Business Tax Topics Flashcards
(191 cards)
1
Q
“Nothing is certain, except death and taxes.” is a quote attributed to:
A
Benjamin Franklin
2
Q
Taxation is a crucial topic for accounting and finance professionals. They must understand the various types of business taxes to assist effectively with all of the following, except:
a. Compliance.
b. Controversy.
c. Cash management.
d. Corporate law.
e. Planning.
A
Corporate law
3
Q
Since the law is complicated, most individual taxpayers complete their Federal income tax returns with outside assistance from tax return preparers and/or use tax software.
True
False
A
True
4
Q
The Federal income tax on individuals generates more revenue than the Federal income tax on corporations.
True
False
A
True
5
Q
The AICPA guidelines suggest that taxes should be transparent and visible. This means that:
a. The taxes affect similarly situated tax payers in a similar manner.
b. The effect of tax rules on taxpayer decision making should be kept to a minimum.
c. Taxpayers should know that a tax exists and how and when it applies to them.
d. Taxes should be due at the same intervals of time each calendar year.
e. Taxpayers should have certainty rather than ambiguity as to when and how a tax is paid, and how to calculate it.
A
C
6
Q
The American Institute of Certified Public Accountants (AICPA) has issued 12 principles that are commonly used as indicators of desirable tax policy. The first four principles are adapted from Adam Smith’s The Wealth of Nations and are:
a. Equity and fairness, certainty, economic growth and efficiency, effective tax administration.
b. Transparency and visibility, certainty, convenience of payment, effective tax administration.
c. Transparency and visibility, neutrality, economic growth and efficiency, effective tax administration.
d. Equity and fairness, neutrality, convenience of payment, effective tax administration.
e. Equity and fairness, certainty, convenience of payment, effective tax administration.
A
E
7
Q
Ad valorem taxes are taxes on:
a. An estate.
b. Property.
c. Income.
d. Gifts.
e. None of these choices are correct.
A
Property
8
Q
Harry and Gloria are married and live in a common law state. Harry wants to make gifts to their four children in 2018. What is the maximum amount of the annual exclusion they will be allowed for these gifts?
a. $0
b. $60,000
c. $120,000
d. $30,000
e. $15,000
A
C 4 (number of donees) × $15,000 (annual exclusion) × 2 (number of donors) = $120,000. It is assumed that Gloria will make the election to split the gifts.
9
Q
Transaction taxes that are based on the notion that the state has an interest in its natural resources (e.g., oil, gas, iron ore, or coal) are called:
a. FUTA taxes.
b. Franchise taxes.
c. Severance taxes.
d. Commodities taxes.
e. None of these choices are correct.
A
Severance taxes
10
Q
For failure to file a tax return by the due date, a penalty of _____ percent per month up to a maximum of _____ percent is imposed on the amount of tax shown as due on the return. Any fraction of a month counts as a full month.
a. 1; 5
b. 5; 25
c. 7; 35
d. 4.5; 13.5
e. 2.5; 10
A
5, 25
11
Q
Geoff underpaid his taxes in the amount of $2,500, of which $2,000 is attributable to negligence. Geoff’s negligence penalty is:
a. $100.
b. $2,000.
c. $2,500.
d. $500.
e. $400.
A
$400
A negligence penalty of 20 percent is imposed if any of the underpayment was for intentional disregard of rules and Regulations without intent to defraud. The penalty applies to just that portion attributable to the negligence. Geoff’s penalty is $2,000 × 20% = $400.
12
Q
Which of the following is a characteristic of the audit process?
a. The IRS does not reward informants even when the information provided leads to the collection of additional taxes.
b. Significant tax issues are handled by means of a correspondence audit.
c. If a taxpayer disagrees with the IRS auditor’s finding, the only resort is to the courts.
d. Self-employed taxpayers are less likely to be selected for audit than employed taxpayers.
e. Taxpayer audits rarely involve “special” agents.
A
E
Special agents are assigned to an audit only when fraud might be involved (“Taxpayer audits rarely involve “special” agents”). Self-employed persons have more flexibility in manipulating income and deductions than do employed taxpayers (“Self-employed taxpayers are less likely to be selected for audit than employed taxpayers”). The next step after an initial audit would be the Appeals Division within the IRS (“If a taxpayer disagrees with the IRS auditor’s finding, the only resort is to the courts”). Settlement at this level could avoid costly litigation.
13
Q
A practitioner may still prepare returns for a client, even if the client refuses to correct an error on a past return.
True
False
A
True
However, if the error is material and carries over to the current year, the preparer should consider withdrawing from the engagement.
14
Q
Economic considerations can be used to justify:
a. Allowing accelerated amortization for the cost of installing pollution control facilities.
b. Allowance of a credit for child care expenses.
c. Allowing a Federal income tax deduction for state and local sales taxes.
d. Allowing excess capital losses to be carried over to other years.
e. None of these choices are correct.
A
A
Equity considerations justify “Allowing a Federal income tax deduction for state and local sales taxes” and “Allowing excess capital losses to be carried over to other years”, and social considerations justify “Allowance of a credit for child care expenses”.
15
Q
Shawn’s business warehouse is destroyed by fire. As the insurance proceeds exceed the basis of the property, a gain results. If Shawn shortly reinvests the proceeds in a new warehouse, gain must be recognized due to the application of the wherewithal to pay concept.
True
False
A
False
Gain is not recognized due to the application of the wherewithal to pay concept.
16
Q
The IRS would prefer that Congress decrease the amount of the standard deduction allowed to individual taxpayers.
True
False
A
False
The IRS would prefer that Congress increase (rather than decrease) the amount of the standard deduction allowed to individual taxpayers.
17
Q
Congress has passed laws that enable the IRS to:
a. Close loopholes in the tax code.
b. Support aggressive tax avoidance strategy.
c. Bear more administrative burden.
d. Support social and equity considerations.
e. Make adjustments based on the substance of a transaction rather than the form of the transaction.
A
E
Congress has passed laws that enable the IRS to make adjustments based on the substance of a transaction rather than the form of the transaction. The IRS does not close loopholes in the tax code (“Make adjustments based on the substance of a transaction rather than the form of the transaction”), Congress or the courts do this—the IRS enforces but does not make code. The IRS does not support social and equity considerations (“Support social and equity considerations”) but it enforces the code. The IRS has been against aggressive tax avoidance strategy (“Support aggressive tax avoidance strategy”). Congress has tried to reduce the IRS’s administrative burden, not increase it (“Bear more administrative burden”).
18
Q
The level and depth of tax knowledge needed for any accounting or tax professional depends on his or her:
a. Certifications earned.
b. Specific job.
c. Career aspirations.
d. Highest degree earned.
e. All of these choices are correct.
A
Specific job
The level and depth of tax knowledge needed for any accounting or tax professional depends on his or her specific job.
19
Q
The top U.S. corporate income tax rate is:
a. 30 percent.
b. 25 percent.
c. 35 percent.
d. 21 percent.
e. 40 percent.
A
21 percent
20
Q
Ordinary, everyday decisions can carry significant tax implications.
True
False
A
True
Even the simplest of decisions can carry tax implications.
21
Q
How often does tax law typically change?
a. Every four years
b. Yearly
c. With each new U.S. president
d. Every two years, with each new Congress
e. None of these choices are correct.
A
Yearly
22
Q
What historic event prompted Congress to enact new tax laws that resulted in a rise from less than 6 percent to more than 74 percent of the U.S. population being subject to Federal income tax?
a. WWII
b. The Great Depression
c. The ratification of the Sixteenth Amendment
d. WWI
e. None of these choices are correct.
A
WWII
By 1945, more than 74 percent of the population was subject to the Federal income tax.
23
Q
The AICPA guidelines suggest that tax policy should follow the neutrality principle. This means that:
a. The collection of taxes should offset revenues so that the budget is balanced, or neutral.
b. The effect of tax rules on taxpayer decision making should be kept to a minimum.
c. The tax affects similarly situated tax payers in a similar manner.
d. Taxpayers should have certainty rather than ambiguity as to when and how a tax is paid.
e. Taxes should be due at the same intervals of time each calendar year.
A
B
The AICPA guidelines suggest that tax policy should follow the neutrality principle. This means that the effect of tax rules on taxpayer decision making should be kept to a minimum.
24
Q
The American Institute of Certified Public Accountants (AICPA) has issued 12 principles that are commonly used as indicators of desirable tax policy. The first four principles are adapted from Adam Smith’s The Wealth of Nations and are:
a. Transparency and visibility, neutrality, economic growth and efficiency, effective tax administration.
b. Transparency and visibility, certainty, convenience of payment, effective tax administration.
c. Equity and fairness, certainty, economic growth and efficiency, effective tax administration.
d. Equity and fairness, certainty, convenience of payment, effective tax administration.
e. Equity and fairness, neutrality, convenience of payment, effective tax administration.
A
D
Adam Smith’s canons (or principles) of taxation are equity, certainty, convenience of payment, and economy in collection, which were adapted by the AICPA as the four in “Equity and fairness, certainty, convenience of payment, effective tax administration”.
25
The basic formula for any tax is:
a. Tax base ÷ Tax rate = Tax liability.
b. Tax base × Tax rate = Tax liability.
c. Tax base – Tax rate = Tax liability.
d. Tax base + Tax rate = Tax liability.
e. None of these choices are correct.
B
26
The use of a client's estimates is not permitted when preparing an income tax return.
True
False
False
| Estimates are allowed if reasonable and not given the appearance of greater accuracy than is the case.
27
Info card:
Approaching Study of Taxation
• What is taxation?
– Meaning from two famous quotes:• “Taxes are what we pay for civilized society.”• “Nothing is certain, except death and taxes.”
– Taxes produce revenue for government operations.– Can also be used to modify behavior.
– Affect many aspects of our lives
– income, spending, savings, asset transfers at death, and more.
28
Info card:
Tax Relevance to Accounting and Finance Professionals
```
• Key tax functions
–Compliance
–Planning
–Controversy
–Cash management
```
29
How to Study Taxation
• Goal – Recognize issues and transactions with tax implications• Find the answers• Focus on understanding the rules– When applicable.– Why designed in a particular way.– When relevant.– For business tax rules – how do they compare to financial reporting treatment
30
Info card:
History of Taxation (slide 1 of 2
• Prior to 1900s income tax financed wars– 1861:First Federal individual income tax enacted» Repealed after Civil War– 1894:New Federal individual income tax enacted» Tax found to be unconstitutional
31
Info card:
History of Taxation (slide 2 of 2)
• Other important events– 1909:First Federal corporate income tax enacted– 1913:16th Amendment ratified» Sanctioned both Federal individual and corporate income taxes
32
Info card:
Tax Structure (slide 1 of 3)
• Legal foundation– Constitution of the taxing jurisdiction– Example –US Constitution• Article I, Section 8 – gives taxing power to Congress• 16thAmendment – allows for an income tax
33
Info card:
Tax Structure (slide 2 of 3)
Tax Structure (slide 2 of 3)• Tax base: amount to which the tax rate is applied– e.g., For the Federal income tax, the tax base is taxable income• Tax rates: applied to the tax base to determine the tax liability– May be proportional or progressive • Incidence of tax: degree to which the tax burden is shared by taxpayers
34
Info card:
Criteria for Evaluating a Tax Structure
• Adam Smith identified the following canons of taxation which are still considered when evaluating tax structures:– Equality– Certainty – Convenience of payment– Economy in collection
35
Info card:
AICPA Guiding Principles of Good Tax Policy
1.Equity and Fairness2.Certainty3.Convenience of Payment4.Effective Tax Administration5.Information Security6.Simplicity 7.Neutrality8.Economic Growth and Efficiency9.Transparency and Visibility10.Minimum Tax Gap11.Accountability to Taxpayers12.Appropriate Government Revenues
36
Info card:
Major Types of Taxes
• Property Taxes (ad valorem)• Transaction Taxes• Taxes on Transfers at Death• Gift Taxes• Income Taxes• Employment Taxes• Other U.S. Taxes• Proposed U.S. Taxes
37
Info card:
Property (ad valorem) Taxes
• Based on the value of the asset– Essentially, a tax on wealth, or capital• Generally imposed on realty or personalty• Exclusive jurisdiction of states and their local political subdivisions• Deductible for Federal income tax purposes
38
Info card:
Transaction Taxes
• Excise taxes• General sales taxes• Severance taxes
39
Info card:
Excise Taxes
• Imposed at the Federal, state, and local levels• Restricted to specific items – Examples: gasoline, tobacco, liquor• Declined in relative importance until recently – Example-two types of excise taxes at the local level have recently become increasingly popular • Hotel occupancy tax • Rental car surcharge – Tax is levied on visitors who cannot vote and often used to fund special projects
40
Info card:
• Currently jurisdiction of states and localities• States that impose sales taxes also charge a use taxon items purchased in other states but used in their jurisdiction• States without sales or use taxes are Alaska, Delaware, Montana, New Hampshire, and Oregon
41
Info card:
Severance taxes
• Tax on natural resources extracted– Important revenue source for states rich in natural resources
42
Death Taxes (slide 1 of 2)
• Tax on the right to transfer property or to receive property upon the death of the owner– If imposed on right to pass property at death• Classified as an estate tax– If imposed on right to receive property from a decedent• Classified as an inheritance tax
43
Death Taxes (slide 2 of 2)
• The value of the property transferred provides the base for determining the amount of the death tax• The Federal government imposes only an estate tax• Many state governments levy inheritance taxes, estate taxes, or both
44
Federal Estate Tax(slide 1 of 2)
• Federal estate tax is on the right to pass property to heirs– Gross estate includes FMV of property decedent owned at time of death • Also includes property interests, such as life insurance proceeds paid to the estate or to a beneficiary other than the estate if the deceased-insured had any ownership rights in the policy
45
Federal Estate Tax(slide 2 of 2)
• Property included in the gross estate is valued on either:– Date of death, or – If elected, the alternate valuation date • Generally 6 months after date of death• Certain deductions and credits allowed in arriving at the taxable estate• Examples - marital deduction, funeral and admin. expenses, certain taxes, debts of decedent
46
Unified Transfer Tax Credit
• Unified credit reduces or eliminates the estate tax liability for certain estates• For 2018, credit is $4,417,800*– Offsets tax on $11.18 million of the tax base• For 2017, credit was $2,141,800– Offsets tax on $5.49 million of the tax base* The Tax Cuts and Jobs Act significantly increased the exemption amount. Effective for estates of decedents dying and gifts made after Dec. 31, 2017 and before Jan. 1, 2026.
47
State Death Taxes
• State death taxes may be estate tax, inheritance tax, or both– Inheritance tax is on the right to receive property from a decedent– Tax is generally based on relationship of heir to decedent• The more closely related, the lower the tax
48
Federal Gift Tax (slide 1 of 3)
• Tax on the right to transfer assets during a person’s lifetime– Applies only to transfers that are not supported by full and adequate consideration• Taxable gift = FMV of gift less annual exclusionless marital deduction (if applicable)• Federal gift tax provides an annual exclusion of $15,000 per donee (in 2018)– Amount is adjusted for inflation
49
Federal Gift Tax (slide 2 of 3)
• Married persons can make a special election to split gifts– Allows one-half of a gift made by a donor-spouse to be treated as having been made by a nondonor-spouse (gift splitting)– Effectively increases the number of annual exclusions available and allows the use of the nondonor-spouse’s unified transfer tax credit
50
Federal Gift Tax (slide 3 of 3)
• The unified transfer tax credit is available for gifts (as well as the estate tax)• The credit for 2018 is $4,417,800– Covers taxable gifts up to $11,180,000• There is only one unified transfer tax credit– It applies to both taxable gifts and the Federal estate tax
51
Income Taxes
•Imposed at the Federal, most state, and some local levels of government–Income taxes generally are imposed on individuals, corporations, and certain fiduciaries (estates and trusts)•Federal income tax base is taxable income (income less allowable exclusions and deductions)•Most jurisdictions attempt to assure tax collection by requiring pay-as-you-go procedures, including–Withholding requirements for employees–Estimated tax prepayments for all taxpayers
52
Corporate Income Tax
• Corporate Taxable Income= Income – Deductions– Does not require the computation of adjusted gross income– Does not provide for the standard deduction or personal and dependency exemptions– All allowable deductions are business expenses
53
State Income Tax (slide 1 of 3)
• All but the following states impose an income tax on individuals:– Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming– New Hampshire and Tennessee impose an individual income tax only on interest and dividends
54
State Income Tax (slide 2 of 3)
• Some characteristics of state income taxes include:– With few exceptions, all states require some form of withholding procedures– Most states use as the tax base the income determination made for Federal income tax purposes• Some states apply a flat rate to Federal AGI• Some states apply a rate to the Federal income tax liability– Referred to as the “piggyback” approach to state income taxation
55
State Income Tax (slide 3 of 3)
• Some states ‘‘decouple’’ from select tax legislation enacted by Congress– State may not be able to afford the loss of revenue resulting from such legislation• Because of tie-ins to the Federal return, states may be notified of changes made by the IRS upon audit of a Federal return– In recent years, the exchange of information between the IRS and state taxing authorities has increased
56
Employment Taxes (slide 1 of 4)
• FICA taxes– Paid by both an employee and employer– The Social Security rate is 6.2% in 2018 on a maximum of $128,400 of wages• The Medicare rate is 1.45% on all wages – A spouse employed by another spouse is subject to FICA– Children under the age of 18 who are employed in parent’s unincorporated trade or business are exempt from FICA
57
Employment Taxes (slide 2 of 4)
• The Affordable Care Act (Obamacare) imposes an additional 0.9% tax on earned income above $200,000 (single filers) or $250,000 (MFJ)• An employer does not have to match the employees’0.9%• A 3.8% tax is imposed on netinvestment income (e.g., rents, taxable interest, dividends, and capital gains)• Applies when modified AGI exceeds $200,000 (single filers) or $250,000 (MFJ)
58
Employment Taxes (slide 3 of 4)
• Self-employment tax– Sole proprietors and independent contractors may also be subject to Social Security taxes• Known as the self-employment tax• Rates are twice that applicable to an employee– Generally, 12.4% for Social Security and 2.9% for Medicare • The tax is imposed on net self-employment income up to a base amount of $128,400 for 2018• The 0.9% tax addition to Medicare also covers situations involving high net income from self-employment
59
Employment Taxes (slide 4 of 4)
• FUTA (unemployment) taxes– Provides funds for state unemployment benefits – In 2018, rate is 6% on first $7,000 of wages for each employee– Administered jointly by states & Fed govt. • Credit is allowed (up to 5.4%) for FUTA paid to the state• Thus, the amount required to be paid to the IRS could be as low as 0.6% (6.0% - 5.4%)– Tax is paid by employer
60
Other Taxes
• Federal customs duties – Tariffs on certain imported goods• Franchise taxes – Levied on the right to do business in the state• Occupational fees – Applicable to various trades or businesses• e.g., liquor store license, taxicab permit, fee to practice a profession
61
Proposed U.S. Taxes
•Flat tax–Would replace the current graduated income tax with a single rate•Value added tax –Taxes the increment in value as goods move through production & manufacturing stages to the market• Paid by the producer and reflected in the sales price of goods and services–Most countries use this (in addition to income tax)•National sales tax–Levied on the final sale of goods and services• Collected from consumer, not from businesses as with VAT •Others – carbon tax, financial transactions tax
62
Tax Administration (slide 1 of 4)
• Internal Revenue Service (IRS)– Responsible for enforcing the Federal tax laws– Audits small percentage of returns filed using mathematical formulas and statistical sampling • To update selection criteria, the IRS selects a cross section of returns, which are subject to various degrees of inspection • Results highlight areas of taxpayer noncompliance and enable the IRS to use its auditors more productively
63
Tax Administration (slide 2 of 4)
• Types of audits: – Correspondence audit– Office audit • Usually restricted in scope and conducted in facilities of IRS – Field audit • Involves examination of numerous items reported on the return and is conducted on premises of taxpayer or taxpayer's representative
64
Tax Administration (slide 3 of 4)
• After the audit, a Revenue Agent’s Report (RAR) is issued summarizing the findings which can result in a:– Refund (tax was overpaid)– Deficiency (tax was underpaid), or– No change (tax was correct) finding
65
Tax Administration (slide 4 of 4)
•If an audit results in an assessment of additional tax–Taxpayer may attempt to negotiate a settlement • An appeal is available through the Appeals Division of the IRS–Appeals Division is authorized to settle all disputes based on the hazard of litigation (i.e., probability of favorable resolution, if litigated)–If a satisfactory settlement is not reached on administrative appeal, the taxpayer can litigate in:• Tax Court• Federal District Court, or• Court of Federal Claims–Litigation is recommended only as a last resort because of • Legal costs involved• Uncertainty of the final outcome
66
Statute of Limitations (slide 1 of 3)
•Statute of limitations offers a defense against a suit brought by another party after the expiration of a specified period of time–Purpose is to preclude parties from prosecuting stale claims• The passage of time makes defense of such claims difficult since witnesses may no longer be available or evidence may have been lost or destroyed•For Federal income tax purposes, the two categories involved relate to the statute of limitations applicable to:–The assessment of additional tax deficiencies by the IRS, and –Claims for refunds by taxpayers
67
Statute of Limitations (slide 2 of 3)
• For a deficiency assessment by IRS– Generally 3 years from the later of the due date or the filing date of the return– For material (more than 25%) omissions of gross income, time period is 6 years– No statute if no return filed or fraudulent return filed
68
Statute of Limitations (slide 3 of 3)
• For a refund claim by taxpayer– Generally 3 years from date return filed or 2 years from date tax paid, whichever is later
69
Interest and Penalties (slide 1 of 2)
• Interest accrues on the taxes due starting from the due date of the return and interest is paid on refunds if not received within 45 days of when the return was filed– Rate for October 1–December 31 of 2017 is 4% (determined quarterly by the IRS)– IRS publishes rate quarterly.
70
Interest and Penalties (slide 2 of 2)
• Tax law provides various penalties for lack of compliance including penalties for:– Failure to file• Penalty is 5% per month up to a max of 25% on the amount of tax shown as due on the return–Any fraction of a month counts as a full month– Failure to pay• Penalty is 0.5% per month up to a max of 25%– Penalties may also apply to underpayment of estimated taxes, negligence, fraud, etc
71
Tax Practice (slide 1 of 4)
• Area of tax practice is largely unregulated– Members of professions must follow certain ethical standards (CPAs, Attorneys)– Various penalties may be imposed upon preparers of Federal tax returns who violate proscribed acts and procedures
72
Tax Practice (slide 2 of 4)
• Ethical guidelines issued by AICPA:– Do not take questionable position on client’s tax return in hope of it not being audited– Client’s estimates may be used if reasonable– Try to answer every question on the tax return (even if disadvantageous to client)– Upon discovery of an error in prior year tax return, advise client to correct
73
Tax Practice (slide 3 of 4)
• Statutory penalties may be levied on tax return preparers for:– Procedural Matters-Failure to:• Provide copy of return to taxpayer• Sign the return as preparer• Keep copies of returns• Maintain a client list• Exercise due diligence when client claims certain tax credits
74
Tax Practice (slide 4 of 4)
• Statutory penalties may be levied on tax return preparers for:– Understatement of tax liability based on a position that lacks a realistic possibility of being sustained– Willful attempts to understate tax– Failure to exercise due diligence in determining eligibility for, or the amount of, the earned income tax credit
75
Understanding the Federal Tax Law (slide 1 of 3)
• The Federal tax law is the vehicle for accomplishing many objectives of the nation such as:– Raising revenue: the major objective of the tax system but not the sole objective– Economic: increasingly important objective is to regulate the economy and encourage certain behavior and businesses considered desirable
76
Understanding the Federal Tax Law (slide 2 of 3)
• Federal tax objectives– Social: encourage socially desirable behavior that provides benefits that government might otherwise provide– Equity: equity within the tax laws (e.g., wherewithal to pay concept) and not necessarily equity across taxpayers
77
Understanding the Federal Tax Law (slide 3 of 3)
• Federal tax objectives– Political: a large segment of the tax law is created through a political process; thus, compromises and special interest dealings occur– Ease of administration: many provisions are meant to aid the IRS in the collection of taxes– Courts: influence tax law and sometimes cause it to change
78
Statutory Sources of Tax Law(slide 1 of 2)
• Internal Revenue Code– Codification of the Federal tax law provisions in a logical sequence– We have had three “codifications”:• 1939, 1954, 1986
79
Statutory Sources of Tax Law (slide 2 of 2)
```
• Example of Code Citation: §2(a)(1)(A)
§= Abbreviation for “Section”
2 = Section number
(a) = Subsection
(1) = Paragraph designation
(A) = Subparagraph designation
```
80
Administrative Sources of Tax Law (slide 1 of 2)
• Treasury Department Regulations • Revenue Rulings• Revenue Procedures, and• Various other administrative pronouncements
81
Regulations(slide 1 of 4)
• Issued by U.S. Treasury Department• Provide general interpretations and guidance in applying the Code
82
Regulations(slide 2 of 4)
•Issued as:–Proposed:Preview of final regulations• Do not have force and effect of law–Temporary:Issued when guidance needed quickly• Same authoritative value as final regulations–Final:• Force and effect of law
83
Regulations(slide 3 of 4)
• Example of Regulation citation: – Reg. § 1.2• Refers to Regulations under Code § 2• Subparts may be added for further identification• The numbering patterns of these subparts often have no correlation with the Code subsections
84
Regulations(slide 4 of 4
• Example of Proposed Regulation citation: – Prop. Reg. §1.2• Example of Temporary Regulation citation:– Temp. Reg. §1.6081–8T
85
Revenue Rulings(slide 1 of 2)
• Officially issued by National Office of IRS– Provide specific interpretations and guidance in applying the Code– Less legal force than Regulations– Issued in weekly Internal Revenue Bulletins
86
Revenue Rulings(slide 2 of 2)
• Example of Temporary Revenue Ruling citation – Rev. Rul. 2017–16, 2017–35 I.R.B. 215.• Explanation: Revenue Ruling Number 16, appearing on page 215 of the 35thweekly issue of the Internal Revenue Bulletin for 2017.
87
Revenue Procedures(slide 1 of 2)
• Concerned with the internal management practices and procedures of the IRS– For example, how to request a change in accounting method– Issued in weekly Internal Revenue Bulletins
88
Revenue Procedures(slide 2 of 2)
• Example of an older Revenue Procedure citation– Rev. Proc. 92-29, 1992-1 CB 748• 29th Rev. Procedure in 1992 found in volume 1 of Cumulative Bulletin on page 748• Note: The IRS stopped the publication of Cumulative Bulletins in 2008. All rulings and procedures are now published in Internal Revenue Bulletins, normally issued each week by the IRS.
89
Letter Rulings(slide 1 of 2)
• Offer guidance to taxpayer on how a transaction will be taxed before proceeding with it– Issued for a fee upon a taxpayer's request– Describe how the IRS will treat a proposed transaction• Apply only to the taxpayer who asks for and obtains the ruling– Post-1984 letter rulings may be substantial authority for purposes of the accuracy-related penalty• Limited to restricted, preannounced areas of taxation
90
Letter Rulings(slide 2 of 2)
• Example of Letter Ruling citation– Ltr. Rul. 201734004– 4thruling issues in the 34thweek of 2017
91
Other Administrative Pronouncements (slide 1 of 3)
• Treasury Decisions - Issued by the Treasury Department to:– Promulgate new or amend existing Regulations– Announce position of the Government on selected court decisions– Published in the Internal Revenue Bulletin
92
Other Administrative Pronouncements (slide 2 of 3)
Other Administrative Pronouncements (slide 2 of 3)• Determination Letters– Issued by Area Director at taxpayer’s request– Usually involve completed transactions– Not published• Made known only to party making the request
93
Other Administrative Pronouncements (slide 3 of 3)
• A variety of internal memoranda that constitute the working law of the IRS also are released but not officially published, such as– General Counsel Memoranda (GCMs)– Technical Advice Memoranda (TAMs)– Internal Legal Memoranda (ILMs)– Field Service Advice Memoranda (FSAs) • The IRS indicates that they may not be cited as precedents by taxpayers– However, these working documents do explain the IRS’s position on various issues.
94
Judicial Sources(slide 1 of 2)
• There are four courts of original jurisdiction (trial courts)– U.S. Tax Court: Regular– U.S. Tax Court: Small Cases Division– Federal District Court– U.S. Court of Federal Claims
95
Appeals Process
• Appeals from District Court or Tax Court go to the U.S. Court of Appeals for circuit where taxpayer resides• Appeals from Court of Federal Claims is to Court of Appeals for the Federal Circuit• Appeal to the Supreme Court is by Writ of Certiorari– Only granted for those cases the Supreme Court wants to hear; only a few every year
96
Courts’ Weights As Precedents
• Precedential Weight (from High to Low):– Supreme Court– Circuit Court of Appeals– Tax Court (Regular), U.S. Court of Federal Claims, and U.S. District Courts• Decisions of Small Cases Division of Tax Court have no precedential value and cannot be appealed
97
Tax Court (slide 1 of 3)
•Issues three types of decisions: Regular, Memorandum, and Summary Opinions–Regular decisions involve novel issues not previously resolved by the court•Regular decisions are published by U.S. government, for example:•Summary opinions–Issued in small tax cases and may not be used as precedent in any other case
98
Tax Court (slide 2 of 3)
• Tax Court Memorandum decisions – Memorandum decisions deal with situations necessitating only the application of already established principles of law– Memorandum decisions were not published by the U.S. Government until recently
99
Tax Court (slide 3 of 3)
• Memorandum decisions were—and continue to be—published by several tax services – Consider, for example, three different ways that Nick R. Hughescan be cited:•Nick R. Hughes, T.C.Memo. 2009–94– The 94th Memorandum decision issued by the Tax Court in 2009•Nick R. Hughes, 97 TCM 1488– Page 1488 of Vol. 97 of the CCH Tax Court Memorandum Decisions•Nick R. Hughes, 2009 RIA T.C.Memo. ¶2009,094– Paragraph 2009,094 of the RIA T.C. Memorandum Decisions
100
Examples Of District Court Decision Citations
•Turner v. U.S., 2004–1 USTC ¶60,478(D.Ct. Tex., 2004) (CCH citation)•Turner v. U.S., 93 AFTR 2d 2004–686(D.Ct. Tex., 2004) (RIA citation)•Turner v. U.S., 306 F.Supp.2d 668(D.Ct. Tex., 2004) (West citation)
101
Tax Treaties
• The U.S. signs tax treaties with foreign countries to: – Avoid double taxation– Render mutual assistance in tax enforcement• Neither a tax law nor a tax treaty takes general precedence– When there is a direct conflict, the most recent item will take precedence
102
Tax Research Tools(slide 1 of 2
• A crucial part of the research process is the ability to locate appropriate sources of the tax law– Both electronic and paper-based research tools are available to aid in this search• Unless the problem is simple (e.g., the Code Section is known or there is a Regulation on point), the research process should begin with a tax service
103
Tax Research Tools(slide 2 of 2)
•Here is a partial list of the available commercial tax services:–Standard Federal Tax Reporter, Commerce Clearing House–CCH IntelliConnect, Commerce Clearing House online service–United States Tax Reporter, Research Institute of America–Thomson Reuters Checkpoint, Research Institute of America –Tax Management Portfolios, Bloomberg BNA–Mertens Law of Federal Income Taxation, Thomson Reuters–Westlaw, Thomson Reuters –Tax Center, LexisNexis
104
Tax Research
• Tax research is the method by which an interested party determines the best solution to a tax situation• Tax research involves:– Identifying and refining the problem– Locating the appropriate tax law sources– Assessing the validity of the tax law sources– Arriving at the solution or at alternative solutions with due consideration given to nontax factors
105
Assessing The Validity Of Tax Law Sources(slide 1 of 4)
• Regulations– IRS agents must give the Code and the Regulations equal weight when dealing with taxpayers and their representatives– Proposed Regulations are not binding on IRS or taxpayer– Burden of proof is on taxpayer to show that a Regulation incorrect– If the taxpayer loses the challenge, a 20% negligence penalty may be imposed
106
Assessing The Validity Of Tax Law Sources(slide 2 of 4)
• Final Regulations tend to be of three types– Procedural: “Housekeeping-type” instructions– Interpretive: Rephrase what is in Committee Reports and the Code• Hard to get overturned– Legislative: Allow the Treasury Department to determine the details of law• Congress has delegated its legislative powers and these cannot generally be overturned
107
Assessing The Validity Of Tax Law Sources(slide 3 of 4)
• Revenue Rulings– Carry less weight than Regulations– Not substantial authority in court disputes
108
Assessing The Validity Of Tax Law Sources(slide 4 of 4)
•Judicial Sources–Consider the level of the court and the legal residence of the taxpayer–Tax Court Regular decisions carry more weight than Memo decisions• Tax Court does not consider Memo decisions to be binding precedents• Tax Court reviewed decisions carry even more weight–Circuit Court decisions where certiorari has been requested and denied by the U.S. Supreme Court carry more weight than a Circuit Court decision that was not appealed–Consider whether the decision has been overturned on appeal
109
Tax Law Sources(slide 1 of 2)
• Primary sources of tax law include:– The Constitution– Legislative history materials– Statutes (e.g., the Internal Revenue Code)– Treaties– Treasury Regulations– IRS pronouncements– Judicial decisions• In general, the IRS considers only primary sources to constitute substantial authority
110
Tax Law Sources(slide 2 of 2)
• Secondary Sources include:– Legal periodicals– Treatises– Legal opinions– General Counsel Memoranda, and – Written determinations• In general, secondary sources are not authority
111
Tax Planning
•The primary purpose of effective tax planning is to maximize the taxpayer’s after-tax wealth–Must consider the legitimate business goals of taxpayer•A secondary objective of effective tax planning is to reduce, defer, or eliminate the tax•Tax avoidance vs. tax evasion –Tax avoidance is the legal minimization of tax liabilities and one goal of tax planning–Tax evasion is the illegal minimization of tax liabilities • Suggests the use of subterfuge and fraud as a means to tax minimization• Can lead to fines and jail
112
Taxation on the CPA Examination
• Taxation is included in the 3-hour Regulation section • The Regulation section is 60% Taxation and 40% Law & Professional Responsibilities (all areas other than Business Structure)• Knowledge is tested using both multiple-choice questions and task-based simulations
113
Various Business Forms
• Business operations can be conducted in a number of different forms including.
– Sole proprietorships
– Partnerships.
– Trusts and estates
– S corporations (also called Subchapter S corps)
– Regular corporations (also called C corps)
– Limited liability companies
114
Sole Proprietorship
• Not a separate taxable entity• Income reported on owner’s Sch. C
115
Partnership (slide 1 of 2)
• Separate entity, but does not pay tax– Files information return (Form 1065)• Business income and expense items are aggregated in computing the ordinary business income (loss) of the partnership • Certain income and expense items are reported separately to the partners– e.g., Interest and dividend income, long term capital gain, charitable contributions and investment expenses
116
Partnership (slide 2 of 2)
• Partnership ordinary business income (loss) and separately reported items are allocated to partners according to their profit and loss sharing ratios – Each partner receives a Schedule K–1 • Reports partner’s share of partnership ordinary business income (loss) and separately stated items– Each partner reports these items on his or her own tax return
117
S Corporation
•Separate entity, only pays special taxes (e.g., built-in gains)–Files information return Form 1120S•Similar to partnership taxation–Ordinary business income (loss) flows through to the shareholders to be reported on their separate returns–Certain items flow through to the shareholders and retain their separate character when reported on the shareholders’ returns•The S corporation ordinary business income (loss) and the separately reported items are allocated to the shareholders according to their stock ownership interests
118
C Corporation
• C corporations are subject to an entity-level Federal income tax which results in what is known as a double taxationeffect– C corporation reports its income and expenses and computes tax using a flat rate of 21% on the taxable income reported on its Form 1120– When corporation distributes its income, the corporation’s shareholders report dividend income on their own tax returns• Thus, income that has already been taxed at the corporate level is also taxed at the shareholder level
119
Dividends
•Double taxation stems, in part, from the fact that dividend distributions are not deductible by the corporation•To alleviate some of the double taxation effect, Congress reduced the tax rate applicable to dividend income of individuals– Qualified dividend income is taxed at a rate of 15% (20% for high-income taxpayers; 0%for lower-income taxpayers)– These rates also apply to long-term capital gains
120
Corporations vs Other Forms of Doing Business
• When comparing C corporations to other business forms, there are a number of factors• to consider including:– Tax rates,– Character of business income,– Business losses,– Employment taxes, and– State taxes
121
Corporate Income Tax Rates(slide 1 of 2)
• A flat rate of 21% applies to corporate taxable income for taxable years beginning after 2017• Historically, however, a graduated corporate tax rate structure has applied• The marginal rates for individuals range from 10% to 37% • In many cases, taxes will be greater in the corporate form
122
Nontax Issues in Selecting Entity Form (slide 1 of 3)
• Liability– Sole proprietors and some partners have unlimited liabilityfor claims against the entity• Capital-raising– Corporations and partnerships to a lesser extent can raise large amounts of capital for entity ventures
123
Nontax Issues in Selecting Entity Form (slide 2 of 3)
• Transferability– Corporate stock is easily sold, but partners must approve partnership interest transfer• Continuity of life– Corporations exist indefinitely
124
Nontax Issues in Selecting Entity Form (slide 3 of 3)
• Centralized management– Corporate actions are governed by a board of directors– Partnership operations may be conducted by each partner without approval by other partners
125
Limited Liability Companies (LLC)
• LLCs have proliferated since 1988 when IRS ruled it would treat qualifying LLCs as partnerships– Major nontax advantage• Allows owners to avoid unlimited liability– Major tax advantage• Allows qualifying business to be treated as a proprietorship or partnership for tax purposes, thereby avoiding double taxation associated with C corporations
126
Entity Classification Prior to 1997 (slide 1 of 2)
Entity Classification Prior to 1997 (slide 1 of 2)• Sometimes difficult to determine if entity will be taxed as a corporation– If entity has a majority of corporate characteristics, it is taxed as a corporation– Most entities have the following characteristics:• Associates• Objective to carry on business and share profits
127
Entity Classification Prior to 1997 (slide 2 of 2)
• If entity has a majority of the following relevant corporate characteristics it is treated as a corporation:– Continuity of life– Centralized management– Limited liability to owners– Free transferability of ownership interests
128
Entity Classification After 1996 (slide 1 of 2
•Check-the-box Regulations– Allows taxpayer to choose tax status of an unincorporated entity without regard to corporate or noncorporate characteristics– Entities with > 1 owner can elect to be classified as partnership or corporation– Entities with only 1 owner can elect to be classified as sole proprietorship or as corporation
129
Entity Classification After 1996 (slide 2 of 2)
•Check-the-box Regulations (cont’d)– If no election is made, multi-owner entities treated as partnerships, single person businesses treated as sole proprietorships– Election is not available to:• Entities incorporated under state law• Entities required to be corporations under federal law (e.g., certain publicly traded partnerships)
130
THE DEDUCTION FOR QUALIFIED BUSINESS INCOME (slide 1 of 2)
THE DEDUCTION FOR QUALIFIED BUSINESS INCOME (slide 1 of 2)• Under the TCJA of 2017, § 199A, Qualified Business Income, was added to the Internal Revenue Code– Allows up to a 20% deduction on the qualified business income (QBI) of noncorporate taxpayers– This deduction is potentially available to individuals, trusts, and estates• Owners of partnerships and S corporations use relevant information provided to them from the entity (on their Schedule K-1 and related attachments) to calculate the deduction on their tax return
131
THE DEDUCTION FOR QUALIFIED BUSINESS INCOME (slide 2 of 2)
• Under the TCJA of 2017, the deduction for qualified business income is temporary– It is in effect from 2018 through 2025• The balance of this chapter explains the deduction for qualified business income– This new deduction includes numerous definitions, limitations, and special rules• Appreciating the purpose of the deduction—to reduce the tax on business income derived outside of the C corporate form—will help in understanding this provision
132
THE DEDUCTION FOR QBI – General Rule (slide 1 of 2)
• The deduction for qualified business income is 20% of qualified business income (QBI) generated through a sole proprietorship, a partnership, or an S corporation• In general, the deduction for qualified business income is the lesser of:– 20% of qualified business income (QBI), or– 20% of modified taxable income• Effectively, the QBI deduction—a from AGI deduction—is the last deduction taken in determining taxable income
133
THE DEDUCTION FOR QBI – General Rule (slide 2 of 2)
• There are three limitations on the QBI deduction:– An overall limitation based on modified taxable income, – Another that applies to high-income taxpayers, and – A third that applies to certain types of services businesses• The second and third limitations only apply when taxable income before the QBI deduction exceeds, in 2018, – $315,000 for married taxpayers filing a joint return, or – $157,500 for all other taxpayers
134
THE DEDUCTION FOR QBI – The Overall Limitation
THE DEDUCTION FOR QBI – The Overall Limitation• In all cases, the § 199A deduction may not exceed 20% of the taxpayer’s modified taxable income– Modified taxable income is taxable income before the deduction for QBI, reduced by any net capital gain• Here, the term net capital gain includes both – A net capital gain » The excess of a long-term capital gain over a short-term capital loss (§ 1222), plus– Any qualified dividend income
135
THE DEDUCTION FOR QBI – Definition of Qualified Business Income(slide 1 of 2)
•Qualified business income (QBI) is defined as the ordinary income less ordinary deductions a taxpayer earns from a “qualified trade or business” conducted in the United States by the taxpayer – It also includes the distributive share of these amounts from each partnership or S corporation interest held by the taxpayer
136
THE DEDUCTION FOR QBI – Definition of Qualified Business Income(slide 2 of 2)
•Qualified business income does not include certain types of investment income, such as:–Capital gains or capital losses;–Dividends;–Interest income (unless “properly allocable” to a trade or business, such as lending); or–Certain other investment items•Nor does qualified business income include:–The “reasonable compensation” paid to the taxpayer with respect to any qualified trade or business, or–Guaranteed payments made to a partner for services rendered
137
THE DEDUCTION FOR QBI – Definition of a Qualified Trade or Business (slide 1 of 3)
• For taxpayers who fall below critical taxable income thresholds established under § 199A, the scope of a qualified trade or business (QTB) is broad– In general, it includes any trade or business other than providing services as an employee–Taxable income thresholds are•$315,000 for married taxpayers filing jointly•$157,500 for all other taxpayers
138
THE DEDUCTION FOR QBI – Definition of a Qualified Trade or Business (slide 2 of 3)
• As a result, the deduction is available to sole proprietors, independent contractors, and noncorporate owners of S corporations, partnerships, and LLCs• High-income taxpayers who are engaged in businesses involving the performance of services in certain “specified” fields are subject to certain restrictions
139
THE DEDUCTION FOR QBI – Definition of a Qualified Trade or Business (slide 3 of 3)
•Taxpayers with Multiple Businesses– The deduction for qualified business income must be determined separately for each qualified trade or business– These independent calculations are then combined becoming the “qualified business income amount” identified in § 199A(a)(1)(A)– This combined amount is then compared to the overall modified taxable income limit
140
THE DEDUCTION FOR QBI – Limitations on the QBI Deduction(slide 1 of 11)
•Once the taxable income thresholds are reached, § 199A imposes two independent limitations–One limitation is based on wages and capital investment–The second limitation applies to income earned from “specified service” businesses including•Doctors•Dentists•Lawyers•Accountants•Consultants•Investment advisers•Entertainers, and •Athletes–Engineers and architects are not subject to this limitation
141
THE DEDUCTION FOR QBI – Limitations on the QBI Deduction(slide 2 of 11)
• These taxable income thresholds—determined without regard to the QBI deduction—are – $315,000 for married taxpayers filing jointly, and– $157,500 for all other taxpayers– These amounts will be indexed for inflation after 2018
142
THE DEDUCTION FOR QBI – Limitations on the QBI Deduction(slide 3 of 11)
• These limitations are fully phased in once taxable income (before the QBI deduction) exceeds – $415,000 for married taxpayers filing jointly, and– $207,500 for all other taxpayers• Within the phase-in ranges, the limitations are each applied by comparing the amount of taxable income that exceeds the threshold amount to the appropriate phase-in range–Phase-in ranges are $100,000 for married taxpayers filing jointly; $50,000 for all other taxpayers
143
THE DEDUCTION FOR QBI – Limitations on the QBI Deduction(slide 4 of 11)
Limitation Based on Wages & Capital Investment• Limits the 20% QBI deduction to the greater of:–50% of the “W−2 wages” paid by the QTB, or–25% of the “W−2 wages” paid by the QTB plus 2.5% of the taxpayer’s share of the unadjusted basis of “qualifying property”• Phased in as a taxpayer’s income exceeds the taxable income thresholds
144
THE DEDUCTION FOR QBI – Limitations on the QBI Deduction(slide 5 of 11)
THE DEDUCTION FOR QBI – Limitations on the QBI Deduction(slide 5 of 11)Limitation Based on Wages & Capital Investment•“W−2 wages” includes – Total amount of wages subject to income tax withholding,– Compensation paid into qualified retirement accounts, and – Certain other forms of deferred compensation
145
THE DEDUCTION FOR QBI – Limitations on the QBI Deduction(slide 6 of 11)
W−2 Wages/Capital Investment Limit• Qualified property includes depreciable tangible property—real or personal—that is used by the QTB during the year and whose “depreciable period” has not ended before the end of the taxable year– Land and intangible assets are not qualified property
146
THE DEDUCTION FOR QBI – Limitations on the QBI Deduction(slide 7 of 11)
THE DEDUCTION FOR QBI – Limitations on the QBI Deduction(slide 7 of 11)Phase-In of Wages/Capital Investment Limit• If taxable income before the QBI deduction is–Less thanthe threshold amounts• This limit does not apply –More thanthe threshold amounts• The W–2 Wages/Capital Investment Limit must be used
147
THE DEDUCTION FOR QBI – Limitations on the QBI Deduction(slide 8 of 11)
Phase-In of Wages/Capital Investment Limit• If taxable income before the QBI deduction is– Between these two amounts and the W–2 Wages/Capital Investment portion of the QBI deduction is capping the deduction, then the general 20% QBI amount is used, but reduced as follows:– 1. Determine difference between the general 20% QBI deduction amount and the W–2 Wages/Capital Investment amount
148
THE DEDUCTION FOR QBI – Limitations on the QBI Deduction(slide 9 of 11)
Phase-In of Wages/Capital Investment Limit– 2. Determine the Reduction Ratio– 3. Determine the Reduction in the W–2 Wages/Capital Investment Limit:• Reduction = Difference [from (1)] X Reduction ratio [from (2)]– 4. Determine QBI amount:• 20% QBI deduction - Reduction [from (3)]
149
THE DEDUCTION FOR QBI – Limitations on the QBI Deduction(slide 10 of 11)
Limitation for “Specified Services” Businesses•For high-income taxpayers, § 199A excludes any “specified service trade or business” from the definition of a qualified trade or business including those involving:–Health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, and brokerage services; investing and investment management, trading or dealing in securities, partnership interests, or commodities; and–Any trade or business where the business’s principal asset is the reputation of one or more of its employees or owners•Architects and engineers are specifically excluded from this definition
150
THE DEDUCTION FOR QBI – Limitations on the QBI Deduction(slide 11 of 11)
Phase-In of the Specified Services Limit• In computing the qualified business income with respect to a “specified services” business, the taxpayer takes into account only the “applicable percentage” of QBI and the components of the W–2 Wages/Capital Investment Limit
151
THE DEDUCTION FOR QBI – Treatment of Losses
• If a taxpayer has a qualified business loss in one year, no QBI deduction is allowed– The loss is carried over to the next year to reduce QBI (but not below zero)– Further, the statute indicates that if a taxpayer has more than one QTB and the net results of all businesses create a loss, the net loss is carried forward to the following year
152
THE DEDUCTION FOR QBI – Coordination with Other Rules
• The QBI deduction is allowed only for income taxes– As a result, the QBI deduction does not reduce the tax bases for self-employment taxes or the net investment income tax (NIIT)• Also, in computing an individual’s alternative minimum taxable income (AMTI)– Qualified business income is not changed by any of the AMT’s preferences or adjustments (like depreciation), that usually apply in determining AMTI
153
Accounting Periods(slide 1 of 3)
• Taxable year– The tax year may be shorter but is usually not longer than 12 months– Taxpayer elects a tax year by the timely filing of the initial return– Permission to change taxable years must be obtained from the IRS
154
Accounting Periods(slide 2 of 3)
• Types of taxable years– Calendar year: January 1 – December 31– Fiscal year: must start on the first day of a month and end the last day of a month, other than December, 12 months later• Example: July 1 – June 30
155
Accounting Periods(slide 3 of 3)
• Types of taxable years– 52/53 week year: ends on same day of week that is either closest to its normal monthly year-end or occurs last in its year• Example: year-end is always the last Saturday in April
156
Accounting Periods—Partnerships
• Tax year-end must be that of (in descending order)– Majority interest partners• Own a > 50% interest in partnership capital & profits– Principal partners• Partner with a 5% or more interest in partnership capital or profits– Least aggregate deferral of income
157
6Accounting Periods—S Corps and PSCs
• Generally, these entities must have a calendar year– Other tax years may be available if certain requirements can be met
158
Accounting Periods—Other Allowable Year-Ends
• Partnerships, S corps, and PSCs can elect to have other fiscal year-ends if any of the following are met:– A valid business purpose can be shown– § 444 election is made and year-end results in no more than a 3-month deferral• Requires certain payments– § 444 election was made to retain the same year as was used for the fiscal year ending in 1987• Requires certain payments
159
Accounting Periods—Valid Business Purpose
• IRS acknowledges only one valid business purpose for using a fiscal year-end– Conforming the tax year to the entity’s natural business year (seasonal businesses)• Example: a September 30 year-end may be a natural business year-end for a swim suit manufacturer
160
Accounting Periods—§444 Deferral and Required Tax Payments
• Partnerships and S corporations (not their owners) must make tax payments at the highest individual rate plus 1% (37% + 1% = 38%) on estimated deferral period income– The amount due is reduced by the amount of required tax payments for the previous year
161
Accounting Periods—§444 Deferral and Required Salary Payments
• PSCs must pay shareholder-employees salaries during the deferral period that are at least proportionate to their salaries for the preceding fiscal year– Failure to make required salary payments reduces PSCs deduction for salaries paid to shareholder-employees
162
Example of § 444 Deferral and Required Salary Payments
• PSC has October 31 year-end and cannot satisfy the business purpose test for a fiscal year– Provides 2 month deferral– Has one shareholder-employee with $60,000 in salary for prior fiscal year – PSC should pay shareholder-employee at least $10,000 in salary during the deferral period• $60,000 × 2/12 = $10,000
163
Change in Accounting Period
• Must obtain IRS consent before changing tax year• IRS will not consent to a change unless taxpayer demonstrates a substantial business purpose for change, such as changing to natural business year
164
13Change in Accounting Period—Natural Business Year
• Objective test: At least 25% of entity’s gross receipts are realized in the final 2 months of the desired tax year for 3 consecutive years• IRS usually establishes certain conditions that the taxpayer must accept if approval for change is to be granted–In particular, if the taxpayer has a capital loss for the short period, the IRS may require that the loss be carried forward• The loss cannot be carried back to prior years
165
Accounting Periods—Short Taxable Year
•A short taxable year is a period of less than 12 calendar months–Can occur in the first taxable year, the last taxable year, or when there is a change in the taxable year•Under prior law, if a short-period year was caused by a change in taxable year, the short-year income had to be annualized–Necessary due to the progressive tax rate structure•The TCJA of 2017 converted the corporate tax rate structure from a progressive one to a flat one–Thus, annualization is not required in calculating the Federal tax liability of a C corporation
166
Mitigation of the Annual Accounting Period Concept (slide 1 of 2
• Several Code provisions provide relief from harsh results produced by the combined effects of an arbitrary accounting period & a progressive rate structure, for example– NOL carryover rules• A loss in one year can be carried forward indefinitely– Special relief is provided for casualty losses pursuant to a disaster and for reporting insurance proceeds from destruction of crops
167
Mitigation of the Annual Accounting Period Concept (slide 2 of 2)
• Farmers and fishermen – Often subject to wide fluctuations in income• Allowed to use an averaging system that helps avoid higher marginal tax rates associated with a large amount of income received in one year• Crop insurance proceeds may be received in a year before the income from the crop would have been realized– Allowed to defer reporting the income until the year following the disaster• Section 451(e) provides similar relief when livestock must be sold on account of drought or other weather-related conditions
168
Distributions by a corporation to its shareholders are presumed to be a dividend unless the parties can prove otherwise. True/False
True
169
A distribution from a corporation will be taxable to the recipient shareholders only to the extent of the corporation's E&P. True/False
False - a distribution is taxed as a dividend to the extent E&P. Distributions in excess of E&P are tax-free recoveries of capital to the extent of stock basis. Distributions in excess of stock basis trigger taxable gain (usually capital gain).
170
A distribution in excess of E&P is treated as capital gain by shareholders. True/False
False - Distributions in excess of both current and accumulated E&P are treated as a tax-free recovery of capital to the extent of stock basis. Distributions in excess of basis trigger capital gain.
171
The terms "earnings and profits" and "retained earnings" are identical in meaning.
True
False
False - The notion of "earnings and profits" is similar in many respects to the accounting concept of "retained earnings". Both are measures of the firm's accumulated capital. A different exists, however, in the way these figures are calculated. The computation of retained earnings is based on financial accounting rules while E&P is determined using rules specified in the tax laws.
172
Dividends paid to shareholders who hold both long and short positions do not qualify for the reduced tax rate available to individuals in certain years. True/False
True
173
Dividends taxed as ordinary income are considered investment income for purposes of the investment interest expense limitation. True/False
True
174
The rules used to determine the taxability of stock dividends also apply to distributions of stock rights. True/False
True
175
Puffin Corporation's 2,000 shares outstanding are owned as follows: Paul, 800 shares; Sandra (Paul's sister), 800 shares; and Greta (Paul's granddaughter), 400 shares. During the current year, Puffin (E & P of $1 million) redeemed 600 shares of Paul's stock for $100,000. If Paul had acquired the 600 shares five years ago for $30,000, he will have a long-term capital gain of $70,000 from the redemption.
True
176
Tern Corporation, a cash basis taxpayer, has taxable income of $500,000 for the current year. Tern elected $25,000 of § 179 expense. It also had a related party loss of $20,000 and a realized (not recognized) gain from an involuntary conversion of $75,000. It paid Federal income tax of $150,000 and paid a nondeductible fine of $10,000. Tern's current E&P is:
```
$340,000
500,000 - 150,000 = 350,000
350,000 - 20,000 = 330,000
330,000 - 10,000 = 320,000
320,000 + (25,000 * .80) = 340,000
```
177
57. Hannah, Greta, and Winston own the stock in Redpoll Corporation (E & P of $900,000) as follows: Hannah, 600 shares; Greta, 400 shares; and Winston, 1,000 shares. Greta is Hannah's daughter, and Winston is Hannah's brother. Redpoll Corporation redeems 400 of Hannah's shares (basis of $55,000) for $240,000. Hannah purchased the stock three years ago as an investment. With respect to the stock redemption, Hannah has:
a. Long-term capital gain of $185,000.
b. Long-term capital gain of $240,000.
c. Dividend income of $185,000.
d. Dividend income of $240,000.
e. None of the above.
ANSWER: a
RATIONALE: The redemption meets both tests of § 302(b)(2) and qualifies for sale or exchange treatment. Before and after the redemption, Hannah is deemed to own the shares owned by Greta, her daughter, but none of the shares owned by Winston. (The family attribution rules do not include siblings.) Thus, before the redemption, Hannah has a 50% interest in Redpoll [(600 shares directly plus 400 shares indirectly from Greta) ÷ 2,000 shares outstanding]. After the redemption, Hannah owns 37.5% of the stock in Redpoll Corporation [600 shares (200 directly plus 400 indirectly from Greta) ÷ 1,600 postredemption shares outstanding]. The 37.5% ownership interest is less than 50% of the total voting power and less than 80% of Hannah's original ownership [37.5% < 40% (80% × 50%)]. Thus, the distribution is a disproportionate redemption and Hannah has a longterm capital gain of $185,000 [$240,000 (amount realized) - $55,000 (stock basis)].
178
Navy Corporation has E & P of $240,000. It distributes land with a fair market value of $70,000 (adjusted basis of $25,000) to its sole shareholder, Troy. The land is subject to a liability of $55,000 that Troy assumes. Troy has:
a. A taxable dividend of $15,000.
b. A taxable dividend of $25,000.
c. A taxable dividend of $45,000.
d. A taxable dividend of $70,000.
e. A basis in the machinery of $55,000.
a
179
Kite Corporation has 1,000 shares of stock outstanding. Kent owns 300 shares, Kent's father owns 200 shares, Kent's daughter owns 100 shares, Kent's aunt owns 200 shares. Plover Corporation owns the other 200 shares in Kite Corporation. Kent owns 75% of the stockin Plover Corporation. Applying the Sec. 318 stock attribution rules, how many shares dows Kent own in Kite Corporation?
500 shares
600 shares
750 shares
950 shares
None of the above.
750 Shares
180
Taxable Dividends
• Distributions from corporate earnings and profits (E & P)– Treated as a dividend distribution• Taxed as ordinary income or as preferentially taxed dividend income• Distributions in excess of E & P– Nontaxable to extent of shareholder’s basis (i.e., a return of capital)• Excess distribution over basis is capital gain
181
Earnings & Profits
• No definition of E & P in Code• Similar to Retained Earnings (financial reporting), but often not the same• E & P represents:– Upper limit on amount of dividend income recognized on corporate distributions– Corporation's economic ability to pay dividend without impairing capital
182
Calculating Earnings & Profits(slide 1 of 4
• Calculation generally begins with taxable income, plus or minus certain adjustments – Add previously excluded income items and certain deductions to taxable income including:• Municipal bond interest• Excluded life insurance proceeds (in excess of cash surrender value)• Federal income tax refunds• Dividends received deduction
183
Calculating Earnings & Profits(slide 2 of 4)
• Calculation generally begins with taxable income, plus or minus certain adjustments (continued)– Subtract certain nondeductible items:• Nondeductible portion of meals• Entertainment expenses• Related-party losses• Expenses incurred to produce tax-exempt income• Federal income taxes paid• Key employee life insurance premiums (net of increase in cash surrender value)• Fines, penalties, and lobbying expenses
184
Calculating Earnings & Profits(slide 3 of 4)
Calculating Earnings & Profits(slide 3 of 4)•Certain E & P adjustments shift effect of transaction from the year of inclusion in or deduction from taxable income to year of economic effect, such as:–Charitable contribution carryovers –NOL carryovers –Capital loss carryovers•Gains and losses from property transactions –Generally affect E & P only to extent recognized for tax purposes–Thus, gains and losses deferred under the like-kind exchange provision and deferred involuntary conversion gains do not affect E & P until recognized
185
Calculating Earnings & Profits(slide 4 of 4)
• Other adjustments– Accounting methods for E & P are generally more conservative than for taxable income, for example:• Installment method is not permitted• Alternative depreciation system required– Also, ADS prohibits additional first-year depreciation• § 179 expense must be deducted over 5 years• Percentage of completion must be used (no completed contract method)• Others
186
Calculating Earnings & Profits(slide 4 of 4)
• Other adjustments– Accounting methods for E & P are generally more conservative than for taxable income, for example:• Installment method is not permitted• Alternative depreciation system required– Also, ADS prohibits additional first-year depreciation• § 179 expense must be deducted over 5 years• Percentage of completion must be used (no completed contract method)• Others
187
Current vs Accumulated E & P(slide 1 of 3)
• Current E & P– Taxable income as adjusted
188
Current vs. Accumulated E & P(slide 2 of 3)
• Accumulated E & P– Total of all prior years’ current E & P (since February 28, 1913) reduced by distributions from E & P
189
Current vs. Accumulated E & P(slide 3 of 3
• Distinguishing between current and accumulated E & P is important – Taxability of corporate distributions depends on how current and accumulated E & P are allocated to each distribution made during year
190
Allocating E & P to Distributions (slide 1 of 4)
• If positive balance in both current and accumulated E & P– Distributions are deemed made first from current E & P, then accumulated E & P– If distributions exceed current E & P, must allocate current and accumulated E & P to each distribution• Allocate current E & P pro rata (using dollar amounts) to each distribution• Apply accumulated E & P in chronological order
191
Allocating E & P to Distributions (slide 2 of 4)
• When the tax years of the corporation and its shareholders are not the same– May be impossible to determine the amount of current E & P on a timely basis– Allocation rules presume that current E & P is sufficient to cover every distribution made during the year until the parties can show otherwise
