ACCT 3350 - Fundamentals of taxation lecture notes from 2020 with Professor Steven Solcher PDF

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Fundamentals of taxation lecture notes from 2020 with Professor Steven Solcher...

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CH 2 Ability to Pay: Tax should be based on how much they can afford to pay Administrative Convenience: The benefit derived from this should exceed the cost ○ Ex. Using my company printer is not included in my income Arm’s Length: A transaction between related parties does not receive deductions Pay as You Go: Taxpayers are required to pay tax as they generate income Entity: ○ Conduit (LLC): Pay tax on taxable income but not dividends ○ Corporations: Pay taxes on my dividends Assignment of Income: All income earned by an entity will be taxed to that entity Tax Benefit Rule: Money received as a result of tax benefits must be reported as income Substance over form: A transaction must be realistic and not contrived to avoid tax ○ Ex. Hiring his 4 year old son to deduct “Salary Expense” All Inclusive Income: All income is taxable unless a provisions of law excludes it ○ Bartering is not allowed Legislative Grace: Any tax relief is the result of Congress, which are strictly applied Capital Recovery: Tax benefits from capital gains and losses Realization: No income is recognized as taxable income until it’s been realized by the taxpayer ○ Realization ( When there is a transaction) ○ Recognized (Taxable portion of the realized gain) ○ Realization doesn’t occur until an amount has been received without restriction ■ Ex. Security deposit isn’t income unless you can prove damage Constructive Receipt: Prevents cash basis from turning their backs on income ○ You need to record it as income when you’re able to receive it, not when you CHOOSE to receive it Deductions (Business Purpose): Only expenses made to generate income is deductible

CH 3 Income (Changed net worth, realization occurred, second party involved, final transaction) ● Earned (Ordinary Income): Has the highest tax rate ● Unearned: Earnings from investments, gains from sales, exchange, etc ○ Money making money ○ Ex. Interests, rental income, annuities, etc ○ Capital Asset ● Transfer (Prizes, unemployment compensation, SS benefits, death benefits, etc) ○ Prizes and awards: Tax free unless… ■ Scientific & Literary achievements given by a qualified charity/gov ■ Employee achievements for length of service/safety ● Tax Free up to $400 or $1600 if it’s a qualified plan ○ Unemployment Compensation: Taxed at a low rate or high income = (Marginal) ○ Social Security: (Only income vs High income 85%) ○ Alimony (No tax consequences) ○ Death Benefit (Included as gross income)

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Imputed ○ Below Market Rate Loans: Charge a below market interest rate on loans ○ Administrative convenience grants exceptions for ■ Loans of $10,000 or less ■ Gift loans of $100,000 or less ○ Payment of Expenses (Family; No Tax, Employer: Tax) ○ Bargain Purchases (Arm’s Length: No Tax & Not Arm’s Length: Tax) Capital Asset: Any asset other than inventory, AR, real property, etc (Ex. Stocks and Bonds) ● Short Term (365 days or less) VS Long Term (365 days or more) ● $3,000 of net capital loss may be deducted per year When is income reported (Cash VS Accrual VS Hybrid) Calendar (Individuals) VS Fiscal (Start any date but fills 12 months) CH 4 (Exclusions) ●

Donative Items ○ Gifts & Inheritances are excluded from tax ○ Life Insurance Proceeds: Excluded unless… ■ Proceeds from policies purchased for consideration ■ Interest earned from annuity is taxable ○ Scholarships: Must be used for tuition, fees, books, and supplies (Education) ■ Must not require student to perform any future services ● Employment Related ○ Foreign Earned Income: Taxpayers can choose to… ■ Exclude up to $107,600 (Low tax rate countries) if they reside in the foreign country for at least 330 days ■ Claim a tax credit that is the lesser of the foreign taxes paid, or the U.S. tax that would have been paid on the foreign-earned income (For high tax rate countries) ■ Payments made by employer are excluded 1. Pension Plan (Not included in income when paid but included when withdrawn) 2. Group Insurance (Cheap & Excluded up to $50,000) a. May not discriminate in favor of highly paid employees 3. Health and Accident (Biggest $): Premiums paid are excluded 4. Meals and Lodging: Excluded if the meal’s on the employer’s business premises & for the employer’s convenience 5. Lodging: Same as meals AND has to be required to be deductible, not a choice 6. Fringe Benefits a. Excludable from income if nondiscriminatory & same line of business b. No Additional cost services (Flight Tickets & Hotels) c. Employee Discounts (Limited to 20%)

d. Qualified retirement planning services: Provided to all employees 7. Discriminatory yet excludable fringe benefits a. Working condition fringes b. De Minimis Fringe Benefits c. Child and dependent care services up to $5,000 d. Educational assistance programs up to $5,250 e. Employer’s athletic facility on premises 8. Cafeteria Plans: Allows employees to choose from a menu of benefits 9. Returns on Human Capital: Any reimbursement for physical injury is tax free a. Physical Injust, sickness and medical payments for emotional distress b. Loss of income payments: Excluded if related to physical injury or sickness c. Payments/ Reimbursements for medical and health costs are excluded 10. Punitive Damage Payments: ALWAYS TAXED (Ex. Lotion hurt my customer) 11. Disability payments: Excluded if the policy was purchased by the employee but not excluded if the policy was purchased by the employer 12. Municipal Bonds (Gov entities that aren’t federal) interest payments are tax free 13. Stock Dividends: Excluded from income 14. CASH IS ALWAYS TAXABLE 15. Discharge of Indebtedness CH 5 (Deductions) All expenditures fall into these categories 1. Trade of business expenses (Profit Motivated) a. Differentiate between hobby and trade of business 2. Expenses for the production of income (Profit Motivated; i.e. investment) a. Deduction may take years 3. Specifically allowed itemized deductions (Personal) 4. Nondeductible Personal expenses (Personal) Mixed use assets & expenditures are used for business as well as personal. This will be treated as two separate and only the business portion will be deductible Tests for Deductibility 1. HAS TO BE Ordinary & Necessary: Expense must be normal, common, appropriate a. Is it common? Do many businesses have similar expenses? b. Ex) A business hiring a lawyer is deductible 2. HAS TO BE reasonable in amount: Unrelated parties dealing at arm’s length resulting in a fair market value a. If a gift is disguised, then it is not reasonable; is not deductible

b. Ex) Two unrelated parties compromising a price for a used car sale 3. CAN’T BE personal: Has to be in motive of making income; not personal a. Ex) If I pay for lunch at a business meeting; then it is deductible 4. CAN’T BE capital expenditures: Should be capitalized as an asset if useful life extends a year a. Any capital expenditures that extend the life of an asset should be capitalized and will be EVENTUALLY deductible (Ex. Depreciation of an equipment) 5. Start Up Costs: Total cost needed until producing first dollar of revenue a. Can expense up to $5,000 in the 1st year; rest is amortized over 180 months b. 1st year’s expense is phased out if total costs are greater than $50,000 c. Start up costs are deducted once you make your first revenue d. Ex) Two companies merging together doesn’t count as start up e. Ex) A restaurant opening up another location isn’t start up 6. CAN’T violate the law: any expense resulting from violation of law is not deductible a. Any fines or tickets going to the gov are not deductible b. Costs of goods sold are always deductible under the capital recovery even if it’s an illegal business c. Ordinary & necessary business expenses are deductible for all illegal businesses except the sale of drugs d. Bribes for any types of businesses are not deductible e. Any expenses related to lobbying are not deductible 7. Any expenses needed to generate tax free income is not deductible a. Ex) Any expenses for life insurance is not deductible 8. You can’t buy someone’s tax deductions Hobby ● Any losses from hobbies are not deductible ● Income generated from hobbies are taxable without any tax benefits Vacation Homes ● A vacation home is considered… ○ Personal residence if rented out for 14 days or less ■ Don’t have to report any income ○ A vacation home is used personally for more than 14 days or more than 10% of the number of days rented ■ Report income and allocate some expenses (No Loss Allowed) ○ A rental property if used personally less than or equal to 14 days, or less than or equal to 10% of the days rented ■ Report income and allocate all expenses (Loss Allowed) Home Office: A room of the house is used ONLY for business purposes because they don’t have any other options ● They must be able to prove that it is required as a condition for work and is convenient ● Can’t create a loss

Timing of deductions ● Cash Method: Claim a deduction in the year an expense is paid ○ Ex) If I pay someone with a check, it’s deductible as soon as I give it to them ○ Prepaid expenses are deductible if used within one tax year ● Accrual CH 6 (Deductions) Expenses related to meals, car usage, travel, and business gifts are deductible but are subject to limitations and strict documentation requirements ● Documents require… ○ Amount ○ Time & place ○ Date & description ○ Business purpose ○ Business relationship with the other person ○ NEED TO BE CONTEMPORANEOUS Meals (Must be related to business) are deductible under limitations ● Only 50% of the allowable costs may be deducted ● May be 100% deductible if ○ Reimbursed expense (Google pays for my lunch) ○ Expenses that are taxable income to a non employee recipient (gifts/prizes) ○ Expenses for recreational or social activities that benefit employees ○ Expenses for goods, services, and facilities, made available to the public ● IF NON EMPLOYEES ARE INVOLVED, THEN IT'S MOST LIKELY 50% DEDUCTIBLE ●

NO DEDUCTIONS FOR ANY ENTERTAINMENT

Auto Usage ● Deductible if it’s used for travel ○ Out of town ○ From home to a temporary workplace ○ From regular workplace to a temporary workplace ○ From workplace to a second job ○ But the cost of commuting is never deductible unless you’re self employed ● Standard Mileage Rate Method (NOT ALLOWED IF MULTIPLE CARS ARE USED) ○ $0.575 per mile ○ Tolls, parking, interest, and property taxes may be added ● Actual Cost Method ○ Business percentage of depreciation, gas, repairs, insurance, etc are deductible

Travel: Travel expenses incurred during a business purpose away from the tax home (At least 50 miles) overnight are deductible ● Over 50% of the activity requiring travel must be business related ○ Personal activity costs during business trips are not deductible ○ Incidental business expenses during a personal trip are not deductible ○ Travel expenses for educational purposes or for investment related meetings are not deductible Business Gifts Deductible with a limitation of $25/year excluding gift wraps, engraving, etc) Education ● Deductible if ○ The education is required by law/employer to maintain employment ○ It maintains or improves current job skills ● Not Deductible if ○ It is necessary to meet minimum job requirements ○ It qualifies the taxpayer for a new trade of business Compensation to employees are generally deductible Bad Debt: Generally deductible under the capital recovery concept ● Business bad debts are deductible only under the accrual method ● Non Business (Investment) bad debts are deductible if the debt is bona fide ○ Reported as a short term capital loss ○ No deduction is allowed if the debt is voluntarily forgiven ○ Ex) I loan money to someone and they don’t pay me back All forms of insurance are deductible EXCEPT life insurance Most business related taxes are deductible unless paid to the fed gov ● Exceptions include ○ Sales taxes related to long lived assets must be capitalized ○ Property taxes related to real estate bought or sold during the year must be allocated between the buyer & seller Legal fees related to business are deductible Reimbursements 1. Accountable Plan 2. Non accountable reimbursement is income CH 7 (Losses) Realized Loss: All of our proceeds - Adjusted Basis Annual Loss: Tax deductions exceed income so you have a loss Transaction Loss: Loss from a transaction due to the capital recovery concept

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Active (If my business requires 10hrs and I put in 10hrs)

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Passive (I only put in 2hrs into my business and my manager does the rest)

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Individual: Carryover and can offset only passive gains (not income)

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Corporation: Can use passive losses to offset ANY type of gain

NOL deduction (Net Operating Loss): When deduction > Income ○

Can’t be personal or investment expenses

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NOL can offset any other income, if they have any (NOT FOR CORP.)

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If you don’t have any other income, NOL can carryover to next year

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If income is less than/equal to NOL carryover, then 80% of income is deductible

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Basis Limitation: You can only record “Loss” for the amount you invested (Ex.Oil Well)

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The only way to use our passive loss in the current year is if we invest in something else and make money (Capital Gain) or we sell the investment

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Investment Losses (Transaction Loss): Capital gain and netting procedure ($3k limit) ○

Non Business Bad Debt: Short Term Capital Loss

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1244: Always a Long Term Capital Gain

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Collectible: Always Long Term

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Losses on related parties & Wash Sales are not allowed

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Personal Losses: Only casualty and thefts are allowed

CH 8

Filing Status 1. Married (Filing jointly): Must be legally married as of the last day of the tax year a. Surviving spouse can use this status for two years after the death if at least one dependent child lives at home AND the surviving spouse has not remarried 2. Married (Filing Separately): On the verge of divorce, Print up (Separate Assets), etc 3. Single: Not married and do not have any dependents 4. Head of Household: Legally married or abandoned spouse (No communication) at the end of the year a. Have to provide more than 50% of the cost of a home for a qualifying dependent

Itemized Deductions (Add up all the deductions and compare to standard deduction) 1. Medical: Unreimbursed medical expenses are deductible if it’s more than 7.5% of AGI 2. Taxes: Amounts paid for … are deductible up to $10,000 a. either sales tax OR state and local income tax b. Real estate and other property tax 3. Mortgage Interest: Interest on mortgage loans of $750k and less are deductible a. THE LOAN MUST BE USED TOWARDS THE HOUSE 4. Charitable Contributions: Contributions made to qualifying charitable organizations are deductible a. The cash paid, value of the property given, $0.14/mi driven, are deductible b. Deduction for ordinary income property (inventory) or short term capital gain property (Stock) are less than the fair market value or the adjusted basis i.

So instead of selling a loss stock, just sell it and donate the cash

c. Deductions for long term capital gain property is FMV i. ii.

(Can’t exceed 30% of your AGI) For short term capital gain, just wait to make it long term gain for better benefits

d. Overall deduction amount can’t exceed 60% of AGI e. Any excess contribution are carried forward for deduction for 5 yrs

Requirement to be a dependency: Financial Support 1. Qualifying Child (HAVE TO PASS ALL 5) a. Age Test: Must be Younger than 19, Or a full time student under 24, Or Permanently and totally disabled b. Non Support Test: Child can’t provide more than half of their own support c. Relationship Test: Child must be the taxpayer’s child, stepchild, foster child, sibling, step sibling, or descendent of any such relative d. Principal Residence Test: Child must live with the taxpayer for more than half a year e. Citizen or Residency Test: Must be a US citizen or resident of the US, Canada, or Mexico 2. Qualifying Relative: (MUST PASS ALL 5) a. Gross Income Test: Must have a gross income less than $4,300 b. Support Test: Taxpayers must provide more than half of a dependent’s support for the year i.

Exception: Custodial parent may always claim a child as a dependent

c. Relationship Test: Dependent must be related to OR reside with the taxpayer (Cousins don’t count but adopted children do) d. Citizenship Test: Must be a US citizen or resident of the US, Canada, or Mexico e. Joint Return: Dependent can’t file a joint return if married i.

Ex. If my daughter gets married and her spouse makes more than $4300, she is no longer dependent

Steps 1. Do we have a dependent? If so, what kind (Child or Relative) 2. Filing Status (Which one of the 5) 3. Standard Deduction VS Itemized Deduction (Which one is better) 4. Credit (Child: $2,000 Dependent: $500)

Restriction on Dependent ● A person that is claimed as a dependent can report a standard deduction of $1,100 or the amount of earned income plus $350, but not more than the regular standard deduction ● If a dependent has more than $2,200 of unearned income (Interest or capital gain), the excess would be taxed at the parents’ marginal tax rate Tax Credits: A direct reduction in the tax liability of the taxpayer ● Child Tax Credit: $2,000 credit for each qualifying child under 17 ● Family Credit: Non Refundable $500 for other dependents ● Earned Income Credit: Provides tax relief for low income taxpayers

CH 9 (Acquisition of Property) Property refers to any asset other than cash Use of Property: Trade or business, Production of Income (Investment), Personal Use Mixed Use Property: A single property that can be used in more than one categories Types of Property 1. Tangible: You can touch it (Ex. Computers, Cars, furniture, etc) a. Real Property: Land and any structure permanently attached to land (Ex. Factory) b. Personal Property: Any property that is not real property (Ex. Machines) 2. Intangible: Rights to the property exist only on paper (Ex. Trademark, stocks, patent, etc) a. Personal Property: Any property that is not real property (Ex. Stocks) Increasing Basis (Value) of a Property 1. Additional Capital Investments: Expenditures made to improve an asset (Can’t be deducted as current expense, it must be capitalized as part of its basis) 2. Reinvestment of income from the property: Taxable income from conduit entities 3. We put more money into the investment Decreasing Basis (Value) of a Property 1. Depreciation 2. Losses from conduit entities 3. We take money out of our investment

Purchasing Assets ● An asset’s basis is the amount paid plus the income recognized from the discount ● For multiple assets, cost must be allocated to the individual asset according to FMV ● If you buy assets if a business, the assets are allocated to individual assets by their FMV ○ (Any excess of purchase price over FMV is considered goodwill) ● Purchase of Corporate Stock: Taxpayer buys stock but no depreciation deductions If you build an asset, the basis (cost) will include ● Direct cost + Indirect costs involved (Interest, taxes, administrative costs, etc) If you acquire an asset as a gift ● Gain basis: If the FMV is greater than the donor’s basis (on the date of the gift) ○ Basis in the property is the donor’s basis plus any gift tax paid on net appreciation ● Loss Basis: If the donor’s basis is greater than the FMV (on the date of the gift) ○ If sold for more than the donor’s basis, use the donor’s basis (will result in a gain) ○ If sold for less than the FMV, use the FMV as the basis (will result in a loss) ○ If sold for an amount between the two, use the sales price as the basis (no gain or loss) If you acquire an asset as an inheritance ● Basis is generally te FMV of the property on the primary valuation date (Date of death) ● Al...