Professional Documents
Culture Documents
Types of income
Note1: the calculation is about the taxable portion of premium paid by the company. However,
the entire amount of insurance proceeds paid by the reason of death will be excluded (that is
classified as life insurance)
Note2: employee death payment paid by the company should be included in gross income.
Note3: Tips. (1) If an individual receives less than 20 tips during one month while working for
one employer, the tips do not have to be reported to the employer and the tips are included in
the gross income when received. (2) If an individual receives more than 20 tips during one
month while working for one employer, the tips have to be reported to the employer by the 10th
day of the next month and the tips are included in the gross income when reported.
Exclusion provisions
There are specific types of income that taxpayers realize but are allowed to permanently exclude from
gross income or temporarily defer from gross income until a subsequent period. Exclusions and
deferrals are the result of specific congressional action and are narrowly defined. Congress allows most
exclusions and deferrals for two primary reasons: (1) to subsidize or encourage particular activities or (2)
to be fair to taxpayers.
1. Municipal interest
Interest on municipal bonds (bonds issued by state and local governments located in the US)
Interest on obligations of a state or one of its political subdivisions, the District of Columbia, and
US possessions is generally excluded from income if the bond proceeds are used to finance
traditional governmental operations.
2. Nontaxable fringe benefits (R1-18)
A. The first 50,000 group term life insurance
B. Health and accident insurance paid for an employee and their spouse and dependents.
C. Cash reimbursement for medical care
D. Meals and lodging for the convenience of the employer
E. Employee educational assistance. Employees can exclude form income up to 5,250 of
employee educational assistance benefits covering tuition, books and fees. Amounts over
5,250 are taxed as compensation to the employee.
F. Employees can exclude up to 5,000 for benefits paid or reimbursed by employers for caring
for children under 13 or dependents or spouses who are physically or mentally unable to
care for themselves.
G. No-additional-cost services. Employees can exclude the value of No-additional-cost services.
These are services employers provide to employees in the ordinary course of business that
generate no substantial costs to the employer.
H. Qualified employee discounts as long as they don’t acquire (1) goods at a price below the
employer’s cost or (2) services at more than a 20 percent discount of the price of the
services to customers.
Eg. Julie purchased a laptop from her company at 1,600 (MFV 2,100) with a cost basis of
1,500. This discount is qualified discount,0 included in her compensation.
Eg. Julie purchased a laptop from her company at 1,600 (MFV 2,100) with a cost basis of
1,700. This 100 discount is not qualified discount, 100 included in her compensation
I. Working condition fringe benefits
5 Regulation Notes By Tomato
J. De Minimis fringe benefits. Small benefits.
K. Qualified transportation fringe: the value of company-owned car pool vehicle for
commuting, the cost of mass transit passes, and the cost of qualified parking near the work
place. The maximum exclusion of the car pool vehicle and mass transit pass is 230/month.
And the maximum exclusion for the qualified parking benefit is also 230/month.
L. Qualified moving expense reimbursement
Cafeteria plan: employer-sponsored benefit packages that offer employees a choice between
taking cash and receiving qualified benefits (such as accident and health insurance). Thus,
employees may select their own menu of benefits. If an employee chooses qualified benefits,
they are excluded from the employee’s gross income to the extent allowed by law. If an
employee chooses cash, it is includible in the gross income.
Note: if the redemption proceeds exceed the qualified higher education expenses, only a pro
rata amount of interest can be excluded. Moreover, the exclusion is subject to phase out.
E.g., During 2009, a married taxpayer redeems series EE bonds receiving 6,000 of principal and
4,000 of accrued interest. Assuming qualified higher education expenses total 9,000, accrued
interest of 3,600 (9,000/10,000*4,000) can be excluded from gross income.
Deferral provisions
Deferral provisions allow taxpayers to defer the recognition of certain types of realized income.
Transactions generating deferred income include installment sales, like-kind exchanges, involuntary
conversions, and contributions to non-Roth qualified retirement accounts.
Deductions
Deductions for AGI are generally preferred over deductions from AGI because deductions above the line
reduce taxable income dollar for dollar. In contrast, deductions from AGI sometimes have no effect on
taxable income. Further, because many of the limitations on tax benefits for higher income taxpayers
are based upon AGI, deductions for AGI often reduce these limitations thereby increasing potential tax
benefits.
Differentiate business activities with investment activities: Business activities require a high level of
involvement or effort from the taxpayer; investment activities are profit-motivated activities that do not
require a high degree of taxpayer involvement or effort. Instead, investment activities involve investing
in property for appreciation or for income payments.
A. Business expenses are deducted for AGI with one exception. The lone exception is
unreimbursed employee business expenses are deductible as itemized deductions.
B. Investment expenses are deducted from AGI with one exception. Expenses associated with
rental and royalty activities are deductible for AGI regardless of whether the activity qualifies
as an investment or business.
1. Business expenses.
1. Passive activity income or loss: income or loss from an activity in which the taxpayer is not a
material participant. Participants in rental activities, including rental real estate, and limited
partners in partnerships are generally deemed to be passive participants and participants in all
other trade or business activities are passive unless their involvement in an activity is regular,
continuous, and substantial.
2. Portfolio income: income from investments including capital gains and losses, dividends,
interest, annuities, and royalties.
3. Active business income: income from sources in which the taxpayer is a material participant.
For individuals, this includes salary and self-employment income.
The impact of segregating income in these baskets is to limit taxpayer’s ability to apply passive
activity losses against income in the other two baskets. Losses from the passive category cannot
offset income from other categories. Passive activity losses are suspended and remain in the passive
income or loss category until the taxpayer generates current year passive income, either from the
passive activity, or until the taxpayer sells the activity that generated the passive loss. (WP377)
10 Regulation Notes By Tomato
Deductions indirectly related to business activities
Taxpayers can incur expenses in activities that are not directly related to making money but that they
would not have incurred if they were not involved in a business activity.
1. Moving expenses
Deductions for AGI if they meet two tests:
A. A distance test (R2-12)
Distance from new job to former residence is at least 50 miles further than distance from
old job to former residence.
B. A business test associated with the move
Taxpayer is employed at least 39 weeks out of 12 months following move. Self-employed
individuals must be employed 78 weeks out of 24 months following move. This test does not
have to be met in case of death, taxpayer’s job at new location ends because of disability, or
taxpayer is laid off for other than willful misconduct.
Taxpayers who receive a flat amount as a moving allowance from their employers are
required to include the allowance in gross income, and can deduct their actual moving
expenses for AGI.
e.g. EWD agreed to reimburse Courtney for 2,000 of actual moving expenses, what amount
would Courtney deduct for moving expenses (transportation: 156, moving company: 5,000,
lodging: 123, meals 75, house-hunting trip 520).
3,279. Courtney could deduct 3,279 in moving expenses. She would not include the
reimbursement in income and she would not deduct the 2,000 of expenses for which she was
reimbursed.
Note: indirect moving expenses such as pre-move house-hunting, temporary living expenses and
meals while moving are not deductible.
1. Alimony payment
2. Contribution to retirement savings (IRA)
3. Educator expenses
a. From 2007 through 2009, eligible educators are allowed deduction up to 250 for
unreimbursed expenses for books, supplies, computer equipment and supplementary
materials used in the classroom.
b. An eligible educator is a kindergarten through grade 12 teachers, instructor, counselor,
principal or aide working in a school for at least 900 hours during the school year.
4. Jury duty pay remitted to employer
a. An employee is allowed to deduct the amount of jury duty pay that was surrendered to an
employer in return for the employer’s payment of compensation during the employee’s jury
service period.
b. Both regular compensation and jury duty pay must be included in gross income.
5. Interest on qualified education loans
Qualified education loans are loans whose proceeds are used to pay qualified education
expenses. Qualified education expenses encompass expenses paid for the education of the
taxpayer, the taxpayer’s spouse, or a taxpayer’s dependent to attend a postsecondary
institution of higher education. These expenses include tuition and fees, books and expenses
required for enrollment, room and board, and other necessary supplies and expenses including
travel. The amount of the maximum education expense deduction (up to 2,500) depends on
Married individuals who file separately are not allowed to deduct this expense under any
circumstance.
Note: non-prescribed medicines and drugs are not deductible (e.g., over-the-counter medicines)
The deduction for medical expenses is limited to the amount of unreimbursed qualifying
medical expenses paid during the year reduced by 7.5% of AGI.
e.g. This year Courtney incurred 2,400 in unreimbursed qualifying medical expenses. Given that
Courtney’s AGI is 162,000, what is the amount of itemized medical expense deduction?
24000-(162,000*7.5%)=0
What amount of deduction if AGI is 30,000? 2,400-(30,000*7.5%)=150
2. Taxes (R2-21)
A. state, local and foreign income taxes; (Note: taxpayers may elect to deduct state and local
sales taxes instead of deducting state and local income taxes)
B. real estate taxes (state, local and foreign) on property held for personal or investment
purposes (when real property is sold, the deduction is apportioned between the buyer and
seller on a daily basis within the real property tax year)
C. Personal property taxes (state and local) that are assessed on the value of the specific
property.
Another nonitemizer deduction exists for state and local property taxes. Nonitemizers are
allowed to increase their standard deduction for the state and local real property taxes paid.
This addition is limited to the lesser of:
(1) The amount of real property taxes paid during the year, or
(2) $500 (1,000 for a married couple filing jointly)
3. Interest paid
(1) Home mortgage interest (Interest paid on loans secured by a personal residence)
a. Taxpayers are allowed to deduct only qualified residence interest as an itemized
deduction. Qualified residence interest is interest paid on the principal amount of
acquisition indebtedness and on the principal amount of home-equity indebtedness.
Both types of indebtedness must be secured by a qualified residence to qualify.
b. Qualified residence: the taxpayer’s principal residence and one other residence. For a
taxpayer with more than two residences, which property is treated as the second
qualified residence is an annual election-that is, the taxpayer can choose to deduct
interest related to a particular second home one year and a different second home the
next. If the taxpayer rents the second residence for part of the year, the residence will
qualify if the taxpayer’s personal use of the home exceeds the grater of (1) 14 days or
(2) 10 percent of the number of rental days during the year.
(2) Investment interest expense (interest expenses on loans used to acquire investments)(R222)
a. Interest paid on loans used to purchase investment assets such as stocks, bonds, or land.
b. The deduction of investment interest is limited to a taxpayer’s net investment income
(gross investment income-deductible investment expenses. Note: investment interest
expense is not an investment expense). Deductible investment expenses are investment
expenses that actually reduce taxable income after applying the 2% of AGI floor.
c. Gross investment income includes interest, annuity, and royalty income not derived in
the ordinary course of a trade or business. It also includes net short-term capital gains,
net capital losses (short-term and long-term), and non-qualifying dividends. However,
investment income generally does not include net long-term capital gains and
qualifying dividends because this income is taxed at a preferential rate. However,
congress allows taxpayers to elect to include preferentially taxed income in investment
income if they are willing to subject this income to tax at the ordinary tax rates.
d. Any investment interest in excess of the net investment income limitation carries
forward to the subsequent year when it is subject to the same limitations. The carryover
amount never expires.
e. Note: investment interest expense is different from investment expenses below.
(3) Out-of-pocket expenses to main a student (domestic and foreign) in a taxpayer’s home are
deductible (limited to $50/month for each month the student is a full-time student) if
a. Student is in 12th or lower grade and not a dependent or relative
b. Based on a written agreement between taxpayer and qualified organization
c. Taxpayer receives no reimbursement
Private operating foundations: privately sponsored foundations that actually fund and
conduct charitable activities
Private non-operating foundations: privately sponsored foundations that disburse funds to
other charities.
Contribution type Public charity and private Private non-operating
operating foundation foundations
Cash
Amount Cash amount Cash amount
AGI limit 50% 30%
Capital gain property
Amount FMV on the date of donation Basis
AGI limit 30% 20%
Ordinary income property
Amount Lesser of FMV or Basis Lesser of FMV or Basis
AGI limit 50% 30%
When taxpayers make contributions that are subject to different percentage limitations,
follow the steps:
(1) Determine the limitation for the 50% contributions.
When a taxpayer’s contributions exceed the AGI ceiling limitation for the year, the excess
contribution is treated as though it was made in the subsequent tax year and is subject to
the same AGI limitations in the next year. The excess contribution can be carried forward
for five years before it expires.
Casualty losses must exceed two separate floor limitations to qualify as itemized deductions:
(1) 500 for each casualty event during the year (100 for years other than 2009); and
(2) 10% of AGI for the whole year
Eg. Courtney has 325 stolen and her car was worth 20,000 and completely destroyed in the
accident. She only received 3,100 from insurance reimbursement. AGI: 162,000
Miscellaneous deductions not subject to 2% AGI floor (that is, full deduction)
1. The amount of a taxpayer’s total itemized deductions other than medical expenses, casualty
losses, investment interest expense, and gambling losses are subject to phase out. (MGICA)
2. Phase-out for 2009 is determined in 2 steps.
(1) Determine the lesser of (a) 3%* (AGI – 166,800 or 83,400 for married filing separately)
or (b) 80% of the total itemized deductions subject to phase-out
(2) Multiply the amount determined in step 1 by one-third. The product is the amount of
the itemized deduction phase-out.
The standard deduction is a flat amount that most individuals can elect to deduct instead of deducting
their itemized deductions. That is, taxpayers generally deduct the grater of their standard deduction or
their itemized deductions.
The amount o standard deduction depends on filing status. Taxpayers who are at least 65 years of age
on the last day of the year or blind are entitled to additional standard deduction amounts above and
beyond their basic standard deduction. (check Becker R2-16)
Following three steps to determine tax liability if a taxpayer has long-term capital gain or qualifying
dividends (those are taxed at a preferential rate 15%)
1. Split taxable income into the portion that is subject to the preferential rate and the portion
taxed at the ordinary rates.
2. Compute the tax separately on each type of income. Note that the income that is not taxed at
the preferential rate is taxed at the ordinary tax rates using the tax rate schedule for the
taxpayer’s filing status.
3. Add both taxes.
Note: to ensure that taxpayers receive some tax benefit from preferentially taxed income, to the
extent that this income would have been taxed at 15% or 10% if it were ordinary income, it is taxed
at a 0 percent preferential rate.
4. For AMT tax purposes long-term capital gain or qualifying dividends are taxed at the same
preferential rate.
5. AMT computation
(1) 26% on the first 175,000 AMT base (87,500 for married filing separately)
(2) 28% on the AMT base in excess of 175,000 (regular AMT bases, that is, not including long-
term capital gain and qualifying dividends)
The amount of credit depends on the filing status, the number of qualifying children who
live in the home for more than half of the year, and the amount of earned income. The
credit is computed by multiplying the appropriate credit percentage times the taxpayer’s
earned income up to a maximum amount.
When the partnership assumes debt of the partner secured by property the partner contributes to
the partnership, the contributing partner must treat her debt relief as a deemed cash distribution
from the partnership that reduces her outside basis. If the debt securing the contributed property is
nonrecourse debt, the amount of the debt in excess of basis of the contributed property is allocated
solely to the contributing partner, and the remaining debt is allocated to all partners according to
their profit-sharing ratios (B20-6) (tax basis 债由本人承担,超过 tax basis 债由所有 partner 分担)
Partner’s holding period in partnership interest
1. If the contributed property is capital assets or 1231 assets, then it includes the period of time
the property was held by the partner.
2. Otherwise, it begins on the day the partnership interest is acquired.
Partnership should create a tax capital account for each new partner, reflecting the tax basis of any
property contributed and cash contributions.
1. Partners’ recognized ordinary income= the amount they would receive if the partnership were
to liquidate, or liquidation value of the capital interest
2. Tax basis= Partners’ recognized ordinary income
3. Partners’ holding period will begin on the date he receives the capital interest.
For partnership:
1. The partnership either deducts or capitalizes the value of the capital interest, depending on the
nature of the services the partner provides.
2. When the partnership deducts the value of capital interest used to compensate partners for
services provided, it allocates the deduction only to the partners not providing services,
because they have effectively transferred a portion of their partnership capital to the service
partner. (i.e., capital interests shift from nonservice partners to service partner)
Although partnerships are not taxpaying entities, they are required to file tax returns annually. In
addition, they supply information to each partner detailing the amount and character of items of income
and loss flowing through the partnership. Partners must report these income and loss items on their tax
returns even if they do not receive cash distributions during the year.
When gathering this information for their partners, partnerships must determine each partner’s share of
ordinary business income (loss) and separately stated items. Separately stated items are treated
differently from ordinary business income from tax purposes (tax rates are different).
Common separately stated items (determined at partnership level rather than partner level) include:
A. Interest income
B. Guaranteed payments
Guaranteed payments are fixed amounts paid to partners regardless of whether the partnership
shows a profit or loss for the year. Because this payment is similar to salary payments, partners
treat them as ordinary income. Note: they are typically deducted in computing a partnership’s
ordinary income or loss for the year.
C. Net earnings (loss) from self-employment
D. Tax-exempt income
E. Net rental real estate income
F. Investment interest expense
G. Section 179 deduction
1. General partners: pay tax on guaranteed payments for services they provide and their share of
ordinary business income (loss)
2. Limited partners: pay tax only on guaranteed payments
3. LLC members: same as general partners if LLC members have personal liability for the debts of
the LLC by reason of being an LLC member, who have authority to contract on behalf of the LLC,
or who participate more than 500 hours in the LLC’ trade or business. Otherwise, same as
limited partners.
Partnership filing
1. File Form 1065 return of partnership income with the IRS by the 15 day of the 4th month after
their year-end. They may receive automatic five-month extension by filing form 7004
2. Partnership prepare schedule K-1 for each partner detailing her individual share of the
partnerships’ ordinary income and separately stated items with Form 1065
The basis in partnership is dynamic and must be adjusted in the order listed:
1. Increase for actual and deemed cash contributions to the partnership during the year.
( increased share of debt in partnership is considered as deemed cash contribution)
2. Increase for partner’s share of ordinary business income and separately stated income/gain
items
3. Decrease for actual and deemed cash distributions during the year. (debt relief by the
partnership is considered as deemed cash distribution)
4. Decrease for partner’s share of nondeductible expenses (fines, penalties, etc)
5. Decrease for partner’s share of ordinary business loss and separately stated expense/loss items.
Basis adjustments that decrease basis may never reduce a partner’s tax basis below 0.
Loss limitations
Ordinary losses from partnerships are deductible against any type of taxable income. However, they are
deductible on the partner’s tax return only when they clear three separate hurdles:
Partners may dispose of their interest in several ways: sell to a third party, sell to another partner, or
transfer the interest back to the partnership.
Seller issues
Hot assets:
1. Unrealized receivables include the right to receive payment for (1) goods delivered or to be
delivered or (2) service rendered, or to be rendered. 1245 Depreciation recapture is also
considered as unrealized receivable.
2. Inventory: Assets other than cash, capital assets, and 1231 assets
When a partner sells her interest in a partnership that holds hot assets, she modifies her calculation of
the gain or loss to ensure the portion that relates to hot assets is property characterized as ordinary
income. The process for determining the gain or loss follows:
Step2: calculate the partner’s share of gain or loss form hot assets as if the partnership sold these assets
at their FMV. This represents the ordinary portion of gain or loss. For specific partner,
Ordinary gain or loss=the gain or loss from hot assets * the partner’s interest percentage.
Step3: subtract the ordinary portion of the gain or loss obtained in step2 from the total gain or loss from
step1. This remaining amount is the capital gain or loss from the sale.
The sale of partners’ interest does not generally affect a partnership’s inside basis in its assets. The new
partner’s share of inside basis is equal to the selling partner’s share of inside basis at the sale date. In a
sale of a partnership interest, the selling partner’s tax capital account carries over to the new investor.
Operating distribution
Like shareholders receiving corporate dividend distributions, partners often receive distributions of the
partnership profits, known as operating distributions. Usually, the general partners determine the
amount and timing of distributions. A distribution from a partnership is an operating distribution when
the partners continue their interest afterwards.
Neither the partnership nor the partners recognize gain or loss on the distribution of property or money
(general rule). The partner simply reduces her outside basis in the partnership interest by the amount of
the distribution.
1. Distribution < tax basis gain=0 and new tax basis=old tax basis-distribution;
2. Distribution > tax basis gain=distribution – tax basis and new tax basis=0;
Neither the partnership nor the partners recognize gain or loss on the distribution of property or money
(general rule).
Allocation of outsider basis in an order: 1. Money; 2. hot assets; and 3. other property.
Step 2: if remaining outside basis > property basis (the partnership basis in the property), then
Otherwise, then:
In essence, a partner treats a reduction of her share of debt as a distribution of money. If the partner
increases her share of debt, the increase is treated as a cash contribution to the partnership.
If there is any change in a partner’s share of partnership debt resulting from a distribution, adjust the
outside basis according to the debt change first before step1 and step2.
Liquidating distributions
Liquidating distributions terminate a partner’s interest in the partnership. The tax issues in liquidating
distributions for partnerships are basically twofold: (1) to determine whether the terminating partner
recognizes gain or loss and (2) to reallocate her entire outside basis to the distributed assets.
The rationale behind the rules for liquidating distributions is simply to replace the partners’ outside
basis with the underlying partnership assets distributed to the terminating partners. Ideally, there would
be no gain or loss on the distribution, and the asset bases would be the same in the partner’s hands as
they were inside the partnership.
In general, neither partnerships nor partners recognize gain or loss from liquidating distributions.
However, there are exceptions.
In contrast to operating distributions, a partner may recognize a loss from a liquidating distribution, but
only when two conditions are met. These conditions are (1) the distribution includes only cash,
unrealized receivables, and/or inventory, and (2) the partner’s outside basis is greater than the sum of
the inside bases of the distributed assets. The loss on the distribution is a capital loss to the partner.
The terminating partner’s share of partnership debt decreases after a liquidating distribution. Any
reduction in the partner’s share of liabilities is considered a distribution of money to the partner and
reduces the outside basis available for allocation of basis to other assets, including inventory and
unrealized receivables.
Note: if there is change in debt liability, then adjust outside basis based on the debt change.
Organizational expenditures
The concept of matching income with the expense of generating that income would require that
partnership organization costs be capitalized and amortized over the life of the partnership.
Organization costs include legal fees for drafting the partnership agreement, accounting fees to
organize the partnership, and state and local filing fees.
A partnership may deduct up to 5000 of organization costs for the tax year in which the partnership
begins business, with any remaining expenditures deducted ratably over the 180-month period
beginning with the month in which the partnership begins business (rather than the date the
partnership is organized) (same for the corporation)
Costs are defined as (1) costs paid or incurred in connection with the investigation or acquisition of
an active trade or business; (2) costs paid or incurred in the creation of such a trade or business, or
(3) pre-activity costs.
A partnership may deduct up to 5000 of start-up costs for the tax year in which the partnership
begins business, with any remaining expenditures deducted ratably over the 180-month period
beginning with the month in which the active trade or business begins
Syndication costs
The costs of issuing and marketing interests in a partnership syndication, such as commissions,
professional fees, and printing costs, must be capitalized and are not subject to amortization.
Note: for corporation, each 5,000 amount is reduced by the amount by which the organizational
expenditures or start-up costs exceed 50,000, respectively.
Depreciation method
The method is an election made by the partnership and may be any method approved by the IRS.
The partnership is not restricted to using the same method as used by its principal partner.
Form 1120 schedule M-1: reconciling to taxable income before the DRD and NOL deductions.
Form 1120 schedule M-1: provides the change in retained earnings during the year and reports the
ending balance (book)
Form 1065: partnership tax (unincorporated entities with more than one owner)
For C corporation,
Personal property includes all tangible property, such as computers, automobiles, furniture, machinery,
and equipment, other than real property (building and land). Personal property and personal-use
property are not the same thing. Personal property denotes any property that is not real property while
personal-use property is any property used for personal purposes.
Note: the holding period of the gift normally assumes the donor’s holding period. However, if the basis=
FMV, then the holding period starts the date of the gift.
Note: if the property carries passive activity loss, then decrease the basis.
Note: property received from decedent is deemed to be held long-term regardless of actual holding
date.
1. If stock dividend is nontaxable, then the shareholders’ original stock basis is allocated between
old stock and new stocks based on relative FMV. In this case, the holding period of the dividend
stock includes the holding period of the original stock.
2. Otherwise, the basis= FMV
Stock dividend is nontaxable (1) if the stock distribution be made with respect to common stock (即
是普通股的股票股利) and (2) it must be pro rata with respect to all shareholders (即不改变股东
的持股比例)
Property exchange
Note: liabilities assumed on either or both sides of the exchange are treated as boot.
a. If liabilities are assumed on both sides of exchange and no cash is involved, they are offset to
determine the net amount of boot given or received.
Liability relief = boot received liability assumption=boot given
b. If liabilities are assumed on both sides of exchange and cash is involved.
a. Liability boot given does not offset boot received in cash or unlike property.
b. Boot given in cash or unlike property does offset liability boot received.
The holding period of boot received begins on the date of its receipt.
For an exchange to qualify as a like-kind exchange, the transaction must meet three criteria:
Like-kind property:
Note: Losses on involuntary conversions are recognized whether the property is replaced or not. This
loss is deductible as a casualty loss. However, a loss on condemnation of property held for personal use
is not deductible.
Eg. Teton’s delivery van had a FMV of 15,000 and an adjust basis of 11,000. It was destroy in an accident
and reimbursed 15,000 by insurance company. Teton was considering two alternatives for replacing the
van:
(1) Purchase a new delivery van for 20,000. No gain recognized in this case.
36 Regulation Notes By Tomato
The basis of the new van=20,000-(15,000-11,000-0)=16,000
(2) Purchase a used delivery van for 14,000. 1,000 (15,000-14,000) gain recognized in this case.
The basis of the new van=14,000-(15,000-11,000-1,000)=11,000
Property dispositions
In order to determine how a recognized gain or loss affects a taxpayer’s income tax, the taxpayer must
determine the character or type of gain or loss recognized:
1. Ordinary assets: assets created or used in a taxpayer’s trade or business such as inventory, AR
and equipment used for one year or less. (B10-6)
2. Capital assets: assets held for investment (stocks and bonds), for the production of income or
for personal use.
3. 1231 assets: depreciable assets and land used in a trade or business held by taxpayers for more
than one year. If a taxpayer recognizes a net 1231 gain, the net gain is treated as a long-term
capital gain. If a taxpayer recognizes a net 1231 loss, the net loss is treated as an ordinary loss.
1231 assets consist of three types: (1) pure 1231: land; (2) 1245: personal property and
intangibles; and (3) 1250: depreciable real property (buildings)
Note: an easy way to remember that is building is so high so it takes the highest sec number
1250 instead of 1245
Note: copyrights or artistic, literacy, compositions created by the taxpayers are not capital
assets but if they are purchased by taxpayer, then they are capital assets.
It is possible that a 1231 asset other than land could be sold at a gain in situations when the asset has
not appreciated in value and even in situations when the asset has declined in value since it was placed
in service. It happens because depreciation deductions relating to the asset could reduce the adjusted
basis of the asset by more than the actual economic decline the asset’s value. For this situation,
Congress introduced the concept of depreciation recapture. When depreciation recapture applies, it
recharacterizes the gain on the sale of a 1231 asset from 1231 gain into ordinary income. However,
the depreciation recapture does not affect 1231 losses. The computation of depreciation recapture
depends on the type of 1231 asset. Note: depreciation recapture changes the character of the gain but
not the amount of the gain.
1. 1245 asset. The amount of ordinary income taxpayers recognize when they sell 1245 property is
the lesser of (1) recognized gain on the sale or (2) total accumulated depreciation. The
remainder of any recognized gain is characterized as 1231 gain. (B10-10)
2. 1250 asset. 1245 depreciation recapture does not apply to it.
A. For corporations, 291 depreciation recapture applies to corporations but not to other
types of taxpayers. Under 291, corporations selling depreciable real property recapture as
ordinary income 20% of the lesser of the (1) recognized gain on the sale or (2) total
Exception: under 1239, when a taxpayer sells depreciable property to a related party and the property
is depreciable property to the buyer, the entire gain on the sale is characterized as ordinary income to
the seller. The definition of the related party: R1-54
After recharacterizing 1231 gain as ordinary income under the 1245 and 291 depreciation recapture
rules and the 1239 related party rules, the remaining 1231 gains and losses are netted together. If the
gains exceed the losses, the net gain becomes a long-term capital gain. If the losses exceed the gains,
the net loss is treated as an ordinary loss. For the capital gain, we should apply 1231 look-back rule.
That is, the taxpayer must look-back to the five year period preceding the current tax year to
determine if, during that period, the taxpayer recognized any unrecaptured 1231 losses. The taxpayer
must recharacterized the current year net 1231 gain as ordinary income to the extent of that prior five
year uncrecaptured 1231 losses.
e.g. suppose that Teton began business in year 1 and that it recognized a 7000 net 1231 loss in year 1
and 2000 net 1231 loss in year 5. Assume that the current year is year 6 and that Teton reports a net
1231 gain of 25,000 for the year. Then 9,000 ordinary income and 16,000 long-term capital gain.
The amount realized by a taxpayer from the sale or other disposition of an asset is everything of value
received from the buyer less any selling costs.
Amount realized=cash received + fair market value of other property + buyer’s assumption of liabilities
Although most long term capital gains are taxed at a maximum 15% rate. There are some exceptions:
Taxpayers selling capital assets that they hold for a year or less recognize short-term capital gains or
losses. Alternatively, taxpayers selling capital assets that they hold for more than a year recognize long-
term capital gains or losses. Short-term capital gains are taxed at ordinary rather than preferential rates.
In contrast, long-term capital gains are taxed at preferential rates. However, not all long-term capital
gains are taxed at a maximum 15% rate, certain long-term capital gains are taxed at a maximum rate of
25% and others are taxed at a maximum 28%.
Netting process for gains and losses (if there is no different maximum tax rate on long-term capital gains)
For individuals, net short-term capital gains are taxed as ordinary income.
For Individual taxpayers, capital losses first offset capital gains, and then are allowed as a deduction up
to 3,000 (1,500 if married filing separately) against ordinary income. Net capital losses in excess of
39 Regulation Notes By Tomato
3,000 retain their short-term and long-term character and are carried forward forever. Short-term
losses are applied first to reduce ordinary income when the taxpayers recognize both short-term and
long-term net capital losses. In contrast, corporation capital losses are only allowed to offset capital
gains, not ordinary income. A net capital loss is carried back three years, and forward five years to
offset capital gains in those years. All capital loss carryback and carryover are treated as short-term
capital losses.
Netting process for gains and losses (if there are different maximum tax rates on long-term capital gains)
(P11-14)
1. Net all short-term gains and short-term losses (including carry forward)
2. Net all long-term gains and long-term losses (including carry forward).
a. If step 1 <0, then there is a net short-term loss and net long-term capital loss.
b. If step1 >0 but step2<0, then there is a net short-term gain if step1>abs (step2).
c. If step1 >0 but step2<0, then there is a net long-term capital loss if step1<abs (step2).
If step2>0, separate all long-term capital gains and losses into the three separate rate groups. Any
long-term capital loss carried forward from the previous year is placed in the 28% group. Then:
1. Net the gains and losses in the 15% group. If the result is a net loss, move the net loss into 28%
group. Net gains remain in the 15% group.
2. If step1 (means the short-term) <0, move the loss into the 28% group.
3. Net the gains and losses in the 28% group. Net gains are taxed at 28%. Net losses move to the
25% group.
4. Net the 25% gains with the net loss from step3. Net gains are taxed at 25% rate. Net losses
move to the 15% group.
5. Net the 15% gain from step1 with the net loss from step 4. The gain is taxed at 15%
1. Losses on the sale of personal-use assets. These losses are not deductible, and therefore never
become part of the netting process.
2. When taxpayers sell capital assets at a loss to related parties, they are not able to deduct the
loss.
3. Wash sales. A wash sale occurs when an investor sells or trades stock or securities at a loss and
within 30 days before or after the day of sale buys substantially identical stocks or securities.
These losses (but realized) are not recognized, instead, the unrecognized losses are added to the
basis of the newly acquired stock. Gain recognized but not loss.
Nick realizes 1,000 long-term capital losses but recognizes 0 capital loss. The basis of Cisco stock
purchased on Jan 3, 2010 is 4100+1000
Assume Nick only purchases 40 shares of Cisco stock on Jan 3, 2010. Since Nick only acquired 40% of
the shares he sold at a loss within the window, Nick must disallow 40% or 400 of the loss and he is
allowed to deduct the remaining 600 loss.
Note: This wash sale rule does not apply to dealers in stock and securities where loss is sustained in
ordinary course of business.
When a taxpayer sells a personal residence at a loss, the loss is a nondeductible personal loss. However,
when a taxpayer sells a personal residence at a gain, taxpayers meeting certain home ownership and
use requirement can permanently exclude from taxable income all, or at least a portion of the realized
gain on the sale.
1. An individual may exclude from income up to 250,000 of gain that is realized on the sale or
exchange of a residence.
Note: this exclusion is determined on an individual basis. That is, a single individual who
otherwise qualifies for the exclusion is entitled to exclude up to 250,000 of gain even though his
spouse has used the exclusion within 2 years before marriage.
2. The exclusion is increased to 50,000 for married filing jointly if either spouse meets the
ownership test, and both spouses meet the use test. This exclusion applies to a sale of
residence that had been jointly owned and occupied by the surviving and deceased spouse if the
sales occur no later than 2 years after the date of death of the individual’s spouse.
3. If the taxpayer does not meet the ownership or use tests, a pro rata amount of 250,000 or
500,000 applies if the sale or exchange is due to a change in place of employment (meet the
distance test of moving expense), health (instructed by doctors), or unforeseen circumstances.
4. If a taxpayer was entitled to take depreciation deductions because the residence was used for
business purposes or as rental property, the taxpayer cannot exclude gain from the deprecation
amount after May 6, 1997. That, exclusion= realized gain- depreciation.
5. Gain from the sale of a principal residence cannot be exclude if during the two-year period
ending on the date of the sale, the taxpayer sold another residence at a gain and excluded all or
part of that gain from income.
Ownership test: the taxpayer must have owned the property for a total of two or more years during the
five-year period ending on the date of sale. It prevents a taxpayer from purchasing a home, fixing it up,
and soon thereafter selling it and excluding the gain- a real estate investment practice termed flipping.
a. If a residence is transferred to a taxpayer incident to a divorce, the time during which the
taxpayer’s spouse or former spouse owned the residence is added to the taxpayer’s period of
ownership.
b. A taxpayer’s period of ownership of a residence includes the period during which the taxpayer’s
deceased spouse owned the residence so long as the taxpayer does not remarry before the date
of sale.
Use test: the taxpayer must have used the property as her principal residence for a total of two or more
years during the five-year period ending on the date of sale. By definition, a taxpayer can only have one
principal residence.
Income from business includes gross profit from inventory sales, income from services provided
and income from renting property to customers.
Business expenses must be made in the pursuit of profits rather than the pursuit of others.
Business expenses must be both ordinary and necessary to be deductible. Ordinary and
necessary expenses are deductible only to the extent they are also reasonable in amount. An
expenditure is not reasonable when it is extravagant or exorbitant. The IRS tests for
extravagance by comparing the amount of the expense to a market price or an arm’s length
amount. If the amount of expense is the amount typically charged in the market by unrelated
parties, the amount is considered to be reasonable.
1. If business property is completely destroyed, the amount of casualty loss = property’s tax
basis.
2. If only partially destroyed, the amount of loss is the lesser of (1) the decline in the value of
property and (2) the adjusted basis of property.
3. Only the loss not reimbursed by insurance is deductible.
4. The loss may be treated as an ordinary loss or a capital loss, depending on the type of asset
involved in the casualty.
R&D expenditures: the firm can elect to deduct qualifying R&D as a current expense if the firm
so elects for the first taxable year in which the cost is incurred. Otherwise, the firm must
capitalize the cost and amortize it over a 60 months or longer.
1. Expenditures against public policy. Businesses are not allowed to deduct fines, penalties,
illegal bribes, or illegal kickbacks.
2. No deduction or credit is allowed for any amount that is paid or incurred in carrying on a
trade or business which consists of trafficking in controlled substances. However, the cost of
goods sold is still deductible.
3. Political contributions and lobbying costs.
4. Capital expenditures
5. Expenses associated with the production of tax-exempt income. For example, interest
expenses for business that borrow money and invest the loan proceeds in municipal bonds.
Life insurance premiums for which corporation is beneficiary pay on policies that cover the
lives of officers or other key employees and compensation the business for the disruption
Entities
For tax purposes, business entities can be classified as either separate taxpaying entities or as flow-
through entities.
1. Unincorporated entities (including LLC) with more than one owner are taxed as partnership
(Form 1065)
2. Unincorporated entities (including LLC) with only one individual owner and single-member
LLCs are taxed as sole proprietorships. (Schedule C)
3. taxable corporation
4. S corporation
Note: owners of LLCs can elect to have their business taxed as taxable corporations instead of as
flow-through entities. Then they would make a second election to treat the “corporation” as an
S corporation for tax purpose.
Accounting method:
1. Taxable corporation: accrual method. Exception: may use cash method if its annual average
gross receipts do not exceed 5 million for the three previous tax years.
2. S corporation: accrual or cash. If the firm previously was a C corporation, all prior accounting
methods carry over to the S corporation.
3. Partnership: cash. Exception: accrual if they have a C corporation, tax shelters, and certain tax-
exempt trusts as a member or partner and the partnership reports annual average gross
receipts in excess of 5 million for the three previous years.
If merchandise inventories are necessary to clearly determine income, only the accrual method of
tax reporting can be used for purchases and sales.
1. Taxable corporation: employee-shareholder pays 7.65% FICA tax and corporations pay 7.65%
2. S corporation: an income allocation received by employee-shareholders is not subject to FICA or
self-employment tax.
3. Partnership: guaranteed payment is subject to 15.3% self-employment tax. Income allocation
received by general partners is subject to 15.3% self-employment tax. But not the income
allocation received by limited partners.
Corporate shareholders are subject to double taxation because they pay a second level of tax
(the first level of tax is corporate tax). The second level of tax depends on whether corporations
retain their after-tax earnings and on the type of shareholders
Taxable Corporation
Corporations generally compute their taxable income by starting with their book or financial accounting
income and make adjustments for book-tax differences. (permanent book-tax differences and
temporary book-tax differences)
Each tax-book difference can be considered to be unfavorable or favorable depending on its effect on
taxable income relative to book income. Any book-tax difference that requires an add-back to book
income to compute taxable income is an unfavorable book-tax difference.
Schedule M1 of tax return form provides a reconciliation of income reported per books with income
reported on the tax return. Generally, items of income and deduction whose book and tax treatment
differ, result in schedule M-1 items. However, schedule M-1 reconciles to taxable income before the
DRD and NOL deductions.
Note: cash received in advance of accrual GAAP income is taxed such as interest income, rental
income and royalty income received in advance.
Taxes:
a. All state and local taxes and federal payroll taxes are deductible when incurred on property or
income relating to business.
b. Federal income taxes are not deductible.
c. Foreign income taxes may be used as a credit.
Interest expense:
a. General business interest expense: paid or accrued during the taxable year incurred for
business purposes are deductible.
b. Interest expense on loans for taxable investment: limited to net taxable investment income.
c. Interest expense on loans for tax-free investment: not deductible.
d. Prepaid interest expense: must be allocated to the proper period to which it is related.
a. DRD is limited to the product of the applicable DRD percentage and DRD modified
taxable income. DRD modified taxable income is the taxable income before deducting
the following:
1. The DRD
2. Any NOL deduction (carryover or carryback)
3. Capital loss carrybacks
4. The DMD
b. However, this limitation does not apply if after deducting the full DRD a corporation
reports a current year net operating loss.
c. Note: to qualify a DRD, the investor corporation must own the investee’s stock for more
than 46 days (90 days for preferred stock) during the 91-day period beginning on the
date 45 days before the ex-dividend date.
d. Note: the DRD does not apply to personal service corporations, personal holding
companies and personally taxed S corporation (Do not take it personally)
e. The amount (Dividend received – DRD) is included in the corporation’s ordinary income.
f. Members of an affiliated group of corporations (80% or more common ownership) may
deduct 100% of the dividends received from a member of the same affiliated group.
(6) Domestic production deduction or domestic manufacturing deduction
Business that manufacture goods are allowed to deduct an artificial business deduction for
tax purposes called DMD or DPD. It is designed to reduce the tax burden on domestic
manufacturers to make investments in domestic manufacturing facilities more attractive.
This deduction is artificial because it does not represent an expenditure per se, but merely
serves to reduce the income taxes the business must pay and thereby increase the after-tax
profitability of domestic manufacturing.
DMD is 6% times the lesser of (1) the business’s taxable income before the deduction (or
modified AGI for individuals) or (2) qualified production activities income (QPAI). QPAI is the
net income from selling or leasing property that was manufactured in the US.
It is designed to require corporations to pay some minimum level of tax even when they have low or no
regular taxable income due to certain tax breaks they gain from the tax code.
Small corporations are exempt from the AMT. For this purpose, small corporations are those with
average annual gross receipts less than 7.5 million for the three years prior to the current tax year.
New corporations are automatically exempt from the AMT in their first year. It is exempt for its second
year if its first year’s gross receipts were 5 million or less. To be exempt for its third year, the average
gross receipts for the first two years must be 7.5 million or less. To be exempt for the fourth year (and
sequent years), average annual gross receipts for all three prior years are below 7.5 million. Once a
corporation fails the AMT gross receipt test, it is no longer exempt from the AMT.
1. Preference items
Common preference items include percentage depletion in excess of cost basis and tax-exempt
interest income from a private activity bond (a municipal bond used to fund a nonpublic
activity- if the bond is for a public purpose, the interest is not a preference item). Tax exempt
interest on private activity bonds issued in 2009 or 2010 is not an AMT tax preference item.
2. Adjustments
Adjustment is positive (unfavorable) or negative (favorable)
(1) Depreciation: depreciation is different for regular tax and AMT purpose. For AMT purpose,
assets are not depreciated as quickly as for regular tax.
(2) Gain or loss on disposition of depreciable assets. Depreciation differences for regular tax
and AMT purposes cause differences in the adjusted basis of the assets for regular tax
purposes and AMT purposes.
(3) The installment method cannot be used for sales of inventory-type items: the difference
between full accrual revenue and installment sales revenue.
(4) Income from long-term contracts must be determined using the percentage of completion
method: the difference between completed contract revenue and percentage of completion
revenue.
(5) ACE (adjusted current earnings) adjustment
ACE adjustment= 75% * (ACE- AMTI before the ACE adjustment)
As a practical matter, ACE adjustment= 75% * the sum of the modifications to AMTI
1. Tax return due date is two and one-half months after the corporation’s year-end.
2. Corporations can request an extension for six months.
3. Corporations with a federal income tax liability of 500 or more are required to pay their tax
liability for the year in quarterly estimated installments. That, the installments are due on the 15
days of the 4th, 6th,9th, and 12th months of their tax year.
Controlled group
A controlled group is a group of corporations that is controlled or owned by the same taxpayer or group
of taxpayers. A controlled group could be parent-subsidiary controlled group, a brother-sister controlled
group or a combined controlled group.
1. Parent-subsidiary: one corporation owns at least 80% of the voting power or stock value of
another corporation on the last day of the year
2. Brother-sister: two or more corporations of which five or fewer persons own more than 50%
(including 50%) of the voting power or stock value of each corporation on the last day of the
year.
3. Combined: three or more corporations, each of which is a member of either a parent-subsidiary
or brother-sister controlled group and one of the corporations is the parent in the parent-
subsidiary controlled group and also is in a brother-sister controlled group.
The controlled group is treated as one corporation for purposes of using the tax rate schedule.
An affiliated group exists when one common corporation directly owns at least 80% of (1) the total
voting power and (2) the total stock value of another corporation. If each member of the group files a
consent, an affiliated group of corporations may elect to file a consolidated tax return in which the
group files a tax return as if it were one entity for tax purposes.
The IRC requires a corporation to keep two separate earnings and profits (E&P) accounts: one for the
current year (current E&P) and one for undistributed E&P accumulated in all prior years (accumulated
E&P)
Whether a distribution is characterized as a dividend depends on whether the balances in the two
accounts are positive or negative.
Note: any distribution should not increase the negative balance of E&P. That is, distribution is
not out of E&P account when the account balance is negative. (Check W P594 question 83)
For shareholder:
For corporation:
Eg. Assume Jim received a parcel of the land as dividend. The FMV of the land is 60,000 and a remaining
mortgage is 75,000. SCR has a tax basis in the land of 20,000.
1. If a corporation sells property to a shareholder for less than FMV, the shareholder is considered
to have received a constructive dividend (taxable) = FMV – priced paid.
2.
Stock dividend
Family attribution: individuals are treated as owning the shares of stock owned by their spouse, children,
grandchildren, and parents. Stock owned constructively through the family attribution rule cannot be
reattributed to another family member through the family attribution rule.
Gain or loss from property exchange not recognized when realized falls into one of two categories: (1)
the gain or loss is excluded from gross income (that is, the gain or loss will never be recognized) or (2)
the gain or loss is deferred from inclusion in gross income (that is, recognition is postponed to a future
period). Incorporations involving transfers of property to a corporation are transactions in which gain or
loss realized may be deferred if certain tax law requirements are met.
Gain or loss deferred in the transfer of property to a corporation in return for stock is reflected in the
shareholder’s tax basis in the stock received in exchange for the property transferred. In essence, the
shareholder’s tax basis in the stock received = the tax basis of property transferred.
For shareholders to receive tax deferral in a transfer of property to a corporation, the transferors must
meet the requirements of IRC 351. The deferral of gain or loss in a 351 transaction is mandatory if the
requirements are met. Section 351 applies to transfers of property to both C corporations and S
corporations.
One or more shareholders transfer property to a corporation in return for stock, and immediately after
the transfer, these same shareholders, in the aggregate, control the corporation to which they
transferred the property.
If a shareholder receives stock in return for property and services in a 351 exchange, all of the stock
received is included in the control test provided the FMV of the property transferred is not of relatively
small value in comparison to the value of the stock received in return for services. The IRS has stated
(1) The tax basis of stock received in a tax-deferred 351 exchange =the tax basis of the property
transferred.
Tax basis of stock= tax basis of property contributed – liabilities assumed by the corporation on
property contributed.
(2) The tax basis of stock received in an exchange that does not meet the 351 requirement,
Tax basis of stock= FMV of the stock received
To shareholder:
Shareholder:
1. Recognized gain= lesser of (1) gain realized (=FMV-tax basis) or (2) the FMV of the boot received.
2. If there are more than one boot, allocating the boot received pro rata to each property using the
relative FMVs of the properties.
3. The character of gain recognized is determined by the type of property to which the boot is
allocated.
4. Tax basis of boot = FMV
5. Shareholders’ tax basis of stock= tax basis of property contributed + gain recognized on the
transfer –FMV of boot received – liabilities assumed by the corporation on property contributed
1. If any of the liabilities assumed by the firm are assumed with the purpose of avoiding the federal
income tax or if there is no corporate business purpose for the assumption, then the liability is
treated as boot.
2. If the liabilities assumed > aggregate tax basis of the properties transferred, recognized
gain=liabilities assume – aggregate tax basis of the properties transferred.
A corporation will never recognize gain or loss on the receipt of money or other property in exchange
for its stock, including treasury stock.
Exception: if the aggregate adjusted tax basis of property transferred > aggregate FMV, the aggregate
tax basis in the hands of corporation cannot exceed aggregate FMV. Then:
1. Adjustment by the corporation: the aggregate reduction in tax basis is allocated among the
assets transferred in proportion to their respective built-in losses immediately before the
transfer.
2. Or adjustment by the shareholder: tax basis of stock = aggregate FMV
Normally, stock is a capital asset for shareholder and gains or losses from sale of stocks are capital. For
individuals, long-term capital gains are taxed at a maximum 15%. Losses can offset capital gains plus
3,000 of ordinary income per year. Section 1244 allows a shareholder to treat a loss on the sale or
exchange of stock as an ordinary loss up to 50,000 per year (100,000 for married filing jointly).
Requirements:
1. The shareholder must be individual or partnership shareholder and the original recipients of the
stock.
2. The issuing corporation must be a small business corporation when the stock is issued.
A small business corporation: the aggregate amount of money and other property received in
return for the stock or as a contribution to capital did not exceed 1 million.
3. For the five taxable years preceding the year in which the stock was sold, the corporation must
have derived more than 50% of its aggregate gross receipts from an active trade or business.
4. The stock must be issued for money or property (other than stock and securities)
5. The issuer must be a domestic corporation
Note: When the property contributed to the firm, if the FMV < tax basis, then the ordinary loss is limited
to (exchange price- FMV)
Stock is redeemed when a corporation acquires its own stock from a shareholder in exchange for
property, regardless of redeemed stock being canceled, retired, or held as treasury stock.
For shareholder, treat stock redemption either as a dividend distribution or as a sale of the stock
redeemed.
If any of the following conditions are met, the exchange is treated as a sale, and the gains or losses are
capital gains and losses. Otherwise, the redemption proceeds are treated as an ordinary distribution,
taxable as dividend to the extent of the distributing corporation’s earnings and profits.
Note: no deduction is allowed for any amount paid or incurred by a corporation in connection with the
redemption of its stock, except for interest expenses on loans to repurchase stock.
Corporation liquidation
A complete liquidation occurs when a corporation acquires all the stocks from all of its shareholders in
exchange for all of its net assets after which time the corporation ceases to do business.
For shareholders
1. Capital gain/loss= FMV of property received- debt assumed – tax basis in stock
2. Tax basis of property received =FMV
For corporation:
60 Regulation Notes By Tomato
1. Gain/loss= FMV of property distributed – tax basis in the property
2. Exception: the firm does not recognize loss if the property is distributed to a related party and
either (1) the distribution is non-pro rata, or (2) the asset distributed is disqualified property.
3. Related party: a shareholder who owns more than 50% of firms’ stock.
4. Disqualified property: property acquired within 5 years of the date of distribution in a tax
deferred 351 transaction or as a nontaxable contribution to capital.
Generally, a corporation will recognize gain or loss on the distribution of its property in complete
liquidation just as if the property were sold to the distributee for its FMV.
Exception: when a parent corporation completely liquidates its 80% or more owned subsidiary, the
liquidation is treated as a mere change in form and the parent corporation will not recognize any gain or
loss on the receipt of liquidating distributions from its subsidiary. Similarly, the subsidiary corporation
will not recognize any gain or loss on distributions to its parent corporation. As a result, there will be a
carryover basis for all of the subsidiary’s assets that are received by the parent-corporation, as well as
carryover of all of the subsidiary’s tax attributes to the parent corporation. The subsidiary’s tax
attributes that carryover to the parent include such items as earnings and profits, capital loss carryovers,
accounting methods, and tax credit carryovers, as well as unused excess charitable contributions, and
net operating loss.
Note: the general expenses incurred in the complete liquidation and dissolution of a corporation are
deductible by the corporation as ordinary and necessary business expenses. These expenses include
filing fees, professional fees, and other expenditures incurred in connection with the liquidation and
dissolution.
Requirements:
1. Domestic corporations.
2. Have only one class of stock.
3. Only U.S. citizens or residents, certain trusts, and certain tax-exempt organizations may be
shareholders, no corporations and partnerships.
4. 100 shareholders or less
S corporation election
1. To formally elect S corporation status effective as of the beginning of the current tax year, the
corporation uses Form 2553, either in the prior tax year or within the first two and half months
after the beginning of the current tax year.
2. Exception: when the corporation makes the election within the first two and half months after
the beginning of the current tax year, the election will not be effective until the subsequent year
if (1) the corporation did not meet the S corporation requirements for each day of the current
tax year before it made the S election; or (2) one or more shareholders who held the stock in the
corporation during the current year and before the S corporation election was made did not
consent to the election. (even if the shareholder sold his stock in the current year,只要他曾经
拥有)
3. Elections after the first two and half months after the beginning of the year are effective at the
beginning of the following year.
4. All shareholders on the date of the election must consent to the election.
Note: NOL losses for C corporations can’t be carried over to the S corporation.
Once the S election becomes effective, the corporation remains an S corporation until the election is
terminated. The termination may be voluntary or involuntary.
Voluntary terminations
The corporation can make a voluntary revocation of the S corporation if shareholders holding more than
50% of the S corporation stock agree (including nonvoting shares). Voluntary revocations made during
the first two and one-half months of the year are effective as of the beginning of the year. A revocation
after this period is effective the first day of the following tax year. Alternatively, a corporation may
specify the termination date as long as the date specified is on or after the date the revocation is made.
Involuntary terminations
S corporation election terminations frequently create an S corporation short tax year (a reporting
year less than 12 months) and a C corporation short tax year. The corporation must then allocate its
income for the full year between the S and C corporation years using the number of days in each
short year (daily method). Or it may use the corporation’s normal accounting rules to allocate
income to the actual period in which it was earned (the specific identification method).
Eg. Suppose CCS was formed as a calendar-year S corporation with Nicole Johnson, Sarah Walker,
and Change Armstrong as equal shareholders. On June 15, 2009, Chance sold his CCS shares to his
solely owned C corporation, Chanzz Inc. terminating CCS’s S election on June 15, 2009. Assume CCS
reported business income for 2009 as follows:
Jan 1 through June 14 (165 days) 100,000
June 15 through Dec 31 (200 days) 265,000
Jan 1 through Dec 31 (365 days) 365,000
Daily method: S corporation short tax year=365,000/365*165
Specific identification: S corporation: 100,000; C corporation : 265,000
S corporation reelections
After terminating or voluntarily revoking S corporation status, the corporation may elect it again,
but it generally must wait until the beginning of the fifth tax year after the tax year in which it
terminated the election.
An S corporation generally allocates income or loss items to shareholders on the last day of its tax
year.
S corporation must allocate profits and losses pro rata, based on the number of outstanding shares
each shareholder owns on each day of the tax year (that is, per share, per day basis). An S
corporation generally allocates income or loss items to shareholders on the last day of its tax year.
If a shareholder sells her shares during the year, she will report her share of S corporation income
loss allocated to the days she owned the stock using a pro rata allocation.
S corporations are required to file tax returns (Form 1120 S) annually. In addition, they supply
information to each shareholder detailing the amount and character of items of income and loss
flowing through the S corporation. Shareholders must report these income and loss items on their
tax returns even if they do not receive cash distributions during the year.
S corporations determine each shareholder’s share of ordinary business income and separately
stated items. Like partnership, ordinary business income (loss) is all income (loss) exclusive of any
separately stated items of income (loss). Separately stated items are tax items that are treated
differently from a shareholder’s share of ordinary business income for tax purposes. The list of
common separately stated items for S corporations is similar to that for partnerships, with a couple
of exceptions. Lists of common separately stated items:
Tax basis in stock received = tax basis of property transferred – liabilities relief + gain recognized- FMV of
boot received
Purchased from other shareholder: tax basis in stock received = purchase price
Basis adjustments that decrease basis may never reduce a partner’s tax basis below 0.
Different from partnerships, S corporation shareholders are not allowed to include any S
corporation debt in their stock basis.
Ordinary losses are deductible against any type of taxable income. However, they are deductible only
when they clear three separate hurdles:
S corporation shareholders’ allocable share of ordinary business income (loss) is not classified as self-
employment income for tax purposes, even when the shareholder actively works for the S corporation.
Fringe benefits
Operating distributions
S corporation distributions are deemed to be paid from the following sources in the order listed:
1. The AAA account (to the extent it has a positive balance)
Distribution from AAA is nontaxable to the extent of the stock basis, and they create capital
gains if they > stock basis.
2. Existing accumulated earnings and profits from years when the corporation is C.
Property distributions
S corporation: if appreciated property, recognized gain= FMV-tax basis. If FMV < tax basis, no loss is
recognized.
Shareholders:
S corporation tax
Although S corporations are flow-through entities generally not subject to tax, three potential taxes
apply to S corporations that previously operated as C corporations.
The net recognized built-in gains for any year are limited to the least of:
(1) The recognized built-in gain – losses-NOL or capital loss carryovers from C corporation eyars.
(2) The net unrealized built-in gains – net recognized built-in gains previous years
(3) Taxable income for the year using the C corporation tax rules exclusive of the DRD and NOL
deduction.
If taxable income limits the net recognized built-in gain for any year, the excess is treated as a
recognized built-in gain the next tax year.
Gross receipts are the total amount of revenues including passive investment income and
capital gains and losses.
Net passive investment income=passive investment income – any expenses connected with
producing that income.
Excess net passive income tax is limited to taxable income computed as if the corporation were
a C corporation.
Estimated tax
S corporations with a federal income tax liability of 500 or more due to the built-in gains tax or
excess net passive income tax must estimate their tax liability for the year and pay it in four
quarterly estimated installments. However, an S corporation is not required to make estimated
tax payments for the LIFO recapture tax.
Depreciation
Businesses calculate their tax depreciation using the Modified Accelerated Cost Recovery System
(MACRS). To compute MACRS depreciation for an asset, the business need only know the asset’s original
cost, the applicable depreciation method, the asset’s recovery period, and the applicable depreciation
convention (the amount of depreciation deductible in the year of acquisition and the year of disposition).
Note: Under MACRS, salvage value is completely ignored for purposes of computing depreciation.
Personal property includes all tangible property, such as computers, automobiles, furniture, machinery,
and equipment, other than real property (building and land). Personal property and personal-use
property are not the same thing. Personal property denotes any property that is not real property while
personal-use property is any property used for personal purposes.
Depreciation method
MACRS provides three acceptable methods for depreciating personal property: 200% declining balance,
150% declining balance and straight-line. The 200% declining balance method is the default method.
This method takes twice the straight-line amount of depreciation in the first year, and continues to take
twice the straight-line percentage on the asset’s declining basis until switching to the straight-line
method in the year that the straight-line method over the remaining life provides a greater
depreciation expense.
Business elects the depreciation method for the assets placed in service during that year. If a business
acquires several different machines during the year, it must use the same method to depreciate all of
the machines.
For tax purposes, recovery period is predetermined by the IRS and based on the category of the assets.
When firms purchase used assets, the fact that the assets are used does not change its MACRS recovery
period.
Depreciation conventions
For personal property, taxpayers must use either the half-year convention or the mid-quarter
convention.
It allows one-half of a full year’s depreciation in the year the asset is placed in service, regardless of
when it was actually placed in service.
Mid-quarter convention
Business treats assets as though they were placed in service during the middle of the quarter in which
the business actually placed the assets into service.
Business must use the mid-quarter convention when more than 40% of their total tangible personal
property that they place in service during the year is placed in service during the fourth quarter.
Step 1: sum the total basis of the tangible personal property that was placed in service during the year.
Step 2: sum the total basis of the tangible personal property that was placed in service in the fourth
quarter.
Step 3: divide the outcome of step2 by the outcome of step1. If the quotient is greater than 40%, the
business must use the mid-quarter convention to determine the depreciation for all personal property
the business places in service during the year. Otherwise, the business uses the half-year convention for
depreciating all property.
Once a business has identified the applicable method, recovery period, and convention for personal
property, tax depreciation is calculated using the depreciation percentage table provided IRS.
The depreciation expense for a particular asset is the product of the percentage from the table and the
asset’s original basis.
Step1: calculate depreciation for the entire year as if the property had not been disposed of. That is, the
product of the percentage from the table and the asset’s original basis.
Step2: multiply the full year deprecation (outcome from step1) by 50%.
Note: if a business acquires and disposes of an asset in the same year, it is not allowed to claim any
depreciation on the asset.
Step1: calculate depreciation for the entire year as if the property had not been disposed of. That is, the
product of the percentage from the table and the asset’s original basis.
Step2: multiply the full year deprecation (outcome from step1) by the applicable percentage provided
by IRS. The percentage is determined by the quarter of which the asset is actually sold.
70 Regulation Notes By Tomato
Immediate expense (179 expense)
It is designed to help small businesses purchasing new or used tangible personal property. Under 179,
businesses may elect to immediately expenses up to 250,000 of tangible personal property placed in
service during 2009 (also 250,000 in 2008). They may also elect to deduct less than the maximum. To
reflect his immediate depreciation expense, they must reduce the basis of the asset or assets to which
they applied the expense before they compute the MACRS depreciation expense on the remaining bases
of these assets.
Requirement: to qualify, the property must be acquired by purchase from an unrelated party for use in
the taxpayer’s active trade or business.
Machinery 260,000
179 expense 80,000
Remaining basis in machinery 180,000
MACRS depreciation rate for 7-year machinery 14.29%
MACRS depreciation expense 25,722
Total depreciation 105,722
1. Under the phase-out limitation, businesses must reduce the 250,000 maximum available
expense dollar for dollar for the amount of tangible personal property purchased and placed in
service during 2009 over an 800,000 threshold.
2. Deductible 179 expense is limited to the business’s net income after deducting all expenses
except the 179 expense. If a business claims more 179 expense than it is allowed to deduct due
to the taxable income limitation, it carries the excess forward and deducts in a subsequent year.
Bonus depreciation
To stimulate the economy, policy makers occasionally implement bonus depreciation. In 2008 and 2009,
taxpayers can elect to immediately expense 50% of qualified property. Qualified property must have a
recovery period of 20 years or less (no real property), the property must be new rather than used and
the property must be placed in service during 2008 and 2009. The bonus depreciation is calculated
after the 179 expense but before MACRS depreciation.
Real property
Real property is classified as land, residential rental property, or nonresidential property. Land is non-
depreciable.
Residential rental property consists of dwelling units such as houses, condominiums, and apartment
complexes.
Nonresidential property consists of all other buildings (office buildings, manufacturing facilities,
shopping malls, and the like). If a building is substantially improved at some point after the initial
purchase, the building addition is treated as a new asset with the same recovery period of the original
building.
Recovery period:
Applicable convention: mid-month convention. It allows the owner of real property to expense one half
of a month’s depreciation for the month in which the property was placed in service regardless of
whether the asset was placed in service at the beginning or at the end of the month. Full depreciation is
for the months following the purchase month.
Mid-month depreciation for year of disposition= Full year’s depreciation * (month in which asset is
disposed of -0.5)/12
If it is sold in March
Amortization
1. It occurs when a business purchases the assets of another business for a single purchase price.
These intangible assets have a recovery period of 180 months regardless of their actual life.
72 Regulation Notes By Tomato
2. Full-month convention applies to both the purchase month and in the month of sale or
disposition.
3. If, at the time of sale or disposal, the business does not hold any other 197 assets that the
business acquired in the same initial transaction as the asset being sold or disposed of, the
business may recognize a loss on the sale or disposition. Otherwise, the taxpayer may not
deduct the loss on the sale or disposition until the business sells or disposes of all of the other
197 intangibles that it purchased in the same initial transaction. The same loss disallowance rule
applies if a 197 asset expires before it is fully amortized. In either case, the loss is allocated to
the remaining 197 assets that were initially acquired in the same transaction pro rata, based on
the relative adjusted bases of the remaining 197 assets. The new basis allocated to each
remaining 197 assets is amortized over the remaining years of the initial 15-year recovery period.
That is, new basis = remaining basis + allocated loss.
1. For capitalized R&D, amortize them using the straight-line method over a period of not less than
60 months, beginning in the month benefits are first derived from the research.
2. Firms must stop amortizing the R&D costs if and when the firms receive a patent relating to the
costs. Instead, firms add any remaining basis in the costs to the basis of the patent and it
amortizes the basis of the patent over the patents’ life.
1. For purchased patents and copyrights (not in an asset acquisition to which 197 applies),
amortize the cost over the remaining life.
2. For self-created patents and copyrights, amortize the cost over the legal lives – up to a
maximum of 17 years for patents and 28 years for copyrights. The cost includes legal costs, fees,
and unamortized R&D expenses related.
Depletion
Business computes annual depletion expense under both the cost and percentage depletion method
and they deduct the larger of the two.
Cost depletion
Because the cost depletion method of depreciation requires business to estimate the number of units of
the resource they will actually extract, it is possible that their estimate will prove to be inaccurate.
1. If they underestimate the number of units, they will fully deplete the cost basis of the resource
before they have fully extracted the resource. Once they have recovered the entire cost basis of
the resource, businesses are not allowed to use cot depletion to determine depletion expense.
However, they may continue to use percentage depletion.
Percentage depletion
It is determined by multiplying the gross income from the resource extraction activity by a fixed
percentage based on the type of natural resource prepared by IRS.
Businesses deduct percentage depletion when they sell the natural resource and they deduct cost
depletion in the year they produce or extract the natural resource. Also percentage depletion cannot
exceed 50% of the net income from the natural resource business activity before the depletion expense,
while cost depletion has so such limitation.
FICA (Federal Insurance Contributions Act) tax consists of a Social Security and a Medicare component
that are payable by both employees and employers. The Social Security tax (12.4%) is intended to
provide basic pension coverage for the retired and disabled. The Medicare tax (2.9%) helps pay medical
costs for qualifying individuals. FICA tax is equally shared by employees and employers. However, self-
employed taxpayers must pay the entire FICA tax burden on their self-employment earnings. FICA taxes
on employees’ salary, wages, and other compensation provided to them by their employers.
The wage base on which employees pay Social Security taxes is limited to an annually determined
amount (106,800 in 2009). However, there is no wage base limit for the Medicare tax.
Self-employment taxes
1. Compute the amount of the taxpayer’s net income from self-employment activities.
2. Multiply the amount from step 1 by 92.35 (one-half of self-employment tax is deductible). The
product is called net earnings from self-employment.
3. If the taxpayers’ net earnings from self-employment are less than 400, the taxpayer is not
required to pay any self-employment tax. If the taxpayers’ net earnings from self-employment
are less than 106,800, then multiply the amount from step by 15.3 percent. If the taxpayers’ net
earnings from self-employment are less than 400 is more than 106,800, calculate Social Security
tax and Medicare tax separately.
Self-employment taxes (if taxpayer receives both employee compensation & self-employment earnings)
1. Determined the limit on the Social Security portion of the self-employment tax base by
subtracting the employee compensation from the Social Security wage base (106,800 in 2009).
(not <0)
2. Determine the net earnings from self-employment (self-employment * 92.35%)
3. Multiply the lesser of step 1 and step by 12.4%. This is the amount of Social Security taxes due
on the self-employment income.
4. Multiply step 2 by 2.9%. This is the amount of Medicare taxes due on the self-employment
income.
5. Add the amounts from step 3 and 4 to calculate the self-employment taxes.
Retirement (B13-12)
1. Defined benefit plans: provides standard retirement benefits to employees based on a fixed
formula. The formula is a function of years of service and employees’ compensation levels as
they near retirement. For employees who retire in 2009, the maximum annual benefit an
employee can receive is the lesser of (1) 100 percent of the average of the employee’s three
highest years of compensation or (2) 195,000.
When an employee works for an employer for only a short time before leaving, her benefit
depends on her salary, the number of full years she worked, and the employer’s vesting
schedule. A taxpayer vests as she meets certain requirement set forth by the employer.
Vesting is the process of becoming legally entitled to a certain right or property.
Under the cliff vesting option, after a certain period of time, benefits vest all at once.
With a graded vesting schedule, the employee’s vested benefit increases each year she works
for the employer.
To ensure that employers are able to meet their defined benefit plan obligations, employers are
required to contribute enough to the plan to fund their expected future liabilities under the plan.
For tax purposes, employers deduct actual contributions to the plan for a given year as long as
they make the contributions by the extended tax return due date for that year.
In recent years, many employers have begun replacing defined benefit plans with defined
contribution plans.
2. Defined contribution plans
(1) Employers maintain separate accounts for each employee participating in a defined
contribution plan.
(2) Specify the up-front contributions the employer will make to the employee’s separate
account rather than specifying the ultimate benefit the employee will receive from the plan.
(3) Employees are frequently allowed to contribute their own defined contribution plan.
(4) Employees are free to choose how amounts in their retirement accounts are invested.
Thus, relative to defined benefit plans, defined contribution plans shift the funding responsibility
and investment risk from the employer to the employee.
Employers may provide different types of defined contribution plans such as 401(k) (used by for-
profit companies), 403(b) plans (used by nonprofit organizations, including educational
institutions), and 457 plans (used by government agencies), and others.
Employer matching
Employees contribute to 401k type plans. Many employees also match employee contributions
to these plans. Whenever possible, employees should contribute enough to receive the full
match from the employer.
For 2009, the sum of employer and employee contributions to an employee’s defined
contribution account is limited to the lesser of:
(1) 49,000 (54,500 for employees who are at least 50 years of age by the end of the year)
(2) 100 percent of the employee’s compensation for the year.
Employee contribution to the 401k plan is limited to 16,500 (or 22,000 for employees who are at
least 50 years of age by the end of the year)
Vesting
When employees contribute to defined contribution plans, they are fully vest in the accrued
benefit from their own contributions (employee contributions + earnings on the contributions).
However, employees vest in the accrued benefit from employer contributions (employer
contributions + earnings on the contributions) based on the employer’s vesting schedule. For
defined
Distributions
When employees receive distributions from defined contribution plans, the distributions are
taxed as ordinary income. However, when employees receive distributions from defined
contribution plans either too early or too late, they must pay a penalty in addition to the
ordinary income taxes they owe on the distributions. Employees who receive distributions
before they reach (1) 59.5 years of age or (2) 55 years of age and have separated from service
are subject to a 10% nondeductible penalty on the amount of the early distributions.
Taxpayers must receive their first minimum distribution from the account by April 1 of the later
of (1) the year after the year in which taxpayer reaches 70.5 years of age or (2) the year after the
year in which employee retires. The amount of the minimum required distribution for a
particular year is the taxpayer’s account balance at the end of the year prior to the year to
which the distribution pertains multiplied by a percentage from an IRS Uniform Lifetime Table.
The percentage is based on the taxpayer’s age at the end of year to which the distribution
pertains. Taxpayers incur a 50% nondeductible penalty on the amount of a minimum
distribution the employee should have received but did not.
Employers that provide traditional 401k plans to employees may also provide Roth 401K plans.
When employers provide Roth 401K plans, employees may elect to contribute to the Roth 401k
instead of or in addition to contributing to a traditional 401k plan. However, employer
contributions to an employee’s 401k account must go the employee’s traditional 401k account
Qualified distributions from Roth 401k accounts are those made after the employee’s account
has been open for five taxable years and the employee is at least 59.5 years of age. All other
distributions are nonqualified distributions. When a taxpayer receives a nonqualified
distribution from a Roth 401k account, the tax consequences of the distribution depends on the
extent to which the distribution is from the account earnings and the extent to which it is from
the employee’s contributions to the account. Nonqualified distributions of the account earnings
are fully taxable and are subject to the 10% earnings distribution penalty. Nonqualified
distributions of the taxpayers’ account contributions are not subject to tax. If less than the
entire balance in the plan is distributed, the nontaxable portion of the distribution is determined
by multiplying the amount of the distribution by the ratio of account contributions to the total
account balance.
It permits employees to defer or contribute current salary in exchange for a future payment
form the employer. The tax consequence is same as qualified defined contribution plans.
IRA is the most common of the individually managed retirement plans. Taxpayers who meet
certain eligibility requirements can contribute to traditional IRAs, to Roth IRAs, or to both. In
most respects, the tax characteristics of traditional 401k plans mirror those of traditional IRAs
and tax characteristics of Roth 401k plans mirror those of Roth IRA accounts.
1. The government provides IRAs primarily to help taxpayers who are not able to participate in
employer-sponsored retirement plans and to help taxpayers with relatively low levels of
income to save for retirement, tax laws restrict who can make deductible contributions to
traditional IRAs. To be able to deduct contributions to traditional IRAs, taxpayers must
(1) Not be a participant in an employer-sponsored retirement plan. The limit for deductible
IRA contributions is 5,000 in 2009 (6,000 if age 50 or older) or the amount of earned
income if it is less. Earned income generally includes income actually earned through
the taxpayer’s efforts such as wages, salaries, tips and other employee compensation
plus the amount of the taxpayer’s net earnings from self-employment. Alimony income
is also considered as earned income for this purpose.
In this case, there is no phase-out of IRA deductions.
Note1: total IRA contributions (whether deductible or not) are subject to the 5,000 or 100% of
compensation limit.
Note2: Special rule: a taxpayer whose AGI is not above the applicable phase-out range can make
a 200 deductible contribution regardless of the proportional phase-out rule. This 200 minimum
applies separately to taxpayer and his spouse.
Note2: The earnings on contributions grow tax-free until the taxpayer receives distributions
from the IRA. On distribution, the taxpayer is taxed on the earnings generated by the
nondeductible contributions but not on the deductible contributions.
The early or late distribution requirement and penalty for traditional 401 apply to IRA.
Roth IRAs
A qualifying distribution is a distribution from funds or earnings from funds in a Roth IRA if
distribution is at least five years after the taxpayer has opened the Roth IRA and the distribution
is (1) made on or after the date the taxpayer reaches 59.5 years of age, (2) made to a beneficiary
(or to the estate of the taxpayer) on or after the death of the taxpayer, (3) attributable to the
taxpayer being disabled or (4) used to pay qualified acquisition costs for first-time homebuyers
(limited to 10,000) . All other distributions are nonqualified distributions.
1. Maximum annual contribution is subject to reduction if the AGI exceeds certain thresholds.
2. Contributions can be made even after the taxpayer reaches age 70.5
3. The contribution must be made by the due date of the taxpayer’s tax return (not including
the extension)
Congress created a number of retirement saving plans targeted toward self-employed taxpayers.
Two of the more popular plans for the self-employed are SEP IRAs and individual (or solo) 401k
plans. These are defined contribution plans that generally work the same as employer-provided
plans (same tax treatment).
A self-employed individual may contribute to a qualified retirement plan called a Keogh plan.
A Simplified employee pension (SEP) can be administered through IRA called a SEP IRA. The
owner of a sole proprietorship can make annual contributions directly to her SEP IRA. For 2009,
the annual contribution is limited to the lesser of (1) 49,000 or (2) 20% of the sole proprietor’s
net earnings from self-employment. If a sole proprietor has hired employees, the sole proprietor
must contribute to their respective SEP IRAs based on their compensation.
Individual 401k