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Topic 32: Income Tax Fundamentals

Topic 32: Income Tax Fundamentals. Primary: Internal Revenue Code Treasury Regulations Revenue Rulings and PLRs (can’t rely on) Court cases Secondary Guides: not law. Determination of Income Tax Liability. Gross Income - “Above the Line Deductions” = AGI (Adjusted Gross Income)

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Topic 32: Income Tax Fundamentals

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  1. Topic 32: Income Tax Fundamentals • Primary: • Internal Revenue Code • Treasury Regulations • Revenue Rulings and PLRs (can’t rely on) • Court cases • Secondary • Guides: not law

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

  3. Topic 33: Tax Compliance • Filing requirements • Income > Standard deduction + personal exemptions • Dependents: Unearned income > $1,000 • All U.S. citizens; no matter where reside • Tax return due dates • Individual: 4/15; six month extension • Partnerships: same as individual; only five month extension • Corporations: 3/15 for calendar corp; six month extend • IRS audits • Statute: three years from due date of return • Longer if fraud (never) or substantial underpayment (6 years)

  4. Topic 33: Tax Compliance • Burden of proof • On IRS if taxpayer keeps adequate records • Privileged communication between CPAs and client if no criminal act committed • Audits • Random sample, scoring, matching 1099s, W-2s • Target high income taxpayers, businesses generating cash • Taxpayer penalties • substantial underpayment: 20% penalty • “substantial”: > 10% tax or $5,000 • failure to pay: ½% per month up to 25% • failure to file: 5% per month up to 25% • Minimum: $100/100% tax due if > 60 days past due • fraud: 75% penalty

  5. Topic 33: Tax Compliance • Assessment: send 30 day letter • Have 90 days to appeal to Tax Court • Not required to pay tax before hearing • Other court venues (District Court) require payment of tax and then filing suit for refund • Only lawyers and CPAs can represent taxpayer in Tax Court

  6. Topic 34: Income Tax Calculation • Gross Income • - “Above the Line Deductions” • = AGI (Adjusted Gross Income) • - > Standard or Itemized Deductions • -Personal and Dependency Exemptions • = Taxable Income • Tax Based on Filing Status

  7. Topic 34: Income Tax Calculation • Filing Status • MFJ: 12/31 or widow for two years • Head of household: single; majority of cost of home for child/dependent • Gross Income • Exclusions • Life insurance • Muni bonds interest (not capital gains) • Gifts/inheritances • Personal injury damages

  8. Topic 34: Income Tax Calculation • Imputed Income • Below market rate loans > $10,000 • Zero coupon bonds • AGI = Gross Income – • SE health insurance • 50% SE tax • $2,500 student loan interest • $5,500 Traditional IRA (under age 50) • Alimony • Moving expenses • Contributions to Health Savings Accounts

  9. Topic 34: Income Tax Calculation • Standard Deduction • MFJ $12,400 • Single $6,200 • Additional standard deduction • Over 65 • Blind

  10. Topic 34: Income Tax Calculation • Itemized Deductions: Schedule A • Medical expenses > 10% AGI • Hospital, doctor, drugs, health insurance, mileage • Property taxes: real estate and personal property • State and local taxes: > of income or sales taxes • Mortgage interest: on two homes; < $1 million • Also points if buying home • Home equity loans: interest on loans up to $100,000 • Use this instead of car loans; credit card interest, etc. • Gambling losses to extent of gambling income

  11. Topic 34: Income Tax Calculation • Itemized deductions • Investment interest: to extent of investment interest income • If included in investment income; can’t use capital gains tax rates. Generally better to not include long-term capital gains and dividends • Contributions • Public charity • Cash: 50% of AGI • Capital gains property: 30% of AGI • Deduct FMV, not cost • Five year carryover for gifts over AGI limit • Receipts for gifts over $250

  12. Topic 34: Income Tax Calculation • Itemized deductions • Casualty losses: • Loss - $100 - 10% of AGI • Miscellaneous • > 2% of AGI • Unreimbursed employee business expenses • Tax prep fees: • Phase Out • For MFJ > $305,050 • Itemized deductions reduced by three percent of (AGI - $305,050) • Maximum reduction is 80% of itemized deductions

  13. Topic 34: Income Tax Calculation • Personal exemptions: $3,950 • Dependent: • Child < 19 or < 24 and full time student • Relatives/household members earning < $3,950 • Provide most support • Divorced parents • Generally custodial parent

  14. Topic 34: Income Tax Calculation • Personal exemptions: $3,950 in 2013 • Phase Out: MFJ AGI > $305,050 • Lose two percent of $3,900 for each $2,500 AGI > $305,050 • Couple MFJ with kids and AGI of $500,003

  15. Topic 34: Income Tax Calculation • Calculating income tax • Rate schedules • Capital gains tax rates • 15%; • 0% for those with <15% ordinary tax rate • 20%; for those with income MFJ > $450,000 AGI • 3.8% Medicare tax on unearned income > $250,000 AGI • Kiddie tax: child under 19; student under 24 (increased in 2007) • Unearned income • First $1,000 no tax; next $1,000 10% tax • Above that, taxed at parent’s rates

  16. Topic 34: Income Tax Calculation • Self-employment tax • Social security: 12.4% of $117,000 s-e income • Technically, 92.35% of s-e income • Medicare: 2.9% of all s-e income • Medicare tax of 3.8% on unearned income above $250,000 MFJ • Medicare tax of 3.8% on wages above $250,000 MFJ • Self-employment income • Business (Schedule C) • Farming (Schedule F) • Partnership (Schedule E): guaranteed payments; doesn’t matter if distributed • Not self-employment income • S corporation earnings (Schedule E) • Dividends and interest (Schedule B) • Rental income (Schedule E)

  17. Topic 34: Income Tax Calculation • Tax credits • Education • See Education Planning Topic • Child Tax • $1,000 for dependent child under 17 • Reduced by $50 for each $1,000 AGI exceeds $110,000

  18. Topic 34: Income Tax Calculation • Tax credits • Dependent Care • Under age 13 • $3,000 one child; $6,000 more than one • Each spouse must earn more than babysitter • Credit is 20% of expenses for AGI > $43,000 • Adoption • Up to $13,190 in 2014 per child • Excludes child of spouse • Non-refundable • Must have expenses of this amount unless special needs child

  19. Topic 34: Income Tax Calculation • Tax credits • Retirement Savings tax credit • Credit for employee contributions to: • 401(k) or other qualified plan • IRAs (including Roth) • MFJ AGI up to $36,000 in 2014 • Get credit for 50% of contributions up to $2,000 for maximum of $1,000 credit • MFJ AGI $36,000 - $60,000 in 2014 • Get credit for 10% of contributions up to $2,000 for maximum of $200 credit • Can’t be a full-time student for five calendar months • Foreign tax credit • Withholding on dividends • Credit is limited to amount of U.S. tax would have paid on dividend • Can carry back excess two years and then forward five years

  20. Topic 34: Income Tax Calculation • Payment of tax • Estimated payments • Four payments each year = • 90% of current year tax • 100% of prior year tax • AGI > $150,000: pay 110% of prior year

  21. Topic 34: Tax Accounting • Accounting periods • Calendar year generally • Accounting methods • Cash • Individuals • Constructive receipt • Accrual • Retailers unless sales < $1 million • FIFO vs LIFO

  22. Topic 34: Tax Accounting • Net Operating Losses • Back 2 years; forward 20 years • Installment sale • Recapture all in year of sale • Capital gain • Return of basis • Interest

  23. Topic 35: Business Entities • Sole Proprietorship: Schedule C • Taxed once; unlimited liability • Book: transfer personal expenses to Sched C??? • General Partnership: Schedule E • Taxed once; unlimited liability • Distribute partnership assets: carryover basis • Limited Partnership: Schedule E • Taxed once; unlimited liability for general partners • Limited partners have limited liability but no say • Requires filing with state • LLP: Schedule E • Taxed once; no liability for other partners torts • LLC • Taxed once; limited liability

  24. Topic 35: Business Entities • Personal holding companies • >60% income from royalties, rents, dividends • Majority owned by five or fewer owners • Pays 15% penalty tax on undistributed earnings • C Corporation • Ability to raise capital; limited liability • Double taxation of dividends • C corp best if plan to retain earnings to grow business • Liquidating dividends treated as sale of stock • Redemption: own < 80% of stock owned previously • Capital gains taxed at ordinary rates

  25. Topic 35: Business Entities • S Corporation • Taxed once; limited liability • <100 shareholders; one class of stock • Basis for shareholder loans • Appropriate if: • income from business will be distributed • Otherwise, pay tax on earnings but no cash to pay it • Earnings of S corp not subject to S-E tax but salaries paid to owners subject to social security taxes • Or if anticipate losses initially • Can’t deduct C corporation losses on stockholder’s 1040

  26. Topic 36: Income Taxation Trusts/Estates • Rates • Generally higher than individual tax rates • Grantor: retains rights making him owner • All income taxed to grantor • Simple: must distribute all income (generally not capital gains) • Income taxed to beneficiaries • Exemption amount: $300

  27. Topic 36: Income Taxation Trusts/Estates • Complex: can accumulate income • Income distributed to beneficiaries taxed to them • DNI: limit on amount of income taxable to beneficiary • Generally does not include capital gains • Estate Income Tax • Income earned during estate administration • Same rules as complex trust • Administration expenses • Can deduct either on estate or income tax return

  28. Topic 37: Basis • Basis: initially cost of asset • Reduced by depreciation (whether taken or not) • Increased by improvements • New roof versus painting building • Gift • Generally carryover basis if asset increased in value • Double basis if asset decreased in value • Inherited • FMV at date of death • Exception if gifted property to decedent within year of death • Separate property versus community property

  29. Topic 37: Depreciation • MACRS: Cost of asset x percent • Tables provided • Useful life: • 7 year: equipment • 27 ½: residential real estate • 39: nonresidential real estate • Listed property • Autos: limits on annual depreciation • Section 179: expense up to $500,000 in 2013; $25,000 in 2014 • Assets used in business • Limited to amount of business income • SUV limited to $25,000 • Not available for real estate • Bonus depreciation: 50% in 2013 for new property; $0 in 2014

  30. Topic 37: Depreciation • Amortization: intangible assets • Can amortize $5,000 of business start-up expenses • Depletion: natural resources • Oil, gravel

  31. Topic 38: Like Kind (1031) Exchanges • Qualifying transactions • Like kind property • Real estate: broad definition • Property used in business or for investment • Personal property must be like kind • Excludes securities and inventory • If no cash received/liabilities assumed • Carryover basis • Cash received/liabilities assumed • Gain recognized equals lesser of: • Cash received/liabilities assumed • Mortgage relieved like receiving cash • Gain realized • Basis = Carryover – Cash Received + Gain Recognized

  32. Topic 38: Like Kind (1031) Exchanges • Related parties: must hold properties two years • Deferred exchange • Identify replacement in 45 days; close in 180 days

  33. Topic 38: Disposition of Property • Capital assets: held more than one year for capital gains tax rates • Collectibles: 28% • Real estate (to extent of depreciation): 25% • Muni bonds capital gains are taxed • Netting gains • Net short and long gains/losses • Then net short against long if one gain/one loss • Can use capital losses up to $3,000 to offset other income • Excess carries over

  34. Topic 38: Disposition of Property • Sale of principal residence • Live in home 2 of last 5 years • Can exclude up to $500,000 gain MFJ • Depreciation recapture • Gain attributable to depreciation deduction is ordinary income • 1231 gain: long-term capital gain to extent not from depreciation • If no 1231 loss in last five years • 1231 loss: ordinary loss • Section 1244 stock • Can deduct up to $100,000 MFJ (versus $3,000)

  35. Topic 38: Disposition of Property • Installment sale • Include portion of payment representing profit in income each year • Depreciation recapture (section 1245) reported all in year of sale • Involuntary conversions • Postpone recognizing gain from insurance if replace within two years

  36. Topic 38: Disposition of Property • Capital gains tax rates • Long-term: 15% • If in 10/15% ordinary rate, 0% • Home office expenses • Can’t create a loss on Schedule C • Interest/property taxes vs. insurance • Depreciation will be recaptured on sale of home • Related parties • Gain recognized on sale • Loss not recognized until sold to non-related party • Wash sales • Buy “substantially identical” securities within prohibited period • 30 days prior/after loss sale • Not identical securities • Disallowed loss added to basis

  37. Topic 39: AMT • Designed to ensure taxpayers with substantial amounts of income pay income tax • If alternative minimum tax exceeds regular tax liability, then pay AMT • Essentially a second income tax system • Even “not so rich” taxpayers are increasingly paying AMT

  38. Topic 39: AMT • AMT Taxable Income (AMTI) • Starts with regular taxable income • Plus/minus adjustments • Plus tax preferences • Minus AMTI exemption • Equals AMTI

  39. Topic 39: AMT • Adjustments • Depreciation • Separate calculation of AMT depreciation • In general, less depreciation in initial years

  40. Topic 39: AMT • Preferences • No standard deduction or personal exemptions allowed • These amounts have increased in recent years

  41. Topic 39: AMT • Preferences • Itemized deductions for AMTI • Medical expenses allowed only to the extent they exceed 10%, not 7.5% • State income taxes aren’t deductible • Real estate and other property taxes aren’t deductible • No reduction of itemized deductions by 3% when AGI exceeds allowable amount

  42. Topic 39: AMT • Preferences • Incentive stock options (ISOs) • Income tax implications ( regular, AMT, basis) • Upon grant • Option price must be equal to stock price (110% of stock price for > 10% owner) • FMV stock thru option exercise must be < $100,000 per year • Expiration: 10 years from date of grant • Typically a portion vests each year (maybe 20% each year) • Can only be transferred on death of employee

  43. Topic 39: AMT • Preferences • Incentive stock options (ISOs) • Upon exercise • Basis is equal to option price • Difference between option price and the value of stock on date of exercise is an AMT preference item • Exercising option before stock price increases reduces preference item but does subject employee to risk associated with ownership of the stock • AMT basis is equal to stock price on date of exercise; not option price • Higher basis for AMT if price has increased

  44. Topic 54: AMT • Preferences • Incentive stock options (ISOs) • Upon sale • If stock has increased in price between date option was vested and date option was exercised, AMT basis will exceed tax basis. Consequently, on sale of stock AMT gain will be smaller than capital gain

  45. Topic 39: AMT • AMTI Exemption • MFJ • $82,100 • less 25% of AMTI over $150,000 • AMT Tax Rate: All other than MFS • 26% of first $175,000 • 28% of all amounts over $175,000 • Minimum Tax Credit: Available if AMT due to timing differences

  46. Topic 39: AMT • Corporations and trusts are subject to AMT • Corporate owned life insurance increases AMTI

  47. Topic 40: Tax Reduction Techniques • Education credits • Only available for amounts paid “out of pocket” • High income clients • Have children pay education expense due to phaseouts for exemptions/education credits

  48. Topic 40: Tax Reduction Techniques • Intrafamily transfers • Not as effective due to extension of kiddie tax to older children • Accelerate deductions • State income taxes • Charitable contributions • Section 179 • Farm/business expenses year-end • Defer income • Contribute to retirement plans • Remember your banker!!! • Future tax rates???

  49. Topic 41: Hobby Losses • Substantial outside income • Engaged in for profit • Had profit three of last five years • Fun?

  50. Topic 41: Passive Activity and At-Risk • At-Risk • Generally deductible losses are limited to amount invested in business, i.e., basis • Calculating basis= • Amount invested • Recourse and nonrecourse loans • Nonrecourse: not personally liable • + Income from business • - Losses from business • - Distributions from business

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