interior portion of a building that is

nonresidential real property, provided certain requirements

were met. The improvement had to be made under or pursuant to a lease either by the lessee (or sublessee), or by

the lessor, of that portion of the building to be occupied exclusively by the lessee (or sublessee). The improvement

had to be placed in service more than three years after the date the building was first placed in service.

Note: Qualified leasehold improvement property did not include

any improvement for which the expenditure was attributable to

the enlargement of the building, any elevator, or escalator, any

structural component benefiting a common area, or the internal

structural framework of the building.

Subsequent Owner

If a lessor made an improvement that qualified as qualified leasehold improvement property, such improvement did not

qualify as qualified leasehold improvement property to any subsequent owner of such improvement. An exception to the

rule applied in the case of death and certain transfers of property that qualify for non recognition treatment.

Qualified 15-Year Retail Improvement Property -

§168(e)(E)(ix)

Qualified retail improvement property placed in service after December 31, 2008 and before January 1, 2014, on an over-3-

year-old building used for a retail business was depreciable over 15 years straight line method.

Qualified Retail Improvement Property

The term "qualified retail improvement property" meant any

improvement to an interior portion of a building which was nonresidential real property if such portion was open to the

general public and was used in the retail trade or business of selling tangible personal property to the general public, and such

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improvement was placed in service more than 3 years after the

date the building was first placed in service.

In the case of an improvement made by the owner of such

improvement, such improvement was qualified retail improvement property (if at all) only so long as such

improvement was held by such owner (this meant that a new buyer could not separately purchase the building and the

previously inserted improvements, taking 15 year life on the improvements). The term ―qualified retail improvements‖ did not

include any improvement for which the expenditure was attributable to the enlargement of the building, any elevator, or

escalator, any structural component benefiting a common area, or the internal structural framework of the building.

Improvements placed in service before January 1, 2009 and after December 31, 2013, did not qualify (§168(e)(8)).

15-Year Restaurant Improvements - §168(e)(7)

A statutory 15 year straight line recovery period was allowed

for qualified restaurant property placed in service after October 22, 2004 and before January 1, 2014. Qualified

restaurant property meant any §1250 property that was an improvement to a building, if such improvement was placed in

service more than three years after the date such building

was first placed in service and more than 50% of the building's square footage was devoted to the preparation of,

and seating for, on premises consumption of prepared meals.

Comment: The bonus depreciation deduction could not be

claimed on any qualified restaurant property

(§168(e)(7)(B), as amended by the Emergency Economic

Act of 2008).

Assignment of a Lease

If a long-term lessee who makes permanent improvements to land

later assigns all lease rights to the taxpayer for money and taxpayer pays the rent required by the lease, the amount taxpayer

pays for the assignment is a capital investment. If the rental value of the leased land increased since the lease began, part of

taxpayer's capital investment is for that increase in the rental value. The rest is for an investment in the permanent

improvements.

The part that is for the increased rental value of the land is a cost

of getting a lease, and the taxpayer amortizes it over the remaining

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term of the lease. The taxpayer can depreciate the part that is for

their investment in the improvements over the recovery period of the property as discussed earlier, without regard to the lease term.

Capitalizing Rent Expenses

Under the uniform capitalization rules, the direct costs and part of

the indirect costs for production or resale activities must be capitalized.

Indirect costs include amounts incurred for renting or leasing

equipment, facilities, or land.

Generally, businesses are subject to the uniform capitalization rules

if they do any of the following:

(1) Produce real or tangible personal property for use in the

business or activity,

(2) Produce real or tangible personal property for sale to

customers, and

(3) Acquire property for resale. However, this rule does not

apply to personal property acquired for resale if the average annual gross receipts for the three previous tax years were not

more than $10 million.

Example

Dan rents construction equipment to build a storage

facility. He must capitalize as part of the cost of the

building the rent he paid for the equipment. Dan

recovers his cost by claiming a deduction for

depreciation on the building.

Interest Expense - §163

Section 163(a) permits the deduction of ―all interest paid or accrued within the taxable year on indebtedness.‖ However, the ability to

deduct interest is restricted depending on the type of interest involved.

Business Interest

Businesses can generally deduct as a business expense all the interest paid or accrued during the tax year on debts related to the

trade or business, provided the business was legally liable for the

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debt. There is no limitation on the deduction business interest,

except when such interest is required to be capitalized.

Note: There are restrictions on the deduction for interest on life

insurance policies.

Interest relates to a taxpayer‘s trade or business if they use the proceeds of the loan for a trade or business expense. It does not

matter what type of property secures the loan (§162).

Interest Paid In Advance

Generally, if a taxpayer pays interest in advance for a period that goes beyond the end of the tax year, they must spread the

interest over the tax years to which it belongs. The taxpayer can

deduct in each year only the interest for that year.

Mortgage Interest

Monthly mortgage payments are usually made up of principal and interest. Taxpayers can only deduct interest associated with

mortgages. If a taxpayer paid mortgage interest of $600 or more during the year on any one mortgage to a mortgage holder

(including a financial institution, a governmental unit, or a

cooperative housing corporation) in the course of that holder‘s trade or business, they will receive a Form 1098 or a similar

statement.

Note: If a taxpayer receives a refund of interest they overpaid

in an earlier year, this amount will be reported on box 3 of Form

1098. They cannot deduct this amount.

Prepayment Penalty

When a taxpayer pays off a mortgage early and pays the lender

a penalty for doing this, they can deduct the penalty as interest.

Points

The term ―points‖ is often used to describe some of the charges paid by a borrower when the borrower takes out a loan or a

mortgage. These charges are also called loan origination fees,

maximum loan charges, or premium charges. If any of these charges is solely for the use of money, it is interest.

These points are interest paid in advance and cannot be deducted all in one tax year. Instead, the taxpayer must deduct

part of the interest in each tax year during the period of the loan.

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To figure how much to deduct in each tax year, divide the part of

the loan period falling within the tax year by the total loan period. Then multiply this answer by the prepaid interest.

Expenses to Obtain a Mortgage

Certain expenses paid to obtain a mortgage cannot be deducted as interest. These expenses, which include mortgage

commissions, abstract fees, and recording fees, are capital

expenses. However, they are not capital expenses that can be added to the basis of the property. If the property mortgaged is

business or income-producing property, the taxpayer can amortize the costs over the life of the mortgage.

Interest on Installment Purchases

If a taxpayer makes an installment purchase of business property,

they will pay interest either as part of each payment or separately.

If no interest or a low rate of interest is charged under the contract, the taxpayer may have to determine the unstated interest amount.

Generally, this may happen if the seller finances the purchase. Unstated interest reduces the taxpayer‘s basis in the property and

increases their interest expense.

Investment Interest

Investment interest generally is the interest paid or accrued on

money borrowed that is properly allocable to property held for investment. When a taxpayer borrows money that is used to

acquire property to be held for investment, the interest paid is investment interest (§212).

Note: Section 163(d)(3)(B)(i) excludes from investment

interest any interest that is taken into account in determining

the taxpayer‘s income or loss from a passive activity under

§469.

The taxpayer can deduct investment interest subject to certain

limits. Generally, the deduction for investment interest expense is limited to the amount of net investment income.

Note: Investment interest does not include any qualified

residence interest, interest incurred to produce tax-exempt

income or any interest taken into account in computing income

or loss from a passive activity.

If the money borrowed is used for business or personal purposes as

well as for investment, the debt must be allocated among those

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purposes. The interest expense on that debt is also allocated

according to how the debt proceeds were used.

Note: Fully deductible home mortgage interest does not have to

be allocated, regardless of how the proceeds are used.

Investment Property

Property held for investment includes property that produces

portfolio income, such as interest, dividends, annuities, or royalties not derived in the ordinary course of a trade or

business. Portfolio income also includes net gain (not derived in the ordinary course of a trade or business) from the sale or trade

of property producing this type of income or held for investment (other than an interest in a passive activity).

Note: An ownership interest in a partnership or S corporation is

treated as investment property to the extent of the taxpayer's

share in the investments of the entity.

Limit on Deduction

The amount deductible as investment interest expense is limited

in two ways:

(1) Taxpayers may not deduct interest on money they

borrow to buy or carry shares in a mutual fund that distributes only exempt-interest dividends; and

Note: If the fund also distributes taxable dividends,

taxpayers must allocate the interest between the taxable

and nontaxable income.

(2) Investment interest is limited by the amount of

investment income.

Note: The investment income limit on investment interest

applies only if: (1) the taxpayer is a noncorporate taxpayer

(including shareholders and partners of S corporations and

partnerships), and (2) paid or accrued interest on money

borrowed to buy or carry property held for investment.

Generally, taxpayers can claim a deduction for investment interest expense up to the amount of their net investment

income. Net investment income under §163(d) is the excess of investment income over investment expenses.

There is no current deduction for excess investment interest

expense. Taxpayers can carry over disallowed investment interest to a succeeding tax year even if it is more than their

taxable income in the year the interest was paid or accrued.

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Note: Partners, shareholders, and beneficiaries determine

whether they exceed the limit on investment interest, by

combining their share of investment interest from a

partnership, S corporation, estate, or trust with their other

investment interest.

Net Investment Income

For purposes of figuring the limit on the deduction for investment interest, a taxpayer determines their net

investment income by subtracting their investment expenses (other than interest expense) from their investment income.

Investment Income

Investment income includes gross income from investment

property, gain attributable to investment property (if the taxpayer elects), and gross portfolio income such as

interest received, dividends, annuities and royalties under the passive loss rule. In addition, investment income

includes income from interests in activities involving a trade or business in which the taxpayer does not materially

participate, if that activity is not treated as a passive

activity under the passive loss rules.

Note: Investment income does not include any income

derived from the conduct of a trade or business, or Alaska

Permanent Fund dividends.

Capital Gain Inclusion Election

Investment income generally does not include net capital

gain from disposing of investment property (including capital gain distributions from mutual funds). However,

taxpayers can choose to include part or all of their net

capital gain in investment income.

This choice must be made by the due date (including

extensions) of the tax return on which the capital gain is reported. Taxpayers make this choice by completing Form

4952 according to its instructions.

If a taxpayer chooses to include any amount of their net

capital gain in investment income, they must reduce their net capital gain that is eligible for the maximum capital

gains rate by the same amount.

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Investment Expenses

For purposes of determining net investment income,

investment expenses include all income-producing expenses (other than interest expense) relating to the

investment property that are allowable deductions after applying the 2% limit that applies to miscellaneous

itemized deductions. In figuring the amount over the 2% limit, expenses that are not investment expenses are

disallowed before any investment expenses are disallowed.

Losses from Passive Activities

Income or expenses used in computing income or loss from a passive activity are not included in determining

investment income or investment expenses (including investment interest expense).

Carryover

The amount of investment interest that could not be deducted

because of this limit can be carried forward to the next tax year. However, the interest carried forward is treated as

investment interest paid or accrued in that later year. Taxpayers can deduct the interest carried forward to the

extent that their net investment income exceeds their

investment interest in that later year.

When to Deduct Investment Interest

If a taxpayer uses the cash method of accounting, they must pay

the interest before they can deduct it. If a taxpayer uses an accrual method of accounting, they can deduct interest over the

period it accrues, regardless of when they pay it.

Form 4952

The Form 4952, Investment Interest Expense Deduction, is used to figure the deduction for investment interest.

However, taxpayers do not have to file Form 4952 if all of the

following apply:

(1) The taxpayer‘s only investment income was from

interest or dividends;

(2) The taxpayer does not have any other deductible

expenses directly connected with the production of that income;

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(3) The investment interest expense is not more than the

total of that income; and

(4) The taxpayer has no carryovers of investment interest

expense from the prior taxable year.

Interest on Margin Accounts

When a taxpayer is a cash-basis taxpayer, they can deduct

interest on margin accounts as investment interest in the year

they paid it. A taxpayer is considered to have paid interest on these accounts only when they actually pay the broker or when

the interest becomes available to the broker through the taxpayer‘s account. Receipts for the payment of interest may

become available in the account when the broker collects dividends or interest from the account, or sells securities for the

taxpayer.

Interest on a Market Discount Bond

The amount a taxpayer can deduct for interest expense incurred to purchase or carry a market discount bond is limited. To find

the amount of the deduction, first figure the excess, if any, of the amount of interest expense incurred for the year to purchase

or carry the bond over the total interest and OID includible in gross income for the bond for the year. This excess is then

reduced by the market discount allocable to the number of days the taxpayer held the bond during the year. The result is the

interest expense deduction for the year.

Nondeductible Interest

Some interest payments cannot be deducted. For example, interest

on debt incurred to purchase tax exempt securities is generally nondeductible. Personal interest incurred for consumption is also

nondeductible. In addition, certain other expenses that may seem to be interest are not, and are not deductible as interest.

Moreover, a number of Code sections limit the deduction of interest. These include:

(1) The ―at-risk‖ limitations (§465),

(2) The passive activity loss limitations (§469),

(3) The uniform capitalization rules (§263A),

(4) Life insurance interest restrictions (§264), and

(5) Related party interest rules (§267(a)(2)).

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Interest on Income Tax Owed

The IRS does not allow a deduction for interest on an income tax

deficiency even if the deficiency is based on a dispute over business income. Thus, interest charged on income tax assessed

on an individual income tax return is not a business deduction even though the tax due is related to income from a trade or

business.

Penalties

Penalties on deficiencies and underestimated tax are not interest and cannot be deducted. Fines and penalties are

generally not deductible.

Commitment Fees & Service Charges

Payments for the use of borrowed money are interest and deductible as such. However, payments for the lender‘s services

are not interest. Lenders often charge a fee for services such as appraisal or investigation of the debtor‘s credit. Such charges

are not deductible as interest (R.R. 67-297).

Capitalized Interest

There are certain interest expenses that must be capitalized rather than deducted. Section 263A(f)(1) requires the

capitalization of interest under the uniform capitalization rules with respect to the production of property and the acquisition of

property for resale in a trade or business.

Note: Section 263A(f)(3) provides that the interest

capitalization rules also apply to interest on debt allocable to

property (e.g., equipment and facilities) which is used to

produce qualified property.

These rules require the capitalization of interest that is paid or incurred on debt that is allocable to the production of ―qualified

property.‖ ―Qualified property‖ is:

(1) Real property,

(2) Personal property with a class life of 20 years or more,

(3) Personal property with an estimated production period of more than 2 years, or

(4) Personal property with an estimated production period of more than one year if the estimated cost of production is

more than $1 million.

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Capitalized interest is treated as a cost of the property produced.

Taxpayers recover the interest when they sell or use the property, or dispose of it under the rules that apply to such

transactions.

Note: Taxpayers recover the capitalized interest through cost of

goods sold, an adjustment to basis, depreciation, amortization,

or other method.

Production Period

A taxpayer is considered to have produced property if they

construct, build, install, manufacture, develop, improve,

create, raise, or grow the property. Property produced under a contract is treated as produced to the extent that payments

are made or costs otherwise incurred in connection with the property.

Interest is required to be capitalized only during the production period. The production period for real property

begins when physical activity is first performed upon the property. For all other property, the production period begins

on the date by which production expenditures equals or exceeds 5% of the total estimated production expenditures.

The production period of property ends on the date that the property is ready to be placed in service or is ready to be held

for sale.

Traced Debt

Section 263A(f)(2) requires that, in determining the interest capitalized, interest on debt directly attributable to the

property‘s production expenditures (―traced debt‖) is capitalized first. Traced debt is determined by applying the

interest allocation rules of Reg. §1.163-8T. Under those rules,

debt is allocated to an expenditure by tracing disbursements of the debt proceeds.

Avoided Cost Debt

After determining the amount of traced debt directly attributable to the property‘s production expenditures,

§263A(f)(2) requires that any other debt is assigned to any

remaining production expenditures and that interest on such debt shall be capitalized, to the extent that the taxpayer‘s

interest costs could have been reduced if such production expenditures had not been incurred (―avoided cost debt‖). For

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taxpayers producing more than one qualified property during

the taxable year, avoided cost debt of the taxpayer is allocated pro-rata to the production expenditures of such

properties, based on the ratio of each property‘s cost to the aggregate costs of all qualified properties under production.

When Interest Is Paid or Incurred

Section 263A(f) requires the capitalization of interest that is

―paid or incurred‖ during the production period. Thus, taxpayers using the cash method of accounting generally

would capitalize interest that was paid during the production period, and taxpayers using an accrual method of accounting

generally would capitalize interest that was incurred during the production period.

Partnerships & S Corporations

The interest capitalization rules are applied first at the level of

the partnership or S corporation, and then at the level of the partners or shareholders. These rules are applied to the

extent the partnership or S corporation has insufficient debt to support the production or construction expenses.

Interest Related To Tax-Exempt Income - §265

Generally, interest related to tax-exempt income is not

deductible (§265). No deduction is allowed for:

(1) Interest on a debt incurred to buy or carry tax-exempt

securities,

(2) Amounts paid or incurred in connection with personal

property used in a short sale, or

Note: If a taxpayer deposits cash as collateral in a short sale

and the cash does not earn a material return during the period

of sale, this rule does not apply.

(3) Amounts paid or incurred by others for the use of any collateral used in connection with a short sale.

The interest deduction is not disallowed merely because the taxpayer is concurrently paying interest on a debt and receiving

tax-exempt interest. Section 265(a)(2) disallows an interest deduction only when a taxpayer incurs or continues

indebtedness to acquire or hold tax-exempt obligations. This purpose may be established by either direct or circumstantial

evidence.

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Interest on Insurance Policy Loans - §264

Single Premium Life Insurance

Under §264(a)(2), no interest deduction is allowed on a debt incurred to buy single-premium life insurance, endowment, or

annuity contracts (including those in which substantially all premiums are paid within four years).

Note: Since the interest element in life insurance is not taxed, it

would be unfair for interest incurred to purchase the insurance

to be deductible.

Systematic Plan of Borrowing

Under §264(a)(3), no interest deduction is allowed on loans

made as part of a systematic plan of financing insurance premiums (generally by borrowing against increases in cash

values under the policy).

However, §264(a)(3) does not apply if:

(1) No part of four of the first seven premiums is

borrowed;

(2) The amount disallowed would be less than $100;

(3) The borrowing occurred because of unforeseen financial problems; or

(4) The borrowing was incurred in connection with trade or business §264(c)).

Key Person Insurance

Under the Health Coverage Availability & Affordability Act of

1996, no deduction is allowed for interest paid or accrued on any indebtedness arising from one or more life insurance

policies or annuity or endowment contracts owned by the taxpayer covering any individual who is either:

(1) An officer or employee of, or

(2) Financially interested in any trade or business carried

on by the taxpayer, regardless of the aggregate amount of debt from policies or contracts covering the individual

(§264(a)(4)).

Note: This disallowance applies even though the loan proceeds

are used for bona fide business purposes.

There is one exception - interest on indebtedness for life

insurance policies covering the greater of five key persons or 5% of total officers and employees (up to 20 individuals) still

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is deductible, as under current law. Under the Act, interest on

policy loans that could otherwise be deducted is limited to an amount calculated using the average Moody‘s corporate bond

yield.

Deductibility of Premiums & Interest on Life Insurance

No deduction is permitted for premiums paid on any life

insurance, annuity or endowment contract, if the taxpayer is

directly or indirectly a beneficiary under the contract.

Also, generally, no deduction is allowed for interest paid or

accrued on any indebtedness with respect to life insurance policy, or endowment or annuity contract, covering the life of

any individual.

In addition, in the case of a taxpayer other than a natural

person, no deduction is allowed for the portion of the taxpayer‘s interest expense that is allocable to unborrowed

policy cash surrender values with respect to any life insurance policy or annuity or endowment contract issued after June 8,

1997.

Existing Interest on Purchase

If a taxpayer buys property and pays interest owed by the seller (for example, by assuming the debt and any interest accrued on

the property), they cannot deduct the interest. The interest paid that the seller owed is added to the basis of the property.

Corporate Acquisition Interest

Section 279 disallows corporate interest deductions in excess of

$5 million per year on ―corporate acquisition indebtedness‖ incurred to acquire the stock, or at least two thirds of the assets,

of another corporation.

Interest Allocation Rules for Multi-Purpose Loans

The rules for deducting interest vary, depending on whether the

loan proceeds are used for business, personal, or investment activities. Interest on a loan is allocated the same way as the loan

is allocated for the same period. Loan proceeds and the related interest are allocated by the use of the proceeds. The allocation is

not affected by the use of property that secures the loan (Reg. §1.163-8T(c)(1)).

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If a loan is used for more than one type of expense, the interest

must be allocated for each use of the loan‘s proceeds among the following categories:

(1) Nonpassive trade or business activity interest,

(2) Passive trade or business activity interest,

(3) Investment interest,

(4) Portfolio interest, and

(5) Personal interest.

In general, interest on a loan is allocated the same way as the loan

proceeds, by tracing disbursements to specific uses. The allocation of loan proceeds and the related interest is not generally affected

by the use of property that secures the loan.

Note: The easiest way to trace disbursements to specific uses is

to keep the proceeds of a particular loan separate from any

other funds.

Example

Dan secures a loan with property used in his

business. He uses the loan proceeds to buy an

automobile for personal use. Dan must allocate

interest expense on the loan to personal use

(purchase of the automobile) even though the loan is

secured by business property.

If the property that secures a loan is taxpayer's home, the taxpayer

generally does not allocate the loan proceeds or the related interest. The interest is usually deductible as qualified home

mortgage interest, regardless of how the loan proceeds are used.

Allocation period

The period for which a loan is allocated to a particular use begins on the date the proceeds are used and ends on the earlier of the

following dates:

(1) The date the loan is repaid, or

(2) The date the loan is reallocated to another use (Reg.

§1.163-8T(c)(2)).

Proceeds Not Disbursed To Borrower

Even if the lender disburses the loan proceeds to a third party,

the allocation of the loan is still based on your use of the funds.

This applies whether you pay for property, services, or anything

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else by incurring a loan, or you take property subject to a debt

(Reg. §1.163-8T(c)(3)(i)).

Proceeds Deposited In Borrower's Account

Treat loan proceeds deposited in an account as property held for

investment. It does not matter whether the account pays interest. Any interest you pay on the loan is investment interest

expense. If you withdraw the proceeds of the loan, you must

reallocate the loan based on the use of the funds (Reg. §1.163-8T(c)(4)(i)).

Example

Connie, a calendar-year taxpayer, borrows $100,000

on January 4 and immediately uses the proceeds to

open a checking account. No other amounts are

deposited in the account during the year and no part

of the loan principal is repaid during the year. On

April 1, Connie uses $20,000 from the checking

account for a passive activity expenditure. On

September 1, Connie uses an additional $40,000

from the account for personal purposes.

Under the interest allocation rules, the entire

$100,000 loan is treated as property held for

investment for the period from January 4 through

March 31. From April 1 through August 31, Connie

must treat $20,000 of the loan as used in the passive

activity and $80,000 of the loan as property held for

investment. From September 1 through December

31, she must treat $40,000 of the loan as used for

personal purposes, $20,000 as used in the passive

activity, and $40,000 as property held for

investment.

Order Of Funds Spent

Generally, you treat loan proceeds deposited in an account as

used (spent) before either of the following amounts:

(1) Any unborrowed amounts held in the same account, or

(2) Any amounts deposited after these loan proceeds (Reg. §1.163-8T(c)(4)(ii)).

Payments From Checking Accounts

Generally, a payment from a checking or similar account is

treated as made at the time the check is written if it is mailed or

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delivered to the payee within a reasonable period after it written.

Taxpayers can treat checks written on the same day as written in any order (Reg. §1.163-8T(c)(4)(iii)(A)).

Amounts Paid Within 30 Days

If loan proceeds are received in cash or if loan proceeds are deposited in an account, any payment (up to the amount of the

proceeds) can be treated as made from any account owned, or

from cash, as made from those proceeds. This applies to any payment made within 30 days before or after the proceeds are

received in cash or deposited in an account (Reg. §1.163-8T(c)(4)(iii)(B); Notice 89-35).

If the loan proceeds are deposited in an account, taxpayers can apply this rule even if the rules stated above under Order Of

Funds Spent would otherwise require the proceeds to be treated as used for other purposes. If this rule is applied to any

payments, disregard those payments (and the proceeds from which they are made) when applying the rules stated under

Order Of Funds Spent.

If loan proceeds are received in cash, taxpayers can treat the

payment as made on the date the cash was received instead of the date the payment was actually made.

Example

Frank gets a loan of $1,000 on August 4 and receives

the proceeds in cash. Frank deposits $1,500 in an

account on August 18 and on August 28 writes a

check on the account for a passive activity expense.

Also, Frank deposits his paycheck, deposits other loan

proceeds, and pays his bills during the same period.

Regardless of these other transactions, Frank can

treat $1,000 of the deposit he made on August 18 as

being paid on August 4 from the loan proceeds. In

addition, Frank can treat the passive activity expense

he paid on August 28 as made from the $1,000 loan

proceeds treated as deposited in the account.

Optional Method For Determining Date Of Reallocation

Taxpayers can use the following optional method to determine the date loan proceeds are reallocated to another use. Under this

optional method, all payments from loan proceeds in an account

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during any month can be treated as taking place on the later of

the following dates:

(1) The first day of that month, or

(2) The date the loan proceeds are deposited in the account.

However, this optional method can only be used if all payments

from the account during the same calendar month are treated in the same way (Reg. §1.163-8T(c)(4)(iv)).

Interest On A Separate Account

If an account contains only loan proceeds and interest earned on

the account, any payment from that account can be treated as being made first from the interest. When the interest earned is

used up, any remaining payments are from loan proceeds (Reg. §1.163-8T(c)(4)(iii)(C)).

Example

Dan borrowed $20,000 and used the proceeds of this

loan to open a new savings account. When the

account had earned interest of $867, he withdrew

$20,000 for personal purposes. Dan can treat the

withdrawal as coming first from the interest earned

on the account, $867, and then from the loan

proceeds, $19,133 ($20,000 - $867). All the interest

charged on the loan from the time it was deposited in

the account until the time of the withdrawal is

investment interest expense. The interest charged on

the part of the proceeds used for personal purposes

($19,133) from the time he withdrew it until he either

repays it or reallocates it to another use is personal

interest expense. The interest charged on the loan

proceeds Dan left in the account ($867) continues to

be investment interest expense until he either repays

it or reallocates it to another use.

Accrued Interest

Accrued interest is treated as a debt until it is paid. Compound

interest accruing on such debt may be allocated between the original expenditure and the new expenditure on a straight-line

basis (i.e., by allocating an equal amount of such interest expense to each day during the taxable year). In addition, a

taxpayer may treat a year as consisting of 12 30-day months for purposes of allocating interest on a straight-line basis.

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Accrued Interest Before Debt Proceeds Are Received

Interest on a debt may accrue before the taxpayer actually

receives the debt proceeds, or before the taxpayer uses the debt proceeds to make an expenditure. During this pre-

receipt (or pre-use) period, the debt is allocated to an investment expenditure.

Loan Repayment

When any part of a loan allocated to more than one use is

repaid, it treated as being repaid in the following order:

(1) Personal use,

(2) Investments and passive activities (other than those included in (3) below),

(3) Passive activities in connection with a rental real estate activity in which you actively participate,

(4) Former passive activities, then

(5) Trade or business use and expenses for certain low-income housing projects (Reg. §1.163-8T(d)(1)).

Example

Taxpayer B borrows $100,000 (―Debt A‖) on July 12,

immediately deposits the proceeds in an account,

and uses the debt proceeds to make the following

expenditures on the following dates:

August 31 $40,000 passive activity expenditure #1

October 5 $20,000 passive activity expenditure #2

December 24 $40,000 personal expenditure

On January 19 of the following year, B repays

$90,000 of Debt A (leaving $10,000 of Debt A

outstanding). The $40,000 of Debt A allocated to the

personal expenditure, the $40,000 allocated to

passive activity expenditure#1, and $10,000 of the

$20,000, allocated to passive activity expenditure #2

are treated as repaid.

Continuous Borrowings

When a taxpayer has a line of credit or similar arrangement that allows them to borrow funds periodically under a single loan

agreement, the following rules apply:

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(1) All borrowings on which interest accrues at the same

fixed or variable rate are treated as a single loan, and

(2) Borrowings or parts of borrowings on which interest

accrues at different fixed or variable rates are treated as different loans (Reg. §1.163-8T(d)(3)).

Note: These loans are treated as repaid in the order in which

they are treated as repaid under the loan agreement.

Loan Refinancing

The replacement loan is allocated to the same expenses as the repaid loan. This is true only to the extent the proceeds of the

new loan are used to repay any part of the original loan (Reg. §1.163-8T(e)).

Special Rules for Partnerships & S Corporations

Special rules apply to the allocation of interest expense in

connection with debt-financed acquisitions of, and distributions from, partnerships and S corporations. These rules do not apply

if the partnership or S corporation is formed or used for the principal purpose of avoiding the interest allocation rules.

Debt-Financed Acquisitions

A debt-financed acquisition is the use of loan proceeds to

purchase an interest in an entity or to make a contribution to the capital of the entity. If an interest in an entity is

purchased, the loan proceeds and the interest expense must be allocated among all the assets of the entity. The allocation

can be based on the fair market value, book value, or adjusted basis of the assets, reduced by any debts allocated

to the assets (Notice 89-35).

If capital is contributed to an entity, the allocation should be made based on the assets or by tracing the loan proceeds to

the entity‘s expenditures. A purchase of an interest in an entity is treated as a contribution to capital to the extent the

entity receives any proceeds of the purchases.

Example

Dan purchases an interest in a partnership for

$20,000 using borrowed funds. The partnership’s only

assets include machinery used in its business valued

at $60,000, and stocks valued at $15,000. Dan

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allocates the loan proceeds based on the value of the

assets. Therefore, $16,000 of the loan proceeds

($60,000 / $75,000 X $20,000) and the interest

expense on that part are allocated to trade or

business use. The amount allocated to investment

use is $4,000 ($15,000 / $75,000 X $20,000) and the

interest on that part.

Reallocation

If a taxpayer allocates the loan proceeds among the assets,

they must make a reallocation if the assets or the use of the assets change.

How to Report

Individuals report the interest expense either on Schedule

A or Schedule E of Form 1040 depending on the type of asset (or expenditure if the allocation is based on the

tracing of loan proceeds) to which the interest expense is allocated.

Debt-Financed Distributions

Generally, if the entity borrows funds the general allocation

rules apply. If those funds are allocated to distributions made to partners or shareholders, the distributed loan proceeds and

related interest expense must be reported to the partners and shareholders separately. This is because the loan proceeds

and the interest expense must be allocated depending on how the partner or shareholder uses the proceeds. For example, if

a shareholder uses distributed loan proceeds to invest in a passive activity, that shareholder‘s portion of the entity‘s

interest expense on the loan proceeds is allocated to a

passive activity use (Notice 89-35).

Optional Method

The entity may choose to allocate the distributed loan

proceeds to other expenditures it makes during the tax

year of the distribution. This allocation is limited to the amount of the other expenditures less any loan proceeds

already allocated to them. For any distributed loan proceeds that are more than the amount allocated to the

other expenditures, the rules in the previous paragraph apply (Notice 88-37).

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How to Report

If the entity does not use the optional method, it reports

the interest expense on the loan proceeds on the line on Schedule K-1 (Form 1065 or Form 1120S) for ―Other

deductions.‖ The expense is identified on an attached schedule as ―Interest expense allocated to debt-financed

distributions.‖ The partner or shareholder claims the interest expense depending on how the distribution was

used.

If the entity uses the optional method, it reports the

interest expense on the loan proceeds allocated to other

expenditures on the appropriate line or lines of Schedule K-1. For example, if the entity chooses to allocate the loan

proceeds and related interest to a rental activity expenditure, the entity will take the interest into account in

figuring the net rental income or loss reported on Schedule K-1.

Deductible Taxes - §164

Businesses can deduct various federal, state, local, and foreign taxes directly attributable to the trade or business as business

expenses. However, federal income taxes, estate and gift taxes, or state inheritance, legacy, and succession taxes are not deductible.

Generally, taxes can be deducted only in the year they are paid, regardless of whether a business uses the cash method or an

accrual method of accounting.

Tax Refunds

If a taxpayer receives a refund for any taxes deducted in an earlier

year, the refund must be included in income to the extent the deduction reduced the taxpayer‘s federal income tax in the earlier

year. In addition, taxpayers include in income any interest received on tax refunds.

Change in Date of Tax Accrual

A taxing jurisdiction can require the use of a date for accruing taxes that is earlier than the date it originally required. However, if a

taxpayer uses the accrual method, and can deduct the tax before it

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is paid, use the original accrual date for the year of change and all

future years to determine when to deduct the tax.

Example

Dan's state imposes a tax on personal property used

in a trade or business conducted in the state. This tax

is assessed and becomes a lien as of July 1 (accrual

date). In 2013, the state changed the assessment

and lien dates from July 1, 2014 to December 31,

2013, for property tax year 2014. He must use the

original accrual date (July 1, 2014) to determine

when he can deduct the tax. Dan must also use the

July 1 accrual date for all future years to determine

when he can deduct the tax.

Real Estate Taxes

Deductible real estate taxes are any state, local, or foreign taxes on

real estate levied for the general public welfare. The taxing authority must base the taxes on the assessed value of the real

estate and charge them uniformly against all property under its jurisdiction.

Local Benefits

Deductible real estate taxes generally do not include taxes

charged for local benefits and improvements that increase the value of the property. These include assessments for streets,

sidewalks, water mains, sewer lines, and public parking facilities. Taxpayers should increase the basis of their property by the

amount of the assessment.

Taxes for local benefits can only be deducted if the taxes are for maintenance, repairs, or interest charges related to those

benefits. If part of the tax is for maintenance, repairs, or interest, taxpayers must be able to show how much of the tax is

for these expenses to claim a deduction for that part of the tax.

Example

Waterfront City, to improve downtown commercial

business, converted a downtown business area

street into an enclosed pedestrian mall. The city

assessed the full cost of construction, financed with

10-year bonds, against the affected properties. The

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city is paying the principal and interest with the

annual payments made by the property owners.

The assessments for construction costs are not

deductible as taxes or as business expenses, but are

depreciable capital expenses. The part of the

payments used to pay the interest charges on the

bonds is deductible as taxes.

Note: Water bills, sewerage, and other service charges

assessed against business property are not real estate taxes,

but are deductible as business expenses.

Real Estate Taxes on Purchase Or Sale

If real estate is sold, the real estate taxes must be allocated

between the buyer and the seller according to the number of

days in the real property tax year (the period to which the tax imposed relates) that each owned the property. Treat the seller

as paying the taxes up to but not including the date of sale. Treat the buyer as paying the taxes beginning with the date of

sale. This information can often be found on the settlement statement you received at closing.

If the seller cannot deduct taxes until they are paid because they use the cash method and the buyer of the property is personally

liable for the tax, the seller is considered to have paid their part of the tax at the time of the sale. This permits the seller to

deduct the part of the tax up to (but not including) the date of sale even though they did not pay it. The seller must also include

the amount of that tax in the selling price of the property.

If the seller uses an accrual method and has not chosen to

ratably accrue real estate taxes, they are considered to have

accrued their part of the tax on the date of sale.

Example

Al Green, a calendar year accrual method taxpayer,

owns real estate in Elm County. He has not chosen to

ratably accrue property taxes. November 30 of each

year is the assessment and lien date for the current

real property tax year, which is the calendar year. He

sold the property on June 30, 2014. Under his

accounting method he would not be able to claim a

deduction for the taxes because the sale occurred

before November 30. He is treated as having accrued

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his part of the tax, 181/366 (January 1–June 29), on

June 30 and he can deduct it for 2014.

Choosing To Ratably Accrue

If a taxpayer uses the accrual method, they can choose to accrue real estate tax related to a definite period ratably over

that period.

Example

John Smith is a calendar year taxpayer who uses an

accrual method. His real estate taxes for the real

property tax year, July 1, 2013, to June 30, 2014,

are $1,200. July 1 is the assessment and lien date.

If John chooses to ratably accrue the taxes, $600 will

accrue in 2013 ($1,200 × 6/12, July 1–December 31)

and the balance will accrue in 2014.

Separate Choices

Taxpayers can choose to ratably accrue the taxes for each

separate trade or business and for nonbusiness activities if they account for them separately. Once a taxpayer has

chosen to ratably accrue real estate taxes, they must use that method unless they get permission from the IRS to

change (see Form 3115).

Making the Choice

If a taxpayer chooses to ratably accrue the taxes for the first year in which they incur real estate taxes, attach a

statement to the income tax return for that year. The statement should show all the following items:

(1) The trades or businesses to which the choice applies and the accounting method or methods used,

(2) The period to which the taxes relate, and

(3) The computation of the real estate tax deduction for

that first year.

Generally, taxpayers must file their return by the due date (including extensions). However, if a taxpayer timely filed

their return for the year without choosing to ratably accrue, they can still make the choice by filing an amended return

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within 6 months after the due date of the return (excluding

extensions).

Form 3115

If a taxpayer chooses to ratably accrue for a year after the

first year in which they incur real estate taxes or if they want to change their choice to ratably accrue real estate

taxes, file Form 3115.

State & Local Income Taxes

A corporation or partnership can deduct state and local income

taxes imposed on the corporation or partnership as business expenses. An individual can deduct state and local income taxes

only as an itemized deduction on Schedule A (Form 1040).

Note: Federal income taxes are not deductible.

However, an individual can deduct a state tax on gross income (as

distinguished from net income) directly attributable to a trade or business as a business expense.

Foreign Income Taxes

Generally, taxpayers can take either a deduction or a credit for

income taxes imposed by a foreign country or a U.S. possession. However, an individual cannot take a deduction or credit for

foreign income taxes paid on income that is exempt from U.S. tax under the foreign earned income exclusion or the foreign

housing exclusion.

States & Local Sales Tax for Individuals

The American Tax Relief Act of 2012 (ATRA) extended the election

to deduct state and local general sales taxes through 2013. Taxpayers could elect to deduct state and local general sales taxes

instead of state and local income taxes as a deduction on Schedule A. However, this deduction did not apply to sales taxes paid on

items used in a trade or business. As of this writing, Congress has not reinstated this provision for 2014.

Temporary Sales Tax Deduction for Qualified Vehicles (Expired)

For purchases on or after February 17, 2009 and before January 1, 2010, the American Recovery & Reinvestment Act (ARRA)

provided an above the line deduction for qualified motor vehicle

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taxes. It expanded the definition of taxes allowed as a deduction

to include qualified motor vehicle taxes paid or accrued within the taxable year.

Employment Taxes

If a business has employees, it must withhold various taxes from

their pay. Most employers must withhold their employees‘ share of social security and Medicare taxes along with state and federal

income taxes. Employers may also need to pay certain employment

taxes, including the share of social security and Medicare, along with unemployment taxes.

The taxes withheld from employees‘ pay should be treated as wages on the employer‘s tax return. The employment taxes the

employer pays are deductible as taxes.

Example

Dan pays his employee $18,000 a year. However,

after he withholds various taxes, the employee

receives $14,500. Dan also pays an additional $1,500

in employment taxes. Dan should deduct the full

$18,000 as wages. Dan can deduct the $1,500 he

pays from his own funds as taxes.

Unemployment Fund Taxes

Employers often have to make payments to a state

unemployment compensation fund or to a state disability benefit fund. These payments are deductible as taxes.

Self-employment Tax

A self-employed person can deduct one-half of his self-

employment tax as a business expense in figuring adjusted gross income. This deduction only affects income tax, not net

earnings from self-employment. To deduct the tax, enter on

Form 1040, line 30, the amount shown on the Deduction for one-half of self-employment tax line of Schedule SE (Form

1040).

Other Taxes

The following are other taxes a business may deduct:

(1) excise taxes,

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(2) franchise taxes,

(3) occupational taxes, and

(4) personal property taxes for property used in a trade or

business,

However, taxes on gasoline, diesel fuel, and other motor fuels used

in a business are usually included as part of the cost of the fuel and ought not to be deducted as a separate item. Similarly, any sales

tax paid on a service or on the purchase or use of property should be treated as part of the cost of the service or property.

Casualty & Theft Losses - §165

A deduction is allowed for all or part of each loss caused by theft or casualty.

A casualty is the damage, destruction, or loss of property resulting from an identifiable event that is sudden, unexpected, or unusual.

There is no casualty loss if the damage is caused by progressive deterioration of property caused by termites, moths, drought,

disease, or rust.

A theft is the unlawful taking and removing of money or property

with the intent to deprive the owner of it. Lost or mislaid money or

property does not qualify for the casualty loss deduction.

Proof of Loss

To take a deduction for a casualty or theft loss a taxpayer must show that there was actually a casualty or theft and they must be

able to support the amount taken as a deduction.

Amount of Loss

The amount of a casualty or theft loss is generally the lesser of:

(1) The decrease in the fair market value of the property as a result of the casualty or theft, or

(2) The taxpayer‘s adjusted basis in the property before the casualty or theft.

Taxpayers may use the cost of replacing or repairing property after a casualty as a measure of the decrease in fair market value if the

value of the repaired or replaced property does not exceed the

value of the property before the casualty.

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Insurance & Other Reimbursements

Any insurance reimbursement must be subtracted from the amount

of the loss when the deduction is figured. If the reimbursement exceeds the taxpayer‘s basis in the property there will be a casualty

gain. If the personal casualty gains for any tax year exceed the personal casualty loss for that year all the gains and losses will be

treated as capital gains and losses. In that event the losses are not subject to the 10% floor.

For casualty and theft losses sustained by individuals, and not attributable to a business or a for profit transaction, a loss covered

by insurance is taken into account only if the taxpayer files a timely claim.

Limitations

There are no limitations on casualty or theft losses on property used in a trade or business. If business casualty losses exceed

business casualty gains they are deductible as ordinary losses on Form 4797.

Nonbusiness casualty and theft losses may be deducted only to the extent that the amount of each separate casualty or theft loss

exceeds $100, and the total amount of all losses during the year

exceeds 10% of the taxpayer‘s adjusted gross income.

Note: Nonbusiness casualty and theft losses in excess of this

10% floor are deducted as itemized deductions on schedule A of

Form 1040.

When property is owned partly for personal use and partly for

business or income-producing purposes, the casualty or theft loss deduction must be figured as though there were two separate

casualties or thefts - one affecting the nonbusiness property and the other affecting the business or income-producing property. The

$100 rule and the 10% rule apply only to the casualty or theft of the nonbusiness property.

Dividends Received Deduction - §243

A corporation is allowed a deduction for a percentage of certain dividends received during its tax year (§243).

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Dividends from Domestic Corporations

A corporation may deduct, with certain limitations, 70% of the

dividends received if the corporation receiving the dividend owns less than 20% of the distributing corporation. Thus, if a corporation

owns stock in another domestic corporation subject to federal taxation, it may deduct from its gross income 70% of the dividends

that it receives from the other corporation (§243(a)(1)).

Note: Small business investment companies may deduct 100%

of the dividends received from a taxable domestic corporation

(§243(a)(2)). In addition, if certain conditions are met,

members of an affiliated group of corporations may deduct

100% of the dividends received from a member of the same

affiliated group (§243(a)(3)).

This deduction reduces the effective federal income tax rate to

10.5% for a corporation in the 35% bracket, and 4.5% for a corporation in the 15% bracket. Dividends that are received by the

corporation from regulated investment companies such as mutual funds are further limited as to deductibility (§243(c)(2)).

80% Exception

A corporation can take a deduction for 80% of the dividends

received or accrued if it owns 20% or more of the paying domestic corporation. This corporation is referred to as a 20%-

owned corporation.

Ownership

Ownership, for these rules, is determined by the amount of voting

power and value of stock (other than certain preferred stock) the corporation owns (§243 (a)(1); §243(c)).

Limitation

Generally, the total deduction for dividends received or accrued is limited (in the following order) to:

(1) 80% of the difference between taxable income and the 100% deduction allowed for dividends received from affiliated

corporations, or by a small business investment company, for dividends received or accrued from 20%-owned corporations,

and

(2) 70% of the difference between taxable income and the

100% deduction allowed for dividends received from affiliated corporations, or by a small business investment company, for

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dividends received or accrued from less-than-20%-owned

corporations (reducing taxable income by the total dividends received from 20%-owned corporations) (§246(b)(1);

§246(b)(3)).

Other Selected Deductible Costs

Home-Office Deduction - §280A

If an individual operates a business out of their home, a portion of the expenses of the residence may be allocated to business.

However, taxpayer must prove that such portion of the home is used exclusively and regularly for business purposes.

Requirements - §280A

1. There must be a specific room or area that is set aside for and

used exclusively on a regular basis as:

a. The principal place of any business, or

b. A place where the taxpayer meets with patients, clients or

customers in the normal course of your trade or business, or

c. A separate structure that is used in your trade or business

and is not attached to your house or residence.

2. An employee can take a home office deduction if he or she

meets the regular and exclusive use test and the use is for the convenience of the employer.

3. No deduction is allowed unless there is a trade or business involved.

Non-Exclusive Use Exceptions

Two special exceptions are made where part of a home is

regularly, but not exclusively, used for business purposes:

Inventory: A wholesaler or retailer who uses part of a home

to store inventory that is held for sale. However, this exception applies only if the dwelling unit is the taxpayer's

sole fixed location of the trade or business.

Day Care Facility: Part of the home is used for day care of

children, physically and mentally handicapped persons, or individuals age 65 or older.

Note: Section 280A does not disallow deductions otherwise

allowed for tax purposes, like home mortgage interest, real

estate taxes, or casualty losses. Moreover, non home-related

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business expenses, such as business supplies, cost of goods

sold, wages, and operating expenses, are not affected by

§280A.

Income Limitation

Deductible home office expense is limited to the gross income

from the home business, reduced by regular operating expenses (wages, supplies, etc.) and an allocable portion of the mortgage

interest, property taxes, and casualty loss deductions. Expenses that aren‘t deducted due to the income limit in one year can be

carried over to future years.

Home Office Deduction After 1998

The TRA ‗97 enhanced the ability of taxpayers who work at home to claim deductions for home office expenses by expanding the

definition of ―principal place of business‖ to include a home office that is used by the taxpayer to conduct administrative or

management activities of the business, provided that there is no other fixed location where the taxpayer conducts substantial

administrative or management activities of the business.

As under pre TRA ‗97 law, deductions will be allowed for a home

office only if the office is exclusively used on a regular basis as a

place of business and, in the case of an employee, only if such exclusive use is for the convenience of the employer.

Example

Doctor Dan consults with patients at local hospitals

and uses a portion of his home exclusively and

regularly to conduct administrative or management

activities. Dan does not conduct any other significant

administrative or management function at another

fixed location. Dan qualifies for the home office

deduction.

Research & Experimental Costs - §174

The costs of research and experimentation are generally capital

expenses. However, a business can choose to deduct these costs as a current business expense (§174). The choice to deduct these

costs is binding for the year it is made and for all later years unless IRS approval is obtained to make a change.

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Note: If certain requirements are met, businesses may choose

to defer and amortize research and experimental costs. In

addition, if a taxpayer pays or incurs qualified research

expenses, they may be able to take the research credit.

Definitions

Research and experimental costs are reasonable costs incurred

in a trade or business for activities intended to provide

information that would eliminate uncertainty about the development or improvement of a product. Uncertainty exists if

the information available does not establish how to develop or improve a product or the appropriate design of a product.

Whether costs qualify as research and experimental costs depends on the nature of the activity to which the costs relate

rather than on the nature of the product or improvement being developed or the level of technological advancement.

Note: The costs of obtaining a patent, including attorneys' fees

paid or incurred in making and perfecting a patent application,

are research and experimental costs. However, costs paid or

incurred to obtain another's patent are not research and

experimental costs.

Product

The term ―product‖ includes any of the following items:

(1) Formula,

(2) Invention,

(3) Patent,

(4) Pilot model,

(5) Process,

(6) Technique, and

(7) Property similar to the items listed above.

It also includes products used by a taxpayer in their trade or

business or held for sale, lease, or license.

Costs Not Included

Research and experimental costs do not include expenses for

any of the following activities:

(1) Advertising or promotions,

(2) Consumer surveys,

(3) Efficiency surveys,

(4) Management studies,

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(5) Quality control testing,

(6) Research in connection with literary, historical, or similar projects, and

(7) The acquisition of another's patent, model, production, or process.

When & How To Choose

You make the choice to deduct research and experimental costs

by deducting them on your tax return for the year in which you first pay or incur research and experimental costs. If you do not

make the choice to deduct research and experimental costs in the first year in which you pay or incur the costs, you can deduct

the costs in a later year only with approval from the IRS.

IF you…. THEN….. Choose to deduct research

and experimental costs as a current business expense.

Deduct all research and

experimental costs in the first year you pay or incur the costs

and all later years. To not deduct research and

experimental costs as a current business expense.

If you meet the requirements,

amortize them over at least 60 months, starting with the month

you first received an economic

benefit from the research.

Business Start-Up & Organizational Costs - §195

Business start-up and organizational costs are generally capital expenditures. Costs paid or incurred before October 23, 2004, must

be capitalized unless an election is made to amortize them. Businesses can now choose to deduct up to $5,000 of business

start-up and $5,000 of organizational costs, paid or incurred as a

current business expense. The $5,000 deduction is reduced by the amount the total start-up or organizational costs exceed $50,000.

Any remaining costs must be amortized over 180 months.

Start-up costs include any amounts paid or incurred in connection

with creating an active trade or business or investigating the creation or acquisition of an active trade or business. Organizational

costs include the costs of creating a corporation.

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How To Make The Choice

Taxpayers choose to deduct the start-up or organizational costs

by claiming the deduction on the income tax return (filed by the due date including extensions) for the taxable year in which the

active trade or business begins.

Carrying Charges

Carrying charges include the taxes and interest paid to carry or

develop real property or to carry, transport, or install personal property. Certain carrying charges must be capitalized under the

uniform capitalization rules. Businesses can choose to capitalize carrying charges not subject to the uniform capitalization rules, but

only if they are otherwise deductible.

Taxpayers can choose to capitalize carrying charges separately for

each project you have and for each type of carrying charge. For unimproved and unproductive real property, the choice is good for

only 1 year. Taxpayers must decide whether to capitalize carrying charges each year the property remains unimproved and

unproductive. For other real property, the choice to capitalize

carrying charges remains in effect until construction or development is completed. For personal property, the choice is effective until the

date a taxpayer installs or first uses it, whichever is later.

Intangible Drilling Costs

The costs of developing oil, gas, or geothermal wells are ordinarily capital expenditures and can usually be recovered through

depreciation or depletion. However, a taxpayer who owns a working

interest can choose to deduct intangible drilling costs (IDCs) as a current business expense.

Only the costs of items with no salvage value can be deducted. These include wages, fuel, repairs, hauling, and supplies related to

drilling wells and preparing them for production, as well as costs for any drilling or development work done by contractors.

Exploration Costs

The costs of determining the existence, location, extent, or quality

of any mineral deposit are ordinarily capital expenditures if the

costs lead to the development of a mine. These costs are normally recovered through depletion as the mineral is removed from the

ground. However, a taxpayer can choose to deduct domestic

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exploration costs paid or incurred before the beginning of the

development stage of the mine (except those for oil, gas, and geothermal wells by taking the deduction on her income tax return,

or on an amended income tax return, for the first tax year for which she wishes to deduct the costs paid or incurred during the tax year.

Partnerships

Each partner, not the partnership, chooses whether to capitalize

or to deduct that partner‘s share of exploration costs.

Reduced Corporate Deductions For Exploration Costs

A corporation (other than an S corporation) can deduct only 70

percent of its domestic exploration costs. It must capitalize the

remaining 30 percent of costs and amortize them over the 60-month period starting with the month the exploration costs are

paid or incurred. A corporation may also elect to capitalize and amortize mining exploration costs over a 10-year period.

Recapture Of Exploration Expenses

When a mine reaches the producing stage, taxpayers must

recapture any exploration costs they chose to deduct.

Mine Development Costs

Taxpayers can deduct costs paid or incurred during the tax year for developing a mine or any other natural deposit (other than an oil or

gas well) located in the United States. These costs must be paid or incurred after the discovery of ores or minerals in commercially

marketable quantities. Development costs include those incurred by

a contractor. Also, development costs include depreciation on improvements used in the development of ores or minerals. They

do not include costs for the acquisition or improvement of depreciable property.

Instead of deducting development costs in the year paid or incurred, taxpayers can choose to treat them as deferred expenses

and deduct them ratably as the units of produced ores or minerals benefited by the expenses are sold. This choice applies each tax

year to expenses paid or incurred in that year. Once made, the choice is binding for the year and cannot be revoked for any

reason.

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Circulation Costs

A publisher can deduct as a current business expense the costs of

establishing, maintaining, or increasing the circulation of a newspaper, magazine, or other periodical.

Reforestation Costs

Reforestation costs paid or incurred before October 23, 2004, must be capitalized unless an election is made to amortize them.

Taxpayers can choose to deduct up to $10,000 of qualifying reforestation costs paid or incurred after October 22, 2004, for each

qualified timber property. The remaining costs can be amortized over an 84-month period.

Qualifying reforestation costs are the direct costs of planting or seeding for forestation or reforestation. Qualified timber property is

property that contains trees in significant commercial quantities

Retired Asset Removal Costs

If a business retires and removes a depreciable asset in connection

with the installation or production of a replacement asset, it can deduct the costs of removing the retired asset. However, if it

replaces a component (part) of a depreciable asset, it must capitalize the removal costs if the replacement is an improvement

and deduct the costs if the replacement is a repair.

Barrier Removal Costs

The cost of an improvement to a business asset is normally a

capital expense. However, a business can choose to deduct the costs of making a facility or public transportation vehicle more

accessible to and usable by those who are disabled or elderly if it owns or leases the facility or vehicle for use in connection with its

trade or business.

A facility is all or any part of buildings, structures, equipment,

roads, walks, parking lots, or similar real or personal property. A public transportation vehicle is a vehicle, such as a bus or railroad

car, that provides transportation service to the public (including service for customers, even if an enterprise is not in the business of

providing transportation services).

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Deduction Limit

The most that can be deducted as a cost of removing barriers to

the disabled and the elderly for any tax year is $15,000. However, taxpayers can add any costs over this limit to the basis

of the property and depreciate these excess costs.

Partners & Partnerships

The $15,000 limit applies to a partnership and also to each partner in the partnership. A partner can allocate the $15,000

limit in any manner among the partner‘s individually incurred costs and the partner‘s distributive share of partnership costs. If

the partner cannot deduct the entire share of partnership costs, the partnership can add any costs not deducted to the basis of

the improved property.

A partnership must be able to show that any amount added to

basis was not deducted by the partner and that it was over a partner‘s $15,000 limit (as determined by the partner). If the

partnership cannot show this, it is presumed that the partner

was able to deduct the distributive share of the partnership‘s costs in full.

Example

John Duke's distributive share of ABC partnership's

deductible expenses for the removal of architectural

barriers was $14,000. John had $12,000 of similar

expenses in his sole proprietorship. He chose to

deduct $7,000 of them. John allocated the remaining

$8,000 of the $15,000 limit to his share of ABC's

expenses. John can add the excess $5,000 of his own

expenses to the basis of the property used in his

business. Also, if ABC can show that John could not

deduct $6,000 ($14,000 – $8,000) of his share of the

partnership's expenses because of how John applied

the limit, ABC can add $6,000 to the basis of its

property.

Qualification Standards

Taxpayers can deduct their costs as a current expense only if the barrier removal meets the guidelines and requirements issued by

the Architectural and Transportation Barriers Compliance Board under the Americans with Disabilities Act (ADA) of 1990).

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Other Barrier Removals

To be deductible, expenses of removing any barrier not covered

by the above standards must meet all three of the following tests:

(1) The removed barrier must be a substantial barrier to access or use of a facility or public transportation vehicle by

persons who have a disability or are elderly;

(2) The removed barrier must have been a barrier for at least

one major group of persons who have a disability or are elderly (such as people who are blind, deaf, or wheelchair

users); and

(3) The barrier must be removed without creating any new barrier that significantly impairs access to or use of the facility

or vehicle by a major group of persons who have a disability or are elderly.

How To Make The Choice

If a taxpayer chooses to deduct their costs for removing

barriers to the disabled or the elderly, the deduction claimed on their income tax return (partnership return for

partnerships) for the tax year the expenses were paid or incurred. Identify the deduction as a separate item. The

choice applies to all the qualifying costs during the year, up to the $15,000 limit.

Amortization

Amortization is a method of recovering (deducting) certain capital costs over a fixed period of time. It is similar to the straight-line

method of depreciation.

Deducting Amortization

Taxpayers deduct amortization that begins during the current year

by completing Part VI of Form 4562 and attaching it to their current year's return. For a later year, do not report the deduction for

amortization on Form 4562 unless beginning to amortize a different amortizable item in that year. In that case, list on the Form 4562

not only the item you are beginning to amortize in the later year, but any items you are still amortizing.

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Start-Up Costs - §195

Start-up costs are costs for creating an active trade or business or

investigating the creation or acquisition of an active trade or business. Start-up costs include any amounts paid or incurred in

connection with any activity engaged in for profit and for the production of income in anticipation of the activity becoming an

active trade or business.

Amortization Period

For costs paid or incurred before October 23, 2004, taxpayers can elect an amortization period of 60 months or more. For costs

paid or incurred after October 22, 2004, taxpayers can elect to deduct a limited amount ($5,000) of start-up and organizational

costs. The costs that are not deducted currently can be amortized ratably over a 180-month period.

Qualifying Costs

A start-up cost is amortizable if it meets both the following tests:

(1) It is a cost that could be deducted if paid or incurred to operate an existing active trade or business (in the same field

as the one entered into); and

(2) It is a cost paid or incurred before the day active trade or

business begins.

Start-up costs include costs for the following items:

(1) An analysis or survey of potential markets, products,

labor supply, transportation facilities, etc,

(2) Advertisements for the opening of the business,

(3) Salaries and wages for employees who are being trained and their instructors,

(4) Travel and other necessary costs for securing prospective distributors, suppliers, or customers, and

(5) Salaries and fees for executives and consultants, or for similar professional services.

Start-up costs do not include deductible interest, taxes, or research and experimental costs.

Purchasing An Active Trade Or Business

Amortizable start-up costs for purchasing an active trade or

business include only investigative costs incurred in the course of a general search for or preliminary investigation of the business.

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These are the costs that help to decide whether to purchase a

new business and which active business to purchase. Costs incurred in an attempt to purchase a specific business are capital

expenses that you cannot amortize.

Example

In June, Dan hired an accounting firm and a law firm

to assist him in the potential purchase of XYZ. They

researched XYZ's industry and analyzed the financial

projections of XYZ. In September, the law firm

prepared and submitted a letter of intent to XYZ.

The letter stated that a binding commitment would

result only after a purchase agreement was signed.

The law firm and accounting firm continued to

provide services including a review of XYZ's books

and records and the preparation of a purchase

agreement. In October, Dan signed a purchase

agreement with XYZ.

The costs to investigate the business before

submitting the letter of intent to XYZ are amortizable

investigative costs. The costs for services after that

time relate to the attempt to purchase the business

and must be capitalized.

Corporate Organizational Costs - §248

The costs of organizing a corporation are the direct costs of creating the corporation. For costs paid or incurred before October 23, 2004,

taxpayers can elect an amortization period of 60 months or more. For costs paid or incurred after October 22, 2004, taxpayers can

elect to deduct a limited amount of start-up and organizational costs. The costs that are not deducted currently can be amortized

ratably over a 180-month period.

Qualifying Costs

You can amortize an organizational cost only if it meets all the following tests:

(1) It is for the creation of the corporation;

(2) It is chargeable to a capital account;

(3) It could be amortized over the life of the corporation if the corporation had a fixed life; and

(4) It is incurred before the end of the first tax year in which the corporation is in business.

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Note: A corporation using the cash method of accounting can

amortize organizational costs incurred within the first tax year,

even if it does not pay them in that year.

The following are examples of organizational costs:

(1) The cost of temporary directors,

(2) The cost of organizational meetings,

(3) State incorporation fees,

(4) The cost of accounting services for setting up the

corporation, and

(5) The cost of legal services (such as drafting the charter,

bylaws, terms of the original stock certificates, and minutes of organizational meetings).

Nonqualifying Costs

The following costs are not organizational costs:

(1) Costs for issuing and selling stock or securities, such as commissions, professional fees, and printing costs, and

(2) Costs associated with the transfer of assets to the corporation.

They are capital expenses that you cannot amortize.

Partnership Organizational Costs - §709

The costs of organizing a partnership are the direct costs of creating

the partnership. For costs paid or incurred before October 23, 2004, taxpayers can elect an amortization period of 60 months or more.

For costs paid or incurred after October 22, 2004, taxpayers can elect to deduct a limited amount of start-up and organizational

costs. The costs that are not deducted currently can be amortized ratably over a 180-month period.

Qualifying Costs

You can amortize an organizational cost only if it meets all the

following tests:

(1) It is for the creation of the partnership and not for

starting or operating the partnership trade or business;

(2) It is chargeable to a capital account;

(3) It could be amortized over the life of the partnership if the partnership had a fixed life;

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(4) It is incurred by the due date of the partnership return

(excluding extensions) for the first tax year in which the partnership is in business; and

(5) It is for a type of item normally expected to benefit the partnership throughout its entire life.

Organizational costs include the following fees:

(1) Legal fees for services incident to the organization of the

partnership, such as negotiation and preparation of the partnership agreement,

(2) Accounting fees for services incident to the organization of the partnership; and

(3) Filing fees.

Nonqualifying Costs

The following costs cannot be amortized:

(1) The cost of acquiring assets for the partnership or

transferring assets to the partnership,

(2) The cost of admitting or removing partners, other than at

the time the partnership is first organized,

(3) The cost of making a contract concerning the operation of

the partnership trade or business (including a contract

between a partner and the partnership), and

(4) The costs for issuing and marketing interests in the

partnership (such as brokerage, registration, and legal fees and printing costs). These ―syndication fees‖ are capital

expenses that cannot be depreciated or amortized.

Partnership Liquidation

If a partnership is liquidated before the end of the amortization period, the unamortized amount of qualifying organizational

costs can be deducted in the partnership's final tax year. However, these costs can be deducted only to the extent they

qualify as a loss from a business.

Costs of Obtaining a Lease

If a taxpayer pays to obtain a lease for business property, they

recover the cost by amortizing it over the term of the lease. The term of the lease for amortization purposes generally includes all

renewal options (and any other period for which you and the lessor reasonably expect the lease to be renewed). However, renewal

periods are not included if 75% or more of the cost of getting the

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lease is for the term of the lease remaining on the acquisition date

(not including any period for which you may choose to renew, extend, or continue the lease).

Section 197 Intangibles

Taxpayers must generally amortize over 15 years the capitalized

costs of §197 intangibles acquired after August 10, 1993. A taxpayer must amortize these costs if they hold the §197

intangibles in connection with their trade or business or in an

activity engaged in for the production of income.

Note: Businesses may not be able to amortize §197 intangibles

acquired in a transaction that did not result in a significant

change in ownership or use.

The amortization deduction each year is the applicable part of the

intangible's adjusted basis (for purposes of determining gain), figured by amortizing it ratably over 15 years (180 months). The

15-year period begins with the later of:

(1) The month the intangible is acquired, or

(2) The month the trade or business or activity engaged in for the production of income begins.

There is no amortization deduction for the month the taxpayer disposes of the intangible. If a taxpayer pays or incurs an amount

that increases the basis of an amortizable §197 intangible after the

15-year period begins, they must amortize it over the remainder of the 15-year period beginning with the month the basis increase

occurs.

Note: For leases after October 22, 2004, the amortization

period for any §197 intangible that is tax-exempt use property

(as defined in §168(h) shall not be less than 125 percent of the

lease term.

Cost Attributable To Other Property

The rules for §197 intangibles do not apply to any amount that is included in determining the cost of property that is not a section

197 intangible. For example, if the cost of computer software is not separately stated from the cost of hardware or other tangible

property and taxpayer consistently treats it as part of the cost of the hardware or other tangible property, these rules do not

apply. Similarly, none of the cost of acquiring real property held

for the production of rental income is considered the cost of goodwill, going concern value, or any other §197 intangible.

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Section 197 Intangibles Defined

The following assets are §197 intangibles:

Goodwill

This is the value of a trade or business based on expected

continued customer patronage due to its name, reputation, or any other factor.

Going Concern Value

This is the additional value of a trade or business that

attaches to property because the property is an integral part of an ongoing business activity. It includes value based on the

ability of a business to continue to function and generate income even though there is a change in ownership (but does

not include any other §197 intangible). It also includes value based on the immediate use or availability of an acquired

trade or business, such as the use of earnings during any period in which the business would not otherwise be available

or operational.

Workforce In Place, Etc.

This includes the composition of a workforce (for example, its experience, education, or training). It also includes the terms

and conditions of employment, whether contractual or otherwise, and any other value placed on employees or any of

their attributes.

For example, taxpayers must amortize the part of the

purchase price of a business that is for the existence of a highly skilled workforce. Also, a taxpayer must amortize the

cost of acquiring an existing employment contract or

relationship with employees or consultants.

Business Books And Records, Etc.

This includes the intangible value of technical manuals,

training manuals or programs, data files, and accounting or

inventory control systems. It also includes the cost of customer lists, subscription lists, insurance expirations,

patient or client files, and lists of newspaper, magazine, radio, and television advertisers.

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Patents, Copyrights, Etc.

This includes package design, computer software, and any

interest in a film, sound recording, videotape, book, or other similar property.

Customer-Based Intangible

This is the composition of market, market share, and any

other value resulting from the future provision of goods or services because of relationships with customers in the

ordinary course of business. For example, taxpayers must amortize the part of the purchase price of a business that is

for the existence of the following intangibles:

(1) A customer base,

(2) A circulation base,

(3) An undeveloped market or market growth,

(4) Insurance in force,

(5) A mortgage servicing contract,

(6) An investment management contract, and

(7) Any other relationship with customers involving the future provision of goods or services.

Accounts receivable or other similar rights to income for goods or services provided to customers before the

acquisition of a trade or business are not §197 intangibles.

Supplier-Based Intangible

This is the value resulting from the future acquisition of goods or services used or sold by the business because of business

relationships with suppliers.

For example, taxpayers must amortize the part of the

purchase price of a business that is for the existence of the following intangibles:

(1) A favorable relationship with distributors (such as favorable shelf or display space at a retail outlet),

(2) A favorable credit rating, and

(3) A favorable supply contract.

Government-Granted License, Permit, Etc.

This is any right granted by a governmental unit or an agency

or instrumentality of a governmental unit. For example, taxpayers must amortize the capitalized costs of acquiring

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(including issuing or renewing) a liquor license, a taxicab

medallion or license, or a television or radio broadcasting license.

Covenant Not To Compete

Unfortunately, §197 intangibles include a covenant not to compete (or similar arrangement) entered into in connection

with the acquisition of an interest in a trade or business, or a

substantial portion of a trade or business. An interest in a trade or business includes an interest in a partnership or a

corporation engaged in a trade or business.

An arrangement that requires the former owner to perform

services (or to provide property or the use of property) is not similar to a covenant not to compete to the extent the

amount paid under the arrangement represents reasonable compensation for those services or for that property or its

use.

Franchise, Trademark, Or Trade Name

A franchise, trademark, or trade name is a §197 intangible. You must amortize its purchase or renewal costs, other than

certain contingent payments that you can deduct currently.

Professional Sports Franchise

For acquisitions after October 22, 2004, a franchise engaged in professional sports and any intangible assets

acquired in connection with acquiring the franchise (including player contracts) is a §197 intangible

amortizable over a 15-year period.

Contract For The Use Of, Or A Term Interest In, A §197

Intangible

Section 197 intangibles include any right under a license,

contract, or other arrangement providing for the use of any §197 intangible. It also includes any term interest in any

§197 intangible, whether the interest is outright or in trust.

Assets That Are Not §197 Intangibles

The following assets are not §197 intangibles:

(1) Any interest in a corporation, partnership, trust, or

estate,

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(2) Any interest under an existing futures contract, foreign

currency contract, notional principal contract, interest rate swap, or similar financial contract,

(3) Any interest in land,

(4) Most computer software,

(5) Any of the following assets not acquired in connection with the acquisition of a trade or business or a substantial

part of a trade or business:

(a) An interest in a film, sound recording, video tape,

book, or similar property,

(b) A right to receive tangible property or services under a

contract or from a governmental agency,

(c) An interest in a patent or copyright, or

(d) Certain rights that have a fixed duration or amount,

(6) An interest under either of the following:

(a) An existing lease or sublease of tangible property, or

(b) A debt that was in existence when the interest was acquired,

(7) A right to service residential mortgages unless the right is acquired in connection with the acquisition of a trade or

business or a substantial part of a trade or business, and

(8) Certain transaction costs incurred by parties to a

corporate organization or reorganization in which any part of a gain or loss is not recognized.

Intangible property that is not amortizable under the rules for §197 intangibles can be depreciated if it meets certain

requirements. Taxpayers generally must use the straight-line method over its useful life. For certain intangibles, the

depreciation period is specified in the law and regulations. For example, the depreciation period for computer software that is

not a §197 intangible is generally 36 months.

Computer Software

Section 197 intangibles do not include the following types of computer software:

(1) Software that meets all the following requirements:

(a) It is, or has been, readily available for purchase by the general public;

(b) It is subject to a nonexclusive license; and

(c) It has not been substantially modified,

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Note: This requirement is considered met if the cost of all

modifications is not more than the greater of 25% of the

price of the publicly available unmodified software or

$2,000.

(2) Software that is not acquired in connection with the

acquisition of a trade or business or a substantial part of a trade or business.

Computer Software Defined

Computer software includes all programs designed to cause a

computer to perform a desired function. It also includes any database or similar item that is in the public domain and is

incidental to the operation of qualifying software.

Rights Of Fixed Duration Or Amount

Section 197 intangibles do not include any right under a contract or from a governmental agency if the right is acquired in the

ordinary course of a trade or business (or in an activity engaged in for the production of income) but not as part of a purchase of

a trade or business and either:

(1) Has a fixed life of less than 15 years, or

(2) Is of a fixed amount that, except for the rules for §197 intangibles, would be recovered under a method similar to the

unit-of-production method of cost recovery.

However, this does not apply to the following intangibles:

(1) Goodwill,

(2) Going concern value,

(3) A covenant not to compete,

(4) A franchise, trademark, or trade name, and

(5) A customer-related information base, customer-based

intangible, or similar item.

Safe Harbor for Creative Property Costs

If taxpayer is engaged in the trade or business of film production, they may be able to amortize the creative property

costs for properties not set for production within 3 years of the first capitalized transaction. These costs may be amortized

ratably over a 15-year period beginning on the first day of the second half of the tax year in which taxpayer properly writes off

the costs for financial accounting purposes. If, during the 15-year period, taxpayer disposes of the creative property rights,

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they must continue to amortize the costs over the remainder of

the 15-year period.

Creative property costs include costs paid or incurred to acquire

and develop screenplays, scripts, story outlines, motion picture production rights to books and plays, and other similar

properties for purposes of potential future film development, production, and exploitation.

Anti-Churning Rules

Anti-churning rules prevent the amortizing of most §197

intangibles if the transaction in which the taxpayer acquired them did not result in a significant change in ownership or use.

These rules apply to goodwill and going concern value, and to any other §197 intangible that is not otherwise depreciable or

amortizable.

Disposition of §197 Intangibles

A section 197 intangible is treated as depreciable property used in a trade or business. If taxpayer held the intangible for more

than 1 year, any gain on its disposition, up to the amount of allowable amortization, is ordinary income (§1245 gain). Any

remaining gain, or any loss, is a §1231 gain or loss. If taxpayer held the intangible 1 year or less, any gain or loss on its

disposition is an ordinary gain or loss.

Nondeductible Loss

Taxpayers cannot deduct any loss on the disposition or worthlessness of a §197 intangible acquired in the same

transaction (or series of related transactions) as other §197 intangibles taxpayer still has. Instead, increase the adjusted

basis of each remaining amortizable §197 intangible by a proportionate part of the nondeductible loss. Figure the

increase by multiplying the nondeductible loss on the disposition of the intangible by the following fraction:

The numerator is the adjusted basis of each remaining

intangible on the date of the disposition.

The denominator is the total adjusted bases of all remaining

amortizable §197 intangibles on the date of the disposition.

Covenant Not To Compete

A covenant not to compete, or similar arrangement, is not considered disposed of or worthless before you dispose of

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your entire interest in the trade or business for which you

entered into the covenant.

Nonrecognition Transfers

If taxpayer acquires a §197 intangible in a nonrecognition

transfer, they are treated as the transferor with respect to the part of their adjusted basis in the intangible that is not more

than the transferor's adjusted basis. This part of the adjusted

basis is amortized over the intangible's remaining amortization period in the hands of the transferor.

Nonrecognition transfers include transfers to a corporation, partnership contributions and distributions, like-kind

exchanges, and involuntary conversions.

In a like-kind exchange or involuntary conversion of a section

197 intangible, you must continue to amortize the part of your adjusted basis in the acquired intangible that is not more

than your adjusted basis in the exchanged or converted intangible over the remaining amortization period of the

exchanged or converted intangible. Amortize over a new 15-year period the part of your adjusted basis in the acquired

intangible that is more than your adjusted basis in the exchanged or converted intangible.

Example

Dan owns a §197 intangible he has amortized for 4

full years. It has a remaining unamortized basis of

$30,000. He exchanges the asset plus $10,000 for a

like-kind §197 intangible. The nonrecognition

provisions of like-kind exchanges apply. Dan

amortizes $30,000 of the $40,000 adjusted basis of

the acquired intangible over the 11 years remaining

in the original 15-year amortization period for the

transferred asset. He amortizes the other $10,000 of

adjusted basis over a new 15-year period.

Research & Experimental Costs

Businesses can amortize their research and experimental costs,

deduct them as current business expenses, or write them off over a 10-year period. If a taxpayer elects to amortize these costs, they

can deduct in equal amounts over 180 months or more. The

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amortization period begins the month taxpayer first receives an

economic benefit from the expenditures

Optional write-off method

Rather than amortize these costs or deduct them as a current

expense, businesses have the option of deducting (writing off) research and experimental costs ratably over a 10-year period

beginning with the tax year in which the costs were incurred.

Amortizable Costs

Taxpayers can amortize costs chargeable to a capital account if they meet both the following requirements:

(1) Taxpayer paid or incurred the costs in their trade or

business; and

(2) Taxpayer is not deducting the costs currently.

Election

To elect to amortize research and experimental costs, complete

Part VI of Form 4562 and attach it to the income tax return. Generally, taxpayers must file the return by the due date

(including extensions).

Pollution Control Facilities

Businesses can elect to amortize over 60 months the cost of a certified pollution control facility.

Certified Pollution Control Facility

A certified pollution control facility is a new identifiable treatment

facility used in connection with a plant or other property in operation before 1976, to reduce or control water or atmospheric

pollution or contamination. The facility must do so by removing, changing, disposing, storing, or preventing the creation or

emission of pollutants, contaminants, wastes, or heat. The

facility must be certified by state and federal certifying authorities.

Note: A new identifiable treatment facility is tangible

depreciable property that is identifiable as a treatment facility. It

does not include a building and its structural components unless

the building is exclusively a treatment facility.

The facility must not significantly increase the output or

capacity, extend the useful life, or reduce the total operating

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costs of the plant or other property. Also, it must not

significantly change the nature of the manufacturing or production process or facility.

Note: The federal certifying authority will not certify property to

the extent it appears taxpayer will recover (over the property's

useful life) all or part of its cost from the profit based on its

operation (such as through sales of recovered wastes). The

federal certifying authority will describe the nature of the

potential cost recovery. The amortizable basis of the facility

must be reduced by this potential recovery.

Businesses can claim a special depreciation allowance on a certified pollution control facility that is qualified property even if

they elect to amortize its cost. The amortizable basis must be reduced by the amount of any special allowance you claim.

Note: A corporation must reduce the amortizable basis of a

pollution control facility by 20% before figuring the amortization

deduction.

Reforestation Costs

Generally, businesses can elect to amortize up to $10,000 ($5,000 if married filing separately) of qualifying reforestation costs paid or

incurred before October 23, 2004, for qualified timber property over an 84-month period. Taxpayers can elect to deduct a limited

amount of reforestation costs paid or incurred after October 22, 2004.

Businesses can elect to amortize the qualifying costs that are not

deducted currently over an 84-month period. There is no limit on the amount of amortization deduction for reforestation costs paid or

incurred after October 22, 2004.

The election to amortize reforestation costs incurred by a

partnership, S corporation, or estate must be made by the partnership, corporation, or estate. A partner, shareholder, or

beneficiary cannot make that election.

Note: A partner's or shareholder's share of amortizable costs is

figured under the general rules for allocating items of income,

loss, deduction, etc., of a partnership or S corporation. The

amortizable costs of an estate are divided between the estate

and the income beneficiary based on the income of the estate

allocable to each.

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Depletion - §613

Depletion is the using up of natural resources by mining, quarrying, drilling, or felling. The depletion deduction allows an owner or

operator to account for the reduction of a product‘s reserves.

Taxpayers who have an economic interest, that is an investment that entitles them to income, in mineral property or standing

timber, can take a deduction for depletion.

Note: Mineral property includes oil and gas wells, mines, and

other natural deposits (including geothermal deposits). For this

purpose, the term ―property‖ means each separate interest

owned in each mineral deposit in each separate tract or parcel

of land. Taxpayers can treat two or more separate interests as

one property or as separate properties.

There are two ways of figuring depletion:

(1) cost depletion, and

(2) percentage depletion.

For mineral property, taxpayers generally must use the method that gives them the larger deduction. For standing timber, cost

depletion must be used.

Cost Depletion

To figure cost depletion taxpayers must first determine:

(1) The property's basis for depletion,

(2) The total recoverable units of mineral in the property's

natural deposit, and

(3) The number of units of mineral sold during the tax year.

Basis For Depletion

To figure the property's basis for depletion, subtract all the

following from the property's adjusted basis:

(1) Amounts recoverable through:

(a) Depreciation deductions,

(b) Deferred expenses (including deferred exploration and

development costs), and

(c) Deductions other than depletion,

(2) The residual value of land and improvements at the end of operations and

(3) The cost or value of land acquired for purposes other

than mineral production.

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Note: The adjusted basis of property is its original cost or other

basis, plus certain additions and improvements, and minus

certain deductions such as depletion allowed or allowable and

casualty losses. Adjusted basis can never be less than zero.

Total Recoverable Units

The total recoverable units are the sum of:

(1) The number of units of mineral remaining at the end of

the year (including units recovered but not sold), and

(2) The number of units of mineral sold during the tax year

(determined under taxpayer's method of accounting).

Taxpayer must estimate or determine recoverable units (tons,

pounds, ounces, barrels, thousands of cubic feet, or other measure) of mineral products using the current industry method

and the most accurate and reliable information obtainable.

Number Of Units Sold

Businesses determine the number of units sold during the tax year based on their method of accounting. According to the IRS,

the following table can be used to make this determination.

Units Sold Chart

IF you use…. THEN the units sold during the year are… The cash method

of accounting.

The units sold for which he received payment

during the tax year (regardless of the year of

sale). An accrual

method of accounting.

The units sold based on your inventories and

method of accounting for inventory.

The number of units sold during the tax year does not include any for which depletion deductions were allowed or allowable in

earlier years.

Determining The Cost Depletion Deduction

Once the property's basis for depletion, the total recoverable units, and the number of units sold during the tax year has been

figured, cost depletion deduction is determined by taking the following steps.

Step Action Result

1 Divide your property's basis Rate per-unit.

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for depletion by total

recovery units. 2 Multiplied the rate per-unit

by units sold during the tax year.

Cost depletion

deduction.

Taxpayers must keep accounts for the depletion of each property

and adjust these accounts each year for units sold and depletion claimed.

Percentage Depletion

To figure percentage depletion, taxpayers multiply a certain percentage, specified for each mineral, by their gross income from

the property during the tax year.

Gross Income

When figuring percentage depletion, subtract from the gross income from the property the following amounts:

(1) Any rents or royalties you paid or incurred for the property, and

(2) The part of any bonus paid for a lease on the property allocable to the product sold (or that otherwise gives rise to

gross income) for the tax year.

A bonus payment includes amounts paid as a lessee to satisfy a

production payment retained by the lessor.

Taxable Income Limit

The percentage depletion deduction generally cannot be more than 50% (100% for oil and gas property) of the taxable income

from the property figured without the depletion deduction.

Taxable income from the property means gross income from the

property minus all allowable deductions (excluding any deduction for depletion) attributable to mining processes, including mining

transportation. These deductible items include the following:

(1) Operating expenses,

(2) Certain selling expenses,

(3) Administrative and financial overhead,

(4) Depreciation,

(5) Intangible drilling and development costs, and

(6) Exploration and development expenditures.

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Partnerships & S Corporations

Generally, each partner or shareholder, and not the partnership or

S corporation, figures the depletion allowance separately. Each partner or shareholder must decide whether to use cost or

percentage depletion. If a partner or shareholder uses percentage depletion, he or she must apply the 65 percent-of-taxable-income

limit using his or her taxable income from all sources.

Partner‟s or Shareholder‟s Adjusted Basis

The partnership or S corporation must allocate to each partner or shareholder his or her share of the adjusted basis of each oil

or gas property held by the partnership or S corporation. The partnership or S corporation makes the allocation as of the date

it acquires the oil or gas property.

Each partner‘s share of the adjusted basis of the oil or gas

property generally is figured according to that partner‘s interest in partnership capital. However, in some cases, it is figured

according to the partner‘s interest in partnership income.

The partnership or S corporation adjusts the partner‘s or

shareholder‘s share of the adjusted basis of the oil and gas

property for any capital expenditures made for the property and for any change in partnership or S corporation interests.

Records

Each partner or shareholder must separately keep records of his

or her share of the adjusted basis in each oil and gas property of the partnership or S corporation. The partner or shareholder

must reduce his or her adjusted basis by the depletion allowed or allowable on the property each year. The partner or

shareholder must use that reduced adjusted basis to figure cost depletion or his or her gain or loss if the partnership or S

corporation disposes of the property.

Reporting the Deduction

Information that a partner or shareholder uses to figure a depletion deduction on oil and gas properties is reported by the

partnership or S corporation on line 20 of Schedule K-1 (Form 1065) or on line 17 of Schedule K-1 (Form 1120S). Deduct oil

and gas depletion for your partnership or S corporation interest on line 20 of Schedule E (Form 1040). The depletion deducted

on Schedule E is included in figuring income or loss from rental

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real estate or royalty properties. The instructions for Schedule E

explain where to report this income or loss and whether you need to file either of the following forms:

(1) Form 6198, At-Risk Limitations, or

(2) Form 8582, Passive Activity Loss Limitations.

Mines & Geothermal Deposits

Certain mines, wells, and other natural deposits, including

geothermal deposits, qualify for percentage depletion.

Mines and other natural deposits. For a natural deposit, the percentage of gross income from the property that can be deducted

as depletion depends on the type of deposit.

The following is a list of the percentage depletion rates for the more

common minerals.

DEPOSITS RATE

Sulfur, uranium, and if from deposits in the

United States, asbestos, lead ore, using ore, nickel ore, and mica

22%

Gold, silver, copper, iron ore, and certain oil shale, if from deposits in the United States

15%

Borax, granite, limestone, marble, mollusks

shells, potash, slate, soapstone, and carbon dioxide produced from a well

14%

Cool, lignite, and sodium chloride 10%

Clay and shale used or sold for use in making

sewer pipe or bricks or used or sold for use as sinterd or burnt lightweight aggregates

7.5%

Clay used or sold in making drainage and

roofing tile, flower pots, and kindred products, and gravel, sand, and stone (other than stone

used or sold for use by a mine owner or operator as dimension or ornamental stone)

5%

A complete list of minerals and their percentage depletion rates is in §613(b).

Gross Income From The Property

For property other than a geothermal deposit or an oil or gas

well, gross income from the property means the gross income from mining. Mining includes all the following:

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(1) Extracting ores or minerals from the ground,

(2) Applying certain treatment processes, and

(3) Transporting ores or minerals (generally, not more than

50 miles) from the point of extraction to the plants or mills in which the treatment processes are applied.

Excise Tax

Gross income from mining includes the separately stated excise

tax received by a mine operator from the sale of coal to compensate the operator for the excise tax the mine operator

must pay to finance black lung benefits.

Extraction

Extracting ores or minerals from the ground includes extraction by mine owners or operators of ores or minerals from the waste

or residue of prior mining. This does not apply to extraction from waste or residue of prior mining by the purchaser of the waste or

residue or the purchaser of the rights to extract ores or minerals from the waste or residue.

Treatment Processes

The processes included as mining depend on the ore or mineral

mined. To qualify as mining, the treatment processes must be applied by the mine owner or operator. For a listing of treatment

processes considered as mining, see §613(c)(4) and the related regulations.

Transportation Of More Than 50 Miles

If the IRS finds that the ore or mineral must be transported

more than 50 miles to plants or mills to be treated because of physical and other requirements, the additional authorized

transportation is considered mining and included in the computation of gross income from mining.

Lessor‟s Gross Income

A lessor‘s gross income from the property that qualifies for percentage depletion usually is the total of the royalties received

from the lease. However, for oil, gas, or geothermal property, gross income does not include lease bonuses, advanced royalties, or

other amounts payable without regard to production from the property.

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Bonuses & Advanced Royalties

Bonuses and advanced royalties are payments a lessee makes

before production to a lessor for the grant of rights in a lease or for minerals, gas, or oil to be extracted from leased property. A

lessor‘s income from bonuses and advanced royalties received is subject to an allowance for depletion.

Timber

Percentage depletion does not apply to timber. Depletion must be based on the cost or other basis in the timber, not including the

cost of land or any amounts recoverable through depreciation.

Depletion takes place when standing timber is cut. To figure the

cost depletion allowance, multiply the number of timber units cut by the depletion unit.

Business Bad Debts - §166

When someone owes a taxpayer money that cannot be collected, there is a bad debt. Taxpayers may generally deduct the amount of

the bad debt owed in the year the debt becomes worthless (§166(a)). There are two kinds of bad debts:

(1) Nonbusiness bad debts, and

(2) Business bad debts.

A business bad debt, generally, is one that comes from operating a

trade or business. All other bad debts are nonbusiness bad debts and are deductible as short-term capital losses (§166(d); §166(e);

Reg. §1.166-1(a)(c); Whipple, 373 US 193 (1963)).

Example

An architect made personal loans to several friends

who were not clients. She could not collect on some

of these loans. They are deductible only as

nonbusiness bad debts, since the architect was not in

the business of lending money and the loans do not

have any relationship to the architect’s business.

A business deducts its bad debts from gross income when figuring

its taxable income. Unlike nonbusiness bad debts, business bad

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debts are not deducted as short-term capital losses (Reg. §1.166-

1(d)(2)).

A business bad debt is a loss from a debt that is created or acquired

in a trade or business. A business bad debt also includes any other worthless debt if there is a very close relationship between the debt

and the trade or business when the debt becomes worthless (§166(d)(2); Reg. §1.166-5(b)).

A debt has a very close relationship to a trade or business if the taxpayer‘s dominant motive for incurring the debt is for a business

reason (Generes, 405 U.S. 93 Ct.D. 1952).

Example

John Smith, an advertising agent, made loans to

certain clients to retain their business. His dominant

reason for making these loans was for his business.

One of these clients later went bankrupt and could

not repay him. Since John’s business was the

dominant reason for making the loan, the debt was a

business debt and he may take a business bad debt

deduction. [Bart, 21 TC 880]

The bad debts of a corporation are always considered business bad debts. However, a bad debt deduction is not allowed for loans made

to a corporation if the loans are actually capital contributions.

Credit Transactions

Business bad debts are mainly the result of credit sales to

customers. They can also be loans to suppliers, clients, employees, or distributors. Goods and services that customers have not yet

paid for are shown in the taxpayer‘s books as either accounts receivable or notes receivable. If the taxpayer is unable to collect

any part of these accounts or notes receivable, the uncollectible

part is a business bad debt. Accounts or notes receivable valued at fair market value at the time of the transaction are deductible only

at fair market value, even though that value may be less than face value (Reg. §1.166-1(d)(2)(i)).

Income Inclusion

A bad debt deduction may be taken on accounts and notes

receivable only if the taxpayer has included the amount owed in gross income for the current or an earlier tax year. This applies

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to amounts owed from all sources of taxable income, such as

sales, services, rents, and interest (Reg. §1.166-1(e)).

Accrual Method Taxpayers

Accrual method taxpayers normally report income that is due

them as soon as it is earned. Therefore, they may take a bad debt deduction when they are unable to collect what is owed

them, provided they have included that amount in income.

Cash Method Taxpayers

Cash method taxpayers normally do not report income that is due them until they actually receive payment. Therefore, they

may not take a bad debt deduction on payments they have

not received or cannot collect (Reg. §1.166-1(c)).

Former Business

When a taxpayer sells their business but keeps its accounts receivable, these debts are business debts since they arose in a

trade or business. If an account becomes worthless, the loss is a business bad debt. These accounts would also be business debts if

sold to the new owner of the business.

If a taxpayer sells their business and sells the accounts receivable, the character of the debts as business or nonbusiness is based on

the activities of the holder of these debts. If the new holder is engaged in trade or business, a loss from one of these accounts is a

business bad debt. If these accounts are sold to someone who is not in a trade or business, a loss from one of these accounts is a

nonbusiness bad debt.

Note: If a taxpayer liquidates their business and some of the

accounts receivable become worthless, they are business bad

debts (Reg. §1.166-5(d)).

Debt Acquired from a Decedent

The character of a loss from a business that is acquired from a decedent is determined in the same way as a debt sold by a

business. Generally, if the taxpayer is in a trade or business, the loss is a business bad debt. If they are not in a trade or

business, the loss is a nonbusiness bad debt.

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Political Debts

If a political party (or other organization that accepts contributions

or spends money to influence elections) owes a taxpayer money and the debt becomes worthless, the taxpayer cannot take a bad

debt deduction unless they use an accrual method of accounting and meet all the following tests:

(1) The debt was from the sale of goods and services in the ordinary course of your trade or business,

(2) More than 30% of all the taxpayer‘s receivables in the year of the sale were from sales made to political parties, and

(3) The taxpayer made substantial continuing efforts to collect on the debt (§271(a); § 271(c)).

Insolvency of Partner

When a business partnership breaks up and one of the former partners is unable to pay any of the partnership‘s debts, a solvent

partner may have to pay more than their share of the partnership‘s debts. When a taxpayer pays any part of an insolvent partner‘s

share of the debts, they can take a bad debt deduction (R.R. 72-505).

Business Loan Guarantees

If a taxpayer guarantees a debt that later becomes worthless and can show that the reason for guaranteeing the debt was closely

related to their trade or business, then the debt can qualify as a business bad debt. Any guarantees made to protect or improve the

taxpayer‘s job are also considered closely related to the taxpayer‘s trade or business as an employee (Reg. §1.166-9(a)).

Example

Bob Zayne owns the Zayne Dress Company. He

guaranteed payment of a $20,000 note for Elegant

Fashions, a dress outlet. Elegant Fashions is one of

Mr. Zayne’s largest clients. Elegant Fashions later

files for bankruptcy and defaults on the loan. Mr.

Zayne makes full payment to the bank. He can take a

business bad debt deduction, since his guarantee was

closely related to his trade or business. He was

motivated by the desire to retain one of his better

clients and keep a sales outlet.

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A payment made on a loan the taxpayer guaranteed is deductible in

the year the payment is made unless the taxpayer has rights against the borrower. If the taxpayer has the right to demand

payment from the borrower, a bad debt deduction cannot be taken until these rights become either partly or totally worthless (Reg.

§1.166-9(e)(2)).

Reporting

If an individual taxpayer has a bad debt from operating a trade or

business, take the deduction on line 9, Part II of Schedule C (Form 1040). If the individual has a bad debt from operating a farm

business, take the deduction on line 35 of Schedule F (Form 1040).

Corporations deduct bad debts on line 15 of Form 1120, line 15 of

Form 1120A, or line 10 of Form 1120S.

Partnerships deduct their business bad debts on line 14 of Form

1065.

Methods of Treating Bad Debts

There are two ways to treat uncollectible amounts:

(1) The specific charge-off method for bad debts, and

(2) The nonaccrual-experience method.

In general, taxpayers must use the specific charge-off method. However, taxpayers may use the nonaccrual-experience method if

certain requirements are met. Taxpayers cannot use the reserve method any longer.

Specific Charge-Off Method

Using the specific charge-off method, taxpayers deduct specific

business bad debts that become either partly or totally worthless during the tax year (Reg. §1.166-3(a)).

Partly Worthless Debts

Specific bad debts that are partly uncollectible may be

deducted. However, the deduction is limited to the amount charged off on the taxpayer‘s books during the tax year.

Taxpayers do not have to annually charge off and deduct their partly worthless debts. Instead they may delay the charge-off

until a later year. In addition, they may wait until more of the debt has become worthless or until they have collected all

they can on the debt and it is totally worthless. Taxpayers may not, however, deduct any part of the bad debt in a year

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after the year in which the debt becomes totally worthless

(Reg. §1.166-3(a)(2); Reg. §1.166-3(b)).

Deduction Disallowed

Usually, taxpayers may take a partial bad debt deduction

only in the year they make the charge-off on their books. However, the Service may not allow the deduction.

If the debt becomes partly worthless in a later tax year,

taxpayers can deduct the amount they charge off in the later year, plus the amount charged off in the earlier year.

The charge-off in the earlier year, unless reversed on the books, fulfills the charge-off requirement for the later year

(Reg. §1.166-3(a)(2)(ii)).

Totally Worthless Debts

A totally worthless debt is deducted only in the tax year it becomes totally worthless. The deduction for the debt must

not include any amount deducted in an earlier tax year when the debt was only partly worthless (Reg. §1.166-3(b)).

Taxpayers are not required to make an actual charge-off on their books to claim a bad debt deduction for a totally

worthless debt. However, they may want to do so. If a debt claimed to be totally worthless is not charged off on the books

and IRS later rules that the debt is only partly worthless, the taxpayer will not be allowed any deduction. A deduction of a

partly worthless bad debt is limited to the amount actually charged off.

Recovery of Bad Debt

If a taxpayer deducted a bad debt and in a later tax year

recovers (collects) all or part of it, they have to include the amount recovered in gross income. However, taxpayers may

exclude from gross income the amount recovered up to the amount of the deduction that did not reduce tax in the year

deducted (Reg. §1.166-1(f)).

Example

In 2013, the Willow Corporation had gross income of

$158,000, a bad debt deduction of $3,500, and other

allowable deductions of $49,437. The corporation

reported on the accrual method of accounting and

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used the specific charge-off method for bad debts. In

2014, the Willow Corporation recovers part of the

$3,500 it deducted in 2013. It must include the part

recovered in income for 2014. The entire bad debt

deduction reduced the tax on the 2013 corporate

return. For 2014, Willow Corporation will report the

recovery as ―Other Income‖ on its corporate return.

Property Received for a Debt

If a taxpayer receives property in partial settlement of a debt,

they must reduce the debt by the fair market value of the property received. Any amount of the unpaid debt remaining

is deductible as a bad debt in the year the debt is determined to be worthless and is charged off.

If the taxpayer later sells this property that they received, any gain from the sale is considered separately from having

received the property in partial settlement of a debt. Therefore, this gain is includible in gross income. Any gain is

not a recovery of a bad debt previously deducted without tax

benefit (R.R. 66-320).

Bankruptcy Claim

Taxpayers can deduct the difference between the amount

owed to them by a bankrupt entity and the amount received

from the distribution of its assets as a bad debt (Reg. §1.166-1(d)(2)(ii)).

Note: If the taxpayer was a shareholder in a bankrupt

corporation, they may be entitled to a loss for worthless stocks

or securities under §165.

Sale of Mortgaged Property

If a taxpayer sells mortgaged or pledged property for less than the amount of the debt, the unpaid balance of the debt

after the sale is a bad debt. If the debt represents capital or

an amount that was previously included in income, they may deduct it as a bad debt in the year it becomes worthless or in

the year it is charged off as partially worthless (Reg. §1.166-6(a)(1)).

Net operating Loss

A bad debt deduction may produce or add to a net operating

loss. If the taxpayer has a net operating loss one year, they

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may carry the loss back or forward to other tax years and

deduct the loss from their income earned in those years. As a result, a bad debt deduction that contributes to a net

operating loss helps lower taxes in the year to which the net operating loss is carried.

Nonaccrual-Experience Accounting Method

If a taxpayer uses an accrual method of accounting and qualifies

under the rules in this section, they may be able to use the nonaccrual-experience method of accounting for bad debts.

Under this method, taxpayers do not have to accrue income that they do not expect to collect.

The nonaccrual-experience method applies only to amounts to be received (accounts receivable) for the performance of

services. It may not be used if the taxpayer requires that interest or penalties be paid for late payments. If the taxpayer

determines that, based on their experience, their accounts receivable will not be collected, they do not include it in gross

income for the tax year (§448(d)(5); Reg. §1.448-2T(b)).

Performing Services

Taxpayers may use the nonaccrual-experience method only for amounts earned by performing services, and that would

otherwise have to be included in income. The nonaccrual-experience method may not be used for amounts owed to the

taxpayer because they are engaged in activities such as lending money, selling goods, or acquiring receivables or

other rights to receive payment from other persons (Reg.

§1.448-2T(d)).

Interest & Late Charges

Generally, the nonaccrual-experience method may not be

used for amounts due for which interest or a late payment penalty is required. However, if the taxpayer offers a discount

for early payment of an amount due, they will not be

regarded as charging interest or requiring a late payment penalty if:

(1) The full amount due is otherwise accrued as gross income at the time the services are provided, and

(2) The taxpayer treats the discount for early payment as an adjustment to gross income in the year of payment,

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provided they receive payment within the time allowed for

the discount (Reg. §1.448-2T(c)(1)).

Taxpayers may apply the nonaccrual-experience method

under either a separate receivable system or a periodic system. Under the separate receivable system, apply the

nonaccrual-experience method separately to each account receivable. Under the periodic system, apply the nonaccrual-

experience method to total qualified accounts receivable at the end of your tax year.

Each system is also treated as a separate method of accounting. Thus, taxpayers generally may not change from

one system to the other without the consent of the IRS.

Taxpayers also need the consent of the IRS to change to

either system under the nonaccrual-experience method from a different method of accounting.

Refueling Property & Electric Vehicles

Alternative Fuel Refueling Property - §30C

Taxpayers could claim a 30-percent credit for the cost of installing qualified clean-fuel vehicle refueling property to be used in a trade

or business of the taxpayer or installed at the principal residence of the taxpayer (§30C).

For property placed in service in 2009 or 2010, the American Recovery & Reinvestment Act increased the maximum credit

available for business property to $200,000 for qualified hydrogen refueling property and to $50,000 for other qualified refueling

property. For nonbusiness property, the maximum credit was

increased to $2,000. In addition, the credit rate was increased from 30 percent to 50 percent, except in the case of hydrogen refueling

property.

Comment: In short, the Act increased the credit to 50%

(limited to $50,000) for property placed in service in 2009 and

2010. The credit was also increased to 50% (limited to $2,000)

for individuals.

ATRA extended through 2013, the 30% investment tax credit for alternative vehicle refueling property. However, as of this writing,

Congress has not extended this provision for 2014.

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Plug-In Electric Drive Motor Vehicle Credit - §30

Under §30D, a credit is available for each qualified plug-in electric

drive motor vehicle placed in service after 2009. This credit was scheduled to terminate after 2014 but was made permanent by

ARRA.

The credit is equal to:

(a) $2,500, plus

(b) $417 for a vehicle drawing propulsion energy from a battery

with at least 5 kilowatt hours of capacity, plus

(c) $417 for each additional kilowatt hour of capacity in excess

of 5 kilowatt hours, up to a maximum aggregate of $5,000.

2- & 3-Wheeled Plug-In Electric Vehicles

For 2012 & 2013, a plug-in electric vehicle credit was also allowed for 2- and 3-wheeled plug-in electric vehicles (§30D(g).

The credit was equal to the lesser of :

(i) 10% of the cost of the qualified 2- or 3-wheeled plug-in

electric drive vehicle; or

(ii) $2,500.

As of this writing, Congress has not extended this provision for

2014.

Advanced Energy Investment Credit - §48C

Effective February 17, 2009, the American Recovery & Reinvestment Act established a 30% credit for investment in

qualified property used in a qualified advanced energy manufacturing project that reequips, expands, or establishes a

manufacturing facility for the production of certain types of

advanced energy property (§48C).

The credit is not allowed for any investment if any of the following

credits are allowed:

(1) the §48 advanced coal project credit,

(2) the §48 energy credit, or

(3) the §48B qualifying gasification project credit.

Depreciation - §168

Depreciation is a loss in the value of property over the time the property is being used. Events that can cause property to

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depreciate include wear and tear, age, deterioration, and

obsolescence. The cost of property is recovered by taking deductions for the cost over a set period of years. Property is

classified as either real or personal and can be used in business or for personal purposes.

The Modified Accelerated Cost Recovery System (MACRS) is required for most property placed in service after 1986. Likewise

Accelerated Cost Recovery System (ACRS) was mandatory for property placed in service after 1980 and before 1987.

Personal Property

ACRS - §168

ACRS placed personal tangible recovery property into three recovery period classes on the basis of 1981 ADR midpoint class

lives (R. P. 83-35).

a. 3 year class - included light trucks, automobiles, R&D

equipment, racehorses over 2 years old and other horses over 12 years old, and other property with an ADR midpoint of 4

years or less.

b. 5 year class - included most depreciable equipment,

furniture, fixtures, computer equipment and all personal tangible property not included in the 3 year and 10 year

classes.

c. 10 year class - included "section 1250 class property" with

an ADR class life of 12.5 years or less.

Comment: The term "section 1250 class property" means real

property including elevators and escalators. The 10-year class

also includes railroad tank cars, manufactured homes, theme

park structures, and road utilization property used in a public

utility power plant.

Applicable Percentage

ACRS provided an annual statutory percentage for all classes

of tangible personal recovery property. These are the

accelerated statutory rates (in percentage) applicable to personal property placed in service after 1980:

If the recovery year is: 3-year 5-year 10-year

1. 25% 15% 8%

2. 38% 22% 14%

3. 37% 21% 12%

4. 21% 10%

5. 21% 10%

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6. 10%

7-10. 9%

Straight-line Election

Taxpayers may elect to deduct the cost of recovery property on a straight-line basis over one of the following optional

recovery periods:

Recovery Period Class Optional Recovery Periods

3 year Property 3, 5, or 12 years

5 year Property 5, 12, or 25 years

10 year Property 10, 25, or 35 years

MACRS

The general effect of MACRS was to lengthen asset lives. MACRS

places personal tangible property into 6 recovery classes based on ADR midpoint life (R. P. 83-35).

(1) 3-Year Class (200% DB) - includes tractor units for use

over the road, special tools used in the manufacturing of motor vehicles, racehorses if 2 years old when placed in

service, breeding hogs and other personal property with an ADR midpoint of 4 years or less (except autos and light

trucks).

(2) 5-Year Class (200% DB) - includes automobiles, buses,

light and heavy general purpose trucks, breeding and dairy cattle, trailers and trailer mounted containers, computers and

peripheral equipment, typewriters, calculators, copiers, R&D property and other personal property with an ADR midpoint of

more than 4 years and less than 10 years.

(3) 7-Year Class (200% DB) - includes office furniture,

fixtures, equipment, breeding and work horses, agricultural machinery and equipment, railroad trucks, single purpose

agricultural or horticultural structures and other property with

an ADR midpoint of 10 years and less than 16 and property not specifically assigned to any other class.

(4) 10-Year Class (200% DB) - includes vessels, barges, tugs, assets used for petroleum refining, manufacture of

grain, sugar, and vegetable oils and other property with an ADR midpoint of 16 years or more but less than 20 years.

(5) 15-Year Class (150% DB) - includes land improvements, assets used for electrical generation, pipeline transportation,

and cement manufacture, railroad track, nuclear production

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plants, sewage treatment plants, and other property with an

ADR midpoint of 20 years or more but less than 25 years.

Comment: An allocation to land improvements in the

acquisition of residential rental and commercial property

results in both a shorter depreciable life (i.e., not the 27.5,

31.5, or 39 years under MACRS) and accelerated

depreciation.

(6) 20-Year Class (150% DB) - includes water utilities, municipal sewer, farm buildings, gas distribution facilities and

other property with an ADR midpoint of 25 years or more.

Elections

MACRS permits a taxpayer to elect straight-line depreciation only over the MACRS class in which the asset belongs. This

election, if made, must be made for all property within a recovery class, but can be made for one class but not

another.

In addition, an election may also be made to use the 150%

declining balance method for property other than 15-year, 20-year, nonresidential real property, residential real

property.

Warning: When this election is made, the alternative

minimum tax calculates the adjustment for accelerated

depreciation using the alternative depreciation system.

Bonus (or Additional First-year) Depreciation - §168(k)

Business taxpayers were allowed a 50% first-year additional depreciation deduction for qualified property placed in service

after December 31, 2011 and before January 1, 2014

(§168(k). As of this writing, Congress has not extended this provision under §168(k).

Comment: This provision also raised the first year limit on

depreciation for passenger automobiles by $8,000 if bonus

depreciation was claimed for a qualifying vehicle.

The amount of the additional allowance was the applicable percentage (50%) of the unadjusted depreciable basis of the

qualified property (Reg. §1.168(k)-1(d)(1)). Unadjusted depreciable basis was the adjusted basis of the property for

determining gain or loss reduced by any §179 amount expensed and any adjustments to basis provided by the Code.

Regular MACRS depreciation was computed after reducing the unadjusted depreciable basis by the bonus depreciation.

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Comment: Section 168(k)(2)(D)(iii) permitted a taxpayer to

elect not to claim bonus depreciation deduction for any class of

property. As a result, if recapture was required, the Service

assumed bonus depreciation was taken unless an election out

was made on the original return.

The additional first-year depreciation deduction was allowed for both regular tax and alternative minimum tax purposes for

the taxable year in which the property was placed in service.

Qualifying Property

In order for property to qualify for the additional first-year depreciation deduction it had to meet all of the following

requirements.

First, the property had to be property:

(1) To which MACRS applied with an applicable recovery period of 20 years or less,

(2) Water utility property (as defined in section 168(e)(5)),

(3) Computer software other than computer software covered by section 197, or

(4) Qualified leasehold improvement property (as defined in section 168(k)(3)).

Second, the original use of the property had to commence with the taxpayer on or after January 1, 2008.

Third, the taxpayer had to purchase the property within the

applicable time period.

Coordination with §179

The § 179 expense allowance was claimed before the

additional depreciation allowance was taken (Reg. §1.168(k)-1(d)).

MACRS Conventions

Generally, only a half-year of MACRS depreciation is allowed

for personal property for the acquisition and disposition year.

Mid-quarter Convention Exception

MACRS substitutes mid-quarter convention for all personal property placed in service during a tax year if more than

40% of the total basis of all personal property placed in service during the year is placed in service during the last

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three months. Property placed in service and disposed of

during the same year is not included in the 40% test.

The mid-quarter convention treats personal property placed

in service or disposed of during any quarter as placed in service or disposed of on the midpoint of that quarter.

Quarter Months of Depreciation

1st 10.5

2nd 7.5

3rd 4.5

4th 1.5

Recapture - §1245

Generally gains from the sale of depreciable tangible personal

property are treated as capital gains under §1231 while losses are treated as ordinary losses. Section 1245 reclassifies gain

from the sale of depreciable tangible personal property from capital gain to ordinary income to the extent depreciation or cost

recovery deductions were claimed on the asset.

The §179 expense election is treated as a MACRS or ACRS

deduction for recapture purposes. Recapture would occur if the

expensed property is converted to personal use prior to the expiration of its life under MACRS or ACRS. A property is

converted to personal use if it is not used predominantly in a trade or business.

Real Property

ACRS

ACRS established arbitrary depreciation recovery periods and abandoned salvage value, useful life and new or used

considerations.

Under ACRS, the recovery periods for real estate are:

(1) 15 Year Real Property- §1250 property (real property which is of a character subject to its allowance for

depreciation) which was placed in service after 1980 and before March 16, 1984.

(2) 18 Year Real Property- §1250 property placed in service after March 15, 1984 and before May 9, 1985.

(3) 19 Year Real Property- §1250 property placed in service after May 8, 1985 and before 1987.

Under ACRS, the recovery methods for real estate are:

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(1) 175% Declining Balance - The accelerated rate for real

property (other than low income housing) in the 15, 18, or 19 year class was 175% declining balance with appropriately

timed switches to straight-line to maximize the deduction. Accelerated cost recovery rates were based on the number of

months the property was in service for the acquisition or disposition year. Low income housing in the 15-year class was

200% declining balance method.

(2) Straight-line Election - Taxpayers could elect to deduct

the cost of recovery property using a straight-line method on a property-by-property basis over any of the following

optional recovery periods:

15-year real property - 15, 35, or 45 years

18-year real property - 18, 35, or 45 years

19-year real property - 19, 35, or 45 years

MACRS

Under MACRS real property is 27.5-year class if it is residential

rental property. All other depreciable real property (e.g., commercial) was assigned to the 31.5-year class. On or after

May 13, 1993, all other depreciable real property is assigned to the 39 year class.

The straight-line method must be used for all real property in the

27.5-year class, 31.5-year class, and the 39-year class.

MACRS uses a half-month convention rules for all real property.

Thus, all real property placed in service during any month is treated as being placed in service on the midpoint of each month

for purposes of computing the MACRS depreciation deduction.

Recapture - §1250 & §1245

There are basically three depreciation recapture provisions: §1245,

§1250, and §291. Recapture converts gain that would have been taxed at capital gains rates into ordinary income.

Section 1245

Section 1245 provides that the portion of gain from the

disposition of §1245 property (including §167 depreciation, §168 cost recovery, §179 expensing, and the old investment credit

50% basis reduction) is recaptured as ordinary income. Although §1245 originally applied solely to depreciable personal property,

nonresidential real estate acquired after 1980 and before 1987

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and for which accelerated depreciation was used is subject to

§1245.

Full Recapture

All depreciation taken is subject to §1245 recapture. The

method of depreciation (straight-line, ACRS or MACRS) does not matter.

Section 1250

Recapture under §1250 is less damaging than under §1245.

Section 1250 only recaptures the excess of accelerated depreciation actually deducted over straight-line depreciation.

Generally, §1250 property is depreciable real property (i.e.,

buildings and improvements) that is not subject to §1245.

Partial Recapture

Straight-line depreciation (except for property held one year

or less) is not recaptured. Thus, §1250 is a partial recapture provision.

MACRS Recapture Exception for Real Property

Since residential real property in the 27.5-year class and

nonresidential real property in the 31.5 or 39 year class is depreciable only under straight-line, MACRS real property is not

subject to recapture.

Alternative Depreciation System - §168(g)

Mandatory Application

Depreciation must be calculated under the alternative

depreciation system in the case of:

(a) Any tangible property that is used predominantly outside

the United States,

(b) Any tax-exempt use (of more than 35% of the property)

and tax-exempt bond financed property,

(c) An election to apply the alternative depreciation system to all property in a class placed in service during the taxable

year, and

Comment: A property-by-property election can be made in the

case of nonresidential real property or residential rental

property. The election once made is irrevocable.

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(d) The alternative minimum tax to determine the portion of

depreciation treated as a tax preference item.

Method

Under the alternative depreciation system recovery periods are:

(a) The ADR midpoint life for property that does not fall into any of the classes listed below,

(b) Five years for qualified technological equipment,

automobiles, and light-duty trucks,

(c) Twelve year for personal property with no class life, and

(d) Forty years for all residential rental property and all nonresidential real property.

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CHAPTER 4

Employee Compensation &

Benefits

Wages, Salary & Pay

Businesses can generally deduct the pay they give employees for

the services they perform (§162). The pay may be in cash, property, or services. It may include wages, or salaries, or other

compensation such as: vacation allowances, bonuses, commissions, and fringe benefits.

In addition, an employer may be able to claim the following employment credits if it hires individuals who meet certain

requirements:

(1) Empowerment zone and renewal community employment credit,

(2) Indian employment credit,

(3) New York Liberty Zone business employee credit,

(4) Welfare-to-work credit, and

(5) Work opportunity credit.

However, businesses that claim any employment credits must reduce their deduction for employee wages by the amount of the

credits claimed.

Employee vs. Contractor Status

An employer must generally withhold income taxes, withhold, and

pay social security and Medicare taxes, and pay unemployment taxes on wages paid to an employee. An employer does not

generally have to withhold or pay any taxes on payments to independent contractors.

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Common-law rules are used to determine whether a person is an

employee for purposes of social security and Medicare taxes (FICA taxes), federal unemployment tax (FUTA tax), and federal income

tax withholding. Under the common-law rules, anyone who performs services that are subject to the will and control of an

employer, as to both what must be done and how it must be done, is an employee.

It does not matter whether the employer allows the employee discretion and freedom of action, as long as the employer has the

legal right to control both the method and the result of the services. Two of the usual characteristics of an employer-employee

relationship are that the employer supplies the employee with tools and a place to work and the employer has the right to discharge the

employee (Reg. §31.3121(d)-1; §3306(i); Reg. §31.3401(c)-1).

Note: If an employer treats an employee as an independent

contractor, the person responsible for the collection and

payment of withholding taxes may be held personally liable for

an amount equal to the employee‘s income, social security, and

Medicare taxes that should have been withheld.

In doubtful cases, the facts will determine whether or not there is

an actual employer-employee relationship. If a taxpayer wants(?) the IRS to determine whether a worker is an employee, file Form

SS-8, Determination of Employee Work Status for Purposes of Federal Employment Taxes and Income Tax Withholding, with the

District Director (Reg. §31.3121(d)-1(c)).

To determine whether an individual is an employee under the

common law rules, the IRS has identified 20 factors. The degree of importance of each factor varies depending on the occupation and

the context in which the services are performed.

Factors

The 20 factors indicating whether an individual is an employee or an independent contractor are:

1. Instructions. An employee must comply with instructions about when, where, and how to work. Even if no instructions

are given, the control factor is present if the employer has the

right to give instructions.

2. Training. An employee is trained to perform services in a

particular manner. Independent contractors ordinarily use their own methods and receive no training from the

purchasers of their services.

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3. Integration. An employee‘s services are integrated into

the business operations because the services are important to the success or continuation of the business. This shows that

the employee is subject to direction and control.

4. Services rendered personally. An employee renders

services personally. This shows that the employer is interested in the methods as well as the results.

5. Hiring assistants. An employee works for an employer who hires, supervises, and pays assistants. An independent

contractor hires, supervises, and pays assistants under a contract that requires him or her to provide materials and

labor and to be responsible only for the result.

6. Continuing relationship. An employee has a continuing

relationship with an employer. A continuing relationship may exist where work is performed at frequently recurring

although irregular intervals.

7. Set hours of work. An employee has set hours of work established by an employer. An independent contractor is the

master of his or her own time.

8. Full-time work. An employee normally works full time for

an employer. An independent contractor can work when and for whom he or she chooses.

9. Work done on premises. An employee works on the premises of an employer, or works on a route or at a location

designated by an employer.

10. Order or sequence set. An employee must perform

services in the order or sequence set by an employer. This shows that the employee is subject to direction and control.

11. Reports. An employee submits reports to an employer. This shows that the employee must account to the employer

for his or her actions.

12. Payments. An employee is paid by the hour, week, or month. An independent contractor is paid by the job or on a

straight commission.

13. Expenses. An employer pays an employee‘s business

and travel expenses. This shows that the employee is subject to regulation and control.

14. Tools and materials. An employer furnishes an employee significant tools, materials, and other equipment.

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15. Investment. An independent contractor has a significant

investment in the facilities he or she uses in performing services for someone else.

16. Profit or loss. An independent contractor can make a profit or suffer a loss.

17. Works for more than one person or firm. An independent contractor gives his or her services to two or

more unrelated persons or firms at the same time.

18. Offers services to general public. An independent

contractor makes his or her services available to the general public.

19. Right to fire. An employer can fire an employee. An independent contractor cannot be fired so long as he or she

produces a result that meets the specifications of the contract.

20. Right to quit. An employee can quit his or her job at any

time without incurring liability. An independent contractor usually agrees to complete a specific job and is responsible

for its satisfactory completion, or is legally obligated to make good for failure to complete it.

Tests for Deducting Pay to Employees

To be deductible, employees‘ pay must be an ordinary and

necessary expense and the employer must pay or incur it in the tax

year.

In addition, the pay must meet both of the following tests:

(1) The pay must be reasonable (Test#1), and

(2) The pay must be for services performed (Test #2).

The form or method of figuring the pay does not affect its deductibility. For example, bonuses and commissions based on

sales or earnings, and paid under an agreement made before the services were performed, are generally deductible.

Test #1 - Reasonableness

Determine the reasonableness of pay by the facts and

circumstances. Generally, reasonable pay is the amount that like enterprises would pay for the same, or similar, services.

Employers must be able to prove that the pay is reasonable. Base this test on the circumstances that exist when contracting

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for the services, not those that exist when the reasonableness is

questioned. If the pay is excessive, the excess is not deductible.

The area of reasonable salaries is by far the most common area

for the owner-employees of a closely held corporation to get themselves into trouble. The reason is simple, salaries and

benefits are deductible expenses. Dividends are not. If you are paying your cousin the janitor $90,000 a year, the IRS will want

to ask you a few questions.

Overall Limitation

An overall limitation on compensation is the doctrine of unreasonable compensation. With rare exception, reasonable

compensation cases always involve closely held companies where the key employees are also shareholders.

Compensation for other employees is infrequently challenged. If the compensation is disallowed, the company loses its

deduction and has made a nondeductible dividend distribution instead. The employee has dividend (since he is also a

shareholder) rather than personal service income.

Allowance of Deduction

Employee compensation is normally deductible under §162. Section 162(a)(1) permits a corporate deduction for ―a

reasonable allowance for salaries or other compensation for personal services actually rendered.‖ Assuming that

payment is made for personal services rendered in the past or present, the issue of reasonableness is very important.

Limitation on Accrual Deduction

If the corporation is on a cash basis accounting method,

then the compensation is deductible only when paid. Where the corporation is on the accrual basis method of

accounting, and compensation due certain related persons (i.e. more than 50% shareholders) is accrued, the

corporation‘s deduction is deferred until the payee is

required to include the compensation in income (§267(a)(2)).

Employment Contracts

Employment contracts are recommended even for sole

shareholder corporations. Salaries, bonuses, vacations,

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working hours, duties, disability, expenses, retirement,

fringe benefits, etc. should all be spelled out precisely.

Scope of Examination

Total compensation is examined when determining whether or

not compensation is reasonable (Levenson and Klein, 67 TC 694 (1980)). Retirement plan contributions, group insurance

premiums, medical reimbursements, sick pay, auto

allowances, and other ―perks‖ are all considered.

Officer‟s Compensation

The test of whether an individual officer‘s pay is reasonable

is based on each individual officer‘s pay and the service

performed, not on the total amount paid to all officers or all employees. For example, even if the total amount a

company pays to its officers is reasonable, it cannot deduct the part of an individual officer‘s pay that is not reasonable.

Factors

Many practitioners seek ―hard and fast‖ guidelines in this

unsettled area but they don‘t exist. The courts look at many factors in deciding issues of reasonable compensation and

each case is decided upon individual facts. These factors include:

Employee‟s Qualifications

An employee‘s educational background, training, and

experience are somewhat tangible and can be measured with a degree of subjectivity. However, the employee‘s

reputation, motivation, and general business acumen are intangible. (See Paramount Clothing Co., TC Memo 64

(1979); Superior Pattern and Mfg. Co., 18 TCM 343 (1959); Bedford Sportswear, Inc., 13 TCM 634 (1954); and

Despatch Oven Co., 4 TCM 680 (1945)).

Size of the Business

The larger a company‘s revenue, the more complex are operations and the greater the need to entice and retain

capable management with an attractive compensation package. In many cases, compensation can be linked to

sales volume. (See Rust-Oleum Corp. v. Sauber, 588-1

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USTC 9258 and Hepinstall Steel Works, Inc., 3 TCM 841

(1944)).

Employee‟s Compensation History

Sudden increases in salary should be justified by increases

in responsibilities and services or as ―catch up‖ payments for below standard compensation made during start up

years. (See Auburn & Associates v. U.S., 72-1 USTC 9170;

Roth Office Equipment Co. v. Gallagher, 49-1 USTC 9165; and Cropland Chemical Corp. v. Commissioner., 75 TC 288

(1980)).

Unreasonably Low Salaries

The flip side is that unreasonably low salaries may also invite attack under §482, especially for sole shareholder

corporations. Borge v. Commissioner., 405 F.2d 673 (2nd Cir. 1968), resulted in an allocation of additional income

to the sole or controlling shareholder.

Past Service

While a shareholder-employee will usually try to justify the amount of current compensation as being reflective of past

years under compensation by the corporation, the courts will not usually consider the value of the employees

services to a predecessor unincorporated business. The problem of reasonable compensation invariably involves the

owner-employees of small closely held corporations who are in a position to control their own compensation, or

employees who are compensated beyond the value of their services (Patton v. Commissioner., 168 F.2d 28, (6th Cir.

1948), (the bookkeeper‘s salary of $46,049 was disallowed to the extent of $33,000)).

Reasonable Dividends

An absence of dividend payments may also trigger an

attack by the IRS. For that reason, most corporations should pay at least a nominal dividend, even if they are a

service corporation. A Court of Claims decision contains language to the effect that even where salaries are deemed

to be reasonable, a portion may be disallowed as a

deduction in the absence of dividends (Charles McCandless Tile Service v. U.S., 422 F.2d 1336 (Ct. Cl. 1970),

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however, see also Rev. Rul. 79-8, 1979-1 C.B. 92 for

further clarification of the IRS‘s position). If other courts agree in the future, a new test of reasonableness plus

dividends will have evolved.

Bonuses as Constituting Dividends

The court holdings in Barton-Gillet Co. v. U.S., 422 F.2d

1343 (4th Cir. 1971) and Nor-Cal Adjusters, 74-2 USTC

(9th Cir. 1974), should give further cause for concern since bonuses may be regarded as dividends even if they

are reasonable in amount with relation to the services actually rendered. In light of the disturbing holding in the

McCandless case, it may be advisable not to transfer real estate or equipment into the corporation. If corporate

assets are minimal, any IRS attack on return on capital would seem to have been circumvented.

Payback Agreements

A useful planning tool is a prior written agreement between

the corporation and the shareholder-employees providing for the repayment of any disallowed amounts. This restores

to the corporation the disallowed amount and affords to the employee a currently deductible expense in the form of the

restoration (Vincent E. Oswald, 49 T.C. 645 1968 (acq. 1968-2 C.B. 1; Rev. Rul. 69-115, 1969-1 C.B. 50).

However, two courts have raised the possibility that a salary restoration agreement might raise the inference that

salaries may be unreasonable (Charles Schneider & Co. v.

Commissioner., 34 AFTR 2d, 74- 5422 (8th Cir. 1974); Saia Electric, Inc., T.C.M. 1974-290, aff‘d 5th Cir. 1976

(unpublished opinion)).

Miscellaneous Factors

Other important factors include:

(a) Employee compensation comparisons,

(b) Compensation ratios,

(c) Contingent compensation,

(d) Compensation timing, and

(e) Formal authorization for compensation.

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Test #2 - For Services Performed

Employers must be able to prove the payment was made for

services actually performed. All services of the employee should be documented. Both quality and effort, in terms of hours

worked, tasks performed, job variety and difficulty, count. (See Hanslik, TC Memo 394 (1978); Ernest Burwell, Inc. v. U.S., 64-2

USTC 9638; and Jewell Ridge Coal Sales Co., 16 TCM 140 (1957)).

Employee-Shareholder Salaries

If a corporation pays an employee who is also a shareholder a

salary that is unreasonably high considering the services actually performed, the excessive part of the salary may be

treated as a constructive distribution of earnings to the employee-shareholder.

Selected Types of Compensation

What follows are just a few of the ways an employer may compensate employees in addition to "regular" wages or salaries.

Some of these forms of compensation are fully taxable, while others are excludable or tax deferred.

Awards

Employers can generally deduct amounts paid to employees as

awards, whether paid in cash or property. However, when an employer gives property to an employee under a qualified §74

employee achievement award program, the employer‘s deduction may be limited.

Bonuses

Employers can generally deduct a bonus paid to an employee if it

was intended as additional pay for services, not as a gift, and the services were performed. However, the total bonuses,

salaries, and other pay must be reasonable for the services performed.

Employee Gifts of Nominal Value

If, to promote employee goodwill, an employer distributes

turkeys, hams, or other merchandise of nominal value to employees at holidays, the employer can deduct the cost of

these items as a nonwage business expense. The deduction

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for de minimus gifts of food or drink are not subject to the 50

percent deduction limit that generally applies to meals.

Education Expenses

If an employer pays or reimburses education expenses for an

employee, the employer can deduct the payments. They should be deducted on the ―employee benefit programs‖ or other

appropriate line of the employer‘s tax return if they are part of a

qualified educational assistance program.

Fringe Benefits

A fringe benefit is a form of pay for the performance of services.

Employers can generally deduct the cost of fringe benefits

provided in whatever category they would otherwise include the cost. For example, if an employer allows an employee to use a

car or other property that is leased, the cost should be deducted as a rent or lease expense.

An employer may be able to exclude all or part of the value of some fringe benefits from employees‘ pay. An employer also

may not owe employment taxes on the value of the fringe benefits.

Life Insurance Coverage

An employer cannot deduct the cost of life insurance coverage

for herself, an employee, or any person with a financial interest in the business, if she is directly or indirectly the beneficiary of

the policy (Reg. §1.264-1).

Welfare Benefit Funds

A welfare benefit fund is a funded plan (or a funded arrangement having the effect of a plan) that provides welfare benefits to

employees, independent contractors, or their beneficiaries. Welfare benefits are any benefits other than deferred

compensation or transfers of restricted property.

An employer‘s deduction for contributions to a welfare benefit

fund is limited to the fund‘s qualified cost for the tax year. If an employer‘s contributions to the fund are more than its qualified

cost, the employer can carry the excess over to the next tax year.

Generally, the fund‘s ―qualified cost‖ is the total of the following

amounts, reduced by the after-tax income of the fund:

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(1) The cost an employer would have been able to deduct

using the cash method of accounting if the employer had paid for the benefits directly; and

(2) The contributions added to a reserve account that are needed to fund claims incurred but not paid as of the end of

the year.

Note: These claims can be for supplemental unemployment

benefits, severance pay, or disability, medical, or life insurance

benefits.

Loans or Advances

An employer generally can deduct as wages an advance made to an employee for services performed if the employer does not

expect the employee to repay the advance. However, if the employee performs no services, the amount advanced should be

treated as a loan. If the employee does not repay the loan, it may be deductible as a bad debt.

Property

If an employer transfers property (including the company‘s

stock) to an employee as payment for services, the employer can generally deduct it as wages. The amount the employer can

deduct is the property‘s fair market value on the date of the transfer less any amount the employee paid for the property.

An employer can claim the deduction only for the tax year in which the employee includes the property‘s value in income. The

employee is deemed to have included the value in income if the employer reports it on Form W-2 in a timely manner.

The employer treats the deductible amount as received in exchange for the property, and must recognize any gain or loss

realized on the transfer. The employer‘s gain or loss is the

difference between the fair market value of the property and its adjusted basis on the date of transfer.

A corporation recognizes no gain or loss when it pays for services with its own stock.

These rules also apply to property transferred to an independent contractor, generally reported on Form 1099-MISC.

Restricted Property

If the property an employer transfers for services is subject to

restrictions that affect its value, the employer generally

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cannot deduct it and does not report gain or loss until it is

substantially vested in the recipient. However, if the recipient pays for the property, the employer must report any gain at

the time of the transfer up to the amount paid.

―Substantially vested‖ means the property is not subject to a

substantial risk of forfeiture. This means that the recipient is not likely to have to give up his or her rights in the property

in the future.

Sick & Vacation Pay

An employer can deduct amounts you paid to employees for sickness and injury, including lump-sum amounts, as wages.

However, the deduction is limited to amounts not compensated by insurance or other means.

Vacation pay is an employee benefit. It includes amounts paid for unused vacation leave. An employer can deduct vacation pay

only in the tax year in which the employee actually receives it. This rule applies regardless of whether the employer uses the

cash or accrual method of accounting.

Payroll Taxes

Employers must generally withhold income tax from wages paid

employees if their wages for any payroll period exceed the amount of their withholding allowances for that period. The amount to be

withheld is figured separately for each payroll period (§3402).

Note: A payroll period is the period of time for which a payment

of wages is made to an employee. Regular payroll periods can

be daily, weekly, biweekly, semimonthly, monthly, quarterly,

semiannually, or annually (Reg. §31.3401(b)-1; Reg.

§31.3402(b)-1(c)).

By the end of the month following each calendar quarter, employers

must file a payroll tax return, reconciling all the tax deposits made during the quarter with wages paid, and paying any underpayment.

The Form 941 is used for this purpose.

Note: If an employer pays their tax late, they may have to pay

a penalty as well as interest on any overdue amounts.

Form 941

Employers are required to report social security and Medicare

taxes and withheld income tax on Form 941, Employer’s Quarterly Federal Tax Return and deposit both the employee and

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employer portions of each tax. Such funds must be deposited

with an appropriately coded federal tax deposit coupon in a bank that is designated as a federal tax depository.

Each return period is divided into a number of shorter deposit periods. Whether or not an employer must make a deposit

depends on their tax liability at the end of the deposit period. If the employer‘s tax liability has reached a certain amount, a

deposit is required.

Note: If by the end of a deposit period the employer‘s tax

liability has not reached the amount requiring a deposit, the

undeposited tax is carried over and added to the tax for the

next period.

Deposit Rules

Simplified deposit rules took effect for wages paid after December 31, 1992. Under these rules, if the employer‘s

accumulated undeposited taxes do not exceed $100,000 at

any time during the year, the employer will know from their tax liability in their lookback period, discussed below, what

their deposit dates will be for the entire year (§6302).

Lookback Period

To find deposit requirements for a calendar year, look to

the employment tax liabilities during a lookback period

which is the 12-month period ending the preceding June 30. For example, the lookback period for calendar year

2014 is the period July 1, 2012, to June 30, 2013.

Note: New employers are treated as having no tax liabilities

during the quarters they had no employees.

Under the new rules, employers are either a monthly

depositor or a semi-weekly depositor. IRS sends a notice each November to confirm, based on the lookback period,

whether the employer is a monthly depositor or a semi-weekly depositor.

In addition to the rules based on the lookback period, there is a one-day rule for accumulated taxes of $100,000 or

more and a de minimis rule for accumulated taxes of less than $500.

Monthly Depositor

An employer is a monthly depositor for a calendar year if

the total amount of reported taxes for the lookback

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period is not more than $50,000. Deposit the taxes

accumulated on paydays during each month of a quarter by the 15th day of the following month.

Semi-Weekly Depositor

An Employer is a semi-weekly depositor for a calendar year if the total amount of accumulated taxes for the

lookback period is more than $50,000 and must:

(1) Deposit taxes accumulated for Wednesday, Thursday, and/or Friday paydays during each week of a

quarter by the following Wednesday, and

(2) Deposit taxes accumulated for Saturday, Sunday,

Monday, and/or Tuesday paydays during each week of a quarter by the following Friday.

Note: If there are fewer than 3 banking days to make a

deposit, a minimum of 3 days are allowed to make the

deposit if you are not subject to the $100,000 One-day

rule.

One-Day Rule

If the amount of the employer‘s accumulated taxes is

$100,000 or more on any day during a deposit period, either monthly or semi-weekly, deposit the taxes on the

next banking day. If an employer is a monthly depositor,

they become a semi-weekly depositor for the remainder of the calendar year and the following calendar year.

De Minimis Rule

If the amount of the employer‘s accumulated taxes during

the quarter is less than $500, deposit the taxes by the end of the following month or pay them with the Form

941. If the amount is $500 or more, the employer must deposit the taxes by the 15th day of the following month.

Form W-4

Employers must furnish to a new employee a federal Form W-4

that they must complete (filling in Social Security number and the number of ‗withholding exemptions‘ claimed) and return. The

W-4 is used to determine how much income tax to withhold, based on the employee‘s income and number of withholding

exemptions claimed.

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In general, an employee can claim withholding allowances equal

to the number of exemptions the employee will be entitled to in figuring income tax on the annual return. An employee may also

be able to claim a special withholding allowance and allowances for deductions and credits (§3402).

Employers should ask each new employee to give them a Form W-4 on or before his or her first day of work. This certificate is

effective for the first payment of wages and will last until the employee files a new one unless the employee claims exemption

from withholding. The certificate must include the employee‘s social security number (§3402(f); Reg. §31.3402(f)(5)-1).

If an employee does not give the employer a Form W-4, the employer must withhold tax as if the employee were a single

person who has claimed no withholding allowances. Married employees (and widows and widowers qualified to figure their

income tax as married persons) who have not indicated on Form

W-4 that they are married will be treated as single persons for withholding purposes (Reg. §31.3402(f)(2)-1(a)).

Whistle-Blowing

Formerly, employers had to send the IRS a copy of any Form W-4 received from an employee who was still employed at

the end of the quarter if:

(1) The employee filing it claimed 11 or more withholding allowances; or

(2) The employee filing it claimed exemption from income tax withholding, but the employee‘s wages were more than

$200 a week (R.P. 97-34; Reg. §31.3402(f)(2)-1(g)).

However, effective April 14, 2005, employers no longer are

required to send copies of potentially questionable Form W-4 withholding forms to the IRS. Employers need only to submit

withholding certificates to the IRS if directed to do so by the Service (IR-2005-45; T.D. 9196).

Form W-2

Employers must furnish copies of Form W-2, Wage and Tax

Statement, to each employee from whom income, social security, or Medicare taxes have been withheld. The employer

must also furnish it to employees from whom income tax would have been withheld if the employee had claimed no more than

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one withholding allowance or had not claimed exemption from

withholding on Form W-4.

The Form W-2 must show the total wages and other

compensation paid (whether or not they are subject to withholding), total wages subject to social security taxes, total

wages subject to Medicare taxes, the amounts deducted for income, social security, and Medicare taxes, and any other

information required on the statement (Reg. §31.6051-1).

Form W-2 is a six-part combined federal-state form designed for

use by employers in states where only federal tax must be withheld and in states where both federal and state taxes must

be withheld. This form may also be used where city or other subdivision taxes are withheld. It is printed in sets of six copies

so that copies are available for filing and for the employees‘ records.

Employer should furnish copies of Form W-2 to employees as

soon as possible after December 31 so they may file their income tax returns early. In any event, the employers must

furnish the employee Form W-2 or its equivalent no later than January 31 of the following year. Any undeliverable employee

copies of Form W-2 should be kept for at least 4 years after the date the tax for the return period to which they relate becomes

due or is paid, whichever is later (Reg. §31.6051-1(a); Reg. §31.6051-1(d)).

Form W-3

Employers must file Form W-3 annually to transmit Forms W-2

to the Social Security Administration in accordance with the instructions for Form W-3. Form W-2 will be processed by the

Social Security Administration that will then furnish the IRS with the income tax data that it needs from the forms (Reg.

§31.6051-2).

Social Security‟s Payroll Tax or FICA - §3111 &

§3121

The Federal Insurance Contributions Act (FICA) provides for a federal system of old age, survivors, disability, and hospital

insurance. Under FICA, there are two Social Security taxes: the

OASDI tax and the Medicare tax. These taxes have different tax rates and wage bases. The wage base is the maximum wage for the

year that is subject to the tax. Employers can multiply each wage

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payment by the tax rate or can use the tables provided in Circular

E. There are no withholding allowances for social security and Medicare taxes. The OASDI tax is paid on earnings up to the

taxable wage base of $117,000 in 2014. The taxable wage base is increased annually to reflect increases in the cost of living. There is

no earnings cap for Medicare tax purposes - the tax is computed on all wages.

Comment: The old age, survivors, and disability insurance part

is financed by the social security tax. The hospital insurance part

is financed by the Medicare tax. Since 1991, each of these taxes

is reported separately.

Social security and Medicare taxes are levied on both the employer

and the employee. However, the employer must collect and pay the employee‘s part of the taxes (Reg. §31.3121(a)-1(e)).

Rates

The OASDI tax rate is 6.20% for both employer and employee

(12.4% for self-employed). The Medicare tax is 1.45% for both employer and employee (2.90% for self-employed).

If a taxpayer is employed, the result is a total FICA rate of 15.3% with the taxpayer and their employer each paying 7.65%

(6.2% plus 1.45%) of the taxpayer‘s gross salary, up to the annually adjusted wage base. The employer collects and pays

the employee‘s part of the taxes but, the employer‘s half of the tax is deductible as a business expense (Reg. §31.3121(a)-

1(e)).

Similarly, if the taxpayer is self-employed, they pay total SECA

rate of 15.3% (12.4% plus 2.9%) on their taxable income up to

the wage base.

Note: For 2011, TRUIRJCA reduced the employee share of

OASDI tax under the FICA from 6.2% to 4.2% for wages up to

the taxable maximum of $106,800. Similarly, the OASDI tax

rate under SECA was reduced by two percentage points to

10.4% for self employed individuals resulting in a total rate of

13.3% (10.4% for OASDI and 2.9% for HI).

Comment: Under the 2010 Hiring Incentives Act (H.R. 2847), a

qualified employer's 6.2% OASDI tax liability was forgiven for

wages paid on previously unemployed new hires for any 2010

period starting after March 18, 2010 through December 31,

2010.

Note: Until January 1, 1988 it was possible to pay wages to

one‘s spouse or to one‘s children under age 21 free of FICA

taxes, but the Revenue Act of 1987 eliminated this ‗loophole‘.

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However, a sole proprietor may still hire his or her children

under age 18 to work in the family business without such wages

being subject to FICA taxes. However, even this limited

exception does not apply to a corporate business or to typical

partnerships.

Deduction

As heavy a tax burden as the FICA tax is, at least the employer‘s half of the tax is deductible as a business expense. Before 1990,

this was more advantageous than the situation for self-employed persons, who paid a somewhat lower total tax rate, but were

unable to deduct any of the Self-Employment tax they paid. In 1990 and thereafter, this difference no longer exists, since the

self-employment tax rate is now the same as the total FICA rate, and half of it is deductible for income tax purposes.

Federal Unemployment (FUTA) Tax - §3302

The Federal Unemployment Tax Act (FUTA), along with state unemployment systems, provides unemployment payments to

workers who have lost their jobs. Most employers pay both a Federal and a state unemployment tax. Only the employer pays

FUTA tax, it is not deducted from the employee‘s wages.

Note: Even if an employer is exempt from state tax, they may

still have to pay the federal tax.

Corporations must pay the federal unemployment tax with one or

more employees. Self-employed persons are not subject to this tax. The federal tax (and in most states, the state tax as well) is

imposed entirely upon the employer. Effective July 1, 2011 and all tax years thereafter, the federal unemployment tax is 6.0% (6.2%

for prior periods when there was a 0.2% FUTA surtax) of the first

$7,000 (state wage bases may be different) of annual wages per employee. Thus, after June 30, 2011, the FUTA tax rate is 6.0%

before any state unemployment tax credits. Generally, the employer can take a credit against the FUTA tax for amounts paid

into state unemployment funds. This credit cannot be more than 5.4% of taxable wages. If an employer is entitled to the maximum

5.4% credit, the FUTA tax rate after the credit is .8% (§3302).

Form 940

FUTA taxes are required for any calendar year if during any calendar quarter of the current or preceding calendar year the

employer paid wages of $1,500, or if during either year the

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employer had one or more employees for at least a portion of a

day during any 20 different calendar weeks during the year.

If the FUTA liability during any of the first 3 calendar quarters is

more than $500, tax must be deposited with a federal tax deposit coupon at an authorized bank during the month following

the end of the quarter. If the tax is $500 or less, no deposit is required, but the employer must add it to the taxes for the next

quarter.

In the fourth quarter, if the undeposited FUTA tax for the year is

more than $500, a deposit must be made with a deposit coupon by January 31. When the tax due at year-end is $100 or less,

either deposit the tax with the coupon or mail it in with the federal unemployment tax return (Form 940) by January 31.

Selected Fringe Benefits

Perhaps the term ―fringe benefits‖ is somewhat of a misnomer, since it connotates peripheral importance. With many companies

expending over a third of their payroll on such items, they are hardly inconsequential.

The Code defines gross income as including ―all income from

whatever sources derived‖ and specifies that it include ―compensation for services‖ (§61). The courts have stated that §61

is broad enough to include in taxable income any financial benefit conferred on the employee as compensation, whatever the form or

mode by which it is effected.

However, certain fringe benefits can provide an unusually tax

favored manner of supplementing the compensation of key executives. In such cases, benefits received under them are not

taxable to the executive, while the cost of providing them is currently deductible to the employer.

Old Dichotomy - Statutory v. Nonstatutory

Formerly there were two basic types of fringe benefits provided to the highly compensated employee. The first group of benefits was

that specifically permitted by statute. The second type had developed over the years under a wide variety of plans that had no

specific basis in the Code. These nonstatutory benefits usually involved the payment of a particular expense by the employer or

the provision of goods and services to the employee. Through a

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long series of cases, rulings, and administrative customs, each of

these plans had developed its own status as to taxability.

Fringe Benefit Provisions

In 1975, the IRS issued proposed regulations for determining

when nonstatutory fringe benefits were taxable as compensation. Congress prohibited the issuance of such

regulations that would be effective before 1984.

TRA „84 - §132

The Tax Reform Act of 1984 scrapped the moratorium for all fringes, other than faculty housing, by providing statutory

rules for excluding certain fringe benefits from an employee‘s

income. The excluded fringes include:

(1) No-additional-cost services;

(2) Qualified employee discounts;

(3) Working condition fringes; and

(4) De minimis fringes;

Discrimination

Under §132, no-additional-cost services, employee discounts, eating facilities, and tuition reductions, must be provided on

substantially the same terms to each member of the group of employees which is defined under a reasonable classification

set up by the employer that does not discriminate in favor of officers, owners, or highly compensated employees.

Note: Neither working condition fringes nor de minimis fringes

are subject to antidiscrimination provisions.

Only Statutory Benefits

Any fringe benefits that do not qualify for exclusion under §132, or any other provision, are taxable for income and

employment tax purposes.

No-Additional-Cost Services - §132(b)

The entire value of any no additional cost service provided by an

employer for an employee‘s use is excludable from gross income (§132(b) & Temp. Reg. §1.132-1T). The exclusion applies if:

(1) The employer incurs no substantial cost (including forgone revenue) in providing the service (Reg. §1.132-2T.);

4 - 2 1

(2) The service is provided by the employer (or another with

whom the employer has a reciprocal arrangement) and is of a type provided to its nonemployee customers;

(3) The service is provided to current or retired employees (and their spouses or dependent children); and

(4) Certain nondiscriminatory requirements are met.

Under this provision, employers may furnish railroad or airline

seats, or hotel accommodations to employees if customers are not displaced and no substantial additional cost is incurred.

Covered Employees

Employees covered by this §132 exclusion include:

(a) Current employees, their spouses and dependent children (including a child whose parents have died and who has not

reached age 25);

(b) An individual formerly employed and who separated from

service because of retirement or disability;

(c) The widow or widower of a former employee; and

(d) Any partner who performs services for a partnership (§132(f) and Reg. §1.132-1T(b)

Line of Business Requirement

The exclusion applies if the service provided to the employee is

the same type that is sold to the public in the course of the employer‘s line of business in which the employee works (Reg.

§1.132-4T(a)). Thus, an airline employee can‘t exclude the value of a free hotel room even if owned by the same employer

because airline and hotel services are considered two different

lines of business.

Definition

A line of business is determined under the Enterprise

Standard Industrial Classification Manual prepared by the

Statistical Policy Division of the U.S. Office of Management and Budget (Reg. §1.132-4T).

Qualified Employee Discounts - §132(c)

Normally, when an employer sells goods or services to the

employee for a price less than the price charged regular customers, the employee realizes income equal to the discount. However,

4 - 2 2

§132(c) and Reg. §1.132-3T(a) allow the employee to exclude the

discount from income if the property or services are provided:

(1) By the employer and are of the same type ordinarily sold to

the public from the same line of business in which the employee works;

(2) To current or retired employees (and their spouses or dependent children); and

(3) On a nondiscriminatory basis

Manner of Discount

The exclusion applies whether the qualified employee discount is provided through a reduced price or through a cash rebate from

a third party.

Real Estate & Investment Property Exclusion

The exclusion is not available for real property or for personal property of the type commonly held for investment

(§132(c)(4)).

Amount of Discount

Employee discounts are excluded only up to specific limits. For merchandise, the discount‘s excludable amount is limited to the

selling price multiplied by the employer‘s gross profit percentage (§132(c)(2)). The discount exclusion for a service cannot exceed

20% of the selling price, regardless of the actual gross profit percentage (§132(c)(1) and Reg.§1.132-3T(a)).

Working Condition Fringes - §132(d)

Property or services provided to an employee are excluded to the extent that they would be deductible as ordinary and necessary

business expenses if the employee had paid for them (§132(d)). Examples include:

(1) Use of a company car or plane for business purposes,

(2) Work uniforms,

(3) Business periodicals,

(4) On the job training,

(5) Use of consumer goods provided for product testing (Reg. §1.132-5T(n)), and

(6) Use of a driver, bodyguard, or car specially designed for security (Reg. §1.132-5T(m).

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Covered Employees

Under Reg. §1.132-1T(b)(2), employees covered by this §132

exclusion include:

(a) Current employees;

(b) A partner who performs services for a partnership;

(c) A director of the employer; and

(d) An independent contractor who performs services for the employer.

Exceptions

In three situations the exclusion is allowed even where the

expense is not deductible by the employee:

(a) The value of a parking space though normally a personal

commuting expense to the employee;

(b) The personal use (e.g., commuting) of a demonstrator by

an auto salesperson; and

(c) Employee business expenses eliminated by the 2% of AGI limitation.

Substantiation

The value of property or services cannot be excluded from the employee income unless the applicable substantiation

requirements of either §274(d) or §162 are met (Reg. §1.132-

5T(c)).

De Minimis Fringes - §132(e)

An exclusion from gross income applies for property or services that are considered of such relatively small value that accounting for

them is impractical (§132(e)). According to the House Report benefits that are excluded include:

(1) Coffee & doughnuts,

(2) Occasional theater or sporting event tickets,

(3) Traditional holiday gifts of property having a low value,

(4) Typing of personal letters by a company secretary,

(5) Occasional personal use of the company copying machine,

(6) Monthly transit passes provided at a discount not over $130 (for 2014),

(7) Occasional supper money or taxi fare because of overtime work, and

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(8) Occasional company cocktail parties or picnics.

Subsidized Eating Facilities

Eating facilities operated by the employer are also excluded as a de minimis fringe if:

(a) Located on or near the employer‘s business premises;

(b) Revenue equals or exceeds direct operating costs; and

(c) Nondiscrimination requirements are met.

Employee Achievement Awards - §74(c) & §274(j)

The general rule of §74 provides that the fair market value of prizes

and awards is includible in gross income. Under Reg. §1.74-1(a), such awards and prizes include amounts received from giveaway

shows, door prizes, contest awards, and awards from an employer to an employee.

Exclusion

Under §74(c), when an employee achievement award (defined

under §274(j)(3)) is deductible by the employer subject to the limits under §274, the fair market value of the award is not

taxed to the employee. There are separate exclusion limits for

employee achievement awards and qualified plan awards. An employee can exclude from income $400 of an employee

achievement award and $1,600 of a qualified plan award.

Definition of Employee Achievement Awards

Section 274(j)(3)(A) provides that an employee achievement

award is an item of tangible personal property that an employer

gives to an employee and is:

(a) Transferred for length of service or safety,

Service & Safety Award Restrictions

Under §274(j)(4)(B), an item is not treated as

having been provided from length of service

achievement if the item is received during the

recipient’s first 5 years of employment or if the

recipient received a service award (other than under

the §132(c) exclusion for de minimis fringe benefits)

during that year or any of the prior 4 years.

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Section 274(j)(3)(C) provides that an item shall not

be treated as having been given for safety

achievement if:

(i) During the year, the employer previously made

safety awards to more than 10% of eligible

employees, or

(ii) Such item is awarded to a manager,

administrator, clerical employee, or other professional

employee.

(b) Awarded as part of a meaningful presentation, and

(c) Awarded under conditions that do not create a significant

likelihood of the payment of disguised compensation.

Qualified Plan Award

A qualified plan award is an employee achievement award provided under a qualified award plan.

A plan is a qualified award plan when:

(a) It is an established written plan or program that does not

discriminate in favor of highly compensated employees (defined in §414(q)) as to eligibility or benefits

(§274(j)(3)B)); and

(b) The average cost per recipient of all achievement awards

made under all such qualified award plans during the tax year does not exceed $400 (§274(j)(3)(B)(ii)).

Employer Deduction Limits

There are separate deduction limits for employee achievement

awards and qualified plan awards. Under §274(j), there is a $400 limit on the employer‘s deduction for all employee

achievement safety and service awards (other than qualified plan awards) provided to the same employee during the tax year. If

the award is a qualified plan award, the deduction ceiling is

raised to $1,600 for safety or service awards made to the same employee. The $400/$1,600 limit is based on the cost (not fair

market value) to the employer of the award item.

Aggregation Limit

The $400 and $1,600 limits cannot be added together to

allow a deduction exceeding $1,600 in aggregate for

employee awards made to the same employee during the tax year (§274(j)(2)(B)).

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Special Partnership Rule

Section 274(j)(4)(A) provides that in the case of an employee

achievement award made by a partnership, the deduction §274 limitations apply to the partnership as well as to each

partner.

Employee Impact

Under §74(c)(2), if any part of the cost of an employee achievement award exceeds the deduction allowed to the

employer under §274, the exclusion does not apply and the employee must include in income the greater of:

(i) The portion of the employer‘s cost of the award that is not allowable as a deduction to the employer, or

(ii) The difference between the fair market value of the award and the maximum allowable deduction.

The remaining portion of the fair market value of the award is not included in the employee‘s gross income.

Group Term Life Insurance - §79

Employers can deduct group term life insurance premiums paid or incurred on policies covering the lives of officers and employees if

the employer is not the beneficiary under the contract (§264(a)(1)).

An employee, generally, must include in income the cost of group term life insurance coverage on his or her life that is more than the

cost of $50,000 of this insurance plus any amount paid by the

employee toward its purchase. The $50,000 relates to insurance protection the employee receives during any part of the tax year

(§79(a)).

Dependent Care Assistance - §129

Section 129 states that employer provided dependent care assistance for employees when given under a written

nondiscriminatory plan is excluded from the employee‘s income,

subject to certain conditions and special rules. The dependent care may be directly provided by the employer or given by a third party.

Amount of Assistance

Under §129(a)(2) and (b)(1), the aggregate amount excluded

from income for dependent care assistance is the smaller of:

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(a) $5,000 (or $2,500 in the case of a married individual

filing separately), or

(b) The earned income of the employee (or the spouse‘s

earned income if lower).

For purposes of determining marital status, the rules of

§21(e)(3) and (4) apply (§129(a)).

Requirements

Under §129(d), a dependent care program must meet the following requirements:

(a) It must be a written plan for the exclusive benefit of employees;

(b) It may not discriminate in favor of highly compensated employees (as defined under §414(q)) or their dependents;

(c) No more than 25% of the amounts paid or incurred by the employer for dependent care assistance during the year

may be provided for shareholders or owners (or their spouses or dependents) owning more than 5% of the company;

(d) Notice of availability and terms of the plan must be provided to eligible employees; and

(e) A written statement must be given to each employee

showing the amounts paid under their plan to that employee during the calendar year.

Conflict with Dependent Care

The amount excluded from income bars the employee from the credit available under §21 for payments for dependent care.

Cafeteria Plans - §125

In many instances, employees will differ widely in age and financial position. As a result, some employees will prefer cash to deferred

and noncash benefits. Fortunately, §125 has a potential solution in the form of a cafeteria plan.

Definition

A cafeteria plan is written program that permits employee-

participants to select among cash and qualified tax-free benefits. Section 125 excludes the employer‘s contribution to the plan

from being included in the employee‘s income to the extent the employee chooses nontaxable benefits (Reg. §1.125-2T and Reg.

§1.125-1).

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Qualified Benefits

A cafeteria plan can offer employees choices that include only

cash and qualified benefits which are excludable under a specific Code section. Such qualified benefits include coverage or

participation under (Reg. §1.125-2T):

(a) A group-term life insurance plan of up to $50,000 (§79);

(b) An accident or health plan (§105 and §106);

(c) A dependent care assistance program (§129);

(d) A qualified cash or deferred arrangement that is part of a profit-sharing or stock bonus plan (§401(k)); and

(e) A vacation days program, provided such vacation days

are not redeemable for cash at a later date.

Non-Qualified Benefits

Cafeteria plans cannot offer the following benefits (Reg.

§1.125-2T):

(i) Scholarships and fellowships under §117;

(ii) Vanpooling under §124;

(iii) Educational assistance under §127;

(iv) Meals and lodging under §119;

(v) Fringe benefits excludable under §132; and

(vi) Deferred compensation other than a profit-sharing or

stock bonus plan that includes a §401(k) cash or deferred arrangement (§125(d)(2).

Controlled Group Rules

The controlled group rules of §414(b), (c) or (m) apply and self-

employed individuals are not eligible. A cafeteria plan must not discriminate in favor of highly compensated employees as to

benefits and contributions.

Salary Reduction Plans

Cafeteria plans may be funded by the employees pursuant to a salary reduction election whereby such funds become employer

contributions for federal income tax purposes. The salary reduction agreement must relate only to compensation that has

not been actually or constructively received by the participant as of the date of the agreement. A cafeteria plan may not offer any

benefit that defers the date of receipt of compensation except for the right of the employees to make elective contributions under

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a §401(k) cash or deferred profit sharing plan. If the plan is

discriminatory for a plan year, a highly compensated participant will be currently taxed on any qualified benefits received during

the plan year.

Nondiscrimination

A cafeteria plan cannot discriminate in favor of highly

compensated participants as to eligibility to participate in the

plan or as to contributions or benefits. If the plan does discriminate, highly compensated participants must include in

their income the value of the benefits that could have been elected (§125(b)(1)).

If qualified benefits provided to key employees are more than 25% of the total of these benefits provided for all employees

under the plan, key employees must include in their income the value of the benefits that could have been elected (§125(b)(2)).

The taxable benefits are treated as having been received or accrued in the tax year of the highly compensated participant or

key employee in which the plan year ends (§125(b)(2); §125(b)(3)).

Meals & Lodging - §119

Income Exclusion

The Code specifically excludes from gross income of an employee the value of any meals or lodging furnished to him, his

spouse, or any of his dependents by or on behalf of his employer for the convenience of the employer but only if, in the case of

meals, the meals are furnished on the business premises of the employer or, in the case of lodging, the employee is required to

accept such lodging on the business premises of his employer as

a condition of his employment (§119(a)).

Convenience of Employer

Numerous cases and rulings exist in this area defining what is

for the convenience of the employer or the employer‘s requirement to live on particular premises. However, most of

these cases relate to rank and file employees and are not

relevant to the highly compensated.

Nevertheless, in Commissioner v. Mabley, 24 T.C.M. 1974

(1965) the Tax Court held that where executives of a corporation meet on a daily basis for a staff luncheon to

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conduct company business, the value of the meals will not be

included in the employee‘s income. However, take a look at the case of John D. Moss, Jr. v. Comm., 80 TC No. 57 (1983)

where similar expenses for a law partner will be held to be personal.

Self-Insured Medical Reimbursement Plans - §105

A medical reimbursement plan is an arrangement provided by an

employer to reimburse employees for medical and dental expenses.

The plan may also cover the employee’s spouse and dependents. Under §105, employer reimbursements for such employee medical

expenses are excludable from income. This exclusion will not apply to highly compensated employees if the §105 plan discriminates in

their favor.

Allowable Expenses

Section 105(b) states that, in the case of amounts attributable to deductions allowed under §213, gross income does not include

amounts paid by an employer to reimburse an employee for expenses incurred by him for medical care.

Requirements

Such amounts received by an employee are generally nontaxable

provided that:

(a) They are received as reimbursements for medical

expenses actually incurred;

(b) The employee received no benefit from the deduction of

the medical expenses in prior years; and

(c) The plan is nondiscriminatory.

Benefits

A plan is discriminatory if key employees have greater benefits

than other employees. This means benefit levels cannot be based on a percentage of compensation. Dollar for dollar

benefits must be provided. While there is no statutory limit on the amount of benefits payable under such plans, all employees

of related companies are combined for purposes of these tests.

Exposure

Companies should be careful to limit their liability under these plans to a reasonable amount. The most effective method is to

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place a ceiling on payments to any one employee and to

purchase health insurance to cover unusually large medical expenses.

Employee Educational Assistance Programs - §127

An individual cannot deduct education unless such expenses are

incurred to maintain or improve skills of their existing employment (Reg. §1.162-5(a)). Educational expenses paid directly by the

employer are normally not taxable to the employee if business

related.

The passage of §127 in 1978 liberalized these provisions making all

employer provided educational assistance nontaxable to the employee if the plan is nondiscriminatory. An employee can receive

up to $5,250 of educational assistance benefits tax-free. The assistance has to be provided under a qualified written plan.

The Tax Relief Act of 2001 extended the exclusion for employer-provided educational assistance to graduate education and made

the exclusion (as applied to both undergraduate and graduate education) permanent.

Employer Provided Automobile - §61 & §132

If an employer provides an auto (or other highway vehicle) to an employee, the employee‘s personal use of the auto is a taxable

fringe benefit (§61 and §132). The employer is required to determine the actual value of this fringe benefit that the employee

must include in income or reimburse the employer. This value may be determined under either one general or three special valuation

methods.

General Valuation Method

Under Reg.§1.61-2T(b)(4), if none of the special methods below are used, the valuation must be determined by reference to the

cost to a hypothetical person of leasing from a hypothetical third party the same or comparable vehicle on the same or

comparable terms in the geographic area in which the vehicle is available for use.

Annual Lease Value Method

Reg. §1.61-2T(d) states that if an employer provides an

employee with an auto, the value of the benefit may be determined using a lease valuation method. Under this method

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an employee reports the annual lease value of the auto from the

tables in Reg. §1.61-2T(d)(2)(iii) based on the auto‘s fair market value when it is first made available to the employee.

Fair Market Value Annual Lease Value

$0 to 999 $600

1,000 to 1,999 850

2,000 to 2,999 1,100

3,000 to 3,999 1,350

4,000 to 4,999 1,600

5,000 to 5,999 1,850

6,000 to 6,999 2,100

7,000 to 7,999 2,350

8,000 to 8,999 2,600

9,000 to 9,9999 2,850

10,000 to 10,999 3,100

11,000 to 11,999 3,350

12,000 to 12,999 3,600

13,000 to 13,999 3,850

14,000 to 14,999 4,100

15,000 to 15,999 4,350

16,000 to 16,999 4,600

17,000 to 17,999 4,850

18,000 to 18,999 5,100

19,000 to 19,999 5,350

20,000 to 20,999 5,600

21,000 to 21,999 5,850

22,000 to 22,999 6,100

23,000 to 23,999 6,350

24,000 to 24,999 6,600

25,000 to 25,999 6,850

26,000 to 27,999 7,250

28,000 to 29,999 7,750

30,000 to 31,999 8,250

32,000 to 33,999 8,750

34,000 to 35,999 9,250

36,000 to 37,999 9,750

38,000 to 39,999 10,250

40,000 to 41,999 10,750

42,000 to 43,999 11,250

44,000 to 45,999 11,750

46,000 to 47,999 12,250

48,000 to 49,999 12,750

50,000 to 51,999 13,250

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52,000 to 53,999 13,750

54,000 to 55,999 14,250

56,000 to 57,999 14,750

58,000 to 59,999 15,250

For vehicles having a fair market value exceeding $59,999, the

annual lease value is equal to: (.25 x automobile fair market value) + $500.

Computation

To determine the value of the employer provided auto:

(1) Find the fair market value of the car when it was first made available to the employee for personal use;

(2) Locate the fair market value on the left hand side of the table;

(3) Find the corresponding annual lease value on the right hand side of the table; and

(4) Multiply the annual lease value by the ratio of personal miles to total miles.

Cents Per Mile Method

For autos with fair market values not exceeding the maximum

recovery deductions allowable for the first five years the auto is placed in service, an employer may determine the value of a

vehicle provided to an employee by multiplying the standard

mileage rate by the total number of personal miles driven by the employee (Reg.§1.61-2T(e)).

Commuting Value Method

If the auto is provided under the written commuting policy statement exception, the value of the employee‘s use of the

vehicle for such commuting purposes is computed as $1.50 per

one way commute (Reg.§1.61-2T(f)(1)).

Interest Free & Below-Market Loans - §7872

An interest free or low interest loan involves the lending of money to an employee who is required to pay no interest or a rate of

interest below the market place. The economic benefit lies in the borrower‘s ability to use the funds or invest them and retain the

return. Below-market interest loans made by the employer offer an

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attractive benefit to those employees to whom the loans are

extended.

Permissible Discrimination

They may be offered on a selective basis without meeting the

nondiscrimination rules that apply to many other fringe benefits.

Employee Needs

In addition, these loans can serve needs related to the

borrower‘s employment, such as the purchase of company stock under a stock purchase plan or stock option

arrangement, as well as purely personal needs, such as

providing college funds, investments or home mortgage loans.

Imputed Interest

However, the Tax Reform Act of 1984 (§7872) reclassified such loans as ―arms-length‖ transactions with the parties treated as

if:

(1) The lender made a loan to the borrower in exchange for a note requiring the payment of interest at the ―applicable

Federal rate‖;

(2) The borrower paid interest in the amount of the ―forgone‖

interest; this treatment requires the lender to treat the forgone interest as income and enables the borrower to take

an interest deduction provided, in the case of an individual, the borrower itemizes; and

(3) The lender:

(a) In the case of a gift loan, made a gift subject to gift

tax;

(b) In the case of a corporation-shareholder loan, paid a

dividend includable in the shareholder‘s income; or

(c) In an employer-to-employee loan situation, paid compensation that‘s includable in the employee‘s income

and deductible by the lender.

Note: The deemed payment to the employee is

compensation income, however, withholding is not required

by an employer on such a deemed payment (§7872(f)(9)).

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Types of Loans

Section 7872 draws a distinction between demand loans and

term loans, although some term loans may be considered demand loans.

Demand Loans

In the case of a demand loan, the employee is treated as

having paid to the employer imputed interest for any day the loan is outstanding. The employer is treated as having

received the imputed amount of interest and as having transferred the same amount to the employee as wages.

Note: The TRA ‗86 gave IRS authority to issue regs treating

loans with indefinite maturities as demand loans (§7872(f)(5)).

Term Loans

In the case of a term loan, wage income is recognized in the year the loan is made and the imputed interest expense of

the employee is recognized over the life of the loan. As a

result, unless the term loan is recharacterized as a demand loan (based on special rules), the term loan does not favor

the employee.

Application of §7872 and Rate Determinations

The applicable federal rate is determined semiannually for demand

loans. The rate for term loans depends on the term of the loan.

Section 7872 applies to the following loans made without interest or at below market rates of interest:

(1) Loans that involve a gift of the foregone interest;

(2) Compensation-related loans between an employer and an

employee and between an independent contractor who has performed services for another person;

(3) Corporation-shareholder loans between a corporation and any shareholder regardless of whether the shareholder is the

lender or borrower;

(4) Loans which are arranged for the principal purpose of

avoidance of federal taxes; and

(5) Any other type of below market rate loan if the interest

arrangement has a significant effect on the federal tax liability of the borrower or the lender.

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Summary

Generally, either the borrower will be deemed to have received a

gift of the foregone interest, the foregone interest will be deemed to have been compensation (or, possibly, a dividend), or

the imputed interest rules will be applied, or any combination of the above. As a rule, interest free loans ceased to be an effective

tax planning tool after TRA 84. Any use to which they could be put would probably be deemed dubious by the IRS, and they will

almost certainly cause more trouble for both the borrower and the lender than they are worth from a viable tax planning point

of view.

Moving Expenses - §217

An executive who moves to a new job location can deduct both

direct and indirect costs of moving (§217). Such expenses are deductible whether the job is new or is a transfer in an existing job.

The company can reimburse the employee. The reimbursement is treated as a qualified fringe benefit. Direct moving expenses such

as the cost of moving furniture and household items are completely

deductible. However, there is a $3,000 dollar limit of indirect expenses such as lodging while waiting to move into a new home.

Employer-Provided Retirement Advice & Planning - §132

Qualified retirement planning services provided to an employee and

his or her spouse by an employer maintaining a qualified plan are excludable from income and wages. The exclusion does not apply

with respect to highly compensated employees unless the services are available on substantially the same terms to each member of

the group of employees normally provided education and information regarding the employer‘s qualified plan.

―Qualified retirement planning services‖ are retirement planning advice and information. The exclusion is not limited to information

regarding the qualified plan, and, thus, for example, applies to advice and information regarding retirement income planning for an

individual and his or her spouse and how the employer‘s plan fits

into the individual‘s overall retirement income plan. On the other hand, the exclusion does not apply to services that may be related

to retirement planning, such as tax preparation, accounting, legal or brokerage services.

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Financial Planning - §67 & §212

One particular benefit that has gained a good deal of popularity

with corporate executives in recent years has been the establishment of a financial counseling program for highly

compensated employees. Financial planning is the result of extending the coverage of tax planning to include maximizing

investment opportunities and adding an analysis of insurance needs.

Popularity

Such programs are conceptually popular for a number of

reasons:

(a) Executives, because of their income levels, frequently can

benefit from such services;

(b) Executives often tend to be so busy that they ignore their

own financial planning; and

(c) Good financial planning results in peace of mind and

promotes better performance in the executive.

Taxation

The IRS has ruled that financial counseling fees paid by a company for the benefit of its executives are taxable income.

(Rev. Rul. 73-13.) However, if fees are incurred for tax or investment advice, they will be deductible by the employee

under §212 (subject to the 2% of AGI limitation). As a result,

such services can be provided at a relatively low price.

Tax Planning - §67 & §212

As one financial institution advertises, ―It‘s not what you make that counts—it‘s what you keep.‖ No topic elicits more interest from

highly compensated individuals than tax planning and sheltering. In addition to regularly preparing federal and other income tax

returns, it is not uncommon for company legal sources to give

executives opinions on significant investment decisions. Historically, company tax attorneys have provided such assistance. However, a

number of executives feel uncomfortable about others in the company knowing their full financial status. As a result, an outside

firm sometimes provides such services.

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Taxation

Costs relating to tax matters involved in carrying on a business,

including costs of tax advice, are deductible, under §162. However, individuals can also deduct tax related expenses as a

―nonbusiness‖ expense under §212. Thus, the employer can establish programs where key executives receive tax advice,

planning, and return preparation. Such amounts will be included in the employee‘s taxable income but the employee will receive a

corresponding deduction subject to §67.

Under §212, individuals can deduct all the ordinary and

necessary expenses incurred in connection with the

determination, collection, or refund of any tax. This rule applies to income, estate, gift, property, and any other tax imposed by

federal, state, municipal, or foreign authorities. It includes the cost of preparing tax returns, determining the extent of liability,

contesting tax liability, obtaining tax counsel, protesting assessments, prosecuting refunds, compromising liability,

income tax planning advice, estate tax planning advice, and costs of substantiating a deduction (Reg. §1.212-1(e)).

Estate Planning - §67 & §212

In recent years, revolutionary changes have occurred in the estate planning area. Because of such concepts as the unlimited marital

deduction and the unified credit, it is now possible to avoid federal death taxes entirely on the death of the first spouse. In some

instances, this can be accomplished by merely using a properly drafted simple will. Much can be done for very little. Similar to the

tax planning programs suggested above, the employer can reward key executives with estate planning services which, while includable

in taxable income, result in a corresponding individual deduction under §212.

Physical Fitness Programs - §132(h)(5)

Many argue that stress brought about during work can be relieved through physical activity and therefore view physical fitness

programs as a logical extension of the company‘s medical program. Some companies choose to join a medically oriented facility near

the company; others incur the construction and related investment cost and elect to develop their own facilities. In general, the fair

market value of any on premises athletic facility provided and operated by an employer for its employees, where substantially all

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the use of the facility is by employees or their spouses and

dependent children, is excluded for income and employment tax purposes (§132(h)(5)). The athletic facility need not be in the same

location as the business premises, but must be located on property owned by the employer.

ERISA Compliance

Many fringe benefits (such as group term life insurance or other

types of employee welfare plan benefits) along with pension or

profit sharing retirement plans have to comply with ERISA. There are a number of different types of civil and criminal penalties for

failures to comply with ERISA requirements.

ERISA covers both pension and welfare plans. Pension plans are

qualified pension and profit sharing plans, including Keogh plans and other benefit programs deferring payments until after

employment has terminated.

WARNING: Welfare‘ plans include the typical fringe benefit

plans adopted by small firms, such as health insurance, long-

term disability, group-term life insurance and accidental death

insurance plans.

Welfare Plans

An employer must prepare a Summary Plan Description (SPD) for distribution to all employees covered by a welfare plan within

120 days after the plan is first adopted. A new employee must be given a copy of the SPD within 90 days after becoming a

participant in the plan. Employers must also make available plan

documents for inspection by employees. Copies must be furnished upon request.

Additional Requirements

When a plan covers 100 or more employees, or if the plan is

an uninsured and funded welfare plan, the employer is subject to additional ERISA requirements, including:

(a) Filing a copy of the SPD with the Department of Labor;

(b) Filing an Annual Return/Report or Registration (Form

5500 series) with the IRS each year;

(c) Preparing and distributing a Summary Annual Report to

covered employees each year;

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(d) Preparing a Summary of Material Modifications of the

plan (if any) and filing it with the Department of Labor and distributing it to covered employees; and

(e) Filing a terminal report if the plan is terminated.

Equity Participation

―Owning a piece of the rock‖ in the form of stock option has long

been an element of executive compensation. Such options allow key employees to buy into the ownership of the corporation at favorable

prices. The benefits of stock options depend upon two important factors:

(1) A determinable fair market value; and

(2) An increase in that fair market value over time.

The option is granted at a point in time when the price of stock is at a given point in time. For the option holder to derive any benefit

from the option, the price of the stock will have to have increased. Thus, the option holder can exercise his option and acquire the

stock at a ―bargain‖ price.

Stock Sales or Unrestricted Stock Plan

A simple and direct way of transferring an equity position in the

employer corporation is to sell the employee voting common stock. In most closely held corporations such a transfer would also be

accompanied by a buy/sell agreement providing for any subsequent lifetime and death transfers. Principals should be cautioned to

maintain control by selling in aggregate only a minority interest in the company. Since small companies rarely pay dividends, the

major benefit to the employee is when the company expands, goes

public, is sold, or acquired. If control is critical several methods can be employed to maintain it. Examples of controlled sales include:

(1) Sale of nonvoting stock,

(2) Sale of stock subject to a voting trust,

(3) Sale of restricted stock keyed to the employee‘s continued employment, and

(4) Sale of stock with an irrevocable proxy.

Stock Plans

A variety of plans exist to provide the executive an equity

ownership interest in the business. This alternative can provide for

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both equity appreciation and a continuing incentive to the employee

to improve the performance of the company.

Stock Bonus

Regulation §1.401-1(a)(2)(iii) defines a stock bonus plan as a

plan to provide employees or their beneficiaries with benefits similar to those of profit sharing plans, except that such benefits

are distributable in stock of the employer and that contributions

by the employer are not dependent upon profits. A stock bonus plan can provide for distribution in cash rather than employer

stock. For purposes of ERISA a stock bonus plan is treated essentially as a profit sharing plan.

ESOT

These are special forms of stock bonus plans. Contributions do

not depend upon profits but must be made according to a formula. ESOTs can purchase stock from the employer and make

loans, guaranteed by the employer, with which to make such purchases. Contributions may be made in cash, stock of the

employer corporation, or a combination of both. When a participant is eligible for a distribution he may receive corporate

stock or cash from the plan. However, the participant has automatic ―puts‖ on any company stock. He can demand that

the company redeem his stock within 90 days of his distribution. The company must, therefore, always plan to set aside funds to

redeem terminating or retiring employees.

Phantom Stock

Phantom stock plans provide future compensation on the basis of company stock that is only hypothetically issued. No stock

actually passes hands or is transferred. The executive is allowed to share in the benefits of stock ownership as if he or she were a

shareholder. All cash dividends, splits, and other shareholder benefits are credited to the executive‘s account. The employee

normally recognizes no income as the shares and dividends are

so credited to the phantom account since such actions do not involve the transfer of property. When the stock or the funds

representing the phantom stock are actually transferred to the executive, ordinary income is recognized based on the fair

market value of the stock or other consideration given. The corporation has a deduction for compensation at the same time

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and in the same amount as the employee. The rules under §83

apply to such plans and distributions.

Advantages

The potential advantages of such plans include the fact that

the employer can provide the employee with the same economic benefits of stock ownership without actually having

to have minority shareholders in the corporation. From the

executive‘s standpoint, he or she is not faced with owning stock for which there may be no market, but instead will

receive an equivalent in cash. The executive is also not required to make an investment in his or her employer‘s

corporation and face the risks that such an investment necessarily entails. With such a cash deferred compensation

plan, as long as constructive receipt is avoided, the employee will not be faced with the problem of having to report taxable

income before he or she receives the cash with which to pay the tax. This problem can occur in a stock option or stock

repurchase agreement.

Comparison with Profit Sharing Plans

Under a qualified profit sharing plan, contributions to the plan usually are based on a percentage of the compensation paid

to all employees participating in the plan, limited to current or accumulated profits. When compared to other qualified plans,

however, qualified profit sharing plans tend to favor employees who are younger, have less service with the

employer, are receiving lower compensation, and who leave

employment before retirement.

Under certain ―phantom stock‖ arrangements, the

contribution to the executive‘s retirement plan (as well as the growth in the value of the deferred compensation) is related

to company profits and company growth. However, the executive is not a shareholder of the corporation. This

arrangement allows the employer to provide the executive with a ―piece of the action‖ without issuing stock.

Repurchase or Restricted Stock Agreement

A company may also transfer stock to an executive with the

condition that the company can repurchase it upon termination of employment and that the stock is nontransferable. This

normally constitutes a ―substantial risk of forfeiture‖ and the

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employee need not report the value of the stock as income when

received. The regulations hold that this is not a property transfer and that the initial transfer is merely to secure the payment of

the deferred compensation (Reg. §1.83-3(a)(2)). Consequently, when the substantial risk of forfeiture lapses, the employee will

have taxable income equal to the fair market value of the stock at the date of lapse. Alternatively, the employee may elect to be

taxed on the value of the stock when he receives it. Any later increase in value of the stock would then be eligible for capital

gains treatment.

Stock Options

A nonqualified stock option is the right of a person to buy stock for

a stated price during a stated period of time. There is no obligation to buy. The option may be granted to either an employee or

independent contractor as payment for services. The grant of the option can create income, even if the intent is to give the employee

an interest in the business rather than pay salary.

Section 83

Nonqualified stock options are taxed under §83 that basically determines the time when the option is going to be taxed. If the

option has a readily ascertainable fair market value and is either nonforfeitable or transferable, then §83(a) treats the option as

income when it is granted to the employee/executive. No income is recognized when the option is exercised. Any gain on

subsequent sale of the stock realized by exercise of the option should be capital gain. The regulations hold that, normally, an

option will have a readily ascertainable value only if it is actively traded (Reg. §1.431-6(c)(2)). Under these rules, an option to

buy stock in a small closely held corporation would rarely be

deemed to have an ascertainable value.

Risk of Forfeiture

If the option is subject to a substantial risk of forfeiture or is

nontransferable, then §83 will not apply. An option is subject

to a substantial risk of forfeiture if the employee‘s full rights are contingent upon his or her performance of future services

(§83(c)(1)). No income is recognized until the option becomes nonforfeitable or transferable. However, any

appreciation during that period will be taxed as compensation when the restrictions lapse.

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Election

The employee may elect to be taxed under §83(b) at the time

of the granting of the option even if it is then subject to substantial risk of forfeiture or is nontransferable. If such an

election is made, the employee will recognize income to the extent that the fair market value of the property exceeds the

amount the employee paid for it. Any subsequent appreciation should be taxed as capital gain. However, this

election can be extremely dangerous. If the property is later forfeited, the employee will not be allowed a deduction. (See

§83(b)(1)).

Stock Appreciation Rights Plans

Another form of the phantom stock approach is called the ―stock appreciation rights‖ arrangement. Under this variation, the plan

participant is not entitled to a ―contribution‖ each year. Instead, the plan specifies that the employee will only receive, as a credit

to the deferred compensation account, the appreciation in the

value of company shares. In other words, only increases and decreases in the value of the company stock provide

adjustments to the account of the executive. (Of course, if the stock drops below the value at the date of the inception of the

plan, the Deferred Compensation Account would drop to zero and the plan would not require the executive to pay the

difference for drops below zero).

Tandem Plans

These plans, sometimes referred to as SARs, are usually in tandem with a nonqualified stock option plan. The SAR

entitles the employee to a cash or stock payment equal to the appreciation in the value of the company‘s stock since the

grant of the SAR. Thus, the employee has a choice of exercising his nonqualified stock option by buying shares from

the company or simply receiving cash or shares. SARs permit cash short employees to enjoy some of the benefits of stock

option plans. The grant of a SAR is not a taxable event. The exercise of a SAR will generate taxable income equal to the

amount received. The company gets a deduction at the time it

is taxable to the employee.

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Qualified Incentive Stock Option

The concept of the incentive stock option was introduced by ERTA in

the form of §422A. These plans permit the purchase of stock of an employer corporation that the employer grants in connection with

the employee‘s employment. If certain criteria are met, at the time the options are exercised the employee will have no income tax

liability and the employer will have no withholding obligation. Thus, when a company adopts such a plan and grants an executive the

right to purchase a number of shares, no taxable income will accrue to that employee. Likewise, when the employee exercises the

option, no income tax will be incurred.

Note: The repeal of long-term capital gains relief reduces the

desirability of ISOs as a compensation device.

Requirements

Section 422A provides various requirements which must be met, including the following:

(1) The option is granted under a plan that is approved by the stockholders within 12 months before or after the

plan‘s adoption;

(2) The plan must specify the number of shares of option

stock to be issued and the employees to receive the options;

(3) The option is granted within 10 years of the date the plan is adopted or approved by the shareholders, whichever

is earlier;

(4) The option is exercisable only within 10 years of the

date it is granted;

(5) The option is equal to or greater than the fair market

value of the option stock when the option is granted;

(6) The option is nontransferable other than at death and is exercisable during the lifetime of the employee only by

the employee;

(7) The employee is not eligible for the option if he owns

more than 10% of the voting power or value of all classes of the company‘s stock unless the option price is equal to

or greater than 110% of the fair market value of the stock and the option is exercisable within 5 years after it is

granted; and

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(8) The plan must limit the fair market value of the

incentive stock optioned to an employee to $100,000 per year, plus any carryover amount.

Note: The TRA ‗86 removed the $100,000 limit on the

amount of option stock that can be subject to ISOs granted

after ‗86 to an employee in any one year and substituted a

limit on the stock that can be acquired in an ISO exercise.

Under the Act, the aggregate fair market value of the option

stock (determined at the time of ISO grant) for which ISOs

are exercisable for the first time under the terms of the

plan, by any employee during any calendar year, cannot

exceed $100,000. For this purpose, all ISO plans of the

employer corporation, its subsidiaries or parent company,

are treated as one plan (§422A(b)(7)).

Nonqualified Deferred Compensation

A substantial percentage of highly compensated individuals either enter into or actively consider deferred compensation arrangements

with their employer. The basic thrust of such arrangements is to postpone the receipt of currently earned income until a later taxable

year.

Postponement of Income

Instead of paying additional compensation now, the employer pays

it to the executive at some future time. These payments are referred to as ―deferred‖ compensation plans because they

represent compensation currently being earned but which will not be paid until a future date.

Note: If the income has already been earned (i.e., the

employee has an undisputed right to it) deferral is generally

impossible.

The term ―nonqualified‖ refers to the fact that the plan does not

attempt to meet the stringent coverage and contribution requirements necessary to obtain government approval for

retirement plan treatment.

Advantages

The biggest advantage of nonqualified deferred compensation is

that the employer is not restricted by the red tape and all of the rules and regulations accompanying qualified plans. Some of those

restrictions include the following:

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IRS Scrutiny & Approval

Every qualified plan must receive a specific approval from the

IRS, in the form of a determination letter, in order to be considered ―legal.‖ Nonqualified plans are not subjected to these

procedures.

Nondiscrimination

The employer may provide nonqualified deferred compensation as a fringe benefit based on merit rather than age and seniority.

Qualified plans may not ―discriminate‖ in favor of certain highly compensated personnel.

ERISA

The Employee Retirement Income Security Act basically

exempts an unfunded arrangement maintained primarily for the purpose of providing deferred compensation for a select

group of management or highly compensated employee (ERISA §201(2)).

Funding

ERISA prescribes specific funding requirements, under which the

employer must write a check on behalf of the plan every year. Nonqualified plans may be ―funded‖ from working capital, from

funds set aside by the employer, or from a combination of both, depending on the needs of the plan and the employer.

No Immediate Cash Outlay

Deferred allows the employer to offer a benefit that does not

require an immediate cash outlay. It also allows the company to replace benefits lost by the new employee.

Annual Report

The Internal Revenue Service must receive an annual report for

every qualified plan. In addition, many plans must provide summary plan descriptions, annual summaries, and other

materials to participants. A nonqualified deferred compensation plan can avoid these costs.

Notice Requirement

However, Department of Labor regulations require that an

employer providing a nonqualified deferred compensation plan send a brief notice (such as a short letter) to the

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Department (ERISA §§110, 104(a)(3) and D.O.L. Regs.

§2520.104-23). The notice must state that a plan has been established and it must describe the overall nature of the

plan.

Purposes

Nonqualified plans have been used for many purposes including the following:

(1) Recruitment,

(2) Retirement benefits for ineligible older employees,

(3) Replacement of lost benefits,

(4) Equalization of retirement benefits among all employees,

(5) Rewards and incentives, and

(6) Reduction of employer‘s costs.

Benefit Formula

A nonqualified retirement benefit can be based on any number of

factors, such as:

(1) Company stock performance,

(2) Return on an investment portfolio,

(3) Employee‘s final five years‘ average pay,

(4) Cost-of-living index, or

(5) Any other logical method.

Incentive

Deferred compensation plans that are tied to company profits

are usually referred to as ―incentive‖ plans. Under these plans, employees may earn deferred bonuses only in years of company

profits.

Alternatively, the portfolio of ―investments‖ of the plan may

consist of the employer‘s stock. Under such plans, company earnings are used to calculate the growth of the phantom

portfolio.

Deferred Bonuses

Bonuses, based on productivity or profits, are helpful to a company as an incentive for top executives. An added

―sweetener‖ to these bonuses is the opportunity to allow the executive to defer some or the entire bonus to a future date. The

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deferral may be for a few years, or may last until the executive

retires.

Tax Status

Service‟s Position

The IRS approaches deferred compensation arrangements with great scrutiny. The focus of the IRS attack is an effort to require

immediate taxation of the ―benefit‖ of the deferred compensation on the employee‘s tax return during the years of accrual.

Even though this result would allow a deduction for the employer

in the same year, the IRS wishes to eliminate the ―tax bracket straddle‖ as well as the tax advantage of the deferral for the

employee.

Moreover, if the employer is a corporation in a lower tax bracket

(such as 15 percent), the IRS might win in two ways: It allows the employer a tax deduction at a low tax rate, while imposing

additional income tax on the employee at a high tax rate.

Note: For the employee, obviously, the result is disastrous, a

high tax bill and no cash with which to pay it. Remember, the

compensation was deferred, and is still being held by the

employer.

Rationale

The Service‘s position is essentially based on R.R. 71-419, R.R. 69-650, and R.R. 60-31. Under these rulings, a taxpayer

will not be in constructive receipt of deferred income if:

(a) The taxpayer elects to defer the income before it is earned,

(b) The deferred income remains subject to the claims of the employer‘s general creditors, and

(c) The deferred income may not be assigned or otherwise anticipated by the taxpayer.

Constructive Receipt

In general, the employee/executive need only report income in the year in which payments are actually received.

Beyond Actual Receipt

However, actual receipt is not always necessary. Income can be constructively received. Accordingly, care must be taken to avoid

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constructive receipt of such compensation prior to the time that

the employee actually receives the cash or benefit. Under the constructive receipt doctrine, a taxpayer who has the right to

receive cash or property, but elects not to, is treated ―as if‖ he actually received it.

Simple Set Asides Are Not Possible

As a result, a corporation cannot just set aside current salary

in an account and pay it to the executive at a later date with the hopes that it will only be taxable when it is taken from the

account. The executive would pay tax currently on the compensation if he or she had a vested right to receive the

payments.

Revenue Ruling 60-31

It is imperative that any deferred payments be viewed in light of this doctrine in order to avoid taxation to the

recipient in the year in which granted. This was defined in R.R. 60-31, which states:

―Under the doctrine of constructive receipt, a

taxpayer may not deliberately turn his back upon

income and thereby select the year for which he will

report it.‖

Regulations

Regulation §1.451-2(a) further defines the doctrine of constructive receipt:

―Income, although not actually reduced to a

taxpayer’s possession is constructively received by

him in the taxable year during which it is credited to

his account, set apart for him, or otherwise made

available so that he may draw upon it at any time, or

so that he could have drawn upon it during the

taxable year if notice of intention to withdraw had

been given. However, income is not constructively

received if the taxpayer’s control of its receipt is

subject to substantial limitations or restrictions.‖

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Time & Control Concept

From the above, it can be seen that the doctrine of constructive

receipt is a time and control concept. It determines when an item of income comes within the control of the taxpayer and

thus is subject to income tax. Let‘s examine these two aspects in more detail:

Control

The key words of Reg. §. 1.451-2(a) are ―made available‖ to

the taxpayer so that he may draw upon it at any time. Constructive receipt is based upon the principle that income

that is subject to a taxpayer‘s unfettered command and he is free to enjoy at his own option is taxed to him whether he

sees fit to enjoy it or not (Corliss v. Bowers, 281 U.S. 376).

Normally, in a deferred compensation arrangement, if the

employee does not have the option to take cash currently in lieu of future income, control is absent.

Timing

Deferral must occur before the employee has a right to the

income. Where compensation is deferred after all services have been performed and deferral is attempted after the

agreed payment date, the income will be subject to current

taxation (Joseph Frank, 22 T.C. 945 (1954) and Richard R. Deupree, 1 T.C. 113 (1942)).

The chances of the constructive receipt doctrine being applied can best be minimized if the individual makes a decision to

enter into the arrangement before the amount is even earned (Ray Robinson, 44 T.C. 20).

Note: Some conservatively interpret this as before January 1 of

the year on which the deferred compensation is agreed upon

citing R.R. 69-650, which indicated that a decision by December

31 was required in connection with compensation to be earned

during the following year.

Economic Benefit

Another tax principle closely allied with the doctrine of constructive

receipt is the theory of economic benefit. The courts have applied this theory of income taxation to impose current tax liability on

taxpayers who receive an ―economic benefit‖ or ―cash equivalent.‖ Receipt is not the issue - ―something‖ generally has been received.

The issue is whether the ―something‖ has a market value.

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Has Something of Value Been Transferred?

The economic benefit concept is that income may be received in

kind as well as in cash. Under §61, gross income means ―all income from whatever source derived.‖ This includes, as income,

a property interest having a fair market value. Under this concept, the IRS attempts to interpret an action by the employer

as resulting in something of market value being given to the employee. For example:

Insurance Coverage Has a Calculable Value

While the mere promise by the company to pay income in the

future may have no economic value (R.R. 60-31), if the payment is funded through a ―split dollar‖ insurance contract

providing a death benefit, then an economic value can be calculated on a yearly basis by comparing the employee‘s cost

with the imputed value of the premium.

The employee received the promise of an insurance company

to pay him benefits in the future. It is the promise of an

insurance company and not the mere promise of the employer that has economic value (Brodie, 1 T.C. 275

(1942)).

Segregated Funds Have Immediate Economic Value

If an employer sets up a trust or escrow account to which the employee has nonforfeitable rights but which is not currently

made available to him, then the amount of annual contribution will be construed to be an economic benefit and

the employee will be taxed that year on the value of that contribution.

Establishing the trust or escrow places the funds beyond the range of corporate creditors and the risks of the business. The

employer‘s promise is a secured one and now has economic or financial value that can be measured. Time alone is not

deemed to be a substantial restriction. Thus, the employee has current taxable income.

General Principles

Under Revenue Ruling 60-31, a deferred compensation benefit is

not "received" for federal income tax purposes until the employer makes actual payment to the employee, as long as the

following three rules are met:

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(1) The decision to defer compensation must be made before

the employee performs any services covered by the deferral;

(2) The deferred compensation account must not be ―funded‖

with a trust or escrow; and

(3) The promise must not be secured by collateral,

promissory note, or other security.

Unfunded Bare Contractual Promise Plan - Type I

An unsecured, unfunded, nonnegotiable promise of the employer to

pay future benefits has no fair market value for tax purposes and is not currently taxable to the employee. See Bedell v. Comm., 30 Fed

622; Richards Estate v. Comm., 150 F.2d 837; and Bella Hammel, 7 T.C. 992.

However, if the employee has a right to presently receive the amount set aside for his benefit, the obligation has a cash

equivalency, or it is funded and consideration separately set aside for the employee, current taxation will result. Thus, in setting up an

unfunded deferred compensation plan and avoiding constructive receipt of income the employer should not set aside funds in an

escrow or trust account but merely promise to pay the executive in the future. The executive‘s rights to payment are therefore no

greater than the rights of a general creditor.

Risk

Thus, the employee is at risk, with respect to the deferred benefits, to the extent that the employee depends upon the

survival and soundness of the company. If the company goes bankrupt, or if all company assets and income become subject to

the claims of creditors, the employee may lose the benefit.

It is the employer‘s ―bare bones promise to pay‖ that ―funds‖ the

employee‘s deferred benefit. To achieve deferral, the employee

must be willing to take the risk of being a general creditor of the employer. While every company expects to exist in near

perpetuity, there are enough bankruptcies to require serious assessment of this probability.

Funded Company Account Plan - Type II

Although deferred cash compensation arrangements are normally

unfunded and evidenced by a mere contractual promise of the

employer, such arrangements may also be funded by company assets or bookkeeping accounts. Funded plans certainly raise the

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specter of constructive receipt and thus taxability to the employee.

However, with careful planning, employee taxation can be avoided.

Ownership & Segregation

The tax treatment of the employer and employee will vary based

on how the deferred amounts in a funded plan are actually segregated and to whom they belong. If funds are set aside they

should belong to the employer not the employee.

Bookkeeping Reserve or Separate Account

Although the employer may not transfer assets to escrow or to a trust (and may not give the employee a collateral interest or

negotiable instrument), the employer may, under limited

circumstances, designate some of its own assets as a ―deferred compensation fund.‖ Even if the deferred amounts are credited

to a bookkeeping reserve or even placed in a separate account, so long as the funds belong to the employer and are subject to

claims by the general creditors of the employer, deferral will still result (R.R. 60-31).

Employee Bears Economic Risk

Because it is necessary that the deferred amounts remain

subject to the general creditors of the employer in order to achieve deferral for tax purposes, the economic viability of the

employer must be weighed carefully.

Limited Protection

There are methods available that have been approved by the IRS to afford the employee some limited protection. Examples

are:

Investment of Deferred Amounts

Based on R.R. 60-31, it appears clear that the employer may invest deferred amounts and the employee will still

qualify for tax deferral. Although invested amounts must remain subject to the general creditors of the employer, an

investment arrangement offers the employee some protection in that, if the employer invests wisely, the plan

will increase the amount of assets available to the employer to actually pay the deferred amounts. According to the IRS,

the employer cannot be specifically required to hold any

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particular asset as a funding device, and the employer

must retain the right to veto any employee.

Some practitioners take the position that if the employee

directs the investing of assets held by the employer, the IRS could interpret this as an exercise of the ―rights‖ over

those funds.

Thus, the IRS could assert that the employee essentially

―owns‖ the funds, and should pay tax on them. If this is a concern or if the ―employee‖ is also an owner of a closely

held corporation, the ongoing management of such assets might be left in the hands of a mutual fund manager,

insurance company, or other third party.

Life Insurance

If the employer purchases life insurance on the executive payable to it and which is owned by it free of restrictions,

the employee will have no rights or interest in the policy, therefore, policy values can be attributed to the employee

only by disregarding the corporation which the courts have not done (Casale v. Comm., 26 T.C. 1020 (1956); and R.R.

59-184). In fact, under R.R. 68-99, the Service has ruled that an employer may, at its option, purchase a life

insurance policy to fund a deferred compensation

arrangement.

The ruling requires that all rights to any benefits under the

insurance contract are solely the property of the employer, and the proceeds of the contract are payable by the

insurance company only to the employer. Thus, the employee does not receive a present economic benefit from

the policy, and consequently the basic concept of deferral is not defeated by the insurance funding (R.R. 72-25).

Premiums

Premiums paid by the employer on the life insurance policy

are not taxable to the employee because he has no rights or interest in the policy. This is so even though the

employer uses the proceeds of the policy to discharge its obligation under the deferred compensation agreement

(Centre v. Comm., 55 T.C. 16 (1970)).

Note that the premium payments would not be deductible

by the employer (§264(a)(i)). Nevertheless, the life insurance proceeds received by the employer upon the

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employee‘s death would be income tax free (§101(a)). The

company is simply transferring some of its cash assets into a cash value account that it controls.

However, life insurance premiums paid by an employer on the life of the employee under circumstance where the

proceeds are payable to the employee‘s beneficiaries will be taxable income to the employee (Reg. §1.61-(2)(d) and

Paul L. Frost, 52 T.C. 89 (1969)). Finally, if the policy is transferred to the employee upon termination of

employment, he will be taxable on the value of the policy received.

Third Party Guarantees

The guarantee of the employer‘s obligation by a third party

does not appear to affect the ability to defer the compensation. In Robinson v. Commissioner, 44 T.C. 20

(1965), acq., deferred compensation for a boxer was personally guaranteed by the president of the promotional

corporation. The Tax Court held that the taxpayer did not constructively receive funds payable in subsequent years

under the deferral agreement.

Segregated Asset Plan - Type III

If the deferred amounts are segregated outside of the company into

a separate account that belongs to the employee and is not subject to the claims of the employer‘s general creditors, the deferred

amount is normally held to be currently taxable. However, it is possible to segregate an amount in an account that is not subject to

the claims of the employer‘s creditors and still avoid employee taxation, provided, the requirements of §83 are met.

Section 83 Approach

There is a limited ―loophole‖ to the requirement that deferred

compensation benefits must be ―unfunded‖ (or funded only from the general assets of the corporation). This loophole is called the

―Section 83" approach. Under this approach, funds covering the

payment of future obligations are transferred to an outside account. However, the benefits themselves are subject to a

"substantial risk of forfeiture," as defined under Reg. §1.83(c)(1). This approach also requires that the funding

arrangement qualify as a ―transfer of property‖ under §83.

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Tight Rope Format

By actually funding the liability (but making the liability itself

contingent on future services), the employer walks the thin line between a ―vested‖ right to an unfunded obligation and a

completely ―non-vested‖ right to an actual fund (in a trust or escrow). Extreme caution must be exercised when walking this

thin line.

Transferable or Not Subject To A Risk of Substantial

Forfeiture

Plans funded using segregated assets are governed by the rules

of §83, which apply to transfers of property for services. Under §83(a), the executive is taxable on a funded plan when the right

to such funds is either transferable or not subject to a risk of substantial forfeiture.

Note the dual criteria of transferability and lack of a substantial restriction. Obviously, property is transferable only if the rights

of a transferee are not subject to a substantial risk of forfeiture.

From a practical viewpoint, therefore, while the statute sets two criteria for the recognition of taxable income, there is only one -

the presence or absence of a substantial risk of forfeiture.

Section 83(c)(1) provides that rights are subject to a substantial

risk of forfeiture when full enjoyment is dependent on the future performance (or refraining from performance) of substantial

services by any individual. Such a risk does not exist if the forfeiture will only occur on death, disability, criminal activity, or

violation of a covenant not to compete (Reg. §1.83).

Substantial Restrictions

Some examples of substantial restrictions might be:

Redemption or Forfeiture

Transfer of property to an employee subject to a binding commitment to resell the property to the employer at its

original value or even forfeit the property entirely if the employee leaves employment for any reason during a test

period, would be a substantial restriction. To the extent that rights to benefits are forfeitable, no immediate benefit

is derived, even though:

(a) The employer acknowledges the liability of benefit

payment by setting up a liability account on the

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employer‘s balance sheet, called ―deferred compensation

account,‖ on behalf of the employee; and

(b) The employee has a legal right to the benefits as long

as the employee continues to work for the employer until retirement (or until the end of the deferral period).

Condition Related to a Purpose of the Transfer

A requirement that property transferred to an employee be

returned if the total earnings of the company do not increase could be a condition related to a purpose of the

transfer.

Noncompetition

Factors, which may be taken into account in determining whether a covenant not to compete constitutes a

substantial risk of forfeiture, are the age of the employee, the availability of alternative employment opportunities, the

likelihood of the employee‘s health, and the practice of the employer to enforce such agreements.

Consultation

Property, transferred to a retiring employee subject to the

sole requirement that it be returned unless he renders consulting services upon the request of his former

employer, will not be considered subject to a substantial risk of forfeiture unless he is in fact expected to perform

substantial services.

Time Alone is Not Enough

The IRS takes the position that if deferred amounts are placed in an irrevocable trust or escrow account and are

not subject to substantial risk of forfeiture, the deferred amounts will be currently taxed to the employee. This

position has been supported in litigation and there appears little dispute on the issue. (See E.T. Sproull v.

Commissioner 16 T.C. 244 (1951) and Jacuzzi v. Commissioner 61 T.C. 262 (1972)).

Realization & Taxation

When the property becomes transferable or not subject to a

substantial risk of forfeiture, the employee is then taxed on the excess of the fair market value of the property received over the

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amount the employee paid for that property. If the recipient of

the property sells or otherwise disposes of it before it is released from the substantial risk of forfeiture, income is realized at that

time.

30-Day Election Period

The employee may elect to be taxed prior to the time that his or

her rights to the property become transferable or are no longer

subject to a substantial risk of forfeiture. Such an election must be made within 30 days after the transfer or grant of the funded

deferred compensation arrangement.

Deduction Allowed

Section 83 allows a deduction to the employer when the employee realizes income as a result of:

(1) Receiving nonforfeitable property,

(2) The property becomes nonforfeitable because it is

relieved of forfeiture restrictions, or

(3) The employee elects to report the income in the year the

property is received.

Timing

Under §162 a deduction is allowed in an amount equal to the income reported by the employee. However, the taxable year for

the employer‘s deduction is the taxable year in which the taxable year of the employee ends.

Withholding

In addition, the employer must deduct and withhold income

taxes as required by §3402, otherwise the deduction will be disallowed (Reg. §1.83-6(a))2)).

Tax Consequences

There was a time, in the early days of the income tax system in this country, when it was possible for an employer to ―accrue‖ a

deferred compensation expense and take a deduction for it. At the same time, the employee did not have to report, as income, the

deferred compensation until it was actually paid.

4 - 6 0

Reciprocal Taxation/Deduction Rule

The Revenue Act of 1942 installed a provision, now known as

§404(a)(5), which provides that accruals under nonqualified deferred compensation plans are deductible on the employer‘s

tax return only in the year in which the employee actually receives the cash (or other property) from the deferred

compensation plan.

Thus, the tax position of the employer and the employee are

reciprocal. The employer will normally only receive a deduction for the contribution to the nonqualified deferred compensation

plan when the employee suffers taxation on the same amount.

Benefit payments will be taxable to the employee only as and when received. No deduction is allowed to the employer at the

time the promise of future benefits is made to the employee.

No Difference for Cash or Accrual

Section 404(a)(5) permits the employer a deduction only

when payments (or benefits) are received by the employee,

regardless of whether the employer is on a cash or accrual basis of accounting (see also Sol Jacobs, Jr., 45 T.C. No.10

(1965)).

Separate Accounts for Two or More Participants

Section 404(a)(5) provides that in a funded plan, if more than one employee participates in the nonqualified plan, separate

accounts must be kept for each in order to obtain the deduction. Remember also, in a funded plan the determining factor for the

employer‘s deduction is the time when the employee‘s interest becomes nonforfeitable, since this constitutes receipt of the

benefits equal to actual payment.

Income Tax on Employer Held Assets

If a company sets aside assets to brace itself against future liabilities, the earnings on those assets are usually taxable to the

company. The company might minimize the tax burden of carrying those assets by:

(a) Buying stock qualifying for the 80% dividends-received deduction,

(b) Investing in municipal bonds or other tax-exempt securities, and

(c) Purchasing life insurance policies.

4 - 6 1

Inclusion in Income Under §409A

Since 2005, new §409A provides comprehensive rules regarding

the inclusion in gross income of deferred compensation under nonqualified deferred compensation plans. As a result, if at any

time a nonqualified deferred compensation plan fails to meet any one of three requirements, the compensation plus related

earnings must be included in taxable income, with the tax increased by a 20% penalty and increased by interest (i.e., at

the IRS underpayment rate plus 1%) on the underpayments that would have occurred had the deferred compensation been

includible in income for the year in which first deferred.

The three requirements that must continuously be met to avoid early taxation plus a penalty and interest are:

(1) The distribution rule;

(2) The election rule; and

(3) The acceleration of benefits rule (i.e., under which the plan may not permit the acceleration of the time or schedule

of any payment, except as provided in regulations).

Essentially, all amounts deferred under a non-qualified deferred

compensation plan in tax years beginning after 2004, now become taxable when they are no longer subject to a substantial

risk of forfeiture, unless certain requirements are satisfied. This effectively means that the distinction between funded and

unfunded plans will no longer apply. This change in the law also appears to make the Rabbi trust a less attractive funding

mechanism for non-qualified deferred compensation plans

(§409A).

Under §409A(a)(1)(A)(i), which was added by the 2004 Jobs

Act, all amounts deferred under a nonqualified deferred compensation (NQDC) plan for all tax years are currently

includible in gross income to the extent not subject to a substantial risk of forfeiture and not previously included in gross

income, unless the plan:

(1) meets the distribution, acceleration of benefit, and

election requirements under §409A; and

(2) is operated in accordance with these requirements.

If a NQDC plan is not in compliance with or does not operate in compliance with these rules at any time during a tax year (i.e.,

starting with the 2005 tax year and thereafter), all amounts deferred under the plan for that tax year and all preceding tax

years, by any participant with respect to whom the failure

4 - 6 2

relates, are included in gross income for that year to the extent

not subject to a substantial risk of forfeiture and not previously included in gross income. The amount included in income also is

subject to:

(1) interest (at the underpayment rate plus one percentage

point) on the tax underpayments that would have occurred had the compensation been included in income for the tax

year when first deferred, or if later, when not subject to a substantial risk of forfeiture; and

(2) additional income tax equal to 20% of the compensation required to be included in gross income.

5 - 1

CHAPTER 5

Automobiles

Operating costs for an automobile, truck, or other vehicle used in a

trade or business are deductible to the extent that they represent transportation expenses to carry on the taxpayer‘s business (Reg.

§1.162-1(a), §1.162-2, and §1.162-6). Thus, when a taxpayer uses his car in his business or employment, he can deduct that portion of

the cost of operating the car.

Apportionment of Personal & Business

Use

When a taxpayer makes both personal and business use of his auto, he must apportion his expenses between business travel and

personal travel, unless the personal use is negligible (§262; Wetzler, TC Memo 10/10/52, 11 TCM 1001; Harley Est., TC Memo

1959-165; Donaldson, 18 BTA 230(A)).

Thus, total car expenses (except business parking fees and tolls)

are deducted in proportion of business to total use. Parking fees and tolls for business uses are deducted in full (R.P. 82-61).

Note: An individual who itemizes his deductions may claim

expenses for state and local personal property taxes, and

certain casualty and theft losses even though the car is used

entirely for personal purposes.

There is no definitive rule for making an apportionment between

business and personal expenses. However, generally accepted methods include:

(1) A proration of actual expenses and depreciation based on

the percentage of business use to total use; and

(2) The standard mileage rate deduction for business miles

driven.

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The taxpayer is free to use whichever method produces the largest

deduction, provided the right to the deduction is properly substantiated.

Example

Dan is a sales representative for a clothing firm and

drives his car 20,000 miles during the year: 12,000

miles for business and 8,000 miles for personal use.

Dan can claim only 60% (12,000/20,000) of the cost

of operating his car as a business expense.

Car Pool

Taxpayers cannot deduct the cost of using their car in a nonprofit

car pool. Payments from the passengers are considered

reimbursements of expenses and not included in income. However, if the taxpayer operates a car pool for profit, they must include

these payments in income and can deduct expenses (R.R. 55-555).

Fines

Fines and collateral for traffic violations are not deductible (§162(f); Reg §1.162-21).

Parking Fees

Parking fees paid to park a car at a taxpayer’s place of work are nondeductible commuting expenses (Henderson, 46 TCM 566

(1983)).

Interest Deduction Limit for Individuals

Since 1990, individual taxpayers can no longer deduct interest

expense on car loans. This applies even if the car is used 100% for business by an employee (§163(h)(2)(A); §163(h)(5)).

Self-Employed Exception

However, self-employed taxpayers who use their car in business

can deduct that part of the interest expense that represents their business use of the car. If the car is used 50% for business, for

example, 50% of the interest can be deducted on Schedule C (Form 1040). The rest of the interest expense is not deductible

(§162(a)).

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Property Taxes

A taxpayer can deduct property taxes paid on their car only if they

itemize deductions on Schedule A. Taxpayers can take this deduction even if they use the standard mileage rate or they do not

use the car for business (§164(a)(2)).

Note: If a taxpayer is self-employed and uses their car in

business, they can deduct the business part of state and local

personal property taxes on motor vehicles on Schedule C, Form

1040 (§162(a)).

Sales Taxes

Luxury and sales taxes are not deductible even if the car is used

100% for business. Such taxes are part of the car‘s basis and must be recovered through depreciation (§164(a); §4001).

2009 Sales Tax Deduction for Qualified Vehicles (Expired) -

§164

For purchases on or after February 17, 2009 and before January 1, 2010, the American Recovery & Reinvestment Act provided an

above the line deduction for qualified motor vehicle taxes. It expanded the definition of taxes allowed as a deduction to

include qualified motor vehicle taxes paid or accrued within the taxable year.

Note: A taxpayer who itemized and made an election to deduct

State and local sales taxes for qualified motor vehicles for the

taxable year was not allowed this increased standard deduction

for qualified motor vehicle taxes.

Qualified Taxes: Qualified motor vehicle taxes include any

State or local sales or excise tax imposed on the purchase of a

qualified motor vehicle.

Qualified Motor Vehicle: A qualified motor vehicle means a

passenger automobile, light truck, or motorcycle which has a gross vehicle weight rating of not more than 8,500 pounds, or a

motor home acquired for use by the taxpayer after February 17, 2009 and before January 1, 2010, the original use of which

commences with the taxpayer.

Deduction Limitation: The deduction was limited to the tax on

up to $49,500 of the purchase price of a qualified motor vehicle. The deduction was phased out for taxpayers with modified

adjusted gross income between $125,000 and $135,000 ($250,000 and $260,000 in the case of a joint return).

5 - 4

Comment: While both domestic and foreign vehicles qualify for

the deduction, sales taxes paid on a lease agreement were not

included.

As of this writing, Congress has not reinstated this provision.

Actual Cost Method

Under this method the taxpayer must substantiate all expenditures

made, and thus extensive record keeping is required. Deductible

expenses are items such as:

(1) Gasoline,

(2) Oil,

(3) Repairs and maintenance,

(4) Interest1 to buy the car,

(5) Lease fees,

(6) Rental fees,

(7) Costs of washing the vehicle,

(8) Garage rent,

(9) Tires,

(10) Highway tolls,

(11) Parking (for business purposes not commute),

(12) License and registration fees,

(13) Insurance premiums, and

(14) A reasonable allowance for depreciation2.

Note: Complex rules for depreciation apply if the actual

cost method is used.

These expenses are totaled and then multiplied by the business-use

percentage to determine the amount of the deduction. Only the

business-use percentage (based on the ratio of business miles to total miles) allowable to business transportation is allowed as a

deduction.

1 Emp l o y e e s c a n n o t d e d u c t a n y i n t e r e s t p a i d o n a c a r l o a n .

T h i s i n t e r e s t i s t r e a t e d a s p e r s o n a l a n d n o n d e d u c t i b l e . 2

On l y t h e a c t u a l c o s t me t h o d a l l o ws f o r a s e p a r a t e

c a l c u l a t i o n o f d e p r e c i a t i o n . T h e s t a n d a r d mi l e a g e me t h o d

s u p p o s e d l y h a s a d e p r e c i a t i o n a l l o wa n c e b u i l t i n t o i t .

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Deduction Limitations

Generally, for cars3 used in business and placed in service after

June 18, 1984, there are a variety of restrictions and limits on the amounts of §179 expensing, investment tax credit (repealed

effective 1986), and depreciation (§280F). In addition, special rules apply if the car is used 50% or less in business.

Definition of Car

For purposes of these restrictions, a car means any four-wheeled

vehicle that is manufactured primarily for use on public streets, roads, and highways and that has an unloaded gross vehicle

weight of 6,000 pounds or less or, gross vehicle weight of 6,000 pounds or less for a truck or van (§280F(d)(5)(A); Reg.§1.280F-

6T(c)(1)).

Note: In PLR 9435039, the IRS ruled that a sport utility vehicle

with a gross weight in excess of 6,000 pounds was not a

―passenger vehicle‖ for purposes of the luxury tax on passenger

vehicles. The all terrain, four-wheel drive vehicle was classified

as a ―truck‖ or ―van‖ for purposes of §4001(a).

A car includes any part, component, or other item that is

physically attached to it and is traditionally included in the purchase price.

A car does not include:

(a) An ambulance, hearse, or combination ambulance-hearse

used directly in a business,

(b) A vehicle used directly in the business of transporting

persons or property for compensation or hire, or

(c) Certain commuter highway vehicles (defined in

§46(c)(6)(B)) placed in service before 1986 (§280F(d)(5)(B)).

Depreciation and Expensing

Unless the standard mileage method is used, an amount can be

deducted each year that represents a reduction in a car‘s value due to wear and tear (§167). Employees use Form 2106 to

figure their depreciation deduction. All other taxpayers use Form 4562.

3

Se c t i o n 2 8 0 F a c t u a l l y u s e s t h e t e r m “ p a s s e n g e r

a u t o mo b i l e s . ”

5 - 6

Note: Taxpayers cannot use the standard mileage rate in a later

year if they decide to take a depreciation deduction other than

straight-line.

Basis

The basis used for figuring depreciation is the same basis that

would be used for figuring the gain on a sale. The original basis of a car is generally its cost. Cost includes sales and

luxury taxes, destination charges, and dealer preparation.

Trade-In of Old Car for New

If a taxpayer trades in a car used entirely in their business for another car that will be used entirely in business, the

unadjusted basis of the new car is the adjusted basis of the old car, plus any additional amount paid for the new car

(Reg §1.280F-2T(g)).

Example from Pub. 463 (Rev „13)

Paul trades in a car that has an adjusted basis of

$5,000 for a new car. In addition, he pays cash of

$20,000 for the new car. His original basis of the new

car is $25.000 (his $5,000 adjusted basis in the old

car plus the $20,000 cash paid). Paul's unadjusted

basis is $25,000 unless he claims the section 179

deduction, or has other increases or decreases to his

original basis..

If a taxpayer trades a car in (acquired after June 18, 1984) that was used partly in their business for a new car that

they will use in business, figure the basis of the new car for

depreciation as follows. Add to the adjusted basis of the old car any additional amount paid for the new car. Then

subtract from that total the excess, if any, of:

(1) The total of the amounts that would have been

allowable as depreciation during the tax years before the trade if 100% of the use of the car had been business

and investment use, over

(2) The total of the amounts actually allowable as

depreciation during those years (Reg. §1.280F-2T(g)(2)(ii)).

5 - 7

Placed in Service

A car is placed in service when it is available for use in the

taxpayer‘s work or business, in the production of income, or in a personal activity (Reg.§1.167(a)-11(e)(1)). However,

auto depreciation can only begin when it is actually used in the taxpayer‘s work, business, or production of income

(Piggly Wiggly Southern, Inc., 84 TC 739 (1985)).

Conversion to Business Use - “Lesser of” Rule

For purposes of computing depreciation, if a taxpayer first starts using a car entirely for personal use and later

converts it to business use, the car is treated as placed in service on the date of conversion. However, the basis is the

lesser of the fair market value or the car‘s adjusted basis on the date of conversion (Prop. Reg. §1.168-2(j)(1); Prop

Reg. §1.168-2(j)(6)(ii); Form 2106 Instructions).

MACRS - 5 (Actually 6) Years

The modified cost recovery system (MACRS) is the depreciation system that applies to tangible property placed

in service after 1986. Under MACRS, cars are classified as 5-year property. However, as a result of the half-year

convention4, the car is actually depreciated over a 6-year

period.

200%Double Declining Balance Method

To figure MACRS depreciation, divide 1 by the recovery

period (5 years for cars). This basic rate (20% for 5-year property) is multiplied by 2 to get the double declining

(200%) balance rate of 40%. Multiply the adjusted basis of

the car (determined by reducing the cost by the percentage of personal use and any §179 deduction) by this 40% and

apply the appropriate convention to figure your depreciation for the first year. This process is continued for

each year of recovery. However, at the point (year 4 for cars) where straight-line is more beneficial, a switch is

made to straight-line.

4

A q u a r t e r l y c o n v e n t i o n c a n a p p l y i f p r o p e r t y i s p l a c e d i n

s e r v i c e d u r i n g t h e l a s t 3 mo n t h s o f t h e t a x y e a r a n d t h e

t o t a l o f s u c h a s s e t s i s mo r e t h a n 4 0 % o f a l l p r o p e r t y p l a c e d

i n s e r v i c e d u r i n g t h e e n t i r e y e a r . 4

5 - 8

Example from Pub. 917 (Rev „91)

In February 1988, Edna purchased an automobile for

$12,000 to use 100% in her plant and floral

business. At night, she parked the vehicle at her

floral shop. She used another vehicle for personal

purposes.

Edna did not purchase any other assets for use in her

business during the year. She did not claim the

section 179 deduction.

Under MACRS, her double declining balance rate is

40% (basic rate of 20% multiplied by 2). For 1988

(the first year), she applied the half-year convention.

Edna computed her 1988 depreciation to be $2,400

($12,000 x 40% x -1/2).

In 1989, her business use of the car remained at

100%. She computed the adjusted basis of $9,600

($12,000 - $2,400) as of the beginning of 1989. Her

second year depreciation was $3,840 ($9,600 x

40%).

Assuming 100% business use, Edna’s adjusted basis

as of 1990 is $5,760 ($12,000 - $2,400 - $3,840)

and her depreciation for 1990 is $2,304 ($5,760 x

40%).

In 1991, she switches to the straight-line method

because it gives her a larger deduction than the

double declining balance method. The car has 2-1/2

years of recovery left and an adjusted basis of $3,456

($12,000 - $2,400 - $3,840 - $2,304). Edna’s

depreciation in 1991 and 1992 is $1,382

($3,456/2.5). In 1993 it is $692 ($3,456 - $1,382 -

$1,382).

Edna can deduct her depreciation for each year in full

because it is not more than the maximum amount

allowable for cars placed in service after 1986.

Note: The IRS discontinued Publication 917 with the 1995 tax

year issue. The guidance formerly provided in Pub. 917 is now

provided in Publication 463, Travel, Entertainment, Gift, and Car

Expenses.

Example from Pub. 463 (Rev „99)

In June 1999, Karl, an outside dental supply

salesman, purchased a car for $25,400 to make

sales calls in a territory that extends 200 miles

5 - 9

around his home base. He uses his car 85% for his

business. Karl does not claim the section 179

deduction and he chooses the 200% DB method to

figure his depreciation deduction.

In 1999, Karl computes his MACRS deduction to be

$4,318 [($25,400 x 85%) x 20%]. However, Karl’s

deduction is limited to $2,601. This is the

depreciation limit ($3,060) multiplied by the

business-use percentage (85%).

Karl continues to use his car 85% for business.

Depreciation in the next four years continues to be

subject to deduction limits. Karl computes his

depreciation limits for those years as follows.

Year Limit x Business Use Depreciation

2000 $5,000 x 85% $ 4,250

2001 2,950 x 85% 2,508

2002, 2003 1,775 x 85% 1,509

If Karl continues to use his car for business after

2004, he can continue to claim a depreciation

deduction for his unrecovered basis. However, he

cannot deduct more than $1,775 multiplied by his

business-use percentage.

150% Declining Balance Method Election

Taxpayers can choose to use the 150% declining balance method to depreciate their car. If they choose this

method, they must depreciate their car over its class life instead of the recovery period. Once a taxpayer makes

this choice, they cannot revoke it (§168(b)(2)(C)).

Straight-Line Method Election

An election to use the straight-line method, with the applicable convention, over the entire recovery period can

also be made. The election to use the straight-line method for a class of property applies to all property in

that class that is placed in service in the year of the election. Once made, the taxpayer cannot revoke this

election. Under this method, salvage value is zero (§168(g)(2); §168(g)(7)).

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Bonus (or Additional First-year) Depreciation -

§168(k)

Business taxpayers are allowed to recover the cost of capital expenditures over time according to a depreciation

schedule (§168). However, at various times, Congress has allowed such taxpayers to take an additional (or

bonus) depreciation deduction allowance equal to either 50% or 100% of the cost of the depreciable property.

For 2011, the additional first-year depreciation was equal to 100%; for 2012, the bonus was reduced to 50%. ATRA

extended 50% bonus depreciation for qualifying property

purchased and placed in service before January 1, 2014 (before January 1, 2015 for certain longer-lived and

transportation assets).

Depreciation Limit Impact: The limitation under §280F

on the amount of depreciation deductions allowed with

respect to certain passenger automobiles was increased in

the first year by $8,000 for automobiles that qualify (and

for which the taxpayer does not elect out of the additional

first-year deduction).

The additional first-year depreciation deduction was

allowed for both regular tax and alternative minimum tax purposes for the taxable year in which the property is

placed in service.

As of this writing, Congress has not extended these

provisions under §168(k).

Half-Year Convention

The half-year depreciation convention treats all property placed in service (or disposed of) during a tax year, as

placed in service (or disposed of) on the mid-point of that tax year (§168(d)(4)(A)).

Taxpayers are allowed a half year of depreciation for the first year they place property in service, regardless of what

month they actually first use the property. A full year of depreciation is taken for each of the remaining years of the

recovery period.

If the property is held for the entire recovery period (5

years for vehicles), a half-year of depreciation is allowed in

the year following the end of the recovery period (year 6 for vehicles).

5 - 11

If a taxpayer deducts actual car expenses and disposes of

their car before the end of its recovery period, they are allowed a reduced depreciation deduction for the year of

disposition.

Such a taxpayer can deduct one-half of the regular

depreciation amount for the year of disposition. Thus, if the property is disposed of before the end of the recovery

period, a half-year of depreciation is allowed in the year of disposition.

The half-year convention must be used unless the taxpayer is required to use the mid-quarter convention

(§168(d)(4)(A)).

Mid-Quarter Convention

Taxpayers must use a mid-quarter convention in the first and last year of the recovery period, instead of a half-year

convention, if:

(1) They place property, including cars, in service during

the last 3 months of their tax year, and

(2) The total basis of these assets is more than 40% of

the total basis of all property placed in service during the entire year.

In determining the total cost of property placed in service

during the year, residential rental and nonresidential real property is disregarded. The taxpayer can also elect to

disregard any property acquired and disposed of within the same year (§168(d)(3)).

Under the mid-quarter convention, all property placed in service (or disposed of) during any quarter of the tax year

is treated as placed in service (or disposed of) at the mid-point of that quarter (§168(d)(4)(C)).

To figure the deduction for property subject to the mid-quarter convention, first compute the depreciation for the

full year. Multiply the result by the percentage from the following table for the quarter of the tax year the property

was placed in service. This table is not for fiscal year taxpayers.

Quarter Percentage

Jan. - Mar. 87.5%

Apr. - June 62.5%

5 - 12

July - Sept. 37.5%

Oct. - Dec. 12.5%

Example from Pub. 917 (Rev „91)

During 1991, Katrina purchases and places into

service a computer for $5,000 in January, a

photocopier for $1,000 in September, and a delivery

van for $23,000 in November. She does not elect

section 179. All property is used 100% in her

business. The combined total basis of all property

she placed in service in 1991 is $29,000 ($5,000 +

$1,000 + $23,000). Since the basis of the van

($23,000), which was placed in service in the last

quarter of the year, is more than 40% of the total

basis of all property ($29,000) she placed in service

in 1991, she must use the mid-quarter convention to

depreciate these three assets. These assets are 5-

year property.

Katrina multiplies the basis of the computer, $5,000,

by 40% to get depreciation of $2,000 for a full year.

Katrina placed the computer in service during the first

quarter of her tax year, so she multiplies the full year

depreciation ($2,000) by the amount from the table

(87.5%) to get her 1991 depreciation deduction of

$1,750 for the computer.

Katrina multiplies the basis of the photocopier,

$1,000, by 40% to get $400 depreciation for a full

year. She placed the photocopier in service in the

third quarter of her tax year, so she multiplies the

$400 by the amount from the table (37.5%) to get

her 1991 depreciation of $150.

Depreciation on the van is subject to the limits on

vehicles, in addition to the mid-quarter convention.

Katrina multiplies the basis of the van ($23,000) by

40% to get $9,200. Since she placed the van in

service in the last quarter of her tax year, she

multiplies the result ($9,200) by 12.5% to get

$1,150, her allowable depreciation on the van for

1991.

Had Katrina placed the van in service during one of

the first 3 quarters of the year, she would have used

the half-year convention, rather than the mid-quarter

convention on all 3 assets. However, the first year

depreciation on the van would have been limited to

$2,660.

5 - 13

Note: The IRS discontinued Publication 917 with the 1995 tax

year issue. The guidance formerly provided in Pub. 917 is now

provided in Publication 463, Travel, Entertainment, Gift, and Car

Expenses. IRS Publication 946 now contains the 40% chart.

Depreciation “Caps”

The maximum depreciation deduction (including the §179

expensing deduction) for any auto first placed in service in

2014 and used 100% for business may not be more than the lesser of:

$3,160 ($11,160 if first year bonus depreciation is extended by Congress into 2014 and used) or 20% for the

first tax year of the recovery period,

$5,100 or 32% for the second year,

$3,050 or 19.2% for the third year,

$1,875 or 11.52% for the fourth year,

$1,875 or 11.52% for the fifth year, and

$1,875 or 5.76% for the sixth year (§280F(a)(2)(A)).

Any depreciable basis remaining after six years is recovered at a rate that cannot exceed $1,875 a year.

Note: The expense deduction allowed under §179 is treated

as depreciation for purposes of applying this limitation

(§280F(d)(1)).

The depreciation limits on MACRS property are reduced only

by the percentage of personal use. They are not reduced if the taxpayer uses a vehicle for less than a full year. There is

no reduction if the taxpayer is using a half-year or mid-quarter convention. This applies even in the year the vehicle

is either placed in service or disposed of (Reg. §1.280F-2T(i)).

Separate Depreciation Caps for Trucks & Vans

Formerly, depreciation limitations for trucks and vans were the same as for passenger vehicles. However, starting in

2003, the IRS issued separate and slightly higher limitations for trucks and vans (R.P. 2003-75).

For 2014, as of this writing, official depreciation caps were not yet available. However, it is estimated that for cars

placed in service in 2014, the depreciation deduction (including the §179 expensing deduction) may not be more

than $3,160 ($11,160 if first year bonus depreciation is extended by Congress into 2014 and used) for the first tax

5 - 14

year of the recovery period, $5,100 for the second year,

$3,050 for the third year, and $1,875 for each later tax year (§280F(a)(2)(A)).

For trucks and vans placed in service in calendar year 2014, the depreciation cap is estimated to be $3,460

($11,460 if bonus depreciation is extended by Congress into 2014 and used) in the first-year, $5,500 in the second

year, $3,400 in the third year, and $1,975 in the fourth year and thereafter.

Note: First year bonus depreciation ($11,160 for autos and

$11,360 for trucks and vans) was automatic for qualifying

vehicles. Taxpayers not wanting the bonus depreciation had

to elect out.

Post-Recovery Period Depreciation - Max Reduction Rule

If at the end of the recovery period, any unrecovered basis

remains and the car is still used in business, depreciation is

continued. However, in determining unrecovered basis, the basis is reduced by the maximum depreciation allowable -

i.e., the service always reduces the remaining basis as if the taxpayer had used the car 100% for business (Reg.

§1.280F-2T(c)(1)).

Example from Pub. 917 (Rev „94)

On May 1, 1988, Bob bought and placed in service a

car that he used 100% in his business. The car cost

$28,600. Bob took a $2,560 section 179 deduction

for the car in 1988, which was the maximum amount

of depreciation and section 179 deduction that he

could deduct for the car that year. His remaining

basis for depreciation is $26,040 ($28,600 -

$2,560). Bob continued to use the car 100% in his

business.

The maximum depreciation allowable for Bob’s car in

1989 was $4,100. This is the lesser of the $4,100

maximum limit or $26,040 multiplied by the 32%

recovery percentage. In 1990, his depreciation

deduction for the car was $2,450 (the lesser of

$2,450 or 19.2% of $26,040). In 1991 and 1992,

Bob’s depreciation deduction for the car was $1,475

(the lesser of $1,475 or 11.52% of $26,040). In

1993, the last year of the recovery period, his

depreciation deduction is also $1,475 (the lesser of

$1,475 or 5.76% of $26,040).

5 - 15

At the beginning of 1994, Bob has an unrecovered

basis in the car of $15,065. This is the original basis

of his car ($28,600) less the depreciation deductions

allowed from 1988 through 1993 ($13,535). If he

continues to use the car 100% for business in 1994

and later years, Bob can deduct $1,475 in 1994 and

succeeding years until his deductions total the

$15,065 unrecovered basis.

If Bob’s business use of the car was less than 100%

during any year, his depreciation deduction would be

less than the maximum amount allowable for that

year. However, in determining his unrecovered basis

in the car, he would still reduce his original basis by

the maximum amount allowable. Bob’s unrecovered

basis at the beginning of 1994 would still be $15,065

in this example. This is true even if his actual

depreciation deduction for any year was less than the

maximum amount shown.

Partial Business Use

If a taxpayer uses a car less than 100% in their business or work, they must determine the depreciation deduction

limits by multiplying the limit amount by the percentage of business and investment use during the tax year (Reg.

§1.280F-2T(i)(1)).

Example from Pub. 463 (Rev „91)

On September 2, 1991, you buy a car and place it in

service. You use it 80% in your business during 1991.

Your total depreciation deduction, including the

section 179 deduction, for 1991 is limited to $2,128

(80% of $2,660). If the business use of the car

remained at 80%, your deduction in 1992 would be

limited to $3,440 (80% of $4,300). In 1993, your

depreciation deduction is limited to $2,040 (80% of

$2,550). After 1993, if your business use remained at

80%, your depreciation deduction would be limited to

$1,260 (80% of $1,575).

Improvements

A major improvement to a car is treated as a new item of recovery property placed in service in the year the

improvement is made. The limits on the depreciation deductions are determined by taking into account as a

5 - 16

whole both the improvement and the car of which the

improvement is a part. The total depreciation deduction for the year on the car and any improvements cannot be more

than the depreciation limit that applies for that year (Reg. §1.280F-2T(f)).

Expensing - §179

The §179 deduction allows an election to treat a portion or all of the

cost of a car as an expense rather than as a capital expenditure. As

an expense, the §179 amount is deductible in the year the car is purchased and placed in service.

For this purpose, ―placed in service‖ means the year when the car is first used for any purpose. Generally, the §179 deduction allowed

for the total cost of qualifying property is limited to $25,000 (in 2014) a year5. The limit is reduced if business use of the car is less

than 100% (§280F(a)(3)).

In addition, the §179 deduction is treated as depreciation for the

tax year a car is placed in service. Thus, if a taxpayer places a car in service in 2014 and elects §179 treatment, it will be deemed

depreciation and limited to $3,160 in the first tax year. For example, if a taxpayer bought and placed in service in 2014, a car

that they used 80% for business, the total §179 deduction and depreciation could not be more than $2,528 (80% x $3,160).

Cost of Car

The cost of the car for purposes of the §179 deduction does not

include any amount figured by reference to any other property held by the taxpayer at any time. For example, if the taxpayer

buys a new car to use in their business, their cost for purposes of the §179 deduction does not include the adjusted basis of the

car traded in on the new vehicle (§179(d)(3)).

Basis Reduction

The amount of the §179 deduction reduces the basis of the car. If the taxpayer elects the §179 deduction, they must reduce the

basis of their car before figuring the depreciation deduction

(§280F(d)(1); §1016(a)(2)).

5

I t i s a l s o s u b j e c t t o t h e b u s i n e s s - u s e p e r c e n t a g e .

5 - 17

Example from Pub. 463 (Rev „01)

On January 2, 2001, Stella bought a car for $12,000,

including sales tax, to use exclusively in her delivery

business. She paid $9,000 cash and receives $3,000

in trade for her old car (also used in her business).

The adjusted basis of her old car was $3,000.

Stella’s cost of the new car is $9,000 for purposes of

section 179. Her basis for depreciation would be

$12,000 if she does not choose section 179. The total

of her section 179 and depreciation deductions is

limited to $3,060 in 2001, the first year maximum. If

she does not choose section 179, her depreciation

deduction, using the MACRS method (discussed

later), would be $2,400 [$12,000 basis x 20%

(double declining balance rate)].

Making the §179 Election

When a taxpayer wants to take the §179 deduction, they must make the election in the tax year they purchase the car and

place it in service for business or work. Employees use Form 2106 to make this election and report the §179 deduction. All

others use Form 4562, Depreciation and Amortization.

Taxpayers must make the election with either:

(1) the original return filed for the tax year the property was placed in service (whether or not the return was filed on

time), or

(2) an amended return filed within the time prescribed by law

for the applicable tax year (§179(c)).

Business Use Reduction

To be eligible to claim the §179 deduction, the taxpayer must use their car more than 50% for business or work in the year

they acquired it. If the business use of the car is 50% or less in a later tax year during the recovery period, they have to include

in income in that later year any excess depreciation. Any §179 deduction claimed on the car is included in calculating the excess

depreciation (Reg §1.280F-3T(c); Reg §1.280F-3T(d)).

SUV Limitation

The American Jobs Creation Act of 2004 limits the ability of taxpayers to claim deductions under §179 for certain vehicles

not subject to §280F to $25,000. The provision applies to sport

5 - 18

utility vehicles rated at 14,000 pounds gross vehicle weight or

less (in place of the 6,000 pound rating).

For this purpose, a sport utility vehicle is defined to exclude any

vehicle that:

(1) is designed for more than nine individuals in seating

rearward of the driver's seat;

(2) is equipped with an open cargo area, or a covered box

not readily accessible from the passenger compartment, of at least six feet in interior length; or

(3) has an integral enclosure, fully enclosing the driver compartment and load carrying device, does not have seating

rearward of the driver's seat, and has no body section protruding more than 30 inches ahead of the leading edge of

the windshield.

Prior vs. Existing Law Example

Wayne purchases a used 2003 Lexus LX 470 for

$45,000. This SUV has a GVW of 6,860 and thus is

not subject to the luxury car limits. If he bought the

SUV prior to the law change (say September 2004)

and it is 100% business use, his 2004 §179 expense

deduction will be $45,000. If Wayne purchased the

SUV after the law change (say November 2004) his

'179 will be limited to $25,000. Wayne can then

depreciate the $20,000 balance using the MACRS

tables for a 5 year asset. If the mid-quarter

convention applies, he'll be able to deduct another

$1,000 in depreciation for a 2004 total of $26,000

versus the $45,000 under the old law.

Predominate Business (More Than 50%) Use Rule

The Tax Reform Act of 1984 created additional limitations on investment tax credits, depreciation and expensing if a car is not

―predominantly used in a qualified business use‖ (§280F(b); Reg.§1.280F-3T).

For the year a car (or other listed property) is placed in service, the percentage of business use is critical. It determines whether §179

expensing and accelerated depreciation are available. Moreover, if these are not available for the property‘s first taxable year (because

of 50%-or-less qualified business use in that year) they will not be

5 - 19

available in a later taxable year even if the qualified business-use

percentage is raised to 100% for each of those later years.

To qualify for MACRS and §179, a taxpayer‘s car (or other vehicle)

must be used predominantly in a qualified business use. Property ―used predominantly in a qualified business use‖ is property whose

business use exceeds 50% (§280F(b)(4)(A); Reg.§1.280F-6T(d)(4)(i)). Thus, this test is only met if the taxpayer uses his car

more than 50% in a qualified business use for each tax year.

Note: The more-than-50%-use test must be met each year of

the recovery period. Thus, the test applies to the car for 6 years

under MACRS (Reg. §1.280F-3T(d)(3)).

Example

Dan bought a car for $15,000 and used it 40% for his

consulting business. Because he did not use the car

more than 50% for business, Dan cannot elect any

§179 deduction, and he must use the straight-line

method over a 5-year period to recover the cost of

his car.

Qualified Business Use

A qualified business use is any use6 in trade or business

(§280F(d)(6)(b); Reg.§1.280F-6T(d)(2)(i)). A qualified business

use does not include use of property held merely for the production of income (i.e., investment use). Thus, if an asset is

used 49% in a trade or business and 51% for the production of income not in a trade or business, the asset is not predominantly

used in a qualified business use (Reg §1.280F-6T(d)(5)).

However, after the taxpayer has satisfied the percentage of

business requirement, he may combine business and investment use to compute any allowable credit or deduction for a tax year

(Reg. §1.280F-6T(d)(3)(i)).

Note: The percentage of qualified business use is figured by

dividing the number of miles the car is driven for business

purposes during the year by the total number of miles the car is

driven during the year for any purpose (Reg §1.280F-6T(e)(2)).

Any use of the taxpayer‘s car by another person (who is not a 5% owner) is treated as use in a trade or business if that use:

6

T h e u s e o f a c a r f o r b u s i n e s s e n t e r t a i n me n t p u r p o s e s i s

t r e a t e d a s b u s i n e s s u s e ( Re g . § 1. 2 8 0 F - 6 T ( d ) ( 3 ) ( i i ) ) .

5 - 2 0

(1) Is directly connected with the taxpayer‘s business,

(2) Is properly reported by the taxpayer as income to the other person and, if required, the taxpayer withheld tax on

the income, or

(3) Results in a payment of fair market rent (Reg §1.280F-

6T(d)(3)(iv)).

Note: Any payment to the taxpayer for the use of their car

is treated as a payment of rent for purposes of (3) earlier.

However, this rule does not apply to 5% owners. Rent

payments (for personal use) made by 5% owners do not

make such use qualified business use.

Example from Reg. §1.280F-6T

N Corp owns several automobiles which its employees

use for business purposes. The employees are also

permitted to take the automobiles home at night.

However, the fair market value of the use of the

automobiles for any personal purpose, for example,

commuting to work, is reported by N Corp as income

to the employees and employment taxes withheld

thereon. The use of the automobiles by the

employees, even the use for personal purposes for

which a fair rental value is reported (and tax

withheld) as income by the employees, is qualified

business use to N Corp.

Exclusions

Qualified business use does not include:

(a) Leasing property7 to any 5% owner of the taxpayer or

to any person related to the taxpayer,

(b) The use of listed property as compensation for services

by a 5% owner or a related person, or

Example from Reg. §1.280F-6T

F is the proprietor of a plumbing contracting business.

F’s brother is employed with F’s company. As part of

his compensation, F’s brother is allowed to use one of

7

L e a s i n g a i r c r a f t t o s u c h p e r s o n s , h o we v e r , i s q u a l i f i e d

b u s i n e s s u s e i f b u s i n e s s u s e , wi t h o u t c o u n t i n g t h e l e a s e

u s e , i s a t l e a s t 2 5 % o f t h e a i r c r a f t ’ s t o t a l u s e .

5 - 2 1

the company automobiles for personal use. The use

of the company automobiles by F’s brother is not a

qualified business use because F and F’s brother are

related parties within the meaning of section 267(b).

(c) The use of listed property as compensation for services

by any person other than a 5% owner or a related person, unless the provider of the property includes the value of

the compensation in the recipient‘s gross income, properly reports it and, where necessary, treats it as wages subject

to withholding (§280F(d)(6)(C)).

Note: Qualified business use does not include use of the

taxpayer‘s business auto for personal purposes by a 5%

owner of the taxpayer (or any person related to the

taxpayer) even if that personal use is treated as

compensation for services by the 5% owner or a related

person.

Example from Reg. §1.280F-6T

X Corporation owns several automobiles which its

employees use for business purposes. The employees

are also allowed to take the automobiles home at

night. However, the fair market value of the use of

the automobile for any personal purpose, e.g.,

commuting to work, is reported by X as income to the

employee and is withheld upon by X. The use of the

automobile by the employee, even for personal

purposes, is a qualified business use with respect to

X.

Change From Personal to Business Use

If a taxpayer changes the use of a car from 100% personal use to business use during the tax year and has no records

for the time before the change to business use, figure the percent of business use for the year as follows:

(a) Determine the percentage of business use for the period following the change by dividing business miles by

total miles driven during that period, and

(b) Multiply that percentage by a fraction, the numerator

(top number) of which is the number of months the car is used for business and the denominator (bottom number) of

which is 12.

5 - 2 2

Example from Pub. 463 (Rev „12)

You use a car only for personal purposes during the

first 6 months of the year. During the last 6 months

of the year, you drive the car a total of 15,000 miles

of which 12,000 miles are for business. This gives you

a business-use percentage of 80% (12,000/15,000)

for that period. Your business use for the year is 40%

(80% x 6/12).

Employee Use of Their Own Car

An employee‘s use of their own car is treated as business use

only if the use is for the convenience of the employer and required as a condition of employment (Reg. §1.280F-6T(a)).

In such a case, the use of the car must be required for the employee to perform their assigned duties properly.

Whether this use is required depends on all the facts and

circumstances. The employer does not have to explicitly require that the employee use their car. However, a mere

statement by the employer that the use of the car is required as a condition of employment is not sufficient (Reg §1.280F-

6T(a)(2)(ii)).

Failure to Meet Predominate Business Use Rule

If a car is not used more than 50% in a qualified business use in the year it is placed in service:

(a) The depreciation8 deduction must be figured using the straight-line percentages over a 5-year recovery period (10%

for the 1st and 6th years and 20% for the 2nd through 5th years);

(b) No §179 expensing deduction is allowed; and

(c) The investment credit is denied (but ITC was repealed

effective 1986 anyway).

Thus, taxpayers must use a car more than 50% for business to

qualify for the §179 and MACRS deduction.

8

Qu a l i f i e d b u s i n e s s u s e i s c r i t i c a l i n t h e f i r s t y e a r t h e

c a r i s p l a c e d i n s e r v i c e . I f MACRS i s u n a v a i l a b l e i n t h e

f i r s t t a x y e a r ( d u e t o f a i l i n g t h e p r e d o mi n a n t u s e t e s t ) , i t

wi l l n o t b e a v a i l a b l e i n a n y s u b s e q u e n t y e a r , e v e n i f t h e

q u a l i f i e d u s a g e r i s e s t o 10 0 %.

5 - 2 3

Later Reduction in Qualified Use

If a taxpayer uses his car more than 50% in a qualified business

use in the year it is placed in service but reduces his qualified business use in a subsequent tax year9, three things can

happen:

(a) ITC recaptures,

(b) Forced straight-line depreciation, and

(c) Excess depreciation recapture.

ITC Recapture - Highly Unlikely

Any reduction of business use will trigger investment tax

credit (if originally claimed) recapture under Reg. §1.47-1(c) and §1.47-2(e). However, this is highly unlikely since the last

time taxpayers could take the investment tax credit was 1985.

In any event, if a taxpayer‘s business use for a later year is less than the percentage for the year the car was placed in

service, he is treated as having disposed of part of the car.

For example, if his business-use percentage is 80% in the year the car was placed in service and in a later year it falls to

60%, the taxpayer is treated as selling one-fourth of the car. Moreover, if the qualified business use falls to 50% or less in

any year, the entire car is deemed sold10.

Straight-line Depreciation

If in a subsequent tax year, the taxpayer fails to use his car more than 50% in a qualified business use, then his

depreciation for that year (and all later years) must be determined using the straight-line percentages over a 5-year

period (Reg. §1.280F-3T(c)(2)). For example, if a taxpayer met the more-than-50%-use test for the first 3 years of the

recovery period but failed to meet it in the fourth year, they determine depreciation for that year using 20% (1/5 (years in

recovery period)).

9

As a r e s u l t o f t h e s e r u l e s , t a x p a y e r s s h o u l d s u p p o r t

q u a l i f i e d b u s i n e s s u s e i n e x c e s s o f 5 0 % a s l o n g a s p o s s i b l e . 10

Pu b l i c a t i o n 9 17 ( Re v . ’ 8 7 ) a t p a g e 5 .

5 - 2 4

Excess Depreciation Recapture

In addition to being forced to use the straight-line method,

any ―excess depreciation‖ must be recaptured, i.e., included in gross income and added to the car‘s adjusted tax basis for

the first year in which the car is used 50% or less in a qualified business use (§280F(b)(3)).

Excess depreciation is the excess, if any, of:

(1) The amount of the depreciation deductions allowed

(including any §179 deduction) for the car for tax years in which the car was used more than 50% in a qualified

business use, over

(2) The amount of the depreciation deductions that would have been allowable for those years if the car had not been

used more than 50% in a qualified business use for the year it was placed in service.

Short Tax Year Depreciation Reduction

The limit for depreciation in a short tax year (tax year of less

than 12 months) is determined by multiplying the limit that would otherwise apply to the tax year by a fraction. The

numerator (top number) of the fraction is the number of months or partial months in the short tax year and the denominator

(bottom number) of the fraction is 12. For example, if a taxpayer uses their car 60% for business in a short tax year consisting of

6 months, the maximum amount they may claim as depreciation is 30% (60% x 6/12) of the applicable limit (Reg. §1.280F-

2T(i)(2)).

Auto Leasing

Leasing laws and customs vary from state to state and leasing

company to leasing company. Before leasing, taxpayers should understand how leases work.

Auto leasing is a method of financing the use of a car over time. However, leasing is not identical to renting. In auto leasing you pay

for the portion of an auto‘s original value that is used up. The amount used up is the depreciation in value while the car is driven.

Regardless of how financed, all vehicles depreciate with time and use. However, different makes depreciate at different rates.

Reliability, reputation, and popularity determine how a car depreciates.

5 - 2 5

Note: Leasing severely restricts vehicle use. Mileage allowances

are limited, modifications to the vehicle can result in hefty fines,

and if the vehicle is not in top condition when it is returned,

excessive wear-and-tear charges may be levied.

When leasing an auto, depreciation is the primary factor that

determines the monthly payment. The lease payment is essentially made up of two parts:

(1) A depreciation payment, and

(2) A finance payment.

Thus, the payment to the leasing firm is for depreciation of their asset (i.e., the auto) and, like a loan, interest on their money. For

example, an auto worth $30,000 may be worth $20,000 (residual

value) after two years. The lease payments are for the difference ($10,000), plus finance charges.

By contrast, there are three parts to a payment when purchasing an auto:

(1) A hidden depreciation payment,

Note: Depreciation is a cost whether you buy or lease an auto.

In either case, its money you never get back.

(2) An interest payment (i.e., a finance payment like on a

lease), and

(3) An equity payment.

Note: Equity is the auto‘s resale value when the loan is paid off.

It‘s the equivalent of residual value in a lease.

Monthly lease and purchase payments both include interest (or finance) charges and depreciation costs (hidden or actual). With

buying, you additionally pay to own the auto‘s value at the end of the loan.

Pros & Cons

If a taxpayer is qualified to lease or finance the purchase of an

auto, consider the following advantages and disadvantages of leasing:

Leasing can offer advantages when the taxpayer:

(1) Likes having a new car every two or three years,

(2) Wants a more expensive car with lower monthly payments,

(3) Likes the option of not making a down payment,

(4) Likes a car that‘s always in warranty, or

(5) Dislikes selling or trading used cars.

5 - 2 6

Leasing can present disadvantages when the taxpayer:

(1) Typically drives a car for years,

(2) Drives on average more than 15,000 miles,

(3) Subjects vehicles to rough treatment and poor maintenance,

(4) Usually sells or trades their cars, or

(5) Buys cars that quickly lose their resale value.

Leasing Terminology

To understand personal auto leasing, you have to understand

leasing terminology. Here are some of the most commonly used terms:

Capitalized Cost (Cap Cost): The price the dealer agrees to lease a vehicle plus any other items and services provided

under the lease. This may also include certain taxes, official fees and other charges. Ideally it should be discounted from

the MSRP, although this may require some negotiation by the leasing customer just like when buying. In short, the

negotiated price minus any down payment (i.e., capitalized cost reduction).

Note: Many leases require payment of various up-front fees

such as, title, lease acquisition, license, security, documentation

fees, as well as the first month‘s payment. Since the up-front

fees can be substantial, they are often included in the

capitalized cost to be paid in the monthly payment.

Negotiate a lease price just as you would if you were buying. Cars have about 10%-18% profit margin in the MSRP (check

Edmunds New Car Guides for exact figures on the Internet at http://www.edmunds.com/ ). In addition the dealer may be

getting a rebate (which averages about 2%) from the manufacturer to further boost his profit.

Capitalized Cost Reduction (Cap Cost Reduction): The total of the cash down, dealer or manufacturer rebates, or

any net allowance received from a trade-in that is used to reduce the capitalized cost.

Note: A down payment is often optional, but making even a

small down payment can often substantially lower the monthly

payment.

Dealer Cost (Invoice Price): A vehicle‘s cost to the dealer,

as invoiced by the manufacturer. A dealer‘s cost may be

5 - 2 7

further reduced by manufacturers‘ incentive payments and

rebates.

Depreciation Cost: This is the capitalized cost minus the

residual cost.

Down Payment: The amount applied to the negotiated price.

It can be either actual cash or the trade-in value of another vehicle.

Excess Mileage: The mileage over the mile-per-year allowance permitted under the lease. When the vehicle is

driven in excess of the yearly allowance an additional charge per excess mile is levied. An excessive mileage charge is

typically $.08 - $.19 per mile. This fee could be very substantial for even a few thousand miles over your limit.

When the taxpayer purchases the vehicle at lease-end, no excess mileage charges are incurred.

Finance Charge: The finance charge is determined by adding

the capitalized cost and residual cost and multiplying that sum by the lease factor. This is equivalent to an interest

payment on a loan.

Lease Factor (a.k.a. Money Factor): A number used to

calculate financing costs in a lease. It‘s like monthly interest in a loan, but specified differently. Roughly, the lease factor is

the yearly interest rate divided by 24. Thus, a lease factor of 0.003 would accrue interest at a rate of about 0.072 or 7.2%.

The lease factor is typically not disclosed in a lease agreement.

Note: To convert to annual percent rate, multiply the lease

factor by 2400 (its always 2400 regardless of the term of the

lease).

Lease Depreciation: Lease depreciation is equal to the

difference between the net capitalized cost and the lease-end residual value. This amount (plus the capitalized cost

reduction) is the expected decrease in the vehicle‘s value during the lease.

Lease Term: The number of scheduled months of the lease. Lease terms are typically 24, 36, or 48 months. Other term

lengths are often available on request.

Note: Shorter lease terms - 24 or 36 months - are preferable.

Some people match the term to the warranty period so that the

car is always covered.

Lessee: The taxpayer who leases the vehicle.

5 - 2 8

Lessor: The dealer that leases the vehicle.

Manufacturers Suggested Retail Price (MSRP): The MSRP is set by car manufacturers and must be posted on a

window sticker.

Note: The price of the vehicle may include distributor and

dealer add-ons, as well as destination delivery charges.

Monthly Payment: This is the sum of the depreciation cost

(the difference in a car‘s value when it‘s new and at the end of the lease) and the finance charge divided by the number of

months in the lease term.

Note: The monthly lease payment can sometimes include sales

taxes. Some states levy sales tax on the entire price of the car;

others simply base the tax on your monthly payment.

Negotiated Price: The price that has been negotiated from

the dealer before the down payment is determined or made.

Net Capitalized Cost: The net capitalized cost is equal to the

capitalized cost minus any capitalized cost reductions.

Purchase Option: An option giving the Lessee the

opportunity to buy the lease vehicle at lease-end for a

predetermined price.

Residual Cost (a.k.a. Lease-End Buyout): This is the

residual factor multiplied by the MSRP. It reflects the projected value of the vehicle at the end of the lease.

Residual Value: The estimated value of the leased vehicle at the end of the lease. It is set at the start of the lease.

Note: This concept is also sometimes called lease-end residual

value, lease-end value, or guaranteed future value.

Ideally, the taxpayer should select a make and model that holds its value well. The best cars to lease are those that

depreciate the least.

Note: Japanese and European cars have traditionally been

better lease candidates than American models, but that is now

improving for many domestic makes.

Residual Factor (Residual Percentage): A percentage

used to calculate residual value of an auto by multiplying it times MSRP.

Residual Percentage: This percentage indicates the

percentage of the MSRP that this vehicle will be valued at the lease-end.

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Security Deposit: A cash deposit made at the beginning of

the lease to be held until lease-end as a security for performance of all lease obligations.

Subsidized Leases: Subsidized leases allow dealers to lower payments by raising residual values, which are guaranteed by

the automaker sponsoring the lease. Any nationally advertised lease is generally subsidized by the manufacturer

to keep lease payments low.

Note: When leasing, try to choose a model with a subsidized

lease. Payments are low and terms are simple to understand.

Closed-End vs. Open-End Lease

Closed-end and open-end refers to the party who bears the risk

of the vehicle‘s worth at the end of the lease. In a closed-end lease, the lessor bears the lease-end market valuation risk.

Thus, the market risk is ―closed‖ to the lessee. At the end of a closed-end lease, sometimes called a walk-away lease, you

simply return the car to the dealer and walk away.

Note: A lease may permit you to purchase the car at lease-end

instead of turning it in. The price is usually the residual value. If

this price is substantially lower than the car‘s market price at

the end of the lease, you could:

(1) Buy it and sell it for a profit,

(2) Keep it and continue driving it, or

(3) Use the higher value as equity in a trade deal on a new

lease.

In an open-end lease, the lessee shares in the responsibility for the vehicle‘s worth at lease-end. If the car is worth more than

anticipated at the end of the lease, the lessee shares in the profit. If the car is worth less, the lessee must pay the

difference.

Note: Most leases will require that you have insurance, pay

taxes, buy licenses, and maintain the condition of the car during

the lease term.

Formula for Monthly Payments

Rather than negotiate the lease price, dealers prefer to focus on monthly payments. As a result, before searching for a car to

lease, you should be able to calculate monthly lease payments and know if you are getting a fair deal.

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Payments are based on capitalized cost, which is the car‘s selling

price. Residual value is the predicted value of the vehicle at the lease-end and is often stated as a percentage of the MSRP. A

money factor, which is like interest, is also involved in the lease payment calculation. When the money factor is expressed as a

percentage, convert the percentage to the money factor by dividing the number by 24.

Calculating an actual lease payment is nearly impossible, but you can arrive at an approximate figure by using the following

formula:

Monthly Payment = Depreciation Fee + Lease Fee

Depreciation Fee = (Cap Cost -- Cap Cost Reduction -- Residual)

/ Lease Term

Lease Fee = (Cap Cost -- Cap Cost Reduction + Residual) x

Money Factor11

Residual = MSRP x Residual Factor12

Leasing Deduction Restrictions

If a taxpayer leases a car, they can deduct the part of each lease

payment that is for the use of the car in business or work. However, any part of a lease payment that is for commuting to

the taxpayer‘s regular job or other personal use of the car is not deductible. Any advance payments must be spread over the

entire lease period. Payments made to buy a car are not deductible even if called lease payments (§262; R.R. 90-23; R.R.

60-122).

Note: A lease with an option to buy the property may be a lease

or a purchase contract, depending on the intent of the parties.

Important considerations in determining intent include whether

any equity is obtained, whether any interest is paid, and

11

I f y o u c a n n o t o b t a i n t h e a c t u a l mo n e y f a c t o r u s e d , y o u c a n

e s t i ma t e i t a s t h e c u r r e n t n e w- c a r l o a n r a t e i n y o u r a r e a

( c a l l y o u r b a n k f o r t h i s i n f o r ma t i o n ) d i v i d e d b y 2 4 0 0 . F o r

e x a mp l e , a 7 % i n t e r e s t r a t e c o n v e r t s t o a . 0 0 2 9 mo n e y

f a c t o r . 12

I f y o u c a n n o t o b t a i n t h e a c t u a l r e s i d u a l f a c t o r u s e d b y

t h e l e a s i n g c o mp a n y , y o u c a n e s t i ma t e i t a s f o l l o ws : . 6 5 f o r

a 2 y e a r l e a s e , . 5 7 f o r 3 y e a r s , . 4 9 f o r 4 y e a r s , a n d . 4 1 f o r 5

y e a r s .

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whether the fair market value is less than the ―lease‖ payment

or the option price when the option to purchase can be

exercised (§162(a)(3); R.R. 55-540).

Income Inclusion Amount

The depreciation and expensing ―caps‖ rules discussed above

cannot be escaped by leasing a car (§280F(c)). In an attempt to equate car owners and lessees, regulations under §280F

require the lessee to include in gross income an ―inclusion amount‖ determined as a percentage of the car‘s fair market

value (on the first day of the lease term) in excess of stated dollar amounts (Reg.§1.280F-5T(d)). This inclusion amount is

designed to approximate the limitations imposed on the owner of a car.

Separate Lease Inclusion Table for Trucks & Vans

Previously, lessees of trucks and vans used the same lease

inclusion table as applied passenger vehicles. However, since 2003, the IRS issues separate tables for lease trucks

and vans (R.P. 2003-76). These tables are not reproduced below but must be separately consulted.

Cars Leased For 30 Days or More After 1986

If a taxpayer leases a car after December 31, 1986, for a

lease term of 30 days or more, they may have to include in their gross income an inclusion amount (Reg. §1.280F-7). In

determining the term of a lease for purposes of the 30-day

rule, options to renew are taken into account. In addition, two or more successive leases that are part of the same

transaction (or a series of related transactions) with respect to the same or substantially similar property is treated as one

lease (§280F(c)(4)).

Note: For leases of listed property for a period of less than 30

days, this rule does not apply (§280F(c)(2)).

This rule applies to each tax year that the taxpayer leases the

car if the fair market value of the car when the lease began was more than $12,800 (this amount is annually adjusted for

inflation).

Fair market value is the price at which the property would

change hands between a buyer and a seller, neither being required to buy or sell, and both having reasonable

knowledge of all the necessary facts. Sales of similar property

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on or about the same date may be helpful in figuring the fair

market value of the property.

The fair market value is the value on the first day of the lease

term. If the capitalized cost of a car is specified in the lease agreement, that amount is treated as the fair market value.

Computation of Inclusion

This inclusion amount is a percentage of part of the fair

market value of the leased car multiplied by the percentage of business and investment use of the car for the tax year. The

inclusion amount is prorated for the number of days of the lease term included in the tax year. The intended effect of

adding this amount to income is to limit the deduction for lease payments so that it equals the depreciation deduction

the taxpayer would have on the car if they owned it.

Thus, for each tax year during which a car is leased, the

inclusion amount is determined as follows:

(1) Determine the dollar amount from tables in Publication

463,

(2) Prorate the dollar amount from the table for the

number of days of the lease term included in the tax year, and

(3) Multiply the prorated amount by the percentage of

business and investment use for the tax year.

Example

On January 17, you leased a car for 3 years and

placed it in service for use in your business. The car

had a fair market value of $29,250 on the first day of

the lease term. You use the car 75% for your

business and 25% for personal purposes during each

year of the lease. As a result, you would include $47

(66 x (349/365) x 75%) in gross income and deduct

all of your lease payments.

To determine the dollar amount from the tables in Publication 463 (see also http://www.smbiz.com/sbrl003.html and R.P.

20143-21), use the fair market value of the car on the first day of the lease term to find the appropriate line of the table.

Use the tax year in which the car is used under the lease to find the appropriate column of the table. However, for the last

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tax year of the lease, use the dollar amount for the preceding

year (Reg. §1.280F-7T(a)(2)(i); Reg. §1.280F-5T(h)(2)).

Dollar Amounts for Autos With a Lease Term Beginning in 2014 (R.P. 2014-21)

Fair Market Value Tax Year During Lease

Over Not Over

1st 2nd 3rd 4th 5th+

18,500 $19,000 3 5 8 10 11

19,000 19,500 3 6 10 11 13

19,500 20,000 3 8 11 13 14

20,000 20,500 4 8 13 14 17

20,500 21,000 4 9 14 17 18

21,000 21,500 5 10 15 18 21

21,500 22,000 5 11 17 20 22

22,000 23,000 6 13 18 23 25

23,000 24,000 7 14 22 26 29

24,000 25,000 8 16 25 29 33

25,000 26,000 8 19 27 32 38

26,000 27,000 9 20 31 35 42

27,000 28,000 10 22 33 40 45

28,000 29,000 11 24 36 43 49

29,000 30,000 12 26 39 46 53

30,000 31,000 13 28 41 50 57

31,000 32,000 14 30 44 53 61

32,000 33,000 14 32 47 56 65

33,000 34,000 15 34 50 59 69

34,000 35,000 16 36 52 64 72

35,000 36,000 17 38 55 67 76

36,000 37,000 18 39 59 70 80

37,000 38,000 19 41 61 74 84

38,000 39,000 20 43 64 77 88

39,000 40,000 21 45 67 80 92

40,000 41,000 21 47 70 84 96

41,000 42,000 22 49 73 87 100

42,000 43,000 23 51 75 91 104

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43,000 44,000 24 53 78 94 108

44,000 45,000 25 55 81 97 112

45,000 46,000 26 56 84 101 116

46,000 47,000 27 58 87 104 120

47,000 48,000 28 60 90 107 124

48,000 49,000 28 62 93 111 127

49,000 50,000 29 64 96 114 131

50,000 51,000 30 66 98 118 135

51,000 52,000 31 68 101 121 139

52,000 53,000 32 70 104 124 143

53,000 54,000 33 72 106 128 147

54,000 55,000 34 74 109 131 151

55,000 56,000 34 76 112 135 155

56,000 57,000 35 78 115 138 159

57,000 58,000 36 80 118 141 163

58,000 59,000 37 81 121 145 167

59,000 60,000 38 83 124 148 171

60,000 62,000 39 86 128 153 177

62,000 64,000 41 90 134 159 185

64,000 66,000 43 94 139 167 192

66,000 68,000 44 98 145 173 201

68,000 70,000 46 102 150 180 209

70,000 72,000 48 105 156 188 216

72,000 74,000 50 109 162 194 224

74,000 76,000 51 113 168 200 232

76,000 78,000 53 117 173 208 239

78,000 80,000 55 120 179 215 247

80,000 85,000 58 127 189 226 261

85,000 90,000 62 137 203 243 281

90,000 95,000 67 146 217 260 301

95,000 100,000 71 156 231 277 320

100,000 110,000 77 170 253 303 349

110,000 120,000 86 189 281 337 389

120,000 130,000 95 208 310 370 428

130,000 140,000 103 228 337 405 467

140,000 150,000 112 247 366 438 507

150,000 160,000 121 266 394 473 545

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160,000 170,000 130 284 423 507 585

170,000 180,000 138 304 451 541 624

180,000 190,000 147 323 479 575 663

190,000 200,000 156 342 507 609 703

200,000 210,000 164 361 536 643 742

210,000 220,000 173 380 565 676 781

220,000 230,000 182 399 593 710 821

230,000 240,000 190 418 622 744 860

240,000 and over 199 437 650 778 899

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Example

On January 17, 2014, Dan leased a car for 3 years and placed it in

service for use in his business. The car‘s FMV was $78,250 on the first day of the lease term. Dan uses the car 75% for his business

and 25% for personal purposes during each year of the lease. For tax years 2014 through 2017, Dan must include the following

amounts in gross income:

Tax Year Dollar Amount ProrationBusiness Use (%) Inclusion

2014 $55 349/365 75% $39 2015 $120 365/365 75% $90

2016 $179 365/365 75% $134 2017 $215 16/365 75% $7

Nine-Month Following Year Rule

If a taxpayer‘s business driving is less than 50% and the lease begins within the last nine months of the taxable year

and continues into the following year, then the total inclusion amount is added to the following year‘s income

(Reg. §1.280F-5T(g)(1)). To compute the inclusion amount, the average business and investment use for both

years is multiplied by the appropriate dollar amount.

Buying v. Leasing

With increased useful lives and the reduced depreciation caps, it can now take many years to recover an investment in mid-

priced or luxury autos through depreciation deductions. However, for leased autos, the rental expense is fully

deductible with a relatively small offsetting income inclusion amount that increases each year of the lease.

Note: Determining which way to go depends on a full

comparison of the relative costs and potential tax savings,

without overlooking any forgone revenue or expense reduction.

In addition, autos leased after 1986 have no additional

inclusion if the business use of the auto is 50% or less in the

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year the auto is placed in service or in any later year (Reg.

§1.280F-7(a)(3)).

Example from Reg. §1.280F-7(a)(3)

On April 1, 1987, A, a calendar year taxpayer, leases and places in service a passenger automobile with a fair market value of

$31,500. The lease is to be for a period of three years. During taxable years 1987 and 1988, A uses the automobile exclusively in

a trade or business. During 1989 and 1990, A‘s business/investment use is 45 percent. The appropriate dollar

amounts from the table in paragraph (a)(2)(iv) of this section are $260 for 1987 (first taxable year during the lease), $568 for 1988

(second taxable year during the lease), $842 for 1989 (third taxable year during the lease), and $842 for 1990. Since 1990 is

the last taxable year during the lease, the dollar amount for the preceding year (the third year) is used, rather than the dollar

amount for the fourth year. For taxable years 1987 through 1990, A‘s inclusion amounts are determined as follows:

Tax Year Dollar Amount ProrationBusiness Use (%) Inclusion

1987 $260 275/365 100 196 1988 $568 366/366 100 568

1989 $842 365/365 45 379 1990 $842 90/365 45 93

Standard Mileage Method

The standard mileage method allows a ―flat‖ or standard amount of deduction for every business mile traveled regardless of actual cost,

and therefore only requires substantiation of the distance traveled in the pursuit of trade or business. No other allocation is necessary

and the taxpayer need not establish the amount of their actual automobile expenses.

Note: An individual businessman or employee must still

maintain adequate records to establish the actual miles his car

was driven for business.

Before 1990, the standard mileage rate was a combination of two

separate rates:

(1) A maximum standard mileage rate, which included an

amount for depreciation and certain other expenses, and

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(2) A lower standard mileage rate, which did not include

depreciation and was used when the maximum mileage rate was not allowed.

Under the old system, the maximum mileage rate was used for the first 60,000 business miles. A taxpayer was limited to a yearly

deduction of 15,000 miles at the maximum rate. After depreciation at the maximum rate for 60,000 business miles the car was treated

as fully depreciated and all further deductions were limited to the lower standard rate. For years after 1989, there is a single standard

mileage rate for all business miles.

For 2014, a standard mileage rate of 56 cents a mile for all

business miles may be used by an individual in claiming a car expense deduction for a passenger car (including motor vehicles

such as van, pickup or panel trucks) instead of actual expenses and depreciation.

Costs incurred for gasoline (and taxes thereon), oil maintenance

and repairs, license fees, insurance, and a reasonable allowance for depreciation are included in this fixed rate and may not be

separately deducted. However, parking fees and tolls are specifically not included in this amount and may be separately

deducted (R.P. 2010-51). Likewise, interest relating to the purchase of the automobile as well as state and local taxes (other than those

included in the cost of gasoline) may be deducted.

When the standard mileage rate is used depreciation is considered

taken at the rate of:

Deemed Depreciation

Year Rate Per Mile

1992-3 11.5¢

1994-1999 12¢

2000 14¢

2001-2002 15¢

2003-2004 16¢

2005-2006 17¢

2007 19¢

2008-2009 21¢

2010 23¢

2011 22¢

2012-14 23¢

Note: For tax years before 1990, the rates applied to the first

15,000 miles. For tax years after 1989, the depreciation rate

applies to all business miles.

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This depreciation reduces the basis of the car to determine the

adjusted basis. In addition, if the taxpayer changes to the actual cost method in a later year, but before the car is considered fully

depreciated, straight-line depreciation must be used over the then remaining useful life of the car (R.P. 2010-51).

Limitations on Standard Mileage Method

Despite its apparent simplicity, there are several limitations

inherent in the use of the standard mileage deduction:

Use, Ownership & Prior Depreciation

The standard mileage rate can only be used by taxpayers who do not:

(1) Hire out the vehicle (such as for a taxi), or

(2) Operate a fleet of cars where five or more cars are used

at the same time (R.P. 2010-51, Sec. 4.05(1); Notice 2010-

88).

Note: A taxpayer who owns two cars, using one as an

alternative or replacement for the other, may still utilize the

standard mileage rate. When an individual uses more than one

car on an alternating basis, he may use the standard mileage

rate when both cars otherwise qualify. The rate is applied to the

total business miles that both cars are driven.

Formerly, a taxpayer had to own the vehicle and could not lease

or rent it. However, final regulations under §274(d) issued in October of 1998 now provide that, effective January 1, 1998,

taxpayers can figure their deduction for business use of a rented automobile by multiplying the number of business miles driven

during the year by a mileage allowance figure (T.D. 8784; REG-122488-97).

In addition, taxpayers cannot use the standard mileage rate if they claimed a deduction for the car in an earlier year using:

(1) ACRS or MACRS depreciation,

(2) A §179 deduction, or

(3) Any method of depreciation other than straight-line for the estimated useful life of the car (R.P. 2010-51).

Switching Methods

Before 1981, either the standard mileage method or the actual expense method could have been elected on a year-to-year basis

for vehicles placed in service. In general, an election to use the

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standard mileage rate after 1980 must be made in the first year the

vehicle is placed in service for business purposes and constitutes an election to exclude the vehicle from depreciation under the modified

accelerated cost recovery system (MACRS)13.

In later years, a taxpayer can continue to use the standard mileage

rate or switch to the actual expense method. If a taxpayer changes to the actual cost method in a later year, but before the car is

considered fully depreciated, the car must be depreciated on the straight-line basis.

Note: When a taxpayer chooses to use the standard mileage

rate, they are considered to have chosen not to use the

depreciation methods under the modified accelerated cost

recovery system (MACRS). This is because the standard mileage

rate includes an allowance for depreciation. The taxpayer also

cannot claim the section 179 deduction.

If a taxpayer did not choose the standard mileage rate in the first year and has used ACRS or MACRS, they may not use standard

mileage rate for that car in any subsequent year. However, if a taxpayer did not choose the standard mileage rate in the first year

but has always used straight-line, they may use the standard mileage rate for that car in any subsequent year (R.P. 2010-51,

Sec. 5.06(3)).

Note: Taxpayers can claim a §179 deduction and a depreciation

method other than straight-line for their car only if they do not

use the standard mileage rate to figure their business-related

car expenses. If they take a depreciation deduction other than

straight-line or a §179 deduction on their car, they cannot take

the standard mileage rate on that car in any future year (R.P.

2010-51).

Charitable Transportation

Taxpayers may deduct 14 cents (in 2014) for each mile they use

their vehicles in work they contribute to a charitable organization, instead of itemizing the expenses (Reg. §1.170A-1(g); R.P. 2010-

51; Notice 2012-72). However, no deduction is allowed for

charitable travel expenses unless there is no significant element of personal pleasure, recreation or vacation in the travel (§170(k)).

Note: In determining whether charitable travel involves a

significant element of personal pleasure, the fact that the

taxpayer enjoys providing services to the charity will not lead to

denial of the deduction.

13

I n a d d i t i o n , t h e t a x p a y e r ma y n o t c l a i m a § 17 9 d e d u c t i o n .

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The disallowance applies to payments made directly by the

taxpayer of his or her own expenses or those of an associated person, to indirect payments such as reimbursement arrangements

with the charity, and to reciprocal arrangements between two unrelated taxpayers.

Note: In lieu of the modest amount one can deduct for miles

driven on behalf of charity, note that expenses incurred for

operation, repair and maintenance of an automobile directly

attributable to its use in rendering gratuitous service to

charitable organizations are deductible.

Medical Transportation

Transportation expenses primarily for medical services are

deductible (§213). Taxpayers can list their auto expenses, or deduct 23.5 cents (in 2014) for each mile. However, the TRA ‗86

requires that medical expenses must exceed 10% of AGI to be deductible (R.P. 2010-51; Notice 2012-72).

Auto Trade-In vs. Sale

Generally, it is better to trade in a car for another rather than sell it when the car was used exclusively for business and its value

exceeds its depreciated basis. The trade-in avoids a current tax that would be generated on a sale. And, while the basis in the new car

will be lower than a cash purchase, there is often no depreciation penalty since the taxpayer‘s new car depreciation during the first

six years may be the same whether he sold the old car or traded it in because of the §280F dollar caps.

Example

Dan’s business car has a basis of zero and is worth

$4,500. He wants to dispose of the car and acquire

another $20,000 car. If Dan sells the car, he will pay

tax on a $4,500 gain and the basis in the new car will

be $20,000. On the other hand, if Dan trades in the

car for the new $20,000 model, he will avoid a tax on

his $4,500 realized gain. Basis of the new car will be

just $15,500 (cost less trade in value). However,

because of the §280F dollar caps, Dan’s depreciation

deductions for the first four years will be exactly the

same as if the car had been bought for cash.

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When the taxpayer‘s basis exceeds the car’s value, the taxpayer

should sell the car rather than trading it in.

Example

Dan bought a $25,000 car in 2013 and used it

entirely for business. In 2014, he acquires a new

$25,000 business car. Because of the depreciation

dollar caps, his total depreciation on the car

(including a half-year’s worth for 2014, the

disposition year) comes to just $9,435. Therefore,

his remaining basis in the car is $15,565. Assume

the car’s cash or trade-in value equals $15,500.

If Dan sells the car for cash, he will have a deductible

loss of $65 ($15,565 remaining basis less $15,500

value). If he trades it in, the loss isn’t recognized.

During the first six years, depreciation deductions on

the new car will be the same whether he sold the old

one or traded it in.

Taxpayers who use the standard mileage allowance method to deduct car-related expenses have a built-in allowance for

depreciation, which must be reflected in the basis of the car. Such depreciation reductions are relatively low so that when it‘s time to

dispose of a car, the taxpayer may be left with a higher remaining basis than the car‘s value. When that is the case, the car should be

sold to recognize the loss.

A special basis rule applies where the traded-in car was used for

personal as well as business purposes. The basis of the new car as computed under the normal trade-in rules must be reduced by any

difference between:

(1) The depreciation that would have been allowable had the car

been used 100% for business driving, and

(2) The depreciation claimed for the actual business use (Reg. §1.280F-2T(g)(2)(ii)).

Working Condition Fringe Benefits

A working-condition fringe benefit is any property or service provided to an employee by an employer to the extent that the cost

of such property or service would have been deductible by the employee as a business expense.

5 - 4 3

The use of an employer-provided vehicle in that employer‘s

business is a working condition fringe and its value is not included in an employee‘s income. However, if the employee also uses that

vehicle for nondeductible commuting or other personal purposes or uses it in another trade or business, the value of such use is

includable in their income (§132(a); §132(d); Reg. §1.132-1(a); Reg. §1.132-5).

Example from Pub. 917 (Rev „91)

You have the use of an employer-provided car. The

value of the availability of the car for a full year is

$2,000. You drive the car 6,000 miles for your

employer’s business and 2,000 miles for personal

reasons. The value of the nontaxable working

condition fringe is $1,500. This is figured by

multiplying the value of the benefit ($2,000) by a

fraction, the numerator of which is the business-use

mileage (6,000) and the denominator of which is the

total mileage (8,000). The amount includable in your

income because of the availability of the employer-

provided car is $500 ($2,000 - $1,500). [Reg §1.132-

5(b)(1)]

Qualified Transportation - §132(f)

An employer can exclude qualified transportation fringe benefits from the gross income of employees, up to certain limits. The

following benefits, provided by an employer to an employee, are qualified transportation fringes:

(1) Transportation in a commuter highway vehicle if the transportation is between the employee‘s home and work place,

Note: A commuter highway vehicle is any highway vehicle that

seats at least 6 adults (not including the driver). In addition, the

employer must reasonably expect that at least 80% of the

vehicle mileage will be for transporting employees between their

homes and work place, with at least one-half of the vehicle

seats (not including the driver‘s) being occupied by employees.

(2) A transit pass, and

Note: A transit pass is any pass, token, farecard, voucher, or

similar item entitling a person, without additional charge or at a

reduced rate, to ride mass transit or in a vehicle that seats at

least 6 adults (not including the driver), if it is operated by a

person in the business of transporting persons for compensation

5 - 4 4

or hire. Mass transit may be publicly or privately operated and

includes, for example, bus, rail, or ferry.

(3) Qualified parking.

Note: Qualified parking is parking provided to employees on or

near the business premises. It also includes parking provided on

or near the location from which employees commute to work

using mass transit, commuter highway vehicles, or carpools. It

does not include parking on or near the employee‘s residence.

Cash reimbursements an employer makes to an employee for these

expenses under a bona fide reimbursement arrangement are also excludable. Cash reimbursements for transit passes qualify only if a

voucher or a similar item that may be exchanged only for a transit pass is not readily available for direct distribution by the employer

to employees.

Only employers may provide qualified transportation fringes to

employees. The definition of employee includes common-law employees and other statutory employees, such as officers of

corporations. Self-employed individuals, including partners, 2% shareholders in S corporations, sole proprietors, and other

independent contractors are not employees for purposes of this fringe benefit.

Exclusion Limits

Employers may exclude from the gross income of each employee

up to:

(1) $130 per month (in 2014) for combined commuter

highway vehicle transportation and transit passes, and

(2) $250 per month (in 2014) for qualified parking

(§132(f)(2)).

If the limits are exceeded in any month, only the amount in

excess of these limits is includible in gross income. Nothing

prohibits the employer from providing these benefits in combination with another.

Employer-Provided Automobile

If an employer provides an auto (or other highway vehicle) to an

employee, the employee‘s personal use of the auto is a taxable fringe benefit (§61 and §132). The employer is required to

determine the actual value of this fringe benefit that the employee

must include in income or reimburse the employer. This value may

5 - 4 5

be determined under either one general or three special valuation

methods.

General Hypothetical Valuation Method

Under Reg.§1.61-2T(b)(4), if none of the special methods below

are used, the valuation must be determined by reference to the cost to a hypothetical person of leasing from a hypothetical third

party the same or comparable vehicle on the same or

comparable terms in the geographic area in which the vehicle is available for use.

Special Method #1 - Lease Value

Reg. §1.61-2T(d) states that if an employer provides an

employee with an auto, the value of the benefit may be determined using a lease valuation method. If an employer

provides an employee with an automobile for an entire calendar year, the automobile‘s annual lease value can be used to value

the benefit. If an employer provides an employee with an automobile for less than an entire calendar year, the value of the

benefit provided is either a prorated annual lease value or the daily lease value. The applicable lease value is included in the

employee‘s gross income unless excluded by law.

When the automobile lease valuation rule is used:

(1) The employer must adopt it by the first day the automobile is made available to an employee for personal

use;

Note: However, if the commuting valuation rule is adopted

when the automobile is first made available to an employee for

personal use, the employer can change to the automobile lease

valuation rule on the first day for which the commuting

valuation rule is not used.

(2) The employer must use the rule for all later years in

which the automobile is made available to any employee, except that for any year during which use of the automobile

qualifies, the employer can use the commuting valuation rule; and

(3) The employer must continue to use the rule if a replacement automobile is provided to the employee and the

primary reason for the replacement is to reduce federal taxes.

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Annual Lease Value - For Entire Calendar Year

Under this method an employee reports the annual lease

value of the auto from the tables in Reg. §1.61-2T(d)(2)(iii) based on the auto‘s fair market value when it is first made

available to the employee.

To determine the value of the employer provided auto:

(1) Find the fair market value of the car when it was first made available to the employee for personal use;

(2) Locate the fair market value on the left hand side of the table;

(3) Find the corresponding annual lease value on the right

hand side of the table; and

(4) Multiply the annual lease value by the ratio of personal

miles to total miles.

Fair Market ValueAnnual Lease Value $0 to 999 $600

1,000 to 1,999 850 2,000 to 2,999 1,100

3,000 to 3,999 1,350 4,000 to 4,999 1,600

5,000 to 5,999 1,850 6,000 to 6,999 2,100

7,000 to 7,999 2,350 8,000 to 8,999 2,600

9,000 to 9,999 2,850

10,000 to 10,999 3,100 11,000 to 11,999 3,350

12,000 to 12,999 3,600 13,000 to 13,999 3,850

14,000 to 14,999 4,100 15,000 to 15,999 4,350

16,000 to 16,999 4,600 17,000 to 17,999 4,850

18,000 to 18,999 5,100 19,000 to 19,999 5,350

20,000 to 20,999 5,600 21,000 to 21,999 5,850

22,000 to 22,999 6,100 23,000 to 23,999 6,350

24,000 to 24,999 6,600

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25,000 to 25,999 6,850

26,000 to 27,999 7,250 28,000 to 29,999 7,750

30,000 to 31,999 8,250 32,000 to 33,999 8,750

34,000 to 35,999 9,250 36,000 to 37,999 9,750

38,000 to 39,999 10,250 40,000 to 41,999 10,750

42,000 to 43,999 11,250 44,000 to 45,999 11,750

46,000 to 47,999 12,250 48,000 to 49,999 12,750

50,000 to 51,999 13,250 52,000 to 53,999 13,750

54,000 to 55,999 14,250

56,000 to 57,999 14,750 58,000 to 59,999 15,250

For vehicles having a fair market value exceeding $59,999, the annual lease value is equal to: (.25 x automobile fair

market value) + $500.

The annual lease values figured under this rule are based on

a 4-year lease term. The annual lease values figured using

the table will generally stay the same for the period that begins with the first date the rule is used for the automobile

and ends on December 31 of the 4th full calendar year following that date.

Note: Unless the primary purpose of a transfer of an auto

from one employee to another is to reduce federal taxes,

the annual lease value can be refigured based on the FMV of

the automobile on January 1 of the calendar year of

transfer.

The annual lease value for each later 4-year period is figured

by determining the FMV of the automobile on January 1 of the first year of the later 4-year period and selecting the amount

in column 2 of the table that corresponds to the appropriate

dollar range in column 1.

Note: If the special accounting period rule is used, the

annual lease value for each later 4-year period is calculated

at the beginning of the special accounting period that starts

immediately before the January 1 date.

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Fair Market Value

To determine the annual lease value of an automobile using

the above table, the FMV of an automobile is the amount a person would pay a third party in the area in which the

vehicle is purchased or leased to purchase the particular automobile provided. That amount includes sales tax and

title fees.

Safe Harbor Value

Employers can use the safe-harbor value as the FMV. For an automobile the employer owns, the safe harbor value

is the employer‘s cost, including tax, title, and other purchase expenses, if the auto was purchased at arm‘s

length.

For a leased automobile, the safe-harbor value is:

(1) The manufacturer‘s invoice price (including options) plus 4%,

(2) The manufacturer‘s suggested retail price less 8%

(including sales tax, title, and other expenses of purchase), or

(3) The retail value of the automobile reported by a nationally recognized pricing source.

Items Included in Annual Lease Value Table

The annual lease values in the table include the FMV of

maintenance and insurance for the automobile. Neither the employer nor the employee can reduce this value by the

FMV of any service included in the amount if the employer does not provide it. For example, the employer cannot

reduce the annual lease value by the FMV of a maintenance service contract or insurance not provided by the employer.

Note: However, the employer can take into account such

services actually provided for the automobile by valuing the

availability of the automobile under the general valuation

rule.

The FMV of any service (other than maintenance and

insurance for an automobile) provided is added to the annual lease value of the automobile in determining the

FMV of the benefit provided.

The annual lease values do not include the FMV of fuel

provided to employees for personal use, regardless of

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whether the employer provides it, reimburses its cost, or

has it charged to the employer. Employer provided fuel can be valued at FMV or at 5.5 cents per mile for all miles

driven by the employee.

Note: However, the employer cannot value at 5.5 cents per

mile fuel provided for miles driven outside the United States

(including its possessions and territories), Canada, and

Mexico.

If the employer reimburses an employee for the cost of fuel, or has it charged to the employer, the fuel is valued at

the amount of reimbursement, or the amount charged to the employer if it was purchased at arm‘s length.

Prorated Annual Lease Value - For 30 Days or More

If an automobile is provided to an employee for continuous

periods of 30 or more days but less than an entire calendar year, the annual lease value can be prorated. The prorated

annual lease value is figured by multiplying the applicable annual lease value by a fraction, using the number of days of

availability as the numerator and 365 as the denominator.

Note: When an automobile is provided continuously for at

least 30 days, but the period covers 2 calendar years (or 2

special accounting periods), the prorated annual lease value

or the daily lease value can be used.

If an automobile is unavailable to the employee because of his or her personal reasons (for example, if the employee is

on vacation), the periods of unavailability cannot be taken into account when using a prorated annual lease value.

Note: A prorated annual lease value cannot be used if the

reduction of federal tax is the main reason the automobile is

unavailable.

Daily Lease Value - For Less Than 30 Days

If an automobile is provided for continuous periods of one or

more but less than 30 days, the daily lease value is used to figure its value. The daily lease value is figured by multiplying

the applicable annual lease value by a fraction, using four times the number of days of availability as the numerator and

365 as the denominator.

However, a prorated annual lease value can be applied for a

period of continuous availability of less than 30 days by

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treating the automobile as if it had been available for 30

days.

Note: Use a prorated annual lease value if it would result in

a lower valuation than applying the daily lease value to the

shorter period of availability.

Special Method #2 - Cents per Mile

An employer may determine the value of a vehicle provided to

an employee by multiplying the standard mileage rate14 by the total number of personal miles driven by the employee, for autos

that:

(1) Are reasonably expected to be regularly used in a trade or business throughout the calendar year (or for a shorter

period during which it is owned or leased), or

(2) Satisfy the mileage rule (Reg. §1.61-2T(e)).

Warning: The value of the use of an automobile cannot be

determined under the vehicle cents-per-mile valuation rule

if the FMV of the automobile is more than the maximum

recovery deductions allowable for luxury automobiles under

§280F for the first five taxable years during which the

automobile is in service ($16,000 for cars and $17,300 for

trucks and vans in 2014 (Reg. §1.61-21(e)(1) (iii)(A))).

The standard mileage rate is applied only to personal miles.

Business miles are disregarded. Personal use is any use of the vehicle other than use in a trade or business.

An employer must adopt the cents-per-mile rule by the first day the vehicle is used by an employee for personal use. If the

commuting valuation rule is adopted when an employee first uses the vehicle for personal purposes, the cents-per-mile rule

can be used on the first day the commuting valuation rule is not used.

Once the cents-per-mile rule is adopted for a vehicle, it is used for all later periods in which the vehicle qualifies. However, the

commuting valuation rule can be used for any period during which the vehicle qualifies for that rate. If a vehicle does not

qualify for the cents-per-mile rule during a later period, any other special valuation rule can be adopted for which the vehicle

then qualifies.

14

T h i s r a t e i s 5 6 c e n t s p e r mi l e f o r 2 0 14 .

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Regular Use - 50% Business

Whether a vehicle is regularly used in an employer‘s trade or

business is determined based on all the facts and circumstances. A vehicle is considered regularly used in a

trade or business if it meets one of the following conditions:

(1) At least 50% of the vehicle‘s total annual mileage is for

that trade or business, or

(2) The vehicle is generally used each workday to drive at

least 3 employees to and from work in an employer-sponsored commuting pool.

Infrequent business use of the vehicle, such as for occasional

trips to the airport or between multiple business premises, does not constitute regular use of the vehicle in a trade or

business.

Mileage Rule - 10,000 Miles

If an employee is provided with a vehicle which the employee

is not expected to use regularly in a trade or business but

that meets the mileage rule, the cents-per-mile method can still be used to value the benefit provided. A vehicle meets

the mileage rule for a calendar year if:

(1) It is actually driven at least 10,000 miles in that year,

and

(2) It is used during the year primarily by employees.

A vehicle is considered used primarily by employees if they use it consistently for commuting. Thus, if only one employee

uses a vehicle during the year and that employee drives the vehicle at least 10,000 miles in that calendar year, the vehicle

meets the mileage rule even if all miles driven by the employee are personal.

Note: If a vehicle is owned or leased only part of the year, the

10,000 mile requirement is reduced proportionately. Use of the

vehicle by an individual (other than the employee) whose use

would be taxed to the employee is not treated as use by the

employee.

Items Included In Cents-Per-Mile Rate

The cents-per-mile rate includes the FMV of maintenance and insurance for the vehicle. The rate is not reduced by the FMV

of any service included in the rate that the employer has not provided. However, the employer can take into account the

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services provided for the automobile by valuing the

automobile under the general valuation rule.

For miles driven in the United States, its territories and

possessions, Canada, and Mexico, the cents-per-mile rate includes the FMV of fuel provided by the employer. If the

employer does not provide fuel, the rate can be reduced by no more than 5.5 cents.

For miles driven outside the United States, Canada, and Mexico, the FMV of fuel provided is not reflected in the cents-

per-mile rate. Accordingly, the employer can reduce the cents-per-mile rate, but by no more than 5.5 cents.

Special Method #3 - Commuting Value

If the auto is provided under the written commuting policy

statement exception15, the value of the employee‘s use of the vehicle for such commuting purposes is computed as $1.50 per

one-way commute (Reg. §1.61-21(f)(1)).

Employers can use this special rule to figure commuting value if

all of the following requirements are met:

(1) The employer owns or leases the vehicle and provides it

to one or more employees for use in a trade or business;

(2) The employer requires the employee to commute to

and/or from work in the vehicle for bona fide

noncompensatory business reasons;

(3) The employer establishes a written policy under which the

employee is not allowed to use the vehicle for personal purposes, other than for commuting or de minimis personal

use (such as a stop for a personal errand on the way between a business delivery and the employee‘s home);

(4) Except for de minimis personal use, the employee does not use the vehicle for personal purpose other than

commuting; and

(5) The employee required to use it for commuting is not a

control employee.

Note: An employer-provided vehicle generally used to carry at

least three employees to and from work in an employer-

15

Un d e r t h i s e x c e p t i o n , t h e e mp l o y e r mu s t h a v e a wr i t t e n

p o l i c y p r o h i b i t i n g e mp l o y e e u s e o f a n a u t o f o r p e r s o n a l

p u r p o s e s o t h e r t h a n c o mmu t i n g .

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sponsored commuting pool meets requirements (1) and (2)

above.

If the vehicle is a chauffeur-driven vehicle, the commuting valuation rule cannot be used for any passenger. However, it can

be used to value the commuting use of the chauffeur.

Control Employee

A control employee of a nongovernment employer is any employee who:

(1) Is a board- or shareholder-appointed, confirmed, or elected officer of the employer and whose compensation is

$50,000 (adjusted annually under §415(d)) or more,

(2) Is a director of the employer,

(3) Receives compensation of $100,000 (adjusted annually under §415(d)) or more from the employer, or

(4) Owns a 1% or more equity, capital, or profits interest in the employer (Reg. §1.61-21(f)(5)).

Note: Any individual who owns (or is considered to own

under §318(a) or principles similar to §318(a) for entities

other than corporations) 1% or more of the FMV of an entity

(the ―owned entity‖) is considered a 1% owner of all other

entities grouped with the owned entity under the rules of

§414(b), (c), (m), or (o). An employee who is an officer or

director of an employer is considered an officer or director

of all entities treated as a single employer under §414(b),

(c), (m), or (o).

A control employee of a government employer is any:

(1) Elected official, or

(2) Employee whose compensation is at least as much as that paid to a federal government employee at Executive

Level V.

For the commuting valuation rule, the term ―government‖ includes any federal, state, or local governmental unit and

any of their agencies or instrumentalities.

Note: If the employee required to use the vehicle for

commuting is a control employee and the vehicle is not an

automobile, the commuting valuation rule can still be used.

Employer-Provided Transportation in Unsafe Areas

Section 1.132-6(d)(2)(iii) of the regulations provides that if

an employer provides transportation (such as taxi fare) to an

employee for use in commuting to, from, or both to and from

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work because of unusual circumstances and because, based

on the facts and circumstances, it is unsafe for the employee to use other available means of transportation, the excess of

the value of each one-way trip over $1.50 per one-way commute is excluded from gross income (Notice 94-3).

Employer-provided transportation is local transportation by a vehicle bought by the employer from an unrelated person to

transport a qualified employee to or from work. It includes transportation by a vehicle bought by the employee and

reimbursed by the employer. Employer reimbursements to an employee under a bona fide reimbursement arrangement to

cover the cost of purchasing transportation, such as hiring a cab, are employer-provided transportation.

The value of the commuting use of employer-provided transportation is $1.50 for a one-way commute if:

(1) The employee is a qualified employee of the employer,

(2) The employee does not use the transportation for personal purposes other than commuting because of unsafe

conditions,

Note: Unsafe conditions exist if, under the facts and

circumstances, a reasonable person would consider it

unsafe for the employee to walk or use public transportation

at the time of day the employee must commute.

(3) The employer provides transportation solely because of unsafe conditions to an employee who would ordinarily

walk or use public transportation for commuting, and

(4) The employer established a written policy under which

the transportation is not provided for the employee‘s personal purposes other than for commuting because of

unsafe conditions and the employer‘s practice follows the established policy.

Qualified Employee

A qualified employee is one who:

(a) Performs services during the current year,

(b) Is paid on an hourly basis,

(c) Is not claimed under §213(a)(1) of the Fair Labor Standards Act of 1938 (as amended) to be exempt from

the minimum wage and maximum hour provisions,

(d) Is within a classification for which the employer

actually pays, or has specified in writing it will pay,

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compensation for overtime equal to or exceeding one and

one-half times the regular rate provided in §207 of the 1938 Act, and

(e) Does not receive compensation in excess of the amount permitted by §414(q)(1)(C) from the employer

(Reg. §1.61-21(k)(6)).

Nonpersonal Use Vehicles - 100% Excludable

All use of a qualified nonpersonal use vehicle qualifies as a working-condition fringe and, therefore, 100% of the value of

that use is excluded from the employee‘s income. A qualified nonpersonal use vehicle is any vehicle that is not likely to be

used more than minimally for personal purposes because of the way it is designed. Qualified nonpersonal use vehicles include:

(1) Clearly marked police and fire vehicles,

(2) Unmarked vehicles used by law enforcement officers

(explained later) if the use is officially authorized,

(3) Ambulances used as such,

(4) Hearses used as such,

(5) Any vehicle that is designed to carry cargo with a loaded

gross vehicle weight over 14,000 pounds,

(6) Delivery trucks with seating for the driver only, or for the driver plus a folding jump seat,

(7) Passenger buses used as such with a capacity of at least 20 passengers,

(8) School buses, and

(9) Tractors and other special purpose farm vehicles (Reg.

§1.132-5(h); Reg. §1.274-5T(k)(2)).

Clearly Marked Police or Fire Vehicles

A police or fire vehicle is a vehicle, owned or leased by a governmental unit (or any of its agencies or

instrumentalities), that is required to be used for commuting by a police officer or fire fighter who is on call at all times.

Any personal use (other than commuting) of the vehicle outside the limit of the police officer‘s arrest powers or the

fire fighter‘s obligation to respond to an emergency must be prohibited by such governmental unit. A police or fire vehicle

is clearly marked if, through a painted symbol or words, it is easy to see that the vehicle is a police or fire vehicle. A

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marking on a license plate is not a clear marking for this

purpose (Reg §1.274-5T(k)(3)).

Unmarked Law Enforcement Vehicles

Any personal use of an unmarked law enforcement vehicle

must be authorized by the federal, state, county, or local governmental agency or department that owns or leases the

vehicle and employs the officer. The personal use must be

necessary to help enforce the law, such as being able to report directly from home to a stakeout site or to an

emergency. Use of an unmarked vehicle for vacation or recreation trips cannot qualify as an authorized use (Reg.

§1.274-5T(k)(6)(i)).

Law Enforcement Officer

A law enforcement officer is a person who is employed on a full-time basis by a governmental unit that is responsible

for preventing or investigating crimes involving injury to persons or property (including catching or detaining

persons for such crimes), who is allowed by law to carry firearms, to execute search warrants, and to make arrests

(other than merely a citizen‘s arrest), and who regularly carries firearms (except when working undercover). It may

include an arson investigator if the investigator otherwise meets these requirements (Reg. §1.274-5T(k)(6)(ii)).

Trucks & Vans

A pickup truck or van is not considered a qualified

nonpersonal use vehicle unless it has been specially modified with the result that it is not likely to be used more than

minimally for personal purposes. The following are guidelines that a pickup truck or van can meet to be a qualified

nonpersonal use vehicle. Even if these guidelines are not met, the vehicle may still qualify, based upon the facts (R.R. 86-

97; R.P. 2003-75; Reg. §1.274-5T(k)(7)).

Pickup Truck Guidelines

A pickup truck with a loaded gross vehicle weight not over 14,000 pounds will qualify if it is clearly marked with

permanently affixed decals or with special painting or other

advertising associated with the employer‘s trade, business, or function and is either:

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(1) Equipped with at least one of the following:

(a) A hydraulic lift gate,

(b) Permanently installed tanks or drums,

(c) Permanently installed side boards or panels that materially raise the level of the sides of the truck bed,

or

(d) Other heavy equipment (such as an electric

generator, welder, boom, or crane used to tow automobiles and other vehicles), or

(2) Actually used primarily for transporting a particular type of load (other than over the public highways) in

connection with a construction, manufacturing, processing, farming, mining, drilling, timbering or other

similar operation for which it has been specially designed or modified to a significant degree (R.R. 86-97; R.P.

2003-75).

Van Guidelines

A van with a loaded gross vehicle weight not over 14,000 pounds will qualify if it is clearly marked with permanently

affixed decals or with special painting or other advertising associated with the employer‘s trade, business, or function,

and has a seat for the driver only or the driver and one

other person, and either:

(1) Permanent shelving has been installed that fills most

of the cargo area, or

(2) The cargo area is open and the van constantly

(during both working and nonworking hours) carries merchandise, material, or equipment used in the

employer‘s trade, business, or function (R.R. 86-97; R.P. 2003-75).

Qualified Automobile Demonstration Use

For a full-time automobile salesperson, qualified automobile

demonstration use is a working condition fringe and, therefore, is excluded from their income. Qualified automobile

demonstration use is any use of a demonstration automobile in the dealer‘s sales area if:

(1) The automobile is provided mainly so the taxpayer can better perform services for their employer, and

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(2) There are substantial restrictions on the taxpayer‘s

personal use of the automobile (Reg. §1.132-5(o)(1)).

A demonstration automobile is an automobile that is currently in

the automobile dealer‘s inventory and available for test drives by customers during normal business hours (Reg. §1.132-5(o)(3)).

The sales area includes the geographic area around the dealer‘s office from which the office regularly gets customers. For a

particular full-time salesperson, the sales area is the larger of:

(a) The area within a 75 mile radius of the sales office, or

(b) The one-way commuting distance for that salesperson (Reg §1.132-5(o)(5)).

Full-time Automobile Salesperson

A full-time automobile salesperson is employed by an

automobile dealer and:

(1) Customarily spends at least half of a normal business

day performing the functions of a floor salesperson or sales manager,

(2) Directly engages in substantial promotion and negotiation of sales to customers,

(3) Customarily works a number of hours considered full-

time in the industry (at a rate of at least 1,000 hours per year), and

(4) Earns at least 25% of their gross income from the dealership directly as a result of the activities above.

The value of the use of a demonstration automobile by anyone other than a full-time automobile salesperson, such

as a mechanic or part-time salesman, is not excludable from income (Reg. §1.132-5(o)(2)(ii)).

Restrictions on Personal Use

Substantial restrictions on personal use of a demonstration

automobile exist when all of the following conditions are met:

(1) Use by anyone other than full-time salespersons (such

as use by members of family) is prohibited,

(2) Use for personal vacation trips is prohibited,

(3) Storage of personal possessions in the automobile is prohibited, and

(4) Use outside of normal working hours is limited to a certain number of miles (Reg. §1.132-5(o)(4)).

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Reporting by Employer

The employer must report on Form W-2, Wage and Tax

Statement, the total of the taxable fringe benefits paid or treated as paid to an employee during the year and the tax withheld for

the benefits. These amounts can be shown either on the Form W-2 for regular pay or on a separate Form W-2. If the employer

provided the employee with a car, truck, or other motor vehicle and chose to treat all of the employee‘s use of it as personal, its

value must be either separately shown on Form W-2 or reported to the employee on a separate statement.

Election Not to Withhold for Income Taxes

The employer can elect not to withhold income tax on the

value of the employee‘s personal use of an employer-provided vehicle. However, the employer must withhold employment

taxes (such as social security). The employer must give the employee written notification of an election not to withhold by

the later of January 31 of the year for which the election

applies or, within 30 days after the date the employer first provides the vehicle to the employee (Ann. 85-113).

Value Reported

The employer can figure and report either:

(1) The actual value of the employee‘s personal use of the vehicle or

(2) The value of the vehicle as if the employee used it entirely for personal purposes (100% income inclusion).

Note: The 100% income inclusion method cannot be used if

the value of the use of the vehicle is determined under the

vehicle cents-per-mile or commuting valuation special

methods.

If the employer includes 100% in the employee‘s income, the

employee can deduct the value of business use of the vehicle by completing Form 2106 by including the entire value of the

employer-provided vehicle on line 25 and completing the remainder of the form (Reg. §1.61-21(e)(4); Ann. 85-113).

Accounting Period

An employer has the option to report an employee‘s taxable

use of an employer-provided vehicle by using either of the following rules:

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(1) The general rule - i.e., value the use for a full calendar

year (January 1 - December 31), or

(2) The special accounting period rule - i.e., treat the value

of use provided during the last two months of the calendar year (or any shorter period) as paid during the following

calendar year.

Special Accounting Period - Pour Over Method

For any fringe benefit, the employer may elect a special accounting period. This allows the employer to treat the

value of benefits actually provided during the last two months of the calendar year (or any shorter period) as paid

during the next calendar year. Under this rule, each year the employer includes the value of benefits provided the

last 2 months of the prior year and the first 10 months of the current year.

If the employer elects the special accounting rule, employees must use it also. Thus, employee deductions

related to a fringe benefit are allowable only in the year the employer includes the value of the fringe benefit in the

employee‘s income. The employer must notify employees if this election is made and of the period involved. Employees

must receive the notice at or near the time they receive

their Form W-2 (Ann. 85-113).

Example

For 2014, you are provided a car by your employer

for both business and personal use. You have the car

for the entire year. Your employer includes 100% of

the value of the use of the car in your income. He

uses the special accounting period and elects to treat

the value of the use of the car during the last two

months of 2014 as paid in 2015. For 2014, you can

deduct only that part of the value that is attributable

to your business use of the car for the first ten

months of 2014. The part attributable to the last two

months is deductible in 2015. However, any

unreimbursed expenses you incurred during the last

two months of 2014 that relate to your business use

of the car (such as fuel, parking, etc.) can be

deducted for 2014.

6 - 1

CHAPTER 6

Business Travel &

Entertainment

Business Travel

Travel, meals, and lodging expenses incurred by a taxpayer while

away from home in connection with his services as an employee are deductible under §162(a)(2). Actual transportation expenses paid

or incurred by a taxpayer even while not away from home in connection with his services as an employee are also deductible. In

any event, such expenses are deductible only if the purpose of the trip is ―primarily for business.‖ If they are primarily for pleasure,

none of the travel expenses are deductible except for actual

business expenses at the destination (Reg. §1.162-2).

Transportation & Travel Distinguished

Travel expenses and transportation expenses both may give rise to tax deductions. However, much confusion exists between the two

concepts. This is especially true since travel can have transportation components.

Travel Expenses

Under §162, travel expenses are defined as ordinary and

necessary expenses incurred while the taxpayer is in travel status (i.e., traveling away from home in pursuit of a trade or

business). Examples of deductible travel expenses undertaken for business include:

(1) Meals (but only 50%, see §274(n)(1)) and lodging, both

enroute and at the destination,

(2) Air, rail, ship, bus, and baggage charges,

6 - 2

(3) Telephone and telegraph expenses,

(4) Cost of transportation by taxi, etc. from the airport or station to the hotel, from the hotel to the airport or station,

from one customer or place of work to another,

(5) Laundry, cleaning, and clothes pressing costs, and

(6) Reasonable tips to the extent incident to any of the above expenses (Reg. §1.162-2(a); R.R. 63-145; Gibson Products

Co., Inc., 8 TC 864(A); Zeagler, TC Memo 1958-93).

However, travel expenses don‘t include the additional cost of

coming home on weekends over what the cost of room and meals would have been at the out of town assignment nor do

they include ―entertainment‖ expenses.

Transportation Expenses

Section 162 allows a deduction for local transportation expenses that are directly attributable to the conduct of taxpayer‘s

business or employment, even if not incurred while ―away from home.‖ Transportation is a narrower concept than travel and

does not include meals and lodging. It includes only the cost of transporting the employee from one place to another in the

course of his employment, while he is not away from home in a travel status (Reg. §1.62-1(g)).

Definition of “Tax Home”

To deduct expenses for travel ―away from home,‖ the taxpayer must first determine where home is. Normally this determination is

not a problem. However, for those who travel, keep two homes or places of business, or have no definite home, it can be hard to

decide where ―home‖ is for tax purposes.

There are two tests, one enforced by the IRS, and another followed

by the Second and Ninth Circuits. At this time, it is difficult to

predict which test will be followed and the courts often switch from one to the other. However, for purposes of our later discussion, I

will ―adopt‖ the Service‘s test.

Circuit Court Test

The Second and Ninth Circuits follow a subjective approach that places emphasis on where the taxpayer regards his residence to

be. These circuits reject the Service‘s ―tax home‖ concept and define ―home‖ as it is commonly conceived, not as the principal

place of business. Home is where the heart is, in these circuits.

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IRS Test

Under the Service‘s position a taxpayer‘s ―tax home‖ is his

principal place of business, employment station, or post of duty, regardless of where his family lives (R.R. 60-189, R.R. 75-432,

Barnhill v. Commissioner, 148 F. 2d 913; Karp, TC Memo 1976-325). Where his family lives is not determinative. Thus, once a

taxpayer moves to a new permanent job location he has established ―tax home,‖ even though his family doesn‘t

immediately join him (Harry Carl Taylor II, TC Memo 1985-449, aff‘d 5/28/86, CA-4; Twomley v. U.S., 3/17/76 Ct. Cl., 37 AFTR

2d 96-1019, 76-1 USTC 9305). In addition, spouses may have

separate tax homes even though they live together and file jointly. (Foote v. Commissioner, 67 T.C. 1 (1976).

Employment Area

According to the Service, the place of employment embraces the entire area, city, or general locality where the taxpayer

usually carries on trade or business (Worden v.

Commissioner, T.C. Memo. 1981-366 and Kammerer, TC Memo 1976-11). Therefore, travel within this general area will

not qualify as away-from-home travel. In R.R. 56-49, 1956-1 C.B. 152, a fireman who was assigned to various locations

within the same city could not deduct his meals while staying for 24 hours at a firehouse away from his main firehouse.

No Tax Home

Where a taxpayer has no principal place of business or

employment but continually changes work locations over an extended area, such as traveling salesmen and musicians, IRS

and the courts agree that his regular residence or place of abode is his tax ―home‖ for purposes of deducting travel expenses (R.R.

73-529, Libby, TC Memo 1964-309; Coburn v. Commissioner, 138 F. 2d 763; Burns v. Gray, 287 F. 2d 698; Harvey v.

Commissioner, 283 F. 2d 491; Weidekamp, 29 TC 16). Moreover, deductions have been denied for recurring seasonal

temporary jobs away from the taxpayer‘s regular ―tax home‖ for several months each year (Dilley, 58 TC 276).

Itinerant Worker

If such a taxpayer has no ―regular place of abode in a real

and substantial sense,‖ the Service classifies him as an ―itinerant worker‖ who isn‘t entitled to deduct travel expense.

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An itinerant‘s ―tax home‖ is deemed to vary with his jobs.

Hence, he is never ―away from home‖ and, therefore, isn‘t permitted to deduct travel expense (R.R. 73-529, 1973-2 CB

37; Letscher, TC Memo 1969-224; Hicks, 47 TC 71; Searles, TC Memo 1966-104; James v .U.S., 176 F Supp 270;

Crossland, TC Memo 1974-277, aff‘d 12/18/75, CA-2, 37 AFTR 2d 76-651, 76-1 USTC 9188).

Two Work Locations

If a taxpayer works at two or more separate locations, his tax

home is where his principal employment or business is located. Costs of traveling to and from the minor place of employment

and meals and lodging at the minor post may be deductible as away from home travel expense (R.R. 75-432, Deery, TC Memo

1954-175).

Temporary & Indefinite Assignments

Once a ―home‖ has been established, what conduct changes the

location of that home for tax purposes?

Temporary Assignment

If a taxpayer engages in temporary work away from his ―tax home,‖ his ―tax home‖ does not shift, and he is deemed away

from home for the entire temporary period. The reasoning is that the taxpayer cannot be expected to establish a new residence for

a temporary assignment (Michaels v. Commissioner, 53 T.C. 269 (1960), acq. 1973-2 C.B. 3). Thus, his presence in the

temporary location is due to his business, rather than a personal choice (Commissioner v. Flowers, 326 U.S. 465, reh‘g denied

326 U.S. 812 (1946)). Therefore, in a temporary change, the ―tax home‖ stays the same and all expenses for traveling, meals,

and lodging are deductible as travel ―away from home.‖ If, however, the change is indefinite (i.e., if its termination cannot

be foreseen within a fixed and reasonably short period), the ―tax home‖ is considered to move with him and no deduction for

travel, meals, and lodging will be allowed.

Indefinite Assignment

When a taxpayer is assigned to work, or changes his business to a new location, for an ―indefinite period‖ of time, the new

location becomes the taxpayer‘s new ―tax home‖ and he cannot deduct the expenses of travel, meals and lodging while there. An

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indefinite period is where termination of work or business at the

new site is not foreseeable within a fixed and reasonably short period. Whether an assignment is temporary or indefinite must

be determined at the time work commences.

Moreover, any amounts an employee on an indefinite

assignment receives from his employer for living expenses must be included in the employee‘s income, even though they may be

called travel allowances and he accounts to his employer for them (Crawford, TC Memo 1968-196).

Time

Time is a critical factor in distinguishing a temporary from an

indefinite job assignment.

Prior Law Presumptions

Prior tax law made a number of presumptions based on whether the job assignment was expected to last:

(1) For less than a year,

(2) More than one but less than two years, or

(3) More than two years.

One-Year IRS Presumption

An assignment or job expected to last for a year or more was considered indefinite and presumed by the Service not

to be temporary. This was referred to as a one-year presumption.

According to the Service ―an employment or stay of anticipated or actual duration of a year or more at a

particular location must be viewed...as strongly tending to indicate presence there beyond a temporary period...‖

(R.R. 60-189).

Thus, if both the anticipated and actual duration was less

than one year and the taxpayer regularly maintained a

home near his usual place of employment, the Service did not question its temporary nature (R.R. 61-95).

Less than Two-Year Exception

Taxpayers could overcome the one-year presumption by showing:

(1) They realistically expected the job to last less than 2

years,

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Note: An expected or actual stay of 2 years or longer is

considered an indefinite stay, regardless of the facts or

circumstances (R.R. 54-497; R.R. 75-432; R.R. 83-82)

(2) They expected to return to their tax home after the

job ended, and

(3) Their claimed tax home is their regular home in a real

and substantial sense (see R.R. 83-82).

Regular Home

Three factors were used to determine if the claimed tax

home was the taxpayer‘s regular home:

(a) The taxpayer worked in the area of the claimed tax home immediately before their present job and

continued to have work contacts (job seeking, leave of absence, on-going business, etc.) in that area during

their absence;

(b) The taxpayer had living expenses at the claimed tax

home that were duplicated because their work required them to be away from that home; and

(c) The taxpayer's spouse or children lived at the claimed tax home, or the taxpayer often continued to

use that home for lodging.

If the taxpayer‘s expectations that the job would last less

than 2 years and that they would return to their tax home were realistic and they met all three factors, their travel

away from home was considered temporary for travel

expense deduction purposes.

If the expectations were realistic, but the taxpayer met

only two of the factors, they might be temporarily away from home depending on the facts and circumstances.

If the taxpayer met only one factor, their travel away from home was not considered temporary, and they could

not deduct travel expenses (R.R. 83-82).

Temporary Job That Became Permanent

The fact that a temporary job eventually became permanent did not disallow travel expense deductions

during the time the job was temporary (Beebe, TC Memo 1971-330). However, many jobs of short duration could

convert a temporary employment into an indefinite one.

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In Norwood v. Commissioner, 66 T.C. 467 (1976), taxpayer

was hired as a bottle maker for one project and then reassigned as foreman for another project, the court found

that he could reasonably have expected to be employed in one capacity or another for an indefinite period, despite the

fact that each of the jobs was temporary in nature. See also Marth v. Commissioner, 342 F.2d 417 (9th Cir. 1965),

aff‘g per curiam 23 T.C.M. 660 (1964), cert. denied 382 U.S. 844 (1965) where, after 8 years, a temporary job was

deemed permanent.

Current Law - One-Year Rigid Time Rule

Effective for amounts paid after 1992, §162(a) now provides that a taxpayer is not temporarily away form home during

any period of employment that exceeds one year. Thus, employment away from home for more than one year is

indefinite, and no deduction for travel expenses is allowed.

Note: There is no indication when the taxpayer should

determine whether a job is to last more than a year. The Energy

Act is apparently designed to end controversies over whether a

job is temporary or indefinite by applying a rigid time rule,

regardless of taxpayer‘s intentions.

This statutory definition of temporary employment does not

change the rule that facts and circumstances still determine whether employment away from home at a single location for

less than one year is temporary or indefinite (Conf Rept No. 102-1018 (PL 102-486) p.430).

Away From Home Requirement

While transportation is deductible whether or not the trip takes the taxpayer away from home, meals and lodging are deductible only if

the taxpayer is ―away from home‖ (§162(a)(2)). To determine whether a taxpayer is away from home the Service has adopted the

so-called ―sleep and rest‖ rule.

Sleep & Rest Rule

The rule requires the taxpayer to prove that it is reasonable to need sleep or rest during release time to meet the demands of

his employment. In other words, his duties require him to be away from the general area of his tax home for a period which is

substantially longer than an ordinary day‘s work and, during

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released time while away, it is reasonable for him to sleep or

rest to meet the needs of his employment or business.

Correll Case

The ―sleep and rest‖ rule was adopted in United States v.

Correll, 389 U.S. 299 (1967), which denied an expense deduction to a traveling salesman for breakfasts and lunches

eaten on the road because he returned home each day for

dinner. Thus, this rule even covers a taxpayer who conducts a minor or secondary business away from home in the evening.

If the taxpayer is able to return to his residence each night he cannot deduct dinner meals taken at the place of his

secondary business (Mazzotta, 57 TC 427, aff‘d 465 F. 2d 1399).

Business Purpose Requirement

All travel expenses must be divided into two categories, (i) travel costs to and from the destination, and (ii) expenses incurred while

at the destination. If a trip is undertaken for other than business purposes, travel costs are nondeductible personal expenses, and

meals and lodging are nondeductible living expenses, even though the taxpayer engages in business activities while away from home

(Reg. §1.162-2; §262). Expenses incurred at the destination must always be allocated between business and personal pleasure. Thus,

even if a trip is primarily personal, expenses incurred while at the destination are deductible if related to taxpayer‘s trade or business,

even though the travel expenses to and from the destinations might not be deductible (Reg. §1.162-2(b)(1)).

All or Nothing

Travel costs are, therefore, an ―all or nothing‖ proposition

depending on the primary business nature of the trip. On the other hand, business related portion of costs at the destination is

always deductible, even if the majority of expenses were personal. Nevertheless, if a taxpayer engages in both business

and personal activities a deduction for travel expenses is not

lost. It is not necessary for the trip to be 100% business related to deduct travel costs. The expenses of travel to and from a

destination are still deductible if the trip is primarily for business (Reg. §1.162-2(b)(1)).

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Primarily for Business Test

Time

Whether a trip is related primarily to a taxpayer‘s trade or business, or is essentially personal in nature, depends on the

facts and circumstances of each case. The most important factor is the amount of time the taxpayer spends on personal

activities in relation to the length of the trip (Reg. §1.162-

2(b)(2)).

Other Factors

However, the Service may also consider other factors,

including the location of the site (e.g., vacation resorts)

and whether the taxpayer had control over planning the trip. The increasing number of organizations that schedule

their conventions and seminars in resort areas has caused the Service to closely examine deductions of alleged

business trips that are merely disguised vacations. Yet, if it can be shown that the expenses were incurred primarily for

business they are deductible despite the resort location.

Existing Trade or Business

In order to be deductible currently, the travel must be related to an existing business. Travel costs to investigate new or different

business opportunities must be capitalized or amortized (except for an initial $5,000) over 180 months under §195.

51/49 Percent Test

How much time must be spent on business to take a travel

deduction? As a general rule, a trip is primarily for business if bona fide business is conducted on over 50% of the trip days.

However, the application of this ―51/49 percent test‖ depends on where the taxpayer is traveling, since different rules apply

to foreign travel as compared to domestic travel.

Domestic Business Travel

If a trip within the United States is primarily for business (i.e., more than 50%), the taxpayer may deduct the entire travel cost

to and from the destination as a business expense (Reg. §1.162-2). In addition, the taxpayer may deduct the cost of meals (up

to 50%), lodging, and other business-related expenses. For tax

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purposes, the United States is defined as travel within the fifty

states and the District of Columbia.

Foreign Business Travel

For travel outside the United States, there are more restrictive

requirements.

Personal Pleasure

If a taxpayer travels outside the U.S. primarily for personal pleasure or for vacation, travel costs to and from the

destination are not allowed but business expenses at the destination are allowed (Reg. §1.162-2(b)).

Primarily Business

If the trip outside the U.S. is primarily for business (e.g.,

more than 50%) but there were some nonbusiness activities, not all of the travel costs from home to the business

destination and back may be deductible by an individual. The cost will have to be allocated between business and

nonbusiness activities. The amount of the foreign travel costs

to and from the business destination, which is not deductible, is obtained by multiplying the total business traveling

expense by the total number of nonbusiness days outside the U.S., and dividing the result by the total number of days

outside the U.S. (Reg. §1.274-4(f)).

Full Deduction

To be fully deductible, foreign travel must be primarily for business (e.g., more than 50%) and meet at least one of the

following conditions (§274(d); Reg. §1.274-4):

(1) The taxpayer is an employee who is not related to his

employer;

Note: An employee is related to his employer if the

employee owns, directly or indirectly, more than 10% (Reg.

§1.274-5(e)(5) and Rev. Rul. 80-62).

(2) The trip lasts less than eight days (including the return

travel day, but excluding the departure day);

(3) Less than 25% of the total number of days on the trip

are nonbusiness days;

(4) Taxpayer had little control over arranging the business trip; or

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Note: The exception regarding control applies if the

taxpayer is on an expense allowance and is not either:

(a) A managing executive who has the power to decide on

the necessity of the trip; or

(b) Related to his employer.

Even if the taxpayer meets one of the two criteria listed

above, lack of control can be established when you are

required to attend a function by a client or customer.

(5) Personal vacation or holiday was not a major consideration in making the trip.

Where the travel is not primarily for business or fails to satisfy one of the above conditions, an allocation of the travel

expenses must be made. A deduction for foreign travel

expenses is not allowed if the trip is primarily personal.

Definition of Business Day

A day is treated as a ―business day‖ if:

(a) The taxpayer travels by a reasonably direct route and

he does not interrupt his travel by engaging in a substantial diversion for nonbusiness reasons (e.g., the day of

departure and the day of return);

(b) The taxpayer must attend a specific business meeting

on a particular day; or

Note: It does not matter that only a small part of the day is

devoted to business purposes and the rest is used for

personal pleasure.

(c) The taxpayer‘s principal activity was business.

If the taxpayer was prevented from engaging in business by circumstances beyond his control, the day is still considered a

business day. Weekends, holidays, or other ―stand-by‖ days that fall between the taxpayer‘s business days are also

considered business days. However, such days are not

business days if they fall at the end of the taxpayer‘s business activities and the taxpayer merely elects to stay for personal

purposes.

Meals & Lodging

The cost of meals and lodging is deductible under §162(a)(2) when the taxpayer is traveling away from home. However, meals and

lodging must be incurred during ―travel status‖ or for entertainment

purposes to be deductible.

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50% Deduction Limitation

The amount of an otherwise allowable deduction for meals (but

not lodging) is reduced by 50% (§274(n)(1)). This reduction applies to travel, entertainment, and former ―quiet business‖

meals.

Conventions & Meetings

The expenses of attending a convention or other meeting, including

the cost of travel, meals, lodging, and incidental expenses, can be deductible as a business expense (Treas. Reg. §1.162-2(d)).

Deductibility depends on whether attendance primarily benefits or advances the taxpayer‘s trade or business. If the convention is

primarily for political, social, or other purposes not directly related to taxpayer‘s trade or business, the expenses are not deductible.

Thus, unless the taxpayer can show that his attendance advances the interest of his own employment or business, travel expenses

incurred in attending a convention are nondeductible and, if paid for by another, must be included in taxpayer‘s income.

Agenda Test

Under R.R. 59-316, the Service compares an individual‘s

business and employment duties with the purposes of the meeting as stated in the program or agenda. The ―primarily for

business‖ test is satisfied when the agenda of the convention or meeting is so related to the conduct of the taxpayer‘s trade or

business that attendance was predominantly for a business

purpose (Reg. §1.162-2(d); R.R. 60-16, R.R. 63-266, and Reed v. Commissioner, 35 T.C. 199 (1960)). Other relevant factors

include:

(1) The amount of time devoted to business compared to

recreational and social activities;

(2) If the location is related to the operation of the taxpayer‘s

trade or business;

(3) The attitude of the organization sponsoring the

convention; and

(4) Whether attendance is mandatory (Thomas v. Patterson,

289 F.2d 108 (5th Cir.), cert. denied 368 U.S. 837 (1961)).

Foreign Conventions

The rules on foreign conventions, which were added to the Code as part of the Tax Reform Act of 1976, are distinct from the rules

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on foreign travel. No deduction is allowed for a convention,

seminar, or similar meeting held outside the North American area, unless the meeting is directly related to the taxpayer‘s

trade or business, and it is as reasonable for the meeting to be held outside as within the North American area (§274(h)(1)).

Factors

The factors determining reasonableness are:

(1) The purpose of the meeting and the activities taking place at the meeting,

(2) The purposes and activities of the sponsoring organizations or groups,

(3) The residences of the active members of the sponsoring organization,

(4) The places at which other meetings of the sponsoring organizations or groups have been held or will be held, and

(5) Such other relevant factors as the taxpayer may present (§274(h)(1)).

There is no limit on the number of trips for which deduction may be claimed, and no subsistence or coach fare deduction

limitations (Summary of Misc. Tax Bills, Staff Joint Committee on Taxation, 12/23/80).

North American Area

The ―North American‖ area means the U.S., its possessions

(including Puerto Rico), the Trust Territory of the Pacific Islands, Canada, and Mexico (§274(h)(3)(A)). Certain

Caribbean countries and Bermuda are included in the term

―North American area‖ and expenses for attending a convention, seminar, or similar meeting in such a country are

deductible, if the country:

(1) Is a ―beneficiary country‖;

(2) Has entered into an agreement with the U.S. (bilateral or multilateral) for the exchange of tax information; and

(3) Has no tax laws discriminating against conventions held in the U.S. (§274(h)(6)(A)).

Allowable Expenses

Expenses permitted under §274(h) include:

(1) Transportation expenses to and from the place of the convention and meals while in travel status;

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(2) Registration fees and other related expenses;

(3) Meals and lodging while away from home attending the convention; and

(4) Other incidental related travel expenses, such as taxi fares.

Cruises

Deduction Limitation

Up to $2,000 per individual per year is deductible for business

conventions conducted on a cruise ship, provided the ship is

registered in the U.S. and all ports of call of the cruise ship are located in the U.S. or U.S. possessions (§274(h)(2)). No

deductions are available for cruises on foreign flag vessels, or for cruises calling on foreign ports. A ―cruise ship‖ means any vessel

sailing within or without the territorial waters of the U.S. (§274(h)(3)(B)).

Reporting Statements

Two written statements must be attached to the return:

(1) A taxpayer's statement, signed by the individual attending the meeting and including information with

respect to:

(a) The total days of the trip (excluding the days of

transportation to and from the cruise ship port),

(b) The number of hours of each day of the trip that the

individual devoted to scheduled business activity,

(c) The program of the scheduled business activity of the

meeting, and

(d) Such other information as may be required by the IRS.

(2) A sponsor’s statement, signed by an officer of the

sponsoring organization or group, including:

(a) A schedule of the business activity of each day of the

meeting,

(b) The number of hours during which the individual

attending the meeting attended such scheduled business activities, and

(c) Such other information as may be required by regs. (§274(h)(5)).

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Luxury Water Travel

Section 274 limits the deduction for travel by ocean liner, cruise

ship, or other form of ―luxury‖ water transportation. The amount deductible is based on highest per diem allowed per day to

employees of the executive branch of the U.S. Government while away from home, but serving in the U.S. The luxury water travel

limitation is twice that per diem multiplied by the number of days the taxpayer is engaged in luxury water travel (§274(m)(1)(A)).

Exceptions

The luxury water travel limitation does not apply to:

(1) Expenses treated as compensation paid to an employee or otherwise included in the gross income of the recipient;

(2) Reimbursed expenses where the services are performed for an employer and the employer hasn‘t treated the

reimbursement as compensation;

(3) Expenses for recreational or social activities primarily for

the benefit of employees;

(4) Services and facilities which are made available by the

taxpayer to the general public; or

(5) Services and facilities which are sold to customers (§274(m)(1)(B)(ii)).

Family Member Travel Expenses

Travel expenses paid or incurred for a spouse, dependent, or other

individual who accompanies a taxpayer on business travel is generally not deductible. Providing incidental services or help is also

not sufficient to generate a deduction (Reg. §1.162-2(c)).

Before 1994, such travel expenses were deductible if the individual‘s presence on the trip had a bona fide business purpose.

In addition, the mere fact that a spouse spent a substantial amount of time on personal matters, such as attending to laundry and

greeting guests, did not rule out a finding of bona fide business purpose.

Since 1994, however, travel expenses paid or incurred for an individual who accompanies the taxpayer on business travel is not

deductible unless the individual:

(1) Is the taxpayer‘s employee,

(2) Has a bona fide business purpose for the travel, and

(3) Would otherwise be allowed to deduct the travel expenses.

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Business Entertainment

Paying for entertainment expenses incurred on behalf of the company due to business responsibilities is a traditional benefit.

Taxpayers may deduct entertainment expenses incurred for

business purposes. To be deductible the expenses must be ordinary and necessary and incurred in the operation of a business regularly

carried on by the taxpayer. In addition, they must be "directly related to" or "associated with" the taxpayer's business and

properly substantiated as such.

Note: Under §274(a)(1), a taxpayer must allocate total

expenses while entertaining between business and nonbusiness,

and the nonbusiness portion is not deductible.

Definition

Entertainment means any amusement or recreational activity and

includes entertaining guests at such places as nightclubs, country clubs, theaters, sporting events, and on yachts, or on hunting,

fishing, vacation, and similar trips. It may also embrace any activity that satisfies the personal, living, or family needs of any individual,

such as food and beverages, a hotel suite, or a car to the taxpayer's business customer or his family.

Note: Entertainment does not include supper money furnished

to an employee, a hotel room maintained for employees while in

business travel, or a car used in the active conduct of a trade or

business even though used for routine personal purposes such

as commuting to and from work. However, if an employer

furnishes the use of a hotel suite or a car to an employee who is

on vacation, this would constitute entertainment of the

employee.

Lavish or Extravagant Restriction

Lavish or extravagant entertainment expenses are not deductible. However, entertainment expenses are not disallowed merely

because they exceed a fixed dollar amount or are incurred in deluxe

restaurants, hotels, nightclubs, and resort establishments. An expense is not lavish or extravagant if considering the facts and

circumstances it is reasonable (Reg. §1.274-1; R. R. 63-144, Q & A 42).

Note: The lavish or extravagant limitation does not apply to any

expenses that are excepted from the 50% meal limitation (See

later discussion and §274(k)(2)).

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Ordinary & Necessary Requirement

Entertainment expenses must be ordinary and necessary expenses

for the carrying on of a trade or business, or for the production or collection of income (§§274(a), 274(e); Reg. §1.162-1(a), Reg.

§1.212-1, Reg. §1.274-1).

In addition to being ordinary and necessary (and not lavish or

extravagant), entertainment expenses must be:

(1) "Directly related" to the active conduct of his trade or

business,

(2) "Associated" with the active conduct of his trade or business,

or

(3) Covered by one of the statutory exceptions.

Directly Related Test

Entertainment expenses are deductible if they are "directly

related" to the active conduct of the taxpayer's trade or business. An entertainment expenditure meets the "directly

related" test, if:

(1) Taxpayer had more than a general expectation of

deriving income or some other specific benefit (other than the

goodwill of the person entertained) at some future time,

(2) Taxpayer did engage in business during the

entertainment period with the person being entertained, and

(3) The principal character or aspect of the combined

business and entertainment was the transaction of business.

A showing that business income or other business benefit

actually resulted from each and every entertainment expenditure is not required.

Clear Business Setting Presumption

Entertainment occurring in a clear business setting is

presumed directly related to the conduct of a trade or business (Reg. §1.274-2(c)(4)). Examples of clear business

settings are:

(a) A "hospitality room" at a convention where business

goodwill is created through the display or discussion of business products, and

(b) Entertainment occurring under circumstances where there is no meaningful personal or social relationship

between the taxpayer and the persons entertained.

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Circumstances that are presumed to lack a clear business

setting are:

(a) Situations where the taxpayer is not present,

(b) Night clubs, theaters, sporting events, or essentially social gatherings such as cocktail parties, or

(c) Where the taxpayer meets with a group that includes persons who aren't business associates at places such as

cocktail lounges, country clubs, golf clubs, athletic clubs, or at vacation resorts (Reg. §1.274-2(c)(7)).

Associated Test

Entertainment expenses which do not meet the "directly related"

test but which are "associated" with a clear business purpose of the taxpayer's trade or business are deductible when the

entertainment directly "precedes or follows" a substantial and bona fide business discussion (R.R. 63-144). Under this rule,

business entertainment at nightclubs, theaters, sporting events, hunting, or fishing trips can be deductible (R.R. 63-144).

Substantial Business Discussion

The existence of a substantial business discussion depends on

all the facts and circumstances of each case. While it must be shown that the taxpayer or his representative actively

engaged in a discussion, meeting, negotiation, or other bona fide business transaction to obtain some specific business

benefit, it is not necessary to establish that:

(a) The meeting be for any specific length of time,

provided the business discussion was substantial in relation

to the entertainment,

(b) More time be devoted to business than entertainment,

or

(c) Business was discussed during the entertainment

period (Reg. §1.274-2(d)(3)(i); R.R. 63-144, Q & A 35).

Timing

Entertainment occurring on the same day as the business discussion is automatically considered as directly preceding or

following the business discussion. But if they do not occur on the same day, the facts and circumstances of each case must

be considered to see if the rule is met (Reg. §1.274-2(d)(3)).

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Note: Amazingly, some courts have held that business

discussions "during" the entertainment do not qualify (St.

Petersburg Bank & Trust Co. v. U.S., 326 F. Supp 674, aff'd 503

F. 2d 1402).

Conventions

Meetings at conventions or similar general assemblies or at

trade or business shows sponsored and conducted by

business and professional organizations are considered substantial business discussions when officially scheduled by

the sponsoring organization (Reg. §1.274-2(d)(3)(i)).

Statutory Exceptions

A third method for entertainment expenses to qualify as a deduction is to come under one of the nine exceptions contained

in §274(e)(1)-(9):

Food and Beverages for Employees

Expenses for food or beverages furnished on the taxpayer's

business premises for employees are deductible (§274(e)(1)).

Also deductible is the cost of maintaining the facilities for furnishing the food and beverages (Reg. §1.274-2(f)(2)(ii)).

Expenses Treated as Compensation

An employer may furnish an employee with goods, services,

and the use of a facility or an allowance that might generally constitute entertainment. These costs are deductible if the

employer includes such items as compensation to the employee and withholds income tax for this compensation

(§274(e)(2)). However, such compensation when added to the employee's other compensation still must be reasonable

(Reg. §1.274-2(f)(2)(iii)).

Reimbursed Expenses

Expenses paid by the taxpayer under a reimbursement or other expense allowance arrangement in connection with the

performance of services is deductible (§274(e)(3)). If such person "adequately accounts" for such expenses, taxpayer is

not required to satisfy either the "directly related" or "associated" test.

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Recreational Expenses for Employees

The expense of providing recreational, social, or similar

activities primarily for the benefit of taxpayer's employees is deductible as is the expense of using a facility for

recreational, social, or similar activities (§274(e)(4)).

Note: Officers, shareholders, or other owners, or highly

compensated employees are not considered employees for

purposes of this exception. A person is a shareholder or other

owner, only if he and his family hold a 10% or more interest in

the business (Reg. §1.274-2(f)(2)(v)).

Employee, Stockholder and Business Meetings

Expenses directly related to business meetings of a firm's

employees, partners, stockholders, agents, or directors are deductible (§274(e)(5). Minor social activities may be

provided. However, the expense is not deductible if the primary purpose of the meeting was social (Reg. §1.274-

2(f)(2)(vi)).

Trade Association Meetings

Expenses directly related to business meetings or conventions of exempt organizations such as business leagues, chambers

of commerce, real estate boards, trade associations and professional associations are deductible (§274(e)(6) and Reg.

§1.274-2(f)(2)(vii)).

Items Available to Public

A taxpayer may deduct the ordinary and necessary cost of providing entertainment or recreational facilities to the

general public as a means of advertising or promoting good will in the community (§274(e)(7)).

Entertainment Sold to Customers

Entertainment expense rules do not apply to the expense of

providing entertainment, goods and services, or use of facilities, which are sold to the public in a bona fide

transaction for adequate and full consideration (§274(e)(8).

Expenses Includible in Income of Non-employees

Expenses includible in the income of persons who are not employees are deductible (§274(e)(9)).

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Quiet Business Meals & Drinks

Prior to the TRA '86, quiet business meals were the tenth

statutory exception under §274(e). The §274(e)(1) exception for business meals was repealed. Effective for taxable years

beginning after December 31, 1986, §274(k) applies to the cost of all business meals. Under this provision, business meals are

deductible only if:

(1) "Directly related to" or "associated with" the active

conduct of a trade or business,

(2) Not lavish or extravagant under the circumstances, and

(3) Taxpayer (or an employee) is present at the meal.

Taxpayer's (or Employee) Presence

For purposes of deducting meal expenses, the "associated with" or "directly related to" requirement (applying to any

business meal other than one consumed alone by an individual who is away from home in the pursuit of a trade or

business) is not met if neither the taxpayer nor any employee

or agent of the taxpayer is present at the meal (§162(k)(3)).

Section 212 Meals Not Deductible

As a result of this new standard, the cost of a meal is not

deductible if it serves non-business purposes of the taxpayer

(e.g., investment purposes). Prior law would have potentially allowed a deduction under §212 rather than §162.

Home Entertainment

Entertaining customers or clients at the taxpayer's home can be an ordinary and necessary expense. However, only the additional

costs incurred because of their presence is deductible. Failure to

show a business purpose for entertaining at home bars a deduction (Denny, 33 BTA 738; Henricks, TC Memo 11/8/49, 8

TCM 993). Moreover, the mere fact that the guests entertained were present or potential customers or clients will not be

sufficient to allow the deduction (Ryman, Jr., 51 TC 799).

Ticket Purchases

A deduction (if otherwise allowable) for the cost of a ticket to an

entertainment activity is limited (prior to other limitations) to the face value of the ticket (§274(1)). The face value of a ticket

includes any amount of ticket tax on the ticket.

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Exception for Charitable Sports Events

The face value limitation does not apply to a charitable sports

event (§274(1)(1)(B)). However, for the full amount paid for the ticket to be an allowable entertainment deduction, the event

must:

(1) Be organized for the primary purpose of benefiting a tax-

exempt charitable organization (See §501(c)(3)),

(2) Contribute 100% of the net proceeds to the charity, and

(3) Use volunteers for substantially all work performed in carrying out the event.

Comment: According to the Committee Report, this exception

applies to the cost of a ticket package (i.e., the amount paid

both for seating at the event, and for related services such as

parking, use of entertainment areas, contestant positions, and

meals furnished at and as part of the event).

Special Limitation for Skyboxes

A special deduction limit is placed on expenses for luxury "skyboxes" at sporting events. If a skybox or other private

luxury box is leased for more than one event, the amount

allowable as a deduction is limited to the face value of non-luxury box seat tickets (§274(1)(2)(A)). The allowable amount is

then reduced by 50% to determine the amount that can be deducted (§274(n)).

Note: There must be a lease for more than one event, for the

skybox rule to apply. However, two or more related leases are

treated as one (§274(1)(2)(A)).

Percentage Reduction for Meals & Entertainment

Deductions for meals and entertainment are reduced by 50%.

Specifically, this reduction applies to any expense for food or

beverages, and any cost for an entertainment activity (§274(n)(1)). The percentage reduction is applied to the amount "allowable" as a

deduction (§274(n)(1)).

Note: Travel and transportation expenses are not affected by

this reduction rule, only meals (including meals while in travel

status) and entertainment.

Related Expenses

The percentage reduction rule also applies to related expenses,

for example, taxes and tips relating to a meal or entertainment

activity. Thus, expenses such as cover charges for admission to

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a night cub, the amount paid for a room which the taxpayer

rents for a dinner or cocktail party, or the amount paid for parking at a sports arena, are deductible only to the extent of

50%.

Application of Reduction Rule

The percentage deduction rule is applied after determining the

amount of the allowable deduction under §162 and §274.

However, in the case of a separately stated meal or entertainment cost incurred in the course of luxury water travel,

the percentage disallowance rule is applied prior to application of the limitation on luxury water travel expenses.

Exceptions

There are eight exceptions provided to the percentage reduction

rule. Most relate to §274(e), and the others are provided in §274(n)(2)(B),(C), and (D). The first six listed below are both

"directly related" to a trade or business and not subject to reduction.

The 50% limitation does not apply to the following:

(1) Expenses treated as compensation (§274(e)(2) and

§274(n)(2)(A)),

(2) Reimbursed expenses (§274(e)(3) and §274(n)(2)(A)),

Note: However, the 50% limitation will apply to the person

making the reimbursement (S Rept No. 99-313 (PL 99-514) p.

71),

(3) Recreational expenses for employees (§274(e)(4) and

§274(n)(2)(A)),

(4) Items available to the public (§274(e)(7) and

§274(n)(2)(A)),

(5) Entertainment sold to customers (§274(e)(8) and

§274(n)(2)(A)),

(6) Expenses includible in income of persons who are not

employees (§274(e)(9) and §274(n)(2)(A)),

(7) Food or beverage excludable from the gross income

under the de minimis fringe benefit rules of §132 (§274(n)(2)(B)), and

(8) A charitable sporting event ticket package (§274(n)(2)(C)).

Note: For such costs to be fully deductible, the event must be

organized for the primary purposes of benefiting a tax-exempt

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charitable organization, contribute 100% of the net proceeds to

the charity, and use volunteers for substantially all work

performed in carrying out the event (§274(1)(1)(B)).

2% Floor on Employee Business Expenses

Section 67 places a 2% floor on miscellaneous itemized deductions. In other words, expenses that fall within this category are

deductible only to the extent that, in the aggregate, they exceed 2% of adjusted gross income (AGI). When miscellaneous itemized

deductions are nondeductible because they don't exceed 2% of AGI, they are lost. There is no carryover.

Miscellaneous Itemized Deductions

The miscellaneous itemized deductions are a particular category

of itemized deductions. Itemized deductions are all allowable deductions other than the deductions allowable in arriving at

adjusted gross income and the deduction for personal exemptions.

Miscellaneous itemized deductions include:

(a) Unreimbursed employee business expenses, including

union and professional dues and office-at-home expenses to the extent deductible;

(b) Expenses related to investment income or property, such

as investment counsel or advisory fees;

(c) Tax return preparation costs and related expenses (Conf

Rept p. II-2); and

(d) Appraisal fees paid to determine the amount of a casualty

loss or a charitable contribution of property.

Note: To the extent that an employee incurs business expenses

for which he is not reimbursed, he may lose part of his

deduction. Employers who don't directly reimburse their

employees for employee business expenses should consider

changing the policy.

Miscellaneous itemized deductions do not include:

(a) The medical deduction under §213;

(b) The deduction for taxes under §164;

(c) The deduction for interest under §163;

(d) The charitable contribution deduction under §170;

(e) Casualty losses deductible under §165;

(f) Gambling losses under §165;

(g) Moving expenses under §217;

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(h) Impairment-related work expenses;

(i) The deduction for estate tax in the case of income in respect of a decedent, under §691;

(j) Any deduction allowable in connection with personal property used in a short sale;

(k) The deduction under §1341 where a taxpayer restores amounts held under a claim of right;

(l) The deduction under §72 where annuity payments cease before investment is recovered;

(m) The deduction for amortizable bond premium under §171; and

(n) Deductions under §216 in connection with co-op housing corporations (§67(b)).

Entertainment Facilities

Deduction for amounts paid or incurred in connection with an "entertainment facility" are generally disallowed (§274(a)(1)(B)).

An "entertainment facility" is one used in connection with an entertainment, amusement, or recreation activity (§274(a)(1)). The

term includes such items as a yacht, hunting lodge, fishing camp, swimming pool, tennis court, bowling alley, motorcar, airplane,

apartment, hotel suite, or a house in a vacation resort.

Exceptions

However, for purposes of disallowance, an entertainment facility, for purposes of the disallowance rules does not include:

(1) Facilities located on the taxpayer's business premises and used in connection with furnishing food and beverages for

employees,

(2) Recreational facilities for employees,

(3) Facilities, the expenses of which are treated as employee

compensation,

(4) Facilities made available to the general public, and

(5) Facilities used in taxpayer's trade or business of selling such facilities or entertainment (Reg. §1.274-2(e)(2); S.

Rept. PL 95-600, 11/6/78, p. 173).

Covered Expenses

Entertainment facility expenses subject to disallowance include depreciation and operating costs, such as rent, and utility

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charges for water and electricity, expenses for maintenance,

preservation, or protection of a facility (for example, repairs, painting, and insurance charges), and salaries or subsistence

expenses paid to caretakers or watchmen (Reg. §1.274-2(e)(3)(i)).

However, the following costs (even though incurred in connection with an entertainment facility) are not subject to the

entertainment facility rules:

(1) Interest, taxes, and casualty losses on entertainment

facilities are deductible as ordinary interest, taxes, or casualty losses,

(2) Out-of-pocket expenses for such items as food and beverages or expenses of catering, gasoline, and fishing bait,

furnished during entertainment at a facility which are subject to the entertainment rules,

(3) Actual business use of a facility, such as using a plane or

car for business transportation or chartering a yacht to an unrelated person, and

(4) Cost of box seats or season tickets to theaters or sporting events must be allocated to the separate amusement events.

Disallowed entertainment facility expenses are considered personal or family assets and not business assets. Thus, the

depreciation deduction and the investment credit on such facilities are barred (Conf Rept, PL 95-600, 11/6/78, p. 249).

Club Dues

Formerly, §274(a)(2) provided an exception to the

entertainment facility rule and allowed deductions for expenditures:

(1) In connection with social, athletic, sporting and other clubs,

(2) Where the taxpayer established that the facility was used primarily for trade or business, and

(3) The expense was directly related to the conduct of such trade or business.

The taxpayer had to use the club more than 50% for business purposes and only that portion of his dues allocable to

entertainment that was "directly related" to the active conduct of

his business was deductible after application of the percentage reduction rule.

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OBRA '93

OBRA '93 allows no deduction for club dues for membership in

any club organized for business, pleasure, recreation, or any other social purpose for taxable year beginning after

December 31, 1993. This rule applies to all types of clubs, including business, social, athletic, luncheon, and sporting

clubs. Specific business expenses (e.g., meals) incurred at a club are still deductible but only to the extent they otherwise

satisfy the standards for deductibility.

Sales Incentive Awards

An employer who entertains an employee or permits him to use an entertainment facility will generally not be allowed to deduct

the expenditure unless he treats the amount as compensation paid to the employee and withholds tax on the payments. If this

isn't done, the entertainment can't be deducted unless it meets the "directly related" or "associated with" tests, or one of the

specific exceptions of §274 (§274(e)(2); §274(e)(3), before

redesignation by §142(a)(2)(A), PL 99-514, 10/22/86; Reg. §1.274-2(f)(2)(iii)). Thus, if an employer rewards an employee

and his wife by giving them an expense paid vacation, the employer will not get a deduction unless that amount is added to

compensation and taxes are withheld (Reg. §1.274-2(f)(2)(iii)).

Substantiation & Record Keeping

The most important requirement in sustaining entertainment

deductions is to keep adequate and detailed records. The three basic sections, 162, 212, and 274, all require record keeping.

However, §274(d) requires thorough documentation to support deductions for the following items:

(1) Travel;

(2) Entertainment;

(3) Entertainment facilities;

(4) Business gifts; and

(5) Foreign conventions.

Documentation

In general, a diary and record of receipts is the best method of satisfying these substantiation requirements. A receipt is

required for every expenditure above $75. The documentation must normally include the:

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(1) Amount of the expenditure,

(2) Date, time, and place incurred,

(3) Business purpose, and

(4) Business relationship.

Contemporaneous Records

The Tax Reform Act of 1984 had contained a contemporaneous record rule for not only autos but for entertainment expenses as

well. However, in May of 1985 Congress, under tremendous public pressure, repealed the contemporaneous record rule and

now requires the taxpayer to keep "adequate records or sufficient evidence corroborating their own statements."

In general, the substantiation and documentation requirements fall on the taxpayer who claims the deduction. However, the

employee's accounting of reimbursed expenses to his employer will shift this burden to the employer (See Reg. §1.274-5(e)).

Payback Agreements

The disallowance of travel and entertainment expenses (and also

unreasonable compensation) can result in a double disallowance for employee/shareholders. When such company expenses are

disallowed the company is not only denied a deduction but the executive can have dividend income. One possible solution is a

payback agreement requiring the executive to return any reimbursement that is later disallowed as a company deduction.

The executive deducts the repayment provided the agreement was binding at the time of the reimbursement.

Employee Expense Reimbursement & Reporting

The TRA '86 changed the deductibility of business expenses incurred by employees. Since 1987, all unreimbursed employee

business expenses are only deductible as miscellaneous itemized deductions - a "below-the-line" deduction. Miscellaneous itemized

deductions are subject to §67 and can only be deducted to the extent (together with all other miscellaneous itemized deductions)

they exceed 2% of adjusted gross income (AGI).

However, reimbursed employee business expenses could be claimed as an "above-the-line" deduction exempt from the 2% limit. This

was accomplished by permitting employees who received expense allowances to net expenses and reimbursements without first

reducing the expenses by the 2% of AGI limit. Only excess

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expenses became itemized deductions; excess reimbursement

constituted ordinary income.

Family Support Act of 1988

Beginning in 1989, the Family Support Act of 1988 severely

limited above-the-line deduction treatment for employee travel expenses. Under the Act, employees who are not required to

account for the expense reimbursements received must include

these amounts in income. Expenses are then only taken as itemized deductions subject to the 2% AGI limit. In addition,

employers must withhold income taxes on reimbursements without regard to any expenses that the employee may have.

The Family Support Act also gave the Service authority to impose FICA and FUTA taxes on unaccounted expense

reimbursements.

Remaining Above-The-Line Deductions

Effective January 1, 1989, employees can only claim above-the-line deductions for business expenses when the expenses are

actually substantiated (under §274(d)) to the person providing the reimbursement under a reimbursement or other expense

allowance arrangement that qualifies as an "accountable plan."

A reimbursement or other expense allowance arrangement is a

system or plan that an employer uses to pay, substantiate, and recover the expenses, advances, reimbursements, and amounts

charged to the employer for employee business expenses. Arrangements can include per diem and mileage allowances.

They can also be a system used to keep track of amounts

received from an employer's agent or a third party (Reg. §1.62-2(c)).

Reimbursements treated as paid under an accountable plan are not reported as compensation. Reimbursements treated as paid

under nonaccountable plans are reported as compensation.

Accountable Plans

To be an accountable plan, the employer's reimbursement or allowance arrangement must meet all three of the following

rules:

(a) Expenses must have a business connection (i.e., the

employee must have paid or incurred deductible expenses while performing services for the employer and the

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advance must reasonably relate to anticipated business

expenses),

(b) Employees must adequately account to the employer

(under §162 & §274) for these expenses within a reasonable period of time, and

(c) Employees must return any excess reimbursement or allowance within a reasonable period of time (§62(a)(2);

Reg. §1.62-2(c)).

If all these rules are met, the employer does not include any

reimbursements in the employee's income (Box 10, Form W-2). If expenses equal reimbursement, the employee does not

complete the Form 2106 since there is no deduction for the employee (Reg. §1.62-2(c)(4); Reg. 1.3231(e)-3(a)).

Reasonable Period of Time

The definition of "reasonable period of time" depends on

the facts. However, the regulations create two "safe harbors."

Fixed Date Safe Harbor

The Service considers it reasonable to:

(i) Receive an advance within 30 days of when the employee has an expense,

(ii) Adequately account for expenses within 60 days after they were paid or incurred, and

(iii) Return any excess reimbursement within 120 days after the expense was paid or incurred (Reg. §1.62-

2(g)(1); Reg. §1.62-2(g)(2)(i)).

Period Statement Safe Harbor

If an employer provides employees with periodic statements (no less frequently than quarterly) stating the

amount, if any, paid under the arrangement in excess of

the expenses the employee has substantiated, and requesting the employee to substantiate any additional

business expenses that have not yet been substantiated (whether or not such expenses relate to the expenses

with respect to which the original advance was paid) and/or to return any amounts remaining unsubstantiated

within 120 days of the statement, an expense substantiated or an amount returned within that period

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will be treated as being substantiated or returned within a

reasonable period of time (Reg. §1.62-2(g)(2)(ii)).

Adequate Accounting

Employees adequately account by giving the employer

documentary evidence of travel and other employee business expenses, along with a statement of expense, an

account book, a diary, or a similar record in which the

employee entered each expense at or near the time they made it. Documentary evidence includes receipts, canceled

checks, and bills (Reg. §1.274-5T(f)(4)).

Per Diem Allowance Arrangements

A per diem allowance satisfies the adequate accounting requirements as to amount if:

(a) The employer reasonably limits payments of the travel expenses to those that are ordinary and

necessary in the conduct of the trade or business,

(b) The allowance is similar in form to and not more

than the federal rate,

(c) The employee is not related (as defined under the

rules applicable to the standard per diem meal allowance) to the employer, and

(d) The time, place, and business purpose of the travel are proved (Reg. §1.62-2(c)(1); Reg. §1.62-2(e); Reg.

§1.274-5T(g); R.P. 2011-47).

Note: A receipt for lodging expenses is not required

in order to apply the Federal per diem rate for the

locality of travel (R.P. 2011-47).

If the IRS finds that an employer's travel allowance practices are not based on reasonably accurate estimates

of travel costs, including recognition of cost differences in different areas, the employee is not considered to have

accounted to the employer, and the employee may be required to prove their expenses (Reg. §1.274-

5T(f)(5)(iii)).

Federal Per Diem Rate

The federal per diem rate can be figured by using any one of three methods:

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(1) The regular federal per diem rate (for combined

lodging, meals, and incidental expenses),

Note: The term "'incidental expenses" includes, but is

not limited to, expenses for laundry, cleaning, and

pressing clothing, and fees and tips for services, such

as for waiters and baggage handlers. The term does

not include taxicab fares or the costs of telegrams or

telephone calls (R.P. 2011-47).

(2) The meals only (or standard meal) allowance (for

meals and incidental expenses only), or

(3) The high-low method (for combined lodging,

meals, and incidental expenses or lodging only).

The regular federal per diem rate and the standard

meal allowance are often grouped together and called the "standard" system. The high-low method is

sometimes referred to as the "simplified" system.

Method #1- Regular Federal Per Diem Rate

The regular federal per diem rate is the highest amount that the federal government will pay to its

employees for lodging, meal, and incidental expenses while they are traveling (away from home) in a

particular area. This rate is equal to the sum of the Federal lodging expense rate and the Federal meal

and incidental expenses (M&IE) rate for the locality of travel.

The rates are different for different locations:

(i) Continental United States: Federal rates

applicable to a particular locality in the continental

United States ("CONUS") are published annually by the General Services Administration.

(ii) Outside the Continental United States: Rates for a particular nonforeign locality outside the

continental United States ("OCONUS") (including Alaska, Hawaii, Puerto Rico, the Northern Mariana

Islands, and the possessions of the United States) are established by the Secretary of Defense and

reprinted by various tax services.

(iii) Foreign Travel: These rates are published once

a month by the Secretary of State.

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The rate in effect for the area where the employee

stops for sleep or rest must be used. IRS Publication 1542 gives the rates in the continental United States.

Method #2 - Meals Only (or Standard Meal) Allowance

The M&IE portion of the regular Federal per diem rate

can be used by itself as a per diem allowance solely

for meals and incidental expenses (Reg. §1.274-5(h); Temp Reg. §1.274-5T(j)). This is often referred to as

the "standard meal allowance" or "meals only per diem allowance." This method replaces the actual cost

method.

Under this method, when a payor pays a per diem

allowance solely for meal and incidental expenses in lieu of reimbursing actual expenses for such expenses

incurred by an employee for travel away from home, the daily expenses deemed substantiated is an

amount equal to the Federal M&IE rate for the locality of travel for such day.

A per diem allowance is treated as paid solely for meal and incidental expenses if:

(1) The payor pays the employee for actual

expenses for lodging based on receipts submitted to the payor,

(2) The payor provides the lodging in kind,

(3) The payor pays the actual expenses for lodging

directly to the provider of the lodging,

(4) The payor does not have a reasonable belief

that lodging expenses were or will be incurred by the employee, or

(5) The allowance is computed on a basis similar to that used in computing the employee's wages or

other compensation (e.g., the number of hours worked, miles traveled, or pieces produced) R.P.

2011-47.

Note: Per diem amounts are deductible without the

need to substantiate actual amounts. However, the

elements of time, place, and business purpose must

still be substantiated.

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Meal Only Deduction by Employees & Self-

Employed

In lieu of using actual expenses, employees and

self-employed individuals, in computing the amount allowable as a deduction for ordinary and necessary

meal and incidental expenses paid or incurred for travel away from home, may use the Federal M&IE

rate for the locality of travel for each calendar day (or part thereof) they are away from home (R.P.

2011-47).

Note: If the taxpayer is not reimbursed for meal

expenses, they can deduct only 50% of the standard

meal allowance. This 50% limit is figured on Form

2106 or Schedule C (§274(n); R.P. 2011-47).

Transportation Workers' Special Rate

Workers in the transportation industry can use a

special standard meal allowance. A taxpayer is in the transportation industry only if their work:

(1) Directly involves moving people or goods by airplane, barge, bus, ship, train, or truck, and

(2) Regularly requires the taxpayer to travel away

from home which, during any single trip away from home, usually involves travel to localities

with differing Federal M&IE rates.

Eligible workers can claim a $59 a day standard

meal allowance for any locality of travel in CONUS and/or $65 for any locality of travel in OCONUS. If

the special rate is used for any trip, the regular standard meal allowance is not permitted for any

other trips that year (R.P. 2011-47, Sec. 4.04).

Limitations

The standard meal allowance cannot be used to prove the amount of meals while traveling for

medical, charitable, or moving purposes. It can be used when traveling for investment reasons and to

prove meal expenses incurred in connection with

qualifying educational expenses while traveling away from home (§162; §212; §274(d); Reg.

§1.1625).

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Method #3 - High-Low Method

If a payor pays a per diem allowance in lieu of

reimbursing actual expenses for lodging, meal, and incidental expenses incurred by an employee for

travel away from home and the payor uses the high-low substantiation method for travel within CONUS,

the expenses deemed substantiated for each day (or part of the day) are equal to a "high" or "low" rate

depending on the locality of travel for such day.

Note: The high-low substantiation method might be

used in lieu of the regular federal per diem rate, but

not the meals only (or standard meal) allowance (R.P.

2011-47).

This is a simplified method of computing the federal per diem rate for travel within the continental United

States ("CONUS"). Called the "high-low method," it

eliminates the need to keep a current list of the per diem rate in effect for each city in the U.S.

From October 1, 2012 until September 30, 2013, the combined lodging, meals and incidental expense

"high" rate is $242 per day ($177 for lodging only) and $163 per day ($111 for lodging only) for all other

locations (R.P. 2010-39, R.P. 2011-47, Sec. 5.02 & Notice 2012-63). For purposes of applying the high-

low substantiation method, the Federal M&IE rate is treated as $65 for a high-cost locality and $52 for any

other locality within CONUS.

Note: Under R.P. 2010-39 & R.P. 2011-47, some areas

are treated as high-cost localities on only a seasonal

basis.

A payor that uses this method with respect to an employee has to use that method for all amounts paid

to that employee during the calendar year.

Note: In July of 2011, the IRS announced its intent

to discontinue the high-low method (Ann. 2011-42).

However, a number of taxpayers asked the IRS to

retain it and, accordingly, R.P. 2011-47, Sec. 5

continues to authorize it.

Related Employer

A taxpayer cannot use the Federal per diem rate, if they

are related to their employer (§267(b)(2); Reg. §1.274-

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5T(f)(5)(ii); R.P. 2011-47). A taxpayer is related to

their employer if:

(1) The employer is their brother or sister, half-

brother or half-sister, spouse, ancestor, or lineal descendent (§267(c)(4)),

(2) The employer is a corporation in which the taxpayer owns, directly or indirectly, more than 10%

in value of the outstanding stock (Reg. §1.2745T(f)(5)(ii)), or

Note: A taxpayer may be considered to indirectly

own stock, if they have an interest in a corporation,

partnership, estate, or trust that owns the stock or if

a family member or partner owns the stock.

(3) Certain fiduciary relationships exist between the

taxpayer and the employer involving grantors, trusts, beneficiaries, etc. (§267(b)).

Meal Break Out

When any per diem allowance is paid for combined

lodging, meal, and incidental expenses (M&IE), the employer must treat an amount equal to the standard

meal allowance for the locality of travel as an expense for food and beverage (R.P. 2011-47). Thus, the payor

is subject to the 50% limitation on meal and entertainment expenses.

If the per diem allowance is paid at a rate that is less than the federal per diem rate, the payor may treat

40% of the allowance as the M&IE rate (R.P. 2011-47).

Partial Days of Travel

Prorations are required on the Federal per diem rate and the Federal M&IE rate if the employee travels less

than 24 hours of any day:

(i) When employees are in a "travel mode" for less than 24 hours on any particular day, the per diem

rates must be prorated using any method that is consistently applied in accordance with reasonable

business practice (e.g., a 9 to 5 may be deemed a full day); or

(ii) The employer may use the Federal travel regulations and prorate total allowance over 6-hour

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segments allowing 1/4 of the standard meal allowance

for each segment (R.P. 2011-47).

Usage & Consistency

The per diem method used is made on an employee-by-

employee basis. The employer must be consistent in the method used for each employee during the calendar

year.

Unproven or Unspent Per Diem Allowances

An employer's reimbursement arrangement is considered an accountable plan even if the employee

does not return the amount of an unspent per diem

allowance to the employer as long as the employee proves that they did travel that day. This is an

accountable plan because the amount (up to the amount computed under the regular per diem rate or

high-low method) of the allowance is considered proven.

The employer includes as income in the employee's Form W-2 the unspent or unproven amount of per diem

allowance as excess reimbursement. This unspent or unproven amount is considered paid under a

nonaccountable plan (R.P. 2011-47).

Travel Advance

If the employer provides the employee with an expense allowance before they actually have the expense, and

the allowance is reasonably calculated not to exceed expected expenses, this is referred to as a travel

advance.

Under an accountable plan, an employee must

adequately account to their employer for this advance and be required to return any excess within a

reasonable period of time. If the employee does not

adequately account or does not return any excess advance within a reasonable period of time, the

unaccounted for or unreturned amount will be treated as having been paid under a nonaccountable plan (Reg.

§1.62-2(c)(3)(ii); Reg. §1.62-2(f)(1); Reg. §1.62-2(g)(2)).

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Reporting Per Diem Allowances

If an employee is reimbursed by a per diem allowance

(daily amount) received under an accountable plan, two facts affect reporting:

(i) The federal rate for the area where the employee traveled, and

(ii) Whether the allowance or the employee's actual expenses were more than the federal rate.

Reimbursement Not More Than Federal Rate

If the per diem allowance is less than or equal to the

federal rate, the allowance will not be included in boxes 1, 3, and 5 of the employee's Form W-2.

The employee does not need to report the related expenses or the per diem allowance on their return if the

expenses are equal to or less than the allowance. They do not complete Form 2106 or claim any of the expenses on

the Form 1040.

Reimbursement More Than Federal Rate

If an employee's per diem allowance is more than the federal rate, the employer is required to include the

allowance amount up to the federal rate in box 13 (code

L) of the employee's Form W-2. This amount is not taxable.

However, the per diem allowance in excess of the federal rate will be included in box 1 (and in boxes 3 and 5 if

applicable) of the employee's Form W-2. The employee must report this part of the allowance as if it were wage

income. The employee is not required to return it to their employer (§3121; Reg. §1.62-2(e)(2)).

If allowance or advance is higher than the federal rate for the area traveled to, the employee does not have to

return the difference between the two rates for the period the employee can prove business-related travel expenses.

However, the difference will be reported as wages on Form W-2 (Reg. §1.62-2(f)).

When the actual expenses are more than the federal rate,

the employee should complete Form 2106 and deduct those expenses that are more than the federal rate on

Schedule A (Form 1040). The employee must report on

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Form 2106 reimbursements up to the federal rate as

shown in box 17 of their Form W-2 and all their expenses (Reg. §1.62-2(c)(2); Reg. §1.62-2(c)(5); Reg. §1.62-

2(e)(2); R.P. 90-60).

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Reporting & Reimbursements Chart from Publication 463 (Rev.

'11)

IF you have expenses

for...

THEN you can deduct the cost of...

transportation travel by airplane, train, bus, or car between your home and your business destination. If

you were provided with a ticket or you are riding free as a result of a frequent traveler or

similar program, your cost is zero. If you travel by ship, see Luxury Water Travel and

Cruise Ships (under Conventions) for additional rules and limits.

taxi,

commuter bus, and

airport limousine

fares for these and other types of

transportation that take you between: • The airport or station and your hotel, and • The

hotel and the work location of your customers or clients, your business meeting place, or

your temporary work location.

baggage and

shipping

sending baggage and sample or display

material between your regular and temporary

work locations.

car operating and maintaining your car when

traveling away from home on business. You can deduct actual expenses or the standard

mileage rate, as well as business-related tolls and parking. If you rent a car while away

from home on business, you can deduct only the business-use portion of the expenses.

lodging and

meals

your lodging and meals if your business trip is

overnight or long enough that you need to stop for sleep or rest to properly perform your

duties. Meals include amounts spent for food, beverages, taxes, and related tips. See Meals

for additional rules and limits.

cleaning dry cleaning and laundry.

telephone business calls while on your business trip. This

includes business communication by fax machine or other communication devices.

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tips tips you pay for any expenses in this chart.

other other similar ordinary and necessary expenses related to your business travel. These

expenses might include transportation to or from a business meal, public stenographer's

fees, computer rental fees, and operating and maintaining a house trailer.

Nonaccountable Plans

A nonaccountable plan is a reimbursement or expense allowance arrangement that does not meet the three rules

listed earlier under the discussion of accountable plans.

In addition, the following payments made under an

accountable plan will be treated as being paid under a

nonaccountable plan:

(1) Excess reimbursements the employee fails to return

to the employer (Reg. §1.62-2(c)(2)(ii)), and

(2) Reimbursement of nondeductible expenses related to

the employer's business (Reg. §1.62-2(d)(2)).

An arrangement that repays the employee for business

expenses by reducing their wages, salary, or other compensation will be treated as a nonaccountable plan

because the employee is entitled to receive the full amount of their compensation regardless of whether they incurred

any business expenses (Reg. §1.62-2(d)(3)(i)).

Reimbursements from nonaccountable plans produce

taxable income for the employee. All advances and reimbursement from nonaccountable plans must be

included on the employee's W-2 in Box 10 (and boxes 12

and 14 if applicable).

The employee must then complete Form 2106 and itemize

their deductions on Schedule A (Form 1040) to deduct expenses for travel, transportation, meals, or

entertainment. Meal and entertainment expenses will be subject to the 50% limit and the 2% of adjusted gross

income limit which applies to most miscellaneous itemized deductions (§62(c); Reg. §1.62-2(c)(5)).

Employers must withhold (optional withholding method is available) on the advances and/or reimbursements. They

6 - 4 2

are subject to FUTA and FICA (noncompliance penalty is

placed on employer).

Non-Reimbursed Employee Expenses

If the taxpayer is an employee and has travel, entertainment, and gift expenses related to the employer's business or his/her work,

they may or may not be able to deduct these on their tax return depending on a number of factors.

If they are not reimbursed for the travel, entertainment, or gift

expenses required by their job, they must complete the Form 2106 to claim a deduction. The employee must itemize deductions to

claim these expenses and keep records and supporting evidence to prove his expenses.

If the employee does receive reimbursement or an allowance for such expenses, they must generally include these payments on

their tax return, unless he satisfies certain rules (e.g., adequate accounting to the employer under an accountable plan).

When an Employee Needs to File Form 2106

Form 2106 must be used when an employee's business expenses

either are:

(1) Not reimbursed, or

(2) Exceed the reimbursed amount.

The Form 2106 is attached to Form 1040 to determine the

amount of the unreimbursed employee business expenses subject to the 2% limitation on miscellaneous itemized

deductions.

Note: If the reimbursements are included on line 1 of the Form

1040 (from Form W-2 or Form 1099), the expenses shown on

the Form 2106 are claimed as itemized deductions.

Self-Employed Persons

Expenses Related to Taxpayer's Business

Self-employed persons must report their income and expenses

on Schedule C or C-EZ (Form 1040) if they are a sole proprietor, or on Schedule F (Form 1040) if they are a farmer. Form 2106 or

Form 2106-EZ is not used.

Schedule C should be used to report:

(1) Travel expenses, except meals, on line 24a,

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(2) Meals (actual cost or standard meal allowance) and

entertainment on line 24b,

(3) Business gift expenses on line 27, and

(4) Local business transportation expenses, other than car and truck expenses, on line 27.

Note: If Schedule C-EZ is filed, all business expenses are

reported on line 2

Expenses Incurred on Behalf of a Client & Reimbursed

An important but fine lined difference exists between entertainment and nonentertainment expenses incurred by an

independent contractor for clients that are later reimbursed. In addition, the treatment of entertainment reimbursements also

differs based on whether the independent contractor adequately accounts to the client.

Note: A taxpayer is considered an independent contractor if

they are self-employed and perform services for a customer or

client (Reg. §1.274-5T(h)(1))

Meal & Entertainment Expenses

With Adequate Accounting

If the taxpayer is reimbursed for meal and entertainment

expenses incurred on behalf of a client and adequately accounts to the client for such expenses, the reimbursed

expenses are not included in the independent contractor's income (Reg. §1.274-5(g)(2); Temp Reg. §1.274-

5T(h)(2)).

Since the reimbursement is not counted as income, the

independent contractor is not entitled to take a deduction. In such case, the client or customer may claim a deduction

for the reimbursement and must substantiate each element of any underlying expense (Reg. §1.274-5(g)(4); Temp

Reg. §1.274-5T(h)(4)). However, the client need not prove the reimbursed entertainment expenses directly related to

or were associated with the client's business (§162) to qualify for the deduction.

Without Adequate Accounting

Expenses Related to Contractor's Business: If the

independent contractor does not account to the client, the contractor must include any reimbursements or allowances

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in income and may only deduct entertainment expenses

that are directly related to or associated with his business.

Contractor Gets Deduction: If the expenses are related

to the contractor's business, the contractor and not the client will be entitled to a deduction.

Expenses Related to Client's Business: If the reimbursed entertainment expenses relate to the client's

business and not the contractor's, the contractor still has income but is denied a deduction for reimbursed

entertainment expenses since:

(1) §274(a) provides no deduction for entertainment

shall be allowed unless directly related to or associated with the taxpayer's (i.e., the contractor's) trade or

business, and

(2) The exception of §274(e)(3)(B) does not apply

because there was no adequate accounting to the client.

Client Gets Deduction: In this a case, the client would be entitled to a deduction for the reimbursement, provided

only that he prove the reimbursed entertainment expenses directly related to or were associated with the client's

business (§162). The client would not have to substantiate each element of any expenditure, since the independent

contractor did not adequately account (Temp. Reg. §1.274-5T(h)(4)).

Non-Entertainment Expense Deduction

If a client reimburses a contractor for non-entertainment

expenses covered by §274(d), then:

(1) To the extent the contractor does substantiate the

reimbursed expenses, the reimbursement is not included in his income and he may not take a deduction; or

(2) To the extent the contractor does not substantiate the reimbursed expenses, the reimbursement is included in

income and he may not take a deduction because he failed to substantiate as required by §274(d)).

In neither case does the contractor get a deduction. However, the client may claim a deduction for the reimbursement

without substantiation (Temp. Reg. §1.274-5T(h)(4)) but

must prove the expense was either "directly related to" or "associated with" his business.

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Employers

Travel, entertainment, meals, and business gifts are normal

business expenses of conducting a trade, business, or profession. Such expenses are usually deductible, provided the requirements of

§162 and §274 are met.

When Can an Expense Be Deducted?

Under the cash method of accounting, business expenses are deducted in the tax year they are actually paid, even if they

were incurred in an earlier year. Under the accrual method of accounting, business expenses are deductible when the taxpayer

becomes liable for them, whether or not paid in the same year. All events that set the amount of the liability must have

happened, and the taxpayer must be able to figure the amount of the expense with reasonable accuracy.

Economic Performance Rule

Business expenses are generally not deductible until economic

performance occurs. If the expense is for property or services provided, or for the use of property, economic performance

occurs as the property or services are provided, or as the property is used (§461(h)).

Corporation

A corporation (other than an S corporation) generally deducts its

expenses for business travel, entertainment, and gifts, including amounts it reimburses or allows its employees of these

expenses, on page 1 of Form 1120.

Nondeductible Meals

Employers must report as other compensation on Form W-2 payments made to an employee for nondeductible meals an

employee has on trips that do not require a stop for sleep or rest. These payments must be reported on Form W-2 if these

payments plus the employee's wages total $600 or more in a calendar year. A separate Form W-2 may be used. Withholding is

not required on such meal payments.

Employer Provided Auto

If the employer provides a car to an employee and allows any personal or commuting use of the car, the employer must report

6 - 4 6

the value of this use as compensation in Box 1 of the employee's

Form W-2.

7 - 1

CHAPTER 7

Retirement Plans

Deferred Compensation

Qualified Deferred Compensation

Qualified deferred compensation plans are the most important form

of compensation used to provide retirement and separation from service benefits.

Qualified v. Nonqualified Plans

A qualified deferred compensation plan is a plan that meets specified requirements in order to obtain special tax treatment.

In general, qualified deferred compensation plans must satisfy

the following requirements:

(i) Minimum participation standards under §410,

(ii) Nondiscrimination standards (i.e., the plan cannot discriminate in favor of highly compensated employees) under

§401(a)(4),

(iii) Minimum vesting standards under §411,

(iv) Minimum funding standards (particularly, for defined benefit plans) under §412, and

(v) Specified limits on benefits and contributions under §415.

In addition, reporting and disclosure requirements mandated by

the Employee Retirement Security Act of 1974 (ERISA) have to be met.

Major Benefit

For many employees the retirement plan will be the primary

vehicle in their employer provided benefit program. These plans are expressly approved by the Government and are significant

7 - 2

wealth building devices. Historically, the employer considered

pension plan benefits a ―gift‖ to the employee. Unfortunately, the current thinking of many employees is that such benefits are

a ―right.‖

Current Deduction

Qualified deferred compensation allows the employer to have

a tax deduction every time the employer puts money aside

for the employee‘s retirement. ―Funding‖ the retirement plan through the use of a trust or similar arrangement does this.

Timing of Deductions

A contribution to a qualified plan is generally deductible in the

employer‘s taxable year when paid. However, §404(a)(6)1 provides that an employer is deemed to have made a

contribution to the plan as of its year-end, if the contribution is made on account of such year and is made by the due date

of its tax return including extensions. A special rule is provided for CODAs.

Part of Total Compensation

Corporate contributions to a qualified plan are currently

deductible as an ordinary and necessary business expense. However, keep in mind that benefits will be combined with

salary to arrive at total compensation that must be ―reasonable.‖ In the case of shareholder employees, who are

common in closely held corporations, this could result in IRS questions when substantial benefits are being provided. It

should be pointed out that the reasonableness test must be met even when plan contributions fall within the maximum

limits as set forth in the Code.

Compensation Base

As a general rule, qualified plan benefits or contributions may not be based on imputed salary or non-qualified deferred

compensation arrangements. Therefore, an employee who draws no current salary may not be included in as a participant in a

qualified plan. Similarly, shareholder-employees who elect to reduce their current salaries under non-qualified deferred

1 Se c t i o n 4 0 4 ( h ) ( 1) ( B) p r o v i d e s t h e s a me t r e a t me n t f o r SEPs .

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compensation contracts may suffer the disadvantages of reduced

contribution limits for qualified plan purposes.

Salary Reduction Amounts

Contributions to a money purchase pension plan, however,

may be based on a salary reduction where the reduced amount was used to purchase a tax-deferred annuity for the

employee of a tax-exempt employer. The IRS has also ruled

that the amount of salary reduction under a §401(k) plan may be counted as compensation for purposes of determining

benefits under a defined benefit plan.

For purposes of determining nondiscrimination under

§401(a)(4), an employee‘s compensation is defined as total compensation included in gross income. An employer also has

the option to include in the definition of compensation salary reductions under a §401(k) plan or §125 plan. A qualified

plan may not consider any employee‘s salary in excess of $260,000 (in 2014) for purposes of determining contributions,

benefits, and deductibility of contributions or nondiscrimination requirements. This limit is indexed to the

CPI.

Benefit Planning

Despite the popularity of qualified retirement plans, benefits are rarely planned with any logic. To have sufficient income to meet

one‘s retirement needs requires some long term planning.

In companies where the key employees are also shareholders,

retirement plan contributions are normally tied to the

fluctuations in company profits and the desire to ―zero out‖ or equalize the tax rates between the owners and the company

rather than any systematic plan to satisfy pre-determined retirement needs. In larger companies, little is done to develop

benefits based on what is needed by the retiree. Here most planning focuses on what is competitive. While this might appear

to be a good approach, there is a defect. Employees can always leave for better pay; retirees cannot leave for better benefits.

In either event, needs analysis should concentrate on after tax income and expenses upon retirement adjusted for the new

lifestyle of the retiree. An excellent text for an accountant in the area of planning for retirement needs is the ―Touche Ross Guide

to Personal Financial Management‖ by W. Thomas Porter.

7 - 4

The material is good and the chart and calculation sheets are

superb. Porter indicates that retirement plans are designed to provide only 35 to 40 percent of one‘s retirement income even

when properly structured and funded. The remaining 60 to 65 percent will hardly come from Social Security. Most people do

not realize the importance of investment income to their retirement dreams until they are just a few years away from

retiring.

Corporate Plans

Advantages

For a small closely held company that can operate in the

corporate form, a qualified corporate pension, or profit-sharing plan generally is the best vehicle for deferring income

until retirement. The principal advantages fall into two categories, current and deferred.

Current

The current benefits are:

(1) The employer corporation obtains a current deduction for the amounts paid or accruable to the qualified plan

(§404(a));

(2) The employee does not recognize income currently

on contributions made by his or her employer even

though the benefits may be nonforfeitable and fully vested (§402(a) & §403(a)); and

(3) Employee benefit trust accumulates tax-free (see §501(a).

Deferred

Among the deferred tax advantages are:

(1) Lump-sum distributions from a qualified employee benefit plan are eligible for favorable five (or in some

cases still ten) year income averaging treatment (§402(e)); and

Note: The Small Business Job Protection Act of 1996

repealed 5-year averaging for tax years beginning after

1999.

(2) Certain distributions may be rolled over tax-free into an IRA.

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Disadvantages

There are two principal disadvantages of a qualified corporate

plan:

Employee Costs

For a closely held corporation, it is often the cost to the shareholder-employee of covering rank and file employees.

Generally, the objective of qualified retirement plans of closely held companies is to provide the greatest benefit to

the controlling shareholders/executives.

Comparison with IRAs & Keoghs

Qualified corporate plans permit substantially larger contributions than an IRA. Formerly, corporate plans also

exceeded Keogh plans as well, but effective 1984, such plans are essentially equal in terms of benefits.

As a result of TEFRA (Tax Equity and Fiscal Responsibility Act of 1982) maximum benefits were reduced, the early

retirement age was raised, new rules were enacted for corporate and non-corporate plans, and restrictions were

established for ―top heavy‖ plans.

Basic ERISA Provisions

ERISA consists of four main sections (Titles):

Title I is primarily concerned with all types of retirement and

welfare benefit programs. Health insurance, group insurance, deferred compensation plans, etc. must all be considered

from the standpoint of the Department of Labor regulations. Reporting and disclosure requirements are provided for under

Title I which requires that detailed plan summaries be

provided to all plan participants and beneficiaries. Similarly, any plan amendments must also be reported to the

participants and beneficiaries. All participants must also receive copies of the plan's financial statement from the

annual report, as well as an annual statement of accrued and vested benefits.

Title II covers only qualified retirement plans and tax-deferred annuities, primarily from a federal tax standpoint.

Title III involves jurisdiction, administration, enforcement, and the enrollment of actuaries.

7 - 6

Title IV outlines the requirements for plan termination

insurance. Because of the complexity and length of these provisions (the DOL it seems, feels obligated to equal or

exceed the standards of administrative confusion which have been so competently laid out by the IRS), we will attempt

only to cursorily cover some of the provisions commonly affecting qualified plans.

ERISA Reporting Requirements

ERISA imposes a large paperwork burden in connection with

any qualified retirement plan. This burden includes preparing reports that must be sent to the IRS, plan participants, plan

beneficiaries, the department of Labor, and the Pension Benefit Guaranty Corporation. When a qualified plan is first

installed, the IRS approval of the plan is usually sought.

In addition, the Department of Labor must receive a plan

description when the plan is first installed (plus additional reports every time the plan is amended). Most plans must file

an annual report that includes financial statements (certified by a Certified Public Accountant), schedules, an actuarial

statement (certified by an enrolled actuary), and other information. Participants and beneficiaries are required to

receive a summary plan description and a summary annual

plan report from the plan.

Moreover, participants and beneficiaries are entitled to

receive, on request, statements concerning certain benefit information.

Fiduciary Responsibilities

The fiduciary responsibilities of plan administration are also

detailed by Title I. A federal prudent man investment rule is imposed on fiduciaries and adequate portfolio diversification is

normally required. Any person who exercises any discretionary control or authority over the management of a

plan, or any authority over the management of the plan‘s assets is a fiduciary. Therefore, while plan trustees are clearly

fiduciaries, other not-so-obvious persons may also be so classified by ERISA and, therefore, be liable for losses if they

violate their fiduciary duties. The law defines a ―party-in-interest‖ as an administrator, officer, fiduciary, employer,

trustee, custodian and legal counsel, as well as certain other parties.

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Bonding Requirement

All fiduciaries, except certain banks, must be bonded. The

amount of the bond must not be less than 10% of the amount of funds handled or $1,000, whichever is greater,

or generally, not more than $500,000. Plans covering only partners and their spouses, or a sole shareholder, or a sole

proprietor and spouse, are not subject to the bonding requirements.

Prohibited Transactions

There are also several prohibited transactions which

fiduciaries are forbidden to engage in with party-in-interest. However, the Department of Labor may grant a specific

exemption to any of these prohibited transactions based upon disclosure and proof of the benefit to the plan. These

prohibited transactions are as follows:

(1) A sale, exchange, or lease of property between the

plan and a party-in-interest;

(2) A loan or other extension of credit between the plan and a party-in-interest;

(3) The furnishing of goods, services, or facilities between the plan and a party-in-interest;

(4) A transfer of plan assets to a party-in-interest or a transfer that is for the use and benefit of a party-in-

interest; and

(5) An acquisition by the plan of employer securities or real

estate that is in violation of ERISA §407(a).

Additional Restrictions

The following actions by plan fiduciaries are also prohibited:

(a) Dealing with the assets of the plan for their own

account;

(b) Receiving any consideration for his own account from

any party dealing with the plan in connection with a transaction involving plan assets; or

(c) Acting in any capacity in any transaction involving a plan on behalf of a party, or in representation of a party,

whose interests are adverse to the interests of the plan,

its participants, or beneficiaries.

7 - 8

Fiduciary Exceptions

There are however, some exceptions to these prohibited

transactions that do not prevent a fiduciary from doing any of the following:

(a) Receiving benefits from the plan as a participant or beneficiary so long as the benefits so received are

consistent with the terms of the plan as applied to all other participants and beneficiaries;

(b) Receiving reasonable compensation for services to the plan unless the fiduciary receives full time pay from

the employer or employee organization;

(c) Receiving reimbursements for expenses actually incurred in the course of his duties to the plan; and/or

(d) Serving as an officer, employee, agent, etc., of a party-in-interest.

Loans

Another important exception to the prohibited transaction

rules permits qualified plans to make loans to plan participants. Any such loans must be made in accordance

with specific provisions in the plan and must provide for a reasonable interest rate and adequate security. Loans must

be made available on a nondiscriminatory basis. That is to say, they must be made available to all plan participants on

a reasonably equivalent basis.

A loan from a qualified plan to a plan participant or

beneficiary is treated as a taxable distribution unless:

(1) The loan must be repaid within 5 years (except for

certain home loans), and

(2) The loan does not exceed the lesser of (a) $50,000,

or (b) the greater of $10,000 or 1/2 of the participant‘s accrued benefit under the plan.

The $50,000 limit for qualified plan loans is reduced where

the participant has an outstanding loan balance during the 1-year period ending on the day before the date of any new

loan (§72(p)(2)(A)(i)). In addition, except as provided in regulations, a plan loan must be amortized in substantially

level payments, made not less frequently than quarterly, over the term of the loan (§72(p)(2)(C)).

7 - 9

Formerly, the above exceptions to the prohibited

transaction rules did not apply to plan loans to owner-employees.

Note: For purposes of the prohibited transaction rules, an

owner-employee means (1) a sole proprietor, (2) a partner

who owns more than 10% of either the capital interest or

the profits interest in the partnership, (3) an employee or

officer of a Subchapter S corporation who owns more than

5% of the outstanding stock of the corporation, and (4) the

owner of an IRA.

However, since 2002, the rules relating to plan loans made to owner employees (other than the owner of an IRA) were

eliminated. Thus, the general statutory exception applies to such transactions.

Employer Securities

With the exception of profit sharing and pre-ERISA money

purchase pension plans, pension plans may not acquire or hold qualifying employer securities or real property in the

plan in excess of 10% of the fair market value of all of the

plan‘s assets.

In addition, ERISA imposes restrictions on the investment of

retirement plan assets in employer stock or employer real property (ERISA §407). Under these restrictions, a retirement

plan may hold only a "qualifying" employer security. Under the Pension Act, in order to satisfy the plan qualification

requirements of the Code and the vesting requirements of ERISA certain defined contribution plans are required to

provide diversification rights with respect to amounts invested in {employer securities.

Such a plan is required to permit applicable individuals to direct that the portion of the individual's account held in

employer securities be invested m alternative investments. An applicable individual includes:

(1) any plan participant, and

(2) any beneficiary who has an account under the plan with respect to which the beneficiary is entitled to exercise

the rights of a participant

Thus, participants must now be allowed to immediately

diversify* any employee contributions or elective contributions invested in employer securities. For employer

contributions, participants must be able to diversify out of

7 - 10

employer stock after they have been in the plan for three

years.

Excise Penalty Tax

Where a disqualified person participates in a prohibited

transaction, an initial non-deductible excise tax equal to 5% of the amount of the transaction is imposed on such person.

An additional tax equal to 100% of the transaction amount is

imposed if the transaction is not corrected within the correction period that is 90 days from the notice of deficiency,

plus any extensions.

PBGC Insurance

Defined benefit pension plans may be subject to the plan termination insurance requirements of the Pension Benefit

Guarantee Corporation (PBGC). The basic purpose is to guarantee payment of vested plan benefits at the time of

termination of a plan where the plan‘s assets are insufficient to pay such benefits.

Sixty-Month Requirement

The PBGC guarantees the plan benefits to the extent that a

plan has been in existence for 60 months at the time of plan termination. This 60-month requirement allows for a

phase-in of 20% per year for plans that have not been in existence for 5 years. The funds to be accumulated by the

PBGC are derived from an annual premium to be paid for each active participant and retiree. Even fully insured plans

are required to obtain PBGC coverage.

Recovery Against Employer

Where the PBGC is required to pay benefits to participants, it may recover such amounts from the employer up to 30%

of the employer‘s net worth plus additional sums. Although this contingent employer liability may be covered by special

risk insurance, the premiums are substantial.

Termination Proceedings

The PBGC can also be thoroughly involved in the operations of defined benefit pension plans. For example, the PBGC may

institute proceedings to terminate a plan if it finds that:

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(1) The plan failed to comply with the minimum funding

standards;

(2) The plan is unable to pay benefits when they become

due;

(3) A distribution is made to an owner-employee of

$10,000 in a 24 month period, unless the payment is made due to the death of the owner-employee if, after the

distribution, there are unfunded vested liabilities; or

(4) The possible long-term liability of the plan to the PBGC

will increase unreasonably if the plan is not terminated.

Plans Exempt from PBGC Coverage

Some plans are specifically excluded from the requirement of PBGC insurance coverage. These plans are as follows:

(a) Individual account plans, such as money purchase pension plans, target benefit plans, profit sharing plans,

thrift and savings plans, and stock bonus plans;

(b) Governmental plans;

(c) A church plan which is not volunteered for coverage, does not cover the employees of a non-related trade or

business and is not a multi-employer plan in which one or more of the employers are not churches or a convention or

association of churches;

(d) Plans established by fraternal societies or other organizations described in §501(c)(8), (9) or (18) which

receive no employer contributions and cover only members (not employees);

(e) A plan that has not, after the date of enactment, provided for employer contributions;

(f) Nonqualified deferred compensation plans established for a select group of management or highly compensated

employees;

(g) A plan outside the United States established for non-

resident aliens;

(h) A plan that is primarily for a limited group of highly

compensated employees where the benefits to be paid, or the contributions to be received, are in excess of the

limitations of §415;

(i) A qualified plan established exclusively for substantial owners;

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(j) A plan of an international organization that is exempt

from tax under the provisions of the International Organizations Immunity Act;

(k) A plan maintained only to comply with worker‘s compensation, unemployment compensation, or disability

insurance laws;

(l) A plan established and maintained by a labor

organization described in §501(c)(5) that does not, after the date of enactment, provide for employer contributions;

(m) A plan which is a defined benefit plan to the extent that it is treated as an individual account plan under

§3(35)B of the Act; or

(n) A plan established and maintained by one or more

professional service employers that has, from the date of enactment, not had more than 25 active participants. Once

one of these plans has more than 25 active participants, it

will remain covered even if the number of active participants subsequently falls back below 25.

Basic Requirements of a Qualified Pension Plan

There are three basic forms of qualified plans: pension plans, profit-

sharing plans, and stock bonus plans. The qualification requirements for all of these plans are identical, except that certain

fundamental differences in the plans require variations in the

application of some rules.

Written Plan

The employer must establish and communicate to its employees

a written plan (and, usually, a trust), which is valid under state law (Reg. §1.401(a)(2)).

Communication

A plan must actually be reduced to a formal written document

and communicated to employees by the end of the employer‘s taxable year, in order to be qualified for such year. Under

ERISA, a summary plan description must be furnished to

participants within 120 days after the plan is established or, if later, 90 days after an employee becomes a participant (DOL

Reg. §2520.104b-2(a)). The summary plan description must be written in such a manner that it will be understood by the

average plan participant and must be sufficiently

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comprehensive in its description of the participant‘s rights and

obligations under the plan (DOL Reg. §2520.102-2).

Trust

The assets of a qualified plan must be held in a valid trust

created or organized in the United States. As an alternative, a custodial account or an annuity contract issued by an insurance

company or a custodial account held by a bank (for a plan which

uses IRAs) may be used (ERISA §403(b)). Under §401(f), these custodial accounts and annuity contracts will be treated as a

qualified trust, and the person holding the assets of the account or contract will be treated as the trustee thereof.

Requirements

A trust is a matter of state law. In order to be a valid trust,

three requirements must be met:

(i) The trust must have a corpus (property);

(ii) The trust must have a trustee; and

(iii) The trust must have a beneficiary.

Both the plan and the trust must be written instruments. They may, however, be two separate or one combined

instrument.

To obtain a deduction for a year, the trust must be

established before year end, although the actual contribution is not required until the due date of filing the employer tax

return including extensions (§404(a)(6). Although this contradicts the requirement that a valid trust have a corpus,

the IRS has held that if the trust is valid in all respects under

local law except for the existence of corpus, and if the contribution is made within the above prescribed time limits,

it will be deemed to have been in existence on the last day of the year (R.R. 81-114).

Permanency

The plan must be a permanent and continuing program. It must

not be a temporary arrangement set up in high tax years as a tax savings scheme to benefit the employer. Although the

employer may reserve the right to terminate the plan and discontinue further contributions, the abandonment of a plan for

any reason other than business necessity can indicate that the plan was not a bona fide program from its inception (Reg.

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§1.401-1(b)(2)). Thus, if a plan is discontinued after only a short

period of years, the IRS may retroactively disqualify the plan.

Exclusive Benefit of Employees

The plan and trust must be for the exclusive benefit of

employees and their beneficiaries. A qualified plan cannot be a subterfuge for the distribution of profits to shareholders. Thus,

the plan cannot discriminate in favor of certain highly

compensated employees.

Highly Compensated Employees

Under §414(q)(1), a ―highly compensated employee‖ is any

employee who:

(1) Was a 5% owner (as defined in §416(i)), at any time during the year or the preceding year, or

(2) For the preceding year, had compensation from the employer in excess of $80,000 (indexed for inflation), and,

if the employer elects this condition, was in the top 20% of employees by compensation for the preceding year

(§414(q)).

Reversion of Trust Assets to Employer

There must ordinarily be no reversion of trust assets and contributions to the employer except for actuarial errors or an

excess of plan assets upon termination of a defined benefit pension plan.

The trust instrument must make it impossible, before the satisfaction of all liabilities to employees and beneficiaries, for

assets to be used for, or diverted to, purposes other than for the exclusive benefit of employees or beneficiaries. This

provision must be written into the trust instrument (Reg. §1.401-2).

Participation & Coverage

The plan must cover a required percentage of employees or

cover a nondiscriminatory classification of employees. The plan may not discriminate in favor of highly compensated employees.

Section 401(a)(3) requires that a plan meet the minimum participation standards of §410. Section 410 divides these

participation standards into two general categories:

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(i) Age and service requirements (that is, the rights of an

employer to exclude certain employees on account of age or years of service), and

(ii) Coverage requirements, which relate to the portion of the employer‘s total work force that must participate in the plan.

Age & Service

A qualified plan cannot exclude any employee from

participation on account of his age or years of service, except for the exclusion of employees who are:

(i) Under age 21, or

(ii) Have less than one ―year of service.‖

Note: In the case of a plan that provides for 100 percent

vesting after no more than two years of service, it can require a

two-year period of service for eligibility to participate.

An employee who has satisfied the minimum age and service requirements of the plan (if any) must actually begin

participation (i.e., enter the plan) no later than the earlier of:

(i) The first day of the first plan year beginning after he

satisfied the requirements; or

(ii) Six months after he satisfied the requirements (Reg. §1.410(a)-4(b)).

A year of service is a 12-consecutive- month period (referred to as the computation period) during which the employee has

at least 1,000 ―hours of service.‖

Hours of service include:

(i) Hours for which the employee is paid, or entitled to payment, for the performance of duties;

(ii) Hours for which the employee is paid, or entitled to payment, during periods when no duties are performed,

such as vacation, illness, disability, maternity or paternity leave; and

Note: The plan does not have to credit the employee with more

than 501 hours of service for this category.

(iii) Hours for which back pay is awarded or agreed to by the employer.

Coverage

To insure that lower paid employees have the benefit of a

retirement plan, tax law requires qualified plans to provide

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coverage for them. This is accomplished by two sets of

requirements. The first set is three tests:

(i) A percentage test,

(ii) A ratio test, and

(iii) An average benefits test.

The second set requires a specific minimum number of covered participants.

Percentage Test

Under this test, the plan must ―benefit‖ at least 70% of all

the employees who are not highly compensated employees.

Note: This is not the same as the 70% test under pre-TRA

‗86 law. This test is broader, since it requires that 70% of

―all nonhighly compensated employees,‖ rather than ―all

employees‖ (which includes both highly and nonhighly

compensated employees).

Ratio Test

To satisfy this test, a plan must benefit a percentage of

nonhighly compensated employees that is at least 70% of the percentage of highly compensated employees

benefiting under the plan.

Example

An employer has two highly compensated employees

and 20 nonhighly compensated employees. If the

plan covers both of the highly compensated

employees (100%), it must cover at least 14 of the

nonhighly compensated employees (70% of 100% =

70% required coverage). If the plan covers only one

of the highly compensated employees (50%), it must

cover at least seven of the nonhighly compensated

employees (70% of 50% = 35% required coverage).

Average Benefits Test

A plan will meet the average benefits test if:

(i) The plan meets a nondiscriminatory classification test (using the §414(q) definition of highly compensated

employees); and

(ii) The average benefit percentage of nonhighly

compensated employees, considered as a group, is at

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least 70% of the average benefit percentage of the highly

compensated employees, considered as a group.

The classification test is met for a plan year if the

classification system is reasonable and established under objective business criteria that identify the employees who

benefit under the plan. This classification must meet a safe and unsafe harbor range that compares the percentage of

nonhighly compensated employees to the percentage of highly compensated employees benefiting under the plan.

Numerical Coverage

The second set of requirements was added to the Code to

eliminate discrimination in favor of highly compensated employees through the use of multiple plans. Section

401(a)(26) provides that a trust will not be qualified unless it benefits the lesser of:

(i) 50 employees; or

(ii) 40% of ―all employees.‖

Thus, each plan must have a minimum number of employees covered, without regard to any designation of

another plan.

The additional participation rules of §401(a)(26) only apply

to defined benefit plans. A defined benefit plan does not

meet the §401(a)(26) rules unless it benefits the lesser of:

(i) 50 employees, or

(ii) The greater of:

(a) 40% of all employees of the employer, or

(b) 2 employees (one employee if there is only one employee).

Related Employers

An employer could attempt to circumvent the coverage

requirements of §410(b) by operating its business through multiple entities. Because of this potential abuse, certain

related employers are treated as a single employer for purposes of the coverage tests. That is, all employees of

each entity in the group are used in computing the percentage or classification tests.

The related employers that fall into this classification are:

(i) Trades or businesses under common control (both

parent-subsidiary and brother-sister forms),

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(ii) Affiliated service groups, and

(iii) Leased employee arrangements.

Vesting

Vesting refers to the percentage of accrued benefit to which an

employee would be entitled if they left employment prior to attaining the normal retirement age under the plan. Vesting

represents that portion of the employee‘s benefit that is

nonforfeitable.

Section 401(a)(7) requires a plan to meet the rules under §411,

regarding vesting standards. These vesting standards contain three classes of vesting:

(i) Full and immediate vesting;

(ii) Minimum vesting under §411(a)(2); and

(iii) Compliance with §401(a)(4) nondiscrimination requirements.

Full & Immediate Vesting

Under §411(a), a participant‘s normal retirement benefit

derived from employer contributions must be nonforfeitable upon the attainment of normal retirement age, regardless of

where the employee happens to fall on the plan‘s vesting schedule at normal retirement age.

Section 411(a)(1) requires that a participant must be fully vested at all times in the accrued benefit derived from the

employee‘s own contributions to the plan. This requirement applies regardless of whether the employee contributions are

voluntary or mandatory.

Section 411(d)(3) requires that a qualified plan provide that accrued benefits become nonforfeitable for participants who

are affected by a complete or partial termination of, or a discontinuance of contributions to, a plan.

Minimum Vesting

For employer contributions, plans have historically had to

meet the requirements of two minimum vesting schedules:

1. Five-Year Cliff Vesting. Under this schedule,

participants who have completed five years of service with the employer must receive a 100% nonforfeitable claim to

employer-derived benefits. Thus, the schedule is as follows:

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Completed Years of Service Nonforfeitable

Percentage 1-4 0%

5 100%

2. Three-to-Seven Year Graded Vesting. This schedule is graded in a similar fashion to the old five-to-15 year

graded schedule, except, of course, that it provides a more rapid rate of vesting. The schedule is:

Completed Years of service Nonforfeitable

Percentage 1-2 0%

3 20% 4 40%

5 60%

6 80% 7 100%

Note: The general rules for counting years of service for

vesting are similar to those for participation. However, three

important differences exist. First, all years of service after

the attainment of age 18 (rather than age 21) must be

counted. Years of service before age 18 may be

disregarded. Second, contributory plans (those with

mandatory employee contributions) may disregard any

years of service in which an employee failed to make a

contribution. Finally, years of service during which the

employer did not maintain the plan or a predecessor plan

may be disregarded.

In the case of matching contributions (as defined in §401(m)(4)(A)), plans had to meet the requirements up to

minimum vesting schedules:

1. Three-Year Cliff Vesting. Under this schedule,

participants who have completed three years of service with the employer must receive a 100% nonforfeitable

claim to employer-derived benefits.

2. Two-to-Six Year Graded Vesting. This schedule is

graded in a similar fashion to the old five-to-15 year graded schedule, except, of course, that it provides a more

rapid rate of vesting. The schedule is:

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Completed Years of service Nonforfeitable

Percentage 2 20%

3 40% 4 60%

5 80% 6 100%

However, for plan years beginning after December 31, 2006, the expedited vesting schedule that applied to employer

matching contributions was extended to all employer contributions to defined contribution plans by Pension

Protection Act of 2006 (§411(a)(2)).

As a result, for plan years beginning after 2006, a defined

contribution plan (e.g.. profit-sharing and §401(k) plans) must vest all employer contributions according to the

schedule that, before 2007, applied only to employer

matching contributions. For example, if a defined contribution plan used cliff vesting, accrued benefits derived from all

employer contributions must now vest with the participant after three years of service. Likewise, if a defined contribution

plan used graduated vesting, all employer contributions must now vest with the participant at the rate of 20% per year,

beginning with the second year of service.

Nondiscrimination Compliance

Even if a plan adopts one of the statutory vesting schedules, it may still discriminate in favor of highly compensated

employees in practice. If the IRS determines either that there has been a ―pattern of abuse‖ under the plan or that there is

reason to believe that there will be an accrual of benefits or forfeitures tending to discriminate in favor of highly

compensated employees, it can require a more accelerated vesting schedule under §411(d)(1).

Contribution & Benefit Limits

Section 401(a)(16) requires a plan to comply with §415

limitations for contributions and benefits. These limitations set the maximum amounts that the employer may provide under the

plan. A plan must include provisions to ensure that these limitations are never exceeded for any participant; otherwise,

the entire plan will become disqualified for the year.

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The limitations imposed on both defined contribution and defined

benefit plans are based on the participant‘s compensation. However, there is a maximum dollar amount of compensation

that may be considered. Initially set at $200,000, for 2014, it is $260,000.

Defined Benefit Plans (Annual Benefits Limitation) - §415

A defined benefit plan may not provide ―annual benefits‖ in

excess of the lesser of:

(i) A dollar limit of $160,000 (subject to COLAS)

((§415(b)(1)(A)); or

(ii) 100% of the participant‘s average annual

compensation for the three consecutive years in which their compensation was the highest (§415(b)(1)(B)).

The $160,000 limit is subject to cost of living adjustments. In 2014 plan years, this amount is $210,000.

The annual benefit means a benefit payable annually at the participant‘s social security retirement age in the form of a

straight-life annuity, with no ancillary benefits, under a plan to which employees do not contribute and under which the

employee makes no rollover contributions.

Note: Employee contributions, whether mandatory or voluntary,

are considered to be a separate defined contribution plan to

which the limitations thereon apply.

Defined Contribution Plans (Annual Addition Limitation) - §415

A defined contribution plan‘s ―annual additions‖ to a

participant‘s account for any limitation year may not exceed the lesser of:

(i) $52,000 in 2014 (or, if greater, one-fourth of the

defined benefit dollar limitation) (§415(c)(1)(A)).; or

(ii) 100% of the participant‘s compensation

(§415(c)(1)(B)).

Annual additions include employer contributions, including

contributions made at the election of the employee (i.e., employee elective deferrals), after-tax employee

contributions, and any forfeitures allocated to the employee (§415(c)(2)).

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Limits on Deductible Contributions - §404

To be deductible, a contribution to a qualified plan must be an

ordinary and necessary expense of carrying on a trade, business or other activity engaged in for the production of

income. In addition, a contribution may not be deducted unless it is actually paid into the plan.

1. Defined contribution plans: For profit-sharing, stock bonus, simplified employee pension, and money purchase

pension plans, deductible contributions are limited to 25% of the compensation otherwise paid or accrued during the

taxable year to plan beneficiaries (§404(a)(3)(A)).

2. Defined benefit plans: An employer is permitted to use either one of two methods for determining the

minimum deductible annual contribution to a defined benefit pension plan:

a. The level funding method (§404(a)(1)(A)(ii)), or

b. The normal cost method (§404(a)(1)(A)(iii)).

Note: However, if the annual contribution necessary to

satisfy the minimum funding standard provided by §412(a)

is greater than the amount determined under either of the

above two, the limit may be increased to that amount.

As to the maximum deductible annual contribution (subject

to a special rule for plans with more than 100 participants), the employer may not deduct an amount that exceeds the

full funding limitation determined under the minimum funding rules (§412).

3. Combination plans: Where any employee is the beneficiary under both a defined benefit and a defined

contribution plan of the employer, deductible contributions are limited to 25% of the compensation otherwise paid or

accrued during the taxable year to plan beneficiaries

(§404(a)(9)).

Assignment & Alienation

Section 401(a)(13) requires qualified plans to provide that the

participants‘ benefits under the plan may not be assigned, alienated or subject to attachment, garnishment, levy,

execution, or other equitable process.

However, several exceptions to this rule exist:

1. Any voluntary revocable assignment of an amount that

does not exceed 10% of any benefit payment, may be made

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by a participant or beneficiary, as long as the purpose of the

assignment is not to defray the costs of plan administration.

2. A loan by the plan to the participant or beneficiary that is

secured by the participant‘s accrued benefit will not be considered an assignment or alienation, if the loan is exempt

from the prohibited transaction tax of §4975 because it meets the requirements under §4975(d)(1).

3. The following arrangements are deemed not to be an assignment or alienation:

(a) Arrangements for the withholding of federal, state, or local taxes from plan benefits;

(b) Arrangements for the recovery by the plan of overpayments of benefits previously made to a participant;

(c) Arrangements for the transfer of benefit rights from the plan to another plan;

(d) Arrangements for the direct deposit of benefit

payments to a bank, savings and loan association or credit union, provided that the arrangement does not constitute

an assignment of benefits; and

(e) Arrangements whereby a participant directs the plan to

pay any portion of a benefit to a third party if it is revocable at any time by the participant or beneficiary and

the third party acknowledges in writing that he has no enforceable right to the benefit payments.

4. The assignment and alienation prohibition does not apply to the creation, assignment, or recognition of a right to any

benefit payable pursuant to a ―qualified domestic relations order‖ (QDRO).

Note: A ―domestic relations order‖ means any judgment,

decree, or order (including approval of a property settlement

agreement) that relates to the provision of child support,

alimony payments, or marital property rights to a spouse,

former spouse, child, or other dependent of a participant and

which is made pursuant to a state domestic relation law

(including a community property law).

Miscellaneous Requirements

Forfeitures arising from the non-vested accounts of terminated

employees under defined benefit plans must be used to reduce employer contributions. Under money purchase or target benefit

plans, forfeitures may be reallocated to the accounts of

remaining participants or used to reduce employer contributions.

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A disability pension and incidental post-retirement and pre-

retirement death benefits can be provided. However, benefits for sickness, accident, hospitalization, or medical expenses may not

be furnished to active plan participants.

One of the most important Code requirements is the minimum

funding standard which must be met by defined benefit, target or assumed benefit and money purchase plans. The major

purpose of this requirement is for the employer to make adequate funding. An excise tax is imposed on the employer for

failure to meet this standard.

When a plan provides for a normal retirement benefit in the form

of an annuity for life, and the employee has been married for the one-year period ending on the annuity starting date, a joint and

survivor spousal annuity must be provided.

Basic Types of Corporate Plans

Under ERISA, qualified corporate retirement plans are one of two

basic types:

(1) Defined contribution plans, or

(2) Defined benefit plans.

Although defined benefit plans offer several advantages, defined

contribution plans are frequently better to start with and are generally more practical for the small corporation.

Defined Benefit

Mechanics

Generally, a defined benefit plan attempts to specify benefit

levels for employees. Once benefit levels are established, contributions are determined based upon actuarial

calculations.

The employer bears the risk of the investment program used

by the employee benefit trust that administers the plan‘s assets. If that program causes the plan assets to fall below

the amount actuarially necessary to pay the defined benefits then the employer must make additional contributions.

Thus, defined benefit plans are subject to the minimum funding requirements under ERISA, whereas those rules have

little meaning for defined contribution plans. In such a plan, income in excess of the forecast levels benefits the employer

by reducing future contributions (§412(b)(3)).

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Although contributions may vary based on the investment

program, such plans are a fixed obligation of the corporation and contributions must be made annually to the plan

regardless of the company‘s profits.

Defined Benefit Pension

The primary form of the defined benefit plan is the defined

benefit pension plan. A defined benefit pension plan must

provide for the payment of definitely determinable benefits to the employees over a period of years after retirement. In

short, it guarantees a monthly income for a participant at retirement age. Benefits are measured by years of service

with the employer, years of participation in the plan, percent of average compensation, or a combination thereof. In

addition, most defined benefit pension plans pay Pension Benefit Guaranty Corporation premiums to insure that

participant‘s guaranteed benefits will always be paid at retirement.

Defined Contribution

Mechanics

In defined contribution plans, an individual account is established for each employee. The total vested amount of

each employee‘s account at termination or retirement will be

the amount available to provide each covered employee with a benefit. The employer defines or fixes the annual cost

rather than defining the benefit it wants to have its employees to receive. Contributions to the employee‘s

account are based on a formula that is usually expressed as a percentage of the employee‘s salary.

Discretion

Contributions need not be mandatory as exampled by profit

sharing plans that are in this category. Considerable discretion by the board of directors is permitted without

jeopardizing the qualification of the plan. (Reg. §1.401-1(b)(1)(ii)). The key is that there is no exact benefit. The

procedure is not one of defining benefits and then determining the contributions necessary to fund it. Benefits

are the result of the contributions made to the plan and the investment performance (or lack thereof) of the employee

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benefits trust that administers the plan‘s assets. As a result,

the participant/employee bears the risk of the investment program and benefits are directly dependent upon it.

Favorable Circumstances

A defined contribution plan can be recommended in the following instances:

(1) The principals are relatively young (e.g. - more than 20

years from retirement) and will have many years to accumulate contributions;

(2) There are older employees and the principals do not want to make the higher contributions necessary to fund a

defined benefit plan for a few years;

(3) The principals want the plan costs tied to compensation

rather than age, actuarial assumptions or the rise and fall of the stock market; or

(4) The business is cyclical and the principals want the flexibility not to make contributions in bad years.

Types of Defined Contribution Plans

There are a variety of defined contribution plans:

Profit Sharing

A profit sharing plan is a defined contribution plan under

which the plan may provide, or the employer may determine, annually, how much will be contributed to the plan out of

profits or otherwise. As a result profit sharing plans cannot provide determinable benefits. However, distributions can

occur prior to retirement.

Requirements for a Qualified Profit Sharing Plan

A profit sharing plan is a vehicle through which an employer may share some of his profits2 with his

employees. We will discuss profit sharing plans of the deferred type only (i.e. payment is to be made to the

participant in a future taxable year). Since each participant is credited with a share of the allocated profits and the

gains or losses thereon, ultimate benefits are unknown. In 2

T RA 8 6 p r o v i d e s t h a t a c o n t r i b u t i o n t o a q u a l i f i e d p r o f i t

s h a r i n g p l a n d o e s n o t r e q u i r e t h a t t h e e mp l o y e r h a v e

c u r r e n t o r a c c u mu l a t e d e a r n i n g s o r p r o f i t s .

7 - 2 7

this respect, profit sharing plans are similar to money

purchase pension plans and are generally more suitable where the employees (or shareholder-employees) are

under age 45.

Written Plan

The Code requirements for a qualified profit sharing plan

are essentially the same as for a qualified pension plan.

However, unlike certain pension plans that do not require a trust (i.e. those funded exclusively with life insurance

and annuity contracts), qualified profit sharing plans usually require a formal written trust agreement and

substantial and recurring employer contributions.

Eligibility

The eligibility requirements for profit sharing plans are generally more liberal than those of pension plans. A

maximum age provision is not permissible however; this poses no great cost problem since actuarial funding is not

required.

In addition, since employer contributions are not required

to be made out of current or accumulated profits or earnings, these plans may be established by private, non-

profit organizations and presumably, by local governments as well.

Deductible Contribution Limit

Since 2002, the maximum annual deduction is 25% of

the aggregate gross compensation of all plan participants. Contribution and some credit carry-overs are also

permitted.

Substantial & Recurrent Rule

Keep in mind the ―substantial and recurrent‖ rule. Generally, the IRS will expect a contribution of some sort

to be made if there are profits. However, a contribution need not be made in every plan year. If contributions are

not made on a fairly consistent basis, the IRS may claim that the plan has been discontinued and require full

vesting to the participants.

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Profit v. Pension Plan

A profit sharing plan may be preferable to a pension

plan based upon the following considerations:

1. When the business is young and substantial

earnings are being retained;

2. When most employees, including owners and

key-employees are young and have limited past

service;

3. When business earnings and profits are erratic or

generally low;

4. When the incentive element is more important to

the plan participants than a guaranteed pension;

5. When the average age of the employees is so

high as to make actuarial contributions prohibitive,

but the employer still wishes to provide some post-

retirement assistance;

6. When the availability of distributions during

employment is an important factor;

7. When a major objective of the employer is to

encourage employee savings through a matching

contribution plan;

8. Profit sharing plans are not subject to minimum

funding requirements, plan termination insurance,

and actuarial certification and reports. Profit sharing

plans offer reduced administrative expenses and

governmental regulations.

Money Purchase Pension

A money purchase plan is a pension plan but, nevertheless, it is categorized as a defined contribution plan. The employer

contributes a fixed amount each year based upon a percentage of each employee‘s compensation. The

employee‘s benefits are the amount of total contributions to the plan plus (or minus) investments gains (or losses).

Profit Sharing & Money Purchase Pension Plans

Planholder Corporations

S corporations

Non-profit organizations

7 - 2 9

Partnerships

Sole proprietorships (i.e., self-employed)

Eligibility

Requirements

The employer must include employees who

have:

Reached age 21

Completed 2 years of service if 100% vesting is

elected or completed

1 year of service if a vesting schedule is elected

The plan must also meet certain coverage and

participant requirements.

Contribution Limits

Profit Sharing: Maximum deductible amount is

25% of total eligible participant compensation.

Employer contributions are discretionary and can be

based on, but are not limited to profits.

Money Purchase: Maximum deductible amount is

25% of total eligible participant compensation.

Employer must contribute a predetermined

percentage each year. Contributions are mandatory

regardless of profits.

Combination Plans: Combined Money Purchase

Pension and Profit Sharing Plans are subject to a

single maximum deductible limit of 25% of

compensation.

Annual Additions Maximum: Annual additions to

any participant‘s account may not exceed 100% of

compensation, or $52,000 (in 2014), if less.

Minimum Employer Contribution may be required if

plan primarily benefits key employees.

Deadlines For

Establishment &

Contributions

Establishment: On or before the last day of the

employer‘s fiscal year, for the year in which the

deduction is taken

Funding: On or before the date the employer‘s

federal income tax return is due, plus extensions.

Pension Plans: Must be funded no later than 8½

months after the plan year-end, even if the deadline

for deduction purposes is later.

Filings: Each year there are assets in the plan, a

5500 series tax form should be filed with the IRS no

later than the last day of the 7th month following the

plan year end (except for certain ―one participant‖

plans with $250,000 or less in assets).

Distributio Earliest (without 10% tax penalty):

7 - 3 0

ns Death

Permanent disability

Attainment of age 59½

Distribution to pay for deductible medical expenses

Separation from service and age 55

Plan termination and age 59½

Separation from service and periodic payments

based on a life expectancy formula that cannot be

modified for at least 5 years or until attainment of

age 59½, if later

Payments made to an alternate payee because of a

divorce settlement as required by a Qualified

Domestic Relations Order

Profit Sharing Plans Only (if plan permits): In-service

withdrawal and age 59½. Hardship withdrawal and

age 59½

Latest (without 50% excise tax penalty):

April 1 of the calendar year following the year in

which the participant reaches age 70½. Special

exceptions apply.

Tax

Treatment on

Distribution

Taxed as ordinary income. Distributions from an

account containing non-deductible voluntary

contributions must consist of a non-taxable portion

and a taxable portion.

Lump-Sum Distributions: Individuals who were

age 50 on 1/1/86 can elect 10-year or 5-year

averaging with limited capital gain treatment. Thus,

averaging is not realistically available unless the

individual was born before 1935.

Cafeteria Compensation Plan

Under a ―cafeteria‖ or ―flexible benefit plan‖ an employee can

select from a package of employer provided benefits, some of which may be taxable and others not taxable. Employer

contributions under a written plan are normally excluded from the employee‘s gross income to the extent that nontaxable

benefits are selected (§125(b)).

Thrift Plan

Thrift plans are a mixed breed of retirement plan. Although they vary in form, in general the employee contributes some

percentage of their compensation to the plan; the employer then matches their contribution dollar for dollar or in some

other way spelled out in the plan. Lower employer costs are a factor in the popularity of these plans.

7 - 3 1

Section 401(k) Plans

This is an arrangement whereby an employee will not be

taxed currently for amounts contributed by an employer to an employee trust, even though the employee could have elected

under the plan to receive the contribution in cash. Section 401(k) has several requirements:

(1) It must be a qualified profit-sharing or stock bonus plan;

(2) Each employee can elect to receive cash or to have an employer contribution made to the employee trust;

(3) Benefits are not distributable to an employee earlier

than age 59½, termination of service, death, disability, or hardship;

(4) Each employee‘s accrued benefit under the plan is fully vested; and

(5) There is no discrimination in favor of highly paid employees.

Section 401(k) Plans

Planholder Corporations

S corporation

Partnerships

Sole proprietorships (i.e., self-employed)

Eligibility

Requirements

Employees who meet age & service

requirements.

The employer must include employees who

have:

Reached age 21

Completed 2 years of service if 100% vesting is

elected or completed 1 year of service if a vesting

schedule is elected

The plan must also meet certain coverage and

participant requirements. Employees who have

completed 1 year of service must be eligible to

make salary deferral contributions.

Contribution

Limits

Maximum Deductible Amount: Maximum

deductible amount is 25% of total eligible

participant compensation. This amount includes

employer basic, employer match and salary

deferral. Employer contributions are discretionary

and can be based on, but not limited to, profits.

Maximum Salary Deferral Amount: Not to

exceed $17,500 (in 2014) and is included in the

7 - 3 2

maximum contribution limit. Subject to a special

anti-discrimination test.

Non-Deductible Voluntary Contributions are

included in the maximum contribution limit. Subject

to a special anti-discrimination test.

Combination Plans: Combined Money Purchase

Pension and 401(k) Plans are subject to a single

maximum deductible limit of 25% of compensation.

Annual Additions Maximum: Annual additions to

any participant‘s account may not exceed 100% of

compensation, or $52,000 (in 2014), if less.

Minimum Employer Contribution may be required if

plan primarily benefits key employees.

Deadlines For Establishment

&

Contributions

Establishment: On or before the last day of the

employer‘s fiscal year, for the year in which the

deduction is taken

Funding: On or before the date the employer‘s

federal income tax return is due, plus extensions.

Filings: Each year there are assets in the plan, a

5500 series tax form should be filed with the IRS no

later than the last day of the 7th month following

the plan year end (except for certain ―one

participant‖ plans with $250,000 or less in assets).

Distributions Earliest (without 10% tax penalty):

Death

Permanent disability

Distribution to pay for deductible medical expenses

Separation from service and age 55

Plan termination and age 59½

Separation from service and periodic payments

based on a life expectancy formula that cannot be

modified for at least 5 years or until attainment of

age 59½, if later

Payments made to an alternate payee because of a

divorce settlement as required by a Qualified

Domestic Relations Order

In-service withdrawal and age 59½

Hardship withdrawal and age 59½

Latest (without 50% excise tax penalty):

April 1 of the calendar year following the year in

which the participant reaches age 70½. Special

exceptions apply.

Tax

Treatment on

Distribution

Taxed as ordinary income. Distributions from an

account containing non-deductible voluntary

contributions must consist of a non-taxable portion

and a taxable portion.

Lump-Sum Distributions: Individuals who were

age 50 on 1/1/86 can elect 10-year or 5-year

averaging with limited capital gain treatment. Thus,

averaging is not realistically available unless the

7 - 3 3

individual was born before 1935.

Death Benefits

Death benefits under a qualified plan are permissible only if they

are ―incidental‖ (Reg. §1.401-1(b)(1)(i)). Although non-insured death benefits must also be incidental, our discussion will be

limited to pre-retirement death benefits that are provided by life insurance.

The specific rules are as follows:

Defined Benefit Plans

Under defined benefit plans, if whole life or (preferably) universal life insurance is purchased, the death benefit is

incidental only if one of the following three requirements is met:

(1) The amount of life insurance does not exceed 100

times the anticipated monthly retirement benefit;

(2) The death benefit is equal to the reserve (cash value)

under the policy plus the participant‘s share of the auxiliary fund; or

(3) Where less than 50% of the total contributions for a participant are used to pay premiums, the total death

benefit may consist of the face amount of insurance plus the participant‘s account or share in the auxiliary fund.

Money Purchase Pension & Target Benefit Plans

Where whole life is purchased, the total life insurance

premiums must be less than 50% of the total contributions made on behalf of a participant. Alternatively, the 100 to 1

rule may be satisfied.

Where pure term or universal life is purchased, the premiums

may not exceed 25% of the contributions for a participant. Where whole life and term are purchased, the term premium

plus 50% of the whole life premium must meet the 25% test.

Employee Contributions

Sometimes an employer establishes a plan that requires employees to contribute as a condition of participation. Under

pension plans, employees may be required to contribute in order to reduce the employer‘s cost. Profit sharing thrift plans require

7 - 3 4

employees to contribute in order to receive the benefit of a

matching employer contribution.

Non-Deductible

In either case, the employee‘s contribution is not deductible.

An important note is that if employee contributions are required, the plan is still not permitted to be discriminatory.

Employees may also be permitted to make voluntary

contributions to the plan that are, of course, also not deductible.

Specific nondiscrimination rules apply to employers making matching contributions. These nondiscrimination rules are

essentially the same as for §401(k) plans.

Life Insurance in the Qualified Plan

Cash value life insurance purchased under the auspices of a qualified plan have the dual advantage of providing cash with

which to fund the retirement aspect of the plan, and simultaneously providing an additional death benefit over and

above the $50,000 limit of group term in the event that the employee dies prior to retirement (although I have had

employees who were dead for years and then retired).

Return

Although the cash accumulation of a life insurance policy is generally a little lower than that of an annuity, it will

generally surpass most CDs, and carries no more risk than an annuity. The advantage of having the death benefit provided

under the same policy that will provide the retirement benefits may be sufficient inducement for an employer to opt

for the slightly lower net yield.

Universal Life

In the event that life insurance policies are used to fund the retirement plan, a universal life product will probably be the

most advantageous product to use. In addition, universal life insurance would be the product of choice in the profit sharing

plan, since the premiums are entirely flexible (i.e., in a year with low profits, you don‘t have to worry a great deal about

lapsed policies or forced contributions in excess of profits to

keep the policies in force).

7 - 3 5

Compare

Although the general requirements for using life insurance to

fund the qualified plan have been discussed, it is not enough to merely know about the use of ―life insurance.‖ The policies

offered by different companies, although similar in function, can have substantial differences in terms of mortality cost,

current rates, methods of determining current rates, interest bonuses, and guaranteed rates to name a few. You should

carefully consider several plans of insurance in several different scenarios before making any specific

recommendations to your client.

Plan Terminations & Corporate Liquidations

A qualified plan must be intended as permanent. If a plan is terminated within a few years of its inception for other than a

valid business reason, the plan may be subject to retroactive disqualification with the resultant loss of all corporate

deductions. For this reason, if a plan termination is

contemplated, a favorable determination should be applied for and received from the IRS prior to any such termination. This

permanency requirement does not impede the employer‘s customarily retained right to unilaterally terminate the plan or

cease contributions. The termination of a plan requires that all participants be fully vested in their accrued benefits or account

balances. ERISA may require specific allocations to be made upon the termination of a defined benefit plan.

10-Year Rule

A consequence of the termination of a profit sharing plan

because of the cessation of contributions is the immediate and full vesting of the account balances. After the plan has

been in existence for ten years, it may be discontinued without the necessity of the employer showing a valid

business reason.

The complete liquidation of an employer would ordinarily be

sufficient grounds for the termination of the plan and trust, thereby avoiding the tax penalties.

Lump-Sum Distributions

As long as lump-sum payments are made to plan participants

on account of their separation from service, or upon attainment of at least age 55½, ten-year income averaging

7 - 3 6

will be available. The IRS has ruled that a separation from

service for tax purposes occurs only upon the employee‘s death, retirement, resignation, or discharge. However, if the

corporation is liquidated and the former owners decide to separately conduct their professional practices, a separation

from corporate service will have occurred.

Asset Dispositions

Another potential way of handling the assets of a qualified plan upon the liquidation of the employer is to terminate the

plan but maintain the trust. Distributions can then be made to the plan participants according to the terms of the trust.

Under ERISA, a qualified lump-sum distribution may be rolled over tax-free into an individual IRA if the transfer is made

within 60 days of the date on which the participant receives such distribution.

Only that portion of the distribution that represents employer contributions may be rolled over. Non-deductible employee

contributions are not eligible for the rollover although the earnings on such contributions and any deductible voluntary

employee contributions may be rolled over.

A major shortcoming of this rollover provision is that

ultimately, the distributions from the IRA will be fully taxable

as ordinary income without the potential but limited benefit of ten-year averaging. If the amounts to be rolled over are

eligible to be rolled over into another qualified corporate or Keogh retirement plan however, ten-year averaging may be

allowed with respect to any ultimate lump-sum distributions.

IRA Limitations

Although an IRA may not receive or invest in a life insurance contract of any kind whatsoever, this provision should not

create any major problems for a split funded corporate retirement plan where it is desirable to keep the life insurance

in force. The reason for this is that partial rollovers are permissible under §402(a)(5) so that employee life insurance

policies need not be rolled over.

Self-Employed Plans - Keogh

Although qualified plans for unincorporated businesses are now

virtually equal with corporate plans, there are still sufficient

7 - 3 7

differences to warrant a brief discussion of them separately from all

other plans. While the federal tax consequences will undoubtedly be a consideration in the decision to incorporate, it is unlikely that the

availability of a corporate retirement plan will weigh considerably as one of the considerations.

Contribution Timing

Cash basis self-employeds are now afforded the advantages of

accrual basis taxpayers for purposes of making their contributions to Keogh plans. That is, a contribution may be

made any time prior to the due date of the return, rather than by the close of the taxable year. This is undoubtedly of

considerable benefit to those taxpayers who have set-up Keogh profit sharing plans. Prior to this change, it was virtually

impossible to determine the allowable amount of the contribution by the close of the tax year since a self-employed individual does

not generally know how much they will earn during a taxable year until the year is over.

However, the Keogh plan itself, as well as any related trust instruments, must be established prior to the close of the

taxable year for which the first contributions are to be made.

Controlled Business

Where an owner-employee controls (either as a sole proprietor or as a more than 50% partner), one unincorporated business

and participates as an owner-employee in the Keogh plan of another unincorporated business, whether or not he or she

controls the second business, he or she must establish a plan for

the regular employees of the business that they control with benefits or contributions similar to those which they are

receiving. Therefore, if a 10% or less partner participates in a Keogh plan, they do not need to establish a similar plan for the

sole proprietorship that they own.

If the individual in question controls more than one business,

they must treat the controlled businesses as one for purposes of figuring the maximum contribution that they can make for

themselves. An owner-employee‘s maximum contribution limits cannot be exceeded even though they participate in more than

one plan. That is to say, participation in two plans does not double the allowable deduction.

7 - 3 8

General Limitations

Under the provisions of ERISA, all businesses that are under

common control, including incorporated businesses, unincorporated businesses, estates and trusts, must be

aggregated for purposes of the limitations on benefits, contributions, participation, and vesting. The regulations to

§414(b) and (c) state that the percentage to be applied to determine if there is common control are 80% in the case of

parent-subsidiary controlled groups and the 80% and more than 50% tests for brother-sister controlled groups.

As a result of ERISA, corporate and noncorporate employees

are generally taxed alike on their distributions. An owner-employee‘s cost basis does not include any taxable or non-

deductible term cost charges when a Keogh plan has been funded with life insurance.

The beneficiary of a deceased self-employed person or owner- employee will generally be taxed in the same manner as the

deceased would have been taxed. When life insurance proceeds are paid as a death benefit, the excess of the

proceeds over the policy‘s cash value will be tax-free.

Effect of Incorporation

A partnership or sole proprietorship may have an existing Keogh plan at the time of incorporation. Since a qualified corporate plan

will generally be created, the following alternatives concerning the disposition of the Keogh account should be considered:

1. The plan may be frozen. All employer and employee contributions simply stop. Life insurance or annuity contracts

may be placed on a reduced, paid-up basis but the extended term insurance option for life insurance in as much as

immediate taxability may result to the self-employed. The assets in the plan or trust will continue to share in dividends,

interest and capital appreciation on a tax-free basis.

Distributions to self- employeds and regular employees will continue to be governed by the plan‘s provisions and the IRC

restrictions. This approach is frequently used although the continued maintenance of the plan or trust typically requires

the payment of administrative fees and annual reporting to the IRS.

2. The assets in the Keogh trust may be sold and the proceeds used by the trustee to purchase single premium

7 - 3 9

nontransferable deferred annuities. These annuities can then

be distributed tax- free to the participants who will be taxed only upon the surrender of the annuities or the

commencement of payments. In addition, the trustee may continue to hold the annuities.

3. The assets of the Keogh plan may be transferred by the trustee, to the trustee of a qualified corporate account. The

transferred Keogh assets must remain segregated from the corporate assets. This will probably increase the

administrative costs somewhat. It is important that any such transfer be made only between the trustees or custodians of

the two plans involved. It may also be possible to arrange for the transfer of a nontransferable annuity or retirement

income endowment policy that is not held by a trustee or custodian (PLR 8332155).

4. Nontransferable annuity contracts which are part of an

unincorporated plan and are not held by a trustee may be surrendered back to the insurer in consideration for which the

insurer will issue new policies to the trustee of the qualified corporate plan (R. R. 73-259).

5. When the Keogh trust owns life insurance contracts, a sale of the contracts for their cash values to the trustee of a

corporate plan is permissible since there is a fair exchange of values (R. R. 73-503). The life insurance contracts now held

by the trustee of the corporate plan are no longer subject to any of the Keogh plan restrictions.

6. A self-employed individual or an owner-employee who receives a qualified lump-sum distribution in cash or property

from his Keogh plan may make a tax-free rollover of all or part of the property or cash to an IRA or annuity. The rollover

may not be made into an endowment contract, and must be

made within the 60-day period.

Mechanics

A sole proprietor or a partnership (but not a partner) can set

up a Keogh plan. Such plans can cover self-employed persons (e.g., the sole proprietor or partners) as well as common law

employees.

Note: A common law employee, a partner or a shareholder in

an S corporation cannot set up such a plan.

7 - 4 0

Under a Keogh plan, a self employed individual (this term

includes a sole proprietor and partners owning 10% or more of an interest in a partnership) is allowed to take a deduction

for money he or she sets aside to provide for retirement. Such a plan is also a means of providing retirement security

for the employees working for the self-employed individual.

Parity with Corporate Plans

Since 1983, Keogh plans essentially match the benefits and contributions provided by corporate plans under the parity

provisions of TEFRA. As a result, self employed individuals who may be disposed to incorporate to secure the greater

corporate benefits will need to make a careful cost/benefit analysis before proceeding to incorporate. Since 1984, a

bank no longer need be trustee.

Figuring Retirement Plan Deductions For Self-Employed

When figuring the deduction for contributions made to a self-employed retirement plan, compensation is net

earnings from self-employment after subtracting:

(i) The deduction allowed for one-half of the self-

employment tax, and

(ii) The deduction for contributions on behalf of the self-

employed taxpayer to the plan.

This adjustment to net earnings in (ii) above is made

indirectly by using a self-employed person‘s rate.

Self-Employed Rate

If the plan‘s contribution rate is a whole number (e.g., 12% rather than 12.5%), taxpayers can use the following

table to find the rate that applies to them.

Self-Employed Rate Table

Plan‟s Rate Self-Employed‟s Rate

1 .009901

2 .019608

3 .029126

4 .038462

5 .047619

6 .056604

7 .065421

7 - 4 1

8 .074074

9 .082569

10 .090909

11 .099099

12 .107143

13 .115044

14 .122807

15 .130435

16 .137931

17 .145299

18 .152542

19 .159664

20 .166667

21 .173554

22 .180328

23 .186992

24 .193548

25 .200000

If the plan‘s contribution rate is not a whole number

(e.g., 10.5%), the taxpayer must calculate their self-employed rate using the following worksheet

Self-Employed Rate Worksheet

1. Plan contributions rate as a decimal (for

example, 10% would be 0.10) $___________

2. Rate in Line 1 plus 1, as a decimal (for

example, 0.10 plus 1 would be 1.10) $___________

3. Divide Line 1 by Line 2, this is the

taxpayer's self-employed rate as a decimal $___________

Determining the Deduction

Once the self-employed rate is determined, taxpayers figure their deduction for contributions on their behalf by completing the

following steps:

Step 1 Enter the self-employed rate from the

Table or Worksheet above ____________

Step 2 Enter the amount of net earnings

from Line 29, Schedule C or Line 36,

Schedule F $___________

Step 3

7 - 4 2

Enter the deduction for self-employment

tax from Line 25, Form 1040 $___________

Step 4 Subtract Step 3 from Step 2 and enter

the amount $___________

Step 5 Multiply Step 4 by Step 1 and enter the

amount $___________

Step 6 Multiply $260,000 (in 2014) by the plan

Contribution rate. Enter the result but

not more than $52,000 (in 2014) $___________

Step 7 Enter the smaller of Step 5 or Step 6.

This is the deductible contribution.

Enter this amount on Line 27, Form 1040

$___________

Individual Plans - IRA‟s

The government wants to encourage everyone to save for retirement. Savings for this purpose also contributes to the

formation of investment capital needed for economic growth. For many individuals, including those covered by corporate retirement

plans, IRAs play an important role.

Deemed IRA

If an eligible retirement plan permits employees to make voluntary employee contributions to a separate account or

annuity that (1) is established under the plan, and (2) meets the requirements that apply to either traditional IRAs or Roth IRAs,

then the separate account or annuity is deemed a traditional IRA or a Roth IRA for all purposes of the code (§408).

Mechanics

Any individual whether or not presently participating in a

qualified retirement plan can set up an individual retirement plan (IRA) and take a deduction from gross income equal to the

lesser of $5,500 (in 2014) or 100% of compensation.

Individuals age 50 and older may make additional catchup IRA

contributions. The maximum contribution limit (before application of adjusted gross income phase-out limits) for an

individual who has celebrated his or her 50th birthday before the

7 - 4 3

end of the tax year is increased by $500 for 2002 through 2005,

and $1,000 for 2006 and later.

Note: One way in which taxation of a lump sum distribution

may be postponed is by transferring it within 60 days of receipt

of payment into an IRA. This postpones the tax until the funds

are withdrawn.

Phase-out

The taxpayer and spouse must be nonactive participants to obtain the full benefits of an IRA. If either is an active

participant in another qualified plan, the deduction limitation is phased out proportionately between $96,000 and $116,000

of AGI in 2014. For single and head of household taxpayers the phase out is between $60,000 and $70,000 in 2014.

AGI

AGI is determined by taking into account §469

passive losses and §86 taxable Social Security

benefits and ignoring any §911 exclusion and IRA

deduction.

Special Spousal Participation Rule - §219(g)(1)

Deductible contributions are permitted for spouses of individuals who are in an employer-sponsored retirement

plan. However, the deduction is phased out for taxpayers with AGI between $181,000 and $191,000 (in 2014).

Individual Retirement Accounts

Planholder Individual taxpayer

Individual taxpayer and non-working spouse

Eligibility

Requirements Individuals under 70½ years old who have earned

income

Contribution

Limits

Maximum Contribution Limit:

$5,500 per working individual $11,000 per

married couple with a working & a non-working

spouse

Tax-Deductible Contributions - Who

Qualifies:

7 - 4 4

If neither individual nor spouse is covered by an

employer-sponsored retirement plan, 100% is

deductible at any income level.

If individual or spouse is covered by an employer-

sponsored plan in 2014:

Adjusted

Gross

Income

Contribution

Married Tax-Deferred Deductibility

Below

$96,000

Yes Full

$96,000 -

$116,000

Yes Partial*

Over

$116,000

Yes No

Single Tax-Deferred Deductibility

Below

$60,000

Yes Full

$60,000 -

$70,000

Yes Partial*

Over $70,000 Yes No

* Subtract $200 of deductibility for each $1,000

of income over the floor amount (round to lowest

$10); $200 minimum.

Deadlines For

Establishment &

Contributions

On or before tax filing deadline, not including

extensions (usually April 15 or the next business

day if April 15 falls on a holiday or weekend).

Penalties:

$50 penalty for failure to file Form 8606 to report

nondeductible contributions

$100 penalty for overstating the designated

amount of nondeductible contributions

Distributions Earliest (without 10% tax penalty):

Death, Permanent disability, Attainment of age

59½: Periodic payments based on a life

expectancy formula that cannot be modified for at

least 5 years or until attainment of age 59½, if

later. Transfer of assets from a participant‘s IRA

to spouse‘s or former spouse‘s IRA in accordance

with a divorce or separation document.

Latest (without 50% excise tax penalty):

April 1 of the calendar year following the year in

which the participant reaches age 70½

7 - 4 5

Tax

Treatment on Distribution

All distributions from any type of IRA are taxed as

ordinary income. Remember, however, that if the

individual made nondeductible contributions, each

distribution consists of a nontaxable portion and a

taxable portion.

Spousal IRA

If a taxpayer files a joint return and their compensation is

less than that of their spouse, the most that can be contributed for the year to the taxpayer‘s IRA is the lesser of:

(1) $5,500 in 2014 (or $6,500 in 2014 if taxpayer is 50 or older), or

(2) Total compensation includable in the gross income of both taxpayer and their spouse for the year, reduced by:

(a) The spouse's IRA contribution for the year to a traditional IRA, and

(b) Any contributions for the year to a Roth IRA on behalf of the spouse.

This means that the total combined contributions that can be made for the year to a taxpayer‘s IRA and their spouse's IRA

can be up to $11,000 in 2014, or $12,000 in 2014 if only one

spouse is 50 or older, or $14,000 in 2014 if both spouses are 50 or older.

Eligibility

Individuals can set up and make contributions to a traditional

IRA if:

(1) They (or, if they file a joint return, their spouse) received

taxable compensation during the year, and

(2) They were not age 70½ by the end of the year.

An individual can have a traditional IRA whether or not they are covered by any other retirement plan. However, a taxpayer may

not be able to deduct all of their contributions if the taxpayer or their spouse is covered by an employer retirement plan.

Contributions & Deductions

Any employer, including a corporation, may establish an IRA

plan for the benefit of some or all of its employees. Contributions may be made by the employer on an additional compensation

basis or on a salary reduction plan. There is no nondiscrimination requirement with respect to the establishment, availability or

funding of an IRA plan. However, employee participation in an

7 - 4 6

IRA plan cannot be used as a basis for determining

nondiscrimination in any other employer provided plan. Installation and trustee fees paid by the employer with respect

to such plans should be deductible as ordinary and necessary business expenses. A separate accounting is required for each

employee‘s interest in the trust, but commingling of assets is permissible for investment purposes.

Employer Contributions

Amounts contributed by an employer will be tax-deductible as

additional compensation and includable in the employee‘s income. However, the employee will be entitled to an

offsetting deduction for the contributed amounts. Employer contributions will be subject to FICA and FUTA but not to

federal income tax withholding if the employer reasonably believes that the employee will be entitled to a deduction for

the contributed amounts.

Retirement Vehicles

Any individual may establish one or more of the types of IRA funding vehicles as long as the annual contributions limit is not

exceeded in the aggregate. The types of funding vehicles available are as follows:

(a) A fixed or variable individual retirement annuity may be purchased. The contract must be nontransferable,

nonforfeitable and may not be pledged as security for a loan except to the issuing insurance company. An endowment

contract must have level premiums and the cash value at

maturity must not be less than the death benefit. In addition, the death benefit at some time during the contract must

exceed the greater of the cash value or the premiums paid. Whole life insurance may not be used and, the annuity

contract may provide for a waiver of premium, but no other collateral benefits.

(b) A written trust or custodial account may be used to fund an individual retirement account. The rules concerning the

trustee are generally the same as those for a Keogh plan. The only prohibited investment for the account is life insurance.

Trust assets must not be commingled with other assets except in a common trust or investment fund.

(c) Retirement bonds were available for purchase prior to April 30, 1982 and may still be retained by some IRA

7 - 4 7

participants. Since these vehicles are no longer available

there is little point in discussing them.

Although the Code does not specifically prohibit an IRA from

investing in certain types of property, an investment in collectibles will be regarded as a currently taxable distribution to

the participant.

Note: Since 1987, United States minted gold and silver coins

after December 31, 1986, are not considered to be collectibles.

Distribution & Settlement Options

In order to encourage participants to set aside funds for their

retirement, tax law imposes a 10% penalty tax on ―pre-mature distributions.‖ That is, distributions that are received by the

participant prior to the attainment of age 59½. This penalty tax is imposed in addition to the participant‘s ordinary income tax

liability. However, this penalty does not occur where the distribution is the result of the death, disability or the timely

repayment of excess contributions.

Life Annuity Exemption

Distributions made prior to age 59½ are exempted from the penalty tax if they are made over a period of years based on

the participant‘s life expectancy. Payments may also be made

in the form of a joint and survivor annuity based on the participant‘s and the spouse‘s life expectancy and must be

substantially equal.

The plan must provide for a lump-sum distribution of the

participant‘s entire interest no later than the required beginning date or for a distribution under one of the following

periods:

(a) The participant‘s life;

(b) The lives of the participant and a designated beneficiary;

(c) A period of years not in excess of the participant‘s life expectancy; or

(d) A period of years not in excess of the life expectancy of the participant and a designated beneficiary.

Minimum Distributions

Funds cannot be kept indefinitely in a traditional IRA.

Eventually they must be distributed. However, the

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requirements for distributing IRA funds differ, depending on

whether the taxpayer is the IRA owner or the beneficiary of a decedent‘s IRA.

Owners of traditional IRAs must start receiving distributions by April first of the year following the year in which they

attained age 70½. April 1st of the year following the year in which a taxpayer reaches age 70½ is referred to as the

required beginning date (RBD).

Note: The minimum distribution amount for the year the

taxpayer attained age 70½ must be received no later than April

1st of the next year. Thereafter, the required minimum

distribution for any year must be made by December 31st of that

later year.

If the minimum required distribution is not made, then an

excise tax equal to 50% of the excess of the minimum required distribution over the amount actually distributed will

be imposed on the payee.

Required Minimum Distribution

The required minimum distribution for each year is

determined by dividing the IRA account balance as of the

close of business on December 31st of the preceding year by the applicable distribution period or life expectancy.

2009 Waiver of Required Minimum Distribution Rules

For 2009, under the Worker, Retiree, and Employer

Recovery Act, no minimum distribution was required for calendar year 2009 from individual retirement plans and

employer-provided qualified retirement plans that were defined contribution plans (within the meaning of

§414(i)).

Definitions

IRA Account Balance

The IRA account balance is the amount in the IRA at the

end of the year preceding the year for which the required minimum distribution is being figured. The IRA

account balance is adjusted by certain contributions, distributions, outstanding rollovers, and

recharacterizations of Roth IRA conversions.

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Designated Beneficiary

The term ―designated beneficiary‖ is a term of art, and

basically means that the beneficiary must be a human being. Thus, an estate is not a ―designated beneficiary‖

nor is a charity or other legal entity. If there is more than one beneficiary, then all of them must be human

beings, or there is no designated beneficiary.

Note: There is an exception to this rule if each beneficiary

has his or her or their own certain separate account.

If the beneficiary is a trust, and all of the beneficiaries

of the trust are human beings, they will be treated as designated beneficiaries, if certain conditions are met.

Date The Designated Beneficiary Is Determined

Generally, the designated beneficiary is determined

on the last day of the calendar year following the calendar year of the IRA owner‘s death. Any person

who was a beneficiary on the date of the owner‘s death, but is not a beneficiary on the last day of the

calendar year following the calendar year of the owner‘s death (because, for example, he or she

disclaimed entitlement or received his or her entire

benefit), will not be taken into account in determining the designated beneficiary.

Distributions during Owner‟s Lifetime & Year of Death after RBD

Required minimum distributions during the owner‘s

lifetime (and in the year of death if the owner dies after

the required beginning date) are based on a distribution period that generally is determined using Table III from

IRS Publication 590 and set forth below. The distribution period (i.e., which table is used) is not affected by the

beneficiary‘s age unless the sole beneficiary is a spouse who is more than 10 years younger than the owner.

Table III

Uniform Lifetime

7 - 5 0

For Use by Unmarried Owners and Owners Whose Spouses Are Not More Than 10 Years Younger

Age Distribution Period Age Distribution Period

70 27.4 93 9.6

71 26.5 94 9.1

72 25.6 95 8.6

73 24.7 96 8.1

74 23.8 97 7.6

75 22.9 98 7.1

76 22.0 99 6.7

77 21.2 100 6.3

78 20.3 101 5.9

79 19.5 102 5.5

80 18.7 103 5.2

81 17.9 104 4.9

82 17.1 105 4.5

83 16.3 106 4.2

84 15.5 107 3.9

85 14.8 108 3.7

86 14.1 109 3.4

87 13.4 110 3.1

88 12.7 111 2.9

89 12.0 112 2.6

90 11.4 113 2.4

91 10.8 114 2.1

92 10.2 115 and over 1.9

To figure the required minimum distribution for the

current year, divide the account balance at the end of the preceding year by the distribution period from the table.

This is the distribution period listed next to the owner‘s age (as of the current year) in Table III below, unless the

sole beneficiary is the owner‘s spouse who is more than 10 years younger.

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Sole Beneficiary Spouse Who Is More Than 10 Years

Younger

If the sole beneficiary is owner‘s spouse and their spouse is more than 10 years younger than the owner, use the

life expectancy from Table II (Joint Life and Last Survivor Expectancy) in IRS Publication 590.

The life expectancy to use is the joint life and last survivor expectancy listed where the row or column

containing the owner‘s age as of their birthday in the current year intersects with the row or column containing

their spouse‘s age as of his or her birthday in the current

year. To figure the required minimum distribution for the current year divide the account balance at the end of the

preceding year by the life expectancy.

Distributions after Owner‟s Death

Beneficiary Is an Individual

If the designated beneficiary is an individual, such as

the owner‘s spouse or child, required minimum distributions for years after the year of the owner‘s

death generally are based on the beneficiary‘s single life expectancy.

Note: This rule applies whether or not the death occurred

before the owner‘s required beginning date.

To figure the required minimum distribution for the current year, divide the account balance at the end of

the preceding year by the appropriate life expectancy from Table I (Single Life Expectancy) (For Use by

Beneficiaries) in IRS Publication 590. Determine the appropriate life expectancy as follows.

• Spouse as sole designated beneficiary. Use the life expectancy listed in the table next to the spouse‘s

age (as of the spouse‘s birthday in the current year).

If the owner died before the year in which he or she reached age 70½, distributions to the spouse do not

need to begin until the year in which the owner would have reached age 70½.

• Surviving spouse. If the designated beneficiary is the owner‘s surviving spouse, and he or she dies

before he or she was required to begin receiving

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distributions, the surviving spouse will be treated as if

he or she were the owner of the IRA.

Note: The Pension Protection Act of 2006 extended the

special treatment granted to spousal beneficiaries to

nonspouse beneficiaries.

• Other designated beneficiary. Use the life

expectancy listed in the table next to the beneficiary‘s age as of his or her birthday in the year following the

year of the owner‘s death, reduced by one for each year since the year following the owner‘s death.

A beneficiary who is an individual may be able to elect to take the entire account by the end of the fifth year

following the year of the owner‘s death. If this election is made, no distribution is required for any year before

that fifth year.

Multiple Individual Beneficiaries

If as of the end of the year following the year in which the owner dies there is more than one beneficiary, the

beneficiary with the shortest life expectancy will be

the designated beneficiary if both of the following apply:

i. All of the beneficiaries are individuals, and

ii. The account or benefit has not been divided into

separate accounts or shares for each beneficiary.

Beneficiary Is Not an Individual

If the owner‘s beneficiary is not an individual (e.g., if the beneficiary is the owner‘s estate), required

minimum distributions for years after the owner‘s death depend on whether the death occurred before the

owner‘s required beginning date.

a. Death on or after required beginning date. To

determine the required minimum distribution for the current year divide the account balance at the end of

the preceding year by the appropriate life expectancy from Table I (Single Life Expectancy) (For Use by

Beneficiaries) in IRS Publication 590. Use the life expectancy listed next to the owner‘s age as of his or

her birthday in the year of death, reduced by one for each year since the year of death.

7 - 5 3

b. Death before required beginning date. The

entire account must be distributed by the end of the fifth year following the year of the owner‘s death. No

distribution is required for any year before that fifth year.

Trust as Beneficiary

A trust cannot be a designated beneficiary even if it is

a named beneficiary. However, the beneficiaries of a trust will be treated as having been designated as

beneficiaries if all of the following are true:

1. The trust is a valid trust under state law, or

would be but for the fact that there is no corpus.

2. The trust is irrevocable or will, by its terms,

become irrevocable upon the death of the employee.

3. The beneficiaries of the trust who are

beneficiaries with respect to the trust‘s interest in the employee‘s benefit are identifiable from the trust

instrument.

4. The IRA trustee, custodian, or issuer has been

provided with either a copy of the trust instrument with the agreement that if the trust instrument is

amended, the administrator will be provided with a

copy of the amendment within a reasonable time, or all of the following:

(a) A list of all of the beneficiaries of the trust (including contingent and remaindermen

beneficiaries with a description of the conditions on their entitlement),

(b) Certification that, to the best of the employee‘s knowledge, the list is correct and

complete and that the requirements of (1), (2), and (3) above, are met,

(c) An agreement that, if the trust instrument is amended at any time in the future, the employee

will, within a reasonable time, provide to the IRA trustee, custodian, or issuer corrected

certifications to the extent that the amendment

changes any information previously certified, and

7 - 5 4

(d) An agreement to provide a copy of the trust

instrument to the IRA trustee, custodian, or issuer upon demand.

If the beneficiary of the trust is another trust and the above requirements for both trusts are met, the

beneficiaries of the other trust will be treated as having been designated as beneficiaries for purposes

of determining the distribution period.

Inherited IRAs

The beneficiaries of a traditional IRA must include in their gross income any distributions they receive. The beneficiaries

of a traditional IRA can include an estate, dependents, and anyone the owner chooses to receive the benefits of the IRA

after he or she dies.

Spouse. If an individual inherits an interest in a traditional

IRA from their spouse, they can elect to treat the entire inherited interest as their own IRA.

Beneficiary other than spouse. Formerly, when an individual inherited a traditional IRA from someone other

than their spouse, they could not treat it as their own IRA. They could not roll over any part of it or roll any amount

over into it (§408(d)(3)(C)). In addition, they were not

permitted to make any contributions to an inherited traditional IRA (§219(d)(4)).

However, the Pension Protection Act of 2006 extended the special treatment granted to spousal beneficiaries to

nonspouse beneficiaries. For distributions after 2006, nonspouse beneficiaries are allowed to roll over (in a

trustee to trustee roll over) to an IRA structured for that purpose amounts inherited as a designated beneficiary.

Thus, the benefits of a beneficiary other than a surviving spouse maybe transferred directly to an IRA

The IRA is treated as an inherited IRA of the nonspouse beneficiary. For example, distributions from the inherited

IRA are subject to the distribution rules applicable to beneficiaries. The provision applies to amounts payable to a

beneficiary under a qualified retirement plan, governmental

§457 plan, or a tax-sheltered annuity.

Note: Nonspouse beneficiaries can also apply for waivers of

the 60 day rollover period. In addition, this provision will

benefit same-sex couples.

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Estate Tax Deduction

A beneficiary may be able to claim a deduction for estate

tax resulting from certain distributions from a traditional IRA. The beneficiary can deduct the estate tax paid on any

part of a distribution that is income in respect of a decedent. He or she can take the deduction for the tax year

the income is reported.

Charitable Distributions from an IRA

If an amount withdrawn from a traditional individual retirement arrangement ("IRA") or a Roth IRA is donated to

a charitable organization, the rules relating to the tax treatment of withdrawals from IRAs apply to the amount

withdrawn and the charitable contribution is subject to the normally applicable limitations on deductibility of such

contributions.

In 2013, an IRA owner, age 70½ or over, could directly

transfer tax free, up to $100,000 per year to an eligible

charitable organization. This provided an exclusion from gross income for otherwise taxable IRA distributions from a

traditional or a Roth IRA in the case of qualified charitable distributions. Eligible IRA owners could take advantage of

this provision, regardless of whether they itemize their deductions. However, as of this writing, Congress has not

extended this provision for 2014.

The rules regarding taxation of IRA distributions and the

deduction of charitable contributions continued to apply to distributions from an IRA that were not qualified charitable

distributions. Qualified charitable distributions were taken into account for purposes of the minimum distribution rules

applicable to traditional IRAs to the same extent the distribution would have been taken into account under such

rules had the distribution not been directly distributed

under the provision.

Post-Retirement Tax Treatment of IRA Distributions

The cost basis of a participant in an IRA account is almost always

zero. Therefore, all distributions are fully taxable as ordinary

income in the year in which they are received. The distribution of an annuity contract to a participant is not taxable when received.

Rather, when the annuity payments begin, they will be fully

7 - 5 6

taxable as ordinary income. Furthermore, the transfer of a

participant‘s interest in an IRA plan to their former spouse under a decree of divorce or a written instrument incident to such

divorce is not a taxable distribution. Thereafter, the IRA will be treated for tax purposes as being owned by the former spouse.

Income In Respect of a Decedent

Distributions to a beneficiary or estate of a deceased

individual will generally be taxed in the same manner as if the participant received them. Life insurance death benefits

however, will not lose their tax-exempt character. Any amounts that are taxable to the beneficiary should be

regarded as income in respect of a decedent. Therefore, the beneficiary will be entitled to a deduction from gross income

for any federal estate taxes attributable to the inclusion of the IRA in the decedent‘s gross estate.

Estate Tax Consequences

The estate tax consequences are generally nil, since the

surviving spouse is usually the beneficiary and is entitled to the unlimited marital deduction. However, there were

previously some interesting rules in effect which worked to exclude $100,000 of the IRA amount from the gross estate of

the decedent. These rules were repealed by TEFRA and, therefore, some estate plans may need reworking to prevent

the over-funding of the ―by-pass trust.‖

Losses on IRA Investments

If a taxpayer has a loss on their traditional IRA investment, they can recognize the loss on their income tax return, but

only when all the amounts in all their traditional IRA accounts have been distributed to them and the total distributions are

less than their unrecovered basis, if any. Basis is the total amount of the nondeductible contributions in the traditional

IRAs.

The loss is claimed as a miscellaneous itemized deduction subject to the 2%-of-adjusted-gross-income. A similar rule

applies to Roth IRAs. The rule applies separately to each kind of IRA. Thus, to report a loss in a Roth IRA, all the Roth IRAs

(but not traditional IRAs) have to be liquidated, and to report a loss in a traditional IRA, all the traditional IRAs (but not

Roth IRAs) have to be liquidated.

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Prohibited Transactions

If an individual engages in a prohibited transaction with their

account, the account will become disqualified retroactively to the first day of the calendar year in which the disqualifying event

occurs. Where an employer or a union has established a retirement account, and a participant engages in a prohibited

transaction, such individual‘s account will be treated as a separate account for disqualification purposes.

The examples of prohibited transactions with a traditional IRA include:

(a) Borrowing money from it,

(b) Selling property to it,

(c) Receiving unreasonable compensation for managing it,

(d) Using it as security for a loan, and

(e) Buying property for personal use (present or future) with

IRA funds.

Effect of Disqualification

If an IRA is disqualified, the participant is taxed as though they received a complete distribution of the fair market value

of the assets in the account. Furthermore, all income accrued in the account subsequent to such disqualification will be

currently taxable to the recipient.

Penalties

For each prohibited transaction by a sponsoring employer or union, the law imposes a tax of 15% of the amount involved.

Such tax is to be paid by any disqualified person who engages in the prohibited transaction, with the exception of a fiduciary

acting only in that capacity. If the transaction is not corrected within the correction period, then an additional tax equal to

100% of the amount involved is imposed. However, an account will not be disqualified where an employer commits

the prohibited transaction. This excise tax of 15% or 100% is not imposed on an individual who engages in a prohibited

transaction with respect to their own account. Prohibited transactions are defined in §4975.

Borrowing on an Annuity Contract

If an owner borrows money against their traditional IRA annuity

contract, they must include in their gross income the fair market

7 - 5 8

value of the annuity contract as of the first day of their tax year.

They may also have to pay the 10% additional tax on early distributions.

Tax-Free Rollovers

Generally, a rollover is a tax-free distribution of cash or other assets from one retirement plan that is contributed to another

retirement plan. The tax-free rollover provisions relate to all

types of qualified plans, IRAs, annuities, and TSAs.

Note: A transfer of funds in a traditional IRA from one trustee

directly to another, either at the taxpayer‘s request or at the

trustee's request, is not a rollover. Since there is no distribution

to the taxpayer, the transfer is tax free. Because it is not a

rollover, it is not affected by the 1-year waiting period required

between rollovers.

Amounts paid or distributed to an individual out of an IRA or

annuity are not currently taxable if:

(1) The amount so received is reinvested into another IRA

within the 60 day period allowed by law; or

Note: For distributions made after December 31, 2001, no

hardship distribution can be rolled over into an IRA.

(2) The amount received represents the amount in the

account or the value of the annuity attributable solely to a rollover contribution from a qualified corporate trust or

qualified annuity plan and the amount, together with any earnings, is paid into another qualified corporate account or

Keogh plan or trust within the 60 day period.

Note: Generally, a rollover is tax free only if a taxpayer makes

the rollover contribution by the 60th day after the day they

receive the distribution. Beginning with distributions after

December 31, 2001, the IRS may waive the 60-day requirement

where it would be against equity or good conscience not to do

so.

Amounts not rolled over within the 60-day period do not qualify

for tax-free rollover treatment. Taxpayers must treat them as a taxable distribution from either their IRA or employer‘s plan.

These amounts are taxable in the year distributed, even if the 60-day period expires in the next year. Taxpayers may also have

to pay a 10% tax on early distributions.

7 - 5 9

Rollover from One IRA to Another

Taxpayers can withdraw, tax-free, all or part of the assets

from one traditional IRA if they reinvest them within 60 days in the same or another traditional IRA. Since this is a rollover,

taxpayers cannot deduct the amount that they reinvest in an IRA.

Waiting Period between Rollovers

If a taxpayer makes a tax-free rollover of any part of a

distribution from a traditional IRA, they cannot, within a one-year period, make a tax-free rollover of any later

distribution from that same IRA. In addition, taxpayers cannot make a tax-free rollover of any amount distributed,

within the same one-year period, from the IRA into which they made the tax-free rollover. The one-year period

begins on the date the taxpayer received the IRA distribution, not on the date they rolled it over into an IRA.

Partial Rollovers

If a taxpayer withdraws assets from a traditional IRA, they

can roll over part of the withdrawal tax free and keep the rest of it. The amount kept will generally be taxable (except

for the part that is a return of nondeductible contributions)

and may be subject to the 10% tax on premature distributions.

Rollovers from Traditional IRAs into Qualified Plans

For distributions after December 31, 2001, taxpayers can roll over tax free a distribution from their IRA into a qualified

plan. The part of the distribution that they can roll over is the

part that would otherwise be taxable. Qualified plans may, but are not required to, accept such rollovers

Rollovers of Distributions from Employer Plans

For distributions after December 31, 2001, taxpayers can roll

over both the taxable and nontaxable part of a distribution from a qualified plan into a traditional IRA. If a taxpayer has

both deductible and nondeductible contributions in their IRA, they will have to keep track of their basis so they will be able

to determine the taxable amount once distributions from the IRA begin.

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Withholding Requirement

If an eligible rollover distribution is paid directly to a

participant, the payer must withhold 20% of it. This applies even if the participant plans to roll over the distribution to a

traditional IRA. This withholding can be avoided by a direct rollover.

Affected

item Result of a payment to you

Result of a direct

rollover

Withholding

The payer must withhold 20%

of the taxable part.

There is no

withholding.

Additional

tax

If you are under age 59½, a

10% additional tax may apply

to the taxable part (including an

amount equal to the tax

withheld) that is not rolled over.

There is no 10%

additional tax.

When to

report as

income

Any taxable part (including the

taxable part of any amount

withheld) not rolled over is

income to you in the year paid.

Any taxable part is not

income to you until

later distributed to you

from the IRA.

Waiting Period between Rollovers

Taxpayers can make more than one rollover of employer

plan distributions within a year. The once-a-year limit on IRA-to-IRA rollovers does not apply to these distributions.

Conduit IRAs

Taxpayers can use a traditional IRA as a holding account

(conduit) for assets they receive in an eligible rollover distribution from one employer's plan that they later roll

over into a new employer's plan. The conduit IRA must be made up of only those assets and gains and earnings on

those assets. A conduit IRA will no longer qualify if mixed with regular contributions or funds from other.

Keogh Rollovers

If a taxpayer is self-employed, they are generally treated

as an employee for rollover purposes. Consequently, if a taxpayer receives an eligible rollover distribution from a

7 - 6 1

Keogh plan (a qualified plan with at least one self-employed

participant), the taxpayer can roll over all or part of the distribution (including a lump-sum distribution) into a

traditional IRA.

Direct Rollovers From Retirement Plans to Roth IRAs

Amounts that have been distributed from a tax-qualified

retirement plan, a tax-sheltered annuity, or a governmental

§457 plan may be rolled over into a traditional IRA, and then rolled over from the traditional IRA into a Roth IRA

However, historically, distributions from such plans could not be rolled over directly into a Roth IRA. The Pension

Protection Act of 2006 now allows distributions from tax-qualified retirement plans, tax-sheltered annuities, and

governmental §457 plans to be rolled over directly from such plan into a Roth IRA, subject to the rules that apply to

rollovers from a traditional IRA into a Roth IRA.

For example, a rollover from a tax-qualified retirement plan

into a Roth IRA is includible in gross income (except to the extent it represents a return of after-tax contributions),

and the 10% early distribution tax does not apply. Similarly, an individual with AGI of S100.000 or more could

not roll over amounts from a tax-qualified retirement plan

directly into a Roth IRA.

Rollovers of §457 Plans into Traditional IRAs

Prior to 2002, taxpayers could not roll over tax free an eligible

rollover distribution from a governmental deferred

compensation plan (as defined in §457) to a traditional IRA. Beginning with distributions after December 31, 2001, if a

taxpayer participates in an eligible deferred compensation plan of a state or local government, they may be able to roll

over part of their account tax free into an eligible retirement plan such as a traditional IRA. The most that a taxpayer can

roll over is the amount that would be taxed if the rollover were not an eligible rollover distribution. Taxpayers cannot

roll over any part of the distribution that would not be taxable. The rollover may be either direct or indirect.

Rollovers of Traditional IRAs into §457 Plans

Prior to 2002, taxpayers could not roll over tax free a

distribution from a traditional IRA to a governmental deferred

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compensation plan. Beginning with distributions after

December 31, 2001, if a taxpayer participates in an eligible deferred compensation plan of a state or local government,

they may be able to roll over a distribution from their traditional IRA into a deferred compensation plan of a state or

local government. Qualified plans may, but are not required to, accept such rollovers.

Rollovers of Traditional IRAs into §403(B) Plans

Prior to 2002, taxpayers could not roll over tax free a

distribution from a traditional IRA into a tax-sheltered annuity. Beginning with distributions after December 31,

2001, a taxpayer may be able to roll over distributions tax free from a traditional IRA into a tax-sheltered annuity. They

cannot roll over any amount that would not have been taxable. Although a tax-sheltered annuity is allowed to accept

such a rollover, it is not required to do so.

Rollovers from SIMPLE IRAs

For distributions after December 31, 2001, taxpayers may be able to roll over tax free a distribution from their SIMPLE IRA

to a qualified plan, a tax-sheltered annuity (§403(b) plan), or deferred compensation plan of a state or local government

(§457 plan). Previously, tax-free rollovers were only allowed to other IRAs.

Rollover Individual Retirement Accounts

Planholder Recipients of partial or lump-sum distributions from

an employer sponsored retirement plan within one

taxable year. Distributions cannot be a series of

periodic payments.

Eligibility

Requirements

Recipients of total distributions due to:

Separation from service*

Attainment of age 59½

Termination of plan by employer

Permanent disability**

Death of employee (if spouse is beneficiary)

Qualified Domestic Relations Order

*Does not apply to self-employed individuals

** Does apply to self-employed individuals

Recipients of partial distribution due to:

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Separation from service

Death of employee (if spouse is beneficiary)

Permanent disability

Contribution

Limits

Maximum Contribution Limit: Up to 100% of the

distribution. Employee voluntary non-deductible

contributions cannot be rolled; earnings on these

contributions can. The participant can keep a

portion of the payout and roll over the rest.

Deadlines For Establishment

& Contributions

Rollovers must be completed by the 60th day after

receipt of the distribution. Rollovers from an

employer-sponsored retirement plan are an

irrevocable election.

Distributions Earliest without 10% tax penalty:

Death

Permanent disability

Attainment of age 59½

Periodic payments based on a life expectancy

formula that cannot be modified for at least 5 years

or until attainment of age 59½, if late

Transfer of assets from a participant‘s IRA to

spouse‘s or former spouse‘s IRA in accordance with

a divorce or separation document.

Latest (without 50% excise tax penalty):

April 1 of the calendar year following the year in

which the participant reaches age 70½

Tax

Treatment on Distribution

All distributions from any type of IRA are taxed as

ordinary income. Remember, however, that if the

individual made nondeductible contributions, each

distribution consists of a nontaxable portion and a

taxable portion.

Roth IRA - §408A

A Roth IRA is a special tax-free nondeductible individual retirement plan for individuals with AGI of $129,000 (in 2014) or

less and married couples with AGI of $191,000 (in 2014) or less. It can be either an account or an annuity.

To be a Roth IRA, the account or annuity must be designated as a Roth IRA when it is set up. Neither a SEP-IRA nor a SIMPLE

IRA can be designated as a Roth IRA.

Unlike a traditional IRA, contributions to a Roth IRA are not

deductible. However, distributions from a Roth IRA are tax free if

made more than 5 years after a Roth IRA has been established and if the distribution is:

(1) Made after age 59½, death, or disability, or

7 - 6 4

(2) For first-time homebuyer expenses (up to $10,000).

Eligibility

Individuals can contribute to a Roth IRA if they have taxable compensation and their modified AGI is less than:

(a) $191,000 (in 2014) for married filing jointly,

(b) $10,000 (in 2014) for married filing separately and taxpayer lived with their spouse at any time during the

year, and

(c) $129,000 (in 2014) for single, head of household,

qualifying widow(er) or married filing separately and taxpayer did not live with their spouse at any time during

the year.

Contributions can be made to a Roth IRA regardless of an

individual‘s age. Contributions can be made to a Roth IRA for a year at any time during the year or by the due date of the

individual‘s return for that year (not including extensions).

Contribution Limitation

The contribution limit for Roth IRAs depends on whether contributions are made only to Roth IRAs or to both

traditional IRAs and Roth IRAs.

Roth IRAs Only

If contributions are made only to Roth IRAs, taxpayer‘s contribution limit generally is the lesser of:

(1) $5,500 in 2014 or $6,500 in 2014 if you are 50 or older, or

(2) Taxpayer‘s taxable compensation.

However, if modified AGI is above a certain amount, the

contribution limit may be reduced. Worksheets for determining modified adjusted gross income and this

reduction are provided in the IRS Publication 590.

Roth IRAs & Traditional IRAs

If contributions are made to both Roth IRAs and traditional IRAs established for the taxpayer‘s benefit, the contribution

limit for Roth IRAs generally is the same as the limit would be if contributions were made only to Roth IRAs, but then

reduced by all contributions (other than employer

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contributions under a SEP or SIMPLE IRA plan) for the year

to all IRAs other than Roth IRAs.

This means that the contribution limit is the lesser of:

(1) $5,500 in 2014 or $6,500 in 2014 if taxpayer is 50 or older minus all contributions (other than employer

contributions under a SEP or SIMPLE IRA plan) for the year to all IRAs other than Roth IRAs, or

(2) Taxpayer‘s taxable compensation minus all contributions (other than employer contributions under a

SEP or SIMPLE IRA plan) for the year to all IRAs other than Roth IRAs.

However, if modified AGI is above a certain amount, the contribution limit may be reduced. Worksheets for

determining modified adjusted gross income and this reduction are provided in the IRS Publication 590.

Effect of Modified AGI on Roth IRA Contribution

IF you have taxable

compensation and your

filing status is:

AND your modified AGI

is: THEN:

Married Filing Jointly

Less than $181,000

You can contribute up

to $5,500 in 2014 or

$6,500 in 2014 if age

50 or older.

At least $181,000 but

less than $191,000

The amount you can

contribute is reduced.

$191,000 or more You cannot contribute

to a Roth IRA.

Married Filing

Separately and you

lived with your spouse

at any time during the

year

Zero (-0-)

You can contribute up

to $5,500 in 2014 or

$6,500 in 2014 if 50

or older.

More than zero (-0-) but

less than $10,000

The amount you can

contribute is reduced.

$10,000 or more You cannot contribute

to a Roth IRA.

Single, Head of

Household, Qualifying

Widow(er), or

Married Filing

Less than $114,000

You can contribute up

to $5,500 in 2014 or

$6,500 in 2014 if age

50 or older.

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Separately and you did

not live with your

spouse at any time

during the year

At least $114,000 but

less than $129,000

The amount you can

contribute is reduced.

$129,000 or more You cannot contribute

to a Roth IRA.

Conversions

It is possible to convert amounts from either a traditional, SEP, or SIMPLE IRA into a Roth IRA. Taxpayers may be able

to recharacterize contributions made to one IRA as having been made directly to a different IRA. In addition, taxpayers

can roll amounts over from one Roth IRA to another Roth IRA.

A conversion from a traditional IRA into a Roth IRA is

allowable if, for the tax year the taxpayer makes a withdrawal from a traditional IRA, both of the following requirements are

met:

(1) Taxpayer‘s modified AGI is not more than $100,000;

and

(2) Taxpayer is not a married individual filing a separate

return.

Amounts can be converted from a traditional IRA to a Roth

IRA in any of the following three ways:

1. Rollover. Taxpayer can receive a distribution from a traditional IRA and roll it over (contribute it) to a Roth IRA

within 60 days after the distribution. A rollover from a Roth IRA to an employer retirement plan is not allowed.

Note: Taxpayers can withdraw all or part of the assets from

a traditional IRA and reinvest them (within 60 days) in a

Roth IRA. If properly (and timely) rolled over, the 10%

additional tax on early distributions will not apply.

Taxpayers must roll over into the Roth IRA the same

property they received from the traditional IRA.

2. Trustee-to-trustee transfer. Taxpayer can direct the trustee of the traditional IRA to transfer an amount from

the traditional IRA to the trustee of the Roth IRA.

3. Same trustee transfer. If the trustee of the traditional

IRA also maintains the Roth IRA, taxpayer can direct the trustee to transfer an amount from the traditional IRA to

the Roth IRA.

Note: Conversions made with the same trustee can be

made by redesignating the traditional IRA as a Roth IRA,

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rather than opening a new account or issuing a new

contract.

Taxpayers must include in their gross income distributions from a traditional IRA that they would have to include in

income if they had not converted them into a Roth IRA.

Recharacterizations

Individuals may be able to treat a contribution made to one type of IRA as having been made to a different type of IRA.

This is called recharacterizing the contribution.

To recharacterize a contribution, the contribution must be

transferred from the first IRA (the one to which it was made) to the second IRA in a trustee-to-trustee transfer. If the

transfer is made by the due date (including extensions) for the tax return for the year during which the contribution was

made, taxpayers can elect to treat the contribution as having been originally made to the second IRA instead of to the first

IRA. It will be treated as having been made to the second IRA

on the same date that it was actually made to the first IRA. Taxpayers must report the recharacterization, and must treat

the contribution as having been made to the second IRA, instead of the first IRA, on their tax return for the year during

which the contribution was made.

Note: If a taxpayer files their return timely without making the

election, they can still make the choice by filing an amended

return within six months of the due date of the return (excluding

extensions).

Reconversions

Taxpayers cannot convert and reconvert an amount during the same taxable year, or if later, during the 30-day period

following a recharacterization. If a taxpayer reconverts during either of these periods, it will be a failed conversion.

Taxation of Distributions

Taxpayers do not include in their gross income qualified

distributions or distributions that are a return of their regular contributions from their Roth IRA(s). They also do not include

distributions from their Roth IRA that they roll over tax free into another Roth IRA.

A qualified distribution is any payment or distribution from a

taxpayer‘s Roth IRA that meets the following requirements:

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(1) It is made after the 5 taxable year period beginning

with the first taxable year for which a contribution was made to a Roth IRA set up for the taxpayer‘s benefit, and

(2) The payment or distribution is:

(a) Made on or after the date taxpayer reaches age 59½,

(b) Made because taxpayer is disabled,

(c) Made to a beneficiary or to taxpayer‘s estate after

taxpayer‘s death, or

(d) One that meets the requirements for first-time

homebuyer expenses (up to a $10,000 lifetime limit).

Taxpayers must pay a 10% additional tax on early

distributions on the taxable part of any distributions that are not qualified distributions. Worksheets are provided in IRS

Publication 590 to figure the taxable part of a distribution that is not a qualified distribution.

No Required Minimum Distributions

Taxpayers are not required to take distributions from their

Roth IRA at any age. The minimum distribution rules that apply to traditional IRAs do not apply to Roth IRAs while

the owner is alive. However, after the death of a Roth IRA owner, certain of the minimum distribution rules that apply

to traditional IRAs also apply to Roth IRAs.

If a Roth IRA owner dies, the minimum distribution rules that apply to traditional IRAs apply to Roth IRAs as though

the Roth IRA owner died before his or her required beginning date. The basis of property distributed from a

Roth IRA is its fair market value (FMV) on the date of distribution, whether or not the distribution is a qualified

distribution.

Simplified Employee Pension Plans (SEPs)

A simplified employee pension (SEP) is a written arrangement (a

plan) that allows an employer to make deductible contributions for the benefit of participating employees. The contributions are made

to individual retirement arrangements (IRAs) set up for participants in the plan. Traditional IRAs set up under a SEP plan are referred to

as SEP-IRAs (§408(k)).

Like an individual IRA, an employee may participate in a SEP even

though he is also a participant in a qualified plan. A simplified

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employee pension plan is an IRA that meets all of the following

requirements:

(a) For the calendar year, the employer contributes for each

employee who has attained age 21 and who has performed any service for the employer during three of the preceding five

years;

Note: Any employee who has not earned at least $300 in the

current year may be excluded; however, most part-time

employees will have to be covered. Contributions and

deductions are available even if the employee has attained age

70½ (the normal IRA age limit).

(b) Contributions must not discriminate in favor of highly compensated employees;

Note: Employees who are members of unions where good faith

bargaining on retirement benefits has occurred, as well as

nonresident aliens with no income from sources within the

United States may be excluded.

(c) Employer contributions may be integrated with Social

Security based upon the rules for qualified defined contribution plans; and

Note: However, contributions based on a salary reduction

arrangement may not be integrated.

(d) Each plan participant must own the IRA account or annuity and employer contributions must not be conditioned upon the

retention in such plan of any amount so contributed.

Note: In other words, 100% immediate vesting and no

prohibitions against withdrawals from the account;

(e) The employer has complete contribution flexibility since the

employer is not required to contribute to the SEP each year regardless of whether or not there are profits. The amount to be

contributed each year may also vary at the election of the

employer so long as the contributions remain nondiscriminatory in nature.

(f) Employer contributions must be made pursuant to a written instrument and be based on a definite written allocation formula

that specifies:

(i) The requirements for an employee to share in an

allocation; and

(ii) The manner in which the amount allocated is to be

computed.

7 - 7 0

The Small Business Job Protection Act of 1996 eliminated salary

reduction simplified employee pension plans (SAR-SEPs) in favor of SIMPLE retirement plans. However, SAR-SEPs in effect on 12/31/96

can continue to receive salary reduction contributions and new employees can make salary reduction contributions.

Salary Reduction (SAR-SEP) & Simplified Employee Pension Plans (SEP-IRA)

Planholder Corporations

S corporations

Non-profit organizations (SEP only)

Partnerships

Sole proprietorships (i.e., self-employed)

Eligibility

Requirements

The employer must include employees who

have:

Reached age 21

Worked at least 3 or more of the last 5 preceding

years

Annual compensation of at least $550 (in 2014)

SEP: All eligible employees must participate in the

plan.

SAR/SEP: Employer must have 25 or fewer

eligible employees at all times during the

preceding year. 50% of all eligible employees must

participate in the salary reduction provision of the

plan.

Contribution Limits

SEP Maximum Contribution Limit: Employer

contributions are limited to 25% of each

participant‘s compensation not to exceed $52,000

in 2014 (overall limit includes employer basic and

salary reduction contributions).

SAR/SEP Maximum Contribution Limit: Salary

reduction contributions are limited to 25% of each

participant‘s compensation not to exceed $17,500

(in 2014). These contributions, reported in Box 16

on the employee‘s W-2 Form, are subject to an

anti-discrimination test.

Minimum SEP & SAR/SEP Contribution:

Minimum employer contribution of 3% may be

required if certain highly compensated or key

employees participate.

Deadlines For

Establishment &

Contributions

On or before the employer‘s tax filing deadline plus

extensions. A SEP may be maintained on a

calendar or fiscal year basis.

Distributions Earliest without 10% tax penalty:

7 - 7 1

Death

Permanent disability

Attainment of age 59½

Periodic payments based on a life expectancy

formula that cannot be modified for at least 5

years or until attainment of age 59½, if later

Transfer of assets from a participant‘s IRA to

spouse‘s or former spouse‘s IRA in accordance with

a divorce or separation document.

Latest (without 50% excise tax penalty):

April 1 of the calendar year following the year in

which the participant reaches age 70½

Tax Treatment on

Distribution

All distributions from any type of IRA are taxed as

ordinary income. Remember, however, that if the

individual made nondeductible contributions, each

distribution consists of a nontaxable portion and a

taxable portion.

Contribution Limits & Taxation

The SEP rules permit an employer to contribute to each participating employee's SEP-IRA up to 25% of the employee's

compensation or $52,000 in 2014, whichever is less. These contributions are funded by the employer.

An employer who signs a SEP agreement does not have to make any contribution to the SEP-IRAs that are set up. But, if the

employer does make contributions, the contributions must be based on a written allocation formula and must not discriminate

in favor of highly compensated employees.

The employer's contributions to a SEP-IRA are excluded from the employee‘s income rather than deducted from it. This means

that, unless there are excess contributions, employees do not include any contributions in their gross income; nor do they

deduct any of them.

Employees can make contributions to their SEP-IRA independent

of employer SEP contributions. They can deduct them the same way as contributions to a regular IRA. However, their deduction

may be reduced or eliminated because, as a participant in a SEP, they are covered by an employer retirement plan.

SIMPLE Plans

A savings incentive match plan for employees (SIMPLE plan) is a tax-favored retirement plan that certain small employers (including

self-employed individuals) can set up for the benefit of their employees. Under a SIMPLE plan, employees can choose to make

7 - 7 2

salary reduction contributions to the plan rather than receiving

these amounts as part of their regular pay. In addition, you will contribute matching or nonelective contributions.

A SIMPLE plan can be set up in either of the following ways:

(1) Using SIMPLE IRAs (SIMPLE IRA plan), or

(2) As part of a §401(k) plan (SIMPLE 401(k) plan).

SIMPLE IRA Plan

A SIMPLE IRA plan is a retirement plan that uses SIMPLE IRAs for each eligible employee. Under a SIMPLE IRA plan, a SIMPLE

IRA must be set up for each eligible employee.

Note: Any employee who received at least $5,000 in

compensation during any 2 years preceding the current calendar

year and is reasonably expected to receive at least $5,000

during the current calendar year is eligible to participate. The

term "employee" includes a self-employed individual who

received earned income.

Employers can set up a SIMPLE IRA plan if they meet both the

following requirements:

(a) They meet the employee limit, and

(b) They do not maintain another qualified plan unless the other plan is for collective bargaining employees.

Employee Limit

Employers can set up a SIMPLE IRA plan only if they had 100

or fewer employees who received $5,000 or more in compensation from the employer for the preceding year.

Under this rule, the employer must take into account all employees employed at any time during the calendar year

regardless of whether they are eligible to participate. Employees include self-employed individuals who received

earned income and leased employees. Once an employer sets up a SIMPLE IRA plan, they must continue to meet the 100-

employee limit each year they maintain the plan.

Other Qualified Plan

The SIMPLE IRA plan generally must be the only retirement plan to which the employer makes contributions, or to which

benefits accrue, for service in any year beginning with the year the SIMPLE IRA plan becomes effective. However, if the

employer maintains a qualified plan for collective bargaining

7 - 7 3

employees, they are permitted to maintain a SIMPLE IRA plan

for other employees.

Set up

Employers can use Form 5304-SIMPLE or Form 5305-SIMPLE

to set up a SIMPLE IRA plan. Each form is a model savings incentive match plan for employees (SIMPLE) plan document.

Which form the employer uses depends on whether they

select a financial institution or their employees select the institution that will receive the contributions.

Use Form 5304-SIMPLE if the employer allows each plan participant to select the financial institution for receiving his

or her SIMPLE IRA plan contributions. Use Form 5305-SIMPLE if the employer requires that all contributions under the

SIMPLE IRA plan be deposited initially at a designated financial institution.

The SIMPLE IRA plan is adopted when the employer has completed all appropriate boxes and blanks on the form and

they (and the designated financial institution, if any) have signed it. Keep the original form. Do not file it with the IRS.

Contribution Limits

Contributions are made up of salary reduction contributions

and employer contributions. The employer must make either matching contributions or nonelective contributions. No other

contributions can be made to the SIMPLE IRA plan. These contributions, which the employer can deduct, must be made

timely.

Salary Reduction Contributions

The amount the employee chooses to have the employer contribute to a SIMPLE IRA on his or her behalf cannot be

more than $12,000 in 2014. These contributions must be expressed as a percentage of the employee's compensation

unless the employer permits the employee to express them

as a specific dollar amount. The employer cannot place restrictions on the contribution amount (such as limiting

the contribution percentage), except to comply with the $12,000 (in 2014) limit. Participants who are age 50 or

over can make a catch-up contribution to a SIMPLE IRA of up to $2,500 in 2014.

7 - 7 4

Employer Matching Contributions

Employers are generally required to match each employee's

salary reduction contributions on a dollar-for-dollar basis up to 3% of the employee's compensation. This requirement

does not apply if the employer makes nonelective contributions.

Instead of matching contributions, employers can choose to make nonelective contributions of 2% of compensation on

behalf of each eligible employee who has at least $5,000 (or some lower amount the employer selects) of

compensation for the year. If the employer makes this

choice, they must make nonelective contributions whether or not the employee chooses to make salary reduction

contributions. Only $260,000 in 2014 of the employee's compensation can be taken into account to figure the

contribution limit.

Deduction of Contributions

Employers can deduct SIMPLE IRA contributions in the tax year with or within which the calendar year for which

contributions were made ends. They can deduct contributions for a particular tax year if they are made for that tax year and

are made by the due date (including extensions) of the employer‘s federal income tax return for that year.

Distributions

Distributions from a SIMPLE IRA are subject to IRA rules and

generally are includible in income for the year received. Tax-free rollovers can be made from one SIMPLE IRA into another

SIMPLE IRA. However, a rollover from a SIMPLE IRA to a non-SIMPLE IRA can be made tax free only after a 2-year

participation in the SIMPLE IRA plan.

Early withdrawals generally are subject to a 10% additional

tax. However, the additional tax is increased to 25% if funds are withdrawn within 2 years of beginning participation.

SIMPLE §401(k) Plan

Employers can adopt a SIMPLE plan as part of a 401(k) plan if

they meet the 100-employee limit. A SIMPLE 401(k) plan is a qualified retirement plan and generally must satisfy the rules

discussed applicable to such type plans. However, a SIMPLE

7 - 7 5

401(k) plan is not subject to the nondiscrimination and top-

heavy rules if the plan meets the following conditions:

(1) Under the plan, an employee can choose to have the

employer make salary reduction contributions for the year to a trust in an amount expressed as a percentage of the

employee's compensation, but not more than $12,000 in 2014 and participants who are age 50 or over can make a

catch-up contribution of up to $2,500 in 2014;

(2) The employer must make either:

(a) Matching contributions up to 3% of compensation for the year, or

(b) Nonelective contributions of 2% of compensation on behalf of each eligible employee who has at least $5,000 of

compensation for the year;

(3) No other contributions can be made to the trust;

(4) No contributions are made, and no benefits accrue, for

services during the year under any other qualified retirement plan of the employer on behalf of any employee eligible to

participate in the SIMPLE §401(k) plan; and

(5) The employee's rights to any contributions are

nonforfeitable.

No more than $260,000 in 2014 of the employee's compensation

can be taken into account in figuring salary reduction contributions, matching contributions, and nonelective

contributions.

8 - 1

CHAPTER 8

Insurance

In general, insurance benefits are intended to address the financial

needs of the employee‘s family after the employee dies. A life insurance program may be designed to preserve the executive‘s

estate assets by providing sufficient liquidity to pay the federal estate and state inheritance taxes, as well as meeting long-term

needs of the beneficiaries. However, life insurance may serve one or more of the following corporate purposes:

(1) Protection against the premature death of a key employee;

(2) Funding of a deferred compensation agreement;

(3) Providing an additional fringe benefit;

(4) Funding a buy-sell agreement or stock redemption arrangement; and

(5) Avoiding the accumulated earnings penalty tax.

Company Paid Insurance

One of the most important employee benefits can be company paid

insurance. It is rare that a company does not maintain some form of insurance coverage for its employees. With perhaps the

exception of health insurance plans, no type of fringe benefit is as common as employer-provided life insurance. In many instances,

the company gets a deduction for the premiums it pays and insurance protection is provided to the employee and his family at a

minimum cost.

Popularity

Life insurance as a fringe benefit has become quite popular among

highly compensated employees. Not only does this coverage provide the economic protection enabling an employee‘s

8 - 2

beneficiaries to maintain an accustomed standard of living, but

these various plans can also provide substantial income tax benefits to the employee.

Types of Life Insurance

Although the products offered by insurance companies seem without limit, there are only two basic types of insurance, whole life

and term. All other forms or ―products‖ are essentially components of these two types of insurance.

Group Term Life - §79

Generally, life insurance premiums are not deductible unless they

are incurred as an ordinary business expense. However, there is a

limited exception for $50,000 of group term life insurance coverage under §79. In order for a policy to constitute a group policy, it must

cover either a group of employees or it must be part of a group of policies covering several employers under a master plan.

Requirements

The requirements for qualifying group term life insurance are:

(1) Coverage must not constitute permanent insurance (Reg. §1.79-1(b);

(2) Disability insurance cannot be included;

(3) Coverage can apply only to employees, although spouses

and dependents can be covered up to $2,000;

(4) Excess benefits are taxable under the tables (Reg. §1.79-

3(d)(2));

(5) The plan must be written;

(6) There must be a formula for determining coverage based upon age, years of service, compensation, or position;

(7) The plan must cover a group of employees which is usually defined as at least 10 or more employees, although

there are special rules for groups less than 10; and

(8) The plan may not discriminate in favor of the key employees.

Cost Of Group-term Life Insurance

The cost of group-term life insurance purchased by an employer for an employee for a taxable year is included in the employee‘s

8 - 3

gross income to the extent that the cost is greater than the sum

of the cost of $50,000 of life insurance plus any employee contributions to the cost of the insurance. Generally, cost is

determined on the basis of uniform premiums, computed with respect to five-year age brackets, under a table prepared by the

IRS. The TRA ‗86 provides that in the case of a discriminatory group-term life insurance plan, the cost of group-term life

insurance on the life of any key employee is the greater of the actual act of the insurance or the cost determined based on the

uniform premium tables (§79(d)(1)(B)).

“Key Employee” Defined

For purpose of applying the group-term insurance rules prohibiting discrimination in favor of key employees, a key

employee is defined as a participant in a group-term insurance plan who:

(1) Is an officer (of the employer) and earns more than 150% of the §415(c)(1)(A) dollar limit on contributions and

other additions to defined contribution plans; or

(2) Is one of the ten employees owning the largest interests

in the employer; or

(3) Owns more than a 5% interest in the stock of a corporate

employer or more than 5% of the capital or profits interest of

a noncorporate employer; or

(4) Owns more than a 1% interest in the stock or profits of

the corporate or noncorporate employer, and has annual compensation from the employer in excess of $150,000.

Retired Lives Reserve

The retired lives reserve fund is generally an extension of a group

term insurance plan. Under such a plan a reserve fund is set up and

actuarially determined contributions are made to the fund. At retirement, the reserve fund uses the accumulated contributions to

buy term life insurance protection for the employee during retirement. These plans tend to benefit the principals of the

corporation since they are most likely to remain with the company through retirement.

8 - 4

Revenue Ruling 68-577

Under Revenue Ruling 68-577, in order for the company to be

able to deduct the premiums, the following requirements must be met:

(a) There must be level annual payments to the fund that are actuarially determined;

(b) The funds must be used exclusively to pay group term insurance premiums as long as any employee is alive;

(c) The estimated cost of funding such a plan must be allocated over each employee‘s working life; and

(d) The plan guarantees that no insurance benefits will ever

be paid but only pays the premiums.

Taxation

The employees are not taxable on the current contributions to

the reserve fund since they realize no current benefit and are not assured of any benefit in the future. Formerly, §79 specifically

excluded retired employees from the imputation of income rules.

As a result, there was no imputation of income and Table 1 did not apply.

Effective for tax years beginning after 1983, the same rules that apply to active employees apply to retired employees. Thus the

cost of the first $50,000 of group term coverage is tax-free. However, the cost of coverage in excess of $50,000 is taxable in

the year coverage is received to the extent it exceeds any contribution made by the retired employee (§79(e)).

Nevertheless, employer paid premiums for group term insurance for retired disabled employees are still 100% tax free even if

coverage exceeds $50,000.

Split Dollar Life

Split-dollar is an arrangement for purchasing a life insurance

contract where the employee and the company split the premium and death benefit of a permanent life insurance contract. Normally,

the employer pays the amount of the annual cash value increase in the policy and the employee pays the difference between that

amount and the full premium. In the early policy year, before the cash value begins to build up, the employee‘s required contribution

is substantial. In later years, however, the employee‘s contribution may drop to zero. At death, the employer receives the cash value

8 - 5

and the employee‘s heir gets the amount at risk—i.e. the difference

between the face amount and the cash value.

Note: Many variations have developed on the ―basic plan‖

outlines above. Often the employer will even pay the entire

premium, but still split the proceeds at death (referred to as a

―noncontributory plan‖). Sometimes the employer will permit

the employee to contribute a level amount over the expected

premium-paying period, rather than the high initial amounts.

Low Cost Term Insurance

The plan gives the employee what is in effect term insurance at

a reduced cost and doesn‘t cost the employer anything because the company gets its money back on the employee‘s death. The

policy‘s cash value belongs to the company. Such plans can discriminate in favor of the highly compensated employees.

Regulatory Requirements

ERISA imposes regulatory requirements upon employee welfare

benefit plans, which include split-dollar insurance plans, even though employee welfare benefit plans are exempt from the

participation, vesting, and plan termination insurance provisions of ERISA. The Department of Labor has issued regulations that

largely exempt split-dollar plans from the reporting and disclosure requirements of the law (DOL Reg. §2520.104).

Taxation

Since the employer is a beneficiary of the policy, there is no

deduction for any portion of the premium that it pays (§264(a)(1)). This is true even though some portion of the

employer‘s premium payment is a taxable economic benefit to

the employee (R.R. 64-328)). Likewise, employees cannot deduct any portion of a split-dollar premium. Moreover,

employees are taxed on the total value of the insurance protection received during the year less any payments made by

them (R.R. 67-154). However, neither the employer nor the heirs are taxed on the proceeds at death (§101(a) and R.R. 64-

328).

Death Benefit Only Plan - Repealed

Formerly, §101(b) excluded the first $5,000 paid by an employer to

a deceased employee‘s heirs. These payments were deductible by the corporation and tax free to the heirs or the decedent‘s estate.

8 - 6

The Small Business Jobs Protection Act of 1996 repealed this

provision.

Business Travel Accident Insurance

This kind of policy provides life insurance if the executive is dismembered or killed accidentally while traveling on company

business. Premiums paid by the employer for such coverage are deductible if the amounts paid are ordinary and necessary expenses

of the employer‘s trade or business under §162. Regulation §1.162-

10(a) provided that an employer may deduct amounts paid or accrued during the taxable year for a sickness, hospitalization,

surgical, medical or accident benefits plan covering it employees, and it appears to be sufficiently broad to cover travel accident

insurance.

Medical & Dental Insurance

Employer paid health or medical insurance plans are so

commonplace for all employees, including the highly compensated, that little thought is given to their tax implications. Such plans

provide a substantial economic and tax benefit to the employee and must not be overlooked when developing a fringe benefit package

for the highly compensated.

Premiums

The premiums are deductible by the employer and are excluded from the employee‘s income (§106 and Reg. §1.106-1). This is

an exception to the general rule of taxation contained in §105(a).

The exclusion under §106 for health insurance premium payments has been, unlike many other exclusionary provisions

of the Code, rather generously interpreted by the IRS.

Disability Income Insurance

Many employers offer disability income plans to their employees

that, in effect, provide income protection in the event that the employee‘s physical condition makes it impossible to work. In

addition, all states have enacted workmen‘s compensation statutes that provide for certain payments in the event of job related

injuries.

8 - 7

Repeal of Exclusion

The disability income provisions of the Code have been so

emasculated that these sections can be expected to provide little or no benefit to the highly compensated. Formerly, §105(d)

provided for an exclusion of disability payments to a taxpayer who had not attained age 65 before the close of the taxable year

and who had retired because of a permanent and total disability. This exclusion was limited to payments of $100 per week and

was phased out on a dollar for dollar basis to the extent that the taxpayer‘s income for the year exceeded $15,000. Section

105(d) was repealed in 1983 by the Social Security Amendments

of 1983 (P.L. 98-21).

Tax Credit for Disabled

The retirement income credit rules apply to taxpayers age 65 or

over and to individuals under age 65 who are retired with permanent and total disability and who have disability income

from a public or private employer on account of the disability

(§22). The maximum allowable credit is $1,125.

Interest Limitation on Policy Loans - §264

Deductibility of Premiums & Interest on Life

Insurance

Exclusion Of Inside Buildup & Amounts Received

No Federal income tax generally is imposed on a policyholder with respect to the earnings under a life insurance contract

(‗‗inside buildup‘‘). Further, an exclusion from Federal income tax is provided for amounts received under a life insurance contract

paid by reason of the death of the insured (§101(a)).

Premium Deduction Limitation

No deduction is permitted for premiums paid on any life insurance policy covering the life of any officer or employee, or

of any person financially interested in any trade or business carried on by the taxpayer, when the taxpayer is directly or

indirectly a beneficiary under such policy (§264(a)(1)).

However, The premium deduction limitation does not apply to

premiums with respect to any annuity contract described in

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§72(s)(5) (relating to certain qualified pension plans, certain

retirement annuities, individual retirement annuities, and qualified funding assets), nor to premiums with respect to any

annuity to which §72(u) applies (relating to current taxation of income on the contract in the case of an annuity contract held by

a person who is not a natural person).

Interest Deduction Disallowance With Respect To Life

Insurance

Generally, no deduction is allowed for interest paid or accrued on

any indebtedness with respect to one or more life insurance contracts or annuity or endowment contracts owned by the

taxpayer covering any individual (the ‗‗COLI‘‘ rules). Thus, the provision limits interest deductibility in the case of such a

contract covering any individual in whom the taxpayer has an insurable interest under applicable State law when the contract

is first issued, except as otherwise provided under present law with respect to key persons and pre-1986 contracts.

This interest deduction disallowance rule generally does not apply to interest on debt with respect to contracts purchased on

or before June 20, 1986; rather, an interest deduction limit based on Moody‘s Corporate Bond Yield Average—Monthly

Average Corporates applies in the case of such contracts.

An exception to this interest disallowance rule is provided for interest on indebtedness with respect to life insurance policies

covering up to 20 key persons. A key person is an individual who is either an officer or a 20-percent owner of the taxpayer. The

number of individuals that can be treated as key persons may not exceed the greater of:

(1) Five individuals, or

(2) The lesser of 5% of the total number of officers and

employees of the taxpayer, or 20 individuals.

For determining who is a 20% owner, all members of a

controlled group are treated as one taxpayer. Interest paid or accrued on debt with respect to a contract covering a key person

is deductible only to the extent the rate of interest does not exceed Moody‘s Corporate Bond Yield Average—Monthly Average

Corporates for each month beginning after December 31, 1995,

that interest is paid or accrued.

Note: The foregoing interest deduction limitation was added in

1996 to existing interest deduction limitations with respect to

life insurance and similar contracts.

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Prorata Disallowance of Interest on Debt to Fund Life

Insurance

In the case of a taxpayer other than a natural person, no deduction is allowed for the portion of the taxpayer‘s interest

expense that is allocable to unborrowed policy cash surrender values with respect to any life insurance policy or annuity or

endowment contract issued after June 8, 1997. Interest expense is allocable to unborrowed policy cash values based

on the ratio of:

(1) The taxpayer‘s average unborrowed policy cash values

of life insurance policies, and annuity and endowment

contracts, issued after June 8, 1997, to

(2) The sum of:

(a) In the case of assets that are life insurance policies or annuity or endowment contracts, the average

unborrowed policy cash values, and

(b) In the case of other assets, the average adjusted

basis for all such other assets of the taxpayer.

An exception is provided for any policy or contract owned by

an entity engaged in a trade or business, which covers one individual who (at the time first insured under the policy or

contract) is:

(1) A 20-percent owner of the entity, or

(2) An individual (who is not a 20-percent owner) who is an officer, director, or employee of the trade or business.

The exception also applies in the case of a joint-life policy or

contract under which the sole insureds are a 20% owner and the spouse of the 20-percent owner. A joint-life contract

under which the sole insureds are a 20-percent owner and his or her spouse is the only type of policy or contract with more

than one insured that comes within the exception. Thus, for example, if the insureds under a contract include an individual

described in the exception (e.g., an employee, officer, director, or 20% owner) and any individual who is not

described in the exception (e.g., a debtor of the entity), then the exception does not apply to the policy or contract. For

purposes of this exception, a 20% owner has the same meaning as under present-law §264(d)(4). In addition, the

Act provides that the pro rata interest disallowance rule does not apply to any annuity contract to which §72(u) applies

(relating to current taxation of income on the contract in the

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case of an annuity contract held by a person who is not a

natural person). The Act provides that any policy or contract that is not subject to the pro rata interest disallowance rule

by reason of this exception (for 20% owners, their spouses, employees, officers and directors, and in the case of an

annuity contract to which §72(u) applies) is not taken into account in applying the ratio to determine the portion of the

taxpayer‘s interest expense that is allocable to unborrowed policy cash values.

The unborrowed policy cash values means the cash surrender value of the policy or contract determined without regard to

any surrender charge, reduced by the amount of any loan with respect to the policy or contract. The cash surrender

value is to be determined without regard to any other contractual or noncontractual arrangement that artificially

depresses the cash value of a contract. If a trade or business

(other than a sole proprietorship or a trade or business of performing services as an employee) is directly or indirectly

the beneficiary under any policy or contract, then the policy or contract is treated as held by the trade or business. For

this purpose, the amount of the unborrowed cash value is treated as not exceeding the amount of the benefit payable to

the trade or business. In the case of a partnership or S corporation, the provision applies at the partnership or

corporate level. The amount of the benefit is intended to take into account the amount payable to the business under the

contract (e.g., as a death benefit) or pursuant to another agreement (e.g., under a split dollar agreement). The amount

of the benefit is intended also to include any amount by which liabilities of the business would be reduced by payments

under the policy or contract (e.g., when payments under the

policy reduce the principal or interest on a liability owed to or by the business).

It is intended that the above exception under new §264(f)(4)(A) (in the case of an employee, officer, director, or

20% owner) not be precluded from applying merely because the trade or business holds an economic interest in the policy

but does not own an interest in the policy, for example, in the case of collateral assignment split dollar insurance. This

situation may arise if an individual employee owns a policy but the trade or business holds an interest in the policy by

reason of being directly or indirectly a beneficiary under the

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policy pursuant to a collateral assignment split dollar

arrangement. No inference is intended as to the treatment under present law of any other aspect of the arrangement

(including, without limitation, the tax treatment of the individual or the trade or business with respect to the actual

or constructive transfer of funds to the individual to pay premiums).

The issuer or policyholder of the life insurance policy or endowment or annuity contract is required to report such

information as is necessary to carry out this rule. The required reporting to the Treasury Secretary is an information

return (within the meaning of §6724(d)(1)), and any reporting required to be made by any other person is a payee

statement (within the meaning of §6724(d)(2)). The Treasury Secretary may require reporting by the issuer or policyholder

of any relevant information either by regulations or by any

other appropriate guidance (including but not limited to publication of a form). This statutory reporting requirement

does not supersede the authority of the Treasury Secretary under §6001 of the Code to require reporting necessary to

apply the premium or interest deduction limitations of the Act, for example, reporting by businesses that own life

insurance, endowment or annuity contracts.

If interest expense is disallowed under other provisions of

§264 (limiting interest deductions with respect to life insurance policies or endowment or annuity contracts) or

under §265 (relating to tax-exempt interest), then the disallowed interest expense is not taken into account under

this provision, and the average adjusted basis of assets is reduced by the amount of debt, interest on which is so

disallowed. The provision is applied before present-law rules

relating to capitalization of certain expenses where the taxpayer produces property (§263A).

An aggregation rule is provided, treating related persons as one for purposes of the provision. This aggregation rule is

intended to prevent taxpayers from avoiding the pro rata interest limitation by owning life insurance, endowment or

annuity contracts, while incurring interest expense through a related person.

The provision does not apply to any insurance company subject to tax under subchapter L of the Code. Rather, the

rules reducing certain deductions for losses incurred, in the

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case of property and casualty companies, and reducing

reserve deductions or dividends received deductions of life insurance companies, are modified to take into account the

increase in cash values of life insurance policies or annuity or endowment contracts held by insurance companies. For

purposes of those rules, an increase in the policy cash value for any policy or contract is:

(1) The amount of the increase in the adjusted cash value, reduced by

(2) The gross premiums received with respect to the policy or contract during the taxable year, and increased by

(3) Distributions under the policy or contract to which §72(e) apply (other than amounts includable in the

policyholder‘s gross income).

For this purpose, the adjusted cash value means the cash

surrender value of the policy or contract, increased by:

(1) Commissions payable with respect to the policy or contract for the taxable year, and

(2) Asset management fees, surrender and mortality charges, and any other fees or charges, specified in

regulations, which are imposed (or would be imposed if the policy or contract were surrendered or canceled) with

respect to the policy or contract for the taxable year.

Interest Limitation for Tax-Exempt

Interest Income

No deduction is allowed for interest on debt incurred or continued to purchase or carry obligations the interest on which is wholly exempt

from Federal income tax (§265(a)(2)). In addition, in the case of a financial institution, a proration rule provides that no deduction is

allowed for that portion of the taxpayer‘s interest that is allocable to tax-exempt interest (§265(b)). The portion of the interest

deduction that is disallowed under this rule generally is the portion determined by the ratio of the taxpayer‘s:

(1) Average adjusted basis of tax-exempt obligations acquired after August 7, 1986, to

(2) The average adjusted basis for all of the taxpayer‘s assets (§265(b)(2)).

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Other Selected Insurances

Self-Employed Health Insurance Deduction

Business owners may be able to deduct 100 percent of the amount paid for medical and dental insurance and qualified long-term care

insurance for themselves, their spouses, and their dependents if they are one of the following:

(1) A self-employed individual with a net profit reported on Schedule C, C-EZ, or F,

(2) A partner with net earnings from self-employment reported on Schedule K-1 (Form 1065), box 14, code A, or

(3) A shareholder owning more than 2% of the outstanding

stock of an S corporation with wages from the corporation reported on Form W-2.

The insurance plan must be established under the business. The taxpayer may be allowed this deduction whether he or she paid the

premiums personally or a partnership or S corporation paid them and the premium amounts were included in the taxpayer‘s gross

income.

Long-Term Care Premiums

Premiums for long-term care insurance and long-term care services

are treated as medical expenses for purposes of the itemized deduction for medical expenses and the exclusion for employer-

provided health benefits.

But, for each person covered in 2014, only the lesser of the

following amounts can be included:

(1) The amount paid for that person, or

(2) The amount shown below:

Age 40 or under – $370.

Age 41 to 50 – $700.

Age 51 to 60 – $1,400.

Age 61 to 70 – $3,720.

Age 71 or over – $4,660 (R.P. 2013-35).

A qualified long-term care insurance contract provides coverage

only of qualified long-term care services. Qualified long-term care services are:

(1) Necessary diagnostic, preventive, therapeutic, curing, treating, mitigating, and rehabilitative services, and

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(2) Maintenance or personal care services.

The services must be required by a chronically ill individual and prescribed by a licensed health care practitioner.

Capitalized Insurance

Under the uniform capitalization rules, the direct costs and part of

the indirect costs for certain production or resale activities must be capitalized, rather than expensed. That means these costs must be

included in the basis of property produced or acquired for resale,

rather than claimed as a current deduction. The costs are recovered through depreciation, amortization, or cost of goods sold when the

property is used, sold, or otherwise disposed of.

Indirect costs include premiums for insurance on a plant or facility,

machinery, equipment, materials, property produced, or property acquired for resale.

Health Savings Accounts

In addition to deductions for insurance, the tax laws authorize other breaks for business owners and their employees. The Medicare

Prescription Drug, Improvement, and Modernization Act of 2003 authorized the establishment of new health savings accounts

effective January 1, 2004. These accounts are similar to Archer Medical Savings Accounts in that they permit eligible individuals to

save for, and pay, health care expenses on a tax-free basis.

Small Business Health Insurance Expense Tax Credit

- §45R

IRC §45R provides a sliding scale tax credit (as part of the §38 general business credit) of up to 50% of nonelective contributions

the business makes on behalf of its employees for insurance premiums for small employers with fewer than 25 employees and

average annual wages of less than $50,000 that purchase health insurance for their employees.

Note: Five-percent owners (as defined in §416) and 2%

shareholders of S corporations are counted as employees.

However, leased employees are considered employees.

The full credit is available to employers with 10 or fewer employees

and average annual wages of less than $25,000 (indexed for inflation after 2013). The credit is reduced based on the number of

employees over 10 and the excess of the employees' average

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wages over $25,000. However, to be eligible for a tax credit, the

employer must contribute at least 50 percent of the total premium cost or 50 percent of a benchmark premium.

In 2010 through 2013, eligible employers could receive a small business tax credit for up to 35 percent of their contribution toward

the employee‘s health insurance premium. Tax-exempt small businesses meeting the above requirements were eligible for tax

credits of up to 25 percent of their contribution.

In 2014 and beyond, eligible employers who purchase coverage

through an exchange can receive a tax credit for two years of up to 50 percent of their contribution. Tax-exempt small businesses

meeting the above requirements are eligible for tax credits of up to 35 percent of their contribution.

The IRS has a detailed ―frequently asked questions‖ website on the small business tax credit located at:

www.irs.gov/newsroom/article/0,,id=220839,00.html .

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CHAPTER 9

Estate Planning

Estate taxes pose a special problem for business owners who want to see a family business stay in the family and whose children

aspire to taking over the business. The reason: unless the business owner's estate includes enough liquid assets like stocks, bonds and

bank accounts to pay estate taxes, or the family members own insurance on the business owner and can use the proceeds to pay

the taxes, it may be necessary for executors to sell assets of the business to raise money to pay estate taxes. If a large portion of a

business‘s assets is sold, it may cripple the business. That makes

estate planning crucial for business owners.

General Estate Planning in Unsettled Times

It has been said that death is the ultimate1 tax shelter. However,

that is certainly a gross misstatement when you consider the size of potential estate tax liability that is incurred upon one‘s death in

cases where prudent planning has not been done.

In 2010, Congress amazingly permitted the long scheduled EGTRRA

one-year repeal of the estate and generation-skipping transfer

taxes to become law. However, late in December of 2010, TRUIRJCA reinstated (subject to a special election for 2010) the

estate and generation skipping transfer taxes effective for decedents dying and transfers made after December 31, 2009. In

addition, the gift and estate taxes were unified such that a single

1 Ne v e r t h e l e s s , i t i s s t i l l h a r d l y a p l a n n i n g t o o l a n d

p e o p l e a r e n o r ma l l y r e l u c t a n t t o p r e ma t u r e l y u s e i t .

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graduated rate schedule and effective exemption amount (indexed

for inflation since 2011) applied to an individual's cumulative taxable gifts and bequests. Applying the exemption amount to the

graduated rates resulted in a top rate of 35% for estate, gift and GST taxes.

Note: Prior to 2002, the gift and the estate tax were unified so

that a single graduated rate schedule applied to the cumulative

taxable transfers made by taxpayer during their life and at

death. Under the 2001 Act, while the estate, gift, and

generation-skipping transfer taxes were reduced between 2002

and 2009, gift taxes continued on separate path with a $1

million exemption and 35% maximum rate. As a result of

TRUIRJCA, for gifts made after December 31, 2010, the gift tax

was once again reunified with the estate tax, with the same

exemption and an identical top estate and gift tax rate of 35%.

In 2013, ATRA permanently increased the top estate, gift, and GST rate from 35% to 40% for transfers over the exemption amount

(§2001 & §2502).

Despite (or because of) these legislative developments, the most

important elements of estate tax planning remain:

(1) The unlimited marital deduction,

(2) The applicable exemption (or exclusion) amount2, and

(3) Stepped-up basis on death.

Unlimited Marital Deduction

The marital deduction is a deduction from the gross estate of the value of property that is included in the gross estate but that

passes, or has passed, to the surviving spouse.

A marital deduction generally is denied for property passing to a

surviving spouse who is not a citizen of the United States. A marital deduction is permitted, however, for property passing to a qualified

domestic trust of which the noncitizen surviving spouse is a

beneficiary. A qualified domestic trust is a trust that has as its trustee at least one U.S. citizen or U.S. corporation. No corpus may

be distributed from a qualified domestic trust unless the U.S. trustee has the right to withhold any estate tax imposed on the

distribution.

A marital deduction can be obtained in a number of different ways.

2

F o r 2 0 13 , t h i s a mo u n t i s $ 5 , 2 5 0 , 0 0 0 .

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Outright To Spouse

Assets left outright to a spouse qualify under the marital

deduction and pass tax-free. The amount transferred to the surviving spouse can come from the deceased spouse‘s separate

or community3 property. ―Outright‖ transfers can be made by:

(1) Joint tenancy,

(2) Will,

(3) Intestate succession,

(4) Beneficiary designation,

(5) Living trust, or

(6) Any other method provided there is no restriction on the

surviving spouse.

Marital Deduction Trust

A marital deduction trust qualifies for the marital deduction.

Under this trust, the first spouse to die leaves their assets in

trust for the survivor‘s benefit. The survivor is required to receive all the trust‘s income and have a general power of

appointment over the assets at death. A general power of appointment means the spouse can leave the trust assets to

anyone upon their death. Such a trust eliminates tax on the first death, but causes the assets to be taxed on the second spouse‘s

death.

Qualified Terminable Interest Property Trust

Generally, a marital deduction is not allowed for a life estate that passes from a decedent to a surviving spouse, because the

surviving spouse's interest terminates when he or she dies. However, a marital deduction may be elected for all or part of

this interest if it meets the requirements of qualified terminable interest property.

A ―qualified terminable interest‖ is property:

(1) Which passes from the decedent,

(2) In which the surviving spouse has a ―qualifying income interest for life,‖ and

(3) To which an election under these rules applies.

A ―qualifying income interest for life‖ exists if:

3

Re a d a s “ ma r i t a l p r o p e r t y ” i n n o n c o mmu n i t y p r o p e r t y

s t a t e s .

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(1) The surviving spouse is entitled to all the income from

the property (payable annually or at more frequent intervals) or the right to use property during the spouse‘s life, and

(2) No person has the power to appoint any part of the property to any person other than the surviving spouse.

A trust for the spouse‘s benefit can be structured to satisfy these requirements. Here, the spouse can get all the trust income for

life, but at death the surviving spouse cannot direct who will get the trust assets. With the terminable interest trust you can delay

tax until the second spouse‘s death and still control the final disposition of the assets.

Applicable Exclusion Amount

Under the 2001 Act, in 2002, the 5% surtax (which phases out the benefit of the graduated rates) and the rates in excess of 50% were

repealed. In addition, in 2002, the applicable exclusion amount (for both estate and gift tax purposes) was $1 million.

Note: The applicable exclusion amount is the size of an estate

that can be passed free of federal estate tax. Everyone is

entitled to the applicable exclusion amount.

In 2003, the estate and gift tax rates in excess of 49% were repealed. In 2004, the estate and gift tax rates in excess of 48%

were repealed, and the applicable exclusion amount for estate tax

purposes became $1.5 million.

Note: Until 2011, the applicable exclusion amount for gift tax

purposes remained at $1 million as increased in 2002. However,

for gifts after December 31, 2010, the exclusion amount was $5

million in 2011 and was $5.12 million in 2012.

In 2005, the estate and gift tax rates in excess of 47% were repealed. In 2006, the estate and gift tax rates in excess of 46%

were repealed, and the applicable exclusion amount for estate tax purposes was increased to $2 million. In 2007, the estate and gift

tax rates in excess of 45% were repealed. In 2009, the applicable exclusion amount was increased to $3.5 million. In 2010, the estate

and generation-skipping transfer taxes were repealed. However, in December of 2010, TRUIRJCA reinstated (subject to a special

election for 2010) the estate and generation skipping transfer taxes effective for decedents dying and transfers made after December

31, 2009. This reenactment of the estate tax was in a complicated section of TRUIRJCA that sunseted certain provisions of EGTRRA as

if they had never been enacted.

9 - 5

Note: The Tax Relief Act of 2001 gradually phased out the state

death tax credit between 2002 and 2004, with the credit

repealed in 2005. Since 2005, the state death tax credit is

replaced by a deduction for state death taxes paid. TRUIRJCA

continued this deduction through 2012 (§2058). ATRA made the

state death tax deduction permanent for decedents dying after

December 31, 2012.

For 2010 and 2011, the estate tax applicable exclusion amount was

$5 million: for 2012 the exclusion was inflation indexed to $5.12 million. Amounts exceeding this exclusion amount were taxed at

35%. ATRA kept the inflation indexed exclusion ($5.34 million in 2014) but, permanently increased the top estate, gift, and GST rate

from 35% to 40% for transfers over the exclusion. As a result, the applicable exclusion amounts and their credit equivalents are as

follows:

Year of death Exclusion Amount Credit

Equivalent

2006 2,000,000 780,000

2007 2,000,000 780,000

2008 2,000,000 780,000

2009 3,500,000 1,455,800

2010 5,000,000 1,730,800

2011 5,000,000 1,730,800

2012 5,120,000 1,772,800

2013 5,250,000 2,045,800

2014 5,340,000 2,081,800

Comment: Gifts made during a decedent‘s lifetime in excess of

the gift tax annual exclusion and using the gift exemption

amount reduce the estate tax applicable exclusion amount on

death and can increase the estate tax. In short, the estate tax

applicable exclusion amount is reduced if any gift exemption

amount has been previously used.

The generation-skipping transfer tax exemption for a given year is

equal to the applicable exclusion amount for estate tax purposes. In addition, the generation-skipping transfer tax rate for a given year

will be the highest estate and gift tax rate in effect for such year.

Spousal Portability of Unused Exemption Amount -

§2010(c)(2)

Under TRUIRJCA, any applicable exclusion amount that remains

unused as of the death of a spouse who dies after December 31, 2010 (the "deceased spousal unused exclusion amount"), is

9 - 6

available for use by the surviving spouse, as an addition to such

surviving spouse's applicable exclusion amount.

Note: The Act does not allow a surviving spouse to use the

unused generation skipping transfer tax exemption of a

predeceased spouse.

If a surviving spouse is predeceased by more than one spouse,

the amount of unused exclusion that is available for use by such surviving spouse is limited to the lesser of $5.34 million (in

2014) or the unused exclusion of the last such deceased spouse. This last deceased spouse limitation applies whether or not the

last deceased spouse has any unused exclusion or the last deceased spouse's estate makes a timely election. A surviving

spouse may use the predeceased spousal carryover amount in addition to such surviving spouse's own $5.34 (in 2014) million

exclusion for taxable transfers made during life or at death.

Note: A deceased spousal unused exclusion amount is available

to a surviving spouse only if an election is made on a timely filed

estate tax return (including extensions) of the predeceased

spouse on which such amount is computed, regardless of

whether the estate of the predeceased spouse otherwise is

required to file an estate tax return.

Stepped-up Basis & Modified Carryover Basis

Property passing from a decedent‘s estate generally takes a

stepped-up basis. ―Stepped-up basis‖ for estate tax purposes means that the basis of property passing from a decedent‘s estate

generally is the fair market value on the date of the decedent‘s death (or, if the alternate valuation date is elected, the earlier of six

months after the decedent‘s death or the date the property is sold or distributed by the estate). This step up (or step down) in basis

eliminates the recognition of income on any appreciation of the property that occurred prior to the decedent‘s death, and has the

effect of eliminating the tax benefit from any unrealized loss.

In community property states, a surviving spouse‘s one-half share of community property held by the decedent and the surviving

spouse (under the community property laws of any State, U.S. possession, or foreign country) generally is treated as having

passed from the decedent, and thus is eligible for stepped-up basis. This rule applies if at least one-half of the whole of the community

interest is includible in the decedent‘s gross estate.

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Modified Carryover Basis - §1022

Without the enactment of TRUIRJCA, the 2010 repeal of the

estate, gift, and generation-skipping transfer taxes would have eliminated stepped up basis and imposed a modified carryover

basis regime. Under this modified carryover basis regime, recipients of property transferred at the decedent‘s death would

have received a basis equal to the lesser of:

(1) The adjusted basis of the decedent, or

(2) The fair market value of the property on the date of the decedent‘s death.

The modified carryover basis rules applied to property acquired

by bequest, devise, or inheritance, or by the decedent‘s estate from the decedent, and property passing from the decedent to

the extent such property passed without consideration.

Property acquired from a decedent was treated as if the property

had been acquired by gift. Thus, the character of gain on the sale of property received from a decedent‘s estate was carried

over to the heir. For example, real estate that had been depreciated and would be subject to recapture if sold by the

decedent would be subject to recapture if sold by the heir.

The modified carryover basis rules applied to property acquired

from the decedent. Property acquired from the decedent is:

(1) Property acquired by bequest, devise, or inheritance,

(2) Property acquired by the decedent‘s estate from the decedent,

(3) Property transferred by the decedent during his or her

lifetime in trust to pay the income for life to or on the order or direction of the decedent, with the right reserved to the

decedent at all times before his death to revoke the trust,

(4) Property transferred by the decedent during his lifetime

in trust to pay the income for life to or on the order or direction of the decedent with the right reserved to the

decedent at all times before his death to make any change to the enjoyment thereof through the exercise of a power to

alter, amend, or terminate the trust,

(5) Property passing from the decedent by reason of the

decedent‘s death to the extent such property passed without consideration (e.g., property held as joint tenants with right

of survivorship or as tenants by the entireties), and

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(6) The surviving spouse‘s one-half share of certain

community property held by the decedent and the surviving spouse as community property.

Limited Basis Increase for Certain Property

The modified carryover basis rules allowed an executor to increase (i.e., step up) the basis in assets owned by the

decedent and acquired by the beneficiaries at death. Under

this rule, each decedent‘s estate generally was permitted to increase (i.e., step up) the basis of assets transferred by up

to a total of $1.3 million.

The $1.3 million was increased by the amount of unused

capital losses, net operating losses, and certain ―built-in‖ losses of the decedent. In addition, the basis of property

transferred to a surviving spouse could be increased by an additional $3 million.

Thus, the basis of property transferred to surviving spouses could have been increased by a total of $4.3 million.

Nonresidents who were not U.S. citizens were allowed to increase the basis of property by up to $60,000. The $60,000,

$1.3 million, and $3 million amounts were to be adjusted annually for inflation occurring after 2010.

In general, the basis of property could have been increased

above the decedent‘s adjusted basis in that property only if the property was owned, or was treated as owned, by the

decedent at the time of the decedent‘s death.

2010 Special Election

For a decedent who died during 2010, TRUIRJCA allowed the executor of such a decedent's estate to elect to apply the

Code as if the TRUIRJCA estate tax and fair market value basis step-up rules had not been enacted. In other words,

instead of applying the reinstated estate tax and basis step-up rules of TRUIRJCA, the executor could elect to have the

law under EGTRRA apply. When such an election was made, the estate was not subject to estate tax but, the basis of

assets acquired from the decedent was determined under the modified carryover basis rules of §1022.

Comment: Estates not covered by the $5 million (in 2010)

applicable exclusion amount should have made this election.

However, the executor would have had to consider a variety of

9 - 9

factors, particularly, the estate tax savings vs. the gain that

would be subject to tax on a future sale of assets.

Basic Estate Planning Goals

An estate plan should be designed not only to achieve the desired

distribution of the decedent‘s assets, but also to provide for the accomplishment of the following five basic goals:

1. Elimination of the federal death tax on the death of the first spouse and minimization of death taxes on the death of the

surviving spouse;

2. Elimination of state inheritance taxes where applicable;

3. Avoidance of often unnecessary and costly probate

administration in the state in which the taxpayer lives and in any state where he may own property;

4. Creation of a system for the continued orderly management of one‘s assets in the event either or both the spouses should

become disabled; and

5. Continued efficient management of the estate after the death

of both spouses for the benefit of children and/or other heirs.

Primary Dispositive Plans

While literally thousands4 of possible estate plans exist, in my

opinion there are three primary ways to wisely dispose of one‘s assets:

(1) A simple will,

(2) A living ―A-B‖ format trust, and

(3) A living ―A-B-C‖ or ―QTIP‖ format trust.

While this list is not all-inclusive, it does reflect the best of the

simplified planning resulting from recent tax changes and a sincere desire to avoid unnecessary probate. What follows is a discussion of

each format along with an explanatory flowchart.

Simple Will

A will is a document that transfers your assets at death. Under laws of most states, you can leave your assets to any individual,

association, corporation, group, or government entity. You may also disinherit your spouse, children, or anyone you want.

4

Ca r l Sa g a n wo u l d p r o b a b l y s a y “ . . . b i l l i o n s a n d

b i l l i o n s . . . ”

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Danger for Larger Estates

In larger estates (e.g. those over the applicable exclusion

amount - $5,250,000 in 2013), a simple will can result in ―stacking‖ the surviving spouse‘s estate and result in severe

death taxes on the survivor‘s death when the remaining assets are conveyed to the children or other heirs.

Example: If a surviving spouse dies with an estate in excess of

the applicable exemption amount then any amount over that

amount will be subject to death tax.

Thus, for larger estates the price of avoiding death taxes on the

first death can be greater death taxes on the second death under this simple format.

Probate

Although joint tenancy will normally avoid probate, a simple

will may not avoid probate. Probate can be costly and time consuming for the surviving spouse and other heirs.

Attorney‘s fees in this area should always be compared even where set by statute.

Assets Not Subject to a Will

There are a number of assets not controlled by your will:

1. Joint Tenancy Assets - A will does not control any joint tenancy assets. Joint tenancy supersedes the will. Such

assets automatically go to the surviving joint tenant.

2. Life Insurance & Employee Death Benefits - These

proceeds are paid directly to the named beneficiary. Only if there is no beneficiary, do the benefits go to your estate

and pass by your will.

3. Living Trust - A will does not control assets in a living

trust, as long as the assets are transferred into the trust before death.

4. Totten Trust - This is a bank or savings account in the name of an individual as trustee for another, such as ―John

Smith, as Trustee for Jane Doe.‖ Jane has no access to the account while John is alive. On John‘s death, the account

automatically passes to Jane.

Note: A bank or savings account can also be set up in a

P.O.D. registration. The funds in such an account are

payable at death to another like a Totten trust.

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Assets Subject to a Will

Your will picks up whatever is in your name alone. A will also

controls whatever is in your name with someone else as tenants in common. In addition, a will picks up what you are

entitled to, even if you have not yet received it.

Note: If you are married and an asset is community property,

only one-half of the asset is subject to your will.

Trusts

A trust is a contractual document for the administration of assets. The trustee administers assets transferred to the trust for the

benefit of the beneficiary. A trust may continue after the beneficiary‘s death, be used for charity, take care of a retarded

child, save death taxes, avoid probate, or eliminate the need for a

conservatorship. Trusts have certain common elements:

(1) A grantor or settlor (i.e., the creator of the trust),

(2) A trustee5 (i.e., the manager of the trust assets),

(3) A beneficiary (i.e., a person receiving income or property

benefits under the trust), and

(4) Property or funds (i.e., corpus or res) in the trust.

Trusts are created for many reasons. Here are some:

1. Management - The trustee can be skilled in managing and

investing.

2. Protection - Some trusts (such as irrevocable trusts) can

protect assets from creditors or against the grantor‘s (or a beneficiary‘s) incapacity.

3. Tax Savings - Trusts can sometimes save current income taxes and often reduce or eliminate estate taxes.

4. Flexibility - Trusts can deal with a variety of situations such as

special learning children, spendthrift relatives, educational needs, spousal support, and long-term custodial care.

5. Privacy - Unlike a will, which becomes part of the public record after the probate process, the details of an inter vivos

(―living‖) trust can be kept confidential. In some cases this confidentiality factor can be very important.

5

A t r u s t e e ma y b e a n i n d i v i d u a l , s e v e r a l i n d i v i d u a l s , a

b a n k , a t r u s t c o mp a n y , o r a c o mb i n a t i o n o f i n d i v i d u a l s a n d

i n s t i t u t i o n s .

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6. Probate - Assets in a living trust are not subject to probate

administration. This saves executor and attorney fees.

Types of Trusts

There are many different types of trusts. Trusts are often

classified in one of two ways: living versus testamentary and revocable versus irrevocable.

Living Trusts

A living trust (sometimes called an ―inter vivos‖ trust) is

created during a person‘s lifetime. A living trust can be set up by husband and wife, or by a single person. Assets

transferred into a living trust avoid probate, but must be

transferred before death.

Testamentary Trusts

This type of trust is created at death under the provisions of

your will. Assets cannot be put into this trust before death, since the trust does not exist until death. To fund such a

trust, assets must go through probate.

Revocable & Irrevocable

A revocable trust can be changed or terminated as the need arises. The terms of an irrevocable trust cannot be altered.

Living “A-B” Revocable Trust

The funded revocable living trust6 permits the taxpayer to avoid

probate on both deaths, avoid federal death tax on the first death and eliminate or reduce to a minimum federal death tax

on the death of the second spouse.

In the example given the trust, along with the accompanying wills, would be created while both spouses were alive. The trust

is thus called a living (or inter vivos) trust. Since only assets in the living trust at death avoid probate it is recommended that

the trust be ―funded‖ by having the spouses make lifetime transfers to the trust. However, during the joint lives of the

6

T r u s t s b e c a me p o p u l a r d u r i n g t h e Wa r o f t h e Ro s e s i n

En g l a n d . No b i l i t y wh o we r e o n t h e wr o n g s i d e n o t o n l y l o s t

t h e i r l i v e s b u t a l l o f t h e i r p r o p e r t y . T o a v o i d t h i s

f o r f e i t u r e , t h e n o b l e c o u l d t r a n s f e r h i s a s s e t s t o s o me o n e

n o t t a k i n g s i d e s f o r t h e u s e o f t h e f a mi l y .

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spouses, the assets can be withdrawn from the trust at any time.

This makes the trust revocable. On the death of the first spouse (normally the husband), the original living trust automatically

divides itself into two trusts—the survivor‘s trust known as ―TRUST A‖ and the decedent‘s trust known as ―TRUST B‖.

Typically, the surviving spouse has control over TRUST A and can withdraw assets or even revoke the trust in its entirety7.

However, in order to reduce or eliminate death taxes on the second death, TRUST B must be irrevocable and only limited

powers over it can be given to the survivor.

Nevertheless, these powers are substantial and are as follows:

1. Right to All Income - the survivor can receive all the income generated by TRUST B;

2. Right to Invade Principal - the survivor for purposes of health, maintenance, and support can withdraw the principal

of the trust;

3. Five Percent or $5,000 Power - annually the survivor can withdraw the greater of 5% of the trust principal or $5,000 ;

4. Limited Power of Appointment - the survivor can retain the power to readjust the childrens‘ or other heirs‘ shares after

the death of the first spouse;

5. Trusteeship - the survivor can have one or more (in fact

all) the above powers and can still be trustee over both TRUST A and TRUST B.

All these powers can be granted without any affect on the living trust‘s ability to save death taxes.

Frequently, the ―A-B‖ format is recommended for moderate size estates that are in excess of the applicable exemption amount.

This is because the applicable exemption amount can pass death tax free from TRUST A to the CHILDRENS‘ TRUST and a like

amount plus growth8 can pass to the CHILDRENS‘ TRUST from

TRUST B.

7

So me t i me s T RUST A i s u n f a i r l y ma d e i r r e v o c a b l e t o t h e

s u r v i v i n g s p o u s e ( i . e . t h e wi f e ) s u p p o s e d l y t o p r e v e n t h e r

f r o m t r a n s f e r r i n g t h e a s s e t s t o a s e c o n d h u s b a n d o r s e x u a l

e q u i v a l e n t . I f t h e s u r v i v i n g s p o u s e d o e s n ’ t c o n s e n t t o

t h i s t h e y a r e f r e q u e n t l y d e n i e d b e n e f i t s u n d e r T RUST B. 8

No r ma l l y , a n a mo u n t e q u a l t o t h e d e c e a s e d s p o u s e ’ s

a p p l i c a b l e e x c l u s i o n a mo u n t i s p u t i n t o T RUST B. T h i s s u m

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Childrens‟ Trust: On the death of the second spouse, the

assets of TRUST A and TRUST B are held in a CHILDRENS‘

TRUST which normally distributes income to the children and

permits them to invade principal for health, maintenance, and

support. When a child reaches a certain age the amount held for

his or her benefit is distributed to them.

Although the living trust is the primary document under this format, the wills are also important. In addition to naming the

executor, the guardian for any minor children and authorizing a variety of necessary actions, the wills permit the passing of

personal items (e.g. household furnishings, clothes, and small incidentals) that are not worth going through the trust and

collect all valuable assets (under the ―pour over‖ provision) that

were not put into the trust and transfers them into trust on the first death. The ―pour over‖ provision is a ―fail safe‖ clause used

to pick up forgotten assets. It doesn‘t avoid probate. The ideal goal is to have all the major assets transferred to the living trust

prior to the first death and never have to invoke the ―pour over‖ provision.

Living “A-B-C” (QTIP) Trust

For those estates above twice the applicable exclusion amount

the ―A-B-C‖ living trust should be considered. Instead of dividing into two trusts upon the first death as in the ―A-B‖ format, it

divides into three (A, B, and C).

TRUST A is again the survivor‘s trust and remains revocable by

the surviving spouse. The former TRUST B (i.e. the decedent‘s trust) is divided between a new TRUST B and TRUST C. The

TRUST B is a ―bypass‖ trust that is funded by and takes advantage of the applicable exclusion amount. The survivor‘s

property goes into TRUST A as before and the balance goes into TRUST C - the QTIP trust.

Example: In an equal and joint estate of $12,000,000 in 2014,

$6,000,000 would go into TRUST A. The decedent‘s half would

go $5,340,000 (the exclusion amount in 2014) into TRUST B

(the bypass trust) and the balance ($660,000) would go into

TRUST C - the QTIP trust.

The decedent‘s portion is not subject to federal death tax because of the unified credit (for TRUST B) and the unlimited

marital deduction (for TRUST C). As a result of ERTA, assets that

p l u s wh a t i t g r o ws t o d u r i n g t h e l i f e o f t h e s u r v i v o r c a n

p a s s d e a t h t a x f r e e f r o m T RUST B t o t h e CHI L DRENS' T RUST .

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go into TRUST C (i.e. the QTIP trust) qualify for the unlimited

marital deduction.

The ―A-B-C‖ format does not necessarily increase the amount

which can pass tax free to the CHILDRENS‘ TRUST but does give the added flexibility of being able to pay part of the death taxes

on the death of the first spouse and part on the death of the second spouse. In some instances this can result in material tax

savings. Paying the death tax entirely on the second death can be far greater than paying in installments on the first and second

deaths. In any event the ―A-B-C‖ format gives the taxpayer the choice.

Impact of Spousal Portability on Trust B under TUIRJCA

―A-B‖ and ―A-B-C‖ trust formats have traditionally been able to

reduce or eliminate estate taxes because funds in a properly drafted Trust B are protected by the applicable exclusion amount

(AEA) and are not taxed when the first spouse dies. Nor are the funds estate taxed when the survivor dies. Thus, the phrase,

―Twice the AEA, plus the growth in Trust B, goes estate tax free.‖

While this still true after TRUIRJCA, portability now makes it unnecessary to use Trust B to preserve the first spouse‘s federal

applicable exclusion amount. Since 2011, surviving spouses can

add the unused applicable exclusion amount of the spouse who died most recently to their own applicable exclusion amount.

Thus, twice the AEA can be passed estate tax free without the use of Trust B. Nevertheless, the use of a funded Trust B may be

necessary to preserve any state estate tax exclusion.

Charitable Trusts

Charitable Remainder Trusts

Under a remainder trust, the donor designates himself or others

as lifetime income recipient. The remainder goes to charity on the death of the income beneficiary. Creating the trust generates

a charitable deduction, reduces the donor‘s estate, and provides income to him or his family. A charitable remainder trust can

make its income payments in several ways:

(1) Annuity - a fixed dollar amount is paid annually;

(2) Unitrust - a fixed percentage of the assets, as valued yearly, is paid; or

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(3) Pooled income fund - assets are mixed with a fund

operated by the charity. Income payments are based on the fund‘s performance.

Charitable Income Trusts

Under an income trust, the charity receives the current income. The remainder later reverts to the donor or his family. The best

assets to be transferred into such a trust are highly appreciated,

low basis, low yield assets. The assets can be sold with no gain by the charity and the proceeds invested in high yield

investments. The income beneficiary gets a greater yield and the donor gets a current tax deduction while reducing his estate.

Insurance Trusts

Life insurance is normally taxable for federal estate tax purposes

under §2042. Thus, if you die owning $200,000 of life insurance at

the time of your death, the value of the life insurance is included in your taxable estate. However, if a spouse is the beneficiary, the

proceeds are exempt from estate tax because of the unlimited marital deduction. On the spouse‘s death, any remaining proceeds

will be included in their estate, possibly subject to probate and only have the unified credit as an exemption. An insurance trust can

address many of these issues.

Having life insurance owned by an irrevocable life insurance trust,

that is also the beneficiary, is another way to keep insurance proceeds out of the insured‘s estate. Funded irrevocable insurance

trusts have income producing assets transferred into them in addition to the insurance, which will pay the premiums on the

insurance policy from the income earned. Unfunded irrevocable insurance trusts usually own just an insurance policy and the

grantor makes annual gifts to the trust with which the trustee can

pay the premiums.

Insurance trusts have certain basic requirements:

(1) The insurance must be put into the trust three years before death,

(2) The insured can‘t have any incidents of ownership in the policy or direct economic enjoyment of the trust, and

(3) The insured should not be named as trustee since this might be deemed an incident of ownership or the power to direct

economic benefit.

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When the trust is structured properly, insurance proceeds can be

eliminated from both the insured‘s and insured‘s spouse‘s estate. When the trustee has the discretionary power to accumulate income

and/or ―sprinkle‖ income among beneficiaries, income tax savings can also result.

Note: Undistributed trust income is taxed to the trust.

Distributed income is taxed to the beneficiaries when received.

When insurance policies have cash surrender value, and are not transferred for value, there may be gift tax on the transfer.

Note: If the policy is transferred for value, the death proceeds

will be exempt from income tax but only to the extent of the

amount paid by the transferee and net premiums paid by the

transferee after the transfer. The rest of the proceeds will be

taxable.

The gift value of an existing policy transferred into a trust is the

interpolated terminal reserve as of the date of transfer plus the value of the unearned portion of the last premium. A way to avoid

the gift tax is to take a full cash value loan on the policy prior to transfer. When a new policy is purchased and immediately put into

the trust, the gift value is the gross premium paid.

Gift tax treatment on later premium payments depends upon if the trust is funded or unfunded. In a funded trust, a gift tax calculation

is made for each transfer to the trust. The value for gift purposes is the transferred asset‘s fair market value.

In an unfunded trust, gift treatment depends on whether the premium payments are ―present interests‖ qualifying for the annual

exclusion. A policy and subsequent premium payments may qualify as gifts of a present interest if the beneficiary(ies) is given the

following powers:

(1) The right to require the trustee to convert the policy(ies) to

income-producing assets,

(2) A noncumulative annual right to withdraw the greater of

$5,000 or 5% of trust principal, and

(3) A limited power to withdraw certain sums from the trust for

a short time after the contribution (i.e., a ―Crummey‖ provision).

Family Documents

No matter which estate format is used everyone should consider:

(1) Natural Death Act Directive (Living Will);

(2) Property Agreement & Inventory;

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(3) Durable Power of Attorney;

(4) Advance Nomination of Conservator;

(5) Funeral Instructions; and

(6) Anatomical Gifts.

Living Will

If you have strong feelings about whether or not you want to be kept alive by artificial means, you should execute a living will

and give copies to your physician. A ―living will‖ is a directive to your doctor showing you do not want to be kept alive by artificial

means. A doctor normally is required to honor this directive, or to transfer the patient, if the patient has been diagnosed as

terminally ill, to another doctor who will honor it. Most physicians will comply with the directive.

Property Agreement & Inventory

Often couples will make a written agreement regarding their

assets. Sometimes this agreement is entered into before marriage and is called a pre-nuptial agreement9. The agreement

need not change the character of the couple‘s property, but can merely inventory each spouse‘s separate property. In the event

of divorce or death this itemization becomes important in identifying separate property.

Note: Couples that live together should also consider such

agreements.

This inventory should also list personal information and the location of key documents and major assets. Such information

should include:

(1) Birth date, birthplace, social security number, and

parents‘ names,

(2) Location of will and any safe deposit box along with key,

(3) Your attorney, accountant, stock broker, life insurance person, and financial planner, and

(4) Location of deeds, stock and bond certificates, savings

passbooks and term certificates of deposit, life insurance policies, and prior income tax returns.

9

Pr e - n u p t i a l s s p e l l o u t t h e e n d b e f o r e t h e b e g i n n i n g .

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Durable Power Of Attorney

Someone can be given the right to act for you, by signing a

notarized document called a ―power of attorney.‖ A power of attorney can be ―general‖ with no limit10, or it can be ―limited‖ to

a specific period of time or to cover a specific asset. A power of attorney ends when you die. A durable power of attorney is a

regular power of attorney that continues after you have become incapacitated.

Note: A problem with a power of attorney is that many banks

refuse to accept it as a ―matter of policy.‖ It is therefore wise to

fill out a power of attorney card for the institution. Financial

institutions will permit someone to sign on an account without

putting their name on the account.

Power of Attorney for Health Care

Some states have adopted a special form of a power of attorney for medical care, called a ―durable power of attorney

for health care.‖ This power of attorney is separate from other powers of attorney and authorizes an individual to make

medical decisions if you are incapacitated.

Conservatorship

A conservatorship allows a court to appoint another to handle your assets and make medical decisions for you. An involved

court proceeding is required. The court appoints a conservator of the ―estate‖ to handle property and a conservator for the

―person‖ to look after your personal needs, authorize medical

treatment and have you placed in a convalescent hospital. After a conservator is appointed, he must file an inventory of the

conservatee‘s assets. In addition, he cannot normally sell or purchase any assets without the court‘s permission.

You can often sign a written document nominating someone as conservator if one is later necessary. However, when no

conservator is nominated, the court will normally appoint the nearest relative.

10

T h e r e a r e a f e w e x c e p t i o n s . An a t t o r n e y i n f a c t c a n ma k e a

l i v i n g t r u s t f o r y o u a n d t r a n s f e r a s s e t s i n t o t h i s t r u s t ,

b u t h e c a n n o t ma k e o r c h a n g e a wi l l f o r y o u . He c a n ma n a g e

y o u r a s s e t s a n d s e l l t h e m, b u t n o t f o r h i s o wn u s e . He c a n n o t

ma k e me d i c a l d e c i s i o n s o r a u t h o r i z e me d i c a l c a r e o r

s u r g e r y f o r y o u .

9 - 2 0

Funeral Arrangements

An individual can specify their desire as to a funeral or cremation

in his will11, or by other written document. Many people have a pre-death contract or other such arrangement. Members of the

family should know this and copies of the contract should be readily available. If no arrangements have been made, the

funeral is normally up to the nearest relatives.

Anatomical Gifts

You can make a donation of parts of your body to any organ bank. Even though you can make such a provision in your will,

this is not a good idea since the will is normally not reviewed for several days. To help insure such organs are given, you can fill

out a donor card available from various organizations or obtain a donation statement from your Department of Motor Vehicles. Be

sure that the other members of the family are aware of the request so that a donation, if applicable, can be made.

Private Annuity

A private annuity is where one person transfers property to another (who is not in the business of selling annuities) for that person‘s

unsecured promise to make fixed periodic payments to the other for life. The property must be transferred for full and adequate

consideration (i.e., the value of the payments must equal the value of the transferred property).

The IRS has issued proposed regs that would eliminate the income

tax advantages of selling appreciated property in exchange for a private annuity. Under the new rules, the property seller's gain

would now be recognized in the year the transaction occurs rather than as payments are received ((Prop. Reg. § 1.72-6, Prop Reg §

1.1001-1)).

The regs generally would apply for transactions entered into after

Oct. 18, 2006. However, certain transactions effected before Apr. 19, 2007 would continue to be subject to prior law rules. For these

grandfathered transactions the advantages and disadvantages are as follows:

11

F u n e r a l i n s t r u c t i o n s s h o u l d n o t b e p u t i n t h e wi l l s i n c e a

wi l l i s o f t e n n o t r e v i e we d u n t i l a f t e r t h e i n d i v i d u a l ’ s

f u n e r a l .

9 - 2 1

Advantages to the Transferor

1. Reduction of the transferor‘s estate.

2. Gain is spread out and taxed over life expectancy.

3. No property management or administration costs.

4. No gift tax liability.

Disadvantages to the Transferor

1. Property transferred for an unsecured promise to make periodic payments.

2. On death of the transferee, the transferor may have to count on the transferee‘s estate for continued payment.

3. Unless the transferor consumes the payments, there will be no estate reduction.

Advantages to the Transferee

1. The transferee‘s basis in the property equals the present

value of the annuity, which is normally greater than the transferor‘s basis.

2. If the transferor dies prematurely, the transferee pays less for the property than its true market value.

3. The transferee gets unencumbered title to valuable property.

Disadvantages to the Transferee

1. If the transferor outlives his/her life expectancy, the transferee can pay more than fair market value for the property.

2. When the transferor dies before his/her life expectancy, the transferee must adjust the property basis to the payments

actually made.

Note: If the property is sold before transferor‘s death, the

excess of the sale price over the actual payments made must be

reported as taxable gain.

3. No part of the payments made to the transferor is deductible (not even as interest).

Special Business Issues

Ownership of a business interest presents a number of estate planning issues and problems. Frequently, there is no ready market

for closely held companies. This creates valuation and liquidity

9 - 2 2

problems. Even estimating the death taxes on the business interest

is difficult because of this uncertainty.

In addition, heirs are often unable to operate the business on the

death of the principal. Thus, if the owner is a key person, the existence of the business itself after the owner‘s death may be in

jeopardy.

The business owner‘s death can also create an ―income gap‖ for

their family. There may be a need to replace the owner‘s business income to provide for their family‘s support after the owner‘s death.

Business Valuation

To value a closely held business, the company‘s net worth, earning power and dividend-paying capacity, and other relevant factors are

considered. Thereafter, the value determined on these factors is usually discounted if it is a minority share interest. In addition, a

buy-sell agreement may fix the value of the business for estate tax purposes.

A business interest must be valued in any estate that will be subject to federal estate tax. This is necessary to:

(1) Estimate the federal estate tax due

(2) Determine the possible use of the marital deduction and

other estate planning tools, and

(3) Determine the means of paying the estate tax (e.g., life

insurance).

However, valuation is an inexact science presenting a frequently litigated issue. Moreover, there are many different ways in which a

business interest can be valued.

Federal estate tax makes a low value appealing. However, when the

estate will not be subject to federal estate tax, a higher valuation may be desirable to give the business interest a high tax basis on

the owner‘s death12. In addition, an older co-owner joining in a buy-sell agreement may want as high a value as possible to maximize

the sales price his family will receive.

Under Regulation §20.2031-1(b), the fair market value of an asset

is ―the price at which the property would change hands between a willing buyer and a willing seller, neither being under any

compulsion to buy or sell and both having reasonable knowledge of relevant facts13.‖

12

The higher basis would result in less taxable gain to the heirs on a later sale. 13

See also Reg. §25.2512-1 for gifts.

9 - 2 3

Relevant Facts

Regulation §20.2031-3 and §20.2031-2(f) state that all relevant

factors are used to determine the ―net value‖ of a business including:

(1) Appraisal of assets,

(2) Demonstrated earning capacity,

(3) Dividend-paying capacity,

(4) Goodwill,

(5) Economic outlook,

(6) Quality of management,

(7) Degree of control represented by the business interest,

and

(8) Values of similar publicly traded businesses.

Revenue Ruling 59-60

R.R. 59-60 (modified by R.R. 83-120) provides IRS guidelines for

valuation of a closely held business for federal estate and gift tax purposes. However, the ruling fails to give an exact formula or

safe harbor. In addition, while all the guidelines cannot be given equal weight, no details are given as to the importance to be

accorded the various factors.

Note: While R.R. 59-60 deals with stock in a closely held

corporation, it also applies to valuation of partnerships and

proprietorships (R.R. 65-192; R.R. 68-609; Reg. §20.2031-

3(c)).

The valuation factors in R.R. 59-60 are:

(1) Nature of the business and its history.

Here, the primary consideration is the riskiness of the business. The greatest weight is given to recent events

with little importance given to past events that are unlikely to recur. This factor could be used in selecting a multiplier

in a capitalization-of-earnings formula. Normally, a higher multiplier would be linked with a more stable business.

(2) Economic outlook.

The economic outlook for the entire economy, this

particular industry, and the particular company in general and in its specific industry are to be considered. If loss of

key personnel will have a significant effect on the value of

the business, a subtraction from earnings to compensate for the loss of a key employee is suggested.

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(3) Book value.

When a business has large amounts of real or tangible personal property, book value is an important beginning in

valuing the business based on the worth of underlying assets. However, in considering book value, remember that

nonoperating assets may command a lower rate of return than operating assets and depreciation deductions affecting

book value can be greater than actual economic depreciation.

(4) Earning capacity.

R.R. 59-60 holds that past income is useful in predicting

future income but averages will be unrealistic if they disregard trends.

(5) Dividends

Actual dividends paid may not be related to the dividend

paying capacity of the business. However, most closely

held corporations try to avoid paying dividends. As a result, evaluating dividend paying capacity is not likely to be

significant in valuing such corporations.

(6) Goodwill.

Goodwill is defined as the excess of net earnings over a fair return on net tangible assets. Thus, when a business is

earning more than a reasonable return on its assets, the additional return must be attributable to prestige, name,

location, and other intangible value. In many service businesses, a large portion of the value is due to such

intangible assets.

(7) Recent sales.

Often, a recent arm‘s length stock sale is the best evidence of value. Moreover, R.R. 59-60 does recognize that the

percentage of the business sold effects valuation. Thus, a

premium for a controlling interest or a discount for a minority interest may be appropriate. However, sales

between unrelated persons are rarely available.

(8) The price of similar traded stock.

When a publicly traded stock in a similar business can be found, the price-earnings ratio of that stock and other

characteristics can be used to determine value. However, such comparisons are rarely available.

9 - 2 5

Many appraisers use an average of several different valuation

methods; however, the IRS does not favor this approach. In fact, R.R. 59-60 specifically disapproves of averaging.

Note: When valuing a business for gift tax purposes, special

valuation rules under §2701 - 2704 apply. The special rules

apply if an older generation owner gives certain interests to

younger family members while retaining rights.

Tangible Assets

In valuing tangible assets, the starting point is book value.

However, each asset should be reviewed to determine whether its book value is a proper indication of value.

Normally, cash, accounts receivable, and inventories are accepted at book value. Machinery, equipment, patents, and real

estate14, unless recently purchased, will have values different from book value.

Special Real Estate Election - §2032A

In general, the value of real estate must be determined based

upon its highest and best use. However, an executor may, when certain requirements are met, elect to value, for estate

tax purposes, real estate used as a farm or other closely held business based on its actual use rather than its highest and

best use (§2032A).

The basic requirements of §2032A are:

(1) The property must pass to or be purchased from the

estate by a qualified heir15;

(2) The decedent or a member of the decedent‘s family16

must have owned the property and have materially participated in the operation of the farm or business for five

out of the eight years preceding the earlier of:

(a) The date of death,

(b) The date on which the decedent became disabled, or

(c) The date on which the decedent began receiving

social security benefits (§2032A(b));

14

Real estate is often worth substantially more than its book value. 15

This term is defined as a member of the decedent’s family, including the decedent’s spouse, parents,

children, stepchildren, and spouses and lineal descendants of those individuals, or a trust for the

exclusive benefit of such persons. 16

A special participation requirement applies for certain surviving spouses (§2032A(b)(5)(A)).

9 - 2 6

Note: If a corporation, partnership, or trust owns the real

property, the decedent (or a member of the decedent‘s

family) must have materially participated in the entity.

(3) The real property must have been used as a farm or in

a trade or business on the decedent‘s death and for five out of eight years immediately before the decedent‘s death;

and

(4) The value of real and personal property used in the

business must be at least 50% of the adjusted value17 of the decedent‘s gross estate, and the qualifying real

property must be at least 25% of the adjusted value of the decedent‘s estate.

When the election is made, assets may be valued as follows:

Farms: A farm is valued by dividing the excess of the

average annual gross cash rental for comparable farm purpose land over the average annual state and local real

estate taxes for such comparable land by the average annual effective interest rate for all Federal Home Loan Bank loans

(§2032A(e)(7)).

Note: Since 1981, if cash rentals for comparable land in the

same locality are not available, the use of net-share rentals is

allowed. The net-share rental is equal to the value of the

produce received by the lessor of comparable land on which the

produce is grown during a calendar year minus the cash

operating expenses (other than real estate taxes) of growing the

produce paid by the lessor.

Business real estate: Such real estate is valued using capitalization of income, capitalization of fair rental value,

assessed land values, and comparable sales (§2032A(e)(8)).

Limitations

The election cannot result in a reduction of more than $750,000 in fair market value. Tax law provides for annual

indexing for inflation, starting with 1999 inflation, of the $750,000 ceiling on special use valuation. In 2014, the

figure is $1,090,000.

If the real property is later sold to nonqualified heirs or the

qualified use of the property ceases, then the tax savings is

recaptured and the amount of additional tax which would

17

Adjusted value means the gross estate less indebtedness attributable to such property.

9 - 2 7

have been payable if the election had not been made is

then required to be paid.

Disposition occurs when the property is sold within 10

years of the decedent‘s death and the qualified heir is still alive.

Qualified use ceases when:

(1) The property ceases to be used for its qualifying

purpose, or

(2) During any eight-year period after the decedent‘s

death there are periods aggregating three years or more during which there is no material participation in the

operation of the farm or other business by the qualified heirs.

Note: The start of the eight-year period is extended for the

lesser of (1) the time that no qualified heir is using the

qualified real property, or (2) two years after the decedent‘s

death.

Related Party Cash Lease

The cash lease of specially-valued real property by a lineal descendant of the decedent to a member of the lineal

descendant‘s family, who continues to operate the farm or closely held business, does not cause the qualified use of

such property to cease for purposes of imposing the additional estate tax under §2032A(c).

Intangible Assets & Goodwill

Whether goodwill existed on a certain date is a question of

earnings in the years immediately preceding that date. Goodwill is an expectation of earnings in excess of a fair return on capital

invested.

Note: It has occasionally been held that even a constantly

losing enterprise may have goodwill (Cooperative Publishing Co

v. Commissioner, 115 F. 2d 1017 (1940, CA-9)).

R.R. 68-609

R.R. 68-609 gives a valuation formula for intangible assets and goodwill18. Once determined, this amount is added to the

18

The ruling cautions that the formula should not be used if there is better evidence to determine

goodwill value.

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value of the tangible assets to arrive at the total value of the

business.

Note: Goodwill is a controversial item in valuing a business.

There should be a specific reason for failing to include some

goodwill value.

The ruling‘s formula requires several steps:

(1) Determine the average annual value of the net tangible assets of the business for at least five years immediately

before the year of valuation;

(2) Determine the percentage return that the average

annual value of tangible assets should earn;

Note: The percentage may be determined by applying the

prevailing rate in the industry, or, if this rate is not

available, a rate of 8 to 10 percent.

(3) Deduct this percentage return on net tangible assets from the average earnings of the business over the same

period to arrive at earnings from the intangible assets; and

Note: Earnings may be determined from profit-and-loss

statements. However, adjustments should be made to take

account abnormal years and trends.

(4) Capitalize the earnings from the intangible assets at a

rate of 15% to 20% to determine the value of the intangible assets.

Land Subject To Conservation Easement - §2032A(c)(8)

An executor may elect to exclude from the taxable estate 40% of

the value of any land subject to a qualified conservation easement that meets the following requirements:

(1) The decedent or a member of the decedent's family must have owned the land for the 3-year period ending on the date

of the decedent's death;

(2) No later than the date the election is made, a qualified conservation easement on the land has been made by the

decedent, a member of the decedent's family, the executor of the decedent's estate, or the trustee of a trust that holds the

land; and

(3) The land is located in the United States or one of its

possessions.

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The maximum exclusion for land subject to a qualified

conservation easement is limited to $400,000 in 2001, and $500,000 in 2002 and thereafter.

The exclusion for land subject to a qualified conservation easement may be taken in addition to the maximum deduction

for qualified family-owned business interests (i.e., there is no coordination between the two provisions). Debt-financed

property is eligible for this provision to the extent of the net equity in the property.

The election to exclude land subject to a conservation easement must be made on a timely filed estate tax return, including

extensions (§2031(c)).

Family Member

Members of the decedent's family include the decedent's spouse; ancestors; lineal descendants of the decedent, of the

decedent's spouse, and of the parents of the decedent; and the spouse of any lineal descendant. A legally adopted child of

an individual is considered a child of the individual by blood.

Indirect Ownership of Land

The qualified conservation easement exclusion applies if the land is owned indirectly through a partnership, corporation, or

trust, if the decedent owned (directly or indirectly) at least 30% of the entity.

Qualified Conservation Easement

A qualified conservation easement is one that would qualify as

a qualified conservation contribution under section 170(h). It must be a contribution:

(1) Of a qualified real property interest;

(2) To a qualified organization; and

(3) Exclusively for conservation purposes.

Qualified Real Property Interest

The term qualified real property interest means any of the following:

(a) The entire interest of the donor, other than a qualified mineral interest;

(b) A remainder interest; or

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(c) A restriction granted in perpetuity on the use that

may be made of the real property. The restriction must include a prohibition on more than a de minimis use for

commercial recreational activity.

Qualified Organization

Qualified organizations include:

(a) The United States, a possession of the United States,

a state (or the District of Columbia), or a political subdivision of them, as long as the gift is for exclusively

public purposes;

(b) A domestic entity that meets the general

requirements for qualifying as a charity under section 170(c)(2) and that generally receives a substantial

amount of its support from a government unit or from the general public; and

(c) Any entity that qualifies under section 170(h)(3)(B).

Conservation Purpose

The term conservation purpose means:

(a) The preservation of land areas for outdoor recreation

by, or the education of, the public;

(b) The protection of a relatively natural habitat of fish,

wildlife, or plants, or a similar ecosystem; or

(c) The preservation of open space (including farmland

and forest land) where such preservation is for the scenic enjoyment of the general public, or pursuant to a clearly

delineated Federal, state, or local conservation policy and

will yield a significant public benefit.

No Additional Income Tax Deduction

In the case of a qualified conservation contribution made after

the date of the decedent‘s death, an estate tax deduction is

allowed under §2055(f). However, no income tax deduction is allowed to the estate or the qualified heirs with respect to

such post-mortem conservation easements.

Note: Even without an income tax deduction, the §2055(f)

estate tax deduction and the exclusion §2031(c) can give major

tax savings to an estate.

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Example

Dan dies with real property worth $500,000. Dan’s

executor grants a conservation easement valued at

$150,000 and takes a §2055(f) charitable estate tax

deduction. In addition, the executor makes an

election to exclude the qualified conservation

easement from the gross estate. The estate tax

exclusion is $140,000 (40% of ($500,000 -

150,000)), leaving $210,000 subject to estate tax.

Valuation Discounts

Both §2031 (gross estate) and §2512(a) (valuation of gifts) use ―value‖ without defining the term. However, Reg. §20.2031-l(b)

defines fair market value as ―the price at which the property would change hands between a willing buyer and a willing seller,

neither being under any compulsion to buy or to sell, and both having reasonable knowledge of relevant facts19.‖ This definition

is important in seeking discounts of fractional interests for marketability and minority interests in transfers to family

members.

After the value of the entire business is determined, the next

step is to value the fractional interest held. Sometimes it is only necessary to divide the total value by the percentage owned.

However, if it is a minority interest, it may be possible to

discount the value.

Minority Interests

A minority stock interest in a closely held business, owned by

a person unrelated to the holders of the majority of the stock,

will normally be valued at a substantial discount for estate and gift tax purposes (R.R. 59-60). This discount is based on

the assumption that a business purchaser will pay less for a non-controlling interest.

R.R. 59-60 allows a discount for a minority interest in a closely held business. A minority owner has little control over

the business. Thus, there is less demand for a minority interest and this justifies a lower value.

However, the IRS has historically taken the position that when the owner and other family members together control a

19

Reg. §25.2512-1 provides a similar definition for gift tax purposes.

9 - 3 2

majority interest, it would not allow a minority discount (R.R.

81-253). Minority discounts were only permitted if there was discord or other factors indicating that the family would not

act as a unit.

Several courts disagreed with the IRS on this point holding

that the relationship between the owners should be disregarded in determining value (Estate of Lee v.

Commissioner, 69 T.C. 860 (1978), Propstra v U.S. (9th Cir 1982) 680 F. 2d 1248; Estate of Bright (5th Cir 1981) 658 F.

2d 999; Estate of Woodbury G. Andrews (1982) 79 T.C. 938, Ward, 87 T.C. 78 (1986); Estate of Berg, 976 F. 2d 1163 (CA-

8, 1992)).

In 1993, the IRS amazingly reversed its position that minority

discounts were not allowed on family transfers of stock if the family in aggregate controlled the business. In R.R. 93-12,

the Service decided to accept the above court decisions

holding that shares owned by family members are not attributed to another family member for purposes of

determining the value of that person‘s shares.

Consequently, the IRS will no longer assume that all voting

power held by family members must be aggregated for purposes of determining whether the transferred interests

should be valued as part of a controlling interest. Likewise, a minority discount will not be disallowed simply because a

transferred interest, when aggregated with the interests of other family members, would be part of a controlling interest.

As a result of this ruling, R.R. 81-253 was revoked.

This new position makes it easier to dispose of an interest in

a closely held business by gifting the interest on a ―discounted‖ basis. The owner of a business could make

sufficient minority interest gifts to family members over a

period of time such that the owner would no longer hold a controlling interest at death. This strategy could accomplish

several objectives:

(1) The lifetime gifts would be valued after applying the

minority interest discount,

(2) Post-gift appreciation would be eliminated from the

donor‘s estate, and

(3) Upon the owner‘s death, their remaining interest would

also be valued as a minority interest.

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Note: Any hoped for minority valuation would still be

subject to the estate freeze rules of §§2701-4. Section 2701

applies to the transfer of interests in corporations and

partnerships. This section provides that if a person transfers

an interest in a corporation or partnership to a family

member and retains an interest in the same business, the

value of the interest will be the value of the entire business

and the value of the retained interest will not be subtracted

or considered. However, there are three general exceptions

where §2701 does not apply:

(a) Where there is only one class of stock or interest

(§2701(a)(2)(B) and (C));

(b) Where there is a proportionate transfer of all classes

of interest (§2701(a)(2)(C)); or

(c) Where market quotations are readily available for the

transferred stock or retained interest (§2701(a)(2)(A)).

Another discounted transfer strategy would be for the estate

owner to bequest a majority interest in the business to the surviving spouse on death and a minority interest to their

children. The bequest to the surviving spouse would be shielded from federal estate tax by the unlimited marital

deduction. To the extent of the applicable exemption amount, the children‘s minority interest would also escape death tax.

Later, the surviving spouse can gradually gift small interests to the children until they own a majority interest. On the

death of the surviving spouse, their interest should also qualify for a minority interest discount.

Special Valuation plus Minority Discount

In Estate of Clara K. Hoover, 76 AFTR 2d § 95-5602 (10th

Cir. 1995), an estate elected to value the decedent‘s minority interest in certain ranch property under §2032A at

its special use value rather than at fair market value. It argued that §2032A allowed it to apply a minority interest

discount to arrive at the fair market value of the decedent‘s

interest in conjunction with reducing that value by the statutory maximum of $750,000 for federal estate tax

reporting purposes. The court agreed with the estate and held that the maximum reduction in value of qualified real

property imposed by §2032A must be subtracted from the true fair market value of a minority interest in the property.

9 - 3 4

Fractional Interests

Recent cases have strengthened arguments for discounting

fractional interests, particularly where real estate is involved. In Estate of Pillsbury, TCM 1992-426, despite criticism of the

taxpayer‘s expert, a 15% discount on a decedent‘s fractional interest in the real estate was allowed.

In A.B. Cervin Est., Dec. 50,219(M), the Tax Court held that an estate was entitled to discount the agreed fair market

value of the decedent‘s one-half interest in farmland and a homestead by 20%. Although it would be difficult to partition

the farmland physically because of the farm‘s varied soil

compositions and layout and its limited access to the main road, it could be partitioned on the basis of value. Therefore,

the discount was appropriate because a partition would involve substantial legal costs, appraisal fees, and delay. In

addition, although the homestead could not be partitioned, a fractional interest owner could petition the court for a forced

sale of the entire homestead. Therefore, a prospective buyer of the homestead would require a sizable discount because,

under applicable state (Texas) law, the purchaser of a fractional interest discount in property incurs all of the costs

associated with a forced sale of property. However, no discount was allowed for repair costs because the poor

condition of the property was considered in determining the agreed fair market value of the homestead.

Even more interesting is Estate of Louis F. Bonner, 77 AFTR

2d Par. 96-868 (Fifth Circuit (June 4, 1996). In Bonner, the Fifth Circuit held that a fractional-interest discount should be

applied in valuing assets owned partly by the decedent and partly by a trust created under his wife‘s will. This was upheld

despite 100% of property being included in the gross estate (c.f. PLR 9608001).

Lack of Marketability

The absence of a ready or existing market for the sale or

purchase of the securities being valued can create a substantial discount. The logic of such a discount is that, to

the extent a prospective purchaser will have difficulty reselling an ownership interest, the value of the interest is

lower (Central Trust Company, 305 F. 2d 393 (Ct. Cls., 1962), Estate of Stoddard, TCM 1975-207).

9 - 3 5

The Service acknowledges that if owners of closely held stock

should try to list a block of securities on a stock exchange for sale to the public, they would have to make the offering

through underwriters and incur costs for registration, distribution, and commissions. Using such costs to determine

a lack of marketability has been upheld by the courts (Groff v. Munford, 150 F. 2d 825 (2d Cir. 1945; Bull v. Smith, 119 F.

2d 490, (2d Cir. 1941)).

However, in calculating the amount of such discount, no

subtraction from the date of death value is allowed for hypothetical underwriting fees and other hypothetical selling

expenses that would have been incurred if there had been a block offering of the stock on the date of death (Gillespie, 73

AFTR 2d. §94-844 (1994)).

In a gift valuation case, Carr, TCM 1985-19, a 25% discount

on the value of shares transferred to children was allowed.

The corporate assets were undeveloped real estate and the court held that it would be difficult for a buyer to estimate the

profit of the corporation. The court reasoned that a minority shareholder might not realize any return on investment until

the corporation was liquidated.

Swing Vote Premium

In PLR 9436005, a sole shareholder transferred approximately 30% of the outstanding shares in a corporation to each of his

three children. At the same time, he transferred 5% to his wife. The IRS ruled that to value gifts of blocks of stock,

representing 30% of a closely held corporation‘s total outstanding shares, the swing-vote characteristic had to be

considered along with its minority nature and any marketability concerns. The IRS concluded that each 30%

block had a swing-vote premium that offset the minority or marketability discounts.

Buy-Sell Agreements

A buy-sell agreement solves many estate planning problems in

businesses where there are multiple owners. A buy-sell agreement is an agreement providing that on a business owner‘s

death, their interest will be purchased. When the remaining owners buy the business interest, the agreement is called a

cross-purchase agreement. When the business buys the interest, it is an entity agreement.

9 - 3 6

Buy-sell agreements have number of purposes, such as business

continuation and liquidity. However, the desire to minimize estate valuation is a primary reason for entering into a buy-sell

agreement. A properly drafted buy-sell agreement can fix the value of a decedent‘s interest for federal estate tax purposes

(Charles M. Land v. U.S., 187 F. Supp. 521 (1960)).

Note: For transfers after 10/9/90, buy-sell agreements may be

ignored for purposes of determining value for gift tax purposes

(§2701 - 2704). However this rule disregarding buy-sell

agreements does not apply if:

(1) It is a bona fide business arrangement (§2703(b)(1));

(2) It is not a device to transfer the property to members of

the decedent‘s family for less than full and adequate

consideration in money or money‘s worth (§2703(b)(2));

and

(3) Its terms are comparable to similar arrangements

entered into by persons in an arm‘s length transaction

(§2703(b)(3)).

The price in the agreement will set the estate tax value, even

though the fair market value of the business interest is then actually higher than the agreed price, provided:

(1) The price is fixed or determinable according to the agreement;

(2) The obligation to sell is binding on the decedent during

lifetime as well as on the estate after death; and

(3) The agreement is bona fide business arrangement and

not a device to pass the interest to related parties without adequate consideration (Reg. §20.2031-2(h)).

Note: There can be no certainty that the agreement will satisfy

the third requirement when related parties purchase the

interest, directly or indirectly.

When a business owner dies leaving the maximum marital deduction to the surviving spouse, there is no estate tax on their

death. Here, there would be no benefit from a buy-sell agreement drafted solely to fix the estate tax value.

Redemptions Under §303

A major estate asset can be stock in a closely held corporation and while the corporation may have liquid assets, the estate may not.

Unless there are co-owners and a buy-sell agreement, the estate may not be able to utilize the corporation‘s liquidity to pay death

9 - 3 7

taxes and expenses. However, most distributions from a

corporation to a shareholder or their estate will be taxable as a dividend (§301(c) & §316).

Section 303 is an exception to this dividend treatment. This provision permits the redemption of a deceased shareholder‘s stock

in an amount not to exceed federal and state death taxes (including the generation-skipping transfer tax and funeral and administration

expenses) without dividend treatment. However, even if the redemption qualifies under §303, there may be a taxable capital

gain on the redemption to the extent the proceeds exceed the stock‘s estate tax value.

Note: The proceeds of the §303 redemption need not be used

to pay the death taxes and funeral and administration expenses.

The redemption may be solely a tool to withdraw corporate

funds without dividend treatment.

Requirements

Distributions in redemption of stock included in a decedent‘s gross estate for federal estate tax purposes are treated as

payment for stock (rather than dividends) up to the sum of:

(a) All death taxes (federal and state), including interest on

the taxes, and

(b) Funeral and administration expenses allowable as federal

estate tax deductions (§303(a)) but only if:

(i) The value of the stock included in the estate exceeds

35% of the decedent‘s adjusted gross estate20 (§303(b)(2)(A));

Note: Stock in two or more corporations is deemed stock of

a single corporation if 20% or more in value of the

outstanding stock of each corporation is included in the

estate. A surviving spouse‘s interest in stock held with the

decedent as community property, joint tenants, tenants by

the entirety, or tenants in common is included in the

decedent‘s gross estate under this 20% test

(§303(b)(2)(B)).

(ii) The redemption distribution takes place after the

decedent‘s death and not later than time specified under §6501(a)21 (§303(b)(1)); and

2 0

Stock gifted within three years of a decedent’s death is included in the gross estate for purposes of

this 35% test.

9 - 3 8

(iii) The redeemed shareholder bears a burden of taxes or

expenses22 (§303(b)(3)).

Note: When a decedent leaves an unlimited marital

deduction bequest to their spouse, there is no federal estate

tax and only that portion of the stock that does not exceed

the amount of state death taxes and funeral and

administration expenses may be redeemed under §303.

When there are plans to use §303, the business owner should not make gifts of stock that reduce ownership below the 35%

requirement. It may also be advisable to gift nonstock assets to insure that the value of the stock in the closely held corporation

will be 35% of the estate.

Corporate Accumulation For §303 Redemption

When a §303 redemption is planned, the corporation may fund the redemption through corporate funds or life insurance on the

stockholder. However, accumulating funds to redeem a shareholder‘s stock at death under §303 has sometimes been

held unreasonable for purpose of the accumulated earnings tax under §531 (Youngs Rubber Corp v Commissioner, 21 TCM 1593

(1962), aff‘d, 331 F. 2d 12 (2d Cir. 1964)).

Under §537, an accumulation to redeem stock to pay death taxes, under §303, is reasonable if the accumulation is:

(1) Needed (or reasonably anticipated to be needed23) to redeem the stock, but is not greater than the amount

required to pay death taxes and certain funeral and administrative expenses (§537(a)(2)), and

(2) Made in the taxable year of the corporation in which the shareholder died or in later years24 (§537(b)(1)).

Accumulation in Anticipation of Shareholder‟s Death

Section 537 doesn‘t apply to accumulations in taxable years of

the corporation before the shareholder dies. The reasonableness 2 1

Essentially within four years of the decedent’s death. However, the time can be extended up to 15

years from death if an election is made to defer payment of estate tax under §6166 and §6166A. 2 2

In planning a §303 redemption, care should be taken that the stock to be redeemed is owned by a

person or entity liable for these items. For example, stock should not be redeemed from a marital

deduction trust (or any other trust) that is not liable for tax payments. 2 3

See Reg. §1.537-1(e)(1) for guidance on the amount needed or reasonably anticipated to be needed

for redemption. 2 4

Note that accumulations before the year of death enjoy no special protection.

9 - 3 9

of accumulation in years before death is determined solely upon

the facts and circumstances existing at the times the accumulations occur (Reg. §1.537-1(e)(3)).

In Wilcox Mfg. Co Inc., T.C. Memo 1979-92, an accumulation ―far in advance‖ of the likelihood of death (such as for a 50-year-

old shareholder not in poor health) was held to be an ―opportunity for abuse,‖ especially where life insurance was a

realistic alternative. However, redemption funds provided by a life insurance policy have been held to be for the reasonable

needs of a corporation‘s business (Oman Construction Co Inc., T.C. Memo 1965-325).

If the redemption exceeds the amount chargeable to the capital account, the excess reduces the earnings and profits account of

the corporation in determining dividend treatment for later distributions (R.R. 79-376). This reduction also reduces the

possibility of future unreasonable accumulation issues.

Under R.R. 65-289, redemption proceeds may be paid by a note or with other assets. However, if appreciated assets are

distributed, the distribution will be a sale, and the corporation will realize taxable gain (§311(b)).

Death of a Spouse

A frequent assumption is that the spouse who is active in the

business will die before the non-active spouse. This may not be the

case and the possibility of a non-active spouse dying first should be considered, particularly, where the business is marital property.

Typically, a non-active spouse‘s interest in a business is valued at death the same as if the active spouse died first. However, this

similarity can be changed when:

(1) The active spouse‘s services were a significant component of

the business goodwill25, or

(2) There is a buy-sell agreement.

A properly drafted buy-sell agreement will set the value of the business interest for death tax purposes. However, often the buy-

sell agreement is only triggered on the active spouse‘s death and is

2 5

If the active spouse’s services contributed to the business goodwill, the value of the business should

be reduced on the active spouse’s death.

9 - 4 0

not binding for death tax valuation purposes on the inactive

spouse‘s death since there is no obligation to sell26.

Bypass Trust

A simple way to avoid estate taxes is to leave everything to a

spouse. No estate taxes are due when a wife inherits property from a husband or vice versa. But simple is not always best.

Indeed, in the case of planning to pass a business to the next

generation in the family, more sophisticated planning than a spousal transfer is needed.

Note: Remember, the surviving spouse may well be in the same

age group as the business owner, and thus estate taxes may be

avoided for only a few years. In addition, this could set up a

situation fraught with conflict: a spouse who has never been

involved in the business now owns it, while a son or daughter

who has been active in it is now working for that person.

When a spouse leaves their entire estate to the surviving spouse using the unlimited marital deduction, there will be no estate tax

on death. However, use of the marital deduction may increase the surviving spouse‘s estate. A bypass trust reduces this result.

Thus, any buy-sell agreement should not prevent the inactive spouse from leaving their interest in the business to a bypass

trust.

The buy-sell agreement should permit a disposition of the

business interest, on the inactive spouse‘s prior death, to a trust for the benefit of the surviving active spouse and/or other

beneficiaries. The active spouse can be named as the trustee of the bypass trust if their powers are limited to an ascertainable

standard. However, as trustee, the active spouse‘s control of the

business interest will be as a fiduciary and other beneficiaries may complain if the business interest is unproductive.

Lifetime Dispositions

An owner may wish to dispose of all or a part of their business

interest before death. While such a disposition could be to third parties, business estate planning primarily examines dispositions to

family members.

2 6

While the buy-sell price may not be determinative of valuation, it is at least one factor to be

considered (R.R. 53-189).

9 - 4 1

Gifts

An excellent technique is to make lifetime gifts of stock in the

business to adult children who may be working in it and to whom the business owner wants to pass the business. Any person may

give up to $14,000 (in 2013) apiece to any number of individuals with no gift or estate tax consequences. Consequently, a

business owner with two children and four grandchildren could give them $84,000 worth of stock in the business in 2013 with

no tax consequence. A business owner who followed this strategy for many years could transfer a sizable portion of the

business during her lifetime.

Generally, taxpayers do not need to file a gift tax return unless they give someone, other than a spouse, money, or property

worth more than the annual exclusion, $14,000 in 2013. If they give more valuable gifts, a return may be required, but no actual

gift tax will become payable until the cumulative lifetime taxable gifts exceed the applicable exclusion amount.

Stock Redemptions Under §302

Normally, a corporation‘s acquisition of its own stock from a

shareholder for cash or property is a dividend to the shareholder. However, when a redemption is within any of the following

categories under §302, the distribution to the shareholder is a payment for stock rather than a dividend:

(1) A redemption that is ―substantially disproportionate‖ with respect to the redeeming shareholder;

(2) A redemption that is ―not essentially equivalent to a dividend‖; or

(3) A complete redemption of all of a shareholder‘s stock in the corporation.

Substantially Disproportionate Redemption - 80/50 Rule

Under §302(b)(2), a redemption is ―substantially

disproportionate‖ if immediately after the redemption:

(1) The ratio of the shareholder‘s voting stock to the

company‘s total outstanding voting stock is less than 80% of that ratio immediately before the redemption: and

Note: This 80% test must be satisfied for the corporation‘s

voting and nonvoting common stock. Thus, a redemption

solely of nonvoting stock does not qualify. However, when

nonvoting (other than section 306 stock) and voting stock

are redeemed at the same time, and the redemption of

9 - 4 2

voting stock is substantially disproportionate, then the

redemption of the nonvoting stock also qualifies (Reg.

§1.302-3(a)).

(2) The shareholder owns less than 50% of the total voting

stock of the company.

Redemptions Not Essentially Equivalent to a Dividend

Whether a redemption is not essentially equivalent to a

dividend is determined based on the change in the redeemed shareholder‘s corporate interest. A redemption is not

essentially equivalent to a dividend if it results in a

meaningful reduction in the redeemed shareholder‘s proportionate interest.

A redemption that is prorata or from a sole shareholder does not result in any reduction in proportionate interest.

A redemption from a majority shareholder (i.e., a shareholder with over 50% of the voting power) usually results in a

meaningful reduction if that shareholder‘s voting power is reduced to 50% or less.

A redemption of voting stock from a substantial minority shareholder is meaningful if, after the redemption, the

shareholder's ability to act without the redeemed shareholder to control the corporation is increased. Any redemption of

voting stock from a low percentage minority shareholder usually is a meaningful reduction.

Complete Redemptions

In a complete redemption, all the shareholder‘s stock must be

redeemed (§302(b)(3)). When a shareholder owns both common and preferred stock, a complete redemption of only

one of the classes will not qualify.

A complete redemption can be done on the installment basis if the purchase agreement binds the parties to complete the

redemption by a certain date for a maximum price.

Constructive Ownership - §318

Under the stock redemption rules, a shareholder owns not

only their own direct holdings, but also those of other related

taxpayers (§302(c)). These constructive ownership rules provide that:

9 - 4 3

(1) An individual is treated as owning stock owned, directly

or indirectly, by their spouse, children, grandchildren, and parents (§318(a)(1));

(2) Stock owned by an S corporation, partnership or estate is deemed owned proportionately by its shareholders,

partners, or beneficiaries (§318(a)(2)(A), (5)(E));

(3) Stock owned by an S shareholder, partner, or estate

beneficiary is attributed in full to the S corporation, partnership, or estate (§318(a)(3)(A), (5)(E));

(4) Stock owned by a trust (except an ESOT) is deemed owned by its beneficiaries in proportion to their actuarial

interest in the trust (§318(a)(2)(B)(i));

(5) Stock owned by a trust beneficiary (other than the

beneficiary of an ESOT) is attributed, in full to the trust (§318(a)(3)(B)(i));

(6) A 50% or more shareholder in a C corporation is

treated as owning a proportionate share of stock in other corporations owned by the C corporation (§318(a)(2)(C));

(7) A C corporation is considered as owning all the stock (except its own) owned by a 50% or more shareholder

(§318(a)(3)(C)); and

(8) The holder of an option to buy stock is treated as the

owner of the stock covered by the option (§318(a)(4)).

Double Attribution

Stock constructively owned by a person is considered as actually owned by them in any further attribution

(§318(a)(5)(A)) except that:

(a) Stock constructively owned by a person under family

attribution rules will not be attributed again to make another family member the constructive owner of that

stock (§318(a)(5)(B)); and

(b) Stock constructively owned by a partnership, estate,

trust or corporation cannot be further attributed from the entity to make another partner, heir, beneficiary or

stockholder the constructive owner of that stock (§318(a)(5)(C)).

Stock Attribution in Complete Redemptions

Family attribution rules do not apply to a person whose

actually owned stock is completely redeemed, if:

9 - 4 4

(a) Immediately after the redemption they have no

personal financial interest in the corporation, other than as a creditor;

Note: They cannot serve as director, officer, or employee.

(b) They do not acquire any such interest (except by

inheritance) or position for a ten-year period running from the date of the redemption;

(c) They did not acquire any of the redeemed stock from close family members within 10 years before the

redemption, and didn‘t transfer any stock to them within that period except for a transfer not principally motivated

by tax avoidance; and

(d) They attach a separate statement (in duplicate) to

their return for the year of redemption, in which they

state that they have not acquired any new interest in the company (except by inheritance) and that they will notify

the district director within 30 days after acquiring any new interest (§302(c)(2); Reg. §1.302-4)

Family attribution is also waived for a partnership, estate, trust or corporation (―entity waiver rule‖) if that entity and

each related person meet the above requirements and agree to be liable for any tax resulting from any acquisition

of interest within the 10-year period (§302(c)(2)(C)).

Stock Recapitalization

Closely held corporations normally have a single class of common stock. Even where there are several shareholders, the

single stock structure can be satisfactory since a buy-sell agreement can cover most events during lifetime and at death.

However, some shareholders may not wish their stock sold at death but instead may desire family members to continue the

business. In such a case, a recapitalization into a multistock structure might accomplish the following objectives:

(1) If some family members are active in the business and

others are not, different classes of stock can be given to different family members;

(2) A recapitalization can be coordinated with a §303 redemption at death so that only a particular class of stock is

redeemed and voting control of the corporation is not affected; and

9 - 4 5

(3) A recapitalization can freeze the value of the

stockholder‘s interest and remove future growth from their estate.

Note: Section 2036(c) prevented the estate freezes by causing

transferred stock to be taxed in the donor‘s estate. However,

§2036(c) was repealed retroactively in 1990. In its place,

Chapter 14 rules (§2701 - §2704) were enacted that focus on

the gift tax aspects of the transfer (see later discussion of estate

freezes).

A recapitalization is a reshuffling of the capital structure of a corporation. For example, a corporation might change an all

common stock structure into one in which some stockholders have common stock and some have preferred stock.

The issuance and exchange of stock normally occurring in a recapitalization are not income taxable events27. The

recapitalization will typically constitute either a tax-free dividend28 under §305(a) or a tax-free corporate reorganization

under §368(a)(1)(E).

Section 306 Taint

Preferred stock, issued in exchange for common stock, will be tainted under §306. If a shareholder has §306 stock and it is

redeemed, the redemption is a dividend to the extent of current earnings and profits (§306(a)(2)). If the §306 stock is

sold, part of the sale price equal to the seller‘s share of the earnings and profits at the time of the earlier stock dividend

is ordinary income (§306(a)(1)). However, this taint does not apply when the shareholder‘s entire stock interest (including

any attributed under §318) is sold or redeemed at one time

(§306(b)(1)). The §306 taint is also removed on the shareholder‘s death.

Deferred Compensation Agreements

A deferred compensation agreement can be a valuable estate

planning tool to replace lost salary income on the death of an active shareholder/employee. The basic thrust of such

agreements is to postpone the receipt of currently earned

2 7

However, they may be gift taxable, particularly, under Chapter 14 rules. 2 8

A transaction purporting to be a recapitalization can be a taxable dividend under §305(b) if it is a

disproportionate distribution. For example, if the preferred stock has an unreasonable redemption

premium, dividend treatment can be imposed (§305(b)(4) & §305(c)).

9 - 4 6

income until a later taxable year. Instead of paying additional

compensation now, the corporation pays it to the shareholder/employee at some future time. These payments are

called ―deferred‖ compensation agreements because they represent compensation currently being earned but which will

not be paid until a future date.

Note: If the income has already been earned (i.e., the employee

has an undisputed right to it) deferral is generally impossible.

The deferred payout period may commence on any given date,

but could be the date of the employee‘s retirement or death, whichever occurs first. The agreement would designate a

beneficiary to receive remaining payments should the employee die before receiving all payments.

Under §2039(a), the commuted value of the remaining payments to be made on or after death is includable in the

employee‘s gross estate (Reg. §20.2031-7(f).).

If the agreement provides that no deferred payments are

payable to the employee during their lifetime, and only a death benefit is payable to a named beneficiary, it is unclear if the

value of the death benefit is includable in the employee‘s estate (Estate of Fermin D Fusz v Commissioner, 46 T.C. 214 (1966)

and R.R. 78-15). The gift tax treatment is also unsettled. R.R.

81-31 provides that the employee who does not retain any rights or benefits in the agreement during life has made a completed

gift of the contractual benefits to the irrevocable beneficiary at the time the employee dies. However, the Tax Court took a

conflicting position in Estate of DiMarco, 87 T.C. 653 (1986).

Nevertheless, one issue is clear. Payments under a deferred

compensation agreement after the decedent‘s death are subject to income tax in the hands of the recipient as income in respect

of a decedent (§691).

Deferred compensation paid to the deceased employee‘s

beneficiary will be deductible by the corporation if such payments constitute reasonable compensation (§162(a)(1)).

Installment Payment of Federal Estate Taxes - §6166

Estates of individuals whose major assets are interests in a closely held business may elect to pay the estate tax in installments if the

value of the closely held business interest relative to the gross estate or taxable estate is large enough.

9 - 4 7

Where the estate is substantially (35% of the adjusted gross

estate) made up of an interest in a closely held business, §6166 permits installment payment of the tax associated with the

business. Under §6166, the tax is deferred for five years (interest only is due) and then paid in ten annual installments. For years 6

through 15 after the decedent‘s death, the tax is payable in equal installments.

Computation

For estate taxes that are deferred under §6166, the tax

attributable to the first $1,450,000 (in 2014) in taxable value of the closely held business (i.e., the first $1,450,000 in value in

excess of the effective exemption provided by the applicable exclusion amount and any other exclusions) is subject to interest

at a rate of 2%. The remainder of such taxes is subject to interest at a rate equal to 45% of the rate applicable to

underpayments of tax, and all taxes paid under §6166 are made nondeductible.

Note: Interest paid on estate taxes deferred under this

provision is not deductible for estate or income tax purposes.

Example

Dan dies in 2014 when the applicable exclusion

amount is $5,340,000. He owned a business that

qualifies for the $1.43 million deferral of tax

payments for qualified family-owned business

interests. If his executor so elects, the amount of

estate tax attributable to the value of the closely held

business between $5,340,000 and $6,790,000 is

eligible for the 2% interest rate.

Eligibility & Court Supervision

If an estate never qualified or ceases to qualify for the

installment payment of estate taxes, the total amount of deferred estate tax is immediately due. However, taxpayers are

given access to the courts to resolve disputes over an estate‘s

eligibility for the §6166 election. The U.S. Tax Court is authorized to provide declaratory judgments regarding initial or

continuing eligibility for deferral under §6166.

9 - 4 8

Closely Held Business

A closely held business is:

(a) A sole proprietorship,

(b) An interest as a partner in a partnership where 20% or

more of the total capital interest in such partnership is included in determining the gross estate of the decedent or

the partnership has 45 or fewer partners, or

(c) Stock in a corporation where 20% or more is included in

the gross estate or the corporation has 45 or fewer shareholders (§6166(b)(1)).

An estate with an interest in a qualifying lending and financing

business is eligible for installment payment of the estate tax. However, an estate with an interest in a qualifying lending and

financing business must make installment payments of estate tax (including both principal and interest) over five years.

Only the stock of holding companies, not that of operating subsidiaries, must be nonreadily tradable to qualify for

installment payment of the estate tax. However, an estate with a qualifying property interest held through holding companies

must also make all installment payments over five years.

Acceleration of Payment

Section 6166(g) provides for acceleration of installments upon default or the disposition or withdrawal of more than fifty

percent in value of the business interest.

9 - 4 9

Glossary

Administration expenses: Expenses incurred in the administration of a decedent's estate, including executors' and

attorneys' fees.

Applicable exemption amount: The amount of a decedent's

estate exempt from federal estate tax.

Buy-sell agreement: An agreement for the disposition of a

shareholder's stock upon the occurrence of certain enumerated events.

Bypass trust: A trust fund that passes assets to children or other heirs while giving lifetime economic benefits to a surviving spouse.

Community property: Property or income of a married couple,

living in a community property state, which is considered to belong equally to each spouse.

Conservatorship: A legal process in which an adult is appointed by a Court to make financial and medical decisions for another who is

deemed incapacitated or disabled.

Deferred compensation: Funds held by an employer or put into

an account for distribution to the employee at a later date. Deferred compensation is normally taxed when received or upon the removal

of certain conditions.

Estate tax: A tax on the value of a decedent's taxable estate after

deductions and credits.

Gift tax: A graduated federal tax paid by donors on gifts exceeding

$14,000 per year (in 2014) per donee.

Income in respect of a decedent: Amounts of gross income to

which a decedent was entitled to prior to death, but which were not

yet reported.

Living trust: A trust that set up during one‘s lifetime used in estate

planning to avoid probate, help deal with incompetency, and manage assets after death.

Marital deduction: A provision that allows for unlimited transfers from one spouse to another without having to pay any gift or estate

taxes.

Net operating loss: A business loss that exceeds current income

and may be carried back against income of prior years or carryforward as a deduction against future income.

Personal holding company: A closely held corporation in which 60% or more of its income is from rents, royalties or dividends.

9 - 5 0

Qualified terminal interest property (QTIP): Property that

qualifies for the unlimited marital deduction even though it may be transferred through a trust.

a

Index of Keywords & Phrases

5

50% limit, 6-24, 6-35, 6-37, 6-41

5-year averaging, 7-4, 7-30, 7-32

A

abandonment, 7-14

accelerated depreciation, 3-86, 3-89, 3-90,

5-21

accident insurance, 8-9

account statement, 1-24

accountable plan, 6-30, 6-31, 6-38, 6-41,

6-42

accounting fees, 2-19

accounting methods, 1-6, 1-33

accounting periods, 5-49

accounts receivable, 3-75, 3-76, 3-81, 3-

82, 9-34

accrual method, 1-15, 1-16, 1-33, 1-34, 2-

5, 3-6, 3-7, 3-8, 3-14, 3-15, 3-25, 3-28,

3-38, 3-39, 3-40, 3-41, 3-69, 3-77, 3-

80, 3-81, 4-11, 6-45

accrued interest, 2-5, 3-23

accumulated adjustments account, 1-18

accumulated earnings tax, 1-17, 9-49

acquisition indebtedness, 3-31

ACRS, ix, 3-84, 3-88, 3-90, 5-40, 5-41

actual cost method, 5-5, 5-39, 5-41, 6-34

additional depreciation, 3-86, 3-87

additional first-year depreciation, 3-87, 5-

10

adequate accounting, 6-32, 6-42, 6-44

adequate records, 5-38, 6-29

adjusted basis, 1-8, 2-4, 2-13, 2-21, 3-4,

3-17, 3-36, 3-44, 3-59, 3-65, 3-66, 3-

68, 3-69, 3-71, 3-86, 4-11, 5-6, 5-7, 5-

8, 5-19, 5-39, 8-12, 8-14, 8-15, 9-7, 9-

9

adjusted current earnings, 1-15, 2-16

adjusted gross income, 3-10, 3-43, 3-45,

6-25, 6-29, 6-41, 7-42

adjustments to basis, 3-86

administration expenses, 9-47, 9-48

administrative fees, 1-5, 7-38

administrator, 4-23, 7-8, 7-52

ADS, 3-17

advance rent, 2-4

affiliated corporation, 1-12, 3-46

affiliated group, 3-45

agents, 6-21

AGI, 1-4, 4-22, 4-36, 5-42, 6-25, 6-29, 6-

30, 7-42, 7-59, 7-61, 7-62, 7-63, 7-64

aliens, 7-69

alimony, 7-24

allocation of interest expense, 3-36

allowed or allowable, 3-69, 3-71

alternative depreciation system, 3-17, 3-

86, 3-90, 3-91

alternative minimum tax, 1-15, 1-17, 2-12,

2-15, 2-16, 3-86, 3-87, 3-90, 5-10

Americans with Disabilities Act, 3-54

amortization, 1-6, 1-30, 1-36, 3-3, 3-10,

3-15, 3-16, 3-27, 3-54, 3-55, 3-56, 3-

57, 3-58, 3-59, 3-64, 3-65, 3-66, 3-67,

8-16

amount at risk, 8-6

amount realized, 2-18

AMT, 1-7, 2-17

AMTI, 2-16

annual addition, 7-22

annual exclusion, 9-5, 9-25, 9-51

annuity, 3-2, 3-29, 3-30, 6-26, 7-14, 7-24,

7-27, 7-34, 7-38, 7-39, 7-41, 7-45, 7-

54, 7-56, 7-60, 7-61, 7-62, 7-69, 8-11,

8-12, 8-13, 8-14, 9-30, 9-31

annuity contract, 3-29, 3-30, 7-14, 7-27,

7-38, 7-45, 7-54, 7-56, 8-11, 8-12, 8-

13, 8-14

annuity starting date, 7-24

applicable exclusion amount, 9-4, 9-5, 9-

10, 9-11, 9-16, 9-19, 9-51, 9-57

applicable exemption amount, 9-11, 9-16,

9-43

b

applicable federal rate, 2-19, 4-34

appraisal fees, 9-44

appreciated property, 9-30

ascertainable standard, 9-51

assessed value, 3-39

assessments, 3-39, 3-40, 4-36

at-risk rules, 1-8, 1-13, 3-6

attribution, 9-53, 9-54

attribution rules, 9-54

auto expenses, 5-42

average annual compensation, 7-21

averaging, 2-20, 7-30, 7-32, 7-36, 9-34

awards, 4-9, 4-23, 4-24

awards and prizes, 4-23

away from home, 6-1, 6-2, 6-3, 6-4, 6-6,

6-7, 6-8, 6-11, 6-13, 6-14, 6-22, 6-33,

6-35, 6-40

B

back pay, 7-16

bad debts, 2-9, 3-74, 3-75, 3-78, 3-79, 3-

80, 3-81

balance sheet, 1-21, 4-54

bankruptcy, 1-11, 2-6, 3-77

barter, 2-2, 2-3

basis reduction, 3-89

beneficial interest, 2-21

beneficiary country, 6-13

bequests, 9-2

bonus depreciation, 3-17, 3-19, 3-86, 5-

10, 5-13, 5-14

bonuses, 3-16, 3-74, 4-1, 4-4, 4-5, 4-7, 4-

9, 4-46, 7-34

book value, 3-36, 9-33, 9-34

business bad debts, 3-75, 3-76, 3-78

business connection, 6-31

business expenses, 1-4, 1-25, 3-6, 3-38,

3-40, 3-42, 3-47, 3-66, 4-21, 4-22, 6-1,

6-10, 6-25, 6-28, 6-29, 6-30, 6-31, 6-

32, 6-41, 6-42, 6-43, 6-44, 6-45, 7-45

business gifts, 6-44

business interest, 1-17, 3-20, 9-31, 9-32,

9-39, 9-45, 9-46, 9-50, 9-51, 9-57, 9-

58

business premises, 4-22, 4-28, 4-37, 5-44,

5-51, 6-20, 6-26

business purpose, 1-20, 1-26, 1-31, 1-32,

3-12, 3-30, 3-46, 3-47, 4-21, 5-5, 5-22,

5-23, 5-40, 5-43, 6-8, 6-11, 6-12, 6-15,

6-19, 6-22, 6-23, 6-27, 6-32, 6-34

business tax credit, 8-17

business transportation, 5-5, 6-27, 6-43

buy-sell agreement, 8-1, 9-31, 9-32, 9-45,

9-46, 9-47, 9-50, 9-51, 9-54

bypass trust, 9-19, 9-50, 9-51

C

C corporation, 1-2, 1-16, 1-17, 1-18, 9-53

calendar year, 1-14, 1-20, 3-7, 3-14, 3-16,

3-40, 3-41, 4-12, 4-13, 4-17, 4-26, 4-

44, 5-13, 5-38, 5-45, 5-48, 5-49, 5-50,

5-51, 5-60, 6-36, 6-38, 6-45, 7-30, 7-

32, 7-43, 7-47, 7-48, 7-55, 7-61, 7-68,

7-70, 7-71, 7-72, 7-74, 9-36

canceled check, 1-22, 1-24, 1-27, 6-32

capital account, 3-56, 3-57, 3-66, 9-49

capital appreciation, 7-38

capital asset, 2-20

capital contribution, 3-75

capital expenditure, 3-50, 3-51, 3-71, 5-

10, 5-18

capital expenses, 3-3, 3-21, 3-40, 3-48, 3-

56, 3-57, 3-58

capital gain distributions, 3-24

capital gains, 1-16, 1-18, 2-7, 2-8, 2-20,

3-24, 3-44, 3-88, 3-89, 4-41, 4-43

capital interest, 7-10, 9-58

capital losses, 2-6, 3-74, 3-75, 9-9

capitalization, 3-27, 3-28, 3-50, 8-14, 9-

33, 9-36

carpools, 5-44

carrying charge, 3-50

carryover basis, 9-7, 9-9, 9-10

carryovers, 2-6, 2-7, 3-25

c

cash equivalent, 4-49

cash method, 1-15, 1-16, 1-33, 3-6, 3-7,

3-8, 3-15, 3-25, 3-28, 3-38, 3-40, 3-57,

3-69, 4-10, 6-45

cash or deferred arrangement, 4-27

cash surrender value, 3-30, 8-12, 8-13, 8-

15, 9-25

casualties, 3-45

casualty, 1-24, 3-4, 3-5, 3-10, 3-44, 3-45,

3-47, 3-69, 5-2, 6-25, 6-27, 8-14

certificates of deposit, 9-26

certified pollution control facility, 3-66, 3-

67

change in accounting method, 1-33

charitable contributions, 7-54

charitable remainder trust, 9-22

charitable sports event, 6-23

charitable travel, 5-41

child support, 7-24

children, 3-47, 4-16, 4-20, 4-37, 6-6, 9-1,

9-10, 9-11, 9-14, 9-16, 9-35, 9-43, 9-

45, 9-51, 9-53

chronically ill individual, 8-16

church plan, 7-12

claim of right, 6-26

clear business setting, 6-19

cliff vesting, 7-20

closing inventory, 1-35

closing statement, 1-24

clothes, 6-2, 9-16

club dues, 6-28

coins, 7-46

collectibles, 7-45, 7-46

commissions, 3-21, 3-57, 4-1, 4-4, 9-45

commodities, 2-9

common law, 4-2, 7-39

common stock, 4-38, 9-52, 9-54, 9-55

communication, 6-40

community property, 7-24, 9-6, 9-9, 9-14,

9-48

commuter highway vehicle, 5-6, 5-44, 5-

45

commuting expenses, 5-3

compensation, 1-5, 1-25, 2-1, 4-1, 4-5, 4-

6, 4-7, 4-8, 4-15, 4-18, 4-19, 4-24, 4-

27, 4-29, 4-33, 4-34, 4-39, 4-40, 4-42,

4-43, 4-44, 4-46, 4-47, 4-48, 4-49, 4-

50, 4-51, 4-53, 4-56, 4-57, 4-58, 4-59,

5-6, 5-23, 5-44, 5-53, 5-54, 5-55, 6-15,

6-21, 6-24, 6-28, 6-30, 6-34, 6-41, 6-

45, 7-1, 7-2, 7-3, 7-13, 7-15, 7-21, 7-

22, 7-23, 7-25, 7-26, 7-27, 7-28, 7-29,

7-30, 7-31, 7-39, 7-42, 7-44, 7-45, 7-

59, 7-60, 7-62, 7-63, 7-70, 7-71, 7-72,

7-73, 7-74, 7-75, 8-2, 8-5, 8-10, 9-56

computer equipment, 3-84

computers, 3-85

conservation easement, 9-39, 9-40, 9-41

conservatorship, 9-14, 9-27

constructive ownership, 9-53

constructive receipt, 4-40, 4-47, 4-48, 4-

49, 4-50, 4-51

contractors, 2-1, 3-51, 4-3

control employee, 5-52, 5-53

controlled group, 4-27, 7-37, 8-11

CONUS, 6-33, 6-35, 6-36

convenience of the employer, 3-47, 3-48,

4-28, 5-24

conventions, 6-9, 6-13, 6-14, 6-20, 6-21,

6-28

cooperative housing, 3-21

copyrights, 2-18

corpus, 7-14, 7-51, 9-3, 9-14

cost basis, 1-35, 7-37, 7-54

cost depletion, 3-68, 3-70, 3-71, 3-74

cost of goods, 1-34, 1-35, 1-36, 3-2, 3-27,

3-47, 8-16

cost of goods sold, 1-35, 1-36, 3-2, 3-27,

3-47, 8-16

cost of living, 4-16, 7-21

country clubs, 6-16, 6-19

covenant not to compete, 3-61, 3-64, 3-

65, 4-54, 4-55

credit union, 7-23

criminal activity, 4-54

cruise ship, 6-14

d

D

day care, 3-47

de minimis fringe benefits, 4-23

dealer property, 2-21

dealers, 2-3, 5-30, 5-31

death benefits, 7-24, 7-32, 7-54

declaratory judgment, 9-58

declining balance method, 3-86, 3-89, 5-8,

5-9

deferred annuity, 7-3

deferred compensation, 1-17, 4-10, 4-40,

4-41, 4-42, 4-44, 4-45, 4-46, 4-48, 4-

49, 4-50, 4-51, 4-52, 4-53, 4-54, 4-56,

4-57, 4-58, 7-1, 7-2, 7-3, 7-7, 7-12, 7-

59, 7-60, 8-1, 9-56

deferred tax, 7-4

defined benefit plan, 7-1, 7-3, 7-13, 7-18,

7-21, 7-24, 7-25, 7-26, 7-33, 7-35

defined contribution plan, 7-10, 7-20, 7-

22, 7-23, 7-24, 7-25, 7-26, 7-28, 7-47,

7-69, 8-5

demand loans, 4-33, 4-34

dental expenses, 4-28

dependent care, 4-25, 4-26, 4-27

depletion allowance, 3-71

depreciable property, 2-7, 2-12, 3-52, 3-

64, 3-67, 5-10

depreciation recapture, 3-89, 5-25

determination letter, 4-44

direct deposit, 7-23

direct rollover, 7-58

disability income, 8-10

disability insurance, 1-4, 1-14, 4-16, 7-13

disaster, 3-5

disclosure, 7-2, 7-7, 7-8, 8-7

disease, 3-44

disqualified person, 7-11, 7-56

dividend reinvestment plan, 2-8

dividends, 1-8, 1-10, 1-12, 1-13, 1-14, 1-

15, 1-16, 1-17, 2-7, 2-8, 2-9, 3-22, 3-

23, 3-24, 3-25, 3-45, 3-46, 4-7, 4-38,

4-40, 4-57, 7-38, 8-14, 9-33, 9-48

documentary evidence, 6-32

domain, 3-63

domestic trust, 9-2

double taxation, 1-15, 1-16, 1-20

drought, 3-44

dwelling unit, 3-47

E

early retirement, 7-7

earned income, 1-8, 4-25, 4-44, 7-43, 7-

72, 9-56

earnings and profits, 2-7, 7-28, 9-49, 9-55

economic effect, 2-14

economic performance, 3-7, 3-15, 6-45

educational expenses, 6-35

electric drive motor vehicle, 3-83

eligible rollover, 7-58, 7-59

eligible rollover distribution, 7-58, 7-59

employee achievement award, 4-9, 4-23,

4-24, 4-25

employee benefit trust, 7-25

employee compensation, 6-26

employee contributions, 7-11, 7-19, 7-20,

7-22, 7-33, 7-35, 7-38, 7-41, 8-2

employee discounts, 4-19

employer identification number, 1-31

employer reimbursements, 4-28

employer-provided educational assistance,

4-30

employer-provided vehicle, 5-43, 5-52, 5-

59, 5-60

entertainment expenses, 3-2, 6-15, 6-16,

6-20, 6-29, 6-37, 6-41, 6-43, 6-44

entertainment facilities, 6-27

entertainment facility, 6-26, 6-27, 6-28

ERISA, xii, xviii, 4-37, 4-38, 4-39, 4-45, 7-

2, 7-7, 7-8, 7-9, 7-10, 7-13, 7-14, 7-24,

7-25, 7-35, 7-37, 8-6

escrow account, 4-49, 4-55

estate tax, 3-11, 3-41, 3-42, 4-36, 6-26,

7-53, 7-54, 9-1, 9-2, 9-3, 9-4, 9-5, 9-6,

9-10, 9-14, 9-19, 9-20, 9-22, 9-31, 9-

32, 9-34, 9-38, 9-39, 9-41, 9-43, 9-44,

e

9-46, 9-47, 9-48, 9-50, 9-51, 9-57, 9-

58

estimated tax, 1-4, 1-10, 1-11, 1-31, 2-9

estimated useful life, 5-40

excess contribution, 7-46, 7-71

excess reimbursement, 6-30, 6-31, 6-38

exchange, 1-9, 1-30, 2-2, 2-5, 2-18, 2-21,

3-16, 4-10, 4-33, 6-13, 7-9, 7-38, 8-17,

9-30, 9-45, 9-55

excise tax, 2-19, 3-43, 3-73, 5-4, 7-11, 7-

24, 7-30, 7-32, 7-43, 7-47, 7-56, 7-61,

7-70

excise taxes, 2-19, 3-43

exclusions, 9-57

exclusive benefit of employees, 4-26, 7-15

executive compensation, 4-38

exemptions, 4-14

expense allowance arrangement, 6-21, 6-

30, 6-41

expensing deduction, 5-12, 5-13, 5-25

extensions, 1-12, 1-32, 1-33, 3-24, 3-41,

3-50, 3-57, 3-66, 7-2, 7-11, 7-14, 7-29,

7-32, 7-43, 7-62, 7-67, 7-70, 7-74, 9-6,

9-39

F

face value, 3-76, 6-23

face value limit, 6-23

failure to file, 1-12, 7-43

failure to pay, 1-12

fair market value, 2-2, 2-3, 2-7, 2-8, 2-18,

3-14, 3-36, 3-44, 3-76, 3-80, 4-10, 4-

11, 4-23, 4-24, 4-25, 4-30, 4-31, 4-32,

4-37, 4-38, 4-40, 4-41, 4-42, 4-43, 4-

44, 4-49, 4-50, 4-55, 5-7, 5-22, 5-23,

5-32, 5-33, 5-38, 5-46, 5-47, 7-10, 7-

55, 7-56, 7-68, 9-6, 9-7, 9-10, 9-25, 9-

31, 9-32, 9-36, 9-41, 9-44, 9-46

fair rental value, 2-2, 3-13, 5-22, 9-36

family attribution, 9-53

family members, 1-20, 9-1, 9-34, 9-42, 9-

43, 9-51, 9-54, 9-55

Family Support Act, xvii, 6-30

farm vehicle, 5-55

farming loss, 3-5

Federal per diem rate, 6-32, 6-34, 6-36, 6-

37

federal unemployment, 2-2, 4-2, 4-17, 4-

18

fellowships, 4-27

FICA, x, 2-2, 4-2, 4-15, 4-16, 4-17, 6-30,

6-41, 7-45

fiduciary responsibilities, 7-8

FIFO, ii, 1-34, 1-35

filing status, 2-10, 2-11, 7-63

finance charges, 5-27

financial accounting, 3-64

financial planning, 4-35

fines, 5-27

fire, 4-4, 5-55

fiscal year, 1-14, 5-11, 7-29, 7-32, 7-70

foregone interest, 2-5, 4-34

foreign conventions, 6-12

foreign earned income, 3-42

foreign earned income exclusion, 3-42

foreign income, 2-2, 3-42

foreign tax credit, 2-6

foreign taxes, 3-38, 3-39

foreign travel, 6-9, 6-10, 6-11, 6-12

Form 1040, 1-3, 1-4, 1-7, 2-9, 2-10, 2-11,

2-13, 2-14, 2-15, 3-10, 3-11, 3-37, 3-

42, 3-43, 3-45, 3-72, 3-78, 5-3, 6-39,

6-41, 6-42, 7-41

Form 1065, i, 1-3, 1-6, 1-7, 2-13, 2-14, 3-

38, 3-72, 3-78, 8-15

Form 1098, 3-21

Form 1099, 1-23, 2-1, 2-3, 2-11, 4-11, 6-

42

Form 1099-G, 2-11

Form 1099-MISC, 1-23, 2-1, 2-3, 4-11

Form 1120, i, 1-11, 1-12, 1-13, 2-14, 2-

15, 3-38, 3-72, 3-78, 6-45

Form 1120S, 2-14, 2-15, 3-38, 3-72, 3-78

Form 2106, xviii, 5-6, 5-7, 5-19, 5-59, 6-

31, 6-35, 6-39, 6-41, 6-42

Form 5305, 7-72

Form 8582, 3-72

f

Form W-2, x, 4-10, 4-15, 5-59, 5-60, 6-

31, 6-38, 6-39, 6-42, 6-45, 8-16

Form W-4, x, 4-14, 4-15

franchise tax, 3-43

fraud, 1-10

fringe benefits, 1-5, 1-14, 1-17, 1-20, 4-1,

4-5, 4-9, 4-18, 4-19, 4-32, 4-37, 5-44,

5-59

FUTA, x, 1-19, 2-2, 4-2, 4-17, 4-18, 6-30,

6-41, 7-45

futures, 3-62

G

garnishment, 7-23

general business credit, 2-6, 2-16, 2-17,

8-17

generation skipping transfer tax, 9-2, 9-4,

9-6

gift tax, 3-38, 4-33, 9-2, 9-4, 9-5, 9-25, 9-

30, 9-32, 9-34, 9-41, 9-42, 9-46, 9-51,

9-55, 9-56

going concern value, 2-22, 3-59, 3-64

gold, 7-46

goodwill, 2-18, 2-22, 3-59, 3-64, 4-9, 6-

19, 9-38, 9-50

grants, 4-43, 9-41

gross estate, 7-54, 9-2, 9-6, 9-35, 9-41,

9-44, 9-47, 9-48, 9-56, 9-57, 9-58

gross income, 1-21, 1-30, 1-33, 2-3, 2-5,

2-6, 2-9, 2-10, 3-10, 3-11, 3-23, 3-26,

3-42, 3-45, 3-47, 3-70, 3-72, 3-73, 3-

74, 3-75, 3-76, 3-79, 3-80, 3-81, 3-82,

4-18, 4-19, 4-22, 4-23, 4-25, 4-28, 4-

29, 4-49, 4-57, 4-58, 4-59, 5-23, 5-26,

5-32, 5-33, 5-37, 5-44, 5-45, 5-46, 5-

54, 5-58, 6-15, 6-25, 7-3, 7-30, 7-42,

7-44, 7-52, 7-53, 7-54, 7-56, 7-59, 7-

65, 7-67, 7-71, 8-2, 8-15, 8-16

gross profit percentage, 4-21

gross vehicle weight, 5-4, 5-5, 5-20, 5-55,

5-57

guaranteed payment, 1-8, 3-77

guarantees, 1-8, 3-77, 7-11, 7-25, 8-5

H

half-year convention, 5-7, 5-8, 5-11, 5-12

handicapped persons, 3-47

head of household, 7-42, 7-62

health insurance, 2-17, 4-29, 4-37, 8-1, 8-

9, 8-17

health savings account, 8-17

highest and best use, 9-34

highly compensated employees, 4-19, 4-

24, 4-26, 4-27, 4-29, 4-35, 6-21, 7-1,

7-12, 7-15, 7-17, 7-18, 7-21, 7-69, 7-

71, 8-1, 8-6

home mortgage interest, 3-22, 3-47

home office, 3-12, 3-47, 3-48

home office expense, 3-47, 3-48

I

identifiable event, 3-44

improvements, 1-23, 3-12, 3-17, 3-18, 3-

19, 3-39, 3-52, 3-69, 3-85, 3-90, 5-18

imputed interest, 3-15, 4-33, 4-34

income averaging, 7-4, 7-35

income in respect of a decedent, 6-26, 7-

53, 7-54, 9-56

indefinite assignment, 6-5

independent contractors, 4-2, 4-10, 5-45

individual retirement arrangements, 7-68

information return, 1-6, 2-13, 2-14, 8-14

inheritance tax, 8-1, 9-10

inherited IRA, 7-53

inside basis, 1-18

inside buildup, 8-10

installment payment of estate tax, 9-57

installment sales, 1-6

insurance dividends, 2-5

insurance premiums, 3-7, 3-10, 3-29, 4-6,

8-5, 8-17

insurance trust, 9-22

intangible asset, 2-18, 3-62, 9-34, 9-38,

9-39

intangible drilling, 3-51

intangible drilling costs, 3-51

interest allocation, 3-28, 3-32, 3-36

g

interest expense, 1-17, 2-5, 3-22, 3-23, 3-

24, 3-26, 3-27, 3-30, 3-31, 3-34, 3-36,

3-37, 3-38, 5-3, 8-12, 8-13, 8-14

interest income, 2-5, 2-7, 2-10

Internet, 5-28

investment company, 1-12, 1-14, 2-8, 3-

46

investment income, 2-8, 2-9, 3-23, 3-24,

3-25, 6-25, 7-4

investment interest, 3-22, 3-23, 3-24, 3-

25, 3-32, 3-34

investment purpose, 6-22, 7-45

investment tax credit, 2-17, 3-82, 5-5, 5-

21, 5-25

involuntary conversion, 1-6, 3-65

IRA, xx, xxi, 7-5, 7-7, 7-10, 7-35, 7-36, 7-

39, 7-41, 7-42, 7-43, 7-44, 7-45, 7-46,

7-47, 7-48, 7-50, 7-52, 7-53, 7-54, 7-

55, 7-56, 7-57, 7-58, 7-59, 7-60, 7-61,

7-62, 7-63, 7-64, 7-65, 7-67, 7-68, 7-

69, 7-70, 7-71, 7-72, 7-73, 7-74

irrevocable trust, 4-55, 9-14, 9-15

itemized deduction recoveries, 2-9

itemized deductions, 2-10, 2-11, 3-24, 3-

45, 6-25, 6-29, 6-30, 6-41, 6-42

itinerant worker, 6-4

J

joint and survivor annuity, 7-46

joint tenancy, 9-11

K

Keogh plans, 4-37, 7-7, 7-36, 7-39

key employees, 4-5, 4-28, 4-29, 4-38, 7-3,

7-29, 7-32, 7-70, 8-2, 8-5

L

lack of marketability, 9-45

late payment penalty, 3-81

leasehold improvements, 2-4

leases, 3-13, 3-14, 3-53, 3-59, 5-26, 5-28,

5-29, 5-30, 5-31, 5-32, 5-38, 5-52, 5-

56, 6-23

legal fees, 3-58

life annuity, 7-21

life estate, 9-3

life expectancy, 7-30, 7-32, 7-43, 7-46, 7-

47, 7-49, 7-50, 7-51, 7-61, 7-70, 9-30,

9-31

life insurance, 3-20, 3-29, 3-30, 4-9, 4-10,

4-52, 4-53, 4-57, 7-27, 7-32, 7-33, 7-

34, 7-36, 7-37, 7-38, 7-45, 8-1, 8-2, 8-

6, 8-9, 8-10, 8-11, 8-12, 8-13, 8-14, 9-

22, 9-26, 9-32, 9-49

LIFO, ii, 1-34, 1-35, 1-36

like-kind exchange, 3-65, 3-66

limited partnerships, 1-5, 1-7

lineal descendent, 6-37

listed property, 2-12, 5-21, 5-23, 5-32

living trust, 9-12, 9-15, 9-16, 9-19, 9-27

living will, 9-26

loan origination fees, 3-21

local taxes, 5-39, 7-23

local transportation, 5-54, 6-2

lodging, 4-27, 4-28, 4-35, 6-1, 6-2, 6-5,

6-6, 6-10, 6-11, 6-12, 6-13, 6-32, 6-33,

6-34, 6-36, 6-37, 6-40

long-term care insurance, 8-16

low-income housing, 3-35

lump sum distribution, 7-42

luxury automobiles, 5-50

M

MACRS, ix, xiv, 3-17, 3-84, 3-85, 3-86, 3-

87, 3-88, 3-89, 3-90, 5-7, 5-8, 5-9, 5-

13, 5-19, 5-20, 5-21, 5-24, 5-25, 5-40,

5-41

made available, 4-30, 4-32, 4-48, 4-49, 5-

46, 6-15, 6-26, 7-9

management fees, 8-15

margin accounts, 3-25

marital deduction, 4-36, 7-54, 9-2, 9-3, 9-

19, 9-22, 9-32, 9-43, 9-46, 9-48, 9-50

marital deduction trust, 9-3, 9-48

marital property, 7-24, 9-3, 9-50

marital status, 4-25

h

market risk, 5-30

material participation, 9-38

meals and lodging, 6-2, 6-4, 6-5, 6-7, 6-8,

6-11

medical expenses, 4-29, 5-42, 7-24, 7-30,

7-32, 8-16

medical insurance, 1-14, 8-9

Medicare, 1-4, 1-10, 1-19, 2-2, 2-13, 3-

42, 4-2, 4-12, 4-15, 4-16, 8-17

mid-quarter convention, 3-87, 3-88, 5-11,

5-12, 5-13, 5-20

mileage allowance, 5-40, 5-43, 6-30

minimum vesting, 7-19, 7-20

modified adjusted gross income, 2-9, 5-4,

7-62, 7-63

money market funds, 2-7

money purchase pension, 7-3, 7-10, 7-12,

7-22, 7-27

monitor, 1-22

mortgages, 3-21, 3-62

moving expenses, 4-35

municipal bonds, 4-57

mutual funds, 3-24, 3-46

N

net income, 1-9, 2-17, 3-42

net investment income, 2-9, 3-22, 3-23, 3-

24, 3-25

net loss, 2-20

net operating loss, 1-13, 1-16, 2-6, 2-17,

3-4, 3-5, 3-6, 3-81, 9-9

net proceeds, 6-23, 6-25

net worth, 1-28, 7-12, 9-31

nonaccountable plans, 6-30, 6-41

nonaccrual-experience method, 3-78, 3-

81, 3-82

nonbusiness bad debts, 3-74, 3-75

nonpersonal use vehicles, 5-55

non-resident aliens, 7-12

nontaxable income, 1-21, 3-23

nonvoting stock, 4-39, 9-52

North American area, 6-12, 6-13

notes, 2-4, 2-21, 3-75, 3-76

O

OCONUS, 6-33, 6-35

OID, 3-26

oil and gas property, 3-70, 3-71

operating expenses, 3-47, 9-36

options, 3-15, 3-16, 3-58, 4-38, 4-41, 4-

43, 5-32, 5-48

ordinary and necessary expenses, 3-1, 4-

36, 6-2, 6-16, 6-40, 8-9

ordinary dividends, 2-7, 2-8

ordinary gains, 2-20

ordinary losses, 3-45, 3-88

organization fees, 1-6

original basis, 5-6, 5-17

outside basis, 1-18

owner employee, 7-10

P

parking, 3-39, 3-53, 4-22, 5-2, 5-39, 5-44,

5-45, 5-60, 6-23, 6-24, 6-40

partnership agreement, 1-3, 1-5, 2-13, 3-

58

passenger vehicles, 5-5, 5-13, 5-32

passive activity, 1-9, 2-6, 2-9, 3-4, 3-6, 3-

22, 3-24, 3-26, 3-32, 3-33, 3-35, 3-37

passive activity losses, 1-9, 2-6

passive income, 1-9, 1-16, 3-4

patents, 2-18, 9-34

PBGC, xviii, xix, 7-11, 7-12

per diem allowance, 6-32, 6-34, 6-36, 6-

37, 6-38, 6-39

percentage depletion, 3-68, 3-70, 3-71, 3-

72, 3-73, 3-74

percentage reduction rule, 6-24, 6-28

percentage test, 7-16

periodic payment, 7-30, 7-32, 7-60, 9-30

permanent improvements, 3-19

personal exemptions, 2-10, 6-25

personal holding company, 1-15, 1-17

personal interest, 3-3, 3-34

personal pleasure, 5-41, 6-8, 6-10, 6-11

personal property, 1-36, 2-3, 2-21, 3-3, 3-

18, 3-20, 3-29, 3-39, 3-43, 3-50, 3-51,

i

3-53, 3-84, 3-85, 3-87, 3-88, 3-89, 3-

91, 4-21, 5-2, 5-3, 6-26, 9-35

personal property tax, 3-43, 5-2, 5-3

personal property taxes, 3-43, 5-2, 5-3

personal service corporation, 1-7, 1-15, 1-

31, 1-32

personal service income, 4-5

personal use, 1-26, 3-4, 3-10, 3-31, 3-45,

3-88, 4-22, 4-30, 4-32, 5-1, 5-2, 5-7,

5-8, 5-13, 5-22, 5-23, 5-31, 5-45, 5-46,

5-49, 5-50, 5-52, 5-55, 5-56, 5-58, 5-

59, 5-60, 7-55

phantom stock, 4-40, 4-42

physical fitness program, 4-37

placed in service, 3-17, 3-18, 3-19, 3-28,

3-82, 3-83, 3-84, 3-85, 3-86, 3-87, 3-

88, 3-89, 3-90, 4-32, 5-5, 5-6, 5-7, 5-8,

5-9, 5-10, 5-11, 5-12, 5-13, 5-17, 5-18,

5-19, 5-21, 5-24, 5-25, 5-26, 5-37, 5-

40

plan year, 4-27, 4-28, 7-16, 7-17, 7-20, 7-

21, 7-28, 7-29, 7-32

points, 1-4, 3-21, 4-16

portfolio income, 3-22, 3-23

power of appointment, 9-3

power of attorney, 9-26, 9-27

preferred stock, 2-7, 3-46, 9-52, 9-55

premature distribution, 7-57

prepaid interest, 3-7, 3-21

present interests, 9-25

primarily for business, 6-1, 6-9, 6-10, 6-

11, 6-12

principal place of business, 3-48, 6-3, 6-4

principal purpose, 3-36, 4-34

principal residence, 3-82

prizes, 4-23

prizes and awards, 4-23

professional associations, 6-22

professional fees, 3-57

profit-sharing plans, 7-13

prohibited transactions, 7-8, 7-9, 7-55

property settlement, 7-24

property taxes, 2-4, 3-40, 3-47, 5-3

Q

QDRO, 7-23

QTIP, xxiii, 9-11, 9-19

qualified business use, 5-21, 5-22, 5-23,

5-24, 5-25, 5-26

qualified deferred compensation, 4-58, 7-

1, 7-3

qualified domestic relations order, 7-23

qualified farm debt, 2-6

qualified home, 3-31

qualified long-term care insurance, 8-15,

8-16

qualified person, 1-13, 1-15

qualified plan award, 4-23, 4-24

qualified residence interest, 3-22

qualified transportation fringes, 5-44

R

ratio test, 7-16

real estate taxes, 2-18, 2-19, 3-39, 3-40,

3-41, 3-47, 9-35, 9-36

real property business debt, 2-6

reasonable cause, 1-12

reasonable compensation, 3-61, 4-5, 4-6,

4-7, 7-9, 9-56

reasonable needs, 9-49

recapture, 2-12, 2-20, 3-51, 3-86, 3-88,

3-90, 5-25, 9-7

recharacterization, 7-67

record-keeping, 1-10

recoveries, 2-9, 2-11

refund of interest, 3-21

refunds, 2-9, 4-36

regular home, 6-6

regulated investment companies, 3-46

reimbursement plan, 1-14, 4-28

reimbursements, 2-9, 4-6, 4-29, 5-2, 5-

44, 5-54, 6-30, 6-31, 6-39, 6-41, 6-42,

6-43, 7-9

REIT, 2-8

related employer, 7-18

related parties, 5-23, 9-46

j

related person, 3-12, 4-5, 5-23, 8-14, 9-

54

remainder interest, 9-40

rental expenses, 3-15

rental income, 2-3, 3-38, 3-59

repair costs, 9-44

repurchase agreement, 4-40

required minimum distribution, 7-47, 7-49,

7-50, 7-51

required payment, 3-13

research expenses, 2-17, 3-48

restricted stock, 4-39

retirement plans, 1-18, 4-37, 7-3, 7-4, 7-

5, 7-7, 7-24, 7-41, 7-47, 7-59, 7-69

revocable trust, 9-15

rollovers, 7-36, 7-47, 7-56, 7-57, 7-58, 7-

59, 7-60, 7-74

Roth IRA, xxi, 7-41, 7-44, 7-47, 7-53, 7-

55, 7-59, 7-61, 7-62, 7-63, 7-64, 7-65,

7-67, 7-68

royalties, 1-8, 1-15, 2-9, 3-22, 3-24, 3-70,

3-74

S

S corporations, 1-7, 1-14, 1-16, 1-17, 1-

18, 1-31, 2-14, 3-8, 3-23, 3-36, 5-45,

7-28, 7-69, 8-17

safe harbor, 5-48, 6-31, 9-33

salary reduction, 4-27, 7-3, 7-44, 7-69, 7-

70, 7-71, 7-73, 7-74, 7-75

sales tax, 2-19, 3-42, 3-43, 5-3, 5-4, 5-

19, 5-29, 5-48

salvage value, 3-51, 3-88, 5-10

self-employed persons, 4-17, 7-39

self-employment tax, 1-4, 1-6, 1-16, 2-13,

3-43, 4-17, 7-39

selling expenses, 3-70, 9-45

selling price, 1-35, 3-40, 4-21, 5-31

SEP, xxi, 7-2, 7-62, 7-63, 7-64, 7-68, 7-

69, 7-70, 7-71

separation from service, 7-1, 7-35

service charges, 1-27, 3-40

severance pay, 4-10

short sale, 3-29, 6-26

short tax year, 5-26

sick pay, 4-6

SIMPLE, xxi, 7-60, 7-62, 7-63, 7-64, 7-69,

7-71, 7-72, 7-73, 7-74, 7-75

simplified employee pension, 7-22, 7-68,

7-69

skybox, 6-23

Social Security, x, 1-4, 4-14, 4-15, 7-4, 7-

42, 7-69, 8-10

Social Security benefits, 7-42

Social Security tax, 4-15

sole proprietorship, 1-2, 1-3, 1-4, 1-5, 1-9,

1-18, 2-13, 3-4, 3-5, 3-53, 7-37, 8-13,

9-58

special use valuation, 9-36

specific charge-off method, 3-78, 3-80

sporting events, 6-16, 6-19, 6-20, 6-23, 6-

27

spousal support, 9-14

standard deduction, 2-10, 2-11, 5-4

standard meal allowance, 6-33, 6-34, 6-

35, 6-37, 6-38, 6-42

standard mileage method, 5-5, 5-6, 5-38,

5-40

standard mileage rate, 4-32, 5-2, 5-3, 5-6,

5-38, 5-39, 5-40, 5-41, 5-50, 6-40

state death tax credit, 9-5

statutory employees, 5-44

statutory exceptions, 6-17

stepped-up basis, 9-6

stock bonus plans, 4-39, 7-12, 7-13

stock purchase plan, 4-32

straight line method, 3-17

straight-line method, 3-17, 3-54, 3-63, 3-

89, 5-8, 5-9, 5-21, 5-26

student loans, 2-6

substantial business discussion, 6-20

substantial restriction, 4-50, 4-54, 5-58

substantiation, 4-22, 5-38, 6-28, 6-29, 6-

36, 6-44

substantiation requirements, 4-22, 6-28

surtax, 4-17, 9-4

suspended losses, 1-9

k

syndication fees, 3-58

T

tangible personal property, 1-36, 3-18, 3-

20, 3-88, 4-23, 9-33

tax attributes, 2-6, 2-7, 3-14

tax benefit rule, 2-11

tax credits, 2-6, 2-12, 4-17, 8-17

tax home, 6-3, 6-4, 6-5, 6-6, 6-8

tax penalties, 7-35

tax planning, 4-34, 4-35, 4-36, 4-37

tax preference items, 2-14

tax refunds, 3-38

tax returns, 1-6, 1-16, 1-20, 1-28, 1-29,

1-30, 2-1, 2-2, 2-15, 3-7, 4-15, 4-36,

9-26

tax year, 1-3, 1-10, 1-11, 1-13, 1-14, 1-

21, 1-28, 1-31, 1-32, 1-33, 1-34, 2-5,

2-11, 2-12, 2-14, 2-15, 2-18, 3-2, 3-3,

3-5, 3-6, 3-7, 3-8, 3-9, 3-12, 3-15, 3-

20, 3-21, 3-23, 3-25, 3-37, 3-39, 3-40,

3-41, 3-44, 3-45, 3-51, 3-52, 3-53, 3-

54, 3-56, 3-57, 3-58, 3-64, 3-66, 3-68,

3-69, 3-70, 3-76, 3-78, 3-79, 3-81, 3-

82, 3-87, 4-4, 4-10, 4-11, 4-17, 4-24,

4-25, 4-28, 4-58, 5-7, 5-9, 5-10, 5-11,

5-12, 5-13, 5-18, 5-19, 5-20, 5-21, 5-

22, 5-23, 5-24, 5-25, 5-26, 5-32, 5-33,

5-37, 5-39, 6-45, 7-4, 7-14, 7-36, 7-42,

7-53, 7-56, 7-64, 7-74, 8-6

taxable event, 4-42, 9-55

taxable income, 1-7, 1-9, 1-11, 1-12, 1-

13, 1-15, 1-18, 1-20, 1-31, 1-33, 1-34,

1-35, 2-9, 2-10, 2-11, 2-12, 2-16, 3-5,

3-6, 3-23, 3-46, 3-70, 3-71, 3-75, 3-76,

4-16, 4-18, 4-36, 4-37, 4-40, 4-41, 4-

42, 4-43, 4-50, 4-53, 4-54, 4-57, 6-41

taxable wage base, 4-16

taxable year, 1-4, 1-11, 2-16, 2-17, 2-20,

3-20, 3-25, 3-28, 3-35, 3-42, 3-50, 3-

87, 3-90, 4-44, 4-48, 4-56, 5-4, 5-10,

5-21, 5-37, 5-38, 5-50, 6-22, 6-28, 7-2,

7-13, 7-22, 7-23, 7-27, 7-36, 7-60, 7-

67, 8-2, 8-9, 8-10, 8-14, 8-15, 9-49, 9-

56

tax-exempt income, 3-22, 3-29

tax-exempt interest, 3-29, 8-14, 8-15

tax-sheltered annuity, 7-53, 7-59, 7-60

temporary assignment, 6-5

tenants by the entirety, 9-48

tenants in common, 9-14, 9-48

term life insurance, 1-14, 4-25, 4-26, 4-

37, 8-2, 8-5

term loans, 4-33, 4-34

terminally ill, 9-26

theft losses, 3-5, 3-44, 3-45, 5-2

thrift plan, 7-33

tips, 6-2, 6-24, 6-33, 6-40

tools, 3-85, 4-2, 4-4, 9-32

totally worthless debt, 3-79

transit passes, 4-22, 5-44, 5-45

transportation expenses, 5-1, 6-1, 6-2, 6-

24

travel advance, 6-38

travel away from home, 6-6, 6-7, 6-34, 6-

35, 6-36

travel expense, 4-3, 6-1, 6-2, 6-4, 6-6, 6-

7, 6-8, 6-11, 6-12, 6-14, 6-15, 6-24, 6-

30, 6-32, 6-39

trust income, 9-4, 9-25

U

unadjusted basis, 5-6

unemployment benefits, 4-10

unemployment compensation, 3-43, 7-13

uniform capitalization rules, 1-35, 1-36, 3-

2, 3-19, 3-26, 3-27, 3-50, 8-16

uniforms, 4-21

universal life insurance, 7-33, 7-34

unrealized loss, 9-6

unreasonable compensation, 4-5, 6-29, 7-

55

unstated interest, 2-5, 2-19, 3-22

use tax, 2-11

useful life, 3-7, 3-13, 3-63, 3-67, 3-88, 5-

39

l

V

vacation days, 4-27

valuation, 1-35, 4-30, 5-30, 5-45, 5-46, 5-

49, 5-50, 5-52, 5-53, 5-59, 9-6, 9-31,

9-32, 9-33, 9-34, 9-38, 9-41, 9-43, 9-

45, 9-46, 9-50

Vesting, xix, 7-18, 7-19, 7-20

W

website, 8-17

welfare benefits, 4-10

working condition fringe, 4-19, 5-43, 5-57

worthless debts, 3-79

worthlessness, 3-64

written plan, 4-24, 4-26, 4-30, 7-13, 7-30