Taxation for Decision Makers

670 Pages·2012·12.113 MB·English

by  Shirley Dennis-Escoffier

TAXATION FOR
DECISION MAKERS
2012 EDITION
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KKaarreenn AA.. FFoorrttiinn
©WILEY
CUSTOM SERVICES
©WILEY
CUSTOM SERVICES
Taxation for Decision Makers, 2012 Edition
Shirley Dennis-Escoffier and Karen A. Fortin
Cover design by Rocky Buckley, Black Diamond Graphics.
Cover photo credits: American hundred dollar bills, US dollar bill, US money, and Pyramid on US
dollar bill: Corbis Digital Stock. The Americas on a Globe: PhotoDisc, Inc./Getty Images.
Copyright © 2012 by Shirley Dennis-Escoffier and Karen A. Fortin
All rights reserved.
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This book was previously published by Pearson Education, Inc.
Printed in the United States of America.
ISBN 978-1-118-09155-5
Printed by Victor Graphics, Inc.
10 9 8 7 6 5 4 3 2 1
Brief Table of Contents
Preface xii
part I INTRODUCTION TO TAXATION AND ITS ENVIRONMENT 1
1 AN INTRODUCTION TO TAXATION 2
2 THE TAX PRACTICE ENVIRONMENT 47
part II INCOME AND EXPENSE DETERMINATION 95
3 DETERMINING GROSS INCOME 96
4 EMPLOYEE COMPENSATION 143
5 BUSINESS EXPENSES 198
part III PROPERTY CONCEPTS AND TRANSACTIONS 245
6 PROPERTY ACQUISITIONS AND COST RECOVERY DEDUCTIONS 246
7 PROPERTY DISPOSITIONS 287
8 TAX-DEFERRED EXCHANGES 337
part IV BUSINESS TAXATION 381
9 TAXATION OF CORPORATIONS 382
10 SOLE PROPRIETORSHIPS AND FLOW-THROUGH ENTITIES 428
part V TAXATION OF INDIVIDUALS 473
11 INCOME TAXATION OF INDIVIDUALS 474
12 WEALTH TRANSFER TAXES 533
APPENDIXA TAX RESEARCH USING RIA CHECKPOINT® 576
APPENDIXB PRESENT VALUE AND FUTURE VALUE TABLES 586
APPENDIXC SAMPLE FILLED-IN TAX RETURNS 588
APPENDIXD TAX RETURN PROBLEMS 631
Index 638
iii
Table of Contents
Preface . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .xii CHARACTERISTICS OF A GOOD TAX . . . . . . . . . . 35
Equity 35
part
Economy 36
I Introduction to Taxation
Certainty 37
and Its Environment 1
Convenience 37
REVISITING THE INTRODUCTORY CASE . . . . . . . . 38
1 AN INTRODUCTION TO TAXATION . . . . . . . . . . . . .2
KEY CONCEPTS . . . . . . . . . . . . . . . . . . . . . . . .2 SUMMARY . . . . . . . . . . . . . . . . . . . . . . . . . . . 38
SETTING THE STAGE—AN INTRODUCTORY CASE . . .3 KEY TERMS . . . . . . . . . . . . . . . . . . . . . . . . . 39
AN INTRODUCTION TO TAXATION . . . . . . . . . . . . .3 TEST YOURSELF . . . . . . . . . . . . . . . . . . . . . . . 39
What Is a Tax? 3 PROBLEM ASSIGNMENTS . . . . . . . . . . . . . . . . . . 40
A Brief History of Income Taxation in the Check Your Understanding 40
United States 3 Crunch the Numbers 41
Objectives of Taxation 4 Think Outside the Text 43
Current Influences on the Tax Law 5 Identify the Issues 44
Search the Internet 44
THE TAXING UNITS AND THE BASIC
Develop Planning Skills 45
INCOME TAX MODELS . . . . . . . . . . . . . . . . . . . .6
ANSWERS TO TEST YOURSELF . . . . . . . . . . . . . . 46
The Individual and Corporate Tax Models 8
Gross Income 8 · Property Transactions 10 · Deductions 11 ·
Determining the Gross Tax Liability 15 · Tax Losses 16 · Additions
2 THE TAX PRACTICE ENVIRONMENT . . . . . . . . . . .47
to the Tax Liability 17 · Tax Prepayments and Credits 18
KEY CONCEPTS . . . . . . . . . . . . . . . . . . . . . . . 47
Other Entities 19
SETTING THE STAGE—AN INTRODUCTORY CASE . . 48
CHOICE OF BUSINESS ENTITY . . . . . . . . . . . . . . 19
AN INTRODUCTION TO TAX PRACTICE . . . . . . . . 48
Sole Proprietorships 20
Partnerships 21 TAXES AND CASH FLOW . . . . . . . . . . . . . . . . . 49
Partner’s Basis Account 22 Cash Flows and Present Value 49
Limited Liability Companies 23 Significance of the Marginal Tax Rate 51
Corporations 24 TAX PLANNING STRATEGIES . . . . . . . . . . . . . . . 51
S Corporations 24 Timing Income and Deductions 51
Comparing Business Entity Attributes 26 Income Shifting 52
Changing the Character of Income 53
OTHER TYPES OF TAXES . . . . . . . . . . . . . . . . . 26
Other Factors Affecting Tax Planning 54
Wealth Taxes 26
Cash Flow 54 · Nontax Considerations and
Wealth Transfer Taxes 28
Judicial Doctrines 55
Consumption Taxes 29
SOURCES OF AUTHORITY . . . . . . . . . . . . . . . . . 57
Tariffs and Duties 31
The Legislative Process 57
TYPES OF TAX RATE SYSTEMS . . . . . . . . . . . . . . 31 Internal Revenue Code 59
The Progressive Tax Rate System 31 Administrative Sources of Authority 60
Proportional “Flat” Tax Rate 33 Treasury Regulations 60 · Other IRS Rulings 61
Regressive Taxes 34 Judicial Sources of Authority 62
iv
Table of Contents v
TAX RESEARCH . . . . . . . . . . . . . . . . . . . . . . . 62 WHAT IS INCOME? . . . . . . . . . . . . . . . . . . . . . 97
Gather the Facts and Identify the Issues 63 Taxable versus Gross Income 97
Locate and Evaluate the Relevant Authority 64 Tax versus Financial Accounting 98
Communicate the Recommendations 64 Return of Capital Principle 98
Keeping Up-To-Date 65
WHEN IS INCOME RECOGNIZED? . . . . . . . . . . . . 99
TAX COMPLIANCE . . . . . . . . . . . . . . . . . . . . . . 65
The Tax Year 100
Filing a Tax Return 65
Accounting Methods 102
Late Filing and Late Payment Penalties 66 · Statute of
Cash Method 102 · Limits on Use of Cash Method 103 · Accrual
Limitations 67
Method 103
Selecting Returns for Audit 68
WHO RECOGNIZES THE INCOME? . . . . . . . . . . . 105
Types of Audits 69
Assignment of Income Doctrine 105
The Appeals Procedure 70
Community Property Laws 106
Taxpayer Noncompliance Penalties 71
Collection Procedures 71 SOURCES OF INCOME . . . . . . . . . . . . . . . . . . 106
Offer in Compromise 71 · Innocent Spouse Relief 72
Interest Income 106
Professional Responsibilities and Ethics 72 Interest on Municipal Bonds 106 · Original Issue Discount 108
Avoidance versus Evasion 72 · Tax Preparer Registration 73 Market Discount 109 · Below-Market-Rate and
Tax Preparer Penalties 73 Interest-Free Loans 109
Tax Professionals’ Dual Responsibilities 74 Dividend Income 112
Sources of Guidance 75 Stock Dividends 113
REVISITING THE INTRODUCTORY CASE . . . . . . . . 77 Annuity Income 114
SUMMARY . . . . . . . . . . . . . . . . . . . . . . . . . . . 77 Transfers from Others 115
Prizes and Awards 115 · Government Transfer
KEY TERMS . . . . . . . . . . . . . . . . . . . . . . . . . 78 Payments 115 · Legal Settlements 117
TEST YOURSELF . . . . . . . . . . . . . . . . . . . . . . . 78 Discharge of Indebtedness 119
PROBLEM ASSIGNMENTS . . . . . . . . . . . . . . . . . . 79 Tax Benefit Rule 120
Check Your Understanding 79
System for Reporting Income 120
Crunch the Numbers 81
Think Outside the Text 82 EXCLUSIONS . . . . . . . . . . . . . . . . . . . . . . . . 121
Gifts and Inheritances 121
Identify the Issues 82
Insurance Proceeds 122
Develop Research Skills 83
Life Insurance 122 · Accident and Health Insurance 123
Search the Internet 84
Scholarships 124
Develop Planning Skills 85
Other Exclusions 125
ANSWERS TO TEST YOURSELF . . . . . . . . . . . . . . .87
APPENDIX 2A TAX RESEARCH . . . . . . . . . . . . . .87 JURISDICTIONAL ISSUES . . . . . . . . . . . . . . . . . 125
Gather the Facts and Identify the Issues 87 International Issues 126
Locate and Evaluate the Relevant Authorities 87 Taxpayers Subject to U.S. Taxation 126
Reading the Code 87 · Committee Reports 88 · Regulations 88 · State and Local Taxation 128
Revenue Rulings and Letter Rulings 88 · Acquiescence
Policy 88 · Other Pronouncements 88 · Court Decisions 89 · EXPANDED TOPICS—SPECIAL METHODS . . . . . . 129
Using a Citator 91 · When to Stop Searching 91
Installment Method 129
Communicating the Recommendations 92
Long-Term Contracts 130
Problem Assignments 93
Check Your Understanding 93 REVISITING THE INTRODUCTORY CASE . . . . . . . . 131
SUMMARY . . . . . . . . . . . . . . . . . . . . . . . . . . 132
part KEY TERMS . . . . . . . . . . . . . . . . . . . . . . . . . 133
II Income and Expense TEST YOURSELF . . . . . . . . . . . . . . . . . . . . . . 133
Determination 95 PROBLEM ASSIGNMENTS . . . . . . . . . . . . . . . . . 134
Check Your Understanding 134
3 DETERMINING GROSS INCOME . . . . . . . . . . . . . .96 Crunch the Numbers 135
KEY CONCEPTS . . . . . . . . . . . . . . . . . . . . . . . 96 Think Outside the Text 139
SETTING THE STAGE—AN INTRODUCTORY CASE . . 97 Identify the Issues 140
vi Table of Contents
Develop Research Skills 140 Excess Housing Cost Exclusion 181
Search the Internet 141 Credit for Foreign Taxes 182
Develop Planning Skills 141 Moving Expenses 183
ANSWERS TO TEST YOURSELF . . . . . . . . . . . . . 142 Tax Reimbursement Plans 183
Tax Treaties 184
4 EMPLOYEE COMPENSATION . . . . . . . . . . . . . . . .143 REVISITING THE INTRODUCTORY CASE . . . . . . . . 184
KEY CONCEPTS . . . . . . . . . . . . . . . . . . . . . . 143 SUMMARY . . . . . . . . . . . . . . . . . . . . . . . . . . 185
SETTING THE STAGE—AN INTRODUCTORY CASE . 144 KEY TERMS . . . . . . . . . . . . . . . . . . . . . . . . . 186
EMPLOYEE COMPENSATION . . . . . . . . . . . . . . . 144 TEST YOURSELF . . . . . . . . . . . . . . . . . . . . . . 187
Payroll Taxes 144
PROBLEM ASSIGNMENTS . . . . . . . . . . . . . . . . . 188
Employee versus Independent Contractor 146
Check Your Understanding 188
Timing of Compensation Deduction 147
Crunch the Numbers 189
Reasonable Compensation 148
Think Outside the Text 193
S Corporations and Unreasonably Low Salaries 149 · Employing
Identify the Issues 194
Children 150
Develop Research Skills 194
EMPLOYEE FRINGE BENEFITS . . . . . . . . . . . . . . 150
Search the Internet 195
Group Term Life Insurance Premiums 151
Develop Planning Skills 196
Health and Accident Insurance Premiums 153
Child and Dependent Care Programs 154 ANSWERS TO TEST YOURSELF . . . . . . . . . . . . . 197
Cafeteria Plans 154
5 BUSINESS EXPENSES . . . . . . . . . . . . . . . . . . . .198
Meals and Lodging 155
No-Additional-Cost Services 156 KEY CONCEPTS . . . . . . . . . . . . . . . . . . . . . . 198
Employee Purchase Discounts 156 SETTING THE STAGE—AN INTRODUCTORY CASE . 198
Employee Achievement Awards 157 CRITERIA FOR DEDUCTIBILITY . . . . . . . . . . . . . 199
De Minimis Fringe Benefits 157 General Provisions for Trade or Business Expenses 199
Working Condition Fringe Benefits 158 Ordinary and Necessary 200
Employee Relocation Expenses 160 Contrary to Public Policy 201
Distance Test 160 · Time Test 161 Related to Tax-Exempt Income 201
Education Expenses 162 Accrued to Related Party 202
Substantiating Business Expenses 163 Obligation of Another Taxpayer 202
EMPLOYEE STOCK AND STOCK OPTIONS . . . . . . 164 Substantiation 202
Restricted Stock 165 TIMING OF DEDUCTIONS . . . . . . . . . . . . . . . . 203
Stock Options 166 Accrual Method 203
Nonqualified Stock Options 166 · Incentive Stock Options 167
Cash Method 204
Phantom Stock and Stock Appreciation Rights 168 Restrictions on Prepaid Expenses 205
DEFERRED COMPENSATION AND Disputed Liabilities 206
RETIREMENT PLANNING . . . . . . . . . . . . . . . . . 168 COSTS OF STARTING A BUSINESS . . . . . . . . . . . 206
Qualified Retirement Plans 168 Business Investigation and Start-up Expenses 207
Types of Retirement Plans 170 Organization Costs 208
Contribution Limits 172 OPERATING EXPENSES . . . . . . . . . . . . . . . . . . 208
Nonqualified Deferred Compensation Plans 173 Business Meals and Entertainment 208
Individual Retirement Accounts 173 Directly Related to or Associated with Entertainment 209 ·
Roth IRAs 175 Restrictions on Deductions 209
SELF-EMPLOYED INDIVIDUALS . . . . . . . . . . . . . 176 Travel and Transportation Expenses 210
Travel Away from Home 210 · Temporary Assignments 210 ·
Employment Tax Consequences 176
Transportation Expenses 211 · Combining Business with
Fringe Benefits Limited 178 Pleasure Travel 212
Retirement Plans 179 Bad Debt Expenses 213
EXPANDED TOPICS—FOREIGN ASSIGNMENTS . . . 180 Insurance Premiums 214
Foreign Earned Income Exclusion 180 Legal Expenses 214
Table of Contents vii
Taxes 214 PROVISIONS LIMITING DEPRECIATION . . . . . . . . 265
LIMITED EXPENSE DEDUCTIONS . . . . . . . . . . . . 215 Mixed-Use Assets 265
Residential Rental Property 215 Reduction in Business Use 266 · Additional Requirements for
Employees 266
De Minimis Exception 216 · Nominal Number of Personal ·
Days 216 · Nominal Number of Rental Days 216 Limits for Passenger Vehicles 267
Home Office Expenses 218 Automobile Leasing 269
Hobby Expenses 219 DEPLETION . . . . . . . . . . . . . . . . . . . . . . . . . 271
EXPANDED TOPICS—BOOK/TAX DIFFERENCES . . 221 AMORTIZATION . . . . . . . . . . . . . . . . . . . . . . 272
Accounting for Income Tax Expense 221 Research and Experimentation Expenditures 273
Calculating Tax Expense 222 · Effects of NOL Carryovers 224 ·
Software 274
Realizing Deferred Tax Assets 225 · Accounting for Uncertainty
in Income Taxes 225 · Exception for Foreign Earnings 228 REVISITING THE INTRODUCTORY CASE . . . . . . . . 274
UNICAP Rules and Inventory 228 SUMMARY . . . . . . . . . . . . . . . . . . . . . . . . . . 276
REVISITING THE INTRODUCTORY CASE . . . . . . . . 230 KEY TERMS . . . . . . . . . . . . . . . . . . . . . . . . . 276
SUMMARY . . . . . . . . . . . . . . . . . . . . . . . . . . 231 TEST YOURSELF . . . . . . . . . . . . . . . . . . . . . . 276
KEY TERMS . . . . . . . . . . . . . . . . . . . . . . . . . 232 PROBLEM ASSIGNMENTS . . . . . . . . . . . . . . . . . 278
TEST YOURSELF . . . . . . . . . . . . . . . . . . . . . . 232 Check Your Understanding 278
PROBLEM ASSIGNMENTS . . . . . . . . . . . . . . . . . 233 Crunch the Numbers 279
Check Your Understanding 233 Think Outside the Text 283
Crunch the Numbers 234 Identify the Issues 283
Think Outside the Text 239 Develop Research Skills 284
Identify the Issues 240 Search the Internet 284
Develop Research Skills 241 Develop Planning Skills 284
Search the Internet 242 ANSWERS TO TEST YOURSELF . . . . . . . . . . . . . 285
Develop Planning Skills 243
ANSWERS TO TEST YOURSELF . . . . . . . . . . . . . 243 7 PROPERTY DISPOSITIONS . . . . . . . . . . . . . . . . .287
KEY CONCEPTS . . . . . . . . . . . . . . . . . . . . . . 287
part
SETTING THE STAGE—AN INTRODUCTORY CASE . 288
III Property Concepts and
DETERMINING GAIN OR LOSS ON DISPOSITIONS . 288
Transactions 245
Property Dispositions and Cash Flow 288
Types of Dispositions 289
6 PROPERTY ACQUISITIONS AND COST RECOVERY Amount Realized 290
DEDUCTIONS . . . . . . . . . . . . . . . . . . . . . . . .246 Realized versus Recognized Gain or Loss 291
KEY CONCEPTS . . . . . . . . . . . . . . . . . . . . . . 246 Holding Period 291
SETTING THE STAGE—AN INTRODUCTORY CASE . 247 Character of Gains and Losses 292
Section 1231 Assets 292 · Capital Assets 293 · Ordinary Income
CAPITAL EXPENDITURES . . . . . . . . . . . . . . . . . 247
Assets 294
BASIS OF PROPERTY . . . . . . . . . . . . . . . . . . . 248
Mixed -Use Assets 294
Acquisition in a Taxable Exchange 250
DISPOSITION OF SECTION 1231 PROPERTY . . . . 294
Acquisition by Gift 250
Depreciation Recapture 295
Acquisition by Inheritance 251
Section 1245 Full Recapture 296 · Section 1250 Partial
CASH FLOW AND AFTER-TAX COST . . . . . . . . . 252 Recapture 297 · Additional Section 291
Corporate Recapture 297
MACRS . . . . . . . . . . . . . . . . . . . . . . . . . . . 253
Unrecaptured Section 1250 Gains for Individuals 298
Averaging Conventions 254
Half-Year Averaging Convention 254 · Mid-Quarter Averaging Section 1231 Netting 299
Convention 255 · Mid-Month Averaging Convention for Corporate Taxpayers 299 · Individual Taxpayers 300
Realty 257
Section 1231 Look-Back Rules 301
Year of Disposition 258
DISPOSITION OF CAPITAL ASSETS . . . . . . . . . . . 303
Alternative Depreciation System (ADS) 259
The Capital Gain and Loss Netting Process 303
Section 179 Expensing Election 260
Tax Treatment of Net Capital Gains and Losses 305
Bonus Depreciation 263 Corporate Taxpayers 305 · Individual Taxpayers 306
viii Table of Contents
DISPOSITION OF ORDINARY INCOME PROPERTY . 309 Casualty and Theft Losses 347
Measuring the Loss 347 · Insurance and Basis
MIXED-USE PROPERTY . . . . . . . . . . . . . . . . . 310 Considerations 348 · Deductible Amount 349 ·
Taxable Year of Deduction 350
SPECIAL RULES FOR SMALL BUSINESS STOCK . . . . 310
Losses on Section 1244 Stock 310 Gains on Involuntary Conversions—Section 1033 351
Tax Deferral on Involuntary Conversions 351 · Qualifying
Section 1202 Gains on Qualified Small Business
Replacement Property 353 · Time Limits for Replacement 353
Stock 312
Involuntary Conversion of a Principal
Comparison of Sections 1244 and 1202 313
Residence 354
SALE OF PRINCIPAL RESIDENCE—SECTION 121 . . 314
ASSET TRANSFERS TO BUSINESSES . . . . . . . . . . . 354
Debt Reductions, Short Sales, and Foreclosures 317
Transfers to Sole Proprietorships 354
LOSSES ON RELATED PARTY SALES . . . . . . . . . . 318 Transfers to Controlled Corporations—Section 351 355
EXPANDED TOPICS—INDIVIDUAL CAPITAL The Control Requirement 355 · Property Other Than Stock
Received 355 · Transferred Services 356 · Basis and Holding
GAINS TAX RATES . . . . . . . . . . . . . . . . . . . . .318
Period 356 · Effect of Liabilities 357 · Transfers to Existing
Determining the Long-Term Capital Gains Tax Rate 319 Corporations 358
Modified Capital Gains Rates 319
Transfers of Property to a Partnership 358
Planning 321 Basis and Holding Period of a Partnership Interest 359 ·
Partnership Basis and Holding Period in Contributed
REVISITING THE INTRODUCTORY CASE . . . . . . . . 322
Property 359 · Effect of Liabilities 360
SUMMARY . . . . . . . . . . . . . . . . . . . . . . . . . . 322
Formation of a Limited Liability Company 360
KEY TERMS . . . . . . . . . . . . . . . . . . . . . . . . . 323 CORPORATE REORGANIZATIONS . . . . . . . . . . . . 361
TEST YOURSELF . . . . . . . . . . . . . . . . . . . . . . 323 REVISITING THE INTRODUCTORY CASE . . . . . . . . 362
PROBLEM ASSIGNMENTS . . . . . . . . . . . . . . . . . 324 SUMMARY . . . . . . . . . . . . . . . . . . . . . . . . . . 362
Check Your Understanding 324 KEY TERMS . . . . . . . . . . . . . . . . . . . . . . . . . 363
Crunch the Numbers 325 TEST YOURSELF . . . . . . . . . . . . . . . . . . . . . . 363
Think Outside the Text 331 PROBLEM ASSIGNMENTS . . . . . . . . . . . . . . . . . 364
Identify the Issues 332 Check Your Understanding 364
Develop Planning Skills 332 Crunch the Numbers 365
Think Outside the Text 371
Search the Internet 334
Identify the Issues 371
Develop Planning Skills 334
Develop Research Skills 372
ANSWERS TO TEST YOURSELF . . . . . . . . . . . . . 335
Search the Internet 372
Develop Planning Skills 373
ANSWERS TO TEST YOURSELF . . . . . . . . . . . . . 373
8 TAX-DEFERRED EXCHANGES . . . . . . . . . . . . . . .337
APPENDIX 8A REORGANIZATIONS . . . . . . . . . . . 374
KEY CONCEPTS . . . . . . . . . . . . . . . . . . . . . . 337
Acquisitive Reorganizations 374
SETTING THE STAGE—AN INTRODUCTORY CASE . 338 Basic Tax Consequences 375 · Type A
BASICS OF TAX-DEFERRED EXCHANGES . . . . . . . 338 Reorganization 376 · Type B Reorganization 376 · Type C
Reorganization 377 · Type D Acquisitive
Basis Adjustments 339
Reorganization 377 · Type D Divisive Reorganization 377
Holding Period 340
Other Reorganizations 378
LIKE-KIND EXCHANGES—SECTION 1031 . . . . . . 340 Other Considerations 379
Qualifying Properties 341 Problem Assignments 379
Determining Realized Gain or Loss and Check Your Understanding 379
the Effect of Boot 342
part
Basis and Holding Period of Like-Kind Property 343 IV Business Taxation 381
Indirect Exchanges 344
OTHER TAX-DEFERRED EXCHANGES . . . . . . . . . 346 9 TAXATION OF CORPORATIONS . . . . . . . . . . . . . .382
Wash Sales 346 KEY CONCEPTS . . . . . . . . . . . . . . . . . . . . . . 382
INVOLUNTARY CONVERSIONS . . . . . . . . . . . . . . 347 SETTING THE STAGE—AN INTRODUCTORY CASE . 383