CH-13-15 Retirement Savings and Deferred Compensation – McGraw-Hill’s Taxation of Individuals and Business Entities 2021 : Chapter Notes

This Document Contains Chapters 13 to 15 Chapter 13 Retirement Savings and Deferred Compensation Learning Objectives 13-1. Describe the tax and nontax aspects of employer-provided defined benefit plans from both the employer’s and the employee’s perspective. 13-2. Explain and determine the tax consequences associated with employer-provided defined contribution plans, including traditional 401(k) and Roth 401(k) plans. 13-3. Describe the tax implications of deferred compensation from both the employer’s and the employee’s perspectives. 13-4. Compare and determine the tax consequences of traditional and Roth IRAs (individual retirement accounts). 13-5. Describe retirement savings account options for self-employed taxpayers and compute the limitations for deductible contributions to these accounts. 13-6. Compute the saver’s credit. Teaching Suggestions This chapter was written to provide students with an overview (and some detail) about options for saving for retirement. Because students will be starting their careers relatively soon, they are naturally interested in retirement savings–related issues. You may want to lead off by making sure students understand from a big picture perspective what the differences are between defined benefit and defined contribution plans (and that defined benefit plans are not as common). The chapter discusses defined benefit plans, various employer-sponsored defined contribution plans, individually managed retirement accounts, and retirement savings accounts for the self-employed. Conceptually, students should understand the difference between traditional and Roth retirement accounts. Students might need help understanding that traditional retirement accounts provide a better rate of return than Roth accounts when marginal tax rates are decreasing and a lesser rate of return when rates are increasing. Also, students may need additional help understanding that a contribution to a traditional account is not the same as a contribution to a Roth account because the contribution to the Roth account is made with after-tax dollars. There are several exhibits throughout the chapter comparing different types of plans on various tax and nontax dimensions (defined contribution versus defined benefit plans; traditional versus Roth 401(k) plans; qualified plans versus nonqualified plans; traditional versus Roth IRA). These exhibits may provide the basis for class discussion. This is particularly true with tax rates decreasing under recent tax legislation. Decisions on whether to contribute to traditional or Roth plans include expectations about future tax rates. Note also that Appendix A provides a flowchart for determining traditional IRA deduction limitations, and Appendix B provides a flowchart for Roth IRA contribution limitations. The self-employment plan section is not intended to be comprehensive but rather provide a couple of the most popular options of saving for retirement for the self-employed. The SEP IRA is easy to set up but may provide lower contribution limits for taxpayers with lower amounts of self-employment income than individual 401(k) plans. Finally, students are always disappointed to learn that the saver’s credit is not available to full-time students. Note: The SECURE Act of 2019 tax legislation introduced the following tax law changes that are included in this chapter. 1. The age for required minimum distributions was increased from 70½ years of age to 72 years of age. This change affects required minimum distributions from defined contributions plans and from traditional IRAs. 2. An exception to the 10% penalty was added for taxpayers receiving early distributions from defined contributions and IRAs for distributions used for child births or adoptions (up to $5,000). 3. Taxpayers are allowed to contribute to traditional IRAs not matter their age. Taxpayers were not previously allowed to contribute to traditional IRAs after they reached age 70½. Assignment Matrix Learning Objectives Text Feature Difficulty LO1 LO2 LO3 LO4 LO5 LO6 Research Planning Tax Forms DQ13-1 10 min. Medium X X DQ13-2 10 min. Medium X DQ13-3 10 min. Medium X X DQ13-4 10 min. Medium X X DQ13-5 10 min. Medium X X DQ13-6 10 min. Medium X DQ13-7 10 min. Medium X DQ13-8 10 min. Medium X X DQ13-9 10 min. Medium X X DQ13-10 10 min. Medium X DQ13-11 10 min. Medium X DQ13-12 10 min. Medium X DQ13-13 10 min. Medium X DQ13-14 10 min. Medium X DQ13-15 10 min. Medium X X DQ13-16 10 min. Medium X DQ13-17 10 min Medium X X DQ13-18 10 min Medium X DQ13-19 10 min Medium X DQ13-20 10 min. Medium X DQ13-21 10 min. Medium X X DQ13-22 10 min. Medium X X DQ13-23 10 min. Medium X DQ13-24 10 min. Medium X X DQ13-25 10 min. Medium X X DQ13-26 10 min. Medium X X DQ13-27 10 min. Medium X X DQ13-28 10 min. Medium X X DQ13-29 10 min. Medium X X DQ13-30 10 min. Medium X DQ13-31 10 min. Medium X DQ13-32 10 min. Medium X X X DQ13-33 5 min. Easy X DQ13-34 5 min. Medium X DQ13-35 5 min. Medium X X DQ13-36 20 min. Hard X DQ13-37 25 min. Hard X DQ13-38 20 min. Hard X DQ13-39 25 min. Hard X DQ13-40 20 min. Hard X DQ13-41 25 min. Hard X DQ13-42 20 min. Hard X DQ13-43 25 min. Hard X DQ13-44 20 min. Medium X DQ13-45 20 min. Medium X DQ13-46 20 min. Medium X X DQ13-47 20 min. Medium X DQ13-48 20 min. Medium X DQ13-49 20 min. Medium X P13-50 30 min. Medium X P13-51 10 min. Medium X P13-52 15 min. Medium X P13-53 40 min. Hard X X P13-54 25 min. Medium X P13-55 25 min. Medium X X P13-56 10 min. Easy X P13-57 10 min Medium X P13-58 10 min. Easy X P13-59 20 min. Medium X X P13-60 20 min. Medium X P13-61 25 min. Hard X X P13-62 30 min. Hard X X P13-63 10 min. Medium X P13-64 15 min. Medium X P13-65 10 min. Medium X P13-66 15 min. Medium X X P13-67 10 min. Medium X P13-68 10 min. Medium X P13-69 10 min. Medium X P13-70 10 min. Medium X P13-71 15 min. Medium X P13-72 15 min. Medium X P13-73 15 min. Medium X X P13-74 10 min. Medium X P13-75 10 min. Medium X P13-76 30 min. Medium X X X P13-77 15 min. Medium X X P13-78 15 min. Medium X X P13-79 15 min. Medium X X P13-80 15 min. Medium X P13-81 15 min. Medium X P13-82 20 min. Medium X P13-83 20 min. Medium X CP13-84 20 min. Hard CP13-85 20 min. Medium CP13-86 30 min. Hard CP13-87 35 min. Hard CP13-88 45min. Hard Lecture Notes 1) Employer-Provided Qualified Plans a) Classified as defined benefit plans and defined contribution plans. b) Must meet certain requirements to be considered a qualified plan. 2) Defined Benefit Plans a) They are traditional pension plans generally used by many older and more established companies and tax-exempt organizations. b) These plans provide standard retirement benefits to employees based on a fixed formula. c) The formula to determine the standard retirement benefit is usually a function of years of service and employees’ compensation levels as they near retirement. i) The maximum compensation that can be taken into account for a particular year in determining an employee’s benefit is capped by the annual compensation limitation for that particular year. ii) The annual compensation limitation is $270,000 for 2017, $275,000 for 2018, $280,000 for 2019, and $285,000 for 2020. d) For employees who retire in 2020, the maximum annual benefit an employee can receive is the lesser of: i) 100 percent of the average of the employee’s three highest consecutive calendar years of compensation, limited to the annual compensation limitation for each of the three years or ii) $230,000. e) Vesting i) The process of becoming legally entitled to a certain right or property. ii) Employee must vest to receive benefits using 5-year cliff vesting schedule or 7-year graded vesting schedule. iii) Under the cliff vesting option, after a certain period of time, benefits vest all at once. iv) With a graded vesting schedule, the employee’s vested benefit increases each year she works for the employer. v) Refer to Exhibit 13-1 for Defined Benefit Plans Minimum Vesting Schedules. f) Distributions i) Early and minimum distribution rules apply but are usually not restrictive. ii) Distributions violating these requirements are penalized. iii) Defined benefit plans typically don’t permit payout arrangements that would trigger the early distribution or minimum distribution penalties; these penalties are of greater concern to participants in defined contribution plans. g) Nontax considerations i) Administratively more burdensome and costly to manage than defined contribution plans. ii) Employer, not employee, bears investment risk. 3) Defined Contribution Plans a) While defined contribution plans and defined benefit plans have similar overall objectives, they are different in important ways: i) Employers maintain separate accounts for each employee participating in a defined contribution plan. ii) Defined contribution plans specify the up-front contributions the employer will make to the employee’s separate account, rather than specifying the ultimate benefit the employee will receive from the plan. iii) Employees are frequently allowed to contribute to their own defined contribution plans, and in many instances they contribute more than their employers do. iv) Employees are generally free to choose how amounts in their retirement accounts are invested. b) Employer specifies amount it will contribute to employee’s retirement account, not the amount the employee will receive at retirement. i) Employers typically match employee contributions. c) Employee chooses (from available options) how funds are invested and bears investment risk. d) Employers may provide different types of defined contribution plans, such as 401(k) plans (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. e) No matter what defined contribution plan(s) employers provide, employers must ensure that their plans meet certain requirements relating to annual contribution limits and vesting requirements. f) Participants in defined contribution plans must be careful to avoid the penalties associated with either early distributions or insufficient minimum distributions from these plans. g) Employer matching i) Employers, but not employees, typically contribute to certain defined contribution plan types such as profit-sharing plans (contributions may be made based on a fixed formula based on profits or may be at the employer’s discretion) and money-purchase plans (contributions are a fixed percentage of the employee’s compensation). ii) When deciding whether to contribute to a 401(k) plan, employees should take into account their employer’s matching policy. iii) For companies matching employee contributions, the match can range from a small percentage (25 cents on the dollar) to a multiple of the employee’s contribution. iv) A dollar-for-dollar match gives employees a 100 percent immediate return on their contributions. v) Whenever possible, employees should contribute enough to receive the full match from the employer because, subject to the employer’s vesting requirements, the match represents an immediate, no-risk return on the amount contributed. h) Contribution limits i) 2020 overall contribution limits for sum of employer and employee contributions: (1) Lesser of $57,000 ($63,500 for employees 50 years old by year-end) or 100 percent of employee’s annual compensation. Note that the extra $6,000 limit (from $57,000 to $63,500) applies to the catch-up adjustment for the employee. It does not affect the amount the employer can contribute. ii) 2020 employee contribution limit to 401(k) plan: (1) $19,500 or (2) $26,000 for employees 50 years old by year-end. i) Vesting i) When employees contribute to defined contribution plans, they are fully vested in the accrued benefit from the contributions (employee contributions plus earnings on the contributions). ii) Employees vest in the accrued benefit from employer contributions (employer contributions plus earnings on the contributions) based on the plan’s vesting schedule. iii) When separate employee accounts are not maintained, the accrued benefit from employee contributions is determined by multiplying the total accrued benefit in the account by the ratio of employee contributions to total contributions (employee plus employer) to the account. iv) The accrued benefit from employer contributions is the difference between the total accrued benefit and the accrued benefit from employee contributions. v) For defined contribution plans, employers have the option of providing three-year cliff or six-year graded vesting (or something more favorable for employees). vi) Refer to Exhibit 13-2 for Defined Contribution Plans Minimum Vesting Schedules. j) After-tax cost of contributions to traditional (non-Roth) defined contribution plans i) Before-tax contribution minus tax savings from contribution k) Distributions from traditional defined contribution plans i) Taxed as ordinary income ii) 10 percent penalty on early distributions (1) Before 59½ years of age if not retired or (2) Before 55 years of age if retired. iii) Minimum distributions requirements: (1) Minimum distributions must be received for the year in which the employee reaches 72 years of age or the year in which the employee retires, if later. Taxpayers must receive their first minimum distribution no later than April 1 of the year after the year to which the distribution pertains. Taxpayers generally must receive minimum distributions for subsequent years by the end of the years to which they pertain. (2) If retired employee waits until the year after the employee turns 72 to begin receiving distributions, the employee must receive two distributions in year of first distribution (one for the year the taxpayer turned 72, by April 1, and one for the next year). (3) 50 percent penalty on excess of required minimum distribution amounts and amount actually distributed. iv) Refer to Exhibit 13-3 for Abbreviated Uniform Lifetime Table (used to determine minimum required distributions). l) After-tax rates of return for traditional defined contribution plans i) For a given before-tax rate of return and a constant tax rate, the longer the taxpayer defers distributions from a qualified retirement account, the greater the taxpayer’s after-tax rate of return on the account, because deferring the distribution reduces the present value of the tax paid on the distribution. ii) Taxpayer’s after-tax rates of return are also sensitive to the taxpayer’s marginal tax rates at the time they contribute to the plan and at the time they receive distributions from the plan. m) Refer to Exhibit 13-4 for Defined Benefit Plan versus Defined Contribution Plan Summary. n) Roth 401(k) plans i) Employees, but not employers, may contribute. (1) Employers contribute to employee’s traditional 401(k). ii) Contributions not deductible. (1) Employees contribute after-tax dollars. (2) Same contribution limits as traditional 401(k) plans. iii) Qualified distributions not taxable. (1) Accounts open for five years. (2) Employee at least 59½ at time of distribution. iv) Nonqualified distributions (1) Distributions of account earnings taxable unless employee is at least 55 years of age and retired or at least 59½ years of age if not retired. (2) Distributions of contributions not taxed or penalized. (3) Distribution × ratio of contributions to account balance is nontaxable. v) After-tax return equals before-tax return. o) Comparing traditional defined contribution plans and Roth 401(k) plans i) In general terms, the traditional 401(k) plans will generate higher (lower) after-tax rates of return than Roth 401(k) plans when taxpayers’ marginal tax rates decrease (increase) from the time of contribution to the time of distribution. ii) Refer to Exhibit 13-5 for Traditional 401(k) Plan versus Roth 401(k) Plan Summary. 4) Nonqualified Deferred Compensation Plans a) Nonqualified plans versus qualified defined contribution plans i) Deferred compensation plans permit employees to defer (or contribute) current salary in exchange for a future payment from the employer. ii) Tax consequences of contributions to and distributions from nonqualified plans receive tax treatment similar to qualified defined contribution plans. b) Employee considerations i) Employees defer current income in exchange for future payment. (1) Employee is taxed when payment received. (2) Employee generally selects deemed investment choices up front to determine return on deferral. (3) Just like traditional deferred compensation plans, after-tax rate of return depends on before-tax rate of return, marginal tax rate at time of deferral, and marginal tax rate at time of distribution. (4) Payment not guaranteed. If employer doesn’t pay, employee becomes unsecured creditor. c) Employer considerations i) Employer promises to pay deferred compensation at some point in future. (1) Deduct when paid to employee. (2) Not required to fund obligation. (3) Can be used to make whole employees who are over contribution limits on qualified plans. Used to be used to circumvent the $1M deduction under §162(m), but the new tax law (effective in 2018) indicates that the limitation applies to deferred compensation received after certain executives retire. (4) Employer’s marginal tax rates at time of deferral relative to those at time of payment affect after-tax cost of providing deferred compensation relative to current compensation. With the lowering of the corporate tax rate, the after-tax cost of providing deferred compensation significantly increases. ii) Refer to Exhibit 13-6 for Qualified Plans versus Nonqualified Plans Summary. 5) Individually Managed Qualified Retirement Plans a) Not all employers provide retirement savings plans, and when they do, some employees may not be eligible to participate, while others who are eligible may elect not to participate in these plans. i) The tax laws provide opportunities for these taxpayers to provide for their own retirement security through individually managed retirement plans. ii) The individual retirement account (IRA) is the most common of the individually managed retirement plans. iii) Other types of individually managed plans are available to self-employed taxpayers. 6) Individual Retirement Accounts (IRA) a) Taxpayers who meet certain eligibility requirements can contribute to traditional IRAs, to Roth IRAs, or to both. b) Traditional IRAs i) One of the limits is based on modified AGI (MAGI). MAGI is the taxpayer’s AGI disregarding the deduction for the traditional IRA itself and certain other items. ii) 2020 contribution limit: (1) Lesser of $6,000 or earned income. (2) For taxpayers who are at least 50 year of age by year-end, the limit is the lesser of $7,000 or earned income. iii) If taxpayer(s) participate in employer-provided plan: (1) Deduction limit phased out for single taxpayers with MAGI between $65,000 and $75,000 and for married filing jointly taxpayers with MAGI between $104,000 and $124,000. (2) Special rules if one spouse is covered by the plan and other is not. iv) If taxpayer does not participate in employer-provided plan but spouse does: (1) Deduction limit phased out for MAGI between $196,000 and $206,000. v) Distributions (1) Distribution taxed as ordinary income. (2) If distribution before taxpayer is 59½, 10 percent penalty generally applies (unless taxpayer rolls over to other qualified account). (3) Required minimum distributions begin for the year in which the taxpayer turns 72 years of age. c) Roth IRAs i) Contributions not deductible. MAGI for this purpose is the same as for traditional IRAs but also excludes income from rolling over a traditional IRA into a Roth IRA. ii) Same contribution limits as traditional IRAs but: (1) Contribution phases out for MAGI between $124,000 and $139,000 for unmarried taxpayers and between $196,000 and $206,000 for married filing jointly taxpayers. iii) Qualified distributions not taxable. (1) To qualify, account must be open for at least five years before distribution and distribution made after taxpayer reaches 59½ years of age (among others). iv) Nonqualified distributions of account earnings (1) Taxed at ordinary rates. (2) Subject to 10 percent penalty unless taxpayer is at least 59½ at time of distribution. (3) Distributions first from contributions and then from account earnings. d) Converting from traditional to Roth IRA i) Can convert through direct transfer or rollover. ii) The amount converted is fully taxable but not necessarily penalized. iii) A direct transfer is not penalized but a distribution must be contributed (rolled over) to the Roth IRA account within 60 days of withdrawal to avoid 10 percent early distribution penalty. iv) Amounts withdrawn but not contributed subject to tax and 10 percent penalty. e) Comparing traditional and Roth IRAs i) Refer to Exhibit 13-7 for Traditional IRA versus Roth IRA Summary. 7) Self-Employed Retirement Accounts a) Popular plans include SEP IRAs and individual 401(k)s. b) Similar to (non-Roth) qualified defined contribution plans: contributions deductible, distributions taxable. c) Simplified employee pension (SEP) IRA i) SEP IRA 2020 contribution limit: (1) Lesser of (1) $57,000 or (2) 20 percent of net Schedule C income minus the deduction for the employer’s portion of self-employment taxes paid. ii) Nontax considerations (1) Must provide plan for employees in order to provide plan for self. d) Individual 401(k) plans i) Individual 401(k) 2020 contribution limit: (1) Lesser of (1) $57,000 or (2) 20 percent of net Schedule C income minus the deduction for the employer’s portion of self-employment taxes paid plus an additional $19,500. (2) Additional $6,500 contribution for those at least 50 years old at the end of the year. (3) The contribution cannot exceed net Schedule C income minus the deduction for the employer’s portion of self-employment taxes paid. ii) Nontax considerations (1) Administrative requirements to set up. 8) Saver’s Credit a) Credit for taxpayers contributing to qualified plan. i) Credit is based on contributions up to $2,000, taxpayer’s filing status, and AGI. ii) Phased out as AGI increases. iii) Maximum credit is $1,000. iv) Unavailable for married filing jointly taxpayers with AGI over $65,000, head of household taxpayers with AGI above $48,750, and all other taxpayers with AGI above $32,500. b) Refer to Exhibit 13-8 for 2020 Applicable Percentages for Saver’s Credit by Filing Status and AGI. Class Activities 1. Suggested class activities ○ 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 85–87). 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 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. ○ Group discussion on defined benefit versus defined contribution plans: Have students form groups of approximately four students each. Tell the students that they have just started a new job and need to decide whether to join the company’s defined benefit plan or its defined contribution [401(k)] plan. This is their only chance to join the defined benefit plan. Without knowing the specifics of each plan, which plan would they opt for? Have the students discuss this in their groups and then report back to the class what was discussed. 2. Ethics discussion From page 13-24: Discussion points: • Without any earned income, Ryan is ineligible to contribute to a Roth IRA. • By reporting $400 of self-employment income, Ryan is reporting earned income on his tax return. However, because he does not exceed $400 of self-employment income, he is not required to pay any self-employment tax on these earnings. Further, it does not appear as though Ryan will have any taxable income. • From Ryan’s perspective, the income allows him to contribute to a Roth IRA (no deduction, but this doesn’t matter because Ryan does not have any taxable income) without costing him anything. • Technically, it appears what Ryan is doing is not consistent with the tax law. • Discuss with students whether they believe this strategy to be OK because Ryan is not reporting income. • It would seem that based on the law, there are reasons to believe this is not appropriate. What arguments can be made that it is appropriate? Chapter 14 Tax Consequences of Home Ownership Learning Objectives 14-1. Determine whether a home is considered a principal residence, a residence (not principal), or a no residence for tax purposes. 14-2. Compute the taxable gain on the sale of a residence. 14-3. Determine the amount of the home mortgage interest deduction. 14-4. Discuss the deductibility of real property taxes. 14-5. Explain the tax issues and consequences associated with rental use of the home. 14-6. Compute the limitations on home office deductions. Teaching Suggestions This chapter discusses many issues associated with home ownership. When they start their careers, students will be faced with the decision of whether to buy or rent a home. This chapter should provide them enough background to make informed decisions not only about whether to buy or rent but also to make informed decisions about financing or refinancing home loans. Tax law changes in recent years that are most relevant to this chapter are the reduction in qualified acquisition indebtedness to $750,000 (for debt incurred before December 16, 2017) from $1,100,000, the elimination of the deduction for interest on home-equity indebtedness, the overall $10,000 limit on the itemized deduction for all taxes (including real property taxes), and the increase in the standard deduction (because fewer taxpayers will itemize). Some of the more difficult topics for students include the break-even period for paying points on a home loan, understanding how to determine whether real property taxes allocated to rental use of a vacation home or home business use are tier 1 or tier 2 expenses, and understanding when the Tax Court method of allocating expenses between rental use and personal use is more favorable for the taxpayer than using the IRS method. This is not an easy determination to make given the recent tax law changes that increased the standard deduction amount and capped the itemized deduction for taxes at $10,000. Students may also struggle with understanding the sample settlement statement (HUD-1) provided in the appendix. You may want to help students make sense of the document so it is familiar to them when they buy or sell property. It is important to note that debt that the lender might call a “home equity loan” may actually be acquisition indebtedness for tax purposes. Exhibit 14-6 summarizes the tax rules associated with renting a home. This exhibit may be a useful discussion tool. Also, Appendix B provides a flowchart of tax rules relating to home use for rental purposes. Note that this chapter includes some discussion of the $25,000 rental real estate exception for passive losses because this rule may be relevant for taxpayers renting a second home. However, most of the passive loss rule discussion is provided in the Investments chapter. Finally, students should understand that it is difficult to qualify for the home office deduction and that deducting home office expenses makes the taxpayer more prone to an audit and may require the taxpayer to recognize gain on the sale of the home that would otherwise be excluded. Starting in 2013, the IRS provided that taxpayers can choose to use the actual expense method for computing the home office expense deduction or the simplified method. Taxpayers can choose one method for one year and the other for another—that is, they don’t have to apply the same method each year. Students should gain an appreciation for the two methods and be able to determine, for a particular year, when one method would be a better choice than the other. This chapter usually generates considerable student interest due to their familiarity with internet platform companies such as VRBO and Airbnb. Try to focus on questions relating to the mainstream topics and avoid questions that get the entire class off track. Assignment Matrix Difficulty LO1 LO2 LO3 LO4 LO5 LO6 Research Planning Tax Forms DQ14-1 10 min. Medium X DQ14-2 10 min. Medium X DQ14-3 10 min. Medium X DQ14-4 10 min. Medium X DQ14-5 10 min. Medium X DQ14-6 10 min. Medium X DQ14-7 10 min. Medium X DQ14-8 10 min. Medium X DQ14-9 10 min. Medium X DQ14-10 10 min. Medium X DQ14-11 10 min. Medium X DQ14-12 10 min. Medium X DQ14-13 10 min. Medium X DQ14-14 10 min. Medium X DQ14-15 10 min. Medium X DQ14-16 10 min. Hard X DQ14-17 10 min. Medium X X DQ14-18 10 min. Medium X DQ14-19 15 min. Medium X X DQ14-20 10 min. Medium X DQ14-21 10 min. Medium DQ14-22 10 min Medium X DQ14-23 10 min Medium X X DQ14-24 10 min Medium X DQ14-25 10 min Medium X X DQ14-26 10 min Medium X DQ14-27 15 min. Hard X DQ14-28 10 min. Medium X DQ14-29 10 min Medium X DQ14-30 10 min Medium X DQ14-31 10 min Medium X X DQ14-32 10 min Medium X DQ14-33 10 min Medium X DQ14-34 10 min Medium X DQ14-35 10 min Medium X DQ14-36 10 min Medium X X P14-37 20 min. Medium X P14-38 20 min. Medium X P14-39 30 min. Medium X P14-40 30 min. Medium X P14-41 5 min. Easy X P14-42 15 min. Medium X P14-43 15 min. Medium X P14-44 15 min. Medium X P14-45 15 min. Medium X P14-46 15 min. Medium X P14-47 25 min. Medium X P14-48 15 min. Medium X P14-49 20 min. Medium X P14-50 40 min. Hard X X P14-51 20 min. Medium X X P14-52 20 min. Medium X P14-53 20 min. Medium X P14-54 20 min. Medium X P14-55 20 min. Hard X P14-56 30 min. Hard X X P14-57 25 min. Medium X P14-58 20 min. Medium X X P14-59 25 min. Medium X P14-60 20 min. Medium X P14-61 20 min. Medium X P14-62 20 min. Medium X X P14-63 10 min. Medium X X P14-64 20 min. Medium X X P14-65 20 min. Medium X P14-66 15 min. Medium X X CP14-67 30 min. Hard X X CP14-68 45 min. Hard X Lecture Notes 1) Is a Dwelling Unit a Principal Residence, Residence, or No residence? a) Residence versus no residence b) Principal residence i) When a taxpayer lives in more than one residence during the year, the determination of which residence is the principal residence depends on facts and circumstances such as: (1) Amount of time the taxpayer spends at each residence during the year. (2) The proximity of each residence to the taxpayer’s employment. (3) The principal place of abode of the taxpayer’s immediate family. (4) The taxpayer’s mailing address for bills and correspondence. ii) A taxpayer’s principal residence could be a houseboat, trailer, or condominium—a residence need not be in a fixed location. c) Dwelling unit property type i) Principal residence ii) Residence (not principal) iii) No residence (rental property) 2) Personal Use of the Home a) Nontax consequences i) Large investment ii) Potential for big return (or loss) on investment with use of leverage iii) Risk of default on home loan iv) Time and costs of maintenance v) Limited mobility b) Tax consequences i) Interest expense deductible ii) Gain on sale excludable iii) Real property taxes on home potentially deductible iv) Rental and business-use possibilities c) Exclusion of Gain on Sale of Personal Residence i) Personal residence is a capital asset; any gain or loss a taxpayer realizes by selling the residence is a capital gain or loss. ii) When a taxpayer sells a personal residence at a loss, the loss is a nondeductible personal loss and when it is at a gain, the tax consequences are generally much more favorable. iii) Basis of home (1) Purchase (2) Inheritance (3) Gift (4) Conversion from rental to residence iv) Maximum exclusion (1) $500,000 if married filing jointly (2) $250,000 otherwise v) Requirements (1) Ownership test (a) Must own home for at least two of five years before sale. (b) Prevents taxpayer from purchasing a home, fixing it up, and soon thereafter selling it and excluding the gain—a real estate investment practice termed flipping. (2) Use test (a) Must use home as principal residence for at least two of five years before sale. (b) For married couples to qualify for exclusion on a joint return, one spouse must meet ownership test and both spouses must meet use test. (c) This test helps to ensure that taxpayers using the exclusion have realized gains from selling the home they actually live in as opposed to selling an investment or rental property. vi) General rule exceptions for nonqualified use, unforeseen circumstances, and depreciation (1) Limitation on exclusion for nonqualified use (a) The amount of gain eligible for exclusion may be limited for taxpayers selling homes after December 31, 2008. (b) The limitation applies if, on or after January 1, 2009, the taxpayer uses the home for something other than a principal residence for a period (termed nonqualified use). (c) The period of nonqualified use does not include any portion of the five-year period that is after the last date that such property is used as the principal residence of the taxpayer or the taxpayer’s spouse. (d) If the limitation applies, the percentage of the gain that is not eligible for exclusion is the ratio of the amount of the nonqualified use divided by the amount of time the taxpayer owned the home (purchase date through date of sale). (2) Unforeseen circumstances (a) Maximum exclusion = full exclusion × months of qualifying ownership and use/24 months. (b) Refer to Exhibit 14-2 for Formula for Determining Maximum Home Sale Exclusion in Unforeseen Circumstances. vii) Exclusion of Gain from Debt Forgiveness on Foreclosure of Home Mortgage d) Home Mortgage Interest Deduction i) A major tax benefit of owning a home is that taxpayers are generally allowed to deduct the interest they pay on their home mortgage loans as an itemized (from AGI) deduction. ii) For taxpayers who itemize deductions (fewer will itemize with standard deduction increase), the mortgage interest expense can generate significant tax savings and reduce the after-tax cost of mortgage payments. iii) Taxpayers are allowed to deduct interest on the principal amount of acquisition indebtedness (up to a limit) as an itemized deduction. iv) Acquisition indebtedness is debt secured by the home that is used to acquire, construct, or substantially improve the home. (1) Once established, it is reduced by principal payments and can only be increased by debt incurred to substantially improve the home. (2) Acquisition indebtedness includes debt that the lender calls a “home equity loan” if the proceeds are secured by the residence and used to substantially improve the home. v) Debt secured by residence (1) The residence is the collateral for the loan. (2) If the owner does not make the payments on the loan, the lender may take possession of the home to satisfy the owner’s responsibility for the loan. vi) Qualified residence (1) Principal residence and one other residence. (2) If rented out, personal use must exceed greater of 14 days or 10 percent of rental days to be qualified residence. vii) Limitation on acquisition indebtedness (1) For loans occurring after December 15, 2017 (a) Limited to $750,000 ($375,000 for MFS) (2) For loans occurring before December 16, 2017 (a) Limited to $1,000,000 ($500,000 for MFS) viii) Mortgage Insurance ix) Points (1) A point is 1 percent of the principal amount of the loan. (2) Loan origination fees are considered to be points as long as they are clearly presented as percentage of the principal amount of the loan and they don’t pay for specific items such as appraisal fees or notary fees. (3) Taxpayers may pay points to lenders in exchange for reduced interest rates on loans, which are commonly referred to as discount points. (4) Points paid for a reduced interest rate (or for a loan origination fee) in refinancing a home loan are not immediately deductible by the homeowner. These points must be amortized and deducted on a straight-line basis over the life of the loan. (5) From an economic standpoint, the buyer must choose between: (a) Paying extra money up front and having lower monthly mortgage payments, or (b) Paying less initially and having larger monthly payments. e) Real Property Taxes i) These taxes are assessed by local governments and are based on the fair market value of the property. ii) These taxes support general public welfare by providing funding for public needs such as schools and roads. iii) Applies to homes, land, business buildings, and other types of real estate. iv) Homeowners frequently pay real property tax bill to escrow account. (1) Deduction timing based on payment of taxes to governmental body and not escrow account. v) When homeowners sell home during year: (1) Deduction is based on proportion of year taxpayer lived in the home, no matter who actually pays the tax. vi) The itemized deduction for all taxes combined is $10,000 ($5,000 if MFS). This includes state and local income tax (or sales tax), real property taxes, and personal property taxes. 3) Rental Use of the Home a) Tax treatment depends on amount of personal and rental use. The three categories are: i) Residence with minimum rental use (principal residence). ii) Residence with significant rental use (vacation home). iii) No residence (rental property). b) Residence with Minimal Rental Use i) Live in the home at least 15 days and rent 14 days or fewer. ii) Exclude all rental income. iii) Don’t deduct rental expenses. c) Residence with Significant Rental Use (Vacation Home) i) Use home for personal purposes for greater of 14 days or more than 10 percent of rental days. ii) Allocate expenses between rental use and personal use. iii) IRS method allocates interest and taxes to rental use based on rental use to total use for the year, while Tax Court method allocates to rental use based on rental use to total days in entire year. iv) Refer to Exhibit 14-3 for Tax Court versus IRS Method of Allocating Expenses. v) Deducting Rental Expenses of Vacation Home (1) Categorize each rental expense as a tier 1, tier 2, or tier 3 expense. (2) Deduct tier 1 expenses in full. (3) Deduct tier 2 expenses, not to exceed excess of gross rental revenue minus tier 1 expense. Excess tier 2 expenses carry over to subsequent year. (4) Deduct tier 3 expense (depreciation), not to exceed gross rental revenue minus the sum of tier 1 and tier 2 expenses. Excess tier 3 expense carries over to subsequent year and does not reduce basis in property. vi) Refer to Exhibit 14-4 for Rental Expenses by Tier and Deduction Sequence. vii) Refer to Exhibit 14-5 for the Jeffersons’ Schedule E for Vacation Home Rental. d) No residence (Rental Property) i) Must rent for one day or more and limit personal use to greater of 14 days or 10 percent of rental days. ii) Allocate expenses to rental and personal use. iii) Rental deductions in excess of rental income are deductible subject to passive loss limitation rules. iv) Interest expense allocated to personal use not deductible. e) Refer to Exhibit 14-6 for Summary of Tax Rules Relating to Home Used for Rental Purposes. f) Losses on Rental Property i) Losses on home rentals in the no residence-use category are passive losses. ii) Passive loss rules generally limit deductions for losses from passive activities such as rental to passive income from other sources. iii) Passive losses in excess of passive income are suspended and deductible against passive income in the future or when the taxpayer sells the passive activity generating the loss. iv) Rental real estate exception to passive loss rules (1) Applies to active participants in rental property. (2) Deduct up to $25,000 of rental real estate loss against ordinary income. (3) $25,000 maximum deduction phased out by 50 cents for every dollar of AGI over $100,000 (excluding the rental loss deduction). Fully phased out at $150,000 of AGI. 4) Business Use of the Home a) Because a personal residence is a personal-use asset, utility payments and depreciation due to wear and tear are not deductible expenses. b) To qualify for home office deductions, a taxpayer must use her home—or part of her home—exclusively and regularly as either the principal place of business for any of the taxpayer’s trade or businesses, or as a place to meet with patients, clients, or customers in the normal course of business. c) When a taxpayer has more than one business location, including the home, which is her principal place of business? This is a facts-and-circumstances determination based upon: i) The total time spent doing work at each location, and ii) The relative amount of income derived from each location. d) 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. e) Actual expense method i) Direct versus indirect expenses ii) Depreciation expense (1) Reduces basis in home. (2) Gain on sale due to depreciation is ineligible for exclusion. (3) This gain is taxed at a maximum 25 percent rate as unrecaptured §1250 gain. f) Simplified method i) Square footage (up to 300 square feet) × $5 application rate ii) No depreciation expense. iii) Limited to gross income minus business expenses unrelated to home. (1) Excess expenses do not carry over to subsequent year. g) Limitations on Deductibility of Expenses i) Must be self-employed to deduct (not allowed for employees). ii) If self-employed, deducted for AGI but deduction limited to net business income before the deduction. iii) If deduction is limited by income limitation, apply the same tiered system as used for rental property when deductions are limited to rental income (for actual expense method). h) Refer to Exhibit 14-7 for Expenses for Business Use of Your Home. 5) Appendix A—Sample Settlement Statement for the Jeffersons 6) Appendix B—Flowchart of Tax Rules Relating to Home Used for Rental Purposes Class Activities 1. Suggested class activities ○ 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. 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. ○ Group discussion on renting versus buying a home: Have students form groups of approximately four students each. Tell the students that they have just started a new job in a new location and they need to decide to buy or rent a home. Have them identify/discuss circumstances that would cause them to prefer to rent and circumstances that would cause them to prefer to buy. A takeaway should be that despite the tax-favored status of home ownership, there may be situations in which renting makes more sense even when you can afford to buy a home. Have the students discuss this in their groups and then report back to the class what was discussed. 2. Ethics discussion From page 14-16: Discussion points: • Is it permissible to depart from specific tax rules in order to obtain fairness? • Substance versus form. Chapter 15 Business Entities Overview Learning Objectives 15-1. Discuss the legal and other nontax characteristics of different types of legal business entities. 15-2. Describe the different types of business entities for tax purposes. 15-3. 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 15-2 for a flowchart illustrating the check-the-box rules. In addition, the chapter compares and contrasts C corporations, S corporations, and 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 the recent tax law changes relating to entity taxation, some of the significant tax variables in entity choice have changed. The chapter compares the taxation of income across entity types and the tax treatment of entity losses across entity types. Exhibit 15-3 presents several tax characteristics, summarizes how each characteristic is treated for tax purposes for each entity type, 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, partnerships, and S 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. Note that this chapter does not get into detail with respect to the deduction for qualified business income. The QBI deduction is a deduction for individuals, not for business entities. Thus, this chapter discusses the deduction only to the extent it is relevant for determining the overall tax rate of business income. Details on the computation and its associated limitations are provided in the chapter discussing individual deductions, which is included in all versions of the book other than the entities version. Assignment Matrix Learning objectives Text Feature Difficulty LO1 LO2 LO3 Research Planning Tax Forms DQ15-1 10 min. Easy X DQ15-2 10 min. Easy X DQ15-3 10 min. Easy X DQ15-4 20 min. Medium X DQ15-5 20 min. Medium X DQ15-6 20 min. Medium X DQ15-7 20 min. Medium X DQ15-8 20 min. Medium X X DQ15-9 20 min. Medium X DQ15-10 20 min. Medium X DQ15-11 20 min. Medium X DQ15-12 10 min. Medium X DQ15-13 5 min. Medium X DQ15-14 10 min. Medium X DQ15-15 10 min. Hard X DQ15-16 10 min. Medium X DQ15-17 10 min. Medium X DQ15-18 10 min. Medium X DQ15-19 10 min. Medium X DQ15-20 10 min. Medium X DQ15-21 10 min. Hard X DQ15-22 10 min. Medium X DQ15-23 10 min. Medium X DQ15-24 10 min. Medium X DQ15-25 5 min. Hard X DQ15-26 5 min. Medium X DQ15-27 10 min. Hard X DQ15-28 10 min. Medium X DQ15-29 5 min. Easy X DQ15-30 10 min. Hard X DQ15-31 5 min. Hard X DQ15-32 10 min. Hard X DQ15-33 10 min. Hard X DQ15-34 5 min. Hard X DQ15-35 10 min. Medium X DQ15-36 10 min. Medium X DQ15-37 10 min. Hard X DQ15-38 15 min. Hard X DQ15-39 10 min. Hard X DQ15-40 15 min. Hard X DQ15-41 20 min. Hard X DQ15-42 15 min. Medium X P15-43 15 min. Easy X X P15-44 15 min. Medium X P15-45 15 min. Medium X P15-46 15 min. Medium X P15-47 25 min. Hard X P15-48 20 min. Medium X P15-49 20 min. Medium X P15-50 20 min. Medium X P15-51 20 min. Medium X P15-52 15 min. Medium X X P15-53 20 min. Medium X X P15-54 15 min. Medium X X P15-55 20 min. Hard X P15-56 10 min. Medium X P15-57 10 min. Medium X P15-58 20 min. Medium X P15-59 20 min. Medium X P15-60 15 min. Medium X X P15-61 15 min. Hard X X P15-62 15 min. Easy X X P15-63 20 min. Medium X X CP15-64 30 min. Hard X X CP15-65 30 min. Hard X 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. (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 15-1 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 that reports its taxable income to the IRS on Form 1120. 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). f) There are really only four categories of business entities recognized by our tax system, as follows: i) C corporation (separate taxpaying entity) ii) S corporation (flow-through entity) iii) Partnership (flow-through entity) iv) Sole proprietorship (flow-through entity) g) Refer to Exhibit 15-2 for flowchart on determining the tax form of a business entity under check-the-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. vi) 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). vii) 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. viii) 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. ix) 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). x) Corporation income is taxed at a flat 21 percent rate. xi) 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. xii) C corporation shareholders are generally eligible to receive a 50, 65, or 100 percent dividends received deduction on dividends received. xiii) 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 and foreign shareholders (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. (b) 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. (5) 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 prior to 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. ii) C corporations with NOLs incurred after 2017 can carry loss forward indefinitely but may only offset 80 percent of the taxable income for that year before the NOL deduction. iii) Losses from C corporations are not available to offset a shareholders’ taxable income. iv) Losses generated by flow-through entities are generally available to offset the owners’ personal income, subject to certain restrictions. v) To be deductible, the losses must clear the basis, at-risk, passive activity limitations, and excess loss limitations. vi) 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. 4) Other Tax Characteristics a) Converting to other business entity types i) Entity choice summary (1) Refer to Exhibit 15-3 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. Class Activities 1. Suggested class activities ○ 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. ○ 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 group’s 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 From page 15-18: 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 Troy 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? • 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 Troy is cutting his salary to a level that is unreasonably low for the services he provides, this could be an issue. If he can reasonably support the salary reduction, his decision is not necessarily unethical. • Get students to see both sides and not just focus on reasons that the decision might be unethical. 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