Contains the notes on the Investment Planning study book material for the CFP Board Exam. It wades through the absurd complexity of the U.S. tax code as it relates to individuals and entities.
The Notes
- If it’s taxed, it’s tested!
- Starred (*) topics are more likely to be on the exam (2021).
- Asset Categories for Taxes
- Capital Assets
- Most personal use assets and investment assets.
- All assets are capital assets except:*
- Accounts/notes receiveable
- Copyright and creative works (held by the creator)
- Inventory
- Depreciable property used in trade/business
- Ordinary Income Assets
- Assets treated as ordinary income when sold.
- Accounts receivable
- Inventory
- Copyright/creative work held by creator
- Assets treated as ordinary income when sold.
- Section 1231 Assets
- Assets used in trade/business.
- Depreciable property
- Real Property
- Ex: Timber, coal, iron ore, livestock, unharvested crops.
- Assets used in trade/business.
- Capital Assets
- Determining Basis
- Basis:
- determines the amount of gain or loss on a sale/disposition.
- determines the amount that can be recovered tax-free through depreciation.
- determines deduction for depletion and obsolescence.
- Cost Basis
- Amount paid in cash, debt, assets, or services for property.
- Is the FMV of property at acquisition or FMV of property given in exchange (basis is carried over).
- Includes:
- Tax (sales, excise, real estate)
- freight
- Install/testing
- Fees (legal, accounting, recording)
- Revenue Stamps
- Adjusting Basis
- Increases to Basis
- Capital improvements — home addition, new roof, etc.
- Assessment for local improvements — sidewalk, roads, etc.
- Cost of restoring damaged property
- Legal fees
- Zoning costs
- Decreases to Basis
- Excluded energy conservation subsidies from income
- Deductions for clean-fuel vehicle and refueling property.
- Casualty/theft loss deductions and reimbursement (businesses)
- Section 179 deductions.
- Qualified electric vehicle credits.
- Depreciation
- Nontaxable corporate distribution.
- Property Acquired in Nontaxable Exchange
- 2 properties of equal value (no boot paid) are exchanged, acquired property has carryover basis.
- Property exchanged for more valuable asset (boot paid), acquired property has carryover basis plus boot paid.
- Poperty exchanged for less valuable asset (boot received), acquired property has carryover basis less boot received.
- Carryover basis = basis of original property “carries over” to the new property.
- Special Basis Rules
- Inherited Property
- Holding period is always long-term for capital gains.
- Gifted Property
- General Rule: Donee’s basis is donor’s basis in gifted property.
- Exception:
- When FMV of gifted asset is less than donor’s basis:
- Use Double Basis Rule:
- Gains Only = basis is adjusted basis of doner.
- Losses Only = basis is FMV of property at date of gift.
- Between FMV at date of gift and doner’s adjusted basis = no gain or loss recognized.
- Use Double Basis Rule:
- When gift tax is paid.
- Donee’s Basis = Donor’s Basis + ((Net Appreciation/Value of Gift) x Gift Tax Paid)
- When FMV of gifted asset is less than donor’s basis:
- Exception:
- Holding Period
- General Rule: Holding period includes the holding period of donor.
- Exception:
- When double basis rule concludes basis is FMV at date of gift, then holding period starts at date of gift.
- Tip: follow the basis.
- Exception:
- General Rule: Holding period includes the holding period of donor.
- General Rule: Donee’s basis is donor’s basis in gifted property.
- Property Transferred Between Spouses in Divorce
- Treated as gifts — carryover basis applies.
- No gain or losses recognized on transfer.
- Must occur within 1 year of date marriage legally ended and be related to it.
- Treated as gifts — carryover basis applies.
- Related Party Transactions
- Only impacts transactions with a loss.
- Transferor’s loss is forever lost.
- Transferee takes assets with Double Basis Rule:
- Gains = basis is transferor’s basis
- Loss = basis is FMV at date of exchange
- Holding Period = date of sale.
- Bargain Sale to Charity
- Sales of property to charity for less than FMV:
- Basis split between portion sold and portion donated.
- Basis for Sale Purposes = (Amount Realized/FMV) x Property Basis
- Sales of property to charity for less than FMV:
- Inherited Property
- Increases to Basis
- Tax Rates
- LTCG rates = 0%, 15%, 20%
- LTCG = holding period of more than one year.
- STCG rate = ordinary income tax rate.
- Medicare Contribution Tax = 3.8% (on investment income when AGI exceeds $200k (single) or $250k (MFJ))
- Exceptions:
- Collectibles = 28%
- Unrecaptured Section 1250 Gain = 25%
- Qualified Small Business Stock (QSBS, Section 1202) = 28% (on portion of gain not excluded and if holding period is at least 5 years).
- 50% excluded if QSBS acquired before Feb. 18, 2009.
- 75% excluded if QSBS acquired after Feb. 17, 2009 and before Sept. 28, 2010.
- 100% excluded if QSBS acquired after Sept. 27, 2010
- Holding Period = day of disposition is included, day of acquisition is not included.
- LTCG rates = 0%, 15%, 20%
- Basis:
- Capital Gains and Losses
- Gain on capital assets only taxed when there is both:
- Realization event
- Sale or exchange of property
- Segregation of gain
- Recognition event
- Occurs when a realized gain is taxed.
- Exceptions:
- Recognition of gain occurs when:
- When debt is relieved.
- When money is taken out of an investment as a loan, and person is not liable for the loan.
- Net gifts (donee pays gift tax).
- Recognition of gain occurs when:
- Realization event
- General Rule: Realized gains are recognized.
- Exception:
- Gain is exempt per tax code.
- Gain is deferred to a future time.
- Examples:
- Like-kind exchange of real property
- Exception:
- Sale/Exchange Requirements
- Most sales and exchanges are obvious. Some less obvious:
- Natural disasters that destroy property create a realized event. Loss may or may not be recognized.
- Bankruptcy of a company creates a realized event. Loss from worthless securities is deductible in year they become worthless.
- Most sales and exchanges are obvious. Some less obvious:
- Calculate Gain or Loss
- Realized Gain/Loss = Amount Realized – Adjusted Basis
- Adjusted Basis = Cost Basis + Capital Additions – Cost Recovery
- Amount Realized = Cash Received – FMV of Property received in exchange – Liabilities shed
- Losses
- Losses on assets for personal use is a personal loss — NOT deductible for tax purposes.
- Wash Sale
- When sell security for a loss and buy a “substantially identical” security within 30 days before or after the loss sale.
- Disallowed loss is added to the cost of the new security to get the new basis.
- Examples:
- index fund for index fund = rule applies
- index fund for managed large cap fund = does not apply.
- convertible preferred for the common = rule applies.
- Applies to sales of securities, options to buy or sell securities, and warrants
- Losses on worthless securities are deductible in the year they become worthless.
- Limits of Capital Losses
- Up to $3,000 in short or long term capital losses can offset income in any one year.
- Excess is carried forward to offset future gains or income.
- Up to $50,000 in small business stock losses deducted as ordinary loss, assuming:
- It’s a domestic corp.
- It was small biz at time of stock issue — less than $1 million in total capital contributions plus paid-in capital
- Incorporated after Nov. 6, 1978
- Original owner of stock and in exchange for money/property.
- Fiver years prior to loss — 50% of gross receipts from sources other than royalties, rents, dividends, interest, annuities, capital gains.
- Disallows losses from direct/indirect sales/exchanges between related parties — siblings, lineal descendants, ancestors, spouse.
- NEVER gift/sell assets to a related party when donor’s basis is greater than FMV!
- Up to $3,000 in short or long term capital losses can offset income in any one year.
- Personal Residence
- Gain
- Exclusion:
- Must own and occupy the principal residence for 2 of last 5 years.
- Can only be used once every 2 years.
- May exclude $250k (single) or $500k (MFJ) of gain on sale of principal residence.
- MFJ = both must meet the use requirement – only used once every 2 years.
- Reduced Exclusion:
- Available if sale is due to:
- Change in Employment — qualified move for either spouse.
- Change in Health — diagnosis, cure, treatment for parents. grandparents, child, siblings, etc.
- Unforeseen Circumstances — disaster area, death, unemployment, divorce — fairly broad.
- Amount of exclusion is based on period of ownership between last sale and current sale (pro rata).
- Exclusion = (Months in home/24 months) x Full Exclusion Amount
- Available if sale is due to:
- Exclusion:
- Loss
- Realized loss on personal residence = loss may not be recognized.
- Gain
- Gains/Losses Summary*
- Personal Use
- Gains — Short or Long Term Gain – based on holding period
- Losses — NOT recognized or deductible.
- Capital Assets
- Gains — Short or Long Term Gain – based on holding period
- Losses — Capital Loss – deductible to extent of gains plus $3,000 (excess loss is carried forward).
- Losses offset gains of the same type, then the opposite type, then income.
- Trade/Business
- Gains — Short or Long Term Gain – based on holding period
- Losses –Ordinary Loss – deductible against ordinary income
- Trade Ordinary Income
- Gains — Ordinary Income
- Losses — Ordinary Loss – deductible against ordinary income
- Personal Use
- Gain on capital assets only taxed when there is both:
- Business Assets
- Business asset gain or loss is typically a Section 1231 gain or loss.
- Section 1245 or Sectio 1250 gain — depreciable property — depreciation recapture is ordinary income, remaining gain is Section 1231 gain
- Section 1231 Assets
- Depreciable real or personal property with a long-term holding period (MUST be more than 1 year).
- Depreciable property — any asset expected to decline in value.
- Benefits
- Gains treated as long term capital gains.
- Losses treated as ordinary income losses.
- Depreciation Recapture
- Section 1245 Property
- Tangible Property — tangible personalty (depreciable property like equipment), patents, copyright, and other intangibles.
- NOT land and building.
- Gain is treated as ordinary income up to depreciation allowed. Excess gain beyond depreciation treated as Section 1231 gain.
- 4 Possible Tax Results on Sale:*
- Sold for adjusted basis — no gain or loss, no depreciation recapture
- Sold less than adjusted basis — ordinary loss, no depreciation recapture
- Sold more than adjusted basis, gain does not exceeds depreciation taken — ordinary gain
- Sold more than adjusted basis, gain exceeds depreciation taken — ordinary income to depreciation taken, capital gains on rest
- A Section 1231 gain on Section 1245 property is only possible if it’s sold for more than the purchase price!
- Section 1250 Property
- Governs recapture on 1231 assets — buildings and real estate — with accelerated depreciation.
- Gain up to excess depreciation less straight-line depreciation treated as ordinary income. Excess gain up to straight-line depreciation taxed at 25% (unrecaptured Section 1250 depreciation). Any remaining gain is capital gain.
- Section 1250 losses are ordinary losses.
- Section 1245 Property
- 5-yr Lookback Rule
- Section 1231 gains/losses are netted over a 5 year period.
- NonTaxable Exchanges
- Tax on realized gain or loss is deferred or exempt.
- Like-Kind Exchange (Section 1031 Exchange)
- No gain or loss recognized at time of exchange.
- Property must be productive use in trade/business or investment.
- It’s mandatory, if like-kind exchange available.
- Property must be similar in nature — not similar uses (interpreted broadly).
- Real Estate Exchanges
- Allowed
- Improved realty for unimproved realty
- Foreign realty for foreign realty
- Not Allowed
- US realty for foreign realty
- Allowed
- Real Estate Exchanges
- Tax Consequences (Trading Up, Down, or Equally)
- Like kind property of similar value = basis and holding period carry over to new property, no tax consequences at exchange.
- Trading Up (exchange for higher valued asset) — old basis + boot (cash given) = new basis.
- Trading Down (exchange for lower valued asset) — Boot (cash received) is recognized as gain.
- If boot exceeds gain — excess boot (amount over gain) — treated as return of capital, reduces basis.
- Losses in exchange not recognized until property is sold.
- Debt relief treated as boot.
- Party that assumes the debt = amount of debt added to basis.
- Party not responsible for debt = amount of debt treated as gain.
- Involuntary Conversion
- Destruction, theft, seizure, condemnation, or threat of condemnation like eminent domain.
- Gains nontaxable if amount reinvested in replacement property equals/exceeds the realized gain.
- Replacement property must be:
- similar in function or use (defined narrowly).
- Owner-users = functional use test applies — used in a similar function as old property.
- Owner-investors = taxpayer use test applies — used in a similar way by taxpayer.
- acquired in specific time period
- starts when involuntary conversion occurs
- ends 2 years from year-end of year the gain is realized.
- 3-years for realty
- similar in function or use (defined narrowly).
- Insurance Policies (Section 1035 Exchange)
- Tax-free exchange of insurance policies:
- Life insurance exchanged for:
- another life insurance contract on same person
- endowment or annuity contract
- Endowment contract exchanged for:
- another endowment contract — payments begin no later than date payments would begin on original contract
- an annuity contract
- Annuity contract exchanged for:
- another annuity contract on same person.
- Life insurance exchanged for:
- Losses not deductible.
- Cash received will trigger gains on amount received.
- Tax-free exchange of insurance policies:
- Basic Income Tax
- Accouting Method
- Cash-Based
- Income recognized when received.
- This is most people.
- Constructive Receipt Doctrine = when income is readily available, and not subject to restrictions/limitations, its deemed received and should be taxed.
- Accrual-Based
- Income recognized when earned.
- This is most businesses.
- Cash-Based
- Taxable Year
- Most taxpayers use the calendar year.
- Fiscal year — 12 month period ending last day of the month (not December) — is possible.
- adequate records must be maintained.
- Individuals file Form 1128 for approval.
- Filling Status
- Single
- Married Filing Jointly
- Must be married by last day of the year
- Taxpayer’s spouse died during the year and did not remarry
- Married Filing Separately
- Head of Household
- For unmarried or considered unmarried by last day of year
- Must pay more than half cost of keeping up the home.
- Qualified person must have lived with taxpayer more than half the year.
- Qualified Widow(er) w/ qualified child
- Eligible to file for 2 years following year spouse died if:
- eligible to file joint return with spouse in year they died
- has not remarried
- child is “qualified”
- child lived in home all year
- taxpayer paid more than half cost of home’s upkeep for year
- Eligible to file for 2 years following year spouse died if:
- Standard Deductions
- Additional Amounts
- Age 65 or older
- $1,700 — individuals, not married, not filing as qualifying widow(er)
- $1,350 — all other taxpayers
- Blind
- $1,700 — individuals, not married, not filing as qualifying widow(er)
- $1,350 — all other taxpayers
- Must file to receive additional deduction.
- Someone 65+ and blind get both added deductions.
- Age 65 or older
- NOT Eligible for Standard Deduction
- Married Filing Separately — when other spouse itemizes. Both must itemize or both must use standard deduction!
- Nonresident aliens
- Filing returns for tax year less than 12 months.
- Claimed as a dependent:
- limited standard deduction greater of:
- $1,100 (2021)
- $350 plus earned income (not to exceed normal standard deduction)
- limited standard deduction greater of:
- Additional Amounts
- Qualifying Child
- MUST Meet 4 Tests:
- Relationship Test
- taxpayer’s child (natural, step, adopted, eligible foster)
- descendent of taxpayers child
- taxpayers brother, sister, step/half brother or sister.
- descendent of taxpayers brother, sister, step/half brother or sister.
- Abode Test
- live with taxpayer more than half the year.
- considered to occupy household during temporary absences like illness, education, vacation, work, military.
- Age Test
- Must be either under 19 or student under 24 as of end of the calendar year
- students must be full time for 5 months of calendar year
- Support Test
- Qualifying child does NOT provide more than half of own financial support during the year.
- Relationship Test
- Tie-Breaker Rules
- If more than 1 person can claim a child:
- Both parents = Goes to parent the child lived with longer
- Child lived w/ both parents equally = Goes to parent with higher adjusted gross income
- Neither is a parent = Taxpayer with higher adjusted gross income
- If more than 1 person can claim a child:
- Divorced/Separated Parents
- Typically qualifying child of custodial parent
- Exception — qualifying child of noncustodial parent — if ALL 4 are met:
- Parents are divorced/legally separated during last six months of year.
- Child gets over half their support from parents
- Child in custody of parents for over half the year
- Custodial parent signs a statement that they will NOT claim the child AND noncustodial parent attaches statement to their return.
- MUST Meet 4 Tests:
- Qualifying Relative
- MUST Meet 4 Tests:
- Relationship Test
- Taxpayer’s child or descendant of child
- Taxpayer’s brother, sister, step/half brother or sister.
- Taxpayer’s father/mother, step father/mother, or ancestor (grand- or great-grandparents)
- Taxpayer’s nephew/neice, uncle/aunt
- Taxpayer’s in-laws — son/daughter, father/mother, brother/sister
- Anyone else who lived with the taxpayer and member of the household for the taxable year.
- Cousins do NOT meet relationship test.
- Gross Income Test
- Must be less than personal exemption amount ($4,300 for 2021)
- Support Test
- Taxpayer must provide more than half support for dependent.
- Only dependent’s income spent on support is included (income saved not counted)
- Taxpayer must provide more than half support for dependent.
- Not Qualifying Child Test
- Can NOT be a qualifying child for tax year.
- Joint Return Test
- Married dependent must NOT file a joint return
- Unless: only filling to claim a refund, neither spouse required to file, and no tax liability for either taxpayer on separate returns
- Citizenship/Residency Test
- Must be a citizen/national or resident of the US, Canada, or Mexico during some part of the year.
- Relationship Test
- MUST Meet 4 Tests:
- Tax Payment Process
- Most income taxes are withheld from paychecks by employer.
- Income NOT withheld, may be subject to estimated tax payments.
- Estimated Payments:
- Due quarterly: April 15, June 15, September 15, January 15 (the next year)
- Required (to avoid penalty) if:
- Expects to owe at least $1,000 in taxes (2021)
- Expects withholdings/credits to be lesser of:
- 90% of taxon 2021 tax return, or
- 100% of tax on prior year’s return.
- Accouting Method
- Gross Income
- Includes earned and unearned income.
- Sources:
- Annuity payments
- Compensation for services
- Gross income from business
- Gains from property dealings
- Interest/dividends
- Rents/royalties
- Alimony payments (finalized by 12/31/2018)
- Income from life insurance/endowment contracts
- Pensions
- Discharge of debt
- Pass-through income from Partnerships, S Corps
- Income in community property states — half earnings of each spouse considers “owned” by other.
- Income from trusts and estates
- Taxation of Annuity Payments
- Combo of return of capital (tax free) and interest (taxable ordinary income)
- Exclusion Ratio — determines the percentage of payment excluded from taxes.
- Exclusion Ratio = Investment in Contract/Expected Total Return.
- Taxation of Qualified Retirement Plan Distributions
- Subject to ordinary income if funded with before-tax contributions
- If funded after-tax contributions, then:
- Combo of return of capital (tax free) and interest (taxable ordinary income)
- Use exclusion ratio.
- Taxation of Traditional IRAs Distributions
- Taxed as ordinary income.
- Exception: Nondeductible IRA contributions and/or IRA rollover that included after-tax contributions.
- Combo of return of adjusted basis (tax free) and interest (taxable ordinary income)
- Adjusted Basis (AB) Ratio = AB before withdrawal/FMV of account at withdrawal
- AB Ratio = percentage of each distribution excluded from taxes.
- Social Security Benefits
- Up to 85% may be taxable.
- Based on Modified AGI (MAGI). AGI plus:
- tax-exempt interest (like Muni-bond interest)
- savings bonds interest (for higher education)
- excluded foreign income earned
- amount excluded from income for employer-provided adoption assistance
- education loan interest deduction amount
- Calculation:
- Hurdles:
- 1st Hurdle
- MFJ – $32k
- Others – $25k
- MFS – 0
- 2nd Hurdle
- MFJ – $44k
- Others – $34k
- MFS – 0
- 1st Hurdle
- If MAGI + 0.5(Social Security Benefits) is:
- Between 1st and 2nd Hurdle, its lessor of:
- 50% Social Security Benefits
- 50% (MAGI + 0.5(Social Security Benefits) – Hurdle 1)
- Exceeds 2nd Hurdle, its lessor of:
- 85% Social Security Benefits
- 85% (MAGI + 0.5(Social Security Benefits) – Hurdle 2) plus:
- $6000 (MFJ) or $4000 (others), or
- 50% (MAGI + 0.5(Social Security Benefits) – Hurdle 1)
- Between 1st and 2nd Hurdle, its lessor of:
- Hurdles:
- Below Market Loans
- Gift loans/tax avoidance loan — “lending” a kid money for a down payment but not collecting interest
- Requires lender to:
- Impute interest income earned on the loan and include with income.
- Imputed interest is considered a gift for tax purposes (may be eligible for annual gift tax exclusion)
- Imputed Interest Rules:
- <= $10,000 — $0 imputed interest
- $10,001 <= $100,000 — Lessor of:
- Net investment income
- If NII <= $10k, then $0 imputed interest
- Calculated AFR interest on loan less stated interest on loan
- AFR = Applicable Federal Rates
- Net investment income
- > $100,000 — Calculated AFR interest on loan less stated interest on loan
- Between a Corp and shareholder = loan is considered a dividend
- Repayment considered interest income
- Between employer and employee = loan considered paid compensation subject employment taxes
- Repayment considered taxable interest income
- Exclusions
- Gifts/Inheritance
- “Gratuitous” transfer of property
- Gifts received are NOT included in gross income (not taxed)
- Life Insurance Proceeds
- NOT included in gross income of beneficiary (not taxed)
- If paid in installments, interest portion is taxed.
- Cashed in policy prior to death
- excess above premiums paid must be recognized
- Sold as Transfer for Value
- Amount received in excess of premiums paid (basis) included in gross income
- Death proceeds taxable to new owner
- Exceptions:
- transferred to insured
- transferred to partner of insured
- transferred to partnership insured is partner
- transferred to corp. insured is shareholder or officer
- transferred by gift/tax-free exchange
- Viatical Settlement
- excluded from gross income
- MEC
- loans/withdrawals treated as gross income to extent of earnings
- basis recovered last.
- NOT included in gross income of beneficiary (not taxed)
- Scholarships
- Qualified scholarships NOT included in gross income
- Scholarship/fellowship grant used for qualified tuition/related expenses.
- does NOT include room/board, amount for room/board is taxable.
- Scholarship/fellowship grant used for qualified tuition/related expenses.
- Qualified scholarships NOT included in gross income
- Roth IRA/Roth 401k/Roth 403b Distributions
- Not included in gross income (tax exempt)
- Injury/Sickness Compensation
- Excluded:
- Workers’ Comp for personal physical injury/sickness
- Damages received on personal physical injury/sickness
- Benefits from accident/health insurance owned by taxpayer
- Punitive Damages
- Included in gross income
- Emotional Distress Damages
- Included in gross income
- unless attributed to personal physical injury/sickness or reimbursing medical costs
- Excluded:
- Employer-Sponsored Accident/Health Plans
- Medical
- General Rule: Excluded from gross income of employee
- Group Term Life
- Employers
- Premiums deductible for employer
- Exceptions:
- Deductions on behalf of sole proprietors/partners
- Deductions on behalf of stockholders (unless provide services)
- Employer is beneficiary
- Employees:
- Taxation:
- First $50k of coverage NOT taxable
- Employee contribution subtracted from cost to get amounttaxable income.
- NOT Taxable to Employees:
- employee terminated for disability
- beneficiary is qualified charity or employer
- Taxation:
- Employers
- Meals/Lodging
- NOT included in employees gross income if offered by employer
- on business premises
- at convenience of employer
- NOT included in employees gross income if offered by employer
- Fringe Benefits
- Dependent Care
- Up to $5000 paid by employer excluded from gross income
- Athletic Facilities
- Excluded from gross income, if on employer’s premises
- Educational Assistance Programs
- Limited to $5,250 per year
- Undergrad Ed — excluded from gross income
- Student Loan Repayments – excluded from gross income
- Adoption Assistance Program
- Limited to $14,440 (2021) of expenses paid by employer
- Phase-out: MAGI $216,660 to $256,660
- Cafeteria Plans
- Let’s employees chose from list of nontaxable benefits or cash
- Cash is taxable.
- Benefits NOT taxable.
- Qualified Employee Discounts
- Taxed if discount exceeds gross profit or 20% on services
- Qualified Transportation
- For work commute — parking/transit passes
- Employee may exclude from income
- For work commute — parking/transit passes
- Qualified Moving Expense
- Reimbursement included in gross income.
- Exception: military member on active duty — move is ordered and permanent change of station.
- Dependent Care
- Medical
- Foreign Earned Income
- Excluded if tax home in foreign country and one of:
- US citizen, resident of foreign country for uninterrupted period entire tax year.
- US resident alien of country with income tax treaty with US and resident of foreign country for uninterrupted period entire tax year.
- US citizen/resident alien physically in foreign countries at least 330 days of any 12 consecutive months.
- Excluded if tax home in foreign country and one of:
- Interest on State/Local Government Obligations
- Tax Exempt
- Exceptions:
- Private Activity Bonds
- Arbitrage Bonds
- Discharge of Indebtedness
- Any gain is taxable
- Gain is lessor of:
- amount of debt canceled
- Excess of assets over liabilities after debt is canceled
- Exceptions:
- Discharged in bankruptcy
- Student loan debt forgiven for public service
- Gifts/Inheritance
- AGI
- AGI used for:
- sets floor limits for medical expenses
- sets ceiling limits for charitable deductions
- sets limits on IRA contributions
- sets phaseouts of tax benefits
- Above the Line Deductions (FOR AGI)
- Subtracted from Gross Income to get Adjusted Gross Income (AGI)
- Gross Income – Adjustments = AGI
- Trade/Business Expenses
- To be deductible, must be:
- Ordinary — normal for similar businesses
- Necessary — prudent person would incur the expense
- Reasonable
- In conduct of business
- To be deductible, must be:
- Alimony
- Divorce decrees after 12/31/2018
- Not income to payee
- Not deductible for payer
- Divorce decrees before 12/31/2018
- Income to payee
- Deductible for payer
- Property Settlement at Divorce
- No deduction for transferred property
- No gain/loss recognized
- Transferee gets carryover basis on property
- Excess Alimony Payments
- 3-year review period
- Watch for OVER $15,000 drop from years 1 and 2 or 2 and 3.
- Excess included in payer’s taxable income in 3rd year.
- Payee allowed deduction equal to amount included in payers income.
- Shortcut formula:
- Recapture = P1 + P2 -2P3 – $37,500
- If > 0, then excess alimony
- NOT Alimony
- elective payments
- payments that extend beyond payee’s life (alimony ends at death of payee).
- child support
- rent-free housing
- Divorce decrees after 12/31/2018
- Charitable Contributions Above the Line
- $300 ($600 MFJ) deductible for taxpayers that do NOT itemize
- Self Employed Above the Line Deduction
- Education Expenses
- Deductible:
- To maintain/improve skill
- Requirements of profession, licensing, state law
- Include:
- tuition, books, supplies, transportation, lodging, meals (50%)
- NOT Deductible:
- To meet minimum education standards
- For a new trade/business
- Deductible:
- Business Gifts
- Limited to $25 per person per year
- If $4 or less with business name on item = advertising
- Home Office Expense
- only deductible for self-employed
- Education Expenses
- AGI Deductions (FROM AGI)
- Either Standard Deduction or Itemized Deductions
- Itemized Deductions
- Medical Expenses
- In excess of 7.5% of AGI (is the floor)
- Include:
- prescriptions
- noncosmetic surgery
- some qualified long term care
- insurance premiums
- tuition for medically necessary schools (school for deaf/blind)
- Capital expenses on property upgrades
- physician advice
- extent that FMV did NOT increase
- handicapped entrance/railing
- State/Local Taxes
- Property taxes (US only)
- State income tax
- State/lock sales tax
- Taxes capped at $10,000 total
- Qualified Charitable Contributions*
- Public charities — the most familiar. churches, schools, hospitals, governmental entities.
- Limits
- Cash = 60% of AGI
- Other Property = either 20%, 30%, or 50% of AGI
- Limits
- Private charities — do not fit definition of public…private foundations, fraternal orders, veterans orgs.
- Limits
- Cash = 30% of AGI
- Other Property = either 20% or 30% of AGI
- Limits
- Carryforward Rules
- Donations in excess of limits can be carried forward for 5 years in FIFO order.
- Public charities — the most familiar. churches, schools, hospitals, governmental entities.
- Deduction Clustering
- Pile a bunch of itemized deductions in a single to get a higher than standard deduction.
- Examples:
- Pay state income/property tax early
- Early mortgage payment before year end
- medical expenses
- Charitable donations
- Traditional IRA Charitable Contributions
- Must be made by IRA trustee to qualified charity
- Owner age 70 1/2 before making contributions
- Cannot exceed $100,000 per year.
- reduced by any IRA contributions.
- Tax Results:
- NOT treated as income
- NOT treated as charitable contribution
- NOT part of RMD
- Casualty Losses
- Deductible in year of loss
- Personal casualty losses only deductible if national disaster declared by President
- NET disaster loss (loss minus gains) is an additional standard deduction subject to $500 per casualty floor.
- Business casualty losses deductible to business
- Estate casualty losses deductible to estate
- Caused by fire, storm, shipwreck, theft, or other.
- Chance of Reimbursement:
- Close to full recovery, any loss (not reimbursed) deducted in year of settlement
- Partial recovery, deduct loss (portion not covered by insurance) in year of loss.
- Exception:
- Business, rental, royalty property = deduction is FOR AGI
- Casualty Gains
- If gains exceed losses, treat gains as capital gains.
- short or long term depends on holding period
- If gains exceed losses, treat gains as capital gains.
- Deductible in year of loss
- Personal Interest Expense
- Investment Interest Expense
- limited to interest income
- carried over indefinitely
- special election made for LTCG treated as ordinary income to offset investment interest income
- Mortgage interest on personal residence
- Limited to $750,000 of mortgage debt (before 12/15/17 limited to $1 million)
- Limited to 2 houses
- No home equity interest
- Qualified Business Income (QBI)
- reduces taxable income not AGI
- take with standard or itemized deduction
- Deduction: 20% of QBI (on pass-through income, not investment income).
- Investment Interest Expense
- Medical Expenses
- AGI used for:
- Taxable Income
- Tax Credits
- Earned Income Credit
- Must have earned income
- Must have a qualifying child
- Exception: credit for some taxpayers without kids — ages 25 to 64
- Qualifying child must meet relationship, residency, age test.
- Credit Amount = Earned Income x Applicable Percentage Rate
- Rate and max. earned income amount depend on number of children
- Adoption Expenses Credit
- Credit for qualifying expenses in adopting a child
- Adoption fees, court costs, attorney fees
- Max Credit = $14,400
- AGI Phaseout = $216,660 to $256,660
- Eligible Child:
- Less than 18, or
- Physically or mentally handicapped
- Credit is nonrefundable, excess is carried forward for 5 years.
- Credit for qualifying expenses in adopting a child
- Child Tax Credit
- $2000 per child under age 17 (2021)
- Includes stepchild and foster child*
- Married taxpayers must file jointly for the credit.
- Eligible child:
- Under 17
- US citizen
- Claimed as dependent on tax return
- Modified AGI Phaseouts
- Limits = up to $1,400 per child may be refundable.
- $2000 per child under age 17 (2021)
- Family Credit (Qualifying Dependent Credit)
- $500 credit to those that qualify as dependent
- Child and Dependent Care Credit
- Must have employment related childcare costs:
- Dependent under 18, or
- Handicapped dependent/spouse
- Credit Amount = Eligible Care Costs x Applicable Rate*
- Applicable Rates Range 20% to 35%
- AGI of $43,000 or more = 20%
- Eligible Care Costs are lessor of:
- 1 person = actual cost or $3,000
- 2+ persons = actual cost or $6,000
- “Care Costs” is NOT paying one child to babysit the other.
- Applicable Rates Range 20% to 35%
- Care Costs include in the home and outside the home
- If handicapped dependent/spouse and outside the home, dependent MUST spend 8 hours a day inside the home.
- Earned Income Limits
- Care Costs cannot exceed earned income
- Full-time student/disabled taxpayer assumed to have earned income up to max. per month limit
- Must have employment related childcare costs:
- Education Tax Credits
- American Opportunity Tax Credit
- Max. Credit $2,500 per student per year (2021) for first 4 years of post-secondary ed.
- 100% of first $2,000 of qualifying expenses, plus
- 25% of next $2,000 of expenses
- Student must take at least 1/2 full-time course load
- NOT eligible if already has a 4-year degree.
- Refundable credit up to 40% or $1,000 (2021)
- Income Limits
- AGI Phaseout (MFJ) = $160,000 to $180,000
- AGI Phaseout (all others) = $80,000 to $90,000
- Max. Credit $2,500 per student per year (2021) for first 4 years of post-secondary ed.
- Lifetime Learning Credit
- Max Credit 20% of qualifying expenses up to $10,000 per year (2021)
- Can NOT be claimed the same year as AOTC is claimed
- Income Limits
- AGI Phaseout (MFJ) = $160,000 to $180,000
- AGI Phaseout (all others) = $80,000 to $90,000
- Max Credit 20% of qualifying expenses up to $10,000 per year (2021)
- American Opportunity Tax Credit
- Earned Income Credit
- Kiddie Tax
- Child under 19 (or 24 if full-time student) with Net Unearned Income = taxed at parents tax rate (or AMT rate)
- Net Unearned Income does NOT include:
- Standard Deduction of $1,100 (2021)
- Next $1,100 taxed at child’s marginal rate
- Kiddie Tax applies to unearned income greater than $2,200*
- Unearned Income = investment income
- Interest
- Dividends
- Capital Gains
- Royalties
- Rents
- Pension/annuity income
- Unearned income from trusts
- Alternative Minimum Tax (AMT)
- Taxpayer is liable for greater of regular tax liability or AMT
- Deductions Allowed:
- Charitable donations
- Estate tax income
- Gambling losses in excess of winnings
- Casualty losses in federal declared disasters
- Medical expenses over 7.5% AGI
- Qualified Business Income
- Qualified Resident Interest
- Investment interest to extent of qualified net investment income.
- Deductions NOT allowed:
- State/local taxes
- Itemized deductions subject to 2%
- Adjustment Items:
- Real property depreciation in excess of 40-year straight line
- Personal property depreciation in excess of 150% declining balance method
- Preference Items:*
- Provide substantial benefits because of deductions/exclusions
- Can only be positive
- Reduce benefit received when calculating regular tax
- Percentage Depletion
- amount of percentage depletion taken for regular tax in excess of adjusted basis of property at year end
- Intangible Drilling Costs
- AMT requires 10-year amortization.
- Currently deductible for regular tax
- Preference = excess of regular tax deduction over (AMT amortization + (65% x net oil x gas income))
- Interest on Private Activity Bonds
- Not taxable for regular tax
- Included in income for AMT
- Expenses not deductible for regular tax
- Expenses offset interest income for AMT
- Loss Limitations
- Rental Property
- Nonvacation Rentals
- Considered trade/business in pursuit of profit
- Ordinary business expenses are deductible from income
- Some rental activities are passive losses only deductible from passive income
- Exceptions:
- Rental activities by dealers are active
- Residential rental losses up to $25,000 deductible for taxpayers with AGI <= $100,000
- Phaseout = $100,000 to $150,000
- Reported on Schedule E or 1040
- Rental Vacation Homes
- Both personal and rental uses
- Rental portion deemed a hobby
- Expenses can not exceed income and expenses treated same as hobby
- Vacation home treatment determined:
- Fewer than 15 rental days:
- No gross income from rentals
- No deductible rental expenses
- Mortgage interest and property taxes treated as personal residence
- More than 14 rental days:
- Depends on personal use:
- Personal use = NOT more the greater of 14 days or 10% of fair rental days
- Deduct all expenses to rental use even if loss results
- Personal use = NOT more the greater of 14 days or 10% of fair rental days
- Depends on personal use:
- Fewer than 15 rental days:
- Rental losses subject to passive loss rule
- Allocating expenses between personal and rental
- Mortgage Interest, Taxes, and others
- Based on total days used
- Mortgage Interest, Taxes, and others
- Tax Treatment of Rental Income/Expenses
- Rental income included in gross income
- Rental expenses deductible FOR AGI
- Reported on Schedule E
- Treatment of Personal Portion of Expenses
- Primarily Rental Use: Taxes deductible FROM AGI, mortgage income not deductible
- Personal Rental Use: Mortgage interest and taxes deductible FROM AGI
- Personal Portion of other expenses nondeductible.
- Nonvacation Rentals
- Hobby Rules
- Activity not entered into for profit
- can be difficult to determine if for-profit or a hobby
- Profit Activity
- deduct expenses FOR AGI, in excess of income from activity
- At-risk and passive loss rule apply
- Hobby Losses
- Not deductible
- Presumptive Rule (Section 183)
- Shows profit 3 of 5 years (2 of 7 years for horses), profit motive presumed
- NOTE: IRS taxes hobby income. Taxpayer could pay less if its a “for-profit” venture due to deductions
- Activity not entered into for profit
- Rental Property
- At-Risk Rules and Passive Activity
- Types of Income:
- Active – include salaries, wages, Schedule C income, trade/business income
- Passive
- Portfolio – include interest, dividends, royalties, annuities
- At-Risk Rules = losses can only be deducted to extent property/money is at risk.
- Passive losses can only offset passive gains
- Passive Activity
- Not material participant
- Exception: Rental Activities
- At least 10% owner and involved in management decisions (tenant approval, arranging repairs)
- only available to individuals and estates (limited partners are not active)
- If actively managed, taxpayer can deduct up to $25,000 against ordinary income
- Phaseout = $1 for every $2 AGI exceeds $100,000 up to $150,000 (completely phased out)
- Material Participation – must meet 1 of following:
- Greater than 500 hours per year
- Constitutes all participation
- Greater than 100 hours and most of any participant
- 100 hours in this activity and exceeds 500 hours in all such activities
- Suspended Loss At Risk
- From At-Risk Activities = losses NOT deductible until At-Risk amount is positive from additions or income
- From Passive Activities = losses are deductible upon disposition
- Publicly Traded Partnerships
- Only deduct passive activities of PTP against income/gain of same PTP
- Non publicly traded partnerships can not offset PTP gain
- Types of Income:
- Tax Credits
- Tax System
- Statute of Limitations
- Taxpayer has a 3-year window to claim a refund if a return is not filed.
- Cannot claim over-payment to other tax years.
- IRS statute of limitations starts when a return has been filed. NO statute for collecting tax if no return has been filed.
- Once return has been filed:
- IRS has 3-year statute of limitations for auditing a tax return.
- IRS has 10-year statute of limitations for collecting tax.
- If taxpayer leaves out income in excess of 25% of stated gross income, statute of limitations is 6 years.
- Once return has been filed:
- Taxpayer has a 3-year window to claim a refund if a return is not filed.
- Interest
- Interest is federal short-term rate plus 3%
- Interest accrues from tax return due date
- Compounds daily
- Interest paid on refunds if not received within 45 days
- Penalties*
- Failure to File
- Accrues monthly, at 5% per month up to 25%.
- If fraudulent failure to file, 15% per month up to 75%
- If filed over 60 days late, minimum penalty is $435 (2021) or amount of tax due.
- Failure to Pay
- Accrues at 0.5% per month up to 25%
- If both a failure to file and pay, the failure to file penalty is reduced by failure to pay penalty
- Still must pay the failure to pay penalty and the reduced failure to file penalty.
- Underpayment of Estimated Tax
- Avoid Estimated Tax Payment
- If withholdings/credits = 100% shown on prior tax year or 90% of current year’s tax liability
- For AGI above $150,000 ($75,000 MFS)
- Estimated taxes paid based on 110% of prior year or 90% of current year by Jan. 15 of following year.
- Does NOT have to pay estimated taxes if:
- NO tax liability previous year, US citizen or resident entire year, and tax year covered 12 month period.
- Penalty
- Same as interest penalty = 5% per month up to 25%
- penalty is not deductible
- Due Dates
- April 15
- June 15
- September 15
- January 15
- Avoid Estimated Tax Payment
- Accuracy-Related Penalty
- 20% penalty for underpayment due to negligence or disregard of rules.
- Cannot exceed 20% of underpayment amount.
- NOT imposed if reasonable cause
- Substantial understatement = exceeds greater of 10% of correct tax or $5,000
- Fraud Penalty = 75% of tax underpayment tied to fraud
- 20% penalty for underpayment due to negligence or disregard of rules.
- Audits
- Tax returns can be examined for any reason.
- Proposed changes to the return can be:
- agreed to and paid
- disagreed to and appeal.
- May be selected based on:
- computer scoring = Discriminant Inventory Function (DIF) system
- high score = high potential for examination and change in tax liability
- info in third-party documents – Form 1099, W-2 — NOT matching reported info
- questionable treatment of an item and/or study behavior of similar taxpayers.
- computer scoring = Discriminant Inventory Function (DIF) system
- IRS must give taxpayers reasonable notice before contacting other persons about tax matters.
- does not apply to criminal investigation
- Statute of Limitations
- For assessment of deficiency
- 3 years from return due date
- 6 years if material omission (25% of income)
- NO statute if fraudulent return
- For refund
- Later of: 3 years from return filing date or 2 years from payment date.
- For assessment of deficiency
- Client Representatives during Audit:
- Attorney
- CPA
- Enrolled Agent (EA)
- Note: NOT CFP
- Failure to File
- Statute of Limitations
- Cost Recovery (Depreciation, Amortization, Depletion)
- Tax deduction that accounts for wear, tear, deterioration, or obsolescence of an asset.
- Basis is reduced by the amount of cost recovery allowed.
- Depreciation
- Depreciation begins when depreciable property is put in service.
- Depreciation ends when total cost or other basis is fully recovered or retires the property, whichever comes first.
- Depreciable Property Must:
- Be owned property
- Be used in business or income-producing activity
- Have determinable useful life
- Last more than 1 year
- Ex: buildings, machinery, vehicles, furniture, patents, copyrights, software
- Property that can NOT be depreciated:
- Solely for personal use.
- If used for personal and business, can deduct depreciation on the business use portion.
- Inventory — property held for sale is not depreciable.
- Land — land does NOT wear out.
- Land preparation costs like landscaping may be depreciable if tied to other depreciable property like a building.
- Property that can NEVER be depreciated:
- Placed in service and disposed of in same year
- Equipment used to build capital improvements — depreciation on the equipment is added improvements for the construction period
- Section 197 Intangibles — costs must be amortized.
- Certain term interests
- Solely for personal use.
- Retired Property:
- Is sold/exchanged
- Converted to personal use
- Abandoned/destroyed
- Transferred to scrap account
- Depreciation Methods
- Straight Line
- Deducts same amount of depreciation per year over life of asset
- Calculated:
- Depreciation Amount = Adjusted Basis – Salvage Value
- Annual Depreciation Deduction = Depreciation Amount/Estimated Useful Life
- First-year use: if property is used less than a full year, depreciation must be prorated for number of months used.
- Patent/Copyright
- use straight line method if depreciable
- Useful life: lesser of life granted by government or remaining life when acquired
- If becomes valueless before end of useful, can deduct remaining costs/other basis in that year.
- Computer Software
- Considered Section 197 intangible — cannot be depreciated
- Exception: can be depreciated if acquired in connection with business acquisition if:
- Available for purchase by general public
- Subject to nonexclusive license, and
- Not been substantially modified.
- If it qualifies, may also meet Section 179 deduction — special depreciation allowance
- Useful life — 36 months
- Accelerated Cost Recovery System (ACRS) & Modified Accelerated Cost Recovery System (MACRS)
- Apply to:
- Assets placed in service after 1980
- Assets subject to wear, tear, obsolescence
- Assets with determinable life
- Assets are tangible personalty or realty
- Note: MACRS must be used to depreciate most property
- Accelerated Cost Recovery System (ACRS)
- Based on recovery periods not useful life
- MACRS replaced ACRS for property in service 1986
- Modified Accelerated Cost Recovery System (MACRS)
- Can NOT be used on:
- Property placed in service before 1987
- Certain property owned/used in 1986
- Intagible property
- Films, video tapes, recordings
- Corporate/partnership property acquired in transfer
- Property elected to exclude from MACRS
- Is Two Depreciation Systems:
- General Depreciation (GDS)
- Property Classifications:*
- 3 Year
- Tractors
- Rent-to-own property
- Race horses over 2 years old
- Other horses over 12 years old
- 5 Year*
- Automobiles, taxis, buses, trucks
- Computers, peripherals
- Office equipment — typewriters, copiers, calculators
- Research equipment
- Cattle — breeding and dairy
- Appliances, carpet, furniture — in residential rental property
- Geothermal, solar, wind energy property
- 7 Year*
- Office furniture, fixtures — desks, files, safes
- Agricultural equipment
- Property without a class life and not designate by law in any other class
- Motorsports entertainment property
- Natural gas gathering lines
- 10 Year
- Barges, vessels, tugs, water transport equipment
- Single purpose agriculture structure
- Tree bearing fruit, nuts
- 15 Year
- Land improvements — shrubs, fences, roads, bridges
- Retail motor fuel outlet
- Municipal wastewater treatment plant
- Qualified lease improvement property
- Qualified Restaurant property
- Land improvements for gas utility property
- Electric transmission property
- Natural gas distribution lines
- 20 Year
- Farm buildings
- Municipal sewers
- 25 Year
- Water utility property
- 27.5 Year
- Residential rental property
- Rental home — if 80% or more of gross rental income from dwelling.
- 39 Year
- Office building, store, warehouse (Section 1250 property)
- Nonresidential real property
- 3 Year
- Property Classifications:*
- Alternative Depreciation System (ADS)
- Must be used for:
- Listed property used 50% or less for business use.
- Tangible property used outside the US during the year
- Tax-exempt use property
- Tax-exempt bond financed property
- Property used in farming business and elected not to apply uniform cap rules to farming costs
- Property imported from foreign country where country has Executive Order in effect with trade restrictions
- Must be used for:
- General Depreciation (GDS)
- MACRS Averaging Convention
- Mid Month Convention*
- For Nonresidential real property, residential rental property
- Treated as property placed in service or disposed of at midpoint of the month.
- 1/2 month depreciation allowed for the first month placed in service.
- Mid Quater Convention
- Treated as property placed in service or disposed of at midpoint of the quarter.
- Half Year Convention
- Treated as property placed in service or disposed of at midpoint of the year.
- Mid Month Convention*
- Depreciation Methods
- GDS — 200% declining balance method
- Non-farm 3, 5, 7, 10-year property
- Higher deduction during early years
- Changes to straight line when it provides equal or higher deduction
- GDS — 150% declining balance method
- Farm property, 15, 20-year property, non-farm 3, 5, 7, 10-year property
- Higher deduction during early years
- Changes to straight line when it provides equal or higher deduction
- GDS — Straight line method
- Nonresidential real property, residential rental property, qualified leasehold improvements, qualified restaurant, fruit trees, water utility, All 3, 5, 7, 10, 15, 20 year property
- Equal yearly deductions (except first and last year)
- ADS — Straight line method
- Equal yearly deductions
- GDS — 200% declining balance method
- Can NOT be used on:
- Apply to:
- Straight Line
- Section 179 – Election to Expense
- Immediately expense up to $1,050,000 (2021) of business tangible property placed in service that year.
- Can NOT be used on realty or income-producing property
- Expensed amount reduces depreciable basis
- Cost recovery on remaining basis
- Section 179 Deduction is lessor of:
- Property placed in service
- Taxable income, or
- $1,050,000 threshold (phased out for PPS > $2,620,000)
- Bonus Deduction
- Immediate 100% first year deduction on qualified new/used equipment placed in service after 9/27/2017 and before 1/1/2023
- Amortization
- Intangible assets amortized over 15 years
- Include:
- Goodwill
- Trademarks
- Covenants not to compete
- Copyrights, patents used in business
- Depletion
- Natural Resources
- Cost Depletion Method
- Deduction = (asset basis/total recoverable units) x number of units sold
- Percentage Depletion Method
- Percentage applied to gross income of property
- Limited to 50%
- Business Entities
- Sole Properietorships
- Owned by single person
- No filings/filing fees required
- No transfer of assets, since entity is legally the proprietor
- Formation
- Easy/cheap to form
- Disposal, Dissolve
- Easy to sell assets
- Dissolve = discontinue business
- Capital
- Limited to owner’s resources and ability to borrow
- Liability
- Personally legally liable for debts/torts
- Management
- Owner has day-to-day management
- Income and Payroll Taxes
- Adds Schedule C to 1040
- Business done under Social Security Number or Employer Identification Number (EIN)
- Pays unemployment taxes on employees, not self
- Pays self-employment tax — employees and employers portion of Social Security and Medicare tax — 15.3%
- Deduct business expenses from gross income
- Profit/loss carries over to 1040
- Advantages
- Easy to form
- Simple to operate
- Easy to sell
- Income passed through to owner
- Disadvantages
- Limited sources of capital
- Unlimited liability
- No continuity beyond owner
- Income subject to self-employment tax
- General Partnerships
- Owned by 2 or more persons/entities
- Not required to register
- General partners participate in management of firm
- Formation
- Easy to form
- Interest, Disposal, Dissolve
- Ownership in form of partnership units, shares, or percentages
- Voting power in proportion to ownership interest
- Hard to sell
- buyer evaluates business and partners
- other partners may need to approve of buyer
- Dissolve = either buy vote or court order.
- Ownership in form of partnership units, shares, or percentages
- Capital
- Capital contributed determines ownership interest
- May be cash, property, or service/idea/expertise
- Liability
- Partners share liability of business obligations
- Management
- Managed equally or name a “managing partner”
- Income and Payroll Taxes
- Income/losses pass through to partners
- Form 1065, Schedule K-1
- Partner adjusts basis based on income/losses
- Basis increases with income
- Basis decreases with loss
- To extent of their investment (at-risk amount)
- Passive activity rules apply
- Basis = amount cash/property contributed
- Exception: contribute ideas/services
- Basis = recognized ordinary income from services
- Exception: contribute ideas/services
- Subject to self-employment tax — 15.3%
- Federal Employer Identification Number (FEIN) required
- Deduct business expenses from income
- Withdrawals
- Treated as return of capital = not taxable
- Reduces partners adjusted basis
- Adjusted basis = 0 — withdrawals are capital gains
- Advantages
- More sources of capital
- More management resources available
- Few administrative burdens
- Income/losses passed through to partners
- Disadvantages
- Transfer/sale is difficult
- Unlimited liability
- Income tax and basis adjustment is complex
- Subject to self-employment tax
- Entitled to few tax-free fringe benefits available to employees (exception: retirement plan)
- Limited Partnership
- Owned by 2 or more persons/entities
- 1 or more persons are limited partners
- Limited partners in management treated as general partners for liability purposes
- At least 1 general partner
- Formation
- File partnership agreement with state
- Written agreement sites which partners are limited and general
- Interest, Disposal, Dissolve
- Hard to transfer/sell
- limited partnership means no say in day-to-day business
- may need approval from other partners
- Liability shield is a benefit
- Hard to transfer/sell
- Capital
- Easier to raise capital
- Easier to attract outside capital from limited partners
- Harder to borrow due to liability shield
- Liability
- Limited for limited partners to stay out of management
- General partners = unlimited liability
- Management
- General partners run the business
- Limited partners avoid running the business
- Income and Payroll Taxes
- Limited partners not subject to self-employment tax
- General partners subject to self-employment tax
- Pass through income
- Form 1065, Schedule K-1
- Advantages
- Income/losses passed through to partners
- Flexible ownership structure
- Limited liability for limited partners
- Disadvantages
- Must file with state
- General partners liable for debts/obligations of business
- Losses are passive losses for limited partners
- Limited Liability Partnership (LLP)
- Partial liability to partners including acts of other partners
- Partners liable for own acts
- Used by licensed professionals — accountants, doctors, attorneys
- Formation
- Must file with state
- Interest, Disposal, Disolve
- Hard to transfer/sell
- Capital
- Amount contributed determines ownership interest, for the most part
- Liability
- General partners not liable for acts, errors, omissions, negligence, incompetence of other partners
- Limited liability on all partners
- Management
- Managed equally or name a “managing partner”
- Income and Payroll Tax
- Income/losses passed through to partners
- Treated as partnership for tax purposes
- Advantages
- Income/losses passed through to partners
- Flexible ownership structure
- Limited liability — not liable for acts of other partners
- Disadvantages
- Must file with state
- Unlimited liability for partners own acts
- Partial liability to partners including acts of other partners
- Family Limited Partnership (FLP)
- Limited partnership for purpose of transferring ownership to younger generations (estate planning benefits)
- General partners keep control while distributing ownership to limited partners
- Formation
- 1 or more family members transfer property to limited partners
- property is usually highly appreciated and will continuing growing
- Interest, Disposal, Dissolve
- Lack of marketability or transfer restrictions
- Limited partnership interest valued at discount to FMV
- 20% to 40% discount for gift tax purposes
- Annual gifting program transfers ownership to limited partners at reduced costs
- Capital
- General partner (original owner) keeps control of property while retaining a small interest.
- Liability
- Assets in an FLP are protected from liens/judgements against limited partners
- Transferring assets to children protect from divorce claims
- General partners = unlimited liability
- Limited partners = limited liability
- Taxes
- Taxed as a partnership
- Form 1065, Schedule K-1
- Payroll depends if the general partner is a person or corporation
- Limited partners not subject to employment tax
- Advantages
- Control retained by senior family members
- Valuation discounts for minority interests
- Annual exclusion gifts to transfer interest to younger generation
- Creditor protection
- Restrict transferability of limited partnership interest
- Estate planning strategy
- Disadvantages
- Setup fees and costs
- Periodic valuation costs
- Operational requirements
- Potential IRS challenges to valuation/discount
- Limited Liability Company (LLC)
- Owned 1 or more persons/entities
- Separate legal entity
- Formation
- Must be registered with state
- state requires resident agent and annual filing
- Charter document is Articles of Organization
- Must be registered with state
- Interest, Disposal, Dissolve
- Contributions determine ownership interest, for the most part
- No limits on number of members. May include: foreign persons, tursts, estate, corporations, etc.
- Disposal/Transfer may be difficult
- May be restricted to named parties
- Capital
- Easier to raise
- Liability
- Owners protected from personal liability from LLC’s debts/obligations
- Management
- Operating Agreement dictates how/who manages LLC
- If no Operating Agreement, governed by state laws for LLCs
- Income and Payroll Taxes
- Single Member/Owner
- Files Schedule C and Form 1040 for LLC
- Pays unemployment taxes on employees, not self
- Pays self-employment tax — 15.3%
- 2 or More Members/Owners
- Taxed as either:
- Partnership
- Form 1065, Schedule K-1
- Income/losses passed through to members/owners
- losses deductible from personal income to extent of basis
- passive activity rules apply
- Usually taxed as partnerships
- Subject to self-employment taxes
- Exception:
- LLC income from rental real estate
- LLC members not managing members (more like limited partners)
- Exception:
- S Corp.
- Form 1120S, Schedule K-1
- C Corp.
- Form 1120, W-2
- Partnership
- Tax status dictates self-employment taxes and fringe benefits
- Taxed as either:
- Single Member/Owner
- Advantages
- Limited Liability
- Unlimited number of members/owners
- Members can be individuals, corps, trusts, LLCs, etc.
- Income passed through to members
- Double taxation avoided if partnership status, unlike C Corps
- Members can be in management
- Distributions do not have to be proportional to ownership interest
- Multiple classes of ownership
- Flexible on tax status
- Disadvantages
- Limited life
- Transfer is hard
- Not allowed in certain industries/professions
- State laws vary and relatively new
- Complex partnership rules
- Members subject to self-employment tax, if partnership status
- C Corporation
- Owned by 1 or more persons/entities
- Separate legal entity
- Formation
- Created by filing articles of incorporation with state
- Discloses name, number of shares, and purpose
- Name registered agent
- Created by filing articles of incorporation with state
- Interest, Disposal, Dissolve
- Ownership through shares of stock
- Transfer may be easy (in a market) or restricted
- Different share classes possible with different values and voting rights
- Capital
- Easily raise capital
- Liability
- Limited liability = to invested capital
- Management
- Run by 1 or more officers appointed by board of directors
- Income and Payroll Taxes
- Taxed as C Corp.
- Form 1120, pays tax on own income
- Owners/employees treated as employees for payroll taxes
- Cash distributions are dividends to shareholders (double taxation)
- Losses are carried forward
- Advantages
- Ease of raising capital
- Limited liability to shareholders
- Unlimited life
- Easily transfer ownership
- More management resources
- Shareholder/employees get full employer-proved tax free fringe benefits
- Disadvantages
- Potential double taxation
- Administrative costs
- Difficult to form
- Dissolution may cause capital gains
- Requires resident agent
- Requires federal tax ID number
- S Corporation
- C Corp with specific requirements:*
- Limited to 100 shareholders
- Limited to US citizens/residents, estates, trusts, charities
- LLCs, partnerships, corps. not allowed to be shareholders
- Not an insurance company, Domestic International Sales Corp (DISC), certain financial institutions
- Only 1 class of stock
- The 1 class can have shares with/without voting rights
- Formation
- Formed same as C Corp, then elected as S Corp
- Interest, Disposal, Dissolve
- Ownership through shares of stock
- Transfer may be restricted
- Capital
- Easier to raise capital
- Liability
- Limited liability = to invested capital
- Exceptions:
- Primary shareholder guarantees loan
- Court ignores corp. as legal entity (piercing the veil) when used for fraud, etc.
- Management
- Run by 1 or more officers appointed by board of directors
- Income and Payroll Tax
- Income passed through to shareholders
- Avoids double taxation
- Owners/employees treated as employees for payroll taxes
- In-kind distributions treated as sale — capital gain to shareholders
- Form 1120S, Schedule K-1
- Distributions considered return of capital to extent of basis
- distributions in excess of adjusted basis is capital gain
- Income passed through to shareholders
- Advantages
- Income passed through to shareholders
- Income tax at individual level
- Limited liability
- Distributions exempt from payroll taxes
- Disadvantages
- Limited to 100 shareholders
- One stock class
- No corp, partnership, LLC, nonresident shareholders
- Employees owning more than 2% pay taxes on certain fringe benefits
- Individual tax rate may be higher than corporate tax rate
- C Corp with specific requirements:*
- Personal Holding Company
- A corporation that meets both:
- Personal Holding Income Test = 60% of adjusted ordinary gross income from dividends, interest, rent, royalties
- Stock Ownership Requirement = 50% of outstanding stock owned by 5 or less individuals in last half tax year
- A corporation that meets both:
- Selection Process:
- Ease/cost of formation
- Simplicity/complexity of management
- Is it easy to transfer or dissolve?
- Liability protection of personal assets
- Reporting requirements and taxation
- Considerations:
- High personal income and expect business losses = choose pass through entities
- Allocate income/loss differently than ownership percentage = choose LLC w/ partnership status
- Liability concerns = avoid sole proprietorship and general partnership
- Expect a lot of income = C Corp.
- Deducting Business Income for Pass-Through Entities
- Can deduct 20% of Qualified Business Income from partnerships, S corp, sole proprietorship
- Can deduct 20% of aggregate qualified REIT dividends, qualified cooperative dividends, qualified publicly traded partnership income
- 20% deduction not allowed in calculating AGI — only reduces taxable income
- Phaseout = $329,800 or more (MFJ) and $164,900 or more (others)
- Sole Properietorships