Presentation on theme: "Chapters 7-13. Bad Debts Review Concept Summary 7-2, Page 7-7 Accounting for Bad Debts For most taxpayers, use the specific charge off method Non business."— Presentation transcript:
Bad Debts Review Concept Summary 7-2, Page 7-7 Accounting for Bad Debts For most taxpayers, use the specific charge off method Non business bad debts A debt unrelated to the taxpayer’s trade or business either when it was created or when it became worthless; treated as a STCL Business bad debts Provides an ordinary loss deduction Deduction is available for partial worthlessness.
§ 1244 (Small Business) Stock Ordinary loss deduction arising from the sale of the stock or its becoming worthless Only individuals who acquired the stock from the corporation are eligible Limited to $ 50,000 ($ 100,000 MFJ), any remainder is capital. $ 1 million limit to contribution to capital. Test is applied at the time the corporation is organized. § 1244 applies to losses, gains are capital.
Casualty and Theft Losses Casualty Definition—”an identifiable event that is sudden, unexpected and unusual.” Theft Definition—”larceny, embezzlement and robbery.”
Deductible Amount of Loss When losses are deductible Normally in the year when the casualty occurred. However, the loss may be deductible in a subsequent year if: It is a theft loss. Must deduct loss in the year the theft is discovered. Reimbursements are reasonably expected in a subsequent year. It is a disaster area loss. Taxpayer can elect the year the loss occurred or the previous year. Business and rental property net casualty losses are 100% deductible for AGI.
Deductible Amount of the Loss Measuring the amount of the loss FMV before and after the casualty For partial destruction rule is < FMV or adjusted basis of the property For total destruction of business or investment property use adjusted basis For total destruction of personal use property use the < of FMV or adjusted basis.
Deductible Amount of the Loss Measuring the Amount of the Loss Generally FMV determined by appraisal If appraisal is difficult or impossible to obtain use the cost of repairs. Limitations on Personal-Use Property Two limitations: Each separate casualty reduced by $ 100 Total amount of all personal-use casualties reduced by 10% of AGI Review Concept Summary 7-3 on Page 7-15,
Deductible Amount of Loss Netting Casualty Gains and Losses on Personal-Use Property Net personal use casualty gains and losses for the year are netted. Losses should be reduced by insurance reimbursements and $ 100 floor. If gains exceed losses result is a capital gain. If losses exceed gains, net loss is reduced by 10% of AGI. The loss is reported on Form 4684 and then on Schedule A.
Research & Experimental Expenditures § 274 “Costs incident to the development of an experimental or pilot model, a plant, process, a product, a formula, an invention or similar property, and the improvement of existing property of the type mentioned.” Three Approaches Expense in Year Incurred. Election in first year R & E expenses occur; must continue to expense in future years. Deferral—Amortize over 60 months. Must elected in the year the first benefit occurs. Capitalization—Deduction not available until project is abandoned or deemed worthless 20% Credit also available see Ch 13
Net Operating Losses General Rule is carry-back two years and carry-forward twenty years. Tax payer may elect to carry forward twenty years Rules for individuals, trusts and estates are much more complex than for C corporations. For corporations: NOL is generally the excess of deductions (including the dividends received deduction) for the year over revenues.
Net Operating Losses Measuring the NOL for Individuals—A Conceptual Approach. Step 1 Accumulate all operating loss amounts: Net proprietorship losses Net ordinary losses from partnerships and S corporations. § 1244 stock ordinary loss deduction § 1231 losses Ordinary bad debt losses Business casualties and personal casualty losses (net of $ 100 floor) taken as an itemized deduction Step 2 Offset total loss from step 1 by income items from business sources—salaries and wages, § 1245 gains, § 1231 gains
Net Operating Losses--Continued Step 3 Offset total non-business income (interest, dividends, and capital gains) against itemized deductions (excluding personal casualties) or the standard deduction, if result is positive, reduce the amount computed in step 2. This approach ignores (correctly) personal and dependency exemptions, the standard deduction or the $ 3,000 capital loss offset against ordinary income.
Computation of Tax Liability for year to which NOL is carried Taxable income and income tax for the carry-back year must be recomputed by including the NOL as a deduction for AGI All deductions except charitable contributions are taken from new AGI after the NOL has been applied
Calculation of the remaining NOL Amount of the carryover loss is the excess of the NOL over the taxable income of the year to which the loss is being applied Taxable income must be determined with the following modifications: No deduction for excess capital losses over capital gains No deduction for NOL that is being carried back Any deductions based on or limited by AGI must be determined after making preceding adjustments No deduction is allowed for personal and dependency exemptions
Depreciation and Cost Recovery Types of Property Tangible property—property that has physical substance (land, buildings, improvements) Real property—land and structures attached to the land. Personal Personal property [personalty]—tangible property that is not real. (equipment, vehicles, furniture) Intangible property—property that does not have physical substance (goodwill, patents, stocks and bonds) Personal use Personal use property—generally capital assets; may be real or personal, or an intangible. These assets are not depreciable or amortizable.
Depreciation and Cost Recovery General Considerations : Methods used depend on when the property was placed in service. Prior to 1981 § 167 (financial accounting) 1981 – 1986 § 168 (ACRS) After 12/31/86 § 168 (MACRS) Common Rules Depreciation must be claimed on property used in a trade or business or for the production of income. No depreciation for land or other assets with an indefinite life. Depreciation for the first year the asset is placed in service Method must be consistent Basis of property reduced by allowable depreciation.
Depreciation Methods MACRS Cost Recovery System: Ignore salvage value Specific asset classes based on life of asset For personalty use either SL or DDB SL; real property—SL For tangible personal property generally use the half year convention for acquisitions and disposals. For depreciable real property; use the mid month convention. Depreciation tables are based on cost.
Calculation of Depreciation Tangible personal property Classifications: 3 yr. Tractor units and special tools 5 yr. Automobiles, trucks, computers, research and experimental equipment equipment. 7 yr. Office furniture and equipment, machinery, property with no class life. 10 yr. Barges, vessels, petroleum and food processing equipment 15 yr. Billboards, service station buildings, land improvements 20 yr. Utilities and sewers
Calculation of Depreciation Bonus Depreciation Qualified property acquired after 9/11/01 and before 9/11/04 and placed in service before 1/01/05. Qualified Property includes MACRS property with a recovery period of 20 years or less,”canned” computer software, qualified leasehold improvement property Bonus depreciation is 50% of adjusted basis for both regular and AMT purposes. Order for deduction is § 179 depreciation, bonus depreciation, MACRS Taxpayer must elect out of bonus depreciation.
Calculation of Depreciation Real Property Classification and Recovery Rates Residential rental property (dwelling units, houses, apartments and manufactured homes)—27.5 years Non-residential rental property—39 years Straight line election under MACRS Alternative Depreciations System (ADS) Used for E & P and AMT purposes Required for tangible personal property used outside the U.S. Use SL method with mid year, quarter, month conventions Elective on a year by year basis, but permanent for the specific property
Calculation of Depreciation Tangible Personal Property § 179 Election For 2004 taxpayers can elect to expense up to $102,000 of the acquisition cost as an ordinary deduction in the year of acquisition. MACRS rules apply to the residual cost. Must be purchased for use in an active trade or business. If the total cost of assets placed in service is more than $ 410,000 the ceiling is reduced on the excess amount. The § 179 deduction cannot exceed the taxpayer’s taxable income (before deducting the § 179 expense) from the trade or business.
Calculation of Depreciation MACRS Restrictions Personal Use Assets—no depreciation deduction Listed Property Rules > 50% use MACRS take bonus depreciation; otherwise use ADS, no bonus depreciation. Must be able to document usage. Recapture of excess depreciation for MACRS property if use decreases to 50% or less. Limits luxury automobiles: Consider first § 179 and bonus depreciation Limit is $ 7,650 for year 1, $ 4,900 year 2, reduced for % of business use. ($ 14,800 is total cost of auto) Special rules for leased automobiles.
Amortization All intangibles are amortized on the straight line basis. Convention is to take a full month’s amortization in the month the intangible is acquired. Major intangible assets § 197 Assets Research and Experimental § 174 Computer Software § 167 (f)(1) Start-Up Expenses § 195 Organization Costs § 248 Pollution Control Facilities § 169
§ 197 Intangibles Amortization deducted ratably over a 15 year period. § 197 applies only to intangible assets that are acquired in connection with the conduct of a trade or business or the production of income. § 197 does not apply to internally created intangibles. §1231 treatment for assets held more than one year. Recapture of gain under § 1245 and postponement of losses on partial disposals.
§ 197 Assets--Continued Definition of a § 197 Asset Goodwill and going concern value Intangible assets related to the workforce, information base, patents, copyrights, formulas, processes, customers and suppliers. Licenses, permits and other rights granted by a governmental unit or agency. Covenants not to compete Franchises, trademarks and trade names
Research and Experimental Expenditures § 174 Include experimental and laboratory costs incidental to the development of a product. 20% credit available for certain R & E expenses Items that qualify: Costs incidental to the development of an experimental or pilot model, a plant process, a product, a formula, an invention Costs associated with product improvements Costs of obtaining a patent, such as attorney fees Research contracted to others Depreciable or cost recovery amounts attributable to capitalized R & E items
Research and Experimental Expenditures--Continued Items that do not qualify. Expenditures for ordinary testing or inspection of materials or products for quality control purposes Efficiency surveys and management studies Marketing research Costs of acquiring another person’s patent, model, production or process. Research incurred in connection with literary and historical projects. Three alternatives for the treatment of R & E Expenditures Expense in the year paid or incurred Defer and amortize or a period of at least 60 months Capitalize and write-off only when the project is abandoned or worthless
Computer Software Developed computer software Can be considered R & D costs under § 174 If it does not qualify under § 174 amortize over 36 months beginning with the month the software is placed in service § 167 (f)(1) Acquired Computer Software Depreciated in one of two ways: Included in the cost of the hardware use MACRS 5 yr. Purchased separately, use SL over 36 months. Leased or Licensed Computer Software Deductible in full in the year paid.
Depletion—The Two Methods Cost Depletion § 611 (a) Can be used on any wasting asset Calculate depletion under both the cost and % approach (if available) and select the larger deduction. [an annual election] Determined using the following formulae: Adjusted Basis of Asset = Depletion per Estimated Recoverable Units Unit Depletion per Unit x Units Sold = Cost Depletion Allowed If estimates are inaccurate revise future calculations
Percentage Depletion § 613(a) Based for a mineral on a specific percentage provided in the IRC Rate is applied to the gross income from the property but cannot exceed 50% of the taxable income from the property before the allowance for depletion. Depletion may produce negative basis, AMT preference
Intangible Drilling and Development Costs (IDC) Two options Available to the Taxpayer Charged off as an expense in the year incurred Capitalized and written off through depletion Cost depletion may limit the usefulness of using percentage depletion approach. Excess intangible drilling costs are a preference for AMT purposes.
Employee Expenses Importance of Proper Classification Self-employed Individuals (Independent Contractors) pay both shares of the Social Security tax on Schedule SE. ½ of the SE taxes paid are deductible for AGI. Employers pay their share of their share of Social Security tax and in addition deposit the share withheld from the employee. Employers also pay unemployment tax.
Travel Expenses Definitions: Travel “includes transportation, meals, lodging, and other reasonable and necessary expenses while “away from home” in the pursuit of a trade or business or an employment related activity.” A deduction for travel expenses is available only if the taxpayer is away from his or her tax home. Transportation include only the cost of transporting the employee from one place to another in the course of employment when the employee is not away from the home on travel status. Such costs include taxi fares, automobile expenses, tolls, and parking. Commuting expenses are non- deductible, but travel between work stations is deductible.
Travel Expense--Continued Transportation Expenses—Automobiles Two methods to deduct allowable expenses: Actual expenses: gas, oil, repairs, depreciation, interest, property taxes, license fees and insurance. Deduction is Total expenses x Business miles Total Miles Standard mileage rate 37.5¢ per mile for 2004 Additional deduction for parking and tolls, auto interest and personal property taxes. Cannot be use if two or more autos are used simultaneously for business purposes.
Moving Expenses § 217 Limited deduction available to employer and employees. Two Conditions: New job location must be at least 50 miles farther from taxpayer’s old residence than old residence was from former place of employment. Time requirement: employed full time at new location for at least 39 weeks in a twelve month period. Deduction for AGI for un-reimbursed amount. Deductible expenses : Cost of moving household goods and personal effects. Cost of traveling (including lodging but excluding meals) from former residence to new residence Mileage rate is 14¢ per mile.
Education Expenses For AGI for trade or business (self-employed) From AGI for un-reimbursed employee expenses (2% miscellaneous) General Requirements: Incurred to maintain or improve skills required for employment or Meet requirements imposed by law or by the employer for retention of employment, rank, or compensation rank. Not deductible if required to meet minimum educational requirements or qualifies for a new trade or business.
Meals and Entertainment Expenses The cutback adjustment—50% of meals and entertainment expenses allowed as a deduction. Includes M & E, taxes, tips, cover charges, M & E room rental fees, parking fees at the location. Also includes face value of tickets and non-luxury box seats. Business meals are deductible only: If they are directly related to or associated with the active conduct of a trade or business The expense is not lavish or extravagant. The taxpayer (or an employee) is present at the meal No deduction for entertainment facilities, club dues
Expenses of Office in the Home Deductibility Based on the Following Criteria: Principal place of business for any trade or business of the taxpayer: The office is used by the taxpayer to conduct administrative or management activities of a trade or business. There must be no other fixed location of the trade or business where the taxpayer conducts these activities. Allowable home office expenses cannot exceed the gross income from the business less all other business expenses attributable to that activity. Deduction for AGI for self employed individuals, Schedule A, Miscellaneous Itemized Deductions for employees. Deductible amount computed on Form 8829
Expenses of Office in the Home-- Continued Ordering rules for deducting the expenses: 1. Mortgage interest and real estate taxes 2. Operating expenses of the residence 3. Depreciation Expenses cannot generate a loss
Employee Expenses Two classifications Reimbursed--§ 62(a)(2) are a deduction for AGI Un-reimbursed are a 2% miscellaneous itemized deduction § 67 Nature of employment relationship Self-employed individuals—§162 all expenses related to the proprietorship are deductible for AGI on schedule C. For employees the tax treatment depends on whether the expenses are reimbursed or un- reimbursed.
Reimbursed Employee Business Expenses Accountable Plans Return any excess reimbursement or allowance. An “excess reimbursement or allowance” is any amount that the employee does not adequately account for as an ordinary and necessary business expense.” Deemed Substantiation Employees reimbursed a per diem allowance. Deemed substantiated if the amount is Federal rate Non Accountable Plans All reimbursements reported on Form W-2 and reported as income, also 2% Misc. Itemized Deductions on Schedule A.
Reimbursed Employee Business Expenses—Continued Reporting Requirements Not reported by employee (accountable plans meeting all requirements) Form 2106 Reimbursed employee expenses under an accountable plan are deductible for AGI. Reimbursement is apportioned between Meals and Entertainment and Other Expenses based on the relation of each to total expenses. Un-reimbursed expenses are deductible from AGI. Total from Form 2106 Schedule A, 2% Misc.
2% Miscellaneous Itemized Deductions An accumulation of various personal expenditures. Un-reimbursed employee business expenses Travel, entertainment, business gifts ($ 25 per gift +wrapping) Investment expenses § 212 Investment advice, custodial fees, safe deposit box rental, publications Other expenses Tax return preparation expenses Special clothing Job-hunting expenses Professional journals, professional dues, union dues, small tools and supplies. Office in the home
2% Miscellaneous Itemized Deductions--Continued The tax benefit of these deduction is limited in several ways: The total expense is reduced by the 2% floor 3% scale down (§ 68) for high income individuals applies 2% miscellaneous items are a positive adjustment for AMT purposes.
Itemized Deductions—Medical Expenses Qualified Individuals Taxpayer and spouse Taxpayer’s dependent (includes those who could be dependents except for the gross income or joint return tests Child of divorced taxpayer (as a dependent)
Itemized Deductions—Medical Expenses Qualified Medical Expenses Diagnosis, cure, mitigation, treatment or prevention of disease The purpose of affecting any structure of function of the body Transportation primarily for and essential to medical care. Qualified long-term care services Health Insurance Limitation on the Amount Deductible—7½% of AGI Medical Insurance Reimbursements Reimbursements in & for the current year offset the deduction. Reimbursement in a subsequent year for the current year may result in gross income in the year received under the tax benefit rule § 111
Itemized Deductions—Taxes § 164 Definition of a tax—a mandatory assessment under the authority of a political entity for the purpose of raising revenue to be used for public or governmental purposes. These do not include: Vehicle registration and inspection fees Registration tags for pets Toll charges Parking meter charges Charges for water, sewer and other services Special assessments against real estate
Itemized Deductions—Taxes Deductible taxes: State, local and foreign real property taxes State and local personal property taxes if based on value State, local and foreign income taxes
Itemized Deductions--Taxes Non-Deductible Taxes Federal income Taxes Federal estate and gift taxes Federal import and tariff duties Employee’s portion of Social Security and other payroll taxes State and local sales taxes, estate, inheritance and gift taxes. Foreign income taxes, if taxpayer elects to take the credit Property taxes on real estate to the extent the taxes are treated as imposed on another taxpayer.
Itemized Deductions--Interest Supreme court defines interest as “compensation for the use or forbearance of money” Old Colony Railroad 52 S. Ct. 211 (USSC, 1932) Allowed and Disallowed Items Interest on qualified education loans. A deduction for AGI. Maximum deduction is $ 2,500, phase-out rules apply Investment interest—an itemized deduction, limited to net investment income (interest, dividends, annuities, royalties, and if elected, capital gains). Investment expenses are those deductible expenses related to investment income. Note that some of these expenses may be eliminated by the 2% miscellaneous itemized deduction floor.
Itemized Deductions—Interest Allowed and Disallowed Items—Continued Qualified Residence Interest Qualified residence interest is interest paid or accrued during the taxable year on indebtedness (subject to limitations) secured by any property that is a qualified residence of the taxpayer Qualified Residence Interest—Acquisition Indebtedness Qualified residence includes the taxpayer’s residence and one other residence of the taxpayer or spouse. Interest paid or accrued during the tax year limited to acquisition indebtedness of $ 1 million or less. Acquisition indebtedness refers to amounts incurred in acquiring, constructing, or substantially improving a qualified residence of the taxpayer.
Itemized Deductions--Interest Qualified Residence Interest—Home Equity Loans Funds from loan can be used for personal purposes Interest is deductible only on the portion of a home equity that does not exceed the lesser of: The fair market value of the residence, reduced by the acquisition indebtedness or $ 100,000 Prepayment Penalty Occurs when the loan is paid off early. Considered interest in the year paid. Subject to the general rules related to deductibility
Itemized Deductions--Interest Related Parties If the debtor uses the accrual basis and the creditor uses the cash basis, accrued but unpaid interest is not deductible until the payment is made. Personal (Consumer) Interest Non-deductible Examples are credit card loans, auto loans
Itemized Deductions--Interest Restrictions on Deductibility and Timing Considerations Taxpayer’s Obligation Debt must represent a bona fide obligation of the taxpayer Taxpayer may not deduct interest paid on behalf of another individual Time of Deduction Cash basis—deductible when paid Accrual basis—over the life of the loan Prepaid Interest Accrual method reporting is imposed on cash basis taxpayers for interest prepayments that extent beyond the end of the taxable year.
Classification of Interest Expense General Rule: Whether interest is deductible for AGI or as an itemized deduction (from) depends on whether the indebtedness has a business investment or personal purpose. Business purpose or for the production of rent or royalty income: Deduction for AGI. Investment purpose not related to rents or royalties: Deduction from AGI Personal purpose (qualified residence interest): Deduction from AGI Exceptions: Early withdrawal penalty/qualified student loan interest are deductions for AGI
Itemized Deductions—Charitable Contributions § 170 (c) Charitable Contribution is a gift made to a qualified organization. The taxpayer has the burden of establishing that the transfer was made from motives of disinterested generosity. Benefit Received Rule—When a donor derives a tangible benefit from the contribution, he or she cannot deduct the value of the benefit. Contribution of services—No deduction is allowed for a contribution of one’s services to a qualified charitable organization.
Itemized Deductions—Charitable Contributions Examples of non-deductible items Rental value of property used by a qualified charity Gifts to individuals Dues paid to fraternal organizations Cost of tuition
Itemized Deductions—Charitable Contributions Qualified Organizations §§ 170(c), 501 A state or possession of the United States or any subdivisions thereof § 501 (a) A corporation, trust, or community chest, fund or foundation that is situated in the United States and is organized exclusively for religious, charitable, scientific, literary or educational purposes or for the prevention of cruelty to children or animals § 501 (c)(3) Veterans’ and fraternal (lodge) organizations, cemetery companies § 501
Itemized Deductions—Charitable Contributions Timing of Deduction For both cash and accrual taxpayers generally in the year payment is made. For property, the date of delivery For credit cards, the date of the charge Record-keeping Requirements No deduction for contributions of $ 250 or more without written substantiation. Additional information required if the value of the donated property is > $500 but < $5,000. Appraisal required for non-cash contributions over $ 5,000
Itemized Deductions—Charitable Contributions Valuation Requirements Property donated to a charity is valued at the FMV at the date of the gift. Taxpayer must maintain reliable written evidence about: FMV and how it was determined. Reduction in value for certain appreciate property Terms of any agreement with the charitable organization dealing with use and potential sale. Signed copy of appraisal
Itemized Deductions—Charitable Contributions Ordinary Income Property Includes any property that if sold will result in the recognition of ordinary income. Examples are ordinary assets such as (1) inventory & (2) depreciable property used in a trade or business for 1 year or less and also capital assets held for 1 year or less. Deduction is usually limited to the adjusted basis.
Itemized Deductions—Charitable Contributions Capital Gain Property Any property that would have resulted in the recognition of long-term capital gain or § 1231 gain if the property had been sold by the donor. Deduction is equal to the fair market value of the property. Exceptions on the deductibility of the appreciation: Donations to certain private non-operating foundations. For tangible personal property, no deduction for the appreciation if the property is put to an unrelated use.
Itemized Deductions—Charitable Contributions General Rule: Overall limit for individuals is 50% of AGI Applies to public charities Applies to private operating foundations Applies to certain private non-operating foundations
Itemized Deductions—Charitable Contributions Special Rules Thirty percent ceiling Applies to cash and ordinary income contributions to certain private non-operating foundations Applies to contributions of appreciated capital gain property by 50% organizations. In the event that contributions for any one tax year include both 50% and 30% property, the allowable deduction comes first from the 50% property Special election permits the taxpayer to take a 50% deduction for capital gain property if he/she forgoes the appreciation. Twenty percent ceiling Applies to contributions of appreciated long term capital gain property to certain private non-operating foundations.
Itemized Deductions—Charitable Contributions Contributions Carryovers Can be carried forward for 5 years. Contributions retain their character (30%, 50%) Consider current year contributions first before applying carryover provisions.
Overall Limitation on Certain Itemized Deductions The cutback adjustment § 68 Applies to taxpayers whose AGI exceeds $ 142,700 for 2004. Relates to the following itemized deductions: Taxes Home mortgage interest Charitable contributions Un-reimbursed employee expenses subject to 2% of AGI floor All other 2% miscellaneous itemized deductions. Not Subject to the cutback adjustment Medical and dental expenses Investment interest expenses Non business casualty thefts and losses Gambling losses
Overall Limitation on Certain Itemized Deductions The cutback adjustment—continued Taxpayers subject to the limitation must reduce itemized deductions by the lesser of: 3 % of the amount by which AGI exceeds $142,700 80% of itemized deductions that are affected by the limit. Overall limit is applied after all other limitations
Passive Activities §469 Any trade or business or income- producing activity in which the taxpayer does not materially participate Subject to certain exceptions, all rental activities
Material Participation Must participate on a regular, continuous, and substantial basis to be material Tests: Based on current participation Based on prior participation Based on facts and circumstances
Passive Activity Losses Designed to discourage taxpayer from investing in tax shelters for tax avoidance purposes. Congress have developed two methods to reduce or eliminate loss deductions from business and income-producing activities. The at-risk limitations The passive activity loss rules
Passive Activity Losses The at-risk limits § 465 Apply to individuals and closely-held corporations. Designed to prevent taxpayers from deducting losses in excess of their economic investment in the activity. Deductible amount for the year is limited to the amount the taxpayer has at risk at the end of the taxable year.
Passive Activity Losses At-risk limits, calculation of at-risk amount Increases to a taxpayer’s at-risk amount Cash and the adjusted basis of contributed property Amounts borrowed for use in the activity for which the taxpayer is personally liable or has pledged security. Taxpayer’s share of increases in non-recourse financing Taxpayer’s share of the activity’s income. Decreases to a taxpayer’s at-risk amount: Withdrawals from the activity Taxpayer’s share of the activity’s loss. Taxpayer’s share of reductions in (a) personal recourse debt and (b) qualified non recourse financing.
Passive Activity Losses At-risk limits, an illustration In year 1, Sue invests $ 40,000 in an oil partnership that, by the use of non-recourse loans, spends $ 60,000 on deductible intangible drilling costs applicable to her interest. Assume Sue’s interest is not subject to the passive activity limits. Result is that Sue has a $ 40,000 deductible loss and a $ 20,000 suspended loss under the at-risk rules. If in year 2 Sue has taxable income of $ 15,000 from the oil partnership and invests $ 10,000 during the year, she can offset the $ 15,000 of income and has $ 5,000 at risk.
PAL Limits Three Categories of Income and Losses Active Income Wages, salaries, commissions, bonuses Profit from a trade or business in which the taxpayer is a material participant. Gain on sale or other disposition of assets used in an active trade or business Income from intangible property is the taxpayer’s personal efforts significantly contributed to the creation of the property. Portfolio Income Interest, dividends, royalties Gain or loss on disposition of property that produces portfolio income or was used for investment purposes/
PAL Limits--Continued § 469 Passive (Activity) Income Any trade or business or income-producing activity in which the taxpayer does not materially participate. Any rental activity except for: § 469 (c)(7) losses associated with real estate professionals. $ 25,000 of losses can offset against active income by individuals who actively participate in a real estate activity. (phase-out for AGI > $ 100,000)
PAL Limits--Continued General Impact Losses or expenses generated by passive activities can be deducted only to the extent of income from all of the taxpayer’s passive activities. Suspended losses can be carried forward indefinitely and used to offset passive income. Suspended losses can also be used when the taxpayer disposes of the activity.
PAL Limits--Continued Carryover of Suspended Losses Taxpayers often own more than one passive activity. In that case any suspended losses must be allocated among the activities in which the taxpayer has an interest The allocation: Disallowed PAL X Loss from activity (all activities) losses from all activities having losses
Passive Activity Losses Taxpayers subject to the Passive Loss Rules Personal service corporations (PSC’s) Closely held C corporations Definition—”If at any time during the year > 50% of the value of the outstanding stock is owned (directly or indirectly) by five or fewer individuals. Individuals Estates Trusts Investments in partnerships and S corporations.
Interaction of the At-risk and Passive Activity Limits The determination of whether a loss is suspended under the passive loss rules is made after the application of the at- risk rules. A loss that is not allowed because the taxpayer is not at risk is suspended under the at-risk provisions and not the passive activity provisions.
Interaction of the At-risk and Passive Activity Limits—An Illustration Jack’s adjusted basis in a a passive activity is $ 10,000 at the beginning of 2003. His loss from the activity in 2003 is $ 4000 Jack has an adjusted basis and at risk amount of $ 6,000 in the activity. The suspended passive loss is $ 4,000. Jack has a loss of $ 9,000 for 2004 A $ 3,000 loss is suspended under the at risk rules. $10.000 is suspended under the passive activity rules. An adjusted basis and an at-risk amount in the activity of zero.
Interaction of the At-risk and Passive Activity Limits—An Illustration Jack realizes $ 1,000 of passive income from the activity in 2005. No taxable passive income $ 2,000 of losses suspended under the at- risk rules $ 10,000 remains suspended under the passive activity rules An adjusted basis and an at-risk amount in the activity of zero.
Dispositions of Passive Interests Taxpayer disposes of an entire interest in a passive activity, any suspended losses may be utilized when calculating the final economic gain or loss on the investment Other situations with specific treatment Disposition at death Disposition by gift Installment sale Nontaxable exchange
Individual Alternative Minimum Tax The AMT Formula : Regular Taxable Income +/- Adjustments + Preferences = AMTI - Exemption = Alternative Minimum Tax Base X 26% or 28% rate = Tentative Minimum Tax before FTC - AMT Foreign Tax Credit = Tentative Minimum Tax - Regular Tax Liability (Net of Regular FTC) = AMT (If the amount is positive)
AMT Components--Continued Exemption Amount Initial Exemption Amounts $ 58,000 MFJ $ 40,250 S, HH Phase Out of 25¢ per $ 1 when AMTI exceeds: $ 112,500 S, HH $ 150,000 MFJ AMT Rate Schedule 26% of first $ 175,000 and 28 % on excess
AMT Components Adjustments Two types: Those that result from (1) timing differences (separate regular and AMT treatments that will eventually reverse) and from (2) permanent differences (disallowed itemized deductions) Timing Differences Circulation Expenditures Depreciation of Post-1986 Real Property (applies only to property placed in service between 1/1/87 and 12/31/98) Depreciation on Post-1986 Personal Property (applies only to property placed in service between 1/1/87 and 12/31/98) Pollution Control Facilities Expenditures Requiring 10 year write off for AMT purposes, (1) mining exploration and development costs and (2) research and experimental expenditures.
AMT Components--Continued Adjustments Timing Differences Use of Completed Contract Accounting for Regular Tax Purposes (% Completion for AMT) Incentive Stock Options Adjusted Gain or Loss When a property is sold during the year or a casualty occurs to business or income-producing property, gain or loss reported for regular income tax may be different than gain or loss determined for AMT. This difference occurs because the adjusted basis of the property for AMT purposes must reflect any current and prior AMT adjustments. (e.g. depreciation, research and experimental expenditures.
AMT Components--Continued Adjustments Timing Differences Passive Activity Losses—A separate calculation of PAL for AMT purposes. NOL deductions—A separate calculation of NOL for AMT purposes. Permanent Differences—Positive Adjustments for Certain Itemized Deductions Taxes 2% Miscellaneous Itemized Deductions Disallowed Interest (For AMT only mortgage interest on principal residence + AMT investment interest is allowed Medical Expenses (AMT threshold is 10% not 7 ½%) Personal and Dependency Exemptions Standard Deduction
AMT Components--Continued Adjustments— Negative Permanent Differences The 3% cutback adjustment (§ 68) that applies to regular income tax itemized deductions does not apply in computing AMT. Tax benefit rule for state income tax refund Preferences—All Positive % Depletion in excess of basis Intangible Drilling Costs Private Activity Bond Interest (> 10% of state and municipal bond proceeds used for private business purposes Depreciation for real property and leased personal property placed in service before 1987 50% exclusion for certain small business stock.
AMT Components--Continued AMT Credit Reduces regular tax liability in a subsequent year. May be carried forward indefinitely Applicable only to timing differences. Not available in connection with AMT permanent differences (exclusions). Itemized Deductions Standard Deduction Personal & Dependency Exemptions Excess % Depletion Private Activity Bond Interest
Tax Credits--Priority of Credits Refundable versus Non-refundable credits Refundable credits are paid to the taxpayer even if the amount of the credit (or credits) exceeds the taxpayer’s tax liability. Refundable credits include: Taxes withheld on wages, estimated income tax payments Earned income credit. Non-refundable credits include: Personal credits Miscellaneous credits Business credits
General Business Credit The sum of the following: Rehabilitation Expenses § 47 Business Energy Credits § 48(a)(2) Work Opportunity Credit § 51 Welfare to Work Credit § 51A Research Activities § 41 Low Income Housing § 42 Disabled Access § 44 Small Employer Pension Start Up Costs § 45E Employer Provided Child Care § 45F
General Business Credit--Continued Carried Back 1 year and Carried Forward 20 years, Use FIFO approach Limited to the Taxpayer’s net income tax (Regular + AMT) reduced by > The tentative minimum tax 25 % of the net regular tax liability > $ 25,000
Tax Credit for Rehabilitation Expenditures § 47 When taking the credit the basis of a rehabilitated building must be reduced by the full rehabilitation credit allowed. To qualify the building must be substantially rehabilitated. Qualified rehabilitation expense must exceed > $ 5,000 The adjusted basis of the property before rehabilitation expenses The credit is 10% of rehabilitation expenses for non- residential buildings and residential rental property (other than certified historic structures) placed in service before 1936. Recapture (< 5 years) if disposed of or is not qualifying property
Work Opportunity Credit § 51 Includes the following qualified groups: AFDC Veterans Ex-Felons High-risk youths Vocational Rehabilitation Summer Youth Local Food Stamp Recipient Qualified SSI Schedule to expire (12/31/03)
Work Opportunity Credit--Continued Credit is 40% of the first $ 6,000 of wages. Minimum employment levels apply (180 days, 400 hours of service for full time employees) Credit reduced to 25 % for employees not reaching minimum levels but working at least 120 hours. Employer must obtain certificate for each qualified employee.
Welfare to Work Credit § 51A Credit is 35% of the qualified first-year wages plus 50% of the qualified second year wages for “long term family assistance recipients” up to a maximum of $ 10,000 of wages. Credit expires 12/31/03 Reduce deductible wages by the amount of the credit taken. Employer cannot take both the work opportunity credit and the welfare to work credit.
Credit for Increasing Research Activities § 41 Two types of activities Credit is 20% of the excess of qualified research expenses for the taxable year over a base amount and 20% of basic research payments made to qualified organizations. Research deduction must be reduced by the amount of the research credit taken. Credit expires 6/30/04
Low Income Housing Credit §42 Amount of the Credit based on the qualified basis of the property (# units rented to low-income tenants) Credits are issued based on a nationwide allocation. Credit = qualified basis X applicable % Applicable % is determined by the IRS each month (e.g. 7.95%) Credit is allowed over a 10 year period if conditions are met. Recapture required for termination, early disposal, or inadequate low income units or amounts at risk.
Employer Provided Child Care § 45F The credit is the sum of the following two amounts: 25 % of qualified child care expenses (amounts paid to acquire, construct, rehabilitate, expand and operate a qualified child care facility) 10 % of qualified care resources and referral expenditures. Total credit cannot exceed $ 150,000 Employers must reduce deductible expenses by the amount of the credit taken. If within 10 years the employer cease to operate the facility, all or part of the credit is recaptured.
Refundable Credits Earned Income Credit A Negative Income Tax Determined by multiplying a maximum amount of earned income by the appropriate percentage. If the taxpayer has children the percentage used in the calculation depends on the number of qualifying children. Phase-outs apply--for MFJ with qualifying children begins at $ 15,040 AGI or earned income. Tables are available to simplify the calculation. Eligibility requirements Taxpayers with children or certain workers without children Relationship test—a “child” of the taxpayer Residency test—share same abode, US Age test– 19 to 64, child < 19, 24 (full-time student)
Personal Tax Credits Offset the Income Tax Liability, before the Miscellaneous Credits and the General Credits. These Credits are Non-Refundable Include: § 21 Child and dependent care credit § 22 Credit for elderly and disabled § 23 Adoption credit § 24 Child tax credit § 25 Residential mortgage credit § 25A HOPE scholarship credit (covered in tax project) § 25A Lifetime learning credit (covered in tax project) § 25B Qualified retirement savings contribution credit
The Foreign Tax Credit § 904 Taxpayer may elect to take the credit (more frequent choice) or to take a deduction. Credit is the the lesser of the actual taxes paid or the credit limitation. Foreign tax Foreign source credit = Pre-credit X taxable income limitation U.S. tax Total taxable income Unused FTC: Carry-back and Carry-forward 2 years 5 years
Personal Tax Credits--Continued § 23 Adoption Credit For Qualified Adoption Expenses—adoption fees, court costs, attorney fees, and other expenses directly related to legal adoption. Not eligible until the year the adoption is finalized If adoption expenses are paid during or after the year the adoption is finalized, credit is allowable in the year paid or incurred. Phase-out 2004 AGI--$ 155,860 $ 195,860 Maximum Credit ($ 10,390—maximum for child with special needs)
Personal Tax Credits--Continued Child Tax Credit § 24 Taxpayers are presently allowed a credit of $ 1,000 for each qualifying child under the age of 17. Qualifying child must be a dependent of the taxpayer and a son or daughter (or lineal descendent), step-child, foster child and a US citizen, national or resident). Phase-out for MAGI of $ 110,000 ($75,000 S,HH) Partially refundable
Personal Tax Credits--Continued § 21 Child and Dependent Care Credit Individual must meet two requirements: Eligible child or dependent care expenses must be incurred to enable the taxpayer to be gainfully employed. The taxpayer must maintain a household for a dependent under age 13 or an incapacitated dependent or spouse. Eligible expenses include amounts spent for housekeeping, nursing, cooking, babysitting in the taxpayer’s home; an outside the home at a qualified dependent care facility. Maximum amount that qualifies is $ 3,000 for one qualifying individual and $ 6,000 for two or more Maximum expenses cannot exceed the individuals earned income. Use smaller earned income level for MFJ Credit ranges 20% to 35%
Withholding of Taxes Employer must withhold Federal (State and local) income taxes and FICA taxes from an employee’s wages. Persons responsible for depositing these taxes are personally liable for failure to pay. Salaries, fees, bonuses, dismissal payments, commissions, vacation pay, and taxable fringe benefits are subject to withholding. Exemptions for certain employment activities.
Withholding Allowances and Methods Form W-4 Each employee must file a Form W-4 which lists the employee’s marital status and number of allowances. $ 500 civil penalty for filing false statements. Employee may claim exempt status if he or she has no income tax liability and anticipates none in the current year. An individual may request that additional amounts be withheld. Each withholding allowance reduces the amount withheld. Computation of Federal Income Tax Withheld. Wage Bracket Tables Optional Percentage Method
Estimated Tax Payments Certain types of income frequently are not subject to withholding Investment Income Rents SE Income Capital Gains Taxpayer files quarterly estimated payments on Form 1040 ES. Payments are normally due 4/15, 6/15, 9/15, and 1/15
Estimated Tax Payments To avoid an underpayment penalty the payments must be the lesser of: 90% of the tax liability shown on the return for the current year. 100% of the liability for the prior year if AGI is $ 150,000 or less; 110% for AGI > $150,000 No penalty is imposed if the liability is < $ 500 or the individual had no liability for the prior year. Complete Form 2210 to determine the amount of liability. Interest rate is approximately Federal short term prime rate + 3%.
Self Employment Tax § 6017 Net Earnings from Self-Employment (Schedule C) Gross Income from a trade or business less allowable trade or business deductions Distributive share of any partnership income or loss derived from a trade or business activity Net income from rendering personal services as an independent contractor.
Self-Employment Tax Individuals with net earnings of $ 400 or more from self-employment are subject to SE tax. Calculation of the Tax (Schedule SE) For 2004 15.3% of SE income up to $ 87,900 and 2.9% on income in excess of $ 87, 900 Deduction for AGI for ½ SE tax paid. Net earnings from self-employment are determined by multiplying SE income X.9235 If an individual is an employee and also has income from self-employment, the tax base for computing the self employment tax is reduced by the wages that are subject to FICA tax. All of the self employment earnings are subject to Medicare tax.