personal regulation notes

1 Regulation Notes By Tomato

Chap1: Individual Tax

Types of income

1. Income from services

Including salary, wages, taxable fringe benefit and fees that a taxpayer earns through services in

a nonemployee capacity (for example, consulting work outside of employment). Income from

services is also referred to as earned income because it is generated by the efforts of the

taxpayer). All compensation (such as fringe benefits) should be taxed on FICA.

Taxable fringe benefits include such things as below-market interest rate loans, gym

memberships, season tickets to the local NBA team, an automobile allowance for a personal

automobile, or anything else not specifically excluded by the tax laws.

Taxable fringe benefit: group-term life insurance, employees must recognize a certain amount

of gross income when employers pay life insurance premiums for the employee for policies with

a death benefit in excess of 50,000. Consequently, a portion of the group-term life insurance

benefit is taxable and a portion is nontaxable. The steps to calculate the annual taxable benefit:

(1) Subtract 50,000 from the life insurance policy

(2) Divide the step 1 result by 1,000 (IRS provides a table with cost per 1,000 insurance) (B12-23)

(3) Multiple result from step 2 by the cost per 1,000 insurance for one month based on the age

(4) Multiply the outcome of step 3 by 12.

Note1: the calculation is about the taxable portion of premium paid by the company. However,

the entire amount of insurance proceeds paid by the reason of death will be excluded (that is

classified as life insurance)

Note2: employee death payment paid by the company should be included in gross income.

Note3: Tips. (1) If an individual receives less than 20 tips during one month while working for

one employer, the tips do not have to be reported to the employer and the tips are included in

the gross income when received. (2) If an individual receives more than 20 tips during one

month while working for one employer, the tips have to be reported to the employer by the 10th

day of the next month and the tips are included in the gross income when reported.

2. Income from property

Often referred to as unearned income and includes gain or loss from the sale of property,

dividends, interest, rents, royalties, and annuities.

A. Annuities (same rules apply to pension benefits)

An annuity is an investment that pays a stream of equal payments over time. Individuals

often purchase annuities as a means of generating a set income stream during retirement.

There are two types of annuities: (1) annuities paid over a fixed period and (2) annuities paid

over a person’s life (for as long as the person lives). For both types of annuities, the tax law

deems a portion of each annuity payment as a nontaxable return of capital and the


remainder as gross income. Taxpayers use the annuity exclusion ratio to determine the

portion of each payment that is a nontaxable return of capital.

Annuity exclusion ratio=original investment/number of payments=return of capital

percentage.

The number of payments is uncertain for annuities paid over a person’s life. For these

annuities, taxpayers must use IRS tables to determine the number of payments (it is called

expected return multiple). If the taxpayer dies before receiving the expected number of

payments, the amount of the unrecovered investment (the initial investment less the

amounts received that is treated as a nontaxable return of capital) is deducted on the

taxpayer’s final income tax return.

B. Dividends (R1-22)

Qualified dividends generally are taxed at a 15% preferential rate. Qualified dividends

holding period: The stock must be held for more than 60 days during the 120-day period

beginning 60 days before the ex-dividend dates (ex-dividend date is the date on which a

purchased share no longer is entitled to any recently declared dividends).

C. Interest

Imputed interest: when employees borrow money from an employer at a below-market

interest rate.

Imputed interest= loan * (actual interest rate – an applicable federal interest rate)

The imputed rule does not apply to loans of 10,000 or less.

A taxpayer’s income include interest on state and federal income tax refunds and interest

on federal obligations, but excludes interest on state obligations.

D. Rents

(1) Net rent income (rent revenue –related expenses) is included in gross income.

(2) Advance payments and lease cancellation must be included in gross income when

received, regardless of the period covered or whether the taxpayer uses the cash or

accrual method.

(3) A security deposit is included in income when not returned to tenant.

E. royalties

F. Gain or loss from sale of an asset

Tax basis: the cost or capital investment in the underlying property. Taxpayers are allowed

to recover their investment in property (tax basis) before they realize any gain. A loss is

realized when the proceeds are less than tax basis in the property.

Sales proceeds-selling expenses=amount realized

Amount realized- tax basis in property sold=gain or loss on sale

3. Other sources of gross income

A. Income from flow-through entities

B. Alimony

The tax law defines alimony as (1) a transfer of cash made under a written separation

agreement or divorce decree, (2) the separation or divorce decree does not designate the

payment as something other than alimony, and (3) the payments cannot continue after the

death of the recipient.


(a) If the payment is alimony, then the amount of the payment is included in the gross income

of the person receiving it and is deductible for AGI by the person paying it.

(b) If a transfer of property between spouses does not meet the definition of alimony, the

recipient of the transfer excludes the value of the transfer from income, and the person

transferring the property is not allowed to deduct the value of the property transferred.

(c) If a divorce agreement specifies both alimony and child support, but less is paid than

required, then payments are first allocated to child support, with only the remainder in

excess of required child support to be treated as alimony.

Alimony recapture

It occurs if payments sharply decline in the second and third years:

(1) Recapture for year2 occurs if the alimony paid in year2 exceeds the third-year alimony by

more than 15,000;

Recapture amount = payment in year2 – (payment in year3+15,000)

(2) Recapture for year1 occurs if the alimony in year1 exceeds the average alimony in year2 and

year3 by more than 15,000.

Average alimony in year2&year3= (year2 payment – recapture in year2 + year3 payment)/2

Recapture amount= year1 payment – (average alimony in year2&year3+15,000)

(3) Recapture will not apply to any year in which payments terminate as a result of the death of

either spouse or the remarriage of the payee.

(4) Recapture does not apply to payments that may fluctuate over three years or more and are

not within the control of the payor spouse.

For the recapture amount (payment – 15,000), the payor includes it in his gross income in

the third year and the payee deduct the same amount (付钱的加入收入，收钱的减收入). 先算第２年再算第１年

C. Prizes, awards, and gambling winnings

The fair market value of prizes and awards is taxable income. An exclusion from income for

certain prizes and awards applies where the winner immediately transfer the award to a

governmental unit or charitable organization. Second exception is for employee awards for

length of service or safety achievement, which is limited to $400 of tangible property other

than cash per employee each year.

D. Social security benefits (SSB)

Taxpayers may be required to include up to 85% of the benefits in gross income depending on

the level of modified AGI and the SSB, which is AGI (before including social security benefits)

+tax-exempt interest +50% of SSB

(1) Low Income = No Social Security benefits are taxable (modified AGI below: single

$25,000/MFJ $32,000)

(2) Upper Income = 85% of Social Security benefits are taxable (income over: single

$34,0OO/MFJ $44,000)

(3) Taxpayers not in group (1) and (2) above include a portion of their benefits up to 50% of the

total SSB


Note: social security retirement benefits are fully excluded by low-income taxpayers (provisional

income less than 25,000); 85% of benefits must be included in gross income by high-income

taxpayers (provisional income more than 60,000)

E. Distribution from traditional 401k plan

F. Stock option

1. Incentive stock option

(a) No income is recognized when option is granted or exercised.

(b) Recognize gain when the stock exercised is sold

If employee holds the exercised stock at least two years from the grant date, and

holds the stock itself for at least one year, then

Employee: long-term capital gain

Employer: no deduction

Otherwise,

Employee: ordinary income = FMV at exercise date – exercise price

Employer: deduction equal to the amount employee reports as ordinary income.

2. Nonqualified stock option

If option has a determinable FMV when it is granted, then include it in the income,

otherwise,

Recognize income= FMV at exercise date- exercise price at exercise date

Employee: income is ordinary income


3. Employee stock purchase plan not discriminating against rand and file employees

(a) No income is recognized when option is granted or exercised.

(b) Recognize gain when the stock exercised is sold

If employee holds the exercised stock at least two years from the grant date, and

holds the stock itself for at least one year, then

Employee: ordinary income is the lesser of (1) FMV at grant date-option price or (2)

FMV at disposition date – option price.

Employer: no deduction

Otherwise,

Employee: ordinary income = FMV at exercise date – exercise price


G. Imputed income

Taxpayers sometime realize indirect economic benefits that they must include in gross income.

E.g., taxpayers realize an economic benefit when (1) they are allowed to purchase products or

services from an employer at less than the market price or (2) they are allowed to borrow

money at less than the market rate of interest. These benefits are named as imputed income.

A. Employees must recognize income to the extent they receive a greater than 20 percent

discount from their employer for the employer’s services or purchase goods from their

employer at a price below the employer’s cost.


B. Imputed income=loan principal* (federal interest rate – interest rate paid). The imputed

interest rules do not apply to loans of $10,000 or less.

H. Discharge of indebtedness

(1) Taxpayers with liabilities, including tax liabilities, exceeding their assets, a discharge of

indebtedness is not taxable if the taxpayer is insolvent before and after the debt forgiveness.

(2) If the discharge of indebtedness makes the taxpayer solvent, the taxpayer recognizes

taxable income to the extent of his solvency.

Exclusion provisions

There are specific types of income that taxpayers realize but are allowed to permanently exclude from

gross income or temporarily defer from gross income until a subsequent period. Exclusions and

deferrals are the result of specific congressional action and are narrowly defined. Congress allows most

exclusions and deferrals for two primary reasons: (1) to subsidize or encourage particular activities or (2)

to be fair to taxpayers.

1. Municipal interest

Interest on municipal bonds (bonds issued by state and local governments located in the US)

Interest on obligations of a state or one of its political subdivisions, the District of Columbia, and

US possessions is generally excluded from income if the bond proceeds are used to finance

traditional governmental operations.

2. Nontaxable fringe benefits (R1-18)

A. The first 50,000 group term life insurance

B. Health and accident insurance paid for an employee and their spouse and dependents.

C. Cash reimbursement for medical care

D. Meals and lodging for the convenience of the employer

E. Employee educational assistance. Employees can exclude form income up to 5,250 of

employee educational assistance benefits covering tuition, books and fees. Amounts over

5,250 are taxed as compensation to the employee.

F. Employees can exclude up to 5,000 for benefits paid or reimbursed by employers for caring

for children under 13 or dependents or spouses who are physically or mentally unable to

care for themselves.

G. No-additional-cost services. Employees can exclude the value of No-additional-cost services.

These are services employers provide to employees in the ordinary course of business that

generate no substantial costs to the employer.

H. Qualified employee discounts as long as they don’t acquire (1) goods at a price below the

employer’s cost or (2) services at more than a 20 percent discount of the price of the

services to customers.

Eg. Julie purchased a laptop from her company at 1,600 (MFV 2,100) with a cost basis of

1,500. This discount is qualified discount,0 included in her compensation.

Eg. Julie purchased a laptop from her company at 1,600 (MFV 2,100) with a cost basis of

1,700. This 100 discount is not qualified discount, 100 included in her compensation

I. Working condition fringe benefits


J. De Minimis fringe benefits. Small benefits.

K. Qualified transportation fringe: the value of company-owned car pool vehicle for

commuting, the cost of mass transit passes, and the cost of qualified parking near the work

place. The maximum exclusion of the car pool vehicle and mass transit pass is 230/month.

And the maximum exclusion for the qualified parking benefit is also 230/month.

L. Qualified moving expense reimbursement

Cafeteria plan: employer-sponsored benefit packages that offer employees a choice between

taking cash and receiving qualified benefits (such as accident and health insurance). Thus,

employees may select their own menu of benefits. If an employee chooses qualified benefits,

they are excluded from the employee’s gross income to the extent allowed by law. If an

employee chooses cash, it is includible in the gross income.

3. Education- related exclusions

An incentive for taxpayers to participate in higher education (education beyond high school)

A. College students seeking a degree can exclude from gross income scholarships that pay for

tuition, fees, books, supplies, and other equipment required for the study. Any excess

scholarship amounts (such as for room or meals) are fully taxable. This applies only if the

recipient is not required to perform services in exchange for receiving the scholarship.

Scholarships that represent compensation for past, current, or future services are fully

taxable.

B. Education IRA (Coverdell educational saving account)

1. Yearly contributions to the account are limited to 2,000 for each beneficiary (until the

beneficiary reaches age 18). This contribution is not deductible. That is, it should be

included in gross income.

2. This is an investment account. The investment returns accumulate tax-free. When

distributions are made from this account, earnings are excluded provided they are used

for qualified education costs of kindergarten through 12th grade and qualified higher

education expenses such as tuition, books, fees, supplies, and reasonable room and

board.

3. The 2,000 contribution limit is phased out as AGI increases from 190,000 to 220,000 for

married filing jointly, and from 95,000 to 110,000 for all other taxpayers.

4. When distribution is made directly to a beneficiary instead of paying the qualified

education expenses, the distribution is taxable and incurs 10% penalty.

5. The amount left in an education IRA before the beneficiary reaches age 30 can be rolled

over to another family member’s education IRA without triggering income taxes or

penalities.

C. The federal government issues bonds that allow taxpayers to acquire the bonds at a

discount and redeem the bonds for a fixed amount over stated time intervals. These bonds

don't generate any cash in the form of interest until the taxpayer redeems the bonds. At

redemption, the amount of the redemption price in excess of the acquisition price is interest


included in gross income. U.S. Series EE bonds fall into this category. However, an exclusion

is available for interest from Series EE bonds.

Requirements for tax exemption of accumulated interest on Series EE US saving bonds:

(1) The bonds must be issued after Dec 31, 1989;

(2) The purchaser of bonds must be the sole owner of the bonds (or joint owner with spouse);

(3) The owners must be at least 24 years old before the bond’s issue date;

(4) The redemption proceeds must be used to pay the tuition and fees incurred by the taxpayer,

spouse, or dependents to attend a college or university or certain vocational schools.

Note: if the redemption proceeds exceed the qualified higher education expenses, only a pro

rata amount of interest can be excluded. Moreover, the exclusion is subject to phase out.

E.g., During 2009, a married taxpayer redeems series EE bonds receiving 6,000 of principal and

4,000 of accrued interest. Assuming qualified higher education expenses total 9,000, accrued

interest of 3,600 (9,000/10,000*4,000) can be excluded from gross income.

4. Gifts and inheritances

Individuals may transfer property to other taxpayers without receiving or expecting to receive

value in return. If the transferor is alive at the time of the transfer, the property transfer is called

a gift. If the property is transferred from the decedent’s estate, it is called an inheritance. Theses

transfers are generally subject to the federal gift tax and federal estate tax (i.e., transfer tax),

not the income tax. Thus, gift and estate taxes are imposed on transfer of the property and not

included in income by the recipient.

5. Life insurance

Life insurance proceeds are similar to inheritances. When the owner of the life insurance policy

dies, the beneficiary receives the death benefit proceeds. The decedent is generally subject to

estate taxation on the amount of the insurance proceeds. In order to avoid potential double

taxation, the tax law allows taxpayers receiving life insurance proceeds to exclude the proceeds

from taxable income. Exceptions:

(1) In the event the life insurance policy is cashed in before the death of the insured individual,

the beneficiary receives the cash surrender value of the policy. In this case, cash surrender

value is not tax exempt. It is taxed at ordinary rates on the total investment gains from the

policy- that is, the difference between the cash surrender value and the premiums invested.

(2) When the insurance proceeds are paid over a period of time (installment) rather than in a

lump sum, a portion of the payments represents interest and must be included in gross

income. The amount included in gross income= payment – principal/payment period.

(3) The exclusion rule does not apply if the life insurance is obtained by the beneficiary in

exchange for valuable consideration from a person rather than the insurance company.

Amount included in the gross income= insurance proceeds – purchase price

6. Qualified distribution from Roth 401k plans

7. Foster child payments

They are excluded from income to the extent they represent reimbursement for expenses

incurred for care of the foster child.


8. Foreign-earned income

U.S. citizens are subject to tax on all income whether it is generated in the US or in foreign

countries. Taxpayers must choose to (by comparing the tax effects of each option)

A. Exclude foreign earned income up to an annual maximum amount (91,400 in 2009).

B. deduct the foreign tax paid on their foreign earned income as itemized deductions

C. claim the foreign tax credit for foreign taxes paid.

Individuals must meet certain requirements to qualify for the foreign earned income exclusion.

A. Be considered a resident of the foreign country

B. Or live in the foreign country for 330 days in a consecutive 12-month period

Note: because the exclusion is computed on a daily basis, the maximum exclusion is

reduced pro rata for each day during the calendar year the taxpayer is not considered to

be a resident of the foreign country or does not actually live in the foreign country

Assume Courtney agrees to rotation but she expects to live in the foreign country for only 340

days. How much of her expected 120,000 salary will she be allowed to exclude from gross

income?

94,100 * 340/365=85,140

Assume Courtney agrees to rotation but she expects to live in the foreign country for only 340

days. How much of her expected 60,000 salary will she be allowed to exclude from gross income?

All 60,000, she can exclude up to 85,140 of salary from income.

9. Sickness and injury-related exclusions

Payments for sickness or injury should not be taxable.

A. Workers’ compensation

Taxpayers receive workers’ compensation benefits when they are unable to work because of

a work-related injury. Any payments a taxpayer receives from a state-sponsored workers’

compensation plan are excluded from the taxable income.

Note: This treatment is opposite that of unemployment compensation, which is fully

taxable. But up to 2,400 of unemployment compensation can be excluded from gross

income for tax years beginning in 2009.

B. Payments associated with personal injury

Payments on account of a physical injury or physical sickness are nontaxable. Damages

taxpayers receive for emotional distress associated with a physical injury are nontaxable.

However, taxpayers receive damages for emotional distress that are not associated with a

physical injury must include those payments in income and only exclude payments for

medical expenses attributable to the emotional distress.

Punitive damages are fully taxable.

C. Health care reimbursement

Any reimbursement a taxpayer receives from a health and accident insurance policy for

medical expenses paid by the taxpayer during the current year is nontaxable regardless of

whether the taxpayer or the taxpayer’s employer purchased the insurance policy. Under the

condition that the taxpayer does not deduct the medical expenses as itemized deductions.

D. Disability insurance


It is also called wage replacement insurance, which pays the insured individual for wages

lost when the individual misses work due to injury or disability. If an individual purchases

disability insurance directly, the cost of the policy is not deductible, not any disability

benefits are nontaxable.

Disability insurance may also be purchased on an individual’s behalf by an employer.

(1) If the premiums paid on the employee’s behalf are taxable compensation to the

employee, the policy is considered to have been purchased by the employee.

(2) If the premium paid for by the employer is a nontaxable fringe benefit to the employee,

the policy is considered to have been purchased by the employer.

Only payments taxpayers receive from an employee-purchased policy are nontaxable.

Deferral provisions

Deferral provisions allow taxpayers to defer the recognition of certain types of realized income.

Transactions generating deferred income include installment sales, like-kind exchanges, involuntary

conversions, and contributions to non-Roth qualified retirement accounts.

Deductions

Deductions for AGI are generally preferred over deductions from AGI because deductions above the line

reduce taxable income dollar for dollar. In contrast, deductions from AGI sometimes have no effect on

taxable income. Further, because many of the limitations on tax benefits for higher income taxpayers

are based upon AGI, deductions for AGI often reduce these limitations thereby increasing potential tax

benefits.

Three categories of deductions for AGI:

1. Deductions directly related to business activities;

2. Deductions indirectly related to business activities;

3. Deductions subsidizing specific activities.

Deductions directly related to business activities

Differentiate business activities with investment activities: Business activities require a high level of

involvement or effort from the taxpayer; investment activities are profit-motivated activities that do not

require a high degree of taxpayer involvement or effort. Instead, investment activities involve investing

in property for appreciation or for income payments.

A. Business expenses are deducted for AGI with one exception. The lone exception is

unreimbursed employee business expenses are deductible as itemized deductions.

B. Investment expenses are deducted from AGI with one exception. Expenses associated with

rental and royalty activities are deductible for AGI regardless of whether the activity qualifies

as an investment or business.

1. Business expenses.


They are not readily visible on the front page of Form 1040. Instead, these deductions are

reported with business revenues on Schedule C (profit of loss from business). Taxpayers transfer

the net income or loss form Schedule C to Form 1040 line 12.

2. Rental and royalty expenses.

Taxpayers are allowed to deduct their expenses associated with generating rental or royalty

income for AGI. They do not appear directly on the front page of Form 1040. Instead, rental and

royalty deductions are reported with rental and royalty revenues on Schedule E (Rental or

royalty income). Taxpayers transfer the net income or loss from Schedule E to line 17.

3. Losses

4. Flow-through entities (confusing part. B11-33)

With partnerships, limited liability company, and S corporations, the operating income or loss

from their trade or business and rental activities flows through to the taxpayer and is treated as

ordinary income or ordinary loss. If trade or business or rental activities generate ordinary

income, taxpayers report it on their tax returns and pay taxes on it. However, if the activities

generate losses, the losses must clear three hurdles to be currently deductible:

(1) Tax basis. The tax basis hurdle limits a taxpayer’s deductible losses to the taxpayer’s tax

basis in the activity.

The tax basis in the activity=initial investment + share of the activity’s debt + share of

income from the activity – distributions of cash and losses.

If the losses from an activity exceed the tax basis, the losses are suspended until the

taxpayer generates enough tax basis to absorb the loss

(2) At risk amount. When a loss clears the tax basis hurdle, it next must clear an at-risk amount.

The rule limits ordinary losses to a taxpayer’s amount at risk in an activity.

(3) Passive loss limits. The passive loss rules are applied to any losses remaining after applying

the tax basis and at-risk loss limits.

Income and loss categories

1. Passive activity income or loss: income or loss from an activity in which the taxpayer is not a

material participant. Participants in rental activities, including rental real estate, and limited

partners in partnerships are generally deemed to be passive participants and participants in all

other trade or business activities are passive unless their involvement in an activity is regular,

continuous, and substantial.

2. Portfolio income: income from investments including capital gains and losses, dividends,

interest, annuities, and royalties.

3. Active business income: income from sources in which the taxpayer is a material participant.

For individuals, this includes salary and self-employment income.

The impact of segregating income in these baskets is to limit taxpayer’s ability to apply passive

activity losses against income in the other two baskets. Losses from the passive category cannot

offset income from other categories. Passive activity losses are suspended and remain in the passive

income or loss category until the taxpayer generates current year passive income, either from the

passive activity, or until the taxpayer sells the activity that generated the passive loss. (WP377)


Deductions indirectly related to business activities

Taxpayers can incur expenses in activities that are not directly related to making money but that they

would not have incurred if they were not involved in a business activity.

1. Moving expenses

Deductions for AGI if they meet two tests:

A. A distance test (R2-12)

Distance from new job to former residence is at least 50 miles further than distance from

old job to former residence.

B. A business test associated with the move

Taxpayer is employed at least 39 weeks out of 12 months following move. Self-employed

individuals must be employed 78 weeks out of 24 months following move. This test does not

have to be met in case of death, taxpayer’s job at new location ends because of disability, or

taxpayer is laid off for other than willful misconduct.

Taxpayers who receive a flat amount as a moving allowance from their employers are

required to include the allowance in gross income, and can deduct their actual moving

expenses for AGI.

e.g. EWD agreed to reimburse Courtney for 2,000 of actual moving expenses, what amount

would Courtney deduct for moving expenses (transportation: 156, moving company: 5,000,

lodging: 123, meals 75, house-hunting trip 520).

3,279. Courtney could deduct 3,279 in moving expenses. She would not include the

reimbursement in income and she would not deduct the 2,000 of expenses for which she was

reimbursed.

Note: indirect moving expenses such as pre-move house-hunting, temporary living expenses and

meals while moving are not deductible.

2. Health insurance premium deduction by self-employed taxpayers

A self-employed individual can deduct 100% of the premiums for medical insurance for the

individual, spouse, and dependents in arriving at AGI. But this deduction cannot exceed the

individual’s net earnings from the trade or business with respect to which the plan providing for

health insurance was established.

No deduction is allowed if the self-employed individual or spouse is eligible to participate in an

employer’s subsidized health plan.

3. Self-employment tax deduction

Self-employed taxpayers are allowed to deduct one-half of the self-employment tax they pay.

4. Self-employment qualified retirement contribution

A self-employed individual may contribute to a qualified retirement plan called a Keogh plan.

1. Maximum annual contribution

The lesser of (1) 49,000 or (2) 100% net earnings from self-employment


2. Maximum annual deductible amount


3. Net earnings from self-employment

= net earnings from self-employment

- One-half self-employment tax

- Keogh deductions.

Thus, 25% net earnings from self-employment = 20% of self-employment income before

after one-half of the self-employment tax, but before the Keogh deduction.

5. Penalty for early withdrawal of saving.

This provision allows a deduction for AGI for any interest income an individual forfeits to a bank

as a penalty for prematurely withdrawing a certificate of deposit or similar deposit.

e.g., Gram invested 100,000 in a CD. She decided to cash out the CD before it is due. She

receives the 4,100 of interest income the CD had generated up to the withdrawal date, less a

410 early withdrawal penalty. How will Gram report the interest and early withdrawal for tax

purposes?

Gram reports 4,100 as interest income this year and deducts the 410 early withdrawal penalty

as a deduction for AGI.

Deductions subsidizing specific activities

1. Alimony payment

2. Contribution to retirement savings (IRA)

3. Educator expenses

a. From 2007 through 2009, eligible educators are allowed deduction up to 250 for

unreimbursed expenses for books, supplies, computer equipment and supplementary

materials used in the classroom.

b. An eligible educator is a kindergarten through grade 12 teachers, instructor, counselor,

principal or aide working in a school for at least 900 hours during the school year.

4. Jury duty pay remitted to employer

a. An employee is allowed to deduct the amount of jury duty pay that was surrendered to an

employer in return for the employer’s payment of compensation during the employee’s jury

service period.

b. Both regular compensation and jury duty pay must be included in gross income.

5. Interest on qualified education loans

Qualified education loans are loans whose proceeds are used to pay qualified education

expenses. Qualified education expenses encompass expenses paid for the education of the

taxpayer, the taxpayer’s spouse, or a taxpayer’s dependent to attend a postsecondary

institution of higher education. These expenses include tuition and fees, books and expenses

required for enrollment, room and board, and other necessary supplies and expenses including

travel. The amount of the maximum education expense deduction (up to 2,500) depends on


filing status and the level of modified AGI. Modified AGI here is AGI before deducting interest

expense on the qualified education loans and before deducting qualified education expenses.

a. Married individuals who file separately are not allowed to deduct this expense under any

circumstance. (Book 6-10)

b. This deduction is not allowed if the individual is claimed as a dependent on another

taxpayer’s tax return.

c. The education expenses must relate to a period when the student was enrolled on at least a

half-time basis.

d. This deduction is phased out for single taxpayers with modified AGI between 60,000 and

75,000 and for married taxpayers with modified AGI between 120,000 and 150,000.

6. Qualified education expenses (R2-11)

Here qualified education expenses are limited to the tuition and fees required for enrollment at

a postsecondary institution of higher education. The amount of the maximum education

expense deduction depends on filing status and the level of modified AGI. Modified AGI here is

AGI after deducting the education loan interest expense but before deducting qualified

education expenses.

The deduction is limited to 4,000 for individual with AGI at or below 65,000 (130,000 for joint)

The deduction is limited to 2,000 for individual with AGI above 65,000 but less than 80,000

The deduction is 0 for individual with AGI above 80,000 (160,000 for joint)

Married individuals who file separately are not allowed to deduct this expense under any

circumstance.

Deductions from AGI

These deductions consist of

(1) The greater of itemized deductions or the standard deduction;

(2) Personal and dependency exemption deductions.

Itemized deductions (Schedule A)

1. Medical expenses (R2-20)

Qualifying medical expenses include any payments for the care, prevention, diagnosis, or cure of

injury, disease, or bodily function that are not reimbursed by health insurance or employer, or

are not paid for through a flexible spending account. Deductible medical expenses include

those incurred by a taxpayer, taxpayer’s spouse, dependents of the taxpayer, or any person

for whom the taxpayer could claim a dependency exemption except that the person had gross

income of 3,650 or more, or filed a joint return. Common medical expenses include:

(1) Prescription medication and medical aids

(2) Payments to medical care providers such as doctors, dentists, and nurses and medical care

facilities such as hospitals.


(3) Transportation for medical purposes

(4) Hospital and long-term care facilities

(5) Health insurance premium and insurance for long-term care service.

(6) Eyeglasses

Note: non-prescribed medicines and drugs are not deductible (e.g., over-the-counter medicines)

The deduction for medical expenses is limited to the amount of unreimbursed qualifying

medical expenses paid during the year reduced by 7.5% of AGI.

e.g. This year Courtney incurred 2,400 in unreimbursed qualifying medical expenses. Given that

Courtney’s AGI is 162,000, what is the amount of itemized medical expense deduction?

24000-(162,000*7.5%)=0

What amount of deduction if AGI is 30,000? 2,400-(30,000*7.5%)=150

2. Taxes (R2-21)

A. state, local and foreign income taxes; (Note: taxpayers may elect to deduct state and local

sales taxes instead of deducting state and local income taxes)

B. real estate taxes (state, local and foreign) on property held for personal or investment

purposes (when real property is sold, the deduction is apportioned between the buyer and

seller on a daily basis within the real property tax year)

C. Personal property taxes (state and local) that are assessed on the value of the specific

property.

Another nonitemizer deduction exists for state and local property taxes. Nonitemizers are

allowed to increase their standard deduction for the state and local real property taxes paid.

This addition is limited to the lesser of:

(1) The amount of real property taxes paid during the year, or

(2) $500 (1,000 for a married couple filing jointly)

3. Interest paid

(1) Home mortgage interest (Interest paid on loans secured by a personal residence)

a. Taxpayers are allowed to deduct only qualified residence interest as an itemized

deduction. Qualified residence interest is interest paid on the principal amount of

acquisition indebtedness and on the principal amount of home-equity indebtedness.

Both types of indebtedness must be secured by a qualified residence to qualify.

b. Qualified residence: the taxpayer’s principal residence and one other residence. For a

taxpayer with more than two residences, which property is treated as the second

qualified residence is an annual election-that is, the taxpayer can choose to deduct

interest related to a particular second home one year and a different second home the

next. If the taxpayer rents the second residence for part of the year, the residence will

qualify if the taxpayer’s personal use of the home exceeds the grater of (1) 14 days or

(2) 10 percent of the number of rental days during the year.


c. Acquisition indebtedness: any debt secured by a qualified residence that is incurred in

acquiring, constructing, or substantially improving the residence. Interest on acquisition

indebtedness is deductible up to 1 million (500,000 if married filing separately).

d. Home-equity indebtedness: any debt, except for acquisition indebtedness, secured by

the qualified residence to the extent it does not exceed the FMV of the residence minus

the acquisition indebtedness. That is, for purposes of deducting interest, total qualifying

home-related debt cannot exceed the total value of the home. Interest on home-equity

indebtedness is deductible up to 100,000 (50,000 if married filing separately)

regardless of how the loan proceeds are used.

e. Qualified mortgage insurance premiums paid in connection with acquisition

indebtedness are deductible as qualified residence interest. However, for every 1,000 by

which the AGI >100,000, the amount of premium treated as interest is reduced by 10%.

This deduction does not apply to mortgage insurance contracts issued before Jan 1 2007.

(2) Investment interest expense (interest expenses on loans used to acquire investments)(R222)

a. Interest paid on loans used to purchase investment assets such as stocks, bonds, or land.

b. The deduction of investment interest is limited to a taxpayer’s net investment income

(gross investment income-deductible investment expenses. Note: investment interest

expense is not an investment expense). Deductible investment expenses are investment

expenses that actually reduce taxable income after applying the 2% of AGI floor.

c. Gross investment income includes interest, annuity, and royalty income not derived in

the ordinary course of a trade or business. It also includes net short-term capital gains,

net capital losses (short-term and long-term), and non-qualifying dividends. However,

investment income generally does not include net long-term capital gains and

qualifying dividends because this income is taxed at a preferential rate. However,

congress allows taxpayers to elect to include preferentially taxed income in investment

income if they are willing to subject this income to tax at the ordinary tax rates.

d. Any investment interest in excess of the net investment income limitation carries

forward to the subsequent year when it is subject to the same limitations. The carryover

amount never expires.

e. Note: investment interest expense is different from investment expenses below.

4. Charitable contributions (R2-24)

Qualifying charitable organizations include organizations that engage in educational, religious,

scientific, governmental, and other public activities. Donations are only deductible if the

contribution is substantiated by written records.

(1) Contributions of money. Cash contribution is deductible in the year paid, including cash,

check, electronic funds transfers, credit card charges, and payroll deductions. While

taxpayers are allowed to deduct their transportation costs and other costs of providing

services for charities, they are not allowed to deduct the value of the services they provide.

(2) Contributions of property other than money. The amount the taxpayer is allowed to deduct

depends on whether the property is capital gain property or ordinary income property.


Taxpayers are allowed to deduct the FMV of capital gain assets on the date of donation.

Capital gain assets are any appreciated assets that would have generated a long-term capital

gain if the taxpayer had sold the property for its FMV instead of contributing them. Certain

contributions of capital gain property do not qualify for a FMV deduction. The deduction for

capital gain property that is tangible personal property is limited to the adjusted basis of the

property if the charity uses the property for a purpose that is unrelated to its charitable

purpose.

Taxpayers contributing ordinary income property can only deduct the lesser of (1) FMV or (2)

the adjusted basis of the property. Ordinary income property is property that if sold would

generate income taxed at ordinary rates. Ordinary income property includes:

A. Assets that taxpayer has held for a year or less

B. Inventory the taxpayers sell in a trade or business

C. Business assets held for more than a year to the extent the taxpayer would recognize

ordinary income under the deprecation recapture rules if the taxpayer had sold the

property.

D. Assets’ FMV < the taxpayer’s basis in the assets (assets have declined in value).

Charitable contribution deduction limitations

(3) Out-of-pocket expenses to main a student (domestic and foreign) in a taxpayer’s home are

deductible (limited to $50/month for each month the student is a full-time student) if

a. Student is in 12th or lower grade and not a dependent or relative

b. Based on a written agreement between taxpayer and qualified organization

c. Taxpayer receives no reimbursement

Private operating foundations: privately sponsored foundations that actually fund and

conduct charitable activities

Private non-operating foundations: privately sponsored foundations that disburse funds to

other charities.

Contribution type Public charity and private

operating foundation

Private non-operating

foundations

Cash

Amount Cash amount Cash amount

AGI limit 50% 30%

Capital gain property

Amount FMV on the date of donation Basis

AGI limit 30% 20%

Ordinary income property

Amount Lesser of FMV or Basis Lesser of FMV or Basis

AGI limit 50% 30%

When taxpayers make contributions that are subject to different percentage limitations,

follow the steps:

(1) Determine the limitation for the 50% contributions.


(2) Apply the limitations to the 30% contribution. The 30% contribution limit is the lesser of

(a) AGI*30% or (b) AGI*50%-amount from step (1)

(3) Apply the limitations to the 20% contribution. The 20% contribution limit is the lesser of

(a) AGI*20% or (b) AGI*30%-amount from step (2)

When a taxpayer’s contributions exceed the AGI ceiling limitation for the year, the excess

contribution is treated as though it was made in the subsequent tax year and is subject to

the same AGI limitations in the next year. The excess contribution can be carried forward

for five years before it expires.

5. Casualty and theft losses on personal-use assets

Individuals cannot deduct losses they realize when they sell or dispose of assets used for

personal purposes (opposed to business and investment assets). However, individuals are

allowed to deduct unreimbursed casualty and theft loss realized on personal use assets. A

casualty loss is a loss arising from a sudden, unexpected, or unusual event such as a fire, storm,

or shipwreck or loss from theft.

The amount of the tax loss is the lesser:

(1) The decline in the value of the property caused by the casualty or

(2) The taxpayer’s tax basis in the damaged or stolen asset.

The loss is reduced by any reimbursements the individual is eligible to receive.

Casualty losses must exceed two separate floor limitations to qualify as itemized deductions:

(1) 500 for each casualty event during the year (100 for years other than 2009); and

(2) 10% of AGI for the whole year

Eg. Courtney has 325 stolen and her car was worth 20,000 and completely destroyed in the

accident. She only received 3,100 from insurance reimbursement. AGI: 162,000

Theft Accident Total

FMV before casualty 325 20000

FMV after the casualty 0 0

(1) Decline in FMV 325 20,000

(2) Tax basis 350 22,000

Loss before reimbursement 325 20,000

Less reimbursement -0 -3,100

Less 500 per casualty floor -500 -500

Unreimbursed casualty loss 0 16,400 16,400

Less 10% of AGI -16,200

Casualty loss deduction after AGI limit 200

Miscellaneous itemized deduction


There are a variety of deductions that address specific objectives but do not fit into any category. These

deductions are called miscellaneous itemized deductions and mostly subject to an AGI floor (only

amounts over the floor are deductible)

Miscellaneous deductions subject to 2% AGI floor

1. Unreimbursed employee business expenses

Expenses that qualify include those that are appropriate and helpful for the employee’s work

such as the cost of professional dues, uniforms and subscriptions to publications related to

employment. The costs of job hunting qualify if the job is in the employee’s current trade or

business, but not for the first job. The cost of education qualifies if it serves to maintain or

improve the employee’s skill in the business, but not if the education is required to qualify for a

new business or profession. The cost of travel and transportation associated with the

employee’s work responsibilities may also qualify as miscellaneous itemized deductions.

However, the cost of commuting-from a residence to work place is personal and non-deductible.

When employees travel on business trips long enough to be away from home overnight, half of

the meals and lodging also qualify as employee business expenses.

Many employees are reimbursed for their business expenses by their employers. As a general

rule, employees include reimbursements in gross income and deduct employee business

expenses as miscellaneous itemized deductions. However, if an employee is required to submit

documentation supporting expenses to receive reimbursement and the employer reimburses

only legitimate business expense, then the employer’s reimbursement plan qualifies as an

accountable plan. Thus, employees exclude expense reimbursements from gross income and do

not deduct the reimbursed expenses. If the expenses exceed the reimbursements, the excess is

deductible as an employee business expenses.

2. Investment expenses (expenses other than interest incurred to generate investment income)

Investment expenses are treated as miscellaneous itemized deductions subject to the 2% of AGI

floor.

3. Tax preparation fees

Ordinary and necessary expenses incurred in connection with determining tax obligations. While

the most common of tax preparation fees are the costs of preparing taxpayer’s tax returns,

taxpayers may also deduct other related expenses such as the cost of property appraisals for

tax purposes and the costs of contesting tax liabilities.

4. Hobby losses

Taxpayers may engage in certain activities for primarily personal enjoyment but these activities

may also generate revenue and losses (hobby). Taxpayers must include the revenue from hobby

activity in gross income and deduct the expenses to the extent of the gross income from the

activity.

Miscellaneous deductions not subject to 2% AGI floor (that is, full deduction)

1. Gambling losses (up to gambling winnings)

2. Federal estate tax paid on income respect of a decedent


Phase-out of itemized deductions

1. The amount of a taxpayer’s total itemized deductions other than medical expenses, casualty

losses, investment interest expense, and gambling losses are subject to phase out. (MGICA)

2. Phase-out for 2009 is determined in 2 steps.

(1) Determine the lesser of (a) 3%* (AGI – 166,800 or 83,400 for married filing separately)

or (b) 80% of the total itemized deductions subject to phase-out

(2) Multiply the amount determined in step 1 by one-third. The product is the amount of

the itemized deduction phase-out.

The standard deduction (R2-16)

The standard deduction is a flat amount that most individuals can elect to deduct instead of deducting

their itemized deductions. That is, taxpayers generally deduct the grater of their standard deduction or

their itemized deductions.

The amount o standard deduction depends on filing status. Taxpayers who are at least 65 years of age

on the last day of the year or blind are entitled to additional standard deduction amounts above and

beyond their basic standard deduction. (check Becker R2-16)

Standard Deduction-Dependent of Another

For 2009, the amount is the greater of $950 or his earned income plus $300. Thus, a dependent

taxpayer with $1,300 earned income could claim a standard deduction of $1 ,600 ($1,360 + $300). The

dependent's standard deduction remains limited by the regular standard deduction for the tax year

(that is, for single, limited to 5,700). Dependent taxpayers may claim the same additional standard

deduction as other taxpayers for blindness and/or age 65 or over status.

Individual income tax computation and tax credits

Following three steps to determine tax liability if a taxpayer has long-term capital gain or qualifying

dividends (those are taxed at a preferential rate 15%)

1. Split taxable income into the portion that is subject to the preferential rate and the portion

taxed at the ordinary rates.

2. Compute the tax separately on each type of income. Note that the income that is not taxed at

the preferential rate is taxed at the ordinary tax rates using the tax rate schedule for the

taxpayer’s filing status.

3. Add both taxes.

Note: to ensure that taxpayers receive some tax benefit from preferentially taxed income, to the

extent that this income would have been taxed at 15% or 10% if it were ordinary income, it is taxed

at a 0 percent preferential rate.

Alternative minimum tax (AMT) (paid in addition to regular tax liability)

Regular taxable income


+/- Adjustments

+ Tax preferences

= alternative minimum taxable income (AMTI)

-exemption amount

=alternative minimum tax base

*26% or 28%

= tentative before foreign tax credit

-AMT foreign tax credit

=tentative minimum tax

-regular tax liability

=AMT tax (if positive)

1. Adjustment to taxable income

a. Personal and dependency exemption and standard deduction if applies (+)

b. Miscellaneous itemized deductions in excess of the 2 percent floor (+)

c. Real property and personal property taxes deducted as itemized deductions (+)

d. State income or sales taxes (+)

e. Home-equity interest expense (+)

f. Depreciation. If the regular tax depreciation exceeds the AMT depreciation, this is a plus

adjustment. If the AMT depreciation exceeds the regular tax depreciation, this is a minus

adjustment.

g. Gain or loss on sale of depreciable assets (due to the difference in depreciation method).

2. Tax preference items

a. The excess of the percentage depletion deduction over the adjusted basis of the property.

b. Excess intangible drilling costs

c. Tax-exempt interest

d. Pre-1987 accelerated depreciation or amortization

e. Exclusion for gains on sale of certain small business stock

3. Exemption

The exemption is phased out by 25%* (AMTI – phase-out threshold)

Filing status Exemption Phase-out begins at this level of AMTI

Married filing jointly 70,950 150,000

Married filing separately 35,495 75,000

Head of household and single 46,700 112,500

4. For AMT tax purposes long-term capital gain or qualifying dividends are taxed at the same

preferential rate.

5. AMT computation

(1) 26% on the first 175,000 AMT base (87,500 for married filing separately)

(2) 28% on the AMT base in excess of 175,000 (regular AMT bases, that is, not including long-

term capital gain and qualifying dividends)


6. Taxpayers who pay the AMT are entitled to a minimum tax credit to use when the regular tax

exceeds the tentative minimum tax. They can use the credit to offset regular tax but not below

the tentative minimum tax for that year. (the carry-forward is forever)

Tax credit (copy Ex7-10 P7-33)

1. Nonrefundable personal credits

Nonrefundable personal tax credits may reduce personal tax liability to zero, but if the amount

of the credit exceeds the amount of the taxpayer’s gross tax liability, the credit in excess of the

gross tax liability is not refunded to the taxpayer and expires without ever providing tax benefits.

A. Child tax credit (B7-24)

1,000 credit for each qualifying child under age 17 at the end of the year and claimed as

dependent. This credit is subject to phase-out based on AGI. The total amount of credit is

phased out, but not below 0, by 50 for each 1,000 over the applicable threshold.

B. Child and dependent care credit

This credit is a tax subsidy to help taxpayers pay the cost of providing care for their

dependents to allow taxpayers to work or look for work.

The amount of credit is based on the amount of the taxpayer’s expenditures to provide care

for one or more qualifying persons.

A qualifying person includes

(1) A qualifying child, under age 13,

(2) A dependent or spouse who is physically or mentally incapable of caring herself and who

lives in the taxpayer’s home for more than half the year.

The amount of expenditures eligible for the credit is the lesser of the following amounts:

(1) The total amount of dependent care expenditures for the year

(2) 3,000 for one qualifying person or 6,000 for two or more qualifying persons

(3) The taxpayer’s earned income or net earnings from self-employment. Married taxpayers

must file a joint tax return and the amount of earned income for this purpose is the

earned income of the lesser-earnings spouse.

The amount of credit is calculated by multiplying qualifying expenditures by the appropriate

credit percentage (between 20% and 35%), which is based on the taxpayer’s AGI and begins

at 35% for taxpayers with AGI less than 15,000.

C. Education credit

Congress provides the Hope scholarship credit and the lifetime learning credit to encourage

taxpayers and their dependents to obtain higher education. Qualifying expenditures for

either credit include amounts paid by dependents of the taxpayer and amounts paid by third

parties on behalf of the taxpayer’s dependents. Married taxpayers filing separate returns

are not eligible for this credit.

(1) The Hope Scholarship Credit is available for a student's first four years of post-

secondary education (post high school) at an eligible educational institution (those

eligible to participate in the federal student loan program). To qualify, students must be

enrolled in a qualified postsecondary educational institution at least half time. The

credit is equal to (maximum credit of $2,500 in 2009-2010): (1) 100% of the first $2,000

in 2009-2010 of qualified expenses, plus (2) 25% of the next $2,000 in 2009-2010 of

expenses paid during the year. The Hope credit is applied on a per student basis. Thus,

a taxpayer with three eligible dependents can claim a maximum Hope credit of 2,500

for each dependent. For 2009, the credit phases out pro rata for taxpayers with AGI


between $80,000 and 90,000 ($160,000-180,000 for a joint return). Note: in 2009, 40%

of a taxpayer’s allowable Hope credit is refundable.

(2) Lifetime learning credit applies to the cost of tuition and fees (but not books) for any

course of instruction to acquire or improve a taxpayer’s job skills. The credit is equal to

20% of eligible expenses up to an annual maximum of 10,000. In contrast to the Hope

scholarship credit, the lifetime learning credit limit applies to the taxpayer. Thus, a

taxpayer with multiple eligible dependents can claim a maximum lifetime learning

credit of only 2,000. The credit phases out pro rata for taxpayers with AGI between

$50,000 and 60,000 ($100,000-120,000 for a joint return).

For expenses that qualify for both the Hope and lifetime learning credits, taxpayers may choose

which credit to use, but they may not claim both credits for the same student in the same year.

In addition, taxpayers may choose to either (1) deduct qualifying education expenses of an

individual as a for AGI deduction or claim an education credit. However, if a taxpayer claims any

educational credit for an individual’s educational expenditures, the taxpayer may not claim any

for AGI deduction.

2. Refundable personal credits

Refundable credits in excess of a taxpayer’s gross tax liability are refunded to the taxpayer.

A. Making work pay credit

The amount of the credit is the lesser of (1) 6.2% of earned income or (2) 400 (800 MFJ).

Taxpayer must reduce the credit by 2% of AGI in excess of 75,000 (150,000 MFJ). Taxpayers

who are dependents of other taxpayers are not eligible for the credit.

B. Earned income credit

The credit is available for qualified individuals who have earned income for the year.

Qualified individuals include

(1) Any individual who has at least one qualifying child or

(2) An individual who does not have a qualifying child for the taxable year, but who lives in

the US for more than half the year, is at least 25 years old but younger than 65 years old

at the end of the year, and is not a dependent of another taxpayer.

The amount of credit depends on the filing status, the number of qualifying children who

live in the home for more than half of the year, and the amount of earned income. The

credit is computed by multiplying the appropriate credit percentage times the taxpayer’s

earned income up to a maximum amount.

3. Business credits (nonrefundable)

This credit is designed to provide incentives for taxpayers to hire certain types of individuals or

to participate in certain business activities.

When business tax credits other than the foreign tax credits, exceed the gross tax for the year,

the credits are carried back one year and forward 20 years to use in years when the taxpayer

has sufficient gross tax liability to use the credits.

Foreign tax credit

When taxpayers pay income taxes to foreign countries, they may treat the payment in one of

three ways:

(1) Taxpayers may exclude the foreign earned income from U.S taxation


(2) Taxpayers may include the foreign income in their gross income and deduct the foreign

taxes paid as itemized deductions

(3) Taxpayers may include foreign income in gross income and claim a foreign tax credit for the

foreign taxes paid. Foreign tax credits are limited to the lesser of: (a) Foreign taxes paid or

(b) (Taxable income from all foreign operations/taxable income +exemptions)*U.S tax rate.

When the use of a foreign tax credit is limited, taxpayers may carry back their unused

credit one year and carry forward up to 10 years.


Chap 2 Partnerships

When a partnership is formed, and afterwards, partners may transfer cash, other tangible or

intangible property, and services to it in exchange for an equity interest called a partnership interest.

Partnership interests represent the bundle of economic rights granted to partners under the

partnership agreements. These rights include the right to receive a share of the partnership assets if

the partnership were to liquidate, called a capital interest, and the right or obligation to receive a

share of future profits or future losses, called a profits interest.

As a general rule, neither partnership nor partners recognize gain or loss when they contribute

property to partnerships. Exceptions:

1. When property secured by debt is contributed to a partnership.

Capital gain = debt relief – tax basis in partnership before deducting debt relief

In this case, partners’ initial basis=0

Partner’s initial tax basis

Partners need to determine the tax basis in their partnership interests to properly compute their

taxable gains and losses when they sell their partnership interest. A partner’s tax basis in her

partnership interest is her outside basis. but, the partnership’s basis in its assets is its inside basis.

1. If the partnership does not have debt.

Partners’ basis in their partnership interest=tax basis of the property and cash they contributed.

2. If the partnership does have debt.(differentiate recourse debt and nonrecourse debt)

Basis=tax basis of the property and cash they contributed+ their share of the partnership’s debt.

a. Recourse debt is only allocated to partners with ultimate responsibility for paying debt

b. Nonrecourse debt is allocated to partners’ profit-sharing ratios.

When the partnership assumes debt of the partner secured by property the partner contributes to

the partnership, the contributing partner must treat her debt relief as a deemed cash distribution

from the partnership that reduces her outside basis. If the debt securing the contributed property is

nonrecourse debt, the amount of the debt in excess of basis of the contributed property is allocated

solely to the contributing partner, and the remaining debt is allocated to all partners according to

their profit-sharing ratios (B20-6) (tax basis 债由本人承担，超过 tax basis 债由所有 partner 分担)

Partner’s holding period in partnership interest

1. If the contributed property is capital assets or 1231 assets, then it includes the period of time

the property was held by the partner.

2. Otherwise, it begins on the day the partnership interest is acquired.

Partnership’s tax basis and holding period in contributed property

1. Tax basis = adjusted basis of contributed property of the partner


2. Like the adjusted basis of contributed property, the holding period of contributed assets also

carries over to the partnership.

Partnership should create a tax capital account for each new partner, reflecting the tax basis of any

property contributed and cash contributions.

Partners contribute services to exchange partnership interest

Unlike property contributions, services contributed in exchange for partnership capital interests may

create immediate tax consequences to both the contributing partner and the partnership.

For partners:

1. Partners’ recognized ordinary income= the amount they would receive if the partnership were

to liquidate, or liquidation value of the capital interest

2. Tax basis= Partners’ recognized ordinary income

3. Partners’ holding period will begin on the date he receives the capital interest.

For partnership:

1. The partnership either deducts or capitalizes the value of the capital interest, depending on the

nature of the services the partner provides.

2. When the partnership deducts the value of capital interest used to compensate partners for

services provided, it allocates the deduction only to the partners not providing services,

because they have effectively transferred a portion of their partnership capital to the service

partner. (i.e., capital interests shift from nonservice partners to service partner)

If the service is exchange for profit interest:

For partners: No income is recognized.

For partnership:

1. Nonservice partners will not receive deductions.

2. When the profit interest is generated, the partnership must adjust debt allocations based on

profit-and-loss-sharing ratios to reflect the service partner’s new or increased share of profits

and losses.

Acquisition method Outside basis Holding period

Contribute property =basis of contributed property-

debt relief +debt allocation+ gain

recognized

capital assets or 1231 assets, the

holding period of the contributed

property tacks on to the partnership

interest. Otherwise, it begins on the

day the partnership interest is

acquired.

Contribute service =Liquidation value of capital

interest + debt allocation;

=debt allocation if only profits

interest received

begins on the day the partnership

interest is acquired.

Purchase =cash + debt allocation begins on the day the partnership


interest is acquired.

Accounting period of partnership

Step1: Majority interest taxable year.

If the taxable year of one or more partners who together own more than 50% of the capital and

profits interests in the partnership. These partners must have same year-end.

If there is majority interest taxable year, then taxable year= majority interest taxable year

Otherwise:

Step2: principal partners test.

If there is principal partners’ taxable year in common, then the required tax year =the taxable

year the principal partners all have in common.

Principal partners: who have more than a 5% interest in the partnership profits and capital.

Otherwise: if step1 and step2 fail, then

Tax year=tax year providing the least aggregate deferral to the partners.

Total tax deferral achieved is calculated by weighting each partner’s months of deferral under

the potential tax year by each partner’s profits percentage and then summing the weighted

months of deferral for all the partners.

Ordinary business income (loss) and separately stated items

Although partnerships are not taxpaying entities, they are required to file tax returns annually. In

addition, they supply information to each partner detailing the amount and character of items of income

and loss flowing through the partnership. Partners must report these income and loss items on their tax

returns even if they do not receive cash distributions during the year.

When gathering this information for their partners, partnerships must determine each partner’s share of

ordinary business income (loss) and separately stated items. Separately stated items are treated

differently from ordinary business income from tax purposes (tax rates are different).

Common separately stated items (determined at partnership level rather than partner level) include:

A. Interest income

B. Guaranteed payments

Guaranteed payments are fixed amounts paid to partners regardless of whether the partnership

shows a profit or loss for the year. Because this payment is similar to salary payments, partners

treat them as ordinary income. Note: they are typically deducted in computing a partnership’s

ordinary income or loss for the year.

C. Net earnings (loss) from self-employment

D. Tax-exempt income

E. Net rental real estate income

F. Investment interest expense

G. Section 179 deduction


Self-employment tax (depends on the extent the partners involve in regular management)

1. General partners: pay tax on guaranteed payments for services they provide and their share of

ordinary business income (loss)

2. Limited partners: pay tax only on guaranteed payments

3. LLC members: same as general partners if LLC members have personal liability for the debts of

the LLC by reason of being an LLC member, who have authority to contract on behalf of the LLC,

or who participate more than 500 hours in the LLC’ trade or business. Otherwise, same as

limited partners.

Partnership filing

1. File Form 1065 return of partnership income with the IRS by the 15 day of the 4th month after

their year-end. They may receive automatic five-month extension by filing form 7004

2. Partnership prepare schedule K-1 for each partner detailing her individual share of the

partnerships’ ordinary income and separately stated items with Form 1065

Partners’ adjusted tax basis in partnership interest

The basis in partnership is dynamic and must be adjusted in the order listed:

1. Increase for actual and deemed cash contributions to the partnership during the year.

( increased share of debt in partnership is considered as deemed cash contribution)

2. Increase for partner’s share of ordinary business income and separately stated income/gain

items

3. Decrease for actual and deemed cash distributions during the year. (debt relief by the

partnership is considered as deemed cash distribution)

4. Decrease for partner’s share of nondeductible expenses (fines, penalties, etc)

5. Decrease for partner’s share of ordinary business loss and separately stated expense/loss items.

Basis adjustments that decrease basis may never reduce a partner’s tax basis below 0.

Loss limitations

Ordinary losses from partnerships are deductible against any type of taxable income. However, they are

deductible on the partner’s tax return only when they clear three separate hurdles:

1. Tax basis limitation

A partner’s basis limits the amount of partnership losses the partner can use to offset other

sources of income. Any losses allocated in excess of their basis must be suspended and carried

forward indefinitely until they have sufficient basis to utilize the losses

2. At-risk limitation=tax basis limitation – tax basis related to nonrecourse debt


The at-risk rules were used to limit the ability of partners to use nonrecourse debt as a means of

creating tax basis to use losses from tax shelter partnerships expressly designed to generate

losses for the partners. The at-risk rules limit partner’s loss to their amount “at risk” in the

partnership- their at-risk amount.

A partner’s at-risk amount is the same as her tax basis except that, with one exception, the

partner’s share of certain nonrecourse debts is not included in the at-risk amount. Specifically

the only nonrecourse debt considered to be at risk is nonrecourse real estate mortgages from

commercial lenders that are unrelated to borrowers. This debt is called qualified nonrecourse

financing.

Partners apply the at-risk limitation after the tax basis limitation. Any losses allocated in excess

of their at-risk amount must be suspended and carried forward indefinitely until they have

sufficient basis to utilize the losses

3. Passive activity loss limitation

The passive activity loss limits the ability of partners in rental real estate partnerships and other

partnerships they don’t actively manage from using their ordinary losses from these activities to

reduce other sources of taxable income.

Sales of partnership interests

Partners may dispose of their interest in several ways: sell to a third party, sell to another partner, or

transfer the interest back to the partnership.

Seller issues

1. Sellers’ gain or loss = the amount realized-her outside basis.

2. Because selling partner is no longer responsible for her share of partnership liabilities, any debt

relief increases the amount the partner realizes from the sale.

3. The character of the gain or loss from a sale of a partnership interest is generally capital,

because partnership interests are capital assets.

4. However, a portion of the gain or loss will be ordinary if a seller realizes any amounts

attributable to unrealized receivables or inventory items. These assets are called hot assets.

Hot assets:

1. Unrealized receivables include the right to receive payment for (1) goods delivered or to be

delivered or (2) service rendered, or to be rendered. 1245 Depreciation recapture is also

considered as unrealized receivable.

2. Inventory: Assets other than cash, capital assets, and 1231 assets

When a partner sells her interest in a partnership that holds hot assets, she modifies her calculation of

the gain or loss to ensure the portion that relates to hot assets is property characterized as ordinary

income. The process for determining the gain or loss follows:


Step1: determine the total gain or loss by subtracting outside basis from the amount realized.

Step2: calculate the partner’s share of gain or loss form hot assets as if the partnership sold these assets

at their FMV. This represents the ordinary portion of gain or loss. For specific partner,

Ordinary gain or loss=the gain or loss from hot assets * the partner’s interest percentage.

Step3: subtract the ordinary portion of the gain or loss obtained in step2 from the total gain or loss from

step1. This remaining amount is the capital gain or loss from the sale.

Buyer and partnership issues

The sale of partners’ interest does not generally affect a partnership’s inside basis in its assets. The new

partner’s share of inside basis is equal to the selling partner’s share of inside basis at the sale date. In a

sale of a partnership interest, the selling partner’s tax capital account carries over to the new investor.

Operating distribution

Like shareholders receiving corporate dividend distributions, partners often receive distributions of the

partnership profits, known as operating distributions. Usually, the general partners determine the

amount and timing of distributions. A distribution from a partnership is an operating distribution when

the partners continue their interest afterwards.

Operating distributions of money only

Neither the partnership nor the partners recognize gain or loss on the distribution of property or money

(general rule). The partner simply reduces her outside basis in the partnership interest by the amount of

the distribution.

1. Distribution < tax basis gain=0 and new tax basis=old tax basis-distribution;

2. Distribution > tax basis gain=distribution – tax basis and new tax basis=0;

Thus, the tax basis can never be below 0;

Operating distributions that include property other than money

Neither the partnership nor the partners recognize gain or loss on the distribution of property or money

(general rule).

Allocation of outsider basis in an order: 1. Money; 2. hot assets; and 3. other property.

Step 1: remaining outside basis= old outside basis – money;

Step 2: if remaining outside basis > property basis (the partnership basis in the property), then

a. new outside basis= remaining outside basis- property basis


b. partners’ basis on property= the partnership basis in the property

Otherwise, then:

a. new outside basis=0;

b. Partners’ basis on property= remaining outside basis.

In essence, a partner treats a reduction of her share of debt as a distribution of money. If the partner

increases her share of debt, the increase is treated as a cash contribution to the partnership.

If there is any change in a partner’s share of partnership debt resulting from a distribution, adjust the

outside basis according to the debt change first before step1 and step2.

Liquidating distributions

Liquidating distributions terminate a partner’s interest in the partnership. The tax issues in liquidating

distributions for partnerships are basically twofold: (1) to determine whether the terminating partner

recognizes gain or loss and (2) to reallocate her entire outside basis to the distributed assets.

Gain or loss recognition in liquidating distributions

The rationale behind the rules for liquidating distributions is simply to replace the partners’ outside

basis with the underlying partnership assets distributed to the terminating partners. Ideally, there would

be no gain or loss on the distribution, and the asset bases would be the same in the partner’s hands as

they were inside the partnership.

In general, neither partnerships nor partners recognize gain or loss from liquidating distributions.

However, there are exceptions.

In contrast to operating distributions, a partner may recognize a loss from a liquidating distribution, but

only when two conditions are met. These conditions are (1) the distribution includes only cash,

unrealized receivables, and/or inventory, and (2) the partner’s outside basis is greater than the sum of

the inside bases of the distributed assets. The loss on the distribution is a capital loss to the partner.

The terminating partner’s share of partnership debt decreases after a liquidating distribution. Any

reduction in the partner’s share of liabilities is considered a distribution of money to the partner and

reduces the outside basis available for allocation of basis to other assets, including inventory and

unrealized receivables.

Basis in distributed property

Note: if there is change in debt liability, then adjust outside basis based on the debt change.

Partner’s outside basis > inside basis of distributed assets

1. If distributed assets only include money and hot assets

Recognized capital loss= partner’s outside basis-inside basis of distributed assets.


Basis in distributed property= inside basis of distributed assets.

2. Other property included in distributions.

Recognized loss=0.

Step 1: remaining outside basis1= outside basis- inside basis of distributed assets (assign a basis

to all distributed property= partnership’s basis in those assets;

Step 2: for other property (i.e., assets other than cash and hot assets)

If FMV > tax basis then assign (FMV-tax basis) to the property’s basis

Step 3: allocate remaining outside basis2 (remaining outside basis1– sum(FMV-tax basis)) to

other property in proportion to the relative FMV of other property.

Partner’s outside basis < inside basis of distributed assets

1. Distribution of money only

Recognized capital gain= cash-partners’ outside basis

2. Distribution of money and hot assets (No gain recognized)

Step1: required decrease= inside basis of distributed assets (assign a basis to all distributed

property= partnership’s basis in those assets) – outside basis;

Step 2: if FMV of hot assets < tax basis, then decrease tax basis by (FMV-tax basis) (A assume)

Step3: then allocate remaining required decrease (required decrease from step 1- A) to the hot

assets in proportion to their adjusted basis.

3. Distribution includes other property

No gain recognized. But decrease the basis in the other property.

Step1: required decrease= inside basis of distributed assets (assign a basis to all distributed

property= partnership’s basis in those assets) – outside basis;

Step2: if FMV of other property < tax basis, decrease tax basis by (FMV-tax basis) (A assume)

Step3: then allocate remaining required decrease (required decrease from step 1- A) to the

other property in proportion to their adjusted basis.

Character and holding period of distributed assets

1. For both operating and liquidating distributions, the character of the distributed assets usually

stays the same for the partner as it was in the partnership.

2. The partners’ holding period generally includes the partnership’s holding period.

Organizational expenditures

The concept of matching income with the expense of generating that income would require that

partnership organization costs be capitalized and amortized over the life of the partnership.

Organization costs include legal fees for drafting the partnership agreement, accounting fees to

organize the partnership, and state and local filing fees.

A partnership may deduct up to 5000 of organization costs for the tax year in which the partnership

begins business, with any remaining expenditures deducted ratably over the 180-month period

beginning with the month in which the partnership begins business (rather than the date the

partnership is organized) (same for the corporation)


Start-up expenditures

Costs are defined as (1) costs paid or incurred in connection with the investigation or acquisition of

an active trade or business; (2) costs paid or incurred in the creation of such a trade or business, or

(3) pre-activity costs.

A partnership may deduct up to 5000 of start-up costs for the tax year in which the partnership

begins business, with any remaining expenditures deducted ratably over the 180-month period

beginning with the month in which the active trade or business begins

Syndication costs

The costs of issuing and marketing interests in a partnership syndication, such as commissions,

professional fees, and printing costs, must be capitalized and are not subject to amortization.

Note: for corporation, each 5,000 amount is reduced by the amount by which the organizational

expenditures or start-up costs exceed 50,000, respectively.

Depreciation method

The method is an election made by the partnership and may be any method approved by the IRS.

The partnership is not restricted to using the same method as used by its principal partner.


LLC with only one individual owner)

Schedule D: Capital gains and losses

Form 1120: C corporation tax

Form 1120 schedule M-1: reconciling to taxable income before the DRD and NOL deductions.

Form 1120 schedule M-1: provides the change in retained earnings during the year and reports the

ending balance (book)

Form 1120S: S corporation tax

Form 1065: partnership tax (unincorporated entities with more than one owner)

Schedule K: Return of partnership income

For C corporation,

1. Net capital loss carries back 3 years and forwards 5 years.

2. Net operating loss carries back 2 years and forwards 20 years.

3. Firms making current year charitable contributions in excess of the 10% modified taxable

limitation may carry forward the excess for up to five years after the year in which the

carryover arises (FIFO order). The excess contribution for individuals also expires in five years.


Chap 3 Property classification

Personal property includes all tangible property, such as computers, automobiles, furniture, machinery,

and equipment, other than real property (building and land). Personal property and personal-use

property are not the same thing. Personal property denotes any property that is not real property while

personal-use property is any property used for personal purposes.

Tax basis for property acquired by gift

1. FMV> Rollover basis basis=rollover basis + gift tax paid if any

Gift tax=Net appreciation value (FMV-Rollover basis)/Taxable amount of gift *gift tax paid

2. FMV<Rollover basis

A. If sales price of gifted property < FMV then basis=FMV

B. If FMV<sales price<rollover basis then basis=sales price

C. If sales price>rollover basis then basis=rollover basis

Note: the holding period of the gift normally assumes the donor’s holding period. However, if the basis=

FMV, then the holding period starts the date of the gift.

Note: if the property carries passive activity loss, then decrease the basis.

Tax basis for property acquired from decedent

1. If alternate valuation date is not elected, tax basis=FMV

2. Otherwise, tax basis=FMV on the six month date or FM on the distribution date (whichever is

earlier)

3. Exception: if the decedent get the appreciable property as a gift and pass the property to the

donor or donor’s spouse, then tax basis=adjusted tax basis of decedent.

Note: property received from decedent is deemed to be held long-term regardless of actual holding

date.

Tax basis for stock dividend:

1. If stock dividend is nontaxable, then the shareholders’ original stock basis is allocated between

old stock and new stocks based on relative FMV. In this case, the holding period of the dividend

stock includes the holding period of the original stock.

2. Otherwise, the basis= FMV

Stock dividend is nontaxable (1) if the stock distribution be made with respect to common stock (即是普通股的股票股利) and (2) it must be pro rata with respect to all shareholders (即不改变股东的持股比例)

Property exchange


1. Taxable exchange

The basis of property received =FMV

Gain or loss recognized = FMV – the adjusted basis of the property exchanged

2. Nontaxable exchange: defer recognizing gain or loss realized on the exchange if they meet

certain requirements.

(1) Like-kind exchange

a. No boot, then the basis of property received= the basis of property transferred

b. If boot is given, no gain/loss is generally recognized. However, gain/loss is recognized if

the boot’s FMV ≠ boot’s basis.

Basis of property received =basis of property transferred (including boots) + gain

recognized-loss recognized.

c. If boot is received, any realized gain is recognized to the extent of the lesser of (1) the

realized gain or (2) FMV of the boot received. No loss is recognized due to the receipt of

boot.

The realized gain =FMV of property received (including boots) –basis of property

transferred

The basis of property received= tax basis of like-kind property transferred + gain

recognized– boot received

The basis of boot received= FMV of the boot.

Note: liabilities assumed on either or both sides of the exchange are treated as boot.

a. If liabilities are assumed on both sides of exchange and no cash is involved, they are offset to

determine the net amount of boot given or received.

Liability relief = boot received liability assumption=boot given

b. If liabilities are assumed on both sides of exchange and cash is involved.

a. Liability boot given does not offset boot received in cash or unlike property.

b. Boot given in cash or unlike property does offset liability boot received.

The holding period of boot received begins on the date of its receipt.

For an exchange to qualify as a like-kind exchange, the transaction must meet three criteria:

a. The property is exchanged solely for like-kind property.

b. Both the property given up and the property received in the exchange by the taxpayer are

either used in a trade or business or are held for investment. (that is, not including personal-

use property)

c. Meet the time restrictions: (1) the taxpayer must identify the like-kind replacement property

within 45 days after transferring the property given up in the exchange and (2) the taxpayer

must receive the replacement like-kind property within 180 days after the taxpayer initially

transfers property in the exchange.

Like-kind property:


a. Real property. All real property is considered to be like-kind with any other type of real property

as long as the real property is used in a trade or business or held for investment.

b. Personal property: tangible personal property qualifies as like-kind if the property transferred

and the property received in the exchange is in the same general asset class by IRS (i.e.,

exchanged assets have the same general use to the taxpayer).

c. Non like-kind property: inventory held for resale (including land held by a developer), most

financial instruments (such as stocks, bonds, or notes), domestic property exchanged for foreign

property, and partnership interests.

(2) Involuntary conversions

Taxpayers may involuntarily dispose of property due to circumstances beyond their control,

such as a natural disaster or accident, stolen, condemned, or seized via eminent domain by

a governmental agency. However they may realize a gain for tax purposes if they receive

replacement property or insurance proceeds in excess of their basis in the property that was

stolen or destroyed. Congress provides special tax laws to allow taxpayers to defer the gains

on such involuntarily conversions.

a. Direct conversion: receiving a direct property replacement for the involuntarily

converted property

No gain recognized. Tax basis of replacement property= tax basis of the involuntarily

converted property

b. Indirect conversion:

Indirect conversion involves taxpayers receiving money for the involuntarily converted

property through insurance reimbursement or some other type of settlement.

Taxpayers can defer realized gains on indirect conversions if they acquire qualified

replacement property within a prescribed time limit, which is generally two years (three

years in case of condemnation). The property must be similar and related in service or

use to qualify. Taxpayers recognize realized gain to the extent that they do not reinvest

the reimbursement proceeds in qualified property.

Recognized gain= the lesser of (1) the gain realized on the conversion (=reimbursement

amount – Tax basis) or (2) the amount of reimbursement the taxpayer does not reinvest in

qualified property.

Tax basis of replacement property = FMV of the replacement property- deferred gain

(=realized gain-recognized gain)

Note: Losses on involuntary conversions are recognized whether the property is replaced or not. This

loss is deductible as a casualty loss. However, a loss on condemnation of property held for personal use

is not deductible.

Eg. Teton’s delivery van had a FMV of 15,000 and an adjust basis of 11,000. It was destroy in an accident

and reimbursed 15,000 by insurance company. Teton was considering two alternatives for replacing the

van:

(1) Purchase a new delivery van for 20,000. No gain recognized in this case.


The basis of the new van=20,000-(15,000-11,000-0)=16,000

(2) Purchase a used delivery van for 14,000. 1,000 (15,000-14,000) gain recognized in this case.

The basis of the new van=14,000-(15,000-11,000-1,000)=11,000

Property dispositions

In order to determine how a recognized gain or loss affects a taxpayer’s income tax, the taxpayer must

determine the character or type of gain or loss recognized:

1. Ordinary assets: assets created or used in a taxpayer’s trade or business such as inventory, AR

and equipment used for one year or less. (B10-6)

2. Capital assets: assets held for investment (stocks and bonds), for the production of income or

for personal use.

3. 1231 assets: depreciable assets and land used in a trade or business held by taxpayers for more

than one year. If a taxpayer recognizes a net 1231 gain, the net gain is treated as a long-term

capital gain. If a taxpayer recognizes a net 1231 loss, the net loss is treated as an ordinary loss.

1231 assets consist of three types: (1) pure 1231: land; (2) 1245: personal property and

intangibles; and (3) 1250: depreciable real property (buildings)

Note: an easy way to remember that is building is so high so it takes the highest sec number

1250 instead of 1245

Note: copyrights or artistic, literacy, compositions created by the taxpayers are not capital

assets but if they are purchased by taxpayer, then they are capital assets.

Depreciation recapture (R3-30,31)

It is possible that a 1231 asset other than land could be sold at a gain in situations when the asset has

not appreciated in value and even in situations when the asset has declined in value since it was placed

in service. It happens because depreciation deductions relating to the asset could reduce the adjusted

basis of the asset by more than the actual economic decline the asset’s value. For this situation,

Congress introduced the concept of depreciation recapture. When depreciation recapture applies, it

recharacterizes the gain on the sale of a 1231 asset from 1231 gain into ordinary income. However,

the depreciation recapture does not affect 1231 losses. The computation of depreciation recapture

depends on the type of 1231 asset. Note: depreciation recapture changes the character of the gain but

not the amount of the gain.

1. 1245 asset. The amount of ordinary income taxpayers recognize when they sell 1245 property is

the lesser of (1) recognized gain on the sale or (2) total accumulated depreciation. The

remainder of any recognized gain is characterized as 1231 gain. (B10-10)

2. 1250 asset. 1245 depreciation recapture does not apply to it.

A. For corporations, 291 depreciation recapture applies to corporations but not to other

types of taxpayers. Under 291, corporations selling depreciable real property recapture as

ordinary income 20% of the lesser of the (1) recognized gain on the sale or (2) total


accumulated depreciation. The remainder of any recognized gain is characterized as 1231

gain.

B. For individuals, tax policy makers determined that the portion of the gain caused by

depreciation deductions reducing the basis (unrecaptured 1250 gain) should be taxed at a

maximum rate of 25%. The amount of gain taxed at a maximum rate of 25% is the lesser of

the (1) recognized gain on the sale or (2) total accumulated depreciation. The remainder of

the gain is taxed at a maximum rate of 15%.

Eg. Teton bought its warehouse for 275,000, depreciated it 15,000, and sold it for 350,000.

350,000 (amount realized) – 260,000 (adjusted basis=275,000-15,000)=90,000 (gain)

90,000(gain) =15,000 (unrecaptured 1250 gain)+75,000 (remaining 1231 gain)

Exception: under 1239, when a taxpayer sells depreciable property to a related party and the property

is depreciable property to the buyer, the entire gain on the sale is characterized as ordinary income to

the seller. The definition of the related party: R1-54

After recharacterizing 1231 gain as ordinary income under the 1245 and 291 depreciation recapture

rules and the 1239 related party rules, the remaining 1231 gains and losses are netted together. If the

gains exceed the losses, the net gain becomes a long-term capital gain. If the losses exceed the gains,

the net loss is treated as an ordinary loss. For the capital gain, we should apply 1231 look-back rule.

That is, the taxpayer must look-back to the five year period preceding the current tax year to

determine if, during that period, the taxpayer recognized any unrecaptured 1231 losses. The taxpayer

must recharacterized the current year net 1231 gain as ordinary income to the extent of that prior five

year uncrecaptured 1231 losses.

e.g. suppose that Teton began business in year 1 and that it recognized a 7000 net 1231 loss in year 1

and 2000 net 1231 loss in year 5. Assume that the current year is year 6 and that Teton reports a net

1231 gain of 25,000 for the year. Then 9,000 ordinary income and 16,000 long-term capital gain.

Capital gains and losses

The amount realized by a taxpayer from the sale or other disposition of an asset is everything of value

received from the buyer less any selling costs.

Amount realized=cash received + fair market value of other property + buyer’s assumption of liabilities

-seller’s expenses (R1-44)

Adjusted basis=cost basis – cost recovery deductions

Gain or loss realized= amount realized – adjusted basis

Although most long term capital gains are taxed at a maximum 15% rate. There are some exceptions:

1. Unrecapured 1250 gain: 25%


2. Gains from collectibles and qualified small business stock: 28%

Taxpayers selling capital assets that they hold for a year or less recognize short-term capital gains or

losses. Alternatively, taxpayers selling capital assets that they hold for more than a year recognize long-

term capital gains or losses. Short-term capital gains are taxed at ordinary rather than preferential rates.

In contrast, long-term capital gains are taxed at preferential rates. However, not all long-term capital

gains are taxed at a maximum 15% rate, certain long-term capital gains are taxed at a maximum rate of

25% and others are taxed at a maximum 28%.

1. Unrecaptured 1250 gain is subject to a maximum tax rate of 25%.

Eg. Assume Jeb sold a rental home for 160,000. He originally acquired the home for 100,000,

and he has fully depreciated it for tax purposes. Assume his marginal ordinary tax rate is 35%,

what tax does he own on the gain if he did not sell any other property during the year?

100,000*25%+ (160,000-100,000)*15%=34,000

2. Gains from two types of capital assets are taxable at a maximum 28%: (1) collectibles, consist of

works of art, any rug or antique, any mental or gem, any stamp or coin, any alcoholic beverage,

or other similar items held for more than one years; (2) qualified small business stock held for

more than five years. Qualified small business stock is stock received at original issue from a C

corporation with a gross tax basis in its assets both before and after the issuance of no more

than 50,000,000 and with at least 80% of the value of its assets used in the active conduct of

certain qualified trades or business. When taxpayers sell qualified small business stock after

holding it for more than five years, they may exclude half of the gain on the sale from regular

taxable income (75% if the stock was acquired after Feb 17, 2009 and before Jan 1, 2011), and

the capital gain not excluded from income is taxed at 28%.

Capital gain type Maximum rate

Short term all 35%

Long term Collectibles 28%

Held >5years Qualified small business stock 28%

Long-term Unrecaptured 1250 gain 25%

Long term Not included above 15%

Netting process for gains and losses (if there is no different maximum tax rate on long-term capital gains)

1. Net all short-term gains and short-term losses.

2. Net all long-term gains and long-term losses.

3. A. if step 1 and step2 both yield gains or losses, then the netting process ends.

B. otherwise, net the short- and long-term outcomes against each other to yield a final net gain

or net loss (might be short or long-term)

For individuals, net short-term capital gains are taxed as ordinary income.

For Individual taxpayers, capital losses first offset capital gains, and then are allowed as a deduction up

to 3,000 (1,500 if married filing separately) against ordinary income. Net capital losses in excess of


3,000 retain their short-term and long-term character and are carried forward forever. Short-term

losses are applied first to reduce ordinary income when the taxpayers recognize both short-term and

long-term net capital losses. In contrast, corporation capital losses are only allowed to offset capital

gains, not ordinary income. A net capital loss is carried back three years, and forward five years to

offset capital gains in those years. All capital loss carryback and carryover are treated as short-term

capital losses.

Netting process for gains and losses (if there are different maximum tax rates on long-term capital gains)

(P11-14)

1. Net all short-term gains and short-term losses (including carry forward)

2. Net all long-term gains and long-term losses (including carry forward).

If step2 <0 (that is, long-term loss)

a. If step 1 <0, then there is a net short-term loss and net long-term capital loss.

b. If step1 >0 but step2<0, then there is a net short-term gain if step1>abs (step2).

c. If step1 >0 but step2<0, then there is a net long-term capital loss if step1<abs (step2).

If step2>0, separate all long-term capital gains and losses into the three separate rate groups. Any

long-term capital loss carried forward from the previous year is placed in the 28% group. Then:

1. Net the gains and losses in the 15% group. If the result is a net loss, move the net loss into 28%

group. Net gains remain in the 15% group.

2. If step1 (means the short-term) <0, move the loss into the 28% group.

3. Net the gains and losses in the 28% group. Net gains are taxed at 28%. Net losses move to the

25% group.

4. Net the 25% gains with the net loss from step3. Net gains are taxed at 25% rate. Net losses

move to the 15% group.

5. Net the 15% gain from step1 with the net loss from step 4. The gain is taxed at 15%

15% group ----28% group----25% group---15%

Limitations on capital losses

1. Losses on the sale of personal-use assets. These losses are not deductible, and therefore never

become part of the netting process.

2. When taxpayers sell capital assets at a loss to related parties, they are not able to deduct the

loss.

3. Wash sales. A wash sale occurs when an investor sells or trades stock or securities at a loss and

within 30 days before or after the day of sale buys substantially identical stocks or securities.

These losses (but realized) are not recognized, instead, the unrecognized losses are added to the

basis of the newly acquired stock. Gain recognized but not loss.


e.g. Nick owns 100 share of Cisco stock that they purchased in June 2008 for $50 a share. On Dec 21,

2009, Nick sells the shares for $40 a share. This sale generates a capital loss of 1,000. Later, Nick

purchase 100 shares of Cisco stock for $41 a share on Jan 3, 2010.

Nick realizes 1,000 long-term capital losses but recognizes 0 capital loss. The basis of Cisco stock

purchased on Jan 3, 2010 is 4100+1000

Assume Nick only purchases 40 shares of Cisco stock on Jan 3, 2010. Since Nick only acquired 40% of

the shares he sold at a loss within the window, Nick must disallow 40% or 400 of the loss and he is

allowed to deduct the remaining 600 loss.

Note: This wash sale rule does not apply to dealers in stock and securities where loss is sustained in

ordinary course of business.


Sale or exchange of principal residence (Wiley P495)

When a taxpayer sells a personal residence at a loss, the loss is a nondeductible personal loss. However,

when a taxpayer sells a personal residence at a gain, taxpayers meeting certain home ownership and

use requirement can permanently exclude from taxable income all, or at least a portion of the realized

gain on the sale.

1. An individual may exclude from income up to 250,000 of gain that is realized on the sale or

exchange of a residence.

Note: this exclusion is determined on an individual basis. That is, a single individual who

otherwise qualifies for the exclusion is entitled to exclude up to 250,000 of gain even though his

spouse has used the exclusion within 2 years before marriage.

2. The exclusion is increased to 50,000 for married filing jointly if either spouse meets the

ownership test, and both spouses meet the use test. This exclusion applies to a sale of

residence that had been jointly owned and occupied by the surviving and deceased spouse if the

sales occur no later than 2 years after the date of death of the individual’s spouse.

3. If the taxpayer does not meet the ownership or use tests, a pro rata amount of 250,000 or

500,000 applies if the sale or exchange is due to a change in place of employment (meet the

distance test of moving expense), health (instructed by doctors), or unforeseen circumstances.

4. If a taxpayer was entitled to take depreciation deductions because the residence was used for

business purposes or as rental property, the taxpayer cannot exclude gain from the deprecation

amount after May 6, 1997. That, exclusion= realized gain- depreciation.

5. Gain from the sale of a principal residence cannot be exclude if during the two-year period

ending on the date of the sale, the taxpayer sold another residence at a gain and excluded all or

part of that gain from income.

Ownership test: the taxpayer must have owned the property for a total of two or more years during the

five-year period ending on the date of sale. It prevents a taxpayer from purchasing a home, fixing it up,

and soon thereafter selling it and excluding the gain- a real estate investment practice termed flipping.

a. If a residence is transferred to a taxpayer incident to a divorce, the time during which the

taxpayer’s spouse or former spouse owned the residence is added to the taxpayer’s period of

ownership.

b. A taxpayer’s period of ownership of a residence includes the period during which the taxpayer’s

deceased spouse owned the residence so long as the taxpayer does not remarry before the date

of sale.

Use test: the taxpayer must have used the property as her principal residence for a total of two or more

years during the five-year period ending on the date of sale. By definition, a taxpayer can only have one

principal residence.


Note: the periods of ownership and use need not be continuous nor do they need to cover the same

two-year period.

Sales and exchange of securities (Wiley 497)

Related-party exchange (Wiley 498)


Chap 4 Corporations

Business income and deductions

Income from business includes gross profit from inventory sales, income from services provided

and income from renting property to customers.

Business expenses must be made in the pursuit of profits rather than the pursuit of others.

Business expenses must be both ordinary and necessary to be deductible. Ordinary and

necessary expenses are deductible only to the extent they are also reasonable in amount. An

expenditure is not reasonable when it is extravagant or exorbitant. The IRS tests for

extravagance by comparing the amount of the expense to a market price or an arm’s length

amount. If the amount of expense is the amount typically charged in the market by unrelated

parties, the amount is considered to be reasonable.

Casualty loss: (different from individual)

1. If business property is completely destroyed, the amount of casualty loss = property’s tax

basis.

2. If only partially destroyed, the amount of loss is the lesser of (1) the decline in the value of

property and (2) the adjusted basis of property.

3. Only the loss not reimbursed by insurance is deductible.

4. The loss may be treated as an ordinary loss or a capital loss, depending on the type of asset

involved in the casualty.

R&D expenditures: the firm can elect to deduct qualifying R&D as a current expense if the firm

so elects for the first taxable year in which the cost is incurred. Otherwise, the firm must

capitalize the cost and amortize it over a 60 months or longer.

Limitation on business expenses (nondeductible)

1. Expenditures against public policy. Businesses are not allowed to deduct fines, penalties,

illegal bribes, or illegal kickbacks.

2. No deduction or credit is allowed for any amount that is paid or incurred in carrying on a

trade or business which consists of trafficking in controlled substances. However, the cost of

goods sold is still deductible.

3. Political contributions and lobbying costs.

4. Capital expenditures

5. Expenses associated with the production of tax-exempt income. For example, interest

expenses for business that borrow money and invest the loan proceeds in municipal bonds.

Life insurance premiums for which corporation is beneficiary pay on policies that cover the

lives of officers or other key employees and compensation the business for the disruption


and lost income they may experience due to a key employee’s death. The death benefit

from the life insurance policy is not taxable.

6. Personal expenditures. Many business owners may be in a position to use business funds to

pay for items that are entirely personal in nature. These expenditures, even though funded

by the business, are not deductible.

7. Business gift. The deduction for business gifts is limited to $25 per recipient each year.

8. Mixed-motive expenditures. The rules for determining the amount of deductible mixed-

motive expenditures depend on the type of the expenditure.

A. Meals

Only 50% of actual business meals are deductible and satisfy (1) the amount must be

reasonable under the circumstances, (2) the employees must be present when the meal

is furnished and (3) the meal must be directly associated with the active conduct of the

taxpayer’s business.

B. Entertainment

Only 50% of actual expenses are deductible and satisfy (1) business associates are

entertained, (2) the amount must be reasonable under the circumstances and (3) the

entertainment must be directly associated with the active conduct of the taxpayer’s

business.

Business associates are individuals with whom the taxpayer reasonably expects to do

business, such as customers, suppliers, employees, or advisors.

C. Travel and transportation

1. If the primary purpose of a trip is business, the transportation costs are fully

deductible, but meals (50%), lodging and incidental expenditures are limited to

those incurred during the business portion of the travel.

2. If the primary purpose of a trip is personal, the transportation costs to arrive at the

location is deductible, and meals (50%), lodging and incidental expenditures are

limited to those incurred during the business portion of the travel.

Entities

For tax purposes, business entities can be classified as either separate taxpaying entities or as flow-

through entities.

1. Unincorporated entities (including LLC) with more than one owner are taxed as partnership

(Form 1065)

2. Unincorporated entities (including LLC) with only one individual owner and single-member

LLCs are taxed as sole proprietorships. (Schedule C)

3. taxable corporation

4. S corporation

Note: owners of LLCs can elect to have their business taxed as taxable corporations instead of as

flow-through entities. Then they would make a second election to treat the “corporation” as an

S corporation for tax purpose.


Accounting periods:

1. Sole proprietorships: the same year-end as the individual proprietor.

2. Partnership: three methods to determine

3. Taxable corporation: any time, the year-end of its owner is not relevant. Elect tax year when

they file their first income tax returns.

4. S corporation: calendar year.

Accounting method:

1. Taxable corporation: accrual method. Exception: may use cash method if its annual average

gross receipts do not exceed 5 million for the three previous tax years.

2. S corporation: accrual or cash. If the firm previously was a C corporation, all prior accounting

methods carry over to the S corporation.

3. Partnership: cash. Exception: accrual if they have a C corporation, tax shelters, and certain tax-

exempt trusts as a member or partner and the partnership reports annual average gross

receipts in excess of 5 million for the three previous years.

If merchandise inventories are necessary to clearly determine income, only the accrual method of

tax reporting can be used for purchases and sales.

FICA and self-employment tax

1. Taxable corporation: employee-shareholder pays 7.65% FICA tax and corporations pay 7.65%

2. S corporation: an income allocation received by employee-shareholders is not subject to FICA or

self-employment tax.

3. Partnership: guaranteed payment is subject to 15.3% self-employment tax. Income allocation

received by general partners is subject to 15.3% self-employment tax. But not the income

allocation received by limited partners.

After-tax earnings distributed by a corporation

Corporate shareholders are subject to double taxation because they pay a second level of tax

(the first level of tax is corporate tax). The second level of tax depends on whether corporations

retain their after-tax earnings and on the type of shareholders

1. Individual shareholders. 15% tax rate on dividends

2. Corporate shareholders. Dividends are not entitled to the reduced dividend tax rate (15%)

available to individual shareholders. Dividends are subject to the corporate shareholder’s

ordinary rates.

3. Institutional shareholders. Pension and retirement funds are some of the largest

institutional shareholders of corporations. They do not pay taxes on dividends. Ultimately,

retirees pay the tax when they receive the distributions from these funds.


4. Tax-exempt and foreign shareholders. Tax-exempt organizations such as churches and

universities are exempt from tax on their investment income. Foreign investors may be

eligible for reduced rates on dividend income depending on the tax treaty with US.

Taxable Corporation

Corporations generally compute their taxable income by starting with their book or financial accounting

income and make adjustments for book-tax differences. (permanent book-tax differences and

temporary book-tax differences)

Each tax-book difference can be considered to be unfavorable or favorable depending on its effect on

taxable income relative to book income. Any book-tax difference that requires an add-back to book

income to compute taxable income is an unfavorable book-tax difference.

Schedule M1 of tax return form provides a reconciliation of income reported per books with income

reported on the tax return. Generally, items of income and deduction whose book and tax treatment

differ, result in schedule M-1 items. However, schedule M-1 reconciles to taxable income before the

DRD and NOL deductions.

Note: cash received in advance of accrual GAAP income is taxed such as interest income, rental

income and royalty income received in advance.

Taxes:

a. All state and local taxes and federal payroll taxes are deductible when incurred on property or

income relating to business.

b. Federal income taxes are not deductible.

c. Foreign income taxes may be used as a credit.

Interest expense:

a. General business interest expense: paid or accrued during the taxable year incurred for

business purposes are deductible.

b. Interest expense on loans for taxable investment: limited to net taxable investment income.

c. Interest expense on loans for tax-free investment: not deductible.

d. Prepaid interest expense: must be allocated to the proper period to which it is related.

1. Common permanent book-tax difference (copy B16-5 EX16-2 )

Federal income tax expense should be added back to book income to compute taxable

income.

Book income

Substract:

Nontaxable income (interest from municipal bonds and death benefits from life insurance

on key employees, the beneficiary muse be company)

Expenses deducted on the tax return but not on the books


Dividends received deduction

Add: (mostly are nondeductible business expensens)

Federal income tax expense

Fines and penalties and political contributions

Premium on life insurance for which corporation is beneficiary

50% of business meals and entertainment

Interest expense on loans to acquire investments generating tax-exempt income

Domestic manufacturing deduction (DMD)

Charitable contribution in excess of 10% limitation

The compensation of CEO and other four highest paid officers in excess of 1 million

2. Common temporary book-tax differences

A. Bad debt

For tax purpose, businesses are allowed to deduct bad debt expense only when the

debt actually becomes worthless within the taxable year (direct write-off method).

For book purpose, allowance method.

B. Depreciation expenses

C. Organizational expenditures and start-up costs

For books purpose: expensed when they are incurred.

For tax purpose: may deduct up to 5000 of organization costs and 5,000 for start-up

costs for the tax year in which the business begins. Each 5,000 is reduced by the amount

by which organization or startup costs exceeds 50,000, respectively. With any remaining

expenditures deducted ratably over the 180-month period beginning with the month

using the straight-line method.

Note: organization costs apply to partnership or corporation, but start-up costs apply to

all types of business forms.

Note: the deduction for organization and start-up costs are calculated separately.

D. Dividends

For tax purpose, the amount (Dividend received – DRD) is included in the corporation’s

ordinary income

For books purpose:

1. If ownership < 20% of distributing corporation, dividend is included in income

2. If 20% of distributing corporation =< ownership<=50% of distributing corporation,

The receiving corporation include the amount (=distributing corporation’s

income*ownership) in the income rather than actual amount of dividend.

3. If ownership > 50% of distributing corporation, consolidated financial statements

are prepared. No any dividend income is recorded.

E. Goodwill acquired in an asset acquisition

For tax purpose, intangibles such as goodwill, licenses, franchises, and trademarks may

be amortized using straight-line basis over a period of 15 years, starting with the month

of acquisition for tax purpose.


For book purpose, firms recover the cost of goodwill only when and only to the extent

goodwill is impaired (FMV of goodwill is less than purchased price of goodwill).

Thus to determine the temporary book-tax difference associated with purchased

goodwill, firms need only compare the amount of goodwill they amortize for tax

purposes with the goodwill impairment expense for book purposes.

3. Corporate-specific deductions and associated book-tax differences

(1) Stock options

(2) Net capital losses

For corporations, all net capital gains (long and short-term) are taxed at ordinary income

rates. Corporations can only deduct capital losses to the extent they recognize capital gains

in a particular year. Corporations carry the capital losses back three years (capital loss

carryback) and forward five years (capital loss carryover) to offset net capital gains in the

three years preceding the current tax year and then to offset net capital gains in the five

years subsequent to the current tax years (carryover must be in an order: three years back

first and five years forward next)

Note: when a corporation has an unused net capital loss that is carried back or carried

forward to another tax year, it is treated as a short-term capital loss whether or not it was

short-term or long-term when sustained.

For book purposes, corporations deduct all net capital losses in the year they sell the

property.

(3) Net operating losses

Firms can carry current year net operating losses back two years and forward 20 years to

offset taxable income and reduce taxes payable ( or already paid) in those years.

(4) Charitable contributions.

Money+ FMV of capital gain property (property that would generate long-term capital gain

if sold) + the adjusted basis of ordinary income property.

Generally, corporations are allowed to deduct charitable contributions at the time they

make payment to charitable organizations. However, corporations using the accrual method

of accounting can deduct contributions in the year before they actually pay the

contribution when (1) the board of directors approves the payment and (2) they actually

pay the contributions within two and one-half months of their tax year. （即在次年 2.15号前支付）

Deductible charitable contributions for the year may not exceed 10% of its charitable

contribution limit modified taxable income. Charitable contribution limit modified taxable

income is taxable income before ducting the following:

A. Any charitable contributions

B. The dividends received deductions

C. NOL carrybacks （carry forward is deductible）

D. The domestic manufacturing deduction (DMD)

E. Capital loss carrybacks （carry forward is deductible）

That is, if modified taxable income=0, then deductible charitable contribution=0


Firms making current year charitable contributions in excess of the 10% modified taxable

limitation may carry forward the excess for up to five years after the year in which the

carryover arises (FIFO order).

(5) Dividends received deductions (R3-22)

When corporations receive dividends from other corporations they are taxed on the

dividends at ordinary tax rate, not the preferential 15% rate available to individual

taxpayers. However, corporations are allowed to deduct a dividends received deduction

(DRD) to mitigate the extent to which corporate earnings are subject to three levels of

taxation.

DRD =dividend amount * deduction percentage.

A. If ownership < 20% of distributing corporation, deduction percentage=70%

B. If 20% of distributing corporation =< ownership<80% of distributing corporation, 80%

C. If ownership > =80% of distributing corporation, 100%

a. DRD is limited to the product of the applicable DRD percentage and DRD modified

taxable income. DRD modified taxable income is the taxable income before deducting

the following:

1. The DRD

2. Any NOL deduction (carryover or carryback)

3. Capital loss carrybacks

4. The DMD

b. However, this limitation does not apply if after deducting the full DRD a corporation

reports a current year net operating loss.

c. Note: to qualify a DRD, the investor corporation must own the investee’s stock for more

than 46 days (90 days for preferred stock) during the 91-day period beginning on the

date 45 days before the ex-dividend date.

d. Note: the DRD does not apply to personal service corporations, personal holding

companies and personally taxed S corporation (Do not take it personally)

e. The amount (Dividend received – DRD) is included in the corporation’s ordinary income.

f. Members of an affiliated group of corporations (80% or more common ownership) may

deduct 100% of the dividends received from a member of the same affiliated group.

(6) Domestic production deduction or domestic manufacturing deduction

Business that manufacture goods are allowed to deduct an artificial business deduction for

tax purposes called DMD or DPD. It is designed to reduce the tax burden on domestic

manufacturers to make investments in domestic manufacturing facilities more attractive.

This deduction is artificial because it does not represent an expenditure per se, but merely

serves to reduce the income taxes the business must pay and thereby increase the after-tax

profitability of domestic manufacturing.

DMD is 6% times the lesser of (1) the business’s taxable income before the deduction (or

modified AGI for individuals) or (2) qualified production activities income (QPAI). QPAI is the

net income from selling or leasing property that was manufactured in the US.


The final deduction cannot exceed 50% of the wages the business paid to employees for

working in qualifying production activities during the year.

Corporate alternative minimum tax

It is designed to require corporations to pay some minimum level of tax even when they have low or no

regular taxable income due to certain tax breaks they gain from the tax code.

Small corporations are exempt from the AMT. For this purpose, small corporations are those with

average annual gross receipts less than 7.5 million for the three years prior to the current tax year.

New corporations are automatically exempt from the AMT in their first year. It is exempt for its second

year if its first year’s gross receipts were 5 million or less. To be exempt for its third year, the average

gross receipts for the first two years must be 7.5 million or less. To be exempt for the fourth year (and

sequent years), average annual gross receipts for all three prior years are below 7.5 million. Once a

corporation fails the AMT gross receipt test, it is no longer exempt from the AMT.

Corporate AMT formula

Taxable income or loss before NOL deduction+ Preference items +/- Adjustment items= Alternative

minimum taxable income (AMTI)

AMTI-Exemption=AMT base

AMT*20%=Tentative minimum tax

1. Preference items

Common preference items include percentage depletion in excess of cost basis and tax-exempt

interest income from a private activity bond (a municipal bond used to fund a nonpublic

activity- if the bond is for a public purpose, the interest is not a preference item). Tax exempt

interest on private activity bonds issued in 2009 or 2010 is not an AMT tax preference item.

2. Adjustments

Adjustment is positive (unfavorable) or negative (favorable)

(1) Depreciation: depreciation is different for regular tax and AMT purpose. For AMT purpose,

assets are not depreciated as quickly as for regular tax.

(2) Gain or loss on disposition of depreciable assets. Depreciation differences for regular tax

and AMT purposes cause differences in the adjusted basis of the assets for regular tax

purposes and AMT purposes.

(3) The installment method cannot be used for sales of inventory-type items: the difference

between full accrual revenue and installment sales revenue.

(4) Income from long-term contracts must be determined using the percentage of completion

method: the difference between completed contract revenue and percentage of completion

revenue.

(5) ACE (adjusted current earnings) adjustment

ACE adjustment= 75% * (ACE- AMTI before the ACE adjustment)

As a practical matter, ACE adjustment= 75% * the sum of the modifications to AMTI


Note: ACE adjustment can be negative or positive, but a negative ACE adjustment is

limited in amount to prior year’s net positive ACE adjustments.

AMTI: alternative minimum taxable income= regular taxable income + preference items +/-

adjustment items

ACE is computed by making certain modifications to their AMTI.

ACE=AMTI

+ Tax-exempt interest income from tax-exempt bond that funds a public activity. If bond

was issued in 2009 or 2010 it is not a modification;

+death benefit from life insurance contracts

+70% DRD (not the 80% or 90% DRD)

+ organizational costs that were expensed during the year

+/- difference between AMT depreciation and ACE depreciation.

+/-difference between AMT and ACE gain or loss on asset disposition

+/- difference between gain reported under the installment method and gain otherwise

reported (installment method not allowed for ACE purposes)

3. AMT exemption

Full exemption: 40,000

Phase out = 25% * (AMTI – 150,000) and completely phase out for AMTI at 310,000

4. Alternative minimum tax

Tentative minimum tax (TMT) = (AMTI – exemption) *20%

If regular tax > TMT, then AMT=0;

Otherwise, AMT = TMT – regular tax.

5. Minimum tax credit

When corporations pay AMT, they generate minimum tax credit that they can carry forward

indefinitely to offset their regular tax liability down to their AMT in years when regular tax

liability > TMT.

Year 1: TMT: 1,183,690; Regular tax liability: 1,000,000

Then in year 1: AMT = 183,690 ---tax credit for future

Year 2: TMT 900,000; Regular tax liability: 1,000,000

Then in year 2: tax liability: 900,000; tax credit carryover= 183,690- (1,000,000-900,000) =83,690

Personal holding company and accumulated earnings tax (W P576)

Corporate tax return due date and estimated tax

1. Tax return due date is two and one-half months after the corporation’s year-end.

2. Corporations can request an extension for six months.

3. Corporations with a federal income tax liability of 500 or more are required to pay their tax

liability for the year in quarterly estimated installments. That, the installments are due on the 15

days of the 4th, 6th,9th, and 12th months of their tax year.


4. Corporations are subject to underpayment penalties if they did not pay in 25%, 50%, 75% and

100% of their required annual payment with their first, second, third and fourth installment

payments, respectively.

5. The required annual payment is the least of：

A. 100% of tax liability on the prior year’s return, but only if there was a positive tax liability

and the prior year return covered a 12-month period.

B. 100% of the current year tax liability

C. 100% of the estimated current year tax liability using the annualized income method.

6. Large corporations defined as corporations with over 1 million of taxable income in any of three

years prior to the current year may use the prior year tax liability to determine their first quarter

estimated tax payments only. And its estimated tax payments must be at least equal to 100% of

current year liability.

Controlled group

A controlled group is a group of corporations that is controlled or owned by the same taxpayer or group

of taxpayers. A controlled group could be parent-subsidiary controlled group, a brother-sister controlled

group or a combined controlled group.

1. Parent-subsidiary: one corporation owns at least 80% of the voting power or stock value of

another corporation on the last day of the year

2. Brother-sister: two or more corporations of which five or fewer persons own more than 50%

(including 50%) of the voting power or stock value of each corporation on the last day of the

year.

3. Combined: three or more corporations, each of which is a member of either a parent-subsidiary

or brother-sister controlled group and one of the corporations is the parent in the parent-

subsidiary controlled group and also is in a brother-sister controlled group.

The controlled group is treated as one corporation for purposes of using the tax rate schedule.

Affiliated group (R3-33)

An affiliated group exists when one common corporation directly owns at least 80% of (1) the total

voting power and (2) the total stock value of another corporation. If each member of the group files a

consent, an affiliated group of corporations may elect to file a consolidated tax return in which the

group files a tax return as if it were one entity for tax purposes.


Corporate distribution (R3-39)

Corporate distribution to shareholder in their capacity as shareholders can be summarized as follows:

1. The portion of the distribution that is a dividend is included in gross income.

2. The portion of the distribution that is not a dividend reduces the shareholder’s tax basis in the

corporation’s stock (that is, it is a nontaxable return of capital)

3. The portion of distribution that is not a dividend and is in excess of the shareholder’s stock tax

basis is treated as capital gain from sale or exchange of the stock (capital gain)

The IRC requires a corporation to keep two separate earnings and profits (E&P) accounts: one for the

current year (current E&P) and one for undistributed E&P accumulated in all prior years (accumulated

E&P)

Adjustment on current E&P

1. Inclusion of income that is excluded from taxable income.

2. Disallowance of certain expenses that are deducted in computing taxable income but do not

require cash flow.

3. Deduction of certain expenses that are excluded from the taxable income but do require cash

outflow.

4. Deferral of deductions or acceleration of income due to separate accounting methods required

for E&P purposes.

Whether a distribution is characterized as a dividend depends on whether the balances in the two

accounts are positive or negative.

1. Positive current E&P, positive accumulated E&P

Distributions are deemed to be paid out of current E&P first. If distributions exceed current E&P,

the amount distributed out of current E&P is allocated pro rata to all of the distributions made

during the year. Any distribution out of accumulated E&P is allocated to the recipients in the

chronological order in which the distributions were made.

Eg. Assume SCR reported current E&P of 40,000 in 2009. The balance in accumulated E&P was

15,000. On Dec 31, 2009, SCR distributed 45,000 to Jim and 15,000 to Ginny.

The distribution is first deemed to be paid from current E&P (30,000 to Jim and 10,000 to Ginny)

30,000=(45,000/(45,000+15,000))*40,000

Because Jim’s distribution took place before Ginny’s distribution, the accumulated E&P is

allocated to Jim first (15,000). Ginny is allocated only 10,000 of E&P, leaving her with an excess

distribution of 5,000 (15,000-10,000).

The amount paid from current and accumulated E&P is considered as taxable dividend.

The excess distribution is treated as a nontaxable reduction of her basis in the SCR stock.

A. Distribution within total E&P is treated as taxable dividend.


B. Distribution over total E&P is treated as nontaxable reduction of basis in the corporation’s

stock.

2. Positive current E&P, negative accumulated E&P

Distributions deemed paid out of current E&P are taxable as dividends. Distributions in excess of

current E&P would first be treated as nontaxable reduction of basis in the corporation’s stock.

Any excess over their stock basis is treated as capital gain from sale or exchange of the stock

(capital gain)

3. Negative current E&P, positive accumulated E&P

Prorate the negative current E&P to the distribution date and add it to accumulated E&P at the

beginning of the year to determine total E&P at the distribution date. Distributions in excess of

total E&P would first be treated as nontaxable reduction of basis in the corporation’s stock. Any

excess over their stock basis is treated as capital gain from sale or exchange of the stock (capital

gain)

Eg. Assume SCR reported negative 20,000 E&P in 2009. The balance in accumulated E&P at the

beginning of the year was 60,000. On June 30, 2009, SCR distributed 48,000 to Jim and 16,000 to

Ginny. Jim has a tax basis of 24,000 and Ginny’s tax basis is 10,000.

SCR prorates its full year negative current E&P to June 30, (6 months/12

months*20,000=10,000). The negative 10,000 is added to the beginning balance of 60,000 to

get total E&P as of July 1 of 50,000.

To Jim: 50,000* (48000/48000+16,000)=37,500

To Ginny: 50,000*0.25=12,500

Adjusted tax basis of Jim: 24,000-10,500=13,500

Adjusted tax basis of Ginny: 10,000-3,500=6,500

4. Negative current E&P, negative accumulated E&P

In this case, none of the distribution is treated as a dividend. Distributions would first be treated

as nontaxable reduction of basis in the corporation’s stock. Any excess over their stock basis is

treated as capital gain from sale or exchange of the stock (capital gain)

Note: any distribution should not increase the negative balance of E&P. That is, distribution is

not out of E&P account when the account balance is negative. (Check W P594 question 83)

Distributions of noncash property to shareholders

For shareholder:

1. Distribution=cash received + FMV of property received – liabilities assumed by shareholder on

property received

2. Taxable distribution to the extent that it is paid out of current and accumulated E&P. Check W

P595 question 85 and 89.

3. A shareholder’s tax basis in noncash property received as a dividend=the property’s FMV

For corporation:


1. Distribution of property to shareholders reduces E&P by the greater of the tax basis or FMV.

2. Recognized gains on property=FMV- tax basis if the FMV of property > basis. However, no

deductible loss is recognized if FMV < basis.

However, if the FMV < the liability assumed, then the gain= liability assumed – tax basis

3. The effect of distribution on E&P=gain recognized–step1 outcome+ liability assumed.

Eg. Assume Jim received a parcel of the land as dividend. The FMV of the land is 60,000 and a remaining

mortgage is 75,000. SCR has a tax basis in the land of 20,000.

Jim should recognize (75,000-20,000) capital gain.

Constructive dividends (B18-14)

1. If a corporation sells property to a shareholder for less than FMV, the shareholder is considered

to have received a constructive dividend (taxable) = FMV – priced paid.

2.

Stock dividend

Family attribution: individuals are treated as owning the shares of stock owned by their spouse, children,

grandchildren, and parents. Stock owned constructively through the family attribution rule cannot be

reattributed to another family member through the family attribution rule.


Corporation formation, reorganization and liquidation

Tax consequences to the shareholders

Gain or loss from property exchange not recognized when realized falls into one of two categories: (1)

the gain or loss is excluded from gross income (that is, the gain or loss will never be recognized) or (2)

the gain or loss is deferred from inclusion in gross income (that is, recognition is postponed to a future

period). Incorporations involving transfers of property to a corporation are transactions in which gain or

loss realized may be deferred if certain tax law requirements are met.

Gain or loss deferred in the transfer of property to a corporation in return for stock is reflected in the

shareholder’s tax basis in the stock received in exchange for the property transferred. In essence, the

shareholder’s tax basis in the stock received = the tax basis of property transferred.

Section 351 transaction

For shareholders to receive tax deferral in a transfer of property to a corporation, the transferors must

meet the requirements of IRC 351. The deferral of gain or loss in a 351 transaction is mandatory if the

requirements are met. Section 351 applies to transfers of property to both C corporations and S

corporations.

The requirement of IRC 351:

One or more shareholders transfer property to a corporation in return for stock, and immediately after

the transfer, these same shareholders, in the aggregate, control the corporation to which they

transferred the property.

1. Shareholder: including individuals, corporations, partnerships, and fiduciaries (estates and

trusts).

2. Property: includes money, tangible assets, and intangible assets. Services are excluded from the

definition of property. That is, everything other than services.

3. The transferor cannot receive something other than qualifying stock from the corporation in

return for the property transferred. This “something” often is referred to as boot.

4. Stock for purposes of 351 does not include stock warrants, rights, or options.

5. Control: 80% or more ownership of the total combined voting power of all voting stock that is

issued and outstanding, and 80% or more of the total number of shares of each class of

nonvoting stock. Whether the control test is met is based on the collective ownership of the

shareholders transferring property to the corporation immediately after the transfer. (that is,

the shareholder providing service is not counted)

If a shareholder receives stock in return for property and services in a 351 exchange, all of the stock

received is included in the control test provided the FMV of the property transferred is not of relatively

small value in comparison to the value of the stock received in return for services. The IRS has stated


that for ruling purposes, property will not be of relatively small value if it equals at least 10% of the

value of the services provided.

Tax basis of stock

(1) The tax basis of stock received in a tax-deferred 351 exchange =the tax basis of the property

transferred.

Tax basis of stock= tax basis of property contributed – liabilities assumed by the corporation on

property contributed.

(2) The tax basis of stock received in an exchange that does not meet the 351 requirement,

Tax basis of stock= FMV of the stock received

When shareholders provide services to exchange stocks

To shareholder:

1. Recognized gain= FMV of stock received

2. Tax basis on stock=FMV of stock received

Tax consequences when a shareholder receives boot

Shareholder:

1. Recognized gain= lesser of (1) gain realized (=FMV-tax basis) or (2) the FMV of the boot received.

2. If there are more than one boot, allocating the boot received pro rata to each property using the

relative FMVs of the properties.

3. The character of gain recognized is determined by the type of property to which the boot is

allocated.

4. Tax basis of boot = FMV

5. Shareholders’ tax basis of stock= tax basis of property contributed + gain recognized on the

transfer –FMV of boot received – liabilities assumed by the corporation on property contributed

If the corporate assumes shareholders’ liability attached to the property transferred:

General rule: the debt is not treated as boot. Exceptions:

1. If any of the liabilities assumed by the firm are assumed with the purpose of avoiding the federal

income tax or if there is no corporate business purpose for the assumption, then the liability is

treated as boot.

2. If the liabilities assumed > aggregate tax basis of the properties transferred, recognized

gain=liabilities assume – aggregate tax basis of the properties transferred.

Tax consequences to the transferee corporation

A corporation will never recognize gain or loss on the receipt of money or other property in exchange

for its stock, including treasury stock.


1. The corporation receiving property in exchange for its stock in a 351 transaction:

No gain or loss recognized on the transfer.

The tax basis of property received by the corporation= the property’s tax basis in the

transferor’s hands.

In this case, the holding period of 1231 property or a capital asset also carries over to the firm.

2. If the shareholder recognizes gain as result of the property transfer:

The tax basis of property received by the corporation= tax basis of property contributed by the

shareholder+ gain recognized on the transfer by the shareholder.

Exception: if the aggregate adjusted tax basis of property transferred > aggregate FMV, the aggregate

tax basis in the hands of corporation cannot exceed aggregate FMV. Then:

1. Adjustment by the corporation: the aggregate reduction in tax basis is allocated among the

assets transferred in proportion to their respective built-in losses immediately before the

transfer.

2. Or adjustment by the shareholder: tax basis of stock = aggregate FMV

Section 1244 stock

Normally, stock is a capital asset for shareholder and gains or losses from sale of stocks are capital. For

individuals, long-term capital gains are taxed at a maximum 15%. Losses can offset capital gains plus

3,000 of ordinary income per year. Section 1244 allows a shareholder to treat a loss on the sale or

exchange of stock as an ordinary loss up to 50,000 per year (100,000 for married filing jointly).

Requirements:

1. The shareholder must be individual or partnership shareholder and the original recipients of the

stock.

2. The issuing corporation must be a small business corporation when the stock is issued.

A small business corporation: the aggregate amount of money and other property received in

return for the stock or as a contribution to capital did not exceed 1 million.

3. For the five taxable years preceding the year in which the stock was sold, the corporation must

have derived more than 50% of its aggregate gross receipts from an active trade or business.

4. The stock must be issued for money or property (other than stock and securities)

5. The issuer must be a domestic corporation

Note: When the property contributed to the firm, if the FMV < tax basis, then the ordinary loss is limited

to (exchange price- FMV)


Stock redemption

Stock is redeemed when a corporation acquires its own stock from a shareholder in exchange for

property, regardless of redeemed stock being canceled, retired, or held as treasury stock.

For shareholder, treat stock redemption either as a dividend distribution or as a sale of the stock

redeemed.

If any of the following conditions are met, the exchange is treated as a sale, and the gains or losses are

capital gains and losses. Otherwise, the redemption proceeds are treated as an ordinary distribution,

taxable as dividend to the extent of the distributing corporation’s earnings and profits.

1. The redemption is not essentially equivalent to a dividend;

2. The redemption is substantially disproportionate;

Meet stock ownership tests:

a. Immediately after the exchange, the shareholder’ ownership < 50% of the total combined

voting power of all classes of stock entitled to vote

b. The shareholder’ ownership of voting stock after redemption < 80% of his ownership before

the redemption.

c. The shareholder’ ownership of the aggregate FMV of common stock (including both voting

and nonvoting) after the redemption < 80% of his ownership before the redemption.

3. The distribution is in complete redemption of all of a shareholder’s stock;

4. The distribution is to a non-corporate shareholder in partial liquidation.

5. The distribution is received by an estate.

For corporation, recognize gain or loss as if the sale of stocks.

Note: no deduction is allowed for any amount paid or incurred by a corporation in connection with the

redemption of its stock, except for interest expenses on loans to repurchase stock.

Corporation liquidation

A complete liquidation occurs when a corporation acquires all the stocks from all of its shareholders in

exchange for all of its net assets after which time the corporation ceases to do business.

For shareholders

1. Capital gain/loss= FMV of property received- debt assumed – tax basis in stock

2. Tax basis of property received =FMV

For corporation:


1. Gain/loss= FMV of property distributed – tax basis in the property

2. Exception: the firm does not recognize loss if the property is distributed to a related party and

either (1) the distribution is non-pro rata, or (2) the asset distributed is disqualified property.

3. Related party: a shareholder who owns more than 50% of firms’ stock.

4. Disqualified property: property acquired within 5 years of the date of distribution in a tax

deferred 351 transaction or as a nontaxable contribution to capital.

Generally, a corporation will recognize gain or loss on the distribution of its property in complete

liquidation just as if the property were sold to the distributee for its FMV.

Exception: when a parent corporation completely liquidates its 80% or more owned subsidiary, the

liquidation is treated as a mere change in form and the parent corporation will not recognize any gain or

loss on the receipt of liquidating distributions from its subsidiary. Similarly, the subsidiary corporation

will not recognize any gain or loss on distributions to its parent corporation. As a result, there will be a

carryover basis for all of the subsidiary’s assets that are received by the parent-corporation, as well as

carryover of all of the subsidiary’s tax attributes to the parent corporation. The subsidiary’s tax

attributes that carryover to the parent include such items as earnings and profits, capital loss carryovers,

accounting methods, and tax credit carryovers, as well as unused excess charitable contributions, and

net operating loss.

Note: the general expenses incurred in the complete liquidation and dissolution of a corporation are

deductible by the corporation as ordinary and necessary business expenses. These expenses include

filing fees, professional fees, and other expenditures incurred in connection with the liquidation and

dissolution.


Chap 5 S corporation

Requirements:

1. Domestic corporations.

2. Have only one class of stock.

3. Only U.S. citizens or residents, certain trusts, and certain tax-exempt organizations may be

shareholders, no corporations and partnerships.

4. 100 shareholders or less

S corporation election

An eligible corporation must make an affirmative election to be treated as an S corporation.

1. To formally elect S corporation status effective as of the beginning of the current tax year, the

corporation uses Form 2553, either in the prior tax year or within the first two and half months

after the beginning of the current tax year.

2. Exception: when the corporation makes the election within the first two and half months after

the beginning of the current tax year, the election will not be effective until the subsequent year

if (1) the corporation did not meet the S corporation requirements for each day of the current

tax year before it made the S election; or (2) one or more shareholders who held the stock in the

corporation during the current year and before the S corporation election was made did not

consent to the election. (even if the shareholder sold his stock in the current year,只要他曾经拥有)

3. Elections after the first two and half months after the beginning of the year are effective at the

beginning of the following year.

4. All shareholders on the date of the election must consent to the election.

Note: NOL losses for C corporations can’t be carried over to the S corporation.

Once the S election becomes effective, the corporation remains an S corporation until the election is

terminated. The termination may be voluntary or involuntary.

Voluntary terminations

The corporation can make a voluntary revocation of the S corporation if shareholders holding more than

50% of the S corporation stock agree (including nonvoting shares). Voluntary revocations made during

the first two and one-half months of the year are effective as of the beginning of the year. A revocation

after this period is effective the first day of the following tax year. Alternatively, a corporation may

specify the termination date as long as the date specified is on or after the date the revocation is made.

Involuntary terminations


Involuntary terminations can result from failure to meet requirements or from an excess of passive

investment income.

1. Failure to meet requirements. A corporation’s S selection is automatically terminated if the

corporation fails to meet the requirements. The termination is effective on the date it fails the

S corporation requirement. If the IRS deems the termination inadvertent, it may allow the

corporation to continue to be treated as an S corporation if, within a reasonable period after the

inadvertent termination, the corporation takes the necessary steps to meet the S corporation

requirements (即刻生效).

2. Excess of passive investment income. (1) If an S corporation has earnings and profits from a

previous C corporation year (or through a reorganization with a corporation that has earnings

and profits), and (2) if the S corporation has passive investment income in excess of 25% of

gross receipts for three consecutive years. If the S corporation never operated as a C

corporation or does not have C corporation earnings and profits, this provision does not apply.

Passive investment income includes royalties, rents, dividends, interest, and annuities. S

corporation election terminations due to excess passive investment income are effective on the

first day of the year following the third consecutive tax year with excess passive investment

income (不不不不是是是是即即即即刻刻刻刻生生生生效效效效).

Short tax years

S corporation election terminations frequently create an S corporation short tax year (a reporting

year less than 12 months) and a C corporation short tax year. The corporation must then allocate its

income for the full year between the S and C corporation years using the number of days in each

short year (daily method). Or it may use the corporation’s normal accounting rules to allocate

income to the actual period in which it was earned (the specific identification method).

Eg. Suppose CCS was formed as a calendar-year S corporation with Nicole Johnson, Sarah Walker,

and Change Armstrong as equal shareholders. On June 15, 2009, Chance sold his CCS shares to his

solely owned C corporation, Chanzz Inc. terminating CCS’s S election on June 15, 2009. Assume CCS

reported business income for 2009 as follows:

Jan 1 through June 14 (165 days) 100,000

June 15 through Dec 31 (200 days) 265,000

Jan 1 through Dec 31 (365 days) 365,000

Daily method: S corporation short tax year=365,000/365*165

Specific identification: S corporation: 100,000; C corporation : 265,000

S corporation reelections

After terminating or voluntarily revoking S corporation status, the corporation may elect it again,

but it generally must wait until the beginning of the fifth tax year after the tax year in which it

terminated the election.


S corporation must allocate profits and losses pro rata, based on the number of outstanding shares

each shareholder owns on each day of the tax year.

An S corporation generally allocates income or loss items to shareholders on the last day of its tax

year.

Income and loss allocations

S corporation must allocate profits and losses pro rata, based on the number of outstanding shares

each shareholder owns on each day of the tax year (that is, per share, per day basis). An S

corporation generally allocates income or loss items to shareholders on the last day of its tax year.

If a shareholder sells her shares during the year, she will report her share of S corporation income

loss allocated to the days she owned the stock using a pro rata allocation.

S corporations are required to file tax returns (Form 1120 S) annually. In addition, they supply

information to each shareholder detailing the amount and character of items of income and loss

flowing through the S corporation. Shareholders must report these income and loss items on their

tax returns even if they do not receive cash distributions during the year.

S corporations determine each shareholder’s share of ordinary business income and separately

stated items. Like partnership, ordinary business income (loss) is all income (loss) exclusive of any

separately stated items of income (loss). Separately stated items are tax items that are treated

differently from a shareholder’s share of ordinary business income for tax purposes. The list of

common separately stated items for S corporations is similar to that for partnerships, with a couple

of exceptions. Lists of common separately stated items:

1. Short-term capital gains and losses

2. Long-term capital gains and losses

3. Section 1231 gains and losses

4. Dividends (S corporation are not entitled to claim the DRD)

5. Interest income

6. Charitable contributions

7. Tax-exempt income

8. Net rental real estate income

9. Investment interest expense

10. Section 179 deduction

Shareholder’s basis (same as C corporations& Section 351 also applies)

Tax basis in stock received = tax basis of property transferred – liabilities relief + gain recognized- FMV of

boot received

Purchased from other shareholder: tax basis in stock received = purchase price

Annual basis adjustment


The basis must be adjusted in the order listed:

6. Increase for any contributions to the S corporation during the year.

7. Increase for shareholder’s share of ordinary business income and separately stated income/gain

items

8. Decrease for distributions during the year.

9. Decrease for shareholders’ share of nondeductible expenses (fines, penalties, etc)

10. Decrease for partner’s share of ordinary business loss and separately stated expense/loss items.

Basis adjustments that decrease basis may never reduce a partner’s tax basis below 0.

Different from partnerships, S corporation shareholders are not allowed to include any S

corporation debt in their stock basis.

Loss limitation (similar to partnerships)

Ordinary losses are deductible against any type of taxable income. However, they are deductible only

when they clear three separate hurdles:

4. Tax basis limitation

Any losses allocated in excess of their basis must be suspended and carried forward indefinitely

until they have sufficient basis to utilize the losses

Shareholders can mitigate the disadvantage of not including S corporation debt in their stock

basis-by loaning money directly to their S corporation. These loans creates debt basis. If the

total amount of items (besides distributions) that decrease the shareholders’ basis for the year >

stock basis, the excess amount decreases the debt basis. Like stock basis, debt basis cannot be

decreased below 0. In subsequent years, any net increase in basis for the year first restores the

debt basis (up to the outstanding debt amount) and then the stock basis. If the S corporation

repays the debt before the debt basis is restored, recognize gain= repayment amount- debt

basis.

5. At-risk limitation (applies to S corporation shareholders rather than at the corporate level)

At risk amount= cash contributed + tax basis of property contributed + direct loan made to S

corporation

6. Passive activity loss limitation

Limit the S corporation shareholders to deduct losses unless they are involved in actively

managing the business.

Self-employment income (different from partnerships)

S corporation shareholders’ allocable share of ordinary business income (loss) is not classified as self-

employment income for tax purposes, even when the shareholder actively works for the S corporation.

Fringe benefits


1. Shareholder- employees who own 2% or less of the entity, the S corporation receives C

corporation tax treatment. That is, it gets a tax deduction for qualifying fringe benefits, and the

benefits are nontaxable to all employees.

2. Shareholder- employees who own more than 2% of the entity, the S corporation receives

partnership tax treatment. That is, these benefits are deductible as compensation by the S

corporation, and included in the shareholder-employees’ gross income in Form W-2.

Operating distributions

1. S corporation with no C corporation accumulated earnings and profits

The rules are very similar to those applicable to partners. That is, shareholder distributions are

tax-free to the extent of the stock basis (determined after increasing the stock basis for income

allocations for the year). If a distribution > tax basis, recognize capital gain=distribution- tax

basis.

2. S corporation with C corporation accumulated earnings and profits

The S corporation is required to maintain an accumulated adjustments accounts (AAA), which

represents the cumulative income or losses for the period the corporation has been an S

corporation.

The beginning year of AA balance

+ Separately stated income/gain items (excluding tax-exempt income)

+ Ordinary income

- Separately stated losses and deductions

- Ordinary losses

- Nondeductible expenses that are not capital expenditures (except deductions related to tax-

exempt income)

- Distributions out of AAA

= End of year AAA balance

AAA may have negative balance, but distributions cannot cause the AAA to go negative or

become more negative. That is, if the adjustment on AAA is due to distribution, then maximum

decrease AAA to 0.

S corporation distributions are deemed to be paid from the following sources in the order listed:

1. The AAA account (to the extent it has a positive balance)

Distribution from AAA is nontaxable to the extent of the stock basis, and they create capital

gains if they > stock basis.

2. Existing accumulated earnings and profits from years when the corporation is C.


Distribution from this source is taxable as dividend to shareholders.

3. The shareholders’ stock basis

Distribution from this source is nontaxable to the extent of the stock basis, and they create

capital gains if they > stock basis.

Property distributions

S corporation: if appreciated property, recognized gain= FMV-tax basis. If FMV < tax basis, no loss is

recognized.

Shareholders:

1. Distribution= FMV – debt assumed.

2. Increase the stock basis by the share of recognized gain by S corporation.

3. Tax basis in property= FMV

S corporation tax

Although S corporations are flow-through entities generally not subject to tax, three potential taxes

apply to S corporations that previously operated as C corporations.

1. Built-in gain tax (taxed at 35%)

It only applies to S corporation that (1) has a net unrealized built-in gain at the time it converts

from a C corporation and (2) subsequently recognize net built-in gains during its first 10 years

operating as an S corporation (first 7 years for assets sales in 2009 and 2010)- built-in gain tax

recognition period.

Net unrealized built-in gain= FMV of all assets – tax basis of all assets on the conversion date

Recognized built-in gains for an S corporation year include:

(1) The gain for any asset sold during the year (limited to the assets at the conversion date)

(2) Any income received during the current year attributable to pre-S corporation years

Recognized built-in losses for an S corporation year include:

(3) The loss for any asset sold during the year (limited to the assets at the conversion date)

(4) Any deduction during the current year attributable to pre-S corporation years

The net recognized built-in gains for any year are limited to the least of:

(1) The recognized built-in gain – losses-NOL or capital loss carryovers from C corporation eyars.

(2) The net unrealized built-in gains – net recognized built-in gains previous years

(3) Taxable income for the year using the C corporation tax rules exclusive of the DRD and NOL

deduction.

If taxable income limits the net recognized built-in gain for any year, the excess is treated as a

recognized built-in gain the next tax year.

2. Excess net passive income tax (35%)


It only applies to the S corporation which has accumulated earnings and profits from a prior C

corporation year.

Gross receipts are the total amount of revenues including passive investment income and

capital gains and losses.

Net passive investment income=passive investment income – any expenses connected with

producing that income.

Excess net passive income tax is limited to taxable income computed as if the corporation were

a C corporation.

3. LIFO recapture tax (taxed at C corporation’s marginal tax rate)

C corporations that elect S corporation status and use the LIFO inventory method are subject to

the LIFO recapture tax. The C corporation must include the LIFO recapture amount in its gross

income in the last year it operates as a C corporation. The amount =inventory basis computed

using the FIFO method – inventory basis computed using the LIFO method at the end of the

corporation’s last tax year as a C corporation. At the same time, increase the adjusted basis in

inventory.

The corporation pays the LIFO recapture tax in four annual installments. The first installment is

due on or before the due date (not including extensions) of the corporation’s last C corporation

tax return. The final three annual installments are due each year on or before the due date of

the S corporation’s tax return.

Estimated tax

S corporations with a federal income tax liability of 500 or more due to the built-in gains tax or

excess net passive income tax must estimate their tax liability for the year and pay it in four

quarterly estimated installments. However, an S corporation is not required to make estimated

tax payments for the LIFO recapture tax.

Depreciation

Businesses calculate their tax depreciation using the Modified Accelerated Cost Recovery System

(MACRS). To compute MACRS depreciation for an asset, the business need only know the asset’s original

cost, the applicable depreciation method, the asset’s recovery period, and the applicable depreciation

convention (the amount of depreciation deductible in the year of acquisition and the year of disposition).


The method, recovery, period, and convention vary based on whether the asset is personal property

or real property.

Note: Under MACRS, salvage value is completely ignored for purposes of computing depreciation.

Personal property depreciation

Personal property includes all tangible property, such as computers, automobiles, furniture, machinery,

and equipment, other than real property (building and land). Personal property and personal-use

property are not the same thing. Personal property denotes any property that is not real property while

personal-use property is any property used for personal purposes.

Depreciation method

MACRS provides three acceptable methods for depreciating personal property: 200% declining balance,

150% declining balance and straight-line. The 200% declining balance method is the default method.

This method takes twice the straight-line amount of depreciation in the first year, and continues to take

twice the straight-line percentage on the asset’s declining basis until switching to the straight-line

method in the year that the straight-line method over the remaining life provides a greater

depreciation expense.

Business elects the depreciation method for the assets placed in service during that year. If a business

acquires several different machines during the year, it must use the same method to depreciate all of

the machines.

Depreciation recovery period

For tax purposes, recovery period is predetermined by the IRS and based on the category of the assets.

When firms purchase used assets, the fact that the assets are used does not change its MACRS recovery

period.

200% declining method

3 year recovery period:

5 year recovery period: automobiles/light trucks/computers/typewriters/copiers, duplicating equipment.

7 year: office furniture and fixtures, equipment and property, railroad track.

10 years

150% declining method

15 years: telephone distribution plants.

20 years: sewer pipes.

Depreciation conventions

For personal property, taxpayers must use either the half-year convention or the mid-quarter

convention.


Half-year convention

It allows one-half of a full year’s depreciation in the year the asset is placed in service, regardless of

when it was actually placed in service.

Mid-quarter convention

Business treats assets as though they were placed in service during the middle of the quarter in which

the business actually placed the assets into service.

Business must use the mid-quarter convention when more than 40% of their total tangible personal

property that they place in service during the year is placed in service during the fourth quarter.

Step 1: sum the total basis of the tangible personal property that was placed in service during the year.

Step 2: sum the total basis of the tangible personal property that was placed in service in the fourth

quarter.

Step 3: divide the outcome of step2 by the outcome of step1. If the quotient is greater than 40%, the

business must use the mid-quarter convention to determine the depreciation for all personal property

the business places in service during the year. Otherwise, the business uses the half-year convention for

depreciating all property.

Calculate depreciation for personal property

Once a business has identified the applicable method, recovery period, and convention for personal

property, tax depreciation is calculated using the depreciation percentage table provided IRS.

The depreciation expense for a particular asset is the product of the percentage from the table and the

asset’s original basis.

Half-year convention for year of disposition

Step1: calculate depreciation for the entire year as if the property had not been disposed of. That is, the

product of the percentage from the table and the asset’s original basis.

Step2: multiply the full year deprecation (outcome from step1) by 50%.

Note: if a business acquires and disposes of an asset in the same year, it is not allowed to claim any

depreciation on the asset.

Mid-quarter convention for year of disposition

Step1: calculate depreciation for the entire year as if the property had not been disposed of. That is, the

product of the percentage from the table and the asset’s original basis.

Step2: multiply the full year deprecation (outcome from step1) by the applicable percentage provided

by IRS. The percentage is determined by the quarter of which the asset is actually sold.


Immediate expense (179 expense)

It is designed to help small businesses purchasing new or used tangible personal property. Under 179,

businesses may elect to immediately expenses up to 250,000 of tangible personal property placed in

service during 2009 (also 250,000 in 2008). They may also elect to deduct less than the maximum. To

reflect his immediate depreciation expense, they must reduce the basis of the asset or assets to which

they applied the expense before they compute the MACRS depreciation expense on the remaining bases

of these assets.

Requirement: to qualify, the property must be acquired by purchase from an unrelated party for use in

the taxpayer’s active trade or business.

Machinery 260,000

179 expense 80,000

Remaining basis in machinery 180,000

MACRS depreciation rate for 7-year machinery 14.29%

MACRS depreciation expense 25,722

Total depreciation 105,722

Limits on immediate expensing

1. Under the phase-out limitation, businesses must reduce the 250,000 maximum available

expense dollar for dollar for the amount of tangible personal property purchased and placed in

service during 2009 over an 800,000 threshold.

2. Deductible 179 expense is limited to the business’s net income after deducting all expenses

except the 179 expense. If a business claims more 179 expense than it is allowed to deduct due

to the taxable income limitation, it carries the excess forward and deducts in a subsequent year.

Eg. Property placed in service in 2009 920,000

Threshold for 179 phase-out (800,000)

Phase-out of maximum 179 expense 120,000

Maximum 179 expense before phase-out 250,000

Phase-out of maximum 179 expense 120,000

Maximum 179 expense after phase out 130,000

Bonus depreciation

To stimulate the economy, policy makers occasionally implement bonus depreciation. In 2008 and 2009,

taxpayers can elect to immediately expense 50% of qualified property. Qualified property must have a

recovery period of 20 years or less (no real property), the property must be new rather than used and

the property must be placed in service during 2008 and 2009. The bonus depreciation is calculated

after the 179 expense but before MACRS depreciation.

Qualified property 285,000


179 expense 250,000

Remaining amount eligible for bonus depreciation 35,000

Bonus depreciation rate 50%

Bonus depreciation 17,500

Real property

Real property is classified as land, residential rental property, or nonresidential property. Land is non-

depreciable.

Residential rental property consists of dwelling units such as houses, condominiums, and apartment

complexes.

Nonresidential property consists of all other buildings (office buildings, manufacturing facilities,

shopping malls, and the like). If a building is substantially improved at some point after the initial

purchase, the building addition is treated as a new asset with the same recovery period of the original

building.

Recovery period:

Residential rental property 27.5years

Nonresidential property placed in service after Dec 31, 1986 and before May 13, 1993 31.5years

Nonresidential property placed in service on or after May 13, 1993 39years

Applicable method: straight line method

Applicable convention: mid-month convention. It allows the owner of real property to expense one half

of a month’s depreciation for the month in which the property was placed in service regardless of

whether the asset was placed in service at the beginning or at the end of the month. Full depreciation is

for the months following the purchase month.

IRS also provides depreciation tables for real property.

Mid-month depreciation for year of disposition= Full year’s depreciation * (month in which asset is

disposed of -0.5)/12

If it is sold in March

Amortization

Section 197 intangibles

1. It occurs when a business purchases the assets of another business for a single purchase price.

These intangible assets have a recovery period of 180 months regardless of their actual life.


2. Full-month convention applies to both the purchase month and in the month of sale or

disposition.

3. If, at the time of sale or disposal, the business does not hold any other 197 assets that the

business acquired in the same initial transaction as the asset being sold or disposed of, the

business may recognize a loss on the sale or disposition. Otherwise, the taxpayer may not

deduct the loss on the sale or disposition until the business sells or disposes of all of the other

197 intangibles that it purchased in the same initial transaction. The same loss disallowance rule

applies if a 197 asset expires before it is fully amortized. In either case, the loss is allocated to

the remaining 197 assets that were initially acquired in the same transaction pro rata, based on

the relative adjusted bases of the remaining 197 assets. The new basis allocated to each

remaining 197 assets is amortized over the remaining years of the initial 15-year recovery period.

That is, new basis = remaining basis + allocated loss.

Organizational expenditures and start-up costs (see the partnership section)

Research and development expenses

1. For capitalized R&D, amortize them using the straight-line method over a period of not less than

60 months, beginning in the month benefits are first derived from the research.

2. Firms must stop amortizing the R&D costs if and when the firms receive a patent relating to the

costs. Instead, firms add any remaining basis in the costs to the basis of the patent and it

amortizes the basis of the patent over the patents’ life.

Patents and copyrights

1. For purchased patents and copyrights (not in an asset acquisition to which 197 applies),

amortize the cost over the remaining life.

2. For self-created patents and copyrights, amortize the cost over the legal lives – up to a

maximum of 17 years for patents and 28 years for copyrights. The cost includes legal costs, fees,

and unamortized R&D expenses related.

Depletion

Business computes annual depletion expense under both the cost and percentage depletion method

and they deduct the larger of the two.

Cost depletion

Because the cost depletion method of depreciation requires business to estimate the number of units of

the resource they will actually extract, it is possible that their estimate will prove to be inaccurate.

1. If they underestimate the number of units, they will fully deplete the cost basis of the resource

before they have fully extracted the resource. Once they have recovered the entire cost basis of

the resource, businesses are not allowed to use cot depletion to determine depletion expense.

However, they may continue to use percentage depletion.


2. If a business overestimates the number of units to be extracted, it will still have basis remaining

after the resources has been fully extracted. In this case, the business would deduct the

unrecovered basis once it had sold all the remaining units.

Percentage depletion

It is determined by multiplying the gross income from the resource extraction activity by a fixed

percentage based on the type of natural resource prepared by IRS.

Businesses deduct percentage depletion when they sell the natural resource and they deduct cost

depletion in the year they produce or extract the natural resource. Also percentage depletion cannot

exceed 50% of the net income from the natural resource business activity before the depletion expense,

while cost depletion has so such limitation.


FICA taxes

FICA (Federal Insurance Contributions Act) tax consists of a Social Security and a Medicare component

that are payable by both employees and employers. The Social Security tax (12.4%) is intended to

provide basic pension coverage for the retired and disabled. The Medicare tax (2.9%) helps pay medical

costs for qualifying individuals. FICA tax is equally shared by employees and employers. However, self-

employed taxpayers must pay the entire FICA tax burden on their self-employment earnings. FICA taxes

on employees’ salary, wages, and other compensation provided to them by their employers.

The wage base on which employees pay Social Security taxes is limited to an annually determined

amount (106,800 in 2009). However, there is no wage base limit for the Medicare tax.

Self-employment taxes

1. Compute the amount of the taxpayer’s net income from self-employment activities.

2. Multiply the amount from step 1 by 92.35 (one-half of self-employment tax is deductible). The

product is called net earnings from self-employment.

3. If the taxpayers’ net earnings from self-employment are less than 400, the taxpayer is not

required to pay any self-employment tax. If the taxpayers’ net earnings from self-employment

are less than 106,800, then multiply the amount from step by 15.3 percent. If the taxpayers’ net

earnings from self-employment are less than 400 is more than 106,800, calculate Social Security

tax and Medicare tax separately.

Self-employment taxes (if taxpayer receives both employee compensation & self-employment earnings)

1. Determined the limit on the Social Security portion of the self-employment tax base by

subtracting the employee compensation from the Social Security wage base (106,800 in 2009).

(not <0)

2. Determine the net earnings from self-employment (self-employment * 92.35%)

3. Multiply the lesser of step 1 and step by 12.4%. This is the amount of Social Security taxes due

on the self-employment income.

4. Multiply step 2 by 2.9%. This is the amount of Medicare taxes due on the self-employment

income.

5. Add the amounts from step 3 and 4 to calculate the self-employment taxes.


4.

Retirement (B13-12)

Qualified retirement plan can be classified as:

1. Defined benefit plans: provides standard retirement benefits to employees based on a fixed

formula. The formula is a function of years of service and employees’ compensation levels as

they near retirement. For employees who retire in 2009, the maximum annual benefit an

employee can receive is the lesser of (1) 100 percent of the average of the employee’s three

highest years of compensation or (2) 195,000.

When an employee works for an employer for only a short time before leaving, her benefit

depends on her salary, the number of full years she worked, and the employer’s vesting

schedule. A taxpayer vests as she meets certain requirement set forth by the employer.

Vesting is the process of becoming legally entitled to a certain right or property.

Under the cliff vesting option, after a certain period of time, benefits vest all at once.

With a graded vesting schedule, the employee’s vested benefit increases each year she works

for the employer.

To ensure that employers are able to meet their defined benefit plan obligations, employers are

required to contribute enough to the plan to fund their expected future liabilities under the plan.

For tax purposes, employers deduct actual contributions to the plan for a given year as long as

they make the contributions by the extended tax return due date for that year.

In recent years, many employers have begun replacing defined benefit plans with defined

contribution plans.

2. Defined contribution plans

(1) Employers maintain separate accounts for each employee participating in a defined

contribution plan.

(2) Specify the up-front contributions the employer will make to the employee’s separate

account rather than specifying the ultimate benefit the employee will receive from the plan.

(3) Employees are frequently allowed to contribute their own defined contribution plan.

(4) Employees are free to choose how amounts in their retirement accounts are invested.

Thus, relative to defined benefit plans, defined contribution plans shift the funding responsibility

and investment risk from the employer to the employee.

Employers may provide different types of defined contribution plans such as 401(k) (used by for-

profit companies), 403(b) plans (used by nonprofit organizations, including educational

institutions), and 457 plans (used by government agencies), and others.

Employer matching

Employees contribute to 401k type plans. Many employees also match employee contributions

to these plans. Whenever possible, employees should contribute enough to receive the full

match from the employer.


Contribution limits

For 2009, the sum of employer and employee contributions to an employee’s defined

contribution account is limited to the lesser of:

(1) 49,000 (54,500 for employees who are at least 50 years of age by the end of the year)

(2) 100 percent of the employee’s compensation for the year.

Employee contribution to the 401k plan is limited to 16,500 (or 22,000 for employees who are at

least 50 years of age by the end of the year)

Vesting

When employees contribute to defined contribution plans, they are fully vest in the accrued

benefit from their own contributions (employee contributions + earnings on the contributions).

However, employees vest in the accrued benefit from employer contributions (employer

contributions + earnings on the contributions) based on the employer’s vesting schedule. For

defined

Distributions

When employees receive distributions from defined contribution plans, the distributions are

taxed as ordinary income. However, when employees receive distributions from defined

contribution plans either too early or too late, they must pay a penalty in addition to the

ordinary income taxes they owe on the distributions. Employees who receive distributions

before they reach (1) 59.5 years of age or (2) 55 years of age and have separated from service

are subject to a 10% nondeductible penalty on the amount of the early distributions.

Taxpayers must receive their first minimum distribution from the account by April 1 of the later

of (1) the year after the year in which taxpayer reaches 70.5 years of age or (2) the year after the

year in which employee retires. The amount of the minimum required distribution for a

particular year is the taxpayer’s account balance at the end of the year prior to the year to

which the distribution pertains multiplied by a percentage from an IRS Uniform Lifetime Table.

The percentage is based on the taxpayer’s age at the end of year to which the distribution

pertains. Taxpayers incur a 50% nondeductible penalty on the amount of a minimum

distribution the employee should have received but did not.

Roth 401(K) plans

Employers that provide traditional 401k plans to employees may also provide Roth 401K plans.

When employers provide Roth 401K plans, employees may elect to contribute to the Roth 401k

instead of or in addition to contributing to a traditional 401k plan. However, employer

contributions to an employee’s 401k account must go the employee’s traditional 401k account


rather than the employee’s Roth 401K plans. Thus, the balance in an employee’s Roth 401K

account must consist of only the employee’s contributions and the earnings on those

contributions. In contrast to contributions to traditional 401k plans, employee contributions to

Roth 401K plans are not tax deductible. However, qualified distributions from Roth 401K plans

are excluded from gross income.

Qualified distributions from Roth 401k accounts are those made after the employee’s account

has been open for five taxable years and the employee is at least 59.5 years of age. All other

distributions are nonqualified distributions. When a taxpayer receives a nonqualified

distribution from a Roth 401k account, the tax consequences of the distribution depends on the

extent to which the distribution is from the account earnings and the extent to which it is from

the employee’s contributions to the account. Nonqualified distributions of the account earnings

are fully taxable and are subject to the 10% earnings distribution penalty. Nonqualified

distributions of the taxpayers’ account contributions are not subject to tax. If less than the

entire balance in the plan is distributed, the nontaxable portion of the distribution is determined

by multiplying the amount of the distribution by the ratio of account contributions to the total

account balance.

Nonqualified deferred compensation plan

It permits employees to defer or contribute current salary in exchange for a future payment

form the employer. The tax consequence is same as qualified defined contribution plans.

Individual retirement accounts (IRA)

IRA is the most common of the individually managed retirement plans. Taxpayers who meet

certain eligibility requirements can contribute to traditional IRAs, to Roth IRAs, or to both. In

most respects, the tax characteristics of traditional 401k plans mirror those of traditional IRAs

and tax characteristics of Roth 401k plans mirror those of Roth IRA accounts.

The differences between employer-sponsored 401k plans and self-managed IRAs

1. The government provides IRAs primarily to help taxpayers who are not able to participate in

employer-sponsored retirement plans and to help taxpayers with relatively low levels of

income to save for retirement, tax laws restrict who can make deductible contributions to

traditional IRAs. To be able to deduct contributions to traditional IRAs, taxpayers must

(1) Not be a participant in an employer-sponsored retirement plan. The limit for deductible

IRA contributions is 5,000 in 2009 (6,000 if age 50 or older) or the amount of earned

income if it is less. Earned income generally includes income actually earned through

the taxpayer’s efforts such as wages, salaries, tips and other employee compensation

plus the amount of the taxpayer’s net earnings from self-employment. Alimony income

is also considered as earned income for this purpose.

In this case, there is no phase-out of IRA deductions.


(2) Taxpayers who do participate in an employer-sponsored retirement plan or keogh plan

can still make deductible contributions to traditional IRAs subject to certain AGI

restrictions. For 2009, unmarried taxpayers with an AGI of 55,000 and below and

married taxpayers filing jointly with AGI of 89,000 and below can make fully deductible

contributions to an IRA account, subject to the 5,000 overall deduction limitation

(6,000 if age 50 or older). The 5,000 deduction limitation is phased-out proportionally

for single taxpayers with AGI between 55,000 and 65,000 and for married taxpayers

filing jointly with AGI between 89000 and 109000.

a. The maximum deductible IRA contribution for an individual who is not an active

participant, but whose spouse is, will be proportionately phased out at a combined

AGI between 166,000 and 176,000.

b. Up to 5,000 deductible each spouse for married couple. The phase-out amount is

also calculated separately for each spouse.

c. An individual will not be considered an active participant in an employer plan

merely because his spouse is an active participant for any part of the plan year.

Note1: total IRA contributions (whether deductible or not) are subject to the 5,000 or 100% of

compensation limit.

Note2: Special rule: a taxpayer whose AGI is not above the applicable phase-out range can make

a 200 deductible contribution regardless of the proportional phase-out rule. This 200 minimum

applies separately to taxpayer and his spouse.

Note2: The earnings on contributions grow tax-free until the taxpayer receives distributions

from the IRA. On distribution, the taxpayer is taxed on the earnings generated by the

nondeductible contributions but not on the deductible contributions.

The early or late distribution requirement and penalty for traditional 401 apply to IRA.

Roth IRAs

An alternative to deductible IRAs, taxpayers meeting certain requirements can contribute to

Roth IRAs. Contributions to Roth IRAs are not deductible and qualifying distributions from

Roth IRAs are not taxable. Roth IRAs are subject to the same annual contribution limits as

traditional IRAs.

A qualifying distribution is a distribution from funds or earnings from funds in a Roth IRA if

distribution is at least five years after the taxpayer has opened the Roth IRA and the distribution

is (1) made on or after the date the taxpayer reaches 59.5 years of age, (2) made to a beneficiary

(or to the estate of the taxpayer) on or after the death of the taxpayer, (3) attributable to the

taxpayer being disabled or (4) used to pay qualified acquisition costs for first-time homebuyers

(limited to 10,000) . All other distributions are nonqualified distributions.


The tax laws allow taxpayers to transfer funds from a traditional IRA to a Roth IRA. This transfer

of funds is called a rollover. This rollover can occur if the AGI < =100,000, and occurs within 60

days of the IERA distribution. When taxpayers do this, however, the entire amount taken out of

the traditional IRA is taxed at ordinary rates but is not subject to the 10% penalty tax as long as

the taxpayer contributes the full amount to a Roth IRA within 60 days of the withdrawal from

the traditional IRA.

1. Maximum annual contribution is subject to reduction if the AGI exceeds certain thresholds.

2. Contributions can be made even after the taxpayer reaches age 70.5

3. The contribution must be made by the due date of the taxpayer’s tax return (not including

the extension)

Self-employed retirement accounts

Congress created a number of retirement saving plans targeted toward self-employed taxpayers.

Two of the more popular plans for the self-employed are SEP IRAs and individual (or solo) 401k

plans. These are defined contribution plans that generally work the same as employer-provided

plans (same tax treatment).

A self-employed individual may contribute to a qualified retirement plan called a Keogh plan.

4. Maximum annual contribution


5. Maximum annual deductible amount


6. Net earnings from self-employment

= net earnings from self-employment

- One-half self-employment tax

- Keogh deductions.

Thus, 25% net earnings from self-employment = 20% of self-employment income before

after one-half of the self-employment tax, but before the Keogh deduction.

Simplified employee pension (SEP) IRA

A Simplified employee pension (SEP) can be administered through IRA called a SEP IRA. The

owner of a sole proprietorship can make annual contributions directly to her SEP IRA. For 2009,

the annual contribution is limited to the lesser of (1) 49,000 or (2) 20% of the sole proprietor’s

net earnings from self-employment. If a sole proprietor has hired employees, the sole proprietor

must contribute to their respective SEP IRAs based on their compensation.

Individual 401k


Individual 401k plans are strictly for sole proprietors (and the spouse of the sole proprietor) who

do not have employees. The sole proprietor can contribute the lesser of (1) (1) 49,000 or (2) 20%

of the sole proprietor’s net earnings from self-employment+16,500. If the sole proprietor is over

50 years old at end of the tax year, she may contribute an additional 5,500.

personal regulation notes

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