Taxation of Business Entities

Taxation of Business Entities Chapter 16 and 17 Taxation of Individuals

Outline • Review of Individual Tax Formula and Gross Income Inclusions and Exclusions • Standard Deduction vs. Itemized Deductions • Personal and Dependency Exemptions • Kiddie Tax • Filing Status • Specific Inclusion and Exclusion Rules applicable to Individuals • Itemized Deductions • Tax Credits for Individuals • Employment-Related Expenses

Tax Formula Income (broadly conceived) $x,xxx Less: Exclusions (x,xxx) Gross Income $x,xxx Less: Deductions for AGI (x,xxx) Adjusted Gross Income (AGI) $x,xxx Less: The greater of total itemized deductions or the standard deduction (x,xxx) Personal & dependency exemptions (x,xxx) Taxable Income $x,xxx

Components of the Tax Formula • Income • A partial list of gross income items is provided in Exhibit 16-2 • Exclusions - common items listed in Exhibit 16-1 • See lines 7-21 of 1040 • Deductions forAdjusted Gross Income include (“Above the line deductions”; see lines 23-35 of 1040): • 1/2 of self-employment tax paid • Alimony paid • Payments to qualified retirement plans (lines 28, and 32) • Certain IRA payments • Ordinary and necessary business expenses • Continued on next slide

FOR AGI Deductions (cont.) • Educator Expense (for 2009) - $250 • Health Savings Account (16-40 thru 16-41) • For taxpayers with high-deductible health insurance plans, allows them to pay for out-of-pocket expenses with before tax dollars • SE Health Insurance deduction (17-42) • Moving Expenses – job related (17-25 thru 17-27) • Student Loan Interest – max $2,500 (16-44) • Subject to phase out: MAGI > $60,000 ($120,000 MFJ) • Tuition and Fees Deduction (currently set to expire in 2009; 17-30 thru 17-31) • Max deduction = $4,000 • Eligibility depends on MAGI • Available for 2009

Components of the Tax Formula – Adjusted Gross Income (AGI) • Important subtotal that serves as: • Basis for computing percentage limitations for certain itemized deductions • Medical expenses (7½% of AGI Floor) • Personal Casualty Loss deduction (10% of AGI Floor) • Charitable Contribution (50% of AGI Ceiling) • Basis for determining the phase-out of: • Itemized deductions • Personal and dependency exemptions • Child Credit and Education Credits • Small Landlord Deduction • Basis for determine eligibility for certain items: • Roth IRA • Traditional IRA • Earned income Credit

Components of the Tax Formula • Itemized Deduction vs. Standard Deduction • Taxpayers are allowed to deduct the greater of total itemized deductions (less phase-out amount) or the standard deduction • Itemized Deductions include certain personal expenses: medical expenses, interest, taxes, charitable contributions, personal casualty losses, and certain other miscellaneous expenses (see Schedule A) • The Standard Deduction includes three possible components: • Basic Standard Deduction • Additional Standard deduction – over 65 and/or blind • Property Tax Deduction – for 2008 and 2009 only

Standard Deductions • The basic standard deduction (BSD) Filing status2009w/prop tax* Single $5,700 $6,200 MFJ, SS 11,400 12,400 HH 8,350 8,850 MFS 5,700 6,200 *For 2008 and 2009, basic standard deduction can be increased by the lesser of: 1) real property taxes paid during year, or, 2) $500 ($1,000 for married filing joint).

Standard Deductions • Additional standard deduction (ASD) • For taxpayers age 65 or older and/or legally blind Filing status2009 Single $1,400 MFJ, SS 1,100 HH 1,400 MFS 1,100

Standard Deductions • 2009 Increase in Standard Deduction: Sales Tax Paid on the Purchase of Autos • This temporary standard deduction is available for auto sales tax paid on purchases that occur from Feb. 17 through Dec. 31, 2009. • Deduction cannot exceed tax on first $49,500 of purchase price. • Deduction is phased-out when taxpayer’s AGI exceeds $125,000 ($250,000 on a joint return). • Purchased vehicle (e.g., cars, SUVs, light trucks, motorcycles) cannot exceed gross weight of 8,500 lbs. • Original use must commence with the taxpayer.

Standard Deduction • Examples (2009 tax year): • 1. Taxpayer is single, pays property taxes of $3,000 and is over age 65 • 2. Taxpayers are married, filing jointly, pay property taxes of $4,000 and are both over age 65 • 3. Taxpayer is single, with an AGI of $90,000, and paid $1,200 in sales tax on a 5/18/09 purchase of a $15,000 SUV.

Standard Deductions • Taxpayers who are ineligible to use the standard deduction: • Married, filing separately, when other spouse itemizes deductions • Nonresident aliens • Individual filing return for tax year of less than 12 months

Standard Deductions • Special limitations on basic standard deduction (BSD) for dependents • Individual claimed as dependent has a BSD limited to the greater of: • $950, OR • $300 plus earned income (but NOT exceeding normal BSD). • Earned income means income from a job or trade/business income. Does NOT include investment income.

Standard Deductions • Example - Dependent’s standard deduction (2009 tax year): • What is the standard deduction for a child who earns $1,500 in wages and is claimed by parents as a dependent?

Personal and Dependency Exemptions • 2009: $3,650 per exemption • Personal Exemption • One per taxpayer • 2 personal exemptions when married, filing jointly • Personal exemption allowed on joint return for spouse who dies during the year. • If taxpayer claimed as a dependent on someone else’s tax return, then can NOT also claim a personal exemption on his/her own tax return. • Dependency Exemption allowed for: • Qualifying Child • Qualifying Relative

Dependency Exemptions • Qualifying Child • Relationship (blood, marriage or adoption) • Son, daughter, sibling, grandchild, niece or nephew • Domicile • Same principal residence as taxpayer for more than half the year • Children of divorced parents are claimed by custodial parent, unless written agreement allowing non-custodial parent to claim deduction • Age • Under 19 OR • Under 24 and full-time student • If disabled, there is no age limit • Must also meet joint return test and (usually) U.S. citizen or resident of U.S., Canada, or Mexico

Dependency Exemptions • Qualifying Relative - must meet ALL of the following “tests”: • Support • Relationship • Gross income • Joint return • Citizen/residency

Support Test • Taxpayer must provide more than 50% of the qualifying relative’s support • Only amounts expended are considered in the support test • Scholarships received by student NOT considered in the support test. • Exception to support test requirement – Multiple Support Agreement • Allows group providing > half support to claim individual even though no one person provides > 50% support • Eligible parties must provide > 10% of support • Each eligible party must meet all other dependency requirements • Example: Allows children of elderly parent to claim exemption for parent when none individually meets the 50% support test.

Relationship Test • Relationship (or household member) • Dependent must be 1 of the specified relatives... • qualifying child definition (e.g. child, sibling) • lineal ascendants (e.g. parent, grandparent) • collateral ascendants (e.g. aunt, uncle) • Certain in-laws (e.g. son, daughter, father, mother, brother, sister) • OR, if an unrelated party, be a member of the taxpayer’s household for the entire year. • Once a relationship is established by marriage, it continues even if there is a change in marital status.

Gross Income Test • Gross income • Dependent’s gross income (subject to tax) must be less than amount allowed for an exemption (i.e., $3,650 for 2009) • Does NOT include items that are exempt, such as: • Non-taxable portion of scholarships (for tuition and fees) • Social security benefits, to a limited extent (Complex formula; if AGI + foreign income excluded + TE income + ½ social security benefit <$25,000 if single and $34,000 if MFJ, then SS is not taxed)

Gross Income Test • Gross income • Example of gross income test (2009 tax year) • Grandparent (age 70) meets all dependency tests for taxpayer except has pension income of $4,500 and social security income of $8,000. Can he be claimed as a dependent? What if he only had social security income?

Other Tests • Joint return • Dependent cannot file a joint return with spouse unless: • Filing solely for refund of all taxes withheld • No tax liability exists for either spouse • Neither spouse required to file return • Citizen or residency • Dependent must be a U.S. citizen or a resident of U.S., Canada, or Mexico (for some part of the calendar year)

Phase Out of Exemptions • For 2009, phase-out of exemption benefits applies when taxpayer’s AGI exceeds: • $250,200 for married, filing jointly, or surviving spouse • $208,500 for head of household • $166,800 for single • $125,100 for married, filing separately • Exemptions deduction is reduced by 2% for every $2,500 ($1,250 for MFS) or part thereof, that AGI exceeds threshold amounts • For 2009, the phase-out amount calculated using this formula is reduced by 2/3 • Minimum exemption amount for 2009: $2,333 • Phase-outs do not apply 2010 onward.

Phase-Out Example • 2009, MFJ, 2 kids – How much is allowed for personal and dependency exemptions if: • AGI = $100,000 • AGI = $275,000

Kiddie Tax • Net unearned income (NUI) of child (if claimed as dependent) is taxed at parents’ rate: • Child under age 19 (or under 24 and full–time student) • NUI generally equals unearned income less $1,900 • Unearned income includes taxable interest, dividends, capital gains, rents, royalties, pension and annuity income, and unearned income from trusts • NUI taxed at parents’ rate • Remainder of child’s taxable income is taxed at child’s rate

Kiddie Tax – Example • In 2009, Son claimed as dependent on parents’ return has interest income of $2,900 and wages of $500. Parents’ rate is 35%. • How much tax is owed on Son’s income if son is 25 and a full-time student? • How much tax is owed on Son’s income if son is 20 and a full-time student?

Filing Status • There are 5 filing statuses • Single • Married, filing jointly • Surviving spouse (qualifying widow or widower) • Head of household • Married, filing separately • Filing status affects tax rate brackets, standard deduction, phase-out limits, limits on eligibility for certain deductions/credits (e.g. IRA, SS thresholds, child tax credit, etc…)

Filing Status • Married Filing Joint • Legally married last day of tax year • Do NOT have to be living together • Must have same tax year-end date • Both must be U.S. citizens or residents • MFJ can be used in year of spouse’s death • Surviving Spouse • Allows surviving spouse to use MFJ rates for two years after spouse’s death if following requirements met: • Qualified for MFJ in year of death, and has not remarried • Has at least one dependent child living at home during the entire year (must be a tax dependent) • Pays over 50% of expenses of the home

Filing Status • Head of Household • Single on last day of tax year • Or if legally married, meets “married persons who live apart” criteria - Lived apart last 6 months of the year (“abandoned spouse”) • U.S. Citizen or resident • Pays over 50% of the expenses of the household in which a dependent relative lives for more than half the year • Single • All unmarried taxpayers who do not qualify for Surviving Spouse or Head of Household status • Married Filing Separately – an option for married taxpayers, usually not financially beneficial

Payments Pursuant to Divorce • Alimony Payments (cash payments pursuant to divorce or separation agreement). • Deductible by payor • Includible in gross income of recipient • Property settlements • Transfer of property to former spouse • No deduction or recognized gain or loss for payor • Carryover of payor’s basis for recipient (not considered income to recipient) • Child support payments • Payments made to satisfy legal obligation to support child of taxpayer • Nondeductible by payor and not taxed to recipient (or child)

Special Rules for Individual Gross Income Items • Prizes and Awards - General rule is that FMV of item is included in income • Exceptions: • Taxpayer designates qualified organization to receive prize or award • Employee awards of tangible personal property made in recognition of length of service or safety achievement • Unemployment Compensation • Generally taxable in full. • For 2009: The first $2,400 of unemployment compensation is excluded from gross income.

Special Rules for Individual Gross Income Items • Social Security Benefits • Depending on income, up to 85% of benefits may be taxable • Taxability based on taxpayer’s modified adjusted gross income (MAGI) • MAGI = AGI + foreign earned income exclusion + tax exempt interest + ½ Social Security Benefit

Gifts and Inheritances • Gifts are nontaxable to donee if: • Transfer is voluntary without adequate consideration, and • Made because of affection, respect, admiration, charity, or donative intent • Inheritances are nontaxable to beneficiary. • Income earned on gifts or inheritances taxable to recipient under normal rules. • Transfers by employers to employees do NOT qualify as excludible gifts. • May be excludible under other provisions, e.g., employee achievement awards.

Scholarships and Fellowships • An amount paid to or for the benefit of a student to aid in pursuing a degree at an educational institution. • Nontaxable to extent of tuition and related expenses (e.g., fees, books, and equipment required for courses). • Amounts received for room and board are taxable.

Compensation for Injuries and Sickness • Personal injury damages • Compensatory damages received due to physicalpersonal injury are excludible • All other personal injury damages taxable. • Compensatory damages for nonphysical injury (e.g. loss of reputation). • All punitive damages. • Payments solely for loss of income are also taxable (unless relate to a physical injury).

Compensation for Injuries and Sickness • Workers’ compensation • Although may be payment for loss of wages, workers’ compensation is specifically excluded from gross income. • Accident and health insurance benefits • Benefits received under policy purchased by taxpayer excludible - even if substitute for income.

Itemized Deductions • Personal expenditures that are deductible FROM AGI as itemized deductions include: • Medical • Certain taxes • Certain interest expense • Charitable Contributions (covered in Ch. 5) • Casualty Losses (covered in Ch. 6) • Miscellaneous • Itemized deductions provide a tax benefit ONLY to extent that in total they exceed the standard deduction amount for the taxpayer.

Medical Expenses • Expenses paid for “diagnosis, cure, mitigation, treatment or prevention of disease” for taxpayer, spouse and dependents • Must be paid with after-tax dollars (e.g. not from a flexible spending account) and not compensated by insurance • Includes cost of insurance and travel (if necessary) • See Exhibit 16-4 for examples of deductible and non-deductible expenses. • There is currently a 7.5% of AGI floor – thus, only those expenses in excess of 7.5% of AGI are deductible (limit increases to 10% in 2013).

Taxes • State and Local Income Taxes or State Sales Tax (2008 and 2009) • Cash Basis taxpayers deduct when paid • Real Estate Taxes • Local benefit items are non-deductible • If property sold during year, must be apportioned between buyer and seller • Personal Property Tax • If ad valorem tax (i.e. based on value) imposed on annual basis then tax is deductible

Interest • Home Mortgage Interest • Qualified Residences (up to 2) • Aggregate maximum acquisition indebtedness = $1,000,000 • Points paid on loan to purchase or improve residence also deductible • Otherwise capitalize and amortize • Home Equity Loan Interest deductible on loan • Maximum loan principal is lesser of: • $100,000 or • FMV of residence less acquisition indebtedness

Interest • Investment Interest Expense • Deductible to the extent of net investment income. • “Investment income” includes gross income from interest, dividends, annuities, royalties (if not derived from business) • Net LTCGs/qualified dividends are treated as “investment income” ONLY if elected • However, if elected, LTCGs and qualified dividends do NOT receive preferential tax treatment (e.g., 15%/0% rate) • Any non-deductible amount can be carried-forward.

Investment Interest Example • In 2009, taxpayer has investment interest expense of $10,000 and investment income consisting of: • LTCG $4,500 • Interest Income $3,200 • How much of the $10,000 can t/p deduct in 2009? • If no special election made for LTCG • If elects treat LTCG as ordinary income

Charitable Contributions • Rules learned in Chapter 5 govern the determination of the deductible amount for non-cash property • Maximum limit for individuals • Generally 50% of AGI • Reduced to 30% of AGI for LTCG property or property contributed to non-operating private foundation • Can carryover amounts that exceed limit • There are strict substantiation requirements

Miscellaneous Itemized Deductions • Subject to 2% of AGI Floor • Unreimbursed employee business expenses • Job hunting costs • Investment related expenses (other than interest) • Hobby related expenses (to the extent of hobby income) • Tax advice/preparation expenses • NOT subject to a floor • Gambling losses (to the extent of gambling winnings) • Other (obscure) deductions

Phase-out of Itemized Deductions • For 2009, Itemized Deductions are subject to phase-out for high-income taxpayers. • 2009 threshold = $166,800 ($83,400 for MFS) • Phase out amount* = 3% X (AGI – threshold amount). • However, for 2008 and 2009, the phase-out ITSELF is being phased. • Actual phase-out = amount computed above X 1/3 *The book also provides an alternative calculation. The phase-out is the lesser of the two. However, the vast majority of the time the lesser amount is the 3% amount. • Phase-outs do not apply 2010 onward.

Itemized Deductions –Phase Out Example • MFJ Taxpayers with AGI = $235,000 and two dependent children have itemized deductions of $20,000 (before phaseout). • Compute their taxable income.

Common Credits Available to Individuals • Child and Dependent Care Credit • Credit ranges from 20%-35% (depending on income) of qualifying expenses up to $3,000 per qualifying child (maximum expenses of $6,000 for 2 or more qualifying children). (pg 16-56 to 58) • Earned Income Credit • Refundable credit (i.e. can result in negative income tax payments) for low-income taxpayers with dependent children. In 2009, maximum credit of $5,657 if three (3) qualifying children. • Adoption Expense Credit • Up to $12,150 in 2009, phase-out begins at AGI of $182,180. Completely phased-out for AGI of $222,180.

Common Credits Available to Individuals • Child Tax Credit • Education Credits • First-Time Home Buyer’s Credit – 2008 and 2009; recently expanded to mid-2010 • Making Work Pay Credit – 2009 • Energy-Related Credits – 2009 and 2010

Child Tax Credit • Credit amount • $1,000 per qualifying child through 2010. • Scheduled to revert to $500 per child in 2011. • Eligible children are: • Under age 17, • US citizen, and • Claimed as dependent on taxpayer’s tax return • Credit is phased out by $50 for each $1,000 of AGI above specified levels • $110,000 for joint filers (MFJ) • $55,000 for married filing separately (MFS) • $75,000 for Single, Head of Household

Child Tax Credit - Example • Tom and Nancy Cleaver, who file a joint return, have 2 qualifying children and an AGI of $120,000. How much is their child tax credit?

Taxation of Business Entities