By Fatskills Exam Guides Team — the exam nerds behind 28,500+ quizzes and 2.1M practice questions across 500+ global exams.
Income Tax Law Statutory Law and Administrative Pronouncements
The Internal Revenue Code of 1986 is the main source of tax law, though the Taxpayer Relief Act of 1997 includes more than 300 modifications and over 300 new provisions. Tax legislation begins in the House Ways and Means Committee. If approved, it moves on to the House of Representatives, Senate Finance Committee, and Senate. If the legislation makes it through all of these steps, the President must approve it before it goes into effect. Treasury regulations, published by the US Treasury, are the official interpretations of statutory tax rules. Revenue rulings stand for the official position of the Internal Revenue Service but have less authority than Code and regulations. Revenue procedures are the official positions of the IRS on matters of tax tables, inflation-indexed amounts, and asset class lives. Letter rulings are more specific interpretations offered by the IRS. Judicial Decisions and Steps to Researching a Tax Question Taxpayers who are involved in a tax-related dispute may always bring their claim to the level of the regional appeals office of the IRS. When cases are unresolved, the taxpayer may take it to one of three federal courts: in the US Tax Court, the taxpayer refuses to pay the deficiency, and will not have a jury trial; in the US District Court, the taxpayer pays the deficiency and sues for a refund, and he or she will receive a jury trial; in the US Court of Federal Claims, the taxpayer pays the deficiency, sues for a refund, and does not receive a jury trial. When cases remain unresolved, the taxpayer can appeal to the US Circuit Court of Appeals, and then may attempt to appeal to the Supreme Court. The steps to researching a tax question are gathering all the facts, diagnosing the problem, locating the authority, evaluating the authority, deriving the solution, and communicating the answer.
Tax Compliance Filing Requirements Every individual US citizen and resident alien must file an income tax return so long as his or her gross income exceeds the standard deduction amount for the individual’s filing status. Individuals who are claimed as a dependent do not have to file a claim unless their unearned income is more than $1000, or unless their total gross income is more than the standard deduction. Individuals will have to file a tax return even if their gross income is below the required amount if they: make more than $400 from self-employment; owe an alternative minimum tax; are nonresident aliens; are a member of certain religious organizations; must pay tax from an IRA or qualified retirement plan; have received tips from which Social Security tax was not withheld; or they have changed their country of residence or citizenship during the year. Authority, Audits The only individuals who have the authority to represent someone else before the IRS are certified public accountants, attorneys, and enrolled agents. Enrolled agents are those people who have been certified by passing a tax exam administered by the IRS. The IRS uses a few different ways to determine who will be audited. The Discriminate Functions System (DIF) screens all of the returns and assigns them a score assessing their audit-worthiness. The Taxpayer Compliance Measurement Program calculates the norms that will be used by the DIF, and so pinpoints where taxpayers are most likely to be cheating. Some audits are simply chosen at random. Most audits are conducted by telephone or mail, but some individuals will be required to go to the IRS district office or have an IRS officer visit their place of business. Penalties
When taxpayers are late in filing their tax returns, they are penalized five percent of the balance of the tax due for each month that the return is late; after 5 months, the penalty increases 0.5% every additional month. Just because the government has cashed a taxpayer’s check or mailed a refund does not mean that an audit is out of the question. In fact, the government has up to three years from the date on which the return was filed to examine it for mistakes. If the taxpayer has omitted an amount of gross income exceeding 25% of the gross income reported, the statute of limitations goes up to six years. For negligence, the IRS usually equals 20% of any underpayment of taxes, though the IRS has the burden of production and must assemble a preponderance of evidence to show that the taxpayer was negligent. A taxpayer found to have committed civil fraud will be penalized 15% for every month or part of a month the return is late up to a maximum of 75%. Fraud, in this case, is any act that is designed to cheat the government. The IRS has the burden of proving that an individual has committed fraud and must provide clear and convincing evidence. In cases of criminal fraud, the IRS must prove guilt beyond a reasonable doubt. Criminal fraud is also known as tax evasion, and it is a felony punishable by fines of up to $250,000 for an individual and $500,000 for a corporation. If the preparer of an income tax return understates the amount of tax, then he or she may be hit with a $250 penalty; if the understatement is intentional, the penalty is $1,000.
Sole Proprietorship The most common form of business is a sole proprietorship. Sole proprietorships are fairly easy to administrate. Unlike corporations, sole proprietorships are not legal entities separate and apart from the owner. This means that the owner’s personal assets are subject to all liabilities incurred by the business. There are no special forms required to start a sole proprietorship. The owner of one will simply file a Schedule C in addition to his or her personal tax forms. Often, the owner of a sole proprietorship will minimize his or her tax burden by shifting income to other family members. Sole proprietorships have no flexible ownership, continuity of life, or capital structure because there is only one owner.
General Partnership
A general partnership consists of multiple owners who perform the operations of the business together and split the income and profits. Often, partners will be bound together by a contract. Each partner will have fiduciary duties and the duty to act in good faith with one another. If a tort is brought against the partnership, all partners are jointly and severally liable, meaning that partners must be sued together and all partners are subject to being sued for the full amount of the claim. Partners are not entitled to any certain salary, though they are entitled to share in the profits. New partners cannot be admitted without the unanimous consent of the other partners. A partnership is dissolved automatically if a partner dies, if a partner goes bankrupt, or if the partnership is dissolved according to the termination provision in the partnership agreement.
Limited Partnership and Limited Liability Partnership (LLP)
A limited partnership is one in which there are one or more general partners and one or more limited partners. Limited partners cannot participate in managing the business, have no authority to bind the business, and cannot use their surname in the title of the business. A limited partner also has a limited liability. Limited partnerships can be terminated by court order, or by the withdrawal, death, insanity, or insolvency of a general partner. If any of the last four befalls a limited partner the partnership is not necessarily cancelled. A limited liability partnership (LLP) is one in which all partners have limited liability. Limited partners in an LLP may be held individually responsible for errors, omissions, and negligence. LLP partners are not usually held liable for any debts or obligations of the partnership.
Limited Liability Company (LLC) A limited liability company (LLC) gives limited liability protection to all of its members but will still be treated as a partnership for income tax purposes. Unlike a limited liability partnership, the partners in a limited liability company are not responsible for the misdeeds of their subordinates. Also, unlike an LLP, a limited liability company does not have to reregister itself every time a partner leaves the group, so they are often less expensive to maintain. LLCs may choose to be taxed as a corporation, S corporation, sole proprietorship, or partnership. Most LLCs, however, will choose to be taxed as a partnership. LLCs have flexible ownership, capital structure, and centralized management. An LLC is a legal entity separate from its members.
S Corporation
Under federal income tax laws, an S corporation is treated as a pass-through entity, so shareholders may receive business profits as dividends. S corporations have limited owner liability, free transferability of ownership interests, centralized management, and continuity of life through stock ownership. There are strict eligibility requirements for S corporations: they must be domestic corporations, have no more than 100 shareholders, have no shareholders that aren’t citizens, and have only one class of stock. If these requirements are not met, the business may be subject to double taxation. The disadvantages of an S corporation are limited flexibility in selecting a tax year, little ability to retain income at a lower current tax cost, and poor tax treatment of fringe benefits.
C Corporation
C corporations are artificial entities that are created when articles of incorporation are filed and a state issues a certificate of incorporation. There are a few different groups with roles in a C corporation. Shareholders are the actual owners of the corporation and vote on the members of the board of directors. These directors are charged with maintaining control over the basic operations of the business; they also select the officers, who oversee daily operations at a more specific level. C corporations are considered for tax purposes as a separate person, distinct from those who formed the corporation or those who own it at present. The shareholders of a corporation have limited liability and can only lose what they have put into the corporation. Typically, corporate tax rates are lower than the individual tax rates for individuals with a high level of income C corporations are taxed separately from their owners. They give owners better tax treatment for owner fringe benefits, the ability to select a tax year, and the ability to take loans from qualified retirement plans. A C corporation may have continuous life and could theoretically continue after the deaths of all the shareholders. The income earned by a C corporation is subject to double taxation, meaning that the corporation has to pay a tax on earnings and shareholders’ dividends will also be taxed. Any corporate tax advantages are also limited by the accumulated earnings tax, which strives to make sure that corporations do not hoard earnings and pretend that they are necessary to the maintenance of the business so as to avoid taxation.
Professional Corporation (PC)
Professional corporations operate much like any other commercial corporation, though their ownership is generally restricted to the members of a certain profession. A professional corporation will have continuity beyond the death of an owner; typically, that owner’s share will either be transferred to another professional or bought up by the corporation itself. Running a business as a professional corporation instead of in an unincorporated form provides the advantage that all the members retain limited liability. Shareholders will remain liable for their own actions as well as for those of people directly under their supervision. Members of a professional corporation will also derive some benefit from the corporate tax structure.
Association and a Business Trust
An association is a group of people that are joined together for a particular purpose. Associations may operate under tax-exempt status under Section 501(a) if they have a written “Articles of Association” in which at least two people assert the creation of the association. In a business trust, on the other hand, a designated trustee takes legal title to a business and operates it on behalf of all other owners and beneficiaries. If a business trust is created for an entity with no economic reality, all of the tax liability will be placed on the individual who formed the trust. If the trust has only one trustee, it will probably be treated as a sole proprietorship. If there are two or more trustees, it may be treated as a partnership. Some business trusts are registered as corporations and treated as such.
Types of Acquisition and Disposition When a business is liquidated, all of the properties are distributed to the shareholders and the business’ stock is cancelled. Many times, the tax treatment after liquidation may be disadvantageous, and so liquidation may not be the appropriate way to end a business. A corporation will have to pay a tax on capital gains when it distributes property to shareholders. In the taxable sale of a business, the sale of stock creates a taxable gain to the people selling stock, which will be equal to the difference between the selling price and their basis. This asset sale will create a taxable gain for the corporation should the selling price exceed the corporation’s basis. In a tax-free disposition of a business, stock sale will qualify as long as 80% of voting power and at least 80% of the other stock in the seller are transferred to the acquiring firm in exchange for only voting stock in the buyer. In a tax-free sale, there is no tax to the seller or to the selling corporation at the date of sale.
Planning of a Taxable Sale When a taxable sale is set up as a payment over a series of installments, the seller’s gain can be spread over the period in which these payments are made. The buyer’s interest payments will be deductible when they are made and are taxable to the seller when they are received. The rules of imputed interest will apply here, meaning that the sale cannot be arranged in such a way that the tax on interest to the seller can be eliminated by understating interest at artificially low rates. In the case of a private annuity, payments will be made for the rest of the seller’s life. Each annuity payment will be composed of three elements: tax-free return of basis, capital gain, and interest.
Income Tax Fundamentals Filing Status A taxpayer is considered single if he or she is unmarried or legally separated on December 31. Taxpayers are considered as married filing jointly if they are married and living together, married and living apart but not legally separated, or living in a common law marriage. Taxpayers are considered as married filing separately if they are married at the end of the year and elect to file separately to avoid joint liability or to pay lower total taxes. A taxpayer can file as a head of household if he was not married at the end of the year, if he paid more than half of the cost of the house, if he was a US citizen or resident for the entire year, and if the home was the main home for one or more family members. A taxpayer is a qualifying widower if his or her spouse died within the two years preceding the year for which the return is filed. Gross Income Gross income that must be included in an income tax return includes: wages, salaries, commissions, and fees; taxable noncash fringe benefits; allocated and unreported tips; gains from real estate, securities, and other property; rents; interest from bank accounts, CDs, securities, loans, etc.; accrued interest from zero coupon bonds; dividends; royalties; alimony and separate maintenance payments; annuities, pensions, and IRA distributions; income from an estate or trust, but not from a gift or bequest; prizes and awards; all other cash and property received, so long as it is not specifically excluded by federal tax laws; and, for some taxpayers, up to 85% of Social Security benefits. Income Excluded from Gross Income The following sources of income may be excluded from gross income: gifts and inheritances; interest on certain municipal bonds and interest from mutual funds that hold such bonds; returns of capital; reimbursements for business expenses; exclusions of up to $250,000 in gain from the sale of a home ($500,000 if married filing jointly); some or all of Social Security benefits; compensation for injury and sickness, including worker’s compensation and certain disability payments; employer-paid health coverage; employer-provided education assistance up to $5,250 (as of 2020); qualified foster care payments; proceeds of life insurance that are paid because of death or chronic illness; payments received under accident, health, and long-term care insurance policies; amounts contributed to a Medical Savings Account or Health Savings Account; employer-provided child or dependent care services; scholarships and fellowships; and employer-paid group life insurance up to $50,000. Adjusted Gross Income Individuals are allowed to make the following deductions from their gross income to arrive at a figure for adjusted gross income: trade or business expenses; self-employed medical insurance premiums up to a limit; 50% of self-employment tax; amounts forfeited to a bank or savings institution for the premature withdrawal of funds from a deposit account; contributions to a tax-favored retirement plan for the self-employed; contributions to individual retirement accounts; deductions in connection with property held for the production of rents or royalties; deductions for interest on qualified education loans; contributions to a Health Savings Account; and losses from the sale or exchange of property. Standard Deduction In 2020, the standard deduction for a taxpayer filing as married filing jointly, or as a surviving spouse, is $24,800; for one filing as married filing separately: $12,400; for single: $12,400; for head of household: $18,650. Dependents are those individuals whom another taxpayer has claimed as such. Dependents are not eligible to claim the regular standard deduction on their tax returns; they may claim the special standard deduction that is the greater of (a) $1,100 or (b) the dependent’s earned income + $350—yet this deduction cannot exceed the individual standard deduction of $12,400. Itemized Deductions Itemized deductions are claimed on Schedule A. These are deductions from adjusted gross income in the calculation of taxable income. There are a few types of itemized deductions: medical expenses may be deducted when they are paid for the taxpayer, his or her dependents, and anyone who would have been a dependent if not for the income test. Deductions are allowed for medical expenses so long as they are for the purposes of maintaining or improving health; and unreimbursed expenses and insurance premiums paid for long-term care. Medical expenses that cannot be deducted include baby-sitting and child care, cosmetic surgery, costs covered by insurance, funeral expenses, health club dues, nonprescription drugs and medicines, nutritional supplements, and weight loss programs that have not been recommended by a doctor. State and local taxes are deductible (capped at $10,000, $5,000 if married filing separately, according to the Tax Cuts and Jobs Act), but federal taxes are not. When a deduction is taken in the year of a payment and a refund is received later, the refund may be considered taxable income in later years. Real estate taxes will be deductible, even in cases where they are paid to a foreign country. These taxes will be deductible for all the properties owned by the taxpayer, though the mortgage deduction will be limited to two homes. If a particular property was only owned for part of the year, only that portion will be included as a deduction. Personal property taxes, too, will be deductible if they are based on the value of the property. Charitable contributions will be included when they are made to a qualified charitable organization. Some mortgage interest on a primary (and one secondary home) may be tax-deductible. For acquisition debt, the deduction is limited to the interest on the first $750,000 of qualified debt. This was $1,000,000 prior to the Tax Cuts and Jobs Act, effective for tax year 2018. The TCJA also suspended the deduction of interest on home equity debt, unless it is taken for the purpose of buying, building, or improving a home. A deduction can also be made for casualty and theft, including any damage, destruction, or loss of property that results from a presidentially declared disaster (Prior to the TCJA, this applied to an identifiable event that is sudden, unexpected, or unusual, but the TCJA restricts casualty and loss deductions to presidentially declared disasters.) The figure for casualty loss will be whichever is less: fair market value before event minus fair market value after event or the adjusted basis.
Of courses, losses will be reduced by any insurance recovery. The deductions that can be made for investment interest costs are limited to the amount of investment income. A taxpayer may include capital gains in investment income if he or she chooses, but this means that any capital gain included in investment income will not be eligible for preferential long-term capital gain rates. Various miscellaneous deductions (e.g. unreimbursed employee expenses and tax preparation fees) used to be taken, subject to a 2% limit, but with the Tax Cuts and Jobs Act, effective in tax year 2018 these will be nondeductible. Other nondeductible expenses include: broker’s commissions paid in connection with property or account; hobby losses; home repairs; lobbying expenses; capital expenses; home repairs, insurance, and rents; and capital expenses. Personal and Dependency Exemptions Prior to the Tax Cuts and Jobs Act, effective starting with tax year 2018, a taxpayer was allowed a personal exemption for himself, his spouse, and his dependents. In 2017 this was worth $4,050 per person, and individuals whom someone else claimed as a dependent could not also have taken the exemption for themselves. The exemption amount could be reduced, even to $0, if the taxpayer’s adjusted gross income exceeded certain thresholds. With the passing of the Tax Cuts and Jobs Act, these exemptions no longer exist. They will return in tax year 2026 according to current tax legislation. Taxable Income Tax Liability Taxable income is simply adjusted gross income minus whichever is greater: allowable itemized deductions or the standard deduction. An individual’s tax liability is determined by using the tax tables (if taxable income is under $100,000) or the tax rate schedules (if taxable income is greater than $100,000). Any tax credits, like childcare, foreign tax credits, and credit for the elderly, will be taken into consideration when determining the total tax due. The basic process of calculating tax liability is: determine total gross income; subtract deductions from gross income to find AGI; deduct either itemized deductions or standard deduction to arrive at taxable income; find tax amount from either tax tables or tax schedule; and subtract tax credits from this amount. Tax Credits Tax credits are one-for-one reductions in actual tax paid; these are in contrast to deductions, which only limit the amount of income subject to tax. Taxpayers may receive credits for each of their children; the credit amount increases per each child that can be claimed for a dependency deduction. A tax credit can also be received for child and dependent care; in order to qualify for this credit, the taxpayer must provide more than half of the cost of keeping up the home and must pay for child or dependent care so that he or she may work or look for work. Tax credits are also available for any individuals who reach the age of 65 before the end of the tax year, or who are under 65 but are retired with a permanent and total disability for which they receive income. An earned income tax credit may be claimed if the individual has not earned a certain amount in the taxable year. The percentage of earned income that qualifies for the tax credit will change depending on the number of children the taxpayer has. An adoption credit may be claimed if the taxpayer has adopted a child that is either younger than 18 or unable to take care of him or herself. A foreign tax credit is allowed so that individuals do not have to pay both foreign and US income tax on the same income. This credit will usually be the lesser amount between the amount of foreign tax paid and the amount of US tax that would have been due on the foreign income. Taxpayers can treat the amount of foreign tax paid as either a deduction from income or as a refundable tax credit. Payment of Tax and Estimated Payment and Withholding Requirements In almost all cases, individuals are required to file Form 1040 by April 15 of the following year. If individuals have adopted a fiscal year, they are required to file by the 15th day of the 4th month after the end of the taxable year. Individuals are permitted an automatic four-month extension, though the individual will have to pay interest on the delinquent payment to the IRS. Many self-employed taxpayers and taxpayers owing in previous years will make small estimated payments throughout the year. Tax law does not allow taxpayers to wait until the date for filing returns to pay all of their taxes. Employers will also be required to withhold a certain amount of money from paychecks for the purposes of paying taxes. Kiddie Tax The kiddie tax is a series of tax rules aimed to keep parents from taking advantage of their children's lower tax rates. Basically, if a child has substantial investment (“unearned”) income, it will be taxed at a higher rate. Prior to the Tax Cuts and Jobs Act, part of this income would be taxed at the parent's marginal rate. But with the Tax Cuts and Jobs Act (starting with tax year 2018), part of this income will be taxed at the same rates imposed on trusts and estates. This essentially boils down to three key features: · It applies to children under the age of 19 and full-time students under the age of 24. · It only affects unearned income, typically from investments held in the child's name. Earned income from jobs or self-employment is completely exempt from the kiddie tax. · It only affects unearned income above an annual threshold: only unearned income above the annual threshold of $2,200 (as of 2020) is affected by the kiddie tax. All unearned “kiddie income” past this threshold is then taxed at the same rate as trusts and estates. If your child is not subject to the kiddie tax, he or she is generally treated like any other unmarried taxpayer (assuming he or she is in fact unmarried). Imputed Interest The rules for imputed interest were created to keep taxpayers from transferring income from high to low tax brackets or from shifting interest income to capital gains income by raising purchase price and charging less interest. When the interest rate falls below a certain amount, the seller is required to add imputed interest. On the other hand, if the applicable federal rate should be above the rate charged at the time of the transfer, the seller can report the additional interest income and the buyer will be allowed an additional interest deduction. There are some exceptions to this rule, as when loans of up to $10,000 are made to purchase nonincome-producing property. The applicable federal rate is set every month by the federal government.
Tax Accounting Methods Cash Method, Accrual Method, and Hybrid Method In the cash method of tax accounting, taxpayers recognize all income when it is received and recognize all expenses when they are paid. Taxpayers include all of the items of income that have been constructively received and deduct all bills that have been paid. Any expenses paid in advance are deducted when they apply. Service businesses or those with little or no inventory use this method most often. In the accrual method, income is recognized when earned; expenses are recognized when incurred; income and expenses are matched for the current year; items of income are included when earned; and all the events that set the individual’s right to receive income must have happened. This method is used in businesses that are constantly purchasing inventory. A hybrid method of tax accounting is any one that includes elements of the cash and accrual methods. Long-Term Contracts and Installment Sales For the purposes of tax accounting, long-term contracts are any for the building, installation, construction, or manufacture of buildings or products that are not completed in the year in which they were begun. Installment sales, on the other hand, occur when payments are received in a year other than the year of the sale. Each payment in an installment sale usually includes interest, gain on the sale, and the recovery of basis. It is mandatory for interest to be paid at a rate that is at least equal to the IRS minimum. Taxpayers may want to avoid installment sales if they will carry a net operating loss forward, if they carry a long-term capital loss forward, or if they have tax credits available. Installment sales offer the advantages of deferring tax, making property easier to sell, and notes that carry higher interest rates than a bank. Accounting Periods and Method Changes In tax accounting periods, accounting periods are the annual time periods over which a taxpayer calculates his or her tax liability. Taxpayers typically file on the basis of the calendar year; in cases where a taxpayer wants to base his or her return on some other fiscal year, he or she must get the permission of the IRS. Also, businesses must receive the permission of the IRS if they want to change their accounting method, even if the original method was incorrect. It is not possible to make these kinds of changes by simply filing a corrected tax return. Some examples of possible changes to which these rules apply are switching from cash basis to accrual basis or changing from one method of inventory valuation to another.
Taxation at Entity Level
Corporations are the only bodies that pay income tax at the entity level. They report their taxable income on Form 1120, are not subject to passive activity loss rules and their taxable income paid and the net income reported on financial statements will usually be different. Typically, the tax rates for corporations are more favorable than those for individuals, although this is then offset by the double taxation of corporation profits. If corporations receive dividends from another corporation, then they are entitled to a deduction. Starting in tax year 2018 with the Tax Cuts and Jobs Act, net operating losses may not be carried back, but they may be carried forward indefinitely in order to offset other income. Capital gains and losses recognized by corporations will be taxed at the same rate as ordinary income and will not be subject to the reduced capital gains rate. Only the deductions for capital losses can offset capital gains, and no amount can be used to offset ordinary income.
Flow Through of Income Losses to Corporations There are a couple of different ways to move cash out of a corporation. If shareholders are considered corporate executives, then they receive salary that is only taxed at the individual level, and a tax deduction is provided to the corporation; if they are treated as creditors, then the interest paid to the shareholder is a deductible expense for the corporation, and the shareholders receive rent payments for leasing property to the corporation. A constructive dividend is a distribution made by a corporation to shareholders that the corporation calls salary, interest, or rent, but that the IRS calls a dividend. Closely-held corporations are often used as tax shelters because they offer lower tax rates; because through the undistributed accumulation of earnings they can avoid double taxation; and because when the stock is sold or liquidated in the future, they recognize a taxable gain while indirectly paying a second tax, thus minimizing the present value of the second tax. Losses to Partnerships and S Corporations
In a partnership, a partner’s initial tax basis will equal his or her initial investment of property plus the share of partnership debt for which the partner may ultimately be held responsible. In an S corporation, the shareholder’s initial basis in stock equals cash plus the adjusted basis of any property transferred in exchange for the stock. As for reporting requirements, neither partnerships nor S corporations are considered taxable entities, and so their taxable income is measured at the entity level and then taxed directly to shareholders or partners. The shareholders of an S corporation will need to fill out a Schedule K-1 and add it to their individual tax return; the calculation of their cash flow from the corporation will not affect their tax liability. In some situations, shareholders will be considered employees of the corporation, and will have to fill out the appropriate W-2 form. In a partnership, basis will be increased by ordinary business income, capital gains, and dividend income; basis will decrease from ordinary business loss, capital loss, and business distributions. When partners are given taxable income but no cash distribution from that income, they are essentially making a larger investment in the partnership: any future cash distribution can be considered as a return on investment. In an S corporation, the basis of a shareholder will increase by his or her share of the corporation’s income or gain; he or she will see his or her basis decrease by the share in the losses of the corporation. Cash distributions are considered as a nontaxable return of investment that decreases the basis. Losses are deductible as far as the owner’s equity investment and debt obligation.
Special Taxes at Entity Level for Flow-Through Entities
The built-in gains tax is levied when a corporation that has purchased another corporation seeks to use gains from one of the corporations to offset pre-acquisition losses in the other. LIFO recapture is the amount of excess FIFO recovery over LIFO. S corporations that were formerly C corporations and owe a net passive income tax (that is, if the corporation's passive income is greater than 25% of gross income) owe excess net passive income tax. A personal holding company is a corporation in which five or fewer individuals own half or more of the value of stock. A personal holding company generates most of its income from investment or passive activities (for instance dividends, rents, or royalties). A personal service corporation provides a service in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting. These companies are, like all C corporations, subject to a flat tax rate of 21% (starting in 2018, down from 35% with the Tax Cuts and Jobs Act) and limitations on passive loss. An accumulated earnings tax will limit the tax advantage of corporate tax rates on earnings accumulated by the corporation. The purpose of this tax is to prevent corporations from avoiding tax. Corporations that accumulate more than $250,000 in earnings must demonstrate that this money is needed for the operations of the business, or else the IRS will impose a tax. As for using losses, partners and shareholders are allowed to deduct any losses that are passed through against income from other sources. Basis, however, cannot be reduced below zero.
Income Taxation of Trusts and Estates
Trustees are required to file Form 1041 if the trust is not tax-exempt, and if the trust has any taxable income for the year, the trust has gross income of over $600, or if any beneficiary is a nonresident alien. The executor of a domestic estate must file Form 1041 if the estate has either gross income exceeding $600 or a beneficiary who is a nonresident alien Trusts and estates that operate on the calendar year must file on April 15; those that use a fiscal year must file by the 15th day of the 4th month after the end of the tax year. Trusts must use the calendar year unless they are tax-exempt, charitable, or grantor trusts. A beneficiary must pay income tax on his or her distributive share of income. The type of income distributed and taxed to beneficiaries is determined by the composition of the distributable net income (DNI).
Income Taxation of Grantor Trusts, Simple Trusts, and Complex Trusts For grantor trusts, the trust grantor and any other person with significant control over the trust can be taxed on his or her income. Grantor trusts are not treated as separate trusts for tax purposes; income from the trust is taxed to the grantor. Simple trusts, on the other hand, are required to distribute all of their trust accounting income to beneficiaries. There is a standard deduction of zero; no distributions are allowed for charity. Complex trusts are those that don’t meet the requirements of simple trusts; in a complex trust, income can accumulate, charitable contributions can be made, and principal may be distributed to beneficiaries. These trusts have a standard deduction of zero and are allowed the same deductions as simple trusts.
Income Taxation of Trust Income and Estate Income Tax Trust accounting income includes interest, dividends, royalties, rents, and other items. If allowed by state law, capital gains may also be included in the income of the trust. Unless indicated otherwise, taxable income for a trust is taxed in the same way as individual income; interest that is tax-exempt for an individual will also be so for a trust. Trusts and estates will be subject to at-risk rules and rules regarding passive activity loss. Trusts and estates may claim a deduction based on the amount of taxable income that is distributed to beneficiaries during the year. Estate income tax is calculated by determining adjusted total income, determining distributable net income (DNI), and subtracting DNI from adjusted total income. The amount left over is subject to tax.
Original Basis
The method of calculation used to assess the value of an asset will be based on the method through which the asset was acquired. For gifts, asset value is calculated as fair market value for losses or donor’s basis for gains. For inherited assets, the value is fair market value on the date of death. For the assumption of debt, the buyer must include any debt that is assumed in the purchase price when calculating original basis. The adjusted basis is the cost plus capital additions minus capital recoveries. In situations where a long-term debt instrument has been issued at a price lower than its par value, the difference is referred to as original issue discount (OID). The interest income that is derived from OID cannot be deferred. The rules of OID do not apply to short-term debt. Carryover basis can be calculated in a few different ways. If it is for the adjusted basis of purchased property, it is found by adding the purchase price, acquisition costs, and any improvements. If it is figured for the adjusted basis of a property acquired through inheritance, it is figured as the fair market value on the date of death (or an alternate valuation date). This is also called a “stepped-up basis.” If carryover basis is figured as an adjusted basis from gifting, then the basis cannot be figured until the sale occurs. If the sales price is greater than both the donor’s cost and the fair market value on the date of the gift, then the basis equals the donor’s cost. If the sales price is less than both the donor’s cost and the fair market value on the date of the gift, the basis is whichever item results in smallest loss. If the sales price is somewhere between donor’s cost and fair market value on the date of gift, the basis equals the sales price.
Stepped-Up Basis
A stepped-up basis is calculated for assets that are included in the taxable estate of a decedent. The receivers of bequests will get a basis on those assets equal to fair market value on the date of death (or six months after the date of death). Stepped-up basis is only available for the assets in the taxable estate. In common law states, there is only a step-up basis for half of the assets; in community property states, there is a full step-up in basis. The property owned by a decedent will typically receive a full step-up basis for the person who acquires it. When there is joint tenancy with right of survivorship, either the husband and wife rule (half of fair market value included in decedent’s estate, surviving spouse’s new basis equals half of the total pre-death basis and half of the fair market value) or consideration furnished rule (each surviving co-owner’s basis is old basis plus the fair market value divided equally) will apply.
Stepped-Up Basis (Tenancy in Common) When figuring a stepped-up basis for a situation in which tenancy is held in common, the surviving spouse’s cost basis at death is the amount included in the estate of the deceased spouse. If it is left to a co-owner, the basis becomes his or her old basis plus an increase of the amount included in the estate of the deceased. Community property law allows couples to hold appreciated property as community property, whereas property that has decreased in value can receive a full step-down in basis at first death. For this reason, community property law is preferable to common law in the calculation of basis.
Depreciable Property, Nondepreciable Property, and the Modified Accelerated Cost Recovery System (MACRS)
Property that is capable of depreciating includes property that is used in a trade or business; that is held to produce income; that loses its value over time; and that has a lifespan of usefulness that is greater than one year. Property that is used and disposed within one year, and equipment that is used for capital improvements, cannot be said to depreciate. Also, neither land nor inventory can be subject to depreciation. The modified accelerated cost recovery system (MACRS) is used to assess the depreciation of assets that have been placed in service after 1986. Here, the term accelerated means that the cost recovery method provides a higher deduction in the early years of the asset’s recovery period than would be found in a deduction that was the same every year.
Operation of the MACRS The modified accelerated cost recovery system (MACRS) does not consider the estimated useful life of an asset when computing tax depreciation. Assets that have a 3-, 5-, 7-, or 10-year recovering period are depreciated using a 200% declining-balance method. This method will be switched to a straight-line computation when the straight-line computation provides a greater reduction. Depreciation is an attempt to recoup the costs of the assets that are purchased for use in a trade or business. It reduces the cost basis of an asset, and therefore it increases future gains. At the same time, depreciation reduces current income by providing a deduction in the calculation of the business’ net income.
Cost Recovery Concepts Repairs, Special Elections, and Amortization When an expense on an asset will increase that asset’s usefulness and longevity, the expense is considered betterment and must be added to the cost of the asset and depreciated over the life of the asset. If the expense only brings the asset back to its normal state of use, however, it is just a repair and may be expensed to reduce current income. Special elections are choices to deduct all or part of the cost of certain qualifying property in the year it is placed in service rather than taking depreciated deductions over a specified recovery period. An amortization is used only for intangible assets that have a definite life. Patents and copyrights are common examples of assets that may be amortized.
Tax Consequences of Like-Kind Exchanges Reporting Requirements and Qualifying Transactions When like-kind exchanges are made, Form 8824 must be filed in the year of exchange and for the following two years after a related party exchange. The property must be identified within 45 days from the date of transfer, and it must be received within 180 days after the old property is transferred, but not later than the due date for the tax return for the year of the transfer of the old property. Nontaxable exchanges are only possible when qualifying property has been disposed or received. No gain or loss may be recognized on property that is used in a trade or business or is held for investment. Gain can be recognized when cash or unlike property is received in addition to like-kind property. The gain will be whichever is less: either the gain realized or the fair market value of the nonqualifying cash or property received. Multiple Properties When a like-kind exchange is made involving multiple properties, the exchange is considered as one of multiple properties if the transferred properties are separable into more than one exchange group, a group all the properties transferred and received within the exchange that are of the same asset class or product class. A typical three-cornered exchange will involve three parties and will qualify for Section 1031 treatment. The three parties are: the buyer, who wants to purchase the property; the trader, who wants to sell the property for other like-kind property for the purposes of avoiding taxes; and the seller, who wants to sell property, but owns no new property. Purchase, sale, and exchange are usually simultaneous, though this is not necessary. Liabilities Some special tax consequences apply to situations in which a property bearing a liability is involved in a like-kind exchange. In a situation where a taxpayer gives up property that is subject to a liability, and the transferee then assumes the liability, the taxpayer is treated as having received cash in the transaction equal to the amount of the liability that is transferred. If the taxpayer has a liability on the property that is assumed, and the taxpayer assumes a liability on the replacement property, these liabilities are netted together in order to calculate the cash received or paid. Boot In a like-kind exchange, the boot is considered as all property other than the like-kind property, including cash. When mortgage properties are exchanged, the relief of debt is the boot received regardless of whether it is loan or mortgage. The assumption of debt is the boot given. In such situations, the basis of the assets received will be reduced by the cash received, loss recognized, and liabilities conveyed. The basis of assets received will be increased by the cash paid, gain recognized, and the liabilities assumed. When both parties are subject to a mortgage, only the net amount of debt is considered when calculating boot given and received; there will be a net cash boot when cash is both given and received. Related Party Transactions Related party transactions are those that occur among parties who share an economic objective and are not dealing at arm’s length. A like-kind exchange between related parties qualifies for nonrecognition treatment. If the property transferred is disposed of within two years after the date of transfer, the original property will not qualify for nonrecognition treatment, and any gain or loss that was not recognized will have to be recognized on the date of disposition. Nonrecognitions will not be affected by dispositions: due to death; for which the avoidance of income tax was not the primary reason; due to the involuntary conversion of property; of property in nonrecognition transactions; or that pertain to transactions that do not include the shifting of basis.
Tax Consequences of Gain or Loss on Sale of Assets Holding Period Capital gains and losses can be based on three different holding periods. Short-term capital gains and losses are taxed as ordinary income and result from the sale of securities that are owned for a year or less. Long-term capital gains or losses receive a preferential tax treatment, and result from the sale of securities owned for more than a year. Qualified five-year gain property for sales after December 31, 2000 of property held for more than five years receives a preferential tax treatment of 18%. Holding period generally begins the day after acquisition and extends through the date of disposition. If the property is received through a gift, and is later sold for a gain, the receiver's holding period will include the time the donor held the property. Sale of Residence and Definition of Capital Assets Capital gains from the sale of a residence can be excluded from income, up to $500,000 for joint filers and $250,000 for individual filers. This exclusion can only be used once every two years and only applies when the taxpayer has lived at this residence two out of the five years before the sale. Capital assets are defined by indicating the things that do not count as capital assets. The following items are not capital assets: business inventories; business accounts or notes receivable; business supplies; real or depreciable business supplies or intangible business assets subject to amortization; creative assets; US government publications; commodities derivatives; and hedging transaction properties. Capital Assets For businesses, capital assets are any that are held for long-term investment instead of active business use. Equity and creditor interests in other firms are considered to be capital. Capital losses can be deducted only to the extent of capital gains. Individuals may carry capital losses forward indefinitely, while businesses can only carry them forward five years and can only carry them back three years. When capital gains and losses are netted, short-term losses are used to offset short-term gains, and long-term losses to offset long-term gains. A net short-term loss offsets long-term gains, though if the net short-term loss is less than the long-term gain, the difference is taxed as long-term capital gain. Net long-term loss offsets short-term gains, and if it is less than the resulting amount is taxed as short-term capital gain. Depreciation Recapture and Real or Personal Property According to Section 1231, personal or real property used in trade or business are those that are held for more than a year and include both depreciable tangible and intangible personal property, as well as both depreciable and nondepreciable real property. This does not include inventory. When a taxpayer has Section 1231 net gain in a current year but has had a net loss in any of the previous five years, the previous year’s loss must be recaptured by treating an equivalent amount of the current gain as ordinary income. The depreciation recapture rule states that gains that are attributable to previous year depreciation or amortization deductions must be characterized as ordinary income. Capital gains are always classified as Section 1231, never Sections 1245 or 1250. Ordinary income, on the other hand, is never 1231, but always either 1245 or 1250. Rules for Personal Property, Rules for Real Property, and Exceptions Section 1245 of the Tax Code applies to personal property. Any gain on the sale of Section 1245 property is treated as ordinary income, insofar as it can be treated as such by depreciation and amortization. Section 1245 does not apply to losses; Section 1231 is used instead. Section 1250 applies to real property; when the property was held for longer than one year, there is no depreciation recapture assuming it was depreciated using a straight-line method. The exceptions to recapture under Sections 1245 and 1250 are gifts, death, charitable transfers, certain nontaxable transactions, like-kind exchanges, and involuntary conversions. Related Parties and Wash Sales When assets are bought and sold among related parties, the gain on the sale is treated the same way as any other gain, but the loss will not be recognized for tax purposes until the related party sells the asset to an unrelated third party. In these instances, related parties include immediate family members, closely held corporations, sister corporations, etc. If shares are sold at a loss and then bought back within 30 days, the ability to deduct the losses on a tax return is lost. The amount of the disallowed loss can be added to the cost basis of the additional shares that were purchased. When these shares are sold, any taxable gain or loss will include the loss incurred on the original shares. This rule applies not only to stocks but also to bonds and mutual funds. Bargain Sales and Section 1244 Stock A bargain sale is one in which an asset is sold for an amount below the fair market value. In the case of individuals, the difference between the fair market value and the sale price will be treated as a gift. In the case of employees, the difference will be taxed as ordinary income. In the case of a shareholder, the difference is characterized as a constructive dividend and is taxable as ordinary income. In the case of a charitable organization, the difference is treated as part sale and part contribution. As for Section 1244 stock, otherwise known as small business stock, losses tend to be capital in nature. However, losses suffered by an individual who received the securities directly from the corporation may be characterized as ordinary.
Alternative Minimum Tax Mechanics The alternative minimum tax (AMT) is used when it creates a higher tax liability than the calculation of regular income taxation. The point of the alternative minimum tax is to make sure that individuals are not able to lower their tax liabilities through the use of various loopholes. The AMT is a mandatory tax that must be paid only when it exceeds regular tax liability. There is a base exemption amount determined by filing status that reduces alternative minimum taxable income. The alternative minimum tax has two tiers, such that a slightly lower tax is levied on the first segment of income. Any capital gains distributions or reported long-term capital gains on Form 1040 may be taxed at a rate of 20% for both regular and alternative minimum taxes Preferences and Adjustments Preferences are any tax benefits that have been restricted by the alternative minimum tax (AMT) system. They are always positive. Adjustments, on the other hand, may be either positive or negative. Children under the age of 14 may have substantial adjustments or preferences that are subject to the rules of the alternative minimum tax. In the AMT, no standard deduction is allowed; additionally, itemized deductions are not allowed for taxes, some interest, and most miscellaneous expenses. The rules for passive activities are basically the same for the AMT as they are for any other taxation. Gain or loss from the sale or exchange of property must be recomputed according to AMT rules, as will the gains and losses from conduit activities for which the taxpayer has basis or at-risk limitations. Exclusion Items vs. Deferral Items Itemized deductions that may be deducted in full from the alternative minimum tax include casualty losses; returns on amounts included in income; estate taxes paid on income with respect to a decedent; charitable contributions; interest on debt that was created in acquiring or improving a qualified residence for the taxpayer; investment interest that is not in excess of qualified net investing income; and medical expenses in which the floor is 10%. Itemized deductions that are completely excluded by the AMT include state and local taxes and home mortgage interest that was not used to buy, build, or improve a primary residence or secondary home. The Tax Cuts & Jobs Act eliminated miscellaneous itemized deductions. Consequently, prior to the TCJA, miscellaneous itemized deductions not subject to the 2%-of-AGI floor could be deducted from AMT, whereas such deductions subject to the 2% floor were completely excluded from AMT—but both of these are irrelevant to AMT for tax years 2018–2025. Credit and Small Business Exemption If the AMT is paid in a given year because of the deferral of deductions, it may be used to offset regular tax in the future when the deductions are used to reduce AMT below regular tax. A minimum tax credit can only be used against the regular tax liability, though it cannot reduce this below AMT liability for the year. The alternative minimum tax does not apply to S corporations and partnerships. C corporations are only exempt from AMT if they can qualify as small corporations. In order to be exempt from AMT, new corporations must have gross receipts of less than $5 million for the corporation’s first three taxable years. After this, they are exempt from the AMT only if annual gross receipts are less than $7.5 million.
Tax Management Techniques Tax Credits Depending on a taxpayer's tax bracket, he or she may find a deduction/exclusion or a tax credit more advantageous. Though deductions or exclusions reduce the amount of taxable income that falls within a person’s tax bracket, credits will reduce the amount of tax calculated on taxable income. Any child or dependent care assistance that is provided by an employer will also reduce the maximum amount computed for taxable income. Individuals will typically save more money, though, if they are able to pay for childcare expenses with money from a tax-advantaged account. Individuals may also claim tax credits for college tuition; taxpayers can reduce the amount of their federal income tax withholding based on the estimated tax benefits of education credits and deductions.
AMT Planning Incentive Stock Options The difference between fair market value and the exercise price of an option is an item of AMT tax and may trigger a significant AMT liability if the exercise of the option involves a large amount of appreciated stock. When this stock is sold, most of the AMT liability will be recovered as an AMT credit against the regular tax if the value of the stock has not decreased since the exercise of the option. AMT gain equals the difference between fair market value of stock at time of sale and exercise price. Regular tax gain equals fair market value at time of sale minus exercise price. Tax liability generally exceeds AMT tentative minimum, so most or all of the credit for AMT paid in previous years will often be claimed against regular tax in the year of sale. Charitable Gifts and Stock Redemption Agreements Appreciated property (like stock) can carry a substantial tax advantage if it provides a charitable contribution deduction for the full appreciated value and if this deduction can be applied to both regular and alternative minimum tax. Another consideration in planning AMT is the redemption of stock: an acquisition by a corporation of its own stock from a shareholder in exchange for property. The main point of a stock redemption is to achieve capital gain treatment instead of dividend treatment on the exchange of stock for money or other property. If the transaction is treated as a dividend distribution, redemption proceeds are taxable as ordinary income. Constructive Dividends, Section 302, and Section 303 Redemptions Corporations do not intend for constructive dividends to be treated as dividends for tax purposes. In cases where the economic effect of such a transaction is the same as if a dividend distribution had been made, though, the IRS may characterize the transaction as a taxable dividend. Dividends may be distributed in a property form other than money. Taxation will be measured by the fair market value of the property distributed. Under Section 302, there are four kinds of redemptions that may affect a shareholder’s percentage of ownership: redemptions that are not essentially equal to a dividend; substantially disproportionate redemptions; complete redemptions; and distributions to noncorporate shareholders in a partial liquidation of the distributing corporation. Section 303 redemptions apply to those estates in which stock constitutes a substantial part of total assets.
Accelerated Deduction When deductions are accelerated, or income is deferred, taxes will be reduced for the current year. This may be a good tax strategy if the marginal tax rate for that taxpayer is likely to be the same or less in the follow year. If the marginal tax rate is going to go up, though, it makes little sense to defer. Ways to accelerate deductions include: early payment of state income or property taxes; early payment of mortgage and qualified education loan interest; year-end charitable contributions; year-end expenses; year-end purchase of assets (as tangible assets may depreciate a half-year if they are purchased in the last month of the year); review of asset acquisitions; year-end purchases; education payments; and the purchase of supplies.
Deferral of Income Individuals may want to defer some of their income to minimize their taxes in the current year. To do so, they may use a qualified retirement plan, through which the taxes on earnings may be deferred, and in which pretax income is used for contributions. Postponing the sale of investments until death can also create significant tax savings. Self-employed individuals who use the cash method of accounting can delay billing late in the year so that collections will not be made until the next year. It is also possible to delay paying year-end bonuses until the beginning of the following year. In a nonqualified deferred compensation plan, some income may be deferred for selected employees for several years.
Estimated Taxes and Withholdings and Net Operating Loss
For most taxpayers, the required annual payment will be whichever is lower: 90% of the tax shown on the current year’s return or 100% of the tax shown on the prior year’s return. A quarter of the required annual payment must be paid by the 15th of April, June, September, and January; if the tax on the return is less than $1,000, though, there can be no underpayment penalty. For corporations, estimated payment is either 100% of the past year’s tax or 100% of the current year’s tax. A net operating loss (NOL) is an excess of business deductions over gross income for a particular tax year. NOL deductions are allowed as either carrybacks or carryovers to other tax years in which gross income exceeded business deductions. NOL deduction is permitted for individuals, corporations, estates, and trusts, but is forbidden for partnerships and S corporations.
At-Risk Rules The at-risk rules are set up to limit the deductible loss a taxpayer claims to the amount that the taxpayer actually risks losing. The at-risk rules may apply to individuals, estates and trusts, partners, shareholders in S corporations, and most C corporations. The amount that is considered to be at risk is calculated as the sum total of: the cash amount and adjusted basis of other property contributed to the activity by the taxpayer; amounts borrowed to be used in the activity for which the taxpayer is liable; amounts borrowed to be used in that activity that are secured by property not to be used in the activity; and the taxpayer’s share of qualified nonrecourse financing (loans from banks or credit unions, for instance) that is secured by the real property used in the activity.
Passive Activity Rules
Losses that qualify for recognition under at-risk rules may also be subject to passive activity rules. Losses from passive activity may be used to offset passive activity income only. Passive activity rules may apply to individuals, estates, trusts, personal service corporations, closely held C corporations, publicly traded partnerships, and the owners of pass-through entity interests. All other corporations and partnerships are not subject to passive activity rules. Passive activity losses may either involve rentals or those businesses in which the taxpayer does not materially participate in a significant way. Income and losses from the following activities are considered passive: equipment leasing, rental real estate, limited partnerships (with some exceptions), and other partnerships or corporations in which the taxpayer does not materially participate. Nonpassive Activities and Rules of Material Participation The income and losses from the following activities are typically considered to be nonpassive: salaries, wages, and 1099 commission income; guaranteed payments; interest and dividends; stocks and bonds; sale of undeveloped land or other investment property; royalties from the ordinary course of business; business in which the taxpayer materially participates; partnerships, S corporations, and limited liability companies in which the taxpayer materially participates; and trusts in which the fiduciary materially participates. An individual is said to have materially participated if he or she: participates more than 500 hours per year to day-to-day activities; participates between 100 and 500 hours, but more than anyone else; has materially participated for any five of the past ten years; or has materially participated in a personal service activity for any three previous years.
At-Risk Loss and Passive Activity Rules Computations, Treatment of Disallowed Losses, and Disposition of Passive Activities When the deductibility of losses is calculated on Form K-1, follow these steps: first, it must be determined whether the partner has sufficient basis; second, it must be determined whether the partner has a sufficient amount at risk; third, it must be determined whether the passive activity rules apply; fourth , it must be determined whether the loss may still not be deductible because of limitations on either net operating loss or capital loss. If the deductibility of loss is limited by basis or amount of risk, suspended losses may be absorbed in subsequent years. The net passive activity losses are suspended and carried forward in order to offset future passive activity income, while the at-risk rules are applied before the passive loss rules. When all of the interest in a passive activity is disposed of, suspended losses are fully deductible against other income. Real Estate Exceptions When an individual has a modified adjusted gross income of less than $100,000, then real estate losses up to $25,000 may be deducted in full. To qualify for this offset, the taxpayer must qualify as an active participant; in other words, he or she must have at least a 10% interest in any rental real estate activity and must substantially participate in management decisions. For vacation properties, in which customer use may be low, the $25,000 offset does not apply. A property is not considered a rental if: average customer use is seven days or less; average customer use is 30 days or less and the owner provides extraordinary services; or the property is used in a partnership.
Tax Implications of Marriage Filing Status and Children If taxpayers are married on the last day of the year, they may elect to file jointly or separately, though filing jointly is usually more beneficial. If a taxpayer has children, the taxation policy depends on whether the child has earned income, unearned income, or both. If a child only has earned income, then the income up to the standard deduction is not taxable. If a child has only unearned income, and is under the age of 14, then his income may be subject to the estate and trust tax rates. Children over age 14 will generally have their unearned income taxed at the child’s rate. When a child under 14 has both earned and unearned income, the unearned income is taxed as usual, and the earned income less the standard deduction is taxed at the child’s rate. Common Law and Community Property According to common law, a husband and wife split ownership of all property. In states that abide by common law, there is a stepped-up basis for half of the assets; this means a step-up in basis for the decedent’s share of ownership, but not for the share of the survivor. Community property, which is recognized in nine states, is property that was acquired by either spouse during the marriage; ownership of this property is divided equally. Community property states have a full-step-up in basis. At death, the new cost basis is the fair market value at the date of death for both halves of the community property, even though only half is included in the estate of the decedent. Couples who reside in community property states should hold appreciated property as community property.
Tax Implications of Divorce
Alimony is a series of payments made by one spouse to another, sometimes through an intermediary. Prior to the Tax Cuts and Jobs Act, the recipient of alimony would be taxed on the alimony, while the payor could deduct it, but the TCJA established that that applies only for divorces done before 2019. Alimony payments must be made in cash; must occur between two parties who do not live together; and must avoid front loading. Front loading is a method of property settlement in which payments are large at the beginning and then decrease quickly. Child support payments will be established by the courts, and will be based on a ratio of each parent’s income, the percentage of time the child spends with each parent, and the amount of alimony. Child support is not deductible by the payor and is not included in the income of the recipient. The child can only be claimed as an exemption by one parent in each year.
Qualified Domestic Relations Order and the Tax Implications of Death
A qualified domestic relations order (QDRO) is a court order instructing a trustee or administrator of a qualified retirement plan how much to pay out to the nonowner spouse after a divorce. These orders ensure that property from a qualified retirement plan can be divided up without adversely affecting taxes. As for the tax implications of death, a tax return must be filed for an individual in the year of his or her death. Though the individual’s tax year will have been shortened by death, all deductions, exemptions, and credits can be taken in full. Income that comes after death and becomes part of the estate of the deceased is called income in respect of decedent. A surviving spouse can file jointly in the year of his or her spouse’s death.
Charitable Contributions and Deductions Qualified Entities and Public vs. Private Charities Qualifying public charities include: churches and educational organizations; hospitals and medical research organizations; government entities; and publicly supported organizations that receive a substantial amount of support from the general public or government (like the Red Cross). Qualifying private charities include: veteran’s organizations, fraternal orders, and certain private nonoperating foundations. Contributions that are made to public charities may not exceed 60% of the taxpayer’s adjusted gross income (per the TCJA), while contributions to private charities may not exceed 30% of AGI. For public charities, there is a 30% ceiling (20% for private charities) on long-term capital gain property. Capital Gain Property Any property that has been held for more than a year may be considered capital gain property for purposes of charitable contributions. There are two categories of capital gain property. Real and intangible personal property includes things like appreciated land and gifts of stock; tangible personal property includes things like cars or jewelry. For real and intangible personal property, the deductions on gifts to charity cannot exceed 30% of AGI if the entire value of the gift is deducted. For tangible personal property, there is a distinction between property that the charity can use directly and that which the charity must sell in order to obtain any value. For use-related contributions, there is a limit of 30% of AGI deduction assuming that the full price of the gift is deducted; for use unrelated gifts, the fair market value of the gift will be reduced by 100% of potential gain, meaning that the deduction is simply the donor’s cost basis. Ordinary Income Property, Carryover Periods, and Partial Interest Gifts to Charity Ordinary income property is any piece of property that would have resulted in ordinary income had it been sold on the date of contribution. The deduction for ordinary income property is limited to the donor’s cost basis. As for carryover periods for charitable contributions, individuals may carry over for five years any contributions that exceed the AGI for the current tax year. These carryover contributions are subject to the original percentage limits and will be deducted after deducting the allowable contributions for the current year. Typically, any contributions that are less than the entire interest in a property are not deductible. Two exceptions to this rule are gifts of a partial interest in a property if that is the donor’s entire interest and property that is held in a charitable lead trust or a charitable remained trust. Nondeductible Contributions and Appraisals Contributions that may not be deducted include money given to: civic leagues, social and sports clubs, labor unions, and chambers of commerce; foreign organizations; groups that are run for personal profit; groups whose purpose is to lobby for law changes; homeowners’ associations; individuals; and political groups or candidates. Also, taxpayers may not make deductions for: the cost of lottery tickets; country club dues; tuition payments; the value of donated blood; or contributions consisting of the right to use property. Appraisals are usually required if a contribution exceeds $5,000. Any charges associated with the appraisal may not be included in the deduction. Qualified appraisals are not required for securities that are publicly listed, so long as quotes are published regularly. Substantiation Requirements To claim deductions on cash donations of less than $250, individuals need to supply receipts or other written records with the date, amount, and name of the organization. Noncash donations of less than $250 do not require receipts unless they are easy to obtain. Cash donations of more than $250 in one day to one organization require written substantiations from that organization. Noncash donations of more than $250 require a written acknowledgement from the receiving organization. Non-cash donations of more than $500 require that the donor demonstrate the means through which the property was acquired, the date acquired, and the adjusted basis. Most noncash contributions of over $5000 will also require an appraisal.
Join 4M+ learners. Unlock unlimited quizzes, wrong-answer tracking, flashcards + reminders, study guides, and 1-on-1 challenges.