1. 1 Topic 32: Income Tax Fundamentals  Primary: Internal Revenue Code Treasury Regulations Revenue Rulings and PLRs (can’t rely on) Court cases  Secondary Guides: not law

2. 2 Determination of Income Tax Liability  Gross Income  - “Above the Line Deductions”  = AGI (Adjusted Gross Income)  - > Standard or Itemized Deductions  -Personal and Dependency Exemptions  = Taxable Income  Tax Based on Filing Status  -Credits  = Tax Due

3. 3 Topic 33: Tax Compliance  Filing requirements Income > Standard deduction + personal exemptions Dependents: Unearned income > $1,000 All U.S. citizens; no matter where reside  Tax return due dates Individual: 4/15; six month extension Partnerships: same as individual; only five month extension Corporations: 3/15 for calendar corp; six month extend  IRS audits Statute: three years from due date of return  Longer if fraud (never) or substantial underpayment (6 years)

4. 4 Topic 33: Tax Compliance  Burden of proof On IRS if taxpayer keeps adequate records Privileged communication between CPAs and client if no criminal act committed  Audits Random sample, scoring, matching 1099s, W-2s  Target high income taxpayers, businesses generating cash  Taxpayer penalties substantial underpayment: 20% penalty  “substantial”: > 10% tax or $5,000 failure to pay: ½% per month up to 25% failure to file: 5% per month up to 25%  Minimum: $100/100% tax due if > 60 days past due fraud: 75% penalty

5. 5 Topic 33: Tax Compliance  Assessment: send 30 day letter  Have 90 days to appeal to Tax Court Not required to pay tax before hearing Other court venues (District Court) require payment of tax and then filing suit for refund  Only lawyers and CPAs can represent taxpayer in Tax Court

6. 6 Topic 34: Income Tax Calculation  Gross Income  - “Above the Line Deductions”  = AGI (Adjusted Gross Income)  - > Standard or Itemized Deductions  -Personal and Dependency Exemptions  = Taxable Income  Tax Based on Filing Status

7. 7 Topic 34: Income Tax Calculation  Filing Status MFJ: 12/31 or widow for two years Head of household: single; majority of cost of home for child/dependent  Gross Income  Exclusions Life insurance Muni bonds interest (not capital gains) Gifts/inheritances Personal injury damages

8. 8 Topic 34: Income Tax Calculation  Imputed Income Below market rate loans > $10,000 Zero coupon bonds  AGI = Gross Income – SE health insurance 50% SE tax $2,500 student loan interest $5,500 Traditional IRA (under age 50) Alimony Moving expenses Contributions to Health Savings Accounts

9. 9 Topic 34: Income Tax Calculation  Standard Deduction MFJ $12,400 Single $6,200 Additional standard deduction  Over 65  Blind

10. 10 Topic 34: Income Tax Calculation  Itemized Deductions: Schedule A Medical expenses > 10% AGI  Hospital, doctor, drugs, health insurance, mileage Property taxes: real estate and personal property State and local taxes: > of income or sales taxes Mortgage interest: on two homes; < $1 million  Also points if buying home  Home equity loans: interest on loans up to $100,000 Use this instead of car loans; credit card interest, etc. Gambling losses to extent of gambling income

11. 11 Topic 34: Income Tax Calculation  Itemized deductions Investment interest: to extent of investment interest income  If included in investment income; can’t use capital gains tax rates. Generally better to not include long- term capital gains and dividends Contributions  Public charity Cash: 50% of AGI Capital gains property: 30% of AGI  Deduct FMV, not cost  Five year carryover for gifts over AGI limit  Receipts for gifts over $250

12. 12 Topic 34: Income Tax Calculation  Itemized deductions Casualty losses:  Loss - $100 - 10% of AGI Miscellaneous  > 2% of AGI  Unreimbursed employee business expenses  Tax prep fees: Phase Out  For MFJ > $305,050 Itemized deductions reduced by three percent of (AGI - $305,050) Maximum reduction is 80% of itemized deductions

13. 13 Topic 34: Income Tax Calculation  Personal exemptions: $3,950  Dependent:  Child < 19 or < 24 and full time student  Relatives/household members earning < $3,950  Provide most support  Divorced parents  Generally custodial parent

14. 14 Topic 34: Income Tax Calculation  Personal exemptions: $3,950 in 2013  Phase Out: MFJ AGI > $305,050  Lose two percent of $3,900 for each $2,500 AGI > $305,050  Couple MFJ with kids and AGI of $500,003

15. 15 Topic 34: Income Tax Calculation  Calculating income tax  Rate schedules  Capital gains tax rates  15%;  0% for those with <15% ordinary tax rate  20%; for those with income MFJ > $450,000 AGI  3.8% Medicare tax on unearned income > $250,000 AGI  Kiddie tax: child under 19; student under 24 (increased in 2007)  Unearned income First $1,000 no tax; next $1,000 10% tax Above that, taxed at parent’s rates

16. 16 Topic 34: Income Tax Calculation  Self-employment tax  Social security: 12.4% of $117,000 s-e income  Technically, 92.35% of s-e income  Medicare: 2.9% of all s-e income  Medicare tax of 3.8% on unearned income above $250,000 MFJ  Medicare tax of 3.8% on wages above $250,000 MFJ  Self-employment income Business (Schedule C) Farming (Schedule F) Partnership (Schedule E): guaranteed payments; doesn’t matter if distributed  Not self-employment income S corporation earnings (Schedule E) Dividends and interest (Schedule B) Rental income (Schedule E)

17. 17 Topic 34: Income Tax Calculation  Tax credits Education  See Education Planning Topic Child Tax  $1,000 for dependent child under 17  Reduced by $50 for each $1,000 AGI exceeds $110,000

18. 18 Topic 34: Income Tax Calculation  Tax credits Dependent Care  Under age 13  $3,000 one child; $6,000 more than one  Each spouse must earn more than babysitter  Credit is 20% of expenses for AGI > $43,000 Adoption  Up to $13,190 in 2014 per child Excludes child of spouse Non-refundable Must have expenses of this amount unless special needs child

19. 19 Topic 34: Income Tax Calculation  Tax credits Retirement Savings tax credit  Credit for employee contributions to: 401(k) or other qualified plan IRAs (including Roth)  MFJ AGI up to $36,000 in 2014  Get credit for 50% of contributions up to $2,000 for maximum of $1,000 credit  MFJ AGI $36,000 - $60,000 in 2014 Get credit for 10% of contributions up to $2,000 for maximum of $200 credit  Can’t be a full-time student for five calendar months  Foreign tax credit Withholding on dividends Credit is limited to amount of U.S. tax would have paid on dividend Can carry back excess two years and then forward five years

20. 20 Topic 34: Income Tax Calculation  Payment of tax Estimated payments  Four payments each year = 90% of current year tax 100% of prior year tax  AGI > $150,000: pay 110% of prior year

21. 21 Topic 34: Tax Accounting  Accounting periods Calendar year generally  Accounting methods Cash  Individuals Constructive receipt Accrual  Retailers unless sales < $1 million  FIFO vs LIFO

22. 22 Topic 34: Tax Accounting  Net Operating Losses Back 2 years; forward 20 years  Installment sale Recapture all in year of sale Capital gain Return of basis Interest

23. 23 Topic 35: Business Entities  Sole Proprietorship: Schedule C Taxed once; unlimited liability Book: transfer personal expenses to Sched C???  General Partnership: Schedule E Taxed once; unlimited liability Distribute partnership assets: carryover basis  Limited Partnership: Schedule E Taxed once; unlimited liability for general partners  Limited partners have limited liability but no say  Requires filing with state  LLP: Schedule E Taxed once; no liability for other partners torts  LLC Taxed once; limited liability

24. 24 Topic 35: Business Entities  Personal holding companies >60% income from royalties, rents, dividends Majority owned by five or fewer owners Pays 15% penalty tax on undistributed earnings  C Corporation Ability to raise capital; limited liability Double taxation of dividends  C corp best if plan to retain earnings to grow business Liquidating dividends treated as sale of stock  Redemption: own < 80% of stock owned previously Capital gains taxed at ordinary rates

25. 25 Topic 35: Business Entities  S Corporation Taxed once; limited liability <100 shareholders; one class of stock Basis for shareholder loans Appropriate if:  income from business will be distributed Otherwise, pay tax on earnings but no cash to pay it Earnings of S corp not subject to S-E tax but salaries paid to owners subject to social security taxes  Or if anticipate losses initially Can’t deduct C corporation losses on stockholder’s 1040

26. 26 Topic 36: Income Taxation Trusts/Estates  Rates Generally higher than individual tax rates  Grantor: retains rights making him owner All income taxed to grantor  Simple: must distribute all income (generally not capital gains) Income taxed to beneficiaries Exemption amount: $300

27. 27 Topic 36: Income Taxation Trusts/Estates  Complex: can accumulate income Income distributed to beneficiaries taxed to them DNI: limit on amount of income taxable to beneficiary  Generally does not include capital gains  Estate Income Tax Income earned during estate administration  Same rules as complex trust Administration expenses  Can deduct either on estate or income tax return

28. 28 Topic 37: Basis  Basis: initially cost of asset Reduced by depreciation (whether taken or not) Increased by improvements  New roof versus painting building  Gift Generally carryover basis if asset increased in value Double basis if asset decreased in value  Inherited FMV at date of death  Exception if gifted property to decedent within year of death  Separate property versus community property

29. 29 Topic 37: Depreciation  MACRS: Cost of asset x percent Tables provided Useful life:  7 year: equipment  27 ½: residential real estate  39: nonresidential real estate  Listed property Autos: limits on annual depreciation  Section 179: expense up to $500,000 in 2013; $25,000 in 2014 Assets used in business  Limited to amount of business income  SUV limited to $25,000  Not available for real estate  Bonus depreciation: 50% in 2013 for new property; $0 in 2014

30. 30 Topic 37: Depreciation  Amortization: intangible assets Can amortize $5,000 of business start-up expenses  Depletion: natural resources Oil, gravel

31. 31 Topic 38: Like Kind (1031) Exchanges  Qualifying transactions Like kind property  Real estate: broad definition  Property used in business or for investment Personal property must be like kind Excludes securities and inventory If no cash received/liabilities assumed  Carryover basis Cash received/liabilities assumed  Gain recognized equals lesser of: Cash received/liabilities assumed  Mortgage relieved like receiving cash Gain realized  Basis = Carryover – Cash Received + Gain Recognized

32. 32 Topic 38: Like Kind (1031) Exchanges  Related parties: must hold properties two years  Deferred exchange Identify replacement in 45 days; close in 180 days

33. 33 Topic 38: Disposition of Property  Capital assets: held more than one year for capital gains tax rates Collectibles: 28% Real estate (to extent of depreciation): 25% Muni bonds capital gains are taxed  Netting gains Net short and long gains/losses Then net short against long if one gain/one loss Can use capital losses up to $3,000 to offset other income  Excess carries over

34. 34 Topic 38: Disposition of Property  Sale of principal residence Live in home 2 of last 5 years Can exclude up to $500,000 gain MFJ  Depreciation recapture Gain attributable to depreciation deduction is ordinary income  1231 gain: long-term capital gain to extent not from depreciation If no 1231 loss in last five years  1231 loss: ordinary loss  Section 1244 stock Can deduct up to $100,000 MFJ (versus $3,000)

35. 35 Topic 38: Disposition of Property  Installment sale Include portion of payment representing profit in income each year Depreciation recapture (section 1245) reported all in year of sale  Involuntary conversions Postpone recognizing gain from insurance if replace within two years

36. 36 Topic 38: Disposition of Property  Capital gains tax rates Long-term: 15%  If in 10/15% ordinary rate, 0%  Home office expenses Can’t create a loss on Schedule C Interest/property taxes vs. insurance Depreciation will be recaptured on sale of home  Related parties Gain recognized on sale Loss not recognized until sold to non-related party  Wash sales Buy “substantially identical” securities within prohibited period  30 days prior/after loss sale  Not identical securities  Disallowed loss added to basis

37. 37 Topic 39: AMT  Designed to ensure taxpayers with substantial amounts of income pay income tax  If alternative minimum tax exceeds regular tax liability, then pay AMT Essentially a second income tax system  Even “not so rich” taxpayers are increasingly paying AMT

38. 38 Topic 39: AMT  AMT Taxable Income (AMTI) Starts with regular taxable income Plus/minus adjustments Plus tax preferences Minus AMTI exemption Equals AMTI

39. 39 Topic 39: AMT  Adjustments Depreciation  Separate calculation of AMT depreciation  In general, less depreciation in initial years

40. 40 Topic 39: AMT  Preferences No standard deduction or personal exemptions allowed  These amounts have increased in recent years

41. 41 Topic 39: AMT  Preferences Itemized deductions for AMTI  Medical expenses allowed only to the extent they exceed 10%, not 7.5%  State income taxes aren’t deductible  Real estate and other property taxes aren’t deductible  No reduction of itemized deductions by 3% when AGI exceeds allowable amount

42. 42 Topic 39: AMT  Preferences  Incentive stock options (ISOs)  Income tax implications ( regular, AMT, basis) Upon grant  Option price must be equal to stock price (110% of stock price for > 10% owner)  FMV stock thru option exercise must be < $100,000 per year  Expiration: 10 years from date of grant  Typically a portion vests each year (maybe 20% each year) Can only be transferred on death of employee

43. 43 Topic 39: AMT  Preferences  Incentive stock options (ISOs) Upon exercise  Basis is equal to option price  Difference between option price and the value of stock on date of exercise is an AMT preference item  Exercising option before stock price increases reduces preference item but does subject employee to risk associated with ownership of the stock  AMT basis is equal to stock price on date of exercise; not option price  Higher basis for AMT if price has increased

44. 44 Topic 54: AMT Preferences  Incentive stock options (ISOs) Upon sale  If stock has increased in price between date option was vested and date option was exercised, AMT basis will exceed tax basis. Consequently, on sale of stock AMT gain will be smaller than capital gain

45. 45 Topic 39: AMT  AMTI Exemption MFJ  $82,100  less 25% of AMTI over $150,000  AMT Tax Rate: All other than MFS 26% of first $175,000 28% of all amounts over $175,000  Minimum Tax Credit: Available if AMT due to timing differences

46. 46 Topic 39: AMT  Corporations and trusts are subject to AMT Corporate owned life insurance increases AMTI

47. 47 Topic 40: Tax Reduction Techniques  Education credits Only available for amounts paid “out of pocket” High income clients  Have children pay education expense due to phaseouts for exemptions/education credits

48. 48 Topic 40: Tax Reduction Techniques  Intrafamily transfers Not as effective due to extension of kiddie tax to older children  Accelerate deductions State income taxes Charitable contributions Section 179 Farm/business expenses year-end  Defer income Contribute to retirement plans  Remember your banker!!!  Future tax rates???

49. 49 Topic 41: Hobby Losses  Substantial outside income  Engaged in for profit  Had profit three of last five years  Fun?

50. 50 Topic 41: Passive Activity and At- Risk  At-Risk Generally deductible losses are limited to amount invested in business, i.e., basis Calculating basis=  Amount invested  Recourse and nonrecourse loans Nonrecourse: not personally liable  + Income from business  - Losses from business  - Distributions from business

51. 51 Topic 41: Passive Activity and At- Risk  At-Risk Losses are also limited to amount at risk  Amount at risk generally does not include nonrecourse loans Rules apply to individuals  And corporations with < five owners Losses can be carried forward Losses can not offset income from other activities

52. 52 Topic 41: Passive Activity and At- Risk  Passive Activity Trade or business in which taxpayer does not materially participate  Material participation: involved in activity on a regular and continuous basis 500 hours per year Do all the work Personal services (attorney, doctor, etc.) Material participation in five of last 10 years or 100 hours per year if more than anyone else’s participation  Limited partners generally also passive Can’t use limited partnership losses to offset other passive income

53. 53 Topic 41: Passive Activity and At- Risk  Passive Activity Rental activities (not short term rentals – hotels)  Doesn’t matter if you materially participate  However, can deduct up to a $25,000 loss MFJ if “actively” participate in real estate Active: approve tenants, decide rental terms, approve repairs and improvements  Must also have at least 10% ownership $25,000 allowance is phased out if AGI is above $100,000 for MFJ  Can’t take $1 of loss for every $2 AGI > $100,000  Also, real estate professionals (more than 750 hours per year) can avoid passive activity loss rules if materially participate

54. 54 Topic 41: Passive Activity and At- Risk  Passive Activity Vacation homes  Rented > 14 days and personal use < 14 days or 10% days rented Business: all income and expenses included on Schedule E  Rented > 14 days and personal use > 14 days or 10% days rented Income included Allocation of expenses between business and personal has been litigated  Rented < 14 days No income or expenses reported Home on Bagelfest parade route in Mattoon

55. 55 Topic 41: Passive Activity and At- Risk  Passive Activity Losses can only be used to offset passive activity income  Can’t offset active or portfolio income Losses can be carried forward but retain their character Losses not previously allowed from a passive activity are allowed in year passive activity is sold  Grouping of passive activities Must group in first year; more group, harder to dispose of entire interest

56. 56 Topic 42: Special Circumstances  Filing status: only December 31 st matters Joint liability  Innocent spouse  Alimony Payor: Deductible, child support is not  Can’t front load alimony ($15,000 more than later years)  Paying ex-spouse’s mortgage, etc. also considered alimony Recipient: Taxable, child support is not

57. 57 Topic 42: Special Circumstances  Property settlement is not taxable  Exemption: generally goes to custodial parent  QDRO: division of retirement assets Defined contribution/IRAs/Defined benefit  Death: still get personal exemption and can file MFJ

58. 58 Topic 43: Charitable Contributions  Qualified organizations Public charity: charitable, religious, education, government  Not: your neighbor who lost his job; not Republicans Private charity: foundation  Must give property Not value of time  Must reduce contribution by value of benefit received Raffle tickets  Paid before end of year Credit cards

59. 59 Topic 43: Charitable Contributions  Cash 50%: public charity Carryover for five years  Capital gain property: deduct FMV 30%: public charity Carryover for five years Elect 50% limit if use cost instead of FMV

60. 60 Topic 43: Charitable Contributions  Substantiation  Must have: a bank record (check) for contribution or documentation from charity  No deduction for: Cash contributions to  Salvation Army  Church? They generally will provide documentation