Tax Planning (Section II.A) (13%, 16 Questions) Flashcards
Marginal Tax Rate
- The tax rate applied to the next marginal (incremental) portion of income earned.
Effective Tax Rate
- The tax rate actually paid on total income calculated by dividing total taxes paid by total income.
All Taxable Income and Taxable Gains
Examples: Wages, Income, Investment interest and taxable gains, qualifying alimony from contract pre-2019, retirement account distributions, etc.
Applicable Deductions (above the line)
Examples: Self-employment tax, self-employed insurance premium deductions. Contributions to retirement accounts, certain education expenses, etc.
Adjustable Gross Income
Equal All taxable income and taxable gains reduced by applicable (above the line) deductions.
Taxable Income
Equals AGI reduced by applicable deductions, for example: Standard or itemized deductions, exemptions. (Below the line)
Total Tax
Equals Taxable Income reduced by applicable credits, for example: Foreign tax credit, dependent care, education credits and other taxes (self-employment tax, household employment tax).
Calculate Adjusted Gross Income Example #1: Employee
Calculate Adjusted Gross Income Example #2: Self-Employed
Calculating Self-Employment Tax
Social Security’s old age, survivors, and disability insurance (OASDI) program taxed at a flat rate (6.20% for employee and 6.20% for employer = 12.40% for self-employed) on net earnings from SE up to maximum income level of $160,200 for 2023.
- Medicare’s Hospital Insurance (HI) program taxed at a flat rate (1.45% for employee and 1.45% for employer = 2.90% for self-employed)
-An income deductions is allowed (above the line) for one half of SE tax paid.
Schedule A Itemized Deductions
- Medical and Dental Expensess (7.5% of AGI Threshold)
- State and local tax deductions limited to $10,000 MFJ interest you paid.
- Gifts to charity
Tax credits
- Directly reduce tax liability (dollar for dollar)
Tax Deductions
- Reduce taxable income which means the value of a tax deductions lies in the marginal rate which rises with additional income.
Estimated Tax Payment Rules
- If prior year AGI was $150k or less, to avoid underpayment penalties, pay 100% of prior year tax or 90% of current year tax, whichever is less.
- If prior year AGI was over $150k, to avoid underpayment penalties, pay 110% of prior year tax of 90% of current year tax,whichever is less.
-Tax withheld from retirement distributions is considered paid evenly throughout the year and qualifies as estimated tax payments.
Distributable Net Income (DNI)
- The amount transferred to unitholders (if an income related trust) or the amount distributed to bene’s (if an estate related trust)
- DNI may be deducted by trusts for tax purposes
-Calculation:
Taxable Income before exemptions, distributions and special deductions
ADD capital losses and net muni income
SUBTRACT capital gains.
Taxation of Trusts: First-Tier Bene
- Must have income distributed to the in the year earned. They are taxed on income actually or constructively distributed to the extent of the trust’s or estate’s distributable net income (DNI).
- Currently DNI must be distributed in the same year tax year as earned.
Taxations of Trusts - Second Tier Bene
- Receive all distributions that are properly paid, credited or required to be distributed other than tier one distributions and gifts or specific bequests or property or sums of money.
- This includes discretionary distributions, distributions required upon a specified occurence, an annuity paid out of corpus and a spousal support allowance required by court order.
Key 2023 Tax Rates
- LTCG = 0-20%
- Ordinary Income = 10-37%
- Collectibles = 28%
- AMT 26 & 28%
Medicare Hospital Insurance Tax & Surtax on Net Investment Income
0.9% Medicare Hospital Insurance Tax
- Tax assessed on earned income above: $250k MFJ & $200k Single.
3.8% Surtax on Net Investment Income
- Tax assessed on certain net investment income when modified AGI is above: $250k MFJ & $200k Single.
Step-Transaction Doctrine
Used to help identify so called sham loans and transactions (that are often found in family transactions)
Gifts to Minors
- UGMA:
- Limited to transfer of certain assets
- Growth can be tax-free
- Ownership typically transfers to child at 18.
- UTMA:
- Growth can be tax-free
- May be included in grantor’s taxable estate until child takes ownership which transfers from age 21-25.
Kiddie Tax
- Amount of unearned income above $2,300 for those dependents under 19 years old and full-time student dependents from 19-23 years old to be taxed at the parent’s rate.
Calculate AMT - 2023
1) Taxable income +/- AMT Adjustments + AMT Preference items = AMTI
2) AMTI - Exemption Amount (subject to phase out) = AMT Base
3) AMT Base x AMT Rate = Preliminary AMT (26% on first $220,700 & 28% on amounts above $220,700)
4) Preliminary AMT - Tax Credits = Tentative AMT
5) Tentative AMT - Regular Tax = AMT Due
AMT Exemptions and Tax Rates - 2023
- Exemptions Amount - $126,500 MFJ
- Exemptions phaseout begins - $1,156,300 for MFJ
- AMT Rates - 26% for amounts up to $220,700 MFJ & 28% for amounts above $220,700 for MFJ.
AMTI Calculation
- Start with taxable income.
- Add or Subtract: Adjustments including:
- Standard Deduction
- Certain itemized
deductions - ISO
- Add: Tax Peerference Items:
- Tax exempt bond interest
from certain private
activity bonds. - Excluded gain on sale of
qualified small business
stock
- Tax exempt bond interest
- Results = AMTI
AMT Example
FACT PATTERN: Susan and Mike Jones are married, have 3 young children
and file a joint return. Their taxable income under the regular income tax
calculation for this year is $2.5 million and their regular income tax liability is
$660,000. They gave $150,000 to qualified public charities over the year and
have an AMT adjustment of $125,000 from various non-tax related itemized
deductions. The Jones’ had preference items from incentive stock options
($75,000) and tax-exempt interest ($15,000) from qualified private activity
bonds. They paid $80,000 in property taxes. Calculate the Jones’ total tax
liability.
Step 1: Calculate AMTI
Taxable Income $2.5m +/- AMT preference items and adjustments ($125,000 +
$75,000 + $15,000 + $10,000) = $2.725m
Note – charitable deductions are not added back; they paid $80k in property taxes but
were only allowed to take a $10k deduction so only the $10k is added back.
Step 2: Calculate AMT base
AMTI $2.725m – exemption amount ($0) = $2.725m
Note – The Jones’ are not allowed to take the AMT exemption because their
income (AMTI) is above the phase-out amount of $1,156,300 (for 2023)
Step 3: Calculate tentative minimum tax
AMT base ($2.725m - $220,700 = $2,504,300) x 28% = 701,204
+ (220,700 x 26% = 57,382) = $758,586
Step 4: Calculate AMT
Tentative minimum tax $758,586 – regular tax liability $660,000 = AMT
$98,586
Note – The Johnson’s have $758,586 in total tax liability (the higher of
AMT tentative tax and regular tax liability).
AMT Planning Opportunities
- Income and Expense Planning:
- Defer deductions for state
income or property taxes. - Defer or accelerate receipt
of income. - Reduce exposure to
private activity bonds - Consider taxable bonds if
subject to AMT. - Time Chartiable
contributions.
- Defer deductions for state
- Stock and Option Planning:
- Defer or accelerate receipt
of capital gains - Consider disqualifying
disposition of ISOs - Consider tandem exercise
of ISOs and NSOs.
- Defer or accelerate receipt
2023 Percentage Deduction LImitation Rules
Gift Property with imbedded loss (depreciated property)
- General rule: the taxpayer deducts the lesser of FMV or cost basis for gifts of depreciated assets.
Gift property encumbered by debt
- FMV of gift property is calculated net of debt.
- The transfer of encumbered property to charity is considered a bargain sale (i.e., the amount of debt is considered an amount realized by the donor.)
Deducting Mortgage Interest
- Primary residence or second home
- Points and other forms of interest
- Limits on deductability:
- $750k aggregate acquisition indebtedness deduction eliminated.
- Home equity
indebtedness deduction
eliminated, - Qualified HELOC interest
is further limited in scope.
Investment Interest
- Interest paid to borrow money to make investments is deductible but limited to the amount of net investment income.
Business Activity Interest
- Interest paid on business loans including rental property and other real estate holdings is deducted from gross income personally or through a business entity “above the line”.
- In most cases, interest expense from passive activites is only deductible to the extent of income from these activities.
Qualified and Non-qualified Dividends
- Dividends are generally taxed as ordinary income.
- Qualified dividends are taxed at capital gains rates.
- Holding period: In order to qualify for lower rates, investors are required to hold commond stock for more than 60 days in the 121-day period beginning 60 days before the ex-divident date.
- Holding period: In order to qualify for the lower rates, investors are required to hold preferred stock for more than 90 days in the 181-day period beginning 90 days before the ex-dividend date.
Netting of Capital Gains
- Net all short-term gains and losses
- Net all long-term gains and losses.
- Loss offsets:
- If total short-term net is a
loss, it may be used to offset
any LTCG - If total long-term net is a
loss, it may be used to offset
any STCG
- If total short-term net is a
- The the net of all capital gains
and losses is a loss:- $3,000 of the capital loss
may offset ordinary income - Balance of capital loss is
carried forward to next year,
- $3,000 of the capital loss
Realized Gain vs. Recognized Gains
Realized = gains occur upon transaction. LIke in an IRA.
Recognized = Gains occur when triggering a taxable event. Like in a JT.
Taxation of Incentive Stock Options
- Holding period requirements: hold 2 years after grant.
- If holding period is met.
*Grant - Not a taxable event
*Exercise - Not a taxable event
*Sale - Taxation upon sale as appropriate. - If holding period is not met.
*Difference between FMV at time of exercise and the option price is considered ordinary income for tax purposes.
ISO Spread Impact on AMT
- The holder of an ISO realizes gain or loss for AMT purposes equal to the difference between the FMV of the stock on the date of exercise and the exercise price (Called the “Spread”).
- The spread is an AMT preference item that must be added bacck when computing AMTI.
Taxation of Non-Qualified Stock Options
- Not taxed at time of grant.
- NQSO are taxed as ordinary income at time of exercise.
- First taxable event: Tax is based on the spread between market price at exercise and the exercise price actually paid by the executive.
- Second taxable event: LTCG/L if stock sold more than one year after the exerrcise. STCG/L if sold less that one year after the exercise.
Flow-through Character
- Partnerships, LLPs and S corps are pass through entities. This means income is passed through from an entity to the individual and is taxed to the individual.
- LLC can elect to be taxed as a corporation, but LLC members usually elect to be taxed as a partnership. With this election an LLC is also a pass-through entity.
Basis in an S Corp
- Calculating basis (re-calc’d each year)
Beginning basis
+Capital contributions
+debt shareholder personally loaned to company
+Income/gains - Distributions
=Adjusted basis before loss allocation - Deductions
=Ending basis
Basis in a Partnership/LLC
- Calculating basis (re-calc’d each year)
Beginning basis
+Capital contributions
+Allocable share of recourse debt
+Allocable share of qualified nonrecourse debt
+Income/gains
-Distributions
=Adjusted basis before loss allocation
-Deduction/losses
=Ending basis
Pass-Through Basis Limitations
- Income tax losses may not be deducted if they exceed the owner’s basis:
*The unused loss is suspended until sufficient basis become available. - An individual partner/shareholder may not have a negative basis in the interest.
- Distributions in excess of basis result in a taxable gain.
Recourse vs Non-recourse Debt
- A recourse debt holds the borrower personally liable. All other debt is considered non-recourse.
- In general, recourse debt allows lenders to collect what is owed even after they’ve taken collateral (home, credit cards). Lender have the right to garnish wages or levy accounts in order to collect what is owed.
Capital Account (Partnership)
- Represents each partners ownership stake in the business. It tracks the initial contributions, additional investments, and their share of profits and losses. Its crucial for understanding each partner’s financial position within the partnership.
Pass Through At Risk Limitations
- Loss deductions are also limited by the amount the taxpayer has at risk.
- S corps - Shareholders include only debt that they personally loan to the corporation.
- Partnerships/LLCs - General partners include all partnership debt on which they have personal liability.
_ Limited parterns and LLC members include only recourse debt for which they are personally exposed and qualified nonrecourse debt for business real estate.
Passive Activities
- A passive activity is a trade of business in which the taxpayer does not materially participate.
- Often involve things like real estate rentals.
- Net income from passive activities is usually ordinary income taxed at rates of up to 37% and the 3.8% surtax on net investment income may apply.
Passive Loss Limitations
- Losses from passive activites are deductible to the extent there is passive income.
1031 Exchanges
- Gain recognition is deferred on like-kind exchanges of real property
*Investment property for investment property
*Trade/business for trade/business
*Does not apply to persona use property or residences - Gain recognized to the extent of “boot” received
*Boot includes cash and debt relief - Losses are not recognized.
Section 1250
- Re-characterization of cap gains as ordinary income to recapture accelerated depreciation on certain real property.
Section 1231
- Depreciable and real property used in trade or business and held for more than one year are allowed cap gains treatment of gains and ordinary income treatment of losses.
Section 1244
- Certaian small company stock owners are allowed ordinary income (vs. cap gains) treatment for losses up to $50k/individual and $100k/joint.
Example: Strategy to maximize the value of interest expense deductions (by deferring)
