BA 128A-1 Review Session 1

• Briefly review Chapters 2,3,4

• Chapter 5

• Chapter 6

• Questions

Chapter 2

• Individual tax formula

• Phaseout provision for Itemized deduction (3% over excess and limit to 80% of total ID besides medical, investment interest, casualty losses and wagering losses)

• Phaseout provision for personal exemption (2% per every $2500 over excess (rounding))

• Dependency test (gross income, support test, can’t file joint return), dependent cannot claim his/own exemption

• Child care credit ($400 per child; subject to phaseout)

• Kiddie Tax - kids under 14, unearned income taxed at parent’s rate - get $700 statutory deduction

Chapter 3&4 Inclusions and Exclusions• Cash basis vs. accrual basis

• Cash basis - constructive receipt

• Accrual basis - prepaid income generally taxable in year of receipt

• Inclusions - Business income, rents and royalties, cash dividends, interest, alimony (deductible by payor and inclusive for recipient, recapture), sale of property, refund of state or local income taxes, annuities (exclusion ratio), pension (amt. contributed / # of anticipated payments = amt. to exclude), income from flow through entities, social security benefits (exclusion provision), price/awards/gambling winnings, treasury finds, income from illegal activities, non medical/life insurance proceeds and court awards, group term life insurance premiums > $50000

Chapter 3&4 Inclusions and Exclusions

• Exclusions: Gifts and inheritances, life insurance (face amount) proceeds and dividends, adoption expenses ($5000 qualified employee assistance plan), scholarships (books, supplies, tuition and equipment only), payments of injuries and sicknesses (personal), foreign income exclusion (may include housing allowance), Employee Fringe benefits (premiums on medical, life and disability, benefits from medical and life, employee awards, meals and lodging furnished under employer’s premise, no additional cost benefits, qualified employee discount, transportation and parking, cafeteria plans and employee death benefits, ), Forgiven debt for bankruptcy and insolvency

Chapter 5 Capital Gains and Losses

• For AGI deduction• Gains or losses from the sale and exchange of

property• Realized gain - amount received from the sale

(if property is received - value at FMV)• Selling expenses reduce the amount realized• Compare to adjusted basis to derive gains and

losses

Definition of capital asset• Not inventory or property used in trade or business• Not Accounts Receivable• Not copyright/literary/musical/artistic composition• Dealers in securities, sale of securities is usually treated

as ordinary gain or loss, but may identify specific property for investment

• Non dealer of real estate, can identify real property as capital asset subject to several requires e.g. holding more than 5 yrs, no substantial improvements made I5-15

Adjusted Basis• Initial basis + capital additions - capital recoveries

• Capital additions - prolong useful life or increase value of property

• Capital recoveries - depreciation

• Costs of acquiring property increase the initial basis of the property (e.g. Taxes, interest, delivery and installation costs)

• Stock purchased at different times - if not adequately identified - FIFO

Property transferred as gifts• Generally donor’s basis

• If FMV < donor’s adjusted basis, donee has dual basis; FMV if sold at loss and donor’s basis if sold at gain

• If value sold in between FMVand donor’s basis, no gain or loss is recognized

• If donor pays a gift tax, donee’s basis is increased (only if donor’s basis is taken); addition =

Gift tax paid * (FMV - donor’s basis)/$ of gift

Property received by decedent

• Transfer at FMV at date of death or an alternative valuation date (6 months after death) - restrictions on alternative date election

• Community Property Law - 1/2 goes to decedent’s estate and 1/2 goes to spouse at FMV

• Common Law - same except the spouse’s part is transferred at old basis

Property converted form personal to business

• Lower of FMV or adjusted Basis - if asset sell at loss, basis = FMV - depreciation; if asset sell at gain , basis = adjusted basis- depreciation

• Prevent tax avoidance for assets that have declined in value

Basis allocation/Stock div/rights• For bulk assets purchase/sale - sales price must be allocated

according to FMV of each asset

• Common costs of purchase has to be capitalized and apportion to each asset purchased

• Stock Divided - reduce existing stock basis, if stock type is different, use FMV. Cost basis of stock/ new # of shares owned

• Stock Right - if FMV of stock rights < 15% of FMV of stock, basis of stock right = 0, unless election is made. If basis is allocated to stock right, stock basis is reduced too.

• If stock right is exercised later, basis is added to exercise price for new stocks acquired. If stock right expires, basis returned to existing stock.

Treatment of capital gains and losses

• Short term <1 year of holding period

• Long term > 1year of holding period

• First - Net STCL with STCG = NSTCL/NSTCG, Net LTCL with LTCG = NLTCL/NLTCG.

• Net Capital Gain (NCG) = Excess of NLTCG > NSTCL

• ANCG (Adjusted Net Capital Gain) is NCG without collectibles gain (28%), unrecaptured section 1250 (25%), section 1202 (Small business stock) - 28% but 1/2 is income exclusion

Treatment of capital gains and losses - cont

• NSTCL >NCTCG - deduct $3000 for AGI, excess carryforward, retain original state

• NLTCL > NSTCG - deduct $3000 for AGI, excess carryforward, retain original state

• If both NSTCL and NLTCL - use NSTCL first for the $3000

• Net gains and losses with the same asset group first and if there is still excess NSTCL over NLTCG for different asset groups, net the 28% group first, then the 25% and then 20% .

Holding period

• Long term asset - 1 year and 1 day after date of acquisition

• Gift transfer - holding period include donor’s if using donor’s basis

• Inherited property (from decedent) - considered long term regardless

• Nontaxable exchange including stock rights and dividends - holding period include original stock’s

Miscellaneous

• Corporation - same in netting and classification except no $3000 deduction, loss is carried forward 5yrs and 3 yrs forward - all treated as STCL

• Max rate is 35%• Capital gains/losses between related parties e.g. family

members are scrutinized• Worthless securities - assume sale/exchange on last day of tax

year, taxpayer has burden of proof. Worthless securities owned by affiliated corporations is not considered as capital asset

• Tax planning issues

Chapter 6- Deductions

• 3 types - Trade or business, production of income, personal expenditures (Chapter 7)

• Production of income - include production and collection of income, management and conservation of property, collection or refund of tax

Deductions for AGI• Trade or business related expenses• Employee expenses that are reimbursed (income include in

GI in the first place)• Loss from sale of trade/bus/investment property• Expenses derived from rent and royalty income• Moving Expenses• IRA • Alimony• Student loan• 1/2 self employment tax

Deductibility • Expenses related to tax-exempt income• Capital expenditure• related to illegal activities or violation of public policy• Specially disallowed by law

Distinction between business and investment expense - business expense has to be:

• Profit motivation• Ordinary/necessary/reasonable• Properly documented

Deductibility• Ordinary - customary, proximate relationship to income• Necessary - appropriate and helpful• Reasonable - e.g. salary expenses <$1M• Investment loss deduct as capital gains, investment

expenses deducted from AGI (misc itemized deduction)• Personal property used in business get $18,500

deduction, if used in investment, needs to be capitalized and amortized

Capitalization vs. Expense

• Goodwill - capitalized

• Add value to asset, prolong useful life - capitalized

• Maintenance and repair that keep asset in normal operating condition - expenses

• Capitalization of deductions - can elect e.g. annual property taxes on unimproved land - good if have NOLs in current year

Disallowance of deduction• Illegal payments - bribes to government officials,

kickbacks/rebates/bribes under medicare/medicaid, payments of fines and penalties, damages under anti-trust lawsuit. Bribes to foreign government is illegal if it is prohibited under the Foreign Corrupt Practices Act. Bribes to other people are illegal if it is unlawful

• Expenses related to illegal activity is deductible if income is included. Exception - drug trafficking

• Political contributions and lobbying expenses except at the local level and is a direct interest to the taxpayer’s business

Disallowance of deduction

• Business start-up expenditure e.g. bus. Investigation expenses, preopening or start-up costs - need to capitalized and amortized

• Expenses on entertainment facility is not deductible - exception - can deduct if facility is for the benefit of the employees

• Club dues for bus., pleasure or recreation is not deductible

• Wash sales - not deductible if a loss is realized on securities that are identical and was acquired 30 days before and after it was sold. Prevent creation of artificial loss. Identical security means similar in terms, can differ in maturity.

Disallowance of deduction

• Transactions between related party - cannot deduct loss on sale of property or expenses unpaid at the end of year (accrual vs. cash)

• Concept of constructive ownership - if an individual owns stock in ABC corp and its business partner also owns stock in ABC, the ownerships will be combined to test for related party transactions

• Hobby losses - not deductible for AGI - only from AGI• Office in home - generally not deductible except if office is

regularly and exclusively used as 1) principal place of business and 2) meets and deals with clients