Answers to Selected PAK Problems Unit07. PAK Chapter I:8. Losses and Bad Debts

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1 Discussion Questions Answers to Selected PAK Problems Unit07. PAK Chapter I:8. Losses and Bad Debts I:0-1 If the worthless securities consist of securities of an affiliated corporation held by a domestic corporation, the loss is treated as an ordinary loss rather than a capital loss. For this exception to apply the domestic corporation must own at least 80% of the voting power of all classes of the affiliated corporation's stock and 80% of the total value of the stock. Additionally, more than 90% of the affiliated corporation's gross receipts for all its taxable years must be from nonpassive income. (i.e., sources other than dividends, interest royalties, rents, annuities, and gains from the sale or exchange of stock and securities.) pp. I:8-3 and I:8-4. I:0-2 a. No. The rental unit qualifies as a real property trade or business with respect to Laura. This is the case because she meets the following requirements: 1. The rental unit is Laura's only business and she spends over 750 hours during the year managing and caring for the rental unit. 2. Because Laura is the sole manager of the unit, she meets the material participation requirements. 3. More than 50% of Laura's personal services for the year is spent in this real estate business. b. Yes. The lab is a passive activity with respect to Kami. A business activity is passive with respect to a taxpayer if the taxpayer does not materially participate in the activity. In order to materially participate, the taxpayer must meet one of several tests: 1. The individual participates in the activity for more than 500 hours during the year. 2. The individual's participation in the activity for the year constitutes substantially all of the participation in the activity by all individuals, including individuals who do not own any interest in the activity. 3. The individual participates in the activity for more than 100 hours during the year, and that participation is more than any other individual's participation for the year. 4. Under the facts and circumstances, the individual participates in the activity on a regular, continuous, and substantial basis during the year. The only test Kami possibly could meet is the fourth one. However, her participation is probably not continuous and substantial. Since Kami does not meet any of these tests, she does not materially participate, and the activity is passive. c. There is a possibility that under the Regulations, the three operations (the lab, the medical supply company, and the medical services partnership) could be combined into one activity. If this is the case, Kami will have materially participated (over 500 hours) in the activity and the activity would not be passive with respect to her. If the three operations are treated as separate activities, she probably does not materially participate in any of them, based upon the tests mentioned in part b above. However, since she has participated over 100 hours in each of them, they are considered "significant participation" activities. Taxpayers can aggregate participation in these significant participation activities for purposes of determining material participation. This

2 aggregation causes her participation to exceed the 500 hour test. Thus, none of the activities is passive with respect to Kami. pp. I:8-11 through I:8-14. I:0-3 Under Sec. 165(h)(4)(E), no casualty loss deduction may be taken on personal-use property to the extent it is covered by insurance if a timely insurance claim is not filed. Since Rulon s insurance will only cover half the damage, he may argue that the uncovered portion is eligible for a casualty loss deduction. However, $4,000 (half of the $9,000 damage minus $500 floor reduction) will not exceed the 10% of AGI limitation (10% x $50,000 = $5,000). Thus, Rulon probably won t be able to deduct any of the casualty loss. p. I:8-20. I:0-4 Dana may not take any deduction with respect to this bad debt. Although it is a bad debt that had been incurred in her business, she has no basis in the debt because she is a cash basis taxpayer and did not report the receivable in income. pp. I:8-25 and I:8-26. I:0-5 a. Generally an NOL is carried back 2 years and carried forward for 20 years. For NOL s arising in certain farming businesses, the carryback period is 5 years. Furthermore, NOLs incurred in a qualified small business that are attributable to a Presidentially declared disaster, or in a casualty or theft sustained by an individual, may be carried back 3 years. Problems b. A taxpayer may elect not to carry back the NOL and to carry the loss forward instead. c. If the taxpayer anticipates higher income in the subsequent years, thus pushing the taxpayer into higher marginal tax rates, it may be advantageous to forego the carryback and carry the NOL forward in order to reduce taxable income. Furthermore, if carrying the NOL back will prevent the use of tax credits that will expire, the taxpayer may want to forego the carryback. pp. I:8-32 and I:8-33. I:0-6 The first step is to compute AGI. This step consists of a two-step process. First the limit on the deduction of the $25,000 real estate exemption for passive losses is computed as follows: Salary $166,000 Interest income 14,000 Net long-term capital gains 5,000 Tentative AGI (for passive loss) $185,000 Thus, the passive loss exemption for real estate is reduced to $0 [$25,000 -($185,000 - $100,000) x 0.50]. AGI is $185,000. AGI $185,000 The next step is to compute the deductions from AGI.

3 AGI $185,000 Itemized Deductions Property taxes on residence 5,000 Interest: Qualified Residence 12,000 Investment Interest ($21,000), Limited to Investment Income ($14,000) 14,000 26,000 Charitable Contributions 8,000 Miscellaneous Itemized: Tax preparation fees 2,500 Unreimbursed Employee Expenses 2,000 Minus 2% AGI ( 3,700) 800 Total Itemized Deduction 39,800 Reduction in Itemized Deduction ($185,000 - $166,800) x.01 (.03 x 1/3) ( 182) ( 39,618) Personal Exemption 3,650 ($185,000 - $166,800) = 7.28 = 8 ( 195) ( 3,455) 2,500 8 x 2% = 16%; 16% x $3,650 = $584; $584 x 1/3 = $195 Taxable Income $141,927 Note: Since Julie did not use net LTCG in computing net investment income; she may use the maximum 15% rate for LTCG when computing her tax. pp. I:8-7 through I:8-16. I:0-53 The bad debt deduction is $0. Since Elaine is a cash-method taxpayer, she does not have any basis in the receivable. pp. I:8-25 and I:8-26. I: : $0. No bad debt deduction is allowed since no bona-fide debtor-creditor relationship exists. 2010: $0. No bad debt deduction is allowed since a bona-fide debtor-creditor relationship does not exist. pp. I:8-26 and I:8-27. I:0-59 a. Taxable Income Interior Design Business Revenues $52,000 Cost of Goods Sold ( 41,000) Advertising ( 3,300) Office Supplies ( 1,700)

4 Rent ( 13,800) Contract Labor ( 28,000) Net-Business Loss ($35,800) Salary 13,500 Net Long-Term Capital Gain ($4,200 - $3,800) 400 Total AGI ($21,900) Itemized Deductions: 5,200 or Standard Deduction 5,700 ( 5,700) Personal Exemption ( 3,650) Taxable Income ($31,250) b. NOL Taxable Income ($31,250) Non-business Deductions $ 5,700 Non-business Income ( 400) Plus: Excess of Non-business Deductions over Non-business Income 5,300 Plus: Personal Exemptions 3,650 Net Operating Loss ($22,300) pp. I:8-29 through I:8-32. Case Study Problems I:8-66 November 10, Current Year Dr. John Brown 444 Physician's Drive, Suite 100 Anytown, USA Dear Dr. Brown: I thank you for the opportunity of helping you with your tax work this year. I understand that for the current year you estimate you will earn $150,000 of taxable income from your medical practice as well as $10,000 in dividends and interest income. You also anticipate that your share of Limited's loss this year will be $10,000 in addition to last year's $15,000 loss. Finally, you estimate $30,000 in taxable income from the new lab that you established this year. The lab is staffed by two full-time qualified technicians and a part-time bookkeeper keeps the accounts. You have managed the lab to date, spending 320 hours during the year. As you will recall, you were unable to deduct the $15,000 loss from Limited last year because of what are known as the passive loss limitations on passive activities. This loss is deferred or suspended into subsequent years and is only deductible against your income from

5 passive activities. Among other things, a business or investment is considered passive if you work less than 500 hours in that activity during the year. Through the end of this year, you will have a total of $25,000 in suspended passive losses from Limited. In general, if you limit your involvement in the lab to less than 500 hours for the year, the lab will also be treated as a passive activity this year. That means that the cumulative losses of $25,000 from Limited can be deducted against the $30,000 income from the lab. On the other hand, if you work in the lab over 500 hours this year you will not be able to deduct the cumulative losses of $25,000 from Limited. Thus, I recommend that you limit your involvement in the lab for the rest of the year. Furthermore, each year we should analyze your involvement in the lab because circumstances may change from year to year. I must mention that the IRS can, under certain circumstances treat a taxpayer's involvement in an activity as active even if the taxpayer's involvement is less than 500 hours. I believe, however, that the facts in your situation do not warrant this treatment since the lab should be self-sustaining without any of your efforts. As always, my recommendations are based upon the facts as I have stated them above. If I have not identified the facts correctly, please contact me immediately since a change in the facts may cause a change in the recommendation. Again, I thank you for the opportunity of serving you. Sincerely,