This Document Contains Chapters 10 to 12 Chapter 10 Property Acquisition and Cost Recovery 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 are set to begin phasing down 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. Assignment Matrix Learning Objectives Text Feature Difficulty LO 10-1 LO 10-2 LO 10-3 LO 10-4 LO 10-5 Research Planning Tax Forms DQ10-1 20 min. Medium X DQ10-2 20 min. Medium X DQ10-3 20 min. Medium X DQ10-4 20 min. Medium X DQ10-5 20 min. Medium X DQ10-6 20 min. Medium X DQ10-7 20 min. Medium X DQ10-8 20 min. Medium X DQ10-9 20 min. Medium X DQ10-10 20 min. Medium X X DQ10-11 20 min. Medium X DQ10-12 10 min. Medium X DQ10-13 10 min. Medium X X DQ10-14 10 min. Medium X DQ10-15 10 min. Medium X DQ10-16 10 min. Medium X DQ10-17 25 min. Hard X DQ10-18 25 min. Hard X DQ10-19 25 min. Hard X X DQ10-20 20 min. Hard X DQ10-21 20 min. Hard X DQ10-22 20 min. Hard X DQ10-23 20 min. Hard X DQ10-24 20 min. Hard X DQ10-25 20 min. Hard X DQ10-26 20 min. Hard X DQ10-27 20 min. Hard X DQ10-28 25 min. Hard X DQ10-29 25 min. Hard X DQ10-30 45 min. Easy X DQ10-31 45 min. Easy X DQ10-32 45 min. Easy X DQ10-33 45 min. Easy X DQ10-34 45 min. Easy X DQ10-35 45 min. Easy X DQ10-36 45 min. Hard X DQ10-37 45 min. Hard X P10-38 20 min. Easy X P10-39 20 min. Easy X X P10-40 20 min. Medium X X P10-41 20 min. Easy X P10-42 20 min. Easy X P10-43 20 min. Easy X P10-44 10 min. Easy X P10-45 10 min. Easy X P10-46 30 min. Medium X P10-47 30 min. Medium X P10-48 30 min. Medium X P10-49 30 min. Medium X X P10-50 25 min. Medium X P10-51 40 min. Hard X P10-52 25 min. Medium X P10-53 30 min. Medium X X P10-54 30 min. Medium X X P10-55 30 min. Medium X X P10-56 30 min. Medium X X P10-57 30 min. Medium X X P10-58 35 min. Medium X X P10-59 45 min. Medium X X X P10-60 30 min. Medium X X X P10-61 30 min. Medium X X P10-62 45 min. Hard X X X X P10-63 35 min. Hard X X X P10-64 30 min. Hard X X X P10-65 25 min. Medium X P10-66 35 min. Medium X P10-67 60 min. Hard X P10-68 45 min. Hard X X X P10-69 30 min. Hard X X P10-70 25 min. Medium X X P10-71 45 min. Hard X X P10-72 45 min. Hard X P10-73 45 min. Hard X P10-74 45 min. Hard X P10-75 45 min. Medium X CP10-76 75 min. Hard X CP10-77 75 min. Hard X CP10-78 75 min. Hard 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 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 (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 mid-quarter 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 (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 was 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 air-conditioning; 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) $1,040,000 of tangible personal property may be immediately expensed in 2020. (3) Businesses are eligible for the full amount of this expense when tangible personal property placed in service is less than $2,590,000 for 2020. Beginning at $2,590,000, the §179 expense is phased out, dollar for dollar. When assets placed in service exceed $3,630,000, no §179 expense can be taken. Both the amount of §179 allowed and the property limitation are indexed for inflation and will 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 are allowed to 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). (3) Work through Example 10-14. 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. However, the TCJA increased the percentage to 100 percent for qualified property acquired after September 27, 2017. (4) This provision (and the enhancement of §179) simplifies the depreciation calculation for many businesses because they can deduct the full amount of certain assets placed in service during the year. (5) Bonus depreciation is a temporary provision, and the percentage phases down after five years. (6) 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. (7) Refer to Exhibit 10-9 for Bonus Depreciation Percentages. (8) Qualified property (a) 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) and must meet one of the following requirements: (i) Have a regular depreciation life of 20 years or less, (ii) Computer software, (iii) Water utility property, or (iv) Qualified film, television, and live theatrical productions. (9) Work through Example 10-15. 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 10-16. 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 actually 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 prior-year 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 10-17. 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. (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 2020, taxpayers are allowed to expense $8,000 of bonus depreciation above the otherwise allowable maximum depreciation (maximum depreciation of $18,100). (6) Work through Example 10-18. (7) Automobiles and §179 (a) Businesses are allowed to deduct §179 expensing on luxury automobiles, but the luxury car limitation in 2020 is $10,100, 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 $50,500, the taxpayer doesn’t benefit by electing §179 because the regular MACRS depreciation deduction would be greater than $10,100 but would be limited to $10,100 anyway. (c) For cars that cost less than $50,500, taxpayers could benefit by electing to take $10,100 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 $18,100 in 2020. (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, technically, all of the allowable depreciation was taken in year 1 (100 percent bonus depreciation) even though the taxpayer was limited by the automobile limitations. This means that there is no regular depreciation remaining for years 2–6. (d) Fortunately, the IRS provides a way (safe harbor) for taxpayers to continue to take depreciation in years 2–6 when they claim bonus depreciation. This method applies to automobiles that have an initial basis greater than $18,100 (the first year depreciation limitation for luxury automobiles) when taxpayers have not elected out of 100 percent bonus depreciation. (9) Work through Examples 10-19 and 10-20. 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 2020 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 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 10-21. 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-for-dollar 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 10-22 to 10-25. 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 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 10-26. 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). e) Taxpayers may expense the larger of cost or percentage depletion. f) Work through Examples 10-27, 10-28, and 10-29. g) Refer to Exhibit 10-16 for Applicable Percentage Depletion Rates. 6) Conclusion 7) Appendix A: MACRS Tables 8) Summary 9) Key Terms Class Activities 1. Suggested class activities ○ 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. 110-289, §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). ○ Legislative Activity: The tax treatment for qualified improvement property is currently ambiguous due to the rapid passage of the TCJA. Qualified improvement property does not currently qualify for bonus depreciation; however, it was likely intended to qualify. Students could research this type of property to see why the legislative language does not allow for bonus depreciation. ○ 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. Chapter 11 Property Dispositions 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. Assignment Matrix Learning Objectives Text Feature Difficulty LO 1 LO 2 LO 3 LO 4 LO 5 LO 6 Research Planning Tax Forms DQ11-1 20 min. Medium X DQ11-2 20 min. Medium X DQ11-3 20 min. Medium X DQ11-4 20 min. Medium X DQ11-5 20 min. Medium X DQ11-6 20 min. Medium X DQ11-7 20 min. Medium X DQ11-8 20 min. Medium X DQ11-9 20 min. Medium X DQ11-10 20 min. Medium X DQ11-11 20 min. Medium X DQ11-12 10 min. Medium X DQ11-13 10 min. Medium X DQ11-14 10 min. Medium X DQ11-15 10 min. Medium X X DQ11-16 10 min. Medium X DQ11-17 25 min. Hard X DQ11-18 25 min. Hard X DQ11-19 25 min. Hard X DQ11-20 20 min. Hard X DQ11-21 10 min. Easy X DQ11-22 25 min. Hard X X DQ11-23 20 min. Hard X DQ11-24 20 min. Hard X DQ11-25 20 min. Hard X DQ11-26 20 min. Hard X DQ11-27 20 min. Hard X DQ11-28 25 min. Hard X DQ11-29 25 min. Hard X DQ11-30 25 min. Hard X DQ11-31 25 min. Hard X P11-32 30 min. Medium X P11-33 30 min. Medium X P11-34 20 min. Medium X P11-35 30 min. Medium X P11-36 20 min. Medium X X P11-37 30 min. Medium X X P11-38 30 min. Medium X X P11-39 20 min. Medium X P11-40 45 min. Hard X X P11-41 20 min. Medium X X P11-42 30 min. Medium X X P11-43 30 min. Medium X X P11-44 30 min. Medium X X P11-45 45 min. Hard X X X X P11-46 25 min. Medium X P11-47 30 min. Medium X P11-48 45 min. Hard X X X P11-49 45 min. Hard X X X P11-50 25 min. Medium X X P11-51 30 min. Medium X P11-52 30 min. Medium X X P11-53 45 min. Hard X P11-54 45 min. Hard X P11-55 30 min. Medium X P11-56 30 min. Medium X P11-57 30 min. Medium X X P11-58 30 min. Medium X X P11-59 30 min. Medium X X P11-60 45 min. Hard X P11-61 30 min. Medium X P11-62 45 min. Hard X P11-63 30 min. Medium X P11-64 30 min. Medium X P11-65 30 min. Medium X X P11-66 30 min. Medium X X P11-67 30 min. Medium X CP11-68 45 min. Hard X X X X X X CP11-69 45 min. Hard X X X X X X CP11-70 45 min. Hard X X X X X X X CP11-71 60 min. Hard X X X X X X X CP11-72 45 min. Hard X X X X X X X CP11-73 60 min. Hard X X X X X X X CP11-74 60 min. Hard X X X X X X 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 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. 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 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 non-depreciation 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 non-recaptured §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. 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 like-kind (§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 (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 10) Key Terms Class Activities 1. Suggested class activities ○ 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. • 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? Chapter 12 Compensation Learning Objectives 12-1. Determine the tax implications of compensation in the form of salary and wages from the perspective of the employee and the employer. 12-2. Describe the tax implications of various forms of equity-based compensation from the perspective of the employee and the employer. 12-3. Compare and contrast taxable and nontaxable fringe benefits and explain their tax consequences for the employee and employer. Teaching Suggestions This chapter is organized around issues dealing with current compensation. There are many topics in this chapter. The instructor may not wish to cover all topics. The tax implications of salary wages are important for students to understand. Whether for personal or professional purposes, compensation is a common topic of discussion, where at least a basic understanding is expected of accounting professionals. From an employee and employer perspective, understanding the after-tax value of the compensation or associated expense is a critical tax planning tool. Equity-based compensation is also important because it is an ever-increasing share of compensation. The form of equity compensation is also shifting from stock options toward restricted stock. There are several important planning considerations with respect to equity-based compensation. Students should understand the benefits of incentive stock options and the importance of a Section 83(b) election with respect to restricted stock. Some may choose not to cover fringe benefits in detail. At least an overview of fringe benefits can provide significant benefits to students who will likely be making many personal choices in the very near future. This knowledge can be useful in helping them maximize the after-tax value of their future compensation package. Proxy statements of publicly traded companies can provide some interesting in-class discussion regarding compensation and benefits. Encourage students to find one for a popular company like Apple. Have them identify whether the fringe benefits are taxable or tax-exempt. Assignment Matrix Learning Objectives Text Feature Difficulty LO1 LO2 LO3 Research Planning Tax Forms DQ12-1 20 min. Medium X DQ12-2 20 min. Medium X DQ12-3 10 min. Easy X DQ12-4 10 min. Easy X DQ12-5 10 min. Easy X DQ12-6 10 min. Easy X DQ12-7 10 min. Easy X DQ12-8 10 min. Easy X DQ12-9 10 min. Easy X DQ12-10 10 min. Easy X DQ12-11 10 min. Easy X DQ12-12 10 min. Easy X DQ12-13 10 min. Easy X DQ12-14 10 min. Easy X DQ12-15 10 min. Easy X DQ12-16 10 min. Easy X DQ12-17 10 min. Easy X DQ12-18 10 min. Easy X DQ12-19 10 min. Easy X DQ12-20 10 min. Easy X DQ12-21 10 min. Easy X DQ12-22 10 min. Easy X P12-23 20 min. Medium X P12-24 20 min. Medium X P12-25 20 min. Medium X P12-26 20 min. Medium X P12-27 25 min. Medium X X P12-28 45 min. Hard X X P12-29 45 min. Hard X P12-30 25 min. Medium X P12-31 25 min. Medium X P12-32 25 min. Medium X X P12-33 45 min. Hard X P12-34 30 min. Medium X P12-35 30 min. Medium X P12-36 25 min. Medium X P12-37 25 min. Medium X X P12-38 30 min. Medium X P12-39 25 min. Medium X X P12-40 30 min. Medium X X P12-41 20 min. Medium X X P12-42 20 min. Medium X X P12-43 30 min. Medium X P12-44 30 min. Medium X P12-45 45 min. Hard X P12-46 30 min. Medium X X P12-47 20 min. Medium X X P12-48 15 min. Medium X P12-49 20 min. Medium X X CP12-50 45 min. Hard X CP12-51 45 min. Hard CP12-52 45 min. Hard X CP12-53 30 min. Hard X Lecture Notes 1) Salary and Wages a) Compensation paid to employees in the form of salary and wages has tax consequences to both employees and employers. b) Employee considerations for salary and wages i) Employees receiving salary generally earn a fixed amount of compensation for the year no matter how many hours they work. ii) Salaried employees may be eligible for bonuses based on satisfying certain criteria. iii) Employees receiving wages generally get paid by the hour. iv) Salary, bonus, and wages are taxed to employees as ordinary income. v) At the end of each year, employees receive a Form W-2 from their employers, summarizing their salary or wage compensation and the various withholding amounts during the year. vi) Refer to Exhibit 12-1 for Form W-2. vii) Form W-2 (1) Summarizes an employee’s taxable salary and wages. (2) Provides annual federal and state withholding information. (3) Generated by employer on an annual basis. viii) Tax withholding (1) When employees begin employment with a firm, employees complete a Form W-4 to supply the information the firm needs to withhold the correct amount of tax from each paycheck. (2) Employees use Form W-4 to indicate: (a) Whether to withhold at the single rate or at the lower married rate, (b) The number of withholding or “personal” allowances the employee chooses to claim (the more personal allowances claimed, the less the withholding amount), and (c) Whether the employee wants an additional amount of tax withheld each period above the amount based on the number of allowances claimed. c) Employer considerations for salary and wages i) Deductibility of salary and wage payments (1) Employers may generally deduct reasonable compensation paid to employees. (2) Determining whether compensation is reasonable in amount is a facts and circumstances test that involves considering the duties of the employee, the complexities of the business, and the amount of salary compared with the income of the business, among other things. (3) The amount of salary in excess of the amount considered reasonable is not deductible. (4) Employers computing taxable income under the cash method of accounting generally deduct salary and wages when they pay the employee. (5) Employers computing taxable income under the accrual method generally deduct wages payable to employees as the employees earn the wages. (a) Compensation expense accrued at end of year is deductible in year accrued if: (i) Paid to an unrelated party. (ii) Paid within two and a half months of year-end. (b) Compensation expense accrued at end of year is deductible when paid if: (i) Paid to related party. (ii) Related party if employee owns more than 50 percent of corporate employer. (6) Work through Example 12-1. (a) The after-tax cost of providing this salary is generally much less than the before-tax cost, because the employer deducts the salary and associated FICA taxes paid. (b) The formula for computing the after-tax cost of the salary: Deductible expenditure × (1 − Marginal tax rate). (c) Work through Example 12-3.Limits on salary deductibility (i) $1,000,000 maximum annual compensation deduction per person. (ii) Limited—applies to CEO, CFO, three other highest compensated officers, and all covered employees from prior years even after the employment relationship ends. 2) Equity-Based Compensation a) Stock Options: Allows employees to purchase stock at a discount. b) Restricted Stock: Form of compensation that provides actual stock ownership to employee after restrictions lapse. c) It is used to motivate employees to take ownership in their companies. d) Refer to Exhibit 12-2 for Excerpt from Adobe’s 2019 Proxy Statement. e) It helps in bringing cash flow benefits to employers as well. f) Employers actually receive cash from their employees in the amount of the exercise price on the options exercised. g) There are a couple of downsides to this benefit: i) Employers experience the opportunity cost of selling shares at a discounted price to employees rather than selling the shares at fair market value on the open market. ii) Because employers must issue new shares to satisfy option exercises and stock grants, the total number of shares outstanding increases, and therefore, earnings per share are diluted, which is a detriment to existing shareholders. h) The only way for employers to mitigate this problem without increasing earnings is to use their cash reserves to acquire their own publicly traded shares to satisfy the options exercise. i) Stock Options i) Stock options differ from restricted stock in that employees must use cash to purchase employer stock once they are allowed to exercise the options, and there is a greater likelihood that options, which have expiration dates, will ultimately be worthless. ii) When stock options vest, employees are legally entitled to buy or exercise employer stock at a stipulated price, referred to as the exercise price or strike price. iii) The future value of stock option awards will depend on the exercise price, the company’s future share price, the exercise date of the options, and the timing for selling the shares received from the option exercise. iv) Work through Example 12-6. v) Work through Example 12-7. vi) Refer to Exhibit 12-3 for Sample Timeline for Nonqualified and Incentive Stock Options. vii) Employee tax considerations for stock options (1) The grant date is the date employees are initially allocated stock options. (2) The exercise date is the date that employees purchase stock using their options. (3) The exercise price is the amount paid to acquire shares with stock options. (4) The bargain element is the difference between the fair market value of stock and the exercise price on the exercise date. (5) The vesting date is the time when stock options granted can be exercised. (6) Incentive stock options (ISO) (a) ISOs satisfy certain tax code requirements to provide favorable tax treatment to employees. (b) Employees experience no tax consequences on the grant date or vesting date. (c) When they exercise ISOs, employees don’t report any income for regular tax purposes (as long as they don’t immediately sell their shares). (d) The holding period for stock acquired begins on the exercise date. (e) Work through Example 12-9. (i) Employees who acquire shares through the exercise of ISOs also have an additional tax benefit: if they hold such shares for at least two years after the grant date and one year after the exercise date, they will not be taxed until they sell the stock. (ii) When they sell, employees will treat the difference between the sale proceeds and the adjusted basis (the exercise price) as a long-term capital gain in the year of disposition. (7) Nonqualified stock options (NQO) (a) NQOs are any options that don’t meet the requirements for being classified as incentive stock options. (b) Employees experience no tax consequences on the grant date or vesting date. (c) When employees exercise nonqualified stock options, they report ordinary income equal to the total bargain element on the shares of stock acquired—whether they hold the shares or sell them immediately. (d) A taxpayer’s basis in NQOs acquired is the fair market value on the date of exercise. (e) The holding period for stock acquired begins on the exercise date. (f) When taxpayers exercise incentive stock options, the bargain element is added to their alternative minimum taxable income, which increases the likelihood that taxpayers exercising incentive stock options will be required to pay the alternative minimum tax—this is almost always true if the bargain element is large. (g) Employees who purchase stock with NQOs and retain the stock are in the same position for tax purposes as any other investor, their basis in the stock is the fair market value on the date they exercised the options (this is the exercise price of the stock plus the bargain element), and any future appreciation or depreciation of the stock will be treated for tax purposes as either short-term or long-term capital gain or loss depending on the holding period, which begins on the date of exercise. (h) Work through the Example 12-10. (i) Employees using NQOs to purchase employer stock are also in the same economic position as any other investor in that the value of the stock is subject to investment risk. (ii) To avoid overweighting their investment portfolios with a single stock, employees exercising nonqualified options often immediately sell all or a significant portion of the shares acquired on the exercise date, a practice referred to as a same-day sale. (iii) If the two-year and one-year requirements are not met, the premature sale of stock is classified as a disqualifying disposition, and the bargain element is taxed at the time of sale as if the option had been a nonqualified option. viii) Employer tax considerations for stock options (1) Nonqualified options (NQOs) (a) No tax consequences on grant date. (b) On exercise date, bargain element is treated as ordinary (compensation) income to employee. (i) Employee holds stock with holding period beginning on date of exercise. (c) Employers deduct bargain element as compensation expense on exercise date. (2) Incentive stock options (ISOs) (a) No tax consequences on grant date. (b) No tax consequences on exercise date if employee holds for two years after grant date and one year after exercise date. (i) If holding requirements are not met (if there is a disqualifying disposition), option becomes an NQO. (c) When employee sells stock, employee recognizes long-term capital gain on difference between selling price and exercise price. (d) No deduction for employers unless employee doesn’t meet holding requirements (3) Accounting issues (a) To increase the comparability of financial statements as well as to ensure that the true cost of stock options would be reflected in the financial statements, FASB mandated the expensing of stock options for financial accounting purposes for years beginning on or after January 1, 2006. (b) Work through the Example 12-13. ix) Stock option expense: GAAP versus tax (1) For tax purposes, employer deducts bargain element on exercise date. (2) For GAAP purposes, employer expenses the estimated value of the option pro rata over the vesting period. (3) Refer to Exhibit 12-4 for TPI’s Tax Deductions and Book Expense from Stock Option Grant to Julie. j) Restricted Stock i) Restricted stock can’t be sold or otherwise treated as owned by employees until they legally have the right to sell the shares on the vesting date. ii) Unlike the stock acquired through options exercises, employees receive restricted stock on the vesting date without having to pay for it, after which they can either sell it immediately or retain it. iii) Refer to Exhibit 12-5 for Sample Timeline for Restricted Stock. iv) Work through Example 12-14. v) Employee tax considerations for restricted stock (1) Restricted stock is taxed like nonqualified stock options with two important distinctions: (a) While employees receiving NQOs are taxed at ordinary rates on the bargain element of the shares when they exercise their options, (b) Employees receiving restricted stock are taxed on the full fair market value of the shares on the date the restricted stock vests. (2) Work through Example 12-15. (3) 83(b) election (a) The tax laws allow employees who receive restricted stock to make a tax election that can significantly change the tax consequences by treating the stock nearly the same as vested stock. (b) Work through the Example 12-16. (c) Restricted stock without a section 83(b) election (i) No tax consequences on grant date. (ii) Employee recognizes ordinary income on value of stock on vesting date. (iii) Holding period for stock begins on vesting date. (iv) Employer deducts value of stock on vesting date. (d) Restricted stock with a section 83(b) election (i) On grant date, employee recognizes market value of stock as ordinary income. (ii) Employee takes fair market value basis in stock. (iii) Holding period for stock begins on grant date. (iv) If employee never vests, no deduction for basis in stock. (v) Employer deducts value of stock on grant date. (e) The 83(b) election is advisable when the potential for growth in the stock value is high and the amount of additional current tax is manageable. (f) If an employee makes a section 83(b) election and then forfeits the stock for any reason, the employee cannot deduct the loss on the forfeiture. (g) The risk of making the election is that if the stock value declines, the employee would have paid taxes on value that the employee never receives. vi) Employer tax considerations for restricted stock (1) The employer’s deduction for restricted stock equals the amount of ordinary income reported by its employees. (2) The timing of the deduction is determined by the employee’s decisions regarding the 83(b) election. (3) If the employee makes a section 83(b) election, the employer claims the deduction in the year the restricted stock is granted. Otherwise, the employer claims a deduction when the restrictions lapse. (4) Refer to Exhibit 12-6 for Excerpt from Apple Inc.’s 2019 Proxy Statement. (5) Work through Example 12-17. (6) Give a brief overview of RSUs and Qualified Equity Grants (some instructors skip the latter). k) Equity-Based Compensation Summary i) Refer to Exhibit 12-7 for Reportable Income and Deductions from Equity-Based Compensation (for given time frame and stock prices). 3) Fringe Benefits a) Taxable Fringe Benefits i) Employees recognize compensation income on all benefits received unless specifically excluded by tax laws. ii) Employee considerations for fringe benefits (1) Employees treat benefits received like taxable cash compensation. (2) Employees recognize ordinary compensation income when they receive taxable benefits and, just as they do with salary, pay FICA taxes on the value of the benefit. (3) As a result, taxable fringe benefits cost employees the amount of tax they must pay on the benefits. (4) Work through Example 12-18. (5) Employees may prefer a taxable benefit to an equivalent amount of cash when they benefit from employer-provided quantity or group discounts associated with the benefit. (6) To compute the annual taxable benefit, taxpayers use the following steps: (a) Subtract $50,000 from the death benefit of their employer-provided group-term life insurance policy. (b) Divide the Step 1 result by $1,000. (c) Multiply the result from Step 2 by the cost per $1,000 of protection for one month from the table based on the taxpayer’s age. (d) Multiply the outcome of Step 3 by the number of months the benefit was received during the taxable year. (7) Refer to Exhibit 12-8 for Uniform Premiums for $1,000 of Group-Term Life Insurance Protection. (8) Work through Example 12-19. (9) When corporations provide taxable fringe benefits to senior executives, they also provide the executives enough cash to cover the taxes so the benefit costs the executive nothing. This is commonly referred to as a gross-up. iii) Employer considerations for taxable fringe benefits (1) Employer deducts cost. (2) Work through Example 12-20. (3) Refer to Exhibit 12-9 for Excerpt from Wal-Mart’s 2019 Proxy Statement. b) Nontaxable Fringe Benefits i) Refer to Exhibit 12-10 for Common Forms of Nontaxable Fringe Benefits. ii) Group-term life insurance (1) Employees may exclude from income the employer-provided benefit for the first $50,000 of group-term life insurance. (2) Any remaining group-term life insurance benefit is taxable. (3) An employer may not discriminate between employees in providing nontaxable group-term life insurance benefits. iii) Health and accident insurance and benefits (1) When employers pay for health and accident insurance for an employee and the employee’s spouse and dependents, the employee excludes the benefit from her gross income. (2) Employers may not discriminate between employees when providing health and accident insurance benefits. iv) Meals and lodging for the convenience of the employer (1) The value of certain meals and lodging the employer provides to an employee may be excluded from an employee’s gross income if the benefit meets two criteria: (a) The meals and lodging are provided on the employer’s business premises to the employee (and the employee’s spouse and dependents, if any), and (b) The meals and lodging are provided for the convenience of the employer. (2) Employers are allowed to deduct 50 percent of meals provided to employees for the convenience of the employer. (3) The cost is not subject to the 50 percent deductibility limitation on meals. (4) Employers may generally discriminate between employees for the convenience of the employer benefits. (5) Work through Example 12-21. (6) Employees may exclude the value of the lodging from gross income. v) Employee educational assistance (1) Employees can exclude from income up to $5,250 of employee educational assistance benefits covering tuition, books, and fees. (2) Amounts excluded from income cannot qualify for educational deductions or credits (such as the American opportunity tax credit and lifetime learning credit). vi) Dependent care benefits (1) Employees can exclude up to $5,000 for benefits paid or reimbursed by employers for caring for children under age 13 or dependents or spouses who are physically or mentally unable to care for themselves. vii) No-additional-cost services (1) Employees can exclude the value of no-additional-cost services. (2) These are any services employers provide to employees in the ordinary course of business that generate no substantial costs to the employer. (3) Refer to Exhibit 12-11 for Flight Benefits. (4) Work through Example 12-22. viii) Qualified employee discounts (1) Employers frequently allow employees to purchase their goods and services at a discount. (2) Employees may exclude qualified employee discounts from income as long as they don’t acquire goods at a discount greater than the average gross profit percentage for the employer’s goods. (3) This can be a fairly significant nontaxable benefit to employees, particularly for higher-priced products. (4) Refer to Exhibit 12-12 for Excerpt from IBM’s Website. (5) Work through Example 12-23. ix) Working condition fringe benefits (1) Employees may exclude from income any benefit or reimbursement of a benefit provided by an employer that would be deductible as an ordinary and necessary expense by the employee if the employee rather than the employer paid the expense (or the employer did not reimburse the employee). (2) Additionally, telephones or computers provided to employees for business use may be excluded. (3) Employers may discriminate between employees with respect to working condition fringe benefits. (4) Work through Example 12-24. x) De minimis fringe benefits (1) Employees can also exclude from income occasional or incidental de minimis fringe benefits (very small). (2) These include occasional personal use of a copy machine, company-sponsored picnics, noncash traditional holiday gifts, and occasional tickets to sporting or theatrical events. (3) Employers are allowed to discriminate between employees when providing de minimis fringe benefits. xi) Qualified transportation fringe benefits (1) Employees may exclude from income the value of certain transportation benefits they receive from employers, whether employers pay for these benefits directly or reimburse employees for the transportation costs. (2) These include the value of company-owned car pool vehicles for commuting to and from work, the cost of mass transit passes, and the cost of qualified parking near the work place. (3) In 2020, the maximum exclusion for the car pool vehicle and mass transit pass is $270 per month and the maximum exclusion for the qualified parking benefit is $270 per month. xii) Cafeteria plans and flexible spending accounts (1) Cafeteria plans (a) Employers determine the total cost of benefits they are willing to provide for each employee. (b) Each employee then either chooses (or buys) benefits up to the determined amount from a menu of nontaxable fringe benefits or may receive a cash equivalent in lieu of forgone benefits. (c) Cash received from a cafeteria plan is taxable compensation to employees. (d) Cafeteria plans are popular because each employee may desire different types of nontaxable fringe benefits. (e) Through this plan, employees can select the benefits best suited to their needs. (2) Flexible spending accounts (FSAs) (a) It allows employees to set aside a portion of their before-tax salary for payment of either health and/or dependent-care benefits. (b) These plans allow employees to set aside either employee contributions (on a before-tax basis) or employer contributions (a leftover cafeteria plan amount) to pay for medical-related expenses (such as co-payments and prescriptions) or dependent care. (c) Taxpayers must use amounts placed in flexible spending accounts to pay for qualified benefits they expend funds on during the FSA plan year (which is often the calendar year), or they forfeit the remaining balance of the account. (d) Employers may no longer allow employees to use the remaining balance from one year within the first two and a half months of the next FSA plan year. xiii) Employee and employer considerations for nontaxable fringe benefits (1) Nontaxable fringe benefits are very attractive to employees because their after-tax cost of these benefits is zero. (2) They do not pay for the benefits and they are not taxed on the value of the benefits they receive. (3) Employers deduct the cost of providing the benefits, which (thanks to group or quantity discounts) can be considerably lower than the cost to the employee of purchasing the benefit(s) separately. c) Tax Planning with Fringe Benefits i) The fact that employees can exclude nontaxable fringe benefits from gross income, while employers can deduct the cost of providing them (just as they deduct the cost of taxable fringe benefits), gives rise to compensation-related tax planning opportunities that may benefit both employee and employer. ii) Work through Example 12-25. iii) Work through Example 12-26. iv) Work through Example 12-27. d) Fringe Benefits Summary i) Refer to Exhibit 12-13 for Excerpt from Disney Company’s 2019 Proxy Statement Dealing with Fringe Benefits. ii) Refer to Exhibit 12-14 for Summary of Julie’s Nonsalary Benefits from TPI. Class Activities 1. Suggested class activities ○ TARP limitations: There are some interesting discussions regarding the TARP compensation limits imposed by the American Recovery and Reinvestment Act of 2009. The Main Street versus Wall Street debate created a firestorm of controversy among ordinary Americans. ○ Elimination: Develop several multiple-choice questions (A, B, C answers) (you could 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. 2. Ethics discussion From page 12-14: Discussion points: • The goal is reestablishing an incentive component for continued hard work and commitment, as well as restoring the retention capability of an employer’s equity compensation plan. • What type of repricing is used? Often companies use one-for-one exchanges, value-for-value exchanges, restricted stock, restricted stock units (RSUs), or even purchase them for cash. • A company listed on the NYSE or NASDAQ must first obtain shareholder approval of a proposed repricing unless the equity compensation plan under which the options in question were issued expressly permits. • See Mark Bruno, “Glub, glub, glub: 40% of options are underwater,” Financial Week, Aug. 25, 2008, at 1, 20, available at: https://www.radford.com/home/press_room/pdf/press_financialweek_082508.pdf. Instructor Manual for McGraw-Hill's Taxation of Individuals and Business Entities 2021 Brian C. Spilker, Benjamin C. Ayers, John A. Barrick, Troy Lewis, John Robinson, Connie Weaver, Ronald G. Worsham 9781260247138, 9781260432534
Download
Close
Close
