Bryant - Course 4. Tax Planning. 16. Tax Management Techniques Flashcards
Module Introduction
The more complex the available tax payment methods, the more choices one has for managing taxes, ranging from different types of credits to carrying back (or forward) net operating losses (NOL).
The Tax Management Techniques module will explain the classification of credits and their use, how incentive stock options, charitable gifts, and stock redemption help in tax planning, Alternative Minimum Tax (AMT) planning, the two principal types of deferred compensation methods, net operating losses, and estimated taxes.
Upon completion of this module, you should be able to:
* Classify the different credits as personal, miscellaneous, general business, and refundable credits,
* Determine which of the two stock-option arrangements will be preferred by employees,
* Differentiate between defined benefit plans and defined contribution plans,
* Describe two common forms of non-qualified plans,
* List steps to add capital loss deductions back to taxable income,
* Identify business and non-business income, and
* Describe carryback and carryover periods.
Module Overview
You can efficiently manage taxes by utilizing various tax management techniques such as tax credits, AMT planning, and deferred compensation. Estimated taxes withholding and carrying back or carrying forward NOL also helps to manage tax liability efficiently.
Tax credits are classified into two broad categories:
* non-refundable
* refundable
In this module, you will be presented with information on how incentive stock options, charitable gifts, and stock redemption help in AMT planning.
Deferred compensation refers to methods of employee compensation based on their current service, but the actual payments are deferred until future periods. Federal income taxes are also collected during the year either through withholding on wages or quarterly estimated tax payments.
A net operating loss (NOL) generally involves only business income and expenses and occurs when taxable income for any year is negative because business expenses exceed business income. A deduction for the NOL arises when a taxpayer carries the NOL to a year in which the taxpayer has taxable income.
To ensure that you have an understanding of tax management techniques, the following lessons will be covered in this module:
* Tax Credits
* Tax Planning
* Deferral of Compensation
* Estimated Taxes and Withholding
* Net Operating Losses
Section 1 - Tax Credits
Nonrefundable credits only offset tax liability.
Non-refundable tax credits are further classified into:
* Miscellaneous credits - Foreign Tax Credit
* Personal credits
* General business credits
Personal tax credits:
* Child Tax Credit
* Child and Dependent Care Credit
* Credit for the Elderly and Disabled
* Adoption Credit
* American Opportunity Tax Credit (AOTC)
* Lifetime Learning Credit.
The general business credits discussed are:
* Disabled Access credit
* Rehabilitation Credit
* Business Energy Credit
* Work Opportunity Credit
Refundable credits, on the other hand, not only offset tax liability, but if the credits exceed the tax liability, the excess will be paid (refunded) directly to the taxpayer.
* The principal refundable credit is the earned income credit.
* Taxes withheld from employee wages are tax prepayments but are also referred to as refundable credits.
* First-Time Homebuyer Credit
To ensure that you have an understanding of tax credits, the following topics will be covered in this lesson:
* Personal Credits
* General Business Credits
* Refundable Credits
* Miscellaneous Credits
Upon completion of this lesson, you should be able to:
* Define different types of non-refundable and refundable credits, and
* Classify the different credits as personal, miscellaneous, general business and refundable.
Describe Personal Credits
As a result of tax legislation in the past several years, the number of personal tax credits has increased significantly. These credits are allowed as an offset against an individual’s tax liability before all other non-refundable credits (i.e., the miscellaneous credits and the general business credits).
Most personal tax credits have been enacted for social welfare rather than economic reasons. Some of the most important personal credits are:
* Child Tax Credit
* Child and Dependent Care Credit
* Tax Credit for the Elderly and Disabled
* Adoption Credit
* American Opportunity Tax Credit
* Lifetime Learning Credit
Describe the Child Tax Credit
- Available to parents with dependents under the age of 17 at the end of the year and who meet certain eligibility requirements.
- Able to claim a credit worth up to $2,000 per child. This year the credit is partially refundable, and there is an earnings threshold to be able to start claiming the up to $1,500 portion known as the Additional Child Tax Credit.
- Taxpayers who owe less in taxes than the refundable amount will have it added to their tax refund, the non-refundable portion will reduce taxes owed dollar-for-dollar.
- For tax years 2022 through 2025, the child must be eligible to be claimed as a dependent on the taxpayer’s return and live at the same residence as the taxpayer for more than half the year. The child cannot provide more than half of their own financial support during the tax year.
- The child must have a Social Security (SSN).
- Parents of eligible children must have an adjusted gross income (AGI) of less than $200,000 for single filers and $400,000 for married filing jointly to claim the full credit.
- For every $1,000, or fraction thereof, in excess of those thresholds, the credit is reduced by $50.
- See **IRS Publication 5549 **for additional information.
Describe the Child and Dependent Care Credit
The Child and Dependent Care Credit provides relief for taxpayers who incur child and dependent care expenses because of employment. To qualify for the credit, an individual must meet two requirements:
* Child or dependent care expenses must be incurred to enable the taxpayer to be gainfully employed, and
* The taxpayer must maintain a household for a dependent under 13 or an incapacitated dependent or spouse.
* The credit is 35% of the qualifying expenses (after the ceiling limitations of $3,000 - individual or $6,000 - family have been applied).
* However, the credit rate is reduced by one percentage point for each $2,000 (or fraction thereof) of adjusted gross income (AGI) above $15,000 but goes no lower than 20%.
* The minimum tax credit (20%) is applied once a taxpayer’s AGI exceeds $43,000 (2023).
Howard and Lonni are married and file a joint return. They have two children, ages 9 and 11. The couple’s combined AGI is $47,000.
This year, Howard and Lonni incurred $5,000 of child-care expenses that were necessary for them to fulfill their work obligations. What is their Child and Dependent Care Credit?
* $1,000
* $3,000
* $2,500
* $6,000
$1,000
The couple spent $5,000 and their AGI of $47,000. Their AGI exceeds the threshold of $43,000 and, as a result, the Child and Dependent Care Credit will be 20% of qualified dependent care expenses, with a ceiling of $6,000 for the family.
$5,000 x 0.20 = $1,000 credit
Describe the Tax Credit for Rehabilitation Expenditures
The law provides incentives for rehabilitating older industrial and commercial buildings and certified historic structures. A credit for rehabilitation expenditures is available subject to the following special rules and qualification requirements:
* The credit is 10% for structures originally placed in service before 1936 and 20% for certified historic structures.
* The credit applies only to trade or business property and property held for depreciable investment. Residential rental property does not qualify unless the building is a certified historic structure.
* Rehabilitation includes renovation, restoration, or construction of a building, but not the enlargement or new construction. For buildings other than certified historic structures, a rehabilitation project must meet certain structural tests.
* For certified historic structures, the total rehabilitation must be certified by the Department of the Interior as being consistent with the historic character of the building.
* Straight-line depreciation generally must be used with the applicable §168 recovery periods for the rehabilitation expenditures. The regular MACRS depreciation rules apply to the portion on the property’s basis that is not eligible for the credit.
* The basis of the property for depreciation is reduced by the full amount of the credit taken.
* The rehabilitation expenditures must exceed the greater of the property’s adjusted basis or $5,000.
* The rehabilitation credit is recaptured at a rate of 20% per year if there is an early disposition of the property.
Describe the Adoption Credit
A nonrefundable credit is allowed for qualified adoption expenses. The amount of the credit in 2023 is limited to a maximum of $15,950 (including a child with special needs) and generally is allowable in the year the adoption is finalized. However, if the adoption expenses are paid or incurred a year after the year the adoption is finalized, the credit is allowable in the later year. If adoption expenses are paid before the year the adoption is finalized, such expenses are deductible in the year the adoption is finalized.
* Further, there is a phase-out of the credit based on AGI.
* For taxpayers with AGI in 2023 between $239,230 and $279,230, the credit is incrementally phased out and is fully phased out when a taxpayer’s AGI reaches $279,230.
* Taxpayers adopting a special needs child are treated as having incurred qualified adoption expenses of $15,950 even if actual expenses are less.
* Qualified adoption expenses include reasonable and necessary adoption fees, court costs, attorney fees, and other expenses directly related to an eligible child’s legal adoption.
* An eligible child is defined as a child who has not reached the age of 18 when the adoption takes place or is physically or mentally incapable of self-care.
Describe the American Opportunity Tax Credit (AOTC)
It is important to understand that the American Opportunity Tax Credit (AOTC) (formerly known as the HOPE credit) applies to each student.
* Taxpayers are allowed up to a $2,500 credit for tuition and related expenses paid during the taxable year for each qualified student. Qualified tuition and related expenses include only tuition and fees required for enrollment and course materials such as textbooks. Qualifying expenses do not include room and board, student activity fees, and other expenses unrelated to an individual’s academic course of instruction.
* Some several requirements and limitations exist for AOTC credits:
* The $2,500 credit is allowed for a maximum of four years per student and is computed by taking 100% of the first $2,000 of tuition and fees plus 25% of the second $2,000 in tuition and fees.
* If a taxpayer pays qualified education expenses in one year, but the expenses relate to an academic period that begins during January, February, or March of the next taxable year, the academic period is treated as beginning during the taxable year in which the payment is made.
* An eligible student must carry at least half (1/2) of the normal full-time load for the course of study that the student is pursuing.
* Not available to any student convicted of a federal or state felony offense for possessing or distributing a controlled substance at the end of the taxable year.
* Qualified tuition and related expenses eligible for the credit must be reduced by amounts received under other sections of the tax law.
* The allowable credit (including both the AOTC and the lifetime learning credit) is reduced for taxpayers who have modified AGI above certain amounts. The phase-out for taxpayers filing joint returns for 2023 is $160,000 to $180,000 ($80,000 to $90,000 for other taxpayers).
* The AOTC applies to each student. Thus, parents with two children in their first four years of college may claim up to $2,500 credit for each child.
Describe the Lifetime Learning Credit
The Lifetime Learning Credit is computed differently from the AOTC and is less restrictive, although most of the definitions regarding eligible students and qualified expenses are identical to the AOTC.
* The credit is 20% of a maximum of $10,000 per year of qualified tuition and fees paid by the taxpayer for one or more eligible students.
* However, unlike the AOTC, the $10,000 limitation is imposed at the taxpayer level, not on a per-student basis. Below are some important requirements for the lifetime learning credit:
* The definition of qualified tuition and related expenses are the same as for the AOTC.
* The lifetime learning credit is available for an unlimited number of years and may be used for undergraduate, graduate, and professional degree expenses.
* The maximum amount of expenses eligible for the credit is $10,000.
* The lifetime learning credit and AOTC may not be taken in the same tax year for the same student’s tuition and related expenses.
* The lifetime learning credit may be claimed for any course (degree or non-degree) at a college or university that helps an individual acquire or improve his or her job skills, such as credit or noncredit courses that qualify as continuing professional education (CPE).
* The lifetime learning credit phases out over a $20,000 range for taxpayers filing joint returns with modified AGI ranging from $160,000 - $180,000 (2023). The phaseout for all other taxpayers is a $10,000 range, with a MAGI phaseout of $80,000 - $90,000 (2023).
In the fall of 2023, Erykah returned to school to earn a master’s degree in Social Work. She incurred $7,000 of qualified education expenses, and her modified AGI for the year was $57,750.
What is her Lifetime Learning Credit?
* $1,500
* $1,400
* $2,000
* $7,000
$1,400
The Lifetime Learning Credit applies to essentially every type of education and is computed as 20% of the qualified educational expenses incurred up to $10,000.
In Erykah’s case, the credit is calculated as follows:
$7,000 x 0.20 = $1,400
General Business Credits
* The tax credits commonly available to businesses are grouped into a special credit category called the general business credits. The general business credits are combined for the purpose of computing an overall dollar limitation on their use because these credits are non-refundable.
* If the general business credits exceed the tax limits, effective for tax years beginning after December 31, 1997, they may be carried back one year and carried forward 20 years.
* During the carryover years, the unused credits from prior years are first applied (commencing with the earliest carryover year) before the current year credits that are earned are used (for example, a first-in, first-out FIFO method is applied). This method permits the use of credits from the earliest of the carryover years and may prevent such carryovers from expiring.
General Business Credit Carryforward Example:
Easter Corporation has unused general business tax credits of $10,000 in 2023 that are carried forward to 2024. Eastern earns $5,000 of additional credits in 2024 and computes an overall credit limitation of $12,000 for the year. The $12,000 of credits that are used consists of the $10,000 carryover from 2023 plus $2,000 from 2024.
* How much credit is carried forward to 2025?
The remaining $3,000 ($5,000-$2,000) of 2024 credit is carried forward to 2025.
List 4 of the general business credits.
- Disabled Access Credit
- Tax Credit for Rehabilitation Expenditures
- Business Energy Credits
- Work Opportunity Credit
Describe theDisabled Access Credit
A non-refundable tax credit is available to eligible small businesses for expenditures incurred to make existing business facilities accessible to disabled individuals. Eligible access expenditures include payments to remove architectural, communication, physical, or transportation barriers that prevent a business from being accessible or usable by disabled individuals.
- Expenditures made in connection with new construction are not eligible for the credit.
- The disabled access credit is equal to 50% of eligible expenditures that exceed $250 but do not exceed $10,000.
- Therefore, the annual credit limitation is $5,000.
- The allowable credit reduces the basis of the property.
- Qualifying business owners attach Form 8826 to their return to claim the credit.
An eligible small business is any business that either:
* Had gross receipts of $1 million or less in the preceding year, or
* In the case of a business failing the first test, had no more than 30 full-time employees in the preceding year and makes a timely election to claim the credit.
Disabled Access Credit Calculation:
Crane Corporation had 14 employees during the proceeding tax year and $2 million of gross receipts. During the current year, Crane installed concrete access ramps at a total cost of $14,000.
* Is Crane an eligible small business that qualifies for the disabled access credit?
* How much of eligible expenditures qualify for the credit?
* How much is the credit?
* What does the credit amount reduce the depreciation basis of the property to?
- Crane is an eligible small business because the company had 30 or fewer full-time employees during the proceeding year even though its gross receipt exceed the threshold amount of $1 million.
- Only $10,000 of eligible expenditures qualify for the credit,
- limiting the credit to $5,000 ($10,000 x 0.50).
- The credit amount reduces the depreciation basis of the property to $9,000 ($14,000 - $5,000).
Describe the Tax Credit for the Elderly and Disabled
The Tax Credit for the Elderly and Disabled is a limited, personal, non-refundable credit provided for certain low-income elderly individuals who have attained age 65 before the end of the tax year and individuals who retired because of a permanent and total disability and who receive insubstantial Social Security benefits.
* Most elderly taxpayers are ineligible for the credit because they receive social security benefits over the ceiling limitations that apply to the credit (for example, an initial amount of $5,000 per year for a single taxpayer), or they have AGI amounts above the limitations that effectively reduce or eliminate, the allowable credit.
* The maximum credit is 15% of an initial $5,000 ($7,500 for married individuals filing jointly if both spouses are 65 or older).
This initial amount is reduced by:
* Social Security, railroad retirement, Veterans Administration pension, or annuity benefits are excluded from gross income.
* One-half of AGI above $7,500 for a single individual ($10,000 for married taxpayers filing a joint return). All types of taxable income items are included in AGI, such as salaries, taxable pension and taxable Social Security benefits, and investment income.
What are the Income Limits for Tax Credit for the Elderly and Disabled?
Filing Status
Single, HoH, or Qualifying Widow(er)
* AGI is ≥ … $17,500
* OR the total of nontaxable Social Security, other nontaxable pension(s), annuities, or disability income is ≥ $5,000
MFJ and only one spouse qualifies
* AGI is ≥ … $20,000
* OR the total of nontaxable Social Security, other nontaxable pension(s), annuities, or disability income is ≥ $5,000
MFJ and both spouses qualify
* AGI is ≥ … $25,000
* OR the total of nontaxable Social Security, other nontaxable pension(s), annuities, or disability income is ≥ $7,500
MFS and living apart from spouse all year
* AGI is ≥ … $12,500
* OR the total of nontaxable Social Security, other nontaxable pension(s), annuities, or disability income is ≥ $3,750
Describe the Work Opportunity Credit
A Work Opportunity Tax Credit (WOTC) is available on an elective basis and is intended to reduce unemployment for individuals who are considered economically disadvantaged.
The WOTC includes the following targeted groups:
* Long-term family assistance recipient,
* Qualified recipient of Temporary Assistance for Needy Families (TANF),
* Qualified veteran,
* Qualified ex-felon,
* Designated community resident,
* Vocational rehabilitation referral,
* Summer youth employee,
* Supplemental Nutrition Assistance Program (SNAP) benefits (food stamps) recipient,
* SSI recipient, or
* Qualified long-term unemployment recipient.
The credit available ranges from $2,400 up to $9,600, depending on the targeted group and qualified wages paid to the new employee generally during the first year of employment.
Generally, the credit is 40% of qualified first-year wages for individuals who work 400+ hours in their first year of employment.
What is the amount of qualified first-year wages that may be considered for an employee certified as a qualified veteran limited to?
The amount of qualified first-year wages that may be considered for an employee certified as a qualified veteran is limited to the following amounts.
* $6,000 for a qualified veteran certified as being either (a) a member of a family receiving SNAP assistance (food stamps) for at least three months during the 15 months ending on the hiring date or (b) unemployed for a period or periods totaling at least four weeks (whether or not consecutive) but less than six months in the one year ending on the hiring date.
* $12,000 for a qualified veteran certified as entitled to compensation for a service-connected disability and hired not more than one year after being discharged or released from active duty in the U.S. Armed Forces.
* $14,000 for a qualified veteran certified as being unemployed for a period totaling at least six months (whether or not consecutive) in the one-year period ending on the hiring date.
* $24,000 for a qualified veteran certified as being entitled to compensation for a service-connected disability and unemployed for a period or periods totaling at least six months (whether or not consecutive) in the 1-year period ending on the hiring date.
What is the amount of qualified first-year wages that may be considered for any employee certified as a summer youth employee limited to?
The amount of qualified first-year wages that may be considered for any employee certified as a summer youth employee is limited to $3,000.
What is the amount of qualified first-year wages that may be considered for any employee certified as a member of any other targeted group limited to?
The amount of qualified first-year wages that may be considered for an employee certified as a member of any other targeted group is $6,000.
What are the WOC Credit Calculation Rules?
Qualified Wages
* Number of Hours Worked
* % of Wages Considered for Credit
First-year wages
* Number of Hours Worked: At least 120, but fewer than 400
* % of Wages Considered for Credit: 25%
First-year wages
* Number of Hours Worked: At least 400
* % of Wages Considered for Credit: 40%
Second-year wages (long-term family assistance recipients only)
* Number of Hours Worked: N/A
* % of Wages Considered for Credit: 50%
The Work Opportunity Credit (WOC) is available for employers hiring from each of the following groups EXCEPT:
* Qualified SSI recipients
* Qualified veterans
* Qualified ex-felons
* New Immigrants
New Immigrants
The WOC includes the following targeted groups:
* Long-term family assistance recipient,
* Qualified recipient of Temporary Assistance for Needy Families (TANF),
* Qualified veteran,
* Qualified ex-felon,
* Designated community resident,
* Vocational rehabilitation referral,
* Summer youth employee,
* Supplemental Nutrition Assistance Program (SNAP) benefits (food stamps) recipient,
* SSI recipient, or
* Qualified long-term unemployment recipient.
Describe the Earned Income Credit
The Earned Income Credit is fully refundable. It is a special “negative income tax” or welfare benefit for certain low-income families based on earned income that includes wages, salaries, tips, and other employee compensation plus net earnings from self-employment.
- The Earned Income Credit encourages low-income individuals to become gainfully employed.
- Eligibility Rules: The credit is available to individuals with qualifying children and certain individuals without children if the earned income and AGI thresholds are met.
- Qualifying children are the taxpayer’s children, stepchildren, foster children, or descendants of the taxpayer’s children. The children must share the same principal place of residence with the taxpayer for more than one-half of the tax year. They must be less than age 19 or be full-time students under age 24 or be permanently and totally disabled.
- The earned income credit applies to married individuals only if a joint return is filed.
When is the Earned Income Credit is available to individuals w/o children?
Individuals without children are eligible only if the following requirements are met:
* The individual’s principal place of residence is in the United States for more than one-half of the tax year.
* The individual (or spouse if married) is at least age 25 and not more than age 64 at the end of the tax year.
* The individual is not a dependent of another taxpayer for the tax year.
* A taxpayer will become ineligible for the earned income credit if the taxpayer has excessive investment income.
* Excessive investment income is defined as disqualified income that exceeds $10,000 for the taxable year 2023.
Disqualified income includes:
* Dividends
* Interest (both taxable and tax-free)
* Net rental income
* Capital gain net income
Describe the foreign tax credit
The miscellaneous credits, except the foreign tax credit, are specialized types of tax credits.
U.S. citizens, resident aliens, and U.S. corporations are subject to U.S. taxation on their worldwide income. To reduce double taxation, the tax law provides a foreign tax credit for income taxes paid or accrued to a foreign country or a U.S. possession.
- Taxpayers may elect to take a deduction for the taxes paid or accrued instead of a foreign tax credit. Generally, the foreign tax credit results in a greater tax benefit because the credit is fully offset against the tax liability, while a deduction merely reduces taxable income.
- Treatment of Unused Credits: If a taxpayer cannot claim a credit for the full amount of qualified foreign income taxes paid or accrued in the year, they are allowed a carryback and/or carryover of the unused foreign income tax, except that no carryback or carryover is allowed for foreign tax on income included under IRC Section 951A. Taxpayers can carry back for one year and then forward for ten years the unused foreign tax.
For more information on this topic, see Publication 514, Foreign Tax Credit for Individuals.
Section One Summary - Tax Credits
Credits may be classified into two broad categories, non-refundable and refundable. Non-refundable tax credits are further classified into personal credits, miscellaneous credits, and general business credits.
In this lesson, we have covered the following:
* Personal Credits are allowed as an offset against an individual’s tax liability before all other non-refundable credits (that is, the miscellaneous credits and the general business credits). Most personal tax credits have been enacted for social welfare rather than economic reasons.
* General Business Credits are combined to compute an overall dollar limitation on their use because these credits are non-refundable. The general business credit may not exceed the net income tax minus the greater of the tentative minimum tax or 25% of the net regular tax liability above $25,000.
- Refundable Credits are typically earned income credits. The Earned Income Credit is a special “negative income tax” or welfare benefit for certain low-income families. The credit is based on earned income that includes wages, salaries, tips, and other employee compensation plus net earnings from self-employment. It is designed to encourage low-income individuals to become gainfully employed.
- The Child Tax Credit is partially refundable in 2023.
- The American Opportunity Credit allows a 40% refundable credit, up to $1,000.
- Miscellaneous Credits are specialized tax credits, except the foreign tax credit. U.S. citizens, resident aliens, and U.S. corporations are subject to U.S. taxation on their worldwide income. To reduce double taxation, the tax law provides a foreign tax credit for income taxes paid or accrued to a foreign country or a U.S. possession.
Which of the following is a fully refundable credit?
* Credit for Elderly and Disabled
* Adoption Credit
* Earned Income Credit
* American Opportunity Tax Credit (AOTC)
Earned Income Credit
Refundable credits not only offset a taxpayer’s income tax liability but, if the refundable credits exceed the taxpayer’s tax liability, such excess will be refunded by the government to the taxpayer.
The only fully refundable credit listed is the Earned Income Credit.
40% of the AOTC is refundable (i.e., up to $1,000). However, the AOTC is categorized as a ‘partially refundable credit.’
Doug and Linda incurred qualified adoption expenses in 2022 of $6,000, and then incurred $9,500 more in 2023 when the adoption of their non-special needs child became final. Their 2022 AGI was $218,000 and their 2023 AGI was $220,000. What is the allowable adoption credit?
* $15,950 in 2023
* $7,975 in 2022 and $7,975 in 2023
* $6,000 in 2021 and $9,500 in 2023
* $15,500 in 2023
$15,950 in 2023
The credit is available the year the adoption becomes final. The 2023 maximum credit is $15,950.
Since the couple is below the phaseout range for 2023 (i.e., $239,230 and $279,230), they are eligible for the full credit.
Which of the following is NOT a general business credit?
* Disabled access credit
* Business energy credit
* Welfare-to-work credit
* Foreign tax credit
Foreign tax credit
A foreign tax credit is a type of miscellaneous credit and not a general business credit.
Section 2 - Tax Planning
There are many areas for tax planning. A few key techniques and issues will be discussed in this lesson. This lesson will also deal with intra-family transfers, planning for incentive stock options, charitable gifting, and certain stock redemptions.
- Intra-family transfers generally allow for the transfer of income-producing property to lower marginal tax bracket family members. It is important to realize that intra-family transfers are made not only for income tax purposes but for estate planning purposes. This lesson will focus on the income tax issues associated with these techniques.
- Incentive Stock Options (ISOs) provide a method of compensating an employee with stock, which may generate capital gain income rather than income taxed at ordinary income rates. These arrangements are preferred when long-term capital gain rates are low compared to ordinary income rates. However, for incentive stock option plans to be valid, they must meet certain employee and employer requirements.
- Under IRC Section 170, corporations and individuals who itemize their deductions can deduct charitable contributions to qualified organizations. The amount of the deduction depends on the type of charity receiving the contribution, the type of property contributed, and the applicable limitations.
-
Two possible tax consequences can result when a corporation repurchases (redeems) some of its outstanding stock from a shareholder:
the redemption is treated as a taxable dividend (to the extent of E & P)
the redemption is treated as an exchange of the stock, which generally results in capital gain or loss treatment by the shareholder.
A tax-free recovery of the shareholder’s stock basis is not permitted if the distribution is a dividend. In contrast, exchange treatment presents shareholders with a tax-free recovery of their investment in the stock.
- The current long-term capital gain tax rates are 0%, 15%, and 20%, based on the taxpayer’s income. The impact of lower tax rates on long-term capital gains has been substantial for tax planning. Some traditional tax planning, such as avoiding dividend treatment for distributions from C corporations, has been altered significantly. The changes are too recent to determine their implications, but major alterations in planning should result from this fundamental change in the tax system.
To ensure that you have an understanding of some tax planning issues, the following topics will be covered in this lesson:
* Intra-family Transfers
* Incentive Stock Options
* Charitable Gifts
* Stock Redemption
Upon completion of this lesson, you should be able to:
* Describe the major intra-family transfer techniques,
* Determine which of the two stock-option arrangements will be preferred by employees,
* List employer and employee requirements for an incentive stock option to be valid,
* List different organizations qualified under IRC Section 170 for charitable contributions,
* Calculate the amount of contribution for various non-cash property donated,
* Determine the limitation applied to contributions in different situations, and
* Describe the application of carryovers in charitable contributions.
Describe Intra-Family Transfers
The most significant benefit of transferring property to other family members is often for wealth transfer reasons or to utilize estate planning techniques.
* Due to the large reduction in marginal tax rates after 1986, the income tax benefits of these transfers have been greatly reduced. Furthermore, the compression (e.g., 10% - 37% versus 11% - 50%) of the marginal tax brackets has also reduced the income tax benefits of intra-family transfers.
In the pages that follow, the following techniques will be reviewed:
* Employment of family members
* Sale-lease backs and gift-lease backs
* Family limited partnerships (FLP)
* Installment sales and self-canceling installment note (SCIN)
* Private annuity
Describe Employment of Family Members
- This technique is usually done in the context of family-owned businesses since children pay taxes at much lower tax rates than parents.
- The key to this strategy is to compensate a child with a wage that matches a market-based rate for the job they are performing.
- Additionally, the child must be qualified and have a skill set equal to the job requirements.
- As long as these two issues are addressed, the employment of a child in a family-owned business should withstand any potential IRS challenge.
Employment of Family Members Example:
Several years ago, a father employed his 12-year-old son as a computer programmer/database analyst in his family business and paid his son a $40,000 salary. The IRS challenged the validity of this employment, claiming the father was just using his son to transfer $40,000 of income from the business to his son, who was taxed at a much lower rate. At the time, the salary of $40,000 for such a position was a fair wage based on the job description. The IRS spent about 20 minutes with the child, asking him to demonstrate and perform his job function. Realizing that the child was a complete computer wiz and more than qualified for the position, the IRS promptly dismissed their challenge.
Describe Sale-Leasebacks and Gift-Leasebacks
The biggest advantage of sale-leasebacks and gift-leasebacks is that they can transfer wealth relatively quickly while gaining some income tax advantages.
* Property that is used in a trade or business is the most appropriate type of property to use for this technique.
* For instance, a parent who is a dentist in the highest marginal tax bracket could sell or gift all of the office equipment to a child who is in a lower tax bracket. The parent would then make lease payments to the child for the equipment, which would be a tax-deductible expense.
* The child would have to report income on the lease payments but pay tax at lower marginal tax rates. The child would be able to offset some of this income by the depreciation expense of the newly acquired equipment.
* The child’s basis in the equipment would represent the depreciable value.
* However, if the equipment was purchased through a sale-leaseback, the purchase price becomes the child’s basis.
* In the case of a gift-leaseback, the child would simply assume the parent’s basis.
* To validate the transaction, it is extremely important to structure the sale and the lease at the prevailing market rates. Not doing so would invite a challenge from the IRS. To the extent that the parent sold the equipment for more than their adjusted basis, there would be recapture issues for the parent under IRC Section 1245. However, the primary motive underlying this technique is the actual transfer of wealth to other family members.
Describe Family Limited Partnerships (FLP)
The family limited partnership (FLP) form of business does not constitute a taxable entity.
* Instead, income is distributed from the business directly to the partners in proportion to their ownership percentage.
* Therefore, a parent can transfer limited partnership shares to children without relinquishing control of the business.
* These shares are significantly discounted in value when transferred to family members because limited partnership shares cannot control the business.
* The combination of these discounts, along with utilizing annual exclusions, allows parents to transfer substantial ownership percentages over time.
* The parents can maintain control by keeping the general partnership share, which can be as little as 1%.
* However, as with a general partnership, the general partners of a family limited partnership have unlimited personal liability.
* This situation can be remedied with the use of a family LLC.
When is the Family Limited Partnerships (FLP) technique most appropriate to use?
The FLP technique is most appropriate to use when the business generates income from capital resources and not from personal services.
* A family business in real estate development, management, etc., would be an ideal situation for a FLP.
* The ability to transfer fractional interests in an apartment building to limited partners is also highly advantageous.
* However, if the family business generates income from personal services, the use of a FLP might be challenged by the IRS under the assignment of income doctrine.
Describe the use of Installment Sales and Self-Canceling Installment Notes (SCIN)
The advantage of using an installment sale is that the seller can defer recognition of capital gain over several years.
* For an installment sale to be structured properly, the note must be secured with the underlying asset being sold.
* An installment sale works well with a sale-leaseback, when the buyer may be a young family member without the ability to pay for assets or down payment in a lump sum amount.
* From an estate planning perspective, an installment sale presents a problem when the seller meets their demise. The reason is that the present value of the remaining installment payments is included in the seller’s gross estate at death. This can be corrected using a self-canceling installment note (SCIN).
* If a seller should die before receiving all scheduled payments using a SCIN, the present value of the future payments will not be in the seller’s gross estate. However, the unrealized capital gain from the forgone remaining SCIN payments will be recognized on the estate’s income tax return. As with a regular installment sale, a self-canceling installment note must be secured with the underlying asset.
Describe the use of Private Annuity
A private annuity has income tax consequences akin to self-canceling installment notes (SCINs).
* For a private annuity to be structured correctly, the annuity payments must be unsecured. This is in direct contrast to the structure of an installment sale or a SCIN.
* Furthermore, the payments must be based on the seller’s actuarial life expectancy.
* The buyer’s basis of the purchased asset is determined by the actual payments made.
* If a buyer should die before the seller, the buyer’s estate must continue to make payments to the seller.
* If the seller should die sooner than actuarially expected, the present value of the remaining payments will not be included in the seller’s estate. This is in direct contrast to outstanding installment sale payments included in the decedent’s estate.
* The unrealized gain from the private annuity will be included on the estate’s income tax return, exactly like the SCIN.
What principles is the income tax treatment of unsecured private annuities based on?
The income tax treatment of unsecured private annuities is based on the following principles:
* Gain is equal to the difference between the present value of the annuity promised and the transferor’s basis.
* Gain should be reported ratably over a period of years measured by the life expectancy of the annuitant.
* The transferor’s investment in the contract is the transferor’s basis in the property.
A portion of each annuity payment payable to the transferor is treated as:
* return of basis;
* capital gain; and
* ordinary income.
Describe Incentive Stock Options (ISOs)
Stock option plans are used by corporate employers to attract and retain key employees.
* Both stock option and restricted property arrangements using the employer’s stock permit the executive to receive a proprietary interest in the corporation. Therefore, an executive may identify more closely with shareholder interests and the firm’s long-run profit-maximization goals. In addition, it allows an undercapitalized corporation to acquire employees without expending cash.
The tax law currently includes two types of stock-option arrangements:
* The incentive stock options (ISOs), and
* The non-qualified stock options (NQSOs).
Each type is treated differently for tax purposes.
In an incentive stock option (ISO), when does taxation and AMT occur?
How is it taxed?
A stock option can qualify as an incentive stock option (ISO) only if all of the requirements of IRC Section 422 are satisfied.
* As a general rule, the employee will not recognize any taxable income upon the grant or the exercise of an ISO. Instead, taxation will occur upon the ultimate sale of the stock acquired through the exercise of the ISO.
* So the timing of the taxable event is within the employee’s control. At that point, the resulting gain is normally taxed as a long-term capital gain.
Although no taxable income is recognized at the exercise of an ISO, the spread does create an adjustment item for alternative minimum tax (AMT) purposes. Since the AMT is often an unexpected (and costly) result of exercising ISOs, proper planning must be done to determine the amount and timing of ISO exercises.
Incentive stock option arrangements are preferred by employees when long-term capital gain rates are low as compared to ordinary income rates. As the long-term capital gain rate has been decreased to a maximum of 20% (2022) and marginal tax rates for ordinary income are significantly higher (37%), individual taxpayers (employees) favor incentive stock option arrangements.
What are the Employer Requirements for ISOs?
An incentive stock option (ISO) must meet the following plan or employer requirements:
* The option price must be equal to or greater than the stock’s FMV on the option’s grant date.
* The option must be granted within ten years of the date the plan is adopted, and the employee must exercise the option within ten years of the grant date.
* The option must be exercisable only by the employee and non-transferable except in the event of death.
* The employee cannot own more than 10% of the voting power of the employer corporation’s stock immediately before the option’s grant date.
* The total FMV of the stock options that become exercisable to an employee in any given year must not exceed $100,000 (for example, an employee can be granted ISOs to acquire $200,000 of stock in one year, provided that no more than $100,000 is exercisable in any given year).
* Other procedural requirements must be met (e.g., shareholder approval of the plan).
ISOs can be a valuable tax planning tool because the earliest they are generally taxed is when they are exercised. Also, when an employee realizes profits from stock options, those profits in certain cases may qualify as capital gains.
What are the Employee Requirements for ISOs?
In addition to the employer plan requirements, the employee must meet the following requirements:
* The employee must neither dispose of the stock within two years of the option’s grant date nor within one year after the option’s exercise date.
* The employee must be employed by the issuing company on the grant date and continue such employment until within three months before the exercise date.
If an employee meets the requirements listed above, no tax consequences occur on the grant date or the exercise date.
* However, the excess of the FMV over the strike price on the exercise date is a tax preference item for purposes of the alternative minimum tax.
* When the employee sells the optioned stock, a long-term capital gain or loss is recognized.
* If the employee meets the two requirements, the employer does not receive a corresponding compensation deduction.
* If the requirements are not met, the option is treated as a non-qualified stock option.
SO Sale (Qualifying Disposition) Example:
American Corporation grants an incentive stock option to Kay, an employee, on January 1, 2019. The option price is $100, and the FMV of the American stock is also $100 on the grant date. The option permits Kay to purchase 100 shares of American stock. Kay exercises the option on June 30, 2021, when the stock’s FMV is $400. Kay sells the 100 shares of American stock on January 1, 2023, for $500 per share.
* Has all of the requirements for an ISO been met?
* What income is recognized on the grant date and on the exercise date?
* How much is a tax preference item for the alternative minimum tax in 2021?
* How much does Kay recognize as long-term capital gain on the sale date in 2023?
* Is American Corporation is entitled to a compensation deduction in any year?
- Because Kay holds the stock for the required period (at least two years from the grant date and one year from the exercise date) and because American Corporation employs Kay on the grant date and within three months before the exercise date, all of the requirements for an ISO have been met.
- No income is recognized on the grant date or the exercise date
- Although $30,000 [($400 - $100) x 100 shares] is a tax preference item for the alternative minimum tax in 2021.
- Kay recognizes a $40,000 [($500 - $100) x 100 shares] long-term capital gain on the sale date in 2023.
- American Corporation is not entitled to a compensation deduction in any year.
ISO Sale (Disqualifying Disposition) Example:
Assume the same facts as the example above, except that Kay disposed of the stock on August 1, 2021, thus violating the one-year holding period requirement.
* What is this known as?
* What must Kay recognize ordinary income on?
* Is the spread between the FMV and the option price a tax preference item?
* Can American Corporation can claim a compensation deduction in 2021? For how much?
* What else does Kay recognizes?
- This is known as a disqualifying disposition.
- Kay must recognize ordinary income on the sale date equal to the spread between the option price and the exercise price, or $30,000 [($400 - $100) x 100 shares].
- The $30,000 spread between the FMV and the option price is no longer a tax preference item because the option ceases to qualify as an ISO.
- American Corporation can claim a $30,000 compensation deduction in 2021.
- Kay also recognizes a $10,000 [($500 - $400 adjusted basis) x 100 shares] short-term capital gain on the sale date that represents the stock’s appreciation from the exercise date to the sale date.
- The gain is short-term because the holding period from the exercise date to the sale date does not exceed one year.
Describe Non-Qualified Stock Options (NQSOs)
Non-Qualified Stock Options (NQSOs) are options that do not meet the requirements of IRC Section 422, either intentionally or otherwise.
* There are generally no tax implications to the recipient of an NQSO on the grant date.
* The only exception is for publicly traded stock options. But it is extremely rare to find nonqualified employee stock options that trade in the public market.
* Note that employee stock options differ from puts and calls that commonly trade on publicly held companies.
NQSOs are a convenient and flexible way to award or encourage employees.
* There are no limits as to how many NQSOs may be granted, how the exercise price is determined, or the time limitation for the expiration of the option.
* NQSOs are sometimes granted at an exercise price that is less than the fair market value of the stock on the grant date. These are referred to as “discounted stock options.”
* But the deferred compensation rules of Code section 409A may cause such discounted stock options to be subject to tax upon grant.
When does the taxation of NQSOs typically occur?
- The taxation of NQSOs typically occurs on the exercise date. At that point, the difference between the fair market value of the stock and the exercise price is recognized as additional compensation unless the stock is restricted (i.e., the stock is subject to a substantial risk of forfeiture and is not transferable).
- Payroll taxes must be withheld upon the exercise of NQSOs (federal, state, and local withholding, FICA, and FUTA).
- The spread is also included on the employee’s Form W-2 wages in the year of exercise.
In what two ways do employers benefit from the exercise of NQSOs?
Employers benefit in two ways from the exercise of NQSOs:
* The company receives the gross exercise cost of the options.
* The company is entitled to a tax deduction for the compensation element that is taxed to the employee.
Which party is treated more favorably under Non-Qualified Stock Option (NQSO) rules?
* Employer
* Employee
Employer
Employers are more favorably treated under the non-qualified stock-option rules. That is, employers receive a tax deduction for the compensation related to a NQSO plan, but do not receive a corresponding deduction if an ISO plan is adopted.
Describe the Charitable Gifts deduction
Under IRC Section 170, corporations and individuals who itemize their deductions can deduct charitable contributions to qualified organizations.
Except for certain contributions made by corporations, taxpayers take the deduction in the year the contribution is made, regardless of the taxpayer’s method of accounting.
The amount of the deduction depends on:
* The type of charity receiving the contribution,
* The type of property contributed, and
* Any applicable limitations.
What are the Type of Property Contributed?
- If a taxpayer contributes cash, the deduction amount is easily determinable. However, if non-cash property is donated, the contribution amount is not as easy to identify.
In the case of non-cash property, the amount of the donation depends on two factors:
* The type of property donated, and
* The type of qualifying organization (public charity or private non-operating foundation) to which the property is given.
A gift of property that consists of less than the donor’s entire interest in the property is not usually considered a contribution of property. For example, no charitable contribution is made when an individual donates the use of a vacation home for a charitable fund-raising auction.
Contribution Of Capital Gain Property
* In general, the amount of a donation of capital gain property is its fair market value (FMV).
* IRC Section 1.170A-1(c)(2) defines a property’s FMV as the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts.
* For charitable contributions, capital gain property is defined as property held over one year on which a capital gain would be recognized if it were sold at its FMV on the date of the contribution.
* If a capital loss or a short-term capital gain would be recognized on the sale of the property, the property is considered to be ordinary income property for purposes of the charitable contribution deduction.
What is the formula to determine Contribution to Private Non-Operating Foundation?
Property’s FMV – Capital Gain that would be recognized = Contribution to Private Non−Operating Foundation
The tax law provides an exception to the above general rule for contributions of capital gain property, other than publically traded stock which qualifies for long-term gain treatment, to private non-operating foundations.
* The amount of the contribution to a private non-operating foundation is the property’s FMV, reduced by the capital gain that would be recognized if the property were sold at its FMV on the date of the contribution.
* This means that generally, the deductible amount of the contribution is the property’s adjusted basis.
What happens if capital gain property (i.e., tangible personal property) is contributed to a public charity and used by the organization for purposes unrelated to the charity’s function?
A second exception applies to capital gain property (i.e., tangible personal property) contributed to a public charity and used by the organization for purposes unrelated to the charity’s function. In such cases, the amount of the contribution deduction is equal to the property’s FMV minus the capital gain that would be recognized if the property were sold at its FMV.
* This amount generally is the property’s adjusted basis.
* Tangible property is all property that is not intangible (e.g., property other than stock, securities, copyrights, patents, etc.).
* Personal property is all property other than real estate.
The taxpayer is responsible for proving that the property was not put to unrelated use.
* However, a taxpayer meets this burden of proof if, at the time of the contribution, the taxpayer reasonably anticipates that the property will not be put to unrelated use. The immediate sale of the property by the charitable organization is considered to be a use unrelated to its tax-exempt purpose.
Related Use & Unrelated Use Charitable Contribution Example:
Laura purchases a painting for $3,000. Several years later, she contributes the painting to a local college. The FMV of the painting is $5,000 at the time the property is contributed. The painting is both tangible personal property and capital gain property. The college places the painting in the library for display and study by art students.
* How much is the amount of Laura’s contribution?
* On the other hand, if the college had sold the painting immediately after receiving it, how much is the amount of Laura’s contribution?
- As the college does not use the painting for purposes unrelated to its function as an educational institution,** the amount of Laura’s contribution is equal to its FMV ($5,000)**.
- On the other hand, if the college had sold the painting immediately after receiving it, the presumption is that the property’s use was unrelated to the college’s tax-exempt purpose. In this case, Laura’s contribution is only $3,000.
How is the Contribution Of Ordinary Income Property calculated?
- In general, if ordinary income property is contributed to a charitable organization, the deduction is equal to the property’s FMV minus the amount of gain recognized if the property were sold at its FMV on the contribution date.
- In most cases, this deduction is equal to the property’s adjusted basis.
- This rule applies regardless of the charitable organization to which the property is donated.
- For this purpose, ordinary income property includes any property that would result in the recognition of income taxed at ordinary income rates if the property were sold.
Therefore, ordinary income property includes: - inventory
- works of art or manuscripts created by the taxpayer
- capital assets that have been held for one year or less
- Section 1231 property (property used in a trade or business that is subject to depreciation) to the extent a sale would result in the recognition of ordinary income due to depreciation recapture
Ordinary Income Property Contribution Example:
During the current year, Bart purchases land as an investment for $10,000. Five months later, he contributes the land to the United Way. At the time of the contribution, the property’s FMV is $15,000.
* What is the amount of Bart’s contribution?
- The amount of Bart’s contribution is $10,000 ($15,000 - [$15,000 - $10,000]) because he held the land for less than one year.
