The Individual Tax Model

1. The Individual Tax Model

2. Taxable Income Computation • Calculate gross income totaling Line 22 on 1040 – based on filing status (S,MFJ, MFS,HH). • Calculate Adjusted Gross Income (AGI) • Subtract the greater of: • itemized deductions or • the standard deduction (based on filing status) • Subtract total personal/dependency exemptions • Result is Taxable Income

3. Individual Tax Model – Gross Income / Exclusions • General Rule: Gross Income is “Broadly Conceived”: Includes all income subject to taxation unless specifically indicated as not taxable by law. • Exclusions include: • unrealized gains, gifts, inheritances, welfare type payments, many fringe benefits, returns of capital, Municipal Interest, some US Govt for higher education, life insurance proceeds. • Scholarships - excludible if • recipient is candidate for degree, amount received is not a payment for services, and is used to pay tuition, books, and other similar educational expenses • Foreign earned Income (Sec. 911) - build U.S. Economy • Exclude up to $82,400 of foreign earned income annually plus a housing allowance (exclusion cannot exceed earned income • Individual must be a bona fide resident of the foreign country for an entire tax year or be in the foreign country for 11 mos in any 12 month period.

4. Individual Tax Model: Special Income Inclusions • Annuities: Amount not taxed: Inv. / Expected Return * Pymts Rec • Deferred Compensation Plans: Defined Contribution Plans, Defined Benefit Plans - Qualified Retirement Plans • Prizes and Awards - include FMV • Social Security Benefits - up 85% may be taxed • Unemployment compensation is taxable • Alimony received is taxable / Child support is not includible but is not deductible either.

5. Special Rules • Dividends (cash and noncash) - FMV of prop received (subject to E& P provisions) • Stock dividends generally not taxable • Damages - personal (special rules) business damages not excludible. • Discharge of indebtedness - generally includible.

6. Business versus Investment • Business activity • Time and talent on regular basis • Profit partially attributable to personal involvement • Income is considered earned income • Hobby losses only deductible to extent of hobby income – not a business activity • Investment activity • Passive role as owner of income-producing property • Income is considered unearned income • Losses on personal use assets are not deductible – gains from sale are treated as capital assets.

7. Gains/Losses on Securities • Realization requires a sale or exchange • Gain/loss = Proceeds -adjusted basis • Character is capital - time period matters • Basis issues • reinvested dividends increase basis. • Sale of stock uses either specific ID or FIFO method of matching basis with sales. • Mutual fund shares sold typically use an average basis.

8. What to do with Capital Gains and Losses • SHORT TERM asset held for <= 1 year – gains taxed as ordinary income • LONG TERM asset held for > 1 year • L/T Gains taxed at lower capital gains tax rate of 15% • Net the gains and losses in each class (net ST, net LT, net 28%LT). • Special rule for sale of principal residence • Exclude only one gain every 2 years. • Limits $500,000 MFJ, $250,000 other

9. Deductions for Adjusted Gross Income and AGI • Deductions for Adjusted Gross Income • Trade/Business Exp from a Sole Proprietorship are reported on Schedule C / or for a rental property are recorded on schedule E • Student Loan interest up to $2500 (Income limits apply) • Self Employed Expenses: 50% of SE tax, percentage of health insurance premiums, Keogh and Simple retirement plans • IRAs, Moving Expenses, Contributions to MSAs • Penalty for early withdrawal of savings • Result of Income less deductions for Adjusted Gross Income –is AGI (very key concept) - many deductions are a function of AGI (e.g., IRA deductions, medical expenses, charitable contributions) • Many items of gross income are also a function of AGI • Social Security Benefits, Passive Activity Losses

10. Itemized Deductions / Personal Losses - • Itemized deductions • a special class of deductions that allow taxpayers to derive tax benefits from certain personal & investment expenditures • Medical, Interest (Mortgage/Investment), Taxes (ad valorem/Sales/State Income Tax), Charity, Miscellaneous (Unreimbursed Employee Bus expenses, Investment Expenses, Tax Prep, Casualty losses) • Individuals deduct the greater of the standard deduction for his/her filing status or the total of his/her itemized deductions. • About 1/3 of all TPs claim itemized deductions • Itemized deductions are shown on Form 1040 Schedule A.

11. Exemptions • Personal exemption for the taxpayer (2 for MFJ). • If you are a dependent on someone else’s return, can you still claim yourself? • Exemption = $3,650 in 2010 for each personal or dependency exemption. • 5 Tests for Dependency?

12. Rich People • Phase-out of itemized deductions – no phase out in 2010. • Phase-out of exemptions – no phase out in 2010, may return in future.

13. Tax Credits • A credit is a dollar for dollar reduction in the tax liability. A deduction only reduces the tax by the marginal tax rate associated with that deduction. • Child Credit = $1,000 per child in 2010. Phases out for rich. • Dependent care credit (child < 13 years old). Credit amount between 30% and 20% of child care costs depending on income range. • Earned income credit. This is refundable - a transfer payment to working poor. Increases progressivity of tax rates. Credit is higher for taxpayers with children and phases out as income increases. • Excess FICA withholding is refunded through a tax return claim.

14. Payment and Filing Requirements • Taxes on wages are withheld each pay period. • Estimated taxes are due on April 15, June 15, September 15, and January 15. • Pay 90% of current year tax, 100% of prior year (or 110% of prior year AGI>$150,000). • Tax return due 4/15, but may be extended to 8/15 then 10/15 (LAST DATE).

15. Taxable Income from Business Operations

16. Taxable Income • Taxable income = gross income less allowable deductions • Gross income “means all income from whatever source derived.” AKA Broadly Conceived. • Deductions are allowed through legislative grace, and include all ordinary and necessary expenses … in carrying on any trade or business.” • Good rule of thumb: receipts are taxable UNLESS you can find a law that says it is excluded. Expenses are deductible ONLY if you can find a law that says it is deductible.

17. Taxable Year • 12-month period which generally corresponds to its fiscal year. • Individual taxpayers must generally choose a calendar year. • Firms generally choose a year = end of an annual operating cycle. • Changing tax years requires permission - most common reason is merger of firms with different year-ends.

18. Accounting Methods • Overall method by which taxpayers determine their income, deductions and credits, as well as the time realized and recognized. Section 482 grants IRS broad powers to “distribute, apportion, or allocate income” among businesses to CLEARLY REFLECT income of each. • CONSISTENTLY APPLIED • Establish a method by using it in the first tax return. • Requires IRS permission to change.

19. Cash Method • Under the cash method, gross income includes cash or property actually RECEIVED during the tax year. • Deductions are usually taken in the year cash or property is PAID. • Cash method income includes receipt of noncash goods • Anti-abuse provision: Constructive receipt doctrine. • Occurs when taxpayer has unrestricted access to and control of the income. • NO constructive receipt if the amount is available only on surrender of a valuable right, or if there are substantial limits on the right to receive it.

20. Exceptions - Cash Method • Cash method - deduct expenses when PAY. A check is payment when mailed. • An asset must be capitalized. The cost of the asset may be recovered over the asset life (e.g. depreciation, cost of goods sold). Major repairs may result in IRS dispute regarding expense versus capitalization. • Inventory must be accounted for on the accrual method, even for cash basis taxpayers. This is called a HYBRID method of accounting.

21. Cash Method Deductions - Prepaid Expenses • Where an expense (e.g., rent or an insurance premium) covers more than the following tax year, the deduction must be spread over the period to which the expense applies. • However, prepaid interest must be capitalized and deducted over the period for which interest is actually charged even if prepayment < next tax year. • Exception - deduct prepaid interest (points) on the purchase of a home. Does not apply to refinancing.

22. Accrual Method of Accounting • Under the accrual method, report income when the right to the income and the amount of the income can be determined with reasonable accuracy. (REALIZATION) • MATCH expenses against revenues. Deduct when ALL EVENTS have occurred that determine the existence of the liability and the amount of the liability can be determined with reasonable accuracy.

23. Book-Tax Differences • Contrasting principles of conservatism. • GAAP - protect shareholders and creditors: don’t overstate book income. • Tax - protect government revenues: Don’t understate taxable income. (Contrasting result may arise due to economic incentives - e.g. accelerated depreciation.)

24. Book-Tax Permanent Differences • Permanent differences do not reverse; Temporary differences reverse over the life of the firm. • Examples of permanent differences • 50% meals and entertainment • political contributions • fines and penalties • interest expense to generate tax-exempt municipal bond income • premiums on life insurance • Tax-exempt municipal bond income • Life insurance proceeds

25. Temporary Book-Tax Differences • Examples of temporary differences: • Depreciation • Timing of accruals • Capital losses • Bad debts (allowance vs. writeoff) • Cash versus accrual accounting

26. Accrual Expenses Exceptions • Related Party Accruals – Sec. 267 • The paying party cannot deduct an expense until the year that a receiving party deducts the expense. • Prevents accrual basis taxpayers from accruing an expense but delaying payment.

27. Sole Proprietorship • Business income and expenses are reported on Schedule C, filed with the individual form 1040. • Net income or loss on Schedule C is ordinary income or loss; combine this net with other items of gross income. • If the Schedule C business loss > other sources of income, the NOL (net operating loss) can be carried back 2 years and forward 20 years.

28. Employment Taxes • FICA = 6.2% Social Security tax (on wages up to $106,800 in 2010) + 1.45% Medicare tax on all wages. Both employer and employee must pay this tax. • Employers withhold income taxes and the employee’s share of FICA. • Employers must remit the withheld taxes to the federal (and state if applicable) governments. • Self-employed taxpayers must pay SE (self-employment) tax, equal to 2 x FICA, or 15.3% of net earnings from self-employment. (See footnote 20 for details). 1/2 of SE tax is deductible on Form 1040.

29. Property Acquisitions and Cost Recovery Deductions

30. Expense vs. Capitalize • Deduction permitted for all “ORDINARY AND NECESSARY” business expenses • Deduction prohibited for “PERMANENT improvements to increase the value of property” • Some types of capitalized costs can be recovered through amortization or depreciation

31. Tax Basis • Tax basis = unrecovered cost (cost - depreciation). • Starting basis generally equals COST basis: • original purchase price regardless of whether acquired by debt, or • FMV of asset if cost more difficult to measure. • Cost recovery of • Inventory = cost of goods sold • Tangible assets = depreciation • Intangible assets = amortization • Natural resources = depletion

32. Depreciation • Depreciation applies to tangible assets (things you can touch versus intangibles like patents, goodwill) that: • Lose value over time due to wear and tear, obsolescence • Buildings depreciate even though real estate often increases in value. • Have a reasonably ascertainable useful life • Artwork is not generally depreciable.

33. Depreciation • MACRS - Modified Accelerated Cost Recovery System • Personalty: • DDB: 3, 5, 7, 10 • 150% DB:15, 20 • General rule is half year convention • Realty: SL method: 27.5 years residential, 39 years non-residential (specialty realty 20, 25, 50) • Mid Month convention

34. Depreciation Conventions - Personalty • Normal is half year convention • Anti-Abuse provision Mid-quarter convention • : IF > 40% personalty is acquired during the last quarter of the year, THEN • Compute depreciation separately for EACH quarter’s acquisition using mid-quarter tables in appendix of chapter 6

35. Automobiles • Maximum annual depreciation limit per vehicle, indexed for inflation. – check limits for 2010 including bonus – • Compute depreciation per MACRS, then limit above.

36. Expensing Election – Section 179 • Applies to tangible personalty. May expense $500,000 of assets purchased after acquired in 2010/11 – also 50% bonus depreciation for 2010. • Expense cannot create a business loss. • Expense reduced $ for $ by purchases > $2,000,000. • Reduces recordkeeping, benefit for small businesses • Planning - if buy a 3-year, 5-year and 7-year asset, which one should you expense?

37. Amortization of Intangibles • Generally requires a determinable useful life. • Organizational costs are amortizable straight line method over 180 months – first 5K generally deductible immediately. • Start-up costs are also amortizable straight line method over 180 months - some exceptions. • Expansion costs may be currently deductible.

38. Leasehold Costs and Improvements • Cost of acquiring lease is amortized over the period of lease. • Improvements to leased property are capitalized and depreciated according to type of property.

39. Purchased Intangibles • Allocate lump-sum price to assets by relative FMVs. • Residual = goodwill. • Tax = 15 years SL • GAAP = 40 years pre-2002. No GAAP amortization post-2001 - evaluate for impairment annually. Book-tax difference is permanent post-2001.

40. Chapter 7 Property Dispositions

41. Realized Gain or Loss • Amount realized on disposition • MINUS adjusted basis of property (e.g. cost - accumulated tax depreciation = “NBV”) • = Realized gain or loss. • GENERALLY, realized (economic) gains and losses on disposition are recognized (result in taxable income or deductions) unless there is a specific exception. See Chapter 8. • Unrealized (mere appreciation or decline in value) gains and losses are neither realized nor recognized.

42. Amount Realized • Cash received • FMV of any property received, including buyer’s note • Relief of debt. AP3. • Reduce the amount realized by selling costs such as sales commissions, broker fees. • No adjustment for “inflationary gains.”

43. Installment Sale Method • Permits deferral of gain recognition until cash is received on the sale. • Gain recognized this year = (cash this year) x (total gain / total sales price). • Not allowed for sales of publicly traded stock or for inventory, or to delay recognition of depreciation recapture. • Financial accounting uses accrual accounting, so installment sales method for tax creates a temporary book-tax difference.

44. Related Party Losses • Relative: • family = spouse, sibling, ancestors, lineal descendants Q10 • 50% controlled corporations • Losses realized on sale of property between related parties are NONdeductible. • Future gain (but NOT loss) by relative can be offset by disallowed loss.

45. Character of Gain or Loss - Overview Ordinary Tax or deduct at ordinary rates Depr. Recapt net 1231 loss 5-yr lookback Section1231 net gain net 1231 gain Net capital gains and losses: Individual may deduct $3000 net loss. Net LT gain taxed at lower rates. Capital

46. Section 1231 Assets • Real or depreciable property used in a trade or business. Q1 • GENERAL rule. • Net Section 1231 gains and losses • IF NET GAIN => add to capital gains and losses. Result is possible lower tax rate on 1231 net gains. • IF NET LOSS => add to ordinary gains and losses. Can also offset salary, interest, dividends, etc. Result is ordinary rate benefit of 1231 net losses.

47. Depreciation Recapture • Gain on each separate asset may be subject to depreciation recapture. • Depreciation recapture does NOT apply if the asset is sold at a loss, nor can it increase the amount of the gain. • For sales of depreciable personalty and amortizable intangibles, the gain is characterized as ordinary up to the amount of accumulated depreciation. • Why? because depreciation has resulted in prior deductions at ordinary rates.

48. Depreciation Recapture • REALTY: • Special rules apply to pre-1986 depreciation on accelerated methods: most of this property is fully depreciated, so rules seldom apply. • Corporations must recapture 20% of amount that would have been ordinary had it been personalty (lesser of gain or depreciation). • Individuals treat lesser of gain or depreciation as a capital gain subject to a special 25% tax rate - see chapter 15.

49. Section 1231 Netting • After all depreciation recapture, NET the remaining Section1231 gains with Section 1231 losses. • If a net loss, treat as an ordinary loss and combine with other ordinary income and losses. • If a net gain, then the net gain is treated as a capital gain UNLESS:

50. Section 1231 Look Back Rule • The net 1231 gain is treated as ordinary income recapture to the extent of unrecaptured Section 1231 losses during the prior five years. • EXAMPLE: Start business in 1990. Section 1231 gains and losses. • 1998 net gain $10 treated as capital. • 1999 net loss ($15) treated as ordinary. • 2000 net gain $23 treated as $15 ordinary (recapture 1991) and $8 capital. • 2001 net loss ($40) treated as ordinary. • 2002 net gain $6 treated as ordinary. Still have $34 unrecaptured loss from 1993. • 2003 net gain $50 treated as $34 ordinary, $16 capital.