This Document Contains Chapters 22 to 25 Chapter 22 S Corporations Learning Objectives 22-1. Describe the requirements and process to elect S corporation status. 22-2. Explain the events that terminate the S corporation election. 22-3. Describe operating issues relating to S corporation accounting periods and methods, and explain income and loss allocations and separately stated items. 22-4. Explain stock-basis calculations, loss limitations, determination of self-employment income, and fringe benefit rules that apply to S corporation shareholders. 22-5. Apply the tax rules for S corporation operating distributions and liquidating distributions. 22-6. Describe the taxes that apply to S corporations, estimated tax requirements, and tax return filing requirements. Teaching Suggestions Throughout this chapter, we highlight the tax similarities between S corporations and C corporations and between S corporations and partnerships, while focusing on the unique rules that apply to S corporations. This chapter provides a great opportunity to review corporate and partnership tax rules and to revisit entity selection. In teaching this chapter, the time that you spend in class will vary based on how much depth you want to cover on the more complex topics that are unique to S corporations such as the built-in gains tax, excess net passive income tax, LIFO recapture tax, and the post-termination transition period loss deductions and distributions. The remaining topics in the chapter either are less technical (e.g., S corporation qualification requirements) or have a lot of overlap with material covered in the prior C corporation chapters (e.g., corporate formations) or partnership chapters (e.g., basis computation). Key points that you may wish to make sure students are clear on: • Liabilities are not included in the shareholder’s stock basis. • A shareholder’s stock basis may not be negative. • Shareholder loans to the corporation may create debt basis that can absorb losses but do not protect distributions from taxation. • Allocations of business income to shareholders are not subject to FICA or self-employment tax. • The S corporation designation is a tax designation only—not a legal designation. • The tax rules for many items are more complex for S corporations that were formerly C corporations with earnings and profits. Assignment Matrix Learning Objectives Text Feature Difficulty LO1 LO2 LO3 LO4 LO5 LO6 Research Planning Forms DQ22-1 10 min. Easy X DQ22-2 10 min. Easy X DQ22-3 5 min. Easy X DQ22-4 5 min. Easy X DQ22-5 5 min. Easy X DQ22-6 5 min. Easy X DQ22-7 5 min. Easy X DQ22-8 5 min. Medium X DQ22-9 5 min. Easy X DQ22-10 5 min. Easy X DQ22-11 10 min. Medium X DQ22-12 10 min. Medium X DQ22-13 10 min. Easy X DQ22-14 5 min. Medium X DQ22-15 5 min. Easy X DQ22-16 10 min. Medium X DQ22-17 10 min. Easy X DQ22-18 10 min. Easy X DQ22-19 5 min. Easy X DQ22-20 10 min. Easy X DQ22-21 10 min. Medium X DQ22-22 10 min. Easy X DQ22-23 10 min. Medium X DQ22-24 10 min. Medium X DQ22-25 10 min. Medium X DQ22-26 10 min. Easy X DQ22-27 10 min. Easy X DQ22-28 10 min. Medium X DQ22-29 10 min. Easy X DQ22-30 10 min. Medium X DQ22-31 10 min. Easy X DQ22-32 10 min. Medium X DQ22-33 10 min. Medium X DQ22-34 10 min. Medium X DQ22-35 10 min. Easy X DQ22-36 10 min. Medium X DQ22-37 10 min. Medium X DQ22-38 10 min. Easy X DQ22-39 10 min. Easy X DQ22-40 10 min. Easy X DQ22-41 30 min. Medium X P22-42 15 min. Medium X P22-43 40 min. Hard X X P22-44 15 min. Medium X P22-45 15 min. Medium X P22-46 15 min. Medium X P22-47 30 min. Medium X P22-48 15 min. Medium X P22-49 20 min. Medium X P22-50 30 min. Medium X X P22-51 15 min. Medium X X P22-52 30 min. Medium X X P22-53 30 min. Medium X X P22-54 15 min. Medium X P22-55 15 min. Medium X P22-56 20 min. Medium X P22-57 15 min. Medium X P22-58 60 min. Hard X X P22-59 30 min. Hard X P22-60 15 min. Medium X X P22-61 60 min. Hard X X P22-62 15 min. Medium X P22-63 30 min. Hard X X P22-64 10 min. Medium X P22-65 15 min. Medium X P22-66 20 min. Medium X P22-67 15 min. Medium X P22-68 25 min. Medium X P22-69 25 min. Medium X P22-70 15 min. Medium X P22-71 30 min. Medium X P22-72 30 min. Medium X P22-73 25 min. Medium X P22-74 20 min. Medium X P22-75 20 min. Medium X P22-76 25 min. Medium X P22-77 20 min. Medium X P22-78 20 min. Medium X P22-79 15 min. Medium X P22-80 60 min. Hard X X X P22-81 15 min. Medium X X P22-82 25 min. Medium X CP22-83 30 min. Medium X CP22-84 60 min. Hard X CP22-85 60 min. Hard CP22-86 60 min. Hard X Lecture Notes 1) S Corporation Elections a) Formations b) S corporation qualification requirements i) Only U.S. citizens or residents, estates, certain trusts, and certain tax-exempt organizations may be S corporation shareholders. ii) S corporations may have no more than 100 shareholders. iii) For purposes of the 100-shareholder limit, family members and their estates count as only one shareholder. iv) Work through Example 22-1. c) S corporation election i) An eligible corporation must make an affirmative election to be treated as an S corporation. ii) Work through Example 22-2. iii) To elect S corporation status, the corporation makes a formal election using Form 2553. iv) Work through Example 22-3. v) Even when the corporation makes the election by the 15th day of the third month of its tax year, the election will not be effective until the subsequent year if: (1) The corporation did not meet the S corporation requirements for each day of the current tax year before it made the S election, or (2) One or more shareholders who held the stock in the corporation during the current year and before the S corporation election was made did not consent to the election. vi) Eligible corporations meet the type and number of shareholder requirements, are domestic corporations, are not specifically identified as ineligible corporations, and have only one class of stock. vii) Work through Example 22-4. 2) S Corporation Terminations a) Voluntary terminations i) The Selection may be revoked by shareholders holding more than 50 percent of the S corporation stock (including nonvoting shares). ii) Work through Example 22-5. b) Involuntary terminations i) Failure to meet requirements (1) A corporation’s Selection is automatically terminated if the S corporation fails to meet the S corporation requirements. (2) The Selection is terminated effective on the date it fails the S corporation requirements. (3) Work through Example 22-6. ii) Excess of passive investment income (1) If an S corporation has earnings and profits from a previous C corporation year (or through a reorganization with a corporation that has earnings and profits), its election is terminated if the S corporation has passive investment income in excess of 25 percent of gross receipts for three consecutive years. (2) Passive investment income (PII) includes gross receipts from royalties, rents, dividends, interest, and annuities. (3) S corporation election terminations due to excess passive investment income are effective on the first day of the year following the third consecutive tax year with excess passive investment income. (4) Work through Example 22-7. c) Short tax years i) Work through Example 22-8. d) S corporation reelections i) If the election was terminated effective the first day of the tax year, the corporation must wait five full years to again become an S corporation. ii) Work through Example 22-9. 3) Operating Issues a) Accounting methods and periods i) S corporations must use a calendar year-end unless they can establish a business purpose for an alternative year-end or a natural business year-end. b) Income and loss allocations i) S corporations, like partnerships, are flow-through entities, and thus their profits and losses flow through to their shareholders annually for tax purposes. ii) S corporations allocate profits and losses to shareholders pro rata, based on the number of outstanding shares each shareholder owns on each day of the tax year. iii) Work through Example 22-10. c) Separately stated items i) Separately stated items are tax items that are treated differently from a shareholder’s share of ordinary business income (loss) for tax purposes. ii) Refer to Exhibit 22-1 for Common Separately Stated Items. iii) S corporations may hold stock in C corporations, and any dividends S corporations receive will flow through to their shareholders. iv) Refer to Exhibit 22-2 for Color Comfort Sheets Income Statement, December 31, 2019 and 2020. v) Work through Example 22-11. 4) Shareholder’s Basis a) A shareholder will increase the tax basis in his/her stock for: i) Contributions ii) Share of ordinary business income iii) Separately stated income/gain items iv) Tax-exempt income b) A shareholder will decrease the tax basis in his/her stock for: i) Cash distributions ii) Share of nondeductible expenses iii) Share of ordinary business loss iv) Separately stated expense/loss items c) A shareholder’s tax basis may not be negative. d) Initial basis i) Specifically, the shareholder’s basis in stock received in the exchange equals the tax basis of the property transferred, less any liabilities assumed by the corporation on the property contributed (substituted basis). ii) Work through Example 22-12. e) Annual basis adjustments i) Specifically, an S corporation shareholder’s stock basis is dynamic and must be adjusted annually to ensure that: (1) Taxable income/gains and deductible expenses/losses are not double-counted by shareholders either when they sell their shares or receive S corporation distributions and (2) Tax-exempt income and nondeductible expenses are not ultimately taxed or deducted. ii) Work through Example 22-13. f) Loss limitations i) Tax-basis limitation (1) Losses not deductible due to the tax-basis limitation are not necessarily lost. Rather, they are suspended until the shareholder generates additional basis. (2) If the shareholder sells the stock before creating additional basis, the suspended loss disappears unused. (3) Work through Example 22-14. (4) Shareholders can mitigate the disadvantage of not including S corporation debt in their stock basis by loaning money directly to their S corporations. These loans create debt basis, separate from the stock basis. (5) Work through Example 22-15. ii) At-risk limitation (1) S corporation shareholders are deemed at risk only for direct loans they make to S corporations. (2) With one notable exception, an S corporation shareholder’s at-risk amount is the same as her stock basis. iii) Post-termination transition period loss limitation (1) PTTP begins on the day after the last day of the corporation’s last taxable year as an S corporation and ends on the later of (a) one year after the last S corporation day or (b) the due date for filing the return for the last year as an S corporation (including extensions). (2) Work through Example 22-16. iv) Passive activity loss limitation (1) As in partnerships, the passive activity loss rules limit the ability of S corporation shareholders to deduct losses unless they are involved in actively managing the business. (2) Work through Example 22-17. v) Excess business loss limitation (1) Taxpayers are not allowed to deduct an “excess business loss” for the year. (2) An excess business loss for the year is the excess of aggregate business deductions for the year over the sum of aggregate business gross income or gain of the taxpayer plus a threshold amount. (3) The provision applies at the shareholder level. vi) Self-employment income (1) S corporation shareholders may desire to avoid payroll taxes by limiting or even eliminating their salary payments. However, if they work as employees, they are required to pay themselves a reasonable salary for the services they perform. vii) Net investment income tax (1) S corporation shareholders are subject to the net investment income tax on their share of an S corporation's gross income from interest, dividends, annuities, royalties, rents, a trade or business that is a passive activity or a trade or business of trading financial instruments or commodities, and generally any net gain from disposing of property, less any allowable deductions from these items. viii) Fringe benefits (1) For shareholder-employees who own 2 percent or less of the entity, the S corporation receives C corporation tax treatment. (2) For shareholder-employees who own more than 2 percent of the S corporation, it receives partnership treatment. 5) Distributions a) Operating distributions i) S corporation with no C corporation accumulated earnings and profits (1) Two sets of historical circumstances could apply here: (a) An entity may have been an S corporation since inception, or (b) It may have been converted from a C corporation but does not have C corporation accumulated earnings and profits at the time of the distribution. (2) Shareholder distributions are tax-free to the extent of the shareholder’s stock basis. (3) If a distribution exceeds the shareholder’s stock basis, the shareholder has a capital gain equal to the excess distribution amount. (4) Work through Example 22-18. ii) S corporations with C corporation accumulated earnings and profits (1) For S corporations, the tax laws require the corporation to maintain an accumulated adjustments account (AAA) to determine the taxability of S corporate distributions. (2) Unlike a shareholder’s stock basis, the AAA may have a negative balance. (3) End of year AAA formula = (The beginning of year AAA balance + Separately stated income/gain items (excluding tax-exempt income) + Ordinary income − Separately stated losses and deductions − Ordinary losses − Nondeductible expenses that are not capital expenditures (except deductions related to generating tax-exempt income) − Distributions out of AAA) (4) Work through Example 22-19. (5) Once an S corporation’s accumulated E&P is fully distributed, the remaining distributions reduce the shareholder’s remaining basis in the S corporation stock (if any) and are nontaxable. (6) Work through Example 22-20. b) Property distributions i) S corporations recognize gains but not losses when they distribute property to their shareholders. ii) The rules for determining the taxability of property distributions at the shareholder level are the same as those for cash distributions. iii) For shareholders, the amount of the distribution is the fair market value of the property received (minus any liabilities the shareholder assumes on the distribution). iv) Shareholders take a fair market value basis in the property received in the distribution. v) Work through Example 22-21. c) Post-termination transition period distributions i) The PTTP for post-termination distributions is generally the same as the PTTP for deducting suspended losses. ii) Special rules apply for distributions after the PTTP for eligible terminated S corporations. d) Liquidating distributions i) Shareholders recognize gain on the distribution if the value of the property exceeds their stock basis; they recognize loss if their stock basis exceeds the value of the property. ii) Work through Example 22-22. 6) S Corporation Taxes and Filing Requirements a) Built-in gains tax i) The built-in gains tax applies only to S corporations that have a net unrealized built-in gain at the time they converted from C corporations and that recognize net built-in gains during their first five years’ operating as an S corporation. ii) The net unrealized built-in gain represents the net gain (if any) that the corporation would recognize if it sold each asset at its fair market value. iii) Work through Example 22-23. iv) Recognized built-in gains (losses) include the gain (loss) for any asset sold during the year [limited to the unrealized gain (loss) for the specific asset at the S conversion date]. v) The net recognized built-in gain for any year is limited to the least of: (1) The net of the recognized built-in gains and losses for the year. (2) The net unrealized built-in gains as of the S election date less the net recognized built-in gains in previous years. (3) The corporation’s taxable income for the year, using the C corporation tax rules exclusive of the dividends received deduction and net operating loss deduction. vi) After the net recognized built-in gain has been determined using the limitations above, it is reduced by any NOL or capital loss carryovers from prior C corporation years. This base is then multiplied by the highest corporate tax rate (21 percent) to determine the built-in gains tax. vii) Work through Example 22-24 b) Excess net passive income tax i) The excess net passive income tax applies only to S corporations that previously operated as C corporations and at the end of the year have accumulated earnings and profits from a prior C corporation year. ii) This tax applies when passive investment income exceeds 25 percent of gross receipts. iii) Passive investment income includes gross receipts from royalties, rents, dividends, interest (including tax-exempt interest), and annuities. iv) Excess net passive income tax = 21% × Excess net passive income v) Net passive investment income is passive investment income decreased by any expenses connected with producing that income. vi) Work through Example 22-25. c) LIFO recapture tax i) C corporations that elect S corporation status and use the LIFO inventory method are subject to the LIFO recapture tax. ii) The corporation pays the LIFO recapture tax in four annual installments. The first installment is due on or before the due date (not including extensions) of the corporation’s last C corporation tax return. The final three annual installments are due each year on or before the due date (not including extensions) of the S corporation’s tax return. iii) Work through Example 22-26. d) Estimated taxes i) S corporations owing the built-in gains tax or excess net passive investment income tax (but not the LIFO recapture tax) must pay the tax based on estimated tax rules similar to C corporations. ii) Refer to Exhibit 22-3 for Part I CCS’s Form 1120S, page 1. iii) Refer to Exhibit 22-3 for Part II CCS’s 2020 partial Schedule K (2019 forms because 2020 forms were unavailable). e) Filing requirements i) S corporations file Form 1120S to report the results of their operations for the year. They request a filing extension on Form 7004. ii) Refer to Exhibit 22-3 for Part III Nicole’s 2020 Schedule K-1 (2019 forms because 2020 forms were unavailable). f) Comparing C and S corporations and partnerships i) Refer to Exhibit 22-4 for Comparison of Tax Consequences for C and S Corporations and Partnerships. 7) Conclusion 8) Summary 9) Key Terms Class Activities 1. Suggested class activities ○ Name that characteristic: This chapter provides a great opportunity to review corporate and partnership tax rules and to emphasize the unique rules for S corporations. One end-of-class exercise that an instructor can incorporate to emphasize the commonalities across entities and the unique features of S corporations is to use Exhibit 22-4 as the basis for a quiz or in-class game in which the instructor chooses a transaction or entity attribute (e.g., S corporation formation) and the students identify whether the S corporate treatment is primarily similar to C corporations or partnerships or is unique. ○ One versus the class: Have one student volunteer as the “one” with the other class members being the “group.” Use the Key Facts boxes in the text to develop multiple-choice questions (A, B, C answers) and then quiz the volunteer and the class on the questions. The volunteer and each class member will need to write the letters A, B, and C on separate sheets of paper and then hold up their appropriate response to the question. Once a student (either the “one” or a member of the “group”) misses a question, he or she is eliminated from the competition. After six (or some other number) of questions, those students left standing receive bonus participation points for the day. ○ Research activity: The end of the chapter provides several research questions that may be assigned to allow students to delve deeper into the rules for S corporations and to refine their research skills. ○ Comprehensive problems: Have students work in groups (two to four students) to complete a comprehensive problem (problem 86 is a good problem for students to compare the tax computation and reporting differences across entities; problems 83–85 are problems dealing with S corporations only). Make yourself available to students to answer questions but try to get them to work together to answer or resolve their questions. You could have students download forms from the IRS website. You could also walk through the C corporation solution before turning them loose on the S corporation and/or partnership portion. 2. Ethics discussion From page 22-5: Discussion points: • What requirement would Chance’s move violate with respect to CCS’s S corporation status? • What are the consequences if Sarah and Nicole ignore the impact on CCS’s S corporation status? Would this action violate tax law? Would this action violate ethical standards? • If Sarah and Nicole pressure Chance to sell his stock, does this action violate tax law? Ethical standards? • From a planning perspective, could you provide CCS with advice as to how to avoid this issue in the future? Chapter 23 State and Local Taxes Learning Objectives 23-1. Describe the primary types of state and local taxes. 23-2. Determine whether a business has sales tax nexus and calculate its sales tax withholding responsibilities. 23-3. Identify whether a business has income tax nexus and determine its state income tax liabilities. Teaching Suggestions This chapter is organized around issues dealing with state and local taxation. There are many topics in this chapter. The instructor may not wish to cover all topics. It is important to note that state and local taxes take many forms, but the primary taxes are sales taxes, income or franchise taxes, and property taxes. The chapter takes a conceptual approach that is focused on learning broadly applicable principles useful in understanding and applying these tax regimes to taxpayers. The most important concept for students to understand is nexus for sales and use taxes and income taxes. This understanding will allow students to identify potential state and local tax problems with future clients. Most accounting firms teach these state and local tax concepts to their professionals to help them identify when it is appropriate to bring state and local tax experts into an engagement. Sales taxes are pervasive, and the concepts are shifting as the economic base moves toward e-commerce. The most important concept is that failure to collect sales taxes when sales tax nexus exists can create significant exposure that can threaten the existence of a taxpayer as a going concern. The Wayfair decision has now created economic sales tax nexus for online sellers, which applies in addition to the physical presence sales tax nexus standard. Another concept for students to understand on a personal level is that most individuals have a use tax requirement, which is likely created through ordering books from an online seller or downloading music from iTunes. Income or franchise taxes are also important, and the concepts—particularly state apportionment methodologies—are shifting constantly. Most states are increasing the sales factor weighting, which favors in-state businesses while increasing the burden of out-of-state businesses. Understanding how Public Law 86-272 protects sellers of tangible personal property from an income tax liability is another important topic. There are significant operational planning strategies that can help taxpayers avoid income tax nexus. Assignment Matrix Learning Objectives Text Feature Difficulty LO1 LO2 LO3 Research Planning Tax Forms DQ23-1 10 min. Easy X DQ23-2 10 min. Easy X DQ23-3 10 min. Easy X DQ23-4 20 min. Medium X DQ23-5 20 min. Medium X DQ23-6 20 min. Medium X DQ23-7 20 min. Medium X DQ23-8 20 min. Medium X DQ23-9 20 min. Medium X DQ23-10 20 min. Medium X DQ23-11 20 min. Medium X DQ23-12 10 min. Medium X DQ23-13 10 min. Medium X DQ23-14 10 min. Medium X DQ23-15 10 min. Medium X DQ23-16 10 min. Medium X DQ23-17 25 min. Hard X DQ23-18 25 min. Hard X DQ23-19 25 min. Hard X DQ23-20 20 min. Hard X DQ23-21 20 min. Hard X DQ23-22 20 min. Hard X DQ23-23 20 min. Hard X DQ23-24 20 min. Hard X DQ23-25 20 min. Hard X DQ23-26 20 min. Hard X DQ23-27 20 min. Hard X P23-28 25 min. Medium X P23-29 20 min. Medium X P23-30 35 min. Medium X P23-31 30 min. Medium X X P23-32 30 min. Medium X P23-33 40 min. Hard X X P23-34 45 min. Hard X P23-35 35 min. Medium X X P23-36 30 min. Medium X P23-37 30 min. Medium X P23-38 35 min. Medium X P23-39 50 min. Medium X X P23-40 50 min. Medium X X P23-41 50 min. Hard X X P23-42 50 min. Hard X X X P23-43 40 min. Hard X P23-44 40 min. Hard X P23-45 35 min. Medium X P23-46 35 min. Hard X P23-47 35 min. Medium X P23-48 35 min. Hard X P23-49 30 min. Medium X CP23-50 60 min. Hard X CP23-51 60 min. Hard CP23-52 110 min. Hard Lecture Notes 1) State and Local Taxes a) Company subject to a state’s taxing regime based on: i) Commercial domicile ii) Nexus b) Refer to Exhibit 23-1 for Wild West’s Activities and Sales by State. c) Refer to Exhibit 23-2 for State Sales and Use Tax Process. d) Refer to Exhibit 23-3 for State Income Tax Process. 2) Sales and Use Taxes a) Sales tax nexus i) Sales tax nexus is the sufficient connection between a business and a state that allows a state to require an out-of-state business to collect sales taxes and remit them to the state. ii) Sales tax nexus was traditionally established through physical presence of salespeople or property in a state. The Wayfair decision creates economic sales tax nexus for online sellers with more than $100,000 or 200 sales transactions within a state on an annual basis. iii) Work through Example 23-1. iv) Refer to Exhibit 23-4 for Excerpt from Wayfair’s Annual Report. b) Sales tax liability i) If the seller doesn’t have nexus, then the customer is responsible for remitting a use tax (at the same tax rate as sales tax) to the state in which the property is used. ii) Work through Example 23-2. iii) Work through Example 23-3. 3) Income Taxes a) Businesses must pay income tax in their state of commercial domicile. b) Four criteria for determining whether states can tax nondomiciliary companies and to what extent: i) Sufficient connection or nexus must exist between the state and the business. ii) A state may tax only a fair portion of a business’s income. Businesses must be able to divide or apportion income among the states where nexus exists. iii) The tax cannot be constructed to discriminate against nonresident businesses. iv) The taxes paid must be fairly related to the services the state provides. c) Income tax nexus is created through physical presence within a state. i) Public Law 86-272 (1) Businesses with income tax nexus are protected from an income tax liability if, and only if, all the following apply: (a) The tax is based on net income (not gross receipts or revenue). (b) The taxpayer sells only tangible personal property in that state. (c) The taxpayer’s in-state activities are limited to solicitation of sales (see below for the definition of solicitation). (d) The taxpayer participates in interstate commerce. (e) The taxpayer is nondomiciliary. (f) The taxpayer approves orders outside the state. (g) The taxpayer delivers goods from outside the state. (2) Work through Example 23-4. (3) Solicitation (a) The Supreme Court determined the following activities meet the definition of solicitation: (i) Soliciting by any form of advertising. (ii) Carrying samples and promotional materials for display or distribution without charge. (iii) Passing inquiries or complaints to the home office. (iv) Checking customer’s inventory for reorder. (v) Maintaining a sample room for two weeks or less; this is known as the trade show rule. (vi) Recruiting, training, and evaluating salespeople using homes or hotels. (vii) Owning or furnishing personal property and autos used in sales activities. (b) The Supreme Court held the following activities do not meet the definition of solicitation and, therefore, create income tax nexus with the state in which they take place: (i) Making repairs. (ii) Collecting delinquent accounts. (iii) Investigating creditworthiness. (iv) Installing or supervising the installation of property. (v) Training for employees other than sales representatives. (vi) Approving or accepting orders. (vii) Repossessing property. (viii) Securing deposits. (ix) Maintaining an office (other than in-home). (c) Work through Example 23-5. (d) Work through Example 23-6. (e) Work through Example 23-7. ii) Economic income tax nexus (1) Work through Example 23-8. (2) Work through Example 23-9. (3) Discuss Factor Presence Nexus (Taxes in the Real World) and Independent Contractors Creating Nexus (Taxes in the Real World) d) Entities included on income tax return i) Separate tax returns (1) Separate-return states require a separate return for each entity that has income tax nexus in the state. (2) Work through Example 23-10. ii) Unitary tax returns (1) Unitary states require members of a unitary group to file a single tax return reflecting the combined income of the unitary group. (2) Any of three factors determine a unitary group: functional integration, centralization of management, and economies of scale. (3) Work through Example 23-11. e) State taxable income i) Federal taxable income—starting point for computing state taxable income ii) Identify federal/state adjustments (differences) for each specific state. iii) Refer to Exhibit 23-5 for Common Federal/State Adjustments. iv) Work through Example 23-12. f) Dividing state tax base among states i) Business income (1) Work through Example 23-13. (2) Apportionment formula (a) Historically, most states determined the apportionment formula for income by relying on a three-factor test: sales, payroll, and property. Most states have shifted to either a single-factor sales formula or a factor that super-weights the sales factor. (b) Businesses determine the factors as the ratio of: (i) Total sales, payroll, or property in a specific state. (ii) Total sales, payroll, or property everywhere. (c) The general rules for determining the amount of sales to include in the sales factor calculation are: (i) Tangible personal property sales are sourced (included) in the destination state (the location the property is delivered and used). (ii) If the business does not have nexus in the destination state, sales are generally “thrown back” to the state from which the property is shipped; this is called the throwback rule. (d) Work through Example 23-14. (e) Payroll factor (i) Payroll includes salaries, commissions, bonuses, and other forms of compensation. (ii) Payroll does not include amounts paid to independent contractors. (iii) Payroll for each employee is apportioned to a single state (payroll for employees who work in more than one state is sourced to the state where they perform the majority of services). (iv) Work through Example 23-15. (f) Property (i) Use the average property values for the year [(beginning + ending) / 2]. (ii) Value property at historical cost rather than adjusted basis (do not subtract accumulated depreciation in determining value). (iii) Include property in transit (such as inventory) in the state of destination. (iv) Include only business property (values of rented investment properties are excluded). (v) Include rented or leased property by multiplying the annual rent by eight and adding this value to the average owned-property factor. (vi) Work through Example 23-16. (g) Work through Example 23-17. ii) Nonbusiness income (1) Common types of nonbusiness income and the rules for allocating them to specific states: (a) Allocate interest and dividends to the state of commercial domicile (except interest on working capital, which is business income). (b) Allocate rental income to the state where the property generating the rental income is located. (c) Allocate royalties to the state where the property is used (if the business has nexus in that state; if not, allocate royalties to the state of commercial domicile). (d) Allocate capital gains from investment property to the state of commercial domicile. (e) Allocate capital gains from selling rental property to the state where the rental property was located. (2) Work through Example 23-18. g) State income tax liability i) Business income is apportioned based on some combination of the following factors: (1) Sales (2) Payroll (3) Property ii) Nonbusiness income is allocated. (1) Investment income is allocated to the state of commercial domicile. (2) Rents and royalties are generally allocated to the state where the property is used. iii) Work through Example 23-19. h) No income-based taxes i) Nexus for no income-based taxes (1) No income-based tax nexus simply requires physical presence. (2) Two examples of no income-based taxes are the Texas Margin Tax and the Washington Business and Occupation tax. (3) Work through Example 23-20. ii) Calculation of a no income-based tax (1) Work through Example 23-21. 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. ○ Income tax amnesty: Have students do a search to see what states are currently offering amnesty to businesses willing to pay some back taxes and agree to voluntarily comply with the state’s tax regime in the future. What are the positive and negative ramifications of offering a tax amnesty? ○ Designing a tax system: Tell students that the class has just been asked to help a sovereign state determine optimal state and local tax policies. The primary consideration is how to weight the primary tax options (sales and use tax, income or franchise tax, and property tax). Additionally, determining the policy regarding the relative burden to be borne by in-state versus nonresident businesses—primarily through apportionment factor methodologies. Have the students break into groups of three to five to design a tax system. As part of this task, they are to evaluate the advantages and disadvantages of their tax. The group judged by the class to have the most advantageous tax system receives bonus participation points for the day. ○ 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, her or she is eliminated from the competition. After six (or some other number of) questions, those students left standing receive bonus participation points for the day. 2. Ethics discussion From page 23-8: Discussion points: • The use tax is owed every time a purchase is made by a retailer not having nexus with the destination state. • Most individuals are unaware that they actually owe the tax. • Not paying the use tax is tantamount to tax evasion. From page 23-9: Discussion points: • The Oklahoma and Pennsylvania laws are law until they are designated as unconstitutional. • Larger retailers like Wayfair and Overstock are complying with these laws, but also vigorously defending themselves in court. The Direct Marketing Association is a trade association that is actively defending online sellers from these types of taxes. • Companies that fail to collect and remit have a FAS 5 contingency on their financial statements. Chapter 24 The U.S. Taxation of Multinational Transactions Learning Objectives 24-1. Describe the basic U.S. framework for taxing multinational transactions and the role of the foreign tax credit limitation. 24-2. Apply the U.S. source rules for common items of gross income and deductions. 24-3. Explain the role of income tax treaties in international tax planning. 24-4. Identify creditable foreign taxes and compute the foreign tax credit limitation. 24-5. Compare the advantages and disadvantages of the different forms of doing business outside the United States. 24-6. Explain the basic U.S. anti-deferral tax regime and identify common sources of subpart F income. Teaching Suggestions International taxation is an extraordinarily complex topic and often is taught as a full semester course. This chapter attempts to provide the basics of U.S. taxation of cross-border transactions. Tax legislation enacted by Congress in December 2017 (Tax Cuts and Jobs Act) added even more complexity to an already complex area. The key topics in this chapter include the basic reason for the FTC and how it is computed, the source rules and why they are important to U.S. and non-U.S. persons, the importance of treaties to international tax planning, the organizational structures through which U.S. corporations conduct international operations, and a brief overview of the anti-deferral (exemption) rules (subpart F and the new GILTI inclusion). Assignment Matrix Learning Objectives Text Feature Difficulty LO1 LO2 LO3 LO4 LO5 LO6 Research Planning Tax Forms DQ24-1 10 min. Easy X DQ24-2 10 min. Easy X DQ24-3 10 min. Easy X DQ24-4 20 min. Medium X DQ24-5 20 min. Medium X DQ24-6 20 min. Medium X DQ24-7 20 min. Medium X DQ24-8 20 min. Medium X DQ24-9 20 min. Medium X DQ24-10 20 min. Medium X DQ24-11 20 min. Medium X DQ24-12 10 min. Medium X DQ24-13 10 min. Medium X DQ24-14 10 min. Medium X DQ24-15 10 min. Medium X DQ24-16 10 min. Medium X DQ24-17 25 min. Hard X DQ24-18 25 min. Hard X DQ24-19 25 min. Hard X DQ24-20 10 min. Easy X DQ24-21 20 min. Hard X DQ24-22 20 min. Hard X DQ24-23 20 min. Hard X DQ24-24 20 min. Hard X DQ24-25 20 min. Hard X DQ24-26 25 min. Hard X DQ24-27 25 min. Hard X DQ24-28 25 min. Hard X DQ24-29 20 min. Hard X DQ24-30 25 min. Hard X DQ24-31 25 min. Hard X DQ24-32 20 min. Hard X DQ24-33 25 min. Hard X DQ24-34 25 min. Hard X DQ24-35 25 min. Hard X P24-36 15 min. Medium X P24-37 25 min. Medium X P24-38 20 min. Medium X P24-39 20 min. Medium X X P24-40 20 min. Medium X X P24-41 20 min. Medium X P24-42 20 min. Medium X P24-43 15 min. Medium X P24-44 15 min. Medium X P24-45 25 min. Medium X P24-46 20 min. Medium X P24-47 20 min. Medium X P24-48 30 min. Medium X X P24-49 25 min. Medium X X P24-50 45 min. Hard X X P24-51 15 min. Medium X P24-52 30 min. Hard X X P24-53 45 min. Medium X P24-54 45 min. Hard X X P24-55 45 min. Hard X X P24-56 30 min. Hard X P24-57 30 min. Hard X P24-58 45 min. Hard X CP24-59 60 min. Hard CP24-60 60 min. Hard CP24-61 60 min. Hard X CP24-62 60 min. Hard X Lecture Notes 1) The U.S. Framework for Taxing Multinational Transactions a) The United States taxes citizens and residents on their worldwide income and nonresidents on their U.S. source income. b) For tax years beginning after 12/31/17, the United States moves the taxation of certain U.S. corporations toward a territorial system by exempting foreign dividends from U.S. taxation (through a 100 percent DRD) if paid to a 10 percent-or-more-owned corporate shareholder by a foreign corporation (this applies only to distributions of income not previously taxed under the anti-deferral rules of subpart F or GILTI). c) U.S. taxation of a nonresident i) Income that is effectively connected with a U.S. trade or business is subject to net taxation (that is, gross income minus deductions) at the U.S. graduated tax rates. ii) A nonresident reports such income and related deductions on either a Form 1120F for a corporation or a Form 1040NR for an individual. iii) U.S. source income earned by a nonresident is classified into two categories for U.S. tax purposes: (1) Effectively connected income (ECI)—taxed on a net basis (taxable income × 21%). (2) Fixed and determinable, annual or periodic income (FDAP)—taxed on a gross basis through a flat withholding tax at the statutory rate of 30 percent under U.S. tax law or a reduced treaty rate. iv) Work through Example 24-1. d) Definition of a resident for U.S. tax purposes i) An individual who is not a U.S. citizen is characterized for U.S. tax purposes as either a resident alien or a nonresident alien. ii) An individual becomes a U.S. resident by satisfying one of two tests found in the IRC: (1) First Test: (also known as the green card test) If the individual possesses a permanent resident visa (“green card”) at any time during the calendar year. (2) Second Test: (also known as the substantial presence test) When the individual is physically present in the United States for 31 days or more during the current calendar year, and the number of days during the current calendar year, plus one-third times the number of days during the first preceding year, plus one-sixth times the number of days during the second preceding year, equals or exceeds 183 days. iii) Exceptions to the physical presence test (1) Individuals who are present in the United States during the current year for less than 183 days and who establish that they have a “closer connection” to another country can elect to be exempt from the physical presence test. (2) Other exemptions apply to individuals who experience unexpected medical conditions that arise while in the United States and to commuters from Canada and Mexico who have a U.S. employer. iv) Work through Example 24-2. e) Overview of the U.S. foreign tax credit system i) Citizens and residents are allowed to claim a foreign tax credit (FTC) for foreign income taxes paid on their foreign source income, which mitigates the double taxation of foreign source income. ii) The goal of the FTC is to keep a U.S. taxpayer’s worldwide effective tax rate (total income taxes paid/taxable income) from exceeding the U.S. statutory tax rate. iii) Foreign tax credit limitation = (Foreign source taxable income/Total taxable income) × Precredit U.S. tax on total taxable income iv) Work through Example 24-3. 2) U.S. Source Rules for Gross Income and Deductions a) The source rules determine whether income and related deductions are from sources within or without the United States. b) These rules are important to non-U.S. persons because they limit the scope of U.S. taxation to only U.S. source income. c) For U.S. persons, the primary purpose of the U.S. source-of-income rules is to calculate foreign source taxable income in the numerator of the foreign tax credit limitation. d) The U.S. imposes a tax on the worldwide income of U.S. individuals and corporations not meeting the ownership requirements to qualify for the 100 percent DRD on dividend distributions, regardless of its source or the U.S. person’s residence. e) The U.S. cedes primary jurisdiction to foreign governments to tax U.S. persons on income earned outside the United States while retaining the residual right to tax foreign source income to the extent it has not been “fully taxed” by the foreign government. f) These rules: i) Are definitional in nature. ii) Do not impose a tax liability, create income, or allow a deduction. g) Source-of-income rules i) Interest (1) Work through Example 24-4. ii) Dividends (1) Work through Example 24-5. iii) Compensation for services (1) The source of compensation received for “labor or personal services” is determined by the location where the service is performed. (2) The Code provides a limited commercial traveler exception, in which personal service compensation earned by nonresidents within the United States is not treated as U.S. source if the individual meets the following criteria: (a) The individual was present in the United States for not more than 90 days during the current taxable year; (b) Compensation for the services does not exceed $3,000; and (c) The services are performed for a nonresident alien, foreign corporation, or foreign partnership or for the foreign office of a domestic corporation. (3) In most cases, the 90-day limit is extended to 183 days, and no dollar limit is put on the amount of compensation received. (4) Work through Example 24-6. iv) Rents and royalties (1) Work through Example 24-7. v) Gain or loss from sale of real property vi) Gain or loss from sale of purchased personal property including investment assets such as stocks vii) Gain or loss from sale of manufactured inventory h) Source-of-deduction rules i) General principles of allocation and apportionment (1) The regulations attempt to match deductions with the gross income such deductions were incurred to produce. (2) Matching usually is done based on the “factual relationship” of the deduction to gross income. (3) Deductions that can be directly associated with a particular item of income are referred to as definitely related deductions. (4) Deductions not directly associated with a particular item of gross income are referred to as not definitely related deductions and are allocated to all gross income. (5) Work through Example 24-8. ii) Special apportionment rules (1) These rules apply to nine categories of deductions, most notably interest, research and experimentation, state and local income taxes, losses on property disposition, and charitable contributions, stewardship expenses attributable to dividends received, supportive expenses, net operating losses, and legal and accounting fees. (2) Work through Example 24-9. 3) Treaties a) Treaties are designed to encourage cross-border trade by reducing or eliminating the double taxation of such income by the countries that are party to the treaty. b) Treaties define whether and when a resident of one country has nexus in the other country. c) Treaties reduce or eliminate the withholding tax imposed on cross-border payments such as interest, dividends, and royalties. d) Refer to Exhibit 24-1 for Form 1118: Foreign Tax Credit Corporations, Schedules A, B, F, and H for 3D Corporation (cumulative facts from Examples 24-8, 24-9, and 24-10). e) Refer to Exhibit 24-2 for Countries with Which the United States Has Income Tax Treaties. f) Work through Examples 24-12, 24-13, and 24-14. 4) Foreign Tax Credits a) FTC limitation categories of taxable income i) Only income taxes can be claimed as a credit on a U.S. tax return. ii) The current year foreign tax credit cannot exceed the FTC limitation. iii) Foreign tax credit allowed in the current year = (Foreign source taxable income/Total taxable income) × Precredit U.S. tax. iv) The FTC limitation is applied to four separate categories (baskets) of foreign source income: global intangible low-taxed income (GILTI), foreign branch income, passive, and general. v) Work through Example 24-15. b) Creditable foreign taxes i) Direct taxes ii) In lieu of taxes (withholding taxes) iii) Indirect (deemed paid) taxes paid on deemed dividends (subpart F or GILTI) 5) Planning for International Operations a) A U.S. taxpayer doing business outside the United States can choose between a branch, partnership, corporation, or hybrid entity. b) A hybrid entity is an entity that is treated as a flow-through entity for U.S. tax purposes and a corporation for foreign tax purposes (in the case of a reverse hybrid entity, the entity is treated as a corporation for U.S. tax purposes and a partnership for home country tax purposes). c) A U.S. taxpayer elects the U.S. tax status of a hybrid entity by “checking the box” on Form 8832. d) Per se entities are not eligible for the check-the-box election (for example, a German A.G.). e) Work through Example 24-16. f) Refer to Exhibit 24-3 for Advantages and Disadvantages of Operating Outside the United States in Different Organizational Forms. 6) U.S. Anti-Deferral Rules a) Refer to Exhibit 24-4 for Symbols for Different Organizational Forms and Their U.S. Tax Status. b) Definition of a controlled foreign corporation i) A CFC is defined as any foreign corporation in which U.S. shareholders collectively own more than 50 percent of the total combined voting power of all classes of stock entitled to vote or the total value of the corporation’s stock on any day during the CFC’s tax year. ii) For purposes of subpart F, a U.S. shareholder is any U.S. person who owns or is deemed to own 10 percent or more of all classes of stock entitled to vote. iii) Constructive ownership rules are used in the calculation of both the 50 percent test for determining CFC status and the 10 percent test for determining who is a U.S. shareholder. iv) Work through Example 24-17. c) Definition of subpart F income i) Subpart F income generally can be characterized as low-taxed passive income (otherwise referred to as foreign personal holding company income) or as “portable” income earned by a CFC. ii) Passive income includes interest, dividends, rents, royalties, annuities, gains from the sale of certain foreign property, foreign currency exchange rate gains, net income from certain commodities transactions, and income equivalent to interest. iii) There are complex exceptions involving payments between CFCs in the same country, export financing interest, and rents and royalties derived in the active conduct of a trade or business. iv) Subpart F income does not include dividends, interest, rents, and royalties received by one CFC from a related CFC to the extent the payment is attributable to non-subpart F income of the payor (“look-through rules”). v) Subpart F income also includes foreign base company sales income, which is defined as income derived by a CFC from the sale or purchase of personal property to (or from) a related person, and the property is manufactured and sold outside the CFC’s country of incorporation. vi) The profit earned by the base company would be subject to the lower (or no) tax imposed by the tax haven country. vii) The base company thus becomes a depository for the multinational company’s excess funds, which can be invested in an active business or passive investment assets outside the United States. viii) The de minimis rule excludes all gross income from being treated as foreign base company income if the sum of the CFC’s gross foreign base company income is less than the lesser of 5 percent of gross income or $1 million. ix) The full inclusion rule treats all of the CFC’s gross income as foreign base company income if more than 70 percent of the CFC’s gross income is foreign base company income. x) High-tax subpart F income is taxed at an effective tax rate that is 90 percent or more of the highest U.S. statutory rate. xi) For a U.S. corporation, the rate currently is 18.9 percent (90% × 21%). xii) The subpart F rules apply in years in which a corporation is a CFC for one day or more during its taxable year. xiii) The computation of the deemed dividend under subpart F is exceptionally complicated and requires the CFC to allocate both deductions and taxes paid to subpart F gross income. xiv) The U.S. shareholder receives a deemed paid foreign tax credit for foreign taxes paid related to subpart F gross income. xv) Earnings of the CFC treated as a deemed dividend under subpart F becomes previously taxed income and subsequently can be distributed to the shareholders without being included in the recipient’s gross income a second time. xvi) Work through Examples 24-18, 24-19, and 24-20. d) Planning to avoid subpart F income i) Refer to Exhibit 24-5 for A Tax-Aligned International Organizational Chart (see Exhibit 24-4 for explanation of symbols). 7) Base Erosion and Profit Shifting Initiatives around the World a) The Organization for Economic Cooperation and Development (OECD) has embarked on a “base erosion and profit shifting” (BEPS) initiative. Its goal is to provide “governments with solutions for closing the gaps in existing international rules that allow corporate profits to ‘disappear’ or be artificially shifted to low/no tax environments, where little or no economic activity takes place.” 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 one of the four comprehensive problems. The comprehensive problems are quite difficult and team learning will be beneficial in solving them. ○ Research the impact of the Tax Cuts and Jobs Act on a corporation’s financial statement: • The TCJA imposed a one-time transition tax on unrepatriated earnings and added several anti–base erosion (BEAT) and anti-deferral provisions (GILTI). • Have your students (individually or in teams) choose a company and research the impact of TCJA on the company’s balance sheet and income statement. What does the financial statement say about the impact of TCJA on the company’s ongoing operations? How much transition tax did the company pay? Does it intend to repatriate these earnings? How does it intend to use the earnings (investment, stock buybacks, reduce debt)? 2. Ethics discussion From page 24-11: Congress enacted the Foreign Corrupt Practices Act (FCPA) to halt the bribery of foreign officials and to restore public confidence in the integrity of the American business system. FCPA contains an explicit exception to the bribery prohibition for any “facilitation or expediting payment to a foreign official, political party, or party official the purpose of which is to expedite or to secure the performance of a routine governmental action by a foreign official, political party, or party official.” There is an exception to the anti-bribery prohibition for payments to facilitate or expedite performance of a “routine governmental action.” The statute lists the following examples: obtaining permits, licenses, or other official documents; processing governmental papers, such as visas and work orders; providing police protection, mail pickup and delivery; providing phone service, power and water supply, loading and unloading cargo, or protecting perishable products; and scheduling inspections associated with contract performance or transit of goods across country. There is no monetary threshold for determining when a payment crosses the line between a facilitation payment and a bribe. The accounting provisions of the FCPA require that facilitation payments must be accurately reflected in an issuer’s books and records, even if the payment itself is permissible under the anti-bribery provisions of the law. The following criminal penalties may be imposed for violations of the FCPA’s anti-bribery provisions: corporations and other business entities are subject to a fine of up to $2,000,000; officers, directors, stockholders, employees, and agents are subject to a fine of up to $100,000 and imprisonment for up to five years. The attorney general or the SEC, as appropriate, may bring a civil action for a fine of up to $10,000 against any firm as well as any officer, director, employee, or agent of a firm, or stockholder acting on behalf of the firm, who violates the anti-bribery provisions. Discussion points: • It appears that the payments may be legal under FCPA if they meet the exceptions for facilitating payments. However, the tax director wants to disguise the true nature of the payment by giving it a generic title to avoid possible IRS/Department of Justice scrutiny. • Under §6694, a tax return preparer may be subject to a penalty with respect to each such return or claim in an amount equal to the greater of $1,000 or 50 percent of the income derived (or to be derived) by the tax return preparer with respect to the return or claim. A tax return preparer can avoid the penalty if the client has “substantial authority” for the position or there is a “reasonable basis” for the position and the position is “adequately disclosed.” • The AICPA Statements on Standards for Tax Practice No. 1, Tax Return Positions and Interpretation 1-1, “Reporting and Disclosure Standards,” state that in most cases, a tax return position must satisfy a “realistic possibility of success” (a one-third possibility that the position will be sustained on its merits) before the tax preparer signs a tax return. This threshold is higher than the “reasonable basis” standard of §6694 (often interpreted as a 20 percent possibility that the position will be sustained on its merits). • The tax director appears to want to play the “audit lottery” by disguising the true nature of the payments. A tax preparer must carefully analyze the merits of the position taken and decide whether to disclose the position on the tax return (usually on Form 8275). Tax preparers who sign tax returns with potentially misleading information or aggressive tax positions run the risk of penalties, loss of reputation, and/or censure by the AICPA. Chapter 25 Transfer Taxes and Wealth Planning Learning Objectives 24-1. Describe the three federal transfer taxes. 24-2. Calculate the federal gift tax. 24-3. Compute the federal estate tax. 24-4. Understand how income and transfer taxation interact to affect wealth planning. Teaching Suggestions The unified transfer taxes operate through a formula applied to cumulative transfers taxed using a unified tax rate schedule. This integrated formula takes into account the cumulative effect of transfers in previous periods when calculating the tax on gifts in the current period. Likewise, lifetime transfers are included in determining the estate tax on assets transferred at death. The most difficult aspect of the unified formula is understanding how the tax computation avoids a double tax on prior transfers. This is accomplished by subtracting the tax on the earlier transfers from the total tax. Ironically, while the unified formula is designed to increase the likelihood that the current transfers will be taxed at a higher marginal tax rate, the combination of tax rate reductions and increases in the applicable credit (previously the unified credit) have virtually eliminated the progressivity of the tax rate schedule. There are two very nice shortcuts available when teaching transfer taxes. First, to calculate the tax, merely subtract $1 million from the taxable transfer and multiply this amount by 40 percent. To the product, add $345,800 (the tax on the first $1 million), and that’s the transfer tax. Another good shortcut is available for tracking the unused applicable (unified) credit amount. Tracking the credit is very difficult because of the annual inflation adjustment. Instead, track the exemption equivalent. Assignment Matrix Learning Objectives Text Feature Difficulty LO1 LO2 LO3 LO4 Research Planning Tax Forms DQ25-1 15 min. Easy X DQ25-2 15 min. Easy X DQ25-3 15 min. Easy X DQ25-4 20 min. Medium X DQ25-5 20 min. Medium X DQ25-6 20 min. Medium X DQ25-7 20 min. Medium X DQ25-8 20 min. Medium X DQ25-9 20 min. Medium X DQ25-10 20 min. Medium X DQ25-11 20 min. Medium X DQ25-12 10 min. Medium X DQ25-13 10 min. Medium X DQ25-14 10 min. Medium X DQ25-15 10 min. Medium X DQ25-16 10 min. Medium X DQ25-17 25 min. Hard X DQ25-18 25 min. Hard X X DQ25-19 25 min. Hard X DQ25-20 20 min. Hard X DQ25-21 10 min. Easy X DQ25-22 10 min. Easy X DQ25-23 20 min. Hard X DQ25-24 20 min. Hard X DQ25-25 20 min. Hard X DQ25-26 20 min. Hard X DQ25-27 20 min. Hard X DQ25-28 25 min. Hard X DQ25-29 25 min. Hard X DQ25-30 20 min. Hard X DQ25-31 20 min. Hard X X DQ25-32 25 min. Hard X X DQ25-33 25 min. Hard X P25-34 10 min. Easy X P25-35 10 min. Easy X P25-36 10 min. Easy X P25-37 10 min. Easy X P25-38 10 min. Easy X P25-39 10 min. Easy X P25-40 10 min. Easy X P25-41 30 min. Medium X P25-42 30 min. Medium X P25-43 20 min. Medium X P25-44 15 min. Easy X P25-45 15 min. Easy X P25-46 15 min. Easy X P25-47 15 min. Easy X P25-48 15 min. Easy X P25-49 20 min. Medium X P25-50 15 min. Medium X X P25-51 15 min. Medium X P25-52 15 min. Medium X P25-53 15 min. Medium X P25-54 15 min. Medium X P25-55 15 min. Medium X P25-56 15 min. Medium X X P25-57 15 min. Medium X P25-58 15 min. Medium X P25-59 30 min. Medium X X P25-60 20 min. Medium X X P25-61 20 min. Medium X P25-62 20 min. Medium X X P25-63 20 min. Medium X P25-64 20 min. Medium X CP25-65 30 min. Hard X CP25-66 45 min. Hard CP25-67 45 min. Hard CP25-68 45 min. Hard Lecture Notes 1) Introduction to Federal Transfer Taxes a) Beginnings i) Testamentary transfers—transfers at death ii) Inter vivo transfers—lifetime transfers b) Common features of integrated transfer taxes i) Property transfers, whether made by gift or at death, are subject to transfer tax using a common (slightly progressive) tax rate schedule. ii) The 2020 applicable (unified) credit exempts cumulative transfers by gift or at the time of death up to $11.58 million—the amount of tax for the UC is calculated using the current rate schedule. iii) Each transfer tax allows a deduction for transfers to charities and surviving spouses (the charitable and marital deductions, respectively). iv) Refer to Exhibit 25-1 for Unified Transfer Tax Rates. v) Valuation (1) Property is included in the transfer tax based (gift, estate, or GST tax) at fair market value on the date of the transfer (with the exception for the alternative valuation date for estate tax). (2) Fair market value is defined by the willing-buyer, willing-seller rule as “the price at which such property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell, and both have reasonable knowledge of the relevant facts.” 2) The Federal Gift Tax a) Refer to Exhibit 25-3 for The Federal Gift Tax Formula. b) Transfers subject to gift tax i) Gifts excluded from the gift tax (1) Incomplete and revocable gifts. (2) Payments for support obligations or debts. (3) Contributions to political parties or candidates. (4) Medical and educational expenses paid on behalf of an unrelated individual. ii) Valuation of remainders and other temporal interests (1) Future interests are valued at present value, calculated by estimating the time until the present interest expires. (2) A present interest, such as an income interest or life estate, is valued by subtracting the value of the remainder interest from the total value of the property. (a) The present value calculation uses the §7520 interest rate published by the Treasury. (b) If the present interest is measured by a person’s life (a life estate), then we estimate the delay by reference to the person’s life expectancy as published in IRS tables. (c) Value of remainder interest = (Future payment)/(1 + r)n. (d) Refer to Exhibit 25-4 for Discount Factors for Estimating the Value of Remainders. iii) The annual exclusion (1) Most gifts are eligible for an annual exclusion of $15,000 (2020) per done per year. (2) Gifts of present interests qualify for the exclusion. (3) Gifts of future interests placed in trust for a minor can also qualify for the exclusion. c) Taxable gifts i) Gift-splitting election ii) Marital deduction (1) Deduct gifts of property to a spouse in computing taxable gifts. (2) Transfers of terminable interests in property, such as a life estate, will not generally qualify for the deduction. (3) The deduction is limited to the value of property included in taxable gifts. iii) Charitable deduction d) Computation of the gift tax i) Prior taxable gifts—tax is calculated using current tax rate schedule. ii) Unused applicable credit—calculated using current tax rate schedule on unused portion of exemption equivalent. (1) Shortcut method for taxable transfers over $1 million allows the unused exemption equivalent to be ignored. (2) Subtract the exemption equivalent from the cumulative transfers and multiply the difference by 40%. (3) If taxes were paid on prior gifts, then also subtract the amount of the taxable portion of the gift. iii) Refer to Exhibit 25-5 for Form 709 Gift Tax Return for Harry Smith. 3) The Federal Estate Tax a) Refer to Exhibit 25-6 for The Federal Estate Tax Formula. b) The gross estate i) Includes property owned at death (the probate estate) and certain transfers effective at death (this property is not technically owned at death and is not included in the probate estate). ii) Probate is the process of gathering property possessed by or titled in the name of a decedent at the time of death, paying the debts of the decedent, and transferring the ownership of any remaining property to the decedent’s heirs. iii) The gross estate consists of the fair market value of property possessed or owned by a decedent at death plus the value of certain automatic property transfers that take effect at death. iv) Specific inclusions (1) The testamentary transfers can occur without the help of a probate court because the ownership transfers by law at the time of death. (2) Example: Property held in joint tenancy with right of survivorship, which legally transfers to the surviving tenant upon the joint tenant’s death. (3) Tenants in common hold divided rights to property and have the ability to transfer these rights during their life or upon death, so this property is included in the probate estate. (4) Jointly owned property. (a) When a decedent’s interest is a tenancy in common, a proportion of the value of the property is included in the gross estate that matches the decedent’s ownership interest. (b) The amount includible for property held as joint tenancy with the right of survivorship depends upon the marital status of the owners. (c) Refer to Exhibit 25-7 for Amount of Jointly Owned Property Included in Gross Estate. (5) Transfers within three years of death (a) These transfers are included in the gross estate for the amount of gift taxes paid (if any) at the time of the transfer. Otherwise, gift taxes paid would escape the estate tax. (6) Valuation—the executor can elect to value the estate on an alternate valuation date, six months after death, if it reduces the gross estate and estate tax. v) The taxable estate (1) Administrative expenses, debts, losses, and state death taxes reduce the taxable estate. (2) Marital and charitable deductions vi) Computation of the estate tax (1) Adjusted taxable gifts (a) Adjusted taxable gifts are added to the taxable estate in calculating cumulative taxable transfers. (b) Lifetime gifts are not subject to double tax because the tax on cumulative transfers is reduced for current taxes on adjusted taxable gifts. (2) Applicable (unified) credit (a) The applicable credit eliminates transfer taxes on estates with minimal lifetime and testamentary transfers. (b) The credit is applied after reducing the total tax on cumulative transfers for taxes payable on adjusted taxable gifts. (c) Refer to Exhibit 25-2 for The Exemption Equivalent. (3) Refer to Exhibit 25-8 for Form 706 Estate Tax Return for Bob Smith. 4) Wealth Planning Concepts a) The generation-skipping tax i) The generation-skipping tax (GST) is a supplemental tax designed to prevent the avoidance of transfer taxes (both estate and gift tax) through transfers that skip a generation of recipients. b) Income tax considerations i) A fiduciary entity is a legal entity that takes possession of property for the benefit of a person. ii) An estate is a fiduciary that comes into existence upon a person’s death to transfer the decedent’s real and personal property. c) Transfer tax planning techniques i) Serial gifts (1) A serial gift strategy saves gift taxes by converting a potentially large taxable transfer into multiple smaller transfers that qualify for the annual exclusion. ii) Surviving spouses are also allowed to claim the unused applicable credit of a deceased spouse (DSUE), thereby allowing a total 2020 applicable credit of up to $23.16 million ($11.58 × 2). iii) Bypass provisions (1) Bypass provisions in a will or bypass trusts reduce estate taxes by using the applicable credit of the deceased spouse, transferring some property to beneficiaries other than the surviving spouse. (2) Contrast the bypass provision with the DSUE (deceased spouse unused exemption) and note that the bypass provision provides some marginal benefits by allowing for control of the property rather than passing the property directly to the surviving spouse. iv) The step-up in tax basis (1) Testamentary transfers allow a step-up in tax basis to fair market value, thereby eliminating income tax on unrealized appreciation. (2) Lifetime gifts eliminate transfer taxes on post-gift appreciation. d) Integrated wealth plans Class Activities 1. Suggested class activities ○ Comprehensive problem: One way to cover the topics in the class is to assign and work one of the comprehensive problems in class. Student teams can be assigned to work each part of the problem on the board or fill in the formula on the overhead. 2. Ethics discussion From page 25-6: Discussion points: • Rudy should file a gift tax return if he does not intend to enforce collection of the “loan.” • Although only Rudy knows the truth of his intentions, he should also consider that whether a transfer of money is interpreted as a loan or gift will be determined by the facts and circumstances surrounding the transfer. • Facts that will point to a loan include whether the loan is evidenced by a note payable, whether Rudy takes collateral for the loan, and whether he takes steps to collect the loan should any payments be missed. 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
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