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www.downloadslide.com www.downloadslide.com www.downloadslide.com TAXATION FOR DECISION MAKERS 2012 EDITION Shirley Dennis-Escoffier Karen A. Fortin ©WILEY CUSTOM SERVICES www.downloadslide.com ©WILEY CUSTOM SERVICES Taxation for Decision Makers, 2012 Edition Shirley Dennis-Escoffier and Karen A. Fortin Cover design by Rocky Buckley, Black Diamond Graphics. Cover photo credits: American hundred dollar bills, US dollar bill, US money, and Pyramid on US dollar bill: Corbis Digital Stock. The Americas on a Globe: PhotoDisc, Inc./Getty Images. Copyright © 2012 by Shirley Dennis-Escoffier and Karen A. Fortin All rights reserved. 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ISBN 978-1-118-09155-5 Printed by Victor Graphics, Inc. 10 9 8 7 6 5 4 3 2 1 www.downloadslide.com Brief Table of Contents Preface xii part I INTRODUCTION TO TAXATION AND ITS ENVIRONMENT 1 1 AN INTRODUCTION TO TAXATION 2 2 THE TAX PRACTICE ENVIRONMENT 47 part II INCOME AND EXPENSE DETERMINATION 95 3 DETERMINING GROSS INCOME 96 4 EMPLOYEE COMPENSATION 143 5 BUSINESS EXPENSES 198 part III PROPERTY CONCEPTS AND TRANSACTIONS 245 6 PROPERTY ACQUISITIONS AND COST RECOVERY DEDUCTIONS 246 7 PROPERTY DISPOSITIONS 287 8 TAX-DEFERRED EXCHANGES 337 part IV BUSINESS TAXATION 381 9 TAXATION OF CORPORATIONS 382 10 SOLE PROPRIETORSHIPS AND FLOW-THROUGH ENTITIES 428 part V TAXATION OF INDIVIDUALS 473 11 INCOME TAXATION OF INDIVIDUALS 474 12 WEALTH TRANSFER TAXES 533 APPENDIX A TAX RESEARCH USING RIA CHECKPOINT® 576 APPENDIX B PRESENT VALUE AND FUTURE VALUE TABLES 586 APPENDIX C SAMPLE FILLED-IN TAX RETURNS 588 APPENDIX D TAX RETURN PROBLEMS 631 Index 638 iii www.downloadslide.com Table of Contents Preface . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .xii CHARACTERISTICS Economy 36 I Introduction to Taxation and Its Environment AN INTRODUCTION TO TAXATION . . . . . . . . . . KEY CONCEPTS . . . . . . . . . . . . . . . . . . . . . SETTING THE STAGE—AN INTRODUCTORY CASE AN INTRODUCTION TO TAXATION . . . . . . . . . . Certainty 37 1 . . . . . . . . Convenience 37 REVISITING .2 .2 .3 .3 THE INTRODUCTORY KEY TERMS . . . . . . . . . . . . . . . . . . . . . . . . . 39 TEST YOURSELF . . . . . . . . . . . . . . . . . . . . . . . 39 PROBLEM ASSIGNMENTS . . . . . . . . . . . . . . . . . . 40 A Brief History of Income Taxation in the Check Your Understanding 40 United States 3 Crunch the Numbers 41 Objectives of Taxation 4 Think Outside the Text 43 Current Influences on the Tax Law 5 Identify the Issues 44 Search the Internet 44 THE TAXING UNITS AND THE BASIC INCOME TAX MODELS . . . . . . . . . . . . . . . . . . . .6 Develop Planning Skills 45 ANSWERS The Individual and Corporate Tax Models 8 Gross Income 8 · Property Transactions 10 · Deductions 11 · Determining the Gross Tax Liability 15 · Tax Losses 16 · Additions to the Tax Liability 17 · Tax Prepayments and Credits 18 Other Entities 19 CHOICE OF CASE . . . . . . . . 38 SUMMARY . . . . . . . . . . . . . . . . . . . . . . . . . . . 38 What Is a Tax? 3 BUSINESS ENTITY . . . . . . . . . . . . . . 19 Sole Proprietorships 20 Partnerships 21 2 TO TEST YOURSELF . . . . . . . . . . . . . . 46 THE TAX PRACTICE ENVIRONMENT . . . . . . . . . . .47 KEY CONCEPTS . . . . . . . . . . . . . . . . . . . . . . . 47 SETTING THE STAGE—AN INTRODUCTORY CASE . . 48 AN INTRODUCTION TO TAX PRACTICE . . . . . . . . 48 TAXES AND CASH FLOW . . . . . . . . . . . . . . . . . 49 Partner’s Basis Account 22 Cash Flows and Present Value 49 Limited Liability Companies 23 Significance of the Marginal Tax Rate 51 TAX PLANNING STRATEGIES . . . . . . . . . . . . . . . 51 Corporations 24 S Corporations 24 Timing Income and Deductions 51 Comparing Business Entity Attributes 26 Income Shifting 52 OTHER TYPES OF TAXES . . . . . . . . . . . . . . . . . 26 Wealth Taxes 26 Wealth Transfer Taxes 28 Consumption Taxes 29 Tariffs and Duties 31 TYPES iv GOOD TAX . . . . . . . . . . 35 Equity 35 part 1 OF A OF TAX RATE SYSTEMS . . . . . . . . . . . . . . 31 Changing the Character of Income 53 Other Factors Affecting Tax Planning 54 Cash Flow 54 · Nontax Considerations and Judicial Doctrines 55 SOURCES OF AUTHORITY . . . . . . . . . . . . . . . . . 57 The Legislative Process 57 Internal Revenue Code 59 The Progressive Tax Rate System 31 Administrative Sources of Authority 60 Proportional “Flat” Tax Rate 33 Treasury Regulations 60 · Other IRS Rulings 61 Regressive Taxes 34 Judicial Sources of Authority 62 www.downloadslide.com v Table of Contents TAX RESEARCH . . . . . . . . . . . . . . . . . . . . . . . 62 WHAT IS INCOME? . . . . . . . . . . . . . . . . . . . . . 97 Gather the Facts and Identify the Issues 63 Taxable versus Gross Income 97 Locate and Evaluate the Relevant Authority 64 Tax versus Financial Accounting 98 Communicate the Recommendations 64 Return of Capital Principle 98 Keeping Up-To-Date 65 TAX COMPLIANCE . . . . . . . . . . . . . . . . . . . . . . 65 Filing a Tax Return 65 WHEN IS INCOME RECOGNIZED? . . . . . . . . . . . . 99 The Tax Year 100 Accounting Methods 102 Late Filing and Late Payment Penalties 66 · Statute of Limitations 67 Cash Method 102 · Limits on Use of Cash Method 103 · Accrual Method 103 Selecting Returns for Audit 68 WHO RECOGNIZES Types of Audits 69 THE INCOME? . . . . . . . . . . . 105 Assignment of Income Doctrine 105 The Appeals Procedure 70 Community Property Laws 106 Taxpayer Noncompliance Penalties 71 Collection Procedures 71 SOURCES Offer in Compromise 71 · Innocent Spouse Relief 72 OF INCOME . . . . . . . . . . . . . . . . . . 106 Interest Income 106 Professional Responsibilities and Ethics 72 Avoidance versus Evasion 72 · Tax Preparer Registration 73 Tax Preparer Penalties 73 Interest on Municipal Bonds 106 · Original Issue Discount 108 Market Discount 109 · Below-Market-Rate and Interest-Free Loans 109 Tax Professionals’ Dual Responsibilities 74 Dividend Income 112 Sources of Guidance 75 Stock Dividends 113 REVISITING THE INTRODUCTORY CASE SUMMARY . . . . . . . . . . . . . . . . . . . KEY TERMS . . . . . . . . . . . . . . . . . TEST YOURSELF . . . . . . . . . . . . . . . PROBLEM ASSIGNMENTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77 77 78 78 79 Check Your Understanding 79 Annuity Income 114 Transfers from Others 115 Prizes and Awards 115 · Government Transfer Payments 115 · Legal Settlements 117 Discharge of Indebtedness 119 Tax Benefit Rule 120 System for Reporting Income 120 Crunch the Numbers 81 EXCLUSIONS . . . . . . . . . . . . . . . . . . . . . . . . 121 Think Outside the Text 82 Identify the Issues 82 Gifts and Inheritances 121 Develop Research Skills 83 Insurance Proceeds 122 Life Insurance 122 · Accident and Health Insurance 123 Search the Internet 84 Scholarships 124 Develop Planning Skills 85 ANSWERS TO TEST YOURSELF . . . . . . . . . . . . . . .87 APPENDIX 2A TAX RESEARCH . . . . . . . . . . . . . .87 Other Exclusions 125 JURISDICTIONAL ISSUES . . . . . . . . . . . . . . . . . 125 Gather the Facts and Identify the Issues 87 International Issues 126 Locate and Evaluate the Relevant Authorities 87 Taxpayers Subject to U.S. Taxation 126 Reading the Code 87 · Committee Reports 88 · Regulations 88 · Revenue Rulings and Letter Rulings 88 · Acquiescence Policy 88 · Other Pronouncements 88 · Court Decisions 89 · Using a Citator 91 · When to Stop Searching 91 State and Local Taxation 128 Communicating the Recommendations 92 Installment Method 129 Long-Term Contracts 130 Problem Assignments 93 Check Your Understanding 93 part II Income and Expense Determination EXPANDED TOPICS—SPECIAL METHODS . . . . . . 129 95 REVISITING THE INTRODUCTORY CASE SUMMARY . . . . . . . . . . . . . . . . . . KEY TERMS . . . . . . . . . . . . . . . . . TEST YOURSELF . . . . . . . . . . . . . . PROBLEM ASSIGNMENTS . . . . . . . . . Check Your Understanding 134 3 DETERMINING GROSS INCOME . . . . . . . . . . . . . .96 KEY CONCEPTS . . . . . . . . . . . . . . . . . . . . . . . 96 SETTING THE STAGE—AN INTRODUCTORY CASE . . 97 Crunch the Numbers 135 Think Outside the Text 139 Identify the Issues 140 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 131 132 133 133 134 www.downloadslide.com vi Table of Contents Develop Research Skills 140 Excess Housing Cost Exclusion 181 Search the Internet 141 Credit for Foreign Taxes 182 Develop Planning Skills 141 Moving Expenses 183 ANSWERS TO Tax Reimbursement Plans 183 TEST YOURSELF . . . . . . . . . . . . . 142 Tax Treaties 184 4 EMPLOYEE COMPENSATION . . . . . . . . . . . . . . . .143 KEY CONCEPTS . . . . . . . . . . . . . . . . . . . . . . 143 SETTING THE STAGE—AN INTRODUCTORY CASE . 144 EMPLOYEE COMPENSATION . . . . . . . . . . . . . . . 144 REVISITING THE INTRODUCTORY CASE SUMMARY . . . . . . . . . . . . . . . . . . KEY TERMS . . . . . . . . . . . . . . . . . TEST YOURSELF . . . . . . . . . . . . . . PROBLEM ASSIGNMENTS . . . . . . . . . Payroll Taxes 144 Employee versus Independent Contractor 146 Check Your Understanding 188 Timing of Compensation Deduction 147 Crunch the Numbers 189 Reasonable Compensation 148 Think Outside the Text 193 S Corporations and Unreasonably Low Salaries 149 · Employing Children 150 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 184 185 186 187 188 Identify the Issues 194 Develop Research Skills 194 EMPLOYEE FRINGE BENEFITS . . . . . . . . . . . . . . 150 Search the Internet 195 Group Term Life Insurance Premiums 151 Develop Planning Skills 196 Health and Accident Insurance Premiums 153 ANSWERS Child and Dependent Care Programs 154 TO TEST YOURSELF . . . . . . . . . . . . . 197 Cafeteria Plans 154 Meals and Lodging 155 No-Additional-Cost Services 156 Employee Purchase Discounts 156 Employee Achievement Awards 157 5 BUSINESS EXPENSES . . . . . . . . . . . . . . . . . . . .198 KEY CONCEPTS . . . . . . . . . . . . . . . . . . . . . . 198 SETTING THE STAGE—AN INTRODUCTORY CASE . 198 CRITERIA FOR DEDUCTIBILITY . . . . . . . . . . . . . 199 De Minimis Fringe Benefits 157 General Provisions for Trade or Business Expenses 199 Working Condition Fringe Benefits 158 Ordinary and Necessary 200 Employee Relocation Expenses 160 Contrary to Public Policy 201 Distance Test 160 · Time Test 161 Related to Tax-Exempt Income 201 Education Expenses 162 Accrued to Related Party 202 Substantiating Business Expenses 163 Obligation of Another Taxpayer 202 EMPLOYEE STOCK AND STOCK OPTIONS . . . . . . 164 Restricted Stock 165 Substantiation 202 TIMING OF DEDUCTIONS . . . . . . . . . . . . . . . . 203 Stock Options 166 Accrual Method 203 Nonqualified Stock Options 166 · Incentive Stock Options 167 Cash Method 204 Phantom Stock and Stock Appreciation Rights 168 Restrictions on Prepaid Expenses 205 DEFERRED COMPENSATION AND RETIREMENT PLANNING . . . . . . . . . . . . . . . . . 168 Qualified Retirement Plans 168 Types of Retirement Plans 170 Contribution Limits 172 Disputed Liabilities 206 COSTS OF STARTING A BUSINESS . . . . . . . . . . . 206 Business Investigation and Start-up Expenses 207 Organization Costs 208 OPERATING EXPENSES . . . . . . . . . . . . . . . . . . 208 Nonqualified Deferred Compensation Plans 173 Business Meals and Entertainment 208 Individual Retirement Accounts 173 Directly Related to or Associated with Entertainment 209 · Restrictions on Deductions 209 Roth IRAs 175 SELF-EMPLOYED INDIVIDUALS . . . . . . . . . . . . . 176 Travel and Transportation Expenses 210 Fringe Benefits Limited 178 Travel Away from Home 210 · Temporary Assignments 210 · Transportation Expenses 211 · Combining Business with Pleasure Travel 212 Retirement Plans 179 Bad Debt Expenses 213 Employment Tax Consequences 176 EXPANDED TOPICS—FOREIGN ASSIGNMENTS . . . 180 Foreign Earned Income Exclusion 180 Insurance Premiums 214 Legal Expenses 214 www.downloadslide.com vii Table of Contents PROVISIONS LIMITING DEPRECIATION . . . . . . . . 265 Taxes 214 LIMITED EXPENSE DEDUCTIONS . . . . . . . . . . . . 215 Mixed-Use Assets 265 Reduction in Business Use 266 · Additional Requirements for Employees 266 Residential Rental Property 215 De Minimis Exception 216 · Nominal Number of Personal · Days 216 · Nominal Number of Rental Days 216 Limits for Passenger Vehicles 267 Automobile Leasing 269 Home Office Expenses 218 Hobby Expenses 219 DEPLETION . . . . . . . . . . . . . . . . . . . . . . . . . 271 AMORTIZATION . . . . . . . . . . . . . . . . . . . . . . 272 EXPANDED TOPICS—BOOK/TAX DIFFERENCES . . 221 Accounting for Income Tax Expense 221 Research and Experimentation Expenditures 273 Calculating Tax Expense 222 · Effects of NOL Carryovers 224 · Realizing Deferred Tax Assets 225 · Accounting for Uncertainty in Income Taxes 225 · Exception for Foreign Earnings 228 Software 274 REVISITING THE INTRODUCTORY CASE SUMMARY . . . . . . . . . . . . . . . . . . KEY TERMS . . . . . . . . . . . . . . . . . TEST YOURSELF . . . . . . . . . . . . . . PROBLEM ASSIGNMENTS . . . . . . . . . UNICAP Rules and Inventory 228 REVISITING THE INTRODUCTORY CASE SUMMARY . . . . . . . . . . . . . . . . . . KEY TERMS . . . . . . . . . . . . . . . . . TEST YOURSELF . . . . . . . . . . . . . . PROBLEM ASSIGNMENTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 230 231 232 232 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 274 276 276 276 278 Check Your Understanding 278 . . . . . . . . 233 Crunch the Numbers 279 Check Your Understanding 233 Think Outside the Text 283 Crunch the Numbers 234 Identify the Issues 283 Think Outside the Text 239 Develop Research Skills 284 Identify the Issues 240 Search the Internet 284 Develop Research Skills 241 Develop Planning Skills 284 Search the Internet 242 ANSWERS TO TEST YOURSELF . . . . . . . . . . . . . 285 Develop Planning Skills 243 ANSWERS TO TEST YOURSELF . . . . . . . . . . . . . 243 part III Property Concepts and Transactions 245 7 PROPERTY DISPOSITIONS . . . . . . . . . . . . . . . . .287 KEY CONCEPTS . . . . . . . . . . . . . . . . . . . . . . 287 SETTING THE STAGE—AN INTRODUCTORY CASE . 288 DETERMINING GAIN OR LOSS ON DISPOSITIONS . 288 Property Dispositions and Cash Flow 288 Types of Dispositions 289 6 PROPERTY ACQUISITIONS AND COST RECOVERY DEDUCTIONS . . . . . . . . . . . . . . . . . . . . . . . .246 KEY CONCEPTS . . . . . . . . . . . . . . . . . . . . . . 246 SETTING THE STAGE—AN INTRODUCTORY CASE . 247 CAPITAL EXPENDITURES . . . . . . . . . . . . . . . . . 247 BASIS OF PROPERTY . . . . . . . . . . . . . . . . . . . 248 Acquisition in a Taxable Exchange 250 Acquisition by Gift 250 Acquisition by Inheritance 251 CASH FLOW AND AFTER-TAX COST . . . . . . . . . 252 MACRS . . . . . . . . . . . . . . . . . . . . . . . . . . . 253 Averaging Conventions 254 Half-Year Averaging Convention 254 · Mid-Quarter Averaging Convention 255 · Mid-Month Averaging Convention for Realty 257 Year of Disposition 258 Alternative Depreciation System (ADS) 259 Section 179 Expensing Election 260 Bonus Depreciation 263 Amount Realized 290 Realized versus Recognized Gain or Loss 291 Holding Period 291 Character of Gains and Losses 292 Section 1231 Assets 292 · Capital Assets 293 · Ordinary Income Assets 294 Mixed-Use Assets 294 DISPOSITION OF SECTION 1231 PROPERTY . . . . 294 Depreciation Recapture 295 Section 1245 Full Recapture 296 · Section 1250 Partial Recapture 297 · Additional Section 291 Corporate Recapture 297 Unrecaptured Section 1250 Gains for Individuals 298 Section 1231 Netting 299 Corporate Taxpayers 299 · Individual Taxpayers 300 Section 1231 Look-Back Rules 301 DISPOSITION OF CAPITAL ASSETS . . . . . . . . . . . 303 The Capital Gain and Loss Netting Process 303 Tax Treatment of Net Capital Gains and Losses 305 Corporate Taxpayers 305 · Individual Taxpayers 306 www.downloadslide.com viii Table of Contents DISPOSITION OF ORDINARY INCOME PROPERTY . 309 Casualty and Theft Losses 347 Measuring the Loss 347 · Insurance and Basis Considerations 348 · Deductible Amount 349 · Taxable Year of Deduction 350 MIXED-USE PROPERTY . . . . . . . . . . . . . . . . . 310 SPECIAL RULES FOR SMALL BUSINESS STOCK . . . . 310 Gains on Involuntary Conversions—Section 1033 351 Losses on Section 1244 Stock 310 Tax Deferral on Involuntary Conversions 351 · Qualifying Replacement Property 353 · Time Limits for Replacement 353 Section 1202 Gains on Qualified Small Business Stock 312 Involuntary Conversion of a Principal Comparison of Sections 1244 and 1202 313 SALE OF Residence 354 PRINCIPAL RESIDENCE—SECTION 121 . . 314 Debt Reductions, Short Sales, and Foreclosures ASSET TRANSFERS 317 TO BUSINESSES . . . . . . . . . . . 354 Transfers to Sole Proprietorships 354 LOSSES ON RELATED PARTY SALES . . . . . . . . . . 318 EXPANDED TOPICS—INDIVIDUAL CAPITAL GAINS TAX RATES . . . . . . . . . . . . . . . . . . . . .318 Transfers to Controlled Corporations—Section 351 355 Determining the Long-Term Capital Gains Tax Rate 319 The Control Requirement 355 · Property Other Than Stock Received 355 · Transferred Services 356 · Basis and Holding Period 356 · Effect of Liabilities 357 · Transfers to Existing Corporations 358 Modified Capital Gains Rates 319 Transfers of Property to a Partnership 358 Planning 321 Basis and Holding Period of a Partnership Interest 359 · Partnership Basis and Holding Period in Contributed Property 359 · Effect of Liabilities 360 REVISITING THE INTRODUCTORY CASE SUMMARY . . . . . . . . . . . . . . . . . . KEY TERMS . . . . . . . . . . . . . . . . . TEST YOURSELF . . . . . . . . . . . . . . PROBLEM ASSIGNMENTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 322 322 323 323 324 Formation of a Limited Liability Company 360 CORPORATE REORGANIZATIONS . . . . REVISITING THE INTRODUCTORY CASE SUMMARY . . . . . . . . . . . . . . . . . . KEY TERMS . . . . . . . . . . . . . . . . . TEST YOURSELF . . . . . . . . . . . . . . PROBLEM ASSIGNMENTS . . . . . . . . . Check Your Understanding 324 Crunch the Numbers 325 Think Outside the Text 331 Identify the Issues 332 Check Your Understanding 364 Develop Planning Skills 332 Crunch the Numbers 365 Search the Internet 334 Think Outside the Text 371 TO . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 361 362 362 363 363 364 Identify the Issues 371 Develop Planning Skills 334 ANSWERS . . . . . . Develop Research Skills 372 TEST YOURSELF . . . . . . . . . . . . . 335 Search the Internet 372 Develop Planning Skills 373 8 ANSWERS TO TEST YOURSELF . . . . . . . . . . . . . 373 APPENDIX 8A REORGANIZATIONS . . . . . . . . . . . 374 TAX-DEFERRED EXCHANGES . . . . . . . . . . . . . . .337 KEY CONCEPTS . . . . . . . . . . . . . . . . . . . . . . 337 SETTING THE Acquisitive Reorganizations 374 STAGE—AN INTRODUCTORY CASE . 338 Basis Adjustments 339 Basic Tax Consequences 375 · Type A Reorganization 376 · Type B Reorganization 376 · Type C Reorganization 377 · Type D Acquisitive Reorganization 377 · Type D Divisive Reorganization 377 Holding Period 340 Other Reorganizations 378 BASICS OF TAX-DEFERRED EXCHANGES . . . . . . . 338 LIKE-KIND EXCHANGES—SECTION 1031 . . . . . . 340 Other Considerations 379 Qualifying Properties 341 Problem Assignments 379 Determining Realized Gain or Loss and Check Your Understanding 379 the Effect of Boot 342 Basis and Holding Period of Like-Kind Property 343 Indirect Exchanges 344 OTHER TAX-DEFERRED EXCHANGES . . . . . . . . . 346 Wash Sales 346 INVOLUNTARY CONVERSIONS . . . . . . . . . . . . . . 347 part IV Business Taxation 9 381 TAXATION OF CORPORATIONS . . . . . . . . . . . . . .382 KEY CONCEPTS . . . . . . . . . . . . . . . . . . . . . . 382 SETTING THE STAGE—AN INTRODUCTORY CASE . 383