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CPA REG SU01 - 05
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CPA REG SU01 Ethics and Professional Responsibilities
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1.1 Practitioners
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Authorized to Practice Before the IRS
- Practice before the Internal Revenue Service (IRS) is the presentation to the IRS or any of its officers or employees of any matter relating to the following under laws or regulations administered by the IRS:
- Client's rights
- Client's privileges
- Client's liabilities
- Practicing before the IRS:
- Includes:
- Representing a taxpayer at conferences, hearings, or meetings with the IRS
- Preparing necessary documents and filing them with the IRS for a taxpayer
- Rendering written advice with respect to any entity, transaction, plan, or arrangement having a potential for tax avoidance or evasion
- Corresponding and communicating with the IRS for a taxpayer
- Authority to Practice
- Persons authorized to practice before the IRS:
- Attorneys
- An attorney who is a member in good standing of the bar of the highest court of any state, possession, territory, commonwealth, or the District of Columbia
- To practice before the IRS, an attorney or a CPA must:
- Not be suspended or disbarred
- File a written declaration for each party (s)he represents that (s)he:
- Is currently qualified
- Has been authorized to represent the party
- CPAs
- A CPA is an individual qualified to practice as a CPA in any state, territory, or possession of the U.S.
- To practice before the IRS, an attorney or a CPA must:
- Not be suspended or disbarred
- File a written declaration for each party (s)he represents that (s)he
- Is currently qualified
- Has been authorized to represent the party
- A CPA owes a general duty to exercise the skill and care of an ordinarily prudent accountant in the same circumstances. Moreover, Treasury Circular 230 states that diligence must be exercised in preparing, approving, and filing returns, documents, and other papers relating to IRS matters. Accordingly, the CPA is responsible for exercising independent professional judgment and complying with the law.
- Enrolled Agents (EAs)
- An EA is an individual, other than an attorney or a CPA, who is eligible, qualified, and certified as authorized to represent a taxpayer before the IRS.
- The EA designation is issued by the IRS to individuals passing the EA exam.
- Enrolled Actuaries
- Enrolled Retirement Plan Agents
- Annual Filing Season Program (AFSP) Participants
- Allowed only limited practice before the IRS:
- 1) Before IRS:
- Revenue agents
- Customer service representatives
- Employees
- 2) During examination only
- 3) Return that tax return preparer signed themselves for the period under examination
- 4) Allowed only limited tax advice related to return or refund participation
- Rules of conduct (9 elements) before the IRS:
- 1) Avoid conflicts of interest
- A conflict of interest exists if:
- The practitioner’s representation of a client will be directly adverse to another client or
- There is a significant risk that the representation of one or more clients will be materially limited by the practitioner’s responsibilities to another or former client, a third person, or by the practitioner’s personal interest(s).
- A practitioner may represent conflicting interests before the IRS only if:
- All directly affected parties provide informed, written consent once the existence of the conflict is known by the practitioner (written consent must be within 30 days of informed consent);
- The representation is not prohibited by law; and
- The practitioner reasonably believes that (s)he can provide competent and diligent representation to each client.
- A practitioner is not required to disclose the conflict of interest to the IRS.
- 2) Exercise diligence
- Diligence must be exercised in preparing and in assisting in preparing, approving, and filing returns, documents, and other papers relating to IRS matters.
- Diligence is presumed if the practitioner:
- Relies upon the work product of another person and
- Uses reasonable care in engaging, supervising, training, and evaluating the person.
- A practitioner may not unreasonably delay the prompt disposition of any matter before the IRS.
- 3) Submit information or records to the IRS
- Information or records properly and lawfully requested by a duly authorized officer or employee of the IRS must be promptly submitted.
- A practitioner also is required to provide information about the identity of persons that (s)he reasonably believes may have possession or control of the requested information if the practitioner does not
- The practitioner is excused from submitting the requested information if reasonable basis exists for a good-faith belief that:
- (a) the information is privileged or
- (b) the request is not proper and lawful
- 4) Advise clients about noncompliance
- A practitioner who knows about a client’s noncompliance which may be:
- (1) that the client has not complied with the revenue laws of the U.S. or
- (2) that the client has made an error or omission
- (3) is required promptly to advise the client of noncompliance and
- (4) the consequences of such noncompliance, error, or omission under the Code and regulations
- Circular 230 does not require the practitioner to notify the IRS.
- 5) Avoid negotiating or endorsing income tax refund checks
- A practitioner must not negotiate, including by endorsement, any income tax refund check issued to a client.
- 6) Avoid charging unconscionable fees
- A practitioner may not charge an unconscionable fee in connection with any matter before the IRS.
- Unconscionable definition:
- not right or reasonable
- unreasonable excessive
- 7) Avoid charging contingent fees
- A practitioner may not charge a contingent fee in relation to any matter before the IRS except in relation to an examination of:
- An original return
- An amended return
- A claim for refund or credit
- A judicial proceeding
- 8) Return client records (regardless of fee disputes)
- A practitioner must return client records on request, regardless of any fee dispute specifically:
- Those records necessary for a client to comply with his or her federal tax obligations.
- However, the practitioner may retain copies of client records including:
- Documents prepared by the practitioner that (s)he is withholding pending payment of a fee, with respect to such documents (provided state law permits retention of records in a fee dispute).
- 9) Advertise and solicit in accordance with laws
- Circular 230 allows advertising and solicitation with the following conditions:
- False, fraudulent, misleading, deceptive, or unfair statements or claims are not allowed. Claims must be subject to factual verification.
- Specialized expertise may not be claimed except as authorized by federal or state agencies having jurisdiction over the practitioner.
- Each of the following fees may be advertised:
- Fixed fees for specific routine services
- A range of fees for particular services
- The fee for an initial consultation
- Hourly rates
- Availability of a written fee schedule
- Best practices for tax advisors:
- Tax advisors should provide clients with the highest quality representation concerning federal tax issues by adhering to best practices in:
- Providing tax advice about federal tax issues
- Written Tax Advice
- When providing written advice about any federal tax matter, a practitioner must:
- Base the advice on reasonable assumptions,
- The advice cannot rely upon representations, statements, findings, or agreements that are unreasonable, i.e., are known to be incorrect, inconsistent, or incomplete.
- A practitioner may rely in good faith on the advice of another practitioner only if that advice is reasonable given all the facts and circumstances.
- The practitioner cannot rely on the advice of a person who either the practitioner knows or should know is not competent to provide the advice or has an unresolved conflict of interest.
- Reasonably consider all relevant facts that are known or should be known, and
- Use reasonable efforts to identify and determine the relevant facts.
- The advice must not consider the possibility that either a tax return will not be audited or a matter will not be raised during the audit in evaluating a federal tax matter.
- Preparing or assisting in preparing a submission to the IRS
- Tax advisors with responsibility for overseeing a firm’s practice for the above items should take reasonable steps to ensure that the firm’s procedures are consistent with the best practices for all:
- Members
- Associates
- Employees
- Best practices include four general elements:
- Performing the steps needed to support the facts for a tax filing
- Establish the facts
- Determine which facts are relevant
- Evaluate the reasonableness of any assumptions or representations
- Relate applicable law to the relevant facts
- Arrive at a conclusion supported by the law and the facts
- Communicating clearly with the client about the terms of the engagement
- Advising the client regarding the importance of the conclusions reached
- For example, whether a taxpayer may avoid accuracy-related penalties under the Internal Revenue Code (IRC) if a taxpayer acts in reliance on the advice
- Acting fairly and with integrity in practice before the IRS
- Does not include:
- Preparing less than substantially all of a:
- Tax return
- Amended return
- Claim for refund
- Furnishing information upon request to the IRS
- Appearing as a witness for a person
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Sanctions and Penalties for Violations
- Sanctions:
- Practitioners may be censured (public reprimand), suspended, or disbarred from practice before the IRS for willful violations of any of the regulations contained in Circular 230.
- The Secretary of the Treasury may censure, suspend, or disbar from practice before the IRS any practitioner who:
- Is shown to be incompetent or disreputable
- Refuses to comply with the rules and regulations relating to practice before the IRS
- Willfully and knowingly, with intent to defraud, deceives, misleads, or threatens any client
- The following is a brief list of conduct that may result in suspension or disbarment:
- Being convicted of an offense involving dishonesty or breach of trust
- Providing false or misleading information to the Treasury Department, including the IRS
- Negotiating a client’s refund check or not promptly remitting a refund check
- Circulating or publishing matter related to practice before the IRS that is deemed libelous or malicious
- Using abusive language
- Suspension from practice as a CPA by any state licensing authority, any federal court of record, or any federal agency, body, or board
- Conviction of any felony involving conduct that renders the practitioner unfit to practice before the IRS
- Attempting to influence the official action of any IRS employee by bestowing a gift, favor, or anything of value
- A notice of disbarment or suspension of a CPA from practice before the IRS is issued to:
- IRS employees
- Interested IRS departments
- Agencies of the federal government
- State licensing authorities
- Penalties:
- Penalty for Understatement:
- Understating a client’s tax liability as a result of an error in calculation will not result in imposition of an IRS penalty unless it is the result of gross negligence or a willful attempt to avoid tax liability.
- Due to unreasonable positions
- Taking an undisclosed position without a reasonable belief that substantial authority exists that it will be sustained on its merits results in a penalty.
- Greater of:
- $1,000 or
- 50% of income derived/to be derived
- The penalty does not apply if:
- The preparer proves that (s)he acted in good faith and reasonable cause exists for the understatement.
- The position is disclosed, its tax treatment must have a reasonable basis.
- Positions relating to tax shelters are unreasonable unless reasonable belief exists that such positions would more likely than not be sustained on their merits.
- Due to willful or reckless conduct
- Greater of:
- $5,000 or
- 75% of income derived/to be derived
- Penalty for Preparing Tax Returns for Other Persons:
- Failure to furnish copy to taxpayer
- Failure to sign return
- Failure to furnish identifying number
- Failure to retain copy or list
- Failure to file correct information returns
- Endorsing or negotiating checks made to taxpayer in respect of taxes imposed
- The tax code provides that any tax return preparer who endorses or otherwise negotiates any check issued to a taxpayer with respect to taxes imposed by the IRC is subject to a penalty. Furthermore, any tax return preparer who operates a check cashing agency that cashes, endorses, or negotiates tax refund checks for returns prepared also is subject to a penalty.
- Failure to be diligent in determining credits and HOH status (for the best benefit of taxpayer)
- Equal to:
- $50 each
- Limited to $27,000 per year
- Equal to:
- $545 each
- Unlimited per year
- Other Penalties:
- Promoting abusive tax shelters
- Lesser of:
- $1,000 per organization/sale of promotion plan
- 100% of income derived/to be derived
- Unauthorized disclosure or use of information
- A penalty is imposed on any tax return preparer who discloses or uses any tax return information without the consent of the taxpayer.
- Equal to:
- $250 per disclosure
- Limited to $10,000 per year
- The penalty for disclosure is not imposed if the disclosure was made in the following circumstances:
- The taxpayer provided consent
- The taxpayer’s consent must be a written, formal consent authorizing the disclosure for a specific purpose.
- The taxpayer must authorize a preparer to:
- Use the taxpayer’s information to solicit additional current business from the taxpayer in matters not related to the IRS
- Disclose the information to additional third parties
- Disclose the information in connection with another person’s return
- In accordance with the Internal Revenue Code
- To a related taxpayer, provided the taxpayer did not expressly prohibit the disclosure
- Under a court order (subpoena) or to the tax return preparer’s legal counsel in the event of legal proceedings
- To tax return preparers within the same firm
- For the purpose of a quality or peer review to the extent necessary to accomplish the review
- For use in preparing, assisting in preparing, or providing services in connection with tax return preparation
- Penalties with Imprisonment:
- Aiding and abetting understatement of tax liability
- A preparer may be subject to only one aiding or abetting penalty per taxpayer (i.e., client) per taxable period (or event when there is no taxable period). However, other types of penalties may still apply.
- The penalty applies to the preparer even when a subordinate has been ordered to understate the tax liability, or the preparer knows but does not attempt to prevent the subordinate from understating the tax liability.
- Any act that constitutes a willful attempt to evade federal tax liability, even that of another person, is subject to criminal penalties, including imprisonment.
- Furthermore, any person who willfully aids or assists in preparation or presentation of a materially false or fraudulent return is guilty of a felony.
- Violations of these rules may result in disciplinary action by the director of the IRS, and an injunction may be issued prohibiting the violator from acting as a tax preparer.
- Equal to:
- $1,000 per year (others)
- $10,000 per year (corporate clients)
- Convicted of knowingly or recklessly disclosing information (misdemeanor)
- Equal to:
- $1,000
- Up to 1 year in prison
- Fraud and false statement
- Fraudulent transactions ordinarily involve a willful or deliberate action with the intent to obtain an unauthorized benefit.
- Equal to:
- $250,000 (others)
- $500,000 (corporate clients)
- Up to 3 years in prison
- Fraudulent returns/statements/other documents
- Equal to:
- $10,000 (others)
- $50,000 (corporate clients)
- Up to 1 year in prison
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1.2 Tax Return Preparers
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Tax Return Preparers:
- Persons who prepares or assists in preparing all or a substantial portion for compensation:
- A tax return
- Includes the following returns:
- Estate or gift tax returns
- Excise tax returns
- Withholding tax returns
- An amended return
- A claim for refund
- A portion of any return or claim for refund is deemed substantial unless a condition for unsubstantiality is satisfied. An unsubstantial portion is either:
- Less than $10,000 or
- Less than $400,000 and also less than 20% of the gross income on the return or claim.
- If more than one schedule, entry, or other portion is involved, all schedules, entries, or other portions shall be combined in determining whether a tax return preparer has prepared a substantial portion of any return or claim for refund.
- Persons who are tax return preparers (provided they are compensated) include the following:
- A person who provides to a taxpayer or other preparer sufficient information and advice so that completion of the return is simply a mechanical matter.
- A nonsigning tax return preparer who prepares all or a substantial portion of a return or claim for refund. Examples include preparers who provide advice that constitutes a substantial portion of the return.
- More than one person may be deemed to be a preparer of a tax return.
- An example of multiple preparers is when you have a signing tax return preparer and a nonsigning tax return preparer.
- Must comply with the following:
- Have a preparer tax identification number.
- Be subject to the duties and restrictions relating to practice before the IRS.
- Practice due diligence.
- Significant aspects of return preparation require:
- Making factual inquiries to ensure clients’ accuracy and truthfulness and
- Taking a position relative to tax law. In other words, assessing the scenario and appropriately applying tax law to the facts
- A tax return preparer may rely, if in good faith, on information provided by the taxpayer without having to obtain third-party verification however:
- The preparer may not ignore the implications of the information.
- The preparer must make reasonable inquiries if the information appears inaccurate or incomplete.
- The preparer should make appropriate inquiries of the taxpayer about the existence of documentation for deductions.
- When a tax return preparer discovers that a taxpayer has made an error in or omission from any document filed with the IRS:
- The tax return preparer must notify the taxpayer of the error or omission immediately.
- The tax return preparer also must advise the taxpayer of the consequences of the error or omission.
- If a taxpayer has made an error or omission on any document filed with the IRS, the tax return preparer must notify the taxpayer of the error or omission immediately upon discovery. However, the statute of limitations for assessment of a deficiency is 3 years from the later of the date the return was due or the date it was filed. If the statute of limitations has passed, the tax return preparer is not required to notify the taxpayer of the error.
- Disclosing reportable transactions.
- A reportable transaction is a transaction described in one or more of the following categories:
- Listed Transactions:
- A listed transaction is a transaction that is the same as, or substantially similar to, one of the types of transactions the IRS has determined to be a tax avoidance transaction. These transactions are identified by notice, regulation, or other form of published guidance as a listed transaction. A taxpayer has participated in a listed transaction if any of the following applies:
- The taxpayer’s tax return reflects tax consequences or a tax strategy described in published guidance that lists the transaction as a tax avoidance transaction.
- The taxpayer knows or has reason to know that tax benefits reflected on the tax return are derived directly or indirectly from such tax consequences or tax strategy.
- The taxpayer is in a type or class of individuals or entities that published guidance treats as participants in a listed transaction.
- Transaction of Interest:
- A transaction of interest is a transaction that the IRS and Treasury Department believe has a potential for tax avoidance or evasion, but for which there is not enough information to determine if it should be identified as a tax avoidance transaction.
- Loss Transactions:
- A Sec. 165 loss transaction is a qualifying loss not offset by any insurance proceeds or other similar compensation.
- Contractual Protection Transactions:
- A transaction with contractual protection is a transaction for which the taxpayer or a related party has the right to a full or partial refund of fees if all or part of the intended tax consequences from the transaction are not sustained.
- It also includes a transaction for which fees are contingent on the taxpayer’s realization of tax benefits from the transaction.
- Confidential Transactions:
- A confidential transaction is a transaction that is offered to the taxpayer or a related party under conditions of confidentiality and for which a minimum fee was paid to an advisor.
- Minimum fee:
- $50,000 (others)
- $250,000 (for a corporation
(excluding S corporations), partnership, or trust in which all of the owners or beneficiaries are corporations (excluding S corporations))
- Meet procedural requirements.
- A return preparer is required to sign the return or claim for refund after it has been completed and before it is presented to the taxpayer.
- Before a return preparer allows the client to sign the prepared return, the return preparer is required to provide a completed copy of the return or refund claim to the taxpayer.
- A return preparer is required to retain a completed copy of each return or claim prepared for 3 years after the close of the return period.
- An alternative is to keep a list that includes, for the returns and claims prepared, the following information:
- The taxpayers’ names
- Taxpayer identification numbers
- Their tax years
- Types of returns or claims prepared
- The return period is the 12-month period beginning on July 1 each year.
- Avoid negligence.
- Negligence includes any failure to make a reasonable attempt to either comply with the provisions of the Internal Revenue laws or exercise ordinary and reasonable care in the preparation of a return.
- Avoid frivolous submissions.
- Filing a frivolous return is penalized. A return is considered frivolous when it:
- Omits information necessary to determine the taxpayer’s tax liability,
- Shows a substantially incorrect tax or willful understatement of tax liability,
- Is based on a frivolous position (e.g., that wages are not income), or
- Is based on the taxpayer’s desire to impede the collection of tax.
- Be subject to the sanctions for violation of the regulations of Circular 230.
- Be subject to the penalties for violation of the regulations of Circular 230.
- Tax return preparers are subject to severe penalties for violations. The degree of severity varies among the penalties.
Individuals with overall supervisory responsibility for advice given by a firm are also subject to penalties.
- Regarding disclosure and confidentiality privilege extended to nonattorneys:
- The confidentiality privilege is extended to certain nonattorneys.
- In noncriminal tax proceedings before the IRS, a taxpayer is entitled to common-law protections of confidentiality with respect to the tax advice given by any federally authorized tax practitioner. They are the same protections a taxpayer would have if the advising individual were an attorney.
- A federally authorized tax practitioner includes any nonattorney who is authorized to practice before the IRS, such as a CPA.
- Tax advice is advice given by an individual with respect to matters that are within the scope of the individual’s authority to practice before the IRS.
- The privilege also applies in any noncriminal tax proceeding in federal court brought by or against the United States.
- The privilege may not be asserted to prevent the disclosure of information to any regulatory body other than the IRS.
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Not Tax Return Preparers:
- Persons who are not tax return preparers include the following:
- An employee who prepares a return for the employer by whom (s)he is regularly and continuously employed
- A fiduciary who prepares a return or refund claim for any person (the trust)
- A person who prepares a refund claim in response to a notice of deficiency issued to another
- A person who provides typing, reproducing, or other mechanical assistance, i.e., clerical
- A person who merely gives an opinion about events that have not happened, i.e., planning
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CPA REG SU02 Liability of CPAs
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2.1 Licensing and Disciplinary Systems
- CPA Examination questions do not test specific state disciplinary systems.
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State Boards of Accountancy
- State boards of accountancy are governmental agencies that license accountants to use the designation Certified Public Accountant
- Requirements for licensure, vary from state to state, include:
- CPA Examination
- License fee
- Education
- Experience
- Residency
- Requirements to remain licensed include:
- Continuing professional education (CPE)
- Peer review
- Ethics standards
- Revocation/suspension:
- State boards can suspend or revoke licensure through administrative process, for example, in board hearings.
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AICPA
- AICPA Disciplinary Mechanisms
- Professional Ethics Division
- The Professional Ethics Division investigates ethics violations by AICPA members.
- It imposes sanctions in less serious cases. For example, it may require a member to take additional CPE courses as a remedial measure.
- Joint Ethics Enforcement Program (JEEP)
- The AICPA and most state societies have agreements that permit referral of an ethics complaint either to the AICPA or to a state society.
- The AICPA handles matters of national concern, those involving two or more states, and those in litigation.
- JEEP also promotes formal cooperation between the ethics committees of the AICPA and of the state societies.
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SEC
- The SEC may seek an injunction from a court to prohibit future violations of the securities laws. Moreover, it may conduct administrative proceedings that are quasi-judicial.
- Such proceedings may result in suspension or permanent revocation of the right to practice before the SEC, including the right to sign any document filed by an SEC registrant.
- Sanctions are imposed if the accountant:
- Does not have the qualifications to represent others
- Lacks character or integrity
- Has engaged in unethical or unprofessional conduct
- Has willfully violated, or willfully aided and abetted the violation of, the federal securities laws or their rules and regulations
- Suspension by the SEC also may result from:
- Conviction of a felony or a misdemeanor involving moral turpitude
- Moral turpitude definition:
- Moral turpitude is a legal concept in the United States and prior to 1976, Canada, that refers to
"an act or behavior that gravely violates the sentiment or accepted standard of the community".
- Revocation or suspension of a license to practice
- Being permanently enjoined from violation of the federal securities acts
- The SEC may impose civil penalties in administrative proceedings.
- Furthermore, the SEC may order a violator to account for and surrender any profits from wrongdoing and may issue cease-and-desist orders for violations.
- Some proceedings have prohibited not only individuals but also accounting firms from accepting SEC clients. Furthermore, the SEC can initiate administrative proceedings against accounting firms.
- Suspension by the SEC also may result from:
- The SEC may, for example, prohibit a firm from appearing before the SEC if it engages in unethical or improper professional conduct. Such misconduct may include negligence.
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IRS
- The IRS may prohibit a CPA from practicing before the IRS if the person is incompetent or disreputable or does not comply with tax rules and regulations.
- The IRS also may impose fines.
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State CPA Societies
- State CPA societies are voluntary, private entities that can admonish, suspend, or expel members.
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Examples of disciplinary actions affecting multiple agencies:
- State Accountancy Board, AICPA, IRS. Filing a frivolous return is a violation of IRS rules. It is also a violation of the AICPA Statement on Standards for Tax Services. Violations of generally accepted standards of practice are grounds for discipline by the state boards of accountancy. The IRS shares information concerning violations of IRS standards with the respective state board of accountancy. The AICPA and most state societies have agreements that permit mutual referral of violations of AICPA Standards. Therefore, a violation uncovered by one organization will lead to sanctions by others.
- State Accountancy Board, SEC, AICPA, IRS. All of the entities can take disciplinary action for conviction of a felony.
- SEC, AICPA, IRS. Because Mary’s license has been revoked by the state accountancy board, no further action would be taken by the state board unless Mary practiced public accounting after her license was revoked. The SEC requires a CPA license to be eligible to practice before them. Therefore, they would revoke Mary’s right to practice. The PCAOB would deregister the firm. The AICPA requires licensure for membership. Revocation of the license results in automatic expulsion from membership. Individuals who wish to represent taxpayers before the IRS must be a CPA, an attorney, or an EA.
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2.2 State Law Liability to Clients and Third Parties
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Nonstatutory/Common Law Disputes/Legal Issues:
- Legal issues in contract disputes and other matters are covered in the contract law outline in Study Unit 18.
- Legal issues include the following:
- Whether the elements of a contract are present,
- The duties of the parties,
- Who may enforce the contract,
- Who is liable for breach of contract,
- What remedies are available for breach, and
- Whether the accountant may delegate responsibility for an engagement.
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Nonstatutory/Common Law Liability
- About Civil Law (Nonstatutory/Common Law):
- To be successful in a lawsuit for accountant’s negligence, there must be:
- Duty
- Breach
- Plaintiff known as intended user
- Reliance
- Loss
- Liable for:
- Liability to Client for Breach of Contract:
- A breach of contract occurs when an accountant fails to perform duties required under a contract. These duties can either be express or implied. All contracts carry the implied duty to perform in a nonnegligent manner. Parties to an enforceable contract are legally obligated to perform as promised. Breach of contract is unexcused failure to perform an unconditional contractual obligation as promised. For a party to be liable for damages, the breach must have resulted in a loss.
- Accountant's duties under contract:
- Reasonable care
- The accountant should have the degree of skill commonly possessed by other accountants in the same or similar circumstances, but an accountant is not a guarantor of the work.
- Exercising independent professional judgment
- Diligence/due care
- Compliance with professional standards
- Compliance with professional standards demonstrates that the accountant exercised reasonable care and diligence and is therefore a defense against negligence claims.
- A CPA is negligent if the CPA exercises less than the degree of care a reasonably competent CPA would exercise under the circumstances.
- Due care. The accountant is implicitly bound by the contract to perform the engagement with due care (nonnegligently) and in compliance with professional standards.
- Compliance with the law
- Contrary to law. A contract must have a legal purpose and is not enforceable if it is contrary to the law or is against public policy as declared by the courts.
- The engagement letter:
- The CPA should establish an understanding with the client regarding the services to be rendered. The engagement letter should describe:
- An engagement letter should be sent by the CPA to the prospective client on each engagement regardless of the services to be performed. If the client agrees to the contractual relationship by signing a copy of the letter and returning it to the CPA, it represents a written contract
- One year. In some cases, a contract must be in writing, for example, if it cannot be completed within 1 year.
- Contract disputes. Although not necessary for the formation of a contract, an engagement letter may prevent contract disputes.
- The services agreed upon by the client and accountant (whether or not required by professional standards),
- Fees to be paid, and
- Other pertinent details.
- The CPA must consult the client and obtain the client’s permission when delegating responsibility (outsourcing services to another firm/person other than an employee) for the engagement. The personal qualities of the CPAs are an inducement to enter the contract.
- Example of an engagement letter:
- EXAMPLE 2-2 Engagement Letter vs. Professional Standards
- Example of letter to tax accountant:
- Dear Mr. Smith:
- Could you please provide me with some guidance regarding the statute of limitations for my 2021 tax return? I have yet to file a waiver or extension agreement for the 2021 tax year, and I was wondering how long the IRS will be able to assess additional tax due for 2021. I believe that all income items are accurately reflected on my 2021 return. Thus, no income item is omitted from the return or understated by more than 25%. However, if an income item has been omitted, I would like to know the statute of limitations on the assessment of additional taxes on the potentially omitted income.
- I would also like to point out that I have never owned any securities, and I have never been involved in a tax shelter. Additionally, the IRS has not filed a return on my behalf. Thank you in advance for your advice.
- Sincerely,
- Eric Jones
- Example of client letter from tax accountant:
- The engagement letter may provide for positive confirmation of all accounts receivable. Professional standards may, in the circumstances of the specific engagement, permit negative confirmation of a sample of accounts receivable.
- Dear Mr. Jones:
- I appreciate the opportunity to advise you regarding this tax matter. To ensure a complete understanding between us, I am stating the pertinent information about the advice that I will be rendering and the facts you provided to me.
- Responsibilities
- I use my judgment in resolving questions where the tax law is unclear or where conflicts may exist between the taxing authorities. Unless you instruct me otherwise, I resolve such questions in your favor whenever possible. However, the opinion I express does not bind the Internal Revenue Service (IRS). Thus, I cannot guarantee the outcome in the event the IRS challenges my opinion. You remain responsible for any tax or related liabilities resulting from an adverse IRS or judicial decision.
- The law imposes various penalties when taxpayers understate their tax liabilities. Tax professionals also may be subject to penalties when an understated tax liability is based on a position that the professional recommends but lacks substantial authority or reasonable basis with disclosure.
- Facts
- The following facts are based on your written correspondence to me dated February 1, 2022. If these facts are incomplete or incorrect, please let me know right away. You are a U.S. citizen, and you have not filed a waiver or extension agreement for the 2021 tax year. Additionally, you have never been involved in a tax shelter, and you have never owned any securities.
- Conclusions and Recommendation
- Assuming no income item is omitted from the return or understated by more than 25%, only the general statutes of limitations rules apply. Thus, your statute of limitations for assessment of a deficiency is three years from the date the return is filed. A return filed before the due date is treated as filed on the due date.
- Please let me know if you wish to discuss any of these issues further. I’ve certainly enjoyed working with you on this project and look forward to assisting you in the future when you need tax advice.
- Best regards,
- Albert B. Smith
- Staff Accountant
- Remedies for breach of contract:
- Compensatory/Monetary damages (usual liability)
- The accountant-client contract is a personal service contract. Recovery for breach of contract ordinarily is limited to compensatory damages, and punitive damages are rarely allowed. Thus, an accountant is usually liable for money damages.
- Damages. Damages for breach of contract depend on the nature of the breach. The breach may be material or minor.
- Rescission (unjustifiable failure to perform)
- Recovery for breach of contract ordinarily is limited to compensatory damages, and punitive damages are rarely allowed. Thus, an accountant is usually liable for money damages.
- Defense of breach of contract:
- Examples of breach of contract:
- EXAMPLE 2-1 Accountant’s Breach of Contract
- An accountant and a client entity contract for the accountant to perform an audit for $2,500. The audit is contracted to be done within 3 months. The audit actually takes 6 months. A breach of contract has occurred.
- Typical defenses include:
- The absence of one or more elements of a contract
- Substantial performance
- The impossibility of the other party to perform
- Suspension or termination of the CPA’s performance is justified due to a material breach of contract by the client. The nonbreaching party (the CPA) is discharged from any obligation to perform.
- Failure of consideration is a defense to a suit based on breach of contract. It is not a defense to neither negligence or fraud.
- Strict liability without fault is not a basis for recovery from an accountant.
- Liability to Client for Negligence:
- An accountant may be liable in tort for losses caused by the accountant’s negligence. A tort is a private wrong resulting from the breach of a legal duty imposed by society. The duty is not created by contract or other private relationship.
- Accountant's duties under contract:
- Reasonable care
- The accountant should have the degree of skill commonly possessed by other accountants in the same or similar circumstances, but an accountant is not a guarantor of the work.
- Exercising independent professional judgment
- Diligence/due care
- Compliance with professional standards
- Compliance with professional standards demonstrates that the accountant exercised reasonable care and diligence and is therefore a defense against negligence claims.
- A professional is held to a higher standard of care than the ordinary person and also must possess and exercise the knowledge and skill of a member of that profession. Thus, the CPA firm must exercise both reasonable care and that expected of a CPA.
- A CPA does not guarantee detection of fraudulent schemes.
- A good faith failure to comply with applicable standards is evidence of negligence.
- Accountants may be liable for failure to communicate to the client findings or circumstances that indicate misstatements in the accounting records or fraud.
- They also must communicate all significant deficiencies and material weaknesses in internal control.
- A CPA is negligent if the CPA exercises less than the degree of care a reasonably competent CPA would exercise under the circumstances.
- Compliance with the law
- A CPA is a professional who must adhere to professional standards of care in the performance of his or her work. A CPA must perform in accordance with that degree of accounting knowledge and skill expected of an ordinary reasonable person who is a CPA. Whether the CPA has met the required standard is partly determined by compliance with:
- Failure to follow these standards results in liability for damages proximately caused by his or her negligence:
- (1) generally accepted auditing standards (GAAS)
- (2) PCAOB standards in a public-company audit
- (3) other applicable auditing standards, or
- (4) statutes that establish the standard of conduct for a reasonable person.
- Types of Negligence:
- Ordinary negligence
- Ordinary negligence may result from an accountant’s act or failure to act given a duty to act, for example, failing to observe inventory or confirm receivables. The accountant’s duty is to exercise the care and competence an ordinarily prudent accountant would under the circumstances.
- Negligent misrepresentation
- Negligent misrepresentation occurs when the accountant makes a false representation of a material fact not known to be false but intended to induce reliance. The plaintiff must reasonably have relied on the accountant’s misrepresentation and incurred damages. Negligent misrepresentation includes all elements of fraud except scienter.
- Under the negligence theory, the misrepresentation relied upon may be oral or written. A written misstatement is not necessary to prove negligent misrepresentation.
- Facts, not opinions, form the bases of a negligent misrepresentation case.
- Remedies for negligent misrepresentation:
- Defense of negligent misrepresentation:
- To prevail in an action for negligence, the client must prove that the CPA did not act with the same degree of skill and judgment possessed by accountants in the locality.
- The elements of common law negligence on the part of a CPA are (1) a duty owed to the client, (2) a loss incurred by the client, (3) a failure to exercise the skill and care of an ordinarily prudent CPA in the same circumstances, and (4) proximate (legal) causation of the loss by the failure to exercise due care.
- Negligent misrepresentation includes all elements of fraud except scienter.
- A plaintiff-client must prove all of the following elements of negligence:
- (1) the CPA owed the client a duty
- Defense to both negligence and fraud. An element of the torts of negligence and fraud is that the defendant owed the plaintiff a duty. In the majority of states, a defendant in a negligence case owes a duty only to foreseen third parties (foreseen users and users within a foreseen class of users). In a fraud case, the duty is to all foreseeable users.
- (2) the CPA breached this duty (aka breach of duty of care)
- Breach of a duty to conform to a specific standard of conduct for the protection of the plaintiff from unreasonable risk of injury
- Suspension or termination of the CPA’s performance is justified due to a material breach of contract by the client. The nonbreaching party (the CPA) is discharged from any obligation to perform.
- Defense to negligence. The plaintiff’s own negligence (contributory or comparative) or a third party’s actions, not the accountant’s behavior, may have caused the loss. In a state that has adopted the comparative negligence doctrine, the plaintiff’s negligence is not a complete defense. Damages are allocated between the plaintiff and defendant according to their comparative fault. However, fraud is not excused by the client’s negligence.
- (3) the CPA’s breach actually and proximately caused the client’s injury
- Proximate cause is a chain of causation that is not interrupted by a new, independent cause. Moreover, the injury would not have occurred without the proximate cause. However, actual causation is insufficient. The injury also must have been reasonably foreseeable. Thus, the concept of proximate cause limits liability to foreseeable damages. Accordingly, lack of proof of proximate cause precludes any recovery of damages.
- Proximate cause is an element of the tort of negligence. Thus, liability is imposed not for all consequences of a negligent act but for those with a relatively close connection.
- The plaintiff must prove that damage to the defendant’s person or property resulted from the negligent act.
- Defense to negligence. One defense to negligence (not fraud) is that the person alleging harm assumed the risk, e.g., by entering into a contract in which the defendant effectively disclaimed liability.
- (4) the client suffered damages
- Defense to both negligence and fraud. An element of the torts of negligence and fraud is damages. A plaintiff who has suffered no harm has no basis for relief.
- Gross negligence
- Gross negligence is failure to use
even slight care.
- The tort of intentional misrepresentation (fraud, deceit) consists of a material misrepresentation made with scienter and an intent to induce reliance. The misstatement also must have proximately caused damage to a plaintiff who justifiably relied upon it. Scienter exists when the defendant makes a false representation with knowledge of its falsity or with reckless disregard as to its truth.
- Remedies for gross negligence:
- In extreme circumstances, an accountant may be liable for punitive damages if (s)he is grossly (not ordinarily) negligent.
- Punitive damages. A court awards punitive damages only when the breach is malicious, willful, or physically injurious to the nonbreaching party.
- Defense of gross negligence:
- A plaintiff-client must prove all of the following elements of negligence:
- Defense to both negligence and fraud. State statutes require that a suit be filed only within a certain period. The length of the period depends on the nature of the claim. The reason for the limitation is that delay may result in loss of evidence.
- (1) scienter
- Scienter exists when the defendant makes a false representation with knowledge of its falsity or with reckless disregard as to its truth.
- Reckless disregard for the truth is an element in proving that a misrepresentation was grossly negligent.
- Defense to fraud. A finding of fraud requires proof that the accountant made a misrepresentation and the misrepresentation was made with scienter, that is, with actual or implied knowledge of fraud, therefore, making a misrepresentation without scienter is a defense to fraud. Since scienter is irrelevant in a negligence suit, lack of scienter is not a defense to negligence.
- (2) reasonable reliance on a misrepresentation
- An element of a fraud action is that the plaintiff relied justifiably on the material misstatement.
- Reasonable reliance on a misrepresentation is an element of fraud or of negligent misrepresentation.
- (3) material misrepresentation
- The tort of intentional misrepresentation
(fraud, deceit) consists of a material misrepresentation made with scienter and an intent to induce reliance. The misstatement also must have proximately caused damage to a plaintiff who justifiably relied upon it. Scienter exists when the defendant makes a false representation with knowledge of its falsity or with reckless disregard as to its truth. The CPA’s best defense would be that the false information is immaterial.
- (4) intent to induce reliance
- (5) proximately caused damage to a plaintiff who justifiably relied upon the misstatement
- Proximate cause is a chain of causation that is not interrupted by a new, independent cause. Moreover, the injury would not have occurred without the proximate cause. However, actual causation is insufficient. The injury also must have been reasonably foreseeable. Thus, the concept of proximate cause limits liability to foreseeable damages. Accordingly, lack of proof of proximate cause precludes any recovery of damages.
- One defense to negligence (not fraud) is that the person alleging harm assumed the risk, e.g., by entering into a contract in which the defendant effectively disclaimed liability.
- Defense to both negligence and fraud. An element of the torts of negligence and fraud is damages. A plaintiff who has suffered no harm has no basis for relief.
- Defense to both negligence and fraud. An element of the torts of negligence and fraud is that the defendant owed the plaintiff a duty. In the majority of states, a defendant in a negligence case owes a duty only to foreseen third parties (foreseen users and users within a foreseen class of users). In a fraud case, the duty is to all foreseeable users.
- Liability to Client for Fraud:
- Fraud is an intentional misrepresentation. It is a willful and deceitful act. An accountant is liable for losses that result from his or her commission of fraud. Punitive and compensatory damages are both permitted.
- Accountant's duties under contract:
- Reasonable care
- The accountant should have the degree of skill commonly possessed by other accountants in the same or similar circumstances, but an accountant is not a guarantor of the work.
- Exercising independent professional judgment
- Diligence/due care
- Compliance with professional standards
- Compliance with professional standards demonstrates that the accountant exercised reasonable care and diligence and is therefore a defense against negligence claims.
- A professional is held to a higher standard of care than the ordinary person and also must possess and exercise the knowledge and skill of a member of that profession. Thus, the CPA firm must exercise both reasonable care and that expected of a CPA.
- A CPA does not guarantee detection of fraudulent schemes.
- A good faith failure to comply with applicable standards is evidence of negligence.
- Accountants may be liable for failure to communicate to the client findings or circumstances that indicate misstatements in the accounting records or fraud.
- They also must communicate all significant deficiencies and material weaknesses in internal control.
- A CPA is negligent if the CPA exercises less than the degree of care a reasonably competent CPA would exercise under the circumstances.
- Compliance with the law
- A CPA is a professional who must adhere to professional standards of care in the performance of his or her work. A CPA must perform in accordance with that degree of accounting knowledge and skill expected of an ordinary reasonable person who is a CPA. Whether the CPA has met the required standard is partly determined by compliance with:
- Failure to follow these standards results in liability for damages proximately caused by his or her negligence:
- (1) generally accepted auditing standards (GAAS)
- (2) PCAOB standards in a public-company audit
- (3) other applicable auditing standards, or
- (4) statutes that establish the standard of conduct for a reasonable person.
- Auditor-accountants have no general duty to discover fraud. Nevertheless, an auditor is held liable for failure to discover fraud when the auditor’s negligence prevented discovery. An auditor who fails to follow professional standards and therefore does not discover fraud will probably be liable if compliance with professional standards would have detected the fraud.
- Example of auditor-accountant duty to discover fraud:
- EXAMPLE 2-7 Duty to Discover Fraud
- U.S. GAAS and PCAOB standards require an auditor to plan and perform the audit to provide reasonable assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud.
- The Public Company Accounting Oversight Board
(PCAOB) is a nonprofit corporation created by the Sarbanes–Oxley Act of 2002 to oversee the audits of public companies and other issuers
- An auditor must:
- (1) identify risks of material misstatement due to fraud
- (2) assess the identified risks
- (3) respond by changing the nature, timing, and extent of audit procedures
- Remedies for fraud:
- Compensatory damanges
- The client is liable for his or her percentage of the damages in a state that applies the comparative negligence rule. Most states have adopted a comparative negligence approach that allows a contributorily negligent plaintiff to recover a percentage of the damages.
- Punitive damages
- Defense of fraud:
- Examples of fraud:
- EXAMPLE 2-6 Fraud
- An accountant is engaged to audit financial statements. To increase profits from the engagement, the accountant planned to and did omit necessary audit procedures. The accountant committed fraud.
- A plaintiff-client must prove all of the following elements of fraud:
- A plaintiff must prove each element of fraud with particularity. Credible evidence that disproves one of the elements tends to negate liability.
- Defense to both negligence and fraud. State statutes require that a suit be filed only within a certain period. The length of the period depends on the nature of the claim. The reason for the limitation is that delay may result in loss of evidence.
- (1) the accountant made a misrepresentation.
- (2) the misrepresentation was made with scienter, that is, with actual knowledge of fraud.
- In an action for fraud, the client must prove scienter (intent to deceive or a reckless disregard for the truth). Scienter is an element of a fraud claim. A plaintiff must prove that the defendant acted with a particular mental state: intending a misstatement and intending that it induce reliance.
- Scienter exists when the defendant makes a false representation with knowledge of its falsity or with reckless disregard as to its truth. Furthermore, scienter is an element of fraud.
- If reckless disregard for the truth or gross negligence results in material misstatement or omission, the scienter element of constructive fraud is present even if the CPA is unaware of the misstatement. Constructive fraud is a fraud claim with the scienter requirement of actual knowledge satisfied by gross negligence. Gross negligence is such a reckless disregard for the truth that fraud is implied.
- Defense to both negligence and fraud. An element of the torts of negligence and fraud is damages. A plaintiff who has suffered no harm has no basis for relief.
- Defense to both negligence and fraud. An element of the torts of negligence and fraud is that the defendant owed the plaintiff a duty. In the majority of states, a defendant in a negligence case owes a duty only to foreseen third parties (foreseen users and users within a foreseen class of users). In a fraud case, the duty is to all foreseeable users.
- Defense to fraud. A finding of fraud requires proof that the accountant made a misrepresentation and the misrepresentation was made with scienter, that is, with actual or implied knowledge of fraud, therefore, making a misrepresentation without scienter is a defense to fraud. Since scienter is irrelevant in a negligence suit, lack of scienter is not a defense to negligence.
- (3) the misrepresentation was of a material fact.
- An element of a fraud action is that the plaintiff relied justifiably on the material misstatement.
- (4) the misrepresentation induced reliance.
- Reasonable reliance on a misrepresentation is an element of fraud or of negligent misrepresentation.
- (5) another person justifiably relied on the misstatement to his or her detriment.
- Liable to:
- Privity of contract (clients)
- Contractual Liability to Client (also called Privity of Contract). The contract between an accountant and a client is a personal service contract, so it can be litigated like any other type of contract. The usual remedy for breach of the contract is compensatory monetary damages.
- A CPA may limit liability by agreement with the client.
- Primary beneficiaries
- Under the primary benefit test, the accountant must have been aware that (s)he was hired to produce a work product to be used and relied upon by a particular third party.
- A third party is a primary beneficiary if:
- (1) The accountant is retained principally to benefit the third party,
- (2) The third party is identified, and
- (3) The benefit pertains to a specific transaction. Thus, the accountant knows the particular purpose for which the third party will use and rely upon the work.
- Example of primary beneficiary:
- EXAMPLE 2-5 Primary Beneficiary
- Smith, CPA, was engaged by Client, Inc., to audit Client’s annual financial statements. Client told Smith that the audited financial statements were required by Bank in connection with a loan application. Bank is a primary beneficiary and may recover damages caused by the CPA’s negligence.
- Under the primary benefit test, the accountant must have been aware that (s)he was hired to produce a work product to be used and relied upon by a particular third party. This is the narrowest test, and most courts allow such a third party to sue the accountant for ordinary negligence.
- Intended beneficiaries. Breach of contract occurs when a duty under the contract is not performed. Accountants are liable for breach of contract both to clients and third parties who are intended beneficiaries of the accountant’s services
- Reasonable foreseen third party users
- The majority rule is that the accountant is liable to foreseen (not necessarily identified in the contract) third parties (foreseen users and users within a foreseen class of users). They are all members of the class of persons whose reliance on the financial statements the accountant may reasonably anticipate.
- Foreseen third parties are those to whom the accountant intends to supply the information or knows the client intends to supply the information. They also include persons who use the information in a way the accountant knows it will be used.
- A foreseeable user is any person that the accountant should have reasonably foreseen would be injured by justifiable reliance on the misrepresentation. Accountant liability can extend to all persons who incur loss resulting from the accountant’s fraud, not only those known to the accountant.
- Because fraud involves intentional wrongdoing, the courts permit all foreseeable users of an accountant’s work product to sue for damages proximately caused by the fraud.
- Examples of foreseen third party users:
- EXAMPLE 2-3 Foreseen Users and Foreseen Class of Users
- Smith, CPA, was engaged by Client, Inc., to audit its annual financial statements. Client’s president told Smith that the financial statements would be distributed to South Bank in connection with a loan application. Smith was negligent in performing the audit. Subsequently, the financial statements were given to West Bank as well. West Bank lent Client $50,000 in reliance on the financial statements. West Bank suffered a loss on the loan. Smith is liable to West Bank because it is within a foreseen class of users, and the loan is a transaction similar to that for which the financial statements were audited.
- EXAMPLE 2-4 Reasonably Foreseeable Third Parties
- Smith, CPA, is engaged to audit the annual financial statements of Client. Smith is not informed of the intended use of the statements. However, Smith knows that they are routinely distributed to lessors, suppliers, trade creditors, and lending institutions. Client uses the statements, which were negligently prepared, to obtain a lease from XYZ, Inc., a reasonably foreseeable party. Smith will be liable to XYZ because it is a member of a class of reasonably foreseeable third parties.
- The traditional rules have been changed with the result that CPAs’ liability to third parties for negligence has been greatly increased. For example, under federal securities regulation, a CPA may be liable to any third party who purchases an initial issue of securities. At the state level, CPAs’ potential liability also has been increased. It now extends to:
- (1) unknown third parties when the CPAs have been grossly negligent (have shown a reckless disregard for the truth) and
- (2) (in a majority of states) foreseen third parties
(foreseen users and a foreseen class of users) when the CPAs have been ordinarily negligent. The majority rule is that the CPA is liable to foreseen (but not necessarily individually identified) third parties (foreseen users and users within a foreseen class of users).
- Adherence to the applicable standards of conduct for a reasonable person in the circumstances indicates at least a good faith effort to apply professional standards. Thus, the CPAs are liable at most for ordinary negligence. In most jurisdictions, however, a party who is merely a reasonably foreseeable user and not is one of the following will have no standing to bring suit for ordinary negligence:
- (1) a foreseen user,
- (2) a member of a class of foreseen users, or
- (3) in privity of contract or a primary beneficiary
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2.3 Privileged Communication and Confidentiality
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Accountant-Client Privilege – Federal Law
- Client communications with accountants retained by attorneys to aid in litigation are protected by the attorney-client privilege. This privilege is recognized in federal and state courts.
- Federal law does not recognize a broad privilege of confidentiality for accountant-client communications.
- Federal law recognizes a limited privilege for accountant-client communications in certain civil tax matters before the IRS or in proceedings in federal court in which the U.S. is a party and applies only to advice on legal issues.
- A confidentiality privilege covers most tax advice provided to a current or prospective client by any individual qualified under federal law to practice before the IRS
(e.g., CPA, attorney, enrolled agent, or enrolled actuary) (The Internal Revenue Service Restructuring and Reform Act of 1998 (RRA98)).
- The privilege applies only to advice on legal issues.
- The privilege does not apply to:
- (1) criminal tax matters,
- (2) private civil matters,
- (3) disclosures to other federal regulatory bodies, or
- (4) state and local tax matters.
-
Accountant-Client Privilege – State Law
- State law does not recognize a privilege for accountant-client communications except in a minority of states.
- If the privilege exists, it belongs to the client. The client can claim an accountant-client privilege only in states that have enacted a statute creating such a privilege.
- If any part of the privileged communication is disclosed by either the client or the accountant, the privilege is lost completely.
- Given the existence of a state privilege, the firm is still liable if, in the specific case, federal law does not preempt state law.
- In states where the privilege exists, it is not limited to audit matters.
- In states where the privilege exists, it also applies to criminal actions.
- Examples of accountant-client privilege in state law:
- EXAMPLE 2-8 Accountant-Client Privilege under State Law
- State law provides for an accountant-client privilege. The IRS, in conducting a proper investigation, requests Accounting Firm to provide it with records on Client. The federal privilege does not apply. Firm complies, and Client sues Firm in state court. Firm asserts that federal law does not recognize the privilege and preempts state law. State court determines that, because the disclosure was without notice to Client and was made in the absence of service of legal process compelling disclosure, Firm is liable to Client for the voluntary disclosure.
- EXAMPLE 2-9 Liability to Client Given a State Privilege
- In Example 2-8, disclosure by Firm to a third party (the IRS) negates the privilege with respect to the information. The information is no longer recognized as a protected confidential communication under the law of the state. However, Firm may still be liable to Client. Given the existence of a state privilege, Firm is still liable if, in the specific case, federal law does not preempt state law. Firm has a professional duty under the AICPA Code of Professional Conduct. It must not disclose confidential client information without consent except, for example, to comply with an enforceable summons or subpoena.
- Client communications with accountants retained by attorneys to aid in litigation are protected by the attorney-client privilege. This privilege is recognized in federal and state courts.
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Accountant-Client Privilege – AICPA
- Confidential Client Information Rule
- A member of the AICPA in public practice must not disclose confidential client information to third parties without the client’s consent. This rule does not affect the following:
- Professional obligations under the Compliance with Standards Rule and the Accounting Principles Rule
- The duty to comply with a valid subpoena or summons or with applicable laws and regulations
- An official review of the member’s professional practice. In a review of the CPA’s professional practice under AICPA or state CPA society or board of accountancy authorization
- Transferring working papers to a purchaser of a practice is communication of the information they contain and violates the AICPA’s Confidential Client Information Rule. The CPA may be liable for malpractice if (s)he allows a third party, including a purchaser of the practice, access to working papers without specific consent of the client. However, this rule does not prohibit review of the CPA’s practice, including a review in conjunction with the purchase, sale, or merger of the practice, if appropriate precautions are taken. One means of protecting the client’s information is to enter into a written confidentiality agreement with the prospective purchaser.
- The member’s right to initiate a complaint with or respond to any inquiry made by an appropriate investigative or disciplinary body,
e.g., during the initiation of a complaint with, or in response to any inquiry made by, the professional ethics division, trial board of the AICPA, or an investigative or disciplinary body of a state CPA society, state CPA society peer review body or board of accountancy.
-
Working papers
- Working papers are confidential records of an accountant’s performance of an engagement. They document:
- Procedures performed
- Evidence obtained
- Conclusions reached
- Working papers are the property of the accountant. Because they are prepared by the accountant, they provide the best evidence of the accountant’s performance however:
- Working papers may be subpoenaed (court ordered) by a third party for use in litigation in the many states that do not recognize a privilege for accountant-client communications or by client consent.
- Working papers may be disclosed to another CPA partner of the accounting firm without the client’s consent because such information has not been communicated to outsiders.
- A CPA is required to obtain the client’s permission before transferring his or her working papers to another CPA. This is true even if the other accountant is purchasing the CPA’s firm.
- Working papers records retention:
- At a minimum, an accountant who does not audit public companies should retain working papers until the state statute of limitations on legal action has lapsed. The limitations period varies by state and according to the type of claim.
- Auditors of public companies must retain working papers for at least 7 years.
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CPA REG SU03 Federal Tax Authority, Procedures, and Individual Taxation
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3.1 Tax Authority
-
Authoritative tax law consists of:
- Legislative law
(Statutory)
- Legislative law, which comes from Congress as signed by the President, is authorized by the Constitution and consists of:
- Committee reports
- Committee Reports along with the Congressional Record are useful tools in determining:
- Congressional intent behind certain tax laws
- Helps examiners apply the law properly
- IRC
- The Internal Revenue Code of 1986 is the primary source of federal tax law. The Code is found at Title 26 of the United States Code (U.S.C.). As long as it is constitutionally valid, each IRC section is binding on the Supreme Court and, by default, all other federal courts. It imposes:
- Income taxes
- Estate taxes
- Gift taxes
- Excise taxes
- Provisions controlling the administration of federal taxation
- Tax Treaties
- US Constitution
- Background to constitutional basis of
federal taxation:
- BACKGROUND 3-1 Constitutional Basis of Federal Taxation
- The U.S. Constitution grants Congress the power to lay and collect taxes. The early federal government relied primarily on tariffs to fund its operations. However, when additional revenue was needed as a result of the Civil War, the United States enacted its first federal income tax in 1861. This tax was allowed to expire shortly after the war ended. Later, in 1894, the federal income tax was reintroduced. However, upon a legal challenge, the United States Supreme Court held that this income tax was a direct tax, and because the Constitution requires direct taxes levied by the federal government to be proportional to each state’s population based on a census, the tax was unconstitutional.
- To remove this constitutional barrier to a federal income tax, the Sixteenth Amendment to the United States Constitution was ratified in 1913. This amendment provides that “Congress shall have the power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several states . . .” Shortly after the amendment was ratified, the modern income tax was passed by Congress with the Revenue Act of 1913.
- Administrative law
- Administrative tax law is a catch-all term for the rules, regulations, and procedures implemented and enforced by the Treasury Department. The IRS is a bureau of the Treasury Department. In practice, the IRS’s Office of Chief Counsel writes administrative tax law, and it is approved by the Secretary of the Treasury, which is a Cabinet-level position nominated by the President and confirmed by the U.S. Senate.
- Treasury Regulations (TDs)
- Treasury Regulations (Proposed, Temporary, or Final) are interpretations of the IRC that allow the Treasury Department to implement the IRC. They are authorized and allowed under law by the IRC, making them a primary authoritative source when conducting tax research. The IRS is bound by the regulations because it is a bureau within the Treasury Department. Courts are bound to follow them to the extent that the court does not find they conflict with the IRC. They are:
- Proposed
- Temporary
- Final
- Treasury Regulations (proposed, temporary, or final) are the top administrative law tax authority after
the U.S. Constitution, the U.S. Supreme Court, and the Internal Revenue Code. A temporary regulation provides this preparer with the highest authority.
- Revenue Rulings
- A revenue ruling is an official interpretation of Internal Revenue law as applied to a given set of facts and is issued by the Internal Revenue Service.
- Revenue rulings are published in Internal Revenue Bulletins to inform and advise taxpayers, the IRS, and others on substantive tax issues.
- Publication of revenue rulings is intended to promote uniform application of tax laws by IRS employees and to reduce the number of letter ruling requests.
- Revenue rulings may be cited as precedent and relied upon when resolving disputes, but they do not have the force and effect of regulations nor are they binding on a court.
- Rulings and procedures may be the basis for appealing adverse return examinations to the tax court and other federal courts.
- Revenue rulings are considered a primary authoritative source when conducting tax research.
- IRS employees must follow revenue rulings and revenue procedures.
- Revenue Procedures
- A revenue procedure is an official IRS statement that prescribes procedures that affect the rights or duties of taxpayers. (i.e. what format/to whom letter ruling requests should be sent to and depreciation methods)
- They primarily address administrative and procedural matters and do not have the force of law, but they may be cited as precedent.
- Rulings and procedures may be the basis for appealing adverse return examinations to the tax court and other federal courts.
- IRS employees must follow revenue rulings and revenue procedures.
- Private Letter Rulings
- In response to a request for guidance, the IRS may respond in writing to a taxpayer concerning guidance on specific facts and situations. This Private Letter Ruling (PLR) binds the IRS and the taxpayer requesting the ruling may rely on it, but other parties who may have similar circumstances may not rely on the PLR.
- However, the IRS sometimes redacts personal information and responds to a request for a PLR with a Revenue Ruling, which becomes binding on all taxpayers and the IRS.
- Thus, third parties may not rely upon a PLR as precedent.
- For example:
A taxpayer contemplates entering into a complex transaction. The taxpayer wants assurance that there will be no adverse tax effects from the transaction.
- Technical Advice Memoranda (TAMs)
- Technical Advice Memoranda (TAMs) are requested by IRS area offices after a return has been filed, often in conjunction with an ongoing examination. Similar to a PLR, a TAM is binding on the IRS in relation to the taxpayer who is the subject of the ruling, but other parties who may have similar circumstances may not rely on the TAM.
- Other related publications/guidance:
- Publications
- Citator
- Citators are a commercial publication of court cases (history and recent developments).
- Federal Register
- Notices of proposed rulemaking are required for proposed regulations and are published in the Federal Register so that interested parties have an opportunity to participate in the rule-making process.
- Internal Revenue Bulletin (IRB)
- The Internal Revenue Bulletin (IRB) is the authoritative announcement from the IRS. It is published on a weekly basis by the Government Printing Office and concerns the following:
- Announcements
- Announcements are public pronouncements on matters of general interest, such as effective dates of temporary regulations, clarification of rulings, and form instructions. They are issued when guidance of a substantive or procedural nature is needed quickly. Announcements can be relied on to the same extent as revenue rulings and revenue procedures. Announcements are identified by a number representing the year and a sequence number. Announcements are temporary in nature.
- Court Decisions
- Committee Reports
- A Committee Report of the House Ways and Means Committee.
- The House Ways and Means Committee is the principal source of legislation concerning issues such as taxation, customs duties, and international trade agreements.
- A Senate Finance Committee Report.
- A Senate Finance Committee Report deals with matters relating to taxation and other revenue measures.
- The Congressional Record.
- The Congressional Record is the official record of the proceedings and debates of the United States Congress and is therefore a source, even if not the best one, for understanding congressional intent.
- Executive Orders
- Legislation/Statues
- Notices
- Notices may be used for material appropriate for announcements, but notices are not of a temporary nature.
- Revenue Procedures
- Revenue Rulings
- Tax Conventions
- Treasury Regulations (TDs)
- Other items of general interest
- Lists of the acquiescences and nonacquiescences of the IRS to decisions of the courts
- US Supreme Court decisions affecting the IRS
- IRS Publications
- IRS Publications explain the law in plain language for taxpayers and their advisors. They typically highlight changes in the law and provide examples illustrating Service positions. Publications are not binding on the Service and do not necessarily cover all positions for a given issue. While a good source of general information, publications should not be cited to sustain a position.
- US Government Printing Office
- The Tax Court’s regular decisions are printed in bound volumes twice each year by the U.S. Government Printing Office. Its memorandum decisions, on the other hand, are printed by private publishers.
- Guidance
- Delegation order
- Commissioner delegation orders formally delegate authority to perform certain tasks or make certain decisions to specified Service employees.
- Judicial law
- Judicial law is common law that originates from the federal court system.
- Court Cases
- Court cases are considered a primary authoritative source when conducting tax research.
- Court Opinions
- Judicial law is common law that originates from the federal court system and is primarily comprised of court opinions.
- Court Decisions
- US Court of Federal Claims
- US District Courts
(and Bankruptcy Courts)
- US Tax Court
- Regular decisions
- Regular decisions establish precedent either through a new tax matter or unique facts and circumstances for a tax matter that has been previously settled. They are printed in bound volumes twice each year by the U.S. Government Printing Office. Its memorandum decisions, on the other hand, are printed by private publishers.
- Memorandum decision
- A Tax Court memorandum decision is a report of a Tax Court decision thought to be of little value as a precedent because the issue has been decided one or more times before.
- The US Tax Court has tax deficiency jurisdiction. The Tax Court’s jurisdiction is defined under Sec. 7442. The Tax Court does not have jurisdiction over employment taxes except for the self-employment tax, which has been classified by the Court as an income tax. In general, the Tax Court’s jurisdiction covers:
- Income
- Self-employment tax is an income tax
- Estate
- Gift
- Excise
- Private foundation taxes
- The Tax Court is based in Washington, D.C. Its judges ride “circuit” and hear cases in Washington and throughout the United States.
- US Circuit Court of Appeals
- Cases from the U.S. Tax Court and the U.S. District Courts are appealed to the appropriate U.S. Circuit Court of Appeals.
- US Court of Appeals for the Federal Circuit
- Cases from the U.S. Court of Federal Claims are appealed to the U.S. Court of Appeals for the Federal Circuit.
- US Supreme Court
- The U.S. Supreme Court can exercise its discretionary authority to review decisions of the courts of appeals and other federal courts.
- A writ of certiorari is an order by the Supreme Court to hear a case. An appellant in an appropriate case may petition the Supreme Court to hear an appeal from the lower court’s decision. The court’s certiorari jurisdiction (i.e., whether the court chooses to hear a case) is purely discretionary. A denial of a petition for a writ of certiorari by the Supreme Court expresses no opinion on the merits of the case, and the previous court’s opinion on the case stands.
- If the Court determines that various lower courts are deciding a tax issue in an inconsistent manner, it may pronounce a decision and resolve the contradiction.
- Trial courts or
courts of original jurisdiction
- Appellate courts
- The US Court of Federal Claims and US District Courts have refund jurisdiction. Juries are available in the district courts only.
- Court Hierarchy:
- US District Courts: 98 (trial courts)
US District Courts Bankruptcy Courts: 98
US District Court Judges: 629
- When there are conflicting sources of tax law within the same tier of the hierarchy (as is the case with revenue rulings and procedures), the most recent rule/law takes precedence.
-
3.2 Tax Procedures
-
Tax Prepayments and
Penalties for Individuals
- Tax Prepayments:
- The IRC is structured to obtain a large portion of the final tax (after nonrefundable credits) through withholding and estimated tax payments. Individuals who earn income not subject to withholding must pay estimated tax on that income in quarterly installments.
- Tax refers to the sum of:
- Regular tax
- AMT
- Self-employment tax
- Household employee tax
- Withholding
- Each of the following is treated as prepayment of tax:
- Overpayment of tax in a prior tax year, which has not been refunded
- Amounts withheld (by an employer) from wages
- The aggregate amount is treated as if equal parts were paid on each due date, unless the individual establishes the actual payment dates.
- Direct payment by the individual (or another on his or her behalf)
- Excess FICA withheld when an employee has two or more employers during a tax year who withheld (in the aggregate) more than the ceiling on FICA taxes
- Refundable tax credits
- Estimated payments
- For a calendar-year taxpayer, the installments are due by:
- April 15th
- June 15
- September 15
- January 15 of the following year.
- IRS Form 1040ES, Estimated Tax for Individuals
- Each installment must be at least 25% of the lowest of the following amounts:
- 100% [110% for taxpayers whose prior year’s AGI exceeds $150,000 ($75,000 for married filing separately)] of the prior year’s tax (if a return was filed)
- 90% of the current year’s tax
- 90% of the annualized current year’s tax (applies when income is uneven)
- EXAMPLE 3-1 Estimated Tax Payments
John’s tax liability for 2020 was $10,000 and his AGI was $100,000. John projects his tax liability for 2021 to be $12,000. In order to avoid an underpayment of estimated tax penalty, John must pay through withholdings and estimated payments throughout the year, i.e., the lesser of $10,000 (100% of prior year tax, the 110% is not applied because John’s prior year AGI is less than $150,000) or $10,800 (90% of the current year tax).
- Penalties:
- A penalty is imposed if, by the quarterly payment date, the total of estimated tax payments and income tax withheld is less than 25% of the required minimum payment for the year.
- The penalty is equal to:
- the federal short-term rate
- PLUS
- 3% times the underpayment
- The penalty is determined each quarter.
- The penalty is not allowed as an interest deduction.
- An automatic extension for filing the return does not extend time for payment. Interest will be charged from the original due date. Failure to file or pay on time results in a penalty based on the unpaid liability (Tax liability – Prepaid amount). When an extension to file is timely requested, a failure-to-pay penalty may be avoided by paying at least 90% of the actual liability by the original due date of the return and paying the remaining balance when the return is filed. Exceptions and adjustments to these rules may apply in unique situations.
- Failure to file:
A failure-to-pay penalty may offset a failure-to-file penalty. A penalty of the following is assessed for failure to file a return:
- 5% per month of unpaid liability (up to 25%)
- Failure to file (on time/late filing):
The minimum penalty for filing a return over 60 days late is:
- The lesser of:
- $435
(for 2021 returns filed in 2022)
- 100% of tax due.
- Failure to pay (tax on time):
A failure-to-pay penalty may offset a failure-to-file penalty. In general, a failure-to-pay penalty is imposed from the due date for taxes (other than the estimated taxes) shown on the return. Any tax liability must be paid by the original due date of the return. An automatic extension for filing the return does not extend time for payment. A penalty of the following is assessed for failure to pay tax:
- 0.5% per month of unpaid liability (up to 25%)
- EXAMPLE 3-2 Underpayment Penalty
Taxpayer has a tax liability of $11,000 for 2021. Taxpayer’s employer withheld $7,000 for 2021. Taxpayer’s 2020 liability was $7,000 and AGI was $160,000.
Even though only $700 [($7,000 prior year liability × 110%) – $7,000 current year withholding] is subject to the penalty, the $1,000 minimum exception does not apply due to the fact that the exception is based on the current year. The total tax liability shown on the tax return of $11,000 minus the amount paid through withholding of $7,000 is greater than $1,000. Hence, the taxpayer will be subject to an underpayment penalty.
- The penalty will not be imposed if any of the following apply:
- Actual tax liability shown on the return for the current tax year (after reduction for withholdings and refundable credits) is less than $1,000.
- Current tax year
liability is exceeded by:
- Refundable credits
- If tax credits exceed the tax liability, the taxpayer will not owe taxes and thus does not have to pay any estimated taxes. A $1 credit reduces tax liability by $1. Thus, if the earned income credit exceeds the tax liability, no taxes are due.
- Withholding
- Less than:
- $1,000
- No tax liability incurred in:
- Prior tax year
- The IRS waives it for reasonable cause shown.
-
Filing Requirements
- If the 15th day falls on a Saturday, Sunday, or legal holiday, the due date is extended until the next business day.
- Individuals
- An individual must file a federal income tax return if:
- (1) gross income is above a threshold:
- Standard Deduction:
Until 2026, the gross income threshold amount generally is the standard deduction (excluding any additional amount for being blind).
- Standard Deduction for (2020) —
• Single or Married filing separately, $12,400
• Married filing jointly or Qualifying widow(er), $24,800
• Head of household, $18,650
- Standard Deduction for (2021) —
• Single or Married filing separately, $12,550
• Married filing jointly or Qualifying widow(er), $25,100
• Head of household, $18,800
- Additional standard deduction over 65 and/or blind:
$1,350 ($1,700 Single/HOH)
- (2) net earnings from self-employment is:
- $400 or more
- (3) (s)he is a dependent has:
- (a) earned income
- Exceeds the standard deduction
- (b) unearned income
- Exceeds the standard deduction
- For a dependent with unearned income,
the standard deduction is:
- The greater of:
- $1,100
- Earned income for the year
- plus $350
- Net unearned income of a dependent child is taxed at the parents' marginal rate:
- Net unearned income of a dependent child is taxed to the dependent at rates higher than the child’s marginal tax rates. This is referred to as the “Kiddie Tax.” This tax is designed to discourage parents from shifting unearned income to their children with lower tax rates. These higher rates are the parents’ marginal tax rates.
- Net unearned income:
- Unearned income
- -
- The sum of:
- $1,100 (first $1,100 clause) and
- The greater of:
- 1) $1,100 of the standard deduction or $1,100 of itemized deductions or
- (2) the amount of allowable deductions that are directly connected with the production of unearned income
- EXAMPLE 3-3 Taxable Income of a Dependent Child
Chris, dependent child age 5, has $4,600 of unearned income and no earned income. How much of his income will be subject to the Kiddie Tax?
Unearned income $4,600
First $1,100 clause (1,100)
Standard deduction (1,100)
Net unearned income $2,400
- Due Dates and Related Extensions:
- Individual tax returns must be filed (postmarked) no later than the 15th day of the 4th month (or 3 months and 15 days) following the close of the tax year. This is April 15 for calendar-year taxpayers.
- An automatic 6-month extension is available by filing Form 4868. This extends the deadline to October 15 for calendar-year taxpayers.
- The extension does not grant any additional time to pay taxes due.
- Corporations
- A corporations (including S corporations) must file an income tax return regardless of gross income
- Due Dates and Related Extensions:
- C corporations
- C corporation tax return due dates changed significantly beginning with the 2016 tax year. Eventually, all C corporations will have original due dates on the 15th day of the 4th month following the end of the tax year.
- Extended due dates 6 months later on the 15th day of the 10th month following the end of the tax year.
- S corporations
- S corporation tax returns must be filed (postmarked) no later than the 15th day of the 3rd month following the close of the tax year. This is March 15 for calendar-year taxpayers.
- An automatic 6-month extension is available by filing Form 7004. This extends the deadline to September 15 for calendar-year taxpayers.
- The extension does not grant any additional time to pay taxes due.
- Partnerships
- Partnership tax returns must be filed (postmarked) no later than the 15th day of the 3rd month following the close of the tax year. This is March 15 for calendar-year taxpayers.
- An automatic 6-month extension is available by filing Form 7004. This extends the deadline to September 15 for calendar-year taxpayers.
- The extension does not grant any additional time to pay taxes due.
-
Disclosure of Tax Positions
- Tax Position
- A tax position may not be adopted without substantial authority for the position. Statute does not generally define an exact probability percentage as substantial authority. However, the Statements on Standards for Tax Services issued by the AICPA suggests it is generally interpreted as requiring that a position has:
- Substantial authority
- approximately a 40% likelihood of being upheld on its merits if challenged.
- There is substantial authority for the tax treatment of an item only if the weight of the authorities supporting the treatment is substantial in relation to the weight of authorities supporting contrary treatment. What constitutes substantial authority is defined by statute and IRS statements. A revenue ruling, for example, constitutes legal authority that, together with other authority, may be found substantial.
- Whether there is substantial authority for the tax treatment of an item depends on the facts and circumstances. Some of the items that may be considered are court opinions, Treasury regulations, revenue rulings, revenue procedures, and notices and announcements issued by the IRS and published in the IRB that involve the same or similar circumstances as the taxpayer’s.
- In addition to adequate disclosure and a reasonable basis, the amount of the understatement may be reduced to the extent the understatement is due to a tax treatment for which the taxpayer has substantial authority.
- For tax shelters, tax preparers are required to have both substantial authority and a reasonable belief for their position. Adequate disclosure has no effect on items attributable to tax shelters. Positions concerning tax shelters may result in or increase an accuracy-related penalty.
- Substantial authority and reasonable belief
- This belief must be “more likely than not” (generally greater than 50% probability) the proper treatment.
- Accuracy-Related Position
- A taxpayer’s accuracy-related penalty due to disregard of rules and regulations, or substantial understatement of income tax, generally, the penalty is:
- Disregard of the rules and regulations
- Disregard of the rules and regulations includes any careless, reckless, or intentional disregard.
- Substantial understatement
- Greater of:
- 10% of the correct tax or
- $5,000
- equal to 20% of the underpayment.
- The penalty may be avoided if:
- Adequately disclosed
- To adequately disclose the relevant facts about the tax treatment of an item, use:
- IRS Form 8275, Disclosure Statement
- There must also be a reasonable basis for the taxpayer’s treatment of the item.
- IRS Form 8275-R, Regulation Disclosure Statement
- This form is used to disclose items or positions contrary to regulations.
- Reasonable basis
- Reasonable basis is a relatively high standard of tax reporting that is significantly higher than not frivolous or not patently improper. The reasonable basis standard is not satisfied by a return position that is merely arguable. Showing a reasonable cause also includes showing actions were taken in good faith. The position, generally, must have:
- greater than 20% probability)
- Reasonable cause
- Acted/taken in good faith
- Substantial authority
- In addition to adequate disclosure and a reasonable basis, the amount of the understatement may be reduced to the extent the understatement is due to a tax treatment for which the taxpayer has substantial authority.
- The penalty is not figured on any part of an underpayment on which the fraud penalty is charged.
-
Recordkeeping
- Books of account or records sufficient to establish the amount of gross income, deductions, credit, or other matters required to substantiate any tax or information return must be kept.
- Records must be maintained as long as the contents may be material in administration of any internal revenue law.
- Employers are required to keep records on employment taxes until at least 4 years after the due date of the return or payment of the tax, whichever is later.
-
Claims for Refund
- A claim for refund of federal income tax overpaid for the current tax year is made by filing a return (Form 1040). A refund claim for a prior year is made by filing an amended return (Form 1040X). Form 843 is used to claim a refund of any other tax.
- Application for a tentative carryback adjustment to get a quick refund for carryback of an unused business credit is made on Form 1045 (individuals) or Form 1139 (corporations). Corporations also use Form 1139 for carrybacks of net capital losses.
- A claim for refund must be made within the statute of limitations period for refunds. In general, most refund claims must be filed by the later of 3 years from the due date (April 15, plus the filing extension time) or 2 years after the tax was paid.
- EXAMPLE 3-4 Refund Claim Expiration -- Due Date
- A calendar-year taxpayer filed his Year 1 return late on June 15, Year 2. The taxpayer had taxes withheld by his employer in Year 1, which are deemed paid on April 15, Year 2. A timely claim for a refund of the taxes withheld must be made by April 15, Year 5 (3 years from the due date). Filing a return late (without an extension) does not change the deadline to file a claim for refund.
- EXAMPLE 3-5 Refund Claim Expiration -- Extension
- Had the taxpayer in Example 3-4 filed for an extension and timely filed his return on June 15, Year 2, the timeframe for claiming a refund of the taxes withheld would expire on June 15, Year 5 (3 years from the due date including extensions).
- EXAMPLE 3-6 Refund Claim Expiration -- Payment Date
- A taxpayer files his Year 1 return on April 15, Year 2. The general refund statute of limitations expires on April 15, Year 5. However, if the taxpayer pays additional tax due of $500 for tax Year 1 on June 15, Year 4, the taxpayer will have until June 15, Year 6, to request a refund of the $500 under the 2-year rule.
- If a taxpayer does not file a return, a refund must be claimed within 2 years from the time the tax was paid. However, a taxpayer can file a late return within 3 years of a tax return’s due date (plus time on extension) and receive a refund of an overpayment of tax.
- EXAMPLE 3-7 Refund Claim Expiration -- Late Return
- An intern works for 3 months over the summer and has taxes withheld from their paycheck and deposited with the IRS but does not file a tax return. The intern has 3 years from the return’s due date to file a late tax return requesting a refund.
- An early return is treated as filed on the due date (April 15).
- Taxes withheld, estimated tax payments, and credits are deemed to be paid on the 15th day of the 4th month following the close of the taxpayer’s tax year (April 15 for calendar-year taxpayers).
- If the claim relates to worthless securities or bad debts, and the fact of worthlessness was not discovered until after the original return was filed, the period of limitation is increased to 7 years.
- EXAMPLE 3-8 Refund Claim Expiration -- Worthless Security/Bad Debt
- A taxpayer did not learn that a security had become worthless during Year 1 until Year 2, after the taxpayer had already filed the tax return. The taxpayer has 7 years (until Year 9) to amend the return.
-
Assessment of Deficiency
- A deficiency is any excess of tax imposed over the sum of amounts shown on the return plus amounts previously assessed (reduced by rebates). Assessment of tax is made by recording the liability of the taxpayer in the office of the Secretary of the Treasury. The following flowchart is provided to illustrate the process:
- Immediate Assessment
- A deficiency must be determined, and a statutory notice of deficiency must be mailed, otherwise, an immediate assessment, i.e., without a notice of deficiency, is allowed for the following:
- Tax shown on a return filed by a taxpayer
- The failure of a taxpayer to file a return does not allow the immediate assessment of taxes
- Mathematical and clerical errors in a return
- Overstatement of prepayment credits
- Waiver of restrictions on assessment
- Computerized Examination or Audit
- Computerized examination or audit of a return may result in an IRS examiner proposing an addition to tax. A letter stating the proposal is sent to the taxpayer. It is referred to as a 30-day letter.
- If the taxpayer agrees with the proposed adjustment(s), the taxpayer accepts the changes and pays any deficiency.
- If the taxpayer does not agree with the proposed adjustment(s), filing an appeal is an appropriate recommendation.
- If consensus is not reached with the examiner in a conference with his or her supervisor or from an administrative appeal, a notice of deficiency (ND) is mailed to the taxpayer, but no sooner than 30 days after a 30-day letter. A notice of deficiency is referred to as a 90-day letter. A notice of deficiency is a prerequisite to assessment. The ND is a prerequisite to a U.S. Tax Court proceeding.
- A taxpayer may institute a proceeding in the U.S. Tax Court within the 90 days following mailing of the ND (150 days if the taxpayer lives outside the U.S.). Payment of the deficiency is not required. Payment after the ND is mailed does not deprive the U.S. Tax Court of jurisdiction. Filing the petition suspends the 90-day period.
- If a petition is not filed with the U.S. Tax Court, taxes may be assessed 90 days after the ND is mailed.
- Partial or full payment of a deficiency prior to mailing of the ND deprives the Tax Court of jurisdiction. After full payment of any deficiency balance, the taxpayer may file a claim for refund and, if it is denied by the IRS, may institute a refund proceeding in a U.S. district court or the U.S. Court of Federal Claims.
- A jury is available only in a U.S. district court. One or more judges decide all issues in the U.S. Tax Court and the U.S. Court of Federal Claims.
- Statue of Limitations on Assessment/Collection
- Authority to assess tax liability is limited by statute to specific periods.
- The general statute of limitations (S/L) for assessment of a deficiency is 3 years from the date the return was filed.
- A return filed before the due date is treated as filed on the due date.
- The S/L period begins to run when a return filed late is received by the IRS.
- The IRS generally has 10 years following the assessment to begin collection of tax by levy or a court proceeding.
- Extension. The S/L period may be extended by an agreement between the taxpayer and the IRS entered into before the S/L expires.
- Each time an extension has been requested (or after expiration if there has been a levy), the IRS must notify the taxpayer that the taxpayer may refuse to extend the period of limitations or may limit the extension to particular issues or to a particular period of time.
- Mitigation of the statute of limitations. In certain circumstances, the statute of limitations may unjustly penalize the taxpayer or the government for a given return position.
- The mitigation provisions are limited to income tax, not gift, etc., when the following circumstances are met:
- There is a “determination” for a tax year concerning the treatment of an item of income (e.g., Tax Court decision);
- On the date of determination, correction of the error must be barred (i.e., statute of limitations);
- There must be a condition necessary for adjustment, i.e., double income (deduction); and
- In the proceeding of determination, the successful party must have taken a position inconsistent with the position in the closed year.
- The S/L is 6 years if there is omission of items of more than 25% of gross income stated in the return. Specifically for goods or services from a trade or business, gross income includes gross receipts before deduction for cost of goods sold. Only items completely omitted are counted. This applies even if the omission is made in good faith.
- Failure to file. The S/L period does not commence before a return is filed.
When no return has been filed, the assessment period is unlimited.
- However, if for example, an individual paid income tax in 2021 through withholding but did not file a 2021 return because his income was insufficient to require the filing of a return, the deadline for claiming a refund by filing a late return is 3 years from the date the return was due. This individual’s tax was paid through withholding before it was due on April 15th.
- Fraud. Attempting to evade tax results in an unlimited assessment period. Fraud cannot be cured by filing a correct amended return.
- Inability to Pay Tax Liability/Assessment
- If unable to pay the full liability (i.e., doubt as to collectibility), the taxpayer may apply for an offer-in-compromise. The IRS considers the taxpayer’s:
- Ability to pay,
- Income,
- Expenses, and
- Asset equity.
- Filing an offer in compromise (doubt as to liability) is an appropriate course of action if the CPA and client do not fully agree with the proposed changes and have exhausted other administrative remedies.
-
Closed Cases
- Cases closed after examination will not be reopened to make adjustments unfavorable to the taxpayer except under certain circumstances. Qualifying circumstances include:
- evidence of fraud,
- malfeasance,
- collusion,
- concealment, or
- misrepresentation of a material fact
-
3.3 Tax Planning
-
Background of tax planning
- BACKGROUND 3-2 Role of Tax Planning Reduction of tax may always be important but should not be the deciding factor behind every financial action. The goal of maximizing “after-tax” wealth is not always the same as minimizing taxes. The role of tax planning is to assist individuals and businesses in reaching maximization of after-tax wealth in the most tax-efficient way possible.
-
Types of tax planning
- The three most basic and common types of tax planning are:
- (1) Timing of income recognition,
- The timing technique accelerates or defers recognition of income and/or deductions. Because choice of depreciation methods accelerate or defer the depreciation deduction, it is a timing strategy. The advice most often heard is to defer income and accelerate deductions. This results in the lowest tax liability for the current year. However, in a year in which the taxpayer’s rates are lower than the rates will be the following year, it is advisable to do just the opposite.
- EXAMPLE 3-11 Maximizing the Depreciation Deduction
- A business wants to maximize the amount of deductions in the current year related to asset depreciation. To accelerate the depreciation deduction, the business would utilize MACRS depreciation instead of electing straight-line depreciation.
- A taxpayer typically has more control over the recognition of some types of income (e.g., sale of capital gain property) than a taxpayer has over other types (e.g., salaries).
- Example:
Contributing property to a partnership in exchange for partnership interest causes a deferral of the recognition of gain until the partnership sells the contributed property.
- The following four items should be considered when evaluating the use of timing techniques:
- Time value of money
- (e.g., can the taxpayer make a higher return on income realized and reinvested this year than the taxpayer can save in taxes by deferring the income to a future date by not selling the capital asset until later?)
- Future (or likelihood of proposed) tax law
- (i.e., will it stay the same or change?)
- Individual circumstances of the taxpayer
- (i.e., a strategy good for one is not necessarily the best strategy for another)
- Doctrine of constructive receipt
- (covered more in Study Unit 5)
- (2) Shifting of income among taxpayers and jurisdictions, and
- The basics of income shifting typically relate to moving income and therefore the accompanying tax liability from one family member to another who is subject to a lower marginal rate, or moving income between entities and their owner(s). However, tax planning also involves shifting income from one tax jurisdiction to another with different marginal tax rates.
- Other rules that may limit or otherwise make income shifting difficult include the “Kiddie Tax” rules and gift/wealth transfer rules.
- Three key terms when discussing shifting income are:
- “assignment of income doctrine,”
- The assignment of income doctrine holds that a taxpayer cannot avoid tax for income the taxpayer earned by assigning it to another person.
- “related party transaction,” and
- Related party transactions are transactions that occur between persons (including corporations) that are related to each other in one of the statutorily defined manners. For example, members of a family are considered related parties, as are a controlling shareholder and the controlled corporation.
- “arm’s-length transaction.”
- An arm’s-length transaction occurs when the involved parties act independently, regardless of any relation. Transactions between unrelated parties are generally considered to be arm’s-length. If the parties are related, a transaction is considered arm’s-length if the results of the transaction are consistent with those that would have been realized if unrelated taxpayers engaged in the same transaction under the same circumstances.
- The purpose of the rules related to these items is to guarantee that all parties act in their own self-interest and not for the common good of all parties involved to the detriment of the IRS.
- Successful shifting of income among family members or entities depends on determining the following:
- Income/assets available for shifting
- Best strategy for realizing the shift
- Best recipient of income/asset within the family or entity
- In the case of shifting income among tax jurisdictions, the jurisdictions among which the income is moved could be city, county, or state jurisdictions within the U.S. In addition, shifting of income also could involve moving the income from U.S. jurisdiction to that of another nation.
- In the case of multiple nations claiming the right to tax an individual or business, credit (subject to specific laws and treaties) will usually be given by each country for tax paid to the other. This helps to avoid double taxation and encourages international business.
-
EXAMPLE 3-12 Shifting Income -- Family Members
Parents with a 32% marginal rate want to invest some of their savings and minimize the overall tax liability on the family. One way these parents can accomplish this goal is to have their adult children, who have only a 12% marginal rate, purchase a rental home and borrow the money from the parents at the lowest allowable rate (i.e., applicable federal rate). This strategy will result in the rental income being taxed at only 12% instead of the higher 32% of the parents and at the lowest cost possible (due to the low rate). The parents have also shifted income to the adult children without being subject to gift tax limits, etc.
- EXAMPLE 3-13 Shifting Income -- Tax Jurisdictions
A player for the National Basketball Association is drawing near to the end of his original/rookie contract in Ohio. He has offers from franchises in Ohio, New York, Illinois, Florida, and California and wishes to minimize his overall tax liability in his next contract. All other issues being equal, the player should accept the offer from the franchise in Florida. By doing so, the player would be shifting his income from a state (Ohio) with a state income tax to the only state of those making offers with no state income tax. Though the federal income tax would go unchanged, the player’s overall tax liability would be reduced.
- (3) Conversion of income among high and low rate activities.
- Converting income from a less favorable category to a more favorable one can be achieved in various ways. Favorable conversions include converting ordinary income property into capital gain property. The opposite applies for losses.
- EXAMPLE 3-14 Favorable Conversion of Income
A taxpayer wants to convert $10,000 FMV of inventory with a basis of $3,000 to capital gain property. The taxpayer will accomplish the goal by transferring the inventory to a controlled corporation for stock (the FMV would be $10,000). The taxpayer’s basis in the stock is $3,000; therefore, selling the stock will result in a $7,000 capital gain for the taxpayer.
If the taxpayer simply sells the inventory (i.e., no conversion), the $7,000 gain will be ordinary.
- Even better than converting property from a high tax rate to a low rate is converting it to nontaxable property. Examples of this include the following:
- Employee benefits, e.g., employer-paid medical reimbursement
- Investing in municipal bonds (i.e., nontaxable investment interest)
- Convert nondeductible personal expense to a business expense
- Some conversions involve a comparative analysis of minimization of current taxes to minimization of future taxes.
- EXAMPLE 3-15 Current vs. Future Taxes
Contributions to an individual retirement account are deductible (subject to limitations) in the year made; however, tax applies to 100% of the withdrawals. So there is a current tax savings or deferral. On the other hand, contributions to a Roth IRA are currently taxed; however, the withdrawals are tax-exempt, including any increase in the investment over the years. This results in tax avoidance.
-
Differences between tax planning (avoidance v. evasion)
- A critical aspect of tax planning is distinguishing between:
- Tax avoidance
- Background of tax avoidance:
- BACKGROUND 3-3 Morality of Tax Avoidance
In a 1947 case, Judge Learned Hand stated, “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 extractions, not voluntary contributions. To demand more in the name of morals is mere cant.”
- Definition of tax avoidance:
- Tax avoidance is minimizing tax liability through legal arrangements and transactions. The goal of a business is to maximize profits, and tax avoidance is a key element in obtaining this goal. Avoidance maneuvers take place prior to incurring a tax liability.
- Tax evasion
- Definition of tax evasion:
- Tax evasion takes place once a tax liability has already been incurred (i.e., taxable actions have been completed). A key distinction between avoidance and evasion is taxpayer “intent.” A taxpayer’s intent is called into question when one of the “badges” of fraud is identified. These indicators include:
- understatement of income
- improper allocation of income
- claiming of fictitious deductions
- questionable conduct of the taxpayer
- accounting irregularities
-
3.4 Filing Status
-
Overview of filing status:
- The amounts of the standard deductions and applicable tax rates vary with filing status.
Filing status on the last day of the year determines the filing status for the entire year.
-
Types of filing status:
- Single
- This is the default status of any taxpayer if the following apply. An individual must file as single if (s)he is:
- Neither married
- Neither qualifies for widow(er)
- Neither qualifies for HOH
- HOH
- An individual qualifies for head of household status if
(s)he satisfies conditions with respect to:
- 1) Filing status
- The HOH filing status individual may not file
as a qualifying widow(er).
- 2) Marital status
- A married person does not qualify for head of household status unless the conditions below are satisfied. A married individual who lives with a dependent apart from the spouse qualifies for head of household status if, for the tax year:
- (S)he files separately;
- (S)he pays more than 50% toward maintaining the household; and:
- For the last 6 months, the spouse is not a member of the household,
- The household is the principal home of a child of the individual, and
- The individual can claim the child as a dependent
- 3) Household maintenance
- To qualify for head of household status, an individual must maintain a household that is the principal place of abode for a qualifying individual for at least half of the tax year.
- The taxpayer must maintain a household that constitutes the principal place of abode for more than half of the taxable year for at least one qualified individual who is:
- A qualifying child or
- A qualifying relative
- There are two special rules concerning a qualifying child/relative:
- A qualifying child
(custodial parent)
- In the case of divorce, the custodial parent of a qualifying child qualifies for head of household status even if the noncustodial parent claims the child as his or her dependent.
- A qualifying relative
(parent living separate)
- The taxpayer with a dependent parent qualifies even if the parent does not live with the taxpayer. Otherwise, the IRS maintains that the qualifying individual must occupy the same household (except for temporary absences).
- Both of these are defined in Subunit 3.5.
- To maintain a household for federal filing status purposes, an individual must furnish more than 50% of the qualifying costs, of mutual benefit, of maintaining the household during the tax year which include:
- Property tax
- Mortgage interest
- Rent
- Utilities
- Upkeep
- Repair
- Property insurance
- Food consumed in-home
- Not included is the value of services rendered in the home by the taxpayer or the rental value of a home owned by the taxpayer.
- 4) Not a NRA
- Nonresident aliens cannot qualify for the head of household status.
- Who Is a Qualifying Person Qualifying the Taxpayer to File as Head of Household?
- IF the person is the taxpayer’s . . .
- qualifying child (such as a son, daughter, or grandchild who lived with the taxpayer more than half the year and meets certain other tests)
- he or she is single
(whether or not the child meets the citizen or resident test (i.e., U.S. citizen, resident alien or national, or resident of Canada or Mexico)
- he or she is married
- AND
- the taxpayer can claim him or her as a dependent
- qualifying relative who is the taxpayer’s father or mother
- the taxpayer can claim him or her as a dependent
- The taxpayer is eligible to file as head of household even if the taxpayer’s parent, whom the taxpayer can claim as a dependent, does not live with the taxpayer. The taxpayer must pay more than half the cost of keeping up a home that was the main home for the entire year for the taxpayer’s parent. This requirement is met if the taxpayer pays more than half the cost of keeping the taxpayer’s parent in an assisted living or nursing facility.
- qualifying relative other than the taxpayer’s father or mother
- he or she lived with the taxpayer more than half the year
- AND
- the taxpayer can claim him or her as a dependent
- is one of the following:
- Children:
- son
- daughter
- stepchild
- fosterchild
- or a descendant of any of the above persons
- Family:
- the taxpayer’s brother
- sister
- half-brother
- half-sister
- or a son or daughter of any of the above persons
- an ancestor or sibling of the taxpayer’s father or mother;
- or stepbrother
- stepsister
- stepfather
- stepmother
- In-Laws:
- son-in-law
- daughter-in-law
- father-in-law
- mother-in-law
- brother-in-law
- or sister-in-law
- MFJ
- Married individuals file a joint return account for items of income, deduction, and credit in the aggregate.
- The IRC provides that neither spouse can be a nonresident alien (NRA) during the tax year and still file a joint return, unless:
- the nonresident alien spouse at year end is married to a:
- U.S. citizen
- OR
- U.S. resident alien
- AND
- BOTH spouses elect to have the nonresident alien treated as a resident alien.
- A joint return is allowed:
- when spouses use different accounting methods
- when two individuals are treated as legally married for the entire tax year if, on the last day of the tax year, they are:
- Legally married and cohabiting as spouses,
- Legally married and living apart but not separated pursuant to a valid divorce decree or separate maintenance agreement, or
- Separated under a valid divorce decree that is not yet final
- when a spouse dies and the surviving spouse does not remarry before the end of the tax year, a joint return may be filed
- A joint return is not allowed:
- when spouses have different tax years
- Filing separately is required when the spouses have different tax year ends.
- MFS
- Each spouse accounts separately for items of income, deduction, and credit.
- A spouse who uses his or her own funds to pay expenses of jointly owned property is entitled to any deduction attributable to the payments.
- Filing separately is required when the spouses have different tax year ends.
- If one spouse files separately, so must the other.
- The decedent's filing status:
A joint return with the deceased spouse may not be filed if the surviving spouse remarried before the end of the year of the decedent’s death. In this case, the filing status of the deceased spouse is that of married filing separate return.
- Qualified Widow(er) or Surviving Spouse
- A widow(er) can file a joint return in the tax year of the death of the spouse. The qualifying widow(er) status is available for 2 years following the year of death of the spouse if the following conditions are satisfied:
- The widow(er) qualified (with the deceased spouse) for married filing joint return status for the tax year of the death of the spouse.
- The taxpayer did not remarry during the tax year.
- A qualifying widow(er) maintains a household for the entire taxable year. Maintenance means the widow(er) furnishes more than 50% of the costs to maintain the household for the tax year.
- The household must be the principal place of abode of a qualifying dependent of the widow(er).
- The dependent must be a son or daughter, a stepson or daughter, or an adopted child. This does not include a foster child. (This is an exception to the general dependent rules covered in detail in the next subunit.)
- The decedent's filing status:
A joint return with the deceased spouse may not be filed if the surviving spouse remarried before the end of the year of the decedent’s death. In this case, the filing status of the deceased spouse is that of married filing separate return.
-
3.5 Dependents
-
Overview of dependents
- To qualify as a taxpayer’s dependent, an individual must be either of the following, the criteria for both are heavily tested on the CPA Exam and by the AICPA:
- a qualifying child or
- a qualifying relative
- Additional requirements:
- Citizenship
- To qualify as a dependent, an individual must generally be a (for any part of the year):
- US citizen
- US resident
- US national
- Filing status
- The taxpayer cannot claim a married person who files a joint return as a dependent unless that joint return is only to claim a refund of income tax withheld or estimated tax paid
- Example: Robert, a full-time graduate student under the age of 24 at the end of the year, and his wife Claire lived with Robert’s father, Mark. Robert had no income but filed a joint return for 2021, owing an additional $500 in taxes on Claire’s income. Because Robert and Claire filed a joint return, for reasons other than to claim a refund, Mark cannot claim Robert as a dependent.
- EXAMPLE 3-17 Filing by Dependents to Obtain a Refund
Mr. and Mrs. Kind provided more than half the support for their married daughter and son-in-law who lived with the Kinds all year. Neither the daughter nor the son-in-law is required to file a 2021 tax return. They do so only to get a refund of withheld taxes. The Kinds may claim the daughter and the son-in-law as dependents on their 2021 joint return.
- Living
- Both a dependent who dies before the end of the year and a child born during the year may be claimed as dependents.
- Sole dependent
- The taxpayer cannot claim any dependents if the taxpayer, or the taxpayer’s spouse if filing jointly, could be claimed as a dependent by another taxpayer.
- The individual must not be a qualifying child of any other taxpayer. A child is not the qualifying child of any other taxpayer if the child’s parent (or any other person for whom the child is defined as a qualifying child) is not required to file an income tax return or files an income tax return only to get a refund of income tax withheld.
- Taxpayer identification number (TIN)
- The taxpayer must provide the correct TIN of a dependent on the income tax return.
- A child being adopted is eligible to be claimed as a dependent by the adopting parents if the adoption taxpayer identification number (ATIN) is assigned
- Personal exemptions allowed
until 2018
- Until 2018, taxpayers were allowed personal exemptions to reduce their adjusted gross income for themselves and any of their qualified dependents. From 2018 through 2025, the exemption amount is $0, essentially eliminating the personal exemption for these years. For that reason, this review course has removed coverage of personal exemptions.
-
Tests To Be a Qualifying Child
- 1. Relationship.
- The child must be the taxpayer’s:
- son
- daughter
- brother
- sister
- halfbrother
- halfsister
- stepchild
- stepbrother
- stepsister
- fosterchild
- adopted individuals qualify
- or a descendant of any of them
- 2. Member of the Household Test.
- The child must have lived with the taxpayer for more than half of the year.
- 3. Age.
- (a) under age 19 at the end of the year,
- (b) under age 24 at the end of the year
- AND
- and a full-time student, or
- To qualify as a full-time student, the dependent must be enrolled at an educational organization for at least 5 months during the tax year
- (c) any age if permanently and totally disabled
- 4. Not Self-Supporting.
- The child must not have provided more than half of his or her own support for the year.
- 5. If the child meets the rules to be a qualifying child of more than one person, tie-breaking rules apply.
- A child is not the qualifying child of any other taxpayer if the child’s parent (or any other person for whom the child is defined as a qualifying child) is:
- Not required to file an income tax return
- OR
- Files an income tax return only to get a refund of income tax withheld
-
Tests To Be a Qualifying Relative
- 1. Relationship.
- The relationship requirement is satisfied the Qualifying Relative Relationship Criteria
- Qualifying Relative Relationship Criteria:
The relationship requirement is satisfied by existence of an extended (by blood) or immediate (by blood, adoption, or marriage) relationship. The relationship need be present to only one of the two married persons who file a joint return. Any relationship established by marriage is not treated as ended by divorce or by death.
- Extended relationships:
- grandchildren and descendants
- grandparents and ancestors
- nephews or nieces
- uncles or aunts
- Immediate relationships:
- Parent:
- Child:
- Sibling:
- Includes:
- natural (full or half sibling)
- adoptive
- step
- in-law
- foster child (who lives with the claimant for the entire tax year)
- OR
- Meets the Member of the Household Test
- Member of the Household Test: The requirement is satisfied if an unrelated person lives with the taxpayer all year as a member of the taxpayer’s household.
- This includes the taxpayer's cousin
- 2. Gross Taxable Income.
- The person’s gross income for the year must be:
- Less than:
- $4,300
- Gross income means all income the person received in the form of money, goods, property, and services that is not exempt from tax (e.g., taxable interest income and taxable scholarships). Does not include Social Security benefits for low-income taxpayers.
- 3. Support.
- The taxpayer must provide more than half of the person’s total (economic) support for the year, see Qualifying Relative Support Criteria.
- Qualifying Relative Support Criteria:
Support includes welfare benefits, Social Security benefits, and any support provided by the exemption claimant, the dependent, and any other person.
- Total support is determined on a yearly basis and is the sum of:
- 1) The fair rental value of lodging,
- 2) The costs of all items of expense paid out directly by or for the benefit of the dependent, and
- 3) A proportionate share of expenses incurred in supporting the whole household.
- Amounts paid in arrears (i.e., payment for child support for a previous year) are not considered support for the current year.
- Multiple support agreement. One person of a group that together provides more than 50% of the support of an individual may, pursuant to an agreement, be allowed the dependency exemption amount if:
- The person must be otherwise eligible to claim the exemption and must provide more than 10% of the support.
- No other person may provide more than 50% of the support.
- Each other person in the group who provides more than 10% of the support must sign a written consent filed with the return of the taxpayer who claims the exemption.
- Divorced/separated taxpayer does not need to meet support test if (s)he and the (ex-)spouse meet (or have met) the following conditions:
- Provided more than 50% of the support
- Had (between them) custody for more than 50% of the year
- The parent having custody for more than 50% of the year is entitled to claim the child, but the ability to claim the child as a dependent may be allocated to the noncustodial parent if there is an agreement signed by both parents and attached to the noncustodial parent’s return
- Lived apart for the last half of the year
- Did not have a multiple support agreement in effect
- Support includes money and items, or amounts spent on items, such as:
- Food
- Clothing
- Shelter
- Utilities
- Medical and dental care
- Medical and dental insurance
- Education
- Child care
- Vacations, etc
- Support does not include:
- Certain items (or amounts spent on them) have not been treated as support, e.g., scholarship received by a dependent child, taxes, or life insurance premiums.
- EXAMPLE 3-16 Total Support
A dependent earns $2,000 and the exemption claimants provide $3,000 of support to the dependent. The total support equals $5,000 ($2,000 provided by dependent + $3,000 provided by exemption claimants).
- 4. The person cannot be the taxpayer’s qualifying child or the qualifying child of any other taxpayer.
- A child is not the qualifying child of any other taxpayer if the child’s parent (or any other person for whom the child is defined as a qualifying child) is:
- Not required to file an income tax return
- OR
- Files an income tax return only to get a refund of income tax withheld
-
CPA REG SU04 Gross Income and Exclusions
-
4.1 Gross Income
-
Overview of gross income:
- Form 1040
US Individual Income Tax Return
- Gross income overview:
- The Internal Revenue Code (IRC) defines gross income as all income from whatever source derived except as otherwise provided
(unless specifically excluded by statue/IRC section). These are certain exceptions to this rule of inclusion of specifically stated.
- Constructive receipt:
- Income, although not actually in a taxpayer’s possession, is constructively received in the taxable year during which it is credited to his or her account, set apart for him or her, or otherwise made available so that (s)he may draw upon it at any time, or so that (s)he could have drawn upon it during the taxable year if notice of intention to withdraw had been given. However, income is not constructively received if the taxpayer’s control of its receipt is subject to substantial limitations or restrictions.
- The AICPA has regularly tested candidates’ knowledge of what types of income constitute gross income. Both theoretical and calculation questions have covered this topic.
- Adjusted gross income (AGI) overview:
- A taxpayer’s adjusted gross income equals all gross income items, as defined by Sec. 61 of the Internal Revenue Code, less any available deductions from gross income, as defined by the Internal Revenue Code.
-
Specifically Stated:
- Alimony and separate maintenance payments
(divorces entered into after 1984 but before 2019/pre-2019 divorces)
- Alimony and separate maintenance payments are included in the gross income of the recipient (payee) and are deducted from the gross income of the payor for divorce decrees executed (i.e., established) prior to 2019. For a divorce finalized (i.e., established) after 2018, alimony is not deductible by the payor and is not included in the gross income of the recipient.
- Form 1040
Schedule 1
Additional Income and Adjustments to Income
- A payment is considered to be alimony (even if paid to a third party) when it is:
- Paid in cash
- Payments to a third party for the benefit of the payor’s ex-spouse are considered qualified alimony payments if all other requirements are met.
- Property settlements are not treated as alimony. Property transferred to a spouse or former spouse incident to a divorce is treated as a transfer by gift, which is specifically excluded from gross income. “Incident to a divorce” means a transfer of property within 1 year after the date the marriage ceases or a transfer of property related to the cessation of the marriage. This exclusion does not apply if the spouse or former spouse is a nonresident alien.
- Paid pursuant to a written divorce or separation instrument
- Terminated at death of recipient
- Not designated as other than alimony (e.g., child support)
- Child support payments are not alimony.
- Child support is neither gross income to the recipient nor deductible by the payor.
- Contingencies related to child support:
- If the divorce or separation instrument specifies payments of both alimony and child support and only partial payments are made, the payments are considered to be child support until this obligation is fully paid:
- any excess is then treated as alimony
- If the payment amount is to be reduced based on a contingency relating to a child (e.g., attaining a certain age, marrying):
- the amount of the payment reduction will be treated as child support
- Not paid to a member of the same household
- Not paid to a spouse with whom the taxpayer is filing a joint return
- Annuities
- Annuity payments are included in gross income unless a statute provides for their exclusion. Retirees are able to recover their contributions to their pensions (cost of annuity) tax-free. Any proceeds in excess of the cost of the annuity or contributions are included in gross income.
- Form 1099-R
Distributions From
Pensions, Annuities,
Retirement or
Profit-Sharing Plans,
IRAs, Insurance
Contracts, etc.
- Dividends
- Generally, payers of dividends send the taxpayer Form 1099-DIV listing ordinary and qualified dividends amounts. Examples of dividends include:
- Ordinary dividends or the taxpayer received, as a nominee, ordinary dividends that actually belong to someone else.
- Qualified dividends are also included in the ordinary dividend total.
- Dividend reinvestment plan:
- If the plan allows a participant to buy more stock at a price less than its fair value, the participant must report as dividend income:
- the fair market value of the additional stock on the dividend payment date.
- Form 1099-INT
Interest Income
- Listed on Form 1040
Schedule B
Attached to the form if:
- More than:
- $1,500
- Form 1040
Schedule B
Interest and Ordinary Dividends
- Interest
- Interest income is gross income for tax purposes unless an exclusion applies. Generally, payers of interest income send the taxpayer Form 1099-INT listing the interest income amount. Examples of interest income include:
- Merchandise premium (e.g., a toaster given to a depositor for opening an interest-bearing account).
- Imputed interest on below-market term loans.
- Interest on state, local, and federal tax refunds.
- Interest from U.S. treasury bonds.
- Form 1099-INT
Interest Income
- Form 1040
Schedule B
Interest and Ordinary Dividends
- Attached to the schedule if:
- More than:
- $1,500
- Pensions
- An individual retirement account (IRA) is a personal savings plan that gives the taxpayer tax advantages for setting aside money for retirement.
- Advantages of an IRA include:
- Contributions the taxpayer makes to an IRA may be fully or partially deductible, depending on which type of IRA the taxpayer has and the taxpayer’s circumstances.
- Generally, amounts in the taxpayer’s IRA (including earnings and gains) are not taxed until distributed. In some cases, amounts are not taxed at all (or partially taxed) if distributed according to the rules.
- Form 1099-R
Distributions From
Pensions, Annuities,
Retirement or
Profit-Sharing Plans,
IRAs, Insurance
Contracts, etc.
- A pension is generally a series of definitely determinable payments (most often paid in the form of an annuity) made to a taxpayer after the taxpayer retires from work. Pension payments are made regularly and are based on such factors as years of service and prior compensation. Therefore, the rules for pensions are similar to the rules for annuities.
- Form 1099-R
Distributions From
Pensions, Annuities,
Retirement or
Profit-Sharing Plans,
IRAs, Insurance
Contracts, etc.
- The investment in the pension is the amount contributed by the employee in after-tax dollars.
- Amounts withdrawn early are treated as a recovery of the employee’s contributions (excluded from gross income) and of the employer’s contributions (included in gross income). After all of the employee’s contributions are recovered, additional withdrawals are fully included in gross income.
- However, a noncontributory plan results in all withdrawals being included in gross income (i.e., the employee made no contribution).
- Rents
- Royalties
- Compensation for personal services, including:
- Wages are all forms of consideration paid for employment, including cash and the cash value of compensation in any medium other than cash. They include:
- (1) wages and salaries,
- 2) commissions (including contingent fees),
- (3) bonuses,
- (4) productivity awards,
- (5) tips,
- (6) vacation and sick pay,
- (7) severance allowances, and
- (8) fringe benefits.
- Employer contributions to qualified retirement plans and elective deferrals are not included in income upon contribution. Instead, the contributions and earnings are included in income and taxed at distribution.
- Form 1040
US Individual Income Tax Return
- Form W-2 Wage and
Tax Statement
- All wages (including tips) received by the taxpayer are listed on Form W-2, Wage and Tax Statement. Supplemental unemployment benefits from a noncontributory fund that is company financed are taxable as wages (not unemployment).
- Form W-2
BOX 1
Wages, tips, other compensation
- If property or credit is given in lieu of cash or check, the FMV of the property or credit is included in gross income.
- If an employer transfers property to an employee at less than its FMV (bargain purchase), the difference may be income to the employee and treated as compensation for personal services.
- Gross income of an employee includes any amount paid by an employer for a liability
(including taxes) or an expense of the employee.
- EXAMPLE 4-2
Employer Payment of a Liability
Rick’s employer pays his car payment in lieu of direct deposit into Rick’s personal account, and the payment is reported as gross income.
- Reimbursed employee expenses plans include those that are:
- Nonaccountable plans:
- Under nonaccountable plans, employee reimbursements
(advances) are included in gross income.
- Accountable plans:
- Under accountable plans, employees must submit requests for reimbursement. Only reimbursements in excess of expenses must be included in gross income.
- EXAMPLE 4-3
Refund of Amount Reimbursed by Employer
John submitted reimbursement requests to his employer for $10,500 in airfare. John was later refunded for $500 of the airfare. If John does not remit the funds to his employer, John must include the $500 in gross income.
- Reimbursements for
moving expenses:
Qualified reimbursements for moving expenses incurred by members of the military are excluded from gross income. , The reimbursement is included in gross income if the reimbursement is:
- Not for qualified moving expenses or
- Not a member of the military
- Household employee:
All wages received as a household employee. An employer is not required to provide a Form W-2 to the taxpayer if the employer paid the taxpayer wages of:
- Less than:
- $2,300 (2021)
- Form W-2
BOX 8
Allocated tips
- Tip income the taxpayer did not report to the employer. This should include any allocated tips reported in box 8 on Form W-2. Also include the value of any noncash tips the taxpayer received, such as tickets, passes, or other items of value.
- Form W-2
BOX 10
Dependent care benefits
- Dependent care benefits that are reported in box 10 of Form W-2.
- Form W-2
BOX 12 (CODE T)
Adoption benefits
not included in box 1
- Employer-provided adoption benefits, which should be shown in box 12 of Form(s) W-2 with code T.
- Excess salary deferrals. The amount deferred is reported in box 12 of Form W-2.
- Scholarships or fellowships received for room, board, or incidental expenses are gross income.
- Distributive share of partnership gross income
- Gains derived from dealings in property
- Investment income (including gains derived from dealings in property). An investor in property seeks a return of the investment
(capital) and gross income from the investment, which may be in the form of gains, interest, rents, royalties, or dividends. A gain on disposition of investment property is generally the net increase (appreciation) in the value of the property.
- Realization of investment income occurs upon a taxable event such as a disposition of the property by a sale or an exchange.
- All gain realized is recognized gain unless a statutory provision provides for its nonrecognition by way of exclusion or deferral. Recognition means the income is to be included in gross income.
- Realized gain is calculated as follows:
- +
- Money received (or to be received)
- +
- FMV of property received (or to be received)
- FMV = Fair market value at time of disposition
- If FMV of other property received is not determinable with reasonable certainty, FMV of the property given up is used.
- +
- Liabilities transferred with the property
- Liability relief (whether recourse or nonrecourse)
- –
- Selling expenses
- Selling expenses are subtracted from gross receivables to yield the amount realized.
- –
- Liabilities assumed
- Liability assumed (whether recourse or nonrecourse)
- –
- Money given up
- FMV = Fair market value at time of disposition
- If FMV of other property received is not determinable with reasonable certainty, FMV of the property given up is used.
- –
- FMV of property given up
- FMV = Fair market value at time of disposition
- If FMV of other property received is not determinable with reasonable certainty, FMV of the property given up is used.
- =
- Amount realized
- –
- Adjusted basis
- Adjusted basis (AB) indicates the amount of capital invested in the property and not yet recovered by tax benefit (i.e., depreciation).
- +
- Basis on acquisition (e.g., acquisition cost, acquisition debt, assumed liabilities)
- ±
- Adjustments to basis (e.g., – depreciation, + improvements)
- =
- AB
- =
- Gain (or loss) realized
- Sell of a capital asset:
- Form 1040
Schedule D
Capital Gains and Losses
- Form 4797
Sales of Business Property
- Form 8949
Sales and Other Dispositions of Capital Assets
- Sell or exchange of assets used in trade/business:
- Form 4797
Sales of Business Property
- Gross income derived from business
- EXAMPLE 4-1
Gross Income -- Lump Sum for Noncompete Agreement
John receives a lump sum for signing a noncompete agreement. John should recognize the entire lump sum as ordinary income in the year received.
- The seller of property treats a covenant not to compete as ordinary income. The noncompete agreement is not part of the capital gain from the sale of the business.
- Business and Supplemental Income:
- Form 1040
Schedule C
Profit or Loss From Business (Sole Proprietorship)
- Net earnings reported on Schedule C (Form 1040) or other schedules used for reporting self-employment income are included in gross income. Gross Income from Self-Employment (Schedule C) is discussed in detail in Study Unit 6.
- Directors:
The director of a corporation who is not employed by the corporation is considered self-employed, and all director and consulting fees received are included in gross income.
- Future Goods/Services:
Generally, amounts that are received in advance for future goods and services are required to be included in the year of receipt. However, accrual-basis taxpayers can elect to defer recognition until the time of performance, up to the year after the payment date.
- EXAMPLE 4-5 Prepaid Income Allocation
Beth is a piano instructor. She is a calendar-year taxpayer using the accrual method of accounting and has elected to defer advance payments for services. On November 2 of Year 1, she received $4,800 for a contract for 96 1-hour lessons beginning on that date. The contract provided Beth give 8 lessons in Year 1 and 48 lessons in Year 2, with the remaining lessons to be given in Year 3. Beth should report $400 on her Year 1 return and the remaining prepayment of $4,400 on her Year 2 return.
- Bartered Goods/Services:
Bartered services or goods are included in gross income at the fair market value of the item(s) received in exchange for the services. Bartered exchanges are required to file Form 1099-B, and the transaction is recorded on Form 1040 Schedule C.
- Form 1099-B
Proceeds From Broker and Barter Exchange Transactions
- Form 1040
Schedule E
Supplemental Income and Loss
- Supplemental income is reported on Schedule E and includes:
- rental real estate
- Rent is income from an investment, not from the operation of a business. Study Unit 9, Subunit 1, has more detailed coverage of when to expense and when to capitalize costs.
- Lessor gross income includes:
- A bonus received for granting a lease.
- Value received to cancel or modify a lease.
- Prepaid rent, with no restriction as to its use, which is income when received regardless of the method of accounting.
- An amount paid by a lessee to maintain the property in lieu of rent, e.g., property tax payments.
- The FMV of lessee improvements made to the property in lieu of rent.
- The lessor includes the payment in gross income and may be entitled to a corresponding deduction, e.g., a property tax deduction. The cost of maintenance may be deducted by the lessor as a rental expense. The cost of capital expenditures may be capitalized and depreciated by the lessor.
- Lessor gross income does not include:
- A lessee’s refundable deposit is not income to the lessor.
- Amounts received by a lessee to cancel a lease, however, are treated as amounts realized on disposition of an asset/property (a capital gain).
- The FMV of lessee improvements not made in lieu of rent are excluded.
- Rental income from a residence unless the residence is rented out for less than 15 days a year. If rental income is excluded, the corresponding rental deductions are also disallowed.
- EXAMPLE 4-6 Less than 15-Day Rental
Betty, who lives in a college town, rents out her home for homecoming weekend for $10,000. She does not rent out her home for any other portion of the year. Because Betty rented her home for less than 15 days, the rental income is excluded from gross income. Any corresponding expenses are nondeductible.
- royalties
- Royalties are payments to an owner by people who use some right belonging to that owner; thus, royalties constitute gross income.
- partnerships and LLCs (from Schedule K-1)
- A partner’s share of partnership income is included in the partner’s gross income, whether distributed or not.
- S corporations (K-1)
- An owner’s pro rata share of S corporation income is included, whether distributed or not.
- estates (K-1)
- trusts (K-1)
- Form 1065
Schedule K-1
Partner’s Share of Income, Deductions, Credits, etc.
- Income in respect of a decedent
(income earned but not received before death)
- Income in respect of a decedent (income earned but not received before death) is included in gross income.
- Income from discharge of indebtedness
- Gross income includes discharge
(cancellation) of indebtedness when a debt is canceled in whole or part for consideration.
- If a debtor performs services to satisfy a debt, the debtor must recognize the amount of the debt as income.
- Gross income does not include
discharges that:
- If a creditor gratuitously cancels a debt, the amount forgiven is treated as a gift.
- Occur in bankruptcy (except a stock for debt transfer).
- Occur when the debtor is insolvent but not in bankruptcy.
- The maximum amount that can be excluded is the amount by which liabilities exceed the FMV of assets.
- Are related to qualified farm indebtedness.
- Are related to a purchase-money debt reduction in which a seller reduces the debt and the debtor is not in bankruptcy and is not insolvent. The discharge is treated as a purchase price adjustment.
- STUDY EXAMPLE
- Ray was notified on December 27, 2021, that the principal amount of $1,000 due on a note secured by a computer he purchased in 2018 had been reduced to $700. The creditor had reduced the amount as to all accounts secured by computers more than a certain number of years old to discourage "walking away" from debt greater in amount than the cost of new updated equipment.
$0. Discharge of indebtedness is a form of gross income. The forgiveness described in this situation does not fall within the purchase-money debt reduction exclusion because the creditor is not the seller. The $300 reduction is gross income to the Smiths.
- Are secured by a principal residence and were incurred in the acquisition, construction, or substantial improvement of the principal residence pursuant to the Mortgage Forgiveness Debt Relief Act (extended through 2025). The exclusion applies for discharges of up to:
- MFS
- $1 million
- Others
- $2 million
- Are related to certain qualified student loans.
- Are for Paycheck Protection Program loans.
- When a taxpayer excludes discharge of indebtedness under these conditions , the taxpayer must reduce his or her tax attributes in the following order:
- The taxpayer may first elect to decrease the basis in depreciable property.
- 1
- NOLs and NOL carryovers
- 2
- General business credit
- 3
- Capital loss carryovers
- 4
- Basis reductions
- 5
- Foreign tax credit carryovers
- Income from an interest in an estate or trust
- Income from an interest in an estate or trust is included in gross income.
- Income from life insurance and endowment contracts
- Some types of gross income not enumerated in Sec. 61 are specifically included by other IRC sections or case law. Other types of income also constitute gross income unless a statute specifically excludes them.
- Business Inducements
- Business inducements transfer value (even as “gifts”) in exchange for past or anticipated economic benefits. The FMV of the inducement is income to the recipient.
- Gambling Winnings
- Gambling winnings are reported in gross income and later in the return can be offset by gambling losses (e.g., non-winning lottery tickets) only to the extent of winnings and only as other itemized deductions. However, gambling losses over winnings for the taxable year cannot be used as a carryover or carryback to reduce gambling income from other years.
- Form 1040
Schedule 1
Additional Income and Adjustments to Income
- Income from Illegal Activities
- Income from illegal activities, such as money from dealing illegal drugs, must be included in the taxpayer’s income on Form 1040 or on Schedule C (Form 1040) if from the taxpayer’s self-employment activity.
- Prizes and Awards
- Prizes or awards in a form other than money are included in gross income at the FMV of the property. The honoree may avoid inclusion by rejecting the prize or award. Some prizes and awards are excludable (e.g., transfers to charities, employee achievement).
- Recovery of Economic/Tax Benefit
- Recovery of a tax benefit item is generally included in:
- gross income
- The recovered amount is included in income to the extent for the applicable tax year:
- total allowable itemized deductions
- exceed the standard deduction
- EXAMPLE 4-8
Recovery of Tax Benefit -- Bad Debt
Taxpayer writes off bad debt in Year 1. In Year 7, the debtor pays Taxpayer the principal of the debt written off, which must be included in gross income because the deduction in Year 1 reduced the tax liability.
- EXAMPLE 7-6
Recovery of Tax Benefit
Anne deducted $6,000 in state and local taxes on her 2020 Schedule A. Anne’s total itemized deductions were $13,400 ($1,000 more than the $12,400 standard deduction in effect during 2020). If Anne receives a $1,500 state and local tax refund in 2021 (i.e., on the 2020 return filed in 2021), $1,000 of the refund will be taxable on her 2021 federal return under the tax benefit rule. Only $1,000 is taxable because this is the amount that actually produced a tax benefit. The remaining $500 is not included in gross income because it did not produce a tax benefit (Anne could have taken the standard deduction instead of deducting the recovered $500).
- Social Security Benefits (SSB)
- Social Security Benefits (SSB) are generally not taxable unless additional income is received. The gross income inclusion is dependent upon the relation of:
- While it is unlikely you would need to complete a detailed calculation like above on the CPA Exam, you should remember the PI calculation and the BA and ABA amounts so you can approximate whether a taxpayer’s SSB are 0%, 50%, or 85% includible.
- Provisional income (PI)
- Adjusted gross income (AGI)
- Foreign-earned income
(excluded)
- SSB (50%)
- Tax-exempt interest
- Only the portion of SSB that exceeds a base amount related to other sources of income is subject to tax. SSB are calculated as follows:
- PI is less than:
- Base amount (BA)
- MFJ
- $32,000
- MFS/MFSLT
- $0
- Others
- $25,000
- SSB is excluded from gross income
- PI is between:
- BA and ABA
- 50% of the lesser of:
- 50% of the lesser of:
- Excess PI over BA
- Incremental BA
- MFJ
- $12,000
- MFS/MFSLT
- $0
- Others
- $9,000
- SSB
- PI is greater than:
- Adjusted base amount (ABA)
- MFJ
- $44,000
- MFS/MFSLT
- $0
- Others
- $34,000
- 85% of the lesser of:
- Excess PI over ABA plus
- 50% of the lesser of:
- 50% of the lesser of:
- Excess PI over BA
- Incremental BA
- MFJ
- $12,000
- MFS/MFSLT
- $0
- Others
- $9,000
- SSB
- (only Excess PI over ABA is multiplied by 85%)
- SSB
- Form SSA-1099
Social Security Benefit Statement
- Subpart F Income
- Subpart F income provisions were enacted to prevent U.S. persons from deferring income recognition by shifting income to low- or no-tax jurisdictions.
- In general, qualified income from controlled foreign corporations (CFC) is included in income for the U.S. shareholder. Qualified income includes a variety of sources; however, the most significant and only source covered in this review is foreign-base-company income (FBCI).
- CFC qualified income includes FBCI:
- Foreign-personal-holding-company income,
- Foreign-base-company sales income, and
- Foreign-base-company services income.
- CFC qualified income terms:
- CFC:
A foreign corporation owned more than 50% by U.S. shareholders.
- U.S. Shareholder:
A U.S. person with 10% or more voting-ownership in the CFC.
- U.S. Person:
A U.S. citizen, resident alien, domestic corporation, partnership, estate, or trust.
- The provisions of Subpart F are exceedingly intricate and contain numerous general rules, special rules, definitions, exceptions, exclusions, and limitations, which require careful consideration. Only the basics required for the CPA Exam are covered in this course.
- EXAMPLE 4-10
Subpart F Income for a CFC
U.S. shareholders own more than 50% of an Ireland-based corporation, making the Irish corporation a CFC. Any service income performed in another country, e.g., Denmark, creates Subpart F income for the CFC (i.e., Irish corporation).
- The sales income only qualifies if:
- Sales item sold:
- Sales item manufactured:
- The service income only qualifies if:
- Service performed:
- Outside of CFC country
- Taxable State and Local Refunds or Credits
- Payers of state or local income tax refunds, credits, or offsets send the taxpayer Form 1099-G listing the amount to be reported. This is referred to as the recovery of tax benefit rule (covered in general in item 11.d. of this subunit.).
- The taxpayer must include the refund in gross income for 2022 to the extent the total 2021 itemized deduction exceeded the 2021 standard deduction unless the taxpayer:
- Did not itemize deductions or
- Did not deduct state and local income taxes.
- EXAMPLE 4-4
Inclusion of Refunded Tax in Gross Income
In 2021, a taxpayer who files single elected to itemize deductions, claiming $10,000 of state income tax paid and $4,000 of investment interest paid for a total itemized deduction of $14,000. In 2022, the state refunded $2,000. The taxpayer must include the refund in gross income for 2022 to the extent the total 2021 itemized deduction exceeded the 2021 standard deduction, which is
$1,450 ($14,000 itemized deduction – $12,550 standard deduction for 2021).
- Form 1040
Schedule 1
Additional Income and Adjustments to Income
- Form 1099-G
Certain Government Payments
- Treasure Troves
- Treasure troves that are undisputedly in the taxpayer’s possession are gross income for the tax year.
- EXAMPLE 4-9
Reporting of a Treasure Trove
Rich purchased an old piano for $500 last year. In the current year, Rich finds $10,000 hidden in the piano. Rich must report the $10,000 as gross income in the current year.
- Unemployment Benefits
- Unemployment benefits received under a federal or state program are gross income.
- Form 1040
Schedule 1
Additional Income and Adjustments to Income
- Form 1099-G
Certain Government Payments
-
4.2 Exclusions
-
Specifically Stated
(Included/Not Included):
- An item of income generally constitutes gross income unless a provision of the IRC specifically states that all or part of it is not treated as income, i.e., is excluded.
- Candidates should expect to see questions testing exclusions from gross income on the exam and may see questions that give a list of items and ask for the amount of those items excluded from gross income.
- Included:
- Not Included
(Excluded):
- Annuity Contracts
- Taxpayers are permitted to recover the cost of the annuity (the price paid) tax-free (e.g., dividends from life insurance policy up to the amount of premiums paid). The nontaxable portion of an annuity is determined as follows:
- Complex Method:
- Nontaxable portion
- The current exclusion is calculated by multiplying the exclusion ratio by the amount received during the year.
- Amount received in current year
- Exclusion ratio
- The exclusion ratio is equal to the investment in the contract (or its cost) divided by the expected return.
- Cost (investment in contract)
- Expected return
- Calculate the expected return, which is equal to the annual payment multiplied by the expected return multiple (life expectancy determined from an actuarial table).
- Annual payment
- X
- Expected return multiple (life expectancy)
- Simplified Method:
- A simplified method is required for retirement plan (employee) annuities with starting dates after:
- November 18, 1996
- The nontaxable portion is calculated by dividing the investment in the contract, as of the annuity starting date, by the number of anticipated monthly payments.
- Nontaxable portion
- Amount received in current year
- X
- Exclusion ratio
- Cost (investment in contract)
- Number of anticipated monthly payments
- Compensation for Injury or Sickness
- Gross income does not include benefits specified that might be received in the form:
- disability pay
- health or accident insurance proceeds
- workers’ compensation awards
- other “damages” for personal physical injury or physical sickness
- Exceptions:
- Specifically included in gross income are:
- Compensation for slander of reputation.
- Damages for lost profits in a business.
- Punitive damages received.
- If a judgment results in both actual and punitive damages, the judgment must be allocated.
- Damages received solely for emotional distress.
- Only damages received for emotional distress are excluded if an injury has its origin in a physical injury or physical sickness (regardless of whether the damages are received by a lawsuit or an agreement).
- Recovery of deductions:
- If the taxpayer incurred medical expenses in Year 1, deducted these expenses on his or her Year 1 tax return, and received reimbursement for the same medical expenses in Year 2, the reimbursement is included in gross income on the Year 2 return in an amount equal to the previous deduction.
- Interest earned on an award for personal injuries is not excluded from gross income.
- Foreign-Earned Income Exclusion
- U.S. citizens may exclude up to the following amount of foreign-earned income:
- $108,700 (calendar year 2021)
- The $108,700 limitation must be prorated if the taxpayer is not present in (or a resident of) the foreign country for the entire year.
- AND
- A statutory housing cost allowance from gross income.
- Your foreign housing amount is the total of your foreign housing expenses for the year minus the base housing amount. The computation of the base housing amount
(line 32 of Form 2555) is tied to the maximum foreign earned income exclusion. The amount is 16% of the maximum exclusion amount divided by 365 (366 if a leap year), then multiplied by the number of days in your qualifying period that fall within your tax year.
- To qualify for exclusion, the taxpayer must be:
- A resident of one or more foreign countries for the entire taxable year
- OR
- Be present in one or more foreign countries for 330 days during a consecutive 12-month period.
- This exclusion is in lieu of the
Foreign Tax Credit.
- Deductions attributed to the excluded foreign-earned income are disallowed.
- Foster Care
- Amounts received in return for foster care are excluded.
- Gain on Sale of Principal Residence
- In general, a taxpayer may exclude up to the following amounts of realized gain on the sale of a principal residence:
- MFJ
- $500,000
- Others
- $250,000
- Gifts
- A gift is a transfer for less than full or adequate consideration. The IRC excludes from the gross income of the recipient the value of property acquired by gift. Gift transfers include:
- inter vivos gifts and
- gifts by:
- bequest,
- leave (a personal estate or one's body) to a person or other beneficiary by a will.
- devise, and
- a clause in a will leaving something, especially real estate, to someone.
- inheritance.
- receive (money, property, or a title) as an heir at the death of the previous holder.
- Exceptions:
- Voluntary transfers from employer to employee are presumed to be compensation, not gifts.
- STUDY EXAMPLE
- On February 1, Year 5, Hall learned that he was bequeathed 500 shares of common stock under his father’s will. Hall’s father had paid $2,500 for the stock in Year 1. Fair market value of the stock on February 1, Year 5, the date of his father’s death, was $4,000 and had increased to $5,500 6 months later. The executor of the estate elected the alternate valuation date for estate tax purposes. Hall sold the stock for $4,500 on June 1, Year 5, the date that the executor distributed the stock to him. How much income should Hall include in his Year 5 individual income tax return for the inheritance of the 500 shares of stock that he received from his father’s estate?
The Internal Revenue Code provides for the exclusion from the gross income of the recipient the value of property acquired by gift. Gift transfers include gifts by bequest, i.e., personal property by a will = $0
- Insurance Payments for
Living Expenses
- If an individual’s principal residence is damaged by casualty or the individual is denied access by governmental authorities to the casualty, then amounts paid to reimburse for living expenses are excluded from gross income. The exclusion is limited:
- to actual living expenses incurred less
- the normal living expenses the taxpayer would have incurred during the period.
- STUDY EXAMPLE
- As a result of a fire, Sam had to vacate his apartment for a month and move to a motel. His rent for the apartment had been $600 per month. No rent was charged for the month the apartment was vacated. His motel rent for this month was $1,000. He normally pays $200 a month for food, but food expenses for the month he lived in the motel were $500. He received $1,100 from his insurance company to cover his living expenses. Based on this information, determine the amount, if any, he must include in income.
A taxpayer whose residence is damaged or destroyed and who must temporarily occupy another residence can exclude from gross income any insurance payment received as reimbursement for living expenses during such period. This exclusion is limited to the excess of actual living expenses incurred by the taxpayer, $1,500 ($1,000 rent + $500 food) over the normal living expenses of $800 ($600 rent + $200 food) the taxpayer would have incurred during the period, or $700 ($1,500 – $800). The exclusion covers additional costs incurred in renting suitable housing and any extraordinary expenses for transportation, food, and miscellaneous items. The amount of the reimbursement included in income is $400 ($1,100 reimbursement – $700 exclusion).
- Interest on State and
Local Government Obligations
(e.g. Municipal Bonds)
- Interest to a holder of a debt obligation incurred by a state or local governmental entity (or political subdivisions of a state) is generally exempt from federal income tax.
- BACKGROUND 4-1
State and Local Government Interest Exemption
Historically, this exemption has been extremely important to state and local governments. It allows them to offer their debt at lower interest rates, thereby lowering their cost of capital.
- Exceptions:
- The interest on certain private activity bonds and arbitrage bonds is not excluded.
- Private activity bonds are bonds of which the lesser of the following applies:
- More than 10% of the proceeds are to be used in a private business
- AND
- More than 10% of the principal or interest is secured or will be paid by private business property or
- OR
- More than 5% or $5 million of the proceeds are to be used for private loans, whichever is lesser.
- Exception to the exception:
- Interest on private activity bonds can still be excluded if the bond is for:
- residential rental housing developments
- public facilities (such as airports or waste removal), or
- other qualified causes.
- Lease Improvements
- The value of improvements made by the real property lessee, including buildings erected, is excludable by the lessor unless:
- The lessee provided the improvements in lieu of rent.
- Income realized by the lessor from the improvements subsequent to termination of the lease is included.
- Amounts received by a retail lessee as cash or rent reductions are not included in gross income of the lessee if used for qualified construction or improvements to the retail space.
- Proceeds from life insurance
- In general, proceeds of a life insurance policy paid by reason of the death of the insured (i.e., death benefit) are excluded from gross income. The exclusion is allowed regardless of form of payment or recipient.
- Accelerated death benefits under a life insurance contract
- Amounts received as accelerated death benefits under a life insurance contract for individuals who are either terminally ill (certified by a physician that death can be reasonably expected to result within 24 months) or chronically ill (unable to perform basic tasks) are excluded from gross income. A chronically ill person must use the funds for medical care to qualify for the exclusion.
- Dividends paid on insurance policies
- Dividends paid on insurance policies are excluded from gross income to the extent cumulative dividends do not exceed cumulative premiums and provided the cash value does not exceed the net investment, which it normally does not.
- Interest on VA insurance dividends
- Interest on Veterans Administration (VA) insurance dividends left on deposit with the VA is excluded from gross income.
- Exceptions:
- Benefits from “employer-owned” life insurance contracts are to be included in gross income of the beneficiary to the extent they exceed premiums paid for policies:
- After:
- August 17, 2006
- Interest earned on proceeds (after death of the insured) is gross income to the beneficiary.
- The amount of each payment in excess of the death benefit principal amount is interest income.
- EXAMPLE 4-11
Life Insurance Proceeds Paid in Installments
A $75,000 policy pays off in $6,000 installments over 15 years. The principal amount per installment, $5,000 ($75,000 ÷ 15 years), is excluded. The remaining $1,000 ($6,000 – $5,000) is taxable interest income.
- If the owner of a policy transfers the policy to another person for consideration, the proceeds are taxable. However, amounts paid to acquire the policy and subsequent premium payments are treated as return of investment capital.
- Recovery of Non-Tax Benefit Item
- Amounts recovered (a similar rule applies to credits) during the tax year that did not provide a tax benefit in the prior year are excluded.
- EXAMPLE 4-13
Recovery Not Providing a Tax Benefit
Taxpayer pays state income tax in excess of the standard deduction and itemizes deductions. Subsequent refunds in excess of the applicable standard deduction must be included in gross income. However, if Taxpayer elected the standard deduction, the refund would not be included because no tax benefit from payment of state income tax was realized.
- Redemption of
Series EE U.S. Savings Bonds
- If a taxpayer pays qualified higher education expenses during the year, a portion of the interest on redemption of a Series EE U.S. Savings Bond is excluded.
- Taken on Form 8815 Exclusion of Interest from Series EE and I U.S. Savings Bonds Issued After 1989 and added to Schedule B Interest and Ordinary Dividends
- The taxpayer, the taxpayer’s spouse, or a dependent incurs tuition and fees to attend an eligible educational institution.
- The purchaser of the bonds must be the sole owner of the bonds (or joint owner with his or her spouse).
- The issue date of the bonds must follow the 24th birthday(s) of the owner(s).
- The bonds must be issued after 1989.
- The exclusion rate equals qualified expenses divided by the total of principal and interest
(not to exceed 100% or 1.0).
- Exclusion ratio:
- Qualified expenses
- The amount of qualified expenses is reduced by the total of:
- Employer-provided educational assistance
- Expenses for American Opportunity credit
- Expenses for Lifetime Learning credit
- Other higher education related benefits
- Qualified scholarships (excluded from income)
- Total principal and interest
- The taxpayer’s modified AGI
(MAGI) must not exceed a certain limit. For 2021:
- Others
- $83,200
- $98,200
- MFJ
- $124,800
- $154,800
- STUDY EXAMPLE
- In February 2021, Paul and Jean, a married couple, cashed a qualified Series EE savings bond they bought in November 2008. They received proceeds of $7,132, representing principal of $5,000 and interest of $2,132. In 2021, they helped pay their daughter’s college tuition. The qualified education expenses they paid in 2021 totaled $4,000. They are not claiming an education credit for the expenses, and they do not have an education IRA. How much interest income can Paul and Jean exclude?
An exclusion from gross income is provided for interest on Series EE United States Savings Bonds used to finance the higher education of a taxpayer, a spouse, or a dependent. Accrued interest is excluded, provided the aggregate redemption proceeds (principal and interest) do not exceed the qualified higher educational expenses incurred during the same year as the redemption. If the gross proceeds are greater than the educational expenses, the amount of interest that is excludable is determined by taking the applicable fraction of interest. The applicable fraction is determined by dividing the total qualified educational expenses by the gross proceeds of the bond redemption ($4,000 ÷ $7,132). This percentage is then multiplied by the amount of interest to obtain the exclusion amount ($2,132 × .561). Therefore, Paul and Jean can exclude $1,196 of interest from income.
- Rental Value of Parsonage
- Ministers may exclude from gross income the rental value of a home or a rental allowance to the extent the allowance is used to provide a home. However, the rental value or allowance is included in self-employment income when calculating self-employment tax.
- Prizes and Awards
- A prize or award may qualify for exclusion as a scholarship. Additionally, a recipient may exclude the FMV of the prize or award if
- The amount received is in recognition of religious, scientific, charitable, or similar meritorious achievement;
- The recipient is selected without action on his or her part;
- The receipt of the award is not conditioned on substantial future services; and
- The amount is paid by the organization making the award to a tax-exempt organization (including a governmental unit) designated by the recipient.
- A qualified employee achievement plan award is provided under an established written program that does not discriminate in favor of highly compensated employees.
- Employee achievement awards may qualify for exclusion from the recipient employee’s gross income if:
- They are awarded as part of a meaningful presentation for safety achievement or length of service and
- Nonqualified plan award:
- The awards do not exceed $400 for all nonqualified plan awards or
- Qualified plan award:
- The awards do not exceed $1,600 for all qualified plan awards.
- The award is tangible personal property (e.g., plaque, watch, etc.). Cash, cash equivalents, and gift cards are not tangible personal property.
- Scholarships and Tuition Reduction
- Scholarships:
- Amounts received by an individual as scholarships or fellowships are excluded from gross income to the extent that:
- the individual is a candidate for a degree from a qualified educational institution and
- the amounts are used for required:
- tuition or fees
- books
- supplies
- or equipment
- (not personal expenses).
- (does not include the value of services and accommodations such as room and board)
- Gross income includes any amount received, e.g., as tuition reduction, in exchange for the performance of such services as:
- Teaching
- Research
- Tuition Reduction:
- Generally, a reduction in undergraduate tuition for an employee of a qualified educational organization does not constitute gross income.
- Exceptions:
- The exclusion is not allowed for amounts representing payments for services (e.g., research, teaching) performed by the student as a condition for receiving the qualified scholarship.
- Stock Dividends
- Generally, a shareholder does not include in gross income the value of a stock dividend
(or right to acquire stock) declared on its own shares
- Exceptions:
- Any shareholder can elect to receive cash or other property.
- If a shareholder receives common stock and cash for a fractional portion of stock, then only the cash received for the fractional portion is included in gross income.
- Some common stock shareholders receive preferred stock, while other common stock shareholders receive common stock.
- The distribution is on preferred stock
- Exception to the exception:
- The distribution is on preferred stock (but a distribution on preferred stock merely to adjust conversion ratios as a result of a stock split or dividend is excluded).
- Student Loan Forgiveness and
Employer Payments
- Federal, state, and/or local government student loan indebtedness may be discharged and excluded from income if:
- the former student engages in certain employment (e.g., in a specified location, for a specified period, or for a specified employer)
- or the discharge is due to death or total and permanent disability.
- Payments made by an employer to an employee or lender during the current year on any qualified educational loan incurred by the employee for the employee’s education may be excluded by the employer from the employee’s taxable wages for up to:
- $5,250 per employee
- Survivor benefits
- Survivor benefits for public safety officers killed in the line of duty. The annuity must be a result of a governmental plan meeting certain requirements and is attributable to the officer’s service as a public safety officer.
-
Not Specifically Stated
(Not Included):
- Certain items are not treated as income for federal income tax purposes even though no IRC section specifically excludes them.
- Not Included
(excluded):
- Intra-family services
- The value of services rendered by a person for himself or herself is not treated as income for tax purposes. The same applies for gratuitous services performed by one member of a family for another.
- Loans
- Receipt of loan funds does not give rise to income.
- Return of capital
- An amount invested in an asset is generally not treated as income for tax purposes upon an otherwise taxable disposition of the asset.
- Receipt of payment of debt principal is return of capital and not income.
- The value of one’s own services, however, is not treated as capital invested.
- Unrealized income
- Income must be realized before it constitutes gross income. Generally, a gain is not realized until the property is sold or disposed. Mere fluctuations in market value are not treated as income for tax purposes.
- Use of one’s own property
- Income is not imputed for the economic benefit of the use of property owned by oneself.
-
CPA REG SU05 Accounting Methods and Special Entities
-
5.1 Accounting Methods
-
Background of Accounting Methods
- The most common accounting methods are:
- Cash method
- Accrual method
- A person must use the method of accounting that:
- clearly reflects income.
- reports income when it can be estimated with reasonable accuracy.
- Adjustments are made in a later year for any differences between the actual amount and the previously reported amounts.
- If an amount of income is properly accrued on the basis of a reasonable estimate and the exact amount is subsequently determined, the difference, if any, shall be taken into account for the taxable year in which such determination is made.
- is regularly used to compute income in keeping books and records.
- Specific provisions of the Internal Revenue Code
(IRC) may override and require specific treatment of certain items.
- Generally, IRS consent is required for changes in accounting method, which include, but are not limited to:
- change in either the overall system of accounting for:
- gross income
- OR
- deductions
- treatment of any material item used in the system
- The accounting rules for income and deduction items under both the cash and accrual methods have often been tested. The AICPA has used questions that have focused on the timing of the inclusions of various income and expense items under each method.
-
Tax Year
- The accounting method determines the tax year in which an item is includible or deductible in computing taxable income. Federal income tax is imposed on taxable income.
- The taxable period is adopted in a person’s first tax year and includes the following:
- Calendar year
- A calendar year is the 12-month period ending on December 31.
- Fiscal year
- A fiscal year is any 12-month period ending on the last day of a month.
- 52- or 53-week tax year
- A 52- or 53-week tax year is also allowed.
- Short tax year
- A short tax year is allowed for a business not in existence for an entire year (365 or 366 days), e.g., the start-up year or the year at dissolution.
- Generally, IRS consent is required for changes in tax years. In such case, a short tax year return is then required.
-
Cash Method
- A cash-method taxpayer accounts for
income when:
- Cash or its equivalent is actually received
- Cash or its equivalent is constructively received
- Rules regarding cash method income:
- Cash Equivalent
- At the time a person receives noncash forms of income, such as property or services, the fair market value is included in gross income. This applies even if the property or service can be currently converted into cash at an amount lower than face value.
- Cash equivalent
- Cash equivalents are so near to maturity that the risk of loss due to a change in value is immaterial.
- A cash equivalent is property that is readily convertible into cash and typically has a maturity of:
- 3 months or less
- Cash equivalents include:
- Checks (valued at face)
- Promissory notes (valued at FMV)
- Property (e.g., land, transferable at current FMV)
- If the value of property received cannot be determined, the value of what was given in exchange for it is treated as the amount of income received.
- EXAMPLE 5-1
Indeterminate Value of Property
A CPA performs various services for a start-up company in exchange for stock options. If the value of the stock options cannot be determined, the value of the services performed is included in income.
- If both the property received and the property given are impossible to value (e.g., an unsecured promise to pay from a person with unknown creditworthiness), the transaction is treated as open, and the consideration is not viewed as income until its value can be ascertained.
- Constructive Receipt
- Constructive Receipt
- Under the doctrine of constructive receipt, an item is included in gross income in the tax year during which:
- a person has an unqualified right to immediate possession
- it is credited to his or her account
- set apart for him or her
- otherwise made available so that (s)he may draw upon it at any time
- it is more than a:
- billing
- offer
- promise to pay
- it includes ability to use on demand:
- as with escrowed funds subject to a person’s order
- as with dividends are constructively received when made subject to the unqualified demand of a shareholder
- If a corporation declares a dividend in December and pays such that the shareholders receive it in January, the dividend is not treated as received in December.
- deferring deposit of a check does not defer income. However, dishonor (i.e., bounced or returned checks) retroactively negates the income
- Constructive receipt by an agent is imputed to the principal
- Not Constructive Receipt
- Income is not constructively received if the taxpayer’s control of its receipt is (e.g., a valid deferred compensation agreement):
- subject to substantial restrictions
- limitations
- EXAMPLE 5-2
Income Not Constructively Received
John is awarded a $10,000 bonus in 2021. If only half of the bonus is payable in 2021 with the other half paid at the end of 2022, contingent upon John completing another year of service for his employer, only $5,000 is taxable in 2021.
- Claim-of-Right
- The claim-of-right doctrine indicates that a taxpayer receiving payments under a claim of right and without restrictions on its use includes the payment in income in the year received even though:
- the right to retain the payment is not yet fixed
- OR
- the taxpayer may later be required to return it
- Economic or Financial Benefit
- The economic or financial benefit conferred on an employee as compensation has been determined by the courts to be included in the definition of gross income. This economic benefit theory is applied by the IRS in situations in which an employee or independent contractor receives a transfer of property that confers an economic benefit that is equivalent to cash. The economic benefit theory applies even when the taxpayer cannot choose to take the equivalent value of the income in cash.
- EXAMPLE 5-3
Economic Benefit of Property Received Included in Gross Income
The fair rental value of a car that a dealership provides for the personal use of its president is gross income.
- Special Cases:
- Bonds
- The seller includes the accrued interest in gross income as interest income. The buyer reduces interest income, as a return of capital, by the same amount. When a bond is sold between interest payment dates, the interest accrued up to the sale date is:
- added to the selling price of the bond.
- Exceptions:
- Prepaid Service Income
- Prepaid income for services may be accrued
if the following condition is met:
- if it does not extend beyond the end of the next tax year.
- The taxpayer recognizes income as it is earned in Year 1, and the balance of the prepaid income is recognized in Year 2, even if it might be earned in Year 3 or later.
- Prepaid Rent
- Prepaid rent is included in gross income when received for taxpayers using either method:
- Cash Method
- Accrual Method
- Lease cancellations are included.
- Tenant improvements, in lieu of rent, are included.
- Exceptions:
- Security deposits are not considered income when the property owner is obligated to return it to the tenant.
- Advance rental payments must be deducted by the payee during the tax periods to which the payments apply.
- Tips
- Tips are gross income when reported. An employee who receives the following working for any employer (as a result of working for one employer, and not combined from several jobs):
- $20 or more in tips per month
- Tips must be reported to the employer:
- by the 10th day of the following month
- These tips are treated as paid when the report is made to the employer.
- A cash-method taxpayer accounts for deductions when:
- Actually paid
- Contingent Liabilities:
Under current case law, reserves for contingent liabilities (such as product warranties) are not determinable in amount with reasonable accuracy. Therefore, only amounts paid are deductible. Both cash-basis and accrual-method taxpayers must use the direct write-off method.
- For example, this formula is used to calculate deductible warranty expense.
- Warranty Reserve Account
- Beginning balance
- +
- Accrued warranty expense
- –
- Ending balance
- =
- Tax deductible warranty expense
- Rules regarding cash method deductions:
- Rules regarding actual payment include the following:
- A promise to pay (e.g., promissory note), without more, is not payment.
- A check represents payment when delivered or sent.
- A second-party (e.g., store) credit card charge transaction is not paid until the charge is paid off.
- A third-party (e.g., bank) credit card charge transaction represents current payment with loan proceeds.
- A cash-method taxpayer usually has no basis in accounts receivable, (s)he may not deduct bad debts.
- For accrual basis payers, adjusted basis in accounts receivable is deductible as bad debt when the debt becomes worthless.
- A person who uses the cash method to report gross income must use the cash method to report expenses.
- Exceptions:
- Prepaid expenses
- For cash-method taxpayers, prepaid expenses are generally:
- not deductible when paid
- prorated over the period of the expense
- Examples of prepaid expenses include:
- Rent
- Insurance
- Loans issued at a discount
(unstated/imputed interest)
- Exception to the exceptions:
- The 12-month rule:
An important exception to the rule above is the 12-month rule. The 12-month rule allows a cash-basis taxpayer to deduct a prepaid expense:
- in the year of payment
- If the following conditions are met:
- 1) the contract period of the expense cannot exceed 12 months (i.e., a taxpayer cannot prepay for 13 months of a service).
- 2) the contract period cannot extend beyond the end of the next taxable year (i.e., a payment in Year 1 cannot be for a benefit in Year 3).
- 3) the prepaid expense is not prepaid interest
- Though common expenses like prepaid rent or prepaid insurance expense are allowed deductions under the 12-month rule, prepaid interest is not allowed a deduction until the year to which the interest relates.
- EXAMPLE 5-5
12-Month Rule
A cash-basis, calendar-year taxpayer pays $12,000 for 1 year of rent on July 1, 2021. The rental period covered by the payment is from July 1, 2021, through June 20, 2022. Because the contract period is 12 months or less and does not extend beyond the end of the next taxable year, the entire $12,000 payment is deductible in 2021.
- EXAMPLE 5-4
Prepaid Expenses
A cash-basis, calendar-year taxpayer pays $24,000 for 2 years of rent on January 1, 2021. The rental period covered by the payment is from January 1, 2021, through December 31, 2022. The taxpayer cannot deduct the full $24,000 payment in 2021. Instead, the expense will be prorated based on the actual contract period, making $12,000 deductible in Year 1 (12 months/24 months) and $12,000 deductible in 2022.
-
Accrual Method
- Generally, an accrual-method taxpayer accounts for income in the period:
- it is actually earned
- all the events have occurred that fix the right to receive it
- A right is not fixed if it is contingent on a future event
- all-events test is satisfied when goods shipped on consignment are sold
- the amount can be determined with reasonable accuracy
- Only in rare and unusual circumstances, in which neither the FMV received nor the FMV given can be ascertained, will the IRS respect holding a transaction open once the right to receive income is fixed. In those circumstances, income is accrued upon receipt.
- Proceeds from settlement of a lawsuit are determinable in amount with reasonable accuracy when received
- If an amount of income is properly accrued on the basis of a reasonable estimate and the exact amount is subsequently determined, the difference, if any, shall be taken into account for the taxable year in which such determination is made.
- Exceptions:
- For taxpayers with applicable financial statements (AFSs), the inclusion is generally:
- no later than the inclusion for financial accounting purposes
- Exceptions:
- This AFS rule does not apply to special methods of accounting including:
- Long-Term Contracts
- Installment Agreements
- Mortgage Servicing Contracts
- Prepaid Merchandise Sales
- Prepayments for merchandise sales must be included when reported for accounting purposes if reported earlier than when earned. The right to income is fixed when it is earned (e.g., when goods are shipped).
- Prepaid Service Income
- Prepaid income for services may be accrued
if the following condition is met:
- if it does not extend beyond the end of the next tax year.
- The taxpayer recognizes income as it is earned in Year 1, and the balance of the prepaid income is recognized in Year 2, even if it might be earned in Year 3 or later.
- Otherwise, generally, income received in advance is included in gross income when received under IRC Sec. 451.
- Prepaid Rent
- Prepaid rent is included in gross income when received for taxpayers using either method:
- Cash Method
- Accrual Method
- Lease cancellations are included.
- Tenant improvements, in lieu of rent, are included.
- Exceptions:
- Security deposits are not considered income when the property owner is obligated to return it to the tenant.
- Advance rental payments must be deducted by the payee during the tax periods to which the payments apply.
- Generally, an accrual-method taxpayer accounts for deductions in the period:
- in which they accrue
- All events have occurred that establish the fact of the liability, including that economic performance has occurred
- Economic performance occurs as:
- services are performed
- property is provided or used
- The amount can be determined with reasonable accuracy
- To the extent the amount of a liability is disputed, the test is not met. But any portion of a (still) contested amount that is paid is deductible.
- Contingent Liabilities:
Under current case law, reserves for contingent liabilities (such as product warranties) are not determinable in amount with reasonable accuracy. Therefore, only amounts paid are deductible. Both cash-basis and accrual-method taxpayers must use the direct write-off method.
- For example, this formula is used to calculate deductible warranty expense.
- Warranty Reserve Account
- Beginning balance
- +
- Accrued warranty expense
- –
- Ending balance
- a
- Tax deductible warranty expense
- Rules regarding accrual-method deductions:
- A taxpayer who uses the accrual method to report gross income must use the accrual method to report expenses.
- If the accrual method is used to report expenses, it must be used to report income items.
- A taxpayer who maintains inventory must use the accrual method with regard to purchases and sales.
- Exceptions:
- Accrued Vacation Pay
- Accrued vacation pay is generally deductible by the employer when:
- actually paid
- OR
- in the year accrued if paid within 2.5 months of year end
- Recurring Expenses
- For expense items that are recurring in nature, a deduction:
- can be taken in the year before economic performance occurs
- In other words, under the recurring item exception a deduction can be taken in Year 1 even though economic performance occurs in Year 2 if the following condition occurs:
- Economic performance in Year 2 must occur before:
- the earlier of the return filing
- OR
- 8.5 months
- EXAMPLE 5-6
Recurring Item
ABC, Inc., a calendar-year, accrual-method taxpayer has a year-end accrual for $10,000 of real property taxes assessed for 2021, but payment is not due until March 1, 2022. Economic performance for property taxes due is considered to occur when the tax is paid. Under the general rules for accrual-method taxpayers, ABC could deduct the property taxes in the year paid (i.e., the all-events test is met and economic performance has occurred). However, with the recurring item exception, ABC will be able to deduct in 2021 the property tax payment made in 2022 (the all-events test is met and economic performance occurs in Year 2 prior to the earlier of return filing or 8.5 months).
- Related Party Transactions
- Deduction of an amount payable to a related party is allowed only when:
- includible in gross income of the related party
- EXAMPLE 5-7
Deduction of a Payable to a Related Party
An individual cash-method taxpayer owns 55% of an accrual-method corporation. The corporation owes the individual $5,000 for rent incurred in Year 1. In Year 2, $5,000 was paid and reported as income by the individual. Because the corporation and individual are related parties, the corporation must wait to take the deduction of $5,000 until Year 2, the year it was reported as income by the related party.
- Tips
- Tips are gross income when reported. An employee who receives the following working for any employer (as a result of working for one employer, and not combined from several jobs):
- $20 or more in tips per month
- Tips must be reported to the employer:
- by the 10th day of the following month
- These tips are treated as paid when the report is made to the employer.
- Required Accrual Method Taxpayers
- C corporations
- Partnerships with C corporation as partner
- Charitable trusts with unrelated income
- Tax Shelters
- Tax shelters include any arrangement for which the principal purpose is:
- avoidance of tax
- any syndicates
- any enterprise in which the interests must be registered as a security
- Exceptions:
- Exceptions to the general rule allow the following taxpayers to use the cash method if the entity is not a tax shelter:
- Entities that meet the gross receipts test:
- Has $26 million or less average gross receipts
- In the 3 preceding years consisting of:
- The test year
- The preceding 2 years
- For each test year
- Farming or tree-raising businesses
- Qualified personal service corporations
-
Inventory Method
- A taxpayer who maintains inventory must use the accrual method with regard to purchases and sales.
- Rules regarding inventory method:
- The inventory method used must:
- clearly reflect income
- Gross income includes:
- Receipts
- -
- COGS whether:
- Purchased Merchandise
- Purchased merchandise is valued at:
- Cost/invoice price
- -
- Trade/cash discounts
- Cash discounts may instead be treated as income.
- +
- Freight in
- +
- Handling charges
- Uniform capitalization required:
- The uniform capitalization rules require the costs for acquiring property for sale to customers
(retail) to be capitalized including costs necessary to prepare the inventory for its intended use that are:
- Direct costs
- Most allocable indirect costs
- Exceptions:
- The uniform capitalization rules do not apply if property is (i.e. these cost may be expensed):
- acquired for resale
- the company:
- has $26 million or less average gross receipts
- in the 3 preceding years consisting of:
- the test year
- the preceding 2 years
- for each test year
- Producted/manufactured
- Full absorption costing required:
- Produced merchandise cost must be calculated using the full absorption costing method including costs that are:
- Direct costs
- Overhead costs
- Nonmanufacturing costs
- Nonmanufacturing costs need not be included in inventory including:
- Marketing
- Interest on property
- that is real
- OR
- requires more than:
- 1 year of production
(if it costs more than $1 million)
- 2 years of production
- conform to generally accepted accounting principles of the trade or business
- Regulations require the particular treatment of certain items or an acceptable alternative treatment
- Any of the following standard methods may be used to determine inventory costs. The inventory method may be valued at:
- Average cost
- Cost
- FIFO
- FIFO assumes that the first items acquired are the first items sold. Ending inventory contains the most recently acquired items.
- LIFO
- LIFO assumes that the latest items acquired are the first items sold. If LIFO is used, inventory must be valued at cost. In a period of rising prices, LIFO results in a higher cost of goods sold than FIFO. Because COGS is higher, net income (NI) is lower, resulting in lower current tax liability.
- LIFO may only be used for tax purposes if it is used for financial reporting.
- LCM
- Specific identification
- Rolling average
- Taxpayers using a rolling-average method for financial accounting purposes are allowed to use the same method for tax purposes if the related safe harbor rules are satisfied:
- (1) Recompute inventory:
- at least once a month
- OR
- upon each purchase/sale
- (2) Rolling average with:
- less than 1% variance
= rolling average cost - actual cost
/ rolling average cost
- OR
- rollover inventory at least 4 times a year
= COGS / average inventory
- Exceptions:
- The following are some of the inventory practices that are not recognized for tax purposes:
- Deducting a reserve for price changes or an estimated amount for depreciation in the value of the inventory
- Taking work in process or other parts of the inventory at a nominal price or less than its full value
- Omitting part of the stock on hand
- Using a constant price or nominal value for so-called normal quantity of materials or goods in stock
- Including stock in transit, shipped either to or by the taxpayer, the title to which the taxpayer does not hold
- Separating direct production costs into fixed and variable production cost classifications and then allocating only the variable costs to cost of goods produced, while treating fixed costs as period costs that are currently deductible (the direct cost method)
- Treating all or almost all indirect production costs (whether fixed or variable) as period costs that are currently deductible (the prime cost method)
- Exceptions:
- Exceptions to this inventory rule of requiring accrual method include qualifying taxpayers who satisfy the gross receipts test:
- Entities that meet the gross receipts test:
- Has $26 million or less average gross receipts
- In the 3 preceding years consisting of:
- The test year
- The preceding 2 years
- For each test year
- Exception to the exception:
- S corporations
are not subject to the $26 million limitation unless:
- Inventory sales are a material part of the S corporation’s operations
-
Long-Term Contracts
- A long-term contract is a contract completed in a tax year subsequent to the one in which it was entered into for items:
- that normally require more than 12 months to complete
- that are unique
- not usually inventory items
- Examples of long-term contract items are:
- buildings
- construction
- installations
- manufacturing
- Rules regarding long-term contracts:
- A trade or business of a taxpayer must use the same method for each of its long-term contracts.
- Long-term contract rules apply to costs
that are:
- Direct costs
- Allocable portions of:
- Labor
- Material
- Overhead costs
- Exceptions:
- Costs of the following do not need to be allocated to a specific contract:
- Marketing
- Research and development
(if not restricted to the specific contract)
- Unaccepted bids
- Types of contract methods used:
- Completed-contract method
- The completed-contract method accounts for
(reports) receipts and expenditures in the tax year in which the contract is completed. The method is allowed only for:
- Home construction projects
- Small businesses with:
- Average annual gross receipts:
- Less than:
- $26 million
- For the 3 preceding tax years
- Whose construction contracts are expected to take:
- Less than:
- 2 years
- Percentage-of-completion method
- The percentage-of-completion method reports as income that portion of the total contract price that represents the percentage of total work completed in the year. It may be measured by the ratio of costs for the tax year to total expected costs.
- When the contract is complete, the taxpayer must pay interest on any additional tax that would have been incurred if actual total costs had been used instead of expected costs.
- The formula is for calculating gross profit under the percentage of completion method is:
- Gross profit recognized in current period
- Gross profit recognized to date
- Estimated total gross profit
- Contract price
- -
- Total estimated cost of contract
- X
- Percent completed
- Cost incurred to date
- /
- Total estimated cost of contract
- Cost incurred to date
- +
- Remaining estimated cost to complete
- -
- Gross profit recognized in prior periods
- Exceptions:
- The taxpayer may elect not to apply this method if the cumulative taxable income or loss using estimated costs is:
- Within 10% of the:
- Cumulative taxable income using actual costs
- Cumulative taxable loss
using actual costs
-
Installment Method
- An installment sale is a disposition of property and applies to gains only if:
- At least one payment is received after the year of sale
- Rules regarding installment sales:
- Unless an election is made not to apply the method, the installment method is required for installment sales by both:
- Cash method taxpayers
- Accrual method taxpayers
- Depreciation Recapture
- The full amount of any depreciation recapture regardless of the amount of installment payments received must be recognized in the year of sale as:
- ordinary income
- Exception:
- This does not apply to unrecaptured Sec. 1250 gains because it is not recharacterized as ordinary income.
- REVIEW
EXAMPLE
- Elan Corp. sold a piece of Sec. 1245 depreciable property for $300,000 in the current year. Elan received no payment this year and will receive 5 installment payments of $60,000 in each of the subsequent 5 years. Elan bought the property for
$200,000 and claimed depreciation of $50,000.
$50,000. The total amount of any depreciation recapture ($50,000) is fully recognized in the year of the sale even if no payments towards principal are received that year.
- Cedar Corp. sold a piece of Sec. 1245 depreciable property for $400,000 in the current year. Cedar received a down payment of $100,000 in the current year and will receive annual payments of $100,000 for each of the subsequent 3 years. Cedar acquired the property for $300,000 and claimed depreciation of $80,000.
$105,000. The total amount of any depreciation recapture ($80,000) is fully recognized in the year of the sale regardless of the payments received. A capital gain of $25,000 is recognized as well under the installment method. Under the installment method, the gain recognized is equal to the proceeds received in the current year multiplied by the gross profit (GP) percentage.
Gain calculation:
1. GP
= $400,000 – $300,000 = $100,000
2. GP%
= $100,000 / $400,000 = 25%
3. Gain
= $100,000 × 25% = $25,000
4. Total gain
= $80,000 + $25,000 = $105,000
- Installment Sale Income
- Installment sale income is determined as follows:
- Calculate cost of goods sold:
- Adjusted basis + Selling expense
- Calculate gross profit:
- Contract (sale) price – Cost of goods sold
- Calculate gross profit percentage:
- Gross profit / Contract (sale) price
- Calculate current-year installment sale income:
- Current-year receipts × Gross profit percentage
- EXAMPLE 5-8
Current-Year Installment Sale Income
A company sold a building for $500,000 with an adjusted basis of $400,000. The company received a down payment of $80,000, as well as principal payments of $105,000 for each of the subsequent 4 years. The gain recognized is $16,000 (20% gross profit percentage × $80,000 proceeds).
- Installment Sales Loss
- A loss on an installment sale is fully recognized in the year realized unless:
- recognition would be deferred
- Exceptions:
- The installment sales method is generally not applied to the following sales:
- Inventory personal property sales
- Revolving credit personal property sales
- Dealer dispositions
- Securities, generally, if publicly traded
- Sales by manufacturers of tangible personal property
-
Hybrid Methods
- Any combination of permissible accounting methods may be employed if the combination clearly reflects income and is consistently used.
- A person may use different methods for separate businesses.
-
5.2 Exempt Organizations
-
Charitable Deduction
- Solicitations for contributions or other payments by tax-exempt organizations must include a statement if:
- payments to that organization
are not deductible as charitable contributions for federal income tax purposes
- Donations to the following organizations
are tax deductible:
- Corporations organized under an Act of Congress
- All 501(c)(3) organizations except:
- those testing for public safety
- Cemetery companies
- Cooperative hospital service organizations
- Cooperative service organizations of operating educational organizations
- Child-care organizations
-
Executive Compensation
- Exempt organizations generally will incur:
- An excise tax of 21%
- On the sum of:
- Compensation in excess of $1 million
- Any excess parachute payment
- paid to:
- a covered individual
- one of the five highest-compensated employees for the current year
- OR
- designated as a covered employee for tax years beginning January 1, 2017
-
Exempt Status
- Exempt status generally depends on the organization's:
- Nature
- Purpose
- An organization is tax-exempt only if:
- It is of a class specifically described by the IRC as one on which exemption is conferred
- 501 (c)(3):
- A broad class of exempt organizations formed and organized exclusively for:
- Charitable
- Religious
- Scientific
- Educational
- Literary
- Other similar purposes
- Private Foundation Designation:
A charitable, religious, or scientific organization is presumed to be a private foundation unless:
- 1) Is a church
- OR
- 2) Annual gross receipts
- Less than:
- $5,000
- OR
- 3) Notifies the IRS that it is not a private foundation (on Form 1023)
- Within:
- 27 months
(from the end of the month in which it was organized)
- Provided the following conditions are met:
- No part of net earnings may inure to the benefit of any private shareholder or individual.
- No substantial part of its activities may attempt to influence legislation or a political candidacy
(e.g., Political Action Committees).
- Directly participates:
- Exempt status will be lost if the organization directly participates in a political campaign.
- Indirectly participates:
- In general, if a substantial part of the activities of an organization consists of attempting to influence legislation, the organization will lose its exempt status
- However, most organizations can elect to replace the substantial part of activities test with:
- A lobbying expenditure limit
- If an election for a tax year is in effect for an organization and that organization exceeds the lobbying expenditure limit:
- An excise tax of 25% will be imposed on the excess amount
- For example:
- A college alumni association
- A foundation organized for the prevention of cruelty to children
- A local chapter of the Salvation Army
- A trust organized and operated for the purpose of testing for public safety
- American Society for Prevention of Cruelty to Animals
- Civic leagues or organizations operated exclusively for the promotion of social welfare
- A local boys club
- Red Cross
- Examples of organization types that may be exempt are:
- Agricultural
- Apostolic
- Athletic clubs
- Certain domestic organizations
- For example:
- A state-chartered credit union
- Certain foreign corporations
- Chambers of commerce
- Civic welfare associations
- Fraternal beneficiary associations
- Fraternal beneficiary associations that:
- operate under the lodge system
- provide payment of life, sick, accident, or other benefits to members and their dependents
- Horticultural
- Labor organizations
- National or international amateur sports competition organizations
- Organizations that foster national or international amateur sports competition may be exempt if:
- they do not provide athletic facilities or equipment
- Political
- Real estate boards
- A homeowners’ association
- A homeowners’ association can be treated as a tax-exempt organization and is organized for:
- acquisition
- construction
- maintenance
- management
- of:
- residential real estate
- condominiums
- Condominium management associations:
For a condominium management association to be treated as tax exempt it must:
- file a separate election for each tax year
- file by the return due date of the applicable year
- A cooperative housing corporation is excluded.
- Religious
- Social clubs
- Social clubs organized that the following activities are substantially all of the activities of which are for:
- pleasure
- recreation
- other nonprofitable purposes
- Provided the following conditions are met:
- No part of net earnings may inure to the benefit of any private shareholder
- Exempt status is lost if:
- 35% or more of its receipts are from sources other than:
- Of this 35% up to 15% may be from
the general public's, etc.
(nonmember's):
- use of the club’s facilities
- use of the club’s services
- membership
- fees
- dues
- assessments
- It may be organized as a:
- Community chest
- Corporation
- Foundation
- Private foundations:
- Each domestic or foreign exempt organization is a private foundation unless:
- Generally, it receives more than a third of its support (annually) from its members and the general public. In this case:
- Organization becomes a public charity
- Private foundation status terminates
- Exempt status of a private foundation is subject to:
- Notification requirements
- Statutory restrictions
- Excise taxes
- Fund
- Feeder organization
- An organization must independently qualify for exempt status. It is not enough that all of its profits are paid to exempt organizations.
- Society
- Trust
- Certain employee trusts lose exempt status if they engage in prohibited transactions:
- Lending without adequate security
- Lending without reasonable interest (at below market rates)
- Paying unreasonable compensation for personal services
- It may be not organized as a:
- Estate
- For-profit organization
- An organization operated for the primary purpose of carrying on a trade or business for profit is generally not tax-exempt.
- For example:
- A privately owned nursing home
- Individual
- Partnership
-
Unrelated Business Income Tax
- Tax-exempt organizations are generally subject to tax on income from unrelated business income (UBI).
- An unrelated business is a trade or business activity:
- regularly carried on for the production of income (even if a loss results)
- Generally, losses from an unrelated trade or business are not permitted to be offset against income from another unrelated trade or business (except for NOL from tax periods before January 1, 2018).
- that is not substantially related to performance of the exempt purpose or function
- that does not contribute more than insubstantial benefits to the exempt purposes
- is not a qualified sponsorship payments received by an exempt organization
- A qualified sponsorship payment is one from which the payor does not expect any substantial return or benefit other than the use or acknowledgment of the payor’s name or logo
- does not include any activity performance for the organization entirely by unpaid volunteers
- Income is not subject to tax as UBI if substantially all the work is performed for the organization by unpaid volunteers
- Is over $1,000 of gross income used in computing the UBI tax for the tax year
- Corporation Exempt Organization:
Unrelated business income (UBI) over
$1,000 of a tax-exempt corporation is subject to tax at:
- corporate regular income tax rates
- Charitable Trust:
UBI, net of a $1,000 UBI exemption allowed by Sec. 512
(b)(12), of an exempt organization is subject to tax.
- Exception:
- Bingo games:
Income derived from bingo games is not treated as unrelated business income if:
- the games are conducted in a state in which bingo games are ordinarily not carried out
- OR
- conducted on a commercial basis
- AND
- if the games are not illegal under the state’s or locality’s law
- An unrelated business income tax return (Form 990-T) is required of an exempt organization with at least:
- $1,000 of gross income used in computing the UBI tax for the tax year [Reg. 1.6012-2(e)].
- UBI, generally, is gross income derived from a trade or business unrelated to the exempt organization’s qualified purpose minus:
- directly connected allowable deductions
- The $1,000 is, technically, a deduction
- Exempt organizations subject to tax on UBI are required to comply with the Code provisions regarding installment payments of estimated income tax by corporations [Sec. 6655(g)(3)].
-
5.3 Trusts
-
Types of trusts:
- Simple Trust
- A simple trust is formed under an instrument having the following characteristics:
- A deduction is allowable for a personal exemption that is $300 for a simple trust.
- Requires current distribution of all its income
- Requires no distribution of the res (i.e., principal, corpus)
- Provides for no charitable contributions by the trust
- Trust income is taxed to the beneficiary of the trust whether distributed or not.
- Complex Trust
- A complex trust is any trust other than a simple trust.
A complex trust can:
- A deduction is allowable for a personal exemption that is $100 for a simple trust.
- Accumulate income
- Distribute amounts other than income
- Provide for charitable contributions
- Grantor Trust
- A grantor trust is:
- any trust to the extent the grantor is the effective beneficiary
- A trust is considered a
grantor trust when:
- the grantor has greater than 5% reversionary interest
- OR
- it is revocable
- disregarded
- may be distributed
- may be accumulated for the grantor’s spouse
- The income is:
- attributable to a trust principal
- treated as owned by the grantor
- taxed to the grantor when:
- it may be applied for the benefit of the grantor
- used for the support of a dependent (not taxed if not used)
- Simple Grantor Trust
- A simple trust requires current distribution of all its income, requires no distribution of the res (i.e., principal, corpus), and provides for no charitable contributions by the trust. A grantor trust is any trust to the extent the grantor is the effective beneficiary. A trust that meets the characteristics of both a simple trust and a grantor trust, it may be classified as a simple grantor trust.
-
Rules regarding trusts:
- The rules for classifying trusts are applied on a year-to-year basis.
- Principal vs. Income
- State law defines principal and income of a trust for federal income tax purposes.
- Revised Uniform Principal and Income Act:
Many states have adopted the Revised Uniform Principal and Income Act, some with modifications:
- The act and state laws provide that trust instrument designations of fiduciary principal and interest components control.
- The act and state law also provide default designations.
- Tax is imposed on taxable income (TI) of trusts, not on items treated as fiduciary principal.
- Generally, principal is property held eventually to be delivered to the remainderman (the person who inherits or is entitled to inherit the property).
- Income is return on, or for use of, the principal.
- It is held for or distributed to the income beneficiary.
- Principal is also referred to as the corpus or res.
- Change in form of principal is not taxable income.
- Examples of allocation of principal vs. income (beneficiary) receipts and disbursements:
- Principal
- Principal Receipts
- Consideration for property, e.g., gain on sale
- Replacement property
- Nontaxable stock dividends
- Stock splits
- Stock rights
- Liquidating dividends
- Depletion allowance (natural resource property) – royalties (90%)
- Principal Disbursements
- Principal payments on debt
- REVIEW EXAMPLE
- Payment of the remaining balance of a loan used to purchase a shopping center
- Capital expenditures
- Major repairs
- Modifications
- Fiduciary fees (e.g., management of principal)
- Tax on principal items, e.g., capital gains
- Beneficiary
- Beneficiary Receipts
- Business income
- Insurance proceeds for lost profits
- Interest
- Rents
- Dividends (taxable)
- Extraordinary dividends
- Stock dividends (taxable)
- Beneficiary Disbursements
- Depletion allowance (natural resource property) – royalties (10%)
- Business expenses
- Ordinary expenses
- Necessary expenses
- Interest expenses
- REVIEW EXAMPLE
- Interest on a loan that was used to purchase a shopping center that a trust would lease to retail stores
- Production of income expenses
- Insurance
- Rent collection fee
- Maintenance
- Repair
- Depreciation
- Fiduciary fees
- Probate court fees/costs
- Tax paid on fiduciary income
- Trust Tax Rates
- Tax is imposed on taxable income of a trust at the following rates for 2021:
- Fiduciary Taxable Income Brackets:
- Applicable Rate:
- From:
- To:
- Add:
- 10%
- $0
- $2,650
- $0
- 24%
- $2,651
- $9,550
- $265
- 35%
- $9,551
- $13,050
- $1,921
- 37%
- +
- +
- $3,146
-
CPA REG SU06 - 10
-
CPA REG SU06 Self-Employment
-
6.1 Business Income and Expenses
- Deductions to compute taxable income are heavily tested on the CPA Exam. The business expense deductions explained in this study unit are also tested in the corporate context. The CPA Exam has decreased its testing of exact amounts of limits. Nevertheless, you should be familiar with limit and threshold amounts.
-
Self-Employment Income
- Self-employment income is income from a trade or business generally earned by a:
- Independent contractor
- Sole proprietor
- They generally report their income and expenses on:
- Schedule C
Profit or Loss From Business
(Sole Proprietorship)
- Gross income (GI) includes all income from a trade or business. Gross income from a business that sells products or commodities is:
- Gross sales (receipts)
- -
- Cost of goods sold
- Cost of goods sold (COGS) is treated as a return of capital, which is not income for tax purposes. COGS for a tax year, typically, is:
- Beginning inventory
- +
- Inventory-related purchases during year
- +
- Costs to produce inventory
(i.e., labor, depreciation, material, and supplies)
- -
- Year-end inventory
- =
- COGS
- COGS should be determined in accordance with the accounting method consistently used by the business.
- +
- Other GI (e.g., rentals)
- =
- GI from the business
-
Business/Trade and Expenses Defined
- A trade or business is a:
- regular and continuous activity
- the taxpayer devotes a substantial amount of business time to the activity
- entered into with the expectation of making a profit
- An activity that results in a profit is presumed not to be a hobby if profit results:
- in any 3 of 5 consecutive tax years
- in any 2 of 7 for the breeding and racing of horses
- Exception:
- Hobby:
An activity that is not engaged in for a profit is a hobby (personal)
- Expenses related to a hobby are not deductible
- Income is included in gross income
- Rules regarding trade/business:
- To be deductible an expense must be:
- Ordinary
- implies that the expense normally occurs or is likely to occur in connection with businesses similar to the one operated by the taxpayer claiming the deduction
- AND
- Necessary
- implies that an expenditure must be appropriate and helpful in developing or maintaining the trade or business
- Reasonable:
Implicit in the “ordinary and necessary” requirement is the requirement that the expenditures be reasonable
- Ordinary and Necessary Expenses
- A deduction from gross income is allowed for all ordinary and necessary expenses paid or incurred during a tax year in carrying on a trade or business.
- These deductions apply to sole proprietors as well as other business entities.
- Examples of trade/business expenses:
- Automobile Expenses
- Actual expenses for automobile use are deductible. Alternatively, the taxpayer may deduct the standard mileage rate.
- Actual expenses:
- Auto services
- Auto repairs
- Auto gas/fuel
- OR
- Standard mileage rate:
- $0.56 per mile (2021)
- Plus:
- Parking fees
- Tolls
- REVIEW EXAMPLE
- Happy Lucky drove her car a total of 18,000 miles during 2021. Of this, 12,000 miles was related to business for JR Enterprises. Happy paid $4,500 for gas, $5,500 for repairs, and $500 for tires during the year. Happy accounted to JR for these actual expenses and received a reimbursement for the business portion. How much may JR deduct as travel and transportation expense?
Under Sec. 162(a), an employer may deduct reimbursements paid to an employee for use of his or her personal car, subject to the substantiation rules of Sec. 274. Although an employee is allowed to report to an employer either the actual expenses or a standard mileage rate for the business miles driven, the employer is allowed to deduct only what is actually reimbursed to the employee. JR reimbursed Happy $7,000 [$10,500 ×
(12,000 miles ÷ 18,000 miles)]. This represented an allocation of Happy’s total automobile expenses, based on the number of business miles driven as compared to the total miles driven. JR may only deduct $7,000.
D. $10,500
- Bad Debts
- A bad debt is the loss that occurs when a customer does not pay amounts owed or an investment becomes worthless. Generally, a bad debt is related to a company’s accounts or trades receivables that cannot be collected.
- Business bad debt
- A business bad debt is one incurred or acquired in connection with the taxpayer’s trade or business.
- A business bad debt is
treated as an:
- Ordinary loss
- A partially worthless business bad debt to the extent they are:
- Worthless
- Specifically written off
- The specific write-off method must generally be used for tax purposes. The allowance method is generally used only for financial accounting purposes.
- Exception:
- Financial institutions the allowance method is allowed for bad debt deductions.
- Non-business bad debt
- A nonbusiness bad debt is a debt other than one incurred or acquired in connection with the taxpayer’s trade or business.
- A wholly worthless nonbusiness debt is treated as a:
- Short-term capital loss
- A partially worthless nonbusiness bad debt is:
- Not deductible
- Excluded from
nonbusiness bad debts are:
- Worthless corporate securities
- They are generally treated as a capital loss.
- Exception:
- Worthless corporate securities from affiliated corporations treated as an:
- Ordinary loss
- A bad debt deduction is allowed only for:
- Based upon a valid and enforceable obligation to pay
- Bona fide debt arising from a
debtor-creditor relationship
- Fixed or determinable sum of money
- A bad debt deduction alternative is:
- The nonaccrual-experience method is a procedure for not recognizing income if it is expected to be uncollectible.
- Business Gifts
- Expenditures for business gifts are deductible. They must be:
- Ordinary
- AND
- Necessary
- Summary
- The deduction is limited to:
- $25 per recipient per year
- Exception:
- The $25 limit does not apply to incidental items that are:
- Examples of incidental items include:
- Advertising
- Displays
- Other promotional materials
(imprint of
donor's name)
- $4 each or less
- Signs
- REVIEW EXAMPLE
- Gulp Oil Company gives miniature souvenir oil rigs with its name imprinted on them to its suppliers and customers. Each costs the company $2 and is worth $5. Sometimes Gulp Oil gives large quantities of these oil rigs to major wholesalers to be given out to retail customers. Gulp Oil also furnishes display racks to dealers that can be used for both Gulp products and other products. These display racks cost the company $40 and are worth $50. In the current year, 20,000 oil rigs and 500 display racks were given away. How much can Gulp Oil deduct for these gifts?
Gifts can constitute a business deduction under Sec. 162(a). They are limited by Sec. 274(b) to $25 per recipient per year. There are exceptions for items that do not cost the taxpayer in excess of $4, and on which the name of the taxpayer is clearly imprinted, and for signs and display racks to be used on the recipient’s business premises. These may be given without limit as long as they meet the ordinary and necessary test under Sec. 162(a). Since the miniature oil rigs did not cost more than $4, there is no limit on the deduction for giving them away. Similarly, the display racks are not limited to $25 per recipient. Consequently, the cost of these items may be deducted in full. The total deduction is $60,000 (20,000 × $2 per oil rig) + (500 × $40 per display rack).
- A husband and wife are treated as one taxpayer, even if they file separate returns and have independent business relationships with the recipient.
- Any item that might be considered either of the following generally will be considered entertainment and, therefore:
- Either a:
- Gift
- OR
- Entertainment
- Not deductible
- Business Meals
- Business meals include food and beverages
provided to a business associate.
- Business Associate:
A business associate is defined as a person with whom the taxpayer could reasonably expect to engage or deal in the active conduct of the taxpayer’s trade or business, such as the taxpayer’s (prospective or established):
- Agent
- Customer
- Client
- Employee
- Partner
- Professional advisor
- Supplier
- The cost of meals includes any:
- Food
- Beverages
- Sales tax
- Tips
- Delivery fees
- Parking fees
- Transportation
- Transportation to a business meal
- Transportation from a business meal
- No limitation
- 50% limit:
There is a 50% limit to deductible amounts for allowable meal expenses and related expenses
- Meal expenses are not deductible if:
- The following are not present at the meal:
- The taxpayer
- OR
- The taxpayer's employee
- For meals (or any portion thereof) that are under the circumstances:
- Lavish
- Extravagant
- No substantiating evidence
- The IRS denies deductions for which the claimant did not provide substantiating evidence for any meal expense:
- over $75
- Meals while traveling for business are also deductible.
- Capital Expenditures
- Capital expenditures are made in:
- acquiring property
- improving property
- adapt the property to a:
- new use
- difference use
- add to the value
- prolong the life of property
- that will have a useful life of:
- longer than 1 year
- If the property is a depreciable asset:
- the cost is recovered through depreciation
- If the property is not a depreciable asset:
- the amount of the capital expenditure might be recovered at the time of disposition
- Examples of capital expenditures:
- replacing machinery (generally)
- wages paid to employees for constructing a new building to be used in the business
- payment made to eliminate competition
- A payment made to eliminate competition increases the value of the business and is a capital expenditure.
- Exception:
- A payment to have machinery moved from one location to another.
- Expenditures to repair damage and put the property back in the same condition as it was before the damage are generally deductible as repairs, provided that they do not materially:
- add to the value
- prolong the life of property
- Compensation
- Cash and the FMV of property paid to an employee as reasonable compensation are deductible by the employer.
- Excluded:
- Unreasonable compensation
- Publicly traded company
- Compensation in excess of $1 million
- Compensation in form of parachute payment
- Compensation
does not include:
- Annuity plan income
- Certain ER-trusts
- Paid before publicly traded
- Pension plan income
- Tax-free benefits
- Paid to:
- A covered individual
- One of the three of highest-compensated employees for the current year
- Principal executive officer (CEO)
- Principal financial officer (CEO)
- A shareholder
(for services rendered)
- Treated as a dividend to extent of E&P
- Any employee subject to the limit in a preceding year remains subject to the limit for the current year.
- Includes amounts accurred up to:
- 2 1/2 months
- After tax year ends
- If services
rendered in tax year
- Employee
Achievement Awards
- An employee achievement award that do not create a significant likelihood that the payment is disguised compensation and is tangible personal property awarded as part of a meaningful presentation for:
- safety achievement
- Safety achievement awards are also not deductible if, during the taxable year, such awards have previously been awarded to:
- more than 10% of the other employees
- OR
- to an employee who is a:
- manager
- clerical employee
- other professional employee
- length of service
- Under Sec. 274(j)(4), further limitations on employee awards are provided whereby length-of-service awards must not be awarded until:
- after the recipient has worked over 5 years
- AND
- the recipient must not have received any such award:
- during the applicable year
- OR
- any of the 4 prior years
- The cost of employee achievement awards is deductible by an employer for:
- Nonqualified plan awards
- Up to $400 per year
- Qualified plan awards
- A qualified plan award is an employee achievement award provided:
- under an established written program
- that does not discriminate in favor of highly compensated employees
- Up to $1,600 per year
- Further limited to the average cost of all awards no greater than:
- If the average cost of all employee achievement awards is greater than $400, then it is not a qualified plan award.
- $400
- Excluded items are:
- bonds
- cash
- cash equivalents
- certificates
- gift cards
- coupons
- event tickets
- theater
- sporting
- lodging
- meals
- other securities
- stocks
- vacations
- Entertainment
- Generally, expenses for entertainment that are ordinary and necessary to the business are no longer deductible.
- Exception:
- Social events primarily for the benefit of employees, for example, a:
- company picnic
- company holiday party
- Foreign Travel
- Traveling expenses of a taxpayer who ventures outside of the United States away from home must be allocated between time spent on the trip for business and time spent for pleasure.
- EXAMPLE 6-3
Deductible Foreign Travel Expenses
Scott’s foreign trip lasts longer than a week, and he spends 35% of his time on a personal vacation. However, he spends the other 65% providing business-related services.
Only 65% of the expenses related to the time providing business services, including transportation, lodging, local travel, etc., may be deducted.
- No allocation is required for costs of getting to and from the destination when:
- The trip is for no more than 1 week,
- The taxpayer can establish that a personal vacation was not the major consideration, or
- The personal time spent on the trip is less than 25% of the total time away from home.
- Insurance Expense
- Trade or business insurance expense paid or incurred during the tax year is deductible.
- A cash-method taxpayer may not deduct a premium before it is paid.
- Exception:
- Prepaid Insurance:
Prepaid insurance must be apportioned over the period of coverage. However, a cash-method taxpayer can deduct prepaid premiums if the 12-month rule applies
(contract is 12 months or less and does not extend beyond the next taxable year).
- 12-Month Rule:
12-month rule applies if the expense is:
- for 12 months or less
- AND
- the payments do not extend beyond the end of the next taxable year
- Intangibles
- The cost of intangibles must generally be:
- capitalized
- Amortization is allowed if the intangible:
- has a determinable useful life
- OR
- was acquired as part of an acquisition of another business
- Loan Costs
- Costs of business borrowing are generally deductible.
- Currently deductible:
- Interest
- Payments in lieu of interest:
- Prepayment penalties
- Amortizable over period of the loan:
- Costs of obtaining a loan
(other than interest):
- Abstract fees
- Mortgage commission
- Recording fees
- Loan origination fees
- Points
- Points paid on refinancing
- Prepaid interest
- Any undeducted balance is deductible in full when the loan is paid off.
- Prepaid interest is not deductible in advance except for the ordinary points paid on a home mortgage. Loan origination fees or points are effectively interest paid in advance. They must be amortized over the period of the loan.
- Exception:
- Ordinary points on acquisition indebtedness of a principal residence may be treated as currently deductible loan costs.
- Medical
Reimbursement Plans
- The cost of medical reimbursement plans is deductible by the employer
- Miscellaneous Ordinary and Necessary Business Expenses
- Miscellaneous ordinary and necessary business expenses are deductible.
- Examples of miscellaneous expenses are:
- Advertising
- Amortization
- Bank fees
- Depreciation
- Office supplies
- Political Contributions and Lobbying Expenses
- Contributions to a political party or candidate and lobbying expenses are:
- Not deductible
- Exception:
- De minimis exception:
In-house lobbying expenses (e.g., travel expenses incurred for a company representative to offer testimony against proposed legislation) that do not exceed:
- $2,000
- If in excess of above:
- Total costs are not deductible
- Public Policy
- A trade or business expenditure that is ordinary, necessary, and reasonable is:
- not deductible
- if allowing the deduction would frustrate public policy
- Examples of such expenditures are:
- Fines and penalties paid to the government for violation of the law
- Illegal bribes and kickbacks
- Illegal drugs expenses as determined by federal law except:
- A adjustment to gross receipts is permitted for:
- the cost of merchandise
- Two-thirds of damages for violation of federal antitrust law
- Rent
- Advance Rental Payments:
Advance rental payments may be deducted by the lessee only during the tax periods to which the payments apply.
- Prepaid Expenses:
Generally, even a cash-method taxpayer must amortize prepaid rent expense over the period to which it applies. The exception to this rule is if the rental contract is:
- 12-Month Rule:
12-month rule applies if the expense is:
- for 12 months or less
- AND
- the payments do not extend beyond the end of the next taxable year
- EXAMPLE 6-1
Cash-Method Prepaid Rent
A cash-method calendar-year taxpayer leases a building at a monthly rental rate of $1,000 beginning July 1, 2021. On June 30, 2021, the taxpayer pays advance rent of $12,000 for the last 6 months of 2021 and the first 6 months of 2022. The taxpayer may deduct the entire $12,000 payment for 2021. The payment applies to the right to use the property that does not extend beyond 12 months after the date the taxpayer received this right. If the taxpayer deducts the $12,000 in 2021, then there is no deduction left for 2022.
- Rental Property
Income and Expense
- For individuals, generally, rental property income and expenses are reported on:
- Schedule E
Supplemental Income and Loss
- If you are in the business of renting personal property income and expenses are reported on:
- Schedule C
Profit and Loss from Business (Sole Proprietorship)
- Expenses related to the production of rental income are generally:
- deductible to arrive at adjusted gross income
- Rental property expenditures
may be deducted:
- by depreciation
- Exception:
- Section 179 Deduction:
Generally, a Sec. 179 deduction (i.e., “bonus depreciation”) is not allowed for rental property. (Study Unit 9, Subunit 2, “Depreciation and Amortization,” has more detail on the Sec. 179 deduction.)
- Exception to the exception:
- Qualified Improvement Property:
The exceptions to this include a deduction for qualified improvement property.
- Limitations on deductions:
- Special rules limit deductions on the rental of a residence or a vacation home.
- If the property passes both the minimum rental-use test and the minimum personal-use test, then all deductions may be taken and a loss may occur, subject to the passive loss limits.
- Minimum rental use.
- For deductions to be allowable the property must be rented for:
- fails the minimum rental-use test
- for less than 15 days during the year
- the rental income does not need to be reported
- the rental expenses cannot be deducted
- more than 14 days during the year
- Minimum personal use.
- Vacation-Home Rules:
The vacation-home rules apply when the taxpayer:
- passes the minimum rental-use test
- AND
- uses the residence for the greater of:
- more than 14 days during the year
- more than 10% of the number of days for which the residence is rented
- Rules regarding vacation home:
- Rental deductions may not exceed:
- the gross income derived from
rental activities and the order of deductions is the allocable portion of expenses:
- Expenses must be allocated:
- Between:
- personal use
- rental use
- Based on the number of days of use of each
- regardless of rental income
- Mortage interest
- Property taxes
- that do not affect basis
- Ordinary repairs
- Ordinary maintenance
- that affect basis
- Depreciation
- Start-Up and
Organizational Costs
- Taxpayers can deduct start-up costs and organizational costs in the taxable year in which the business begins. All deductible expenses occur prior to the start or purchase of the business in the amount of:
- up to $5,000 of start-up costs
- up to $5,000 of organizational costs
- Any start-up or organizational costs in excess of $5,000 are capitalized and amortized proportionally over a period of not less than:
- 180-month (15 year) period
- beginning with the month in which the active trade or business begins
- The total start-up and organizational costs deducted for the first year are:
- The sum total of the $5,000 limit
- +
- The amortized amount allocated to the first year
- Reduced by:
- The cumulative cost of the start-up costs or organizational costs that exceed:
- $50,000
- Not be below zero
- Taxpayers are not required to file a separate election statement. The taxpayer needs only to expense or capitalize the cost; from there, the election is irrevocable.
- Examples of start-up costs are:
- Advertisements for the opening of business
- Costs incurred to prepare to enter into the trade or business
- Costs to obtain certain supplies and equipment
- Costs to secure suppliers and customers
- Surveying potential markets
- Examples of organizational costs are:
- Expenses of meetings with:
- temporary
directors
- partners
- shareholders
- Fees paid to the state of incorporation
- Legal and accounting fees to
draft a corporate charter
- They do not include syndication fees such as:
- Accounting fees to prepare the representations in offering materials.
- Syndication fees are expenses related to the issuance or sale of partnership interests.
- Example:
- Taxes
- Taxes paid or accrued in a trade or business are deductible including:
- Occupational license taxes
- Property taxes
- Tax on real and personal property is an itemized deduction for individuals.
- Tax on business property is a business expense (i.e., deducted on a business return, for example, Schedule C or E).
- Exception:
- Local improvements
- Taxes assessed for local benefit that tend to increase the value of real property are added to the property’s adjusted basis and are not currently deductible as tax expense.
- Income taxes
- State and local taxes imposed on net income of an individual are not deductible on Schedule C. They are deductible as a personal, itemized deduction. They are not a business expense of a sole proprietorship. Individual taxpayers may claim an itemized deduction for:
- State and local sales taxes (general)
- OR
- State income taxes
- Exception:
- Federal income taxes generally are not deductible.
- Employment taxes
- Deductible FICA and FUTA taxes are covered in detail in Subunit 6.2.
- The itemized deduction for the sum total of all taxes paid (e.g., property, income) is limited:
- Others
- $10,000
- MFS
- $5,000
- Exception:
- Taxes paid or accrued to purchase property are treated as part of the cost of the property.
- Sales tax is treated as part of the property’s cost.
- If capitalized, the sales tax may be recoverable as depreciation.
- Exception to the exception:
- If the cost of the property is currently expensed and deductible, so is the tax.
- Tax-Exempt Income
- An expenditure related to producing tax-exempt income is:
- not deductible
- Examples of tax-exempt expenditures:
- interest on a loan used to purchase tax-exempt bonds
- Travel
- While away from home overnight on business, travel expenses are deductible including:
- Lodging
- Lodging While Not Traveling Away From Home:
A rule allows for lodging deductions when not traveling away from home for:
- Conference
- Trade show held at a local hotel with evening events
- If qualified under one of the two tests/rules:
- All the facts and circumstances indicate the lodging is for carrying on a taxpayer’s trade or business
- One factor under this test is whether the taxpayer incurs an expense because of a bona fide condition or requirement of employment imposed by the taxpayer’s employer.
- A safe harbor rule applies if:
- The lodging is necessary for the individual to participate fully in, or be available for, a bona fide business meeting, conference, training activity, or other business function;
- The lodging is for a period that:
- Does not exceed 5 calendar days
- AND
- Occurs once per calendar quarter
- The employee’s employer requires the employee to remain at the activity or function overnight (if the individual is an employee); and
- The lodging under the circumstances is not:
- Lavish
- Extravagant
- Providing any significant element of:
- Personal pleasure
- Recreation
- Benefit
- If more days are spent for personal purposes than for business purposes, meals and lodging must always be allocated between personal and business.
- Meal expenses in an employment-related context
- If more days are spent for personal purposes than for business purposes, meals and lodging must always be allocated between personal and business.
- Transportation
- Transportation is deductible only if the trip is primarily related to the taxpayer’s trade or business. If more days are spent for personal purposes than for business purposes, none of the transportation is deductible.
- Travel expenses are not deductible if:
- Attending investment meetings
- Commuting between home and work
- The travel expenses are for the taxpayer’s spouse unless:
- There is a bona fide business purpose for the spouse’s presence
- The spouse is an employee
- The expenses would be otherwise deductible
- The travel is a form of education
- Example:
A Spanish teacher cannot deduct a trip to Spain to improve his or her Spanish language skills
- The travel is primarily personal in nature
- Vacant Land
- The following expenses on vacant land
are deductible:
- Interest on vacant land
- Taxes on vacant land
-
6.2 FICA and FUTA Taxes
-
Federal Insurance Contributions Act (FICA)
- Employer must pay:
- Social Security/OASDI
- 6.2%
- $142,800 (2021)
- OASDI:
- Stands for old age, survivors, and disability insurance program
- Medicare Tax
- 1.45%
- No cap
- Employee's FICA portion:
- Social Security/OASDI
- 6.2%
- $142,800 (2021)
- Medicare Tax
- 1.45%
- No cap
- Additional Medicare
- 0.9%
- Single
- HOH
- Qualified Widower
- MFJ
- MFS
- $200,000
- $250,000
- $125,000
- CARES Act:
The CARES Act allows a refundable credit against employment taxes for eligible employers carrying on a trade or business during calendar year 2021 if:
- The provision only applies to
wages paid:
- After:
- March 12, 2020
- Before:
- July 1, 2021
- If one of the following applies:
- The operation of the trade or business is fully or partially suspended by an appropriate governmental authority due to COVID-19 during:
- Any calendar quarter
- The employer suffers a significant decline in gross receipts such that the gross receipts during:
- Any calendar quarter
- For same calendar quarter in 2019:
- Employers that did not exist in 2019 can use the corresponding quarter in 2020 to measure the decline in their gross receipts.
- Less than
- 80% of
gross receipts
- Employer must file/deposit:
- File quarterly returns
- Deposit payments:
- Quarterly
- Monthly
- By 15th day of following month
- Semi-weekly
- This tax has penalties imposed if:
- Failure to deposit correct amounts
- Failure to deposit on time
- Failure by persons who file returns and other documents without supplying taxpayer identification numbers
- While assessed on both employees and employers, employers are the ones required to deposit to the IRS this payroll tax based on the employee’s pay.
- Household EEs:
An employer must pay FICA taxes for all household employees who are paid more than:
- $2,300 (2021)
-
Federal Unemployment Tax Act (FUTA)
- This tax is imposed on employers. The employee does not pay any portion of FUTA:
- 6.0% of the first:
- $7,000 of wages paid annually to each employee
- Up to 5.4% credit if:
- ER paid into state unemployment funds
- Paid in full
(all wages subject to FUTA)
- Paid on time
(by due date of Form 940)
- Additional considerations:
- The amount paid to a state usually depends on the employer’s past experience regarding the frequency and amount of unemployment claims
- The percentage used to determine the credit may be reduced if the employer pays unemployment taxes in a credit reduction state.
- This tax is imposed on employers that:
- If one of the following applies:
- Employs one or more persons covered by the Social Security Act
- For at least part of a day:
- In each of 20 different calendar weeks:
- In a year
- In the preceding year
- Pays wages of:
- $1,500 or more
- In any calendar quarter:
- In a year
- In the preceding year
- This general test does not apply to household employees or farmworkers.
- FUTA is available for workers who were:
- 1) Able, available, and willing to work but could not find work
- 2) Employed and laid off through no fault of their own
- 3) Filed a claim for benefits
- Taxable wages and employment taxes are reported only when wages are actually paid. Employment taxes are imposed by a separate part of the Internal Revenue Code and have no relationship to the employer’s method of accounting for income tax purposes:
- Accrued wages are not included
on Form 940 ER's Annual Federal Unemployment (FUTA).
-
Net Investment Income Tax (NIIT)
- This tax essentially applies FICA taxes to income that previously was not subject to the taxes. All investment income in excess of deductions allowable for such income and income from passive activities
are subject to a:
- 3.8% NIIT
- The tax is imposed for the tax year on:
- Lesser of:
- Net investment income
- Any excess of modified adjusted gross income
(MAGI) over:
- Single
- HOH
- MFJ
- Qualified Widower
- MFS
- MAGI:
MAGI is the sum of:
- AGI
- Foreign-earned income (excluded)
- Foreign-earned income housing costs (excluded)
- After any:
- Credits
- Deductions
- Exclusions
- $200,000
- $250,000
- $125,000
- Net investment income tax
does not apply to nonresident aliens.
-
Self-Employment Tax
- Self-employment taxes are paid through estimated payments, not withholding. The FICA tax liability is imposed on net earnings from self-employment at:
- The employer rate
- The employer must pay:
- Social Security/OASDI
- 6.2%
- $142,800 (2021)
- Medicare Tax
- 1.45%
- No cap
- +
- The employee rate
- Employee's portion of:
- Social Security/OASDI
- 6.2%
- $142,800 (2021)
- Medicare Tax
- 1.45%
- No cap
- Additional Medicare
- 0.9%
- Single
- HOH
- Qualified Widower
- MFJ
- MFS
- $200,000
- $250,000
- $125,000
- REVIEW EXAMPLE
- Self-Employment Tax Deduction for Farmer:
Net earnings from self-employment:
$96,968. Richard’s net earnings from self-employment are calculated as follows: $105,000 net profit (loss) from Schedules F and C × .9235.
Self-employment tax:
$14,836. Richard’s calculation for self-employment tax before deduction is
$14,836 ($96,968 × .153).
Employee portion of self-employment tax:
$7,418. Richard’s deduction for the employee portion of self-employment tax is the employment tax multiplied by 50%, i.e., $7,418 ($14,836 × .50).
- Self-employment taxes requires calculating
net earnings from self-employment:
- Net income from self-employment
- Net income from self-employment includes:
- Director's fees
- Distributive share of income from partnership
(general partner --- active/inactive)
- Guaranteed payments from partnership
- Income or expenses from business/trade
- Payments from loss earnings
- Net income from self-employment does not include:
- Capital gain or loss
- Charitable contributions
- Dividends
- Gain or loss from disposition of business property
- Income or expenses related to personal activities
- Income or expenses from S corporations
- NOLs
- Nonbusiness interest
- Rents
- Self-employment tax
- Self-employment health insurance
- Wages, salaries, or tips received as an employee
- -
- Net income from self-employment
- x
- 7.65%
- The employer rate
- The employer must pay:
- Social Security/OASDI
- 6.2%
- $142,800 (2021)
- Medicare Tax
- 1.45%
- No cap
- Alternately, calculate by:
- Net income from self-employment
- x
- 0.9235
- Self-employment taxes is calculated by:
- Net earnings from self-employment
- x
- 15.3%
- A self-employed person is allowed a deduction (above-the-line deduction) for the employer’s portion of the FICA taxes paid to arrive at his or her AGI. For 2021, this equals the following.
- The employee’s portion of the FICA taxes is not deductible.
- The additional 0.9% Medicare tax is only imposed on the employee portion of self-employment tax, therefore, it is not deductible.
- The employer rate
- The employer must pay:
- Social Security/OASDI
- 6.2%
- $142,800 (2021)
- Medicare Tax
- 1.45%
- No cap
- Self-employment taxes:
Net Earnings Self-Employment and Wages:
Individuals with wages and self-employment net earnings calculate their tax liabilities in three steps:
- Step 1
- Calculate the tax on any wages in excess of the applicable threshold:
- Without regard to any withholding
- Step 2
- Reduce the applicable threshold:
- By the total amount of Medicare wages received
- Not below zero
- Step 3
- Calculate the tax on any self-employment net earnings in excess of the reduced threshold
- EXAMPLE 6-6
Tax on Self-Employment Net Earnings
C, a single filer, has $130,000 in wages and $145,000 in self-employment net earnings. C’s wages are not in excess of the $200,000 threshold for single filers, so C is not liable for the surtax on these wages. Before calculating the tax on self-employment net earnings, the $200,000 threshold for single filers is reduced by C’s $130,000 in wages, resulting in a reduced self-employment threshold of $70,000. C is liable to pay the additional 0.9% tax on $75,000 of self-employment net earnings ($145,000 – $70,000).
- Mr. Y operates his own tax practice. For 2021, his books and records reflect the following:
Fees received $69,500
Operating expenses 24,300
Loss on office equipment destroyed by fire (400)
Gain on sale of computer used in the business 350
Mr. Y also had a part-time job for which he received $22,100 in wages that were subject to Social Security tax. What is the amount of earnings Mr. Y will have to pay self-employment tax on?
$41,742
Answer (D) is correct.
The Social Security component of the self-employment tax is imposed at a 12.4% tax rate on the first $142,800 of net earnings from self-employment in 2021, reduced by any wages that were already subject to the Social Security tax. The ceiling for Mr. Y in 2021 is $120,700 ($142,800 – $22,100). (There is no ceiling for the Medicare component of the FICA tax.)
Mr. Y’s net income from self-employment for 2021 is $45,200 ($69,500 – $24,300 operating expenses). The casualty loss of business property and the gain on the sale of business property are not included in the calculation of net earnings from self-employment. The net income amount is reduced by the product of the employer’s portion of the self-employment tax rate (7.65%) times the net income from self-employment ($45,200) [Sec. 1402(a)(12)]. Net earnings from self-employment for Mr. Y equals $41,742 ($45,200 – $3,458). Taxes will be paid on this amount since it is less than the Social Security ceiling.
-
Differences between ER payments for EEs and ER payments to independent contractors:
- Taxpayers have different reporting responsibilities for payments to employees than to independent contractors:
- Employee
- Independent Contractor
- The employer must pay the employer’s
half of FICA.
- Generally, the contractor is responsible for federal income taxes and FICA.
- As well as FUTA
- No FUTA responsibility.
- The employer must issue Form W-2, Wage and Tax Statement, to the employee and send copies to the IRS.
- The taxpayer must issue the contractor Form 1099-NEC and file copies with the IRS if the taxpayer pays the contractor $600 or more during the year.
-
6.3 Employee Benefits
-
Accident and Health Plans
- Benefits received by an employee under an accident and health plan under which the employer paid the premiums or contributed to an independent fund are excluded from gross income of the employee.
- The benefits must be either:
- Payments made due to:
- permanent injury
- loss of bodily function
- OR
- Reimbursement paid to the employee for medical expenses of the:
- employee
- EE's spouse
- EE's dependents
- Any reimbursement in excess of medical expenses is included in income.
-
Cafeteria Plans
- A cafeteria plan is a benefit plan is:
- all participants are employees
- Self-employed individuals are not included.
- Nonemployee beneficiaries (e.g., spouses) may not participate in a cafeteria plan. However, they might benefit, however, depending on the plan selection.
- each participant has the opportunity to select between:
- Cash
- If the participant chooses cash, such cash is gross income.
- Nontaxable benefits
- If qualified benefits are chosen, they are excludable to the extent permitted by the IRC.
- Nontaxable benefits include:
- Accident and health benefits
- Dependent care assistance
- Disability benefits
- Group legal services
- Group term life insurance coverage up to $50,000
- The employee must choose the benefit before the tax year begins.
- Any unused benefit is forfeited.
- CARES Act:
Under the CARES Act, mid-year elections are permitted during calendar year 2021. And, an employer, in its discretion, may permit extended claim periods for unused amounts during calendar years 2020 and 2021.
- a plan that cannot discriminate in favor of highly compensated employees
- Employers may offer participation in a cafeteria plan to an employee on the employee’s first day of employment, but employers must offer participation after the employee:
- completes 3 years of employment
- Every employer maintaining a cafeteria plan must file an information return reporting:
- the number of eligible and participating employees
- the total cost of the plan for the tax year
- the number of highly compensated employees
- Plans may not offer:
- educational assistance
- deferred compensation plans
- other than 401(k) plans
- scholarships and fellowship grants or tuition reductions
- other fringe benefits
- meals and lodging (for the convenience of the employer)
-
Death Benefits
- All death benefits received by the beneficiaries or the estate of an employee from or on behalf of an employer are:
- Included in gross income
- The pension payments must be included unless the taxpayer made contributions to the pension plan.
- This is for employer paid death benefits, not to be confused with death benefits of a life insurance plan provided by an employer.
-
Educational Assistance
- The value of employer-provided educational assistance are deductible up to:
- $5,250 per year
- Excludable assistance payments may
not include the costs of:
- meals
- lodging
- transportation
- tools
- supplies
- That the employee retains after the course
- CARES Act:
Under the CARES Act, payments made by an employer to an employee or lender on any qualified educational loan incurred by the employee for his or her education may be excluded by the employer from the employee’s taxable wages for payments between:
- March 27, 2020
- January 1, 2026
-
Employee Discounts
- Certain employee discounts on the selling price of qualified property or services of their employer are excluded from gross income.
- The employee discount may not exceed:
- 100% of gross profit percentage normally earned on merchandise
- 20% of the price offered to customers in the case of qualified services
- REVIEW EXAMPLE
- Midwest Department Stores allows all its employees to purchase goods worth up to
$1,000 in retail value each year at a 50% discount. Mark, an employee of Midwest, took full advantage of this policy one year and received a $500 discount. Midwest’s gross profit percentage on sales to customers is 45%. The normal industry discount was only 30%. How much must Mark include in gross income?
$50
Answer (B) is correct.
Section 132(a)(2) provides an exclusion from gross income for qualified discounts provided by an employer to an employee. The amount of the discount must not exceed the employer’s gross profit percentage based on the price normally sold to customers. Since Midwest’s gross profit percentage is normally 45%, any discount in excess of 45% must be included in the employee’s gross income. Here the excess discount is 5% (50% – 45%). Accordingly, Mark must include $50 in his gross income ($1,000 × 5%).
-
Fringe Benefits
- An employee’s gross income does not include the cost of any qualified fringe benefit supplied or paid for by the employer.
-
De Minimis
- The value of property or services (not cash) provided to an employee is excludable as a de minimis fringe benefit if the value is so minimal that accounting for it would be unreasonable or impracticable.
- Examples of de minimis fringe benefits:
- Occasional use of company copy machines
- Occasional company parties or picnics
- Occasional tickets to entertainment/sporting events (not season tickets)
- Occasional taxi fare or meal money due to overtime work
- On-premises athletic facility provided by an employer
- Traditional noncash holiday gifts with a small FMV
- Exceptions:
- These are never excludable as de minimis fringe benefits:
- Use of an employer-provided car more than once a month for commuting
- Membership to a private country club or athletic facility
-
Incentive Stock Options
- An employee may not recognize income on an incentive stock option depending upon certain restrictions when the option is:
- exercised
- granted
- The employee recognizes gain if the stock is:
- sold 1 years or more after the option was exercised
- sold 2 years or more after the option was granted
- The gain realized is:
- long-term capital gain
- In this case, the employer is not allowed a deduction.
- The employee must be employed by the company on the grant date until 3 months prior to the exercise date
- The employee recognizes gain if the stock is:
- sold
- The gain realized is:
- ordinary income
- FMV over the option price on the date of exercise
- In this case, the employer may deduct this amount.
- Nonqualified stock option:
An employee stock option is not a qualified incentive stock option if:
- The option's FMV is ascertainable on the grant date:
- The employee has gross income equal to the FMV of the option.
- The employer is allowed a deduction.
- There are no tax consequences when the option is exercised.
- Capital gain or loss is reported when the stock is sold.
- The option's FMV is not ascertainable on the grant date:
- The excess of FMV over the option price is gross income to the employee when the option is exercised.
- The employer is allowed a corresponding compensation deduction.
- The employee’s basis in the stock is the exercise price plus the amount taken into ordinary income.
-
Life Insurance
- Proceeds of a life insurance policy for which the employer paid the premiums may be excluded from the employee’s gross income.
- The cost (e.g., premiums paid by the employer) is excluded from the employee’s gross income of group term life insurance up to a coverage amount:
- $50,000
- The employer must report the amount taxable to the employee on Form W-2.
- The exclusion applies only to coverage of the employee. Payments for coverage of an employee’s spouse or dependent are included as gross income.
- EXAMPLE 6-7
Employer-Provided Life Insurance
Janet, who is 40 years old, is provided with $150,000 of nondiscriminatory group term life insurance by her employer. Based on the IRS uniform premium cost table, the total annual cost of a policy of this type is $1.20 per $1,000 of coverage. Janet contributed $50 toward the policy. Janet should include $70 in gross income.
Amount in excess of $50,000 is $100,000
Cost of $100,000 policy is $120
– Janet’s contribution of $50
Gross income to Janet = 70
- In addition, the plan cannot discriminate in favor of highly compensated employees.
-
Meals and Lodging
- The value of meals furnished to an employee by or on behalf of the employer is excluded from the employee’s gross income if:
- the meals are furnished on the employer’s business premises
- AND
- for the employer’s convenience
- The exclusion does not cover meal allowances.
- EXAMPLE 6-8
Employer-Provided Meals
An accounting firm provides catering some nights during busy season so employees can work longer hours. These meals would be excluded from the employee’s gross income.
- The value of lodging is excluded from gross income if:
- the lodging is on the employer’s premises
- AND
- for the employer’s convenience
- AND
- must be accepted as a condition of employment
- EXAMPLE 6-9
Employer-Provided Lodging
A hotel requires its manager to reside in a room at the hotel so she is readily available. The FMV of the lodging is excluded from the manager’s gross income.
-
No Additional Cost Services
- Employees can exclude from gross income the value of no additional cost services provided by their employer.
- The service provided must be:
- in the employer’s line of business
- AND
- offered to customers in the ordinary course of business
- EXAMPLE 6-10
No Additional Cost Service
An airline allows its employees to fly for free on flights that are not full (i.e., no revenue is forgone). The value of the flight is excluded from the employee’s gross income.
-
Qualified Transportation
- The value of qualified transportation provided by the employer are deductible up to:
- $270 per month
- The following are excluded:
- employer-provided transit passes
- employer-provided “commuter highway vehicle" transportation
- employer-provided parking
- Employees may use any or all of these exclusions.
-
CPA REG SU07 Adjustments and Deductions from AGI
-
7.1 Above-the-Line Deductions
-
Above-the-line deductions are adjustments deducted from gross income to arrive at adjusted gross income (AGI) for individual taxpayers. Individual taxpayers are also allowed to take certain deductions from AGI, including the greater of the standard or itemized deductions, and the new qualified business income deduction.
- Form 1040 US Individual Income Tax Return
- ADJUSTED GROSS INCOME
- W-2 Wages and Tax Statement
- Schedule B Interest and Ordinary Dividends
- Schedule D Capital Gains and Losses
- Schedule 1 Additional Income and Adjustments to Income
- Schedule C Profit and Loss From Business (Sole Proprietorship)
- Schedule SE Self-Employment Tax
- Schedule E Supplemental Income and Loss
- Schedule F Profit and Loss From Farming
- Standard Deduction or Itemized Deductions
- Schedule A Itemized Deductions
- Other Itemized Deductions
- Gambling losses (gambling losses include, but aren't limited to, the cost of non-winning bingo, lottery, and raffle tickets), but only to the extent of gambling winnings reported on Schedule 1 (Form 1040), line 8.
- Casualty and theft losses of income-producing property from Form 4684, lines 32 and 38b, or Form 4797, line 18a.
- Federal estate tax on income in respect of a decedent.
- A deduction for amortizable bond premium (for example, a deduction allowed for a bond premium carryforward or a deduction for amortizable bond premium on bonds acquired before October 23, 1986).
- An ordinary loss attributable to a contingent payment debt instrument or an inflation-indexed debt instrument (for example, a Treasury Inflation-Protected Security).
- Deduction for repayment of amounts under a claim of right if over $3,000. See Pub. 525 for details.
- Certain unrecovered investment in a pension.
- Impairment-related work expenses of a disabled person.
- Standard Deduction
- QBID
- TAXABLE INCOME
- TAX
- Individual Income Tax Rates and Brackets (2021):
- Filing Status/Rate:
- 10%
- 12%
- 22%
- 24%
- 32%
- 35%
- 37%
- Single
- $9,950
- $40,525
- $86,375
- $164,925
- $209,425
- $523,600
- $Balance
- HOH
- $14,200
- $54,200
- $86,350
- $164,900
- $209,400
- $523,600
- $Balance
- MFJ
- $19,900
- $81,050
- $172,750
- $329,850
- $418,850
- $628,300
- $Balance
- MFS
- $9,950
- $40,525
- $86,375
- $164,925
- $209,425
- $314,150
- $Balance
- Qualified Widower
- $19,900
- $81,050
- $172,750
- $329,850
- $418,850
- $628,300
- $Balance
- The CPA Exam tests the method of computing income tax liability. In the past, however, candidates have generally not been required to memorize the tax rates for each bracket for each filing status. The computation questions have generally provided brackets and rates to be applied for specific questions. Nevertheless, candidates should be prepared to answer questions on the current rate-bracket structure (e.g., what is the highest marginal rate?).
-
Rules regarding above-the-line deductions
- “Above-the-line deductions” is a term used in our materials, but they can also be
referred to as:
- Adjustments
- Deductions to arrive at AGI
- Deductions for AGI
- Above-the-Line Deductions
(in order on Form 1040 Schedule 1):
- Educator Expenses
- Educators may claim an above-the-line deduction for unreimbursed expenses paid or incurred who during the school year:
- Kindgarten through grade 12:
- Aide
- Instructor
- Principal
- Teacher
- Worked at least 900 hours
- Eligible expenses up to $250 annually
- Each taxpayer (educator) on a joint return may deduct up to the maximum amount.
- Examples of educator eligible expenses:
- All items must be used in the classroom
- Books
- Computer equipment
- (including related software and services)
- Supplementary materials
- Supplies
- (including personal protective equipment such as face masks and disinfectants)
- Health Savings Account Deduction
- A Health Savings Account is a tax-exempt account the taxpayer sets up with a U.S. financial institution to save money used exclusively for:
- Future medical expenses
- Eligible HSA contributions include contributions made until:
- April 15, 2022 (2021)
- Eligible HSA deduction amounts:
- For self-only coverage, the taxpayer
or his or her employer can contribute:
- up to $3,600
- an additional $1,000
(age 55 and over)
- For family coverage, the taxpayer
or his or her employer can contribute:
- up to $7,200
- an additional $2,000
(both spouses age 55 and over)
- Moving Expenses
- Military members are allowed a deduction for relocation expenses if:
- On active duty
- Pursuant to military order
- Due to permanent change of station
- Self-Employment Tax
- Self-Employed SEP and Qualified Plans
- A self-employed individual can deduct specified amounts paid on his or her behalf to a qualified retirement or profit-sharing plan, such as a SEP plan.
- The most common self-employed retirement plan used is a SEP (Keogh) plan.
- The maximum annual contribution is:
- The lesser of:
- 25% of:
- Net self-employment earnings
- Self-employed earnings are reduced by the deductible part of self-employment taxes. Contributions to the plan are subtracted from net earnings to calculate self-employed earnings, creating a circular computation. For convenience, to calculate the allowable deduction to the standard rate of:
- 20% of:
- Net self-employment earnings
- -
- Deductible self-employment tax
- -
- Deductible self-employment tax
- -
- Contributions self-employment plan
- $58,000 (2021)
- Self-Employed Health Insurance Deduction
- Self-employed individuals can deduct payments made for health insurance coverage for:
- 100% of payments made
- Taxpayer
- Taxpayer spouse
- Taxpayer dependents
- The deduction is limited to:
- Taxpayer’s earned income derived
(from the business for which the insurance plan was established)
- Penalty on Early Withdrawal of Savings
- Deduction is allowable for penalties from an early withdrawal of funds from:
- Certificates of deposit
- Other time savings accounts
- The deduction is taken:
- In the year the penalty is incurred
- Alimony Paid
- Whether alimony is deductible or not depends on when the divorce was executed or modified alimony paid is:
- Divorces executed pre-2019:
- Recipient:
- Gross income
- Payor:
- Deductible
- Divorces executed/modified 2019 and after:
- Recipient:
- Excluded
- Payor:
- Not Deductible
- IRA Deduction
- Individual Retirement Arrangement (IRA) Contributions (Traditional IRAs)
- IRA contribution:
- Contributions are deductible
and limited to:
- Up to $6,000
- An additional $1,000
(age 50 and over)
- Nonworking Spouse/
Spouse Earning Less Income:
Double the above contribution is deductible if for the taxable year:
- A joint return is filed
- Combined contributions do not exceed:
- Their combined compensation for the year
- Eligible IRA contributions include contributions made until (without regard to extensions):
- April 15, 2022 (2021)
- IRA contribution excess:
- Excessive contributions may be subject to:
- 6% excise tax
- IRA earned income limitation
(MAGI):
- IRA earned income includes:
- Alimony
- Earned income
- Exclusions from earned income:
- Annuities
- Pensions
- Other deferred compensation distributions
- Modified Adjusted Gross Income
(MAGI):
- Adoption Benefits (ER-provided)
- AGI
- Social Security Benefits (taxable)
- Foreign Earned Income (excluded)
- Foreign Housing (excluded)
- ER-sponsored retirement plan
(taxpayer):
- Single
- HOH
- MFJ
- Qualified widower
- MFS
- $105,000
- $125,000
- $66,000
- $76,000
- $0
- $10,000
- ER-sponsored retirement plan
(taxpayer spouse):
- MFJ
- MFS
- $198,000
- $208,000
- $0
- $10,000
- Neither covered:
- Single
- HOH
- MFJ
- Qualified widower
- MFS
- Any amount
- IRA distributions:
- Distributions are included gross income
(since contributions are deducted from
gross income) as:
- Ordinary income
- Distributions are taxed but
not subject to penalty if:
- Received by April 1 of the calendar year
- Following the later of:
- The calendar year in which the employee attains age 72
- The calendar year in which the employee retires
- Distributions are taxed but
subject to penalty if:
- Received before age 59 1/2
- Subject to taxation plus:
- 10% early withdrawal penalty
- Exceptions:
- Birth or adoption of a child:
- Up to $5,000
- Death or disability
- First-time home buyer:
- Up to $10,000
- Medical expenses in excess of:
- 7.5% of AGI
- Qualified higher education expenses
- Exceptions:
- Contributions can still be made to an IRA (up to the $6,000/$7,000 limits) even if nondeductible. This is often called a nondeductible IRA. Because there is no deduction upon contribution, and because earnings are taxed upon withdrawal, the nondeductible IRA is less advantageous than a deductible IRA or a Roth IRA. But, like a traditional IRA, a nondeductible IRA does allow earnings to grow tax-free until withdrawal.
- Roth IRAs and Roth 401(k)s
- Roth IRA contribution:
- Contributions are not deductible
and limited to:
- Up to $6,000
- An additional $1,000
(age 50 and over)
- Nonworking Spouse/
Spouse Earning Less Income:
Double the above contribution is deductible if for the taxable year:
- A joint return is filed
- Combined contributions do not exceed:
- Their combined compensation for the year
- Eligible IRA contributions include contributions made until (without regard to extensions):
- April 15, 2022 (2021)
- IRA earned income limitation
(MAGI):
- Roth IRA distributions:
- Distributions are not taxed If:
- Satisfies a 5-year holding period
- The holding period begins with the tax year to which the contribution relates, not the year of contribution.
- EXAMPLE 7-2
Roth IRA Withdrawals
A contribution made on April 6, 2017, designated as a 2016 contribution, may be withdrawn tax-free in 2021 if it is otherwise a qualified distribution.
- AND
- Meets one of the following requirements:
- Made on or after the date on which the individual attains age 59 1/2,
- Made to a beneficiary or the individual’s estate on or after the individual’s death,
- Attributed to the individual’s disability, or
- To pay for qualified first-time homebuyer expenses
- Distributions are treated as made from contributions first; thus, no portion of a distribution is treated as attributable to earnings or, if nonqualified, includible in gross income until the total of all distributions from the Roth IRA exceeds the amount of contributions.
- Distributions are taxed if:
- Nonqualified based on above conditions
- Subject to:
- 10% early withdrawal penalty
- EXAMPLE 7-3
Roth IRA -- 10% Penalty
John made $6,000 in contributions to his Roth IRA over the last decade. The value of John’s Roth IRA is now $9,000. If the $9,000 is distributed and the distribution is qualified, John will not owe any tax or 10% penalty. If the distribution is unqualified, John will owe taxes at his marginal tax rate on the $3,000 in earnings and will owe a penalty ($300) of 10% of the earnings.
- Student Loan Interest Deduction
- Taxpayers may deduct interest paid on qualified educational loans in 2021. This deduction is available for each year interest is paid up to:
- $2,500 per year
- REVIEW EXAMPLE
- $1,667. Taxpayers may deduct up to $2,500 of interest paid on qualified educational loans in 2021. The phaseout range begins when AGI exceeds $70,000 and is completely phased out when AGI reaches $85,000. Student X’s deduction is reduced by $833 {[($75,000 AGI – $70,000) ÷ $15,000 phaseout range] × $2,500}. Therefore, Student X may deduct $1,667 ($2,500 – $833) of interest paid on qualified educational loans.
- The deduction is subject to AGI limitation:
- Single
- HOH
- MFS
- MFJ
- Qualified Widower
- $70,000
- $85,000
- $140,000
- $170,000
- Coverdell Education Savings Accounts
(CESA) contributions:
- Contributions are not deductible
- Contributions are limited to:
- $2,000 per child (beneficiary) per year
- Distributions are not taxable if:
- Earnings are:
- Used for qualified education expenses
- AGI
phase out:
- Single
- HOH
- MFS
- MFJ
- Qualified Widower
- $95,000
- $110,000
- $190,000
- $220,000
- Disallowed in any year either of the following credit used:
- American Opportunity Credit
- Lifetime Learning Credit
- Jury Duty Pay/
Write-In Adjustment
- Jury duty pay is included in:
- Gross income
- Jury duty pay is not included if:
- Remitted to an employer in
exchange for regular pay
- As a "Write-In" above-the-line adjustment on Schedule 1 Line 22
- Charitable Contributions/
Standard Deduction
- For 2021, an above-the-line charitable contribution deduction of:
- Others
- Up to $300
- MFJ
- Up to $600
- For individual taxpayers who do not itemize
- To eligible charitable organizations
-
7.2 Standard and Itemized Deductions
- Generally, the taxpayer itemizes deductions if the total amount of allowable itemized deductions is greater than the amount of the standard deduction. Otherwise, the taxpayer claims the standard deduction. A taxpayer must elect to itemize, or no itemized deductions will be allowed.
- Traditionally, the AICPA has heavily tested itemized deductions, mostly with questions requiring calculations. Always read the questions very carefully. A question may contain one small, easily missed detail that changes the amount of the deduction.
-
Rules regarding itemized deductions:
- Itemized deduction required for:
- An individual who files a separate return and whose spouse itemizes
- An individual who files a “short period” return
- A individual who itemizes deductions
- A nonresident alien
- Corporations
- Estates
- Partnerships
- Trusts
- Itemized deduction election:
- Election is made by filing Schedule A of Form 1040 or Form 1040-SR.
- Election made in any other taxable year is not relevant.
- Election may be changed by filing an amended return (Form 1040X).
- Itemized deductions include:
- Medical and dental expenses
- Amounts paid for qualified medical expenses paid (not be compensated for by insurance or otherwise) during the tax year that exceed:
- The service
(expense) could have been rendered
(incurred) in a prior year.
- 7.5% of AGI
- For the:
- Taxpayer
- Taxpayer's spouse
- Taxpayer's dependents
- Qualified medical expenses are:
- alleviate
- cure
- diagnose
- mitigate
- prevent
- treat
- The following:
- A mental disability
- A mental illness
- A physical disability
- A physical illness
- affecting any structure or function of the body
- Qualified medical expenses include:
- Building construction if:
- new building construction
- permanent improvements to existing structures
- the cost of operating and maintaining the asset operated primarily for medical care
- the excess over the increase in property value
- Examples include:
- ramps
- elevators
- widening of doorways
- lowering of kitchen cabinets or equipment
- modifying equipment
- In-patient hospital care including:
- Meals
- Lodging
- If the principal reason an individual is in an institution (e.g., nursing home, rehabilitation facility, or disability-specific school) other than a hospital is:
- the need for and availability of the medical care furnished by the institution
- the full cost of necessary services for furnishing medical care are deductible including:
- Meals
- Lodging
- Other services
- Special schooling
- Long-term care including:
- Premiums
- Services
- Medical insurance premiums that:
- provides for reimbursement of medical care expenses
- Medicare A premiums are not deductible unless voluntarily paid by a taxpayer otherwise ineligible for coverage.
- Prescription drugs
- Special equipment/tools:
- A guide dog
- Air conditioning
- Dehumidifying equipment
- Eyeglasses and contact lenses
- Special beds
- Wheelchair, crutches, or artificial limbs
- Transportation primarily for and essential to medical care
- Disqualified medical expenses include:
- Amount paid for any activity or treatment designed merely to improve an individual's:
- general health
- sense of wellness
- even if recommended by a physician
- Examples include:
- participation in a health club
- stop-smoking clinic
- weight-loss institute
- Exception:
- Such expenses may be deductible if:
- The services are prescribed by a physician who provides a written statement that they are necessary to:
- alleviate
- The following:
- A mental defect
- A mental illness
- A physical defect
- A physical illness
- Taxes You Paid
- State and local income taxes
- OR
- State and local sales taxes
- For state and local income taxes, they are deductible even if the income is exempt from federal tax
- State and local real estate taxes
- If real property is bought or sold during the year, the real property tax is apportioned between the buyer and the seller on the basis of the
(regardless of nonproration agreements between buyers and sellers):
- number of days each one held the property during the real property tax year
- State and local personal property taxes
- If the tax is:
- Substantially in proportion to the value of the property (ad valorem)
- Imposed on an annual basis, and
- Actually imposed
- Other taxes:
- Foreign country taxes
- A taxpayer may elect for “taxes you paid” to other countries or U.S. possessions either as a:
- Credit
- OR
- Itemized Deduction/
"Taxes You Paid"
- GST (on certain income distributions)
- Exceptions:
- The following taxes are not deductible:
- Federal taxes on:
- income
- estates
- gifts
- inheritances
- legacies
- successions
- State taxes on:
- cigarettes and tobacco
- alcoholic beverages
- gasoline
- registration
- estates
- gifts
- inheritances
- legacies
- successions
- Limited to:
- Others
- $10,000
- MFS
- $5,000
- Interest You Paid
- Home mortgage interest and points
- Home mortgage insurance premiums
- Investment interest
- Example:
- Limited to:
- The sum of both acquisition and home equity indebtedness up to:
- Others
- $750,000
- MFS
- $375,000
- Acquisition indebtedness is debt for a qualified residence incurred in:
- Acquiring
- Constructing
- Substantially improving
- Home equity indebtedness is any debt secured by the residence other than acquisition indebtedness that does not exceed:
- The fair market value of the residence
- Reduced by any acquisition indebtness
- For 2018 through 2025, the home equity indebtedness must be used in:
- Acquiring
- Constructing
- Substantially improving
- Points paid by the borrower are prepaid interest, which is typically deductible over the term of the loan. Amounts paid as points may be deducted in the year paid if:
- The loan is used to buy or improve a taxpayer’s principal home and is secured by that home;
- Payment of points is an established business practice in the area where the loan is made; and
- The points paid do not exceed points generally charged in the area.
- Secured by:
- A principal residence owned by taxpayer
- A second residence owned by taxpayer
- If more than one residence is owned, taxpayer may select each year which residence used.
- Limited to:
- Investment interest paid or incurred (on debt) to:
- purchase or carry property held for investment
- Investment interest must not exceed:
- Net taxable investment income
- Trade or business income from:
- Interest in such activities if:
- Does not
materially participate
- Not a passive activity
under the PAL rules
- Non-trade or nonbusiness income from:
- Annuities
- Interest
- Dividends
- Not subject to capital gains tax
- Gross portfolio income
- Under the PAL rules
- Property held for investment
- Gross income from such property
- Net gain on disposition of such property
- Not subject/elected to
capital gains tax
- Royalties
- Disallowed investment interest is carried forward indefinitely. It is deductible to the extent of investment income in a subsequent tax year.
- Investment interest does not include:
- qualified residence interest
- passive activity interest
- Passive activity interest is includible with passive activities and deductible within the passive loss rules.
- Rental real estate activity in which the taxpayer actively participates.
- interest related to producing tax-exempt income
- REVIEW EXAMPLE
- Charles Wolfe purchased the following long-term investments at par during 2021:
$20,000 general obligation bonds of Burlington County (wholly tax-exempt)
$10,000 debentures of Arrow Corporation
Wolfe financed these purchases by obtaining a $30,000 loan from Union National Bank. For 2021, Wolfe made the following interest payments:
Union National Bank $3,600
Qualified residence interest on home mortgage $3,000
Credit card interest $500
Wolfe’s net investment income for the year was $10,000. What amount can Wolfe utilize as interest expense in calculating itemized deductions for 2021?
The IRC allows a deduction for certain interest paid or accrued during the year on indebtednesses. Investment interest is deductible up to the taxpayer’s net investment income for the year. Personal or consumer interest is disallowed. Qualified residence interest is deductible. The IRC disallows a deduction for interest on debt incurred to purchase or carry tax-exempt securities. Since Wolfe used two-thirds of the loan from Union National Bank to purchase tax-exempt securities, two-thirds of the interest on this loan is disallowed as a deduction. Wolfe may deduct:
Union National Bank ($3,600 × 1/3) $1,200
Interest on home mortgage $3,000
Interest deduction = $4,200
- personal interest including interest relating to:
- credit card debt
- revolving charge accounts
- revolving lines of credit
- car loans
- medical fees
- premiums
- Exception to the exception:
- Personal interest expense does not include:
- Interest on the unpaid portion of certain estate taxes
- Interest on trade or business debt
- Investment interest
- Qualified residence interest
- Passive activity interest
- Student loan interest
- Charitable deduction
- Charitable contributions are deductible only if they are made to qualified organizations. Qualified organizations can be either:
- Public organizations
- Private organizations
- Qualified charitable deductions are:
- Cash
- Cash or cash equivalent donations require a bank record alone or a receipt, letter, etc., from the donee regardless of the amount. These must:
- Be provided at the time of donation
- State the name of the organization
- Include the date of the donation
- Include the amount of the donation
- Cash over $250 requires:
- Substantiation by a written receipt from the organization (the bank record alone is insufficient).
- Noncash property
- Noncash property of clothing and household items donated must be:
- in good condition
- OR
- in better condition
- Exception:
- The exception to this rule is that a single item donation in less than good condition but still a $500 value or more is deductible with:
- A qualified appraisal
- Noncash property over $5,000 requires:
- A qualified appraisal
- If a donation is in the form of property, the amount of the donation depends on:
- the type of property
- Capital gain property is property on which a long-term capital gain would be recognized if it were sold on the date of the contribution.
- Ordinary income property is property on which ordinary income or short-term capital gain would be recognized if it were sold on the date of the contribution.
- the type of organization
that receives the property
- 50% limit organizations
- 50% limit organizations, which encompass the majority of qualified charitable organizations, are generally public organizations (See IRS Publication 526 contains a complete, detailed list):
- Churches
- Educational organizations
- Hospitals and certain medical research organizations
- Organizations that are operated only to receive, hold, invest, and administer property and to make expenditures to or for the benefit of state and municipal colleges and universities
- The United States or any state, the District of Columbia, a U.S. possession (including Puerto Rico), a political subdivision of a state or U.S. possession, or an Indian tribal government
- Private operating foundations
- Private nonoperating foundations that make qualifying distributions of 100% of contributions within 2 1/2 months following the year they receive the contribution
- Non-50% limit organizations
- Non-50% limit organizations are all qualified charities that are not designated as 50% limit organizations. They are generally other private organizations.
- The value of services provided to a charitable organization is not deductible.
- Out-of-pocket, unreimbursed expenses incurred in rendering the services
- Actual expenses incurred for maintaining a qualified student may be deducted if there is a written agreement with the sponsoring charitable organization:
- Up to $50 per month
- REVIEW EXAMPLE
- Under a written agreement between Mrs. Norma Lowe and an approved religious exempt organization, a 10-year-old girl from Vietnam came to live in Mrs. Lowe’s home on August 1, 2021, in order to be able to start school in the U.S. on September 3, 2021. Mrs. Lowe actually spent $500 for food, clothing, and school supplies for the student during 2021, without receiving any compensation or reimbursement of costs. What portion of the $500 may Mrs. Lowe deduct on her 2021 income tax return as a charitable contribution?
Amounts paid by a taxpayer to maintain an individual other than a dependent as a member of his or her household under a written agreement between the taxpayer and a qualified organization to provide educational opportunity for pupils or students in private homes are deductible up to $50 per month. The student must attend full-time in the 12th or any lower grade of a qualified educational organization located in the United States. The deduction is only available for the months the child is a full-time student, which is 4 months in this case: September-December. Mrs. Lowe’s expenditures qualify under this provision as a charitable contribution deduction of $200 ($50 × 4 months in 2021).
- All rights and interest to the donation must be transferred to the qualified organization.
- REVIEW EXAMPLE
- During 2021, Vincent Tally gave to the municipal art museum title to his private collection of rare books that was appraised and valued at $60,000. However, he reserved the right to the collection’s use and possession during his lifetime. For 2021, he reported an adjusted gross income of $100,000. Assuming that this was his only contribution during the year and that there were no carryovers from prior years, what amount can he deduct as contributions for 2021?
Payment of a charitable contribution that consists of a future interest in tangible personal property is treated as made only when all intervening interests and rights to the actual possession and enjoyment of the property have expired or are held by persons other than the taxpayer or those related to the taxpayer. Therefore, the contribution of the rare books will be treated as made only when Tally’s intervening lifetime right to use and possess the books has terminated, i.e., at his death.
- Qualified charitable deductions limited to:
- Cash
- 50% limit organizations
- 60% of AGI
- Exception:
- The limitation for certain cash contributions paid in 2021 has been suspended for taxpayers who itemize deductions. Taxpayers may deduct up to the amount by which their contribution base. This covers the vast majority of contributions, i.e., those made to churches, nonprofit educational and medical institutions, and public charities. The amount is limited to:
- 100% of AGI:
- without regard to NOL carrybacks
- Deducting a Carryback
- If you carry back your NOL, you can use either Form 1045 or Form 1040-X. You can get your refund faster by using Form 1045, but you have a shorter time to file it. You can use Form 1045 to apply an NOL to all carryback years. If you use Form 1040-X, you must use a separate Form 1040-X for each carryback year to which you apply the NOL.
- in excess of the deduction for other charitable contributions
- Non-50% limit organizations
- 30% of AGI
- Noncash property
- 50% limit organizations
- Ordinary income property
- The lesser of:
- FMV
- AB
- Further limited to the lesser of:
- 50% of AGI
- Capital gain property
- 30% of AGI
- It is only applicable if the donor elects not to reduce the fair market value of the donated property by the amount that would have been long-term capital gain if (s)he had sold the property.
- See Study Unit 9, Subunit 3, defines capital assets
- Non-50% limit organizations
- Capital gain property
- The lesser of:
- AB
- FMV
- Further limited to the lesser of:
- 20% of AGI
- 30% of AGI
(minus capital gain contributions to public charities)
- Any donations that exceed these limitations can be carried forward and potentially deducted in the next 5 tax years.
- Carryforward:
- 5 years
- In accounting for the different limitations, all donations are considered in this order:
- All donations subject to the 50%/60%/100% limit
- All donations subject to the 30% limit
- In carrying over excess contributions to subsequent tax years, the excess must be:
- Carried over to the appropriate limitation categories
- Example:
- Casualty and theft losses
- Generally, the itemized deduction for personal casualty and theft losses for tax years 2018 through 2025 has been:
- Suspended
- Exceptions:
- Federally declared disaster losses
- Non-federally declared disaster losses limited to:
- casualty gains
- Limitations on the deductibility
for the exceptions:
- The amount of the loss over:
- $100
- The aggregate amount of all losses in excess of:
- 10% of AGI
- Other itemized deductions
- 1) Amortizable premium on taxable bonds
- 2) Casualty and theft losses from income-producing property
- 3) Federal estate tax on income in respect of a decedent
- 4) Gambling losses up to the amount of gambling winnings
- 5) Impairment-related work expenses of persons with disabilities
- 6) Repayments of more than $3,000 under a claim of right
- 7) Unrecovered investment in a pension
-
Rules regarding standard deduction:
- Standard deduction limits:
- Standard deduction (additional amounts):
- The individual is entitled to the amount if (s)he before the end of the tax year (before death):
- Reaches age 65
- Is blind
- Single/HOH
- $1,700
- MFJ/MFS/
Qualified Widower
- $1,350
- If both conditions apply, the taxpayer is entitled to twice the amount
-
7.3 Qualified Business Income Deduction (QBID)
- QBID in the context of individual taxpayers is the setting the CPA Exam is most likely to test.
-
QBID (aka Section 199A) was created to provide similar tax reductions in comparison to the low, flat tax rate of 21% for C corporations for:
- Qualified Trade Businesses (QTB):
- Pass-through or flow-through business entities:
- The Sec. 199A deduction does not affect the taxpayer’s basis in the pass-through entity.
- Estates
- Partnerships
- S corporations
- Trusts
- Specified Service Trades or Businesses (SSTBs)
- SSTB refers to trades or businesses where the principal asset of one or more of its employees or owners is their:
- Reputation
- Skill
- While the provision of reputation as a principal asset sounds like it could encompass many businesses, regulations indicate that the Treasury will only interpret this provision to include businesses that generate income from:
- appearance fees
- endorsements
- use of one's likeness
- EXAMPLE 7-8
Reputation and Skill
Bill owns Bill’s Plumbing, a sole proprietorship. Bill’s Plumbing’s motto is “Bill is a very skilled plumber with a great reputation.” According to the regulations, because Bill’s Plumbing does not involve endorsements, compensation for use of one’s likeness, or appearance fees, Bill’s Plumbing’s principal asset is not the reputation or skill of one or more of its employees or owners. Thus, Bill’s Plumbing is not considered a specified service business.
- SSTB gross receipts de minimis rule:
- 100% of gross receipts attributed to SSTB unless:
- For the current tax year, gross receipts are:
- No more than:
- $25 million
- Up to 10% of gross receipts can be excluded from SSTB treatment
- For the current tax year, gross receipts are:
- More than:
- $25 million
- Up to 5% of gross receipts can be excluded from SSTB treatment
- EXAMPLE 7-10
SSTB De Minimus Rule
Acme, Inc. (an S corporation), is primarily a retailer with $24 million in gross receipts during the current year. Of Acme’s $24 million in gross receipts, $22 million comes from retail activities and $2 million comes from consulting. Consulting is a specified service. However, because Acme’s gross receipts are below $25 million, Acme will only be considered a specified service business if greater than 10% of its total gross receipts come from specified services. In this case, because less than 10% of Acme’s gross receipts come from consulting, Acme is not considered a specified service business under the de minimis rule.
- Examples of SSTBs include:
- Accounting
- Actuarial science
- Athletics
- Brokerage services
- Consulting
- Financial services:
- Financial advisors
- Investment bankers
- Retirement advisors
- Wealth planners
- Health:
- physicians
- nurses
- dentists
- Law
- Performing arts
- Any trade or business where the principal asset of one or more of its employees or owners is their:
- Reputation
- Skill
- Examples of SSTBs exclude:
- Architecture
- Engineering
-
QBID calculation steps:
- Step 1:
- Calculate QBI
- Step 1a:
- Ensure the income is:
- Effectively connected with the conduct of a trade or business within the United States or Puerto Rico
- AND
- Included in the determination of taxable income for the tax year
- Income disallowed or limited by tax basis, at-risk, passive losses, and excess business loss rules (TAPE) is not included in taxable income for determining QBI, therefore, QBI excludes:
- Step 1b:
- Ensure the income is from
pass-through business entities:
- Partnerships
- S corporations
- Sole proprietorships
- Step 1c:
- Reduce net income by items from:
- Non-core activities including:
- Capital gains and losses
- Dividend income
- Foreign currency gains
(in excess of gains of core businesses)
- Nonoperating interest income
- Working capital interest income
- Businesses as reasonable compensation including:
- Partnerships as:
- Guaranteed payments
- S corporations as:
- Salaries and wages
- EXAMPLE 7-7
Compensation
Aly is a 50% owner of ABC, Inc. (an S corporation). Aly is also the president of ABC. For her services as president, Aly receives a salary of $200,000. Aly’s salary will not constitute QBI. However, her 50% share of the corporation’s ordinary income will constitute QBI.
- Step 2:
- Calculate QBID
- Step 2a:
- Determine QBID
taxable income limitation:
- Threshold:
- Others
- $164,900
- $214,900
- MFJ
- $329,800
- $429,800
- Within the
threshold for:
- SSTB
- Limited to:
- W-2 Wage Limit Test
- Step 2a(1):
- Calculate the reduction ratio based on taxable income
- Taxable income equals adjusted gross income (line 8b of Form 1040) minus standard or itemized deductions (line 9 of Form 1040).
- Step 2a(2):
- Calculate W-2 limit
- The greater of:
- 50% of W-2 wages paid
- 25% of W-2 wages paid
- +
- 2.5% of the UBIA
(unadjusted basis of qualifying property immediately after acquisition)
- Qualifying property is generally depreciable property. Land is not depreciable and is thus excluded.
- REVIEW EXAMPLE
- Nova owns a sole proprietorship and is also a one-third owner of a partnership. Both businesses are qualified businesses. Which of the following statements is correct in calculating W-2 wage limitation to determine Nova’s deductible amount for each business under Sec. 199A?
When calculating the W-2 wages limitation, Nova should take into account all W-2 wages paid to employees by the sole proprietorship and the allocable share of W-2 wages paid by the partnership, respectively.
Because Nova is the sole owner of the sole proprietorship, she should take into account all W-2 wages paid to employees by the sole proprietorship. Because the partnership has multiple owners, Nova should take into account the allocable share of W-2 wages paid by the partnership.
- If the W2-limit is greater than:
- 20%
- x
- QBI
- Continue to determine the overall QBID limitation
- If the W2-limit is
less than:
- 20%
- x
- QBI
- Continue to the next step
- Step 2a(3):
- Calculate excess amount
- 20%
- x
- QBI
- -
- W-2 limit
- Step 2a(4):
- Calculate allowed QBI amount
- 20%
- x
- QBI
- -
- Reduction ratio
- x
- Excess amount
- QTB
- Limited to:
- W-2 Wage Limit Test
- Step 2a(1):
- Calculate the reduction ratio based on taxable income
- Taxable income equals adjusted gross income (line 8b of Form 1040) minus standard or itemized deductions (line 9 of Form 1040).
- Step 2a(2):
- Calculate the applicable percentage
- Applicable percentage
- =
- 100% minus the reduction ratio above
- Step 2a(3):
- Apply the applicable percentage
- The totals of:
- QBI
- UBIA
- Wages
- x
- Applicable percentage
- =
- Includible QBI
- Includible UBIA
- Includible Wages
- Step 2a(4):
- Calculate W-2 limit
- The greater of:
- 50% of Includible W-2 wages paid
- 25% of Includible W-2 wages paid
- +
- 2.5% of the Includible UBIA
(unadjusted basis of qualifying property immediately after acquisition)
- Qualifying property is generally depreciable property. Land is not depreciable and is thus excluded.
- If the W2-limit is greater than:
- 20%
- x
- QBI
- Continue to determine the over QBID limitation
- If the W2-limit is
less than:
- 20%
- x
- QBI
- Continue to the next step
- Step 2a(5):
- Calculate excess amount
- 20%
- x
- Includible QBI
- -
- W-2 limit
- Step 2a(6):
- Calculate allowed QBI amount
- 20%
- x
- Includible QBI
- -
- Reduction ratio
- x
- Excess amount
- Over the
threshold for:
- SSTB
- No QBID allowed
- QTB
- Limited to:
- W-2 Wage Limit Test
- Step 2a(1):
- Calculate W-2 limit
- The greater of:
- 50% of W-2 wages paid
- 25% of W-2 wages paid
- +
- 2.5% of the UBIA
(unadjusted basis of qualifying property immediately after acquisition)
- Qualifying property is generally depreciable property. Land is not depreciable and is thus excluded.
- Step 2a(2):
- Calculate QBI allowed
- The lesser of:
- W-2 limit above
- 20%
- x
- QBI
- Determine overall QBID limitation
- The lesser of:
- 20%
- x
- QBI
- 20%
- x
- The
total of:
- Taxable Income
- -
- Net capital gains
- This income is excluded because this income is already taxed at preferential rates. Net capital gains is defined as:
- Net long-term capital gains
- Long-term capital gain in excess of long-term capital loss
- -
- Net short-term capital loss
- Short-term capital loss in excess of short-term capital gain
- Step 3:
- Determine QBI aggregatIon
- QTBs can aggregate QBIs if:
- An advantage of aggregation is that it allows QTBs with insufficient wages and property to use those of other QTBs to generate a larger QBID.
- QBIs of all aggregated businesses have:
- The same tax year and
- The same taxpayer or group of persons (e.g., a family):
- Owns 50% of more of each trade or business after satisfying certain criteria
- QTBs must aggregate QBIs if:
- QBIs for previous years were aggregated
- Step 4:
- Determine QBL carryover
- QBI is treated as a
Qualified Business Loss (QBL) if:
- The net QBI for the year from all entities is negative
- QBLs are carried forward to later years, allocated proportionately among that year’s QBI per entity.
- QBL carryforward is used only to compute future QBIDs
- QBL does not affect the determination of whether a business loss is deductible in the computation of taxable income for example:
- NOL
- EXAMPLE 7-13
Carryover
Charlie has QBI in 2020 of negative $100. This $(100) is a QBL that will carry forward to 2021. If Charlie has a positive QBI of $500 in 2021, the amount eligible for the QBID will be reduced by the $100 QBL carryforward. Thus, Charlie’s maximum QBID would be $80 [20% × ($500 – $100)].
- Examples:
-
CPA REG SU08 Credits and Losses
-
8.1 Tax Credits
-
Overview of tax credits:
- Tax credits are used to achieve policy objectives such as:
- Encouraging energy conservation
- Providing tax relief to low-income taxpayers
-
Nonrefundable tax credits:
- Adoption Credit
- A credit is allowed for qualified adoption expenses incurred by the taxpayer:
- $14,440 per qualifying child
- Special Needs Adoption:
The maximum credit amount is allowed for the adoption of a child with special needs regardless of the actual expenses paid or incurred in the year the adoption becomes final.
- A credit is available for qualified adoption expenses including:
- Adoption fees
- Attorney fees
- Court costs
- Other directly-related costs
- A credit is subject to limitations on MAGI:
- Phased out:
- $216,660
- $256,660
- Any unused credit may be:
- Carryforward
- Carryforward is not subject to MAGI limitations
- 5 years
- Child and Dependent Care Credit
- This credit is for offsetting child and dependent care expenses. A taxpayer is eligible for this credit only if both conditions are satisfied:
- Child and dependent care expenses are incurred to enable a taxpayer to:
- Maintain gainful employment
- When the taxpayer:
- Is employed
- Actively seeking employment
- The taxpayer provides:
- More than half the cost of maintaining a household
- For a qualifying dependent:
- Under age 13
- An incapacitated spouse
- An incapacitated dependent
- This credit is for qualifying expenses including:
- Household services:
- Babysitting
- Housekeeping
- Nursing
- Includes:
- The parent-employer’s portion of Social Security tax paid on wages for a person to take care of dependent children while the parents work is an expense incurred to enable the taxpayer to be gainfully employed.
- The cost of meals for a housekeeper who provides necessary care for a dependent child while the parents work.
- Outside services:
- Day care facilities in qualified facilities
- If dependent:
- Spends 8 hours a day in taxpayer's home
- Limited to:
- $3,000 per year
- 1 qualifying dependent
- $6,000 per year
- 2+ qualifying dependents
- Limited to:
(in addition)
- 35% of qualifying expenses
- Reduced by:
- 1% (not below 20%)
- For each:
- $2,000
- By which AGI exceeds:
- $15,000
- At 20% for AGI's over $43,000
- The maximum amount of employment-related expenses less excludable employer dependent-care assistance program payments.
- The payments cannot be to someone that you or your spouse can claim as a dependent.
- This credit is for earned income:
- Limited to:
- Taxpayer's earned income
- For married taxpayers:
- The smaller of the earned income of the spouses
- If one of the spouses is:
- Full-time student
- Unable to take care of themselves
- Their income is equal to:
- $250 per month
- 1 qualifying dependent
- $500 per month
- 2+ qualifying dependents
- Example:
- EXAMPLE 8-1
Child and Dependent Care Credit
The taxpayer remarried on December 3 and the taxpayer’s earned income for the year was $18,000. The taxpayer’s new spouse’s earned income for the year was $2,000. The taxpayer paid work-related expenses of $3,000 for the care of the taxpayer’s 5-year-old child and qualified to claim the credit. The amount of expenses the taxpayer uses to figure the taxpayer’s credit cannot be more than $2,000 (i.e., the smaller of the taxpayer’s earned income or that of the taxpayer’s spouse).
- REVIEW EXAMPLE
- Carmella is divorced and has two children, ages 3 and 9. For 2021, her adjusted gross income is $30,000, all of which is earned income. Carmella’s younger child stays at her employer’s on-site child-care center while she works. The benefits from this child-care center qualify to be excluded from her income. Carmella’s employer reports the value of this service as $3,000 for the year. This amount is shown in box 10 of Carmella’s Form W-2, but is not included in taxable wages in box 1. A neighbor cares for Carmella’s older child after school, on holidays, and during the summer. Carmella pays her neighbor $2,400 for this care. What is Carmella’s Child Care Credit for 2021?
$648
Answer (B) is correct.
A credit equal to the applicable percentage of employment-related expenses is allowed. The applicable percentage is 35%, reduced (but not below 20%) by one percentage point for each $2,000 (or fraction thereof) by which adjusted gross income exceeds $15,000. Carmella’s adjusted gross income of $30,000 exceeded $15,000 by $15,000. The amount by which to reduce the applicable percentage is calculated by dividing $15,000 by $2,000, which is equal to 7.5, and must be rounded up to 8. Thus, the applicable percentage is 27% (35% – 8%).
Because Carmella has two qualifying children, she may apply the credit up to $5,400 (the expenses paid) of her child care expenses less the excludable employer dependent-related expenses of $3,000. Therefore, Carmella’s maximum credit is $648 [($5,400 – $3,000) × 27%].
- Child Tax Credit and
Credit for Other Dependents
- This credit is for taxpayers who are entitled to a Child Tax Credit and Credit for Other Dependents:
- Qualifying child
- Under age 17
- $2,000 per child
- Qualifying child/relative
- Over age 17
- $500 per relative
- Must met all conditions to be qualified.
- This credit is available for MAGI:
- Phased out:
- Others
- $200,000
- MFJ
- $400,000
- Reduced by:
(above thresholds)
- $50
- For each:
- $1,000
- In excess of
above thresholds
- Credit for the Elderly or the Disabled
- An individual may be eligible for this credit if before the close of the tax year:
- Age 65
- OR
- Retired due to:
- Total and permanent disability
- This credit is available for eligible taxpayers:
- Limited to:
- The initial base amount:
- Single
- MFJ w/one qualified spouse
- MFJ both qualified
- MFS
- $5,000
- $7,500
- $3,750
- Reduced by:
- Social Security benefits
(tax-exempt)
- Pension or annuity benefits
(excluded from gross income)
- Disability income
(if under 65)
- For permanently and totally disabled individuals under age 65, the applicable initial amount noted above may not exceed the amount of disability income.
- 50% of excess of AGI over:
- Single
- $7,500
- MFJ
- $10,000
- MFS
- $5,000
- Multiplied by:
- 15%
- Limited to:
(in addition)
- Tax before credits
- The credit may be claimed only to the extent of the tax owed before credits.
- This credit is not available to:
- MFSLT
- A married person filing separately may not claim the credit who lives with the spouse:
- At any time during the year
- NRA
- An NRA may not claim the credit
- REVIEW EXAMPLE:
- Mr. Klein is 67 years old, single, and retired. During 2021, he received a taxable pension from his former employer in the amount of $4,000. His adjusted gross income is $15,200, and he received $500 of nontaxable Social Security benefits. His tax before credits is $95. What is Mr. Klein’s credit for the elderly?
Answer (B) is correct.
An individual who has attained age 65 is allowed a credit equal to 15% of the individual’s reduced base amount. For a single individual, the initial base amount is $5,000, reduced by any amounts received as Social Security benefits or otherwise excluded from gross income. The base amount is also reduced by one-half of the excess of AGI over $7,500 (for a single individual).
Initial base amount $5,000
Less: AGI limitation [($15,200 – $7,500) × 50%] (3,850)
Less: Social Security benefits (500)
Reduced base amount $650
× .15
= Klein’s credit for the elderly $ 98
Since the taxpayer’s tax before credits is $95, only $95 of the credit can be claimed.
- Foreign Tax Credit
- Taxpayers with foreign earned income can either receive a deduction or a credit. The credit is equal to:
- The lesser of:
- Foreign taxes paid/accrued during the tax year
- Qualified foreign taxes include:
- Foreign taxes on:
- Income
- War profits
- Excess profits
- Foreign taxes must:
- Analogous to US income tax
- Based on a form of net annual income including gain and concepts such as realization.
- Not used if paid on:
- Excluded (by US tax):
- Foreign earned income
- Foreign housing costs
- Portion of U.S. tax liability (before all other credits) attributed to all foreign-earned income:
- Foreign Tax Credit (FTC):
- US Income Tax Before FTC
- x
- Foreign-Earned Taxable Income
- Worldwide Taxable Income
- Limited to:
- Portion of U.S. tax liability (before all other credits) attributed to all foreign-earned income
- Any difference between foreign taxes paid/accrued during the tax year and the above can be:
- Carryback
- 1 year
- Carryforward
- 10 years
- Limited to:
(in addition)
- For FTC in GILTI basket:
- GILTI, or "global intangible low-taxed income", is a deemed amount of income derived from CFCs in which a U.S. person is a 10% direct or indirect shareholder. It is computed, roughly, by determining the taxable income (or loss) of a CFC as if the CFC were a U.S. person.
- 80% of the allowable credit
- Any difference:
- Cannot be carried forward
- For non-US taxpayer,
limited to:
(in addition):
- Foreign taxes paid/accrued during the tax year on:
- Portion of U.S. tax liability (before all other credits) attributed to:
- US effectively connected income with conduct of a business/trade in the US
- The limit must be applied separately to:
- Foreign branch income
- General income
- GILTI
- Passive income
- Example:
- General Business Credit
- The General Business Credit (GBC) is a set of more than 30 credits commonly available to businesses. The GBC includes credits for investment, research, work opportunity, low-income housing, and alternative motor vehicles, among others. This credit is an overall limitation of:
- Net income tax
- Income tax
- Form 1040
Line 18
- Form 1040
Line 16
- Regular tax
- The regular tax (line 16) is the tax computed on
taxable income.
- +
- Form 1040
Line 17
- AMT
- Excess of the
Advance Premium Tax Credit Repayment
- Form 1040
Schedule 2
Line 3
- -
- Nonrefundable credits
- Form 1040
Line 20
- Adoption credit
- Child and dependent care expenses credit
- Credit for the Elderly or the Disabled
- Education credits
- Foreign tax credit
- GBC
- Excluded
- Minimum tax credit
- Residential
energy credits
- Retirement savings contributions credit
- Form 1040
Schedule 3
Line 7
- -
- The greater of:
- Tentative AMT
- Tentative minimum tax is an amount used in computing the alternative minimum tax.
- 25% of:
- Net regular tax over
- Net regular tax is
net income tax without AMT
- $25,000
- For corporations:
- As of 2018, corporations are not subject to alternative minimum tax (AMT), and therefore, do not have tentative minimum tax for this limitation.
- 25% of:
- Net regular tax over
- $25,000
- This credit is subject to additional limitations:
- GBC not allowed when:
- AMT exceeds:
- Regular tax
- Current deduction GBC exceeds:
- WOTC
- Other credits
- Any excess of the current deduction may be:
- Carryback
- 1 year
- Carryforward
- 20 years
- This credit includes the following credits:
- WOTC
- Employers may take a credit paid to employees from certain targeted groups for qualified wages:
- Through:
- December 31, 2025
- Limited to:
- 40%
- At least:
- 400 hours
- 25%
- At least:
- 120 hours
- Of the first year:
- $10,000
- Long-time family assistance recipients
- $6,000
- Others
- $3,000
- Qualified summer youth
- Of the second year:
- 50% of
$10,000
- Long-time family assistance recipients
- The combined credit may not exceed:
- For the 2 years:
- $9,000
- Per qualified employee
- This credit is available to:
- Certain targeted groups
- Wages for:
- Amount received under accident and health plans
- Contributions by employers to accident and health plans
- Dependent care expenses
- Educational assistance
- Remuneration for employment
- Research Credit
- A credit is allowed for the amount by which the taxpayer’s qualified research expenditures for a tax year exceed its base-period amount:
- 20%
- Exceed:
- Base-period amount
- An alternative simplified credit is available:
- 14%
- Exceed:
- 50%
- Average expenses
- For preceding:
- 3 years
- Qualified Employer Plan Credit
- A credit is allowed for employers who include an automatic contribution arrangement in a qualified employer plan:
- $500 per year
- For the first:
- 3 years
- Example:
- Lifetime Learning Credit
- This credit is for qualified tuition expenses paid by the taxpayer:
- Per taxpayer:
- Limited to:
- $2,000 per year
- 20% of the first $10,000
- This credit is limited to AGI:
- Phased out:
- Others
- $59,000
- $69,000
- MFJ
- $119,000
- $139,000
- This credit is available when:
- Can be used for:
- Graduate-level courses
- Undergraduate-level courses
- Unlimited number of years
- Tuition statement (Form 1098-T) provided to the taxpayer must include:
- Student's name
- Student's address
- Student's TIN
- American Opportunity Credit is not claimed with respect to the same student
- Example:
- EXAMPLE 8-2
Lifetime Learning Credit
Weasley and Brandy Kat, who file a joint tax return, have an adjusted gross income (AGI) of $117,000 for 2021. Their daughter Honey began her first year of graduate school on July 21, 2020. Weasley and Brandy incurred expenses in 2021 of $12,000 for tuition.
A Lifetime Learning Credit is limited to the amount of 20% of the first $10,000 of tuition paid. The Lifetime Learning Credit is available in years the American Opportunity Credit is not claimed. The Kats’ credit for 2021 will be $2,000 ($10,000 × 20%). There is no phaseout of the Lifetime Learning Credit for the Kats because the credit phaseout for married taxpayers filing jointly commences when modified AGI is $119,000 and ends at $139,000.
- Retirement Savings Contribution Credit
- This credit is in addition to the exclusion or deduction from gross income for qualified contributions. In general, a taxpayer may claim a credit for an eligible contribution to an eligible retirement plan.
- This credit is for eligible contributions:
- Limited to:
- Others
- $2,000
- MFJ
- $4,000
- This credit is for eligible AGI:
- Limited to:
- Filing status/
Rate:
- 50%
- 20%
- 10%
- 0%
- Others
- $19,750
- $21,500
- $33,000
- +
- HOH
- $29,625
- $32,250
- $49,500
- +
- MFJ
- $39,500
- $43,000
- $66,000
- +
-
Refundable tax credits:
- Additional Child Tax Credit
- This credit is available for certain taxpayers who get less than the full amount of the Child Tax Credit. The credit is refundable up to:
- Qualifying child
- $1,400 per child
- Qualifying relative
- $500 per relative
- The credit is available but limited to:
- The lesser of:
- 15% of:
- Earned income
- In excess of:
- $2,500
- Unclaimed portion of the nonrefundable credit
- American Opportunity Credit
- This credit provides a credit per student per year for the first 4 years of post-secondary education. The credit may be used for qualified tuition and expenses for:
- Per student:
- 100% of the first:
- $2,000
- 25% of the second:
- $2,000
- For the first:
- 4 years
- Post-secondary education
- Refundable up to:
- 40%
- The credit is limited to AGI:
- Phased out:
- Others
- $80,000
- $90,000
- MFJ
- $160,000
- $180,000
- The credit is available for qualifying expenses:
- Tuition
- Fees
- Course materials
- The credit is not available for:
- Room and board
- Activity fees
- Any other fees not related to the academic course of instruction
- Lifetime Learning Credit is used
- Credit for Taxes Withheld
- Withholdings from employee wages for income tax are treated as a refundable credit. Withholdings from wages for Social Security
(FICA) tax are also refundable but only if an aggregate is withheld in excess of the maximum by two or more employers.
- Earned Income Credit
- A refundable credit is payable as a refund to the extent the credit amount exceeds tax otherwise due. To qualify for EIC, must meet all of the following criteria:
- Citizenship
- US citizen
- US resident alien:
- All years
- OR
- NRA and all of the following:
- US citizen spouse
- MFJ
- Elected to be treated as resident alien
- SS#
- Must be a valid social security number
- Earned income
- Includes:
- Wages
- Including:
- Union strike benefits
- ER-provided dependent
care benefits
- ER-provided meals and lodging (furnished for the convenience of the ER)
- Salaries
- Tips
- Net earnings from self-employment
- Excludes:
- Investment income
- Annuities
- Dividends
- Interest
- Pensions
- Nontaxable compensation
- Exceptions:
- Combat pay
- Military allowances
(basic quarters and subsistence)
- Parsonage allowances
- A minister's housing allowance is sometimes called a parsonage allowance or a rental allowance.
- Social security benefits
- Taxable scholarships/fellowships
- Unemployment income
- Welfare benefits
- Worker's compensation
- Filing status
(Single or MFJ)
- Not filing MFS. Spouses must file jointly, which also means one spouse cannot be a dependent of the other.
- Investment income
- Less than:
- $3,650 (2021)
- Mets QC conditions:
- If has a qualifying child:
- All tests must be met:
- Age:
- (a) under age 19 at the end of the year,
- (b) under age 24 at the end of the year
- AND
- and a full-time student, or
- To qualify as a full-time student, the dependent must be enrolled at an educational organization for at least:
- 5 months during the tax year
- (c) any age if permanently and totally disabled
- Relationship:
- QC cannot be the qualifying child (QC) of another person
- By adoption
- By birth
- By foster
- Residency:
- The taxpayer must provide the child’s principal place of abode for:
- More than half the year
- If does not
have a qualifying child:
- All tests must be met:
- Age:
- a) at least age 25
- b) under age 64
- Relationship:
- QC cannot be the qualifying child (QC) of another person
- Residency:
- The taxpayer must have his or her principal residence in the U.S. for:
- More than half the year
- To calculate EIC and the applicable limitation:
- To calculate EIC:
- Earned income amount
- x
- % rate
- # QCs
- % rate:
- Maximum
earned income
- Maximum EIC
- 0
- 7.65%
- $7,100
- $543
- 1
- 34%
- $10,640
- $3,618
- 2
- 40%
- $14,950
- $5,980
- 3+
- 45%
- $14,950
- $6,728
- Decrease
maximum EIC by:
- Excess AGI
(or earned income, if more)
- In excess of
beginning
phaseout
- No EIC is available after complete phaseout
- For filing status:
- Single
- # QCs
- % rate:
- Beginning
phaseout
- Complete
phaseout
- 0
- 7.65%
- $8,880
- $15,980
- 1
- 15.98%
- $19,520
- $42,158
- 2
- 21.06%
- $19,520
- $47,915
- 3+
- 21.06%
- $19,520
- $51,464
- For filing status:
- MFJ
- # QCs
- % rate:
- Beginning
phaseout
- Complete
phaseout
- 0
- 7.65%
- $14,820
- $21,920
- 1
- 15.98%
- $25,470
- $48,108
- 2
- 21.06%
- $25,470
- $53,865
- 3+
- 21.06%
- $25,470
- $57,414
- Additional rules for EIC:
- EIC may not be used
in a year that uses any:
- Carryback
- Carryforward
- EIC is subtracted from:
- Tax owed by the taxpayer
- Premium Tax Credit
- Taxpayers who obtain health insurance coverage through the Health Insurance Marketplace may be eligible for the Health Insurance Premium Tax Credit. The PTC is a refundable credit. The credit is available to households with income:
- No greater than 400%
of the federal poverty line
for their family size
- To be eligible for the credit, a taxpayer must:
- Buy health insurance
through the Marketplace
- Be ineligible for
coverage through:
- ER
- Government plan
- Medicare
- Medicaid
- Not filing MFS
- Not file a return as married filing separately (unless the taxpayer is a victim of domestic violence).
- Not a dependent
- Not be claimed as a dependent by another person.
- Eligible taxpayers may receive:
- Advanced payments toward their health insurance premiums
- Taxpayers who receive advance payments must file a tax return regardless of whether their income is below the filing threshold.
- OR
- Regular credit at the end of the year
- The amount of the credit is:
- Insurance marketplace silver plan premium
- -
- % of household income share of required premiums
- A taxpayer’s required share of premiums increases as the taxpayer’s income increases up to a maximum of:
- 9.83% of household income
-
8.2 Losses and Limits
-
At-Risk Rules
- At-risk rules apply at the close of the tax year and are the amount of a loss allowable as a deduction:
- Limited to:
- At-risk amount
- Limited by:
(in addition)
- Activity's deductions
- Exceed:
- Activity's gross income
- At-risk rules apply to the following:
- Certain
closely-held C corporations
- Exception:
- The at-risk rules apply to most business and income-producing activities. However, there is an exception for a closely held corporation actively engaged in equipment leasing:
- A closely held corporation for this purpose is defined as one owned:
- More than 50%:
- During the
last half of the year
- By 5 or fewer individuals
- Gross receipts from equipment leasing of:
- At least:
- 50%
- Individuals
- LLC members
- Partnership partners
- S corporation shareholders
- At-risk rules apply separately for each:
- Business
- Income-producing activity
- Trade
- At-risk rules apply to amounts that include:
- Borrowed amounts:
- Recourse Debt
- Debt secured by:
- Personal liability
- Excludes:
- Personal liability is protected against by:
- Insurance
- Guarantees
- Stop-loss agreements
- Similar agreements
- OR
- Pledged property
- Excludes:
- Property pledged used in the activity.
- Also excludes
if the creditor
is/has:
- An interest in the activity
- Related to the taxpayer
- Nonrecourse Debt
- Nonrecourse debt is generally excluded from the amount at risk.
- Exception:
- Qualified nonrecourse financing (QNRF)
- Financing
secured by:
- Real property
- Incurred in a real estate activity
- Not convertible to an ownership interest
- From a/an:
- Guarantee by government entity
- Related party if:
- Commercially reasonable terms
- Unrelated third party
- The debt to the seller is not included because the seller is a person from whom the taxpayer acquired the property (i.e. cannot be the seller or the seller's relative).
- Contributed amounts:
- Money
- Property (AB)
- At-risk rules apply to amounts adjusted if:
- Increased by:
- Contributed amounts
- Borrowed amounts
- Recourse debt
- QNRF
- Income from the activity
- Decreased by:
- Distributions
- Liability reductions
- Tax deductions if:
- Allowable at year end
- Reduce at-risk amount no lower than zero
- If the amount at risk decreases below zero, previously allowed losses must be recaptured as income.
- Reducing property basis and disallowed deductions by at-risk rules:
- If a deduction would:
- Reduce basis in property
- AND
- Part or all of the deduction is disallowed by the at-risk rules
- The basis is reduced anyway.
- Disallowed losses are carried forward.
- Example:
- EXAMPLE 8-7
At-Risk Rules
Mooch Financial purchased rental real estate with some money borrowed from a related bank at commercially reasonable terms and the rest of the money borrowed from the seller. Both loans were nonrecourse and only secured by the property. Mooch Financial is at risk for the loan from the related bank because of the commercially reasonable terms and the nonrecourse loan is for real property. Regardless of the terms, Mooch Financial is not at risk for the seller’s loan.
- REVIEW EXAMPLE
- Jill Perry invested $10,000 for a 5% interest in a limited partnership on January 1, Year 1. There is one general partner with a 50% interest. In Year 1, the partnership purchased an office building to rent and incurred a nonrecourse debt of $100,000 to a bank paying interest for only 5 years. The debt has no conversion feature. The partnership incurred a loss of $150,000 in Year 1 and a loss of $200,000 in Year 2. How much can Jill deduct each year, ignoring any passive loss rules?
$7,500 Year 2 $7,500
Answer (B) is correct.
A limited partner in a partnership is considered to have at risk the amount of cash and adjusted basis of property contributed to the partnership (or used to purchase the partnership interest) and also a share of any qualified nonrecourse financing on real estate (Sec. 465). The existence of a general partner does not affect the fact that Jill will receive a 5% allocation of the nonrecourse debt, provided that no partner has any personal liability on this particular debt. Therefore, Jill’s at-risk amount is $15,000 ($10,000 invested + $5,000 share of nonrecourse debt).
Her share of loss in Year 1 is $7,500 ($150,000 loss × 5% interest), which may be deducted in full. Her share of loss in Year 2 is $10,000 ($200,000 loss × 5% interest), but the limitation on the Year 2 deduction is $7,500 ($15,000 at risk – $7,500 deducted in Year 1). Note that there may be further limitations on the deduction of a loss based on the passive loss rules.
-
Capital Losses
- Capital gain or loss realized on the sale or exchange of a capital asset is discussed in Study Unit 9, Subunit 3.
- An individual taxpayer may deduct
net capital losses:
- Limited to:
- The lesser of:
- Ordinary income
- Set amount of:
- Others
- $3,000
- MFS
- $1,500
- The individual may carry forward any excess capital losses indefinitely:
- Carryforward
- Unlimited
- A corporate taxpayer may deduct
net capital losses:
- Limited to:
- Capital gains
- The corporation must either carry forward or carry back any excess losses to the extent possible limited to:
- Carryback
- 3 years
- Carryforward
- 5 years
- All carryovers are characterized as:
- STCL
- A corporation
cannot carryover:
- S corporation losses
- As an increase to NOL
- To produce NOL
- From the newest loss
- When utilizing a capital loss carryback/carryover, the oldest loss is used first.
-
Casualty and Theft Losses
- The IRC allows deduction for losses caused by theft or casualties, whether business or personal. However, as of 2018, personal casualty and theft losses only apply to federally declared disasters and losses to the extent of casualty gains:
- Casualty and Theft Losses (Business)
- Casualty and Theft Losses (Personal)
- As of 2018:
- Limited to:
- Federally declared disasters
- To the extent of:
- Casualty gains
- A casualty loss arises from:
- An event that is:
- Sudden
- Unexpected
- Unusual
- An event that is caused by:
- External force
- Examples:
- A fire
- A storm
- Earthquake
- Shipwreck
- Sonic boom
- A casualty loss is deductible in the tax year in which it occurs.
- A casualty theft arises from:
- Blackmail
- Extortion
- Larceny
- Robbery
- A theft loss is deductible when it is discovered.
- A casualty loss/theft is limited to:
- The lesser of:
- Decline in FMV
- AB
- -
- Insurance reimbursement
- Any excess recovered over the amount of property basis is gain.
- If personal property:
- Must be a federally declared disaster
- Casualty losses on personal-use capital assets are itemized deductions. The deduction for personal casualty and theft losses is suspended for the tax years 2018 through 2025. However, losses attributed to a federally declared disaster and losses to the extent of casualty gains are deductible.
- Additional limitation:
- Floor for:
- $100 per event
- 10% of AGI all events
- If the disaster loss is claimed on the preceding year’s return, the AGI limitation is based on the prior year’s AGI.
- If business or investment property:
- Completely:
- Lost
- Stolen
- Equal to:
- AB
- A casualty loss/theft of inventory is handled:
- By deduction through:
- Increase COGS
- By properly reporting the opening and closing inventories.
- Any insurance or other reimbursement received for the loss is included in gross income.
- OR
- Deducting loss separately
- By making a downward adjustment to opening inventory or purchases
- Any reimbursement received reduces the loss and is not included in gross income.
-
Disaster Areas
- A taxpayer is subject to a special rule if (s)he sustains a loss from a federally declared disaster area. The taxpayer has the option of deducting the loss on:
- The return for the year in which the loss actually occurred
- Revocation of the election must be made for the year of loss before:
- Due date of the return
- OR
- The preceding year’s return
(by filing an amended return)
-
Excess Business Losses
- Non-C corporate business losses, after passing the at-risk limit and the passive activity loss rule, are subject to the excess business loss limit:
- After passing:
- At-risk
- PAL rules
- Limited to:
- All deductions from trades/business
- -
- Limitation
- Gross income/gain from trades/business
- +
- Others
- $262,000
- MFJ
- $524,000
- The excess business loss is carried forward as an NOL. In carryover years, NOL is limited to 80% of the future year’s taxable income:
- Carry forward
- Unlimited years
- Limited to:
- 80% of
taxable income
- C corporations business loss can offset:
- Pass-through losses
- Against:
- Nonbusiness income including:
- Capital gains
-
Net Operating Loss (NOL)
- A net operating loss occurs when:
- Business deductions
- Exceed:
- Business income
- A net operating loss current year
deductibility depends on:
- The year the loss occurred
- Prior to 2018:
- Carryback
- 2 years
- Carryforward
- 20 years
- Carryforward:
- Not limited by taxable income
- CARES Act
2018 - 2020:
- Carryback
- 5 years
- Carryforward
- Unlimited
- Carryforward:
- Not limited by taxable income
- CARES Act
2021+:
- Carryback
- Cancelled
- Carryforward
- Unlimited
- Carryforward:
- 80% of taxable income for the year it is carried to
- When utilizing NOLs, the earliest year is used first.
- If taxable income exists
- A net operating loss current year
deductibility (for an individual) calculation:
- Capital losses are included in NOL if:
- Nonbusiness capital gains
- Exceed:
- Nonbusiness capital losses
- The excess of nonbusiness capital gains is applied to the excess of:
- Nonbusiness deductions
- Exceed:
- Nonbusiness income
- If nonbusiness CG still exceeds excess nonbusiness deductions may offset:
- Business deductions
- Exceed:
- Business income
- (Taxable income)
- Start with taxable income
(a negative amount)
- Add back:
- Excess of:
- Nonbusiness deductions:
- Alimony (pre-2019)
- Investment property sale losses
- Self-employed retirement plans contributions
- Either:
- Standard deduction
- Itemized deductions
- Exceptions:
- Moving expenses
(active military)
- Rental property losses
- Exceed:
- Nonbusiness income:
- Dividends
- Interest
- Investment property sale gains
- Treasure trove
- Exceptions:
- Personal casualty losses
- Rent
- Wages
- NOLs for individuals, rents and wages are considered business income.
- NOLs carryforward
- An NOL carried forward is a deduction to arrive at AGI.
- QBID
- A net operating loss current year
deductibility (for corporation) calculation:
- Taxable income
- Add back:
- Charitable deductions
- Foreign-derived intangible income
(FDII) deductions
- NOLs carryover
- QBID
- Excess of:
- Nonbusiness deductions:
- Alimony (pre-2019)
- Investment property sale losses
- Self-employed retirement plans contributions
- Either:
- Standard deduction
- Itemized deductions
- Exceptions:
- Moving expenses
(active military)
- Rental property losses
- Exceed:
- Nonbusiness income:
- Dividends
- Interest
- Investment property sale gains
- Treasure trove
- Exceptions:
- Personal casualty losses
- Rent
- Wages
- NOLs for individuals, rents and wages are considered business income.
-
Passive Activity Loss (PAL) Limitation Rules
- Whether the participation is active or passive is usually given on the REG exam, except for limited partnerships, which you should assume to be passive.
- Passive activities loss rules apply to
the amount of a loss:
- Allowable as a:
- Credit
- OR
- Deduction
- Limited to:
- Passive activity gross income
- Rental activites
exception to above limits:
- Excess of passive activity gross income is further
deductible up to:
- $25,000 per year
- Phased out:
- 50% of excess MAGI over:
- MAGI is:
- AGI
- Without regard to:
- IRA contributions
- Passive losses
- SS benefits
- $100,000
- $150,000
- From:
- Active gross income
- OR
- Portfolio gross income
- This exception is often referred to as the “small landlord” exception or “mom and pop” exception.
- OR
- Passive activity tax
- All passive activities in the aggregate
- Rules regarding carry forward:
- The excess is deductible or creditable in a future year, subject to the same limits.
- Rules regarding PAL activities ceasing to be passive:
- PALs continue to be treated as PALs even after the activity ceases to be passive in a subsequent tax year, except that it may also be deducted against income from that activity.
- Rules regarding PAL activities disposition:
- Suspended (and current-year) losses from a passive activity become deductible in full in the year the taxpayer completely disposes of all interest in the passive activity. The loss is:
- Deductible from:
- Net income/gain from other passive activities
- Then deductible from:
- Nonpassive income
- Passive activities loss rules apply to:
- Estates
- Closely-held C corporations
- Exception:
- Closely-held C corporations and
Real property trades/businesses:
For the tax year are from real property trades or businesses in which the corporation materially participated, PAL rules do not apply if gross receipts make up:
- 50% of total gross receipts
- Individuals:
- Grantor trusts owners
- S corporation shareholders
- Partnership partners
- LLCs
- PSCs
- Trusts
- Excluding grantor trusts
- Passive activities loss rules does not apply to:
- Credit
- Income
- Loss
- C corporations
- That is:
- Active
- Business use of home
- Casualty/theft
- Porfolio
- Qualified home
mortgage interest
- Vacation home rental
- Working interest that does not limit
personal liability in an:
- Oil well
- Gas well
- Passive activities are defined as:
- Business
- Trade
- In which the taxpayer does not:
- Materially participate
- Material participation in an activity during a tax year one of the following applies when participation is:
- Constituting a basis that is:
- Continuous
- Regular
- Substantial
- Constituting substantially all the participation
- More than:
- 500 hours
- OR
- 100 hours
- AND
- Exceeds
any other individual
- More than:
- 5 years
- OF
- 10 years
- Preceding the year in question
- Any of the:
- 3 years
- For personal service activities
- Preceding the year in question
- Passive activities are defined as also:
- Rental activities
- A passive activity includes a rental activity when the average rental period is not short-term.
- In which the taxpayer does:
- Actively participate
- Active participation is a less stringent requirement than material participation. It is met with participation in:
- Management decisions
- Arranging for others to provide services (such as repairs)
- AND
- Owns at least:
- 10% of activity by value
- For the entire year
- Exception:
- Real property trades/business:
The passive activity loss rules do not apply to certain taxpayers who are involved in real property trades or businesses if:
- Materially participates
- Material participation in an activity during a tax year one of the following applies when participation is:
- More than:
- 50%
- of
- Personal service performed
- AND
- 750 hours
- of
- Real property trades/businesses
- An estate is considered to participate actively in an activity following the death of a taxpayer who actively participated in the year of death for only:
- 2 years after death
- Example:
- EXAMPLE 8-8
PAL Limitation
A wealthy taxpayer invested in an architecture partnership as a passive investor. Because the taxpayer does not engage in the business outside of occasional business consulting, any income or loss derived from the business is passive in nature. Therefore, any losses derived from the partnership may only offset passive activity gains.
- EXAMPLE 8-9
Allowed Rental Loss
A MFJ taxpayer actively participated in rental activity and incurred a rental loss of $30,000 in the current year. If the taxpayer’s MAGI is
$120,000, what is the amount of rental loss that is deductible?
MAGI $120,000
Threshold (100,000)
Excess $ 20,000
Reduction % × 50%
Reduction $ 10,000
Loss limit $25,000
Reduction (10,000)
Allowed loss $15,000
- EXAMPLE 8-10
PAL Limitation -- Active Participation
Lynne, a single taxpayer, has $70,000 in wages, $15,000 income from a limited partnership, and a $26,000 loss from rental real estate activities in which she actively participated and is not subject to the modified adjusted gross income phaseout rule. She can use $15,000 of her $26,000 loss to offset her $15,000 passive income from the partnership. She actively participated in her rental real estate activities, so she can use the remaining $11,000 rental real estate loss to offset $11,000 of her income (wages).
- REVIEW EXAMPLE
- Dietz is a passive investor in three activities which have been profitable in previous years. The profit and losses for the current year are as follows:
Gain (Loss)
Activity X $(30,000)
Activity Y (50,000)
Activity Z 20,000
Total $(60,000)
What amount of suspended loss should Dietz allocate to Activity X?
$22,500
Answer (C) is correct.
The passive activity income is allocated pro rata between the two activities with passive losses. As Activity X accounts for 37.5% ($30,000 ÷ $80,000 total loss) of the passive losses, it is allocated $7,500 ($20,000 × 37.5%) of the passive activity income. This results in a net $22,500 ($30,000 – $7,500) passive activity loss allocable to Activity X.
-
CPA REG SU09 Property Transactions Basis and Gains
-
9.1 Basis
-
Overview of Property Transaction Basis
- The tax treatment of property transactions is integrated with that of other transactions on the CPA Exam. Visualize the following steps to analyze the income tax consequences of property transactions:
- 1) Determine amount realized:
- Gain
- OR
- Loss
- 2) Apply capital loss rules
- 3) Apply other loss rules:
- At-risk rules
- Passive activity loss rules
- Excess business loss rules
- Net operating loss rules
- 4) Report:
- Recognized gross income
- Claim deductions
- Compute taxable income
- Compute tax liability
- For example:
- Recognize gross income:
- according to installment sales rules
- Claim deductions:
- for allowable capital losses
- Compute taxable income:
- for capital gains
- for other income
- Compute tax liability:
- for capital gains
- for other income
- Business sale transactions:
- The tax treatment of business sale transactions requires special attention. When more than one asset of a business is transferred in bulk (total consideration exchanged for assets in combination), including all the assets of a sole proprietorship,
gain or loss must be:
- Allocation among assets of consideration paid or to be paid is by agreement of parties is:
- By relative FMV of assets
- By the residual method
- Accounted for separately for
each asset transferred
- Capital gain or loss may arise:
Capital gain or loss might arise from assets that have no fixed or determinable useful life, such as goodwill that was not amortized (self-created goodwill) under Sec. 197 or an exclusive franchise.
- No fixed or determinable useful life assets
- Ordinary income or loss may arise:
Ordinary income or loss might arise from the certain assets.
- Inventory
- Accounts receivable
- Covenants not to compete:
- Ordinary income
- Section 1231 property:
- For example, land and depreciable trade or business property which includes:
- Property held for greater than 1 year
- Section 1245 property:
- Equipment
- Section 1250 property:
- Depreciable realty
- Property sale transctions:
- The tax treatment of property sale transactions requires special attention. When a taxpayer acquires property, his or her basis in the property is initially:
- Its basis by:
- Acquistion/Cost
- Cost basis is the sum of capitalized acquisition costs.
- Cost basis includes the fair market value of property given up. If it is not determinable with reasonable certainty, use FMV of property received.
- A rebate to the purchaser is treated as a reduction of the purchase price. It is not included in gross income.
- Amounts included in gross income increase cost basis.
- Stepped-up (or down) basis occurs when property is acquired through inheritance and basis reflects FMV at the time of death.
- Equal to:
- At date of death:
- FMV
- Transfer
- Transferred basis is computed by reference to basis in the property in the hands of another. This is also commonly referred to as a carryover basis.
- Exchange
- Exchanged basis is computed by reference to basis in other property previously held.
- The basis of property converted into business use is the lesser of the FMV of the property at the conversion date or the adjusted basis at conversion. This prevents personal losses from being converted into business losses.
- Lesser of:
- At date of conversion:
- FMV
- AB
-
Adjusted Basis
- Initial basis is adjusted consistent with tax-relevant events. Adjustments include the following expenditures subsequent to acquisition:
- Increase to basis:
- Assessments
- If the assessment increases the value of the property the basis is increased.
- Legal fees to defend title
- Shareholder's contributed property
- The shareholder’s stock basis equals his or her basis in the contributed property. The corporation has a transferred basis in the property.
- A shareholder does not recognize gain on the voluntary contribution of capital to a corporation.
- Title insurance premiums
- Zoning changes
- Decrease to basis:
- Building rehabilitation credit
- Credit for building rehabilitation. The full amount of the credit must be deducted from the basis.
- Casualty/theft losses
- Casualty losses reduce basis by the amount of the loss, by any amounts recovered by insurance, and by any amounts for which no tax benefit was received, e.g., $100 floor for individuals with losses only attributed to a federally declared disaster and losses to the extent of casualty gains are deductible. Casualty or theft loss deductions (losses only attributed to a federally declared disaster and losses to the extent of casualty gains are deductible) and insurance reimbursements.
- Depreciation
- The larger of:
- Allowed
- Amortization
- Depletion
- Depreciation (MACRS)
- Section 179 deduction
- Allowable
(even if not claimed)
- Discharged debt
- Specific exclusion from gross income is allowed to certain insolvent persons for debt discharged. Taxpayers may elect to reduce basis in depreciable assets by the amount of the exclusion. If an election is not made, they must reduce certain tax attributes.
- Energy conservation subsidies
- Exclusion from income of subsidies for energy conservation measures.
- Certain vehicle credits
- Involuntary conversion losses
- The basis of the replacement property from an involuntary conversion is reduced:
- Gain not recognized
- Loss recognized
- Shareholder's return of capital
- A return of capital distribution reduces basis and becomes a capital gain when the shareholder’s basis in the stock reaches zero.
- Nontaxable corporate distributions
- Rebates
- Rebates treated as adjustments to the
sales price.
- No adjustment to basis:
- Nontaxable stock distribution
- If new and old shares are:
- Identical
- Allocated in proportion to:
- FMV of original stock
- AND
- FMV on date of distribution
- Example:
- In January Year 1, Joan Hill bought one share of Orban Corp. stock for $300. On March 1, Year 3, Orban distributed one share of preferred stock for each share of common stock held. This distribution was nontaxable. On March 1, Year 3, Joan’s one share of common stock had a fair market value of $450, while the preferred stock had a fair market value of $150. After the distribution of the preferred stock, Joan’s bases for her Orban stocks are
Common $225 Preferred $75
Your answer is correct.
Since the preferred stock dividend was nontaxable, the original basis of the common stock is allocated between the common stock and the preferred stock based on the relative fair market value of each on the date of the stock dividend. Joan’s tax basis in the common stock after the receipt of the dividend is ($450 ÷ $600) × $300 = $225. Joan’s tax basis in the preferred stock is ($150 ÷ $600) × $300 = $75.
- Different
- The old basis is simply divided among the new total of shares
- Less than 15% of:
- FMV of the stock
upon which it was issued:
- The rights have a basis of $0.
- Unless an election is made to allocate basis
- Example:
- EXAMPLE 9-10
Adjusted Basis
In order to save money on their utility bills, Mr. and Mrs. Thrifty paid to replace their old roof with a new one with better insulation. The new roof materially increased the value of the house, so the cost of the roof should be added to the basis of the house.
-
Capitalized Costs
- Capitalized costs are costs included with the initial basis of purchased property. Capitalized costs are also called capital expenditures purchased with:
- Cash
- Cash equivalent
- Liability
- Other property
- Services
- Capitalized costs include:
- Cosing costs
- Attorney fees
- Brokerage commissions
- Document review, preparation
- Excise taxes
- Recording fees
- Title insurance
- Title transfer taxes
- Major improvements
- Demolition costs and losses
- Costs and losses associated with demolishing a structure are allocated to the land.
- Extending water line to property
- New electrical wiring
- New gutters
- New painting (building's exterior)
- In the case of repainting a building’s exterior, the basic rules are:
- If painting is the only thing being done, the painting costs are:
- Expensed
- If painting is part of a larger project that includes capital improvements to the building’s structure, the painting costs are:
- Capitalized
- New roof
- Major improvements to unit of property if:
- (1) results in its betterment
- An expenditure is a betterment if it ameliorates a condition or defect that existed before acquisition of the property or arose during the production of the property; is for a material addition to the property; or increases the property’s productivity, efficiency, strength, etc.
- (2) adapts it to a new or different use
- An expenditure is an adaptation to a new or different use if it adapts the unit of property to a use inconsistent with the taxpayer’s intended ordinary use at the time the taxpayer originally placed the property into service.
- (3) results in its restoration
- An expenditure is a restoration if it:
- Restores a basis that has been taken into account,
- Returns the unit of property to working order from a state of nonfunctional disrepair,
- Results in a rebuilding of the unit of property to a like-new condition after the end of the property’s alternative depreciation system class life, or
- Replaces a major component or substantial structural part of the unit of property.
- Miscellaneous costs
- Appraisal fees
- Freight
- Installation
- Testing
- Purchase price
- Acquisition costs of:
- Personal property
- Real property
- A taxpayer must capitalize amounts paid to facilitate the acquisition of real or personal property. This treatment applies when the amount is paid in the process of investigating or otherwise pursuing the acquisition.
- Appraisal fees
- Finders’ fees
- Inspection costs
- Sales and transfer taxes
- Title registration costs
- Transportation costs
- Do not include:
- Acquisition determination
- Amounts paid to determine whether to acquire real property or which real property to acquire. Such amounts are current deductions.
- Overhead EE compensation
- Amounts paid for employee compensation and overhead are treated as amounts that do not facilitate the acquisition of real or personal property.
- Example:
- EXAMPLE 9-2
Facilitative Cost
Susan is a manager of a family-owned grocery store and is assigned to determine where to open a second location. The compensation for Susan’s time is deducted, not capitalized, by the grocery store as a facilitative cost. If the work had been performed by a real estate professional and paid as commission, the amount would have to be capitalized because it was paid to facilitate the acquisition of real property.
- Pre-purchase taxes
- Property's liability
- Including the liability to which property is subject to regardless of whether the debt is:
- Recourse debt
- Nonrecourse debt
- Does not include the unstated interest
- Sales tax on purchase
- Capitalized costs do not include:
- Routine maintenance
- The costs of performing certain routine maintenance activities for property may result in an improvement to the unit of property, i.e., capitalized costs. However, a safe harbor allows routine repairs and maintenance to be expensed.
- This safe harbor applies to actions that maintain the asset and is reasonably expected to be:
- Performed more than once
- For the asset’s class life
under the ADS
- Ordinary repair and maintenance
- Expenses not properly chargeable to a capital account. Costs of maintaining and operating property are not added to basis.
- Warranties
- The extended warranty is
not a capitalized cost.
- Example:
- EXAMPLE 9-1
Tax Basis -- Building with a Mortgage
If an individual buys a building for $20,000 cash and assumes a mortgage of $80,000 on it, his or her basis is $100,000.
-
De Minimis Expense
- A de minimis amount is a cost that is so small that it is not worth tracking. Taxpayers can make an election to deduct a de minimis amount for each transaction relating to tangible property with an:
- Economic useful life of at least:
- 12 months
- Cost of
less than:
- $2,500 per invoice/item
- Cost of
up to:
- $5,000 per invoice/item
- If financial statements are
audited/approved.
- Example:
- EXAMPLE 9-3
De Minimis Expense
Henry, a business owner who does not have his financial statements audited, purchases 2 computers for $3,000 and pays $500 to have them installed. The cost per computer is $1,750 [($3,000 + $500) ÷ 2], which allows the computers to be expensed as a de minimis expense.
-
Gifts
- The donee’s basis in property acquired by gift is the donor’s basis (transferred basis), increased for any gift tax paid attributable to appreciation:
- Donor's basis
- Increased by:
- Gift tax paid
- x
- FMV at time of gift
- -
- Donor's basis
- FMV at time of gift
- -
- Annual exclusion
- The 2021 annual exclusion for gift tax purposes is
$15,000 per person [i.e., a donor can give a donee $15,000 each year without paying gift tax or using a portion of their lifetime exemption (gift tax exclusions are covered in more detail in Study Unit 10)
- Rules concerning gift property:
- If gift property is dual basis:
- If FMV at time of gift is:
- Less than:
- Donor's basis
- Dual basis
- Subsequent transfer:
- Loss basis:
- FMV at time of gift
- Gain basis:
- Donor's basis
- In other words, the unrecognized loss must be recognized upon subsequent transfer
- If the property is later transferred for more than FMV at the date of the gift but for less than the donor’s basis at the date of the gift, no gain (loss) is recognized.
- If gift property is converted
from personal to business use, its basis is:
- Lesser of:
- At date of conversion:
- AB
- FMV
- If gift property is contributed
by a nonsharesholder (for example, the government), its basis is:
- Transferred basis:
- Zero
- If gift property is taxed:
- Equal to:
- Donor's basis
- Minus:
- Annual exclusion:
- $15,000
- Minus:
(in addition)
- Marital exclusion
- Example:
- EXAMPLE 9-7
Sale of Gift Property
Bobby received a house as a gift from his father. At the time of the gift, the house had a FMV of $80,000 and the father’s adjusted basis was $100,000. If no events occurred that changed the basis and Bobby sells the house for $120,000, Bobby will have a $20,000 gain because he must use the father’s adjusted basis ($100,000) at the time of the gift to figure his gain. If he sells the house for $70,000, he will have a $10,000 loss because he must use the FMV ($80,000) at the time of the gift to figure his loss.
If the sale was between $80,000 and $100,000, Bobby would not recognize a gain or a loss.
-
Lump-Sum Assets
- When more than one asset is purchased for a lump sum, the basis of each is computed pro rata by apportioning the total cost based on the relative FMV of each asset.
- Allocation among assets of consideration paid or to be paid is by agreement of parties is:
- By the residual method
- The residual method must be used for any transfers of a group of assets that constitutes a trade or business and for which the buyer’s basis is determined only by the amount paid for the assets.
- To calculate:
- Allocate purchase price up to FMV in the following order:
- 1) Cash and cash equivalents
- When the purchase price is lower than the aggregate FMV of the assets other than goodwill/going-concern value, the price is allocated first to the face amount of cash and then to assets 2. through 6. above, according to relative FMVs.
- By relative FMV of assets
- To calculate:
- Allocable cost (basis)
- =
- FMV of asset
- FMV of all assets purchased
- x
- Lump sum purchase price
- 2) Near-cash items, such as CDs, U.S. government securities, foreign currency, and other marketable securities
- 3) Accounts receivable, mortgages, and credit card receivables acquired in the ordinary course of business
- 4) Property held primarily for sale to customers in the ordinary course of a trade or business or stocks included in dealer inventory
- 5) Assets not listed in 1. through 4. above
- 6) Section 197 intangibles, such as patents and covenants not to compete except goodwill and going-concern value
- 7) Goodwill and going-concern value
- Allocation specific FMV of assets
by agreement is:
- The transferor and transferee agreement in writing as to the allocation of consideration or the FMV of any assets. The agreement is binding unless the IRS deems it improper.
- Example:
-
Inherited Property
- Basis for inherited property is:
- FMV on date of death
- If the executor elects the alternative valuation method for the estate tax return:
- Earlier of:
- FMV at date:
- 6 months after death
- FMV at date of:
- Sale
- Distribution
- In addition, if widower in qualified joint interest
inherited property:
- Qualified joint interest property
- Tenants by the entirety
- Joint tenants
with right of survivorship
- Surviving spouse basis is:
- 50% of:
- Cost
- AND
- FMV on date of death
- Basis for inherited property applies to:
- Property received prior to death without full and adequate consideration if:
- Life estate was retained in it
- Subject to a right of revocation
- Basis is reduced by the depreciation deductions allowed to the donee.
- 50% of community property interests
- Exception:
- Incident to divorce
- Property transferred to a spouse or former spouse incident to divorce is treated as a transfer by gift is:
- Donor's basis
- Property acquired by:
- Form of ownership
- Right of survivorship
- Exception:
- If consideration was paid to acquire the property from a nonspouse.
- Example:
- EXAMPLE 9-8
Basis of Inherited Property
A purchased 10 shares of ABC, Inc., in 1980 for $200. When A dies in the current year, she leaves the stock to her grandson, B, in her will. At the date of A’s death, the stock has a FMV of $1,000. The estate has not elected an alternative valuation date. B’s basis in the stock is $1,000.
- EXAMPLE 9-9
Alternate Valuation Date
A purchased 10 shares of XYC, Inc., in 1980 for $200. When A dies on February 1 of the current year, she leaves the stock to her grandson, B, in her will. At the date of A’s death, the stock has a FMV of $1,000. The FMV of the stock remains unchanged until October 1 of the current year, when the FMV of the stock declined to $980. The estate has elected the alternate valuation date. B’s basis in the stock is $1,000 (the FMV of the stock on August 1, 6 months after A’s death).
-
Property for Services
- The FMV of property received in exchange for services is income (compensation) to the provider when it is not subject to a substantial risk of forfeiture and not restricted as to transfer. The property acquired has a tax cost basis equal to the:
- FMV of the property
- Sale of restricted stock to an employee is treated as gross income to the extent the FMV exceeds the price paid. This amount is included in gross income in the first taxable year in which the property is unrestricted.
- FMV exceeds the price paid
(if property/stock restricted)
- The amount included in income
-
Uniform Capitalization Rules (UNICAP)
- Uniform capitalization rules apply to:
- Real property
- Tangible personal property
- Used in trade/business:
- Acquired for resale
- Constructed
- The basis of any new building constructed on the land is its original cost (not FMV).
- Construction period interest and taxes must be capitalized as part of building cost.
- Manufactured
- Produced
- Uniform capitalization required:
- The uniform capitalization rules require the costs for acquiring property for sale to customers
(retail) to be capitalized including costs necessary to prepare the inventory for its intended use that are:
- Direct costs
- Most allocable indirect costs
- Engineering
- Equipment rental
- Interest
- Material
- Permits
- Storage
- Taxes
- Do not include:
- Advertising
- Distribution
- Experimental
- Marketing
- Research
- Section 179
- Selling
- Service costs (that are currently deductible)
- Strike
- Unsuccessful bids
- Exceptions:
- The uniform capitalization rules do not apply if property is (i.e. these cost may be expensed):
- Acquired for resale
- If a producer/reseller with:
- $26 million or less average gross receipts
- In the 3 preceding years consisting of:
- the test year
- the preceding 2 years
- For each test year
-
Unit of Property
- Unit of property defined:
- Unit of property:
Group of functionally interdependent components which can be a/an:
- Functionally interdependence:
- The placing in service of one component by the taxpayer is dependent on the placing in service of the other component by the taxpayer
- Asset
- Defined portion of an asset
- Group of assets
- Unit of property determines
whether costs are:
- Capitalized
- OR
- Deducted/expensed
- Unit of property classifications:
- Components with different property classes
- Improvements to a unit of property
- Network assets
- Personal and other real property
- Plant property
- Unit of property classifications
are further divided into:
- Major components
- Substructual parts
- Absent an available exception, costs to replace a major component or substantial structural part must be:
- Capitalized
-
9.2 Depreciation and Amortization
-
Overview of
Depreciation and Amortization
- Candidates should expect to be tested on capital cost recovery for corporations, including depreciation, Sec. 179 expense, and amortization.
-
Depreciation allowed for:
- Tangible property used in:
- Business/Trade
- Production of Income
- Tangible property that has a:
- Determinable
- Limited
- Useful Life
- Tangible property during:
- Year of disposition
- Exception:
- Depreciation is allowed during a disposition year. However, no depreciation is allowed if:
- Same year:
- Placed in service
- Year of disposition
- Accelerated Depreciation
- BACKGROUND 9-1
Accelerated Depreciation
Accelerated depreciation is a tax relief measure highly desired by businesses. Quickly expensing the cost of investment in plant and equipment for tax purposes allows businesses to significantly reduce their tax liability and thus reduce the cost of capital investment. However, it is important to note that the benefit provided by accelerated depreciation is based on the time value of money (i.e., a deduction today is better than a deduction tomorrow).
-
Depreciation allowable by the IRS:
- Depreciation methods:
- Straight-Line (S/L)
- (Basis - Salvage Value) / Useful LIfe
- For assets:
- Recovery periods:
- 3 years
- 5 years
- 7 years
- 10 years
- 15 years
- 20 years
- Real property
- Nonresidential
- Residential
- Section 168(k)(4) property:
- Elected:
- Before 2018
- Section 168(e)(6) qualified improvement property:
- Placed in service:
- After 2017
- Trees/vines bearing fruit or nuts
- Water utility property
- 150% Declining Balance (DB)
- AB x (150% / Useful LIfe)
- For assets:
- Recovery periods:
- 3 years
- 5 years
- 7 years
- 10 years
- 15 years
- 20 years
- Used assets
- 200% Declining Balance
- AB x (200% / Useful LIfe)
- For assets:
- Recovery periods:
- 3 years
- 5 years
- 7 years
- 10 years
- Farm property:
- Placed in service:
- After 2017
- Unit of Production
- (Basis - Salvage Value) x
(# of units produced during tax year) /
(Estimated total units asset will produce)
- Operating Days
- (Basis - Salvage Value) x
(# of days used during tax year) /
(Estimated total days asset can be used)
- Depreciation systems:
- Asset Depreciation Range (ADR)
- Useful life ranges
- By type of asset
- Modified Accelerated Cost Recoery System (MACRS)
- For assets:
- Placed in service:
- After 1986
- Business/Trade
- Production of Income
- Investment property
- Additional rules for assets under MACRS:
- Real property costs are recovered using a straight-line rate on unadjusted basis.
- Salvage value is ignored
- Two types of recovery systems under MACRS:
- Alternative Depreciation
System (ADS)
- For assets:
- Elected
- Business/trade
- Qualified improvement property
- Qualified Improvement Property
(QIP) means any improvement to an interior portion of a building which is nonresidential real property if such improvement is placed in service after the date such building was first placed in service.
- Recovery period:
- 15 years (ADS)
- 20 years (MACRS)
- Do not include:
- Elevators/escalators
- Enlargement of building
- Internal structural framework
- Real property
- Nonresidential
- Residential
- Farm property:
- 10 years or more GDS
- When an election not to apply the uniform capitalization rules is in effect.
- Election
Irrevocable:
- This election is irrevocable once made [Sec. 168(g)(7)(B)] and must be made for all assets acquired that year in a particular recovery class of property. Nonresidential real property and residential rental property elections are made on a property-by-property basis.
- Listed property
- Entertainment/recreation property
- Passenger automobiles
- Property specified by regulations
- Imported property
- Property used predominantly outside U.S.
- Tax-exempt property
- Tax-exempt bond-financed property
- Transportation vehicles
- Used 50% or less for business
- Depreciation method(s):
- S/L
- Recovery periods:
- Longer than GDS
- Example
recovery periods:
- Residential rental property:
- The ADS recovery period of residential rental property is reduced from 40 years to 30 years for acquisitions:
- Placed in service:
- After 2017
- General Depreciation
System (GDS)
- For assets:
- All assets
- Exception:
- ADS:
- Elected
- Election must be made by the due date, including extensions, for the tax return of the year in which the property was placed in service.
- By due date
(including extensions)
- A switch is made to straight-line on adjusted (reduced for allowable depreciation) basis when it yields a higher amount. However, the current year’s depreciation cannot exceed the item’s adjusted basis.
- Switch to S/L when
yields a higher deduction
- Required
- Depreciation method(s):
- All methods
- Conventions:
- Mid-year
- For assets:
- Personal property
- Under the mid-year convention, each asset is treated as placed into service at the midpoint of the year in which it was actually placed into service. The assets using this method are commonly called half-year property.
- Mid-month
- For assets:
- Real property
- Under the mid-month convention, each asset is treated as placed into service at the midpoint of the month in which it was actually placed into service.
- Mid-quarter
- For assets:
- Personal property
- Under the mid-quarter convention, each asset is treated as placed in service at the midpoint of the quarter in which it actually was placed in service.
- The convention is applied to all depreciable property acquired during the tax year when:
- Sum of bases of assets
- Placed in service:
- During the last quarter
- Exceeds:
- 40% of all assets
- Placed in service:
- During the year
- The first year depreciation is calculated by:
- Multiplying the full-year amount by the following percentages:
- Placed in service:
- 1st quarter:
- 87.5%
- 2nd quarter:
- 62.5%
- 3rd quarter:
- 37.5%
- 4th quarter:
- 12.5%
- Example:
- EXAMPLE 9-11
Mid-Quarter Convention
The formula for 3-year property placed in service in the third quarter is AB × (200% ÷ Useful life) × 37.5%.
- Recovery periods:
- 3 - 20 years
- Example
recovery periods:
- Equipment/machinery:
- The cost recovery period is revised from 7 to 5 years for any machinery or equipment (other than any grain bin, cotton ginning asset, fence, or other land improvement used in a farming business):
- Placed in service:
- After 2017
- Residential rental property:
- 80% of gross rents coming from dwelling units
- Partial use by the owner is included
- Transient use of more than half the units excludes the property (for example, a motel)
- Depreciation other methods:
- Bonus Depreciation
- Rules for bonus depreciation:
- Taken before:
- Regular depreciation
- For assets:
- Qualified property
- Certain planted/grafted plants bearing fruits and nuts
- Excluded for:
- Real property trade/business
- Regulated public utility company property
- Acquired
from/for:
- Unrelated party
- Taxpayer's first use
- New
- Used
- Limited to:
- 100%
- Placed in service:
- 1st year of use
- Tax year(s):
- September 27, 2017
- 2022
- Longer production period property:
- 2023
- 80%
- Placed in service:
- Tax year(s):
- 2023
- Longer production period property:
- 2024
- 60%
- Placed in service:
- Tax year(s):
- 2024
- Longer production period property:
- 2025
- 40%
- Placed in service:
- Tax year(s):
- 2025
- Longer production period property:
- 2026
- 20%
- Placed in service:
- Tax year(s):
- 2026
- Longer production period property:
- 2027
- Depletion
- Depletion accounts for recovery of investment for natural resource
(mineral) property for persons with an economic interest in them.
- Economic interest if:
- Acquires by
investment through:
- Cash
- Land
- Land that ensures control over access to the mineral
- Equipment
- Stationary equipment used to extract and produce the mineral
- Derives income from extraction of the mineral
- Looks to the extraction of the mineral for return of capital
- An economic interest in:
- Natural resource
(mineral) property
- Depletion
calculated by:
- Cost depletion:
- AB in mineral property
- /
- Estimated mineral units
(available at year's start)
- Limited to:
- Unrecovered
capital investment
- x
- Minerals units
sold during year
- Percentage depletion:
- The lesser of:
- 50% of:
- Taxable income
before depletion
- 100% of:
- Taxable income
before depletion
- Oil/gas property
- OR
- Percentage
(specified by statue)
- x
- Gross income
from the property
- Less:
- Related
paid/incurred:
- Rents
- Royalties
- Not limited to:
- Unrecovered
capital investment
- Percentage depletion allows deduction in excess of capital investment.
- Section 179 Expense
- Rules for Section 179 expenses:
- Elected
- Excluded for:
- Estates
- Trusts
- Subject to depreciation recapture if:
- Section 1245 property
- Business use reduced to:
- Less than:
- 50% of
total use
- Disposed of prior to:
- End of MACRS recovery period
- Recapture amount is:
- Excess of
Section 179 deduction over:
- MACRS allowable
- Included in gross income
- Taken before:
- Any other depreciation
- Reduces basis in the property (but not below zero) prior to computation of any other depreciation deduction allowable for the first year.
- For assets:
- Recovery period:
- 20 years or less
- Business/Trade
- Leasehold improvements
- Personal tangible property
- Real property
- Nonresidential
- Includes
nonresidential QIP including:
- HVAC
- Includes Standard 90.1-2007 property
- Roofs
- Security systems
- Alarm
- Fire protection
- Acquired
from/for:
- Unrelated party
- Taxpayer's first use
- New
- Used
- Limited to:
- Greater of:
- $1,050,000
- Minus excess eligible Section 179 assets acquistions over:
- $2,620,000
- No Section 179 deduction it total acquisition cost exceeds:
- $3,670,000
- Taxable income (TI)
- Current-year excess over TI may be carried forward and treated as Sec. 179 cost in a subsequent year subject to the overall limitation:
- Carryforward:
- Unlimited
- Subject to
above limitations
- Exception:
- Cars and luxury items excess cannot be taken over a set statutory amount
- Example:
- EXAMPLE 9-12
Maximum Sec. 179 Deduction
In 2021, Diana’s Corner Stores upgraded various equipment and computers at a total cost of $2,920,000. All assets purchased are eligible for Sec. 179 treatment. The Sec. 179 deduction is phased out dollar for dollar once the minimum threshold for purchases is exceeded. Therefore, the maximum Sec. 179 deduction Diana’s Corner Stores can take is
$750,000 [$1,050,000 maximum deduction – ($2,920,000 purchases – $2,620,000 phaseout)].
- A taxpayer purchased and placed in service during the year a $100,000 piece of equipment. The equipment is 7-year property. The first-year depreciation for 7-year property is
14.29%. Assume that, of the allowable Sec. 179 limit for the current year, $25,000 is allocated to this piece of equipment. The taxpayer has opted out of bonus depreciation. What amount is the maximum allowable depreciation?
$35,718
Answer (C) is correct.
Depreciation for an asset is first determined based upon the election of the taxpayer to take a Sec. 179 expense on the asset. However, if the taxpayer chooses to expense any of the property, the property’s adjusted basis is reduced by the Sec. 179 expense in determining the applicable depreciation base. Therefore, the depreciation is calculated as follows:
Purchase price of asset $100,000
Less: Sec. 179 expense (25,000)
Depreciable basis $75,000
Times: Depreciation rate (14.29%) (10,718)
New adjusted basis of equipment $ 64,282
Total depreciation for the first year equals $25,000 + $10,718 = $35,718.
- On May 10, 2021, Larry purchased and placed in service a pickup truck (GVWR 7,000 lbs. and a 7-ft. bed). The selling price was $12,000. He received a trade-in allowance of $2,000 on his old truck and received a loan for the $10,000 balance. He had an adjusted basis of $3,000 in his old truck. He used the old and new truck 90% for business. Taxable income from his business for 2021 (before the Sec. 179 election) was $50,000. Larry did not place any other assets in service in 2021. What amount may Larry take as a Sec. 179 deduction in 2021?
$9,000
Answer (B) is correct.
Section 179 allows a taxpayer to treat up to $1,050,000 of the cost of Sec. 179 property acquired in 2021 as an expense rather than as a capital expenditure. But the cost of Sec. 179 property does not include the basis determined by reference to other property held by the taxpayer [Sec. 179(d)(3)]. Under Secs. 1012 and 1031(d), the basis of the new truck is $12,000 ($2,000 basis of old truck + $10,000 loan due). Since Sec. 179 does not apply to any portion of the basis that references an asset that was previously held by the taxpayer, only $10,000 of basis is eligible for Sec. 179 [Reg. 1.179-4(d)]. Only the 90% portion of the truck used for business will qualify, however. Therefore, the Sec. 179 expense is $9,000 (90% × $10,000 cost). The truck is not considered to be a passenger automobile, so it is not subject to the luxury automobile limitations.
-
Amortization allowable by the IRS:
- Intangible assets amortization:
- Amortization accounts for recovery of capital (e.g., intangible assets, Sec. 197) in a similar manner as straight-line depreciation. Intangible assets make up the majority of amortizable assets and are recovered over the asset’s useful life or, in the case of Sec. 197 intangibles, 15 years. Other items are amortized over a period specified for that item.
- Intangible assets include:
- Business/trade property
- Production of Income Property
- Acquired
(not created)
- Examples:
- Goodwill
- Covenants
not to compete
- Customers
- Franchise
- Going-concern value
- Information base
- Licenses
- Including rights granted by governmental units
- Know-how
- Patent
- Permits
- Suppliers
- Trademark
- Trade name
- Work force
- Intangible assets
do not include:
- Interests in:
- Corporations
- Estates
- Land
- Partnerships
- Trusts
- Financial instruments
- Financial contracts
- Personal intangible property leases
- Professional sports franchises
- Amortized over:
- 15 years
- Starts the later of:
- Acquired
- Active business/trade begins
- Loss realized on disposition:
- Disallowed if the taxpayer retains other qualified intangibles acquired in the same (set of) transaction(s). The amount disallowed is added to the basis of the intangibles retained.
- Example:
- Geological/Geophysical expense amortization:
- Amortized over:
- 2 years
- Starts in month:
- Six
(mid-point) of the year costs incurred
- Costs related to:
- Oil and gas exploration/development
- Lease amortization:
- Amortized over:
- Lease term
- Include renewal option term if:
- Less than:
- 75% of the cost is attributable to the period prior to renewal
- Unless contract
(reasonably) specifies otherwise
- Improvements by the lessee are not amortized but deducted under the MACRS method.
- For a lease entered into before September 26, 1985, the lessee could elect to recover the costs over the remaining lease term.
- Elect to amortize
- Lease before:
- September 26, 1985
- Pollution control facility cost amortiation:
- Amortized over:
- 5 years
- Exception:
- Atmospheric facilities
- 7 years
- Reforestation amortization:
- Amortized over:
- 7 years
- Starts in month:
- Six (mid-point) of the year costs incurred
- Research and development cost amortization:
- Amortized over:
- 5 years
- Starts in month:
- Costs are realized
- Research and experimental costs must generally be capitalized and recovered when the project is abandoned or becomes worthless:
- Capitalized when
(not amortized/expensed):
- Project:
- Abandoned
- Worthless
- Research and development
costs do not include:
- Art development
- Market research
- Sociological research
- Organization/Start-up cost amortization:
- Amortized over:
- 15 years
- Starts in month:
- Active business/trade begins
- Limited to:
- $5,000 immediate deduction (each)
- Reduced by:
- Total costs exceed:
- $50,000
- Expenditures incurred:
- Before end of the tax year
- Active business/trade begins
- The election is irrevocable and deemed to be automatically made by taxpayers.
-
9.3 Capital Gains and Losses
-
Bond Premium Treatment
- For bond premium treatment, the bond holder can elect to amortize the bond premium:
- The bondholder
may either:
- (1) elect to amortize the premium until bond maturity
- AND
- Reduce the basis by the premium
- (2) elect not to amortize
- AND
- Increase the basis by the premium
-
Business Start-Up Costs
- Capitalized amounts not yet amortized upon disposition of the business are treated as a capital loss.
- Disposed
- Not yet amortized
- Capital loss
-
Capital Assets
- All property is characterized as a capital asset, unless expressly excluded. The following types of property are not capital assets.
- Capital assets include:
- Personal use property
- Property held for personal use only, rather than for investment, is a capital asset, and a gain from its sale must be reported as a capital gain. However, a loss from selling personal use property cannot be deducted.
- Production of income property
- Bonds
- Commodities
- Goodwill
(internal)
- Goodwill is a capital asset when generated within the business. If a business sells its assets and receives more than the FMV of those assets, the remainder is considered a capital gain from the sale of goodwill.
- Land
- Patents
(not business)
- Example:
- Halbert Zweistein is a renowned physicist and Nobel Prize winner who holds numerous patents. Halbert owns the copyrights to the 75 books he wrote in a long career. He has also collected his voluminous correspondence, notes, journals, and other papers that he plans to sell to a library in a major eastern city. Which of the following will result in capital gain or capital loss?
The sale of the patents.
Answer (A) is correct.
A capital gain or loss results from a sale or exchange of a capital asset. Patents are capital assets since they are not excluded from being capital assets by Sec. 1221.
- Stocks
- Capital assets do not include:
- Business/Trade
- Accounts (or notes) receivable
- Related to:
- Inventory (or stock in trade)
- Personal tangible property
- Real property
- Services rendered
- Artistic compositions
- Artistic compositions held by the person who composed them.
- Copyright compositions
- Copyright compositions held by the person who composed them.
- However, copyrights are explicitly excluded from Sec. 1231 treatment.
- Goodwill (acquired)
- Goodwill acquired is thus treated as amortizable property, which is not a capital asset. Internally generated goodwill, however, is a capital asset:
- Goodwill acquired after:
- July 25, 1991
- Inventory (or stock in trade)
- Property held primarily for sale to customers in the ordinary course of a trade or business. Dealer property included unless:
- The dealer “identifies” the stock as an:
- Investment
- By the close of the business day of acquisition
- Personal tangible property
- Publications
- Certain U.S. government publications acquired at reduced cost
- Real property
- Land
- Generally, the subdivision of land into parcels converts the parcels into property held primarily for sale to customers, unless the following requirements are met:
- Held for:
- At least:
- 5 years
- No substantial improvements
to land during period held
- Not a corporation
- Not held any other real property
for sale to customers:
- In the same year in which the sale occurs
- Not previously held the land for sale to customers
- Real estate
-
Capital Gains and Taxation
- Capital gain rates:
- Capital gains rates (2021):
- Filing status/
Rates:
- 15%
- 20%
- Single
- $40,400
- $445,850
- HOH
- $54,100
- $473,750
- MFJ
- $80,800
- $501,600
- MFS
- $40,400
- $250,800
- Estates
- $2,700
- $13,250
- Trusts
- $2,700
- $13,250
- 25%
- Section 1250 unrecaptured
- The capital gains rate is 25% on unrecaptured Sec. 1250 gains (discussed further in Study Unit 10, Subunit 4).
- 28%
- Collectibles sales
- Section 1202 stock gains
- The maximum capital gains rate is 28% on gains and losses from the sale of collectibles and the taxable portion of gains from qualified Sec. 1202 stock (i.e., gains from certain small business stock after the 50% or 75% exclusion is applied).
- Rules for taxation for capital gains:
- Capital gain (baskets):
- If a long-term basket has gains and losses, losses for each long-term basket are used to offset any gains within that basket.
- If a long-term basket has a net loss, the loss will be used to offset net gain for the highest long-term rate basket, then to offset the next highest rate basket and so on.
- A carryover of a net long-term loss from a prior year, is used first to offset any net gain in the 28% basket, then to offset any net gain in the 20% basket, and finally to offset any net gain in the 15% basket. Likewise, net STCL is also used first to offset net gain for the highest long-term basket and so on.
- Examples:
- EXAMPLE 9-15
Capital Gains (Losses) and Grouping by Tax Rates
A taxpayer realizes a $10,000 net loss in the 15% basket, a $5,000 net gain in the 25% basket, and an $8,000 net gain in the 28% basket. The taxpayer will first apply the net loss against the gain in the 28% basket, reducing the gain in this basket to zero. Then, the remaining $2,000 loss is applied against the gain in the 25% basket, leaving a $3,000 net capital gain in the 25% basket.
- EXAMPLE 9-16
Long-Term Capital Loss Carryover and Net STCL
A taxpayer has a $1,000 long-term capital loss carryover, a net short-term capital loss of $2,000, a $1,000 net gain in the 28% basket, and a $5,000 net gain in the 15% basket. Both losses are first applied to offset the 28% rate gain, using the $1,000 loss carryover first until completely exhausted. Since no gain exists in the 28% basket after applying the carryover, the net STCL is then applied against the next highest gain in the 15% basket. As a result, only a $3,000 net capital gain remains in the 15% basket.
- Capital gains/loss (net):
- For an individual, they may deduct a net capital loss in the current year up to:
- The lesser of:
- Ordinary income
- Equal to:
- Others
- $3,000
- MFS
- $1,500
- Excess can:
- Carryforward:
- Unlimited
- Treated as:
- Net STCL
- Treated as deducted in prior year before:
- Net LTCL
- The 28% basket includes any net short-term capital loss for the tax year and long-term capital loss carryovers from other years.
- For an corporation, they may not deduct a net capital loss in the current year.
- CLs only to offset CGs each year.
- All capital gain is taxed at the corporation’s regular tax rate.
- Excess must:
- Carryback:
- 3 years
- Carryforward:
- 5 years
- Treated as:
- STCL
- Regardless of original character
- Example:
- EXAMPLE 9-17
Excess Capital Loss
ABC, Inc., a C corporation, has $500 in capital gains and $600 in capital losses. Only $500 of the capital losses can offset the capital gains. The remaining $100 of capital loss is nondeductible in the current year and is carried back 3 years and forward 5 years.
- Capital gain/loss tax forms:
- Schedule D (Form 1040) US Individual Income Tax Return, Capital Gains and Losses is used to compute and summarize capital gains and/or losses on the sale or disposition of capital assets listed on Form 8949 Sales and Other Dispositions of Capital Assets, and the summary combines the long-term gains (losses) with the short-term gains (losses). When these capital gains and losses all net to a gain, it is called capital gain net income.
- Casualties
-
Gain (Loss) Realized and Recognized
- Capital gains and losses has been a heavily tested topic on the CPA Exam, with both conceptual and calculation questions being used to test this area.
- Rules regarding
gains/loss realized and recognized
- Gain/loss realized upon:
- Disposal
- Exchange
- Sale
- Transfer
- Treated as sale/exchanges:
- Liquidating distributions
- Worthless securities
- Gain/loss realized upon:
- The earlier of:
- Date of conveyance
- Conveyance:
The action or process of transporting someone or something from one place to another
- Date of burdens of ownership are passed to the buyer
- For capital assets:
- Wholly worthless during the year
- Last date of the year
- Franchises are
treated as capital asset if:
- Transferor does not retain any significant power, rights, or continuing interest with respect to the franchise.
- The transfer is not a sale but merely a licensing agreement, and all the income is ordinary income.
- Gain/loss calculation:
- Gain/loss recognized:
- Realized gains recognized
- All realized gains must be recognized unless the IRC expressly provides otherwise.
- Realized losses not recognized
- All losses are not recognizable unless the IRC expressly provides for it.
- Example:
- Personal use property:
Though personal-use property is a capital asset and gains from such property are recognized, a loss is not deductible
- Example:
- EXAMPLE 9-14
Realized Gain
The purchase price of a building was $400,000 ($100,000 cash + $300,000 mortgage). Two years later, improvements of $80,000 were made to the building. The building sold for
$700,000 ($600,000 cash + $100,000 mortgage balance). A total of $180,000 depreciation had been taken as of the date sold. The adjusted basis is $300,000 ($400,000 original basis + $80,000 improvements – $180,000 depreciation taken). The realized gain is $400,000 ($700,000 cash and liability relief – $300,000 adjusted basis).
-
Holding Period
- Rules regarding holding period:
- Measured in:
- Calendar months
- Begins:
- Date after:
- Acquisition
- Exchange
- Includes:
- Date of disposal
- Types of capital gain periods:
- Short-term capital gain/loss (STCG/L):
- Assets held:
- 1 year or less
- Long-term capital gain/loss (LTCG/L):
- Assets held:
- More than:
- 1 year
- Net capital gain (NCG):
- Net LTCG
- LTCG
- Excess over:
- LTCL
- Excess over:
- Net STCL
- STCL
- Excess over:
- STCG
- Treated as:
- Capital gain
- Capital gain net income:
- Net LTCG
- LTCG
- Excess over:
- LTCL
- -
- Net STCG
- STCG
- Excess over:
- STCL
- Treated as:
- Ordinary income
- May offset:
- Net LTCL
- Rules regarding holding period (specifics):
- Nontaxable exchanges
- Corporate stock (351)
- Add contributed asset HP
- Corporation (351)
- Add transferor's HP
- Involuntary conversion (1033)
(business/trade or personal)
- Add converted asset HP
- Like-kind property (1031)
- Add exchange asset HP
- Only if capital asset or Sec. 1231 property; otherwise, the holding period starts the day after date of exchange.
- Partnership interest (721)
- Add contributed asset HP
- Only if capital asset or Sec. 1231 property; otherwise, the holding period starts the day after date of exchange.
- Exchange
(ordinary income property)
- Partnership (351)
- Add transferor's HP
- Only if capital asset or Sec. 1231 property; otherwise, the holding period starts the day after date of exchange.
- Residence (1034)
- Add old home HP
- Taxable exchanges
- Conversion different use
(business/trade or personal)
- Add period of prior use
- Commodity futures
(after 6-month HP)
- Long-term (automatically)
- Gift: For gains
- Donor's acquisition
- Gift: For losses
- Acquisition
- Inheritance
- Long-term (automatically)
- Under Sec. 1223(11), if property acquired from a decedent is sold or otherwise disposed of by the recipient within 12 months of the decedent’s death, then the property is considered to have been held for more than 12 months.
- Optioned property
- Exclude option period
- Sales/exchange
- Acquisition
- Securities
- Trading date
- Short sales
- Earlier of:
- Closing date
- Property sale date
-
Market Discount Bonds
- For market discount bonds, gain on sale is treated as ordinary income to the extent the market discount could have accrued as interest. In other words, if bond is not held to maturity the difference is considered oridinary income. If held to maturity, then the
gain is capital gain:
- If market discount could be
accrued as:
- Interest
- Gain on sale
treated as:
- Ordinary income
- For market discount bonds, accrued interest:
- Market discount
- x
- # of days security held
- /
- # of days to maturity
- Example:
- EXAMPLE 9-23
Sale of Market Discount Bonds
John purchases a $100, 360-day bond for $90. The market discount equals $10. If John sells the bond 180 days later, he must recognize $5 (half of the discount) as ordinary income (interest).
-
Nonbusiness Bad Debt
- A business bad debt is deductible to arrive at AGI (above-the-line) as ordinary loss. A nonbusiness bad debt is treated as a STCL:
- Business bad debt:
- Above-the-line deduction as:
- Ordinary loss
- Nonbusiness bad debt:
- STCL
-
Return of Capital
- The amount of a distribution is a dividend to the extent of earnings and profits. Dividends do not reduce the shareholder’s basis in the stock. A shareholder treats the amount of a distribution in excess of earnings and profits (E&P) as tax-exempt return of capital to the extent of his or her basis. A distribution in excess of basis is a:
- Distribution of stock in
excess of:
- Earnings and profits (E&P)
- Capital gain
-
Short Sales
- Short Sales types:
- Borrowed from broker shares
- Holding Period
- From date:
- Bought (identical) shares from market
to replace the (borrowed from broker) shares that were sold to third party
- To date:
- Returned (borrowed from broker) shares
- Gain recognized date:
- Returned (borrowed from broker) shares
- Not considered date:
- Sold (borrowed from broker) shares
- Original shares
- Holding Period
- From date:
- Bought (original) shares from market
that were sold to third party
- To date:
- Sold (original) shares
- Gain recognized date:
- Returned (borrowed from broker) shares
- Not considered date:
- Bought (identical) shares from market
to replace the (borrowed from broker) shares that were sold to third party
- Example:
-
Small Business Stock Losses
- Section 1244 stock is stock (common or preferred, voting or nonvoting) of a small business corporation held since its issuance
(e.g., not acquired by gift) and issued for money or other property (not stock or securities):
- Small business corporation stock purchased with:
- Cash
- Property
- Basis in the stock is equal to the property’s basis in the hands of the transferor when contributed.
- Basis is increased for additional investments, however, without issuance of additional shares increase is considered capital interest
(losses would be capital losses).
- Small business corporation stock can be:
- Common
- Preferred
- Voting
- Nonvoting
- Loss realized on:
- Disposition
- Worthlessness
- Not acquired by gift and also excludes purchase with other stock or securities
- Section 1244 stock losses are limited to:
- Ordinary loss
- Others
- $50,000
- MFJ
- $100,000
- The loss is considered to be from a trade or business for NOL purposes.
- For purchase with property, limited to:
(in addition)
- FMV in excess of basis:
- Capital loss
- Additional investment without issuance of additional shares of Sec. 1244 stock increases original basis loss apportioned between:
- Qualifying
- Nonqualifying
- Section 1244 stock determined by:
- Small business corporation:
- Aggregate amount of:
- Money
- Property
- Less than:
- $1,000,000
- Small business corporation since date of:
- Stock issuance
- Even if the contributions exceed $1 million, part of the stock (up to $1 million) may be designated by the corporation as qualifying for Sec. 1244 ordinary loss treatment.
- Example:
- Maria Mordant acquired all of the original stock of The Diamond, Inc., a Sec. 1244 small business, on January 10, Year 1, for $10,000. She contributed another $9,000 to capital before selling all of her stock on June 30, Year 5, for $10,000. How much loss should Maria report on her Year 5 return, and is the loss capital or ordinary?
Deduct $4,737 as ordinary loss and $4,263 as capital loss subject to limitations.
Answer (A) is correct.
If an owner of Sec. 1244 stock invests additional capital but is not issued additional shares of stock, the amount of the additional investment is added to the basis of the originally issued stock, but this subsequent increase to the basis of the originally issued stock does not qualify for ordinary loss treatment. Any resulting loss must then be apportioned between the qualifying Sec. 1244 stock and the nonqualifying additional capital interest. Since the additional capital interest of $9,000 is 9/19 of the total basis of $19,000, the $9,000 loss is apportioned as follows: $4,263 of capital loss (9/19 of $9,000) and $4,737 of qualifying ordinary loss.
- In the current year, Fitz, a single taxpayer, sustained a $48,000 loss on Sec. 1244 stock in JJJ Corp., a qualifying small business corporation, and a $20,000 loss on Sec. 1244 stock in MMM Corp., another qualifying small business corporation. What is the maximum amount of loss that Fitz can deduct for the current year?
$50,000 ordinary loss and $18,000 capital loss.
Answer (D) is correct.
Up to $50,000 of loss realized on disposition or worthlessness of Sec. 1244 stock is treated as an ordinary loss. This limit applies to Sec. 1244 stock held in all corporations. The remaining $18,000 ($48,000 + $20,000 – $50,000) is a capital loss.
-
Small Business Stock Exclusion
- Section 1202 stock is of a small business stock held more than a set period of time and receives gain exclusion treatment.
- Held more than:
- 5 years
- Stock seller is:
- Original
stock owner
- Section 1202 stock gain exclusion limited to:
- 100% of gain:
- Issued after:
- September 27, 2010
- 75% of gain:
- Issued after:
- February 17, 2009
- 50% of gain:
- Issued after:
- August 10, 1993
- Limited to:
(in addition)
- Equal to:
- Others
- $10,000,000
- MFS
- $5,000,000
- Multiply:
- 10
- x
- AB in stock
- Section 1202 stock determined by:
- Small business corporation:
- Gross
amount of:
- Assets
- Less than:
- $50,000,000
- Small business corporation:
- Domestic
C corp.
- Even if the contributions exceed $1 million, part of the stock (up to $1 million) may be designated by the corporation as qualifying for Sec. 1244 ordinary loss treatment.
-
Wash Sales
- For wash sales, to prevent abusive transactions in which a taxpayer sells property at a loss but quickly repurchases the property, leaving the taxpayer in the position of still having the property but with the benefit of recognizing a loss, a current loss realized on a wash sale of securities is not recognized. A wash sale occurs when:
- Loss on sale:
- Before
- After
- Within:
- 30 days
- Substantially the same securities are purchased
- Spouse purchases are included together (treated as one person)
- For wash sales, the disallowed loss is:
- Added to the basis of the new stock purchased
- For wash sales, the holding period includes:
- Original stock HP
- Examples:
- EXAMPLE 9-18
Wash Sales -- Same Number of Shares
Taxpayer sells 100 shares of ABC stock for $400, at a loss of $200. Within 30 days, Taxpayer purchases an identical 100 shares of ABC for $500 and sells all 100 shares two months later for $900. Taxpayer recognizes no loss on the first sale and only a $200 gain ($900 sale price – $500 cost – $200 basis adjustment due to loss) on the subsequent sale of stock.
- EXAMPLE 9-19
Wash Sales -- Repurchase Fewer Shares
Taxpayer sells 100 shares of ABC stock for $400, at a loss of $200. Within 30 days, Taxpayer purchases an identical 40 shares of ABC for $200 and sells all 40 shares two months later for $320. Taxpayer recognizes a loss of $120 [$200 loss × (60 ÷ 100) proportion of shares not repurchased] on the first sale and a gain on the subsequent sale of stock of $40 ($320 sale price – $200 cost – $80 basis adjustment due to loss).
- EXAMPLE 9-20
Wash Sales -- Repurchase More Shares
Taxpayer sells 100 shares of ABC stock for $400, at a loss of $200. Within 30 days, Taxpayer purchases an identical 120 shares of ABC for $600 and sells all 120 shares two months later for $1,080. Taxpayer recognizes no loss on the first sale and a gain on the subsequent sale of stock of $280 ($1,080 sale price – $600 cost – $200 basis adjustment due to loss).
-
CPA REG SU10 Property Transactions Special Topics
-
10.1 Related Party Sales
-
Overview of Related Party Sales
- The tax treatment of property transactions is integrated with that of other transactions on the CPA Exam. Visualize the following steps to analyze the income tax consequences of property transactions:
- 1) Apply related party sales rules
- 2) Apply nonrecognition rules
- 3) Apply recapture rules
- 4) Characterize gains/losses
- 5) Review other property rules
-
Limited Tax Avoidance
- These rules limit tax avoidance between related parties. Gain recognized on an asset transfer to a related person:
- Depreciable asset sold gain:
- Ordinary income
- If the property is depreciable in the hands of the transferee
- Depreciable asset sold loss:
- Not recognized/
deductible
- Depreciable asset sold
insufficient stated interest is:
(credit extended)
- Imputed interest
- For each year, loan is outstanding
- Related party defined:
- Ancestors
- Controlled entities
- More than:
- 50% ownership
- Constructive ownership rules apply
- Partnership when person owns interest:
- Capital
- OR
- Profits
- Lineal descendants
- Siblings
- Spouses
- Trusts
- Trusts
(beneficiaries)
- Related party transferee basis:
- Acquisition HP
- Cost basis
- Related party transferee subsequent sale:
- Gain recognized
- Cost basis
- Add disallowed loss
- Loss recognized
- Cost basis
- If sold to unrelated
(tax-indifferent) third party:
- After:
- January 1, 2016
- Gain recognized
- Cost basis
- Tax-indifferent third party defined:
- Not subject to federal income tax
- Item sold would have no substantial income tax impact
- Example:
- Government entity
- Non-US persons
- Tax-exempt organizations
-
Constructive Ownership – Corporation Stock
- Constructive ownership rules for
corporate stock:
- Shareholder
(proportionately owns)
stocked owed by:
- Ancestors
- Parents
- Grandparents
- Lineal descendants
- Children
- Grandchildren
- Siblings
- (whole or half)
- Spouses
- Not legally separated
- Stock Redemptions:
Shareholder
(directly/indirectly owns)
stocked owed by:
- Ancestors
- Parents
- Corporation
- Not S corporation
- At least:
- 50% of
value of stock
- Estate
- Beneficiary
- Owner
- Lineal descendants
- Children
- Grandchildren
- Partnership
- Spouses
- Trusts
- Stock included is:
- Stock which shareholder holds an option to buy
-
Constructive Ownership – Partnership Interest
- Constructive ownership rules
for partnership interest:
- Taxpayer owns
interest owed by:
- Ancestors
- Parents
- Lineal descendants
- Children
- Grandchildren
- Siblings
- Spouses
- Shareholder/partner/beneficiaries
(proportionately owns)
interest owed by:
- Corporation
- Not S corporation
- At least:
- 50% of
value of stock
- Estate
- Partnership
- Includes a family partnership:
- A family partnership is one consisting of:
- Ancestors
- Parents
- Grandparents
- Lineal descendants
- Children
- Grandchildren
- Spouses
- Taxpayer
- Trust
(for their
primary benefit)
- Trust
-
10.2 Installment Sales
-
Overview of installment sales
- An installment sale is a disposition of property in which:
- At least:
- One payment
- Received after:
- Close of tax year of disposition
-
Rules for installment sales:
- Installment sales mandatory
- Not required for:
- Farming business
- Farm real property
- Farm personal property
- Farm produced property
- Certain sales subject to interest on deferred tax for:
- Residential lots
- Residential timeshares
- Disallowed
for the
following dispositions:
- Personal property inventory
- Personal property sales
(revolving credit)
- Personal property dealer
- Personal property regularly sold under installment plan
- Real property dealer
- Real property held for sale in ordinary course of trade/business
- Securities
- If publicly traded (generally)
- Sales on agreement
to establish an
(irrevocable) escrow account
- Taxayer can elect not to use the installment method.
- Can elect to use installment method
- Installment sales recapture
- Determined by:
- Nature of property
in hands of transferor
- Character types:
- Section 1245
- Section 1250
- Depreciation
recapture recognized:
- In tax year of
installment sale as:
- Ordinary income
- Remaining gain:
- Under
installment method
- The installment method can apply to Sec. 1231 property, therefore, apply to installment sales Section 1231 recapture as well.
- Installment sales recognized gain/loss
- Amount of gain recognized in tax year:
- Gross profit %
- Gross profit
- =
- Sales price
- Cash received
- Buyer installment notes
- Liability relief
- When the liability exceeds AB and selling expenses, the gross profit percentage is 100%.
- The seller is required to recognize the excess mortgage as a payment in year of sale
- Does not include:
- Imputed interest
- -
- Selling expenses
- Includes
debt forgiveness
- AB
- If subject to Section 1245 recapture, to determine gain:
- AB
- -
- Section 1245
recapture
- /
- Contract price
- =
- Sales price
- -
- Liability relief
(that does not exceed the seller’s basis in the property)
- +
- If liability relief
exceeds seller's basis:
- +
- Excess over AB
- -
- Selling expenses
- x
- Curent year payments received
- A payment is considered paid in full if the balance is placed into an irrevocable escrow account
(i.e., amounts that cannot revert to the purchaser) at a later date.
- The date the installment payment is received determines the capital gains rate to be applied rather than the date the asset was sold under an installment sales contract.
- If sales price is reduced in
future year:
- Gross profit %
(new/reduced)
- Gross profit
- =
- Sales price
(new/reduced)
- -
- Gross profit
(recognized)
- /
- Contract price
- =
- Sales price
(new/reduced)
- x
- Curent year payments received
- Installment sales repossessions
- Recognized
gain/loss
in tax year:
- Repossessed property (FMV)
- -
- AB of installment obligation
satisfied by the repossession:
- Unpaid balance of installment obligation
- -
- Unrealized profit:
- Unpaid balance of installment obligation
- x
- Gross profit percentage
- OR
- Face value method:
- Face value
(Sales price - Payments rec'd)
- x
- 100%
- -
- Gross profit percentage
- If real property
gain recognized is:
- The lesser of:
- Excess of
previous gain recognized:
- Previous gain recognized
- -
- Cash received
- AND
- Other property (FMV) received
- Gross profit remaining:
- Gross profit on original sale
- -
- Previous gain recognized
- Repossession costs
- Installment sales subject to interest deferred tax
- Nondealer sales
- Interest on deferred tax
- Applied if:
- At close of tax year
installment receivables of:
- More than:
- $5,000,000
- From:
- Installment sales
that occurred during
the tax year:
- More than:
- $150,000
(in annual payments)
- Not applied if:
- Farming business
- Farm use property
- Farm produced property
- Personal-use property
- Residential lots
- Residential timeshares
- Installment sales transfers
- Recognized
gain/loss
in tax year:
- Installment obligation
(FMV/amount realized)
- -
- AB of installment obligation
- Gift transfers:
Recognized
gain/loss:
- Installment obligation
(Face value)
(Sales price - payments rec'd)
- -
- AB of installment obligation
- Gift transfer
subsequent sale:
Recognized
gain/loss:
(recognized by transferor)
- Installment obligation
(FMV/amount realized)
- -
- AB of installment obligation
- Not recognized
gain/loss if:
- Transfers to:
- Controlled entity
- Spouses incident to divorce
- Corporation:
- Liquidations
- Reorganizations
- Partnership:
- Capital contributions
- Distributions
- In these cases, the transferee would handle the installment under the same installment method as the transferor.
-
Example:
- EXAMPLE 10-4
Installment Sale
Harold sold his house to Jennifer in January Year 2 for
$200,000. Jennifer paid a $50,000 down payment, and the remainder is owner-financed by Harold with a 3% interest rate. Jennifer must make 18 equal monthly payments beginning in February Year 2. Harold considers the sale of his home an installment sale because the payments continue beyond Year 2.
- EXAMPLE 10-5
Installment Sale -- Gross Profit Percentage
In 2021, Drew sold 40 acres of land for $200,000 to be collected over 10 years. The land was purchased in 1990 for $80,000. Drew’s gross profit is $120,000 ($200,000 –
$80,000). The contract price is $200,000, the amount received. The gross profit percentage is 60% ($120,000 gross profit ÷ $200,000 contract price). In 2021, Drew received $50,000 as a down payment and includes $30,000 as a capital gain ($50,000 received × 60% gross profit percentage).
- EXAMPLE 10-6
Installment Sale -- Mortgage Assumed by Buyer
Taylor sold a piece of property for $105,000. The property had a basis of $40,000 with a $55,000 mortgage attached that was assumed by the buyer. The buyer paid a $6,000 down payment and financed $44,000 through Taylor. The selling expenses were $5,000. The gross profit is $60,000
($105,000 selling price – $40,000 basis – $5,000 selling expenses). The contract price is $60,000 ($6,000 down payment + $44,000 mortgage + $15,000 excess of mortgage assumed over basis – $5,000 selling expenses). Because the $55,000 mortgage is greater than the $50,000 collection, the excess of liabilities over AB and selling expenses is added to the amount collected. The gross profit percentage is 100% ($60,000 gross profit ÷ $60,000 contract price). The amount collected in the first year is $16,000 ($6,000 cash +
$15,000 excess mortgage – $5,000 selling expenses).
- EXAMPLE 10-7
Interest on Installment Sale
Hans sold his construction company for $10 million to be paid in 25 annual payments of $400,000. Because (1) the installment receivables are more than $5 million and (2) there are annual payments of more than $150,000, Hans needs to report interest income on the installment sale.
-
10.3 Nonrecognition Transactions
-
The general rule is to recognize all gain realized during the tax year. This topic discusses some transactions for which the IRC requires or permits exclusion or deferral of all or part of the gain realized in the current tax year.
- (General) gain/loss recognition:
- Realized gains recognized
- All realized gains must be recognized unless the IRC expressly provides otherwise.
- Realized losses not recognized
- All losses are not recognizable unless the IRC expressly provides for it.
- (Special) nonrecognition:
- Like-Kind Exchanges (LKE) (1031)
- Involuntary Conversions
- Sale of Principal Residence
- Qualified Small Business Stock
-
Rules regarding nonrecognition transactions
- Like-Kind Exchanges (LKE)
(Section 1031)
- Section 1031 defers recognizing gain or loss to the extent that real property productively used in a trade or business or held for the production of income (investment) is exchanged for property of like kind.
- Like-kind exchange property
- US real property
- Business/trade
- Production of income
- US foreign real property
- Business/trade
- Production of income
- A lease of
real property terms of:
- More than:
- 30 years
- US real estate and foreign real estate are not like-kind.
- Without regard to differences:
- In use
- Business/trade
- Production of income
- In improvements
- House
- Undeveloped land
- In location
- City
- Rural
- In proximity
- Section 1031 basis of acquired property
- AB of property given up
- +
- Boot given
- Cash given
- Liability incurred
- Other property
(FMV) given
- Gain recognized
- -
- Boot received
- Cash received
- Liability relief
- Other property
(FMV) received
- +
- Excess
exchange expenses
- Loss recognized
(boot given)
- Section 1031 qualified exchange agreements
- With a qualified exchange accommodation agreement, the property given up or the replacement property is transferred to a qualified intermediary (QI), also referred to as exchange accommodation titleholder (EAT) or facilitator. The QI is considered the beneficial owner of the property. This arrangement allows a transfer in which a taxpayer acquires replacement property before transferring relinquished property to qualify as a tax-free exchange.
- Property given/replacement property
- Transferred to:
- QI/EAT
- Requirements:
- EAT property ownership
- EAT has qualified indications of ownership of the property
- Time limits satisfied
- Time limits for identifying and transferring the property are satisfied
- Written agreement
- Section 1031 recapture
- Determined by:
- Nature of property
in hands of transferor
- Character types:
- Section 1245
- Total of:
- Gain recognized
- Non-Section 1245 property received (FMV)
in excess of:
- Gain recognized
- Section 1250
- Greater of:
- Gain recognized
- Potential
Section 1250 ordinary income in excess of:
- Section 1250 property received (FMV)
- Depreciation
recapture recognized:
- In tax year of
installment sale as:
- Ordinary income
- Section 1031 recognition gain/loss
- Recognized gain:
- Lesser of:
- Boot received
- Boot defined:
- Nonqualified property transferred in the exchange includes:
- Cash received
- Net liability relief
- Liabilities are treated as money paid or received.
- Liabilities include
mortgages on property.
- If each party assumes a liability of the other, only the net liability given or received is treated as boot.
- Under Reg. 1.1031(d)-2, excess mortgage incurred cannot be netted against cash received to reduce the amount of boot received.
- Other nonqualified property (FMV) received
- Gain realized
- Recognized loss:
- Limited to:
- Boot given
- Exchange expenses are either:
- Deducted from:
- Boot received
- Cash received
- Net liability relief
- Other nonqualified property (FMV) received
- Exchange expenses in excess of above:
- Add to:
- Basis in
property received
- Example:
- EXAMPLE 10-8
Like-Kind Exchange with Boot
Scott owned a parcel of real estate that he was holding for investment. It had an adjusted basis of $50,000. Scott exchanged the real estate for a piece of land with a fair market value of $60,000, a boat for personal use that had a fair market value of $3,000, and $2,000 cash. Scott’s basis in the land received is equal to the adjusted basis of the real estate transferred ($50,000), less the boot received of the boat ($3,000) and the cash ($2,000), plus the gain recognized on the transaction. Gain is recognized to the extent of boot received. Here, the boat and the cash are boot; therefore, a gain of $5,000 must be recognized. This recognized gain increases basis of the land to $50,000.
- EXAMPLE 10-9 Like-Kind Exchange
Real property with an adjusted basis of $50,000 is exchanged for $20,000 cash and like-kind property with a FMV of $40,000. The recognized gain is $10,000 ($40,000 + $20,000 – $50,000), the lesser of the gain realized ($10,000) and the boot received ($20,000).
- EXAMPLE 10-10 Like-Kind Qualified Property
Alan exchanged real property with a basis of $60,000 plus $5,000 cash for like-kind property with a FMV of $63,000. Alan’s $2,000 loss [$63,000 – ($60,000 + $5,000)] is not deductible.
- Involuntary Conversions
(Section 1033)
- A taxpayer may elect to defer recognition of gain if property is involuntarily converted into money or property that is similar or related in service or use under Sec. 1033.
- Involuntary conversion from:
- Condemnation
- Destruction
- Requisition
- Seizure
- Theft
- Threat of:
- Condemnation
- Requisition
- Property must be:
- Business/trade
- Personal property
- Real property
- Production of income
- Section 1033 basis of replacement property
- FMV of replacement property
- -
- Gain not recognized/
deferred gain
- If loss recognized:
- FMV of replacement property
- Section 1033 mandatory
- Nonrecognition is mandatory, not elective, on direct conversion to the extent of any amount realized in the form of qualified replacement property.
- Section 1033 recapture
- Determined by:
- Nature of property
in hands of transferor
- Character types:
- Section 1245
- Total of:
- Gain recognized
- Non-Section 1245 property received (FMV) in excess of:
- Gain recognized
- Section 1250
- Greater of:
- Gain recognized
- Potential
Section 1250 ordinary income in excess of:
- Section 1250 property received (FMV)
- Depreciation
recapture recognized:
- In tax year of
installment sale as:
- Ordinary income
- Section 1033 recognized gain/loss
- Gain not recognized if:
- Replacement property
is purchased:
- Similar/related in:
- Service
- Use
- Includes:
- Construction of qualified replacement property
- Types:
- Owner-user
- Functionally similar/functional use test:
- Have similiar
physical characteristics
- Be used for the
same purpose
- Owner-investor
- Close relationship to:
- Service of the
previous investor
- Use of the
previous investor
- Risks, management activities, services performed
continue without substantial change
- Exception:
- If conversion is by condemnation, like-kind property qualifies as replacement. This standard is less stringent.
- Exception:
- Generally, if property held for investment or for productive use in a trade or business is involuntarily converted due to a federally declared disaster, the tangible replacement property will be deemed similar or related in service or use.
- Replacement property
is purchased by acquiring control of corporation with replacement property:
- Control of:
- At least:
- 80%
- Voting stock
- AND
- Non-voting stock
- AND
- Replacement property is purchased within replacement period:
- Begins:
- The earlier of:
- Date of disposition
- Threat of condemnation
- Ends:
- 2 years after
- Close of first tax year
in which part of the
gain is realized
- Ends:
- 3 years after
- Close of first tax year
in which part of the
gain is realized
- Threat of:
- Condemnation
- Requisition
- Gain recognized if:
- Excess over any cost of replacement property
- Lesser of:
- Gain realized
- Reimbursement not reinvested
- Loss recognized if:
- Loss realized
- Example:
- EXAMPLE 10-11 Involuntary Conversion
Jennifer’s office building is requisitioned by the city government under eminent domain to expand a road. Jennifer is paid $500,000 for the office, which had an adjusted basis of $200,000 for the building and
$125,000 for the land. Jennifer uses the $500,000 to purchase a $600,000 office building within 6 months. Involuntary conversion rules allow Jennifer to defer recognition of the $175,000 realized gain.
- Gwen owned a duplex and lived in one-half. The other half was rental property. The cost of the property was $80,000, of which $70,000 was allocated to the building and $10,000 to the land. During the current year, the property was condemned by the city. Up to that time, she had allowed/allowable depreciation of $23,000. The city paid Gwen $70,000. She bought another duplex for $85,000. Gwen lived in one-half, and the other half is a rental. What is the basis of the replacement property?
$67,000
Your answer is correct.
Gwen has two assets, one for rental and one for personal use. Each asset must be computed separately. The basis of the rental building before the sale was $17,000 ($40,000 purchase price – $23,000 depreciation taken). That portion of the building was sold for $35,000, leaving a gain of $18,000. The gain is deferred, leaving a basis for the replacement property of $24,500 ($42,500 – $18,000). The personal-use building has a $5,000 loss ($35,000 selling price – $40,000 basis). That loss is a nondeductible personal loss. The replacement portion has a basis of $42,500, the purchase price. The total basis is $67,000 ($24,500 rental portion + $42,500 personal-use portion).
- Sale of Principal Residence
(Section 121)
- Section 121 provides an exclusion upon the sale of a principal residence. No loss may be recognized on the sale of a personal residence.
- Section 121 recognized gain/loss
- Gain recognized:
- In excess of:
- After:
- May 6, 1997
- Depreciation adjustments with respect to:
- Rental or business/trade use
- Exclude up to:
- Others
- $250,000
- MFJ
- $500,000
- If either spouse:
- Met ownership requirement
- If both spouses:
- Met use requirement
- If neither spouses:
- Sold/exchanged
residence within last:
- 2 years
- If one spouse fails to meet these requirements, the other qualifying spouse is not prevented from claiming a $250,000 exclusion.
- The exclusion may be:
- Used only once every:
- 2 years
- Loss not recognized:
- No loss may be recognized on the sale of a personal residence.
- In addition, no loss will be deducted as a result of the abandoned property.
- Requirements:
- Ownership
- AND
- Use
- Limited to:
- Qualified use
- After:
- January 1, 2009
- All dates
up to:
- Last date used as principal residence
- Otherwise must be:
- Prorated
- Aggregate of:
- 2 years of:
- 5 prior years
- If ownership and use tests are not met:
- If sale was prior to the 2 years
due to:
- Qualified hardship
- Health reasons
- Job change
- Other unforeseen
circumstances
- The exclusion may be:
- Prorated to:
- Dates of qualified use
- /
- Dates presale total
- x
- Exclusion
- Section 121 basis (in new home)
- Cost basis
- Examples:
- EXAMPLE 10-12
Sale of Principal Residence Exclusion
Harry, who is eligible for the exclusion, marries Sally, who used her exclusion last year. Harry can still claim the $250,000 exclusion even though Sally used her exclusion last year. However, the couple is not entitled to the full $500,000 exclusion available to married taxpayers who both meet the requirements for the exclusion.
- EXAMPLE 10-13
Sale of Principal Residence Exclusion
Alex purchased a home on January 1, 2021, for $200,000. He used the home as his personal residence until he sold it for $475,000 on July 1, 2022. He sold it because of a change of employment. His exclusion is limited to $187,500 [$250,000 × (18 months ÷ 24 months)].
- Qualified Small Business Stock
(Section 1202)
- Corporation Stock Exchange
(Section 351)
- Section 351 basis
- Shareholder basis in stock:
- Property transferred:
- Cash
- Property (AB)
- Intangible
- Tangible
- Services
(FMV of stock)
- -
- Boot received
- Cash
- Property (FMV)
- -
- Liability relieved
- +
- Gain recognized
- +
- Amount treated as dividend
- Holding period is tacked. The holding period of the property exchanged for stock is added to the holding period of the stock.
- Shareholder basis in boot:
- Boot received
- Cash
- Property (FMV)
- Corporation basis in property:
- Property transferred:
- Property (AB)
- Intangible
- Tangible
- When the shareholder’s AB in the property exceeds the FMV (i.e., when a built-in loss exists), the basis is limited to the FMV.
- +
- Gain recognized
- Allowable depreciation is apportioned based on the number of months the corporation owned the asset.
- Holding period is tacked. The holding period of the property exchanged includes the HP transferor.
- Section 351 mandatory
- Nonrecognition is mandatory, not elective.
- C corporation
- S corporation
- Section 351 recapture
- Determined by:
- Nature of property
in hands of transferor
- Character types:
- Section 1245
- Gain recognized
- Section 1250
- Gain recognized
- Depreciation
recapture recognized:
- In tax year of
sale as:
- Ordinary income
- Section 351 recognized gain/loss
- Exchange for stock:
- No gain/loss recognized
- Corporation
- Including treasury
stock
- Shareholder
- Exception:
- Corporation
- Gain recognized:
- The corporation recognizes gain on exchanging other property (neither money nor its stock), even with a shareholder, unless an exception applies.
- Shareholder
- Gain recognized:
- Lesser of:
- Boot received
- If cash in addition to stock is received, taxpayer must recognize gain under Sec. 351(b) to the extent of boot received by corporation:
- Cash received
- Constructive dividend received
- Liability relieved
in excess of:
- All property transferred AB
- Exception:
- All liability relieved
is gain recognized if:
- If liabilities are transferred for the purpose of tax avoidance, the full amount of liabilities will be treated as boot.
- No business purpose for the property transfer
- Tax avoidance
- Nonqualified preferred stock
- Services rendered to corporation
(equal to the FMV of the stock)
- Gain realized
- FMV of stock
- Boot received
- -
- Property transferred AB
- Gain character:
- Depends on the property transferred
- If
following apply:
- Property transferred:
- Cash
- Property
- Intangible
- Tangible
- Services do not count toward ownership control.
- By one or more persons
- Control of:
- At least:
- 80%
- Voting stock
- AND
- Non-voting stock
- Liquidation:
- Normally gain or loss is recognized on a liquidating distribution of assets [Sec. 336(a)].
- Exception:
- Loss recognized:
- Under Sec. 336(d)(1), a loss is not recognized in a liquidation on the distribution of property to a related person (which includes a greater-than-50% shareholder) unless:
- Property distributed:
- BOTH
- Prorata basis to all shareholders
- Not acquired in Section 351
- OR
- Not contributed during preceding 5 years (called disqualified property)
- Limited to:
- Post-contribution loss
- Permanent disallowance results if these conditions are not met even if the decline in value occurred post-contribution.
-
10.4 Business Property Recharacterization
-
Overview of business property recharacterization
- BACKGROUND 10-1 Special Treatment for Capital Gains
Before 1938, productive assets used in business were treated as capital property. As the Great Depression dragged on, however, it became clear that relief was needed. Businesses struggling to sell their outmoded equipment found themselves subject to the limitations on recognizing capital losses. Thus, the Revenue Act of 1938 carved out an exception to capital gain-and-loss treatment for business property. By 1942, however, another change was called for, since the treatment needed during a depression was not appropriate for a wartime economy. Firms making large profits selling to the government needed lower rates on capital gains, so Sec. 117 (forerunner of the current Sec. 1231) was modified once again to provide special treatment for capital gains.
- The topic of business property gain (loss) recharacterization often intimidates CPA candidates as they study for the exam due to the different rules applied under Secs. 1231, 1245, and 1250. Because the AICPA has tested this area relatively often, you should have a solid understanding of these rules. Take the time necessary to understand the outline and answer the multiple-choice questions to reinforce your knowledge of this area.
-
Section 1231 property
- Section 1231 property defined
- Held more than:
- 1 year
- Includes:
- Business/trade
- Involuntarily converted capital assets
- Personal property
- Tangible
- Intangible
- Real property
- Examples:
- Land
- Land is not depreciable. Thus, it does not fall within Sec. 1245 or Sec. 1250. Land is referred to as pure Sec. 1231 property if used for trade or business and held for more than 1 year.
- Manufacturing equipment
- Involuntarily converted investment artwork
- Exludes:
- Business/trade
- Accounts Receivable
- Fixtures
- Inventory
- Personal
- Personal-use property
- Section 1231 property gains/losses
- Step 1:
- Determine net gain/loss:
- Only Section 1231 casualties/thefts for the tax year
- Net loss
- Gains
- Ordinary gain
- Losses
- Ordinary loss
- Net gain
- Continue to Step 2
- Step 2:
- Determine net gain/loss:
- All Section 1231 dispositions for the tax year
- Including involuntary conversions
- Net loss
- Gains
- Ordinary gain
- Losses
- Ordinary loss
- Net gain
- Gains
- Long-term capital asset gains
- Losses
- Long-term capital asset losses
- Limited to
excess of:
- Section 1231 property recapture
- Section 1231 property recapture
- Net gains treated as:
- Ordinary gain
- Equal to:
- Unrecaptured losses
prior tax years (lookback rule):
- For the last:
- 5 tax years
- Example:
-
Section 1245 property
- Section 1245 property defined
- Held more than:
- 1 year
- Includes:
- Business/trade
- Involuntarily converted capital assets
- Personal property
- Tangible
- Intangible
- Copyrights are explicitly excluded from Sec. 1231 treatment.
- Examples:
- Goodwill
(acquired)
- Involuntarily converted investment artwork
- Leaseholds of Section 1245 property
- Manufacturing equipment
- Covenants not to compete
- Patents
- Professional athletic contracts
- Exludes:
- Business/trade
- Land
- Land is not depreciable. Thus, it does not fall within Sec. 1245 or Sec. 1250. Land is referred to as pure Sec. 1231 property if used for trade or business and held for more than 1 year.
- Section 1245 property gains/losses
- Gain recognized:
- Subject to recapture as:
- Ordinary income
- Lesser of:
- Depreciation taken
- Includes amounts expensed under Section 179
- Gain recognized
- For corporation,
gain must be computed:
- Under Section 1245
- AND
- Under Section 1250
- If excess of
Section 1245 results than 20% of the difference is:
- Ordinary income
- Excess gain:
- Section 1231 gain
- Gain not recognized:
- Refer to
nonrecognition transactions
- Loss recognized:
- Section 1231 loss
- Section 1245/1250 recapture only applies toward gains. If disposition of business property results in a loss, it is a
Section 1231 loss.
- Section 1245 property recapture
- Section 1245/1250 recapture above is computed before Section 1231 recapture
- Examples:
- EXAMPLE 10-17
Section 1245 Ordinary Income
Stewart purchased a machine for $20,000. He took $14,000 in depreciation before selling the asset for $9,000. The basis on the machine is $6,000 ($20,000 cost basis – $14,000 depreciation), so he has a $3,000 gain ($9,000 selling price – $6,000 basis). The
$3,000 is ordinary income (the lesser of the gain or depreciation taken).
- EXAMPLE 10-18
Section 1245 Ordinary Income and Section 1231 Gain
Assume the same information from Example 10-17 except Stewart sells the machine for $25,000. The realized gain is $19,000 ($25,000 – $6,000 basis). This gain has both Sec. 1245 gain and Sec. 1231 gain. The $14,000 of depreciation taken on the equipment is a Sec. 1245 gain (the lesser of the gain or depreciation taken), and the remaining gain of
$5,000 is a Sec. 1231 gain.
- EXAMPLE 10-20
Section 1245 Recapture
On January 17, Year 1, Relief Corp. purchased and placed into service 7-year MACRS tangible property costing $100,000. On December 21, Year 4, Relief Corp. sold the property for $105,000 after taking $60,000 in MACRS depreciation deductions.
The adjusted basis of the property is $40,000 ($100,000 historical cost – $60,000 depreciation); therefore, Relief will recognize a gain of $65,000 ($105,000 selling price – $40,000 adjusted basis). Since this property qualifies for Sec. 1245 recapture, the gain will be recaptured as ordinary income to the extent of the lesser of all depreciation taken or gain realized. Thus, Relief will have $60,000 of Sec. 1245 (ordinary) gain. The remaining $5,000 of gain is Sec. 1231 (capital) gain.
-
Section 1250 property
- Section 1250 property defined
- Held more than:
- 1 year
- Includes:
- Business/trade
- Real property
- Land improvements
- Examples:
- Apartment building
- Building
- Building structural compenents
- Elevators/
escalators
- Leases of land
- Section 1250 intangible properties
- Low-income housing
- Office building
- Residential rental property
- Shopping malls
- Exludes:
- Business/trade
- Land
- Land is not depreciable. Thus, it does not fall within Sec. 1245 or Sec. 1250. Land is referred to as pure Sec. 1231 property if used for trade or business and held for more than 1 year.
- May be
treated as land:
- Dams
- Irrigation systems
- Section 1250 property gains/losses
- Gain recognized:
- Subject to recapture as:
- Ordinary income
- Equal to:
- Accelerated depreciation taken
in excess of:
- Most Sec. 1250 property (e.g., 39-year nonresidential real property and 27.5-year residential real property) has been depreciated using straight-line since 1987, it is relatively uncommon to encounter Sec. 1250 recapture.
- Low-income housing/
rehabilitation structures:
Partial reduction of excess depreciation is provided for under Sec. 1250 for low-income housing and rehabilitated structures.
- S/L depreciation
- If property held for less than:
- 1 year
- Equal to:
- Remaining depreciation
- For corporation,
gain must be computed:
- Under Section 1245
- AND
- Under Section 1250
- OR
- Equal to:
- Ordinary income
- 20%
- x
- Lesser of:
- Recognized gain
- Accumulated depreciation
- If excess of
Section 1245 results than 20% of the difference is:
- Ordinary income
- Excess gain:
- Unrecaptured
1250 gain
- For amount
attributed to:
- S/L depreciation
- Section
1231 gain
- For amount
attributed to:
- Remaining gain
- Gain not recognized:
- Refer to
nonrecognition transactions
- Loss recognized:
- Section 1231 loss
- Section 1245/1250 recapture only applies toward gains. If disposition of business property results in a loss, it is a
Section 1231 loss.
- Section 1250 property recapture
- Section 1245/1250 recapture above is computed before Section 1231 recapture
- Examples:
- EXAMPLE 10-17
Section 1245 Ordinary Income
Stewart purchased a machine for $20,000. He took $14,000 in depreciation before selling the asset for $9,000. The basis on the machine is $6,000 ($20,000 cost basis – $14,000 depreciation), so he has a $3,000 gain ($9,000 selling price – $6,000 basis). The
$3,000 is ordinary income (the lesser of the gain or depreciation taken).
- EXAMPLE 10-18
Section 1245 Ordinary Income and Section 1231 Gain
Assume the same information from Example 10-17 except Stewart sells the machine for $25,000. The realized gain is $19,000 ($25,000 – $6,000 basis). This gain has both Sec. 1245 gain and Sec. 1231 gain. The $14,000 of depreciation taken on the equipment is a Sec. 1245 gain (the lesser of the gain or depreciation taken), and the remaining gain of
$5,000 is a Sec. 1231 gain.
- EXAMPLE 10-22
Section 1250 Unrecapture
Martha purchased and placed into service Sec. 1250 property costing $600,000. After 5 years, the property was sold for $650,000 after having taken $300,000 in straight-line depreciation deductions.
The adjusted basis of the property is $300,000 ($600,000 historical cost – $300,000 depreciation); therefore, Martha recognizes a gain of $350,000 ($650,000 selling price – $300,000 adjusted basis). Because the property was depreciated using straight-line depreciation, Sec. 1250 recapture will not apply. Thus, Martha will have $350,000 of Sec. 1231 (capital) gain, $300,000 of which is Sec. 1250 unrecaptured gain taxed at a maximum rate of 25%.
-
Acquired and mixed use property:
- Income received or accrued for more than one asset is allocated to each asset by agreement, by FMV, or by the residual method.
- Section 1245/1250 recapture:
- Ordinary income
- By amount realized allocated according to:
- Type of use
(1245/1250)
for each tax year
-
Example:
-
10.5 Gift Tax
- The AICPA has historically tested candidates’ knowledge on the various aspects of gift tax, specifically the annual exclusion, medical or tuition costs, and marital deductions.
-
The gift tax is a tax of the transfer
imposed on the donor referred to as:
- Gift tax liability
- Imposed on
inter vivos gifts only:
- Gifts completed
when the donor is alive
- Gift loans included unless outstanding principal exceeds:
- $10,000
- Trust transfers included
- Political contributions are not subject to gift tax.
-
The gift tax basic gift formula calculation is:
- Gift tax liability
- =
- Tentative gift tax
- Taxable gifts to date
- =
- Taxable gifts for current year
- =
- All gifts in calendar year
- FMV on date of gift
- Cash
- Includes relief of indebtedness (debt cancellation/discharge of debt to family member)
- FMV transferred property
- Includes:
- Excess:
- FMV transferred property
- Over:
- FMV consideration received
- Cash
- FMV property
- A gift is complete when the giver has given over dominion and control such that (s)he is without legal power to change its disposition.
- -
- Exclusions
- Annual exclusion:
- $15,000 (2021)
per donee
- Only allowed to gifts of present interests.
- Present interests
- A present interest in property includes an unrestricted right to the immediate possession or enjoyment of property or the income from property:
- Life estate
- Term of years
- Future interests
- Remainders
- Reversions
- Amounts
(paid directly)
on behalf of another for:
- Education tuition
- Paid directly to educational organization
- Excludes:
- Books
- Room and board
- Medical care
- Paid directly to medical provider
- Excluded from the requirement for filing:
- Charitable contributions
- The charitable contribution qualifies for exclusion when no other items are taxable.
- Medical care
- Education tuition
- -
- Deductions
- Charitable
- Deduction is FMV of property donated in excess of exclusion above
- Excluded from the requirement for filing:
- The charitable contribution qualifies for exclusion when no other items are taxable.
- Marital
- Must be:
- Married at time of gift
- Not be a support transfer
- Limited to:
- Non-US citizen spouse donee
- $159,000 (2021)
- Deduction is FMV of gift given in excess of exclusion above
- +
- Taxable gifts for prior years
- x
- Current tax rate
- The current
tax rate is:
- Starting:
- 18%
- Taxable gifts
up to:
- $10,000
- Increased in small increments over numerous brackets
- Starting:
- 40%
- Taxable gifts
in excess of:
- $1,000,000
(2021)
- -
- Prior year's gifts
- x
- Current tax rate
- AND
- Applicable
credit amount
-
Example:
- EXAMPLE 10-24
Joint Bank Account -- Completion of Gift
R opens a joint bank account with A, I, and H, with R the only depositor to the account. R, A, I, and H may each withdraw money. A gift is complete only when A, I, or H withdraws money.
- EXAMPLE 10-25
Basis of a Gift of Land
Amanda made a gift to her daughter of a piece of land with a FMV of $95,000. The land had a basis to Amanda of $60,000. She paid a taxable gift of $80,000 ($95,000 FMV – $15,000 annual exclusion) and a gift tax of $32,000 ($80,000 × 40%). The basis of the land to the daughter is carryover basis of $60,000 plus the gift tax attributable to the appreciation.
$60,000 donor's basis
+ ($35,000 increase in value /
$80,000 taxable gift)
× $32,000 gift tax
= $74,000 land basis
- EXAMPLE 10-26
Gift of a Present Interest and a Future Interest
Edward sets up a trust with the income going to his daughter for her life and the remainder to his granddaughter. Edward has made a gift of a present interest to his daughter and a future interest to his granddaughter.
- EXAMPLE 10-27
Marital Deduction
Sid Smith gave his wife, Mary, a diamond ring valued at $20,000 and cash gifts of $30,000 during 2021. Sid is entitled to a $15,000 exclusion with respect to the gifts to Mary. The marital deduction allows Sid to exclude an additional $35,000 ($20,000 + $30,000 – $15,000).
-
CPA REG SU11 - 15
-
CPA REG SU11 Corporate Taxable Income
-
11.1 Definition and Accounting
- Entities that are classified as C corporations for federal tax purposes are subject to an entity-level income tax. In addition, when a C corporation distributes its profits to its owners as dividends, the owners are subject to income taxation on the dividend income they receive. This “double” taxation is the hallmark of C corporation status.
-
Definitions by entity types:
- Corporate entities
- Tax calculated similar to individuals:
- Gross income
- All income unless excluded by code section
- Deductions
- Taxable income
- Dividend-received deductions (DRD)
- Net operating loss
(NOL)
- Tax liability
- Prepayments
(estimated payments)
- Tax credits
- Tax due/
refund receivable
- Considered special deductions
- Differences:
- No AGI
- Therefore:
No Above
or Below
-the line adjustments
- No personal
credits/deductions
- Special flat tax
rate of 21%
- Special rules
for property held
- Special taxes in addition to
income tax:
- Personal Holding Company (PHC) Tax
- Accumulated Earnings Tax (AET)
- Subject to double taxation on:
- Distributions to
shareholders
- Gross income
- Example:
- EXAMPLE 11-1
Double Taxation
Peter and Paul each own 50% of AZY Company. Assume AZY has taxable income of $500,000. If AZY is a C corporation, AZY will file Form 1120 and pay tax at a rate of 21%. So, AZY will pay $105,000 in corporate income taxes and have net income after taxes of $395,000. If AZY chooses to distribute this income to its shareholders ($197,500 each), the income will be included on Peter and Paul’s individual tax returns as dividend income and will be taxed once again. Assuming Peter and Paul qualify for a 15% tax rate on dividends, they will each incur an additional $29,625 in tax. Due to this double taxation, the total tax levied on the $500,000 of corporate income is $164,250 ($105,000 + $29,625 + $29,625).
- Can elect for classification as:
- S corp
- S corps have:
- One class of stock
- No more than 100 shareholders
- Considered a
pass-through entity:
- Shareholder share in:
- Income
- Deductions
- Credits
- Required to be taxed as corporations:
- Associations
- Foreign LLCs are by default associations
- Certain banks
- Certain foreign organizations
- Insurance companies
- Joint-stock companies
- Personal service corporation (PSC)
- Performs personal services:
- EE-owners own:
- More than:
- 10% stock
- Substantially all activities involved services perfomed:
- More than:
- 95%
gross receipts
- Substantially all activities involve services performed
in fields of:
- Accounting
- Actuarial science
- Architecture
- Consulting
- Engineering
- Health
- physicians
- nurses
- dentists
- Law
- Performing arts
- IRS allocates between
the PSC and its EE-owners:
- Income
- Deductions
- Credits
- Subject to the
corporate tax rate:
- Tax years:
- 2018
- If following conditions apply:
- All services performed for one other:
- Corporation
- Entity
- Partnership
- Principal purpose is:
- Tax avoidance
- Professional organization (PA)
- Organized under state's professional association act
- Operated as a corporation
- Publicly-traded partnerships
- State-owned organizations
- Noncorporate entities
- Disregarded entities
- Noncorporate entities with only one owner (e.g., a single-member LLC) are classified as disregarded entities. Disregarded entities are included in the tax return of their owner.
- Partnerships
- By default, noncorporate entities (e.g., LLCs, LLPs, etc.) with two or more owners are classified as partnerships for federal tax purposes.
- LLCs
- Can elect for classification as:
- C corp
- S corp
- Partnership
- LLCs have:
- Limited liability to owners
- Unlimited owners
- Ownership
operation participation
- Example:
- EXAMPLE 11-2
Check-the-Box
ABC, LLP, a limited liability partnership, is taxed as a partnership for federal tax by default because it has two or more owners (recall that a partnership must have at least two owners). However, ABC can elect under the check-the-box regulations to be taxed as a C corporation. Note that the check-the-box election does not change ABC’s entity type under state law; instead, only ABC’s classification for federal tax has changed. And, once ABC is a C corporation, if eligible, it can make an S election to be taxed as an S corporation.
- Entity classification election:
- Form 8832, Entity Classification Election:
Used to make an election to change entity classification. The entity generally cannot change its classification by election:
- During:
- 60 months
- After:
- Effective date of election
-
Accounting by entity types:
- Accounting tax year:
- Calendar year
- Fiscal year
- Corporation
- Corporation
- PSC
- PSC exception if:
- Valid business reason
- Minimum distribution
- Accounting method:
-
11.2 Formation
- Corporation Stock Exchange
(Section 351):
-
11.3 Gross Income of a Corporation
-
All income from whatever source is included in gross income of a corporation unless an specially excluded by code:
- Excluded
(Not included)
- Corporate stock/treasury stock gains
- Exception:
- When property (including stock) other than cash is distributed in exchange for services, the employer must recognize a gain on the deemed sale
- Nonshareholder transfers
- Money
- Property
- If property is contributed within 1 year of gift of money, AB of property is equal to the month contributed reduced in proportion to the relative basis of the property.
- Exception:
- If nonshareholder is:
- Civic group
- Customer
- Actual
- Potential
- Government entity
- If transfers subsequently donated to charity:
- If a taxpayer receives unsolicited samples from a supplier that are of a type normally inventoried and sold in the ordinary course of business, and are subsequently given to an exempt organization, the FMV of the samples is gross income. The FMV is then allowable as a charitable contribution deduction.
- Transfers of:
- Part of normal inventory
- Property
(FMV as gross income)
- Shareholder capital contributions
- Included
- Income assigned to another
by the corporation
- Sinking fund earnings
- If a corporation establishes a sinking fund under the control of a trustee for the payment of its debt, any gain arising from the fund must be included in income of the corporation. Including both the interest and the net long-term capital gains.
-
11.4 Deductions of a Corporation
- Deductions of a corporation have been regularly tested on the CPA Exam. You should be familiar with calculating both corporate book income and corporate taxable income. In a question testing corporate deductions, you may be given corporate book income, along with other information, and asked to calculate corporate taxable income.
- Business/trade and expenses
-
Charitable contributions
- A corporation’s charitable contribution is deductible only if:
- Qualified organization
- Cash
- Property
- Capital gain property
- The property must be used in a manner related to the organization’s exempt purpose. It must not be disposed of for value.
- Ordinary
income property
- Inventory
- AB
- FMV if:
- See link
- Qualified food/book inventory
- AB
- +
- 50% of FMV gain
- Cannot exceed twice the AB
- +
- Any additional costs to provide the food to the food bank
- Paid during the tax year including amounts accrued if:
- Authorized by board of directors during the tax year
- Paid no later than:
- 3 1/2 months
- After the tax year
- Limited to:
- Under CARES Act:
- Tax years:
- 2020
- 2021
- Tax years:
- All others
- 10% of
- Excess over
taxable income:
- Carryforward
- 5 years
- Current-year contributions are deducted first.
- FIFO treatment applies to carryforwards.
- 25% of
- Contributions paid in cash for relief efforts in qualified disaster areas (excluding COVID-19) is:
- 100% of
- Taxable income (TI)
before:
- Bond premium deduction
- Allowable under Section 249
- Capital loss carrybacks
- Charitable contributions
- DRD
-
Dividends-received deduction (DRD)
- A special C corporate deduction
(DRD not eligible for S corporations) for dividends received from domestic taxable corporations is allowed.
- Dividends received from:
- Corporation
- Domestic
(unaffiliated)
- Taxable
- A dividend received by one from another member of a group filing a consolidated return is eliminated. The recipient adjusts its taxable income to eliminate the dividend from the group’s consolidated taxable income.
- Foreign
- Taxable
- In addition, the credit for foreign taxes deemed paid by the corporation on the dividend producing earnings and profit (E&P) may be allowable.
- Not a foreign holding company
- Stock ownership at least:
- 10%
- US effectively connected income
- The DRD is allowable only on the portion of the dividends attributable to the effectively connected income.
- Does not hold short position
- A corporation cannot take a DRD if it holds a short position in substantially similar or related property.
- Stock held:
- More than:
- 46 days
- To be eligible for the DRD, a corporation must hold the stock at least 46 days during the 91-day period that begins 45 days before the stock becomes ex-dividend with respect to the dividend.
- Disallowed if dividend received from:
- Domestic international
sales corporations (generally)
- Exempt corporations
- Exempt during the distribution year
- Mutual savings banks
- Dividends are considered interest
- Public utilities
- Dividends from preferred stock
- Real estate investment trusts
- Limited to:
- Taxable income (TI) before:
- For stock ownership %:
- Less than:
- 20%
- Deduct:
- Lesser of:
- 50% of dividend
- 50% of TI
- Less than:
- 80%
- Deduct:
- Lesser of:
- 65% of dividend
- 65% of TI
- Less than:
- 100%
- Deduct:
- Equal to:
- 100% of dividend
- First, compute the limit with respect to 20%-and-more-owned corporate dividends.
- Before:
- Capital loss carrybacks
- Certain adjustments for extraordinary dividends
- DRD
- NOL carrybacks
- QBID
- Investment company
limited (in addition):
- Investment company receives substantial amounts of income from sources other than dividends from domestic corporations eligible for the DRD.
- Taxable income limit does not apply if:
- Current NOL exists
- NOL results from DRD
-
Interest expense deduction
- Limited to:
- Business interest income
- 30% of:
- Business adjusted taxable income
- Taxable income before:
- Amortization
- Depletion
- Depreciation
- NOL deduction
- Nonbusiness/trade:
- Deduction
- Gain
- Income
- Loss
- QBID
- Floor plan financing interest
- Floor plan financing interest refers to interest paid or accrued on debt used to finance the acquisition of a motor vehicle held for sale or lease and secured by the inventory.
- Interest paid/incurred on debt:
- Secured by:
- Inventory
- To finance:
- Motor vehicle held for sale
- Motor vehicle held for lease
- Excess of interest expense deduction limitation:
- Carryforward
- Unlimited
- Exception:
- Limitation on the interest expense deduction does not apply to small businesses who met the gross receipts test:
- Entities that meet the gross receipts test:
- Has $26 million or less average gross receipts
- In the 3 preceding years consisting of:
- The test year
- The preceding 2 years
- For each test year
- Interest expense deductions include:
- Original issue discount (OID)
- Further limited to:
- Constant yield method
to amortize the discount
- 1st year:
- Original issue price
- x
- Yield to maturity %
- x
- Accrual period
- -
- Face amount
- x
- Bond issue %
- x
- Accrual period
- =
- Interest
- Following years:
- Adjusted issue price
(Original issue price
+ Interest above)
- x
- Yield to maturity %
- x
- Accrual period
- -
- Face amount
- x
- Bond issue %
- x
- Accrual period
- =
- Interest
- Bond repurchase premiums
- Further limited to:
- If excess of repurchase price over issue price adjusted for OID:
- Bond repurchase price
- Exceeds:
- Original issue price
- No more than the normal call premium on nonconvertible debt is allowable, unless the corporation can show that the excess is not attributed to a conversion feature.
- A call premium not exceeding 1 year’s interest at the rate stated in the bond is considered normal.
- If excess of issue price over the repurchase price:
- Original issue price
- -
- Premium income
previously recognized
- Exceeds:
- Bond repurchase price
- The difference is included in income for the taxable year.
- Example:
- Interest expense deductions do not include:
- Stock redemption of
related person costs
- Stock redemption for
corporate reorganization costs
- Interest expense incurred on business borrowings is deductible in the period in which it is paid or accrued. However, other expenses related to a stock repurchase or reorganization are not deductible.
- Organization/start-up cost amortization
-
11.5 Losses of a Corporation
- Capital losses
- Net operating loss (NOL)
-
CPA REG SU12 Corporate Tax Computations
-
12.1 Regular Income Tax and Credits
- Foreign Tax Credit
-
12.2 Consolidated Returns
- The AICPA has tested candidates’ knowledge of the rules and regulations for filing consolidated returns. Most of the released AICPA questions test the theory and do not require calculations.
-
A consolidated return (single federal income tax return) may be filed by two or more includible corporations that are members of an affiliated group.
- Consolidated return if:
- Affiliated group:
- At least:
- 1 includible (parent)
corporate member
- Owns stock of at least 1 includible corporate member.
- 1 Includible
corporate member
- The other group members must directly own stock in the parent corporation.
- Stock ownership
(directly):
- 80% of:
- Voting power
- 80% of:
- Total value
outstanding
-
Consolidated return calculation
- Step 1
- Compute taxable income of each member of the group
- Step 2
- Compute certain
consolidated amounts
- Capital gains/losses
- Charitable contribution deductions
- Dividends paid deductions
- Dividends received deductions
- A dividend distributed by one member of a group filing a consolidated tax return to another member of that group is eliminated. The recipient of the dividend makes an adjustment to its separate taxable income that eliminates the dividend from the affiliated group’s consolidated taxable income.
- NOL deductions
- In general, a pre-consolidation NOL carryforward from a company that joins a consolidated group can only offset that company’s taxable income (not another company’s income in the consolidated group).
- Percentage depletion of
mineral properties
- Section 1231 gains/losses
- Step 3
- Compute consolidated NOL
- Operating losses of one group member must be used to offset current-year operating profits of other group members before a net operating loss carryforward can occur.
- Taxable income
(separate net taxable income)
- +
- Net capital gains
- -
- Charitable contribution deductions
- Dividends received deductions
- Dividends paid deductions
- Section 1231 net loss
- =
- Consolidated NOL
-
Consolidated return excluded corporations
- Domestic international sales corporations (DISC)
- Foreign sales corporations (FSC)
- Insurance corporations
- Regulated
investment companies
- Real estate
investment trusts (REIT)
- S corporations
- Tax-exempt corporations
-
Consolidated return rules
- Consented by each includible corporate member
- Each includible corporate member (subsidiary) that has been a member of a parent-subsidiary affiliated group during any part of the taxable year for which the first consolidated return is to be filed must consent to the initial filing
- Each includible corporate member (subsidiary) must adopt the parent's tax year
- Each includible corporate member (subsidiary) allowed to keep its cash/accrual method
- Controlled group restrictions (mandatory rules for certain related companies) apply without regard to some of its members filing a consolidated return
- Consented by IRS to terminate election
- Consolidated return intercompany transfers:
- Intercompany property purchases:
For consolidation purposes, the buyer in the intercompany transaction assumes:
- Transferor:
- Basis
- Character of property
- Determined with reference to the consolidated group.
- HP
- Gain/loss recognized when:
- Buyer claims depreciation
- One of the parties leaves the consolidated group
- Sold to (outside) third party
- Lesser of:
- Sum of:
- Intercompany gain
- Third party gain
- Third party gain
- Called the
"single-entity approach"
- Intercompany transactions:
In certain other intercompany transactions, the income and expense items net each other out.
- An intercompany distribution paid by the distributing member is:
- Not included in the gross income of the distributee member if the distribution:
- (1) would otherwise be taxable under Sec. 301 and
- (2) produces a corresponding negative adjustment to the basis of the distributing corporation’s stock
- Stock basis is generally decreased for intercompany distributions, whether paid from preaffiliation or post-affiliation earnings.
- Example:
- EXAMPLE 12-3
Character of Gain or Loss -- Sale Outside Consolidated Entity
P and S are two affiliated corporations that file consolidated tax returns. P sells an asset held for investment (i.e., a capital asset) to S at a gain of $10,000. S holds the property as inventory and sells to an unrelated party at an additional gain of $5,000. Under the single-entity approach, the consolidated entity recognizes $15,000 of ordinary income upon the sale to the outside party.
If the gain on the sale to the unrelated party were $2,000 less than the intercompany gain of $10,000, the recognized gain of the consolidated entity would be only $8,000.
- Elected by filing a consolidate return
-
12.3 Controlled Groups
- A controlled group of corporations includes corporations with a specified degree of relationship by stock ownership.
-
Controlled group types:
- Parent-Subsidiary Controlled Group
- At least:
- 1 includible (parent)
corporate member
- 1 Includible
corporate member
- Stock ownership
of each other
(directly):
- 80% of:
- Voting power
- OR
- 80% of:
- Total value
outstanding
- Any other corporation that own stock in one of the corporations above.
- Example:
- EXAMPLE 12-4
Parent-Subsidiary Controlled Group
Each corporation has a single class of stock. P owns 80% of S stock. P and S each own 40% of O stock. P, S, and O each own 30% of T stock. P, S, O, and T are a controlled group.
- Brother-Sister Controlled Group
- At least:
- Five persons
(individual/
estates/trusts)
- Stock ownership
of each corporation
(directly):
- 80% of:
- Voting power
- OR
- 80% of:
- Total value
outstanding
- At least:
- Five persons
(individual/
estates/trusts)
[Counting only identical interests]
- The stock of each corporation counting only identical ownership interests (i.e., the smallest amount owned by each person in any of the corporations is all that is counted).
- Stock ownership
of any corporation
(directly):
- 50% of:
- Voting power
- OR
- 50% of:
- Total value
outstanding
- Example:
-
Controlled group rules:
- Controlled group constructive ownership:
- Stock both actually and constructively owned is counted. Generally, for purposes of determining whether a control group exists, a person constructively owns stock owned by a:
- Person also owns
stocked owed by:
- Ancestors
- Parents
- Grandparents
- Lineal descendants
- Children
- Grandchildren
- Spouses
- Not legally separated
- Stock included is:
- Stock which shareholder holds an option to buy
- Person also owns
stocked owed by:
- Corporation
- Not S corporation
- At least:
- 50% of
value of stock
- Estate
- Beneficiary
- Owner
- Partnership
- Trusts
- Stock included is:
- Stock which shareholder holds an option to buy
- Person must own at least:
- 5% interest
in these entities
- In proportion to that interest
- Controlled group shared tax benefits:
- Accumulate earnings tax
- $250,000
- General business credit
- $25,000
- Section 179 maximum of:
- $1,050,000 (2021)
- A controlled group generally may choose any method to allocate the amounts among themselves. By default, an item is divided equally among members.
- Controlled group intercompany transfers:
- Intercompany property transfers:
For controlled group purposes, the buyer in the intercompany transaction assumes:
- Transferor:
- Basis
- Character of property
- HP
- Gain/loss recognized when:
- Buyer claims depreciation
- One of the parties leaves the consolidated group
- Sold to (outside) third party
- Lesser of:
- Sum of:
- Intercompany gain
- Third party gain
- Third party gain
- Called the
"single-entity approach"
- The IRS is authorized to redetermine the price for property transferred between members of a controlled group to reflect income clearly or to prevent tax evasion.
- Three methods to determine an arm’s-length price are by reference to:
- Comparable uncontrolled prices
- Cost plus return
- Resale prices
- Intercompany transactions:
Expenditure to a controlled group member is not deductible before being included in the income of the payee.
-
12.4 Estimated Tax
- Corporate due dates
-
Corporate estimated payments
- For a calendar-year taxpayer, the installments are due by:
- April 15th
- June 15
- September 15
- December 15
- Each installment must be at least 25% of the lowest of the following amounts:
- 100% of the prior year’s tax
- Tax liability existed
- Tax year full 12 months
- Disallowed if:
- Large corporation
- Taxable income
more than:
- $1 million
- Preceding:
- 3 years
- 100% of the current year’s tax
- 100% of the annualized year’s tax or
the adjusted seasonal installment method
- Uneven cash flows
- Any increase in estimated tax during the year should be reconciled and paid on the next estimated payment. A large corporation may make its first quarter estimated tax payment based on the preceding year’s tax liability and make up any difference in its second quarter payment.
-
Corporate penalties
- Estimated tax penalty:
A penalty is imposed if, by the quarterly payment date, the total of estimated tax payments and income tax withheld is less than 25% of the required minimum payment for the year.
- Estimated tax penalty:
Interest will be charged from the original due date.
- The penalty is equal to:
- Federal
short-term rate
- +
- 3% times the underpayment
- 5% times underpayments exceeding:
- $100,000
- The penalty is determined each quarter.
- The penalty is not allowed as an interest deduction.
- Estimated tax penalty will not be imposed if any of the following apply:
- Actual tax liability shown on the return for current tax year:
- Current tax year
liability is exceeded by:
- Refundable credits
- If tax credits exceed the tax liability, the taxpayer will not owe taxes and thus does not have to pay any estimated taxes. A $1 credit reduces tax liability by $1.
- Withholding
- Less than:
- $500
- The IRS waives all or part of the penalty for:
- Good cause
- An erroneous IRS notice to a large corporation is withdrawn by the IRS
- EXAMPLE 3-2 Underpayment Penalty
Taxpayer has a tax liability of $11,000 for 2021. Taxpayer’s employer withheld $7,000 for 2021. Taxpayer’s 2020 liability was $7,000 and AGI was $160,000.
Even though only $700 [($7,000 prior year liability × 110%) – $7,000 current year withholding] is subject to the penalty, the $1,000 minimum exception does not apply due to the fact that the exception is based on the current year. The total tax liability shown on the tax return of $11,000 minus the amount paid through withholding of $7,000 is greater than $1,000. Hence, the taxpayer will be subject to an underpayment penalty.
- Estimated tax overpayment refund request:
A corporation may obtain a quick refund of estimated tax paid if:
- Overpayment is:
- At least:
- $500
- AND
- At least:
- 10% of the estimated tax liability
- The application (Form 4466 Corporation Application for Quick Refund of Overpayment of Estimated Tax) must be filed:
- After:
- Close of the tax year
- Before:
- Return due date
(without extensions)
- Failure to file or pay on time penalty:
Results in a penalty based on the unpaid liability (Tax liability – Prepaid amount).
- Failure to file:
A failure-to-pay penalty may offset a failure-to-file penalty. A penalty of the following is assessed for failure to file a return:
- 5% per month of unpaid liability
(up to 25%)
- Failure to file (on time/late filing):
The minimum penalty for filing a return over 60 days late is:
- The lesser of:
- $435
(for 2021 returns filed in 2022)
- 100% of tax due.
- Failure to pay (tax on time):
A failure-to-pay penalty may offset a failure-to-file penalty. In general, a failure-to-pay penalty is imposed from the due date for taxes (other than the estimated taxes) shown on the return. Any tax liability must be paid by the original due date of the return, however, if at least 90% of its tax liability is paid by the original due date no penalty will be imposed. A penalty of the following is assessed for failure to pay tax:
- 0.5% per month of unpaid liability
(up to 25%)
- Interest penalty:
Interest accrues from the date the payment was due until it is received by the IRS.
-
12.5 Earnings and Profits
-
E&P defined: The term “earnings and profits”
(E&P) is the federal tax accounting version of financial accounting’s retained earnings. Though similar in purpose, they are not the same amount. E&P determines whether corporate distributions are taxable dividends.
- Current E&P
- Current year
taxable income/loss
- +
- Positive adjustments
- Capital carryover
- Completed-contract method income
- DRD
- Excluded life insurance proceeds
- Excess depreciation
- Exempt income
- Installment sale deferred income
- -
- Negative adjustments
- Charitable deduction exclusion
(excess of AGI limit)
- Entertainment expenses
- Excessive compensation
- Federal income taxes
- Fines
- Life insurance premiums
- Installment sales
(prior years)
- Meals expense exclusion (50%)
- Municipal bond expenses
- Penalties
- Exceptions:
- Exclusions from both E&P and taxable income:
- Gifts
- Shareholder
capital contributions
- State tax refunds
(no tax benefit)
- Unrealized gains/losses
- Accumulated E&P
- Current E&P
- -
- Dividend
distributions
- Any distributions in excess of current E&P reduce the accumulated E&P balance
- +
- Shareholder distributions recognized gains
(net of related federal tax)
- Tax on the gain and FMV reduce E&P
- Example:
-
12.6 Distributions
- The CPA Exam has often contained questions regarding shareholder treatment of corporate distributions. A common question format has asked for the distribution amount that is taxable as dividend income to the shareholder.
-
Distribution defined: A distribution is any transfer of property by a corporation to any of its shareholders with respect to the shareholder’s shares in the corporation.
- Property transferred to shareholder:
- +
- Bonds (FMV)
- Cash
- Stock (FMV)
(other corps)
- Receivables
- Tangible property
(FMV)
- -
- Liabilities
- Recourse
- Nonrecourse
- =
- Distributed
amount
-
Distribution in the form of dividends
- Amount of a distribution
is a dividend (to extent of E&P):
- Dividend distribution
- To extent of:
- Current E&P
- Dividend distributions during the year are prorated computed on current E&P
as of the close of the tax year
- 1st preferred stock
- 2nd common stock
- Then:
- Accumulated E&P
- Deficit in accumulated E&P does not offset current E&P. It never results from a distribution. It results from:
- Current E&P deficit
- In excess of:
- Accumulated E&P
- Dividend distributions include:
- Constructive dividends
- Money borrowed to purchase personal items
- Use of corporate vehicles
- Amount of a distribution
is a dividend (in excess of E&P):
- Return of capital
- To extent of:
- Shareholder's basis in stock
- Then:
- Capital gain
- When distributions during the year exceed current E&P, pro rata portions of each distribution are deemed to be from current E&P.
- Example:
- Amount of a distribution
is an extraordinary dividend:
- Subsequent sale:
- Additional gain recognized on extraordinary dividend
- Extraordinary dividend:
- Stock
held at least:
- 2 years
- Exceeds
basis in stock by:
- 10%
- 5%
for preferred
- Gain recognized:
- Nontaxed (DRD)
portion of the dividend
- Exceeds:
- Stock basis
-
Distribution in the form of stock
- Corporate gain/loss recognition
on stock distribution (its stock)
- No gain/loss recognized
- Shareholder gain/loss recognition
on taxable stock distribution
(or rights to acquire stock)
- Gain recognized
- Gross income
if one of the following apply:
- Disproportionate distribution
- Distribution in lieu of cash (i.e., the shareholder had the option to take cash instead of the stock)
- Distribution of common and preferred stock, resulting in receipt of preferred stock by some shareholders and common stock by other shareholders
- Distribution of convertible preferred stock and the effect is to change the shareholder’s proportionate stock ownership
- Distribution on preferred stock
- Distribution of constructive stock that change proportionate interests resulting from, e.g., a change in conversion ratio or redemption price
- Greater of:
- Stock (FMV)
- Cash/other property (FMV)
- The holding period begins the day following the acquisition date.
- Shareholder gain/loss recognition
on (nontaxable) stock distribution
- No gain/loss recognized
- Nontaxable stock distribution
if one of the following apply:
- Proportionate distribution
- A shareholder allocates the aggregate basis (AB) in the old stock to the old stock and new stock in proportion to the FMV of the old and new stock. Basis is apportioned by relative FMV to different types (e.g., common, preferred) of stock if applicable.
- The holding period of the distributed stock includes that of the old stock.
- Stock rights
- Basis is allocated based on the FMV of the rights plus the exercise price. No deduction is allowed for basis allocated to stock rights that lapse. Basis otherwise allocated remains in the underlying stock.
- FMV of the stock
upon which it was issued:
- The rights have a basis of $0.
- If stock rights aggregate FMV:
- Less than:
- 15%
- Unless an election is made to allocate basis
- The holding period of the stock begins on the exercise date.
- Stock split
- Basis in the old stock is also “split” and allocated to the new stock.
- The holding period of the new stock includes that of the old stock.
-
Distribution rules
- Corporation required to file for distribution during the calendar year:
- 1099-DIV
- Each shareholder distribution:
- At least:
- $10
- Any withheld federal income taxes under backup withholding rules
- Liquidations
(complete or partial)
- At least:
- $600
- Corporation distributes property to shareholder gain/loss recognition:
- Gain recognized:
- Gain recognized on gain realized
on property at (FMV)
- Liabilities. FMV is conclusively presumed to be no less than liabilities related to the property subject to which the shareholder assumes or takes the property, whether with recourse or not.
- If gain recognized:
- More than:
- 50% shareholder distributee
- Gain is:
- Ordinary income
- If gain recognized
(on depreciated property):
- Lesser of:
- Depreciation taken
- Gain realized
- Gain is:
- Ordinary income
- Loss recognized:
- Loss not recognized on realized loss
- Gain realized on a subsequent taxable disposition to an unrelated party is recognized only to the extent it exceeds the previously disallowed loss.
- Exception:
- Loss not recognized on realized loss unless the redemption is:
- Complete liquidation of corporation
- Estate shareholder
(to pay death taxes)
- Exception to the exception:
- Liquidation of 50% shareholder
-
12.7 Accumulated Earnings Tax (AET)
-
The AET is a penalty tax imposed on C corporations that, for the purpose of avoiding income tax at the shareholder level, allow current-year earnings to accumulate instead of distributing them to shareholders. This tax is in addition to the corporate income tax.
- AET liability determined by IRS audit:
- A corporation does not file a form to compute AET with its annual income tax return.
- 20% of accumulated taxable income (ATI)
- ATI calculated by:
- Current E&P
- -
- Dividends paid
- -
- Accumulated earnings credit (AEC)
- Limited to:
- Greater of:
- (1)
- Accumulated earnings credit (AEC)
- Others
- $250,000
- PSCs
- $150,000
- -
- Accumulated E&P
(prior year)
- (2)
- Reasonable
business needs
- Reasonable needs of a business include only those items required to meet future needs documented
in plans that are:
- Foreseeable
- Specific
- Reasonable items:
- Acquistion of related business
- Business contingencies (realistic)
- Business debt retirement
- Equipment update
- Investments or loans to suppliers or customers
- Production facilities expansion
- Product liability loss reserves
- Raw materials purchase
- Redeeming stock in gross estate of a shareholder
- Working capital
- Not reasonable items:
- Business hazard protection (unrealistic)
- Funding plans to declare a stock dividend or redeem stock of a shareholder
- Investment property unrelated to business activities of the corporation
- Loans to shareholders
- =
- ATI
- x
- 20%
- =
- AET
- No offsetting credit or deduction is allowed for either the corporation or its shareholders, not even upon subsequent distribution of the earnings.
- AET not taxed on following entities:
- Passive foreign investment companies
- Personal holding companies
(foreign/domestic)
- S corporations
- Tax-exempt corporations
-
12.8 Personal Holding Company (PHC) Tax
- The AICPA has tested candidates’ knowledge of the personal holding company tax. Remember that one income amount, personal holding company income, is used to determine whether or not a corporation meets the nature of income test in determining if it is a PHC. If the corporation is a personal holding company, then another income amount, undistributed personal holding company income, is used to calculate the amount of personal holding company tax owed by the corporation. Be careful not to confuse these two amounts.
-
The PHC tax is a penalty tax imposed on the undistributed income of personal holding companies. The tax is designed to deter passive investors from using a C corporation to avoid higher individual rates.
The penalty tax is in addition to the regular corporate income tax. A corporation cannot be subject to the PHC tax and the AET in the same year.
- PHC tax liability determined by PHC:
- Self-assessment of PHC tax liability is required. Schedule PH is filed with Form 1120 by a PHC.
- Statue of
filing limitations:
- 6 years
- If a corporation determines that it is liable for the PHC tax, it can reduce or eliminate the tax by paying a deficiency dividend within:
- 90 days
- Pay deficiencydividend
- 20% of undistributed UPHCI
- UPHCI
- Undistributed PHCI:
- PHCI
- -
- Dividends paid
- The full amount of distributions treated as ordinary dividend income are deductible, as are consent dividends. A consent dividend is treated as a dividend currently taxable to the shareholders even though no distribution was made.
- One type is a throwback dividend, a dividend paid during the 3 1/2 months following the tax year (and treated as paid on the last day of the preceding tax year).
- Federal taxes accrued
- Capital gains
(net of related federal tax)
- PHC tax liability determined by:
- Stock ownership test
- More than:
- 50% of value of shares
(directly/
indirectly)
- At least:
- Five or fewer shareholders
- If 10 or more unrelated taxpayers own equal shares, the ownership requirement cannot be met.
- At any
time during:
- The last half of the year
- Nature of income test
- At least:
- 60% of
AOGI is PHCI
- AOGI
- Adjusted ordinary gross income:
- Gross income (for regular tax)
- -
- Capital gains from
asset dispositions
- -
- Certain deductions
(rental/royalty deductions)
- PHCI
- Specifically defined passive income:
- Dividends (domestic unrelated)
- Net rental income
- Personal services income
(25% or more owner)
- Royalties
- Taxable interest
- PHC not taxed on following entities:
- Banks
- Insurance companies
- Personal holding companies (foreign)
- S corporations
- Tax-exempt corporations
-
CPA REG SU13 Corporate Tax Special Topics
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13.1 Redemptions
-
Overview of redemptions:
Stock is redeemed when a corporation acquires its own stock from a shareholder in exchange for property, regardless of redeemed stock being canceled, retired, or held as treasury stock. A shareholder is required to treat amounts realized on a redemption (not in liquidation) either as a distribution (a corporate dividend) or as a sale of stock redeemed.
- Stock redeemed:
- Corporation acquires stock from shareholder in exchange for property.
- Corporation realized gain:
- Shareholder realized gain:
- Dividend distribution
- Stock sale
- Capital gain/loss treatment
- Property
received in exchange:
- Cash
- Property (FMV)
- -
- Liabilities assumed
- The holding period for the property starts the day after the redemption exchange.
- -
- Shareholder's basis in stock
- Allocation of capital gain/loss to each block of stock is required.
- If one of the following apply:
- Distribution:
- Complete redemption of
all of shareholder's stock
- Family attribution rules apply can be waived if shareholder does not:
- (1) Retain an interest
(as EE, officer, director, or SH, creditor excepted)
- As creditor is allowable
- (2) Reacquire any interest for 10 years
- By bequest/inheritance
is allowable
- (3) Written agreement filed with IRS that ex-SH will notifiy IRS if
interest reacquired
- Estate shareholder
- Redeemed stock:
- 35% of the gross estate
(net of deductions)
- Deductions allowed:
- Administrative expenses
- Claims against the estate
(including death taxes)
- Funeral expenses
- Unpaid mortgages
- Partial liquidation of noncorporate shareholder's stock
- If the following conditions apply:
- Distribution occurs:
- In year of the plan
- In year of
after the plan
- Genuine contraction of corporate business:
- Safe harbor:
- Contracted business operated for at least 5 years ending with
date of distribution
- After distribution, active business/trade continues by corporation was conducted at least 5 years
- Partial liquidation plan filing required
- Form 966 Corporate Dissolution or Liquidation
- Redemption:
- Not essentially equivalent
to a dividend
- Meaningful reduction in the shareholder’s proportionate interest in the corporation. Reduction in voting power is generally required for a redemption. Shareholders in control of a corporation must generally lose control to qualify as not essentially equivalent to a dividend.
- Reduction from:
- 51%
- Reduction to:
- 49%
- Substantially disproportionate
- Determined by ownership percentage
(including
constructive ownership):
- After redemption:
- Less than:
- 50% of voting power
- AND
- Less than:
- 80% of:
- Common stock before redemption
- Voting stock before redemption
- Stock acquired can be:
- Canceled
- Held as treasury stock
- Retired
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13.2 Complete Liquidation
- Corporation complete liquidation treatment
- Shareholder complete liquidation treatment
-
Liquidation expenses (complete/partial liquidation) incurred are deductible in full by the dissolved corporation on final tax return including:
- Filing fees
- Liquidation-related expenses
- Professional fees
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13.3 Partial Liquidation
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Corporation partial liquidation treatment
- The corporation making the distribution recognizes gain but not loss.
- Shareholder partial liquidation treatment
-
13.4 Subsidiary Liquidation
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Neither the parent corporation nor a controlled subsidiary recognizes gain or loss on a liquidating distribution to the parent.
- No gain/loss recognized
- Included is no gain recognition on distributions that satisfy obligations of the subsidiary to the parent.
- Carryover applied to:
- Basis property transferred
- HP property transferred
- Tax attributes including:
- Capital losses
- Charitable contribution carryover
- NOLs
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13.5 Reorganizations
- The CPA Exam has required candidates to determine from a series of facts whether a qualified reorganization has occurred. It also has tested candidates on the basic characteristics of the types of reorganizations.
-
For federal tax purposes, a qualified reorganization of one or more corporations is considered a mere change in form of investment rather than a disposition of assets. For this reason, a general rule of nonrecognition applies to qualifying reorganizations. However, gain is recognized to the extent of boot received.
- Reorganization gain/loss recognition:
- Reorganization
gain/loss recognition:
(Corp transferor)
- Gain recognized
to extent of
boot distributed/not distributed to transferee
- Cash distributed/not distributed to transferee
- Property
distributed/not distributed to transferee
- Liability relief if it was for a nonbusiness or tax-avoidance purpose is included. The amount of liability in excess of basis is treated as the FMV of the property.
- Liability
- In
excess of:
- Property basis
- Loss not recognized
- Exception:
- No loss is recognized unless distribution is to a creditor.
- No loss is recognized unless post-acquisition gain realized
- Reorganization
gain/loss recognition:
(Corp transferee)
- Gain recognized
to extent of
appreciated property distributed to the transferor
- Appreciated Property distributed to transferor
- Loss not recognized
- Reorganization
transferee basis in:
- Property acquired from transferor
- Exchange basis
- +
- Gain recognized
- Reorganization
gain/loss recognition:
(Shareholder)
- Gain recognized
to extent of
boot received
- Lesser of:
- Gain realized
- Property (FMV)
- Securities received when none are surrendered are included in property
(FMV).
- Treated as:
- Dividend to extent to E&P
- The shareholder is deemed to have received only stock and then to have redeemed the stock for cash. Gain is treated as a dividend (OI) to the extent of E&P, if the exchange has the effect of a dividend distribution.
- Example:
- Loss not recognized
- Reorganization
shareholder basis in:
- Stock
- Exchange basis
- Boot
- Tax cost
- Reorganization rules:
- Reorganization nonrecognition
- Reorganization nonrecognition applies only:
- To the extent each of several statutory and judicially sourced requirements are met.
- With respect to distributions in exchange for stock or securities of a corporation that is a party to the reorganization
- Reorganization plan required
- Reorganization must be pursuant to a plan, a copy of which is filed with the tax return of each participating corporation.
- Business purpose, other than tax avoidance, must be present.
- Reorganization
original owner's interest
- At least:
- 40% continuity of
equity interest by value
(is the benchmark)
- Business purpose, other than tax avoidance, must be present.
- Reorganization
original business continuity
- The acquiring corporation must continue:
- Operating the historic business of the acquired corporation
- OR
- Use a significant portion of the acquired corporation’s historic business assets
- Continuing a significant line of business is sufficient if there was more than one.
- Reorganization rules apply to:
- C corporations
- S corporations
- Reorganization types:
- Type A:
- Statutory consolidation/merger
- Consolidation
- Existing corporations are combined into a newly formed corporation.
- Merger
- Under state law, two corporations merge into one. Stock in the non-surviving corporation is canceled. In exchange, its shareholders receive stock in the surviving corporation. One of the corporations remains, while the other is no longer in existence.
- Type B:
- Stock-for-stock
- Shareholders acquire stock of a corporation solely for part or all of the voting stock of the acquiring corporation or its parent.
- Stock-for-stock
Controlled Group
- Stock ownership
of transferor
(directly):
- 80% of:
- Voting stock of transferee
- Boot not exhanged/allowable.
- Type C:
- Stock-for-assets
- One corporation acquires substantially all the assets of another in exchange for its voting stock (or its parent’s). The transferor (sale of assets) corporation must liquidate.
- Substantially all assets:
- Equal to:
- 90% of
Net assets
(FMV)
- Net assets:
- Assets
- -
- Liabilities
- AND
- 70% of
Gross assets
- Boot limited/allowable.
- Exchange of assets for nonvoting stock:
- Limited to:
- 20% of
Assets acquired
- Type D:
- Division
- A corporation transfers all or part of its assets to another in exchange for the other’s stock. The transferor or its shareholders must control the transferee after the exchange. The stock or securities of the controlled corporation must be distributed to shareholders of the corporation that transferred assets to the controlled corporation. Distribution of the stock need not be pro rata among the shareholders of the corporation that transferred assets to the controlled corporation. Thus, division of the original corporation may result.
- Division Controlled Group
- Stock ownership
of transferor
(directly):
- 80% of:
- Voting stock of transferee
- AND
- 80% of:
- Each class of nonvoting stock of transferee
- Type E:
- Recapitalization
- The capital structure of the corporation is modified by exchanges of stock and securities between the corporation and its shareholders.
- Type F:
- Reincorporation
- Stock and securities are exchanged upon a mere change in the name, form, or place of incorporation.
- Type G:
- Bankruptcy reorganization
- Stock, securities, and property are exchanged pursuant to a court-supervised bankruptcy proceeding.
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13.6 Multiple Jurisdictions
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Multijurisdictional Issues for State Taxes
- A tax jurisdiction is a geographic area with its own distinct set of tax rules and regulations, e.g., a municipality, county, state, or country. When a taxable transaction has occurred across multiple jurisdictions, authoritative guidance must be established in order to reconcile or override the distinct sets of tax rules that may apply (e.g. Foreign Tax Credit).
This subunit explains two of the longest-standing rules for interstate taxation:
- Public Law (PL) 86-272
- Uniform Division of Income for Tax Purposes Act (UDITPA)
- Tax Jurisdiction:
- Geographic area with its own set of tax rules and regulations examples include:
- County
- Country
- Municipality
- State
- Although the applicable taxes are state (not federal) taxes, these rules are tested as federal taxation by the AICPA because they are established at the federal level.
-
Cross-Boundary Taxation
- In tax law, a “foreign” entity (not a citizen of a given tax jurisdiction, e.g., city, county, state, nation) is required to have a nexus to the tax jurisdiction before a sales tax or income tax may be imposed on the activities of that entity.
- Before income/sales tax imposed:
- Nexus required
(sufficient physical presence)
-
Multiple Jurisdictions Sales Tax
- In 1967 and 1992, the U.S. Supreme Court ruled that states cannot collect sales taxes on retailers unless there is a physical presence (nexus) within the state. In 2018, the U.S. Supreme Court reversed direction and ruled in the Wayfair case that the physical presence test of the prior cases was unsound and incorrect. This has resulted in:
- Before sales tax imposed:
- By state (almost every state)
- Nexus required
(based on economic threshold)
- Nexus may be having an
in state:
- A physical location
- Employees who
regularly solicit business
- Real or intangible property
(owned or rented)
- Resident employees
- Significant sales or transactions
- Nexus may be avoided by:
- Forwarding services in states without sales taxes (e.g., Oregon) have been used to avoid the sales tax; however, if that occurs, the sale may be traced back up the distribution chain.
- An entity is generally allowed to offset taxes paid to another jurisdiction either by:
- Credit
- A direct tax credit for U.S. taxes
- For the tax credit, the payer must not receive a specific benefit from paying the tax. The right to engage in business is not considered a benefit for this purpose.
- Deduction
- A deduction of the foreign taxes paid
-
Multiple Jurisdictions Income Tax
- The form of organization may influence how cross-border events and transactions are taxed including:
- A Corporate Branch
- A branch is not a separate legal entity of the parent company, but is a legal extension of the head office. The parent company is subject to taxes on all income, not just branch income.
- A Corporate Subsidiary
- A subsidiary is a separate legal entity owned by a parent company. The most common are single-member limited liability corporations (LLCs), which are pass-through entities in which the owner pays the income tax. However, a subsidiary may be set up so the income does not pass through to the owner.
- A branch is a legal extension of a head office and is more advantageous when losses exist, whereas a subsidiary may be set up so the income is not passed to the owner and is advantageous where profits exist.
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Public Law (PL) 86-272 (Interstate Act of 1959)
- Before a state can tax a nonresident (e.g., a resident of another state), a minimum presence in the taxing state by the nonresident must be established. As mentioned above, sufficient presence to tax the nonresident is nexus. Multistate Tax Commission’s (MTC’s) “Statement of Information Concerning Practices of Multistate Tax Commission and Signatory States Under Public Law 86-272”.
- Before income/sales tax imposed:
- Nexus required
(minimum physical presence)
- Nexus is established if:
(unprotected activities list)
- Approving or accepting orders
- Carrying samples for sale, exchange, or distribution in any manner for consideration or other value
- Collecting on accounts
- Conducting any activity not listed as protected that is not entirely ancillary to requests for orders, even if such activity helps to increase purchases
- Conducting training courses, seminars, or lectures for non-soliciting personnel
- Consigning stock of goods or other tangible personal property for sale
- Entering into or disposing of a franchise or licensing agreement or transferring related tangible personal property
- Hiring, training, or supervising personnel (other than personnel involved only in solicitation)
- Installing a product at or after shipment or delivery
- Investigating creditworthiness
- Investigating, handling, or otherwise assisting in resolving customer complaints, other than mediating direct customer complaints with the sole purpose of ingratiating the sales personnel with the customer
- Making repairs to or performing maintenance or service on the property sold or to be sold
- Maintaining a sample or display room at any one location in excess of 14 days during the tax year
- Maintaining, by the employee or other representative, an office or place of business of any kind other than a qualified “in-home” office
- NOTE: Generally, telephone or other public listings indicating company/employee contact at a specific location creates nexus; however, normal distribution of business cards/stationery does not create nexus.
- Owning, leasing, using, or maintaining any of the following facilities or property in-state:
- Meeting place for directors, officers, or employees
- Mobile stores
- Office other than “in-home” office
- Parts department
- Real property or fixtures to real property of any kind
- Repair shop
- Stocks of goods other than samples
- Telephone-answering service publicly attributed to the company/representative
- Warehouse
- Picking up or replacing damaged or returned property
- Providing technical assistance or service for purposes other than the facilitation of the solicitation of orders
- For example, engineering assistance or design service
- Repossessing property
- Securing deposits on sales
- Using agency stock checks or any other instrument or process by which sales are made within the home state by sales personnel
- The MTC’s uniformity committee has issued a whitepaper on the Wayfair Implementation, but this topic is still evolving.
- Nexus is not established if:
- All of the following three requirements are met:
- Orders sent out of state for approval/rejection
- Orders shipped/delivered from a point out of state
- Solicitation of orders of tangible personal property
- Nexus is not established if:
(protected activities list)
- Carrying free samples and promotional materials for display or distribution
- Checking customers’ inventories (e.g., reorder, but not quality control)
- Coordinating shipment/delivery and providing related information without charge
- Furnishing display racks and advising customers of the products without charge
- Maintaining a sample/display room at one location for less than 14 days during the tax year
- Mediating customer complaints solely for ingratiating the sales personnel with the customer and facilitating order request
- Missionary sales activities
- For example, a manufacturer’s solicitation of retailers to buy the manufacturer’s goods from the manufacturer’s wholesale customers
- Owning, leasing, using, or maintaining personal property for use in the employee’s “in-home” office or automobile that is solely limited to the conducting of protected activities
- Passing orders, inquiries, and complaints on to the home office
- Providing automobiles for conducting protected activities
- Recruiting, training, and evaluating sales personnel
- Soliciting orders for sales by any type of advertising
- Soliciting orders by an in-state resident with only an “in-home” office
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Uniform Division of Income for Tax Purposes Act (UDITPA)
- The UDITPA was drafted by the National Conference of Commissioners on Uniform State Laws and is recommended for enactment in all states.
- Each state decides adoption of UDITPA
- If nexus is established:
- UDITPA provides:
- Uniform method for:
- Apportioning business income
- Uses the formula below to calculate the average amount of business income a company brings in by conducting operations within the taxing state
- Allocating nonbusiness income
- To a specific state or local taxing authority for income derived solely from assets held for investment purposes
- UDITPA business income apportionment
- UDITPA formula:
- Payroll factor
- In-state compensation paid
- /
- All compensation paid
- Property factor
- Average value of in-state
real/tangible personal property
- /
- Average value of all
real/tangible personal property
- Property owned:
- Original cost (not AB)
- Property rented:
- Net annual rental rate
(rate paid
- rate received
from subrentals)
- x 8
- Sales factor
- In-state sales
- /
- All sales
- Most states use only the single sales factor.
- Sales means net sales after discounts and returns.
- Sales shipped to a state with no taxation of the taxpayer (i.e., no nexus) may be thrown back and taxed by the shipped-from state. If neither state taxes the taxpayer, the state in which the order was taken may be apportioned the sale.
- All factors:
- Totaled and
divided into 3
- UDITPA nonbusiness income allocation
- UDITPA by property type:
- Capital gains/losses
- Real property
- By property location
- Intangible personal property
- By commercial domicile (home state)
- Tangible personal property
- By property location at time of sale or
commercial domicile if not taxed in state property located at time of sale
- Dividends
- By commercial domicile (home state)
- Interest
- By commercial domicile (home state)
- Rents (net)
- Real property
- By property location
- Tangible personal property
- By proportional use within state or
commercial domicile if not organized or taxed in the state the property is used
- Royalties (net)
- Real property
- By property location
- Tangible personal property
- By proportional use within state or
commercial domicile if not organized or taxed in the state the property is used
- Royalties
(Copyright/Patents)
- By proportional use within state or
commercial domicile (home state)
- UDITPA allocation/apportionment alternative
- If the allocation and apportionment provisions do not fairly represent the taxpayer’s in-state activity, the taxpayer may request or the state may require:
- The employment of any other method to equitably
allocate and apportion the income
- The exclusion of any one or more factors
- The inclusion of one or more additional factors
- Separate accounting (typically costly and difficult to carry out)
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Multijurisdictional Issues for Multinational Transactions
- Noncorporate U.S. taxpayers are subject to tax on worldwide income. This may result in the income being subject to double-taxation. In an effort to mitigate double-taxation, various allowances have been made (e.g., foreign earned income exclusion, Foreign Tax Credit). These allowances, to varying degrees, give up U.S. jurisdiction over foreign income.
- Noncorporate US taxpayers taxed on:
- Worldwide income using either:
- Foreign-earned income exclusion
- Foreign tax credit
- Corporate taxpayers have moved from a worldwide system of taxation to a quasi-territorial system of taxation. The result is that the foreign-sourced income of foreign corporations at least 10% owned by U.S. corporations is not subject to U.S. taxation
(the participation exemption) with some notable and significant exceptions (e.g., Subpart F, GILTI).
- Corporate US taxpayers taxed on:
- More than:
- 10% owned by US corporation income
- Subpart F income
- To prevent improper avoidance, the IRS may attempt to reallocate items affecting taxable income as if the transactions were conducted in an arm’s-length transaction between uncontrolled parties.
- Nonresident aliens are usually only subject to U.S. income tax on U.S. source income.
- Nonresident aliens taxed on:
- US source income
-
Base-Erosion and Anti-Abuse Tax (BEAT)
- The Tax Cuts and Jobs Act added Sec. 59A, Payments of Taxpayers With Substantial Gross Receipts, which imposes on each applicable taxpayer a tax:
- Foreign person treated as:
- Related party for which a deduction is allowable
- Related party with meaning of:
- Section 267
- Section 482
- Equal to:
- Base erosion minimum tax for the taxable year
- Tax year after:
- 2017
- Foreign related party ownership of:
- 25% of:
- Voting power of all classes of stock of applicable taxpayer
- OR
- Value of stock of all classes stock of applicable taxpayer
- 25% of:
- Owner of the foreign related party taxpayer
- Section 59A does not apply to:
- Real estate investment trust
- Regulated investment company
- S corporation
- Section 59A does apply to:
- Passes
gross receipts test:
- Average annual gross receipts
- Prior:
- 3 tax years
- At least:
- $500 million
- Base erosion percentage
for the tax year of:
- At least:
- 3%
- 2% for affiliated group member
- Base erosion percentage:
- Aggregate base erosion tax benefits for tax year
- /
- Allowable
base erosion deductions
- Section 59A minimum tax for taxable year
- 10% of:
- Modified taxable income
- Exceeds:
- Applicable taxpayer's
regular tax liability
- -
- Certain specified tax credits
-
Global Intangible Low-Taxed Income (GILTI)
- In an attempt to encourage the return of intangible property to the U.S., new provisions have been created to move U.S. taxation to a more territorial system than the historical taxation on worldwide income.
- Incentive
- Foreign-Derived Intangible Income (FDII)
- Penalty
- Global Intangible Low-Taxed Income (GILTI)
- Foreign-sourced income that is
included in U.S. corporate income with a:
- GILTI imposed on domestic taxpayer:
- Corporation
- Estate
- Individual
- Partnership
- Trust
- GILTI calculation:
- Formula:
- GILTI
- =
- Net CFC tested income
- -
- Net deemed tangible income return
- 10% of QBAI
- -
- Specified interest expense
- Limited to:
- 80% of allowable FTC
(no carryover allowed)
- Components:
- Qualified Business Asset Investment (QBAI)
- Basically includes the adjusted basis of tangible property used in the business and depreciable property. In essence, a corporation will face a GILTI inclusion of the excess if:
- Earns a return
- In
excess of:
- 10% of QBAI
- Specified interest expense
- The amount of interest expense taken into account in determining the net CFC tested income for the taxable year to the extent the interest income attributable to that expense is not taken into account in determining the net CFC tested income.
- Part I of
Form 8992
- Net CFC tested income
- Sum of pro rata share CFC tested income
- -
- Sum of pro rata share CFC tested loss
- CFC tested income defined:
- Gross income (less exclusions)
- CFC tested loss defined:
- Deductions (including taxes) allocable to the income
- Domestic taxpayer ownership in CFC:
- At least:
- 10% of voting rights
- Required to include its GILTI as currently taxable income, regardless of whether any amount is distributed to the shareholder.
- 50% deduction is allowed for GILTI income
- Equal to:
- 10.5% minimum tax on
certain global income
- The 10.5% is derived from 21% corporate tax rate less the 50% GILTI deduction.
-
Foreign-Derived Intangible Income (FDII)
- Foreign-Derived Intangible Income (FDII)
- Foreign-sourced income that is
included in U.S. corporate income with a:
- FDII imposed on domestic taxpayer:
- C corporation
- FDII calculation:
- FDII formula:
- FDII
- =
- Deemed intangible income
- Deduction-eligible income
- -
- 10% of QBAI
- x
- Foreign-derived
deduction-eligible income
- /
- Deduction-eligible income
- This is gross income less exceptions and allocable deductions.
- FDII consideration:
- Is the income deduction-eligible income?
- Income does not include:
- CFC dividends received
- Domestic oil and gas extraction income
- Finance service income
- Foreign branch income
- GILTI
- Subpart F income
- Is the income foreign-derived deduction-eligible income?
- Subsequent questions used to answer:
- Was the property sold to a non-U.S. person or the service provided outside the U.S., and in the case of property sold, was it for use, consumption, or disposition not within the U.S.?
- Was the property sold or service provided to an unrelated domestic intermediary? If so, the income is not foreign even if it is subsequently sold to or provided for a foreign use.
- Was the property sold to a non-U.S. person or the service provided outside the U.S. to a related party, as defined in item 3. in Study Unit 12, Subunit 2, except with a 50% threshold instead of 80%, who is not a U.S. person? If so, the subsequent sale or service to an unrelated party must be foreign as well, i.e., not sold or provided to a U.S. person.
- From Study Unit 12
Subunit 2:
- Affiliated group:
- At least:
- 1 includible (parent)
corporate member
- Owns stock of at least 1 includible corporate member.
- 1 Includible
corporate member
- The other group members must directly own stock in the parent corporation.
- Stock ownership
(directly):
- 50% of:
- Voting power
- 50% of:
- Total value
outstanding
- 37.5% deduction is allowed for FDII income
- Equal to:
- 13.125% tax rate on certain foreign income
- The 13.125% is derived from 21% corporate tax rate less one minus a
37.5% deduction.
-
Federal Filing Requirements for Cross-Border Business Investments
- Another significant filing requirement is the reporting of:
- Foreign financial accounts
- Reporting required of:
- US citizen
- US resident
- Any taxpayer
doing business in US
- Signatory authority or other authority over any number of foreign financial accounts:
- Must file:
- Form FinCEN Report 114 Report of Foreign Bank and Financial Acounts (FBAR)
- A related form is Part III of Form 1040 Schedule B.
- Filed electronically through the Bank Secrecy Act (BSA) e-file system with the Treasury’s Financial Crimes Enforcement Network
(FinCEN).
- Due by:
- April 15th
(or extension)
- Aggregate value
more than:
- $10,000
- Anytime during calendar year
- Failure to file an FBAR is subject to both
civil and criminal penalties.
- Foreign financial assets
(specified)
- Reporting required of:
- US citizen
- US resident
- Any taxpayer
doing business in US
- Signatory authority or other authority over specified financial assets:
- Must file:
- Form 8938
Statement of Specified Foreign Financial Assets
- Form 8938 is required to be filed with an individual’s annual income tax return. Individuals not required to file an annual income tax return are not required to file Form 8938.
- Due by:
- April 15th
(or extension)
- Aggregate value
more than:
- $50,000
- Last day of year
- Aggregate value
more than:
- $75,000
- Anytime during calendar year
- MFJ
- $100,000
- Last day of year
- $150,000
- Anytime during calendar year
-
Tax Withholding in the U.S.
- Three types of tax withholding are imposed in the U.S., depending on the payment source:
- Withholding on:
- Wages earned
- Income tax
- Medicare
- Social security
- Payments to:
- Foreign corporations
- Foreign partnerships
- Foreign parners
- Foreign persons
- NRA
- Payments of:
- Dividends
- Interest
- Required if:
- A person fails to provide a tax identification number to the payer
- The IRS has notified the payer that the payer must withhold taxes
- Backup withholding generally:
- 30%
-
CPA REG SU14 S Corporations
-
14.1 Eligibility and Election
-
S corporation overview
- The AICPA has used theoretical questions to test candidates’ knowledge of requirements for S corporation eligibility, election, and termination.
- An S corporation is generally not subject to a federal tax on its income. Its items of income, loss, deduction, and credit are passed through to its shareholders on a per-day and per-share basis. Each shareholder is taxed on his or her share of the S corporation’s income as it is earned (the qualified business income deduction is discussed in Study Unit 7, Subunit 3). Distributions of cash or property generally are not income to its shareholders.
-
S corporation election
- Can elect
S corporation status:
- Domestic corporations
- Financial institutions that are:
- Cooperative bank
- Domestic building/loan associations
- Mutual savings banks
- Must be without
capital stock organized/operated for mutual purposes and without profit
- Cannot elect S corporation status:
- Domestic international sales corporations (DISC) (current/former)
- Financial institutions using:
- Allowance method of accounting
- Reserve method of accounting
for bad debts
- Insurance companies
- Possession corporation
- A type of corporation permitted under the US tax code whose branch operation in a US possession can obtain tax benefits as though it were operating as a foreign subsidiary.
-
S corporation eligibility
- S corporation
stock class:
- Only 1 class of stock permitted
- Variation in voting rights of that one class of stock is permitted.
- Rights to profits and assets on liquidation must be identical.
- Debt may be treated as a disqualifying second class of stock.
- Issuance of debt does not disqualify S corporation status. A conversion feature or some other provision that would entitle the debtholder to control of the corporation is generally needed to disqualify S corporation status.
- S corporation
shareholders:
- Only up to 100 shareholders allowed
- A husband and wife are considered a single shareholder for this purpose.
- Family members in a six-generation range are considered one shareholder (up to six generations from the common ancestors of lineal descendants).
- Family attribution rules apply:
- Individual also owns
stock owned by:
- Children
- Grandchildren
- Parents
- Spouse
- Not legally separated
- A nonresident alien (NRA) may not own any shares.
- Cannot be S corporation
shareholders:
- Corporations
- An entity subject to the federal corporate income tax
- CRAT/CRUTs
- Charitable Remainder Unitrusts, and Charitable Remainder Annuity Trusts
- NRA
- Partnerships
- Each shareholder must be a/an:
- Estate
- Individual
- US citizen
- US resident
- Includes an individual owner of a single-member LLC
- Trust
- Certain small business trusts
- Individually-owned trust
- Qualified after death:
(begins day of death)
- 2 years
- Qualified after death
stock transfer to trust:
(begins transfer date)
- 2 years
- A trust created primarily to exercise the voting power of stock transferred to it.
- Tax-exempt organizations
- For example, qualified retirement plan and only charitable organizations under Sec. 401(a) or
501(c)(3).
- S corporation
incorporation:
- The S corporation must be incorporated in the U.S. An S corporation no longer has to be a domestic corporation, but only has to be a domestic entity that elects to be taxed as a corporation under the check-the-box regulations.
- S corporation
can own:
- C corporations
- Qualified Subchapter S Subsidiaries
(QSSS)
- A QSSS is an electing domestic corporation that qualifies as an S corporation and is 100% owned by an S corporation parent. The operations of a QSSS are included in the parent’s tax return.
- S corporations can have qualified subsidiaries. The subsidiary can be either an S or a C corporation, and the ownership requirement is 80% or more of the stock of the subsidiary. Unlike its C corporation subsidiaries, however, an S corporation cannot elect to file a consolidated return with its affiliated C corporations. Dividends received by the S corporation from the C corporation are not considered passive investment income to the extent the dividends are related to the earnings and profits of the C corporation derived from the active conduct of a trade or business.
-
S corporation rules
- S corporation elections
- Accounting method
- Elected by S corporation
- Accrual method if:
- Inventory sales are a material part of the S corporation’s operations, the accrual method must be used to calculate gross profit.
- Elected by S corporation shareholders:
- Foreign income tax
- Credit
- OR
- Deduction
- Oil/gas properties depletion
- Cost depletion
- OR
- Percentage depletion
- Mining exploration expenditures (treatment)
- Tax treatment
- S corporation
- Administrative and judicial proceedings to determine proper treatment of items are unified at the level of the S corporation.
- The S corporation items of income, loss, deduction, and credit are determined at the corporate level.
- The S corporation files a tax return
(Form 1120-S U.S. Income Tax Return
for an S Corporation)
- Due by:
- 15th day of the 3rd month following the close of the tax year
- S corporation shareholder
- Each shareholder must report a pro rata share of income and expenses on his or her personal tax return.
- The shareholder’s pro rata share of items is reported on his or her tax return for his or her tax year in which the S corporation tax year ends.
- The shareholder’s reporting must be consistent with the corporate return. The shareholder characterizes each item as the corporation would.
- An exception applies if the shareholder notifies the IRS of the inconsistency.
- Example:
- EXAMPLE 14-3
Time of Reporting S Corporation Items
Compliance Corporation is a calendar-year S corporation. Compliance has two shareholders: Shelly, with a year end of June 30 of the current year, and Julie, with a year end of December 31 of the current year. Because Julie is a calendar-year taxpayer, she will report any current-year income from Compliance on her current-year return. Shelly, on the other hand, will report any current-year income from Compliance on her return for the following year.
- Tax year
- Adopt fiscal year if:
- IRS consents
- With IRS consent, if it establishes a valid business purpose for doing so, that coincides with a natural business year.
- Natural business year ends:
- Peak or seasonal period of a cyclical business (ski resort)
- OR
- Greater than:
- 25% of
gross receipts
- Ooccur in last two months of proposed year
- Over a 3-year period
- New S corporation files/deposits
(Section 444 election)
- Form 8716 Election To Have a Tax Year
Other Than a Required Tax Year
- Due by:
- Earlier of:
- 15th day of the 5th month following the 1st month
of effective tax year
- Tax return due date for the tax year resulting from the election
- Deposit:
- Deferred tax amount
- Up to:
- 3 months deferred income
- Old S corporation continues
- May continue to use the fiscal year previously adopted
- Example:
- EXAMPLE 14-1
Fiscal Year Natural Business Year
Acme, Inc., an S corporation, provides tax preparation services. Normally its required tax year would be a calendar year. However, because greater than 25% of Acme’s gross receipts have occurred in March and April over the past 3 years, Acme has a business purpose for a fiscal year ending on April 30.
- S corporation revocation
- Effective no earlier than:
(without IRS consent)
- 5 years
(after election date)
- Effective revocation
consented by:
- 50% majority shareholders
(voting/nonvoting)
- A new shareholder who owns more than 50% of the S corporation stock may revoke the election within 60 days after his or her stock acquisition and also at any time thereafter
- S corporation status filing
- Form 2553 Election by a Small Business Corporation
- For 1st year effective date
due by:
- 2.5 months of the beginning of the corporation's tax year
- Election made after will become effective on the first day of the following tax year.
- The IRS can treat a late-filed election as timely filed if it determines that reasonable cause existed for failing to file the election in a timely manner.
- Consented by:
- All shareholders at the time the election is made includes each person who was a shareholder at any time during the part of the tax year before the election is made.
- If any former shareholders do not consent, the election is considered made for the following year.
- The IRS can waive the effect of an invalid election resulting from failure to qualify as an S corporation and/or failing to obtain the necessary shareholder consents.
- S corporation termination
- Upon a terminating event,
S corporation status:
- C corporation
- The IRS may waive termination. The terminating event must be inadvertent and corrected within a reasonable time.
- Terminating event:
- Effective revocation
- Eligibility failure
(only any one day)
- Passive investment income (PII) termination
- When S status is terminated, creating a short year, nonseparately computed income is allocated on a pro rata basis unless an election is made to allocate items according to the books and records of the corporation (its accounting methods) instead of by daily proration.
- Effective date of termination:
- Terminating event date
- Following tax year for PII if:
- For 3
consecutive tax years
- Has:
- Passive Investment Income (PII) Tax Payment
- Terminating event
(re-eligibility of
S corporation status):
- 5 years
(after the first taxable year in which the termination was made, unless IRS consent is given)
-
14.2 Operations
- Past CPA Exams have contained questions asking for calculations of both a shareholder’s adjusted basis in S corporation stock and a shareholder’s share of net income from the S corporation.
-
S corporation additional tax treatment
- Additional tax considerations
- Excess Business Loss
- Failure to File/Pay (on time) Penalty
- If tax is due:
- Failure to File
(filed late/incomplete) penalty
- AND
- Failure to pay (on time) penalty
- 5% (up to 25%)
per month
of the unpaid balance
- Includes portion of a month late
- More than:
- 60 days late
- Lesser of:
- Tax due
- $435
- Failure to File
(filed late/incomplete) penalty
- $210 per month
late or incomplete
- Includes portion of a month late
- x
- # of shareholders
during any part of the year
- Not subject to following taxes:
- Corporate income tax
- Consequently, no C corporation NOL carryovers with the exception of the built-in gains tax (see Subunit 14.4).
- AET (accumulated earnings tax)
- PHC (personal holding company) tax
- Report of nonseparately stated items
(pass-through items)
- Amortizable items
- Circulation increases
(of a periodical)
- Recovery period:
- 3 years
- Intangible drilling costs
- Recovery period:
- 5 years
- Mining exploration and
development costs
- Recovery period:
- 10 years
- Research and
experimentation costs
- Recovery period:
- 10 years
- Employee fringe benefits
- Special rules:
- More than:
- 2% of stock
S corporation
shareholder of all the outstanding stock
- Any day during the tax year
- Any amount paid on their behalf:
- Deductible compensation
- Include in
gross income
- Includes:
- Accidents and health plan premium payments (includes 2% shareholder)
- Excludable for Social Security and Medicare if the payments are made under a “qualified plan”
(treat all employees uniformly and do not give preferential treatment to key employees) such as a cafeteria plan.
- 2% shareholder or more owner must include in income however they may take deduction for-AGI to extent of self-employment earnings.
- Cafeteria plans
- Employment achievement award
- Group-term life insurance coverage up to $50,000
- Health savings account contributions
- Meals and lodging furnished for the convenience of the employer
- Medical reimbursement plans and disability plans
- Personal use of employer-provided property or services
- Qualified transportation benefits
- Excludes:
- Adoption assistance program
- Educational assistance program
- Compensation for injury and sickness
- Dependent care assistance program
- De minimis fringe
- Employee achievement award
- No-additional-cost service
- On-premise athletic facilities
- Pension payments
- Profit-sharing plan payments
- Qualified employee discount
- Qualifying retirement planning services
- Working condition fringe
- Interest expense (noninvestment)
- Other income/expense items
- Organizational costs
- Taxes (excluding federal income tax)
- A deduction is not allowed for federal income taxes paid during the year.
- Utilities
- Allocation based on shareholder's basis:
- Per-day
- Per-share
- HP includes:
- Date after acquisition
- Date of disposition
- Exception:
- IRS reallocation:
- Pro rata shares of S corporation items passed through may be reallocated by the IRS among shareholders who are members of the same family.
- Distributive shares must reflect reasonable compensation for services or capital furnished to the corporation by family members.
- The IRS may disregard a stock transfer (by gift or sale) motivated primarily by tax avoidance.
- Report of separately stated items
- Amounts previously deducted
(e.g., bad debts)
- Charitable contributions
- Credits
- Dividends
- Investment income and related expense
- Net short-term
capital gains and losses
- Net long-term
capital gains and losses
- Other deductions whose separate treatment could affect a shareholder’s tax liability
- Real estate activities
- Section 1231 gains and losses
- Section 179 deduction (immediate expensing of new business equipment)
- Tax-exempt interest and related expense
- Taxes paid to a foreign country or to a U.S. possession
-
S corporation shareholder basis
- Stock basis:
- Cost
- Property transferred for stock (AB)
- Section 351 nontaxable transfer
- Debt basis:
- Loan amount
- If shareholder guarantees third-party loan must:
- Make payments on the loan
- Be recourse debt
- Be primary signer on the note
(S corporation as guarantor)
- If shareholder lends to the
S corporation must:
- Have personal liability
(recourse debt)
- Pledged as security for repayment property not used in activity of the S corporation
- Stock/debt basis recalculated with
increases/decrease of pro rate share:
- End of tax year
- Nonseparately/separately
stated items
- Decreased for:
- Distributions to shareholder
- Decreased before determining allowable loss deduction
- Nondeductible expenses
- A nondeductible expense decreases stock basis so that the nondeductible expense does not result in less gain recognized upon disposition of the stock.
- S corporation losses
- Current tax
deductibility
limited to:
- At-risk rules
- Stock basis
- Debt basis
- Once stock basis has been reduced to zero, the shareholder's basis in debt (owed by S corporation to the SH) is reduced (not below zero):
- Subsequent losses
- Limited to:
- Excess of restored debt
- In other words, subsequent losses may be deducted in a subsequent tax year in which basis is restored to debt. Disallowed losses can be carried forward indefinitely.
- Passive activity rules
- Passive activity losses
- Limited to:
- Passive activity income
- Passive activity includes rental activity or any activity of the corporation in which the shareholder does not materially participate. Material participation by the S corporation is not sufficient.
- Basis is decreased even if current deductibility of the loss is prohibited by the at-risk or passive activity rules.
- Increased for:
- Oil/gas properties depletion
- Depletion deduction
- In excess of:
- Depletion property basis
- Passive Investment Income (PII) Items
- PII tax liability is allocated to the PII items and reduces the amount of the item passed through to shareholders.
- SH stock
holding period:
- Includes:
- Date after acquisition
- Date of disposition
-
14.3 Distributions
- Distributions include nonliquidating and liquidating distributions of money or other property but not of the S corporation’s own stock or obligations. The amount of a particular distribution is the sum of any money plus the FMV of property distributed.
-
Distributions related to shareholder accounts
- Distributions of property to SH
- Gain recognized on distributions of appreciated property
(FMV over AB)
- Ordinary income results if the property is depreciable in the hands of a more-than-50% shareholder.
- Gain not recognized on liquidating distributions of installment obligations
- The shareholder treats each payment as a passed-through item.
- Loss not recognized on distributions of property
(AB over FMV)
- Loss nondeductible/not recognized by SH
- Loss decreases the
SH stock basis
- SH takes the
distributed property's FMV
- Types of shareholder accounts
- These accounts are adjusted before each shareholder determines the proper treatment of his or her distributions.
- Accumulated adjustments account (AAA)
- AAA includes:
- Increases:
- S corporation operation income
- Gain recognized on distributions of appreciated property
(FMV over AB)
- Ordinary income results if the property is depreciable in the hands of a more-than-50% shareholder.
- Decreases:
- Nondeductible expenditures
- AAA balance can be reduced below zero by the corporation’s operations
- AAA excludes:
- Losses
- In excess of:
- Income/gains
- Tax-exempt income
- Tax-exempt income related expenses
- Previously taxed income account (PTI)
- Accumulated (Subchapter C) E&P
- Other adjustments account (OAA)
- OAA includes:
- Increases:
- Life insurance proceeds
- Tax-exempt income
- Decreases:
- Life insurance proceeds related expenses
- Tax-exempt income related expenses
- Shareholder stock/debt basis
- Distribution based on following order of SH accounts:
- Accumulated adjustments account (AAA)
- Cash distributions within a relatively short transition period subsequent to termination of an S election are treated as a return of capital to the extent of the AAA.
- Treated as:
- Reduces AAA and basis
- Tax-free return of capital
- Previously taxed income account (PTI)
- Money distributions then come from previously taxed income after the accumulated adjustments account has been exhausted.
- Treated as:
- Reduces PTI and basis
- Tax-free return of capital
- Accumulated (Subchapter C) E&P
- An election may be made to treat distributions as coming first from Subchapter C E&P.
- Treated as:
- Reduces AE&P
- Taxed as dividend
- Other adjustments account (OAA)
- Treated as:
- Reduces OAA and basis
- Tax-free return of capital
- Shareholder stock/debt basis
- Treated as:
- Reduces basis
- Tax-free return of capital
- Shareholder stock/debt basis (excess of)
- Treated as:
- Excess of basis
(basis = zero)
- Capital gain
-
Example:
-
14.4 Special Taxes
-
Although S corporations are not generally subject to income tax, the following four special taxes are imposed on S corporations.
- Built-In Gains (BIG) Tax
- BIG tax recognition period:
- Start:
- Date of conversion
(effective date of
S corporation election)
- End:
- 5 years later
- BIG tax liability if:
- Has:
- Subchapter C
net appreciated assets
(upon conversion
after 1986
to end of the
recognition period)
- To avoid circumvention of a taxable liquidation, an S corporation that, upon conversion from C to S status, had net appreciation inherent in its assets up to the amount of built-in gain on conversion during the recognition period.
- Offset by:
- Gasoline tax credits
- Subchapter C Capital loss carryover
- Subchapter C NOL carryover
- BIG tax liability
- Lesser of:
- Net appreciated assets
(net recognized built-in gain)
- Taxable income
if not a S corporation without regard to:
- Dividends-received deduction
- Dividends-paid deduction
- NOL deduction
- x
- 21%
- The tax liability is passed through, as a loss, pro rata to its shareholders. It reduces basis in each shareholder’s stock and any AAA balance. Subchapter C E&P are not reduced by BIG tax liability.
- S corporations are required to make estimated payments of BIG tax.
- Example:
- General Business Credit (GBC) Recapture
- GBC recapture if:
- Has:
- GBC credits used during C corporation tax years
- An S corporation remains liable for any recapture attributable to credits during C corporation tax years.
- LIFO Recapture
- Recapture income spread over four equal installments:
- Start:
- Last C corporation year
- End:
- First three
S corporation years
- LIFO recapture if:
- Has:
- FIFO inventory value
- Any excess of the FIFO inventory value over the LIFO inventory value at the close of the last tax year of C corporation status is gross income to a corporation that used the LIFO method to inventory goods.
- In excess of:
- LIFO inventory value
(at close of last C corporation year)
- LIFO recapture:
- Excess LIFO
- Gross income
- Four equal installments
- Basis of the inventory is increased by the amount on which the recapture tax is imposed.
- Passive Investment Income (PII) Tax
- Net PII (NPI):
- PII:
- Gross receipts
- Annuities
- Dividends
- Interest
- Includes tax-exempt interest
- Rents
- Royalties
- -
- Interest on accounts/notes receivable for inventory sold in ordinary course of business/trade
- Rents from a lease under which significant services are rendered to the lessee (those not customarily rendered)
- -
- Related expenses directly attributable
to the production of PII
- PII tax liability if:
- Has:
- Subchapter C E&P
(on last day)
- Former C corporation E&P or acquired E&P in a tax-free reorganization
- PII
- Greater than:
- 25% of
gross receipts
- Gross receipts are gross receipts of the S corporation for the tax year
- -
- Capital losses
(excluding stock/security)
- To extent of:
- Capital gains
- PII tax liability
- Excess NPI
- NPI
(for the tax year)
- x
- PII
- Greater than:
- 25% of
gross receipts
- /
- PII
(for tax year)
- x
- 21%
- PII tax liability is allocated to the PII items and reduces the amount of the item passed through to shareholders.
- S corporations are required to make estimated payments of PII tax.
-
CPA REG SU15 Partnerships Formation and Income
-
15.1 Partnership Formation and Tax Year
- The AICPA has tested on the calculation of the initial basis of a partner’s interest in a partnership. Questions have described the various items contributed by a partner and asked for the amount of the contributing partner’s basis in the partnership.
- Some prior exam questions have neglected to identify an interest as capital or profits. In these cases, the interest was tested as capital. We suggest that if you see a question not indicating the type of interest, you should assume it is capital.
-
A partnership is a business organization other than a corporation, trust, estate, or qualified joint venture co-owned by two or more persons and operated for a profit.
- Partnership is:
- Flow-through entity
- Owned by:
- 2 or more individuals
- Operated for profit
- Partnership is not:
- Estate
- Corporation
- Qualified
joint venture
- Trust
-
Partnership basis
- Partnership basis (inside basis)
- Property contributed
for interest (AB)
- If partner's interest is subsequently purchased by the partnership, partnership basis is:
- Partner basis
(unless Section 754 election)
- Section 754 election:
- Assets (AB)
adjusted by difference between:
- Transferor's basis in partnership interest
- Transferor's proportionate share in partnership's assets (AB)
- Assets adjusted in following order:
- Section 1231 assets
- Capital assets
- Other property
- Upward adjustment allocation based on the basis of relative appreciation of classes/assets
- Downward adjustment allocation based on the basis of relative depreciation of classes/assets
- Property contributed
for interest (AB)
(investment partnerships):
- +
- Gain recognized on contributed property/services
- An investment partnership is one that would be treated as an investment company if it were incorporated.
- Example:
- Partnership's holding period:
- Includes:
- Partner's HP
-
Partnership partners' basis
- Partner basis (outside basis)
- Cash contributed
- Property contributed
for interest (AB)
- Section 721 nontaxable transfer
- Realized gain or loss is not generally recognized by a partner when a partnership interest is received in exchange for property contributed to the partnership. There is no boot in a Sec. 721 exchange. Instead, if property in addition to a partnership interest is received in exchange for contributed property, the transaction will be split into a part tax-free contribution and part sale.
- Gain recognized on contributed property/services
- Gain recognized on contributed property:
- To the extent liabilities assumed by the partnership exceed the partner’s aggregate AB in all property contributed, the partner recognizes gain, and basis in the partnership interest is zero.
- The gain recognized may be characterized as ordinary income by Secs. 1245 and 1250. Ordinary income recapture potential in excess of the amount of gain recognized (remains with the property in the hands of the partnership).
- Gain recognized on contributed services:
- FMV of the partnership capital interest (gross income)
- The interest received cannot be subject to substantial risk of forfeiture or restrictions on transfer.
- Example:
- Share of partnership liabilities
- -
- Partner's liability
assumed by partnership
- If the partnership assumes a liability of the contributing partner, the partner is treated as receiving a distribution of money from the partnership in the amount of the liability. A distribution reduces the partner’s basis in the partnership interest.
- Exception:
- Gain not recognized on property received by contributing partner
(treated as sale)
- Example:
- Partner basis recalculated
with increases/decrease in
distributive share:
- End of tax year
- Nonseparately/
separately stated items
- Partnership losses
- Current tax
deductibility
limited to:
- At-risk rules
- Partner basis
- Partner basis
(limited partner)
- Partnership losses
- Limited to:
- Limited partner contributions
- Share of qualified nonrecourse financing
- A limited partner is at risk in the partnership to the extent of contributions and his or her share of qualified nonrecourse financing, that is, the amount the partner would lose if the partnership suddenly became worthless.
- Passive activity rules
- Passive activity losses
- Limited to:
- Passive activity income
- Passive activity includes rental activity or any activity of the partnership in which the shareholder does not materially participate.
- Excess business loss
- Basis is decreased even if current deductibility of the loss is prohibited by the at-risk or passive activity rules.
- Partnership liabilities variations
- Partner interest types:
- Capital interest
- A capital interest is the partner’s share of the assets currently owned by the partnership upon liquidation. Partner capital accounts are not adjusted for partnership liability variations.
- A partner’s initial capital account balance is the FMV of the assets (net of liabilities) (s)he contributed to the partnership (book capital account). Capital accounts are used to ensure that a partnership’s allocations for tax match their underlying economic agreement.
- A partner's tax capital account represents the book capital account adjusted for tax code requirements
(tax capital account).
- Profit interest
- A profits interest is the partner’s share of future income and losses of the partnership.
- Partner's interest holding period:
- Includes:
- Contributed capital HP
- Contributed
Section 1231 assets HP
- Contributed
cash/ordinary income property/services
(date after exchange)
-
Partnership rules
- Family partnership
- Family partnership members:
- Ancestors
- Parents
- Grandparents
- Lineal descendants
- Children
- Grandchildren
- Spouses
- Spouses special election
out of family partnership by:
- Both materially participate
- Both choose to be treated as:
- Qualified
joint venture
- Each spouse will be treated as a sole proprietor, allowing both to receive Social Security benefits.
- Taxpayer
- Trust
(for their
primary benefit)
- Family partnership types:
- Services
- Interest is acquired by:
- Services rendered that are considered to the partnership:
- Substantial
- OR
- Vital
- Capital
- Capital is a material-income producing factor
- Interest is acquired by:
- Gift
- OR
- Purchase
- The partnership agreement is disregarded to the extent a partner receives less than reasonable compensation for services. This rule applies to all partners, not just family members.
- Example:
- EXAMPLE 15-11
Family Partnership -- Gift to Child
R gives Son a gift of $250,000. Son contributes it in exchange for a 50% interest in a newly formed partnership with R. R&S Partnership continues what was R’s sole proprietorship. The reasonable value of R’s services the following tax year is $75,000. Of R&S’s gross income of $125,000, $75,000 must be allocated to R for his services. Son’s distributive share attributable to his capital interest is no more than $25,000 [($125,000 – $75,000) × 50%].
- Partnership elections
- Elected by partnership
- Accounting method
- Depreciation method
- Inventory method
- Installment sales
- Involuntary conversion gains
- Section 179 elections
- Start-up/organizational costs
- Tax year
- Required tax year
- 1) Majority partner tax year
- Use tax year of majority partner
- Majority partner:
- Merging partner:
- Merger: The merging partnership’s tax year is used if the partners of the merged firms own more than 50% of the resulting partnership. Otherwise, a new tax year is started.
- Split: The old partnership’s tax year continues; however, if partners owned less than 50% of the original partnership, a new tax year should be started.
- Example:
- EXAMPLE 16-11
Split of a Partnership
Tin-Pan-Alley-Cat Partnership is in the manufacturing and wholesaling business. Tin owns a 40% interest in the capital and profits of the partnership, while each of the other partners owns a 20% interest. All of the partners are calendar-year taxpayers. On November 3 of the current year, a decision is made to separate the manufacturing business from the wholesaling business, and two new partnerships are formed. Tin-Pan Partnership takes over the manufacturing business, and Alley-Cat Partnership takes over the wholesaling business. For tax purposes, Tin-Pan is considered to be a continuation of the Tin-Pan-Alley-Cat Partnership because Tin-Pan owned more than 50% of the original partnership. Alley-Cat Partnership will start a new tax year.
- Owns more than:
- 50% of:
- Capital
- AND
- Profits
- 2) Principal partner tax year
- Use tax year of principal partners
(those with the same tax year)
- Principal partner:
- Owns
more than:
- 5% of:
- Capital
- OR
- Profits
- 3) Least aggregate deferral
- Step 1:
- Each partner's ownership percentage
- x
- # of months income deferred
- Begin:
- Potential tax year
- End:
- Partner's tax year
- Step 2:
- Select least deferral amount
- Any time there is a change in partners or a partner changes his or her tax year, the partnership may be required to change its tax year.
- Other than required tax year
(IRS approval required)
- 1) Natural business year
- IRS approval required
- Natural
business year:
- In any 12-month period
- At least:
- 25% of
annual gross receipts
- Last 2 months of year
- Each preceding:
- 3 years
- 2) Section 444 (fiscal year)
- IRS approval required
- Income deferred
- Limited to:
- 3 months
- Begin:
- Potential tax year
- End:
- Required tax year
- Deposit:
- Deferred tax amount
- Amount of additional tax that would have resulted had the election not been made
- Up to:
- 3 months deferred income
- Each partner reports his or her distributive share of partnership items, including guaranteed payments, in the tax year in which the partnership’s tax year ends.
- Elected by partners
- Foreign income tax
- Credit
- OR
- Deduction
- Discharge of indebtedness
- Order of tax attributes
- Tax treatment
- Partnership
- A partnership is required to file an initial return for the:
- First year it receives:
- Income
- OR
- Incurs deductible expenses (for federal income tax purposes)
- A partnership is required to prepare a Schedule K-1 for each partner and contains the partner’s distributive share of partnership income and separately stated items to be reported on the partner’s tax return.
- A partnership files a tax return
(Form 1065 U.S. Return of Partnership Income)
- Signature by any partner is evidence that the partner was authorized to sign the return. Only one partner is required to sign the return.
- The IRC provides for designation of a partnership representative (PR) who has sole authority to commit the partnership to tax and litigation matters.
- Due by:
- 15th day of the 3rd month following the close of the tax year
- Partnership partner
- Each partner's share of items is reported on his or her tax return for his or her tax year in which the partnership tax year ends.
- Each partner must report his or her share of items consistent with their treatment on the partnership return and character.
- An exception applies if:
- The partner identifies an inconsistency on a filed statement
- OR
- The partnership has:
- Up to:
- 10 partners
- Not estate
- Not NRA
-
15.2 Partner’s Taxable Income
- To better understand the need to separately state certain items, consider the following: The ability of individuals to deduct charitable contributions as itemized deductions is based on an AGI ceiling. Different individuals will have different AGIs. Moreover, C corporation partners can only deduct charitable contributions that do not exceed 25% of taxable income.
-
Form 1065 Schedule K-1
U.S. Return of Partnership Income, Partner’s Share of Income, Deductions, Credits, etc.
-
Partnership additional tax treatment
- Additional tax considerations
- Not subject to following taxes:
- Federal income tax
- Report of disposal of the
partner's interest
- By sale:
- Determined (generally) at partner's level
- Capital gain/loss:
- Partner's basis
- -
- Share of partnership liabilities
- Ordinary
gain/loss:
- Share of partnership "hot" assets
ordinary income property
(inventory/unrealized receivables)
- "Hot" assets include:
- Franchises
- Inventory
- Other
Section 1231 property
- Copyrights
- Section 1245 recapture
- Section 1250 recapture
- Trademarks
- Tradenames
- Unrealized receivables
- Example:
- Partial liquidation
- Complete Liquidation
- By gift:
- Generally, no gain is recognized upon the gift. However, if partnership liabilities allocable to the gifted interest exceed the AB of the partnership interest, the donor must recognize gain. No loss is recognized on the gift.
- Subsequent sale of partner's gifted interest
- Capital loss:
- FMV of partner's gifted interest
- For purposes of computing a loss on a subsequent sale of the interest by the donee, the FMV of the interest immediately prior to the gift is used if the FMV of the gifted partnership interest is lower than the basis at the time of the gift.
- -
- Sales proceeds
- Capital gain:
- Share of partnership liabilities
- Generally, partnership interest gifted to a related minor is attributed to others (e.g., parents). There are limits on the amount of partnership income that can be allocated to a related minor.
- -
- Partner's basis
- The donee’s basis in the interest is the donor’s basis after adjustment for the donor’s distributive share of partnership items up to the date of the gift.
- By inheritance:
- The tax year of a partnership closes with respect to a partner whose entire interest in the partnership terminates, whether by death, liquidation, or otherwise. The partnership tax year does not close with respect to the other partners.
- Subsequent sale of partner's inherited interest
- Capital gain/loss:
- FMV of partner's inherited interest
- The successor has a FMV basis in the interest.
- Report of nonseparately stated items
(pass-through items)
- Depletion (excluded
oil/gas mineral property depletion)
- Circulation increases
(of a periodical)
- Recovery period:
- 3 years
- Intangible drilling costs
- Recovery period:
- 5 years
- Mining exploration and
development costs
- Recovery period:
- 10 years
- Research and
experimentation costs
- Recovery period:
- 10 years
- Employee fringe benefits
- Guaranteed payments to partners
- Net farm profit
- Allocation based on:
- Partner's interest
- If the partnership agreement does not allocate a partnership item or lacks substantial economic effect, the item must be allocated to partners according to their interests in the partnership.
- Substantial economic effect: There is a reasonable possibility that the allocation will significantly affect the after-tax economic position of the partners.
- If the size of a partner’s interest in the partnership varies (e.g., by sale, purchase, exchange, liquidation) during a partnership tax year, the distributive shares of partnership items must be allocated between periods of varying ownership (the interim closing method). The partnership may change profit and loss ratios up to the date of the return.
- Alternatively, the partners can elect to apportion based on days (the proration method).
- Cash-basis partnership allocate partner's distribute share on accrual basis for:
- Interest income/expense
- Payments of services
- Taxes
- Use of property
- Report of separately stated items
- Amounts previously deducted
(e.g., prior taxes, bad debts)
- Cancellation of debt
- Charitable contributions
- Distributions
- Dividends
- Oil/gas mineral property depletion
- Interest income
- Investment income and related expense
- Guaranteed payments
- Net short-term
capital gains and losses
- Net long-term
capital gains and losses
- Other deductions whose separate treatment could affect a shareholder’s tax liability
- Portfolio income
- Qualified items of income/gain/loss for QBID deduction
- Real estate activities and related expenses
- Royalties
- Section 1231 gains and losses
- Section 179 deduction (immediate expensing of new business equipment)
- Tax-exempt interest and related expense
- Taxes paid to a foreign country or to a U.S. possession
-
CPA REG SU16 - 20
-
CPA REG SU16 Partnership Transactions and Book-to-Tax Differences
-
16.1 Partners Dealing with Own Partnership
-
A guaranteed payment reported in 3 places:
- (1) as a deduction used to compute ordinary business income or loss, which is shared among all partners, taken on Form 1065, page 1, line 10
- (2) as a separately stated item on Schedule K, line 4, which is allocated to the receiving partner
- (3) on the receiving partner’s Schedule K-1, line 4a - 4c
- The Code recognizes that a partner can engage in property, services, and loan transactions with the partnership in a capacity other than as a partner, i.e., as an independent, outside third party. The tax result, in general, is as if the transaction took place between two unrelated persons after arm’s-length negotiations.
-
Form 1065 Schedule K
U.S. Return of Partnership Income,
Partners' Distributive Share Items
-
Rules regarding partnership transactions
- Guaranteed payment
- Guaranteed payments are included as income in the recipient’s tax year, which includes the end of the partnership tax year in which they were deducted.
- Guaranteed minimum payments
- The guaranteed payment is the excess of the partner’s guaranteed minimum over the partner’s distributive share.
- Ordinary income
- Partner's stated minimum amount
- Excess of:
- Partner's share of partnership income
- Example:
- Guaranteed fixed payments
- If the partnership agreement provides for a GP in a fixed amount, e.g., annual salary amount, the GP amount is the stated amount.
- Loans (to partnership)
- Interest paid to a partner on a
(true) loan is all gross income to the partner and a deductible partnership item.
- Sales between partner/ship
- Sale of property
- Sale to (nonpartner)
- A partner acting as a nonpartner (independent third party, outsider) can sell (or exchange) property to (or with) the partnership, and vice-versa. Gain or loss on the transaction is recognized, unless an exception applies.
- Example:
- EXAMPLE 16-2
Sale to Partner Acting as a Nonpartner
Partnership sells land to Partner. Partnership recognizes loss unless the sale is to a related party. The loss is a partnership item allocable to partners as distributive shares. Partner takes a cost basis in the property.
- Sales to majority partner
(more than 50%)
- Sale to another partnership
(more than 50% capital/profits)
- Character and loss limits apply
- Any gain recognized is ordinary income if the property is held as:
- Other than a capital asset by the acquiring partner or partnership
- Any gain recognized if partner contributes property then:
- Immediately receives a distribution (treated as sale, property deemed purchased by other partners)
- Any loss realized is
not recognized and is held at:
- Cost basis (acquiring party)
- Subsequent sales results in gain is limited to the
previous unrecognized gain
- Expenditures are deductible when the amount is includible in:
- Gross income (payee)
- Example:
- EXAMPLE 16-3
Sale of Capital Assets -- Change in Character
Dora has held a capital asset for several years. The asset has a basis of $16,000 and a FMV of $24,000. She sells the asset to a partnership in which she is more than a 50% owner. The partnership will hold the property as a depreciable asset. Her gain of $8,000 ($24,000 – $16,000) will be ordinary income since she sold a capital asset to a more than 50% owned partnership that is not a capital asset to the partnership. If the partnership were to hold the asset as a capital asset, her gain would be capital gain.
- EXAMPLE 16-4
Recognized Gain -- Purchase by Other Partner
P and Q contributed land with FMVs of $250,000 and $500,000, respectively, each in exchange for a 50% interest in PQ Partnership. PQ mortgaged the land for $550,000 and distributed $250,000 of the proceeds to Q. Q recognizes any gain realized on 50% of the land she contributed. Fifty percent of the AB in the land is included in Q’s basis in her partnership interest.
-
16.2 Treatment of Partnership Liabilities
- The CPA Exam often does not specify whether the liability is recourse or nonrecourse. Candidates should presume that the liabilities are recourse for exam purposes.
- A partner’s share of partnership liabilities affects the partner’s basis in his or her partnership interest and can result in increased gain being recognized by the partner. Any increase in a partner’s share of liabilities of the partnership increases the partner’s basis. The opposite is true for a decrease in partnership liabilities.
-
Rules regarding partnership liabilities
- Recourse Debt
- General partner
- Recourse debt is included in limited partner's basis based on:
- Regulations allocate a recourse liability to the partner(s) who would be liable for it if at the time all partnership debts were due:
- All partnership assets:
- $0
(FMV)
- Liquidation occurred
(hypothetical)
- Bad debt deduction allowed to:
- Partner who pays more than his or her proportionate share of a partnership debt that becomes uncollectible equal to the amount in excess of that partner’s share of the debt.
- Partner's ratio of sharing losses
(unlimited liability)
- Any partner can be sued for the entirety of a partnership’s business debts.
- Limited partner
- Recourse debt is not included in limited partner's basis
- Nonrecourse Debt
- General partner
- Recourse debt is included in limited partner's basis based on:
- Partner's ratio of sharing profits
- The creditor has no claim against any partners. At most, the creditor has a claim against a particular secured item of partnership property.
- Limited partner
- Recourse debt is included in limited partner's basis
- Example:
- EXAMPLE 16-6
Nonrecourse Liabilities
ABC, LLP, purchased a building for $100,000 with a $90,000 mortgage from XYZ Bank. The loan was secured by the building itself and no partner made a personal guarantee on the loan. In the event that ABC defaults and is unable to pay the loan, XYZ’s only option is to foreclose and sell the property. If the property’s value has decreased and the sale proceeds are insufficient to recover the balance of the loan, XYZ has no other legal remedy. This is because ABC’s partners have limited liability by being partners in an LLP and are not generally liable for the debts of the partnership. Thus, the loan is nonrecourse to the partners of ABC (i.e., the lender bears the economic risk, not the partners).
- EXAMPLE 16-7
Recourse and Nonrecourse Liabilities
ABC Partnership is a limited partnership. A is a general partner, while B and C are limited partners. A, B, and C are equal partners. ABC purchased a building for $100,000 with a $90,000 mortgage from DEF Bank. The building is not secured by itself, so it is a recourse liability. Also, ABC purchased a warehouse for $70,000 with a $60,000 mortgage secured by the warehouse itself. The mortgage of the warehouse is thus a nonrecourse liability. ABC defaults on the two mortgages. The partners’ bases on the mortgages are as follows:
A’s basis = $110,000 [$90,000 recourse + ($60,000 ÷ 3) nonrecourse]
B’s basis = $20,000 [($60,000 ÷ 3) nonrecourse]
C’s basis = $20,000 [($60,000 ÷ 3) nonrecourse]
-
16.3 Distribution of Partnership Assets
- Be prepared to answer questions regarding basis and gain (loss) calculations resulting from both current and liquidating distributions of partnership assets.
- A distribution is a transfer of value from the partnership to a partner in reference to his or her interest in the partnership.
-
Form 1065 Schedule M-2
U.S. Return of Partnership Income,
Analysis of Partner's Capital Accounts
-
Rules regarding partnership distributions
- Types of distributions
- Current distributions
- Treatment:
- Not taxable
- Partner's basis
- Decreases basis
- Excess of basis/immediately before distribution
(capital gain)
- Loss not recognized, basis cannot be reduced be zero.
- Property distributions
- Treatment:
- Capital:
- Contributed property
to noncontributing partner
- Allocate the (built-in gain/precontribution gain) to the contributing partner. The contributing partner’s basis in his or her partnership interest is increased. Basis in the property is also increased. The distributee has a transferred basis
(basis + gain recognized = FMV at contribution), see example below.
- Up to:
- 7 years
(after contribution)
- To extent of:
- Contributed
built-in gain/loss
- Ordinary:
- Contributed ordinary income property
to noncontributing partner
(inventory/unrealized receivables)
- Inventory is considered substantially appreciated if:
- FMV exceeds:
- 120% of
partnership
property (AB)
- Up to:
- 7 years
(after contribution)
- To extent of:
- Contributed
built-in gain/loss
- Example:
- EXAMPLE 15-7
Postcontribution Gain or Loss
Tony and Mary form a partnership as equal partners. Tony contributes cash of $100,000, and Mary contributes an asset with a basis of $80,000 and a FMV of $100,000. Two years later, the partnership sells the asset for $110,000. The $30,000 gain ($110,000 selling price – $80,000 basis) is allocated, $25,000 to Mary [$20,000 precontribution gain + (50% partnership interest × $10,000 postcontribution gain)] and $5,000 to Tony (50% partnership interest × $10,000 postcontribution gain).
- Precontribution gain/loss
(sale to noncontributing partner)
- Depreciation allocated to non-contributing partner.
- If the distributee sells or exchanges the inventory 5 years or more after distribution, capital gain treatment may be available.
- Property/money distributions
- Treatment:
(in order)
- Allocate
partner's basis
- Money distribution
- Ordinary income property
(inventory/unrealized receivables)
- Other (noncash) property
(liquidating distributions)
- If does not exceed:
- Partner's AB
- Allocate
increase:
- Partnership property AB
- Assets relative appreciation
- Assets relative FMV
- Other (noncash) property
- If exceeds:
- Partner's AB
- Allocate
decrease:
- Partnership property AB
- Assets that declined
in value (FMV < AB)
- Assets relative AB at this point in calculation
- The partner’s holding period in the distributed property includes that of the partnership.
- Loss recognized is limited to any excess of the AB in the partnership interest over the sum of money and the AB in the URs and inventory. Loss recognized is characterized as if from sale of a capital asset.
-
Rules regarding partnership termination
- Types of terminations
- By liquidation
- If any gain is recognized by the distributee partner, the partnership may elect under Sec. 754 to increase its basis in its retained property by the amount of that recognized gain. The increase/decrease is allocate to the purchasing partner basis of partnership property as the result of a transfer of a partnership interest
(under Section 754):
- Example:
- By death (of partner)
- A deceased partner’s allocable share of partnership items up to the date of death will be taxed to the decedent on his or her final return. Any items allocated after the date of death will be the responsibility of the successor in interest. The partnership’s tax year does not end.
- Payments made to retiring partner or successor in interest of a deceased partner that are not made in exchange for an interest in the partnership property are treated as either:
- (1) based on partnership income are taxable as a distributive share of partnership income
- (2) not based on partnership income, it is a guaranteed payment
- By other means
- A partnership terminates for federal tax purposes only when operations of the partnership cease. The partnership’s tax year ends on the date of termination.
- A return must be filed for the short period, which is the period from the beginning of the tax year through the date of termination.
-
16.4 Reconciling Book and Taxable Income
- The reconciliation of book and taxable income applies to both corporations and partnerships. The presentation assumes knowledge of the information in Study Units 11-15 as well as Subunits 16.1-16.3.
-
Form 1065 Schedule M-1
U.S. Return of Partnership Income,
Reconciliation of Income (Loss) per Books With Income (Loss) per Return
- Form 1120 Schedule M-3
U.S. Corporation Income Tax Return,
Net Income (Loss) Reconciliation for Corporations With Total Assets of
$10 Million or More
-
Rules regarding reconciling income
- Income tax liability reported by:
- Current income tax liability/
Current refund receivable
- Temporary book-to-tax differences
- Temporary differences are timing differences and occur because tax laws require the recognition of certain items of income and expense in different tax years than are required for book purposes. Temporary differences originate in 1 tax year and reverse or terminate in 1 or more subsequent tax years.
- Accelerated depreciation
(e.g., 100%-expensing, Sec. 179, MACRS, lease-type)
- Amortization
- Capitalized inventory costs
(i.e., Sec. 263A)
- Charitable contributions
- Installment sale income
- Net capital loss carryover
- Net operating loss carryover
- Prepayments of income
- Reserves:
- Bad debt/credit losses
- Bonus compensation
- Permanent book-to-tax differences
- Club dues
- Dividends-received deduction
- Life insurance proceeds
(and associated expenses)
- Lobbying and political expenditures
- Nondeductible meals (50%) and entertainment
- Nondeductible penalties and fines
- Tax-exempt interest income
(and associated expenses)
- Deferred income tax liability/
Deferred income tax asset
- Future tax consequences:
Temporary book-to-tax differences
- Deferred income tax liability
- Deferred income tax asset
-
CPA REG SU17 Business Organizations
-
17.1 General Partnerships
- The AICPA often tests sharing of profits, losses, and distributions in partnerships. Candidates should understand that sharing is determined by the RUPA’s equal distribution default rule only when the partners have not agreed otherwise.
- The AICPA has tested candidates’ knowledge of how general partnerships terminate, especially the effects of a partner’s death on the partnership and the rights of the deceased partner’s heirs.
-
Overview of general partnerships
- BACKGROUND 17-1
Uniform Acts
In the U.S., partnership law was codified in the Uniform Partnership Act of 1914 (UPA) and updated in the Revised Uniform Partnership Act (RUPA) in 1994. The revised act was amended in 1997 to include provisions for limited liability partnerships
(LLPs). These changes conform the law of partnership to modern business practice while retaining many features of the original act.
-
Definition of general partnerships
- RUPA definition:
An association of two or more persons to carry on as co-owners a business for profit.
- RUPA profits definition:
Unless otherwise agreed upon, partners share:
- Profits equally
- Losses in proportion as profits
- RUPA statement of partnership authority:
The RUPA provides for filing a statement of partnership authority that gives notice of any limitations on the authority of a partner.
- Subject to a filed statement of authority, property in the name of the partnership may be transferred by any partner in the partnership name.
- RUPA statement of dissolution:
The RUPA provides that a partner who dissolves will remain liable to creditors for predissociation obligations and any post-dissociation contracts for up to 2 years unless (s)he files a statement of dissociation.
- A partner has a right to dissociate at any time
- A partner who wrongfully dissociates is liable for any resulting damages to the other partners
- After dissociation, business:
- Continues after purchase of
dissociated partner's interest or
- Dissolution begins
- Advantages:
- No formalities/no filings/no agreement/no intent
- Although an intent to form a partnership is not required, the co-owners must intend to make a profit even if no profit is earned.
- A person who receives a share of the profit is assumed to be a partner.
- Assumption is overcome for amounts received if:
- Payment for annuity or other retirement or health benefit to deceased partner's representative
- Payment for sale
- Payment of debt
- Payment of rent
- Payment of wages
- If the elements of a partnership are present, it is formed even if the parties do not intend to be partners.
- No taxation
- An advantage of a partnership (general or limited) is that it is a tax reporting, not a tax paying, entity.
- Profit or loss is passed through to the partners.
- Exceptions:
- Fictitious Name Statement:
Fictitious name statutes have been enacted in most states to protect creditors. Registration permits creditors to discover the persons liable for the entity’s debts. Have little effect on the creation or operation of a partnership other than the imposition of a fine or other minor penalty for noncompliance.
- Partnership by Estoppel:
A partnership by estoppel may be recognized when an actual partnership does not exist to prevent injustice. The duties and liabilities of a partner sometimes may be imposed on a nonpartner (a purported partner).
- Purported Partner:
A purported partner has represented that (s)he is a partner or has consented to such a representation.
- A third party who has reasonably relied on the representation and suffered harm as a result may assert the existence of a partnership.
- Statute of Frauds:
Under the Statute of Frauds, most oral agreements to enter into a partnership are valid if the partnership agreement is for a period in excess of 1 year. However, the majority of states require that the partnership agreement be in writing to be enforceable. This is consistent with the “year clause” of the statute of frauds. If the statute of frauds is not complied with, a partnership at will results.
- Disadvantages:
- A major disadvantage of a general partnership is that each partner has unlimited personal liability for all losses and debts of the business.
- One of the distinguishing characteristics of the partnership form of business is its lack of continuity of life.
- Assignment
(partner's transferable interest):
- Partner retains:
- Performance of the duties and obligations of a partner
- Rights or incur the
liabilities of a partner
- Assignee obtains:
- Partner’s share of partnership
profits and losses
- Right to receive distributions
- The assignee does not automatically become a partner and cannot act as an agent of the partnership. Partners and their creditors, assignees, and heirs (inherited according to a valid will) have no interest in any specific partnership property. The transferee has no management rights.
- A judgment creditor of a general or limited partner may attach the partner’s transferable interest only by securing a charging order (a lien on the interest) from a court. If the limited partner is insolvent, a creditor may obtain a charging order from a court that acts as an involuntary assignment.
- The estate does not become a partner. The estate is responsible for the partner’s allocated share of any partnership liabilities.
- Capitalization:
- A general partnership cannot raise equity by selling shares.
- Distributions:
- A partner also has the right to distributions. A distribution is a transfer of partnership property from the partnership to a partner for profits, payment for services, or reimbursements.
-
Rules regarding general partnerships
- Law of agency
- Duties
- Duty of care
- The duty of care is limited to:
- An obligation of:
- Fair dealing
- Good faith
- Not engaging in
gross negligence
- Not engaging in
intentional wrongdoing
- Not engaging in knowing violations of the law
- Duty of loyalty
- The duty of loyalty is limited to:
- Not acting as a party with an adverse interest
- Not competing with the partnership
- Not exploiting a partnership opportunity or secretly using partnership assets
- Liabilities
- Each general partner is:
- Jointly liable
- Severally liable
- Includes:
- By admission
- Admission into an existing partnership results in liability for partnership obligations incurred prior to admission to the extent of the investment.
- By tort
- (1) within the ordinary course and scope of the partnership business
- (2) with the authorization of the other partners
- A plaintiff may sue one partner or the partnership. But only a partner who is a judgment debtor is personally liable.
- Upon withdrawal
- Novation:
A withdrawing partner remains liable for partnership debts incurred before withdrawal unless the creditors contractually agree otherwise. Also, without a novation, a withdrawing partner remains liable for debts incurred prior to withdrawal.
- Example:
- Power
- Each partner consents
to being both:
- Agent
- Principal
- Apparent authority:
- A general partnership and the other general partners are bound by a contract made by a partner acting within the scope of his or her actual or apparent authority (limited to carrying on in the ordinary course the partnership business or business of the kind carried on by the partnership).
- If a partner acts without actual or apparent authority, the partnership and the other partners are not bound unless the other partners ratify. Ratification is approval after the fact of an unauthorized act and binds the partnership as if the partner had been initially authorized. Ratification may be express or implied from conduct of the principal.
- Although actual authority to act on behalf of the partnership ceases at dissolution, apparent authority to conduct business in the usual way continues until notice is given to third parties or the partnership business winds up.
- A statement of dissociation may be filed by the partnership or dissociating partner. Within 90 days after filing, notice of dissociation terminates the partner’s apparent authority and post-dissociation obligations.
- Results from words or actions of the principal (the partnership) that reasonably induce a third party to rely on the agent’s
(partner’s) authority.
- Rights
- Partners may agree to limit their rights apart from the following:
- Partner's rights
- Equal participation
in management
- Ordinary matters:
- Majority rules
- Other matters:
- Unanimous vote:
- To admit a new partner
- The right to choose associates means that admission as a partner requires the consent of all partners. Unanimous consent vests in the new partner all the rights, duties, and powers of a partner.
- To amend the
partnership agreement
- To determine
non-routine matters
- Access to
partnership information
(active/inactive partners)
(not former partners)
- Copy of
books/records
- Inspecting
books/records
- A reasonable demand for other partnership information also must be honored.
- Partnership rights
- Use partnership property
- Possess partnership property
- The right to use or possess partnership property may be exercised only on behalf of the partnership.
- Termination of partnership
- The partners may choose to limit the duration of the partnership to a definite term or the completion of a specific undertaking.
The partnership also may be at will. A partnership at will is not limited to “a definite term or the completion of a specific undertaking.”
- Termination of partnership (by dissolution):
- Dissociation is a partner’s ceasing to be associated in carrying on the business of the partnership (other than winding up affairs). A partner can dissociate at any time, subject to payment of damages if the dissociation is wrongful:
- Apparent authority:
A dissociated partner
(or the estate of a deceased partner) has apparent authority for
2 years to bind the partnership to contracts with third parties.
- An event specified in the agreement
- Bankruptcy or insolvency
- Expulsion under the
partnership agreement
- Incapacity or death
- The personal representative of a decedent’s estate has the rights and liabilities of a limited partner solely for the purpose of settling the estate.
- If the business is not wound up, the partnership must purchase the dissociated partner’s interest for a price based on a hypothetical sale of the partnership at the dissociation date. Thus, the decedent’s estate (or beneficiaries, presumably including a surviving spouse) is entitled to the value of the decedent’s partnership interest but not to any specific partnership property.
- Notice to the partnership of a partner’s express will to withdraw
- Statement of Dissolution:
A statement of dissociation may be filed by the partnership or a dissociated partner. It is deemed to provide notice of dissociation 90 days after filing.
- Operation of law
- Dissolution may be by operation of law, for example, because of an event that makes the partnership’s business illegal. Moreover, a court may order dissolution, for example, because the economic purpose of the partnership cannot be achieved.
- Termination of partnership (winding up):
- Winding up (order of distributions):
- Payment to creditors
- Creditors are paid in full before any distributions are made to partners. However, partners who are creditors share equally with nonpartner creditors under the RUPA.
- Payment to partners
(from contributions)
- After payment of creditors, any surplus is paid in cash to the partners. A partner has no right to a distribution in kind (of noncash assets) and need not accept a distribution in kind.
- Payment to partners
(from profits)
- If a partner’s account has a negative
(debit) balance, the partner is liable to contribute the amount of the balance. If a partner does not make a required contribution, the other partners must pay the difference in the same proportion in which they share losses.
- Example:
- EXAMPLE 17-3
Allocation of Profit after Liquidation
Zoe and Zed are the only partners in a general partnership. Zoe contributes $10,000 in cash, and Zed contributes services only. No partnership agreement states how partnership profits and losses are to be allocated. When the partnership dissolves, Zoe and Zed liquidate its assets. The net receipts are $60,000 in cash. If creditors are owed $45,000, the following is the determination of profit:
Cash $60,000
Payments to creditors (45,000)
Available cash $15,000
Zoe’s contribution (10,000)
Profit $5,000
Zoe and Zed did not agree on the allocation of profit. It therefore is shared equally ($5,000 ÷ 2 = $2,500 to each partner). Zoe receives $12,500 ($10,000 contribution + $2,500), and Zed receives $2,500 ($0 contribution + $2,500).
- EXAMPLE 17-4
Allocation of Loss after Liquidation
In Example 17-3, assume that the net receipts after liquidation of assets equaled $50,000. The following is the determination of the loss:
Cash $50,000
Payments to creditors (45,000)
Available cash $5,000
Zoe’s contribution (10,000)
Loss $(5,000)
Zoe and Zed did not agree on the allocation of loss. It therefore is shared equally [$(5,000) ÷ 2 = $(2,500) to each partner]. Zoe receives $7,500 [$10,000 contribution + $(2,500) share of loss], and Zed is liable for $2,500.
-
Rules regarding limited liability partnerships
- Full shield statute
- All partners are general partners who have limited liability for the acts of other parties. In most states, liability is limited for all partnership obligations, including those resulting from contracts. Thus, a full shield statute imposes liability only to the extent of the LLP’s assets, with certain exceptions.
- For example, a partner remains liable for obligations s(he) personally guaranteed or incurred and for wrongful acts.
- A partner who is an immediate supervisor also is liable for the wrongs committed within the scope of employment by an employee.
- Statement of qualification
- An LLP is a general partnership with limited liability. It is a favorable form of organization for professionals who have not incorporated. In many states, this form is restricted to use by professionals. An LLP must file a statement of qualification with the secretary of state and maintain professional liability insurance.
-
Rules regarding joint ventures
- Treated as partnership
- A joint venture is an easily formed business structure common in international commerce. It is an association of persons who as co-owners engage in a specific undertaking for profit. A joint venture is treated as a partnership in most cases.
- The most significant difference between joint venturers and partners is that joint venturers typically have less implied and apparent authority to bind their associates due to the limited scope of the joint venture. Thus, an advantage of the joint venture is that no joint venture is liable for similar activities of other joint ventures outside the scope of the venture.
-
17.2 Limited Partnerships
-
Definition of limited partnerships
- RULPA definition:
A limited partnership has one or more general partners and one or more limited partners. A business entity may be a partner.
- A person may be both a general partner and a limited partner with the rights and liabilities of each.
- Limited partnership interests are securities that must be registered with the SEC unless an exemption applies.
- The operation of a limited partnership is similar to that of a general partnership. One exception is that, without a contrary agreement, profits and losses are shared on the basis of the value of contributions actually made by each partner.
-
Rules regarding limited partnerships
- Law of agency
- General partner
- Limited partner
- Duties
- Liabilities
- Partnership liabilities only to the extent of his or her capital contribution.
- Power
- Assignment
(partner's transferable interest)
- A general or limited partner may assign the interest to creditors or others without dissolving the partnership.
- Dissolution
- Apply for dissolution of the partnership.
- Propose/vote
- Propose and vote on partnership affairs that do not directly control partnership operations, e.g., admission or removal of a general partner.
- Withdrawal
- Withdraw upon 6 months’ notice or according to the partnership agreement. A limited partner may not withdraw the capital contribution if the effect is to impair creditors’ rights.
- Rights
- Partners may agree to limit their rights apart from the following:
- Business
w/partnership
- Do business with the partnership, e.g., become a creditor (secured or unsecured) by lending it money.
- Partner's rights
- Access to
partnership information
- Copy of
books/records
- Inspecting
books/records
- Obtain an accounting of partnership affairs.
- An investor:
- Not an agent
- Not a manager
- Certificate of limited partnership
- A written certificate of limited partnership must be filed in the state where it is organized to give creditors notice of the limited liability of the limited partners. Without a filing, the entity is treated as a general partnership.
- Termination of partnership
- Winding up (order of distributions):
- Payment to creditors
- Creditors, including creditors who are partners.
- Payment to partners
(present/former)
(unpaid distributions)
- Payment to partners
(from contributions)
- The partners as a return of their contributions.
- Payment to partners
(from profits)
- The partners according to the limited partnership agreement in the proportions in which they share distributions.
-
17.3 Limited Liability Companies (LLCs)
-
Definition of limited liability companies
- An LLC is a noncorporate hybrid business structure that combines the limited liability of the corporation and the limited partnership with the tax advantages of the general partnership and the limited partnership.
- An LLC is a legal entity separate from its owner-investors (called members). Individuals and any corporate and noncorporate business entities may be members.
- Advantages:
- Members may elect to be taxed as partners in a partnership (a pass-through entity). But single-member LLCs (called “disregarded entities” for tax purposes) are taxed as sole proprietorships.
- Taxation as a corporation (a taxable entity) may be advantageous if reinvestment in the LLC is desired, and corporate rates are lower than personal rates.
- Assignment
(partner's transferable interest):
- A member may transfer (assign) his or her distributional interest without dissolving the LLC. This interest is personal property.
- Capitalization:
- A general partnership cannot raise equity by selling shares.
- Distributions:
- Without a contrary agreement, statutes most often provide for profits, losses, and distributions to be shared based on the values of members’ contributions.
-
Rules regarding limited liability companies
- Law of agency
- Member-managed
- All members have a right to participate, and most business matters are decided by the majority. An LLC is deemed to be member-managed unless the articles provide otherwise.
- Member-managers have limited liability.
- Manager-managed
- Each manager, who need not be a member, has equal rights, and most business matters are decided by the manager or by a majority of the managers.
- Articles of organization
- An LLC may be formed for any lawful purpose under a state statute. An LLC is formed by one or more persons when articles of organization are filed with the appropriate secretary of state (or the equivalent).
The articles of organization should state at a minimum:
- 1) LLC's name
- 2) LLC's address of the principal place of business or registered office
- 3) Name and street address of the initial agent for service of process
- 3) Whether managers, who may not be members, will manage the LLC
- The LLC must at all times maintain a registered agent for service of process and a registered office in the state.
- Contract/operating agreement
- Not legally required
- If used:
- May be amended only by a unanimous resolution of the members.
- May address such matters as the following:
- Access to records
- Circumstances causing dissolution
- Death of a member
- Management arrangements
- Member meetings
- Sharing of
profits and losses
- Transfer of
members' interests
- Voting rights
- Termination of LLC
- Termination of LLC (by dissolution):
- An LLC is dissolved upon one of following:
- Consent of a number or percentage of members provided in their agreement.
- Death of a member if noted in the articles.
- Expiration of a specified time period or occurrence of a specified event.
- Judicial determination of the following:
- Equitability of liquidation
- Frustration of purpose
- Impracticability of continuing (e.g., because of a member’s conduct)
- Inappropriate behavior
-
17.4 Corporate Formation
-
Overview of corporate formation
- BACKGROUND 17-2
MBCA
Corporations are established under state law. To provide guidance for state lawmakers, the American Bar Association issued the Model Business Corporation Act (MBCA). The MBCA has been adopted at least in part by every state. The Revised Model Business Corporation Act of 1984 (RMBCA) applies to publicly held and closely held corporations. This outline is based on the RMBCA.
-
Definition of corporate formation
- RMBCA definition:
A corporation is a separate legal entity created under a state statute by filing its organizational document (articles of incorporation) with the proper state authority.
- The corporation ordinarily is treated as a legal person with rights and obligations separate from its owners and managers.
- Corporations are owned by shareholders (owners) who elect a board of directors and approve fundamental changes in the corporate structure.
- Closely-held corporation
- Does not sell its stock to the public
- Commonly owned by
its officers and directors
- Has shareholder-managers
- Owned by relatively few shareholders
- More than 50%:
- During the
last half of the year
- By 5 or fewer individuals
-
Rules regarding corporate formation
- Articles of incorporation
- Files its organizational document
(articles of incorporation) with the proper state authority. Incorporation may be in any state. Articles of incorporation (the corporate charter) must be filed with the secretary of state or another designated official.
- Articles of incorporation must contain:
- 1) Corporation’s name
- 2) Number of authorized shares
- 3) Name and street address of the corporation’s registered agent
- 4) Name and street address of
each incorporator (parties who sign the filed articles)
- Incorporators sign the articles.
Only one incorporator is required.
- Incorporators elect the members of the initial board of directors if they have not been named in the articles. The incorporators then resign.
- The board of directors holds an organizational meeting to take all steps needed to complete the organizational structure. The new board:
- Shareholders hold the voting power of a corporation. Thus, the shareholders have the power to govern the corporation. This power gives them the ability to:
- 1) Approve fundamental changes in the corporate structure
- 2) Elect a board of directors
- Adopts bylaws if they were not adopted by the incorporators
- Bylaws govern the internal structure and operation of the corporation. They may contain any provision for managing the business as long as it does not conflict with the law or the articles.
- Elects officers
- Corporate officers are responsible for the day-to-day management of the organization.
- Articles of incorporation may contain:
- Optional provisions
- Pre-incorporation contracts:
- Promoter
- A promoter arranges for the formation of the corporation. (S)he provides for the financing of the corporation and for compliance with any relevant securities law.
- Prior to incorporation, the promoter enters into ordinary and necessary contracts required for initial operation.
- Preincorporation subscription agreement:
- The promoter secures potential investors using preincorporation subscription agreements. Each subscriber agrees to purchase a certain amount of shares at a specified price, payable at an agreed future time. A preincorporation subscription agreement is irrevocable for 6 months, unless otherwise provided in the agreement, or all subscribers consent to revocation. Many state statutes require the agreement to be written.
- Promoter liability:
- Promoters generally are personally liable on their contracts.
- The corporation is not liable because a promoter cannot be an agent of a nonexistent entity
- Corporation liability:
- A corporation may not ratify a preincorporation contract because no principal existed at the time of contracting. However, adoption of the contract is a legal substitute for ratification. It may be implied from accepting the benefits of the contract.
- Adoption is an assignment of rights and delegation of duties from the promoter to the corporation. But it is not retroactive and does not release the promoter from liability.
- If the promoter, the third party, and the corporation enter into a novation substituting the corporation for the promoter, only the corporation is liable, and the promoter is released.
- Certificate of authority (foreign)
- A foreign corporation is one that does business in any state other than the one in which it is incorporated. A certificate of authority is required to do business within the borders of another state.
- Foreign corporation minimum contracts rule:
A state may exercise authority over a foreign corporation if the corporation has at least minimum contacts with the state. The minimum contacts consist of activities that:
- (1) are not isolated
- (2) either are purposefully directed toward the state or place a product in the stream of interstate commerce with an expectation or intent that it will be used in the state
- Maintaining an office in State B to conduct intrastate business creates minimum contacts under this test.
-
17.5 Corporate Operation, Financing, and Distributions
-
Rules regarding corporate oper./fin./distrib.
- Law of agency
- Liability
- Respondeat superior:
A corporation may be held liable for the actions of its employees. Under the law of agency (respondeat superior, or “let the master answer”), a corporate principal may be liable for an agent’s torts (civil wrongs not resulting from contracts) committed within the scope of employment.
- Ultra vires/Piercing the corporate veil:
Shareholders may be held liable for corporate actions. The doctrine of ultra vires prohibits actions beyond powers inherent in the corporation’s existence, the articles of incorporation, and the incorporation statutes. Courts disregard the corporate form when it is used merely to:
- Circumvent the law
- Commit wrongdoing
- Shield its shareholders from
liability for fraud
- A court might disregard a corporate entity if it finds the shareholders have not conducted the business on a corporate basis, for example, if:
- Assets commingled
- Established for a sham purpose
- Formalities ignored
- Inadequately capitalized
to carry on its intended business
- Corporate liabilities:
- Debt financing
- Increases corporation's risk.
Must be repaid at fixed times event if corporation is not profitable. In bankruptcy, creditors have priority in remaining assets. Debt holders have claims on the corporation’s assets. In the event of a liquidation, the debt holders’ claims must be satisfied before any distribution to common shareholders.
- These instruments, usually in the form of bonds or notes, represent an obligation of the corporation to repay the holder within a stated amount of time, accompanied by interest.
- Equity financing
- Transfers ownership interests.
Shareholders are not creditors. Shareholders have the status of unsecured creditors once a dividend is declared. Dividends are equity securities and are discretionary.
- The board has discretion to determine the time and amount of distributions. Following prerequisites are used to determine whether a board will distribute dividends:
- 1) After distribution, corporation not insolvent, otherwise, the distribution is illegal
(or not paid w/statutorily designated funds).
- 2) Board must authorize the dividend through a declaration by resolution.
- Types of dividends:
- Common shareholder dividends
- Preferred shareholder dividends
(paid first/fixed amount)
- If the preferred shares are cumulative, any dividends not paid in preceding years (dividends in arrears) are carried forward and must be paid before the common shareholders receive anything. Cumulative preferred stock is not necessarily convertible.
- RMBCA cumulative/noncumulative:
RMBCA suggests that whether stock is cumulative or noncumulative should be included in the articles.
- Liquidating shareholder dividends
- Liquidating dividends are a return of, not a return on, a shareholder’s capital.
- Stock (share) dividends
- Stock (share) dividends are payable in the shares of the corporation as a percentage of the shares outstanding.
When a stock dividend is declared, the corporation transfers the legally required amount from earned surplus (retained earnings) to stated capital (common stock). A stock dividend is a corporation’s ratable distribution of additional shares of stock to its stockholders. Total equity is not changed.
- A stock split differs from stock dividends in that par value, rather than retained earnings is reduced, and the number of authorized shares is increased.
- Stock (share) split
- Stock (share) split is an issuance of shares to reduce the unit value of each share. The value of each share changes, not the shareholder’s proportionate ownership interest. A stock split does not increase a shareholder’s proportionate ownership. It merely increases the number of shares outstanding.
- RMBCA distribution definition:
Under RMBCA, a distribution is “a direct or indirect transfer of money or other property (except its own shares) or incurrence of indebtedness by a corporation to or for the benefit of its shareholders in respect of any of its shares.”
- Power
- Ultra vires:
Under the doctrine of ultra vires, a corporation may not act beyond its implied or express powers. But a corporate action generally may not be challenged on the ground that the corporation lacked power to act. A corporation essentially has the same powers as an individual. Moreover, the ultra vires doctrine has been eliminated as a defense by either party in a suit involving a corporation.
- RMBCA power:
RMBCA grants a corporation the “same powers as an individual to do all the things necessary or convenient to carry out its business and affairs.” A corporation may not exceed its express or implied powers. he RMBCA states that, with certain exceptions, “the validity of corporate action may not be challenged on the ground that the corporation lacks or lacked power to act.” Those exceptions provide a cause of action in three instances in which the power to act may be questioned:
- Corporations can
proceed against directors or officers
- Shareholder can seek an injunction
- State attorney general can
proceed against the corporation
-
17.6 Shareholders’ Rights
-
Rules regarding shareholders' rights
- Law of agency
- Duties
(SH primary participation)
- Meeting annually
- Shareholders must approve
fundamental corporate changes including:
- Articles of incorporation amendments that materially and adversely affect shareholders’ rights
- Shareholders may amend or repeal the articles of incorporation and the bylaws.
- Dissolutions
- Mergers and share exchanges other than short-form mergers
- Sale/disposition of substantially all assets that leave the corporation with no significant continuing business activity
- Electing directors
- Directors are elected by a plurality of the votes (the most votes, not a majority) cast by the shares entitled to vote at a meeting at which a quorum is present
- In most states, shareholders have a right to remove, with or without cause, any director or the entire board by a majority vote.
- A quorum is the minimum number of shareholders necessary to conduct the meeting
- Controlling/majority shareholders
- Power
- Direct SH suit
- Direct suits by shareholders are lawsuits filed on their own behalf, either individually or as members of a class.
- Shareholders may bring such an action when the board of directors refuses to act on the corporation’s behalf. Generally, the shareholder must show:
- (1) (s)he owned stock at the time of the wrongdoing
- (2) (s)he made a written demand to the corporation to bring suit or take other appropriate action
- (3) a bad-faith refusal of the board of directors to pursue the corporation’s interest
- Derivative SH suit
- A shareholder derivative suit is to recover for wrongs done to the corporation. The action is for the benefit of the corporation, and any recovery belongs to it, not to the shareholder. The corporation is the true plaintiff. An example is a suit to recover damages from management for an ultra vires act
(actions outside the corporation’s authority).
- Rights
- The articles may specify the limit of their rights apart from the following:
- Dissenters'/
Appraisal Rights
- Shareholders who disagree with and vote against fundamental corporate changes may have dissenters’ (appraisal) rights. A shareholder with dissenters’ rights may demand that the corporation purchase the shares for their fair value in cash immediately before the action is taken, plus interest accrued from that date to the date of payment (RMBCA).
- Example:
- Compulsory Share Exchanges:
In a compulsory share exchange, the acquirer obtains the shares of the acquiree in a transaction that is binding if approved by:
- (1) the respective boards
- (2) a majority of the acquiree’s shareholders
- Disposition of assets that leaves the corporation without a significant continuing business activity
- A sale of all assets outside the regular course of business requires the approval of shareholders.
- Short-Form Mergers:
Mergers and share exchanges. Shareholder awareness of dissenters’ rights is especially important in a short-form merger (a parent that owns a statutory percentage (90% under the RMBCA) of a subsidiary) because notice of the merger is not required to be given to shareholders of the parent.
- No shareholder approval is required if a corporation that owns at least 90% of a subsidiary merges with the subsidiary using a short-form merger.
- Inspection rights
- Access to
corporate information
- Inspecting
books/records
- Including:
- Annual report
- Articles
- Minutes
- Inspection must be in good faith and for a proper purpose that relates to the shareholders’ interest in the corporation.
- Improper purpose:
- Development of a mailing list for sale or similar use
- Discovery of trade secrets
- Gaining a competitive advantage for another company
- Preemptive rights
- These are important to owners of a closely held corporation. They give a shareholder an option to subscribe to a new issuance of shares in proportion to their current interest in the corporation. Thus, they limit dilution of equity.
- RMBCA preemptive rights:
Under the RMBCA, preemptive rights do not apply to stock issued as:
- (1) an incentive to officers, directors, or employees
- (2) in satisfaction of conversion or option rights
- (3) within 6 months from the effective date of incorporation
- (4) for something other than money
- Voting rights
- The articles may establish the voting rights per share.
-
17.7 Directors and Officers: Authority, Duties, and Liability
- Directors’ and officers’ fiduciary duty and the duties of care and loyalty owed to their corporations have been highly publicized because of the major scandals involving improper practices. You most likely will see questions covering these topics on your exam.
-
Rules regarding directors and officers
- Law of agency
- Duties
- Number of directors
- Each state has a specific requirement with respect to the number of directors elected to sit on the board. Many states require a minimum of three.
- The initial board is usually appointed by the incorporators or named in the articles, and this board serves until the first meeting of the shareholders.
- RMBCA directors:
Under the RMBCA, a minimum of one director is required. However, the RMBCA also permits a corporation to dispense with a board by unanimous shareholder agreement.
- Officers'
fiduciary duty
- Agents/managers
- Officers owe the same fiduciary duty
as directors to the corporation
- Directors'
fiduciary duty
- Directors (and controlling/majority shareholders) owe a fiduciary duty
to the corporation to:
- 1) Act in its best interests
- Directors may not usurp any corporate opportunity. A director must give the corporation the right of first refusal.
- Diversion of corporate opportunities to themselves.
- 2) Be loyal
- Duty of loyalty:
- Good faith
- Manner reasonably believes in best interest of corporation
- Care that a person in similar position would reasonable believe appropriate under similar circumstances
- Reliance on others. In exercising reasonable care, a director may rely on information, reports, opinions, and statements prepared or presented by persons (an appropriate officer, employee, or specialist) whom the director reasonably believes to be competent in the matters presented.
- 3) Use due diligence in discharging responsibilities
- Duty of care (tested objectively):
Must discharge director duties in:
- Good faith
- Manner reasonably believes in best interest of corporation
- Care that a person in similar position would reasonable believe appropriate under similar circumstances
- Reliance on others. In exercising reasonable care, a director may rely on information, reports, opinions, and statements prepared or presented by persons (an appropriate officer, employee, or specialist) whom the director reasonably believes to be competent in the matters presented.
- 4) Be informed about information relevant to the corporation
- 5) Disclose conflicts of interest
- Conflicting-interest transactions. To protect the corporation against self-dealing, a director is required to make full disclosure of any financial interest (s)he may have in any transaction to which both the director and the corporation may be a party. A director must not make a secret profit.
- A transaction is not improper merely on the grounds of a director’s conflict of interest. If the transaction:
- (1) is fair to the corporation
- (2) has been approved by a majority of informed, disinterested directors or shareholders, it is not voidable even if the director profits
- Liability
- Business
judgement rule
- Protects directors/officers from personal liability for honest errors in judgment if:
- The law does recognize human fallibility and allows for directors to be safe from liability for honest errors of judgment.
- Acted in good faith
- Not grossly negligent
- Not motivated
by conflict of interest
- Not motivated
by fraud
- Not motivated
by illegality
- RMBCA
articles of incorporation indemnification
- Protects directors/officers from money damages (for expense of ligation involving business judgments) unless:
- Grossly negligent
(as matter of
public policy)
- Exception:
- Acted fairly and reasonably entitled
(in view of relevant circumstances)
- Wrongful acts of a director
- To avoid
personal liability, directors/officers must:
- Informed decisions
(educated
about issues)
- No
conflicts of interest
- Rational basis to support position
- Power
- Director power
- Directors formulate overall policy for the corporation, but they are neither trustees nor agents of the corporation. A director cannot act individually to bind the corporation. Authority to formulate and implement corporate policy is vested in the board, including:
- (1) selecting of officers
- (2) determining
capital structure
- (3) proposing
fundamental changes
- (4) declaring dividends
- (5) setting
management compensation
- Officer power
- Officers are agents of the corporation and manage the corporation. They act with:
- Express authority
- To confer with bylaws/board
- Implied authority
- To act as reasonably necessary to accomplish their express duties
- Rights
- The articles may specify the limit of their rights apart from the following:
- Dissenters'/
Appraisal Rights
- Shareholders who disagree with fundamental corporate changes may be paid the fair value of their shares in cash.
- Example:
- Disposition of assets that leaves the corporation without a significant continuing business activity
- Mergers and share exchanges. Shareholder awareness of dissenters’ rights is especially important in a short-form merger because notice of the merger is not required to be given to shareholders of the parent.
- Inspection rights
- Access to
corporate information
- Inspecting
books/records
- Including:
- Annual report
- Articles
- Minutes
- Inspection must be in good faith and for a proper purpose that relates to the shareholders’ interest in the corporation.
- Improper purpose:
- Development of a mailing list for sale or similar use
- Discovery of trade secrets
- Gaining a competitive advantage for another company
- Preemptive rights
- These are important to owners of a closely held corporation. They give a shareholder an option to subscribe to a new issuance of shares in proportion to their current interest in the corporation. Thus, they limit dilution of equity.
- Voting rights
- The articles may establish the voting rights per share.
-
17.8 Mergers and Termination
-
Rules regarding mergers/termination
- Consolidation
- In a consolidation, a new corporation is formed, and the two or more consolidating corporations cease operating as separate entities. Otherwise, the requirements and effects of the combination are similar to those for a merger.
- A consolidation of two corporations usually requires all of the following:
- 1) approval by the board of directors of each corporation
- 2) shareholders have dissenters’ (appraisal) rights. Thus, consolidation may require a fair value buy-out of the shares of dissenting shareholders
- 3) majority of voting shares of each original corporation
- Dissolution
- A corporation that has issued stock and commenced business may be by:
- Majority shareholder vote at a special meeting called for the purpose if the directors have adopted a resolution of dissolution. A majority of the shares entitled to vote must be represented at the special meeting.
- If a corporation has issued stock and commenced business, its voluntary dissolution requires:
- 1) board approval of a dissolution resolution
- 2) shareholder vote of approval
- 3) filing of articles of dissolution with the secretary of state. This filing serves to dissolve the corporation on its effective date.
- Voluntary dissolution without a board resolution is permitted upon unanimous written consent of the shareholders.
- Shareholders may seek a judicial dissolution when a deadlock of the board is harmful to the corporation, or the directors’ actions are contrary to the best interests of the corporation.
- Mergers
- A merger combines two or more corporations. One corporation is absorbed by the other and ceases to exist. The surviving corporation succeeds to the legal rights and duties, liabilities to creditors, and assets of the merged corporation. In contrast, a corporation can purchase solely the assets of a corporation and then it does not assume the corporation’s liabilities. Under the RMBCA, when a merger becomes effective, (1) the entity designated in the plan of merger as the survivor comes into existence when:
- (1) the entity designated in the plan of merger as the survivor comes into existence
- (2) every entity merged ceases to exist separately
- 3) the property and contract rights of the merged entities are vested in the survivor
- (4) the liabilities of the merged entities also are vested in the survivor
- Additional considerations:
- The shareholders of a merged corporation may receive shares or other securities issued by the surviving corporation. Shares of the merged (acquired) corporation are canceled.
- The purchase or lease of substantially all of the assets of another corporation or an acquisition of another corporation’s shares that allows the acquirer a controlling interest is (not a merger). The acquiree is legally a separate entity. These transactions do not require shareholder approval.
- A merger requires the approval of:
- 1) Each board
- 2) Shareholders entitled to vote
for each corporation. Approval is generally by a majority vote unless state law or the articles require a supermajority. After appropriate notice, shareholder approval must be given at a special meeting.
- Special meeting requirements:
- Appraisal rights
- Approval rights if substantially all corporation's assets are sold outside regular course of business
- Copy of plan of merger
- Tender Offers
- An acquirer may bypass board approval of a business combination by extending a tender offer of cash or shares, usually at a higher-than-market price, directly to shareholders to purchase a certain number of the outstanding shares.
- Managements of target corporations have implemented diverse strategies to counter hostile tender offers. The following are examples of antitakeover strategies:
- Issuing stock.
The target significantly increases its outstanding stock.
- Self-tender.
The target borrows to tender an offer to repurchase its shares.
- Legal action.
A target may challenge one or more aspects of a tender offer. A resulting delay increases costs for the raider and enables further defensive action.
-
17.9 Advantages and Disadvantages of Corporations
-
Review of corporation advantages
- A shareholder has no interest in specific property.
- Constitutional rights. A corporation is considered a person for most purposes under the U.S. Constitution. Thus, it has the right to equal protection, due process, freedom from unreasonable searches and seizures, and freedom of speech. It also has the right to make nearly unlimited contributions of money for political purposes.
- Ease of raising capital. A corporation raises capital (to start or expand the business) by selling stock or issuing bonds.
- Free transferability of interests. Without contractual or legal restriction, shares may be freely transferred, e.g., by sale, gift, pledge, or inheritance.
- Limited liability. A shareholder’s exposure to corporate liabilities is limited to the investment.
- Perpetual life. A corporation has perpetual existence unless the articles provide for a shorter life, or it is dissolved by the state.
- Separation of ownership from management. Shareholders have no inherent right to participate in management.
- Transfers of property to a controlled corporation. A transfer of assets for shares of any corporation is tax-free if the transferors gain control immediately after the exchange. Two or more transferors of appreciated property receive the benefit if together they meet the control test. Property includes money.
-
Review of corporation disadvantages
- An inability of a minority shareholder in a close corporation to liquidate his or her interest or to influence the conduct of the business
- Hostile takeover of a publicly traded corporation
- Payment of taxes on corporate income and payment by the shareholders of taxes on distributions received from the corporation
- Reduced individual control of a business operated by managers, not owners
- Sale or other transfer of unrestricted shares in a close corporation
- State and federal regulation of securities transactions
- Substantial costs of meeting the requirements of corporate formation and operation
-
CPA REG SU18 Contracts
-
18.1 Nature and Classification of Contracts
-
This study unit covers the general concepts of contract law. A contract is formed when its elements are present. But a writing is not required to form a contract. A contract may be oral. The required elements in formation of a contract are:
- 1) Capacity
- 2) Consideration
- 3) Legality
- 4) Mutual assent
(offer and acceptance)
- Objective standard applied to contract breaches/formation:
- If a valid, enforceable contract is formed, the law provides remedies if an obligation under the contract is breached. The law applies an objective standard (a reasonable person standard) to determine whether a contract was formed or breached. A valid contract is legally binding on both parties.
-
Rules regarding contract classification/nature
- Contract classification
- Express contract
- The terms of an express contract are stated, either in writing or orally.
- Implied contract
- The terms of an implied contract are wholly or partially inferred from conduct and circumstances but not from written or spoken words.
- Implied in fact:
A contract is implied in fact when the facts indicate a contract was formed.
- Bilateral contract
- In a bilateral contract, both parties make promises. One promise is consideration for the other.
- Promisor 1:
- (S)he makes the promise and is obligated to keep the promise
- Promisor 2:
- (S)he makes the promise and is obligated to keep the promise
- Unilateral contract
- In a unilateral contract, only one party makes a promise.
- Actor/promisee:
- (S)he performs a defined action
(an acceptance)
- Promisor:
- (S)he makes the promise and is obligated to keep the promise if the defined action
(an acceptance) is taken
- Unenforceable contract
- An unenforceable contract is a valid contract because it has all the elements of a contract. But the law will not enforce the contract because it does not comply with another legal requirement.
- Illegal
- Not enforceable
- Valid contract
- Valid contract
- A valid contract has all the elements of a contract, and the law provides a remedy if breached. A valid contract is legally binding on both parties.
- Legal
- Enforceable
- Legal remedy available
- Valid contract
- Void contract
- A void contract is not binding and is considered void since its inception. A void contract cannot be ratified and enforced.
- Illegal
- Not enforceable
- Invalid contract
- Voidable contract
- A party may choose to either enforce or nullify a voidable contract.
- Legal
- Enforceable/
Nullifiable
- Legal remedy available
(if not nullified)
- Valid contract
-
18.2 Mutual Assent (Offer and Acceptance)
- The AICPA has consistently tested candidates on the mailbox rule, including when an offeror attempts revocation after an acceptance has been dispatched.
-
Rules regarding mutual assent (offer/acc.)
- Acceptance
- The offeree has an exclusive power of acceptance, but neither the offeror nor the offeree is obligated until acceptance. The offeror may expressly limit what constitutes acceptance. This principle is the mirror image rule. An acceptance must:
- Acceptance must be communicated to the offeror by any words or actions that a reasonable person would understand as an acceptance.
However, an offeror generally cannot require the offeree to respond to avoid being contractually bound.
- Generally, acceptance by an unauthorized means is effective upon receipt by the offeror, assuming the offer has not expired or been revoked.
- If an offeror specifies a means of acceptance, it must be used. The offeror may waive compliance with particular terms of an offer regarding acceptance. For example, a deficient or late acceptance may be a new offer that the original offeror chooses to accept.
- Mailbox rule:
The offer may state that acceptance is effective on receipt. If it does not, the law applies the mailbox rule to determine when the offer is accepted. Under the mailbox rule, acceptance is effective when:
- Mail is dispatched if:
- If it was properly addressed and had proper postage affixed, the acceptance is considered legally effective even if it never reaches the offeror.
- Acceptance is effective even if the offeror attempts revocation while it is in transit. This outcome is avoided if the offeror explicitly states that the “acceptance must be received to be effective.”
- (1) the offeree has used an authorized means of acceptance to communicate to the offeror
- (2) the offer is still open
- 1) Be positive
- 2) Be unconditional
- If a conditional acceptance requires the offeror’s agreement to additional or different terms, it is a counteroffer, not an acceptance.
- 3) Be unequivocal
- 4) Relate to the terms of the offer
- Offer
- An offer is a statement or other communication by which the offeror grants the offeree the power to accept a condition and form a contract. An offer must:
- Advertisements usually are not offers but invitations to submit offers. However, an advertisement can constitute an offer if it uses clear, definite, and explicit language that leaves nothing open for negotiation.
- Invitations to negotiate and preliminary negotiations do not constitute an offer. Invitations to negotiate include phrases, such as, “Are you interested in. . .” or “I’ll probably take. . .” They differ from the language of an offer, which indicates commitment and intent to contract.
- 1) Be communicated to an offeree
- 2) Be in a communication
authorized by the offeror
- No specific manner of communication of the offer is required. An offer need not take any particular form. For example, nonverbal communication may be appropriate.
- 3) Be sufficiently definite and certain
- Material terms:
Generally, a contract must be reasonably definite as to material terms and clearly state the rights and duties of the parties. If a term is missing, it can be implied by the court (with the exception of a quantity term, which must be supplied by the parties). The presumption is that the parties intended to include a reasonable term. Essential terms include:
- 1) Names of the parties involved
- 2) Price and quantity
- Price terms:
The law requires definiteness of the price term and generally will not imply the price (e.g., of real estate).
- Quantity terms:
Quantity terms must be supplied by the parties. A quantity term is sufficiently definite if it is defined by the:
- Buyer's reasonable requirements
- OR
- Seller's reasonable output
- 3) Subject matter involved
- 4) Time and place of performance
- 4) Objective intent:
Indicate an objective intent to enter into a contract as determined in accordance with a reasonable-person standard
- Termination of offer
- Death or incompetence
- Death or incompetence of either the offeror or the offeree generally terminates
(the power of acceptance), whether or not the other party had notice.
- Death or incompetence generally does not terminate an existing contract, including an offer in a valid option contract. The offeree has already given consideration.
- Incompetence is a lack of legally required qualifications or physical or psychological fitness to bind oneself by contract.
- Destruction or loss
- Destruction or loss of the
(specific subject matter) terminates an offer.
- Illegality
- Illegality of a proposed contract or performance terminates the offer.
- Lapse of time
- If no time is stated in the offer, the offer terminates after a reasonable period. Under the Uniform Commercial Code (UCC), a merchant’s written, signed firm offer to:
- Sell goods that is to be held open for a stated or a reasonable period:
- Up to:
- 3 months
- Offer irrevocable
- If time is stated in the offer, the offer may be legally withdrawn at any time prior to acceptance for an offer for sale of land, even though it states it will be held open for a specified period. Under the UCC an offer to:
- An offer for (sale of a building) because it is not for a sale of goods it is:
- Not a firm offer
- Rejection
- Rejection terminates the offer. It implies an intent not to accept the offer. After rejection is effective, later attempted acceptance becomes a new offer.
- Rejection is effective when:
- Received by offeror
- Rejection communication by
any reasonable means:
- Express
- It may be expressed or implied by words or conduct. A counteroffer is rejection of an offer and a new offer from the original offeree. In contrast, a mere inquiry about the proposed terms of an offer is tentative and does not indicate intent to reject the offer.
- Implied
- It may be expressed or implied by words or conduct.
- Revocation
- The offeror may revoke an offer at any time prior to acceptance. Revocation must be communicated to the offeree prior to the offeree’s acceptance.
- Revocation is effective when:
- Received by offeree
- Revocation communication by
any reasonable means:
- Direct
- An offer stating it will remain open may be terminated by notice that it has been revoked. But if consideration is given for an option or a firm offer is made, the offer is not revocable.
- Indirect
- For example, an offeree may receive indirect notice of revocation if given actual notice of sale of the subject matter to another party. The offeree’s knowledge that a third party has offered to buy the subject matter of the offer is not a revocation.
- A contract is formed when a party accepts an offer.
-
18.3 Consideration
-
Consideration is something of value given in a bargained-for exchange. It is the promise, act, or forbearance to do or not do something that parties agree to as part of their agreement. The elements of consideration are:
- 1) Legal sufficiency
- 2) Bargained-for exchange (mutuality of consideration)
- Consideration is always in the form of a/an:
- Act
- Forbearance
- Patient self-control; restraint and tolerance
- "Forbearance from taking action"
- Promise
-
Rules regarding consideration
- Bargained-for exchange (mutuality of consideration)
- A bargained-for exchange occurs when:
- One party makes a promise or performance in exchange for a
- Return promise or performance by the other party
- Legal sufficiency
- Consideration is legally sufficient to render a promise enforceable if:
- 1) Promisee incurs a
legal detriment
- To incur a legal detriment, the promisee must:
- Inequality/parity of value is not required. Consideration may be legally sufficient without a simultaneous exchange and despite the form of the consideration.
- But extreme inadequacy or inequality of consideration may be evidence of fraud, a mistake, or a gift.
- 1) Do something (s)he is not legally obligated to do
- 2) Forebear to do something (s)he has a legal right to do
- 2) Promisor receives a legal benefit
- Items not sufficient consideration
- Part payment of disputed/
undisputed debt
- Disputed (unliquidated) debt:
Part payment of an disputed
(unliquidated) debt is consideration for the creditor's forgiveness of the remainder, however, the dispute must be in good faith.
- Undisputed (liquidated) debt:
Part payment of an undisputed (liquidated) debt is not consideration for a promise by the creditor to accept the part payment in full satisfaction of the debt.
- Past consideration
- Past consideration cannot be bargained for. Such acts have already happened, and the acting party cannot effectively promise to incur any legal detriment.
- Pre-existing
legal duty
- Consideration does not
exist if:
- Existing duty was
imposed by law
- Person is already under contract to render a specified performance
- Substitutes for consideration
- Promissory estoppel
- Promissory estoppel
(prevent action/forbearance)
applies when:
- Injustice can be avoided only by enforcing the promise
- Promise is given that the promisor should reasonably expect to induce action or forbearance (restraint)
by the promisee
- Promise induces action or forbearance by the promisee
- Quasi-contract
(contract implied in law)
- A court finds that a quasi-contract (contract implied in law) exists when:
- Parties make no promises
- AND
- Reach no agreement
- One of the parties is substantially benefited at the expense of the other, and no legal remedy is adequate
- To avoid unjust enrichment of the receiving party:
- Party who provided the benefit is entitled to the reasonable value (not the contract price)
- For the services rendered or property delivered
-
18.4 Capacity
-
Parties to a contract must have the legal capacity to contract. The UCC (Uniform Commercial Code) adopts the common law in determining legal capacity to contract. The following do not have legal capacity to contract:
- Incompetent
- Intoxicated
- Minors
-
Rules regarding capacity
- Incompetent
- Judicially determined
- Before contract:
If a person was judicially determined to be insane or otherwise incompetent before contract formation, the contract is:
- Not ratified
- Void
- After contract:
If a person was judicially determined to be insane or otherwise incompetent after contract formation, the contract is:
- Voidable
- Did not understand the nature and consequences of his or her actions
- Intoxicated
- Other party must have reason to know
- If the other party had reason to know that the intoxicated person:
- Did not understand the nature and consequences of his or her actions
- OR
- Unable to act reasonably
- At the option of the intoxicated person the contract is:
- Voidable
- Minors
- Disaffirm
(void a contract)
- Any unequivocal act that indicates an intent to disaffirm is sufficient. A written disaffirmance is not required. Performance is not a condition of disaffirmance.
- Because a minor does not have legal capacity to enter contracts, a minor may disaffirm his or her contract. Thus, the contract is voidable by the minor.
- However, the minor is liable until disaffirmance. Moreover, regardless of disaffirmance, a minor is always liable based on a quasi-contract for the reasonable value, not the contract price, of necessaries (e.g., food, shelter, and clothing).
- When the contract has been partially or wholly performed, the minor must, if possible, return any consideration received from the other party.
- Minor may disaffirm even if
(s)he cannot return the consideration or the consideration is damaged.
- Power to disaffirm continues until a reasonable time after the minor reaches the age of majority.
- Ratification
- A contract entered into by a minor may be ratified by the minor orally or in writing after (s)he has reached the age of majority.
- Ratification may be either expressed or implied.
- Ratification occurs if:
- Minor retains the consideration for an unreasonable time after (s)he reaches majority. Selling or donating property is ratification by the minor
- Minor fails to disaffirm for a reasonable period after reaching majority
-
18.5 Legality
- A promise to commit, or induce the commission of, a tort or crime is void on grounds of public policy. Agreements not to press criminal charges are not enforceable. They interfere with the state’s duty to protect society by prosecuting criminals.
-
Rules regarding legality (of contracts)
- Contracts in
restraint of trade
- A contract in restraint of trade restricts competition or otherwise interferes with the normal flow of goods or services. Thus, courts are reluctant to enforce them and they are narrowly construed (interpreted in a narrow way).
- Covenant not to compete
- A typical restraint on trade is a covenant not to compete. It is an agreement not to engage in a particular trade, profession, or business. This restraint may be valid if:
- Purpose is to protect a property interest of the promisee
- Restraint is no more extensive in scope and duration than is reasonably necessary to protect that property or legitimate business interest
- Employment contract
- An employment contract may include a covenant not to compete during or after the period of employment.
- Restrictions on future employment tend to be:
- More strictly scrutinized than covenants not to compete in agreements to sell a business
- Restraint that is unreasonable (for example, because of its effect on the ability to find other employment) by the court may be:
- Revised
- Voided
- Licensing statues
- A regulatory statute is enacted for the protection of the public against unqualified or incompetent persons.
- If a licensing statute is:
- Revenue measure
(solely)
- Enforceable
- If a licensing statute is:
- Protection of the public against:
- Disqualification
- Incompetency
- Regulatory
- Not enforceable
- Even if the defendant was benefited and the work performed was satisfactory.
- Statutory violations
- A contract that cannot be performed without violating a statute is void.
- Commission of an illegal act during performance of a contract does not make the contract illegal. If the formation of the contract violated no law and the contract could be performed without violating any law, the contract is enforceable.
- Party who agrees to supply goods or services while unaware that such goods or services will be used for an unlawful purpose can enforce the contract.
- Person who intends to accomplish an unlawful purpose may not enforce a contract made for that purpose.
- Enforceable
- Not enforceable
- Void
-
18.6 Lack of Genuine Assent
-
A contract induced by an intentional misrepresentation or the omission of a material fact is considered procured by fraud and is therefore voidable.
- Lack of
genuine assent
(contract fraud):
- Intentional misrepresentation
- Intentional omission of a material fact
- Voidable
-
Rules regarding lack of genuine assent
- Elements of fraud:
- 1) Misrepresentation
- Actual/implied
false representation of a material fact
- Actual/implied
concealment of a material fact
- Types of misrepresentation and misrepresentation remedies:
- Fraudulent misrepresentation
- Damages
(injury caused by misrepr.)
- Rescission
of contract
- Innocent misrepresentation
- Damages
(occasionally/reliance upon misrepr.)
- Material fact
(misrepr.)
- Believed fact true
- No knowledge
of falsity
- Relied upon
- Acted with due care
- Reasonably relied on
- Rescission
of contract
- Negligent misrepresentation
- Damages
(only losses)
- Material fact
(misrepr.)
- No knowledge
of falsity
- Relied upon
- Acted with due care
- Mistaken misrepresentation
- Rescission
of contract
- Material fact
(misrepr.)
- Mutually mistaken about fact
(not value/quality)
- Defense
sufficient for:
- Failure to
perform contract
- Unilateral mistaken misrepresentation
- Rescission
of contract
- Material fact
(misrepr.)
- Party was mistaken about fact
(limited cases) If:
- Enforcement would result in extreme hardship constituting injustice
- Error was due to a mathematical mistake or omission of items in computing the cost of the contract
- Other party knew/should have known of mistake
- Mistake was due to fraud, duress, or
undue influence
- Relied upon
- Acted with due care
- 2) Intent to misrepresent
(scienter)
- The intent element is satisfied
if the defendant:
- (1) knew the representation was false
- (2) recklessly disregarded
its truth of falsity
- 3) Intent to induce reliance
- 4) Justifiable actual reliance by the innocent party based on the misrepresentation
- 5) Damage (loss) suffered by the innocent party
- Other considerations regarding fraud:
- Duty to disclose facts
- Failure to do any of the following duties to disclose facts constitutes actual fraud in these circumstances:
- Important fact is misstated. It must be corrected as soon as possible
- Parties have a fiduciary relationship
- Party knows a material fact and the other could not reasonably discover it
- Fraud in the execution
- Fraud in the execution occurs when the signature of a party is obtained by a fraudulent misrepresentation that directly relates to the signing of a contract. The purported contract is:
- Void
- Fraud in the inducement
- Fraud in the inducement occurs when the defrauded party is aware of entering into a contract and intends to do so, but the contract is procured by fraud.
- Defrauded party intentionally deceived about a material fact to the contract (e.g., the nature or value of the goods or services). Contract is:
- Voidable
- Statement of fact/opinion
- A statement of opinion or a prediction is not usually the basis of a fraud claim. An opinion or prediction is generally subject to debate.
- A statement of fact is objective
and verifiable.
- Types of duress
- Civil suit threat:
A threat of a civil suit is not improper unless it is made in bad faith, that is, when such an action has no legal basis.
- Bad faith:
No legal basis
- Criminal prosecution threat:
A threat of criminal prosecution is improper. Although a person has a legal right to report a crime to the police, (s)he may not do so for private gain.
- Economic duress:
Economic duress may arise when one party exerts extreme economic pressure that leaves the threatened party with no reasonable alternative but to comply.
- Inadequacy of consideration is not an element of duress.
- Merely taking advantage of another’s financial difficulty is not duress.
- Improper threat:
Improper threat that instills fear in a second party, effectively denies the second party’s exercise of free will. An improper threat must have:
- Bad faith:
No legal basis
- Sufficent coercive effect:
Actually induces the particular person to agree to the contract
- Ulterior motive
- Personal violence threat:
Physical compulsion with threats of personal violence renders the contract void.
- Void
- Undue influence:
Undue influence occurs when a dominant party (for example, a trusted lawyer, physician, or guardian) [wrongly exploits a confidential relationship] to persuade a second party to enter into an unfavorable contract.
- Voidable
- A threat based on a legal right and not constituting a tort or a crime may be improper if made in bad faith and with an ulterior motive.
- Voidable
- See also
Study Unit 2.2
-
18.7 Statute of Frauds
-
An oral contract is usually enforceable. However, the statute of frauds requires certain contracts to be in writing and signed by the defendant. The statute of frauds relates to contract enforceability,
not contract formation.
- Statue of frauds addresses:
- Enforceability
- Not formation
-
Rules regarding statue of frauds
- Types of agreements covered by statue of frauds:
- Agreement for debt payment
- Agreements to answer for the debt of another. A suretyship agreement must be in writing if the promise is secondary.
- Main purpose rule:
The promise is designated as primary or secondary.
- Primary promise:
Main purpose is to benefit the promisor
(the party who agrees to pay if the debtor defaults)
- Primary promises are enforceable even if not in writing.
- Secondary promise:
Main purpose is to benefit the debtor
- Agreement for goods
- Agreements for the sale of goods for $500 or more. An agreement for the sale of goods for $500 or more is not enforceable without a writing sufficient to indicate that a contract for sale has been made between the parties.
- Agreement for land
- Agreements for the sale of an interest in land. An interest may be a long-term lease (more than 1 year), mortgage, full ownership, or any other interest in land.
- Agreement for marriage
- Agreements made in contemplation of marriage. A promise to marry must be made in writing (with consideration) other than mutual promises to marry.
- Agreement for performance
- Agreements that cannot be performed within 1 year of the making of the contract. If performance, however difficult or improbable, is possible within 1 year, the agreement is not covered by the statute of frauds.
- Agreement written memo
requirements covered by statue of frauds:
- See contrast with an offer
- A written memorandum complies with the statute if it contains the following:
- 1) Reasonably certain description of the parties and the subject matter
- 2) Essential terms and conditions of the contract
- 3) Description of the consideration
(no minimum or adequate amount is required)
- 4) Signatures of the parties against whom the writing is to be enforced
- A party who signs a sufficient writing may be bound to performance, even if the other parties do not sign.
- 5) May consist of several writings if:
- Facts clearly indicate that all writings relate to the same transaction
- Written agreement signed
(at least one of the writings)
- Enforceable
- The day the contract is made is excluded.
- 1-year period expires at the close of the contract’s express termination date.
- Enforceable
- Parties to an oral contract have fully performed
(written requirement not required)
- Lack of written evidence ordinarily does not prevent enforcement if one party has fully performed.
- Parties to an oral contract partly performed
for sale of land. If part performance is established, a court may grant specific performance and force the transfer of the land
(written requirement not required)
- The purchaser
must have:
- 1) Taken action that is clearly based on the oral agreement
- 2) Reasonably relied on it to his or her substantial detriment
-
18.8 Parol Evidence Rule
- The AICPA often tests whether the parol evidence rule applies to terms in a contract.
-
The parol evidence rule excludes any prior agreement or an oral agreement made at the time of the final writing that would tend to vary or contradict the terms of a written agreement intended to be complete. If the parties meant their written agreement to be entire, only terms incorporated directly or by reference are part of the contract as it existed at the time it was set forth in writing and signed.
- Parol evidence rule excludes:
- Prior/oral agreement prior to final writing
- Exception:
- Parol evidence is admissible to prove or explain the following:
- Circumstances that make the written contract void, voidable, or unenforceable
- Examples:
- Capacity
(lack thereof)
- Duress
- Fraud
- Legality
(lack thereof)
- Mistake
- Precedent
condition failure
- Undue influence
- Meaning of ambiguous terms in contract explained or supplemented by:
- a) Course of dealing or performance
- b) Usage of trade
- Subsequent mutual modification
or rescission
- A writing apparently complete on its face is assumed to be completely integrated
at the time of its making.
- Most contracts contain a merger or integration clause that states the writing constitutes the entire and final agreement between the parties.
- To determine the meaning of the contract, the parties must rely upon the wording in the document and cannot offer other evidence as to its meaning.
-
18.9 Performance, Discharge, and Breach
-
Rules regarding contract perf./disch./breach
- Contract performance additional considerations
- Condition classifications
- Failure of a condition does not subject either party to liability because it is an event that must occur for the contract to continue. Conditions may be classified based on their timing:
- Concurrent condition
- Event must occur or be performed simultaneously
- Precedent condition
- Event must occur before performance is due
- Subsequent condition
- Event terminates party's duty and another's right to damages for breach of duty. For example, a supplier has no contractual duty to deliver if the buyer ceases operations
- Type of condition
- Express condition
- Explicitly stated condition usually preceded by terms such as "on condition that" or "subject to"
- Implied condition
- Not expressly stated in contract but inferred
- Implied-in-fact
- Implied-in-fact conditions are understood by both parties to be part of the agreement.
- Implied-in-law
- Implied-in-law conditions are imposed by law to promote fairness.
- Types of breach
- A breach is the failure of a party to perform a duty required under a contract. The following are types of breaches:
- Anticipatory breach
- An anticipatory breach occurs when one party repudiates the contract. An anticipatory repudiation is an express or implied indication that (s)he has no intention to perform the contract prior to the time set for performance.
- Material breach
- A material breach is an unjustified failure to perform obligations arising from a contract, such that one party is deprived of what (s)he bargained for. A material breach discharges the nonbreaching party from any obligation to perform under the contract and entitles that party to sue for breach of contract.
- Nonmaterial breach
- A nonmaterial breach is unintended, and the injured party receives substantially all of the benefits reasonably anticipated.
- Statute of limitations
- A statute of limitations is a law that designates a time period after which litigation may not be commenced. Expiration of the time period bars a judicial remedy. The statutory period begins to run for a breach of contract claim from the:
- Later of:
- Date of breach
- Date party should reasonably have discovered the breach
- Types of discharge
- Discharge by agreement
- Composition with creditors:
In a composition with creditors, the participating creditors agree to extend time for payment, take lesser sums in
(satisfaction) of the debts owed, or accept some other plan of financial adjustment.
- The consideration is provided by the mutual promises of the creditors to accept less than the amounts due.
- Modification:
Modification of an existing contract’s term(s) traditionally requires new consideration.
- Consideration exception:
Under Restatement
(Second) of Contract,
modifications do not require consideration if:
- Nonperformance
of contract
- Modification fair given facts the parties did not anticipate when the contract was formed
- Consideration exception:
Under the UCC, modifications do not require consideration if:
- Made in good faith
- Sale of goods
- Mutual rescission:
Mutual rescission occurs when the parties to a contract agree
to cancel it.
- Accord/satisfaction:
By an accord, a promisee agrees to accept a substituted performance by the promisor. Parties to a contract may make a new contract (an accord) in which the prior and the new contracts are to be discharged by performance
(satisfaction) of the new contract.
- The implied promises not to sue provide the consideration.
- Example:
- EXAMPLE 18-20
Accord and Satisfaction
A general contractor and a homeowner contract for the construction of a deck on the back of the house. The contract specifies that the deck is to be constructed of pine, and the homeowner will pay $5,000. As construction is nearing completion, the homeowner discovers that pine has not been used in the deck and addresses this issue with the contractor. Both parties agree that the price of the deck construction will be lowered to $4,000 given the contractor’s mistake. After the construction is completed, and the homeowner pays the contractor $4,000, neither party can sue successfully because of the inferior wood or decreased payment. The accord and satisfaction bars this legal action.
- Release:
One party releases another of performance obligations without restoration to all parties’ original positions. Releases are commonly used to settle differences if liability is contingent or disputed.
- Substituted contract:
A substituted contract is an agreement among all parties that cancels an existing contract.
- New contract is supported by new consideration, which may include a promise made by a new party.
- Novation:
A novation is a special form of substituted contract that replaces a party to the prior contract with another who was not originally a party. It completely releases the replaced party.
- The promise of the new party to perform in accordance with the novation is consideration for release of the replaced party.
- Discharge by
operation of law
- Commercial impracticability
- Commercial impracticability results from an unforeseen and unjust hardship. It is a less rigid doctrine than the impossibility exception. Impracticability results from occurrence of an event if its nonoccurrence was a basic assumption of the contract. An issue is whether the promisor assumed the risk of such an event.
- Nonoccurence of event basic
contract assumption
- Unforeseen event
- Unjust hardship
- Frustration of purpose
- Doctrine of frustration of purpose is a doctrine that permits discharge of parties even though performance is still possible. Frustration occurs when a contract becomes valueless, that is, when the purpose for which it was entered is no longer available because it has been destroyed by an intervening event that was not reasonably foreseeable.
- Purpose of contract destroyed by event
(valueless contract)
- Unforeseen event
- Legality (lack thereof)
- The nonperformance of a contractual duty may be excused if, after formation, the contract becomes objectively impossible to perform (e.g., the law changes, making the contract illegal).
- Objective impossibility
- Strict performance exception
(impossibility of performance)
- Impossibility is an exception to the general rule of strict performance. The impossibility (must be objective) in the sense that no one could perform the duty or duties specified in the contract. Circumstances must have
(changed so completely since the contract was formed) that the parties could not reasonably have foreseen and expressly provided for the change.
- Circumstances changed completely
- Objective impossibility
- Unforeseen event
- Example:
- For example, an essential party to the performance of a contract dies or is incapacitated, an essential item or commodity is destroyed, or an intervening change of law makes performance illegal.
- However, the death, incapacity, or bankruptcy of a party who is to receive the performance does not discharge the duty.
- Discharge by
strict performance
- A party discharges his or her contractual obligations by performing according to the terms of the contract.
- Discharge by
substantial performance
- Substantial performance is a lesser standard of performance. It applies when duties are difficult to perform without some deviation from perfection. Substantial performance in good faith may be achieved even with an immaterial breach of contract.
- Doctrine is not applied if the party has (intentionally committed) this immaterial breach.
- Good faith is expected of the parties in performing contractual promises. Each party has a duty not to prevent another party from performing.
- Example:
- EXAMPLE 18-19
Discharge by Substantial Performance
A contractor has just completed a mansion. Upon inspection, the homeowner finds that cheap water fixtures were used even though she explicitly required an expensive brand. Accordingly, she refuses to pay for or accept the home, attempting to void the contract. Because the breach is immaterial in relation to the total contract, the homeowner must pay for and accept the house. The contractor must pay damages for the repair or replacement of the fixtures.
-
18.10 Remedies
-
Rules regarding contract remedies
- Types of damages
- The most common remedy for breach of contract is a judgment awarding an amount of money to compensate for damages. Damages is a typical remedy for breach of a contract involving personal property. Types of damages include:
- Compensatory damages
- Awarded for breach of contract when:
- Compensatory damages are intended to place the injured party in as good a position as if the breaching party had performed under the contract.
- Wrongful conduct
- Following are measures of compensatory damages:
- Consequential damages are not incidental damages. They are additional damages resulting from special circumstances that the defendant had reason to foresee.
- Foreseeable
- Incidental damages:
Incidental damages result directly
from the breach.
- Direct
(result of)
- Punitive damages
- Awarded for breach of contract when:
- Punitive damages punish a breaching party and set a public policy example for others.
- Malicious
- Physically injurious
- Willful
- Liquidated damages
- Awarded when contract clause is enforceable:
- Liquidated (undisputed) damages are agreed upon money damages in advance of an actual breach.
- Clause not intended
as penalty
- Loss difficult to calculate
- Reasonably forecasts probable loss due to breach
- Mitigation requirement
- An injured party is required to take reasonable steps to mitigate damages (s)he may sustain as a result of the breach.
- Other remedies
- Injunction
- An injunction is a court’s order to do or not do some act.
- Reformation
- When the parties’ written agreement imperfectly expresses the parties’ intent, it can be rewritten.
- Replevin
- Replevin is an action to recover personal property taken unlawfully.
- Rescission
- Rescission results from:
- Rescission cancels a contract and returns the parties to the positions they would have been in if the contract had not been made. Nonbreaching party may, if the breach is material, elect to rescind and not be bound by the contract. This remedy is customarily available for personal property.
- Conduct of parties
- Court order
- Mutual consent
- Restitution
- Restitution is available when a party’s performance conferred a recoverable benefit on the other party.
- Specific performance
- Awarded when contract clause is enforceable:
- Specific performance is a nonmonetary judgment entered by the court requiring the breaching party to perform the duties specified in the contract.
- Equitable remedy of specific performance will be granted when the legal remedy of damages is insufficient, for example, because the subject matter is unique.
- Parcels of realty are considered unique, so contracts to sell real estate are specifically enforceable. Although contracts for the sale of antiques, heirlooms, and other rare items also are specifically enforceable, most contracts involving personal property are not.
- Not awarded for
personal service contract.
- Irreparable injury will result if specific performance is not granted
- Other legal remedy inadequate
- Monetary damages
not available/inadequate
- Subject matter of contract unique
-
18.11 Contract Beneficiaries
-
Rules regarding contract beneficiaries
- Intended beneficiary
- Creditor beneficiary
- If a promisee’s main purpose in entering the contract with promisor is to discharge a debt (s)he owes to a third party, the third party is an intended creditor beneficiary. If the contract in Example 18-21 above is breached, the creditor (Cathy) may sue the promisor (Adam) as a third-party beneficiary. But the creditor also may sue the original debtor (Ben).
- A creditor beneficiary has standing to enforce a contract to which (s)he is a third party. Because the intent of the promisee in entering into the contract with promisor was specifically to have return performance (payment) to discharge the debt to a third party, the third party is a creditor beneficiary.
- Creditor awareness is not sufficient. The parties to the contract must have intended direct benefit to the third party.
- Donee beneficiary
- If a promisee’s main purpose is to confer a benefit on a third party as a gift, the third party is a donee beneficiary (e.g., a beneficiary of life insurance).
- A person is a donee beneficiary if the promisor’s performance was intended as a gift to that person.
- Incidental beneficiary
- An incidental beneficiary is a nonparty who might benefit if the contract is performed but whom the parties did not intend to benefit directly. Because an incidental beneficiary is not an intended beneficiary, (s)he has no legal right to sue for performance of the contract. Reliance is irrelevant.
- Privity of contract beneficiary
- Promisor
- Promisee
- Third-party intended beneficiary
- In a third-party beneficiary contract, at least one performance is intended for the direct benefit of a person not a party to the contract (not in privity of contract). This person is an intended beneficiary. Intended third-party beneficiaries have rights under the contract.
- An intended third-party beneficiary’s rights are derivative and therefore they are the same rights as the promisee’s. The promisor may assert any defense against the beneficiary that the promisor could have asserted against the promisee.
- Examples:
-
18.12 Assignment and Delegation
-
Rules regarding contract assignm./deleg.
- Assignment of contract rights
- A party to a contract ordinarily may transfer his or her rights under the contract to a third person without discharging the other party’s duty to perform.
- Obligee
- Recipient of the payment or benefit
- Right of the obligee is the obligor’s performance (e.g., a payment)
- Assignment:
- An assignment is a manifestation of the assignor’s intent to transfer the right to the obligor’s performance
(due to the obligee) to a third party, the assignee.
- Assignment are assignable without consent of the obligor.
- A right cannot be assigned without consent if the assignment would result in a material increase or alteration of the duties or risks of the obligor (e.g., insurance policies).
- Assignments of highly personal services contracts without consent are invalid. Examples are accounting, legal, medical, architectural, and artistic services.
- Reliance by one party on the character or creditworthiness of the other party cannot be assigned without consent.
- Assignment can be effective without notice to the obligor.
- Assignment may be gratuitous
(without consideration).
- Assignment need not be written unless required by statute.
- Exception:
- An attempted assignment of a contract right is not effective if:
- Expressly stated in contract that contract is not assignable
- Nevertheless, the following are assignable despite an agreement not to assign:
- Negotiable instruments
- Right to
receive money
- Assignee
- Recipient of the assignment
- Right of the assignee is the assignor's performance (e.g., transfer of assignment). Assignee acquires all of the assignor’s rights. The assignee stands in the shoes of the assignor
- The assignor’s right to the obligor’s performance is extinguished in whole or in part if the assignment is unconditional.
- Assignor
- Contractually committed to provide the payment or benefit to the assignee
- Obligee
- Assignment:
(subleases)
- An assignment transfers the lessee’s interest for the entire unexpired term of the original lease. A sublease is a partial transfer of the tenant’s rights, and the sublessee is not in privity of estate or contract with the lessor.
- Assignment are assignable without consent of the landlord.
- A lease term that prohibits assignment does not necessarily prohibit subleasing and vice versa.
- Exception:
- An assignment or sublease does not alter the legal relationship between the original lessee and lessor.
- The right may be restricted by the lease agreement.
- Subleasee
- Recipient of the interest in the entire unexpired term of the original lease
- Subleasor
- Contractually committed to provide the payment or benefit to the subleasee
- Lessee
- Obligor
- Contractually committed to provide the payment or benefit to the obligee
- Obligor can assert the same defenses against the assignor and assignee.
- Notice of assignment
- Between assignor and assignee, assignment is effective when made, even if no notice of assignment has been communicated to the obligor.
- Performance before assignor notice
- Performance that the obligor renders to the assignor before receiving notice discharges the obligor’s contract obligation to the assignee to the extent of the performance.
- If the assignee does not give proper notice, (s)he cannot sue the obligor and force a repeat performance but instead must sue the assignor.
- After notice of the assignment is given, the assignee has the additional option of suing the obligor for payments made to the assignor.
- Performance assignor/trustee
- The assignor is a trustee for the assignee of pre-notice or post-notice amounts received from the obligor after the assignment. The assignor must account to the assignee for these amounts.
- Example:
- Revocability of assignment
- Assignment with consideration:
An assignment given for consideration is irrevocable.
- Assignment (gratuitous):
A gratuitous assignment is usually revocable by the assignor.
- Following are means of revocation:
- Assignor’s receipt of performance directly from the obligor
- Assignor’s subsequent assignment of the same right to another assignee
- Bankruptcy of the assignor
- Death or insanity of the assignor
- Notice of revocation communicated by the assignor to the assignee or obligor
- Following are means of
preventing any revocation:
- Assignee has collected
from the obligor
- Assignee has made a further assignment for consideration
- Effective delivery of the gratuitous assignment to the assignee by the assignor. An example is a physical delivery of a signed, written assignment of the right
- Warranties of assignment
- Assignment with consideration:
If assignment is for consideration, the assignor impliedly warrants that the assignor will:
- Honor right assigned exists and is not subject to any limitations or defense against the assignor, except any that are stated or apparent
- Honor writing (any writing) shown to the assignee as evidence of the right is genuine
- Not impair the value of the assignment and has no knowledge of any fact that would
- If an assignee releases the obligor, the assignor also is released.
- Example:
- Delegation of contract performance
- Delegation means that a person under a duty to perform authorizes another person to render the performance.
- Obligor
- Contractually committed to provide the payment or benefit to the obligee
- The obligee may sue the delegatee, the obligor, or both after a breach.
- Delegation:
- A delegator may delegate performance if the delegatee’s performance will be substantially similar to the delegator’s (e.g., paying money, manufacturing ordinary goods, building according to a set of plans and specifications, or delivering standard merchandise).
- Assignment are assignable without consent of the obligee
- General language, such as “I hereby assign the contract,” is a delegation of performance as well as an assignment of rights.
- Assignment are assignable without notice to the obligee
- Delegation of performance does not relieve the obligor of liability even if notice is given to the obligee (unless the contract provides otherwise).
- Exception:
- Assignment is ineffective if a risk or duty of a party to the contract is materially increased, or an exception otherwise applies.
- Delegator
- Recipient of the delegation
- Delegatee
- Contractually committed to provide the payment or benefit to the obligee
- Obligor
- Example:
-
CPA REG SU19 Agency and Regulation
-
19.1 Agency Formation
-
The law of agency is a common law concept that allows one person to employ another to do his or her work. The American Law Institute’s Restatement (Second) of the Law of Agency summarizes the common law.
- Law of Agency
- Common/federal/statutory law
- Summarized in:
- American Law Institute's
Restatement (Second) of the Law of Agency
- American Law Institute's
Restatement of the Law Third, Agency
- CPA exam emphasis:
- Agency
- Formation
- Significance of disclosure
- Termination
- Relates to
rights and duties of:
- Agents
- Authority
- Actual
- Apparent
- To principal
- To third parties
- Principals
- To agent
- To third parties
-
Rules regarding agency formation
- Agency
- Agency describes an express or implied consensual relationship whereby two parties mutually agree that one party (the “agent”) will act on behalf of the other party (the “principal”) in dealing with third parties.
- Appointment
- General power of attorney
- Special power of attorney
- Durable power of attorney
- Remains in effect during period of principal's incapcity
- General and special powers of attorney ordinarily terminate upon incapacity of the principal. But any power of attorney may be exercised in good faith and with no knowledge of the principal’s incapacity.
- Formation
- Additional considerations:
- Conduct
- An agency relationship can be formed by actions even if the parties do not orally or in writing express their consent
- Consideration
- Agencies formed with contracts and consideration are legally enforceable
- Agencies formed with contracts without consideration are not legally enforceable. Agents are considered gratuitous agents but have the rights and duties of paid agents
- Contracts
- Sale of land:
The agency relationship must be in writing if the contract involves a
sale of land
- Equal-dignities rule:
Agency relationship must be in writing if the agent is entering contractual transactions with third parties that must be in writing to be enforceable under the statute of frauds
- Consent
- Court's use a reasonable person
standard for consent. The testing is objective. An agency exists when a reasonable person would conclude that:
- (1) one person (the principal) has consented to another’s acting on his or her behalf and subject to his or her control
- (2) the other person (the agent) has consented to do so
- Estoppel
- Agency by estoppel
(prevented from asserting the nonexistence of an agency) if:
- Person represents as principal's agent
- Person knows of the representation as principal's agent
- Third party relies on the existence of the agency
- Intent implied by law
- Agencies formed for an illegal purpose are terminated by operation of law
- Legal purpose
- Agencies formed for an illegal purpose are terminated by operation of law
- Statue of frauds apply
- Statute of frauds apply if performance under the contract cannot be fulfilled within 1 year of contract formation
- Ratification
- An agency may be formed by ratification of another’s acts
- Requirements to form an
agency relationship:
- 1) Agreement between principal and agent on the relationship and subject matter
- 2) Capacity of the principal
- 3) Legality of the subject matter
- Agents
- Authority
- Actual
- Apparent
- To act on behalf of the principal
(as fiduciary) in dealing with third parties
- Personal acts, such as executing a will, may not be delegated
- To principal
- To be subject to principal's control
- To third parties
- Types of agents
- Agency from power given as security
- Power given as security includes the traditional agency coupled with an interest. In this form of agency, the agent has a specific, current, beneficial interest in the subject matter of the agency
- The agent’s interest in the subject matter is not exercised for the benefit of the principal
- An example is an agent-creditor’s power to sell collateral if the debt is not paid
- An agent coupled with an interest has a property right in the subject matter of the agency that may take the form of an ownership interest or a security interest. Because it is property, the agency is not cancelable by the principal.
- The principal does not have the right or power of termination
- Del credere agent
- Perform guarantees of third party's obligation to the principal (salesperson/broker/guarantor of credit/surety)
- Not subject to statue of frauds (need not be in writing) because guarantee is for the agent's benefit to close the deal
- General agents
- Perform all acts relevant to the engagement
- Special agents
- Perform particular activities/transactions
subject to specific instructions
- Universal agents
- Perform all acts principal may legally delegate
- Principals
- Capacity
- Legal capacity to perform an act assigned to agent
- Incompetent principal contract is voidable by the principal. Agent held liable for contract
- Incompetent agent contract is enforceable to a competent principal
- To agent
- To intend for agent to act on principal's behalf
- To third parties
-
19.2 Agent's Authority and Duties
-
The CPA Exam has tested candidates’ knowledge of an agent’s actual and apparent authority. Candidates need to remember that the principal is liable on contracts made by an agent who has actual, apparent, or emergency authority.
- Principal is liable on third party contracts by agent that has:
- Actual
- Apparent
- Emergency Authority
-
Rules regarding agent's authority and duties
- Agents
- Authority
- Actual
- Express
- Principals express
written or spoken word
- Express authority to achieve a result necessarily implies the authority to use reasonable means to accomplish the expressly authorized action
- Implied
- Principals inferred
conduct or spoken word
(by custom/business usage/virtue of agent's position relative to purpose of agency)
- Conveyed by the principal's action/conduct
- Apparent
- Apparent authority results from the principal’s words, conduct, or other facts and circumstances that would induce a reasonable person justifiably to conclude that the agent has actual authority
- Apparent authority gives the agent the power, but not necessarily the right, to bind the principal to third parties
- Apparent authority cannot exist:
- After termination and notification to third party
- Second Restatement - apparent authority automatically terminated by operation of law
- Third Restatement - apparent authority ends if unreasonable for 3rd party to believe
- If third party knows the agent lacks
actual authority
- Without disclosure of the principal
- Justifiable reliance on principal's conduct
- Emergency
- Emergency authority may be granted to the courts when prompt action is needed
- Emergency authority may be extended in service of the public's interest
- Justifiable reliance on principal's conduct
- To principal
- To be subject to carry out duties and
not delegate them to others
- Generally, an agent is chosen because of his or her personal qualities. Thus, an agent does not have the power to delegate authority or to appoint a subagent unless the principal intends to grant it
- Delegation that is not expressly authorized may be appropriate in an emergency
- Permitted to delegate if:
- Character of the business
- Express authorization
- Prior conduct of the agent and principal
- Usage or trade
- Subagent's delegation is:
- Agent of both principal and agent
- Binds the principal as if agent
- Fiduciary duty owed to agent/principal
- To be subject to liability to principal for breaches of actual authority/duty
- Transactions between the principal and the agent may be voidable by the principal.
- A constructive trust in favor of the principal is imposed on profits obtained by the agent as a result of breaching the fiduciary duty.
- The agent, in effect, holds the profits in trust for the benefit of the principal.
- The principal recovers the profits by suing the agent.
- If the principal is sued for the agent’s negligence or the agent ignores the principal’s instructions, the principal has a right to indemnification (compensation from harm/loss) from the agent.
- To be subject to principal's control
- To third parties
- To be subject to contractual liability if:
- Being party to the contract with principal
- Guaranteeing the principal’s performance
- Making the contract in his or her name
- Principal is undisclosed/partially disclosed (breach of the implied warranty of authority)
- Torts against agent (e.g., negligence) even when acting as an agent of another
- Types of duties
- The agency relationship itself is independent of any contract between the parties. It is subject to the following five duties and obligations set forth under agency law for:
- Duty of Accounting
- Account for money or property received or expended on behalf of the principal
- Not commingle his or her money or property with that of the principal
- Duty of Care/
Diligence
- Act prudently (care and thought for the future) and cautiously to avoid injury to the interests of the principal
- Use the care and skill of a reasonable person in like circumstances
- Use their special skills or knowledge in performing agency duties
- Duty to Loyalty
- Act solely in the principal’s economic interest with utmost loyalty and in good faith by refraiing from:
- Accepting secret profits or transactions entered into on behalf of the principal
- Competing with the principal
- Disclosing the principal’s confidential information for the agent’s own benefit or for the benefit of third parties
- Misappropriating the principal’s property
- Purchasing goods from the agent for the principal without the principal’s knowledge or permission
- Representing the principal, if doing so creates a conflict of interest between parties
- Duty to Disclosure/Notification
- Make reasonable efforts to disclosure/notify principal of all materials facts that agent possesses relating to the business and principal may need/desire to know
(valuable/imputed)
- Material facts relevant to the subject matter of the agency
- Actual knowledge of a fact, having reason to know of its existence, or receiving formal notice by an agent authorized is assumed to be known by the principal if it is important to an authorized transaction.
- EXAMPLE 19-3
Attribution of Agent’s Knowledge to Principal
Allan is Peter’s agent for the sale of art. Allan falsely and intentionally overstates the value of a painting to a buyer. Peter is assumed to have knowledge of the fraud.
- Duty to Obedience
- Follow lawful, explicit instructions of the principal within the bounds of authority conferred
- If the instructions are not clear, the agent must act in good faith and in a reasonable manner considering the circumstances.
- If an emergency arises and the agent cannot reach the principal, the agent may deviate from instructions to the extent that is appropriate.
-
19.3 Principal's Duties and Liabilities
-
Rules regarding principal duties and liability
- Overview:
- Principals
- To agent
- To intend for agent to act on principal's behalf
- Financial duties to agent for:
- Compensation for payments made or expenses incurred by agent acting on behalf of principal
- Compensation for services (even if not expressly excluded in contract)
- Indemnification from losses suffered or expenses incurred while agent:
- Acted as instructed in a legal transaction
- Acted in a transaction that agent did not know was wrongful
- Occupational duties to agent for:
- Disclose known risks involved in the task for which the agent is engaged and of which the agent is unaware
- Duty of care to agent from the existence principal-agent relationship
- Not impairing agent's performance
- Provide safe working conditions
- To third parties
- Any agreement between a principal and agent limiting the principal’s liability has no effect on the liability of the principal to third parties.
- Liable for contracts entered into by agent with actual or apparent authority if:
- By type of principal disclosure:
- Disclosed principal
- Third party knows the agent is acting for a principal and the identity of the principal, an agent who acts within actual or apparent authority ordinarily is not liable to the third party.
- Partially disclosed principal
- Third party knows the agent is acting for a principal but does not know the identity of the principal.
- Liability of the agent and a partially disclosed principal is joint and several liability. The third party may sue either or both the principal and agent and collect any amount from either until the judgment is satisfied.
- Undisclosed principal
- Third party must elect whether to hold the principal or the agent liable for performance.
- Third party has no right to void an otherwise valid contract.
- Undisclosed principal generally may sue or be sued on the contract except when it would be unfair or unjust to the other party.
- Undisclosed principal generally is not liable to the third party unless agent has actual authority.
- Undisclosed principal may not be able to enforce a contract that:
- Involves nondelegable duties
- Involves unique personal services of the agent
- Negotiable instrument signed by the agent with no indication of his or her status
- Requires that credit be extended by the third party
- Criminal liability:
- A principal is liable for his or her own criminal conduct.
- A principal is generally not liable for a crime committed by the agent but may be held criminally liable for a crime of the agent if
- The principal approves or directs the crime,
- The principal participates or assists in the crime, or
- Violation of a regulatory statute constituted the crime
- Ratified by principal:
- Ratification is a voluntary election to treat as authorized an unauthorized act/contract purportedly done or entered into on principal’s behalf if:
- Ratification is all-or-nothing. The principal may not ratify part of a transaction.
- Ratification is irrevocable.
- Ratification relates back to the time of the act. The act is treated as if it had been authorized at the time it was performed.
- Principal aware of all material facts regardless of agent's lack of fiduciary duty or duty of due care
- Principal does not lack capacity at time of unauthorized act and at time of ratification
- Principal expresses or implies (intent of) ratification by word or conduct
- Strict liability:
- Strict liability is generally not vicarious
- Some duties cannot be delegated as a matter of law or public policy, for example, an employer’s duty to provide employees with a safe workplace
- Persons engaging in ultrahazardous activity have strict liability. Contracting out ultrahazardous activities is not a shield against liability
- Tort liability is:
- A principal may be liable in tort because of a personal act or the agent’s wrongful act that results in harm to a third party.
- The principal’s liability is greater when the agent is an employee rather than an independent contractor.
- Whether an agent is an
employee depends on:
- Agreement about the degree of control of the manner and means of an employee’s work
- Duration of the relationship
- Extent of supervision by the principal
- Payment arrangement, whether at the end of all work or periodically per unit of time
- Place of work, tools, and supplies provided by principal
- Principal is generally not liable for the torts of the independent contractor
- Relationship of the nature of the business and the work of the agent
- Services provided by agent as exclusively for the principal
- Skills and specialization required for the task
- Direct liability:
- Direct liability results from the principal’s negligent or reckless action or failure to act in conducting business through agents.
Examples include:
- Allowing wrongful conduct
- Failing to employ the proper person or machinery given risk of harm
- Failing to give proper orders or make proper regulations
- Failing to supervise the agent
- Negligently selecting an agent
- Vicarious liability:
- Vicarious liability results from the actions of the agent for which the principal, whether or not disclosed, is liable. Thus, both the principal and the agent are liable.
- Respondeat superior:
"Let the master reply". A doctrine of vicarious liability that holds ERs liable for the tortious conduct of their EEs. For example:
- Commits a tort, whether negligently or intentionally
- Was not authorized by the principal to perform the act
- Performs the act within the scope of employment (work assigned by ER or conduct subject to the ER's control or intended by EE to serve ER's purpose)
- Material misrepresentation of EE or independent contractor within scope of actual or apparent authority including:
- Tort of defamation
- Torts of fraud (that includes innocent misrepresentation (without scienter))
- Torts of negligence
- Principal expresses or implies (intent of) ratification by word or conduct
- Additional considerations:
- Second Restatement:
An undisclosed principal cannot ratify
- Third Restatement:
An undisclosed principal can ratify if unauthorized act was done on principal's behalf
- Ratification termination:
Certain condistions terminate the power of principal's ratification:
- Change in circumstances
- Failure to ratify within a reasonable time
- Third party’s withdrawal, death, or loss of capacity
- Remedies against breaches of principal duties:
- Counterclaiming if the principal sues
- Demanding an accounting
- Filing a civil action seeking tort and contract remedies
- For contract remedies such as specific performance if contract formed
- Withholding performance or terminating the agency relationship
-
19.4 Agency Termination
-
Rules regarding agency termination
- Termination --- agency coupled with an interest
- Can be terminated by:
- Subject matter of agency destroyed
- Surrender by agent of authority
- Terms of agreement/contract
- Cannot be terminated by:
(generally)
- Principal
- Dies
- Principal
- Incapacitated
- Principal
- Revokes agent's authority
- Termination --- apparent authority
- Can be terminated by:
- Agent/principal
- Notice
- Constructive notification
(trade journal/general circulation where agent operates)
- Effective notification required if 3rd party already involved
- If the authorization of the agent was in writing, the revocation of authorization also must be written.
- Termination --- by either party
- Can be terminated by:
- At will by either party
with or without breach of contract
- If termination breaches a contract, the nonbreaching party has remedies provided by contract law
- Renounced by agent (with notice)
(grant of authority renounced)
- Revoked by principal (explicit/implicit)
(grant of authority revoked)
- Terms of agreement/contract
(specific termination time defined)
- Termination --- by operation of law
- Second Restatement:
Termination of actual/apparent authority when:
- Agent
- Commits illegal
acts/duties
- A change of law that makes an authorized act illegal also terminates the agency
- Agent/principal
- Dies
- Agent/principal
- Incapacitated
- Circumstances changed
- Actual authority terminated when significant change in business conditions/value of property that infers such authority has terminated
- Can be revived upon a return to the initial circumstances
- If the agent has reasonable doubts as to how or whether the principal wants the agent to act, the agent may act reasonably and agency is not terminated
- If agency knows principal is aware of change principal must give new directions in order to terminate
- Principal
- Files a petition
in bankruptcy
- Subject matter of the agency
- Destroyed
(making purpose of agency impossible)
- Third Restatement:
Termination of actual authority when:
(According to this restatement, termination of actual authority does not end apparent authority unless it is unreasonable for a 3rd party to believe agent has actual authority)
- Circumstances changed
(action deemed unreasonable)
- Actual authority terminated when changes occur that acting on behalf of principal is unreasonable
- Notice
- Actual authority terminated when notice is given to the agent even though terminated by Second Restatement
- Manifestation(s) of principal
- Actual authority terminated when agent believes principal does not want agent to act based on manifestations to the agent
-
19.5 Employment Tax
- For details, see Study Unit 6.2
-
19.6 Qualified Health Plans
-
Qualified health plans are insurance plans that cover all of the required benefits of the Affordable Care Act. The goal of the Patient Protection and Affordable Care Act of 2010
(ACA) was to increase health insurance coverage by the following means of:
- Allowing nondependent coverage to age 26
- Creating insurance exchanges/markets
- If a state does not set up an exchange, a federal exchange is established
- Expanding Medicaid
- U.S. Supreme Court ruled that states cannot be compelled to participate in the Medicaid expansion
- Providing insurance premium subsidies
- Low- to middle-income
- Requiring ER affordable minimum coverage
- Including requiring ER to:
- Disclose coverage
- List on W2 coverage cost
- Mandatory for employers that filed at least 250 W-2 forms the previous year
- Inform EE of exchanges
- Provide comparison of benefits/coverage summaries
- Requiring TP affordable minimum coverage
- TP without ER or Medicare coverage
- Stopping lifetime limits/arbitrary cancellations
- ERs charged a penalty for lack of affordable minimum essential coverage with:
- EEs of at least:
- 50 FT
- or
- 50 FTE
- No coverage:
- $2,700
- x
- Total FTEs
- -
- 30 FTEs
- No affordable coverage
- No minimum
actuarial value provided
- No minimum essential provided
- Additional
plan requirements:
- Actuarial Value:
- Bronze
- 60%
- +/- 2%
- Minimum actuarial value allowed for an eligible employer plan is 60%. Thus, an employee should not pay more than 40% in deductibles, co-payments, and co-insurance
(excluding the premium contribution). Actuarial value is the expected percentage of covered expenses that the plan will pay.
- Minimum actuarial value may be increased by ER contributions to health-savings accounts
(HSAs) or health-reimbursement arrangements (HRAs).
- Silver
- 70%
- +/- 2%
- Gold
- 80%
- +/- 2%
- Platinum
- 90%
- +/- 2%
- Affordability
determined by:
- Employee-only coverage
(excluding family or
any other tier of coverage)
- Lowest applicable wage paid by ER
- Lowest-cost eligible plan of ER
- Premium contribution of EE
- Not to exceed:
- 9.83% of:
- Annual federal poverty level
- /
- 12
- Annual income
- W2
- Box 1
- /
- 12
- Household income
- Monthly income
(Based on rate of pay and monthly hours worked)
- Essential
health benefits:
- Ambulatory patient services
- Emergency services
- Hospitalization
- Laboratory services
- Maternity and newborn care
- Mental health and substance use disorder services (including behavioral health treatment)
- Pediatric services including
oral and vision care
- Prescription drugs
- Preventive and wellness services and chronic disease management
- Rehabilitative and habilitiatve
services and devices
- Waiting period for coverage:
- 90 days (max)
- FTE determined by:
- All employees who work 30 or more hours
- Current employees who work variable hours
- New employees whose hours are variable or have not yet been specified
- Lesser of:
- $2,700
- x
- Total FTEs
- -
- 30 FTEs
- $4,060
- x
- FTEs who received PTC
-
Rules regarding "grandfathered" plans:
- If plan in place as of ACA
[March 23, 2010] many of its element may continue if:
- Benefits not reduced
- Co-payments/deductibles not materially changed
- Insurers not changed
-
CPA REG SU20 Secured Transactions and Debtor-Creditor Relationships
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20.1 Security Interests and Attachment
-
This study unit covers issues related to debtor-creditor relationships. The first four subunits review the rights and duties of debtors and creditors under UCC Article 9, Secured Transactions.
- UCC (Uniform Commercial Code)
- Article 9 (Secured Transactions)
- Governs debtor-creditor transactions involving security interests.
-
Rules regarding security interest/attachment
- After-acquired property clause
- Creates an interest in most types of personal property acquired by the debtor in the future through a:
- Floating lien
- Attaches (floats) a specified property that the debtor acquires in the future.
- Attachment
- A security interest in collateral is not effective against the debtor or third parties until it attaches. Attachment must occur to be enforceable against the debtor, barring an explicit agreement stating otherwise if:
- Authentication/possession
- Authentication
- Signed (manually or electronically) a security agreement (contract) that reasonably describes the collateral
- If the contract was not signed by the seller, the statute of frauds applying to a sale of goods for $500 or more prevents its enforcement against the seller. Nevertheless, partial performance (the $500 down payment) renders the contract enforceable to the extent of payment made and accepted. Acceptance of a partial payment is the seller’s admission (at least to the extent of payment) that a contract exists.
- Possession
- Secured party is in possession
(or control) of the collateral means evidence of authentication exists.
- Rights
- Rights are given to the secured party and power to transfer such rights. Attachment of a security interest in collateral gives the secured party rights to debtor of:
- Rights to collateral
- Rights to collateral proceeds
- Rights to transfer security interest
(not transfer of title)
- For personal defenses effective against an assignee of a security interest, the debtor is bound by the waiver only if the assignee has taken:
(1) for value
(2) in good faith
(3) without notice of a
claim or defense
- Value
- Secured party has given value. Contract consideration suffices and need not be new. An example is an agreement to take a security interest instead of enforcing a previously existing debt is considered value.
- (1) satisfaction of a
preexisting debt or
(2) a binding agreement to
extend credit
- Secured party
- Before the purchaser pays, the seller often retains a security interest in the property sold.
- Lender or seller who holds a security interest in the pledged asset.
- Security interest
- Secures payment or performance of an obligation regardless of form/name, in most cases, whether title has passed for:
- A security interest is a separate right that must be agreed to by the parties. Identification of the goods to the contract or passage of title does not give any party a security interest.
- Consignments
- Reservation of title by a lessor or consignor, which is intended to act as a security interest in the property.
- Fixtures
- Goods that become part of real property (buildings or land) under state law.
- Goods
- Personal property consists of all things movable and ownable. Tangible personal property are goods are goods when the security interest attaches. The following are goods:
- Consumer goods
- Goods like personal, family, or household purposes. Security interest attaches to consumer goods under the clause only if the debtor acquires rights in the goods within:
- 10 days after secured party
gives value
- Equipment
- Goods that are not consumer goods, inventory, or farm products.
- Farm products
- Goods like crops, livestock, supplies, and unprocessed products of crops or livestock.
- Inventory
- Goods held for sale or lease or to be provided under a contract for service.
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20.2 Perfection of Securities Interests
-
A secured party perfects its security interest to prioritize its claim over any other third party’s interest in the collateral of unperfected interests and subsequent perfected secured interests. Third parties include:
- Priority among perfected security interests is determined by:
- Earlier of:
- Date of filing a financing statement
- Date of perfection
- Third party buyers
- Third party creditors
- Third party trustees
in bankruptcy
-
Rules regarding perfecting secured interests
- Perfection of a
security interest occurs after:
- Attachment
- Depending on the collateral if:
- Perfection (Automatic)
- A security interest may be automatically perfected for the following:
- PMSI in consumer goods
- Purchase money security interest results when:
- Debtor obtains credit
- Debtor obtains credit to use to acquire property
- Property is the
collateral for the debt
- Perfection by Control
- A security interest may be perfected by control of the following:
- Perfection ends when the secured party no longer has control.
- Deposit accounts
- Security interest in deposit accounts may be perfected only by control.
- Electronic chattel paper
- Investment property
- Letter of credit rights
- Perfection by
Filing a Financing Statement
- Debtor’s location controls the place of filing
- If debtor moves out of jurisdiction where security interest is perfected, lapses until the earliest of:
- 4 months of debtor's change of location
- 1 year transfer to debtor in another jurisdiction
- Original period of perfection
- Gives notice of the filer’s security interest. May be filed before a security agreement is reached or a security interest attaches. Filing is not a condition of attachment
- Required to perfect a security interest without a specific exception
- Additional considerations:
- Effective: 5 years
(continuation statement extends for another 5 years, may be filed in
last 6 months)
- Perfection of a security interest in accounts ordinarily is created only by filing. Unless an insignificant amount of the assignor’s accounts is transferred, perfection is by attachment.
- UCC requires for filing financing statement:
- Collateral
description/indication
- Name of debtor
(not trade name only)
- Name of secured party
- Perfection by Possession
- A security interest may be perfected by possession of the following:
- Goods
- Instruments
- For negotiable instruments, perfection by possession is limited to the 20-day automatic perfection period and new value must be given under an authenicated security agreement
- Negotiable instrument is a signed document that promises a sum of payment to a specified person or the assignee
- Money
- Possession is the only way to perfect a security interest in money other than identifiable cash proceeds.
- Negotiable
documents of title
- For negotiable documents of title, possession substitutes for the requirement of an authenticated security agreement.
- Warehouse receipts are negotiable if by their terms the goods that they represent are to be delivered
(1) to the bearer or
(2) to the order of a named person
- Tangible chattel paper
- Additional considerations:
- Generally, the security interest becomes unperfected when possession ceases unless the secured party files a financing statement while in possession.
- If attachment occurs when the secured party takes possession of the collateral according to the security agreement, perfection and attachment are simultaneous.
- Perfection by possession is not limited to the
20-day automatic perfection period.
- Automatic perfection 20-day period with authenticated security agreement. Must perfect by other means then control on 21st day for the following:
- Certificated securities
- Bearer form
- Control requires:
- Delivery to the
secured party
- Registered form
- Control requires:
- Delivery to the
secured party
- And one of the following:
- Endorsement
- Registration
- Bear form means that the security is traded without any records and physical possession of the security is the sole evidence of ownership.
- Uncertificated securities
- Registered form
- Control requires:
- One of the following:
- Delivery to the secured party
- Issuer’s agreement to comply with instructions without the further consent of the debtor-registered owner
- Instruments
- Negotiable documents
-
Rules regarding perfection and proceeds
- Proceeds are perfected if the security interest in the collateral was perfected. Perfection of proceeds occurs after:
- Proceeds include:
- All items received upon disposition of collateral
- Any collateral that has changed form
- Attachment (through 20th day)
- Unperfected (on the 21st day)
unless identifiable amounts of cash/in certain other cases
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20.3 Priorities
-
Protection provided by a security interest varies with its priority:
- General rule #1
- Perfected security interests
- Lien creditors include:
- (a) Assignee for the benefit of creditors
- (b) Creditor who acquires a lien by judicial process
- (c) Trustee in bankruptcy
- Trustee in bankruptcy has the status of a hypothetical lien creditor and can defeat a nonperfected security interest in personal property.
- Unless a state statue provides otherwise, lienholders (with possession) have priority over perfected security interests. Knowledge of security interests does not affect priority.
- Lienholders typically have provided services or materials with respect to the goods in the ordinary course of business and have possession of the goods.
- Mechanic’s liens are nonpossessory liens against the real property benefited. They secure unpaid debts from contracts for materials or services to improve specific real property (e.g., for work on a roof). Attachment of the lien to the property dates to when the first work is done or materials are supplied. It has priority over all other security interests in the real property other than a mortgage that attached before the work was done. However, a statute may provide otherwise.
- Possessory lien is in the ordinary course of business furnishes services or materials with respect to goods may receive a common law or statutory lien to secure payment if the goods are in the person’s possession. It has priority over a security interest in the goods (whether or not perfected) unless the lien is statutory and the statute expressly provides otherwise.
- General rule #2
- Unperfected security interests
(according to the first to attach or to become effective)
- General creditors (creditors with no security interests/unsecured creditors)
- General rule #3
- Continuous perfected security interests
(according to order of filing/perfection)
- Priority to the extent of the value of the collateral the exception is:
- d
- Bankruptcy still allows secured creditor with a perfected PMSI may to seek its remedy against the specific collateral.
- Ordinarily extends to a perfected security interest in the identifiable proceeds of goods.
- Priority is recognized even if the conflicting interest was perfected first.
- After:
- Possession
(by debtor)
- Perfected within:
- 20 days
- PMSI in inventory if:
- PMSI in inventory extends to identifiable cash proceeds received no later than the time of delivery to a buyer and to proceeds in the form of:
- Chattel paper and
its proceeds
(for example, note/security agreement)
- Instruments
- Floating lien is retained by the secured party against the inventory of a debtor even though the items in the inventory change over time. Such a lien arises under an after-acquired property clause in the security agreement.
- Authenticated notice sent to
other secured party if:
- Describes the collateral
- Received within:
- 5 years before possession
- States that the sender has or expects to have a PMSI in the debtor’s inventory
- Perfected with:
- Possession
-
Rules regarding priorities add'l considerations
- Buyers of goods
- Not subject to any security interest
(except one purchasing farm products from a farmer) given by the seller to another if the purchase
is all the following:
- (a) Business of selling like goods
(not a pawnbroker)
- (b) Good faith
- (c) Made without
knowledge that sale violates
third party's rights
- (d) Ordinary course of business
- Buyers of
consumer goods
- Not subject to any security interest given by the seller to another if the purchase
is all the following:
- (a) For value
- (b) For consumer purposes
- (c) Made without
knowledge of the security interest
- (d) Prior to the security party's filing
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20.4 Rights and Duties of
Debtors, Creditors, and Third Parties
- The secured party in possession of collateral is a bailee who is strictly liable for unauthorized use or misdelivery. The obligations and rights of the secured party in possession are to in the rules section below.
-
Rules regarding rights/duties of debtors, etc.
- Duties
- Bailee/
Secured Party
- Accounting
- Secured party generally must comply with a debtor’s request for an accounting (e.g., the unpaid amount of the debt), a statement of account, or a list of collateral:
- Within:
- 14 days
- Identification
- Keep the collateral identifiable, although interchangeable collateral, such as grain, may be commingled.
- Notice
- Default
disposal notice
- Reasonable authenticated notice of the disposition must be given to the debtor. The debtor cannot prevent sale.
- Debtor may waive notice.
- Reasonable authenticated notice of the disposition must be given to other secured parties.
- Failure to notify another secured party may result in liability.
- Unnecessary to give notice for consumer goods. PMSI in consumer goods is perfected by attachment alone.
- Example:
- EXAMPLE 20-23
Notice of Disposition
Leo, with a loan from Local Bank, purchases a van and a boat. He signs, with respect to each purchase, a promissory note for half the loan amount and a security agreement. Leo thereby conveys to Bank a security interest in both the van and the boat, each securing payment when due of half the remaining amount on the loan. Leo defaults on payments to Bank. Bank takes lawful possession of both van and boat. Bank sends proper written notice to Leo that the van will be sold at auction 4 weeks after date of notice. The boat and van are sold at auction. Bank sues Leo for a deficiency in the net proceeds. With regard to the half of the amount secured by the van, the court awards a judgment for the deficiency. Because no reasonable notice was given regarding the sale of the boat, Bank is not entitled to a deficiency judgment for the part of the loan it secured.
- Notice is reasonable if the debtor has adequate time to protect its interests:
- By private sale
- Time after which disposition may occur
- By public sale
- Time
- Place
- Notice not required
if collateral
normally sold:
- Likely to decline in value
- Perishable
- Recognized market
- Strict
foreclosure consent and notice
- Debtor must consent to the acceptance
(strict foreclosure) in satisfaction of the debt.
- Secured party must send an authenticated notice to other claimants for strict foreclosure.
- Strict foreclosure not allowed if consent objected:
- Within:
- 20 days of notice
- Reasonable care
- Failure to use reasonable care is negligence, and the bailee may be liable for damages.
- To preserve collateral
- Strict liability
- Misdelivery
- Unauthorized use
- Termination statement
- Secured party must file a termination statement of record:
- Earlier of:
- 1 month
- 20 days of authenticated demand from debtor
- If:
- 1) Collateral consists of consumer goods
- 2) No commitment
to give value exists
- 3) No obligation secured by collateral
- Debtor
- Reasonable expenses
- Bear the cost of reasonable expenses incurred for preservation, use, or custody of the collateral, e.g., insurance and taxes.
- Debtor has the risk of accidental loss or damage to the extent effective insurance coverage is deficient.
- Rights
- Bailee/
Secured Party
- Create
security interest
- Create a security interest in the collateral.
- Default
- Secured party has three options if the debtor defaults:
- 1) Accept (retain)
the collateral
- Acceptance of the collateral
(strict foreclosure) may be an alternative to disposition.
- 2) Peaceably take possession and dispose of the collateral
- Disposal
- By private sale
- By public sale
- Commercially reasonable aspects relating to:
- Manner
- Method
- Place
- Terms
- Discharges security interest under which the
disposition was made
- Discharges subordinate security interests or liens
(unless a statute provides otherwise)
- Transfers to a transferee for value all of the debtor’s rights
- Transferee who acts in good faith is not subject to prior interests even if the secured party does not comply with applicable requirements.
- Time
- Repossession
- Repossession
by judicial action
- Repossession by judicial action requires a court order or judgment against the debtor.
- Self-help repossession
- Disposal required:
- Amount paid
at least:
- (1) 60% of the cash price in the case of a PMSI in consumer goods
- (2) 60% of the principal amount of the secured obligation in the case of a non-PMSI in consumer goods
- Within:
- 90 days of possession
- Debtor and all secondary obligors may agree to a longer period in an authenticated agreement.
- 3) Sue debtor for the amount due (reduce the claim to judgment for the deficiency)
- If the disposition is commercially reasonable but the proceeds are insufficient, the debtor is liable for any deficiency.
- Proceeds
- Keep proceeds from the collateral as security (excluding money or funds).
- Disposal proceeds:
- The proceeds of collection or enforcement are applied in the following order:
- Payment of reasonable expenses
of collection or enforcement
- Satisfaction of the debt owed
to the secured party
- Satisfaction of the debts owed
to subordinate secured parties
- Payment of any surplus to the debtor
- Debtor
- Notice
- Consent to strict foreclosure
- Debtor must consent to the acceptance
(strict foreclosure) in satisfaction of the debt.
- Default
disposal notice
- Reasonable authenticated notice of the disposition must be given to the debtor. The debtor cannot prevent sale.
- Debtor may waive notice.
- Reasonable expenses
- Bear the cost of reasonable expenses incurred for preservation, use, or custody of the collateral, e.g., insurance and taxes.
- Debtor has the risk of accidental loss or damage to the extent effective insurance coverage is deficient.
- Remedies
- Debtor may redeem his or her interest in the collateral at any time before:
- Disposal
- Including before contract for the disposition of the collateral is
entered into.
- Repossession
- Strict foreclosure
- Righ to damages resulting from losses from disposal if:
- Secured party
fails to comply with
UCC Article 9
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20.5 Bankruptcy Administration
-
Be prepared to answer bankruptcy questions. The AICPA tests this topic often. Exam questions have tested the details of bankruptcy law, such as the number of creditors and dollar amounts involved in filing an involuntary bankruptcy petition against a debtor.
- Bankruptcy law tests:
- Dollar amounts
- Number of creditors
-
Rules regarding bankruptcy administration
- Bankruptcy Reform Act of 1978
- Federal statute allowing Congress exclusive power to establish uniform bankruptcy laws pursuant to
US Constitution Article I.
- Bankruptcy code objectives:
- 1) Ensure debtors assets are fairly distributed to creditors
- 2) Debtor given a fresh start
- Bankruptcy code chapters:
- Additional chapters:
- Chapter 9 Municipalities
- Chapter 12 Farmers
- Chapter 13 Individual Debt
- Chapter 15 Cross-border
- Chapter 7 Liquidation
- Involuntary/Voluntary Liquidation
- Corporation
- Individual
- Includes MFJ subject to disqualification by a means test
- Partnership
- Excludes:
- Bank
- Credit union
- Insurer
- Municipality
- Railroad
- Savings
and Loan
- Chapter 11 Reorganization
- Involuntary/Voluntary Reorganization
- Corporation
- Individual
- Partnership
- Railroads
- Excludes:
- Bank
- Commodity
- Credit union
- Insurer
- Municipality
- Savings
and Loan
- Shareholder
- Stockbroker
- Bankruptcy code proceedings:
- Petition filed that identifies the bankruptcy chapter
- Involuntary
- Filing requirements exclude:
- Insolvency existing
- Prior petition filing(s)
- Voluntary
- Filing requirements exclude:
- Insolvency existing
- Prior petition filing(s)
- Involuntary petition may not be filed against:
- Bank
- Debtors unless:
- Less than:
- 12 creditors
- At least:
- 1 or more creditors together
- Unsecured debt amount
at least:
- $16,750
- At least:
- 12 creditors
- At least:
- 3 or more creditors together
- Unsecured debt amount
at least:
- $16,750
- Relationship to debtor:
- Director
- Employee
- Officer
- Partner
- Relative
- Farmer
- Insurer
- NFP
- Railroad
- Automatic stay of (most)
civil actions against the debtor or his or her property until the court acts from:
- Judgment creditors
- Secured parties
- Additional considerations:
- Debtor may continue to use, acquire, and dispose of his or her property until the court orders otherwise.
- Debtor may incur new debts and operate a business.
- If necessary, the court may order the appointment of a temporary trustee to preserve the debtor’s assets.
- Petition
auto-stay of collection action
does not:
- Terminate alimony
- Terminate child support
- Terminate
criminal proceedings
- Terminate lien(s)
- Terminate security interest
- Terminate tax liability
(notice of tax deficiency)
- Estate established as a separate legal entity at:
- a) Time of filing petition
- b) Time becomes subject to proceeding
- US District Court
Bankruptcy Judge Assigned
- Exclusive authority over the case by judge
- Estate appointed a
interim trustee by judge within reasonable time after the order
- 1) Represents the debtor’s estate
- 2) Investigates the
financial affairs of the debtor
- 3) Holds the first meeting of creditors
- Trustee appointments by type of bankruptcy chapter:
- Chapter 7 Liquidation
- Interim trustee appointment required by judge
- Permanent trustee elected by qualified creditors
(at required meeting)
- Chapter 11 Reorganization
- Interim trustee appointment not required by judge
- Permanent trustee elected by qualified creditors
- Trustee
appointed power to:
- Assuming and performing an unperformed contract or unexpired lease, rejecting it, or assigning it to a third party with court approval
- Rejection is assumed unless the trustee acts within 60 days after the order for relief.
- Collecting and accounting for property
- Court may allow the debtor to file a bond and reacquire property from the trustee.
- Distributing assets and closing the estate
- Filing reports
- Hiring professionals
- Qualified trustee may perform professional services for reasonable compensation with court approval.
- Service as a trustee impairs a CPA’s independence regarding the debtor.
- Investing estate money
- Objecting to creditor claims
- Operating the debtor’s business
- Objecting to a discharge in a proper case
- Performing investigations
- Selling, using, or leasing estate property
- Voiding preferential transfers
- Assuming the other requirements are met, transfer also is voidable if made to an insider between 90 days and 1 year prior to filing.
- An insider is close enough to the debtor to justify scrutiny, e.g., (a) a relative; (b) a general partner of a debtor entity; (c) a corporation controlled by a debtor; or (d) an officer, director, or controlling shareholder of a corporate debtor.
- A transfer may be direct or indirect and dispose of property or an interest in property (e.g., a security interest).
- Voidable preferential transfer if:
- Prior to between:
- 90 days of petition filing
- 1 year of petition filing
- A voidable preferential transfer is made:
(1) to or for the benefit of a creditor
(2) for or on account of an antecedent
(preexisting) debt but not for new value
(3) during the debtor’s insolvency
(4) within 90 days prior to filing the petition, during which time the debtor is presumed to be insolvent
(5) to allow the creditor to receive a larger portion of its claim than from a distribution in bankruptcy
- Transfers not voidable as preferences include the following:
- Bona fide transfers for domestic support obligations
- If the debtor is an individual, payment of up to $725 on a consumer debt within 90 days preceding the filing of the petition
- Consumer debt:
- Before:
- 90 days of petition filing
- Payment due up to:
- $725
- If an individual’s debts are primarily nonconsumer debts, any transfer worth less than $6,825
- Nonconsumer debt:
(primarily)
- Transfer worth less than:
- $6,825
- Payments of accounts payable in the ordinary course of the debtor’s and transferee’s business or financial affairs
- Purchase money security interest
(PMSI) enabling the debtor to acquire the property if the PMSI is perfected within 20 days after the debtor takes possession
- Transfers that involve a contemporaneous exchange for new value, such as materials or goods acquired in exchange for cash or a security interest
- Voiding fraudulent transfers
- Property transfer is voidable if it was made within 2 years prior to filing with actual intent to hinder, delay, or defraud creditors.
- Voidable fraudulent transfer if:
- Within:
- 2 years of petition filing
- With:
- Intent to hinder, delay, or defraud creditors
- Mandatory creditor's meeting held within reasonable time after the order
- Creditor committees may be required or permitted. The committee is responsible for facilitating communication among the debtor, the trustee, and the creditors.
- Termination of stay of collection action granted
- Secured creditor may ask the court to recognize the priority of the existing security interest and allow foreclosure.
- Serial petition filings:
- Second filing
- Within:
- 1 year of dismissal
of first case
- Terminates of stay
in 30 days
- Termination of stay disallowed
if second filing
is shown to be
in good faith
- Third filing
- Within:
- 1 year of dismissal
of second filing
- Termination of stay immediate (stay will not be allowed)
- Termination of stay disallowed
if third filing
is shown to be
in good faith
- Order for relief
- If the debtor does not oppose the petition, however, the court will enter an order for relief.
- If the debtor opposes the petition, the court must hold a hearing:
- Order for relief granted to creditors if it finds that either of two statutory grounds for involuntary bankruptcy exists:
- Statutory ground #1:
Debtor not paying undisputed debts as they become due
- Statutory ground #2:
Possession of
debtors property by:
- Before:
- 120 days of
filing of petition
- Possess by:
- Assignee
- Custodian
- General receiver
- Case dismissed
- If the case is dismissed, the creditors may be required to:
- Pay attorney's fees
- Pay punitive damages for harm caused to debtor's reputation (if petitioner
acted in bad faith)
- Post bond to
compensate the debtor
(for example, when the trustee took possession of the debtor’s property)
-
20.6 Bankruptcy Liquidations
- Liquidation converts a debtor’s nonexempt assets to cash distributed in conformity with the Code. Debtor discharged from the remaining debts and given a fresh start.
-
Rules regarding bankruptcy liquidations
- Debtor's Estate
- Exempt interests:
- Basic necessities
- Contributions to ER retirement
- Contributions to educational/state tuition programs:
- Before filing
- More than
1 year before filing
- Property acquistions
- After filing
- Nonexempt interests:
- Divorce settlements
- Before filing
- 180 days
- Life insurance proceeds/payments
- Before filing
- 180 days
- Estate property acquisitions
- After filing
- Estate property receipts
- Inheritances
- Before filing
- 180 days
- Property interests
- Property recovered by trustee
(under avoidance powers)
- Exemption as defined by state law
(may include following
federal exemptions):
- Alimony and support
- Debtor's residence equity
- Up to:
- $25,150
- Unused portion used toward other property
- Disability benefits
- Household goods
- Up to:
- $625
- Limit:
- $13,400
- Jewelry
- Up to:
- $1,700
- Life insurance
(unmatured)
(owned by debtor)
- Motor vehicle equity
- Up to:
- $4,000
- Other property
- Up to:
- $1,325
- Unused portion of
debtor's resident equity
- Pension benefits (certain)
- Personal injury and
other awards
- Up to:
- $25,150
- Retirement
(tax-exempt federal/state)
- Up to:
- $4,000
- Social security
- Trade tools
- Up to:
- $2,525
- Veteran's benefits
- Welfare benefits
- Unemployment compensation
- Household goods include:
- Animals
- Appliances
- Books
- Clothings
- Crops
- Furnishings
- Musical instruments
- Claims Distribution Process
- Commences with creditors
filing proof of claim
- 90 day filing required
(for unsecured creditors)
- After objection,
can be timely filed
unless court disallows
- Distribution
(in following order)
- Secured creditors
- Unsecured creditors
(priority creditors)
- Members of a higher class of priority creditors are paid in full before members of a lower class receive anything. If the assets are insufficient to pay all claims in a given class, the claimants in the class share pro rata.
- Paid in following order:
- 1. Domestic support obligations
- 2. Claims for estate expenses
- 3. Claims of tradespeople (gap creditors) who extend unsecured credit in the ordinary course of business after the filing of an involuntary petition but before the earlier of the appointment of a trustee or the entry of the order for relief
- After filing
- Involuntary petition
- Before
earlier of
- Appointment of a trustee
- Entry for order of relief
- 4. Wages (compensation)
earned by employees
- Up to
- $13,650
- Owed within
- 180 days
prior to
- Earlier of
- Cessation of debtor's business
- Date filed
- 5. Certain contributions owed to the debtor’s employee benefit plans resulting from employee services
- Performed within
- 180 days
prior to
- Earlier of
- Cessation of debtor's business
- Date filed
- 6. Claims of grain or fish producers for grain or fish deposited with the debtor but not paid for or returned
- Up to
- $6,725
each
grain/fish deposited
- 7. Claims of consumers
for the return of deposits
- Up to
- $3,025
each deposit
- 8. Certain income and other taxes owed to governmental entities
- 9. Death and injury claims from operation of a motor vehicle by a legally intoxicated person
- Unsecured creditors
(general creditors)
- If any money remains after payments to secured creditors and priority creditors, the timely filed claims of general creditors are paid.
- Debit Discharged
- Discharges applicable to:
- Unpaid debt
(after distribution)
- Unpaid debt
(secured creditors)
- Discharges exclude:
- Case is dismissed debtor is not discharged
- Debts incurred on the basis of materially false financial statements if both
- Financial statements issued with the intent to deceive
- Creditor reasonably
relied on them
- Debts resulting from alimony, maintenance, or child support awards
- Debts resulting from certain educational loans made, funded, or guaranteed by a governmental unit
- Debts resulting from fraud (including securities fraud), misrepresentation, embezzlement, larceny, or breach of fiduciary duty but not negligence
- Debts resulting from willful and malicious
(but not unintentional) injury to another person or conversion of that person’s property
- Discharge previously granted may be revoked if the trustee or a creditor proves that:
- Within
- 1 year
before filing
- Discharge was obtained fraudulently
- Debtor knowingly and fraudulently retained property of the estate
- Debtor failed to obey a court order
- Governmental fines and penalties, except those relating to dischargeable taxes
- Taxes including federal income tax
coming due
- Within
- 3 years
before filing
- Unscheduled debts not included in required filings in time to permit a creditor without notice of the case to timely file a proof of claim
- Debts resulting from liability for operating a motor vehicle while legally intoxicated
- Discharges available to eligible debtors
once every 8 years
- Not available to:
- Corporations
- Partnerships
- Discharges granted by court
at court proceedings
- Grounds for denial of discharge are:
- Being subject to a proceeding that may limit the homestead exemption
- Committing any of these acts in a case involving an insider
- Within
- 1 year
before filing
- Giving or receiving a bribe in connection with the case
- Failing to complete a personal financial management course
- Failing to explain satisfactorily any loss or deficiency of assets
- Filing a written waiver of discharge approved by the court
- Fraudulently transferring or concealing property
- Within
- 1 year
before filing
- Estate property
- 1 year
after filing
- Making a false oath, a fraudulent account, or a false claim
- Refusing to testify or to obey lawful orders of the court
- Unjustifiably concealing or destroying business records or failing to keep adequate business records
- 20.7 Reorganizations