ACTG-401 Principles of Federal Taxation – Individuals Chapter 8 Depreciation, Cost Recovery, Amortization, and Depletion LO.1 – State the rationale for allowing the cost recovery of an asset and identify when the various tax systems (depreciation, ACRS, and MACRS) apply. LO.2 – Determine the amount of cost recovery under MACRS. LO.3 – Recognize when and how to make the § 179 expensing election and use additional firstyear depreciation and calculate the amount of these deductions as part of the MACRS calculation. LO.4 – Identify listed property and apply the deduction limitations on listed property and on luxury automobiles. LO.5 – Determine when and how to use the alternative depreciation system (ADS). LO.6 – Report cost recovery deductions appropriately. LO.7 – Identify intangible assets that are eligible for amortization and calculate the amount of the deduction. LO.8 – Determine the amount of depletion expense, including being able to apply the alternative tax treatments for intangible drilling and development costs. LO.9 – Identify tax planning opportunities for cost recovery, amortization, and depletion. Cost Recovery • Recovery of the cost of business or income-producing assets is through: – Cost recovery or depreciation: tangible assets – Amortization: intangible assets – Depletion: natural resources Nature of Property • Property includes both realty (real property) and personalty (personal property) o Realty generally includes land and buildings permanently affixed to the land o Personalty is defined as any asset that is not realty ▪ Personalty includes furniture, machinery, equipment, and many other types of assets • Personalty (or personal property) should not be confused with personal use property o Personal use property is any property (realty or personalty) that is held for personal use rather than for use in a trade or business or an income-producing activity ▪ Cost recovery deductions are not allowed for personal use assets Placed in Service Requirement • Cost recovery begins on the date an asset is placed in service (ready and available for use), not the date of purchase • This is important for an asset purchased near the end of the tax year, but not placed in service until the following tax year Cost Recovery Allowed or Allowable 1 • Basis in an asset is reduced by the amount of cost recovery that is allowed and by not less than the allowable amount o Allowed cost recovery is cost recovery actually taken o Allowable cost recovery is amount that could have been taken under the applicable cost recovery method • If no cost recovery is claimed on property o The basis of the property must still be reduced by the amount that should have been deducted ▪ That is, the allowable cost recovery Cost Recovery Basis for Personal Use Assets Converted to Business or Income-Producing Use • If personal use assets are converted to business or income-producing use o Basis for cost recovery and for loss is lower of ▪ Adjusted basis or ▪ Fair market value at the time property was converted o Decline in value that occurred while the property was a personal use asset is not eligible for cost recovery o Modified Accelerated Cost Recovery System (MACRS): General Rules • Under the modified accelerated cost recovery system (M A C R S), the cost of an asset is recovered over a time period that generally is shorter than the economic life of an asset • MACRS provides separate cost recovery systems for realty and personalty • IRS provides tables that identify cost recovery allowances for personalty and for realty Modified Personalty (and Certain Realty): Recovery Periods and Methods • Classification of Property o MACRS provides that the basis of eligible personalty (and certain realty) is recovered over 3, 5, 7, 10, 15, or 20 years ▪ Double declining balance is used for the 3-, 5-, 7-, and 10-year classes, with a switch-over to straight-line depreciation when appropriate ▪ Cost recovery for the 15- and 20-year classes is based on the 150 percent declining-balance method, with an appropriate straight-line switchover Half-Year Convention • General rule for personalty • Cost recovery in the year the asset is placed in service, as well as the year it is removed from service, is based on the assumption that the asset was used for exactly one half of the year, allowing a half-year of cost recovery Mid-Quarter Convention • Applies when more than 40% of the cost of property other than real estate is placed in service during the last quarter of the year 2 • If the mid-quarter convention applies, property acquisitions are grouped by the quarter of acquisition Qualified Improvement Property • Nonresidential realty has a 39-year life, and any improvements made to this property would normally have a 39-year life o An exception to this general rule is provided for qualified improvement property o Qualified improvement property is recovered over a 15-year life using the halfyear convention and the straight-line method • Qualified improvement property o Any improvement to an interior portion of nonresidential real property made after the property is placed in service • Including leasehold improvements o Does not include • Costs of an elevator or escalator or • Improvements that enlarge a building or modify its internal framework Straight-line Election • A taxpayer may elect to use the straight-line method for personal property • The property is depreciated using the MACRS life of the asset with a half-year convention or a mid-quarter convention, whichever applies o The election is available on a class-by-class and year-by-year basis MACRS-Personalty • MACRS characteristics: MACRS Personalty . Statutory lives: 3, 5, 7, 10 yrs 15, 20 yrs Method: 200% DB 150% DB Convention: Half Yr or Mid-Quarter DB = declining balance with switch to straight-line Straight-line depreciation may be elected Realty: Recovery Periods and Methods • Under MACRS, the cost of most real property is recovered using the straight-line method o The recovery for residential rental real estate is 27.5 years • Residential rental real estate o Includes property where 80% or more of gross rental revenues are from residential units ▪ Example: an apartment building o Hotels, motels, and similar establishments are not residential rental property o Nonresidential real estate is recovered over 39 years 3 MACRS Realty • MACRS characteristics: MACRS Realty Residential Rental Nonresid. Realty Statutory lives: 27.5 yrs 31.5 yrs or 39 yrs Method: Straight-line Convention: Mid-month • Residential rental real estate – Includes property where 80% or more of gross rental revenues are from nontransient dwelling units • e.g., Apartment building – Hotels, motels, and similar establishments are not residential rental property • Mid-Month Convention o One-half month’s cost recovery is allowed for the month the property is placed in service o So if a calendar year taxpayer places MACRS real estate in service on June 2 of the current tax year, it will be able to deduct six and one-half months of cost recovery (June 15 to December 31) Modified Accelerated Cost Recovery System (MACRS): Special Rules • Special rules apply under MACRS o Immediate expensing (§ 179) and o Additional first-year depreciation (bonus depreciation) Election to Expense Assets -Section 179 • § 179 General rules o Permits the taxpayer to deduct up to $1,040,000 in 2020 (1,020,000 in 2019) of the acquisition cost of specific types of trade or business property o Amounts that are expensed under § 179 reduce the asset’s basis for additional firstyear depreciation and MACRS cost recovery o § 179 Not available for real property or for property used for the production of income o Any elected § 179 expense is taken before additional first-year depreciation is computed • The base for calculating the standard M A C R S deduction is net of the § 179 expense and the additional first-year depreciation • Deduction limitations: o Ceiling amount • A taxpayer’s § 179 deduction cannot exceed an annual ceiling amount ($1,040,000 in 2020; $1,020,000 in 2019) o Property placed in service maximum 4 • The § 179 deduction ceiling amount ($1,040,000 in 2020) is reduced dollar for dollar when § 179 property placed in service during the taxable year exceeds a specified maximum amount ($2,590,000 in 2020; $2,550,000 in 2019) • In 2020, a taxpayer who places in service $3,630,000 or more of qualifying property ($1,040,000 + $2,590,000) cannot claim a § 179 deduction o Business income limitation ▪ The § 179 deduction allowed for a taxable year cannot exceed the taxpayer’s business income for the year Example: Jill owns a computer service and operates it as a sole proprietorship. In 2020, taxable income is $138,000 before considering any § 179 deduction. If Jill spends $2,730,000 on new equipment, her § 179 expense deduction for the year is computed as follows: Additional First-Year Depreciation (Bonus Deprecation) • In a significant expansion of this provision, the T C J A of 2017 allows taxpayers to deduct 100% cost recovery in the year qualified property is placed in service • Qualified property includes most depreciable assets other than buildings with a recovery period of 20 years or less • Bonus depreciation applies to both new and used property • Additional first-year depreciation is taken in the year in which the qualifying property is placed in service • It is computed after any immediate expense (§ 179) deduction is claimed • After the additional first-year depreciation is determined, the regular M A C R S cost recovery deduction is calculated by multiplying the remaining cost recovery basis by the appropriate M A C R S percentage • A taxpayer may elect not to take additional first-year depreciation Example Additional First-Year Depreciation 5 Kelly acquires equipment (a 5-year class asset) on February 1, 2020, at a cost of $1,345,000 and elects to expense $1,040,000 under § 179. Kelly also chooses to take bonus depreciation. As a result, her total cost recovery deduction for the year is calculated as follows: Alternatively, Kelly could choose not to elect § 179 on the equipment and completely deduct the cost of the equipment using bonus depreciation Business and Personal Use of Automobiles and Other Listed Property • Listed property includes the following: o Passenger automobile o Other property used as a means of transportation o Property used for entertainment, recreation, or amusement o Any other property specified in the Regulations • A computer or peripheral equipment placed in service after 2017 is not listed property • Automobiles and other listed property used predominantly in business o To be considered as predominantly used in business, business use must exceed 50% • Use of listed property for production of income is not considered in the 50% test • However, both production of income and business use percentages are used to compute the cost recovery deduction • Limits on cost recovery for automobiles o The law places further limits on the annual cost recovery deductions for passenger automobiles ▪ A passenger automobile is any four-wheeled vehicle manufactured for use on public streets, roads, and highways with an unloaded gross vehicle weight (GVW) rating of 6,000 pounds or less ▪ The acquisition made in 2019, the initial-year cost recovery limitation increases from $10,100 to $18,100 ($10,100 + $8,100) • Special limitation for Sport-Utility Vehicles (SUVs) o Some sport-utility vehicles (SUVs) are not considered passenger automobiles and, therefore, are not subject to the luxury automobile limitations o However, in 2020, a $25,900 limits applies for the § 179 deduction when the luxury auto limits do not apply ($25,500 in 2019) ▪ The limit is in effect for SUVs with an unloaded GVW rating of more than 6000 pounds and not more than 14,000 pounds • Automobiles and other listed property not used predominantly in business 6 o If asset is not used predominantly in business in the year of acquisition, (i.e., 50 percent or less) ▪ Must use straight-line method ▪ Under this system, the straight-line recovery period for automobiles is five years • Change from predominantly business use o If the business use percentage falls to 50% or lower after the year the property is placed in service, the property is subject to cost recovery recapture o The amount recaptured as ordinary income is the excess cost recovery ▪ Excess cost recovery is the excess of the cost recovery deductions taken in prior years using the statutory percentage method over the amount that would have been allowed if the straight-line method had been used • Leased automobiles o Taxpayers who lease rather than purchase a passenger automobile for business purposes are not subject to the luxury auto limits o To prevent taxpayers from circumventing the luxury auto limits by deducting the full amount of rental payments associated with a luxury automobile leased for business, the law required these taxpayers to report an inclusion amount in gross income o The inclusion amount (determined from an IRS table) is based on the fair market value of the automobile Alternative Depreciation System (A D S) • A D S is an alternative depreciation system that is used: o To calculate the portion of depreciation treated as an alternative minimum tax (A M T) adjustment o For residential and nonresidential real estate and any qualified improvement property placed in service after 2017 by a “real property trade or business” that opts out of the interest expense limitations of § 163(j) ▪ In general, the interest expense limitation rules only apply to businesses with annual gross receipts in excess of $26 million (in 2019 and 2020) o To compute depreciation allowances for earnings and profits purposes • ADS depreciation is computed using straight-line method • For A M T, 150% declining balance is allowed for personalty o Half-year, mid-quarter, and mid-month conventions still apply • To simplify reporting, taxpayers may elect to use the 150% declining-balance method to compute cost recovery for the regular income tax o If this election is made, there is no difference between the regular income tax and AMT cost recovery Amortization • Taxpayers can claim amortization deduction on § 197 intangibles 7 • • • • o Use straight-line recovery over 15 years beginning in month in which the intangible is acquired § 197 intangibles include acquired goodwill, going-concern value, franchises, trademarks, copyrights, patents, and covenants not to compete Startup expenditures are partially amortizable o Treatment is available only by election Allows the taxpayer to deduct the lesser of: o The amount of startup expenditures, or o $5,000, reduced by the amount startup expenditures exceed $50,000 Any amounts not deducted may be amortized ratably over a 180-month period, beginning in the month trade or business begins Depletion • Two methods of natural resource depletion o Cost depletion – used on any wasting asset o Percentage depletion – particularly for oil and gas deposits • Cost depletion o Depletion is computed on a per unit basis o Per unit amount is determined by dividing the basis of the resource by the estimated recoverable units of resource • Number of units sold in year × per unit depletion = depletion for year • Percentage depletion o Uses a specified percentage provided by the Code o This percentage varies according to the type of mineral interest involved o Rate is applied to the gross income from the property 8 ACTG-401 Principles of Federal Taxation – Individual Chapter 7 Deductions and Losses: Certain Business Expenses and Losses LO.1- Determine the amount, classification, and timing of the bad debt deduction. LO.2 – State and illustrate the tax treatment of worthless securities, including § 1244 stock. LO.3 – Distinguish between deductible and non-deductible losses of individuals. LO.4 – Identify a casualty and determine the amount, classification, and timing of casualty and theft losses. LO.5 – State and apply the alternative tax treatments for research and experimental expenditures. LO.6 – Apply the excess business loss limitation rules. LO.7 – Describe the tax impact of a net operating loss and review the effect of the carryback and carryover Provisions on previous and subsequent years’ taxable income. LO.8 – Identify tax planning opportunities in deducting certain business expenses, business losses, and personal losses. Bad Debt • If an account receivable arising from credit sale of goods or services becomes worthless – A bad debt deduction is permitted only if income arising from creation of the receivable was previously included in income – No deduction is allowed if taxpayer is on the cash basis since no income is reported until the cash has been collected Business Bad Debt • Specific charge-off method must be used o Exception: Reserve method is allowed for some financial institutions • Claim deduction in the year when a specific business debt becomes either partially or wholly worthless • In the case of business debt, partial worthlessness can result in a deduction o Only the balance of the debt that is deemed to be uncollectible can be deducted in the later year • Business bad debt is treated as an ordinary deduction in the year incurred • If a receivable has been written off o The collection of the receivable in a later tax year may result in income being recognized o Income will result if the deduction yielded a tax benefit in the year it was taken Non-Business Bad Debt • Nonbusiness bad debt o Debt unrelated to the taxpayer’s trade or business • Treated as a short-term capital loss o No deduction is allowed for partial worthlessness of a nonbusiness bad debt 1 • Loans to relatives or friends are the most common type of nonbusiness bad debt Loans between Related Parties • Loans between related parties raise the issue of whether the transaction was a bona fide loan or a gift • Regulations indicate that individual circumstances must be examined to determine whether advances between related parties are gifts or loans • Some considerations are: • Was a note properly executed? • Was there a reasonable rate of interest? • Was collateral provided? • What collection efforts were made? • What was the intent of the parties? Worthless Securities • Loss on worthless securities is deductible in the year they become completely worthless 2 – These losses are capital losses deemed to have occurred on the last day of the year in which the securities became worthless – Capital losses may be of limited benefit due to the $3,000 capital loss limitation Section 1244 Stock • Sale or worthlessness of § 1244 stock results in ordinary loss rather than capital loss for individuals – Ordinary loss treatment (per year) is limited to $50,000 ($100,000 for MFJ taxpayers) • Loss in excess of per year limit is treated as capital loss • Section 1244 loss treatment is limited to stock owned by original purchaser who acquired the stock from the corporation • Corporation must meet certain requirements for stock to qualify – Major requirement is limit of $1 million of capital contributions • Section 1244 does not apply to gains Losses of Individuals • Only the following losses are deductible by individuals: – Losses incurred in a trade or business, – Losses incurred in a transaction entered into for profit, – Losses caused by fire, storm, shipwreck, or other casualty or by theft • From 2018 through 2025, personal casualty or theft losses are deductible only if attributable to a Federally declared disaster Casualty Loss • Losses or damages to the taxpayer’s property that arise from fire, storm, shipwreck, or other casualty or theft o Loss is from event that is identifiable, damaging to taxpayer’s property, and sudden, unexpected, and unusual in nature Events That Are Not Casualties • Not all acts of nature are treated as casualty losses for income tax purposes • Casualties must be sudden, unexpected, unusual o Losses resulting from a decline in value rather than an actual loss of the property is not a casualty o Events not treated as casualties include disease and insect damage Theft Losses • Theft includes, but is not necessarily limited to, larceny, embezzlement and robbery o Does not include misplaced items • Theft losses are deducted in the year of discovery, which may not be the same as the year of the theft 3 When to Deuct Casualty Losses • General Rule o A casualty loss is deducted in the year the loss occurs • Disaster Area Losses o An exception to the general rule for the time of deduction is allowed for disaster area losses, which are casualties sustained in an area designated as a disaster are by the President of the United States • If reasonable prospect of full recovery: o No casualty loss is permitted o Deduct in year of settlement any amount not reimbursed • If only partial recovery is expected, deduct in year of loss any amount not covered o Remainder is deducted in year claim is settled Measuring the Amount of Loss • Amount of loss o The rules for determining the amount of a loss depend in part on: ▪ Whether business use, income-producing use, or personal use property was involved ▪ Whether the property was partially or completely destroyed o If a business or rental property is completely destroyed, the loss is equal to the adjusted basis of the property at the time of destruction o Different measurement rules applies for partial destruction of business or rental property and for partial or complete destruction of personal use property. Here, the loss is the lesser of the following: ▪ The adjusted basis of the property ▪ The difference between the FMV of the property before the event and the FMV immediately after the event • Personal Use Loss Reductions: The $100-per-Event and 10%-of-AGI Floors o The amount of the allowed loss for personal use property must be further reduced by a $100-per-event floor and a 10%-of-AGI aggregate floor o The $100 floor applies separately to each casualty and applies to the entire loss from each casualty o The losses are then added together, and the total is reduced by 10 percent of the taxpayer’s AGI Excess personal casualty gain $(500) Personal Casualty Gains and Losses • If a taxpayer has both personal casualty & theft gains as well as losses, an exception to the rule that disallows a deduction for personal casualty losses other than those in Federally declared disaster areas applies o In this case, the taxpayer may use a personal casualty loss (or losses) not attributable to a Federally declared disaster to offset any personal casualty gains ▪ After this netting process, if any loss remains, it is not deductible (since it relates to a non-Federally declared disaster area casualty) 4 ▪ If, however, a net personal casualty gain remains, it is offset by any Federally declared disaster area casualty losses o If the gains exceed the losses, the gains and losses are treated as gains and losses from the sale of capital assets ▪ The capital gains and losses are short term or long term, depending on how long the taxpayer held each of the assets ▪ Personal casualty and theft gains and losses are not netted with the gains and losses on business and income producing property o If personal casualty losses exceed personal casualty gains, all gains and losses are treated as ordinary items • Calculating Personal Casualty Gains and Losses • During 2020, Emmanuel has A G I of $50,000 and the following personal casualty gains and losses (after deducting the $100 floor): • Emmanuel first offsets the non-Federally declared disaster area losses against the personal casualty gain, resulting in an excess personal casualty gain of $500, computed as follows: • Next, the excess personal casualty gain offsets the Federally declared disaster area loss. Emmanuel’s overall net personal casualty loss is $8,500, computed as follows: • After this second netting process, because a net personal casualty loss remains, it will be deductible to the extent of the 10%-of-A G I floor. Emmanuel’s itemized deduction for casualty losses is $3,500, computed as follows: 5 Research and Experimental Expenditures • Meaning of research and experimental expenditures o Costs incident to the for the development or improvement of a product (including an experimental or pilot model, a plant process, a product, a formula, an invention, or similar property) o The term includes the costs of obtaining a patent, such as attorney’s fees expended in making and perfecting a patent application • Three alternatives are available for handling research and experimental expenditures: o Expensed in the year paid or incurred o Deferred and amortized o Capitalized • Expense Method o Taxpayers can expense all of the research and experimental expenditures incurred provided this method is adopted for the first taxable year in which these expenditures were paid or incurred o The taxpayer must continue to expense all qualifying expenditures unless a request for a change is made to, and approved by, the IRS o Expense method will not be available in taxable years beginning after December 31, 2021 • Deferral and Amortization Method o Taxable years beginning before January 1, 2022 • Research and experimental expenditures may be deferred and amortized ratably over a period of not less than 60 months • Any change in the election requires permission form the IRS • Usually employed when a company does not have sufficient income to offset the expenses • Deferral and Amortization Method o Taxable years beginning after December 31, 2021 • Research and experimental expenditures paid or incurred in taxable years beginning after December 31, 2021, must be capitalized and amortized • Amortization begins at the midpoint of the year the expenses are paid or incurred, rather than the month in which the taxpayer first realizes benefits 6 • The expenditures are amortized ratably over a five-year period (15 years for foreign research expenses), rather than ratably over a period of not less than 60 months Excess Business Losses • If a noncorporate taxpayer has an excess business loss for the year, it is not allowed o Instead, it is carried forward and treated as part of the taxpayer’s net operating loss (NOL) carryforward in subsequent years o An “excess business loss” is defined as ▪ The aggregate deductions for the year attributable to the taxpayer’s businesses ▪ Less: The sum of aggregate gross income or gain of the taxpayer ▪ Less: A threshold amount o $518,000 for married taxpayers filing a joint return in 2020 o $259,000 for all other taxpayers in 2020 • The purpose is to limit the amount of nonbusiness income that can be “sheltered” from tax as a result of business losses • Applies to the aggregate gross income and deductions from all of a taxpayer’s trades or businesses o If a married couple files a joint return, information from all of the couple’s trades or businesses must be consolidated ▪ The losses of one spouse can be used to offset the other spouse’s nonbusiness income (up to the $518,000 limit in 2020) • Losses from Partnerships or S Corporations o For a partnership or an S corporation, the excess business loss limitation applies at the partner or shareholder level o The rules also treat similarly situated owners differently (based on their filing status • Other Rules o The excess business loss limitation is applied after the application of the § 469 passive activity loss rules Net Operating Losses • N O L s for any one year can be offset against taxable income of other years o Only losses from the operation of a trade or business and casualty and theft losses can create an N O L • Carryforward Only o In general, an NOL can be carried forward indefinitely • In taxable years prior to 2018, an NOL could be carried back 2 tax years and forward 20 years • Beginning in 2018, taxpayers must wait at least one year to receive a tax benefit from the loss • NOL Deduction Limit 7 o In general, an NOL deduction is limited to 80% of taxable income, determined without regard to the NOL deduction itself • If the NOL carryover is less than the computed limitation, the entire carryover is allowed as a deduction • NOLs and the Deduction for Qualified Business Income o The deduction for qualified business income will not create or increase a net operating loss • Losses from qualified businesses are carried over separately and will offset future income from qualified businesses, reducing the related deduction for qualified business income • NOLs and Self-Employment Taxes o An NOL cannot be used to reduce self-employment income • As a result, a taxpayer’s self-employment tax liability will not change as the result of an NOL deduction 8 ACTG-401 Principles of Federal Taxation – Individual Chapter 6 Deductions and Losses: In General LO.1 – Differentiate between deductions for and from adjusted gross income and describe the relevance of the differentiation. LO.2 – Describe the cash and accrual methods of accounting with emphasis on the deduction aspects. LO.3 – Apply the Internal Revenue Code deduction disallowance provisions associated with the following: public policy limitations, political activities, excessive executive compensation, investigation of business opportunities, hobby losses, vacation home rentals, payment of others’ expenses, personal expenditures, capital expenditures, related-party transactions, business interest expense, and expenses related to tax-exempt income. LO.4 – Identify tax planning opportunities for maximizing deductions and minimizing the disallowance of deductions. • Deductions for AGI o Can be claimed even if taxpayer does not itemize o Important in determining the amount of certain itemized deductions ▪ Certain itemized deductions are limited to amounts in excess of specified percentages of A G I o For example, medical expenses and personal casualty losses • Deductions from AGI: o In total, must exceed the standard deduction to provide any tax benefit o Called itemized deductions Common Deductions for AGI • list includes: o Alimony payments (divorce decrees before 2019) o Expenses attributable to property held for the production of rents and royalties o Expenses attributable to a trade or business o Employee business expenses (reimbursed) o Professional development and supplies (up to $250) for elementary and secondary school teachers o Student loan interest o Contributions to retirement plans o Medical insurance premiums paid by a self-employed taxpayer o Self employment taxes o Losses on the sale or exchange of property o Penalty on premature withdrawal of funds from time savings accounts Section 212 Expenses 1 • § 212 allows deductions for ordinary and necessary expenses paid or incurred for the following: o The production or collection of income o The management, conservation, or maintenance of property held for the production of income o Expenses paid in connection with the determination, collection, or refund of any tax • § 212 expenses that are deductions for A G I include: o Expenses related to rent and royalty income o Professional fees paid by a sole proprietor or a farmer • All other § 212 expenses are itemized deductions (deductions from A G I) o For example, investment interest expense o All other investment-related expenses (e.g., safe deposit box rentals) are miscellaneous itemized deductions and, from 2018 through 2025, are not deductible Section 162 Trade or Business Deductions • § 162(a) permits a deduction for all ordinary and necessary expenses paid or incurred in carrying on a trade or business including: o Reasonable salaries paid for services o Expenses for the use of business property o One-half of self-employment taxes paid • Such expenses are deducted for A G I • Section 162 excludes the following items from classification as trade or business expenses: o Charitable contributions or gifts o Illegal bribes and kickbacks and certain treble damage payments o Fines and penalties Deduction Criteria for § 162 and § 212 • To be deductible, expenses must be: o Ordinary: normal, usual, or customary for others in similar business, and not capital in nature o Necessary: prudent businessperson would incur same expense o Reasonable: question of fact o Personal Expenses • Expenses are usually deductions from AGI • Common deductions are o Contributions to qualified charitable organizations o Mortgage interest expense o State and local taxes o Medical expenses 2 o Personal casualty losses Business and Non-business Losses • Deductible losses of individual taxpayers are limited to those: o Incurred in a trade or business, o Incurred in a transaction entered into for profit • Individuals may also deduct casualty losses from fire, storm, shipwreck, and theft that occurred in a Federally declared disaster area Deduction for Qualified Business Income • An individual is allowed a 20% deduction for “Qualified Business Income” (Q B I) from a sole proprietorship, a partnership, or an S corporation o In general, the from A G I deduction for Q B I is the lesser of 20% of: ▪ Qualified business income, or ▪ Modified taxable income (taxable income before the Q B I deduction, reduced by any net capital gain) o Q B I is the ordinary income less ordinary deductions from a “qualified trade or business” ▪ Q B I does not include wages, capital gains or losses, dividend income, and interest income • Limit on the Q B I deduction o If taxable income before the QBI deduction is more than $326,600 (married, filing jointly) or $163,300 (single and head of household), the Q B I deduction cannot exceed the greater of: ▪ 50% of the W–2 wages relating to the qualified trade or business, or ▪ The sum of: o 25% of W–2 wages relating to the qualified trade or business, and o 2.5% of the unadjusted basis (immediately after acquisition) of all qualified property o This limit is phased in over $100,000 (married, filing jointly) or $50,000 (all other taxpayers) of taxable income ▪ Once a married couple has taxable income over $426,600 ($213,300 for singles and heads of household), the W–2 wages and capital investment limitation will be completely in play • A qualified trade or business means any trade or business other than a “specified service trade or business” o Specified services include: ▪ Health ▪ Law ▪ Accounting ▪ Actuarial Science ▪ Performing Arts ▪ Consulting 3 ▪ Athletics ▪ Financial Services ▪ Brokerage Services o Special rules apply to specified service businesses Format of Form 1040 Importance of Taxpayer’s Method of Accounting • The method of accounting affects when deductions are taken o Cash: Expenses are deductible only when paid o Accrual: Expenses are deductible when incurred ▪ Apply the all events test and the economic performance test o For both cash and accrual taxpayers, a “12-month” rule applies for prepaid expenses o Exception to the economic performance test for recurring items allows immediate deduction if: ▪ The item is recurring in nature and is treated consistently 4 ▪ Either the accrued item is not material or accruing it in the current period results in better matching of income and expenses ▪ All of the events have occurred that determine the existence of the liability, and the amount of the liability can be determined with reasonable accuracy ▪ Economic performance occurs within a reasonable period (but not later than 8½ months after the close of the taxable year) Prepaid Expenses – The “12-Month Rule” • Taxpayer doesn’t have to capitalize amounts paid to create a benefit that doesn’t extend beyond the earlier o 12 months after the first date on which the taxpayer realized the benefit or o The end of the tax year following the tax year in which the payment was made (the “12-month rule”) o Disallowance Possibilities • The tax law disallows the deduction of certain types of expenses for a variety of reasons • The tax law may restrict a taxpayer’s attempts to deduct certain items that, in reality, are personal expenditures o For example, specific tax rules are provided to determine whether an expense is for trade or business purposes or is related to a personal hobby Public Policy Limitations • Deductions are disallowed for certain specific types of expenditures that are considered contrary to public policy o Examples: penalties, fines, bribes and kickbacks, two-thirds of treble damage payments for violation of anti-trust law Legal Expenses Incurred In Defense Of Civil Or Criminal Penalties • To deduct legal expenses, the taxpayer must be able to show that the origin and character of the claim are directly related to: o A trade or business o An income producing activity • Personal legal expenses are not deductible • Ordinary and necessary expenses incurred in connection with a trade or business or with rental or royalty property held for the production of income are deductible for AGI Expenses Relating To an Illegal Business • Usual expenses of operating an illegal business are deductible o However, deduction for fines, bribes to public officials, illegal kickbacks, and other illegal payments are disallowed • Drug dealers are not allowed a deduction for ordinary and necessary business expenses incurred in their business, except for cost of goods sold 5 Political Contributions and Lobbying Activities • Generally, no business deduction is allowed for payments made for political purposes • Lobbying expenses incurred in attempting to influence local, state, or Federal legislation or the actions of certain high-ranking public officials are not deductible o Exceptions are allowed for lobbying: ▪ To monitor legislation, and ▪ De minimis exception for annual in-house expenses (limited to $2,000) o If greater than $2,000, none can be deducted Excessive Executive Compensation • For publicly held corporations: o Deduction for compensation paid to covered executives is limited to $1 million annually ▪ Covered employees are the C E O, the C F O, and the three other most highly compensated executives o Any individual who is a covered employee after 2016 will be subject to this rule for all future years o Applies to compensation, commissions based on individual performance, and performance-based compensation tied to overall company performance ▪ Before 2018, the $1 million limit excluded commissions and performancebased compensation o Contracts in place on November 2, 2017, are grandfathered into pre2018 law as long as there are no material changes to the contract Investigation of a Business • Investigation expenses: Paid or incurred to determine the feasibility of entering a new business or expanding an existing business o Include costs such as travel, engineering, architectural surveys, marketing reports and various legal and accounting services • Tax treatment of these expenses depends on: o The current business, if any, of the taxpayer o The nature of the business being investigated o The extent to which the investigation has proceeded o Whether the acquisition actually takes place • If the taxpayer is in a business that is the same as or similar to that being investigated o Investigation expenses are deductible in the year paid or incurred • The tax result is the same whether or not the taxpayer acquires the business being investigated • When the taxpayer is not in a business the same as or similar to the one being investigated o Tax result depends on whether new business is acquired • If not acquired • All investigation expenses generally are nondeductible 6 • If acquired • Investigation expenses must be capitalized as “startup expenditures” • May elect to deduct the first $5,000 of expenses currently • Any excess expenses can be amortized over a period of not less than 180 months (15 years) • In arriving at the $5,000 immediate deduction allowed, a dollar-fordollar reduction must be made for those expenses in excess of $50,000 Hobby Losses • Hobby defined o Activity not entered into for profit ▪ Personal pleasure associated with activity ▪ Examples: raising horses and operating a farm used as a weekend residence • If an activity is not engaged in for profit, the hobby loss rules apply o Hobby expenses are deductible only to the extent of hobby income • Nine factors to consider whether an activity is profit-seeking or is a hobby o Whether the activity is conducted in a businesslike manner o The expertise of the taxpayers or their advisers o The time and effort expended o The expectation that the assets of the activity will appreciate in value o The taxpayer’s previous success in conducting similar activities o The history of income or losses from the activity o The relationship of profits earned to losses incurred o The financial status of the taxpayer (e.g., if the taxpayer does not have substantial amounts of other income, this may indicate that the activity is engaged in for profit) o Elements of personal pleasure or recreation in the activity • Presumptive rule of § 183 o If activity shows profit in three out of five years (two out of seven years for horses), the activity is presumed to be a trade or business rather than a personal hobby ▪ Rebuttable presumption, shifts burden of proof to I R S o Otherwise, taxpayer has burden to prove profit motive • If an activity is a hobby: o Expenses are deductible only to the extent of the gross income from the hobby o Expenses must be deducted in the following order ▪ Amounts deductible under other Code sections without regard to the nature of the activity – property taxes and home mortgage interest 7 ▪ Amounts deductible under other Code sections if the activity had been engaged in for profit, but only if those amounts do not affect adjusted basis – maintenance, utilities, and supplies ▪ Amounts for depreciation, amortization, and depletion Rental of Vacation Homes • May have both personal and rental use of a vacation home • Deduction of rental expenses may be limited to rental income if primarily used for personal purposes • Determination of vacation home treatment is dependent upon the relative time the residence is used for personal use versus rental use • Primarily personal use • Less than 15 days: No gross income recognized from rentals and no deductible rental expenses • Mortgage interest and real estate taxes treated as if on personal residence • 15 or more days: Treatment depends on amount of personal use • Primarily rental use o If rented for 15 days or more and personal use days NOT more than the greater of 14 days or 10 percent of fair rental days o Allocate expenses between personal and rental days if there are any personal use days during the year o Can deduct allocated rental expenses even if loss results ▪ Rental loss subject to at-risk and passive loss rules • Personal/rental use o If rented for 15 days or more and personal use days exceed the greater of 14 days or 10% of total rental days o Treated similar to hobby ▪ Rental expenses deducted in three step process ▪ No rental loss allowed ▪ Carryforward of disallowed rental expenses • Allocation of expenses between personal and rental o Mortgage interest and real estate taxes ▪ IRS requires allocation based on total days used ▪ Courts have allowed allocation based on days in year o Other expenses are allocated based on total days used Expenditures Incurred for Taxpayer’s Benefit or Obligation • No deduction is allowed for payment of another taxpayer’s expenses – Must be incurred for taxpayer’s benefit or arise from taxpayer’s obligation – Exception: Payment of medical expenses for a dependent 8 Personal Expenditures • Unless otherwise provided in the Code, personal expenses are not deductible Disallowance of Deductions for Capital Expenditures • Deductions not allowed for amounts paid for new buildings or for permanent improvements or betterments that increase the value of any property • Amounts are capitalized • Incidental repairs and maintenance of the property are not capital expenditures and can be deducted as ordinary and necessary business expenses • Asset may be subject to depreciation (or cost recovery), amortization, or depletion Transactions between Related Parties • The Code disallows losses from sales or exchanges of property between related parties o Constructive ownership provisions apply o Loss disallowed may reduce gain on subsequent disposition to unrelated third party Substantiation Requirements • The taxpayer has the burden of proof for substantiating expenses deducted on the returns and must retain adequate records • Upon audit, the IRS can disallow any undocumented or unsubstantiated deductions • Substantiation is also important for establishing the basis of an asset Expenses and Interest Relating to Tax-Exempt Income • Expenses relating to production of tax-exempt income are not deductible o Example: interest on debt used to purchase or hold tax-exempt financial instruments Other Disallowances • The following expenditures also are disallowed: o Settlements or payments, including attorney’s fees, related to sexual harassment or sexual abuse if subject to a nondisclosure disagreement o Payments for qualified transportation fringe benefits, including mass transit and qualified parking o Net interest expense, which is limited to business interest income plus 30 percent of adjusted taxable income – does not apply to businesses that have annual average gross receipts of $26 million or less during the prior three taxable years o Any disallowed interest is carried forward indefinitely 9 ACTG-401 Principles of Federal Taxation – Individuals Chapter 5 Gross Income Exclusions LO.1- Recognize that statutory authority is required to exclude an item from gross income. LO.2 – Identify the circumstances under which various items are excludible from gross income. LO.3 – Determine the extent to which receipts can be excluded under the tax benefit rule. LO.4 – Describe the circumstances under which income must be reported from the discharge of indebtedness. LO.5 – Identify tax planning strategies for obtaining the maximum benefit from allowable exclusion. Statutory Authority • Items of income that are specifically designated as exclusion in gross income • Exclusions are generally found in Sections 101 through 140 • Some exclusions o Intended as tax relief measures o To encourage and support certain activities o Relate to design of the income tax Gifts and Inheritance • Gifts are nontaxable to donee if: o Transfer is voluntary without adequate consideration and o Made out of affection, respect, admiration, charity or like impulses o It is not intended to be for services rendered • Inheritances are nontaxable to beneficiary • Income earned on gifts or inheritances is taxable under normal rules • Example – Father gifts corporate bond to daughter. Gift is excluded from daughter’s gross income, but interest income earned after gift date is taxable to her • • Transfers from employers to employees do not qualify as excludible gifts o May be excludible under other provisions, for example, employee achievement awards o Victims of a qualified disaster who are reimbursed by their employers for living expenses, funeral expenses, and property damage can exclude the payments from gross income, code §139 • Employee death benefits—Amount paid by employer to deceased employee’s surviving spouse, children, or other beneficiaries o If decedent had a nonforfeitable right to payments (example—accrued salary), amounts are taxable to recipient as if the employee had lived and collected the payments • Employee death benefits may be excludible as a gift if: o Paid to surviving spouse or children (not employee’s estate) 1 o o o o Employer derived no benefit from payments Surviving spouse and children performed no services for employer Decedent had been fully compensated for services rendered, and Payments made pursuant to board of directors’ resolution under a general company policy • Income in respect of a decedent – Income earned by an employee that was not received by the employee prior to his or her death • It is not an employee death benefit • It is taxable income to the decedent’s beneficiary Life Insurance Proceeds – Paid to the beneficiary because of the death of the insured are excluded from gross income • Life insurance proceeds are chosen to be exempt due to the following: o Life insurance proceeds serve much the same purpose as a nontaxable inheritance o Replace an economic loss suffered by the business • Accelerated death benefits o Gain on cash surrender or transfer of life insurance policy by terminally or chronically ill individual is excludible ▪ Exclusion for chronically ill is limited to amounts used for long-term care • Transfers for valuable consideration • If policy is transferred for valuable consideration, proceeds are taxable to the extent they exceed amount paid for policy plus subsequent premiums paid • Exceptions exist for policy transfers to the following: • The insured under the policy • A partner of the insured • A partnership in which the insured is a partner • A corporation in which the insured is an officer or shareholder • A transferee whose basis in the policy is determined by reference to the transferor’s basis • Applicable to policies transferred in a tax-free exchange or were received by gift • • Investment earnings arising from the reinvestment of life insurance proceeds are generally subject to income tax – Beneficiary will elect to collect the insurance proceeds in installments • The annuity rules are used to apportion the installment payment between the principal element (excludible) and the interest element (includible) Scholarship • An amount paid to or for the benefit of a student to aid in pursuing a degree at an educational institution 2 o Nontaxable to the extent of tuition and related expenses (example: fees, books, supplies, and equipment required for courses) ▪ Amounts received for room and board are taxable • Qualified tuition waivers or reductions by nonprofit educational institutions are excluded from income o Generally limited to undergraduate tuition waivers o Exception for graduate teaching or research assistants Damages • Tax consequences of receipt of damages – Depends on type of harm taxpayer experienced – The taxpayer may seek damages for: • Loss of income • Expenses incurred • Property destroyed • Personal injury • Tax treatment of damages received for: – Loss of income • Generally, taxed the same as the income replaced – Exceptions exist related to personal injury – Reimbursement for expenses incurred • Not income, unless the expense was deducted – Damages that are a recovery of the taxpayer’s previously deducted expenses are generally taxable under the tax benefit rule • Tax treatment of damages received for: – Property damaged or destroyed • Treated as an amount received in a sale or exchange of the property – Thus, taxpayer has realized gain if damage payments exceed property’s basis – Personal injury • Receives special treatment Compensation for Injury and Sickness • Personal injury damages – Compensatory damages received on account of physical personal injury or physical sickness are excludible • Include amounts received for loss of income associated with the physical personal injury or physical sickness – All other personal injury damages are taxable • Compensatory damages for nonphysical injury 3 • All punitive damages (paid by the person who caused the harm) • Wrongful Incarceration – Section 139F, enacted in 2015, exempts amounts received as damages for being wrongfully incarcerated – The exclusion applies to the individual who was convicted of a Federal or state crime but is later exonerated • Workers’ compensation – Although may be payment for loss of wages, workers’ compensation is specifically excluded from gross income Compensation for Injuries and Sickness • Accident and health insurance benefits o Benefits received under policy purchased by taxpayer are excludible ▪ Even if benefits are substitute for income o Different rules apply if the accident and health insurance protection was purchased by the individual’s employer Employer Sponsored Accident and Health Plans • Premiums paid by employer for insurance coverage of employee, spouse, and dependents are deductible by the employer and excluded from the employee’s income • Employee has includible income when she or he collects the insurable benefits; two exceptions are provided o Payments received for medical care of the employee, spouse and dependents are excluded o Amounts received from insurance are not taxable when received for medical care or for permanent loss of body part or function • Payments for expenses that do not meet the Code’s definition of medical care must be included in gross income • Amounts received for medical expenses deducted on a prior return must be included in gross income • One way to provide a medical reimbursement plan for employees is as follows: o The employer purchases a medical insurance plan with a high-deductible and then makes contributions to the employee’s Health Savings Account (HSA) ▪ Employer’s contribution to HSA and earnings on funds in the account are excludible ▪ Contributions limited to 100% of deductible amount for individual or family coverage 4 o Monthly deductible amount is limited to one-twelfth of $3,500 under a high-deductible plan for self-only coverage (one-twelfth of $7,000 for an individual who has family coverage) o Withdrawals from HSA must be used to reimburse the employee for the medical expenses paid by the employee that are not covered under the high-deductible plan Long-Term Care Insurance • Employer-paid insurance premiums for employee’s long-term care are excludible subject to annual limits o Premiums paid by the employer o Benefits collected under the employer’s plan o Benefits collected from the individual’s policy • Individual who purchases his or her own policy can exclude the benefits from gross income • Reduced by any amounts received from other third parties (for example, Medicare, Medicaid) Meals and Lodging • Not taxable to employee if: o Furnished by the employer ▪ On the employer’s business premises ▪ For the convenience of the employer o In case of lodging, the employee is required to accept the lodging as a condition of employment o From 2018 through 2025, the employer may only deduct 50% of the cost of the meals provided (rather than 100%) ▪ After 2025, employers may not claim any deduction for these meals o If the employer continues to provide such meals, their value remains as an exclusion for the employees o Other Housing Exclusions • Campus housing provided by the employer to an employee of an educational institution o If the employee pays annual rents equal to or greater than 5 percent of the appraised value of the facility, it is excluded and other wise, the deficiency must be included in the total income • Ministers of the gospel and other religious leaders can exclude o The rental value of home furnished as compensation o Rental allowance paid to them as compensation, to the extent allowance is used to rent, buy or provide a home o The rental value of home owned by the minister • Housing allowance is a compensation for the conduct of religious worship, the administration and maintenance of religious organizations, or the performance of teaching and administrative duties at theological seminaries 5 • Military personnel are allowed housing exclusions under various circumstances Employee Fringe Benefits • Child and dependent care o Up to $5,000 per year of care costs paid for by the employer can be excluded ($2,500 if married and filing separately) • Athletic facilities o Value of the use of athletic facilities located on employer premises can be excluded • Educational assistance programs o Employer-provided educational assistance for undergraduate and graduate education is excludible • Exclusion limited to $5,250 per year • Includes tuition, fees, books, and supplies o Do not cover • Meals, lodging, and transportation costs • Educational payments for courses involving sports, games, or hobbies • Adoption assistance programs o Employee adoption expenses paid or reimbursed by employer are excludible • Exclusion limited to $14,300 in 2020 • Exclusion phases out as A G I increases from $214,520 to $254,520 Cafeteria Plans • Allow employees to choose between cash and certain nontaxable benefits o If cash is chosen, the amount received is taxable o If a nontaxable benefit is chosen, the benefit remains nontaxable • Provide tremendous flexibility in tailoring the employee pay package to fit individual needs Flexible Spending Plans • Allow employees to accept lower cash compensation in return for employer agreeing to pay certain costs without the employee recognizing income • Annual inflation-adjusted cap applies to these plans ($2,750 in 2020) o Called use or lose plan since reduction in pay cannot be recovered if covered expenses are less than expected • Recently issued I R S rules allow a 2½ month grace period (until the fifteenth day of the third month after the end of the plan year) to use the funds for qualified expenses General Class of Excluded Benefits • No-additional-cost services • Qualified employee discounts • Working condition fringes • De minimis fringes • Qualified transportation fringes 6 • Qualified moving expense reimbursements • Qualified retirement planning services • Qualified military base realignment and closure fringes No-Additional-Cost Services • Value of the services is nontaxable if: o Employee receives services (not property) o Employer incurs no substantial additional cost in providing the services o Services offered are in the ordinary course of business in which the employee works o Exclusion is not allowed to highly compensated employees unless it is available on a nondiscriminatory basis Qualified Employee Discounts • Are nontaxable if: o Exclusion is not on real property or investment property o Property or services must be from the same line of business in which the employee works o In case of property, exclusion is limited to the gross profit component of the customer price o In case of services, exclusion cannot exceed 20% of the customer price on services Working Condition Fringes • Not taxable if the employee could deduct the cost of items if they had actually paid for them o Can be made available on a discriminatory basis and still qualify for the exclusion De Minimis Fringes • These benefits are so small that accounting for them is impractical and thus excludible o Examples include: ▪ Occasional supper money or taxi fare for employees because of overtime work ▪ Occasional personal use of company copying machine ▪ Occasional company cocktail parties or picnics for employees ▪ Certain holiday gifts of property with a low fair market value ▪ Subsidized eating facilities operated by employer are excluded if: ▪ Located on or near employer’s business premises ▪ Revenue equals or exceeds direct operating costs ▪ Nondiscrimination requirements are met Qualified Transportation Fringes • This fringe benefit is designed to encourage the use of mass transit for commuting to and from work 7 o Includes: ▪ Transportation in commuter highway vehicle and transit passes o Annual limit on the exclusion for 2020 is $270 per month ▪ Qualified parking o Annual limit on the exclusion for 2020 is $270 per month o May be provided directly by the employer or may be in the form of cash reimbursements • The T C J A of 2017 prohibits employers from deducting qualified transportation fringe benefits provided to employees [§ 274(a)(4)] o If the employer provides the benefit, though, the employee may exclude it from income within the limits stated above Qualified Moving Expenses • Prior to enactment of the T C J A of 2017, employer payment or reimbursement of employee’s qualified moving expenses was excludible o For 2018 through 2025, the exclusion only applies to members of the Armed Forces on active duty Qualified Retirement Planning Services • Value of any retirement planning advice or information provided by an employer who maintains a qualified retirement plan is excluded from income o Designed to motivate more employers to provide retirement planning services Qualified Military Base Realignment and Closure Fringe • Payments made under the Demonstration Cities and Metropolitan Development Act of 1966 are excluded from income Nondiscrimination Provisions • For no-additional-cost services, qualified employee discounts, and qualified retirement planning services o If the plan is discriminatory in favor of highly compensated employees, these key employees are denied exclusion treatment o Non-highly compensated employees can still exclude these benefits from income Group Term Life Insurance • The premium on the first $ 50,000 of group term life insurance protection are excludible from the employee’s and former employee’s gross income • The benefits of this exclusion are available only to employees • Proprietors and partners are not considered employees Foreign Earned Income • Income from personal services rendered in a foreign country can be either: 8 o Included in taxable income and then claim a credit for foreign taxes paid or o Excluded from U.S. gross income • To qualify for the exclusion, taxpayer must be either: o A bona fide resident of the foreign country or o Present in a foreign country at least 330 days during any 12 consecutive months • Exclusion amount is limited to $107,600 for 2020 o For married persons, both with foreign earned income, the exclusion is computed separately for each spouse o Congress recently decreased its benefit by requiring a special tax computation • The tax on taxable income after the foreign earned income exclusion is calculated using the tax rate that would apply if the excluded foreign earned income were included in gross income Interest on State and Local Government Obligations • Interest from municipal bonds is tax exempt o Reduces borrowing costs of state and local governments o High-income taxpayers can increase after-tax yields with municipal bonds o Municipal interest is considered for Social Security benefits inclusion and may be considered for alternative minimum tax calculation Corporate Distributions to Shareholders • Taxable to the extent of payments made out of either current or accumulated earnings and profits (E & P) • Distributions in excess of E & P are treated: o As nontaxable return of capital to extent of stock basis (which is reduced) o As capital gain to extent in excess of basis Stock Dividends • Stock dividends (e.g., common stock issued to common shareholders) are not taxable – If shareholder has the option to receive stock or cash, the dividend is taxable whether the shareholder receives cash or stock Educational Savings Bonds • Interest on Series E E U.S. government savings bonds may be excluded from income if: o Proceeds are used to pay for qualified higher educational expenses and o Bonds are issued to a person at least 24 years old • Exclusion is phased out once modified A G I exceeds threshold amount • The phaseout begins at $ 82,350 ($ 123,550 on a joint return) • The phaseout is completed when MAGI exceeds the threshold amount by more than $ 15,000 ($ 30,000 on a joint return) Qualified Tuition Program • Amounts contributed must be used to pay qualified higher education expenses 9 • Qualified higher education expenses include: o Tuition, fees, books, supplies, room and board, and equipment required for enrollment or attendance o Computers and peripheral equipment, including software that provides access to the Internet • Tuition paid to public, private, and religious K-12 schools are also included • Earnings on contributions, including discounted tuition for plan participants, are not taxable if used for qualified higher education expenses o Refunds from program are taxable to the extent they exceed contributions Coverdell Education Savings Account • Used to save for K-12 education as well as postsecondary education expenses • The contributions are limited to $2,000 in a year • The beneficiary must be under 18 or must be a special needs beneficiary • The income to the beneficiary is nontaxable provided the funds are used for qualified education expenses Qualified Able Programs (Section 529A Plans) • The qualified ABLE (Achieving a Better Life Experience) program was created to assist individuals who became blind or disabled before age 26 • The qualified ABLE program allows for § 529A plans, or ABLE plans, similar in concept to § 529 plans o The program must be established by a state o The ABLE account must be for the benefit of a designated beneficiary’s disability expenses, and o The beneficiary must have a disability certification from the government • Contributions to the account must be in cash and may not, in aggregate, exceed the annual gift tax exclusion for the year ($15,000 for 2020 and 2019) o Contributions to the account are not deductible • The tax benefit of an ABLE account is that its earnings are not taxable o Distributions from the account also are not taxable provided they do not exceed the qualified disability expenses of the designated beneficiary • The TCJA of 2017 permits certain rollovers from a § 529 account to an ABLE account (for 2018 through 2025) Tax Benefit Rule • If taxpayer claims a deduction for an item in one year and in a later year recovers all or a portion of the prior deduction, the recovery is included in gross income – Amount included in income is limited to the amount for which a tax benefit was received Discharge from Indebtedness Income • Income from the forgiveness of debt is taxable 10 o Certain discharge of indebtedness situations get special exclusion treatment: ▪ Creditors’ gifts ▪ Discharges in bankruptcy and when debtor is insolvent ▪ Discharge of farm debt ▪ Discharge of qualified real property business indebtedness ▪ Seller’s cancellation of buyer’s debt ▪ Shareholder’s cancellation of corporation’s indebtedness ▪ Forgiveness of certain student loans ▪ Discharge of indebtedness on taxpayer’s principal residence that occurs between January 1, 2007, and January 1, 2021, and is the result of the financial condition of the debtor Turn to page 5-35 in situations 2, 3, 4, 5 and 9 the Code allows the debtor to reduce his or her basis in the assets by the realized gain from the discharge. Foot note # 89 code §108 11
Purchase answer to see full attachment