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- determined by Gross Income – above the line deduction = AGI.
- AGI – itemized deductions = Taxable Income.
- TI x tax rate = tentative tax liability.
- TTL – credits = final tax liability
- Gross income includes any economic benefit or clearly realized accession to wealth (If not cash, FMV of property or services received).
- Prizes and windfalls are income.
- So are cancellations of indebtedness (but not reductions in purchase price), unless the debtor’s insolvent, bankrupt, or the cancellation is a gift.
- Property or funds received under a claim of right (rec'd w/out restriction as to use or disposition) are taxable even if the TxP later has to return/repay Funds/property received with restrictions as to use/disposition are not under a claim of right (funds in escrow pending appeal).
- Stolen is part of gross income.
- Increases in value aren’t taxed until there’s been a realization event - a sale or transfer of the asset.
Tax Benefit Rule
The tax benefit rule applies if a TxP claims a deduction but later recovers the property giving rise to the deduction. In that case, the TxP doesn’t amend the previous year but claims the amount deducted as income.
*Alimony & Child Support
- Alimony is income to the spouse who receives it and a deduction for the paying spouse.
- Child support is the opposite - the receiver doesn’t count it as income and the payor doesn’t deduct it.
- Alimony must be pursuant to a written divorce or separation agreement.
- The payor and payee can’t live in the same household.
- Payments must be in cash (not property) and cease by the donee’s death.
- Alimony disguised as child support counts as child support. If a payor's payments reduce with the child leaving the home or turning a certain age, the reduction is child support, and the remainder is alimony.
Life insurance proceeds are excluded if received in a lump-sum at death of insured. Any interest counts as income.
- Gross income does not include amounts rec'd be bequest, devise, or inheritance.
- But if compensation for work it is taxed.
- Gifts (transfers made out of detached and disinterested generosity - love, affection) are excluded.
- Look carefully to determine that it is not compensation.
- Irrebutable presumption that ER's don't make gifts to EE's
- Tort damages received for physical injuries, including lost wages, and sickness are excluded
- Punitive damages and damages for emotional distress are not considered “on account of personal injury” and count as income
- Qualified scholarships for tuition and related expenses (not room/board) are excluded.
- Careful about ER's and EE's.
Benefits from ER's
- If an employee receives health insurance, he doesn’t have to count as income the premiums him employer pays or any reimbursements his employer pays to him for his medical expenses.
- Employees also do not have to include premiums for the first $50k in life insurance.
- Meals and lodging provided in-kind for the employer’s convenience on his premises are excluded.
- So are other fringe benefits: de minimus, no additional cost (plane tickets to standby airline employees), qualified employee discounts, pension plan contributions, and employee awards made at a ceremony
Deductions and Exemptions
Above the Line (arriving at AGI)
Above the line deductions include ordinary and necessary business expenses (salaries to employees, rent, supplies, business interest, business taxes), depreciation of business property (not personal property), net losses on capital assets (cap of $3k/yr), alimony, work-related moving expenses not reimbursed (reimbursement excluded).
Below the Line
- Below the line (itemized) deductions include interest on home mortgages up to 1$M and home equity loans up to $100k, state and local government taxes, unreimbursed sudden and unexpected casualty losses over $100 to the extent they exceed 10% of AGI, unreimbursed medical expenses to the extent they exceed 7.5% in aggregate, charitable contributions where there is no direct personal benefit, and miscellaneous (unreimbursed employee expenses, educational expenses to maintain skills) to the extent they exceed 2% of AGI in aggregate.
- Personal expenses (commuting expenses, clothes) are not deductible.
- TxPs receive an exemption for themselves and one for each dependent (people, not pets).
- Unless there’s a written release, the custodial parent gets the exemption after divorce.
Allocation of Tax
- Income is allocated to the person who earns it (can't shift by directing to another person) or to the person who owns the property.
- Life tenants are considered owners for tax purposes
- Under cash method accounting, income is reported when payment is received and deductions occur when payment was made. *A TxP has contructive receipt when funds/property are credited to her account, made available so she may draw upon them.
- Under accrual method accounting, income is reported when the TxP incurs the right to receive it. Deductions are taken when liability’s been established and the amount can be determined with reasonable accuracy.
Gains/Losses on Property
- Gains on property are realized when there’s been a sale, disposition, or exchange.
- The gain is the amount realized minus adjusted basis.
- The amount realized include mortgages/liabilities the buyer assumes.
- If I sell my property for $600k, but the buyer assumes my $500k mortgage, the amount realized is $1.1M. If I bought it for $700k, my basis is $700k; so my gain is $400k.
- Improving the property increases basis.
- Depreciation and tax-free basis recoveries (corporate payments not from profit/earnings) reduce basis.
- A person gets substituted/carryover basis if they receive property as *a gift or part of *a divorce settlement.
- *Inherited property gets stepped up basis (assets worth more than when initially obtained), the FMV at decedent’s death.
Generally, a TxP recognizes his gain when he realizes it. There are exceptions for involuntary conversions (lost, damaged, converted to money, and TxP buys similar replacement property within 2 yrs), like-kind exchanges of trade/business property (real estate swaps), and *sale of a primary residence ($250/500k, lived in it for 2 of the last 5 yrs; can only use every 2 years).
- Capital gains are taxed at a lower rate (15%) than ordinary income.
- Gains are capital if they are made on capital assets (investment assets held for > 1 yr - stock, real estate; not inventory, depreciable property, copyrights).
- Ordinary income includes salary, rents, interest, royalties.
- LLCs, S-Corps (<100 shareholders), and partnerships are single-tax entities.
- They are pass-through entities and pay no tax on their own.
- The members/SHs/partners pay their share whether or not they actually receive it.
- Formation is a tax free event.
- If the business reinvests the gain, they members still pay tax.
- C-Corps are double-tax entities, and publicly traded partnerships are treated as corporations for tax purposes.
- LLCs and S-Corps offer the best of both worlds because they also have limited liability.
- Double Tax: Corporations pay tax, and their shareholders also pay tax on their dividends (unless the corporation doesn’t have any profits/earnings that year, then the money received is tax-free recovery of the SHs basis in her stock, and her basis is reduced by that amount. Any money in excess of basis is gain).
- Corporations don’t receive gains for tax purposes when they receive money and property upon formation.
- The shareholders who contribute that money and property (but not services) don’t have income from the stock they receive in exchange if they retain at least 80% of the outstanding shares.
ESTATE & GIFT TAXATION
- The donor pays. Upon a wealth transfer to another.
- A unified rate structure is applied.
- Gift taxes are imposed on any completed or irrevocable donative transfer (anything less than adequate consideration) - bargain sales and interest-free loans to family members, joint bank accounts.
- *TxPs may exclude $13k/donee/yr (up to $5M for estate tax purposes), and transfers to spouses are unlimited.
- Estate taxes apply to estates over $5M.
- In 2010, decedent’s estates can either pay the estate tax and give stepped-up basis or not pay it and give carryover basis.
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