Tax Planning and Consulting Notes

Dale Bandy

Kenneth G. Dixon School of Accounting

Introduction to Tax Planning and Consulting
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.


 Present values factors
 Quotes Relating to Tax Planning
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

Basic Tax Questions

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. 


Should you form a corporation, partnership, limited liability company, or other type of entity? Is the entity a corporation or a partnership for tax purposes? How many entities should be formed? How are economic activities and the related items of income and expense allocated between entities? What is the taxpayer's filing status?  Is tax exempt status available? 

Fundamentals or Mechanics 
What income is taxable? What expenses are deductible? 

When is income taxable, and when are expenses deductible? What taxable period is used? 

Is income taxable by U. S., by a foreign government, or by both? Same questions applies to both U. S. taxpayers and to foreign taxpayers with U. S. source income.  Same questions are relevant to state and local taxes. 

Compliance (procedures and planning)
Forms, correspondence, record keeping, deadlines, and similar issues plus the related planning. 


Tax Planning Methods

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.

  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
3. Reduce tax rate (favorably taxed income)


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 

Marginal Tax Rates

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).

Prepay an Expense

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. 

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


Net cost of making early payment:

Pay out money now 
Avoid April 10th payment ($1,000 /1.02192) where .02192 is 100 days interest at 8%


$1,000.00      978.55 




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. 

Risk and Performance Measures
Decisions often have long run implications. This means that tax planners must consider the present value of alternatives and the relative risk of alternatives.

The rate of return over time is usually cited as an indication of an investment's desirability. Reported returns are often over stated because they are before tax and ignore both transaction and interest costs. 

Risk Measures 
Standard Deviation
How much an investment's rate of return varies over time is an indication of its risk. Thus, an investment that consistently earns 8% is less risky than an investment that averages 8%, but fluctuates widely from year to year. The investment which earned 8% consistently would have a standard deviation of zero. 

Coefficient of Determination
R ²  represents the correlation between an investment's price fluctuation and the "market's" price fluctuation. If the coefficient of determination approaches 100% it means that the price of an investment moves with the market. 

Beta is the ratio of the average change in an investment's value divided by the average change in the "market". Thus, an investment that's value, on average, changes 1.2% when the market changes 1% is said to have a Beta of 1.2 (1.2%/1%). A Beta greater than 1 suggests that an investment's price fluctuates more than the market, and  it therefore is said to be a "riskier" investment. A Beta less than 1 indicates that the investment is less risky than the market.

Alpha is the difference between an investment's actual return and the expected return given the investment's risk (as measured by its Beta). Thus, if the "market" is returning 10% and an investment's Beta is 1.2, then that investment should be returning 12% (10% X 1.2). 

Constraints on Tax Planning

Substance over form
The essential characteristics of a transaction determines how it will be treated not the labels that are placed on the transaction by the parties. For example, an investment in a corporation is treated as a loan, stock, or a lease depending on the characteristics of the investment and not merely the labels used. In tax cases the idea is sometimes referred to as the economic substance (or economic reality) of the transaction. For tax issues, often it is the economic impact of a transaction that indicates it substance.

Business purpose
The tax motivated spin-off of a corporation's liquid assets into a new corporation followed by liquidation of the new corporation was taxed as a dividend even though transaction met the requirements of reorganization-liquidation. Supreme Court established business purpose as a requirement for some but not all transactions. Evelyn F. Gregory v. Helvering, 14 AFTR 1191, 35-1 USTC  ¶ 9043 (USSC, 1935).

Step transaction
Combine many steps to determine appropriate treatment of events. Rule from common law. Could be applied to Gregory situation.

Clear reflection of income
Accounting methods used by taxpayer must clearly reflect income. IRS can accelerate the reporting income or defer deductions or make other changes in order to clearly reflect income. Sec. 446(b).

Constructive receipt
Taxed on income if it is available to taxpayer even if taxpayer has not yet received it.

Reasonable amount
Sec. 162 limits the deduction for compensation to a "reasonable amount." This limitation probably can be extended to rent, interest, royalties, etc. In other words, arm's length dealing and fair market value are ways to determine the substance of a transaction. Thus, rent paid in excess of fair market value may be an indication that the payment is actually a nondeductible dividend. 

Assignment of income
Lucas v. Guy C. Earl, 8 AFTR 10287, 2 USTC  ¶ 496 (USSC, 1930)-- husband's income taxed to him in spite of agreement to share income with wife. 

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
Sec. 482 grants the IRS authority to reallocate income, deductions, gains, losses, and credits among related taxpayers. An extension of assignment of income that is particularly useful relative to families, related corporations, and international operations. Thus, salary to child actually dividend to father and a gift to the child, and income of foreign subsidiary actually income of parent.

Major Loss Limitations
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
Jim invests $10,000 in a partnership and receives a 40% interest.  The partnership borrows $400,000 on a nonrecourse basis. Jim's basis in the partnership is $170,000 ($10,000 + 40% x $400,000), but he is at-risk for only $10,000 because the loan is non-recourse. The partnership buys and leases equipment.  Jim materially participates in the business. During the first year, the rental revenue is $70,000, depreciation is $40,000, interest expense is $35,000 and other expenses are $25,000. The loss is $30,000 ($70,000 - $40,000 - $35,000 - $25,000). Jim's share of the loss is $12,000 (40% x $30,000).    Jim can only deduct $10,000 of loss because he is at-risk for only $10,000. Jim can deduct no future losses unless he invests additional capital or he becomes liable for partnership debts. In reality, what the rule says is that because he is not liable for the debt that is creating the basis for the equipment,  his deduction for the depreciation that the debt is generating is limited. He could walk away from the partnership without any obligation to pay the partnership's debt.  The rule limits how much depreciation Jim can deduct but not other expenses which are paid or for which he is personally liable.

Investment interest example
Jill and Jerry borrow $100,000 at 8% interest to buy stock.  The stock pays dividends of $2,000. They  have $1,000 of interest income from other investments.  They pay $8,000 of interest expense on the borrowed funds. Assuming they elect to have the dividend taxed at ordinary rates, they can claim an itemized deduction of $3,000 for investment interest.  The remaining $5,000 of interest is carried over and can be deducted from future investment income. 

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. 


Tax Case: Loss limiters
Business Operations

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.

New Business Checklist

When you start: 

  • Obtain necessary federal, state, and local business licenses  
  • Check on local zoning ordinances  
  • Apply for sales and use tax seller's permit  
  • File with county clerk and publish a fictitious business name, also file an affidavit and proof of publication with the state  
  • Obtain necessary insurance coverage  
  • Form legal entity which normally involves filing required document with state Secretary of State (for example, articles of incorporation and bylaws for a corporation or certificate of limited partnership for a limited partnership)  
  • Apply for employer identification number by filing federal Form SS-4  
  • Make an S election, if applicable  
  • Open bank account, issue stock, elect directors, hold directors' meeting, transfer assets (title) to business  
During the year: 
  • File monthly sales tax form--often transfers of assets or leases of assets to a corporation/partnership are subject to sales tax  
  • Make quarterly estimated payments (entity or owner must almost always file even during the first year unless a loss is expected)--do not forget Florida F-1120ES if a corporation.  
  • Make payroll tax deposits and file payroll tax forms  
  • File annual tax information returns, Forms 1096, 1098, 1099, W-2, etc.  
  • File federal tax return (Form 1120, 1120S, etc.) and Florida Form F-1120, if applicable and make new estimated payments  
  • File annual report with State and pay necessary fee  
  • Renew licenses  
  • File Personal Property Tax Return, Form DR-405 with the county by April 1.  
  • File Intangible Personal Property Tax Return, Form DR-601 with the state by June 30. 

        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.

Accounting Methods and Periods
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.

  Uniform Capitalization Rules
Sec. 263A
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 
In general, when valuing inventory and contracts taxpayers must include a broadly defined group of overhead costs. Previously, many businesses included only factory overhead costs in inventory omitting service costs such as personnel, purchasing, payroll, legal departments, and data processing. Now, such costs must be included in inventory to the extent they are associated with production. UNICAP does not require the inclusion of marketing, internal audit, tax departments and certain other specified activities. 

In the case of resale businesses, only off-site storage, purchasing, and handling must be included in inventory, but only if average gross receipts during the previous three years exceed $10 million. 

Depreciation and interest 
When determining the amount to include in inventory, tax depreciation (not financial depreciation) is used. 

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. 

These additional costs may be allocated to inventory in a manner similar to an overhead application rate. For example, if these costs are equal to 20% of other manufacturing costs, then the inventory value can simply be increased by 20%. In the case of LIFO users, the adjustment is made only to the current LIFO layer which means no addition is made in years when the ending inventory is lower than the beginning inventory. 


   Tax Case: Starting a Business
Some of the major tax related factors influencing property decisions include: 

  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
Tax Planning and Employee Compensation

Much tax planning relating to employee compensation relates to four issues.

Regulating amount of compensation: too high or low 
Unreasonably high compensation is sometimes paid to the C corporation shareholders and their relatives in order to reduce the corporate income tax.  The current low tax rate for dividend income makes this less beneficial especially when payroll taxes are considered.
Low compensation is sometimes paid to owners of S corporations in an effort to avoid payroll taxes or to effectively shift income to other family members who are shareholders.  High compensation can be paid to family members in an effort to shift income to such members, but that can be at the cost of payroll taxes. Such shifts are done to move income to individuals in lower income tax brackets and to move income between generations without transfer taxes.

Controlling employee/ independent contractor status 
Whether a worker is "controlled" by a business is a critical factor in deciding whether that worker is an employee or independent contractor.  If a business is successful in avoiding control, a business is able to avoid payroll taxes, worker's compensation, fringe benefits coverage, and even liability for the worker's actions. 
Avoiding "control" can also permit the worker to deduct the cost of equipment, tools, transportation, travel, etc. for payroll tax purposes as well as income taxes (if use standard deduction or itemize and face the 2% of AGI floor). Expense reimbursement can sometimes be used as an alternative to assist employees. Often under reporting of income is a hidden motive behind efforts to avoid employee status. Employment status is often an important issue for drivers, plumbers, electricians, real estate and other outside sales personnel, appraisers, surveyors, etc. 

Effectively utilizing fringe benefits and deferred compensation 
As noted below, many fringe benefits are tax favored which means employers should effectively utilize "desired" benefits. Some benefits produce employer deductions without employee income (e.g., health insurance). Some benefits, profit sharing in particular can be used to  "zero out" a businesses taxable income.  Other benefits provide employers deductions without cash (stock bonus, ESOP). 
Controlling coverage is important to assure that benefits are not provided to employees who do not perceive the benefits as being worthwhile. 

Controlling timing of deduction and income 
A fiscal year C corporation can pay bonuses to employees in January and obtain a current deduction for itself while employee delays recognition of income. An accrual basis calendar year corporation can accrue bonuses to "unrelated" employees in December and pay bonuses in January. Result is a current deduction for the company with delayed income to the employee. In general, these techniques cannot be used by personal service corporations and corporations controlled by the employees who are receiving the benefit.
Other forms of compensation such as stock options and qualified retirement plans, which are discussed below,  impact when employees report income and when employers are entitled to any related deduction.  Another provision, Sec. 83, permits stock and other property to be issued to employees without current taxes.  The property must be restricted. That is, to keep the property the employee must remain with the company for a specified time period and the property cannot be sold until the employment obligation if fulfilled.  The employer's deduction is also delayed. When the restrictions lapse, the employee reports the value of the property at that time and the employer receives a deduction at the same time. 

Tax Favored Fringe Benefits
Current deduction for employer without taxable income to beneficiary 

May be part of a Sec. 125 cafeteria plan 
a. Sec. 79 Group-term life insurance (limited to $50,000) 
b. Sec. 106 Medical and disability insurance (premiums only) 
c. Sec. 105 Medical reimbursement 
d. Sec. 129 Dependent care assistance (maximum $5,000)* 
e. Sec. 132 Parking, transportation, recreation and athletic facility*
f.  Sec. 137 Adoption assistance program (maximum $10,000)

Not part of cafeteria plan 
g. Sec. 132 Fringe benefits (no additional cost*, employee discounts*, working condition*, de minimis*, moving expense, and retirement planning)
h. Sec. 274 Employee awards 
i. Sec. 119 Meals* and lodging 
j. Sec. 127 Educational assistance (maximum $5,250)* 
k. Business auto*, etc. 

*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
Beginning in 2002, employers may take a credit equal to 25% of qualified child care expenditures (10% of qualified resource and referral expenditures) up to a maximum credit of $150,000.  The credit is allowed in lieu of a deduction for the expenditures. Low tax bracket employers  prefer the credit to a deduction.  Because eligible costs include the cost of constructing a facility the credit will benefit high tax bracket employers who incur such costs..

Current deduction for employer, deferred income for employee 
a. Sec. 401 Pension, profit sharing, and stock bonus 
b. Sec. 401 Cash or deferred arrangement (if choose deferral)
c. Sec. 423 Employee stock purchase plan option 

No deduction, and deferred income for employer 
a. Sec. 422A Incentive stock option 
b. Sec. 83 Restricted property (appreciation not deductible, balance is a deferred deduction).

More information is provided below for retirement plans and options.


 More detailed information on retirement plans.
Cost/Benefit Analysis
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 
A corporation in the 35% tax bracket pays a bonus of $100 to an employee in the 33% tax bracket. Medicare tax (1.45%), but not Social Security tax, is applicable. 

Company's cost
FICA tax
Less: Income tax saved
Net cost

$ 65.94
Employee's benefit
Less: FICA tax
Less: Income tax
Net benefit

Cost benefit ratio    1.006

$  65.55

  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.
Company's cost
Less: Income tax savings
Net cost

Employee's benefit

Cost benefit ratio .650

  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. 
Company's cost
FICA tax*
Less: Income tax savings
Net  cost

*.0145 X 2 X $138

Employee's benefit
Employee's perceived value
Less: Income tax on benefit**
Net benefit
**.33 X $138

Cost benefit ratio .751

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. 
Company's cost
Less: Income tax savings
Net cost

$  .65
Employee's benefit
Future benefit
Less: Income tax on benefit
Net future benefit
Present value of after tax benefit

Cost benefit ratio .439

If employee discount rate of 8%, then result is .580. 

If employee discount rate of 10%, then result is .766.


 Tax Case: Employee compensation
Stock Options
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.

Several employer and employee conditions must be met in order that options be covered by ISO rules: 

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. 

The treatment of an NSO depends on whether the options have a "readily ascertainable fair market value." If the option price is lower than the value of the stock, the option will likely be deemed to have a market value at least equal to the difference. In such cases, the value of the option is taxable at the time the option is received, and the employer receives a deduction for the value. No tax is imposed on the exercise of such options, but the sale of the stock itself is taxable as a capital gain or loss (selling price minus the total of the cost of the stock and the income recognized when the option was received). 

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).

The option price may as low as 85% of the value of the stock at the time the option is granted or alternatively 85% of the value of the stock at the time the option is exercised.. Employees are limited to receiving options for no more than $25,000 of stock per year. If the option price is tied to the value of the stock at the time the option is exercised, the term of the option can be as long as 5 year.  If the option price is tied to the value of the stock at the time the option is received, the term of the option can be no longer than 27 months. Option must be offered to most employees (may exclude certain new, part-time, seasonal and highly compensated employees).  Employee reports no income until stock is sold. If meet holding period requirement (a minimum of two years after date of the option and a minimum of one year after date of acquisition of stock) the employee reports a capital gain if option price was no lower than the market value of the stock at the time the option was received.  If option price was lower than the market value of the stock at the time the option was received, the amount of the discount must be reported as ordinary income and any additional gain is a capital gain. Employer receives no deduction if the holding period requirements are met. The employee reports ordinary income and the employer receives a deduction if holding period requirements are not met.

Stock Option Example
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:

  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.

Multi-Jurisdictional Taxation Issues
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.

Florida Taxes
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. 

Document Stamp Tax--Florida imposes a tax  at issuance on the face value of notes, bonds, mortgages, and other written obligations at a rate of .35% (.0035) and on the transfer price of real estate at a rate of .7% (.007). The tax on stocks was repealed in 2002.  All parties to the transaction are responsible for the tax.  Typically, however, the borrower pays the tax on debt and the seller pays the tax on the transfer of real estate title. 

 Apportioning Multi-State Income

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.

  • Mississippi favors the use of "separate accounting" which is an allocation system, but permits apportionment. Separate accounting is effectively used by the federal government in determining the U.S. taxable income of foreign businesses with U.S. source income.  
  • Many states use "separate accounting" for special industries (agriculture, real estate rental, construction, and oil and gas are common).  
  • Separate accounting is used by almost all states for non-business income such as dividends and interest.  
Uniform Division of Income for Tax Purposes Act (UDITPA) specifies that the sales, payroll, and property factors are to be equally weighted in the apportionment formula. Over the years, many states have increased the weight on sales and reduced the weight on other factors. 
  • 13 states (AK, AL, CO, DE, HI, KS, MO, MS, MT, ND, OK, UT, VT) and DC use UDITPA rules and assign equal weight to each of the three factors (sales, payroll, and property).  
  • 24 states (AR, AZ, CA, CT, FL, GA, ID, IN, KY, LA, MA, MD, ME, NC, NH, NJ, NM, NY, RI, SC, TN, VA, WI, and WV) place 50% weight on sales and 25% each on property and payroll.  
  • 8 states (CT,  IA, IL, MA, MS, MO, NE, and  SC) use sales factor only. TX uses sales only in determining state capital stock tax. 
  • 5 states (MI, MN, OH, OR, and PA) weight sales more than 50% but less than 100%. Sales are weighted  90%, 75%, 60%, 80%,and 60% respectively.
  • 1 state (CO) uses sales and property only.
  • 6 states (CO, CT,  MA, MS, MO, and SC) permit two or more methods.
  • 5 states (NV, SD, TX, WA, and WY) have no state income tax.  
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.
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.
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.

 Multinational Taxation

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.


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 
Shareholders receive a credit for taxes paid by corporation. The system is used by U.S. for foreign taxes paid by subsidiary and for foreign taxes paid by an S corporation on items such as taxes paid on dividends received by the S corporation. This is the system employed by Denmark, Ireland, UK (including Canada, Australia, and New Zealand) France, and Italy. Limited use in Germany. 

Split-rate system 
Corporate profits taxed at different rates, depending on whether they are retained or distributed. Used by Greece and limited use in Germany. 

Exemption system 
Dividends from a foreign subsidiary are exempt. Not exclusively used in any major country, but used to some extent in Belgium and Spain. 


The major provisions intended to reduce the burden of double taxation of international income and to
encourage international business activity include:
Foreign Tax Credit
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: 
a) Actual foreign income tax, or 
b) Taxable foreign income /Taxable income* x Gross U. S. income tax**
*Before personal and dependency exemptions.
**Net of personal credits such as the child care credit.

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  
  • In lieu of the credit may deduct $110,000. If company chooses the credit, the excess foreign tax of $5,000 can be carried back 1 years and carried over 10 years.  
  • Why would anyone take the deduction? If the foreign tax rate is greater than 100%, which could occur when there is a profit in one foreign country but a loss in another.  
  • Also, the credit must be figured separately for passive income (such as dividends, interest, and rents) if the foreign tax rate is lower than the U. S. rate. 

Foreign Earned Income Exclusion
  • May exclude a limited amount of income earned while working in a foreign country (does not cover U. S. government employees).  
  • 30% limitation for business income.  
  • Resident or Physical presence (facts and circumstances v. 330 days out of 12 months)  
  • Lesser of $80,000 (adjusted for inflation and pro rated if less than 12 months) or earned income + housing costs over 16% x GS-14, step 1 salary.  
Prorate related deductions and credits such as moving and employee: 

Nondeductible portion = Deductions X (Exclusion/Foreign Earned Income) 

Export Income/Production Income
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.


 Possessions Income

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. 
Residents of U.S. Possessions
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:
Controlled Foreign Corporation
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
To be classified as a CFC over 50% of a corporation's voting stock must be owned by U. S. shareholders. U. S. shareholders are persons holding at least 10% of voting power.

Attribution rules are used to determine if a person owns over 10%:

  • spouse, child, grandchild, parent 
  • stock owned by partnership, trust, estate is attributed to beneficiary on basis of interest in entity 
  • 50% shareholders are attributed stock held by corporation.
Subpart F Income
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".

U. S. shareholders are taxed currently on the CFC's income. If foreign base sales are under 5% of gross income and under $1 million--then exempt. From 5% to 70%-- proportional part is taxed. Over 70%--taxed on all income. U. S. shareholders are taxed currently on the CFC's income. 

Special Rules Relating to International Income
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. 

Foreign Currency Transactions
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 
In some cases international transactions are recorded using the U.S. dollar. Gains and losses are reported from currency exchanges, debt payments etc. This is often the method used in the case of sales to foreign customers even if payments are received in the foreign currency. 

Reports kept using a foreign currency 
International records are kept in the local currency. Income is computed in the foreign currency and translated into the dollar. 

In general, businesses keep records in the currency of the country where the economic activity takes place. In some cases the U.S. dollar is used rather than the local currency. This may be because the dollar is the medium of exchange in spite of the fact that the economic activity is in a foreign country. It may also be because of hyperinflation of the foreign currency. 

How Foreigners Are Taxed
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)
Sale of real estate   10% of amount realized  
Capital gains

Alternative Minimum Tax

 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
= 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
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.
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 deduction, if any, is recomputed using AMT rules, and is limited to 90% of AMTI before the NOL deduction.

ACE depreciation and gains and losses must be recomputed.
Exempt income (e.g., interest and life insurance proceeds) is included in ACE. Related deductions are allowed.
Installment method is not allowed.
The 70% dividend received deduction is disallowed, but the 80% and 100% dividend received deductions are allowed.
Organizational costs may not be deducted forACE.
LIFO is not allowed for ACE.
Depletion is based on cost.
Charitable contribution deduction is recomputed using ACE income.

AMT Exemption
The AMT does not apply to small corporations (generally those with gross receipts of less than $5,000,000 during the 3 prior years).

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
Taxpayers are allowed to carryover any minimum tax they pay (the difference between AMT and the regular income tax), and subtract it from any regular income tax in the future, as long as it does not reduce that tax below that year's AMT.


AMT Example:
AMT Inc.'s taxable income is computed as follows:
Gross margin
Installment gain
Dividends received
Operating expenses
NOL deduction
Charitable contribution
Dividend rec'd. deduction
Taxable income
    (    - 0 -   ) 

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
Operating expenses
NOL deduction
Charitable contribution
Dividend rec'd. deduction
ACE adjustment


  $  763,200




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



  Tax Case: AMT
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.

Summary of Tax Depreciation Rules
  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.  
  • AMT Alternative minimum tax  
  • ACE Adjusted current earnings  
  • ACRS Accelerated cost recovery system  
  • MACRS Modified accelerated cost recovery system  
  • ADS Alternative depreciation system   (Tables needed for case are available here.)

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.

AMT for Individuals
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.)


  Family Tax Planning

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.

Financial Planning
Financial planning is a growing area of financial services offered by accountants.

Comprehensive plan includes:

  • Personal financial statements  
  • Cash budget  
  • Analysis of debt (payment problems, refinancing for deductibility or lower rate, or longer term)  
  • Investment analysis (amount, diversification, risk)  
  • Retirement plan (establish pension plan, SEP, etc.)  
  • Tax plan (projections, ways to reduce taxes)  
  • Insurance analysis (life, medical, long-term care, homeowners, liability, automobile, and business)  
  • Estate plan (wills, gifts, trusts, title to property)  
Financial Planning Steps
Steps to follow: 
  • Gather factual data (tax returns, wills, investment information etc.)  
  • Gather preference information (risk preferences, plans, problems, etc.)  
  • Write up a summary of data relating to insurance, retirement plans, wills, investments, etc.  
  • Prepare a status quo cash flow projection (leave open for taxes). Include personal, business, and investment items, debt service etc.  
  • Prepare a status quo tax projection (and complete cash flow).  
  • Prepare a current and projected status quo balance sheet.  
  • Develop estate plan, investment plan, retirement plan, insurance plan, etc. Involves a subjective weighing of attitude towards risk, plans for retirement, etc.  
  • Prepare revised cash flow, tax projections, and balance sheets.  

A useful Excel file for computing  future net worth  is available.
Another Excel file projects  retirement income and wealth.
Tax Favored Investments
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
Can deduct interest currently.
Depreciation based on a 39 year recovery period (27.5 years in case of residential property).
Gains on sale qualify for capital gain treatment. Can use installment method or like kind exchange.
Generally subject to the passive loss limitation.

Low Income Housing
Receive a credit spread over 10 years with a present value equal to 70% of the basis of the building (or portion that is low income housing). If construction is government subsidized the credit is 30%.
Rental rate is limited. For example, for households with income less than 50% of the median income in the area, rent is limited to 15% of the median income. To illustrate, if the median income is $30,000 and family's income is $12,000, rent is limited to $4,500.
Although losses are subject to the passive loss limitation, the income phase out is inapplicable.

Building Rehabilitation Credit
The rehabilitation credit is equal to 10% of the qualified rehabilitation costs for nonresidential buildings originally placed in service before 1936. In the case of certified historic structures (including rental residential property) the credit is equal to 20% of the qualified rehabilitation costs. The cost of the rehabilitation must be no less than the greater of $5,000 or the basis of the building at the time the rehabilitation begins.
Although losses are subject to the passive loss limitation, the income phase out is based on $200,000 of AGI.
Basis of property is reduced by the credit.



                                                                                Tax Favored Investments and Tax Planning

 Tax Planning Method


     Taxable  Bonds

  Exempt Bonds

    Real Estate

    Oil and Gas

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



Defer sale, Installment sale, Exchange, Exclude gain on personal residence (limited)

Defer sale, Installment sale, Exchange

Accelerate deductions







Prepay some expenses    (Passive loss rules apply)

Intangible drilling costs , Prepay expenses (Passive loss rules normally do not apply)

Defer tax payment












Reduce taxable income (convert to exempt income)



Savings bonds may qualify for education exclusion

Interest is exempt





Reduce taxable income (maximize deductions)

 Dividend received deduction (corporations)







Depletion, Production deduction


Reduce tax rate (smooth income)

Timing sales



Timing sale, Installment sale


Reduce tax rate (split/shift income, etc.)

Joint ownership,    Gift, Family partnership


Joint ownership,    Gift, Family partnership




Joint ownership, Partnership including family partnership,  Gift. 

Joint ownership, Partnership including family partnership,   Gift

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


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


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.


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
              Gift Tax
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. 

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: 

  • Gifts between spouses and property settlements that are part of a divorce are exempt.
  • Taxpayers who fulfill their legal obligation to provide support are not making taxable gifts, but support provided that does not fulfill a legal obligation is a gift.  An exception permits taxpayers to directly pay medical expenses and tuition without the payments being considered gifts.
  • Charitable contributions and political contributions are exempt from the gift tax. Charitable contributions, but not political contributions, are deductible for income taxes.
  • Qualified disclaimers are not taxable gifts. An individual who is entitled to inherit property may decline the inheritance without the disclaimer being treated as a gift.
             Estate 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. 
              Planning Techniques
Common estate planning techniques include:
  • Make annual gifts to multiple donees to take advantage of the annual gift tax exclusions and to reduce the size of the taxable estate. Married couples can both make gifts doubling the amount of the annual exclusion. Valuable assets can be transferred this way by using "Self-Canceling Installment Notes."
  • Make both lifetime and testamentary charitable charitable contributions to reduce the size of the taxable estate.  "Charitable Lead Trusts" permit the donor to take a charitable deduction for a temporary interest given to charity.  The  present value of remainder interest  is a taxable gift to named beneficiaries.  "Charitable Remainder Trusts" permit the donor to take a charitable deduction for the present value of a future interest given to charity. The donor benefits from the retained interest while removing the property for the donor's estate.
  • Form a "Family Limited Partnership" in order to obtain valuation discounts based on limited marketability and lack of control.
  • Gift assets expected to increase in value. Examples include interests in a newly formed business and  life insurance policies. "Insurance Trusts" are sometimes formed to fund life insurance premiums.
  • Use both spouses' unified credit and lower brackets. The law provides for "Qualified Terminable Interest Property" which allows the surviving spouse to receive limited interest in the deceased spouse's property without the interest being included in the survivor's eventual estate.
  • Use marriage deduction to defer tax to the death of the second spouse.
  • Use generation skipping transfers to avoid tax (note a separate tax does limit this technique). Gifts to grandchildren and great-grandchildren can skip the estate tax that might be paid by the intermediate generations. Trusts created for this purpose are sometimes called "Dynasty Trusts." Especially useful for assets that family plans to retain such as a vacation home. Florida law allows trusts to be created for a term up to 360 years.
  • Sell options for family members to purchase assets in order to lock-in values. "Intentionally Defective Irrevocable Trusts" are sometime used to produce a similar result. Assets are sold to a grantor trust which names heir as remainder beneficiary. Selling price sets value for transfer tax purposes, but is ignored for income tax purposes as transaction is between grantor and the trust.  These techniques are subject to IRS challenge.
  • Gifts of future interests are taxed on the present value of the interest.  The unified credit (but not the annual exclusion) can be used to offset any gift tax. If donor dies during the interim, the full value of the property is included in the estate.  If donor outlives term, the interest passes to the donees without additional tax. Works well for assets expected to appreciate. Residence can be transferred through "Qualified Personal Residence Trust." Other assets can be transferred through "Grantor Retained Annuity Trust."

Tax Exempt Organizations
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: 
Exemptions extend from both judicial and statutory sources. McCulloch v. State of Maryland, 4 AFTR 4491 (USSC, 1819) established the doctrine of inter-government immunity, and contains the phrase, "The power to tax is the power to destroy." The Code does not contain  specific exemptions for cities, states, and counties, but instead exempts income derived from providing any essential government service (Sec. 115). As a result, some government services, such as city owned power companies are taxed. Although one might argue that utilities are essential services, the view is that it is not essential that the service be provided by the government.

Other statutory exemptions include Secs. 501(a) and 401. 

  • Sec. 501 lists 21 different categories of tax exempt organizations.  
  • Sec. 401 exempts pension, profit sharing, stock bonus, and certain other retirement plans.  

Exempt accounts and programs include Secs. 220, 223, 529 and 530.

  • Sec. 220 Archer medical savings accounts--limited plan that expires in 2005. Predecessor to Sec. 223 plans.
  • Sec. 223  Health savings accounts--provides that individuals who are covered by high deductible medical insurance plans  (which can be as low as $1,000 per covered individual) may make deductible contributions (up to $2,250 or higher for an individual, $4,500 for a family couple) to a tax-exempt health savings account. Withdrawals are exempt if used to pay medical expenses. Withdrawals used for other purposes are taxable and subject to a 10% penalty.
  • Sec. 529 Qualified tuition programs--prepaid tuition programs offered by states and educational institutions are generally exempt from income tax.  Individuals may purchase tuition, books, fees, supplies, equipment, meals and housing for family members. Such purchases are subject to gift tax, but not income tax. Income earned by program from investing funds is generally tax exempt. Distributions are exempt if used for education purposes.
  • Sec. 530 Coverdell educational savings accounts--banks and other approved institutions may offer education savings accounts.  Lower and middle income individuals may contribute up to $2,000 per year to accounts set up to pay education expenses of designated beneficiaries. Amounts in account accumulate on tax exempt basis. Distributions are exempt if funds are used pay educations expenses.
Partial exemptions include Secs. 526, 527, and 528.
  • Sec. 527 Political parties and campaign committees--contributions are not taxed; investment income taxed at the maximum corporate rates except congressional campaign committee which are taxed at regular corporate tax rates.  
  • Sec. 528 Home owners associations--dues are exempt; investment income is taxable at 30% with a $100 exemption.  
  • Sec. 526 Shipowner's associations--dividends and interest are taxable at corporate rates.  
Note the difference between: 
  • Nonprofit (American Automobile Association)  
  • Tax exempt (Labor union, pension plans)  
  • Partially exempt (Republican party)  
  • Qualified charitable (UCF or Red Cross)  
Nonprofit is an organizational form granted by the state.  Tax exempt status is granted by the federal government. In most cases the federal exemption also exempts the entity from state income taxes, and in some cases other taxes.  Qualified charities are eligible to receive deductible charitable contributions.  If not, recipient must report as income (assuming distributions are permitted (e. g., assets of a pension or profit sharing plan)). 

Tax exempt status is available to qualified organizations that apply and are granted such status. Application for tax exempt status is made on: 

  • Form 1023 [Application for Recognition of Exemption under Sec. 501(c)(3)] or  
  • Form 1024 [Application for Recognition of Exemption under Sec. 501(a)].  
Annual Filing: 
Form 990 [Return of Organizations Exempt from Income Tax]   
  • Churches, government agencies, and organizations with gross receipts of $25,000 or less are exempt from filing.  
  • Form 990T [Unrelated Business Income Tax]  
  • Form 990PF [Private Foundations]  
  • Form 4720 [Excise Tax on Private Foundations]  
Conditions for exempt status include
  • For the common good--means that the organization must benefit a broad group of individuals and not a narrowly defined group such as members of a single family. 
  • Not-for-profit--means that if revenue exceeds expenses that the difference is plowed back into the organization rather than being distributed in the form of dividends or otherwise.
  • Net earnings do not inure to the benefit of any private individual --Excess salary can be a problem. Should the organization liquidate, assets must normally be passed on to other exempt organizations. 
  • Not political--Political activity is prohibited for churches and private foundations. Other exempt organizations, at their elections, are permitted to engage in limited amounts of lobbying and grass roots political activity, but are subject to a tax under Sec. 4911. Note that campaigning for specific candidates is precluded even for electing organizations. Lobbying includes both expenditures to influence legislation and expenditures to influence public opinion. Grass roots political activity is permitted, but the distinction between electioneering and grass roots activity is often difficult to make.
  • Not contrary to public policy--Although not clearly defined, discrimination by a private university (Bob Jones University v. U.S., 52 AFTR2d 83-5001, 83-1 USTC ¶ 9366 (USSC, 1983)) caused it to lose its tax exempt status.   


Unrelated Business Income
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. 


  • The AICPA publishes the Journal of Accountancy. Subscription income is considered related, but advertising is unrelated.  
  • A college bookstore is a related activity, but could possibly grow to the point that it became unrelated--e.g., sold significant amounts of clothing to non-students. Similarly, rental income received during summer from the operation of a summer tennis camp constituted unrelated business income (Rev. Rul. 76-402, 1976-2 CB 177).  
  • Salvation Army's Thrift Stores are related, because the activity is a part of the training efforts of the organization.  
What is a business--on going as opposed to occasional--e. g., candy sale by high school students raising money for a band trip would not normally be a business. Investment income is not business income. Therefore, dividend and interest income is not subject to the tax. 

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.

Private Foundations
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: 

  • Fall within an entity definition: Sec.501(c)(3) organization (other than church, hospital, educational and a few others), and  
  • Lack public support: less than one third of support comes from "public" (the term public excludes substantial contributors (2%)) or over one third of support comes from gross investment income and net unrelated business income.  
Private foundations are generally subject to a 2% (4% for foreign private foundations) tax on investment income. Investment income includes interest, dividends, rents, royalties, and certain capital gains. The tax can be reduced to 1% if certain conditions are met which include having payouts of at least 5% of asset value. 

A series of "taxes" apply to private foundations, their managers, and other related persons if they engage in activities that are judged inappropriate.

 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.

Charitable Contributions
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.
Individual Limitations
AGI Limitation
Applicable to
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.

Contributions in excess of the above limitations may be carried over five years, and are subject to the same AGI limitations when they are carried over.

No Deduction
There is no deduction for contributions of services or for contributions to individuals, nonqualified organizations, or to foreign charities. Individuals may not deduct pledges.

The contribution limitation for corporations is 10% of taxable income computed without the contribution deduction, the dividend received deduction, or NOL or capital loss carrybacks. Corporations may deduct pledges if the actual contribution is made by the normal return due date. Corporations can deduct the value of inventory reduced by 50% of the income that would be recognized if the property were sold at its FMV (limited to twice the basis of the property), but the exception only applies to certain scientific equipment and to property used for the care of the ill, needy, or infants.