ONLINE COMPANION
to Accompany
A Guide to Federal Taxation
Jeffrey A. Helewitz
Prepared by
Brian Halsey
Australia
Canada
Mexico
Singapore
Spain
United Kingdom
United States
CONTENTS
Chapter 1: Sources of Tax Law 1
Lecture Notes 1
Study Tips 4
Application Exercises 6
Internet Exercises 7
Review Quiz 8
Answers to Review Quiz 9
Chapter 2: Individual Income Taxation 10
Lecture Notes 10
Study Tips 19
Application Exercises 28
Internet Exercises 29
Review Quiz 30
Answers to Review Quiz 31
Chapter 3: Income Taxation of the Sole Proprietorship 32
Lecture Notes 32
Study Tips 35
Application Exercises 39
Internet Exercises 40
Review Quiz 41
Answers to Review Quiz 42
Chapter 4: Income Taxation of Partnerships 43
Lecture Notes 43
Study Tips 52
Application Exercises 61
Internet Exercises 62
Review Quiz 63
Answers to Review Quiz 64
Chapter 5: Income Taxation of Corporations 65
Lecture Notes 65
Study Tips 74
Application Exercises 82
Internet Exercises 83
Review Quiz 84
Answers to Review Quiz 85
iii
Chapter 6: Estate and Gift Taxation 86
Lecture Notes 86
Study Tips 92
Application Exercises 97
Internet Exercises 98
Review Quiz 99
Answers to Review Quiz 100
Chapter 7: Fiduciary Income Taxes 101
Lecture Notes 101
Study Tips 104
Application Exercises 106
Internet Exercises 107
Review Quiz 108
Answers to Review Quiz 109
iv
Chapter 1: Sources of Tax Law
Lecture Notes
Chapter 1 addresses the sources and theories behind the federal tax law. The
major points for lecture are:
1. Genesis of the tax law
a. Direct taxes
b. Indirect taxes
c. The Constitution; apportionment and the 16th Amendment
i. The lecture should discuss the 16th amendment as the
basis for modern tax law.
d. Where to find the tax laws
i. Codifications
ii. Internal Revenue Code of 1986 is current official
codification.
e. Enacting tax laws
i. Revenue bills originate in the House via a sponsor.
ii. Usually revenue bills are proposed by the president through
a congressional sponsor.
iii. Bill printed on slip and referred to the appropriate House or
Senate committee.
iv. Hearings in committee
v. House or Senate debate and possibly pass bill.
vi. Passed bills go to other chamber for approval/disapproval.
vii. Conference committees work out differences.
viii. Passed bill goes to president for signature or veto.
2. Internal Revenue Service
a. Federal agency in executive branch that administers the tax laws.
b. IRS administrative decisions have a legal impact—the force of law.
1
3. Three sources of tax law
a. Statutes (discussion of where to find statutes should follow)
b. Administrative action (discussion of IRS regulations and private
letter rulings should follow)
c. Judicial decisions (cases)—procedure through:
i. Tax Court
ii. Court of Federal Claims
iii. Regular Federal Courts (district, circuit, Supreme)
4. General Proceedings
a. Recent restructurings
i. Taxpayer Bills of Rights Acts of 1988 and 1996
ii. Internal Revenue Service Restructure and Reform Act of
1998
b. Procedure
i. Determination by IRS
ii. Audit (examination)
(a) correspondence audit
(b) office audit
(c) field examination
iii. results of examination
(a) no-change letter
(b) deficiency letter
(c) 30-day letter
(d) 90-day letter
c. Difference between honest errors and fraudulent claims—criminal
liability
d. Judicial review of administrative procedures
i. Small case tax procedure
ii. Regular court system
e. Burden of proof (IRC sec. 7491)
2
5. Ethical Concerns
a. Circular 230
b. Due diligence
i. Reasonable expectations of substantiation
ii. Penalties
3
Study Tips
This chapter addresses the sources and theories behind the federal tax law.
Note where you can find the tax laws:
1. Codifications
2. Internal Revenue Code of 1986 is current official codification.
Note how tax laws are enacted:
1. Revenue bills originate in the House via a sponsor.
2. Usually revenue bills are proposed by the president through a
congressional sponsor.
3. Bill printed on slip and referred to the appropriate House or Senate
committee.
4. Hearings in committee
5. House or Senate debate and possibly pass bill.
6. Passed bills go to other chamber for approval/disapproval.
7. Conference committees work out differences.
8. Passed bill goes to president for signing or veto.
Note the role of the Internal Revenue Service:
1. Federal agency in executive branch that administers the tax laws.
2. IRS administrative decisions have a legal impact—the force of law.
Know the three sources of the tax laws:
1. Statutes
2. Administrative action
3. Judicial decisions (cases) through the Tax Court, Court of Federal Claims,
and regular federal courts (district, circuit, Supreme)
4
Know of the most recent IRS restructurings:
1. Taxpayer Bills of Rights Acts of 1988 and 1996
2. Internal Revenue Service Restructure and Reform Act of 1998
Be aware of the basic procedure followed by the IRS when it looks at a
taxpayer’s returns:
1. Determination by IRS
2. Audit (examination)
3. Correspondence audit
4. Office audit
5. Field examination
6. Results of examination
a. No-change letter
b. Deficiency letter
c. 30-day letter
d. 90-day letter
Note the difference between honest errors and fraudulent claims—criminal
liability attaches to fraudulent claims
Note that there is always judicial review of administrative procedures and other
elements that are important to the tax system:
1. Small case tax procedure
2. Regular court system
3. Burden of proof (IRC sec. 7491)
4. Circular 230
5. Due diligence
6. Reasonable expectations of substantiation
7. Penalties
5
Application Exercises
1. Locate the nearest office of the Internal Revenue Service. Where is it
located? Does the IRS have multiple offices in your area?
2. Research the Taxpayer Bills of Rights Acts of 1988 and 1996, the Internal
Revenue Service Restructure and Reform Act of 1998, and any new IRS
restructurings. Identify how the rights of a taxpayer have changed
because of these restructurings.
3. Prepare a memorandum that details the different consequences of both
honest errors and fraudulent claims on a taxpayer’s tax returns. Be sure
to give your source authority (statutes, cases, IRS regulations or
publications, etc.).
4. Identify all the steps in the progression of an audit, from the initial contact
between the IRS and a taxpayer to a final resolution.
5. Identify at least one current proposal before Congress to reform the tax
laws. Identify the basics of the proposal, its status, and its previous
history, and predict its chances of passage in the current political climate.
Do you think that this proposal is a good one? Why or why not?
6
Internet Exercises
1. Learning to access the forms that are the basis for tax practice is
fundamental. Go to the Internal Revenue Service Web site at
http://www.irs.gov. Download the following forms: SS-4; the SS-4
instructions; form 1040ez; and form W-4.
2. Tax law and policy is always changing. Go to the White House’s Web
site at http://www.whitehouse.gov and find current tax proposals
supported by the president. Download the text of the proposal(s) and
draft a brief memorandum explaining the proposal(s). Be sure to include
specific links to the source of your information.
3. Researching the tax laws is very important. The Internet can serve as a
valuable tool to learn about the tax code, to confirm current law, and find
authoritative legal sources. Search the Internet for a least three tax
research or general law or accounting Web sites that provide information
about the tax code. Analyze these Web sites. What credence do you
give these Web sites? Are they reputable? trustworthy? Why or why not?
7
Review Quiz
1. The Constitution is the basis for modern tax law. True or false?
2. Internal Revenue Code of 1956 is current official codification of the tax
law. True or false?
3. The _____________________ is the federal agency in the executive branch
that administers the tax laws.
4. There are four types of IRS audits: the correspondence audit; the office
audit; the field examination; and the walk-in audit. True or false?
5. Criminal liability attaches to both honest errors and fraudulent claims by
a taxpayer. True or false?
6. There are no ethical concerns in tax law. True or false?
7. Due diligence requires reasonable expectations of substantiation.
8. The Burden of Proof in tax cases is found in IRC section _______________.
9. The small case tax procedure is available for small taxpayers in order to
smooth the resolution of tax disputes. True or false?
10. The Senate proposes tax laws. True or false?
8
Review Quiz Answers
1. True.
2. False. The Code of 1986 is the current official code.
3. Internal Revenue Service.
4. False. The correspondence audit, the office audit, and the field
examination are the three types of audits.
5. False. Criminal liability applies to fraudulent claims.
6. False. Tax law is replete with ethical considerations.
7. True.
8. 7491.
9. True.
10. False. All tax proposals must originate in the House.
9
Chapter 2: Individual Income Taxation
Lecture Notes
Chapter 2 addresses the consequences of the federal tax system on individual
taxpayers. The major points for lecture are:
1. Introduction
2. Introduction to form 1040
3. Discussion of who is liable for filing
a. U.S. Citizens
b. Residents of the United States and Puerto Rico
4. Taxpayer filing status
a. Single
b. Married filing jointly
c. Married filing separately
d. Head of household
e. Qualified widow(er) with dependent child
5. Exemptions
a. Personal exemptions
i. Dependent exemptions
(a)
Who may claim dependent exemptions
(1)
Children of divorced parents
6. Sources of income
a. Gross income—“all income from whatever source derived”
b. Less deductions
c. Arrives at taxable income
d. De minimus rule
e. Quantifiable items are reportable as gross income—bartering
f. Income divided into several subsets
10
i. Wages and salaries
(a)
Exceptions for fringe benefits offered to all
employees
(b)
Non-discriminatory test to determine whether
fringe benefits are taxable
(1) Qualified employee discount not exceeding
20 percent of services not taxable
(2) Qualified employee discount not exceeding
the employer’s gross profit on the item not
taxable
(3) Working condition fringe benefit (company
cars)
(4) De minimus benefits
(5) Qualified transportation (limited)
(6) Qualified moving expenses
(7) Athletic facilities on employer’s premises or
operated by employer for employees and
families
ii. Interest and dividends
(a)
Interest from use of money from passive
investments
(b)
Dividends from share of profits of business
(c)
Discussion of the concept of basis
(1) Adjusted basis issues
iii. Rental income
(a) Advance rents—taxable in year received
(b) Security deposits
(c) Reduced by expenses of maintenance
(1) Expenses apportioned between rental and
personal use
11
iv. Retirement income
(a)
Annuities
(1) Return of contributions not taxable
(2) Amount apart from contribution is taxable
(b)
General Rule and simplified rule of distributions
v. Other income
(a)
Alimony
(1) Income to recipient
(2) Deduction for the payor
(b)
Court awards
(c)
Cancelled debts
(d)
Barter goods (value quantified and counted as
income)
(e)
Royalties
g. Certain items of income not subject to federal tax
i. Accident and health insurance benefits
ii. Proceeds form a life insurance policy
iii. Gifts
iv. Government transfer payments (public assistance, welfare
and veteran’s benefits)
v. Scholarships
(a) Tuition, fees, books, supplies, and equipment not
taxable
(b) Room, board, or other living expenses are taxable
7. Allocation of income
a. Who is the recipient of income
b. Person who earns income reports income
c. Income shifting
i. Review of Lucas v. Earl
12
8. Gains and losses
a. Gain or loss from property sold or exchanged
b. Determination of basis
i. Cost of purchase plus sales tax, professional fees, freight
and storage fees, and other acquisition fees
ii. For gifts, taxpayer’s basis is donor’s basis for gains; for
losses, basis is FMV on date of gift
iii. Step up in basis to FMV or donor’s basis for testamentary
gifts (whichever is highest)
iv. As compensation for services, property’s basis is FMV of
services
v. Like-kind exchange
(a) Property received must be similar to property given
and must be held for business use
(b) basis of property originally transferred remains as
basis
(c) no tax due on exchange date
(d) See Maxwell v. U.S.
c. Non-taxable events
i. Gifts
ii. Transfers between spouses
iii. Like-kind exchanges
d. Capital gains or losses
i. Capital assets
(a) Property owned and used for personal purposes
and investment
(b) Long-term gain or loss—asset held for more than
one year
(c) Short-term gain or loss—asset held for less than one
year
13
ii. Non-capital assets
(a) Business’ inventory, accounts receivable
(b) Different tax rates apply.
iii. Corn Products case details difference between capital and
non-capital assets
iv. Sale of personal residence
(a)
Every two years
(1) $250,000 in gain sheltered
(2) $500,000 for married couples
(3) No rollover requirement
9. Adjustments to income
a. Reduction of gross income to taxable income
b. Gross income less deduction = taxable income
c. Taxpayers may choose standard deduction or itemized deductions
i. Standard deduction
(a) Set amount based on tax status (single, married,
etc.)
ii. Itemized deductions
(a) Certain items are deductible
(1) Medical and dental expenses that exceed
7.5% adjusted gross income deductible
[a] Does not include bills for which
taxpayer was reimbursed
[b] Health insurance—self-employed
health insurance premiums (to a
degree)
(2)
Taxes
[a] Deduction for certain taxes already
paid
14
[1] State, local, and foreign income
taxes
[2]
State, local, and foreign real
estate taxes
[3] state and local personal
property taxes
[b] Non-deductible taxes
[c] Estate taxes
[d] Federal income taxes
[e] Social security taxes
[f]
Fines for delinquent tax payments
(3) Foreign taxes payable in certain
circumstances
(b)
Interest
(1) Only certain items of interest are deductible
(2) Personal interest not deductible
(3) Certain personal interest is deductible
[a] Student loan interest (restrictions)
[b] Mortgage loan interest, most home
equity interest, and points paid up
front to purchase property
[1] Investment interest
[2] Business interest
(4) Charitable gifts
[a] To charity or nonprofit under IRC sec
170
[b] No quid pro quo
[c] Necessity of paper trail for larger gifts
(exceeding $500)
(c)
Casualty and theft losses
15
(1) Must document ownership, the nature of the
loss, and value of property lost
(2) First $100 of loss is not deductible
(3) To determine loss, use adjusted basis or
decrease is FMV caused by loss (whichever
is less)
(d)
Job and miscellaneous expenses
(1) Travel expenses
(2) Meals and lodging
[a] Up to 50% of meals if on business trip
(3) Entertainment (50% deductible)
(4) Gifts ($25 limit)
(5) Union dues and license fees required as a
condition of the taxpayer’s job
[a] Fees to become licensed are not
deductible
(6) Tax preparation fees
(7) Accounting and legal fees related to
production or maintaining of income
(e)
Moving expenses
(1) New job must be more than 50 miles away
from current job
(2) Job must be full time
(3) Taxpayer must maintain new job for 39
weeks
(4) Special provisions for the self-employed
10. Alternative Minimum Tax (AMT)
a. Additional tax on persons above a certain income
b. See Klaassen
16
11. Tax Credits
a. Direct reduction of taxes due
b. Child and dependent care
i. Amounts expended for care of child under age 13 or
disabled dependent
ii. Care must be necessary for taxpayer to seek employment
iii. Child or dependent must live with the taxpayer
iv. Limitations:
(a) Credit cannot exceed earned income for year
(b) Credit cannot exceed specific maximum dollar limit
(c) Must subtract any reimbursements from employer
(d) Credit calculated as a percentage of adjusted gross
income as per IRS tables
c. Employer taxes for household help
i. Employer contributions for employee’s taxes are permitted
as tax credit
d. Credit for elderly and disabled
i. Over 65 or errantly disabled
ii. U.S. citizens or permanent residents
iii. Schedule R
iv. Limited by amount of AGI and the amount on non-taxable
Social Security benefits
e. Child care credit
i. Note difference from dependent allowance
ii. For children under 17
(a) U.S. citizens or permanent resident
(b) Dependent of taxpayer
iii. Maximum credit is $500
f. Education credits
i. Hope credit
17
(a) Up to $1500 for tuition and related expenses
(b) For eligible students who are at least part time
(c) No convicted felons
(d) For first two years of college—can only be taken in
two years
ii. Lifetime learning credit
(a) Taken for tuition and related expenses
(b) For any educational period (lifetime)
g. Earned income credit
i. For low income taxpayers
ii. Criteria
(a) Valid social security card
(b) Cannot file “Married filing separately”
(c) Must be U.S. citizen or lawful permanent resident
(d) Cannot file for Foreign Earned Income Credit
(e) Investment income must be below threshold
(f)
Must have earned income from salaries, wages, or
tips or be self-employed
(g) Must have qualifying child or disabled dependent
h. Foreign tax credit
i. Option instead of foreign taxes deduction discussed earlier
ii. Direct credit for foreign income taxes paid
i. Adoption credit
i. Credit up to $5000 for adopting a disabled person or a minor
12. Ethical concerns
a. Is there a reasonable legal argument for reporting an item?
b. Cannot advise to hide income or exaggerate expenses
18
Study Tips
This chapter addresses the consequences of the federal tax system on
individual taxpayers.
An effective way to study the basics of individual taxes is to review federal form
1040.
Also be aware of who is liable for filing individual federal income tax forms
1. U.S. citizens
2. Residents of the United States and Puerto Rico
Also note the different filing statuses that taxpayers may select:
1. Single
2. Married filing jointly
3. Married filing separately
4. Head of household
5. Qualified widow(er) with dependent child
Be aware of the different personal exemptions that are available for taxpayers:
1. Personal exemptions
2. Dependent exemptions—note that there can be an issue as to who may
claim dependent exemptions (this occurs with the children of divorced
parents)
Note that income includes all income—gross income is described as “all
income from whatever source derived.” Taxable income is calculated by
subtracting deductions from gross income to arrive at a taxable income figure.
19
All the following items qualify as gross income:
1. Wages and salaries
a. Exceptions for fringe benefits offered to all employees
b. Non-discriminatory test to determine whether fringe benefits are
taxable
i. Qualified employee discount not exceeding 20% of services
not taxable
ii. Qualified employee discount not exceeding the employer’s
gross profit on the item not taxable
iii. Working condition fringe benefit (company cars)
iv. De minimus benefits
v. Qualified transportation (limited)
vi. Qualified moving expenses
vii. Athletic facilities on employer’s premises or operated by
employer for employees and families
2. Interest and dividends
a. Interest from use of money from passive investments
b. Dividends from share of profits of business
c. Discussion of the concept of basis
i. Adjusted basis issues
3. Rental income
a. Advance rents—taxable in year received
b. Security deposits
c. Reduced by expenses of maintenance
i. Expenses apportioned between rental and personal use
4. Retirement income
a. Annuities
i. return of contributions not taxable
ii. amount apart form contribution is taxable
b. General Rule and simplified rule of distributions
20
5. Other income
a. Alimony
i. Income to recipient
ii. Deduction for the payor
b. Court awards
c. Cancelled debts
d. Barter goods (value quantified and counted as income)
e. Royalties
Note that the de minimus rule allows certain items to be nontaxable (the value
of coffee that you have at work, for example).
Also note that items that are traded through bartering and are quantifiable (that
are capable of assignment of value) are taxable as well.
Certain items of income are not subject to federal tax:
1. Accident and health insurance benefits
2. Proceeds from a life insurance policy
3. Gifts
4. Government transfer payments (public assistance, welfare, and veteran’s
benefits)
5. Scholarships
a. tuition, fees, books, supplies, and equipment not taxable
b. room, board, or other living expenses are taxable
Note the outcome of Lucas v. Earl regarding allocation of income. The person
who earns income reports income. Income shifting to someone else is not
acceptable.
21
Note that there is a detailed and painstaking way to determine gains and losses,
and thus what is taxable under the tax code. It is important to determine what a
taxpayer’s basis is in a property sold or exchanged, because the basis is
subtracted from the property’s value in order to determine the taxable gain:
1. Determination of basis
a. Cost of purchase plus sales tax, professional fees, freight and
storage fees, and other acquisition fees
b. For gifts, taxpayer’s basis is donor’s basis for gains; for losses, basis
is FMV on date of gift
c. Step up in basis to FMV or donor’s basis for testamentary gifts
(whichever is highest)
d. As compensation for services, property’s basis is FMV of services
e. Like-kind exchange
i. Property received must be similar to property given and must
be held for business use
ii. Basis of property originally transferred remains as basis
iii. No tax due on exchange date
iv. See Maxwell v. U.S.
Note that there are certain events that are non-taxable:
1. Gifts
2. Transfers between spouses
3. Like-kind exchanges
Note that there are certain items that qualify for capital gain or loss
treatment:
1. Capital Assets
a. Property owned and used for personal purposes and investment
b. Long-term gain or loss—asset held for more than one year
22
c. Short-term gain or loss—asset held for less than one year
2.
Non-capital Assets
a. Business’ inventory, accounts receivable
b. Different tax rates apply
Note that there are special rules for the sale of one’s primary personal
residence:
1. Every two years
2. $250,000 in gain sheltered
3. $500,000 for married couples
4. No rollover requirement to a new house
Remember that once gross income is determined, a taxpayer performs
adjustments to income that result in a reduction of gross income to taxable
income:
1. Gross income less deduction = taxable income
2. Taxpayers may choose standard deduction or itemized deductions
a. Standard deduction is a set amount based on tax status (single,
married, etc.)
b. Itemized deductions—certain items are deductible
i. Medical and dental expenses that exceed 7.5% adjusted
gross income deductible
1. (a)
Does not include bills for which taxpayer was
reimbursed
2. (b)
Health insurance—self-employed health
insurance premiums (to a degree)
ii. Taxes
(a)
Deduction for certain taxes already paid
(1) State, local, and foreign income taxes
(2) State, local, and foreign real estate taxes
23
(3) State and local personal property taxes
(b) Non-deductible taxes
(c) Estate taxes
(d) Federal income taxes
(e) Social security taxes
(f)
Fines for delinquent tax payments
(g) Foreign taxes payable in certain circumstances
iii. Interest
(a) Only certain items of interest are deductible
(b) Personal interest not deductible
(c) Certain personal interest is deductible
(1) Student loan interest (restrictions)
(2) Mortgage loan interest, most home equity
interest, and points paid up front to purchase
property
[a] Investment interest
[b] Business interest
iv. Charitable gifts
(a)
To charity or nonprofit under IRC sec 170
(b) No quid pro quo
(c) Necessity of paper trail for larger gifts (exceeding
$500)
v. Casualty and theft losses
(a)
Must document ownership, the nature of the loss,
and value of property lost
(b) First $100 of loss is not deductible
(c) To determine loss, use adjusted basis or decrease is
FMV caused by loss (whichever is less)
vi. Job and miscellaneous expenses
(a) Travel expenses
24
(b) Meals and lodging
(1) Up to 50% of meals if on business trip
(c) Entertainment (50% deductible)
(d) Gifts ($25 limit)
(e) Union dues and license fees required as a condition
of the taxpayer’s job
(1) Fees to become licensed are not deductible
(f) Tax preparation fees
(g) Accounting and legal fees related to production or
maintaining of income
vii. Moving expenses
(a) New job must be more than 50 miles away from
current job
(b) Job must be full time
(c) Taxpayer must maintain new job for 39 weeks
(d) Special provisions for the self-employed
Although this tax is not seen for most taxpayers, high-income taxpayers can be
subject to the Alternative Minimum Tax (AMT), which is an additional tax on
persons above a certain income. Students should be aware that it exists.
Note that after tax income is determined, tax credits are applied—to reduce the
total amount owed. Be aware of the difference between tax credits and tax
deductions. Tax credits are a direct reduction of taxes due. Following are
examples:
1. Child and dependent care
a. Amounts expended for care of child under age 13 or disabled
dependent
b. Care must be necessary for taxpayer to seek employment
c. Child or dependent must live with the taxpayer
25
d. Limitations:
i. Credit cannot exceed earned income for year
ii. Credit cannot exceed specific maximum dollar limit
iii. Must subtract any reimbursements from employer
iv. Credit calculated as a percentage of adjusted gross income
as per IRS tables
2. Employer taxes for household help
a. Employer contributions for employee’s taxes are permitted as tax
credit
3. Credit for elderly and disabled
a. Over 65 or permanently disabled
b. U.S. citizens or permanent residents
c. Schedule R
d. Limited by amount of AGI and the amount on non-taxable Social
Security benefits
4. Child care credit
a. Note difference from dependent allowance
b. For children under 17
i. U.S. citizens or permanent resident
ii. Dependent of taxpayer
c. Maximum credit is $500
5. Education credits
a. Hope credit
i. Up to $1500 for tuition and related expenses
ii. For eligible students who are at least part time
iii. No convicted felons
iv. For first two years of college—can only be taken in two
years
b. Lifetime learning credit
i. Taken for tuition and related expenses
26
ii. For any educational period (lifetime)
6. Earned income credit
a. For low income taxpayers
b. Criteria
i. Valid social security card
ii. Cannot file “married filing separately”
iii. Must be U.S. citizen or lawful permanent resident
iv. Cannot file for Foreign Earned Income Credit
v. Investment income must be below threshold
vi. Must have earned income from salaries, wages, or tips or be
self-employed
vii. Must have qualifying child or disabled dependent
7. Foreign tax credit
a. Option instead of foreign taxes deduction discussed earlier
b. Direct credit for foreign income taxes paid
8. Adoption credit
a. Credit up to $5000 for adopting a disabled person or a minor
Be aware that there are ethical concerns when you prepare a 1040. Ask yourself
if there a reasonable legal argument for reporting an item as a deduction or
credit. You cannot advise a client to hide income or exaggerate expenses.
27
Application Exercises
1. Identify the different consequences of a taxpayer’s filing her return as
married filing jointly or married filing separately. Are there instances
where it is appropriate or advisable for a married person to file
separately? What advantages do married persons give up by choosing
that filing status? Place your conclusions in a short memorandum that is
backed up by your source material.
2. Complete a form 1040 for yourself using your current financial situation. If
you feel more comfortable, you may make up fictional facts to complete
this assignment. Do not include your real social security number on the
form. Complete the form twice—once using the standard deduction and
once using itemized deductions. In which scenario do you fare better?
Why?
3. Explain the treatment of alimony under the tax code. What tax impact
does the payment of alimony have on the payor of alimony? on the
recipient? Are there any limitations to this rule? Explain in detail and
back up your work with source material.
4. Frank Barber bought a house in 1960 for $10,000. He died in 2004 when
his house was worth $400,000. Just before Frank’s death, his adjusted
basis in the house was $50,000 after accounting for all the repair work
that he performed on the house over the years. His daughter, Frances,
inherited the house on his death. What is Frances’ basis in the house?
Explain in detail and back up your work with source material.
5. John Smith owes $10,000 to Mary Jones. Mary cancels the debt. Does
John Smith have any income tax issues because of this cancellation?
Explain in detail and back up your work with source material.
28
Internet Exercises
1. Go to the IRS Web site at http://ww.irs.gov and find the IRS’ explanation
of the Earned Income Tax Credit. Download that explanation and prepare
a brief one-page memorandum summarizing its key provisions. Include
the downloaded information as an addendum to your memorandum. Do
not cut and paste from a Web site—put this in your own words.
2. Go to the U.S. Congress Joint Committee on Taxation Web site at
http://www.house.gov/jct/ and research what bills the committee is
currently considering that would impact individual taxation. Download
the information and prepare a brief one- to three-page memorandum
summarizing the current bill. Analyze the bill. Do you support it? Why or
why not? Be specific. Include the downloaded information as an
addendum to your memorandum. Do not cut and paste from a Web
site—put this in your own words.
3. Research on the Internet at least two different software or accounting
companies that offer tax preparation software. What are the costs and
benefits of utilizing such software? From your research, does the IRS
encourage or discourage online or computerized tax preparation and
filing? Why? Prepare a brief one- to two-page memorandum summarizing your findings. Do not cut and paste from a Web site—put this in
your own words.
29
Review Quiz
1. All U.S. citizens are liable for filing their tax returns each year. True or
false?
2. A taxpayer who was married on December 31 of the tax year must file
either married filing jointly or ________________.
3. Both divorced parents of a minor child may claim the child as a
dependent to gain a tax exemption. True or false?
4. Gross income is defined as “all income from whatever source derived.”
True or false?
5. The de minimus rule means that the value of items like employerprovided coffee is includable in an employee’s gross income. True or
false?
6. A company car is generally not taxable. True or false?
7. Alimony is a deduction to the payor and income to the recipient. True or
false?
8. Proceeds from a life insurance policy are generally taxable. True or
false?
9. There are different tax schedules for ordinary income and capital gains.
True or false?
10. Long-term capital assets are held for more than _____________.
11. In order to shelter the gains from the sale of a personal residence, a
taxpayer must roll over the gains into a new home. True or false?
12. Itemized deductions are always required. True or false?
13. Personal interest is generally not deductible. True or false?
30
Review Quiz Answers
1. True.
2. married filing separately
3. False. Only one parent may claim the child.
4. True.
5. False. The rule provides that such small items are not includable in
income.
6. True.
7. True.
8. False.
9. True.
10. one year
11. False. Sale of personal residence is sheltered once every two years.
$250,000 in gain is sheltered for a single person and $500,000 for married
couples. There is no rollover requirement.
12. False. A taxpayer, in most cases, has a choice to select either itemized or
standard deductions.
13. True. Except in certain circumstances (like student loans and home
mortgage interest deductions), personal interest is not deductible.
31
Chapter 3: Income Taxation of the Sole
Proprietorship
Lecture Notes
Chapter 3 addresses the income taxation of the sole proprietorship. The major
points for lecture are:
1. Defining the sole proprietorship
a. One person owns and operates a business as himself or herself
b. All that is needed is a declaration that the person is “in business”
c. Generally no specific filings required (not considering local
operational licenses, etc.)
d. If no employees, operates under owner’s social security number
e. If employees are hired, must obtain a TIN
f. Note federal form SS-4
2. Advantages of the sole proprietorship
a. Legally, no distinction between person and business
b. All income is deemed to be income of owner
c. Owner may have benefit of certain deductions not otherwise
available
i. Portions of rent, utilities, and other expenses that are
directly attributable to the operation of the business
d. Items are reported on Schedule C
3. Income of a sole proprietorship (as shown on Schedule C)
a. Gross receipts
i. From sale of product and rents in the ordinary course of
business
ii. Interest and dividends attributable to the sole proprietorship
iii. Working capital (from loans) is not gross receipts income
32
b. Gross profit
i. Gross receipts less:
(a)
Returns (self-explanatory) and allowances
(discounts)
(b)
Cost of goods sold
(1) Costs related to manufacturing product or
providing a good
(2) If business does not manufacture a product
(usually service companies such as law
firms), there is no COGS
4. Expenses of a sole proprietorship (as shown on Schedule C)
a. Must be directly attributable to the ordinary and necessary
operating expenses of operating the sole proprietorship
b. Advertising
c. Bad debts
i. Uncollectible—must provide evidence
d. Car expenses
i. Exception—commuting miles
ii. Pro-rated between business and personal miles
e. Commissions and fees
i. Licensing fees
ii. Commissions to sales personnel
f. Depletion
i. Natural resources due to use
ii. Calculated over life expectancies
g. Depreciation
i. Taxpayer may deduct a percentage of the item’s total cost
until its useful life is exhausted
ii. Straight line or accelerated deprecation
iii. Method depends on character of item under ACRS
33
iv. IRC Section 179 deduction and relationship to depreciation
over time
h. Employee Benefit programs
i. Certain employee benefits are allowable as deductions
i. Insurance
i. Exception—health insurance
ii. Fire, theft, casualty, and so on, deductible
j. Interest
k. Legal and professional services
l. Office expenses
m. Pension and profit sharing plans
n. Rent of facilities for operating business
o. Repairs and maintenance
i. Costs of repairing and maintaining equipment
p. Supplies
i. All other office and business supplies (postage, paper, etc.)
q. Taxes and licenses
i. Local and state taxes and license fees required for doing
business
r. Travel, Meals, and Entertainment
i. Same requirements as discussed in chapter 2
s. Utilities
t. Wages paid to employees
u. Other expenses
i. Subscription to trade journals
ii. Gifts
5. Ethical concerns
a. Business versus personal expenses
b. Issues when business is operated from sole proprietor’s home
6. Schedule C must be filed for each business run by a sole proprietor
34
Study Tips
This chapter addresses the consequences of the federal tax system on a sole
proprietorship.
An effective way to study the basics of individual taxes is to review federal form
1040.
Note that a sole proprietorship is defined as a business that one person owns
and operates as himself or herself. All that is needed is a declaration that the
person is “in business.” Generally, no specific filings are required (not
considering local operational licenses, etc.).
Note that if there are no employees, the business operates under the owner’s
social security number. If the owner hires employees, he or she must obtain a
TIN using federal form SS-4.
Note that there are several advantages to the sole proprietorship:
1. Legally, no distinction between person and business
2. All income is deemed to be income of owner
3. Owner may have benefit of certain deduction not otherwise available
a. Portions of rent, utilities, and other expenses that are directly
attributable to the operation of the business
4. Items are reported on Schedule C
Schedule C of form 1040 is a great study guide to help the student to understand
the basic determination of the income of a sole proprietorship:
1. Gross receipts
a. From sale of product and rents in the ordinary course of business
35
b. Interest and dividends attributable to the sole proprietorship
c. Working capital (from loans) is not gross receipts income
2. Gross profit
a. Gross receipts less:
i.
Returns (self-explanatory) and allowances (discounts)
ii.
Cost of goods sold
(a)
Costs related to manufacturing product or providing a
good
(b)
If business does not manufacture a product (usually
service companies such as law firms), there is no
COGS
Expenses of a sole proprietorship (as shown on Schedule C) are also great
study/comprehension tools. Remember that expenses must be directly
attributable to the ordinary and necessary operating expenses of the sole
proprietorship. Examples of expenses are the following:
1. Advertising
2. Bad debts
a. Uncollectible—must provide evidence
3. Car expenses
a. Exception—commuting miles
b. Pro-rated between business and personal miles
4. Commissions and fees
a. Licensing fees
b. Commissions to sales personnel
5. Depletion
a. Natural resources due to use
b. Calculated over life expectancies
6. Depreciation
36
a. Taxpayer may deduct a percentage of the item’s total cost until its
useful life is exhausted
b. Straight line or accelerated deprecation
c. Method depends on character of item under ACRS
d. IRC Section 179 deduction and relationship to depreciation over
time
7. Employee benefit programs
a. Certain employee benefits are allowable as deductions
8. Insurance
a. Exception—health insurance
b. Fire, theft, casualty, etc. deductible
9. Interest
10. Legal and professional services
11. Office expenses
12. Pension and profit sharing plans
13. Rent of facilities for operating business
14. Repairs and maintenance
a. Costs of repairing and maintaining equipment
15. Supplies
a. All other office and business supplies (postage, paper, etc.)
16. Taxes and licenses
a. Local and state taxes and license fees required for doing business
17. Travel, Meals, and Entertainment
a. Same requirements as discussed in chapter 2
18. Utilities
19. Wages paid to employees
20. Other expenses
a. Subscription to trade journals
b. Gifts
37
Also be aware that there are ethical concerns present because of the close
relationship between the person and his or her business. That can lead to a
blurring of business versus personal expenses. There are especially issues
when the business is operated from the sole proprietor’s home.
Finally, note that a separate Schedule C must be filed for each business run by a
sole proprietor.
38
Application Exercises
1. Can you explain why a businessperson would choose a sole proprietorship despite the fact that he or she has no protection against personal
liability under that form of business? Give a detailed answer in a short
memorandum format.
2. Procure a Schedule C to form 1040. Complete the Schedule C for
yourself. Assume that you are running a sole proprietorship (now is your
chance to start that fantasy business!). You may make up fictional facts to
complete this assignment. Do not include your real social security
number on the form.
3. John Smith runs a sole proprietorship. As a part of his business, he uses
his automobile. He uses the automobile for 15,000 miles per tax year.
3,000 of those miles are for commuting between home and the office,
5,000 of those are personal miles, and the remainder are for travel
between client work sites. What are the tax ramifications of John’s use
of the automobile?
4. Research the Section 179 deduction. How is that deduction useful to the
sole proprietor? Can you identify any instances where it could be
abused?
5. When must a sole proprietor obtain an employer (taxpayer) identification
number? How is that accomplished? Obtain the correct form to obtain
an EIN and complete it for your fictional business.
39
Internet Exercises
1. Assume that you have just created your new corporation. You wish to
receive your EIN as soon as possible. Go to the IRS Web site at
http://www.irs.gov and determine what methods, if any, there are for you
to obtain the number quickly instead of waiting for it in the mail.
2. Perform research on the Internet, including on http://www.irs.gov, to
determine the probability that you, as a Schedule C filer, will be audited
by the IRS. The IRS and several other organizations publish this
information on the Internet. Prepare a brief one- to two-page
memorandum summarizing your findings.
3. Perform research on the Internet, including on http://www.irs.gov, to
determine when a sole proprietorship must file a full Schedule C and
when it may file a schedule C-EZ. Prepare a brief one- to two-page
memorandum summarizing your findings. Do not cut and paste from a
Web site—put this in your own words.
40
Review Quiz
1. Sole proprietor obtains an EIN (TIN) on federal form _________ when he
or she hires an employee.
2. The sole proprietor is legally the same entity as his business. True or
false?
3. The expenses of a sole proprietorship (as shown on Schedule C) must be
directly attributable to the ________________________ operating expenses
of the sole proprietorship.
4. The sole proprietor has immunity from the debts of the business. True or
false?
5. The sole proprietor files the business tax returns on Schedule C to form
1040. True or false?
6. Commuting miles are deductible by the sole proprietor. True or false?
7. A sole proprietor can generally begin and end the business’ existence
without any type of official filing. True or false?
8. Interest paid on business debt is deductible. True or false?
9. Only one Schedule C must be filed for all of the sole proprietor’s
businesses. True or false?
10. Local and state taxes and license fees required for doing business are
deductible by the sole proprietorship. True or false?
41
Review Quiz Answers
1. SS-4.
2. True.
3. ordinary and necessary
4. False. The sole proprietor has liability for debts (including tax debts) of
the business.
5. True.
6. True.
7. True.
8. True.
9. False. A separate Schedule C must be filed for each business run by a
sole proprietor.
10. True.
42
Chapter 4: Income Taxation of Partnerships
Lecture Notes
Chapter 4 addresses the income taxation of partnerships. The major points for
lecture are:
1. Defining limited and general partnerships
a. General partnership is an association of two or more persons
engaged in business for profit as co-owners.
b. Limited partnership is defined as an association of two or more
persons engaged in business for profits as co-owners, with one or
more general partners and one or more limited partners.
c. General partners have unlimited personal liability for the
obligations of the partnership.
d. Limited partners are insulated from liability beyond their
contribution to the business.
e. LLCs (Limited Liability Companies) are treated as partnerships for
tax purposes (can elect in certain circumstances to be treated as a
corporation).
2. Partnerships are created under state law—generally does not require
paperwork or formalities to create a general partnership—paper trail
required to create a limited partnership
3. Relevant tax law: IRC 761(a) and 7701(a)(2); Subchapter K
a. Aggregate approach
i. Pass-through tax entity
(a) Files information returns (form 1065-B; Schedule K-1)
(b) Distributive share of partnership income or losses
is imputed to the partners in accordance with the
ownership interest
43
(1)
Distributive share determined by the written
partnership agreement, or distributive shares
can be determined by “substantial economic
effect” generated by each partner’s
contribution
(2)
Two types of profit and loss
[a]
Income or loss from operation of
business is ordinary income or loss
[b]
Return of capital on the partner’s
investment is treated as a capital
gain or loss
(c) Basis for determining gains and loss
(1)
Outside basis—contribution made to
business by partner in order to “buy in” to
business
(2)
Inside basis—represents the partnership’s
overall value as it is operated over time
(3)
Determining basis is a most difficult area of
the basic tax law to understand
(4) Contribution of partner of cash or property to
partnership is not income to the partnership
(5) Contribution of services to the partnership by
a partner can be construed as taxable
income as per Rev. Proc. 93-27
ii. Publicly traded partnerships are treated as corporations for
tax purposes
b. Filing requirements for domestic partnerships (including LLCs)
i. Form 1065
(a) More than 100 partners—must be filed electronically
ii. Elections
44
(a)
Selection to expense certain tangible property
under the Section 179 election
(b)
Depletion allowances
(c)
Involuntary conversions
(d)
Optional adjustments to basis
iii. Trades and activities should be grouped by the partnership
to reflect a reasonable financial method of operation
(similar types of activities can be grouped together,
dissimilar should be grouped apart)
c. Net passive income from certain activities must be treated as
ordinary activities
i. Significant participation passive activities in which the
partner participates more than 100 hours per year
ii. No-depreciable rental property activity (see IRC 167) and
30 percent rule
iii. Passive equity-financed lending
iv. Rental property incidental to a development activity
v. Rental of property to a non-passive activity
vi. Acquisition of an interest in a pass-through entity that
licenses intangible property (royalties for intellectual
property)
d. Permissible deductions after calculating gross profit or loss on
form 1065
i. Salary and wages to employees (not partners)
ii. Guaranteed payments to partners pursuant to the
partnership agreement
iii. Repairs and maintenance
iv. Bad debts
v. Rent
vi. Taxes and licenses
45
vii. Interest
viii. Depreciation
ix. Depletion, except oil and gas depletion
x. Contributions to retirement plans
xi. Contributions to employee benefit plans
xii. Other deductions
(a) Legal fees
(b) Supplies
(c) Insurance premiums
e. Gross profit or loss less deductions equals ordinary income or loss
i. Distribution of the partner’s share of income or loss is
calculated on Schedule K
ii. Characterization of income as ordinary or passive is made
at the partnership level
iii. Reportable items:
(a)
Income (passive or ordinary)
(b)
Deductions for charitable contributions and other
expenses
(c) Credits (low-income housing, etc.)
(d) Investment interest
(e) Self-employment items
(f)
Adjustment and tax preference items
(g) Foreign taxes
(h) Other
iv. The balance sheet requirement of form 1065
(a)
Appears on Schedules L, M1, and M2
(b) No completion requirement if:
(1) Partnership’s receipts for tax year are less
than $250,000
46
(2) Total assets at end of tax year are less than
$600,000
(3) Schedule Ks are filed with the return and
forwarded to the partners on or before the
due date of the return
(c) Balance Sheet
(1)
Assets = Liabilities + Equity
[a] Assets: all items of value that are
owned by the partnership
[b] Liabilities: debts of partnership
[c] Equity: partner’s contributions to the
partnership as well as net gains or
losses
4. Tax accounting for partnerships
a. Exclusion from partnership accounting rules
i. Available if nominal partnership is not actually engaged in
operating an ongoing business
ii. All partners must agree to calculate income on an individual
basis
iii. Two types of partnership qualify for the exclusion
(a) Operating agreement partnership
(1)
Formed for the production, extraction, or
use of property, but not for selling of the
services or property produced or extracted
(2)
Requirements:
[a] Partners own property as co-owners
[b] Each partner can dispose of his or
her share of property
[c] Partners do not jointly sell the
property
47
(b)
Investing partnerships
(1)
Do not operate business but rather invest in
other enterprises
[a]
Partners own property as co-owners
[b]
Each partner can dispose of his or
her share of property
[c]
Partners do not engage in the
conduct of a business, either
directly or indirectly
b. Accounting principles
i. Cash or accrual method is acceptable
ii. If one partner is a C corp, must use cash method
iii. Partnership determines distributive share
iv. Partnership income and loss (distributive share) to partner
is reported on the individual partner’s tax return
v. Partner cannot take a loss that causes outside basis to fall
below 0
vi. Partnership is not entitled to take certain deductions:
(a) Personal exemption
(b) Foreign taxes paid
(c) Charitable contributions
(d) Net operating loss
(e) Other itemized deductions
(f) Deductions allowable to the individual partner
(g) Prevents double deductions
vii. Determining the individual partner’s profit or loss
(a) Ordering rules
(1) Adjust partner’s outside basis
[a] Upward adjustments made on last
day of tax year
48
[b]
Downward adjustments determined
when actual distribution is made
(2) Any actual increase in excess of a partner’s
outside basis is an ordinary gain
(b) At-risk rules
(1)
Partner can only deduct losses to the extent
that partner is “at-risk”
(c) Passive loss limitation
(1)
Losses from passive activities cannot offset
increases from non-passive activities
viii. Determining the partnership’s income or loss
(a) Items reportable in a determination:
(1)
Ordinary profit or loss from the partnership
activities
(2)
Net profit or loss from real estate activities
(3)
Net profit or loss from rental activities
(4)
Gains or losses from the sale or exchange of
a capital asset
(5)
Gain or loss from the sale or exchange of
section 1231 property
(6)
Charitable contributions
(7)
Deductions that pass through to corporate
partners
(b)
(8)
Foreign taxes paid
(9)
Other items of income, loss, and deductions
Partnership must determine other items:
(1)
depreciation method
(2)
non-recognition of gain or loss from
(3)
depletion method
49
5. Partnership distributions
a. Current distributions
i. Any distribution that is not a liquidation of the partner’s
entire interest
ii. Include
(a) Current earnings
(b) Return of capital
(c) Distribution to partner of their contribution resulting
in a decrease in his or her percentage share in the
business
iii. Partnership recognizes no gain or loss
iv. Partner’s adjusted basis lower by amount distributed, but
not lower than 0
v. Partner recognizes gain that amount distributed exceeds
amount of adjusted basis
(a)
Only applies to distributions of cash and
marketable securities
(b)
If distribution is of property, no gain until property
is disposed of
vi. Partner must recognize gain on the distribution of property
that was contributed by the partner to the partnership
within seven years prior to the distribution
(a)
The gain the partner must recognize is lesser to the
difference between the FMV of property and the
adjusted basis; or
(b) The net pre-contribution gain of the property
(c)
Recognition of gain results in an upward
adjustment in the partner’s basis
vii. Partner may recognize the loss resulting from a distribution
if:
50
(a)
The outside basis exceeds the distribution
(b)
The entire partner’s interest is extinguished
(c)
The distribution takes the form of cash, unrealized
receivables, or inventory
viii. Partner’s basis is adjusted for cash and marketable
securities received
ix. Partner’s basis is adjusted for property distributions only
when there is a complete partnership interest liquidation
x. Special rules for inheritance
(a)
Special adjusted basis
b. Liquidating distributions
i. Partner’s interest in partnership terminated
ii. Liquidating partner recognizes any gain for cash so
distributed that exceeds adjusted basis
iii. Loss recognized only if partner receives only cash,
unrealized receivables, or inventory—“hot assets” reducible
to cash
c. Allocation of distributions
i. Pursuant to partnership agreement or in accordance with
“substantial economic effect”
ii. Must logically allocate profits and losses between partners
iii. Alternative economic effect test for limited partnerships and
LLCs
6. Termination of a partnership
a. Tax year ends on date of termination
b. Terminated when:
i. All operations are suspended
ii. Or at least 50% of its total interests are sold or exchanged
within a twelve-month period
iii. No termination if converted to an LLC
51
Study Tips
This chapter addresses the consequences of the federal tax system on a
partnership.
Remember that partnership taxation is by far the hardest concept in tax law to
grasp.
Remember that a general partnership is an association of two or more persons
engaged in business for profit as co-owners. A limited partnership is defined as
an association of two or more persons engaged in business for profits as coowners, with one or more general partners and one or more limited partners.
General partners have unlimited personal liability for the obligations of the
partnership. Limited partners are insulated from liability beyond their
contribution to the business.
Note that LLCs (Limited Liability Companies) are treated as partnerships for tax
purposes (can elect in certain circumstances to be treated as a corporation).
Partnerships are created under state law. Their creation generally does not
require paperwork or formalities to create a general partnership. However, a
paper trail is usually required to create a limited partnership. The relevant tax
law is IRC 761(a) and 7701(a)(2); Subchapter K.
There is an aggregate approach to the taxation of partnerships. They are passthrough tax entities, and they file information returns (form 1065-B; Schedule
K-1).
Note that the distributive share of partnership income or losses is imputed to the
partners in accordance with the ownership interest. That distributive share is
52
determined by the written partnership agreement, or distributive shares can
be determined by “substantial economic effect” generated by each partner’s
contribution. There are two types of profit and loss:
1. Income or loss from operation of business is ordinary income or loss.
2. Return of capital on the partner’s investment is treated as a capital gain or
loss.
There are specific bases for determining gains and losses as well. Outside basis
is determined by the contribution made to the business by a partner in order to
“buy in” to business. Inside basis represents the partnership’s overall value as it
is operated over time. Remember that determining basis is a most difficult area
of the basic tax law to understand.
Note that a contribution of a partner of cash or property to partnership is not
income to the partnership. Contribution of services to the partnership by a
partner can be construed as taxable income as per Rev. Proc. 93-27.
Note the exception: Publicly traded partnerships are treated as a corporation
for tax purposes.
There are certain filing requirements for domestic partnerships (including
LLCs). They all file on form 1065. However, if there are more than 100 partners,
then the form must be filed electronically.
Note that there are certain elections that are available as well:
1. Selection to expense certain tangible property under the Section 179
election
2. Depletion allowances
3. Involuntary conversions
4. Optional adjustments to basis
53
Trades and activities should be grouped by the partnership to reflect a
reasonable financial method of operation (similar types of activities can be
grouped together, dissimilar should be grouped apart).
Note that net passive income from certain activities must be treated as ordinary
activities:
1. Significant participation passive activities in which the partner
participates more than 100 hours per year
2. No-depreciable rental property activity (see IRC 167) and 30% rule
3. Passive equity-financed lending
4. Rental property incidental to a development activity
5. Rental of property to a non-passive activity
6. Acquisition of an interest in a pass-through entity that licenses intangible
property (royalties for intellectual property)
There are many permissible deductions after calculating gross profit or loss on
Form 1065:
1. Salary and wages to employees (not partners)
2. Guaranteed payments to partners pursuant to the partnership agreement
3. Repairs and maintenance
4. Bad debts
5. Rent
6. Taxes and licenses
7. Interest
8. Depreciation
9. Depletion, except oil and gas depletion
10. Contributions to retirement plans
11. Contributions to employee benefit plans
12. Other deductions
a. legal fees
54
b. supplies
c. insurance premiums
The particular distribution of the partner’s share of income or loss is calculated
on Schedule K. Characterization of income as ordinary or passive is made at
the partnership level and is carried down to the partners’ personal return.
There are certain items that are reportable on the partner’s 1040 return:
1. Income (passive or ordinary)
2. Deductions for charitable contributions and other expenses
3. Credits (low-income housing, etc.)
4. Investment interest
5. Self-employment items
6. Adjustment and tax preference items
7. Foreign taxes
8. Other
Be aware that Schedule Ks are filed with the return and forwarded to the
partners on or before the due date of the return.
Note that there is a balance sheet requirement on form 1065. It appears on
schedules L, M1, and M2. There is no completion requirement if:
1. Partnership’s receipts for tax year are less than $250,000
2. Total assets at end of tax year are less that $600,000
A quick review of what a balance sheet shows follows:
1. Assets = Liabilities + Equity
2. Assets: all items of value that are owned by the partnership
3. Liabilities: debts of partnership
55
4. Equity: partner’s contributions to the partnership as well as net gains or
losses
Be aware that certain types of partnerships are excluded from the partnership
accounting rules. They are available if nominal partnership is not actually
engaged in operating an ongoing business. All partners must agree to calculate
income on an individual basis. Two types of partnership qualify for the
exclusion.
1. Operating agreement partnership
a. Formed for the production, extraction, or use of property, but
not for selling of the services or property produced or extracted
b. Requirements:
i. Partners own property as co-owners
ii. Each partner can dispose of his or her share of property
iii. Partners do not jointly sell the property
2. Investing partnerships
a. Do not operate business but rather invest in other enterprises
i. Partners own property as co-owners
ii. Each partner can dispose of his or her share of property
iii. Partners do not engage in the conduct of a business,
either directly or indirectly
There are certain accounting principles that are important to understanding the
taxation of partnerships:
Note that both the cash and accrual methods are acceptable. If one partner is a
C corporation, then the cash method must be used. The partnership
determines each partner’s distributive share. The partnership income and loss
(distributive share) to partner is reported on the individual partner’s tax return.
56
Also note that a partner cannot take a loss that causes his or her outside basis to
fall below 0.
It is important to realize that a partnership is not entitled to take certain
deductions:
1. Personal exemption
2. Foreign taxes paid
3. Charitable contributions
4. Net operating loss
5. Other itemized deductions
These deductions are allowable to the individual partner. It prevents double
deductions.
There are certain steps required to determine the individual partner’s profit or
loss.
1. Ordering rules
a. Adjust partner’s outside basis
i. Upward adjustments are made on last day of tax year
ii. Downward adjustments are determined when actual
distribution is made
b. Any actual increase in excess of a partner’s outside basis is an
ordinary gain
2. At-risk rules
a. Partner can only deduct losses to the extent that partner is “at-risk”
3. Passive loss limitation
a. Losses from passive activities cannot offset increases from nonpassive activities
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There are certain steps required to determine the partnership’s income or loss:
1. Items reportable in a determination
a. Ordinary profit or loss from the partnership activities
b. Net profit or loss from real estate activities
c. Net profit or loss from rental activities
d. Gains or losses from the sale or exchange of a capital asset
e. Gain or loss from the sale or exchange of section 1231 property
f. Charitable contributions
g. Deductions that pass through to corporate partners
h. Foreign taxes paid
i. Other items of income, loss, and deductions
2. The partnership must determine other items as well:
a. Depreciation method
b. Non-recognition of gain or loss from
c. Depletion method
Note the following overview of how partnership distributions are treated:
current distribution is distribution that is not a liquidation of the partner’s entire
interest.
It includes:
1. Current earnings
2. Return of capital
3. Distribution to partner of their contribution resulting in a decrease in his
or her percentage share in the business
Remember that the partnership recognizes no gain or loss. The partner’s
adjusted basis is lowered by the amount distributed, but not lower than 0. The
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partner recognizes gain that amount distributed exceeds amount of adjusted
basis. This item only applies to distributions of cash and marketable securities.
If the distribution is of property, there is no gain until the property is disposed of.
A partner must recognize gain on the distribution of property that was
contributed by the partner to the partnership within seven years prior to the
distribution. The gain the partner must recognize is lesser to the difference
between the FMV of property and the adjusted basis; or the net pre-contribution
gain of the property recognition of gain results in an upward adjustment in the
partner’s basis.
Note that a partner may recognize the loss resulting from a distribution if:
1. the outside basis exceeds the distribution.
2. the entire partner’s interest is extinguished.
3. the distribution takes the form of cash, unrealized receivables or
inventory.
A partner’s basis is adjusted for property distributions immediately only when
there is a complete partnership interest liquidation. Note that there are special
rules for inheritance (stepped up basis).
Note that during a liquidating distribution, the partner’s interest in the partnership is terminated. The liquidating partner recognizes any gain for cash so
distributed that exceeds adjusted basis. The loss is recognized only if the
partner receives only cash, unrealized receivables, or inventory—in other words,
“hot assets” reducible to cash.
The allocation of distributions occurs pursuant to the partnership agreement (if
any) or in accordance with “substantial economic effect.” It must logically
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allocate profits and losses between the partners. There is an alternative
economic effect test for limited partnerships and LLCs.
During the termination of a partnership, the tax year ends on date of
termination. It is terminated when:
1. all operations are suspended.
2. at least 50% of its total interests are sold or exchanged within a twelvemonth period.
There is no termination if the partnership is converted to an LLC.
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Application Exercises
1. Partnerships are created under state law. States generally do not require
paperwork or formalities to create a general partnership. However, a
paper trail is usually required to create a limited partnership. Look up
your state’s law to determine what steps are needed to create a general
partnership. Describe those steps in a memorandum. Be sure to include
citations to your source material.
2. Obtain federal form 1065 and review it. Describe the purpose of Schedule
K. To whom are the Schedule Ks sent after they are completed?
3. What does it mean for a partnership to be a pass-through tax entity?
Describe in detail what “pass-through” tax treatment actually means in
practice. Is this an advantage or a disadvantage? Why? Explain with
reference to your source material.
4. What is the difference between inside basis and outside basis? Explain
with reference to your source material.
5. What is the role of a limited partner in a limited partnership? How does
the limited partner differ from the general partner? What advantages and
disadvantages are inherent in being a limited partner? Explain with
reference to your source material.
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Internet Exercises
1. There is a balance sheet requirement for partnerships as they file their
annual returns. Download form 1065 from the IRS Web site at
http://www.irs.gov and determine from that form and the accompanying
instructions what the threshold requirements are that trigger the balance
sheet requirement. Prepare a brief one- to two-page memorandum
summarizing your findings. Do not cut and paste from a Web site—put
this in your own words.
2. Perform research on the Internet generally and specifically on the IRS
Web site at http://www.irs.gov to determine what the differences are
between outside and inside basis. Prepare a brief one- to two-page
memorandum summarizing your findings. Do not cut and paste from a
Web site—put this in your own words. Include your source material as
an addendum to your memorandum.
3. Perform research on the Internet to find a recent example of a partnership converting to an LLC. Describe the transactions and explain, using
the tax laws, why the transition was or was not considered to be a
termination of the partnership.
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Review Quiz
1. A ______________________ is an association of two or more persons
engaged in business for profit as co-owners.
2. A ______________________ is defined as an association of two or more
persons engaged in business for profits as co-owners, with one or more
general partners and one or more limited partners.
3. Partnerships pay their own taxes. True or false?
4. Partnerships file federal form ___________.
5. There is just one type of profit and loss from the operation of a business.
True or false?
6. ________________ represents the contribution made to the business by a
partner in order to “buy in” to the business.
7. ________________ represents the partnership’s overall value as it is
operated over time.
8. A partnership may generally choose either the cash or accrual method of
accounting. True or false?
9. A partnership may take a deduction for charitable contributions. True or
false?
10. A _________________________ is any distribution that is not a liquidation
of the partner’s entire interest.
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Review Quiz Answers
1. general partnership
2. limited partnership
3. False. Partnerships are pass-through tax entities.
4. 1065
5. False. The two types of profit and loss are income or loss from operation
of business (ordinary income or losses); and return of capital on the
partner’s investment (capital gain or loss)
6. Outside basis
7. Inside basis
8. True.
9. False. A partnership may not take a charitable deduction. It passes
through to the partners.
10. current distribution
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Chapter 5: Income Taxation of Corporations
Lecture Notes
Chapter 5 addresses the income taxation of corporations. The major points for
lecture are:
1. Defining the corporation
a. Legal entity separate from the shareholders
b. Corporation is responsible for its own obligations
c. Limited liability for shareholders
d. Double taxation (for C corporations)
i. Recognized transactions are taxable in current fiscal year
ii. Non-recognition provisions provide a safety valve
(a) Non-recognized = non-taxable in current year
(b) Non-recognition occurs when assets and
investments are merely being changed
(c) Non-recognition tests
(1)
Business purpose test—if not for legitimate
business purpose, then subject to immediate
taxation
(2)
Substance test—is transaction a legitimate
reorganization of assets or a tax avoidance
scheme?
(3)
Step transaction doctrine—series of related
transactions will be viewed as one
transaction
[a]
Binding commitment test—does the
first step bind the parties to
subsequent steps?
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[b]
Mutual interdependence test—is the
first step meaningless without the
subsequent steps?
[c]
End result test—did the parties
view it as part of a single integrated
transaction?
2. Corporations as tax shelters
a. Warnings signs
i. Pre-tax profits that are insignificant compared to the tax
benefits
ii. Parties that can absorb the gain without tax consequences
iii. Minimum economic risk
iv. Transactions that bear little relationship to taxpayer’s
normal endeavors
v. High promoter fees
vi. Requirements that parties maintain strict confidentiality
b. Tax shelters required to list themselves with the government
3. Corporations can be subject to the AMT
4. S corporations
a. Small corporation exception to the double taxation rule
b. Treated as partnerships for the purposes of taxation—pass-through
tax entity
5. Special corporate taxes
a. Accumulated earnings tax
b. Personal holding company tax
6. Balance sheet and income statements
a. Assets = liabilities + equity
b. Equity divided into two subaccounts
i. Capital (called boot if returned to the shareholder)
ii. Retained earnings
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c. Income statements
i. All items of income included less all items of expense
d. Must maintain books and records
7. Dividends
a. Ordinary dividends—distribution of ordinary income to the
investor
b. Liquidating dividends—occurs when there is liquidation of the
corporation—represents capital gains
c. Ordinary dividends come from current or accumulated earnings
and profits of corporation under IRC Section 316
d. Dividends of cash are reportable as ordinary income by the
receiving shareholder
e. Dividends of property—shareholders must report FMV as ordinary
income
f. Dividends of stock—shareholders do not recognize income until it
is sold or exchanged
g. Permissible dividend distributions are regulated by state law
h. Intercorporate dividends
i. Deductions permissible to prevent double taxation of
dividends
ii. Amount of deduction depends upon ownership percentage
of shareholder corporation in the distributing corporation
i. Redemption
i. Corporation exchanges cash or property for its own shares
held by shareholders
ii. Redemption treated as an exchange of property for stock or
as a non-liquidating distribution depending upon facts
(a)
Exchange of property if
(1)
Redemption does not have the same effect
as a dividend
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(2)
The redemption must substantially reduce
the shareholder’s interest in the corporation
pursuant to IRC section 302(b)(2)
(3)
Will be treated as an exchange if results in
complete redemption of all the
shareholder’s stock in the corporation
(4)
Will be treated as an exchange if it is a
partial liquidation of the corporation
8. Reorganizations
a. IRC Sections 354 and 361
b. Corporation may transfer and exchange assets without having to
recognize any gain or loss at the time of such transfer or exchange
c. Six major types of reorganizations
i. “A” reorganizations
(a)
Merger—one corporation takes over assets and
liabilities of another
(b)
Consolidation—two or more corporations form a
new corporation and transfer their assets and
liabilities and business to it
(c)
Tests to determine a type a reorganization:
(1) Continuity in shareholder’s interests
(2) The business enterprise continues to exist as
a business entity
ii. “B” reorganizations
(a)
Corporate exchange that creates a parent—
subsidiary relationship
iii. “C” reorganizations
(a)
Corporate exchange that creates a “holding
company”
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(b)
Holding company does not operate a business but
receives dividends from corporation that acquired
its assets
iv. “D” reorganizations
(a)
Divisive transactions
(1) Split-ups
(2) Spin-offs
(b)
Non-divisive transaction
v. “E” reorganizations
(a)
Recapitalizations—stock splits
vi. “F” reorganizations
(a)
Corporation changes its form
(1) Reincorporation in another state
(2) Conversion to an LLC
9. Form 1120
a. 1120—long form
b. 1120A—short form for smaller corporations
c. Corporations with at least a $500 tax bill must file quarterly
estimated income taxes
d. Review of Form 1120 contents
i. Income
(a) Gross receipts
(b) Cost of goods
(c) Gross profit
(d) Other income items
(e) Discussion of LIFO concepts
ii. Deductions
(a) Limitations on deductions
(1) Some items must be included in adjusted
basis
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(2) List at IRC Section 263A
(b)
Detailed list of deductions on 1120 (not repeated
here)
(1)
Differential in charitable contributions by a
corporation
[a]
Written contribution confirmation
[b]
Deduction must be reduced by gain
if property sold at FMV on the
market
iii. Computation of taxes due
(a)
Line 30 of Form 1120 notes the corporation’s
taxable income
(1)
If taxable income is zero or less; then net
operating loss
[a]
NOL is carried back two years and
then carried forward
[b]
Requires filing of amended returns
for previous tax years
[c]
Corporation may elect not to carry
back
(2) Taxes and penalties determined on lines 31
through 35
(b) Form 1120 schedules
(1)
Schedule A—Cost of Goods Sold
[a] Note that qualifying taxpayers and
qualifying small businesses (smaller
corporations) may deduct the cost of
raw materials and goods purchased
for resale in the year the goods are
sold
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[b] All other corporations must
determine cost of goods sold with
reference to goods on hand at
beginning as compared to end of tax
year
[c] Simplified production method
[1] Certain costs must be capitalized
[d] Simplified resale method
[1] Additional costs are permitted to
be used to determine the cost of
goods sold
(a). Off-site storage and
warehousing
(b). Purchasing, handling,
repackaging, processing,
and transporting
(c). General administrative
costs
(2) Schedule C—Dividends and Special
Deductions
[a] Accounts for dividends received by
corporation as a shareholder of other
corporations
[b] Addresses different types of
dividends received
(3) Schedule E—Compensation of officers
[a] Completed if corporation’s total
receipts are over $500,000
(4) Schedule J—Tax computation
[a] Calculates corporate tax
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[b] Calculates the AMT
(5) Schedule K—Other information
[a] Provides general information about
the operation of the corporation
(6) Schedule L—Balance Sheet
[a] Substantiates the figures reported in
the rest of the return
[b] Must balance
(7) Schedule M1—Reconciliation
[a] Reconciles Schedule L balance
sheet to the tax return as a whole
(8) Schedule M2—Analysis of Unappreciated
Retained Earnings
[a] Indicates distribution of retained
earnings
10. Subchapter S Corporations
a. Domestic corporation with one class of stock and no more than 75
shareholders
b. Shareholders must be individuals, or certain other organizations
i. Husband and wife are treated as single shareholders
c. Corporation taxed as a pass-through entity like a partnership
d. Status conferred annually by election by all of the shareholders
e. Loss limitations to shareholders
i. Shareholders may not claim more than their basis in their
shares as losses
ii. Excess losses carried forward until basis in shares increases
f. S Corporation may still be taxed for excess net passive income
i. If accumulated earnings and profits from passive
investment income exceeds 25% of gross receipts
ii. Taxable at highest corporate rate
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g. Distributions of appreciated property to shareholders are treated a
recognition events at the corporate level
h. Avoids two tiered levels of taxation
i. Tax filings made on Form 1120S
i. S corporation status revoked with consent of shareholders
holding at least 50% of the shares
ii. Automatically revoked if corporation then fails the
definitional requirements of an S corporation
iii. Automatically revoked if 25% of gross receipts came from
passive investment income for three consecutive years
iv. Note that Form 1120S is far simpler than Form 1120
v. S Corporation does not take charitable deductions—goes to
individual shareholders instead
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Study Tips
This chapter addresses the federal taxation of corporations.
An effective way to study the basics of individual taxes is to review federal form
1120.
Note that the corporation is a legal entity created separate from the
shareholders. The corporation is responsible for its own obligations, while
providing limited liability for the shareholders.
Note that there is double taxation (for C corporations). Recognized transactions
of the corporation are taxable in the current fiscal year.
Note that there are non-recognition provisions that provide a safety valve. If an
item is non-recognized, it is non-taxable in the current year. Non-recognition
occurs when assets and investments are merely being changed.
The non-recognition tests are as follows:
1. Business purpose test—if the transaction is not for a legitimate business
purpose, then the transaction is subject to immediate taxation.
2. Substance test—is the transaction a legitimate reorganization of assets or
a tax avoidance scheme?
a. Step transaction doctrine—a series of related transactions will be
viewed as one transaction
i. Binding commitment test—does the first step bind the
parties to subsequent steps?
ii. Mutual interdependence test—is the first step meaningless
without the subsequent steps?
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iii. End result test—did the parties view it as part of a single
integrated transaction?
Note that corporations are also used as tax shelters. Tax shelters are risky
enterprises that are generally illegal. There are certain warnings signs that will
alert you to a tax shelter scheme:
1. Pre-tax profits that are insignificant compared to the tax benefits
2. Parties that can absorb the gain without tax consequences
3. Minimum economic risk
4. Transactions that bear little relationship to taxpayer’s normal endeavors
5. High promoter fees
6. Requirements that parties maintain strict confidentiality
Tax shelters are required to list themselves with the government.
Note that corporations can be subject to the AMT just as individuals are.
S corporations are a different animal—they have special treatment in some
areas. The greatest benefit of S corporation status is the exception to the double
taxation rule. S corporations are treated as partnerships for the purposes of
taxation. They pay no income taxes. Instead they are pass-through tax entities.
An S corporation is a domestic corporation with one class of stock and no more
than 75 shareholders. The shareholders must be individuals, or certain other
organizations. A husband and wife are treated as single shareholders. S
corporation status is conferred annually by election by all of the shareholders.
In addition, there are loss limitations to the shareholders. Shareholders may not
claim more than their basis in their shares as losses. Excess losses are carried
forward until their basis in shares increases. S Corporations may still be taxed
for excess net passive income if accumulated earnings and profits from passive
investment income exceeds 25% of gross receipts. That excess is taxable at the
75
highest corporate rate. Distributions of appreciated property to shareholders are
treated as recognition events at the corporate level. Tax filings are made on
form 1120S. S corporation status is revoked with the consent of shareholders
holding at least 50% of the shares. It is automatically revoked if the corporation
then fails the definitional requirements of an S corporation. It is also
automatically revoked if 25% of gross receipts came from passive investment
income for three consecutive years. Finally, an S Corporation does not take
charitable deductions—goes to individual shareholders instead.
There are special corporate taxes to note: the accumulated earnings tax and the
personal holding company tax.
As in the partnership discussion in the previous chapter, the balance sheet and
income statements matter in corporate taxation. As always, assets = liabilities
+ equity. Equity is divided into two subaccounts: capital (called boot if returned
to the shareholder) and retained earnings.
Income statements detail all items of income included less all items of expense.
The corporation has an obligation to maintain these books and records.
Note the different types of dividends:
1. Ordinary dividends—distribution of ordinary income to the investor
2. Liquidating dividends—occur when there is liquidation of the corporation
—represent capital gains
Ordinary dividends come from current or accumulated earnings and profits of
the corporation under IRC Section 316. Dividends of cash are reportable as
ordinary income by the receiving shareholder. Dividends of property are
reported at FMV as ordinary income by the shareholder. Dividends of stock are
not recognized as income until they are sold or exchanged.
76
The types of permissible dividend distributions are regulated by state law.
There are special rules for intercorporate dividends. Deductions are allowed to
prevent double taxation of dividends. The amount of deduction depends upon
ownership percentage of the shareholder corporation in the distributing
corporation.
Redemption is best explained as when a corporation exchanges cash or
property for its own shares held by shareholders. Redemption is treated as an
exchange of property for stock or as a non-liquidating distribution depending
upon facts. It is an exchange of property if
1. redemption does not have the same effect as a dividend.
2. the redemption substantially reduces the shareholder’s interest in the
corporation pursuant to IRC section 302(b)(2).
3. it results in complete redemption of all the shareholder’s stock in the
corporation.
4. it is a partial liquidation of the corporation.
Note that reorganizations are dealt with under IRC Sections 354 and 361. A
corporation may transfer and exchange assets without having to recognize any
gain or loss at the time of such transfer or exchange. There are six major types
of reorganizations:
1. “A” reorganizations
a. Merger—one corporation takes over assets and liabilities of
another
b. Consolidation—two or more corporations form a new corporation
and transfer their assets and liabilities and business to it
c. Tests to determine a type “A” reorganization:
i. Continuity in shareholders’ interests
ii. The business enterprise continues to exist as a business
entity
77
2. “B” reorganizations
a. Corporate exchange that creates a parent-subsidiary relationship
3. “C” reorganizations
a. Corporate exchange that creates a “holding company”
b. Holding company does not operate a business but receives
dividends from corporation that acquired its assets
4. “D” reorganizations
a. Divisive transactions
i. Split-ups
ii. Spin-offs
b. Non-divisive transaction
5. “E” reorganizations
a. Recapitalizations—stock splits
6. “F” reorganizations
a. Corporation changes its form
i. Reincorporation in another state
ii. Conversion to an LLC
As we noted earlier, form 1120 is an excellent tool to understand the structure of
corporate taxation. There are two versions of the form, 1120—long form and
1120A—short form for smaller corporations.
Note as well that corporations with at least a $500 tax bill must file quarterly
estimated income taxes.
This is a brief review of the form 1120 contents. It is strongly suggested that
students familiarize themselves with the actual form.
1. Income
a. Gross receipts
b. Cost of goods
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c. Gross profit
d. Other income items
2. Deductions
a. Limitations on deductions
i. Some items must be included in adjusted basis
ii. List at IRC Section 263A
b. Detailed list of deductions on 1120 (not repeated here)
i. Differential in charitable contributions by a corporation
(a) Written contribution confirmation
(b) Deduction must be reduced by gain if property
sold a FMV on the market
3. Computation of taxes due
a. Line 30 of Form 1120 notes the corporation’s taxable income
i. If taxable income is zero or less; then there is a net
operating loss
(a) NOL is carried back two years and then carried
forward
(b) Requires filing of amended returns for previous
tax years
(c) Corporation may elect not to carry back
ii. Taxes and penalties determined on lines 31 through 35
b. Form 1120 schedules are as follows:
i. Schedule A—Cost of Goods Sold
(a) Note that qualifying taxpayers and qualifying
small businesses (smaller corporations) may
deduct the cost of raw materials and goods
purchased for resale in the year the goods are
sold.
79
(b) All other corporations must determine cost of
goods sold with reference to goods on hand at
beginning as compared to end of tax year.
(c) Simplified production method
(1) Certain costs must be capitalized
(d) Simplified resale method
(1) Additional costs are permitted to be used
to determine the cost of goods sold
[a] Off-site storage and warehousing
[b] Purchasing, handling, repackaging, processing, and transporting
[c] General administrative costs
ii. Schedule C—Dividends and Special Deductions
(a) Accounts for dividends received by corporation
as a shareholder of other corporations
(b) Addresses different types of dividends received
iii. Schedule E—Compensation of officers
(a) Completed if corporation’s total receipts are
over $500,000
iv. Schedule J—Tax computation
(a) Calculates corporate tax
(b) Calculates the AMT
v. Schedule K—Other information
(a) Provides general information about the
operation of the corporation
vi. Schedule L—Balance Sheet
(a) Substantiates the figures reported in the rest of
the return
(b) Must balance
vii. Schedule M1—Reconciliation
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(a) Reconciles Schedule L balance sheet to the tax
return as a whole
viii. Schedule M2—Analysis of Unappreciated Retained
Earnings
(a) Indicates distribution of retained earnings
81
Application Exercises
1. Most smaller corporations opt for S corporation status. What are the
advantages of S corporation status? Detail, for instance, the differences
between the double taxation of the C corporation and the pass-through
taxation of the S corporation. Explain with reference to your source
material.
2. Pick a current corporate reorganization in the news. Under IRC Sections
354 and 361, a corporation may transfer and exchange assets without
having to recognize any gain or loss at the time of such transfer or
exchange. There are six major types of reorganizations. What type of
reorganization is your chosen event? Explain with reference to your
source material.
3. Obtain form 1120 and review Schedule A. How does a corporation
determine the cost of goods sold? Explain the process and calculations
in detail with reference to your source material.
4. Research the current corporate tax rates and explain them with
reference to your source material.
5. What is a “tax shelter”? Research and identify a tax shelter and explain in
detail how you determined that the subject of your research is a tax
shelter. Reference your source material.
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Internet Exercises
1. Assume that you have just created your new corporation. You wish to
receive your EIN as soon as possible. Go to the IRS Web site at
http://www.irs.gov and determine what methods, if any, there are for you
to obtain the number quickly instead of waiting for it in the mail.
2. Your corporation must pay estimated taxes at least quarterly. Research
the payment methods available to you through the Electronic Federal Tax
Payment System on the Internet and through the IRS Web site at
http://www.irs.gov. Prepare a brief one- to two-page memorandum
summarizing your findings. Do not cut and paste from a Web site—put
this in your own words.
3. Assume that your corporation has filed an innocently incorrect tax return.
Go to the IRS Web site at http://www.irs.gov and determine what
methods are available to you to correct that return. Download the
appropriate forms and prepare a brief one- to two-page memorandum
summarizing your findings. Attach the materials that you have found to
the memorandum. Do not cut and paste from a Web site—put this in
your own words.
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Review Quiz
1. All corporations are subject to double taxation. True or false?
2. A corporation, and not the shareholders, is responsible for its own
obligations. True or false?
3. The _________________ holds that a series of related transactions will be
viewed as one transaction.
4. Corporations are not subject to the Alternative Minimum Tax (AMT).
True or false?
5. The following is one sign that a corporation is a tax shelter:
_____________________________________________________.
6. Dividends of cash are reportable as ordinary income by the receiving
shareholder. True or false?
7. Ordinary dividends come from ________________________________ of the
corporation under IRC Section 316.
8. For dividends of property, shareholders must report the basis of the
dividend as ordinary income. True or false?
9. Assets = liabilities less equity. True or false?
10. Corporations file their tax returns on form _________.
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Review Quiz Answers
1. False. S corporations are pass-through tax entities.
2. True.
3. Step transaction doctrine
4. False. Corporations are subject to the AMT.
5. Any of the following is acceptable:
a. Pre-tax profits that are insignificant compared to the tax benefits
b. Parties that can absorb the gain without tax consequences
c. Minimum economic risk
d. Transactions that bear little relationship to taxpayer’s normal
endeavors
e. High promoter fees
f. Requirements that parties maintain strict confidentiality
g. Dividends of cash are reportable as ordinary income by the
receiving shareholder
6. True.
7. current or accumulated earnings and profits
8. False. For dividends of property, the shareholders must report FMV as
ordinary income.
9. False. Assets = liabilities + equity
10. 1120
85
Chapter 6: Estate and Gift Taxation
Lecture Notes
Chapter 6 addresses estate and gift taxation. The major points for lecture are:
1. Defining the parties responsible for filing
a. Executor
b. Personal administrator
c. Personally responsible for filing and misapplication of assets
before payment of taxes due
2. Federal form 706 is the federal estate tax return
a. Filing deadlines
i. Due within nine months of date of death
ii. Extension of time possible through form 4768
b. Required to obtain EIN number through SS-4 form
c. Major parts of 706
i. General information
ii. Compilation of total tax due
iii. Tax elections (including valuation date of assets)
iv. General information regarding authority to file return (death
certificate, court authority of personal representative,
description of the beneficiaries of the estate)
v. Recapitulation
3. Filing necessary only if gross taxable estate exceeds the current Unified
Credit amount
a. Unified credit amount that can pass estate tax free:
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i. For decedents dying in 2004—2005
$1.5 million
ii. For decedents dying in 2006—2008
2 million
iii. For decedents dying in 2009
3.5 million
iv. For decedents dying in 2010
No estate tax
v. For decedents dying in 2011
Reverts to prior law
4. Note difference between estate (on a person’s death) and lifetime gifts
taxes
a. Persons may transfer $11,000 worth of property per year per donee
without gift taxation—amount doubled if gifted concurrently with
spouse
b. Gifts above $11,000 must be reported on IRS form 709
i. Excludes
(a) Gifts to spouses
(b) Gifts to charities
(c) Gifts for tuition
(d) Gifts for medical care
c. Amount above $11,000 reduces the $1 million lifetime gift tax
exemption
i. When gift tax exemption reaches $0, then amount above
$11,000 taxable under gift tax rates
5. Form 706 schedules
a. Schedule A
i. Real estate—valued at FMV
ii. Not reduced by value of mortgages on property
iii. IRS places a lien on all real estate owned by a decedent
(a) Lien removed only when 706 is filed and tax paid;
or
(b) IRS is satisfied that no 706 need be filed
(c) Must receive a release from IRS before transferring
assets
b. Schedule B
i. Stocks and bonds
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(a) Publicly traded stocks valued at the mean trading
average for the valuation date
(1) Proved by New York Times or Wall Street
Journal
(2) Died on weekend—average of trading days
before and after death
(b) IRD—income in respect to a decedent
(1) Dividends (ordinary income) payable on
stocks and bonds after date of decedent’s
death is taxable to the beneficiary and gives
beneficiary an estate tax deduction for that
same amount
(c) Closely held stocks
(1) Not easily valued
[a]
Valuation from buy-sell agreement
[b]
Valuation from independent
appraisal
ii. Shares in co-op residences included on Schedule B
iii. Series E government bonds valued at redemption rate on
date of death
iv. Treasury bills and other items traded on the open market
valued as stocks and bonds
c. Schedule C
i. Mortgages, Notes, and Cash
(a)
Decedent is creditor
(b)
Valued at discount rate at date of death
ii. Bank and checking accounts valued at date of death
iii. All valued by letters from bank or institution
d. Schedule D
i. Insurance on decedent’s life
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ii. Taxable even though probably not probatable under state
law
iii. All that is required is that decedent had incident of
ownership in the policy within three years of death
e. Schedule E
i. Jointly held property
(a)
Full value of property included unless proof that
surviving joint tenants contributed to acquisition of
property—then pro-rated
(b)
If surviving joint tenant is a spouse, then half of
value included
f. Schedule F
i. Other miscellaneous property
(a)
All property not otherwise included
g. Schedule G
i. Transfers during decedent’s life
(a)
All transfers without consideration within three
years of death and for which no gift tax was
reported
h. Schedule H
i. Powers of appointment
(a)
All property over which decedent had a general
power of appointment is includable
(b)
If power is only exercisable in favor of persons
other than the decedent, property is not considered
part of the estate
i. Schedule I
i. Annuities
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(a)
If decedent was annuitant and policy had survivor’s
annuity payment provisions, then actuarial value of
the annuity is included as part of the estate
j. Schedule J
i. Funeral and Administrative Expenses deduction
(a)
All reasonable expenses of funeral and burial
(b)
Also deductible on form 1041—one or other can
take deduction
ii. Legal fees (for legal matters, not for an attorney acting as
personal representative)
iii. Accounting fees
iv. Insurance expenses
k. Schedule K
i. All debts owed by decedent are deductible
ii. Must be proven
iii. Must be paid from estate funds
iv. Secured and unsecured debts
l. Schedule L
i. Net losses during administration deduction
ii. Losses for casualty and theft
m. Schedule M
i. Bequests to surviving spouse deduction
ii. Amount of all assets transferred to spouse are deductible
iii. Spouse must inherit outright or receive qualified terminable
interest in property
iv. Q-Tip trusts
v. Unlimited deduction
n. Schedule N
i. Qualified ESOP sales deduction
ii. Abolished
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o. Schedule O
i. Charitable, public, and similar gifts and bequests deduction
ii. Unlimited deduction for gifts to charities
(a)
Charity must qualify as charity under IRS rules
(b)
Value of gift must be proven
(1) Appraisal
p. Schedule P
i. Credit for foreign taxes due
ii. Credit for estate tax paid to foreign governments
q. Schedule Q
i. Credit for tax on prior transfer
ii. Sliding scale of credit for estate tax paid on property that is
currently part of the estate and that the decedent received
from another decedent that paid original tax
iii. Proof and record keeping issues
r. Schedule R
i. Generation skipping transfer
(a)
Transfer where the beneficiaries are two or more
generations removed from the transferor
(b)
$1,000,000 exclusion for gifts
(c)
Two or more generations of beneficiaries—rules
apply
ii. Serious potential planning trap
s. Schedule S
i. Increased estate tax due to excess retirement
accumulations
ii. Repealed in 1997
6. Ethical concerns
a. Multiple fees as scrivener of estate plan and as fiduciary/ personal
representative
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Study Tips
This chapter addresses the federal taxation of estate and gift taxes.
Studying form 706 is the best way to understand the structure of the estate and
gift tax structure.
The party responsible for filing form 706 is the executor or personal administrator. The responsible party is personally responsible for the filing and
misapplication of assets before payment of taxes due.
Note that the filing deadline is within nine months of date of death. There is an
extension of time possible through form 4768. The executor is required to
obtain an EIN number through the SS-4 form.
The major parts of 706 are as follows for review purposes:
1. General information
2. Compilation of total tax due
3. Tax elections (including valuation date of assets)
4. General information regarding authority to file return (death certificate,
court authority of personal representative, description of the beneficiaries
of the estate)
5. Recapitulation
Filing is only necessary if the gross taxable estate exceeds the current Unified
Credit amount.
The current Unified Credit amount (the amount of the estate that can pass
estate tax free):
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1. For decedents dying in 2004–2005
$1.5 million
2. For decedents dying in 2006–2008
2 million
3. For decedents dying in 2009
3.5 million
4. For decedents dying in 2010
No estate tax
5. For decedents dying in 2011
Reverts to prior law
Note the difference between the estate (created on a person’s death) and
lifetime gift taxes. A single person may transfer $11,000 worth of property per
year per donee without gift taxation—and that amount is doubled if it is gifted
concurrently with spouse. All gifts of cash or property valued above $11,000
must be reported on IRS form 709.
The gift tax rules exclude gifts to spouses, gifts to charities, gifts for tuition, and
gifts for medical care.
Note that the amount of the gift above $11,000 reduces the $1 million lifetime
gift tax exemption. When the gift tax exemption is used up and reaches $0,
then the amount above $11,000 is taxable under gift tax rates.
The following is a quick review of the structure of the form 706 schedules:
Schedule A addresses real estate that is valued at FMV. Value is not reduced by
the value of mortgages on property. The IRS places a lien on all real estate
owned by a decedent, and that lien is removed only when 706 is filed and the
tax paid; or the IRS is satisfied that no 706 need be filed. The personal
representative must receive a release from the IRS before transferring assets.
Schedule B addresses stocks and bonds. Publicly traded stocks are valued at
the mean trading average for the valuation date as proved by the New York
Times or Wall Street Journal. If the decedent died on a weekend—use average
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of trading days before and after death. Note that IRD is income in respect to a
decedent and that it appears on this schedule as well. Thus, dividends
(ordinary income) payable on stocks and bonds after date of decedent’s death
is taxable to the beneficiary and gives beneficiary an estate tax deduction for
that same amount. Closely held stocks, on the other hand, are not easily
valued. Valuation can come from a buy-sell agreement or valuation from an
independent appraisal. Note that shares in co-op residences are included on
Schedule B. Series E government bonds are valued at redemption rate on date
of death and appear here. Treasury bills and other items traded on the open
market are valued as stocks and bonds.
Schedule C addresses mortgages, notes, and cash where the decedent is
creditor. These items are valued at discount rate at the date of death. Bank and
checking accounts are valued at the date of death. All are proved by letters
from the appropriate bank or institution.
Schedule D addresses insurance on the decedent’s life. It is taxable even
though it is probably not probatable under state law. All that is required is that
decedent had incident of ownership in the policy within three years of death to
bring it under the estate tax.
Schedule E addresses jointly held property. The full value of the property is
included in the estate unless proof that the surviving joint tenants contributed to
acquisition of property—then it is pro-rated. If the surviving joint tenant is a
spouse, then half of the value is included.
Schedule F addresses other miscellaneous property and all property not
otherwise included in the other schedules.
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Schedule G addresses transfers during the decedent’s life. It includes all
transfers without consideration within three years of death and for which no gift
tax was reported.
Schedule H addresses powers of appointment. All property over which
decedent had a general power of appointment is includable on the schedule. If
power is only exercisable in favor of persons other than the decedent, property
is not considered part of the estate.
Schedule I addresses annuities. If the decedent was an annuitant and the policy
had survivor’s annuity payment provisions, then the actuarial value of the
annuity is included as part of the estate.
Schedule J provides a funeral and administrative expenses deduction. It allows
a deduction for all reasonable expenses of funeral and burial. Note that these
expenses are also deductible on form 1041 so either one form or the other can
take the deduction. It also allows deductions for legal fees (for legal matters,
not for an attorney acting as personal representative), accounting fees, and
insurance expenses.
Schedule K provides that all debts owed by decedent are deductible. These
debts must be proven and must be paid from estate funds. It includes both
secured and unsecured debts.
Schedule L provides a deduction for net losses during the administration of the
estate. It allows for losses for casualty and theft.
Schedule M provides space for the all important bequests to surviving spouse
deduction. Note that all assets that are transferred to a spouse are deductible.
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The spouse must inherit outright or receive qualified terminable interest in
property.
Schedule O provides for the charitable, public, and similar gifts and bequests
deduction. There is an unlimited deduction for gifts to charities. The charity
must qualify as charity under IRS rules and the value of gifts must be proven by
appraisal.
Schedule P provides credit for any foreign taxes due and credit for any estate
tax paid to foreign governments.
Schedule Q provides credit for taxes paid on a prior transfer. There is a sliding
scale of credit for estate tax paid on property that is currently part of the estate
and that the decedent received from another decedent that paid the original
tax.
Schedule R provides for Generation Skipping transfers. It applies when there is
a transfer where the beneficiaries are two or more generations removed from
the transferor. Remember that there is a $1,000,000 exclusion for gifts. The key
item to remember is that if there are two or more generations of beneficiaries,
then the rules apply. This is a serious potential planning trap.
Also note that there can be ethical concerns if there are multiple fees, as for the
professional who serves as both the drafter of the estate plan and as a fiduciary/
personal representative.
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Application Exercises
1. Obtain federal form 706 and review it. How do Schedule A and Schedule
K interrelate with regard to real estate and the debts that are attached to
real estate? Is it appropriate to include the gross value of real estate on
one schedule and then reduce that value with a deduction for debts
secured by that real estate on another schedule? Explain with reference
to your source material.
2. Research what the current Unified Credit amount is. What will the
Unified Credit amount be next year? in 2008? in 2015? Explain with
reference to your source material.
3. John Smith dies with no assets that are part of his probatable estate. He
does, however, have a $3 million insurance policy that he controlled and
that passed to his designated beneficiary. From these facts, what is the
size of John Smith’s estate for federal estate tax purposes, and does his
estate have to file a form 706? Explain with reference to your source
material.
4. Assume instead that John Smith dies with $500,000 in assets in his own
name and no insurance policies. From these facts, does John Smith’s
estate need to file a form 706? Explain with reference to your source
material.
5. Obtain federal form 706 and review it. How does Schedule B value stocks
and bonds held by the decedent’s estate? What is the valuation of a
stock if the decedent passed away on a weekend? Explain with
reference to your source material.
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Internet Exercises
1. Tax law and policy is always changing. Go to the White House’s Web
site at http://www.whitehouse.gov, the U.S. House Web site at
http://www.house.gov and the U.S. Senate Web site at
http://www.senate.gov and find current tax proposals impacting the
estate and gift tax code. Download the text of the proposal(s) and draft a
brief memorandum explaining the proposal(s). Be sure to include
specific links to the source of your information.
2. Perform research on the Internet to determine what any famous person’s
estate has paid in death taxes. If possible, find the return itself and
analyze it. Would that person have paid estate taxes under the present
tax laws? Prepare a brief one- to two-page memorandum summarizing
your findings. Attach the materials that you have found to the
memorandum. Do not cut and paste from a Web site—put this in your
own words.
3. Perform research throughout the Internet and at the IRS Web site at
http://www.irs.gov to determine what the estate tax will be in 2011.
Prepare a brief one- to two-page memorandum summarizing your
findings. Attach the materials that you have found to the memorandum.
Do not cut and paste from a Web site—put this in your own words.
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Review Quiz
1. Form _______________ is the federal trust and estate tax form.
2. Filing the form 706 is necessary nine months after the death of all
persons. True or false?
3. A single person may transfer $11,000 worth of property per year per
donee without gift taxation or the need to file form 706. True or false?
4. IRD is an abbreviation for ___________________________.
5. Closely held stock cannot be valued by the provisions of a buy-sell
agreement. True or false?
6. Insurance on a person’s life is usually not income taxable, but it is subject
to the estate tax. True or false?
7. Schedule _________ of form 706 reports all transfers without
consideration within three years of death and for which no gift tax was
reported.
8. All assets transferred to a surviving spouse are deductible—even if it is
$1 billion. True or false?
9. A generation skipping transfer is a transfer where the beneficiaries are
___________ or more generations removed from the transferor.
10. Bank and checking accounts are valued on the following date as
evidenced by a letter from the financial institution: ________________.
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Review Quiz Answers
1. 706
2. False. Filing is necessary only if the gross taxable estate exceeds the
current Unified Credit amount.
3. True.
4. IRD—income in respect to a decedent
5. False.
6. True.
7. G
8. True.
9. two
10. date of death
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Chapter 7: Fiduciary Income Taxes
Lecture Notes
Chapter 7 addresses fiduciary income taxes. The major points for lecture are:
1. Applies to fiduciaries
a. All executors
b. Administrators
c. Trustees
2. Filed on form 1041
a. All entities with greater than $600 annual income or that have as a
beneficiary a nonresident alien
b. Signed by fiduciary
c. Each beneficiary receives a form K-1
3. Treatment of Grantor trusts
a. Revocable trusts and trusts where grantor has incidents of
ownership that tie them to the trust corpus
b. Grantor trust considered to be part of the grantor for tax persons—
does not pay separate taxes
4. Form 1041 reviewed:
a. General information
i. Computation of income
(a) Includes income with respect of a decedent
(b) Interest income
(c) Ordinary dividends
(d) Business income or loss
(e) Capital gains and losses
(f)
Rents, royalties, partnerships, other estates and
trusts
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(g) Farm income
(h) Ordinary gains (or losses)
(i)
Other income
ii. Deductions
(a)
Limitations for passive investment income
(b)
Interest paid
(c)
Taxes (state, local, and real estate taxes)
(d)
Fiduciary fees
(e)
Charitable deductions
(f)
Attorney, accountant, and return preparer fees
(g)
Other deductions not subject to 2% floor
(h)
Income distribution deduction
(i)
Estate tax deduction for taxes paid on form 706
(j)
Exemptions
iii. Taxes and payments
iv. Schedules
(a)
Schedule A—Charitable deduction
(b)
Schedule B—Income distribution deduction
(1) Distributions from income
(2) Distributions from principal
(3) Distributable net income
(c)
Schedule D—Tax computation
v. Credits
(a)
Foreign tax credits
(b)
General business credit
(c)
Other non-business credits
vi. Income distribution deduction on a minimum tax basis
vii. Alternative minimum tax
viii. Capital gains and losses
5. Schedule K-1
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a. Informational item sent to beneficiaries
6. Ethical concerns
a. Counsel should be qualified before attempting to perform the
financial calculations under a 1041
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Study Tips
This chapter addresses fiduciary income taxes.
Studying form 1041 is the best way to understand the structure of fiduciary
income taxes.
Note that the filing requirements of form 1041 apply to all fiduciaries (executors,
administrators, trustees). All entities with greater than $600 annual income or
that have as a beneficiary a nonresident alien must file. The form is signed by a
fiduciary. Each beneficiary receives a form K-1 to indicate their distribution
from the trust.
Grantor trusts receive a different treatment. Grantor trusts generally are
revocable trusts and trusts where the grantors have incidents of ownership that
tie them to the trust corpus. A grantor trust is considered to be part of the
grantor for tax purposes. It does not pay separate taxes
Form 1041 has the following general components. It is very similar to the
individual’s form 1040 reviewed previously:
1. General information
2. Computation of income
a. Includes income with respect of a decedent
b. Interest income
c. Ordinary dividends
d. Business income or loss
e. Capital gains and losses
f. Rents, royalties, partnerships, other estates and trusts
g. Farm income
h. Ordinary gains (or losses)
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i. Other income
3. Deductions
a. Limitations for passive investment income
b. Interest paid
c. Taxes (state, local, and real estate taxes)
d. Fiduciary fees
e. Charitable deductions
f. Attorney, accountant, and return preparer fees
g. Other deductions not subject to 2% floor
h. Income distribution deduction
i. Estate tax deduction for taxes paid on form 706
4. Exemptions
5. Taxes and payments
6. Schedules
a. Schedule A—Charitable deduction
b. Schedule B—Income distribution deduction
i. Distributions from income
ii. Distributions from principal
iii. Distributable net income
c. Schedule D—Tax computation
7. Credits
a. Foreign tax credits
b. General business credit
c. Other non-business credits
d. Income distribution deduction on a minimum tax basis
Note the primary ethical concerns in completing the 1041—counsel should be
qualified before attempting to perform the financial calculations required here.
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Application Exercises
1. Research grantor trusts. How do they differ from other trusts? How does
one identify a grantor trust, and what benefits are there to intentionally
creating a grantor trust? Explain with reference to your source material.
2. Obtain federal form 1041 and review it. How are fiduciary fees treated for
tax purposes on the forms and its schedules? Explain with reference to
your source material.
3. Obtain federal form K-1. Describe how it relates to the information on
form 1041. Who receives the K-1? Is it filed with the IRS? Explain with
reference to your source material.
4. Who is responsible for filing federal form 1041? Explain with reference to
your source material.
5. Research and detail the tax rates that are currently applicable to nongrantor trusts filing form 1041. Are they more restrictive than the rates
applicable to individuals? Explain with reference to your source material.
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Internet Exercises
1. Go to the IRS Web site at http://www.irs.gov and determine what the
penalties are for a fiduciary who fails to file form 1041. Prepare a brief
one- to two-page memorandum summarizing your findings. Attach the
materials that you have found to the memorandum. Do not cut and paste
from a Web site—put this in your own words.
2. Go to the IRS Web site at http://www.irs.gov and determine what the
filing deadlines are for form 1041. Are there situations where they vary?
Why? Prepare a brief one- to two-page memorandum summarizing your
findings. Attach the materials that you have found to the memorandum.
Do not cut and paste from a Web site—put this in your own words.
3. Search the Internet generally to determine the services available to
fiduciaries to assist them in the preparation of form 1041. Determine the
services and their respective costs. Prepare a brief one- to two-page
memorandum summarizing your findings. Attach the materials that you
have found to the memorandum. Do not cut and paste from a Web
site—put this in your own words.
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Review Quiz
1. Executors, administrators, and _________________ are all fiduciaries.
2. Form 1041 is the fiduciary income tax return. True or false?
3. A _______________ trust is a trust where the creator of the trust has
incidents of ownership that tie him or her to the trust corpus.
4. Schedule _____________ is sent to beneficiaries of trusts to inform them
of their distributions from the trust.
5. All trusts that have greater than $600 annual income or that have as a
beneficiary a nonresident alien must file form 1041. True or false?
6. Attorney, accountant, and return preparer fees are not deductible on
form 1041. True or false?
7. Schedule A of form 1041 deals with ________________________.
8. Form 1041 is very similar to form 1040. True or false?
9. Form 1041 is signed by the beneficiaries. True or false?
10. There is a deduction on form 1041 for estate taxes paid on form 706.
True or false?
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Review Quiz Answers
1. trustees
2. True.
3. True.
4. K-1
5. True.
6. False.
7. charitable deductions
8. True.
9. False. Form 1041 is signed by the fiduciary.
10. True.
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