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Introduction to Income Tax Planning Virtual Class 1 of 3

Introduction to Income Tax Planning Virtual Class 1 of 3. Form 1040 – Course Overview, Income Tax Law Fundamentals, Gross Income, Income Tax Fundamentals and Calculations, Alternative Minimum Tax (AMT), and Tax Accounting. Add Value to Your Practice!.

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Introduction to Income Tax Planning Virtual Class 1 of 3

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  1. Introduction to Income Tax PlanningVirtual Class 1 of 3 Form 1040 – Course Overview, Income Tax Law Fundamentals, Gross Income, Income Tax Fundamentals and Calculations, Alternative Minimum Tax (AMT), and Tax Accounting Tax Planning – Session 1 of 3

  2. Add Value to Your Practice! • The difference between a good planner and a great planner is knowledge of the tax code. • Understanding tax issues will help you in all major areas of the financial planning curriculum. • Attain knowledge of- • AMT • Basis • Property disposition • At-risk rules and Passive Activity Loss rules Tax Planning – Session 1 of 3

  3. Income Tax Law Fundamentals Sources of authority • Primary - In tax court or before the IRS, only primary sources of authority carry any weight. • Congress passes the laws (legislative branch). • Treasury department (via the IRS) enforces the laws (executive branch). • Tax court interprets the law (judicial branch). Tax Planning – Session 1 of 3

  4. Income Tax Law Fundamentals Sources of authority • Secondary - The major sources are listed below. All explain the IRC. • RIA – Research Institute of America • CCH – Commerce Clearing House • BNA – Bureau of National Affairs Tax Planning – Session 1 of 3

  5. Income Tax Law Fundamentals Research sources • Treasury Regulations carry the “full force and effect of the law”. • Congressional Committee Reports show Congress’s intent of the law. • Revenue Rulings are published by the IRS. A taxpayer can cite as precedent in a similar situation. • TAM – Technical Advice Memos can also be cited as precedent for a taxpayer in a similar situation. • Private Letter Rulings only apply to a taxpayer for whom it was written. No guarantee the IRS will treat a different taxpayer in the same way. Tax Planning – Session 1 of 3

  6. Gross Income IRC defines as: “Except as otherwise provided . . . gross income means all income from whatever source derived.” Key gross income inclusions as they relate to the curriculum: • Debt cancellation if not bankrupt • K-1 pass through income/loss from S corps, partnerships, and LLCs • Sole proprietor (schedule C) income • Capital gains/losses (schedule D) • Dividends and interest (schedule B) • Salary, bonuses, wages, tips, unemployment compensation, severance pay, back-pay • Qualifying alimony received • Gambling winnings • Personal nonphysical damages, punitive damages, court awards and damages if they replace income • Recapture from the disposition of Section 1231 property • Distributions from IRA, SEP, SIMPLE, other qualified plans, pensions, and the taxable portion of annuity payments • Rental income/loss, royalties • Taxable Social Security benefits • Imputed income Tax Planning – Session 1 of 3

  7. Gross Income – Key Exclusions Key gross income exclusions as they relate to the curriculum: • Life insurance proceeds • Life insurance death benefits paid to terminally ill • Gifts received and inheritances • Municipal bond interest • Child support • Certain life insurance dividends and other items that are considered a return of capital • Withdrawals of §529 plans if used to pay educational expenses • Employer paid group life insurance up to $50,000 • Educational assistance provided by the employer up to $5,250 • §121 exclusions subject to certain limits (sale of a personal residence) • Disability income for the portion of employee paid premiums • Workers compensation Tax Planning – Session 1 of 3

  8. Imputed Interest Income • The IRS is authorized to impute an interest charge if the taxpayer charges less than an adequate rate of interest. • IRS looks closely at three situations: • Gift loans – provided out of love, affection, or generosity • Corporate shareholder loans – from a corporation to its shareholder • Compensation-related loans – from employer to employee Tax Planning – Session 1 of 3

  9. Imputed Interest Income 5 exceptions when imputed income does not apply: • Loans between individuals totaling $10,000 or less; except when the borrowed funds are used to purchase income-producing property • Corporate loans and compensation related loans totaling $10,000 or less • Debt subject to original issue discount provisions • Sales of property for $3,000 or less • When all of the payments are due within six months Tax Planning – Session 1 of 3

  10. Imputed Interest Income • When loans exceed $100,000, the imputed interest is charged based on the Applicable Federal Rate (AFR) • When loans are greater than $10,000 and up to and including $100,000, the imputed interest is the lesser of the AFR or the borrower’s net investment income • If borrower’s net investment income is $1,000 or less, imputed income will not apply Tax Planning – Session 1 of 3

  11. Examples in the $10,001 - $100,000 Range Assume that the Applicable Federal Rate (AFR) = 7%, and the term of loan is one year Loan Amount Net Investment Income The Lender Imputes $10,000 $100,000 $100,000 $100,000 $100,100 N/A $1,000 $1,800 $7,300 N/A $0. (The loan was for $10,000 or less.) $0. (The net investment income was $1,000 or less.) $1,800 (This would be less than the AFR amount.) $7,000 (the AFR amount - it is less than net investment income.) $7,007 (the AFR amount - the net investment income does not matter. Tax Planning – Session 1 of 3

  12. Income Tax Fundamentals and Calculations Basic Formula of Tax Return Income from whatever source derived Minus: Exclusions Gross Income Minus: Deductions for adjusted gross income Adjusted Gross Income Minus: Deductions from adjusted gross income: Greater of itemized deductions or the standard deduction Personal and dependency exemptions Taxable Income Times: Tax rate or rates (from tax table or schedule) Gross Tax Minus: Tax credits Final Tax Due Minus: prepayments (withholdings and estimated payments) Net tax payable or refund due $ xxx,xxx (xxx) $ xx,xxx (xxx) $ x,xxx (xx) (xx) $ x,xxx .xx $ xx (x) $ xx (x) $ xx Tax Planning – Session 1 of 3

  13. What is the Marginal Tax Bracket? • In a progressive tax system, the marginal tax (MTB) is the highest bracket in which that the taxpayer pays taxes - based on their last dollar of taxable income • The MTB is usually used for analysis purposes 2012 TAX RATES Married Filing Jointly (MFJ) Tax Rates Single (S) 10% 15% 25% 28% 33% 35% 0 – 8,700 8,701 – 35,350 35,351 – 85,650 85,651 – 178,650 178,651 – 388,350 Over 388,350 0 – 17,400 17,401 – 70,700 70,701 – 142,700 142,701 – 217,450 217,451 – 388,350 Over 388,350 Tax Planning – Session 1 of 3

  14. Tax Credits vs. Tax Deductions • Tax credit is a dollar for dollar reduction of taxpayer’s tax liability • Tax deduction reduces taxable income; therefore tax liability is reduced by deduction times marginal tax bracket • Need to know how to calculate: • Equivalent deduction given a tax credit TC / MTB = Equivalent tax deduction • Equivalent tax credit given a tax deduction TD X MTB = Equivalent tax credit Tax Planning – Session 1 of 3

  15. Equivalent Deduction • A Taxpayer has a dependent care credit of $1,200 and is in the 35% marginaltax bracket. Calculate an equivalent tax deduction: $1,200 / .35 = $3,429 • A Taxpayer has a dependent care credit of $1,200 and is in the 25% marginaltax bracket. Calculate an equivalent tax deduction: $1,200 / .25 = $4,800 • A Taxpayer has a dependent care credit of $1,200 and is in the 15% marginaltax bracket. Calculate an equivalent tax deduction: $1,200 / .15 = $8,000 Tax Planning – Session 1 of 3

  16. Equivalent Tax Credit • Taxpayer has a tax deduction of $2,000 and is in the 35% marginal tax bracket. Calculate an equivalent tax credit: $2,000 X .35 = $700 • Taxpayer has a tax deduction of $2,000 and is in the 25% marginaltax bracket. Calculate an equivalent tax credit: $2,000 X .25 = $500 • Taxpayer has a tax deduction of $2,000 and is in the 15% marginaltax bracket. Calculate an equivalent tax credit: $2,000 X .15 = $300 Tax Planning – Session 1 of 3

  17. Itemized Tax Deductions Taxpayer is allowed the greater of either the standard deduction or itemized deductions Itemized deductions (Schedule A) • Medical and Dental Expenses • Taxes You Paid • Interest Paid • Gifts to Charity • Casualty and Theft Losses • Job Expenses and Certain Miscellaneous Deductions Tax Planning – Session 1 of 3

  18. Medical and Dental Expenses • Unreimbursed qualifying expenses that exceed 7.5% of taxpayer’s AGI • Generally, you will not have to worry about the minutia of what qualifying expenses are – • With the exception of long-term care premiums Tax Planning – Session 1 of 3

  19. Taxes You Paid • These include: • State and local income taxes OR sales tax (which ever is greater) • Property taxes paid on your primary and secondary residences • Property or excise taxes paid on your automobiles and/or boats, trailers, etc. Tax Planning – Session 1 of 3

  20. Interest Paid • Acquisition debt up to $1,000,000 for primary and secondary residences only • Home equity loans up to $100,000 (used for any purpose) • Investment Interest (i.e. margin account) limited to net investment income Tax Planning – Session 1 of 3

  21. Gifts to Charity • Overall limit of 50% of AGI • We will discuss property type, valuation limits, and the so-called 30% and 50% organizations during our last virtual class in taxes Tax Planning – Session 1 of 3

  22. Casualty and Theft Losses • Procedure for determining deduction begins with valuation, which is the lesser of FMV or basis • Then subtract any reimbursements (i.e. insurance payments) • Then subtract a special $100 deductible This procedure is for each casualty and theft loss during the tax year. Finally, the result from above is subject to a 10% of AGI threshold Tax Planning – Session 1 of 3

  23. Casualty and Theft Loss Example Tom and June Clever have an adjusted gross income (AGI) of $138,000 for the current tax year. June was bathing and her diamond engagement ring came off and went down the drain. Unfortunately, Tom did not have any special endorsement on their homeowners policy and the insurance company only paid them $1,000 for the ring. Tom had paid $16,000 for the ring several years ago and the FMV at the time of the loss was $22,000. How much can they deduct for the lost ring? Lesser of FMV or basis Subtract the reimbursement Subtract the special deductable Subtract the 10% AGI Threshold Deductable loss $ 16,000 1,000 100 $13,800 $1,100 - - - Tax Planning – Session 1 of 3

  24. Job Expenses and Certain Miscellaneous Deductions • There are two types of miscellaneous deductions • Deductions that are not subject to a 2% of AGI threshold • Deductions that are subject to a 2% of AGI threshold Tax Planning – Session 1 of 3

  25. Deductions not subject to 2% of AGI Threshold • Gambling losses – these losses are limited to gambling winnings • Job related expenses for a handicapped individual • Recoupment of basis in an annuity contract Tax Planning – Session 1 of 3

  26. Deductions that are subject to a 2% of AGI Threshold • Unreimbursed business expenses • Income tax preparation fees • Investment related expenses – other than investment interest (Investment advisor fees, custodial fees, subscriptions to WSJ, IBD, etc.) Tax Planning – Session 1 of 3

  27. What is Net Investment Income? • Net investment income is important because it is part of the calculation for: • imputed interest • determining how much investment interest is deductible • Net investment income is gross investment income less “deductible” other investment related expenses (miscellaneous deductions subject to 2% of AGI threshold) • Once you determine the “deductible” other investment related expenses, the question becomes: What is gross investment income? Tax Planning – Session 1 of 3

  28. What is Gross Investment Income? • Default items include: • Taxable interest • Non-qualifying dividends • Short-term capital gains • An election is available to the taxpayer to include any dollar amount of: • Qualifying dividends • Long-term capital gains • Taxpayer forfeits their 15%/0% tax rate on any elected amounts to be included in gross investment income Tax Planning – Session 1 of 3

  29. Example of Investment Interest Deduction • Selected items from tax return • Adjusted gross income (AGI) • Taxable interest • Tax-exempt interest • Qualifying dividends • Non-qualifying dividends • Short-term capital gains • Long-term capital gains • Investment advisor fees • Investment interest expense $ 150,000 1,900 3,000 1,000 2,100 500 2,200 5,000 3,800 How much investment interest is deductible? I can deduct investment interest to the extent of my net investment income What is my net investment income (NII)? My NII is my gross investment income – “deductible” other investment expenses What are my “deductible” other investment expenses (I/A fees)? $5,000 – ($150,000 X .02) = $2,000 What is my gross investment income? → (1,900 + 2,100 + 500) = $4,500 What is my NII? → $4,500 - $2,000 = $2,500; therefore I can deduct $2,500 Tax Planning – Session 1 of 3

  30. Tax Credits • CFP Board’s focus on tax credits has been on the long-term credits that have been in the Code for a while, not on the special credits that may change annually. • Child and dependent care expenses • Child tax credit • American Opportunity Tax Credit (AOTC) • Lifetime Learning tax credit • Adoption tax credit Tax Planning – Session 1 of 3

  31. Kiddie Tax • If the Kiddie tax rules apply, any unearned income over $1,900 will automatically be taxed at the parent’s rate • Child will be entitled to a standard deduction which is the greater of $950 or earned income plus $300, not to exceed the otherwise allowable standard amount of $5,950 (2012) • If the child turns age 18 in the tax year, the kiddie tax rules will still apply if the child’s earned income is equal to 50% or less of the child’s support cost • If the child is 19 to 23, the kiddie tax rules will still apply if the child’s earned income is equal to 50% or less of the child’s support cost AND the child is at least a full-time student Tax Planning – Session 1 of 3

  32. Calculation ofSelf-employment (SE) Tax There are two possible situations: 1. SE earnings X .9235 + other W-2 wages <= $110,100 • SE net earnings X .9235 X .133 = SE Tax 2. SE earnings X .9235 + other W-2 wages > $110,100 • SE net earnings X .9235 X .029 = Medicare Tax • ($110,100 - W-2 wages) X .104 = OASDI tax • Add together for the total self-employment tax due NOTE: Approximately one-half of SE tax due is a deduction for AGI Tax Planning – Session 1 of 3

  33. Alternative Minimum Tax (AMT) • Established in 1969 and was originally known as an “add on tax” • In 1978, it became the Alternative Minimum Tax and is essentially the same system we have today • The AMT method is always done in conjunction with the regular tax system • Every taxpayer should have their taxes prepared with computer software so any AMT exposure is not missed • The tax liability, as determined by the AMT method, is the minimum amount (a floor) of tax liability owed to the government • The vast majority of American taxpayers still have a higher regular tax liability versus the AMT liability and therefore pay more than what is required under AMT • When AMT liability exceeds the regular tax liability, the difference is known as “AMT payable” Tax Planning – Session 1 of 3

  34. AMT Mechanics • The tax return (as well as the AMT module in the course content) describe the procedure for determining AMT as beginning with the regular taxable income and working backwards, making many adjustments to arrive at AMTI – Alternative Minimum Taxable Income • An easier method to arrive at AMTI is to begin with AGI, add preference items, and then subtract the allowable itemized deductions • Then subtract the allowable AMT exemption (subject to phaseout) to arrive at the AMT base • The first $175,000 of AMT base is taxed at a flat 26%, and any amount of AMT base that exceeds $175,000 is taxed at 28% • Note that the AMT method still honors the favorable 15%/0% rate on qualifying dividends and long-term capital gains • Taxpayer is responsible for paying the higher of the two liabilities → AMT or regular tax Tax Planning – Session 1 of 3

  35. Preference Items and Adjustments • Source of confusion – there are two types of adjustments. • There are adjustments made to taxable income to calculate AMTI. Examples include adding back personal exemptions and adding back certain itemized deductions such as taxes paid and miscellaneous deductions • There are “adjustments” in the tax code that people generically refer to as preference items. Examples include the bargain element on the exercise of an Incentive Stock Option (ISO), and the completed contract method restated to the percentage of completion method under the AMT methodology • These “adjustments” in the tax code are also referred to as deferrals, since the AMT exposure that results is temporary and will reverse over time Tax Planning – Session 1 of 3

  36. Preference Items Preference items from the tax code: • Interest earned on private-activity bonds (Except for bonds issued in 2009 and 2010 – part of the American Reinvestment and Recovery Act of 2009 {ARRA}) • Excess of accelerated over hypothetical straight-line depreciation on both real and leased property placed in service before 1987 • 3.5% of the total gain (or 7% of the excluded gain) on §1202 (small business) stock • Excess of amortization allowance over depreciation on pollution control facilities • Percentage depletion in excess of a property’s adjusted basis (mining properties) • Excess intangible drilling costs reduced by 65% on the net income from oil, gas, and geothermal properties Key • = More Important • = Less Important Tax Planning – Session 1 of 3

  37. Adjustments • Adjustments in the tax code (referred to as “preference items” by most people) • Bargain element of an ISO (Incentive Stock Option) • Completed contract has to be restated to the percentage of completion method • Real property placed in service after 1986 and before 1999 – the difference between the MACRS depreciation claimed using the property’s actual recovery period and the hypothetical straight-line method of depreciation using a 40-year life • Personal property placed in service after 1998 – the adjustment is the difference in depreciation between the MACRS method and the 150% declining balance method • These adjustments are known as deferrals since they are merely timing differences, and the AMT exposure will reverse over time Tax Planning – Session 1 of 3

  38. Other Adjustments • These adjustments would be made to taxable income under the regular method to arrive at AMTI • Add back the amount taken for personal exemptions • Add back the standard deduction if the taxpayer does not itemize • Reduce regular taxable income by the itemized deduction reduction (if applicable – currently suspended) • Add back to taxable income all of the itemized deductions that are not allowed under AMT such as property taxes, income taxes, and miscellaneous deductions • Make an adjustment to allow for the favorable 15%/0% tax rate on qualifying dividends and long-term capital gains Tax Planning – Session 1 of 3

  39. Exclusion Items Vs. Deferral Items • Exclusions are items that create a permanent exposure to AMT such as certain private-activity municipal bonds and taxable income adjustments like taxes paid • Deferral items create a temporary exposure to AMT and are merely timing differences such as the bargain element of an ISO and the treatment for long-term contract accounting Tax Planning – Session 1 of 3

  40. Allowable Itemized Deductions Under the AMT Method • GIMICC • Gambling losses – still limited to winnings; just like regular method • Interest on home mortgage (acquisition debt up to $1 million) NOTE: Home equity loan interest is NOT allowed under AMT unless proceeds were used for home improvements, i.e. considered acquisition debt • Medical expenses are allowed but only to the extent they exceed 10% of AGI • Investment interest is allowed – still limited to net investment income • Casualty and theft losses – same treatment under the regular method • Charitable contributions – overall limit is 50% of AGI Estate tax deduction on IRD – Income in respect of a decedent (less important) Tax Planning – Session 1 of 3

  41. AMT Credit: Creation, Usage and Limitations • AMT credit is created when a taxpayer has AMT exposure that resulted from a deferral item (timing difference) • Credit can be used to the extent that regular tax liability is greater than the AMT liability • Credit is limited and can not be used in years when the AMT liability exceeds the regular liability • Can be carried over until final tax return Tax Planning – Session 1 of 3

  42. AMT Planning • If a taxpayer is subject to AMT in the current tax year: • Accelerate income into the AMT year • Defer tax deductions until a regular tax year • Optimal strategy would be to do as above until the AMT liability equals the regular liability Tax Planning – Session 1 of 3

  43. Accounting Methods • Cash method • Accrual method • Hybrid method Tax Planning – Session 1 of 3

  44. Cash Method • Recognizes expenses when they are actually paid and revenue when they are actually received or constructively received • Constructive receipt occurs when the funds are available without restriction Tax Planning – Session 1 of 3

  45. Accrual Method • Revenue is recognized when the right to receive it exists (i.e. accounts receivable); not when the payment is actually received • The all events test is used for revenue determination • The right to receive income is established and not contingent upon a future event • The amount can be estimated with reasonable accuracy • Expenses are recognized when the liability can clearly be established – not when the payment is actually made • The all events test is used for expense determination • Determine liability exists (contingent expenses not allowed) • The amount can be estimated with reasonable accuracy • Economic performance must have occurred (was the work done?) Tax Planning – Session 1 of 3

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