Kenneth G. Dixon School of Accounting
Kenneth G. Dixon School of Accounting
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Purpose of Tax Planning  |
| Is it to reduce or minimize tax liability? |
| Forgoing income or investing in tax exempt bonds is not always the best answer. |
| Is it to maximize after tax income? Or perhaps to maximize the present value of net of tax cash flows? |
| That would mean you should work a 100 hour week and not retire until you are too feeble to work. |
| Is it to maximize an individual's well being (or utility as economists might say)? |
| That would help explain charitable contributions, gifts to family members, early retirement, vacations, and even marriage and having children. |
| Is it to maximize society's (or the world's) well being? Is there some social responsibility? |
| Although a CPA's responsibility is to serve clients, professional ethics limit how far CPAs can go in achieving that objective. For example, ethical standards prohibit participation in tax evasion schemes. In general, tax advisors can support tax positions that are not clear cut as long as the the position has a realistic possibility of prevailing if challenged. A position that does not have a realistic possibility of prevailing can be taken if disclosed as long as the disclosed position is not frivolous. Tax advisors should be aware of the fact that such position may result in a penalty for the taxpayer even if they are consistent with the tax advisor's legal and professional responsibility. Perhaps CPAs should not favor or oppose tax legislation simply because of how it affects the interest of clients unless the CPAs makes it clear that this is the role they are playing. |
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| Once each year the daily press dutifully reports the number of individual taxpayers who earned an income of $200,000 or more in the preceding year, but paid no taxes. That annual announcement triggers two basic emotions--namely, disgust for a tax system that allows it to happen and curiosity about how it might apply to us individually. |
| Ray Sommerfeld: Federal Taxes and Management Decisions. |
| Over and over again courts have said that there is nothing sinister in so arranging one's affairs as to keep taxes as low as possible. Everybody does so, rich or poor, and all do right, for nobody owes any public duty to pay more than the law demands: Taxes are enforced exactions, not voluntary contributions. To demand more in the name of morals is mere cant. |
| Learned Hand: CIR v. Sidney R. Newman, 35 AFTR 857, 57-1 USTC ¶ 9175 (CA-2, 1947). |
| In my own case the words of such an act as the income tax, for example, merely dance before my eyes in meaningless procession: cross-reference to cross-reference, exception upon exception--couched in abstract terms that offer no handle to seize hold of--leave in my mind only a confused purport, which it is my duty to extract, but which is within my power, if at all, only after the most inordinate expenditure of time. |
| Learned Hand: 57 Yale Law Journal 169 (1957). |
| If you are walking along a precipice no human being can tell you how near you can go to the precipice without falling over, because you may stumble on a loose stone, you may slip, and go over; but anybody can tell you where you can walk perfectly safely within convenient distance of that precipice. |
| Mason Brandesis: A Free Man's Life (Viking Press, 1946) |
| Tax evasion is characterized by fraud and deceit. Tax avoidance, by open and full disclosure. The difference is not always clear. "...the very meaning of a line in the law is that you may intentionally go as close as you can if you do not pass it." |
| Oliver Wendell Holmes: Superior Oil Co. v. Mississippi, 280 US 395 (1930). |
| Tax laws are "so complex that mechanical rules have caused some tax lawyers to lose sight of the fact that their stock-in trade as lawyers should be sound judgment, not an ability to recall an obscure paragraph and manipulate its language to derive unintended tax benefits." |
| Former IRS Commissioner Richardson: Wall Street Journal |
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It can be said that there are only five basic tax questions. Therefore, tax planning can be described as finding the best way to answer those questions. |
| Entity
Fundamentals or Mechanics Accounting
Jurisdictional
Compliance (procedures and planning)
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Tax planning methods fall into two categories: those that defer taxes and those that reduce taxes. Tax planning can be accomplished by either controlling the facts (changing what the taxpayer does) or by making tax saving elections. Tax planning involves employing these methods to answer the basic questions listed above. Shown below are basic ways of deferring and reducing taxes along with examples of elections and ways of controlling facts that utilize the listed methods. |
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| Election | Control Facts | |
| Defer Tax
1. Defer income recognition |
Installment method |
Defer sale |
| 2. Accelerate deduction | Sec. 179 write-off | Prepay expense |
| 3. Defer payment of tax | Tax year | Control estimated payments and withholding |
| Reduce Tax
1. Reduce taxable income (convert to exempt income) |
Cafeteria plan participation |
Invest in tax exempt bonds |
| 2. Reduce taxable income (maximize deductions) | Choose itemized or standard deduction | Contribute appreciated asset to charity |
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Invest in capital asset |
| 4. Reduce tax rate (smooth income) | Installment method | Timing sales |
| 5. Reduce tax rate (split/shift income) | Joint return | Form corporation |
| 6. Reduce tax paid | Take credit | Form exempt organization, remove income from jurisdiction |
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Tax planners must look at the marginal impact of tax decisions. This requires familiarity with marginal tax rates. |
| Explicit Taxes |
| Marginal tax rates are often the key to determining
the tax impact of decisions. Because tax rates are progressive it is
not always easy. Large items can change the marginal tax rate. Also, marginal
tax rate is often the combination of multiple taxes. Should consider state
taxes, payroll taxes, etc. as is appropriate.
For example, in Florida corporations pay a state corporate income tax. If the corporation is in the 35% federal tax bracket, the combined marginal rate is as below: 35% + 5.5% - (35% x 5.5%) = 38.575% In the case of income from a partnership or proprietorship, self-employment tax and individual income tax apply. One-half of the self-employment tax is deductible in computing both the income tax and the self-employment tax. |
| Example: Husband finishes education and begins a business. Wife is successful, and they already are in the 35% tax bracket. First dollar of husband's business income is subject to 35% federal income tax and 15.3% (about 11.45% given half is deductible) self-employment tax. So, total tax is 46.45%. |
| Example: Withdrawal from retirement plan or IRA that resulted in a 35% federal income tax, a 12% state income tax (7.8% effective rate given state tax is deductible on the federal return) plus a 10% penalty for premature distribution. The result was a tax of 52.8%. The result was a problem because the taxpayer may not have the cash to pay the tax. |
| Implicit Taxes |
| Explicit and implicit rates may not be the
same. Explicit rate is usually obvious, but includes the taxes on corporations
and shareholders, the alternative minimum
tax, the 10% penalty tax for premature distributions, foreign taxes, and
state and local taxes.
Implicit tax rate is the "real" tax rate considering things such as the fact that the tax law impacts prices (tax exempt bonds pay a lower interest rate) or that this year's tax situation may impact future taxes (what is the marginal tax rate of a taxpayer with an NOL carryover?). |
| Changing Rates
Changing rates may also impact decisions. Rates may change for a number of reasons including changing income, statutory changes, change in status (incorporation or change in jurisdiction). |
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Illustration: Should a taxpayer prepay an expense in order to get the tax deduction earlier? Although accelerating deductions is one tax planning method, it is not always desirable to do so. |
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| Facts: | ||||
| Due date: | April 10th | |||
| Amount: | $1,000 | |||
| Tax bracket: | 30% | |||
| Discount rate: | 8% | |||
| Net benefit of early
deduction:
Current deduction saves taxes now (.30 x $1,000) Give up deduction next year (.30 x $1,000 /1.08) |
$300.00 277.78 |
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| Net cost of making early payment:
Pay out money now
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$1,000.00 978.55 |
21.45 |
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| Net difference | .77 | |||
| Note that changing the discount
rate does not change the value of the early payment. Changing the tax rate
does.
Rule of thumb: Tax rate X 365 days gives the prepayment period in days. |
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| Decisions often have long run implications.
This means that tax planners must consider the present value of alternatives
and the relative risk of alternatives.
Return
Risk Measures
Coefficient of Determination
Beta
Alpha
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Substance over form
Business purpose
Step transaction
Clear reflection of income
Constructive receipt
Reasonable amount
Assignment of income
Helvering v. Paul R. Horst, 24 AFTR 1058, 40-2 USTC ¶ 9787 (USSC, 1940)--coupon interest taxed to father who owned bonds rather than son who was given the coupons and cashed them. George B. Clifford, Jr. v. Helvering, 23 AFTR 1077, 40-1 USTC ¶ 9265 (USSC, 1940)--income from a grantor trust is taxed to the grantor. Reallocation of income
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| Listed below are three rules intended to prevent taxpayers from investing in "tax shelters" designed to generate losses that offset other income. The investment interest limitation prevents taxpayers from using interest deductions to offset income from activities other than the investments. The at-risk rule prevents taxpayers from deducting depreciation, amortization, depletion and other expenses that do not require current cash flow in sutuations where basis is generated by loans for which that taxpayer is not personally liable (i.e., at-risk). The passive loss limitation prevents taxpayers from deducting losses from activities that involve limited amounts of personal participation. | |||
| Investment Interest Limitation | At-Risk Rule | Passive Loss Limitation | |
| What is limited | Investment interest deduction is limited to net investment income. Investment income includes taxable interest income. Capital gains and dividend income are included if taxed at ordinary rates. | Deductions for depreciation and amortization are limited to basis of investment reduced by nonrecourse debt and any net income generated from the activity. | Net passive loss cannot be offset against other income until investment is sold. An exception permits investors to deduct up to $25,000 of losses from rental real estate if AGI is $100,000 or less. If AGI exceeds $100,000, the $25,000 limitation is reduced $1 of each $2 of excess AGI. |
| Order of application | Investment is exempt from IIL if PLL applies. Applies before AR. | Applied before PLL, after IIL | Applied after AR. |
| Covered activities | Portfolio investments and "pure investments" | All activities | Passive activities |
| Aggregate or per activity limitation | Aggregate | Each activity | Aggregate |
| Carryover | Indefinite. Offset against future investment income. | Indefinite. Available as amount at-risk increases. | Indefinite. Use against future passive income or upon sale of investment. |
| Applicable to credits | No | Yes | Yes |
| Passive loss limitation example
Jane purchases a producing orange grove. Jane hires an employee who takes care of the grove. Jane, a physician, provides the capital. During the first year, the business reports a loss of $20,000 because prices are low and the relatively young trees produce only a few oranges. Jane cannot offset the loss against her medical practice income as she does not materially participate in the business. If Jane held other passive investments that generated a profit, she could deduct the loss from the passive income they generated. During the second year, the business reports another loss of $20,000. Again, the passive loss limitation prevents Jane from deducting the loss. She now has a $40,000 carryover. In year three, the business earns $15,000. Jane can use the suspended passive loss to offset her $15,000 income from the orange grove leaving her with a remaining suspended passive loss of $25,000 ($20,000 + $20,000 - $15,000). At the beginning of year four, Jane sells the business for a gain of $15,000. Jane can deduct the passive loss carryover of $25,000 resulting in a deductible net passive loss of $10,000 for the year. As she sold her complete interest in the business she can deduct the full amount of the suspended loss even though the amount of the loss is greater than the gain. At-risk rules example
Investment interest example
The next year they sell the stock for $104,000. They retire the loan and pay $7,000 of interest. They received $1,000 of dividends before they sell the stock and again have $1,000 of interest income. They can deduct $6,000 of interest if they elect to have the gain from the stock sale and the dividend income taxed at ordinary rates. If they so elect, they will have an investment interest carryover to future years of $6,000. If they do not elect to have the gain or the dividends taxed at ordinary rates, they can only deduct $1,000 of investment interest in the first and second years. They have a $7,000 ($8,000 - $1,000) carryover from the first year to the second, and an additional $7,000 (total of $14,000) from the second to the third year. They may be better off to elect to have the dividend income and gain taxed at ordinary rates so they can claim the larger current investment interest deduction. Otherwise, at a rate of $1,000 per year, it would take 14 additional years to use the full carryover. |
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Tax planning impacts business operations. From the beginning,
decisions such as organizational form, jurisdiction (where to form business),
capital structure (e.g., whether to receive stock or debt), organizational
control, transfers of property, lease or buy, status of workers (as employees
or independent contractors), and accounting methods all have major tax
implications. Some are difficult, if not practically impossible to change.
After considering some practical problems encountered by new business, we will is a look at just a few of the
major tax issues.
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When you start:
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| Major Decisions
with Tax Implications Associated with the Start of a New Business
Entity choice: What organization form is to be used? How many entities are to be formed? If a corporation is formed should an S election be made? Capitalization and capital structure: How much capital is required? Should the entity issue debt? Are assets to be leased or purchased? What about other types of equity interests? Ownership: Who has ownership interest: Family members, passive investors? How much interest and what type of interest does each investor have? This affects who is taxed on income and influences estate plans. Employment: Are workers employees or independent contractors? What benefits are to be provided? What compensation level is appropriate? When is compensation provided? Jurisdiction: Where is the entity to be formed? Where does it have nexus? Are multiple entities in multiple jurisdictions appropriate? Related entities pricing: Inter-company pricing influences who reports income, who benefits from the income, and where the income is taxed. Inter-company pricing includes transfer prices for inventory, capital, and services. Accounting methods and periods: What accounting methods are to be used? What inventory valuation is used? What taxable period is utilized? |
Selecting Organizational Form |
| The tax law divides entities into four groups each of
which contains two major types. The four groups are taxpayers, pass-through entities,
hybrid entities, and tax-exempt entities. The taxpayers are C Corporations
and individuals. Both are taxed on their income which means a dividend
paid by a C Corporation to an individual is taxed twice. Now, however,
dividends are taxed at favorable rates. The pass-through entities are S
Corporations and partnerships. In general, their income is taxed to the
owners, not to the entity itself. Trusts and estates are hybrid entities.
They are taxed on the income they retain, but are not taxed on income they
currently distribute. Beneficiaries are taxed on currently distributed
income. Exempt entities include retirement plans and other tax-exempt entities
such as charities and churches.
Most large businesses operate as C Corporations because of liability protection, because other organizational forms are unavailable (e.g., having more than 100 investors or foreign investors), because of access to capital markets, because of certainty regarding the law, and because of favorable fringe benefits rules. Smaller businesses that operate as C Corporations often use compensation and other payments to owners to reduce or eliminate double taxation. Even with "double taxation" smaller C corporations may pay less tax than would be owed with other organizational forms because lower tax rates apply to small amounts of income retained by the business. There are about 2 million C Corporations with most actually being smaller businesses. Only about 100,000 report taxable income of $50,000 or greater. S Corporations are often used to avoid double taxation, obtain liability protection, limit self-employment tax, and because of somewhat favorable fringe benefits rules. Losses pass through S-Corporations, but are unavailable currently to shareholders who do not materially participate. There are about 3 million S Corporations. The partnership form is often chosen to avoid double taxation, to utilize special allocations, and to facilitate capital contributions and withdrawals. Many are family partnerships, professional partnerships, and investment partnerships (e.g., real estate partnerships and investment clubs). LLPs, LLC, and other organizational variations have made the partnership form more attractive because they can provide liability protection. Nevertheless, liability protection may be limited because of the partner's direct personal involvement in the business and because lenders often require partners to personally guarantee loans. As with S Corporations, losses may not be currently deductible because of loss limiters. There are about 2 million partnerships. Many small businesses operate as proprietorships to avoid double taxation and because of the simplicity of that organizational form. Liability protection might not be available for reasons noted above even if the owner selected another organizational form. Many trade workers, professionals, farmers, and other small businesses use this form. There are about 17 million proprietorships. |
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| In most instances, the cash method of reporting
is preferred to the accrual method of reporting income for tax purposes.
The cash method is simpler to use. The cash method also results
in income being reported when the taxpayer receives the cash needed to
pay the related tax. The cash method also provides the advantage of permitting
taxpayers to control when expenses are deductible by accelerating or delaying
payment. In contrast, accrual basis taxpayers must include receivables
in income even though they have not received payment and, in some cases,
may never receive payment.
C Corporations and partnerships with a corporate partner may use the cash method if their average gross receipts during the three previous years was $5 million or less or if they provide personal services (e.g., law and accounting). The IRS for years would not allow any taxpayer with inventories to use the cash method. Taxpayers with inventories may now use the cash method if their average gross receipts during the previous three years was $1 million or less. Taxpayers whose primary business is not the sale of inventory may use the cash method if their average gross receipts during the previous three years was $10 million or less. This is true even if they have incidental inventories. Because C Corporations and partnerships with corporate partners must use the accrual method, the threshold for them is $5 million. Thus, qualifying businesses need not report revenue from sales until the amounts are received. The IRS, however, says that cash basis taxpayers must determine the cost of sales by reducing the amount paid during the year for merchandise by the amount paid for merchandise still on hand. For example, if a new business purchased $500,000 of merchandise during the year but still owes $40,000 for the merchandise, its cash purchases equal $460,000. If the company has $100,000 of inventory on hand at year end, its is assumed to have paid for $60,000 ($100,000 - $40,000) of that inventory. Thus, the cash method cost of sales is equal to $400,000 ($460,000 - $60,000). Note that this results in the same cost of sales as is computed using the accrual method, $400,000 ($500,000 - $100,000). It is not clear what would be done if the amount owed at year end was greater than the amount of inventory on hand. The taxpayer using the cash method benefits because receivables are not included in income until payment is actually received. One provision that simplifies reporting for accrual basis taxpayers and at the same time provide a small tax advantage is found is Sec. 461(h) which permits taxpayers to effectively deduct many recurring expenses when paid. A number of requirements must be met--for example, the prepayment cannot be greater than 8.5 months. For example, an accrual basis taxpayer that pays it annual insurance premium on July 1, can deduct the premium in the year paid without having to accrue one-half of the premium as a prepaid expense at year end. For many years it was common for partnerships and S Corporations to choose fiscal years, often years ending on January 31. This was because owners did not have to report their respective shares of the fiscal year income until the end of their own tax year, usually December 31. That resulted in a delayed tax payment. The tax law now limits that option. The result is that most partnerships and S corporations now must use a calendar tax year. A fiscal year is available to partnerships and S Corporations if the owners are also on the same fiscal year, if there is a business reason for using a fiscal year (e.g., a seasonal business may be able to use a fiscal year), or if the company makes "required payments" that are much like prepayments of the otherwise delayed tax amount. |
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| The Uniform Capitalization Rules (UNICAP)
define what amounts must be included in inventory and capitalized in the
cost of long-term contracts.
Manufacturing and long-term contracts
Resale
Depreciation and interest
Interest must be included in inventory in the case of property with either a long production period or a long useful life. A long production period is 2 years or longer (one year or longer in the case of property costing more than $1 million). Property has a long useful life if it is real estate or if the class life is 20 years or longer. Application
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Ordinary tax rates: The relative tax rates of family members and corporations often indicate who will benefit from deductions and who will have to pay a higher tax on income. Capital gains: Tax planning relative to property transactions for individual taxpayers involves an effort to insure favorable capital gains treatment when property was sold. Corporate capital gains, however, are taxed at the same rate as other income. Moreover, the fact that it is difficult to remove assets from corporations without recognizing gain and the fact that creditors have access to corporate assets means that it is often desirable to keep major assets out of closely held corporations. Alternative minimum tax: The AMT provisions require investors choosing tax favored investments to add back many of the items that reduce taxable income in the computation of alternative minimum taxable income. For example, in some instances less depreciation is allowed. Loss limiters: Passive loss, at-risk, and investment interest can all be factors affecting the tax associated with property investments. While they influence individuals taxpayers, the rules are less an issue for a corporation. Depreciation: The nature of real estate investments as well as real estate actually used in a business is that the owner receives a depreciation deduction on an asset that may actually be appreciating. Of course, interest and other expenses offset revenues, hence, the asset may show a tax loss at a time when it is actually producing economic income. Trapping: The question of whether to transfer property to a corporation is often influenced by to a fear of having the appreciation trapped in the corporation. It is difficult to remove appreciated property from a corporation. See above. Lock in: Owners of appreciated property often feel locked into the property because the sale will produce a large tax. Like kind exchange and other nonrecognition rules may be beneficial. The step-up in basis rules associated with inherited property under current law can permit assist with basis increases, but the step up in basis provision is scheduled to expire in 2010. Liabilities: The possibility of unexpected liabilities often influences who holds title to property. Frequently real estate and other major assets are separately held. Often a partnership is formed to hold such assets. The assets are in turn leased to the corporation. Sales Tax: Florida imposes a sales tax on the rental of both real and personal property used in a business even if the property is owned by the individuals who own the business. Can expense reimbursements be used to reduce or completely avoid the sales tax in such cases? Nonrecognition Rules/Installment sales: Tax on appreciation can be delayed or avoided by Secs. 1031 and 453. |
Tax
Case: Real Estate Transaction
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Much tax planning relating to employee compensation relates to four issues. Regulating amount of compensation: too high or low
Controlling employee/ independent contractor status
Effectively utilizing fringe benefits and deferred
compensation
Controlling timing of deduction and income
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| Current deduction for employer without taxable
income to beneficiary
May be part of a Sec. 125 cafeteria plan
Not part of cafeteria plan
*May also be provided to proprietors, partners, and greater than 2% S corporation shareholders on a tax favored basis. Credit for employer, no taxable income to beneficiary
Current deduction for employer, deferred income for
employee
No deduction, and deferred income for employer
More information is provided below for retirement plans and options. |
More detailed information on retirement
plans.
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| Alternative forms of compensation
often can be compared by looking at the ratio of the employer's after tax cost
to the employee's after tax benefit. The lower the
ratio the more desirable the form of compensation. In general, employers
should not utilize forms of compensation that have a higher ratio than
cash compensation as cash compensation is more efficient.
A major limitation of such computations is that the computations
often produce very different results for individual employees meaning that a
form of compensation that is perceived as very beneficial by one employee
is perceived as being much less beneficial by another employee. 1. Cash Bonus
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| Company's cost
Bonus FICA tax Less: Income tax saved Net cost |
$100.00 1.45 (35.51) $ 65.94 |
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| Employee's benefit
Bonus Less: FICA tax Less: Income tax Net benefit Cost benefit ratio 1.006
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$100.00 (1.45) (33.00) $ 65.55 |
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2a. Group-Term Life Insurance (first $50,000) Corporation takes out $50,000 of group-term life insurance. Employee is age 50, and annual premiums are $400. Perceived benefit equals cost of coverage. |
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| Company's cost
Premium Less: Income tax savings Net cost |
$400.00 140.00 $260.00 |
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| Employee's benefit
Cost benefit ratio .650 |
$400.00 | ||||||||||
| Perceived benefit equal expected payoff (probability of death within year equals .006). | |||||||||||
| Employee's benefit | $300.00 | ||||||||||
| Cost benefit ratio .867 | |||||||||||
| Perceives no benefit. | |||||||||||
| Employee's benefit 0 | |||||||||||
| Cost benefit ratio Infinite | |||||||||||
| 2b. Group-Term Life Insurance
(over $50,000)
For an additional $50,000 of coverage. Employer pays both halves of Social Security and Medicare tax. Employee pays income tax on coverage. Taxable amount is specified by Regulation (.23 X 12 X $50,000/$1,000 = $138). Benefit equals premiums paid. |
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| Company's cost
Premium FICA tax* Less: Income tax savings Net cost *.0145 X 2 X $138 |
$400.00 4.00 (141.40) $262.60 |
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| Employee's benefit
Employee's perceived value Less: Income tax on benefit** Net benefit **.33 X $138 Cost benefit ratio .751 |
$400.00 (45.54) $354.46 |
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| 3. Defined Benefit Plan
Employee is 15 years from retirement and will be in the 15% tax bracket at retirement. Funds in plan will grow at a rate of 10% per year (resulting in a $1 contributed now being worth $4.18 at retirement). Assume employee discount rate of 6% (meaning that a $1 which will be received in 15 years is now worth .417. |
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| Company's cost
Contribution Less: Income tax savings Net cost |
$1.00 .35 $ .65 |
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| Employee's benefit
Future benefit Less: Income tax on benefit Net future benefit Present value of after tax benefit Cost benefit ratio .439 |
$4.18 .63 $3.55 $1.48 |
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| If employee discount rate of
8%, then result is .580.
If employee discount rate of 10%, then result is .766. |
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Tax
Case: Employee compensation
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| There are three types of stock options: Incentive
Stock Options (ISO's) and Nonqualified Stock Options (NSO's) and Employee
Stock Purchase Plan Options (ESPPO's). Each is subject to income taxation under specific
rules described below. ISOs and ESPPOs are exempt from FICA and FUTA taxes.
The IRS' position is that NSO are subject FICA and FUTA taxes. The illustrations below omit payroll taxes
for purposes of simplifying the computations.
ISO
The option price must be no lower than the stock's FMV at the time the option is granted. Employees owning more than 10% of the company must pay at least 110% of the FMV at the time the option is granted. The options must be nontransferable except at death or the result of a divorce. The amount of options that may be exercised by an employee in a year is limited to $100,000. Procedural requirements must be met (e.g., shareholder approval of plan, 10 year limit on plan, etc.). The employee must not dispose of the stock within two years of the grant date and within one year of the exercise date. The employee must work for the company at the grant date and until within three months before the exercise date. The advantage of an ISO is that the employee ordinarily reports no income when the ISO is received or exercised (the value of the stock in excess of the option price at the time of exercise is an alternative minimum tax adjustment). The employee reports a capital gain or loss when the stock itself is sold (selling price minus cost of stock) if the holding period requirements are met. Ordinary income if not. If all ISO requirements are met, the employer receives no deduction. NSO's are often chosen by employers over ISO's because employers do receive deductions. NSO
The granting of an NSO with no "readily ascertainable fair market value" has no tax consequence. The exercise of such options results in ordinary income to the employee (and a deduction for the employer) equal to the "discount" (FMV of the stock at the time the option is exercised minus the option price). The employee reports a capital gain or loss when the stock itself is sold (selling price minus FMV of stock at date option is exercised). ESPPO
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| Stock is worth $1 per share today
and is appreciating at rate of 10%. Company and employee discount rates
are both 10%. Company is in 35% tax bracket. Employee is in 33% ordinary
income tax bracket and 15% capital gains bracket.
ISOs and NSOs are at current market value, and must be exercised within five years. Employee will exercise option just before it expires (when the stock will be worth $1.61) and sell stock two years later (when it will be worth $1.95). Employee does not owe AMT. ESPPO are at $.85, and must be exercised within two years Employee will exercise option just before it expires (when the stock will be worth $1.21) and sell stock five years later (when it will be worth $1.95). If option is ISO: |
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| Cost | ($1.61 - $1) X .621 | .379 | = 1.23 | ||
| Benefit | ($1.95 - .15 X ( $1.95 - $1)) X .513 - $1 X .621 | .307 | |||
| If option is NSO (no readily ascertainable FMV): | |||||
| Cost | ($1.61 -$1 -.35 X ($1.61 - $1)) X .621 | .246 | = 1.08 | ||
| Benefit | ($1.95 - .15 X ($1.95 - $1.61)) X .513 - ($1 +.33 X ($1.61 - $1)) X .621 | .228 | |||
| If option is NSO (market value $.20): | |||||
| Cost | ($1.61 -$1) X .621 - .20 X.35 | .309 | = 1.21 | ||
| Benefit | ($1.95 - .15 X ($1.95 - $1.20)) X .513 - $1 X .621 - $.20 X .33 | .256 | |||
| If option is ESPPO: | ||
| Cost | ($1.21 - .85) X .821 | .296 = 1.48 |
| Benefit | ($1.95 - .15 X ($1.95 - $1.00) - .33 X ($1.00 -$.85)) X .513 - $.85 X .821 | .200 |
The ESPPO example is not directly comparable to the other examples because the ESPPO rules limit the option period. As noted the IRS's position is that the NSO is subject to payroll taxes which is not incorporated into the example. The computation, as illustrated above, suggests that stock options may not always be an efficient form of compensation. They have been touted because they may both help retain and motivate employees and, in the past at least, could be used without having to show the cost as an expense on financial statements.
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Florida Tax Issues From formation, business must deal with state and local taxes, but as they grow they are faced with taxes in other jurisdictions. Often that is taxes in other states and then taxes in other countries. This is a look at those areas. |
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| Some basics of Florida Taxes are summarized
below:
Individual Income Tax--none (1 of 7 states without an individual income tax). Corporate Income Tax--the state taxes corporations at 5.5% (3.3% AMT). Honors an S election. Return due first day of fourth month following year end. Tax year same as federal. Some differences between Federal and Florida taxable income include: state income taxes not deductible, no NOL or capital loss carryback, foreign income taxes are deductible, a $5,000 exemption is allowed, a consolidation adjustment is available, and federal interest is exempt while state interest is taxable. Gift Tax--none. Estate Tax--Florida statutes specify that the Florida estate tax is equal to the amount of federal credit for state death taxes. As the credit was replaced by a deduction after 2004, the Florida estate tax has effectively been repealed. Sales and Use Tax--6% state tax plus a local tax in some areas. Most food, medicine, real estate, services, and items purchased for resale are exempt. Mail orders and rentals are generally taxable. Transfers/transactions between related parties are generally taxable. Real Property--no state tax, but counties, cities, school districts, and other units impose tax. The rate varies between districts, but averages about 1.9% state wide. There is a $25,000 homestead exemption as well as several other exemptions. Personal Property--no state tax, but counties, cities, school districts, and other units impose a tax on the value of tangible personal property used in a business such as such as equipment and business furniture. Real property, intangibles, inventories, and automobiles are exempt along with personal use property such as jewelry and clothing. Rate is the same as real property tax. Intangible Property--Florida taxes intangibles (such as stocks, bonds, and money market funds) at a rate of .1% (.001) in 2005. The tax is computed on the value of intangibles on December 31 of the prior year. The tax is imposed on the investor, but a corporation may elect to pay the tax on its stock. There are exemptions for cash, bank accounts, receivables, insurance policies, Florida bonds, assets in retirement accounts (pensions, IRAs etc.), and mortgages (which are subject to the nonrecurring intangible tax). Exemption of $250,000 ($500,000 for a joint return) in 2005. Due June 30. Discount generally equal to 1% per month, if paid early. The tax does not have to be paid if tax is less than $60. The state imposes a nonrecurring intangible tax of .2% (.002) on mortgages secured by Florida real estate. This tax is imposed on the borrower.
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| While the Federal Government taxes the worldwide
income of U.S. businesses, states tax only the income determined to have
been generated within the state.
All states with an income tax use apportionment to determine
the portion of a business's income generated within the state.
Apportionment is a formula system that varies somewhat
between states. In most states, however, the formula is based on the percentages
of sales, payroll, and property within the state.
Although all states use apportionment, it is not used exclusively.
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| Sales |
| Point of delivery is used to determine the location of sales, and where work is done is used to determine the location of services. P. L. 86-272 prevents a business from being taxed if its only contact with a state is to have customers and to solicit orders there. A "throwback" rule is used by most states. Under the "throwback" rule income not taxed elsewhere is taxed at home. |
| Property |
| Generally based on average book value. Typically the average of beginning and end of year book values. Intangible property is usually omitted. Property owned by someone else and rented by the taxpayer typically is included in property. Approximately forty states value rented assets at eight times annual rental. |
| Payroll |
| Wages are attributed to state where services are performed. Usually excludes services of independent contractors. |
| Other income |
| Generally apportioned if part of business activity, but allocated if not. For example, interest on notes receivable from customers would typically be apportioned, while rental income might be allocated to the state where the rental property is located. |
| Multiple entities |
| Businesses can, in some instances, limit the need to apportion or allocate by forming separate corporations in order to isolate the income generated within the specific state. States, however, may ignore the existence of multiple corporations in cases of unitary businesses. Thus, multiple corporations may be recognized in the case of a chain of restaurants but ignored in the case of an integrated manufacturing company. |
| S Corporations and partnerships
Ordinarily, partners and S corporation shareholders must file individual state income tax returns in states where their businesses have income. Some states permit an S corporation to pay a flat tax tax on its apportioned income in lieu of owners filing individual returns and reporting their respective shares of the corporation's income. Some states (CA, DC, LA, MI, NH, and TN) do not recognize S corporations. These states tax S corporations on their income. Some states (AR, NJ, NY, ND, OH, and PA) recognize S corporation status, but require a separate state election. |
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The United States taxes most of the world-wide income of it citizens and corporations. At the same time, the United States taxes the U.S. source income of foreign taxpayers. This pattern is followed by most countries which means much income is taxed by two countries. Working to limit taxes on multinational income is one of the largest areas for tax planning today. There are several provisions in the tax law that provide relief. One major form of relief is the Foreign Tax Credit. Taxpayers may claim a credit against the U. S. income tax for foreign income taxes. The "extraterritorial income exclusion" also provides relief . This exclusion effectively replaces the DISC and FSC rules. There is a limited exclusion for foreign earned income available only to individual taxpayers. There also are relief provision associated with U. S. possessions such as Puerto Rico. At the same time, the pattern provides some opportunity of tax avoidance because U.S. companies can form foreign subsidiaries that operate abroad and, as a result, pay no U.S. income tax until the income is returned to the U.S. in the form of dividends. Also, there are several provisions in the tax law intended to limit tax planning associated with multinational income. These are found in Secs. 267, 367, 482, and in Subpart F. All are intended to prevent efforts to avoid U. S. tax on international income. We will briefly look at the tax systems used by various countries. These can be divided into four groups. Finally, we will look at how the U. S. taxes income earned in the U. S. by foreign taxpayers.
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| Alternative Systems |
| Classical or double tax system
Shareholders pay a tax on dividends received from foreign corporations. The system is used by U.S. for dividends received by individuals from foreign corporations. Also used by Luxembourg and Netherlands. Credit or imputation system
Split-rate system
Exemption system
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The major provisions intended to reduce the burden of double taxation
of international income and to
encourage international business activity include:
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| The most important relief from the double
taxation that can result from classical scheme of taxing multinational
income is the foreign tax credit. The credit for foreign taxes is subtracted
from the U.S. income tax thereby reducing if not eliminating double taxation.
Credit equals lesser of:
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| Income | Foreign Tax | |||
| Foreign source income | ||||
| Country X | $100,000 | $30,000 | ||
| Country Y | 200,000 | 80,000 | ||
| U. S. income | 500,000 | |||
| Taxable income | $800,000 | |||
| Gross U. S. tax (35% x $800,000) | $280,000 | |||
| Foreign tax credit | ||||
| ($300,000/$800,000 X $280,000) | (105,000) | |||
| Net | $175,000 | |||
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| Prorate related deductions and credits such
as moving and employee:
Nondeductible portion = Deductions X (Exclusion/Foreign Earned Income) |
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| Congress has attempted in the past to create incentives
in the tax law designed to encourage American companies to export more
products and services in order to create jobs and improve the balance of
payments. Incentives have included Domestic International Sales
Companies (DISCs), Foreign Sales Companies (FSC's), and the
Extraterritorial Income Exclusion (ETIE). Challenges by trading
partners and decisions by the World Trade Organization have caused the
DISC provisions to be curtailed to the point they have little implication
and have led to the repeal of the FSC rules and effective 2007 the ETIE rules. The Deduction Relating to U. S. Production Activities (DRUSPA) has been created to replace the previous incentives. With DRUSPA, taxpayers will receive a deduction equal to a phased-in percentage multiplied times the lesser of taxable income (or an individual's adjusted gross income) or qualified U. S. production activities income. The phased-in percentage will be 9% beginning in 2010 (3% in 2005 and 2006, 6% in 2007, 2008, and 2009). Under the system, taxpayers will determine the amount of their income from U. S. production activities (such as manufacturing, producing, growing, and extracting) and take a deduction that is based on that income. Note that this deduction is tied to the type of income being produced by the business and not whether the income is related to export activities. As a result, a manufacturer will be taxed at a lower rate than a retailer.
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Possessions Corporations |
| A Credit for Possessions Corporations was repealed in 1996. A transition rule permits existing Puerto Rican Possessions Corporations to take advantage of the credit through 2005. |
| A credit against the U.S. income tax was allowed for possession's income. The credit was equal to the lesser of 100% of the U.S. tax on that income, or the sum of (1) qualified possession income taxes for the year, (2) 60% of qualified possession wages and allocable fringe benefits and, (3) 15%, 40%, and 65% of the depreciation for short-life, medium-life, and long-life qualified tangible property. Alternatively, a corporation may elect a credit equal to a percent of U. S. tax on possession income (40% in 1998 through 2002 (2005 in Puerto Rico). |
| Dividends received from Possessions Corporations qualify for the 70%, 80%, and 100% dividend received deduction. |
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| Under Secs. 931-935 income earned by bona fide residents of U.S. possessions (from possession sources) is exempt from the U.S. income tax. The income is subject to tax by the possession. Applies only to residents of Puerto Rico, U.S. Virgin Islands, and Guam. Treaty negotiations are underway with other possessions. |
Constraints on tax planning relating to international income include:
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| Subpart F is designed to prevent taxpayers
from channeling income to foreign tax havens such as Netherlands Antilles,
Liechtenstein, Bahamas, Switzerland, etc. Shareholders of Controlled Foreign
Corporations (CFC) are taxed on the corporation's Subpart F income currently
even if it is not distributed.
Controlled Foreign Corporation
Attribution rules are used to determine if a person owns over 10%:
Subpart F income is foreign base income associated with products purchased or produced in a country other than the host country and sold in a third country. Exempt from Subpart F, if foreign tax is 90% of U. S. rate (90% x 35% = 31.5%). This means the rule only applies to "tax havens". Result
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| Sec. 482 |
| Sec. 482 gives the IRS the right to allocate income, deduction, gains, losses, credits, etc. among related persons. Is available to IRS in situations when subpart F is not. For example, direct sales to a subsidiary |
| Sec. 367 |
| Sec. 367 is intended to prevent tax avoidance on both outbound (Sec. 367(a)) and inbound (Sec. 367(b)) property transfers. |
| Outbound example: Transfer appreciated assets to a foreign subsidiary and to use Sec. 351 to avoid gain recognition. Liquidate a U.S. subsidiary into a foreign parent under Sec. 332. A foreign corporation acquires a U.S. corporation's assets in a C reorganization. |
| Sec. 367(a) generally requires the transferor to currently recognize gain on non business assets and specific business assets (inventory, receivables, installment obligations, foreign currency, leased property, and property involving Secs. 1245 and 1250 gain). |
| Inbound example: Liquidate a foreign subsidiary into a U.S. parent under Sec. 332 (and certain "B", "C" and "D" reorganizations). |
| Sec. 367(b) generally requires recognition of "dividend" income equal to earnings and profits. |
| Sec. 267 |
| States that the secretary shall by regulation apply the matching principle in cases in which the person to whom the payment is to be made is not a U. S. person. |
| Example: Foreign shareholder loans money to an accrual basis U.S. corporation. U.S. corporation cannot deduct related interest expense until paid. |
| This rule applies even when the foreign taxpayer uses the accrual basis and reports the income before it is paid. An important exception does apply to trade of business income which is reported currently by accrual basis taxpayers. |
| Example: U.S. corporation owes sales commissions on its products to a foreign subsidiary. Both corporations use accrual method. Deduction is allowed currently. |
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| Because currency exchange rates fluctuate,
taxpayers who engage in international business activities realize gains
and losses from currency transactions. There are two alternative methods
of reporting international transactions.
Records kept using the U.S. dollar
Reports kept using a foreign currency
Requirements
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| How foreign taxpayers are taxed by the U. S. is based on the following rules unless a treaty between the U. S. and the foreign taxpayer's country specifies different treatment. The rules apply apply to foreign individuals and other foreign entities (corporations, partnerships, estates, trusts, etc.) Foreign individuals are citizens of other countries who neither hold a "green card" or meet a substantial presence test (e.g., present in the U.S. for at least 183 days during the calendar year, or 183 days using a formula computation weighting days over three years). | |||
| Type of Income | Exempt | Flat Rate | Regular Tax |
| Trade or business and effectively connected income | X | ||
| Investment income such as dividends and interest
(interest on savings accounts and a few other types of investment income
is exempt)
A 30% branch profit tax can apply if a foreign corporation operates in the U.S. without using a subsidiary. |
30% or lower treaty rate | ||
| Rental of personal property
Rental of real property |
30% or lower treaty rate
Same or |
X (elect) |
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| Sale of real estate | 10% of amount realized | ||
| Capital gains |
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The rules below summarize the Alternative Minimum Tax (AMT) as it applies to corporations. |
| Basic formula |
| Taxable income or loss before NOL deduction |
| + Tax preferences |
| + or - Adjustments |
| - AMT NOL |
| = Alternative minimum taxable income |
| - Statutory exemption |
| = Tax base |
| x Tax rate .20 |
| = Gross AMT |
| - AMT foreign tax credit |
| - (Gross regular income tax - foreign tax credit) |
| = Net AMT |
| Preferences |
| Tax-exempt interest on private activity bonds issued after August 8, 1986. |
| Excess deductions for depletion, intangible drilling costs, bad debt deductions for financial institutions, depreciation on buildings acquired before 1987, amortization of certified pollution control facilities acquired before 1987, and depreciation of leased personal property acquired before 1987. |
| Adjustments |
| For assets acquired after 1986, difference
between MACRS and ADS depreciation.
The difference in the gain or loss on assets sold caused by different depreciation methods. Difference between percentage of completion profit and reported profit on long-term contracts. ACE adjustment is equal to 75% of the difference between ACE and AMTI (before this adjustment and the NOL deduction). Difference in charitable contribution because of higher limitation. NOL
ACE
AMT Exemption
Corporations are entitled to an exemption of $40,000, but the exemption is is reduced by 25% of AMTI over $150,000 resulting in the elimination of the exemption when AMTI is over $310,000. Note that corporations with gross receipts over $5,000,000 may still have relatively small AMTI, and benefit from the exemption. Minimum Tax Credit
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AMT Example:
AMT Inc.'s taxable income is computed as follows:
| Gross margin
Installment gain Dividends received Depreciation Operating expenses NOL deduction Net Charitable contribution Dividend rec'd. deduction Taxable income |
$8,000,000
1,000,000 200,000 (128,200) (4,071,800) (6,000,000) ($1,000,000) ( - 0 - ) (140,000) ($1,140,000) |
| AMT, Inc. received $3,000,000 of interest
on tax exempt bonds issued by the local school
district to pay for the construction of schools. Charitable contributions equal $100,000. The company owns an office building with a depreciable basis of $5,000,000 which was purchased a few years ago. Depreciation is $128,200 (.02564 X $5,000,000) for income tax purposes and $125,000 (.025 X $5,000,000) for AMT purposes. The company's AMT NOL carryover is $4,000,000. The company sold land on the installment basis reporting 40% of the gain currently. The AMT is computed as follows: |
| Gross margin
Installment gain Dividends received Exempt interest Depreciation Operating expenses NOL deduction Net Charitable contribution Dividend rec'd. deduction Net ACE adjustment AMTI AMT |
AMTI $8,000,000 1,000,000 200,000 (125,000)
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ACE
$8,000,000 2,500,000 200,000 3,000,000 (125,000) (4,071,800) (4,000,000) $5,503,200 (100,000) $5,403,200
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| The difference between taxable income and
AMTI consists of the decrease in the NOL and
depreciation deductions ($2,000,000 and $3,200 respectively) plus the ACE adjustment of $3,480,000 (which is equal to 75% of $4,640,000 ($5,403,200 - $763,200)) minus the charitable contributions deduction ($100,000). Alternatively the ACE adjustment can be thought of as 75% of the total of the lost dividend received deduction ($140,000),the additional installment gain ($1,500,000) and, the "tax-exempt income" ($3,000,000)) |
This can be computed as follows:
| Taxable income
Adjustments: Depreciation NOL Charitable ACE AMTI |
($1,140,000)
3,200
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| The depreciation rules for the AMT are much simpler today than they have been in the past. Nevertheless, previous rules still apply to assets acquired when the rules were in effect. In the past, separate rules applied to depreciation computed for taxable income purposes, alternative minimum tax purposes, adjusted current earnings purposes. In computing taxable income, MACRS depreciation rules are used to determine depreciation on recently acquired assets. That is, most personal property is depreciated using 200% declining balance over 5 or 7 years. Straight line depreciation is used for real property and the recovery period is 27.5 for residential and 39 years for nonresidential. In computing alternative minimum taxable income and adjusted current earning, personal property is depreciated over MACRS recovery periods using 150% declining balance while real property depreciation is same as taxable income depreciation (i.e., MACRS --27.5 or 39 years straight line). Although the rules for earlier acquisition are very complex, the fact is that in most cases there is no difference between taxable income depreciation and either AMT or ACE depreciation because of the passage of time. |
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| Income Tax | AMT | ACE | |
| Regular (pre-1981 acq.) | Regular accounting rules. No table. | Buildings: straight line over estimated life. Equipment: Same as income tax depreciation. (As item is a preference, not an adjustment, the amount cannot be less than income tax depreciation. No table. | Use regular income tax depreciation. No table. |
| ACRS (1981-1986 acq.) | Most personal property was 3 or 5 years and now is fully depreciated. Real property is 15, 18, or 19 years depending on when acquired. Use ACRS tables. | Buildings: straight line over 15, 18, or 19 years. Equipment: Same as income tax depreciation, fully depreciated. (As item is a preference, not an adjustment, amount cannot be less than income tax depreciation.) | The remaining basis (at the end of 1989) for regular income tax purposes is recovered over the remaining ADS life using straight line. No table. |
| Early MACRS
(1987-1989 acq.) |
Most personal property is depreciated using 200% declining balance over 5 or 7 years. Straight line depreciation is used for real property and the recovery period is 27.5 for residential and 31.5 for nonresidential. Use MACRS tables. | ADS depreciation under which personal property is depreciated using 150% declining balance, but generally over a longer recovery period. Real property is depreciated over 40 years. Use ADS tables. | The remaining AMT basis (at the end of 1989) is recovered over the remaining ADS life using straight line. No table. |
| Middle MACRS (1990-1993 acq.) | Same as above. | Same as above. | ADS with both personal and real property depreciated using straight line. Use ADS tables. |
| Late MACRS (1994-1998 acq.) | Same as above except that nonresidential real estate is 39 years. | Same as above. | Same as AMT MACRS (i.e.,150% declining balance and longer recovery period for personal property and straight line for real). Use ADS tables. |
| Current MACRS (1999- and subsequent acq.) | Same as above. | Personal property is depreciated over MACRS recovery periods using 150% declining balance except when bonus depreciation is used. Use regular MACRS on real property (27.5 or 39 year straight line) and on personal property if bonus depreciation is claimed. | Same as AMT MACRS. |
| Bonus depreciation and Sec. 179 write-offs are not adjustments. | |||
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Exempt and Private Activity Bonds
| Government activity | Qualified private activity | Unqualified private activity |
| Build schools, roads, court house | Student loans, low income housing | Build arena, loans to businesses |
| Exempt from income tax.
Not a preference. Included in ACE |
Exempt from income tax.
Included as a preference. Included in ACE. |
Included in taxable income. Not a preference
as already in taxable income.
Included in ACE. |
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| Differences between individuals and corporations
include:
No ACE adjustment. Personal exemptions and some itemized deductions (taxes, home equity loan interest, and most miscellaneous deductions) are lost. Medical deduction allowed only to extent expenses exceed 10% of AGI. The bargain element of Incentive Stock Options (the difference between the value of the stock and the option price) is included in AMTI in the year the options are exercised (except in cases where the stock itself is sold during the same year). A compensating adjustment is made in the year the stock is sold. Exemption is different. For example, for married couples filing jointly the exemption is $58,000 for 2005, but is reduced by 25% of AMTI over $150,000 which means the full amount of the exemption is phased-out at $382,000. The exemption for single taxpayers is $40,250, and with the phased out beginning with AMTI of $112,500. Rates are 26% of first $175,000, and 28% of additional amounts (except that capital gains and dividend income are taxed at their usual rates). AMT credit not allowed for tax caused by permanent differences (mainly, private activity bond interest, personal exemptions, some depletion, and itemized deduction differences). Credit is allowed for AMT attributed to timing differences (e.g., depreciation and long-term contracts, etc.) |
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Family tax planning includes personal financial planning, retirement planning, estate planning, and contributions and tax exempt organizations. Here is a brief look at financial planning , contributions, and tax exempt organizations. |
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| Financial planning is a growing area of financial
services offered by accountants.
Comprehensive plan includes: |
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Steps to follow:
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A useful Excel file for computing future
net worth is available.
Another Excel file projects retirement
income and wealth.
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| Oil and Gas
Write off intangible drilling costs and dry hole costs. Can take percentage depletion (15% of receipts) or cost depletion which ever is greater. Percentage depletion is not limited to basis. Losses from a "working interest" are not subject to the passive loss limitation. Rental Real Estate
Low Income Housing
Building Rehabilitation Credit
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Tax Favored Investments and Tax Planning
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Tax Planning Method |
Stock |
Taxable Bonds |
Exempt Bonds |
Real Estate |
Oil and Gas |
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Defer income recognition |
Defer sale, Installment sale (unlisted stocks), Reorganizations, Reinvestment of proceeds from sale of Sec. 1202 stock |
Savings bonds taxable when they mature |
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Defer sale, Installment sale, Exchange, Exclude gain on personal residence (limited) |
Defer sale, Installment sale, Exchange |
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Accelerate deductions |
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Prepay some expenses (Passive loss rules apply) |
Intangible drilling costs , Prepay expenses (Passive loss rules normally do not apply) |
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Defer tax payment |
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Reduce taxable income (convert to exempt income) |
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Savings bonds may qualify for education exclusion |
Interest is exempt |
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Reduce taxable income (maximize deductions) |
Dividend received deduction (corporations)
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Depletion, Production deduction
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Reduce tax rate (smooth income) |
Timing sales |
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Timing sale, Installment sale |
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Reduce tax rate (split/shift income, etc.) |
Joint ownership, Gift, Family partnership
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Joint ownership, Gift, Family partnership
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Joint ownership, Partnership including family partnership, Gift. |
Joint ownership, Partnership including family partnership, Gift |
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Reduce tax (other) |
Capital gain treatment, Dividends favorably taxed |
Capital gain treatment |
Capital gain treatment |
Low income housing credit, Capital gain treatment |
Capital gain treatment |
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Oil & Gas Passive loss exemption Losses incurred by taxpayers with a with a "working interest" in oil and gas ventures are exempt from the passive loss limitation. Intangible drilling costs Investors in oil and gas ventures may deduct the cost of dry holes (cost of unsuccessful efforts) and may deduct the drilling costs of successful efforts. Lease acquisition Lease acquisition costs are capitalized and depleted. Typically the investor acquires the right to produce the oil and does not purchase the land itself. A payment to have access to the property is call "lease acquisition cost". Taxpayers may use either cost or percentage depletion. Cost depletion involves dividing the capitalized cost over the production period using years or barrels. Alternatively, taxpayers may elect percentage depletion which generally is equal to 14% of sales. Percentage depletion is not limited to the amount of capitalized cost. In many cases, producers contract to pay a royalty to the owner of the land (in lieu of a lease acquisition payment) and deduct both the royalty and percentage depletion. Tax preference Only taxpayers who are substantially invested in oil and gas have a tax preference. The following illustrates the rule: Assume a taxpayer invests in two oil and gas ventures incurring $50,000 of IDC costs on each property. There is no oil or gas income as production has not began. Assume AMTI is $600,000. First compute "excess IDC" on each property which is IDC in excess of the amount of deduction that would be available if the cost were amortized over 10 years. Excess IDC = IDC - IDC/10 = $50,000 - $50,000/10 = $45,000 Next, compute aggregate excess IDC which is the total excess IDC reduced by 65% of net oil and gas income. Aggregate excess IDC = $45,000 X 2 - 65% X net oil and gas income = $90,000 - 0 = $90,000 Finally, compute the preference. The preference is aggregate excess IDC over 40% of AMTI Preference = Aggregate Excess IDC - 40% X AMTI = $90,000 - 40% X $600,000 = $90,000 - $240,000 = No preference |
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Low Income Housing Credit Low income housing is subject to the passive loss limitation. It is treated the same as other real estate rentals except that the AGI phase-out does not apply and that the credit must be converted into an equivalent deduction in order to apply the $25,000 limitation. Rental losses from the low income property or other rentals reduce the $25,000 allowance while net passive income increase the $25,000 allowance. Then, the credit is translated into an equivalent deduction. Example: Taxpayer has an a loss on low income housing of $10,000 and a tentative credit of $7,000. The taxpayer is in the 35% tax bracket. The allowable credit is $5,250 = 35% ( $25,000 - $10,000). The remaining credit of $1,750 ($7,000 - $5,250) is carried over or back. The credit can be deducted from the income tax, but not from the AMT. Business credits including the low income housing credit cannot reduce the income tax below the AMT. Thus, if the credit of $5,250 reduced the income tax below the AMT, the allowable amount would be further limited. If the AMT were greater than the income tax none of the credit would be available currently. |
Tax
Case: Tax Sheltered Investments
Estate Planning |
The gift tax is a cumulative tax paid by the donor. There is an annual per donee exclusion of $11,000, and a lifetime unified credit $345,800that is the equivalent of a $1,000,000 exclusion in 2005. Gifts in excess of the equivalent exclusion are taxed at 47%. The rate is scheduled to be phased down to 45% in 2009 and apply to taxable gifts over $1,500,000. In 2010, the rate is scheduled to drop to 35% and apply to taxable gifts over $500,000.Gift Tax The tax is computed on the fair market value of taxable gifts. The fair market value of gifts is the value of the property in excess of any mortgage or other debt and any consideration paid by the donee. Husbands and wives may split gifts of separately owned property. In general, gifts of jointly owned property are considered to gifts made by the owners. The following transfers are not subject to the gift tax:
Tax is imposed on the taxable value of estates. This is the value of assets in excess of decedent's debts, funeral and administration expenses, casualty and theft losses, charitable contributions, and marital deduction. In order to prevent individuals from avoiding the estate tax, taxable gifts made after 1976 are added to the taxable estate, and any gift tax paid can be subtracted from the estate tax. Estates are entitled to a credit that is the equivalent of a $1,500,000 exemption in 2005. This exempts most estates from the tax. The credit is scheduled to reach the equivalent of a $3,500,000 exemption in 2009. If Congress does nothing there will be no estate tax in 2010, but the tax will return in 2011 at the 2001 level. The rates that apply to taxable estates in excess of the equivalent exemption is 47% in 2005 with the top rate scheduled to be reduced to 45% in 2009. If Congress does nothing the rates will revert to their 2001 level in 2011 with the highest rate being 55% and the equivalent exemption being $1,000,000.Estate Tax Common estate planning techniques include:Planning Techniques
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| Governmental agencies are generally exempt
from taxation under the Constitution. Other organizations are tax exempt
because they perform services that would have to be performed by the government
if the organizations did not perform them. These organizations includes
educational organizations, churches, social clubs, chambers of commerce, and others. Organizations
exempt from income taxation are not automatically exempt from social security
taxes, state, or local taxes.
Exemptions extend from:
Other statutory exemptions include Secs. 501(a) and 401.
Exempt accounts and programs include Secs. 220, 223, 529 and 530.
Tax exempt status is available to qualified organizations that apply and are granted such status. Application for tax exempt status is made on:
Form 990 [Return of Organizations Exempt from Income Tax]
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| Business is related if the activity in and
of itself carries out the exempt purpose. The fact that the profits are
used to carry out the exempt purpose is irrelevant.
Examples:
Debt financed income is unrelated without regard to whether it is otherwise unrelated. Therefore, if borrow money in order to engage in a business, the net income is taxable. In general, corporate tax rules apply. For example, the
tax rates and charitable contribution deduction limitation are based on
the rules for a corporation. A $1,000 exemption
is available.
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| Stated simply, private foundations
are family (or perhaps business) supported tax exempt organizations. A
private foundation maintains its tax exempt status, and is permitted to
receive deductible charitable contribution. They are subject to closer
examination by the IRS than other tax exempt organizations and are subject
to several special taxes. Although contributions made to private foundations
are deductible, they are subject to special limitations.
Two tests to determine if an entity is a private foundation:
A series of "taxes" apply to private foundations, their managers, and other related persons if they engage in activities that are judged inappropriate. |
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| Penalty Tax | Foundation | Manager | Self Dealer |
| Self dealing | 2.5% and 50% | 5% and 200% | |
| Undistributed income | 15% and 100% | ||
| Excess business holdings | 5% and 200% | ||
| Jeopardy investments | 5% and 25% | 5% maximum $5,000 and 5% maximum $10,000 | |
| Taxable expenditures | 10% and 100% | 2.5% maximum $5,000 and 50% maximum $10,000 | |
| Key: Initial tax and additional tax. | |||
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| Amount of the Deduction
Deduction is normally the lower of the value of the property or its basis. An important exception allows taxpayers to deduct the value of certain appreciated capital assets. The value of contributed property can be deducted if the property is intangible (e.g., stock) or real (e.g., land) and is given to a public charity. In the case of tangible personal property (e.g., a painting), the value can be deducted only if the property is used by the charity in its exempt function (e.g., displayed in a museum as opposed to being sold). In the case of property subject to depreciation recapture, the deduction is equal to the value of the property reduced by depreciation recapture. Lower AGI limitations apply if a taxpayer deducts the value of appreciated capital assets. |
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| AGI Limitation |
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| 50% | The overall limitation for deductible charitable contributions is 50% of AGI, and applies to contributions made to public charities. The limitation is applied first, but in the initial computation amounts subject to the 30% and 20% limitations are ignored. |
| 30% | The limitation applies to contributions of capital again property to public charities if the taxpayer chooses to deduct the value of the property and to contributions to private nonoperating foundations (other than capital gain property). The 50% limitation is reapplied and contributions deductible under the 30% limitation are now considered. |
| 20% | The limitation applies to contributions of capital gain property to private nonoperating foundations. The 50% and 30% limitations are reapplied considering these gifts to private nonoperating foundations. In general, deductions are limited to the basis of the property. |
| Can avoid the 20% and 30% limitations
for contribution of appreciated assets by electing to deduct the basis
rather than the value of the property.
Carryovers
No Deduction
Corporations
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