INSTRUCTOR’S MANUAL for McGraw-Hill’s Essentials of Federal Taxation 2024 Edition, 15th Edition By B

Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al.

INSTRUCTOR’S MANUAL for McGraw-Hill’s Essentials of Federal Taxation 2024 Edition, 15th Edition By Brian Spilker

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al.

Chapter 1 An Introduction to Tax INSTRUCTOR’S MANUAL

Learning Objectives 1-1. Demonstrate how taxes influence basic business, investment, personal, and political decisions.

1-2. Discuss what constitutes a tax and the general objectives of taxation.

1-3. Describe the different tax rate structures and calculate a tax.

1-4. Identify the various federal, state, and local taxes.

1-5. Apply appropriate criteria to evaluate alternate tax systems.

Teaching Suggestions This chapter provides an overview of why taxes are important, what a tax is, how to calculate a tax, various tax rates and tax rate structures, different types of federal, state, and local taxes, and how to evaluate a tax system. One intent of the chapter is to get students thinking about the pervasive influence of taxes and thus why it is important for a business or accounting student to understand taxes. Discussing how taxes affect decisions that they will face (buying a house, investing for retirement, etc.) is an effective way to pique students’ interest.

This chapter also provides an opportunity to motivate students by discussing the political importance of taxes and the debate over alternative tax systems. Throughout most of the chapter, you can tie the material discussed back to the debate over alternative tax systems. This is easily done in the section on evaluating alternative tax systems and alternative tax rate structures but may also be done for other parts of the text.

For example, when discussing how to calculate a tax, you can point out that once the tax base is computed, it is very easy to calculate virtually any tax. The difficulty is in determining the tax base. The implication of this understanding is that the tax rate structure (e.g., progressive versus proportional) has little effect on tax complexity.

In teaching this chapter, the time that you spend in class will vary based on how much discussion that you want to incorporate regarding evaluating tax systems and implicit taxes. Most of the concepts in this chapter are relatively straightforward, and thus, the chapter provides students with an introduction to tax without overwhelming them on the first day or so of class. This is particularly important if your students 1-2

Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al. have some trepidation regarding their first tax course.

Implicit tax is typically a difficult concept for students to understand. The text provides a good overview of implicit tax. If you plan to cover implicit tax in some detail, you might alert students that this is a difficult concept and that they should be careful to get familiar with this discussion in the text prior to class.

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al.

Assignment Matrix

DQ1-1 DQ1-2 DQ1-3 DQ1-4 DQ1-5 DQ1-6 DQ1-7 DQ1-8 DQ1-9 DQ1-10 DQ1-11 DQ1-12 DQ1-13 DQ1-14 DQ1-15 DQ1-16 DQ1-17 DQ1-18 DQ1-19 DQ1-20 DQ1-21 DQ1-22 DQ1-23 DQ1-24 DQ1-25 DQ1-26 DQ1-27 DQ1-28 DQ1-29 DQ1-30 DQ1-31 DQ1-32 DQ1-33 P1-34 P1-35 P1-36 P1-37 P1-38 P1-39 P1-40

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al.

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Lecture Notes 1) Who Cares About Taxes and Why? a) Businesses b) Politicians c) Individuals 2) What Qualifies as a Tax? a) Definition of a tax i) Key components of definition: payment is required, imposed by a government agency, and not directly tied to any benefit received by the taxpayer from the government b) Earmarked tax—definition and why this is considered a tax c) Quiz students on tax definition using examples in the PowerPoint slides.

3) How to Calculate a Tax a) Tax = Tax Base × Tax Rate i) Tax Base—what is actually taxed, usually expressed in monetary terms ii) Tax Rate—level of taxes imposed on the tax base, usually expressed as a percentage iii) Flat taxes iv) Graduated taxes v) Brackets b) Different ways to measure tax rates i) Marginal tax rate (1) Definition—tax rate that applies to the next additional increment of a taxpayer’s taxable income (or deductions)

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al.

(2)(2) Formula —

Tax



(New Total Tax  Old Total Tax) (New Taxable Income  Old Taxable Income)

Taxable Income (3) Useful in tax planning ii) Average tax rate (1) Definition—a taxpayer’s average level of taxation on each dollar of taxable income Total Tax (2)(2) Formula — Taxable Income (3) Useful in budgeting tax expenses or comparing the relative tax burdens of taxpayers iii) Effective tax rate (1) Definition—taxpayer’s average rate of taxation on each dollar of total income, including taxable and nontaxable income Total Tax (2)(2) Formula — Taxable Income (3) Provides the best depiction of a taxpayer’s tax burden iv) Work example in the PowerPoint slides calculating tax liability, marginal, average, and effective tax rates. c) Tax rate structures i) Proportional tax rate structure (1) Definition—also known as a flat tax, imposes a constant tax rate throughout the tax base (2) As the tax base increases, the taxes paid increase proportionally.

(3) The marginal tax rate remains constant and equals the average tax rate across the tax base.

(4) The most common example of a proportional tax is a sales tax. ii) Progressive tax rate structure (1) Definition—imposes an increasing marginal tax rate as the tax base increases.

(2) As the tax base increases, both the marginal tax rate and the taxes paid increase.

(3) Common examples of progressive tax rate structures include federal and state income taxes and federal estate and gift taxes. iii) Regressive tax rate structure (1) Definition—imposes a decreasing marginal tax rate as the tax base increases.

(2) As the tax base increases, the taxes paid increase, but the marginal tax rate decreases.

(3) Regressive tax rate structures are not common. In the United States, the Social Security tax and federal and state unemployment taxes employ a regressive tax rate structure. iv) Discuss how different taxes can be viewed as having different rate structures when you consider effective tax rates versus marginal tax rates (e.g., the sales tax).

4) Types of Taxes a) Federal taxes i) Income tax: Imposed on individuals, corporations, estates, and trusts. The largest federal tax. ii) Employment taxes: Employment taxes consist of the OASDI tax (Social Security tax) and the MHI tax (Medicare tax). The tax base for these taxes is wages or salary and employers and employees split these taxes equally. Self-employed individuals must pay these taxes in their entirety. iii) Unemployment taxes: Employers are also required to pay federal and state unemployment taxes, which fund temporary unemployment benefits for individuals terminated from their jobs without cause. iv) Excise taxes: A tax based on quantity of goods or services purchased. Common examples include taxes on alcohol, diesel fuel, gasoline, and tobacco products and on services such as telephone use and air transportation.

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al. v) Transfer taxes: The estate tax and gift taxes are based on the fair market values of wealth transfers upon death or by gift, respectively. b) State and local taxes i) Income tax: Most states impose an income tax. The calculation varies by state. ii) Sales and use taxes: The tax base for a sales tax is the retail sales of goods and some services.

Retailers collect and remit this tax. The tax base for the use tax is the retail price of goods owned, possessed, or consumed within a state that were not purchased within the state. The purpose of a use tax is to discourage taxpayers from buying goods out of state in order to avoid or minimize the sales tax in their home state. iii) Property taxes: Assessed on the fair market value of real property and personal property.

These are ad valorem taxes. iv) Excise taxes c) Implicit taxes i) Indirect taxes that result from a tax advantage the government grants to certain transactions. ii) Defined as the reduced before-tax return that a tax-favored asset produces because of its taxadvantaged status. iii) Difficult to quantify but important to understand in evaluating the relative tax burdens of taxadvantaged investments. iv) Walk through examples of implicit taxes in text.

5) Evaluating Alternative Tax Systems a) Sufficiency

i) Involves assessing the aggregate size of the tax revenues that must be generated and making sure that the tax system provides these revenues. ii) Static forecasting: Forecasting revenue ignores how taxpayers might alter their activities in response to a tax law change and to base projected tax revenues on the existing state of transactions. iii) Dynamic forecasting: Forecasting that tries to predict possible responses by taxpayers to new tax laws. iv) Income effect: As tax rates go up, people will work harder to maintain same after-tax income. v) Substitution effect: As tax rates go up, people will substitute nontaxable activities because the marginal value of taxable ones has decreased. vi) Equity: A tax system is considered fair or equitable if the tax is based on the taxpayer’s ability to pay. vii) Horizontal equity: Two taxpayers in similar situations pay the same tax. viii) Vertical equity: Taxpayers with greater ability to pay tax pay more tax relative to taxpayers with a lesser ability to pay tax. Vertical equity can be viewed in terms of tax dollars paid or tax rates. Vertical equity may also be evaluated using effective tax rates instead of simply considering the tax rate structure. ix) Certainty: Taxpayers should be able to determine when to pay the tax, where to pay the tax, and how to determine the tax. b) Convenience i) A tax system should be designed to be collected without undue hardship to the taxpayer. c) Economy i) A tax system should minimize the compliance and administration costs associated with the tax system. ii) Can be viewed from the taxpayer’s and government’s perspective.

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al. d) Compare the income tax and sales tax using the equity, certainty, convenience, and economy criteria. e) Evaluating tax systems—the trade-off i) Much of the debate regarding alternative tax systems reduces to a choice between simplicity and fairness. ii) Those taxes that generally are simpler and easier to administer are typically viewed as less fair. Those taxes that may be viewed as more fair are often more complex to administer.

Class Activities 1. Suggested class activities o

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Designing a tax system: Tell students that the class has just seceded from the United States and needs to develop a tax system sufficient to generate $XX, XXX from the class members. Have the students break into groups of three to five to design a tax system. As part of this task, they are to evaluate the advantages and disadvantages of their tax. The group judged by the class to have the most advantageous tax system receives bonus participation points for the day.

What is fair? Put two different tax systems in front of the class—one a proportional tax rate, one a progressive tax system. Poll the class by show of hands to determine which tax system each person views as being fairer. Either in groups or as a class, have the students discuss why they view a specific system as being fairer. After the discussion, poll the class by show of hands to determine if anyone has changed their view of which tax is fairer. Then discuss with the class that there is no right answer as to which system is fairer. Instead, the answer depends on a person’s individual views on fairness.

One versus the class: Have one student volunteer as the “one” with the other class members being the “group.” Use the key facts boxes in the text to develop multiple-choice questions (A, B, C answers) and then quiz the volunteer and the class on the questions. The volunteer and each class member will need to write the letters A, B, and C on separate sheets of paper and then hold up their appropriate response to the question. Once a student (either the “one” or a member of the “group”) misses a question, he or she is eliminated from the competition. After six (or some other number) of questions, those students left standing receive bonus participation points for the day.

Discuss current tax policy topics: Find a few recent articles discussing tax reform, the current income distribution, or the millionaire surtax. Post the articles so that students can read before class and ask a few questions to begin the class discussion.

2. Research activities o o

Show the class the IRS website and some of the materials included in the website—e.g., publications, IRS forms, etc.

Have students research the presidential candidates’ tax platforms and compare and contrast the likely changes to the Internal Revenue Code.

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al.

Chapter 2 Tax Compliance, the IRS, and Tax Authorities INSTRUCTOR’S MANUAL

Learning Objectives 2-1.Identify the filing requirements for income tax returns and the statute of limitations for assessment.

2-2. Outline the IRS audit process, how returns are selected, the different types of audits, and what happens after the audit.

2-3. Evaluate the relative weights of the various tax law sources.

2-4. Describe the legislative process as it pertains to taxation.

2-5. Perform the basic steps in tax research.

2-6. Describe tax professional responsibilities in providing tax advice.

2-7. Identify taxpayer and tax professional penalties.

Teaching Suggestions This chapter provides a summary of the filing requirements for income tax returns, the IRS audit process, tax law sources and tax research, tax professional responsibilities, and taxpayer and tax practitioner penalties. The time allotted to this chapter will vary based on your expectations regarding the students’ abilities to conduct research in the course. The remaining material in the chapter (filing requirements, IRS audit process, tax professional responsibilities, and taxpayer and tax practitioner penalties) can be covered in a class session (or two).

Compared to Chapter 1 and later chapters, the material in Chapter 2 could be considered somewhat “dry.”

Thus, it is important to bring this material to life in the classroom as much as possible. Some suggestions for the class discussion include:  

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Filing requirements: Provide a basic overview of the filing requirements by entity and statute of limitations and then use discussion questions 1 through 3 and problems 43 through 49 to quiz students on their understanding.

IRS audit process: Most students are interested in how the IRS selects returns for audit.

Discussing high-profile IRS cases (Richard Hatch, Survivor; Willie Nelson; Al Capone) or personal experiences with IRS audits is typically well received. After the discussion, quizzing the students on identifying the selection method and audit type for various fact patterns is an effective way to make sure that your students can apply the concepts from this discussion.

Tax law sources: The depth to which you cover the various sources will vary with your expectations regarding the students’ abilities to conduct research. If students will be expected to research problems, read primary authorities, etc., showing examples of the specific types of authorities that they will research (code sections, regulations, etc.), highlighting their attributes, contrasting different authorities, and discussing how to locate the authorities and make sure that they are “current” should prove beneficial. This discussion could then be followed with a discussion of how to conduct research and an in-class example of a simple research problem. [As an out-of-class exercise, you might assign students to locate specific

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al. primary authorities (e.g., court cases, revenue rulings, etc.) and related discussion in an available tax service (CCH, RIA, BNA, etc.) and have the students summarize the issue addressed in the primary authority and tax service and how they located each authority.]

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If instead students are simply required to have a basic understanding of tax authorities with little or no research expectation, most of the discussion of authorities could focus on comparing different authorities and their relative weights. This discussion can then be reinforced with classroom questions comparing the weight of different authorities or contrasting different authorities using the “one versus the group” activity suggested below.

Tax legislation: This discussion may be aided by displaying Exhibit 2-7. You may also remind your class of the Schoolhouse Rock song “I’m Just A Bill,” which highlights the legislative process. You can watch this song on YouTube.

Basic tax research steps: This discussion may be enhanced by walking students through the research example in the text or through one of the end of chapter research problems.

Tax professional standards/taxpayer and tax practitioner penalties: This discussion may be enhanced by a discussion of the IRS’s crackdown on tax shelters, the dire consequences associated with not meeting professional standards, and the recent increased thresholds to avoid tax practitioner penalties.

Assignment Matrix

DQ2-1 DQ2-2 DQ2-3 DQ2-4 DQ2-5 DQ2-6 DQ2-7 DQ2-8 DQ2-9 DQ2-10 DQ2-11 DQ2-12 DQ2-13 DQ2-14 DQ2-15 DQ2-16 DQ2-17 DQ2-18 DQ2-19 DQ2-20 DQ2-21

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al.

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Lecture Notes 1) Taxpayer Filing Requirements a) Filing requirements by entity i) Individuals (show Exhibit 2-1) ii) Corporations b) Tax return due date and extensions i) Individuals and C corporations ii) Partnerships and S corporations c) Statute of limitations i) The period in which the taxpayer can file an amended tax return or the IRS can assess a tax deficiency for a specific tax year. ii) Generally ends three years from the later of (1) the date the tax return was actually filed or (2) the tax return’s original due date. iii) A six-year statute of limitations applies to IRS assessments if the taxpayer omits items of gross income that exceed 25 percent of the gross income reported on the tax return. iv) For fraudulent returns, or if the taxpayer fails to file a tax return, the statute of limitations remains open indefinitely.

2) IRS Audit Selection a) Methods of selection i) DIF system ii) Document perfection iii) Information matching iv) Other methods b) Types of audits i) Correspondence examinations ii) Office examinations iii) Field examinations c) After the audit (show Exhibit 2-2) i) Proposed adjustment ii) 30-day letter

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al. iii) Appeals conference iv) 90-day letter v) Petition courts vi) Trial-level courts and their differences: Tax Court, U.S. District Court, U.S. Court of Federal Claims vii) Choosing a trial-level court (show Exhibit 2-3) viii) Circuit Court of Appeals (show Exhibit 2-4) ix) Supreme Court 3) Tax Law Sources a) Primary and secondary sources i) Primary tax authorities (show Exhibit 2-5) ii) Secondary authorities (show Exhibit 2-6) b) Legislative sources: Congress and the Constitution i) U.S. Constitution ii) Internal Revenue Code iii) Legislative process for tax laws (show Exhibit 2-7) iv) Basic organization of the code (show Exhibit 2-8) v) Tax treaties c) Judicial sources: The courts i) The hierarchy of the courts (trial level, appeals, Supreme Court) ii) Stare decisis iii) Golsen rule d) Administrative sources: The U.S. Treasury i) Regulations: Three different forms (final, temporary, proposed); three different purposes (interpretative, procedural, legislative); highest administrative authority. ii) Revenue Rulings and Revenue Procedures: More detailed than regulations; second in administrative weight. Definition of each. iii) Letter rulings: Lower authoritative weight; contrast private letter rulings with determination letters and technical advice memorandums. iv) Acquiescence, nonacquiescence, and actions on decision: Define and explain why important.

4) Tax Research a) Understand facts i) Open and closed facts ii) How do you determine facts for a research question? b) Identify issues i) Ability to identify issues varies with experience. ii) Understand facts, combine facts with understanding of law, identify general issues. (Is this income taxable? Is this expense deductible?) iii) Research will allow you to identify more specific issues. iv) Discuss Example 2-4 in class. c) Locate relevant authorities i) Annotated tax services: Definition and what they contain. ii) Topical tax services: Definition and what they contain. iii) How to use these services? iv) Keyword search: Area of law and key facts; suggestions if key word searching is not proving beneficial. v) Topical index vi) Browsing the service vii) Discuss Example 2-5. d) Analyze tax authorities

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Questions of fact: Hinges upon the facts and circumstances of the taxpayer’s transaction. In this type of question, the researcher will focus on understanding how various facts affect the research answer and identifying authorities with fact patterns similar to her client’s. For these types of research questions, judicial sources (court cases) will often specifically state this clearly and then focus their discussion on the facts and circumstances. ii) Questions of law: Hinges upon the interpretation of the law, such as interpreting a particular phrase in a code section. If a researcher is faced with this type of question, they will spend much of their time researching the various interpretations of the code section and take note of which authorities interpret the code differently and why. iii) Identifying whether a research question is a question of fact or question of law is primarily helpful when there is some uncertainty in the application of tax law. Distinguishing between these two types of questions helps the tax researcher focus their efforts appropriately. For many tax questions, the answer is quite clear (e.g., the question is answered definitively in the Internal Revenue Code, Regulations, etc.). In these situations, there is no need to attempt to distinguish the question as a question of fact or question of law. iv) Conflicting authorities: The tax researcher should evaluate the hierarchical level, jurisdiction, and age of the authorities, placing more weight on higher and newer authorities that have jurisdiction over the taxpayer. v) Checking the status of authorities: Citators and methods to check the status of authorities. e) Communicate the results i) The basic parts of a memo: Facts, issues, authorities, conclusion, and analysis. ii) Facts: Discuss facts that provide necessary background of the transaction and those facts that may influence the research answer. iii) Issues: State the specific issues that the memo addresses. Issues should be written as specifically as possible and be limited to one or two sentences per issue. iv) Authorities: The researcher cites the relevant tax authorities that apply to the issue, such as the IRC, court cases, and revenue rulings. Cite enough to provide a clear understanding of the issue and interpretation of the law. v) Conclusion: One conclusion per issue. Each conclusion should answer the question as briefly as possible, and preferably indicate why the answer is what it is. vi) Analysis: The goal of the analysis is for the researcher to provide the reader a clear understanding of the area of law and specific authorities that apply. Typically an analysis will be organized to discuss the general area(s) of law first (the Code section) and then the specific authorities (court cases, revenue rulings) that apply to the research question. After you discuss the relevant authorities, apply the authorities to your client’s transaction and explain how the authorities result in your conclusion. vii) The basic parts of a client letter: Salutation and social graces, research question and limitations, facts, analysis, and closing.

5) Tax Professional Responsibilities a) Tax professionals are subject to various statutes, rules, and codes of conduct. i) AICPA Code of Professional Conduct ii) AICPA Statement on Standards for Tax Services iii) IRS’s Circular 230 iv) State board of accountancy statutes v) Common law b) Failure to comply with statutes can result in being admonished, suspended, or barred from practicing.

6) Taxpayer and Tax Return Preparer Penalties a) Civil penalties i) Generally monetary penalties ii) Imposed when tax practitioners or taxpayers violate tax statutes without reasonable cause. i)

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al. b) Criminal penalties i) Much less common than civil penalties. ii) Penalties are much higher and can include prison sentences. c) Taxpayer underpayment penalty: No underpayment penalty if there is substantial authority that supports the tax return position or if there is a reasonable basis for the position and it is disclosed on the taxpayer’s tax return. d) A tax return preparer will not be subject to penalty if there is substantial authority that supports the tax return position or if there is a reasonable basis for the position and it is disclosed on the taxpayer’s tax return.

Class Activities 1. Suggested class activities Let’s choose a court: Split the class into groups. Explain to the class that you will be asking a series of questions to the class regarding the choice of trial-level courts after an audit. After you ask the question, a group may buzz in to answer the question when a group member raises his or her hand. If the person gets the question correct, the group will receive one point. If the person misses the question, the group loses one point. The group with the most points after the series of questions will receive bonus participation points for the day. Use the individual court differences and differences in their respective appellate courts to generate questions. See problem 57 for examples of questions to pose. o One versus the class: Have one student volunteer as the “one,” with the other class members being the “group.” Use the key facts boxes in the text to develop basic multiple-choice questions (A, B, C answers) and then quiz the volunteer and the class on the questions. The volunteer and each class member will need to write the letters A, B, and C on separate sheets of paper and then hold up their appropriate response to the question. Once a student (either the “one” or a member of the “group”) misses a question, they are eliminated from the competition. After six (or some other number) of questions, those students left standing receive bonus participation points for the day. o

2. Research activities o

Take one or more of the research problems at the end of the chapter and pose the following questions after reading the problem: (1) What are the key facts in the problem? (2) What is the general issue to be addressed? (3) What key words would you use to research this question? Then walk the students through how you would conduct the research using an available on-line service.

3. Ethics discussion From page 2-5:

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al.

Discussion points:    

What are the timing requirements for filing a tax return and paying taxes owed? Does Bill’s action likely violate any IRS regulation? If Bill’s action does not violate IRS rules, is it ethical? Are ethics and IRS rules the same?

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al.

Chapter 3 Tax Planning Strategies and Related Limitations INSTRUCTOR’S MANUAL

Learning Objectives 3-1. Identify the objectives of basic tax planning strategies.

3-2. Apply the timing strategy.

3-3. Apply the concept of present value to tax planning.

3-4. Apply the income-shifting strategy.

3-5. Apply the conversion strategy.

3-6. Describe basic judicial doctrines that limit tax planning strategies.

3-7. Contrast tax avoidance and tax evasion

Teaching Suggestions This chapter provides an overview of the basic tax planning strategies that represent the building blocks of tax planning. It is placed early in the text to emphasize the importance of tax planning and to allow the students to form an early foundation of the basic planning techniques. In later chapters as you discuss specific technical content (e.g., investments, compensation, property transactions), students should be able to identify and apply the basic tax planning strategies that apply to each transaction.

This chapter can be covered in one to one and a half class sessions. Most of the concepts in the chapter are relatively straightforward and thus should not present students with tremendous difficulty. If students have not been exposed to the concept of present value, this discussion may require more time. If students are familiar with present value, a short review should suffice. This chapter should be of interest to students given the importance of tax planning and the related wealth impact that these strategies can have.

Thus, students should have a natural interest in the chapter’s material. Nonetheless, discussing real-life examples of these strategies should pique students’ interests even more so (see, for example, the “Taxes in the Real World” boxes in the text).

The chapter lends itself to covering in-class examples of each strategy. Included in the text are several basic examples of the strategies, with additional problems in the end of chapter material that may prove useful. Post-TCJA, taxpayers may rethink the income-shifting strategy for their business income to accommodate the lower corporate tax rate (21 percent). We may see more business incorporations take advantage of this lower tax rate.

In addition to discussing the basic tax planning strategies, the chapter introduces several judicial doctrines that limit tax planning (and apply in numerous tax settings). These doctrines represent key components of the tax law and will also be discussed later in the text when applicable. When discussing these doctrines, it may be useful to provide specific examples of their application (e.g., Example 3-6 in the text).

Finally, this chapter provides a brief discussion of tax avoidance and tax evasion. This discussion provides an opportunity to discuss the importance of ethics in the accounting profession and the negative consequences associated with tax evasion. This discussion also provides an opportunity for students to remember the discussion of tax practitioner professional standards and civil and criminal penalties in Chapter 2. .

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Assignment Matrix

DQ3-1 DQ3-2 DQ3-3 DQ3-4 DQ3-5 DQ3-6 DQ3-7 DQ3-8 DQ3-9 DQ3-10 DQ3-11 DQ3-12 DQ3-13 DQ3-14 DQ3-15 DQ3-16 DQ3-17 DQ3-18 DQ3-19 DQ3-20 DQ3-21 DQ3-22 DQ3-23 DQ3-24 DQ3-25 DQ3-26 DQ3-27 DQ3-28 DQ3-29 DQ3-30 DQ3-31 DQ3-32 DQ3-33 DQ3-34

10 min.

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Tax Forms

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Text Feature

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Learning Objectives

Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al.

P3-39 P3-40 P3-41 P3-42 P3-43 P3-44 P3-45 P3-46 P3-47 P3-48 P3-49 P3-50 P3-51 P3-52 P3-53 P3-54 P3-55 P3-56 P3-57 P3-58 P3-59 P3-60 P3-61 P3-62 P3-63 P3-64 P3-65 P3-66 P3-67 P3-68

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Lecture Notes 1) Basic Tax Planning Overview a) Effective tax planning i) Goal of tax planning: Maximizing the taxpayer’s after-tax wealth while achieving the taxpayer’s nontax goals. ii) Three parties to every transaction: Taxpayer, other transacting party, and the government. iii) Astute tax planning requires understanding the tax and nontax costs from the taxpayer’s and other party’s perspective. iv) Three basic tax planning strategies: Timing, income shifting, and conversion.

2) Timing Strategies a) Timing i) When income is taxed or expense is deducted affects the associated “real” tax costs or savings.

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al. ii) The time when income is taxed or an expense is deducted affects the present value of the taxes paid on income or the tax savings on deductions. iii) The tax costs of income and tax savings income vary as tax rates change. The tax costs on income are higher when tax rates are higher and lower when tax rates are lower. Likewise, the tax savings on deductions are higher when tax rates are higher and lower when tax rates are lower. b) Present value of money i) $1 today will be worth more than $1 in the future. ii) The implication of the time value of money for tax planning is that the timing of a cash inflow or a cash outflow affects the present value of the income or expense. iii) When considering cash inflows, higher present values are preferred; when considering cash outflows, lower present values are preferred. iv) Future Value  Present Value (1 r)n v) Present Value = Future Value/(1 + r)n vi) Exhibit 3-1 provides discount rates for a single payment received in n periods using various rates of return. vii) Work through Example 3-2. c) The timing strategy when tax rates are constant i) Two basic tax-related timing strategies ii) Accelerating deductions: Essentially accelerating a current cash inflow. iii) Deferring income: Essentially deferring a current cash outflow. iv) Work through Example 3-3. d) The timing strategy when tax rates change i) When tax rates are increasing, the taxpayer must calculate the optimal tax strategies for deductions and income. Why? ii) The taxpayer must calculate whether the benefit of accelerating deductions outweighs the disadvantage of recognizing deductions in a lower-tax-rate year. iii) The taxpayer must calculate whether the benefit of deferring income outweighs the disadvantage of recognizing income in a higher-tax-rate year. iv) When tax rates are decreasing, taxpayers should accelerate tax deductions into earlier years and defer taxable income to later years. Why? v) Accelerating deductions maximizes the present value of tax savings from deductions due to the acceleration of the deductions into earlier years with a higher tax rate. vi) Deferring income minimizes the present value of taxes paid due to the deferral of the income to later years with a lower tax rate. vii) Work through Example 3-5. e) Limitations to timing strategies i) (1) Tax deductions often cannot be accelerated without also accelerating the actual cash outflow that generates the deduction. (2) Tax law generally requires taxpayers to continue their investment to defer income. (3) A deferral strategy may not be optimal if the taxpayer has severe cash flow needs, if continuing the investment would generate a low rate of return compared to other investments, if the current investment would subject the taxpayer to unnecessary risk, and so on. (4) Constructive receipt doctrine: taxpayer must recognize income when it is actually or constructively received.

3) Income-Shifting Strategies a) Income shifting exploits the differences in tax rates across taxpayers by shifting income from high-tax-rate taxpayers (or jurisdictions) to low-tax-rate taxpayers (or jurisdictions) or shifting deductions from low-tax-rate taxpayers (or jurisdictions) to high-tax-rate taxpayers (or jurisdictions). b) Transactions between family members .

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al. i)

Children generally have lower marginal tax rates, and therefore parents may shift income to children so it will be taxed at the child’s tax rate. ii) Assignment of income, IRS scrutiny of related-party transactions, and the kiddie tax limit this strategy. c) Transactions between owners and their businesses i) Incorporating a business and thus shifting income from an individual to the corporation may result in lower current taxation of the business income. [See Example 3-8] ii) Shifting income from a corporation to an owner through tax-deductible expenses (e.g., compensation, interest, rent) allows the owners to avoid double taxation on corporate profits. iii) IRS scrutiny of related-party transactions limits this strategy. d) Income shifting across jurisdictions i) Income earned in different jurisdictions—whether in the United States or abroad, and for state income tax purposes, income earned in different states—is often taxed very differently.

With a proper understanding of the differences in tax laws across jurisdictions, taxpayers can use these differences to maximize their after-tax wealth. ii) IRS scrutiny of transfer pricing, implicit taxes, and negative publicity (e.g., for moving operations abroad) limits this strategy.

4) Conversion Strategies a) Tax rates can vary across different activities; ordinary income is taxed at ordinary rates; longterm capital gains are taxed at preferential rates; some income is tax-exempt. b) The conversion strategy is based on the understanding that the tax law does not treat all types of income or deductions the same. c) To implement the conversion strategy, you must be aware of the underlying differences in tax treatment across various types of income, expenses, and activities and have some ability to alter the nature of the income or expense to receive the more advantageous tax treatment. d) Work through Example 3-10 e) When the investment period is longer than one year, taxpayers can receive benefits from combining the timing strategy and the conversion strategy. f) Work through Example 3-11. g) Limitations of conversion strategies i) The Code itself contains provisions to prevent a taxpayer from changing the nature of expenses and income. ii) Implicit taxes may also reduce or eliminate the advantages of conversion strategies.

5) Additional Limitations to Tax Planning Strategies: Judicially Based Doctrines a) The IRS also has several other doctrines at its disposal for situations where it expects taxpayer abuse. These doctrines apply across a wide variety of transactions and planning strategies (timing, income shifting, and conversion). b) Business purpose doctrine: IRS has the power to disallow business expenses for transactions that don’t have a business purpose. c) Step-transaction doctrine: IRS has the power to collapse a series of transactions into one to determine tax liability. d) Substance-over-form doctrine: IRS can reclassify a transaction according to its substance (instead of its form). e) Economic substance doctrine: Transactions must meet two criteria 1) the transaction must meaningfully change a taxpayer’s economic position (excluding any federal income tax effects) and 2) the taxpayer must have a substantial purpose (other than tax avoidance) for engaging in the transaction.

6) Tax Avoidance versus Tax Evasion a) Tax avoidance is the legal act of arranging one’s transactions to minimize taxes paid. b) Tax evasion is the willful attempt to defraud the government by not paying taxes legally owed. c) Tax evasion falls outside the confines of legal tax avoidance. .

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Class Activities 1. Suggested class activities o

o

Let’s make a deal: This chapter provides a great opportunity for students to research tax planning in the real world. As a game, you can assign students to locate via Internet research a discussion of a transaction in which tax planning played a major role (i.e., the Disney-Marvel acquisition). Split the students into groups and have them add up the dollar value of the related transactions (one per group member) that they located in their research. The group with the aggregated largest value of transactions receives bonus participation points. As part of this game, the students should be required to print documentation regarding the transaction, describe the specific tax planning strategy, and classify it based on the tax strategies discussed in the text.

One versus the class: Have one student volunteer as the “one” with the other class members being the “group.” Use the key facts boxes in the text to develop basic multiple-choice questions (A, B, C answers) and then quiz the volunteer and the class on the questions. The volunteer and each class member will need to write the letters A, B, and C on separate sheets of paper and then hold up their appropriate response to the question. Once a student (either the “one” or a member of the “group”) misses a question, her or she is eliminated from the competition. After six (or some other number) of questions, those students left standing receive bonus participation points for the day.

2. Research activities o

This chapter provides a good opportunity to get students to form the habit of identifying tax planning strategies using available resources (Internet, tax services, etc.). As an ongoing class exercise, you can instruct the class that they will receive a certain specified number of points for every tax article (maximum of X points for the course) they submit that discusses a tax planning idea relating to the material covered in class. For every article submitted, students should classify the type of tax planning strategy (timing, income shifting, conversion) and be ready to provide a brief overview of the tax planning strategy to the class with a three to five minute presentation (for additional points as deemed appropriate). This exercise is a great way to stress the importance and relevance of tax planning and to get students actively engaged in applying the material discussed in class. To the extent short class presentations are utilized, this exercise should also enhance students’ presentation skills.

3. Ethics discussion From page 3-14:

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Discussion points:   

Agnes would like to reduce her overall tax burden.

One way to accomplish this would be to shift income to her lower-taxed children.

One issue to discuss is whether the salary paid to the children represents reasonable compensation for the services they provide. It may be questionable as to whether children of these ages can perform enough janitorial and clerical services to reach this standard.

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al.

Chapter 4 Individual Income Tax Overview, Dependents, and Filing Status INSTRUCTOR’S MANUAL

Learning Objectives 4-1. Describe the formula for calculating an individual taxpayer’s taxes due or refund.

4-2. Explain the requirements for determining who qualifies as a taxpayer’s dependent.

4-3. Determine a taxpayer’s filing status.

Teaching Suggestions The first part of this chapter dealing with the individual income tax formula (Learning Objective 4-1) was designed to provide students with an overview of individual taxation.

It is important that students understand that this part of the chapter is introducing, at a high level, material that they will be learning in more depth in subsequent chapters (and later in this chapter). The objective is to help students understand the big picture. Students should come away from this portion of the chapter with enough understanding of individual taxation to be able to answer the following types of questions: What is gross income? Why is all realized income not included in gross income? What is the difference between an exclusion item and a deferral item? What is the character of income and why is income character important? What is the difference between a “for” and a “from” AGI deduction? What is an itemized deduction? What is a standard deduction? At a general level, how do you compute taxable income? At a general level, how do you compute a taxpayer’s tax liability given taxable income? What is a tax credit? How do taxpayers pay their tax liabilities? The section “Character of Income” is intended to discuss in general terms the rates at which different types of income are taxed in the current year. Further, this section introduces capital assets and capital gains and losses. Because these concepts come up in several chapters of the text, it is important to introduce them early in the chapter sequence. The chapter describes (in exhibits) common income items (and their character), common for AGI deductions, the deduction for qualified business income, and the main categories of itemized deductions. The chapter also provides the amounts of the standard deduction by filing status. Students should understand that this information provided under the first learning objective is to give them a general sense of what they will learn in more detail in later chapters. Students should not feel like they need to know the technical nuances of the items listed in these exhibits at this point. They should, however, be able to recognize common income and deduction items. Students should also understand that only income that is not excluded or deferred is reported on and affects taxable income on the tax return. In terms of the reporting on the actual tax return, gross income is the starting point for determining taxable income. Finally, note that this chapter presents 2022 tax forms because the 2023 forms were not available at press time.

The second and third parts of the chapter dealing with who qualifies as a taxpayer’s dependent (Learning Objective 4-2) and filing status (Learning Objective 4-3) were designed to provide the technical details on these topics. That is, the technical detail on these topics is not provided elsewhere in the text. Because filing status may depend on a taxpayer’s dependents, the chapter discusses who qualifies as a taxpayer’s dependent before discussing filing status. Students should understand why it is important to determine who qualifies as the taxpayer’s dependents even though taxpayers are no longer allowed to deduct dependency amounts. The chapter discusses the tests for qualifying children and qualifying relatives.

Exhibit 4-8 provides a framework for students to use when evaluating whether someone qualifies as a .

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al. dependent. It is important to help students understand that someone can meet the relationship test for a qualifying relative even if that person is not actually related to the taxpayer as long as that person lives with the taxpayer for the entire year.

In the “Filing Status” section, it is important that students understand that from a tax perspective that it would be unusual for a couple to gain a tax advantage by filing separately. Couples who file separately usually do so for nontax purposes. Students generally have the most difficulty understanding the rules for qualifying for head of household status. This is especially true when the taxpayer’s dependent is a qualifying relative, not a qualifying child. In order for the taxpayer to qualify for head of household status, the dependent must have a qualifying family relationship with the taxpayer (taxpayer’s descendant or ancestor, sibling, stepmother, stepfather, stepbrother, or sister, nephews, nieces, aunts, uncles, or inlaws) and not be considered a relative just because the dependent lives with the taxpayer for the entire year. The text includes detail and discussion of the requirements for the head of household filing status.

Students may need extra help understanding the abandoned spouse rule and its implications for head of household status. Finally, note that the consistent with the 2022 tax forms, the filing status of qualifying widow or widower has been changed to qualifying surviving spouse.

Assignment Matrix

DQ4-1 DQ4-2 DQ4-3 DQ4-4 DQ4-5 DQ4-6 DQ4-7 DQ4-8 DQ4-9 DQ4-10 DQ4-11 DQ4-12 DQ4-13 DQ4-14 DQ4-15 DQ4-16 DQ4-17 DQ4-18 DQ4-19 DQ4-20 DQ4-21 DQ4-22 DQ4-23

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al.

DQ4-24 DQ4-25 DQ4-26 DQ4-27 DQ4-28 P4-29 P4-30 P4-31 P4-32 P4-33 P4-34 P4-35 P4-36 P4-37 P4-38 P4-39 P4-40 P4-41 P4-42 P4-43 P4-44 P4-45 P4-46 P4-47 P4-48 P4-49 P4-50 P4-51 P4-52 P4-53 P4-54 P4-55 CP4-56 CP4-57 CP4-58 CP4-59

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Medium Medium Hard Medium Easy Medium Medium Easy Medium Hard Hard Medium Medium Medium Medium Medium Hard Hard Hard Hard Medium Hard Medium Easy Medium Hard Medium Medium Medium Easy Medium Medium Medium Medium Medium Easy

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Lecture Notes 1) The Individual Income Tax Formula a) Reporting taxable income i) Income tax Form 1040 generally used to report taxable income. ii) Refer to Exhibit 4-1 for Individual Tax Formula (but note that what is included on the tax return generally starts with gross income). iii) Refer to Exhibit 4-2 for Form 1040. The exhibit provides the 2022 tax forms because the 2023 forms were not available at press time. b) Realized income, exclusions, deferrals, and gross income

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c)

d)

e)

f)

Realized income (1) All-inclusive income concept (a) Realized income is income generated in a transaction with a second party in which there is a measurable change in property rights between parties. (i) Refer to Exhibit 4-3 for common income items (including character). (b) Discuss concept of deferral versus exclusion. (i) Refer to Exhibit 4-4 for common exclusions and deferrals.

Character of income i) Determines rate at which income will be taxed for the year ii) Tax-exempt iii) Tax-deferred iv) Ordinary v) Capital (1) Capital gain or loss from selling capital assets (2) Capital asset (a) Accounts receivable (b) Inventory (c) Property used in trade or business, including supplies (3) Long-term capital gains (a) Generally taxed at 0 percent, 15 percent, or 20 percent (net long-term gains in excess of net short-term losses). The IRS provides a separate schedule to that gives the break points for the different rates (see Appendix C). May mention, but don’t discuss, 25 percent and 28 percent long-term capital gains.

(4) Short-term capital gains (a) Generally taxed at ordinary rates (5) Net capital losses (a) Deduct $3,000 against ordinary income. (b) Carryover excess loss to future years (indefinite carryover). vi) Qualified dividend (1) Taxed at 0 percent, 15 percent, or 20 percent. Break points for the different rates are provided by the IRS (see Appendix C).

Deductions: Taxpayers are not allowed to deduct anything unless a specific tax provision allows them to do so. i) Deductions for AGI (1) Above the line (2) Refer to Exhibit 4-5 for Partial Listing of Common for AGI Deductions. ii) Deductions from AGI (1) Below the line.

(2) Refer to Exhibit 4-6 for Primary Categories of Itemized Deductions.

(3) Refer to Exhibit 4-7 for Standard Deduction Amounts by Filing Status. D (4) Deduction for qualified business income (from AGI deduction but not itemized deduction). Equal to qualified business income × 20%.

Income tax calculation i) Taxpayers generally calculate their income tax liability using either a tax table or a tax rate schedule, depending on their filing status and income level. This chapter covers the tax tables but does not deal directly with the tax tables. (You could pull up a tax table to show students.)

The current tax rates range from 10 percent to 37 percent.

Other taxes i) Alternative minimum tax and the self-employment tax (both covered in the Individual Income Tax Computation and Tax Credits chapter).

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al. ii) The 3.8 percent net investment income tax (on unearned income) and the .9 percent additional Medicare tax (on earned income) are covered in the Individual Income Tax Computation and Tax Credits chapter. g) Tax credits i) Individual taxpayers may reduce their tax liabilities by tax credits to determine their total taxes payable. h) Tax prepayments i) Income taxes withheld from the taxpayer’s salary or wages by the employer; ii) Estimated tax payments the taxpayer makes for the year; and iii) Taxes overpaid in the previous year that the taxpayer elects to apply as an estimated payment for the current year.

2) Dependents of the Taxpayer a) Dependency requirements i) To qualify as a dependent of another, an individual: (1) Must be a citizen of the United States or a resident of the United States, Canada, or Mexico.

(2) Must not file a joint return with the individual’s spouse unless there is no tax liability on the couple’s joint return and there would not have been any tax liability on either spouse’s tax return if they had filed separately.

(3) Must be considered either a qualifying child of the taxpayer or a qualifying relative of the taxpayer. ii) Qualifying child (1) Relationship test (2) Age test (3) Residence test (4) Support test (5) Tiebreaking rules iii) Qualifying Relative (1) Relationship test (2) Support test (3) Gross income test iv) Refer to Exhibit 4-8 for Summary of Dependency Requirements. v) Refer to Appendix A of this chapter for flowchart to determine who qualifies as the taxpayer’s dependent.

3) Filing Status a) Each year taxpayers determine their filing status according to their marital status at year-end and whether they have any dependents. b) Married filing jointly i) Taxpayers must be legally married as of the last day of the year. ii) When one spouse dies during the year, the surviving spouse is still considered to be married for tax purposes during the year of the spouse’s death. iii) Both spouses are ultimately responsible for paying the joint tax. c) Married filing separately i) Each spouse files his or her own tax return. ii) Generally, there is no tax advantage for filing separately. iii) Each spouse is ultimately responsible for paying own tax. iv) Generally, for nontax reasons, couples may choose to file separately.

(1) Limit liability for other spouse’s taxes. v) Requirements for married taxpayers to be treated as unmarried at end of year (also known as abandoned spouse rules) Qualifies if: .

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4) 5) 6) 7)

(a) Taxpayer not legally separated from spouse. (b) Taxpayer does not file joint return with spouse. (c) Spouse has not lived in taxpayer’s home at all during last six months of year (excluding temporary absences due to illness, military, etc.). (d) Taxpayer pays more than half the costs of maintaining a home that is principal place of abode for qualifying child. (e) Taxpayer is eligible to file as head of household (see below) d) Qualifying surviving spouse i) Generally treated as married filing jointly. ii) When the taxpayer’s spouse dies, the surviving spouse can file as qualifying surviving spouse for two years after the year of the spouse’s death if the surviving spouse remains unmarried and maintains a household for a dependent child. e) Single i) Unmarried taxpayers who do not qualify for head of household status file as single taxpayers. f) Head of household i) Unmarried or considered to be unmarried at year-end ii) Not a qualifying surviving spouse iii) Pay more than half the costs of maintaining home during year iv) Lived in taxpayer’s home with a qualifying person for more than half the year (1) See exception for parents who qualify as taxpayer’s dependents.

(2) Qualifying person (a) Qualifying child (b) Qualifying relative must live with taxpayer for more than half the year, be taxpayer’s dependent, and must have qualifying family relationship. (c) Parent, even if parent doesn’t live with taxpayer, if parent qualifies as taxpayer’s dependent. (d) See Exhibit 4-9 for description of who is a qualifying person for purposes of the head of household test. See Appendix B to this chapter for a flowchart to use to determine who is a qualifying person for head of household filing status.

Summary of Income Tax Formula a) Refer to Exhibit 4-10 for summary of the Halls’ taxable income.

Appendix A: Flowchart for determining who qualifies as a dependent.

Appendix B: Flowchart for determining who is a qualifying person for head of household status.

Appendix C: Flowchart for determining filing status.

Class Activities 1. Suggested class activities o

Movie clip: As a way to introduce individual income taxes, you could show a clip from The Simpsons episode “The Trouble with Trillions” (the twentieth episode of the ninth season). See the episode’s Wikipedia article for information on the episode. The individual income tax portion runs through about 7 minutes and 40 seconds of the episode (the introduction runs about the first 54 seconds). Relate general concepts to first two pages and Schedule 1 of Form 1040: Have students identify where the items in Exhibit 4-1 show up on the first two pages and Schedule 1 of Form 1040. Gross income (realized income from whatever source derived minus excluded or deferred income) is found somewhere in lines 1–8, inclusive, and Schedule 1 lines 1–8; for AGI

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o o

o

deductions don’t show up directly on page 1 but they generally show up in lines 11–25 of Schedule 1, inclusive. However, for AGI deductions could also show up on line 3 (Schedule C), line 4 (Form 4797), or line 5 (Schedule E) of Schedule 1 and/or Line 7 of page 1 (Schedule D) of Form 1040. Students could work on this individually or work on it in groups. This could be a competition for bonus points or simply a learning activity.

Research activity: Have students download the first two pages and Schedule 1 of Form 1040 from the IRS website. Students can use this form in the second class activity suggested above.

Comprehensive problems: Have students work in groups (two to four students) to complete a comprehensive problem. Make yourself available to students to answer questions, but try to get them to work together to resolve their questions. You could choose one question (what is taxable income? or what are taxes due?) for students to report to you. You can write the answer from each group on the board and then reveal the correct answer. Give credit to the group(s) that is (are) correct/closest.

Elimination: Develop several multiple-choice questions (A, B, C answers) relating to important topics from the chapter. You could also draw questions from the test bank. Have each class member write the letters A, B, and C on separate sheets of paper. Have the entire class stand up.

When you ask a question, have each class member hold up their appropriate response to the question (A, B, or C). Those who miss must sit down. Continue until you have asked all your questions or until all but one student has been eliminated. Award bonus points (or acknowledgment of a job well done) to those still standing.

2. Ethics discussion From page 4-19: Blake was 21 years of age at the end of the year. During the year, he was a full-time college student. He also worked part-time and earned $8,000, which he used to pay all $6,000 of his living expenses. Blake’s parents, Troy and Camille, claimed him as a dependent on their joint tax return. After filing the return, Troy told Blake they owed him $3,001 for his annual living expenses. What do you think of Troy and Camille’s strategy to claim Blake as a dependent?

Discussion points:     

For Blake to qualify as his parents’ dependent, he must do so as a qualifying child because he has too much income to qualify as a qualifying relative.

To qualify as a qualifying child, Blake must not have provided his own support.

During the year, Blake provided all his own support, but Blake’s father, Troy, informed Blake that Troy and Camille (Blake’s parents) owed Blake enough money such that Blake’s parents would have provided more than half the support for Blake.

Since this was done after the fact, who has provided Blake’s living expenses? Did Blake provide all of his own support or did his parents provide more than half?

Are Blake’s parents going to actually transfer the money to Blake? What was the nature of the arrangement? Is this simply a ploy to justify claiming Blake as a dependent in order to secure a tax benefit such as the (expanded) child tax credit or the American opportunity credit, or is there something more to it?

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al.

Chapter 5 Gross Income and Exclusions INSTRUCTOR’S MANUAL

Learning Objectives 5-1. Apply the concept of realization and explain when taxpayers recognize gross income.

5-2. Understand the distinctions between the various sources of income, including income from services and property.

5-3. Apply basic income exclusion and deferral provisions to compute gross income.

Teaching Suggestions Chapter 4 presented an overview of individual taxation, and this chapter digs deeper into the tax formula to determine gross income. The focus is on the sources of income and whether a particular type of income is excluded from a taxpayer’s gross income. Chapter 4 defined gross income as income that is realized and recognized during the year. Now we learn that realized income is from whatever source derived minus income that is either excluded from taxation or deferred until a subsequent year. In the previous chapter, we discussed gross income in general terms. In this chapter we explain the requirements for taxpayers to recognize gross income, and we describe the most common sources of gross income. This content requires describing many of the judicially created tax doctrines (such as constructive receipt and tax benefit) and calculating the return of capital, most dramatically demonstrated by an annuity calculation. The chapter concludes with a description of the most common exclusion and deferral provisions.

Assignment Matrix

DQ5-1 DQ5-2 DQ5-3 DQ5-4 DQ5-5 DQ5-6 DQ5-7 DQ5-8 DQ5-9

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20 min.

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5-1

Ethics

Planning

Research

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Text Feature

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LO1

Learning Objectives

Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al.

DQ5-10 DQ5-11 DQ5-12 DQ5-13 DQ5-14 DQ5-15 DQ5-16 DQ5-17 DQ5-18 DQ5-19 DQ5-20 DQ5-21 DQ5-22 DQ5-23 DQ5-24 DQ5-25 DQ5-26 DQ5-27 DQ5-28 DQ5-29 DQ5-30 DQ5-31 DQ5-32 DQ5-33 DQ5-34 DQ5-35 DQ5-36 DQ5-37 DQ5-38 DQ5-39 DQ5-40 DQ5-41 DQ5-42 DQ5-43 P5-44 P5-45 P5-46 P5-47 P5-48 P5-49 P5-50 P5-51 P5-52 P5-53 P5-54 P5-55 P5-56 P5-57

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20 min.

10 min.

10 min.

10 min.

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10 min.

25 min.

25 min.

25 min.

20 min.

20 min.

20 min.

20 min.

20 min.

20 min.

20 min.

25 min.

25 min.

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15 min.

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45 min.

90 min.

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30 min.

15 min.

15 min.

15 min.

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45 min.

Medium Medium Medium Medium Medium Medium Medium Hard Hard Hard Hard Medium Medium Hard Hard Hard Hard Hard Hard Hard Hard Hard Hard Medium Hard Hard Hard Hard Hard Hard Hard Hard Hard Hard Medium Medium Medium Hard Medium Easy Medium Medium Medium Easy Easy Medium Medium Hard

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al.

P5-58 P5-59 P5-60 P5-61 P5-62 P5-63 P5-64 P5-65 P5-66 P5-67 P5-68 P5-69 P5-70 P5-71 P5-72 P5-73 P5-74 P5-75 P5-76 P5-77 P5-78 P5-79 P5-80 P5-81 P5-82 P5-83 CP5-84 CP5-85 CP5-86 CP5-87 CP5-88

20 min.

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20 min.

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15 min.

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15 min.

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20 min.

20 min.

20 min.

20 min.

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20 min.

50 min.

50 min.

60 min.

45 min.

120 min.

Medium Medium Hard Medium Medium Medium Medium Medium Medium Medium Hard Medium Medium Hard Hard Medium Medium Medium Medium Hard Medium Medium Medium Medium Medium Medium Hard Hard Hard Medium Hard

X X X X X X X X X X X X

X

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X

X

X X X

Lecture Notes 1) Realization and Recognition of Income a) What is included in gross income? i) Reg. §1.61-(a) provides further insight into the definition of gross income as follows: “Gross income means all income from whatever source derived, unless excluded by law.

Gross income includes income realized in any form, whether in money, property, or services.”

(1) Economic benefit (2) Realization principle (a) Income is realized when: (i) A taxpayer engages in a transaction with another party, and (ii) The transaction results in a measurable change in property rights. (b) Work through Example 5-1.

(3) Recognition .

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al. b)

Other income concepts i) Form of receipt (1) Work through Example 5-2. ii) Return of capital principle iii) Recovery of amounts previously deducted (1) Work through Example 5-3. c) When do taxpayers recognize income? i) Accounting methods (1) Accrual method (2) Cash method ii) Constructive receipt (1) The constructive receipt doctrine states that a taxpayer must realize and recognize income when it is actually or constructively received.

(2) Work through Example 5-4. iii) Claim of right d) Who recognizes the income? i) Taxpayers attempt to shift income to other related taxpayers through the income-shifting strategy. ii) Example of income-shifting strategy: a parent (with a high marginal income tax rate) might wish to assign their paycheck to their child (with a low marginal income tax rate) to minimize their collective tax burden. iii) Assignment of income (a) Work through Example 5-5. iv) Community property systems (1) For federal income tax purposes, the community property system has the following consequences: (a) Half of the income earned from the services of one spouse is included in the gross income of the other spouse. (b) Half of the income from property held as community property by the married couple is included in the gross income of each spouse. (c) In five community property states (Arizona, California, Nevada, New Mexico, and Washington), all of the income from property owned separately by one spouse is included in that spouse’s gross income. (d) In Texas, Louisiana, Wisconsin, and Idaho, half of the income from property owned separately by one spouse is included in the gross income of each spouse. v) Common law systems (1) For federal income tax purposes, the common law system has the following consequences: (a) All of the income earned from the services of one spouse is included in the gross income of the spouse who earned it. (b) For property owned separately, all of the income from the separately owned property is included in that spouse’s gross income. (c) For property owned jointly (that is, not separately), each co-owner is taxed on the income attributable to their share of the property. For example, suppose that a parcel of property is jointly owned by husband and wife. One-half of the income from the property would be included in the gross income of each spouse. Similarly, income from property owned by three or more persons would be included in the gross income of each co-owner based on their respective ownership share.

(2) Work through Example 5-6.

2) Types of Income a) Income from services .

5-4

Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al. i) One of the most common sources of gross income—income from labor. ii) Payments for services, including salary, wages, and fees that a taxpayer earns through services in a nonemployee capacity, are all considered income from services. iii) Income from services is also referred to as earned income. (a) Work through Example 5-7. iv) Employee stock options (a) No tax consequences on the grant date or exercise date. (b) When they exercise NQOs, employees report ordinary income for the bargain element. (c) When they exercise ISOs, employees don’t report income for regular tax purposes and their basis is the exercise price. If they hold such shares for at least two years after the grant date and one year after the exercise date, they will treat the difference between the sales proceeds and the tax basis (the exercise price) as a long-term capital gain in the year of disposition. Otherwise, the bargain element is treated as compensation income upon sale. (d) Work through Examples 5-8, 5-9, 5-10, and 5-11. b) Income from property i) Work through Examples 5-12, 5-13, and 5-14. ii) Annuities (1) An annuity is an investment that pays a stream of equal payments over time.

(2) Annuities paid over a fixed period.

(3) Annuities paid over a person’s life (for as long as the person lives).

(4) Use of annuity exclusion ratio to determine the return of capital (nontaxable) portion of each payment.

(5) Use of IRS tables to determine the expected number of payments based upon the taxpayer’s life expectancy at the start of the annuity. (a) Work through Example 5-15. iii) Property dispositions (1) Taxpayers can realize a gain or loss when disposing of an asset.

(2) Taxpayers are allowed to recover the capital invested in property tax-free.

(3) Payments from purchased annuities are part income and part return of capital.

(4) When property is sold or disposed, the realized gain or loss equals the sale proceeds reduced by the tax basis of the property.

(5) Formula for calculation of gain or loss: Sales proceeds (−) Selling expenses (=) Amount realized (−) Tax basis (investment) in property sold (=) Gain (loss) on sale.

(6) Taxpayers who haven’t adequately tracked the basis in their stock are required to use the first-in, first-out (FIFO) method of determining the basis of the shares they sell. However, if they maintain good records, they can use the specific identification method to determine the basis of the shares they sell.

(7) The rate at which taxpayers are taxed on gains from property dispositions and the extent to which they can deduct losses from property dispositions depends on whether the taxpayer used the asset for business purposes, investment purposes, or personal purposes.

(8) Work through Example 5-16. iv) Capital gains and losses (1) Capital assets are typically investment-type assets and personal-use assets.

(2) Taxpayers selling capital assets that they hold for a year or less recognize short-term capital gains or losses. Alternatively, taxpayers selling capital assets they hold for more than a year recognize long-term capital gains or losses.

(3) Short-term capital gains are taxed at ordinary rather than preferential rates. In contrast, long-term capital gains are taxed at preferential rates.

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al.

(4) Although long-term capital gains are generally taxed at 0 percent, 15 percent, or 20 percent, depending on the taxpayer’s income, there are several exceptions. For example, certain long-term capital gains are taxed at a maximum rate of 25 percent (unrecaptured §1250 gain discussed in Chapter 11), gains from the sale of collectibles are taxed at a maximum 28 percent rate, and §1202 gains are taxed at a 0 percent tax rate.

(5) Exhibit 5-3 shows the maximum capital gains tax rates. v) Netting process for gains and losses (1) To determine the appropriate tax treatment for the capital gains and losses recognized during the year, the taxpayer must engage in a netting process.

(2) Work through Example 5-17. vi) Losses on sales to related parties (1) When taxpayers sell assets at a loss to related parties, they are not able to deduct the loss.

(2) Instead, the related party acquiring the asset adds the disallowed loss to their basis in the asset and may eventually be allowed to deduct all, a portion, or none of the disallowed loss on a subsequent sale. vii) Wash sales (1) A wash sale occurs when an investor sells or trades stock or securities at a loss and within 30 days either before or after the day of sale buys substantially identical stocks or securities.

(2) When the wash sale provisions apply to a sale of stock, realized losses are not recognized; instead, the amount of the unrecognized loss is added to the basis of the newly acquired stock.

(3) Congress created this rule to prevent taxpayers from accelerating losses on securities that have declined in value without actually altering their investment in the securities.

(4) Work through Example 5-18. c) Other sources of gross income i) Income from flow-through entities (a) Work through Example 5-19. ii) Alimony (1) When couples legally separate or divorce, one spouse may be required to provide financial support to the other in the form of alimony.

(2) The tax law defines alimony as (a) a transfer of cash made under a written separation agreement or divorce decree, (b) the separation or divorce decree does not designate the payment as something other than alimony, (c) in the case of legally separated (or divorced) taxpayers under a separation or divorce decree, the spouses do not live together when the payment is made, and (d) the payments cannot continue after the death of the recipient.

(3) For divorce or separation agreement executed before January 1, 2019, alimony is included in gross income of the recipient and deductible for AGI by the payor.

(4) For divorce or separation agreements executed after 2018, alimony is not taxable to the recipient or deductible by the payor.

(5) Work through Examples 5-20, 5-21, and 5-22. iii) Prizes, awards, and gambling winnings (1) Awards are included in gross income unless (a) made for scientific, literary, or charitable achievement and transferred to a federal, state, or local government unit or a qualified charity; (b) made to employees for length of service or safety achievement (limited to $400 of tangible property per employee per year); or (c) made to Team USA athletes from U.S. Olympic Committee on account of their competition in Olympic and Paralympic games (AGI limit applies). (a) Work through Example 5-23. iv) Social Security benefits .

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al.

(1) A taxpayer may be required to include up to 85 percent of Social Security benefits in gross income depending on the taxpayer’s filing status, Social Security benefits, and modified AGI. (2) Modified AGI is regular AGI (excluding Social Security benefits) plus tax-exempt interest income, excluded foreign income, and certain other deductions for AGI. Highincome individuals include a portion of their benefits up to a maximum of 85 percent of the total Social Security benefits.

(3) As an example, show calculation summary for single taxpayers in text.

(4) Work through Example 5-24. v) Imputed income (1) Work through Examples 5-25 and 5-26. vi) Discharge of indebtedness (1) When a taxpayer’s debt is forgiven by a lender (the debt is discharged), the taxpayer must include the amount of debt relief in gross income.

(2) Note that there are other circumstances in which taxpayers may exclude a discharge of indebtedness (e.g., home mortgage forgiveness).

(3) In order to provide tax relief for insolvent taxpayers—taxpayers with liabilities, including tax liabilities, exceeding their assets—a discharge of indebtedness is not taxable if the taxpayer is insolvent before and after the debt forgiveness.

(4) If the discharge of indebtedness makes the taxpayer solvent, the taxpayer recognizes taxable income to the extent of their solvency.

(5) Taxpayers, regardless of solvency, are also allowed to exclude from gross income most discharges of student loans (loans for post-secondary educational expenses) after 2020 and before 2026.

(6) Work through Example 5-27.

3) Exclusion and Deferral Provisions a) Common exclusions i) Municipal bond interest (1) Municipal bonds include bonds issued by state and local governments located in the United States, and this exclusion is generally recognized as a subsidy to state and local governments.

(2) Work through Example 5-28. ii) Gain on the sale of personal residence (1) $250,000 exclusion ($500,000 if married filing jointly) (2) Ownership test (3) Use test (4) Work through Example 5-29. iii) Fringe benefits (1) The value of these benefits is included in the employee’s gross income as compensation for services.

(2) Certain “qualifying fringe benefits” are excluded from gross income. (a) Common qualifying fringe benefits are medical and dental health insurance coverage, life insurance coverage, and de minimis (small) benefits.

(3) Work through Examples 5-30 and 5-31. iv) Education-related exclusions (1) Scholarships (a) Students seeking a college degree can exclude scholarships that pay for required tuition, fees, books, and supplies. (b) Work through Example 5-32.

(2) Other educational subsidies

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5-7

Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al. (a) Taxpayers are allowed to exclude from gross income earnings on investments in qualified education plans such as 529 plans and Coverdell education savings accounts as long as they use the earnings to pay for qualifying educational expenditures. (b) Taxpayers can elect to exclude interest earned on Series EE savings bonds when the redemption proceeds are used to pay qualified higher education expenses. (c) The exclusion of interest on Series EE savings bonds is restricted to taxpayers with modified AGI below specific limits. v) Exclusions that mitigate double taxation (1) Gifts and inheritances (a) Individuals may transfer property to other taxpayers without receiving or expecting to receive value in return. (b) If the transferor is alive at the time of the transfer, the property transfer is called a gift. (c) If the property is transferred from the decedent’s estate (transferor is deceased), it is called an inheritance. (d) Gifts and inheritances are subject to federal transfer taxes and are, therefore, excluded from the income of the recipient. (e) Work through Example 5-33.

(2) Life insurance proceeds (a) In some ways, life insurance proceeds are similar to inheritances. (b) If the policyholder dies, the beneficiary receives the death benefit proceeds. The decedent is generally subject to estate taxation on the amount of the insurance proceeds. (c) In order to avoid potential double taxation on the life insurance proceeds, the tax laws allow taxpayers receiving life insurance proceeds to exclude the proceeds from taxable income. (d) If the insurance proceeds are paid over a period of time rather than in a lump sum, a portion of the payments represents interest and must be included in gross income. (e) The life insurance proceeds exclusion generally does not apply when a life insurance policy is transferred to another party for valuable consideration. In this case, the eventual life insurance proceeds collected by the purchaser are excluded up to the sum of the purchase price of the policy and any subsequent premiums with remaining proceeds taxable as ordinary income. (f) If a taxpayer simply cancels a life insurance contract and is paid the policy’s cash surrender value, she would recognize ordinary income to the extent the proceeds received exceed previous premiums paid. If premiums paid exceed the proceeds received, the loss is not deductible. (g) If the taxpayer is terminally ill (medically certified with an illness expected to cause death within 24 months), early receipt of life insurance proceeds (accelerated death benefits) is not taxable. (h) Work through Example 5-34.

(3) Foreign-earned income (a) A maximum of $120,000 (2023) of foreign-earned income can be excluded from gross income for qualifying individuals. (b) To be eligible for the foreign-earned income and housing exclusions, the taxpayer must have their tax home in a foreign country and (1) be considered a resident of the foreign country or (2) live in the foreign country for 330 days in a consecutive 12month period. (c) Taxpayers meeting the requirement for the foreign-earned income exclusion may also exclude from income reasonable housing costs that exceed 16 percent of the statutory foreign-earned income exclusion amount for the year (exceed 16 percent × $120,000 .

5-8

Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al. = $19,200 in 2023). The exclusion, however, is limited to a maximum of 14 percent of the statutory exclusion amount (14 percent × $120,000 = $16,800 in 2023). (d) Work through Example 5-35. vi) Sickness and injury-related exclusions (1) Workers’ compensation (a) Payments from workers’ compensation plans are excluded from gross income.

(2) Payments associated with personal injury (a) Payments received as compensation for a physical injury are excluded from gross income, but punitive damages are included in gross income. (b) Work through Example 5-36.

(3) Health care reimbursement (a) Reimbursements by health and accident insurance policies for medical expenses paid by the taxpayer are excluded from gross income.

(4) Disability insurance (a) Disability insurance, also called wage replacement insurance, pays the insured individual for wages lost when the individual misses work due to injury or disability. (b) Disability benefit payments received from an individually purchased policy (or an employer-purchased policy with the premiums treated as taxable compensation to the employee) are excluded from gross income. (c) Work through Example 5-37. b) Deferral provisions—allow taxpayers to defer (but not permanently exclude) the recognition of certain types of realized income. i) Employer-provided qualified retirement plans (1) Many employers help employees save for retirement by sponsoring retirement plans on behalf of their employees.

(2) These plans may be “qualified” retirement plans or “nonqualified” deferred compensation plans. Qualified plans are subject2to certain restrictions not applicable to nonqualified plans.

(3) Employer-provided qualified plans can be generally classified as defined benefit plans or defined contribution plans.

(4) Defined benefit plans spell out the specific benefit the employee will receive on retirement based on a fixed formula. (a) For employees who retire in 2023, the maximum annual benefit an employee can receive is the lesser of (1) 100 percent of the average of the employee’s three highest years of compensation or (2) $265,000. (b) Defined benefit plans are typically funded through a combination of employer contributions and employee contributions of a portion of their salary. (c) Neither contribution is taxable (except employee contributions are still subject to FICA taxes), as employees are subject to tax on the distributions from defined benefit plans, not the contribution.

(5) Defined contribution plans specify the maximum annual contributions that employers and employees may contribute to the plan. (a) Employers may provide different types of defined contribution plans, such as 401(k) (used by for-profit companies), 403(b) plans (used by nonprofit organizations, including educational institutions), and 457 plans (used by government agencies), profit-sharing plans, and money purchase pension plans. (b) For 2023, the sum of employer and employee contributions to an employee’s defined contribution account(s) is limited to the lesser of (1) $66,000 ($73,500 for employees who are at least 50 years of age by the end of the year) or (2) 100 percent of the employee’s compensation for the year.

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5-9

Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al. (c) Employee contributions to an employee’s 401(k) account are limited to $22,500 (or $30,000 for employees that reach age 50 by the end of the year). While this limit applies only to employee contributions, the $66,000 (or $73,500) limit still applies to the sum of employer and employee contributions. (d) As with defined benefits, neither employer nor employee contributions to defined contribution plans are taxable (except for Roth 401(k) plans), as employees are subject to tax on the distributions from defined benefit plans, not the contribution.

Employee contributions, however, are still subject to FICA taxes.

(6) Work through Example 5-38.

(7) Distributions (a) When employees receive distributions from defined benefit or defined contribution plans (other than Roth 401(k) plans), the distributions are taxed as ordinary income. (b) However, when employees receive distributions (or take withdrawals) from defined benefit or contribution plans either too early or too late, they must pay a penalty in addition to the ordinary income taxes they owe on the distributions. (c) Generally, employees who receive distributions before they reach:  59½ years of age or  55 years of age and have separated from service (retired or let go) are subject to a 10 percent nondeductible penalty on the amount of the early distributions. (d) Taxpayers who fail to receive minimum distributions for (pertaining to) a particular year are also penalized. The year for which taxpayers must receive their first minimum distribution is the later of:  the year in which the employee reaches 72 years of age or  the year in which the employee retires.

Taxpayers must receive this distribution no later than April 1 of the year after the year to which the first minimum distribution pertains. (e) Taxpayers generally must receive minimum distributions for subsequent years by the end of the years to which they pertain. (f) Work through Example 5-39.

Class Activities 1. Suggested class activities A good activity for helping students understand constructive receipt is using examples based upon a “parade of horribles.” Begin with the question of whether a taxpayer should be able to avoid income by simply refusing to cash a check for services. Then, progressively extend the example to more difficult situations (e.g., a check received on December 31st, December 31st after the banks have closed, December 31st and the check is postdated January 1st). This example will help students understand that rules are typically based upon a continuum of behaviors and that judgment may be necessary in determining what type of behavior breaks the spirit of the rule.

Probably the most difficult of the legal doctrines in this chapter is tax benefit. You might consider revisiting this type of problem in Chapter 7 after students have had an opportunity to study itemized deductions (especially state income taxes).

2. Ethics discussion

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al.

From page 5-24:

Discussion points:    

Do you think that finding $100 meets the definition of gross income?

Is there a “materiality” threshold for when you have to report income?

Does not reporting the $100 violate tax law and/or ethical standards?

If you are more likely to report the $100,000, why? Does not reporting the $100,000 violate tax law and/or ethical standards?

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al

Chapter 6 Individual For AGI Deductions INSTRUCTOR’S MANUAL

Learning Objectives 6-1. Identify for AGI deductions directly related to business activities.

6-2. Describe the loss limitation rules for passive activities, the rental use of a home, and home office deductions.

6-3. Explain for AGI deductions indirectly related to business activities and for AGI deductions that subsidize specific activities.

Teaching Suggestions In Chapter 5, we discussed the calculation of gross income and identified several specific types of taxable income and exclusions. In Chapter 6, we describe the deductions allowed in computing adjusted gross income. It is important to emphasize that taxpayers are only allowed to deduct expenditures if there is a specific tax law authorizing the deductions. Of course, Congress grants many deductions for taxpayers for a variety of reasons, and these deductions appear in one of two places in the individual income tax formula. Deductions “for AGI” (also called deductions “above the line”) are subtracted directly from gross income. In contrast, deductions “from AGI” (also called deductions “below the line”) are subtracted from AGI. Deductions for AGI are preferred over deductions from AGI because these deductions reduce taxable income dollar for dollar. An indirect benefit of deductions for AGI is that these deductions reduce AGI. Because many of the limitations on tax benefits for higher-income taxpayers are based upon AGI, deductions for AGI reduce these limitations, thereby increasing potential tax benefits. In contrast to deductions for AGI, itemized deductions will have no effect on taxable income unless the total exceeds the standard deduction. Students often confuse the location of the deduction with the deduction rule. So, a good rule is to emphasize the order of the questions. First, determine if the expense is deductible. Next, determine the location of the deduction (for or from).

If the students have already been exposed to the calculation of taxable income for other entities (e.g., corporations, partnerships, etc.), it might be helpful to discuss which deductions and limitations are specific to individuals relative to other entities. For example, the distinction between for and from AGI deductions does not exist for corporations.

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al

Assignment Matrix

30 min.

30 min.

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20 min.

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20 min.

20 min.

25 min.

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20 min.

20 min.

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15 min.

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15 min.

15 min.

10 min.

15 min.

15 min.

15 min.

15 min.

15 min.

15 min.

15 min.

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15 min.

10 min.

15 min.

30 min.

20 min.

25 min.

20 min.

20 min.

20 min.

25 min.

X X X X X X X X X X X X X X X

Forms

Planning

X X

LO3

Medium Medium Medium Medium Medium Medium Medium Medium Medium Medium Medium Medium Medium Medium Medium Medium Medium Easy Easy Easy Easy Medium Medium Easy Easy Easy Easy Easy Easy Easy Easy Medium Medium Medium Medium Medium Medium Medium Medium Medium

LO2

LO1

DQ6-1 DQ6-2 DQ6-3 DQ6-4 DQ6-5 DQ6-6 DQ6-7 DQ6-8 DQ6-9 DQ6-10 DQ6-11 DQ6-12 DQ6-13 DQ6-14 DQ6-15 DQ6-16 DQ6-17 DQ6-18 DQ6-19 DQ6-20 DQ6-21 DQ6-22 DQ6-23 DQ6-24 DQ6-25 DQ6-26 DQ6-27 DQ6-28 DQ6-29 DQ6-30 DQ6-31 DQ6-32 DQ6-33 P6-34 P6-35 P6-36 P6-37 P6-38 P6-39 P6-40

Difficulty

Research

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6-2

Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al P6-41 P6-42 P6-43 P6-44 P6-45 P6-46 P6-47 P6-48 P6-49 P6-50 P6-51 P6-52 P6-53 P6-54 P6-55 P6-56 P6-57 P6-58 P6-59 P6-60 P6-61 P6-62 P6-63 P6-64 P6-65 P6-66 CP6-67 CP6-68 CP6-69

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Lecture Notes 1) Deductions Directly Related to Business Activities a) Congress allows taxpayers to claim a variety of deductions for AGI. b) Work through Example 6-1. c) Refer to Exhibit 6-1 for Individual Business and Investment-Related Expense Deductions for AGI, from AGI, and not deductible. d) Trade or business expenses i) Refer to Exhibit 6-2 Parts I and II from Schedule C Profit or Loss from Business. ii) Work through Example 6-2. e) Rental and royalty expenses i) Taxpayers are allowed to deduct their expenses associated with generating rental or royalty income for AGI. ii) Refer to Exhibit 6-3 Page 1 of Schedule E Rental or Royalty Income. iii) Work through Example 6-3. f) Losses on dispositions i) Taxpayers disposing of business assets at a loss are allowed to deduct the losses as for AGI deductions. g) Flow-through entities 6-3

Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al i)

Income from flow-through entities such as partnerships, LLCs, and S corporations passes through to the owners of those entities and is reported on the tax returns of the owners. ii) Any expenses and losses incurred by the entity pass through to the entity owners, who typically treat them as deductions for AGI, subject to certain restrictions.

2) Loss Limitation Rules a) If trade or business or rental activities (held either directly or through flow-through entities) generate operating losses, the losses must clear three hurdles to be currently deductible. The three hurdles are tax basis, at-risk amount, and passive loss limits. In addition, for losses that clear each of the three hurdles, taxpayers are not allowed to deduct excess business losses as described below. b) Tax basis i) The tax basis hurdle limits a taxpayer’s deductible losses to the taxpayer’s tax basis in the activity. ii) In order to apply the tax-basis loss limitation, we must first compute the taxpayer’s tax basis in the activity. iii) Distributions of cash and losses reduce tax basis; but if the taxpayer’s losses from an activity exceed her tax basis in the activity, the losses are suspended until the taxpayer generates enough tax basis to absorb the loss. iv) When a loss from a business or business-related activity clears the tax-basis hurdle, it next must clear an at-risk hurdle on its journey toward deductibility. c) At-risk i) The at-risk rules are meant to limit the ability of investors to deduct “artificial” ordinary losses produced with certain types of debt. These rules limit ordinary losses to a taxpayer’s amount at risk in an activity. ii) Losses that do not clear the at-risk hurdle are suspended until the taxpayer generates more atrisk amounts to absorb the loss or until the activity is sold. iii) Work through Example 6-4. d) Passive activity income and losses i) The passive loss rules limit the ability of investors to deduct losses from passive activities against other sources of taxable income (portfolio income or active income). e) Passive activity definition i) Defined as “any activity which involves the conduct of a trade or business, and in which the taxpayer does not materially participate.” ii) According to the tax code, participants in rental activities, including rental real estate, and limited partners in partnerships are generally deemed to be passive participants, and participants in all other trade or business activities are passive unless their involvement in an activity is “regular, continuous, and substantial.” Clearly, these terms are quite subjective and difficult to apply. iii) Refer to Exhibit 6-4 for Tests for Material Participation. f) Income and loss categories i) The three different categories are as follows: (1) Passive activity income or loss—income or loss from an activity in which the taxpayer is not a material participant.

(2) Portfolio income—income from investments including capital gains and losses, dividends, interest, annuities, and royalties.

(3) Active business income—income from sources in which the taxpayer is a material participant. ii) Work through Example 6-5. g) Rental real estate exception to the passive activity loss rules i) Applies to active participants in rental property. ii) Deduct up to $25,000 of rental real estate loss against ordinary income.

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al iii) $25,000 maximum deduction phased out by 50 cents for every dollar of AGI over $100,000 (excluding the rental loss deduction). iv) Fully phased out at $150,000 of AGI. v) Work through Example 6-6. h) Excess business loss limitation i) Excess business loss is excess of aggregate business deductions over the sum of business gross income or gain plus a threshold amount. ii) The threshold amount for 2023 is $289,000 ($578,000 for married filing jointly). iii) Excess business loss is not deductible but is carried forward as net operating loss. iv) Work through Example 6-7. i) Loss limitation rules—rental use of the home i) The tax consequences of owning a second home depend on whether the home qualifies as a residence and on the number of days the taxpayer rents out the home. The home is categorized in one of three ways: (1) Residence with minimal rental use (rents home for 14 or fewer days) (2) Residence with significant rental use (rents home for 15 or more days) (3) Nonresidence ii) A property is considered a “residence” for tax purposes if the taxpayer uses the home for personal purposes for more than the greater of 14 days or 10 percent of the number of rental days during the year. j) Residence with minimal rental use i) The law is simple for homeowners who rent a home that qualifies as a residence for a minimal amount of time during the year. That is, they live in it for at least 15 days and they rent it for 14 or fewer days. ii) Taxpayers are not required to include the gross receipts in rental income and are not allowed to deduct any expenses related to the rental. iii) Work through Example 6-8. k) Residence with significant rental use (vacation home) i) When a home qualifies as a residence and the taxpayer rents out the home for 15 days or more, the rental revenue is included in gross income, expenses to obtain tenants (advertising and realtor commissions) are fully deductible as direct rental expenses, and expenses relating to the home are allocated between personal and rental use. The expenses allocated to personal use are not deductible except as itemized under nonrental tax provisions. ii) Expenses are generally allocated to rental use based on the ratio of the number of days of rental use to the total number of days the property was used for rental and personal purposes.

(See Exhibit 6-5.) iii) However, the Tax Court allocates interest and taxes to rental use based on the ratio of days that the property was rented over the number of days in the year, rather than the number of days the property was used for any purpose during the year. (See Exhibit 6-5.) iv) When the gross rental revenue exceeds the sum of the direct rental expenses and the expenses allocated to the rental use of the home, the taxpayer is allowed to deduct the expenses in full. v) However, when the sum of direct rental expenses and expenses allocated to the rental use of the home exceeds the rental revenue, the deductibility of the expenses depends on the type of expenses. In these situations, taxpayers assign each of the rental expenses into one of three categories or “tiers.” vi) Tier 1 expenses include expenses to obtain tenants and potentially mortgage interest expense and real property taxes allocated to the rental use of the home. Tier 2 expenses include all expenses allocated to rental use of the home that are not tier 1 expenses or tier 3 expenses.

Tier 3 expense is depreciation expense allocated to the rental use of the home. vii) If the taxpayer claims the standard deduction, all mortgage interest expense and real property taxes allocated to rental use of the home are tier 2 expenses. If the taxpayer itemizes 6-5

Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al deductions, whether mortgage interest expense and real property taxes allocated to rental use of the home are treated as tier 1 expenses or as tier 2 expenses is determined as follows: (1) All mortgage interest expense on acquisition indebtedness is a tier 1 expense. Any remaining mortgage interest expense is a tier 2 expense.

(2) If the sum of the taxpayer’s state and local income (or sales) tax and nonrental property taxes equals or exceeds the $10,000 tax deduction limit ($5,000 if married filing separately), all rental real property taxes are tier 2 expenses.

(3) If the sum of the taxpayer’s state and local income (or sales) tax and nonrental property taxes is less than the $10,000 tax deduction limit ($5,000 if married filing separately), all rental real property taxes are tier 1 expenses up to the difference between the tax deduction limit and the taxpayer’s nonrental state and local taxes. The remaining rental real property taxes are tier 2 expenses. For example, if the taxpayer’s itemized deduction for (nonrental) state and local taxes is $8,000 and the rental real property taxes are $3,000, then $2,000 ($10,000 minus $8,000) of the rental real property taxes is tier 1 and $1,000 ($3,000 minus $2,000) of the rental real property taxes is tier 2. viii) See Exhibit 6-6 for Rental Expenses by Tier and Deduction Sequence. ix) The taxpayer first deducts tier 1 (expenses to obtain tenants and mortgage interest and real property taxes allocated to rental use) expenses in full. This is true even when tier 1 expenses exceed the gross rental revenue. x) Second, the taxpayer deducts tier 2 expenses. However, the tier 2 expense deductions are limited to the gross rental revenue in excess of tier 1 expenses. Any tier 2 expenses not deducted in the current year due to the income limitation are suspended and carried forward to the next year. xi) Finally, the taxpayer deducts tier 3 expenses (depreciation). The tier 3 expense deduction is limited to the gross rental revenue in excess of tier 1 and tier 2 expenses. Any tier 3 expenses not deductible because of the income limitation are suspended and carried forward to next year. xii) Work through Example 6-9. xiii) See Exhibit 6-7 for Courtney’s Schedule E for Vacation Home Rental. l) Nonresidence (rental property) i) For property in this category, the taxpayer includes the rental revenue in gross income and deducts all rental expenses allocated to the rental use of the property as for AGI deductions (all on Schedule E). ii) When the property is used for even a day for personal purposes, the expenses must be allocated between the rental usage and the personal usage. iii) The tax law does not allow the taxpayer to deduct mortgage interest not allocated to rental use because the taxpayer does not meet the minimum amount of personal use required for the deduction (the home is not a qualified residence—see prior discussion). However, the taxpayer is still allowed to deduct, as an itemized deduction, real property taxes not allocated to the rental. iv) If the rental expenses exceed the gross income from the home in this category, the deductibility of the loss is not subject to a gross income limitation but it is subject to the passive activity restrictions. v) Work through Example 6-10. vi) See Exhibit 6-8 for Summary of Tax Rules Relating to Home Used for Rental Purposes. m) Business use of home deduction limitations i) To qualify for home office deductions, a taxpayer must use her home—or part of her home— exclusively and regularly as either: (1) The principal place of business for any of the taxpayer’s trade or businesses, or (2) As a place to meet with patients, clients, or customers in the normal course of business. ii) Taxpayers fail the exclusive use test if they use the area of the home in question for both 6-6

Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al business and personal purposes. iii) Work through Example 6-11. iv) The taxpayer is not required to meet the exclusive use test in order to claim the home office deduction to the extent the taxpayer either: (1) Uses part of the home for the storage of inventory or product samples, or (2) Uses part of the home as a day care facility. v) If a taxpayer has more than one business location, the facts-and-circumstances determination of the principal place of business is based upon: (1) The importance of the activities performed at each place where the taxpayer conducts business and (2) The total time spent doing work at each location. vi) However, by definition, a taxpayer’s principal place of business also includes the place of business used by the taxpayer for the administrative or management activities of the taxpayer’s trade or business if there is no other fixed location of the trade or business where the taxpayer conducts substantial administrative or management activities of the trade or business. vii) If a taxpayer meets with clients or patients in her home during the normal course of business, she qualifies for the home office deduction even if the home is not her principal place of business. viii) Work through Example 6-12. ix) Self-employed taxpayers deduct home office expenses on Schedule C. x) Employees cannot deduct home office expenses (as employee expenses are generally nondeductible). Employees, however, can deduct their mortgage interest and real estate taxes as itemized deductions without limitation from the home office deduction rules (but subject to the limitations specific to these itemized deductions). n) Direct versus indirect expenses i) When a taxpayer qualifies for home office deductions the deductions are limited to expenses that are related—either directly or indirectly—to the business.

(1) Direct expenses are expenses incurred in maintaining the room or part of the home that is set aside for business use.

(2) Indirect expenses include insurance, utilities, interest, real property taxes, general repairs, and depreciation on the home as if it were used entirely for business purposes. In contrast to direct expenses, only indirect expenses allocated to the home office space are deductible.

(3) Indirect expenses are allocated either per room (if rooms of the house are of equal size) or by square footage (more typical).

(4) Taxpayers electing the simplified method deduct the allowable business use square footage of the office (not to exceed 300 feet) multiplied by $5 per square foot. In addition, taxpayers using this method are allowed to deduct all of their home mortgage interest and real property taxes as itemized deductions on Schedule A. Taxpayers may choose from year to year whether to use the simplified method or the actual expense method. ii) Work through Example 6-13. o) Limitations on deductibility of expenses i) To determine the home office deduction, the taxpayer uses a process very similar to the process to determine the deductible expenses for a vacation home. ii) If the taxpayer claims the standard deduction, the mortgage interest and property taxes allocated to the home office are tier 2 expenses. If the taxpayer itemizes deductions, whether mortgage interest expense and real property taxes allocated to business use of the home are treated as tier 1 expenses or as tier 2 expenses is determined as follows:

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al (1) All mortgage interest expense on acquisition indebtedness is a tier 1 expense. Any remaining mortgage interest expense is a tier 2 expense.

(2) If the sum of the taxpayer’s state and local income (or sales) tax and non-home business property taxes equals or exceeds the $10,000 tax deduction limit ($5,000 if married filing separately), all business real property taxes are tier 2 expenses.

(3) If the sum of the taxpayer’s state and local income (or sales) tax and non-home business property taxes is less than the $10,000 tax deduction limit ($5,000 if married filing separately), all business real property taxes are tier 1 expenses up to the difference between the tax deduction limit and the taxpayer’s non-home business state and local taxes. The remaining home business real property taxes are tier 2 expenses. For example, if the taxpayer’s itemized deduction for (non–home business) state and local taxes is $8,000 and the home business real property taxes are $3,000, then $2,000 ($10,000 minus $8,000) of the home business real property taxes are tier 1 and $1,000 ($3,000 minus $2,000) of the home business real property taxes are tier 2. iii) The taxpayer first deducts tier 1 expenses in full even when tier 1 expenses exceed gross net Schedule C income (before home office expenses). iv) Second, the taxpayer deducts tier 2 expenses. However, the amount of the deductible tier 2 expenses is limited to net Schedule C income minus tier 1 expenses. Any tier 2 expenses not deductible due to the income limitation are suspended and carried forward to the next year, subject to the same limitations. v) Finally, the taxpayer deducts tier 3 expense. However, the amount of the deductible tier 3 expense is limited to net Schedule C income (before home office expenses) minus tier 1 expenses minus deductible tier 2 expenses. The nondeductible portion of tier 3 expense is carried forward to next year, subject to the same limitations. vi) Under the simplified method, the expense, as calculated by multiplying the square footage by the $5 application rate, is limited to net Schedule C income before home office deductions.

Taxpayers using the simplified method (a) may not carry over any excess expenses under the simplified method or (b) deduct expenses disallowed and carried over under the actual expense method. Carryover expenses under the actual expense method may be deducted (subject to income limitations) when the taxpayer uses the actual method again. vii) Work through Example 6-14. viii) When a taxpayer deducts depreciation as a home office expense, the depreciation expense reduces the taxpayer’s basis in the home. The gain on the sale of the home attributable to the depreciation deductions is not eligible to be excluded under the home sale exclusion provisions. Rather, this gain is treated as unrecaptured §1250 gain and is subject to a maximum 25 percent tax rate (see Chapter 11 for detailed discussion of §1250 gain). ix) Taxpayers using the simplified method are not allowed to deduct depreciation expense. If a taxpayer switches from the simplified method in one year to the actual expense method in a subsequent year, the taxpayer is required to use modified depreciation tables to compute depreciation expense under the actual expense method.

3) Deductions Indirectly Related to Business Activities a) Individual retirement accounts i) Taxpayers who meet certain eligibility requirements can contribute to traditional IRAs, to Roth IRAs, or to both. b) Traditional IRAs i) Deductible contributions to IRAs are for AGI deductions. The maximum deductible contribution for a taxpayer in 2023 depends on the taxpayer’s age as follows: (1) $6,500 deduction limit if the taxpayer is less than 50 years of age at year-end.

(2) $7,500 deduction limit if the taxpayer is at least 50 years of age at year-end. ii) The deductible contribution limit may be further restricted depending on the following factors: 6-8

Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al (1) Whether the taxpayer is an active participant in an employer-sponsored retirement plan (2) The amount of the taxpayer’s earned income (3) The taxpayer’s filing status (4) The taxpayer’s modified AGI iii) Unmarried taxpayers not participating in an employer-sponsored retirement plan may deduct IRA contributions up to the lesser of (1) $6,500 ($7,500 for taxpayers 50+ years of age) or (2) Earned income. iv) For unmarried taxpayers who actively participate in an employer-sponsored retirement plan, the deduction limits are the same as for those who do not participate except that the maximum deduction is phased out based on the taxpayer’s MAGI as follows: (1) No phase-out if MAGI is equal to or less than $73,000 (2) Proportional phase-out of full limit for AGI between $73,000 and $83,000 (3) Full phase-out (no deduction) if MAGI is equal to or greater than $83,000 v) Work through Example 6-15. vi) Married taxpayers not participating in an employer-sponsored retirement plan can make deductible contributions to separate IRAs (IRA for each spouse), subject to limitations.

(1) If neither spouse participates in an employer-sponsored plan and the couple files jointly, the deduction for contributions to the traditional IRA of the spouse with the higher amount of earned income is the same as it is for unmarried taxpayers [$6,5000 (plus $1,000 if at least 50 years of age at year-end) or earned income if it is less].

(2) However, for the spouse with the lesser amount of earned income, the deduction is limited to the lesser of (a) $6,500 ($7,500 if this spouse is age 50+) or (b) Total earned income of both spouses reduced by deductible and nondeductible contributions to the other spouse’s traditional IRA and by contributions to the other spouse’s Roth IRA. (3) If a spouse is an active participant in an employer’s retirement plan, and the couple files jointly, the deduction for that spouse is phased out based on the couple’s MAGI as follows: (a) No phase-out if the couple’s MAGI is equal to or less than $116,000. (b) Proportional phase-out of full limit for MAGI between $116,000 and $136,000. (c) Full phase-out (no deduction) if MAGI is equal to or greater than $136,000.

(4) If one spouse is an active participant in an employer’s retirement plan and the other is not and the couple files jointly, the deduction for the spouse who is not an active participant is phased out based on the couple’s MAGI as follows: (a) No phase-out if the couple’s MAGI is equal to or less than $218,000. (b) Proportional phase-out of full limit for MAGI between $218,000 and $228,000. (c) Full phase-out (no deduction) if MAGI is equal to or greater than $228,000. vii) Married taxpayers who file separately may also make deductible contributions to an IRA. (1) The maximum deduction is the lesser of: (a) $6,500 ($7,500 if taxpayer is 50+) or (b) Earned income.

(2) However, if either spouse is an active participant in an employer’s retirement plan and they file separately, then each spouse’s deductible contribution (including the nonactive participant spouse) is phased out over the couple’s MAGI as follows: (a) No phase-out if the couple’s MAGI is $0 (also no tax benefit of deducting). (b) Proportional phase-out of full limit for MAGI between $0 and $10,000. (c) Full phase-out (no deduction) if MAGI is equal to or greater than $10,000. viii) For all taxpayers, when the $6,500 ($7,500 for taxpayers 50+ years of age) deductible contribution limitation is phased out, taxpayers can still make nondeductible contributions to 6-9

Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al reach the $6,500 (or $7,500) contribution limit subject to earned income limits. Specifically, the earned income limitations (including the spousal IRA limits) that apply and limit deductible IRA contributions also apply and limit nondeductible contributions.

(1) While these contributions are not deductible, the earnings on the contributions grow taxfree until the taxpayer receives distributions from the IRA. (2) On distribution, the taxpayer is taxed on the earnings generated by the nondeductible contributions but not on the actual nondeductible contributions.

(3) When taxpayers take partial distributions from an IRA to which they have made deductible and nondeductible contributions, each distribution consists of a taxable and nontaxable component. The portion of the distribution that is nontaxable is as follows: Nondeductible contributions/Total account balance at time of distribution ix) Most taxpayers exceeding the deductibility limits on traditional IRAs would likely do better by contributing to a Roth IRA, if eligible, instead of making nondeductible contributions to traditional IRAs. x) Taxpayers who are eligible to contribute to an IRA may contribute to the IRA up to April 15 of the subsequent year (the unextended tax return due date). xi) Distributions from traditional IRAs are taxed as ordinary income to the taxpayer. xii) Taxpayers withdrawing funds from traditional IRAs before reaching the age of 59½ are subject to a 10 percent early distribution penalty on the amount of the withdrawal. xiii) The IRA rules exempt certain distributions from the 10 percent penalty for early withdrawal.

Among others, these distributions include proceeds distributed in the form of a life annuity (fixed payment each month or year over the taxpayer’s life) and proceeds used for qualifying medical expenses, health insurance premiums for the owner, qualified higher education expenses, first-time home purchases, and up to $5,000 following the birth or adoption of a child (for married taxpayers, each spouse can withdraw up to $5,000 from his or her account penalty free). xiv) Taxpayers are also subject to the same minimum distribution requirements applicable to traditional 401(k) and other qualified retirement plans. c) Roth IRAs i) Contributions to Roth IRAs are not deductible and qualifying distributions from Roth IRAs are not taxable. ii) Whether or not they participate in an employer-sponsored retirement plan, taxpayers are allowed to contribute to Roth IRAs as long as their AGI does not exceed specified thresholds. iii) For 2022, the $6,500 Roth IRA contribution limitation (or $7,500 if age 50 or older) phases out as follows: (1) Unmarried taxpayers (a) No phase-out if the taxpayer’s AGI is $138,000 or below. (b) Proportional phase-out of full limit for AGI between $138,000 and $153,000. (c) Full phase-out (no contribution) if AGI is $153,000 or higher.

(2) Married taxpayer filing jointly (a) No phase-out if the taxpayer’s AGI is $218,000 or below. (b) Proportional phase-out of full limit for AGI between $218,000 and $228,000. (c) Full phase-out (no contribution) if AGI is $228,000 or higher.

(3) Married taxpayers filing separately (a) No phase-out if the taxpayer’s MAGI is $0 (also no tax benefit of deducting). (b) Proportional phase-out of full limit for MAGI between $0 and $10,000. (c) Full phase-out (no contribution) if MAGI is equal to or greater than $10,000. iv) Qualified distributions from Roth IRAs are not taxable. A qualified distribution is a distribution from funds or earnings from funds in a Roth IRA if the distribution is at least five 6-10

Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al years after the taxpayer opened the Roth IRA and the distribution meets one of the following requirements: (1) Distribution is made on or after the date the taxpayer reaches 59½ years of age, (2) Distribution is made to a beneficiary (or to the estate of the taxpayer) on or after the death of the taxpayer, (3) Distribution is attributable to the taxpayer being disabled, or (4) Distribution is used to pay qualified acquisition costs for first-time homebuyers (limited to $10,000). v) All other distributions are considered to be nonqualified distributions.

(1) Nonqualified distributions are not necessarily taxable.

(2) Because taxpayers contributing to a Roth IRA contribute after-tax dollars (they don’t deduct the contribution), they are able to withdraw the contributions tax-free at any time.

(3) However, nonqualified distributions of the earnings of a Roth IRA are taxable as ordinary income and subject to a 10 percent penalty.

(4) Nonqualified distributions are deemed to come first from the taxpayer’s contributions and then from the earnings after the total contributions have been distributed. vi) Work through Example 6-16. vii) In contrast to taxpayers with traditional IRAs, taxpayers are not required to take minimum distributions from Roth IRAs. d) Rollover from traditional to Roth IRA i) When taxpayers do this, the entire amount taken out of the traditional IRA is taxed at ordinary rates but is not subject to the 10 percent penalty tax as long as the taxpayer contributes the full amount to a Roth IRA within 60 days of the withdrawal from the traditional IRA. ii) Work through Example 6-17. iii) Typically, a rollover from a traditional to a Roth IRA makes sense when a taxpayer’s marginal tax rate is currently low (when the tax cost of the rollover is low) and expected to be significantly higher in the future (when the expected benefit of the rollover is high). iv) High-income taxpayers may not be allowed to contribute to Roth IRAs due to the AGI restrictions on contribution limits. However, because currently there is no AGI restriction on who may roll over funds from a traditional IRA (or other qualified defined contribution plan) into a Roth IRA, high-income taxpayers who would like to fund a Roth IRA may do so through a rollover. e) Comparing traditional and Roth IRAs i) In general, after-tax rates of return from traditional IRAs will exceed those from Roth IRAs when marginal tax rates decline. However, after-tax rates of return from Roth IRAs will exceed those from traditional IRAs when tax rates increase. ii) Roth IRAs have other advantages relative to traditional IRAs. (1) The minimum distribution requirements for traditional IRAs do not apply to Roth IRAs. This provision permits owners of Roth IRAs to use their accounts to generate tax-free returns long after retirement.

(2) Taxpayers can withdraw their Roth contributions tax-free at any time without paying tax or paying a penalty. Taxpayers who withdraw their traditional IRA contributions are taxed on the distribution and potentially penalized. iii) Exhibit 6-9 compares traditional and Roth IRAs. f) Self-employed retirement accounts i) Two of the more popular plans for the self-employed are SEP IRAs and individual (or “selfemployed”) 401(k) plans. ii) These are defined contribution plans that generally work the same as employer-provided plans. That is, amounts set aside in these plans are deducted from income, earnings are free from tax until distributed, and distributions from the plans are fully taxable.

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al g) Moving expenses i) Not deductible. ii) Employer reimbursements are taxable. iii) Exception for active duty military. iv) Work through Example 6-18. h) Health insurance deduction by self-employed taxpayers i) Congress allows self-employed taxpayers to claim personal health insurance premiums for the taxpayer, the taxpayer’s spouse, and the taxpayer’s dependents under age 27 as deductions for AGI, but only to the extent of the self-employment income derived from the specific trade or business. ii) Self-employed taxpayers are not allowed to use this deduction if the taxpayer is eligible to participate in an employer-provided health plan. i) Self-employment tax deduction i) Self-employed taxpayers are allowed to deduct the employer portion of the self-employment taxes they pay. ii) Work through Example 6-19. j) Deduction for health savings accounts (HSAs) i) HSAs allow individuals covered by a high deductible health plan with no other health coverage to set aside amounts for payment of qualified medical and dental expenses for the taxpayer, spouse, and dependents. ii) For 2023, high deductible health plans have a minimum annual deductible of $1,500 for selfonly coverage ($3,000 for family coverage) and their maximum annual deductible and other out-of-pocket expenses cannot exceed $7,500 for self-only coverage ($15,000 for family coverage). iii) For 2023, individuals can contribute up to $3,850 for self-only coverage ($7,750 for family coverage) to a HSA and deduct these contributions for AGI. Individuals age 55 or older at the end of the tax year may contribute and deduct an additional $1,000 annually. iv) Distributions from a HSA are tax free if they pay for qualified medical expenses of the taxpayer, spouse, and dependents that occurred after the HSA was established (even if the distribution occurs in a year after the expense was incurred or in a year in which the taxpayer is no longer covered under a high deductible health plan). v) Otherwise, distributions are taxed as ordinary income (and subject to an additional 20% tax unless the taxpayer is disabled, age 65 or older, or deceased). vi) Work through Example 6-20. k) Penalty for early withdrawal of savings i) Allows a deduction for AGI for any interest income an individual forfeits to a bank as a penalty for prematurely withdrawing a certificate of deposit or similar deposit. ii) Work through Example 6-21. l) Deductions subsidizing specific activities i) Deduction for interest on qualified education loans (1) Up to $2,500 of interest on education loans is deductible for AGI. (2) A loan qualifies as an education loan if the proceeds are used to fund qualified education.

(3) The interest deduction is phased out for taxpayers with AGI exceeding $75,000 ($155,000 if married filing jointly).

(4) Refer to Exhibit 6-10 for Summary of Limitations on Deduction of Interest on Education Loans.

(5) Work through Example 6-22.

4) Summary: deductions for AGI a) Refer to Exhibits 6-11, 6-12, 6-13, and 6-14.

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al

Class Activities 1. Suggested class activities A great activity for this chapter is to compile a list of the deductions that are to be emphasized in the chapter (business, rental/royalty, flow-through entities, retirement plan contributions, etc.) and have students prepare a set of examples for each type of deduction. Alternatively, prepare a list of expenditures and have students determine whether the expenditure is deductible and, if so, what limitations apply.

2. Ethics discussion From page 6-12:

Discussion points:    

If Tabitha treats the property as being rented for 23 days, what are the tax consequences?

If Tabitha treats the property as being rented for 14 days, what are the tax consequences?

Does Tabitha’s use of the 14-day rule violate tax law and/or ethical standards?

How do you think the IRS would view this transaction? Does the substance of the transaction outweigh the form?

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al.

Chapter 7 Individual From AGI Deductions INSTRUCTOR’S MANUAL

Learning Objectives 7-1. Describe the different types of itemized deductions available to individuals and compute itemized deductions.

7-2. Determine the standard deduction available to individuals.

7-3. Calculate the deduction for qualified business income.

Teaching Suggestions In Chapter 5, we discussed the calculation of gross income and identified several specific types of taxable income and exclusions. In Chapter 6, we described the for AGI deductions. In this chapter, we complete the computation of taxable income by explaining deductions “from AGI.” The chapter provides sufficient detail for a rather in-depth understanding of itemized deductions, which could easily be covered in one class session. The deduction for qualified business income can be a bit complex and will require a bit more time to cover in detail.

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al.

Assignment Matrix

DQ7-1 DQ7-2 DQ7-3 DQ7-4 DQ7-5 DQ7-6 DQ7-7 DQ7-8 DQ7-9 DQ7-10 DQ7-11 DQ7-12 DQ7-13 DQ7-14 DQ7-15 DQ7-16 DQ7-17 DQ7-18 P7-19 P7-20 P7-21 P7-22 P7-23 P7-24 P7-25 P7-26 P7-27 P7-28 P7-29 P7-30 P7-31 P7-32 P7-33 P7-34 P7-35 P7-36 P7-37 P7-38 P7-39

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Lecture Notes 1) Itemized Deductions a) Medical expenses i) Designed to provide relief for taxpayers whose ability to pay taxes is seriously hindered by health-related circumstances ii) Qualified medical expenses include any payments for the care, prevention, diagnosis, or cure of injury, disease, or bodily function that are not reimbursed by health insurance or are not paid for through a “flexible spending account” or “health savings account.” iii) Common medical expenses include: (1) Prescription medication and medical aids such as eyeglasses, contact lenses, and wheelchairs.

(2) Payments to medical care providers such as doctors, dentists, and nurses and medical care facilities such as hospitals.

(3) Transportation for medical purposes.

(4) Hospitals and long-term care facilities.

(5) Health insurance premiums (if not deducted for AGI by self-employed taxpayers) and insurance for long-term care services. iv) Work through Example 7-1. v) Transportation and travel for medical purposes (1) Taxpayers traveling for the primary purpose of receiving essential and deductible medical care may deduct the cost of the travel (including meals and lodging, with certain restrictions) and transportation.

(2) Taxpayers using personal automobiles for medical transportation purposes may deduct a standard mileage allowance in lieu of actual costs.

(3) Work through Example 7-2. vi) Hospitals and long-term care facilities (1) Taxpayers may deduct the cost of meals and lodging at hospitals.

(2) Work through Example 7-3. vii) Medical expense deduction limitation (1) The deduction for medical expenses is limited to the amount of unreimbursed qualifying medical expenses paid during the year (no matter when the services were provided) reduced by 7.5 percent of the taxpayer’s AGI. (2) Work through Example 7-4. b) Taxes i) State, local, and foreign income taxes, including state and local taxes paid during the year through employer withholding, estimated tax payments, and overpayments on the prior-year return that the taxpayer applies to the current year. ii) State and local sales tax deduction in lieu of state and local income tax. iii) State and local real estate taxes on property held for personal or investment purposes. iv) State and local personal property taxes that are assessed on the value of the specific property.

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al.

g)

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v) The total itemized deduction for state and local taxes is limited to $10,000 ($5,000 married filing separately). The itemized deduction for foreign income taxes is not subject to this limitation. vi) Work through Example 7-5. c) Interest i) Individuals can deduct interest paid on loans secured by a personal residence (on acquisition indebtedness up to $1,000,000 if indebtedness originated before December 16, 2017; $750,000 if indebtedness originated after December 15, 2017). ii) Individuals can also deduct interest paid on loans used to purchase investment assets such as stocks, bonds, or land. iii) Work through Examples 7-6 and 7-7. d) Charitable contributions i) Congress encourages donations to charities by allowing taxpayers to deduct contributions of money and other property to qualified domestic charitable organizations. ii) Qualified charitable organizations include organizations that engage in educational, religious, scientific, governmental, and other public activities. iii) Work through Example 7-8. iv) Contributions of money (1) Cash contributions are deductible in the year paid, including donations of cash or by check, electronic funds transfers, credit card charges, and payroll deductions.

(2) Work through Example 7-9. v) Contributions of property other than money (1) When a taxpayer donates property to charity, the amount the taxpayer is allowed to deduct depends on whether the property is capital gain property or ordinary income property.

(2) Work through Examples 7-10, 7-11, and 7-12. vi) Charitable contribution deduction limitations (1) The amount of a taxpayer’s charitable contribution deduction for the year is limited to a ceiling or maximum deduction.

(2) Refer to Exhibit 7-1 for a Summary of Charitable Contribution Limitation Rules.

(3) Work through Example 7-13. e) Casualty and theft losses on personal-use assets i) Only casualty losses on personal-use assets attributable to a federally declared disaster (subject to $100 floor and 10 percent of AGI floor). f) Other itemized deductions i) Employee business expenses, tax preparation fees, investment expenses (other than investment interest expense), and hobby expenses are no longer deductible. ii) Gambling expenses and losses are deductible to the extent of gambling winnings for the year. iii) Casualty and theft losses on property held for investment (not personal use property) are deductible as miscellaneous itemized deduction. iv) Unrecovered cost of a life annuity (if the taxpayer died before recovering the full cost of the annuity) is deductible as miscellaneous itemized deduction.

Summary of itemized deductions i) Work through Example 7-14. ii) Refer to Exhibit 7-2 for Courtney’s Form 1040, Schedule A. The Standard Deduction a) Standard deduction i) A flat amount that most individuals can elect to deduct instead of deducting their itemized deductions (if any). ii) Taxpayers generally deduct the greater of their standard deduction or their itemized deductions.

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al. iii) The amount of the standard deduction varies according to the taxpayer’s filing status, age, and eyesight. iv) The basic standard deduction is greater for married taxpayers filing jointly and those supporting a family (head of household) than it is for married taxpayers filing separately and unmarried taxpayers not supporting a family. v) Taxpayers who are at least 65 years of age on the last day of the year or are blind are entitled to additional standard deduction amounts above and beyond their basic standard deduction. vi) Refer to Exhibit 7-3 for Standard Deduction Amounts. vii) Work through Examples 7-15 and 7-16. viii)Bunching itemized deductions (1) Some taxpayers may deduct the standard deduction every year because their itemized deductions always fall just short of the standard deduction amount and thus never produce any tax benefit.

(2) The basic strategy consists of shifting itemized deductions into one year such that the amount of itemized deductions exceeds the standard deduction for the year, and then deducting the standard deduction in the next year (or vice versa).

(3) Work through Example 7-17.

3) Deduction for Qualified Business Income a) 20 percent deduction for qualified business income i) Deduction is limited to qualified trade or business (1) Excludes specified service trade or business (except for taxpayers with taxable income below $182,100; $364,200 joint returns; $182,100 for married filing separate). ii) Deduction is subject to wage limitation and taxable income limitation. iii) Work through Examples 7-18 and 7-19.

4) Taxable Income Summary a) Refer to Exhibits 7-4, 7-5, and 7-6.

Class Activities 1. Suggested class activities A great activity for this chapter is to compile a list of the deductions that are to be emphasized in the chapter (medical, charitable, taxes, interest, etc.) and have students prepare a set of examples for each type of deduction. Alternatively, prepare a list of expenditures and have students determine whether the expenditure is deductible and, if so, where the deduction is claimed.

2. Ethics discussion From page 7-12:

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al.

Discussion points:    

If Sabrina gets an appraisal that states the value of the clothes is $6,000, how much tax deduction will she receive for the clothes?

If Sabrina’s clothes are worth $6,000, is she better off getting the appraisal or reporting a deduction of $4,900? What information would you need to answer this question?

Does Sabrina’s reporting $4,900 violate tax law and/or ethical standards?

Do you think the IRS has reason to be suspicious of contributions that fall just below $5,000?

Why?

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al.

Chapter 8 Individual Income Tax Computation and Tax Credits INSTRUCTOR’S MANUAL

Learning Objectives 8-1. Determine a taxpayer’s regular tax liability.

8-2. Compute a taxpayer’s alternative minimum tax liability.

8-3. Calculate a taxpayer’s net investment income tax, and employment and self-employment taxes.

8-4. Compute a taxpayer’s allowable child tax credit, child and dependent care credit, American opportunity tax credit, lifetime learning credit, and earned income credit.

8-5. Explain how to compute a taxpayer’s underpayment, late filing, and late payment penalties.

Teaching Suggestions This chapter is organized around issues dealing with computing a taxpayer’s tax liability. There are many topics in this chapter. The instructor may not wish to cover all topics.

Students should be able to understand that they must know more than the amount of taxpayer’s taxable income to determine the tax liability. Potential trouble spots for students include understanding that preferentially taxed income (qualified dividends and net capital gains) are included in taxable income, but the income is subject to different tax rates. Students may have a difficult time understanding that the rate at which preferentially taxed income is taxed depends on the amount of the taxpayer’s income subject to ordinary tax rates. Students may also need extra help in determining the tax liability for a child with unearned income. This includes determining the child’s taxable income (including the allowable standard deduction) and the child’s tax liability, given taxable income. Some income is taxed at the child’s marginal rate but some is taxed at the parents’ marginal rate.

The AMT section was written to provide a general understanding of the individual AMT without getting into many of the details (for example, computation of the minimum tax credit). Students should come to understand what the AMT is supposed to accomplish and who is most likely to pay it.

In the additional taxes section, students should understand the taxpayer’s Social Security and Medicare tax payment responsibilities when the taxpayer is an employee, when the taxpayer is self-employed, and when the taxpayer is both an employee and self-employed. Students may need extra help understanding the Medicare tax calculation and how the Social Security wage base limit applies to self-employed taxpayers. Some key points are that (1) the additional Medicare tax rate applies on the salaries or wages or self-employment exceeding $200,000 ($125,000 for married filing separately; $250,000 married filing jointly), (2) only 92.35 percent of self-employment income is subject to self-employment taxes (unless this is less than $400), and (3) employee wages use up the wage base limitation before self-employment income when a taxpayer is both an employee and an independent contractor. Also, make sure students understand that the self-employment tax is a tax in addition to the regular income tax. Consequently, if a self-employed taxpayer reports less than $400 of net earnings from self-employment, the taxpayer must pay income tax on the income even if she does not pay self-employment tax on the income. Students

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al. should also have a feel for whether a worker should be considered an employee or independent contractor for tax purposes and why this matters from a tax perspective.

For credits, discuss the difference between a refundable and nonrefundable credit. Point out that due to phase-out provisions, many credits are not available to higher-income taxpayers. Because it is relevant to them, students want to understand the American opportunity (formerly Hope scholarship) and lifetime learning credits. Also, note that the American opportunity credit is 40 percent refundable. You may want to emphasize that the American opportunity credit is a per-student credit, while the lifetime learning credit is a per-taxpayer credit. Also, you might discuss the child tax credit in detail, as this is a prevalent credit for taxpayers.

In the final section, make sure students understand the difference between an underpayment penalty, a late filing penalty, and a late payment penalty. Note that the combined maximum penalty for late filing and late payment is limited to 5 percent monthly, not 5.5 percent. The text provides a discussion of how this monthly maximum impacts the cumulative maximum late filing and late payment penalties.

Assignment Matrix

DQ8-1 DQ8-2 DQ8-3 DQ8-4 DQ8-5 DQ8-6 DQ8-7 DQ8-8 DQ8-9 DQ8-10 DQ8-11 DQ8-12 DQ8-13 DQ8-14 DQ8-15 DQ8-16 DQ8-17 DQ8-18 DQ8-19 DQ8-20 DQ8-21 DQ8-22 DQ8-23 DQ8-24

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al.

DQ8-25 DQ8-26 DQ8-27 DQ8-28 DQ8-29 DQ8-30 DQ8-31 DQ8-32 DQ8-33 DQ8-34 DQ8-35 DQ8-36 DQ8-37 DQ8-38 DQ8-39 DQ8-40 DQ8-41 DQ8-42 DQ8-43 DQ8-44 DQ8-45 DQ8-46 P8-47 P8-48 P8-49 P8-50 P8-51 P8-52 P8-53 P8-54 P8-55 P8-56 P8-57 P8-58 P8-59 P8-60 P8-61 P8-62 P8-63 P8-64 P8-65 P8-66 P8-67 P8-68 P8-69 P8-70 P8-71 P8-72 P8-73

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al.

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Lecture Notes 1) Regular Federal Income Tax Computation a) Tax rate schedules i) Schedule depends on filing status. ii) Each separate range of income subject to a different tax rate is referred to as a tax bracket. iii) Each filing status has its own tax rate schedules, which consist of tax brackets taxed at 10 percent, 12 percent, 22 percent, 24 percent, 32 percent, 35 percent, and 37 percent. iv) The IRS provides tax tables that present the gross tax for various amounts of taxable income under $100,000 and filing status. b) Marriage penalty or benefit i) Marriage penalty (benefit) occurs because dual-earning spouses pay more (less) combined tax than if they each filed single. ii) Refer to Exhibit 8-1 for 2023 Marriage Penalty (Benefit): Two-Income vs. Single-Income Married Couple. c) Exceptions to the basic tax computation i) Preferential tax rates for capital gains and dividends (1) Net long-term capital gains and qualified dividends are generally taxed at 0 percent, 15 percent, or 20 percent.

(2) The tax rate tables and tax rate schedules allow taxpayers to compute their tax on ordinary but not preferentially taxed income even though it is included in adjusted gross income (AGI) and taxable income.

(3) Three steps to determine tax liability when income is subject to preferential rate: (a) Split taxable income into the portion that is subject to the preferential rate and the portion taxed at the ordinary rates. (b) Compute the tax separately on each type of income. Note that the income that is not taxed at the preferential rate is taxed at the ordinary tax rates using the tax rate schedule for the taxpayer’s filing status. (c) Add the tax on the income subject to the preferential tax rates and the tax on the income subject to the ordinary rates. This is the taxpayer’s regular tax liability. Note that rate at which preferentially taxed income would have been taxed if it were ordinary income is important. ii) Kiddie tax (1) Unearned income in excess of $2,500 is taxed at parent’s marginal tax rate if child is: (a) Under age 18 at year-end, (b) 18 at year-end but earned income does not exceed one-half of support, or

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al. (c) Over 18 and under 24 at year-end, full-time student, and earned income does not exceed half of support (excluding scholarships).

2) Alternative Minimum Tax (AMT) a) Implemented to ensure taxpayers pay some minimum level of income tax. b) Alternative minimum tax formula i) Start with taxable income and make adjustments to determine alternative minimum taxable income. ii) Refer to Exhibit 8-2 for Formula for Computing the Alternative Minimum Tax. iii) Alternative minimum taxable income (AMTI) (1) Adjustments (a) Add the standard deduction (if deducted for regular tax purposes) back to regular taxable income in determining AMTI. (b) The major itemized deductions that are deductible for both regular tax and AMT purposes using the same limitations for both systems are: (i) Charitable contributions. (ii) Home mortgage interest expenses. (iii) Gambling losses. (c) Some deductions are deductible for regular tax and AMT purposes but have different limitations for each system, e.g., investment interest expense. (d) Refer to Exhibit 8-3 for Common AMT Adjustments and Exhibit 8-4 for Alternative Minimum Tax—Individuals. iv) AMT exemption (1) Allows taxpayers to determine their alternative tax base to deduct an AMT exemption.

(2) The exemption is phased out (reduced) by 25 cents for every dollar the AMTI exceeds the threshold amount.

(3) Refer to Exhibit 8-5 for 2023 AMT Exemptions and phase-out thresholds. v) Tentative minimum tax and AMT computation (1) AMT rate schedule consists of the following two brackets: (a) 26 percent on first $220,700 (indexed for inflation annually) of AMT base for all taxpayers other than married taxpayers filing separately ($110,350, indexed for inflation annually, for married taxpayers filing separately). (b) 28 percent on AMT base in excess of $220,700 (indexed for inflation annually) for all taxpayers other than married taxpayers filing separately ($110,350, indexed for inflation annually, for married taxpayers filing separately).

(2) AMT = tentative minimum tax − regular tax liability (3) Net long-term capital gains and qualifying dividends taxed at same preferential rates used for regular tax purposes (generally 0 percent, 15 percent, or 20 percent).

3) Additional Taxes i) Net investment income tax (1) 3.8 percent tax imposed on lesser of: (a) Net investment income or (b) Excess of modified AGI over $250,000 (married filing jointly and surviving spouses), $125,000 (married filing separately), and $200,000 (all others). b) Employment and self-employment taxes i) Employee FICA taxes payable (1) Social Security tax (a) Tax rate is 6.2 percent rate on wage base. (b) 2023 wage base limit is $160,200.

(2) Medicare tax (a) Tax rate is 1.45 percent rate on wage base.

(3) Additional Medicare tax 8-5

Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al. (a) Tax rate is .9 percent rate on salary or wages in excess of $200,000 ($125,000 for married filing separately; $250,000 of combined salary or wages for married filing jointly).

(4) Employer FICA taxes payable (a) Social Security tax (i) Tax rate is 6.2 percent rate on wage base. (ii) 2023 wage base limit is $160,200. (b) Medicare tax (i) 1.45 percent of employee salary of wages. ii) Self-employment taxes (1) The process for determining the taxpayer’s self-employment taxes (and additional Medicare tax) payable on self-employment earnings requires the following steps: (a) Step 1: Compute taxpayer’s net income from self-employment activities that is subject to self-employment taxes. This is generally the taxpayer’s net income from Schedule C of Form 1040. (b) Step 2: Compute net earnings from self-employment = Step 1 × 92.35 percent. (c) Step 3: Compute the Social Security tax. The Social Security tax component of the self-employment tax equals 12.4 percent [the combined Social Security tax rate for employer and employee (6.2% + 6.2% = 12.4%)] multiplied by the lesser of: (i) the taxpayer’s net earnings from self-employment (from Step 2) or (ii) $147,000 (the maximum tax base for the Social Security tax). (d) Step 4: Compute the Medicare tax. The Medicare tax component of the selfemployment tax equals 2.9 percent [the combined Medicare tax rate for employer and employee (1.45% + 1.45% = 2.9%)] multiplied by the net earnings from selfemployment (from Step 2). (e) Step 5: Compute the additional Medicare tax. The additional Medicare tax due on net self-employment earnings equals .9 percent multiplied by the greater of: (i) zero or (ii) net earnings from self-employment (from Step 2) less $200,000 ($125,000 for married filing separately; $250,000 for married filing jointly). The additional Medicare tax is considered an “employee” tax (and not a “self-employment” tax).

(2) When a taxpayer receives both employee compensation and self-employment earnings, the calculation of the taxpayer’s FICA taxes on self-employment earnings in these settings can be determined as follows: (a) Social Security Tax: (i) Step 1: Determine the limit on the Social Security portion of the self-employment tax base by subtracting the employee compensation from the Social Security wage base ($160,200 in 2023) (not below $0). (ii) Step 2: Determine the net earnings from self-employment (self-employment earnings times 92.35 percent). (iii) Step 3: Multiply the lesser of Steps (1) and (2) by 12.4 percent. This is the amount of Social Security taxes due on the self-employment income. (b) Medicare Tax: (i) Step 4: Multiply the amount from Step (2) by 2.9 percent, the combined Medicare tax rate for employer and employee. (c) Additional Medicare Tax: (i) Step 5: Add the amount from Step (2) and the taxpayer’s compensation. If married filing jointly, also add the spouse’s compensation and net earnings from self-employment (spouse’s self-employment earnings times 92.35 percent).

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al. (ii) Step 6: Multiply the greater of [(a) zero or (b) the amount from Step (5) minus $200,000 ($125,000 for married filing separately; $250,000 for married filing jointly)] by .9 percent. (iii) Step 7: Take the amount from Step 6 and subtract the amount of the additional Medicare tax withheld by the taxpayer’s employer (and his or her spouse’s employer if married filing jointly). This is the additional Medicare tax due on the self-employment income. iii) Employee versus self-employed (independent contractor) (1) A few of the factors suggesting independent contractor rather than employee status include the contractor’s ability to: (a) Set own working hours (b) Work part-time (c) Work for more than one firm (d) Realize either a profit or loss from the activities (e) Perform work somewhere other than on employer’s premises (f) Work without frequent oversight (g) Others in published IRS guidance (2) Employee versus independent contractor comparison (a) The two primary tax differences between independent contractors and employees relate to: (i) The amount of their FICA taxes payable and (ii) The deductibility of their business expenses (and possibly the qualified business income deduction). (b) The key facts: Employee vs. independent contractor (i) Employees 1. Less control over how, when, and where to perform duties.

2. Pay 6.2 percent Social Security tax subject to limit.

3. Pay 1.45 percent Medicare tax (no limit).

4. Pay additional Medicare tax of .9 percent wage base in excess of $200,000 ($125,000 for married filing separately; $250,000 married filing jointly).

5. Unreimbursed employee business expenses are not deductible. (ii) Independent contractors 1. More control over how, when, and where to perform duties.

2. Report income and expenses on Form 1040, Schedule C. a. Expenses are for AGI deductions.

3. Pay 12.4 percent Social Security tax subject to limit.

4. Pay 2.9 percent Medicare tax (no limit).

5. Pay additional Medicare tax of .9 percent of net self-employment earnings in excess of $200,000 ($125,000 for married filing separately; $250,000 married filing jointly).

6. Self-employment tax base is 92.35 percent of net self-employment income.

7. Deduct employer portion of self-employment taxes paid for AGI. 4) Tax Credits a) Nonrefundable personal credits i) Child tax credit (1) $2,000 credit for each qualifying child under age 17 at the end of the year and who is claimed as the taxpayer’s dependent.

(2) $500 credit for other qualifying dependents.

(3) The child tax credit is partially refundable. The $500 child tax credit is nonrefundable.

(4) Credit is phased out for taxpayers with AGI above threshold. (a) Lose $50 for every $1,000 or portion thereof by which AGI exceeds threshold.

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ii)

(5) See Exhibit 8-8 for Child Tax Credit Phase-Out Threshold (based on filing status).

(6) Determining their allowable child tax credit after the phase-out by using the following four steps: (a) Step 1: Determine the excess AGI by subtracting the threshold amount from the taxpayer’s AGI. (b) Step 2: Divide the excess AGI from Step (1) by 1,000 and round up to the next whole number. (c) Step 3: Multiply the amount from Step (2) by $50. This is the amount of the total credit that is phased out or disallowed. (d) Step 4: Subtract the amount from Step (3) from the total credit before phase-out (limited to $0) to determine the allowable child tax credit. ii) Child and dependent care credit (1) Credit to help taxpayers who work or seek work when they must provide care for dependents.

(2) Credit is a nonrefundable credit.

(3) Credit is based on maximum qualifying expenditures multiplied by the rate based on AGI. (4) Maximum expenditures are $3,000 for one qualifying person or $6,000 for two or more qualifying persons. (a) Highest rate (for low AGI taxpayers) is 35 percent for the lowest AGI taxpayers and 20 percent for the highest.

(5) Refer to Exhibit 8-9 for Child and Dependent Care Credit Percentage. iii) Education credits (1) American opportunity credit (a) Qualifying expenses include tuition, fees, and course materials (cost of books and other materials) needed for courses of instruction at an eligible educational institution. (b) Maximum credit of $2,500 per student calculated as percentage of maximum of $4,000 qualifying expenses (100 percent of first $2,000 plus 25 percent of next $2,000). (c) Subject to phase-out for taxpayers with AGI in excess of $80,000 ($160,000 MFJ). (d) 40 percent of credit is refundable.

(2) Lifetime learning credit (a) Qualifying expenses include costs at a qualifying institution associated with acquiring or improving job skills. (b) Maximum credit of $2,000 per taxpayer calculated as percentage of maximum of $10,000 in annual expenses. (c) Subject to phase-out for taxpayers with AGI in excess of $80,000 ($160,000 MFJ). b) Refundable personal credits i) Earned income credit (1) Designed to offset employment taxes for lower-income taxpayers.

(2) Available to qualified individuals with earned income (a) Individual with at least one qualifying child. (b) Individual with no qualifying child who lives in United States for more than half the year, is at least 25 years of age but younger than 65, and is not the dependent of another taxpayer.

(3) Refer to Exhibit 8-10 for 2023 Earned Income Credit Table.

Other refundable personal credits (1) Portion of the child tax credit (2) Portion of the American opportunity tax credit (3) Excess FICA withholdings 8-8

Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al.

(4) Taxes withheld on wages and estimated tax payments c) Business tax credits i) They are designed to provide incentives for taxpayers to hire certain types of individuals or to participate in certain business activities. ii) When business credits other than the foreign tax credit exceed the taxpayer’s gross tax for the year, the credits are carried back one year and forward 20 years to use in years when the taxpayer has sufficient gross tax liability to use the credits. iii) Foreign tax credit (1) U.S. citizens must pay U.S. tax on their worldwide income. However, when they generate some or all of their income in other countries, they generally are required to pay income taxes to the foreign country where they earned their income.

(2) Without some form of tax relief, taxpayers earning income overseas would be doubletaxed on this income.

(3) The foreign tax credit helps reduce the double tax taxpayers may face when they pay income taxes on foreign-earned income to the United States and to foreign countries. d) Tax credit summary i) Refer to Exhibit 8-11 for Summary of Selected Tax Credits. e) Credit application sequence i) Nonrefundable personal first, then business, then refundable personal. ii) Refer to Exhibit 8-12 for Credit Application.

5) Taxpayer Prepayments and Filing Requirements a) Prepayments i) Taxpayers prepay their tax via withholding from salary or through periodic estimated tax payments during the tax year. ii) Estimated tax payments are required only if withholdings are insufficient to meet the taxpayer’s tax liability. iii) For calendar-year taxpayers, estimated tax payments are due on April 15, June 15, and September 15 of the current year and January 15 of the following year. If the due date falls on a Saturday, Sunday, or holiday, it is automatically extended to the next day that is not a Saturday, Sunday, or holiday. iv) Underpayment penalties (1) The tax laws provide some safe-harbor provisions under which they can avoid underpayment penalties if their withholdings and estimated tax payments equal or exceed one of the following two safe harbors: (a) 90 percent of their current tax liability or (b) 100 percent of their previous-year tax liability (110 percent for individuals with AGI greater than $150,000).

(2) The underpayment penalty is determined by multiplying the federal short-term interest rate plus 3 percentage points by the amount of tax underpayment per quarter. b) Filing requirements i) Individual taxpayers are required to file a tax return only if their gross income exceeds certain thresholds, which vary based on the taxpayer’s filing status and age. ii) Individual tax returns are due on April 15 for calendar-year individuals. If the due date falls on a Saturday, Sunday, or holiday, it is automatically extended to the next day that is not a Saturday, Sunday, or holiday. iii) Taxpayers unable to file a tax return by the original due date can request (by that same deadline) a six-month extension to file, which is granted automatically by the IRS. The extension gives the taxpayer additional time to file the tax return, but it does not extend the due date for paying the tax. iv) Late filing penalty

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(1) Imposed on taxpayers that do not file tax return by the required date (the original due date plus extension).

(2) Penalty is 5 percent of the amount of tax owed for each month (or fraction of a month) that the tax return is late, with a maximum penalty of 25 percent.

(3) For fraudulent failure to file, the penalty is 15 percent of the amount of tax owed per month, with a maximum penalty of 75 percent. v) Late payment penalty (1) Imposed if taxpayer fails to pay entire balance of tax owed by the original due date of return. (a) 5 percent of the amount of tax owed each month (or fraction of a month) that the tax is not paid.

(2) If the late filing penalty and late payment penalty both apply in the same month, the late filing penalty of 5 percent for the month (and its corresponding maximum penalty of 25 percent) is reduced by the .5 percent late payment penalty for the month. If the fraudulent late filing penalty applies, a similar reduction applies to the 15 percent monthly penalty and maximum 75 percent penalty.

(3) In contrast, the late payment penalty of .5 percent and its corresponding maximum penalty of 25 percent are not reduced by the late filing penalty when they both apply.

Thus, when both the late filing penalty and late payment penalty apply, the combined total penalty can be as high as 47.5 percent (22.5 percent for late filing and 25 percent for late payment) when both penalties apply for their maximum periods. Similarly, when both the fraudulent late filing penalty and late payment apply, the combined total penalty can be as high as 97.5 percent (72.5 percent for fraudulent late filing and 25 percent for late payment).

Class Activities 1. Suggested class activities o

o

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Movie clip: As a way to wrap up the individual income tax reporting portion of the course, you could show a clip from The Simpsons episode “The Trouble with Trillions” (the 20th episode of the ninth season): See the episode’s Wikipedia page for information. The individual income tax portion runs through about 7 minutes and 40 seconds of the episode (the introduction runs about the first 54 seconds).

Elimination: Develop several multiple-choice questions (A, B, C answers) and/or draw questions from the test bank relating to important topics from the chapter. Have each class member write the letters A, B, and C on separate sheets of paper. Have the entire class stand up. When you ask a question, have each class member hold up their appropriate response to the question (A, B, or C).

Those who miss must sit down. Continue until you have asked all your questions or until all but one student has been eliminated. Award bonus points (or acknowledgment of a job well done) to those still standing.

Comprehensive problems: Have students work in groups (two to four students) to complete a comprehensive problem (problems 84 and 85 are comprehensive across Chapters 4 through 8; problem 83 is a tax planning problem relating to Chapter 8 content). Make yourself available to students to answer questions but try to get them to work together to resolve their questions. You could choose one question (what is taxable income? or what are taxes payable or taxes due?) for students to report to you. You can write the answer from each group on the board and then reveal the correct answer. Give credit to the group(s) that is (are) correct/closest.

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What is the marginal tax rate of a self-employed taxpayer? Have students work individually (or in groups) to determine the combined income and self-employment tax rate assuming the taxpayer is subject to a 24 percent regular taxable income rate and the taxpayer is not over the Social Security wage base limitation. The answer should be 36.29 percent, computed as follows:

Description (1) Regular tax marginal tax rate (2) Self-employment tax rate (3) Benefit (at 24%) from deducting employer portion of self-employment tax Combined marginal tax rate

Rate 24.00% 14.13%

Explanation 100% × 15.3% × 92.35%

(1.84%) 7.65% × 24% 36.29% Sum of (1)–(3)

2. Ethics discussion From page 8-22:

Discussion points:       

What are some attributes that may distinguish an employee from an independent contractor?

What are the ramifications to Sudipta and her employer if Sudipta is treated as an employee?

What are the ramifications to Sudipta and her employer if Sudipta is treated as an independent contractor?

Which treatment is generally less costly for the employer?

Do you think employers intentionally misclassify employees as independent contractors? Does this practice violate tax laws and/or ethical standards?

What are the consequences to the employer if the IRS asserts that Sudipta is actually an employee?

What are your recommendations for Sudipta?

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Chapter 9 Business Income, Deductions, and Accounting Methods INSTRUCTOR’S MANUAL

Learning Objectives 9-1. Identify common business deductions.

9-2. Determine the limits on deducting business expenses.

9-3. Describe accounting periods available to businesses.

9-4. Apply cash and accrual methods to determine business income and expense deductions.

Teaching Suggestions Congress intended for taxable income to reflect the net increase in wealth from a business, so it is only fair that businesses be allowed to deduct expenses incurred to generate business income. This chapter focuses on business deductions from a proprietor’s perspective, but the rules generally apply to all types of business entities including sole proprietorships, partnerships, S corporations, and C corporations.

While Congress provides specific statutory rules authorizing deductions, IRC §162 is relatively broad and ambiguous. Hence, understanding the deductibility of business expenses is a critical component of a tax practitioner’s skill set.

The chapter reiterates the general rules for business expenses introduced in Chapter 7 and then proceeds to describe the four types of expenditures that are not deductible (against public policy, capital, associated with tax-exempt income, and personal). The chapter introduces several specific limitations of which the mixed-motive and business interest limitations are the most complex.

The last two sections of the chapter plunge into accounting periods and methods, and these are details that some instructors may prefer to cover in a more advanced class.

Section 9-4 describes the options for different tax years, and this topic is primarily applicable to corporations. The last section (9-5) describes the rules for accounting for taxable income, specifically which items of income and deductions must be recognized during a particular year. It is important to stress that accounting methods are very important because they affect when a taxpayer is allowed or required to report income and deductions. The material on economic performance is among the most complex in the text.

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al

Lecture Notes 1) Business Gross Income a) Gross receipts test for determining small businesses i) A business that qualifies as a “small” business under a gross receipts test is exempt from certain complex tax law provisions (discussed later in the chapter) for each year in which it meets the test. ii) A business meets the gross receipts test for a particular year if its average annual gross receipts for the three prior taxable years does not exceed $29 million. iii) If the business has less than three years of experience, use the periods available including a short year adjusted to represent a 12-month period. iv) For purposes of the test, gross receipts include total sales (net of returns and allowances but not cost of goods sold), amounts received for services, and income from investments (including tax-exempt interest).

2) Business Deductions a) Ordinary and necessary i) A deduction must be ordinary and necessary (i.e., appropriate and helpful). ii) An ordinary expense is an expense that is normal or appropriate for the business under the circumstances. iii) A necessary expense is an expense that is helpful or conducive to the business activity, but the expenditure need not be essential or indispensable. iv) Refer to Exhibit 9-1 for Examples of Typical Ordinary and Necessary Business Expenses. b) Reasonable in amount i) Ordinary and necessary business expense are deductible only to the extent they are reasonable in amount. ii) Limits on reasonableness are typically based on personal benefits.

3) Limitations on Business Deductions a) Expenditures against public policy i) No business deductions for expenditures against public policy (illegal bribes, fines, penalties or illegal kickbacks). b) Political contributions and lobbying costs i) To avoid the perception that the federal government subsidizes taxpayer efforts to influence politics, the tax laws prohibit deductions for political contributions and most lobbying expenses. c) Capital expenditures i) Businesses must capitalize expenditures for tangible assets (i.e., assets or properties that have a useful life for more than one year) that are generally recovered through depreciation. ii) Businesses must also capitalize the cost to create or acquire intangible assets that are generally recovered through amortization (when the tax laws allow them to do so) or upon disposition of the assets. d) Expenses associated with the production of tax-exempt income i) Expenses that generate tax-exempt income are not allowed to offset taxable income. e) Personal expenditures i) Taxpayers are not allowed to deduct personal expenses unless the expenses are “expressly” authorized by a provision in the law. ii) There are inevitable exceptions when personal items are specially adapted to business use. f) Mixed-motive expenditures i) Businesses often make expenditures that are motivated by both personal and business concerns.

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al ii) These mixed-motive expenditures are of particular concern to lawmakers and the IRS because of the tax incentive to disguise nondeductible personal expenses as deductible business expenses. iii) Thus, deductions for business expenditures accompanied by personal benefits are closely monitored and restricted. iv) The rules for determining the amount of deductible mixed-motive expenditures depend on the type of expenditure. v) Entertainment and meals (1) Only 50 percent of business meals and entertainment are deductible.

(2) To deduct any portion of cost of the meal as a business expense, (a) the amount must be ordinary, necessary, and reasonable in amount, (b) the taxpayer or an employee must be present when the meal is furnished, (c) the meal must be provided to a current or potential client or business contact, and (d) if the meal is provided during or at an entertainment activity, the meal must be purchased separately from the entertainment or the cost stated separately on invoices or receipts. vi) Travel and transportation (1) Transportation expenses relate to the direct cost of transporting the taxpayer to and from business sites.

(2) In contrast to transportation expenses, travel expenses are only deductible if the taxpayer is away from home overnight while traveling. This distinction is important because, besides the cost of transportation, the deduction for travel expenses includes the cost of meals limited to 50 percent unless related to specific exceptions (e.g., employee entertainment), lodging, and incidental expenses. vii) Property use (1) Several types of property may be used for both business and personal purposes.

(2) Because expenses relating to these assets are deductible only to the extent the assets are used for business purposes, taxpayers must allocate the expenses between the business and personal use portions. viii) Record keeping and other requirements (1) Because distinguishing business purposes from personal purposes is a difficult and subjective task, the tax laws include provisions designed to help the courts and the IRS determine the business element of mixed-motive transactions.

(2) Under these provisions, taxpayers must maintain specific, written, contemporaneous records (of time, amount, and business purpose) for mixed-motive expenses. g) Limitation on business interest deductions i) The deduction of interest paid or accrued on indebtedness allocable to a trade or business. ii) The purpose of this limitation is to limit the extent to which a business utilizes debt to avoid income taxes. iii) Business interest is defined as an amount that is paid, received, or accrued as compensation for the use or forbearance of money under the terms of an instrument or contractual arrangement. iv) The amount of the deduction is, in general, limited to the sum of (1) business interest income and (2) 30 percent of the adjusted taxable income of the taxpayer for the taxable year. v) This limit is not applied to firms passing the gross receipts test. vi) Calculating the interest limitation (1) Adjusted taxable income is defined as taxable income allocable to the business computed without regard to: (a) any item of income, gain, deduction, or loss that is not properly allocable to a trade or business, .

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al (b) any business interest expense or income, and (c) any net operating loss deduction.

(2) Any business interest disallowed by the limitation is carried forward indefinitely. h) Losses on dispositions of business property i) Losses on sales of business assets are generally deductible. ii) Losses on sales of a business asset to a related party are not deductible by the seller. i) Business casualty losses (1) Casualty losses are events when businesses incur losses in selling or when their assets are stolen, damaged, or completely destroyed by a force outside the control of the business.

(2) The amount of the loss deduction depends on whether the asset is: (a) Completely destroyed or stolen (b) Only partially destroyed (3) If the asset is damaged but not completely destroyed, the amount of the loss is the amount of the insurance proceeds minus the lesser of: (a) The asset’s adjusted tax basis (b) The decline in the value of the asset due to the casualty 4) Accounting Periods a) Individuals and proprietorships account for income on a calendar year. b) C corporations are allowed to choose a calendar year, a fiscal year, or a 52/53-week year. c) Partnerships and S corporations are flow-through entities (partners and S corporation owners report the entity’s income directly on their own tax returns), and these entities generally must adopt tax years consistent with the owners’ tax years.

5) Accounting Methods a) The taxpayer’s accounting methods determine the tax year in which a business recognizes a particular item of income or deduction. b) Financial and tax accounting methods i) In reporting financial statement income, businesses have incentives to select accounting methods permissible under GAAP that accelerate income and defer deductions. ii) For tax planning purposes, businesses have incentives to choose accounting methods that defer income and accelerate deductions. c) Overall accounting method i) Cash method (1) The cash method can be elected by any taxpayer that qualifies under the gross receipts test.

(2) Businesses that qualify under the gross receipts test do not need to request the consent of the IRS to elect the cash method. ii) Accrual method (1) Businesses using the accrual method to determine taxable income follow rules similar to GAAP with two basic differences. (a) The requirements for recognizing taxable income tend to be structured to recognize income earlier than the recognition rules for financial accounting. (b) The requirements for accruing tax deductions tend to be structured to recognize less accrued expenses than the recognition rules for financial reporting purposes. d) Accrual income i) Businesses using the accrual method of accounting generally recognize income when they meet the all-events test. ii) All-events test for income (1) This test requires that businesses recognize income when: (a) all events have occurred that determine or fix their right to receive the income and (b) the amount of the income can be determined with reasonable accuracy. e) Taxation of advance payments of income (unearned income) .

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al i)

In some cases, taxpayers receive income payments before they actually earn the income (e.g., unearned income or advance payments). ii) Taxpayers using the cash method include these payments in gross income in the year the payment is received. iii) When an accrual-method taxpayer must include unearned income in gross income depends, in part, on the type of income.

(1) For example, all taxpayers must recognize interest and rental income immediately upon receipt (i.e., the income is taxable when received even if is not yet earned). iv) For other types of income, accrual-method businesses can elect to defer recognition of unearned income for one year.

(1) Specifically, businesses using the accrual method may elect to defer recognizing advance payments for goods or services until the next tax year. v) This one-year deferral method does not apply if the income is actually earned by the end of the year of receipt or if the unearned income is recognized for financial reporting purposes. f) Inventories i) Businesses must use the accrual method to account for inventories if sales are an incomeproducing activity.

(1) Businesses qualifying under the gross receipts test can elect to treat goods as nonincidental materials or use the inventory method used for financial reporting purposes.

(2) Non-incidental materials are accounted for as materials are used. ii) Uniform capitalization (1) The UNICAP rules require capitalization of most indirect costs of production unless the business qualifies as a small business under the gross income test. (a) Businesses qualifying under the gross receipts test can ignore UNICAP adjustments. (b) Tax laws require businesses to capitalize in the cost of inventory certain direct and indirect costs associated with inventories. iii) Inventory cost-flow methods (1) Once a business determines the cost of its inventory, it must use an inventory cost-flow method to determine its cost of goods sold.

(2) Three primary cost-flow methods are (a) First-in, first-out (FIFO), (b) Last-in, first-out (LIFO), and (c) Specific identification.

(3) Tax laws require that a business can use LIFO for tax purposes only if it also uses LIFO for financial reporting purposes.

(4) Small businesses (under the gross income test) can account for inventory using nonincidential materials (expense as used) or using the method employed for financial accounting. g) Accrual deductions i) To claim a tax deduction for an accrued expense, the expense must meet both an all-events test and an economic performance test.

(1) The all-events test for deductions requires that events have occurred to establish both that a liability to pay exists and that the amount of the liability is determinable with reasonable accuracy. ii) Economic performance (exceedingly complex material for many students) (1) Economic performance generally requires that the activity generating the liability has occurred in order for the associated expense to be deductible (e.g., the service has been performed or the goods have been delivered).

(2) Specific requirements for the economic performance test differ based on whether the liability arose from: (a) Receiving goods or services from another party. .

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al (b) Renting or leasing property from another party. (c) Providing goods or services to another party (d) Certain activities creating payment liabilities (3) Receiving goods and (or) services from another person (a) When a business receives goods or services from another person, the business deducts the expense associated with the liability when the other person provides the goods or services (assuming the all-events test is met for the liability). (b) However, there is an exception when a business actually pays the liability before the other person provides the goods or services. (i) In this circumstance, the business can elect to treat the actual payment as economic performance as long as it reasonably expects the other person to provide the goods or the services within three and one-half months after the payment.

(4) Renting or leasing property from another person (a) When a business enters into an agreement to use property (rent or lease property) from another person, economic performance occurs over the term of the lease. (b) Thus, the business is allowed to deduct the rental expense over the term of the lease.

(5) Providing goods and services to another person (a) Businesses liable for providing goods and services to other persons meet the economic performance test as they provide the goods or services that satisfy the liability.

(6) Payment liabilities (a) Economic performance occurs for certain liabilities only when the business actually pays the liability. (b) Thus, accrual-method businesses incurring payment liabilities are essentially on the cash method for deducting the associated expenses. (c) Refer to Exhibit 9-2 for Categories of Payment Liabilities and 9-3 for Economic Performance.

(7) Recurring item exception (a) This exception is designed to reduce the administrative cost of applying economic performance to expenses that occur on a regular basis. (b) Under this exception, accrual-method taxpayers can deduct certain accrued expenses even if economic performance has not occurred by year-end. (c) A recurring item is a liability that is expected to recur in future years and either the liability is not material in amount or deducting the expense more properly matches with revenue. (d) In addition, the all-events test must be satisfied at year-end and actual economic performance of the item must occur within a reasonable time after year-end (but prior to the filing of the tax return, which could be up to 8½ months after year-end with an extension). (e) The recurring item exception does not apply to workers’ compensation or tort liabilities. iii) Bad debt expense (1) When accrual method businesses sell a product or a service on credit, they debit accounts receivable and credit sales revenue for both financial and tax purposes. However, because businesses usually are unable to collect the full amount of their accounts receivable, they incur bad debt expense (a customer owes them a debt that the customer will not pay).

(2) For financial reporting purposes, the business estimates the amount of the bad debt and creates a reserve account, the allowance for doubtful accounts.

(3) However, for tax purposes, businesses are only allowed to deduct bad debt expense when the debt actually becomes worthless within the taxable year. .

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al (4) Consequently, for tax purposes, when businesses determine which specific debts are uncollectible, they are entitled to a deduction. This method of determining bad debt expense for tax purposes is called the direct write-off method.

(5) In contrast, the method used for financial reporting purposes is called the allowance method. iv) Limitations on accruals to related persons (1) To prevent businesses and related persons from working together to defer taxes, the tax laws prevent an accrual-method business from accruing (and deducting) an expense for a liability owed to a related person using the cash method until the related person recognizes the income associated with the payment.

(2) For this purpose, related persons include: (a) Family members, including parents, siblings, and spouses. (b) Shareholders and C corporations when the shareholder owns more than 50 percent of the corporation’s stock. (c) Owners of partnerships and S corporations no matter the ownership percentage. h) Comparison of accrual and cash methods i) The two primary advantages of adopting the cash method over the accrual method are that (1) the cash method provides the business with more flexibility to time income and deductions by accelerating or deferring payments (timing tax planning strategy) and (2) bookkeeping for the cash method is easier. ii) The primary advantage of the accrual method over the cash method is that it better matches revenues and expenses. iii) Refer to Exhibit 9-4 for Comparison of Cash and Accrual Methods. i) Adopting an accounting method i) Businesses generally elect their accounting methods by using them on their tax returns. ii) However, when the business technically adopts a method depends on whether it is a permissible accounting method or an impermissible accounting method. iii) Refer to Exhibit 9-5 for Green Acres’s Net Business Income. j) Changing accounting methods i) Once a business has adopted an accounting method, it must generally receive permission to change the method, regardless of whether it is a permissible or an impermissible method. ii) There are three important exceptions to this general rule that apply to businesses that qualify under the gross receipts test: (1) Businesses are allowed to switch to use the cash method, (2) treat inventories as nonincidental materials, and (3) ignore the UNICAP rules once the gross receipts test is satisfied. iii) Refer to Exhibit 9-6 for Green Acres Schedule C. iv) Tax consequences of changing accounting method (1) When a business changes from one accounting method to another, the business determines its taxable income for the year of change using the new method.

(2) Furthermore, the business must make an adjustment to taxable income that effectively represents the cumulative difference, as of the beginning of the tax year, between the amount of income (or deductions) recognized under the old accounting method and the amount that would have been recognized for all prior years if the new method had been applied.

(3) This adjustment is called a §481 adjustment, and it prevents the duplication or omission of items of income or deduction due to a change in accounting method.

6) Conclusion 7) Summary 8) Key Terms

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al

Class Activities 1. Suggested class activities When discussing advanced payments, a nice case that demonstrates the importance of the issue is Tampa Bay Devil Rays, TC Memo 2002‐281. The primary issue in this case is whether deposits a partnership received on advance season tickets and on private suite reservations for Major League Baseball games (expected to be played in 1998) are to be included in the income of the partnership when received, or in 1998 when the advance season tickets and the private suite reservations would be used.

A good review activity is to work through a problem by using the trial balance of a business to convert reported income into taxable income. Problem 9-82 can be assigned to all students and then a class period can be invested into working through the trial balances. This chapter provides a great introduction into deriving a Schedule M-3 and calculating taxable income for corporations (for later in the term or in an advanced course).

One of the most difficult aspects of economic performance is the interaction of accrual expenses and the 12-month rule. As depicted in the slides, economic performance is a prerequisite to the application of the 12-month rule. To facilitate understanding, compare prepayment for 12 months of insurance with a prepayment for 12 months of rent. The cash-basis taxpayer can deduct both under the 12-month rule (assuming the rent is not typically renewed and neither prepayment extends beyond the end of the next tax year). However, an accrual-basis taxpayer can only deduct the insurance prepayment because economic performance does not occur for the rent until the property is used. In contrast, payment is sufficient for economic performance with the insurance because it is a payment liability.

Another difficult topic is the recurring item exception, and some instructors may want to discuss this exception in depth. Rev. Rul. 2012-1, 2012-02 IRB provides a nice explanation and an illustration of this rule that supplements the material in the text.

2. Ethics discussion From page 9-5:

Discussion points:

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al    

“Ordinary and necessary” is the phrase that likely applies to Sheri’s deduction of the personal assistant’s salary, and the deduction would be evaluated according to the facts and circumstances in each particular instance.

Sheri would need to demonstrate the extent to which this use of the personal assistant is helpful and conducive to her business. Factors such as new (demanding) clients would certainly work in Sheri’s favor.

Other facts that suggest this use of a personal assistant is common in Sheri’s profession would also support the deduction.

The likely ethical issue here is whether Sheri is really using her personal assistant to promote the business or just to make her life easier. It is likely that only Sheri will know the answer to that question.

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al.

Chapter 10 Property Acquisition and Cost Recovery INSTRUCTOR’S MANUAL

Learning Objectives 10-1. Describe the cost recovery methods for recovering the cost of personal property, real property, intangible assets, and natural resources.

10-2. Determine the applicable cost recovery (depreciation) life, method, and convention for tangible personal and real property and the deduction allowable under basic MACRS. 10-3. Calculate the deduction allowable under the additional special cost recovery rules (§179, bonus, and listed property).

10-4. Calculate the deduction for amortization.

10-5. Explain cost recovery of natural resources and the allowable depletion methods.

Teaching Suggestions This chapter is organized around issues dealing with acquiring assets and cost recovery. There are many topics in this chapter. The instructor may not wish to cover all topics.

Depreciation is something accounting students have learned in an introduction to financial and management accounting, so it is easy to build on that background. The section was written to cover the basics of method, recovery period, and convention. Once these principles are understood, the application to any tax depreciation problem is relatively simple. There has been a significant amount of legislative activity providing preferences to specific assets, which can be interesting to discuss (e.g., motorsports entertainment complexes, qualified improvement property, etc.). There are also a lot of provisions designed to prevent perceived abuses in the listed property area. Another development is the recent issuance of the repair regulations. Although the chapter does not provide great detail on the new regulations, it provides instructors with an opportunity to add a research component for this content.

The Tax Cuts and Jobs Act, enacted December 22, 2017, expanded bonus depreciation and additional §179 expensing such that, for many taxpayers, these provisions will provide the primary methods for depreciating their personal property. These items can either be discussed in detail or from a theoretical perspective. The bonus depreciation rules are temporary and begin phasing out in 2023 and will expire in 2027. The discussion of depreciation covers basic MACRS first, then the special provisions under §179 expensing and bonus depreciation.

Amortization can be relatively straightforward. For those focusing on small business, the start-up expenditures and organizational cost provisions are important. Others may want to focus on the acquisition of §197 intangibles.

Depletion is a topic that is often not covered; however, we include a brief discussion of this method of cost recovery for those instructors who choose to cover the topic.

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al.

Assignment Matrix

DQ10-1 DQ10-2 DQ10-3 DQ10-4 DQ10-5 DQ10-6 DQ10-7 DQ10-8 DQ10-9 DQ10-10 DQ10-11 DQ10-12 DQ10-13 DQ10-14 DQ10-15 DQ10-16 DQ10-17 DQ10-18 DQ10-19 DQ10-20 DQ10-21 DQ10-22 DQ10-23 DQ10-24 DQ10-25 DQ10-26 DQ10-27 DQ10-28 DQ10-29 DQ10-30 DQ10-31 DQ10-32 DQ10-33 DQ10-34 DQ10-35 DQ10-36 DQ10-37 P10-38 P10-39 P10-40

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al.

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Lecture Notes 1) Cost Recovery and Tax Basis for Cost Recovery a) For financial accounting and tax accounting purposes, businesses must capitalize the cost of assets with a useful life of more than one year (on the balance sheet) rather than expense the cost immediately. b) Methods used to recover the cost of assets through cost recovery deductions: i) Depreciation ii) Amortization

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al. iii) Depletion iv) Refer to Exhibit 10-1 for Assets and Cost Recovery and Exhibit 10-2 for Weyerhaeuser Assets. c) Basis for cost recovery i) Businesses may begin recouping the cost of purchased business assets once they begin using the asset in their business (place it in service). ii) The amount of an asset’s cost that has yet to be recovered through cost recovery deductions is called the asset’s adjusted basis or tax basis.

(1) Asset’s Adjusted Basis = Asset’s Initial Cost or Historical Cost minus Accumulated Depreciation (or Amortization or Depletion) iii) Cost basis is usually the same for book and tax purposes (although exceptions exist). iv) An asset’s cost basis includes all expenses needed to purchase the asset, prepare it for use, and begin using it.

(1) Work through Example 10-1. v) Repair regulations provide guidance on whether costs incurred after acquisition should be capitalized or immediately deducted. Several safe harbors exist: de minimis and routine maintenance for example.

(1) Work through Example 10-2. vi) Special basis rules apply when personal assets are converted to business use and when assets are acquired through nontaxable transactions, gifts, or inheritances.

2) Depreciation a) Today businesses use MACRS (Modified Accelerated Cost Recovery System) along with special depreciation allowances (§179 expensing, bonus depreciation, and listed property). b) To compute MACRS depreciation for an asset, the business need only know: i) The asset’s depreciable basis ii) The date the asset was placed in service iii) The applicable depreciation method iv) The asset’s recovery period v) The applicable depreciation convention c) Personal property depreciation i) Includes all tangible property, such as computers, automobiles, furniture, machinery, and equipment, other than real property. ii) Personal property is relatively short-lived and subject to obsolescence when compared to real property. iii) Depreciation method (1) MACRS provides three acceptable methods for depreciating personal property: (a) 200 percent (double) declining balance (default method); (b) 150 percent declining balance; and (c) Straight-line.

(2) Work through Example 10-3. iv) Depreciation recovery period (1) For financial accounting purposes, an asset’s recovery period (depreciable life) is based on its taxpayer-determined estimated useful life.

(2) For tax purposes, an asset’s recovery period is predetermined by the IRS in the Rev. Proc. 87-56, which helps taxpayers to categorize each of their assets based upon the property’s description. (a) Refer to Exhibit 10-3 for Excerpt from Revenue Procedure 87-56. (b) Refer to Exhibit 10-4 for Recovery Period for Most Common Business Assets. (c) Refer to Exhibit 10-5 for Teton Personal Property Summary (Base Scenario). v) Depreciation Conventions

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(1) The convention specifies the portion of a full year’s depreciation the business can deduct for an asset in the year the asset is first placed in service and in the year the asset is sold.

(2) For personal property, taxpayers must either use the half-year convention or the midquarter convention. (a) Half-year convention (i) One-half of a year’s depreciation is allowed in the first and the last year of an asset’s life. (ii) The IRS depreciation tables automatically account for the half-year convention.

1. Refer to Table 1 in Appendix A for MACRS Half-Year Convention.

2. Work through Example 10-4. (b) Mid-quarter convention (i) The mid-quarter convention is required when more than 40 percent of a taxpayer’s total tangible personal property placed in service during the year was placed during the fourth quarter. (ii) The IRS depreciation tables have built in the mid-quarter convention to simplify the calculations. vi) Calculating depreciation for personal property (1) IRS provides depreciation percentage tables in Rev. Proc. 87-57.

(2) Steps to determine the depreciation for an asset for the year: (a) Determine the appropriate convention (half-year or mid-quarter) by determining whether more than 40 percent of qualified property was placed in service in the last quarter of the tax year. (b) Locate the applicable table provided in Rev. Proc. 87-57 (reproduced in Appendix A of this chapter). (c) Select the column that corresponds with the asset’s recovery period. (d) Find the row identifying the year of the asset’s recovery period. vii) Applying the half-year convention (1) Work through Example 10-5.

(2) Half-year convention for year of disposition (a) Work through Example 10-6. viii)Applying the mid-quarter convention (1) Work through Example 10-7.

(2) Refer to Tables 2a–d in Appendix A for Mid-Quarter Convention Tables.

(3) Mid-quarter convention for year of disposition (a) Work through Example 10-8. d) Real property i) Real property is depreciated using the straight-line method. ii) Real property uses the mid-month convention. iii) Residential property has a recovery period of 27.5 years. iv) Nonresidential property placed in service on or after May 13, 1993, has a life of 39 years. v) Nonresidential property placed in service after December 31, 1986, but before May 13, 1993, has a recovery period of 31.5 years. vi) Refer to Exhibit 10-7 for Recovery Period for Real Property. vii) Applicable method (1) All depreciable real property is depreciated for tax purposes using the straight-line method. viii) Applicable convention (1) All real property is depreciated using the mid-month convention. ix) Depreciation tables (1) Work through Example 10-9.

(2) Mid-month convention for year of disposition .

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al. (a) Process for calculating mid-month convention depreciation for the year of sale: (i) Determine the amount of depreciation deduction for the asset as if the asset were held for the entire year. (ii) Subtract one-half of a month from the month in which the asset was sold (if sold in third month, subtract .5 from 3 to get 2.5). (Subtract half of a month because the business is treated as though the asset was disposed of in the middle of the third month—not the end.) (iii) Divide the amount determined in Step 2 by 12 months (2.5/12). This is the fraction of the full year’s depreciation the business is eligible to deduct. (iv) Multiply the Step 3 outcome by the full depreciation determined in Step 1. (v) Formula: Mid-month depreciation for year of disposition = Full-year’s depreciation × ((Month in which asset was disposed of − 0.5)/12) (vi) Work through Example 10-10.

3) Special Rules Relating to Cost Recovery a) Immediate expensing (§179) i) Policy makers created §179 as an incentive to help small businesses purchasing qualified property. This incentive is commonly referred to as the §179 expense or immediate expensing election. ii) Qualified real property means improvements to nonresidential real property placed in service after the date the building was placed in service, including roofs; heating, ventilation, and airconditioning; fire protection and alarm systems; and security systems. iii) Work through Example 10-11. iv) Limits on immediate expensing (1) The maximum amount of §179 expense a business may elect to claim for the year is subject to a phase-out limitation.

(2) $1,080,000 of tangible personal property may be immediately expensed in 2023.

(3) Businesses are eligible for the full amount of this expense when tangible personal property placed in service is less than $2,7000,000 for 2023. Beginning at $2,700,000, the §179 expense is phased out, dollar for dollar. When assets placed in service exceed $3,780,000, no §179 expense can be taken. Both the amount of §179 allowed and the property limitation are indexed for inflation and change each year. (a) Work through Examples 10-12 and 10-13.

(4) §179 expenses are also limited to a business’s taxable income before the §179 expense. §179 expenses cannot create losses. v) Choosing the assets to immediately expense (1) Businesses qualifying for immediate expensing can choose the asset or assets (from tangible personal property placed in service during the year) they immediately expense under §179.

(2) If a business’s objective is to maximize its current depreciation deduction, it should immediately expense the asset with the lowest first-year cost recovery percentage including bonus depreciation (discussed in the next section). vi) Bonus depreciation (1) Since 2001, businesses have had the ability to immediately deduct a percentage of the acquisition cost of qualifying assets under rules known as bonus depreciation.

(2) The percentage allowable for each tax year during this period has changed many times, ranging from 30 percent to 100 percent.

(3) Just prior to the Tax Cuts and Jobs Act (TCJA), the bonus percentage was 50 percent.

The TCJA increased the percentage to 100 percent for qualified property acquired after September 27, 2017 through December 31, 2022.

(4) Bonus depreciation is a temporary provision, and beginning in 2023 the percentage phases down over five years until it expires in 2027. . .

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(5) Bonus depreciation is mandatory for all taxpayers that qualify. However, taxpayers may elect out of bonus depreciation (on a property class basis) by attaching a statement to their tax return indicating they are electing not to claim bonus depreciation.

(6) Refer to Exhibit 10-9 for Bonus Depreciation Percentages.

(7) Qualified property (i) Taxpayers must first determine whether the assets acquired during the year are eligible for bonus depreciation. To qualify, property must be new or used property (as long as the property has not previously been used by the taxpayer within the past five years) and must generally have a regular depreciation life of 20 years or less. (a) Qualified improvement property: Prior to TCJA, qualified improvements were considered eligible for bonus depreciation and Congress intended for this property to be eligible after TCJA. However, due to a technical error in the TCJA, qualified improvement property was considered 39-year property and not eligible for bonus depreciation. The CARES Act corrected this error by changing the recovery period to 15 years. To qualify, the improvements must be made by the taxpayer after the building was first placed in service by the taxpayer (Reg §1.168(b)-1(a)(5)(i)(A)).

(8) When taxpayers claim §179 expense and bonus depreciation, §179 is determined first, then bonus depreciation, and finally regular MACRS is calculated on the remaining basis.

(9) Work through Example 10-14. b) Listed property i) When an asset is used for both personal and business use, calculate the business-use percentage. ii) If the business-use percentage is above 50 percent, the allowable depreciation is limited to the business-use percentage. iii) If a listed property’s business-use percentage ever falls to or below 50 percent, depreciation for all previous years is retroactively restated using the MACRS straight-line method. iv) Work through Example 10-15. v) Businesses can use the following five steps to determine its current depreciation expense for the asset when business use falls to 50 percent or below: (1) Compute depreciation for the year it drops to 50 percent or below using the straight-line method (this method also applies to all subsequent years).

(2) Compute the amount of depreciation the taxpayer would have deducted if the taxpayer had used the straight-line method over the ADS recovery period for all prior years (recall that depreciation is limited to the business-use percentage in those years).

(3) Compute the amount of depreciation (including §179 and bonus depreciation) the taxpayer deducted on the asset for all prior years.

(4) Subtract the amount from Step 2 from the amount in Step 3. The difference is the prioryear accelerated depreciation in excess of straight-line depreciation.

(5) Subtract the excess accelerated depreciation determined in Step 4 from the current-year straight-line depreciation in Step 1. This is the business’s allowable depreciation expense on the asset for the year. If the prior-year excess depreciation from Step 4 exceeds the current-year straight-line depreciation in Step 1, the business is not allowed to deduct any depreciation on the asset for the year and must recognize additional ordinary income for the amount of the excess.

(6) Work through Example 10-16. vi) Luxury automobiles (1) Depreciation on automobiles weighing less than 6,000 pounds is subject to luxury auto provisions.

(2) Luxury automobiles have a maximum depreciation limit for each year.

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al.

(3) Listed property rules are also applicable to luxury automobiles.

(4) Refer to Exhibit 10-10 for Automobile Depreciation Limits.

(5) Each year, the IRS provides a maximum depreciation schedule for automobiles placed in service during that particular year. In 2023, taxpayers can deduct $8,000 of bonus depreciation above the otherwise allowable maximum depreciation (maximum depreciation of $20,200).

(6) Work through Example 10-17.

(7) Automobiles and §179 (a) Businesses may deduct §179 expensing on luxury automobiles, but the luxury car limitation in 2023 is $12,200, and this limit applies regardless of whether the taxpayer claims regular MACRS depreciation or §179 expensing on the car. (b) For cars that cost more than $61,000, the taxpayer doesn’t benefit by electing §179 because the regular MACRS depreciation deduction would be greater than $12,200 and would be limited to $12,200. (c) For cars that cost less than $61,000, taxpayers could benefit by electing to take $12,200 of §179 expense on the car to boost the depreciation deduction in the first year.

(8) Automobiles and bonus depreciation (a) For passenger cars (automobiles weighing 6,000 pounds or less), the luxury automobile limitations still apply. With bonus depreciation, taxpayers are allowed to increase the limitation in the first year by $8,000, making the first-year limit $20,200 in 2023. (b) However, in years 2–6 (recovery period for passenger cars), taxpayers must again compare the regular MACRS amount in each year to the automobile limitation in Exhibit 10-10 for the year. (c) If the taxpayer claims bonus depreciation, then, much of the allowable depreciation was taken in year 1 (80 percent bonus depreciation) even though the taxpayer was limited by the automobile limitations. This means that there is very little regular depreciation remaining for years 2–6. (d) Fortunately, the IRS provides a way (safe harbor) for taxpayers to continue to take additional depreciation in years 2–6 when they claim bonus depreciation. This method applies to automobiles that have an initial basis greater than $25,250 (the first year depreciation limitation for luxury automobiles of $20,200/80 percent) when taxpayers have not elected out of bonus depreciation.

(9) Work through Examples 10-18 and 10-19. c) Depreciation for the alternative minimum tax i) For AMT purposes, the allowable recovery period and conventions are the same for all depreciable assets as they are for regular tax purposes. ii) The difference between regular tax depreciation and AMT depreciation is an adjustment that is either added to or subtracted from regular taxable income in computing the alternative minimum tax base. d) Depreciation summary i) Refer to Exhibit 10-11 for Teton’s 2023 Depreciation Expense and 10-12 for Teton’s Form 4562 Parts I–IV for Depreciation.

4) Amortization a) Businesses recover the cost of intangible assets through amortization rather than depreciation. b) For tax purposes, an intangible asset can be placed into one of the following four general categories: i) §197 purchased intangibles ii) Organizational expenditures and start-up costs iii) Research and experimentation costs .

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al. iv) Patents and copyrights c) Section 197 intangibles i) §197 intangibles have a recovery period of 180 months (15 years), regardless of their actual life. ii) The full-month convention applies to amortizable assets, which allows taxpayers to deduct an entire month’s worth of amortization for the month of purchase and all subsequent months in the year. iii) Work through Example 10-20. d) Organizational expenditures and start-up costs (1) Organizational expenditures include expenditures to form and organize a business in the form of a corporation or an entity taxed as a partnership.

(2) Start-up costs are costs businesses incur to start up a business.

(3) Refer to Exhibit 10-13 for Summary of Timing for Organizational Expenditures, Start-up Costs, and Normal Trade or Business Expenses.

(4) Businesses may immediately expense up to $5,000 of organizational expenditures.

(5) However, corporations and partnerships incurring more than $50,000 in organizational expenditures must phase out (reduce) the $5,000 immediate expense amount dollar-fordollar for expenditures exceeding $50,000. Thus, businesses incurring at least $55,000 of organizational expenditures are not allowed to immediately expense any of the expenditures.

(6) The rules for immediately expensing and amortizing start-up costs are the same as those for immediately expensing and amortizing organizational expenditures. Consequently, businesses incurring at least $55,000 of start-up costs are not allowed to immediately expense any of the costs.

(7) Work through Examples 10-21 to 10-24. e) Research and experimentation expenditures i) Businesses often invest in activities they believe will generate innovative products or significantly improve their current products or processes.

(1) Includes expenditures for research laboratories, including salaries, materials, and other related expenses (2) These expenditures are capitalized and amortized over 5 years beginning with the midpoint of the year in which the costs were incurred. Research and experimentation expenditures attributable to research conducted outside the United States are capitalized and amortized ratably over a period of 15 years. f) Patents and copyrights i) The manner in which a business amortizes a patent or copyright depends on whether the business directly purchases the patent or copyright or whether it self-creates the intangibles. ii) Work through Example 10-25. g) Amortizable intangible asset summary i) Refer to Exhibit 10-14 for Summary of Amortizable Assets. ii) Refer to Exhibit 10-15 for Teton Form 4562, Part VI Amortization of Organizational Expenditures and Patent.

5) Depletion a) The method taxpayers use to recover their capital investment in natural resources. b) It is a particularly significant deduction for businesses in the mining, oil and gas, and forestry industries. c) Cost depletion involves estimating resource reserves and allocating a pro rata share of basis based on the number of units extracted. d) Percentage depletion is determined by a statutory percentage of gross income that is permitted to be expensed each year. Different resources have different statutory percentages (i.e., gold, tin, coal). .

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6) 7) 8) 9)

e) Taxpayers may expense the larger of cost or percentage depletion. f) Work through Examples 10-26, 10-27, and 10-28. g) Refer to Exhibit 10-16 for Applicable Percentage Depletion Rates.

Conclusion Appendix A: MACRS Tables Summary Key Terms

Class Activities 1. Suggested class activities o o

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Tax Research: Have students search for Revenue Procedure 87-56 and find the recovery period for some obscure assets. You can create a discussion around what the actual recovery period of certain assets should be.

An interesting provision related to bonus depreciation is Section 168(k)(4). The provision was designed as a stimulus measure for NOL companies that could not take advantage of the current deductions provided by bonus depreciation. The provision provides an ability to cash out historic R&D and AMT credits in lieu of bonus depreciation. A thought-provoking exercise is to have students locate the off-code provision contained in the history of this section (see also P.L. 110289, §3081(b)). This provision was designed to provide Chrysler LLC with the same benefits that GM and Ford were to receive as C corporations under Section 168(k)(4).

Comprehensive Problems: Have students work in groups (three to five students) to complete comprehensive problem 76. Make yourself available to students to answer questions but try to get them to work together to resolve their questions. If time is short, you can skip part C.

2. Ethics discussion From page 10-6:

Discussion points:   

When converting assets from personal use to business use, the basis for business use will be the lesser of (1) the cost basis of the asset or (2) the fair market value on the date of conversion.

The business basis is used to compute depreciation, gain or loss upon sale of the asset, and the character of any resulting gain or loss on the sale.

Catherine may be trying to convert a nondeductible personal loss into a deductible business loss by choosing to use her cost basis rather than obtaining appraisals for the assets.

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al.

Chapter 11 Property Dispositions INSTRUCTOR’S MANUAL

Learning Objectives 11-1. Calculate the amount of gain or loss recognized on the disposition of assets used in a trade or business.

11-2. Describe the general character types of gain or loss recognized on property dispositions.

11-3. Calculate depreciation recapture.

11-4. Describe the tax treatment of unrecaptured §1250 gains.

11-5. Describe the tax treatment of §1231 gains or losses, including the §1231 netting process.

11-6. Explain common deferral exceptions to the general rule that realized gains and losses are recognized currently.

Teaching Suggestions This chapter is organized around issues dealing with the disposition of assets. There are many topics in this chapter. The instructor may not wish to cover all topics.

Calculation of gain or loss is something accounting students have learned in an introduction to financial and management accounting. The primary problem for students is determining the character of the gain or loss. The understanding of ordinary, capital, and §1231 assets is critical to properly determining a taxpayer’s liability. This area can be difficult for some students.

Depreciation recapture is a relatively simple concept with which students often have difficulty. The primary issue relates to the character of the gain. For §1245 assets, there are only three possible scenarios—understanding this concept can greatly increase a student’s understanding. The exhibits (e.g., Exhibit 11-6) can help some visual learners much more than discussing the rules related to depreciation recapture. The nonrecaptured §1250 gain can also be a difficult concept for students who have no background regarding the §1250 gains that are generally no longer applicable. Exhibit 11-7 can help students visualize how the taxable sales of assets used in a trade or business are characterized.

The §1231 netting process is another rule-intensive process that must be understood correctly before a taxpayer’s tax liability can be properly determined. Exhibit 11-8 can help those who are having difficulty understanding the rules.

Included in the end-of-chapter comprehensive problems are two problems that cover material from Chapter 7 as well as this chapter. These problems provide a comprehensive application of the disposition of ordinary, §1231, and capital assets.

Some instructors may choose not to cover Learning Objective 6 on nonrecognition transactions. It is recommended that at least some overview discussion indicate that these are important exceptions to the general rule that realized gains and losses are recognized in the current taxable year. One item to note is that post-TCJA, only real property is eligible property for like-kind exchanges.

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al.

Assignment Matrix

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Lecture Notes 1) Dispositions a) Every asset disposition triggers a realization event for tax purposes. b) To calculate the amount of gain or loss taxpayers realize when they sell assets, they must determine the amount realized on the sale and their adjusted basis in each asset they are selling. c) Amount realized i) The amount realized by a taxpayer from the sale or other disposition of an asset is everything of value received from the buyer less any selling costs. ii) Taxpayers selling assets such as real property subject to loans or mortgages must increase their amount realized by the amount of debt relief (the buyer’s assumption of the seller’s liability increases the seller’s amount realized). iii) Amount realized = Cash received + Fair market value of other property + Buyer’s assumption of liabilities − Seller’s expenses 11-3

Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al. iv) Work through Example 11-1. d) Determination of adjusted basis i) An asset’s cost basis is the amount subject to cost recovery. ii) Initial basis is generally its cost. Exceptions apply for gifts, inherited property, and property converted from personal to business use. iii) Adjusted basis = Initial basis − Cost recovery deductions iv) Work through Examples 11-2 and 11-3. e) Realized gain or loss on disposition i) Gain or (loss) realized = Amount realized − Adjusted basis ii) Work through Example 11-4. iii) Refer to Exhibit 11-1 for Summary of Formulas for Computing Gain or Loss Realized on an Asset Disposition. f) Refer to Exhibit 11-2 for Teton’s Asset Dispositions: Realized Gain (Loss) for Tax Purposes. g) Recognized gain or loss on disposition i) Recognized gains or losses are gains (losses) that increase (decrease) taxpayers’ gross income. ii) Taxpayers must report recognized gains and losses on their tax returns. iii) In certain circumstances taxpayers may be allowed to defer recognizing gains to subsequent periods, or they may be allowed to permanently exclude the gains from taxable income. iv) Taxpayers may also be required to defer losses to later periods and, in more extreme cases, they may have their realized losses permanently disallowed.

2) Character of Gain or Loss a) Taxpayer must determine the character or type of gain or loss recognized that affects the taxpayer’s income tax liability. b) Every gain or loss is characterized as either ordinary or capital (long-term or short-term). c) Refer to Exhibit 11-3 for Character of Assets Depending on Property Use and Holding Period. d) Ordinary assets i) Assets created or used in a taxpayer’s trade or business. ii) Business assets held for less than a year. iii) Examples of ordinary assets—inventory, accounts receivable, machinery, and equipment if they have been used in business for one year or less e) Capital assets i) Assets held for investment purposes for production of income. ii) Assets held for personal-use purposes. iii) Refer to Exhibit 11-4 for Review of Capital Gains and Losses. f) §1231 assets i) Depreciable assets and land used in a trade or business held for more than one year. ii) Work through Example 11-5.

3) Depreciation Recapture a) Potentially applies to gains (but not losses) on the sale of depreciable or amortizable business property. b) Recharacterizes the gain on the sale of a §1231 asset (all or a portion of the gain) from §1231 gain into ordinary income. c) The method for computing the amount of depreciation recapture depends on the type of §1231 assets the taxpayer is selling (personal property or real property). d) Refer to Exhibit 11-5 for §1231 Asset Types. e) §1245 property i) The gain from the sale of §1245 property is characterized as ordinary income to the extent the gain was created by depreciation or amortization deductions. ii) The lesser of (1) gain recognized or (2) accumulated depreciation is recaptured (characterized) as ordinary income under §1245.

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al. iii) Any remaining gain is §1231 gain. iv) There is no depreciation recapture on assets sold at a loss. v) When taxpayers sell or dispose of §1245 property, they encounter one of the following three scenarios involving gain or loss: (1) Gain created solely through cost recovery deductions (a) Most §1231 assets that experience wear and tear or obsolescence generally do not appreciate in value. (b) When a taxpayer sells these types of assets at a gain, the gain is usually created because the taxpayer’s depreciation deductions associated with the asset reduced the asset’s adjusted basis faster than the real decline in the asset’s economic value. (c) The entire gain is artificially generated through depreciation the taxpayer claims before disposing of the asset (i.e., absent depreciation deductions; the taxpayer would recognize a loss on the sale of the asset). (d) Work through Example 11-6.

(2) Gain due to both cost recovery deductions and asset appreciation (a) Assets subject to cost recovery deductions may actually appreciate in value over time. (b) When these assets are sold, the recognized gain must be divided into ordinary gain from depreciation recapture and §1231 gain. (c) The portion of the gain created through cost recovery deductions is recaptured as ordinary income and remaining gain (the gain due to economic appreciation) is §1231 gain. (d) Work through Example 11-7.

(3) Assets sold at a loss (a) Many §1231 assets, such as computer equipment or automobiles, tend to decline in value faster than the corresponding depreciation deductions reduce the asset’s adjusted basis. (b) When taxpayers sell or dispose of these assets before the assets are fully depreciated, they recognize a loss on the disposition. (c) Because the depreciation recapture rules don’t apply to losses, taxpayers selling §1245 property at a loss recognize §1231 loss. (d) Work through Example 11-8.

(4) Refer to Exhibit 11-6 for Machinery §1245 Depreciation Recapture Scenarios 1, 2, and 3. vi) Work through Example 11-9. f) §1250 depreciation recapture for real property i) Depreciable real property, such as an office building or a warehouse, sold at a gain is not subject to §1245 depreciation recapture. Rather, it is subject to a different type of recapture called §1250 depreciation recapture. ii) Thus, depreciable real property is frequently referred to as §1250 property. iii) When depreciable real property is sold at a gain, the amount of gain recaptured as ordinary income is limited to the excess of accelerated depreciation deductions on the property over the amount that would have been deducted if the taxpayer had used the straight-line method of depreciation to depreciate the asset. iv) §1250 recapture generally no longer applies to gains on the disposition of real property.

Instead, a modified version called §291 depreciation recapture applies to corporations but not to other types of taxpayers. §1250 recapture applies to the gains on real property held one year or less even if the taxpayer used straight-line depreciation. v) Under §291, C corporations selling depreciable real property recapture as ordinary income 20 percent of the lesser of (1) the recognized gain or (2) the accumulated depreciation. vi) Work through Example 11-10.

4) Other Provisions Affecting the Rate at Which Gains Are Taxed 11-5

Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al. a) Other provisions, other than depreciation recapture, may affect the rate at which taxpayer gains are taxed. b) Unrecaptured §1250 gain for individuals i) A gain resulting from the disposition of §1250 property is a §1231 gain and is netted with other §1231 gains and losses to determine whether the taxpayer has a net §1231 gain for the year or a net §1231 loss for the year. ii) Unrecaptured §1250 gain is §1231 gain that, if ultimately characterized as a long-term capital gain, is taxed at a maximum rate of 25 percent. iii) When an individual sells §1250 property at a gain, the amount of the gain taxed at a maximum rate of 25 percent is the lesser of the (1) recognized gain or (2) the accumulated depreciation on the asset, and the remainder of the gain is taxed at a rate of 0/15/20 percent. iv) Work through Example 11-11. c) Characterizing gains on the sale of depreciable property to related persons i) All gain recognized from selling property that is a depreciable asset to a related buyer is ordinary income (regardless of the character of the asset to the seller). ii) Related persons include family relationships (including siblings, spouses, ancestors, lineal descendants), and corporations in which the individual owns more than 50 percent of the stock. See §267(b) for more related-person relationships. iii) Work through Example 11-12.

5) Calculating Net §1231 Gains or Losses a) After recharacterizing §1231 gain as ordinary income under the §1245 and §291 (if applicable) depreciation recapture rules and the §1239 recharacterization rules, the remaining §1231 gains and losses are netted together. b) If the gains exceed the losses, the net gain becomes a long-term capital gain (a portion of which may be taxed at a maximum rate of 25 percent). If the losses exceed the gains, the net loss is treated as an ordinary loss. c) A taxpayer could gain significant tax benefits by discovering a way to have all §1231 gains treated as long-term capital gains and all §1231 losses treated as ordinary losses. d) The annual netting process makes this task impossible for a particular year. e) A taxpayer who owns multiple §1231 assets could sell the §1231 loss assets at the end of year 1 and the §1231 gain assets at the beginning of year 2. f) The taxpayer could benefit from this strategy in three ways: i) Accelerating losses into year 1, ii) Deferring gains until year 2, iii) Characterizing the gains and losses due to the §1231 netting process g) §1231 look-back rule i) A nondepreciation recapture rule that applies in situations like the one we just described to turn what would otherwise be §1231 gain into ordinary income. ii) The rule affects the character but not the amount of gains on which a taxpayer is taxed. iii) §1231 gains and losses from individual asset dispositions are annually netted together. iv) The §1231 look-back rule is designed to require taxpayers who recognize net §1231 gains in the current year to recapture (recharacterize) those gains as ordinary gains to the extent they recognized §1231 losses that were treated as ordinary losses in prior years. v) Without the look-back rule, taxpayers could carefully time the year in which the §1231 assets are sold to maximize the tax benefits. vi) Determine whether the taxpayer recognized any nonrecaptured §1231 losses (losses that were deducted as ordinary losses that have not caused subsequent §1231 gains to be recharacterized as ordinary income). vii) Work through Example 11-13. h) Refer to Exhibit 11-7 for a flowchart to explain the entire classification process for taxable sale of assets used in a trade or business.

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al. i) Refer to Exhibit 11-8 for §1231 Netting Process.

6) Gain or Loss Summary a) Refer to Exhibit 11-9 for Summary of Teton Gains and Losses on Property Dispositions.

7) Tax-Deferred Transactions a) Like-kind exchanges i) Taxpayers exchanging property realize gains (or losses) on exchanges just as taxpayers do by selling property for cash. ii) Taxpayers exchanging property for property are in a different situation than taxpayers selling the same property for cash. iii) Taxpayers exchanging one piece of business property for another haven’t changed their relative economic position, since both before and after the exchange they hold similar assets for use in their business. iv) Exchanges of property do not generate the wherewithal (cash) for the taxpayers to pay taxes on the gain they realize on the exchanges. v) While taxpayers selling real property for cash must immediately recognize gain on the sale, taxpayers exchanging property for assets other than cash must defer recognizing gain (or loss) realized on the exchange if they meet certain requirements. This is commonly known as likekind (§1031) exchange. vi) Refer to Exhibit 11-10 for Teton’s (on Steve’s return) Form 4797. vii) Refer to Exhibit 11-11 for Steve’s Schedule D (Assumes Steve had no other capital gains and losses other than those incurred by Teton). viii) For an exchange to qualify as a like-kind exchange for tax purposes, the transaction must meet the following three criteria: (1) Real property is exchanged “solely for like-kind” property.

(2) Both the real property given up and the real property received in the exchange by the taxpayer are either “used in a trade or business” or are “held for investment” by the taxpayer.

(3) The exchange must meet certain time restrictions. ix) Definition of like-kind property (1) Real property (a) All real property used in a trade or business or held for investment is considered “like-kind” with other real property used in a trade or business or held for investment.

(2) Property ineligible for like-kind treatment (a) Real property held for sale (b) Personal property (c) Domestic property exchanged for property used in a foreign country, and (d) All property used in a foreign country. x) Property use xi) Timing requirements for a like-kind exchange (1) It may involve intermediaries.

(2) Taxpayers must identify replacement “like-kind” property within 45 days of giving up their property.

(3) “Like-kind” property must be received within 180 days of when the taxpayer transfers property in a “like-kind” exchange.

(4) The tax laws do not require a simultaneous exchange of assets, but they do impose some timing requirements to ensure that a transaction is completed within a reasonable time in order to qualify as a deferred like-kind exchange—often referred to as a Starker exchange.

(5) Refer to Exhibit 11-12 for Diagram of Deferred or Starker Exchange.

(6) Work through Example 11-14. xii) Tax consequences when like-kind property is exchanged solely for like-kind property 11-7

Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al.

(1) Work through Example 11-15. xiii) Tax consequences of transfers involving like-kind and non-like-kind property (boot) (1) Non-like-kind property is known as boot.

(2) When boot is given as part of a like-kind transaction, the asset received is recorded in two parts: property received in exchange for like-kind property and property received in a sale (bought by the boot).

(3) When boot is received: (a) Boot received usually creates recognized gain. (b) Gain recognized is lesser of gain realized or boot received. (c) The basis of boot received is the fair market value of the boot. (d) Work through Example 11-16. (e) Work through Example 11-17.

(4) Basis in like-kind property = Fair market value of like-kind property received (−) deferred gain (+) deferred loss (5) When no gain is recognized on the exchange, the basis of the new property is the same as taxpayer’s basis in the old like-kind property. xiv) Reporting like-kind exchanges xv) Involuntary conversions (1) Gain is deferred when appreciated property is involuntarily converted in an accident or natural disaster.

(2) Basis of property directly converted is carried over from the old property to the new property.

(3) In an indirect conversion, gain recognized is the lesser of: (a) Gain realized, or (b) Amount of reimbursement the taxpayer does not reinvest in qualified property.

(4) Qualified replacement property must be of a similar or related use to the original property. xvi) Refer to Exhibit 11-14 Form 8824, Part III (From exchange in Example 11-15). xvii)Work through Example 11-18. b) Installment sales i) Sale of property where the seller receives the sale proceeds in more than one period. ii) Must recognize a portion of gain on each installment payment received. iii) Gains from installments sales: Gross profit percentage = Gross profit/Contract price iv) Inventory, marketable securities, and depreciation recapture cannot be accounted for under installment sale rules. v) Does not apply to losses. vi) Work through Example 11-19. c) Gains ineligible for installment reporting i) Work through Example 11-20. d) Other tax-deferred provisions e) Related-person loss disallowance rules i) The tax laws essentially treat related parties as though they are the same taxpayer. ii) Related persons are defined in §267 and include certain family members, related corporations, and other entities (partnerships). iii) Losses on sales to related persons are not deductible by the seller. iv) The related person may deduct the previously disallowed loss to the extent of the gain on the sale to the unrelated third person. v) Work through Example 11-21. vi) Work through Example 11-22.

8) Conclusion 9) Summary 11-8

Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al.

10) Key Terms

Class Activities 1. Suggested class activities o o

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Comprehensive problem: Have students work in groups (three to five students) to complete comprehensive problem 71 or 73. Make yourself available to students to answer questions but try to get them to work together to resolve their questions.

Self-created problems: Have students work in pairs to create a large comprehensive problem and solution that includes calculating gain or loss on the disposition of assets, determining the character of the gain, depreciation recapture, and the §1231 netting process. Then have them give the problem to another student pair. This activity requires them to fully understand, apply, and explain the rules to another group of students. This activity is particularly effective in helping students gauge whether they understand the material well enough to be successful on an examination.

One versus the class: Have one student volunteer as the “one” with the other class members being the “group.” Use the Key Facts boxes in the text to develop multiple-choice questions (A, B, C answers) and then quiz the volunteer and the class on the questions. The volunteer and each class member will need to write the letters A, B, and C on separate sheets of paper and then hold up their appropriate response to the question. Once a student (either the “one” or a member of the “group”) misses a question, he or she is eliminated from the competition. After six (or some other number) of questions, those students left standing receive bonus participation points for the day.

2. Ethics discussion From page 11-19:

Discussion points:   

The look-back rule requires that taxpayers recharacterize gain this year for any net §1231 losses taken in the prior five years (treated as ordinary).

Emma appears to be trying to thwart this rule by selling her gain property this year and the loss property next year.

The rules do not address the situation that Emma is contemplating.

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al. 

Will Emma have other sales during the two years to negate her planning efforts? What risk does she bear for holding the loss asset for a longer period of time?

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Chapter 12 Business Entities Overview INSTRUCTOR’S MANUAL

Learning Objectives 12-1. Discuss the legal and other nontax characteristics of different types of legal business entities.

12-2. Describe the different types of business entities for tax purposes.

12-3. Identify fundamental differences in tax characteristics across business entity types.

Teaching Suggestions This chapter helps students understand how tax and nontax considerations affect entity selection.

Specifically, the chapter describes available legal entities and how they are classified for tax purposes under the check-the-box rules. See Exhibit 12-2 for a flowchart illustrating the check-the-box rules. In addition, the chapter compares and contrasts C corporations, S corporations, and entities taxed as partnerships along several important tax dimensions. The focus of the chapter is on decision making, using a story line to illustrate how entrepreneurs weigh tax and nontax considerations when making this important decision. Use the decision-making focus of this chapter to help students understand that tax is about more than just learning the rules. With tax law changes effective in 2018 relating to entity taxation, some of the significant tax variables in entity choice have changed from what they have been historically.

The chapter compares the taxation of income across entity types and the tax treatment of entity losses across entity types. Exhibit 12-3 compares main tax characteristics across different types of tax entities.

Further, Exhibit 12-4 summarizes other tax treatment of other tax characteristics and provides a relative ranking in terms of the tax-favored status for each entity type as it pertains to the particular tax characteristic.

This chapter may be used either as an introduction to a module on entity taxation, or it may be used after teaching the chapters on C corporations, S corporations and partnerships, corporations to summarize key differences between the entities that may not have been obvious to students when these topics were initially discussed. The objective of this chapter is to understand what the different entity types are from a nontax and a tax perspective and to gain an appreciation for central tax issues associated with selecting a particular entity type.

The QBI deduction is a deduction for individuals, not for business entities. However, this chapter provides enough details on the computing the QBI deduction so that students can (1) understand how the QBI deduction may influence entity choice and (2) to get a sense of some of the complexities of computing the QBI deduction. This chapter also includes enough detail on the self-employment tax computation to be able to compute the self-employment tax when income is below and when it is over the social security wage base limitation. This is important because the self-employment tax is an important factor in determining entity choice because it is not constant across entity types. Details on the QBI deduction and self-employment tax computations are also provided in the chapter discussing individual deductions and the chapter discussing the individual tax computation. These chapters are included of all versions of the book other than the business entities version.

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al.

This chapter also provides discussion and examples relating to how paying salary to an employee/shareholder of an S corporation or C corporation affect the overall tax burden (income and employment tax consequences) of the business income.

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al.

Assignment Matrix

DQ12-1 DQ12-2 DQ12-3 DQ12-4 DQ12-5 DQ12-6 DQ12-7 DQ12-8 DQ12-9 DQ12-10 DQ12-11 DQ12-12 DQ12-13 DQ12-14 DQ12-15 DQ12-16 DQ12-17 DQ12-18 DQ12-19 DQ12-20 DQ12-21 DQ12-22 DQ12-23 DQ12-24 DQ12-25 DQ12-26 DQ12-27 DQ12-28 DQ12-29 DQ12-30 DQ12-31 DQ12-32 DQ12-33 DQ12-34 DQ12-35 DQ12-36 DQ12-37 DQ12-38 DQ12-39 DQ12-40

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al.

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Lecture Notes 1) Business Entity Legal Classification and Nontax Characteristics a) Legal Classification i) State laws recognize corporations or limited liability companies (LLCs) as legal entities separate from their owners (shareholders or members). ii) Business owners legally form corporations by filing articles of incorporation with the state in which they organize the business. iii) General partnerships may be formed by written agreement among the partners, called a partnership agreement, or may be formed informally without a written agreement when two or more owners join together in an activity to generate profits. iv) Limited partnerships are usually organized by written agreement and must typically file a certificate of limited partnership to be recognized by the state. b) Nontax Characteristics i) The different legal entity types may differ from or share similarities with other legal entity types with respect to certain nontax characteristics. ii) Responsibility for liabilities (1) Whether the entity or the owner(s) is ultimately responsible for paying the liabilities of the business depends on the type of entity.

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al.

(2) A corporation is solely responsible for its liabilities, whereas LLCs and not their members are responsible for their liabilities.

(3) For entities formed as partnerships, all general partners are ultimately responsible and limited partners are not responsible for the liabilities of the partnership.

(4) In a sole proprietorship, the individual owner is responsible for the liabilities of the business. iii) Rights, responsibilities, and legal arrangements among owners (1) State corporation laws specify the rights and responsibilities of corporations and their shareholders.

(2) Shareholders have no flexibility to alter their legal treatment with respect to one another, with respect to the corporation, and with respect to outsiders, whereas LLCs allow more flexible business arrangements.

(3) State partnership laws provide default provisions in which partners have flexibility to depart, specifying the partners’ legal rights and responsibilities for dealing with each other absent an agreement. c) Refer to Exhibit 12-1 for Business Types: Legal Entities and Nontax Characteristics.

2) Business Entity Tax Classification a) For tax purposes business entities can be classified as either separate taxpaying entities or as flow-through entities, which don’t pay taxes because income from these entities flows through to their business owners, who are responsible for paying tax on the income. b) If a business is legally a corporation under state law, by default it is treated as a C corporation. c) Corporations are C corporations unless their shareholders make a valid “S” election permitting the corporation to be taxed as a flow-through entity called an S corporation. d) Unincorporated entities are taxed as partnerships if they have more than one owner, as sole proprietorships if held by an individual, or as disregarded entities if held by some other entity. e) Unincorporated entities may elect to be treated as C corporations. Unincorporated eligible entities may elect to become corporations for tax purposes and elect to become S corporations simultaneously by filing a timely S corporation election (they don’t need to separately elect to be taxed as a corporation first). However, sole proprietorships are eligible for the election only if they are legally organized as single member LLCs. f) There are really only four categories of business entities recognized by our tax system, as follows: i) C corporation (separate taxpaying entity; income reported on Form 1120). ii) S corporation (flow-through entity; income reported on Form 1120-S) iii) Partnership (flow-through entity; income reported on Form 1065) iv) Sole proprietorship (flow-through entity; income reported on Form 1040 Schedule C) g) Refer to Exhibit 12-2 for flowchart on determining the tax form of a business entity under checkthe-box regulations.

3) Business Entity Tax Characteristics a) Among the available options for taxing business ventures, owners and their advisors must carefully consider whether tax rules that apply to a particular tax classification would be either more or less favorable than tax rules under other alternative tax classifications. b) Taxation of Business Entity Income i) Flow-through entity income is taxed once—when allocated to the owner, whether or not the income is distributed to the shareholder. ii) Corporate income is taxed twice. Once at the corporate level and again at the shareholder level when they receive distributions from the corporation or sell their appreciated stock. iii) Flow-through entity income retains its character and is allocated (on paper) or “flows through” to entity owners. iv) The owners generally pay tax on their share of the income as if they had earned it themselves. v) Flow-through entity owners are taxed when the income is allocated to them (on paper), not when they receive distributions.

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al. vi) While distributions to C corporation shareholders are generally taxable as dividends, distributions to flow-through entity owners are generally a nontaxable return of basis. vii) Flow-through entity owners may qualify for the deduction for qualified business income. This deduction is generally 20 percent of the business income from nonservice activities generated in the United States (reduced by other deductions attributable to the trade or business, such as the taxpayer's self-employment tax deduction [presumably for self-employment income included in QBI], self-employed health insurance deduction, and self-employed retirement plan contribution deductions).

(1) The deduction is subject to a wage-based limitation and a taxable income limitation. The wage-based limitation is phased based on taxpayer’s income.

(2) The specified service requirement is phased in based on the taxpayer’s income. viii)Flow-through entity income of passive owners is subject to the 3.8 percent net investment income tax for owners with AGI over a threshold amount. ix) The flow-through business income of an S corporation is not self-employment income. The income of a sole proprietorship is self-employment income. Whether the income of an entity taxed as a partnership is flow-through income depends on the extent to which the owner is involved in the entity’s business activities. x) Self-employment income is subject to self-employment tax and additional Medicare tax.

Technically, net earnings from self-employment is the base for the taxes (self-employment income × .9235).

(1) In 2023, the first $160,200 of net earnings from self-employment (the Social Security wage base limit) is taxed at 15.3% and the amount over the limit is taxed at 2.9%. xi) Corporation income is taxed at a flat 21 percent rate. xii) Individual C corporation shareholders are generally taxed at a 0, 15, or 20 percent rate on dividends, depending on the taxpayer’s income. They may also be subject to a 3.8 percent net investment income tax, depending on the shareholder’s income level. xiii) C corporation shareholders are generally eligible to receive a 50, 65, or 100 percent dividends received deduction on dividends received. xiv) When a corporation distributes its earnings to: (1) Individual shareholders (a) Individual shareholders receiving distributions from C corporations pay the second tax on the dividends they receive at a 0, 15, or 20 percent rate, depending on the taxpayer’s income. Further, individual shareholders may be required to pay a 3.8 percent net investment income tax on dividends, depending on the taxpayer’s income level.

(2) Corporate shareholders (a) For corporate shareholders, dividends are taxed at the same rate as other corporate income. However, corporations are allowed to claim the dividends received deduction (DRD).

(3) Institutional shareholders (a) Pension and retirement funds are some of the largest institutional shareholders of corporations. However, these entities do not pay shareholder-level tax on the dividends they receive. (b) Retirees pay the second tax on this income at ordinary rates when they receive retirement distributions from these funds.

(4) Tax-exempt organizations (a) Tax-exempt organizations such as churches and universities are exempt from tax on their investment income, including dividend income from investments in corporate stock.

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al. (b) Tax-exempt organizations must pay the unrelated business income tax (UBIT) on business income unrelated to the tax-exempt purpose (generally all business income).

The tax rate is the corporate tax rate of 21%.

(5) Foreign shareholders (a) Foreign investors may be eligible for reduced rates on dividend income depending on the tax treaty, if any, their country of residence has signed with the United States.

(6) To the extent corporations retain earnings (a) C corporation shareholders generally pay tax on capital gains when shares are sold at a gain. (b) Individual shareholders pay the second level tax at capital gain rates (0, 15, or 20 percent rate, depending on the taxpayer’s income) on this undistributed income when they realize the appreciation in their stock (from the retained earnings) by selling their shares. They may also be subject to a 3.8 percent net investment income tax on capital gains, depending on the shareholder’s income level. (c) If a corporation with corporate shareholders retains after-tax earnings, corporate shareholders are taxed on capital gains at the 21 percent corporate rate (there is no preferential tax rate on capital gains for corporations) when they eventually sell the stock. (d) A corporate shareholder’s income from capital appreciation may be subject to more than two levels of taxation because income from capital appreciation doesn’t qualify for the dividends received deduction. Also, institutional shareholders don’t pay tax when they sell their stock and recognize capital gains. (e) Retirees generally pay tax on the gains at ordinary rates when they receive distributions from their retirement accounts. (f) Tax-exempt shareholders do not pay tax on capital gains from selling stock, and foreign investors are generally not subject to U.S. tax on their capital gains from selling corporate stock. (g) Note that the personal holding company tax and the accumulated earnings tax are penalty taxes to prevent corporations from retaining earnings for tax avoidance purposes. The accumulated earnings tax applies when corporations retain earnings to avoid the second tax on corporate income. c) Owner compensation i) Owners who work for business are compensated in different ways, depending on the entity type.

(1) Owners of S corporations and C corporations receive employee compensation that is subject to FICA tax. Employee compensation is deducted by the entity to compute business income. Employee compensation is income that is not eligible for the qualified business income deduction.

(2) Owners of sole proprietorships do not receive compensation because entity and owner are the same. The income of a sole proprietorship is self-employment income.

(3) Owners of entities taxed as partnerships are compensated with guaranteed payments.

These are deductible by the entity and are self-employment income to the owner-worker. ii) Owners, in certain situations, may be able to save taxes by reducing owner compensation, which will increase business income allocations.

(1) Potential FICA tax savings (2) Potentially higher QBI deduction to owner d) Deductibility of entity losses i) C corporations with net operating losses incurred in tax years beginning before 2018 can carry the loss forward for up to 20 years and back 2 years. The NOL may offset up to 100 percent of the taxable income in any given year.

12-7

Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al. ii) C corporations with NOLs incurred in tax years beginning after 2017 (and remaining at the end of 2020) can carryover the NOLs indefinitely but they are no allowed to carry back the NOLs. In carryover years, the NOL can offset up to 80 percent of the taxable income remaining after deducting NOLs incurred in tax years beginning before 2018. iii) NOL carryovers are deducting on a FIFO basis (i.e., oldest first, to the extent deductible). iv) Losses from C corporations are not available to offset a shareholders’ taxable income. v) Losses generated by flow-through entities are generally available to offset the owners’ personal income, subject to certain restrictions. vi) To be deductible, the losses must clear the basis, at-risk, passive activity limitations, and excess loss limitations. vii) The ability to deduct flow-through losses against other sources of income can be a significant issue for owners of new businesses, as they tend to report losses early on as the businesses get established. e) Refer to Exhibit 12-3 for a summary of the tax consequences of several primary tax characteristics across different tax entity types.

4) Other Tax Characteristics a) Converting to other business entity types i) Entity choice summary (1) Refer to Exhibit 12-4 for Comparison of Tax Characteristics across Entities. ii) The tax cost of converting to C corporation from partnership or S corporation is minimal.

However, the tax cost of converting from a C corporation to a flow-through entity can be more significant because the corporation must liquidate first and recognize the gain built into its assets. The reduction in the corporate tax rate to 21 percent reduces the cost, but the cost can still be significant. See the taxes in the real world dealing with The Blackstone Group’s decision to become a corporation.

12-8

Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al.

Class Activities 1. Suggested class activities o

o

o o

Elimination: Develop several multiple-choice questions (A, B, C answers) or draw questions from the test bank relating to important topics from the chapter. Have each class member write the letters A, B, and C on separate sheets of paper. Have the entire class stand up. When you ask a question, have each class member hold up their appropriate response to the question (A, B, or C).

Those who miss must sit down. Continue until you have asked all your questions or until all but one student has been eliminated. Award bonus points (or acknowledgment of a job well done) to those still standing.

Comprehensive problems: Have students work in groups (two to four students) to complete a comprehensive problem (problem 64 deals with entity selection for a new business entity, and problem 65 deals with converting an existing business to another type of tax entity). Make yourself available to students to answer questions but try to get them to work together to answer their questions. You could choose one question for students to report to you. You can write the answer from each group on the board and then reveal the correct or best answer. Give credit to the group(s) that is (are) correct/closest. Given the drop in C corporation tax rates relative to individual rates, the optimal tax entity choice may no longer be clear in many circumstances.

Also, problem 66 is comprehensive problem comparing the overall tax burden of three different tax entity types. Students could do this case in groups and learn from each other.

Interviewing local entrepreneurs: Assign student groups to interview local entrepreneurs to learn what tax and nontax factors led to their choice of entity. Have the groups report their findings to the rest of the class. Summarize important insights and help students draw conclusions.

Impact of future tax law changes: Have students look at proposed or enacted future changes to the tax law. Discuss the likely impact on entity selection and the relative attractiveness of various entities.

2. Ethics discussion

ETHICS Meghna is the sole shareholder and CEO of BQT. BQT is a very profitable S corporation. Until recently, Meghna's salary was in line with the salaries of comparable CEOs. However, Meghna recently learned that she could reduce her tax burden if she were to reduce her salary. In particular, by lowering her salary, Meghna would receive less employee compensation that is subject to FICA tax and is not eligible for the qualified business income deduction, and he would be allocated more business income that is not subject to FICA tax and qualifies for the qualified business income deduction. After considering the potential benefits, Meghna decided to cut her salary in half. Do you think Meghna’s decision is ethical? Why or why not?

Discussion points:   

The strategy appears to be tax motivated, but is that the sole purpose?

Determining reasonable compensation is a subjectively based determination. Certainly, salaries paid to similarly situated CEOs in similar industries can be used as a benchmark.

Does Meghna have other reasons for reducing his salary other than the salary paid to similarly situated executives? How is his company performing compared with other companies in the industry?

12-9

Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al.     

What is the range of salaries of comparable CEOs? What is the average compensation of comparable CEOs? There is no right or wrong answer to the scenario, but the bottom line is that if Meghna is cutting her salary to a level that is unreasonably low for the services she provides, this could be an issue.

If she can reasonably support the salary reduction, her decision is not necessarily unethical.

Get students to see both sides and not just focus on reasons that the decision might be unethical.

See taxed in the real world dealing with S corporation shareholder compensation court cases.

12-10

Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al.

Chapter 13 Corporate Formations and Operations INSTRUCTOR’S MANUAL

Learning Objectives 13-1. Compute the tax consequences of transactions in which shareholders transfer property or services to corporations in exchange for stock of the corporation.

13-2. Describe the corporate income tax formula, and discuss tax considerations relating to corporations’ accounting periods and accounting methods.

13-3. Identify common permanent and temporary book–tax differences, and compute a corporation’s taxable income and associated income tax liability.

13-4. Describe a corporation’s tax return reporting and estimated tax payment obligations.

Teaching Suggestions In the Business Entity Overview chapter, students followed Nicole Johnson as she was evaluating how she should form her business for tax purposes. Consistent with that chapter, this chapter assumes that Nicole chose to form her business as a C corporation. This chapter and the next cover the life cycle of a corporation from a tax perspective. This chapter uses Nicole’s business, Custom Comfort Sheets (CCS), to illustrate the tax consequences of corporate formations (contributions to controlled corporations) and corporate operations. The next chapter covers the tax consequences of corporate distributions, stock redemptions, and corporate liquidations. The following two chapters assume Nicole’s business is formed as an LLC and discuss tax issues associated with a partnership. Finally, the S Corporations chapter assumes Nicole operates CCS as an S corporation and it addresses tax issues from the S corporation perspective. In setting up the discussion for this chapter, you may want to discuss the events involved in the life cycle of a corporation and point out where tax issues associated with events will be addressed in the text. You could also point out that subsequent chapters address tax issues associated with operating the business as other entity types.

In the formations portion of the chapter, it may be important to help students understand why we have §351 and related provisions. These provisions are similar to other types of tax-deferred transactions (e.g., like-kind exchanges). You may also want to point out how §351 is different from §721. That is, for shareholders to qualify for tax deferral on the contribution of contributed property to corporations, shareholders transferring property must in the aggregate own 80 percent of the corporation after the transaction. In contrast, there is no ownership threshold for partners contributing property to partnerships in exchange for partnership interests.

The corporate operations portion of the chapter helps students understand how to compute a corporation’s taxable income. The basic approach assumes that the corporation computes book income under GAAP accounting, and the book highlights many book–tax adjustments that corporations will make to book income in computing taxable income. The chapter points out that not all book–tax differences are the same—some are permanent, and some are temporary. This has implications for reporting the differences (on the Schedule M-3), tracking the differences, and computing the corporation’s income tax expense.

Many of the book–tax differences discussed early in the chapter relate to business income and deduction 13-1

Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al. items and methods discussed in the “Business Income, Deductions, and Accounting Methods” chapter.

The chapter assumes that the students have already worked through the business chapter. Students may struggle with the following topics:  Corporations may report book–tax differences associated with reporting income from stock investments—how much income to report for books versus the amount of dividend received.  Deductions allowed in determining a corporation’s NOL for the year. This is particularly important because NOLs arising in tax years beginning before 2018 are treated one way and NOLs arising in years in tax years beginning after 2017 are treated another. Further, NOLs incurred after 2017 and before 2021 are treated differently than NOLs incurred after 2020.  Allowable deductions in determining the taxable income limit for the charitable contribution limitation.  The limitation on the dividends received deduction and the allowable deductions in determining DRD modified taxable income.  Note that you may want to do problems that don’t involve complicated deduction sequencing (that is, focus on percentage of taxable income before the charitable contribution, but don’t worry about the DRD and capital loss carrybacks).  The annualized income method for determining estimated tax payment requirements.

The comprehensive problems are very useful to help students see the big picture.

Recent tax legislation affects this chapter in two areas as follows:  For 2023, meals expense is generally 50% deductible, even if the meals are provided by a restaurant. In 2022, meals provided by a restaurant were100% deductible. 

For tax years beginning after 2022, certain corporations are subject to a new corporate AMT that is the greater of the regular tax liability and 15% of a corporation’s “adjusted financial statement income.” In general, the AMT applies to corporations with average annual adjusted financial statement income in excess of $1 billion for the prior three tax years. Projections by the Joint Committee on Taxation estimate that the AMT would apply to approximately 150 corporations.

Assignment Matrix

DQ13-1 DQ13-2 DQ13-3 DQ13-4 DQ13-5 DQ13-6 DQ13-7 DQ13-8 DQ13-9 DQ13-10

5 min.

5 min.

5 min.

5 min.

5 min.

5 min.

5 min.

5 min.

5 min.

5 min.

13-2

Tax Forms

Planning

Research

LO4

X X X X X X X X X X

LO3

Medium Medium Medium Medium Medium Medium Medium Medium Medium Medium

LO2

Difficulty

LO1

Text Feature

Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al.

DQ13-11 DQ13-12 DQ13-13 DQ13-14 DQ13-15 DQ13-16 DQ13-17 DQ13-18 DQ13-19 DQ13-20 DQ13-21 DQ13-22 DQ13-23 DQ13-24 DQ13-25 DQ13-26 DQ13-27 DQ13-28 DQ13-29 DQ13-30 DQ13-31 DQ13-32 DQ13-33 DQ13-34 DQ13-35 DQ13-36 DQ13-37 DQ13-38 DQ13-39 DQ13-40 P13-41 P13-42 P13-43 P13-44 P13-45 P13-46 P13-47 P13-48 P13-49 P13-50 P13-51 P13-52 P13-53 P13-54 P13-55 P13-56 P13-57

5 min.

5 min.

5 min.

5 min.

5 min.

5 min.

5 min.

5 min.

5 min.

5 min.

5 min.

5 min.

5 min.

5 min.

5 min.

5 min.

10 min.

5 min.

5 min.

5 min.

5 min.

5 min.

5 min.

5 min.

5 min.

5 min.

10 min.

10 min.

10 min.

10 min.

5min.

5 min.

10 min.

10 min.

10 min.

10 min.

20 min.

5 min.

10 min.

5 min.

15 min.

10 min.

20 min.

10 min.

15 min.

20 min.

5 min.

Medium Medium Medium Medium Medium Medium Medium Medium Medium Medium Medium Medium Medium Medium Medium Medium Hard Medium Medium Medium Medium Medium Medium Medium Medium Medium Medium Medium Medium Medium Medium Medium Medium Medium Medium Medium Hard Easy Medium Medium Medium Medium Medium Medium Medium Medium Medium

X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X

X

X

13-3

X

X

Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al.

P13-58 P13-59 P13-60 P13-61 P13-62 P13-63 P13-64 P13-65 P13-66 P13-67 P13-68 P13-69 P13-70 P13-71 P13-72 P13-73 P13-74 P13-75 P13-76 P13-77 P13-78 CP13-79 CP13-80 CP13-81 CP13-82 CP13-83

10 min.

20 min.

10 min.

15 min.

15 min.

15 min.

10 min.

10 min.

15 min.

10 min.

10 min.

10 min.

25 min.

15 min.

15 min.

5 min.

15 min.

5 min.

20 min.

20 min.

25 min.

40 min.

40 min.

40 min.

50 min.

75 min.

Medium Medium Medium Medium Medium Medium Medium Medium Hard Medium Medium Medium Hard Medium Medium Easy Medium Easy Medium Medium Hard Hard Hard Hard Hard Hard

X X X X X X X X X X X X X X X X

X

X X X X X

X

Lecture Notes 1) Transfers of Property to a Corporation a) Transactions subject to a tax deferral i) Shareholders must transfer property. ii) Shareholders must receive stock of the transferee corporation in the exchange. iii) Shareholders transferring property together must be in control of the transferee corporation immediately after the transfer. b) Tax consequences to shareholders in a qualifying §351 exchange with no boot c) Tax consequences to shareholders in a qualifying §351 exchange with boot d) Assumption of shareholder liabilities by transferee corporation i) Tax-avoidance transactions ii) Liabilities in excess of basis e) Shareholders’ basis in stock received in a qualifying §351 exchange f) Tax consequences to the transferee corporation in a qualifying §351 exchange g) Issues related to incorporating an ongoing business h) Contributions to capital 2) Corporate Taxable Income Formula a) Refer to Exhibit 13-2 for Corporate and Individual Tax Formulas.

13-4

Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al. b) The corporate tax formula is similar to the individual tax formula, but corporations don’t claim the deduction for qualified business income and they don’t itemize deductions or claim the standard deduction. c) Accounting periods and methods i) Corporations with average gross receipts of $29 million or less over the three prior tax years (assuming 2023 is the current tax year) or a shorter period for new corporations may use the cash method.

3) Computing Corporate Taxable Income a) To compute taxable income, corporations generally start with book or financial reporting income and then make adjustments for book–tax differences to reconcile to the tax numbers. i) Corporations using tax accounting methods to determine book income need not reconcile. b) Book–tax differences i) Favorable (unfavorable) book–tax differences decrease (increase) book income relative to taxable income. ii) Permanent book–tax differences arise in one year and never reverse. iii) Temporary book–tax differences arise in one year and reverse in a subsequent year. iv) Common permanent book–tax differences (1) Refer to Exhibit 13-3 for Common Permanent Book–Tax Differences. v) Common temporary book–tax differences (1) Refer to Exhibit 13-4 for Common Temporary Book–Tax Differences Associated with Items Discussed in Other Chapters.

(2) Corporations experience temporary book–tax differences because the accounting methods they apply to determine certain items of income and expense for financial reporting purposes differ from those they use for tax purposes.

(3) Unlike permanent book–tax differences, temporary book-tax differences balance out so that over time corporations recognize the same amount of income or deduction for the particular item. c) Corporate-specific deductions and associated book–tax differences i) Stock options (1) For tax purposes, the tax treatment to the corporation (and the employee) depends on whether the options are incentive stock options (ISOs) (less common, more administrative requirements for the corporation to qualify) or nonqualified stock options (NQOs) (more common, options that don’t qualify as ISOs).

(2) Corporations issuing incentive stock options generally do not deduct any compensation expense associated with the options for tax purposes. The only exception to this is when the employee makes a disqualifying disposition of the ISOs. This chapter does not cover disqualifying dispositions but rather emphasizes the general rule of no deduction.

(3) For nonqualified options, corporations deduct the difference between the fair market value of the stock and the exercise price of the option (the bargain element) in the year in which employees exercise the stock options.

(4) For the purposes of this chapter we assume that all NQOs are exercised and fully expensed for books in the same period so all book–tax differences for stock options are permanent differences.

(5) The amount of the permanent difference is the difference between the estimated value of the stock options exercised minus the bargain element of the stock options exercised during the year.

(6) If the estimated value of stock options exercised exceeds the bargain element of the stock options exercised, the permanent book–tax difference is unfavorable; otherwise it is favorable.

(7) The permanent book–tax difference is recognized in the year the options are exercised.

13-5

Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al. ii) Net capital losses (1) Corporations are not allowed to deduct net capital losses in a given year.

(2) Net capital losses are carried back three years and forward five years to offset net capital gains in those years.

(3) Net capital losses are deductible for book purposes.

(4) Unfavorable book–tax difference in year net capital loss occurs. Favorable book–tax difference in year of carryback or carryover. iii) Net operating losses (treatment depends on year incurred). See new Exhibit 13-6 for summary of rules.

(1) NOLs incurred in years beginning before 2018 (a) Carry back two years and carry forward 20 years. (b) Can offset up to 100 percent of taxable income (before the NOL deduction) in any given year.

(2) NOLs incurred in years beginning after 2017 and before 2021 (a) Carry back five years (can forgo the carryback). Can offset up to 100% of taxable income before the NOL deduction in carryback years. (b) Indefinite carryover period. (c) Can offset up to 100 percent of taxable income before the NOL deduction in tax years beginning before 2021. (d) Can offset up to up to 80 percent of taxable income remaining after deducting NOL carryovers from NOLs incurred in tax years beginning before 2018.

(3) NOLs incurred in tax years beginning after 2020. (a) No carryback. (b) Indefinite carryover (c) Can offset up to 80 percent of taxable income remaining after deducting NOL carryovers from NOLs incurred in tax years beginning before 2018.

(4) A corporation can elect to forgo the NOL carryback and simply carry the NOL forward to future years. Also, if a corporation carries back a NOL, it must carry it back to the earlies year first (i.e., two years prior or five years prior, depending on the year the NOL was created). iv) Charitable contributions (1) For accrual-method corporations, deductible when accrued if approved by board of directors and paid within three and one-half months of year-end. June 30 year-end corporations must pay accrued charitable contributions within two and one-half months of year-end (by September 15) to deduct in the prior year.

(2) For 2023 charitable donations are limited to 10 percent of charitable contribution deduction modified taxable income.

(3) Contributions in excess of percentage limit carried forward up to five years.

(4) A corporation’s charitable contribution limit modified taxable income is its taxable income before deducting the following: (a) Any charitable contributions (b) The dividends received deduction (DRD) (discussed below) (c) Capital loss carrybacks v) Dividends-received deduction (1) Deduction percentage is 50 percent if corporation owns less than 20 percent of distributing corporation’s stock, 65 percent if corporation owns at least 20 percent but less than 80 percent of distributing corporation’s stock, and 100 percent if corporation owns 80 percent or more of distributing corporation’s stock. (a) Refer to Exhibit 13-7 for Stock Ownership and Dividends Received Deduction Percentage.

13-6

Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al.

(2) Amount of deduction is generally lesser of deduction percentage (50 percent, 65 percent, or 100 percent) based on ownership times the amount of the dividend, limited to the deduction percentage times DRD modified taxable income.

(3) Limitation doesn’t apply if full DRD creates or increases a corporation’s NOL. (4) Generates favorable permanent difference.

(5) DRD modified taxable income (a) Dividend receiving corporation’s taxable income before deducting the following: (i) The DRD (ii) Any NOL deduction (carryover or carryback) (iii) Capital loss carrybacks (b) The modified taxable income limitation does not apply if after deducting the full dividends received deduction (dividend × DRD percentage) a corporation reports a current-year net operating loss. (c) If the full dividends received deduction either creates or increases a corporation’s net operating loss, the corporation is allowed to deduct the full dividends received deduction even when the DRD limitation based on modified taxable income is lower. d) Taxable income summary i) Refer to Exhibit 13-8 for CCS Book–Tax Reconciliation Template. e) Tax liability i) Corporate taxable income is taxed at a flat 21 percent rate. ii) The corporate tax rate schedule is not indexed for inflation like the individual tax rate schedules are. iii) A new corporate AMT applies to certain large corporations with book income in excess of taxable income for tax years beginning after 2023.

4) Compliance a) Corporations report their taxable income on Form 1120. See Exhibit 13-9 for Form 1120. b) Corporations with total assets of less than $10M report book–tax differences on Schedule M-1 of Form 1120. Corporations with more than $10M of assets but less than $50M have the option of filing Schedule M-1 in place of Schedule M-3 parts II and III. However, they must file Schedule M-3 lines 1–12. Corporations with at least $50M of assets must report book–tax differences on Schedule M-3. Note that the Schedule M-3 is much more detailed with many more line items for book–tax differences than for the Schedule M-1. Also, Schedule M-3 requires taxpayers to report book–tax differences as permanent or temporary but Schedule M-1 does not. c) Refer to Exhibit 13-10 for Form 1120, Schedule M-1. d) Consolidated tax returns i) An affiliated group may file a consolidated tax return. ii) Corporations essentially treated as one for tax return purposes. e) Corporate tax return due dates and estimated taxes i) Tax return due date is three and one-half months after year-end (two and one-half months after year-end for June 30 year-end corporations). ii) Six-month extensions for filing return (not paying taxes) are available for all corporations except 6/30 year-end corporations. June 30 year end corporations can get a seven-month extension. f) Corporations pay expected annual tax liability through estimated tax payments. i) Installments due in 4th, 6th, 9th, and 12th months of their taxable year. ii) Underpayment penalties if don’t pay in adequate estimated tax payments. iii) Refer to Examples 13-26 through 13-28 for examples illustrating the computation of estimated tax payments for corporations.

13-7

Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al.

Class Activities 1. Suggested class activities o

o

o

Elimination: Develop several multiple-choice questions (A, B, C answers) and/or draw questions from the test bank relating to important topics from the chapter. Have each class member write the letters A, B, and C on separate sheets of paper. Have the entire class stand up. When you ask a question, have each class member hold up their appropriate response to the question (A, B, or C).

Those who miss must sit down. Continue until you have asked all your questions or until all but one student has been eliminated. Award bonus points (or acknowledgment of a job well done) to those still standing.

Comprehensive problems: Have students work in groups (two to four students) to complete one of the comprehensive problems. Make yourself available to students to answer questions but try to get them to work together to resolve their questions. You could choose one question (what is taxable income? or what are taxes payable or taxes due?) for students to report to you. You can write the answer from each group on the board and then reveal the correct answer. Give credit to the group(s) that is (are) correct/closest.

Schedule M-3 research activity: Have students look up Schedule M-3 on the IRS website and ask them to point out the differences between Schedule M-1 and Schedule M-3.

2. Ethics discussion From page 13-7:

Ethics Li is the sole proprietor of a business that manufactures solar panels. This week Li was approached to exchange her business assets for shares in Burns Power Corporation. As part of the exchange, Li is requiring Burns Power Corporation to assume the home-equity loan on her home. Do you think that Li should argue that there is no tax-avoidance motive in this arrangement? Suppose that Li established her business five years ago by investing funds from the home-equity loan on her home. Does this fact change your answer?

Discussion points:  

If there is a tax-avoidance motive, the debt relief would be boot to Li and would likely trigger gains to her.

What factors would you consider to determine whether this is tax avoidance?

13-8

Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al.

Chapter 14 Corporate Nonliquidating and Liquidating Distributions INSTRUCTOR’S MANUAL

Learning Objectives 14-1. Explain the basic tax law framework that applies to property distributions from a corporation to a shareholder.

14-2. Compute a corporation’s earnings and profits, and calculate a shareholder’s dividend income on distributions received.

14-3. Explain the taxation of stock distributions.

14-4. Understand the tax consequences of stock redemptions, including partial liquidations.

14-5. Calculate the tax consequences of the complete liquidation of a corporation.

Teaching Suggestions This chapter provides the basic framework for taxing distributions from a corporation to its shareholders in their capacity as shareholders. Renowned corporate tax experts Bittker and Eustice call this topic “wondrously complex.” The topics build from basic dividends to stock distributions to redemptions to partial liquidations to complete liquidations. The most difficult part of the material is the computation of current earnings and profits and the impact on E&P from the distributions themselves. As the instructor, you should decide if you want to go through the four different combinations of E&P balances (both positive, both negative, one positive and the other negative). You could also choose to focus on both the positive scenario and skip the other three possibilities. With stock redemptions, you can discuss the attribution rules and focus on the family attribution rules that apply to closely held companies. Partial liquidations are very rare; you might decide to pass on the technical discussion. Finally, in terms of complete liquidations, students may struggle with the loss disallowance rules in §336(d). You may need to give extra attention to these rules.

Based on tax law effective for 2021 and 2022, the cost of meals purchased from restaurants is 100% deductible so only the cost of meals purchased from sources other than restaurants would lead to adjustment to taxable income when determining current E&P. However, for 2023, the cost of meals is generally 50% deductible (even when purchased from a restaurant). Also, as part of the Inflation Reduction Act, publicly traded corporations are subject to a 1% excise tax on stock repurchases after 2022. A stock repurchase includes redemptions and other economically equivalent transactions (see §4501).

Assignment Matrix

DQ14-1

10 min.

14-1

Forms

Planning

Research

LO5

LO4

X

LO3

Medium

LO2

Difficulty

LO1

Text Feature

Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al.

DQ14-2 DQ14-3 DQ14-4 DQ14-5 DQ14-6 DQ14-7 DQ14-8 DQ14-9 DQ14-10 DQ14-11 DQ14-12 DQ14-13 DQ14-14 DQ14-15 DQ14-16 DQ14-17 DQ14-18 DQ14-19 DQ14-20 DQ14-21 DQ14-22 DQ14-23 DQ14-24 DQ14-25 DQ14-26 DQ14-27 DQ14-28 DQ14-29 DQ14-30 DQ14-31 DQ14-32 DQ14-33 DQ14-34 P14-35 P14-36 P14-37 P14-38 P14-39 P14-40 P14-41 P14-42 P14-43 P14-44 P14-45 P14-46 P14-47 P14-48 P14-49

10 min.

10 min.

10 min.

10 min.

10 min.

10 min.

10 min.

10 min.

10 min.

10 min.

10 min.

10 min.

10 min.

10 min.

10 min.

10 min.

10 min.

10 min.

10 min.

10 min.

10 min.

10 min.

10 min.

10 min.

10 min.

10 min.

10 min.

10 min.

10 min.

10 min.

10 min.

10 min.

10 min.

5 min.

10 min.

10 min.

10 min.

10 min.

10 min.

10 min.

10 min.

10 min.

15 min.

15 min.

15 min.

15 min.

15 min.

15 min.

Medium Medium Medium Medium Medium Medium Medium Medium Medium Medium Medium Medium Medium Medium Medium Medium Medium Medium Medium Medium Medium Medium Medium Medium Medium Medium Medium Medium Medium Medium Medium Medium Medium Easy Medium Medium Medium Medium Medium Medium Medium Medium Medium Medium Medium Medium Medium Medium

X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X

X X

14-2

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al.

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Lecture Notes 1) The Basic Tax Law Framework that Applies to Property Distributions a) If the tax law characterizes the distribution as a dividend, the corporation cannot deduct the amount paid in computing its taxable income. b) The gross amount of a dividend received is included in a shareholders’ gross income. c) The nondeductibility of the distribution by the corporation, coupled with the taxation of the distribution to the shareholder, creates double taxation of the corporation’s income, first at the corporate level and then at the shareholder level. d) The double taxation of distributed corporate income is a fundamental principle of the U.S. income tax system, having been made part of the tax code in 1913. e) The cost of double taxation has been significantly reduced and even eliminated in some cases with the relatively low corporate tax rate of 21 percent, which is considerably lower than the top individual tax rate of 37%. f) The recipient of a dividend or payment in exchange for corporate stock (stock redemption) generally receives preferential tax treatment on the distribution, in the form of a nontaxable return of capital and a preferential tax rate on the gain. g) The tax rate applied to dividends and capital gains received by individuals is generally lower than the ordinary rate (could be taxed at 0 percent, 15 percent, or 20 percent depending on the taxpayer’s income level—however, both dividends and capital gains could also be subject to an additional 3.8 percent tax on net investment income). Corporate shareholders receiving dividends

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al. are taxed at the ordinary rate (21 percent). Corporate shareholders receiving dividends are entitled to a dividends received deduction of 50 percent, 65 percent, or 100 percent depending on the extent of ownership in the distributing corporation.

2) Computing Earnings and Profits and Calculating a Shareholder’s Dividend Income on Distributions Received a) Overview of the shareholder taxation of corporate distributions i) When a corporation distributes property to shareholders in their capacity as shareholders, the tax consequences of the distribution to the shareholder can be summarized as follows: (1) The portion of the distribution that is a dividend is included in gross income.

(2) The portion of the distribution that is not a dividend reduces the shareholder’s tax basis in the corporation’s stock (that is, it is a nontaxable return of capital).

(3) The portion of the distribution that is not a dividend and is in excess of the shareholder’s stock tax basis is treated as gain from sale or exchange of the stock (capital gain). ii) Corporate distributions of “property” usually take the form of cash, but they can include debt and other tangible or intangible assets. b) Definition of a dividend i) The tax law defines a dividend as any distribution of property made by a corporation to its shareholders out of its earnings and profits (E&P) account. ii) Congress intended earnings and profits to be a measure of the corporation’s economic earnings available for distribution to its shareholders. iii) The IRC requires a corporation to keep two separate E&P accounts: (1) The current year (current earnings and profits) (2) Undistributed earnings and profits accumulated in all prior years (accumulated earnings and profits) iv) Distributions first are deemed paid out of current E&P, with any excess deemed paid from accumulated E&P. v) Current E&P not distributed to shareholders during the year is added to accumulated E&P at the beginning of the next taxable year. vi) The IRS does not require a corporation to keep contemporaneous records to track its E&P balance, provided they do not pay out more than current E&P each year. vii) A corporation that pays a distribution in excess of its total E&P must report the distribution on Form 5452 and include a calculation of its E&P balance to support the tax treatment. c) Computing earnings and profits i) Earnings and profits include taxable and nontaxable income, reflecting the fact that Congress intended E&P to represent a corporation’s economic income. ii) Current E&P is calculated at the end of the year with reduction for distributions made during the year. iii) Shareholders may be taxed on distributions of income not subject to tax at the corporate level. iv) The corporation begins its computation of current E&P with taxable income or loss. v) It then makes adjustments required by the Internal Revenue Code (IRC) or the accompanying regulations and IRS rulings. The adjustments are: (1) Add back economic income that is excluded from taxable income. (a) The regulations state that “all income exempted by statute” must be added back to taxable income in computing E&P. (b) Common examples of tax-exempt income included in E&P are tax-exempt interest and tax-exempt life insurance proceeds. (c) Exempt income not included in E&P includes gifts and bequests and contributions to capital.

(2) Add back certain expenses that are deducted in computing taxable income but do not require an economic outflow.

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al. (a) Deductions that are allowed in computing taxable income but disallowed in the computation of E&P generally are deductions that require no cash outlay by the corporation or are carryovers from a different tax year. (b) Examples: dividends received deduction, net capital loss carryovers from a different tax year, net operating loss carryovers from a different tax year, and charitable contribution carryovers from a prior tax year.

(3) Subtract certain expenses that are excluded from the computation of taxable income but do require an economic outflow. (a) A corporation reduces its E&P for certain items that are not deductible in computing its taxable income but require a cash outflow. (b) Examples of such expenses are: (i) Federal income taxes paid or accrued (depending on the corporation’s method of accounting). (ii) Expenses incurred in earning tax-exempt income (such income is included in E&P). (iii) Disallowed business interest expense. (iv) Premiums on life insurance contracts in excess of the increase in the policy’s cash surrender value. (v) Current-year net capital loss (there is no limit on capital losses). (vi) Meal expenses disallowed (generally 50 percent of the total for meals purchased). (vii) Entertainment expenses. (viii) Nondeductible lobbying expenses and political contributions. (ix) Penalties and fines.

(4) Add or subtract income or deductions for difference in accounting methods for taxable income and E&P purposes. (a) A corporation using the accrual method for regular income tax purposes generally must use the accrual method for E&P purposes. (b) Some income deferred from inclusion in the computation of current-year taxable income must be included in the computation of current E&P in the year in which the transaction occurs. (c) Certain expenses currently deducted in the computation of taxable income are deferred in computing E&P. (d) Organizational expenditures, which can be deducted currently or amortized for income tax purposes, must be capitalized for E&P purposes. (e) Amounts expensed under §179 (first year expensing) must be amortized over five years for E&P purposes. (f) Bonus depreciation is not allowed for E&P purposes. (g) Refer to Exhibit 14-1 for a Template for Computing Current Earnings and Profits. d) Ordering of E&P distributions i) A corporation must maintain two separate E&P accounts: current E&P and accumulated E&P. ii) Whether a distribution is characterized as a dividend depends on the amount of the distribution and the balances in the E&P accounts. iii) There are four possible scenarios: (1) Positive current E&P, positive accumulated E&P (a) Corporate distributions are deemed to be paid out of current E&P first. (b) If distributions exceed current E&P, the amount distributed out of current E&P is allocated pro rata to all of the distributions made during the year. Distributions in excess of current E&P come out of accumulated E&P on a first come first served

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al. basis. Distributions in excess of both current and accumulated E&P are capital gain to the shareholder. (c) The ordering of distributions is necessary only when distributions exceed current E&P and either the identity of the shareholders receiving the distributions changes or a shareholder’s percentage ownership changes during the year.

(2) Positive current E&P, negative accumulated E&P (a) Distributions deemed paid out of current E&P are taxable as dividends. (b) Distributions in excess of current E&P in this scenario would first be treated as nontaxable reductions in the shareholders’ tax basis in their stock. (c) Any excess received over their stock basis would be treated as a (capital) gain from sale of the stock. (d) Note the “Taxes in the Real World” example relating to Visteon Corporation. This is a real-life example of the possible application of this rule.

(3) Negative current E&P, positive accumulated E&P (a) When current E&P is negative, the tax status of a dividend is determined by E&P on the date of the distribution. (b) This requires the corporation to prorate the negative current E&P to the distribution date and add it to accumulated E&P at the beginning of the year to determine E&P at the distribution date. (c) Distributions in excess of E&P in this scenario are treated as reductions in the shareholders’ tax basis in their stock. Any excess over their stock basis would be treated as a capital gain.

(4) Negative current E&P, negative accumulated E&P (a) None of the distribution is treated as a dividend. (b) Distributions in this scenario would first be treated as reductions in the shareholders’ tax basis in their stock. (c) Any excess over their stock basis would be treated as a capital gain. e) Distributions of noncash property to shareholders i) Amount distributed = Money received + Fair market value − Liabilities assumed by the shareholder on property received ii) As a general rule, a shareholder’s tax basis in noncash property received as a distribution equals the property’s fair market value. iii) Tax consequences to a corporation distributing noncash property (1) The IRC provides that realized gains (but not losses) are recognized by a corporation on the distribution of noncash property.

(2) To the extent the fair market value of property distributed exceeds the corporation’s tax basis in the property, the corporation recognizes a taxable gain on the distribution, which increases current E&P by virtue of the fact that it increases taxable income.

(3) If the fair market value of the property distributed is less than the corporation’s tax basis in the property, the corporation does not recognize a deductible loss on the distribution.

(4) E&P is reduced by the distributed property’s fair market value if the property is appreciated (gain is recognized) and by the property’s E&P basis if the property is depreciated (loss is not recognized). iv) Liabilities (1) If the property’s fair market value is less than the amount of the liability assumed, the property’s fair market value is deemed to be the amount of the liability assumed by the shareholder.

(2) If the liability assumed is less than the property’s fair market value, the gain recognized on the distribution is the excess of the property’s fair market value over its tax basis (that is, the liability is ignored).

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al. v) Effect of noncash property distributions on E&P (1) In the case of noncash property distributions, the corporation reduces E&P by the fair market value of appreciated property (FMV > E&P basis) and by the adjusted basis of depreciated property (E&P basis > FMV).

(2) When appreciated property is distributed by the corporation, the corporation recognizes E&P gain to the extent the property’s fair market value exceeds the corporation’s E&P tax basis in the property.

(3) The corporation increases E&P by the amount of liability assumed by the shareholder in the distribution.

(4) A distribution of property can only reduce E&P to the extent E&P is positive.

(5) A distribution cannot create negative E&P or increase already existing negative E&P that results from operations.

3) Stock Distributions a) Tax consequences to shareholders receiving a stock distribution i) Nontaxable stock distributions (1) As a general rule, the stock distribution must meet two conditions: (a) It must be made with respect to the corporation’s common stock, and (b) It must be pro rata with respect to all shareholders (that is, the shareholders’ relative equity positions do not change as a result of the distribution).

(2) The recipient of a nontaxable stock dividend allocates a portion of the tax basis from the stock on which the stock distribution was issued to the newly issued stock based on the relative fair market value (FMV) of the stock.

(3) Adjusted basis of “new stock” = (FMV of stock received/Total FMV of new and old stock) × Adjusted basis of “old stock” (4) The holding period of the new stock includes the holding period for which the shareholder held the old stock.

(5) Pro rata distributions generally are nontaxable. ii) Taxable stock distributions (1) Non-pro rata stock distributions are usually taxable.

(2) Shareholders take a fair market value basis in stock received as a taxable stock distribution.

4) Stock Redemptions a) The form of a stock redemption i) The tax law defines redemption as an acquisition by a corporation of its stock from a shareholder in exchange for property, whether or not the stock so acquired is canceled, retired, or held as treasury stock.

(1) Publicly traded corporations are generally subject to a 1% excise tax on stock redemptions after 2022. ii) Stock redemptions take the form of an exchange; that is, the shareholders exchange their stock in the corporation for property, usually cash. iii) The IRC attempts to provide both “bright line” and subjective tests to distinguish when redemption should be treated as an exchange or a potential dividend. iv) Individuals generally prefer exchange treatment while corporate shareholders generally have more incentive for dividend treatment. v) Dividends from domestic corporations are eligible for the dividends received deduction (usually 50 percent or 65 percent), whereas the full amount of capital gain is taxed at the corporate rate (21 percent). vi) A corporate shareholder might prefer exchange treatment if the redemption results in a loss or its stock tax basis as a percentage of the redemption price exceeds the dividends received deduction ratio.

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al. b) Redemptions that reduce a shareholder’s ownership interest i) The IRC allows a shareholder to treat redemption as an exchange if the transaction meets one of three change-in-stock-ownership tests. ii) Redemptions that are substantially disproportionate with respect to the shareholder (1) If the redemption is “substantially disproportionate with respect to the shareholder” (2) A shareholder meets this requirement by satisfying three mechanical (“bright line”) stock ownership tests: (a) Immediately after the exchange, the shareholder owns less than 50 percent of the total combined voting power of all classes of stock entitled to vote. (b) The shareholder’s percentage ownership of voting stock after the redemption is less than 80 percent of his or her percentage ownership before the redemption. (c) The shareholder’s percentage ownership of the aggregate fair market value of the corporation’s common stock (voting and nonvoting) after the redemption is less than 80 percent of his or her percentage ownership before the redemption.

(3) Family attribution (4) Attribution from entities to owners or beneficiaries (5) Attribution from owners or beneficiaries to entities (6) Option attribution iii) Redemptions in complete redemption of all of a shareholder’s stock in a corporation (1) This test seems redundant with the substantially disproportionate test discussed previously; after all, a complete redemption appears to satisfy the 50 percent and 80 percent tests. However, due to the application of stock attribution rules, this may not be the case.

(2) The stock attribution rules previously discussed also apply to a complete redemption.

(3) The shareholder has no interest in the corporation immediately after the exchange other than as a creditor. Interests as a shareholder, employee, director, officer or consultant are specifically identified as prohibited interests.

(4) The shareholder does not acquire a prohibited interest within 10 years after the redemption, unless by inheritance (this is known as the 10-year look-forward rule).

(5) The shareholder must agree to notify the IRS district director within 30 days if he or she acquires a prohibited interest within 10 years after the redemption. These agreements are referred to as triple i agreements. iv) Redemptions that are not essentially equivalent to a dividend (1) To satisfy this requirement the taxpayer must have a “meaningful” reduction in the shareholder’s ownership interest in the corporation as a result of the redemption. v) Tax consequences to the distributing corporation (1) The corporation distributing property to shareholders in redemption generally recognizes gain on distributions of appreciated property but is not permitted to recognize loss on distribution of property with a fair market value less than its tax basis.

(2) If the shareholder treats the redemption as a distribution/dividend, the corporation reduces its E&P by the cash distributed and the fair market value of other property distributed (to the extent of E&P).

(3) If the shareholder treats the redemption as an exchange, the corporation reduces E&P at the date of distribution by the percentage of stock redeemed (that is, if 50 percent of the stock is redeemed, E&P is reduced by 50 percent), not to exceed the fair market value of the property distributed.

(4) The distributing corporation generally reduces its E&P by any dividend distributions made during the year before reducing its E&P for redemptions treated as exchanges.

5) Partial Liquidations a) Noncorporate shareholders receive exchange treatment.

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al. b) Corporate shareholders determine their tax consequences using the change-in-stock-ownership rules that apply to stock redemptions.

6) Complete liquidation of a corporation a) Fully taxable complete liquidation i) Tax consequences to liquidating corporation (1) Treated as having sold each asset for its fair market value.

(2) Gains recognized.

(3) Losses generally recognized. (a) Exception may apply if distributed to related person (owns 50% or more of the value of the stock of the corporation). (b) Exception may apply if sale or distribute loss property that was contributed with a built-in loss. (i) Requires tax-avoidance motive. ii) Tax consequences to shareholders (1) Treated as a sale of stock (FMV of amount received minus basis in stock equals gain or loss on liquidation). b) Nontaxable and partially taxable complete liquidations i) Tax consequences to liquidating corporation (1) No gain or loss on distribution to parent (80 percent or more ownership of voting power and value of liquidating corporation’s stock).

(2) Gain but no loss on distribution to other shareholders. ii) Tax consequences to shareholders (1) Corporate shareholders owning at least 80 percent of the voting power and value of the liquidating corporation do not recognize gain or loss on receiving liquidating distribution and take carryover basis in assets received from liquidating corporation.

(2) Minority shareholders (own less than 80 percent of corporation) recognize gain or loss on liquidating distribution and take fair market value basis in assets received. c) 7) Conclusion

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Elimination: Develop several multiple-choice questions (A, B, C answers) or draw questions from the test bank relating to important topics from the chapter. Have each class member write the letters A, B, and C on separate sheets of paper. Have the entire class stand up. When you ask a question, have each class member hold up their appropriate response to the question (A, B, or C).

Those who miss must sit down. Continue until you have asked all your questions or until all but one student has been eliminated. Award bonus points (or acknowledgment of a job well done) to those still standing.

Comprehensive problems. Have students work in groups (two to four students) to complete one of the four comprehensive problems.

2. Ethics discussion From page 14-13:

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Ethics Karsten is the sole shareholder of XYZ Corporation. XYZ Corporation owned a parcel of vacant land that Karsten thought would be an ideal location to build a personal residence. Consequently, XYZ distributed the land to Karsten. Karsten had the land appraised to determine the income both Karsten and XYZ would recognize on the distribution. Because the first appraisal came in higher than expected, Karsten paid for a second appraisal from a different appraiser. The second appraisal was quite a bit lower so Karsten used the second appraisal to determine the income Karsten and XYZ recognized on the distribution. What do you think of Karsten's approach to determining the value of the land?

Discussion points:   

What should a taxpayer do when different property appraisals come in at different values?

Is it unethical to use the appraisal that most benefits the taxpayer?

Were both appraisals in the “reasonable” range?

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al.

Chapter 15 Forming and Operating Partnerships INSTRUCTOR’S MANUAL

Learning Objectives 15-1. Describe tax flow-through entities and determine whether they are taxed as partnerships or S corporations.

15-2. Resolve tax issues applicable to partnership formations and other acquisitions of partnership interests, including gain recognition to partners and tax basis for partners and partnerships.

15-3. Determine the appropriate accounting periods and methods for partnerships.

15-4. Calculate and characterize a partnership’s ordinary business income or loss and its separately stated items and demonstrate how to report these items to partners.

15-5. Explain the importance of a partner’s tax basis in her partnership interest and the adjustments that affect it.

15-6. Apply the tax-basis, at-risk, passive activity loss, and excess business loss limits to losses from partnerships.

Teaching Suggestions This chapter provides an overview of partnership formations and operations. In the formations area, the chapter focuses on the tax consequences to partners and partnerships when partners contribute either property or services in exchange for a partnership interest. As part of this analysis, the chapter discusses general principles regarding partnership debt allocation. In the operations area, the chapter covers separately stated items and tax reporting, self-employment issues affecting partners, partner basis adjustments, and limitations on tax losses from partnerships. The chapter is written in such a way that instructors who prefer to cover only formations or only operations can do so.

We recommend one of two possible approaches when covering this chapter. First, you might consider discussing the Entities Overview chapter first as a general introduction to the taxation of flow-through entities, and then follow it with a discussion of this chapter and possibly the chapter that follows on S corporations. Alternatively, you might begin a module on flow-through entities with this chapter, followed by the next chapter on S corporations, and ending with the Entities Overview chapter to highlight important differences between partnerships and S corporations.

Of all the topics included in the chapter, students tend to have the most difficulty with partnership debt allocation and the tax basis, the at-risk, and the passive activity loss limitations. These areas are likely to require more time in the classroom relative to other topics in the chapter.

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Assignment Matrix

DQ15-1 DQ15-2 DQ15-3 DQ15-4 DQ15-5 DQ15-6 DQ15-7 DQ15-8 DQ15-9 DQ15-10 DQ15-11 DQ15-12 DQ15-13 DQ15-14 DQ15-15 DQ15-16 DQ15-17 DQ15-18 DQ15-19 DQ15-20 DQ15-21 DQ15-22 DQ15-23 DQ15-24 DQ15-25 DQ15-26 DQ15-27 DQ15-28 DQ15-29 DQ15-30 DQ15-31 DQ15-32 DQ15-33 DQ15-34 DQ15-35 DQ15-36

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Lecture Notes 1) Flow-Through Entities Overview a) Income earned by flow-through entities is usually not taxed at the entity level. b) The owners of flow-through entities are taxed on the share of entity-level income allocated to them. c) Income from flow-through entities is taxed only once—when it “flows through” to owners of these entities. d) Aggregate and entity concepts i) An entity approach treats tax partnerships as entities separate from their partners. ii) An aggregate approach treats tax partnerships as an aggregation of the partners’ separate interests in the assets and liabilities of the partnership.

2) Partnership Formations and Acquisitions of Partnership Interests a) Acquiring partnership interests when partnerships are formed i) Partnership interests represent the bundle of economic rights granted to partners under the partnership agreement. ii) These rights include the right to receive a share of the partnership assets if the partnership were to liquidate, called a capital interest, and the right or obligation to receive a share of future profits or future losses, called a profits interest. iii) The distinction between capital and profits interests is important because the tax rules for partnerships are sometimes applied to them differently. iv) Contributions of property (1) Gains and losses from the exchange of contributed property for partnership interests are either fully or partially deferred for tax purposes depending on the specifics of the transaction.

(2) The tax rules in this area allow entrepreneurs to organize their businesses without having to pay taxes.

(3) The tax rules follow the aggregate theory of partnership taxation because they recognize that partners contributing property to a partnership still own the contributed property, albeit a smaller percentage, since other partners will also indirectly own the contributed property through their partnership interests. (a) Gain and loss recognition (i) Partners don’t generally recognize gain or loss when they contribute property to partnerships. (ii) The general rule facilitates contributions of property with built-in gains (fair market value is greater than tax basis) but discourages contributions of property with built-in losses (fair market value is less than tax basis). (iii) Work through Example 15-1. (b) Partner’s initial tax basis (i) Initial tax basis for partners contributing property = basis of contributed property − debt securing contributed property + partnership debt allocated to contributing partner + gain recognized. (ii) A partner’s tax basis in his/her partnership interest is his/her outside basis, and the partnership’s basis in its assets is its inside basis. .

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(x) (4)

(iii) Partners will simply have a basis in their partnership interest equivalent to the tax basis of the property and cash they contributed, which ensures that realized gains and losses on contributed property are merely deferred until either the contributing partner sells her partnership interest or the partnership sells the contributed property. (iv) Recourse debt 1. Recourse debts are those for which partners have economic risks of loss— that is, they may have to legally satisfy the debt with their own funds.

2. Example: the unsecured debts of general partnerships, such as payables, are recourse debt because general partners are legally responsible for the debts of the partnership. (v) Nonrecourse debts 1. Nonrecourse debts don’t provide creditors the same level of legal recourse against partners.

2. Example: mortgages are typically secured by real property and only give lenders the right to obtain the secured property in the event the partnership defaults on the debt.

3. Because partners are responsible for paying nonrecourse debts only to the extent the partnership generates sufficient profits, such debts are generally allocated according to partners’ profit-sharing ratios. (vi) The fundamental difference between the two types of debt lies in the legal responsibility partners assume for ultimately paying the debt. (vii) Refer to Exhibit 15-1 for Basic Rules for Allocating Partnership Debt to Partners. (viii) Work through Example 15-3. (ix) If the debt securing the contributed property is nonrecourse debt, the amount of the debt in excess of the basis of the contributed property is allocated solely to the contributing partner, and the remaining debt is allocated to all partners according to their profit-sharing ratios.

Work through Examples 15-4 and 15-5 Partner’s holding period in partnership interest (a) Contributing partner’s holding period in a partnership interest depends on the type of property contributed. (b) As partnership interest is a capital asset, its holding period determines whether gains or losses from the disposition of the partnership interest are short-term or long-term capital gains or losses. (c) Work through Example 15-6.

(5) Partnership’s tax basis and holding period in contributed property (a) Contributing partner’s tax basis and holding period in contributed property carries over to the partnership. (b) Measuring both the partner’s outside basis and the partnership’s inside basis must be consistent with the entity theory of partnership taxation. (c) Partnerships generally take a basis in the property equal to the contributing partner’s basis in the property at the time of the contribution. (d) Whether gains or losses on dispositions of contributed property are capital or ordinary usually depends on the manner in which the partnership uses contributed property. (e) A new partnership would prepare its initial balance sheet using the tax basis for its assets. It would also create a tax capital account for each new partner, reflecting the tax basis of any property contributed and cash contributions. (f) A partnership’s tax basis balance sheet can provide useful tax-related information.

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al. (g) Partners set up §704(b) capital accounts in much the same way as tax capital accounts, except that §704(b) capital accounts reflect the fair market value rather than the tax basis of contributed assets. §704(b) capital accounts can be adjusted so they continue to reflect the fair market value of partners’ capital interests as accurately as possible and are a better measure of the true value of partner’s capital interests. (h) Work through Example 15-7. (i) Refer to Exhibit 15-2 for Color Comfort Sheets LLC. v) Contribution of services (1) Capital interests (a) The service partner’s tax basis in the capital interest he/she receives will equal the amount of ordinary income he recognizes, and his holding period will begin on the date he receives the capital interest. (b) The partnership either deducts or capitalizes the value of the capital interest, depending on the nature of the services the partner provides. (c) When the partnership deducts the value of capital interests used to compensate partners for services provided, it allocates the deduction only to the nonservice partners because they have effectively transferred a portion of their partnership capital to the service partner. (d) Work through Example 15-8.

(2) Profits interests (a) Service partners receiving profits interests do not report ordinary income. (b) The only economic benefit they provide is the right to share in the future profits of the partnership. (c) They have no liquidation value at the time they are received. (d) Nonservice partners generally prefer to compensate service partners with profits interests because they don’t have to forgo their current share of capital in the partnership and don’t have to give up anything if the partnership is ultimately unprofitable. (e) As there is no immediate liquidation value associated with a profits interest, the service partner will not recognize income and the nonservice partners will not receive deductions. (f) Work through Examples 15-9 and 15-10.

(3) Organizational, start-up, and syndication costs b) Acquisitions of partnership interests i) Refer to Exhibit 15-3 for Summary of Partner’s Outside Basis and Holding Period by Acquisition Method. ii) Work through Example 15-11.

3) Partnership Accounting: Tax Elections, Accounting Periods, and Accounting Methods a) Tax elections i) The partnership tax rules rely on the entity theory of partnership taxation and make the partnership responsible for tax elections. ii) The partnership makes other tax elections by filing a request with the IRS, such as Form 3115 to change an accounting method. iii) Work through Example 15-12. b) Accounting periods i) Required year-ends (1) Results in tax deferral for some or all of the partners.

(2) Refer to Exhibit 15-4 for Partner Defers 11 Months of Income for One Year.

(3) The government’s desire to reduce the aggregate tax deferral of partners provides the underlying rationale behind the rules requiring certain partnership taxable year-ends.

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(4) The majority interest taxable year is the taxable year of one or more partners who together own more than 50 percent of the capital and profits interests in the partnership.

(5) Under the principal partners test, the required tax year is the taxable year the principal partners all have in common and principal partners are those have 5 percent or more interest in the partnership profits and capital.

(6) The tax year with the least aggregate deferral is the one among the tax years of the partners that provides the partner group as a whole with the smallest amount of aggregate tax deferral.

(7) Work through Example 15-13. c) Accounting methods i) Partnerships may not use the cash method under certain conditions as it facilitates the deferral of income and acceleration of deductions. If partnerships’ average annual gross receipts for the three prior taxable years are less than $27 million, partnerships with C corporation partners may use the cash method if they otherwise qualify. ii) Work through Example 15-14.

4) Reporting the Results of Partnership Operations a) Persons carrying on business as partners shall be liable for income tax only in their separate or individual capacities. b) Ordinary business income (loss) and separately stated items i) Partnerships file annual information returns reporting their ordinary business income (loss) and separately stated items. ii) Ordinary business income (loss) = Partnership overall income or loss exclusive of separately stated items. iii) Separately stated items change partners’ tax liabilities according to each partner’s unique situation. iv) Refer to Exhibit 15-6 for Common Separately Stated Items. v) Work through Examples 15-15 and 15-16. vi) Guaranteed payments (1) Guaranteed payments are separately stated items, are treated as ordinary income by partners receiving them, and are either capitalized or expensed by partnerships.

(2) Guaranteed payments for services are always treated as self-employment income.

(3) Refer to Exhibit 15-7 for Color Comfort Sheets LLC. (4) Work through Example 15-17. vii) Self-employment tax (1) Shares of ordinary business income (loss) are always treated as self-employment income (loss) by general partners and never treated as self-employment (loss) by limited partners.

(2) Shares of ordinary business income (loss) may or may not be treated by LLC members as self-employment income (loss), depending on the extent of their involvement with the LLC. (3) Work through Examples 15-18 and 15-19. c) Limitation on Business Interest Expense i) A partnership’s deduction for business interest is limited to its business interest income plus 30 percent of its adjusted taxable income for the year. ii) Any disallowed business interest expense is allocated to the partners, reducing their basis in their partnership interests. iii) Partners carry forward their share of disallowed business interest expense until the partnership has excess business interest expense limitation to allocate to the partners. iv) The limitation on the deduction for business interest only applies to partnerships with average annual gross receipts for the prior three years greater than $27 million (indexed for inflation). d) Deduction for Qualified Business Income (QBI)

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Noncorporate partners may generally deduct 20 percent of the qualified business income allocated to them. ii) Qualified business income does not include a partnership’s income from specified service trade or businesses, and investment income such as capital gains, dividends, and investment interest income. iii) Qualified business income does not include partners’ guaranteed payments. iv) Partnerships must disclose, for each qualified trade or business, any information the partners require in order to calculate any limitation on QBI deduction. e) Net investment income tax i) A partner’s share of gross income from interest, dividends, annuities, royalties, or rents is included in the partner’s net investment income when calculating the net investment income tax. ii) A partner’s share of business income from a trade or business that is a passive activity and net gain from the sale of property other than property used in an active trade or business is also included in the partner’s net investment income. f) Allocating partners’ shares of income and loss i) Tremendous flexibility in allocating overall profit and loss as well as specific items of profit and loss to partners, as long as partners agree to the allocations and they have “substantial economic effect.” ii) Tax regulations presume the partners’ interests to be equal on a per capita basis but allow consideration for other factors reflecting the partners’ economic arrangement, such as their capital contributions, distribution rights, and interests in economic profits and losses. iii) Partnership allocations inconsistent with partners’ capital interests or overall profit-and-losssharing ratios are called special allocations. g) Work through Example 15-20. h) Partnership compliance issues i) Refer to Exhibit 15-8 (PART I) for Page 1 Form 1065. ii) Refer to Exhibit 15-8 (PART II) for Page 3 Form 1065. iii) Refer to Exhibit 15-8 (PART III) for 2019 Schedule K-1 for Sarah Walker (on 2018 forms) CCS Operates as an LLC. 5) Partner’s Adjusted Tax Basis in Partnership Interest a) A partner will increase the tax basis in her partnership interest for: i) Contributions ii) Share of ordinary business income iii) Separately stated income/gain items iv) Tax-exempt income b) A partner will decrease the tax basis in his/her partnership interest for: i) Cash distributions ii) Share of nondeductible expenses iii) Share of ordinary business loss iv) Separately stated expense/loss items c) A partner’s tax basis may not be negative. d) Work through Examples 15-21 and 15-22. e) Cash distributions in operating partnerships i) Even after a partnership has been formed, partners are likely to continue to receive actual and deemed cash distributions. ii) If cash is distributed when partners have a positive tax basis in their partnership interests, the distribution effectively represents: (1) A distribution of profits that have been previously taxed.

(2) A return of capital previously contributed by the partner to the partnership.

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(3) A distribution of cash the partnership has borrowed.

(4) A combination of the three given above. iii) Work through Example 15-23.

6) Loss Limitations a) Tax-basis limitation i) Partnership losses in excess of a partner’s tax basis are suspended and carried forward until additional basis is created. ii) A partner’s basis represents the amount a partner has invested in a partnership and it limits the amount of partnership losses the partner can use to offset other sources of income. iii) Partners may create additional tax basis in the future by making capital contributions, by guaranteeing more partnership debt, and by helping their partnership to become profitable. iv) Work through Example 15-24. b) At-risk limitation i) Remaining partnership losses are further suspended by the at-risk rules to the extent a partner is allocated nonrecourse debt not secured by real property. ii) Partners apply the at-risk limitation after the tax-basis limitation. iii) Work through Example 15-25. c) Passive activity loss limitation i) Passive activity loss (PAL) rules: these rules were enacted as a backstop to the at-risk rules and are applied after the tax-basis and at-risk limitations. ii) It limits the ability of partners in rental real estate partnerships and other partnerships they don’t actively manage from using their ordinary losses from these activities (remaining after the application of the tax basis and at-risk limitations) to reduce other sources of taxable income.

(1) Passive activity defined (a) The passive activity rules define a passive activity as “any activity which involves the conduct of a trade or business, and in which the taxpayer does not materially participate.” (b) Participants in all other activities are passive unless their involvement in an activity is “regular, continuous, and substantial.”

(2) Refer to Exhibit 15-9 for Tests for Material Participation. iii) Income and loss baskets (1) Losses from the passive basket are not allowed to offset income from other baskets.

(2) The three baskets are: (a) Passive activity income or loss. (b) Portfolio income. (c) Active business income.

(3) Refer to Exhibit 15-10 for Income and Loss Baskets.

(4) Work through Examples 15-26 and 15-27. d) Excess Business Loss Limitation i) Partnership losses otherwise deductible under the basis, at-risk, and passive loss rules are only deductible by noncorporate partners to the extent of their other trade or business income for the year plus a threshold amount. ii) The threshold amount is a function of the noncorporate partner’s filing status and is indexed for inflation.

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Class Activities 1. Suggested class activities o

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Elimination: Develop several multiple-choice questions (A, B, C answers) or draw questions from the test bank relating to important topics from the chapter. Have each class member write the letters A, B, and C on separate sheets of paper. Have the entire class stand up. When you ask a question, have each class member hold up their appropriate response to the question (A, B, or C).

Those who miss must sit down. Continue until you have asked all your questions or until all but one student has been eliminated. Award bonus points (or acknowledgment of a job well done) to those still standing.

Comprehensive problems: Have students work in groups (two to four students) to complete a comprehensive problem (problems 80 and 82 focus on determining partners’ shares of ordinary business income and separately stated items while problem 81 focuses more on partner loss limitations). Make yourself available to students to answer questions but try to get them to work together to resolve their questions. You could choose one question (“what does the partner report?” or “how much loss is deductible currently?”) for students to report to you. You can write the answer from each group on the board and then reveal the correct answer. Give credit to the group(s) that is (are) correct/closest.

Partnership or LLC agreement activity: Obtain a redacted partnership or LLC agreement from a local CPA firm. Bring the agreement to class and assign students to work in groups (two to four students) to analyze a provision in the tax section of the agreement and describe how it relates to material you are discussing from the chapter. After sufficient time has passed, have the groups report their findings to the rest of the class. Use this activity to reinforce concepts already learned and to introduce new concepts as well.

Web activity: Have students use their laptops to search for promotional materials on master limited partnerships or hedge fund partnerships. Use this material to help them understand that some partnerships may have many partners. Students typically think of partnerships as being closely held with just a few partners.

Ethics activity: See the ethics discussion points below, then refer students to the situation discussed in the ethics box in the chapter and solicit their input. Time permitting, have them find authority to support their positions. At a minimum, they should locate Reg. §1.469-5T(f)(4), which provides the following: “The extent of an individual’s participation in an activity may be established by any reasonable means. Contemporaneous daily time reports, logs, or similar documents are not required if the extent of such participation may be established by other reasonable means. Reasonable means for purposes of this paragraph may include but are not limited to the identification of services performed over a period of time and the approximate number of hours spent performing such services during such period, based on appointment books, calendars, or narrative summaries.” Conclude by asking students how they would advise Carlo if he were their client.

2. Ethics discussion From page 15-34:

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Discussion points:    

For Carlo to deduct his share of the loss this year, he must establish that he worked more than 500 hours in the business this year.

Refer students to Reg. Sec. 1.469-5T(f)(4), which allows taxpayers to “approximate” the number of hours of work performed based on appointment books or calendars.

Ask students if they believe Carlo’s process for approximating his time spent is sufficiently precise to allow him to claim he worked more than 500 hours during the year.

Finally, if most students believe Carlo meets the requirement, ask what process for documenting time spent would not be acceptable to the IRS or the courts. Note that the courts have typically not accepted a taxpayer’s oral testimony without supporting evidence.

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Chapter 16 Dispositions of Partnership Interests and Partnership Distributions INSTRUCTOR’S MANUAL

Learning Objectives 16-1. Determine the tax consequences to the buyer and seller of the disposition of a partnership interest, including the amount and character of gain or loss recognized.

16-2. List the reasons for distributions, and compare operating and liquidating distributions.

16-3. Determine the tax consequences of proportionate operating distributions.

16-4. Determine the tax consequences of proportionate liquidating distributions.

16-5. Explain the significance of disproportionate distributions.

16-6. Explain the rationale for special basis adjustments, determine when they are necessary, and calculate the special basis adjustment for dispositions and distributions.

Teaching Suggestions This chapter provides an overview of partnership dispositions (i.e., sales of partnership interests) and distributions. In the distribution area, the chapter focuses primarily on proportionate operating and liquidating distributions; however, disproportionate distributions are discussed without going into great depth. In addition, the chapter briefly discusses special basis adjustments under §754 and the general treatment when an adjustment arises from sales of partnership interests and distributions. One objective of the chapter is to provide a fundamental structure for thinking about these issues so that students may ultimately use their knowledge to engage in more complicated tax planning involving partnerships.

It seems reasonable to expect that much of the time spent covering this chapter will be on the distribution area. To that end, the chapter provides a structure of five different scenarios to illustrate the consequences of distributions of cash, hot assets, and other property when the partner’s basis is either greater or less than the amount of the distribution. These scenarios can be useful to help students understand the key factors (type of assets distributed and amount of distribution relative to partnership basis) that determine the tax treatment of these transactions.

In teaching the chapter, you may want to highlight the important differences in partner tax consequences if a partner exits his/her interest in a partnership by selling the interest or by receiving a liquidating distribution. The chapter provides an extended example to use as an illustration of these differences and how individual partners may place differing weights on the tax consequences from each alternative to arrive at a decision about which alternative is best for their situation.

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Assignment Matrix

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P16-42 P16-43 P16-44 P16-45 P16-46 P16-47 P16-48 P16-49 P16-50 P16-51 P16-52 P16-53 P16-54 P16-55 P16-56 P16-57 P16-58 P16-59 P16-60 CP16-61 CP16-62 CP16-63

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Lecture Notes 1) Basics of Sales of Partnership Interests a) Seller issues (1) Realized gain or loss = Cash and fair market value of property received plus debt relief − Basis in partnership interest (2) Work through Example 16-1.

(3) Hot assets (a) A portion of the gain or loss will be ordinary if a seller realizes any amounts attributable to unrealized receivables or inventory items, which are referred to as hot assets. (b) The process for determining the gain or loss follows: (i) Step 1: Total gain or loss = Amount realized − Outside basis (ii) Step 2: Calculate the partner’s share of gain or loss from hot assets as if the partnership sold these assets at their fair market value. This represents the ordinary portion of the gain or loss. (iii) Step 3: Capital gain or loss from the sale = Step 1 − Step 2 (c) Work through Examples 16-2, 16-3, 16-4, and 16-5. b) Buyer and partnership issues i) Outside basis = cost of the partnership interest + share of partnership’s liabilities. ii) Inside basis—selling partner’s inside basis at sale date. iii) No changes to partnership asset bases (unless §754 election is in effect). iv) Tax year closes with respect to selling partner. v) Work through Examples 16-6, 16-7, 16-8, and 16-9.

2) Basics of Partnership Distributions

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ii)

a) Partners often receive distributions of the partnership profits, known as operating distributions. b) Partners may also receive liquidating distributions. Because the market for partnership interests is much smaller than for publicly traded stock, partners may have a difficult time finding buyers for their interests. c) Liquidating distributions are similar to corporate redemptions of a shareholder’s stock. d) Operating distributions i) Operating distributions of money only (1) Partners generally do not recognize gain or loss. One exception occurs when the partnership distributes money only and the amount is greater than the partner’s outside basis.

(2) Work through Examples 16-10 and 16-11. ii) Operating distributions that include property other than money (1) Partners generally take a carryover basis in the distributed assets.

(2) If the partnership distribution includes other property and the combined inside basis is greater than the partner’s outside basis, the bases of the other property distributed will be reduced.

(3) In general, partners reduce outside basis by money and other property distributed.

(4) Work through Examples 16-12, 16-13, and 16-14. e) Liquidating distributions i) The tax issues in liquidating distributions for partnerships are basically twofold: (1) To determine whether the terminating partner recognizes gain or loss and (2) To reallocate his or her entire outside basis to the distributed assets. ii) The rationale behind the rules for liquidating distributions is simply to replace the partner’s outside basis with the underlying partnership assets distributed to the terminating partner. iii) Gain or loss recognition in liquidating distributions (1) Generally (a) Partners and partnerships do not recognize gain or loss.

(2) Exceptions (a) Gain: Partner recognizes gain when partnership distributes money and the amount exceeds the partner’s outside basis in the partnership interest. (b) Loss: Partner recognizes loss when two conditions are met: (i) Distribution consists of only cash and hot assets. (ii) The partner’s outside basis exceeds the sum of the bases of the distributed assets. iv) Basis in distributed property (1) Refer to Exhibit 16-1 for Alternative Scenarios for Determining Basis in Distributed Property. f) Partner’s outside basis is greater than inside basis of distributed assets i) Scenarios (1) Scenario 1: Distributions of money, inventory, and /or unrealized receivables. (a) Work through Example 16-16.

(2) Scenario 2: Other property included in distributions. (a) Work through Examples 16-17 and 16-18. g) Partner’s outside basis is less than inside bases of distributed assets i) Scenarios (1) Scenario 3: Distributions of money only.

(2) Scenario 4: Distributions of money, inventory, and/or unrealized receivables. (a) Work through Examples 16-19 and 16-20.

(3) Scenario 5: Other property included in distributions. (a) Work through Example 16-21.

Character and holding period of distributed assets (a) Work through Examples 16-22 and 16-23.

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3) Disproportionate distributions a) Both operating and liquidating distributions can be disproportionate distributions. b) When distribution changes a partner’s relative share of unrealized appreciation or losses in a partnership’s hot assets. c) It helps to prevent partners from converting ordinary income into capital gains through distributions. d) Partner and partnership must treat distribution as a sale or exchange, which may change the character and timing of income or losses that are recognized. e) Work through Example 16-24.

4) Special Basis Adjustments a) The tax rules allow the partnership to make an election for a special basis adjustment to eliminate discrepancies between the inside and outside bases and correct the artificial income or loss at the partnership level. b) It is elective with a §754 election in effect and: i) When a new investor purchases a partnership interest, or ii) When a partner recognizes a gain or loss in a distribution, or iii) When a partner takes a basis in distributed property that differs from the partnership basis in the property. c) It is mandatory: i) When a partner sells a partnership interest and the partnership has a substantial built-in loss at the time of sale, or ii) When a partnership has a substantial basis reduction from a distribution. d) It helps to prevent partners from being temporarily overtaxed or undertaxed after a partnership interest is transferred or after a distribution occurs. e) Work through Example 16-25. f) Refer to Exhibit 16-2 for Special Basis Adjustments. g) Special basis adjustments for dispositions i) It must be allocated to the assets under allocation rules in §755. h) Special basis adjustments for distributions i) A positive basis adjustment will increase the basis in the partnership assets: (1) When a partner receiving distributed property recognizes a gain on the distribution, and (2) When a partner receiving distributed property takes a basis in the property less than the partnership’s basis in the property. The positive adjustment will equal the sum of the gain recognized by the partners receiving distributed property and the amount of the basis reduction. ii) A negative basis adjustment will decrease the basis in partnership assets: (1) When a partner receiving distributed property in a liquidating distribution recognizes a loss on the distribution, and (2) When a partner receiving distributed property takes a basis in the property greater than the partnership’s basis in the property. The negative adjustment will equal the sum of the recognized loss and the amount of the basis increase made by the partners receiving the distribution.

Class Activities 1. Suggested class activities o

One versus the class: Have one student volunteer as the “one” with the other class members being the “group.” Use the Key Facts boxes in the text to develop multiple-choice questions (A, B, C answers) and then quiz the volunteer and the class on the questions. The volunteer and each

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class member will need to write the letters A, B, and C on separate sheets of paper and then hold up their appropriate response to the question. Once a student (either the “one” or a member of the “group”) misses a question, he or she is eliminated from the competition. After six (or some other number) questions, those students left standing receive bonus participation points for the day.

Group teaching liquidating distributions: Divide the class into five groups. These groups will each be assigned to one of the five scenarios in Exhibit 16-1. Essentially, each group will be responsible for “teaching” the remaining groups the material necessary for understanding the tax consequences in their particular scenario. Give the groups 10–15 minutes to read their material and prepare their presentation for discussion. Ask each group to present their scenario to the class. Each of the non-presenting groups should be responsible for asking one to two questions of the presenting group during their presentation time. After all groups have presented, the instructor should do a quick five-minute summary of the topic.

Disposition or distribution? Using the facts in Example 16-22 (or another similar set of facts) have half of the class determine the tax consequences if the partner sells his/her partnership interest and the other half determine the tax consequences if the partner receives a liquidating distribution from the partnership. Have a volunteer from each half present their results. Then have the students engage in a discussion about which structure they would recommend and why.

Ethics discussion: Have students refer to the Ethics box included in the chapter. Ask them why the valuation of hot assets would matter to Sarah. Discuss how valuation concerns are applicable in this area as well as in other areas. Solicit student’s opinions and add your own thoughts and insights. See the ethics discussion points above.

2. Ethics discussion From page 16-7:

Discussion points: 

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Reg. Sec. 1.751-1(a)(2) requires that Sarah’s ordinary gain or loss be determined through a deemed sale of the partnership’s hot assets at its “fair market value.” Further, Reg. Sec. 1.7511(a)(3) requires that Sarah attach a separate statement to her return supporting her calculation of gain or loss attributable to the partnership’s hot assets. Thus, if the dollar amounts involved are material, the transaction will likely invite IRS scrutiny.

Ask students which appraisal they would use and why two appraisals could be different.

Finally, conclude by pointing out that valuations issues frequently come up in tax practice and that taxpayers are not necessarily obligated to use an appraisal that favors the government.

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However, emphasize that taxpayers should only rely on appraisals that are reasonable given the facts and circumstances.

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Chapter 17 S Corporations INSTRUCTOR’S MANUAL

Learning Objectives 17-1. Describe the requirements and process to elect S corporation status.

17-2. Explain the events that terminate the S corporation election.

17-3. Describe operating issues relating to S corporation accounting periods and methods, and explain income and loss allocations and separately stated items.

17-4. Explain stock-basis calculations, loss limitations, determination of self-employment income, and fringe benefit rules that apply to S corporation shareholders.

17-5. Apply the tax rules for S corporation operating distributions and liquidating distributions.

17-6. Describe the taxes that apply to S corporations, estimated tax requirements, and tax return filing requirements.

Teaching Suggestions Throughout this chapter, we highlight the tax similarities between S corporations and C corporations and between S corporations and partnerships, while focusing on the unique rules that apply to S corporations.

This chapter provides a great opportunity to review corporate and partnership tax rules and to revisit entity selection.

In teaching this chapter, the time that you spend in class will vary based on how much depth you want to cover on the more complex topics that are unique to S corporations such as the built-in gains tax, excess net passive income tax, LIFO recapture tax, and the post-termination transition period loss deductions and distributions. The remaining topics in the chapter either are less technical (e.g., S corporation qualification requirements) or have a lot of overlap with material covered in the prior C corporation chapters (e.g., corporate formations) or partnership chapters (e.g., basis computation).

Key points that you may wish to make sure students are clear on:  Liabilities are not included in the shareholder’s stock basis.  A shareholder’s stock basis may not be negative.  Shareholder loans to the corporation may create debt basis that can absorb losses but do not protect distributions from taxation.  Allocations of business income to shareholders are not subject to FICA or self-employment tax.  The S corporation designation is a tax designation only—not a legal designation.  The tax rules for many items are more complex for S corporations that were formerly C corporations with earnings and profits.

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Assignment Matrix

DQ17-1 DQ17-2 DQ17-3 DQ17-4 DQ17-5 DQ17-6 DQ17-7 DQ17-8 DQ17-9 DQ17-10 DQ17-11 DQ17-12 DQ17-13 DQ17-14 DQ17-15 DQ17-16 DQ17-17 DQ17-18 DQ17-19 DQ17-20 DQ17-21 DQ17-22 DQ17-23 DQ17-24 DQ17-25 DQ17-26 DQ17-27 DQ17-28 DQ17-29 DQ17-30 DQ17-31 DQ17-32 DQ17-33 DQ17-34 DQ17-35 DQ17-36 DQ17-37

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al.

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al.

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Lecture Notes 1) S Corporation Elections a) Formations b) S corporation qualification requirements i) Only U.S. citizens or residents, estates, certain trusts, and certain tax-exempt organizations may be S corporation shareholders. ii) S corporations may have no more than 100 shareholders. iii) For purposes of the 100-shareholder limit, family members and their estates count as only one shareholder. iv) Work through Example 17-1. c) S corporation election i) An eligible corporation must make an affirmative election to be treated as an S corporation. ii) Work through Example 17-2. iii) To elect S corporation status, the corporation makes a formal election using Form 2553. iv) Work through Example 17-3. v) Even when the corporation makes the election by the 15th day of the third month of its tax year, the election will not be effective until the subsequent year if: (1) The corporation did not meet the S corporation requirements for each day of the current tax year before it made the S election, or (2) One or more shareholders who held the stock in the corporation during the current year and before the S corporation election was made did not consent to the election. vi) Eligible corporations meet the type and number of shareholder requirements, are domestic corporations, are not specifically identified as ineligible corporations, and have only one class of stock. vii) Work through Example 17-4.

2) S Corporation Terminations a) Voluntary terminations i) The S election may be revoked by shareholders holding more than 50 percent of the S corporation stock (including nonvoting shares). ii) Work through Example 17-5. b) Involuntary terminations i) Failure to meet requirements (1) A corporation’s S election is automatically terminated if the S corporation fails to meet the S corporation requirements.

(2) The S election is terminated effective on the date it fails the S corporation requirements.

(3) Work through Example 17-6. ii) Excess of passive investment income (1) If an S corporation has earnings and profits from a previous C corporation year (or through a reorganization with a corporation that has earnings and profits), its election is terminated if the S corporation has passive investment income in excess of 25 percent of gross receipts for three consecutive years.

(2) Passive investment income (PII) includes gross receipts from royalties, rents, dividends, interest, and annuities.

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al.

(3) S corporation election terminations due to excess passive investment income are effective on the first day of the year following the third consecutive tax year with excess passive investment income.

(4) Work through Example 17-7. c) Short tax years i) Work through Example 17-8. d) S corporation reelections i) If the election was terminated effective the first day of the tax year, the corporation must wait five full years to again become an S corporation. ii) Work through Example 17-9.

3) Operating Issues a) Accounting methods and periods i) S corporations must use a calendar year-end unless they can establish a business purpose for an alternative year-end or a natural business year-end. b) Income and loss allocations i) S corporations, like partnerships, are flow-through entities, and thus their profits and losses flow through to their shareholders annually for tax purposes. ii) S corporations allocate profits and losses to shareholders pro rata, based on the number of outstanding shares each shareholder owns on each day of the tax year. iii) Work through Example 17-10. c) Separately stated items i) Separately stated items are tax items that are treated differently from a shareholder’s share of ordinary business income (loss) for tax purposes. ii) Refer to Exhibit 17-1 for Common Separately Stated Items. iii) S corporations may hold stock in C corporations, and any dividends S corporations receive will flow through to their shareholders. iv) Refer to Exhibit 17-2 for Color Comfort Sheets Income Statement, December 31, 2022 and 2023. v) Work through Example 17-11.

4) Shareholder’s Basis a) A shareholder will increase the tax basis in his/her stock for: i) Contributions ii) Share of ordinary business income iii) Separately stated income/gain items iv) Tax-exempt income b) A shareholder will decrease the tax basis in his/her stock for: i) Cash distributions ii) Share of nondeductible expenses iii) Share of ordinary business loss iv) Separately stated expense/loss items c) A shareholder’s tax basis may not be negative. d) Initial basis i) Specifically, the shareholder’s basis in stock received in the exchange equals the tax basis of the property transferred, less any liabilities assumed by the corporation on the property contributed (substituted basis). ii) Work through Example 17-12. e) Annual basis adjustments i) Specifically, an S corporation shareholder’s stock basis is dynamic and must be adjusted annually to ensure that: (1) Taxable income/gains and deductible expenses/losses are not double-counted by shareholders either when they sell their shares or receive S corporation distributions and 17-5

Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al.

(2) Tax-exempt income and nondeductible expenses are not ultimately taxed or deducted. ii) Work through Example 17-13. f) Loss limitations i) Tax-basis limitation (1) Losses not deductible due to the tax-basis limitation are not necessarily lost. Rather, they are suspended until the shareholder generates additional basis.

(2) If the shareholder sells the stock before creating additional basis, the suspended loss disappears unused.

(3) Work through Example 17-14.

(4) Shareholders can mitigate the disadvantage of not including S corporation debt in their stock basis by loaning money directly to their S corporations. These loans create debt basis, separate from the stock basis.

(5) Work through Example 17-15. ii) At-risk limitation (1) S corporation shareholders are deemed at risk only for direct loans they make to S corporations.

(2) With one notable exception, an S corporation shareholder’s at-risk amount is the same as their stock basis. iii) Post-termination transition period loss limitation (1) PTTP begins on the day after the last day of the corporation’s last taxable year as an S corporation and ends on the later of (a) one year after the last S corporation day or (b) the due date for filing the return for the last year as an S corporation (including extensions).

(2) Work through Example 17-16. iv) Passive activity loss limitation (1) As in partnerships, the passive activity loss rules limit the ability of S corporation shareholders to deduct losses unless they are involved in actively managing the business.

(2) Work through Example 17-17. v) Excess business loss limitation (1) Taxpayers are not allowed to deduct an “excess business loss” for the year.

(2) An excess business loss for the year is the excess of aggregate business deductions for the year over the sum of aggregate business gross income or gain of the taxpayer plus a threshold amount.

(3) The provision applies at the shareholder level. vi) Self-employment income (1) S corporation shareholders may desire to avoid payroll taxes by limiting or even eliminating their salary payments. However, if they work as employees, they are required to pay themselves a reasonable salary for the services they perform. vii) Net investment income tax (1) S corporation shareholders are subject to the net investment income tax on their share of an S corporation's gross income from interest, dividends, annuities, royalties, rents, a trade or business that is a passive activity or a trade or business of trading financial instruments or commodities, and generally any net gain from disposing of property, less any allowable deductions from these items. viii) Fringe benefits (1) For shareholder-employees who own 2 percent or less of the entity, the S corporation receives C corporation tax treatment.

(2) For shareholder-employees who own more than 2 percent of the S corporation, it receives partnership treatment.

5) Distributions a) Operating distributions i) S corporation with no C corporation accumulated earnings and profits 17-6

Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al.

(1) Two sets of historical circumstances could apply here: (a) An entity may have been an S corporation since inception, or (b) It may have been converted from a C corporation but does not have C corporation accumulated earnings and profits at the time of the distribution.

(2) Shareholder distributions are tax-free to the extent of the shareholder’s stock basis.

(3) If a distribution exceeds the shareholder’s stock basis, the shareholder has a capital gain equal to the excess distribution amount.

(4) Work through Example 17-18. ii) S corporations with C corporation accumulated earnings and profits (1) For S corporations, the tax laws require the corporation to maintain an accumulated adjustments account (AAA) to determine the taxability of S corporate distributions.

(2) Unlike a shareholder’s stock basis, the AAA may have a negative balance.

(3) End of year AAA formula = (The beginning of year AAA balance + Separately stated income/gain items (excluding tax-exempt income) + Ordinary income − Separately stated losses and deductions − Ordinary losses − Nondeductible expenses that are not capital expenditures (except deductions related to generating tax-exempt income) − Distributions out of AAA) (4) Work through Example 17-19.

(5) Once an S corporation’s accumulated E&P is fully distributed, the remaining distributions reduce the shareholder’s remaining basis in the S corporation stock (if any) and are nontaxable.

(6) Work through Example 17-20. b) Property distributions i) S corporations recognize gains but not losses when they distribute property to their shareholders. ii) The rules for determining the taxability of property distributions at the shareholder level are the same as those for cash distributions. iii) For shareholders, the amount of the distribution is the fair market value of the property received (minus any liabilities the shareholder assumes on the distribution). iv) Shareholders take a fair market value basis in the property received in the distribution. v) Work through Example 17-21. c) Post-termination transition period distributions i) The PTTP for post-termination distributions is generally the same as the PTTP for deducting suspended losses. ii) Special rules apply for distributions after the PTTP for eligible terminated S corporations. d) Liquidating distributions i) Shareholders recognize gain on the distribution if the value of the property exceeds their stock basis; they recognize loss if their stock basis exceeds the value of the property. ii) Work through Example 17-22.

6) S Corporation Taxes and Filing Requirements a) Built-in gains tax i) The built-in gains tax applies only to S corporations that have a net unrealized built-in gain at the time they converted from C corporations and that recognize net built-in gains during their first five years operating as an S corporation. ii) The net unrealized built-in gain represents the net gain (if any) that the corporation would recognize if it sold each asset at its fair market value. iii) Work through Example 17-23. iv) Recognized built-in gains (losses) include the gain (loss) for any asset sold during the year [limited to the unrealized gain (loss) for the specific asset at the S conversion date]. v) The net recognized built-in gain for any year is limited to the least of:

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al.

(1) The net of the recognized built-in gains and losses for the year.

(2) The net unrealized built-in gains as of the S election date less the net recognized built-in gains in previous years.

(3) The corporation’s taxable income for the year, using the C corporation tax rules exclusive of the dividends received deduction and net operating loss deduction. vi) After the net recognized built-in gain has been determined using the limitations above, it is reduced by any NOL or capital loss carryovers from prior C corporation years. This base is then multiplied by the highest corporate tax rate (21 percent) to determine the built-in gains tax. vii) Work through Example 17-24 b) Excess net passive income tax i) The excess net passive income tax applies only to S corporations that previously operated as C corporations and at the end of the year have accumulated earnings and profits from a prior C corporation year. ii) This tax applies when passive investment income exceeds 25 percent of gross receipts. iii) Passive investment income includes gross receipts from royalties, rents, dividends, interest (including tax-exempt interest), and annuities. iv) Excess net passive income tax = 21% × Excess net passive income v) Net passive investment income is passive investment income decreased by any expenses connected with producing that income. vi) Work through Example 17-25. c) LIFO recapture tax i) C corporations that elect S corporation status and use the LIFO inventory method are subject to the LIFO recapture tax. ii) The corporation pays the LIFO recapture tax in four annual installments. The first installment is due on or before the due date (not including extensions) of the corporation’s last C corporation tax return. The final three annual installments are due each year on or before the due date (not including extensions) of the S corporation’s tax return. iii) Work through Example 17-26. d) Estimated taxes i) S corporations owing the built-in gains tax or excess net passive investment income tax (but not the LIFO recapture tax) must pay the tax based on estimated tax rules similar to C corporations. ii) Refer to Exhibit 17-3 for Part I CCS’s Form 1120-S, page 1. iii) Refer to Exhibit 17-3 for Part II CCS’s 2023 partial Schedule K (2022 forms because 2023 forms were unavailable). e) Filing requirements i) S corporations file Form 1120-S to report the results of their operations for the year. They request a filing extension on Form 7004. ii) Refer to Exhibit 17-3 for Part III Nicole’s 2023 Schedule K-1 (2022 forms because 2023 forms were unavailable). f) Comparing C and S corporations and partnerships i) Refer to Exhibit 17-4 for Comparison of Tax Consequences for C and S Corporations and Partnerships.

7) Conclusion 8) Summary 9) Key Terms

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al.

Class Activities 1. Suggested class activities o

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Name that characteristic: This chapter provides a great opportunity to review corporate and partnership tax rules and to emphasize the unique rules for S corporations. One end-of-class exercise that an instructor can incorporate to emphasize the commonalities across entities and the unique features of S corporations is to use Exhibit 17-4 as the basis for a quiz or in-class game in which the instructor chooses a transaction or entity attribute (e.g., S corporation formation) and the students identify whether the S corporate treatment is primarily similar to C corporations or partnerships or is unique.

One versus the class: Have one student volunteer as the “one” with the other class members being the “group.” Use the Key Facts boxes in the text to develop multiple-choice questions (A, B, C answers) and then quiz the volunteer and the class on the questions. The volunteer and each class member will need to write the letters A, B, and C on separate sheets of paper and then hold up their appropriate response to the question. Once a student (either the “one” or a member of the “group”) misses a question, he or she is eliminated from the competition. After six (or some other number) of questions, those students left standing receive bonus participation points for the day.

Research activity: The end of the chapter provides several research questions that may be assigned to allow students to delve deeper into the rules for S corporations and to refine their research skills.

Comprehensive problems: Have students work in groups (two to four students) to complete a comprehensive problem (problem 86 is a good problem for students to compare the tax computation and reporting differences across entities; problems 83–85 are problems dealing with S corporations only). Make yourself available to students to answer questions but try to get them to work together to answer or resolve their questions. You could have students download forms from the IRS website. You could also walk through the C corporation solution before turning them loose on the S corporation and/or partnership portion.

2. Ethics discussion From page 17-5:

Discussion points: 

What requirement would Chance’s move violate with respect to CCS’s S corporation status?

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Instructor’s Manual – McGraw-Hill’s Taxation, by Spilker et al.   

What are the consequences if Sarah and Nicole ignore the impact on CCS’s S corporation status?

Would this action violate tax law? Would this action violate ethical standards?

If Sarah and Nicole pressure Chance to sell his stock, does this action violate tax law? Ethical standards?

From a planning perspective, could you provide CCS with advice as to how to avoid this issue in the future?

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