Assets, Income and Cash

Transcription

1 Assets, Income and Cash Publication Date: February 2017

2 Assets, Income & Cash By Danny C. Santucci The author is not engaged by this text or any accompanying lecture or electronic media in the rendering of legal, tax, accounting, or similar professional services. While the legal, tax, and accounting issues discussed in this material have been reviewed with sources believed to be reliable, concepts discussed can be affected by changes in the law or in the interpretation of such laws since this text was printed. For that reason, the accuracy and completeness of this information and the author's opinions based thereon cannot be guaranteed. In addition, state or local tax laws and procedural rules may have a material impact on the general discussion. As a result, the strategies suggested may not be suitable for every individual. Before taking any action, all references and citations should be checked and updated accordingly. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert advice is required, the services of a competent professional person should be sought. -From a Declaration of Principles jointly adopted by a committee of the American Bar Association and a Committee of Publishers and Associations. Copyright 2017 Danny Santucci ii

3 Table of Contents Financial Tax Planning... 1 Comparing Goals & Purposes... 1 Investment Purposes... 1 Purpose #1 - Comfortable Retirement... 1 Myths of Retirement... 1 Plan For 10 to 15 Retirement Years... 1 Stay With One Company to Retire With the Best Benefits... 1 Preserve Capital... 1 Retirees Are Taxed Less... 1 Housing Costs Are Less... 3 Just the Spouse and Me... 3 Company Insurance & Medicare Will Cover Medical Bills... 3 Retirees End Up In a Nursing Home... 3 Purpose #2 - Education... 3 Purpose #3 - Family & Personal Stability... 3 Purpose #4 - Enjoyment of Life... 3 Purpose #5 - Commitment... 3 Investment Goals... 3 Know Thy Investment Self... 4 Investment Vehicles & Entities... 4 Retirement Now - The Ultimate Objective... 4 Defining Retirement... 4 Determining Retirement Costs & Income Needs... 5 Basic Planning Elements... 5 Building an Estate... 5 Assets, Income & Cash... 5 Income... 6 Type #1 - Taxable... 6 Type #2 - Tax-free... 6 Type #3 - Tax-Deferred... 6 Type #4 - Tax-sheltered... 6 Budgeting... 6 Cash... 7 Acquisition... 7 Assets... 7 Management... 8 Deferral... 9 Section 1031 Like Kind Exchanges... 9 Three Elements... 9 Exchange Requirement... 9 Qualified Property Requirement Like-Kind Requirement i

4 Related Party Exchanges Retirement Plans Sources of Retirement Income Qualified Corporate Programs Defined Contribution Plans Defined Benefit SIMPLE Plans Self-employed Plans Individual Retirement Accounts Roth IRA - 408A Penalty-Free Withdrawals Tax-deferred Annuities Simplified Employee Pension (SEP) Plan Participant Loan Regulations Additional Loan Requirements Installment Sales Requirements Formula Deferred Compensation Options Reduction Tax Credits Earned Income Tax Credit Child Tax Credit Child and Dependent Care Credit Adoption Credit Credit for the Elderly and Disabled Education (American Opportunity) Credits - 25A Retirement Savings Contribution Credit 25B Work Opportunity Tax Credit (WOTC) Targeted Groups Credit Amount Research & Development Credit Rehabilitation Tax Credit Low Income Housing Credit Estimated Taxes General Rule Basic Deductions Interest Investment Interest Prepaid Interest Points Prepayment Penalty Interest on Real Estate Rental Property Home Owners Automobile Deductions Employee Automobile Deductions Business/Personal Proration Actual Cost Method Standard Mileage Rate ii

5 Depreciation ( Caps ) Limits - 280F(a) Leasing Restrictions Expensing Commuting - Local Business Transportation Revenue Rulings & Business Entertainment Directly Related Test Associated Test Statutory Exceptions Food and Beverages for Employees Expenses Treated as Compensation Reimbursed Expenses Recreational Expenses for Employees Employee, Stockholder and Business Meetings Trade Association Meetings Items Available to Public Entertainment Sold to Customers Expenses Includible in Income of Non-employees Depreciation & Cost Recovery & Net Operating Losses Income Splitting Using Progressive Tax Rates Major Formats Unincorporated Business Deductible Business Expenses Home-Office Write-Off - 280A Hiring Your Children Hiring Your Spouse Travel Expenses Casualty Losses Bad Debts Self-employment Tax (SECA) C or Regular Corporation Formation Cash for Stock Property for Stock Stock for Services Stock for Debt Repeal of the General Utilities Doctrine S Corporation Single Taxation Tax Advantages Corporations That Qualify Income-splitting Family Partnership - 704(e) Family Members Children Custodianship Employer Dependent Care Program Education Savings Bonds Education Loans iii

6 Gifts Interest Free Loans Elimination $500,000 Home Sale Exclusion Two Year Ownership & Use Requirements Tacking of Prior Holding Period Prorata Exception Municipal Bonds Tax-exempt Interest on Qualified State or Local Obligations Reporting Divorce & Separation Settlements Alimony Child Support Property Division Dependency Exemption Gifts & Inheritances Income from Property Given to a Child Life Insurance Fringe Benefits Prizes & Awards - 74(b) Group Life Insurance Premiums Accident and Health Plans & Meals & Lodging Cafeteria Plans Educational Assistance Program Dependent Care Assistance Section Social Security Earnings Record iv

7 Learning Objectives After reading the materials, participants will be able to: 1. Identify investment purposes and retirement misconceptions, the multi-step retirement process and the elements of investment planning. 2. Determine income types, from a tax perspective, to be budgeted into cash so that income-producing assets can be acquired and managed for an effective investment plan. 3. Recognize the means of achieving tax deferral noting like-kind exchanges, retirement plans and installment sales, and specify the double financial benefit of exchanging through tax postponement and possible tax elimination. 4. Determine how to use tax credits, estimated taxes, and basic deductions to effectively reduce federal income tax and thereby increase discretionary income for investment purposes. 5. Specify formats for income splitting that can benefit taxpayers by lowering overall taxes as a unit and permitting wealth and tax allocation among individuals or entities. 6. Identify the tax benefits of the $500,000 home sale exclusion, municipal bonds, divorce and separation settlements, gifts and inheritances, life insurance, fringe benefits, and Social Security to eliminate tax on realized gain and ordinary income. v

8 Comparing Goals & Purposes Financial Tax Planning Goals and purposes are different. Goals are often immediate and of short duration compared to purposes and values which are long term. Investment Purposes In carrying out an investment program the following purposes are suggested: Purpose #1 - Comfortable Retirement Retirement planning is a major element of any financial plan. In essence, retirement planning is the process of determining the amount of funds needed at retirement. Myths of Retirement Retirement has more than its share of falsehoods. Here are some misconceptions to avoid: Plan For 10 to 15 Retirement Years While the average life span is approaching 80 years and most people retire by age 62, this average counts the entire population, including the 21% who die before age 65. At age 62, your life expectancy is well past the average. Planning for 25 years of retirement is far more realistic. Stay With One Company to Retire With the Best Benefits Fixed pensions usually offer a retirement benefit of no more than 50% of the highest salary attained before retiring. If changing employers can increase your salary, you will also increase retirement benefits. Preserve Capital Preserve buying power not capital. Retirees Are Taxed Less Even while retirement income may put you in a lower bracket, don t assume less will go to taxes. 1

9 Retirement Myths Stay With One Company Retirees Are Taxed Less Housing Costs Are less Never Touch Your Principal Just The Spouse & Me Switch All Assets To Income-Producing Medicare Will Cover Medical Bills Plan For 10 To 15 Retirement Years Retirees End Up In Nursing Homes 2

10 Housing Costs Are Less Even if you pay off your mortgage by the time you retire, the real costs will be property taxes and maintenance, which continue to rise. Just the Spouse and Me Like swallows to Capistrano, children often return to the nest, or if elderly parents need care, you could find yourself retired in a full house. Company Insurance & Medicare Will Cover Medical Bills Medicare pays on average less than half of health care bills. Moreover, you usually can t collect until age 65 under Medicare, even if you retire sooner. Retirees End Up In a Nursing Home The odds of long term commitment to a nursing home are small - about 8% for women, 5% for men. Purpose #2 - Education Education is an extraordinary investment. However, credentialed education must be balanced with practical knowledge of how to make a living and plan for financial security. Purpose #3 - Family & Personal Stability Personal and family stability are the most precious of assets. A key ingredient to balanced living is the proper connection between people and things. Purpose #4 - Enjoyment of Life Financial planning gives peace of mind and security to your economic activities. This harmony applies not only to future events, but also to current transactions. Being well planned permits enjoyment of present purchases without the worry of jeopardizing your retirement. Purpose #5 - Commitment Financial planning demands commitment and work - i.e., determination plus objectives. Determination means the desire to make financial planning an integral part of your life - from now until death. Investment Goals Goals are essentially financial targets. They are in terms of either money or action, i.e., specific uses to which your dollars or energy can be put. However, the achievement of goals means decisions and tradeoffs, since one cannot realize an infinite number of goals. To seek one alternative means to forego another. As a result, you must: (1) Select realistic goals, (2) Define them precisely, 3

11 (3) Write them down, (4) Assign priorities, and (5) Allocate resources. Know Thy Investment Self Before launching ourselves off into a personal financial program, it s important to know who owns what and exactly for whom we are planning. This requires that methods of holding title must be analyzed, considered, and selected. How you invest is just as important as what you invest in. Investment Vehicles & Entities There are nine basic persons for which planning can be done. These persons also represent the basic ways to hold title to assets. We will be drawing on this list of players from time to time: (1) Individual, (2) Corporate, (3) Trust, (4) Co-tenancy, (5) Partnership, (6) Limited liability company, (7) Retirement plan, (8) Custodianship under UGMA or UTMA, and (9) Estate. Retirement Now - The Ultimate Objective Everyone must design their own retirement map to suit their personality and lifestyle. However, preparing for retirement is a step-by-step process and should be guided by certain principles and priorities. The major steps in that process are: (1) Gathering needed background information regarding the basic elements of retirement such as income, financial resources, health, housing, and lifestyle; (2) Talking things over with friends (particularly those who are retired) and professionals; (3) Setting definite but realistic goals; (4) Putting the map or plan in writing along with a list of needed actions and deadlines; and (5) Reviewing and updating the plan annually. Defining Retirement There are three major levels of retirement and any plan must interrelate them: (1) Active, (2) Sedentary, and 4

12 (3) Terminal. Despite these various levels, one s initial retirement is principally defined by three key questions: (1) When do I want to retire? (2) What kind of lifestyle do I want after retirement? (3) Do I want to move when I retire? The answers to these three questions have financial and human ramifications that bounce off each other. Determining Retirement Costs & Income Needs Once you have defined (envisioned?) your retirement lifestyle and goals, you must determine if you have the financial resources to attain them. A recent comprehensive study by Georgia State University estimates that you will need 75% to 80% of your current income to live comfortably in retirement. The study took into account differences in spending between workers and retirees and figured in the cost of taxing Social Security benefits. Basic Planning Elements Investment planning is composed of three basic elements: 1. BUILDING AN ESTATE & CREATING WEALTH. Before you learn how to shelter or distribute money you obviously need to know how to make it; 2. PRESERVING WEALTH. Once you have a little money, the next move is to discover how to keep it; and 3. DISTRIBUTING WEALTH TO HEIRS. Providing for the smooth, thoughtful, and tax-free transfer of your assets to your family and heirs completes the plan. All information you acquire regarding money, taxes, and finances can be categorized under these three elements. They are an excellent learning matrix to organize financial knowledge. Whenever you learn a planning technique, it can be mentally filed under one of these elements. Assets, Income & Cash Building an Estate Understanding wealth requires mastering three basic elements - assets, income, and cash. Income must be budgeted into cash. Cash must be used to acquire assets. Assets must be managed to produce more income. And the cycle starts again. 5

13 Income All income is not the same! There are various types of income and each has different financial characteristics. The four basic types of income are: Type #1 - Taxable Taxable income is wages, salary, commissions, rents, interest, dividends, and royalties. Taxable earned income is difficult to protect. Type #2 - Tax-free Tax-free municipal bonds are the most popularly thought of example of tax-free income. However, the return on such bonds is already discounted by the issuer to reflect their tax-free nature. Fringe benefits are a better type of tax-free income. Type #3 - Tax-Deferred Tax deferral has two benefits. First, deferral is the equivalent of an interest free loan from the government. Second, when taxes are deferred for even a few years, it is possible to earn enough on the postponed taxes to perhaps pay the original tax. Type #4 - Tax-sheltered There are many kinds of income that are not taxable. Types of income that you don t pay federal income tax on: (1) Gifts, (2) Borrowed money, (3) Gain on home sales, (4) IRA rollovers, (5) Inheritances, (6) Life insurance proceeds, (7) Property settlements, (8) Child support payments, (9) Money recovered for personal injuries, (10) Workers compensation payments, (11) Certain disability payments, (12) Tax refunds, (13) Municipal bond interest, (14) Vacation home rental, (15) A portion of children s wages, (16) A portion of children s investment income, and (17) Scholarships. Budgeting There are five basic budget rules: 6

14 Cash 1. Control your expenses so they do not exceed 60% of your gross income. 2. Keep income taxes at 20% or less of your gross income. 3. Save 10% of your gross income. 4. Spend 10% of your income on continuing practical education that motivates you to act (i.e., take risk) and teaches you financial principles % of any benefit or found money (e.g., inheritances, tax refunds, gifts, salary raises, etc.) goes to savings and the other 50% can be blown on lifestyle without any feeling of guilt. The result of budgeting is net cash or what is often called discretionary income. Discretionary income can be used four ways: (1) Spent on a higher lifestyle; (2) Put aside as emergency funds; (3) Saved; or (4) Used to acquire assets. Acquisition Few individuals have any idea of how to approach the purchase of investment assets. There are six basic guidelines to be applied when buying assets: (1) Stay liquid - be able to get your money back, (2) Grow - make money on your money, (3) Shelter - get tax benefits, (4) Build - don t spend your benefits, (5) Avoid linking - each investment must stand on its own, and (6) Analyze - investigate the investment. Assets Cash should be used to acquire assets! Assets should then work for you. An effective strategy would be to consider only the major tax advantaged investments - the ones that pop up 90% of the time. Such a group is: (1) You, your job, and career, (2) Real estate, (3) Business opportunities, (4) Money market funds, (5) Personal property and equipment, (6) Oil & gas, (7) Stocks & bonds, and (8) Wild & woollies - gold, coins, & stamps. 7

15 Management Assets must be managed to produce income. Since you are your best asset, this includes management of yourself. The six basic management rules are: (1) Develop cash flow, (2) Learn to negotiate, (3) Manage risk, (4) Diversify, (5) Monitor assets, and (6) Use systems. Review Questions Under NASBA-AICPA self study standards, self study sponsors are required to present review questions intermittently throughout each self-study course. The following questions are designed to meet those requirements and increase the benefit of the materials. However, they do not have to be completed to receive any credit you may be seeking with regards to the text. Nevertheless, they may help you to prepare for any final exam. Short explanations for both correct and incorrect answers are given after the list of questions. We recommend that you answer each of the following questions and then compare your answers. For more detailed explanations and reference, you may do an electronic search using Ctrl+F (if you are viewing this course on computer), consult the text Index, or review the general Glossary. 1. According to the author, what is a purpose in carrying out an investment program? a. work. b. savings. c. budget. d. education. 2. What is the first basic element of investment planning? a. preserve wealth. b. create wealth. c. save wealth. d. distribute wealth. 3. What is included as taxable income? a. property received as a gift. b. property received as a bequest. 8

16 c. property received as inheritance. d. property received as wages or salary. 4. What is a basic rule of budgeting? a. save 15% of your gross income. b. put 15% of your gross income toward education. c. spend no more than 30% of your gross income on expenses. d. 20% or less of your gross income should be allocated to income taxes. Deferral Section 1031 Like Kind Exchanges Exchanging allows the real estate owner to move from one property to another without reducing equity build up by income taxes due on any gain. In fact, careful tax planning can even permit the investor to receive cash before or after the exchange through properly timed refinancing. Thus, a double benefit is possible: tax deferral, plus later cash. Three Elements Based upon 1031 of the Internal Revenue Code, exchanging has only three basic requirements: (1) The properties must actually be exchanged and not sold (exchange requirement); (2) Both the property exchanged and the property received must be held for productive use in trade or business or for investment (qualified property requirement); and (3) The properties must be of a like-kind with one another (like-kind requirement). Exchange Requirement Under 1031, there must be a reciprocal transfer of property, as distinguished from a transfer of property solely for money. In short, there must be a trade and not a sale. Despite the critical need for a precise definition, neither the Code nor the Regulations contain a description of what is a valid exchange. Instead the taxpayer is referred to caselaw for the necessary definition and mechanics. Over the years, the exchangors have gravitated toward three caselaw formats: (1) Two-party exchanges, (2) Multiparty exchanges, and (3) Delayed exchanges. 9

17 Qualified Property Requirement Only qualified property can be traded under There are three basic types of qualified property: (1) Property used in your business (other than inventory), (2) Rental property, and (3) Investment property. Like-Kind Requirement The final requirement of an exchange is that the property given must be like-kind to the property received. The term like-kind is the subject of much confusion, but is best understood as a simple distinction between real and personal property. Real estate is like-kind to other real estate. Personal property is like-kind to other personal property. However, real estate is not like-kind to personal property and vice versa. Related Party Exchanges If a taxpayer exchanges property with a related party, the original exchange will not qualify for tax deferral if either of the exchanged properties is sold or disposed of within two years of the transfer ( 1031(f)). Retirement Plans To have enough income to meet one s retirement needs does require long term planning. The two most popular methods for providing for retirement needs are qualified retirement plans and social security. Sources of Retirement Income There are a variety of common sources of retirement income. Each should be checked thoroughly by any investor seriously planning for his retirement. The best planning involves a diversified program using all such sources of income. Qualified Corporate Programs Qualified corporate retirement plans divide themselves into two basic categories. The first is defined contribution plans. These plans are primarily designed and structured from a standpoint of 10

18 what contribution is to be made to the plan. The company does not bear responsibility for any growth in the plan assets or in any determinable benefit at age retirement. Defined Contribution Plans There are several basic types of such plans: (1) Profit sharing plan, (2) Money purchase pension plan, (3) Stock bonus plan, (4) Employee stock ownership plan, and (5) 401(k) plan. Defined Benefit SIMPLE Plans The second basic type of qualified corporate retirement plan is the defined benefit plan. The two most popular variations of this type of plan are: (1) Defined benefit pension plan, and (2) Annuity plan. Employers with 100 or less employees earning at least $5,000 and who do not maintain another retirement plan can set up a SIMPLE plan. SIMPLE plans are not subject to many of the complicated rules applicable to other retirement plans and can be adopted as an IRA or as part of a 401(k) plan. All employees earning more than $5,000 a year must be eligible to participate. Selfemployed individuals may also participate in SIMPLE plans. Generally, an employer must either: (1) Match elective employee contributions dollar-for-dollar up to 3% of compensation, or (2) Make a nonelective contribution of 2% of compensation of each eligible employee. Contributions to a SIMPLE plan are deductible by the employer and not taxable to the employee until withdrawn. Self-employed Plans If you operate a business as a sole proprietor or a partner either full time or part time, you could establish a Keogh plan. Such plans can either be defined contribution or defined benefit plans. You can direct investments and even be your own trustee. There is a limit on the deduction which the self-employed can claim with respect to a contribution on his or her behalf. A maximum of 13.04% of net business income can be deducted if a profitsharing Keogh plan is established. Contributions to a money purchase pension Keogh are limited to 20% of the net profit (after contribution), but no more than $54,000 (in 2017) can be contributed to the plan for the owner in any one year. Individual Retirement Accounts All individuals, employees and the self-employed can annually contribute to an individual retirement account. The contribution amount can either be $5,500 (in 2017) or entire earned income, 11

19 whichever is less. However, if you or your spouse is a participant in a company plan, Keogh, SEP or government plan, your ability to set up a deductible IRA is phased out above certain income amounts. The TRA 97 permits deductible contributions for spouses of individuals who are in an employersponsored retirement plan. However, the deduction is phased out for taxpayers with AGI between $186,000 and $196,000 in Roth IRA - 408A The TRA 97 created a tax-free nondeductible IRA called the Roth IRA but it is phased out for individuals with AGI between $118,000 and $133,000 and married couples with AGI between $186,000 and $196,000 in Distributions from a Roth IRA are tax free if made more than 5 years after a Roth IRA has been established and if the distribution is: (1) Made after age 59½, death, or disability, or (2) For first-time home buyer expenses (up to $10,000). Penalty-Free Withdrawals The Tax Reform Act of 1986 created a penalty-free way to withdraw money from the account before you reach age 59½. An under 59½ year old IRA owner can withdraw funds from an IRA and avoid a 10% penalty tax by undertaking a series of substantially equal annual withdrawals from the IRA over his life expectancy or over his and his designated beneficiary s joint life expectancy. Once the taxpayer reaches age 59½ and has withdrawn scheduled annual amounts for at least 5 years, he can modify the amount he withdraws or stop any further withdrawals entirely until reaching age 70½. Tax-deferred Annuities Deferred annuities can serve as an attractive alternative for individuals unable to make deductible IRA contributions. Although contributions to a deferred annuity are not tax deductible, earnings do accumulate tax deferred. Note: There is no limit to the amount of money you can invest in an annuity. Simplified Employee Pension (SEP) Plan A SEP plan is essentially an IRA set up by an employer for employees. The employer can take a deduction for contributions to a SEP equal to the lesser of 25% of the employee s earnings or $54,000 (in 2017). Employer contributions are exempt from FICA, FUTA, and current income taxes. The employee also may personally contribute up to $5,500 (in 2017) as a regular IRA contribution each year. Participant Loan Regulations Normally, a loan from a qualified retirement plan to a participant is a prohibited transaction under 4975 unless the following requirements are met: (1) Loans must be made available to all participants on a reasonably equivalent basis; (2) Loans must not be made to highly compensated employees in amounts proportionately greater than for other employees; 12

20 (3) A loan must be made in accordance with specific provisions in the plan; (4) A loan must have a reasonable interest rate; and (5) A loan must be adequately secured. If a loan fails to meet these requirements, excise taxes may be assessed. Note: No loans can be made to owner employees (i.e., partners with a 10% capital or profits interest or 5% or shareholders of S corporations, or members of their families). Additional Loan Requirements A plan must also meet the following rules in order to avoid having the participant-borrower income taxed on the loan amount: (a) A loan must be repaid within 5 years; Exception: This rule does not apply when the borrowed amount is used for the purchase or rehabilitation of the borrower s primary residence. (b) A loan must be paid in level amounts on at least a quarterly basis; and (c) An employee can borrow the lesser of $50,000 or 50% of their vested benefits. Exception: Participants with vested benefits of $10,000 or less can borrow the lesser of $10,000 or 100% of their vested benefits. If these rules are not satisfied, the amount borrowed is treated as a plan distribution subject not only to federal and state tax but a 10% early distribution tax as well. Installment Sales An installment sale can permit a taxpayer to pay his taxes on the disposition of property as he receives the payments. This deferral can result in a huge tax savings. Requirements The basic requirements of an installment sale are: (1) There must be a sale of property (as contrasted with services), (2) The property must not be of a kind which is required to be included in the inventory of the taxpayer if on hand at the close of the taxable year ( 453(b)(1)(B)), and (3) There must be an installment sale. Note: All that is needed to meet this requirement is that at least one payment will be received in a tax year other than the year of sale ( 453(b)(1)). If the above requirements are met, installment sale treatment is automatic. A special election must be made to report the gain by any other method of accounting. The election must be made by the due date of the income tax return for the year of the sale. The regulations permit a late election only in rare cases when IRS concludes that the taxpayer had good cause for filing a late election. Formula The gain reported on an installment sale is computed using the following formula: 13

21 Total Gain X Payments Received = Recognized gain Contract Price Historically, losses sustained on an installment sale were fully deductible in the year of sale (R.R ). This rule has been modified by 469 which now requires installment reporting of certain losses (e.g., suspended losses under the passive loss limitation rules) in an installment sale. Deferred Compensation Revenue Ruling tells you how to defer compensation from one year to another. Under that ruling there are three basic types of deferred compensation agreements: TYPE I - A MERE CONTRACTUAL PROMISE TO PAY. This format is a contractual agreement between you and your (perhaps wholly owned) company to pay you compensation in the future for services yet to be performed. TYPE II - CONTRACT PLUS GUARANTEES. Under this method the company still promises to pay compensation in the future but in addition, the contract can be backed up by: (1) Life insurance, (2) Third party guarantees, and (3) You can even direct how the money is invested if funds are set aside in the company s accounts. TYPE III - SEGREGATED FUNDS WITH SUBSTANTIAL RESTRICTION. The funds necessary to pay the deferred compensation can be deposited with a third party stakeholder (e.g., an escrow or bank) with instructions to pay the funds in the future. If time were the only restriction, this would result in immediate constructive receipt of the money. However, if payment is dependent on continued employment, deferral is accomplished. Options Tax deferral does not have to be complicated. In fact, it can be affected very simply, with the use of an option. Let s say that you need $2,000, and that you have already incurred large amounts of taxable income and you are in a high tax bracket. You are afraid the government will take a large portion of that money if you sell. One way to receive the income, without having to pay the tax until subsequent years, would be to grant an option on one of your properties. The option consideration that you receive would not be taxable until the option was either exercised or expired. You could also put in the agreement that the option could not be exercised for a year or two years, thereby insuring that you would have the tax-free use of the funds, at least until that period of time expired, or the person who had the option exercised it. 14

22 Reduction Three basic methods to reduce federal income tax are: (1) Tax credits, (2) Correct withholding, and (3) The use of net operating losses. Tax Credits Tax credits are not deductible from income. They directly reduce tax. As a result, they are a great way to reduce taxes on a dollar for dollar basis. A credit absorbs its full weight in tax. Earned Income Tax Credit - 32 This is a refundable credit for low-income working individuals and families. Income and family size determine the amount of the EITC. When the EITC exceeds the amount of taxes owed, it results in a tax refund to those who claim and qualify for the credit. Child Tax Credit - 24 This credit is for people who have a qualifying child. The maximum amount of the credit is $1,000 for each qualifying child. This credit can be claimed in addition to the credit for child and dependent care expenses. Child and Dependent Care Credit - 21 This is for expenses paid for the care of children under age 13, or for a disabled spouse or dependent, to enable the taxpayer to work. There is a limit to the amount of qualifying expenses. The credit is a percentage of those qualifying expenses. Adoption Credit - 23 Adoptive parents can take a tax credit of up to $10,000 (adjusted for inflation) for qualifying expenses paid to adopt an eligible child. The credit may be allowed for the adoption of a child with special needs even if the taxpayer does not have any qualifying expenses. Credit for the Elderly and Disabled - 22 This credit is available to individuals who are either age 65 or older or are under age 65 and retired on permanent and total disability, and who are citizens or residents. There are income limitations. Education (American Opportunity) Credits - 25A There are two credits available, the Hope Credit and the Lifetime Learning Credit, for people who pay higher education costs. The Hope Credit is for the payment of the first two years of tuition and 15

23 related expenses for an eligible student for whom the taxpayer claims an exemption on the tax return. The Lifetime Learning Credit is available for all post-secondary education for an unlimited number of years. A taxpayer cannot claim both credits for the same student in one year. In 2009, the Hope Credit was modified and renamed the American Opportunity Tax credit. Retirement Savings Contribution Credit 25B Eligible individuals may be able to claim a credit for a percentage of their qualified retirement savings contributions, such as contributions to a traditional or Roth IRA or salary reduction contributions to a SEP or SIMPLE plan. To be eligible, you must be at least age 18 at the end of the year and not a student or an individual for whom someone else claims a personal exemption. Also, your adjusted gross income (AGI) must be below a certain amount. Work Opportunity Tax Credit (WOTC) 51 Section 51 has a history of expanded and contracted coverage together with expiring and reinstated effective dates. As a result of the PATH Act, the provision now provides a work opportunity credit (formerly known as the targeted jobs credit) for employers hiring individuals from one or more of nine targeted groups before January 1, 2020 ( 51(c)(4)). Targeted Groups Note: From 1998 thru 2006, taxpayers were allowed a welfare-to-work credit was allowed for 35% of the first-year wages and 50% of the second-year wages paid to long-term family assistance recipients. However, due to the similarities, the welfare-to-work credit (former 51A) was incorporated into the work opportunity credit ( 51) for recipients beginning work after December 31, 2006 ( 51(d)(1)). The employed individual must be a member of a targeted group. These groups include: (1) qualified TANF recipients ( 51(d)(1)(A)), (2) qualified veterans ( 51(d)(1)(B)), (3) qualified ex-felons ( 51(d)(1)(C)), (4) designated community residents ( 51(d)(1)(D)), (5) vocational rehabilitation referrals ( 51(d)(1)(E)), (6) qualified summer youth employees ( 51(d)(1)(F)), (7) qualified food and nutrition recipients ( 51(d)(1)(G)), (8) qualified SSI recipients ( 51(d)(1)(H)), and (9) long-term family assistance recipients ( 51(d)(1)(I)). Employers must obtain certification that a new-hire is a targeted group member to claim the WOTC. Credit Amount The credit available to an employer for qualified wages paid to members of all targeted groups except for long-term family assistance recipients equals 40% (25% for employment of 400 hours or less) of qualified first-year wages. 16

24 Generally, qualified first-year wages are qualified wages (not in excess of $6,000) attributable to a targeted group member during the one-year period beginning with the day the individual started working. Therefore, the maximum credit per employee is $2,400 (40% of the first $6,000 of qualified first-year wages). For qualified summer youth employees, the maximum credit is $1,200 (40% of the first $3,000 of qualified first-year wages). Except for long-term family assistance recipients, no credit is allowed for second-year wages. Note: For summer youths, it applies to wages paid during a 90-day period from May 1 to September 15. Comment: In the case of long-term family assistance recipients, the credit equals 40% (25% for employment of 400 hours or less) of $10,000 for qualified first-year wages and 50% of the first $10,000 of qualified second-year wages. Note: The VOW to Hire Heroes Act of 2011 ( VOW ), modified the work opportunity credit with respect to qualified veterans, by adding five additional subcategories. A veteran is an individual who has served on active duty (other than for training) in the Armed Forces for more than 180 days or who has been discharged or released from active duty in the Armed Forces for a service-connected disability. Research & Development Credit - 41 Constantly permitted to expire only to be later reinstated, the 41 research credit has been generally available with respect to incremental increases in qualified research. It last expiration was for taxable year beginning after December 31, Note: The 41 research tax credit has never been a permanent provision of the federal tax code. Since its enactment in mid-1981, the credit has been extended 15 times and significantly modified five times. However, under the PATH Act, the 41 research credit has been reinstated and made permanent. In addition, the PATH Act provides that, in the case of a small business (as defined in 38), the credit is a specified credit for taxable years beginning after December 31, Thus, the research credits of a 38 small business may offset both regular tax and AMT liabilities. Rehabilitation Tax Credit - 47 The credit is 20% for rehabilitation of certified historical structures and 10% for other qualified building originally placed in service before 1936 ( 47(a)). The 10% credit for building other than certified historic buildings is limited to nonresidential buildings. The 20% credit for historical buildings is available for nonresidential and residential buildings. To qualify for the credit, the law requires the retention of at least 75% of the existing external walls, including at least 50% as external walls as well as, at least 75% of the building s internal structural framework. The law requires a basis reduction equal to 100% of the rehabilitation tax credits claimed. 17

25 Low Income Housing Credit - 42 Section 42 creates three separate credits that may be claimed by owners of residential rental projects providing low-income housing. The credit rate is set up so the annualized credit amounts have a present value of 80% or 30% of the basis attributable to qualifying low-income units, depending on the income of the tenant qualifying for the credit. The low-income housing credit was made permanent by OBRA 93. Three separate credits are provided: 1. A maximum credit of 9% each year for 10 years is allowed on expenditures for new construction and rehabilitation of each qualifying low-income housing unit. This credit has a present value of 80%. 2. If the new construction or rehabilitation is financed with tax-exempt bonds or similar Federal subsidies, the maximum credit is 4% each year for 10 years. This credit has a present value of 30%. 3. A maximum credit of 4% each year for 10 years will be allowed on the cost of acquisition of existing low-income housing units. This credit has a present value of 30%. To qualify, the property may not have been previously placed in service within 10 years. Estimated Taxes Estimated tax is the method used to pay tax on income that is not subject to withholding. This includes income from self-employment, unemployment compensation, interest, dividends, alimony, rent, gains from the sale of assets, prizes, and awards. The estimated tax is used to pay both income tax and self-employment tax. If you do not pay enough through withholding or by making estimated tax payments, you may be charged a penalty. It is important not to overlook opportunities to cut estimated tax payments to the legal minimum. General Rule Choose the payment rule giving the lowest required payment. Underpayment penalties are not applied when taxpayers make estimated payments at an appropriate rate through the year that equal to the smaller of: (1) 90% of the actual tax liability for the current year; or (2) The amount of actual tax liability in the prior year. This amount is called the required annual payment and is generally due in four equal quarterly installments. 18

26 Basic Deductions Interest Under 163(a), a deduction is allowed for all interest paid or accrued within the taxable year on indebtedness. However, this general rule is subject to a number of restrictions. In addition, tax reform imposed strict limits on interest deductions, breaking interest payments into over thirteen distinct categories, each with its own separate and complex rules. Investment Interest In the case of a taxpayer (other than a corporation), the deduction for investment interest is limited to the amount of the net investment income ( 163(d)(1)). Disallowed investment interest is carried forward and treated as investment interest in succeeding taxable years to the extent of net investment income in any such year ( 163(d)(1)). Prepaid Interest Points Prepaid interest is deductible only in the period to which it relates and must be capitalized and deducted over the period of the loan to the extent it represents the cost of using borrowed funds during such period ( 461(g)(1)). Points that are in the nature of an additional interest charge constitute prepaid interest. As such, they must be capitalized by a cash-basis taxpayer and deducted ratably over the term of the loan if incurred in a business transaction, the same as if the taxpayer were on the accrual basis ( 461(g)(1)). However, points are currently deductible if paid on indebtedness incurred in connection with the purchase or improvement of the taxpayer s principal residence, provided the indebtedness is secured by the residence. Points paid to refinance an existing home mortgage are incurred for the purpose of repaying an existing indebtedness, not to purchase or improve a home. Such points do not qualify under the statute (I.R ). Prepayment Penalty The prepayment penalty is treated as additional interest and is deductible as such (R.R ). The same rule applies where the mortgagor refinances. The penalty payment is not amortized over the life of the new loan but is deducted immediately Interest on Real Estate Rental Property Mortgage interest on a passive activity, such as a house you rent can only be used to offset passive income. However, if your AGI is under $100,000, you can deduct up to $25,000 of loss against your other income. Note: Suspended losses from passive activities (e.g., those you can t use because your AGI is too high) can be carried forward to future years. 19

27 Home Owners Get as big a mortgage as possible when you buy. Interest is fully deductible on mortgages of up to $1 million spent to acquire, construct, or substantially improve a principal or second residence. If you need to borrow further, through refinancing, second mortgages, or homeequity loans, interest will be fully deductible on only $100,000 additional. Note: When you buy a home, be sure to have all the appliances - from refrigerator to dishwasher to trash compactor - installed by the builder or seller. That way you can consolidate all the costs within your purchase mortgage payment and still get a full interest deduction. Land: The IRS has ruled that interest on debt incurred to add land adjoining a taxpayer s home is acquisition indebtedness (PLR ). Automobile Deductions Operating costs for an automobile, truck, or other vehicle used in a business (or for investment purposes, such as meeting with your stockbroker or checking on your rental property) are deductible to the extent that they represent transportation expenses to carry on the taxpayer s business. Thus, when a taxpayer uses his car in his business or employment, he can deduct that portion of the cost of operating the car. Employee Automobile Deductions Employees are subject to stricter rules and may deduct only the following employment related automobile expenses: (a) Expenses of travel while away from home in the performance of services as an employee, (b) Local transportation expenses, and (c) Expenses covered by a reimbursement or other expense allowance arrangement with the taxpayer s employer. Employees may not take depreciation on an automobile unless, in addition to the above requirements: (a) It is required as a condition of employment; and (b) It is for the convenience of the employer (Reg F-6T). Business/Personal Proration If an automobile is used for both personal and business purposes, there must be an allocation of expenses based on the total annual mileage driven. Thus, only the business portion of interest, tax, or casualty loss is a deduction. Once the business percentage has been determined, there are two methods for calculating the deductible costs - actual cost and standard mileage. Actual Cost Method Under this method the taxpayer must substantiate every expenditure made, and thus extensive recordkeeping is required. Deductible expenses are items such as gasoline, oil, repairs and maintenance, interest to buy the car, costs of washing the vehicle, garage rent, tires, highway tolls, parking, license and registration fees, insurance premiums, and a reasonable allowance for depreciation. Complex rules for depreciation apply if the actual cost method is used. 20

28 Standard Mileage Rate The standard mileage deduction allows a flat or standard amount of deduction for every business mile traveled regardless of actual cost, and therefore only requires substantiation of the distance traveled in the pursuit of a trade or business. No other allocation is necessary and the taxpayer need not establish the amount of his actual automobile expenses. Note: An individual businessman or employee must still maintain adequate records to establish the actual miles his car was driven for business. The standard mileage rate is 53.5 cents in This applies to all business miles. Costs incurred for gasoline (and the taxes thereon), oil, maintenance and repairs, license fees, insurance, and a reasonable allowance for depreciation are included in this fixed rate and may not be separately deducted. However, parking fees, tolls, car loan interest, and state and local property taxes attributable to business use are specifically not included in this amount and may be separately deducted. Note: Automobile interest allocated by an employee to his employer s business is treated as personal interest ( 163(h)), which is no longer deductible as an itemized deduction. Depreciation ( Caps ) Limits - 280F(a) For cars placed in service in 2017, the projected depreciation deduction (including the 179 expensing deduction) may not be more than $3,160 ($11,160 if first year bonus depreciation is used) for the first tax year of the recovery period, $5,100 for the second year, $3,050 for the third year, and $1,875 for each later tax year same figures as in For trucks and vans placed in service in calendar year 2017, the projected depreciation cap is $3,560 ($11,560 if bonus depreciation is used) in the first-year, $5,700 in the second year, $3,450 in the third year, and $2,075 in the fourth year and thereafter ( 280F(a)(2)(A)). If you use the car only partly for business, the limits are reduced proportionately. Leasing Restrictions The depreciation and expensing caps and the predominant business use rules discussed above cannot be escaped by leasing a car ( 280F(c)). In order to equate car owners and lessees, regulations under 280F require the lessee to include in gross income an inclusion amount determined as a percentage of the car s fair market value (on the first day of the lease term) in excess of stated dollar amounts (Reg F-5T(d)). This inclusion amount is designed to approximate the limitations imposed on the owner of a car. Expensing Buyers of depreciable business property can annually deduct up to $510,000 (in 2017) of their purchases. The balance, if any, must be depreciated. However, for cars the depreciation "cap" applies to the total of expensing and first-year depreciation. 21