Tax Planning

Question 1

What are the formulas for regular federal income tax calculations?

Answer 1

1. Determine filing status
2. Determine gross income for the taxable year
3. Subtract certain deductions from gross income to arrive at adjusted gross income
4. Determine the deduction for personal and dependency exemptions, taking into considerations the phase-out amounts, if any
5. First total itemized deductions and compare to the standard deduction. Compare and deduct the greater of itemized or standard deductions. Add the deduction for exemptions from AGI to arrive at taxable income
6. Apply the proper tax rate to taxable income to determine the tax
7. Subtract credits and prepayments toward the tax to determine the net tax payable or the overpayment to be refunded

Question 2

List the income and deduction limitations on each interest classification

Answer 2

• Limits deductibility of investment interest to net investment income
• Net capital gains/loss +- Net ordinary gain/loss = Gain/loss
• Can only deduct a capital loss up to $3,000. Losses can be carried forward to future years, but if losses are larger than gains, only $3,000 can be deducted for the given tax year, after offsetting the gains
• Up to 20% capital gains rate, up to 37% marginal tax rate for ordinary
• Collectibles, 1202, and 1250 have different tax rates (28% and 25% 1250)
• 1244 small business stock can be used as ordinary loss if loss in value, use capital gain rate if increase in value

Question 3

Apply tax requirements and safe harbors to an individual tax situation

Answer 3

• Taxpayers are required to pay taxes on income earned at the time they receive it. Can be done either through tax estimates or withholding
• Withholding is required by an employer
• For tax estimates, they are required if they owed at least $1000 in previous year and if the taxpayer believes their withholding will be less than 90% tax owed in current year or 100% of tax owed in previous year. Total annual payment is the lesser of these two
• If paying quarterly tax estimates, must pay at least 22.5% Q1, 45% Q2, 67.5% Q3, and 90% by Q4
• Underpayment penalty payment of 3% above AFR

Question 4

Tax Implications of self-settled trusts

Answer 4

• The person that creates the trust is also the beneficiary
• They are irrevocable trusts to help protect the assets from any creditors
• The trustee holds legal title to the trusts and will distribute income based on the trust provisions
• If grantor retains right to principal, will be taxed to grantor. If grantor only is able to receive distributions with the consent of an independent trustee, the trust will pay tax

Question 5

Tax Implications of Domestic Asset Protection Trusts (DAPT)

Answer 5

• Works as a self-settled trust
• If grantor retains rights to the trust

Question 6

Tax Implications of Grantor Trusts (GRITs, GRATs, GRUTs)

Answer 6

• GRIT - The grantor’s retained interest is valued at zero for gift tax purposes if the remainder beneficiary is a spouse or a lineal descendant. The gift tax is assessed on the total FMV of the assets transferred into the trust rather than to only the remainder interest. Useful if the remainder beneficiary is a niece, nephew, or other distant relative/unrelated party. Grantor retains income interest and will pay income tax on the income received by the trust while the property in the trust appreciates and will pass to the beneficiary gift tax free
• GRAT/GRUT- The present value of the remainder interest of the trust is subject to gift taxes, not the full FMV of the assets transferred into the trust. The gift tax value for the remainder interest is less than the full FMV of the assets transferred into the trust because the beneficiaries do not have current use of the trust assets and cannot receive the assets until the grantor’s income term has ended. DNI applies to these trusts

Question 7

Tax Implications of Dynastic Trusts

Answer 7

• Assets transferred to a dynasty trust can be subject to gift, estate, and GSTT taxes only when the transfer is made and if the assets exceed federal tax exemptions
• Income taxes apply to the trust if it produces income; best to transfer non-income producing assets like tax-free muni bonds or non-dividend paying stocks
• Assets in the trust are removed from the grantor’s taxable estate

Question 8

Tax Implications of Charitable Lead and Charitable Remainder Trusts (CLT/CRT)

Answer 8

• CLT - It is a split-interest trust that provides current income stream to a charity with the remainder interest passing to the beneficiary. A grantor CLT has a reversionary interest in the trust greater than 5%. Grantor receives a large up-front income tax deduction the year the trust is funded. Will have to pay income tax that the trust earns each year. Income tax deduction is based on the present value of the charity’s future rights to annuity or unitrust payments. A non-grantor CLT doesn’t have a deduction at the time the trust is funded. Avoids % limitations on gifts to charities. Transfer can be made at death and there is no income tax deduction, but there’s a step-up in basis in the assets going into the trust
• CRT - It is a split-interest trust that provides current income stream to an individual beneficiary with the remainder interest passing to a charity. Selling assets within the trust does not create a taxable event. The donor can receive an income tax deduction the year the trust is funded; the value of it is the present value of the charity’s remainder interest. The value of the remainder interest is determined by a calculation using actuarial factors based on the beneficiary’s age (or the specified term of the trust), the annual amount payable to the beneficiary, and the appropriate monthly section 7520 rate. If funded at death, the estate will take an estate tax deduction of the present value of the charity’s remainder interest. Payment to beneficiary is taxed as ordinary income, capital gain, other income, and as tax-free distribution

Question 9

Tax Implications of Revocable Trusts

Answer 9

• Income and taxes are reported on the grantor’s income tax return since the grantor and the trust are considered a single taxpayer
• Trust income is taxed at grantor’s tax rates since they retain interest

Question 10

Tax Implications of Irrevocable Trusts

Answer 10

• Income is reported on trust’s taxes
• Distributed income to beneficiaries is reportable on the bene’s taxes. Undistributed income is taxed to the trust. Deductions available based on DNI calculation
• Taxed at trust rates for the income generated in the trust
• Subject to 3.8% NIIT at earlier thresholds

Question 11

Tax Implications of Spendthrift Trusts

Answer 11

• A beneficiary is prohibited from assigning an interest in the trust so that the interest in the trust is not subject to claims of creditors while in the trust
• Once beneficiary received distribution, that money may be reached by a creditor
• Irrevocable, the grantor doesn’t have access to the money; the trust pays taxes on the income generated from the trust
• Income generated may be taxed at trust rate

Question 12

Tax Implications of Marital A/B Trusts (Credit Shelter Trusts)

Answer 12

• Bypass (B) Trust - Pass the estate tax exclusion to the bypass trust. Property is included in gross estate, but the unified credit is used to offset the estate tax on the property, making sure that the decedent’s estate is not over-qualified for the marital deduction. Property in the trust is not subject to estate tax. Surviving spouse has limited access to income and principal of the trust
• Marital (A) Trust - Surviving spouse receives trust income for life and gives spouse the right to name beneficiary after her death to anyone. Property qualifies for marital deduction in the decedent spouse’s estate; this property will be included in surviving spouse’s estate at death unless it’s consumed or given away by that time

Question 13

Tax Implications of Generation Skipping Trusts (GST)

Answer 13

• Transfers assets from the grantor’s estate to grandchildren, avoids estate taxes that would apply if the assets came into possession of the next generation first
• Subject to generation skipping tax

Question 14

Tax Implications of Irrevocable Life Insurance Trusts (ILIT)

Answer 14

• Grantor-policy owner can transfer a policy to the trust or can make a cash gift to the trust to enable the trustee to purchase a new policy. Trustee becomes owner and primary beneficiary of the grantor’s insurance policy to ensure that the proceeds are paid to the trust at the grantor’s death. Grantor shouldn’t be trustee
• Removes the death benefit from the grantor’s estate and the trust can shelter proceeds and future appreciation from the surviving spouse’s gross estate
• Assets in the trust are protected from creditors
• Cash value accumulating in a life insurance policy is free from taxation and so is the death benefit
• Separate tax entity and income is subject to trust taxes

Question 15

What are common tax issues for high net worth individuals?

Answer 15

Income tax planning is an issue for HNW individuals. With estate and gift tax currently high, there is less planning that needs to go into transferring wealth out of their names, but managing the taxes that they pay during their life

Question 16

Describe intra family income-shifting strategies

Answer 16

• When it comes to shifting income within the family, it can significantly help reduce the tax burden on the family as a whole if income is moved from grandparents and parents to 2nd generation
• Gifting assets that have growth potential (and maybe interest/dividend burden) to children in lower brackets can help shave some of that income that a parent would otherwise pay
• Be aware of the kiddie tax, for children who are 18-24 may be subject to their parents’ tax bracket if they receive too much income

Question 17

Describe intra family tax planning opportunities

Answer 17

• Annual and lifetime gifting
• Family limited partnership allows gradual transfer of ownership of a business to other family members
• Grantor retained trusts
• QPRTs
• 529 plans

Question 18

What are the formulas for the Alternative Minimum Tax (AMT)?

Answer 18

1. Compute taxable income on Form 1040
2. Compute AMTI by adding or subtracting certain adjustments to taxable income
3. Add tax preferences to AMTI
4. Compute the applicable exemption amount and subtract it from AMTI
5. Compute the AMT on AMTI as reduced by the appropriate exemption
6. Reduce AMT liability by available credits

Question 19

What are common components of the tax calculation that would trigger the use of the AMT tax?

Answer 19

Itemized deductions:
* Medical
* Taxes
* Mortgage Interest
* Investment Interest
* Misc. Itemized Deductions

Question 20

Strategies to avoid or minimize the AMT

Answer 20

1. Move income into an AMT year when the current year is 28% or less when in future years it will exceed 28%
2. Moving deductions into a non-AMT year
3. Timing of adjustments and preferences
4. Incentive Stock Options
5. Making elections to minimize AMT
6. Utilizing Alternative Tax Net Operating Loss (ATNOL)

Question 21

Strategies to maximize the use of AMT credits

Answer 21

• Deducting home office on Schedule C
• Rental schedule, Schedule E
• Farm schedule, Schedule F
• Pre-tax 401(k) contributions
• Charitable donations
• Cafeteria plans
• FSAs

Question 22

Identify the deduction amounts for donations to private foundations and public charities

Answer 22

• Deduction limits may vary based on the tax year; currently 60% public charities and 30% private foundations
• Private foundations typically allow less of a deduction than public charities. Donors have more control over the investment and distribution of the funds and is typically something a family puts together to establish a common charitable goal
• Public charities have to be qualified charities, but generally receive 30-60% deduction of AGI
• Types of public charities - Churches, educational organizations, hospitals, organizations that benefit public colleges and universities, governmental units, publicly-supported charities, supporting organizations, DAF, certain private foundations (would assume most fall under private fdn rules though)

Question 23

Tax Treatment of Donations to Private Foundations

Answer 23

• For private foundations, the limitation % may vary, but the type of property and the deductibility amount rules should stay the same
• Cash = FMV, 30%
• Ordinary income property = lesser of basis or FMV, 30%
• LT capital gain property = FMV, 20%
• Tangible personal property charity uses = FMV, 20%
• Tangible personal property put to unrelated use = lesser of basis or FMV, 30%

Question 24

Tax Treatment of Donations to Public Charities

Answer 24

• For public charities, the limitation % may vary, but the type of property and the deductibility amount rules should stay the same
• Cash = FMV, 60%
• Ordinary income property = lesser of basis or FMV, 60%
• LT capital gain property = FMV, 30%
• Tangible personal property charity uses = FMV, 30%
• Tangible personal property put to unrelated use = lesser of basis or FMV, 60%

Question 25

List interest expense classifications and applicable limitations

Answer 25

• Able to deduct the amount of interest paid on a mortgage for below the line deduction for itemized deductions
• This amount can be added back to AMTI calculation, so may have to pay AMT as well

Question 26

Treatment of Mortgage Interest

Answer 26

• Mortgage interest is a below-the-line deduction, meaning it reduces your AGI number when looking for the taxable income amount
• Is found when you itemize deductions rather than use standard
• No floor amount, so can deduct the full mortgage interest paid

Question 27

What is active income?

Answer 27

Any activity where money is earned where direct involvement in providing services or labor occurred

Question 28

What is passive income?

Answer 28

Any activity that involves the conduct of a trade or business in which the individual does not “materially participate”

Question 29

Treatment of Investment Interest on Business Activities

Answer 29

The interest expense deduction is limited to the sum of:
* Business interest income
* 30% of the business’ adjusted taxable income
* Floor plan financing interest

Question 30

What are qualified dividends?

Answer 30

• They are paid from a US corporation or qualified corporation and fulfill the holding period requirements
• The stock was held for 60 days before the ex-dividend date
  These dividends are taxed at capital gains rates

Question 31

What are non-qualified dividends?

Answer 31

Non-qualified dividends are those that don’t meet the specifications of qualified dividends, as well as:
* Are capital gains distributions
* Dividends paid on bank deposits
* Paid to an ESOP
* Tax-exempt corporations dividends
* Dividends held on a short derivative position
* Payments in lieu of dividends
* Paid by REITs or MLPs
* Liquidating dividends
* Non dividend distributions

Question 32

What are the rules for a wash sale?

Answer 32

If a taxpayer sells stock or securities at a loss and within a period beginning 30 days before the sale and ending 30 days after the sale, the taxpayer acquires or enters into a contract to acquire substantially identical stock or securities the loss will not be allowed
a 61-day period covering 30 days before and after the sale

Question 33

What are short-term capital gains/losses?

Answer 33

When a capital asset is held for one year or less, it’s notated as this
Gains are taxed at ordinary income rates, which are usually less favorable

Question 34

What are long-term capital gains/losses?

Answer 34

When the capital asset is held for more than one year, it is considered long-term
Long-term gains are subject to lower tax rates than ordinary income

Question 35

What are the rates for short-term capital gains?

Answer 35

The rates are taxed at the same rates as any other type of ordinary income

Question 36

What are the rates for long-term capital gains?

Answer 36

0%, 15%, and 20%, depending on tax bracket

Question 37

How do short-term and long-term capital gains and losses offset each other?

Answer 37

First, net short-term gains and losses. Then, net long-term gains and losses. Then, net the short-term gains/losses with long-term gains/losses

Question 38

What are the tax liabilities of exercising executive stock options?

Answer 38

It’s important to plan around the exercise/sale of executive stock options. It creates large taxable events (income or capital gains) and often, individuals aren’t fully prepared for the AMT that likely follows

Question 39

List the tax implications of exercising ISOs

Answer 39

• At the exercise of ISOs, the difference between the FMV of the shares at exercise and the exercise price is included in the AMT calculation. This will be taxed per AMT rules
• At the sale of the shares, you want to avoid double taxation of AMT. The difference between the value of the shares sold and the value of the spread of the ISO that was realized fro AMT previously will be included in AMTI
• Taxation occurs at the date the stock is sold and is subject to capital gains treatment if held for more than 2 years after the grant date and more than 1 year after the exercise date

Question 40

What is the relationship between holding periods, basis, timing to options tax treatment for ISOs?

Answer 40

• Basis in stock is the strike/exercise price
• Holding period is if it’s a qualifying disposition; stock must be held more than 2 years since grant date and more than 1 year since exercise date. Allows the sale of the stock later to be recognized as capital gain
• Strategies to realize tax for ISOs include staggering the exercises of ISOs, planning for restricted stock, utilizing Section 83(b), use of leverage to buy dividend paying stocks, and exchanging stock for stock

Question 41

What are the implications of executive stock options on a client’s potential for AMT?

Answer 41

• ISOs create an AMT adjustment event. The difference between the FMV at the exercise date and the strike price is considered the AMT adjustment
• The difference between the FMV at the sale of the stock and the FMV at the exercise date is considered the AMT capital gain
• The spread is added to AMTI only; will have two tax bases - for regular tax it’s the exercise cost, and for AMT it’s the FMV on the exercise date

Question 42

What are the tax treatments of ISOs?

Answer 42

• At the sale of the stock, the gain receives capital gain treatment if held for longer than the ISO holding period requirements
• Qualifying disposition occurs more than 2 years after grant date and more than 1 year from exercise date

Question 43

What are the tax treatments of NQSOs?

Answer 43

The spread is considered ordinary income and is on the employee’s W-2

Question 44

What are the tax implications of exercising NQSOs?

Answer 44

• Taxation typically occurs on the exercise date
• The difference between the FMV and the exercise price is recognized as additional compensation
• Withhold payroll taxes upon exercise
• Spread on W-2

Question 45

How do you properly characterize income to the individual tax-payer based on the nature of the pass-through entity?

Answer 45

• Sole proprietorship - Income and deductions from the SP are filed under Schedule C of Form 1040. Owner has to file one single return for themself and the business. Losses from the business can be deducted from ordinary income. Owner is responsible for all liabilities
• Partnerships - Each partner receives a Schedule K-1 which notates on the form their portion of the income and deductions based on how much they invested. The income and deductions are specially stated. Some partnerships don’t have to file so that the income is distributed proportionally, considered special allocations and has specific rules. General partners retain responsibility for the liabilities the business owns
• LLC - Can be set up to have the tax consequences of any other entity, including sole proprietorship. LLC will follow the rules of the entity they classify as. LLCs protect the members from liabilities. They are not responsible for liabilities nor can their personal assets be used to cover the liabilities
• C-Corp - A separate tax entity that will file it’s own taxes and shareholders aren’t responsible for the corporate debt (Form 1120). Capital gains and losses are netted. Double taxation of the dividend will occur. Corporation gets taxes, and so does the shareholder when they receive the dividend
• S-Corp - The income passes through to the shareholders. This income is includable in gross income, must be proportional to stock ownership

Question 46

List the Passive Loss Limitations

Answer 46

• Must pass a test every year to show that the taxpayer (and spouse, if applicable), do not materially participate in the activity
• Suspended passive activity losses are carried forward indefinitely to offset future income from passive activity

Question 47

List the Carry-Forward Rules

Answer 47

Realized losses can be used to offset the year’s capital gains and reduce income by $3,000
If losses exceed the gains by more than $3,000, the losses can be utilized in future years until the bank of losses is fully used

Question 48

Describe the Treatment of Passive Losses and the Disposition of Passive Activities

Answer 48

• Any suspended losses from the activity are no longer treated as passive activity losses and are allowable as a deduction against the taxpayer’s income in this order (when the passive activity is disposed)
  1. Income or gain from the passive activity for the taxable year
  2. Net income or gain for the taxable year from all passive activities
  3. Any other income or gain
• Passive losses can be taken as long as they don’t exceed the passive income produced for that tax year
• Losses can be carried forward indefinitely to offset income in future years
• If disposition is not a complete, fully taxable disposition, then the suspended losses remain suspended
• If a taxpayer disposes of their entire interest in a passive activity in a fully taxable transaction, then any suspended passive activity losses may be applied against their nonpassive income

Question 49

Describe the Tax Basis Rules and Gains from Disposition as they Apply to Pass-Through Entities Owned by Individuals

Answer 49

• Sole Proprietorship - The basis will be the initial investment in the partnership. May increase or decrease based on profit, losses, distributions, etc.
• Partnership - The basis begins with initial investment in the partnership. It may be different if partner acquired partnership interest in any way other than as a direct purchase. Increases and decreases will occur over time for distributions of income, losses, etc.
• LLC - Follows the basis rules of the entity that it will be taxed as the entity it mirrors for tax purposes (partnership, corporation, etc.)
• C-Corp - Basis is the initial investment. May increase or decrease
• S-Corp - May have two different adjusted basis numbers to track, one for stock and one for debt basis. Does not adjust basis for partner’s share of the S-Corp liabilities. Increases or decreases based on adjustments such as share of income, distributions, items of loss, etc.
• Basis cannot be a negative number, but losses in previous years can be deducted in future years if there is income generated or the individual invests more in the pass-through entity

Question 50

Identify strategies to defer gains on various property transactions, including like-kind exchanges and sales of certain small business stock

Answer 50

• Gain deferral strategy is about pushing back when taxes are due for investments and property. The best strategies are the ones that exclude gain from income forever, but there are few options that accomplish this
• Like-Kind exchanges are a type of gain deferral strategy where the individual is exchanging property they have with another and it’s of equal value and likeness. The exchange doesn’t create a gain because it leaves the person off the same way as before the exchange. Be cognizant of boot, though. That could create a gain
• With sales of small business stock, if the individual rolls over the proceeds into stock or partnership of another small business within 60 days of the original sale, they can defer gains

Question 51

What is gross income?

Answer 51

• It is broadly defined and includes “all income from whatever source derived”
• An item received in any form (money, property, or services) in return for a benefit conferred or a sacrifice made by the recipient may constitute income
  15 types of gross income

Question 52

Ordinary income vs. capital gains

Answer 52

• Ordinary income is any type of gross income with the exception of gain from the sale or exchange of a capital asset or property
• Capital gain is from the sale or exchange of a capital asset

Question 53

What is passive activity?

Answer 53

Any activity that involves the conduct of a trade or business in which the individual does not “materially participate”

Question 54

Three rate gain baskets that must also be considered

Answer 54

28% gain for collectibles and Section 1202 stock
25% gain for unrecaptured Section 1250 stock
15% gain for all other long-term capital gains

Question 55

Section 1231 Assets

Answer 55

Depreciable or real property that is used in a trade or business and is held for more than one year

Question 56

Netting capital gains and losses

Answer 56

If one rate gain basket has a net loss, the loss is used to offset the net gain in the rate gain basket with the highest rate, then the next highest rate gain basket, etc.

Question 57

Treatment of Section 1245 gains

Answer 57

A taxpayer who realizes a capital gain on the disposition of depreciable or amortizable (Section 1231) property MUST “recapture” all or part of the gain as ordinary income

Question 58

Treatment of Section 1250 gains (real property subject to depreciation)

Answer 58

• Straight line depreciation is the only type of depreciation allowed with respect to real estate
• The amount of recognized gain to the extent of straight line depreciation claimed is taxed at a maximum capital gain rate of 25%

Question 59

Deductible Business Losses

Answer 59

1. Loss from sale of property
2. Net operating loss (NOL)
3. Bad business debts
4. Evidence of worthlessness

Question 60

Tax Deduction vs. Tax Credit

Answer 60

• Deduction reduces the amount of income subject to tax
• Credit reduces the actual tax liability dollar-for-dollar
• A tax credit is usually more advantageous than a tax deduction

Question 61

Floor and Ceiling on deductions

Answer 61

• Floor is where a deduction isn’t allowed until the amount of the potential deduction exceeds the floor
• Ceiling is where the deduction is limited to a certain percentage of AGI

Question 62

Which investment activities are not included in the at-risk limitation rules?

Answer 62

Real Estate