This Document Contains Chapters 8 to 9 Chapter 8 Individual Income Tax Computation and Tax Credits Learning Objectives 8-1. Determine a taxpayer’s regular tax liability. 8-2. Compute a taxpayer’s alternative minimum tax liability. 8-3. Calculate a taxpayer’s net investment income tax, and employment and self-employment taxes. 8-4. Compute a taxpayer’s allowable child tax credit, child and dependent care credit, American opportunity tax credit, lifetime learning credit, and earned income credit. 8-5. Explain how to compute a taxpayer’s underpayment, late filing, and late payment penalties. Teaching Suggestions This chapter is organized around issues dealing with computing a taxpayer’s tax liability. There are many topics in this chapter. The instructor may not wish to cover all topics. Students should be able to understand that they must know more than the amount of taxpayer’s taxable income to determine the tax liability. Potential trouble spots for students include understanding that preferentially taxed income (qualified dividends and net capital gains) are included in taxable income, but the income is subject to different tax rates. Students may have a difficult time understanding that the rate at which preferentially taxed income is taxed depends on the amount of the taxpayer’s income subject to ordinary tax rates. Students may also need extra help in determining the tax liability for a child with unearned income. This includes determining the child’s taxable income (including the allowable standard deduction) and the child’s tax liability, given taxable income. Some income is taxed at the child’s marginal rate but some is taxed at the parents’ marginal rate. The AMT section was written to provide a general understanding of the individual AMT without getting into many of the details (for example, computation of the minimum tax credit). Students should come to understand what the AMT is supposed to accomplish and who is most likely to pay it. In the additional taxes section, students should understand the taxpayer’s Social Security and Medicare tax payment responsibilities when the taxpayer is an employee, when the taxpayer is self-employed, and when the taxpayer is both an employee and self-employed. Students may need extra help understanding the Medicare tax calculation and how the Social Security wage base limit applies to self-employed taxpayers. Some key points are that (1) the additional Medicare tax rate applies on the salaries or wages or self-employment exceeding $200,000 ($125,000 for married filing separately; $250,000 married filing jointly), (2) only 92.35 percent of self-employment income is subject to self-employment taxes (unless this is less than $400), and (3) employee wages use up the wage base limitation before self-employment income when a taxpayer is both an employee and an independent contractor. Also, make sure students understand that the self-employment tax is a tax in addition to the regular income tax. Consequently, if a self-employed taxpayer reports less than $400 of net earnings from self-employment, the taxpayer must pay income tax on the income even if she does not pay self-employment tax on the income. Students should also have a feel for whether a worker should be considered an employee or independent contractor for tax purposes and why this matters from a tax perspective. For credits, discuss the difference between a refundable and nonrefundable credit. Point out that due to phase-out provisions, many credits are not available to higher-income taxpayers. Because it is relevant to them, students want to understand the American opportunity (formerly Hope scholarship) and lifetime learning credits. Also, note that the American opportunity credit is 40 percent refundable. You may want to emphasize that the American opportunity credit is a per-student credit, while the lifetime learning credit is a per-taxpayer credit. Also, you might discuss the child tax credit in detail, as this is a prevalent credit for taxpayers. In the final section, make sure students understand the difference between an underpayment penalty, a late filing penalty, and a late payment penalty. Note that the combined maximum penalty for late filing and late payment is limited to 5 percent, not 5.5 percent. Assignment Matrix Learning Objectives Text Feature Difficulty LO1 LO2 LO3 LO4 LO5 Research Planning Tax Forms DQ8-1 5 min. Easy X DQ8-2 5 min. Easy X DQ8-3 5 min. Easy X DQ8-4 15 min. Medium X DQ8-5 30 min. Hard X X DQ8-6 10 min. Easy X DQ8-7 10 min. Easy X DQ8-8 10 min. Medium X DQ8-9 10 min. Medium X DQ8-10 10 min. Medium X DQ8-11 10 min. Medium X DQ8-12 10 min. Medium X DQ8-13 10 min. Easy X DQ8-14 10 min. Easy X DQ8-15 15 min. Medium X DQ8-16 15 min. Medium X DQ8-17 10 min. Easy X X DQ8-18 10 min. Hard X DQ8-19 10 min. Medium X DQ8-20 10 min. Easy X DQ8-21 10 min. Medium X DQ8-22 10 min. Easy X DQ8-23 10 min. Medium X DQ8-24 15 min. Medium X DQ8-25 15 min. Medium X DQ8-26 15 min. Medium X X DQ8-27 10 min. Easy X DQ8-28 10 min. Easy X DQ8-29 10 min. Easy X DQ8-30 10 min. Easy X DQ8-31 10 min. Medium X DQ8-32 15 min. Medium X DQ8-33 10 min. Medium X DQ8-34 15 min. Medium X DQ8-35 30 min. Medium X X DQ8-36 10 min. Easy X DQ8-37 10 min. Medium X DQ8-38 15 min. Medium X DQ8-39 10 min. Medium X DQ8-40 15 min. Medium X DQ8-41 10 min. Easy X DQ8-42 15 min. Medium X DQ8-43 10 min. Medium X DQ8-44 15 min. Medium X DQ8-45 5 min. Easy X DQ8-46 10 min. Medium X P8-47 10 min. Easy X P8-48 10 min. Medium X P8-49 15 min. Medium X P8-50 15 min. Medium X P8-51 20 min. Hard X P8-52 30 min. Hard X P8-53 10 min. Easy X P8-54 10 min. Easy X P8-55 30 min. Medium X X P8-56 25 min. Hard X X P8-57 10 min. Medium X P8-58 10 min. Medium X P8-59 10 min. Medium X P8-60 10 min. Easy X P8-61 25 min. Hard X X P8-62 25 min. Hard X X P8-63 20 min. Medium X X P8-64 15 min. Medium X P8-65 10 min. Easy X P8-66 15 min. Medium X P8-67 15 min. Medium X P8-68 25 min. Medium X P8-69 60 min. Hard X X P8-70 15 min. Medium X P8-71 25 min. Medium X P8-72 15 min. Medium X P8-73 25 min. Medium X X P8-74 30 min. Medium X P8-75 30 min. Medium X P8-76 10 min. Medium X P8-77 20 min. Medium X X P8-78 15 min. Medium X X P8-79 15 min. Medium X X P8-80 10 min. Medium X P8-81 10 min. Medium X P8-82 15 min. Medium X X CP8-83 15 min. Medium X X X CP8-84 45 min. Medium X X X X X X CP8-85 60 min. Medium X X X X X X Lecture Notes 1) Regular Federal Income Tax Computation a) Tax rate schedules i) Schedule depends on filing status. ii) Each separate range of income subject to a different tax rate is referred to as a tax bracket. iii) Each filing status has its own tax rate schedules, which consist of tax brackets taxed at 10 percent, 12 percent, 22 percent, 24 percent, 32 percent, 35 percent, and 37 percent. iv) The IRS provides tax tables that present the gross tax for various amounts of taxable income under $100,000 and filing status. b) Marriage penalty or benefit i) Marriage penalty (benefit) occurs because dual-earning spouses pay more (less) combined tax than if they each filed single. ii) Refer to Exhibit 8-1 for 2020 Marriage Penalty (Benefit): Two-Income vs. Single-Income Married Couple. c) Exceptions to the basic tax computation i) Preferential tax rates for capital gains and dividends (1) Net long-term capital gains and qualified dividends are generally taxed at 0 percent, 15 percent, or 20 percent. (2) The tax rate tables and tax rate schedules allow taxpayers to compute their tax on ordinary but not preferentially taxed income even though it is included in adjusted gross income (AGI) and taxable income. (3) Three steps to determine tax liability when income is subject to preferential rate: (a) Split taxable income into the portion that is subject to the preferential rate and the portion taxed at the ordinary rates. (b) Compute the tax separately on each type of income. Note that the income that is not taxed at the preferential rate is taxed at the ordinary tax rates using the tax rate schedule for the taxpayer’s filing status. (c) Add the tax on the income subject to the preferential tax rates and the tax on the income subject to the ordinary rates. This is the taxpayer’s regular tax liability. Note that rate at which preferentially taxed income would have been taxed if it were ordinary income is important. ii) Kiddie tax (1) Unearned income in excess of $2,200 is taxed at parent’s marginal tax rate if child is: (a) Under age 18 at year-end, (b) 18 at year-end but earned income does not exceed one-half of support, or (c) Over 18 and under 24 at year-end, full-time student, and earned income does not exceed half of support (excluding scholarships). 2) Alternative Minimum Tax (AMT) a) Implemented to ensure taxpayers pay some minimum level of income tax. b) Alternative minimum tax formula i) Start with taxable income and make adjustments to determine alternative minimum taxable income. ii) Refer to Exhibit 8-2 for Formula for Computing the Alternative Minimum Tax. iii) Alternative minimum taxable income (AMTI) (1) Adjustments (a) Add the standard deduction (if deducted for regular tax purposes) back to regular taxable income in determining AMTI. (b) The major itemized deductions that are deductible for both regular tax and AMT purposes using the same limitations for both systems are: (i) Charitable contributions. (ii) Home mortgage interest expenses. (iii) Gambling losses. (c) Some deductions are deductible for regular tax and AMT purposes but have different limitations for each system, e.g., investment interest expense. (d) Refer to Exhibit 8-3 for Common AMT Adjustments and Exhibit 8-4 for Alternative Minimum Tax—Individuals. iv) AMT exemption (1) Allows taxpayers to determine their alternative tax base to deduct an AMT exemption. (2) The exemption is phased out (reduced) by 25 cents for every dollar the AMTI exceeds the threshold amount. (3) Refer to Exhibit 8-5 for 2020 AMT Exemptions and phase-out thresholds. v) Tentative minimum tax and AMT computation (1) AMT rate schedule consists of the following two brackets: (a) 26 percent on first $197,900 (indexed for inflation annually) of AMT base for all taxpayers other than married taxpayers filing separately ($98,950, indexed for inflation annually, for married taxpayers filing separately). (b) 28 percent on AMT base in excess of $197,900 (indexed for inflation annually) for all taxpayers other than married taxpayers filing separately ($98,950, indexed for inflation annually, for married taxpayers filing separately). (2) AMT = tentative minimum tax − regular tax liability (3) Net long-term capital gains and qualifying dividends taxed at same preferential rates used for regular tax purposes (generally 0 percent, 15 percent, or 20 percent). 3) Additional Taxes i) Net investment income tax (1) 3.8 percent tax imposed on lesser of: (a) Net investment income or (b) Excess of modified AGI over $250,000 (married filing jointly and surviving spouses), $125,000 (married filing separately), and $200,000 (all others). b) Employment and self-employment taxes i) Employee FICA taxes payable (1) Social Security tax (a) Tax rate is 6.2 percent rate on wage base. (b) 2020 wage base limit is $137,700. (2) Medicare tax (a) Tax rate is 1.45 percent rate on wage base. (3) Additional Medicare tax (a) Tax rate is .9 percent rate on salary or wages in excess of $200,000 ($125,000 for married filing separately; $250,000 of combined salary or wages for married filing jointly). (4) Employer FICA taxes payable (a) Social Security tax (i) Tax rate is 6.2 percent rate on wage base. (ii) 2020 wage base limit is $137,700. (b) Medicare tax (i) 1.45 percent of employee salary of wages. ii) Self-employment taxes (1) The process for determining the taxpayer’s self-employment taxes (and additional Medicare tax) payable on self-employment earnings requires the following steps: (a) Step 1: Compute taxpayer’s net income from self-employment activities that is subject to self-employment taxes. This is generally the taxpayer’s net income from Schedule C of Form 1040. (b) Step 2: Compute net earnings from self-employment = Step 1 × 92.35 percent. (c) Step 3: Compute the Social Security tax. The Social Security tax component of the self-employment tax equals 12.4 percent [the combined Social Security tax rate for employer and employee (6.2% + 6.2% = 12.4%)] multiplied by the lesser of: (i) the taxpayer’s net earnings from self-employment (from Step 2) or (ii) $137,700 (the maximum tax base for the Social Security tax). (d) Step 4: Compute the Medicare tax. The Medicare tax component of the self-employment tax equals 2.9 percent [the combined Medicare tax rate for employer and employee (1.45% + 1.45% = 2.9%)] multiplied by the net earnings from self-employment (from Step 2). (e) Step 5: Compute the additional Medicare tax. The additional Medicare tax due on net self-employment earnings equals .9 percent multiplied by the greater of: (i) zero or (ii) net earnings from self-employment (from Step 2) less $200,000 ($125,000 for married filing separately; $250,000 for married filing jointly). The additional Medicare tax is considered an “employee” tax (and not a “self-employment” tax). (2) When a taxpayer receives both employee compensation and self-employment earnings, the calculation of the taxpayer’s FICA taxes on self-employment earnings in these settings can be determined as follows: (a) Social Security Tax: (i) Step 1: Determine the limit on the Social Security portion of the self-employment tax base by subtracting the employee compensation from the Social Security wage base ($137,700 in 2020) (not below $0). (ii) Step 2: Determine the net earnings from self-employment (self-employment earnings times 92.35 percent). (iii) Step 3: Multiply the lesser of Steps (1) and (2) by 12.4 percent. This is the amount of Social Security taxes due on the self-employment income. (b) Medicare Tax: (i) Step 4: Multiply the amount from Step (2) by 2.9 percent, the combined Medicare tax rate for employer and employee. (c) Additional Medicare Tax: (i) Step 5: Add the amount from Step (2) and the taxpayer’s compensation. If married filing jointly, also add the spouse’s compensation and net earnings from self-employment (spouse’s self-employment earnings times 92.35 percent). (ii) Step 6: Multiply the greater of [(a) zero or (b) the amount from Step (5) minus $200,000 ($125,000 for married filing separately; $250,000 for married filing jointly)] by .9 percent. (iii) Step 7: Take the amount from Step 6 and subtract the amount of the additional Medicare tax withheld by the taxpayer’s employer (and his or her spouse’s employer if married filing jointly). This is the additional Medicare tax due on the self-employment income. iii) Employee versus self-employed (independent contractor) (1) A few of the factors suggesting independent contractor rather than employee status include the contractor’s ability to: (a) Set own working hours (b) Work part-time (c) Work for more than one firm (d) Realize either a profit or loss from the activities (e) Perform work somewhere other than on employer’s premises (f) Work without frequent oversight (g) Others in published IRS guidance (2) Employee versus independent contractor comparison (a) The two primary tax differences between independent contractors and employees relate to: (i) The amount of their FICA taxes payable and (ii) The deductibility of their business expenses (and possibly the qualified business income deduction). (b) The key facts: Employee vs. independent contractor (i) Employees 1. Less control over how, when, and where to perform duties. 2. Pay 6.2 percent Social Security tax subject to limit. 3. Pay 1.45 percent Medicare tax (no limit). 4. Pay additional Medicare tax of .9 percent wage base in excess of $200,000 ($125,000 for married filing separately; $250,000 married filing jointly). 5. Unreimbursed employee business expenses are not deductible. (ii) Independent contractors 1. More control over how, when, and where to perform duties. 2. Report income and expenses on Form 1040, Schedule C. a. Expenses are for AGI deductions. 3. Pay 12.4 percent Social Security tax subject to limit. 4. Pay 2.9 percent Medicare tax (no limit). 5. Pay additional Medicare tax of .9 percent of net self-employment earnings in excess of $200,000 ($125,000 for married filing separately; $250,000 married filing jointly). 6. Self-employment tax base is 92.35 percent of net self-employment income. 7. Deduct employer portion of self-employment taxes paid for AGI. 4) Tax Credits a) Nonrefundable personal credits i) Child tax credit (1) $2,000 credit for each qualifying child under age 17 at the end of the year and who is claimed as the taxpayer’s dependent. (2) $500 credit for other qualifying dependents. (3) The child tax credit is partially refundable. The $500 child tax credit is nonrefundable. (4) Credit is phased out for taxpayers with AGI above threshold. (a) Lose $50 for every $1,000 or portion thereof by which AGI exceeds threshold. (5) See Exhibit 8-8 for Child Tax Credit Phase-Out Threshold (based on filing status). (6) Determining their allowable child tax credit after the phase-out by using the following four steps: (a) Step 1: Determine the excess AGI by subtracting the threshold amount from the taxpayer’s AGI. (b) Step 2: Divide the excess AGI from Step (1) by 1,000 and round up to the next whole number. (c) Step 3: Multiply the amount from Step (2) by $50. This is the amount of the total credit that is phased out or disallowed. (d) Step 4: Subtract the amount from Step (3) from the total credit before phase-out (limited to $0) to determine the allowable child tax credit. ii) Child and dependent care credit (1) Credit to help taxpayers who work or seek work when they must provide care for dependents. (2) Credit is a nonrefundable credit. (3) Credit is based on maximum qualifying expenditures multiplied by the rate based on AGI. (4) Maximum expenditures are $3,000 for one qualifying person or $6,000 for two or more qualifying persons. (a) Highest rate (for low AGI taxpayers) is 35 percent for the lowest AGI taxpayers and 20 percent for the highest. (5) Refer to Exhibit 8-9 for Child and Dependent Care Credit Percentage. iii) Education credits (1) American opportunity credit (a) Qualifying expenses include tuition, fees, and course materials (cost of books and other materials) needed for courses of instruction at an eligible educational institution. (b) Maximum credit of $2,500 per student calculated as percentage of maximum of $4,000 qualifying expenses (100 percent of first $2,000 plus 25 percent of next $2,000). (c) Subject to phase-out for taxpayers with AGI in excess of $80,000 ($160,000 MFJ). (d) 40 percent of credit is refundable. (2) Lifetime learning credit (a) Qualifying expenses include costs at a qualifying institution associated with acquiring or improving job skills. (b) Maximum credit of $2,000 per taxpayer calculated as percentage of maximum of $10,000 in annual expenses. (c) Subject to phase-out for taxpayers with AGI in excess of $59,000 ($118,000 MFJ). b) Refundable personal credits i) Earned income credit (1) Designed to offset employment taxes for lower-income taxpayers. (2) Available to qualified individuals with earned income (a) Individual with at least one qualifying child. (b) Individual with no qualifying child who lives in United States for more than half the year, is at least 25 years of age but younger than 65, and is not the dependent of another taxpayer. (3) Refer to Exhibit 8-10 for 2020 Earned Income Credit Table. ii) Other refundable personal credits (1) Portion of the child tax credit (2) Portion of the American opportunity tax credit (3) Excess FICA withholdings (4) Taxes withheld on wages and estimated tax payments c) Business tax credits i) They are designed to provide incentives for taxpayers to hire certain types of individuals or to participate in certain business activities. ii) When business credits other than the foreign tax credit exceed the taxpayer’s gross tax for the year, the credits are carried back one year and forward 20 years to use in years when the taxpayer has sufficient gross tax liability to use the credits. iii) Foreign tax credit (1) U.S. citizens must pay U.S. tax on their worldwide income. However, when they generate some or all of their income in other countries, they generally are required to pay income taxes to the foreign country where they earned their income. (2) Without some form of tax relief, taxpayers earning income overseas would be double-taxed on this income. (3) The foreign tax credit helps reduce the double tax taxpayers may face when they pay income taxes on foreign-earned income to the United States and to foreign countries. d) Tax credit summary i) Refer to Exhibit 8-11 for Summary of Selected Tax Credits. e) Credit application sequence i) Nonrefundable personal first, then business, then refundable personal. ii) Refer to Exhibit 8-12 for Credit Application. 5) Taxpayer Prepayments and Filing Requirements a) Prepayments i) Taxpayers prepay their tax via withholding from salary or through periodic estimated tax payments during the tax year. ii) Estimated tax payments are required only if withholdings are insufficient to meet the taxpayer’s tax liability. iii) For calendar-year taxpayers, estimated tax payments are due on April 15, June 15, and September 15 of the current year and January 15 of the following year. If the due date falls on a Saturday, Sunday, or holiday, it is automatically extended to the next day that is not a Saturday, Sunday, or holiday. iv) Underpayment penalties (1) The tax laws provide some safe-harbor provisions under which they can avoid underpayment penalties if their withholdings and estimated tax payments equal or exceed one of the following two safe harbors: (a) 90 percent of their current tax liability or (b) 100 percent of their previous-year tax liability (110 percent for individuals with AGI greater than $150,000). (2) The underpayment penalty is determined by multiplying the federal short-term interest rate plus 3 percentage points by the amount of tax underpayment per quarter. b) Filing requirements i) Individual taxpayers are required to file a tax return only if their gross income exceeds certain thresholds, which vary based on the taxpayer’s filing status and age. ii) Individual tax returns are due on April 15 for calendar-year individuals. If the due date falls on a Saturday, Sunday, or holiday, it is automatically extended to the next day that is not a Saturday, Sunday, or holiday. iii) Taxpayers unable to file a tax return by the original due date can request (by that same deadline) a six-month extension to file, which is granted automatically by the IRS. The extension gives the taxpayer additional time to file the tax return, but it does not extend the due date for paying the tax. iv) Late filing penalty (1) Imposed on taxpayers that do not file tax return by the required date (the original due date plus extension). (2) Penalty is 5 percent of the amount of tax owed for each month (or fraction of a month) that the tax return is late, with a maximum penalty of 25 percent. v) Late payment penalty (1) Imposed if taxpayer fails to pay entire balance of tax owed by the original due date of return. (a) .5 percent of the amount of tax owed each month (or fraction of a month) that the tax is not paid. (b) Combined late filing (nonfraudulent) and late payment penalty may not exceed 5 percent per month (25 percent in total). Class Activities 1. Suggested class activities ○ Movie clip: As a way to wrap up the individual income tax reporting portion of the course, you could show a clip from The Simpsons episode “The Trouble with Trillions” (the 20th episode of the ninth season): See the episode’s Wikipedia page for information. The individual income tax portion runs through about 7 minutes and 40 seconds of the episode (the introduction runs about the first 54 seconds). ○ Elimination: Develop several multiple-choice questions (A, B, C answers) and/or draw questions from the test bank relating to important topics from the chapter. Have each class member write the letters A, B, and C on separate sheets of paper. Have the entire class stand up. When you ask a question, have each class member hold up their appropriate response to the question (A, B, or C). Those who miss must sit down. Continue until you have asked all your questions or until all but one student has been eliminated. Award bonus points (or acknowledgment of a job well done) to those still standing. ○ Comprehensive problems: Have students work in groups (two to four students) to complete a comprehensive problem (problems 84 and 85 are comprehensive across Chapters 4 through 8; problem 83 is a tax planning problem relating to Chapter 8 content). Make yourself available to students to answer questions but try to get them to work together to resolve their questions. You could choose one question (what is taxable income? or what are taxes payable or taxes due?) for students to report to you. You can write the answer from each group on the board and then reveal the correct answer. Give credit to the group(s) that is (are) correct/closest. ○ What is the marginal tax rate of a self-employed taxpayer? Have students work individually (or in groups) to determine the combined income and self-employment tax rate assuming the taxpayer is subject to a 24 percent regular taxable income rate and the taxpayer is not over the Social Security wage base limitation. The answer should be 36.29 percent, computed as follows: Description Rate Explanation (1) Regular tax marginal tax rate 24.00% (2) Self-employment tax rate 14.13% 100% × 15.3% × 92.35% (3) Benefit (at 24%) from deducting employer portion of self-employment tax (1.84%) 7.65% × 24% Combined marginal tax rate 36.29% Sum of (1)–(3) 2. Ethics discussion From page 8-22: Discussion points: • What are some attributes that may distinguish an employee from an independent contractor? • What are the ramifications to Sudipta and his employer if Sudipta is treated as an employee? • What are the ramifications to Sudipta and his employer if Sudipta is treated as an independent contractor? • Which treatment is generally less costly for the employer? • Do you think employers intentionally misclassify employees as independent contractors? Does this practice violate tax laws and/or ethical standards? • What are the consequences to the employer if the IRS asserts that Sudipta is actually an employee? • What are your recommendations for Sudipta? Chapter 9 Business Income, Deductions, and Accounting Methods Learning Objectives 9-1. Identify common business deductions. 9-2. Determine the limits on deducting business expenses. 9-3. Describe accounting periods available to businesses. 9-4. Apply cash and accrual methods to determine business income and expense deductions. Teaching Suggestions Congress intended for taxable income to reflect the net increase in wealth from a business, so it is only fair that businesses be allowed to deduct expenses incurred to generate business income. This chapter focuses on business deductions from a proprietor’s perspective, but the rules generally apply to all types of business entities including sole proprietorships, partnerships, S corporations, and C corporations. While Congress provides specific statutory rules authorizing deductions, IRC §162 is relatively broad and ambiguous. Hence, understanding the deductibility of business expenses is a critical component of a tax practitioner’s skill set. The chapter reiterates the general rules for business expenses introduced in Chapter 7 and then proceeds to describe the four types of expenditures that are not deductible (against public policy, capital, associated with tax-exempt income, and personal). The chapter introduces several specific limitations of which the mixed-motive and business interest limitations are the most complex. The last two sections of the chapter plunge into accounting periods and methods, and these are details that some instructors may prefer to cover in a more advanced class. Section 9-4 describes the options for different tax years, and this topic is primarily applicable to corporations. The last section (9-5) describes the rules for accounting for taxable income, specifically which items of income and deductions must be recognized during a particular year. It is important to stress that accounting methods are very important because they affect when a taxpayer is allowed or required to report income and deductions. The material on economic performance is among the most complex in the text. Assignment Matrix Number Time Estimate Difficulty LO1 LO2 LO3 LO4 Research Planning Tax Forms DQ9-1 20 min. Easy X DQ9-2 20 min. Easy X DQ9-3 20 min. Medium X DQ9-4 20 min. Medium X DQ9-5 20 min. Easy X DQ9-6 20 min. Easy X DQ9-7 20 min. Easy X X DQ9-8 20 min. Medium X DQ9-9 20 min. Medium X DQ9-10 20 min. Medium X DQ9-11 20 min. Medium X X DQ9-12 10 min. Medium X DQ9-13 10 min. Medium X DQ9-14 10 min. Medium X DQ9-15 10 min. Medium X DQ9-16 25 min. Easy X DQ9-17 25 min. Easy X DQ9-18 25 min. Easy X DQ9-19 20 min. Easy X DQ9-20 20 min. Medium X DQ9-21 20 min. Medium X DQ9-22 20 min. Medium X DQ9-23 20 min. Medium X DQ9-24 20 min. Medium X DQ9-25 20 min. Hard X DQ9-26 20 min. Hard X DQ9-27 25 min. Hard X DQ9-28 25 min. Hard X DQ9-29 25 min. Hard X DQ9-30 25 min. Hard X DQ9-31 25 min. Hard X X DQ9-32 25 min. Hard X DQ9-33 25 min. Hard X DQ9-34 25 min. Hard X DQ9-35 25 min. Hard X DQ9-36 25 min. Hard X DQ9-37 25 min. Hard X DQ9-38 25 min. Hard X DQ9-39 25 min. Hard X DQ9-40 25 min. Hard X DQ9-41 25 min. Hard X DQ9-42 25 min. Hard X DQ9-43 25 min. Hard X DQ9-44 25 min. Hard X P9-45 10 min. Easy X P9-46 10 min. Easy X X P9-47 20 min. Easy X X P9-48 20 min. Easy X X P9-49 30 min. Medium X P9-50 30 min. Medium X P9-51 30 min. Medium X P9-52 20 min. Medium X X X P9-53 15 min. Easy X P9-54 20 min. Medium X X P9-55 30 min. Hard X P9-56 30 min. Hard X P9-57 25 min. Medium X P9-58 20 min. Medium X X P9-59 25 min. Medium X X P9-60 25 min. Medium X P9-61 25 min. Medium X P9-62 25 min. Medium X P9-63 15 min. Easy X X P9-64 20 min. Medium X P9-65 25 min. Medium X P9-66 25 min. Medium X P9-67 20 min. Medium X P9-68 20 min. Medium X P9-69 20 min. Medium X P9-70 20 min. Medium X P9-71 20 min. Medium X P9-72 20 min. Medium X X P9-73 30 min. Medium X P9-74 30 min. Medium X P9-75 20 min. Medium X P9-76 30 min. Medium X P9-77 30 min. Medium X P9-78 30 min. Medium X CP9-79 45 min. Medium X X X X CP9-80 45 min. Medium X X X X CP9-81 60 min. Hard X X X X CP9-82 60 min. Hard X X X X CP9-83 75 min. Hard X X X X Lecture Notes 1) Business Gross Income a) Gross receipts test for determining small businesses i) A business that qualifies as a “small” business under a gross receipts test is exempt from certain complex tax law provisions (discussed later in the chapter) for each year in which it meets the test. ii) A business meets the gross receipts test for a particular year if its average annual gross receipts for the three prior taxable years does not exceed $26 million. iii) For purposes of the test, gross receipts include total sales (net of returns and allowances but not cost of goods sold), amounts received for services, and income from investments (including tax-exempt interest). 2) Business Deductions a) Ordinary and necessary i) A deduction must be ordinary and necessary (i.e., appropriate and helpful). ii) An ordinary expense is an expense that is normal or appropriate for the business under the circumstances. iii) A necessary expense is an expense that is helpful or conducive to the business activity, but the expenditure need not be essential or indispensable. iv) Refer to Exhibit 9-1 for Examples of Typical Ordinary and Necessary Business Expenses. v) Work through Example 9-2. b) Reasonable in amount i) Ordinary and necessary business expense are deductible only to the extent they are reasonable in amount. ii) Work through Example 9-3. 3) Limitations on Business Deductions a) Expenditures against public policy i) No business deductions for expenditures against public policy (illegal bribes, fines, penalties or illegal kickbacks). b) Political contributions and lobbying costs i) To avoid the perception that the federal government subsidizes taxpayer efforts to influence politics, the tax laws prohibit deductions for political contributions and most lobbying expenses. c) Capital expenditures i) Businesses must capitalize expenditures for tangible assets (i.e., assets or properties that have a useful life for more than one year) that are generally recovered through depreciation. ii) Businesses must also capitalize the cost to create or acquire intangible assets that are generally recovered through amortization (when the tax laws allow them to do so) or upon disposition of the assets. d) Expenses associated with the production of tax-exempt income i) Expenses that generate tax-exempt income are not allowed to offset taxable income. e) Personal expenditures i) Taxpayers are not allowed to deduct personal expenses unless the expenses are “expressly” authorized by a provision in the law. ii) There are inevitable exceptions when personal items are specially adapted to business use. f) Mixed-motive expenditures i) Businesses often make expenditures that are motivated by both personal and business concerns. ii) These mixed-motive expenditures are of particular concern to lawmakers and the IRS because of the tax incentive to disguise nondeductible personal expenses as deductible business expenses. iii) Thus, deductions for business expenditures accompanied by personal benefits are closely monitored and restricted. iv) The rules for determining the amount of deductible mixed-motive expenditures depend on the type of expenditure. v) Entertainment and meals (1) Only 50 percent of business meals and entertainment are deductible. (2) To deduct any portion of cost of the meal as a business expense, (a) the amount must be ordinary, necessary, and reasonable in amount, (b) the taxpayer or an employee must be present when the meal is furnished, (c) the meal must be provided to a current or potential client or business contact, and (d) if the meal is provided during or at an entertainment activity, the meal must be purchased separately from the entertainment or the cost stated separately on invoices or receipts. vi) Travel and transportation (1) Transportation expenses relate to the direct cost of transporting the taxpayer to and from business sites. (2) In contrast to transportation expenses, travel expenses are only deductible if the taxpayer is away from home overnight while traveling. This distinction is important because, besides the cost of transportation, the deduction for travel expenses includes the cost of meals (limited to 50 percent), lodging, and incidental expenses. vii) Property use (1) Several types of property may be used for both business and personal purposes. (2) Because expenses relating to these assets are deductible only to the extent the assets are used for business purposes, taxpayers must allocate the expenses between the business and personal use portions. viii) Record keeping and other requirements (1) Because distinguishing business purposes from personal purposes is a difficult and subjective task, the tax laws include provisions designed to help the courts and the IRS determine the business element of mixed-motive transactions. (2) Under these provisions, taxpayers must maintain specific, written, contemporaneous records (of time, amount, and business purpose) for mixed-motive expenses. g) Limitation on business interest deductions i) Starting in 2018 Congress limited the deduction of interest paid or accrued on indebtedness allocable to a trade or business. ii) The purpose of this limitation is to limit the extent to which a business utilizes debt to avoid income taxes. iii) Business interest is defined as an amount that is paid, received, or accrued as compensation for the use or forbearance of money under the terms of an instrument or contractual arrangement. iv) The amount of the deduction is, in general, limited to the sum of (1) business interest income and (2) 30 percent of the adjusted taxable income of the taxpayer for the taxable year. v) This limit is not applied to firms passing the gross receipts test. vi) Calculating the interest limitation (1) Adjusted taxable income is defined as taxable income allocable to the business computed without regard to: (a) any item of income, gain, deduction, or loss that is not properly allocable to a trade or business, (b) any business interest expense or income, (c) deductions allowable for depreciation, amortization, or depletion, and (d) any net operating loss deduction. (2) Any business interest disallowed by the limitation is carried forward indefinitely. h) Losses on dispositions of business property i) Losses on sales of business assets are generally deductible. ii) Losses on sales of a business asset to a related party are not deductible by the seller. i) Business casualty losses (1) Casualty losses are events when businesses incur losses in selling or when their assets are stolen, damaged, or completely destroyed by a force outside the control of the business. (2) The amount of the loss deduction depends on whether the asset is: (a) Completely destroyed or stolen (b) Only partially destroyed (3) If the asset is damaged but not completely destroyed, the amount of the loss is the amount of the insurance proceeds minus the lesser of: (a) The asset’s adjusted tax basis (b) The decline in the value of the asset due to the casualty 4) Accounting Periods a) Individuals and proprietorships account for income on a calendar year. b) C corporations are allowed to choose a calendar year, a fiscal year, or a 52/53-week year. c) Partnerships and S corporations are flow-through entities (partners and S corporation owners report the entity’s income directly on their own tax returns), and these entities generally must adopt tax years consistent with the owners’ tax years. 5) Accounting Methods a) The taxpayer’s accounting methods determine the tax year in which a business recognizes a particular item of income or deduction. b) Financial and tax accounting methods i) In reporting financial statement income, businesses have incentives to select accounting methods permissible under GAAP that accelerate income and defer deductions. ii) For tax planning purposes, businesses have incentives to choose accounting methods that defer income and accelerate deductions. c) Overall accounting method i) Cash method (1) The cash method can be elected by any taxpayer that qualifies under the gross receipts test. (2) Businesses that qualify under the gross receipts test do not need to request the consent of the IRS to elect the cash method. ii) Accrual method (1) Businesses using the accrual method to determine taxable income follow rules similar to GAAP with two basic differences. (a) The requirements for recognizing taxable income tend to be structured to recognize income earlier than the recognition rules for financial accounting. (b) The requirements for accruing tax deductions tend to be structured to recognize less accrued expenses than the recognition rules for financial reporting purposes. d) Accrual income i) Businesses using the accrual method of accounting generally recognize income when they meet the all-events test. ii) All-events test for income (1) This test requires that businesses recognize income when: (a) all events have occurred that determine or fix their right to receive the income and (b) the amount of the income can be determined with reasonable accuracy. e) Taxation of advance payments of income (unearned income) i) In some cases, taxpayers receive income payments before they actually earn the income (e.g., unearned income or advance payments). ii) Taxpayers using the cash method include these payments in gross income in the year the payment is received. iii) When an accrual-method taxpayer must include unearned income in gross income depends, in part, on the type of income. (1) For example, all taxpayers must recognize interest and rental income immediately upon receipt (i.e., the income is taxable when received even if is not yet earned). iv) For other types of income, accrual-method businesses can elect to defer recognition of unearned income for one year. (1) Specifically, businesses using the accrual method may elect to defer recognizing advance payments for goods or services until the next tax year. v) This one-year deferral method does not apply if the income is actually earned by the end of the year of receipt or if the unearned income is recognized for financial reporting purposes. f) Inventories i) Businesses must use the accrual method to account for inventories if sales are an income-producing activity. (1) Businesses qualifying under the gross receipts test can elect to treat goods as non-incidental materials or use the inventory method used for financial reporting purposes. (2) Non-incidental materials are accounted for as materials are used. ii) Uniform capitalization (1) The UNICAP rules require capitalization of most indirect costs of production. (a) Businesses qualifying under the gross receipts test can ignore UNICAP adjustments. (b) Tax laws require businesses to capitalize in the cost of inventory certain direct and indirect costs associated with inventories. iii) Inventory cost-flow methods (1) Once a business determines the cost of its inventory, it must use an inventory cost-flow method to determine its cost of goods sold. (2) Three primary cost-flow methods are (a) First-in, first-out (FIFO), (b) Last-in, first-out (LIFO), and (c) Specific identification. (3) Tax laws require that a business can use LIFO for tax purposes only if it also uses LIFO for financial reporting purposes. g) Accrual deductions i) To claim a tax deduction for an accrued expense, the expense must meet both an all-events test and an economic performance test. (1) The all-events test for deductions requires that events have occurred to establish both that a liability to pay exists and that the amount of the liability is determinable with reasonable accuracy. ii) Economic performance (exceedingly complex material for many students) (1) Economic performance generally requires that the activity generating the liability has occurred in order for the associated expense to be deductible (e.g., the service has been performed or the goods have been delivered). (2) Specific requirements for the economic performance test differ based on whether the liability arose from: (a) Receiving goods or services from another party. (b) Renting or leasing property from another party. (c) Providing goods or services to another party (d) Certain activities creating payment liabilities (3) Receiving goods and (or) services from another person (a) When a business receives goods or services from another person, the business deducts the expense associated with the liability when the other person provides the goods or services (assuming the all-events test is met for the liability). (b) However, there is an exception when a business actually pays the liability before the other person provides the goods or services. (i) In this circumstance, the business can elect to treat the actual payment as economic performance as long as it reasonably expects the other person to provide the goods or the services within three and one-half months after the payment. (4) Renting or leasing property from another person (a) When a business enters into an agreement to use property (rent or lease property) from another person, economic performance occurs over the term of the lease. (b) Thus, the business is allowed to deduct the rental expense over the term of the lease. (5) Providing goods and services to another person (a) Businesses liable for providing goods and services to other persons meet the economic performance test as they provide the goods or services that satisfy the liability. (6) Payment liabilities (a) Economic performance occurs for certain liabilities only when the business actually pays the liability. (b) Thus, accrual-method businesses incurring payment liabilities are essentially on the cash method for deducting the associated expenses. (c) Refer to Exhibit 9-2 for Categories of Payment Liabilities and 9-3 for Economic Performance. (7) Recurring item exception (a) This exception is designed to reduce the administrative cost of applying economic performance to expenses that occur on a regular basis. (b) Under this exception, accrual-method taxpayers can deduct certain accrued expenses even if economic performance has not occurred by year-end. (c) A recurring item is a liability that is expected to recur in future years and either the liability is not material in amount or deducting the expense more properly matches with revenue. (d) In addition, the all-events test must be satisfied at year-end and actual economic performance of the item must occur within a reasonable time after year-end (but prior to the filing of the tax return, which could be up to 8½ months after year-end with an extension). (e) The recurring item exception does not apply to workers’ compensation or tort liabilities. iii) Bad debt expense (1) When accrual method businesses sell a product or a service on credit, they debit accounts receivable and credit sales revenue for both financial and tax purposes. However, because businesses usually are unable to collect the full amount of their accounts receivable, they incur bad debt expense (a customer owes them a debt that the customer will not pay). (2) For financial reporting purposes, the business estimates the amount of the bad debt and creates a reserve account, the allowance for doubtful accounts. (3) However, for tax purposes, businesses are only allowed to deduct bad debt expense when the debt actually becomes worthless within the taxable year. (4) Consequently, for tax purposes, when businesses determine which specific debts are uncollectible, they are entitled to a deduction. This method of determining bad debt expense for tax purposes is called the direct write-off method. (5) In contrast, the method used for financial reporting purposes is called the allowance method. iv) Limitations on accruals to related persons (1) To prevent businesses and related persons from working together to defer taxes, the tax laws prevent an accrual-method business from accruing (and deducting) an expense for a liability owed to a related person using the cash method until the related person recognizes the income associated with the payment. (2) For this purpose, related persons include: (a) Family members, including parents, siblings, and spouses. (b) Shareholders and C corporations when the shareholder owns more than 50 percent of the corporation’s stock. (c) Owners of partnerships and S corporations no matter the ownership percentage. h) Comparison of accrual and cash methods i) The two primary advantages of adopting the cash method over the accrual method are that (1) the cash method provides the business with more flexibility to time income and deductions by accelerating or deferring payments (timing tax planning strategy) and (2) bookkeeping for the cash method is easier. ii) The primary advantage of the accrual method over the cash method is that it better matches revenues and expenses. iii) Refer to Exhibit 9-4 for Comparison of Cash and Accrual Methods. i) Adopting an accounting method i) Businesses generally elect their accounting methods by using them on their tax returns. ii) However, when the business technically adopts a method depends on whether it is a permissible accounting method or an impermissible accounting method. iii) Refer to Exhibit 9-5 for Green Acres’s Net Business Income. j) Changing accounting methods i) Once a business has adopted an accounting method, it must generally receive permission to change the method, regardless of whether it is a permissible or an impermissible method. ii) There are three important exceptions to this general rule that apply to businesses that qualify under the gross receipts test: (1) Businesses are allowed to switch to use the cash method, (2) treat inventories as nonincidental materials, and (3) ignore the UNICAP rules once the gross receipts test is satisfied. iii) Refer to Exhibit 9-6 for Green Acres Schedule C. iv) Tax consequences of changing accounting method (1) When a business changes from one accounting method to another, the business determines its taxable income for the year of change using the new method. (2) Furthermore, the business must make an adjustment to taxable income that effectively represents the cumulative difference, as of the beginning of the tax year, between the amount of income (or deductions) recognized under the old accounting method and the amount that would have been recognized for all prior years if the new method had been applied. (3) This adjustment is called a §481 adjustment, and it prevents the duplication or omission of items of income or deduction due to a change in accounting method. 6) Conclusion 7) Summary 8) Key Terms Class Activities 1. Suggested class activities When discussing advanced payments, a nice case that demonstrates the importance of the issue is Tampa Bay Devil Rays, TC Memo 2002‐281. The primary issue in this case is whether deposits a partnership received on advance season tickets and on private suite reservations for Major League Baseball games (expected to be played in 1998) are to be included in the income of the partnership when received, or in 1998 when the advance season tickets and the private suite reservations would be used. A good review activity is to work through a problem by using the trial balance of a business to convert reported income into taxable income. Problem 9-82 can be assigned to all students and then a class period can be invested into working through the trial balances. This chapter provides a great introduction into deriving a Schedule M-3 and calculating taxable income for corporations (for later in the term or in an advanced course). One of the most difficult aspects of economic performance is the interaction of accrual expenses and the 12-month rule. As depicted in the slides, economic performance is a prerequisite to the application of the 12-month rule. To facilitate understanding, compare prepayment for 12 months of insurance with a prepayment for 12 months of rent. The cash-basis taxpayer can deduct both under the 12-month rule (assuming the rent is not typically renewed and neither prepayment extends beyond the end of the next tax year). However, an accrual-basis taxpayer can only deduct the insurance prepayment because economic performance does not occur for the rent until the property is used. In contrast, payment is sufficient for economic performance with the insurance because it is a payment liability. Another difficult topic is the recurring item exception, and some instructors may want to discuss this exception in depth. Rev. Rul. 2012-1, 2012-02 IRB provides a nice explanation and an illustration of this rule that supplements the material in the text. 2. Ethics discussion From page 9-4: Discussion points: • “Ordinary and necessary” is the phrase that likely applies to Sheri’s deduction of the personal assistant’s salary, and the deduction would be evaluated according to the facts and circumstances in each particular instance. • Sheri would need to demonstrate the extent to which this use of the personal assistant is helpful and conducive to her business. Factors such as new (demanding) clients would certainly work in Sheri’s favor. • Other facts that suggest this use of a personal assistant is common in Sheri’s profession would also support the deduction. • The likely ethical issue here is whether Sheri is really using her personal assistant to promote the business or just to make her life easier. It is likely that only Sheri will know the answer to that question. 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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