Front Loading SolutionsFront Loading SolutionsFormula:

a) First recaptureY2 – Y3 – 15,000 = 1st recapture

b) Second recapture

Problem 1:a) 45,000 – 30,000 – 15,000 = 0b) 60,000 – (75,000/2) – 15,000 = 7,500

Total recapture = 0 + 7,500 = $7,500

Front Loading Solutions Cont.Front Loading Solutions Cont.Problem 2:

a) 0 – 0 – 15,000 = (15,000) (No first recapture)b) 100,000 – 0 – 15,000 = 85,000

Total recapture = 0 + 85,000 = $85,000

Problem 3:a) 60,000 – 40,000 – 15,000 = 5,000b) 80,000 – ([60,000 + 40,000 – 5000]/2)-15,000 =

17,500Total recapture = 5,000 + 17,500 = $22,500

Property SettlementsProperty Settlements

Current Law: Transfers during marriage, upon divorce, or within one year thereof are considered tax free gifts. (No income to the husband and wife gets carryover basis.)

Child SupportChild SupportOld law – if you want something to be child support it

MUST be specified as such

Current law – any payment upon a happening related to a child (birthday, graduation, etc.) is child support.

Example: H owes W $8,000 (5,000 alimony and 3,000 child support). H pays W $4,000. What are the tax consequences?

Answer: $3,000 treated as child support and $1,000 treated as alimony.

Delinquent payments are first allocated to child support.

GiftsGiftsWhat is a gift?

Transfer of property without consideration.

What is consideration?Value or the expectation of something in return.

Gifts are fully excludable from Gross Income.

Note: It must truly be a gift. There is a rebuttable presumption that payments made by an employer to an employee are compensation. Note: There is also a rebuttable presumption that transfers between a parent and child are gifts.

Bequests and InheritancesBequests and Inheritances

Example: Great Uncle dies and leaves you $100,000 in his will.

Inheritances are FULLY EXCLUDABLE from GI.

Note: Gifts and inheritances are tax-free, but income earned on property received as a gift or inheritance is fully taxable.

Life InsuranceLife InsuranceThere are two types of life insurance: term insurance and whole-life.

Example: Your great uncle dies and names you as the beneficiary of his $100,000 insurance policy.

Life insurance proceeds paid by reason of death are fully excludable.

Example: TP cashes in $100,000 policy (paid 30,000 in premiums) and receives $65,000 cash surrender value.

Tax Consequences: $35,000 is included in gross income. $30,000 is excluded as cost recovery.

Life Insurance ProblemsLife Insurance Problems1. TP buys policy from friend for $30,000. He dies 5 years later and TP receives $100,000 death benefit. What are the tax consequences.

2. Husband dies. Wife is the beneficiary on a $100,000 policy. Wife elects to take $13,000 per year for 10 years. What are the tax consequences.

AnnuitiesAnnuitiesAn individual can purchase an annuity to pay a fixed amount for the remainder of their life.

We will only deal with single life annuities, NOT joint and survivor annuities.

Example: Individual invests $10,000 in an annuity to pay $1,000/year starting at age 65. What are the tax consequences when the individual is age 65 and collects their first $1,000 payment?

AnnuitiesAnnuitiesInvestment in Contract

Expected ReturnX

AnnualAmountReceived

= AmountExcluded

10,00020 x 1,000

X 1,000 =$500 excluded

Note: This is cost recovery. If individual lives beyond 20 years. There is NO EXCLUSION from that point on. (Cost has fully been recovered)

Note: If individual dies before recouping full cost on final return, deduction is available for unrecouped cost

Employer/Employee Annuities Employer/Employee Annuities (Pensions)(Pensions)

Non-Contributory: No cost to be recovered; therefore fully taxable

Contributory: Use annuity exclusion ratio, but include only employee’s cost in the numerator

DamagesDamages

CompensatoryLost wages are taxable. The wages would have been

taxed, therefore any substitute for taxable income is taxed.

Personal injury are tax free. Brings individual back to position prior to injury.

PunitiveALL punitive damages are fully taxable, unless state

wrongful death statute applies.

Prizes, Awards and ScholarshipsPrizes, Awards and ScholarshipsPrizes and awards

-Prizes and awards are generally taxable-Exceptions: certain awards to employees not to exceed

$400 per award, maximum of $1,600/year

Scholarships-Generally tuition, fees, and books are tax free.-Generally room and board are taxable.

Note: Recipient must be a candidate for a degree (undergraduate or graduate). Research grants to non-degree individuals are fully taxed.

Meals & LodgingMeals & LodgingExample: Intern is hired to work in hospital and be on call 24 hours. He is offered the following:

a) Eat all meals in employee/doctor cafeteria cost free. (During the year intern eats in the cafeteria-value of meals is $8,000. NOTE: Employee doesn’t have to eat there.)

b) Live in dormitory room in hospital-cost free. Intern does not have to live there, but must live within 4 miles of hospital. (During the year the intern lives in the dorm-FMV $5,000)

c) What is included in employee’s gross income?

Meals and LodgingMeals and Lodging

Meals are tax free if:1. Meals are provided for the convenience of the

employer; and2. They are provided on the premises of the employer

Note: Meal money and groceries are taxable. Must be meals!!!

Lodging is tax free if:1. it is provided for the convenience of the employer;

and2. It is provided on the premises of the employer; and3. It must be a condition of employment.

Imputed InterestImputed InterestThe doctrine of the fruit and tree prevents income shifting. Where the parent doesn’t want to give away the tree there used to be an alternative to shift income: an interest free loan.

P C

Invests money earns income

Lends $100,000 w/o interest

Demand loan; retains ownership of $100,000.

Imputed InterestImputed InterestGovernment enacted the imputed interest rules to overcome this. Where there is a loan between two parties and there is no interest charged (or interest charged below market rates) the government imputes income to the lender.

Monthly the government establishes an Applicable Federal Rate (AFR) as the market rate.

Reconsider the previous example assuming a 6% AFR.

P CLends $100,000 w/o interest

Deemed payment $6,000Step 1:$6,000 interest income

Step 1: $6,000 interest deduction

Deemed gift of $6,000Step 2: No deduction

Step 2:

No income

Imputed InterestImputed Interest

Employer/Employee Interest Free Loans-Step 2 amount is considered to be compensation.

Corporation/Shareholder Interest-Free Loans-Step 2 amount is considered to be a dividend.

Interest charged below AFR-Difference is imputed interest

Additional Considerations:

Imputed Interest ExceptionImputed Interest Exception

Where loan between Parent and Child does not exceed $100,000 impute the lesser of normal imputed interest OR unearned income of the child.

P CLends $100,000 w/o interest

Example:

Child has unearned income of $3,500.What is the amount of imputed interest?

What if the child has unearned income of $10,500?.

Employee Fringe BenefitsEmployee Fringe BenefitsAccident and Health:

- Employee can exclude the value of accident and health plans provided by the employer. In addition, medical reimbursements are also excluded whether employer or employee pays for the plan.

No additional-cost services:- Excluded from gross income. Example: airline

employee flies free on availability basis

Qualified employee discounts:- Excluded from gross income. Example: 10% discount

if you work for Macy’s

Employee Fringe BenefitsEmployee Fringe BenefitsWorking condition fringes:

- Excluded from gross income. Examples: professional dues paid by employer; auto given to auto salesman

De Minimis Rule:- If too small to account for excluded from gross

income. Example: secretary types personal letter for employee

Foreign Earned IncomeForeign Earned IncomeIf an individual earns income abroad it is subject to tax of BOTH the U.S. and the foreign country in which it is earned. (Double Tax)

To alleviate a portion of this double-tax the government allows individuals to exclude up to $80,000 annually for Foreign Earned Income. (Does NOT apply to to Unearned income.)

Foreign Earned IncomeForeign Earned IncomeTo be eligible for the exclusion the individual must EITHER be:

b) Meet the physical presence test (must be in the foreign country at least 330 days during ANY consecutive 12 months).

If you are in the foreign country for less than the entire year, the exclusion must be prorated on a DAILY BASIS.

a) A bona-fide resident of that foreign country.or

Foreign Earned IncomeForeign Earned IncomeExample: Individual moved to Japan 11/1/11 and stayed until 10/31/12. What is excluded in 2011 and 2012?

Forgiveness of DebtForgiveness of DebtYou owe me $10,000 and I tell you to forget it. Your wealth has been increased by $10,000.

Remember basic accounting formula:Assets – Liabilities = Capital (Net Worth)

If the liabilities decrease, your capital (net worth) increases. Therefore the government’s general rule is: “to the extent that there is forgiveness of debt the debtor must include the forgiveness in gross income.”

Forgiveness of DebtForgiveness of DebtEXCEPTIONS:

1) Gifts – parent forgives loan to a child (Remember the presumption that transfers between related parties are gifts) caveat employer/employee forgiveness

2) Bankruptcy – federal bankruptcy statute allows debtor “fresh start” by relieving debtor of most debts. If this was to result in taxable income, how could debtor pay the tax?

3) Insolvency – individual is insolvent if liabilities are greater than assets at fair market value

Forgiveness of Debt - InsolvencyForgiveness of Debt - InsolvencyExample:Individual has assets of $50,000 and liabilities of $100,000. If creditors get together they could force an individual into bankruptcy, but the expenses (trustees’ fees, attorney’s fee, accounting fees, etc.) could eat up most of the assets. Therefore, the creditors agree to release $40,000 of their debt. Does the individual have $40,000 of income?

Forgiveness of Debt - InsolvencyForgiveness of Debt - InsolvencyExample:Same facts as previous example. What if the creditors agree to forgive $60,000 of debt so that:

Forgiveness 60,000Assets 50,000Liabilities 40,000

Does the individual have $60,000 of income?