Tax Management Techniques - Examples Flashcards
Accelerated or Deferred Deductions - Some deductions may be more valuable to a taxpayer in a year other than the year in which the expense that gives rise to the deduction is incurred. Accelerating or deferring deductions can be a useful planning tool for AMT or regular tax planning.
Because of the limitations on the use of certain deductions for regular tax (for example, charitable deductions, medical deductions, and others.)
For example, John has an AGI of $100,000 in the current year and has a sole medical expense of $7,000 that is unpaid, and the year is coming to a close. If John pays the $7,000 before year-end, he will get no benefit of the deduction since medical expenses are limited to amounts in excess of 7.5 % of AGI (For John, that would be a threshold of $7,500). If John makes the payment after January 1, and his AGI for the following year is expected to be, say $70,000, he will be able to use $1,750 ($7,000 − $5,250 (7.5 % of $70,000) as a deduction; as well as any other medical expenses he may have in the new year.
Accelerated or Deferred Deductions - Some deductions may be more valuable to a taxpayer in a year other than the year in which the expense that gives rise to the deduction is incurred. Accelerating or deferring deductions can be a useful planning tool for AMT or regular tax planning.
For AMT (for example, state tax deductions), the timing of the payment of a deduction can provide an opportunity for a taxpayer to choose the tax year in which the deduction will arise.
For example, If Mary is subject to AMT in the current year because of an ISO option exercise, she should not pay her state income tax before the end of the year. Since state tax is not deductible for AMT purposes, such a payment would not reduce her AMT and thus not reduce her tax liability. If she waits and pays the state tax in January, when she will not likely be subject to AMT since she will have no ISO option exercises, she can take full advantage of the state tax deduction against regular tax liability in that year.
Net Investment Income - NII is gross investment income minus the “deductible” portion of investment expenses (other than investment interest expense). However, beginning in 2018, the Tax Cuts and Jobs Act eliminated the deduction of investment expenses such as investment advisory fees, tax preparation costs, unreimbursed business expenses, others as miscellaneous deductions subject to 2% of AGI. Therefore, as of 2018, gross investment income is the same as net investment income due to the elimination of these deductions.
For example, the Spencers file a joint return in 2019 with $280,000 of MAGI which includes $18,000 of net investment income. They must pay the 3.8% Medicare tax on the $18,000, since that is less than their MAGI less the threshold ($280,000 − $250,000 = $30,000).
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 the 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.
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 salary of $40,000. 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.
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 would 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.
Family Limited Partnerships (FLPs) - The family partnership 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.
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.
Incentive Stock Options - Employee 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.
For example, American Corporation granted an incentive stock option to Kay, an employee, on January 1, 20X4. 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, 20X6, when the stock’s FMV is $400. Kay sells the 100 shares of American stock on January 1, 20X8, for $500 per share. 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 Kay is employed by American Corporation 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) × 100 shares] is a tax preference item for the alternative minimum tax in 20X6 Kay recognizes a $40,000 [($500 − $100) × 100 shares] long-term capital gain on the sale date in 20X8. American Corporation is not entitled to a compensation deduction in any year.
Assume the same facts as the example above, except that Kay disposes of the stock on August 1, 20X6, thus violating the one-year holding period requirement. 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) × 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 2025. Kay also recognizes a $10,000 [($500 − $400 adjusted basis) × 100 shares] short-term capital gain on the sale date that represents the appreciation of the stock 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.
Pension Plans - Defined contribution pension plan - In a defined contribution pension plan, a separate account is established for each participant and fixed amounts are contributed based on a specific formula (for example, a specified percentage of compensation). The retirement benefits are based on the value of a participant’s account (including the amount of earnings that accrue to the account) at the time of retirement.
For example, Alabama Corporation establishes a qualified pension plan for its employees that provides for employer contributions equal to 8% of each participant’s salary. Retirement payments to each participant are based on the amount of accumulated benefits in the employee’s account at the retirement date. The pension plan is a defined contribution plan because the contribution rate is based on a specific and fixed percentage of compensation.
Pension Plans - Defined Benefit Plans - Defined benefit plans establish a contribution formula based on actuarial techniques that are sufficient to fund a fixed benefit amount to be paid upon retirement.
For example, a defined benefit plan might provide fixed retirement benefits equal to 40% of an employee’s average salary for the five years before retirement.
A distinguishing feature of a defined benefit plan is that forfeitures of unvested amounts (due to employee resignations, for example) must be used to reduce the employer contributions that would otherwise be made under the plan. In a defined contribution plan, however, the forfeitures related to unvested amounts may either be reallocated to the other participants in a non-discriminatory manner or used to reduce future employer contributions.
Pension Plans - Tax Treatment to Employees and Employer - Employer contributions to a qualified plan are immediately deductible (subject to specific limitations on contribution amounts), and earnings on pension fund investments are tax-exempt to the plan. Amounts paid into a plan by or for an employee are not taxable until the pension payments are received, normally at retirement.
For example, Larry is an employee of Cisco Corporation, which maintains a Section 401(k) plan. Larry contributes 5% of his gross salary into the plan on a pre-tax basis. During the current year, Larry’s gross salary is $80,000, so his Section 401(k) contribution is $4,000. Since Larry’s contribution is made on a pre-tax basis, his taxable salary for the current year will be $76,000. In effect, Larry is able to deduct the $4,000 from his salary in the current year. When Larry retires and begins withdrawing amounts from the plan, the entire amount withdrawn will be subject to income taxation.
Conversely, an employee may elect to contribute to a qualified plan on an after-tax basis. If, in the example above, Larry contributed to the Section 401(k) plan on an after-tax basis, his taxable salary would have been $80,000. The $4,000 contributed to the plan is treated as an investment in the plan and is considered a tax-free return of capital when this amount is withdrawn at retirement.
Pension Plans - Employee Retirement Payments - An employee’s retirement benefits are generally taxed under the Section 72 annuity rules. If the plan is non-contributory (no employee contributions are made to the plan), all of the pension benefits when received by the employee are fully taxable. If the plan is contributory, each payment is treated, in part, as a tax-free return of the employee’s contributions and the remainder is taxable. The excluded portion is based on the ratio of the employee’s investment in the contract to the expected return under the contract.
For example, Kevin retires in 20X4 at age 64 and will receive annuity payments for life from his employer’s qualified pension plan of $24,000 per year beginning in January 20X4. Kevin’s investment in the contract (represented by his contributions made on an after-tax basis) is $100,000. Kevin’s life expectancy per Section 72 is 260 months from the annuity starting date. So, for the next 260 months, Kevin can exclude $384.62 per payment (calculated as: [($100,000 after-tax basis / ($2,000 payment x 260 actuarial number of payments)] × $2,000 = $384.62). In 20X4, Kevin would exclude $4,615.44 ($384.62 × 12 months) and $19,384.56 would be taxable ($24,000 − $4,615.44). After Kevin receives payments for 260 months and his $100,000 investment in the contract is recovered, all subsequent payments are fully taxable.
Estimated Taxes and Witholding - Required Estimated Tax Payments -
90% of the tax liability shown on the return for the current year;
100% of the tax liability shown on the return for the prior year if the taxpayer’s AGI for such prior year was $150,000 or less. If the taxpayer AGI is greater than $150,000, no penalty will be imposed if the taxpayer pays estimated tax payments in the current year equal to 110% of the prior year tax.
90% of the tax liability shown on the return for the current year computed on an annualized basis.
For example, Sarah does not make quarterly estimated tax payments for 20X3, even though she has a substantial amount of income not subject to withholding. Her taxable income is $140,000. Her actual tax liability (including self-employment taxes and the alternative minimum tax) for 2022 is $40,000. Withholdings from her salary (W-2) are $30,000. She pays the $10,000 balance due to the IRS with the filing of the 20X3 return in April 20X4. Sarah’s tax liability for the prior year was $28,000. There is no penalty for failure to make the quarterly estimated tax payments because she meets one or more of the exceptions relating to the minimum payment requirement. Although the first exception is not met because her $30,000 of withholdings (plus zero estimated tax payments) is less than 90% of her $40,000 tax liability for 20X2 ($30,000 / $40,000 = 75%), she meets the second exception because the $30,000 of withholdings is more than 100% of her $28,000 tax liability for the prior year.
If Sarah’s AGI for the prior year was more than $150,000, the second exception safe harbor amount would be 110% (instead of 100%) of the prior year’s tax or $30,800 ($28,000 × 1.10). Because the $30,000 of withholding is not more than 110% of her $28,000 prior year tax liability, Sarah would not meet the second exception and would be subject to the underpayment penalty.
Estimated Taxes and Witholding - Add Back Any Capital Loss Deduction
To compute taxable income, individuals may deduct up to a maximum of $3,000 in capital losses in excess of capital gains in any year. Any capital loss in excess of this limit can be carried over and deducted in a subsequent tax year, subject to the same limitation.
For example, during the current year, Steve recognizes a short-term capital loss of $10,000 on the sale of an investment capital asset. He also recognizes a $5,000 long-term capital gain on the sale of a business capital asset. For taxable income purposes, the loss is netted against the gain, leaving a $5,000 net short-term capital loss. This loss provides a $3,000 deduction from taxable income, with the remaining $2,000 being carried forward to the following year.
To compute the NOL, however, none of the $10,000 non-business capital loss is deductible. Thus, the $3,000 deduction as well as the $5,000 loss that offset the business capital gain must be added back.
