Assets, Income and Cash

Publication Date: February 2017

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Assets, Income & Cash

By

Danny C. Santucci

The author is not engaged by this text or any accompanying lecture or electronic media in the ren-dering of legal, tax, accounting, or similar professional services. While the legal, tax, and accounting issues discussed in this material have been reviewed with sources believed to be reliable, concepts discussed can be affected by changes in the law or in the interpretation of such laws since this text was printed. For that reason, the accuracy and completeness of this information and the author's opinions based thereon cannot be guaranteed. In addition, state or local tax laws and procedural rules may have a material impact on the general discussion. As a result, the strategies suggested may not be suitable for every individual. Before taking any action, all references and citations should be checked and updated accordingly.

This publication is designed to provide accurate and authoritative information in regard to the sub-ject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert advice is required, the services of a competent professional person should be sought.

—-From a Declaration of Principles jointly adopted by a committee of the American Bar Association and a Committee of Publishers and Associations.

Copyright 2017

Danny Santucci

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Table of Contents

Financial Tax Planning ............................................................................... 1 Comparing Goals & Purposes .................................................................................................................... 1

Investment Purposes ........................................................................................................................... 1 Purpose #1 - Comfortable Retirement.......................................................................................... 1

Myths of Retirement ............................................................................................................... 1 Plan For 10 to 15 Retirement Years .................................................................................... 1 Stay With One Company to Retire With the Best Benefits ................................................. 1 Preserve Capital .................................................................................................................. 1 Retirees Are Taxed Less ...................................................................................................... 1 Housing Costs Are Less ....................................................................................................... 3 Just the Spouse and Me ...................................................................................................... 3 Company Insurance & Medicare Will Cover Medical Bills .................................................. 3 Retirees End Up In a Nursing Home .................................................................................... 3

Purpose #2 - Education ................................................................................................................. 3 Purpose #3 - Family & Personal Stability ...................................................................................... 3 Purpose #4 - Enjoyment of Life ..................................................................................................... 3 Purpose #5 - Commitment ............................................................................................................ 3

Investment Goals ....................................................................................................................................... 3 “Know Thy Investment Self” ...................................................................................................................... 4

Investment Vehicles & Entities ............................................................................................................ 4 Retirement Now - The Ultimate Objective ................................................................................................ 4

Defining Retirement ............................................................................................................................. 4 Determining Retirement Costs & Income Needs ................................................................................. 5

Basic Planning Elements ............................................................................................................................ 5

Building an Estate ...................................................................................... 5 Assets, Income & Cash ............................................................................................................................... 5

Income ................................................................................................................................................. 6 Type #1 - Taxable .......................................................................................................................... 6 Type #2 - Tax-free ......................................................................................................................... 6 Type #3 - Tax-Deferred ................................................................................................................. 6 Type #4 - Tax-sheltered ................................................................................................................ 6

Budgeting ............................................................................................................................................. 6 Cash ...................................................................................................................................................... 7 Acquisition ........................................................................................................................................... 7 Assets ................................................................................................................................................... 7 Management ........................................................................................................................................ 8

Deferral ..................................................................................................... 9 Section 1031 “Like Kind” Exchanges .......................................................................................................... 9

Three Elements .................................................................................................................................... 9 Exchange Requirement ................................................................................................................. 9 Qualified Property Requirement .................................................................................................. 10 Like-Kind Requirement ................................................................................................................. 10

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Related Party Exchanges ...................................................................................................................... 10 Retirement Plans ....................................................................................................................................... 10

Sources of Retirement Income ............................................................................................................ 10 Qualified Corporate Programs ...................................................................................................... 10

Defined Contribution Plans ..................................................................................................... 11 Defined Benefit ....................................................................................................................... 11

SIMPLE Plans ................................................................................................................................. 11 Self-employed Plans ..................................................................................................................... 11 Individual Retirement Accounts ................................................................................................... 11

Roth IRA - §408A ..................................................................................................................... 12 Penalty-Free Withdrawals ....................................................................................................... 12

Tax-deferred Annuities ................................................................................................................. 12 Simplified Employee Pension (SEP) Plan ....................................................................................... 12 Participant Loan Regulations ........................................................................................................ 12

Additional Loan Requirements................................................................................................ 13 Installment Sales - §453 ............................................................................................................................. 13

Requirements ....................................................................................................................................... 13 Formula ................................................................................................................................................ 13

Deferred Compensation ............................................................................................................................ 14 Options - §1234 ......................................................................................................................................... 14

Reduction .................................................................................................. 15 Tax Credits ................................................................................................................................................. 15

Earned Income Tax Credit - §32 ........................................................................................................... 15 Child Tax Credit - §24 ........................................................................................................................... 15 Child and Dependent Care Credit - §21 ............................................................................................... 15 Adoption Credit - §23 ........................................................................................................................... 15 Credit for the Elderly and Disabled - §22 ............................................................................................. 15 Education (American Opportunity) Credits - §25A .............................................................................. 15 Retirement Savings Contribution Credit – §25B .................................................................................. 16 Work Opportunity Tax Credit (WOTC) – §51 ....................................................................................... 16

Targeted Groups ........................................................................................................................... 16 Credit Amount .............................................................................................................................. 16

Research & Development Credit - §41 ................................................................................................ 17 Rehabilitation Tax Credit - §47............................................................................................................. 17 Low Income Housing Credit - §42 ........................................................................................................ 18

Estimated Taxes - §6654 ............................................................................................................................ 18 General Rule ........................................................................................................................................ 18

Basic Deductions ........................................................................................................................................ 19 Interest - §163 ...................................................................................................................................... 19

Investment Interest ...................................................................................................................... 19 Prepaid Interest ............................................................................................................................ 19 Points ............................................................................................................................................ 19 Prepayment Penalty ..................................................................................................................... 19 Interest on Real Estate - §164 ....................................................................................................... 19

Rental Property ....................................................................................................................... 19 Home Owners ......................................................................................................................... 20

Automobile Deductions ....................................................................................................................... 20 Employee Automobile Deductions ............................................................................................... 20 Business/Personal Proration ......................................................................................................... 20 Actual Cost Method ...................................................................................................................... 20 Standard Mileage Rate ................................................................................................................. 21

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Depreciation (“Caps”) Limits - §280F(a) ....................................................................................... 21 Leasing Restrictions ................................................................................................................. 21 Expensing - §179 ..................................................................................................................... 21

Commuting - Local Business Transportation ....................................................................................... 22 Revenue Rulings 90-23 & 99-7 ...................................................................................................... 22

Business Entertainment ....................................................................................................................... 22 Directly Related Test ..................................................................................................................... 22 Associated Test ............................................................................................................................. 22 Statutory Exceptions ..................................................................................................................... 22

Food and Beverages for Employees ........................................................................................ 23 Expenses Treated as Compensation ....................................................................................... 23 Reimbursed Expenses ............................................................................................................. 23 Recreational Expenses for Employees .................................................................................... 23 Employee, Stockholder and Business Meetings ...................................................................... 23 Trade Association Meetings .................................................................................................... 23 Items Available to Public ......................................................................................................... 23 Entertainment Sold to Customers ........................................................................................... 23 Expenses Includible in Income of Non-employees.................................................................. 24

Depreciation & Cost Recovery - §167 & §168 ...................................................................................... 24 Net Operating Losses - §172 ................................................................................................................ 24

Income Splitting ......................................................................................... 26 Using Progressive Tax Rates ...................................................................................................................... 26

Major Formats ..................................................................................................................................... 26 Unincorporated Business ........................................................................................................................... 27

Deductible Business Expenses - §162 .................................................................................................. 27 Home-Office Write-Off - §280A ........................................................................................................... 27 Hiring Your Children ............................................................................................................................. 27 Hiring Your Spouse ............................................................................................................................... 27 Travel Expenses .................................................................................................................................... 27 Casualty Losses - §165 ......................................................................................................................... 27 Bad Debts - §166 .................................................................................................................................. 28 Self-employment Tax (SECA) ................................................................................................................ 28

“C” or Regular Corporation ........................................................................................................................ 28 Formation - §351 ................................................................................................................................. 28

Cash for Stock ............................................................................................................................... 28 Property for Stock ......................................................................................................................... 28 Stock for Services .......................................................................................................................... 29 Stock for Debt ............................................................................................................................... 29

Repeal of the “General Utilities” Doctrine ........................................................................................... 29 “S” Corporation ......................................................................................................................................... 29

Single Taxation ..................................................................................................................................... 30 Tax Advantages .................................................................................................................................... 30 Corporations That Qualify .................................................................................................................... 30 Income-splitting ................................................................................................................................... 31

Family Partnership - §704(e) ..................................................................................................................... 31 Family Members .................................................................................................................................. 31

Children ..................................................................................................................................................... 32 Custodianship ...................................................................................................................................... 32 Employer Dependent Care Program - §129 ......................................................................................... 32 Education Savings Bonds - §135 .......................................................................................................... 32 Education Loans - §221 ........................................................................................................................ 32

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Gifts ........................................................................................................................................................... 33 Interest Free Loans - §7872 ................................................................................................................. 33

Elimination ................................................................................................ 34 $500,000 Home Sale Exclusion - §121 ....................................................................................................... 34

Two Year Ownership & Use Requirements .......................................................................................... 34 Tacking of Prior Holding Period ........................................................................................................... 34 Prorata Exception ................................................................................................................................ 34

Municipal Bonds - §103 ............................................................................................................................. 35 Tax-exempt Interest on Qualified State or Local Obligations .............................................................. 35

Reporting ...................................................................................................................................... 35 Divorce & Separation Settlements ............................................................................................................ 35

Alimony - §71 ....................................................................................................................................... 35 Child Support ....................................................................................................................................... 35 Property Division - §1041..................................................................................................................... 36 Dependency Exemption. ...................................................................................................................... 36

Gifts & Inheritances ................................................................................................................................... 36 Income from Property Given to a Child ............................................................................................... 36

Life Insurance............................................................................................................................................. 36 Fringe Benefits ........................................................................................................................................... 36

Prizes & Awards - §74(b) ...................................................................................................................... 37 Group Life Insurance Premiums - §79 .................................................................................................. 37 Accident and Health Plans - §106 & §105 ............................................................................................ 37 Meals & Lodging - §119 ....................................................................................................................... 37 Cafeteria Plans - §125 .......................................................................................................................... 37 Educational Assistance Program - §127 ............................................................................................... 37 Dependent Care Assistance - §129 ...................................................................................................... 37 Section 132 .......................................................................................................................................... 38

Social Security ............................................................................................................................................ 38 Earnings Record ................................................................................................................................... 38

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Learning Objectives

After reading the materials, participants will be able to:

1. Identify investment purposes and retirement misconceptions, the multi-step retirement process and the elements of investment planning.

2. Determine income types, from a tax perspective, to be budgeted into cash so that in-come-producing assets can be acquired and managed for an effective investment plan.

3. Recognize the means of achieving tax deferral noting like-kind exchanges, retirement plans and installment sales, and specify the double financial benefit of exchanging through tax postponement and possible tax elimination.

4. Determine how to use tax credits, estimated taxes, and basic deductions to effectively reduce federal income tax and thereby increase discretionary income for investment pur-poses.

5. Specify formats for income splitting that can benefit taxpayers by lowering overall taxes as a unit and permitting wealth and tax allocation among individuals or entities.

6. Identify the tax benefits of the $500,000 home sale exclusion, municipal bonds, divorce and separation settlements, gifts and inheritances, life insurance, fringe benefits, and So-cial Security to eliminate tax on realized gain and ordinary income.

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Financial Tax Planning

Comparing Goals & Purposes

Goals and purposes are different. Goals are often immediate and of short duration compared to purposes and values which are long term.

Investment Purposes

In carrying out an investment program the following purposes are suggested:

Purpose #1 - Comfortable Retirement

Retirement planning is a major element of any financial plan. In essence, retirement planning is the process of determining the amount of funds needed at retirement.

Myths of Retirement

Retirement has more than its share of falsehoods. Here are some misconceptions to avoid:

Plan For 10 to 15 Retirement Years

While the average life span is approaching 80 years and most people retire by age 62, this average counts the entire population, including the 21% who die before age 65. At age 62, your life expectancy is well past the average. Planning for 25 years of retirement is far more realistic.

Stay With One Company to Retire With the Best Benefits

Fixed pensions usually offer a retirement benefit of no more than 50% of the highest salary attained before retiring. If changing employers can increase your salary, you will also in-crease retirement benefits.

Preserve Capital

Preserve buying power not capital.

Retirees Are Taxed Less

Even while retirement income may put you in a lower bracket, don’t assume less will go to taxes.

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Retirement Myths

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Plan For 10 To 15 Retirement Years

Stay With One Company

Never Touch Your Principal

Retirees Are Taxed Less

Housing Costs Are less

Just The Spouse & Me

Retirees End Up In Nursing Homes

Medicare Will Cover Medical Bills

Switch All Assets To Income-Producing

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Housing Costs Are Less

Even if you pay off your mortgage by the time you retire, the real costs will be property taxes and maintenance, which continue to rise.

Just the Spouse and Me

Like swallows to Capistrano, children often return to the nest, or if elderly parents need care, you could find yourself retired in a full house.

Company Insurance & Medicare Will Cover Medical Bills

Medicare pays on average less than half of health care bills. Moreover, you usually can’t collect until age 65 under Medicare, even if you retire sooner.

Retirees End Up In a Nursing Home

The odds of long term commitment to a nursing home are small - about 8% for women, 5% for men.

Purpose #2 - Education

Education is an extraordinary investment. However, credentialed education must be balanced with practical knowledge of how to make a living and plan for financial security.

Purpose #3 - Family & Personal Stability

Personal and family stability are the most precious of “assets.” A key ingredient to balanced living is the proper connection between people and things.

Purpose #4 - Enjoyment of Life

Financial planning gives peace of mind and security to your economic activities. This harmony applies not only to future events, but also to current transactions. Being well planned permits enjoyment of present purchases without the worry of jeopardizing your retirement.

Purpose #5 - Commitment

Financial planning demands commitment and work - i.e., determination plus objectives. Deter-mination means the desire to make financial planning an integral part of your life - from now until death.

Investment Goals

Goals are essentially financial targets. They are in terms of either money or action, i.e., specific uses to which your dollars or energy can be put. However, the achievement of goals means decisions and tradeoffs, since one cannot realize an infinite number of goals. To seek one alternative means to forego another. As a result, you must:

(1) Select realistic goals,

(2) Define them precisely,

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(3) Write them down,

(4) Assign priorities, and

(5) Allocate resources.

“Know Thy Investment Self”

Before launching ourselves off into a personal financial program, it’s important to know who owns what and exactly for whom we are planning. This requires that methods of holding title must be analyzed, considered, and selected. How you invest is just as important as what you invest in.

Investment Vehicles & Entities

There are nine basic “persons” for which planning can be done. These “persons” also represent the basic ways to hold title to assets. We will be drawing on this list of players from time to time:

(1) Individual,

(2) Corporate,

(3) Trust,

(4) Co-tenancy,

(5) Partnership,

(6) Limited liability company,

(7) Retirement plan,

(8) Custodianship under UGMA or UTMA, and

(9) Estate.

Retirement Now - The Ultimate Objective

Everyone must design their own retirement map to suit their personality and lifestyle. However, pre-paring for retirement is a step-by-step process and should be guided by certain principles and prior-ities. The major steps in that process are:

(1) Gathering needed background information regarding the basic elements of retirement such as income, financial resources, health, housing, and lifestyle;

(2) Talking things over with friends (particularly those who are retired) and professionals;

(3) Setting definite but realistic goals;

(4) Putting the map or plan in writing along with a list of needed actions and deadlines; and

(5) Reviewing and updating the plan annually.

Defining Retirement

There are three major levels of retirement and any plan must interrelate them:

(1) Active,

(2) Sedentary, and

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(3) Terminal.

Despite these various levels, one’s initial retirement is principally defined by three key questions:

(1) When do I want to retire?

(2) What kind of lifestyle do I want after retirement?

(3) Do I want to move when I retire?

The answers to these three questions have financial and human ramifications that bounce off each other.

Determining Retirement Costs & Income Needs

Once you have defined (envisioned?) your retirement lifestyle and goals, you must determine if you have the financial resources to attain them.

A recent comprehensive study by Georgia State University estimates that you will need 75% to 80% of your current income to live comfortably in retirement. The study took into account differences in spending between workers and retirees and figured in the cost of taxing Social Security benefits.

Basic Planning Elements

Investment planning is composed of three basic elements:

1. BUILDING AN ESTATE & CREATING WEALTH. Before you learn how to shelter or distribute money you obviously need to know how to make it;

2. PRESERVING WEALTH. Once you have a little money, the next move is to discover how to keep it; and

3. DISTRIBUTING WEALTH TO HEIRS. Providing for the smooth, thoughtful, and tax-free transfer of your assets to your family and heirs completes the plan.

All information you acquire regarding money, taxes, and finances can be categorized under these three elements. They are an excellent learning matrix to organize financial knowledge. Whenever you learn a planning technique, it can be mentally “filed” under one of these elements.

Building an Estate

Assets, Income & Cash

Understanding wealth requires mastering three basic elements - assets, income, and cash. Income must be budgeted into cash. Cash must be used to acquire assets. Assets must be managed to pro-duce more income. And the cycle starts again.

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Income

All income is not the same! There are various types of income and each has different financial char-acteristics. The four basic types of income are:

Type #1 - Taxable

Taxable income is wages, salary, commissions, rents, interest, dividends, and royalties. Taxable earned income is difficult to protect.

Type #2 - Tax-free

Tax-free municipal bonds are the most popularly thought of example of tax-free income. How-ever, the return on such bonds is already discounted by the issuer to reflect their tax-free nature. Fringe benefits are a better type of tax-free income.

Type #3 - Tax-Deferred

Tax deferral has two benefits. First, deferral is the equivalent of an “interest free” loan from the government. Second, when taxes are deferred for even a few years, it is possible to earn enough on the postponed taxes to perhaps pay the original tax.

Type #4 - Tax-sheltered

There are many kinds of income that are not taxable. Types of income that you don’t pay federal income tax on:

(1) Gifts,

(2) Borrowed money,

(3) Gain on home sales,

(4) IRA rollovers,

(5) Inheritances,

(6) Life insurance proceeds,

(7) Property settlements,

(8) Child support payments,

(9) Money recovered for personal injuries,

(10) Workers compensation payments,

(11) Certain disability payments,

(12) Tax refunds,

(13) Municipal bond interest,

(14) Vacation home rental,

(15) A portion of children’s wages,

(16) A portion of children’s investment income, and

(17) Scholarships.

Budgeting

There are five basic budget rules:

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1. Control your expenses so they do not exceed 60% of your gross income.

2. Keep income taxes at 20% or less of your gross income.

3. Save 10% of your gross income.

4. Spend 10% of your income on continuing practical education that motivates you to act (i.e., take risk) and teaches you financial principles.

5. 50% of any benefit or “found” money (e.g., inheritances, tax refunds, gifts, salary raises, etc.) goes to savings and the other 50% can be “blown” on lifestyle without any feeling of guilt.

Cash

The result of budgeting is net cash or what is often called “discretionary income.” Discretionary in-come can be used four ways:

(1) Spent on a higher lifestyle;

(2) Put aside as emergency funds;

(3) Saved; or

(4) Used to acquire assets.

Acquisition

Few individuals have any idea of how to approach the purchase of investment assets. There are six basic guidelines to be applied when buying assets:

(1) Stay liquid - be able to get your money back,

(2) Grow - make money on your money,

(3) Shelter - get tax benefits,

(4) Build - don’t spend your benefits,

(5) Avoid linking - each investment must stand on its own, and

(6) Analyze - investigate the investment.

Assets

Cash should be used to acquire assets! Assets should then work for you. An effective strategy would be to consider only the major tax advantaged investments - the ones that pop up 90% of the time. Such a group is:

(1) You, your job, and career,

(2) Real estate,

(3) Business opportunities,

(4) Money market funds,

(5) Personal property and equipment,

(6) Oil & gas,

(7) Stocks & bonds, and

(8) “Wild & woollies”- gold, coins, & stamps.

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Management

Assets must be managed to produce income. Since you are your best asset, this includes manage-ment of yourself. The six basic management rules are:

(1) Develop cash flow,

(2) Learn to negotiate,

(3) Manage risk,

(4) Diversify,

(5) Monitor assets, and

(6) Use systems.

Review Questions

Under NASBA-AICPA self study standards, self study sponsors are required to present review ques-tions intermittently throughout each self-study course. The following questions are designed to meet those requirements and increase the benefit of the materials. However, they do not have to be com-pleted to receive any credit you may be seeking with regards to the text. Nevertheless, they may help you to prepare for any final exam.

Short explanations for both correct and incorrect answers are given after the list of questions. We recommend that you answer each of the following questions and then compare your answers. For more detailed explanations and reference, you may do an electronic search using Ctrl+F (if you are viewing this course on computer), consult the text Index, or review the general Glossary.

1. According to the author, what is a purpose in carrying out an investment program?

a. work.

b. savings.

c. budget.

d. education.

2. What is the first basic element of investment planning?

a. preserve wealth.

b. create wealth.

c. save wealth.

d. distribute wealth.

3. What is included as taxable income?

a. property received as a gift.

b. property received as a bequest.

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c. property received as inheritance.

d. property received as wages or salary.

4. What is a basic rule of budgeting?

a. save 15% of your gross income.

b. put 15% of your gross income toward education.

c. spend no more than 30% of your gross income on expenses.

d. 20% or less of your gross income should be allocated to income taxes.

Deferral

Section 1031 “Like Kind” Exchanges

Exchanging allows the real estate owner to move from one property to another without reducing equity build up by income taxes due on any gain. In fact, careful tax planning can even permit the investor to receive cash before or after the exchange through properly timed refinancing. Thus, a double benefit is possible: tax deferral, plus later cash.

Three Elements

Based upon §1031 of the Internal Revenue Code, exchanging has only three basic requirements:

(1) The properties must actually be exchanged and not sold (exchange requirement);

(2) Both the property exchanged and the property received must be held for productive use in trade or business or for investment (qualified property requirement); and

(3) The properties must be of a “like-kind” with one another (like-kind requirement).

Exchange Requirement

Under §1031, there must be a reciprocal transfer of property, as distinguished from a transfer of property solely for money. In short, there must be a trade and not a sale.

Despite the critical need for a precise definition, neither the Code nor the Regulations contain a description of what is a valid exchange. Instead the taxpayer is referred to caselaw for the nec-essary definition and mechanics.

Over the years, the exchangors have gravitated toward three caselaw formats:

(1) Two-party exchanges,

(2) Multiparty exchanges, and

(3) Delayed exchanges.

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Qualified Property Requirement

Only qualified property can be traded under §1031. There are three basic types of qualified prop-erty:

(1) Property used in your business (other than inventory),

(2) Rental property, and

(3) Investment property.

Like-Kind Requirement

The final requirement of an exchange is that the property given must be like-kind to the property received. The term “like-kind” is the subject of much confusion, but is best understood as a simple distinction between real and personal property. Real estate is like-kind to other real estate. Per-sonal property is like-kind to other personal property. However, real estate is not like-kind to personal property and vice versa.

Related Party Exchanges

If a taxpayer exchanges property with a related party, the original exchange will not qualify for tax deferral if either of the exchanged properties is sold or disposed of within two years of the transfer (§1031(f)).

Retirement Plans

To have enough income to meet one’s retirement needs does require long term planning. The two most popular methods for providing for retirement needs are qualified retirement plans and social security.

Sources of Retirement Income

There are a variety of common sources of retirement income. Each should be checked thoroughly by any investor seriously planning for his retirement. The best planning involves a diversified program using all such sources of income.

Qualified Corporate Programs

Qualified corporate retirement plans divide themselves into two basic categories. The first is de-fined contribution plans. These plans are primarily designed and structured from a standpoint of

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what contribution is to be made to the plan. The company does not bear responsibility for any growth in the plan assets or in any determinable benefit at age retirement.

Defined Contribution Plans

There are several basic types of such plans:

(1) Profit sharing plan,

(2) Money purchase pension plan,

(3) Stock bonus plan,

(4) Employee stock ownership plan, and

(5) 401(k) plan.

Defined Benefit

The second basic type of qualified corporate retirement plan is the defined benefit plan. The two most popular variations of this type of plan are:

(1) Defined benefit pension plan, and

(2) Annuity plan.

SIMPLE Plans

Employers with 100 or less employees earning at least $5,000 and who do not maintain another retirement plan can set up a SIMPLE plan. SIMPLE plans are not subject to many of the compli-cated rules applicable to other retirement plans and can be adopted as an IRA or as part of a §401(k) plan. All employees earning more than $5,000 a year must be eligible to participate. Self-employed individuals may also participate in SIMPLE plans.

Generally, an employer must either:

(1) Match elective employee contributions dollar-for-dollar up to 3% of compensation, or

(2) Make a “nonelective” contribution of 2% of compensation of each eligible employee.

Contributions to a SIMPLE plan are deductible by the employer and not taxable to the employee until withdrawn.

Self-employed Plans

If you operate a business as a sole proprietor or a partner either full time or part time, you could establish a Keogh plan. Such plans can either be defined contribution or defined benefit plans. You can direct investments and even be your own trustee.

There is a limit on the deduction which the self-employed can claim with respect to a contribution on his or her behalf. A maximum of 13.04% of net business income can be deducted if a profit-sharing Keogh plan is established. Contributions to a money purchase pension Keogh are limited to 20% of the net profit (after contribution), but no more than $54,000 (in 2017) can be contrib-uted to the plan for the owner in any one year.

Individual Retirement Accounts

All individuals, employees and the self-employed can annually contribute to an individual retire-ment account. The contribution amount can either be $5,500 (in 2017) or entire earned income,

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whichever is less. However, if you or your spouse is a participant in a company plan, Keogh, SEP or government plan, your ability to set up a deductible IRA is phased out above certain income amounts.

The TRA ‘97 permits deductible contributions for spouses of individuals who are in an employer-sponsored retirement plan. However, the deduction is phased out for taxpayers with AGI be-tween $186,000 and $196,000 in 2017.

Roth IRA - §408A

The TRA ‘97 created a tax-free nondeductible IRA called the “Roth IRA” but it is phased out for individuals with AGI between $118,000 and $133,000 and married couples with AGI be-tween $186,000 and $196,000 in 2017. Distributions from a Roth IRA are tax free if made more than 5 years after a Roth IRA has been established and if the distribution is:

(1) Made after age 59½, death, or disability, or

(2) For first-time home buyer expenses (up to $10,000).

Penalty-Free Withdrawals

The Tax Reform Act of 1986 created a penalty-free way to withdraw money from the account before you reach age 59½. An under 59½ year old IRA owner can withdraw funds from an IRA and avoid a 10% penalty tax by undertaking a series of substantially equal annual withdrawals from the IRA over his life expectancy or over his and his designated beneficiary’s joint life expectancy. Once the taxpayer reaches age 59½ and has withdrawn scheduled annual amounts for at least 5 years, he can modify the amount he withdraws or stop any further withdrawals entirely until reaching age 70½.

Tax-deferred Annuities

Deferred annuities can serve as an attractive alternative for individuals unable to make deducti-ble IRA contributions. Although contributions to a deferred annuity are not tax deductible, earn-ings do accumulate tax deferred.

Note: There is no limit to the amount of money you can invest in an annuity.

Simplified Employee Pension (SEP) Plan

A SEP plan is essentially an IRA set up by an employer for employees. The employer can take a deduction for contributions to a SEP equal to the lesser of 25% of the employee’s earnings or $54,000 (in 2017). Employer contributions are exempt from FICA, FUTA, and current income taxes. The employee also may personally contribute up to $5,500 (in 2017) as a regular IRA con-tribution each year.

Participant Loan Regulations

Normally, a loan from a qualified retirement plan to a participant is a prohibited transaction un-der §4975 unless the following requirements are met:

(1) Loans must be made available to all participants on a reasonably equivalent basis;

(2) Loans must not be made to highly compensated employees in amounts proportionately greater than for other employees;

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(3) A loan must be made in accordance with specific provisions in the plan;

(4) A loan must have a reasonable interest rate; and

(5) A loan must be adequately secured.

If a loan fails to meet these requirements, excise taxes may be assessed.

Note: No loans can be made to owner employees (i.e., partners with a 10% capital or profits interest or 5% or shareholders of S corporations, or members of their families).

Additional Loan Requirements

A plan must also meet the following rules in order to avoid having the participant-borrower income taxed on the loan amount:

(a) A loan must be repaid within 5 years;

Exception: This rule does not apply when the borrowed amount is used for the purchase or rehabilitation of the borrower’s primary residence.

(b) A loan must be paid in level amounts on at least a quarterly basis; and

(c) An employee can borrow the lesser of $50,000 or 50% of their vested benefits.

Exception: Participants with vested benefits of $10,000 or less can borrow the lesser of $10,000 or 100% of their vested benefits.

If these rules are not satisfied, the amount borrowed is treated as a plan distribution subject not only to federal and state tax but a 10% early distribution tax as well.

Installment Sales - §453

An installment sale can permit a taxpayer to pay his taxes on the disposition of property as he re-ceives the payments. This deferral can result in a huge tax savings.

Requirements

The basic requirements of an installment sale are:

(1) There must be a sale of property (as contrasted with services),

(2) The property must not be of a kind which is required to be included in the inventory of the taxpayer if on hand at the close of the taxable year (§453(b)(1)(B)), and

(3) There must be an installment sale.

Note: All that is needed to meet this requirement is that at least one payment will be received in a tax year other than the year of sale (§453(b)(1)).

If the above requirements are met, installment sale treatment is automatic. A special election must be made to report the gain by any other method of accounting. The election must be made by the due date of the income tax return for the year of the sale. The regulations permit a late election only in rare cases when IRS concludes that the taxpayer had good cause for filing a late election.

Formula

The gain reported on an installment sale is computed using the following formula:

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Total Gain

Contract Price X Payments Received = Recognized gain

Historically, losses sustained on an installment sale were fully deductible in the year of sale (R.R. 70-430). This rule has been modified by §469 which now requires installment reporting of certain losses (e.g., suspended losses under the passive loss limitation rules) in an installment sale.

Deferred Compensation

Revenue Ruling 60-31 tells you how to defer compensation from one year to another. Under that ruling there are three basic types of deferred compensation agreements:

TYPE I - A MERE CONTRACTUAL PROMISE TO PAY. This format is a contractual agreement be-tween you and your (perhaps wholly owned) company to pay you compensation in the future for services yet to be performed.

TYPE II - CONTRACT PLUS GUARANTEES. Under this method the company still promises to pay compensation in the future but in addition, the contract can be “backed up” by:

(1) Life insurance,

(2) Third party guarantees, and

(3) You can even direct how the money is invested if funds are set aside in the company’s accounts.

TYPE III - SEGREGATED FUNDS WITH SUBSTANTIAL RESTRICTION. The funds necessary to pay the deferred compensation can be deposited with a third party stakeholder (e.g., an escrow or bank) with instructions to pay the funds in the future. If time were the only restriction, this would result in immediate “constructive receipt” of the money. However, if payment is dependent on continued employment, deferral is accomplished.

Options - §1234

Tax deferral does not have to be complicated. In fact, it can be affected very simply, with the use of an option. Let’s say that you need $2,000, and that you have already incurred large amounts of tax-able income and you are in a high tax bracket. You are afraid the government will take a large portion of that money if you sell. One way to receive the income, without having to pay the tax until subse-quent years, would be to grant an option on one of your properties. The option consideration that you receive would not be taxable until the option was either exercised or expired. You could also put in the agreement that the option could not be exercised for a year or two years, thereby insuring that you would have the tax-free use of the funds, at least until that period of time expired, or the person who had the option exercised it.

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Reduction

Three basic methods to reduce federal income tax are:

(1) Tax credits,

(2) Correct withholding, and

(3) The use of net operating losses.

Tax Credits

Tax credits are not deductible from income. They directly reduce tax. As a result, they are a great way to reduce taxes on a dollar for dollar basis. A credit absorbs its full weight in tax.

Earned Income Tax Credit - §32

This is a refundable credit for low-income working individuals and families. Income and family size determine the amount of the EITC. When the EITC exceeds the amount of taxes owed, it results in a tax refund to those who claim and qualify for the credit.

Child Tax Credit - §24

This credit is for people who have a qualifying child. The maximum amount of the credit is $1,000 for each qualifying child. This credit can be claimed in addition to the credit for child and dependent care expenses.

Child and Dependent Care Credit - §21

This is for expenses paid for the care of children under age 13, or for a disabled spouse or dependent, to enable the taxpayer to work. There is a limit to the amount of qualifying expenses. The credit is a percentage of those qualifying expenses.

Adoption Credit - §23

Adoptive parents can take a tax credit of up to $10,000 (adjusted for inflation) for qualifying expenses paid to adopt an eligible child. The credit may be allowed for the adoption of a child with special needs even if the taxpayer does not have any qualifying expenses.

Credit for the Elderly and Disabled - §22

This credit is available to individuals who are either age 65 or older or are under age 65 and retired on permanent and total disability, and who are citizens or residents. There are income limitations.

Education (American Opportunity) Credits - §25A

There are two credits available, the Hope Credit and the Lifetime Learning Credit, for people who pay higher education costs. The Hope Credit is for the payment of the first two years of tuition and

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related expenses for an eligible student for whom the taxpayer claims an exemption on the tax re-turn. The Lifetime Learning Credit is available for all post-secondary education for an unlimited num-ber of years. A taxpayer cannot claim both credits for the same student in one year. In 2009, the Hope Credit was modified and renamed the “American Opportunity Tax” credit.

Retirement Savings Contribution Credit – §25B

Eligible individuals may be able to claim a credit for a percentage of their qualified retirement savings contributions, such as contributions to a traditional or Roth IRA or salary reduction contributions to a SEP or SIMPLE plan. To be eligible, you must be at least age 18 at the end of the year and not a student or an individual for whom someone else claims a personal exemption. Also, your adjusted gross income (AGI) must be below a certain amount.

Work Opportunity Tax Credit (WOTC) – §51

Section 51 has a history of expanded and contracted coverage together with expiring and reinstated effective dates. As a result of the PATH Act, the provision now provides a work opportunity credit (formerly known as the targeted jobs credit) for employers hiring individuals from one or more of nine targeted groups before January 1, 2020 (§51(c)(4)).

Note: From 1998 thru 2006, taxpayers were allowed a welfare-to-work credit was allowed for 35% of the first-year wages and 50% of the second-year wages paid to long-term family assistance re-cipients. However, due to the similarities, the welfare-to-work credit (former §51A) was incorpo-rated into the work opportunity credit (§51) for recipients beginning work after December 31, 2006 (§51(d)(1)).

Targeted Groups

The employed individual must be a member of a targeted group. These groups include:

(1) qualified TANF recipients (§51(d)(1)(A)),

(2) qualified veterans (§51(d)(1)(B)),

(3) qualified ex-felons (§51(d)(1)(C)),

(4) designated community residents (§51(d)(1)(D)),

(5) vocational rehabilitation referrals (§51(d)(1)(E)),

(6) qualified summer youth employees (§51(d)(1)(F)),

(7) qualified food and nutrition recipients (§51(d)(1)(G)),

(8) qualified SSI recipients (§51(d)(1)(H)), and

(9) long-term family assistance recipients (§51(d)(1)(I)).

Employers must obtain certification that a new-hire is a targeted group member to claim the WOTC.

Credit Amount

The credit available to an employer for qualified wages paid to members of all targeted groups except for long-term family assistance recipients equals 40% (25% for employment of 400 hours or less) of qualified first-year wages.

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Generally, qualified first-year wages are qualified wages (not in excess of $6,000) attributable to a targeted group member during the one-year period beginning with the day the individual started working. Therefore, the maximum credit per employee is $2,400 (40% of the first $6,000 of qualified first-year wages).

For qualified summer youth employees, the maximum credit is $1,200 (40% of the first $3,000 of qualified first-year wages). Except for long-term family assistance recipients, no credit is allowed for second-year wages.

Note: For summer youths, it applies to wages paid during a 90-day period from May 1 to September 15.

Comment: In the case of long-term family assistance recipients, the credit equals 40% (25% for employment of 400 hours or less) of $10,000 for qualified first-year wages and 50% of the first $10,000 of qualified second-year wages.

Note: The “VOW to Hire Heroes Act of 2011” (“VOW”), modified the work opportunity credit with respect to qualified veterans, by adding five additional subcategories. A veteran is an individual who has served on active duty (other than for training) in the Armed Forces for more than 180 days or who has been discharged or released from active duty in the Armed Forces for a service-connected disability.

Research & Development Credit - §41

Constantly permitted to expire only to be later reinstated, the §41 research credit has been generally available with respect to incremental increases in qualified research. It last expiration was for taxable year beginning after December 31, 2014.

Note: The §41 research tax credit has never been a permanent provision of the federal tax code. Since its enactment in mid-1981, the credit has been extended 15 times and significantly modified five times.

However, under the PATH Act, the §41 research credit has been reinstated and made permanent. In addition, the PATH Act provides that, in the case of a small business (as defined in §38), the credit is a specified credit for taxable years beginning after December 31, 2015. Thus, the research credits of a §38 small business may offset both regular tax and AMT liabilities.

Rehabilitation Tax Credit - §47

The credit is 20% for rehabilitation of certified historical structures and 10% for other qualified build-ing originally placed in service before 1936 (§47(a)).

The 10% credit for building other than certified historic buildings is limited to nonresidential build-ings. The 20% credit for historical buildings is available for nonresidential and residential buildings.

To qualify for the credit, the law requires the retention of at least 75% of the existing external walls, including at least 50% as external walls as well as, at least 75% of the building’s internal structural framework.

The law requires a basis reduction equal to 100% of the rehabilitation tax credits claimed.

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Low Income Housing Credit - §42

Section 42 creates three separate credits that may be claimed by owners of residential rental projects providing low-income housing. The credit rate is set up so the annualized credit amounts have a present value of 80% or 30% of the basis attributable to qualifying low-income units, depending on the income of the tenant qualifying for the credit. The low-income housing credit was made perma-nent by OBRA ‘93.

Three separate credits are provided:

1. A maximum credit of 9% each year for 10 years is allowed on expenditures for new construc-tion and rehabilitation of each qualifying low-income housing unit. This credit has a present value of 80%.

2. If the new construction or rehabilitation is financed with tax-exempt bonds or similar Federal subsidies, the maximum credit is 4% each year for 10 years. This credit has a present value of 30%.

3. A maximum credit of 4% each year for 10 years will be allowed on the cost of acquisition of existing low-income housing units. This credit has a present value of 30%. To qualify, the property may not have been previously placed in service within 10 years.

Estimated Taxes - §6654

Estimated tax is the method used to pay tax on income that is not subject to withholding. This in-cludes income from self-employment, unemployment compensation, interest, dividends, alimony, rent, gains from the sale of assets, prizes, and awards. The estimated tax is used to pay both income tax and self-employment tax. If you do not pay enough through withholding or by making estimated tax payments, you may be charged a penalty. It is important not to overlook opportunities to cut estimated tax payments to the legal minimum.

General Rule

Choose the payment rule giving the lowest required payment. Underpayment penalties are not ap-plied when taxpayers make estimated payments at an appropriate rate through the year that equal to the smaller of:

(1) 90% of the actual tax liability for the current year; or

(2) The amount of actual tax liability in the prior year.

This amount is called the required annual payment and is generally due in four equal quarterly in-stallments.

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Basic Deductions

Interest - §163

Under §163(a), a deduction is allowed for “all interest paid or accrued within the taxable year on indebtedness.” However, this general rule is subject to a number of restrictions. In addition, tax re-form imposed strict limits on interest deductions, breaking interest payments into over thirteen dis-tinct categories, each with its own separate and complex rules.

Investment Interest

In the case of a taxpayer (other than a corporation), the deduction for investment interest is limited to the amount of the net investment income (§163(d)(1)). Disallowed investment interest is carried forward and treated as investment interest in succeeding taxable years to the extent of net investment income in any such year (§163(d)(1)).

Prepaid Interest

Prepaid interest is deductible only in the period to which it relates and must be capitalized and deducted over the period of the loan to the extent it represents the cost of using borrowed funds during such period (§461(g)(1)).

Points

Points that are in the nature of an additional interest charge constitute prepaid interest. As such, they must be capitalized by a cash-basis taxpayer and deducted ratably over the term of the loan if incurred in a business transaction, the same as if the taxpayer were on the accrual basis (§461(g)(1)). However, points are currently deductible if paid on indebtedness incurred in con-nection with the purchase or improvement of the taxpayer’s principal residence, provided the indebtedness is secured by the residence.

Points paid to refinance an existing home mortgage are incurred for the purpose of repaying an existing indebtedness, not to purchase or improve a home. Such points do not qualify under the statute (I.R. 86-68).

Prepayment Penalty

The prepayment penalty is treated as additional interest and is deductible as such (R.R. 57-198). The same rule applies where the mortgagor refinances. The penalty payment is not amortized over the life of the new loan but is deducted immediately

Interest on Real Estate - §164

Rental Property

Mortgage interest on a “passive activity,” such as a house you rent can only be used to offset passive income. However, if your AGI is under $100,000, you can deduct up to $25,000 of loss against your other income.

Note: Suspended losses from passive activities (e.g., those you can’t use because your AGI is too high) can be carried forward to future years.

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Home Owners

Get as big a mortgage as possible when you buy. Interest is fully deductible on mortgages of up to $1 million spent to acquire, construct, or substantially improve a principal or second residence. If you need to borrow further, through refinancing, second mortgages, or home-equity loans, interest will be fully deductible on only $100,000 additional.

Note: When you buy a home, be sure to have all the appliances - from refrigerator to dishwasher to trash compactor - installed by the builder or seller. That way you can consolidate all the costs within your purchase mortgage payment and still get a full interest deduction.

Land: The IRS has ruled that interest on debt incurred to add land adjoining a taxpayer’s home is acquisition indebtedness (PLR 8950016).

Automobile Deductions

Operating costs for an automobile, truck, or other vehicle used in a business (or for investment pur-poses, such as meeting with your stockbroker or checking on your rental property) are deductible to the extent that they represent transportation expenses to carry on the taxpayer’s business. Thus, when a taxpayer uses his car in his business or employment, he can deduct that portion of the cost of operating the car.

Employee Automobile Deductions

Employees are subject to stricter rules and may deduct only the following employment related automobile expenses:

(a) Expenses of travel while away from home in the performance of services as an employee,

(b) Local transportation expenses, and

(c) Expenses covered by a reimbursement or other expense allowance arrangement with the taxpayer’s employer.

Employees may not take depreciation on an automobile unless, in addition to the above require-ments:

(a) It is required as a condition of employment; and

(b) It is for the convenience of the employer (Reg. §1.280F-6T).

Business/Personal Proration

If an automobile is used for both personal and business purposes, there must be an allocation of expenses based on the total annual mileage driven. Thus, only the business portion of interest, tax, or casualty loss is a deduction. Once the business percentage has been determined, there are two methods for calculating the deductible costs - actual cost and standard mileage.

Actual Cost Method

Under this method the taxpayer must substantiate every expenditure made, and thus extensive recordkeeping is required. Deductible expenses are items such as gasoline, oil, repairs and maintenance, interest to buy the car, costs of washing the vehicle, garage rent, tires, highway tolls, parking, license and registration fees, insurance premiums, and a reasonable allowance for depreciation. Complex rules for depreciation apply if the actual cost method is used.

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Standard Mileage Rate

The standard mileage deduction allows a “flat” or standard amount of deduction for every busi-ness mile traveled regardless of actual cost, and therefore only requires substantiation of the distance traveled in the pursuit of a trade or business. No other allocation is necessary and the taxpayer need not establish the amount of his actual automobile expenses.

Note: An individual businessman or employee must still maintain adequate records to establish the actual miles his car was driven for business.

The standard mileage rate is 53.5 cents in 2017. This applies to all business miles.

Costs incurred for gasoline (and the taxes thereon), oil, maintenance and repairs, license fees, insurance, and a reasonable allowance for depreciation are included in this fixed rate and may not be separately deducted. However, parking fees, tolls, car loan interest, and state and local property taxes attributable to business use are specifically not included in this amount and may be separately deducted.

Note: Automobile interest allocated by an employee to his employer’s business is treated as per-sonal interest (§163(h)), which is no longer deductible as an itemized deduction.

Depreciation (“Caps”) Limits - §280F(a)

For cars placed in service in 2017, the projected depreciation deduction (including the §179 ex-pensing deduction) may not be more than $3,160 ($11,160 if first year bonus depreciation is used) for the first tax year of the recovery period, $5,100 for the second year, $3,050 for the third year, and $1,875 for each later tax year – same figures as in 2016.

For trucks and vans placed in service in calendar year 2017, the projected depreciation cap is $3,560 ($11,560 if bonus depreciation is used) in the first-year, $5,700 in the second year, $3,450 in the third year, and $2,075 in the fourth year and thereafter (§280F(a)(2)(A)).

If you use the car only partly for business, the limits are reduced proportionately.

Leasing Restrictions

The depreciation and expensing “caps” and the predominant business use rules discussed above cannot be escaped by leasing a car (§280F(c)). In order to equate car owners and les-sees, regulations under §280F require the lessee to include in gross income an “inclusion amount” determined as a percentage of the car’s fair market value (on the first day of the lease term) in excess of stated dollar amounts (Reg.§1.280F-5T(d)). This inclusion amount is designed to approximate the limitations imposed on the owner of a car.

Expensing - §179

Buyers of depreciable business property can annually deduct up to $510,000 (in 2017) of their purchases. The balance, if any, must be depreciated. However, for cars the depreciation "cap" applies to the total of expensing and first-year depreciation.

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Commuting - Local Business Transportation

Transportation expenses between a taxpayer’s residence and a regular place of business are nonde-ductible commuting expenses (§262). However, transportation expenses between two specific busi-ness sites (in the same or different businesses) are deductible (R.R. 55-109).

Revenue Rulings 90-23 & 99-7

R.R. 90-23 and 99-7 provide that transportation between a residence and temporary work loca-tions by a taxpayer who has one or more regular places of business is deductible, no matter the distance (within or outside of the metropolitan area). Transportation between a taxpayer’s resi-dence and one or more regular places of business remains non-deductible.

Note: Employee taxpayers deduct daily transportation expenses only as miscellaneous itemized de-ductions subject to the 2% floor (§67).

Business Entertainment

Taxpayers may deduct entertainment expenses incurred for business purposes. To be deductible the expenses must be ordinary and necessary and incurred in the operation of a business regularly car-ried on by the taxpayer.

In addition to being ordinary and necessary (and not lavish or extravagant), entertainment expenses must be:

(1) “Directly related” to the active conduct of his trade or business,

(2) “Associated” with the active conduct of his trade or business, or

(3) Covered by one of the statutory exceptions.

Directly Related Test

Entertainment expenses are deductible if they are “directly related” to the active conduct of the taxpayer’s trade or business. An entertainment expenditure meets the “directly related” test, if:

(a) Taxpayer had more than a general expectation of deriving income or some other specific benefit (other than the goodwill of the person entertained) at some future time;

(b) Taxpayer did engage in business during the entertainment period with the person being entertained; and

(c) The principal character or aspect of the combined business and entertainment was the transaction of business.

Associated Test

The cost of entertainment immediately before or after a substantial and bona fide business dis-cussion (including meetings at a convention) can be deducted if the taxpayer can establish that the items are “associated with” the active conduct of their trade or business (§274(a); Reg. §1.274-2(d)).

Statutory Exceptions

A third method for entertainment expenses to qualify as a deduction is to come under one of the nine exceptions contained in §274(e)(1)-(9):

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Food and Beverages for Employees

Expenses for food or beverages furnished on the taxpayer’s business premises primarily for employees are deductible (§274(e)(1)). Also deductible is the cost of maintaining the facilities for furnishing the food and beverages (Reg. §1.274-2(f)(2)(ii)).

Expenses Treated as Compensation

An employer may furnish an employee with goods, services, and the use of a facility or an allowance which might generally constitute entertainment. These costs are deductible if the employer uses such items as compensation to the employee and withholds income tax for this compensation (§274(e)(2)).

Reimbursed Expenses

Expenses paid by the taxpayer under a reimbursement or other expense allowance arrange-ment in connection with the performance of services are deductible (§274(e)(3)). If such per-son “adequately accounts” for such expenses, a taxpayer is not required to satisfy either the “directly related” or “associated” test.

Recreational Expenses for Employees

The expense of providing recreational, social or similar activities primarily for the benefit of a taxpayer’s employees is deductible as is the expense of using a facility for recreational, social or similar activities (§274(e)(4)).

Employee, Stockholder and Business Meetings

Expenses directly related to business meetings of a firm’s employees, partners, stockholders, agents or directors are deductible (§274(e)(5). Minor social activities may be provided. How-ever, the expense is not deductible if the primary purpose of the meeting was social (Reg. §1.274-2(f)(2)(vi)).

Trade Association Meetings

Expenses directly related to business meetings or conventions of exempt organizations such as business leagues, chambers of commerce, real estate boards, trade associations and pro-fessional associations are deductible (§274(e)(6) and Reg. §1.274-2(f)(2)(vii)).

Items Available to Public

A taxpayer may deduct the ordinary and necessary cost of providing entertainment or recre-ational facilities to the general public as a means of advertising or promoting good will in the community (§274(e)(7)).

Entertainment Sold to Customers

Entertainment expense rules do not apply to the expense of providing entertainment, goods and services, or use of facilities, which are sold to the public in a bona fide transaction for adequate and full consideration (§274(e)(8).

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Expenses Includible in Income of Non-employees

Expenses includible in the income of persons who are not employees are deductible (§274(e)(9)).

Depreciation & Cost Recovery - §167 & §168

The Modified Accelerated Cost Recovery System (MACRS), is required for most property placed in service after 1986. Likewise Accelerated Cost Recovery System (ACRS) is mandatory for property placed in service after 1980 and before 1987 as well as property placed in service after 1986 qualify-ing as transitional property.

Net Operating Losses - §172

If your deductions for the year are more than your income for the year, you may have a net operating loss (NOL). However, certain deductions are not considered in computing an NOL. There are different limits for individuals and corporations.

A net operating loss can be created by any of the following:

(1) A loss from operating a sole proprietorship,

(2) A casualty or theft loss of business or personal use property,

(3) A partnership loss, and

(4) A “S” corporation loss.

The TRA ‘97 limited the NOL carryback period to two years (from three years) and extends the NOL carryforward period to 20 years (from 15 years). The 3-year carryback is retained for NOLs attribut-able to casualty losses of individuals and NOLs of farmers and small businesses attributable to losses incurred in Presidentially declared disaster areas.

Note: Starting in 2008, the American Recovery & Reinvestment Act provided an eligible small busi-ness with an election to increase the existing-law carryback period for an applicable 2008 & 2009 NOL from two years to any whole number of years elected by the taxpayer that was more than two and less than six. As a result, qualified businesses had the choice to carryback NOLs three, four, or five years. However, this temporary provision applied only to NOLs for any tax year beginning or ending in 2008 or 2009. Since 2010, the net operating loss carryback period is two years and the carryforward period is 20 years.

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Review Questions

Under NASBA-AICPA self study standards, self study sponsors are required to present review ques-tions intermittently throughout each self-study course. The following questions are designed to meet those requirements and increase the benefit of the materials. However, they do not have to be com-pleted to receive any credit you may be seeking with regards to the text. Nevertheless, they may help you to prepare for any final exam.

Short explanations for both correct and incorrect answers are given after the list of questions. We recommend that you answer each of the following questions and then compare your answers. For more detailed explanations and reference, you may do an electronic search using Ctrl+F (if you are viewing this course on computer), consult the text Index, or review the general Glossary.

5. What does a §1031 exchange require?

a. that property given be of like-use to the property received.

b. that property given be identical to the property received.

c. that property given be like-kind with the property received.

d. that property given be of equal fair market value to property received.

6. How are qualified corporate retirement plans categorized?

a. into funded corporate plans and unfunded corporate plans.

b. into hundreds of uniquely structured plans.

c. into actual pension plans and implied corporate annuity plans.

d. into defined contribution plans and defined benefit plans.

7. What does the installment sale method permit a taxpayer to do?

a. pay taxes on the disposition of property as payments are received.

b. trade properties of equal fair market value.

c. avoid mortgage in excess of basis.

d. eliminate taxes on the disposition of property.

8. When may owners of residential rental projects claim credits?

a. if they provide high-speed Internet connections.

b. if they provide extraordinary services under §469.

c. if they provide low-income housing.

d. if they provide childcare services.

9. What is the estimated tax designed to do?

a. solely to pay self-employment tax.

b. to tax income not subject to withholding.

c. to help employees pay their federal income tax.

d. to detect unreported taxable income.

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10. When are points currently deductible if paid on indebtedness incurred in connection with the purchase or improvement of the taxpayer’s principal residence?

a. if the taxpayer lives in the home two out of the last five years.

b. if the mortgage does not exceed $100,000.

c. if improvements are energy-efficient and less than $5,000 in amount.

d. if the indebtedness is secured by the residence.

Income Splitting

There are two major benefits to income splitting:

(1) Lower overall taxes as a unit (and we’ll later define what that unit can be composed), and

(2) Income splitting can permit wealth allocation among individuals or entities.

Using Progressive Tax Rates

Progressive in this case does not mean new, modern, or desirable. It means the more you earn, the more they take. By “splitting” the income among my family members, I will pay a lower overall tax because each will be in a lower bracket and lesser absolute dollars will go to the government.

Major Formats

There are six major formats for income splitting:

(1) Unincorporated business - sole proprietorship or partnership,

(2)“C” (or regular) corporation,

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(3)“S” corporation,

(4) Family partnership under §704 (e),

(5) Custodianship under UGMA and UTMA, and

(6) In certain limited instances (see TRA ‘84), an interest free loan.

Unincorporated Business

Because of tax reform, one of the best tax shelters is your own business. Consider the following tax advantages:

Deductible Business Expenses - §162

For the self-employed, business expenses are deductible in full directly from gross income. On the other hand, employees may only deduct their business expenses when they itemize, and the deduc-tion is reduced by 2% of AGI.

Home-Office Write-Off - §280A

If you operate a business out of your home, a portion of the expenses of your residence may be allocated to business. However, you must prove that such portion of the home is used exclusively and regularly for business purposes.

Hiring Your Children

Having your child work for the family-owned business can be a tax benefit. Earned income is taxed at the child’s tax rate. In addition, the company gets a deduction for the child’s salary. However, children must perform actual services for reasonable compensation.

Hiring Your Spouse

When a spouse is an employee, they may participate in any retirement plans that you have for em-ployees (pension, §401(k), etc.). In some cases, they may qualify for deductible IRA contributions.

Travel Expenses

Travel deductions are easier for business owners. IRS auditors often ask employees why they weren’t reimbursed by their company if their travel costs were truly “ordinary and necessary.”

Casualty Losses - §165

Business casualty losses can be deducted in full against business income. However, personal casualty losses are deductible only for itemizers, and are reduced by 10% of AGI plus a $100 deductible (§165).

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Bad Debts - §166

Business bad debts are fully deductible in the year they become uncollectible because they are in-curred in connection with a trade or business (§166(a)). However, personal bad debts are treated like capital losses - taxpayers may deduct only up to $3,000 a year.

Self-employment Tax (SECA)

The self-employment tax is the non-employee portion of the Social Security tax-raising system. In 2017, self-employment tax takes 15.3% of income (12.4% for social security [OASDI] and 2.9% for Medicare [HI]).

Note: The OASDI tax rate under the SECA tax was temporarily reduced by two percentage points to 10.4 percent for taxable years of individuals that began in 2011 or 2012.

Deductible items like home mortgage interest, real estate taxes, state income tax, Keogh plan or IRA deductions, etc. don’t reduce self-employment tax. However, since 1990, business deductions, plus an amount equal to the self-employment tax on half of self-employment income, are allowable in reducing the self-employment income.

In 2017, the social security tax is imposed on the first $127,200 of self-employment income and the Medicare tax is imposed on all self-employment income.

“C” or Regular Corporation

A regular corporation is both a separate legal and tax entity. As a result, it can be a great device to not only split income, but also to obtain fringe benefits not otherwise available.

Corporate profits normally are taxed to the corporation. When the profits are distributed as divi-dends, the dividends are taxed to the shareholders. In figuring its taxable income, a corporation gen-erally takes the same deductions as a sole proprietorship. However, corporations are also entitled to a number of special deductions.

Formation - §351

Forming a corporation involves a transfer of either money, property, or both, by the prospective shareholders in exchange for capital stock in the corporation. This process is sometimes referred to as “capitalization.”

Cash for Stock

If money is exchanged for stock, no gain or loss is realized by the shareholder or the corporation. The stock received by the shareholder has a basis equal to the amount of money transferred to the corporation by the shareholder.

Property for Stock

If property is exchanged for stock, it may be a nontaxable exchange of property for stock under §351. For the nonrecognition rule of §351 to apply, the transferors of property to the corporation

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must, as a group, have control of the corporation immediately after the exchange. Gain, but not loss, is recognized if the transferors receive other property in addition to stock.

Note: Control means at least 80% of the voting stock and at least 80% of the total number of shares of all other classes of stock. If a transferor had control of the corporation, but gave away part of the stock received, so he fell below 80%, the §351 nonrecognition rule still applies to the transfer.

Stock for Services

Stock issued for services (past, present, or future) is not issued in exchange for property.

Stock for Debt

When a corporation issues stock in discharge of its own outstanding debt, both the corporation and the shareholder may have income on the exchange. The corporation has debt cancellation income if the value of the new stock is less than the amount of the debt (§108). Stock issued for unpaid interest of the debtor corporation is not issued in exchange for property under §351.

Section 1244 Stock

Investors who have losses on the sale of stock in small corporations need to check §1244. Normally, only $3,000 of your net capital losses is deductible in any one year. However, this limit doesn’t apply to stock qualifying under §1244. Section 1244 per-mits a deduction of up to $50,000 a year ($100,000 on joint returns).

Stock qualifies for §1244 treatment by meeting three tests:

The corporation’s paid-in capital (including the §1244 stock) doesn’t exceed $1,000,000.

For five years prior to the loss, the corporation derived most of its income from busi-ness operations.

The stock was issued in exchange for cash or property.

Repeal of the “General Utilities” Doctrine

The “General Utilities” doctrine refers to the nonrecognition treatment formerly accorded liquidat-ing as well as nonliquidating distributions to shareholders and to liquidating sales. The Tax Reform Act of 1986 repealed this doctrine. Thus, gain or loss is recognized by a corporation on a liquidating sale of its assets and on a liquidating distribution of assets as if the corporation had sold the assets to the distributee at fair market value (§336(a)).

“S” Corporation

The “S” corporation is a true corporation. It has shareholders, directors, officers, and limited liability. However, from a federal income tax standpoint, they are taxed as individuals (when there is one shareholder) or as a partnership (when there are two or more shareholders). Thus, income and ex-penses are “passed through” to the shareholders.

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Single Taxation

The income of regular corporations is taxed twice, first on the corporation’s tax return and then on the shareholder’s return when he receives dividends. The tax advantage an S corporation has over regular corporations is that income is taxed only once, directly to the shareholders.

Tax Advantages

Even if S corporation status won’t save you much in income tax - it may still pay to convert from a regular corporation. Tax advantages to being an S corporation:

1. Escape accumulated earnings tax problems. The IRS can’t raise this issue if you are an S corpo-ration.

2. Eliminate unreasonable compensation problems. Because all S corporation income passes through to the shareholders, high compensation is not an issue.

3. Avoid double taxation on disallowed deductions, such as personal travel and entertainment expenses. When you’re an S corporation, there’s only a single tax on any extra income the IRS charges to the corporation.

4. Split-election. If your state permits businesses to operate as S corporations, it may be advisable not to elect S status for state purposes while still electing it for federal purposes. A split election saves when:

(a) Your state has a high individual income tax rate, and

(b) Your company does only part of its business there.

5. Avoid the repeal of the “General Utilities” doctrine. When a regular corporation liquidates its assets, the corporation has to pay tax on the gain, and the shareholders have to pay tax on the part of the gain that is passed through to them. It is possible to avoid the double tax by electing S corporation status.

Corporations That Qualify

To qualify for S corporation status, a corporation must meet all six of the following requirements:

1. It must be a domestic corporation.

2. It must have only one class of stock.

3. It must have no more than 100 shareholders. When counting shareholders, the following rules apply:

a) Count husband and wife, and their estates, as one shareholder; and

b) Count the beneficiaries of a trust, not the trust itself, as shareholders.

4. It must have only individuals, estates, and certain trusts as shareholders.

5. It must have shareholders that are citizens or residents of the United States. Thus, nonresident aliens cannot be shareholders.

6. It must not be:

a) A DISC corporation;

b) A corporation that takes the Puerto Rico and possessions tax credit for doing business in a United States possession; or

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c) An insurance company.

Income-splitting

“S” corporations are common income-splitting vehicles. The major shareholder can give or install-ment sell stock to his children who are then taxed on their share of the corporate income. Such a format is a way to split business income with your children without hiring them as employees.

Family Partnership - §704(e)

Family partnerships can be used to minimize both income taxes and estate taxes. The partnership can be formed by the taxpayer contributing income producing real property to the partnership. This transfer is normally tax free under §721. The taxpayer then proceeds to gift or installment sell limited partnership interests to his children and grandchildren (or other heirs or family members).

Family Members

Family members include only husband and wife, ancestors, lineal descendants, and any trusts for their primary benefit. Brothers and sisters are not included. Generally, a family member will be rec-ognized as a partner in either of the following cases:

(a) Where capital is a material income-producing item and a family member’s capital interest was received in a bona fide transaction in which ownership, dominion, and control were acquired; and

(b) Where capital is not a material income-producing factor, but the family member contributes substantial or vital services (Reg.§1.754-1).

Real

Property

FAMILY PARTNERSHIP

CHILD CHILD CHILD

INDIVIDUAL

TAXPAYER

PARENT

GIFT OR SALE

OF LIMITED

INTEREST

REAL PROPERTY

PARTNERSHIP

INTEREST

§721

FAMILY LIMITED PARTNERSHIP

§704(E)

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Children

Custodianship

Custodianship can be an excellent way to split income. Most states have enacted a version of the Uniform Gifts to Minors Act or the Uniform Transfer to Minors Act, which permits parents to transfer property to children and open accounts in their behalf. The child has legal title to the property or funds, but it is registered in the name of a custodian for the child’s benefit.

Employer Dependent Care Program - §129

When an employer provides an employee with dependent care assistance, the employer can exclude from the employee’s income up to $5,000 ($2,500 for a married person filing a separate return) of the amount paid or incurred by the employer each year. Amounts paid that exceed this limit must be included in the employee’s income. An employee includes a self-employed person. Thus, the §129 exclusion applies to plans established by partnerships and sole proprietorships for the owners of the business and their employees.

Note: Effective 1988, employers are required to include the excess amount in the employee’s gross income for the year in which the dependent care assistance is provided, even if the employer pays for it in a later year.

Education Savings Bonds - §135

Since 1990, interest on US savings bonds that are cashed in to pay for education expenses are tax-free income for certain taxpayers (§135). This provision applies only to interest earned on US savings bonds issued after December 31, 1989.

Education Loans - §221

Under the TRA ‘97, certain individuals who have paid interest on qualified education loans may claim an above-the-line deduction for such interest expenses, up to a maximum deduction of $2,500 per year.

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Gifts

Gifts are not only a way to reduce your estate and thereby eliminate death taxes, but they are great income splitting devices. You can give away up to $14,000 per year to as many different people (do-nees) as you wish, and you do not have to report the gift. This $14,000 per year exemption is called the annual exclusion. As long as the gift does not exceed $14,000, no gift tax return need be filed. If a gift is made of more than $14,000 (in 2017) in one year to one person, then a gift tax return must be filed by the donor.

Interest Free Loans - §7872

The use of interest free loans represented a flexible and significant income splitting vehicle for tax-payers. However, §7872 now severely limits their use.

The §7872 recharacterizes a below market or interest free loan as an arms-length transaction in which the lender (i) extends a loan to the borrower in exchange for a note requiring the payment of interest at a statutory rate and (ii) makes a gift to the borrower which, in turn, is used by the borrower to pay the interest.

LEGAL

RELATIONSHIP

INCOME TAX

RELATIONSHIP

GIFT TAX

RELATIONSHIP

CHILD

PARENTS

#1

IMPUTED

INTEREST

(AT AFR)

#2

IMPUTED

GIFT

(AT AFR)

LOAN

$

SECTION 7872 DOUBLE

IMPUTATION

$10,000 EXCEPTION:

$100,000 EXCEPTION:

NO IMPUTED INTEREST

NO IMPUTED GIFT

NO IMPUTED INTEREST

IMPUTED GIFT

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Elimination

Tax planning techniques rarely offer the ability to completely eliminate tax on realized gain. How-ever, there are a select few that do and the taxpayer should be on the alert to take advantage of them. Samples of some are:

$500,000 Home Sale Exclusion - §121

Under the TRA ‘97, old §121 and §1034 rules for gains on the sale of a personal residence were replaced with a $500,000 exclusion for joint filers ($250,000 for single filers), effective generally for sales after May 6, 1997. This exclusion can be used once every two years.

Note: This exclusion does not apply to any gain attributable to depreciation deductions taken in connection with the rental or business use of the property for periods after May 6, 1997.

Two Year Ownership & Use Requirements

The new exclusion requires a taxpayer to have owned and used the property as his or her principal residence for at least two years during the five-year period ending on the date of the sale or ex-change. The exclusion is allowed each time a taxpayer who sells or exchanges a principal residence meets the eligibility requirements, but no more often than once every two years.

Married couples filing a joint return are entitled to a $500,000 exclusion where:

(1) Either spouse meets the ownership requirement;

(2) Both spouses meet the use requirement; and

(3) Neither spouse has had a sale in the preceding two years subject to the exclusion.

Married couples not sharing a principal residence, but filing a joint return, are each entitled to a $250,000 exclusion. In addition, single taxpayers who marry a taxpayer who has used the exclusion within two years are allowed a $250,000 exclusion.

Note: Once both spouses satisfy the eligibility requirements and two years have passed since the last exclusion was allowed to either spouse, a full $500,000 exclusion is available for the next sale or exchange of their principal residence.

Tacking of Prior Holding Period

If a taxpayer acquired their residence in a transaction covered by the prior rollover rules, the periods of ownership and use of the prior residence count in determining ownership and use of the current home.

Prorata Exception

A taxpayer may be entitled to a prorated exclusion if they fail to meet either two-year requirement because of a change in:

(a) Place of employment,

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(b) Health, or

(c) Other unforeseen circumstances.

Municipal Bonds - §103

The interest that you receive on obligations of a state or local government may or may not be taxable depending on the type of obligation issued and the nature of the activity funded. However, relatively low risk results in a lower yield on municipal obligations than you can obtain from other forms of investment.

Tax-exempt Interest on Qualified State or Local Obligations

Interest on obligations of a state or one of its political subdivisions, the District of Columbia, a pos-session of the United States, or one of its political subdivisions, is not subject to federal income tax. In many cases, it is exempt from state and city tax in the issuing state as well.

Reporting

Tax-exempt interest must be shown on your tax return. Prior to the Tax Reform Act of 1986, only taxpayers with taxable social security benefits were required to provide this information.

Divorce & Separation Settlements

Care must be taken when drafting separation and divorce agreements. Here are some points to con-sider:

Alimony - §71

Alimony payments are fully deductible. However, payments can’t be called alimony unless specified as such in a written agreement or court decree. Alimony must consist of regular periodic payments of approximately equal amounts over a period of at least three years.

Recapture rules penalize those who pay much larger amounts in the first year or years and smaller amounts in the last years. The first-year payment can exceed the average of the second- and third-year payments by $15,000 before recapture rules come into play. The second-year payment can ex-ceed the third-year payment by $15,000.

Child Support

Child support isn’t a deductible expense or income to the recipient. Unless child support is specified in a separation agreement or divorce decree, then all payments are presumed to be alimony. How-ever, where payments may be reduced upon the happening of an event related to the child and specified in the agreement or decree, then that portion of the payment is treated as child support and the balance as alimony.

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Property Division - §1041

In general, no gain or loss is recognized on the transfer of property incident to divorce (§1041). As in the case of a gift, the transferee spouse takes the transferor’s basis. This preserves the inherent gain or loss in the property so that when the transferee ultimately disposes of the property that spouse will bear the tax burden from the property.

Dependency Exemption.

Generally, the parent having custody of the child takes the dependency exemption. However, the divorce settlement can modify this.

Note: Often the parent with custody can file as an head of household, even though the divorce is not final.

Gifts & Inheritances

Property received as a gift, bequest, or inheritance is not included in your income. But if property you receive this way later produces income such as interest, dividends, or rentals, that income is taxable to you. If property is given to a trust and the income from it is paid, credited, or distributed to you, that also is income to you. If the gift, bequest, or inheritance is the income from the property, that income is taxable to you.

Income from Property Given to a Child

Property a parent gives to a child under one of the uniform gifts to minors acts or any similar law is a true gift. Income from property given to a child in such a way is taxable to the child unless it is used in any way to satisfy a legal obligation of support. The income is taxable to the parent or guardian to the extent that it is used for the child’s support.

Life Insurance

Life insurance proceeds paid to you because of the death of the insured person are not taxable unless the policy was turned over to you for a price (§101). This applies even if they were paid under an accident or health insurance policy or an endowment contract.

Fringe Benefits

Fringe benefits are best provided in a “C” (or regular) corporation, however, some are permitted in “S” corporations, partnerships, and even sole proprietorships.

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Prizes & Awards - §74(b)

Employee achievement awards are excluded from gross income. However, the TRA ‘86 limits deduct-ible employee achievement awards to include only those awards made for length of service or safety (§274(j)).

Group Life Insurance Premiums - §79

Premiums paid by an employer for group life insurance providing only for term coverage are not taxable income to a covered employee if the employee’s coverage does not exceed $50,000.

Accident and Health Plans - §106 & §105

Contributions, paid by an employer to accident and health plans for compensation to the employee for personal injuries or sickness, are excluded from the employee’s gross income. In addition, em-ployer payments which reimburse employees for medical expenses of the employee, a spouse or dependents are also excluded from income.

Meals & Lodging - §119

An employee can exclude from his gross income the value of any meals or lodging furnished to him, his spouse or any of his dependents by his employer for the convenience of the employer, if:

(1) In the case of meals, the meals are furnished on the employer’s business premises; or

(2) In the case of lodging, the employee is required to accept the lodging on the employer’s busi-ness premises as a condition of his employment.

Cafeteria Plans - §125

A cafeteria plan is a written plan under which participants may choose among two or more benefits consisting of cash and qualified benefits without resulting in the benefit being included in the em-ployee’s gross income.

Educational Assistance Program - §127

Employers can set up educational assistance programs under which employees receive tax-free ed-ucational benefits of up to $5,250 per year.

Dependent Care Assistance - §129

An employee’s income does not include expenses paid or incurred by an employer for dependent care assistance provided under a qualified §129 program. The excluded amount cannot exceed $5,000 ($2,500 for marrieds filing separately) or the earned income of the lower earning spouse.

Comment: A taxpayer is not allowed both an exclusion from income under §129 and a child and dependent care credit under 21 on the same amount. Child care expenses are reduced dollar for dollar by the amount of reimbursement.

Employees are required to include in income excess amounts (above an exclusion level) that an em-ployer provides for dependent care assistance. Dependent care assistance must be included in the

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employee’s income in the year in which services are provided, even if the actual payment is made later.

Section 132

Section 132 provides rules for excluding several categories of fringe benefits from gross income, in-cluding:

(1) No additional cost services,

(2) Qualified employee discounts,

(3) Working condition fringe benefits,

(4) De minimis fringe benefits,

(5) Qualified transportation fringe benefits,

(6) Qualified moving expense reimbursements,

(7) Qualified retirement planning services, and

(8) On the premises athletic facilities.

Social Security

The fundamental concept of our contributory social security system is the obligation of people to provide a security program for themselves. Our social security system provides a monthly sum to replace part of a person or a family’s earnings when a worker retires, dies, or becomes disabled. Thus, its general payments fall under one of the following headings: retirement benefits, survivor’s benefits, disability benefits, and Medicare benefits.

Earnings Record

Your retirement benefits are based upon your earnings record. However, to qualify for benefits you must be considered insured. Generally, you are fully insured once you have worked forty quarters. The amount of your benefits depends on your average yearly earnings. You are entitled to full bene-fits at age 65, and reduced benefits at age 62.

Note: A dependent spouse gets 50% of your benefits on reaching age 65, or 37.5% at age 62.

The full benefit age (now age 65) has been gradually increased to age 67 since 2000. If you were born in 1943 - 1959, full benefit age is your 66th birthday plus two months for every year that your birth year was after 1954. If you were born in 1960 or after, your full benefit age is 67.

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Review Questions

Under NASBA-AICPA self study standards, self study sponsors are required to present review ques-tions intermittently throughout each self-study course. The following questions are designed to meet those requirements and increase the benefit of the materials. However, they do not have to be com-pleted to receive any credit you may be seeking with regards to the text. Nevertheless, they may help you to prepare for any final exam.

Short explanations for both correct and incorrect answers are given after the list of questions. We recommend that you answer each of the following questions and then compare your answers. For more detailed explanations and reference, you may do an electronic search using Ctrl+F (if you are viewing this course on computer), consult the text Index, or review the general Glossary.

11. Under §351, what can an exchange of property for corporate stock be?

a. a combining reorganization.

b. a nontaxable capitalization.

c. a divisive reorganization.

d. a taxable liquidation.

12. In an S corporation, how is income typically taxed?

a. once at the shareholder level.

b. once at the entity level.

c. twice at the shareholder and entity level.

d. as alternative minimum taxable income.

13. What is the amount up to $14,000 that may be gifted per year?

a. the annual exclusion.

b. the required annual payment.

c. discretionary income.

d. an interest free loan

14. Who is entitled to a $500,000 exclusion for the sale or exchange of their principal residence?

a. a single taxpayer who marries a taxpayer who has used the exclusion within two years.

b. married couples filing a joint return, but not using the property as their principal residence for at least two years during the five-year period.

c. married couples sharing a principal residence and filing a joint return.

d. married couples who have sold a primary residence in the preceding two years.

15. Under §101, when are life insurance proceeds paid to you because of the death of the insured person taxable?

a. if life insurance proceeds were paid under a health insurance policy.

b. if life insurance proceeds were paid under an accident.

c. if life insurance proceeds were paid under an endowment contract.

d. if the policy was turned over to you for a price.

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Answers & Explanations

1. According to the author, what is a purpose in carrying out an investment program?

a. Incorrect. In order to preserve wealth through investment programs, individuals must build an estate and create wealth.

b. Incorrect. Saving is a part of budgeting, and savings should be used to acquire assets.

c. Incorrect. Budgeting is a way to turn income into cash, and cash should be used to acquire assets.

d. Correct. According to the author, education is a purpose in carrying out an investment pro-gram. Individuals must balance credentialed education with practical knowledge of planning for financial security.

2. What is the first basic element of investment planning?

a. Incorrect. You cannot preserve wealth if you do not have it. Preserving wealth comes after creating it.

b. Correct. The first basic element of investment planning is creating wealth and building an es-tate.

c. Incorrect. Saving wealth is not one of the three basic elements of investment planning. Saving is a part of creating wealth. You must use savings to acquire assets.

d. Incorrect. The third basic element of investment planning is distributing wealth to heirs. The ultimate goal is to transfer your assets tax free to your family and heirs.

3. What is included as taxable income?

a. Incorrect. Property received as a gift is not included in your income. But if property you receive this way later produces income such as interest, dividends, or rentals, that income is taxable to you.

b. Incorrect. Property received as a bequest is not included in your income. However, if property is given to a trust and the income from it is paid, credited, or distributed to you, that is income to you.

c. Incorrect. Property received as an inheritance is not included in your income. While not subject to income tax, inheritances can be subject to death taxes and probate costs.

d. Correct. Under §61, taxable income includes income derived from wages or salary.

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4. What is a basic rule of budgeting?

a. Incorrect. The third basic budgetary rule is to save 10% of your gross income.

b. Incorrect. The fourth basic budgetary rule is to spend 10% of your income on continuing prac-tical education that motivates you to act and teaches you financial principles.

c. Incorrect. The first basic budgetary rule is to spend no more than 60% of your gross income on your expenses.

d. Correct. The second basic budgetary rule is that 20% or less of your gross income should be allocated to income taxes.

5. What does a §1031 exchange require?

a. Incorrect. The like use standard, sometimes used by §1033, is often confused with the like kind requirement of §1031. The two requirements are very different.

b. Incorrect. Section 1031 does not require that the properties traded be identical. While this is clear with regards to real estate, recent regulations have tightened up the like kind test for per-sonal property by requiring the property to be at least of a like class.

c. Correct. The final requirement of an exchange is that the property given must be like-kind to the property received. The term “like-kind” is the subject of much confusion, but is best under-stood as a simple distinction between real and personal property. Real estate is like-kind to other real estate. Personal property is like-kind to other personal property. However, real estate is not like-kind to personal property and vice versa.

d. Incorrect. Section 1031 does not require that the properties traded be of an equal fair market value. In fact, in many cases, they are not equal in value and additional consideration must be added by one of the parties.

6. How are qualified corporate retirement plans categorized?

a. Incorrect. Pension law requires that qualified corporate retirement plans be funded. Without being funded, a corporate retirement plan would not be qualified.

b. Incorrect. Defined benefit and defined contribution are the two basic types of qualified corpo-rate retirement plans. While a variety of corporate retirement plans exist, they are essentially variations or combinations of these two basic types.

c. Incorrect. ERISA requires that qualified plans be in writing and communicated to employees. There is no provision for implied qualified plans.

d. Correct. There are two basic categories of qualified corporate retirement plans. The first is defined contribution plans. These plans are primarily designed and structured from a standpoint of what contribution is to be made to the plan. The company does not bear responsibility for any growth in the plan assets or in any determinable benefit at age retirement. The second basic type of qualified corporate retirement plan is the defined benefit plan.

7. What does the installment sale method permit a taxpayer to do?

a. Correct. An installment sale can permit a taxpayer to pay his taxes on the disposition of prop-erty as he receives the payments. While, this deferral can result in a huge tax savings, it does not eliminate taxes on the disposition of property.

b. Incorrect. The installment method is a sale not an exchange of property. While some may con-sider an installment sale to be an exchange of a debt instrument for property, gain is realized and recognized.

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c. Incorrect. The installment method does not avoid mortgage in excess of basis. In fact, one of the major defects of the method is that an installment sale triggers taxation on mortgage in ex-cess of basis by considering it a deemed down payment.

d. Incorrect. The installment sale method is a tax deferral device. It postpones the payment of tax until payments are actually received.

8. When may owners of residential rental projects claim credits?

a. Incorrect. There is no federal income tax credit tied directly or specifically to the providing of high-speed Internet connections for residential housing projects.

b. Incorrect. Section 469 relates to the passive loss rules. While it does relate to rental real estate, §469 essentially suspends losses until there is a fully taxable disposition. It provides no credit.

c. Correct. Section 42 creates three separate credits that may be claimed by owners of residential rental projects providing low-income housing. The credit rate is set up so the annualized credit amounts have a present value of 80% or 30% of the basis attributable to qualifying low-income units, depending on the income of the tenant qualifying for the credit. The low-income housing credit was made permanent by OBRA ‘93.

d. Incorrect. While §21 and other Code provisions provide credits and deductions for childcare services necessary for the taxpayer to be able to work, none of these provisions provide a credit to owners of residential rental projects.

9. What is the estimated tax designed to do?

a. Incorrect. The estimated tax is used to pay both income tax and self-employment tax. If you do not pay enough through withholding or by making estimated tax payments, you may be charged a penalty.

b. Correct. Estimated tax is the method used to pay tax on income that is not subject to with-holding. This includes income from self-employment, unemployment compensation, interest, dividends, alimony, rent, gains from the sale of assets, prizes, and awards.

c. Incorrect. The self-employment tax primarily targets the self-employed not employees. The withholding system is designed to help employees pay their federal income tax.

d. Incorrect. The estimated tax system is not designed to detect unreported taxable income. Its purpose is to collect taxes on income not subject to withholding.

10. When are points currently deductible if paid on indebtedness incurred in connection with the purchase or improvement of the taxpayer’s principal residence?

a. Incorrect. There is no two out of five year requirement with regard to points. However, such a requirement is contained in the home sale exclusion provided by §121.

b. Incorrect. The $100,000 limitation is part of the definition of qualified home mortgage interest under which home equity indebtedness cannot exceed this amount (§163). There is no $100,000 mortgage limitation for points.

c. Incorrect. While recent legislation has provided a number of credits and deductions for energy-efficient property, these provisions have not changed rules with regard to the deductibility of points.

d. Correct. Points that are in the nature of an additional interest charge constitute prepaid inter-est. As such, they must be capitalized by a cash-basis taxpayer and deducted ratably over the term of the loan if incurred in a business transaction, the same as if the taxpayer were on the

44

accrual basis (§461(g)(1)). However, points are currently deductible if paid on indebtedness in-curred in connection with the purchase or improvement of the taxpayer’s principal residence, provided the indebtedness is secured by the residence.

11. Under §351, what can an exchange of property for corporate stock be?

a. Incorrect. Combining reorganizations are under §368 not §351. Such reorganizations are where two or more corporations combined to form one. If the procedures of §368 are followed, such reorganizations are typically tax-free.

b. Correct. If property is exchanged for stock, it may be a nontaxable exchange of property for stock under §351. For the nonrecognition rule of §351 to apply, the transferors of property to the corporation must, as a group, have control of the corporation immediately after the ex-change. Gain, but not loss, is recognized if the transferors receive other property in addition to stock.

c. Incorrect. Divisive reorganizations are under §355 not §351. Such reorganizations are where one corporation divides or splits itself into two or more. If the procedures of §355 are followed, such reorganizations are typically tax-free.

d. Incorrect. Section 351 involves the capitalization of a corporation not its liquidation. A variety of provisions control the liquidation of a corporation. Such liquidations are typically taxable to either the corporation, its shareholders or both.

12. In an S corporation, how is income typically taxed?

a. Correct. A tax advantage an S corporation has over a regular corporation is that income is taxed only once, directly to the shareholders.

b. Incorrect. Although there are exceptions for certain types of income and some state law vari-ations, an S corporation is essentially a conduit for federal income tax purposes. Thus, there is basically only a single level of taxation on S corporation income and this occurs at the shareholder level.

c. Incorrect. The income of regular corporations, but not S corporations, is taxed twice, first on the corporation’s tax return and then on the shareholder’s return when he receives dividends.

d. Incorrect. S corporations are not subject to the alternative minimum tax.

13. What is the amount up to $14,000 that may be gifted per year?

a. Correct. The annual exclusion amount is the amount up to $14,000 that may be gifted per year. Any amount more than $14,000 that is given as a gift must be reported.

b. Incorrect. The required annual payment is the amount a taxpayer pays for estimated taxes.

c. Incorrect. Discretionary income is net cash, which is the result of budgeting.

d. Incorrect. In contrast to gifts, loans must be repaid. Interest free loans were used to split in-come. However, below market or interest free loans are recharacterized as arms-length transac-tions under §7872.

14. Who is entitled to a $500,000 exclusion for the sale or exchange of the principal residence?

a. Incorrect. A single taxpayer who marries a taxpayer who has used the exclusion within two years is allowed a $250,000 exclusion.

b. Incorrect. Married couples who do not use the property as their principal residence for at least two years during the five-year period ending on the date of the sale or exchange do not meet the use requirement and therefore do not qualify for the full $500,000 exclusion.

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c. Correct. Married couples filing a joint return are entitled to a $500,000 exclusion where both spouses meet the use requirement.

d. Incorrect. Married couples filing a joint return are entitled to a $500,000 exclusion where nei-ther spouse has had a sale in the preceding two years subject to the exclusion.

15. Under §101, when are life insurance proceeds paid to you because of the death of the insured person taxable?

a. Incorrect. Life insurance proceeds paid to you because of the death of the insured person are not taxable even if they were paid under a health insurance policy.

b. Incorrect. Life insurance proceeds paid to you because of the death of the insured person are not taxable even if they were paid under an accident.

c. Incorrect. Life insurance proceeds paid to you because of the death of the insured person are not taxable even if they were paid under an endowment contract.

d. Correct. Life insurance proceeds paid to you because of the death of the insured person are not taxable unless the policy was turned over to you for a price (§101).

46

Glossary

ACRS (Accelerated Cost Recovery System): A statutory method of depreciation allowing accelerated rates for most types of property used in business during the years 1981 through 1986.

Annuity: An annual payment of money by a company or individual to a person called an annuitant.

Bad debts: Legally binding debts owed a taxpayer that are partially or totally worthless and uncol-lectible.

Business purpose: A requirement that an expense claimed as a deduction from taxable business in-come must serve a genuine business purpose.

Entertainment expense: Costs incurred in hosting social events for customers or suppliers to obtain or maintain their business patronage or goodwill.

Fringe benefits: Non-wage employer provided benefits such as retirement, health insurance, and transportation.

Gift tax: A graduated federal tax paid by donors on gifts exceeding $14,000 per year per donee.

Gross income: Money, goods, services, and property a person receives that must be reported on a tax return. Includes unemployment compensation and certain scholarships. It does not include wel-fare benefits and nontaxable Social Security benefits.

IRA: An acronym for an "individual retirement arrangement."

MACRS: an acronym for "Modified Accelerated Cost Recovery System."

Net operating loss: A business loss that exceeds current income and may be carried back against income of prior years or carryforward as a deduction against future income.

Placed in service: When property is available for use.

S corporation: A particular type of corporation established under the Code that is taxed like but not as a partnership.

Self-employment tax: Similar to Social Security and Medicare taxes, but for self-employed individu-als.

Tax year: An annual accounting period for reporting income and keeping records.

a

Index of Keywords & Phrases

A

accident and health plan, 38

accumulated earnings tax, 30

acquisition indebtedness, 20

ACRS, 24

actual cost method, 21

adequate records, 21

agents, 24

AGI, 12, 20, 27, 28

aliens, 31

alimony, 18, 36

annual exclusion, 34

annuity, 11, 12

awards, 18, 38

away from home, 20

B

bad debts, 28

basis reduction, 18

bonus depreciation, 21

business expenses, 27

business premises, 23, 38

business purpose, 21, 22, 28

C

calendar year, 22

capital interest, 32

capital losses, 28, 30

capitalization, 29

child support, 6, 36

children, 3, 6, 28, 32, 33

cofuture, but, 14

coins, 8

commissions, 6

commuting expenses, 22

compensation, 11, 14, 23, 31, 38

constructive receipt, 14

convenience of the employer, 21, 38

custodianship, 27

custody, 37

custodya, 37

D

deferred annuity, 12

deferred compensation, 14

defined benefit plan, 11

defined contribution plan, 11

delayed exchange, 10

dependency exemption, 37

dependent care, 33, 38, 39

dependent care credit, 39

disaster areas, 25

dividends, 6, 18, 29, 30, 37

double taxation, 31

E

earned income, 6, 12, 38

employee achievement award, 38

employee contributions, 11

employee discounts, 39

entertainment expenses, 22, 23, 31

estate tax, 32

estimated tax, 18

expense allowance arrangement, 20, 23

expensing deduction, 21

F

fair market value, 22, 30

family members, 27, 32

FICA, 12

financial planning, 3

fringe benefits, 29, 39

FUTA, 13

G

gift tax, 34

gold, 8

goodwill, 23

gross income, 7, 22, 27, 33, 38, 39

group life insurance, 38

b

H

head of household, 37

health insurance, 37, 41, 46

highly compensated employees, 13

home mortgage interest, 28

I

incident to divorce, 37

insurance premiums, 21

interest expense, 33

investment income, 6, 19

investment interest, 19

investment purpose, 20

IRA, 6, 11, 12, 28

itemized deductions, 22

J

joint returns, 30

L

life expectancy, 1, 12

life insurance, 6

local transportation, 20

low-income housing, 18

M

MACRS, 24

made available, 13

medical expenses, 38

Medicare, 3, 29, 39

money market funds, 7

money purchase pension, 11, 12

mortgages, 20

municipal bonds, 6

N

net investment income, 19

net operating loss, 15, 24

nonliquidating distributions, 30

O

owner employee, 13

P

parking, 21

passive activity, 20

passive income, 20

periodic payment, 36

personal interest, 21

personal use, 25

placed in service, 18, 22, 24

points, 19, 36

prepaid interest, 19

principal residence, 19, 35, 40

prizes, 18

professional associations, 24

property settlement, 6

property settlements, 6

property taxes, 3, 21

R

real estate taxes, 28

reasonable compensation, 28

recapture, 36

record-keeping, 21

refinancing, 9, 20

regular corporations, 30

reimbursements, 39

required payment, 19

retirement plans, 10, 11, 28

rollovers, 6

Roth IRA, 12

royalties, 6

S

S corporations, 13, 31

savings bonds, 33

scholarships, 6

self-employment tax, 18, 28

SEP, 12

SIMPLE, 11

single taxpayers, 35, 40

Social Security, 5, 28, 39

Social Security benefits, 5

Social Security tax, 28

sole proprietorship, 25, 27, 29, 33, 37

standard mileage rate, 21

c

statutory exceptions, 23

substantiation, 21

suspended losses, 14

T

tax credits, 18

tax planning, 9

tax refunds, 6, 7

tax shelters, 27

tax year, 14, 21, 25

taxable income, 15, 29, 38

taxable year, 14, 19, 28

tax-free income, 6, 33

transportation expenses, 20, 22

U

undertaking, 12

unemployment compensation, 18

unforeseen circumstances, 36

Uniform Gifts to Minors Act, 33

unreasonable compensation, 31

W

workers compensation, 6

written plan, 38