TAXATION FOR DECISION MAKERS 2008 EDITION pdf

2 The Tax Practice Environment 41part II INCOME AND EXPENSE DETERMINATION 86 3 Determining Gross Income 87 4 Employee Compensation 131 5 Business Expenses 182 part III PROPERTYCONCEPTS A

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2 The Tax Practice Environment 41

part II INCOME AND EXPENSE DETERMINATION 86

3 Determining Gross Income 87

4 Employee Compensation 131

5 Business Expenses 182

part III PROPERTYCONCEPTS AND TRANSACTIONS 227

6 Property Acquisitions and Cost Recovery Deductions 228

7 Property Dispositions 263

8 Tax-Deferred Exchanges 308

part IV BUSINESS TAXATION 349

9 Taxation of Corporations 350

10 Sole Proprietorships and Flow-Through Entities 394

part V TAXATION OFINDIVIDUALS435

11 Income Taxation of Individuals 436

12 Wealth Transfer Taxes 488

Appendix A Tax Research Using RIA Checkpoint® 523

Appendix B Present Value and Future Value Tables 543

Appendix C Sample Filled-in Tax Returns 545

Appendix D Tax Return Problems 569

Index 577

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Preface xii

part I INTRODUCTION TO TAXATION AND ITS ENVIRONMENT 1 1 An Introduction to Taxation 2

Key Concepts 2

Setting the Stage—An Introductory Case 3

An Introduction to Taxation 3

What Is a Tax? 3 A Brief History of Income Taxation in the United States 3 Objectives of Taxation 4 Current Influences on the Tax Law 5 The Taxing Units and the Basic Income Tax Models 6

The Individual and Corporate Tax Models 7 Gross Income 8 • Property Transactions 10 • Deductions 11 • Determining the Gross Tax Liability 14 • Tax Losses 15 • Additions to the Tax Liability 16 • Tax Prepayments and Credits 16 Other Entities 17 Choice of Business Entity 18

Sole Proprietorships 19 Partnerships 20 Partner’s Basis Account 20 Corporations 21 S Corporations 22 Comparing Business Entity Attributes 23 Other Types of Taxes 23

Wealth Taxes 23 Wealth Transfer Taxes 25 Consumption Taxes 26 Tariffs and Duties 27 Types of Tax Rate Systems 28

The Progressive Tax Rate System 28 Proportional “Flat” Tax Rate 30 Regressive Taxes 30 Characteristics of a Good Tax 31

Equity 31 Economy 32 Certainty 33 Convenience 33 Revisiting the Introductory Case 33

Summary 34

Key Terms 35

Test Yourself 35

Problem Assignments 35

Check Your Understanding 35 Crunch the Numbers 36 Think Outside the Text 38 Identify the Issues 39 Search the Internet 39 Develop Planning Skills 40 Answers to Test Yourself 40

2 The Tax Practice Environment 41

Key Concepts 41

An Introduction to Tax Practice 42

Taxes and Cash Flow 43

Cash Flows and Present Value 43 Significance of the Marginal Tax Rate 44 Tax Planning Strategies 45

Timing Income and Deductions 45 Income Shifting 46 Changing the Character of Income 47 Other Factors Affecting Tax Planning 48 Cash Flow 48 • Nontax Considerations and Judicial Doctrines 49 Sources of Authority 51 The Legislative Process 51

Internal Revenue Code 53 Administrative Sources of Authority 54

Treasury Regulations 54 • Other IRS Rulings 55

Judicial Sources of Authority 55

Table of Contents

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What Is Income? 88

Taxable versus Gross Income 88 Tax versus Financial Accounting 89 Return of Capital Principle 89 When Is Income Recognized? 90

The Tax Year 91 Accounting Methods 93 Cash Method 93 Limits on Use of Cash Method 94 Accrual Method 95 Who Recognizes the Income? 96

Assignment of Income Doctrine 96 Community Property Laws 97 Sources of Income 97

Interest Income 97 Interest on Municipal Bonds 97 • Original Issue Discount 99 • Market Discount 100 • Below-Market-Rate and Interest-Free Loans 100 Dividend Income 102 Stock Dividends 103 Annuity Income 104 Transfers from Others 105 Prizes and Awards 105 • Government Transfer Payments 105 • Legal Settlements 107 Discharge of Indebtedness 109 Tax Benefit Rule 110 Exclusions 110

Gifts and Inheritances 110 Insurance Proceeds 111 Life Insurance 111 • Accident and Health Insurance 113 Scholarships 114 Other Exclusions 114 Jurisdictional Issues 115

International Issues 115 Taxpayers Subject to U.S Taxation 116 State and Local Taxation 117 Expanded Topics—Special Methods 118

Installment Method 118 Long-Term Contracts 119 Revisiting the Introductory Case 120

Summary 121

Key Terms 122

Test Yourself 122

Problem Assignments 123

Check Your Understanding 123 Crunch the Numbers 124 Think Outside the Text 127 Identify the Issues 128 Develop Research Skills 128 Tax Research 57

Gather the Facts and Identify the Issues 57 Locate and Evaluate the Relevant Authority 57 Communicate the Recommendations 58 Keeping Up-To-Date 59 Tax Compliance 59

Filing a Tax Return 59 Late Filing and Late Payment Penalties 60 • Statute of Limitations 60 Selecting Returns for Audit 61 Types of Audits 63 The Appeals Procedure 63 Taxpayer Noncompliance Penalties 64 Collection Procedures 65 Offer in Compromise 65 • Innocent Spouse Relief 65 Professional Responsibilities and Ethics 66 Avoidance versus Evasion 66 • Tax Preparer Penalties 66 Tax Professionals’ Dual Responsibilities 67 Sources of Guidance 67 Revisiting the Introductory Case 70

Summary 70

Key Terms 71

Test Yourself 71

Problem Assignments 72

Check Your Understanding 72 Crunch the Numbers 73 Think Outside the Text 74 Identify the Issues 75 Develop Research Skills 75 Search the Internet 77 Develop Planning Skills 77 Answers to Test Yourself 79

Appendix 2A Tax Research 79

Gather the Facts and Identify the Issues 79 Locate and Evaluate the Relevant Authorities 79 Reading the Code 80 • Committee Reports 80 • Regulations 80 Revenue Rulings and Letter Rulings 80 • Acquiescence Policy 80 • Other Pronouncements 81 • Court Decisions 81 • Using a Citator 83 • When to Stop Researching 83 Communicating the Recommendations 83 Problem Assignments 85 Check Your Understanding 85 part II INCOME AND EXPENSE DETERMINATION 86 3 Determining Gross Income 87

Key Concepts 87

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Credit for Foreign Taxes 167 Moving Expenses 168 Tax Reimbursement Plans 168 Tax Treaties 169

Revisiting the Introductory Case 169

Summary 170

Key Terms 171

Check Your Understanding 172 Crunch the Numbers 173 Think Outside the Text 177 Identify the Issues 177 Develop Research Skills 178 Search the Internet 179 Develop Planning Skills 179 Answers to Test Yourself 180

5 Business Expenses 182

Key Concepts 182

Setting the Stage—An Introductory Case 183

Criteria for Deductibility 183

General Provisions for Trade or Business Expenses 183 Ordinary and Necessary 184 Contrary to Public Policy 185 Related to Tax-Exempt Income 185 Accrued to Related Party 186 Obligation of Another Taxpayer 186 Substantiation 186 Timing of Deductions 187

Accrual Method 187 Cash Method 188 Restrictions on Prepaid Expenses 189 Disputed Liabilities 190 Costs of Starting a Business 190

Business Investigation and Start-up Expenses 191 Organization Costs 192 Operating Expenses 192

Business Meals and Entertainment 192 Directly Related to or Associated with Entertainment 193 • Restrictions on Deductions 193 Travel and Transportation Expenses 194 Travel Away from Home 194 • Temporary Assignments 195 • Transportation Expenses 195 • Combining Business with Pleasure Travel 196 Bad Debt Expenses 197 Insurance Premiums 198 Legal Expenses 198 Taxes 198 Search the Internet 129 Develop Planning Skills 129 Answers to Test Yourself 130

4 Employee Compensation 131

Employee Compensation 132

Payroll Taxes 132 Employee versus Independent Contractor 133 Timing of Compensation Deduction 135 Reasonable Compensation 135 S Corporations and Unreasonably Low Salaries 136 • Employing Children 136 Employee Fringe Benefits 137

Group Term Life Insurance Premiums 139 Health and Accident Insurance Premiums 140 Child and Dependent Care Programs 140 Cafeteria Plans 141 Meals and Lodging 141 No-Additional-Cost Services 142 Employee Purchase Discounts 143 Employee Achievement Awards 143 De Minimis Fringe Benefits 143 Working Condition Fringe Benefits 144 Employee Relocation Expenses 146 Distance Test 146 • Time Test 147 Education Expenses 147 Substantiating Business Expenses 150 Employee Stock and Stock Options 150

Restricted Stock 151 Stock Options 152 Nonqualified Stock Options 152 • Incentive Stock Options 153 Phantom Stock and Stock Appreciation Rights 154 Deferred Compensation and Retirement Planning 154

Qualified Retirement Plans 154 Types of Retirement Plans 156 Contribution Limits 157 Nonqualified Deferred Compensation Plans 158 Individual Retirement Accounts 159 Roth IRAs 160 Self-Employed Individuals 161

Employment Tax Consequences 162 Fringe Benefits Limited 163 Retirement Plans 163 Expanded Topics—Foreign Assignments 165

Foreign Earned Income Exclusion 165

Excess Housing Cost Exclusion 166

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Limited Expense Deductions 199

Residential Rental Property 199 Home Office Expenses 201 Hobby Expenses 203 Expanded Topics—Book/Tax Differences 204

Accounting for Income Tax Expense 204 Calculating Tax Expense 206 • Effects of NOL Carryovers 207 • Realizing Deferred Tax Assets 208 • FIN 48: Accounting for Uncertainty in Income Taxes 209 • APB 23 Exception for Foreign Earnings 211 UNICAP Rules and Inventory 212 Revisiting the Introductory Case 213

Summary 214

Key Terms 215

part III PROPERTYCONCEPTS AND TRANSATIONS 227 6 Property Acquisitions and Cost Recovery Deductions 228

Capital Expenditures 229

Basis of Property 230

Acquisition in a Taxable Exchange 232 Acquisition by Gift 232 Acquisition by Inheritance 233 Cash Flow and After-Tax Cost 234

MACRS 235

Averaging Conventions 236 Half-Year Averaging Convention 236 • Mid-Quarter Averaging Convention 237 • Mid-Month Averaging Convention for Realty 238 Year of Disposition 240 Alternative Depreciation System (ADS) 240 Section 179 Expensing Election 241 Provisions Limiting Depreciation 243

Mixed-Use Assets 243 Reduction in Business Use 244 • Additional Requirements for Employees 245 Limits for Passenger Vehicles 245 Automobile Leasing 246 Depletion 248

Amortization 249

Research and Experimentation Expenditures 250 Software 251 Expanded Topics—Bonus Depreciation 251

Summary 253

Key Terms 254

7 Property Dispositions 263

Determining Gain or Loss on Dispositions 264

Property Dispositions and Cash Flow 264 Types of Dispositions 265 Amount Realized 266 Realized versus Recognized Gain or Loss 267 Holding Period 267 Character of Gains and Losses 268 Section 1231 Assets 268 • Capital Assets 269 • Ordinary Income Assets 270 Mixed-Use Assets 270 Disposition of Section 1231 Property 270

Depreciation Recapture 271 Section 1245 Full Recapture 272 • Section 1250 Partial Recapture 273 • Additional Section 291 Corporate Recapture 273 Unrecaptured Section 1250 Gains for Individuals 274 Section 1231 Netting 274 Corporate Taxpayers 275 • Individual Taxpayers 275 Section 1231 Look-Back Rules 277 Disposition of Capital Assets 279

The Capital Gain and Loss Netting Process 279 Tax Treatment of Net Capital Gains and Losses 280 Corporate Taxpayers 280 • Individual Taxpayers 282 Disposition of Ordinary Income Property 284

Mixed-Use Property 285

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Special Rules for Small Business Stock 286

Losses on Section 1244 Stock 286 Section 1202 Gains on Qualified Small Business Stock 287 Comparison of Sections 1244 and 1202 288 Sale of Principal Residence—Section 121 289

Losses on Related Party Sales 291

Expanded Topics—Individual Capital Gains Tax Rates 291

Determining the Long-Term Capital Gains Tax Rate 292 Modified Capital Gains Rates 293 Planning 294 Revisiting the Introductory Case 295

Summary 295

Key Terms 296

8 Tax-Deferred Exchanges 308

Basics of Tax-Deferred Exchanges 309

Basis Adjustments 310 Holding Period 311 Like-Kind Exchanges—Section 1031 311

Qualifying Properties 312 Determining Realized Gain or Loss and the Effect of Boot 312 Basis and Holding Period of Like-Kind Property 314 Indirect Exchanges 315 Other Tax-Deferred Exchanges 316

Wash Sales 317 Involuntary Conversions 317

Casualty and Theft Losses 318 Measuring the Loss 318 • Insurance and Basis Considerations 319 • Deductible Amount 319 • Taxable Year of Deduction 321 Gains on Involuntary Conversions—Section 1033 321 Tax Deferral on Involuntary Conversions 322 • Qualifying Replacement Property 323 • Time Limits for Replacement 324 Involuntary Conversion of a Principal Residence 324 Asset Transfers to Businesses 325

Transfers to Sole Proprietorships 325 Transfers to Controlled Corporations—Section 351 325 The Control Requirement 325 • Property Other Than Stock Received 326 • Transferred Services 326 • Basis and Holding Period 327 • Effect of Liabilities 328 • Transfers to Existing Corporations 328 Transfers of Property to a Partnership 329 Basis and Holding Period of a Partnership Interest 329 • Partnership Basis and Holding Period in Contributed Property 330 • Effect of Liabilities 330 Corporate Reorganizations 331

Summary 332

Key Terms 333

Appendix 8A Reorganizations 343

Acquisitive Reorganizations 343 Basic Tax Consequences 343 • Type A Reorganization 345 • Type B Reorganization 346 • Type C Reorganization 346 • Type D Acquisitive Reorganization 346 • Type D Divisive Reorganization 346 Other Reorganizations 347 Other Considerations 348 Problem Assignments 348 Check Your Understanding 348 part IV BUSINESS TAXATION 349 9 Taxation of Corporations 350

Introduction to Corporations 351

Corporate Advantages 352 Disadvantages of the Corporate Form 353 Capital Structure 353 Taxation of C Corporations 354 Dividend Received Deduction 355

Charitable Contribution Deduction 356 Capital Gains and Losses 357

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Deduction for Qualified U.S Production

Activities 357

Net Operating Losses 358

Computing the Corporate Income Tax 359

Reconciling Book and Taxable Income 360

Tax Credits 362

Alternative Minimum Tax 363

Filing and Payment Requirements 364

Consolidated Returns 365

Consolidated Net Income 366 Corporate Distributions 367

Property Distributions 367 Stock Dividends 368 Corporate Redemptions 369 Partial Liquidation 371 Liquidating Distributions 371 Dividend and Redemption Planning Issues 372 Issues for Closely Held Corporations 373

Constructive Dividends 373 Penalty Taxes to Encourage Dividend Payments 374 Personal Holding Companies 374 • Accumulated Earnings Tax 375 Controlled Corporate Groups 375 Expanded Topics—Earnings and Profits 377

Summary 380

Key Terms 380

Appendix 9A Exempt Organizations 388

Unrelated Business Income Tax 389 Excise Taxes on Certain Transactions 390 Private Foundations 390 Problem Assignments 390

Check Your Understanding 390 Appendix 9B Multistate Issues 391

Income Taxes 391 Sales Taxes 392 Problem Assignments 393

Check Your Understanding 393 10 Sole Proprietorships and Flow-Through Entities 394

Introduction to Flow-Through Business Entities 395

The Sole Proprietorship 396

Forming the Sole Proprietorship 396 Operating the Sole Proprietorship 397 Self-Employment Taxes 399 Partnerships 400

Types of Partnerships 400 Advantages and Disadvantages of Partnerships and LLCs 401 Entity versus Aggregate Concepts 401 Partnership Operations 402 Partner’s Basis and Capital Account 402 • Partner’s Interests 402 • Selection of a Partnership Tax Year 402 • Partnership Operating Results 403 Partner’s Basis Account 404 Effects of Liabilities 404 Loss Limitation Rules 405 General Loss Rules 405 • At-Risk Rules 406 • Passive Loss Rules 406 Partnership Distributions 407 Guaranteed and Nonguaranteed Payments 407 • Nonliquidating Distributions 407 • Liquidating Distributions 408 Selling a Partnership Interest 409 S Corporation Characteristics 410

Eligibility Requirements for S Status 410 Corporate Restrictions 410 • Shareholder Restrictions 411 Making the S Election 411 Terminating the S Election 411 Termination Election 411 • Terminating Events 412 S Corporation Operations 412 Loss Limitations 413 Basis Adjustments 414 The Accumulated Adjustments Account 414 Property Distributions 415 The S Corporation Schedules M-1, M-2, and M-3 416 S Corporation Taxes 416 The Built-in-Gains Tax 416 • The Excess Net Passive Investment Income Tax 416 • LIFO Recapture Tax 417 Redemptions and Liquidations by S Corporations 417 The U.S Production Activities Deduction 418

Comparison of Total Tax Burden by Entity 419

Expanded Topics—The Passive Deduction Limitations 420 Rental Relief for Middle-Income Taxpayers 421

Real Property Business Exception 422

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Summary 424

Key Terms 424

part V TAXATION OF INDIVIDUALS 435 11 Income Taxation of Individuals 436

The Individual Tax Model 437

Income 437 Deductions for Adjusted Gross Income 438 Educator Expenses 439 • Student Loan Interest Deduction 439 • Tuition and Fees Deduction 440 • Health Savings Accounts 440 • Penalty on Early Withdrawals of Savings 441 • Other Deductions for AGI 441 Adjusted Gross Income 442 Deductions from Adjusted Gross Income 422 Determining the Tax Liability 422 Personal and Dependency Exemptions 443

Qualifying Child 444 Qualifying Relatives 444 Support Test 445 • Gross Income Test 446 Phaseout of Exemptions 447 Filing Status 448

Married Filing Jointly 448 Surviving Spouse 449 Married Filing Separately 449 Head of Household 450 Single (Unmarried) Individual 451 Standard Deduction 451

Basic Standard Deduction 451 Additional Standard Deduction 452 Standard Deduction for Dependents 452 Itemized Deductions 453

Medical Expenses 454 Taxes 455 Income Taxes 456 • Real Property Taxes 456 Interest Expense 457 Investment Interest 457 • Qualified Residence Interest 458 Charitable Contributions 459 Contributions of Property 460 • Maximizing the Tax Benefit from Contributions 461 Casualty and Theft Losses 462 Miscellaneous Itemized Deductions 463 Phaseout of Itemized Deductions for High-Income Taxpayers 464 Net Operating Loss 464

Computing the Tax 465

Tax Credits 467

Credits versus Deductions 467 Child Tax Credit 467 Education Credits 467 Earned Income Credit 469 Dependent Care Credit 470 Retirement Contributions by Low-Income Wage Earners 470 Excess Payroll Tax Withheld 471 Credits to Encourage Energy Efficiency 471 Payment of Income Tax 472

Who Must File a Return? 472 Expanded Topics—Additional Taxes 473

Alternative Minimum Tax 473 Revisiting the Introductory Case 477

Summary 478

Key Terms 478

12 Wealth Transfer Taxes 488

Overview of Wealth Transfer Taxation 489 The Unified Transfer Tax 489

Major Exclusions 490

Annual Gift Tax Exclusion 490 • Lifetime Transfer Tax Exclusion—The Unified Credit 491

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The Federal Gift Tax 491

Transfers Subject to Gift Tax 491 Transfers for Insufficient Consideration 492 • Joint Property Transfers 492 • Life Insurance Transfers 493 • Transfers to a Trust 493 • Cessation of Donor’s Control 494 Transfers Excluded from Gift Taxes 494 Transfers of Marital Property Pursuant to a Divorce 494 • Other Exclusions 495 Valuation of Gift Property 495 Special Rules Affecting the Annual Gift Tax Exclusion 495 Present versus Future Interests 496 • Gifts to Minors 496 • Gift Splitting 497 Gift Tax Deductions 498 Charitable Deduction 498 • Marital Deduction 498 Tax Consequences for Donees 498

Kiddie Tax 499 Special Education Savings Plans 499 The Taxable Estate 500

Identifying the Gross Estate 500 Valuation Issues 502 Estate Deductions 503 Generation-Skipping Transfer Taxes 503 Transfer Tax Planning 504

Selecting the Right Property to Give 504 Advantages of Making Lifetime Gifts 505 Shielding of Post-Gift Appreciation from Estate Taxes 505 • Using the Annual Exclusion and Gift Splitting 505 • Nontax Advantages of Trusts 506 Disadvantages of Lifetime Gifts 506 Carryover Basis on Gift Property 506 • Early Payment of Transfer Taxes 507 Fiduciary Income Tax Issues 507

The Decedent’s Final Tax Return 507 Income Tax Consequences of Inherited Property 507 Income Taxation of Trusts and Estates 508 Expanded Topics—The Tax Calculations 509

Computing the Gift Tax 509 Computing the Estate Tax 510 Computing the Kiddie Tax 511 Computing the Fiduciary Income Tax 512 Revisiting the Introductory Case 513

Summary 514

Key Terms 514

APPENDIX A: Tax Research Using RIA Checkpoint® 523

APPENDIX B: Present Value and Future Value Tables 543

APPENDIX C: Sample Filled-in Tax Returns 545

APPENDIX D: Tax Return Problems 569

Index 577

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Comprehensive Yet Brief and Concise

This is the only text to introduce all topics on the CPA exam in only 12 chapterswhile striking the perfect balance between concepts and details Tax concepts andapplications are presented in a clear, concise, student-friendly writing style Itincludes sufficient technical detail to provide a foundation for future practice in tax-ation and consulting while not overwhelming the student with seldom-encounteredminutia

Tax Planning

The importance of tax planning is emphasized It is woven into each chapter with gin icons highlighting planning opportunities Tax planning strategies are introducedearly in Chapter 2 along with the impact of taxes on cash flow

mar-Technology Applications

A six-month access card to RIA Checkpoint®Student Edition is available as a

bun-dled option with each new text Appendix A includes a tutorial with screen captures

providing students an overview of searching using RIA Checkpoint®before they goonline, saving class instruction time Internet assignments and research problems

that can be solved with RIA Checkpoint® build valuable research skills that aretested on the CPA examination

Key Concepts

Each chapter begins with an introduction to the included topics, emphasizing why

deci-sion makers need to understand these topics This is followed by a list of Key Concepts

that provide an executive summary of the most important concepts students shouldmaster

Setting the Stage—An Introductory Case

Each chapter-opening case introduces key issues while promoting critical analysis anddecision-making skills The case is then revisited at the end of the chapter

Preface

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Rigorous topics are tackled through numerous simple but realistic examples

EXAMPLE 46

When Alex Rodriguez, the former Texas Rangers shortstop, lived in Texas (a state with no

individ-ual income tax), he owed more than $271,000 to California (which assesses a 9.3% nonresident

income tax) for games he played in that state during baseball season It was estimated that if the

Rangers had played all their games at home, A-Rod’s state tax bill could have been reduced by

more than half a million dollars a year When A-Rod switched to the New York Yankees, his state

and local tax burden increased dramatically On the $155 million that A-Rod will be paid over

his seven-year contract, he is expected to owe $3.57 million to New York City and an additional

$6.19 million to the State of New York for income taxes.

Key Cases

Key Cases bring real world applications into the classroom.

KEY CASE In May 2006, Richard Hatch was sentenced to 51 months in federal prison

for failing to report $1 million in income won from the first “Survivor” television series along

with income from some other sources He was also ordered to pay almost $475,000 in taxes,

interest and penalties

Expanded Topics

The Expanded Topics section included at the end of several chapters contains more

advanced topics for instructors who wish to challenge their students These advanced

discussions relate to the other material within the chapters, but which our adopters and

reviewers have indicated could be omitted to allow more time for the more critical

material

Summary

Each chapter closes with a Summary of the most important topics introduced in the

chapter, reinforcing important concepts for students

Key Terms

A list of Key Terms is included at the end of each chapter They appear in bold print

and are keyed to the first page on which the term is discussed

Test Yourself

Each chapter includes a Test Yourself section of five multiple-choice questions for

stu-dents to assess their understanding of topics covered in the chapter Answers to these

questions follow the end-of-chapter materials

Problem Assignments

More than 60 problems are included at the end of each chapter Check Your

Understanding includes a wide variety of noncomputational questions that review

the topics included in the chapter Crunch the Numbers presents quantitative problems

covering the computational aspects of chapter materials Comprehensive problems

integrate topics covered in several different chapters

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Think Outside the Text

For instructors wishing to challenge their students, Think Outside the Text questions

develop critical thinking skills by requiring students to expand their thinking beyondthe material covered in the chapter

Identify the IssuesIdentify the Issues includes short scenarios designed to challenge the students to iden-

tify issues and formulate research questions These scenarios, however, do not provideenough information to enable students to develop definitive solutions but are designed

to help students practice the issue-identification step in the research process, a stepthat many new tax students consider the most difficult

Develop Research SkillsDevelop Research Skills requires students to research the relevant authorities and

present possible solutions These can be solved using RIA Checkpoint®Student Edition

or free Internet sources For most of these problems, citations to relevant InternalRevenue Code sections, cases, and rulings are included only in the Instructor’s Manualallowing each instructor to decide what, if any, hints should be given to students when

Tax Research Appendix

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Appendix A at the end of the text provides a tutorial with screen captures of RIA

Checkpoint®Student Edition Students can use the tutorial to become acquainted with

the basics of searching before going on line After requiring the students to complete

the tutorial, the instructor can begin to assign basic research problems without taking

up class time on search instruction For those with access to a paid subscription to the

professional version of RIA Checkpoint®, screen captures illustrate some of the

addi-tional resources available in this widely-used professional tax service This is the only

introductory-level tax text that includes screen captures of RIA Checkpoint®

Sample Tax Returns

Sample Filled-In Tax Returns are included in Appendix C for a C corporation, S

corpo-ration, partnership, and a self-employed individual

Tax Return Problems

Six Tax Return Problems, covering the four types of business entities as well as

individ-uals, are included in Appendix D Using an appendix allows the instructor to assign an

entire tax return problem or portion of a problem at whichever point in the term best

suits a particular class

Up-To-Date

This text has been completely updated for new legislation, including the Pension

Protection Act of 2006 and the Tax Relief and Health Care Act of 2006 This text has

been updated for all IRS pronouncements available as of the end of April 2007,

including the automobile ceiling limits In addition, reference has been made to

pending legislation that could affect text material where appropriate We will use the

web site associated with the text at www.thomsonedu.com/taxation/dennis-escoffier

to provide any additional updates

Organization

This text is ideal for schools with only one required tax course as it includes all the

top-ics specified for the first course in the AICPA’s Model Tax Curriculum Its 12 chapters

can be covered in one semester, with time for assessments, eliminating the need to omit

chapters The Model Tax Curriculum emphasizes tax planning to stimulate students’

thinking in terms of the effect taxation has on decisions for entities as well as

individ-uals Although the text includes entity planning, it does not do so to the exclusion of

individuals An example of this dual planning orientation is illustrated in the discussion

of employee compensation in Chapter 4 Most authors relegate compensation

plan-ning to the end of the text where, unfortunately, many students never see it We chose

this topics as an opportunity for students to view transactions from both the

individ-ual’s perspective (minimizing taxable income) and the employer’s perspective

(maxi-mizing deductions while providing a compensation plan that will attract valuable

employees) This chapter is the bridge between the chapters on gross income and

busi-ness expenses This text maintains this planning orientation and integrates both entity

and individual topics throughout Parts II and III as income, expense, and property

transaction concepts are introduced

Brief Contents

PART I: INTRODUCTION TO TAXATION AND ITS ENVIRONMENT

Chapter 1: An Introduction to Taxation

Chapter 2: The Tax Practice Environment

Appendix 2A: Tax Research

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PART II: INCOME AND EXPENSE DETERMINATION

Chapter 3: Determining Gross IncomeChapter 4: Employee CompensationChapter 5: Business ExpensesPART III: PROPERTY CONCEPTS AND TRANSACTIONS

Chapter 6: Property Acquisitions and Cost Recovery DeductionsChapter 7: Property Dispositions

Chapter 8: Tax-Deferred Exchanges

Appendix 8A: ReorganizationPART IV: BUSINESS TAXATION

Chapter 9: Taxation of Corporations

Appendix 9A: Exempt OrganizationsAppendix 9B: Multistate IssuesChapter 10: Sole Proprietorships and Flow-Through EntitiesPART V: TAXATION OF INDIVIDUALS

Chapter 11: Income Taxation of IndividualsChapter 12: Wealth Transfer Taxes

Appendix A Tax Research Using RIA Checkpoint®

Appendix B Present Value and Future Value TablesAppendix C Sample Filled-in Tax Returns

Appendix D Tax Return ProblemsIndex

Your Course Your Way

Although this text is designed primarily for those who wish to provide an introduction

to all entities before tackling the topics unique to individuals, the flexibility of this textmakes it easy for those who wish to change the sequence of chapters For example, suf-ficient notes and references to basic concepts in the preceding chapters are included

within Chapter 11: Income Taxation of Individuals making it easy for instructors who

wish to cover this chapter early in the term (such as after Chapter 4)

Supplements

Supplements include an author-prepared Solutions Manual (including full text ofend-of-chapter problems for easy reference as well as solutions), an Instructor’sManual with an extensive Test Bank, and PowerPoint slides All supplemental itemsare conveniently available on the Instructor’s Resource CD-ROM

Comments and Suggestions

We realize that it is almost impossible for a text to be completely free of technicalerrors or to include every relevant topic We welcome comments and suggestions onhow we can improve the next edition Please email your comments and suggestions tosdennis@miami.edu

Acknowledgments

We wish to acknowledge and thank Howard Godfrey, University of North Carolina atCharlotte, and Stewart Karlinsky, San Jose State University, for their suggestedimprovements to the text We also wish to thank James Young, Northern IllinoisUniversity, for providing advanced copy of the 2007 inflation adjustments We aregrateful to the entire Thomson team for their assistance, particularly Keith Chassé andJessica Kempf

Shirley Dennis-Escoffier and Karen A Fortin

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About the Authors

Shirley Dennis-Escoffieris an associate professor at the University of

Miami, where she teaches both graduate and undergraduate tax classes

She received her Ph.D from the University of Miami and returned to UM

after teaching at the University of Hawaii and California State University

in Hayward She is a Certified Public Accountant licensed to practice in

Florida She served as President of the American Taxation Association for

2000–2001 and remains actively involved in the association receiving the

Outstanding Service Award for 2004 She is also actively involved with the

American Institute of Certified Public Accountants She has received

several teaching awards including the University of Miami Excellence

in Teaching Award and the School of Business Alumni Association

Excellence in Teaching Award She has published numerous articles in tax

and accounting journals and is the recipient of an Ernst and Young

Foundation tax research grant In her free time, she and her husband,

Marcel Escoffier, enjoy seeking out fine wine and gourmet food

Karen A Fortinretired from her position as Professor of Accounting and

Taxation at the University of Baltimore, where she had been Department

Chair and taught graduate and undergraduate tax classes in both the

Business School and the Law School She received her Ph.D from the

University of South Carolina and held teaching positions at the University

of Wisconsin–Milwaukee and the University of Miami She is a Wisconsin

Certified Public Accountant and a recipient of a Sells Award During her

teaching years, she was active in the American Taxation Association and the

American Accounting Association as an editor, reviewer, and chairperson

for numerous events As a member of the AICPA she served on several

committees and task forces She has published numerous articles in tax and

accounting journals and has co-authored and edited a number of textbooks

In between her extensive travels, she teaches part-time and volunteers in a

local grade school tutoring students in mathematics

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To my family, especially my ever-patient partner, John, our children and their spouses, and our grandchildren.

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The Taxing Units and the Basic

Income Tax Models .6

Choice of Business Entity .18

Other Types of Taxes .23

Types of Tax Rate Systems .28

gen-After defining a tax and providing some background information on theincome tax, this chapter introduces those taxable persons that pay incometaxes—individuals, C corporations, and fiduciaries The concepts of gross income,taxable income, tax rates, gross tax liability, and tax credits are introduced in thecontext of both the corporate and individual tax models The individual taxmodel includes several unique features, including adjusted gross income, deduc-

tions for adjusted gross income, deductions from adjusted gross income, and

personal and dependency exemptions Some of the basic concepts related toproperty transactions are also introduced

The various types of business entities, including sole proprietorships, ships, C corporations, and S corporations, are compared The individual owner of

partner-a sole proprietorship is tpartner-axed on the business’s income Ppartner-artnerships partner-and S rations are conduits or flow-through entities because they pass their income andloss items through to their owners for taxation at the owner level A C corpora-tion’s income is subject to double taxation, once at the entity level when earned

corpo-by the corporation and a second time at the shareholder level when distributed toshareholders as dividends

Consumption, wealth, and wealth transfer taxes are discussed The concepts ofprogressive, proportional, and regressive taxes follow the discussion of averageand marginal tax rates Adam Smith’s canons of taxation are also presented.These canons provide a framework for assessing a “good” tax

KEY CONCEPTS

● Only individuals, C corporations, and fiduciaries pay income taxes

● Corporations are taxed on taxable income, which is the difference between grossincome and deductions The nominal tax rates for corporations vary from 15 to

35 percent

● In determining taxable income, individuals are allowed two sets of deductions

from gross income—deductions for adjusted gross income and deductions from

adjusted gross income They also are allowed to deduct personal anddependency exemptions Individual tax rates vary from 10 to 35 percent

● Sole proprietorships, partnerships, and S corporations are all business entitieswhose income and losses are passed through to owners and included in owners’tax returns for payment of income taxes

● Other taxes levied by governmental units include sales or use taxes, wealth

or property taxes, and wealth transfer taxes

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S ETTING THE S TAGE —A N I NTRODUCTORY C ASE

Wing Hue, an engineer from China with U.S residency status, recently obtained

per-manent employment with a U.S consulting firm Before coming to the United States,

Hue developed a totally new system of gears for bicycles He has obtained a patent

on his gear design and plans to solicit some venture capitalists for funds to begin

man-ufacturing and marketing the gears He would like to sell the gears to both bicycle

manufacturers and to repair shops as replacements for existing gears

As a student in China, Hue never had sufficient income to pay taxes He

under-stands that as a U.S resident, he will be subject to a variety of taxes He is particularly

interested in the potential taxation of his gear manufacturing enterprise He asks you

for a brief explanation of the tax landscape that he faces We will return to this case at

the end of this chapter

What Is a Tax?

A tax is a forced payment made to a governmental unit that is unrelated to the value

of goods or services provided Taxes are not voluntary If we have income, we pay

income taxes on that income to the federal government and possibly to state and local

governments.1If we purchase certain goods, the state may require the seller to collect

a sales tax If we fail to pay or remit these taxes to the government, we may be subject

to civil, or even criminal, penalties If we own real estate, the local government places

an assessed value on that property and sends us a bill for property taxes These taxes

must be paid or the government may seize the property

There are hidden taxes as well Hidden taxes are those that are paid but that are not

specifically itemized as part of the payment When we buy gasoline for our

automo-biles, there are significant taxes imbedded in the price paid The same is true for many

other items, such as cigarettes and alcoholic beverages Nevertheless, if we want that

particular good (legally, that is), we pay the tax

Taxes are not levied as punishment (as are fines for speeding), nor are they levied

as payment for particular goods or services rendered by the government (such as a

garbage collection fee) Although we may benefit from many governmental activities

that are paid for by taxes, there is no direct connection between the benefit received

by a taxpayer and the amount of tax the taxpayer must pay Property taxes to support

education are levied on the value of one’s property, with no relationship to the

num-ber of children, if any, a person may have that are benefiting from free public school

education Thus, taxes are often termed forced extractions You must pay them, but you

may not necessarily derive any benefit from them

A Brief History of Income Taxation in the United States

Although there had been a federal income tax during the Civil War, the income tax

system as we know it today did not begin until 1913 when the 16th Amendment to the

U.S Constitution was ratified The 16th Amendment gave Congress the power to lay

and collect taxes “on income, from whatever source derived,” without the previous

requirement that all direct taxes be imposed based on population This first federal

income tax law enacted in 1913 consisted of only 16 pages and required only a simple

individual income tax return

Each time the income tax statutes were revised between 1913 and 1939, an entire

set of new provisions replaced the existing law In 1939 this procedure changed, and

the income tax laws were codified as the Internal Revenue Code Amendments and

1 Individuals are assessed federal income taxes only if their income exceeds a certain minimum amount.

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revisions were then made to the specific sections of the Code, rather than replacingthe old law with an entirely new set of statutes.

In 1954, there was another major overhaul of the tax laws In this 1954

recodifica-tion, the income, estate, gift, and excise tax laws were incorporated into the Internal

Revenue Code of 1954 There were many significant tax law changes between then and

1986, each amending the Internal Revenue Code of 1954 Because the Tax Reform Act

of 1986 was so extensive, the Code was renamed the Internal Revenue Code of 1986 Any current changes to the tax laws are now amendments to the Internal Revenue

Code of 1986; for example, the Jobs and Growth Tax Relief Reconciliation Act of 2003

(the 2003 Act) amended the Internal Revenue Code of 1986.

Over the years, the tax rates have gone up and down numerous times, the tions and deductions have varied, additional filing statuses were added, multiplerate schedules were developed based on these added filing statuses, and the index-ing of many provisions with specified numerical amounts was expanded The com-plexity of business taxation has also expanded at an ever-increasing pace It is nowalmost impossible for one person to be familiar with all areas of the federal tax law

exemp-In addition, as the United States has developed a greater presence in the globaleconomy, the necessity to understand the tax laws of other countries has becomemore apparent Add to this the tax laws of the 50 states, which often differ fromone another and from federal law, and it is obvious that the tax profession will con-tinue to grow and to need well-trained professionals to assist both businesses andindividuals

Objectives of Taxation

Raising revenue is only one of the many goals of taxation The tax laws foster manyeconomic and social goals such as wealth redistribution, price stability, economicgrowth, full employment, home ownership, charitable activities, and envionmentalpreservation For example, the government encourages contributions to charitiesthrough the charitable contribution deduction If the charitable organizations did notexist, the government would have to undertake many of the activities the charities pro-vide Thus, the tax law is used to achieve this social objective

Tax policy struggles to achieve fairness Differing notions of fairness, however,guarantee that this goal remains elusive The fairness debate revolves around two very

different concepts of what is fair Horizontal equity, one of the key principles of tax

fairness, asserts that persons in similar circumstances should face similar tax burdens.The difficult part is determining when different taxpayers are in similar circumstances

EXAMPLE 1

Susan rents a condominium for $2,500 per month Barry pays $2,500 per month on the mortgage for his condominium in the same building Both Susan and Barry are single, have no dependents, and have annual incomes of $55,000 Susan cannot deduct any portion of her rent, but Barry can deduct the interest portion of his mortgage payment In this case, the goal of horizontal equity gives way to the objective of encouraging home ownership.

The other major fairness concept is vertical equity Vertical equity asserts that

per-sons with higher incomes should pay not only more tax but also higher percentages oftheir income as tax.2Underlying this is the economic theory that income has diminish-ing marginal utility In other words, as a person’s income rises, each dollar is worth less

to that person As a result, higher rates are necessary to obtain approximately rable sacrifices from all taxpayers Although this has long been a feature of the U.S taxsystem (as evidenced by the progressive tax rates), it remains controversial, especiallyamong those subject to the higher tax rates

compa-2 Vertical and horizontal equity are discussed in more detail in the latter part of the chapter.

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EXAMPLE 2

Bill and Susan are married and have two children In 2007, they have taxable income of $63,700

John are married and have two children Their taxable income is $128,500 and they pay taxes of

is 2.02 times ($128,500兾63,700) that of Bill and Susan, but Shelly and John pay 2.85 times

Fairness also underlies the preferential treatment given to a married taxpayer who

supports a spouse The married taxpayer will pay less tax than a single individual with

the same taxable income because of the differences in tax rate schedules applicable to

their taxable income

EXAMPLE 3

John and Laura each have $50,000 in taxable income in 2007 John is married and files a joint

return, but his wife has no income as she attends college Laura, however, is single John’s tax

lia-bility is $6,717.50 while Laura’s is $8,923.75.

On the other hand, two married persons each with moderately high incomes will

pay more taxes than two single persons with the same incomes This is commonly called

the marriage penalty

EXAMPLE 4

Barbara is single and has taxable income of $77,100 in 2007 As a single individual, she will pay taxes

of $15,698.75 Shelly and John are married and have $154,200 in taxable income, one-half earned

more than they would pay if each of them was taxed separately as a single individual The $771 is

their marriage penalty.

The 2003 Act, which accelerated scheduled marriage penalty relief for years 2003

and 2004, was extended in the latter part of 2004 by the Working Families Tax Relief

Act of 2004 This relief, however, only eliminates the penalty for a married couple

whose taxable income does not exceed $128,500 in 2007 Although the standard

deduction for a married couple is increased to twice that of the single person, only

the 10 and 15 percent bracket widths in the tax rate schedules are doubled to twice

those of the single person.4As a result, upper income taxpayers will still face a

mar-riage penalty These changes did, however, provide a greater marmar-riage bonus for a

couple when one of the spouses earns all or a greater portion of their combined

income

Current Influences on the Tax Law

A number of factors influence the tax laws, but probably the makeup of Congress is

the most important The political parties have different views of the level of taxation

relative to the services that should be provided by the federal government In

gener-al, the Democratic party believes that the federal government is best able to service

the public, while the Republicans would leave far more in the hands of the states and

local governments Individual states or regions have particular interests that their

elected representatives espouse and bargain to achieve This often leads to rather

strange results Although the federal government successfully sued the tobacco

3 The calculation of taxes paid in this and the following examples will be explained later.

4 The standard deduction for joint filers is doubled to twice that of the standard deduction for single

persons through year 2008; the expansion of the 10% and 15% brackets for joint filers is effective

through 2007.

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industry for the harm done by cigarette smoking, it still has subsidy programs fortobacco farmers.

Washington is full of lobbyists who try to influence representatives and senators tosponsor or vote for legislation favorable to their particular industries This influence

is manifested in two ways First, industries contribute substantial monies to electioncampaigns They will generally pour the greatest amount of money into the campaigns

of persons they believe will support their positions—whether incumbent or not.Campaign finance reform sought to address some of the perceived abuses of theunlimited amount of “soft money” that could be contributed to various campaignorganizations Second, however, is the fact that many of the lobbyists and politicalaction committees (PACs) have extremely large staffs available to research varioustechnical issues They can funnel this research, which is often slanted in their desireddirection, to the various members of Congress It is not unusual for a lobbyist to pro-vide the basic text of a tax law to be introduced to Congress

The attempt to satisfy the many constituencies of our elected representatives hasled to a collection of tax laws that are becoming more and more complex for the tax-payer to comply with and the IRS to administer effectively In spite of many calls forsimplification, each tax law adds complexity to the system The 2003 Act reduced taxrates on one class of long-term capital gains to 5 percent or 15 percent depending onthe taxpayer’s marginal tax rate This change, however, was only effective for capitalassets sold after May 5, 2003 Assets sold before May 6, 2003 were taxed under theprior long-term capital gains rate schedule Thus, a taxpayer with asset sales before andafter the change date faced a daunting task in calculating his or her 2003 tax liability.The 2003 Act made numerous temporary changes that were to revert to prior lawafter a specified time period Uncertainty surrounding the extension of those provisionsmade tax planning increasingly difficult for tax years beyond 2004 It was not until lateSeptember 2004 that Congress passed the Working Families Tax Relief Act of 2004 thatextended many of the expiring provisions to the 2005 tax year and beyond It is proba-bly not by coincidence that these changes were passed shortly before the presidentialand congressional elections of November 2004 This was not the case in 2006, however.With potential changes in the makeup of the Senate and House of Representatives due

to the increasing controversy over the war in Iraq, the anticipated extenders did notmaterialize prior to the general elections The bills were again brought up during thelame duck session and many of the expiring provisions were made effective retroac-tively to 2006 and extended through 2007

There are only three types of persons5subject to income taxation in the United States:the individual, the C corporation,6and the fiduciary An individual is a male or female

person subject to the tax A C corporation is a business entity formed under state law

on which the income tax is levied directly A fiduciary is either an estate or a trust; it may

be subject to income taxes, but in most cases the income is passed through to the income

beneficiaries and is included in the beneficiaries’ income for taxation The fiduciary is a

modified “flow-through” entity because the tax may be levied on income retained byeither the estate or the trust, or it may be levied on the recipients to whom the income

is distributed Partnerships and S corporations are flow-through entities

5 Any entity subject to the income tax is a taxable person; the term “individual” is reserved exclusively for

a man, woman, or child subject to an income tax.

6 The term “C” or “regular corporation” (called “C” corporation because its governing tax rules are contained in Internal Revenue Code subchapter C) is used to distinguish it from a Subchapter S (or simply “S”) corporation (whose rules are contained in IRC subchapter S), which is a flow-through entity.

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Individual and corporate taxpayers pay the bulk of all income taxes collected The

corporation is the basic business unit, but it is not the only form in which a business

can operate In addition to the C or regular corporate form, a business may be

organ-ized as a sole proprietorship, an S corporation, or a partnership, including a limited

liability company (LLC) and a limited liability partnership (LLP) The income taxes

on these businesses are not levied or paid by the businesses; instead their income

flows through to the owners and the owners pay the taxes.7If one flow-though entity

is an owner of all or part of another flow-through entity, the income continues to flow

through to the owners until it finally reaches an individual, a C corporation, or a

fidu-ciary, which then pays the tax

EXAMPLE 5

The BST partnership is owned one-third by Bob (an individual); one-third by S, an S

corpora-tion (owned 100 percent by Jane); and one-third by T (a trust fiduciary) The partnership

reports $300 of income at the end of the current tax year One hundred dollars of income flows

through to each of the owners: Bob, S, and T T distributes only $50 of its $100 income to its

beneficiary, Sarah Bob includes all $100 of income along with his other income and pays taxes

on the total S does not pay taxes on the $100 This $100 is combined with its other income;

the total then flows through to Jane, the owner of all of the S corporation stock Jane includes

all of this income on her personal tax return T pays taxes on the $50 retained in the trust; the

remaining $50 is taxed to Sarah on her individual tax return, along with her other sources of

income.

The income of C corporations is subject to double taxation: once at the

corpo-rate level and again at the owner level when the income is distributed as dividends

to the owners The pass-through entities avoid double taxation because their

income is taxed once only at the owner level The income of a sole proprietorship

is reported and taxed along with the individual taxpayer owner’s other income The

advantages and disadvantages of each of these forms of business will be explored

later in this chapter At this point, it is not necessary to have a detailed

understand-ing of taxable and flow-through entities It is, however, important to understand

that individuals and C corporations are the primary taxpaying entities The primary

focus of the text is on tax planning for individuals, C corporations, and

flow-through entities because of the latter’s effects on the taxation of individuals and

C corporations

The fiduciary has a vastly different role than a business A trust is established for

a specific purpose, such as managing the assets for beneficiaries who are unable or

unwilling to manage the assets themselves and must follow the dictates of the person

establishing the trust An estate is created at the death of an individual, and its

pri-mary purpose is to manage the decedent’s assets until they can be distributed to his

or her heirs Income tax planning opportunities are limited for estates and trusts

The final chapter of this text addresses the basics of estate and trust taxation, along

with the estate and gift transfer tax The first eleven chapters are devoted to the two

primary tax-paying entities and the related flow-through businesses, although the basic

principles of income, deduction, gain, and loss discussed throughout this text also apply

to fiduciary entities

The Individual and Corporate Tax Models

It is important to get an overall sense of the basic taxing units before studying the

details of the tax laws This will aid in understanding how the terms and concepts

referred to throughout our study of tax fit into the scheme of the basic tax models The

7 An S corporation that was previously a C corporation may be subject to tax on specific types of income.

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corporate and individual tax models are shown in Figure 1.1 and should be referencedthroughout the following discussions:

8An individual reports his or her gross income to the Internal Revenue Service on Form 1040: U.S Individual Income Tax Return A sample filled-in tax return is included in Appendix C.

FIGURE

1.1 THE CORPORATE AND INDIVIDUAL TAX MODELS

Corporate Tax Model

Gross revenue

Individual Tax Model

Gross income

(greater of itemized or standard deduction)

Gross Income

The term gross income is used in slightly different contexts for individual and corporate taxpayers Gross revenue and gross income have different meanings for businesses

under the tax laws Gross revenue is the title given to a business’s total receipts that

result from the sale of its goods and兾or services Gross income denotes a business’s gross

receipts reduced by its cost of goods sold (This is similar to its use for financial

account-ing.) The term total income is used by the corporation to designate its gross income

(gross revenue less cost of goods sold) plus all other income items subject to tax It doesnot include those items that are excluded from taxable income, however

For an individual, gross income is an all-inclusive term that includes not only net ness income (or loss) from a sole proprietorship and income (or loss) passed throughfrom a partnership or S corporation It also includes all other items of income not specif-ically excluded.8Certain “income” items may, however, be negative amounts or losses.They reduce other positive income items in determining corporate total income or indi-vidual gross income In general, these loss items are limited to losses from businesses orproperty transactions Figure 1.2 provides examples of the types of income and loss itemsincluded in gross income Gross income inclusions are examined in detail in Chapter 3

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busi-EXAMPLE 6

The Brogan Corporation has gross income from the sales of shoes of $4,500,000 In addition, it has

taxable interest income of $50,000 and a loss of $400,000 from a partnership in which it has an

80 percent interest that it deducts from its positive income As a result, it has total income

Losses (negative income) can be grouped into three broad categories: business

losses, investment losses, and personal losses.9These losses are deducted from positive

income items, except that most personal losses are not deductible by individuals.10

Losses incurred as part of an active business are deductible in full against ordinary

income Most investment losses, however, are subject to limitations on their

deductibil-ity because they are capital losses Individuals can deduct only $3,000 of capital losses

in excess of capital gains annually Capital losses that are not deductible in the current

year may be carried forward indefinitely by individuals Corporations can only offset

capital losses against capital gains; they are not permitted to deduct capital losses

against other income Capital losses in excess of those that offset capital gains can

be carried back three years and then forward five years to offset gains realized in

those years

EXAMPLE 7

John incurred a $17,000 net capital loss in the current year He is permitted to deduct only $3,000

against other income; however, the remaining $14,000 can be carried forward and deducted in

future years subject to the $3,000 annual limitation.

EXAMPLE 8

Jonah Corporation incurred a net capital loss of $5,000 in 2007 Jonah may not deduct any of this

loss currently; instead, the corporation may carry it back first to 2004, then to 2005 and 2006 If it is

FIGURE

1.2 ITEMS INCLUDED IN GROSS INCOME (TOTAL INCOME FOR THE

CORPORATION)

Corporations

Gross income from the sale of

goods and services

Taxable interest

Dividends

Tax refunds

Gains on capital assets

(losses in excess of gains are not

Gains and losses (subject to limitation)

on capital assets Gains and losses on other property transactions

Income and loss from sole proprietorships, partnerships, and S corporations

Income and loss from rental real estate Taxable pension plan distributions Unemployment compensation Alimony received

Taxable portion of Social Security benefits

9 Losses are distinguished from deductions for which there must be a specific provision in the Code that

allows a reduction in corporate or individual taxable income.

10 Casualty and theft losses of personal property are deductible as itemized deductions to the extent that

they exceed 10 percent of the individual’s adjusted gross income.

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not offset by capital gains completely in those years then it may be carried forward sequentially to years 2008 through 2012 If Jonah had been an individual, he would have been able to deduct

$3,000 of the loss currently and carry the remaining $2,000 forward to the next year.

Over the years, certain items have been excluded from gross income These excludeditems may not even be reported anywhere on the tax return Only in those instances inwhich the excluded item may affect some other reporting provision is it required to bereported along with taxable items For example, interest on tax-exempt municipal bonds

is excluded from income An individual taxpayer must report it, however, because it isused to determine if part of the taxpayer’s Social Security benefits will be subject totax On the other hand, an individual who is a beneficiary of life insurance proceedsexcluded from income does not report these proceeds anywhere on the tax return.Figure 1.3 provides examples of the types of items excluded from income Exclusionsfrom gross income are examined in detail in Chapter 3

EXAMPLE 9

Brogan Corporation (example 6) had $4,150,000 of total income If it had also received $100,000 of tax-exempt interest, collected $1,000,000 from the life insurance policy on the life of its controller

total income would remain $4,150,000 as each of these items can be excluded from income.

Property Transactions

The recognized gains and losses from sales or exchanges of assets are included in the

gross income of both a corporation and an individual The gain or loss is determined

by subtracting the adjusted basis of the asset from the amount realized on the

disposi-tion of the assets The amount the taxpayer realizes on the disposidisposi-tion is the sum of thecash and fair market value of property received

EXAMPLE 10

John received $10,000 cash and property with a fair market value of $5,000 in exchange for an asset The amount realized for the asset is $15,000.

FIGURE

1.3 EXCLUSIONS FROM GROSS INCOME

Corporate and Individual Taxpayers

Tax-exempt interest Nontaxable stock dividends Nontaxable stock rights Proceeds of life insurance policies Tax refunds to the extent no prior tax benefit was received

Gains and losses on property transactions subject to disallowance

or nonrecognition provisions Unrealized gains and losses

Individual Taxpayers Only

Nontaxable portion of pension plan distributions

Nontaxable portion of Social Security benefits

Damages awarded for physical injury Gifts and inheritances

Welfare benefits including food stamps, workman’s compensation, and family aid

Up to $250,000 gain on the sale of personal residence ($500,000 if married filing jointly)

Scholarships Qualified employee fringe benefits

11 Income is taxed (recognized) only when realized Thus, if securities have appreciated in value from

$5,000 to $9,000, the $4,000 in appreciation will not be taxed until the securities are sold.

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A property’s adjusted basis is similar to book value When an asset is purchased, its

beginning basis is its cost If the asset is a business asset, it may be subject to

depreci-ation As the asset is depreciated, its basis is reduced for any depreciation claimed If a

capital improvement is made, its basis is increased The original cost less reductions for

depreciation plus increases for improvements is the asset’s adjusted basis

EXAMPLE 11

John bought an asset for $30,000 for his sole proprietorship He claimed $13,000 of depreciation

deductions and made a major addition to the asset valued at $7,000 His adjusted basis in the

When the asset is sold, the realized gain is the excess of the amount realized over

the adjusted basis of the property sold The realized loss is the excess of the adjusted

basis of the property sold over the amount realized on the transaction

EXAMPLE 12

John receives $24,000 for an asset that has an adjusted basis of $15,000 John has a realized gain

After the realized gain or loss is determined, the taxpayer must determine if all or

part of the realized gain or loss will be recognized If a gain is recognized, it is

includ-ed in income; if a loss is recognizinclud-ed, it is dinclud-eductinclud-ed from other income Not all realizinclud-ed

gains or losses are recognized when realized, however There are a number of

provi-sions applicable to realized gains and losses that either defer gain or loss recognition

to a later period or provide for nonrecognition entirely These provisions are discussed

later in the text There is never recognition, however, unless the taxpayer has a realized

gain or loss

EXAMPLE 13

John will recognize (include in income) the $9,000 gain realized in the preceding problem

unless there is a specific provision that either defers recognition to a later period or provides for

nonrecognition.

The details of property transactions are examined in Chapter 7 and nontaxable

exchanges are examined in Chapter 8

Deductions

After the corporation determines its total income and the individual determines his or

her gross income, certain deductions are permitted For an item to be deductible by

either an individual or business, there must be either a specific provision or a general

category in the Internal Revenue Code that permits the deduction If no provision can

be found that allows an item as a deduction, then it cannot be deducted In addition,

cer-tain items might fall into one of the categories for which a deduction has specifically

been disallowed

For a corporation, its allowable expenses are simply deductions from its total income

In general, all businesses, regardless of their form of operation, are allowed deductions

for business expenses that are ordinary, reasonable, and necessary There is a general

pre-sumption that all expenses of a business are deductible unless there is a gross violation

of the ordinary, necessary, and reasonable criteria The tax laws do, however, include

sev-eral disallowance provisions that render certain items nondeductible; for example fines,

bribes, and expenses related to tax-exempt income are not deductible expenses.12

12 The latter is an example of the matching principle.

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EXAMPLE 14

After determining its $4,150,000 of total income, Brogan Corporation (example 9) calculates

$2,300,000 of ordinary and necessary business expenses As a result, its taxable income is

Individual taxpayers have two sets of deductions, the deductions for adjusted gross

income (or the above-the-line deductions) and deductions from adjusted gross income

(the below-the-line deductions) Deductions for adjusted gross income consist of a

fairly short list of adjustments to gross income Subtracting these deductions results in

an intermediate subtotal between gross income and taxable income called adjusted

gross income (AGI), a subtotal unique to individual taxpayers Deductions from

adjusted gross income are then subtracted from the AGI subtotal to determine taxable

income The deductions from adjusted gross income for actual personal expenditures

are called itemized deductions Itemized deductions are subject to limitations orthresholds based on an individual’s AGI For example, an individual’s actual expendi-ture for medical and dental expenses is one of several itemized deductions; they aredeductible, however, only to the extent they exceed 7.5 percent of AGI Thus, AGI isused as a measure of a person’s ability to absorb personal expenses by placing certainlimits on or thresholds for the deductibility of personal expenses that are allowable as

itemized deductions There are other deductions from AGI that have their amounts

prescribed by the tax laws; for example, personal and dependency exemptions and thestandard deduction in place of itemized deductions; these are not necessarily related toany actual expenditures

Deductions for AGI have two advantages over itemized deductions First, they are

deductible and reduce gross income (before adjusted gross income is calculated) pendent of the taxpayer’s choice to use the standard deduction or itemize his or herdeductions Second, they do not have to exceed a certain percentage based on AGIbefore the excess can be deducted Figure 1.4 presents examples of an individual’s

inde-deductions for and from adjusted gross income Deductions related to employee

expenses are examined in Chapter 4; the other deductions are examined in Chapter 11

13 Prior to 2006, a $4,000 deduction for AGI was available for qualified higher education expenses This deduction expired at the end of 2005 but was extended retroactively through 2007.

14 The maximum deductible interest for 2007 is $2,500, although increases have been proposed.

FIGURE

1.4 DEDUCTIONS OF INDIVIDUAL TAXPAYERS

Deductions for Adjusted Gross

Income 13

Contributions to certain pension or retirement plans (including IRAs) Health savings account contributions Moving expenses

One-half of self-employment taxes Self-employed health insurance premiums

Penalty on early withdrawal of savings Alimony paid

Itemized Deductions (Deductions

from AGI)

Medical and dental expenses (in excess

of 7.5% of AGI) Taxes (state, local, and foreign income and property taxes)

Interest (mortgage interest and investment interest expense) Charitable contributions (up to 50%

of AGI) Casualty and theft losses (in excess of 10% of AGI)

Unreimbursed employee business expenses, investment expenses, and tax preparation fees (in excess

of 2% tax of AGI) Gambling losses (to extent of gambling winnings)

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EXAMPLE 15

In 2007, James was paid a salary of $62,000 He also had a $4,000 deductible loss from a

partner-ship in which he is a material participant He paid alimony to his former spouse of $6,000 and

made a deductible contribution to his IRA of $3,000 His itemized deductions (including mortgage

interest, real estate taxes, and charitable deductions) total $12,000 James has gross income of

To reduce record keeping for taxpayers and the administrative burden on the IRS,

all individuals are permitted a standard deduction allowance, a minimum deduction

from adjusted gross income Individuals will only itemize their deductions if their total

deductions exceed their standard deduction allowance This standard deduction varies

by the filing status of the taxpayer; that is, if a taxpayer is single, his or her standard

deduction is less than the deduction allowed a married couple filing a joint return as

shown in Table 1.1.15Thus, an individual may always deduct some amount from his or

her adjusted gross income—either the standard deduction or his or her itemized

deductions—but not both

EXAMPLE 16

Assume James in the preceding example has only $3,000 of itemized deductions and qualifies as

head of household as a single parent James would now have taxable income before his personal

and dependency exemptions of $41,150 ($49,000 AGI – $7,850 standard deduction).

The standard deduction varies by filing status because of the assumption that single

persons have fewer personal expenses than married couples or those who qualify as

heads of household.16Thus, a single person who owns a home and pays mortgage

inter-est and property taxes is more likely to itemize than a married couple paying the same

amount of interest and taxes

Individuals are permitted to take another deduction called the exemption

deduc-tion For 2007, the exemption amount is $3,400; it was $3,300 in 2006 A taxpayer

gen-erally is permitted a deduction for him- or herself (called a personal exemption) on the

tax return (or two exemptions for married persons filing jointly) and an exemption for

each person claimed as a dependent (called dependency exemptions) Between the

standard deduction allowance (based on the person’s filing status) and the exemptions

allowed (based on the taxpayer’s personal and dependency exemptions), the taxpayer

can receive a significant amount of income free of income tax These basic allowances

exempt a substantial number of low-income taxpayers from filing annual tax returns

For example, a married couple’s taxable income would need to exceed $17,500

($10,700⫹ $3,400 ⫹ $3,400) before they would be required to file an income tax

15 Additions to the standard deductions are made for taxpayers who are blind and Ⲑor over age 65.

16 To qualify for head of household status, the taxpayer must be a single individual and maintain a home

for a child or qualified dependent A single parent with a dependent child could qualify for head of

household status.

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return for 2007 Corporations, on the other hand, do not have any such personal ordependency exemptions They must file returns annually regardless of whether theyreport net income or loss for the tax year.

EXAMPLE 17

Assume James in the previous examples is a single parent caring for his two small children James’s taxable income after his personal exemption and two dependency exemptions is $30,950

After a corporation has taken all of its deductions from total income or an

individ-ual has reduced his or her gross income by the allowable deductions for and from

adjusted gross income and exemptions, taxable income is reached

Determining the Gross Tax Liability

A corporation uses the corporate rate schedule to determine its tax once taxableincome is determined The corporate tax rates and the income levels at which they areapplied are given in Table 1.2:

TABLE

1.2 CORPORATE TAX RATES

TAXABLE INCOME TAX RATE

by the taxpayer’s filing status as shown in Table 1.3

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intro-long-term capital gains and dividends are taxed at 5 percent If taxable income exceeds

the 15 percent bracket, the long-term capital gain and dividend portion of that income

is taxed at 15 percent Corporate taxpayers, however, are not allowed to use these

alternate tax rates for long-term capital gains or dividends.17

Tax Losses

Taxpayers do not always show positive taxable income when they subtract all of their

deductions from their income items For corporate taxpayers, their negative income is

a net operating loss (NOL) that the corporation may carry back to the two prior tax

years to receive a refund of taxes paid in those years, or it may carry the net operating

loss forward for 20 years

EXAMPLE 20

Baba Corporation had the following five-year history of income and loss:

YEAR INCOME (LOSS)

15% tax rate) in taxes for 2004 In 2005, it carries its $2,000 loss back to 2004, offsetting $2,000 of its

remaining $5,000 of income, by filing Form 1045: Application for Tentative Refund to request a refund

a full refund of taxes paid in that year The remaining $4,000 loss can be carried forward up to 20 years

to offset future income Although it still had positive income in 2004, that year is beyond the

allow-able carryback period for 2007 losses.

Due to the time value of money, however, losses that are carried forward do not

provide the same tax relief as losses that are carried back

EXAMPLE 21

Gee Corporation has a $10,000 net operating loss in the current year If it had $10,000 of

taxable income in the previous year, it could carry the $10,000 loss back and receive an immediate

not expect $10,000 in profits until 10 years in the future, the present value of a $1,500 tax refund to

17 Corporations, however, are permitted a dividend received deduction for all or part of a dividend

received from another corporation, as discussed in Chapter 9, but the taxable portion of the dividend and

net capital gains are subject to the regular corporate tax rates.

18 Present value concepts are discussed in Chapter 2.

TABLE

1.3 2007 TAX RATES FOR INDIVIDUAL TAXPAYERS BY FILING STATUS

MARRIED FILING MARRIED FILING

TAX RATES JOINTLY SEPARATELY HEAD OF HOUSEHOLD SINGLE INDIVIDUAL

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Individuals are also permitted to carry their net operating losses back two yearsand forward 20 years, but their NOLs must be adjusted to reflect business-relatedlosses only For example, the standard deduction and personal and dependencyexemptions do not represent business expenses; thus, their total must be addedback when calculating the amount of the individual’s loss subject to the NOLprovision.

Additions to the Tax Liability

Both corporate and individual taxpayers may be liable for an addition to the regular

tax called the alternative minimum tax If the taxpayer takes what is considered to be

“excess” advantage of certain benefits built into the tax laws, the taxpayer may besubject to the alternative minimum tax, which is almost a “flat” tax.19Corporationsand individuals determine this tax by including certain items20 that were excludedfrom regular taxable income in an expanded tax base called alternative minimum tax-able income, reducing or eliminating deductions for other items and changing the tim-ing of the inclusion of income items and the deduction for deductible items.21Thealternative tax rate is then applied to this expanded tax base Corporations are sub-ject to a single 20 percent tax rate; individuals are subject to two rates—26 percent onalternative taxable income up to $175,000 and 28 percent on income in excess

of $175,000

EXAMPLE 22

The Z Corporation owes a regular tax of $43,000 It has alternative taxable income of $340,000.

Tax Prepayments and Credits

After determining the tax liability, an individual or corporation deducts certain items

of prepayment and credit from the tax owing The most common credit (which is notreally a credit at all, but a prepayment of the tax) is for the taxes withheld and for esti-mated tax payments Taxpayers are required to make some form of prepayment of theanticipated tax liability For corporations, this takes the form of estimated tax pay-ments For most individuals, prepayments take the form of withholding on salary orwages If, however, the taxpayer has self-employment income or transactions resulting

in significant income on which there is no withholding (such as gain on sale of ments), then the individual must also make estimated tax payments Failure to makethe appropriate amount of tax prepayments subjects the taxpayer to penalties andinterest

invest-19 A tax that defines income very broadly, allows few deductions, and has a single tax rate applicable to all taxpayers is normally considered a flat tax.

20 Tax-exempt interest income from private activity bonds (municipal bonds whose proceeds benefit private businesses) is an example of an item that is not taxable for regular tax purposes but is subject to the alternative minimum tax.

21 For example, the depreciation adjustment is the difference between depreciation calculated for regular tax purposes and depreciation calculated under an alternative set of rules using longer lives and less accelerated methods.

22 Self-employment income includes income from sole proprietorships and most income passed through from partnerships to their general partners.

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EXAMPLE 23

Z Corporation in the previous example paid $67,500 in estimated tax payments It now only

owes $500 in tax because its estimated tax payments offset the tax liability determined for

the year.

The taxpayer may be entitled to other credits for having participated in certain

activities, such as the research credit for specified research activities, or for having

made certain qualifying expenditures, such as paying for child care Credits are a

direct reduction in the tax liability of the taxpayer If the taxpayer’s tax liability

exceeds the credits, then the taxpayer must pay the additional tax If the taxpayer’s

credits are greater than the tax liability, generally only those taxes withheld or

pre-paid through estimated tax payments are refunded.23If other credits exceed the tax

liability, some credits may be carried to other years to offset a tax liability in the

car-ryover year (for example, the general business credit), but other credits are lost

entirely (for example, the dependent care credit) Figure 1.5 provides examples of

credits

Other Entities

A business operated as a sole proprietorship, partnership (including limited liability

companies electing partnership treatment and limited liability partnerships), or S

cor-poration follows the corporate tax model, except the model ends at taxable income or

loss This taxable income or loss is reported directly to the business owners who then

include their share of it in their tax returns

The third type of taxable entity, the fiduciary entity, is either a trust or an estate

Trusts and estates are nonbusiness legal entities that hold assets and may have income

An estate is created when a person who has any assets dies An executor or personal

representative manages the estate assets until they can be distributed to the heirs or

beneficiaries A trust is created by a person (called a grantor) placing assets in the

hands of a trustee for the benefit of a third party (called a beneficiary) Because trusts

and estates may hold assets that earn income, they are subject to income taxes Their

tax formula has characteristics of both the individual tax model and the pass-through

entity Income is generally taxed at the entity level to the extent the income remains in

FIGURE

1.5 TAX CREDITS

Credits Applicable to All

Taxpayers

Alternative minimum tax credit

Foreign tax credit

Investment tax credit

Other general business credits

including:

Credit for research expenditures

Work incentive credit

Orphan drug credit

Alcohol fuels credit

Credits Applicable to Individual Taxpayers Only

Earned income credit Education credits Child tax credit Dependent care credit Adoption credit Credit for the elderly and disabled

23 There are several refundable credits—that is, credits that will result in a payment to the taxpayer even if

there is no tax liability One such refundable credit is the earned income credit applicable to low-income

taxpayers This credit acts like a negative income tax.

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The tax brackets for estates and trusts are much more compact than the individualtax brackets They reach the highest tax bracket at taxable income of more than $10,450and there is no 10 percent tax bracket Because the beneficiaries are usually in lowermarginal tax brackets, distributing the income annually to the beneficiaries usuallyresults in lower taxes overall.

EXAMPLE 24

A trust has $6,000 of taxable interest that it receives in the current year It can retain the income or distribute it to the beneficiary, Craig, who is 19 years old and a college student with no other income, is claimed as a dependent on his parents’ tax return The trust’s taxable income is $5,900

claimed on his parents’ tax return and he is permitted no personal exemption If the $6,000 is tributed to Craig, he has taxable income of $5,150, all taxed at 10 percent—a tax of $515 Thus,

C HOICE OF B USINESS E NTITY

Businesses are normally operated as sole proprietorships, partnerships, or tions Corporations can be divided into C or regular corporations and S corporations.There is a relatively new type of entity called the limited liability company (LLC) Thiscombines many of the advantages of a partnership with the advantages of a corpora-tion Additionally, other special variations on the partnership form include the limitedliability partnership (LLP) and the professional limited liability partnership (PLLP).The differences among these special forms revolve around the liability protection

corpora-afforded the owners For tax return purposes, however, there are only four types of

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fol-also pass their income through to their owners, who are then taxed on that income.

The businesses, however, file information tax returns with the IRS.24

Sole Proprietorships

A one-owner business can operate as a sole proprietorship or a corporation Because a

partnership requires co-owners, and many states with limited liability company statutes

do not allow one-person limited liability companies, these forms are not available to a

sole owner Individuals who do business as independent contractors usually operate as

sole proprietors

There are both advantages and disadvantages of a sole proprietorship A sole

pro-prietorship requires no formal filing with the state, which a corporation is required to

do In other words, nothing extra must be done to form a sole proprietorship

A sole proprietorship may have no employees or it can be a large business with

many employees It can operate any type of business—manufacturing, distribution,

retail, or service However, the owner of a sole proprietorship is considered a

self-employed individual, so self-employment tax25 must be paid on the net profit of the

business Also, because the sole proprietor is not considered an employee, he or she is

not eligible for the tax-free employee fringe benefits for which a corporate employee

is eligible.26

Income and expenses for a sole proprietorship are reported on Schedule C: Profit

or Loss from Business (Sole Proprietorship) of the individual’s Form 1040 and

self-employment tax is computed on Form SE: Self-Employment Tax No separate business

tax return is due The sole proprietor reports all of the net profits from the business as

income regardless of how much he or she withdrew from the business during the year

EXAMPLE 25

Gary is the sole proprietor of Gary’s Garage Gross income for the business is $100,000 and

oper-ating expenses are $40,000 for the year During the year Gary withdraws $50,000 from the

busi-ness for his living expenses Gary reports the operating income and expenses on Schedule C,

profit from his business on his Form 1040, where he computes taxable income for the year, even

though he withdrew only $50,000 Gary must also pay self-employment tax on the $60,000 net

business profits.

A tax advantage for a sole proprietorship is that a business loss can offset the

tax-payer’s other income in calculating taxable income for the individual

EXAMPLE 26

Christina owns a sole proprietorship that has a net loss of $10,000 Christina also works as an

employee for another business from which she receives a salary of $30,000 Christina will be able

to use her $10,000 sole proprietorship loss to shelter part of her salary from taxation, reducing her

adjusted gross income to $20,000.

The primary disadvantage of the sole proprietorship is that the owner is fully liable

for all the debts of the business and could lose all of his or her personal assets to satisfy

a judgment against the business A sole proprietorship is not considered an entity

sepa-rate from its owner

24 An information return is a tax return that reports each owner’s share of profits or losses to the IRS.

No tax is paid with this return; instead any tax owed is paid by the owners with their tax returns.

25 Self-employed individuals pay both the employer’s and employee’s share of Social Security and

Medicare taxes resulting in a combined rate of 15.3% on the first $97,500 of self-employment income

and 2.9% on the excess in 2007 If the business has a loss, no self-employment tax is owed that year.

26 Employee fringe benefits are discussed in Chapter 4 Examples include health insurance and life

insurance.

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EXAMPLE 27

Jason owns a small bicycle shop that he operates as a sole proprietorship He recently assembled

a bicycle and sold it to a customer Unfortunately when Jason assembled the bicycle, he failed to tighten the lug nuts that secure the front tire The customer was riding her new bicycle when the front wheel came off and she was thrown off the bike, breaking her collarbone and injuring her neck She filed a lawsuit against the bicycle shop for negligence Assuming that Jason loses this lawsuit, he would have to use his personal assets to cover any judgment if his insurance is not sufficient to cover his liability for damages Jason can lose more than he has invested in his business activity.

Partnerships

A partnership consists of two or more individuals (or other entities) who join together to

carry on a business One advantage of the partnership form is the absence of restrictions

on who can be a partner A partner can be an individual or any type of entity, includinganother partnership, a corporation, an estate, or a trust Similar to sole proprietors, how-ever, general partners have unlimited liability for partnership debts and cannot beemployees of the partnership and participate in employee fringe benefits

A partnership is referred to as a “conduit” because it passes the income, gains,

loss-es, deductions, and credits through to its owners to be taxed on their individual returnsand does not pay tax itself Although a partnership must file a separate tax return

(Form 1065: U.S Partnership Return of Income, which is due by April 15 for

calendar-year partnerships), it is only an informational return that reports each partner’s share

of the profits or losses to the IRS so that the IRS knows how much each partner should

be reporting on his or her individual tax return Most of the items of income or tion that pass through to the partners retain their individual character For example, apartnership’s long-term capital gain will be taxed as a long-term capital gain to thepartners receiving it

deduc-One disadvantage of conduit taxation is that the owners are taxed on their share ofthe profits, regardless of whether they receive any distributions from the business.Thus, if profits are retained in the business, the partners must pay taxes on theseretained profits, even though they receive no cash distributions These profits can bedistributed at a later date, however, without incurring a second tax

EXAMPLE 28

Ginny owns a one-third interest in the PEP Partnership The partnership reports $21,000 of income for the current tax year but makes no distributions to the partners In spite of not having received

income for the tax year However, Ginny can later withdraw $7,000 from the partnership without being subject to additional tax.

If a partnership incurs a loss, the loss is also passed through to the partners and may

be deductible from the partner’s other income The total loss that an owner may deductfrom an investment in a partnership is limited to the partner’s basis in the partnershipinterest.27

Partner’s Basis Account

The partner’s basis account is a measure of a partner’s investment in the partnership

at any given time It ensures that the partnership’s income is taxed only once and isthe upper limit on the amount a partner may receive as a tax-free distribution, as well

as the limit on the amount of loss that can be deducted A partner’s beginning basis

27 The passive income and at-risk rules may also prevent the deduction unless the partner actively participates in the partnership and his or her investment is at risk These rules are discussed in Chapter 10.

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is the cash and the adjusted basis of any property that is contributed to the

partner-ship The partner’s basis is then increased by any income or gains that flow through

to the partner and is decreased by any losses and distributions The deduction for

losses that flow through is limited to the partner’s basis in the partnership interest

(after all adjustments for gains, income, and distributions) because the partner’s basis

can never be negative Once a partner’s basis is reduced to zero, no additional loss

can be deducted This excess loss is carried forward until the partner again has

posi-tive basis

EXAMPLE 29

Jennifer is a 40 percent partner At the beginning of year 1, her basis in the partnership is $200.

During this year, the partnership has $2,000 of ordinary income The partnership distributes $500

$2,000 as income, increasing her basis to $2,000 and then deducts the $500 loss carried over from

A unique feature of the partnership form is the increase in the partners’ bases for

their share of partnership liabilities Thus, a greater share of losses may be deducted

by a partner of a partnership that has liabilities than one without When the liabilities

are repaid, however, partners must also reduce their bases for their share of

dis-charged debt

EXAMPLE 30

Assume the partnership in Example 29 borrows $5,000 at the beginning of year 2 As a 40 percent

as a result of the debt She is now able to deduct the entire second-year loss of $1,000, reducing

Corporations

Corporations must file articles of incorporation with the state in which their principal

office is located A corporation sells its stock and the shareholders are only at risk for

their capital investment If the corporation fails, the shareholders are not liable for the

outstanding debts of the corporation If a shareholder desires to withdraw from the

corporation, he or she need only find a buyer for the stock

A corporation facilitates centralized management so that day-to-day operations do

not require the input of all the owners Additionally, the corporation’s life is not

restricted The death of an owner or a transfer of stock ownership does not end the

cor-poration’s legal existence

The owners of a corporation are also allowed to be employees Shareholder-employees

can benefit from fringe benefits in before-tax dollars while owner-workers of other

busi-ness forms are not granted this tax-favored treatment Also, when the corporate rates are

lower than the individual tax rates, the owners have increased capital for reinvestment

and business expansion

28 Jennifer can increase her basis by contributing cash or other property to the partnership Her basis will

also be increased when the partnership earns a profit and allocates Jennifer’s share of that profit to her

basis account.

Tiêu đề	Taxation for Decision Makers 2008 Edition
Tác giả	Shirley Dennis-Escoffier, Karen A. Fortin
Người hướng dẫn	Jack W. Calhoun, John Barans, Michelle Kunkler, Rob Dewey, John Rich, Patti Hudepohl, Keith Chasse, Joanna Grote, Jessica Kempf, Doug Wilke, Kristen Hurd
Trường học	Thomson South-Western
Chuyên ngành	Taxation
Thể loại	Textbook
Năm xuất bản	2008
Thành phố	Pondicherry

Định dạng
Số trang	606
Dung lượng	30,27 MB