2017 Continuing Education Course. THE TAX INSTITUTE th St Bakersfield CA THE TAX INSTITUTE S ANNUAL CPE COURSE 20HR COURSE

Transcription

1 THE TAX INSTITUTE th St Bakersfield CA Continuing Education Course THE TAX INSTITUTE S ANNUAL CPE COURSE 20HR COURSE CTEC # 1007-CE-0017; IRS # N56QT-T S, N56QT-U S, & N56QT-E S The Tax Institute

2

3 2017 IRS AND CTEC CONTINUING EDUCATION COURSE IN FEDERAL AND STATE INCOME TAX LAW, THEORY, AND PRACTICE We at the Tax Institute thank you for ordering this home study course. This course qualifies for most recent 2017 CTEC annual continuing education requirements. This course also incorporates the new CTEC Interactive Standard. Credits will be granted for IRS Continuing Education as normal. This year we have included several special topics that you will find interesting. New CTEC requirements increase the text materials. Failure to comply with these CTEC standards would result in a cancellation of provider s materials. This course complies with new CTEC standards for Continuing Education Courses regarding word counting length. To complete this course read this entire book and the sections with review questions and explanations, complete the open book final test, and mail it or fax it back to us for grading. If you pass, a certificate will be sent and the IRS and California Tax Education Council will be notified. You have to renew your registration with CTEC; we will just upload your passing grade. When renewing your California state registration, list this course. District Court enjoined the IRS continuing education RTRP program on 2013; this will not affect our right to upload your information to the IRS for the voluntary program and being included in the IRS database. This study material was prepared in May of By the time you are reading this study material, the government s new rulings, recent developments, and tax court cases will make parts of this book obsolete. Please be aware that our website at provides an end-of-the-year update free of charge for any subsequent law changes. It is important for you to determine whether the information and interpretations provided in the following pages are accurate and how they apply to your practice and clients. Thank you for selecting us. Good times! Copyright 2017 All Rights Reserved Certain portions of this course may not be reproduced by any means in any form, without the written permission of the publisher. You can send your answer sheet by mail to: th St. Bakersfield CA By Fax: Now you can also your complete exam at Exam@taxcollege.com. PDF is the only format accepted. Thank you for choosing The Tax Institute for your tax education needs. The Tax Institute s Annual CPE Course does not pretend to be all-inclusive. It is important for you to determine whether the information and interpretations provided in the following pages are accurate and how they apply to your practice. Study of all the material is important and should be included in your daily practice routine.

4

5 2017 TABLE OF CONTENTS Pages Part 1 Federal Tax Law Rental Income, Rental Expenses, IRS Regulation over Repairs and Capitalization, Business entities for Rental Properties, LLC or S-Corp for Rentals, Trust and Estates for Rentals, Section 1031 exchanges, Using Section 121 and 1031, Depreciation, Section 179, Energy Tax Credits and Cancellation of Debt. Part 2 Tax Updates 1-40 New Verification Code on Form W-2, In-Home Supportive Services excluded from income, Individual Shared Responsibility Payment awareness, IRS and collection agencies, Changes to FAFSA, Reminders of the PATH Act, Security tips for Taxpros and Taxpayers. Online and phone threats for Taxpros and Taxpayers. Part 3 Ethics 1-26 IRC Section 6103 Sharing Taxpayers information, Best Practices for Tax Practitioners, Performing Due Diligence, Form 2848 and 8821, Practicing before the IRS, Disreputable Conduct, and Tax Preparers penalties. Part 4 California 1-60 New Electronic Withdrawal Payment without Income Tax Requirement, New option to the Power of Attorney, State and state cities verifying tax compliance, Sales tax rates, Sales tax districts, Income tax in California, Filing Requirements, Business License in California, Part-Year Residents, Community Property, Prenuptial agreements, FTB Head Of Household Audits and California tax credits and tax rates.

6

7 TAX LAW 2017

8

9 Rental income is received for the use or occupation of property either real or personal property. If the taxpayer is in the business of renting out personal property, Schedule C should be completed and filed. If the taxpayer is renting out real property, they should complete and file Schedule E. Supplemental Income and Loss. However, if the taxpayer provides services in addition to just a room (such as a bed and breakfast or a boarding house), the income and expenses should be reported on Schedule C and SE rather than Schedule E. Note that income from rents reported on Schedule E is not considered earned income for the purposes of the Earned Income Credit, the Additional Child Tax Credit or for the purposes of making a contribution to an IRA. When to Report Rental Income. When the taxpayer should report rental income depends partly on whether or not the taxpayer is a cash basis or accrual basis taxpayer. Cash method. Taxpayers under this method report their rental income in the year they actually or constructively receive it, regardless of when it was earned. They constructively receive income when it is made available, for example, by being credited to your bank account. Accrual method. Taxpayers under this method report income when they earn it rather than when they receive it. They generally deduct their expenses when they incur them, rather than when they pay them. If a taxpayer receives advanced rent (rent for a period of time in the future), they must report the income when received no matter if they are a cash basis or accrual basis taxpayer. A cash basis taxpayer should not report in income any uncollected rent. Since it is not includible in income, no deduction should be taken. An accrual basis taxpayer, the rental income is reported when earned. If the taxpayer is then unable to collect the amount due, they may be able to deduct it as a bad debt. 1

10 Types of Rental Income The following are some forms in which payments from rental property are received. o Advance rent. Advance rent is any amount of payment that is received before the period covered. Any advance rent is included in rental income in the year it was received, regardless of the period covered. o Security deposits. A security deposit is any money that landlord takes from tenant other than advance payment of rent. The security deposit serves to protect the landlord if the tenant breaks or violates the terms of the lease or rental agreement. It may be used to cover damage to the property, cleaning, key replacement, or back rent. If a taxpayer receives any amount of money as a security deposit, and they plan to return it to their tenant at the end of the lease, it should not be included in income. If a landlord makes a decision to keep all or a portion of a security deposit because their tenant has not lived up to the terms of their lease, it should be included in income at that time. A security deposit is different from money received as first and last months of rent (which is includible in income). o Expenses paid by tenant. If the tenants pay any of the expenses to fix the rental property, the payments are rental income. Taxpayers must include them in their rental income. Example. Tenant pays the water and sewage bill for the rental property and deducts it from the normal rent payment. Under the terms of the lease, the tenant does not have to pay this bill. In this case, the landlord has to report the net amount of the rent payment and the amount that the tenant paid for the fixture. Example. While the landlord is out of town, the furnace in his/her rental property stops working. The tenant pays for the necessary repairs and deducts the repair bill from the rent payment. The landlord must include in his/her rental income both the net amount of the rent payment and the amount the tenant paid for the utility bills and the repairs. o Property or services in lieu of rent. Taxpayers that receive property or services, instead of money as rent, must include the fair market value of the property or services in your rental income. If the services are provided at an agreed upon or specified price, that price is the fair market value unless there is evidence to the contrary. o Lease with option to buy. If the rental agreement gives the tenant the right to buy the rental property, the payments received under the agreement are generally rental income. If the tenant exercises the right to buy the property, the payments received for the period after the date of sale are considered part of the selling price. o Part interest. Taxpayers that own part of interest in rental property, report their percentage of the rental income from the property. o Rental of property also used as the main home. Taxpayers who rent a property that is also used as a home and rent it fewer than 15 days during the year do not include the rent received and do not deduct rental expenses. However, they can deduct on Schedule A 2

11 (Form 1040), Itemized Deductions, interest, taxes, casualty and theft losses that are allowed for the nonrental property. RENTAL EXPENSES Generally the taxpayer may deduct the ordinary and necessary expenses paid to produce rental income. If the taxpayer rents part of their property and uses part for personal use, the expenses must be prorated between rental and personal use. Repairs vs. Improvements. It is important to differentiate between a repair and an improvement because the tax treatment is different. The taxpayer can deduct the cost of a repair to their property in the year incurred; they cannot deduct the cost of improvements. The cost of improvements is recovered by taking a depreciation deduction. The recovery period for depreciable property used in a rental activity is generally the same as if it was used for any other business property and can be determined by looking at the Class Lives Tables discussed in the chapter on depreciation. Some common General Depreciation System recovery periods include: Appliances such as stoves and refrigerators Furniture used in rental property Shrubbery and fences Residential rental structures and components (like kitchen cabinets) 7 years 5 years 15 years 27.5 years Additions and improvements, such as a new roof for a rental house have the same recovery period as that of the property to which the addition or improvement was made, determined as if the property were placed in service at the same time as the addition or improvement. They are treated as separate property for depreciation property. Example of Improvements Additions Lawn & Grounds Heating & Air Conditioning Bedroom Bathroom Deck Garage Porch or Patio Landscaping Driveway Sprinkler system Fence or retaining wall Swimming pool Heating system Central air conditioning Furnace Filtration system Ductwork Plumbing Interior Improvements Miscellaneous Built-in appliances New roof Kitchen Modernization Security system Flooring Satellite dish Wall-to-wall carpeting. Wiring upgrades Septic system Water heater Soft water system Filtration system Repairs. A repair keeps the property in good operating condition but does not materially add to the value of the property or prolong its life. Repainting property, fixing gutters, fixing leaks, plastering, and replacing broken windows are examples of repairs. 3

12 IRS REGULATIONS FOR REPAIRS AND CAPITALIZATION FOR TAX YEARS 2014 AND AFTER AFFECTING RENTALS. Effective January 1, 2014, the IRS issued final regulations under Section 1.263(a)-1, -2, and -3 that completely revamp the way a taxpayer must evaluate certain expenditures in order to determine whether the costs represent immediately deductible repair expenses or capital improvements that must be depreciated over time. Depreciation or repair expense. Section 162 of the Internal Revenue Code (IRC) allows taxpayers to deduct all the ordinary and necessary expenses incurred during the taxable year in carrying on their trade or business, including the costs of certain materials, supplies, repairs, and maintenance. However, section 263(a) of the IRC requires them to capitalize the costs of acquiring, producing and improving tangible property, regardless of the size or the cost incurred. The tangible property regulations are intended to provide guidance to taxpayers on whether certain expenditures should be capitalized or deductible as a business expense and to provide them with more objective measurements. The tangible property regulations under Secs. 263(a) and 162(a) are organized as follows: Regs. Sec Materials and supplies; Regs. Sec Repairs and maintenance; Regs. Sec (a)-1 General rules for capital expenditures; Regs. Sec (a)-2 Amounts paid for acquisition or production of tangible property; and Regs. Sec (a)-3 Amounts paid for improvement of tangible property. The final MACRS tangible property regulations addressed, among other matters: Regs. Sec (i)-1 Dispositions from a general asset account; and Regs. Sec (i)-8 Dispositions of tangible property other than from a general asset account. Materials and supplies are defined in Regs. Sec (c) as: A unit of property costing $200 or less; A unit of property with an economic useful life of 12 months or less; A component to maintain, repair, or improve a unit of property, including rotable, temporary, and standby emergency parts; Fuel, lubricants, water, etc., reasonably expected to be consumed in 12 months or less; and Any item identified as a material or supply in other IRS guidance. Under Regs. Sec (a), amounts paid to acquire or produce incidental materials and supplies are deductible when those amounts are paid. Amounts paid to acquire or produce 4

13 nonincidental materials and supplies are deductible in the year the materials and supplies are first used or consumed. Rotable and temporary spare parts are treated as used or consumed when a taxpayer disposes of the parts. New regulations apply to anyone with a business. The final tangibles regulations under Section 1.263(a) apply to anyone who pays or incurs amounts to acquire, produce or improve tangible real or personal property. These regulations apply to corporations, S corporations, partnerships, LLCs, and individuals filing a Form 1040 with Schedule C, E, or F. Under the new regulation, taxpayers are required to formally adopt a new method of accounting using Form While certain safe harbors and elections are implemented through filing statements or treatment of an item on a timely filed federal tax return, the IRS considers the remaining provisions to be accounting methods. A taxpayer seeking to change to a method of accounting permitted by the final regulations must secure the IRS s consent before implementing that new method. Under the temporary regulations, the IRS granted consent through the automatic consent procedures in Rev. Proc The IRS indicated it would follow the same procedures and publish accompanying revenue procedures allowing taxpayers to use Rev. Proc to obtain consent to change their accounting methods to comply with the final regulations. Under the automatic consent procedures, the IRS will grant consent when the taxpayer accurately completes a Form 3115, Application for Change in Accounting Method, attaches the form to the taxpayer s timely filed tax return for the year of change (with extensions), and submits a signed copy to the IRS s national office. With the new regulations effective for tax years beginning on or after Jan. 1, 2014, almost every federal tax return for businesses that own tangible property should have at least one Form 3115 or an election statement that the taxpayers will need to file to adopt the rules under the final regulations. For example, taxpayers will need to file a Form 3115 to adopt the materials-andsupplies provision or file an election statement to use the de minimis rules. Failure to include the Form 3115 or election statement may indicate either an unauthorized accounting method change or the taxpayer s noncompliance with the final regulations. Materials and Supplies. Materials and supplies mean, under the regulation, tangible property used or consumed in the taxpayer s business operations that is not inventory and that is: A component that is acquired to maintain, repair, or improve a unit of tangible property owned, leased, or serviced by the taxpayer, but is not acquired as part of any single unit of tangible property; Fuel, lubricants, water, and similar items that are reasonably expected to be consumed in 12 months or less, beginning when used in a taxpayer s operations; A unit of property that has an economic useful life of 12 months or less, beginning when the property is used or consumed in the taxpayer s operations; A unit of property with an acquisition or production cost less than $200 under the final 5

14 regulations; or Identified by the IRS in published guidance. Analysis for distinguishing capital improvements from deductible repairs. Step 1. The unit of property to which the improvements rules apply: For buildings The unit of property is generally the entire building including its structural components. However, under the final tangibles regulations and for these purposes only, the improvement analysis applies to the building structure and each of the key building systems. The key building systems are the plumbing system, electrical system, HVAC system, elevator system, escalator system, fire protection and alarm system, gas distribution system, and the security system. Lessees of portions of buildings apply the analysis to the portion of the building structure and portion of each building system subject to the lease. Lessors of an entire building apply the improvement rules to the entire building structure and each of the key building systems. For non-buildings The unit of property is, and the analysis applies to, all components that are functionally interdependent. Components of property are functionally interdependent if taxpayers cannot place in service one component of property without placing in service another component of property. For plant property, e.g., manufacturing plant, generation plant, etc. The unit of property is, and the analysis applies to, each component or group of components within the plant that performs a discrete and major function or operation. For network assets, e.g., railroad track, oil and gas pipelines, etc. Taxpayers particular facts and circumstances or industry guidance from the Treasury Department and the IRS determines the unit of property and the application of the improvement analysis. There are two additional rules, based on depreciation conformity, that determine when a component or group of components of a unit of property must be treated as a separate unit of property. These are as follows: For the Year Placed in Service - This rule, only for non-building property, is triggered at the time taxpayer initially placed the unit of property into service. If at the time the unit of property is first placed in service, taxpayers properly treat the component of the unit of property as being within a different MACRS class than the MACRS class for the unit of property of which the component is a part, or taxpayers properly depreciate the component using a different depreciation method than the depreciation method used for the unit of property of which the component is a part, then they must treat the component as a separate unit of property. Subsequent Change in Classification - This rule, for both building and non-building property, is triggered when taxpayers make a subsequent change in their classification of the property for MACRS. In any taxable year after the unit of property is initially placed in service, if taxpayers or the IRS changes the treatment of that property to a proper MACRS class or a 6

15 proper depreciation method (for example, as a result of a cost segregation study or a change in the use of the property), then they must change the unit of property determination for that property under this rule to be consistent with their change in treatment for depreciation purposes. Step 2. Improvement to the unit of property, or in the case of a building, the building structure or any key building system, identified in Step 1. A unit of tangible property is improved only if the amounts paid are: For a betterment to the unit of property; or To restore the unit of property; or To adapt the unit of property to a new or different use. Betterment can be described as: Amounts paid to fix a material condition or material defect that existed before the acquisition or arose during production of the unit of property; or Amounts paid for a material addition, including a physical enlargement, expansion, extension, or addition of a major component, to the property or a material increase in capacity, including additional cubic or linear space, of the unit of property; or Amounts paid that are reasonably expected to materially increase productivity, efficiency, strength, quality, or output of the unit of property where applicable. Example 1 of betterment. Charley acquires land with a leaking underground storage tank left by previous owner. Costs to clean up the land would be an improvement because they fix a material condition or defect that arose prior to the acquisition. Example 2 of betterment. Monica adds a stairway and loft to its retail building to increase its selling space. Costs to build the stairway and loft are for an improvement because they materially increase the capacity of taxpayers' building structure. Example 3 of betterment. Michael adds expansion bolts to its building that is located in an earthquake prone area. These bolts anchor the building frame to its foundation, providing additional structural support and resistance to seismic forces. Costs to add these expansion bolts would be an improvement because they increase the strength of the building structure. Restoration can be defined as: Replacement of a major component or substantial structural part Amounts paid for the replacement of a part or combination of parts that make up a major component or a substantial structural part of the unit of property; or Recognition of gains or losses and basis adjustments - Taxpayers have taken into account or adjusted the basis of the unit of property or component of the unit of property, including: o Deducted Loss Amounts paid for the replacement of a component of the unit of property and they have properly deducted a loss for that component, other than a casualty loss; or o Sale or exchange Amounts paid for the replacement of a component of the unit 7

16 o of property and they have properly taken into account the adjusted basis of the component in realizing gain or loss resulting from the sale or exchange of the component; or Casualty loss or event Amounts paid for the restoration of damage to the unit of property for which they are required to take a basis adjustment because of a casualty loss under section 165, or relating to a casualty event described in section 165, but limited to the basis in the unit of property; or Deterioration to state of disrepair Amount paid to return the unit of property to its ordinarily efficient operating condition, if the unit of property has deteriorated to a state of disrepair and is no longer functional for its intended use; or Rebuilding to like-new condition Amounts paid for the rebuilding of the unit of property to a like-new condition after the end of its class life. Something that adapts the unit of property to a new or different when: An amount is paid to adapt a unit of property to a new or different use if the adaptation is not consistent with taxpayers ordinary use of the unit of property at the time they originally placed it in service. Reviewing if it was repair or depreciation. Typically, when taxpayers change their method of accounting, they must go back and review their accounting for items of income and deduction. With Form 3115, taxpayers will be required to review their prior year s repairs and deductions under the new method of accounting selected and see if those items were correctly capitalized or they should have been deducted as repairs. This could have a tax impact on taxpayers. For example, if an item was depreciated and under the new regulations it would have to be deducted as repairs. As a result, taxpayers could apply the rules back to the beginning of time, as required with Form 3115, and take the complete deductions remaining in the current year. Example. Taxpayers have a store and they made modifications to the store for the new tenant that moved in in They spent $150,000 making the modifications for the new tenant s needs. These costs were capitalized and depreciated over 15 years. Under new regulations and tests these costs did not 1) result in a material increase to the size, capacity, efficiency, strength, or quality of the building structure that would qualify as betterment, nor did they 2) represent a major component or a substantial portion of the building structure that would meet the standards of a restoration. As a result, those costs should have been deducted under the new rules. Thus, on the Form 3115 it is required to take a favorable Section 481 adjustment and expense the remaining basis of the $150,000 assets. This obviously could generate a significant deduction for the client in the current year. Taxpayers that do not make the election using Form 3115, will be subject to Section of the revenue code. Under this section, the IRS could audit the depreciations on taxpayer s return and disallow completely any asset that was improperly depreciated. This means that taxpayer s could lose the expense under the use it or lose it rule. 8

17 Under the final regulations, every repair cost must be evaluated through a series of steps that, if done correctly, will yield the proper treatment of the cost: capitalize or deduct. Taxpayers can see if they can benefit from one of the following safe-harbors that exist under the final regulations to avoid the facts and circumstances analysis: The $5,000/$2,500 de minimis safe harbor; The small building safe harbor for buildings that cost $1 million or less to deduct up to $10,000 of maintenance costs or, if less, two percent of the building s adjusted basis; The routine maintenance to buildings safe harbor; A new annual election to capitalize repair costs that are capitalized on a taxpayer s books and records; and The refinement of the criteria for defining betterments and restorations to tangible property. Safe-harbors. Effective for taxable years beginning on or after January 1, 2016, the Internal Revenue Service increased the de minimis safe harbor threshold from $500 to $2500 per invoice or item for taxpayers without applicable financial statements. In addition, the IRS will provide audit protection to eligible businesses by not challenging the use of the $2,500 threshold for tax years ending before January 1, 2016 if the taxpayer otherwise satisfies the requirements of Treasury Regulation 1.263(a)-1(f)(1)(ii). $5,000 or $2,500 safe harbor election and requirements. Taxpayers may elect to apply a de minimis safe harbor to amounts paid to acquire or produce tangible property to the extent such amounts are deducted by them for financial accounting purposes or in keeping their books and records. If taxpayers have an applicable financial statement (AFS), they may use this safe harbor to deduct amounts paid for tangible property up to $5,000 per invoice or item (as substantiated by invoice). If taxpayers do not have an AFS, they may use the safe harbor to deduct amounts up to $2,500 ($500 prior to ) per invoice or item (as substantiated by invoice). Neither the IRC nor prior regulations included a de minimis safe harbor exception to capitalization; taxpayers were required to determine whether each expenditure for tangible property, regardless of amount, was required to be capitalized. The de minimis safe harbor election eliminates the burden of determining whether every small-dollar expenditure for the acquisition or production of property is properly deductible or capitalizable. If taxpayers elect to use the de minimis safe harbor, they do not have to capitalize the cost of qualifying de minimis acquisitions or improvements. However, de minimis amounts paid for tangible property may be subject to capitalization under 263A, if the amounts include the direct or allocable indirect costs of other property that was produced or acquired for resale. For example, taxpayers must capitalize all the direct and allocable indirect costs of constructing a new building. Safe-harbor for Small Businesses. Small businesses are not required to capitalize as an improvement, and therefore may be permitted to deduct, the costs of work performed on owned or leased buildings, e.g., repairs, maintenance, improvements or similar costs, that fall into the safe harbor election for small taxpayers. The requirements of the safe harbor election for small taxpayers are: 9

18 Average annual gross receipts of $10 million or less; and Owns or leases building property with an unadjusted basis of less than $1 million or less; and The total amount paid during the taxable year for repairs, maintenance, improvements, or similar activities performed on such building property does not exceed the lesser of- o Two percent of the unadjusted basis of the eligible building property; or o $10,000 Taxpayers make the election to use the safe harbor for each taxable year in which qualifying amounts are incurred. o The election is made by attaching a statement to their income tax return for the taxable year. o An annual election is not a change in method of accounting. Therefore, taxpayers should not file Form 3115, Application for Change in Method of Accounting, to make this election or to stop applying the safe harbor in a subsequent year. Safe Harbor for Routine Maintenance. Taxpayers are not required to capitalize as an improvement, and therefore may deduct, amounts that meet all of the following criteria: Amounts paid for recurring activities that they expect to perform; As a result of the use of the property in their trade or business; To keep the property in its ordinarily efficient operating condition; and Taxpayers reasonably expect, at the time the property is placed in service, to perform the activities: o For building structures and building systems, more than once during the 10-year period beginning when placed in service, or o For property other than buildings, more than once during the class life of the unit of property. Small Businesses not making any election using Form By not making the election taxpayers can lose their audit protection for 2012 and Taxpayers that do not make the election and prefer to use the simplified procedures will have the following tax impact: If taxpayers have a trade or business that qualified under the simplified procedures for small taxpayers and they did not file a Form 3115 and include a Section 481(a) adjustment for their first taxable year beginning January 1, 2014, then they will be presumed to have changed their trade or business's method of accounting for amounts incurred under the final tangibles regulations unless they can provide proof of facts and circumstances that demonstrate otherwise. If taxpayers utilized (or were presumed to have utilized) the simplified procedure for their qualifying trade or business its first taxable year beginning and want to change the specified accounting methods for that trade or business in a later taxable year by filing a Form 3115 and calculating a section 481(a) adjustment in the later year, then the section 481(a) adjustment is calculated by taking into account only amounts paid or incurred, and dispositions, in taxable years beginning in Taxpayers should also refer to section 5.01 of Rev. Proc to determine if they are eligible to use the automatic consent procedures or must receive advance consent for the change. 10

19 If taxpayers filed a statement with their 2014 tax return indicating that their qualifying trade or business is not applying the simplified procedure of Rev. Proc and they did not file a Form 3115 for the 2014 taxable year, they may still be required to file an application to change their accounting method for changes under the final tangibles regulations for this trade or business. In this situation, they cannot use the simplified procedure but must comply with the requirements of Rev. Proc and Rev. Proc to change their methods of accounting for tax years beginning on or after Accounting Methods Changes Options for 2015 Taxable Year. Any business that is not being examined by the IRS can ask the IRS for permission to change accounting method. As a general rule, they use Form 3115 to request a change. A change in the accounting method includes a change not only in taxpayers overall system of accounting but also in the treatment of any material item. A material item is one that affects their income or their ability to take a deduction. Some examples of changes in accounting method that typically require IRS approval include: A change from the cash method to an accrual method, or vice versa A change in the method or basis used to value inventory A change in the depreciation or amortization method Applications can be made at any time during the tax year, but the earlier the better. taxpayers may be able to get a six-month extension to file the application so long as their tax return for the year in which the change is requested is filed on time. Many accounting method changes were required for the 2014 tax year to comply with the tangible property regulations. Other accounting method changes were optional for taxpayers in Rev. Procs and provide guidance on accounting method changes related to the tangible property regulations. The draft Form 3115, Application for Change in Accounting Method, that taxpayers will use for an accounting method change in tax year 2015 has been made available by the IRS. The IRS plans to release the final form and instructions prior to the 2016 (2015 tax year) tax season. Taxpayers will need to use the new Form 3115 for all tax year 2015 accounting method changes. The most common accounting method changes related to the tangible property regulation are: DCN 184, 186, 187, or 192: Designated automatic accounting method change number (DCN) 184, 186, 187, or 192 was required to be filed on a Form 3115 in tax year 2014 for all applicable taxpayers. DCN 184, 186, 187, or 192 allowed taxpayers to comply with the final regulations for their repair and maintenance costs, units of property, materials and supplies, and acquisition and production costs. If a taxpayer did not file DCN 184, 186, 187, or 192 for tax year 2014, it can file these method changes for tax year 2015, as long as the IRS has not notified it of, or it is not under, an audit. Filing the method change in 2015 will allow a taxpayer to take advantage of a potential negative 11

20 Sec. 481(a) adjustment and to provide audit protection. DCN 21: This DCN applies when a taxpayer wants to change its method of accounting for removal costs in disposal of a depreciable asset, including a partial disposition. The taxpayer can currently deduct removal costs if it has filed a DCN 21. A taxpayer may make this method change for tax year 2015 if it has removal costs in the year that it would like to currently expense. A taxpayer can still decide to capitalize removal costs even if it filed a DCN 21. DCN 7: This DCN applies to taxpayers that are changing their depreciation from an impermissible method to a permissible one. The taxpayer will have either a positive or negative Sec. 481(a) adjustment included on Form A taxpayer may file this method change in tax year 2015 if it needs to correct an impermissible depreciation method from any year prior to DCN 205/206: DCN 205 applies to a taxpayer that has disposed of a building or structural component, and DCN 206 applies to dispositions of other tangible depreciable assets, including land improvements. A taxpayer that has a depreciable asset (separately broken out) on its fixedasset listing more than once can file a DCN 205 or 206 to remove the depreciable asset that had been disposed of in the past but was not written off the fixed-asset listing. The taxpayer can file this method change with its timely filed 2015 tax return to remove the prior disposed-of asset from its fixed-asset listing. The Sec. 481(a) adjustment will be the remaining tax basis of the asset that the taxpayer is removing. DCN 196: This DCN applied to a taxpayer that was making a late partial disposition election. DCN 196 afforded taxpayers the ability to take into account the remaining basis of the portion of the asset in the year of change. Unfortunately, this method change was allowed only for a tax year beginning on or after Jan. 1, 2012, and before Jan. 1, A taxpayer cannot make this method change for tax year

21 Review Questions Section 1 Read and answer the following review questions. The correct answers are found on the next page with an explanation to strengthen up your knowledge. Note: This is not part of your Final Test. 1. Taxpayers with just rental income will qualify for the following tax credit: a) The Earned Income Credit. b) The Additional Child Tax Credit. c) Making an IRA contribution. d) None of the above. 2. If a cash basis taxpayer receives advance rent for a period of time in the next tax year, they should: a) Wait until the next tax year to report the income. b) Report the income in both the current and the next tax year. c) Report the income in the current tax year only. d) Not report the income at all. 3. If a taxpayer receives a security deposit from a tenant and they plan to return it to the tenant at the end of the lease,. a) It should be reported as income when received. b) It should be considered first and last month of rent. c) It should not be included in income unless the landlord makes a decision to keep all or part of the funds. d) A security deposit should not be received if it is planned to be returned to tenant. 4. If a tenant pays any expenses of the landlord, the payments are considered to be. a) Rental income for the landlord. b) A deduction for the landlord if it is an allowable expense. c) An incidental benefit to the landlord, thus not includible in income. d) Both (a) and (b). 5. Under Section 1.263(a) taxpayers will be required to pay attention to the following when file their business income tax return. a) They are required to depreciate their assets using the correct method of depreciation. b) They are required to determine if an expense represents immediately repair expense or a capital improvement that must be depreciated. c) They are required to determine if an expense is for business use or personal use. d) They are required to carry over any unused depreciation by making the proper election on Form

22 6. In general, Section 162 and Section 263(a) of the Internal Revenue Code (IRS) differ to each other. All the following are the differences between these IRS sections, except: a) Section 162 allows taxpayer to deduct the materials expenses in the current year; Section 263 (a) requires taxpayers to capitalize the expenses for improving tangible property. b) Section 263(a) requires taxpayers to capitalize the expenses for producing tangible property; Section 162 allows taxpayers to deduct all the ordinary supplies for the business. c) Section 162 allows deductions in the current year while Section 263(a) requires taxpayers to capitalize the cost related to tangible property. d) All of the above are valid differences. 7. What is the requirement for taxpayers when filing their business income tax return for taxable years 2014 and after? a) They are required to file Form 3115 to increase their depreciation amount. b) They are required to File Form 3115 to adopt the new regulations and the new method of accounting. c) They are required to complete Form 3115 in case they want to treat all the materials and supplies as repair expenses. d) Form 3115 will be required in order for taxpayer to depreciate any asset in the future. 8. Safe harbor exists to the existing process that helps distinguish correctly between repairs or amortization expenses, the safe harbor is: a) The Small building safe harbor for building costing less than $1 million. b) The $5,000/$2,500 de minimis safe harbor. c) The routing maintenance to building safe harbor. d) All of the above. 9. In order to take a deduction for the repair or depreciate the expense, taxpayers will be required to know all the following, except: a) Taxpayers need to know if the expense if for a betterment of the unit of property. b) Taxpayers are required to know if the expense is to restore the unit of property. c) Taxpayers are required to know if the item will be sold in the near future. d) Taxpayers need to know if the expense is to adapt the unit of property to a new or different use. Questions Section 1 Answers and Discussion 1. Answer d. Income from rents reported on Schedule E is not considered earned income for the purposes of the Earned Income Credit, the additional child tax credit or for the purposes of making a contribution to an IRA. 2. Answer c. If a taxpayer receives advanced rent (rent for a period of time in the future), they must report the income when received no matter if they are a cash basis or accrual basis taxpayer. 3. Answer c. If a taxpayer receives any amount of money as a security deposit, and they plan to 14

23 return it to their tenant at the end of the lease, it should not be included in income. If a landlord makes a decision to keep all or a portion of a security deposit because their tenant has not lived up to the terms of their lease, it should be included in income at that time. A security deposit is different from money received as first and last months of rent (which is includible in income). 4. Answer d. If the tenants pay any of the expenses to fix the rental property, the payments are rental income. Taxpayers must include them in their rental income. 5. Answer b. The IRS issued final regulations under Section 1.263(a)-1, -2, and -3 that completely revamp the way a taxpayer must evaluate certain expenditures in order to determine whether the costs represent immediately deductible repair expenses or capital improvements that must be depreciated over time. 6. Answer d. Section 162 of the Internal Revenue Code (IRC) allows taxpayers to deduct all the ordinary and necessary expenses incurred during the taxable year in carrying on their trade or business, including the costs of certain materials, supplies, repairs, and maintenance. However, section 263(a) of the IRC requires them to capitalize the costs of acquiring, producing, and improving tangible property, regardless of the size or the cost incurred. The tangible property regulations are intended to provide guidance to taxpayers on whether certain expenditures should be capitalized or deductible as a business expense and to provide them with more objective measurements. 7. Answer b. With the new regulations effective for tax years beginning on or after Jan. 1, 2014, almost every federal tax return for businesses that own tangible property should have at least one Form 3115 or an election statement that the taxpayers will need to file to adopt the rules under the final regulations. For example, taxpayers will need to file a Form 3115 to adopt the materials-and-supplies provision or file an election statement to use the de minimis rules. Failure to include the Form 3115 or election statement may indicate either an unauthorized accounting method change or the taxpayer s noncompliance with the final regulations. 8. Answer c. Under the final regulations, every repair cost must be evaluated through a series of steps that, if done correctly, will yield the proper treatment of the cost: capitalize or deduct. The series of steps are the following: For a betterment to the unit of property; or To restore the unit of property; or To adapt the unit of property to a new or different use. Expenses done for the above will be proper capitalized and depreciated. 9. Answer d. Taxpayers can see if they can benefit from one of the following safe-harbors that exist under the final regulations to avoid the facts and circumstances analysis: The $5,000/$2,500 de minimis safe harbor; The small building safe harbor for buildings that cost $1 million or less. The routine maintenance to buildings safe harbor; A new annual election to capitalize repair costs that are capitalized on a taxpayer s books and records; and The refinement of the criteria for defining betterments and restorations to tangible property. 15

24 Option for Small Business Tax Payers for the Repair Regulation. A small business taxpayer that qualifies for the small business safe harbor can choose to change to certain methods of accounting under the final regulations. They can do this by taking into account only amounts paid or incurred in tax years beginning on or after Jan. 1, The taxpayer will not have a Sec. 481(a) adjustment for the first tax year beginning in 2014 and will not be required to file a Form 3115 for that year (other than for certain concurrent changes). The taxpayer will be implementing the tangible property regulations prospectively. The taxpayer will only need to file its 2014 federal tax return to comply with the final tangible property regulations under Rev. Proc If a taxpayer chooses these procedures, it will not receive audit protection for prior-year tangible property regulations issues as mentioned before. For the 2015 tax year, a small business taxpayer will need to continue applying the tangible property regulations to its repairs and maintenance, asset acquisitions, materials and supplies, capital expenditures, and asset disposals. Election not Made on 2014 Tax Return. Many taxpayers met the criteria for the simplified procedures under Rev. Proc and did not file any Forms 3115 related to the tangible property regulations in These taxpayers might now want to file those accounting method changes in tax year 2015 to take advantage of a prior-year negative Sec. 481(a) adjustment or to get audit protection for years prior to Some tax practitioners believe that a taxpayer that "defaults" to accepting relief under Rev. Proc automatically forfeits any opportunity to correct expenditures that it could have expensed in years prior to This is true, however as long as a taxpayer has not violated the eligibility rules of filing automatic method changes of Rev. Proc , it has not forfeited its ability to file tangible property regulations method changes in tax years after If taxpayers plan to file Forms 3115 in tax year 2015 and want to include items in prior tax years, it must include a statement with its 2014 tax return stating that it is not following Rev. Proc Currently, it is uncertain whether a small business taxpayer can include items from prior years in a Form 3115 filing if it did not include a statement with its 2014 tax return opting out of the Rev. Proc procedures. Small business taxpayers should wait until there is more clarification from the IRS before deciding whether to file those Forms One thing that is clear is that a taxpayer cannot file a DCN 196 in tax year 2015, even if the taxpayer explicitly opted out of Rev. Proc When to Change a Method of Accounting under the New Regulations. Under the IRC, a change in method of accounting includes a change in the treatment of an item affecting the timing for including the item in income or taking the item as a deduction. For example, taxpayers are changing their method of accounting if they have been capitalizing certain amounts that they characterized as improvements and would like to currently deduct the amounts as repairs and maintenance costs pursuant to the final tangibles regulations. They must get the IRS Commissioner's consent to change a current accounting method to a new accounting method. The Treasury Department and the IRS provides automatic consent procedures for those who want to change to a method of accounting permitted under the final tangibles regulations. 16

25 Generally, taxpayers receive automatic consent to change a method of accounting by completing and filing Form 3115, Application for Change in Accounting Method (Rev. Dec. 2015), and including it with their timely filed original federal tax return for the year of change. They also mail a duplicate copy of the Form 3115 to Covington, KY. The Form 3115 will identify the taxpayer, describe the methods that are being changed, identify the type of property involved in the change, and include a section 481(a) adjustment, if applicable. There is no fee for filing an automatic consent to change a method of accounting. The section 481(a) adjustment takes into account how taxpayers treated certain expenditures in years before the effective date of the final tangibles regulations to avoid duplication or omission of amounts in the taxable income. Taxpayers cannot file an amended return to make the change in method of accounting. The only exception is a limited late filing provision found in section 6.03(4) of Revenue Procedure These provisions grant, for a taxpayer who has timely filed (including any extension) its original federal income tax return for the year of change, an automatic extension of 6 months from the due date (excluding any extension) of the federal income tax return for the year of change to file an amended return in a manner that is consistent with the taxpayer's changed method of accounting and includes the original Form The return must also have a statement attached to the Form 3115 that the application is being filed pursuant to Treas. Reg (b) of the Procedure and Administration Regulations. Remember to also file a copy with Covington, KY. OTHER COMMON RENTAL EXPENSES. In addition to depreciation and repairs, most other ordinary and necessary expenses of renting out property can be subtracted from rental income. Some of the more common expenses include: Advertising. Cleaning and maintenance. Commissions. Depreciation. Insurance. Interest (other). Legal fees. Management fees. Mortgage interest. Rental payments. Repairs. Tax return preparation fees. Taxes. Travel expenses. Utilities. Property not rented for profit. If taxpayer does not rent their property to make a profit, they can deduct their expenses only up to the amount of their rental income. Any rental expenses that are greater than the rental income cannot be carried forward. In this case, do not complete and file Schedule E. Instead report the income on line 21, Form If the taxpayer uses the property as their main home or second home, mortgage interest and real estate taxes can be deducted as usual on Schedule A. Other rental expenses will be included as miscellaneous deductions on line 22 of Schedule A, subject to the 2% limitation. 17

26 Renting part of principal residence. If the taxpayer rents only part of their property and uses part for personal use, they must divide up certain expenses incurred. Expenses directly related to the rental portion of the property are deductible in full. For example, the expense for painting or wallpapering a room used strictly for rental purposes is deductible in full. However those expenses paid for the entire property may need to be divided up between rental and personal use. The taxpayer can use any reasonable method for dividing the expenses. It may be easiest to divide certain expenses based on the number of people involved (such as certain utility items). The two most common methods for dividing expenses are one based on the number of rooms in the property and one based on the square footage of the property. Rental of vacation home or other personal dwelling. If a vacation home or other dwelling unit is used by the taxpayer for personal use part of the time and also rented at fair rental value for 15 days or more during the year, the expenses must be prorated. A dwelling unit includes a house, apartment, mobile home, boat, apartment or other similar property. Ordinarily, any rental income received is taxable. However, taxpayers can rent their vacation home for up to 14 days per year and all the rental income received is tax free, no matter how much is earned. Taxpayer will not be required to report the income to the IRS. The taxpayer uses a dwelling unit as a home during the tax year if they use it for personal purposes more than the greater of: 14 days; or The home is rented for less than 15 days. Personal use by the taxpayer includes any day that the unit is used by any of the following: The taxpayer or any other person who has an interest in the property (co-owner), unless it is rented to the other owner as his main home under a shared equity financing agreement. A member of the taxpayer s family (or family member of another owner) unless that person uses the dwelling as their main home and pays a fair rental price. For the purposes of this discussion, family includes brothers, sisters, half-brothers, half-sisters, spouses, ancestors (parents, grandparents) and lineal descendants (children, grandchildren) Anyone under an arrangement that lets the taxpayer use another dwelling unit; or Anyone that pays the taxpayer less than a fair rental price for the dwelling unit. 18

27 Rented fewer than 15 days. If the taxpayer uses a dwelling unit as a home and rents it fewer than 15 days during the year, they are not required to include that rental income on their tax return. However they cannot deduct any expenses as rental expenses. If the dwelling is used as a residence and also rented for 15 days or more, then some expenses are deductible in full; some expenses are deductible only to the extent of the income reported. Any expenses that cannot be deducted in the current year because of the rental income limit can be carried over to the following year. Expenses are deductible in the following order: 1. The rental portion of interest, taxes and casualty losses. The rental portion is deductible on Schedule E. The personal portion will be deductible on Schedule A if the taxpayer itemizes deductions. 2. Rental expenses not directly related to the dwelling unit, such as advertising, related travel, commissions, fees, office supplies, etc. These items are fully deductible. 3. Expenses directly related to the dwelling unit such as repairs, maintenance, trash pickup, lawn care, etc. 4. Depreciation 19

28 If items (1) and (2) exceed the gross rent, a loss may be claimed on the vacation home. If operating expenses (3) exceed gross rent minus items (1) and (2), they must be carried forward to the next year. DEDUCTING RENTAL LOSSES. Rental real estate activities are generally considered passive activities and the amount of loss that the taxpayer can deduct is limited. Generally a loss from rental real estate activities is not deductible unless the taxpayer has income from other passive activities. However, if the taxpayer actively or materially participates in the rental activity, they may be able to deduct some of the losses. Active Participation. A taxpayer actively participates in a rental real estate activity if they owned at least 10% of the rental property and made significant management decisions. Management decisions include approving new tenants, deciding on rental terms, approving expenditures, etc. Material Participation. A taxpayer materially participates in an activity if they were involved in its operations on a regular, continuous and substantial basis during the year. If the taxpayer actively participated in the rental activity and their rental losses are less than $25,000, generally they are allowed to deduct the full amount of the loss. However If the taxpayer s modified adjusted gross income is more than $100,000 ($50,000 MFS), they will not be able to deduct the full amount of the $25,000. If their modified adjusted gross income is $150,000 or more ($75,000 MFS) they generally cannot deduct a loss at all. If the taxpayer is married filing a separate return, and lived apart from their spouse all year, their special allowance cannot be more than $12,500. If they are filing a separate return and lived with their spouse for any part of the year, they cannot use the special allowance to reduce their nonpassive income or tax on nonpassive income. Rental Real Estate Professionals. Rental activities in which the taxpayer materially participates are not passive activities if, for that year, the taxpayer was a real estate professional. A taxpayer qualifies as a real estate professional for the year if they meet both of the following requirements: 1. More than half of the personal services they performed in all trades or businesses during the year were performed in real property trades or businesses in which the taxpayer materially participated 2. They performed more than 750 hours of services during the tax year in real property trades or businesses in which they materially participated. 20

29 Reporting rental income and expenses. Unless the taxpayer is reporting rental income for a not-for-profit activity or provides significant services primarily for the tenant s convenience, file and complete Part 1, Schedule E, Form 1040, listing total income, expenses and depreciation for each property. If the taxpayer has more than three rental properties, compete and attach additional Schedules E as needed. Complete lines 1 and 2 for each property. Fill in the Totals column on only one Schedule E. The figure in the Totals column on that one Schedule E should be the combined total of all Schedules E. Rental expenses that can be claimed, explained. The following items can be deducted on Part I of Schedule E as rental expenses. These expenses should not be confused with business expenses or itemized deductions. Advertising. "Reasonable" expenses for advertising include printing business cards, yellow pages ads, newspaper advertisements, TV and Radio ads. Auto and travel. Taxpayers can deduct ordinary and necessary transportation expenses incurred with the rental activities. Some of those expenses include collecting the rent, managing, conserving, or maintain the rental property. Generally, taxpayers that use their personal car, pickup truck, or light van for rental activities can deduct the expenses using one of two methods: actual expenses or the standard mileage rate. For 2014, the standard mileage rate for business use is 56 cents per mile. For more information, see chapter 4 of Publication 463. Taxpayers will be required to complete Form 4562, Part V, and attach it to the tax return. Taxpayers must keep records that follow the rules in chapter 5 of Publication

30 Transportation Recordkeeping for Travel Expenses Amount Time Place or Description Cost of each separate expense. For car expenses, the cost of the Date of the expense. For car The business car and any improvements. The expenses, the date of the use destination. mileage for each business use, of the car. and the total miles for the year. Date Recordkeeping for Car Mileage Expenses. Miles this trip Destination (City, Town, or Area) Business Purpose Start Stop Type (Gas, oil, tolls, etc.) Amount Weekly Total Total Year-to-Date Cleaning and maintenance. Taxpayers can deduct cleaning and maintenance expenses to keep the property in good working condition. Common expenses are lawn maintenance, carpet cleaning, and other janitorial services. Commissions. Rental agencies and property managers usually charge commissions for collecting rent, making repairs, finding and managing tenants. Depreciation. The depreciation of the rental property can be taken once the property is ready and available for rent. Even if the property is not rented, because of a temporary repair or improvement, taxpayers can continue claiming the depreciation. Stop depreciating the property when the total basis of property has been recovered. Taxpayers must also stop depreciating the property when it is retired from service, even if the basis has not been fully recovered. Taxpayers also stop deducting the property when it is withdrawn from use as a rental property. The following events will require stopping depreciating the property: o Taxpayers sell or exchange the property. o The property is converted to personal use property. o The property is abandoned. o The property is destroyed. Property taxes. Charges for local benefits that increase the benefit of the property, such as charges for putting in streets or water and sewer systems are not deductible. They are considered non-depreciable capital assets, the cost of which is added to the taxpayer s basis in the property. Local taxes for maintaining, repairing or paying interest charges for the benefits are deductible. Insurance premiums. If the taxpayer pays an insurance premium in advance for more than one year, they can only deduct the part of the premium payment that applies to the current year. 22

31 Tax return preparation fees. If taxpayer paid for forms and schedules pertaining to rental income they can claim it as rental expense. OTHER SCHEDULE E ITEMS Page 1 of Schedule E is used to report income/loss from royalties received from sources such as oil and gas wells, or other natural resources. Page 2 of Schedule E is used to report income or loss from partnerships, S corporations, estates, trusts, and real estate mortgage investment conduits. LLC OR S-CORPORATIONS FOR RENTAL PROPERTIES. Taxpayers may want to decide between a corporation and an LLC structure. Typically LLCs are formed to hold rental properties and s-corporations are intended for operating businesses. The big difference will be at the time of filing the income taxes. Taxpayers with many rental properties would divide them into different LLCs to avoid being a target of a suit and loss all their properties at once. If they split the properties into two or more LLCs the risk is lower. The authority to create a limited liability company rests exclusively with the local governments of the states and the District of Columbia. As a result of many jurisdictions adopting the principles of the Revised Uniform Limited Liability Company Act, the bodies of law governing LLCs have become relatively uniform. Most of these laws do not prohibit business owners from creating multiple LLCs or from acquiring numerous membership interests. Real Property and Trusts. Taxpayers may want to protect their real properties by using an LLC or a trust. A trust can be used if the taxpayer personally owns real estate that is not part of a business; this means they are not in the business of purchasing and selling properties. Taxpayers 23

32 may benefit from having a trust for properties that are not part of a business and will be inherited once the taxpayer passes away. Taxpayers can form a revocable trust or irrevocable trust: Revocable trust. It is also known as a living trust. A revocable trust can help assets pass outside of probate, yet allows taxpayers to retain control of the assets during their lifetime. It is flexible and can be dissolved at any time. A revocable trust typically becomes irrevocable upon the death of the grantor. Irrevocable trust. An irrevocable trust typically transfers the taxpayers assets out of their estate and potentially out of the reach of estate taxes and probate, but cannot be altered by the grantor after it has been executed. Therefore, once taxpayers establish the trust, they will transfer the assets and property into the name of the trust. With this they lose control over the assets and cannot change any terms or decide to dissolve the trust. Creating a trust for some taxpayers is a good option in order to avoid state probate once taxpayer passes away. Trusts can be arranged in many ways and can specify exactly how and when the assets pass to the beneficiaries. Trust or will for personal assets? Since trusts usually avoid probate, the beneficiaries may gain access to these assets more quickly than they might to assets that are transferred using a will. Additionally, if it is an irrevocable trust, it may not be considered part of the taxable estate, so fewer taxes may be due upon taxpayers pass away. Assets in a trust may also be able to pass outside of probate, saving time, court fees, and potentially reducing estate taxes as well. In a probate, the taxpayers will go through a legal process of settling an estate in which the validity of the will is proven. After this, the deceased's assets are collected and accounted, debts and taxes are paid, and remaining probate estate assets are distributed. Trust for real property. Once again, if taxpayers own real estate that is not part of a business, they can benefit from placing it in an asset-protection trust. They can be the trustees and may continue to claim ownership of the property, but they must manage it for the benefit of the beneficiary. The beneficiary is the person to whom the property will pass upon their death. This beneficiary does not own the property while the taxpayers are alive, and cannot pledge it as collateral or sell it. A trust can protect both the trustee and the beneficiary from creditors and lawsuits, because the trust holds the property and neither the trustee nor the beneficiary may pull it out of the trust. LLC for real property. The benefit of LLCs is that they enjoy the limited liability of corporations along with the operational and managerial flexibility of partnerships. Taxpayers can even form a one-person LLC. Although the LLC is designed for operating a business, taxpayers can form an LLC and then contribute property to it, which then legally belongs to the LLC. Nevertheless, as long as taxpayers own the LLC, they indirectly own the property. Owners may dissolve an LLC at any time and take back any assets that are not owed to LLC creditors. Owners can also receive periodic distributions of any LLC profits. 24

33 Probate for trusts and LLCs. The assets of a revocable trust are counted as part of taxpayers estate for the purpose of assessing estate tax. In contrast, the assets of an irrevocable trust are not counted as part of taxpayers estate. Taxpayers interest in an LLC passes through probate and is considered part of their estate assets when they die. Taxpayers can, however, structure their LLC so that they own only a small part of it, while their family members own most of it, and retain managerial control over the LLC, in accordance with the operating agreement, until the taxpayer dies. In this way, the taxpayer can control the LLC assets but still keep them out of the estate to avoid estate tax. Trusts and LLCs must pay Federal taxes. The income of a revocable family trust is taxed as the taxpayers personal income. If the family trust is irrevocable, its income is taxed independently and the trustee must file a trust tax return. Estate tax is not assessed against irrevocable trusts. With an LLC, normally each owner is taxed on his proportionate share of LLC profits at individual income tax rates. An LLC may choose to be taxed as a corporation. We will talk more about corporation taxes in the following pages. Taxation of Trust and Estates, General Information. Trusts, like estates, are a taxable entity. A trust is a fiduciary entity whose objective is to hold and invest money or property held in the trust for the benefit of the beneficiaries. Trust property consists of principal or corpus, which is the property transferred to the trust by the grantor. The trust can earn income usually from investments. If the trust retains income beyond the end of the calendar year, then it must pay taxes on it. If money is distributed to the beneficiaries, then whether it is taxable or not to the beneficiaries will depend on whether principal or income was distributed, and if it was income, then whether it was tax-free income or retained income from previous years that the trust has already paid tax on. Because trusts are not subject to double taxation, either principal or income on which the trust paid taxes can be distributed tax-free to the beneficiaries. Likewise, any taxable distribution to beneficiaries is deductible by the trust. Gift taxes may also apply to either property transfers to a trust or distributions to beneficiaries. Property transfers to an irrevocable trust may be subject to gift tax, but for revocable trusts, gift tax liability will not be incurred until the property is transferred to a beneficiary or when the trust becomes irrevocable. Income tax requirement. A trust must use a calendar year. If the trust has taxable income or gross income of $600 or more, or if any of the beneficiaries are non-resident aliens, then it must file Form 1041, U.S. Income Tax Return for Estates and Trusts and may also have to make estimated tax payments. In general, taxpayers will not have to file IRS Form 1041, U.S. Income Tax Return for Estates and Trusts for their revocable living trust, at least not as long as they are alive and well and they are also serving as the sole trustee or as a co-trustee of the trust. Annual filing requirement for revocable living trust. Taxpayers will report the trust information on their personal income tax return Form For example, all of the mortgage interest and property taxes is still reported on Schedule A, Interest income and dividends on Schedule B, and capital gains and losses on Schedule D. 25

34 The tax ID number that is used to file the return is the taxpayer s Social Security number. All interest, dividends and other income earned by the assets held in the trust will be reported to the Internal Revenue Service on the taxpayer s income tax return. All income earned by the revocable living trust is reported on the taxpayer personal Form 1040, not on a separate revocable trust tax return. This is only the case for revocable living trusts. Irrevocable trusts are their own tax entities. Taxpayers will have to file Form 1041 if they become mentally incapacitated and their successor trustees will have to obtain an Employer Identification Number. Income tax for irrevocable trust. An irrevocable trust is treated as an entity that is legally independent of its grantor for tax purposes. Accordingly, trust income is taxable, and the trustee must file a tax return on behalf of the trust. The trustee must file Form 1041 if the trust has any taxable income for the year or if it has at least $600 in income for the year even if none of it is taxable. Form 1041 requires the trust to report its identification information, details of its income and deductions and tax payments. Trust deductions include expenses for attorney's fees, accountant's fees, trustee compensation, interest, state and local taxes, certain investment losses and bad debts, payment to beneficiaries and expenses for the production or collection of income that exceed 2 percent of the trust's adjusted gross income. Certain additional deductions apply to special types of trusts. Charitable trusts. Many trusts are established for charitable purposes. If the trust claims a charitable deduction under Section 642c of the Internal Revenue Code, it must file Form 1041-A. Certain types of trusts are exempt from this requirement. Form 1041-A requires the trust to provide details of its income, deductions, charitable distributions from income and charitable distributions from principal. It must also fill out a balance sheet report. 26

35 Review Questions Section 2 Read and answer the following review questions. The correct answers are found on the next page with an explanation to strengthen up your knowledge. Note: This is not part of your Final Test. 10. If a taxpayer does not rent their property to make a profit,. a) They should complete Schedule E. b) They should complete Schedule C. c) They should report their income on line 21, Form d) The income is not considered to be taxable. 11. If taxpayer rents only part of their property and uses part for personal use,. a) They must compete Schedule C b) All of their expenses are considered nondeductible c) All of their expenses are considered deductible d) Expenses directly related to the rental portion of the property are deductible in full. 12. A dwelling unit includes. a) A mobile home b) An apartment c) A boat d) All of the above 13. Which of the following statements is false if the taxpayer rents a dwelling for 15 days or more and also uses it for a residence? a) Some expenses are deductible in full; some are deductible only to the extent of the income reported. b) Expenses that cannot be deducted in the current year cannot be carried over. c) Rental expenses not directly related to the dwelling unit, such as advertising, commissions, etc. are deductible in full. d) The rental portion of interest and taxes is deductible on Schedule E; the personal portion is deductible on Schedule A if the taxpayer itemizes. 14. Taxpayers will generally be able to deduct the full amount of their rental loss if they. a) Rented their home for the complete year. b) They have passive activities. c) They actively participates and their loss is less than $25,000 d) Purchase the home in the current year. 15. A taxpayer actively participates in a rental real estate activity if they meet one of the following requirements: a) They owned at least 10% of the rental property. b) They spend at least 15% of their income making repairs to the property. c) They do not make the significant management decisions. d) They hire a company to mage the rental properties. 27

36 16. If a taxpayer actively participates in a rental activity, they will generally be able to deduct the full amount of rental loss if it meets one of the following requirements: a) The rental loss includes $15,000 of depreciation. b) The rental loss is less than $25,000 and subject to income limits. c) The rental loss is 100% carried forward. d) The rental loss is $12,500 if taxpayers are married filing a joint return. 17. Taxpayers that are not reporting rental income for a nonprofit organization will normally report their rental income and expenses by: a) Completing part 1 and 2 of Schedule C. b) Completing Part 1 of Schedule E and attaching it to Form c) Completing Part 2 of Schedule E and sending it alone to the IRS. d) Completing line 21 of Form In the event that taxpayer has more than three rental properties, they will report their rental income and expenses by: a) Completing 3 separate Schedules E; one for each property with separate totals for each one. b) Completing as many Schedules E required but combining the totals in one Schedule E. c) Completing only one Schedule E with the totals for all the properties. d) None of the above. 28

37 Questions Section 2 Answers and Discussion 10. Answer c. If taxpayer does not rent their property to make a profit, they can deduct their expenses only up to the amount of their rental income. Any rental expenses that are greater than the rental income cannot be carried forward. In this case, do not complete and file Schedule E. 11. Answer d. If the taxpayer rents only part of their property and uses part for personal use, they must divide up certain expenses incurred. Expenses directly related to the rental portion of the property are deductible in full. 12. Answer d. A dwelling unit includes a house, apartment, mobile home, boat, apartment or other similar property. 13. Answer b. If the dwelling is used as a residence and also rented for 15 days or more, then some expenses are deductible in full; some expenses are deductible only to the extent of the income reported. Any expenses that cannot be deducted in the current year because of the rental income limit can be carried over to the following year. 14. Answer c. A taxpayer materially participates in an activity if they were involved in its operations on a regular, continuous and substantial basis during the year. If the taxpayer actively participated in the rental activity and their rental losses are less than $25,000, generally they are allowed to deduct the full amount of the loss. 15. Answer a. A taxpayer actively participates in a rental real estate activity if they owned at least 10% of the rental property and made significant management decisions. 16. Answer b. A taxpayer materially participates in an activity if they were involved in its operations on a regular, continuous and substantial basis during the year. If the taxpayer actively participated in the rental activity and their rental losses are less than $25,000, generally they are allowed to deduct the full amount of the loss. 17. Answer b. Unless the taxpayer is reporting rental income for a not-for-profit activity or provides significant services primarily for the tenant s convenience, they will file and complete Part 1, Schedule E, Form 1040, listing total income, expenses and depreciation for each property. 18. Answer b. If the taxpayer has more than three rental properties, complete and attach additional Schedules E as needed. Complete lines 1 and 2 for each property. Fill in the Totals column on only one Schedule E. The figure in the Totals column on that one Schedule E should be the combined total of all Schedules E. 29

38 Income tax aspects of a trust. The complexity of trust taxation arises because of several factors: The trust is a taxable entity. Beneficiaries usually have to pay tax on the income that they receive from the trust. Trusts are not subject to double taxation, so any taxable income distributed to the beneficiaries is deductible by the trust. Money distributed to beneficiaries retains its character, so that, for example, if the trust distributes long-term capital gains to the beneficiaries, then it will be listed as long-term capital gains on their tax returns. Most income earned by the trust is taxable, but the principal is not. Therefore, if the trust distributes both principal and income, then the trust must allocate the principal and income to each beneficiary. Generally, the tax rules that apply to trusts are the same as those that apply to individuals, but the actual calculation is more complex: 1. calculate trust accounting income; 2. calculate the tentative taxable income before subtracting the distribution deduction, which is the amount that the trust can deduct because of the distribution; 3. calculate the distributable net income (DNI) so that the distribution deduction can be calculated and so that tax-free and taxable distributions can be allocated to the beneficiaries; 4. subtract the distribution deduction from the tentative taxable income to determine trust taxable income; 5. calculate trust tax liability; 6. allocate DNI and the distribution deduction to the beneficiaries to determine the character and the amount of income taxed to each beneficiary. When a trust earns income or pays expenses, the income or expenses are allocated either to principal or to income. In most cases, the trust document specifies which income or expenses are allocated to the principal or to income. If the trust document does not specify the allocation, then state law applies. Most states have adopted all or part of the Uniform Principal and Income Act (UPIA). Example of Allocating Income or Expenses to Principal or Income If a trust has a single beneficiary and: Trust principal = $100,000 income = $10,000 trustee fees = $2000 the trust document stipulates that there be a 50% allocation of expenses between principal and income. Then: income beneficiary receives $10,000 ($ %) = $10,000 $1000 = $9000 trust principal declines to $100,000 $1000 = $99,000. A trust is considered by tax law to be a modified conduit, because usually only some of the income and deductions pass through to the beneficiaries. The trust itself often retains some income, especially capital gains, which is usually allocated to the trust corpus. However, 30

39 distributions from the trust usually have both taxable and tax-free portions. The tax-free portion of the distribution may result from tax-exempt income, such as the tax-exempt interest earned from municipal bonds, or from retained earnings of the trust on which it has already paid taxes in previous years or from trust principal which is generally not taxable because of the recovery of capital doctrine. In other words, the money or property invested in the trust is the contributed capital, so any distributions from contributed capital are simply distributions of the original investment, and, therefore, not taxable. Generally, taxes on taxable income must be paid either by the trust or by the beneficiaries, but not both. If the trust retains income beyond year-end, then the trust must pay taxes on it. However, if the income is distributed, then the beneficiaries pay taxes on it and the trust is permitted to deduct it. If the trust accounting income consists of both tax-free and taxable income, then the tax-free and taxable portions of the income that is distributed must be allocated to each beneficiary. The trust can deduct the taxable portion of the distributions but not the taxfree portion nor any expenses that must be allocated to the tax-free portion of income. To calculate this allocation, an intermediate result must first be calculated, called the distributable net income. The estate has 2 types of tax requirements. 1. Estate income tax return which is Form This tax is imposed on the income which is earned by the Estate. 2. Estate tax (Form 706). This is the tax which is imposed when the actual estate is transferred to the beneficiary. Estate tax is also called as transfer tax. Distributions from Estates and Trusts. The trust or estate will issue Schedules K-1, Beneficiary's Share of Income, Deductions, Credits, etc. of Form 1041, U.S. Income Tax Return for Estates and Trusts to each beneficiary, listing the beneficiary's share of income and deductions. Only taxable income is listed; tax-exempt income is omitted. Tax Rate for Trust and Estates. Trusts and estates are subject to most of the same tax rules that apply to individuals. They even have the same percentage tax brackets, but the boundaries of the tax brackets occur at much lower income levels. Tax Brackets for 2016:Estate Income Tax and Trust Rates Marginal Rate Estates & Trusts 15% $2,550 25% $2,551 $5,950 28% $5,951 $9,050 33% $9,051 $12, % Over $12,400 Additional Taxes for Trust. Trusts are subject to the Net Investment Income Tax (NIIT) of 3.8% on undistributed investment income that exceeds the threshold for the top marginal rate for trusts. By contrast, the NIIT only applies to individuals who earn a minimum of $400,000 ($450,000 for a couple filing jointly). Hence, the total tax on undistributed capital 31

40 gains in the top bracket will be 23.8%. However, the following types of trusts are not subject to the NIIT: trusts that are exempt from income taxes, such as charitable trusts and qualified retirement plan trusts; a trust for which all unexpired interests are devoted to charitable, religious, scientific, literary, or educational purposes, or some other purpose delineated in IRC 170(c)(2)(B); grantor trusts, since the taxes on such income is included on the grantor's tax return; trusts that are not classified as such for federal income tax purposes, such as real estate investment trusts (REITs) and common trust funds. Final income tax for the decedent. The first step is to file the decedent s taxes for the year of his or her death. This final 1040 covers the period from Jan. 1 though through the date of death. The return is due on the standard date, meaning, for example, April 18, 2016, for someone who died in If the decedent was unmarried, the final 1040 is prepared in the usual fashion. When there s a surviving spouse, the final 1040 can be a joint return filed as if the decedent were still alive as of year s end. The final joint return includes the decedent s income and deductions up to the time of death plus the surviving spouse s income and deductions for the entire year. Income for the estate Form In addition to filing the decedent s final income taxes, the responsible party may have to file the estate s income tax return as well. Essentially, what happens here is that once the individual has died, any income generated by his or her holdings after death is now part of the estate. And that income does not escape the reach of taxable income. The estate income tax return, Form 1041, will be filed if the estate has annual gross income of $600 or more for the year. Individuals can file the estate s first income tax return at any time up to 12 months after the date of death. The estate s first income-tax year begins immediately after death. The tax year-end can be Dec. 31 or the end of any other month that results in an initial tax period of 12 months or less. If the return is for a fiscal year or a short tax year (less than 12 months), fill in the tax year space at the top of the form. Taxpayers must file Form 1041 (U.S. Income Tax Return for Estates and Trusts) by the 15th day of the fourth month after the tax year-end (adjusted for weekends and holidays). So for a person who died in 2015, the deadline is April 18, 2016, when the standard Dec. 31 tax year-end is chosen. Before filing Form 1041, taxpayers will need to obtain a tax ID number for the estate. Avoiding estate income tax return. The key to avoiding an estate return is preplanning. If taxpayers can keep the estate income under $600, they will not have to file an estate return. Before a person dies, it s important to make sure everything is in order. For example, if a rental house is intended to go to the surviving spouse, it should be held in joint tenancy. That way, when one spouse dies, the property immediately goes to the other spouse. Any rental income then becomes income to the surviving spouse not the estate. 32

41 After the date of death, the more quickly the distribution is given to heirs, the less income the estate is likely to earn. Due dates for the estate income tax return. The estate tax year is not likely to be the same as a calendar year. The estate tax year begins on the date of death and ends on the last day of a month. Taxpayer can file the estate s first income tax return at any time up to 12 months after the date of death. Estate Income Tax Return Due Dates. Month of Death Latest Year End Due Date for Estate Income Tax The Next: Return January December 31 April 15 February January 31 May 15 March February 28 (29) June 15 April March 31 July 15 May April 30 August 15 June May 31 September 15 July June 30 October 15 August July 31 November 15 September August 31 December 15 October September 30 January 15 November October 31 February 15 December November 30 March 15 If more time is needed to file the estate return, apply for an automatic 5 month extension of time to file using IRS Form 7004, Application for Automatic Extension of Time to File Certain Business Income Tax, Information, and Other Returns. Estate tax return Form 706 requirement. The federal estate tax return is filed on Form 706 (United States Estate Tax Return). Assuming the decedent did not make any sizable gifts before dying, no estate tax is due, and no Form 706 is required, unless the estate is worth over $5.43 million for a person who died in 2015 or $5.45 million for someone who dies in 2016 (effectively $10.9 million per married couple). Sizable gifts are those in excess of $14,000 to a single gift recipient in a single year for gifts in If sizable gifts were made, the excess over the $14,000 threshold is added back to the estate to see if the estate tax exemption ($5.45 million for 2016) is surpassed. If it is, there will be a 40% federal estate tax on the excess. Form 706 is due nine months after death, but the deadline can be extended up to six months. Individuals may request an extension of time for payment by filing Form 4768, Application for Extension of Time to File a Return and/or Pay U.S. Estate (and Generation-Skipping Transfer) Taxes. Income for the estate income tax return. Similar to the concept of gross income on a personal income tax return, calculating estate tax starts with the gross estate. The gross estate includes the 33

42 fair market value of all property that the taxpayer owned or had an interest in at the time of death including the life insurance and annuity proceeds. In certain instances, the gross estate can include the value of the property owned in the three years right before the family member s death. Deductions for the estate tax. Once taxpayers have accounted the Gross Estate, certain deductions (and in special circumstances, reductions to value) are allowed in arriving to the "Taxable Estate." These deductions include funeral expenses, payments to satisfy outstanding debt, the value of the property intended for donation after death, any state death taxes and the value of property that transfers to a surviving spouse. Do not deduct the deceased person s medical or funeral expenses on Form Funeral expenses paid by the estate are not deductible in figuring the estate's taxable income on Form They are deductible only for determining the taxable estate for federal estate tax purposes on Form 706. Income distributions are reported to beneficiaries and the IRS on Schedules K-1 (Form 1041). Form 1041 and Form 706. As mentioned before, there are two kinds of taxes owed by an estate. One on the transfer of assets from the decedent to their beneficiaries and heirs known as estate tax or transfer tax (Form 706), and another on income generated by assets of the decedent s estate known as income tax (Form 1041). Items included and not included. While life-insurance proceeds are generally free of any income tax, they are usually included in the decedent s estate for estate-tax purposes even though the money may go directly to policy beneficiaries. In fact, life-insurance proceeds are the most common cause of unexpected estate-tax bills. An exception to this rule though is if the beneficiary is the surviving spouse: Assets inherited by a surviving spouse (including lifeinsurance payouts) are not included in the decedent s estate, as long as the surviving spouse is a U.S. citizen. This is the so-called unlimited marital-deduction privilege, and it is the most common reason why many large estates do not owe any federal estate tax. Estate tax rates for Form 706. For 2016, the estate tax rates remain unchanged. The formula for computing estate taxes is rather complicated -- there are 12 different estate tax "brackets", ranging from 18% to 40%. The executor of an estate must file a federal estate tax return of a person s death if that person s gross estate exceeds the exempt amount. The taxable estate will be the gross estate less the allowable deductions mentioned before. After getting the taxable estate, taxpayers will get a credit that will exempt a large portion of the estate. The credit for 2016 is $5.45 million for singles. Any value of the estate over $5.45 million is generally taxed at the top rate of 40 percent. Although tax rates are graduated, all transfers in excess of the exemption are taxed at the top rate because the exemption exceeds the threshold at which the top rate applies. Regardless of size, inheritances are not taxable income to the recipient. 34

43 Estate Tax Rate for *before credits A. For Taxable Estates Between B. And... C. The tax is. D. Tax rate on excess in Column A* $0 $10,000 $0 18% $10,000 $20,000 $1,800 20% $20,000 $40,000 $3,800 22% $40,000 $60,000 $8,200 24% $60,000 $80,000 $13,000 26% $80,000 $100,000 $18,200 28% $100,000 $150,000 $23,800 30% $150,000 $250,000 $38,800 32% $250,000 $500,000 $70,800 34% $500,000 $750,000 $155,800 37% $750,000 $1,000,000 $248,300 39% $1,000, $345,800 40% Gift tax and generation-skipping transfer. The gift tax applies to transfers made while a person is living. The generation-skipping transfer tax is an additional tax on a transfer of property that skips a generation. Gift tax Form 709. The tax provides a lifetime exemption of $5.45 million per donor in This exemption is the same that applies to the estate tax and is integrated with it (i.e., gifts reduce the exemption amount available for estate tax purposes). Beyond that exemption, donors pay gift tax at the same top rate (40 percent) that applies for estate tax purposes. An additional amount each year is also exempted from both the gift tax and the lifetime exemption. This exemption, $14,000 in 2016, is indexed for inflation in $1,000 increments and is granted separately for each recipient. Thus, a married couple with three children could give their children a total of $84,000 each year ($14,000 from each parent to each child $14,000*3=$42,000*2=84,000) without owing tax or counting toward the lifetime exemption. Regardless of size, gifts received are not taxable income to the recipient. Any person who gave away more than $14,000 to any one person will have to file a Form 709, the gift tax return. This does not necessarily mean they have to pay taxes; this will depend on whether taxpayer reaches the lifetime exclusion of $5.45 million for The amount is counted per person; this means that taxpayers can give $14,000 to as many people as they want always considering the lifetime exclusion. Taxpayers can give someone $14,000 per year without affecting their lifetime exemption (because gifts below the annual threshold are not considered taxable). If taxpayers exceed the $14,000 annual gift tax threshold, they must file Form 709 and report the amount that counts against their lifetime exemption. Taxpayers should also hold onto any relevant paperwork so their heirs can properly compute the estate tax later. Payments made on someone's behalf directly to qualified tuition or medical expenses do not count towards the annual limit or lifetime exclusion. 35

44 Generation-skipping trust tax Form 709. This tax is often referred to as the "Grandparents Tax". Congress enacted the Generation-skipping trust tax (GST) in 1976 to prevent families from avoiding the estate tax for one or more generations by making gifts or bequests directly to grandchildren or great-grandchildren. The GST tax effectively imposes a second layer of tax (using the exemption and the top tax rate under the estate tax) on wealth transfers to recipients who are two or more generations younger than the donor, normally 37.5 years younger or more. Everyone has a lifetime exemption from the generation-skipping tax. For 2016, that amount is $5.45 million, and it gets adjusted for inflation each year. People with estates smaller than the exempt amount generally don't have to worry about GSTT at all, as they can allocate the exemption amount to their assets with room to spare. Taxpayers can make gifts annually to grandchildren and others subject to GSTT without triggering tax liability. For 2016, the maximum annual gift is $14,000. The gift amount is also annually adjusted for inflation. Taxpayers, estates, and trustees who make any gifts that skip a generation in excess of the annual exclusion allowance must report this gift as a GST taxable transaction on Part 2 of Schedule A of the United States Gift Tax Return (Form 709). Below are the rate and exemption levels for gift and estate taxes in 2016: Unified State Tax Credit. The $5.45 million exemption applies to gift, estate taxes and generation-skipping trust tax combined whatever exemption used for making a gift will reduce the amount that taxpayers can use for the estate tax. (This is what the IRS refers to as a "unified state tax credit.") The credit is one single $5.45 million exclusion for estate, gifts and generationskipping trust tax. Taxpayers can use it to shelter their estate from taxation when they die, or they can use it to defray the tax burden of giving more than the annual gift tax exclusion amount to any individual per year. Example. If taxpayer gives someone $20,000 in one calendar year, the taxpayer can either pay the gift tax on the additional $6,000 over the annual exclusion, or he/she can let the lifetime exemption of $5.45 million cover it. If taxpayer decides not to pay the gift tax on that extra $6,000 given, he/she must file a gift tax return anyway, Form 709, and indicate on the return that she/he wants to use the lifetime exemption provided by the Unified Tax Credit. This is a comparatively modest reduction in the credit -- $6,000 would hardly be missed from a $5.45 million exemption. If taxpayers have nowhere near $5 million-plus in assets, this may be a good deal. But if they expect to have considerable wealth by the time they die, enough that the $5.45 million Unified Tax Credit might not shelter the entire estate from estate taxes, using it to cover gifts in excess of the annual inclusion might put your estate at risk. The top federal estate tax rate is also 40 percent as mentioned before. That said, surviving spouses may claim any unused exemption from the deceased spouse. 36

45 2. Estate and gift tax exemptions and exclusions are adjusted annually for inflation over a certain threshold. Estate tax Gift tax Top rate Exemption Top rate Exemption 40% $5,450,000 per person 2 40% $5,450,000 per person 2 Example 1: Taxpayer is unmarried and gives away $3 million (over the $14,000 per person annual exclusion) during his/her lifetime. After the taxpayer dies, $2.45 million of his/her estate is still exempted from the estate tax. Example 2: Taxpayer and Taxpayer s spouse give away $4 million and $1 million respectively (over the $14,000 per person annual exclusion) during their lifetimes. If one of them passes away, the surviving spouse will have a $5.9 million estate tax exemption ($1.45 million of unused exemption from the other spouse plus $4.45 million of an unused exemption). Gift Tax Exclusions. There are a number of ways to reduce the amount of Gift Taxes: Gifts to the spouse: Taxpayers do not have to pay taxes on any amount given to the spouse as a gift, unless they are not a U.S. citizen. Education and Medical Expenses: Taxpayers will not owe tax on any amount paid for someone else's tuition or medical bills. The payment must be made directly to the educational or medical institution and not to the person receiving the education or medical care. Charitable Donations: Charitable contributions made to qualifying charities are not only deductible on itemized tax returns taxpayers may also deduct the value of the charitable donations from the amount of Gift Taxes owed. Political Contributions: Political donations are considered gifts, not deductible charitable contributions, and taxpayers may exclude any amount given to political organizations. The organization must use the money for its own purposes and may not be acting as an intermediary to dispense the funds to a third party. Business Gifts to Employees: Taxpayers can deduct up to $25 worth of business gifts offered to an individual during the year. The following items do not count towards the $25 limit: o Identical, widely distributed items of $4 or less that have taxpayers name clearly and permanently imprinted o Signs, racks, and promotional materials displayed on the recipient's business premises Probate and Taxes in California. If taxpayers do not have a trust, their legal and financial affairs will be settled through probate after their death. In California probate proceedings are conducted in the Superior Court for the county in which the decedent lived, and can take at least eight months and sometimes as long as several years. 37

46 Taxpayers that did not have a will or testament. If there is no will or testament, the assets will be transferred according to the state intestate succession laws. In California, residents who died without a will or trust will die "intestate" and the laws of intestate succession are used to determine who will inherit the estate. Determining the heirs involves answering a series of questions about the person who died. The following discussion applies only to California residents and the intestate succession law of other states may be different. The first question is whether the decedent was married. If the decedent was not married, the estate is distributed as follows: 1. To the decedent's children, who take in equal shares if they are in the same generation. 2. If there are no children or other issue (issue is the legal term for children, grandchildren, great-grandchildren, etc.) living, the estate goes to the decedent's parents. 3. If there are no parents living, the estate is distributed to the "issue of the parents." If the decedent had brothers or sisters, they will inherit the estate. If there are deceased brothers and sisters, and they had issue, the issue will inherit the share of the estate that the deceased brother or sister would have inherited. 4. If there are no brothers or sisters, the decedent's grandparents will inherit the estate. 5. If there are no living grandparents, then the "issue of the grandparents" will inherit the estate. This could include the decedent's aunts and uncles, or if there aren't any aunts and uncles, the decedent's cousins. Generally, the oldest generation that has surviving issue will inherit, but if there are deceased issue in that generation, their issue will inherit their share. Estate or intestate. The major difference between dying testate and dying intestate is that an intestate estate is distributed according to state law ("intestate succession"). A testate estate is distributed according to the instructions left by the decedent in his or her will. Probate required for estate or intestate. Most people think of probate as involving a will. If a person dies and leaves a will, then probate is required to implement the provisions of that will. However, a probate process also can happen if a person dies without a will and has property that needs to be distributed under the state intestacy law. If the decedent owned an account that named a beneficiary (such as a retirement account) but the beneficiary has passed away before the owner of the account, probate law requires that account to go through the court so that the funds can be passed to the person legally entitled to them under state law. The filing of the will in court, referred to as admitting the will into probate, is a necessary step in almost every case. Although exceptions can be made for small estates, even the claimants of those estates may choose to open a probate case in order to give notice, make claims, or address any debts or possible credit claims that might still exist. Probate court takes action to settle the estate and give the will legal effect. While the deceased often names a specific person or persons, referred to as a trustee or executor, to be in charge of these affairs, probate courts officially verify that the steps taken are legal and orderly. 38

47 The probate process. The probate process starts when the person who is nominated in the will or testament as executor files a petition with the Superior Court asking that he or she be appointed as executor. If there is no will, the Probate Code provides a list of persons who have priority to petition to become administrator. The will also is filed with the petition, and notices are sent to the heirs and/or relatives to let them know when the hearing will be held. If there are objections to the petition, or if the validity of the will is contested, the hearing will be used to resolve any problems that have arisen. In some cases this may mean that the validity of the will is not upheld, or that some other person than the original petitioner is chosen to administer the estate. The executor then makes an inventory of the estate's assets, locates creditors, pays bills, files tax returns, and manages the estate assets. When all of the duties of the executor are completed, another petition is filed with the court asking that the estate be distributed to the heirs. If this petition is granted, the estate administrated is completed by distributing the assets to the heirs and filing final tax returns. It is important to note that not all property in an estate will necessarily go through probate court. What is required to be probated and what is not depends on what state taxpayers are in because each state has its own probate regulations. For example, in some states, probate requirements are based on the overall value of the estate. The probate cost. California Probate Code section sets the maximum statutory fees that attorneys can charge for a probate. Higher fees can be ordered by a court for more complicated cases. The fees are four percent of the first $100,000 of the estate, three percent of the next $100,000, two percent of the next $800,000, one percent of the next $9,000,000, and one-half percent of the next $15,000,000. For estates larger than $25,000,000, the court will determine the fee for the amount that is greater than $25,000,000. The fees listed below are the California statutory fees used to compensate attorneys and executors in probate cases for various sizes of estates. If both the attorney and the executor receive a fee, the amount paid will be double. The value of the estate is determined, in general, by the inventory for the estate. (If an accounting of the estate has been waived, the total value of the estate for attorney's fees purposes is the inventory, plus gains on sales, minus losses on sales.) Debts are not included in determining attorney's fees, and if a house is appraised at $1,000,000, for example, and it has a mortgage of $800,000, it is still considered a $1,000,000 asset for the purpose of calculating attorney's fees. 39

48 Probate Attorney Fees. Estate Value Statutory Fee Estate Value Statutory Fee $100,000 $4,000 $2 million $33,000 $200,000 $7,000 $3 million $43,000 $300,000 $9,000 $4 million $53,000 $400,000 $11,000 $5 million $63,000 $500,000 $13,000 $6 million $73,000 $600,000 $15,000 $7 million $83,000 $700,000 $17,000 $8 million $93,000 $800,000 $19,000 $9 million $103,000 $900,000 $21,000 $10 million $113,000 $1 million $23,000 $15 million $138,000 $1.5 million $28,000 $20 million $163,000 Estates are appraised by probate referees, who are appointed by the State Controller to determine the fair market value of the asset. Probate referees receive a fee based on.1 percent of the assets that have been appraised. Probate not required for small estate in California. There are many ways to avoid probate in California, and using the small estates law is one of them. Estates of decedents that do not exceed $150,000 do not need to be probated in California. An affidavit or declaration signed under penalty of perjury at least 40 days after the death can be used to collect the assets for the beneficiaries or heirs of the estate. No documents are required to be filed with the Superior Court if the small estates law (California Probate Code Sections to 13116) is used. Figuring out if the estate is worth $150,000 or less. To calculate the value of the estate: Include: All real and personal property. All life insurance or retirement benefits that will be paid to the estate (but not any insurance or retirement benefits designated to be paid to some other person). Do not include: Cars, boats or mobile homes. Real property outside of California. Property held in trust, including a living trust. Real or personal property that the person who died owned with someone else (joint tenancy). Property (community, quasi-community, or separate) that passed directly to the surviving spouse or domestic partner. Life insurance, death benefits or other assets not subject to probate that pass directly to the beneficiaries. Unpaid salary or other compensation up to $5,000 owed to the person who died. 40

49 The debts or mortgages of the person who died. (Taxpayers not allowed to subtract the debts of the person who died.) Bank accounts that are owned by multiple persons, including the person who died. In order to use a small estate affidavit for an estate that also includes real property, California law requires an inventory and appraisal of the real property to be attached to the affidavit. Taxpayers can obtain the required inventory and appraisal by using the services of a probate referee appointed by the California State Controller's Office. The affidavit with the attached inventory and appraisal is then used to acquire the personal property. Taxpayers must file a small estate affidavit. The contents of the affidavit must conform to the requirements set forth in California Probate Code Section Oftentimes, a blank small estate affidavit form can be obtained from a law library, courthouse or online legal document provider. Additionally, financial institutions may require taxpayers to use their small estate affidavit form to gain access to accounts at their institution. After completing the small estate affidavit, provide it to the holder of the property, such as a bank, along with a certified copy of the death certificate and any other requested documents in exchange for the property. It can be very complicated to figure out if an individual has the legal right to inherit the property. If there is no valid will, the law will indicate how to determine if someone is a legal heir by looking at the type of property, the relationship between all the persons claiming to be heirs, and other issues. Ways to avoid Probate. There are three basic ways to title a joint account and avoid probate; each of them has distinct implications for estate planning, depending on taxpayers situation: Joint tenancy with rights of survivorship: When one owner dies, property ownership transfers to the surviving owner(s) through the right of survivorship. Probate may be avoided by jointly owning an account or property with another person often, but not necessarily, a spouse. Tenancy by entirety: This is similar to joint tenancy with rights of survivorship, except that it applies only to married couples, which would include married same-sex couples in some states. Community property. Taxpayers that live in a community property state may be able to avoid probate by taking title to property as community property with the right of survivorship. If this option is available to the taxpayers, it is likely to be a better choice than joint tenancy. (Tenancy by the entirety, another probate-avoiding way for couples to hold title, is not available in community property states.) To turn property into right-ofsurvivorship community property, taxpayers simply need to put the right words on the title document. In California they will put "community property with right of survivorship." If an asset is owned by two or more people as joint tenants, it will usually not be probated. These assets can be identified by the words "joint tenants," or "in joint tenancy," "JT TEN," or similar wording. When a joint tenant dies, the other joint tenant takes 100 percent ownership of the asset. This occurs regardless of the provisions of the will or trust of the deceased joint tenant. In 41

50 other words if a house is held in joint tenancy by persons A and B, and A dies, it does not matter what A's will said about the house because the joint tenancy has a higher priority and the house will be owned 100 percent by B. This automatic transfer to the survivors is called the "right of survivorship." Example of joint tenancy that can avoid probate. Evelyn and her daughter Miya own a car together, registered in their names as joint tenants with right of survivorship. When Evelyn dies, her half-interest in the car will go to her daughter without probate. To get the car registered in her name alone, Miya will need only to fill out a simple form and file it with the state motor vehicles agency. However, on the death of the surviving spouse, there will be a probate unless the surviving spouse creates a new joint tenancy or places his or her assets in a living trust. Tax implications of community property with rights of survivorship vs Joint Tenancy. There is no practical difference in the taxation of income from joint tenancy or community property during the joint lifetimes of the spouses. The difference may be dramatic, however, after the death of the first spouse. As a general rule, assets acquired from a decedent as a result of death receive a new stepped-up (or stepped-down) tax basis equal to the property's fair market value at date of death. As a consequence, if property acquired from a decedent is sold shortly after death, no gain or loss should generally be recognized. In the case of substantially appreciated property, the benefit of this basis step-up is dramatic: all gain and the income tax attributable to that is avoided. In the case of joint tenancy property, only the deceased spouse's one-half interest in the property is considered acquired from a decedent and entitled to the fair market value basis adjustment, it is not stepped up (26 U.S.C ) Thus, if the surviving spouse were to sell an appreciated property shortly after death, he or she would have to pay tax on the gain attributable to his or her one-half interest. Joint tenancy example. Husband and Wife purchased their house for $100,000 with each spouse's tax basis at $50,000. At the date of Husband's death the property's fair market value was $200,000. Since they held the property in joint tenancy, Wife automatically received Husband's 1/2 interest upon his death. Husband's 1/2 interest tax basis (originally $50,000) is "stepped up" to the fair market value at his death (i.e.,$100,000). Wife then has property worth $200,000 with a tax basis of $150,000 (her original $50,000 basis plus her deceased husband's stepped up basis of $100,000). If the property were sold for $200,000, there would be $50,000 of taxable gain. In the case of community property, however, both half interests in the property are considered acquired from a decedent and entitled to the fair market value basis adjustment. As a result, in the exact same sale scenario, the surviving spouse would pay no tax. The tax savings of the community property form can be considerable. 42

51 Community property example. Assume the same $100,000 purchase and $200,000 value at date of death and further assume Husband willed his interest to Wife. Wife's original $50,000 basis gets stepped-up along with Husband's original $50,000 basis to the current $200,000 fair market value. Wife then has property worth $200,000 with a basis of $200,000. If the property were sold for $200,000, there would be no taxable gain. Conversely, if the property has lost value, joint tenancy yields the better tax result because the property will receive a one-half step-down in basis on death, as opposed to a full step-down in basis with community property. On the personal residence taxpayers may qualify for the $500,000 capital gain exclusion for married couples. But in order to get the $500,000 home exclusion the surviving spouse has to sell the property in the year of the death, otherwise the exclusion is $250,000, the same as for single people. This is true if the surviving does not remarry on the same year. 43

52 Review Questions Section 3 Read and answer the following review questions. The correct answers are found on the next page with an explanation to strengthen up your knowledge. Note: This is not part of your Final Test. 19. Taxpayers can create a trust to hold real property that is used for rental purposes. Which of the following tax statements is true regarding trusts? a) Trusts are separate taxable entities. b) Trusts are not subject to double taxation, so any taxable income distributed to the beneficiaries is deductible by the trust. c) Money distributed will retain its long-term and short-term character accordingly. d) All of the above are true. 20. If the estate is worth over $5.45 million in 2016, they will be required to report this to the IRS by: a) Filing Form 1041 before the due date. b) They will report the transfer using form c) They will report the transfer using Form 706. d) They are required to call the IRS. 21. Distributions of income, deductions and credits from estates and trust will be made to beneficiaries using the one of the following methods: a) The distribution is made using Form 1099-Misc and a separate list of expenses. b) The estate or trust will issue Schedule K-1 which will contain the income and deductions for the year. c) The estate or trusts do not distribute income or deductions because they file their own income tax return. d) The estate and trust issues Form 1099-INT that will show only the tax-exempt income. 22. For income tax purposes Trust and estate are treated as follows: a) They are subject to most of the same tax rules that apply to individuals. b) They are subject to more complex tax rules that do not apply to individuals. c) They pay a flat rate income tax. d) They always pay a 33% income tax rate. 23. For income tax purposes the gross income for the estate income tax return (Form 1041) will generally include one of the following: a) The fair market value of all the property owned by taxpayer. b) The fair market value of property in which the taxpayer had an interest. c) The value of the life insurance and annuity proceeds that taxpayer had. d) All of the above. 44

53 24. The estate tax return of an estate (Form 706) will contain also deductions that will be applied against any estate income, which of the following deductions can be taken on the estate s tax return? a) Funeral expenses. b) The value of property transferred to the surviving spouse. c) Payments for decedent s outstanding debts. d) All of the above. 25. The gift lifetime exemption for 2016 is $5.45 million; this exempt amount will apply to taxpayers in one of the following ways: a) The complete amount applies to both taxpayers in case they are married. b) The exempt amount applies to each taxpayer even if they are married. c) The exempt amount applies to the complete household, meaning that the amount is divided into all the member of the taxpayer s household. d) None of the above. 26. Rose is a single taxpayer that sent a $15,000 cash gift to each of her 3 sons in 2016; at the end of the year she came to see what will be the tax requirement for the three gifts that she made and that totaled $45,000. In this case Rose will be required to do one of the following: a) She will be required to pay gift tax right away using Form b) She will be required to file Form 1041 and pay the corresponding gift tax. c) She can file Form 709 and count the excess amount against her lifetime exemption amount. d) She is not required because the amount given does not exceed the annual limit amount. 27. Taxpayers that want to use the lifetime exemption amount on any given year that they exceed the gift limit amount will be required to do one of the following: a) They need to make a note on Form b) They file a letter along with Form c) They make the proper selection using Form 709. d) They make the proper selection using Form 706 and attach it to Form

54 Questions Section 3 Answers and Discussion 19. Answer is d. The complexity of trust taxation arises because of several factors: The trust is a taxable entity; beneficiaries usually have to pay tax on the income that they receive from the trust; trusts are not subject to double taxation, so any taxable income distributed to the beneficiaries is deductible by the trust; money distributed to beneficiaries retains its character, so that, for example, if the trust distributes long-term capital gains to the beneficiaries, then it will be listed as long-term capital gains on their tax returns. 20. Answer c. Estate tax (Form 706). This is the tax which is imposed when the actual estate is transferred to the beneficiary. Estate tax is also called as transfer tax. 21. Answer b. The trust or estate will issue Schedules K-1, Beneficiary's Share of Income, Deductions, Credits, etc. of Form 1041, U.S. Income Tax Return for Estates and Trusts to each beneficiary, listing the beneficiary's share of income and deductions. Only taxable income is listed; tax-exempt income is omitted. 22. Answer a. Trusts and estates are subject to most of the same tax rules that apply to individuals. They even have the same percentage tax brackets, but the boundaries of the tax brackets occur at much lower income levels. 23. Answer d. Similar to the concept of gross income on a personal income tax return, calculating estate tax starts with the gross estate. The gross estate includes the fair market value of all property that the taxpayer owned or had an interest in at the time of death including the life insurance and annuity proceeds. In certain instances, the gross estate can include the value of the property owned in the three years right before the family member s death. 24. Answer d. To arrive to the taxable estate some deductions can be taken. These deductions include funeral expenses, payments to satisfy outstanding debt, the value of the property intended for donation after death, any state death taxes and the value of property that transfers to a surviving spouse. These deductions only for determining the taxable estate for federal estate tax purposes on Form Answer b. The tax provides a lifetime exemption of $5.45 million per donor in This exemption is the same that applies to the estate tax and is integrated with it (i.e., gifts reduce the exemption amount available for estate tax purposes). Beyond that exemption, donors pay gift tax at the same top rate (40 percent) that applies for estate tax purposes. 26. Answer c. If taxpayer decides not to pay the gift tax on that extra $6,000 given, he/she must file a gift tax return anyway, Form 709, and indicate on the return that she/he wants to use the lifetime exemption provided by the Unified Tax Credit. 27. Answer c. If taxpayers exceed the $14,000 annual gift tax threshold, they must file Form 709 and report the amount that counts against their lifetime exemption. Taxpayers should also hold onto any relevant paperwork so their heirs can properly compute the estate tax later. 46

55 Tenancy in common does not avoid probate. Unlike joint tenancy with rights of survivorship, tenancy in common does not avoid probate. When a joint owner dies, that owner s interest in the property will become part of the deceased owner s estate and will be passed on according to his or her will. This arrangement does not carry rights of survivorship. If one of the taxpayers died and the survivor owned property together as tenants in common, certain laws and rules determine who will inherit the ownership interest. It will not automatically be given to the survivor. A tenancy in common is a form of property ownership between two or more people. The tenants do not have to have equal ownership interest -- one can own a 25-percent share in the property while the other holds 75-percent ownership. They are both entitled to use of the entire property regardless. Unlike with some other forms of property ownership, tenants in common are free to sell or transfer their shares to other people without the consent or permission of the other tenant or tenants. Each tenant reserves the right to include his share of the property in his estate plan, leaving it to anyone he likes when he dies. This type of ownership is common among unmarried individuals when one contributes more financially to the property than the others. His percentage ownership in the property is typically commensurate with his contributions, so he has the right to transfer that interest to someone else during his lifetime or after his death. Tax consequences under the tenancy in common. Each party can leave his or her shares to any beneficiary on death or sell their interest to any other party without the consent of the other owners (taxpayers can modify that by drafting an agreement that puts restrictions on the transfer). Each party can also encumber (borrow on) his or her interest in the property (the rule here varies by state). All parties should keep a record of the expenditures they pay, paying attention to the type of expenditure. That is, whether the funds were used for general upkeep (maintenance, property taxes, etc.) or to pay the mortgage or for capital improvements. Keep in mind that each owner is jointly and severally liable for the mortgage. That means should the other parties not pay, the taxpayer can be responsible for the entire amount. What happens if taxpayers have not chosen a form of ownership after purchasing property with another party? In many states, ownership as tenants in common is assumed. Probate is not avoided when the following occurs: Probate is not avoided when the last owner dies. The probate-avoidance part of joint tenancy works only at the death of the first co-owner. (Or, if there are three joint tenants, only at the death of the first two, and so on.) When the last co-owner dies, the property must go through probate before it goes to whomever inherits it, unless the last owner used a different probate-avoidance method, such as transferring the property to a living trust. Probate is not avoided if both owners die simultaneously. In that very unlikely event, each owner's share of the property would pass under the terms of his or her will. If a joint tenant died without a valid will, the property would go to each owner's closest relatives under state law. 47

56 One owner's incapacity may hobble the others. If one joint owner became incapacitated and could not make decisions, the other owners' freedom to act would be restricted. This problem can be avoided if each joint owner signs a document called a "Durable Power of Attorney," giving someone authority to manage their affairs if they cannot, or if the property is transferred to a living trust. S-corporation for rental property. S Corporations can be an option for taxpayers that are in the real estate business. Taxpayers that flip properties, run their professional practice, or do construction can benefit from an S-corporation. S-corporations provide great asset protection and may help minimize the self-employment tax that taxpayers would normally have with an LLC. An S-Corporation may also help avoiding the double taxation that C-Corporations have. However, if you own rental real estate, then you may want to consider forming a different entity. Issues when transferring appreciated property under an S-corporation. Taxpayers that own real property may have issues when taking their properties out of the s-corporation. In general, they will be subject to a sale transaction in which they have to recognize any gain. This may not be a problem if there is one or two shareholders, the problem may arise when more than two shareholders do not agree in recognizing gain on that specific property. Section 1363(d) of the revenue code requires an S-corporation to recognize gain on the distribution of appreciated property to its shareholders. No deferral of gain at the time of the distribution is available. The amount of gain is determined as if the S-corporation had sold the property to the distributee at its fair market value. The distributee shareholder receives basis in the property distributed equal to its fair market value under Section 301(d)(1). Section 311(b)(2) mandates that the fair market value of the property for determination of gain recognition by the corporation is not less than the amount of any corporate liability assumed by the distributee in connection with the distribution. If the requirements of Section 1231, property used in the trade or business and involuntary conversions are met, the S corporation`s gain on distributions of appreciated property will be taxed as long term capital gain to the shareholder. However, Section 1231 excludes from capital gain treatment any inventory or property held primarily for sale in the ordinary course of the corporation`s trade or business. In addition, Sections 1245 and 1250 require that any depreciation recapture inherent in the gain be reclassified as ordinary income. Further, if appreciated depreciable property is distributed to a shareholder owning 50 percent or more of the S corporation`s stock, Section 1239 requires that the portion of the corporate gain attributable to the distribution received by such shareholder be reclassified as ordinary income. Section 1363(e) provides that a distribution of appreciated property from an S corporation may be accomplished without gain if it is pursuant to a tax-free spin-off, split-up, or split-off (all divisive reorganizations). However, all requirements related to Section 355 (including the 80 percent control requirement, the five-year active business requirement, the device test, requisite business purpose, and continuity of interest) must be met in order for the transaction to be tax free. 48

57 Reporting partnerships, s-corporations and trust on Schedule E. Taxpayers that are members of a partnership or joint venture or shareholders in an S corporation, will be required to use Part II of Schedule E to report their share of the partnership or S corporation income (even if not received) or loss. Taxpayers will receive Schedule K-1 from the partnership or S-corporation. They do not have to attach Schedules K-1 to their return. Estate and Trust. An estate or trust can generate income that must be reported on form 1041, United States Income Tax Return for Estates and Trusts. However, if trust and estate beneficiaries are entitled to receive the income, the beneficiaries must pay the income tax rather than the trust or estate. At the end of the year, all income distributions made to beneficiaries must be reported on a Schedule K-1. The trust needs to file a return if it has a gross income of $600 or more during the trust tax year or there is a nonresident alien beneficiary or if there is any taxable income. An estate needs to file a return if it has a gross income of $600 or there is a nonresident alien beneficiary. The 1041 reports income retained by the trust or estate, as well as the income distributed to beneficiaries, but income taxes are only paid by the trust or estate if the distributions are required. Unless the trust document specifies otherwise, capital gains and losses stay with the trust since they are part of the corpus. Example. John is the trustee, and the terms of the trust require all dividend income from a stock portfolio to be distributed equally among the beneficiaries. John must report all dividend income on Form 1041, and he also reports the share of dividend income for each beneficiary on Schedule K-1s. John must furnish a copy of each K-1 to the appropriate beneficiary, and attach all copies to Form 1041 when he files the return with the Internal Revenue Service EXCHANGES IN RENTAL PROPERTIES. IRC Section 1031 exchange allows investors to sell property, to reinvest the proceeds in a new property, and to defer all capital gain taxes. Section 1031 applies to real property held for investment; under this section no gain or loss will be recognized on the exchange of property held for productive use in a trade or business or for investment. The property should be exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment. Section 1031 exchange allows an individual to sell an asset and carry their basis forward into a new property. Example of Section 1031 exchange: John has owned a duplex for several years, and over time, the property has gone up in value considerably. He purchased the property for $75,000, but today it is worth almost $200,000. If he were to sell, he would need to pay long-term capital gains tax on all the profit, as well as the recapture of depreciation. If his long-term capital gains tax rate was 15% and his profit was $125,000; that would be $18,750 for the capital gains tax and potentially another several thousand for the recapture of depreciation. If he uses 1031 Exchange, he instead can take the profit and uses it as a down payment on another property for example a $1,000,000 apartment complex. Because he did not have to pay that $18,750 to the 49

58 government, John was able to use it as part of his 20% down payment, allowing him to afford to buy another $93,750 worth of property (20% of $93,750 is $18,750). As the above example demonstrates, 1031 exchanges allow investors to defer capital gain taxes as well as facilitate significant portfolio growth and increased return on investment. In order to access the full potential of these benefits, it is crucial to have a comprehensive knowledge of the exchange process and the Section 1031 code. For instance, an accurate understanding of the key term like-kind often mistakenly thought to mean the same exact types of property can reveal possibilities that might have been dismissed or overlooked. Owners of investment and business property may qualify for a Section 1031 deferral. Individuals, C corporations, S corporations, partnerships (general or limited), limited liability companies, trusts and any other taxpaying entity may set up an exchange of business or investment properties for business or investment properties under Section Section Rules. IRS has some pretty strict rules that govern the 1031 Exchange. These rules must be followed strictly, or the investor may lose the entire benefit and be forced to pay the tax. These rules are: The Exchange Must Be For a Like-Kind Asset. In other words, taxpayers cannot sell a house and buy a brand store franchise. However, like-kind is a loosely defined term, so taxpayers could sell a house and buy an apartment, a piece of land, or a mobile home park. There Are Time Limits. After the sale of the property, the clock starts ticking on two important timelines: the identification window and the closing window. The IRS requires that taxpayers identify the property they plan to buy within 45 days (taxpayers can identify three possible properties), and they also must close on that property within 180 days. Taxpayers Cannot Touch the Cash. Once the property is sold, taxpayers cannot touch the profit from the sale. Instead, they must use an intermediary who will hold onto the cash while they wait to close on the new deal. If taxpayers take out some of the profit; they will pay taxes on that portion of the profit. The 3-Property Rule. This rule simply states that the replacement property identification can be made for up to three properties without regard to the fair market values of the properties. At one time in the history of 1031 exchanges, there was a requirement to prioritize identified properties. At those times, if a taxpayer wished to acquire a second identified property, they could not do so unless the first identified property fell through due to circumstances beyond the taxpayer s control. Presumably this harsh requirement played a role in the 1991 Treasury Regulations where the 3-Property Rule is found. By far and away, most taxpayers utilize this rule. 50

59 Two hundred percent rule. Taxpayers can identify more than 3 properties as long as the value does not exceed 200 percent of the property sold. In this case, taxpayers can identify any number of properties and actually close on any number of them if the sum of the market value of all of them does not exceed twice the market value of the relinquished property. Using a listing price would be a safe choice. 95-percent exception rule. If the value exceeds 200 percent, as indicated on the 200- percent rule, then 95 percent of what is identified must be purchased. Due to the extend amount of rules, many taxpayers find it difficult to get a good deal within the 1031 Exchange frame. For this reason, some investors simply pay the tax and avoid the But for those who are willing to take on the government s 1031 Exchange challenge, faster growth and larger profits can result. Treatment of cash and profits under Section 1031 Exchange. Taking control of cash or other proceeds before the exchange is complete may disqualify the entire transaction from like-kind exchange treatment and make all gain immediately taxable. If cash or other proceeds that are not like-kind property are received at the conclusion of the exchange, the transaction will still qualify as a like-kind exchange. Gain may be taxable, but only to the extent of the proceeds that are not like-kind property. One way to avoid premature receipt of cash or other proceeds is to use a qualified intermediary or other exchange facilitator to hold those proceeds until the exchange is complete. Taxpayers cannot act as their own facilitator. The facilitator cannot be the taxpayer s employee or former employee. Reporting Section 1031 Exchange. Taxpayers must report an exchange to the IRS on Form 8824, Like-Kind Exchanges and file it with their personal tax return for the year in which the exchange occurred. The following information is required in order to complete Form 8824: Descriptions of the properties exchanged Dates that properties were identified and transferred Any relationship between the parties to the exchange Value of the like-kind and other property received Gain or loss on sale of other (non-like-kind) property given up Cash received or paid; liabilities relieved or assumed Adjusted basis of like-kind property given up; realized gain Rental residence converted to primary residence. The government has acknowledged the possibility of this scenario by creating a special rule that applies specifically to it. When a property has been acquired through a 1031 Exchange and later converted to a primary residence, the owner faces a mandatory five-year hold period before having the ability to sell obtaining the Section 121 exclusion. IRC section 121 allows taxpayers to exclude up to $250,000 ($500,000 for certain taxpayers who file a joint return) of the gain from the sale (or exchange) of property owned and used as a principal residence for at least two of the five years before the sale. 51

60 Items excluded from Section Certain types of property are specifically excluded from Section 1031 treatment. Section 1031 does not apply to exchanges of: Inventory or stock in trade Stocks, bonds, or notes Other securities or debt Partnership interests Certificates of trust Selecting Section 121 exclusion or Section 1031 Exchange. Taxpayers can get the advantage of either one of the Revenue Sections under specific situations. If a taxpayer was married and later one became single, the exclusion under Section 121 may be affected if his/her house is worth more than 250,000. Section 1031 could be an option in this scenario if within the las five years the taxpayer used the property for rental. Example. Charlie and Mary bought a house that used as their primary residence during the first two years, year 1 and year 2. At the end of year 2, they move out and turn the house into a rental property. Now they rent it out for years 3, 4 and 5. At the end of year 5 they sell the house. Would this property be able to qualify for the personal residence exclusion? The answer would be yes, due to the fact Charlie and Mary lived there for 2 of the 5 years preceding the sale of the property. Now would this scenario also qualify for a 1031 exchange? The answer to this would be yes, because it was an investment property for the last year and 1 day before they sold it. Under the above example, the Revenue codes overlap. In the sale of a personal residence the IRS actually lets taxpayers pick the code section that gives them the biggest tax benefit. In the example above, Charlie and Mary should treat the transaction as the sale of a personal residence. In doing so will allow them to take up to $500,000 of their tax gain off the table totally tax free. If they treated the sale as a 1031 exchange, they would have to end up paying tax on the gain someday even though the tax gain can be deferred right now. Now in the case the gain from the sale of their house exceeded their personal residence exclusion. Charlie and Mary are allowed to "maximize their exclusion" and they can roll the rest of the tax gain over into a 1031 exchange. Assume the same taxpayers sell the house/property for a tax gain of $600,000. They would first apply their personal residence exclusion of $500,000 to the gain, which still leaves a gain of 100,000 dollars. As a result they may rollover the extra $100,000 into a 1031 exchange and avoid being taxed on any of this $100,000. Let's look at a different example showing a different scenario of these two IRS tax code sections. Say Charlie and Mary are selling a (4-Plex) home that they have owned for more than 2 years and during the time they owned it, they lived in 1 unit as their residence and rented out the other 3 units. In a situation like this they have a transaction that is both a combination of IRS tax code sections. As a result they have both the sale of their personal residence, for 1/4 of the sale, and a 1031 exchange for 3/4 of the sale. So in a nutshell, they have 2 transactions with this one particular sale. 52

61 Section 1031 property cannot be primary residence right away. Section 1031 Exchange does not apply when taxpayers get the new property to live in as primary residence. The statute says that taxpayers cannot move into the new property for a period of 2 years. There is a movement to overturn the ruling to 12 months, but as of right now it is advised to wait at least 2 years before moving into a replacement property. CONVERTING RENTAL PROPERTY INTO PRIMARY RESIDENCE AFTER A 1031 EXCHANGE. Notably, an additional anti-abuse rule applies to rental property converted to a primary residence that was previously subject to a 1031 exchange for instance, in a situation where an individual completes a 1031 exchange of a small apartment building into a single family home, rents the single family home for a period of time, then moves into the single family home as a primary residence, and ultimately sells it (trying to apply the primary residence capital gains exclusion to all gains cumulatively back to the original purchase, including gains that occurred during the time it was an apartment building). To limit this, American Jobs Creation Act of 2004 (Section 840) introduced a new requirement (now IRC Section 121(d)) that stipulates the capital gains exclusion on a primary residence that was previously part of a 1031 exchange is only available if the property has been held for 5 years since the exchange. Example. Assume that Harold s original ownership was of an apartment building since 2000; and in early 2011 he had completed a 1031 exchange to a single family home, with the ultimate intention of moving into the property as a primary residence to claim the capital gains exclusion. Even if Harold moves into the property in early 2013 and lives there for 2 years, he will not be eligible for any capital gains exclusion until 2016 (five years after the 1031 exchange). At that time, he can complete the sale and be eligible for the exclusion. He will still have 4 years of nonqualifying use (2009 after the effective date, though the end of 2012 when the property was still a rental), but will now have 12 years of qualifying use ( inclusive, and ), which means 12/16ths of his gains will be eligible for the exclusion and 4/16ths will be deemed nonqualifying use capital gains and subject to taxes (in addition to any depreciation recapture). However, while the rules do limit the exclusion of capital gains attributable to periods of nonqualifying use (after 2009) in the case of a rental property converted to a primary residence, the rules are more flexible in the other direction, where a primary residence is converted into a rental property. IRC section 121(b)(4)(C)(ii)(I) allows taxpayers to ignore any nonqualifying use that occurs after the last date the property was used as a primary residence, though the 2-of-5 ownership-and-use tests must still be satisfied. Example. Jessica has lived in her property as a primary residence since In 2012, she received a new job opportunity across the country, but decided she did not want to sell the property yet as home values were still recovering in her area, so she rented the property instead. In 2014, as home prices have continued to appreciate, she wishes to sell the property. Even though there have been 2 years of otherwise-nonqualifying-use as a rental, Donna does not have to count nonqualifying use that occurred after she lived in the property as a primary residence. 53

62 As a result, all gains will be treated as qualifying, and eligible for the capital gains exclusion (except to the extent of any depreciation recapture). Even though Donna does not still live in the house as a primary residence, she has still used it as a primary residence in at least 2 of the past 5 years (as she lived there in 2010 and 2011 before renting in 2012), so the Section 121 exclusion is available. However, it s notable that if Donna waits until 2016 to sell, at that point there will be 4 years of rental use and only 1 year of use as a primary residence, so Donna will lose access to the Section 121 exclusion simply because she no longer meets the 2-of-5 ownership-and-use test. If Donna had chosen to subsequently exchange her converted rental property to a new one under IRC Section 1031, additional rules apply under IRC Section to properly allocate gains between Section 121 exclusion and Section 1031 deferral. CONVERTING RENTAL PROPERTY INTO PRINCIPAL RESIDENCE. Congress and the IRS have implemented several restrictions to the Section 121 capital gains exclusion in the case of a primary residence that was previously used as rental real estate. The first, created as part of the original rule under IRC Section 121(d)(6), stipulates that the capital gains exclusion shall not apply to any gains attributable to depreciation since May 6, 1997 (the date the rule was enacted), ensuring that the depreciation recapture will still be taxed (at a maximum rate of 25%). Example 2a. Harold has a property in 2012 that was purchased for $200,000 and is now worth $350,000. It was rented for a period of years (during which $29,000 of depreciation deductions were taken), and last year Harold moved into the property as a primary residence. The current cost basis is now $171,000 (after depreciation deductions), which means the total potential capital gain is $179,000. However, at the most (subject to further limitations discussed below), Harold will only be eligible to exclude $150,000 of gains (the appreciation above the original cost basis) if he uses the property as a primary residence for the requisite two years, because the $29,000 of depreciation recapture gain is not eligible for the Section 121 exclusion. In addition to the limitation of Section 121 regarding depreciation recapture, as a part of the Housing Assistance Tax Act of 2008, Congress further limited the exclusion of capital gains for property that was converted from a rental to a primary residence. The rules, included in IRC Section 121(b)(4), stipulate that the capital gains exclusion is specifically available only for periods during which the property was actually used as a primary residence; any other time (since January 1 st, 2014 in the example above) that the property was not used as a primary residence is deemed nonqualifying use. Accordingly, to the extent gains are allocable to periods of nonqualifying use (gains are assumed to be pro-rata over the holding period); those gains are not eligible for the exclusion. Example. Continuing the earlier example, if Harold had actually rented out the property for four years (2012, 2013, 2014, and 2015) and then used it as a primary residence for two years (2016 and 2017) to qualify for the capital gains exclusion, and sell it next year (after meeting the 2- year use test), the total $150,000 of capital gains (above the original cost) must be allocated between these periods of qualifying and non-qualifying use. Since there are only 2 years of 54

63 qualifying use out of a total of 6 years the property was held, only 1/3rds of the gains (or $50,000) are deemed qualifying (and will be fully excluded, as $50,000 of qualifying gains is less than the $250,000 maximum amount of qualifying gains that can be excluded). As a result of these limitations, the remaining $100,000 of capital gains attributable to nonqualifying use will be subject to long-term capital gains tax rates (along with the $29,000 of depreciation recapture). Example 2c. Assume instead that Harold had purchased the property not in 2012, but in 2003, and rented it for 13 years (from 2003 to 2015, inclusive) before moving into the property in early 2015 to live there for 2 years, with a plan to sell in 2017 and maximize the Section 121 capital gains exclusion. Because only nonqualifying use since 2012 counts under IRC Section 121(b)(4), Harold will be deemed to have 4 years of non-qualifying use (2012, 2013, 2014, and 2015), and 11 years of qualifying use ( inclusive, and ). As a result, 11/15ths of gains, or $110,000, would be qualifying gains eligible to be excluded (and since that s less than the $250,000 maximum exclusion amount, it would all be excluded), while only 4/15ths of the gains, or $40,000, would be nonqualifying and subject to capital gains taxes. In addition, any depreciation recapture since 2003 would still be taxed as well. NET INVESTMENT INCOME TAX (NIIT) (3.8%) The Net Investment Income Tax (NIIT) was included as part of the Affordable Care Act and became effective in This tax is imposed on high-income individuals, estates and trusts that have net investment income above applicable threshold amounts. Computation of Tax for individuals. Taxpayers must pay an additional 3.8% on any net investment income that they have if their modified adjusted gross income is more the following: 1. $250,000 for a joint return or surviving spouse 2. $125,000 for a married individual filing a separate return, and 3. $200,000 for all others. These amounts will not be indexed for inflation. 55

64 Net investment income. Net investment income (NII) is investment income reduced by allowable investment expenses. Reg. Section (a)(1) breaks the definition of net investment income into three subparagraphs: (i) Gross income from interest, dividends, annuities, royalties, rents, substitute interest payments, and substitute dividend payments (as defined in Reg. Section (d)); (ii) Other gross income derived from a trade or business which is a passive activity or trading in financial instruments or commodities described in Reg. Section ; and (iii)net gain attributable to the disposition of property that was not held in a trade or business in which NIIT does not apply (as described in Reg. Section (d)). The three categories above are known as one little i income, two little i income, and three little i income. Rental Income as One Little i income. Before the proposed regulations for Sec 1411 were released many believed that qualifying as a real estate professional and materially participating in a rental activity would shield the rental income from the 3.8% unearned income tax. However, that is not enough. According to the preamble of the regulations, to be excluded each rental must meet the following criteria: a) Is engaged in a trade or business under the meaning of the tax law (measured at the business level). b) The income must be earned in the ordinary course of the trade or business (measured at the business level). c) The income must not be passive to the individual owner (determined at the owner level). Being a real estate professional satisfies requirements b) and c) but what about a), the requirement to be engaged in a trade or business? In order for a rental activity to rise to the level of a trade or business, the taxpayer s involvement in the activity must be regular, continuous, and substantial. Key factual elements that may be relevant in determining if the rental rises to the level of a trade or business include, but are not limited to, the following, according to the IRS in the preamble to the final regulations: Type of property (commercial real property versus a residential condominium versus personal property, for example); Number of properties rented; Day-to-day involvement of the owner or his agent; Type of rental (for example, a net lease versus a traditional lease, short-term versus longterm lease) 56

65 The IRS verifies if it is for trade or business. The IRS concedes in the preamble to the final regulations that a single rental could require regular and continuous involvement such that the rental activity is a trade or business under Sec 162. But the IRS warns that not every single property rises to the level of a trade or business as a matter of law. 1. Example of trade or business in rental Taxpayer rents a single-family residence and just collects a monthly rental check. That clearly does not rise to the level of a trade or business, and therefore the rents from that rental are subject to the 3.8% tax after expenses are deducted. 2. Example of trade or business in rental Taxpayer owns a 20-tenant commercial rental that produces $1,000,000 in annual income. The taxpayer s involvement in the activity is regular, continuous, and substantial. As a result, the rental activity is clearly a trade or business and not subject to the Sec 1411 tax. When the properties are sold in the examples above, the gain from the property in example #1 will be subject to the 3.8% tax while the gain from the property in example #2 will not. Passive Income versus Trade or Business Income - Making the allocation between passive and trade or business activities in order to avoid the 3.8% tax may have some unexpected ramifications that should be carefully considered. Two Little i Income. Subparagraph two little i of Reg. Section (a)(1) operates by reference to Reg. Section , stating that net investment income includes all other gross income derived from a trade or business described within that regulation section which is: 1. The trade or business of trading in financial instruments or commodities this includes any and all income earned from the trading in financial instruments or commodities, regardless of whether the individual owner materially participates in the business. The regulations define financial instruments as stocks and other equity interests, evidences of indebtedness, options, forward or futures contracts, notional principal contracts, any other derivatives, or any evidence of an interest in any of these items, such as a short position or partial units of these items. 2. A passive activity - Under this provision, all of the income allocated to an individual owner from a business even if the income represents normal, operating income rather than items that we normally associate with investment income, such as dividends and interest will be included in net investment income if the activity is passive to the individual. Three Little i Income. Gains from the sale of property are covered separately under Reg. Section (a)(1)(iii). Included in this category of income are long-term and short-term capital gain, Section 1231 gain, Section 1245 ordinary income recapture, and unrecaptured Section 1250 gain. Exempt from this category of income are gains derived from a trade or business. Impact of home sales - Where there is a home sale gain, after taking the Sec 121 exclusion, the 57

66 remaining gain is reported on Form 8949 (Schedule D) and will end up in the computation for net investment income. As a result, in cases where there is a taxable home sale gain and the taxpayer s MAGI exceeds the threshold amount, then some or all of the taxable home sale gain profit could be subject to this surtax. On the other hand, the entire gain from the sale of a second home or one held strictly for investment purposes would be included in the investment income computation. Example Miguel & Sandy sell their home that they have owned and lived in for 35 years for $900,000. Their basis in the home is $200,000. Their gain from the sale is $700,000 and they are able to exclude $500,000 under Sec 121. That leaves them with a $200,000 taxable gain that will also be included in the computation of the net investment income for purposes of the 3.8% surtax. Exclusion for Certain Gains - Gain from the sale of property will not be included in net investment income, if: 1. The property was held in a trade or business, 2. The trade or business is not the trade or business of trading in financial instruments, and 3. The trade or business is not passive to the taxpayer. Investment Income subject to Net Investment Income Tax (3.8%) Subject to 3.8% Excluded Interest Tax-exempt bond interest Dividends Qualified retirement plan distributions Capital Gains Some business income Annuities Wages Royalties Active trade Rents Gain from the sale of a personal residence (if less than the Some Pass-through income allowable exclusion$250,000 or $500,000) 58

67 Review Questions Section 4 Read and answer the following review questions. The correct answers are found on the next page with an explanation to strengthen up your knowledge. Note: This is not part of your Final Test. 28. Antonio is a single taxpayer who wants to set up an S-Corporation to manage his rental properties and his business of selling cars; he will add other shareholders to the S- Corporation that will participate only on the business of selling cars. If this is the case, why is forming an S-Corporation not recommendable for Antonio and his rental properties? a) Antonio will be required to file too many forms to the IRS every year for holding rental properties. b) There is no disadvantage in forming an S-Corporation since it could bring protection and extra capital to the rentals from the selling of cars. c) Antonio will deal with sharing rental income on his properties. He must also allocate any taxable gain from the selling of any rental among all the shareholders and this can cause extra taxes on the other shareholders. d) Antonio will be required to separate the income and expenses and give Form 1099-Misc to each shareholder at the end of the year with the proper amount of their share. 29. Any estate or trust that was used for rental properties will generate income that must be reported to the IRS under one of the following ways: a) Taxpayers must report the income using Form b) They must report the income using Form 1041 and distribute the income to the beneficiaries using Schedule K-1 c) They must report the income and pay the proper taxes using Form d) They must report the income on Form 709 even if it is under $ Under rule of IRC Section 1031 exchange of rental properties, taxpayers can perform one of the following rental properties transactions: a) Taxpayer can sell their rental property at a gain and take the money to purchase whatever property they. b) Taxpayers can sell their rental properties and carry forward the gain to purchase properties of the same kind. c) Taxpayers can sell their properties but must spend the complete gain on a more expensive investment property. d) None of the above. 31. Section 1031 exchange is very strict and must be followed accordingly; one of the rules indicates that the exchange must be for a like-kind asset this basically means that taxpayer cannot do one of the following: a) Taxpayer sold an investment property and purchased a business. b) Taxpayer sold an investment property and purchased and investment land. c) Taxpayer sold and investment property and purchased and investment apartment. d) None of the above can be performed under the 1031 exchange. 59

68 32. Taxpayers who want to use the Two Hundred Percent Rule of the 1031 exchange will be required to do one of the following at the time of purchasing the new property: a) They are required to spend more than 200 percent of the amount received as a gain from the old property. b) They can identify more than 3 properties but the total value of all of them cannot exceed 200 percent of the property sold. c) Taxpayers must identify less than 3 new properties and the value can exceed 200 percent of the property sold. d) Taxpayers can exclude from income 200 percent of the amount received as a gain. 33. Taxpayers that convert their rental properties into primary residence will be required to stick to one to the following procedure in order to avoid any taxable gain at the time of selling that property: a) Taxpayers are required to avoid transferring properties using Section 1031 at all. b) Taxpayers are required to wait a five-year period after converting the rental into primary residence to avoid any taxable gain. c) They are required to wait a two-year period to avoid any taxable gain. d) They can convert their rental into primary at any time without any tax gain consequence. 34. If taxpayers have investment income above the threshold amount will be required to: a) Pay a penalty. b) Pay their lower income tax rate. c) Pay a net investment income tax d) Exclude them from income. 35. If taxpayers have earned income exceeding $200,000 will be subject to: a) A net investment income tax. b) Additional income tax withheld. c) Additional Medicare Tax. d) Additional income tax credit. 36. One of the following is not subject to the net investment income tax: a) Unemployment compensation b) Self-employment income c) Social Security Benefits d) All of the above Questions Section 4 Answers and Discussion 28. Answer c. Taxpayers that own real property may have issues when taking their properties out of the s-corporation. In general, they will be subject to a sale transaction in which they have to recognize any gain. This may not be a problem if there are one or two shareholders; the problem may arise when more than two shareholders do not agree in recognizing any gain on that specific rental property. 60

69 29. Answer b. An estate or trust can generate income that must be reported on form 1041, United States Income Tax Return for Estates and Trusts. However, if trust and estate beneficiaries are entitled to receive the income, the beneficiaries must pay the income tax rather than the trust or estate. At the end of the year, all income distributions made to beneficiaries must be reported on a Schedule K Answer b. Section 1031 applies to real property held for investment; under this section no gain or loss will be recognized on the exchange of property held for productive use in a trade or business or for investment. The property should be exchanged solely for property of likekind which is to be held either for productive use in a trade or business or for investment. Section 1031 exchange allows an individual to sell an asset and carry their basis forward into a new property. 31. Answer a. The Exchange Must Be For a Like-Kind Asset. In other words, taxpayers cannot sell a house and buy a brand store franchise. However, like-kind is a loosely defined term, so taxpayers could sell a house and buy an apartment, a piece of land, or a mobile home park. 32. Answer b. When a property has been acquired through a 1031 Exchange and later converted to a primary residence, the owner faces a mandatory five-year hold period before having the ability to sell obtaining the Section 121 exclusion. 33. Answer b. Under the two hundred percent rule taxpayers can identify more than 3 properties as long as the value does not exceed 200 percent of the property sold. In this case, taxpayers can identify any number of properties and actually close on any number of them if the sum of the market value of all of them does not exceed twice the market value of the relinquished property. 34. Answer c. Taxpayers must pay an additional 3.8% on any net investment income that they have if their modified adjusted gross income is more the following: $250,000 for a joint return or surviving spouse $125,000 for a married individual filing a separate return, and $200,000 for all others. 35. Answer c. Individuals with an income exceeding $200,000 are subject to the Additional Medicare Tax of 0.9% (.009). Whit this addition the Medicare tax will increase from 1.45% to 2.35% for higher earnings. This increase applies to earnings that are subject to wage withholding and self-employment tax. 36. Correct answer is d. Some common types of income that are not Net Investment Income are: Wages, unemployment compensation; operating income from a nonpassive business, Social Security Benefits, alimony, tax-exempt interest, self-employment income, Alaska Permanent Fund Dividends and distributions from certain Qualified Plans. 61

70 Expenses taken out of investment income. Before taxpayers pay the additional tax on their investment income, they can deduct certain expenses. Exclusions from Gross Income. For surtax purposes, gross income does not include excluded items, such as interest on tax-exempt bonds, veterans' benefits, and excluded gain from the sale of a principal residence (Code Sec 1411(d)). Investment Expenses. Expenses allowable in computing NII include deductions that are properly allocable to items of Gross Investment Income. Examples include (IRS Q&A 12): Investment interest expense, Investment advisory and brokerage fees, Expenses related to rental and royalty income, and State and local income taxes properly allocable to items included in Net Investment Income. Investment interest expenses, State and local income taxes, and Investment advisory and brokerage fees are included in a taxpayer s itemized deductions. The amounts allowed are after the reduction of miscellaneous deductions by 2% of AGI (in the case of investment advisory and brokerage fees) and after the Pease limitation (phase out of itemized deductions) for Schedule A deductions for higher income taxpayers. If a taxpayer claims the standard deduction, investment income may not be reduced by these expenses when computing NII. If a credit is claimed for foreign income taxes, those foreign taxes are not deductible in computing net investment income. Example of Net Investment Income Tax for a single taxpayer: A single taxpayer has net investment income of $100,000 and MAGI of $220,000. The taxpayer would pay a net investment income tax only on the $20,000 amount by which his MAGI exceeds his threshold amount of $200,000, because that is less than his net investment income of $100,000. Thus, the taxpayer's Net Investment Income Tax would be $760 ($20, %). Example of Net Investment Income tax for Married: Married taxpayers filing jointly have net investment income of $100,000, the husband has wages of $300,000, and their MAGI is $375,000. The couple would pay a Net Investment Income Tax of $3,800 ($100,000 x 3.8%) since 62

71 their MAGI exceeds the MAGI threshold by more than their net investment income ($375, ,000 = $125,000). Of special note: In addition to paying the net investment income tax of $3,800, the taxpayers would also pay an additional Medicare tax of $450 ($50,000 x 0.9%) on his wages in excess of $250,000. Net investment income tax for Estates & Trusts. For an estate or trust, the surtax is 3.8% of the lesser of: 1. Undistributed net investment income or 2. The excess of AGI over the dollar amount at which the highest income tax bracket applicable to an estate or trust begins. Chart Estate & Trust Tax Brackets If Taxable Income Is The Tax Is Not over $2,500 15% of taxable income Over $2,500 but not over $5,800 $ plus 25% of the excess over $2,500 Over $5,800 but not over $8,900 $1, plus 28% of the excess over $5,800 Over $8,900 but not over $12,150 $2, plus 33% of the excess over $8,900 Over $12,150 $3, plus 39.6% of the excess over $12,150 Example of Net Investment Income Tax for Trust: In 2014 a trust has undistributed net investment income of $20,000. The highest tax bracket for a trust in 2014 begins at $12,150. The trust s AGI is $30,000. The excess of the AGI over the initiation point of the highest tax bracket is $17,850. Since $17,850 is less than the $20,000 of undistributed NII, the surtax will be $ (3.8% of $17,850). Net Investment Income for Most Taxpayers. Thus, for taxpayers that do not engage in passive activities or a commodities trading business net investment income will include non-business income from interest, dividends, annuities, rents, and capital gains less allowable deductions. The surtax does not apply to: Income from other trades or businesses conducted by a sole proprietor, partnership, or S corporation (Committee Report). However, income, gain, or loss on working capital is not treated as derived from a trade or business and thus is subject to the tax (Code Sec. 1411(c)(3)). A nonresident alien, A trust of all the unexpired interests in which are devoted to charitable purposes, A trust that's tax-exempt under Code Sec. 501, A charitable remainder trust tax-exempt under Code Sec. 664 or Distributions from qualified retirement plans (qualified pension, stock bonus or profit sharing plans; qualified annuity plan; tax-sheltered annuity plan; traditional and Roth IRAs; Sec. 457(b) plans of state and local governments and tax-exempt organizations). Self-employment income for such taxable year on which the 0.9% HI surtax tax is imposed. 63

72 Exceptions to being classified as investment income. classified as investment income in this category: there are four exceptions to being 1. Tax-exempt interest earned on state and local tax-exempt bonds. 2. Distributions from qualified pension plans. 3. Interest paid to an employee by an employer under a nonqualified deferred compensation plan. 4. Income earned in the ordinary course of a trade or business. Examples of Exemptions of being classified as investment income. A taxpayer is in the mortgage loan business and earns interest on the loans. The interest income earned is income earned in the course of a trade or business and is NOT subject to the tax on investment income. Taxpayer sold furniture on time and carried back the paper then the interest earned on the notes would be income earned in the course of a trade or business and IS NOT subject to the tax on investment income. Thus income from an S-Corporation, a partnership and a sole proprietorship will be treated as investment income unless all three of the following tests are met: a) The entity or sole proprietorship is engaged in a trade or business under the meaning of the tax law (measured at the business level). b) The income must be earned in the ordinary course of the trade or business (measured at the business level). c) The income must not be passive to the individual owner (determined at the owner level). Intangibles & Goodwill - The regulations make it clear that this exclusion includes the gain from the sale of intangible assets, such as self-created goodwill, provided the goodwill was created by a trade or business that is neither the trading of financial instruments nor passive to the taxpayer. The 2013 Prop. Reg. Section contains information related to goodwill and partnership distributions. Installment Sales - Gain deferred under the Sec 453 installment sale rules is not subject to the surtax in the year of the sale. Tax Deferred Exchanges - Gain deferred under Sec 1031 is not subject to the surtax to the extent it is deferred into another property. Other issues. Any income subject to self-employment tax will not be subject to the 3.8% tax. The same income cannot be subject to both taxes (Reg. Section ). Kiddie Tax - The amounts of Net Investment Income that are included in a taxpayer s income by reason of Form 8814, Parent's Election to Report Child's Interest and Dividends, are included in calculating the taxpayer s Net Investment Income for the surtax. But NII does not include (a) amounts excluded due to the threshold amounts on Form 8814 and (b) amounts attributable to 64

73 Alaska Permanent Fund Dividends. Hobby Loss and At Risk Rules are not considered when making the determination of a trade or business for purposes of the NII tax. RENTAL AND DEPRECIATION. What is depreciation? Depreciation is an income tax deduction that allows a taxpayer to recover the cost or other basis of certain property. It is an annual allowance for the wear and tear, deterioration, or obsolescence of the property. Most types of tangible property (except, land), such as buildings, machinery, vehicles, furniture, and equipment are depreciable. Likewise, certain intangible property, such as patents, copyrights, and computer software is depreciable. A taxpayer will calculate his correspondence depreciation on Form Requirements. In order for a taxpayer to be allowed a depreciation deduction for a property, the property must meet all the following requirements: The taxpayer must own the property. Taxpayers may also depreciate any capital improvements for property the taxpayer leases. A taxpayer must use the property in business or in an income-producing activity. If a taxpayer uses a property for business and for personal purposes, the taxpayer can only deduct depreciation based only on the business use of that property. The property must have a determinable useful life of more than one year. Depreciation period. Depreciation begins when a taxpayer places property in service for use in a trade or business or for the production of income. The property ceases to be depreciable when the taxpayer has fully recovered the property s cost or other basis, or when the taxpayer retires it from service, whichever comes first. In order to determine the basis of property, we need to know how the property was acquired, the cost and/or FMV of the property and the manner in which title to the property is held. Basis of the Property. Taxpayers that want to take the depreciation for an asset will require to know the basis for the asset. The following is a consideration to know what the basis is of an asset according to the way it was acquired. 65

74 Basis of Purchased Property. The basis of property that is bought is usually its cost. The cost includes amounts paid with cash, credit, loans, traded property or services. The following amounts are also included in the basis of property: Sales tax Freight Installation and testing charges Excise taxes Capitalized legal and accounting fees Revenue stamps Recording fees Real estate taxes assumed for the seller. If the taxpayer paid real estate taxes that the seller owed and was not reimbursed, those taxes are added to the basis of the property. Do not deduct them as real estate taxes paid. If the taxpayer reimbursed the seller for property taxes paid, those amounts are usually deducted as an expense in the year of sale. Do not include those taxes in the basis of property. Taxpayers cannot include in property basis the costs associated with getting a loan to purchase the property, so mortgage interest is not added to the property basis. Basis of Property Transferred from Spouse. The basis of property transferred to taxpayer directly or in a trust by the spouse or former, is the same as the spouse's adjusted basis. Basis of Inherited Property. The basis of property that is inherited is generally the value of the property for federal estate tax purposes: FMV of the property on the date of decedent s death; or FMV of the property on the alternate date if an estate tax return is filed and an alternate valuation date is elected; or The value based on actual use, if an estate tax return is filed and special-use valuation is elected. Appreciated property at inheritance, stepped up basis Appreciated property is any property whose FMV on the day it was given to the decedent is more than its adjusted basis. Special rules apply for basis of appreciated property that was received from a decedent if the receiver or receiver s spouse originally gave the property to the decedent within 1 year before the decedent's death. The basis in this property is the same as the decedent's adjusted basis in the property immediately before his or her death, rather than the FMV. When title to property is taken in the name of two or more persons as joint tenants, the assets will automatically pass to the surviving tenant(s) at death. Both parties are assumed to have an equal (50/50) share in the property. Joint tenancy supersedes the deceased individual s will, if any. If assets are held by a husband and wife as joint tenants, then one-half of each asset gets a 66

75 stepped-up basis at the death of the first spouse Example. Assume that a husband and wife purchased a home for $80,000 twenty years ago. At the time of death of the first spouse, the FMV of the home was $200,000. The surviving spouse has a basis in the house of $140,000. (1/2 X the original cost $80,000) + (1/2 X the FMV value $200,000) $40,000 + $100,000 = $140,000 Tenants in common When title to property is held as tenants in common, the parties involved do not have to have an equal interest in the property. Each party can specify in his/her will their interest in the property. Holding property as tenants in common is similar to sole ownership. None of the parties involved in holding property as tenants in common have right of survivorship. Title or not title at inheritance If title to property is held as an individual and the person is unmarried, the decedent s will determines who inherits an asset. If the decedent dies intestate (without a will) generally state laws control who inherits an asset. However, if title is held in the individual s name alone and the person is married, additional questions must be answered to determine the nature of the asset. If the asset in question was acquired during marriage while the husband and wife lived in a community property state then the asset is community property. Not an automatic community property In addition, quasi-community property is a concept recognized by some community property states. Typically, such property is treated as if it were community property at the time of divorce or death of a spouse, but in California, at least, property acquired while married and domiciled in a non-community property jurisdiction does not become community property just because the married parties move to a community property jurisdiction. It is the new event of divorce or death while domiciled in the community property state that allows that state to treat such property as quasi-community property. Points to consider for inherited property The manner in which the title to property is held also determines what happens to the basis of assets at death. State law determines property ownership. In California, the most common ways of holding property are: An individual Joint tenants Tenants in common Community property (husband and wife) Community property with right of survivorship. Community Property. Can refer both to the nature of assets held by a husband and wife during the time of their marriage and a manner of holding property. When property is held as community property there is no right of survivorship and the parties involved can will the 67

76 property to whomever they choose. Recently, some states also allow a husband and wife to take title as community property with right of survivorship. This allows a couple to hold property as community property, but allows the assets to pass at death to the surviving spouse without a court or probate proceedings. A husband and wife must both initial or sign the document making the transfer to indicate their desire to hold property in this manner. Rights of survivor in a community property When a husband and wife hold property as community property or community property with right of survivorship, both halves (50/50) of the home get a stepped up basis as of the date of death of the first spouse. Again, at the death of the first spouse, all of the property held as community property gets a new valuation and there will be no tax due on the capital gain until that point. If the title to a property is not stated implicitly and there is more than one person involved, the following guidelines can be used: If the title document shows the parties to be husband and wife, title is treated as if it were community property; If the title document shows the parties to not be husband and wife, title is treated as tenants in common with each party having an equal interest. The title to property is never presumed to be joint tenancy. Basis of Property Received as a Gift. Generally, to determine the basis of property received as a gift, it is necessary to have the following information: The donor s adjusted basis in the gift; Any gift tax paid on the property; and The FMV of the property at the time of the gift. If the FMV of the property is higher than the donor s adjusted basis (the item has appreciated in value), the basis of the gift is the giver s adjusted basis plus any gift tax paid on the property. If the giver s adjusted basis is higher than the FMV of the property (the item has decreased in value), the basis depends on whether the recipient has a gain or a loss when they dispose of the property. The recipient s basis for determining a loss in the sale of the property is limited to the FMV at the time of the gift. The basis for figuring a gain is the same as the donor s adjusted basis. If the recipient uses the donor s adjusted basis to figure a gain and gets a loss, and then uses the FMV to figure a loss and gets a gain, there is neither gain nor loss on the disposition of the property. Other rules for determining basis apply depending on the specific method of acquiring property. For additional information on basis, get IRS Publication 551, Basis of Assets. 68

77 Nontaxable Exchanges. A nontaxable exchange is an exchange in which taxpayers are not taxed on any gain and they cannot deduct any loss. If taxpayers receive property in a nontaxable exchange, its basis is usually the same as the basis of the property transferred. A nontaxable gain or loss is also known as an unrecognized gain or loss. Like-Kind Exchanges. The exchange of property for the same kind of property is the most common type of nontaxable exchange. To qualify as a like-kind exchange, taxpayers must hold for business or investment purposes both the property transferred and the property received. There must also be an exchange of likekind property. The basis of the property received is the same as the basis of the property given up. Example Taxpayers exchange real estate (adjusted basis $50,000, FMV $80,000) held for investment for another real estate (FMV $80,000) that was held for investment also. The basis in the new property is the same as the basis of the old ($50,000). Basis of Property. Acquired from: Basis: Holding Period Starts: Inherited Property. FMV on the date of the On the date of decedent s death or decedent s death (or alternate valuation date if elected) alternate valuation period. Inherited property is always considered to have been held long-term. Purchased Property. Purchase price plus other charges On the date of purchase Gift property sold at a gain. Gift property sold at a loss. Acquired by taxable exchange. Acquired by nontaxable exchange. like tax, freight, installation, etc. Donor s basis Lesser of Donor s basis or FMV at the time of gift FMV at the time of exchange Generally, basis of traded property plus any cash paid. Date donor s holding period Began If the donor s basis is used, date donor s holding period began is used. If FMV value is used, holding period begins on the date of gift. On the date property was acquired The date the property that was traded was originally acquired Adjusting the Basis of the Property. Before figuring gain or loss on a sale, exchange, or other disposition of property or figuring allowable depreciation, depletion, or amortization, taxpayers must usually make certain adjustments to the basis of the property. The result of these adjustments to the basis is the adjusted basis. Generally speaking, improvements, additions and certain fees paid in conjunction with property increase its basis. Deductions or credits taken decrease the basis of property. 69

78 Increases to Basis Putting an addition on your home. Replacing an entire roof. Paving your driveway. Installing central air conditioning. Rewiring your home. Water connections. Sidewalks. Roads. Restoring damaged property. Cost of defending and perfecting a title. Adjusted Basis Decreases to Basis Exclusion from income of subsidies for energy conservation measures. Casualty or theft loss deductions and insurance reimbursements. Vehicle credits. Section 179 deduction. Depreciation. Nontaxable corporate distributions. Cancelled Debt Place in Service. Taxpayers will begin depreciating their property once the property is placed in service for use in the trade or business, or for the production of income. They will stop depreciating property once they have fully recovered the cost or other basis of the property or when the property is retired from service, whichever comes first. Even if the property is not used, it is in service when it is ready and available for its specific use. History of Depreciation. This chapter primarily covers the depreciation convention used most often today (MACRS) and the Section 179 deduction. First however, we ll briefly cover a short history of depreciation and the methods used. Different methods were used to depreciate. Prior to 1971, these deductions could be computed in a variety of manners over a wide range of methods. In 1971, Congress introduced the Class Life Asset Depreciation Range (ADR) system in an attempt to simplify calculations and provide some uniformity. An asset s basis, useful life and salvage value (estimated value of the property at the end of its useful life) were used to calculate depreciation. During those years taxpayers were allowed to use any reasonably consistent method of costrecovery as long as the deductions during the first two-thirds of the property s useful life did not exceed those using the double-declining balance method. An asset s basis, useful life and salvage value (estimated value of the property at the end of its useful life) were used to calculate depreciation. The most commonly used methods were the straight-line and double-declining methods followed by sum-of-the-years digits and units of production. From those methods of depreciation, today straight-line and declining balance methods are still in use. 70

79 The origin of ACRS. In 1981, Congress again changed the depreciation system to the Accelerated Cost Recovery System (ACRS), for property placed in service before 1987 and after The salvage value of an asset was no longer taken into account and specific class lives and depreciation methods were assigned to property types. ACRS provided prescribed percentages that were based on the 150, 175 and 200 percent declining balance methods. There were four classes of personal property under the ACRS rules: 3-, 5-, 10-, and 15-year classes. Under ACRS, automobiles were in the 3-year class, and most other property (other than public utilities properties) was in the 5-year class. ACRS recovery tables were based on the half-year convention and the 150% declining-balance method with a switch to straight-line at the optimum point. Depreciation Methods Used Today. Today the depreciation methods are different from the one mentioned above. The methods of depreciation were changed and a result of many analysis and legislations we have the current methods of depreciation. Selecting a depreciation method and recovery period is one of the few post year-end planning decisions a taxpayer can make. Generally, a taxpayer will want to elect the depreciation method that gives the quickest recovery (biggest deduction) of an asset. In certain cases, however, choosing a slower depreciation method (lower deduction) can be advantageous. The Modified Accelerated Cost Recovery System (MACRS). The Modified Accelerated Cost Recovery System (MACRS) is the current tax depreciation method. The present MACRS system was adopted as part of the Tax Reform Act of Under MACRS, the basis of most business and investment property, placed in service after 1986, is recovered over a specified life by annual deductions for depreciation. Methods of depreciation under MACRS. The deduction for depreciation is computed using one of the following two methods: Straight Line (SL) or Declining Balances (DB) switching to Straight Line (SL) 71

80 Review Questions Section 5 Read and answer the following review questions. The correct answers are found on the next page with an explanation to strengthen up your knowledge. Note: This is not part of your Final Test. 37. In order for taxpayer to start taking depreciation for an asset on their business income tax return, the asset must meet one of the following criteria: a) The taxpayer must be the owner of the asset or be the principal party in case is a leased property. b) The asset must have been determined that will last more than one year. c) The taxpayer must use the asset for business income-producing activity and depreciate the business use for listed property. d) All of the above are requirements. 38. To take a deduction for an asset the taxpayers must know the basis of the property; the basis can include one of the following expenses: a) Taxpayers can include the sales tax of the asset to increase the basis. b) Taxpayers can include the freight cost to increase the basis c) Taxpayers can count the recording fees of the asset towards the basis. d) All of the above can be included into the basis of the asset. 39. At the time of selling the property taxpayer will need to figure their gain or loss; in order to arrive to the amount of gain or loss, taxpayer will be required to perform one of the following operations: a) Taxpayers will be required to decrease the basis of the property by subtracting any Section 179 deduction. b) Taxpayers will be required to increase their basis by adding any amount spent on improvements to the property. c) Taxpayers will be required to decrease the basis of the property by any insurance reimbursement amount. d) All of these are required to arrive to the gain or loss amount. 40. From the systems of depreciation used before 1981 and after 1971 taxpayers can still use the following methods to depreciate assets in 2016: a) The Class Life Asset Depreciation Range (ADR) b) Useful life and salvage value. c) The straight-line and declining balance. d) None of the above. 41. What of the following assets CANNOT be depreciated? a) Buildings. b) Furniture. c) Copyrights d) Land. 72

81 42. When does the depreciation on an asset start? a) Once taxpayer purchase the asset. b) When taxpayer signs the purchase agreement. c) When taxpayer place the property in service. d) When taxpayer has the property under his/her name. 43. Taxpayers that want to take the depreciation of an asset will require the following information: a) The name of the seller. b) The condition of the asset. c) The previous depreciation amount before purchase. d) The basis of the property. 44. The most current tax depreciation method today is: a) The Class Life Asset Depreciation Range (ADR) b) Salvage Life of Depreciation. c) The sum-of-the-year s digits. d) The Modified Accelerated Cost Recovery System (MACRS) 45. The deduction for depreciation is computed using: a) The Straight Line and the Declining Balance. b) The Percentage amount and the Dollar amount. c) The Year amount and the Dollar amount. d) The Complete Year amount and the Complete Year Dollar amount. Questions Section 5 Answers and Discussion 37. Answer d. In order for a taxpayer to be allowed a depreciation deduction for a property, the property must meet all the following requirements: The taxpayer must own the property. Taxpayers may also depreciate any capital improvements for property the taxpayer leases. A taxpayer must use the property in business or in an income-producing activity. If a taxpayer uses a property for business and for personal purposes, the taxpayer can only deduct depreciation based only on the business use of that property. The property must have a determinable useful life of more than one year. 73

82 38. Answer d. The cost includes amounts paid with cash, credit, loans, traded property or services. The following amounts are also included in the basis of property: Sales tax, freight, installation and testing charges Excise taxes Capitalized legal and accounting fees Revenue stamps Recording fees 39. Answer d. Before figuring gain or loss on a sale, exchange, or other disposition of property or figuring allowable depreciation, depletion, or amortization, taxpayers must usually make certain adjustments to the basis of the property. The result of these adjustments to the basis is the adjusted basis. Generally speaking, improvements, additions and certain fees paid in conjunction with property increase its basis. Deductions or credits taken decrease the basis of property. 40. Answer c. Prior to 1971, these deductions could be computed in a variety of manners over a wide range of methods. In 1971, Congress introduced the Class Life Asset Depreciation Range (ADR). An asset s basis, useful life and salvage value (estimated value of the property at the end of its useful life) were used to calculate depreciation. From those methods of depreciation, today straight-line and declining balance methods are still in use. 41. Answer d. Most types of tangible property (except, land), such as buildings, machinery, vehicles, furniture, and equipment are depreciable. Likewise, certain intangible property, such as patents, copyrights, and computer software is depreciable. 42. Answer c. Depreciation begins when a taxpayer places property in service for use in a trade or business or for the production of income. 43. Answer d. Taxpayers that want to take the depreciation for an asset will require to know the basis for the asset. The following is a consideration to know what the basis is of an asset according to the way it was acquired. 44. Answer d. The Modified Accelerated Cost Recovery System (MACRS) is the current tax depreciation method. The present MACRS system was adopted as part of the Tax Reform Act of Answer a. The deduction for depreciation is computed using one of the following two methods: Straight Line (SL) or Declining Balances (DB) switching to Straight Line (SL) 74

83 Straight-Line (SL) Method. Straight-line depreciation is the easiest and most constant method of calculating cost recovery of an asset. When using the straight line method, taxpayers can use a different depreciation rate each year to the adjusted basis of their property. They must use the applicable convention in the year they place the property in service and the year they dispose the property. Example. Using the Straight-Line Method. 1) Number of Years. Sandy has a piece of equipment that she would like to depreciate over five years using straight-line depreciation. She purchased the equipment for $7500. The simplest way to calculate the annual depreciation is by dividing the basis (cost) by the number of years. $ years = $1500 per year 2) Percentage Method. Using the same scenario as above, the percentage method will bring about the same result. The difference is that we will calculate the percentage of cost to be recovered each year. To find the percentage, divide the number one (1) by the total number of years. 1 5 =.20 or 20% Then multiply the depreciable basis by that percentage. $7500 x 20% = $1500 per year Rate of depreciation under the Straight-Line method To determine the straight line depreciation rate for the year it is required to divide the number 1 by the number of years remaining in the recovery period, as explained before in the previous example. If the number of years remaining is less than 1, the depreciation rate for that tax year is 1.0 (100%). Declining Balance (DB) Method. Depreciation methods that provide for a higher depreciation charge in the first year of an asset's life and gradually decreasing charges in subsequent years, are called Accelerated Depreciation Methods. This may be a more realistic reflection of an asset's actual expected benefit from the use of the asset: many assets are most useful when they are new. One popular accelerated method is the Declining- Balance Method. 75

84 The most common Declining Balance (DB) methods are: 1) 150 DB, meaning 1.5 times the straight line amount is used as a multiplier; or 2) 200 DB (Double-Declining Balance (DDB)), which means that twice the straight line amount is used. Using Declining-Balance Method for the same year that the property was place in service as follows: 1. Multiply the adjusted basis in the property by the declining balance rate. 2. Apply the applicable convention, explained later. Using the Decline-Balance Method for all other years (before the year in which taxpayers switch to the straight line method) as follows: 1. Reduce the adjusted basis in the property by the depreciation allowed or allowable in earlier years. 2. Multiply this new adjusted basis by the same declining balance rate used in earlier years. To figure the declining balance rate it is required to divide the specified declining balance percentage (150% or 200% changed to a decimal) by the number of years in the property's recovery period. For example, for 3-year property depreciated using the 200% declining balance method, divide 2.00 (200%) by 3 to get , or a 66.67% declining balance rate. For 15-year property depreciated using the 150% declining balance method, divide 1.50 (150%) by 15 to get 0.10, or a 10% declining balance rate. The table below illustrates the correlation between the class life of an asset and the MACRS property class. Nonresidential real and residential rental property is not included. Property Classes. The first thing to do when depreciating property, is determine in which class the property belongs. The class determines the recovery period, or for how long an asset is depreciated, for most types of property. According to the IRS rules, the life of the asset is not how long a producer plans to use it, but instead depends on its IRS Property Classes. One of the key elements in determining the correct annual depreciation amount is selecting the appropriate property class. The property classes are used for both the General Depreciation System (GDS) and the Alternative Depreciation System (ADS). The amount of depreciation that can be claimed each year depends then on the useful life of the property, as defined in the tax code. 76

85 Property Classification Property Class Years Class Life Years 3-year CL 4 5-year 4 > CL < 10 7-year 10 CL < year 16 CL < year 20 CL < year 25 CL Property Classes and Declining-Balance Methods. If the class life in years is: The MACRS Property Class is: Example in Declining- Balance Method: Declining- Balance Rate: 4 years or less. 3-year 200% DB % More than 4, but less than year 200% DB or more, but less than year 200% DB or more but less than year 200% DB or more but less than year 150% DB or more. 20-year 150% DB 7.5 MACRS Conventions. Under MACRS, averaging conventions establish when the recovery period begins and ends. The convention selected determines the number of months for which the depreciation can be claimed in the year that taxpayers place the property in service and in the year that the property will be disposed. MACRS has three conventions used to determine when the property is considered to have been placed in service: 1) The Mid-month convention (MM) This convention is for nonresidential real property, residential rental property, and any railroad grading or tunnel bore. The half-year convention treats all personal-type property as being placed in service (or disposed of) on the midpoint of the month. This means that a one-half month of depreciation is allowed for the month the property is placed in service or disposed. 2) The Mid-quarter convention (MQ) This convention is used when more than 40% of the total depreciable basis of personal-type MACRS property is placed in service during the last quarter (three months) of the year. For the assets placed in service during the last quarter, the depreciation deduction is smaller than what it would be using the half-year convention. Under this convention, property is considered to have been placed in service (or disposed of) at the midpoint of the quarter. The Half-year convention (HY) Under this convention, all the property is treated as been placed in service or disposed at the midpoint of the year. This means that a one-half year of depreciation is allowed for the year the property is placed in service or disposed. 77

86 Property Classification in Detail Under MACRS. Property Class Examples (More details on IRS Publication 946) 3-year property Tractor units for over-the-road use Any race horse over 2 years old when placed in service Qualified rent-to-own property 5-year property Automobiles, taxis, buses, and trucks Computers and peripheral equipment Office machinery Any property used in research and experimentation Breeding cattle and dairy cattle Appliances, carpets, furniture, etc., used in a residential rental real estate activity 7-year property Office furniture and fixtures (such as desks, files, and safes) Agricultural machinery and equipment Any property that does not have a class life and has not been designated by law as being in any other class 10- year Vessels, barges, tugs, and similar water transportation equipment property Any single purpose agricultural or horticultural structure 15-year property 20-year property 25-year property Residential rental property. Nonresidential real property Any tree or vine bearing fruits or nuts Certain improvements made directly to land or added to it (such as shrubbery, fences, roads, sidewalks, and bridges) Any municipal wastewater treatment plant Any qualified restaurant property placed in service before January 1, 2012 Farm buildings (other than single purpose agricultural or horticultural structures) Initial clearing and grading land improvements for electric utility transmission and distribution plants Property that is an integral part of the gathering, treatment, or commercial distribution of water, and that, without regard to this provision, would be 20-year property Municipal sewers other than property placed in service under a binding contract in effect at all times since June 9, Includes any building or structure in which 80% or more of its gross rental income for the tax year is from dwelling units. It includes rental homes or mobile homes, but does not include units in a hotel or motel where more than half the units are used on a transient basis. Section 1250 property such as an office building, store or warehouse, which is neither residential rental property nor property with a class life of less than 27.5 years. 78

87 Example using property classification and convention together. Calculating with: Declining-Balance Depreciation Half-Year Convention Five-year property. Assume that the basis of an asset is $15,000 and that the taxpayer wishes to recover the cost over five years. The method will be double declining balance or 200% declining balance using the half-year convention. 1) Calculate the straight line percentage: 1 5 =.20 or 20% 2) remember that the 200% means that taxpayers will use double the straight line percentage. The half year convention means that in the first and last years the taxpayers will get ½ the deduction actually calculated. Year Straight Line Double Declining Balance of Asset 1 $15, X 12 = $2727 $15,000 X 20% = $3,000 $15,000 - $3,000 = $12,000 2 $12, X 12 = $2666 $12,000 X 40% = $4,800 $12,000 - $4,800 = $7,200 3 $7, X 12 = $2057 $7,200 X 40% = $2,880 $7,200-2,880 = $4,320 4* $ X 12 = $1728 $4320 X 40% = $1728 $ = $ $ X 12 = $1728 $2592 X 40% = $1037 $ = $864 6 Remaining $864 *Note: Switch to straight-line in Year 4. $ = $0 MACRS Depreciation Systems. Under MACRS there are two systems of depreciation that can be used. The following are the two systems : The General Depreciation System (GDS) and The Alternative Depreciation System (ADS). Generally, these systems provide different methods and recovery periods to use in figuring depreciation deductions. It is possible to use of either the General Depreciation System (GDS) or the Alternative Depreciation System (ADS) to depreciate property under MACRS. Each system determines what depreciation method and recovery period will be used. Taxpayers generally must use GDS unless they are specifically required by law to use ADS or they elect to use ADS. General Depreciation System (GDS). MACRS provides three depreciation methods under GDS: 1) The 200% declining balance method over a GDS recovery period (200 DB) 2) The 150% declining balance method over a GDS recovery period. (150 DB) 3) The straight line method over a GDS recovery period. (SL) The GDS also includes two property classifications: a. Property Classification: The first thing to do when depreciating property is to determine 79

88 which class the property belongs to. It could be the Description of Property Classification (ex. Office Furniture) and Property Classification in years (ex. 10-year property). b. Recovery Period of Property: The recovery period of property is the number of years over which you recover its cost or other basis. How to use the Table of Class Lives and Recovery Periods Of IRS publication 946 Select the Property Classification (description) Select the Property Classification (In Years) Select the Recovery Period under GDR or ADS 80

89 Recovery Period of Property under the General Depreciation System Recovery Period Under GDS 3 Years (1) (1) 5 years for qualified rent-to-own property placed in service before 5 Years August 6, Years 10 Years 15 Years (2) 20 Years 25 Years (3) 17.5 Years 39 Years (4) (2) 39 years for property that is a retail motor fuels outlet placed in service before August 20, 1996 (31.5 years if placed in service before May 13, 1993), unless you elected to depreciate it over 15 years. (3) 20 years for property placed in service before June 13, 1996, or under a binding contract in effect before June 10, (4) 31.5 years for property placed in service before May 13, 1993 (or before January 1, 1994, if the purchase or construction of the property is under a binding contract in effect before May 13, 1993, or if construction began before May 13, 1993). Alternative Depreciation System (ADS). MACRS provides one depreciation method under ADS: 1) The straight line method over an ADS recovery period. ADS is required for certain property, such as imported property, foreign-use property, taxexempt use property, tax-exempt bond financed property, and luxury automobiles and other listed property used 50% or less for business. Although the property may qualify for GDS, taxpayers can elect to use ADS. The election generally must cover all property in the same property class that was placed in service during the year. However, the election for residential rental property and nonresidential real property can be made on a property-by-property basis. Once the election is made, taxpayers can never revoke it. The ADS straight-line method provides for equal yearly deductions and is elected by completing line 20 in part III of Form Recovery Periods under ADS The recovery periods for most property are generally longer under ADS than they are under GDS. The following table shows some of the ADS recovery periods. 81

90 Recovery Period In years 4 Rent-to-own property. Recovery Periods Under ADS Example of Property Automobiles and light duty trucks. 5 Computers and peripheral equipment. High technology telephone station equipment installed on customer premises. High technology medical equipment. 12 Personal property with no class life. 14 Natural gas gathering lines. 15 Single purpose agricultural and horticultural structures. 20 Any tree or vine bearing fruit or nuts. Initial clearing and grading land improvements for gas utility property. 25 Initial clearing and grading land improvements for electric utility transmission and distribution plants. 30 Electric transmission property used in the transmission at 69 or more kilovolts of electricity. 35 Natural gas distribution lines. 39 Any qualified leasehold improvement property. Any qualified restaurant property. 40 Nonresidential real property. Residential rental property. Section 1245 real property not listed in Appendix B. 50 Railroad grading and tunnel bore. Example: A taxpayer places in service a $15,000 machine which he purchased on June 1, The table above shows the depreciation each year using the various depreciation methods available. Notice how the depreciation amounts vary from year to year and from method to method. The taxpayer should take into account their income in the current year as well as projected income in future years before selecting a depreciation method. Year GDS 200 DB GDS 150 DB GDS S/L ADS S/L 1 $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $

91 Depreciation Methods and Benefits Comparison Method Type of Property Benefit Nonfarm 3-, 5-, 7-, and 10-year property GDS using 200% DB GDS using 150% DB GDS using SL ADS using SL All farm property (except real property) All 15- and 20-year property (except qualified leasehold improvement property and qualified restaurant property placed in service before January 1, 2012) Nonfarm 3-, 5-, 7-, and 10-year property Nonresidential real property Qualified leasehold improvement property placed in service before January 1, 2012 Residential rental property Trees or vines bearing fruit or nuts All 3-, 5-, 7-, 10-, 15-, and 20- year property Listed property used 50% or less for business Property used predominantly outside the U.S. Qualified restaurant property placed in service before January 1, 2012 Tax-exempt property Tax-exempt bond-financed property Imported property Provides a greater deduction during the earlier recovery years Changes to SL when that method provides an equal or greater deduction Provides a greater deduction during the earlier recovery years Changes to SL when that method provides an equal or greater deduction Provides for equal yearly deductions (except for the first and last years) Provides for equal yearly deductions 83

92 Depreciation Deduction Flow MACRS Select Depreciation System General Depreciation System (GDS) Alternative Depreciation System (ADS) Select Property Class by year or Description Property Class required Date placed in service Date placed in service Recovery Period (In years according to property class) Recovery Period (In years according to property class) Convention (MM, MQ, HY) Convention (MM, MQ, HY) Depreciation Method (DB) or (SL) Depreciation Method (SL) 84

93 Use Form 4562 to depreciate property Attach it to the Income Tax Return Part III of Form 4562 is used for MACRS Depreciation Section B of Part III of Form 4562 is used for GDS Section C of Part III of Form 4562 is used for ADS Tables for MACRS deductions. To help you figure your deduction under MACRS, the IRS has established percentage tables that incorporate the applicable convention and depreciation method. These percentage tables are in Appendix A of Publication 946. Which table to use? Appendix A contains the MACRS Percentage Table Guide, which is designed to help you locate the correct percentage table to use for depreciating your property. The percentage tables immediately follow the guide. 85

94 Select the System, Method, Recovery Period, Convention, Class, and Date Select the correct Table Example Table A-1 covers Class 3- to 20- Year Property. Under the Half- Year Convention. For GDS, 200% Happily, there is generally no need for a taxpayer (or tax professional) to do these calculations themselves. The MACRS tables have all of the percentages already calculated and the tax soft wares contain all the programs to make the calculations. Just make sure to select the appropriate method and property class. 86

95 Review Questions Section 6 Read and answer the following review questions. The correct answers are found on the next page with an explanation to strengthen up your knowledge. Note: This is not part of your Final Test. 46. The depreciation methods that provide for a higher depreciation charge in the first year of an asset s life and decrease gradually the charge in the remaining time are called: a) Section 179 methods. b) Current methods of depreciation. c) Accelerated Depreciation Methods. d) Mid-quarter depreciation methods. 47. Under the property classification for MACRS one of the following items will not qualify for the 5-year property class: a) Machinery used for business. b) Furniture used in the office of the business. c) Computers used in the business. d) Trucks used for business. 48. Taxpayers who want to take depreciation for their assets will be required to select a property class; the property class basically indicates one of the following: a) The property class indicates how many year it will take for taxpayer to pay the asset in full. b) The property class indicates how many years the taxpayer plans to use the asset. c) The property class indicates how long an asset will be depreciated. d) The property class indicates how long an asset will be in service. 49. Under the Mid-month convention (MM) used for MACRS Convention, taxpayers will be able to depreciate their asset. This Mid-month convention basically indicates that the asset will be depreciated as follows: a) The asset will be depreciated as if it had been placed in business at the midpoint of a given quarter of the year. b) The asset will be depreciated as if it had been placed in service at the midpoint of the year. c) The asset will be depreciated as if it had been placed in service at the midpoint of the month. d) The asset will be depreciated as if had been placed in service at the beginning of the month. 50. Under the Half-year convention taxpayers are indicating that they: a) Are filing their income taxes at the midpoint of the year. b) Are planning to purchase an asset on June of each year. c) Are placing in service an asset at the midpoint of the year. d) Are paying the sales tax of an asset in mid-year. 87

96 51. Under MACRS exists the General Depreciation System and the Alternative Depreciation System, under these systems taxpayers can: a) Select different methods and depreciation rebates. b) Select different methods and recovery periods for depreciation. c) Select the amount of refund for depreciation. d) Select the depreciation bonus amount that will be taken in the first year. 52. One of the following methods is NOT included under the General Depreciation System: a) The bonus depreciation for first year. b) The 200% declining balance over a GDS recovery period (200DB) c) The straight line method over a GDS recovery period (SL) d) The 150% declining balance over a GDS recovery period (150) DB) 53. Under the Alternative Depreciation System taxpayers can elect methods of depreciation. a) 1. b) 3 c) None d) 50% 54. In order to take depreciation for an asset, taxpayers are required to: a) Figure the depreciation on their own and transfer the amount to Form b) Figure the depreciation on Form 4562 and attached it to the tax return. c) Make the calculations directly on Schedule C. d) All the depreciations are taken on Schedule A. 88

97 Questions Section 6 Answers and Discussion 46. Answer c. Depreciation methods that provide for a higher depreciation charge in the first year of an asset's life and gradually decreasing charges in subsequent years, are called Accelerated Depreciation Methods. This may be a more realistic reflection of an asset's actual expected benefit from the use of the asset: many assets are most useful when they are new. 47. Answer b. Office furniture and fixtures do not fall into the 5-year classification code for MACRS, instead they are classified as 7-year property. 48. Answer c. The class determines the recovery period, or for how long an asset is depreciated, for most types of property. According to the IRS rules, the life of the asset is not how long a producer plans to use it, but instead depends on its IRS Property Classes. 49. Answer c. This convention is for nonresidential real property, residential rental property, and any railroad grading or tunnel bore. The half-year convention treats all personal-type property as being placed in service (or disposed of) on the midpoint of the month. This means that a one-half month of depreciation is allowed for the month the property is placed in service or disposed. 50. Answer c. The Half-year convention (HY) Under this convention, all the property is treated as been placed in service or disposed at the midpoint of the year. This means that a one-half year of depreciation is allowed for the year the property is placed in service or disposed. 51. Answer b. Under MACRS there are two systems of depreciation that can be used. The following are the two systems : The General Depreciation System (GDS) and The Alternative Depreciation System (ADS). 52. Answer a. MACRS provides three depreciation methods under GDS: The 200% declining balance method over a GDS recovery period (200 DB) The 150% declining balance method over a GDS recovery period. (150 DB) The straight line method over a GDS recovery period. (SL) 53. Answer a. MACRS provides one depreciation method under ADS: The straight line method over an ADS recovery period. 54. Answer b. In order to take a depreciation taxpayers will need Form 4562 and attach it to the income tax return. 89

98 Important Points of Depreciation. In order for a taxpayer to take a depreciation deduction for property, it must meet all of the following requirements: Generally, the taxpayer must own the property. The taxpayer may also depreciate any capital improvements for property the taxpayer leases. A taxpayer must use the property in business or in an income-producing activity. If a taxpayer uses a property for both business and personal purposes, they can only take a depreciation deduction for the business portion of the property. The property must have a determinable useful life of more than one year. Even if the taxpayer meets the above requirements, they cannot depreciate the following: Property that is placed in service and disposed of in the same year. Equipment used to build capital improvements. In this case, a taxpayer must add the otherwise allowable depreciation amount to the basis of the improvements. Most types of tangible property such as buildings, machinery, vehicles, furniture and equipment is depreciable. Land is not depreciated. Certain intangible property such as patents, copyrights and computer software is also depreciable. SECTION 179 DEDUCTION. Section 179 of the United States Internal Revenue Code (26 U.S.C. 179), allows a sole proprietor to elect to deduct all or part of the cost of certain types of property up to a limit, by deducting it in the year the property was placed in service, rather than recovering the cost of the property by taking depreciation over the years. The total amount that can be deducted under section 179 is subject to: A dollar limit and A business income limit. Dollar limit. The total dollar limit deduction for property placed in service in 2015 generally cannot be more than $500,000. If more than one item of qualifying Section 179 property is placed in service during the year, the $500,000 limit can be allocated between the properties in any way as long as the total deduction is not more than $500,000. To qualify for Section 179 Deduction, the property must meet some requirements: It must have been acquired by purchase. It must be acquired for business use. 90

99 Business Income Limit. The total cost that can be deducted each year after applying the dollar limit is limited to the taxable income from the active conduct of any trade or business during the year. Any cost not deductible in one year under section 179 because of this limit can be carried to the next year. Property Aquired by Purchase. Section 179 property is generally any tangible property that can be depreciated under MACRS. To qualify for the section 179 deduction, the property must have been acquired by purchase from an unrelated party for use in an active trade or business. For example, property acquired by gift or inheritance does not qualify. If qualifying property is purchased with cash and a trade-in, its cost for purposes of the Section 179 deduction is limited to the cash paid. Example. John Gomez, a retail bakery, traded two ovens having a total adjusted basis of $680 for a new oven costing $1,320. They received an $800 trade-in allowance for the old ovens and paid $520 in cash for the new oven. The bakery also traded a used van with an adjusted basis of $4,500 for a new van costing $9,000. They received a $4,800 trade-in allowance on the used van and paid $4,200 in cash for the new van. Only the portion of the new property's basis paid by cash qualifies for the section 179 deduction. Therefore, John Gome's qualifying costs for the section 179 deduction are $4,720 ($520 + $4,200). Electing Section 179 Deduction. The Section 179 election is made on an item by item basis for eligible property and does not have to be used on all eligible property placed in service in the current year. However, the election must be made in the tax year the property is first placed in service and it must be made on the original tax return filed for the year the property was placed in service. The only time that the Section 179 deduction can be taken on an amended return is if the amended return was filed by the due date (including extensions) for the return for the year the property was placed in service. How to elect Section 179 Deduction. The election to use the Section 179 deduction is made by completing Part I of Form 4562 (and Part V for listed property). Once the election is made, it cannot be revoked without IRS approval. The IRS will grant approval only in extraordinary circumstances. 91

100 Taxpayers must keep records that show the specific identification of each piece of qualifying section 179 property. These records must show how the property was acquired, the person acquired from, and when it was placed in service. Advantages and Disadvantages of Section 179. The Section 179 deduction can be beneficial to the taxpayer because it allows them to reduce the business income for that year or escape the mid-quarter convention for depreciation purposes. Property acquired for business use. To qualify for the section 179 deduction, the property must have been acquired for use in the trade or business. Property acquired only for the production of income, such as investment property, rental property (if renting property is not the trade or business), and property that produces royalties, does not qualify. Partial business use. When taxpayers use property for both business and nonbusiness purposes, they can elect the section 179 deduction only if they use the property more than 50% for business in the year it was placed in service. If taxpayers use the property more than 50% for business, multiply the cost of the property by the percentage of business use. Use the resulting business cost to figure the section 179 deduction. Example. Mike Trejo bought and placed in service an item of section 179 property costing $11,000. He used the property 80% for his business and 20% for personal purposes. The business part of the cost of the property is $8,800 (80% $11,000). Property that does not qualify. Property that does not qualify for the section 179 deduction is 92

101 property that is: Held only for the production of income investment property, rental property (if property rental is not the trade or business) or property that produces royalties; Used outside the United States; Used by certain tax-exempt organizations; Certain property for lease to others; Property used by certain government agencies or foreign persons or entities. New additions to Section 179 under PATH. Previously, air conditioning and heating units were an excluded property type for the Section 179 deduction. The PATH Act of 2015 removed the language excluding air conditioning and heating units from being eligible Section 179 property. The following types of property now qualify for Section 179: portable air conditioning and heating units, whether for human comfort or business purposes; and, the portion of an HVAC system that is air conditioning or heating property used for a business purpose, or for human comfort. Property No Longer for Business. Taxpayers may have to recapture the section 179 deduction if, in any year during the property's recovery period, the percentage of business use drops to 50% or less. In the year the business use of the property drops to less than 50%, taxpayers include the recapture amount as ordinary income in Part IV of Form They also increase the basis of the property by the recapture amount. Example. In January 2015, Tom Jackson, a calendar year taxpayer, bought and placed in service section 179 property costing $10,000. The property is not listed property. The property is a 3- year property. He elected a $5,000 section 179 deduction for the property and also elected not to claim a special depreciation allowance. He used the property only for business in 2015 and In 2017, he used the property 40% for business and 60% for personal use. He figures his recapture amount as follows. Recapture Example Section 179 deduction claimed (2015) $5,000 Minus: Allowable depreciation using Table A-1 (instead of section 179 deduction): For 2015: $ For 2016: $$2, For 2017: $ * 40%= $ Total From Table A-1= $4, $4, Section 179 minus Table A1= $5,000 - $ = $ Recapture amount reported as income for 2017= $ Other Method Options when falling less than 50%. If the property is not eligible for Section 179 Deduction then the property can be depreciated under the regular MACRS method. If the MACRS method does not apply then the depreciation must be calculated using the straight-line method over the ADS recovery period. 93

102 Note: If the use business use percentage increases over 50% taxpayers must continue using the straight-line method over the ADS recovery period. Eligible Property for Section 179 Deduction Machinery and equipment. Tangible personal property: Property contained in or attached to a building such as refrigerators, grocery store counters, office equipment, printing presses, testing equipment, and signs. Gasoline storage tanks and pumps at retail service stations. Livestock, including horses, cattle, hogs, sheep, goats, and mink and other furbearing animals. Other tangible property used as: An integral part of manufacturing, production, or extraction, or of furnishing transportation, communications, electricity, gas, water, or sewage disposal services, A research facility used in connection with any of the activities listed above. Single purpose agricultural (livestock) or horticultural structures Off-the-shelf computer software. Qualified real property Storage facilities (except buildings and their structural components) used in connection with distributing petroleum or any primary product of petroleum. Qualified leasehold improvement property, Qualified restaurant property, or Qualified retail improvement property. The Dollar Limit, explained. The total amount that taxpayer can elect to deduct under section 179 for most property placed in service in 2015 generally cannot be more than $500,000. If they acquire and place in service more than one item of qualifying property during the year, they can allocate the section 179 deduction among the items in any way, as long as the total deduction is not more than $500,000. They do not have to claim the full $500,

103 Qualified real property that you elected to treat as section 179 real property is limited to $250,000. Dollar Limit Reduction. If the cost of the qualifying section 179 property placed in service in a year is more than $2,000,000, taxpayers generally must reduce the dollar limit (but not below zero) by the amount of cost over $2,000,000. If the cost of their section 179 property placed in service during 2015 is $2,500,000 or more, they cannot take a section 179 deduction. Example. In 2015, Tammy placed in service machinery costing $2,100,000. This cost is $100,000 more than $2,000,000, so she must reduce her dollar limit to $400,000 ($500,000 $100,000). If the machinery price is $2,500,000. This cost is $500,000 more than $2,000,000, so Tammy would get no Section 179 Deduction at all ($500,000 - $500,000 = 0). Exceptions to this rule apply to properties place in service in qualified Disaster Areas. Dollar Limit for Sport Utilities and Certain Other Vehicles. The taxpayer cannot elect to expense more than $25,000 of the cost of any heavy sport utility vehicle (SUV) and certain other vehicles placed in service during the year. This rule applies to any 4-wheel vehicle primarily designed or used to carry passengers over public streets, roads or highways that is rated at more than 6,000 pounds gross vehicle weight and not more than 14,000 pounds gross vehicle weight. However, the $25,000 limit does not apply to any vehicle: Designed to seat more than nine passengers Equipped with a cargo area at least six feet in interior length that is not readily accessible from the passenger compartment, or That has an integral enclosure fully enclosing the driver compartment and load carrying device, does not have seating behind the driver s seat and has no body section protruding more than 30 inches ahead of the windshield. Dollar Limit for Married Individuals. Married taxpayers are treated as one taxpayer in determining any reduction to the dollar limit, regardless of who purchased the property or placed it in service both get the same deduction but not over the limit. For married individuals filing separate returns, they are treated as one taxpayer for the dollar limit, including any reduction of costs over $2,000,000. The spouses can allocate any percentages between them as long as the total does not exceed 100%. If the percentages do not equal 100%, 50% percent will be allocated to each spouse. If after filing separate returns, the taxpayers decide to file a joint return after the due date of filing the returns, the dollar limit on the joint return is the lesser of: 95

104 The total dollar limit (after reduction for any cost of section 179 property over $2,000,000). The total cost of section 179 property expensed on the separate returns. Examples for Married Individuals Filing Separate - Gill Mart is a married taxpayer. He and his wife file separate returns. Gill bought and placed in service $2,000,000 of qualified farm machinery in His wife has her own business, and she bought and placed in service $30,000 of qualified business equipment. Their combined dollar limit is $470,000. This is because they must figure the limit as if they were one taxpayer. They reduce the $500,000 dollar limit by the $30,000 (excess of their costs over $2,000,000) total of $470,000 They elect to allocate the $470,000 dollar limit as follows. $446,500 ($470,000 x 95%) to Mr. Mart's machinery. $23,500 ($470,000 x 5%) to Mrs. Mart's equipment. If they did not make an election to allocate their costs in this way, they would have to allocate $235,000 ($470,000 50%) to each of them. Example of Married Individuals Filing Jointly after Separate Returns. The facts are the same as in the previous example except that Gill elected to deduct $30,000 of the cost of section 179 property on his separate return and his wife elected to deduct $2,000. After the due date of their returns, they file a joint return. Their dollar limit for the section 179 deduction is $32,000. This is the lesser of the following amounts. $470,000 The dollar limit less the cost of section 179 property over $2,000,000. $32,000 The total they elected to expense on their separate returns. Business Income Limit (or Taxable Income Limit), Explained. The Section 179 deduction is also limited to taxpayer s (and spouse, if applicable) taxable income from any trade or business without regard of any expensed amounts. For the purposes of the Section 179 deduction, taxable income from a trade or business includes: Wages, salaries, tips and other employee compensation; Income as a sole proprietor; Ordinary net income from a partnership or S corporation; Section 1231 gains (or losses); Section 1245 and 1250 depreciation recapture; and Interest earned from working capital related to a trade or business Taxable income is not reduced by: 96

105 The section 179 deduction. The self-employment tax deduction. Any net operating loss carryback or carryforward. Any unreimbursed employee business expenses. Carryover of Disallowed Section 179 Deduction. Any Section 179 deduction limited by taxable income can be carried forward indefinitely. The deduction is claimed as the taxpayer earns sufficient trade or business income. The carryover can be allocated to a specific asset (or assets) selected by the taxpayer in the year the assets are placed in service. If no allocation is made, the carryover is prorated equally between the expensed properties. This disallowed deduction amount is shown on line 13 of Form Taxpayers can use the amount carried over to determine their section 179 deduction in the next year. Enter that amount on line 10 of Form 4562 for next year. If they place more than one property in service in a year, they can select the properties for which all or part of the costs will be carried forward. Taxpayers selection must be shown in their books and records. Dollar Limitations for Passenger Automobiles. The depreciation deduction, including the section 179 and any special depreciation allowance for a passenger automobile is limited each year. What is a Passenger Automobile? A passenger automobile is any four-wheeled vehicle made primarily for use on public streets, roads, and highways and rated at 6,000 pounds or less of unloaded gross vehicle weight (6,000 pounds or less of gross vehicle weight for trucks and vans). It includes any part, component, or other item physically attached to the automobile at the time of purchase or usually included in the purchase price of an automobile. The following vehicles are not considered passenger automobiles for these purposes: An ambulance, hearse, or combination ambulance-hearse used directly in a trade or business. A vehicle used directly in the trade or business of transporting persons or property for pay or hire. A truck or van that is a qualified non-personal use vehicle. Maximum Depreciation Deduction for Passenger Automobiles. The maximum depreciation deduction for passenger automobiles is based on the year the vehicle was placed in service. The maximum depreciation deduction claimed for qualified passenger automobiles cannot exceed the applicable first year limits shown in the tables below. 97

106 Maximum Depreciation Deduction for Passenger Automobiles Table Placed in Service 1 st year 2 nd year 3 rd year 4 th year & later years 2014 $11,160 1 $5,100 $3,050 $1, $11,160 1 $5,100 $3,050 $1, $11,160 1 $5,100 $3,050 $1, $11,060 2 $4,900 $2,950 $1, $11,060 2 $4,900 $2,950 $1, $10,960 3 $4,800 $2,850 $1, $10,960 3 $4,800 $2,850 $1, $3,060 $4,900 $2,850 $1, $2,960 $4,800 $2,850 $1, $2,960 $4,700 $2,850 $1, $10,610 4 $4,800 $2,850 $1,675 5/6/03 2/31/03 $10,710 4 $4,900 $2,950 $1,775 1/1/03 5/5/03 $7,660 5 $4,900 $2,950 $1,775 (1) Taxpayers that elect not to claim any special depreciation allowance for the vehicle or if the vehicle is not qualified property, the maximum deduction is $3,160. (2) Taxpayers that elect not to claim any special depreciation allowance for the vehicle or if the vehicle is not qualified property the maximum deduction is $3,060. (3) Taxpayers that did not elect to claim any special depreciation allowance for the vehicle or if the vehicle is not a qualified property, the maximum deduction is $2,960. (4) Taxpayers that elect not to claim any special depreciation allowance for the vehicle, the vehicle is not qualified Liberty Zone property, the maximum deduction is $2,960. Unrecovered Basis. If the depreciation deductions for a passenger automobile are limited in any year, there will be an unrecovered basis in the vehicle at the end of its recovery period. The taxpayer can continue to claim depreciation in succeeding years until the full basis of the automobile has been recovered. The unrecovered basis in the vehicle is calculated assuming the vehicle had been used 100% for business, even if actual business use was less. Example of Unrecovered Basis. In May 2015, taxpayers bought and placed in service a car costing $31,500. The car was 5-year property under GDS (MACRS). Taxpayers did not elect a section 179 deduction and elected not to claim any special depreciation allowance for the car. They used the car exclusively for business during the recovery period (2015 through 2020). Their depreciation is figured as shown follows: Year Percentage Buss. Use Amount Limit Allowed Multiply $31,500 * percentage % $6,300 $2,960 $2, % $10,080 $4,800 $4, % $6,048 $2,850 $2, % $3,629 $1,675 $1, % $3,629 $1,675 $1, % $1,814 $1,675 $1,675 TOTAL $31,500 $15,635 $15,635 98

107 At the end of 2020, taxpayers had an unrecovered basis of $15,865 ($31,500 $15,635). If in 2021 and later years they continue to use the car 100% for business, they can deduct each year the lesser of $1,675 or the remaining unrecovered basis. Listed Property. Certain property eligible for depreciation and the Section 179 deduction is classified as listed property. Generally, listed property includes property that is likely to be used for personal purposes, including computers, automobiles, video cameras, cell phones, etc. These items are on a special IRS list to ensure that no depreciation is taken for personal use of these items. Special rules for depreciation and recordkeeping exist. Special recordkeeping, business use and dollar limitation rules are placed upon listed property. Listed Property includes: Passenger automobiles weighing 6,000 pounds or less. Any other property used for transportation, unless it is an excepted vehicle. Property generally used for entertainment, recreation, or amusement (including photographic, phonographic, communication, and video-recording equipment). Computers and related peripheral equipment, unless used only at a regular business establishment and owned or leased by the person operating the establishment. A regular business establishment includes a portion of a dwelling unit that is used both regularly and exclusively for business as discussed in Publication 587. Business-Use Requirements of Listed Property. You can claim the section 179 deduction and a special depreciation allowance for listed property and depreciate listed property using GDS as well as a declining balance method if the property meets the business-use requirement. To meet this requirement, listed property must be used predominantly more than 50% of its total use for qualified business use. Property not used predominantly for qualified business use during the year it is placed in service does not qualify for the section 179 deduction. To determine if this test is met, use must be allocated if the item is used for more than one purpose during the year. Qualified business use does not include: Lease of the property to any 5% owner or related party; Use of property as pay for the service of 5% owner or related person; or Use of property as pay for the service of any person not a 5% owner or related person, unless the value of the use in that person s gross income. Use of the property to produce investment income. However, investment use is included when figuring the depreciation deduction for the asset. How Is Listed Property Information Reported? You must provide the information about your listed property requested in Part V of Form 4562, Section A, if you claim either of the following deductions: Any deduction for a vehicle. A depreciation deduction for any other listed property. 99

108 If you claim any deduction for a vehicle, you also must provide the information requested in Section B. If you provide the vehicle for your employee's use, the employee must give you this information. If you provide any vehicle for use by an employee, you must first answer the questions in Section C to see if you meet an exception in order to complete Section B for that vehicle. Recordkeeping. No depreciation deduction or Section 179 expense can be claimed for the use of listed property unless the taxpayer can prove business/investment use with adequate records. Generally business-use records must be written, such as an account book, log, detailed calendar or other documents to establish each element of use. The records of business use must support the following: Cost and related expenses such as capital improvements, lease payments, etc.; The amount of each business and investment use (can be mileage for vehicles or time for other listed property); The date of expense or use; The business or investment purpose for expense or use. These records must be kept for as long as any excess depreciation can be recaptured. Special Depreciation Allowance for the First Year of Service. Taxpayers can take a special depreciation allowance of 50% to recover part of the cost of qualified property placed in service during the tax year. The allowance applies only for the first year in which the property was placed in service. The allowance is an additional deduction taken after any section 179 deduction and before the calculation of depreciation under the regular MACRS for the year in which the qualified property is placed in service. Qualified Property for the special deduction. Qualifying property includes the following: Qualified reuse and recycling property. Qualified second generation biofuel plant property placed in service before Certain qualified property acquired after December 31, 2007 and before 2015 Taking the special deduction allowance. Figure the special depreciation allowance by multiplying the depreciable basis of qualified reuse and recycling property, qualified second generation biofuel plant property, and certain qualified property acquired after December 31, 2007, by 50%. For qualified property other than listed property, enter the special allowance on Form 4562, Part II, line 14. For qualified property that is listed property, enter the special allowance on Form 4562, Part V, line

109 Example with special depreciation allowance and MACRS. On November 1, 2014, Tom Brown bought and placed in service in his business qualified property that cost $450,000. He did not elect to claim a section 179 deduction. He deducts 50% of the cost ($225,000) as a special depreciation allowance for He uses the remaining $225,000 of cost to figure his regular MACRS depreciation deduction for 2014 and later years. Example of special depreciation allowance and Section 179. On June 1, 2013, Mike places in service a machine purchased for $150,000. The machine meets all of the requirements necessary to claim the special depreciation allowance and Mike wishes to claim as much depreciation as possible in the allowable year. He takes Section 179 deduction of $100,000 50% bonus depreciation. $25,000 (($150,000 - $100,000) x 50%) Regular deprecation.. $3,573 (($150, ,000 25,000) x 14.29%) Total depreciation $128,

110 Review Questions Section 7 Read and answer the following review questions. The correct answers are found on the next page with an explanation to strengthen up your knowledge. Note: This is not part of your Final Test. 55. In order for taxpayers to take a Section 179 deduction the asset must comply with one of the following requirements: a) The property must be a tangible property that can be depreciated under MACRS. b) The business property must have been purchased or acquired from an unrelated party. c) In case the property was acquired with a trade in, the actual cost paid after the trade in will count towards Section 179 deduction. d) All of the above are requirements for Section 179 deduction. 56. One of the requirements of Section 179 deduction is that in case taxpayers purchase more than one qualifying asset and place them in service in the same year, they must. a) Take the Section 179 deduction for no more than 5 assets in a given year. b) Take the Section 179 deduction for the desired assets only in the year they were place in service. c) Take the Section 179 deduction for any asset in the year they were placed in service or in the year in which taxpayer wants take the deduction. d) Take the Section 179 deduction only for one asset at a time during and split the rest into the following years. 57. Section 179 deduction will not be available when taxpayers acquire or purchase one of the following items: a) A special heavy tractor that will be used for the business in a branch in Canada. b) A land that will produce income from rentals so the main business of selling cars get an extra income. c) An asset that will be used for a tax-exempt organization. d) All of the above do not qualify for the Section 179 deduction. 58. If the property for which taxpayer claimed the Section 179 deduction fall in use under 50% or less, taxpayer will be required to do one of the following: a) They are required to recapture the Section 179 deduction b) Taxpayers will be required to include any recapture amount of Section 179 as income. c) Taxpayers will be required to use Form 4797 to include any income from Section 179 recapture. d) All of the above is required. 59. John purchased 3 parts of equipment in 2015 for his business; the equipment will be used entirely for business purposes. The total amount spend on the equipment is $850,250. John wants to take a Section 179 deduction for the equipment, how can he take the special deduction for the equipment purchased? a) The special deduction can only be taken for just one piece of equipment during the year up to the Section 179 limit. b) John can take the Section 179 deduction up to a limit; he is required to allocate the limit amount among all the pieces. c) John cannot take Section 179 deduction if he purchased more than one piece of equipment in the same year. d) John can take Section 179 deduction of the total amount of the purchase because he purchased more than one piece of equipment in the same year. 102

111 60. Mike purchased a van in 2015 for $23,450; after reviewing the business use of the van he finds that he uses it 70% for business and 30% for personal. What is the amount of Section 179 deduction that Mike can take? a) He cannot take Section 179 deduction on items that are for business and personal use. b) He can take Section 179 deduction on the complete $23,450 because the van is used more than 50% for business purposes. c) He can take Section 179 deduction only on the first $16,415 value of the van. d) He can take Section 179 deduction on the first $11,725 value of the van. 61. John purchased an electric generator for $18,500 for his business; for the same year he has a business loss and he could just take a partial Section 179 deduction. What will happen with the remaining deduction that he did not take? a) The Section 179 deduction not taken will be lost. b) The Section 179 deduction not taken can be carried forward. c) The Section 179 deduction cannot be taken at all if the business has a loss. d) None of the above. 62. Mike purchased a van that he uses for work and personal purposes; he wants to take Section 179 deduction for the van in the current year. What is the requirement so he can take Section 179 for the van? a) He must have the records proving the business use of the vehicle. b) He must show the date of the business use of the van. c) He must show the purpose of the use of the van for the period indicated. d) All of the above is required. 63. A special depreciation of an asset indicates that: a) The taxpayer can take Section 179 deduction in a specific year. b) Taxpayer can take a special 50% deduction in any year. c) Taxpayer can take a special deduction for the first year on top of any Section 179 taken. d) None of the above. Questions Section 7 Answers and Discussion 55. Answer d. Taxpayers may have to recapture the section 179 deduction if, in any year during the property's recovery period, the percentage of business use drops to 50% or less. In the year the business use of the property drops to less than 50%, taxpayers include the recapture amount as ordinary income in Part IV of Form They also increase the basis of the property by the recapture amount. 56. Answer b. The Section 179 election is made on an item by item basis for eligible property and does not have to be used on all eligible property placed in service in the current year. However, the election must be made in the tax year the property is first placed in service and it must be made on the original tax return filed for the year the property was placed in service. The only time that the Section 179 deduction can be taken on an amended return is if the amended return was filed by the due date (including extensions) for the return for the year the property was placed in service. 103

112 57. Answer d. Property that does not qualify for the section 179 deduction is property that is: Held only for the production of income investment property, rental property (if property rental is not the trade or business) or property that produces royalties; Used outside the United States; Used by certain tax-exempt organizations; Certain property for lease to others; Property used by certain government agencies or foreign persons or entities 58. Answer d. Section 179 property is generally any tangible property that can be depreciated under MACRS. To qualify for the section 179 deduction, the property must have been acquired by purchase from an unrelated party for use in an active trade or business. For example, property acquired by gift or inheritance does not qualify. If qualifying property is purchased with cash and a trade-in, its cost for purposes of the Section 179 deduction is limited to the cash paid. 59. Answer b. If more than one item of qualifying Section 179 property is placed in service during the year, the $500,000 limit can be allocated between the properties in any way as long as the total deduction is not more than $500, Answer c. When taxpayers use property for both business and nonbusiness purposes, they can elect the section 179 deduction only if they use the property more than 50% for business in the year it was placed in service. If taxpayers use the property more than 50% for business, multiply the cost of the property by the percentage of business use. Use the resulting business cost to figure the section 179 deduction. 61. Answer b. Any Section 179 deduction limited by taxable income can be carried forward indefinitely. The deduction is claimed as the taxpayer earns sufficient trade or business income. The carryover can be allocated to a specific asset (or assets) selected by the taxpayer in the year the assets are placed in service. If no allocation is made, the carryover is prorated equally between the expensed properties. 62. Answer d. No depreciation deduction or Section 179 expense can be claimed for the use of listed property unless the taxpayer can prove business/investment use with adequate records. Generally business-use records must be written, such as an account book, log, detailed calendar or other documents to establish each element of use. The records of business use must support the following: Cost and related expenses such as capital improvements, lease payments, etc.; The amount of each business and investment use (can be mileage for vehicles or time for other listed property); The date of expense or use; The business or investment purpose for expense or use. 63. Answer c. Taxpayers can take a special depreciation allowance of 50% to recover part of the cost of qualified property placed in service during the tax year. The allowance applies only for the first year in which the property was placed in service. The allowance is an additional deduction taken after any section 179 deduction and before the calculation of depreciation under the regular MACRS for the year in which the qualified property is placed in service. 104

113 AMORTIZATION. Amortization is similar to the straight line method of depreciation in that an annual deduction is allowed to recover certain costs over a fixed time period. Taxpayers can amortize such items as the costs of starting a business, goodwill, and certain other intangibles. If they amortize property, the part amortized does not qualify for the section 179 expense deduction or for depreciation. The following items including Section 197 can be amortized: Geological and geophysical expenditures (section 167(h)). Pollution control facilities (section 169). Bond premium (section 171). Research and experimental expenditures (section 174). The cost of acquiring a lease (section 178). Qualified forestation and reforestation costs (section 194). Optional write-off of certain tax preferences over the period specified in section 59(e). Certain Section 197 intangibles. The following costs must be amortized over 15 years (180 months) starting with the later of (a) the month the intangibles were acquired or (b) the month the trade or business or activity engaged in for the production of income begins: o Goodwill; o Going concern value; o Workforce in place; o Business books and records, operating systems, or any other information base; o A patent, copyright, formula, process, design, pattern, know-how, format, or similar item; o A customer-based intangible (e.g., composition of market or market share); o A supplier-based intangible; o A license, permit, or other right granted by a governmental unit; o A covenant not to compete entered into in connection with the acquisition of a business; and o A franchise, trademark, or trade name (including renewals). When taxpayers dispose a section 197 intangible, any gain on the disposition, up to the amount of allowable amortization, is recaptured as ordinary income. Start-up and organizational costs. Section 197 restriction. The Section 197 rules generally do not apply to an intangible created by the taxpayer, so a taxpayer cannot amortize the goodwill or going concern value of a business they started. Rather, the rules apply to the purchase of businesses where part of the purchase price has been allocated to one of the above intangibles. Claiming the amortization. Attach any information the Code and regulations may require to make a valid election. See the applicable Code section, regulations, and Pub. 535 for more information. 105

114 A sole proprietor would report amortization on Schedule C using also Form If the taxpayer is reporting amortization of costs that began before the current year and is not required to file Form 4562 for any other reason, report the amortization on the appropriate form or schedule (i.e., Schedule C). Depletion. Depletion is the using up of natural resources by mining, drilling, quarrying stone, or cutting timber. The depletion deduction allows an owner or operator to account for the reduction of a product's reserves. There are two ways of figuring depletion: Cost depletion, and Percentage depletion. Qualifying Resources. Qualifying taxpayers can take the depletion for the following resources: Mineral property, and Standing timber. For mineral property taxpayers generally must use the method that gives them the larger deduction. For standing timber, they must use cost depletion. Eligible taxpayers that can claim depletion. Taxpayers that have an economic interest in mineral property or standing timber can take a deduction for depletion. More than one person can have an economic interest in the same mineral deposit or timber. In the case of leased property, the depletion deduction is divided between the lessor and the lessee. Taxpayers are considered to have an economic interest if both the following conditions apply: Taxpayers have acquired by investment any interest in mineral deposits or standing 106

115 timber. Taxpayers have a legal right to income from the extraction of the mineral or cutting of the timber to which they must look for a return of their capital investment. A contractual relationship that allows taxpayers an economic or monetary advantage from products of the mineral deposit or standing timber is not, in itself, an economic interest. A production payment carved out of, or retained on the sale of, mineral property is not an economic interest. More information and requirements can be found on IRS Publication 535. THE ENERGY TAX CREDIT FOR PRINCIPAL RESIDENCE. As solar has become more popular and prevalent through the U.S, there are a lot of misconceptions regarding the available tax incentives and credits for installing solar. Some of the misconceptions are that every taxpayer is going to get a tax refund from the government for installing solar panels. These misconceptions may be propagated through the sales techniques and proposals by some solar installers. The Energy Tax Credit. There is a 30 percent federal tax credit that is available through the end of The tax credit then phases out over the following two years, going to a 26 percent level in 2020, and a 22 percent level in After the end of 2022, as the current legislation reads, there will be no federal tax credit for solar. The official name of the federal tax credit is the Residential Renewable Energy Tax Credit. The tax credit is based on the amount of investment in solar property and includes the full installed cost of all equipment and does not have a maximum. How is the Tax Credit Given. This tax incentive is a tax credit that reduces any tax liability. If the taxpayer owes taxes to the IRS, the credit will be applied towards the tax itself. The tax incentive cannot be used to reduce the taxable income; the credit only applies to any tax liability and is not refundable for taxpayers that do not owe taxes. Example. Mark has a tax liability for 2016 of $10,000. During this year, Mark installed solar and has $7,000 in available tax credits through the Residential Renewable Energy Tax Credit. Let s say his federal withholdings are $12,000 then they would receive a federal refund of $9,000. The amount from the renewable energy tax credit is taken first against the tax liability ($10,000 - $7,000 = $3,000) and then the remainder of the tax liability is deducted from the amount of tax that was withheld throughout the tax year to result in the individual s federal refund ($12,000 - $3,000 = $9,000 refunded). In the example above, the taxpayer received a refund coming from his income tax withholdings made at work not from the energy credit itself. Taxpayers must know that there is no way to get a refund based solely on the energy credit. 107

116 Solar Leases and Purchase Agreements. Taxpayers that do not pay for their solar system up front will use a solar lease agreement or a Power Purchase Agreement (PPA). These arrangements do not qualify for the tax credit. Rebates from the Solar Company. Taxpayers that installed their solar system with a solar lease or a solar PPA are not eligible for the tax credit because the leasing company owns the solar system, so they will receive the Energy Tax Credit. Some companies take into consideration the value of the 30% tax credit when calculating the lease rate. Taxpayers that received a rebate from the company reducing the cost of the solar system, will calculate their federal tax credit based on the cost after any rebates. For example, taxpayers that purchased a system that costs $20,000 and received a $5,000 rebate from the utility company will calculate the tax credit based on $15,000 price. Selling the house with the solar system. Taxpayers that installed solar system on their home and did not pay for it upfront will have either the solar lease or the Power Purchase Agreement (PPA). Any potential buyer will be required to apply with the solar company in order to take over the solar lease or any PPA, which usually has a life of about 20 years. In case the buyer does not want the system, the owner is required to compensate or pay off any balance. Some solar leases and PPAs were acquired with a $0 down; in this case the solar lease/ppa contracts may include an annual payment increase called a payment escalator that will raise the potential home buyer's payment by up to 2.9% per year, every year for 20 years. The Energy Credit when a Home is sold. Taxpayers that want to acquire a home with an existing solar lease or PPA attached to it will not be able to claim the 30% federal tax credit because it was used by the solar company. Getting the Energy Tax Credit on principal residence. Taxpayers that want to get the tax credit will be required to make the tax credit calculations on Form 5695 and transfer the proper credit to Form If there is not tax liability or the credit is more than the tax owed, taxpayers can carry the credit over to the following tax year. Carry over of the tax credit. The Solar Tax Credit is available through 2019, this would suggest that taxpayer has those years to claim or use the portion that was not claimed on the current tax year. In 2016, the Congress agreed to extend the solar ITC at the current 30% rate through 2019, after which it will fall to 26% in 2020, 22% in 2021 and 10% in Amount considered for the Energy Tax Credit. The credit is based on the cost of the system. The complete cost of the solar system is used to calculate the tax credit; the taxpayers will claim the complete cost once the system is installed. This is true even if taxpayers have not paid the system yet. Taxpayers will claim all the costs of the installation no matter when it was paid. Taxpayers must take into consideration that the credit is given for a purchased system rather than a leased or PPA system. Credit at the state level. Taxpayers that receive a state tax credit for the solar panels will use the purchase amount minus any rebate or grant received. 108

117 Energy Projects financed by local programs. Taxpayers can start their energy-saving projects using any property assessed clean energy program (PACE). These programs offer loans to finance energy saving improvements. There are other programs offered by the local or state government. The energy-saving projects can include solar panels, air conditioning, roofing, windows, lighting controls, and landscape-related products. In order to get the loan, taxpayers apply for a home energy program. Once they are approved they can use the proceeds to make energy improvements to their home. In some programs, the loan is secured by a lien on the home and appears as a special assessment on their real estate property tax bill over the period of the loan. The payments on these loans may appear to be deductible real estate taxes; however, they are not deductible real estate taxes. Assessments associated with a specific improvement benefitting one home are not deductible. However, the interest portion of the payment may be deductible as home mortgage interest. Tax treatment of the Energy Program in California. In California neither the principal nor interest amounts paid on a taxpayer's property tax bill for energy saving projects are deductible real estate taxes. Similar to the IRS, taxpayers may be able to deduct some or all of the interest as a home mortgage interest deduction. CANCELLATION OF DEBT OF RENTALS AND OTHER ASSETS (COD) Taxpayers often question the taxability of canceled debt because they did not receive money in hand. In situations where property is surrendered, such as a foreclosure, they feel that by giving up the property they are relieved from any further obligation. It is necessary to explain to them that the relief is only from personal liability to pay the debt. Borrowers collecting debt after filing Form 1099-C. Receiving a 1099-C should always mean the debt is canceled and no longer subject to collection. But it may be up to the taxpayer to make sure. Until 2016, IRS rules allowed creditors to file a 1099-C if no payments had been made on a debt for 36 months. This resulted in many 1099-C forms being issued for debts that were delinquent but not actually forgiven. The IRS Taxpayer Advocate Service cited the resulting confusion in its annual reports to congress as a priority for the agency to clear up. Under an IRS bulletin published in November 2016, creditors are no longer expected to issue a 1099-C form merely because a debt has gone 36 months without a payment. If taxpayers receive a 1099-C for a debt they were not aware was discharged, clarify the status of the debt with the creditor. If they are following the old rule, request that they rescind the 1099-C under Internal Revenue Bulletin Rescinding the 1099-C will alert the IRS that it was issued in error. If the creditor will not rescind the form, or confirm the debt is forgiven, taxpayers will need to use the IRS dispute process outlined in publication 4681to show that no taxes are owed. Cancellation of Debt. If taxpayers borrow money from a commercial lender and the lender later cancels or forgives the debt, they may have to include the cancelled amount as income for tax purposes, depending on the circumstances. When the taxpayers borrow the money they were not required to include the loan proceeds as income because they had an obligation to repay the lender. When that obligation is subsequently forgiven, the amount received as loan proceeds is 109

118 reportable as income because the taxpayers no longer have an obligation to repay to the lender. If a lender cancels a debt and issues Form 1099-C, the lender will indicate on the form in box 5 if the borrower was personally liable (recourse) for repayment of the debt. The tax impact depends on the type of debt - recourse or nonrecourse. Abandonment. The abandonment of property is a disposition of property. Taxpayers abandon the property when they voluntarily and permanently give up possession and use of the property with the intention of ending their ownership, but without passing it on to anyone else. Generally, abandonment is not treated as a sale or exchange of the property. If the amount realized (if any) is more than the adjusted basis, then they have a gain. If the adjusted basis is more than the amount realized (if any), then there is a loss. Loss from abandonment of business or investment property is deductible as a loss. A loss from an abandonment of business or investment property that is not treated as a sale or exchange is generally an ordinary loss. This rule also applies to leasehold improvements the lessor made for the lessee that were abandoned. If the property is foreclosed on or repossessed in lieu of abandonment, gain or loss is figured as Foreclosure and Repossessions. The abandonment loss is deducted in the tax year in which the loss is sustained. The tax consequences of abandonment of property that is secured by debt depend on whether it is recourse debt or nonrecourse debt. Borrower is Recourse Debt Nonrecourse Debt Personally liable Not personally liable Cancelled portion of the debt is generally Gain or loss on disposition of the property Treated as ordinary income and included in gross income (unless it qualifies as an exception or exclusion) Generally determined by the difference between the FMV of the property and the adjusted basis Nonrecourse debt is satisfied by the surrender of the secured property regardless of the FMV at the time of surrender. The amount realized includes the balance of the nonrecourse debt at the time of the disposition of the property. This is true even if the FMV of the property is less than the outstanding debt Generally, if the taxpayer abandons property that secures debt for which the taxpayer is personally liable, the taxpayer does not have gain or loss until the later foreclosure is completed. If the taxpayer abandons property that secures debt, for which the taxpayer is not personally liable, the abandonment is treated as a sale or exchange. Foreclosures and Repossessions. If taxpayers do not make payments on a loan secured by the property, the lender may foreclose on the loan or repossess the property. The foreclosure or repossession is treated as a sale or exchange from which taxpayers may realize gain or loss. This is true even if they voluntarily return the property to the lender. They also may realize ordinary income from cancellation of debt if the loan balance is more than the fair market value of the property. 110

119 Buyer's Gain or Loss. Taxpayers figure and report gain or loss from a foreclosure or repossession in the same way as gain or loss from a sale or exchange. The gain or loss is the difference between your adjusted basis in the transferred property and the amount realized. Forms 1099-A and 1099-C. If a property was taken by the lender (foreclosure) or given up by the borrower (abandonment), the lender usually sends the taxpayer Form 1099-A, Acquisition or Abandonment of Secured Property. Form 1099-A will have information needed to determine the gain or loss due to the foreclosure or abandonment. If the debt is canceled, the taxpayer will receive Form 1099-C, Cancellation of Debt. If foreclosure/abandonment and debt cancellation occur in the same calendar year, the lender may issue only Form 1099-C, including the information otherwise reported on Form 1099-A. A financial institution, credit union, federal government agency or others in the business of lending money must issue a 1099-C if the debt relief is $600 or more. Individual lenders such as the seller of the property are not required to file the 1099-C. This form will generally provide the information needed to determine the amount of debt relief. The 1099-C can be issued for a variety of circumstances related to debt forgiveness including credit card debt, vehicle repossessions, home foreclosures, etc. EXCEPTIONS AND EXCLUSIONS. Some canceled or forgiven debts may be eliminated from income by applying exceptions, or reduced by applying exclusions to the general rule. Exceptions are applied before exclusions. Exceptions. There are several exceptions to the inclusion of canceled debt in income. Exceptions may allow the taxpayer to eliminate the following types of canceled debt from income: Amounts otherwise excluded from income (e.g., gifts and bequests) Certain student loans (e.g., doctors, nurses, and teachers serving in rural or low-income areas) Deductible debt (e.g., home mortgage interest that would have been deductible on Schedule A) Price reduced after purchase (e.g., debt on solvent taxpayer's property is reduced by the seller; basis of property must be reduced) Exclusions. There are several exclusions from the general rule for reporting canceled debt as income. Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness, must be used to show the amount of the canceled debt excluded. The exclusions are: A. Debt canceled in a Title 11 bankruptcy case 111

120 B. Debt canceled during insolvency C. Cancellation of qualified farm indebtedness D. Cancellation of qualified real property business indebtedness (not for C corporations) E. Cancellation of qualified principal residence. Applicable Tax Years. The Mortgage Forgiveness Debt Relief Act of 2007 generally allows taxpayers to exclude income from the discharge of debt on their principal residence. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualify for this relief. This provision applies to debt forgiven in calendar years 2007 through Up to $2 million of forgiven debt is eligible for this exclusion ($1 million if married filing separately). The exclusion doesn t apply if the discharge is due to services performed for the lender or any other reason not directly related to a decline in the home s value or the taxpayer s financial condition. The amount excluded reduces the taxpayer s cost basis in the home. Canceled qualified principal residence indebtedness cannot be excluded from income if the cancellation was for services performed for the lender or on account of any factor not directly related to a decline in the value of the residence or the taxpayer's financial condition. Under this provision a borrower can be excused from paying tax on forgiven home mortgage debt (up to $2 million), so long as the debt is secured by a principal residence and the total amount of the outstanding mortgage does not exceed the original purchase price plus the cost of improvements. Thus, the cancelation of mortgage debt rules provides relief to a limited number of taxpayers. Example: Assume a family purchased their home for $175,000, with a mortgage of $150,000. Later, they need to sell the home due to a change in employment. They find that the value of homes in their area has declined and they can sell for only $120,000. At the time of the sale, the outstanding balance on their mortgage is $132,000. Thus, there will not be enough cash at settlement to repay the lender the full balance of the mortgage. If the lender forgives the entire difference between the amount owed and the sales price, the debt forgiven will be $12,000. Lenders might forgive some portion of mortgage debt in a sale known as a short sale (as in the example, when the sales price is less than the amount owed), in foreclosure, or when there is no sale, but the lender agrees to reduce the outstanding balance on a refinanced mortgage. Most current version Mortgage Forgiveness Debt Relief Act. A version of the mortgage relief provision passed the House in 1999 and 2000, but was not enacted. The rules of current law were enacted in 2007 as part of H.R. 3648, a bill focused solely on housing issues. The original rules were effective from January 1, 2007 through December 31, The provision was extended through December 31, 2012 in 2008, and it was again extended through 2013 in the American Taxpayer Relief Act of Next, the Tax Increase Prevention Act of 2014 extended the provision through the end of The most recent extension was for two years (through December 31, 2016) in the Protecting American Taxpayers from Tax Hikes (PATH) Act of

121 The relief provision can apply to either an original or a refinanced mortgage. If the mortgage has been refinanced at any time, the relief is available only up to the amount of the original debt used to acquire the residence (plus the cost of any improvements). Thus, if the original mortgage was $125,000 and the homeowner later refinanced in a cash-out arrangement for a debt totaling $140,000, the $15,000 cash-out is not eligible for relief if a lender later forgives some amount related to the cash-out. Relief is generally not available for second mortgages or home-equity lines of credit where the funds are not used for home improvement. Form 982. This Form is divided into three sections: 1) The Exclusion Options to exclude canceled debt from income, 2) The Reduction of Tax Attributes and 3) Adjustment of Basis for Corporations. 113

122 One Form 982 It is possible that a taxpayer can have multiple discharges of debt during the year or use multiple exclusion methods for a single discharge of debt. However, only one Form 982 can be submitted. The instructions for the 982 indicate to check the appropriate box(es) indicating the type of exclusion or exclusions used. This can create some confusion if the exclusion of income or reduction of attributes is subsequently challenged. It is recommended that a separate Form 982 be completed as a worksheet, for each separate event and each different exclusion method used for each event. Number them in sequence and combine the results for the single Form 982 to be filed. Keep them in case they are required in an audit. Exclusion under a Title 11 bankruptcy case (Form 982 Part I. Line 1a). In general, when an individual files a Chapter 7 (liquidation) or Chapter 11 (reorganization) petition, a bankruptcy estate is established. A bankruptcy estate is treated as a separate taxable entity from the individual debtor and generally includes all legal and equitable interests in property of the debtor as of the initiation of the case. A bankruptcy estate continues until the bankruptcy proceeding is closed and the bankruptcy trustee is responsible for filing the estate s tax returns and paying its taxes (Sec 6012(b)(4)). When a bankruptcy petition is filed tax attributes of the individual debtor that existed on the first day of the debtor s taxable year (i.e., January 1st) are deemed to be transferred to the bankruptcy estate. (Sec 1398(g)) These tax attributes include: 1. NOL Carryovers 2. Charitable contribution carryovers 3. Recovery of tax benefit items 4. Tax credit carryovers 5. Capital loss carryovers 6. Asset basis 7. Asset holding periods 8. Character of assets 9. Method of accounting 10. Unused passive losses 11. Unused losses limited by at risk rules 12. Principal residence exclusion 13. and other tax attributes as provided by the regulations 114

123 If a debtor excludes canceled debt from income because it is canceled in a bankruptcy case, he or she must use the excluded amount to reduce certain tax attributes. By reducing the tax attributes, the tax on the canceled debt is partially postponed instead of being entirely forgiven. This prevents an excessive tax benefit from the debt cancellation. If a separate bankruptcy estate was created, the trustee or debtor-inpossession must reduce the estate's attributes (but not below zero) by the canceled debt. If the debtor is an individual who files for bankruptcy under chapter 11, the bankruptcy estate is treated as a new taxable entity, separate from the individual taxpayer. In chapter 11, the debtor often remains in control of the assets as a debtor-inpossession and acts as the bankruptcy trustee. Bankruptcy under Chapter 11 If the debtor filed a chapter case, the debtor must file a Form 1040 for the tax year involved or Form 1041 if taxpayer (s) remain as the debtor-in-possession. If the debtor is an individual in a chapter 11 bankruptcy, the income, deductions, or credits that belong to the bankruptcy estate are not included on Form In an individual bankruptcy under Chapter 7 or 11 of title 11, the required reduction of tax attributes must be made to the attributes of the bankruptcy estate, a separate taxable entity resulting from the filing of the case. The trustee of the bankruptcy estate must make the choice of whether to reduce the basis of depreciable property first before reducing other tax attributes. Upon termination of the bankruptcy estate, the unused portions of the same tax attributes are deemed to be transferred back to the debtor (Sec 1398(i)). COD income that results from a bankruptcy discharge is reportable on the return for the bankruptcy estate. For Chapter 7 and 11 cases, the tax attributes to be reduced are those of the bankruptcy estate not the individual debtor (Sec 108(d)(8)). To show that the taxpayers debt was canceled in a bankruptcy and is excluded from income, use Form 982 checking the box on line 1a. Lines 1b through 1e do not apply to a cancellation that occurs in a title 11 bankruptcy case. Enter the total amount of debt canceled in the title 11 bankruptcy case on line 2. Taxpayers must also reduce their tax attributes in Part II of Form

124 Review Questions Section 8 Read and answer the following review questions. The correct answers are found on the next page with an explanation to strengthen up your knowledge. Note: This is not part of your Final Test. 64. Mike wants to take depletion for a mineral property located in the country; what is the requirement in order for Mike to take depletion on the mineral property. a) He must be the only person with economic interest in the property. b) He must have the legal right to income from the extraction of the mineral. c) The depletion cannot be taken for a leased property. d) He is not required to have an economic interest on the property. 65. Taxpayers can get the energy tax credit for solar panels installed on their principal residence; in general the credit is given in one of the following ways: a) The credit is applied to reduce the taxable income and thus reduce the taxable amount. b) The credit is used to reduce any tax liability and the remaining balance will be refunded to taxpayer. c) The credit is used to reduce any tax liability and any remaining balance will be carried forward. d) The credit is used to reduce any tax liability and any remaining balance is lost. 66. In case taxpayers get their solar panels for their principal home in 2016 using a lease agreement, the credit will be: a) The credit will be reduced by 50% because taxpayer will not own the panels at the end of the lease. b) The credit will be denied because taxpayers are not purchasing the solar panels. c) The credit can be taken in full even if taxpayer is using a lease agreement to get the solar panels. d) The credit will be reduced in 70% 67. In general, leasing the solar panels or install them using a Power Purchase Agreement (PPA) indicate that taxpayers. a) Taxpayers are the real owners of the solar panels. b) Taxpayers are not the owner of the solar panels; instead the leasing company takes any credit because they are the real owner. c) Taxpayers are not the owner of the solar panels but the leasing company will force the IRS to give them the tax energy credit. d) Taxpayers are the owners and can take the credit while the solar panels are installed at taxpayers home. 68. Canceled Debt income exists where: a) Debt for which the taxpayer is personally liable is forgiven. b) Debt for which the taxpayer is not personally liable is forgiven. c) None of the above. d) Both of the above. 116

125 69. The tax impact of a canceled debt will depend on. e) The type of debt f) The loan proceeds reported in income g) The type of lender h) None of the above 70. Abandonment of property exists where: i) Property is secured by recourse debt j) Property is secured by nonrecourse debt k) Property is repossessed l) Ownership of property is given up. 71. Which statement is incorrect with respect to recourse loans? m) The lender may hold the borrower personally responsible for the full face value of the loan. n) Gain or loss from a disposition of the property cannot be determined o) Taxpayer has no gain until the foreclosure is completed p) Most refinanced loans are recourse loans. q) None of the above. 72. Which of the following lenders would not be required to issue Form 1099-A or 1099-C after acquiring real property that had secured a loan on which the buyer has stopped making payments? r) A savings and loan. s) A credit union. t) An individual who sold his principal residence on the installment basis. u) All of the above. v) None of the above. Questions Section 8 Answers and Discussion 64. Answer b. Taxpayers that have an economic interest in mineral property or standing timber can take a deduction for depletion. More than one person can have an economic interest in the same mineral deposit or timber. In the case of leased property, the depletion deduction is divided between the lessor and the lessee. Taxpayers are considered to have an economic interest if both the following conditions apply: Taxpayers have acquired by investment any interest in mineral deposits or standing timber. Taxpayers have a legal right to income from the extraction of the mineral or cutting of the timber to which they must look for a return of their capital investment. 65. Answer c. This tax incentive is a tax credit that reduces any tax liability. If the taxpayer owes taxes to the IRS, the credit will be applied towards the tax itself. The tax incentive cannot be used to reduce the taxable income; the credit only applies to any tax liability and is not refundable for taxpayers that do not owe taxes. The portion of the credit not used can be carried over. 117

126 66. Answer b. Taxpayers that do not pay for their solar system up front will use a solar lease agreement or a Power Purchase Agreement (PPA). These arrangements do not qualify for the tax credit. 67. Answer b. Taxpayers that installed their solar system with a solar lease or a solar PPA are not eligible for the tax credit because the leasing company owns the solar system, so they will receive the Energy Tax Credit. Some companies take into consideration the value of the 30% tax credit when calculating the lease rate. 68. There is no COD income where the debtor is not personally liable for the debt. That is where the lender s only recourse is against the property secured by the debt. Therefore the correct answer is A. 69. The tax impact depends on the type of debt - recourse or nonrecourse. The Proceeds are not included in income because you have an obligation to repay the lender. The type of lender and borrower does not have any impact on tax impact. Therefore the correct answer is A. 70. The abandonment of property is when you voluntarily and permanently give up possession and use of the property with the intention of ending your ownership but without passing it on to anyone else. Thus, D is the correct answer. 71. Recourse loans allow the lender to hold a borrower personally responsible for the full face value of the loan. If the reacquired property is not valuable enough to pay off the note, then there could be a gain. Refinanced loans, second mortgages and home improvement loans are usually recourse. The correct answer is B because the gain or loss on a disposition is generally determined by the difference between the FMV of the property and the adjusted basis. 72. Issuance of a Form 1099-A or 1099-C is only mandatory for financial institutions, credit unions, federal government agencies or others in the business of lending money if the debt relief is $600 or more. Thus, a loan or sale by an individual taxpayer does not trigger that reporting requirement. Therefore, only answer C is correct. 118

127 Exclusion under Insolvency (Form 982 Part I. Line 1b). If the indebtedness is canceled when the debtor is insolvent (but not in a bankruptcy case), the discharge is excluded from the debtor's gross income up to the amount of the insolvency (Sec 108(a)(1)(B)). When is Insolvency Determined? The insolvency is determined immediately before the debt is canceled. (Code Sec. 108(d)(3)). The taxpayer's financial status immediately after the discharge is irrelevant. Do not include a canceled debt in income to the extent that the taxpayer was insolvent immediately before the cancellation. Taxpayers were insolvent immediately before the cancellation to the extent that the total of all of their liabilities were more than the Fair Market Value (FMV) of all of their assets immediately before the cancellation. Liabilities include: The entire amount of recourse debts, The amount of nonrecourse debt that is not in excess of the FMV of the property that is security for the debt, and The amount of nonrecourse debt in excess of the FMV of the property subject to the nonrecourse debt to the extent nonrecourse debt in excess of the FMV of the property subject to the debt is forgiven. Coordinating Exclusions. 1) If an exclusion of income is registered under a Bankruptcy Title 11 all others do not apply. 2) If an exclusion of income is registered under Insolvency, then the qualified farm exclusion and qualified real property business exclusion do not apply to a discharge to the extent the taxpayer is insolvent. 3) If an exclusion of income is registered under principal residence exclusion, then the insolvency exclusion do not apply unless elected otherwise. Only one can be chosen. Insolvency does not apply to: This exclusion under insolvency does not apply to a cancellation of debt that occurs in a title 11 bankruptcy case. Exclusion under insolvency does not apply if the debt is qualified principal residence indebtedness, unless you elect to apply the insolvency exclusion instead of the qualified principal residence indebtedness exclusion. How to Exclude COD under Insolvency Use Form 982. Check the box on line 1b. On line 2, include the smaller amount of the debt canceled or the amount by which you were insolvent immediately before the cancellation. You must also reduce your tax attributes in Part II. 119

128 Exclusion under Insolvency Worksheet. Taxpayers can use the Insolvency Worksheet, to calculate the extent that you were insolvent immediately before the cancellation. Date debt was canceled (mm/dd/yy) Part I. Total liabilities imm ediately before the cancellation (do not include the sam e liability in more than one category) Amount Owed Imm ediately Liabilities (debts) Before the Cancellation 1. Credit card debt $ Mortgage(s) on real property (including first and second mortgages and hom e equity loans) 2. (m ortgage(s) can be on personal residence, any additional residence, or property held for $ investm ent or used in a trade or business) 3. Car and other vehicle loans $ 4. Medical bills owed $ 5. Student loans $ 6. Accrued or past - due m ortgage interest $ 7. Accrued or past - due real estate taxes $ 8. Accrued or past - due utilities (water, gas, electric) $ 9. Accrued or past - due child care costs $ 10. Federal or state income taxes remaining due (for prior tax years) $ 11. Judgm ents $ 12. Business debts (including those owed as a sole proprietor or partner) $ Margin debt on stocks and other debt to purchase or secured by investment assets other than real 13. $ property 14. Other liabilities (debts) not included above $ 15. Total liabilities immediately before the cancellation. Add lines 1 through 14. $ Part II. Fair market value (FMV) of assets owned imm ediately before the cancellation (do not include the FMV of the same asset in m ore than one category) FMV Immediately Assets Before the Cancellation 16. Cash and bank account balances $ Homes (including the value of land) (can be main home, any additional hom e, or property held for 17. $ investm ent or used in a trade or business) 18. Cars and other vehicles $ 19. Computers $ 20. Household goods and furnishings (for exam ple, appliances, electronics, furniture, etc.) $ 21. Tools $ 22. Jewelry $ 23. Clothing $ 24. Books $ 25. Stocks and bonds $ 26. Investments in coins, stamps, paintings, or other collectibles $ 27. Firearms, sports, photographic, and other hobby equipm ent $ 28. Interest in retirement accounts (IRA accounts, 401(k) accounts, and other retirement accounts) $ 29. Interest in a pension plan $ 30. Interest in education accounts $ 31. Cash value of life insurance $ 32. Security deposits with landlords, utilities, and others $ 33. Interests in partnerships $ 34. Value of investment in a business $ Other investm ents (for exam ple, annuity contracts, guaranteed investm ent contracts, m utual funds, 35. $ comm odity accounts, interests in hedge funds, and options) 36. Other assets not included above $ 37. FMV of total assets immediately before the cancellation. Add lines 16 through 36. $ Part III. Insolvency 38. Amount of Insolvency. Subtract line 37 from line 15. If zero or less, you are not insolvent. $ 120

129 Amount Excluded from Income Liabilities (X) ($15,000) Assets (Y) ($7,000) (FMV) Insolvency $C. X-Y = C ($8,000) (This amount can be excluded from income) Reduction of Tax Attributes. If the canceled debt is excluded by reason of the bankruptcy Title 11 or Insolvency, taxpayers must use the excluded debt to reduce the tax attributes. The taxpayer may elect to apply any portion of the reduction to reduce the basis of the depreciable property of the taxpayer. If taxpayer has tax attributes, they must be reduced to the extent of the insolvency exclusion. If the attributes are less than the exclusion, they are simply reduced to zero (but not below zero) and the debtor is still able to exclude the debt to the extent of insolvency. If a separate bankruptcy estate was created, the trustee or debtor-in-possession must reduce the estate's attributes (but not below zero) by the canceled debt. Where to reduce the Tax Attributes Use Part II of Form 982 to reduce your tax attributes. The order in which the tax attributes are reduced depends on the reason the canceled debt was excluded from income. If the total amount of canceled debt excluded from income (line 2 of Form 982) was more than your total tax attributes, the total reduction of tax attributes in Part II of Form 982 will be less than the amount on line

130 Information about Tax Attributes Taxpayer's tax attributes are: Aspects of Reducing the Tax Attributes When reducing NOL or capital loss carryovers, the reduction in tax attributes must be in the order of the taxable years that each carryover was created in. Net operating loss (NOL) of the taxable year of the cancellation NOL carryover to the taxable year of the cancellation General business credit - Any carryover to or from the taxable year of a cancellation of an amount for purposes in determining the amount allowable as a credit under 26 U.S.C. 38 (relating to general business credit) Minimum tax credit available under 26 U.S.C. 53(b) as of the beginning of the tax year immediately following the taxable year of the cancellation Net capital loss of the taxable year of the discharge Capital loss carryover to the taxable year of the cancellation Basis reduction of the property of the taxpayer Passive activity loss and credit carryovers under 26 U.S.C. 469(b) from the taxable year of the cancellation Foreign tax credit carryovers to or from the taxable year of the cancellation for purposes of determining the amount of the credit allowable under 26 U.S.C. 27 Reducing the Tax Attributes prevents creating a new tax burden on insolvent and bankrupt taxpayers, who are likely in a situation where they financially need that benefit, and who would likely be difficult or impossible to collect from. Reducing the taxpayer's tax attributes does not create a new tax burden on the taxpayer. It instead reduces tax credits and carryforwards that would be used to offset future earned income. If a taxpayer's tax attributes were not reduced, taxpayers could intentionally create large tax attributes by creating debt, canceling the debt, and unjustly reducing their future taxes without paying on the debt. For example, a taxpayer could intentionally run up large amounts of business debt and losses, creating a large NOL. Then, after filing a bankruptcy to wipe out the debt, they could use the NOL carryforward for up to twenty years or until it was exhausted. The reductions in tax attributes are dollarfor-dollar to the amount of excluded COD income for the: NOL, capital loss carryover, and basis reduction. The reductions in tax attributes are 33 1/3 cents-for-dollar of amount of excluded COD income for the: general business credit, maximum tax credit, passive activity loss and credit carryovers, and foreign tax credit carryovers. 122

131 Form 982. Part I Exclusion under one of the following: Insolvency. (Line 1b) Enter excluded income on Line 2 NO Form 982 Part II Reduction of Basis first? Section 108 (b) YES THEN Line Form 982 THEN Line 5. Form 982 Form 982 Part II Reduction of Tax Attributes is made in the following order: Section 108 (b)((2) Line 6 1) Net Operating Loss Line 7 2) General business credit Line 8 3) Minimum tax credit Line 9 4) Capital loss carryovers Line 10a 5) Basis reduction Line 12 6) Passive activity loss and credit carryovers Line 13 7) Foreign tax credit carryovers: Reduction of the Basis of Depreciable Assets Section 108(b)(5) The basis reduction limitation that normally applies to insolvency does not apply when the election to reduce basis of depreciable assets is made first (Sec 1017(b)(2)). RATE OF REDUCTION Loss Carryovers: Dollar for Dollar Credit Carryovers 33 1/3 Cents of credit for each dollar excluded. Sec 108(b)(3) Form 982. Part II Line 5 Basis Reduction Limitation The basis reduction is limited to the taxpayer s insolvency immediately after the discharge (Sec 1017(b)(2)). FMV of Assets Liabilities.. < > Limit.. (Not below Zero) 123

132 When Are the Tax Attributes Reduced? The reductions are generally made after the tax is computed for the tax year of the discharge. That means a calendar year taxpayer will adjust the attributes at the beginning of the year following to the debt relief year. Thus, the debtor can utilize many of the attributes in the year of the relief. (Code Sec. 108(b)(4)(A)). How to Reduce the Tax Attributes. The reduction of following Tax Attributes is made in the following order: 1) Net Operating Loss: Any net operating loss for the taxable year of the discharge, and any net operating loss carryover to such taxable year. 2) General business credit: Any carryover to or from the taxable year of a discharge of an amount for purposes on determining the amount allowable as a credit under section 38 (relating to general business credit). 3) Minimum tax credit: The carryover amount to the year immediately following the taxable year of the discharge is reduced $1 for each $3 of debt relief. 4) Capital loss carryovers: First, reduce any net capital loss and then any capital loss carryover. Reduce the capital loss or carryover by one dollar for each dollar of excluded canceled debt. 5) Basis reduction: The bases of the property held are reduced at the beginning of the year following the year of debt cancellation. Here again, there is a strict order for which property bases are reduced first: a) Trade, business or held for investment property purchased with the proceeds of the debt that was forgiven; b) Personal property used in trade, investment or business securing the loan; c) All other trade or business assets; d) Inventory and notes and accounts receivable; e) Property held for investment; f) Personal-use property. Reduce the basis by one dollar for each dollar of excluded canceled debt. However, the reduction cannot be more than the excess of the total bases of the property and the amount of money you held immediately after the debt cancellation over your total liabilities immediately after the cancellation. 6) Passive activity loss and credit carryovers: Reduce the loss carryover by one dollar for each dollar of excluded canceled debt. Reduce the credit carryover by $1 for each $3 of excluded canceled debt. 7) Foreign tax credit carryovers: Reduce the credit carryovers in the order in which they are taken into account. Reduce the carryover by $1 for each $3 of excluded canceled debt. 124

133 Electing to Reduce the Basis of Depreciable Property before Reducing the Tax Attributes. Rather than reduce other tax attributes first, a taxpayer can elect (on Form 982) to apply any or the entire canceled debt amount first to reduce his basis in depreciable assets (or real property held as inventory) before any other tax attributes are reduced under the normal ordering rules. (Code Sec. 108(b)(5)(A)) This special rule may be attractive to taxpayers who have net operating losses or other attributes that can be carried over and used in subsequent years and where the concern for basis reduction is a secondary issue. However, it should be noted that if the basis reduction is insufficient to offset the COD income, then the other tax attributes must be reduced beginning in the normal manner. Basis of property is reduced in the following order. 1. Depreciable real property used in your trade or business or held for investment that secured the canceled debt. 2. Depreciable personal property used in your trade or business or held for investment that secured the canceled debt. 3. Other depreciable property used in your trade or business or held for investment. 4. Real property held primarily for sale to customers if you elect to treat it as if it were depreciable property on Form 982. Taxpayers must attach a statement describing the transactions that resulted in the reduction in basis under section 1017 and identifying the property for which you reduced the basis. If you do not make the election on line 5, then reduce the tax attributes completing lines 6 through 13 (excluding line 10b). Reason for Making the Basis Reduction Election. This election is generally made by a debtor who wants to preserve the Net Operating Loss deduction, General Business Credit, Alternative Minimum Tax Credit, and Capital Loss Carryovers. If the taxpayer does not have sufficient depreciable property basis to cover the excluded debt income he may acquire additional up to end of the year of discharge. However, the reduced basis will recapture as ordinary income when and if the property whose basis was reduced is sold. Therefore, the decision is whether to utilize the tax benefit currently and suffer the consequences in the future. Special Election Dealers in Real Property. Dealers in real property may elect to treat real property held for sale in the ordinary course of business as depreciable. This election must be made on the original return for the year of debt forgiveness and can only be revoked or elected on a later return with reasonable cause and IRS consent. (Sec. 1017(b)(3)(E)) 125

134 Example 1 amount of insolvency more than canceled debt. In 2015, Greg was released from his obligation to pay his personal credit card debt in the amount of $5,000. Greg received a 2015 Form 1099-C from his credit card lender showing canceled debt of $5,000 in box 2. None of the exceptions to the general rule that canceled debt is included in income applies. Greg uses the insolvency worksheet to determine that his total liabilities immediately before the cancellation were $15,000 and the FMV of his total assets immediately before the cancellation was $7,000. This means that immediately before the cancellation, Greg was insolvent to the extent of $8,000 ($15,000 total liabilities minus $7,000 FMV of his total assets). Because the amount by which Greg was insolvent immediately before the cancellation was more than the amount of his debt canceled, Greg can exclude the entire $5,000 canceled debt from income. Example 2 amount of insolvency less than canceled debt. The facts are the same as in Example 1 except that Greg's total liabilities immediately before the cancellation were $10,000 and the FMV of his total assets immediately before the cancellation was $7,000. In this case, Greg is insolvent to the extent of $3,000 ($10,000 total liabilities minus $7,000 FMV of his total assets) immediately before the cancellation. Because the amount of the canceled debt was more than the amount by which Greg was insolvent immediately before the cancellation, Greg can exclude only $3,000 of the $5,000 canceled debt from income under the insolvency exclusion. Greg checks the box on line 1b of Form 982 and includes $3,000 on line 2. In addition, Greg completes Part II to reduce his tax attributes. Additionally, Greg must include $2,000 of canceled debt on line 21 of his Form 1040 (unless another exclusion applies). Exclusion under Qualified Farm Indebtedness (Form 982 Part I. Line 1c). Qualified farm indebtedness is the amount of indebtedness incurred directly in connection with the trade or business of farming. In addition, 50% or more of the aggregate gross receipts for the 3 tax years preceding the tax year in which the discharge of such indebtedness occurs must be from the trade or business of farming. Reduction of Tax Attributes. Taxpayers that exclude canceled debt from income under both the insolvency exclusion and the exclusion for qualified farm indebtedness must first reduce their tax attributes by the amount excluded under the insolvency exclusion. Then reduce the remaining tax attributes (but not below zero) by the amount of canceled debt that qualifies for the farm debt exclusion. 126

135 The tax attributes for canceled qualified farm indebtedness are reduced in the same following order. 1) Net Operating Loss: Any net operating loss for the taxable year of the discharge, and any net operating loss carryover to such taxable year. 2) General business credit: Any carryover to or from the taxable year of a discharge of an amount for purposes for determining the amount allowable as a credit under section 38 (relating to general business credit). 3) Minimum tax credit: The carryover amount to the year immediately following the taxable year of the discharge is reduced $1 for each $3 of debt relief. 4) Capital loss carryovers: First, reduce any net capital loss and then any capital loss carryover. Reduce the capital loss or carryover by one dollar for each dollar of excluded canceled debt. Reduction of Bases of Qualified Property. Under qualified farm indebtedness, taxpayers have to reduce only the basis of qualified property. Qualified property is any property used or held for use in the trade or business or for the production of income. Reduce the basis of qualified property in the following order. 1. Depreciable qualified property. Taxpayers can elect, using Form 982, to treat real property held primarily for sale to customers as if it were depreciable property. 2. Land that is qualified property and is used or held for use in a farming business. 3. Other qualified property. A qualified person must have made the discharge. A qualified person generally means a lender who is unrelated to the debtor or to the seller of the property. In addition, a qualified person includes any federal, state or local government or agency or instrumentality of a government. (Code Sec. 108(g)(1)(B)). Rate of Reduction. Loss Carryovers: Dollar for Dollar Credit Carryovers 33 1/3 Cents of credit for each dollar excluded. Sec 108(b)(3) 127

136 NO Form 982 Part II Reduction of Tax Attributes Qualified Farm Indebtedness Check Box Line 1C Enter Excluded Income on Line 2 Reduction of Bases of Qualified Property first? YES THEN THEN Form 982 Part II Reduction of Tax Attributes is made in the following order: Section 108 (b)((2) Line 6 1) Net Operating Loss Line 7 2) General business credit Line 8 3) Minimum tax credit Line 9 4) Capital loss carryovers Reduction of the Basis of Depreciable Property Section 108(b)(5) Qualified property means any property used or held for use in a trade or business or for the production of income. (Code Sec. 108(g)(3)(C)) Reduce the basis of qualified property in the following order. Line 11a. (1)Depreciable qualified property held primarily for sale to customers as if it were depreciable property. Line 11b. (2)Land that is qualified property and is used or held for use in your farming business. Line 11c. (3)Other qualified property. Line 12 Passive activity loss and credit carryovers Line 13 Foreign tax credit carryovers. 128

137 Review Questions Section 9 Read and answer the following review questions. The correct answers are found on the next page with an explanation to strengthen up your knowledge. Note: This is not part of your Final Test. 73. If a debtor receives a cancellation of debt due to the insolvency, he/she will be able to exclude the following amount of debt from income. a) Taxpayers can exclude from gross income any amount of debt cancelled under insolvency. b) Taxpayers can exclude from gross income the amount cancelled up to the insolvency amount. c) Taxpayer cannot exclude any amount from gross income if the debt was cancelled under insolvency. d) Taxpayers can exclude from gross income only 50% of the amount cancelled under insolvency. 74. Timing the insolvency is important because taxpayers will be able to exclude from gross income the following amount: a) The amount cancelled after the taxpayer was insolvent. b) The amount cancelled immediately before the taxpayer was insolvent. c) Taxpayers can deduct any amount under insolvency. d) None of the above. 75. Taxpayers will be considered insolvent before the cancellation only if one of the following occurs: a) Taxpayers liabilities are more than the Fair Market Value (FMV) of all their assets after the cancellation. b) Taxpayers liabilities equal the Fair Market Value (FMV) of taxpayer s assets one year before the cancellation occurs. c) Taxpayers liabilities are more than the Fair Market Value (FMV) of all their assets immediately before the cancellation occurs. d) None of the above. 76. To exclude cancelled debt from gross income taxpayers have to coordinate their exclusion options; which of the following is NOT an option when coordinating exclusions: a) Taxpayers that use an exclusion of income under Bankruptcy Title 11 will not use any of the other options. b) Taxpayers that exclude income under insolvency will not use the qualified farm exclusion or the qualified real property business exclusion. c) Taxpayers that exclude income under principal residence exclusion will not use the insolvency unless elected otherwise. d) All of the above are correct ways to coordinate the exclusions. 129

138 77. John wants to exclude income under Insolvency exclusion, how much can John exclude? a) The total amount of debt before it is canceled b) The total amount of debt that is based on John s financial status immediately after the discharge. c) $250,000 ($125,000 for Married Filing Separately) d) The total amount of insolvency e) None of the above 78. Insolvency exists when one of the following occurs: f) Your total liabilities are greater than the assets after the cancellation of debt g) The insolvency is determined when the amount of nonrecourse equals the FMV of assets h) Your Tax Attributes are greater than your assets i) Your total liabilities were more than the FMV of all your assets before the cancellation of debt 79. The following is not required to exclude income under Insolvency in Form 982. j) Check box on line 1b k) Include on line 2 the amount of insolvency if less than the amount of canceled debt l) Increase your Tax Attributes on Part II m) Include on line 2 the amount of canceled debt if it is more than the insolvency amount. 80. Tax Attributes includes the following, except: n) Net Operating Loss (NOL) of the taxable year of the cancellation o) General business credit from the taxable year of cancellation p) Passive activity loss and credit carryovers from the taxable year of the cancellation q) Net capital loss of the taxable year of the discharge r) None of the above 81. If the canceled debt is excluded by reason of insolvency then the excluded debt is used to: s) Reduce the tax attributes but not below zero t) Reduce the basis of the depreciable property u) Increment the tax attributes for future use v) A and b are correct w) None of the above Questions Section 9 Answers and Discussion 73. Answer b. If the indebtedness is canceled when the debtor is insolvent (but not in a bankruptcy case), the discharge is excluded from the debtor's gross income up to the amount of the insolvency (Sec 108(a)(1)(B)). 74. Answer b. The insolvency is determined immediately before the debt is canceled. (Code Sec. 108(d)(3)). The taxpayer's financial status immediately after the discharge is irrelevant. Do not include a canceled debt in income to the extent that the taxpayer was insolvent immediately before the cancellation. 130

139 75. Answer c. Taxpayers were insolvent immediately before the cancellation to the extent that the total of all of their liabilities were more than the Fair Market Value (FMV) of all of their assets immediately before the cancellation. 76. Answer d. Taxpayers can exclude cancelled debt by using the available exclusions; they have to be used in order using the following coordination of exclusions: 1. If an exclusion of income is registered under a Bankruptcy Title 11 all others do not apply. 2. If an exclusion of income is registered under Insolvency, then the qualified farm exclusion and qualified real property business exclusion do not apply to a discharge to the extent the taxpayer is insolvent. 3. If an exclusion of income is registered under principal residence exclusion, then the insolvency exclusion do not apply unless elected otherwise. Only one can be chosen. 77. Based on Sec 108 (a)(1)(b) If the indebtedness is canceled when the debtor is insolvent (but not in a bankruptcy case), the discharge is excluded from the debtor's gross income up to the amount of the insolvency. Thus D is the correct answer. 78. You were insolvent immediately before the cancellation to the extent that the total of all of your liabilities was more than the FMV of all of your assets immediately before the cancellation. The financial status immediately after the discharge is irrelevant. Therefore D is the correct answer. 79. Whenever you exclude COD under Insolvency you have to include on line 2 the smaller of the amount of the debt canceled or the amount by which you were insolvent immediately before the cancellation. Therefore D is the correct answer. 80. Taxpayer s tax attributes includes: Net Operating Loss (NOL) of the taxable year of the cancellation, General business credit from the taxable year of cancellation, Passive activity loss and credit carryovers from the taxable year of the cancellation, Net capital loss of the taxable year of the discharge. All of these are included in taxpayer s tax attributes. Thus D is the correct answer. 81. If the canceled debt is excluded because of the bankruptcy Title 11 or Insolvency you must use the excluded debt to reduce the tax attributes. The taxpayer may elect to apply any portion of the reduction to reduce the basis of the depreciable property. One of these options is valid in this case. Thus, D is correct. 131

140 Exclusion under Qualified Real Property Business Indebtedness (Form 982 Part I. Line 1d). The exclusion of income from the discharge of qualified real property business indebtedness applies only to taxpayers who are not C corporations and applies only where the insolvency exception does not apply (Code Sec. 108(a)(2)(B)). Definition of Qualified Real Property Business Indebtedness. Qualified real property business indebtedness is indebtedness (other than qualified farm indebtedness) that: a) Is incurred or assumed in connection with real property used in a trade or business, b) Is secured by that real property, and c) With respect to which taxpayers have made an election under this provision. This provision does not apply to a corporation (other than an S corporation). Indebtedness incurred or assumed after 1992 is not qualified as real property business indebtedness unless it is either: a) Debt incurred to refinance qualified real property business indebtedness incurred or assumed before 1993 (but only to the extent the amount of such debt does not exceed the amount of debt being refinanced) or b) Qualified acquisition indebtedness. Definition of Qualified Acquisition Indebtedness. Qualified acquisition indebtedness is: a) Debt incurred or assumed to acquire, construct, reconstruct, or substantially improve real property that is secured by such debt and b) Debt resulting from the refinancing of qualified acquisition indebtedness to the extent the amount of such debt does not exceed the amount of debt being refinanced. Taxpayers cannot exclude more than the excess of the outstanding principal amount of the debt (immediately before the discharge) over the net Fair Market Value (as of that time) of the property securing the debt reduced by the outstanding principal amount of other qualified real property business indebtedness secured by that property (as of that time). The amount excluded is further limited to the aggregate adjusted basis (as of the first day of the next tax year or, if earlier, the date of disposition) of depreciable real property (determined after any reductions under sections 108(b) and (g)) held immediately before the discharge (other than property acquired in contemplation of the discharge). Any excess is included in income. Reduction of Basis of Depreciable Real Property. If taxpayers make an election to exclude canceled qualified real property business debt from income, they must reduce the basis of their 132

141 depreciable real property (but not below zero) by the amount of canceled qualified real property business debt excluded from income. When to Make the Basis Adjustment? If taxpayer retains the Property, the basis adjustment takes effect on the first day of the tax year following the tax year in which the discharge takes place. (Code Sec. 1017(a)) If taxpayer disposes of the real property before the beginning of the next tax year, the reduction in basis is made immediately before the disposition of the property. Code Sec. 1017(b)(3)(F)(iii). WHEN TO MAKE THE BASIS ADJUSTMENT If the business property subject to cancellation of debt is sold (or foreclosed upon) in year of debt relief, adjust the basis of the affected property to the extent allowable immediately before the disposition. Make all other appropriate business property basis adjustments (and corresponding depreciation adjustments) effective January 1 of the subsequent Year. YEAR 1 FOLLOWING YEAR Cancellation of Debt 133

142 Form 982. Qualified Real Property Business Indebtedness Check Box Line 1d Enter excluded income on Line 2 IMPORTANT The amount excludable on line 2 Is limited to and must match the Amount of the basis adjustment On form 982 line 4. Any excess Is taxable on 1040 Line 21. Form 982 Part II Line 4 Reduce the Basis of Depreciable Assets Basis Reduction Limitation The Basis reduction is limited to the taxpayer s Mortgage over FMV and Mortgage Over Basis limit in depreciable properties (basis Cannot be reduced below zero) How to elect the qualified real property business debt exclusion? Taxpayers must make an election to exclude canceled qualified real property business debt from gross income. The election must be made on a timely filed (including extensions) federal income tax return for the current year and can be revoked only with IRS consent. The election is made on Form 982. Send it with the income tax return. Include the amount of canceled qualified real property business debt (but not more than the amount of the exclusion limit) on line 2 of Form 982. If taxpayers timely filed their tax return without making this election, they can still make the election by filing an amended return within 6 months of the due date of the return (excluding extensions). Enter Filed pursuant to section on the amended return and file it at the same place they filed the original return. 134

143 Exclusion under Qualified Principal Residence Indebtedness (Form 982 Part I. Line 1e). This exclusion applies where a taxpayer: Restructures the acquisition debt on a principal residence, Loses a principal residence in a foreclosure, or Sells a principal residence in a short sale. There are also some requirements to exclude income under Qualified Principal Residence Indebtedness The home was never used in a business or as rental property The debt was not canceled because the taxpayer filed bankruptcy (Form 1099-C, box 6 is not checked) The taxpayer is not in bankruptcy. Form 1099-C, box 3 does not include an amount for interest If taxpayers do not meet these requirements, they may exclude income under Insolvency, Bankruptcy or Qualified Real Property Business Indebtedness. Principal Residence. A principal residence is generally the home where the taxpayer lives most of the time. A taxpayer can have only one principal residence at a time C: A financial institution, credit union, federal government agency or others in the business of lending money must issue a 1099-C if the debt relief is $600 or more. Individual lenders such as the seller of the property are not required for file the 1009-C. This form will generally provide the information needed to determine the amount of debt relief. The 1099-C can be issued for a variety of circumstances related to debt forgiveness including credit card debt, vehicle repossessions, home foreclosures, etc. Forms 1099-A: A lender who acquires an interest in a property through foreclosure or repossession should issue Form 1099-A showing the information needed to figure the taxpayer s gain or loss. However, if the lender also cancels part of the debt and must file Form 1099-C, the lender can include the information about the foreclosure or repossession on 1099-C form instead of Form 1099-A. The 1099-A includes the amount of the debt relieved and the FMV of the property which should be the auction price. Taxpayer does not have a Form 1099-C or 1099-A yet? Because of the identifiable event rules the 1099-C may show up in a year other than the year when a 1099-A is issued. The IRS provides no special guidance in situations such as this even though the regulations acknowledge that the debt relief may have occurred prior to the issuance of the 1099-C. There are facts and circumstances, to help tax preparers, to determine when and if debt relief actually took place. It may not necessarily be in the year when the 1099-C was issued and may have not occurred at all. Financial institutions frequently do not actually relieve the debt in the 135

144 year of the foreclosure. Others may not relieve the debt at all in hopes of collecting on the liability in a future year before the state statute for the collection of a debt expires. When no 1099-C is issued there is generally no debt relief and a practitioner should exercise caution in arbitrarily adding COD income to a client s tax return. Where no 1099-C is issued and the practitioner has determined debt relief has occurred, the amount of the debt relieved is generally the amount in 1099-A Box 2 minus the amount in Box 4. Practitioners may wish to utilize the Form 8275 Disclosure Statement to provide an explanation of why the COD income was reported in a year when a 1099-C was not issued or why the COD income is not included in the year the 1099-C was issued. The Mortgage Forgiveness Debt Relief Act and Debt Cancellation. The Mortgage Debt Relief Act of 2007 generally allows taxpayers to exclude income from the discharge of debt on their principal residence. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualifies for the relief. Can I exclude debt forgiven on my second home, credit card, or car loans? Under this provision, only cancelled debt used to buy, build or improve your principal residence or refinance debt incurred for those purposes qualifies for this exclusion. What does exclusion of income mean? Normally, debt that is forgiven or cancelled by a lender must be included as income on your tax return and is taxable. But the Mortgage Forgiveness Debt Relief Act allows you to exclude certain cancelled debt on your principal residence from income. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualifies for the relief. I lost money on the foreclosure of my home. Can I claim a loss on my tax return? No. Losses from the sale or foreclosure of personal property are not deductible. Qualified Principal Residence Indebtedness. Qualified Principal Residence Indebtedness is any mortgage the taxpayer took out to buy, build, or substantially improve their main home. It must also be secured by the main home. Qualified principal residence indebtedness also includes any debt secured by taxpayers main home that is used to refinance a mortgage that was taken to buy, build, or substantially improve taxpayer s main home (Acquisition indebtedness), but only up to the amount of the old mortgage principal just before the refinancing. 136

145 Examples John refinanced his personal residence and used the loan proceeds from the equity in his home to build a new master bedroom suite on the main level of his house. This debt is qualified principal residence indebtedness. Bob refinanced his personal residence and used the loan proceeds from the equity in his home to pay off credit cards and buy a car. This debt is not qualified principal residence indebtedness. Exclusion Limit. The maximum amount you can treat as qualified principal residence indebtedness is $2 million ($1 million if married filing separately). You cannot exclude canceled qualified principal residence indebtedness from income if the cancellation was for services performed for the lender, or on account of any other factor not directly related to a decline in the value of your home or to your financial condition. Forgiveness ordering rule. If only a part of a loan is qualified principal residence indebtedness, the exclusion applies only to the extent the amount discharged exceeds the amount of the loan (immediately before the discharge) that is not qualified principal residence indebtedness. The exclusion does not apply to a taxpayer s designated 2nd (vacation) residence. The exclusion does not apply to the discharge of a loan, if the discharge is on account of services performed for the lender, or any other factor not directly related to a decline in the value of the residence, or to the taxpayer's financial condition. The exclusion only applies to the discharge of qualified principal residence acquisition debt. Thus equity debt is not included as part of the exclusion. Acquisition indebtedness of a principal residence is indebtedness incurred in the acquisition, construction, or substantial improvement of an individual's principal residence that is secured by the residence. It includes refinancing of debt to the extent the amount of the refinancing does not exceed the amount of the refinanced indebtedness. (Joint Committee on Taxation, JCX ) Debt used to refinance qualified principal residence indebtedness is eligible for the exclusion up to the amount of the old mortgage principal just before the refinancing. (H Rept No (PL ) p. 5) If the amount of the taxpayer's original mortgage is more than the cost of the principal residence plus the cost of any substantial improvements, only the debt that does not exceed the cost of the principal residence, plus improvements is qualified as principal residence indebtedness. (Form 982 Instructions, 3/2009, p. 4). 137

146 Example. Ken incurred recourse debt of $800,000 when he bought his main home for $880,000. When the FMV of the property was $1,000,000, Ken refinanced the debt for $850,000. At the time of the refinancing, the principal balance of the original mortgage loan was $740,000. Ken used the $110,000 he obtained from the refinancing ($850,000 minus $740,000) to pay off his credit cards and to buy a new car. About 2 years after the refinancing, Ken lost his job and was unable to get another job paying a comparable salary. Ken's home had declined in value to between $700,000 and $750,000. Based on Ken's circumstances, the lender agreed to allow a short sale of the property for $735,000 and to cancel the remaining $115,000 of the $850,000 debt. Under the ordering rule, Ken can exclude only $5,000 of the canceled debt from his income under the exclusion for canceled qualified principal residence indebtedness ($115,000 canceled debt minus the $110,000 amount of the debt that was not qualified principal residence indebtedness). Ken must include the remaining $110,000 of canceled debt in income on line 21 of his Form 1040 (unless another exclusion applies). Exclusion ordering rule. The principal residence exclusion takes precedence over the insolvency exclusion unless elected otherwise (Code Sec 108(a)(2)(C)). If only a part of a loan is qualified principal residence indebtedness, the exclusion from income for canceled qualified principal residence indebtedness applies only to the extent the amount canceled exceeds the amount of the loan (immediately before the cancellation) that is not qualified principal residence indebtedness. The remaining part of the loan may qualify for another Sec 108 exclusion. Adjustment of Basis. If the taxpayer excludes canceled qualified principal residence indebtedness from income and continues to own the residence after the cancellation, the taxpayer must reduce the basis of the residence (but not below zero) by the amount of the canceled qualified principal residence indebtedness excluded from income. Enter the amount of the basis reduction on line 10b of Form 982. Thus, basis adjustment would be required in a loan modification where the taxpayer retains the home. However, no basis adjustment is required in a foreclosure, short sale or abandonment because the taxpayer no longer owns the residence. This may or may not create a problem in the future since any gain will be subject to the Sec 121 home sale gain exclusion. Electing another exclusion instead of Qualified Principal Residence Indebtedness. An insolvent taxpayer (other than one in a Title 11 bankruptcy) can elect to have the mortgage forgiveness exclusion not apply and can instead rely on the Code Sec. 108(a)(1)(B) exclusion for insolvent taxpayers. (Code Sec. 108(a)(2), as amended by Act 2(c)) Thus, where a taxpayer has significantly tapped the equity in the home, and has a significant amount of debt discharge that does not qualify for the exclusion, it may be to their advantage to forgo the mortgage relief exclusion and instead use the insolvent taxpayer exclusion. 138

147 Form 982 Part II Reduction of Tax Attributes Qualified Principal Residence Indebtedness Check Box Line 1e Enter Excluded Income on Line 2 YES Does the taxpayer continue to own his principal residence after the debt cancellation? NO THEN Line 10b. Form 982 THEN Line 10b. Form 982 Reduce basis of the principal residence but not less than zero Enter zero on Line 10b End. No other attributes are reduced Selecting One or More Exclusions Type of Debt Options to COD Exceptions and Exclusions Qualified Principal Residence Principal Residence Indebtedness Insolvency Second Home Insolvency Vacant Land Credit Card Student Loans Insolvency Qualified Real Property Indebtedness Student Loans Insolvency Student Loan Exception Farm Debt Insolvency Qualified Farm Indebtedness 139

148 Exclusions from Principal Residence. If a property subject to the debt relief is the taxpayer s primary home then the Sec 121 (home sale gain) exclusion applies, or if needed, the unforeseen circumstances reduced-gain exclusion applies. If there is a loss the loss would not be deductible since it is personal use property. If there was a gain from the sale of the main home, you may qualify to exclude all or part of that gain from your income. In general, you are eligible for the exclusion if you have owned and used your home as your main home for a period aggregating at least two years out of the five years prior to its sale. You can exclude up to $250,000 of the gain. Generally, you are not eligible for the exclusion if you excluded the gain from the sale of another home during the two-year period prior to the sale of your home. Report the sale of your main home only if you have a gain that is not excluded from your income. In most cases, if you have a gain that is not excluded, you must report it on Form 1040, Schedule D, Capital Gains and Losses. Home Affordable Modification Program. Any Pay-for-Performance Success Payments that reduce the principal balance of your home mortgage under the Home Affordable Modification Program are not taxable. Interest included in canceled debt. If any interest is forgiven and included in the amount of canceled debt in box 2 of Form 1099-C, the interest portion that is included in box 2 will be shown in box 3. Whether the interest portion of the canceled debt must be included in your income depends on whether the interest would be deductible if you paid it. If the interest would not be deductible (such as interest on a personal loan) and you do not meet any other exception or exclusion, include in your income the amount from Form 1099-C, box 2. If the interest would be deductible (such as on a business loan) and you do not meet any other exception or exclusion include in your income the net amount of the canceled debt (the amount shown in box 2 minus the interest amount shown in box 3). Example Home Mortgage Debt Cancellation Mike lost his home to foreclosure. He had refinanced the home s original purchase money debt of $270,000 and at the time of the foreclosure the debt was $500,000. None of the extra debt was used for substantial home improvements nor can any excess debt be traced to other deductible purposes. Mike s original loan would have been $250,000 at the time of the foreclosure. The amount in Box 2 of the C is $200,000 and Box 3 includes an amount of $55,000. Thus the amount in Box 3 must be prorated between deductible and non-deductible interest. Mike can deduct the interest for acquisition debt and $100,000 of equity debt. Thus the amount of the interest that would have been deductible is $38,500 (((250, ,000)/$500,000) x $55,000). As a result Frank s COD income is reduced to $161,500 ($200,000 - $38,500) 140

149 Example Business Debt Suppose that you have a dental lab business and you work for a cash basis dentist. The dentist business falls on hard times and cannot meet all of its liabilities. You decide to forgive a portion of the amount the business owes you. The forgiven amount becomes debt relief income to the business but is excluded from that company s income because it would have been deductible if paid. Example Credit Card Debt Cancellation Mike had credit card consumer debt cancelled. In Box 2 of the 1099-C was an amount of $10,000 and in Box 3 an amount of $1,000. The $1,000 represents unpaid consumer interest, which is not deductible so the COD income is $10,000, which includes the $1,000 interest. However, assuming the card was used exclusively for Rob s Schedule C business the COD income would only be $9,000 ($10,000 - $1,000) since the interest would have been deductible as a business expense. Student Loan Cancellation Forgiveness. Certain student loans provide that all or part of the debt incurred to attend a qualified educational institution will be canceled if the person who received the loan works for a certain period of time in certain professions for any of a broad class of employers. If your student loan is canceled as the result of this type of provision, the cancellation of this debt is not included in your gross income. To qualify for this treatment, the loan must have been made by: 1. The federal government, a state or local government, or an instrumentality agency, or subdivision thereof, 2. A tax-exempt public benefit corporation that has assumed control of a state, county, or municipal hospital, and whose employees are considered public employees under state law, or 3. An educational institution: a. Under an agreement with an entity described in (1) or (2) that provided the funds to the institution to make the loan, or b. As part of a program of the institution designed to encourage students to serve in occupations or areas with unmet needs and under which the services provided are for or under the direction of a governmental unit or a tax-exempt section 501(c)(3) organization (ex. charitable org.) A loan to refinance a qualified student loan will also qualify if it was made by an educational institution or a tax-exempt section 501(a) organization under its program designed as described in (3)(b) above. Example: Taxpayer student received $200,000 under a medical educational loan program. Under the terms of the program, one-fifth of the loan (or $40,000) is canceled each year he practices medicine in a qualifying state hospital. He does not include the forgiven amounts in income. 141

150 Exception. The cancellation of a student loan made by an educational institution because of services you performed for that institution or another organization that provided funds for the loan must be included in the gross income on your tax return unless one of the exceptions or exclusions applied. Price Reduced After Purchase. If the seller reduces a debt, from a not insolvent buyer of property, the reduction is treated as an adjustment of the purchase price not as debt cancellation income. (Code Sec. 108(e)(5)(A)). In this case you must reduce your basis in the property by the amount of the reduction of your debt to the seller. Note. This exclusion only applies where the seller is also the lender. Example William purchased property from Jeff for $125,000. William made a $25,000 down payment and Jeff carried back the $100,000 balance secured by the property. In year three, William agreed to reduce the $100,000 debt by $20,000. Assuming William was not in bankruptcy and remained solvent, the $20,000 debt reduction was an adjustment to the purchase price rather than debt cancellation income. Disposition of assets. If the debt cancelled was secured by an asset, then the disposition of the asset must also be accounted for. Here are some possible scenarios: Short Sale In a short sale, by agreement with the lender, the property is sold for a value less than the mortgage balance. Even though the lender ends up with all the net proceeds from the sale, the borrower must report the transaction as a sale on the tax return in the normal manner. Except if an exclusion applies. Whenever taxpayers sell a home, they need to calculate their capital gains to determine whether they owe any tax. If taxpayers engage in a short sale or the mortgage lender forecloses on taxpayers home, the Internal Revenue Service treats it just like a sale. Foreclosures and short sales, may also require taxpayers to recognize ordinary income if the lender cancels any of the outstanding mortgage balance and the taxpayer is ineligible for an exclusion. Similar to a foreclosure, any debt that the mortgage lender cancels because of a short sale is taxable only if the terms of the mortgage hold the taxpayer personally liable for the full amount of the loan. Regardless of the tax consequences, the lender will report the debt cancellation on a 1099-C form. For example, if taxpayers owe $500,000 to the mortgage lender and short sale the home for $450,000, the lender will report $50,000 of canceled debt on Form 1099-C. Since most mortgage lenders wouldn t agree to a short sale if the value of the home exceeds the outstanding mortgage balance, no capital gains issues exist. Foreclosure (or abandonment) In a foreclosure, the lender has taken possession of the property through legal channels. This usually generates a Form 1099-A. The property sale must be reported on the tax return in the normal manner. Determine the sales price from the table below. Except if any exclusion can be used. 142

151 Repossession Generally a term associated with having a vehicle reclaimed by the lender of personal property. If that personal property was also business property (in whole or in part) the disposition of the business portion of the property must be reported as a sale. Report the sale in the normal manner for the asset. Note: Generally all debts on personal property are recourse; thus the sales price would be the lesser of the FMV or the loan balance. Exception to this rule exists under Insolvency. Disposition of Assets Price Type of Loan Foreclosure or Abandonment Short Sale Recourse Lesser: FMV or Loan Bal. Lesser: FMV or Loan Bal. Non Recourse Greater of Loan Bal. or FMV Loan Balance Gifts. Generally, you do not have income from canceled debt if the cancellation or forgiveness of the debt is a gift. Form 1099-C or 1099-A do not arrive on time. Unfortunately, creditors have a lot of wiggle room about when to report canceled income to the IRS. Statutes of limitations vary by state and by type of debt, but creditors are not required to file a 1099-C at that time of the event since they can continue to try to collect on a debt indefinitely. Consumer advocates argue that under IRS guidelines, creditors should send a 1099-C three years after there has been no activity on the debt, but they acknowledge the rules are unclear. And plenty of taxpayers have been getting 1099-Cs for debt that's many years -- or even decades -- old. If this happens to taxpayers, first try calling the creditor. Sometimes, it turns out to be a mistake and the creditor will issue an amended form. If that's not the case, taxpayers will need to include the 1099-C on their tax return. Taxpayers can explain to the IRS why it should have been filed a long time ago and make that case as part of the tax return. Or it may be easier to simply use one of the exemptions to avoid paying on the amount. However, the age of the debt can work against taxpayers. The time of financial hardship that caused the debt to go unpaid may have passed, leaving the taxpayer with reduced ability to exclude the debt from income because of insolvency. 143

152 Review Questions Section 10 Read and answer the following review questions. The correct answers are found on the next page with an explanation to strengthen up your knowledge. Note: This is not part of your Final Test. 82. What is the purpose of lines 11a, 11b and 11c of Form 982? a) Discharge of indebtedness in a title 11 case requires lines 11a, 11b and 11c to reduce basis of depreciable property. b) Discharge of qualified real property business indebtedness requires lines 11a, 11b and 11c to reduce tax attributes. c) Discharge of qualified farm indebtedness requires lines 11a, 11b and 11c to reduce tax attributes. d) Discharge of qualified farm indebtedness requires lines 11a, 11b and 11c to reduce the basis of qualified property. 83. Excluding canceled debt from a Qualified Real Property Business Indebtedness is possible by using the following lines on Form 982: a) Line 1d, Line 2 and Line 6 through 9 to reduce the tax attributes b) Line 1d, Line 2 (the amount on this line is limited to the amount on line 4, excess is taxable on Form line 21) c) Line 1d, Line 2 and reduce the basis on Line 11 d) All of the above 84. The following are requirements to elect the qualified real property business debt exclusion, except: a) The election must be made on a timely filed (including extensions) federal income tax return for the current year b) The election can be revoked only with IRS consent. c) The election is made on Form 982 Including the canceled debt amount on line 2 d) If the income tax was filed timely without making the election you can amend your return within six months and write Filed pursuant to section e) None of the above 85. The exclusion under Qualified Principal Residence Indebtedness applies where a taxpayer: a) Restructures the acquisition debt on a principal residence b) Loses a principal residence in a foreclosure c) Sells a principal residence in a short sale. d) Excludes income under insolvency 86. Taxpayer B refinanced his personal residence and used the equity money of his home to buy a car. This is a. a) Qualified principal residence indebtedness b) Not a qualified principal residence indebtedness c) Insolvency d) None of the above 144

153 87. Which of the following is included in the forgiveness ordering rule for Qualified Principal Residence indebtedness? a) The exclusion does not apply to a taxpayer s designated second (vacation) residence. b) The exclusion doesn't apply to the discharge of a loan on account of services performed for the lender. c) The exclusion only applies to the discharge of qualified principal residence acquisition debt. d) Debt used to refinance qualified principal residence indebtedness is not eligible. 88. Bob received a form 1099C. The form included interest forgiven on box 3. Does Bob have to include those interests in income? a) If the interest would not be deductible and no exception or exclusion exists, the interest is included in income. b) If the interest would be deductible and no exception or exclusion exists, the interest is not included in income. c) Either A or B are correct d) Neither A or B are correct 89. Cancellation of student loans exist if one of the following condition is meet: a) The student loan provides relief, if the student attending a qualified educational institution works in the facility. b) The canceled debt is forgiven, but it must be included in income. c) The student loan provides relief if at least 50% is paid in cash and the rest with work in the facility. d) The student loan is canceled from the institution even if it was not made by a qualified federal agency. 90. Cindy s house was repossessed. She was personally liable for it. There is no exception or exclusion to apply. What is the price of Cindy s property? a) The greater of the tax attributes b) The greater or the loan c) The greater of the FMV d) The lesser of the FMV or Loan Balance Questions Section 10 Answers and Discussion 82. When a taxpayer wants to exclude income under the qualified farm indebtedness exclusion, they have to reduce the tax attributes on lines 6 through 9. They also need to adjust the basis of qualified property on lines 11a, 11b and 11c following the correct order: 1) Line 11a: Depreciable qualified property held primarily for sale to customers as if it were depreciable property, 2) Line 11b: Land that is qualified property and is used or held for use in your farming business. And 3) Line 11c: Other qualified property. Therefore d is the correct answer. 145

154 83. To exclude income under the Qualified Real Property Business Indebtedness, it is necessary to: Check Box Line 1d, enter excluded income on Line 2. It is important to know that the amount excludable on Line 2 is limited to and must match the Amount of the basis adjustment on form 982 Line 4. Any excess is taxable on 1040 Line 21. Thus B is the correct answer. 84. All the following are valid options about excluding canceled debt under the qualified real property business indebtedness: The election must be made on a timely filed (including extensions) federal income tax return for the current year. The election can be revoked only with IRS consent. The election is made on Form 982 Including the canceled debt amount on line 2. If the income tax was filed timely without making the election, you can amend your return within six months and write Filed pursuant to section Since all are correct, D should be selected. 85. This exclusion under Qualified Principal Residence indebtedness applies where a taxpayer restructures the acquisition debt on a principal residence, loses a principal residence in a foreclosure, or sells a principal residence in a short sale. Thus, D is the correct selection. 86. If a taxpayer refinanced his personal residence and used the loan proceeds from the equity in his home to pay off credit cards and buy a car the debt is not qualified principal residence indebtedness. Therefore, B is the correct answer. 87. The ordering rule states that debt used to refinance qualified principal residence indebtedness is eligible for the exclusion up to the amount of the old mortgage principal just before the refinancing. (H Rept No (PL ) p. 5). Thus, D is the correct selection. 88. If the interest would not be deductible (such as interest on a personal loan) and you do not meet any other exception or exclusion, include in your income the amount from Form C, box 2. If the interest would be deductible (such as on a business loan) and you do not meet any other exception or exclusion, include in your income the net amount of the canceled debt (the amount shown in box 2 minus the interest amount shown in box 3). In this last option the interest is not included. Therefore, C is the correct answer. 89. Certain student loans provide that all or part of the debt incurred to attend a qualified educational institution will be canceled if the person who received the loan works for a certain period of time in certain professions for any of a broad class of employers. Thus, A is the correct answer. 90. In this case the lender has taken possession of Cindy s property through legal channels. This usually generates a Form 1099-A. The property sale must be reported on the tax return in the normal manner. The sales price is the lesser of the FMV or the Loan Balance. D is the correct answer. 146

155 TAX UPDATES

156

157 TAX UPDATES 2017 IRS Tests W-2 Verification Code for Filing Season For filing season 2017, the Internal Revenue Service will expand an initiative to verify the authenticity of Form W-2 data. This initiative is one in a series of steps to combat tax-related identity theft and refund fraud. The objective is to verify Form W-2 data submitted by taxpayers on e-filed individual tax returns. The IRS has partnered with certain Payroll Service Providers (PSPs) to include a 16- digit code and a new Verification Code field on a limited number of Form W-2 copies provided to employees. Verification codes will appear on approximately 50 million Forms W-2 in 2017, up from the 2 million forms in Tax professionals are urged to look for Verification Code on W-2s because location will vary. The code will be displayed in four groups of four alphanumeric characters, separated by hyphens. Example: XXXX-XXXX-XXXX-XXXX. The Verification Code will appear on some versions of payroll firms Form W-2 copies B and C, in a separate, labeled box (Copy B is "To be filed with employee's federal tax return" and Copy C is "For employee's records.") The form will include these instructions to taxpayer and tax preparers: Verification Code. If this field is populated on the Form W2, tax professionals will enter this code when it is requested by their tax return preparation software. It is possible that the software will not request the code. The code is not used when the income tax is filed by regular mail. Some Forms W-2 that employees will receive for 2017 will not have a verification code. In this case, taxpayers do not need to request one or enter any information in that code area. The tax software will not force to enter one. For the purposes of an IRS test, omitted and incorrect W-2 Verification Codes will not delay the processing of a tax return. The code will not be included in Forms W-2 or W-2 data submitted by the PSPs to the Social Security Administration or any state or local departments of revenue. Nor will this pilot affect state and local income tax returns or paper federal returns. 3 HR. Federal Tax Updates. 1

158 Certain Medicaid Waiver Payments May Be Excludable From Income. On January 3, 2014, the Internal Revenue Service issued Notice , I.R.B Notice provides guidance on the federal income tax treatment of certain payments to individual care providers for the care of eligible individuals under a state Medicaid Home and Community-Based Services waiver program described in section 1915(c) of the Social Security Act (Medicaid Waiver payments). Section 1915(c) enables individuals who otherwise would require care in a hospital, nursing facility, or intermediate care facility to receive care in the individual care provider s home. The notice provides that the Service will treat these Medicaid waiver payments as difficulty of care payments excludable from gross income under 131 of the Internal Revenue Code. Before 2014, the IRS maintained that these payments were subject to income tax. The new ruling indicates that certain payments made to some caregivers in state-run programs are not taxable, even if the caregiver would like them to be. The rule applies to state Medicaid Home and Community-Based Services waiver programs. California s is called In-Home Supportive Services or IHSS. The exclusion only applies to payments for care in the individual care provider s home where the care recipient lives under the recipient s plan of care. Example 1. John is the parent of a disabled child, and he receives state Medicaid Home and Community-Based waiver payments excludable from gross income under Notice for the care of his child in John s home. John s sister lives with them, and she also receives state Medicaid Home and Community-Based waiver payments for the care of John s child. In example 1. John and his sister can exclude the income they receive for the care of John s son. They can do this because the care provider is living in the home with the care recipient. Example 2. Antony is a care provider; he provides personal care and supportive services to disabled individuals in their homes, or in Antony s home where the care recipient does not live. Antony receives payments for this care under a state Medicaid Home and Community-Based Services waiver program. In example 2. Antony cannot exclude the income from gross income because the exclusion only applies to payments for care in the individual care provider s home where the care recipient lives under the recipient s plan of care. In this example, Antony would be considered to have a business of taking care of disabled individuals and do not live with them. Exception to the rule. Care payments are not excludable to the extent that the payments are for more than 10 qualified foster individuals who have not attained age 19 or 5 qualified foster individuals who have attained age 19. What is IHSS? IHSS pays people to provide personal care to low-income elderly, blind or disabled people in a private home, thereby keeping them out of nursing homes or assisted living. About 70 percent of participants are cared for by family members. To qualify for care under 3 HR. Federal Tax Updates. 2

159 these programs, a person must be older than 65, disabled or blind and meet other Medi-Cal eligibility requirements. They can get up to 283 hours of paid care per month, depending on their needs. The care providers get a W-2 from IHSS, although technically the person being cared for is the employer. Before 2014, the IRS maintained that these payments were subject to income tax. As mentioned before, in January 2014 the IRS issued a new rule that said people do not owe income tax on these payments. Those payments are not taxable if they live full time in the same home as the person getting the care. If the caregiver is not living in the same home, the payments are taxable. The rule is the same whether the caregiver and person getting care are related or not. The rule, known as IRS notice , was largely under the radar and ignored. It also raised one big question; can people decide to treat it taxable or not taxable income at their own convenience? The answer is no. The tax treatment is mandatory for 2014 and subsequent years. That is bad news for some low-income caregivers. Why is this so important? The answer in most cases is the refundable tax credits. Many taxpayers only receive this income during the year and they want this income to be taxable because it allows them to claim the earned income tax credit. Under this new ruling, caregivers will treat this income as not taxable and get smaller or zero tax refund. This IRS ruling can also have an impact on caregivers health insurance. Tax practitioners may find this new rule surprising because it is rare that the IRS requires taxpayers to exclude W-2 income from the income tax return. What is even more unusual is that the IRS made this change after it prevailed in several lawsuits challenging its previous position on the tax. IHSS payments may or may not be subject to Social Security and Medicare tax, depending on the relationship between the caregiver and client. The IRS ruling does not impact these taxes, only income tax. People who are exempt from income tax on these payments should proceed cautiously when they file their tax return. If their payments are not taxable, they could request a corrected W-2. If they cannot get a corrected W-2, they should report the income on line 7 of Form 1040 and subtract it on line 21 using a minus symbol. Taxpayers that had other source of earned income during the year may qualify for the EITC however it cannot be based on IHSS payments. IHSS has a legacy program, known as IHSS Residual, is not Medicaid-funded. Payments from this program likely do not qualify for tax-free treatment. Its two main programs, Medi-Cal Personal Care Services and Independence Plus Waiver, do qualify. 3 HR. Federal Tax Updates. 3

160 Excluding IHSS from income. Income reported on Form 1099-MISC, Box 3: Generally, the amount reported in Box 3 of Form 1099-MISC is reported on Form 1040, Line 21 as other income. However, if taxpayer will exclude the income, they can enter the amount and exclude it on the same line or simply put zero. If they file the return on paper they will write "Notice " to the left of Line 21. Form 1099-MISC, Box 7: Generally, the amount reported to you in Box 7 of Form 1099-MISC is reported on Schedule C as business income. Taxpayers can exclude it from income reporting the payment as income on Schedule C and claiming the an expense for the same amount. The same is possible when taxpayers receive Form 1099-MISC, with income on Box 7. Form W-2: Generally, amounts reported to you in Box 1 of Form W-2 are reported on Form 1040, Line 7 as wages. Taxpayers can exclude these payments from income as a negative adjustment on Form 1040, Line 21. Additional Information: Please understand, the Notice exclusion only applies to income tax. It does not address when these payments are subject to FICA tax (i.e. Social Security and Medicare taxes). The IRS has not yet provided guidance on this matter. Generally the payor should not issue a Form W-2 or 1099-MISC if they know the difficulty of care payments are excludable from your income. If you receive a Form W-2 or 1099-MISC reporting excludable difficulty of care payments, notify the payor that you are choosing to exclude the payments from your gross income. They should file and issue a corrected Form 1099-MISC or Form W-2c. Otherwise, use the information above to report the income and exclusion. The IRS is allowing taxpayers who received and reported payments in prior years to amend those prior year returns in order to exclude the income based on the new rules outlined in Notice Generally, for a credit or refund, you must file Form 1040X within 3 years (including extensions) after the date you filed your original return or within 2 years after the date you paid the tax, whichever is later. Individual Shared Responsibility Provision The IRS is alert to the reviewing of any change to the Affordable Care Act better known as Obamacare. Until further IRS notice, taxpayers should continue filing their tax returns as they normally would. The individual shared responsibility provision requires taxpayers to do at least one of the following: Have qualifying health coverage called minimum essential coverage Qualify for a health coverage exemption Make a shared responsibility payment with your federal income tax return for the months that you did not have coverage or an exemption. 3 HR. Federal Tax Updates. 4

161 Most taxpayers have qualifying health care coverage for all 12 months in the year, and will check the "Full-year coverage" box on their return. Due to the uncertainty of the ACA act, the IRS canceled the tax system changes that would reject tax returns during processing in instances where the taxpayer did not provide information related to health coverage. Basically, the IRS has decided to allow electronic and paper returns to be accepted for processing in instances where a taxpayer does not indicate their coverage status. However, legislative provisions of the ACA law are still in force until changed by the Congress, and taxpayers remain required to follow the law and pay what they may owe. Processing silent returns means that taxpayer returns are not systemically rejected by the IRS at the time of filing, allowing the returns to be processed and minimizing burden on taxpayers, including those expecting a refund. When the IRS has questions about a tax return, taxpayers may receive follow-up questions and correspondence at a future date, after the filing process is completed. This is similar to how the IRS handled this in previous years, and this reflects the normal IRS post-filing compliance procedures requirements. New, IRS turning to Private Debt Collection. The Internal Revenue Service began a new private collection program of certain overdue federal tax debts selecting four contractors to implement it. The new program, authorized under a federal law enacted by Congress, enables these designated contractors to collect, on the government s behalf, outstanding inactive tax receivables. Authorized under a federal law enacted by Congress in December 2015, Section of the Fixing America s Surface Transportation Act (FAST Act) requires the IRS to use private collection agencies for the collection of outstanding inactive tax receivables. The collection agencies and more. As a condition of receiving a contract, these agencies must respect taxpayer rights including, among other things, abiding by the consumer protection provisions of the Fair Debt Collection Practices Act. These private collection agencies will work on accounts where taxpayers owe money, but the IRS is no longer actively working them. Several factors contribute to the IRS assigning these accounts to private collection agencies, including older, overdue tax accounts or lack of resources preventing the IRS from working the cases. The IRS will give taxpayers and their representative written notice that the accounts are being transferred to the private collection agencies. The agencies will send a second, separate letter to the taxpayer and their representative confirming this transfer. Private collection agencies will be able to identify themselves as contractors of the IRS collecting taxes. Employees of these collection agencies must follow provisions of the Fair Debt Collection Practices Act and should be courteous and respect taxpayer rights. 3 HR. Federal Tax Updates. 5

162 The IRS will do everything it can to help taxpayers avoid confusion and understand their rights and tax responsibilities, particularly in light of continual phone scams where callers impersonate IRS agents and request immediate payment. Private collection agencies will not ask for payment on a prepaid debit, itunes or gift card. Taxpayers will be informed about electronic payment options for taxpayers on IRS.gov/Pay Your Tax Bill. Payment by check should be payable to the U.S. Treasury and sent directly to IRS, not the private collection agency. Private Collection Agencies Selected The IRS will assign cases to these private collection agencies: CBE P.O. Box 2217 Waterloo, IA ConServe P.O. Box 307 Fairport, NY Performant P.O. Box 9045 Pleasanton CA Pioneer PO Box 500 Horseheads, NY Taxpayers that do not want to work with the assigned private collection agency to settle their overdue tax accounts, must submit a request in writing to the private collection agency. Accounts Not Assigned To Private Collection Agencies. IRS will not assign accounts to private collection agencies involving taxpayers who are: Deceased Under the age of 18 In designated combat zones Victims of tax-related identity theft Currently under examination, litigation, criminal investigation or levy Subject to pending or active offers in compromise Subject to an installment agreement 3 HR. Federal Tax Updates. 6

163 Subject to a right of appeal Classified as innocent spouse cases In presidentially declared disaster areas and requesting relief from collection Private collection agencies will return accounts to the IRS if taxpayers and their accounts fall into any of these 10 situations after assignment to the private collection agencies. Stay Vigilant Against Scams. The IRS urges taxpayers to be on the lookout for unexpected scam phone calls from anyone claiming to be collecting on behalf of the tax agency. The IRS will do everything it can do to help taxpayers you avoid confusion and ensure taxpayers understand their rights and tax responsibilities when it assigns their case to a private collection agency. This is particularly important in light of continuing scams where callers impersonate IRS agents and request immediate payment. Even with private debt collection, taxpayers should not receive unexpected phone calls from the IRS demanding payment. When people owe tax, the IRS always sends several collection notices through the mail before making phone calls. TIGTA Hotline. To make a complaint about a private collection agency or report misconduct by its employee, call the TIGTA hotline at or visit or write to: Treasury Inspector General for Tax Administration Hotline Post Office Box 589 Ben Franklin Station Washington, DC FAFSA Changes release pressure on 2016 income tax returns. Starting with the Free Application for Federal Student Aid (FAFSA), the following changes have been put in place: Students are now able to submit an FAFSA earlier. Students have been able to file a FAFSA since Oct. 1, 2016, rather than beginning on Jan. 1, The earlier submission date is a permanent change, enabling students to complete and submit an FAFSA as early as Oct. 1 every year. Students now report earlier income information. Beginning with the FAFSA, students are required to report income information from an earlier tax year. For example, on the FAFSA, students (and parents, as appropriate) must report their 2015 income information, rather than their 2016 income information. This will enable taxpayers to have more time and less pressure to file their income tax return for 2016 taxable year. 3 HR. Federal Tax Updates. 7

164 Benefits of these changes: Taxpayers will not need to estimate their tax information and then go back into the FAFSA to update it once the return is ready. Taxpayers will be able to use the IRS Data Retrieval Tool (IRS DRT) to import their tax information into their FAFSA automatically. Taxpayers will be able to provide their most current information that could benefit their application. The FAFSA application will allow them to provide the 2016 information and make the proper addition or subtraction to the 2015 reported income. Internal Revenue Service (IRS) and U.S. Department of Education Office of Federal Student Aid (FSA) are Reviewing the Application Process. To protect sensitive taxpayer data, the IRS and FSA are reviewing the Data Retrieval Tool on fafsa.gov and StudentLoans.gov. They stop the services of these Data Retrieval Tool to add security tools to it. The tool was disabled in March of 2017 due to security concerns. The IRS has been working closely with FSA to safely return the tool to service. While the Data Retrieval Tool is unavailable, FSA and the IRS remind applicants that online applications are still available and are operable. The income information needed to complete the FAFSA and apply for an income-driven repayment (IDR) plan can be found on a previously filed tax return. Students and parents completing a and FAFSA should manually enter 2015 tax information (not 2016). Borrowers applying for an IDR plan should submit alternative documentation of income to their federal loan servicers after they complete and submit the online IDR application. The process for submitting the alternative documentation of income is explained to borrowers as part of the online IDR application. While the Data Retrieval Tool is unavailable, a borrower may submit a paper copy of his or her tax return, copies of pay stubs or other acceptable forms of documentation explained online during the application process. If a copy of the tax return is not readily available, the applicant may be able to access the tax software used to prepare the return or contact their tax preparer to obtain a copy. If necessary, a summary of a previously filed tax return, called a tax transcript, may be viewed and downloaded from at Get Transcript Online, with the proper identity verification. Additionally, Get Transcript by Mail can be accessed online, or the taxpayer can call , and a transcript will be delivered to the address of record within five to 10 days. IRS Takes Additional Steps to Protect Taxpayers. The IRS is working to identify the number of taxpayers affected by questionable use of the Data Retrieval Tool. Identity thieves may have used personal information obtained outside the tax system to access the FAFSA form in an 3 HR. Federal Tax Updates. 8

165 attempt to secure tax information through the DRT. The IRS continues to review the extent to which this contributed to fraudulently filed tax returns. The IRS has identified instances where our strengthened fraud reviews stopped questionable tax returns by filers who also accessed the DRT. As the IRS identifies taxpayers with personal information at risk through misuse of the data tool, it is marking and locking down those taxpayer accounts to provide additional protection against an identity thief filing a fraudulent tax return. As an internal review continues, the IRS also is finalizing plans to notify affected taxpayers by mail about possible identity theft concerns. The scope of affected taxpayers is still being determined. ITIN Renewal Reminder. ITINs are used by people who have tax-filing or payment obligations under U.S. law but are not eligible for a Social Security number. Under a recent change in law, any ITIN not used on a tax return at least once in the past three years will expire on Jan. 1, In addition, any ITIN with middle digits of either 78 or 79 (9NN-78-NNNN or 9NN-79-NNNN) will also expire on that date. This means that anyone with an expiring ITIN and need to file a tax return in the upcoming filing season should file a renewal application in the next few weeks to avoid lengthy refund and processing delays. Failure to renew early could result in refund delays and denial of some tax benefits until the ITIN is renewed. An ITIN renewal application filed now will be processed before one submitted at the height of tax season from mid-january to February. Currently, a complete and accurate renewal application can be processed in as little as seven weeks. But this timeframe is expected to expand to as much as 11 weeks during tax season, which runs from mid-january through April. Several common errors are currently slowing down or holding up ITIN renewal applications. The mistakes generally center on missing information, and/or insufficient supporting documentation. Information reporting by brokers on certain tax-exempt obligations. Under Code Sec. 6045, every person doing business as a broker must make a return showing the name and address of each customer, with details regarding gross proceeds and other information as IRS may require. Specifically, brokers must report adjusted basis for a covered security (as defined by Code Sec. 6045(g)(3)(A)) and whether any gain or loss upon the sale of the security is long-term or short-term. Additionally, Code Sec requires the reporting of interest payments (including accruals of original issue discount, or OID, treated as payments). Under final regs, for tax-exempt obligations acquired on or after Jan. 1, 2017, a payor must report under Code Sec the daily portions of OID on a tax-exempt obligation. (Reg (a)) In addition, for tax years beginning after Dec. 31, 2016, the final regs allow, but don't require, a broker to report OID and acquisition discount for a tax-exempt obligation that is a covered security acquired before Jan. 1, (Reg (c)) 3 HR. Federal Tax Updates. 9

166 Remainder of the Filing Deadlines for Income Tax and Extensions for Businesses. The government also is changing the dates for filing by businesses and individuals filing for extensions. The Surface Transportation and Veterans Health Care Choice Improvement Act of 2015 changed the filing deadlines for partnerships and S corporations, among others. The Act sets new due dates for partnership returns, C corporation returns, FBAR returns, (i.e., FinCEN Form 114, Report of Foreign Bank and Financial Accounts), and several other IRS information returns. For a partnership return (IRS Form 1065, U.S. Return of Partnership Income), the new due date is March 15 for calendar-year partnerships and the 15th day of the third month following the close of the fiscal year for fiscal-year partnerships. This is a one-month acceleration in due date for partnership returns. There also is a maximum extension of six months allowed for partnership returns that are extended. For C corporations, the new due date is the 15th day of the fourth month following the close of the corporation's year. This is a one-month deferral in due date for C corporations. C corporations also generally will be allowed a six-month extension: a calendar-year C corporation is allowed a five-month extension until 2026, and a C corporation with a June 30 year end would get a seven-month extension until These new tax return due dates apply to tax returns for tax years beginning after Dec. 31, The due date for the return, which is now filed using critically important FBAR, FinCEN Form 114, was changed from June 30 to April 15. Moreover, for the first time, taxpayers will be allowed a six-month extension for filing this information return. The Act also provides specific penalty waiver authority for taxpayers that are required to file an FBAR return for the first time if they file it late by mistake. The due date for Form 3520, Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts, will be April 15 for calendar-year filers, with a maximum sixmonth extension. The new law also makes changes to other miscellaneous tax return due dates and extension periods. Taxpayers who cannot file on time now have additional extension options to comply with paperwork related to partnership income (Form 1065 new six-month extension), estate and trust affairs (Form 1041 new 5 ½-month extension) and employee benefit plans (Form 5500 series new 3 ½-month extension). 3 HR. Federal Tax Updates. 10

167 Return Current Original and New Due and Type Extended Due Date Extended Date Partnership April 15 March 15 Form 1065 September 15 September 15 C Corporation March 15 April 15 Form 1120 September 15 September 15 Trust and Estate April 15 April 15 Form 1041 September 15 September 30 Exempt Organizations May 15 May 15 Form 990 August 15 November 15 Employee Benefit Plans July 31 July 31 Form 5500 October 15 November 15 FinCen June 30 April 15 Report 114 October 15 Tax Forms under the ACA act for Employers. Employers with 50 or more full-time employees, including full-time equivalent employees, will use Form 1095-C, Employer-Provided Health Insurance Offer and Coverage, to report the information required about offers of health coverage and enrollment in health coverage for their employees. Form 1095-C is used to report information about each employee C to Employees for Tax Returns. Employers that offer employer-sponsored self-insured coverage also use Form 1095-C to report information to the IRS and to employees about individuals who have minimum essential coverage under the employer plan and therefore are not liable for the individual shared responsibility payment for the months that they are covered under the plan. An employer must furnish a Form 1095-C to each of its full-time employees by January 31 of the year following the year to which the Form 1095-C relates. Employers will meet the requirement to furnish Form 1095-C to an employee if the form is properly addressed and mailed on or before the due date. If the regular due date falls on a Saturday, Sunday, or legal holiday, employers may file by the next business day. The Form 1095-C that employers send may include only the last four digits of the employee s social security number, replacing the first five digits with asterisks or Xs. Forms 1095-C must be sent on paper by mail or hand delivered, unless the employee consents to receive the statement in an electronic format. The consent ensures that the employee can access 3 HR. Federal Tax Updates. 11

168 the electronic statement. If mailed, the statement must be sent to the employee s last known permanent address, or if no permanent address is known, to the employee s temporary address. Individuals who worked for multiple employers that are required to file Form 1095-C may receive a Form 1095-C from each employer. Employers will send all Forms 1095-C to the IRS using the Form 1094-C with the totals. Forms 1095-A, 1095-B and 1095-C for Income Tax Returns. Form 1094-A is given to taxpayer by the marketplace, the insurer or the employer self-insured will provide the taxpayer with Form 1095-B, and the employer will give Form 1095-C to the employee. Form 1095-C only describes the coverage that was made available to an employee. A separate form, the 1095-B, will provide details about an employee s actual insurance coverage, including who in the worker s family was covered. This form is sent and provided by the insurance provider rather than the employer. Taxpayers will need these forms to prove their coverage, get a tax credit or pay their shared responsibility payment for The forms will help fill out Form 1040 line 61, Premium Tax Credit Form 8962, or Form 8965, Health Coverage Exemptions, and to fill out the worksheet for figuring out the Shared Responsibility Payment. All the forms will contain the taxpayers information and the months covered, this is important because the tax credit or shared responsibility payment are calculated based on that information. How many forms 1095 will be received? If covered by health insurance, taxpayers can use the information from the following three 1095 statements when preparing their taxes: Form 1095-A is the Health Insurance Marketplace Statement. Taxpayers will get this version if they bought health coverage through the "Marketplace". Form 1095-B is a statement from the health insurance company verifying that taxpayers and other members of their household have insurance coverage that meets the requirements of the ACA. This is for people whose insurance comes from a source other than the Marketplaces. Form 1095-C is a statement from an employer providing details about employersponsored health insurance benefits. Many taxpayers will receive both 1095-B and 1095-C. Depending on how their employersponsored insurance is set up, they may receive "B" and "C" on a single combined form. Form 1095-A, the only one required to file taxes. Taxpayers should wait to receive Form A in order to file their income tax return. It is not necessary to wait for Forms 1095-B or 1095-C in order to file. Taxpayers are not required to attach any of these forms to their tax return. Some taxpayers may not receive a Form 1095-B or Form 1095-C by the time they are ready to file their 2015 tax return. While the information on these forms may assist in preparing a return, 3 HR. Federal Tax Updates. 12

169 they are not required. Individual taxpayers will generally not be affected by this extension and should file their returns as they normally would. Splitting the Premium Tax Credit among Dependents filing their own tax return. In order to complete Form 8962 taxpayers will require Form 1095-A. However, if taxpayers file their income tax return but do not claim their own personal exemptions, their family size is 0 and cannot take the PTC using Form In order to distribute the proper percentage of PTC among the dependents, taxpayers will need the second lowest cost silver plan (SLCSP). If they do not have one or want to know the correct SLCSP they can use the marketplace tool to look up the SLCSP premium that applies to the family for each month. In some cases taxpayers request coverage for their dependents but the dependents file their own income tax returns claiming their own exemption. In these cases the dependents can receive Form 1095-A only if the parents told the Healthcare Marketplace that they will not claim the child as a dependent. If the child do not receive Form 1095-A, the child will need a copy of his/her parents' 1095-A to complete his/her income tax return. In this case parents and child will complete Form 8962 Part IV. If taxpayers indicate that they would claim the dependent and the dependent file his/her own income tax return claiming his/her own exemption, Form 1095-A sent by the Marketplace for the policy will not accurately reflect the members of the coverage family and the taxpayer s filing his/her own return. In that case, both taxpayers must allocate the enrollment premiums (box e), the APTC (box g), and the applicable SLCSP premium (box f). Allocating coverage on Form 8962 by percentage. Both taxpayers, parents and child, in this case may agree on any allocation percentage from zero through one hundred percent. Taxpayers filing the return using the same Form 1095-A may use the percentage agreed on for every month for which this allocation rule applies, or they may agree on different percentages for different 3 HR. Federal Tax Updates. 13

170 months. However, they must use the same allocation percentage for all policy amounts (enrollment premiums, applicable SLCSP premiums, and APTC) in a month. Allocating coverage on Form 8962 by number of individuals. If taxpayers cannot agree on an allocation percentage, the allocation percentage can be divided between the enrolled individuals in the same policy. The allocation percentage used and that the one indicated on line 30 of Form 8962 is the percentage of the policy amounts for the coverage that will be used to compute the PTC and reconcile APTC. If 100% of the policy amounts are allocated to the parents, they will check Yes on line 9 and complete Part IV by entering 100 in the appropriate box(es) for their allocation percentage. If 0% of the policy amounts are allocated to the parents, they complete Part IV by entering -0- in the appropriate box(es) for their allocation percentage. Splitting the Advanced Payment of the PTC. Parents have the option to claim 100% of the A on their tax return, or to "allocate" part (or all) of it to the dependent. If both parents and dependent agree, the allocation can be anywhere from 0% to 100%. If they cannot agree and Advance credit was received (column C on the 1095-A), then it is divided by the number of people on the insurance policy. For example, if the insurance policy covers 4 people, each person is allocated 25%. Getting the benefit of splitting the APTC. Assuming that the dependent is in a lower "poverty level" than the parents (lower income per household size, see Line 5 of Form 8962), it is usually more beneficial for all of the 1095-A to be "allocated" to the individual in the lower poverty level. Example of splitting the APTC using a divorced case. Joe and Alice have been divorced since January 2014 and have two children, Chris and Jane. Joe enrolls himself, Chris, and Jane in a qualified health plan for The premium for the plan is $13,000. Based on a family size and coverage family of three and an applicable SLCSP premium of $12,000, Joe is approved for and receives APTC computed as follows: Joe s projected household income for 2015 is $59,370 (300% of the Federal poverty line for a family size of three). Joe s APTC for 2015 is $6,324 ($12,000 applicable SLCSP premium less $5,676 contribution amount (household income $59,370 x applicable figure )). Joe s actual household income for 2015 is $59,774. Jane lives with Alice for more than half of 2015 and Alice claims Jane as a dependent. Joe and Alice agree to an allocation percentage of 20% to determine how much of the policy amounts for the qualified health plan are for Jane s coverage. Therefore, 20% of the enrollment premiums, APTC, and the applicable SLCSP premium are allocated to Alice and 80% are allocated to Joe. In computing PTC, Joe takes into account $10,400 of enrollment premiums ($13,000 x 0.80). Joe must reconcile $5,059 of APTC ($6,324 x 0.80). Joe s tax family for 2015 includes only Joe and Chris, and Joe s household income of $59,774 is 380% of the Federal poverty line for a family size of two. Joe s applicable SLCSP premium for 2015 is $9,600 (the applicable SLCSP premium covering Joe, Chris, and Jane of $12,000, minus the amount allocated to Alice of $2,400 ($12,000 x 0.20)). Joe s PTC for 2015 is $3,886 (the lesser of $3,886, the excess of Joe s applicable SLCSP premium of $9,600 minus the contribution amount of $5,714 ($59,774 x 3 HR. Federal Tax Updates. 14

171 0.0956), and $10,400, Joe's enrollment premiums). Joe has excess APTC of $1,173 (the excess of the APTC of $5,059 over the PTC of $3,886). When Joe completes Part IV of Form 8962, he enters Alice s social security number on line 30, column (b), and enters 0.80 in columns (e), (f), and (g). Alice is responsible for reconciling $1,265 ($6,324 x 0.20) of APTC for Jane s coverage. If Alice is eligible for the PTC, she will take into account $2,600 ($13,000 x 0.20) of the enrollment premiums for Jane and $2,400 ($12,000 x 0.20) of the applicable SLCSP premiums. Alice must compute her contribution amount using the Federal poverty line percentage for the household income and family size reported on her Form The above example can be used also for parents allocating the APTC with the dependent filing his/her own income tax return. Using the mentioned method, taxpayers can check what is more beneficial for them. In case a higher allocation is better for the child, taxpayers should explore the scenarios on both tax returns. Relief for 2015 for wrong Form 1095-A. Regarding additional incorrect information on certain Marketplace Forms 1095-A, the Department of the Treasury is giving a tax relief which will mitigate any harm to tax filers. Any individual who enrolled in qualifying Marketplace coverage, received an incorrect Form 1095-A, and filed his or her tax return based on that form does not need to file an amended tax return. The IRS will not pursue the collection of any additional taxes from these individuals based on updated information in the corrected forms. This relief applies to tax filers who enrolled through the federally facilitated marketplace or a state-based marketplace. As before, some individuals may choose to file amended returns if that have a direct tax impact on their tax return. The relief would not apply to an individual who did not enroll in Marketplace coverage, but received a Form 1095-A and erroneously claimed a premium tax credit on his or her return. It also would not apply to an individual who was enrolled in Marketplace coverage, did not receive a Form 1095-A, and filed a return without this information. Those taxpayers should file amended tax returns. If taxpayers in these situations choose not to amend, the IRS may contact them following its normal procedures in cases where additional taxes are due. Forms 1098 including more information, tax return not affected by this. For information returns and statements due after Dec. 31, 2016, additional information will be included in the mortgage information statements that must be sent by lenders (or lender's agents) to individuals who pay more than $600 in mortgage interest during a tax year. These statements now must report the outstanding principal balance on the mortgage at the beginning of the calendar year, the mortgage origination date, and the address of the property securing the mortgage. 3 HR. Federal Tax Updates. 15

172 Provisions under the PATH Act. Some credits are now permanents and EITC limits for new SSN owners. See Section 204 below. On Friday, December 18, 2015, the Protecting Americans from Tax Hikes (PATH) Act of 2015 was signed by the President. This bill extends the Work Opportunity Tax Credit (WOTC) for five years (from January 1, 2015 through December 31, 2019). In addition to the extension of the program, a new eligibility category has been added. "Long-Term Unemployed" is a new eligible category, defined as an individual unemployed for not less than 27 weeks and received unemployment compensation under state or federal law. The bill that is part of the Consolidated Appropriations Act, 2016 made permanent some tax credits for businesses and working families. It contains 151 sections relating tax extenders. The bill made permanent the following tax credits: 3 HR. Federal Tax Updates. 16

173 Review Questions Section 1 Read and answer the following review questions. The correct answers are found on the next page with an explanation to strengthen up your knowledge. Note: This is not part of your Final Test. 1. A new security code has been implemented to Form W-2; the new security information will be used when taxpayers file their income tax return electronically but what will happen when they file their income tax return on paper? a) They will not be able to file their tax return on paper anymore starting 2018 filing season. b) They will be required to write a code at the top of Form c) They will not be required to do anything when filing on paper. d) They will receive a letter from the IRS in which taxpayers will write the code. 2. The IRS implemented new due dates for income tax returns; the new due dates will affect: a) All taxpayers in general b) Corporations. c) Small businesses only. d) None of the above. 3. The new due date for Partnership returns will be on: a) April 18. b) February 15 for calendar-year. c) March 15 for calendar-year. d) January 15 for all partnerships. 4. The new extended due date for partnerships returns will be on: a) The same date as previously (October 15); the change only affects the filing date. b) There is also a one-month acceleration in the extended due date (September 15) c) The extended due date is now November 15. d) None of the above. 5. The reporting of foreign accounts under FBAR will be changed as follow: a) The Form 114 is now due on January 15. b) The Form 114 is still due on June 30 but taxpayers have a six month extension. c) Form 114 is now due on April 15 but taxpayers have a six month extension. d) Form 114 is now due on March 15 with no extension of time. 6. Exempt organizations will now be required to file their tax returns on: a) Filing due date is April 15 and the extended due date is August 15. b) Filing due date is March 15 and the extended due date is September 15. c) Filing due date is May 15 and the extended due date is November 15. d) Filing due April 15 and extended due date is October HR. Federal Tax Updates. 17

174 7. Taxpayers that received an incorrect Form 1095-A and file their income tax return using the incorrect form will be required to: a) Amend their income tax return as soon as possible. b) Pay a penalty for filing with erroneous information. c) They are granted a relief from penalty and filing an amended return is optional. d) They are granted a relief from penalty only if they file an amended return on time. 8. Who of the following individuals is required to file an amended return to avoid additional taxes on his/her return for information related to Form 1095-A? a) Taxpayer that did not enroll in the marketplace and claimed the premium tax credit with an erroneous Form 1095-A received. b) Taxpayers that enrolled in the marketplace coverage and did not receive Form 1095-A but file their return without this form. c) None of the above. d) All of the above 9. Mortgage interest statements received by the bank should now provide one of the following information: a) The date of the origination mortgage. b) The address of the property purchased. c) The outstanding principal balance. d) All of the above. 10. The Protecting Americans from Tax Hikes Acts approved at the end of 2015 was created in order to: a) Provide new tax laws at the state level. b) Provide tax practitioners with a continuing education requirement. c) Extend some tax credits and make permanent some others. d) Increase the tax fee that tax practitioners can charge to their clients. 11. A new eligibility category has been added to the tax law regarding unemployed individuals, this new definition is for: a) Last-year unemployment individuals, referring to individuals who are unemployed for at least 12 months. b) Long-year unemployment individuals, referring to individuals who are unemployed not less than one year. c) Long-term unemployed, referring to individuals who are unemployed not less than 27 weeks. d) None of the above. 3 HR. Federal Tax Updates. 18

175 Questions Section 1 Answers and Discussion 1. Answer c. For the purposes of an IRS test, omitted and incorrect W-2 Verification Codes will not delay the processing of a tax return. The code will not be included in Forms W-2 or W-2 data submitted by the PSPs to the Social Security Administration or any state or local departments of revenue. Nor will this pilot affect state and local income tax returns or paper federal returns. 2. Answer b. The Surface Transportation and Veterans Health Care Choice Improvement Act of 2015 changed the filing deadlines for partnerships and S corporations, among others. 3. Answer c. For a partnership return (IRS Form 1065, U.S. Return of Partnership Income), the new due date is March 15 for calendar-year partnerships and the 15th day of the third month following the close of the fiscal year for fiscal-year partnerships. 4. Answer b. This is a one-month acceleration in due date for partnership returns. There also is a maximum extension of six months allowed for partnership returns that are extended. 5. Answer c. The due date for the return, which is now filed using critically important FBAR, FinCEN Form 114, was changed from June 30 to April 15. Moreover, for the first time, taxpayers will be allowed a six-month extension for filing this information return. 6. Answer c. The new due date for exempt organizations Form 990 is May 15 and the extended due date is November Answer c. Regarding additional incorrect information on certain Marketplace Forms 1095-A, the Department of the Treasury is giving a tax relief which will mitigate any harm to tax filers. Any individual who enrolled in qualifying Marketplace coverage, received an incorrect Form 1095-A, and filed his or her tax return based on that form does not need to file an amended tax return. 8. Answer d. The relief would not apply to an individual who did not enroll in Marketplace coverage, but received a Form 1095-A and erroneously claimed a premium tax credit on his or her return. It also would not apply to an individual who was enrolled in Marketplace coverage, did not receive a Form 1095-A, and filed a return without this information. 9. Answer d. These statements now must report the outstanding principal balance on the mortgage at the beginning of the calendar year, the mortgage origination date, and the address of the property securing the mortgage. 10. Answer c. In addition to the extension of the program, a new eligibility category has been added. "Long-Term Unemployed" is a new eligible category, defined as an individual unemployed for not less than 27 weeks and received unemployment compensation under state or federal law. 11. Answer c. The Protecting Americans from Tax Hikes (PATH) Act of 2015 signed by the President is a bill that extends many tax credits and make permanents others. 3 HR. Federal Tax Updates. 19

176 SEC Enhanced Child Tax Credit made permanent. SEC Enhanced American Opportunity Tax Credit made permanent. The amendments made by this section shall apply to taxable years beginning after the date of the enactment of this Act. SEC Enhanced Earned Income Tax Credit made permanent. The credit for 3 or more qualifying child is now permanent. The credit percentage and the phase-out percentage shall be determined as follows: SEC Extension and modification of deduction for certain expenses of elementary and secondary school teachers. The amount will stay at $250 and is effective to taxable years beginning after December 31, 2014 and to taxable years beginning after December 31, SEC Extension and modification of special rule for contributions of capital gain real property made for conservation purposes. SEC Extension of tax-free distributions from Individual Retirement plans for charitable purposes. SEC Extension and modification of charitable deduction for contributions of food inventory. SEC Extension and modification of employer wage credit for employees who are active duty members of the uniformed services. Section 124. Extension and modification of increased expensing limitations and treatment of certain real property as section 179 property. The provision permanently extends the small business expensing limitation and phase-out amounts in effect from 2010 to 2014 ($500,000 and $2 million, respectively). These amounts currently are $25,000 and $200,000, respectively. The 3 HR. Federal Tax Updates. 20

177 special rules that allow expensing for computer software and qualified real property (qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property) also are permanently extended. The provision modifies the expensing limitation by indexing both the $500,000 and $2 million limits for inflation beginning in 2016 and by treating air conditioning and heating units placed in service in tax years beginning after 2015 as eligible for expensing. The provision further modifies the expensing limitation with respect to qualified real property by eliminating the $250,000 cap beginning in Section 143. Extension and modification of bonus depreciation. The provision extends bonus depreciation for property acquired and placed in service during 2015 through 2019 (with an additional year for certain property with a longer production period). The bonus depreciation percentage is 50 percent for property placed in service during 2015, 2016 and 2017 and phases down, with 40 percent in 2018, and 30 percent in The provision continues to allow taxpayers to elect to accelerate the use of AMT credits in lieu of bonus depreciation under special rules for property placed in service during The provision modifies the AMT rules beginning in 2016 by increasing the amount of unused AMT credits that may be claimed in lieu of bonus depreciation. The provision also modifies bonus depreciation to include qualified improvement property and to permit certain trees, vines, and plants bearing fruit or nuts to be eligible for bonus depreciation when planted or grafted, rather than when placed in service. SEC Extension and modification of exclusion from gross income of discharge of qualified principal residence indebtedness. The provision is extended to January 1, The discharge counts for indebtedness incurred before January 1, 2017, or subject to an arrangement that is entered into and evidenced in writing before January 1, SEC Extension and modification of credit for nonbusiness energy property. The credit is available through December 31, SEC Extension of credit for energy-efficient new homes. The credit is good through December 31, 2016 for homes acquired after December 31, SEC Modification of filing dates of returns and statements relating to employee wage information and nonemployee compensation to improve compliance. This section refers to returns and statement for employee wage information and nonemployee compensation, Form W- 2 and Form W-3 and any statement regarding nonemployee compensation. These returns information shall be filed on or before January 31 of the year following the calendar year to which such returns relate. The current due date for filing these forms with the IRS is Feb. 28 for paper copies and March 31 for e-filed copies. The new due dates are effective for returns and statements relating to calendar years after the date of enactment. Date for certain refunds under this provision. No credit or refund of an overpayment for a taxable year shall be made to a taxpayer before the 15th day of the second month following the close of such taxable year if a credit is allowed to such taxpayer under section 24 or 32 for such taxable year. The section is referring to credits or refunds made after December 31, HR. Federal Tax Updates. 21

178 The provision requires that certain information returns be filed by January 31, generally the same date as the due date for employee and payee statements, and are no longer eligible for the extended filing date for electronically filed returns under section 6071(b). This section is accelerating the filing requirement of information regarding wages reportable on Form W-2 and nonemployee compensation. The due date for employee and payee statements remains the same. Nonemployee compensation generally includes fees for professional services, commissions, awards, travel expense reimbursements, or other forms of payments for services performed for the payor s trade or business by someone other than in the capacity of an employee. Additionally, the provision is requiring that from 2016 and on, no credit or refund for an overpayment for a taxable year can be given to a taxpayer before the 15th day of the second month following the close of that taxable year, if the taxpayer claimed the EITC or additional child tax credit on the tax return. Individual taxpayers are generally calendar year taxpayers, thus, for most taxpayers who claim the EITC or additional child tax credit this rule would apply such that a refund of tax would not be made to such taxpayer prior to February 15th of the year following the calendar year to which the taxes relate. The provision is effective for returns and statements relating to calendar years beginning after the date of enactment. The provision pertaining to the payment of certain refunds shall apply to credits or refunds made after December 31, Penalties under the present law. Failure to comply with the information reporting requirements will result in penalties, which may include a penalty for failure to file the information return, to furnish payee statements, or to comply with other various reporting requirements. No penalty is imposed if the failure is due to reasonable cause. Any person who is required to file an information return statement, or furnish a payee statement, but who fails to do so on or before the prescribed due date, is subject to a penalty that varies based on when, if at all, the information return is filed. Both the failure to file and failure to furnish penalties are adjusted annually to account for inflation. In the Trade Preferences Extension Act of 2015,381 the penalties were increased for information returns or payee statements due after December 31, The penalty amounts, whether they are limited to a maximum amount in a calendar year, and the changes enacted in the Trade Preferences Extension Act, are described below. Penalties for returns or statement due before January 1, If a person files an information return after the prescribed filing date but on or before the date that is 30 days after the prescribed filing date, the amount of the penalty is $30 per return ( first-tier penalty ), with a maximum penalty of $250,000 per calendar year. If a person files an information return after the date that is 30 days after the prescribed filing date but on or before August 1, the amount of the penalty is $60 per return ( second-tier penalty ), with a maximum penalty of $500,000 per calendar year. If an information return is not filed on or before August 1 of any year, the amount of the penalty is $100 per return ( third-tier penalty ), with a maximum penalty of $1,500,000 per calendar year. If a failure to file is due to intentional disregard of a filing requirement, the minimum penalty for each failure is $250, with no calendar year limit. 3 HR. Federal Tax Updates. 22

179 Penalties for returns or statements due after December 31, The Trade Preferences Extension Act of 2015 increased the penalties to the following amounts for information returns or payee statements due after December 31, The first-tier penalty is $50 per return, with a maximum penalty of $500,000 per calendar year. The second tier penalty increases to $100 per return, with a maximum penalty of $1,500,000 per calendar year. The third-tier penalty increases to $250 per return, with a maximum penalty of $3,000,000 per calendar year. The lower maximum levels applicable to small businesses also were increased, as follows. The maximum penalties for small businesses are: $175,000 if the failures are corrected on or before 30 days after the prescribed filing date; $500,000 if the failures are corrected on or before August 1; and $1,000,000 if the failures are not corrected on or before August 1. For failures or misstatements due to intentional disregard, the penalty per return or statement increased to $500, with no calendar year limit. No distinction between small businesses and other persons required to report is made in such cases. Safe harbor for penalty. Under the new provision, taxpayers can have a safe harbor from the application of the penalty for failure to file a correct information return and the penalty for failure to furnish a correct payee statement in circumstances in which the information return or payee statement is otherwise correctly filed but includes a de minimis error of the amount required to be reported on such return or statement. In general, a de minimis error of an amount on the information return or statement need not be corrected if the error for any single amount does not exceed $100. A lower threshold of $25 is established for errors with respect to the reporting of an amount of withholding or backup withholding. The provision requires broker reporting to be consistent with amounts reported on uncorrected returns which are eligible for the safe harbor. If any person receiving payee statements requests a corrected statement, the penalty for failure to file a correct information return and the penalty for failure to furnish a correct payee statement would continue to apply in the case of a de minimis error. SEC Prevention of retroactive claims of earned income credit after issuance of social security number. This provision limits claims by Social Security Number (SSN) and Individual Taxpayer Identification Number (ITIN) Recipients: Prevents retroactive claims of the earned income tax credit (EITC), the child tax credit (CTC), and the American opportunity tax credit (AOTC) after issuance of new SSNs or ITINs. The Additional Child Tax Credit is also affected because taxpayers cannot take the Additional Child Tax Credit if they do not first qualify for the Child Tax Credit. Taxpayer may not file an amended return claiming the credit for any year in which they did not have a valid ITIN or did not have SSN. Refundable credits. An individual may reduce his or her tax liability by any available tax credits. In some instances the refundable credit may result in a refund in excess of any credits for withheld taxes or estimated tax payments available to the individual. Three major credits are affected under this provision the child tax credit, the earned income tax credit ( EITC ) and the American opportunity tax credit. An individual may claim a tax credit for each qualifying child under the age of 17. The amount of the credit per child is $1,000. The aggregate amount of child credits that may be claimed is 3 HR. Federal Tax Updates. 23

180 phased out for individuals with income over certain threshold amounts. Specifically, the otherwise allowable child tax credit is reduced by $50 for each $1,000 (or fraction above the limit) of modified adjusted gross income over $75,000 for single individuals or heads of households, $110,000 for married individuals filing joint returns, and $55,000 for married individuals filing separate returns. To the extent the child credit exceeds the taxpayer s tax liability; the taxpayer is eligible for a refundable credit (the additional child tax credit) equal to 15 percent of earned income in excess of $3,000. The EITC is available to low-income workers who satisfy certain requirements. The amount of the EITC varies depending upon the taxpayer s earned income and whether the taxpayer has one, two, more than two, or no qualifying children. In 2015, the maximum EITC is $6,242 for taxpayers with more than two qualifying children, $5,548 for taxpayers with two qualifying children, $3,359 for taxpayers with one qualifying child, and $503 for taxpayers with no qualifying children. The credit amount begins to phaseout at an income level of $23,630 for joint-filers with children, $18,110 for other taxpayers with children, $13,750 for joint-filers with no children and $8,240 for other taxpayers with no qualifying children. The phaseout percentages are for taxpayers with one qualifying child, for two or more qualifying children and 7.65 for no qualifying children. The American Opportunity tax credit, refers to modifications to the Hope credit that apply for taxable years beginning in 2009 and extended through The maximum allowable modified credit is $2,500 per eligible student per year for qualified tuition and related expenses paid for each of the first four years of the student s post-secondary education in a degree or certificate program. The modified credit rate is 100 percent on the first $2,000 of qualified tuition and related expenses, and 25 percent on the next $2,000 of qualified tuition and related expenses. Forty percent of a taxpayer s otherwise allowable American opportunity tax credit is refundable. Identification requirement for these credits. In order to claim the earned income credit, a taxpayer must include his or her taxpayer identification number (and if the taxpayer is married filing a joint return, the taxpayer identification number of the taxpayer s spouse) on the tax return. For these purposes, a taxpayer identification number must be a Social Security number ( SSN ) issued by the Social Security Administration. Similarly, any child claimed by a taxpayer for purposes of determining the earned income credit must also be affiliated with a taxpayer identification number on the tax return. Again, for these purposes, such number must be an SSN issued by the Social Security Administration. The child credit may not be claimed with respect to any qualifying child unless the taxpayer includes the name and taxpayer identification number of such qualifying child on the tax return for the taxable year. For these purposes, taxpayer identification number is not limited to an SSN, as is the case for the earned income credit. Thus, a taxpayer may claim a child using an IRS individual taxpayer identification number ( ITIN ), issued by the IRS for those who are not eligible to be issued an SSN but who still have tax filing obligations. Additionally, a child may be identified on the return using an adoption taxpayer identification number ( ATIN ). There are no specific rules regarding the identifying number affiliated with the taxpayer claiming the child credit. Thus, the general rules applicable to all taxpayers, requiring that an identifying number accompany the return, are applicable. 3 HR. Federal Tax Updates. 24

181 For the American opportunity credit (in addition to the other credits with respect to amounts paid for educational expenses), no credit may be claimed by a taxpayer with respect to the qualifying tuition and related expenses of an individual, unless that individual s taxpayer identification number is included on the tax return. As with the child credit, for these purposes a taxpayer identification number is not limited to a Social Security number. Thus, a taxpayer may claim the credit with the use of an ITIN (either the taxpayer s own ITIN, if they are filing as a nondependent and claiming tuition expenses incurred on their own behalf, or the ITIN of a dependent to whom the credit relates). The provision limitations. The provision denies to any taxpayer the EITC, child credit, and American opportunity tax credit, with respect to any taxable year for which such taxpayer has a taxpayer identification number that has been issued after the due date for filing the return for such taxable year. Similarly, a qualifying child (in the case of the EITC and child credit) or a student (in the case of the American opportunity credit) is not taken into account with respect to any taxable year for which such child or student is associated with a taxpayer identification number that has been issued after the due date for filing the return for such taxable year. Effective date of the provision. The provision generally applies to any return of tax, and any amendment or supplement to any return of tax, which is filed after the date of the enactment. However, the provision is not going to apply to any return of tax (other than an amendment or supplement to any return of tax) for any taxable year which includes the date of the enactment, if such return is filed on or before the due date for such return of tax. Section 205. Prevention of retroactive claims of child tax credit. The provision prohibits an individual from retroactively claiming the child tax credit by amending a return (or filing an original return if he failed to file) for any prior year in which the individual or a qualifying child for whom the credit is claimed did not have an ITIN. The provision applies to returns, and any amendment or supplement to a return, filed after the date of enactment. Section 206. Prevention of retroactive claims of American opportunity tax credit. The provision prohibits an individual from retroactively claiming the American Opportunity Tax Credit by amending a return (or filing an original return if he failed to file) for any prior year in which the individual or a student for whom the credit is claimed did not have an ITIN. The provision applies to returns, and any amendment or supplement to a return, filed after the date of enactment. Section 207. Procedures to reduce improper claims. The provision expands the paid preparer due diligence requirements with respect to the earned income tax credit, and the associated $500 penalty for failures to comply, to cover returns claiming the child tax credit and American Opportunity Tax Credit. The provision also requires the IRS to study the effectiveness of the due diligence requirements and whether such requirements should apply to taxpayer who file online or by filing a paper form. The provision applies to tax years beginning after December 31, HR. Federal Tax Updates. 25

182 Section 208. Restrictions on taxpayers who improperly claimed credits in prior year. The provision expands the rules under current law, which bars individuals from claiming the earned income tax credit for ten year if they are convicted of fraud and for two years if they are found to have recklessly or intentionally disregarded the rules, to apply to the child tax credit and American Opportunity Tax Credit. The provision adds math error authority, which permits the IRS to disallow improper credits without a formal audit if the taxpayer claims the credit in a period during which he is barred from doing so due to fraud or reckless or intentional disregard. The provision applies to tax years beginning after December 31, Section 209. Treatment of credits for purposes of certain penalties. The provision applies the 20-percent penalty for erroneous claims under current law to the refundable portion of credits (reversing the Tax Court decision in Rand v. Commissioner). The provision also eliminates the exception from the penalty for erroneous refunds and credits that currently applies to the earned income tax credit, and the provision provides reasonable-cause relief from the penalty. The provision generally applies to returns filed after December 31, Section 210. Increase the penalty applicable to paid tax preparers who engage in willful or reckless conduct. The provision expands the penalty for tax preparers who engage in willful or reckless conduct, which is currently the greater of $5,000 or 50 percent of the preparer s income with respect to the return, by increasing the 50 percent amount to 75 percent. The provision applies to returns prepared for tax years ending after the date of enactment. Section 211. Employer identification number required for American opportunity tax credit. The provision requires a taxpayer claiming the American opportunity tax credit to report the employer identification number (EIN) of the educational institution to which the taxpayer makes qualified payments under the credit. The provision applies to tax years beginning after December 31, 2015, and expenses paid after such date for education furnished in academic periods beginning after such date. Section 212. Higher education information reporting only to include qualified tuition and related expenses actually paid. The provision reforms the reporting requirements for Form 1098-T so that educational institutions are required to report only qualified tuition and related expenses actually paid, rather than choosing between amounts paid and amounts billed, as under current law. The provision applies to expenses paid after December 31, 2015 for education furnished in academic periods beginning after such date. 3 HR. Federal Tax Updates. 26

183 Review Questions Section 2 Read and answer the following review questions. The correct answers are found on the next page with an explanation to strengthen up your knowledge. Note: This is not part of your Final Test. 12. Under the new tax extender, Protecting the Americans from Tax Hikes, the child tax credit is now: a) Permanent and does not need a tax extender. b) Higher and taxpayers can get a bigger refund. c) Lower because fewer taxpayers are claiming it. d) None of the above. 13. Under the new tax extender, the enhanced American Opportunity credit is now: a) Zero, it was eliminated to bring back the Hope Credit. b) Increased. c) Reduced. d) Made permanent. 14. The tax extenders of 2015 will give the Earned Income Tax Credit the following treatment: a) The EITC is now permanent and does not need a tax extender. b) The EITC is now higher and will be granted for 4 children. c) The EITC will now be available for 2 children. d) None of the above. 15. The tax extender of 2015 gave the following tax benefits under the bonus depreciation: a) Taxpayers can now take bonus depreciation from 2015 through b) Taxpayers can take a bonus depreciation starting at 50% though 30% at the end of the period. c) Taxpayers can take a bonus depreciation for certain fruit trees once there are planted, rather than when placed in service. d) All of the above. 16. The exclusion from gross income of discharge of qualified principal residence indebtedness includes discharges made on: a) 2016 and prior. b) January 1, 2017 and prior. c) December 2017 and prior. d) Only for 2015 and prior. 17. Tax preparers that engage in willful or reckless conduct will now be subject to the following action: a) They will be penalized with $5,000 or 75% of the preparer s income with respect of the return, whichever is greater. b) They will be penalized with $500 for each conduct. c) They will be subject to $750 penalty for each conduct. d) They will be penalized with $5,000 or 50% of the preparer s income with respect of the return, whichever is lower. 3 HR. Federal Tax Updates. 27

184 18. The American Opportunity Credit can now be taken by eligible taxpayers only if they provide the following information on their tax return: a) The number of classes taken at the qualifying school. b) The Employer Identification Number of the school in question. c) The Number of students of the school in question. d) None of the above. 19. Under current law before the tax extender came into effect, required educational institutions to report the following tax information to their students. a) The amount actually paid for books on Form 1098-T b) The amount billed for tuition on Form 1908-T c) The amount of credit that taxpayers can take on their tax return. d) None of the above. 20. The tax extender now requires educational institutions to report on Form 1098-T the following information: a) The time the student spent at school. b) The course that the student is taken. c) Qualified tuitions and relates expenses actually paid. d) Tuitions and fees received paid by others. 3 HR. Federal Tax Updates. 28

185 Questions Section 2 Answers and Discussion 12. Answer a. Under the Protecting Americans from Tax Hikes (PATH) Act of 2015, the enhanced Child Tax Credit was made permanent. 13. Answer d. Under the Protecting Americans from Tax Hikes (PATH) Act of 2015, the enhanced American Opportunity Tax Credit was made permanent. 14. Answer a. The enhanced Earned Income Tax Credit was made permanent under the PATH Act of 2015; the credit for 3 or more qualifying child is now permanent. 15. Answer d. The provision extends bonus depreciation for property acquired and placed in service during 2015 through 2019 (with an additional year for certain property with a longer production period). The bonus depreciation percentage is 50 percent for property placed in service during 2015, 2016 and 2017 and phases down, with 40 percent in 2018, and 30 percent in Answer b. The provision is extended to January 1, The discharge counts for indebtedness incurred before January 1, 2017, or subject to an arrangement that is entered into and evidenced in writing before January 1, Answer a. The provision expands the penalty for tax preparers who engage in willful or reckless conduct, which is currently the greater of $5,000 or 50 percent of the preparer s income with respect to the return, by increasing the 50 percent amount to 75 percent. 18. Answer b. The provision requires a taxpayer claiming the American opportunity tax credit to report the employer identification number (EIN) of the educational institution to which the taxpayer makes qualified payments under the credit. 19. Answer b. Under current law, educational institutions can choose to report on Form 1098-T between amounts paid and amounts billed. 20. Answer c. The provision reforms the reporting requirements for Form 1098-T so that educational institutions are required to report only qualified tuition and related expenses actually paid 3 HR. Federal Tax Updates. 29

186 Section 301. Exclusion for amounts received under the work colleges program. Under present law, an individual who is a candidate for a degree at a qualifying educational organization may exclude amounts received as a qualified scholarship from gross income and wages. In addition, present law provides an exclusion from gross income and wages for qualified tuition reductions for certain education provided to employees of certain educational organizations. The exclusions for qualified scholarships and qualified tuition reductions do not apply to any amount received by a student that represents payment for teaching, research, or other services by the student required as a condition for receiving the scholarship or tuition reduction. Payments for such services are includible in gross income and wages. An exception to this rule applies in the case of the National Health Services Corps Scholarship Program and the F. Edward Herbert Armed Forces Health Professions Scholarship and Financial Assistance Program. The provision exempts from gross income any payments from a comprehensive student worklearning-service program (as defined in section 448(e) of the Higher Education Act of 1965) operated by a work college (as defined in such section). Specifically, a work college must require resident students to participate in a work-learning-service program that is an integral and stated part of the institution s educational philosophy and program. Section 304. Exclusion from gross income of certain amounts received by wrongly incarcerated individuals. Under the current law, the taxability of damages, i.e., the amounts received as a result of a claim or legal action for compensation for injury, depends upon the nature of the underlying claim. If a direct payment on the underlying claim would be includible as income under section 61, and no specific exemption for that type of income is otherwise provided in the Code, then damages intended to compensate for loss of that includible income are themselves includible income. Section 104 of the Code specifically excludes from gross income most compensation for physical injuries or physical sickness. Damages for non-physical injuries, such as mental anguish, damage to reputation, discrimination, or lost income, are not within the purview of the section 104 exclusion. Compensation related to wrongful incarceration but not physical injuries or physical sickness is not specifically addressed by the Code. Benefits of the provision. Under the provision, with respect to any wrongfully incarcerated individual, gross income shall not include any civil damages, restitution, or other monetary award (including compensatory or statutory damages and restitution imposed in a criminal matter) relating to the incarceration of such individual for the covered offense for which such individual was convicted. A wrongfully incarcerated individual means an individual: 1) who was convicted of a covered offense; 2) who served all or part of a sentence of imprisonment relating to that covered offense; and i. was pardoned, granted clemency, or granted amnesty for such offense because the individual was innocent, or ii. for whom the judgment of conviction for the offense was reversed or vacated, and whom the indictment, information, or other accusatory instrument for that covered 3 HR. Federal Tax Updates. 30

187 offense was dismissed or who was found not guilty at a new trial after the judgment of conviction for that covered offense was reversed or vacated. For these purposes, a covered offense is any criminal offense under Federal or State law, and includes any criminal offense arising from the same course of conduct as that criminal offense. The provision contains a special rule allowing individuals to make a claim for credit or refund of any overpayment of tax resulting from the exclusion, even if such claim would be disallowed under the Code or by operation of any law or rule of law (including res judicata), if the claim for credit or refund is filed before the close of the one-year period beginning on the date of enactment of this Act. This provision is valid for taxable years beginning, on, or after December Security tips and information due to the increase of Tax Criminals. Driver s License Information. Tax preparation programs, the IRS and the state are implementing security layers to protect taxpayers and their information; these entities will ask for the taxpayers driver s license number or a state-issued identification number. This information is optional for most state tax returns, but a few states do require it to complete the electronic filing process. It is also optional for a federal tax return. However, providing these identification numbers will help the IRS verify taxpayers identity. This measurement can prevent unnecessary delays in tax return processing due to the possibility that there exist an identity theft issue. Safeguarding Taxpayer Data Make a Security Plan. Cybercriminals want sensitive clients data that tax professionals have, so the tax preparation community is a target. Tax professionals can take the initial step to safeguard their clients data by assessing their risks and making a security plan. It s more important than ever that tax professionals take aggressive steps to protect taxpayers information. Developing a good security plan not only makes practitioners think about areas where they could be vulnerable to intrusions, it also helps them focus on prevention. How can tax professionals get started on developing a plan that is workable for their business? Here are some initial steps: Step 1: Complete a risk assessment. This means identifying the risks and potential impacts of unauthorized access, use or disclosure of information. It also means looking at what happens if someone modifies or destroys that information or the computer systems that can be used to access taxpayer data. Review and answer these questions: How vulnerable is the customer s data to theft, disclosure, alteration or unrecoverable loss? 3 HR. Federal Tax Updates. 31

188 What can tax practitioners do to reduce the impact to their customers and their business in such an event? What can be done to reduce vulnerability? Step 2: Write and follow an Information Security Plan The plan should: Address every item identified in the risk assessment. Define safeguards for the complete tax staff, affiliates and service providers to follow. Require a responsible person to review and approve the Information Security Plan. Require a responsible person to monitor, revise and test the Information Security Plan on a periodic (annual) basis to address any system or business changes or problems identified. Step 3: At least once a year, if not more, perform an internal assessment Evaluate and test the security plan and other safeguards that are in place. Document any deficiencies. Create and execute a plan to address them. Steps to protect the Computer. Here are a few basic steps to help protect the computers located at the tax office: 1. Use pre-installed security software. Many computers come pre-installed with firewall and anti-virus protections. A good broad-based antimalware program should be able to protect those computers from viruses, Trojans, spyware and adware. 2. Turn on automatic updates. Set the security software to update automatically so it can be upgraded as threats emerge. Also, make sure the security software is on at all times. 3. Investigate the security software options. Search out trusted sources to learn more about security software options. This will make easier to decide if it required to invest in security software that gives the tax office more stronger protections and options. 4. Consider encryption software. Practitioners that retain important financial documents, such as prior-year tax returns, on the computer, should consider investing in encryption software to prevent unauthorized access by hackers or identity thieves. 5. Protect computers from children. If tax practitioners children also use the same device, make sure it has parental control options to protect them from malicious websites. Educate the children about the threats of opening suspicious web pages, s or documents. Avoid using the office computer for personal use or for gaming. 3 HR. Federal Tax Updates. 32

189 6. Set password protections for all devices. Whether it s the practitioner s computer, tablet or mobile phone, always set a password on them. If one of them is lost or stolen, the device will be protected from access. 7. Protect the wireless network. Set password and encryption protections for the wireless network. If the home or business Wi-Fi is unsecured it also allows any computer within range to access the wireless signal and steal information from practitioners computer. 8. Never download security software from a pop-up ad. A pervasive ploy is a pop-up ad that indicates it has detected a virus on the computer. It urges practitioners to download a security software package. Do not fall for it. It most likely will install some type of malware; reputable companies will not offer protection for free on pop up ads. 9. Avoid downloads from suspicious sources. Never open a PDF document or picture attached in an from an unknown source. It may contain malware. Here are a few basic tips to recognize and avoid a phishing Tax practitioners should be aware of s that can harm their computers and moreover steal their client s tax information. The following are some steps to identify s that can contain malicious information or programs that could affect the computer. The contains a link. Scammers often pose as the IRS, financial institutions, credit card companies or even tax companies or software providers. They may claim they need practitioners to update their account or ask them to change a password. The offers a link to a spoofing site that may look similar to the legitimate official website. Do not click on the link. If in doubt, go directly to the legitimate website and access the original account. The contains an attachment. Another option for scammers is to include an attachment to the . This attachment may be infected with malware that can download malicious software to the computer in the shadow. If it is spyware, it can track the keystrokes to obtain information about passwords, Social Security number, credit cards or other sensitive data. Do not open attachments from unknown sources. The says it comes from a government agency. Scammers attempt to frighten people into opening links by posing as government agencies. Thieves often try to imitate the IRS and other government agencies. The seems to be an off from a friend. Scammers also hack accounts and try to leverage the stolen addresses. Practitioners may receive an from a friend that just does not seem right. It may be missing a subject for the 3 HR. Federal Tax Updates. 33

190 subject line or contain odd requests or language. If it seems off, avoid it and do not click on any links, erase it. The has a lookalike URL. The questionable may try to trick practitioners with a fake web address. For example, instead of it may be a false lookalike such as Practitioners can check the address before clicking it by placing the cursor over the text to view a pop-up of the real URL. Do not click it. Use security features. Practitioners browser and providers must have anti-spam and phishing features. Do not install search engines from unknown companies. Make sure to use all of the security software features included on the explorer or . Opening a phishing and clicking on the link or attachment is one of the most common ways thieves are able not just steal the identity or personal information but also to enter into computer networks and create other mischief. Learning to recognize and avoid phishing s and sharing that knowledge with family members is critical to combating identity theft and data loss. Businesses should educate employees about the dangers. Tax Practitioners, Creating and Protecting computer and online Passwords. Many of us use the same sign-on and password over and over for our online accounts. That is why phishing scams, which often seek password information, are so successful. Once a criminal has the password for one account, it s highly likely that they will use the same on other accounts to see if they open. The IRS, state revenue departments and the tax industry have teamed up to combat identity theft in the tax arena. They are implementing new stronger standards that will appear more often on tax software products. These security locks will include: A password that has eight or more characters, including upper case, and lower case letters as well as numbers and a special character. Try to write hints to the password on a paper or in an electronic device. Do not write the complete password. New features include a timed lockout and limits on unsuccessful log-in attempts. Practitioners must complete three security questions. Tax software partners must verify addresses. In many cases, this means a PIN will be sent to the address or cell phone used to verify the tax software. These are just a few of the new protections that are implemented already. Most of the protections features will occur at the IRS and other agencies place. Practitioners should start thinking about their passwords and try to strengthen them every time. Remember not to use the same password for multiple accounts. 3 HR. Federal Tax Updates. 34

191 Responding to an e-attack in which Tax Data is at risk. Tax professionals are increasingly targets of cybercriminals seeking access to client data. Criminals use the stolen information to file fraudulent tax returns for refunds. Tax practitioners should be prepared to protect their clients and their own sensitive information. Tax practitioners that experience a data compromise should take the following steps to minimize the impact. Preliminary steps include: Contact the IRS and law enforcement: Internal Revenue Service - Report client data theft to the local IRS Stakeholder Liaison. The Liaisons will notify IRS Criminal Investigation and others within the agency directly. Speed is critical. If reported quickly, the IRS can take steps to block fraudulent returns in the affected clients names. Federal Bureau of Investigation Contact the local office and notify about the issue. Secret Service Practitioners can also contact their local office (if directed). Local police File a police report on the data breach. Contact states in which you prepare state returns: State Tax Agencies - Contact each state in which you prepare returns State Attorneys General- Contact each state in which you prepare returns. Most states require that the attorney general be notified of data breaches. This notification process may involve multiple offices. Contact experts: Security expert They can determine the cause and scope of the breach, what to do to stop the breach and prevent further breaches from occurring. Insurance company Report the breach and check if your insurance policy covers data breach mitigation expenses. Contact clients and other services: Federal Trade Commission offers tips and templates for businesses that suffer data compromise, including suggested language for informing clients. Clients Send an individual letter to victims to inform them of the breach but work with law enforcement on timing. Remember that you may need to contact former clients if their prior year data was still in your system. Your tax software provider They may need to take steps to prevent inappropriate use of your account for e-filing. Your web site/client portal provider(s) It s possible that your firm and client passwords may have been compromised and need to be reset. Federal Trade Commission offers tips and templates for businesses that suffer data compromise, including suggested language for informing clients. Credit/ID theft protection agency - Certain states require offering credit monitoring/id theft protection to victims of ID theft. Credit bureaus Notify them if there is a compromise. Clients may seek their services. 3 HR. Federal Tax Updates. 35

192 The IRS reminds tax professionals that toll-free assisters cannot accept third-party notification of tax-related identity theft. Clients should file a Form 14039, Identity Theft Affidavit, only if their electronic return is rejected as a duplicate or they are directed to do so. Tax Criminals focus also on Phone Calls; do not fall to the Telephone Scam Calls. More and more, practitioners and taxpayers are receiving calls from what it seems to be the IRS. However, the Internal Revenue Service is warning practitioners and taxpayers about more sophisticated phone scams. On these calls, victims are hocked with the warning that they owe money to the IRS and it must be paid promptly through a pre-loaded debit card or wire transfer. If the victim refuses to cooperate, they are then threatened with arrest, deportation or suspension of a business or driver s license. In many cases, the caller becomes hostile and insulting. The call has been affecting taxpayers in nearly every state in the country. Taxpayers and practitioners should be aware so they can react to these scams. Rest assured, the IRS does not and will not ask for credit card numbers over the phone, nor request a pre-paid debit card or wire transfers. The IRS will always contact taxpayers by regular mail. Other characteristics of this scam include: Scammers use fake names and IRS badge numbers. They generally use common names and surnames to identify themselves. Scammers may be able to recite the last four digits of a victim s Social Security Number or what it seem to be the correct last digits of the SSN; under pressure taxpayers can believe it is the correct one. Scammers spoof the IRS toll-free number on caller ID to make it appear that it s the IRS calling. Scammers sometimes send bogus IRS s to some victims to support their bogus calls. Victims hear background noise of other calls being conducted to mimic a call site. After threatening victims with jail time or driver s license revocation, scammers hang up and others soon call back pretending to be from the local police or DMV, and the caller ID supports their claim. Taxpayers, who get a phone call from someone claiming to be from the IRS, should do the following: If they know they owe taxes or they think to owe taxes, call the IRS at The IRS employees at that line can help them with a payment issue if there really is such an issue. If taxpayers know they do not owe taxes or have no reason to think that they owe any taxes (for example, they have never received a bill or the caller made some bogus threats 3 HR. Federal Tax Updates. 36

193 as described above), then call and report the incident to the Treasury Inspector General for Tax Administration at You can file a complaint using the FTC Complaint Assistant; choose Other and then Imposter Scams. If the complaint involves someone impersonating the IRS, include the words IRS Telephone Scam in the notes. Taxpayers should be aware that there are other unrelated scams (such as a lottery sweepstakes) and solicitations (such as debt relief) that fraudulently claim to be from the IRS. The IRS encourages taxpayers to be vigilant against phone and scams that use the IRS as a lure. The IRS does not initiate contact with taxpayers by to request personal or financial information. This includes any type of electronic communication, such as text messages and social media channels. The IRS also does not ask for PINs, passwords or similar confidential access information for credit card, bank or other financial accounts. Recipients should not open any attachments or click on any links contained in the message. Instead, forward the to phishing@irs.gov. Review Questions Section 3 Read and answer the following review questions. The correct answers are found on the next page with an explanation to strengthen up your knowledge. Note: This is not part of your Final Test. 21. Under the law before the tax extender came into effect, the income received by wrongly incarcerated individuals to compensate the damage was: a) Excluded from income. b) Retained for two years. c) Given to the State. d) Included in income. 22. Under Section 104 of the Revenue Code all the following items were excluded from income, except: a) Compensations for physical injuries. b) Compensation for physical sickness. c) Compensations for non-physical injuries. d) None of the above is covered under Section Under new provisions of the law, wrongfully incarcerated individuals can exclude from income: a) The payments received from civil damages. b) The payments received from restitution. c) The payments received as an award relating to the conviction d) All of the above. 3 HR. Federal Tax Updates. 37

194 24. One of the following will be considered a wrongfully incarcerated individual: a) An individual convicted under a covered offense. b) An individual who was pardoned because the individual was innocent. c) An individual whose judgment for the offense was reversed. d) All of the above. 25. Under the law before the tax extender came into effect, the reimbursements under an employer-provided accident plan for medical care expenses for employees are excluded from income if they are paid for: a) The employee. b) The employee s spouse. c) The employee s children under age 27 d) All of the above. 26. In general the new corrections to the law will include the exclusion from income of reimbursed medical care expenses for one of the following: a) The plans funded by a medical trust. b) The plans funded by a medical trust that is connected to a public retirement system. c) To plans funded by a medical trust that was established by a State. d) All of the above. 27. Under new tax provision, the rollovers of distributions from employer-sponsored retirement plans into a Simple IRA are allowed if they: a) Are less than the threshold amount. b) After the expiration of the two-year period in which taxpayer first participated in the SIMPLE IRA. c) They are from the same IRA. d) None of the above. 28. New provision will give the Internal Revenue Service authority over Form W-2 so employers can provide: a) Their employee s residence status. b) Their employee s identifying number rather than their SSN. c) Their employees SSN rather than their identifying number. d) Their employees tax court debts. 29. Under the new provision the Department of the Treasury will allow employers to provide one of the following information: a) Their employees truncated SSN. b) Their employees ITIN c) Their employees name and last name only. d) None of the above 3 HR. Federal Tax Updates. 38

195 30. Under current law before the tax extender came into effect, employers must provide to the IRS their employees : a) Complete SSN b) Complete ITIN c) The last four digits of their SSN d) None of the above. 31. The IRS, the state tax agencies, and the tax software companies are implementing a new layer of protection for income tax purposes; these entities will ask for taxpayers driver license number or state id number, this means that without one of the following can occur: a) The IRS will reject the income tax return because this information is required. b) The IRS will still process the tax return but delays can occur if in reality there is an identity theft issue. c) This information is only sent to the IRS so all the states are accepting the return without this information. d) Taxpayers will be able to provide this information directly into their IRS online account. Questions Section 3 Answers and Discussion 21. Answer d. Under the current law, the taxability of damages, i.e., the amounts received as a result of a claim or legal action for compensation for injury, depends upon the nature of the underlying claim. If a direct payment on the underlying claim would be includible as income under section 61, and no specific exemption for that type of income is otherwise provided in the Code, then damages intended to compensate for loss of that includible income are themselves includible income. 22. Answer c. Section 104 of the Code specifically excludes from gross income most compensation for physical injuries or physical sickness. Damages for non-physical injuries, such as mental anguish, damage to reputation, discrimination, or lost income, are not within the purview of the section 104 exclusion. 23. Answer d. Under the provision, with respect to any wrongfully incarcerated individual, gross income shall not include any civil damages, restitution, or other monetary award (including compensatory or statutory damages and restitution imposed in a criminal matter) relating to the incarceration of such individual for the covered offense for which such individual was convicted. 24. Answer d. A wrongfully incarcerated individual means an individual: 3) who was convicted of a covered offense; 4) who served all or part of a sentence of imprisonment relating to that covered offense; and iii. was pardoned, granted clemency, or granted amnesty for such offense because the individual was innocent, or iv. for whom the judgment of conviction for the offense was reversed or vacated, and whom the indictment, information, or other accusatory instrument for that covered 3 HR. Federal Tax Updates. 39

196 offense was dismissed or who was found not guilty at a new trial after the judgment of conviction for that covered offense was reversed or vacated. 25. Answer d. Under the current law, reimbursements under an employer-provided accident or health plan for medical care expenses for employees, their spouses, their dependents, and adult children under age 27 are excludible from gross income. 26. Answer d. The provision expands the exception to apply to plans funded by medical trusts in addition to those covered under present law. As expanded, the exception would apply to a plan funded by a medical trust (1) that is either established in connection with a public retirement system or established by or on behalf of a State or political subdivision thereof, and 27. Answer b. The provision permits rollovers of distributions from employer-sponsored retirement plans and traditional IRAs (that are not SIMPLE IRAs) into a SIMPLE IRA after the expiration of the two-year period following the date the employee first participated in the SIMPLE IRA (the two-year period during which the additional income tax on distributions from a SIMPLE IRA is 25 percent instead of 10 percent). 28. Answer b. The new tax extender provision extends the Internal Revenue Service s authority to require truncated Social Security numbers on Form W Answer a. The provision requires employers to include an identifying number for each employee, rather than an employee s SSN, on Form W Answer a. Under the present law, section 6051(a) generally requires that an employer provide a written statement to each employee on or before January 31 of the succeeding year showing the remuneration paid to that employee during the calendar year and other information including the employee s Social Security number. 31. Answer b. This information is optional for most state tax returns, but a few states do require it to complete the electronic filing process. It is also optional for a federal tax return. However, providing these identification numbers will help the IRS verify taxpayers identity. This measurement can prevent unnecessary delays in tax return processing due to the possibility that there exist an identity theft issue. 3 HR. Federal Tax Updates. 40

197 ETHICS 2017

198

199 Tax practitioners and Taxpayers under Section 6103, sharing their Tax Information. Tax practitioners, in their position as taxpayers, and other taxpayers as well must know that the law protects their tax return information from disclosure to other parties by the Internal Revenue Service. IRC Section 6103 generally prohibits the release of tax information by an IRS employee. However, there are important exceptions under this section that all taxpayers must be aware of: IRC 6103(d) provides that return information may be shared with state agencies responsible for tax administration. The state agency must request this information in writing, and the request must be signed by an official designated to request tax information. IRC 6103(i)(1) provides that, pursuant to court order, return information may be shared with law enforcement agencies for investigation and prosecution of non-tax criminal laws. IRC 6103(k)(6) allows the IRS to make limited disclosures of return information in the course of official tax administration investigations to third parties if necessary to obtain information that is not otherwise reasonably available. IRC 6103(l)(1) provides that return information related to taxes imposed under chapters 2, 21, and 24 may be disclosed to the Social Security Administration (SSA) as needed to carry out its responsibilities under the Social Security Act. Chapter 2 relates to self-employment income and does not normally concern employers. Chapter 21 concerns social security and Medicare (FICA) tax, and chapter 24 deals with income tax withholding. The IRS may therefore share information with SSA about social security and Medicare tax liability if necessary to establish the taxpayer s liability. This provision does not allow the IRS to disclose that tax information to SSA for any other reason. SSA employees who receive this information are bound by the same confidentiality rules as IRS employees. Therefore, they generally cannot disclose the information to state social security administrators, state officials or other Federal agencies. IRC 6103(e)(6) and (c) provide for disclosures to powers of attorney and other designees. If taxpayers are notified of an audit by the IRS, they may want to have someone other than the authorized officer of their entity represent them or participate in the meeting. Taxpayers may bring any individual they wish into the discussion, in person or by telephone. They may give oral consent to speak with a third party if necessary to resolve a Federal tax matter. However, oral consent does not substitute for a power of attorney or a legal designation, and the discussion is limited to the issue for which the consent is given. To officially establish a legal representative, taxpayers must provide consent using one of the following forms: Form Use this form if you want someone to represent you before the IRS. An individual named on a Form 2848 is authorized to take actions on your behalf, including signing returns and making agreements with the IRS. Form 2848 may be used to designate only those admitted to practice before the Service. 2 HR. Ethics. 1

200 Form Taxpayers can give this form to someone to inspect or receive their confidential tax information. It can be sent to an accounts management center that handles the tax return information, or directly to the office handling a matter. OPR and Section The Office of Professional Responsibility (OPR) has created a standard section 6103 information-request letter for practitioners and their representatives to use to request tax information maintained in OPR case files and obtained as part of an inquiry into possible violations of the regulations governing practice before the IRS (Circular 230). The letter functions as a request under section 6013 of the Internal Revenue Code for access to tax returns and related tax information. A practitioner, or an authorized representative on a practitioner s behalf, can use the letter to request copies of (1) the practitioner s own tax information; (2) relevant tax information of other taxpayers, such as clients or former clients of the practitioner; or (3) both the practitioner s own tax information and the tax information of third parties, depending on the particular case. The section 6103 information-request letter is based on certain provisions of the statute, which are different in their coverage: The provisions in section 6103(e)(1) and (7) provide the method for a practitioner, in his or her status as a taxpayer, to obtain disclosure of the practitioner s tax information contained in the case file associated with the practitioner. More specifically, the provisions authorize a taxpayer, through a written request, to inspect and receive the taxpayer s returns filed with the IRS and the taxpayer s return information (defined in section 6103(b)(2)), unless the IRS determines that disclosure of some or all of the return information would seriously impair federal tax administration. With respect to another taxpayer s returns and return information, section 6103(l)(4) authorizes their disclosure, upon written request, to any person... whose rights are or may be affected by an administrative action or proceeding under Circular 230. Additionally, the same returns and return information may also be disclosed to a duly authorized legal representative of the person. Disclosure under this provision is limited only to returns and return information that are or may be relevant and material to the action or proceeding involving Circular 230. A practitioner, or a practitioner s authorized representative, therefore, may use subsection (l)(4) in a Circular 230 matter or proceeding to request disclosure of relevant third-party tax information. It is important to note that any information disclosed under section 6103(l)(4) is solely for use in, or to prepare for, the action or proceeding. Any other use or disclosure of the third-party tax data is prohibited. A practitioner or representative who makes an unauthorized disclosure is subject to potential civil and criminal liability. The section 6103 information-request letter includes acknowledgments by the requester(s) of the disclosure restrictions and potential penalties for violations. The section 6103 information-request letter is distinct from a Freedom of Information Act (FOIA) request. The section 6103 information-request letter generally will be an easier way to obtain the information requested and most often result in greater release of information than a FOIA request. 2 HR. Ethics. 2

201 Best Practices for Tax Practitioners. Tax practitioners should provide clients with the highest quality representation concerning Federal tax issues by adhering to best practices in providing advice and in preparing or assisting in the preparation of a submission to the Internal Revenue Service. Best practices include the following: Communicating. A practitioner should insure clear communication with the client regarding the terms of the engagement. For example, the advisor should determine the client s expected purpose for and use of the advice given and should have a clear understanding with the client regarding the form and scope of the advice or assistance to be rendered. Establishing facts. A practitioner should determine which facts are relevant, evaluate the reasonableness of any assumptions or representations, and relate the applicable law (including potentially applicable judicial doctrines) to the relevant facts, and arrive at a conclusion supported by the law and the facts. Giving Advise. A practitioner should advise the client regarding the import of the conclusions reached, including, for example, whether a taxpayer may avoid accuracy-related penalties under the Internal Revenue Code if a taxpayer acts in reliance on the advice. Practice before the IRS. A practitioner should always act fairly and with integrity in practice before the Internal Revenue Service. Tax advisors with responsibility for overseeing a firm s practice of providing advice concerning Federal tax issues or of preparing or assisting in the preparation of submissions to the Internal Revenue Service should take reasonable steps to ensure that the firm s procedures for all members, associates, and employees are consistent with the best practices set forth above. Performing Due Diligence as a Tax Preparer. Professional tax return preparers have the responsibility to provide quality service and to abide by certain ethical standards. When they obtain their Annual Filing Season Certificate from the IRS, there are ethical standards that they must be familiar with and abide by. Tax professionals are required to maintain a certain level of due diligence to help insure that the tax returns that you are submitting to the IRS and state agencies are accurate and correct. Ethical standards that they must abide by include the following: Never knowingly prepare false returns Never engage in criminal, infamous, dishonest, notoriously disgraceful conduct, or any other conduct deemed to have a negative effect on the IRS Treat all taxpayers in a professional, courteous, and respectful manner Obtain training to obtain the knowledge necessary to complete accurate tax returns and keep up to date on tax law changes Complete the proper steps when electronically filing tax returns Safeguard the personal information acquired so as to maintain the privacy and confidentiality of all individuals whose information tax professionals obtain and only use 2 HR. Ethics. 3

202 that information for purposes of filing tax returns. What is due diligence? Due diligence means that tax practitioners must do their part to ensure tax returns are correct, including verifying the identity and social security numbers of all individuals included on a tax return. As IRS certified tax preparers, practitioners ensure the information on the return prepared or reviewing is correct and complete. Tax practitioners will do their part when they: Confirming a taxpayer s (and spouse if applicable) identity including complete legal names and Social Security Numbers Providing top-quality service by helping taxpayers understand and meet their tax responsibilities Making sure the facts presented by the taxpayer make sense to you and paint a reasonable picture of the facts being presented. Generally practitioners can rely on good faith for taxpayer information without requiring documentation as verification. However, exercise caution when taxpayers want to claim a refundable credit such as the Earned Income Credit or education credits, especially if these credits are maximized. Things to Remember about Due Diligence: Ensure the tax return is correct. Question any unusual, inconsistent, or incomplete items. Remind taxpayers that when they sign their tax returns, they are stating under penalty of perjury that the return is accurate to the best of their knowledge. Follow due diligence guidelines and take reasonable steps to ensure the tax return is correct by abiding by the following: Ask enough questions to determine if allowable expenses were incurred and that income reported is correct. Add all taxable income to the tax return, even if the taxpayer does not agree with you. If the item is questionable and/or unallowable, do not claim the deduction or credit on the tax return. If you are uncomfortable with the information and/or documentation provided by a taxpayer, do not prepare the tax return. If the taxpayer does not agree with your advice, you should not prepare the return. Tax return integrity means that you must take reasonable steps to ensure the tax return is correct, which includes: Verifying that all social security numbers presented by the taxpayer match the social security numbers listed on the tax return. Not preparing returns that you are unfamiliar with (for example, preparing a corporate 2 HR. Ethics. 4

203 form 1120 tax return when you have had no prior training for this type of return). Explaining to the taxpayer why the deduction or credit can or cannot be included on their return. Use IRS reference materials used to support your statements. Not making changes or corrections to the tax return after the taxpayer leaves your office/location without first notifying the taxpayer. Power of Attorney & Authorization Forms: Form 2848 & 8821 When taxpayers authorize a tax practitioner or a third party to receive confidential tax information or authorize them to act on their behalf regarding federal tax matters, taxpayers must make the appropriate filing with IRS. There are two different ways to give authorization to a person. The way they choose depend on the amount of power they are willing to give to the person that is going to be helping them. Power of attorney gives them the most power; representatives can act on taxpayers behalf for tax matters. Taxpayers can also limit their power by just authorizing them access specific confidential tax information by filling out and filing the tax information authorization form. IRS Form 2848 Power of Attorney and Declaration of Representative. With IRS form 2848, taxpayers are giving power of attorney to the specific representative. Once the form is completed, the individual to represent the taxpayer before the IRS can receive and inspect confidential information about the taxpayer s taxes. The person authorized on the form must be eligible to represent taxpayer before the IRS. The Power of Attorney and Declaration of Representative is a two part form in which the taxpayer information must be provided and the representative s also. The representative can provide a CAF number, if there is one. This CAF number is assigned by the IRS in order to identify representatives. The second part of the form is the declaration of representative. In this part, the representative must sign, date, and enter the designation under which they are allowed to practice before the IRS. IRS Form 8821 Tax Information Authorization. IRS form 8821 is only used to authorize any individual, corporation, firm, organization, or partnership to inspect and/or receive taxpayer s private tax information. They can receive information from any IRS office for the tax information and years that are listed on the form. This form gives the appointee limited power over taxpayer s financial information. Completing this form does not give representation rights before the IRS, nor execute waives, neither sign documents nor closing agreements. If taxpayers want to give more power to their representative, they must complete a Power of Attorney. 2 HR. Ethics. 5

204 CIRCULAR 230 AND FORM 4764, LB&I EXAMINATION PLAN-GUIDANCE Individuals may also consider that under the corporate officers or employees identified in Section 1(b) of Form 4764, Communications Agreement, LB&I Examination Plan, they can have unlimited rights to practice before the IRS. Over this, Circular 230 regulates the representation activity by practitioners, and others, meaning those who represent (advocate) or otherwise practice before the IRS. The Large Business & International (LB&I) Communications Agreement allows a corporate taxpayer to designate one or more employees to 1) discuss tax matters, 2) provide and receive information, or 3) receive and discuss adjustments (or some combination of these three). The LB&I Communications Agreement operates as an authorization to receive tax information, similar to Form 8821, Tax Information Authorization. The LB&I Communications Agreement does NOT replace the Form When a corporate employee is merely providing or accepting information to, or from, the IRS, there is no representation activity or practice occurring and the Form 4764 will suffice. However, when the employee advocates, negotiates, disputes or does anything which goes beyond mere delivery of facts, general explanation, or acceptance of materials, the employee is engaged in representation activities ( practicing ) before the agency and the Form 4764 is not sufficient. In the LB&I context, this typically involves advocating or defending certain positions related to the corporation s tax liability or adjustments proposed thereto. Corporations that want a specific employee to advocate, negotiate, or dispute issues with the IRS on behalf of the corporation, then a Form 2848, Power of Attorney, must be obtained from the corporation authorizing that representation. The Form 2848 must be signed by a duly elected officer or director of the corporation as identified in the corporate articles or by-laws (typically, the same officer who signs the corporation s tax returns and consents to extend the time for assessment of tax). Vanity-titled officers of a corporation are not legally authorized to execute the Form 2848 on behalf of the corporation. The IRS point of contact should request the Form 2848 from the appropriate corporate official when representation activities are about to, or have, begun. By providing a vanity-title on the form, the representative will not receive special treatment or get faster answer to the issue in question. IRS employees make referrals to OPR for alleged Circular 230 misconduct using Form 8484, Suspected Practitioner Misconduct Report for the Office of Professional Responsibility (rev ). Form 8484 asks for evidence of the subject s practice before the IRS for Circular 230 jurisdiction to be established. A Form 2848 submitted to the IRS is one source of evidence of practice for purposes of establishing Circular 230 s jurisdiction over the individual designated on the Form Other forms of evidence of practice can include a tax opinion written for the corporation to support taking a position in its tax return (31 USC 330(d)), or conduct that involves the preparation for compensation of all or a substantial portion of a document for submission to the IRS with respect to a corporate taxpayer s tax liabilities (31 CFR sec. 10.8(c); sec (b)). In any referral situation, a thorough and complete narrative must be provided that describes the individual s conduct and the alleged Circular 230 violation(s). This information assists OPR in 2 HR. Ethics. 6

205 beginning an investigation. Upon receipt of the 8484, OPR conducts an independent investigation of the facts and circumstances and determines whether, and to what extent, discipline may be necessary. THIRD PARTY DESIGNEE USING THE INCOME TAX RETURN CHECK BOX. Taxpayers that check the Yes box on the Third Party Designee line are authorizing the IRS to call the designee to answer any questions that may arise during the processing of the return. This designation includes both taxpayers in case they are filing a joint return. By using this option taxpayers are authorizing the designee to: Give the IRS any information that is missing from the return, Call the IRS for information about the processing of the return or the status of the refund or payment(s), Receive copies of notices or transcripts related to the return, upon request, and Respond to certain IRS notices about math errors, offsets, and return preparation. This designation does not grant authorization to tax professional to receive any refund check, bind taxpayers to anything (including any additional tax liability), or otherwise represent taxpayers before the IRS. If taxpayers want to expand the designee's authorization, they must complete a Power of Attorney. The authorization will automatically expire no later than the due date (not counting extensions) for filing the tax return in question. For example if the tax return is for 2016, the expiration date is April 18, This is true for most people because once their refund arrives there would be no other issue to discuss. The OPR. The Office of Professional Responsibility (OPR) administers and enforces the regulations governing practice before the IRS. In very general terms, individuals who are eligible to "practice" are eligible to represent taxpayers before the IRS. The regulations governing practice are set out in title 31, Code of Federal Regulations, part 10, and are published in pamphlet form as Treasury Department Circular No The enabling legislation for the Circular 230 regulations appears in title 31, United States Code, section 330. Circular 230. Circular 230 is a document containing the statute and regulations detailing a tax professional s duties and obligations while practicing before the IRS. The document contains the sanctions for violations of the duties and obligations as well as the disciplinary actions. Circular 230 is the common name given to the body of regulations promulgated from the enabling statute found at Title 31, United States Code 330. This statute and the body of regulations are the source of OPR s authority 2 HR. Ethics. 7

206 Practice before the IRS. What Is Practice Before the IRS? Practice before the IRS covers all matters relating to any of the following. Communicating with the IRS for a taxpayer regarding the taxpayer's rights, privileges, or liabilities under laws and regulations administered by the IRS. Representing a taxpayer at conferences, hearings, or meetings with the IRS. Preparing and filing documents with the IRS for a taxpayer. Corresponding and communicating. Just preparing a tax return, furnishing information at the request of the IRS, or appearing as a witness for the taxpayer is not practice before the IRS. These acts can be performed by anyone. Who is eligible to Practice before the IRS? Any of the following individuals can practice before the IRS. However, any individual who is recognized to practice (a recognized representative) must be designated as the taxpayer's power of attorney and file a written declaration with the IRS stating that he or she is authorized and qualified to represent a particular taxpayer. Form 2848 can be used for this purpose. State licensed Attorneys and Certified Public Accountants authorized and in good standing with their state licensing authority who interacts with tax administrative at any level and in any capacity. Persons enrolled to practice before the IRS- Enrolled Agents, Enrolled Retirement Plan Agents, and Enrolled Actuaries. Persons providing appraisals used in connection with tax matters (e.g., charitable contributions; estate and gift assets; fair market value for sales gain, etc.). Unlicensed individuals who represent taxpayers before the examination, customer service and the Taxpayer Advocate Service in connection with returns they prepared and signed. Licensed and unlicensed individuals who give written advice with respect to any entity, transaction, plan or arrangement; or other plan or arrangement, which is of a type the IRS determines as having a potential for tax avoidance or evasion. For this purposes written advice contemplates all forms of written material, including the content of an , given in connection with any law or regulation administered by the IRS. Any person submitting a power of attorney in connection with limited representation or special authorization to represent before the IRS with respect to a specific matter before the Agency. The New Annual Federal Tax Refresher and Practice before the IRS. Tax preparers that secure their voluntary Annual Filing Season Program will need to adhere to the duties and restrictions found in subpart B and Section of Treasury Department Circular 230 in order to receive their Annual Filing Season Program Record of Completion, be listed on the IRS website, and have the right to represent their clients before the IRS. 2 HR. Ethics. 8

207 Regarding the Record of Completion. Detailed information is found under Rev. Proc regarding the new requirements and benefits offered under the Annual Filing Season Program. Section 4 of Rev. Proc indicates that the Record of Completion is effective for one calendar year. Once issued, the Record of Completion is effective for tax returns and claims for refund prepared and signed from the later of January 1 of the year covered by the Record of Completion or the date the Record of Completion is issued until December 31 of that year. The following is the list of restrictions listed on Subpart B of Treasury Department Circular 230: SECTION INFORMATION TO BE FURNISHED TO THE IRS A. A practitioner must promptly submit information to the IRS unless it is privileged [Section 10.20(a)(1)]. B. If a third party possesses requested information, the practitioner must provide any identity information they have [Section 10.20(a)(2)]. C. A practitioner cannot interfere with the IRS in obtaining information unless it is privileged [Section 10.20(b)]. II. SECTION KNOWLEDGE OF CLIENT S OMISSION A. A practitioner must promptly advise their client of: (i) an error or omission or noncompliance; and (ii) the consequences of such items [Section 10.21]. III. SECTION DILIGENCE TO DETERMINE ACCURACY A. A practitioner must exercise due diligence in (i) preparing IRS returns and documents, (ii) determining the correctness of representations made to the IRS and (iii) determining the correctness of representations made to their client [Section 10.22(a)]. B. A practitioner may generally rely upon the work product of others, if reasonable care is used in evaluating the work product and the other person [Section 10.22(b)]. IV. SECTION PROMPT DISPOSITION OF PENDING MATTERS A. A practitioner may not unreasonably delay the disposition of a matter before the IRS [Section 10.23]. V. SECTION FEE A. A practitioner may not charge an unconscionable fee in connection with a matter before the IRS [Section 10.27]. VI. SECTION RETURN OF A CLIENT S RECORDS A. Generally a practitioner must promptly return client records upon request even if there is a fee dispute [Section 10.28(a)]. B. Records include items that: (i) preexisted the practitioner s retention; or (ii) were 2 HR. Ethics. 9

208 prepared by the client or a third party [Section 10.28(b)]. C. Records do not include practitioner prepared documents, which are withheld pending the payment of fees with respect to that document [Section 10.28(b)]. SECTION CONFLICTING INTERESTS A. A practitioner may not represent a client if: (i) the representation of one client is adverse to the interest of or responsibility to another client; or (ii) the representation of a client would be limited due to the personal interests of the practitioner [Section 10.29(a)]. B. Even if a conflict exists, representation is permitted if: (i) the practitioner reasonably believes that they can provide competent and diligent representation; and (ii) the client waives the conflict and gives informed written consent [Section 10.29(b)]. VIII. SECTION PREPARATION STANDARDS A. A practitioner may not sign a return or advise a client to take a position that: (i) lacks a reasonable basis; (ii) willfully attempts to understate the tax; or (iii) intentionally disregards the rules and regulations [Section 10.34(a)]. B. A practitioner may not advise or allow a client to submit a document or paper to the IRS that is: (i) frivolous; or (ii) intentionally disregards the rules and regulations [Section 10.34(b)]. C. A practitioner may generally rely on information furnished by the client without verification; however, they cannot ignore what is actually known [Section 10.34(d)]. D. A practitioner must make reasonable inquiries if information appears to be: (i) incorrect; (ii) incomplete; or (iii) inconsistent with another fact [Section 10.34(d)]. IX. PROPOSED SECTION COMPETENCE A. A practitioner must possess the requisite competence to practice before the IRS [Proposed Section 10.35]. B. Competence requires knowledge, skill, thoroughness and preparation necessary for the matter [Proposed Section 10.35]. X. SECTION PROCEDURES TO ENSURE COMPLIANCE A. A practitioner with the principal responsibility for overseeing the firm s practice of preparing returns or documents for submission to the IRS, must ensure that Circular 230 compliance procedures are in place for all members [Section 10.36(b)] B. If the practitioner with the principal responsibility knows or should know a firm member has engaged in a pattern of practice that is in violation of Circular 230 and fails to take prompt action to correct the non-compliance, they may be subject to disciplinary action [Section 10.36(b)] Section Tax preparers participating in the program must also adhere to Section of Circular 230 which indicates the sanctions under The following are some of the sanctions for incompetence and disreputable conduct of tax preparers: Conviction of any criminal offense under the Federal tax laws. Conviction of any criminal offense involving dishonesty or breach of trust. Conviction of any felony under Federal or State law for which the conduct involved 2 HR. Ethics. 10

209 renders the practitioner unfit to practice before the Internal Revenue Service. Individuals who fail to comply with the duties and restrictions relating to practice before the IRS in subpart B and section of Circular 230 or with any of the requirements described in this revenue procedure will have their Record of Completion revoked and may be prohibited from participating in the Annual Filing Season Program in the future based on the facts and circumstances, including the act that resulted in the noncompliance. Representation Before the IRS after December 31, Tax preparers with a Record of Completion can represent taxpayers before the IRS during an examination of a tax return or claim for refund that they prepared and signed (or prepared if there is no signature space on the form). Requirements. Tax preparers must have the following to represent their clients before the IRS: A valid Annual Filing Season Program Record of Completion for the calendar year in which the tax return or claim for refund was prepared and signed; and A valid Annual Filing Season Program Record of Completion for the year or years in which the representation occurs. The representation permitted under this section does not permit an individual who has a Record of Completion to represent the taxpayer before appeals officers, revenue officers, Counsel, or similar officers or employees of the IRS. After the December 31, 2015 unenrolled tax return preparer without a Record of Completion will not be able to represent a taxpayer during an examination if the tax return preparer prepared and signed the taxpayer s return that is under examination (or prepared the taxpayer s return that is under examination if there is no signature space on the form). IRS listing. Tax preparers can now be listed in the IRS directory. The IRS launched a public directory of tax return preparers to help taxpayers find a tax professional with credentials and select qualifications to help them prepare their tax returns. The searchable directory is located on IRS.gov. To be in this new directory tax professionals may be required to complete the new IRS Annual Filing Season Program and have current their PTINs. Program participants are not included in the directory, nor are volunteer tax return preparers who offer free services. Attorneys. Any attorney who is not currently under suspension or disbarment from practice before the IRS and who is a member in good standing of the bar of the highest court of any state, possession, territory, commonwealth, or of the District of Columbia may practice before the IRS. Certified public accountants (CPAs). Any CPA who is not currently under suspension or disbarment from practice before the IRS and who is duly qualified to practice as a CPA in any 2 HR. Ethics. 11

210 state, possession, territory, commonwealth, or in the District of Columbia may practice before the IRS. Enrolled agents. Any enrolled agent in active status may practice before the IRS. Enrolled retirement plan agents. Any enrolled retirement plan agent in active status may practice before the IRS. The practice of enrolled retirement plan agent is limited to certain Internal Revenue Code sections that relate to their area of expertise, principally those sections governing employee retirement plans. Student attorney. A student who receives permission to practice before the IRS by virtue of their status as a law student under section 10.7(d) of Circular 230. See Students in LITCs and STCP under Authorization for Special Appearances on page 4. Student CPA. A student who receives permission to practice before the IRS by virtue of their status as a CPA student under section 10.7(d) of Circular 230. See Students in LITCs and STCP under Authorization for Special Appearances on page 4. Other unenrolled individuals. Because of their special relationship with a taxpayer, the following unenrolled individuals can represent the specified taxpayers before the IRS, provided they present satisfactory identification and, except in the case of an individual described in (1) below, proof of authority to represent the taxpayer. An individual. An individual can represent himself or herself before the IRS and does not have to file a written declaration of qualification and authority. A family member. An individual can represent members of his or her immediate family. Immediate family means a spouse, child, parent, brother, or sister of the individual. An officer. A bona fide officer of a corporation (including a parent, subsidiary, or other affiliated corporation), association, or organized group can represent the corporation, association, or organized group. An officer of a governmental unit, agency, or authority, in the course of his or her official duties, can represent the organization before the IRS. A partner. A general partner can represent the partnership before the IRS. An employee. A regular full-time employee can represent his or her employer. An employer can be, but is not limited to, an individual, partnership, corporation (including a parent, subsidiary, or other affiliated corporation), association, trust, receivership, guardianship, estate, organized group, governmental unit, agency, or authority. A fiduciary. A fiduciary (trustee, executor, administrator, receiver, or guardian) stands in the position of a taxpayer and acts as the taxpayer, not as a representative. See Fiduciary under When Is a Power of Attorney Not Required, later. 2 HR. Ethics. 12

211 How Does an Individual Become an Enrolled Agent. The Office of Professional Responsibility can grant enrollment to practice before the IRS to an applicant who demonstrates special competence in tax matters by passing a written examination administered by the IRS. Enrollment also can be granted to an applicant who qualifies because of past service and technical experience in the IRS. In either case, certain application forms, discussed next, must be filed. Additionally, an applicant must not have engaged in any conduct that would justify suspension or disbarment from practice before the IRS. Form Applicants can apply to take the special enrollment examination by filing Form 2587, Application for Special Enrollment Examination. Part 4 of the form should be mailed with the examination fee to the address shown on the form. The amount of the fee is also shown on Form The form is revised annually and is available in mid-june each year. The form must be postmarked no later than July 31. Form 23. Individuals who have passed the examination or are applying based on past service and technical experience with the IRS can apply for enrollment by filing Form 23, Application for Enrollment to Practice before the Internal Revenue Service, with the Office of Professional Responsibility. The application must include a check or money order for fee shown on Form HR. Ethics. 13

212 Review Questions Section 1 Read and answer the following review questions. The correct answers are found on the next page with an explanation to strengthen up your knowledge. Note: This is not part of your Final Test. 1. Which of the following constitute best practices that should be followed by a tax practitioner? a) A practitioner should insure clear communication with the client regarding the terms of the engagement. b) A practitioner should determine which facts are relevant, evaluate the reasonableness of any assumptions or representations, and relate the applicable law (including potentially applicable judicial doctrines) to the relevant facts, and arrive at a conclusion supported by the law and the facts. c) A practitioner should advise the client regarding the import of the conclusions reached, including, for example, whether a taxpayer may avoid accuracy-related penalties under the Internal Revenue Code if a taxpayer acts in reliance on the advice. d) All of the above are best practices that a practitioner should follow. 2. Which of the following statements regarding performing "due diligence" by a tax practitioner is not accurate? a) Confirming a taxpayer s (and spouse if applicable) identity is not the tax practitioner's responsibility. b) A tax practitioner should make sure that facts presented by the taxpayer make sense and seem reasonable based on the facts being presented. c) A tax practitioner should help taxpayers with better understanding their tax responsibilities. d) All of the above statements are accurate. 3. If taxpayers want to give authorization to a tax practitioner to act on their behalf before the IRS, they should: a) Sign a blank document and give it to the tax professional. b) Call the IRS to give the proper authorization. c) They must file the proper form to the IRS. d) Tax practitioners can represent their clients always. 4. Corporate officers can have under the LB&I Examination plan one of the following rights: a) They can discuss any matter with the IRS. b) They have unlimited rights before the IRS. c) They can receive any tax refund and benefits over the corporation. d) None of the above. 5. In general the LB&I Examination Plan refers to: a) How large businesses communicate within the corporation. b) How large businesses will pay tax preparers for their service. c) How large businesses will communicate with the IRS. d) How large businesses will receive any tax refund. 2 HR. Ethics. 14

213 6. Tax professionals that want to practice before the IRS will be regulated by: a) The Department of the Treasury. b) The Association of Tax preparers. c) The Office of Professional Responsibility d) The Office of Tax Preparers. 7. Practice before the IRS includes the following: a) Communicating with the IRS regarding taxpayer s liabilities. b) Preparing taxpayer s documents that will be filed to the IRS. c) Corresponding and communicating with the IRS d) All of the above. 8. In general, preparing the income tax for a taxpayer or furnishing information at the request of the IRS will be considered: a) Practice before the IRS. b) Not practicing before the IRS. c) Reserved right for tax practitioners. d) None of the above. 9. A record of completion is given by the IRS to: a) All tax preparers that file their clients 2015 income tax return. b) Tax preparers that file their own income tax return on time. c) Tax preparers that secure their voluntary continuing education and adhere to Circular 230. d) Tax preparers that complete their annual continuing education. 10. A tax practitioner must exercise due diligence when. a) Preparing a tax return. b) Preparing a document to be sent to the IRS. c) Determining the correctness of oral and written representations made to the IRS. d) All of the above. 11. If there is a fee in dispute between the client and the tax preparer, tax preparer should: a) Retain the client s records until the fee is paid. b) Retain the client s records and contact the IRS. c) Promptly return the client s records upon request. d) Promptly return all the documents that were prepared by tax preparer. 12. A new IRS listing exist for tax practitioners, this new listing was designed for: a) Tax practitioners to advertise their own businesses. b) Taxpayers find a cheapest tax preparation services. c) Tax practitioners with credentials and that completed their Annual Filing Season Program d) All tax practitioners in general. 2 HR. Ethics. 15

214 13. From the following professionals, who is not authorized to practice before the IRS. a) An attorney who is not under suspension. b) An enrolled agent who is in active status. c) A student attorney who is under section 10.7 of Circular 230 d) None of the above, all of them are authorized. 14. John is a tax professional who want to become an enrolled agent; he can become an enrolled agent under all the following, except: a) He will get enrollment under the OPR approval by completing a tax examination. b) He can get enrollment by demonstrating past service. c) He can get enrollment by demonstrating technical experience in the IRS. d) All the above are correct steps to become an enrolled agent. Questions Section 1 Answers and Discussion 1. Answer d. A practitioner should determine which facts are relevant, evaluate the reasonableness of any assumptions or representations, and relate the applicable law (including potentially applicable judicial doctrines) to the relevant facts, and arrive at a conclusion supported by the law and the facts. A practitioner should also advise the client regarding the import of the conclusions reached, including, for example, whether a taxpayer may avoid accuracy-related penalties under the Internal Revenue Code if a taxpayer acts in reliance on the advice. 2. Answer a. Due diligence means that tax practitioners must do their part to ensure tax returns are correct, including verifying the identity and social security numbers of all individuals included on a tax return. As IRS certified tax preparers, practitioners ensure the information on the return prepared or reviewing is correct and complete. 3. Answer c. When taxpayers authorize a tax practitioner or a third party to receive confidential tax information or authorize them to act on their behalf regarding federal tax matters, taxpayers must make the appropriate filing with IRS. 4. Answer d. Individuals may consider that under the corporate officers or employees identified in Section 1(b) of Form 4764, Communications Agreement, LB&I Examination Plan, they can have unlimited rights to practice before the IRS. 5. Answer c. The Large Business & International (LB&I) Communications Agreement allows a corporate taxpayer to designate one or more employees to 1) discuss tax matters, 2) provide and receive information, or 3) receive and discuss adjustments (or some combination of these three). 6. Answer c. The Office of Professional Responsibility (OPR) administers and enforces the regulations governing practice before the IRS. 7. Answer d. Practice before the IRS covers all matters relating to any of the following. 2 HR. Ethics. 16

215 Communicating with the IRS for a taxpayer regarding the taxpayer's rights, privileges, or liabilities under laws and regulations administered by the IRS. Preparing and filing documents with the IRS for a taxpayer. Corresponding and communicating. 8. Answer b. Just preparing a tax return, furnishing information at the request of the IRS, or appearing as a witness for the taxpayer is not practice before the IRS. These acts can be performed by anyone. 9. Answer c. Tax preparers that secure their voluntary Annual Filing Season Program will need to adhere to the duties and restrictions found in subpart B and Section of Treasury Department Circular 230 in order to receive their Annual Filing Season Program Record of Completion 10. Answer d. A practitioner must exercise due diligence in (i) preparing IRS returns and documents, (ii) determining the correctness of representations made to the IRS and (iii) determining the correctness of representations made to their client 11. Answer c. Generally a practitioner must promptly return client records upon request even if there is a fee dispute [Section 10.28(a)]. Records include items that: (i) preexisted the practitioner s retention; or (ii) were prepared by the client or a third party [Section 10.28(b)]. Records do not include practitioner prepared documents, which are withheld pending the payment of fees with respect to that document [Section 10.28(b)]. 12. Answer c. The IRS launched a public directory of tax return preparers to help taxpayers find a tax professional with credentials and select qualifications to help them prepare their tax returns. The searchable directory is located on IRS.gov. To be in this new directory tax professionals may be required to complete the new IRS Annual Filing Season Program and have current their PTINs. 13. Answer d. Individuals who are allowed to practice before the IRS are any attorney who is not currently under suspension; any enrolled agent who is in active status; a student who receives permission to practice before the IRS by virtue of their status as a law student under section 10.7(d) of Circular Answer d. The Office of Professional Responsibility can grant enrollment to practice before the IRS to an applicant who demonstrates special competence in tax matters by passing a written examination administered by the IRS. Enrollment also can be granted to an applicant who qualifies because of past service and technical experience in the IRS. In either case, certain application forms, discussed next, must be filed. 2 HR. Ethics. 17

216 Period of enrollment. An enrollment card will be issued to each individual whose application is approved. The individual is enrolled until the expiration date shown on the enrollment card. To continue practicing beyond the expiration date, the individual must request renewal of the enrollment. Form Applicants for renewal of enrollment must file Form 8554, Application for Renewal of Enrollment to practice before the Internal Revenue Service. To qualify for renewal, applicants must complete the necessary hours of continuing professional education during each 3-year enrollment cycle. Practitioners are restricted from engaging in certain practices. Some of these restricted practices are shown below: Delays. A practitioner must not unreasonably delay the prompt disposition of any matter before the IRS. A practitioner must not knowingly, directly or indirectly, do the following: o Accept assistance from any person who is under disbarment or suspension from practice before the IRS if the assistance relates to matters considered practice before the IRS. o Accept assistance from any former government employee where provisions of Treasury Department Circular No. 230 or any federal law would be violated. o Performance as a notary. A practitioner who is a notary public and is employed as counsel, attorney, or agent in a matter before the IRS, or has a material interest in the matter, cannot engage in any notary activities related to that matter. o Negotiations of taxpayer refund checks. Practitioners who are income tax return preparers must not endorse or otherwise negotiate (cash) any refund check issued to the taxpayer. Disreputable Conduct. Any practitioner or unenrolled return preparer may be disbarred or suspended from practice before the IRS, or censured, for disreputable conduct. The following list contains examples of conduct that is considered disreputable. Being convicted of any criminal offense under the revenue laws or of any offense involving dishonesty or breach of trust. Knowingly giving false or misleading information in connection with federal tax matters, or participating in such activity. Soliciting employment by prohibited means as discussed in section of Treasury Department Circular No Willfully failing to file a tax return, evading or attempting to evade any federal tax or payment, or participating in such actions. Misappropriating, or failing to properly and promptly remit, funds received from clients for payment of taxes or other obligations due the United States. Directly or indirectly attempting to influence the official action of IRS employees by the use of threats, false accusations, duress, or coercion, or by offering gifts, favors, or any special inducements. 2 HR. Ethics. 18

217 Being disbarred or suspended from practice as an attorney, CPA, public accountant, or actuary, by the District of Columbia or any state, possession, territory, commonwealth, or any federal court, or anybody or board of any federal agency. Knowingly aiding and abetting another person to practice before the IRS during a period of suspension, disbarment, or ineligibility. Using abusive language, making false accusations and statements knowing them to be false, circulating or publishing malicious or libelous matter, or engaging in any contemptuous conduct in connection with practice before the IRS. Giving a false opinion knowingly, recklessly, or through gross incompetence; or following a pattern of providing incompetent opinions in questions arising under the federal tax laws. Censure, Disbarments, and Suspensions. The Office of Professional Responsibility may censure or institute proceedings to suspend or disbar any attorney, CPA, or enrolled agent who the Office of Professional Responsibility has reason to believe violated the rules of practice. Except in certain unusual circumstances, the Director will not institute a proceeding for censure, suspension, or disbarment against a practitioner until the facts (or conduct) which may warrant such action have been given in writing to that practitioner and the practitioner has been given the opportunity to demonstrate or achieve compliance with the rules. Due Diligence. A practitioner must exercise due diligence when performing the following: Preparing, assisting in preparing, approving, and filing of returns, documents, affidavits and other papers relating to IRS matters. Determining the correctness of oral or written representation made by them to the Department of the Treasury. Determining the correctness of oral or written representation made by them to clients with reference to any matter administered by the IRS. Restrictions. A practitioner must not unreasonably delay the prompt disposition of any matter before the IRS. In addition, a practitioner must not knowingly (directly or indirectly) do the following: Employ or accept assistance from any person who is under suspension or disbarment from practice before the IRS Accept employment as an associate from or share fees with any individual who is under suspension or disbarment from practice before the IRS Accept assistance from any former government employee where provisions of Circular 230 or any federal law would be violated A practitioner who is a notary cannot perform any notary activities in regards to any matters in which they are a principal. Practitioners who are return preparers must not endorse or cash any refund checks issued to the taxpayer. 2 HR. Ethics. 19

218 FRIVOLOUS TAX ARGUMENTS. Below is one of many common frivolous arguments that as a tax preparer you must be aware of. Contention: Taxpayers can reduce their federal income tax liability by filing a zero return. Some taxpayers are attempting to reduce their federal income tax liability by filing a tax return that reports no income and no tax liability (a zero return ) even though they have taxable income. Many of these taxpayers also request a refund of any taxes withheld by an employer. These individuals typically attach to the zero return a Form W-2, or another information return that reports income and income tax withholding, and rely on one or more of the frivolous arguments discussed throughout this outline to support their position. The Law: There is no authority that permits a taxpayer that has taxable income to avoid income tax by filing a zero return. Section 61 provides that gross income include all income from whatever source derived, including compensation for services. Courts have repeatedly penalized taxpayers for making the frivolous argument that the filing of a zero return can allow a taxpayer to avoid income tax liability or permit a refund of tax withheld by an employer. Courts have also imposed the frivolous return and failure to file penalties because such forms do not evidence an honest and reasonable attempt to satisfy the tax laws or contain sufficient data to calculate the tax liability. The IRS issued Revenue Ruling , C.B. 619, warning taxpayers of the consequences of making this argument. Furthermore, the inclusion of the phrase nunc pro tunc, or other legal phrase, does not have any legal effect and does not serve to validate a zero return. In February 2008, a federal court in Dallas permanently barred Phillip M. Ballard from preparing federal income tax returns for anyone other than himself. The court found that Ballard, whose business is called Asset & IRS Shield, Inc., prepared federal income tax returns for customers that falsely showed nothing but zeroes on most, if not all, lines. Relevant Case Law: Lindberg v. Commissioner, T.C. Memo in granting the IRS s motion for summary judgment, the court upheld a frivolous return penalty on the taxpayer based on the zero-wage return he filed. The court also imposed a $1,000 section 6673 penalty on the taxpayer for wasting the court s limited resources. THE DEPARTMENT OF JUSTICE. The Judiciary Act of 1789 created the Office of the Attorney General which evolved over the years into the head of the Department of Justice and chief law enforcement officer of the Federal Government. The Department of Justice has a large list of agencies that work on specific areas to enforce the law and prevent potential threats. One of those agencies is focused in the Tax Division and is in 2 HR. Ethics. 20

219 charge of enforcing the nation s tax laws fully, fairly, and consistently, through both criminal and civil litigation. The agency of Tax matters is in charge of promoting voluntary compliance with the tax laws, maintain public confidence in the integrity of the tax system, and promote the sound development of the law. The Tax Division is divided in the following sections: Civil trial section Court of Federal claims section. This section defends all tax suits filed in the United States Court of Federal Claims. Appellate section. Assist the United State Tax Court and other state courts. Office of review. Criminal enforcement section. This section investigates and prosecutes individuals and corporations that attempt to evade taxes, willfully fail to file returns, submit false tax forms, and otherwise attempt to defraud taxpayers. This section cooperates with the IRS Criminal Investigation and the Treasury Inspector General for Tax Administration. Criminal appeals and tax enforcement policy section. TAX PREPARER PENALTIES IRC 6694 Understatement of taxpayer s liability by tax return preparer. IRC 6694(a) Understatement due to unreasonable positions. The penalty is the greater of $1,000 or 50% of the income derived by the tax return preparer with respect to the return or claim for refund. In this case the tax preparer knew (or reasonably should have known) of the position in order to pay the penalty. The penalty would not apply if it is shown that there is reasonable cause for the understatement and the tax return preparer acted in good faith. IRC 6694(b) Understatement due to willful or reckless conduct. The penalty is the greater of $5,000 or 50% of the income derived by the tax return preparer with respect to the return or claim for refund. The penalized conduct of tax preparer is one in which: The preparer willfully attempts in any manner to understate the liability for tax on the return or claim, or The tax preparer recklessly or intentionally disregard of rules or regulations. The amount of any penalty payable by any person by reason of this action for any return or claim for refund may be reduced by the amount of the penalty paid by such person by reason of acting 2 HR. Ethics. 21

220 in good faith or not knowing the cause. IRC 6695 Other assessable penalties with respect to the preparation of tax returns for other persons. IRC 6695(a) Failure to furnish copy to taxpayer. The penalty is $50 for each failure to comply with IRC 6107 regarding furnishing a copy of a return or claim to a taxpayer. The maximum penalty imposed on any tax return preparer shall not exceed $25,000 in a calendar year. IRC 6695(b) Failure to sign return. The penalty is $50 for each failure to sign a return or claim for refund as required by regulations. The maximum penalty imposed on any tax return preparer shall not exceed $25,000 in a calendar year. IRC 6695(c) Failure to furnish identifying number. The penalty is $50 for each failure to comply with IRC 6109(a)(4) regarding furnishing an identifying number on a return or claim. The maximum penalty imposed on any tax return preparer shall not exceed $25,000 in a calendar year. IRC 6695(d) Failure to retain copy or list. The penalty is $50 for each failure to comply with IRC 6107(b) regarding retaining a copy or list of a return or claim. The maximum penalty imposed on any tax return preparer shall not exceed $25,000 in a return period. IRC 6695(e) Failure to file correct information returns. The penalty is $50 for each failure to comply with IRC The maximum penalty imposed on any tax return preparer shall not exceed $25,000 in a return period. IRC 6695(f) Negotiation of check. The penalty is $500 for a tax return preparer who endorses or negotiates any check made in respect of taxes imposed by Title 26 which is issued to a taxpayer. IRC 6695(g) Failure to be diligent in determining eligibility for earned income credit. The penalty is $500 for each failure to comply with the EIC due diligence requirements imposed in regulations. IRC 6700 Promoting abusive tax shelters. The penalty is for a promoter of an abusive tax shelter and is generally equal to $1,000 for each organization or sale of an abusive plan or arrangement (or, if lesser, 100 percent of the income derived from the activity). IRC 6701 Penalties for aiding and abetting understatement of tax liability. The penalty is $1000 ($10,000 if the conduct relates to a corporation s tax return) for aiding and abetting in an understatement of a tax liability. Any person subject to the penalty shall be penalized only once for documents relating to the same taxpayer for a single tax period or event. 2 HR. Ethics. 22

221 IRC 6713 Disclosure or use of information by preparers of returns. The penalty is $250 for each unauthorized disclosure or use of information furnished for, or in connection with, the preparation of a return. The maximum penalty on any person shall not exceed $10,000 in a calendar year. IRC 7206 Fraud and false statements. Guilty of a felony and, upon conviction, a fine of not more than $100,000 ($500,000 in the case of a corporation), imprisonment of not more than three years, or both (together with the costs of prosecution). IRC 7207 Fraudulent returns, statements, or other documents. Guilty of a misdemeanor and, upon conviction, a fine of not more than $10,000 ($50,000 in the case of a corporation), imprisonment of not more than one year, or both. IRC 7216 Disclosure or use of information by preparers of returns. Guilty of a misdemeanor for knowingly or recklessly disclosing information furnished in connection with a tax return or using such information for any purpose other than preparing or assisting in the preparation of such return. Upon conviction, a fine of not more than $1,000, imprisonment for not more than 1 year, or both (together with the costs of prosecution). IRC 7407 Action to enjoin tax return preparers. A federal district court may enjoin a tax return preparer from engaging in certain proscribed conduct, or in extreme cases, from continuing to act as a tax return preparer altogether. IRC 7408 Action to enjoin specified conduct related to tax shelters and reportable transactions A federal district court may enjoin a person from engaging in certain proscribed conduct (including any action, or failure to take action, which is in violation of Circular 230). Tax preparer recordkeeping requirement. Paid preparers are required to retain certain information regarding those returns for specified period of time according to Section 6107(b) through 3(b). Tax preparer in this case should retain the records of the return for a period ending 3 years after the close of the return period. This includes to retain a completed copy of such return or claim, or retain, on a list, the name and taxpayer identification number of the taxpayer for whom such return or claim was prepared, and make such copy or list available for inspection upon request by the Secretary. Example 1. A tax practitioner prepares Form 1040 for the calendar year The return is not extended and is presented to the taxpayer for signature on April 1, The preparer must retain a copy of this return until June 30, Example 2. A tax practitioner prepares Form 1040 for the calendar year The return is extended to August 15, 2015 and is presented to the taxpayer for signature on August 1, The preparer must retain a copy of this return until June 30, HR. Ethics. 23

222 Review Questions Section 2 Read and answer the following review questions. The correct answers are found on the next page with an explanation to strengthen up your knowledge. Note: This is not part of your Final Test. 15. Once an individual become enrolled agent he/she will serve as enrolled agent for: a) Undefined time. b) The expiration date shown on his/her card. c) 6 months. d) 10 years. 16. In order to have a renewal of enrollment, individuals must: a) Pass a tax examination again. b) Serve the IRS for 1 year. c) Serve tax payers for free. d) Complete their required continuing professional education. 17. Restrictions to tax practitioners included on Circular 230 include all the following, except: a) Give the opportunity to practice to an individual even if the individual is under disbarment. b) Receive assistant from a former government employee regarding federal law and how to avoid it. c) Perform as a notary over activities related to the matter. d) All the above are restrictions included on Circular The OPR has the right to disbar from practice one of the following individuals: a) Attorneys b) Tax professionals c) CPAs d) All of the above 19. If tax practitioners help their clients file a zero income tax return, they will: a) Receive a bigger refund. b) Be exempt from filing future income tax returns. c) Can be barred from preparing future income tax returns. d) Will be awarded. 20. The penalty for understatement due to unreasonable position is: a) $100 for each position. b) $1,000 or 50% of the income derived by the tax return. c) $1,000 or 50% of the income derived over the year. d) None of the above. 2 HR. Ethics. 24

223 21. Tax professionals that fail to furnish a copy to taxpayers will be subject to: a) Immediate removal. b) Penalty of $50 for each failure up to $25,000 in a year. c) Penalty of $1,000 in any calendar year. d) Penalty of $100 for each failure up to 10 clients. 22. In case tax practitioner file a client income tax return for a fee and do not sign the return, the preparer will have to: a) Amend the income tax return. b) Pay a penalty of $50. c) Call the IRS to give his/her personal information. d) Tax practitioner s signature is not requested. Questions Section 2 Answers and Discussion 15. Answer b. An enrollment card will be issued to each individual whose application is approved. The individual is enrolled until the expiration date shown on the enrollment card. To continue practicing beyond the expiration date, the individual must request renewal of the enrollment. 16. Answer d. Applicants for renewal of enrollment must file Form 8554, Application for Renewal of Enrollment to practice before the Internal Revenue Service. To qualify for renewal, applicants must complete the necessary hours of continuing professional education during each 3-year enrollment cycle. 17. Answer d. Practitioners are restricted from: a) Accept assistance from any person who is under disbarment or suspension from practice before the IRS if the assistance relates to matters considered practice before the IRS. b) Accept assistance from any former government employee where provisions of Treasury Department Circular No. 230 or any federal law would be violated. c) A practitioner who is a notary public and is employed as counsel, attorney, or agent in a matter before the IRS, or has a material interest in the matter, cannot engage in any notary activities related to that matter. 18. Answer d. The Office of Professional Responsibility may censure or institute proceedings to suspend or disbar any attorney, CPA, or enrolled agent who the Office of Professional Responsibility has reason to believe violated the rules of practice. 19. Answer c. In February 2008, a federal court in Dallas permanently barred Phillip M. Ballard from preparing federal income tax returns for anyone other than himself. The court found that Ballard, whose business is called Asset & IRS Shield, Inc., prepared federal income tax returns for customers that falsely showed nothing but zeroes on most, if not all, lines. 2 HR. Ethics. 25

224 20. Answer b. IRC 6694(a) Understatement due to unreasonable positions. The penalty is the greater of $1,000 or 50% of the income derived by the tax return preparer with respect to the return or claim for refund. 21. Answer b. The penalty is $50 for each failure to comply with IRC 6107 regarding furnishing a copy of a return or claim to a taxpayer. The maximum penalty imposed on any tax return preparer shall not exceed $25,000 in a calendar year. 22. Answer b. The penalty is $50 for each failure to sign a return or claim for refund as required by regulations. The maximum penalty imposed on any tax return preparer shall not exceed $25,000 in a calendar year. 2 HR. Ethics. 26

225 CALIFORNIA 2017

226

227 CALIFORNIA NEWS, LAWS AND MORE FOR 2017 Income tax refund expected time. During the income tax season, many taxpayers wonder why their federal refund was received while the state refund takes more than expected. The FTB has indicated that the normal time to process an electronic tax return for an individual is up to 2 weeks. After this period the FTB will normally deal with other steps to complete the process and issue the refund. Taxpayers should receive their refund, or a notice from the FTB requesting additional information within the following time frame: Individuals e-file 1 month paper 1 month Businesses e-file 5 months paper 5 months Amended Returns Individuals: 6 months Businesses: 6 months According to this time frame, taxpayers should not hurry to tax prepare s office to ask for their state refund if the time frame has not passed yet. New Electronic Fund Withdrawal Option. Beginning January 2017, taxpayers and tax practitioners will have the ability to submit an Electronic Fund Withdrawal (EFW) request for extension and estimate payments using tax preparation software. What is new is that these payment requests will be accepted as stand-alone, and can be submitted separately from the e-file return. The return can be filed at a later date. The following payment types will be available: o Individuals and Fiduciary (Estate/Trust) Estimate Extension o Business Entities (Corporations/LLCs/Partnerships) Extension Taxpayers and tax practitioners will still have the ability to submit EFW requests for return and estimate payments with the e-filed return using tax preparation software. Practitioners should contact their software provider to see if they are supporting Stand Alone EFW payments. New Implied Consent; an option to the POAD. The FTB has implemented a new implied consent; an alternative or option to a processed Power of Attorney Declaration. These new option provides practitioners with prompt assistance to resolve their clients tax matters. The FTB improved the procedures so the staff can interact with representatives easily 5 HR. California Tax, 1

228 and quickly. In many situations the new implied consent avoids the Power of Attorney (POA) Declaration requirement. Implied consent occurs when a taxpayer s representative can provide enough information from a Franchise Tax Board (FTB) notice or a taxpayer s account to infer that the representative has authorization to discuss specific account information. Implied consent does not replace the potential need for a POA declaration, if you wish to discuss any tax years that are not included in the notice or will be representing the taxpayer on an ongoing basis. The implied consent is not intended to be used as a basis to discuss all tax years or all tax matters. No Deduction for Energy System Paid with Loan Programs. Some homeowners finance energy saving improvements through government-approved loan programs. The payments on these loans are collected through taxpayer s tax bill, so they may appear to be deductible real estate taxes. However, the payments are not deductible real estate taxes. Tax practitioners must know that in general the loan programs have similar facts. Taxpayers sign up for a home energy system loan and use the proceeds to make home energy improvements to their home. The home energy system loan is secured by a lien on their home. The taxpayer repays the principal and interest associated with this home energy system loan over some period agreed to in the documents they signed. This is billed to them through specific assessments, i.e., additional amounts due to the governmental entity. These specific assessments appear on their real estate property tax bill over the period of the loan. The taxpayer s real estate tax bill may not list the breakdown between principal and interest. However, in reality, the total amount due reflects an amount for principal repayment and an amount for interest expense, using the interest rate applicable to the loan. The documents the taxpayer signed may list this breakdown. As stated above, the amount that is billed to the taxpayer through the specific assessment is not deductible as a real estate tax. This amount is not deductible because it is a specific assessment associated with a specific improvement benefitting the taxpayer s home. In other words, it is not in the nature of a general assessment. It is not similar to other typical real estate tax assessments that are levied against all real estate in their jurisdiction for more general governmental funding purposes, i.e., to fund public schools, fire departments, bridge construction projects, etc. However, the interest portion of the taxpayer s payment may be deductible as qualified residence interest, i.e., home mortgage interest expense. Clients wonder why they received a 1099G from Previous Years. Receiving a 1099G for a year beyond one year from the return year for an overpayment credited forward or a refund issued is not uncommon. 5 HR. California Tax, 2

229 This may occur when an amended return is filed, a return is filed beyond the extended due date, or when significant steps beyond normal processing are required by the FTB to process a return. Practitioners may have seen that their clients received a G for their timely-filed 2014 return instead of a G as they expected. In these instances, the taxpayers filed by the extended deadline, applied their 2014 overpayment forward to their 2015 estimated tax, and reported the California overpayment as income on their 2015 federal return. We properly credited their 2014 overpayments to their 2015 estimated tax as requested. However, due to the implementation of a new return processing systems in the latter part of 2015, some 2014 overpayments (even though properly credited to taxpayers accounts in 2015) weren t posted to the FTB accounting systems until early This resulted in the FTB issuing the corresponding Gs for the 2016 tax year. Practitioners may suggest clients to contact the FTB to verify that the form was issued following the new process. For example, if the clients timely filed their 2014 return, applied their 2014 overpayment to 2015 and reported the income from the overpayment for federal purposes in 2015, but received a G from us, they may need to contact the FTB so they can revise the 1099G accordingly. Options for Clients with Balances Due. Practitioners may have clients that want to explore a way to pay their balance due with the state. In some cases, the client may be eligible to pay their balance by making installment payments over time. Generally, taxpayers are eligible to request an installment agreement (IA) through FTB s automated system if they meet all of the following conditions: Their tax liability does not exceed $25,000. The installment period to clear the balance cannot exceed 60 months (5 years). The taxpayer must have filed all required valid personal income tax returns. Taxpayers do not have an existing installment agreement. If taxpayers are eligible, they should make the largest monthly payment possible because their tax liability will continue to accrue interest and possibly penalties until it is fully paid. If taxpayers do not meet these criteria, or if they currently have an order to withhold, continuous order to withhold, or earnings withholding order for taxes in effect, please ask them to contact the FRB to discuss their options. The FTB approves or rejects installment agreement requests based on the taxpayer s ability to pay and their compliance history. The FTB may file a lien and/or request a financial statement as a condition for approval. Taxpayers under installment agreements. By entering into an installment agreement, taxpayers agree to make timely monthly payments to pay the balance due. They also agree to meet all future tax obligations, including filing valid tax returns timely and paying all future tax liabilities timely. Practitioners can ensure that their clients have enough withholding or estimated tax payments to pay their tax liability in full for future years. 5 HR. California Tax, 3

230 By requesting an installment agreement taxpayers should be aware of the following: If the installment agreement is through an authorized electronic funds transfer, payments will be automatically deducted from their bank account. Therefore, they must keep adequate funds in their bank account to satisfy monthly payments. Additional interest and some penalties continue to accrue while they make their scheduled payments. They agree to pay a $34 installment agreement fee. The FTB will add the fee to the balance due. The FTB will keep any state tax refund that the taxpayer expects during the term of the installment agreement and use it to reduce amount owed. The refund amount will not replace their monthly payment. If the client fails to make timely payments or if they incur an outstanding past due amount in a future year, they will be in default of the installment agreement. If this occurs, the FTB will send a notice of its intent to terminate the installment agreement. Requesting an installment agreement is possible by using one of the following methods. Online Phone - Call to use the Interactive Voice Response (IVR) system 24 hours a day, 7 days a week. Mail - Complete and mail FTB 3567, Installment Agreement Request. Incomplete information will delay the processing of your request. State and local government Verify Tax Return Compliance of Taxpayers. New in 2012, counties within California are now eligible to exchange limited confidential taxpayer tax data with the FTB through a reciprocal Standard Agreement. Participating counties will provide data to the FTB on local business taxpayers. In return the FTB will provide participating county tax officials data for individuals operating a business with an address within the county s jurisdiction. This exchange of data is designed to identify businesses who are not filing required income tax returns and provides a county with potential leads in finding unlicensed businesses. What information is shared so State and Cities can find delinquent taxpayers? Cities/Counties provide FTB: FTB provides Cities/Counties: Business and owner's name Taxpayer name Business or residence address Taxpayer address FEIN or SSN Taxpayer SSN or FEIN North American Industry Entity type Classification Code or Standard Principal Business Activity (PBA) Industry Classification Code Code The transmittal of the information is not made by regular mail, instead the FTB and the participating cities and counties use the Secure Web Internet File Transfer (SWIFT). 5 HR. California Tax, 4

231 New Nonprofit Corporations Administrative Dissolution. Beginning January 2017, the FTB will move forward to administratively dissolve qualified inactive nonprofit corporations. Assembly Bill 557, which becomes effective January 1, 2017, provides for the administrative dissolution of qualified inactive nonprofit corporations. Affected entities are those that are suspended or forfeited by the FTB for a period of 48 continuous months or more and are no longer in business. The process will start with a correspondence letter to the selected nonprofit corporation informing them of the pending administrative dissolution to the last known valid mailing address. A list of the selected corporations pending administrative dissolution will be posted on the California Secretary of State (SOS) website. If a corporation does not have a known valid mailing address, notification will only occur by the posting on the SOS website. Corporations will have 60 days to object in writing to the pending administrative dissolution. If the corporation objects in writing during the 60 day notice period, then it will have 90 days from the date of the written notice to pay any owed taxes, penalties, and interest and file any missing returns and a current Statement of Information with SOS, or it will be administratively dissolved/surrendered at the end of the 90 day period. Additional information will be made available on our Charities and Nonprofits webpage to provide guidance to nonprofit corporations on the administrative dissolution process as procedures are developed. New California Law Puts Charge in Lead-Acid Battery Sales. Beginning April 1, 2017, sales of lead-acid batteries will be subject to two $1 fees. Manufacturers will pay a $1 fee for every lead-acid battery sold to a retailer, wholesaler, distributor, or other person for retail sale in California. Consumers will pay a $1 fee on each purchase of a replacement lead-acid battery. Retailers are required to register, collect, and remit the fee to the Board of Equalization (BOE); while manufacturers are required to register and remit the fee to the BOE. Manufacturers who are considered retailers are required to collect the $1 California battery fee as well as pay the $1 manufacturer battery fee. Retailers, who purchase and import lead-acid batteries from a manufacturer who is not subject to the jurisdiction of California, must pay the $1 manufacturer battery fee. A lead-acid battery is a battery that is commonly found in vehicles. These batteries weigh more than 11 pounds. The primary composition of these batteries is both lead and sulfuric acid; they have a capacity of six or more volts. Retailers will charge a refundable deposit, subject to sales tax, when a consumer purchases a replacement lead-acid battery and does not simultaneously provide a used lead-acid battery to the dealer. The fee is expected to generate $26 million annually. Revenues collected will be deposited into the Lead-Acid Battery Cleanup Fund, where they will be used to investigate, evaluate, clean up, 5 HR. California Tax, 5

232 remediate, remove, monitor, or otherwise respond to any area in the state that may have been contaminated by the operation of a lead-acid battery recycling facility. Beginning April 1, 2022, manufacturers will no longer be required to collect and remit the $1 fee. Instead, consumers will pay a $2 fee upon purchase of a replacement lead-acid battery. SALES TAX RATES AND DETAILS. The statewide sales and use tax rate starting January 1, 2017 is 7.25 percent (0.0725). However, the rate is higher in locations where voters have approved additional "district" taxes. Most of these districts encompass an entire countywide area; however, some districts are limited to a single city. District taxes may be used for special services such as transportation or libraries, or they may be used to support general services. Examples In Santa Barbara County the tax rate is 7.75 percent. This rate reflects the 7.25 percent statewide base rate plus 0.50 percent for the Santa Barbara County Transportation Authority. The rate applies countywide. In the City of Sonora, located in Tuolumne County, the tax rate is 7.75 percent. This rate reflects the 7.25 percent statewide base plus 0.50 percent for a city transactions and use tax. The 7.75 percent rate applies only within the city limits of Sonora. The tax rate in areas of Tuolumne County outside the City of Sonora is 7.25 percent. Sales beyond Taxpayers District Lines. Taxpayers and business may want to know what amount of sales tax they should collect when selling their products in other districts. They can follow the next guidelines to charge the proper amount of sales tax. Property sold in a district which is delivered or first used in that district. If the business is located in a district, the sales are generally subject to transactions (sales) tax when the business delivers the property to the purchaser in the same district. The transactions (sales) tax applies even if the purchaser intends to immediately transport and use the property outside the district. Property delivered to another district. District use tax is due on property that the customer first stores, uses, or otherwise consumes in a district. A customer who is liable for district use tax on property first used in a district is allowed a credit for any transactions (sales) tax reimbursement already paid. This credit is limited to the amount of transactions (sales) tax reimbursement paid by the customer in the district of origin. That is, a refund of district tax is not available if the tax owed in the district of first use is less than the transactions (sales) tax reimbursement already paid on the purchase. For example, taxpayers business is located in a district and they sell merchandise to a customer who is located in an area where there is no district. If their customer picks up the merchandise at business location, the sale is subject to the business district s tax, even if the customer intends to take the merchandise back to his or her location. On the other hand, if the business ships the property to the purchaser s location, the sale is generally not subject to the business districts transactions (sales) tax. Either the retailer or purchaser may be responsible for reporting district 5 HR. California Tax, 6

233 use tax to the BOE, depending on the circumstances of the sale or use of the property, as discussed in the following sections. Retailers. Retailer are required to collect and report district use tax on a sale in the district in which they are engaged in business. Engaged in business basically means that they do business in a district when they: Maintains, occupies, or uses any type of office, sales room, warehouse, or other place of business in the district, even if it is used temporarily, indirectly, or through an agent or subsidiary. Has any kind of representative operating in the district for the purposes of making sales or deliveries, installing or assembling tangible personal property, or taking orders. Receives rentals from a lease of tangible personal property located in the district. Sells or leases vehicles or undocumented vessels which will be registered in a district. Retailers can report the district use tax in their own district if one of the following conditions applies: They ship or deliver the property into the district. They participate in the sale of the property within that district. Participation includes solicitation whether director indirect. It also includes receipt of orders at a place of business in the district or through any representative, agent, canvasser, solicitor, subsidiary, or any other person working in the district under their authority. They are a licensed dealer of vehicles or undocumented vessels that are registered by the purchaser in a county with district taxes. If a sale meets these conditions, they must collect district use tax on all taxable charges including those taxable charges which result from repairs or reconditioning. The following example illustrates when retailers should collect and report district use tax: A retailer in Santa Clara County makes a taxable sale of property which is delivered to and used by the purchaser in unincorporated Alameda County. Even though it is subject to the general sales tax, the sale would be exempt from Santa Clara County district taxes because the property was delivered according to the contract of sale outside the county for use outside the county. However, use of the property in Alameda County makes the sale subject to the district use tax in Alameda County. If the retailer is engaged in business in Alameda County and ships or delivers the property within Alameda County, he or she is responsible for collecting and reporting all applicable county-wide district use taxes on his or her sales. If the retailer is not engaged in business in the county, the purchaser is generally responsible for reporting and paying district use tax on his or her purchases. Purchasers. Purchaser are generally required to report and pay district use tax on the purchase price of tangible personal property when: They make the first taxable use of the property in a district. They purchased the property without district tax or at a lesser rate of district tax than is imposed in the district of use. 5 HR. California Tax, 7

234 The retailer has no obligation to collect and report the tax. As stated above, they are eligible for a credit of tax paid to another district, but only up to the amount of tax due in the district of use. Example: A consumer buys merchandise and pays district tax of 1.00 percent. The consumer then first uses the property in another location where the district tax rate is.50 percent. The consumer is liable for the district use tax at the.50 percent rate, but is eligible for a credit based on the transactions (sales) tax of 1.00 percent paid to the other district. However, no refund is allowed for the additional.50 percent district tax paid on the purchase. Please note: Certain cities within counties may have higher rates due to citywide district taxes. If the consumer buys merchandise in a location and pays district tax of.50 percent and then first uses it in another location where the district tax rate is 1.00 percent, he or she is liable for the district use tax of 1.00 percent. The consumer is allowed a credit for the.50 percent district tax paid, but owes the additional.50 percent district tax due in the location where the property was first used. The Franchise Tax Board The agency in California that corresponds to the Internal Revenue Service is the Franchise Tax Board (FTB). The FTB is responsible for administering two of California's major tax programs: Personal Income Tax and the Corporation Tax. The Franchise Tax Board also have responsibility for administering other nontax programs and delinquent debt collection functions, including delinquent vehicle registration debt collections on behalf of the Department of Motor Vehicles, court ordered debt, and Industrial Health and Safety assessments. California Income Tax The California return begins with the federal adjusted gross income and adjustments are made to account for differences in federal and state laws. California tax forms. California has two different individual resident income tax forms: Form 540 2EZ and Form 540. Another frequently used tax form is the Schedule CA (540). Schedule CA is used with Form 540 to make adjustments to the federal AGI and federal itemized deductions. Taxpayers who are not full-year residents of California must file Form 540NR instead of Form 540. Rules about taxation of part-year and non-year residents differ slightly from taxation of full-year residents. California residents are taxed on all their income. California part year residents are taxed on all of their income while a California resident and their income from California sources (if any) when a nonresident. Nonresidents are taxed only on their income from California sources. Another form in California is Form 540X. This form is used to amend any previously filed California tax return. Form 540A was discontinued for tax years 2013 and later. 5 HR. California Tax, 8

235 Form 540 2EZ Residency California resident the entire year Filing Status Single, married/rdp filing jointly, head of household, qualifying widow(er) Which Form Should I Use? Form Form 540 Short Form 540 A 540NR DISCON California California TINUED resident the resident the entire AS OF entire year year 2013 Any status filing Dependents 0-3 allowed All qualifying dependents Amount of $100,000 if single or Any amount of income head of household income $200,000 married/rdp filing jointly or qualifying widow(er) Single, married/rdp filing jointly, head of household, qualifying widow(er) Long Form 540NR Not a California resident the entire year Any filing status 0-5 allowed All qualifying dependents Total income of Any amount of $100,000 or less income Sources Income of Wages, salaries, tips Taxable interest, dividends and pensions Unemployment compensation reported on Form 1099G Taxable scholarship and fellowship grants (only if reported on Form(s) W-2) Paid family leave U.S. social security benefits Tier 1 and tier 2 railroad retirement payments Capital gains from mutual funds All sources of income Only income from: Wages, salaries, tips Taxable interest Unemployment compensation Paid family leave insurance Note: California does not tax unemployment compensation All sources of income Filing Requirements. An individual must file a return if either their gross income or their adjusted gross income (AGI) was more than the amount defined by law. California residents must consider their total worldwide gross income to determine their filing requirement. 5 HR. California Tax, 9

236 Part-Year residents. Part-year residents must file a return if they have any income taxable by California (which includes income from all sources while a resident and California source income while a nonresident), and their income from all sources is more than the filing requirement amounts for residents. Nonresidents. Nonresidents must file a return if they have any California source income and their income from all sources is more than the filing requirement amounts for residents. Individual Filing Requirements Chart. If your gross income or adjusted gross income is more than the amount shown in the chart below for your filing status, age, and number of dependents, then you have a filing requirement. Filing Status Age as of December 31, 2016* California Gross Income Dependents California Adjusted Gross Income Dependents Single or head of household Married/RDP filing jointly or separately Qualifying widow(er) Dependent of another person (Any filing status) Under 65 $16,597 $28,064 $36,664 $13,278 $24,745 $33, or older $22,147 $30,747 $37,627 $18,828 $27,428 $34,308 Under 65 (both spouses/rdps) 65 or older (one spouse) 65 or older (both spouses/rdps) $33,197 $44,664 $53,264 $26,558 $38,025 $46,625 $38,747 $47,347 $54,227 $32,108 $40,708 $47,588 $44,297 $52,897 $59,777 $37,658 $46,258 $53,138 Under 65 N/A $28,064 $36,664 N/A $24,745 $33, or older N/A $30,747 $37,627 N/A $27,428 $34,308 Under 65 More than your standard deduction 65 or older More than your standard deduction Dependent s Filing Requirements. Dependents that have taxable income exceeding their standard deduction will be required to file their income tax return. The dependent's standard deduction is the larger of: The dependent's earned income plus $350, or $1,050 for the 2016 taxable year. The dependent's standard deduction can never be more than the normal standard deduction $4, HR. California Tax, 10

237 Nonresident spouse. Taxpayers that file a joint tax return for federal may file separately for California if either spouse was: An active member of the United States armed forces or any auxiliary military branch during A nonresident for the entire year and had no income from California sources during This exemption will not be valid if the spouse with California source income is domiciled in a community property state, unless the income is separate income Half of the nonresident s wages are taxable to California because California is a community property state and the spouse/rdp is a resident of California. Example. Mark and Carmen are married and California residents. Mark agreed to work overseas for 20 months under an employment contract. The family remained in California for that period. During those 20 months Mark visited his family in California for a month. In this case Mark can be considered a nonresident during his absence and the month-long visit to California is considered temporary. During the year, Mark earned $80,000 on his overseas assignment and Carmen earned $30,000 as a teacher in California. They decide to file separate returns and the separate income is as follows: Mark and Carmen separate return. Income Mark s California Nonresident Return Carmen California Return Total AGI CA AGI. Schedule CA Adjusted. Total AGI no adjustments. Mark $40,000 $0 $40,000 Carmen $15,000 $15,000 $15,000 Total Wages $55,000 $15,000 $55,000 Residency. Residency is significant because it determines how income is taxed by California. A resident is any individual who meets any of the following: Present in California for other than a temporary or transitory purpose. Domiciled in California, but outside California for a temporary or transitory purpose. A nonresident is any individual who is not a resident. A part-year resident is any individual who is a California resident for part of the year and a nonresident for part of the year. The underlying theory of residency is that you are a resident of the place where you have the closest connections. The following list shows some of the factors that taxpayers can use to help determine their residency status. Since the residence is usually the place where they have the closest ties, they should compare their ties to California with the ties elsewhere. In using these factors, it is the strength of taxpayers ties, not just the number of ties that determines their residency. 5 HR. California Tax, 11

238 9 Month or 6 Month Rule. California law provides two presumptions. The first presumption is that a taxpayer who, in the aggregate, spends more than 9 months of a taxable year in California will be presumed to be a California resident. The second presumption is that an individual whose presence in California does not exceed 6 months within a taxable year and who maintains a permanent home outside California is not considered a California resident provided the taxpayer does not engage in any activity or conduct within the State other than as a seasonal visitor, tourist, or guest. The following factors are helpful in planning to establish nonresident status in California. These factors look to the State in which the following occurred: Amount of time you spend in California versus amount of time you spend outside California. Birth, marriage, raising family. Location of your spouse/rdp and children. Location of your principal residence. State that issued your driver s license. State where your vehicles are registered. State in which you maintain your professional licenses. State in which you are registered to vote. Location of the banks where you maintain accounts. The origination point of your financial transactions. Location of your medical professionals and other healthcare providers (doctors, dentists etc.), accountants, and attorneys. Location of your social ties, such as your place of worship, professional associations, or social and country clubs of which you are a member. Location of your real property and investments. Permanence of your work assignments in California. This is only a partial list of the factors to consider. Consider all the facts of your particular situation to determine your residency status. Meaning of Domicile. The term domicile has a special legal definition that is not the same as residence. While many states consider domicile and residence to be the same, California makes a distinction and views them as two separate concepts, even though they may often overlap. For instance, you may be domiciled in California but not be a California resident or you may be domiciled in another state but be a California resident for income tax purposes. Domicile is defined for tax purposes as the place where you voluntarily establish yourself and family, not merely for a special or limited purpose, but with a present intention of making it your true, fixed, permanent home and principal establishment. It is the place where, whenever you are absent, you intend to return. Change of Domicile. You can have only one domicile at a time. Once you acquire a domicile, you retain that domicile until you acquire another. 5 HR. California Tax, 12

239 A change of domicile requires all of the following: Abandonment of your prior domicile. Physically moving to and residing in the new locality. Intent to remain in the new locality permanently or indefinitely as demonstrated by your actions. Temporary or Transitory Purposes. Generally, your state of residence is where you have your closest connections. If you leave your state of residence, it is important to determine if your presence in a different location is for a temporary or transitory purpose. You should consider the purpose and length of your stay when determining your residency. Military Residency Information. The Military Spouses Residency Relief Act ((MSRRA) passed in 2009 allows the option of aligning the military individuals residency along their own spouses. This new law supports military spouses from a number of things arising from residency issues including: Taxes, Auto registration, Property ownership, and Others. Under the Act spouses can keep their original state of residency no matter where the military spouse is stationed. Hence, spouses can have protection in their taxes. For example if a military member is stationed in California but his/her home of record is in Texas, the spouse is not required to pay California state taxes while employed in California. In this case military members should complete Form DE4 to request exemption from California State Taxes. But the same is true in the opposite way. If a military member s spouse is residing in California the income is taxable to California. Military service members domiciled in California must include their military pay in total income. In addition, they must include their military pay in California source income when stationed in California. Non-California domicile stationed in California. Nonresident military personnel merely having a duty station within California (whose legal residence is not California) are not required to file a California income tax return unless they have earned income from California sources other than military pay (example: you had a part-time job while you were living in California on military orders). If they have earned income in California other than military pay, they are required to file a nonresident return. A military service member whose domicile is outside of California but that is stationed in California is considered a non-resident. The California tax on part-year residents or nonresidents is the California taxable income multiplied by a California tax rate. Nonresidents use either: (1) the Short Form 540NR; or (2) the Long Form 540NR and Schedule CA (540NR) to compute their tax. 5 HR. California Tax, 13

240 A spouse who is not in the military generally has the same domicile as the military spouse unless proven otherwise. Because of this, if taxpayers are filing Married Filing Jointly, they would file a Resident return for the state that the military member is a resident of. If the member of the military is a California resident, the spouse would generally file a California Resident Married Filing Joint return. If the member of the military is a nonresident of California the spouse would generally file a California Nonresident Married Filing Joint return. If taxpayers are filing Married Filing Separate returns, the military member would file a Married Filing Separate return for his or her resident state. If the husband and wife are both in military service, each could be a resident of a different state under the Soldiers and Sailors Civil Relief Act. Non-California domiciled Military stationed in or out of California all year. Military members domiciled outside of California are considered nonresidents for tax purposes even when stationed in California on PCS orders. Each member of a military couple follows the rules applicable to each of them as individual military members. California-domicile stationed outside the state. An individual domiciled in California when entering the military is considered to be a: Resident while stationed in California; Resident while stationed in California on Permanent Change of Station (PCS) orders and Temporary Duty (TDY) assignments outside California, regardless of the duration; and Nonresident while stationed outside California on PCS orders. California military members who leave California under PCS orders become nonresidents of California for income tax purposes when they leave California. All income received or earned prior to departure is subject to tax by California. After departure, only income from California sources is subject to tax by California. Nonresidents are generally not taxed by California on income from intangibles, such as dividends from stocks or interest from bonds or bank accounts. California military members who leave California under a TDY assignment continue to be California residents even though absent from the state. California military members on a ship whose home port is in California remain California residents while on sea duty, regardless of the ship s location. Coming into California. When you are present in California for temporary or transitory purposes, you are a nonresident of California. For instance, if you come to California for a vacation, or to complete a transaction, or are simply passing through, your purpose is temporary or transitory. As a nonresident, you are taxed only on your income from California sources. 5 HR. California Tax, 14

241 When you are in California for other than a temporary or transitory purpose, you are a California resident. For instance, if your employer assigns you to an office in California for a long or indefinite period, if you retire and come to California with no specific plans to leave, or if you are ill and are in California for an indefinite recuperation period, your stay is other than temporary or transitory. As a resident, you are taxed on income from all sources. You will be presumed to be a California resident for any taxable year in which you spend more than nine months in this state. Although you may have connections with another state, if your stay in California is for other than a temporary or transitory purpose, you are a California resident. As a resident, your income from all sources is taxable by California. Business Licenses Required in California. Businesses coming to California will need to comply with the requirements to do business in California. The following is a list of the most common business licenses in California. California Licenses, Permits and Registration. 1. Tax Registration. Employer Identification Number (EIN): All employers who have employees, including business partnerships and corporations, must be assigned an Employer Identification Number (EIN) or Employer Tax ID from the IRS California Tax Registration: Those businesses operating within the state of California are additionally required to register for more specific identification numbers, licenses or permits for different tax purposes. Examples of these include income tax withholding, sellers permits for sales and use tax, and unemployment insurance tax. The California Tax Service Center provides all the specific information regarding business owner tax obligations and registration procedures. 2. Business Licenses. Each business may require an additional business-specific license to operate. For example a tree service may require a Tree Service Contractor License or a Barber may require a Barber License to operate in California. 3. Local Permits. The local government in each County or City may require specific permits and licenses. Each municipality may have its own unique regulations. Here are some of the most common licenses and permits that they may require: Alarm Permit Building Permit Business License and/or Tax Permit Health Permit Occupational Permit Signage Permit Zoning Permit 5 HR. California Tax, 15

242 4. Incorporation Filing. Businesses which operate as corporations, limited liability companies (LLC), a partnership (either limited or limited liability) or who are a nonprofit organization need to register with the Secretary of the State. 5. Doing Business As (DBA). Filing for a fictitious name allows the creation of a business name which is then separate from the individual s legal name. This is called Doing Business As, or DBA. Sole proprietors wishing to do business under a business or company name which is different from the proprietor s legal name will have to file a fictitious name with their county registrar at the county clerk s office. Partnerships, corporations, or LLCs may also choose to file a DBA. The FTB and participating cities in the state exchange data through reciprocal agreement using Senate Bill 1146 (Cedillo) (Chapter 345, Statutes of 2008). With this exchange the city data helps identify self-employed individuals who have income tax filing requirements. Cities provide to FTB with: Business and owner's name Business or residence address FEIN or SSN North American Industry Classification Code or Standard Industry Classification Code FTB provides to cities with: Taxpayer name Taxpayer address Taxpayer SSN or FEIN Entity type Principal Business Activity (PBA) Code from Form California Resident Income Tax Return 5 HR. California Tax, 16

243 Review Questions Section 1 Read and answer the following review questions. The correct answers are found on the next page with an explanation to strengthen up your knowledge. Note: This is not part of your Final Test. 1. The agency in California that corresponds to the Internal Revenue Service is the. a) Franchise Tax Board. b) California Tax Education Council c) Board of Equalization. d) The California Office of Professional. 2. The California s tax agency collects other nontax programs including: a) Delinquent vehicle registration. b) Court-ordered debts c) Industrial Health and Safety assessments d) All of the above. 3. California income tax returns are filing using: a) The same form 1040 writing For California at the top b) Using Form 540 2EZ, Form 540 or Form 540NR. c) Using Form 540 CA for all taxpayers d) Using Form 100CA 4. In order to make adjustments to the federal AGI and itemized deductions in California, taxpayers will need to: a) Complete a separate Schedule A with the proper deductions for California. b) File Form 540NR c) Complete a separate Schedule C for California. d) Complete Schedule CA. 5. Taxpayers who were not full-year residents of California will be required to: a) File Form 540 and Form 540NR at the same time. b) File only their federal tax return. c) File Form 540 NR alone d) File Schedule CA alone. 6. California residents are taxed on the income received from: a) All their income from all sources b) None of their income c) California source income only d) Non-California source income only 7. California part-year residents are taxed on the income received from: a) All their income from all sources b) None of their income c) All of their income while a California resident and their income from California sources when a nonresident d) Non-California source income only 5 HR. California Tax, 17

244 8. California nonresidents will pay taxes on the following income: a) All their income from all sources. b) None of their income. c) California source income only. d) Non-California source income only. 9. In general, the main theory of resident is based on: a) The age of taxpayer. b) The taxpayer s closest connections. c) The taxpayer s favorite place. d) The taxpayer s future place. 10. If taxpayers who, in aggregate, spend more than nine months in California will be considered: a) California non-resident. b) Taxpayer with California tax benefits. c) California resident. d) California part-year resident. 11. In order for taxpayers to avoid being considered California residents one of the following must be true: a) They spend less than 6 months in California. b) They maintain a permanent home outside California. c) They came as tourist or guest but do not to engage in any business. d) All of the above. 12. In order for taxpayers to change their domicile they have to do all the following, except one: a) Abandon their prior domicile. b) Intent to remain in the new locality permanently and demonstrate it by actions. c) Leave any mail box or car registration open. d) Physically move to the new location. 13. Under the Military Spouses Residency Relief Act taxpayers in the military and spouses can: a) File their taxes with zero income. b) Claim extra tax deductions. c) Align their residency for tax purposes. d) Exclude any California income from their tax return. 14. For California, nonresident military personnel with a duty station within California receiving only military payments will: a) File a California return with their military payment. b) Not file any California return. c) Pay taxes on their staying period. d) Receive a tax credit. 5 HR. California Tax, 18

245 15. Businesses in California will be required to get one of the following applicable licenses: a) Business License. b) Alarm permit. c) Building permit. d) All of the above. Questions Section 2 Answers and Discussion 1. Answer a. The agency in California that corresponds to the Internal Revenue Service is the Franchise Tax Board (FTB). 2. Answer d. The Franchise Tax Board also have responsibility for administering other nontax programs and delinquent debt collection functions, including delinquent vehicle registration debt collections on behalf of the Department of Motor Vehicles, court ordered debt, and Industrial Health and Safety assessments. 3. Answer b. California has two different individual resident income tax forms: Form 540 2EZ and Form 540. Taxpayers who are not full-year residents of California must file Form 540NR instead of Form Answer d. Schedule CA is used with Form 540 to make adjustments to the federal AGI and federal itemized deductions. 5. Answer c. Taxpayers who were not a California resident the entire year will be required to file Form 540NR 6. Answer a. California residents must consider their total worldwide gross income to determine their filing requirement. 7. Answer c. Part-year residents must file a return if they have any income taxable by California (which includes income from all sources while a resident and California source income while a nonresident). 8. Answer c. Nonresidents must file a return if they have any California source income and their income from all sources is more than the filing requirement amounts for residents. 9. Answer b. The underlying theory of residency is that taxpayers are a resident of the place where they have the closest connections. 10. Answer c. The first presumption is that a taxpayer who, in the aggregate, spends more than 9 months of a taxable year in California will be presumed to be a California resident. 11. Answer d. The second presumption is that an individual whose presence in California does not exceed 6 months within a taxable year and who maintains a permanent home outside 5 HR. California Tax, 19

246 California is not considered a California resident provided the taxpayer does not engage in any activity or conduct within the State other than as a seasonal visitor, tourist, or guest. 12. Answer c. A change of domicile requires all of the following: Abandonment of prior domicile. Physically moving to and residing in the new locality. Intent to remain in the new locality permanently or indefinitely as demonstrated by taxpayer s actions. 13. Answer c. The Military Spouses Residency Relief Act ((MSRRA) passed in 2009 allows the option of aligning the military individuals residency along their own spouses. 14. Answer b. Nonresident military personnel merely having a duty station within California (whose legal residence is not California) are not required to file a California income tax return unless they have earned income from California sources other than military pay. 15. Answer d. Each municipality may have its own unique regulations. Here are some of the most common licenses and permits that they may require: Alarm Permit Building Permit Business License and/or Tax Permit 5 HR. California Tax, 20

247 Sourcing Deductions for Part Year Residents. Taxpayers that changed their residency during the year can compute their income and deductions using the resident rules for the period of the year that they were a California resident and nonresident rules for the period of the year that they were a nonresident. These taxpayers can compute any suspended passive losses as if they were a California resident for all prior years and as if they were a nonresident for all prior years. Under this situation they need to prorate both suspended passive loss amounts based upon the period of California residency and the period of non-residency during the year. The personal and dependent exemptions apply also to nonresidents and part-year residents. They are allowed to claim those exemption if they qualify. The additional blind exemption can be also taken. Most of the California deductions are available to part-year residents also. Taxpayers under this category may be eligible for the California nonrefundable child and dependent care expenses credit. If taxpayers under this category qualify for the credit, file the Long Form 540NR. They can also qualify for the nonrefundable renter s credit if they paid rent for at least six months for the tax year in question on their principal residence located in California. California allows a credit against net tax for tax paid to another state on income that is taxed by both states. Taxpayers cannot apply the credit against city, local, or foreign taxes paid. To take the credit part-year residents will take a deduction for the amount paid as part-year resident for California. Residents of or Individuals in Foreign Countries. If taxpayers are a resident of a foreign country and perform services in California and/or receive income from California sources, they may have a California income tax filing requirement even if they do not have a federal filing requirement. Tax Treaty. A tax treaty between the U.S. Government and a foreign country may exempt some types of income from federal taxation. Generally, unless the treaty specifically excludes the income from taxation by California, the income is taxable. Safe Harbor when leaving under Employment Contract. Safe harbor is available for certain individuals leaving California under employment-related contracts. The safe harbor provides that an individual domiciled in California who is outside California under an employment-related contract for an uninterrupted period of at least 546 consecutive days will be considered a nonresident unless any of the following is met: The individual has intangible income exceeding $200,000 in any taxable year during which the employment-related contract is in effect. The principal purpose of the absence from California is to avoid personal income tax. 5 HR. California Tax, 21

248 The spouse/rdp of the individual covered by this safe harbor rule will also be considered a nonresident while accompanying the individual outside California for at least 546 consecutive days. Return visits to California that do not exceed a total of 45 days during any taxable year covered by the employment contract are considered temporary. Income Taxable by California Residents of California are taxed on ALL income, including income from sources outside California. Nonresidents of California are taxed only on income from California sources. Nonresidents of California are not taxed on pensions received after December 31, Part-year residents of California are taxed on all income received while a resident and only on income from California sources while a nonresident. For taxable years beginning in 2002 and later, nonresidents and part-year residents determine their California tax by multiplying their California taxable income by an effective tax rate. The effective tax rate is the California tax on all income as if they were a California resident for the entire year and for all prior tax years for any carryover items, deferred income, suspended losses, or suspended deductions, divided by that income. The following formula can be used: Prorated tax = California taxable income X (Tax on total taxable income/total taxable income) Moving out of California. Taxpayers that move out of the state will normally file a part-year return for each requiring state that they lived in during the year. Taxpayers that work in California before moving to a new state will be required to file a 540NR California tax return. For the following year the taxpayer will file only the income for the state in which he/she is residing. Taxpayers that are required to be out of the state for work purposes will be presumed to be out of the state after 18 months. In this case taxpayers moving out of the state will required enough time to prove they are not residents of California anymore. Taxpayers domicile is their true, fixed permanent home, the place where they intent to return even when they are gone. Taxpayers will count their resident factors to confirm that they are no longer residents of California. The factors can start with the location of taxpayer s home. In case there are several, taxpayers can compare the size and value of each one. Wages and Salaries. Wages and salaries have a source where the services are performed. Neither the location of the employer, where the payment is issued, nor your location when you receive payment affect the source of this income. 5 HR. California Tax, 22

249 Form W-2. Boxes 15 through 20 of the federal Form W-2 generally list the applicable California tax amounts. Box 15. Box 15 indicates the postal abbreviation of the state about which income and tax withholding is being reported and the employer s state tax identification number. Employees who have worked for the same employer in more than one state may show entries for more than one state in this box. Box 16. Box 16 shows the amount of wages being reported to the Franchise Tax Board (FTB). This amount and the amount of federal wages in Box 2 will normally be the same. However California wages may differ from federal wages because of: Wages earned prior to becoming a California resident California ridesharing benefits. Under federal law, qualified transportation benefits are excluded from gross income. Under the California law, there are no monthly limits for the exclusion of these benefits and California s definitions are more expansive. Enter the amount of ridesharing benefits received and included in federal income on line 7, column B. Employer provided tuition assistance Certain sick pay received Income exempt by U.S. treaties California qualified stock option income, or Certain California employer provided meals Box 17. This box shows the amount of income tax withholding for the state shown in Box 15. Box 18, 19, and 20. SDI & VPDI. California has an additional tax called California State Disability Insurance or Voluntary Plan Disability Insurance (CASDI, SDI or VPDI). The purpose of California SDI is to provide temporary benefit payments to workers for nonwork-related disabilities. The SDI is a state-mandated program funded though employee payroll deductions. The State Disability Insurance (SDI) withholding rate for 2016 is 0.9 percent. The taxable wage limit is $106,742 for each employee per calendar year. The maximum to withhold for each employee is $ Taxpayers can deduct their SDI payments on their federal income tax return but not in the state. The SDI program provides short-term Disability Insurance (SDI) and Paid Family Leave (PFL) wage replacement benefits to eligible California workers who need time off work. Taxpayers may be eligible for SDI if they are unable to work due to non-work-related illness or injury, pregnancy, or childbirth. They may be also eligible for PFL to care for a seriously ill family member or to bond with a new child. The SDI and the Worker s compensation are not the same. Workers compensation helps workers when their injury or illness is work-related. Workers compensation may also pay medical bills, benefits for temporary or permanent disabilities, and retraining benefits. Excess SDI/VPDI. State Disability Insurance (SDI) or Voluntary Plan Disability Insurance (VPDI) is usually shown in Boxes 14, 18, 19 or 20 of Form W-2 (although they may be listed 5 HR. California Tax, 23

250 elsewhere on the form). If all of the following are true, the taxpayer may claim a credit on their tax return for excess disability insurance withheld: A client had two or more employers during The client received more than $106,742 in combined wages during 2016 from more than one employer. The amount of SDI or VPDI withholding appears on the Forms W-2. Excess SDI/VPDI is calculated separately for taxpayer and spouse. Also, if the taxpayer had excess (more than 0.9%) SDI/VPDI withheld from only one employer, they must get a refund of the excess amount from their employer. They cannot claim the overage as a credit on their tax return. If the taxpayer meets the requirements listed above, they can take a credit for the amount over $ on Form 540A or Form 540 line 74. Voluntary Plan for Disability Insurance (VPDI) is not deductible on the federal tax return (Schedule A) per Rev. Rul Business Income and Loss. A nonresident s income from California sources includes income from a business, trade, or profession carried on in California. If the nonresident s business, trade, or profession is carried on both within and outside California and the part outside California is separate and distinct from the part within California, only income from the part conducted within California is California source income. If, however, there is any business relationship between the parts within and outside California (flow of goods, etc.), the portion of income (or loss) taxable by California is normally determined by using the apportionment formula for corporations engaged in multistate businesses. You can review Cal. Code Regs., tit. 18 section and California Schedule R for more information. Pensions and Keoghs. Residents: Distributions from employer-sponsored and self-employment (Keogh) pension, profit sharing, stock bonus plans, or other deferred compensation arrangements are taxable by California regardless of where the services were performed. Nonresidents: Distributions are not taxable by California if received after December 31, Sale of Stocks and Bonds. The gain or loss from the sale of stocks or bonds has a source where taxpayer is a resident at the time of the sale. Example Sandra is a resident of Oregon and sells stock of a California corporation at a gain. Because she is an Oregon resident, the gain has an Oregon source. The gain is not taxable by California. Sale of Real State. The gain or loss from the sale of real estate has a source where the property is located. If you sell your California real estate and move out of state, the gain is taxable by California. The gain is taxable by California even if the real estate is sold when you are a nonresident. 5 HR. California Tax, 24

251 Review Questions Section 2 Read and answer the following review questions. The correct answers are found on the next page with an explanation to strengthen up your knowledge. Note: This is not part of your Final Test. 16. Taxpayers that change their resident during the present year will be required to figure their taxable income and deductions as follows: a) They have to use the part-year resident rules for the whole year. b) They have to use the resident rules for the period that they were residents. c) They will not pay taxes to California. d) They will use the nonresident rules to file their income tax return. 17. For residency purposes, taxpayers wages and salaries will have their source from: a) The location where the services are performed. b) The location where the employer is located. c) The location where the payment is made. d) They mailing address where the Form W-2 was sent from. 18. State wages in Box 16 of Form W-2 may differ from federal wages because of any of the following, except: a) California ridesharing benefits b) Certain sick pay received c) Adoption assistance benefits d) Certain California employer provided meals 19. Workers with non-work-related disabilities can get one of the following benefits: a) They can get a disability tax credit. b) They can get State Disability Insurance. c) They can get California Social Security benefits. d) None of the above 20. Employers are required to withhold for SDI on the first wages for a) $500 - $10,000 b) 0.9% - $106,742 c) $1,000 month of wages. d) None of the above. 21. For California residents, the distributions from employer-sponsored and self-employment pensions are: a) Never taxable to California. b) Taxable to California if the business services were performed in California. c) Always taxable, regardless of where the services were performed. d) Excluded from income. 5 HR. California Tax, 25

252 22. The sale of stocks or bonds will be taxable to: a) The gain is taxable to the state where the payment comes from. b) The gain is taxable to the state where the taxpayer is a resident of. c) The gain of stocks and bonds is not taxable. d) The gain is always excluded from income. Questions Section 2 Answers and Discussion 16. Answer b. Taxpayers that changed their residency during the year can compute their income and deductions using the resident rules for the period of the year that they were a California resident and nonresident rules for the period of the year that they were a nonresident. 17. Answer a. Wages and salaries have a source where the services are performed. Neither the location of the employer, where the payment is issued, nor your location when you receive payment affect the source of this income. 18. Answer c. California wages may differ from federal wages because of: California ridesharing benefits. Under federal law, qualified transportation benefits are excluded from gross income. Certain sick pay received Certain California employer provided meals Adoption assistant does not change the wages. 19. Answer b. California has an additional tax called California State Disability Insurance or Voluntary Plan Disability Insurance (CASDI, SDI or VPDI). The purpose of California SDI is to provide temporary benefit payments to workers for non-work-related disabilities. 20. Answer b. The State Disability Insurance (SDI) withholding rate for 2016 is 0.9 percent. The taxable wage limit is $106,742 for each employee per calendar year. 21. Answer c. Distributions from employer-sponsored and self-employment (Keogh) pension, profit sharing, stock bonus plans, or other deferred compensation arrangements are taxable by California regardless of where the services were performed. 22. Answer b. The gain or loss from the sale of stocks or bonds has a source where taxpayer is a resident at the time of the sale. Example Sandra is a resident of Oregon and sells stock of a California corporation at a gain. Because she is an Oregon resident, the gain has an Oregon source. 5 HR. California Tax, 26

253 Alimony. A nonresident who receives alimony does not owe tax to California even if a California resident pays the alimony and claims a deduction for the payment. If the taxpayer is a nonresident alien and did not deduct alimony on their federal return, enter the amount paid in column C. Stock options. California taxes the wage income received by a nonresident from employee stock options on a source basis, whether they were always a nonresident or were formerly a resident. Trade or business property. The depreciation methods and useful lives of trade or business property must be acceptable to California. If an unacceptable method was used before the taxpayer moved into California, the straight-line method must be used to compute the basis in property Like-kind exchanges. If the taxpayer is a nonresident and exchanges real property located within California for property located outside California, the realized gain will be sourced to California even though the taxpayer is not taxed until the gain is recognized. If the taxpayer exchanges property located outside California for property located within California the gain recognized when the California property is sold has a California source and is taxable to California. Installment sales. California taxes income from installment sales of real property based upon where the property is located. Income from the sale of intangible property is generally sourced to the recipient s state of residence at the time of the sale. Passive activities. Nonresidents of California determine allowed passive activity losses based only upon California source passive income. If the taxpayer moves in to California, the passive losses need to be restated as if they had been a California resident for all prior years. If the taxpayer moves out of California, they would determine their passive losses as if they had been a nonresident of California for all prior years (source income only). Part-year residents must prorate their passive loss amounts based upon the amount of time as a resident and the amount of time as a nonresident. Internet Taxable Transactions. Internet transactions can be taxable. California can apply tax on income from online sales or sales or use tax on purchases made online. Taxpayers that are online auction sellers or buyers may have tax responsibilities. California residents will need to pay sales tax or use tax for purchases of tangible property that will be used, consumed, or stored in California. California law requires tax on in-state purchases, and also requires tax on items purchased out-of-state for use in California. 5 HR. California Tax, 27

254 If an out-of-state or online retailer does not collect the tax for an item delivered to California, the purchaser may owe "use tax," which is simply a tax on the use, storage, or consumption of personal property in California. Items that are exempt from sales tax are exempt from use tax as well. Use tax liabilities are often created by Internet or mail order purchases with out-of-state retailers not required to collect the tax. Taxpayers that are purchasing from an online auction seller may have a Use Tax responsibility. Be sure to review your receipts for Internet and other out-of-state purchases to determine if tax was charged. Reporting and paying use tax. Taxpayers holding a seller s permit. Taxpayers that hold a seller s permit are required to pay use tax when submitting their sales and use tax return. The purchases are reported under "Purchases subject to use tax" on the return for the period that includes the date when the item was used, stored, or consumed in California. The FTB has the calendar reporting for each type of seller. The reporting could be on a monthly, quarterly, or annual basis. Taxpayers that are required to register with the BOE to report use tax. California law requires a "qualified purchaser" to register with the BOE and annually report and pay use tax directly to the BOE. A "qualified purchaser" includes any business with at least $100,000 in annual gross receipts from business operations. The "qualified purchaser" is required to file a return, and report and pay use tax on the total purchase price of tangible merchandise that is subject to use tax during the preceding calendar year, and for which tax was not paid to a retailer required to collect the use tax. Taxpayers paying use tax on their California income tax return. Taxpayers that do not hold a permit with the BOE can pay the use tax to the Franchise Tax Board (FTB) on their California income tax return. Getting a use tax account. Taxpayers that make frequent taxable purchases from out-of-state sellers can register with the BOE. The BOE will provide an account number and the ability to electronically file the return. Community Property Community property is all of the property that is not separate property acquired by a husband/rdp or wife/rdp or both while domiciled in a community property state. California is a community property state. This means that all property married couples acquire while domiciled in California is community property. Each spouse owns an equal share of all community property. Separate property is all property owned separately by the husband or wife before marriage. It includes all property acquired separately after marriage, such as gifts or inheritances. Separate property also includes money earned while domiciled in a separate property state. All property declared separate property in a valid pre- or post-nuptial agreement is also separate property. 5 HR. California Tax, 28

255 Each spouse/rdp owns one-half of all community property.. If property cannot be specifically identified as separate property, it is considered community property. The following are community property states (and U.S. territories): Arizona California Idaho Louisiana Nevada Guam New Mexico Wisconsin Texas Washington Puerto Rico Northern Mariana Islands Community property ends when either one of the spouses dies. It also ends when the decree of dissolution becomes final or when the couple separates with no intention of rejoining. For more information on community property, see IRS Publication 555, Community Property. See also the chart on community property on the following page. Community Income. Income generated from community property is community income. Community income also includes compensation for services if one of the spouse/rdp that is earning the compensation is domiciled in a community property state. Divide the community income equally between you and your spouse/rdp when separate returns are filed. Generally, community income is income from: Community property. Salaries, wages, and other pay received for the services performed by taxpayer, spouse (or registered domestic partner), or both during their marriage (or registered domestic partnership) while domiciled in a community property state. Real estate that is treated as community property under the laws of the state where the property is located. Separate Property Separate property includes the following: Property owned separately by each spouse/rdp before marriage or registering as a domestic partnership. Property received separately as gifts or inheritances. Property purchased with separate property funds. Money earned while domiciled in a separate property state. All property declared separate property in a valid agreement. Separate property is all property owned separately by the husband or wife before marriage. It includes all property acquired separately after marriage, such as gifts or inheritances. Separate 5 HR. California Tax, 29

256 property also includes money earned while domiciled in a separate property state. All property declared separate property in a valid pre- or post-nuptial agreement is also separate property. Maintain separate property separately. If the property or the income from the property is used for community purposes, or commingled, it could lose its separate property character, overriding any agreements. Separate Income. Generally, income from separate property is income of the spouse/rdp who owns the property. When filing, you and your spouse/rdp report your income(s) separately on your separate returns. Commingled Property. In practically any marriage, one or both spouses have money or other assets before they get married. Savings and other bank accounts are good examples. After they got married, one or both spouses earn or acquire more money and assets, like when both spouses work and earn paychecks. When it comes to divorce and dividing the couple's property, there's often a problem with how to treat the property each one had before the marriage. This is because that property or money could be commingled. Commingling occurs when one spouse's separate property (property the spouse had before the marriage) is mixed or combined with the other spouse's separate property or mixed with the couple's marital property (property earned or acquired during the marriage). For example, a taxpayer that took his/her money when she was single and adds it to a bank account belonging to the taxpayer and his/her new spouse, in this the money is commingled. When there is a divorce and the property has to be divided, some states follow the equitable distribution rules while other states follow the community property rules. Equitable Distribution States. In this case the state a separate property is commingled or mixed with the other spouse's property or with marital property, the separate property becomes indistinguishable from the marital property. By commingling, the separate property loses its status as separate property and becomes marital property subject to being equitably divided by the court. For example, if taxpayer puts his/her separate money into a marital checking account, the money is no longer considered a separate property. However, in most states, if the taxpayer can come up with deposit and withdrawal slips, bank statements and other records to trace that specific money, it may be set apart and the spouse will not get a share of it. Community Property States. In this case the state the commingling does not automatically change the separate property into community property. However, commingling raises a presumption that the commingled money is community property. The state will assume that the taxpayer wanted to share the money because he/she mixed his/her money to a married account. 5 HR. California Tax, 30

257 Review Questions Section 3 Read and answer the following review questions. The correct answers are found on the next page with an explanation to strengthen up your knowledge. Note: This is not part of your Final Test. 23. A who receives alimony does not owe tax to California even if a California resident pays the alimony and claims a deduction for the payment. a) Nonresident b) Resident c) Single parent d) Working mom 24. California taxes the wage income received by a nonresident from employee stock options based on: a) The amount of income the nonresident is receiving. b) Case by case basis. c) The source basis. d) None of the above. 25. If the taxpayer is and exchanges real property located within California for property located outside California, the realized gain will be sourced to California even though the taxpayer is not taxed until the gain is recognized. a) A resident b) A nonresident c) A real estate professional d) A sole proprietor 26. California taxes income from installment sales based on: a) Where the taxpayer receives the payments. b) Where the real property is located. c) Where the buyer is located at. d) None of the above. 27. If the taxpayer moves in to California, the passive losses will be treated as: a) Losses not allowed in California. b) Losses restated to California for all prior year. c) Losses remaining at their original state. d) None of the above. 28. Community property begins. a) At birth b) When a taxpayer moves out of a community property state c) When a couple get married in a community property state d) When a prenuptial agreement is signed 5 HR. California Tax, 31

258 29. Community property ends. a) When one of the spouses dies. b) When a decree of dissolution becomes final. c) When the couple separates with no intention of rejoining. d) All of the above. Questions Section 3 Answers and Discussion 23. Answer a. A nonresident who receives alimony does not owe tax to California even if a California resident pays the alimony and claims a deduction for the payment. 24. Answer c. California taxes the wage income received by a nonresident from employee stock options on a source basis, whether they were always a nonresident or were formerly a resident. 25. Answer a. If the taxpayer is a nonresident and exchanges real property located within California for property located outside California, the realized gain will be sourced to California even though the taxpayer is not taxed until the gain is recognized. 26. Answer b. California taxes income from installment sales of real property based upon where the property is located. Income from the sale of intangible property is generally sourced to the recipient s state of residence at the time of the sale. 27. Answer b. If the taxpayer moves in to California, the passive losses need to be restated as if they had been a California resident for all prior years. 28. Answer c. Community property is all of the property that is not separate property acquired by a husband/rdp or wife/rdp or both while domiciled in a community property state. 29. Answer d. Community property ends when either one of the spouses dies. It also ends when the decree of dissolution becomes final or when the couple separates with no intention of rejoining. 5 HR. California Tax, 32

259 The money can be separated if the taxpayer can identify the separate property. If, however, separate and community property have been so intermingled that it is impossible to trace to the source property, the whole will be treated as community property. Purchases. It's common for one or both spouses to withdraw money from a commingled account and use it to purchase something, like a car or other property. The spouse who claims that the acquired property is separate must prove that separate funds were withdrawn from the account to purchase the property. Otherwise, the property will be considered community property under the rule that property acquired during marriage is presumed to be community property. Prenuptial Agreements. A prenuptial agreement (also known as a "premarital agreement," or sometimes simply a "prenup") is an agreement that clarifies what property is considered separate property when taxpayers get married. The Uniform Premarital Agreement Act (UPAA) has applied to California prenups since In general, this law states that written prenuptial agreements signed by both parties will automatically become effective once the couple marries. An agreement can cover a couple s present and future property rights, as well as other matters related to the marriage this does not include child support. Child support is a child s right, not a parents, so parents cannot contract away a child s right to support. Taxpayers that are not under a prenup will fall into the commingled property or community property, whichever applies. Amendments to the UPAA that apply to California prenuptial agreements made after 2002 state that agreements will be enforced against a spouse only if that spouse: received complete information about the other spouse s property and finances prior to signing the agreement had at least 7 days between first receiving the agreement and signing it (to allow enough time to have an attorney review the agreement), and was represented by a separate attorney when signing the agreement, unless the spouse: o received full information in writing about the terms and basic effect of the agreement, including any rights and obligations the agreement would nullify, and o signed a separate document acknowledging receipt of such information, identifying the person who provided the information, and expressly waiving the right to an attorney. Prenups and community property, which one is effective? In the absence of a prenup, California community property law provides that all community property (any property acquired during the marriage that is not a gift or an inheritance) is divided equally upon divorce. It usually does not matter if the property is in one party s name if it is acquired during marriage, with some exceptions, it is community property. 5 HR. California Tax, 33

260 Property owned before marriage (or acquired by gift or inheritance) is considered separate property which means it belongs exclusively to the spouse that acquired it and does not fall under the commingled property rule. Earnings are considered community property if no prenup exists. For example if taxpayer without a prenup earned $50,000,000 during his/her marriage, the entire sum would be community property. That means the spouse would own one-half of that property and anything purchased with that property. A prenup can regulate all aspects of how separate and community property assets and liabilities are treated. In the case of a financially independent couple with their own resources, a prenup can provide that all income, assets and debts acquired or incurred remain separate property. On the other hand, a couple might agree that all property accumulated during the marriage remain community property but that certain property brought into the marriage, such as family businesses or funds, always remains separate. Filing Status (Line 1 5). Generally, a taxpayer must use the same filing status on both their California and federal returns. However, there is an exception for married taxpayers who file a joint federal income tax return in either of the following situations: Either the taxpayer or spouse was an active duty member of the U.S. armed forces; The taxpayer is a Registered Domestic Partner (RDP); Either the taxpayer or spouse was a nonresident for the entire year and had no income from California sources. In this case, income from California sources includes community income earned by the spouse. Head of Household. Taxpayer may file as head of household for California purposes only if he/she meets the requirements to be considered unmarried or considered not in a domestic partnership. If taxpayer did not file a federal return because he/she did not have a federal filing requirement, the taxpayer may use any filing status on the California return that he/she was entitled to use on the federal return had he/she been required to file a federal return. To qualify for HOH filing status, taxpayer must have a qualifying person who is related to he/she and meets the requirements to be either a qualifying child or qualifying relative. Taxpayer must also pay more than half the cost of keeping up the home in which the taxpayer and the qualifying person lived for more than half the year. The child can qualify only one parent for the Head of Household filing status in a particular taxable year, and that parent must meet all the HOH requirements. To claim the HOH filing status, the child must have lived with one taxpayer for more than 50 percent of the taxable year. If the child did not live in either taxpayer s home more than half of the taxable year, the taxpayer may qualify for the Credit for Joint Custody Head of Household. Join Custody Head of Household Credit. Taxpayers can claim the Joint Custody Head of Household credit. This is a non-refundable credit that is available to the taxpayer that does not 5 HR. California Tax, 34

261 qualify for the head of household filing status or qualifying widow(er) with a dependent child filing status. In order to qualify for this credit the taxpayer must meets the following requirements: The taxpayer must be unmarried at the end of the tax year; or, was married, lived apart from the taxpayer's spouse the entire year, and used the married filing separately filing status, The taxpayer paid more than half the cost of keeping up the taxpayer's household during the year, The taxpayer s home was the main home for at least 146 days but not more than 219 days for the unmarried child, stepchild, or grandchild; or married child, stepchild, or child's descendant whom the taxpayer could claim as a dependent. The period in which the child lived on the taxpayer s home was covered under a decree of dissolution or separate maintenance, or under a written agreement specified between the parents that was in effect during the period between the petition and issuance of the final decree. The amount of the credit for joint custody is the lesser of 30 percent of tax or the maximum allowable amount per tax year. If the taxpayer qualifies for the Credit for Joint Custody Head of Household and the Credit for Dependent Parent, he/she can claim only one credit. Select the credit that allows the maximum benefit. To figure the amount of time that the dependent spend with one parent the following table can be used. In this table the time spend with the child does not include the time spend with spouse while living together. Joint Custody and Time spend with each parent. If: And: Then: Taxpayers separated during the period January 1 to June 30. Taxpayer and spouse were separated during the period July 1 to December 31 If taxpayer and spouse were separated during the year Taxpayers were still married at the end of the year Taxpayers were still married at the end of the year They were legally separated by the end of the year Count only half of the time that taxpayer, spouse, and the son lived together and all the time that taxpayer and the son lived together without the spouse. The taxpayer cannot qualify for HOH filing status because to be considered unmarried, the taxpayer must have lived apart from the spouse at all times during the last six months of the year. The taxpayer can count half of the time that the taxpayer, spouse, and the son lived together and all the time that the taxpayer and the son lived together without spouse. 5 HR. California Tax, 35

262 Dependent Parent Credit. Stepparents are treated the same as parents for tax purposes. If taxpayers were unmarried and not an RDP, they may be eligible for the head of household filing status even if the father or mother did not live with the taxpayer. However, taxpayers parent must have been a citizen or national of the United States, or a resident of the United States, Canada, or Mexico. Taxpayers must be entitled to claim a Dependent Exemption Credit for the parent. That is, the parent must meet the requirements of a qualifying relative and taxpayer must have paid more than half the cost of keeping up a home that was the parent s main home for the entire year. Taxpayers main home could have been his or her own home, such as a house or apartment, or could have been any other living accommodation. FTB Auditing Head of Household. The Franchise Tax Board (FTB) reviews, every year, the tax returns of those who claim the HOH. The FTB also mails audit letters to taxpayers to verify their Head of Household (HOH) filing status. This filing status generally results in lower tax liabilities for unmarried taxpayers who care for a dependent. To qualify, the taxpayer must provide care for more than one-half of the year and pay more than one-half the cost of maintaining their home. The qualifying person must be related to the taxpayer and meet the requirements to be a qualifying child or relative. FTB advises taxpayers who receive an HOH letter to respond promptly by completing the enclosed questionnaire. Failure to respond could result in a tax assessment and penalty. Same-sex Married Couple. Beginning with the 2008 taxable year, same-sex married couples (SSMC) were required to file their California income tax return using either the married filing jointly or married filing separately filing status. Common Law Marriage. Some states recognize the union between two people who intend to be married by living together for some years. No license or wedding is involved. This type of marriage is known as a common law marriage. In some states this common law marriages are treated as a legal marriage despite never obtaining a marriage license. Thus, when a common law marriage comes to an end, the couple must go through a formal divorce to end the relationship. The following states recognize common-law marriage: Alabama New Hampshire (inheritance only) Colorado Oklahoma District of Columbia Pennsylvania Iowa Rhode Island Kansas South Carolina Montana Texas Utah In 1895 California eliminated the common law marriage in the state. Marriage in California is statutorily defined in Family Code Section 300 to be a personal relation arising out of a civil contract between two persons (before a man and a woman), to which the consent of the parties 5 HR. California Tax, 36

263 capable of making that contract is necessary. Consent alone does not constitute marriage. Consent must be followed by the issuance of a license and solemnization Couples who are in a common law relationship in California often assume that they will automatically be able to make a claim to their partner s assets when he/she passes away or that they will be able to make important financial or medical decisions for the partner. However, this is not the case since California does not recognize common law marriages. Therefore, it is important to consider having a will and having power of attorney forms filled out. California does not allow common law marriages formed in California. However, if a taxpayer moves into the state having entered into a common law marriage in a state that does recognize the relationship, California will accept the marriage as valid. However, see Registered Domestic Partners, next. Domestic Partners. California Family Code section 297 provides that "domestic partners are two adults who have chosen to share one another's lives in an intimate and committed relationship of mutual caring." A domestic partnership is established in California when both persons file a Declaration of Domestic Partnership with the Secretary of State, and at the time of filing, all of the following requirements are met: Both persons have a common residence. Neither person is married to someone else or is a member of another domestic partnership with someone else that has not been terminated, dissolved, or adjudged a nullity. The two persons are not related by blood in a way that would prevent them from being married to each other in this State. Both persons are at least 18 years of age. Either of the following: o Both persons are members of the same sex. o One or both of the persons is/are over the age of 62 and meet the eligibility criteria under Title II of the Social Security Act as defined in 42 U.S.C. Section 402(a) for old-age insurance benefits or Title XVI of the Social Security Act as defined in 42 U.S.C. Section 1381 for aged individuals. Both persons are capable of consenting to the domestic partnership. The definition of "common residence" means that both domestic partners share the same residence. It is not necessary that the legal right to possess the common residence be in both of their names. Two people have a common residence even if one or both have additional residences. Domestic partners do not cease to have a common residence if one leaves the common residence but intends to return. The June 26, 2015, United States Supreme Court ruling in Obergefell v. Hodges (regarding the right to a same-sex marriage and whether states must recognize same-sex marriages from other states) did not invalidate or change any of the California Family Code sections related to 5 HR. California Tax, 37

264 registered domestic partners. Domestic partnership registrations are different from marriage licenses. A domestic partnership is established when persons meeting the criteria specified by California Family Code section 297 file either a Declaration of Domestic Partnership (Form NP/SF DP-1) or a Confidential Declaration of Domestic Partnership (Form NP/SF DP-1A) with the California Secretary of State. Taxation of RDPs. In general, California now affords the same rights and responsibilities to RDPs that previously were available only to married individuals. For California tax purposes, the same rules applicable to married individuals (relating to filing status, community property income, etc.) now apply to RDPs. However, because the federal government does not recognize domestic partners as married individuals for federal tax (IRS) purposes, RDPs will continue to file as unmarried individuals on their federal returns. Only domestic partners who are registered with the California Secretary of State are required to file using the married filing joint or married filing separate filing status. Domestic partners cannot file a married filing joint or married filing separate return for tax years prior to A domestic partner is required to use the same filing status for state income tax purposes that was used or would have been used for federal income tax purposes. For tax years beginning on or after January 1, 2007, domestic partners are required to use the same filing status as married couples. Earned income of domestic partners is not treated as community property for state income tax purposes for tax years prior to Head of Household Issues. If taxpayer, RDP, and qualifying dependent child lived together at any time during the last 6 months of the year, the taxpayer or RDP will not qualify to use the HOH filing status for California purposes even if they use that filing status for the IRS. CALIFORNIA STANDARD DEDUCTION (Line 18) The California standard deduction is subtracted from California Adjusted Gross Income to arrive at income subject to tax. For 2015 the California standard deduction amounts are: Single or Married/RDP Filing Separately $4,044 Married Filing Jointly, Qualifying Widow(er) or Head of Household $8,088 Minimum standard deduction for dependent $1,050 California law is the same as federal law concerning the standard deduction on the dependent child's tax return. If the child has only investment income for the calendar year, the child may claim a maximum of $1,050 as a standard deduction. If the child has earned income also, the standard deduction is limited to $1,050 or the amount of their earned income plus $350, not to exceed the regular standard deduction. 5 HR. California Tax, 38

265 CALIFORNIA PERSONAL EXEMPTION CREDIT. Find the Personal exemption credit amounts in the exemption section of Form 540. (Line 7). The California exemption amounts for 2016 are $111 for personal exemptions and $344 for dependent exemptions. A taxpayer also gets an additional exemption amount if they are blind or over age 65. Higher income taxpayers may have their exemption amounts limited. California Personal Exemptions Chart If the circle on line 6 is blank and the filing Then enter on line 7 status is: Single 1 Married/RDP filing jointly 2 Married/RDP filing separately 1 Head of Household 1 Qualifying widow(er), 2 If you did check the circle on line 6 and the filing status is: Single, married/rdp filing separately, head of household or married/rdp filing jointly, and both taxpayers and their spouse/rdp can be claimed as a dependent, enter zero. Married/RDP filing jointly and only the taxpayers or their spouse/rdp can be claimed as a dependent, enter one. Then, multiply the number by $111 and enter the amount on line 7 of Form 540. Important Info: This exemption credit cannot be taken if taxpayers can be claimed as a dependent on someone else s tax return. Blind (Line 8) Claim an additional personal exemption credit if taxpayers or spouse/rdp is visually impaired. If this exemption is claimed for the first time, attach a doctor s statement verifying the visual impairment to the back of the tax return. Visually impaired defined. Vision impaired means vision is no better than 20/200 while wearing glasses or contact lenses, or that the field of vision is not more than 20 degrees. Senior (Line 9). Claim an additional personal exemption credit if taxpayers, or their spouse/rdp, if filing jointly, are 65 years of age or older by December 31, Enter 1 if taxpayer qualifies or 2 if taxpayer and spouse/rdp are 65 or older. Multiple this number by $109 and enter the amount on line 9 of Form 540. If taxpayers 65th birthday is on January 1, 2016, they are considered age 65 on December 31, Dependents (Line 10). An exemption credit is allowed for each dependent. Write the name and relationship of each dependent in the appropriate space. Listed dependents must be the same on both federal and state tax returns. 5 HR. California Tax, 39

266 Count the number of dependents listed, and put the total in the appropriate boxes on the forms. Multiply the number of dependents by $337 and enter the amount on line 10 of Form 540. Important Info: The Dependent Exemption Credit on Form 540 2EZ is included in Form 540 2EZ tax tables. Phaseout of exemption credits. Higher-income taxpayers' exemption credits are reduced as follows: Filing status Reduce credit by: each For each: Federal exceeds: Single $6 $2,500 $182,459 Married/RDP filing separately $6 $1,250 $182,459 Head of household $6 $2,500 $273,692 Married/RDP filing jointly $12 $2,500 $364,923 Qualifying widow(er) $12 $2,500 $364,923 AGI When applying the phaseout amount, apply the $6/$12 amount to each exemption credit, but do not reduce the credit below zero. If a personal exemption credit is less than the phaseout amount, do not apply the excess against a dependent exemption credit. DETERMINING CALIFORNIA TAX (Line 31) The computation of California taxable income starts with the federal Adjusted Gross Income. Then adjustments are made, either additions or subtractions, based on differences between federal and California tax law. Next, either the California standard deduction or the California itemized deduction amount is subtracted to arrive at taxable income. In California, tax is calculated before subtracting an exemption amount from income. The exemption amount is a credit subtracted directly from the calculated tax. Any tax credits are then subtracted; any additional taxes are added to arrive at net tax for California. If the amount of the taxpayer s withholding and estimated payments are greater than the tax, the taxpayer receives a refund. If the amount of tax is larger, the taxpayer has a balance due. 5 HR. California Tax, 40

267 Review Questions Section 4 Read and answer the following review questions. The correct answers are found on the next page with an explanation to strengthen up your knowledge. Note: This is not part of your Final Test. 30. All property declared separate property in a valid is considered separate property. a) Pre-nuptial agreement b) Post-nuptial agreement c) Both (a) and (b) d) Neither (a) nor (b) 31. If no agreement exists between spouses the earnings will be considered: a) Separate income. b) Community property. c) Nontaxable. d) Non-reportable. 32. In which of the following situations can California taxpayers use a different filing status on their federal and state tax returns? a) They want to avoid a higher income tax in California. b) They cannot use different filing status. c) Either the taxpayer or spouse was an active duty member of the U.S. armed forces d) They traveled a lot to other states. 33. Taxpayers that did not file their federal income tax return but want to file their California return will be required to use the following filing status: a) The filing status that they prefer b) Always the Head of Household. c) The filing status that they would have used for federal purposes. d) They cannot file their California income tax return if they did not file their federal return. 34. The Joint Custody Head of Household credit is available to one of the following taxpayers: a) Taxpayers that are single and want to get an extra credit. b) Taxpayers who are married. c) All taxpayers in general. d) Unmarried taxpayers whose house was the main home of the unmarried child for 146 days. 35. Taxpayers that qualify for both the Joint Custody Head of Household credit and the Dependent Parent credit will: a) Take both credits at the same time. b) Carry over one of them. c) Leave both credits. d) Take only one credit. 5 HR. California Tax, 41

268 36. Taxpayers who filed their California income tax return using the Head of Household status, can probably receive: a) An IRS audit letter. b) An IRS warning. c) A FTB HOH letter. d) A FTB HOH extra credit. 37. In California the common law marriage that was recognized in another state will be: a) Invalid in California. b) Automatically cancelled in California. c) Valid in California. d) Better for taxpayers because they will get higher tax deductions. 38. In general a domestic partnership will be established in California by: a) Filing the income tax return jointly. b) Request permission from the IRS. c) Domestic partnership cannot be established in California. d) Filing a declaration to the Secretary of the State. 39. To arrive to the taxable income taxpayers will need to subtract one of the following from their California AGI: a) Their federal itemized deductions. b) Their standard deduction. c) Their Alternative Minimum Tax. d) None of the above. 40. For California, if the dependent child has only investment income for the year, his standard deduction will be: a) Lost b) Double c) Only $1050. d) The normal standard deduction. 41. For California, if the dependent child has earned income only, his standard deduction will be: a) Only $1050. b) Only $6200 c) Zero d) $1050 or his/her earned income plus $350 not to exceed the normal amount. 42. In California, if taxpayer can be claimed as a dependent on another s income tax return his personal exemption will be: a) The normal amount. b) $109 c) Reduced. d) Lost. 5 HR. California Tax, 42

269 43. The computation of the California taxable income will start with: a) The California income. b) The federal AGI c) The federal gross income. d) The past year s income tax return income Questions Section 4 Answers and Discussion 30. Answer b. A prenuptial agreement (also known as a "premarital agreement," or sometimes simply a "prenup") is an agreement that clarifies what property is considered separate property when taxpayers get married. 31. Answer b. Earnings are considered community property if no prenup exists. For example if taxpayer without a prenup earned $50,000,000 during his/her marriage, the entire sum would be community property. 32. Answer c. Generally, a taxpayer must use the same filing status on both their California and federal returns. However, there is an exception if either the taxpayer or spouse was an active duty member of the U.S. armed forces. 33. Answer c. If taxpayer did not file a federal return because he/she did not have a federal filing requirement, the taxpayer may use any filing status on the California return that he/she was entitled to use on the federal return had he/she been required to file a federal return. 34. Answer d. In order to qualify for this credit the taxpayer s home was the main home for at least 146 days but not more than 219 days for the unmarried child, stepchild, or grandchild; or married child, stepchild, or child's descendant whom the taxpayer could claim as a dependent. 35. Answer d. If the taxpayer qualifies for the Credit for Joint Custody Head of Household and the Credit for Dependent Parent, he/she can claim only one credit. Select the credit that allows the maximum benefit. 36. Answer c. The Franchise Tax Board (FTB) reviews, every year, the tax returns of those who claim the HOH. The FTB also mails audit letters to taxpayers to verify their Head of Household (HOH) filing status. 37. Answer c. California does not allow common law marriages formed in California. However, if a taxpayer moves into the state having entered into a common law marriage in a state that does recognize the relationship, California will accept the marriage as valid. 38. Answer d. In general, a domestic partnership is established in California when both persons file a Declaration of Domestic Partnership with the Secretary of State. 5 HR. California Tax, 43

270 39. Answer b. The California standard deduction is subtracted from California Adjusted Gross Income to arrive at income subject to tax 40. Answer c. California law is the same as federal law concerning the standard deduction on the dependent child's tax return. If the child has only investment income for the calendar year, the child may claim a maximum of $1,050 as a standard deduction. 41. Answer d. If the child has earned income also, the standard deduction is limited to $1,050 or the amount of their earned income plus $350, not to exceed the regular standard deduction. 42. Answer d. The exemption credit cannot be taken if taxpayers can be claimed as a dependent on someone else s tax return. 43. Answer b. The computation of California taxable income starts with the federal Adjusted Gross Income. Then adjustments are made, either additions or subtractions, based on differences between federal and California tax law. 5 HR. California Tax, 44

271 Determine your client s tax by using the tax table in the 540/540A Booklet. Do not use the Form 540 2EZ tax tables for either Form 540 or 540A. Follow the instructions at the top of the table. Use the correct filing status and taxable income from your client s Form 540, line 19. Filing Status for Tax Table If the number is: Then the Filing Status Is: 1 or 3 Single or Married/RDP filing separately 2 or 5 Married/RDP filing jointly or Qualifying widow- (er) 4 Head of Household Finding the correct Tax Using the Tax Table Read down the column labeled If Your Taxable Income Is... to find the range that includes your taxable income from Form 540/540A, line 19. Read across the columns labeled The Tax for Filing Status until you find the tax that applies for your taxable income and filing status. Find the taxable income Select the Filing Status Then arrive to the tax amount 5 HR. California Tax, 45

272 Individual Income Tax Rate. Individual tax rates for 2016: The maximum rate for individuals is 12.3% California has ten marginal tax brackets, ranging from 1.00% (the lowest California tax bracket) to 12.30% (the highest California tax bracket). Each marginal rate only applies to earnings within the applicable marginal tax bracket, which are the same in California for single filers and couples filing jointly. The Federal Income Tax, by contrast, has different tax brackets for married, single, and Head of Household taxpayers. Tax Bracket (Single) Marginal Tax Rate $ % $8, % $19, % $29, % $41, % $52, % $268, % $322, % $537, % Tax Bracket (Married) Marginal Tax Rate $ % $16, % $38, % $59, % $83, % $105, % $537, % $644, % $1,074, % In California, taxpayers will not pay only on the tax bracket for their income; they will pay all of the California marginal tax rates from zero up to the amount of income. The following is an example of this situation in California for a Single taxpayer: For earnings between $0.00 and $7,582, single taxpayers will pay 1.00% For earnings between $8, and $19,001, they will pay 2.00% plus $80.15 For earnings between $19, and $29,898, they will pay 4.00% plus $ For earnings between $29, and $41,629, they will pay 6.00% plus $ Alternative Minimum Tax Rate. California has an alternative minimum tax (AMT) that is similar to the Federal AMT. Like the Federal AMT, the purpose of the California AMT is to make sure that certain taxpayers do not use various tax incentives to pay little or no California income tax. The California alternative minimum tax rate is 7% of the taxpayer s alternative minimum tax base. Like the calculation for Federal AMT, the alternative minimum tax base is calculated by adding to and subtracting from 5 HR. California Tax, 46

273 taxable income certain adjustments and preferences, and subtracting an AMT exemption allowance. AMT exemption for 2016 Filing status Amount Married/RDP filing jointly or qualifying widow(er) $89,467 Single or head of household $67,101 Married/RDP filing separately, estates, or trusts $44,732 Alternative Minimum Tax Like federal law, California tax law gives special treatment to some items of income and allows deductions and credits for some items of expense. Many individuals who benefit from these provisions must pay at least a minimum amount of tax and/or limit the amount of their credits. Taxpayers should use Schedule P (540) to determine if both of the following apply: They owe AMT. Their credits must be reduced or eliminated. Their credits maybe limited even if they do not owe AMT, so be sure to complete Side 1 and Side 2 of Schedule P (540). The tentative minimum tax rate in California, after exemptions is 7.00%. Small businesses and the AMT. Business deductions are allowed in full under the AMT because it is a cost of doing business. Taxpayers that have a rental property will qualify as a business property for the AMT. In this case, the property tax paid is a business expense and is reported on Schedule E. It is allowed in full and is not phased out. Business expenses claimed on Schedule C are allowed under AMT. California law does not conform to federal law regarding the elimination of AMT for small businesses. Use Tax and Internet Taxable Transactions. California enacted the use tax on July 1, This use tax applies to purchases from out of state sellers, similar to sales tax paid on purchases made in California. In general, taxpayers pay California use tax on purchases from out of state (i.e., telephone, over the Internet, by mail, or in person) if both apply: The seller did not collect California sales or use tax. Taxpayer used, gave away, stored, or consumed the item in California. Generally, if sales tax would apply when the taxpayer buys physical merchandise in California, use tax applies when the taxpayer makes a similar purchase without tax from a business located outside the state. 5 HR. California Tax, 47

274 If taxpayers owe use tax but chooses not to report it on their income tax return, they must report and pay the tax to the State Board of Equalization. What Tangible products are taxable in California? First of all there are some items that are exempt from tax ant they include certain groceries, food, prescription medicine and medical devices. The items that are not exempt include toys, furniture, giftware, antiques and clothing. In addition, some service and labor costs are subject to sales tax if they result in the creation of tangible personal property. Individuals and businesses must report use tax instead of sales tax if they purchase items to be used in California from an out-of-state retailer not collecting tax. The tax rate for sales tax and use tax is the same. Business with seller s permit. Taxpayers that have a California seller's permit must pay the use tax due on business related purchases with their sales and use tax return in the period when they first used, stored, or consumed the item in California. If taxpayer is a qualified purchaser, he/she must pay the use tax on their income tax return. Out-of-state businesses are required to collect sales tax if they have sales tax nexus in California. This is true if they store items in a physical location in the state including an Amazon Fulfillment Center. Businesses must identify if their storage at Amazon is located in California. Use tax. Taxpayers that purchase items over the internet from out of the state are required to pay use tax. Taxpayers are required to pay use taxes on items that would have been taxable if purchased from California retailers. For example, purchases of clothing, appliances, toys, books, furniture, or CDs would be subject to use tax. Purchases not subject to use tax include food for human consumption such as peanut butter and chocolate. Electronically downloaded software, music, and games are not subject to tax if no tangible storage media is obtained. The use tax rate will vary depending on the area in which taxpayer lives. California has a variety of sales and use tax rates that are set according to the county or city in which taxpayer lives. Foreign Purchases. If taxpayers purchase tangible personal properties from outside the United States and brought them into California for storage, use, or other consumption they will be required to pay use tax. Some exemption may apply: Taxpayer is not required to pay use tax on the first $800 of tangible personal property that he/she carried by hand into this state and reports it on a single declaration. The exemption is available only once within any 30 day period. Shipped or sent items do not qualify. If taxpayers purchase the items for resale, demonstration, or display then the use tax is not applied. Taxpayer must keep records of the resale. Items that were purchased for use outside California. Taxpayers must keep records that document how the items will be used. Purchases of property first used outside California for more than 90 days before entering into the state. 5 HR. California Tax, 48

275 Gifts that taxpayer received while abroad. Taxpayer should keep a letter from the giver describing the item and stating it was a gift (i.e. not some form of compensation). Other exempt purchases such as food, prescription medication/eyeglasses, or any other exempt transactions as allowed by the California Sales and Use Tax Law. Each claim for exemption must be clearly explained. If the items are tax exempt if they were purchase to be resale or to be sold to the U.S government or out of the state. Mortgage relief upon sale or other disposition of principal residence. California law conforms, with modifications, to federal mortgage forgiveness debt relief for discharges that occurred in tax years 2007 through December 31, The amount of qualifying indebtedness is less than the federal amount and California imposes a state-only limitation on the total amount of relief excluded from gross income. The following summarizes the differences between the federal and California provisions. Federal provision applies to discharges occurring in 2007 through 2012, and: Limits the amount of qualified principal residence indebtedness to $2,000,000 for taxpayers who file as married filing jointly, single, head of household, or widow/widower, and to $1,000,000 for taxpayers who file as married filing separately. Does not limit the debt relief amount; it only limits the indebtedness amount used to calculate the debt relief amount California provision applies to discharges that occurred in 2007 through 2012, and: Taxable years 2009 through Limits the amount of qualified principal residence indebtedness to $800,000 for taxpayers who file as married/registered domestic partners (RDP) filing jointly, single, head of household, or widow/widower, and to $400,000 for taxpayers who file as married/rdp filing separately. Limits debt relief to $500,000 for taxpayers who file as married/rdp filing jointly, single, head of household, or widow/widower, and to $250,000 for taxpayers who file as married/rdp filing separately. Taxable years 2007 and 2008 Limited the amount of qualified principal residence indebtedness to $800,000 for taxpayers who file as married/(rdp) filing jointly, single, head of household, or widow/widower, and to $400,000 for taxpayers who file as married/rdp filing separately. Limited debt relief to $250,000 for taxpayers who file as married/rdp filing jointly, single, head of household, or widow/widower, and to $125,000 for taxpayers who file as married/rdp filing separately. 5 HR. California Tax, 49

276 Claiming mortgage forgiveness debt relief on an original tax return. The taxpayer can file for debt relief on their original Form 540, California Resident Income Tax Return, or Form 540NR, California Nonresident or Part-Year Resident Income Tax Return. If the amount of debt relief for federal purposes is the same as or less than the California limit, then no adjustment is necessary on Schedule CA (540/540NR). If the amount of debt relief for federal purposes is more than the California limit, include the amount in excess of the California limit on Schedule CA (540/540NR) line 21f, column C. Include a copy of the federal return, including Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment), with the original California tax return. There is no similar California form. ADDITIONS AND SUBTRACTIONS TO THE CALIFORNIA INCOME TAX UNEMPLOYMENT COMPENSATION. California does not tax unemployment benefits received by the taxpayer. If the taxpayer included UI benefits on their federal return, they must make an adjustment to subtract them from income on their California return. On Form 540, the adjustment is made on line 19, column B. California also does not tax amounts received under the Paid Family Leave Program (PFL). The adjustment made is the same as the one for unemployment compensation. Taxpayers that received unemployment benefits during the year will receive Form 1099-G Certain Government Payments that lists the total amount of compensation received. Unemployment benefits are not subject to Social Security or Medicare tax. Taxpayers can request to have 10 percent of their unemployment check withheld for federal taxes to avoid owing federal taxes at the end of the year. Use Schedule CA (540), California Adjustments Residents, to make adjustments to taxpayer s federal adjusted gross income. SOCIAL SECURITY INCOME. California does not tax social security benefits including survivor's benefits and disability benefits. California does not tax also equivalent tier 1 railroad retirement benefits. Enter on Schedule CA (540), line 20, column B the amount of benefits included in adjusted gross income on the federal return. The amount will be entered as positive numbers. Railroad retirement tiers I and II. California law differs from federal law in that California does not tax: Tier 1 railroad retirement benefits. Tier 2 railroad retirement benefits reported on federal Form RRB 1099-R. 5 HR. California Tax, 50

277 The state law does not apply to railroad benefits paid by individual railroads; these benefits are taxable by California. The California law applies only to United States social security and railroad retirement. Foreign social security is taxable by California as annuity income. A tax treaty between the United States and another country which excludes the foreign social security from federal income or which treats the foreign social security as if it were United States social security does not apply for California purposes. Supplemental Social Security Income. In California there is another program called the Supplemental Security Income which is funded by taxes from the general fund. This program is based on individual financial need and is designed to assist those who have limited income and resources. Social Security Disability Insurance is not the same because this program is paid for by FICA deductions from wages. This is a social insurance program that pays benefits based on contributions made by a wage earner. OTHER MISCELLANEOUS INCOME. State tax refund. If the taxpayer included their state income tax refund in income on their federal return, it will be subtracted from income before calculating California tax. The state will send Form 1099-G including the refund amount. The state FEIN number is The Form 1099-G will notify taxpayers of the amount of California Personal Income Tax Refund, Credit, or Offset received for a specific tax year. Taxpayers may not actually receive the refund but it is considered received if the amount was: Directly deposited into taxpayer s bank account. Offset for other liabilities such as tax, penalties and interest. Credited towards estimated tax payments. Intercepted by other state, city or county agencies or the IRS. Donated as a Voluntary Contribution. Applied to a Use Tax payment. The amount reported on the Form 1099-G must be reported in the year it was received. The state income tax refund received will be subtracted from California income using column B of Schedule CA. The amount will be entered as positive numbers. California lottery winnings. California does not tax California lottery winnings. Lottery winners should make an adjustment on Schedule CA, Part I, line 21a, column B. Form 540A cannot be used. The IRS requires the California Lottery to withhold federal taxes from many prizes. The withholding rate for federal income tax is based, in part, on a claimant s resident status. The Lottery is required to withhold federal taxes of 25% for U.S. citizens and resident aliens providing a social security number, and 28% for U.S. citizens and resident aliens not providing a social security number. Claimants who do not mark the citizenship status on the Lottery Claim 5 HR. California Tax, 51

278 Form will have 30% withheld from all prizes. Federal tax rates are subject to change. California Lottery winner will receive Form W2-G reporting the amount of the Lottery winnings. Judgment liens, tax levies, or offsets may be filed against taxpayers prize winnings by creditors or government agencies for payment of their debts No adjustment is made for lottery winnings from other states. They are taxable by California. Rewards authorized by a government agency. California does not tax rewards authorized by a government agency or amounts received from a crime hotline established by a government agency or nonprofit organization. The appropriate adjustment should be made on line 21f, column B, Schedule CA. Money received for recycling empty beverage containers. If a taxpayer included in income received for recycling empty beverage containers, it should be subtracted on line 21f, column B, Schedule CA. Paid Family Leave (PFL) Benefits. California s Paid Family Leave program is part of the state disability insurance program administered by the Employment Development Department. Compensation paid from the PFL program is not taxable by California. However, it is taxable for federal purposes. If the taxpayer included in income money received from the PFL program, enter the amount on Schedule CA (540), line 19, column B. Educator expenses. Federal law allows a deduction for teachers, instructors, counselors, principals or aides for grades K-12. California has not conformed. Enter the amount for the adjustment on Schedule CA (540), line 23, column B. Tuition and fees deduction. The taxpayer may have taken a deduction from income for up to $4,000 in higher education expense. California does not allow this deduction. Enter the amount for the adjustment on Schedule CA (540), line 23, column B. INTEREST AND DIVIDENDS Interest income from a regular savings account or credit union is taxable to California just as it is on the federal return so no adjustment is necessary. However, certain type of interest income that is taxable on the federal return is exempt from California tax. Also, some interest income that is exempt from federal tax is taxable to California. Direct U.S. Obligations or securities. These securities include US Treasury bills, notes and bonds that are debt obligations of the U.S. government. Interest from federal bonds is included in gross income on the federal return. California does not tax this type of interest income. The amount of federal bond interest included in federal income is subtracted on Schedule CA (540) line 8, column B. The following are not considered U.S. obligations for California purposes: Federal National Mortgage Association (Fannie Mae); Government National Mortgage Association (Ginnie Mae); or 5 HR. California Tax, 52

279 Federal Home Loan Mortgage Corporation (Freddie Mac). A subtraction will be required for the following items if a California taxpayer reports these on his/her federal income tax return: U.S. savings bonds (except for interest from series EE U.S. savings bonds issued after 1989 that qualified for the Education Savings Bond Program exclusion). U.S. Treasury bills, notes, and bonds. Any other bonds or obligations of the United States and its territories. Interest from Ottoman Turkish Empire Settlement Payments. Interest income from children under age 19 or students under age 24 included on the child's federal tax return and reported on the California tax return by the parent. Certain mutual funds pay "exempt-interest dividends." If the mutual fund has at least 50% of its assets invested in tax-exempt U.S. obligations and/or in California or its municipal obligations, that amount of dividend is exempt from California tax. The proportion of dividends that are taxexempt will be shown on your annual statement or statement issued with Form 1099-DIV, Dividends and Distributions. California Municipal Bonds. California does not tax interest received from municipal bonds issued by the State of California. However, California does tax interest from municipal bonds issued outside of California. Federal law does not tax interest from state or local bonds, so out of-state municipal bond interest must be added back to income for California purposes. Make this adjustment on Schedule CA (540), Line 8, column C. No adjustment is necessary for California municipal bond interest. Dividends. California taxes dividends from mutual funds that are paid from interest received from obligations issued by states or municipalities other than California sources. California does not tax dividends paid by a fund if more than 50% of the fund s assets would be exempt from California tax. If more than 50% of the fund s assets are derived from obligations that pay interest that is not taxed by California, an adjustment must be made. Enter the amount of exempt interest dividends attributable to U.S. obligations on Schedule CA, line 9, column B. The fund will generally provide an end-of-the year statement with an allocated breakdown by state or municipality of the exempt-interest dividends received by the mutual fund. Children with Investment Income. California law is the same as federal law for the income of children under age 18 or a student under age 24. For each child that meet the age requirement and that received more than $2,100 of investment income for the taxable year 2016, complete Form 540 and form FTB 3800, Tax Computation for Children Under Age 18 or student under age 24 with Investment Income, to figure the tax on a separate Form 540 for the child. Note: If they qualify, the taxpayer may elect to report their child's income of $10,000 or less on their return by completing form FTB 3803, Parent's Election to Report Child's Interest and Dividends. To make this election, the child's income must be only from interest and/or dividends. 5 HR. California Tax, 53

280 Taxpayers are not required to report the same as federal. If parents report federal Kiddie Tax on their own return, they can choose to report the child s return for California and vice versa. Schedule CA adjustments would be needed. Kiddie Tax. Form If the child has an individual filing requirement, Form 3800 will be attached to the child s tax return to report the Kiddie Tax. In this case, parents should also verify whether or not the child can be claimed as a dependent. A child who can be claimed as a dependent cannot take a personal exemption on their own tax return. This is true even if the other person who can claim the exemption does not actually claim it. If the child has earned income that exceeds over half of their support, the Kiddie Tax is not applicable. In this case Form 3800 must not be sent. Conformity with the IRS. In general, for taxable years beginning on or after January 1, 2010, California law conforms to the Internal Revenue Code (IRC) as of January 1, For federal Kiddie Tax rules, see IRC Section 1(g). B. Subtract the income that is taxable to the IRS but not for California A. Start with your federal income C. Add back the income that is nontaxable to the IRS but taxable for California RECORDKEEPING. The Franchise Tax Board requires that a taxpayer keep records and receipts for as long as they are applicable to the enforcement of tax law. For California the statute of limitations is usually the later of four years from the due date of the return or three years from the date the return was filed. California Statute of Limitations. Extension for Returns Automatic. Prior to For income tax returns prior to 1990 the final due date for FTB to assess additional tax was four years from the original April 15 due date of the return. If the taxpayer received an 5 HR. California Tax, 54