Tax Planning Flashcards
Sole Proprietor
Liability: unlimited
Participants: 1
Taxation: individual level; must file form 1040, schedule C
Income (reported on form 1040 schedule C) is self-employment income
General Partnership
Liability: unlimited
Participants: >1; no maximum
Taxation: flow through; must file form 1065
Income (reported on schedule K-1) is self-employment income
Limited Partnership
Liability: general partner - unlimited; limited partner - limited
Participants: at least one general partner and one limited partner; no maximum
Taxation: flow through; must file form 1065
Income (reported on schedule K-1) is self-employment income for the general partner - may or may not be for the limited partners
Limited Liability Partnership (LLP)
Liability: limited
Participants: >1; no maximum
Taxation: flow through; must file form 1065
Income could be self-employment or ordinary reported on schedule K-1
Family Limited Partnership (FLP)
Liability: limited for limited partners; unlimited for general partner (though GP often retains small % ownership (such as 1%))
Participants: >1; no maximum
Taxation: taxed as partnership; entity form 1065; schedule K-1s issued to general and limited partners
Purpose is to transfer assets to younger generations using annual exclusions and valuation discounts for minority interest and lack of marketability; FLPs, if properly structured, work extremely well for estate planning
Limited Liability Company (LLC)
Liability: limited
Participants: 1 or more members
Taxation: can be taxed as a sole proprietorship (file form 1040, schedule C), partnership (file form 1065), corporation (file form 1120), or s-corporation (file form 1120S)
Income could be self-employment, W-2 income and ordinary income, W-2 income; note that partnerships (in addition to LLCs) may also be taxed as another type of entity by filing form 8832 entity classification election
S-Corporation
Liability: limited
Participants: no more than 100 shareholders
Taxation: flow through; must file form 1120S
Owners’ income flows through on schedule K-1; employee’s income is reported on W-2; owner employees receive both schedule K-1 and W-2
Must be a domestic corporation.
May not be owned by C Corporations, partnerships, and certain trusts.
Allowed only one class of outstanding stock, however, can have shares with or without voting rights.
Corporation
Liability: limited
Participants: no restrictions
Taxation: entity level - corporation pays tax; must file form 1120
Income (reported on W-2 and form 1099-div) could be W-2 income and dividend income
Capital Assets
Most personal use assets and most investment assets.
Cost Basis
The amount paid in cash, debt obligations, other property, or services. Includes:
Sales Tax
Freight
Installation and testing
Excise taxes
Legal and account fees (when they must be capitalized)
Revenue stamps
Recording fees
Real estate taxes (if assumed for the seller)
Gain on inherited assets
Always long-term capital gain
Holding period of capital gains
To qualify for long-term capital gains rate, asset must be held for at least a year and is taxed at a minimum rate of 20%.
Short-term capital gains are taxed as ordinary income.
In calculating the holding period, the day of disposition is included but the day of acquisition is not.
Adjusted Basis
Cost of property
+ Capital additions
- Cost recovery
= Adjusted basis
Loss Property
Never gift or sell an asset to a related party when the donor’s basis is greater than the FMV of the asset.
What are NOT considered capital assets?
ACID:
- Accounts/notes receivable
- Copyrights and creative works
- Inventory
- Depreciable property used in a trade or business
What is the ONLY way to have a 1231 gain on a 1245 property?
To sell it for more than it was originally purchased for. Any sale amount in excess of the original purchase price of a section 1245 asset is a section 1231 gain.
1231 Gain
Any sale amount in excess of the original purchase price of a 1231 asset.
The lesser of the gain or the difference between depreciation taken and straight-line depreciation is taxed as ordinary income.
Kiddie Tax
Only applies to unearned income in excess of $2,500.
Applies to children under age 19 (or 24 if a full-time student).
First $1,250 standard deduction, second $1,250 taxed at child’s rate, remaining amount taxed at parent’s marginal rate.
Earned income standard deduction is the greater of:
$1,250 OR
$400 plus the earned income amount
(maximum deduction is $13,850)
The remainder is taxed at the child’s tax rate.
MACRS Property Classes
5 Year: Autos, computers, office equipment
7 Year: Office furniture and fixtures
*CAT/Corn
*Nonresidential and residential real property use mid-month convention
MACRS for Real Estate
Residential rental: straight-line depreciation over 27.5 years
Commercial: straight-line depreciation over 39 years
Straight Line Depreciation
Adjusted Basis
- Salvage Value
= Depreciable Amount
/ Estimated Useful Life
= Annual Depreciation Deduction
Underpayment penalty
Most people can avoid paying estimated tax if their withholding and credits equal 100% of the tax shown on the prior year’s return or 90% of the current year’s tax liability.
- Taxpayers can not rely on this rule if they had a short (less than 12 months) taxable year for the prior year.
A taxpayer does not have to pay estimated tax if:
- The taxpayer had no tax liability for the previous year;
- The taxpayer was a US citizen or resident for the entire year;
- And the taxpayer’s tax year covered a 12 month period.
1231 Asset
It is used in a trade or business and is either depreciable property or real property. I.e. buildings, machinery, equipment, land and buildings used for business, and leasehold improvements.
Specifically includes:
- Timber
- Coal
- Iron Ore
- Certain livestock
- Unharvested crops (under certain conditions)
Does NOT include:
- Inventory
- Property held by the taxpayer primarily for sale to customers in the ordinary course of business
- Copyright or creative works
Items that can increase the basis of an asset
Capital improvements - an addition on your home, a new roof, paving your driveway, installing central AC, rewiring your home.
Assessments for local improvements - water connections, sidewalks, roads.
Cost of restoring damaged property after a casualty loss.
Legal fees - cost of defending and perfecting a title to the property.
Zoning costs.
Items that can decrease the basis of an asset
Casualty or theft loss deductions, if applicable due to federally declared disaster.
Deduction for clean-fuel vehicles and clean-fuel vehicle refueling property.
Section 179 deduction.
Credit for qualified electric vehicles.
Depreciation.
Non-taxable corporate distributions.
Exclusion from income of subsidies for energy conservation measures.
Formula for donee’s basis when a gift tax is paid
Donor’s basis / (Net appreciation in value of gift / Value of taxable gift) x Gift tax paid
The basis of gifts of appreciated property to the donee is increased by the gift tax formula.
Wash Sale Rules
Occurs when a taxpayer disposes of securities at a loss and acquires substantially identical securities within 30 days before or after the date of the loss sale.
The disallowed loss is added to the cost of the new security to determine the new basis of the substantially identical security.
Do not apply to gains.
Sale of Personal Residence (Section 1231)
Qualification requirements for the exclusion under Section 121:
- The property must have been owned and occupied as a principal residence for 2/5 of the last years (one year stay in a nursing home does not count towards the 2 year requirement).
- The exclusion can only be used once every 2 years.
- Any appreciation during non-qualified use periods are not subject to the exclusion.
Single taxpayers can exclude up to $250k of gain.
Married taxpayers filing jointly can exclude up to $500k of gain. Both spouses must meet the use requirement and not have utilized the exclusion within the last 2 years, but either may meet the ownership requirement.
*A pro rated amount will pro rate the exclusion amount - not the gain.
(# of months of use/24) x Applibicable exclusion
Steps for netting capital gains and losses
- Net long term capital gains and long term capital losses.
- Net short term capital gains and short term capital losses.
- If the taxpayer has net loss in one category and net gain in the other, then the net long term gain/loss should be netted against the short term gain/loss.
Section 1244 Small Business Stock
A single taxpayer can deduct up to $50k ($100k if MFJ) of the loss on small business stock as an ordinary loss in any given year if:
- The stock represents ownership in a domestic corporation.
- The corporation was a small business (less than $1 million in total capital contributions plus paid-in capital) at the time the stock was issued.
- The company was incorporated after 11/6/1978.
- The loss was sustained by the original owner of the stock, who is not a corporation, trust, or estate.
Any loss in excess of the per year limit is treated as capital loss.
Does not apply to gains.
Married Filing Jointly Requirements
- The taxpayer and spouse must have been married as of the last day of the year.
- The the taxpayer’s spouse died during the year and the taxpayer did not remarry, the taxpayer may still file a joint return with that spouse for the year of death.
Qualifying Relative Test
- Not a qualified child test - the person cannot be the qualified child of any other taxpayer.
- Relationship test - the person either (a) must be related to the taxpayer (son, daughter, stepchild, foster child, brother/sister, half brother/sister, stepbrother/sister, or a decedent of any of them) or (b) must live with the taxpayer all year as a member of their household (and the relationship must not violate local law).
- Gross income test - the person’s gross income for the year must be less than $4,700.
- Support test - the taxpayer must provide more than half of the person’s total support for the year.
Additional: joint return test, and citizenship/residency test.
Qualifying Child Test
- Relationship test - the child of the taxpayer must be the taxpayer’s son/daughter, stepchild, foster child, brother/sister, half brother/sister, stepbrother/sister, or a descendant of any of them.
- Age test - the child must be (a) under age 19 at the end of the year, (b) under age 24 at the end of the year and a full time student, or (c) any age if permanently and totally disabled.
- Abode test - the child must have lived with the taxpayer for more than half of the year.
- Support test - the child must not have provided more than half of his or her own support for the year.
Additional: joint return test and citizenship/residence test.
Exclusion Ratio for the taxation of annuity payments
Exclusion ratio = Investment in the contract / Expected total return
Life insurance transfer for value exceptions
The proceeds of a life insurance policy can still be excluded from gross income even if the policy is transferred for valuable consideration. This includes:
- If the policy is transferred to the insured
- If the policy is transferred to a partner of the insured
- If the policy is transferred to a partnership in which the insured is a partner
- If the policy is transferred to a corporation in which the insured is a shareholder or officer
- If the policy is transferred by tax-free exchange or gift
Workers’ compensation
Excluded from taxable income
Punitive Damages
Included in taxable icome
Damages for emotional distress
Included in taxable income
Deductions FOR AGI (Above the line)
- Trade or business expenses
- Deductions from losses on sale or exchange of business property
- Deductions from rental and royalty property expenses
- Alimony payments if finalized BEFORE 2019
- 1/2 of self-employment tax paid
- 100% of health insurance premiums paid by a self-employed individual
- Contributions to pension, profit sharing, annuity plans, IRAs, etc.
- Penalty on premature withdrawals from time savings accounts or deposits
- Interest on student loans
- Tuition and fees for tax years 2018-2020
- Health savings accounts
- Moving expenses (armed forces)
Deductions from AGI (below the line/itemized)
- Medical expenses above 7.5% of AGI
- Taxes
- Interest
- Charitable contributions
- Casualty losses
Miscellaneous itemized deductions (those subject to the 2% hurdle repealed)
Deductible Medical Expenses
- Prescriptions
- Health insurance premiums (after tax, out of pocket payments - not what is paid through employer plans)
- Eligible capital improvements (home modifications to better mobility)
- Nursing home and special schools
- Travel and lodging for out of state treatments
*Deductible to the extent that these expenses exceed 7.5% of AGI
Nondeductible Medical Expenses
- Elective cosmetic surgery
- General health items (vitamins)
- Health club dues
- Marijuana
- Over the counter drugs
- Dance lessons
Requirements for a home office deduction
Office must be used exclusively and on a regular basis as the principal place of business or a place of business used by clients/patients/customers. For employees, office must also be for the convenience of the employer.
Qualifies as a principal place of business if:
- Taxpayer conducts administrative and management activities in the office, and
- There is no other fixed location where taxpayer conducts these activities.
Expenses cannot cause net loss from the business activity.
Deduction limited to business gross income in excess of other business expenses. Excess is carried forward subject to limit.
Adoption expenses credit
Credit for qualified adoption expenses incurred in adoption of eligible child (adoption fees, court costs, attorney fees).
Maximum credit is $15,950 - phased out for modified AGI between $239,230 - $279,230.
Eligible child is less than 18 or physically or mentally handicapped.
Nonrefundable credit but the excess may be carried forward for 5 years.
Child tax credit
$2,000 for each dependent child under 17.
Includes step and foster children.
Married taxpayers must file jointly to be eligible.
Credit is phased out by $50 for each $1,000 of AGI above:
- $400k for joint filers
- $200k for married filing separately
- $200k for single filers
Up to $1,600 is refundable per child subject to limitations.
Child and dependent care credit
Must have employment related care costs for a depending under age 13 or a handicapped dependent or spouse.
Married taxpayers must file jointly to be eligible.
Credit amount: eligible care costs x applicable %
- Applicable % ranges from 20-35%; 20% applies to AGI over $43k
Amount of qualifying costs is the lesser of actual costs or $3k for one qualified individual, and $6k for two or more qualified individuals.
- Costs for care of qualified individual within taxpayer’s home or outside home
- If outside home, handicapped dependent or spouse must spend at least 8 hours a day within taxpayer’s home
AMT preference items
- Percentage depletion: the amount of percentage depletion taken for regular tax in excess of the adjusted basis of the property at the end of the year is a preference item.
- Intangible drilling costs:
- AMT requires 10 year amortization. Currently deductible for regular tax.
- Preference is excess of regular tax deduction over [AMT amortization + (65% x net oil and gas income)] - Interest on private activity bonds: not taxable for regular tax purposes, but included in income for AMT.
- Expenses incurred in carrying these bonds are not deductible for regular tax purposes, but offset the interest income in computing the AMT preference.
Rental property passive losses
Rental losses on non-vacation rental property up to $25k are deductible against ordinary income by taxpayers with AGI less than or equal to $100k - phase out between $100-150k.
Personal Use Property
Rented for less than 15 days a year.
Income is NOT taxable and rental expenses are NOT deductible.
Mortgage interest and property taxes are 100% allowed on Schedule A.
Rental Use Property
Rented for 15 days or more, and used personally less than or equal to the greater of 10% of rental days or 14 days.
Income is taxable.
Apportion expenses between rental use and personal use. Rental use expenses are deductible beyond income (up to $25k, phased out at $150k).
The personal apportionment of mortgage interest and property taxes are deductible on Schedule A, other personal expenses are nondeductible.
Mixed Use Property
Rented for 15 days or more, and used personally more than the greater of 10% of rental days or 14 days.
Income is taxable.
Apportion expenses between rental use and personal use.
Rental use expenses are NOT deductible beyond income - no loss for mixed use property.
The personal apportionment of mortgage interest and property taxes are deductible on Schedule A, other personal expenses are nondeductible.
Material participation
Greater than 500 hours per year
OR
Greater than 100 hours and the most of any participant
Suspended losses at risk
- If suspended losses are from “at risk” activity, they are NOT deductible until the at risk amount is positive from additions or income.
- If losses are suspended under passive activity rules, the losses are deductible upon disposition.
Treasury Department regulations
- Proposed regulations: a preview of final regulations and do not have legal precedence.
- Temporary regulations: issued when guidance is needed quickly and have the same authoritative value as final regulations.
- Final regulations: have the full force and effect of law and are the second highest authority of tax law (after the IRC)
Types of Final Regulations
- Procedural: essentially housekeeping instructions
- Interpretive: implement the intent of committee reports and the IRC.
Legislative: allow the Treasury to determine the details of the law. However, Congress must specifically delegate this authority to the Treasury.
Revenue Rulings
Interpretations of the tax laws issued by the IRS. They are usually provided in response to a taxpayer request and are based on facts common to tax payers.
Do not have the full force and effect of the law, but they are binding on officials of the IRS.
Revenue Procedures
Describe internal practices and procedures within the IRS.
Like revenue rulings, they are published in the Internal Revenue Bulletin.
Generally, they state changes in techniques and administrative procedures used by the IRS.
Private Letter Rulings
Issued by the IRS at the request of the taxpayer. The IRS is bound by it’s determination in the ruling only to the requesting taxpayer.
They are made available to the public after deletion of certain materials and can be used by other taxpayers as guidance regarding the described transaction.
Cannot be relied on by other taxpayers as precedent.
Noncompliance with the Internal Revenue Code
Interest accrues from the original due date of the return, even if the taxpayer obtained an extension.
Interest is compounded daily. The rate is the federal short-term rate plus 3%. It is determined every 3 months.
Interest is paid on refunds if not received within 45 days of the taxpayer filing a claim for refund.
Statute of Limitations
For assessment of deficiency:
- 3 years from the due date of the return
- 6 years if material omission (25% of income or more)
- No statute if fraudulent return
For refund:
- Later of 3 years from date return is filed or 2 years from date of payment.
Who can represent a client during an audit by the IRS?
ACE -
Attorney
CPA
Enrolled agent
The US Tax Court
- No payment of tax is necessary in order to bring a claim before the US Tax Court.
- Trial by jury is not available.
- The Small Tax Case Division handles deficiencies under $50k at the taxpayer’s request. This is an informal procedure with no appeal rights, taxpayer can represent themselves.
- Decisions do not bind the IRS with respect to other taxpayers.
- Appeals are to the US Court of Appeals.
US Court of Federal Claims
- Sits only in Washington DC.
- Tax deficiencies must be paid to proceed in this forum.
- Appeals are to the US Court of Appeals for the Federal Circuit.
US District Court
- Tax deficiencies must be paid to proceed in this forum.
- The ONLY forum that allows a trial by jury.
- Bound by decisions of its Appeals Court and the US Supreme Court.
US Court of Appeals
- 12 Circuit Courts located throughout the US.
- Handles appeals from Tax Court and District Court.
- The Court of Appeals of one region is not bound to follow the decisions of the Court of Appeals in another region.
US Supreme Court
- Decisions of the US Supreme Court are binding on taxpayers and the IRS.
- Generally reviews tax cases if: there is a conflict between circuit courts, an important and recurring problem in tax law administration is involved, many taxpayers are involved, or if the decision of a lower court conflicts with long-standing practice or regulations.
Requirements of depreciable property
- Must be property you own
- Must be used in your business or income-producing activity
- Must have a determinable useful life
- Must be expected to last more than one year
Property that CANNOT be depreciated
Property that is used solely for personal activities.
- If property is used for business/investment purposes and for personal purposes, you can deduct depreciation based only on the business or investment use.
Cannot depreciate inventory as it is not held for use in business - it is held for sale to customers in the ordinary course of business.
Land cannot be depreciated.
Election to expense assets - Section 179
- Can elect to immediately expense up to $1,160,000 of business tangible property placed in service during the year.
- Cannot use Section 179 for realty or production of income property.
- The amount expensed reduces depreciable basis.
- Cost recovery is available on remaining basis.
- Expense limitation is reduced by amount of Section 179 property placed in service during year that exceeds $2,890,000. The result is a dollar-for-dollar reduction.
Assets subject to amortization
Goodwill
Trademarks
Covenants not to compete
Copyrights and patents used in a trade/business
What entities are flow through?
Partnership
LLP
S Corp
LLC (depends on taxpayer election)
What entities have unlimited liability?
Sole proprietor
General partnership
What is the nature of an owner’s income from various entities?
Self employment income (subject to self employment tax):
- Proprietor
- General partnership
- LLP
W-2 income:
- Corporation (C Corp)
- S Corp
LLC will depend on the taxpayer’s election.
Individual Income Tax Calculation
Gross Income
- Above the line deductions (FOR AGI)
= AGI
- Below the line deductions (FROM AGI; standard or itemized)
- Personal and dependency exemptions (suspended 2018-2025)
= Taxable Income
Calculate tax based on filing status
- Credits
+ Other taxes
- Prepayments
= Tax or Refund Due
Domestic Employee Tax
Taxpayers with domestic employees (ex. nannies) must pay social security and Medicare taxes on 100% of compensation paid to the domestic employees.
- Social Security taxes: 12.4% on the first $160,200 of earnings
- Medicare taxes: 2.9% on all earnings
There is NO above the line deduction for domestic employee taxes.
Tax return due dates
Individual income tax returns
- April 15th
- Can be extended for up to 6 months
Partnership and S Corporation income tax returns
- 15h day of the 3rd month after tax year end
- Can be extended for up to 6 months
C Corporation income tax returns
- 15th day of the 4th month after tax year end
- Can be extended for up to 6 months
Extension of time to file does not extend the time to pay the tax.
Tax reduction/management techniques to defer income
- Qualified retirement plans
- Defer selling investment until later years
- Defer billing for cash basis clients
- Defer year end bonuses
- Incentive stock options
- Non-qualified deferred compensation
- Installment sales
- Like-kind exchanges
- Earning on annuities
Tax reduction/management techniques to accelerate deductions
Pay deductible expenses due early next year
- Estimated state tax payments
- Real estate taxes
- Mortgage payments
- Charitable contributions
- Repairs and maintenance
- Acquire assets (section 179 expense, half year convention if qualify, proper classification of depreciable assets)
Limitations on the ability to defer income and/or accelerate deductions
A taxpayer’s ability to defer income or accelerate deductions depends on:
- Available cash flow
- Current needs
- Strategies that counteract each other (need to collect the income in order to buy the asset)
- Alternative minimum tax
Inherited Property Basis
The basis of inherited property is the FMV at date of death or the alternate valuation date, if properly elected by the executor.
Holding period is always long term.
Basis of property transferred incident to divorce
Treated the same as gifts - carryover basis applies.
No gain or loss is recognized.
Must occur within 1 year of the date on which the marriage legally ended and is related to the cessation of the marriage.
Related party transactions
Only affects loss transactions.
If property is sold to a related party at a loss, the seller is not permitted to deduct the loss and double basis rules will apply.
Holding period always begins at date of sale.
If the sale results in a gain, normal basis rules apply.
Bargain sales to charity
If a taxpayer sells property to a charity for less than its FMV, the basis must be allocated between the portion of the property sold and the portion given to charity.
(amount realized / FMV) x basis of property = basis for sale purposes
Gains and losses for different types of assets
Nonrecognition Transactions
“Realized” but not “recognized” income
Like-kind exchanges
Principal residence
Investment real estate
Life insurance policies
Nontaxable vs. tax-free transactions
Nontaxable:
- Realized gain/loss not currently recognized
- Recognition is postponed to a future date (via carryover basis)
- Carryover basis
- Holding period for new asset is carried over from the holding period of the asset surrendered
- Depreciation recapture
Tax-free:
- Nonrecognition of gain is permanent
Involuntary conversion
The destruction, theft, seizure, condemnation, or sale/exchange under threat of condemnation of property (i.e. eminent domain).
To avoid recognition of the gain, the taxpayer must reinvest the proceeds in a replacement property that has a similar use to the converted property either:
- 2 years from the end of the year in which realization (not the event) occurs
- 3 years if caused by government
- 4 years if presidentially declared national disaster
Head of household filing status
Allowed for individuals who are either unmarried or are considered unmarried as of the last day of the taxable year.
- Considered unmarried if he filed a separate return, paid more than half the cost of keeping up the home, the taxpayer’s spouse did not live in the home during the last 6 months of the year (abandoned spouse), taxpayer’s home was the main home of the child for more than half the year, taxpayer is eligible to claim a credit for the child.
A “qualifying” person must have lived with the taxpayer for more than half of the year.
Qualifying widower filing status
Taxpayer with qualified child for 2 years following the year in which the taxpayer’s spouse died if all of the following apply:
- The taxpayer was eligible to file a joint return with his or her spouse in the year in which the spouse died
- The taxpayer has not remarried
- The taxpayer has a child or stepchild for whom the taxpayer can claim as qualified
- The child lived in the taxpayer’s home all year
- The taxpayer paid more than half the cost of keeping up a home during the year
Below-market loans
Gross Income Exclusions
- Cash or property received by gifts and inheritances
- Life insurance proceeds
- Scholarships
- Gain on sale of personal residence (up to specified limits)
- Qualified distributions from Roth accounts
- Compensation for injuries or sickness
- Employer sponsored health plans
- Specified employee fringe benefits
- Child support payments received
- Interest income from municipal bonds
- Deferral contributions to certain retirement plans
Items included in gross income
- Gains from the sale of assets
- Distributions from retirement plans
- Rental income
- Unemployment compensation benefits
- Royalty income
- Compensation (salaries/wages)
- Interest income
- Dividend income
- Alimony received pre-2019
- Gross income from self-employment
Cafeteria plans
Allows employees to choose between cash and certain nontaxable benefits.
- If cash is chosen, the amount received is taxable.
- If nontaxable benefits are chosen, the benefit remains nontaxable.
Charitable contribution deductions
For cash, adjusted basis = FMV
Unrelated use property, ordinary income property, short-term capital gain property, and loss property are typically converted to cash - same AGI limit
Deduction in year of donation plus 5 year carry forward
Tax credits
- Earned income credit
- Adoption expenses credit
- Child tax credit
- Family credit (qualifying dependent child)
- Child & dependent care credit
- Education tax credits
AMT
Taxable income
+/- Adjustments
+ Preferences
= AMTI
- Exemption
= AMT Tax Base
x AMT Rate(s)
= Tentative Minimum Tax
- Foreign Tax Credit
- Regular Tax
= AMT
Active real estate rental participation requirements
Only available to estates and individuals.
Requires at least 10% ownership, as well as involvement in management decisions, such as approving new tenants or arranging for repairs.
If actively managed, taxpayer can deduct up to $25k against ordinary income.
Subject to phase out of $.50 for every $1 that exceeds $100k. Completely phased out at $150k.
Penalties for tax noncompliance
Failure to File: accrues on a monthly basis at 5% per month up to 25% (5 months)
Failure to pay: accrues at .5% per month up to 25% (50 months)
If both penalties apply, failure to file is reduced by the failure to pay penalty - pay reduced amount for failure to file plus the penalty for failure to pay.
*If under 5 months, just use failure to file to get total.
Sole Proprietorship Advantages/Disadvantages
Advantages:
- Easy to form
- Simple to operate
- Easy to sell business assets
- Few administrative burdens
- Income is generally passed through to the owner on Schedule C of Form 1040
Disadvantages:
- Generally have limited sources of capital
- Unlimited liability
- No guarantee of continuity beyond the proprietor
- Business income is subject to self-employment tax
General Partnerships Advantages/Disadvantages
Advantages:
- More sources of initial capital than proprietorships
- Usually have more management resources available than proprietorships
- Have fewer administrative burdens than corporations
- Income and losses are generally passed through tot he partners for tax purposes
Disadvantages:
- Transfer of interests is more difficult than for proprietorships
- Unlimited liability - each partner is liable for partnership debts and obligations
- Partnership income tax and basis adjustment rules can be complex
- Business net income is subject to self-employment tax
- Partners are entitled to few tax-free fringe benefits that are generally available to employees
Limited Partnerships Advantages/Disadvantages
Advantages:
- Favorable pass-through partnership taxation status
- Flexibility in structuring ownership interests
- Limited partners are not personally liable for the debts and obligations of the limited partnership as long as they do not engage in management
Disadvantages:
- Must file with the state to register
- In most states, general partners are liable for debts and other obligations of the limited partnership
- Losses for limited partners are generally passive losses
Limited Liability Partnership Advantages/Disadvantages
Advantages:
- Favorable pass-through partnership taxation status available
- Flexibility in structuring ownership interests
- Partners can insulate themselves from the acts of other partners
Disadvantages:
- Required to file with the state to register
- Unlimited liability for own acts of malpractice
Family Limited Partnership Advantages/Disadvantages
Advantages:
- Control retained by senior family member
- Valuation discounts are available for minority interests
- Annual exclusion gifts are generally used to transfer interests to family members
- Some creditor protection
- Restrictions can be placed on transferability of limited partnership interests of junior family members
- FLP is commonly used as an estate planning strategy
Disadvantages:
- Attorney set up fees
- Periodic valuation costs
- Operational requirements
- Potential IRS challenges regarding valuations and discounts
LLCs Advantages/Disadvantages
Advantages:
- Members have limited liability
- Number of members is unlimited but a single member LLC is a disregarded entity for tax purposes (File form 1040 schedule C)
- Members may be individuals, corporations, trusts, other LLCs, and other entities
- Income is passed through to the members, usually schedule K-1
- Double taxation effecting most C corporations is avoided if partnership tax status is elected
- Members can participate in managing the LLC
- Distributions to members do not have to be directly proportional to the members’ ownership interests as they do for S corporations
- Can have multiple classes of ownership
- Entity may elect to be taxed as a partnership, an S corporation, or a C corporation
Disadvantages:
- May have limited life (often by termination on death or bankruptcy of a member)
- Transfers of interests is difficult and sometimes limited by operating agreement
- Some industries or professions may not be permitted to use LLC status
- Laws vary from state to state
- Laws are relatively new for LLCs; therefore, precedent from prior court cases are limited
- For tax purposes, the complex partnership rules generally apply
- Members not meeting exceptions are subject to self-employment tax on all earned income if partnership status is elected
C Corporation Advantages/Disadvantages
Advantages:
- Relative ease of raising capital
- Limited liability of shareholders
- Unlimited life of entity
- Ease of transfer of ownership interests
- Generally more management resources
- Shareholders/employees may receive the full array of employer-provided tax-free fringe benefits
Disadvantages:
- Potential for double taxation due to entity level taxation
- Administrative burdens
- More difficult to form and dissolution can cause taxable gains
- Borrowing may be difficult without stockholder personal guarantees, which negates part of the advantage of limited liability
- Requires a registered agent
- Requires a federal tax ID number
S Corporation Advantages/Disadvantages
Advantages:
- Income is passed through to the shareholders for federal income tax purposes
- Income is taxed at the individual level which may be a lower tax rate than the applicable corporate rate
- Shareholders have limited liability
- Distributions are exempt from the payroll tax system, assuming the corporation provides an adequate compensation to those shareholders who are employees of the corporation
Disadvantages:
- Limited to 100 shareholders
- Only one class of stock is permitted
- Cannot have corporate, partnership, certain trusts, or nonresident alien shareholders
- Shareholder employees owning more than 2% of the company must pay taxes on a range of employee fringe benefits that would be tax-free to a shareholder/employee of a C corporation
- The tax rate of the individual shareholder may be higher than the corporate tax rate
- Borrowing may be difficult without stockholder personal guarantees, which negates part of the advantage of limited liability
Dividend received deductions based on ownership percentages of C Corporations
Standard Deductions
Sources of Tax Law
Statutory: IRC - first primary source of tax law
Administrative Sources - second primary source of tax law (in order highest to lowest)
- Regulations
- Revenue Rulings
- Revenue Procedures
- Private Letter Rulings
- Determination Letters
- Technical Advice Memorandums
Judicial Sources - third primary source of tax law
MACRS - Mid Month Convention
Used for nonresidential and residential real property.
Treat all property placed in service or disposed of during a month as placed in service or disposed of at the midpoint of the month - this means that a 1/2 month of depreciation is allowed for that month.
Investment items included in gross income
- Capital gains
- Interest income
- Original issue discount (OID) bonds
- Accrued income when transferring a debt instrument (gift or sale)
- Dividend income
3.8% Medicare Tax
Taxpayers with AGI over $200k (single) or $250k (MFJ) will be subject to the 3.8% medicare contribution tax on investment income. This is on top of the tax rates for long term capital gains and qualifying dividends.
Tax is imposed on the lesser of the individual’s net investment income for the tax year or modified AGI in excess of the limits.
Passive income is considered net investment income for this tax.
Foreign Income
Taxpayer can exclude up to $120k of foreign earned income IF your home is in a foreign country and you are one of the following:
- US citizen that is a bone fide resident of a foreign country for an uninterrupted period that includes an entire tax year
- US resident alien that is a citizen or national of a country that the US has an income tax treaty in effect (plus the above)
- US citizen or resident alien who is physically present in a foreign country for at least 330 full days during any period of 12 consecutive months
Unemployment vs Workers Comp
Unemployment: compensation included in gross income
Workers Comp: excludable from gross income - seen as making taxpayer whole
Penalties
- 6% excise tax on excess contributions to IRAs
- 10% early distribution penalty prior to 59.5 (except for death, disability, equal payments/QDRO/medical, birth or adoption)
- 50% minimum distribution penalty after 72
Recourse Debt
Allows a lender to pursue a borrower’s personal assets for satisfaction of the indebtedness.
Adds to the taxpayer’s basis.
Income in Respect of Decedent (IRD Assets)
The basis does not receive a step to FMV at the death of the transferor because the assets were not subject to ordinary income tax during the life of the transferor.
Assets are included in the gross estate of the decedent and subject to income tax when received by the bene.
Ex. IRAs, annuities, installment notes
Double Basis Rule
Applies to gifts of loss property (FMV is less than the donor’s basis).
Donee’s basis = FMV when sold for a loss
Donee’s basis = donor’s basis if sold for a gain
No gain or loss if sold between FMV and the donor’s basis
Basis of jointly held property
Always use actual contribution rule EXCEPT:
- Spouse use deemed 50% contribution rule
- Spouses that are tenants in common use actual contribution
1035 Exchanges
Insurance products that can be exchanged without tax recognition:
Life insurance - Life insurance
Life insurance - Annuity
Annuity - Annuity
*Annuity - Life insurance is a taxable event
Rental property exceptions to passive categorization
- Customer use less than or equal to 7 days
- Customer use less than or equal to 30 days and significant personal services provided
- Extraordinary personal services are provided
- Rental activities incidental to non-rental activity
- Rental activity available during business hours for nonexclusive use of customers
- Rental property used in an activity conducted by partnership, etc. where the taxpayer is the owner and an active participant
