Tax Accounting- Multiple Choice

CHAPTER 11

· Tax Shelters. Activities providing deductions/credits to an investor which reduce the tax liability with respect to income from other sources.

· At-Risk Rules . Disallow losses that are in excess of an investor’s amount at risk. The disallowed losses are carried over into a future tax year until (and to the extent) the taxpayer becomes at risk. Basically, the argument behind these rules is that an investor should only be able to lose (i.e., deduct) what he/she has really invested (i.e., what he/she put “at risk”). Determining the amount at risk:

Cash invested (common starting point)

+ Adjusted basis of other property invested

+ Borrowings for which investor is personally liable

+ Borrowings for which investor has pledged collateral

+ Allocated portion of income

- Allocated portion of losses

- Withdraws

= Amount at Risk

EXAMPLE

In 2014, Monika invested in the DY Limited Partnership (“DY L.P.”) by paying $50,000 cash and contributing additional assets worth $20,000 (and having a basis equal to $10,000 on the date of the contribution). What amount did Monika have at risk in DY L.P. as of January 1, 2015, if DY L.P. broke even in 2014 (i.e., DY L.P. had no income or loss in 2014)?

a. $0

b. $50,000

c. $60,000

d. $70,000

What if DY L.P. allocated to Monika net income of $5,000 from operations in 2014?

What if Monika also withdrew $10,000 in 2014?

· Classification of Income :

· ACTIVE: If attributed to direct efforts of TP (e.g., salary, wages).

· PASSIVE: Attributed to passive activities (more below) (e.g., operations of a limited partnership when TP is the LP).

· PORTFOLIO: Interest, dividends, annuities, and royalties not derived in the ordinary course of a T or B and gain/loss from sale of property that produces portfolio income (e.g., stocks/bonds).

· Passive Activity Loss Rules. At-Risk rules are applied first. Then, a passive loss (i.e., to the extent the loss amount survives the at-risks rules) can be used the following ways:

· Offset passive income;

· Offset other income (but, only under certain conditions – e.g., fully taxable disposition); and/or,

· Become suspended – may be deductible against future income from passive activities (must keep suspended losses for each activity separate – e.g., in case an activity is disposed of).

· Result of the At-Risk Rules and Passive Activity Loss Rules?

EXAMPLES

Kevin was at risk for $25,000 in Partnership X and $15,000 in Partnership Z on January 1, 2014. Both partnerships are passive activities to Kevin (these are Kevin’s only passive activities). Kevin’s share of net income from Partnership X during 2014 was $10,000. Kevin’s share of losses from Partnership Z during 2014 was $60,000.

Q1: How much is Kevin at risk for Partnership X on January 1, 2015?

a. $35,000

b. $25,000

c. $10,000

d. $0

Q2: How much is Kevin at risk for Partnership Z on January 1, 2015?

a. $60,000

b. $45,000

c. $15,000

d. $0

Q3: Refer to the facts in the previous question. What is Kevin’s carryover under the at-risk rules for Partnership Z in 2014?

a. $60,000

b. $45,000

c. $15,000

d. $0

Q4: Refer to the facts in the previous question. What is amount of the loss from Partnership Z that Kevin may actually deduct in 2014?

a. $60,000

b. $45,000

c. $15,000

d. $10,000

e. $5,000

f. $0

Q5: Refer to the facts in the previous question. What is Kevin’s suspended loss under the passive loss rules for Partnership Z in 2014?

a. $60,000

b. $45,000

c. $15,000

d. $10,000

e. $5,000

f. $0

Q6: Account for the pieces of the 2014 Partnership Z $60,000 loss--- answer 5,000

· Taxpayers Affected by Passive Losses. Individuals, estates, trusts, personal service corporations (basically, C-Corps whose principal activity is the performance of services by employee-owners), and closely held corporations (non-personal service corporations with not more than 5 stockholders owning more than 50% of the corporation) (but the closely held corporations may use passive losses to offset net active income – just not portfolio income – See Example 14). Partners and S-Corp shareholders are hit at the individual level (i.e., as a result of pass-through taxation)

· Passive Activities v. “Material Participation” (and “Active”). A passive activity is any T or B or income producing activity in which the TP does NOT materially participate and generally all rental activities without regard to extent of TP’s participation (but there are exceptions whereby losses from rental-like activities or even rental activities can be treated as active losses).

· Material participation requires TP to be involved in the operations of an activity on a regular, continuous, and substantial basis. See SEVEN TESTS summarized in Table 11.2.

· Per pages 11-14 to 11-15, some rental-like activities (e.g., renting movies for a few days) will NOT be treated as “rental activities” here (and thus these activities may produce active losses – i.e., if a material participation test is satisfied)

· Per page 11-17, losses from real estate rental activities are NOT treated as passive losses for certain real estate professionals (if (i) >50% of personal services TP performs in T or Bs are performed in real property T or Bs in which TP materially participates and (ii) TP performs >750 hours of services in these real property T or Bs as a material participant)

· Per page 11-18 to 11-20, non-real estate professionals may also deduct up to $25,000 of losses from real estate rental activities against active and portfolio income if (i) TP actively participates in the real estate rental activity and (ii) TP owns at least 10% of all interests in the activity.

· Unlike material participation, active participation does not require regular, continuous, and substantial involvement in operations (instead, TP must just participate in making management decisions in a significant and bona fide sense).

· $25,000 amount phases out with AGI (generally, reduced by 50% of TP’s AGI>$100K).

· Identifying an “Activity”. Are two or more undertakings one activity? Important, for example, when deciding whether or not TP is materially participating. Basically, a facts and circumstances approach is used to determine whether or not various undertakings may be treated as a single activity. There is some flexibility in applying the facts and circumstances – if a reasonable method is used (e.g., similarities in types of businesses, extent of common control/ownership, geographical locations, interdependence of the undertakings) (but, it’s generally tough to group rental undertakings with non-rental trades or businesses).

· Disposition of a Passive Activity. If a passive activity is disposed of in a fully taxable transaction, any losses (including suspended losses) may be recognized by the taxpayer in the year of disposition and used to offset active and portfolio income (unless the sale was to a related party).

· Investment Interest Includes investment interest on debt incurred to purchase or carry property held for investment. Limitation on deduction – i.e., the interest deduction is limited to the amount of NET investment income; but, disallowed piece can be carried forward indefinitely.

EXAMPLE. In 2014, Catherine and Tim (who file a joint return) had an interest expense of $5,000 on a loan that was used to purchase a variety of stock and bonds (all producing taxable income). Assume further that, in 2014, Catherine and Tim had net investment income of $2,000. Assume they itemize deductions, what was their maximum interest expense deduction in 2014?

a. $5,000

b. $3,000

c. $2,000

d. $0

CHAPTER 12

WHAT is the AMT and WHY do we have it?

http://www.forbes.com/sites/matthewcampione/2012/05/04/alternative-minimum-tax-explained/

AMT FORMULA – INDIRECT APPROACH (Figure 12.1 on page 12-3; Form 6251 on page 12-23):

i. (Regular) Taxable Income (increased by any standard deduction and exemptions)

ii. Add/subtract net “Adjustments To Taxable Income,” including:

· Itemized deductions: may or may not be allowed - or may be calculated differently (e.g., deduction for taxes and miscellaneous itemized deductions are not allowed for AMT purposes and medical expenses have a 10% of AGI floor regardless of age (i.e., no 7.5% AGI floor for TPs 65 and up))

· Depreciation (amounts may need to be added back or there may be additional deductions)

· Notice how some adjustments are timing differences (whereas others are permanent)

· Circulation expenditures (e.g., costs to establish circulation of a newspaper)

· Incentive stock options (Example 7):

· Fair market value of stock when option exercised less what you paid for stock when option exercised (include this difference – even though you have not sold the stock).

· Net Operating Losses (calculated under special rules and special carryback and carryforward rules)

· Other

iii. Add tax preference items (result = alternative minimum taxable income or AMTI), including:

· Private activity bond interest (usually – but not on bonds issued after 12/31/08 and before 01/01/11)

· Other (e.g., 7% of excluded 1202 gain – but, per Small Business Jobs Act (“SBJA”), bigger break under regular system (0%) & here for stock acquired post-SBJA & before 01/01/14).

· Effect: Govt. takes away tax preference items under regular tax system

iv. Subtract applicable exemption amount (result = NET AMTI or AMT BASE ):

· For 2014 AMT exemption amounts are: $52,800 (single/head of household); $82,100 (joint/qualifying widow(er); and, $41,050 (if married and separate return)

· Exemption is phased-out if AMTI is above a certain level (thus, AMTI is similar to AGI under regular system) (See Example 1)

v. Multiply result by applicable percentage(s) (26%/28%)

· Use of brackets

· Some items (e.g., qualified dividends, long-term capital gains) still get benefit of lower rates (e.g., 20%)

· If subject to the AMT, could be a lower marginal rate (thus incentive to accelerate income to YR)

vi. = tentative minimum tax before foreign tax credit

vii. Less AMT Foreign Tax Credit and personal refundable credits (and eligible small business credits under the SBJA), if any = TENTATIVE MINIMUM TAX

viii. Tentative minimum tax less regular tax liability = AMT

AMT paid in one year may be carried forward indefinitely as a credit against the regular tax liability (to the extent the regular tax liability then exceeds the tentative minimum tax).

Potential problems with AMT (e.g., Compliance Costs/ISOs)?

EXAMPLES

Assume that Jose and Mary file a joint return and have the following items for 2014:

Taxable income: $75,000

Positive adjustments: $45,000

Preferences: $30,000

Regular tax ability: $10,463

What is their AMTI? 75+45+30=150k

What is their exemption amount for the AMT calculation? 82,100

What is their NET AMTI or AMT Base? 67,900

What is their tentative minimum tax? Rate on 1206- answer 17,654

What is their AMT? 7,191 (17,654 – 10,463)

For purposes of this question, assume that Jose and Mary had AMTI of $200,000 what is the amount of their 2014 exemption for the AMT?

200,000 43500*25%

71,225

CHAPTER 13

· Tax Credits: What are they?

· Direct offset of TP’s computed income tax liability. Reduce tax by 100% of the credit.

· Versus exclusions, which reduce taxable income

· Versus deductions, which reduce taxable income

· Also, one does not need to itemize for credits

· Thus, credits are more likely to motivate behavior and be in the spotlight.

· Refundable versus nonrefundable (See Partial Listing in Exhibit 13.1).

· Nonrefundable: NOT treated like prepayments to the government (i.e., TP cannot get a refund of the credit if the credit amount exceeds the gross tax amount).

· Excess may be carried to another tax year (for some credits)

· Refundable: Generally, treated like prepayments to the government.

· Think of withholdings - but also other refundable credits (e.g., the earned income credit and possibly the child tax credit).

· General Business Credit.

· Combines several credits (computed separately under separate rules) into one amount to limit the amount of business credits that can be used to offset TP’s income tax liability

· Per Exhibit 13-1, the separate credits include:

· Tax credit for rehabilitation expenditures

· Work opportunity tax credit

· Research activities credit

· Low-income housing credit

· Disabled access credit

· Credit for small employer pension plan startup costs

· Credit for employer-provided child care

· Any unused credits must be carried back 1 year, then forward 20 years (FIFO method is applied to carrybacks, carryovers, and utilization of credits earned during a particular year)

· For any year, general business credit is limited in amount to TP’s net income tax reduced by the greater of: (a) the tentative minimum tax or (b) 25% of the net regular tax liability that exceeds $25,000:

· See pages 13-6 to 13-7 and Examples 7 and 8 for definitions/illustrations of net income tax, tentative minimum tax, regular tax liability, and net regular tax liability and use of general business credit carryovers.

Other Nonrefundable Tax Credits:

1. Child and Dependent Care Credit . Common scenario: TP has someone take care of kid(s) so TP can work.

· Employment-related expenses can be up to $3,000 for 1 qualifying individual and up to $6,000 for two or more individuals (amounts subject to earned income limits – because purpose is to get/keep TPs working):

i. Maximum expense amounts are reduced by excluded benefits TP received that were provided under an employer-provided dependent care assistance plan (i.e., no doubling up).

ii. Credit = X% of eligible expenses

· Where X is between 20% and 35%.

· Specific % depends on AGI – as AGI increases, X decreases (page 13-23)

· Thus, maximum credit for:

a. 1 qualifying individual is $1,050 (35% x $3,000)

b. 2 or more qualifying individuals is $2,100 (35% x $6,000)

iii. Employment-related expenses:

· Expenses paid for household and personal care of qualifying individuals which are necessary for TP to be gainfully employed or in active search for employment (ordinary and necessary household services to maintain a home; however, child care expenses can occur outside of the home – e.g., daycare).

· Qualifying individuals, include:

· Dependent under 13; or,

· Dependent (of any age) or spouse who is physically/mentally handicapped and lives with TP for >50% of year

· Earned income limitation:

i. If married, both spouses must work (limit looks at lower earned income amount) or have “deemed” earned income – $250 per month if one qualifying individual OR $500 a month if two or more qualifying individuals – because:

· Full-time student, or

· Physically or mentally disabled

Deemed income used only to compute lower earned income amount of the two spouses (i.e., it is not included in income of the taxpayers or used when looking at table on page 13-23).

· Married individuals generally must file a joint return to claim the credit.

EXAMPLE. Thomas and Cristine are married and file a joint return. In 2014, Cristine worked fulltime and earned $32,000, while Thomas attended graduate school fulltime for the entire year (i.e., 12 months). Assume their 2014 AGI equals $32,000. They incurred $9,000 of legitimate child care expenses during 2014 for their THREE dependent children, Sascha, Kayanna and Mayelin (ages 2, 4 and 6, respectively). What is their child and dependent care CREDIT amount? Page 1323

a. $9,000 6000*26%

b. $3,000

c. $1,560

d. $0 (because Thomas did not work during the year)

2. Educational Credits.

· Credits intended to help low and middle-income individuals with certain education costs:

· Can be used for the TP, spouse, and dependents

· Need to also consider impact of education-related deductions and exclusions

· Hope (now called the “American Opportunity” tax credit) THROUGH 2017:

· Up to $2,500 PER student PER year

· 100% of first $2,000 of qualified expenses (i.e., tuition, fees, and course materials) and 25% of the second $2,000 of qualified expenses

· Must be enrolled at least 1/2 time

· Recent “enhancements” include: higher credit amount; higher AGI amounts where phaseouts start at $80K/$160K (phaseout range = $10K; $20K for joint filers); first 4 years of college/secondary education; 40% of the credit may be refundable

· Lifetime Learning:

· 20% credit on up to $10,000 of qualified expenses per year (i.e., tuition, fees, and required course materials)

· Amounts are PER taxpayer – not per student

· No 50% normal course load requirement

· Even graduate work and continuing education programs are eligible (i.e., not just first 4 years of college/secondary education)

· Also $10K ($20K for joint filers) phaseout range with lower AGI phaseout starting points (i.e., $54K/$108K)

3. Child Tax Credit amount = $1,000 per qualified child

· A portion of the credit may be refundable

· Refundable to extent of 15% of TP’s earned income in excess of $3,000 (through 2017), up to the per child credit amount (TPs with 3 or more kids may use an alternative calculation).

· Under the age of 17 on December 31 and claimed as TP’s dependent

· Credit phased out $50 for every $1,000 (or fraction thereof) Modified AGI exceeds:

· $75k (single)

· $110k (married/joint return)

· $55k (married/separate return)

· Eligible child generally uses the same relationships as used in the uniform definition of a child for purposes of the dependency exemption

4. Other nonrefundable credits include :

· Elderly and Disabled Persons Credit (but maximum allowable credit of $1,125 may be reduced by SS benefits or AGI exceeding specified amounts; see page 13-17 to 13-18)

· Credit for Certain Retirement Plan Contributions

i. For 2014, possible for joint return with AGI of $60,000 or less; HOH returns with $45,000 or less; single returns of $30,000 or less

· Adoption Assistance Credit (for 2014, up to $13,190) of qualified adoption expenses per child (also, consider exclusion per Chapter 5)

· Foreign Tax Credit for income taxes paid to foreign countries (U.S. citizens taxed on WWI but “home yields to source”) the credit limited to the lesser of:

i. The foreign taxes paid, or

ii. U.S. tax before the FTC x (FI/WWI)

(Again, consider the potential exclusion as an alternative)

· Residential Energy Property Credit of up to $1,500 (e.g., for purchase of qualified doors, windows, insulation placed in service before 01/01/17) (see Exhibit 13.2 for summary of the energy credits).

Refundable Tax Credits:

a. Credit for withheld taxes on wages

b. Estimated tax payment credit

c. Social Security tax refund credit (e.g., where TP has SS taken out by more than one employer on amounts exceeding $117,000 – for 2014)

d. First-time Homebuyer Tax Credit:

i. For purchases on or after April 9, 2008 and before July 1, 2009*

· No ownership of principal residence during 3 years before buying “new home”

· Credit is 10% of purchase price up to $75,000 or price; thus, up to $7,500 of credit ($3,750 if married/separate return)

· Credit must be repaid in equal installments over 15 years (starting 2 years after residence is purchased) (no interest on this “loan”)

· Accelerated recapture (repayment) of credit if house sold (to extent of gain)

· Phase-out started when AGI > $75K ($150K if joint)

* Changes in the law bumped the $7,500 amount to $8,000 (for closings after 12/31/08) and said no “PAY BACK” (if you stay in the house for 36 months) – i.e., the credit “is really a credit” (not just a loan)

· Worker, Homeownership, and Business Assistance Act of 2009:

· Extended $8K first-time homebuyer credit expiration date to April 30, 2010

· A different (and then new) $6.5K credit became possible if TP had owned home and used it as a principal residence for any 5 year-consecutive year period during the previous 8 year period

· TP had to enter into a binding contract before May 1, 2010 and closed before July 1, 2010 (however, tougher bank financing circumstances slowed closings).

· Thus, closing date deadline was later extended to September 30, 2010

e. Earned Income Credit (EIC)

ii. Low income workers (usually with a “qualifying child”).

iii. Qualifying child: Generally, the same as the uniform definition of child contained in the dependency exemption rules.

iv. Earned income includes wages, salaries, tips, and employee compensation – as well as net earnings from self-employment (losses from self-employment reduce earned income)

v. For 2014,

· No child, EIC is 7.65% of EI up to $6,480 (or, $496)

· One child, EIC is 34% of EI up to $9,720 (or, $3,305)

· Two children, EIC is 40% of EI up to $13,650 (or, $5,460)

· Three children, EIC is 45% of EI up to $13,650 (or, $6,143)

· BUT, credit subject to reduction based on the: (a) higher of TP’s EI or AGI; (b) phaseout base; and, (c) phaseout percentage (which is based on the number of children)

· See Table 13.2

EXAMPLE. Nicole, a single parent, lives in an apartment with TWO minor sons, whom Nicole supports. For 2014, Nicole will have AGI and earned income of $20,000. Calculate the amount, if any, of Nicole’s earned income credit.

a. $0

b. $2,000

c. $5,003

d. $5,460

f. Per above, portions of the Child Tax Credit and American Opportunity Credit may also be refundable

Self-Employment Tax.

· In general, tax is levied, assessed, and collected as part of the regular income tax.

· Scope of tax: Generally sole proprietorships and partnerships – but can get tricky.

· For 2014 :

SS* 12.4% (only on first $117,000)

Medicare 2.9% 15.3%

* Old-age, survivors, and disability insurance (OASDI or “SS”).

· Per Figure 13.1 (on page 13-40), there is also a special deduction whereby the effect is to multiply net earnings from self-employment by 92.35% (100% - 7.65%, or ½ the 2014 self-employment tax rate). The goal is to simulate the ER/EE world where an EE would not have the ER’s employment tax expense included in the EE income amount that is subject to the tax.

· For 2014, ½ of self-employment tax liability is a business deduction in figuring AGI (the goal, again, is to simulate the ER/EE world where the ER would get a tax deduction for its employment tax expense relating to the EE).

· Per pages 13-41 to 13-43, increased Medicare taxes for high-income individuals beginning in 2013: (1) an additional 0.9% on wages in excess of specified amounts (e.g., $250K for joint TPs, $125K for married filing separately TPs, and $200K for single TPs); and, (2) an additional 3.8% on the lesser of TP’s (a) net investment income or (b) MAGI in excess of a certain amount ($250K for joint TPs, $125 for married filing separately TPS, and $200K for single TPs). Moreover, the base amounts are indexed for inflation.