Table of Contents

Table of Contents

Introduction

Course Objectives

How to Prepare for the Exam

About the Computer Based SEE Exam

Obtain a PTIN

Registering and Scheduling an Examination Appointment

Chapter One - Business Entities

Employer Identification Number

Entity Default Rules

Sole Proprietorship

Partnership

C Corporation

S Corporation

Limited Liability Company (LLC)

Estate

Trust

Exempt Organizations

Accounting Periods

Types of Accounting Methods

Chapter Two - Partnerships

Partnership Formation

Terminating a Partnership

Partnership Filing Requirements

Tax Year

Partnership Income or Loss

Partner’s Income and Loss

Partnership Distributions

Transactions between Partner and Partnership

Basis of Partner’s Interest

Disposition of Partner’s Interest

Bipartisan Budget Act of 2015 (BBA)

Chapter Three - C Corporations

Businesses Taxed as Corporations

Property Exchanged for Stock

Return Filing and Tax Payment Requirements

Accounting Periods and Methods

Income, Deductions, and Special Provisions

Figuring Tax

Accumulated Earnings Tax

Distributions to Shareholders

Stock Redemption

Liquidations

Chapter Four - S Corporations

The Election

Termination of Status

Filing Requirements and Extensions

Permitted Tax Year

Income and Expenses

Shareholder's Basis in Stock

Taxes

Distributions to Shareholders

Chapter Five - Business Income, Expenses, Losses, Credits and Taxes

Information Returns

Depreciation, Depletion and Amortization

Limitation on Losses

General Business Credits

Excise Taxes

Highway Use Tax

Chapter Six - Business Assets

Basis of Property

Sale of Business Property

Nontaxable Property Transactions

Chapter Seven - Estate and Trust Income Tax

Estate Income Tax

What is a Trust?

Chapter Eight - Tax Exempt Organizations

Qualifying for Exemption (Section 501(c)(3) Organizations)

Application for Recognition of Exemption

Filing Requirements

Chapter Nine - Retirement Plans

Qualified Plans

Simplified Employee Pensions (SEPs)

SIMPLE Plans

Elective Deferrals (401(k) Plans)

Retirement Plan Rules for 2022

Chapter Ten - Farm Accounting

Farm Income

Livestock and Crops

Farm Inventory

Sale of a Farm

Section 1231 Transactions

Appendix - Business Forms & Schedules at a Glance

Phoenix Tax Group Refund Policies

Evaluation

Introduction

The Phoenix Tax Group Guarantee

We have been successfully preparing tax practitioners to pass the Special Enrollment Exam for over 20 years. Practitioners who have used our study materials, study strategies and have put in the time and effort have had over a 90% passing rate.

30 Day Refund

If you are not satisfied with any of our products, you can return them for a full refund, excluding shipping and handling charges.

A refund must be requested within 30 days of purchase, and all hardcopy materials must be returned in the original box. No credit will be given for any materials marked on, missing or damaged in any way. To request a refund, fill out the Refund Request form at the link below.

Pass Guarantee Refund

The Pass Guarantee applies only to products designated as "Packages."

To receive a refund, you must have taken and failed a test or exam twice.

You must provide your failed scores for both failed exams by filling out the online Refund Request Form (see link below). This must be done within 30 days of the second failed exam.

Hard copy materials must be returned within 30 days of the second failed exam.

If you purchased Enrolled Agent study materials together in a 3 part package, refunds will be pro-rated for the part being returned.

The refund will only apply to the person who purchased the study materials from The Phoenix Tax Group. The refund policy does not apply to companies purchasing study materials for employees.

Instructions

To ensure proper credit, please fill out our online refund request form.

http://www.phoenixtax.com/about/refunds

Course Objectives

This course is designed to prepare students to pass the IRS Special Enrollment Examination the first time they take the exam. After completing our course, you should have the tax knowledge needed to pass the exam.

This course is taught at an intermediate level. It is helpful if the student has had some beginning level courses relating to tax laws and at least a year of income tax preparation experience.

Our course is broken down into three parts similar to the parts on the exam. Part 1 discusses individual income tax law, Part 2 discusses sole proprietorship and partnership, corporation (including S corporation), fiduciary, estate, and trust tax law and tax-exempt organizations, and Part 3 discusses practitioner ethics, recordkeeping, IRS tax examination, appeals, and collection procedures, practitioner rules and penalties, and research materials. All the materials have been updated to 2022 tax law.

Note: All references on the examination are to the Internal Revenue Code, forms and publications, as amended through December 31, 2022. Also, unless otherwise stated, all questions relate to the calendar year 2022. Questions that contain the term ‘current tax year’ refer to the calendar year 2022.

We feel we have the best and most comprehensive enrolled agent exam preparatory course available. However, we are always looking for ways to improve our course. We would appreciate it if you would take a moment to complete the course evaluation located at the end of each part of the course or complete our online evaluation at www.phoenixtax.com.

If you have any questions, please email us at support@phoenixtax.com. Do not call our 800 number.

Good luck on the exam.

How to Prepare for the Exam

The following is a set of guidelines for preparing for the exam:

We recommend that you study a minimum of 100 to 120 hours total for all three parts of the exam. For Part 1, we recommend 35-45 hours of study. For Part 2, we recommend 45-60 hours of study. For Part 3, we recommend 20-25 hours of study. Break up your study time. Do not try to study 3 or 4 hours at a time. Most people's comprehension level starts to fade after an hour. You will be surprised how much you can absorb by studying in intervals of 15 to 30 minutes.

DO NOT rely on your tax experience to pass this exam. It has been our experience that people with limited tax experience (one year or less) have a far better success rate on this exam than people with many years of tax experience. The reason is that preparers with years of experience tend to rely on their practical knowledge of taxes. This exam tests on theory, not practical experience. The IRS is primarily interested in your ability to understand the tax law and to properly and accurately determine taxable income (i.e., figuring basis in an asset to determine gain, what income is taxable, what deductions are allowed, etc.).

You can now use a calculator to do the computational questions. Prometric will provide you with a hand-held calculator. You cannot bring your own calculator.

Be familiar with the tax forms and the filing dates for those forms. There is a quick reference in the Appendix.

The exam will test on a specific tax law in more than one part. For example, questions pertaining to property basis or retirement plans will be tested in both Part 1 and Part 2; questions pertaining to recordkeeping in Part 1 and Part 2 could be tested in Part 3; taxpayer penalties could be tested in all three parts. Therefore, we strongly recommend you to take the exam in the following order. Take Part 1 first, Part 2 second and Part 3 last. You should also take all three parts of the exam as close together as possible.

You must have a positive attitude toward this exam. If you do not think you can pass this exam, you won't. Fifty percent of preparing for this exam is being mentally prepared.

About the Computer Based SEE Exam

The Internal Revenue Service has contracted with Prometric to conduct its examination program. Prometric provides computerized testing at test centers throughout the world. The IRS and Prometric are working together closely to ensure that examinations meet federal requirements as well as professional examination development standards.

Testing Dates

The 2023 SEE examination begins May 1, 2023 and examinations will be offered continuously through February 28, 2024.

The exam is in three parts. The three parts DO NOT have to be taken at once. You can take one part at a time. Once you have taken and passed one part, you have two years from the date of passing that part to take and pass the other two parts.

Testing Fees

The exam costs $206 per part.

Exam Questions

Each part of the exam has 100 questions. All questions are weighted equally.

Time Limited for the Exam

You are given 3.5 hours to complete each part of the exam. The actual seat time is 4 hours to allow for a tutorial at the beginning and a survey at the end.

Examination Results

The exam is graded on a scale of 40 - 130 with 40 being the lowest score and 130 being the highest score possible. You must have a score of 105 or better for each part of the exam to pass. You will receive your scores immediately after taking the exam.

Passing Score. If you pass, the score will only show a passing designation. It will not show a score.

Failing Score. If you fail, your score report will show a scaled score between 40 and 104. You will also receive diagnostic information to assist you with future examination preparation. Diagnostic information will show an indicator of 1, 2, or 3 meaning:

Considerably below the minimally acceptable score. It is important for you to approach how you study this topic as you prepare to take the test again. You may want to consider taking a course or participating actively in a study group on this topic.

Marginally below the minimally acceptable score. You should study this topic in detail as you prepare to take the test again.

At or above the minimally acceptable score. Be sure to review this topic as you prepare to take the test again.

Experimental Questions

The examination may include some experimental questions that will not be scored.

If present, they are distributed throughout the exam and will not be identified as such. These are used to gather statistical information on the questions before they are added to the exam as scored items. These experimental questions will not be counted for or against your final score.

Obtain a PTIN

You must have a PTIN to sign up for the Enrolled Agent Exam. Chances are you already have your PTIN, but if you do not, you can still get one. The IRS Tax Professional PTIN Sign-up System is available at www.irs.gov/ptin. Once online, you will need to:

Create Your Account. Provide your name, email address, and security question information. The system will then email your temporary password, which you will change when you go back to enter your information in the PTIN application.

Apply for Your PTIN. Complete the online application by providing personal information, information about your previous year’s tax return, professional credentials, and more.

Get Your PTIN. Your PTIN will be provided online.

It takes about 15 minutes to sign up online and receive your PTIN. If you opt to use the paper application, Form W-12 IRS Paid Preparer Tax Identification Number (PTIN) Application, it will take 4-6 weeks to process.

PTIN renewal. PTINs must be renewed annually by December 31 for the following year. Renewal Open Season usually begins each year in mid-October.

Registering and Scheduling an Examination Appointment

Registration Process

You can register and schedule the exam using one of the three following options:

A. Online—a one-step process

The quickest way to register and schedule an examination is online. This is the only way to register and schedule an exam in the same day.

To register and schedule an examination online, follow these steps:

Access www.prometric.com/see.

Click the Obtain a PTIN/Register for My Test button.

If it’s your first time, click Create Account button to set up your user ID and password.

Register and pay for the test. You will be asked to provide your PTIN number. Prometric will assign you a candidate number. It will be the same as your PTIN.

Schedule your test. Again, go to www.prometric.com/see. Click on the Schedule My Test button. You will be asked to provide the candidate number that Prometric assigned to you when you registered for your test in step 4. Schedule your test at your closest testing center at a convenient date and time.

B.  By phone

Call Prometric at 800.306.3926

C.  By mail

Mail your completed Form 2587 to:

Prometric

Attn: IRS Special Enrollment Examination

7941 Corporate Drive

Nottingham, MD 21236

Wait six to 10 calendar days for delivery and processing before scheduling an examination appointment.

Scheduling an Examination

Candidates can take each part of the examination at their convenience.

Consequently, parts do not have to be taken on the same day, or on consecutive days. All parts do not have to be taken or scheduled during an examination window.

Candidates can take examination parts up to four times each during the testing period (May 1, 2023 to February 28, 2024). Once your registration has been processed, you can schedule an examination appointment at any time online at www.prometric.com/irs or by calling 800-306-3926 between 8 a.m. and 9 p.m. (Eastern Time), Monday through Friday. You will be provided a number confirming your appointment. Record and keep this confirmation number for your records—you will need it to reschedule, cancel or change your appointment in any way.

Examination Locations

Examinations are administered by computer at a Prometric Testing Center.

Currently, the Special Enrollment Examination is given at nearly 300 Prometric testing centers located across the United States and internationally. Test centers are located in most major metropolitan areas. A complete list of these testing centers, addresses and driving directions is located at www.prometric.com/irs. In the box titled Do More, click on “Continue” and select your preferred test location. Most locations are open on Saturdays and some locations are open on Sundays and evenings.

Testing Fees

The testing fee is $206 for each part of the examination.

This fee is paid at the time you schedule your examination. Accepted forms of payment include: MasterCard, Visa, American Express, Discover, Diner's Club cards bearing the MasterCard symbol and JCB. Electronic checks are also accepted when scheduling by phone. Money orders, paper checks and cash are not accepted. Examination testing fees are not refundable or transferable.

Rescheduling Your Appointment

If you need to reschedule an examination for another date, time or location, you must contact Prometric. Rescheduling fees will apply as follows:

No fee if you reschedule at least 30 calendar days prior to your appointment.

$35 fee if you reschedule five to 29 calendar days before your appointment.

Another $206 full examination fee if you reschedule less than five calendar days before your appointment date.

Chapter One - Business Entities

Business Entities

Chapter One sets the stage for your studies by defining the different legal business entities. It describes the various EIN and reporting requirements as well as accounting periods and methods available to each business entity. The tax treatment of these eight business entities is the primary knowledge area assessed by Part 2 of the Enrolled Agent Exam.

In This Chapter

Employer Identification Number

Sole Proprietorship

Partnership

C Corporation

S Corporation

Limited Liability Company (LLC)

Estate

Trust

Exempt Organizations

Accounting Periods

Accounting Methods

Employer Identification Number

An employer Identification Number (EIN) is required for the following entities:

Reporting employment taxes and excise taxes.

A partnership.

A corporation.

Limited Liability Company (LLC).

A trust or an estate.

An employee plan.

An exempt organization.

How to Apply for an EIN

A taxpayer can apply for an EIN by telephone, fax, mail or online at

IRS.gov/Businesses.

Form SS-4

Use Form SS-4, Application for Employer Identification Number, to apply for an EIN.

Entity Default Rules

An eligible entity is classified for federal tax purposes under the default rules described below unless it files Form 8832, Entity Classification Election or Form 2553, Election by a Small Business Corporation (S corporation).

Domestic Default Rule

Unless an election is made on Form 8832, a domestic eligible entity is:

A partnership if it has two or more members.

Disregarded as an entity separate from its owner if it has a single owner.

A change in the number of members of an eligible entity classified as an association does not affect the entity’s classification. However, an eligible entity classified as a partnership will become a disregarded entity when the entity’s membership is reduced to one member and a disregarded entity will be classified as a partnership when the entity has more than one member.

Foreign Default Rule

Unless an election is made on Form 8832, a foreign eligible entity is:

A partnership if it has two or more members and at least one member does not have limited liability.

An association taxable as a corporation if all members have limited liability.

Disregarded as an entity separate from its owner if it has a single owner that does not have limited liability.

Association

For purposes of the above rules, an association is an eligible entity taxable as a corporation by election or, for foreign eligible entities, under the default rules.

Sole Proprietorship

Definition

A sole proprietorship is an unincorporated business that is owned by one individual. The business is not a separate entity apart from its owner. Its liabilities are personal liabilities and the owner undertakes the risk of the business for all assets owned, whether or not used in the business.

Reporting Requirements

Business profits or losses of a sole proprietorship are reported on Schedule C (Form 1040 or 1040-SR). A sole proprietor may also be required to file other returns (such as employment or excise tax returns).

Employer Identification Number (EIN)

A sole proprietorship does not need a separate EIN, unless required to file employment or excise tax returns.

New EIN Required

A sole proprietor will need a new EIN if any of the following are true:

Filing for bankruptcy under Chapter 7 (liquidation) or Chapter 11 (reorganization).

Incorporating.

A sole proprietor that takes in partners and operate as a partnership.

Establishing a pension, profit sharing, or retirement plan.

New EIN Not Required

A sole proprietor will not need a new EIN if any of the following are true:

Change the name of the business.

Change location or add locations.

Operating multiple businesses.

Partnership

Definition

A partnership is the relationship between two or more persons who join together to carry on a trade or business.

Each partner contributes money, property, labor or skill, and expects to share in the profits and losses of the business. An unincorporated organization with two or more members is generally classified as a partnership for federal tax purposes if its members carry on a trade, business, financial operation, or venture and divide its profits. Partners in a partnership are personally liable for its debts. A qualified joint venture conducted by a husband and wife who file a joint return is not rated as a partnership for federal tax purposes. A qualified joint venture, for purposes of this provision, includes only businesses that are owned and operated by spouses as co-owners, and not in the name of a state law entity (including a general or limited liability company). A partnership must file an annual information return to report the income, deductions, gains, losses, etc., from its operations, but it does not pay income tax. Instead, it “passes through” any profits or losses to its partners. Each partner includes his or her share of the partnership's items on his or her tax return.

Reporting Requirements

A partnership files Form 1065, U.S. Return of Partnership of Income, plus other returns that apply (such as employment or excise tax returns). The partnership is required to send a copy of Schedule K-1 (Form 1065) to each partner showing each partner’s share of the partnership’s income, gain, loss, deductions, and credits for the tax year.

Employer Identification Number (EIN)

A partnership is required to obtain an EIN.

New EIN Required

A partnership will need a new EIN if any of the following are true:

Incorporating.

One partner takes over and operates as a sole proprietorship.

The partnership is terminated and a new partnership is begun.

New EIN Not Required

A partnership will not need a new EIN if any of the following are true:

The partnership declares bankruptcy. However, if a liquidating trust is established for a partnership that is in bankruptcy, an EIN for that trust is required.

The partnership name changes.

Change location or add locations.

The partnership terminates under IRC Section 708(b)(1)(B). A partnership shall be considered terminated if within a 12-month period there is a sale or exchange of at least 50% of the total interest in partnership capital and profits to another partner. If the purchaser and remaining partners immediately contribute the properties to a new partnership, they can retain the old partnership EIN.

C Corporation

Definition

A corporation is defined as a legal entity or structure created under the authority of the laws of a state consisting of a person, or group of persons, who become shareholders.

The entity’s existence is considered separate and distinct from that of its members. Since a corporation is an entity in its own right, it is liable for its own debts and obligations. In forming a corporation, prospective shareholders transfer money, property, or both, for the corporation’s capital stock. A corporation generally takes the same deductions as a sole proprietorship to figure its taxable income. A corporation can also take special deductions. The profit of a corporation is taxed to the corporation when earned, and then is taxed to the shareholders when distributed as dividends (double taxation). However, shareholders cannot deduct any loss of the corporation.

Reporting Requirements

C Corporations usually file a Form 1120 series return, plus other returns that apply (such as employment or excise tax returns).

Employer Identification Number (EIN)

A corporation is required to obtain an EIN.

New EIN Required

A corporation will need a new EIN if any of the following are true:

The corporation is a subsidiary of a corporation and currently uses the parent’s corporate EIN.

The corporation becomes a subsidiary of a corporation.

The corporation becomes a partnership or a sole proprietorship.

The corporation creates a new corporation after a statutory merger.

The corporation receives a new corporate charter.

New EIN Not Required

A corporation will not need a new EIN if any of the following are true:

The corporation is a division of a corporation.

After a corporate merger, the surviving corporation uses its existing EIN.

A corporation declares bankruptcy. However, if a liquidating trust is established for a corporation that is in bankruptcy, an EIN for that trust is required.

Corporate name change or change in location or add locations.

The corporation elects to be taxed as an S Corporation by filing Form 2553.

The corporation is sold and the assets, liabilities and charters are obtained by the buyer.

After a corporate reorganization, the corporation only changes identity, form, or place of organization.

S Corporation

Definition

An eligible domestic corporation can avoid double taxation (once to the corporation and again to the shareholders) by electing to be treated as an S corporation.

S corporations are corporations that elect to pass corporate income, losses, deductions and credit through to their shareholders for federal tax purposes. Shareholders of S corporations report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates. This allows S corporations to avoid double taxation on the corporate income. Generally, an S corporation is exempt from federal income tax other than tax on certain capital gains and passive income.

Form 2553

In order to become an S corporation, the corporation must submit Form 2553 Election by a Small Business Corporation (PDF), and be signed by all the shareholders.

Reporting Requirements

S Corporations file a Form 1120S, U.S. Income Tax Return for an S Corporation, plus other returns that apply (such as employment or excise tax returns). The S corporation is required to send a copy of Schedule K-1 (Form 1120S) to each shareholder showing each shareholder’s share of the S corporation’s income, gain, loss, deductions, and credits for the tax year.

Employer Identification Number (EIN)

An S corporation is required to obtain an EIN.

Limited Liability Company (LLC)

Definition

A limited liability company (LLC) is an entity formed under state law by filing articles of organization as an LLC. Unlike a partnership, none of the members of an LLC are personally liable for its debts. An LLC may be classified for federal income tax purposes as a partnership, a corporation, or an entity disregarded as an entity separate from its owner by applying the rules in regulations section 301.7701-3. A domestic LLC with at least two members that does not file Form 8832 is classified as a partnership for federal income tax purposes.

Single Member LLC

A single member LLC generally has the following choices:

File Form 8832 to be taxed as a corporation.

If qualified, file Form 2553, Election by a Small Business Corporation (Under Section 1362 of the Internal Revenue Code), to be taxed as an S corporation.

Be taxed (by default) as a disregarded entity:

If the single member is an individual, the LLC will be taxed as a sole proprietorship.

If the single member is a business entity, the LLC will be taxed as a division of the corporation.

Note: While a single member entity, that does not elect corporate status, will default to a disregarded status for some federal tax purposes, it will not be disregarded for all federal tax purposes. For federal employment taxes (after 1/1/2009) and certain excise taxes (after 1/1/2008) it will be treated as a separate entity.

Multiple Members LLC

A multiple members LLC generally have the following choices:

File Form 8832 to be taxed as a corporation.

If qualified, file Form 2553 to be taxed as an S-Corporation.

Be taxed (by default) as a partnership.

Estate

Definition

An estate is a legal entity created as the result of a person’s death.

The decedent’s estate is a separate legal entity for federal tax purposes. An estate consists of real and/or personal property of the deceased person. The estate pays any debts owed by the decedent and then distributes the balance of the estate’s assets to the beneficiaries of the estate. The estate exists until the final distribution of the assets is made to the heirs and other beneficiaries.

Reporting Requirements

Estates file either Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return, and/or Form 1041, U.S. Income Tax Return for Estates and Trusts, plus other returns that apply (such as employment or excise tax returns).

Employer Identification Number (EIN)

An estate is required to obtain an EIN.

Trust

Definition

A trust is an arrangement through which trustees take title to property for the purpose of protecting or conserving it for the beneficiaries under the ordinary rules applied in chancery or probate courts. A trust is a legal entity created under state law and taxed under federal law. A trust may be created during an individual’s lifetime (inter vivos) or at the time of his or her death under a will (testamentary).

Revocable/Irrevocable Trust

An irrevocable trust is a trust, which, by its terms, cannot be modified, amended, or revoked.

For tax purposes, an irrevocable trust can be treated as a simple, complex, or grantor trust, depending on the powers listed in the trust instrument. A revocable trust may be revoked and is considered a grantor trust (IRC § 676). State law and the trust instrument establish whether a trust is revocable or irrevocable. If the trust instrument is silent on revocability, then most states consider the trust revocable.

Living Trust

A living person creates an inter vivos trust during that person’s lifetime. An inter vivos trust can be established as revocable or irrevocable. An inter vivos trust can be a simple, complex, or grantor trust depending on the trust instrument.

Testamentary Trust

A testamentary trust is created by a will, which begins its existence upon the death of the person making the will, when property is transferred from the decedent’s estate. Testamentary trusts are generally simple or complex trusts. A testamentary trust is irrevocable by definition, as it comes into being at the death of the grantor.

Grantor

The grantor (also known as trustor, settlor, or creator) is the creator of the trust relationship and is generally the owner of the assets initially contributed to the trust.

The grantor generally establishes, in the trust instrument, the terms and provisions of the trust relationship between the grantor, the trustee, and the beneficiary. The grantor may retain control over all or a portion of the trust, which may result in the grantor being subject to tax on the income from that portion of the trust.

Reporting Requirements

Form 1041, U.S. Income Tax Return for Estates and Trusts, plus other returns that apply (such as employment tax returns).

Employer Identification Number (EIN).

A trust is required to obtain an EIN.

New EIN Required

A trust will need a new EIN if any of the following are true:

A trust changes to an estate.

A living (inter vivos) trust changes to a testamentary trust.

The revocable trust changes to an irrevocable trust.

New EIN Not Required

A trust will not need a new EIN if any of the following are true:

The trustee changes.

The grantor or beneficiary changes his or her name or address.

Exempt Organizations

Definition

A tax exempt organization is a non-profit organization that is exempt from certain taxes because it is described under Section 501 of the Internal Revenue Code (IRC). Certain organizations are required to apply to the IRS for a determination letter that grants them formal tax exemption, while other organizations are treated as tax exempt as long as they are organized and operated under an applicable section of the Code.

IRC Section 501(c)(3) Organization

This is an organization that is organized and operated exclusively for one or more of the following purposes: charitable, religious, educational, scientific, literary, testing for public safety, fostering national or international amateur sports competition (but only if none of its activities involve providing athletic facilities or equipment),  or the prevention of cruelty to animals. To qualify, the organization must be a corporation, community chest, fund, unincorporated association, or foundation. A trust is a fund or foundation and will qualify. However, an individual or a partnership will not qualify.

Reporting Requirements

Exempt organizations usually file a Form 990 series return plus other returns that apply (such as employment or excise tax returns).

Employer Identification Number (EIN)

All non-profit organizations must apply for an EIN before filing for exempt status.

Accounting Periods

The following are acceptable tax years:

Calendar year.

Fiscal year (12 consecutive months ending on the last day of any month except December).

52-53 week tax year. The 52-53 week tax year must always end on:

Whatever date this same day of the week last occurs in a calendar month, or

Whatever date this same day of the week falls that is nearest to the last day of the calendar month.

Adopting a Tax Year

A taxpayer adopts a tax year when filing his or her first income tax return by the due date (NOT including extensions) for filing a return for that year.

Calendar Year

A taxpayer must adopt the calendar year if:

A taxpayer keeps no books or records;

A taxpayer has no annual accounting period;

A taxpayer’s present tax year does not qualify as a fiscal year; or

A taxpayer is required to use a calendar year by a provision in the Internal Revenue Code or the Income Tax Regulations

Short Tax Year

A short tax year is a tax year of less than 12 months. A short period tax return may be required when a taxable entity is not in existence for an entire tax year, or changed accounting period.

Death of Individual

When a taxpayer dies, a tax return must be filed for the decedent by the 15th day of the 4th month after the close of the taxpayer's regular tax year. The decedent's final return will be a short period tax return that begins on January 1st, and ends on the date of death.

Change in Accounting Period

A taxpayer must, with certain exceptions, get approval from the IRS to change tax years. To get approval, the taxpayer must file Form 1128, Application to Change a Tax Year, by the due date (not including extensions) of the tax return for the short period required to effect the change.

Individuals

Generally, individuals must adopt the calendar year as their tax year. An individual can adopt a fiscal year provided that the individual maintains his or her books and records on the basis of the adopted fiscal year.

Married Couple

A newly married couple can adopt the accounting period of the other spouse without first getting approval.

Partnerships, S Corporations, and Personal Service Corporations

Generally, partnerships, S corporations (including electing S corporations), and Personal Service Corporations (PSCs) must use a required tax year. A required tax year is a tax year that is required under the Internal Revenue Code and Income Tax Regulations. The entity does not have to use the required tax year if it receives IRS approval to use another permitted tax year or makes an election under section 444 of the Internal Revenue Code.

Types of Accounting Methods

There are 4 types of accounting methods:

Cash method.

Accrual method.

Special methods of accounting for certain item of income and expenses.

A hybrid method which combines elements of two or more of the above accounting methods.

Combination (hybrid) Method

A taxpayer can use any combination of cash, accrual, and special methods of accounting if the combination clearly shows income and it is used consistently. However, the following restrictions apply:

If an inventory is necessary to account for income, the accrual method must be used for purchases and sales. Generally, the cash method can be used for all other items of income and expenses.

If the cash method is used for reporting income, the cash method must also be used for reporting expenses.

If the accrual method is used for reporting expenses, the accrual method must also be used for reporting income.

Any combination that includes the cash method is treated as the cash method.

Two or More Businesses

A taxpayer can use a different accounting method for each separate and distinct business if the method used clearly shows income.

Cash Method

The cash method of accounting is used by most individuals and many small businesses with no inventories. The following entities cannot use the cash method:

A corporation (other than an S corporation or a qualified personal service corporation) with average annual gross receipts for the 3 preceding tax years exceeding $27 Million.

A partnership with a corporation (other than an S corporation and a qualified personal service corporation) as a partner and with the partnership having average annual gross receipts for the preceding 3 years exceeding $27 Million.

A tax shelter, as defined in section 448(d)(3).

Exceptions

The following entities are not prohibited from using the cash method of accounting.

Any corporation or partnership, other than a tax shelter, that meets the gross receipts test.

A qualified personal service corporation (PSC).

Gross receipts test. A corporation or a partnership meets the test if its average annual gross receipts for the 3 preceding tax years were $27 Million or less (indexed for inflation).

Determine an entity’s average annual gross receipts by:

Adding the gross receipts for that tax year and the 3 preceding tax years, and

Dividing the total by 3.

Qualified Personal Service Corporation (PSC)

A qualified PSC is a corporation that meets the following function and ownership tests can use the cash method.

Function test. A corporation meets the function test if at least 95% of its activities are in the performance of services in the fields of health, veterinary services, law, engineering (including surveying and mapping), architecture, accounting, actuarial science, performing arts, or consulting.

Ownership test. A corporation meets the ownership test if at least 95% of its stock is owned, directly or indirectly, at all times during the year by one or more of the following.

Employees performing services for the corporation in a field qualifying under the function test.

Retired employees who had performed services in those fields.

The estate of an employee described in (1) or (2).

Any other person who acquired the stock by reason of the death of an employee referred to in (1) or (2), but only for the 2-year period beginning on the date of death.

Special Rules for Farming Businesses

Generally, a taxpayer engaged in the trade or business of farming is allowed to use the cash method for its farming business. However, certain corporations (other than S corporations) and partnerships that have a partner that is a corporation must use an accrual method for their farming business, unless they meet the gross receipts test discussed above.

Change to accrual method

A corporation or partnership that fails to meet the gross receipts test for any tax year cannot use the cash method and must change to an accrual method of accounting, effective for the tax year in which the entity fails to meet this test. The entity must file Form 3115 to request the change.

Income

Include in gross income all items of income actually or constructively received or made available without restriction during the year. The taxpayer cannot delay receipt of income.

Expenses

Deduct expenses in the year they were actually paid.

Expenses Paid in Advance

Expenses paid in advance are deductible only in the year to which it applies, unless the expense qualifies for the 12-month rule. Under the 12-month rule, a taxpayer is not required to capitalize amounts paid to create certain benefits for the taxpayer that do not extend beyond the earlier of the following.

12 months after the right or benefit begins, or

The end of the tax year after the tax year in which payment is made.

Accrual Method

Under an accrual method of accounting, income is reported in the year earned and expenses are deducted or capitalized in the year incurred. The purpose of this method of accounting is to match income and expenses in the correct year.

Income

Report income on the earliest of the following dates:

When payment is received.

When the income is due.

When the income is earned.

When title has passed.

Advance Payment for Services

Postpone including the advance payments in income until they are earned. Do not postpone including the payments beyond the following tax year.

Expenses

Deduct or capitalize business expenses when they become a liability, whether or not paid in the same year.

Related Persons

Do not deduct business expenses and interest owed to a related cash basis person until the payments have been made and the related person includes the payments in their gross income. For the purpose of the related party rule, the following are related persons:

Member of a family including brother and sisters (either whole or half), spouses, ancestors, and lineal descendants.

Two entities (e.g., partnership, corporation, fiduciary) if the same individual has more than 50% interest in each entity.

The fiduciaries of two different trusts, and the fiduciary and beneficiary of two different trusts, if the same person is the grantor of both trusts.

A tax-exempt educational or charitable organization and a person (if an individual, including the members of the individual's family) who directly or indirectly controls such an organization.

The grantor and fiduciary, and the fiduciary and beneficiary, of any trust.

A PSC and any employee-owner, regardless of the amount of stock owned by the employee-owner.

Inventories

Items Included in Inventory

Merchandise or stock in trade. Merchandise includes the following:

Purchased merchandise if the title has passed to the taxpayer.

Goods under contract for sale that has not yet been segregated and applied to the contract.

Goods out on consignment.

Goods held for sale in display rooms, merchandise mart rooms, or booths located away from place of business.

Merchandise not included in inventory:

Goods sold, but only if title has passed to buyer.

Goods consigned to the taxpayer.

Goods ordered to future delivery if the taxpayer does not have title.

Raw materials.

Work in process.

Finished products.

Supplies that physically become a part of the item intended for sale.

C.O.D. mail sales (C.O.D. payment not received).

Containers.

Cost Identification

There are three methods of identifying items in inventory:

Specific identification method. This method is used to identify the cost of each inventoried item by matching the item with its cost of acquisition in addition to other allocable costs, such as labor and transportation.

First-in first-out (FIFO) method. This method assumes that the items of inventory purchased or produced first are sold first. The items in inventory at the end of the year are valued as the items most recently purchased or produced.

Last-in first-out (LIFO) method. This method assumes that the items in inventory purchased or produced last are sold first. The items included in closing inventory are considered to be those from the opening inventory plus those items acquired in the current year and not sold.

Valuing Inventory

The following are common ways to value inventory:

Cost method. The cost of acquisition in addition to costs allocable to the merchandise.

Lower of cost or market method. This method compares the market value of each item in inventory with its cost and uses the lower value as its inventory value.

Retail method. The total retail selling price of goods on hand at the end of the year in each department or of each class of goods is reduced to approximate cost by using an average markup expressed as a percentage of the total selling price.

Uniform Capitalization Rules

Under the uniform capitalization rule, direct costs and most indirect costs incurred in production and resale activities must be capitalized (added to basis). Recover these costs through depreciation, amortization, or cost of goods sold.

The following activities are subject to the uniform capitalization rules:

Production of real property or tangible personal property for use in a trade or business or an activity.

Production of real property or tangible personal property for sale to customers.

Acquired property for resale.

Producing Property

A taxpayer is producing property if he or she constructs, builds, installs, manufactures, develops, improves, creates, raises, or grows the property. Property produced for the taxpayer under a contract is treated as produced to the extent that the taxpayer makes payments or otherwise incur costs in connection with the property.

Tangible Personal Property

Tangible personal property includes films, sound recordings, video tapes, books, artwork, photographs, or similar property containing words, ideas, concepts, images, or sounds. However, free-lance authors, photographers, and artists are exempt from the uniform capitalization rules if they qualify.

Exceptions to the Uniform Capitalization Rules

A taxpayer is not subject to the uniform capitalization rules if the taxpayer’s average annual gross receipts are $27 Million or less for the 3 preceding tax years and is not a tax shelter. In addition, the following are not subject to the uniform capitalization rules.

Property produce that is not use in a trade, business, or activity conducted for profit.

Qualified creative expenses paid or incurred as a freelance (self-employed) writer, photographer, or artist that are otherwise deductible on the taxpayer’s tax return.

Property produce under a long-term contract, except for certain home construction contracts.

Research and experimental expenses deductible under section 174 of the IRC.

Before 2018, costs for personal property acquired for resale if the average annual gross receipts for the 3 previous tax years do not exceed $10 million.

Change in Accounting Method

Approval Required

The following changes in accounting methods require the consent of the IRS (use Form 3115, Application for Change in Accounting Methods).

Change from cash method to the accrual method or vice versa.

Change in the method or basis used to value inventory.

Change in the method of figuring depreciation or amortization method (except for certain permitted changes to the straight-line method).

Change involving the adoption, use, or discontinuance of any other specialized method of computing taxable income.

Change where the IRC and Treasury Regulations requires the IRS consent before adopting the change.

Approval Not Required

The following changes in accounting methods do not require the consent of the IRS:

A correction of mathematical or posting errors.

A correction of errors in computing tax liability (such as an error in computing credits).

An adjustment of any item of income or deduction that does not involve the proper time for including it in income or deducting it.

Certain adjustments in the useful life of a depreciable or amortizable asset.

Chapter Two - Partnerships

Partnerships

Generally, a partnership does not pay tax on its income but “passes through” any profits or losses to its partners. Partners must include partnership items on their tax returns. Chapter Two addresses the formation and termination of a partnership, the partnership's filing requirements, and how partnership income is "passed through" to the partners.

In This Chapter

Partnership Formation

Terminating a Partnership

Partnership Filing Requirements

Tax Year

Partnership Income or Loss

Partner's Income and Loss

Partnership Distributions

Transactions between Partner and Partnership

Basis of Partner's Interest

Disposition of Partner's Interest

Partnership Formation

Organizations Classified as Partnerships

An unincorporated organization with two or more members is generally classified as a partnership for federal tax purposes if its members carry on a trade, business, financial operation, or venture and divide its profits. However, a joint undertaking merely to share expenses is not a partnership. For example, co-ownership of property maintained and rented or leased is not a partnership unless the co-owners provide services to the tenants.

Organizations Formed after 1996

An Organization formed after 1996 is classified as a partnership for federal tax purposes if it has two or more members and it is none of the following:

An organization formed under a federal or state law that refers to it as a corporation, body corporate, or body politic.

An organization formed under a state law that refers to it as a joint-stock company or joint-stock association.

An insurance company.

Certain banks.

An organization wholly owned by a state, local, or foreign government.

An organization specifically required to be taxed as a corporation by the Internal Revenue Code (for example, certain publicly traded partnerships).

Certain foreign organizations identified in section 301.7701-2(b)(8) of the regulations.

A tax-exempt organization.

A real estate investment trust.

An organization classified as a trust under section 301.7701-4 of the regulations.

Any other organization that elects to be classified as a corporation by filing Form 8832.

Partnership Interests Held in Connection With Performance of Services

For tax years beginning after 2017, to get long-term capital gain treatment for certain gains attributable to "applicable partnership interests," the required asset holding period is greater than 3 years (not 1 year). Net long-term capital gain is the net of long-term capital gain over long-term capital loss.

Applicable Partnership Interest

An applicable partnership interest is any interest in a partnership that, directly or indirectly, is transferred to (or is held by) the taxpayer in connection with the performance of substantial services by the taxpayer, or any other related person, in any "applicable trade or business." The special recharacterization rule applies to:

Capital gains recognized by a partner from the sale or exchange of an applicable partnership interest under Internal Revenue Code sections 741(a) and 731(a); and

Capital gains recognized by a partnership, allocated to a partner with respect to an applicable partnership interest.

Applicable Trade or Business

An applicable trade or business means any activity conducted on a regular, continuous, and substantial basis (regardless of whether the activity is conducted through one or more entities) which consists in whole or in part of:

Raising or returning capital, and either:

Investing in or disposing of "specific assets" (or identifying specified assets for investing or disposition), or

Developing specified assets.

Specified Assets

Specified assets are:

Securities (as defined in Internal Revenue Code section 475(c)(2), under rules for mark-to-market accounting for securities dealers),

Commodities (as defined under rules for mark-to-market accounting for commodities dealers in Internal Revenue Code section 475(e)(2)),

Real estate held for rental or investment,

Options or derivative contracts with respect to such securities,

Cash or cash equivalents, or

An interest in a partnership to the extent of the partnership’s proportionate interest in the foregoing.

Security

A security for this purpose means any of the following.

Share of corporate stock.

Partnership interest or beneficial ownership interest in a widely held or publicly traded partnership or trust.

Note, bond, debenture, or other evidence of indebtedness.

Interest rate, currency, or equity notional principal contract.

Interest in, or derivative financial instrument in, any such security or any currency (regardless of whether Internal Revenue Code section 1256 applies to the contract).

Position that is not such a security and is a hedge with respect to such a security and is clearly identified.

Family Partnerships

A family partnership includes only spouses, ancestors (e.g. parent), and lineal descendants (e.g. child) or any trust for the primary benefit of those persons. Family members will be recognized as partners only if one of the following requirements is met:

If capital is a material income-producing factor, they acquired their capital interest in a bona fide transaction (even if by gift or purchase from another family member), and they actually own and control the partnership interest.

If capital is not a material income-producing factor, they joined together in good faith to conduct a business. They agreed that contributions of each entitle them to a share in the profits, and some capital or service has been (or is) provided by each partner.

Capital is Material

Capital is a material income-producing factor if a substantial part of the gross income of the business comes from the use of capital. Capital is ordinarily an income-producing factor if the operation of the business requires substantial inventories or investments in plants, machinery, or equipment.

Capital is Not Material

In general, capital is not a material income-producing factor if the income of the business consists principally of fees, commissions, or other compensation for personal services performed by members or employees of the partnership.

Capital Interest

A capital interest in a partnership is an interest in its assets that is distributable to the owner of the interest in either of the following situations.

The owner withdraws from the partnership.

The partnership liquidates.

The mere right to share in earnings and profits is not a capital interest in the partnership.

Gift of Capital Interest

If a family member (or any other person) receives a gift of a capital interest in a partnership in which capital is a material income-producing factor, the donee's distributive share of partnership income is subject to both of the following restrictions.

It must be figured by reducing the partnership income by reasonable compensation for services the donor renders to the partnership.

The donee's distributive share of partnership income attributable to donated capital must not be proportionately greater than the donor's distributive share attributable to the donor's capital.

Purchase

For purposes of determining a partner's distributive share, an interest purchased by one family member from another family member is considered a gift from the seller. The fair market value of the purchased interest is considered donated capital. For this purpose, members of a family include only spouses, ancestors, and lineal descendants (or a trust for the primary benefit of those persons).

Business Owned and Operated by Spouses

If spouses carry on a business together and share in the profits and losses, they may be partners whether or not they have a formal partnership agreement.

If so, they should report income and loss from the business on Form 1065. They should not report the income on a Schedule C (Form 1040 or 1040-SR) in the name of one spouse as a sole proprietor. However, the spouses can elect not to treat the joint venture as a partnership by making a Qualified Joint Venture Election.

Qualified Joint Venture Election

Spouses can make a qualified joint venture election if they meet all of the following:

The only members of the joint venture are the husband and wife.

The filing status of the husband and wife is married filing jointly.

Both spouses materially participate in the trade or business.

Both spouses elect this treatment.

Under this election, a qualified joint venture conducted by spouses who file a joint return is not treated as a partnership for federal tax purposes and therefore does not file Form 1065. All items of income, gain, deduction, loss, and credit are divided between the spouses based on their respective interests in the venture. Each spouse takes into account his or her respective share of these items as a sole proprietor. Each spouse would account for his or her respective share on the appropriate form, such as Schedule C (Form 1040 or 1040-SR).

Partnership Agreements

The agreement or any modification can be oral or written.

Partners can modify the agreement for a particular tax year after the close of the year but not later than the date for filing (excluding extensions) the partnership return for that year. The modifications must be agreed to by all the partners or adopted in any other manner provided by the partnership agreement. A partner’s share of income, gains, losses, deductions, or credits is usually determined by the partnership agreement. If the partnership agreement or any modification is silent on any matter, the provisions of local law are treated as part of the agreement.

Exclusion from Partnership Treatment

Certain partnerships that do not actively conduct a business can choose to be completely or partially excluded from being treated as partnerships for federal income tax purposes. All the partners must agree to make the choice, and the partners must be able to compute their own taxable income without computing the partnership's income.

Electing the Exclusion

An eligible organization that wishes to be excluded from the partnership rules must make the election not later than the time for filing (including extensions) the partnership return for the first tax year for which exclusion is desired.

Terminating a Partnership

A partnership terminates when one of the following events takes place:

All its operations are discontinued and no part of any business, financial operation, or venture is continued by any of its partners in a partnership.

At least 50% of the total interest in partnership capital and profits is sold or exchanged within a 12-month period, including a sale or exchange to another partner.

Date of Termination

The partnership's tax year ends on the date of termination. For the event described in (1), above, the date of termination is the date the partnership completes the winding up of its affairs.

For the event described in (2), above, the date of termination is the date of the sale or exchange of a partnership interest that, by itself or together with other sales or exchanges in the preceding 12 months, transfers an interest of 50% or more in both capital and profits.

Short Period Return

If a partnership is terminated before the end of what would otherwise be its tax year, Form 1065 must be filed for the short period, which is the period from the beginning of the tax year through the date of termination. The return is due the 15th day of the 3th month following the date of termination.

Conversion of Partnership into Limited Liability Company (LLC)

The conversion of a partnership into an LLC classified as a partnership for federal tax purposes does not terminate the partnership.

However, the conversion may change some of the partners' bases in their partnership interests if the partnership has recourse liabilities that become nonrecourse liabilities. Because the partners share recourse and nonrecourse liabilities differently, their bases must be adjusted to reflect the new sharing ratios. If a decrease in a partner's share of liabilities exceeds the partner's basis, he or she must recognize gain on the excess.

Partnership Filing Requirements

Partnership Return (Form 1065)

Every partnership that engages in a trade or business or has gross income must file an informational return on Form 1065.

A partnership is not considered to engage in a trade or business, and is not required to file a Form 1065, for any tax year in which it neither receives income nor has any expenses treated as deductions or credits for federal tax purposes. The partnership return must be signed by a general partner. If a limited liability company is treated as a partnership, it must file Form 1065 and one of its members must sign the return.

Electronic Filing

Certain partnerships with more than 100 partners are required to file Form 1065, Schedules K-1, and related forms and schedules electronically.

Due Date

Form 1065 must be filed by the 15th day of the 3rd month following the close of the partnership’s tax year. Partnerships with more than 100 partners must e-file the return.

Extension of Time to File

A partnership can request an automatic 6-month extension of time to file by filing Form 7004 by the regular due date of the partnership return.

Other Schedules for Form 1065

Schedule K

Schedule K is a summary schedule of all the partners' shares of the partnership's income, credits, deductions, etc. All partnerships must complete Schedule K. Rental activity income (loss) and portfolio income aren't reported on page 1 of Form 1065. These amounts aren't combined with trade or business activity income (loss). Schedule K is used to report the totals of these and other amounts.

Schedule K-1

Schedule K-1 shows each partner's separate share. Attach a copy of each Schedule K-1 to the Form 1065 filed with the IRS.

Schedules L, M-1, and M-2

Schedule L, Balance Sheets per Books, schedule M-1, Reconciliation of Income (Loss) per Books With Income (Loss) per Return and schedule M-2, Analysis of Partners’ Capital Accounts, are not required to be completed if the partnership satisfy all four of the following conditions.

The partnership’s total receipts for the tax year were less than $250,000.

The partnership’s total assets at the end of the tax year were less than $1 million.

Schedules K-1 are filed with the return and furnished to the partners on or before the due date (including extensions) for the partnership return.

The partnership is not filing and is not required to file Schedule M-3.

Schedule M-3

Schedule M-3, Net Income (Loss) Reconciliation for Corporations With Total Assets of $10 Million or More, must be filed if any of the following is true:

The amount of total assets at the end of the tax year is equal to $10 million or more.

The amount of adjusted total assets for the tax year is equal to $10 million or more.

The amount of total receipts for the tax year is equal to $35 million or more.

An entity that is a reportable entity partner with respect to the partnership owns or is deemed to own, directly or indirectly, an interest of 50% or more in the partnership's capital, profit, or loss, on any day during the tax year of the partnership.

Penalties

Failure to File Penalty

The failure to file penalty is $220 times the total number of partners in the partnership during any part of the year for each month (or part of a month) the return is late or incomplete, up to 12 months.

Failure to Furnish Information Timely

For each failure to furnish Schedule K-1 to a partner when due and each failure to include on Schedule K-1 all the information required to be shown (or the inclusion of incorrect information), a $290 penalty may be imposed with respect to each Schedule K-1 for which a failure occurs. The maximum penalty is $3,532,500 for all such failures during a calendar year. If the requirement to report correct information is intentionally disregarded, each $290 penalty is increased to $580 or, if greater, 10% of the aggregate amount of items required to be reported. There is no limit to the amount of the penalty.

Information Return Required of Partnership

If a partner exchanges a partnership interest attributed to unrealized receivables or inventory for money or property, he or she must notify the partnership in writing within 30 days.

When the partnership is notified of an exchange, the partnership must file Form 8308, Report of a Sale or Exchange of Certain Partnership Interests. Form 8308 is filed with Form 1065. If notified of an exchange after filing Form 1065, the partnership must file Form 8308 separately, within 30 days of the notification.  

Tax Year

A partnership determines its tax year as if it were a taxpayer. In general, a partnership must use its required tax year.

Required Tax Year

A partnership must adapt its tax year to its partners' tax year as follows:

Majority interest tax year. If one or more partners having the same tax year own more than a 50% (majority) interest, the partnership must use the tax year of those partners.

Principal partner. If there is no majority interest tax year, the partnership is required to use the tax year of its principal partners (5% or more interest).

Least aggregate deferral of income. If there is no majority interest tax year or the principal partners do not have the same tax year, the partnership must use a tax year that results in the least aggregate deferral of income to the partners.

Exceptions

There are three exceptions to the required tax year rule:

Business purpose tax year. If a partnership establishes an acceptable business purpose for having a tax year that is different from its required tax year.

The partnership can make a section 444 election.

A partnership can use a tax year other than its required tax year if it elects a 52-53-week tax year that ends with reference to either its required tax year or a tax year elected under section 444.

Least Aggregate Deferral of Income

Compare the deferral that all the partners would get if the partnership used the tax year of one of its partners. A computation must be made for each partner whose tax year is different from the other partners as follows:

Determine the number of months of deferral for each partner using one partner's tax year. The months of deferral are found by counting the months from the end of the partnership's tax year forward to the end of that partner’s tax year.

Multiply each other partner's deferral period found in step (1) by that partner's share of his or her interest in the partnership profits for the year.

Add the amounts figured in step (2) to get the aggregate (that is, the total amount of) deferral for that partner's tax year.

Repeat steps (1) through (3) for each partner's tax year that is different from the other partners' years.

Changing Tax Years

When a partnership changes its tax year, a short period return must be filed. The short period return covers the number of months between the end prior tax year and the beginning of the newly elected tax year.

Section 444 Election

Under section 444 of the IRC, certain partnerships can elect to use a tax year different from their required tax year. To be eligible to make the election, a partnership must meet all of the following conditions:

It is not a member of a tiered structure (e.g., the partnership owns or is owned by another partnership).

It has not previously had a section 444 election in effect.

It does not choose a tax year where the deferral period is longer than:

Three months, or

The deferral period of the tax year being changed, if this period is shorter.

Note: A partnership should not make a section 444 election when it wants to establish a business purpose for having a tax year different from its required year. If a section 444 election is made, a partnership must file the required returns including Form 8716, Election To Have a Tax Year Other Than a Required Tax Year and must make certain required payments by the earlier of:

The 15th day of the 5th month following the month that includes the 1st day of the tax year the election will be effective, or

The due date (without extensions) of the return resulting from the election.

Partnership Income or Loss

A partnership computes its income and files its return in the same manner as an individual. However, certain deductions are not allowed to the partnership.

Elections Made by the Partnership

The partnership, not the partners, makes most choices about how to compute income. These include choices for the following:

Accounting methods.

Depreciation methods and section 179 elections.

Accounting for specific items, such as depletion or installment sales.

Nonrecognition of gain on involuntary conversions of property.

Amortization of certain organization fees and business start-up costs of the partnership.

Elections Made by the Partners

Elections under the following sections are made by each partner separately on the partner’s tax return:

Section 59(e) (election to deduct ratably certain qualified expenditures such as intangible drilling costs, mining exploration expenses, or research and experimental expenditures).

Section 108 (income from discharge of indebtedness).

Section 617 (deduction or recapture of certain mining exploration expenditures paid or incurred).

Section 901 (foreign tax credit).

Organizational and Start-Up Costs

A partnership can elect to deduct up to $5,000 of business start-up costs and another $5,000 in organizational expenses in the year the business is started. The $5,000 deduction is reduced by the amount the total costs exceed $50,000. If the total costs exceed $55,000 or more, the deduction is reduced to zero. Any costs not deducted must be amortized over 180 months (15 years) beginning with the month the partnership begins business.

Start-Up Costs

Start-up costs include amounts paid for the following:

An analysis or survey of potential markets, products, labor supply, transportation facilities, etc.

Advertisements for the opening of the business.

Salaries and wages for employees who are being trained and their instructors.

Travel and other necessary costs for securing prospective distributors, suppliers, or customers.

Salaries and fees for executives and consultants, or for similar professional services.

Organizational Costs

The costs to organize a partnership are the direct costs of creating the partnership. Organizational costs include the following fees:

Legal fees for services incident to the organization of the partnership, such as negotiation and preparation of the partnership agreement.

Accounting fees for services incident to the organization of the partnership.

Filing fees.

Nonqualifying Costs

The following costs cannot be amortized:

The cost of acquiring assets for the partnership or transferring assets to the partnership.

The cost of admitting or removing partners, other than at the time the partnership is first organized.

The cost of making a contract concerning the operation of the partnership trade or business including a contract between a partner and the partnership.

The costs for issuing and marketing interests in the partnership such as brokerage, registration, and legal fees and printing costs. These “syndication fees” are capital expenses that cannot be depreciated or amortized.

Separately Stated Items

Certain items must be separately stated on the partnership return (listed on Schedule K of Form 1065) and deducted on the partner’s individual return.

Schedule K is a summary schedule of all partners’ share of the partnership’s income, credits, deductions, etc. Partner items are furnished to the partner on Schedule K-1 (Form 1065). A partnership is required to furnish copies of Schedule K-1 to each partner. The partnership is subject to a $290 penalty for each failure to furnish a Schedule K-1 to a partner. The maximum penalty is $3,532,500 for the calendar year. If the reporting requirement is intentionally disregarded, each $290 penalty is increased to $580 or, if greater, 10% of the aggregate amount of items required to be reported. There is no limit to the amount of the penalty. These items are the following:

Ordinary income or loss from trade or business activities.

Net income or loss from rental real estate activities.

Net income or loss from other rental activities.

Guaranteed payments.

Interest income.

Ordinary dividends.

Qualified dividends.

Royalties.

Net short-term capital gain (loss).

Net long-term capital gain (loss).

Collectibles (28%) gain (loss).

Unrecaptured section 1250 gain.

Net section 1231 gain (loss).

Other income (loss).

Section 179 deduction.

Other deductions including charitable contribution, portfolio deductions, investment interest expense, pensions and IRAs.

Self-employment earnings.

Credits.

Foreign transactions including taxes paid or accrued to foreign countries and U.S. possessions.

Alternative minimum tax items.

Tax-exempt income and nondeductible expenses.

Distributions.

Other information on items of income, gain, loss, deduction, or credit, as provided by regulations.

Foreign taxes paid or accrued.

Partner’s Income and Loss

A partner’s income or loss from a partnership is his or her distributive share of partnership items for the partnership’s tax year that ends with or within the partner’s tax year. A partner must report his or her distributive share of partnership items (e.g., income, gain, loss, deduction, or credit) on his or her tax return, whether or not it is actually distributed.

Limits on Losses

A partner's distributive share of partnership loss is allowed only to the extent of the adjusted basis of the partner’s partnership interest.

The adjusted basis is figured at the end of the partnership’s tax year in which the loss occurred, before taking the loss into account. Any loss that is more than the adjusted basis is not deductible for that year and must be carried over to a year in which the partner's adjusted basis is more than zero.

At-Risk Limits

The at-risk rules limit a partner’s deductible loss to the amounts for which the partner is considered at risk in the activity. A partner is considered at risk for all of the following amounts:

The money and adjusted basis of any property contributed to the activity.

The partner’s share of net income retained by the partnership.

Certain amounts borrowed by the partnership for use in the activity if the partner is personally liable for repayment or the amounts borrowed are secured by the partner’s property (other than property used in the activity).

Self-Employment Tax

General Partner

Include distributive share of partnership income, include guaranteed payments in figuring self-employment tax. General partners' net earnings (loss) from self-employment do not include the following.

Dividends on any shares of stock and interest on any bonds, debentures, notes, etc., unless the dividends or interest are received in the course of a trade or business, such as a dealer in stocks or securities or interest on notes or accounts receivable.

Rentals from real estate, except rentals of real estate held for sale to customers in the course of a trade or business as a real estate dealer or payments for rooms or space when significant services are provided.

Royalty income, except royalty income received in the course of a trade or business.

Limited Partner

Exclude distributive share of partnership income, include guaranteed payments in figuring self-employment tax.

Inactive Partner

Include distributive share of partnership income and guaranteed payments in figuring self-employment tax.

Deceased Partner

Include distributive share of partnership income through the end of the month in which death occurs in figuring self-employment tax.

Spouses as Partners

Both spouses include business income in figuring self-employment tax and must file separate Schedules SE (Form 1040 or 1040-SR) to report self-employment tax.

Retired Partner

Include distributive share of partnership income and guaranteed payments in figuring self-employment tax.

Partnership Distributions

Actual Distribution

Distributions are usually not taxable since a partner must include in income any share of partnership income, whether it is distributed or not.

Certain Distributions Treated as a Sale or Exchange

When a partnership distributes the following items, the distribution may be treated as a sale or exchange of property rather than a distribution:

Unrealized receivables or substantially appreciated inventory items distributed in exchange for any part of the partner's interest in other partnership property, including money.

Other property (including money) distributed in exchange for any part of a partner's interest in unrealized receivables or substantially appreciated inventory items.

Exception. This treatment does not apply to the following distributions:

A distribution of property to the partner who contributed the property to the partnership.

Payments made to a retiring partner or successor in interest of a deceased partner that are the partner's distributive share of partnership income or guaranteed payments.

Substantially Appreciated Inventory Items

Inventory items of the partnership are considered to have appreciated substantially in value if, at the time of the distribution, their total fair market value is more than 120% of the partnership's adjusted basis for the property. However, if a principal purpose for acquiring inventory property is to avoid ordinary income treatment by reducing the appreciation to less than 120%, that property is excluded.

Partner's Gain or Loss

A partner generally recognizes gain on a partnership distribution only to the extent any money (and marketable securities treated as money) included in the distribution exceeds the adjusted basis of the partner's interest in the partnership.

Any gain recognized is generally treated as capital gain from the sale of the partnership interest on the date of the distribution. If partnership property (other than marketable securities treated as money) is distributed to a partner, he or she generally does not recognize any gain until the sale or other disposition of the property.

Marketable Securities Treated as Money

A market security distributed to a partner is treated as money in determining whether gain is recognized on the distribution. However, this treatment does not apply if that partner contributed the security to the partnership or an investment partnership made the distribution to an eligible partner.

Loss on Distribution

A partner does not recognize loss on a partnership distribution unless all of the following requirements are met:

The adjusted basis of the partner’s interest in the partnership exceeds the distribution.

The partner’s entire interest in the partnership is liquidated.

The distribution is in money, unrealized receivables, or inventory items.

Distribution of Partner's Debt

If a partnership acquires a partner's debt and extinguishes the debt by distributing it to the partner, the partner will recognize capital gain or loss to the extent the fair market value of the debt differs from the basis of the debt.

The partner is treated as having satisfied the debt for its fair market value. If the issue price (adjusted for any premium or discount) of the debt exceeds its fair market value when distributed, the partner may have to include the excess amount in income as canceled debt.

Cancelation of Debt (COD)

The cancelation of partnership debt is considered income unless certain exclusions apply. The partner recognizes his or her pro rata share of COD income. The partner's basis in the partnership is increased by the partner's share of COD income.

Excluded Debt

Exclude COD income from gross income in the following situations:

The debt is canceled in a bankruptcy case under title 11 of the U.S. Code.

The debt is canceled when the taxpayer is insolvent. However, a taxpayer cannot exclude any amount of canceled debt that is more than the amount by which taxpayer is insolvent.

The debt is qualified farm debt and is canceled by a qualified person.

The debt is qualified real property business debt.

Note: The rules for excluding COD from gross income are applied at the partner's level and not at the partnership level.

Partner's Basis for Distributed Property

Unless there is a complete liquidation of a partner's interest, the basis of property distributed to a partner by a partnership is its adjusted basis to the partnership immediately before the distribution. However, the basis of the property to the partner cannot be more than the partner's adjusted basis in the partnership reduced by any money received in the same transaction.

Complete Liquidation of Partner's Interest

The basis of property received in complete liquidation of a partner's interest is the adjusted basis of the partner's interest in the partnership reduced by any money distributed to the partner in the same transaction.

Holding Period for Distributed Property

A partner's holding period for property distributed to the partner includes the period the property was held by the partnership. If the property was contributed to the partnership by a partner, then the period it was held by that partner is also included.

Basis Divided Among Properties

If the basis of property received is the adjusted basis of the partner's interest in the partnership (reduced by money received in the same transaction), it must be divided among the properties distributed to the partner. For property distributed after August 5, 1997, allocate the basis using the following rules:

Allocate the basis first to unrealized receivables and inventory items included in the distribution by assigning a basis to each item equal to the partnership's adjusted basis in the item immediately before the distribution. If the total of these assigned bases exceeds the allocable basis, decrease the assigned bases by the amount of the excess.

Allocate any remaining basis to properties other than unrealized receivables and inventory items by assigning a basis to each property equal to the partnership's adjusted basis in the property immediately before the distribution. If the allocable basis exceeds the total of these assigned bases, increase the assigned bases by the amount of the excess. If the total of these assigned bases exceeds the allocable basis, decrease the assigned bases by the amount of the excess.

Allocating a Basis Increase

Allocate any basis increase required in rule (2), above, first to properties with unrealized appreciation to the extent of the unrealized appreciation. If the basis increase is less than the total unrealized appreciation, allocate it among those properties in proportion to their respective amounts of unrealized appreciation. Allocate any remaining basis increase among all the properties in proportion to their respective fair market values.

Allocating a Basis Decrease

Use the following rules to allocate any basis decrease required in rule (1) or rule (2) above:

Allocate the basis decrease first to items with unrealized depreciation to the extent of the unrealized depreciation. If the basis decrease is less than the total unrealized depreciation, allocate it among those items in proportion to their respective amounts of unrealized depreciation.

Allocate any remaining basis decrease among all the items in proportion to their respective assigned basis amounts (as decreased in (1)).

Distributions Before August 6, 1997

For property distributed before August 6, 1997, allocate the basis using the following rules:

Allocate the basis first to unrealized receivables and inventory items included in the distribution to the extent of the partnership's adjusted basis in those items. If the partnership's adjusted basis in those items exceeded the allocable basis, allocate the basis among the items in proportion to their adjusted bases to the partnership.

Allocate any remaining basis to other distributed properties in proportion to their adjusted bases to the partnership.

Partner's Basis More Than Partnership Basis

If the basis of a partner's interest to be divided in a complete liquidation of the partner's interest is more than the partnership's adjusted basis for the unrealized receivables and inventory items distributed, and if no other property is distributed to which the partner can apply the remaining basis, the partner has a capital loss to the extent of the remaining basis of the partnership interest.

Special Adjustment to Basis

A partner who acquired any part of his or her partnership interest in a sale or exchange or upon the death of another partner may be able to choose a special basis adjustment for property distributed by the partnership.

To choose the special adjustment, the partner must have received the distribution within 2 years after acquiring the partnership interest. Also, the partnership must not have chosen the optional adjustment to basis when the partner acquired the partnership interest.

Transactions between Partner and Partnership

Guaranteed Payments

Payments to a partner for services, or for use of capital, to the extent they are figured without regard to the income of the partnership are treated the same way as payments made to a person who is not a partner. This treatment is for purposes of determining gross income and deductible business expenses.

Minimum Payment

If a partner is to receive a minimum payment from the partnership, the guaranteed payment is the amount by which the minimum payment is more than the partner’s distributive share of the partnership income before taking into account the guaranteed payment.

Partner's Treatment of Guaranteed Payments

The partner includes the guaranteed payments in income in the partner's tax year in which the partnership's tax year ends.

Partnership Treatment of Guaranteed Payments

Guaranteed payments are generally deducted by the partnership as a business expense.

Exception: Guaranteed payments made to a partner for organizing the partnership or syndicating interests in the partnership must be capitalized.

Payments Resulting in Loss

If a partnership agreement provides for guaranteed payments to a partner and the payments result in a partnership loss in which the partner shares, the partner must:

Report the full amount of the guaranteed payments as ordinary income, and

Separately take into account the appropriate distributive share of the partnership loss.

Self-Employed Health Insurance Premiums

Premiums for health insurance paid by a partnership on behalf of a partner for services rendered as a partner are treated as guaranteed payments.

The partnership can deduct the payments as a business expense, and the partner must include them in gross income. However, if the partnership accounts for insurance paid for a partner as a reduction in distributions to the partner, the partnership cannot deduct the premiums. A partner who qualifies can deduct 100% of the health insurance premiums paid by the partnership on his or her behalf as an adjustment to income.

Sale and Exchange of Property to Related Parties

Gains

Gains are treated as ordinary income in a sale or exchange of property directly or indirectly between a partner and a partnership or between two partnerships if both of the following apply:

More than 50% of interest in the partnership(s) is directly or indirectly owned by the same partner(s), and

The property transferred is not a capital asset such as accounts receivables, inventory, stock-in-trade, and real property used in a business.

Losses

Losses are not allowed from a sale or exchange of property (other than an interest in the partnership) between a partnership and a person who directly or indirectly owns more than 50% interest of the capital or profit in the partnership. If the purchaser later sells the property, any gain realized will be taxable only to the extent it is more than the loss that was not allowed.

More than 50% Ownership

To determine if there is more than a 50% ownership in partnership capital or profits, the following rules apply:

An interest directly or indirectly owned by a corporation, partnership, estate, or trust is considered to be owned proportionately by its shareholders, partners, or beneficiaries.

An individual is considered to own the interest directly or indirectly owned by a family member. Family member includes only brothers, sisters, half-brothers, half-sisters, spouses, ancestors, and lineal descendants.

If a person is considered to own an interest using rule (1), that person (the “constructive owner”) is treated as if actually owning that interest when rules (1) and (2) are applied. However, if a person is considered to own an interest using rule (2), that person is not treated as actually owning that interest in reapplying rule (2) to make another person the constructive owner.

Contribution of Property

Neither the partners nor the partnership recognizes a gain or loss when property is contributed to the partnership in exchange for a partnership interest. If a partner contributes property to a partnership, the partnership basis in the property is the same as a partner adjusted basis of the property increased by any gain recognized by the partner.

Exception

A gain or loss is recognized if a partner contributes property to a partnership and:

Before or after the contribution, other property is distributed to the contributing partner, or

After the contribution, the contributed property is distributed to another partner within 7 years. Note: A gain is recognized by the partner if the property contributed to a partnership is subject to liabilities in excess of the partner’s basis in the property.

Disguised Sales

A contribution of money or other property to the partnership followed by a distribution of different property from the partnership to the partner is not treated as a contribution, but as a sale of property, if both of the following tests are met:

The distribution would not have been made but for the contribution.

The partner’s right to the distribution does not depend on the success of partnership operations.

All facts and circumstances are considered in determining if the contribution and distribution are more properly characterized as a sale. However, if the contribution and distribution occur within 2 years of each other, the transfers are presumed to be a sale unless the facts clearly indicate that the transfers are not a sale.

Form 8275 Required

A partner must attach Form 8275, Disclosure Statement, (or other statement) to his or her return if the partner contributes property to a partnership and, within 2 years (before or after the contribution), the partnership transfers money or other consideration to the partner.

A partnership must attach Form 8275 (or other statement) to its return if it distributes property to a partner, and, within 2 years (before or after the distribution), the partner transfers money or other consideration to the partnership.

Partnership's Gain or Loss on Contributed Property

The following rules determine the character of the partnership's gain or loss on a disposition of certain types of contributed property:

Unrealized receivables. If the property was an unrealized receivable in the hands of the contributing partner, any gain or loss on its disposition by the partnership is ordinary income or loss.

Inventory items. If the property was an inventory item in the hands of the contributing partner, any gain or loss on its disposition by the partnership within 5 years after the contribution is ordinary income or loss.

Capital assets. If the property was a capital asset in the contributing partner's hands, any loss on its disposition by the partnership within 5 years after the contribution is a capital loss. The capital loss is limited to the amount by which the partner’s adjusted basis for the property exceeded the property’s fair market value immediately before the contribution.

Contribution of Services

If a partner acquires an interest in partnership capital as compensation for services performed, the FMV of the interest must be included in the partner's gross income.

Basis of Partner’s Interest

Original Basis

The money a partner contributed plus the adjusted basis of property he or she contributed.

Adjustments to Basis

The partner’s original basis of an interest is

Increased by:

The partner's additional contributions to the partnership, including an increased share of, or assumption of, partnership liabilities.

The partner’s distributive share of both taxable and nontaxable partnership income.

The partner’s distributive share of the excess of the deductions for depletion over the basis of the depletable property, unless the property is oil or gas wells whose basis has been allocated to partners.

Decreased by:

The money (including a decreased share of partnership liabilities or an assumption of the partner's individual liabilities by the partnership) and adjusted basis of property distributed to the partner by the partnership.

The partner’s distributive share of the partnership losses (including capital losses).

The partner’s distributive share of nondeductible partnership expenses that are not capital expenditures. This includes the partner's share of any section 179 expenses, even if the partner cannot deduct the entire amount on his or her individual income tax return.

The amount of any deduction for depletion for oil and gas wells, up to the proportionate share of the adjusted basis of the wells allocated to the partner.

Partner's Liabilities Assumed by Partnership

If contributed property is subject to a debt or if a partner's liabilities are assumed by the partnership, the basis of that partner's interest is reduced (but not below zero) by the liability assumed by the other partners.

This partner must reduce his or her basis because the assumption of the liability is treated as a distribution of money to that partner. The other partners' assumption of the liability is treated as a contribution by them of money to the partnership.

Effect of Partnership Liabilities

A partner’s basis in a partnership interest includes the partner’s share of a partnership liability only if, and to the extent that, the liability:

Creates or increases the partnership’s basis in any of its assets,

Gives rise to a current deduction to the partnership, or

Is a nondeductible, noncapital expense of the partnership.

Property Subject to a Liability

If property contributed to a partnership by a partner or distributed by the partnership to a partner is subject to a liability, the transferee is treated as having assumed the liability to the extent it does not exceed the fair market value of the property.

Partner's Share of Recourse Liabilities

A partnership liability is a recourse liability to the extent that any partner has an economic risk of loss for that liability.

A partner's share of a recourse liability equals his or her economic risk of loss for that liability. A partner has an economic risk of loss if that partner would be obligated (whether by agreement or law) to make a net payment to the creditor or a contribution to the partnership with respect to the liability if the partnership were constructively liquidated. A partner who is the creditor for a liability that would otherwise be a nonrecourse liability of the partnership has an economic risk of loss in that liability.

Partner's Share of Nonrecourse liabilities

A partnership liability is a nonrecourse liability if no partner or related person has an economic risk of loss for that liability.

A partner's share of nonrecourse liabilities is generally proportionate to his or her share of partnership profits. However, this rule may not apply if the partnership has taken deductions attributable to nonrecourse liabilities or the partnership holds property that was contributed by a partner.

Economic Risk of Loss

A partner has an economic risk of loss if the partner would be obligated to make a payment to the creditor or a contribution to the partnership with respect to the liability if the partnership was liquidated.

Limited Partner

A limited partner generally has no obligation to contribute additional capital to the partnership and therefore does not have an economic risk of loss in partnership recourse liabilities. Thus, absent some other factor, such as the guarantee of a partnership liability by the limited partner or the limited partner making a loan to the partnership, a limited partner generally does not have a share of partnership recourse liabilities.

Disposition of Partner’s Interest

Abandoned or Worthless Partnership Interest

A loss incurred from the abandonment or worthlessness of a partnership interest is an ordinary loss only if both of the following tests are met:

The transaction is not a sale or exchange.

The partner has not received an actual or deemed distribution from the partnership.

If the partner receives even a de minimis actual or deemed distribution, the entire loss generally is a capital loss.

Sale, Exchange, or Other Transfer

Gain on Disposition

Upon the receipt of the distribution, the partner will recognize a gain on the distribution to the extent that money distributed is more than the partner’s adjusted basis. The gain is a capital gain.

Relief of Liabilities

If a partner is relieved of any partnership liabilities, that partner must include the amount of the liability relieved as part of the amount realized for his or her interest.

Loss on Disposition

The partner will recognize a loss only if the distribution is in money, unrealized receivables, and inventory items. No loss is recognized if any other property is received.

Installment Sale of Partnership Interest

A partner who sells a partnership interest at a gain may be able to report the sale on the installment method.

However, the gain allocated to unrealized receivables or inventory items is ordinary income and must be reported in the year of the sale. The gain allocated to the other assets is capital gain and can be reported under the installment method.

Payments for Unrealized Receivables and Inventory Items

If a partner receives money or property in exchange for any part of a partnership interest, the amount due to his or her share of the partnership's unrealized receivables or inventory items results in ordinary income or loss. This amount is treated as if it were received for the sale or exchange of property that is not a capital asset.

Unrealized Receivables

Unrealized receivables include any rights to payment not already included in income for the following items:

Goods delivered or to be delivered to the extent the payment would be treated as received for property other than a capital asset.

Services rendered or to be rendered.

Inventory Items

Inventory items are not limited to stock-in-trade of the partnership. They also include the following property:

Property that would properly be included in the partnership’s inventory if on hand at the end of the tax year or that is held primarily for sale to customers in the normal course of business.

Property that, if sold or exchanged by the partnership, would not be a capital asset or section 1231 property (real or depreciable business property held for more than one year). For example, accounts receivable acquired for services or from the sale of inventory and unrealized receivables are inventory items.

Property held by the partnership that would be considered inventory if held by the partner selling the partnership interest or receiving the distribution.

Notification Required of Partner

If a partner exchanges a partnership interest attributable to unrealized receivables or inventory for money or property, he or she must notify the partnership in writing.

This must be done within 30 days of the transaction or, if earlier, by January 15 of the calendar year following the calendar year of the exchange. A partner may be subject to a $50 penalty for each failure to notify the partnership about such a transaction, unless the failure was due to reasonable cause and not willful neglect.

Information Return Required of Partnership

When a partnership is notified of an exchange of partnership interests involving unrealized receivables or inventory items, the partnership must file Form 8308. Form 8308 is filed with Form 1065 for the tax year that includes the last day of the calendar year in which the exchange took place.

If notified of an exchange after filing Form 1065, the partnership must file Form 8308 separately, within 30 days of the notification. The partnership must provide a copy of Form 8308 (or a written statement with the same information) to each transferee and transferor by the later of January 31 following the end of the calendar year or 30 days after it receives notice of the exchange. The partnership may be subject to a penalty of up to $260 for each failure to timely file Form 8308 and a $260 penalty for each failure to furnish a copy of Form 8308 to a transferor or transferee, unless the failure is due to reasonable cause and not willful neglect.

Partner's Disposition of Distributed Unrealized Receivables or Inventory Items

In general, any gain or loss on a sale or exchange of unrealized receivables or inventory items a partner received in a distribution is an ordinary gain or loss. For this purpose, inventory items do not include real or depreciable business property, even if they are not held more than 1 year.

Exception for Inventory Items Held for More than 5 Years

If a partner sells inventory items that he or she held for more than 5 years and the items were capital assets in the partner's hands at the time of sale, it is considered a capital gain or loss.

Note: The 5-year rule does not apply to accounts receivable.

Closing of Partnership Year

The partnership's tax year is not closed because of the sale, exchange, or liquidation of a partner's interest, the death of a partner, or the entry of a new partner. However, if a partner sells, exchanges, or liquidates his or her entire interest, the partnership's tax year is considered closed for that partner.

Liquidation at Partner's Retirement or Death

Deceased Partner

For partnership tax years beginning after 1997, the death of a partner closes the partnership’s tax year for that partner. The deceased partner’s share of partnership’s items must be included in the partner’s final tax return (Form 1040 or 1040-SR).

Payments in Liquidation of Interest in Partnership Property

Payments made in liquidation of the interest of a retiring or deceased partner in exchange for his or her interest in partnership property are considered a distribution, not a distributive share or guaranteed payment that could give rise to a deduction for the partnership.

Payments Not in Liquidation of Interest in Partnership Property.

Payments made by the partnership to a retiring partner or successor in interest of a deceased partner that are not made in exchange for an interest in partnership property are treated as distributive shares of partnership income or guaranteed payments.

Bipartisan Budget Act of 2015 (BBA)

The BBA created a new centralized partnership audit regime effective for partnership tax years beginning after 2017. The new audit regime applies to all partnerships unless the partnership is an eligible partnership and elects out by making a valid election.

Role of Partnership Representative

Under the centralized partnership audit regime, partnerships are required to designate a partnership representative.

The partnership representative will have the sole authority to act on behalf of the partnership under the centralized partnership audit regime. The designated partnership representative is a partner or other person with substantial presence in the U.S. If the designated partnership representative is an entity, the partnership must also appoint a designated individual to act on behalf of the entity partnership representative. The partnership must include information regarding the partnership representative and designated individual (if applicable) on Form 1065, Schedule B.

Electing Out of the Centralized Partnership Audit Regime

A partnership can elect out of the centralized partnership audit regime for a tax year if the partnership has 100 or fewer eligible partners.

The number of partners is calculated using the number of Schedules K-1 required to be issued by the partnership. A partner is an eligible partner if it is an individual, C corporation, foreign entity that would be treated as a C corporation if it was domestic, S corporation, or an estate of a deceased partner.The determination as to whether the partnership has 100 or fewer partners is made by adding the number of Schedules K-1 required to be issued by the partnership to the number of Schedules K-1 required to be issued by any partner that is an S corporation to its shareholders for the tax year of the S corporation ending with or within the partnership tax year. A partnership is not an eligible partnership if it is required to issue a Schedule K-1 to any of the following partners.

A partnership.

A trust.

A foreign entity that would not be treated as a C corporation were it a domestic entity.

A disregarded entity described in Regulations section 301.7701-2(c)(2)(i).

An estate of an individual other than a deceased partner.

Any person that holds an interest in the partnership on behalf of another person.

Chapter Three - C Corporations

C Corporations

Generally, a C corporation is subject to federal tax laws and takes the same deductions as a sole proprietorship to figure its taxable income. The corporation's profit is taxed when earned, and then is taxed to the shareholders when distributed as dividends, unless the corporation elects to be an S Corporation. Chapter Three discusses the tax laws that apply to ordinary domestic C corporations and is focused primarily on the knowledge you will need to pass Part 2 of the Enrolled Agent Exam.

In This Chapter

Businesses Taxed as Corporations

Property Exchanged for Stock

Return Filing and Tax Payment Requirements

Accounting Periods and Methods

Income, Deductions, and Special Provisions

Figuring Tax

Accumulated Earnings Tax

Distributions to Shareholders

Stock Redemption

Liquidations

Businesses Taxed as Corporations

Businesses Formed Before 1997

A business formed before 1997 and taxed as a corporation under the old rules will generally continue to be taxed as a corporation.

Businesses Formed After 1996

The following businesses formed after 1996 are taxed as corporations:

A business formed under a federal or state law that refers to the business as a corporation, body corporate, or body politic.

A business formed under a state law that refers to the business as a joint-stock company or joint-stock association.

An insurance company.

Certain banks.

A business wholly owned by a state or local government.

A business specifically required to be taxed as a corporation by the Internal Revenue Code. (For example, certain publicly traded partnerships).

Certain foreign businesses.

Any other business that elects to be taxed as a corporation (for example a limited liability company (LLC)) by filing Form 8832, Entity Classification Election within 75 days the election takes effect.

Personal Service Corporations

A corporation is a personal service corporation if it meets all of the following requirements:

Its principal activity during the “testing period” is performing personal services. Generally, the testing period for any tax year is the prior tax year. If the corporation has just been formed, the testing period begins on the first day of its tax year and ends on the earlier of:

The last day of its tax year, or

The last day of the calendar year in which its tax year begins.

Its employee-owners substantially perform the services in (1). This requirement is met if more than 20% of the corporation's compensation cost for its activities of performing personal services during the testing period is for personal services performed by employee-owners.

Its employee-owners own more than 10% of the fair market value of its outstanding stock on the last day of the testing period.

Personal Services

Personal services include any activity performed in the fields of accounting, actuarial science, architecture, consulting, engineering, health (including veterinary services), law, and the performing arts.

Employee-Owners

A person is an employee-owner of a personal service corporation if both of the following apply:

He or she is an employee of the corporation or performs personal services for, or on behalf of, the corporation (even if he or she is an independent contractor for other purposes) on any day of the testing period.

He or she owns any stock in the corporation at any time during the testing period.

Closely Held Corporations

A corporation is closely held if all of the following apply:

It is not a personal service corporation.

At any time during the last half of the tax year, more than 50% of the value of its outstanding stock is, directly or indirectly, owned by or for five or fewer individuals. “Individual” includes certain trusts and private foundations.

Types of Controlled Groups

Parent–Subsidiary Group

A parent–subsidiary group is one or more chains of corporations connected through stock ownership with a common parent corporation if:

Stock possessing at least 80% of the total combined voting power of all classes of stock entitled to vote or at least 80% of the total value of shares of all classes of stock of each of the corporations, except the common parent corporation, is directly or indirectly owned by one or more of the other corporations; and

The common parent corporation directly or indirectly owns stock possessing at least 80% of the total combined voting power of all classes of stock entitled to vote or at least 80% of the total value of shares of all classes of stock of at least one of the other corporations, excluding, in computing such voting power or value, stock owned directly by such other corporations.

For purposes of determining whether a corporation is a member of a parent–subsidiary controlled group within the meaning of section 1563(a)(1), stock owned by a corporation means:

Stock owned directly by the corporation, and

Stock constructively owned by that corporation under sections 1563(e)(1), (2), and (3).

Brother–Sister Group.

A brother–sister group generally is two or more corporations where the same five or fewer persons who are individuals, estates, or trusts directly or indirectly own stock possessing:

At least 80% of the total combined voting power of all classes of stock entitled to vote or at least 80% of the total value of shares of all classes of the stock of each corporation (the 80% test), and

More than 50% of the total combined voting power of all classes of stock entitled to vote or more than 50% of the total value of shares of all classes of stock of each corporation, taking into account the stock ownership of each such person only to the extent such stock ownership is identical with respect to each such corporation (the 50% test).

Property Exchanged for Stock

Control of a Corporation

If one or more persons (individuals, corporations, partnerships, trusts or estates) transfer money or property to a corporation solely in exchange for stock of that corporation, and immediately after the exchange, the transferor(s) controls the corporation, no gain or loss is recognized by the transferor(s) or the corporation (Section 351). To be in control, the transferors must, as a group, own:

At least 80% of the total combined voting power of all classes of stock entitled to vote, and

At least 80% of the total number of shares of all other classes of stock.

Exception

This rule does not apply in the following situations:

The corporation is an investment company.

The taxpayer transfers the property in a bankruptcy proceeding in exchange for stock used to pay creditors.

The stock is received in exchange for the corporation's debt (other than a security) or for interest on the corporation's debt (including a security) that accrued while shareholder held the debt.

Services Exchanged for Stock

Transfer of services to a corporation in return for stock results in taxable compensation in the amount of the FMV of the stock.

Money or Other Property Received

If property is received, including money, in addition to stock in exchange for property transferred to a corporation, the gain (if any) is taxable to the extent of the money or FMV of the property received.

Gain or Loss Not Recognized by Corporation

No gain or loss is recognized by a corporation for property received in exchange for stock.

Nonqualified Preferred Stock

Nonqualified preferred stock is treated as property other than stock. Generally, it is preferred stock with any of the following features:

The holder has the right to require the issuer or a related person to redeem or buy the stock.

The issuer or a related person is required to redeem or buy the stock.

The issuer or a related person has the right to redeem or buy the stock and, on the issue date, it is more likely than not that the right will be exercised.

The dividend rate on the stock varies with reference to interest rates, commodity prices, or similar indices.

Assumption of Liabilities

If a property subject to liabilities is transferred to a corporation, the exchange is not treated as money or other property received by the shareholder in determining recognized (taxable) gain on the transaction. There are two exceptions to this treatment:

If the liabilities the corporation assumes are more than the adjusted basis in the property transferred, gain is recognized up to the difference. However, if the liabilities assumed give rise to a deduction when paid, such as a trade account payable or interest, no gain is recognized.

If there is no good business reason for the corporation to assume the liabilities, or if the main purpose in the exchange is to avoid federal income tax, the assumption is treated as if money is received in the amount of the liabilities.

Basis of Stock Received

The basis of stock received in exchange for the transfer of property to a corporation is the same as the basis of property transferred:

Decreased by:

The FMV of any other property received.

The amount of money received.

Any loss recognized on the exchange.

Increased by:

Any amount treated as a dividend.

Any gain recognized on the exchange.

Basis of Other Property Received

The basis of other property received is its fair market value on the date of the trade.

Basis of Property Transferred

80% control transaction

If a corporation receives property by issuing stock in exchange, in an 80% control transaction, the basis of the property to the corporation is the same as the transferor had in the property increased by any gain recognized on the exchange by the transferor. The corporation's holding period for the property received includes the time held by the transferor.

Election to Reduce Basis

In a section 351 transaction, if the adjusted basis of the property transferred exceeds the property's fair market value, the transferor and transferee may make an irrevocable election to treat the basis of the stock received by the transferor as having a basis equal to the fair market value of the property transferred. The transferor and transferee make this election by attaching a statement to their tax returns filed by the due date (including extensions) for the tax year in which the transaction occurred.

Other than 80% transaction

If a corporation receives property by issuing stock for it, other than in an 80% control transaction, the basis of the property to the corporation is the FMV of the stock at the time of the exchange.

Note:  If the stock has no established value, the FMV of the property may be used to set the value of the stock if all outstanding stock is issued in exchange for that property.

Return Filing and Tax Payment Requirements

Filing Requirements (Form 1120)

A corporation must file a return unless it has dissolved, even if it has stopped doing business and disposed of all its assets except for a small sum of cash retained to pay state taxes to preserve its corporate charter or if it is in bankruptcy.

Required e-Filing

Certain corporations with total assets of $10 million or more that file at least 250 returns a year are required to e-file Form 1120. However, in certain instances, these corporations can request a waiver.

Filing Due Date

Calendar year corporation - April 15.

Fiscal year corporation - 15th day of the 4th month following the close of fiscal year.

Note: A corporation with a fiscal tax year ending June 30 must file by the 15th day of the 3rd month after the end of its tax year.

Extensions

Extension of time to file (Form 7004). A corporation will receive an automatic 6-month extension by submitting Form 7004. Any tax due must be paid with Form 7004. A corporation with a fiscal tax year ending June 30, the automatic extension is for 7 months.

Who Must Sign the Return

The return must be signed and dated by:

The president, vice president, treasurer, assistant treasurer, chief accounting officer; or

Any other corporate officer (such as tax officer) authorized to sign.

Tax Payments

A corporation must pay its tax due in full no later than the 15th day of the 4th month after the end of its tax year.

Electronic Deposit Requirement

Corporations generally must use electronic funds transfers to make all federal tax deposits (such as deposits for employment, excise, and corporate income tax). Generally electronic funds transfers are made using the Electronic Federal Tax Payment System (EFTPS). However, if the corporation does not want to use EFTPS, it can arrange for its tax professional, financial institution, payroll service, or other trusted third party to make deposits on its behalf.

Penalties

Late filing of return - 5% per month not exceeding 25% of the unpaid tax. Minimum penalty for a return over 60 days late is the smaller of the tax due or $450.

Late payment of tax - 0.5% per month not exceeding 25% of the unpaid tax.

Recordkeeping

A corporation should keep its records for as long as they may be needed for the administration of any provision of the Internal Revenue Code.

Usually records that support items of income, deductions, or credits on the return must be kept for 3 years from the date the return is due or filed, whichever is later. Records that verify the corporation’s basis in property should be kept for as long as they are needed to figure the basis of the original or replacement property.

Estimated Tax

Estimated Tax Requirement

A corporation must make installment payments if it expects its estimated tax for the year to be $500 or more.

Estimated Tax Payments Dates

Installment payments of estimated tax are due by the 15th day of the 4th, 6th, 9th, 12th months of the corporation’s tax year.

Methods Used to Figure Each Installment:

Method 1. Each required installment is 25% of the income tax the corporation will show on its return for the current year.

Method 2. Each required installment is 25% of the income tax shown on the corporation’s return for the previous year.

Other Methods

If a corporation's income is expected to vary during the year because, for example, its business is seasonal, it may be able to lower the amount of one or more required installments by using one or both of the following methods:

The annualized income installment method.

The adjusted seasonal installment method.

How to Pay Estimated Tax

A corporation is generally required to use EFTPS to pay its taxes.

Quick Refund of Overpayments

A corporation that overpays its estimated tax may use Form 4466, Corporation Application for Quick Refund of Overpayment of Estimated Tax, for a quick refund of any overpayment. The form is filed after the close of the corporation’s tax year and no later than the due date for filing the corporation’s tax return (not including extensions).

The overpayment must be:

At least 10% of tax liability, and

At least $500.

Accounting Periods and Methods

Accounting Periods

Corporations can use either a calendar year or a fiscal year as its tax year. A corporation must adopt a tax year by the due date (not including extensions) of its first income tax return.

Personal Service Corporation

A personal service corporation must use a calendar year as its tax year unless:

It elects to use a 52-53 week tax year that ends with reference to the calendar year,

It can establish a business purpose for a different tax year and obtains approval of the IRS, or

It elects under section 444 of the Internal Revenue Code to have a tax year other than a calendar year. Use Form 8716, Election to Have a Tax Year Other Than a Required Tax Year, to make the election.

Accounting Methods

A corporation can use the following methods of accounting:

Cash,

Accrual, or

Any other method authorized by the Internal Revenue Code.

Accrual Method

A corporation, other than a qualified personal service corporation, must use the accrual method of accounting if it is not a small business taxpayer (average annual gross receipts of $27 Million or less for the 3 prior tax years and is not a tax shelter).

If inventories are required, the accrual method generally must be used for sales and purchases of merchandise. However, a small business taxpayer using a cash method can adopt or change its accounting method to account for inventories in the same manner as materials and supplies that are nonincidental.

Nonaccrual Experience Method

Accrual method corporations are not required to maintain accruals for certain amounts from the performance of services that, on the basis of their experience, will not be collected, if:

The services are in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting, or

The corporation is a small business taxpayer (average annual gross receipts of $27 Million or less for the 3 prior tax years and is not a tax shelter).

Income, Deductions, and Special Provisions

Cost of Going into Business

A corporation can elect to deduct up to $5,000 of business start-up costs and another $5,000 in organizational expenses in the year the business is started. The $5,000 deduction is reduced by the amount the total costs exceed $50,000. If the total costs exceed $55,000 or more, the deduction is reduced to zero. Any costs not deducted must be amortized over 180 months (15 years) beginning with the month the partnership begins business.

Start-Up Costs

Start-up costs include amounts paid for the following:

An analysis or survey of potential markets, products, labor supply, transportation facilities, etc.

Advertisements for the opening of the business.

Salaries and wages for employees who are being trained and their instructors.

Travel and other necessary costs for securing prospective distributors, suppliers, or customers.

Salaries and fees for executives and consultants, or for similar professional services.

Choosing to Amortize

To amortize, complete Form 4562 and attach it to the corporate return for the year in which the amortization period begins.

Organizational Expenses

A corporation can elect to deduct up to $5,000 of organizational costs as current expenses.

The $5,000 deduction is reduced by the amount the total costs exceed $50,000. If the total costs exceed $55,000 or more, the deduction is reduced to zero. Any costs not deducted must be amortized over 180 months (15 years) beginning with the month the corporation begins business. These expenses must be incurred before the end of the first year the corporation is in business. A cash or accrual basis corporation can amortize organizational costs incurred in the first year, even if it does not pay them in that year.

Organizational expenses include:

Expenses of temporary directors and organizational meetings of directors or shareholders,

State incorporation fees, and

Accounting expenses and legal fees incident to organization, e.g., drafting the charter, bylaws, minutes of organizational meetings, and terms of the original stock certificates.

Expenses that cannot be deducted or amortized:

Expenses for issuance or sale of stock or securities, such as commissions, professional fees, and printing costs, and

Expenses for the transfer of assets to the corporation.

Related Party Transactions

A corporation that uses an accrual method of accounting cannot deduct business expenses and interest owed to a related person who uses the cash method of accounting until the corporation makes the payment and the corresponding amount is includible in the related person's gross income.

Determine the relationship, for this rule, as of the end of the tax year for which the expense or interest would otherwise be deductible. If a deduction is denied, the rule will continue to apply even if the corporation's relationship with the person ends before the expense or interest is includible in the gross income of that person. These rules also deny the deduction of losses on the sale or exchange of property between related persons.

Related Persons

For purposes of this rule, the following persons are related to a corporation:

Another corporation that is a member of the same controlled group as defined in section 267 (f) of the Internal Revenue Code.

An individual who owns, directly or indirectly, more than 50% of the value of the outstanding stock of the corporation.

A trust fiduciary when the trust or the grantor of the trust owns, directly or indirectly, more than 50% in value of the outstanding stock of the corporation.

An S corporation if the same persons own more than 50% in value of the outstanding stock of each corporation.

A partnership if the same persons own more than 50% in value of the outstanding stock of the corporation and more than 50% of the capital or profits interest in the partnership.

Any employee-owner if the corporation is a personal service corporation, regardless of the amount of stock owned by the employee-owner.

Ownership of Stock

To determine whether an individual directly or indirectly owns any of the outstanding stock of a corporation, the following rules apply:

Stock owned, directly or indirectly, by or for a corporation, partnership, estate, or trust is treated as being owned proportionately by or for its shareholders, partners, or beneficiaries.

An individual is treated as owning the stock owned, directly or indirectly, by or for the individual's family. Family includes only brothers and sisters (including half-brothers and half-sisters), a spouse, ancestors, and lineal descendants.

Any individual owning (other than by applying rule (2)) any stock in a corporation is treated as owning the stock owned directly or indirectly by that individual's partner.

To apply rule (1), (2), or (3), stock constructively owned by a person under rule (1) is treated as actually owned by that person. But stock constructively owned by an individual under rule (2) or (3) is not treated as actually owned by the individual for applying either rule (2) or (3) to make another person the constructive owner of that stock.

Complete Liquidations

The disallowance of losses from the sale or exchange of property between related persons does not apply to liquidating distributions.

Corporate Preference Items

A corporation must make special adjustments to certain items before it takes them into account in determining its taxable income. These items are known as corporate preference items and they include the following:

Gain on the disposition of section 1250 property.

Percentage depletion for iron ore and coal (including lignite).

Amortization of pollution control facilities.

Mineral exploration and development costs.

Dividend Received Deduction

A corporation is allowed a deduction for a percentage of certain dividends received during its tax year.

Dividends from Foreign Corporations

Generally, 100% of the foreign-source portion of dividends (and items treated as dividends) from 10%-owned foreign corporations received after December 31, 2017, may be deducted. The stock with respect to which such dividends are received must meet a special 365-day holding period and does not include certain “hybrid” dividend payments.

Dividends from Domestic Corporations

A corporation can deduct, within certain limits, 50% of the dividends received if the corporation receiving the dividend owns less than 20% of the corporation distributing the dividend. If the corporation owns 20% or more of the distributing cor-poration's stock, it can, subject to certain limits, deduct 65% of the dividends received.

Small Business Investment Companies

Small business investment companies can deduct 100% of the dividends received from taxable domestic corporations.

No Deduction Allowed for Certain Dividends

Corporations cannot take a deduction for dividends received from the following entities:

A real estate investment trust (REIT).

A corporation exempt from tax under section 501 or 521 of the Internal Revenue Code either for the tax year of the distribution or the preceding tax year.

A corporation whose stock has been held less than 46 days during the 91-day period beginning 45 days before the stock became ex-dividend with respect to the dividend.

A corporation whose preferred stock was held less than 91 days during the 181-day period beginning 90 days before the stock became ex-dividend with respect to the dividend if the dividend received on it are for a period or periods totaling more than 360 days. Ex-dividend means the holder has not rights to the dividend.

Any corporation, if the corporation is under an obligation (pursuant to a short sale or otherwise) to make related payments for substantially similar or related property.

Limit on Deduction for Dividends

The total deduction for dividends received or accrued is generally limited (in the following order) to:

65% of the difference between taxable income and the 100% deduction allowed for dividends received from affiliated corporations, or by a small business investment company, for dividends received or accrued from 20%-owned corporations, then

80% of the difference between taxable income and the 100% deduction allowed for dividends received from affiliated corporations, or by a small business investment company, for dividends received or accrued from less-than-20%-owned corporations (reducing taxable income by the total dividends received from 20%-owned corporations).

Figuring the Limit

In figuring the limit, determine taxable income without the following items:

The net operating loss deduction.

The deduction for income attributable to domestic production activities of specified agricultural or horticultural cooperatives.

The deduction for dividends received.

Any adjustment due to the nontaxable part of an extraordinary dividend.

Any capital loss carryback to the tax year.

Effect of Net Operating Loss

If a corporation has a net operating loss (NOL) for a tax year, the limit of 65% (or 50%) of taxable income does not apply. To determine whether a corporation has an NOL, figure the dividends-received deduction without the 65% (or 50%) of taxable income limit.

Charitable Contributions

Limits on Charitable Contributions

Contributions are limited to 10% of taxable income. Taxable income for this purpose is figured without taking into account the following:

The deduction for charitable contributions.

The dividends-received deduction.

Any domestic activities production deduction.

Any capital loss carryback to the tax year.

The deduction allowed under section 249 of the IRC for bond premium.

Any net operating loss carryback to the tax year.

Disaster Relief Charitable Contributions

The 10% limit on the deduction for charitable contributions does not apply to contributions made after December 31,2019, and before February 26, 2021, to certain charitable organizations for relief in qualified disaster areas.

Carryover of Excess Contributions

Charitable contributions over the 10% limit can be carried over to each of the following 5 years. Any excess not used up within that period is lost.

Cash Contributions

A corporation must maintain a record of any contribution of cash, check, or other monetary contribution, regardless of the amount. The record can be a bank record, receipt, letter, or other written communication from the donee indicating the name of the organization, the date of the contribution, and the amount of the contribution.

Contributions of Property Other than Cash

If a corporation (other than a closely-held or a personal service corporation) claims a deduction of more than $500 for contributions of property other than cash, a schedule describing the property and the method used to determine its fair market value must be attached to the corporation's return. In addition, the corporation should keep a record of:

The approximate date and manner of acquisition of the donated property and

The cost or other basis of the donated property held by the donor for less than 12 months prior to contribution.

Closely Held and Personal Service Corporations

Closely held and personal service corporations must complete and attach Form 8283, Noncash Charitable Contributions, to their returns if they claim a deduction of more than $500 for non-cash contributions.

All Other Corporations

For all other corporations, if the deduction claimed for donated property exceeds $5,000, complete Form 8283 and attach it to the corporation's return.

Reduced Deduction for Contributions of Certain Property

For a charitable contribution of property, the corporation must reduce the contribution by the sum of:

The ordinary income and short-term capital gain that would have resulted if the property were sold at its fair market value (FMV), and

For certain contributions, the long-term capital gain that would have resulted if the property were sold at its FMV. The reduction for the long-term gain applies to:

Contributions of tangible personal property for use by an exempt organization for a purpose or function unrelated to the basis for its exemption,

Contributions of any property to or for the use of certain private foundations except for stock for which market quotations are readily available, and

Contributions of any patent, certain copyrights, trademark, trade name, trade secret, know- how, software (that is a section 197 intangible), or similar property, or applications or registrations of such property.

Capital Gains and Losses

Capital Gains

The capital gains tax rate for corporations is the same as the income tax rate. All income for a corporation is taxed at the federal corporate tax (flat 21% after 2017).

Capital Losses

Deduct capital losses only to the extent of capital gains. When deducting the losses:

First: Carryback losses 3 years (apply the loss to the earliest year first).

Then: Carryover losses 5 years.

Note: Once the election has been made to forgo the carryback period, it cannot be changed.

Treatment of Capital Loss

Capital losses are treated as a short-term loss when carried to another year.

S Corporation Status

Capital loss cannot be carried back from, or to, a year in which the corporation was an S corporation.

Refunds

When carrying back a capital loss to an earlier tax year, refigure the tax for that year. If the corrected tax is less than the tax originally owed, use either Form 1139, Corporate Application for Tentative Refund, or Form 1120X, Amended U.S. Corporation Income Tax Return, to apply for a refund.

Form 1139

A corporation can get a refund faster by using Form 1139, Corporation Application for Tentative Refund. It cannot file Form 1139 before filing the return for the corporation's capital loss year, but it must file Form 1139 no later than 1 year after the year it sustains the capital loss.

Net Operating Losses

A corporation generally figures and deducts an NOL the same way an individual does. For losses incurred in tax years beginning after December 31, 2020, only farming losses and losses of an insurance company (other than a life insurance company) can be carried back. The carryback period for these losses is 2 years. For NOLs that can be carried back, the corporation can elect to waive the carryback period and instead carry the NOL forward indefinitely to future years.

Figuring an NOL

If the NOL available for a carryback or carryforward year is greater than the taxable income for that year, the corporation must modify its taxable income to figure how much of the NOL it will use up in that year and how much it can carry over to the next tax year. Its carryover is the excess of the available NOL over its modified taxable income for the carryback or carryforward year.

Modified Taxable Income

A corporation figures its modified taxable income the same way it figures its taxable income, with the following exceptions.

It can deduct NOLs only from years before the NOL year whose carryover is being figured.

The corporation must figure its deduction for charitable contributions without considering any NOL carrybacks.

It cannot take any domestic activities production deduction.

The modified taxable income for any year cannot be less than zero.

At-Risk Limits

The at-risk rules limit losses from most activities to the amount at risk in the activity. The at-risk limits apply to certain closely held corporations (other than S corporations). The amount at risk generally equals:

The money and the adjusted basis of property contributed by the taxpayer to the activity, and

The money borrowed for the activity.

Closely Held Corporation

For the at-risk rules, a corporation is a closely held corporation if, at any time during the last half of the tax year, more than 50% in value of its outstanding stock is owned directly or indirectly by, or for, five or fewer individuals. To figure if more than 50% in value of the stock is owned by five or fewer individuals, apply the following rules:

Stock owned, directly or indirectly, by or for a corporation, partnership, estate, or trust is considered owned proportionately by its shareholders, partners, or beneficiaries.

An individual is considered to own the stock owned, directly or indirectly, by or for his or her family. Family includes only brothers and sisters (including half-brothers and half-sisters), a spouse, ancestors, and lineal descendants.

If a person holds an option to buy stock, he or she is considered to be the owner of that stock.

When applying rule (1) or (2), stock considered owned by a person under rule (1) or (3) is treated as actually owned by that person. Stock considered owned by an individual under rule (2) is not treated as owned by the individual for again applying rule (2) to consider another the owner of that stock.

Passive Activity Limits

The passive activity rules apply to personal service corporations and closely held corporations other than S corporations. Corporations subject to the passive activity limitations must complete Form 8810, Corporate Passive Activity Loss and Credit Limitations.

Figuring Tax

Tax Rates

Corporations, including qualified personal service corporations, figure their tax by multiplying taxable income by a flat tax rate of 21%.

Base Erosion Minimum Tax

If a corporation is an applicable taxpayer, a tax equal to the base erosion minimum tax amount for the tax year may be imposed. This tax is reported using Form 8991.

Applicable Taxpayer

An applicable taxpayer is, with respect to any tax year, a taxpayer which meets all of the following criteria.

The taxpayer is a corporation other than a regulated investment company, a real estate investment trust, or an S corporation.

The taxpayer has average annual gross receipts for the 3-tax-year period ending with the preceding tax year that are at least $500 million (the “gross receipts test”).

The taxpayer has a base erosion percentage for the tax year of 3% or higher; 2% or higher for a taxpayer who is a member of an affiliated group which includes a bank or a registered securities dealer as defined in section 59A(b)(3)(B) (the “base erosion percentage test”).

Alternative Minimum Tax

The alternative minimum tax does not apply to corporations for tax years beginning after 2017 and before 2023. In addition, corporations may treat a portion of their prior year alternative minimum tax credit carryover as refundable. Corporations use Form 8827 to figure the minimum tax credit, if any, for AMT incurred in prior tax years, the refundable AMT credit amount, and to figure any minimum tax credit carryforward.

Earnings and Profits

Determining Accumulated Earnings and Profits

Figuring accumulated E & P with current year profit:

Begin with: Accumulated E & P - 1/1/2022

Add: Current year profit

Subtract: Distributions for the year

Equals: Accumulated E & P - 12/31/2022

Figuring accumulated E & P with current year operating loss:

Begin with: Accumulated E & P - 1/1/2022

Subtract: Prorated operating loss to date of distribution

Equals: E & P available at date of distribution

Subtract: Distributions for the year

Equals: Accumulated E & P - 12/31/2022

Adjustment to Earnings and Profits

Property Distributed to Shareholder | Earnings & Profits
Cash | Decreased by amount of cash (not below zero)
Obligation to corporation | Decreased by principal amount of obligation
OID obligation | Decreased by the issue price of obligation
Other property | Decreased by adjusted basis of property

Appreciated Property

For a distribution of appreciated property (other than the corporation’s obligations), increase earnings and profits by the excess of the FMV over the adjusted basis of the property. Decrease E&P, but not below zero, by the FMV of the appreciated property.

Reconciliation of Tax Versus Book Income (Loss)

Schedule M-1

Schedule M-1 provides for the necessary adjustments to reconcile net income (loss) shown on the corporation’s books to taxable income shown on the corporation’s tax return. The following is an example on how to reconcile book income (loss) to taxable income (loss):

Net Income (Loss) Per Books

Add items that reduce book income but not taxable income:

+ Federal income tax

+ Excess of capital losses over capital gains

+ Income subject to tax not recorded on books

+ Excess charitable contribution (not tax deductible for that year)

+ Travel and entertainment over the 50% limit

+ Life insurance premiums not deductible on tax return

Subtract items that increase book income but not taxable income:

- Tax-exempt interest

- Depreciation: tax depreciation over book depreciation

= Taxable income shown on tax return

Schedules M-1 and M-2

Corporations with total receipts and total assets at the end of the year less than $250,000 are not required to file Schedule M-1, Reconciliation of Income (Loss) per Books With Income per Return and Schedule M-2, Analysis of Unappropriated Retained Earnings per Books.

Schedule M-3

A corporation with total assets (non-consolidated or consolidated for all corporations included within a tax consolidated group) of $10 million or more on the last day of the tax year must complete Schedule M-3 (Form 1120), Net Income (Loss) Reconciliation for Corporations With Total Assets of $10 Million or More, instead of Schedule M-1.

Accumulated Earnings Tax

A corporation can accumulate its earnings for a possible expansion or other bona fide business reasons.

However, if a corporation allows earnings to accumulate beyond the reasonable needs of the business, it may be subject to an accumulated earnings tax of 20%. If the accumulated earnings tax applies, interest applies to the tax from the date the corporate return was originally due, without extensions.

To determine if the corporation is subject to this tax, first treat an accumulation of $250,000 or less generally as within the reasonable needs of most businesses. Treat an accumulation of $150,000 or less as within the reasonable needs of a business whose principal function is performing services in the fields of accounting, actuarial science, architecture, consulting, engineering, health (including veterinary services), law, and the performing arts.

Reasonable Needs

Reasonable needs of the business include the following:

Specific, definite, and feasible plans for use of the earnings accumulation in the business.

The amount necessary to redeem the corporation's stock included in a deceased shareholder's gross estate, if the amount does not exceed the reasonably anticipated total estate and inheritance taxes and funeral and administration expenses incurred by the shareholder's estate.

Distributions to Shareholders

Distributions to shareholders are treated as:

A dividend (to the extent of current and accumulated earnings and profits),

Return of capital (amount over earnings and profits - the shareholder must reduce his or her adjusted basis in the stock by this amount), and

Capital gain (amount received in excess of shareholder’s basis).

Money or Property Distributions

Most distributions are in money, but they may also be in stock or other property. For this purpose, “property” generally does not include stock in the corporation or rights to acquire this stock.

Amount of Distribution

The amount of distribution received by a shareholder is any money plus the FMV of other property received and reduced by liabilities of the corporation assumed by the shareholder. The basis of property received by the shareholder is its FMV.

Property includes money, securities, and indebtedness to the corporation, except stock of the distributing corporation or rights to acquire such stock.

The amount of a distribution is generally the amount of any money paid to the shareholder plus the fair market value (FMV) of any property transferred to the shareholder. However, this amount is reduced (but not below zero) by the following liabilities:

Any liability of the corporation the shareholder assumes in connection with the distribution.

Any liability to which the property is subject immediately before, and immediately after, the distribution.

Note: The FMV of any property distributed becomes the shareholder's basis in that property.

Gain from Property Distributions

A corporation will recognize a gain on the distribution of property to a shareholder if the FMV of the property is more than its adjusted basis. This is generally the same treatment the corporation would receive if the property were sold. However, for this purpose, the FMV of the property is the greater of the following amounts:

The actual FMV.

The amount of any liabilities the shareholder assumed in connection with the distribution of the property.

If the property was depreciable or amortizable, the corporation may have to treat all or part of the gain as ordinary income from depreciation recapture.

Distribution of Stock or Stock Rights

Distributions by a corporation of its own stock are commonly known as stock dividends.

Stock rights (also known as “stock options”) are distributions by a corporation of rights to acquire its stock. A distribution to shareholders of stock or rights to acquire stock is not included in the shareholder's gross income unless it is one of the following:

Any shareholder has the choice to receive cash or other property instead of stock or stock rights.

A disproportionate distribution. The distribution gives cash or other property to some shareholders and an increase in the percentage interest in the corporation’s assets or earnings and profits to other shareholders.

The distribution is in convertible preferred stock and has the same result as in (2).

The distribution gives preferred stock to some common stock shareholders and gives common stock to other common stock shareholder.

The distribution is on preferred stock.

Constructive Distributions

The following are transactions that may be treated as distributions.

Below-Market Loans

If a corporation gives a shareholder a loan on which no interest is charged or on which interest is charged at a rate below the applicable federal rate, the interest not charged may be treated as a distribution to the shareholder.

Corporation Cancels Shareholder's Debt

If a corporation cancels a shareholder's debt without repayment by the shareholder, the amount canceled is treated as a distribution to the shareholder.

Transfers of Property to Shareholder below FMV

A sale or exchange of property to a shareholder (who is not a corporation) below FMV is a dividend to the extent that FMV exceeds price paid by shareholder.

Unreasonable Rents

If a corporation rents property from a shareholder and the rent is unreasonably more than the shareholder would charge to a stranger for use of the same property, the excessive part of the rent may be treated as a distribution to the shareholder.

Unreasonable Salaries

If a corporation pays an employee who is also a shareholder a salary that is unreasonably high considering the services actually performed by the shareholder-employee, the excessive part of the salary may be treated as a distribution to the shareholder-employee.

Dividends and Distributions

Distribution of Appreciated Property

If a corporation distributes property, other than its own stock, to a shareholder and the FMV exceeds the adjusted basis of the property, the corporation will recognize gain on the excess of FMV over adjusted basis.

Distribution of Depreciated Property

If the FMV of depreciated property distributed to shareholders, either as a dividend or in liquidation, exceeds the adjusted basis, the corporation must report the difference as ordinary income because of the depreciation.

Distribution of Property Subject to Liability

If a corporation distributes property subject to a liability to a shareholder and the shareholder assumes the liability, the corporation will recognize a gain in the amount that the liability assumed by the shareholder exceeds the corporation’s adjusted basis in the property.

For gain recognition purposes, the FMV of a property is the greater of the actual FMV of the property or the amount of liabilities the shareholder assumes in connection with the distribution of the property.

Transfer of Stock to Creditor

If a corporation transfers stock to a creditor to satisfy a debt, the debt is considered paid with money equal to the FMV of the stock.

The corporation will recognize income from the discharge of indebtedness if the debt exceeds the FMV of the stock. A corporation can exclude all or a portion of the income created by the stock for debt transfer if it is in a bankruptcy proceeding. If it is not in a bankruptcy proceeding, it can exclude the income to the extent it is insolvent.

Reporting Dividends and Other Distributions

Form 1099-DIV

A corporation must file Form 1099-DIV, Dividends and Distributions, with the IRS for each shareholder to whom the corporation paid gross dividends of $10 or more during the calendar year.

If a payer makes a payment that may be a dividend but the payer is unable to determine whether any part of the payment is a dividend by the time Form 1099-DIV must be filed, the entire payment must be reported as a dividend. The corporation must file Form 1096, Annual Summary and Transmittal, by February 28 (March 31 if filing electronically) of the year following the close of the calendar year in which the dividends or distributions were made. Form 1099-DIV must be furnished to shareholders by January 31 of the following year.

Form 5452

File Form 5452, Corporate Report of Nondividend Distributions, if nondividend distributions were made to shareholders.

A calendar tax year corporation must file Form 5452 with its income tax return for the tax year in which the nondividend distributions were made. A fiscal tax year corporation must file Form 5452 with its income tax return due for the first fiscal year ending after the calendar year in which the nondividend distributions were made.

Withholding Tax

Withholding Agent

A withholding agent is any person required to withhold the tax. A withholding agent may be an individual, a trust, estate, partnership, corporation, etc.

Withholding of Income to Foreign Entities

A withholding agent is required to withhold tax at the rate of 30% on payments of rents, dividends, interest, and other fixed or determinable annual or periodic income from sources within the U.S. to a nonresident alien individual, foreign partnership, or foreign corporation.

If this income is connected with the conduct of a trade or business in the U.S., the person receiving the payments may claim exemption from withholding by filing a statement with the withholding agent.

Returns Required

Form 1042, Annual Withholding Tax Return for U.S. Source Income of Foreign Persons, is required to be filed by the withholding agent by March 15 of the following year. Even if no taxes were withheld during the year, a separate Form 1042-S is required for each payee (recipient) of income to whom payments were made regardless of the amount of tax withheld. This form must be transmitted with the annual Form 1042.

Backup Withholding

A corporate payer must withhold 24% (backup withholding rate) from a reportable payment made to a U.S. person that is subject to Form 1099 reporting for any of the following reasons:

The U.S. person has not provided its taxpayer identification number (TIN) in the manner required.

The IRS notifies the payer that the TIN furnished by the payee is incorrect.

There has been a notified payee underreporting.

There has been a payee certification failure.

Payments Subject to Backup Withholding

The following payments can be subject to backup withholding:

Interest payment.

Dividends.

Patronage dividends, but only if at least half the payment is in money.

Rents, profits, or other gains.

Commissions, fees, or other payments to an independent contractor.

Recordkeeping

All records on employment taxes must be kept for at least 4 years and should be available for IRS review.

Stock Redemption

Constructive Ownership of Stock

An individual is considered owning stock that is owned, directly or indirectly, by any of the following:

Spouse (if not legally separated).

Children.

Grandchildren.

Parents.

A trust (if beneficiary).

A partnership (in proportion to the individual's interest).

A corporation (in proportion to interest) if the individual owns more than 50% of stock.

Note:  An individual is not considered to own stock that is owned by brothers, sisters, aunts or uncles.

Distribution in Redemption of Stock (Complete Redemption).

If a corporation redeems its stock, the redemption is treated as a distribution, in part or full payment, in exchange for stock, if the distribution:

Is not equivalent to a dividend,

Is a substantially disproportionate redemption of stock,

Terminates the shareholder's interest, or

Is a redemption from noncorporate shareholder in partial liquidation.

Substantially Disproportionate Redemption of Stock

After a stock redemption, if a shareholder's ownership percentage of all voting stock is less than 80% of his percentage of all voting stock held before the redemption, and the shareholder owns less than 50% of all voting stock of the corporation after the redemption, the redemption is considered substantially disproportionate.

Complete Redemption

A complete redemption of shareholder's stock is treated as a sale and the shareholder recognizes a capital gain or loss on the transaction. Because the redemption terminates the shareholder's interest, none of the payment received is considered a dividend. Therefore, earnings and profits are ignored.

Partial Redemption

In a partial redemption, the shareholder's interest is not terminated. Hence, a distribution is considered a dividend to the extent of current earnings and accumulated earnings and profits.

Liquidations

Form 966, Corporate Dissolution or Liquidation

A corporation must report the adoption of a resolution or plan for the dissolution of the corporation or for the liquidation of all or part of its stock to the IRS within 30 days by filing Form 966.

Request for Prompt Assessment

A corporation that is contemplating dissolution, is in the process of dissolving, or has already dissolved, may file a written request with the IRS for a prompt assessment. An assessment or a proceeding in court without assessment for the tax must then begin within 18 months after the receipt of a written request or 3 years after the return was filed.

Form 1099-DIV

A corporation making any distribution as part of a liquidation must file Form 1099- DIV in each calendar year of the liquidation for each shareholder to whom it makes distributions of $600 or more by the last day of February of the next year.

Partial Liquidation

A distribution that is treated as being in redemption of stock if the distribution is:

Not essentially equivalent to a dividend,

In redemption of stock held by a shareholder who is not a corporation, and

In partial liquidation of the distributing corporation.

Complete Liquidation

A distribution that is one of a series of distributions in redemption of all of the stock of the corporation pursuant to a plan and is not essentially equivalent to a dividend.

Corporation's Gain or Loss in Complete Liquidation

A corporation will recognize a gain or loss upon distribution of property in complete liquidation to a noncorporate shareholder as if the corporation had sold property to shareholder at FMV. If property distributed is subject to a liability that is assumed by the shareholder, the FMV of the property distributed will be treated as having a FMV not less than the liabilities.

Corporation's gain or loss = FMV - adjusted basis

Shareholder's Basis in Property Received in Liquidation

If property is distributed in complete liquidation and there is a gain or loss recognized by the shareholder, then the basis to shareholder is the FMV.

Liabilities Assumed by Shareholder

If the amount liabilities assumed on the property is less that it’s FMV, the liabilities have no effect on shareholder's basis in property received. If the liabilities are more than FMV, shareholder's basis will be the amount of liabilities assumed.

Chapter Four - S Corporations

S Corporations

Some corporations may meet the qualifications for electing to be S corporations. S Corporations avoid the "Double Taxation" situation, and instead income "flows through" to the shareholders. Chapter four addresses the formation and termination of an S Corporation, the S Corporation's filing requirements, and how income "flows through" to the shareholders. The topics covered focus primarily on the information you will need to pass Part 2 of the Enrolled Agent Exam.

In This Chapter

The Election

Termination of Status

Filing Requirements and Extensions

Permitted Tax Year

Income and Expenses

Shareholder's Basis in Stock

Taxes

Distributions to Shareholders

The Election

Becoming an S Corporation

A corporation can become an S corporation if:

It meets the requirements of S corporation status,

All its shareholders consent to S corporation status,

It uses a permitted tax year, or elects to use a tax year other than a permitted tax year, and

It files Form 2553, Election by a Small Business Corporation, to indicate it chooses S corporation status.

Requirements of an S Corporation

To qualify for S corporation status, a corporation must meet all of the following requirements:

It must be a domestic corporation.

It must have only one class of stock.

It must have no more than 100 shareholders. Treat a taxpayer and his or her spouse (and their estates) as one shareholder for this test.

It must have as shareholders only individuals, estates, and certain trusts and financial institutions. Partnerships and corporations cannot be shareholders.

It must have shareholders who are citizens or residents of the U.S. Nonresident aliens cannot be shareholders.

Ineligible Domestic Corporations

The following are domestic corporations ineligible to elect S corporation status.

A bank or thrift institution that uses the reserve method of accounting for bad debts under section 585.

A DISC (Domestic International Sales Corporation).

A corporation that has elected to be treated as a possessions corporation under section 936.

An insurance company taxed under Subchapter L of the IRC.

One Class of Stock

The outstanding shares of the corporation must be identical as to the rights of the holders in the profits and in the assets of the corporation. Stock may have differences in voting rights and still be considered one class of stock.

Form 2553 - Electing S Corporation Status

The election of S corporation status is effective for a tax year if Form 2553 is filed:

Any time during the previous tax year, or

By the 15th day of the 3rd month of the tax year to which the election applies.

Note: Certain corporations with reasonable cause for not timely filing Form 2553 can request to have the form treated as timely filed by filing Form 2553 as an attachment to Form 1120S, U.S. Income Tax Return for an S Corporation.

Termination of Status

The corporation's status as an S corporation may be terminated in any of the following ways:

By revoking the election,

By ceasing to qualify as an S corporation, or

By violating the passive investment income restrictions on S corporations with pre-S corporation’s earnings and profits for three consecutive tax years.

Note: Terminations are effective on the date of the terminating event.

Terminating Events

The following events will cause the corporation’s S status to be terminated:

Having more than 100 shareholders,

Transferring stock in the S corporation to a corporation, partnership, ineligible trust, or a nonresident alien,

Creating a second class of stock, or

Acquiring a subsidiary, other than certain nonoperating subsidiaries.

Five-Year Waiting Period

If a corporation's S status has been terminated, it must wait 5 tax years before becoming an S corporation again. If the corporation received the permission of the IRS, the waiting period may be less than 5 years.

Revoking Status

An S corporation election may be revoked by the corporation for any tax year.

The election can be revoked only if the shareholders who collectively own more than 50% of the outstanding shares in the S corporation’s stock consent to the revocation. The revocation may specify a revocation date that is on or after the date the revocation is filed.

S Termination Year

The corporation will have to file two returns to cover the S termination year.

One covers the 1120S (S corporation) short year and one covers the 1120 (C corporation) short year. The S termination year will count only as one tax year for figuring carrybacks and carryovers, even though two returns are filed for the year.

After the S termination year is divided into an 1120S short year and an 1120 short year, the separately stated items of income, loss, credit, and deduction, and the amount of the nonseparately stated income or loss must be divided between the periods.

Filing Requirements and Extensions

Due Date of Return

File Form 1120S by the 15th day of the 3rd month after the end of the tax year.

Required e-Filing

Certain corporations with total assets of $10 million or more that file at least 250 returns a year are required to e-file Form 1120. However, in certain instances, these corporations can request a waiver.

Extension of Time for Filing

File Form 7004 for an automatic 6-month extension.

Penalties

Late filing of return - 5% per month not exceeding 25% of the unpaid tax. Minimum penalty for a return over 60 days late is the smaller of the tax due or $450.

Late payment of tax - 0.5% per month not exceeding 25% of the unpaid tax.

Failure to Furnish Information Timely

For each failure to furnish Schedule K-1 to a shareholder when due and each failure to include on Schedule K-1 all the information required to be shown (or the inclusion of incorrect information), a $290 penalty may be imposed with respect to each Schedule K-1 for which a failure occurs.

The maximum penalty is $3,532,500 for all such failures during a calendar year. If the requirement to report correct information is intentionally disregarded, each $290 penalty is increased to $580 or, if greater, 10% of the aggregate amount of items required to be reported. There is no limit to the amount of the penalty.

Permitted Tax Year

A permitted tax year is a calendar year or any other fiscal year for which the corporation establishes a substantial business purpose to the satisfaction of the IRS. An S corporation may elect under section 444 to have a tax year other than the permitted tax year.

Section 444 Election

To be eligible to make the election, an S corporation must meet all of the following conditions:

It is not a member of a tiered structure (other than those made up of one or more partnerships or S corporations, all of which have the same tax year),

It has not previously had a section 444 election in effect, and

It adopts a fiscal year where the deferral period (the number of months between the end of the elected tax year and the close of the required tax year) is 3 months or less.

Making the Election

Make the section 444 election by filing Form 8716, Election to Have a Tax Year Other Than a Required Tax Year, with the IRS by the earlier of:

Any time during the previous year, or

By the 15th day of the 3rd month of the tax year to which the election applies.

Income and Expenses

Figuring Income and Expenses

To figure income, divide the items of income, loss, expense, and credit into two categories:

Separately stated items, and

Items used to figure nonseparately stated income or loss.

Note: The separately stated items and the nonseparately stated income or loss are known as pass-through items. These items are passed through to the shareholders on a pro rata basis figured on each shareholder's percentage of stock owned and the number of days in the tax year that the shareholder owned the stock.

Separately Stated Items

The list of items that must be separately stated includes, but is not limited to:

Ordinary business income (loss).

Net income or loss from rental real estate activities.

Net income or loss from other rental activities.

Portfolio income or loss:

Interest income.

Dividend income.

Royalty income.

Short-term capital gain or loss.

Long-term capital gain or loss.

Collectibles (28%) gain or loss.

Unrecaptured section 1250 gain.

Section 1231 net gain or loss.

Charitable contributions.

Section 179 expense deductions.

Expenses related to portfolio income or loss.

Credits.

Tax preference and adjustment items needed to figure shareholder's alternative minimum tax.

Corporate Deductions

The following are expenses deducted by the S corporation (not passed through) in computing ordinary income and loss:

Compensation to officers.

Salary and wages.

Repairs and maintenance.

Bad debts.

Rental expense.

Taxes and licenses.

Interest expense.

Depreciation not claimed on Form 1125-A or elsewhere on return.

Depletion (Do not deduct oil and gas depletion.)

Advertising.

Employee benefit program.

Pension and profit sharing.

Start-up and organizational expenses.

Cancelation of Debt (COD)

The cancelation of an S corporation debt is considered income unless certain exclusions apply. Unlike a partnership, COD income in an S corporation is recognized at the corporate level. The taxable portion of the COD income after the exclusions are applied are then passed through to the shareholders.

Excluded Debt

Exclude COD income from gross income in the following situations:

The debt is canceled in a bankruptcy case under title 11 of the U.S. Code.

The debt is canceled when the taxpayer is insolvent. However, a taxpayer cannot exclude any amount of canceled debt that is more than the amount by which taxpayer is insolvent.

The debt is qualified farm debt and is canceled by a qualified person.

The debt is qualified real property business debt.

Note: Unlike partnerships, the rules for excluding COD from gross income in an S corporation are applied at the S corporation's level and not the partner's level.

Shareholder's Basis in Stock

Adjustment to Basis of Shareholder's Stock

Increases:

All income that is separately stated and passed through to the shareholder,

Any nonseparately stated income of the S corporation.

The amount of the deductions for depletion that is more than the basis of the property being depleted.

Decreases:

Distributions that were not included in the shareholder's income.

All losses and deductions of the S corporation that are separately stated and passed through to the shareholder.

Any nonseparately stated loss of the S corporation.

Any expense of the S corporation that is not deductible in figuring its income and not properly chargeable to a capital account.

The shareholder's deduction for depletion of oil and gas property held by the S corporation to the extent it does not exceed the proportionate share of the adjusted basis of that property allocated to the shareholder.

Shareholder's Losses and Deductions

S corporation shareholders claim their share of corporate losses and deductions, subject to limitations, on their individual tax returns.

Limits on Losses

The amount of losses and deductions a shareholder can take is limited to the adjusted basis of:

The shareholder's stock, plus

Any loans the shareholder makes to the corporation.

Carryover of Loss and Deductions

If a shareholder's share of loss or deductions exceeds his or her basis in the stock, the shareholder may carry the unused loss or deductions forward, and deduct the excess in later years until used up, unless limited by some other provision.

Taxes

An S corporation may be subject to the following taxes:

Tax on excess net passive investment income.

Tax on built-in gains.

Investment credit recapture tax.

LIFO recapture tax.

Tax on Excess Net Passive Income

If an S corporation has pre-S corporation earnings and profits and its passive investment income is more than 25% of its gross receipts, the S corporation may be subject to a tax on excess net passive income.

If passive investment income is more than 25% of gross receipts for 3 consecutive tax years, and the corporation has pre-S corporation earnings and profit at the end of those tax years, the corporation's S corporation status will be terminated.

Passive Investment Income

Passive investment income includes gross receipts from royalties, rents, dividends, interest, annuities.

Net Passive Income

Net passive income is passive income reduced by deductions directly connected with the production of passive investment income.

Excess Net Passive Income

Excess net passive income is the amount that has the same ratio to net passive income as the amount of passive investment income that exceeds 25% of gross receipts as to passive investment income.

Note: An S corporation will not be subject to the tax on excess net passive income if it has been an S corporation for each of its tax years.

Tax on Built-in Gains

If a C corporation elects to be taxed as an S corporation, it could be subject to a built-in gains tax on appreciation that arose prior to converting to an S corporation.

The S corporation may owe the tax if it has net recognized built-in gains during the recognized period. The recognized period is 5 years beginning on the first day of the first taxable year for which the corporation was an S corporation or the year in which the assets were acquired.

Investment Credit Recapture Tax

Tax may apply if the corporation claimed investment credit on a prior year's corporate tax return before becoming an S corporation. If the S corporation makes an early disposition of the property, the S corporation, and not its shareholders, will be liable for payment of the tax.

LIFO Recapture Tax

If a corporation made the election to be an S corporation after Dec. 17, 1987, and used the LIFO inventory pricing method for its last tax year before its S election, the corporation may be liable for LIFO recapture.

Distributions to Shareholders

Treatment of Distributions

If an S corporation has accumulated earnings and profits, the distribution is a dividend to the extent of earnings and profits.

Earnings and Profits

An S corporation is not considered to have earnings and profits for tax years beginning after 1982 in which it was an S corporation. However, an S corporation can have earning & profits from:

Liquidations, redemptions, and reorganizations governed by the rules of Subchapter C of the IRC.

Tax years in which the corporation was not an S corporation.

Any of the S corporation's tax years that began before 1983.

A corporation acquisition that results in a carryover of earnings and profits under section 381 of the IRC.

Shareholder's Treatment of Distributions

S Corporation with No Earnings & Profits

If an S corporation has no earnings and profits, a distribution to shareholders is treated as:

A return of capital (reduce shareholder's basis), and

A capital gain (amount in excess of shareholder's basis).

Distribution of appreciated property

Corporation will treat distribution as if it had sold the property to the distributee for FMV. The corporation will have to recognize a gain and pass that gain through to its shareholders.

S corporation as a Shareholder

If an S corporation is a shareholder in another corporation, the S corporation is treated as an individual.

S Corporation with Earnings & Profits

If an S corporation has earnings and profits but has not elected to distribute them first, any distribution made will come from one or more of the following sources (in order):

First, treat the distribution as coming out of the accumulated adjustment account (AAA), to the extent of the AAA. This distribution is a return of capital and reduces the shareholder’s adjusted basis.

Second, treat any cash distributed as coming out of previously taxed income (PTI) from S corporation tax years beginning before 1983, after the distributions have reduced the AAA to zero.

Third, treat that portion of the distribution remaining as a dividend to the extent of earnings and profits.

Fourth, any excess is treated as return of capital and reduces any remaining basis of the shareholder’s stock.

Fifth, any excess is taxed as a gain from the sale or exchange of property.

Note:  An S corporation can elect, with the consent of their shareholders, to first distribute earnings and profits.

Chapter Five - Business Income, Expenses, Losses, Credits and Taxes

Business Income, Expenses, Losses, Credits and Taxes

Chapter Five primarily covers the adjustments that can be made to business income. The beginning of the chapter discusses common business expenses (both deductible and nondeductible), how to depreciate property owned by a business, and how to deduct business losses. The end of the chapter covers credits that can be taken by businesses, and specific taxes that apply only to businesses.

In This Chapter

Business Income and Expenses

Depreciation, Depletion and Amortization

Limitation on Losses

General Business Credits

Excise Taxes

Highway Use Tax

Information Returns

Transactions between Partner and Partnership

Which Form to File and the Due Dates

Form
Due Date

W-2 (to employee).

W-2 and W-3 (to the social security administration.

January 31.

January 31, whether filing paper forms or electronically.

941 or 944, Social security and Medicare taxes and income tax withholding.

April 30, July 31, October 31 and January 31 of the next year.

940, Federal unemployment (FUTA) tax.

January 31.

April 30, July 31, October 31, and January 31, but only if the liability for unpaid tax is more than $500.

1099-MISC, required for payment of $600 or more, royalty payments of 10 or more and if taxes were withheld from payment.

January 31 to payee.

Last day in February to IRS (March 31 if filing electronically.

Form 8300, Report of Cash Payments Over $10,000 Received in a Trade or Business.

15 days after receiving the $10,000 payment.

Self-Employment Income

Types of Self-Employment Income:

Income from sole proprietorship and non-employee compensation.

Corporate director fees.

Partnership income from partnership operating a business (unless limited partner).

Guaranteed payment from a partnership.

Bartering income.

Real estate rent (if received as a real estate dealer).

Income paid to retired insurance agents based on commissions received prior to retirement.

Interest received in a trade or business.

Newspaper vendor’s income if vendor is 18 or over.

Net earnings of members of the clergy (unless taken a vow of poverty).

Gains and losses by a dealer in options or commodities from dealing or trading in section 1256 contracts or property related to those contracts.

A professional fiduciary who administers a deceased person’s estate.

Income Not Considered Self-Employment Income:

Shareholder’s share of S corporation’s taxable income.

Fees received for services performed as a notary public.

Cost of Goods Sold

If a taxpayer makes or buys goods to sell, the taxpayer can deduct the cost of goods sold from gross receipts on Schedule C. However, to determine these costs, the taxpayer must value inventory at the beginning and end of each tax year.

Figuring Cost of Goods Sold

Figure cost of goods sold by filling out lines 35 through 42 of Schedule C as follows:

35. | Inventory at beginning of year | $     
36. | Purchases less cost of items withdrawn for personal use | $     
37. | Cost of labor. Do not include any amounts paid to the taxpayer | $     
38. | Materials and supplies | $     
39. | Other costs | $
40. | Add lines 35 through 39 | $     
41. | Inventory at end of year | $     
42. | Cost of goods sold. Subtract line 41 from line 40. |
| Enter the result here and on page 1, line 4. | $     

Who are Employees?

Before an employer can know how to treat payments made to workers for services, the employer must first know the business relationship that exists between employer and the person performing the services. The person performing the services may be one of the following:

An independent contractor.

A common-law employee.

A statutory employee.

A statutory nonemployee.

Independent Contractor

People such as lawyers, contractors, subcontractors, and auctioneers who follow an independent trade, business, or profession in which they offer their services to the public, are generally not employees. However, whether such people are employees or independent contractors depends on the facts in each case. The general rule is that an individual is an independent contractor if the person for whom the services are performed, has the right to control or direct only the result of the work and not the means and methods of accomplishing the result.

Employee or Independent Contractor

An employer must generally withhold federal income taxes, withhold and pay over social security and Medicare taxes, and pay unemployment tax on wages paid to an employee. An employer doesn't generally have to withhold or pay over any federal taxes on payments to independent contractors.

Common-Law Rules

To determine whether an individual is an employee or an independent contractor under the common law, the relationship of the worker and the business must be examined. In any employee-independent contractor determination, all information that provides evidence of the degree of control and the degree of independence must be considered.

Common-Law Employee

Under common-law rules, anyone who performs services for a taxpayer is the taxpayer’s employee if the taxpayer has the right to control what will be done and how it will be done. This is so even when the taxpayer gives the employee freedom of action. What matters is the right to control the details of how the services are performed.

Statutory Employee

If workers are independent contractors under the common law rules, such workers may nevertheless be treated as employees by statute (“statutory employees”) for certain employment tax purposes if they fall within any one of the following four categories and meet the three conditions described under Social security and Medicare taxes on the next card:

A driver who distributes beverages (other than milk) or meat, vegetable, fruit, or bakery products; or who picks up and delivers laundry or dry cleaning, if the driver is a taxpayer’s agent or is paid on commission.

A full-time life insurance sales agent whose principal business activity is selling life insurance or annuity contracts, or both, primarily for one life insurance company.

An individual who works at home on materials or goods that employer supplies and that must be returned to employer, if employer also furnish specifications for the work to be done.

A full-time traveling or city salesperson who works on behalf of an employer and turns in orders to the employer from wholesalers, retailers, contractors, or operators of hotels, restaurants, or other similar establishments.  The goods sold must be merchandise for resale or supplies for use in the buyer's business operation. The work performed for employer must be the salesperson's principal business activity.

Social Security and Medicare Taxes

Social security and Medicare taxes are withheld from the wages of statutory employees if all three of the following conditions apply:

The service contract states or implies that substantially all the services are to be performed personally by them.

They do not have a substantial investment in the equipment and property used to perform the services (other than an investment in transportation facilities).

The services are performed on a continuing basis for the same payer.

Statutory Nonemployee

There are three categories of statutory nonemployees: direct sellers, licensed real estate agents, and certain companion sitters. Direct sellers and licensed real estate agents are treated as self-employed for all federal tax purposes, including income and employment taxes, if both of the following apply:

Substantially all payments for their services as direct sellers or real estate agents are directly related to sales or other output, rather than to the number of hours worked.

Their services are performed under a written contract providing that they will not be treated as employees for federal tax purposes.

Family Employees

Child Employed by Parents

Payments for services of a child under age 18 who works for his or her parent in a business are not subject to social security and Medicare taxes if the business is a sole proprietorship or a partnership in which each partner is a parent of the child.

If these payments are for work other than in a business, such as domestic work in the parent's private home, they are not subject to social security, Medicare, and FUTA taxes until the child reaches age 21. The payments are generally subject to income tax withholding unless the payments are for domestic work in the parent's home, or unless the payments are for work other than in a trade or business and are less than $50 in the quarter or the child is not regularly employed to do such work.

One Spouse Employed by Another

The wages for the services of an individual who works for his or her spouse in a trade or business are subject to income tax withholding and social security and Medicare taxes, but not to FUTA tax. However, the payments for services of one spouse employed by another in other than a trade or business, such as domestic service in a private home, are not subject to social security, Medicare, and FUTA taxes.

Covered Services of a Child or Spouse

The wages for the services of a child or spouse are subject to income tax withholding as well as social security, Medicare, and FUTA taxes if he or she works for:

A corporation, even if it is controlled by the child’s parent or the individual’s spouse.

A partnership, even if the child’s parent is a partner, unless each partner is a parent of the child.

A partnership, even if the individual's spouse is a partner.

An estate, even if it is the estate of a deceased parent.

Employees' Pay

To be deductible, employees’ pay must be an ordinary and necessary expense and must be paid or incurred. In addition, the pay must meet both of the following tests:

Test 1. It must be reasonable.

Test 2. It must be for services performed.

Awards

An employer can deduct amounts paid to employees as awards, whether paid in cash or property.

Achievement Awards

An achievement award is an item of tangible personal property that meets all the following requirements:

It is given to an employee for length of service or safety achievement.

It is awarded as part of a meaningful presentation.

It is awarded under conditions and circumstances that do not create a significant likelihood of disguised pay.

Length-of-Service Award

An award will qualify as a length-of-service award only if either of the following applies.

The employee receives the award after his or her first 5 years of employment.

The employee did not receive another length-of-service award (other than one of very small value) during the same year or in any of the prior 4 years.

Safety Achievement Award

An award for safety achievement will qualify as an achievement award unless one of the following applies:

It is given to a manager, administrator, clerical employee, or other professional employee.

During the tax year, more than 10% of employees, excluding those listed in (1), have already received a safety achievement award (other than one of very small value).

Deduction Limit for Awards

The deduction for the cost of employee achievement awards given to any one employee during the tax year is limited to the following:

$400 for awards that are not qualified plan awards.

$1,600 for all awards, whether or not qualified plan awards.

Bonuses

Bonuses are deductible if the bonus is intended as additional pay for services that were actually performed and not as a gift. This applies whether the bonus was cash or property.

Gifts of Nominal Value

An employer can deduct as nonwage business expense, food or merchandise of nominal value distributed to employees at holidays. The deduction for de minimis gifts of food or drink are not subject to the 50% deduction limit that generally applies to meals.

Educational Expenses

If an employer pays or reimburses education expenses for an employee, the employer can deduct the payments if they are part of a qualified educational assistance program.

Fringe Benefits

Deduct the cost of fringe benefits. The values of some fringe benefits are also excluded from employees’ pay.

Meals and Lodging

Deduct the cost of furnishing meals and lodging to employees.

Deduction Limit on Meals

An employer can generally deduct only 50% of the cost of furnishing meals to employees. However, the employer can deduct the full cost of the following meals:

Meals whose value is included in an employee's wages.

Meals that qualify as a de minimis fringe benefit. This includes meals furnished to employees at the employer’s place of business if more than half of these employees are provided the meals for the employer’s convenience.

Meals furnished to employees at the work site when the employer operates a restaurant or catering service.

Meals furnished to employees as part of the expense of providing recreational or social activities, such as a company picnic.

Vacation Pay

Deduct vacation pay only in the tax year in which the employee actually receives it. This rule applies regardless of whether the employer uses the cash or accrual method of accounting.

Compensation for Injuries

Deduct amounts paid to employees for sickness and injury, including lump-sum payments paid or accrued.

Employee Benefit Programs

Deduct amounts spent on employee benefit programs. Employ benefit programs include the following:

Accident and health plans.

Adoption assistance.

Cafeteria plans.

Dependent care assistance.

Educational assistance.

Life insurance coverage.

Welfare benefits funds.

Property as Compensation

Transfer of property (including company stock) to employees for services are deductible as wages. The deductible amount is the fair market value on the date of the transfer. The difference between FMV and the adjusted basis is considered a capital gain or loss to the employer.

Construction of Capital Assets

Salaries and other payments incurred for constructing capital assets cannot be deducted. The costs must be included in the basis of the constructed asset and depreciated.

Employer Shared Responsibility Provisions

Under the Affordable Care Act’s employer shared responsibility provisions, certain employers (called applicable large employers or ALEs) must either offer minimum essential coverage that is “affordable” and that provides “minimum value” to their full-time employees (and their dependents), or potentially make an employer shared responsibility payment to the IRS.

The employer shared responsibility provisions are sometimes referred to as “the employer mandate” or “the pay or play provisions.” The vast majority of employers will fall below the ALE threshold number of employees and, therefore, will not be subject to the employer shared responsibility provisions. To be an ALE for a particular calendar year, an employer must have had an average of at least 50 full-time employees (including full-time-equivalent employees) during the preceding calendar year.

Reporting Expenses and Reimbursements

A reimbursement or allowance arrangement provides for payment of advances, reimbursements, and allowances for travel and non-entertainment related meals expenses incurred by employees during the ordinary course of business. How to deduct a business expense under a reimbursement or allowance arrangement depends on whether the employer has:

An accountable plan, or

A nonaccountable plan.

Accountable Plans

An accountable plan requires employees to meet all of the following requirements. Each employee must:

Have paid or incurred deductible expenses while performing services as an employee,

Adequately account to the employer for these expenses within a reasonable period of time, and

Return any excess reimbursement or allowance within a reasonable period of time.

An arrangement under which an employer advances money to employees is treated as meeting (3) above only if the following requirements are also met.

The advance is reasonably calculated not to exceed the amount of anticipated expenses.

The employer makes the advance within a reasonable period of time of the employee paying or incurring the expense.

Reasonable Period of Time

A reasonable period of time depends on the facts and circumstances. Generally, actions that take place within the times specified in the following list will be treated as taking place within a reasonable period of time.

Employer gives an advance within 30 days of the time the employee pays or incurs the expense.

Employees adequately account for their expenses within 60 days after the expenses were paid or incurred.

Employees return any excess reimbursement within 120 days after the expenses were paid or incurred.

Employer gives a periodic statement (at least quarterly) to his or her employees that asks them to either return or adequately account for outstanding advances and they comply within 120 days of the date of the statement.

Nonaccountable Plans

A nonaccountable plan is an arrangement that does not meet the requirements for an accountable plan.

All amounts paid, or treated as paid, under a nonaccountable plan are reported as wages on Form W-2. The payments are subject to income tax withholding, social security, Medicare, and federal unemployment taxes. Deduct the reimbursement as compensation or wages only to the extent it meets the deductibility tests for employees' pay.

Employment Taxes

Keep all records of employment taxes for at least 4 years. These should be available for IRS review. The records should include the following:

The employer’s identification number (EIN).

Amounts and dates of all wage, annuity, and pension payments.

Amounts of tips reported to the employer by the employer’s employees.

Records of allocated tips.

The fair market value of in-kind wages paid.

Names, addresses, social security numbers, and occupations of employees and recipients.

Any employee copies of Forms W-2 and W-2c that were returned to the employer as undeliverable.

Dates of employment for each employee.

Periods for which employees and recipients were paid while absent due to sickness or injury and the amount and weekly rate of payments the employer or third party payers made to them.

Copies of employees’ and recipients' income tax withholding allowance certificates (Forms W-4, W-4P, W-4(SP), W-4S, and W-4V).

Dates and amounts of tax deposits that the employer made and acknowledgment numbers for deposits made by EFTPS.

Copies of returns filed and confirmation numbers.

Records of fringe benefits and expense reimbursements provided to employees, including substantiation.

Documentation to substantiate any credit claimed.

Form W-4

When hiring an employee, the employer must have the employee complete a Form W-4, Employee's Withholding Allowance Certificate.

Form W-4 tells the employer, the marital status, the number of withholding allowances, and any additional amount to use when deducting federal income tax from the employee's pay. If an employee fails to give the employer a properly completed Form W-4, the employer must withhold federal income taxes from the employee’s wages as if the employee was single and claiming no withholding allowances.

Depositing Employment Taxes

There are two deposit schedules: monthly or semiweekly.

The deposit schedule that a calendar year employer must use is based on the total tax liability that the employer reported on Form 941 during the four-quarter lookback period that begins July 1 and ends June 30 of the previous year. If the employer reported payroll taxes of $50,000 or less for the lookback period, the employer makes monthly deposits. If the employer reported payroll taxes of more than $50,000 the lookback period, the employer makes semiweekly deposits.

Deposit Penalties

For amounts not properly or timely deposited, the penalty rates are as follows:

2% - Deposits made 1 to 5 days late.

5% - Deposits made 6 to 15 days late.

10% - Deposits made 16 or more days late. Also applies to amounts paid within 10 days of the date of the first notice the IRS sent asking for the tax due.

10% - Amounts that should have been deposited, but instead were paid directly to the IRS, or paid with the tax return.

15% - Amounts still unpaid more than 10 days after the date of the first notice the IRS sent asking for the tax due or the day on which the taxpayer received notice and demand for immediate payment, whichever is earlier.

Withholding & Social Security Tax

Trust Fund Taxes

Trust fund taxes are income tax, social security tax, and Medicare tax withheld from the employee’s wages. Certain excise taxes are also considered trust fund taxes because they are collected and held in trust for the government until submitted in a federal tax deposit.

Trust Fund Recovery Penalty (TFRP)

If federal income, Social Security, and Medicare taxes are not withheld or are not paid to the IRS, a penalty may be assessed against any person responsible for collecting, accounting for, and paying over these taxes and who acted willfully in not doing so. A responsible person may be:

An officer or an employee of a corporation.

A member or employee of a partnership.

A corporate director or shareholder.

A member of a board of trustees of a nonprofit organization.

Another person with sufficient authority and control over funds to direct their disbursement including someone who signs checks for the business.

Another corporation or third party payer.

Payroll Service Providers (PSP) or responsible parties within a PSP.

Professional Employer Organizations (PEO) or responsible parties within a PEO.

Responsible parties within the common law employer (client of PSP/PEO).

For willfulness to exist, the responsible person:

Must have been, or should have been aware of the outstanding taxes and

Either intentionally disregarded the law or was plainly indifferent to its requirement.

Figuring the TFRP Amount

This penalty does not apply to the employer’s portion of social security or FUTA. The penalty is computed based on two amounts which constitute trust fund tax:

The unpaid income taxes that should have been withheld, or were withheld but not paid, plus

The employee’s portion of the Social Security and Medicare taxes that should have been withheld, or were withheld but not paid.

Assessing the TFRP

If the IRS determines that someone is a responsible person, they will provide that person with a letter stating that the IRS plans to assess the TFRP for that person. The person has 60 days (75 days if this letter is addressed outside the U.S.) from the date of this letter to appeal the penalty.

Recordkeeping

All records on employment taxes must be kept for at least 4 years and should be available for IRS review.

Rent Expense

Rent Paid in Advance

If rent is paid in advance, deduct only the amount that applies to the use of the rented property for the tax year. The balance can be deducted only over the period to which it applies.

Unreasonable Rent

A taxpayer cannot take a rental deduction for unreasonable rent. Ordinarily, the issue of reasonableness arises only if the taxpayer and the lessor are related. Rent paid to a related person is reasonable if it is the same amount the taxpayer would pay to a stranger for use of the same property. Rent isn’t unreasonable just because it is figured as a percentage of gross sales.

Cost of Acquiring a Lease

Any amount paid to acquire an existing lease must be amortized over the remaining term of the lease.

Commissions, Bonuses, and Fees

Commissions, bonuses, fees and other amounts paid to obtain a lease on a property used for business are capital expenses and must be amortized over the term of the lease.

Leasehold Improvements

The cost of improvements to a leased property must be depreciated using MACRS. The cost is depreciated over its appropriate recovery period. Do not amortize the cost over the remaining term of the lease.

Assignment of a Lease

If a long-term lessee makes capital improvements to land and later assigns all lease rights to a taxpayer, the amount that is paid to the assignment is a capital investment to the taxpayer.

If the rental value of the leased land increases since the lease began, part of the capital investment is for the increased rental value. This increase is a cost of getting the lease and must be amortized over the remaining term of the lease.

Interest Expenses

Allocation of Interest

Allocate the interest on a loan used for business, personal, investment, and passive activities. Allocate interest on a loan the same way as allocating the loan proceeds.

Secured Loan

The allocation of loan proceeds and the related interest is not affected by the use of the property that secures the loan. For example, if a business property is used to secure a loan where the proceeds are used for personal use, the interest is allocated to personal use even though the loan is secured by business property.

Points

Points on a loan relating to a trade or business must be amortized over the life of the loan.

Prepaid Interest

Deductible only in the year to which it pertains.

Delinquent Debt

An accrual basis taxpayer can still deduct interest on a loan he or she is unlikely to be able to repay.

Prepayment Penalty

Deduct the penalty as interest.

Business Related Debt

Deduct all interest on a debt related to a trade or business.

Cash basis taxpayer. Deduct only payments of interest actually paid during tax year.

Accrual basis taxpayer. Deduct interest when it accrues during tax year.

Nondeductible Interest Expenses:

Commitment fees or standby charges. Fees incurred to have business funds readily available over a period of time, but not for the actual use of funds.

Interest on individual income tax owed.

Interest related to tax exempt income.

Interest Capitalization

Under the uniform capitalization rules, interest must be capitalized on debt used to finance the production of real or tangible personal property. Capitalize interest incurred during the production of the following properties:

Real property.

Tangible personal property with a class life of 20 years or more.

Tangible personal property with an estimated production period of more than 2 years.

Tangible personal property with an estimated production period of more than one year if cost of production is more than $1 million.

Interest Expense Limitation

Business interest expense paid or accrue during the tax year must be limited unless an exception to the limitation is met. The business interest expense deduction allowed for a taxable year is generally limited to the sum of:

Business interest income,

30% of the adjustable taxable income, and

Floor plan financing interest.

Small business taxpayer. A small business taxpayer (average annual gross receipts of $27 Million or less for the 3 prior tax years) is not subject to the limitation.

Taxes

Deductible Taxes

A taxpayer can deduct various federal, state, local, and foreign taxes directly attributed to his or her trade or business. The following are deductible taxes:

Real estate taxes.

State and local income taxes.

Employment taxes.

Personal property tax.

State unemployment payments.

Foreign income taxes.

Franchise taxes.

Fuel taxes.

Excise taxes.

Occupational taxes.

One-half of self-employment tax.

Taxes for Local Benefits

Taxes for local benefits that tend to increase the value of the property such as assessments for construction of streets, sidewalks, and water and sewer systems, are not deductible.

These assessments must be capitalized. Assessments for maintenance and repairs such as repairing streets, sidewalks, and water and sewer systems, are deductible as business expenses.

Sales Tax

Treat any sales tax paid on a service or on the purchase or use of property as part of the cost of the service or property. If the service or property is a deductible expense the sales tax is deductible. If the property is for resale, the sales tax is part of the cost of merchandise.

Insurance Expenses

Deductible Premiums

Fire, theft, flood or other casualty insurance.

Merchandise and inventory insurance.

Credit insurance to cover losses from business bad debts. Report any proceeds from this insurance as ordinary income.

Group hospitalization and medical insurance for employees, including long-term care insurance.

If a partnership pays accident and health insurance premiums for its partners, it generally can deduct them as guaranteed payments to partners.

If an S corporation pays accident and health insurance premiums for its more-than-2% shareholder-employees, it generally can deduct them, but must also include them in the shareholder's wages subject to federal income tax withholding.

Liability insurance.

Malpractice insurance.

Workers' compensation insurance set by state law that covers any claims for bodily injuries or job-related diseases suffered by employees in the business, regardless of fault.

If a partnership pays workers' compensation premiums for its partners, it generally can deduct them as guaranteed payments to partners.

If an S corporation pays workers' compensation premiums for its more-than-2% shareholder-employees, it generally can deduct them, but must also include them in the shareholder's wages.

Contributions to a state unemployment insurance fund.

Overhead insurance. Covers overhead expenses during long period of disability of taxpayer.

Car and other vehicle insurance. Deduct only the part of premiums that applies to business use.

Life Insurance covering officers and employees if employer is not the beneficiary under the contract and can show that the premiums represent the current pay.

Business interruption insurance that pays for lost profits if the business is shut down due to a fire or other cause.

Nondeductible Premiums

Premiums included in the cost of goods sold.

Self-insurance reserve funds.

Premiums for a policy covering loss of earnings.

Life Insurance policy as security for business loan.

Certain life insurance and annuities.

Prepayment

A taxpayer cannot deduct the entire premiums for an insurance policy that covers more than one tax year in the year the payment is made or incurred. Deduct only the part of the premium that applies to that year. For each later year, deduct the part that applies for that year.

If a cash basis taxpayer pays a premium that covers part of the previous year, the taxpayer can deduct the part of the premium that applies to the previous years as well as the part that applies to the tax year the premium is paid.

Bad Debts

Qualifications for deductible bad debt:

Must be a true creditor-debtor relationship.

Must be a legal obligation to pay debt.

Must realize a loss due to bad debt (i.e. actual loss of money that was reported as income).

Must show that the debt is worthless.

Must have taken reasonable steps to collect the debt.

Two Types of Bad Debt

There are two types of bad debts: business and nonbusiness.

Business Bad Debt

A business bad debt is a loss from the worthlessness of a debt that was either:

Created or acquired in a trade or business, or

Closely related to a trade or business.

Types of business bad debts:

Mainly the result of credit sales to customers.

Loans to suppliers, clients, employees, or distributors.

Partner can deduct amount paid for an insolvent partner’s share of debt.

A business loan is guaranteed if the taxpayer:

Made the guarantee in the course of a trade or business,

Has a legal duty to pay the debt,

Made the guarantee before the debt became worthless, and

Received reasonable consideration for making the guarantee.

How to Claim a Business Bad Debt

There are two methods to claim a business bad debt.

Specific charge-off

All taxpayer's must use this method, except financial institutions, unless the requirements to use the nonaccrual-experience method are met.

Partial bad debt: Deduction is limited to the amount charged-off the books that year.

Totally worthless debts: Deduct only in the tax year it becomes worthless. Not required to make actual charge-off on the books.

Nonaccrual-experience. Under this method of accounting, an accrual basis taxpayer does not have to accrue income that is not expected to be collected. Applies to amounts to be received (accounts receivable) for the performance of services. This method cannot be used if interest and penalties are required to be paid for late payments.

Non-Business Bad Debt

All bad debts not relating to trade or business.

Must be totally worthless to be deducted.

Deducted as short-term capital loss on Form 8949.

A loan to a relative or friend that is later forgiven is a gift and not deductible.

Cash Basis Taxpayer

Cannot take a bad debt deduction for amounts owed to cash basis taxpayers because it was never included in income. The taxpayer must have a basis in the debt.

Accrual Basis Taxpayer

Accrual basis taxpayers deduct bad debt against income previously reported.

Recovery of a Bad Debt

Include in income any amount of bad debt recovered in a later year, but only up to the amount of the deduction that reduced tax in the year deducted. Report the recovery as “Other income” on the appropriate business form or schedule.

Business Travel, Entertainment and Business Gift Expenses

Travel in the U.S.

Travel entirely for business. Deduct all travel expenses.

Travel primarily for business. Deduct only business-related travel expenses including travel expenses to and from business destination.

Travel primarily for personal reasons. Deduct only business-related expenses. Do not include travel expenses to and from destination.

Travel Outside the U.S.

Travel entirely for business. Deduct all travel expenses.

Travel primarily for business. If at least 25% of the trip is spent on nonbusiness activities, deduct only business-related expenses and allocate travel expenses to and from destination between business and non-business activities.

Travel primarily for vacation. Deduct only business-related expenses. Do not include travel expenses to and from destination.

Travel Considered Entirely for Business

Even if a taxpayer did not spend his or her entire time on business activities, the trip is considered entirely for business if one of the following four exceptions is met.

The taxpayer did not have substantial control over arranging the trip.

The taxpayer was outside the U.S. for no more than a week.

Less than 25% of the time was spent on personal activities.

Vacation was not a major consideration.

Travel Expenses for Others

Travel expenses paid for others (including spouse,  dependent, or employee) cannot be deducted unless the individual is an employee, has a bona fide business purpose for the travel, and the travel expenses would otherwise be deductible.

Meals and Entertainment

In general, entertainment expenses are nondeductible. However, there are a few exceptions to the general rule including:

Entertainment treated as compensation on and treated as wages to the taxpayer’s employees.

Recreational expenses for employees such as a holiday party or a summer picnic.

Expenses related to attending business meetings or conventions of certain exempt organizations such as business leagues, chambers of commerce, professional associations, etc.

Entertainment sold to customers. For example, if the Taxpayer’s runs a nightclub, the expenses for the entertainment furnish to the customers, such as a floor show, are not subject to the nondeductible rules.

Examples of Nondeductible Entertainment:

Entertainment events. This includes expenses for entertaining guests at nightclubs, at social, athletic, and sporting clubs, at theaters, at sporting events.

Entertainment facilities. Any expense for the use of an entertainment facility.

Club dues and membership fees. Dues (including initiation fees) for membership in any club organized for business, pleasure, recreation, or other social purposes.

50% Limit

Only 50% of meals and entertainment can be deducted. However, a taxpayer can deduct 100% of meal expenses if the meals are food and beverages provided by a restaurant, and paid or incurred after December 31, 2020, and before January 1, 2023.

Taking Turns Paying for Meals or Entertainment

Expenses are not deductible when a group of business acquaintances take turns picking up each other’s meals and entertainment checks without regard to whether any business purposes are served.

Business Gift Expenses

The following are limits on business gifts:

Deduct no more than $25 per person.

Gift to spouse or family member of a customer is treated as a gift to that customer.

The taxpayer and spouse are treated as one taxpayer under the $25 per person limit rule.

Casualty and Theft Losses

Casualty and theft losses on business or income producing properties are treated the same as nonbusiness casualty losses except:

Losses do not have to be attributed to a federally declared disaster.

There is no deduction limit on business losses,

The replacement period to postpone reporting gain is 3 years, and

A condemnation loss can be deducted.

Part Business and Part Personal-Use Property

The casualty/theft loss deduction must be figured as though there were two separate casualties/thefts:

One affecting the personal use property, and

One affecting the business or income producing property.

Disaster Area Loss

Generally a casualty loss must deduct in the disaster year. However, if a casualty loss is from a federally declared disaster that occurred in an area warranting public or individual assistance (or both), the taxpayer can elect to deduct that loss on the return or amended return for the tax year immediately preceding the disaster year.

Loss of Inventory

A casualty/theft loss of inventory is automatically claimed through the increase in the cost of goods sold by reducing ending inventory. A taxpayer can choose to deduct the loss separately by eliminating the item from cost of goods sold by lowering opening inventory or purchases by the amount of the loss.

Business Use of the Home

A taxpayer's home office will qualify his or her principal place of business for deducting expenses for its use it the following requirements are met:

Exclusively and regularly as a principal place of business,

Exclusively and regularly as a place where the taxpayer meets or deal with patients, clients, or customers in the normal course of a trade or business,

In the case of a separate structure which is not attached to the home, in connection with the trade or business,

On a regular basis for certain storage use,

For rental use, or

As a daycare facility.

Exclusive use

To qualify for the exclusive use test, the specific area used for business must be used only for the taxpayer's trade or business. The area cannot be used for personal purposes. The area used for business can be a room or other separately identifiable space. The space does not need to be marked off by a permanent partition.

Regular use

To qualify for the regular use test, the specific area used for business must be used on a regular basis. This test will not be met if the area is used only occasional or incidental, even if it is used only for business use.

Administrative or management activities

There are many activities that are administrative or managerial in nature. The following are a few examples:

Billing customers, clients, or patients.

Keeping books and records.

Ordering supplies.

Setting up appointments.

Forwarding orders or writing reports.

Principal Place of Business

To qualify to deduct the expenses for the business use of the home under the principal place of business test, the home must be the taxpayer's principal place of business for that trade or business.

To determine the taxpayer's principal place of business, consider all the facts and circumstances. The home office will qualify as the taxpayer's principal place of business for deducting expenses for its use if the following requirements are met:

Used exclusively and regularly for administrative or management activities of the trade or business.

The taxpayer has no other fixed location where to conduct substantial administrative or management activities of the trade or business.

Administrative or Management Activities

There are many activities that are administrative or managerial in nature. The following are a few examples:

Billing customers, clients, or patients.

Keeping books and records.

Ordering supplies.

Setting up appointments.

Forwarding orders or writing reports.

Separate Structure

A taxpayer can deduct expenses for a separate free-standing structure, such as a studio, workshop, garage, or barn, if used exclusively and regularly for the business. The structure does not have to be the principal place of business or a place where the taxpayer meets patients, clients, or customers.

Figuring the Deduction

To figure the deduction, the taxpayer will need to figure the percentage of the home used for business and the limit on the deduction.

To find the business percentage, compare the size of the part of the home use for business to the whole house. Use the resulting percentage to figure the business part of the expenses for operating the entire home. Use any reasonable method to determine the business percentage. The following are two commonly used methods for figuring the percentage:

Divide the area (length multiplied by the width) used for business by the total area of the home.

If the rooms in the home are all about the same size, divide the number of rooms used for business by the total number of rooms in the home.

Part-Year Use

A taxpayer cannot deduct expenses for the business use of the home incurred during any part of the year the home is not used for business purposes.

Deduction Limit

If the taxpayer's gross income from the business use of the home equals or exceeds the total business expenses (including depreciation), the taxpayer can deduct all business expenses related to the use of the home.

If the taxpayer's gross income from the business use of the home is less than the total business expenses, the deduction for certain expenses for the business use of the home is limited.

The deduction of otherwise nondeductible expenses, such as insurance, utilities, and depreciation (with depreciation taken last), that are allocable to the business, is limited to the gross income from the business use of the home minus the sum of the following:

The business part of expenses the could be deduct even if the taxpayer did not use the home for business (such as mortgage interest, real estate taxes, and casualty and theft losses that are allowable as itemized deductions on Schedule A (Form 1040 or 1040-SR)).

The business expenses that relate to the business activity in the home (for example, business phone, supplies, and depreciation on equipment), but not to the use of the home itself.

If self-employed, do not include in (2) above the deduction for the deductible part of self-employment tax.

Carryover of Unallowed Expenses

If the deductions are greater than the current year's limit, the taxpayer can carry over the excess to the next year. They are subject to the deduction limit for that year, whether or not the taxpayer lived in the same home during that year.

More Than One Place of Business

If part of the gross income from the trade or business is from the business use of part of the home and part is from a place other than the home, the taxpayer must determine the part of the gross income from the business use of the home before figuring the deduction limit. In making this determination, consider the time spent at each location, the business investment in each location, and any other relevant facts and circumstances.

If the home office qualifies as the taxpayer's principal place of business, the taxpayer can deduct daily transportation costs between the home and another work location in the same trade or business.

Deducting Expenses

If a taxpayer qualifies to deduct expenses for the business use of the home, the taxpayer must divide the expenses of operating the home between personal and business use.

Types of Expenses

The part of a home operating expense that can be used to figure the deduction depends on both of the following:

Whether the expense is direct, indirect, or unrelated.

The percentage of the home used for business.

Depreciating the Home

If the taxpayer owns the home and qualifies to deduct expenses for its business use, the taxpayer can claim a deduction for depreciation of the home (not the value of the land).

Figuring the Depreciation Deduction for the Current Year

Depreciate the business part as nonresidential real property under the modified accelerated cost recovery system (MACRS). Under MACRS, nonresidential real property is depreciated using the straight line method over 39 years.

Using the Simplified Method

The simplified method is an alternative to the calculation, allocation, and substantiation of actual expenses.

In most cases, figure the deductions by multiplying $5, the prescribed rate, by the area of the home used for a qualified business use. The area use to figure the deduction is limited to 300 square feet.

Actual Expenses and Depreciation of the Home.

If electing to use the simplified method, do not deduct any actual expenses for the business except for business expenses that are not related to the use of the home.

Do not deduct any depreciation (including any additional first-year depreciation) or section 179 expense for the portion of the home that is used for a qualified business use. The depreciation deduction allowable for that portion of the home is deemed to be zero for a year using the simplified method.

Note: Although no deduction is allowed for any depreciation or section 179 expense for the portion of the home used for a qualified business use, the taxpayer can still claim depreciation or the section 179 expense deduction on other assets used in the business (for example, furniture and equipment).

Other Deductible Business Expenses

Licenses and regulatory fees.

Penalties and fines for nonperformance of a contract.

Environmental cleanup costs (the cost of cleaning up and treating groundwater contaminated with hazardous waste resulting from business operations).

Expenses for moving machinery from one city or plant to another.

Nondeductible Business Expenses

Anticipated liabilities or reserves.

Lobbying and political expenses and political contributions.

Bribes and kickbacks (if paid to government employee or to others in violation of federal and state law).

Dues paid for membership in any club organized for business, pleasure, recreation, or any other social purpose.

Charitable contributions (must be deducted as itemized deductions on Schedule A).

Kickbacks, bribes, and rebates paid in Medicare or Medicaid programs.

Penalties and fines paid to any government for violation of any law.

Demolition expenses or losses of a structure. Must be added to basis of the land.

Qualified Business Income (QBI) Deduction

Owners of sole proprietorships, partnerships, S corporations and some trusts and estates may be eligible for a qualified business income (QBI) deduction (Section 199A) for tax years beginning after December 31, 2017. The QBI deduction has two components:

QBI Component. This component of the deduction equals 20% of QBI from a domestic business operated as a sole proprietorship or through a partnership, S corporation, trust or estate. The QBI Component is subject to limitations, depending on the taxpayer’s taxable income, that may include the type of trade or business, the amount of W-2 wages paid by the qualified trade or business and the unadjusted basis immediately after acquisition (UBIA) of qualified property held by the trade or business.

REIT/PTP Component. This component of the deduction equals 20% of qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership (PTP) income. This component is not limited by W-2 wages or the UBIA of qualified property. Depending on the taxpayer’s taxable income, the amount of PTP income that qualifies may be limited depending on the PTP’s trade or business.

Qualified Business Income (QBI)

QBI is the net amount of qualified items of income, gain, deduction and loss from any qualified trade or business, including income from partnerships, S corporations, sole proprietorships, and certain trusts.

Generally this includes, but is not limited to, the deductible part of self-employment tax, self-employed health insurance, and deductions for contributions to qualified retirement plans (e.g. SEP, SIMPLE and qualified plan deductions).

QBI does not include the following items:

Items that are not properly includable in taxable income

Investment items such as capital gains or losses or dividends

Interest income not properly allocable to a trade or business

Wage income

Income that is not effectively connected with the conduct of business within the U.S.

Commodities transactions or foreign currency gains or losses

Certain dividends and payments in lieu of dividends

Income, loss, or deductions from notional principal contracts

Annuities, unless received in connection with the trade or business

Amounts received as reasonable compensation from an S corporation

Amounts received as guaranteed payments from a partnership

Payments received by a partner for services other than in a capacity as a partner

Items treated as capital gains or losses

Qualified REIT dividends (deducted under the REIT/PTP component)

Qualified PTP income (deducted under the REIT/PTP component)

Deduction Limits

The deduction is limited to the lesser of the QBI component plus the REIT/PTP component or 20 percent of the taxable income minus net capital gain.

For the QBI component, if the trade or business is a specified trade or business (SSTB), the T/P can claim the credit only if his or her taxable income is less than or equal to $170,050 ($340,100 if married filing jointly). For business owners with taxable income in excess of $220,050 ($440,100 if married filing jointly), no deduction is allowed against income earned in a SSTB.

Specified Trade or Business (SSTB)

An SSTB is defined as any trade or business that performs services in the fields of:

Health

Law

Accounting

Actuarial science

Performing arts

Consulting

Athletics

Financial services

Brokerage services (including investment management and investing, trading, or dealing in securities, commodities, or partnership interests)

Any trade or business where the principal asset is the reputation or skill of one or more of its employees, as demonstrated by:

Receiving fees, compensation, or other income for endorsing products or services,

Licensing or receiving fees, com-pensation or other income for the use of an individual’s image, likeness, name, signature, voice, trademark, or any other symbols associated with the individual’s identity, or

Receiving fees, compensation, or other income for appearing at an event or on radio, television, or another media format.

Form 8995

Individuals and eligible estates and trusts that have QBI use Form 8995 to figure the QBI deduction.

Depreciation, Depletion and Amortization

Depreciable Property

To be depreciable, the property must meet all the following requirements:

It must be property owned.

Must be used in a business or income-producing activity.

It must have a determinable useful life.

It must be expected to last more than one year.

Depreciable property may be:

Tangible. Property that can be seen or touched. Two types:

Real property. Land and anything that is erected on, growing on, or attached to the land. However, land itself is never depreciable.

Personal property. Machinery or equipment that is not real estate.

Intangible. Property that cannot be seen or touched.

Copyright

Patent

Computer software

Nondepreciable Property

Property placed in service and disposed of in the same year.

Equipment used to build capital improvements (Uniform Capitalization Rules)

Section 197 intangibles (must be amortized).

Land.

Demolition of buildings. Add these costs to the basis of the land.

Leased property.

When Does Depreciation Begin?

Begin depreciating property when it is placed in service for use in a trade or business or for the production of income.

Placed in Service

A property is placed in service when it is ready and available for a specific use, even if it is not actually being used.

Idle Property

Continue to claim a deduction for depreciation on property used in a business or for the production of income even if it is temporarily idle (not in use). For example, if a machine is not being used because there is a temporary lack of a market for a product made with that machine, continue to deduct depreciation on the machine.

Basis of Depreciable Property

To figure the depreciation deduction, first determine the basis of the property.

Cost as Basis

The basis of property purchased is its cost, plus amounts paid for items such as sales tax, freight charges, and installation and testing fees. The cost includes the amount paid in cash, debt obligations, other property, or services.

Property Changed from Personal Use

If property held for personal use is later converted to use in a business or income-producing activity, the depreciable basis is the lesser of the following:

The fair market value (FMV) of the property on the date of the change in use.

The original cost or other basis adjusted as follows.

Increased by the cost of any permanent improvements or additions and other costs that must be added to basis.

Decreased by any deductions claimed for casualty and theft losses and other items that reduced the basis.

How to Correct Depreciation Deductions

If a taxpayer deducted an incorrect amount of depreciation in any year, the taxpayer may be able to make a correction by filing an amended return for that year.

If the taxpayer is not allowed to make the correction on an amended return, he or she may be able to change his or her accounting method to claim the correct amount of depreciation.

Filing an Amended Return

A taxpayer can file an amended return to correct the amount of depreciation claimed for any property in any of the following situations.

The taxpayer claimed the incorrect amount because of a mathematical error made in any year.

The taxpayer claimed the incorrect amount because of a posting error made in any year.

The taxpayer did not adopted a method of accounting for property placed in service in tax years ending after December 29, 2003.

The taxpayer claimed the incorrect amount on property placed in service in tax years ending before December 30, 2003.

When to file. If an amended return is allowed, the taxpayer must file it by the later of the following.

3 years from the date the original return was filed. A return filed before an unextended due date is considered filed on that due date.

2 years from the time the taxpayer paid the taxes for that year.

Changing Accounting Method

Generally, a taxpayer must get IRS approval to change his or her method of accounting. File Form 3115, Application for Change in Accounting Method, to request a change in the method of accounting for depreciation.

The following are examples of a change in method of accounting for depreciation.

A change from an impermissible method of determining depreciation for depreciable property, if the impermissible method was used in two or more consecutively filed tax returns.

A change in the treatment of an asset from nondepreciable to depreciable or vice versa.

A change in the depreciation method, period of recovery, or convention of a depreciable asset.

A change from not claiming to claiming the special depreciation allowance if the taxpayer did not make the election to not claim any special allowance.

A change from claiming a 50% special depreciation allowance to claiming a 100% special depreciation allowance for qualified property acquired and placed in service after September 27, 2017 (if the taxpayer did not make the election under section 168(k)(10) to claim 50% special depreciation allowance).

Changes in depreciation that are not a change in method of accounting (and may only be made on an amended return) include the following.

An adjustment in the useful life of a depreciable asset for which depreciation is determined under section 167.

A change in use of an asset in the hands of the same taxpayer.

Making a late depreciation election or revoking a timely valid depreciation election (including the election not to deduct the special depreciation allowance). If the taxpayer elected not to claim any special depreciation allowance, a change from not claiming to claiming the special depreciation allowance is a revocation of the election and is not an accounting method change. Generally, a taxpayer must get IRS approval to make a late depreciation election or revoke a depreciation election. The taxpayer must submit a request for a letter ruling to make a late election or revoke an election.

Any change in the placed in service date of a depreciable asset.

Modified Accelerated Cost Recovery System (MACRS)

Applies to all tangible property placed in service after 1986. There are two systems for depreciating property:

Regular MACRS also called the General Depreciation System applies to most properties.

Alternate MACRS (ADS).

Property Classes Under Regular MACRS

3-year property. Includes tractor units and race horses over 2 years old.

5-year property. Includes trucks, computers, office machinery, and automobiles.

7-year property. Includes office furniture and fixtures and any property that does not have a class life.

10-year property. Includes vessels, barges, and similar water transportation equipment, and trees or vines bearing fruit or nuts.

15-year property. Includes certain depreciable improvements made directly to land or added to it, such as shrubbery, fences, roads, and bridges.

20-year property. Includes municipal sewers and farm buildings.

Residential rental property. Depreciated over 27.5 years.

Nonresidential real property. Includes sec. 1250 property; depreciated over 39 years.

Conventions

Half-year convention. Use this convention to figure depreciation for property other than nonresidential real and residential rental property. This convention treats all property placed in service, or disposed of, during the tax year as placed in service, or disposed of, on the midpoint of that tax year.

Mid-quarter convention. Use this convention if total depreciable bases of MACRS property placed in service during the last three months of the tax year exceed 40% of the total depreciable bases of all property placed in service that year.

Mid-month convention. Use this convention for all nonresidential real and residential rental property. Treat property placed in service, or disposed of, during any month as placed in service, or disposed of, on the midpoint of that month.

Depreciation Methods

MACRS provides three depreciation methods under GDS and one depreciation method under ADS.

The 200% declining balance method over a GDS recovery period.

The 150% declining balance method over a GDS recovery period.

The straight line method over a GDS recovery period.

The straight line method over an ADS recovery period.

Alternate MACRS (ADS)

Under alternative MACRS, depreciation is figured using the straight line method but over alternate MACRS recovery period.

Property
Recovery Period
Convention

Residential rental property

30 years

Mid-month

Nonresidential real property
40 years
Mid-month

Autos & trucks

5 years

Half-year, or mid-quarter

Single purpose agricultural & horticultural structures

15 years

Half-year, or mid-quarter

Trees or vines bearing fruit or nuts

20 years

Half-year, or mid-quarter

Election

Make the election to use the alternate MACRS by the tax return due date (including extensions) for the year property is placed in service. Once the election is made to use the alternate MACRS method, the taxpayer cannot switch to any other method.

ADS must be used for the following properties:

Nonresidential real property, residential real property, and qualified improvement property held by an electing real property trade or business (as defined in section 163(j)(7)(B) of the IRC).

Any property with a recovery period of 10 years or more under the GDS held by an electing farming business (as defined in section 163(j)(7)(C) of the IRC).

Any tax-exempt use property.

Any tax-exempt bond-financed property.

All property used predominantly in a farming business and placed in service during any tax year in which an election is made not to apply the uniform capitalization rules to certain farming costs.

Any property imported from a foreign country for which an Executive Order is in effect because the country maintains trade restrictions or engages in other discriminatory acts.

Any tangible property used predominately outside the U.S. during the year.

Any listed property used 50% or less in a qualified business use during the tax year.

Accelerated Cost Recovery System (ACRS)

ACRS was used for tangible depreciable property placed in service after 1980 and before 1987. Property placed in service in those years must continue to use ACRS to figure depreciation.

All ACRS properties use the half-year convention except 19 year real property which uses the mid- month convention.

Section 179 Deduction

By electing to take a section 179 deduction, a taxpayer can expense certain qualifying property instead of depreciating the property.

Qualified Property

To qualify for the section 179 deduction, the property must meet all the following requirements:

It must be eligible property.

It must be acquired for business use.

It must have been acquired by purchase.

Eligible Property

To qualify for the section 179 deduction, the property must be one of the following types of depreciable property:

Tangible personal property.

Other tangible property (except buildings and their structural components) 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 in (a) above, or

A facility used in connection with any of the activities in (a) for the bulk storage of fungible commodities.

Single purpose agricultural (livestock) or horticultural structures.

Storage facilities (except buildings and their structural components) used in connection with distributing petroleum or any primary product of petroleum.

Off-the-shelf computer software.

Qualified section 179 real property. Qualified real property that is:

Qualified improvement property as described in section 168(e)(6) of the Internal Revenue Code, and

Any of the following improvements to nonresidential real property placed in service after the date the non-residential real property was first placed in service.

Roofs.

Heating, ventilation, and air-conditioning property.

Fire protection and alarm systems.

Security systems.

Property That Does Not Qualify

The following properties do not qualify for the Section 179 deduction.

Land and land improvements including buildings paved parking areas and fences.

Certain property leased to others (if taxpayer is a noncorporate lessor).

Property used predominantly outside the U.S. except property described in section 168(g)(4) of the IRC.

Property used by certain tax-exempt organizations, except property used in connection with the production of income subject to the tax on unrelated trade or business income.

Property used by governmental units or foreign per-sons or entities, except property used under a lease with a term of less than 6 months.

Property acquired from a related person.

Partial Business Use

To elect the section 179 deduction, more than 50% of the properties' use must be for trade or business. If property is used for both business and personal, allocate the cost of the property to reflect only the business use by multiplying the cost by the percentage of business use.

Trade-in of Other Property

If the qualifying property was purchased with cash and a trade-in, its cost for purposes of the section 179 deduction includes only the cash paid.

Deduction Limit

For 2022, the maximum section 179 expense deduction is $1,080,000.

Investment Limit

For each dollar that the cost for section 179 property is over $2,700,000, reduce the $1,080,000 limit by one dollar. If the cost of section 179 property placed in service during the tax year is $3,780,000 or more, no section 179 deduction is allowed.

Taxable Business Income Limit

The total amount expensed cannot exceed the taxable income from all trade and businesses for that year. Excess amount must be carried over to the next year and figured into the section 179 deduction for that year.

Depreciation Limits on Cars, Trucks, and Vans

The first-year limit on the total amount of section 179 deduction, special depreciation allowance, and depreciation deduction that can be claimed for passenger autos, including trucks and vans and placed in service in 2022 is $19,200 ($11,200 if electing not to claim the special depreciation allowance). The maximum section 179 expense deduction for sport utility vehicles placed in service in tax years beginning in 2022 is $27,000.

Election

To take the section 179 deduction, complete Part I of Form 4562.

Place in Service Rule

For purposes of the section 179 deduction, a property is placed in service in the tax year if it is first made ready and available for a specific use. For example, if the property is first made ready and available in 2021 but is not actually used until 2022, the property is considered placed in service in 2021.

Partnerships and Partners

The section 179 deduction limits apply both to the partnership and to each partner.

The partnership determines its section 179 deduction subject to the limits. It then allocates the deduction among its partners. Each partner adds the amount allocated from partnerships to his or her nonpartnership section 179 costs and then applies the dollar limit to this total. To determine any reduction in the dollar limit for costs over $2,700,000, the partner does not include any of the cost of section 179 property placed in service by the partnership. After the dollar limit (reduced for any nonpartnership section 179 costs over $2,700,000) is applied, any remaining cost of the partnership and nonpartnership section 179 property is subject to the business income limit.

S Corporations and shareholders

Generally, the rules that apply to a partnership and its partners also apply to an S corporation and its shareholders. The deduction limits apply to an S corporation and to each shareholder. The S corporation allocates its deduction to the shareholders who then take their section 179 deduction subject to the limits.

Section 179 Recapture

A taxpayer may have to recapture the section 179 deduction if, in any year during the property’s recovery period, the business use drops to 50% or less. In the year the business use drops to 50% or less, the taxpayer must report as ordinary income the difference between the amount taken as a section 179 deduction and the amount of depreciation that would have been allowable on the property.

Where to Figure and Report Recapture

Use Form 4797, Part IV, to figure the recapture amount.

Report the recapture amount as other income on the same form or schedule used to take the depreciation deduction. For example, report the recapture amount as other income on Schedule C (Form 1040 or 1040-SR) if the depreciation deduction was taken on Schedule C. If the depreciation deduction was taken on Form 2106, report the recapture amount as other income on Schedule 1 (Form 1040 or 1040-SR).

Claiming the Special Depreciation Allowance

For certain qualified property acquired after September 27, 2017 and before January 1, 2023, a taxpayer can take an additional 100% special allowance. The allowance is an additional deduction taken after any section 179 deduction and before figuring regular depreciation under MACRS.

Qualified Property

Qualified property is one of the following:

Qualified reuse and recycling property.

Certain qualified property acquired after September 27, 2017.

Certain plants bearing fruits and nuts.

Certain Qualified Property Acquired After September 27, 2017

A taxpayer can take a 100% special depreciation deduction allowance for certain qualified property acquired after September 27, 2017 and before January 1, 2023. Qualified property is one of the following:

Tangible property depreciated under MACRS with a recovery period of 20 years or less.

Computer software defined in and depreciated under section 167(f)(1) of the IRC.

Water utility property.

Qualified film, television, and live theatrical productions, as defined in sections 181(d) and (e) of the IRC.

A specified plant for which the taxpayer made the election to apply section 168(k)(5) for the tax year in which the plant is planted or grafted.

It is not excepted property.

Electing Out of the Special Depreciation Allowance

A taxpayer can elect, for any class of property, to not deduct any special depreciation for all such property during the tax year. To make the election, attach a statement with the return.

Section 197 Intangibles

Section 197 intangibles acquired after August 10, 1993, must be amortized over 15 years. The following assets are section 197 intangibles:

Goodwill.

Going concern value.

Workforce in place.

Business books and records, operating systems, or any other information base, including lists or other information concerning current or prospective customers.

A patent, copyright, formula, process, design, pattern, know-how, format, or similar item.

A customer-based intangible.

A supplier-based intangible.

A license, permit, or other right granted by a governmental unit or agency (including issuances and renewals).

A covenant not to compete entered into in connection with the acquisition of an interest in a trade or business.

A franchise, trademark, or trade name.

Depletion

Depletion is the using up of natural resources by mining, quarrying, drilling, or felling. The depletion deduction allows an owner or operator to account for the reduction of a product's reserves. Depletion can be deducted for mineral property or standing timber.

Mineral Property

Mineral property includes oil and gas wells, mines, and other natural deposits (including geothermal deposits). There are two ways of figuring depletion on mineral property:

Cost depletion.

Percentage depletion.

Use the method that gives the larger deduction. However, unless the taxpayer is an independent producer or royalty owner, the taxpayer generally cannot use percentage depletion for oil and gas wells.

Timber

Figure timber depletion only by the cost method. Percentage depletion does not apply to timber.

Limitation on Losses

Net Operating Loss (NOL)

If a taxpayer's business deductions are more than business income, the taxpayer may have an NOL. Examples of typical losses include, but are not limited to, losses from the following:

A trade or business.

Unreimbursed employee business expenses (only for employees still eligible to take employee business expenses).

Casualty and theft losses resulting from a federally declared disaster.

Moving expenses (only for member of the Armed Forces on active duty that qualify to deduct moving expenses).

Rental property.

How to Figure an NOL

Separate business income and deductions from non-business income and deductions.

Business Income

The following are business income for figuring an NOL:

Gross receipts from trade or business.

Salary or wages earned.

Share of income from partnerships or S corporations.

Rental income.

Gain from the sale or exchange of depreciable property or real estate used in business.

Business Deductions

The following are deductions that are connected to a trade or business:

If itemizing deductions, casualty and theft losses resulting from a federally declared disaster (even if they involve nonbusiness property).

Moving expenses.

State income tax on income attributable to trade or business (including wages, salary, and unemployment compensation).

Rental losses.

The deduction for the deductible part of self-employed health insurance and the deduction for the deductible part of self-employment tax.

Domestic production activities deduction.

Loss on sale or exchange of business real estate or depreciable property.

Loss on the sale of accounts receivable (if an accrual basis taxpayer).

Ordinary loss on the sale or exchange of section 1244 (small business) stock.

Business loss from a partnership or S corporation.

Interest and litigation expenses on state and federal income taxes related to business.

Unrecovered investment in a pension or annuity claimed on a decedent’s final return.

Ordinary loss on the sale or exchange of stock in a small business corporation or a small business investment company.

Educator expenses.

Payment by a federal employee to buy back sick leave in an earlier year.

Figure an NOL without deducting the following items:

Capital losses in excess of capital gains.

The section 1202 exclusion of the gain from the sale or exchange of qualified small business stock.

Nonbusiness deductions in excess of nonbusiness income.

Net operating loss deduction.

The section 199A deduction for qualified business income.

Nonbusiness Income
Nonbusiness Deductions

Dividends.

Alimony paid.

Interest.
Deductions for contributions to an IRA or a self-employed retirement plan.

Annuities.
HSA and Archer MSA deductions.

Income from endowments.
Most itemized deductions (except casualty and theft losses, state income tax on business income, and any employee business expenses.)

The standard deduction.

Charitable deduction if taking the standard deduction.

Business Income - Business Deductions = NOL

Ignore NOL carryover from previous years when computing NOL.

When to use an NOL:

Carryback: No carryback.

Carryforward: Indefinitely

Exceptions to the No Carryback Rule

Farming losses qualify for a 2-year carryback period. Only the farming loss part of an NOL can be carried back 2 years.

Farming loss. A farming loss is the smaller of:

The amount that would be the NOL for the tax year if only income and deductions attributable to farming businesses were taken into account, or

The NOL for the tax year.

NOL Limitation

The NOL deduction cannot exceed 80% of taxable income (determined without any NOL deduction) for losses arising in tax years beginning after 2017.

Electing to Forgo Carryback Period

A taxpayer can choose not to carry back an NOL due to farming loses. If this choice is made, carry the NOL forward indefinitely until it is used. To make this choice, attach a statement to the original return filed by the due date (including extensions) for the NOL year. This statement must show that the taxpayer is choosing to waive the carryback period under section 172(b).

Deducting a Carryback

If carrying back an NOL, use either Form 1045 or Form 1040X. A taxpayer can get a refund faster by using Form 1045, but has a shorter time to file it (no later than one year after the end of the NOL year). Use Form 1045 to apply an NOL to all carryback years.

Not for Profit Activities

These activities are considered hobbies and the losses are limited to the income from such activities.

The losses cannot be used to offset other income. The limit on not-for-profit losses applies to individuals, partnerships, estates, trusts, and S corporations. It does not apply to corporations other than S corporations. In determining whether an activity is carried on for a profit, several factors are taken into account. No one factor alone is decisive. Among the factors to consider are whether:

The activity was carry on in a businesslike manner.

The time and effort put into the activity.

The taxpayer depends on the income for his or her livelihood.

Losses are due to circumstances beyond the control of the taxpayer (or are normal in the start-up phase of that type of business).

Changes in methods of operation are made in an attempt to improve profitability.

The taxpayer (or advisors) have the knowledge needed to carry on the activity as a successful business.

The taxpayer was successful in making a profit in similar activities in the past.

The activity makes a profit in some years.

The taxpayer can expect to make a future profit from the appreciation of the assets used in the activity.

Presumption of Profit

An activity is presumed to be carried on for profit if it produced a profit in at least:

3 of the last 5 years, or

2 of the last 7 years for activities in breeding, training, showing or racing horses.

Form 5213

By filing Form 5213, a taxpayer can postpone any determination that the activity is not carried on for profit until 5 (or 7) years have passed since starting the activity. The benefit gained by making this election is that the IRS will not immediately question whether the activity is engaged in for profit.

Limit on Deductions

Deductions taken for personal as well as for business activities are allowed in full.

For individuals, all nonbusiness deductions, such as those for home mortgage interest, taxes, and casualty losses (attributed to a federally declared disaster) may also be deducted. Miscellaneous itemized deductions subject to the 2% of AGI are no longer deductible.

The limit on not-for-profit losses applies to individuals, partnerships, estates, trusts, and S corporations. It does not apply to corporations other than S corporations.

Partnerships and S corporations

If a partnership or S corporation carries on a not-for-profit activity, these limits apply at the partnership or S corporation level. They are reflected in the individual shareholder's or partner's distributive shares.

At-Risk Limits

The at-risk rules limit losses from most activities to the loss or the amount at risk, whichever is less.

Amount at Risk:

The money and adjusted basis of property contributed to the activity, and

Amounts borrowed for use in the activity are at-risk if:

The taxpayer is personally liable for repayment, or

The taxpayer pledges property (other than property used in the activity) as security for the loan.

Amounts Borrowed

A taxpayer is at risk if the amounts borrowed are secured by property other than property used in the activity. In this case, the amount considered at risk is the net fair market value of the taxpayer's interest in the pledged property.

Passive Activity Limits

Who Must Use These Rules?

The passive activity rules apply to:

Individuals.

Estates.

Trusts (other than grantor trusts).

Personal service corporations.

Closely held corporations.

Even though the rules do not apply to grantor trusts, partnerships, and S corporations directly, they do apply to the owners of these entities.

Types of Passive Activities

Two types of passive activities:

Trade or business activity in which the taxpayer does not materially participate.

Rental activity, even if materially participated in them, unless a real estate professional.

Loss Limits

Deduct losses up to income from passive activities. Cannot offset income, other than passive income, with losses from passive activities.

Exception: Deduct up to $25,000 ($12,500 for MFS) of losses from rental real estate, in which the taxpayer actively participated, from non-passive income.

Note: First determine the amount at risk, before using the passive activity rules.

Material Participation

A trade or business activity is not a passive activity if the taxpayer materially participated in the activity.

Material Participation Tests

A taxpayer materially participated in a trade or business activity for a tax year if any of the following tests is met:

The taxpayer participated in the activity for more than 500 hours.

The taxpayer participation was substantially all the participation in the activity of all individuals for the tax year, including the participation of individuals who did not own any interest in the activity.

The taxpayer participated in the activity for more than 100 hours during the tax year, and participated at least as much as any other individual (including individuals who did not own any interest in the activity) for the year.

The activity is a significant participation activity, and the taxpayer participated in all significant participation activities for more than 500 hours. A significant participation activity is any trade or business activity in which the taxpayer participated for more than 100 hours during the year and in which the taxpayer did not materially participate under any of the material participation tests, other than this test.

The taxpayer materially participated in the activity for any 5 (whether or not consecutive) of the 10 immediately preceding tax years.

The activity is a personal service activity in which the taxpayer materially participated for any 3 (whether or not consecutive) preceding tax years. An activity is a personal service activity if it involves the performance of personal services in the fields of health (including veterinary services), law, engineering, architecture, accounting, actuarial science, performing arts, consulting, or any other trade or business in which capital is not a material income-producing factor.

Based on all the facts and circumstances, the taxpayer participated in the activity on a regular, continuous, and substantial basis during the year.

General Business Credits

Types of General Business Credits

The general business credit includes the following credits:

Credit for increasing research activities (Form 6765). The credit is 20% of the amount by which research expenses for the year are more than the average base period amount.

Investment credit (Form 3468). The investment credit is the total of the following credits:

Rehabilitation Credit.

Business Energy Credit.

Qualifying Advance Coal Project Credit.

Qualifying Gasification Project Credit.

Qualifying Advance Energy Project Credit.

Low-income housing credit (Form 8586). The credit applies to qualified low-income housing buildings placed in service after 1986.

Disabled access credit (Form 8826). The credit is 50% of the amount of eligible access expenditures incurred to make a business accessible to disabled individuals.

Biodiesel and renewable diesel fuels credit. For certain fuel sold or used in business.

Orphan drug credit (Form 8820). The credit is 25% of qualified expenses incurred in testing certain drugs for rare diseases and conditions.

Renewable electricity, refined coal, and Indian coal production credit (Form 8835). The credit is 1.5 cents per kilowatt hour of electricity produced from a qualified energy resource at a qualified facility during the 10-year period after the facility is placed in service.

Empowerment zone and renewal community employment credit (Form 8844). Employer located in empowerment zones are entitled to a 20% wages credit on the first $15,000 of annual wages paid to residences of the empowerment zone.

Credit for employer social security and Medicare taxes paid on certain employee tips (Form 8846). The credit is equal to the employer’s portion of social security and Medicare taxes paid on tips received by employees of a food and beverage establishment.

Qualified plug-in electric drive motor vehicle credit (Form 8936). This credit is for new qualified plug-in electric drive motor vehicles placed in service during the tax year.

Credit for employer-provided childcare facilities and services (Form 8882). The credit is 25% of qualified expenses an employer pays for childcare and 10% of qualified expenses paid for childcare resources and referral services. This credit is limited to $150,000 each year.

Credit for small employer pension plan startup costs (Form 8881). This credit applies to pension plan setup costs. The credit equals 50% of the cost to set up and administer the plan, up to $500 per year for each of the first 3 years of the plan.  A taxpayer can choose to start claiming the credit in the tax year before the tax year in which the plan becomes effective.

Credit for small employer health insurance premiums (Form 8941). For eligible small employers, the maximum credit is 50% (35% for tax-exempt small employers) of premiums paid and can be taken against both regular and alternative minimum tax. The credit is claimed as part of the general business credit on Form 3800. An eligible small employer is an employer with fewer than 25 full-time employees and the average wages for the tax year is less than $58,000 per employee.

Credit for paid family and medical leave (Form 8994). An eligible employer uses Form 8994 to figure the employer credit for paid family and medical leave. The credit ranges from 12.5% to 25% of certain wages paid to a qualifying employee while the employee is on family and medical leave.

Work opportunity credit (Form 5884). An employer can take this credit for qualified first-year wages paid to the following targeted groups:

Qualified recipient of Temporary Assistance for Needy Families (TANF).

A qualified veteran.

A qualified ex-felon.

Long-term family assistance recipient.

A vocational rehabilitation referral.

A qualified summer youth employee.

Designated community resident.

An SSI recipient.

Supplemental Nutrition Assistance Program (SNAP) benefits (food stamps) recipient.

A qualified long-term unemployment recipient.

Limitations on Business Credits

The general business credit is limited to the taxpayer's net income tax minus the larger of:

Tentative minimum tax, or

25% of income tax liability that is more than $25,000.

Carryback and Carryforward Unused Credit

Carry unused credit back one year. The remaining amount is carried forward 20 years.

Excise Taxes

Form 720

The federal excise taxes reported on Form 720, Quarterly Federal Excise Tax Return, consist of several broad categories of taxes, including the following:

Fuel taxes.

Communications and air transportation taxes.

Retail tax on heavy trucks, trailers, and tractors.

Environmental taxes on crude oil and petroleum products, the sale or use of ozone-depleting chemicals and imported products containing or manufactured with these chemicals.

Manufacturers taxes on the sales or use of a variety of different articles.

When to File Form 720

Form 720 is required to be filed for each quarter of the calendar year on the following dates:

Quarter covered | Due date
January - March | April 30
April - June | July 31
July - September | October 31
October - December | January 31

Payment of Excise Taxes

Generally, semimonthly deposits of excise taxes are required. A semimonthly period is the first 15 days of a month (the first semimonthly period) or the 16th through the last day of a month (the second semimonthly period). However, no deposit is required for the situations listed below; the taxes are payable with Form 720:

The net liability for taxes listed in Part I (Form 720) does not exceed $2,500 for the quarter.

The gas guzzler tax is being paid on a one-time filing.

The liability is for taxes listed in Part II (Form 720), except for the floor stocks tax which generally requires a single deposit.

When to Make Deposit

There are two methods for determining deposits:

Regular method. The deposit of tax for a semimonthly period is due by the 14th day following that period. Generally, this is the 29th day of a month for the first semimonthly period and the 14th day of the following month for the second semimonthly period.

Alternative method. Deposits of communications and air transportation taxes may be based on taxes included in amounts billed or tickets sold during a semimonthly period instead of on taxes actually collected during the period. Under the alternative method, the tax included in amounts billed or tickets sold during a semimonthly period is considered collected during the first 7 days of the second following semimonthly period. The deposit of tax is due by the 3rd banking day after the 7th day of that period.

Highway Use Tax

Vehicles Subject to the Highway Use Tax

A truck or truck tractor is subject to the highway use tax if it meets all the following tests:

It is a highway motor vehicle.

It is required to be registered for highway use.

It is used on a public highway.

It has a taxable gross weight of at least 55,000 pounds.

Note: If the vehicle is expected to be used for 5,000 miles or less (7,500 miles or less for agricultural vehicles) the highway use tax liability may be suspended during that particular tax period. Form 2290 must still be filed and the taxpayer must sign the Statement in Support of Suspension of Tax. The vehicle will be exempt from the use tax if its public highway use does not exceed 5,000 miles during the tax period.

Filing Form 2290

Form 2290, Heavy Highway Vehicle Use Tax Return, must be filed by the last day of the month after the month the vehicle is first used on the public highways. The tax period runs from July 1 of the current year through June 30 of the next year. File a single return for all vehicles first used in the same month.

Required e-Filing

If reporting 25 or more trucks on a return (Form 2290), the taxpayer must file electronically.

Paying the Tax

The tax must be paid when filing Form 2290 or the taxpayer can elect to make payment in four equal installments.  

Chapter Six - Business Assets

Business Assets

Chapter Six is all about computing the basis of business assets. Basis is the amount of business investment in property for tax purposes. Basis must be known in order to figure depreciation, amortization, depletion and casualty losses, as well as gain or loss on the sale of property. It is important that an Enrolled Agent know how to accurately calculate property basis, and it is a key skill that is assessed by Part 2 of the Enrolled Agent Exam.

In This Chapter

Property Basis

Sale of Business Property

Nontaxable Property Transactions

Basis of Property

Purchase of Property

The cost basis of property is the amount of cash paid and the FMV of other property or services provided in the transaction. The following must also be included in the basis:

Sales and excise taxes on the purchase.

Freight charges to obtain the property.

Installation and testing charges.

Excise taxes.

Legal and accounting fees (when they must be capitalized).

Revenue stamps.

Recording fees.

Real estate taxes (if assumed for the seller).

Purchase of Real Property

If property purchased is real property, the following fees and other expenses are part of the basis in the property:

Real estate taxes owed by the seller paid by the buyer.

Assumption of existing mortgage. Basis includes amount paid on the mortgage assumed.

Settlement costs. The following are some of the settlement costs included in basis:

Abstract fees.

Charges for installing utility services.

Surveys.

Transfer taxes.

Title insurance.

Recording fees.

Legal fees (including title search and preparing sales contract and deed).

Any amounts the seller owes that the purchaser pays such as back taxes, closing costs, sales commissions, interest, etc.

Settlement costs do not include amounts placed in escrow for future payments such as taxes and insurance. The following settlement costs cannot be included in the basis of the property:

Casualty insurance premiums.

Rent for occupancy of the property before closing.

Charges for utilities or other services relating to occupancy of the property before closing.

Charges connected with getting a loan, such as points, mortgage insurance premiums, loan assumption fees, cost of a credit report, and fees for an appraisal required by lender.

Fees for refinancing a mortgage.

Property Received by Gift

Figuring the Basis

The following three amounts must be known to figure the basis of property received by gift:

The fair market value (FMV) of property at time of gift.

Adjusted basis in hand of donor.

Amount of gift tax paid.

FMV less than donor's adjusted basis:

Basis is donor's adjusted basis in figuring depreciation and gain when sold.

Basis is FMV when figuring loss when sold.

FMV equal to or more than the donor's adjusted basis:

Basis is donor's adjusted basis, and

Part of the gift tax paid, depending on the date of gift.

Gift received before 1977: Increase basis by the total gift tax paid.

Gift received after 1976: Increase basis by part of the gift tax paid:

Donee's basis = Donor's adjusted basis + gift tax × ((FMV - Donor's adj. basis) ÷ (FMV - annual gift tax exclusion for the year of the gift))

Inherited Property

Basis in property inherited from a decedent is generally one of the following:

FMV at the date of the decedent's death.

FMV at the alternative valuation date, if the estate elects to use alternative valuation on the federal estate tax return.

The value under the special-use valuation method for real property used in farming or a closely held business if chosen for estate tax purposes.

The decedent’s adjusted basis in land to the extent of the value excluded from the decedent’s taxable estate as a qualified conservation easement.

Note: If a federal estate tax return does not have to be filed, basis in the property is its appraised value at the date of death for state inheritance or transmission taxes.

Appreciated Property

The above rule does not apply to appreciated property received from a decedent if a taxpayer or taxpayer’s spouse originally gave the property to the decedent within 1 year before the decedent's death.

The taxpayer’s basis in this property is the same as the decedent's adjusted basis in the property immediately before his or her death, rather than its FMV. Appreciated property is any property whose FMV on the day it was given to the decedent is more than its adjusted basis.

Community Property

In community property states (Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin), married individuals are each usually considered to own half the community property.

When either spouse dies, the total value of the community property, even the part belonging to the surviving spouse, generally becomes the basis of the entire property. For this rule to apply, at least half the value of the community property interest must be includable in the decedent's gross estate, whether or not the estate must file a return.

Qualified Joint Interest

Include one-half of the value of a qualified joint interest in the decedent's gross estate. It does not matter how much each spouse contributed to the purchase price. Also, it does not matter which spouse dies first.

A qualified joint interest is any interest in property held by married individuals as either of the following.

Tenants by the entirety, or

Joint tenants with right of survivorship if the married couple are the only joint tenants.

Basis. The surviving spouse's basis in the property owned with his or her spouse as a qualified joint interest is the cost of the surviving spouse's half of the property with certain adjustments. Decrease the cost by any deductions allowed to the surviving spouse for depreciation and depletion. Increase the reduced cost by the basis in the half inherited.

Property Received for Services

Property received for services must be included in income at its FMV. The FMV becomes the basis in the property. If the services were performed for a price agreed on beforehand, it will be accepted as the FMV of the property if there is no evidence to the contrary.

Property Purchased from Employer below FMV

Include in income the difference between the purchase price and the FMV.

Exception: The difference represents a qualified employee discount.

Restricted Property

If property received for services is subject to certain restrictions, the basis in the property is its FMV when it becomes substantially vested unless the taxpayer makes a section 83(b) election. The property is substantially vested when it is transferable or not subject to a risk of forfeiture (losing the property).

Section 83(b) Election

The taxpayer can choose under IRC section 83(b) to include the property in income in the year of transfer. If the election is taken the basis of the property will be the FMV at the date of transfer.

Involuntary Conversions

If property is received as a result of an involuntary conversion, such as a casualty, theft, or condemnation, figure the basis of the replacement property receive using the basis of the converted property.

Similar or Related Property

If the replacement property is similar or related in service or use to the converted property, the replacement property's basis is the old property's basis on the date of the conversion. However, make the following adjustments.

Decrease the basis by the following.

Any loss recognized on the conversion, and

Any money received that was not spend on similar property.

Increase the basis by the following.

Any gain recognized on the conversion, and

Any cost of acquiring the replacement property.

Money or Property Not Similar or Related

If a taxpayer received money or property not similar or related in service or use to the converted property, and the taxpayer buys replacement property similar or related in service or use to the converted property, the basis of the new property is its cost decreased by the gain not recognized on the conversion.

Allocating the Basis

If purchasing more than one piece of replacement property, allocate the basis among the properties based on their respective costs.

Property Changed to Business or Rental Use

If a taxpayer holds a property for personal use and then change it to business use or use it to produce rent, the taxpayer must figure its basis for depreciation.

Basis for the Sale of the Property

The basis of the property sold will depend on whether the taxpayer is figuring a gain or loss.

Gain. The basis for figuring a gain is the adjusted basis when the property is sold.

Loss. Figure the basis for a loss by starting with the smaller of the adjusted basis or the FMV of the property at the time of the change to business or rental use. Then adjust this amount for the period after the change in the property's use to arrive at a basis for loss.

Nontaxable Exchanges

A nontaxable exchange is an exchange of real property used in a business or held for investment for other real property used for business or investment real property of a like-kind.

Like-Kind Exchanges

To be nontaxable, a like-kind exchange must meet all of the following conditions:

Both the property transferred and the property received must be real property used in a trade or business or investment property.

The real property must not be held primarily for sale.

There must be an exchange of like-kind real property.

Real property to be received must be identified within 45 days after the date of transfer of the real property given up in the exchange.

The exchange must be completed on or before the earlier of:

The 180th day after the date the property being exchanged was transferred, or

The due date, including extensions, for filing that year's tax return.

The following are examples of like-kind exchanges:

An exchange of one rental property (e.g., apartment house) with another rental property (e.g., rented store building).

An exchange of city property for farm land.

An exchange of improved real property for unimproved real property.

An exchange of real estate owned for a real estate lease that runs 30 years or more.

Not Like-Kind Property

The rules of like-kind exchanges do not apply to the following property:

Real property used for personal purposes such as a home.

Real property held primarily for sale.

Any personal or intangible property.

Basis of Property

The basis of property received in a nontaxable exchange is the same as the basis of the property exchanged:

Decreased by any money received and any loss recognized on the exchanged, and

Increased by any additional cost incurred and any gain recognized on the exchange.

Stock Dividends, Rights, and Splits

Basis of Stock

The basis is the purchase price plus the cost of the purchase such as commissions or recording fees.

Taxable Distribution

The basis in a taxable stock dividend or stock right is its FMV at the time of the distribution.

Nontaxable Distribution

Considered a return of capital; Reduce basis by distribution amount.

Stock Dividend or Split

The basis per share of stock must be adjusted if additional stock is received through stock dividend or splits.

Example: Purchased 50 shares of ABC Corp stock for $1,500 or $30 a share in 2020.

Purchased 100 shares of ABC Corp stock for $4,500 or $45 a share in 2021. ABC declares a 3-for-2 stock split in 2022.

Basis in stock in 2022:

50 × 3/2 = 75 shares with a basis of $1,500 ÷ 75 = $20 a share

100 × 3/2 = 150 shares with a basis of $4,500 ÷ 150 = $30 a share

Note: The total basis amount does not change.

Property Transfers between Spouses

No gain or loss is recognized on a transfer of property from an individual to (or in trust for the benefit of) a spouse or, if incident to a divorce, a former spouse. This nonrecognition rule does not apply in the following situations:

The recipient spouse or former spouse is a nonresident alien.

Property is transferred in trust. Gain must be recognized to the extent the amount of the liabilities assumed by the trust, plus any liabilities on the property, exceed the adjusted basis of the property.

Basis in Transferred Property

The transferee's basis in the property will be the same as the adjusted basis of the transferor. However, for property transferred in trust, the basis is adjusted for any gain recognized by the transferor if the liabilities assumed, plus the liabilities to which the property is subject, are more than the adjusted basis of the property transferred.

Adjustments to Basis

Increases to Basis:

Cost of improvements that add to the value of the property.

Rehabilitation expenses.

The cost of extending utility service lines to the property.

Legal fees, such as the cost of defending and perfecting title.

Legal fees for obtaining a decrease in an assessment levied against property.

Zoning costs.

The capitalized value of a redeemable ground rent.

Assessments for local improvements.

Decreases to Basis:

Section 179 deduction.

Nontaxable corporate distribution.

Recognized losses on involuntary exchanges.

Deduction for allowed or allowable depreciation, amortization, and depletion.

Casualty and theft losses.

Certain vehicle credits.

Easements.

Residential energy credit.

Rebates received from the manufacturer or seller.

Investment credit (part or all of credit) taken.

Postpone gain from sale of home.

Certain canceled debt excluded from income.

Rebates treated as adjustments to the sales price.

Partial disposition of MACRS property, whether electing to recognize the partial disposition or are required to recognize it.

Allocating the Basis

If a group of assets in a trade or business are acquired, allocate the purchase price to the various assets acquired. Allocate the business assets received in proportion to (but not more than) their fair market value in the following order:

Cash, demand deposits, and similar accounts.

Certificates of deposits, U.S. Government securities, readily marketable stock or securities, and foreign currency.

Property that would be included in inventory or held for sale to customers.

Accounts receivable, mortgages, and credit card receivables that arose in the ordinary course of business.

All other assets except section 197 intangibles, goodwill, and going concern value.

Section 197 intangibles except goodwill and going concern value.

Goodwill and going concern value (whether or not they qualify as section 197 intangibles.

Goodwill

Intangible property that represents the advantage or benefit acquired in a business beyond the value of its other assets. Other section 197 intangibles include patents, copyrights, franchise, trademark, and trade name.

Reporting Requirement

Both the buyer and seller involved in the sale of business assets must report to the IRS the allocation of the sales price among section 197 intangibles and the other business assets. Use Form 8594 to provide this information. The buyer and seller should each attach Form 8594 to their federal income tax return for the year in which the sale occurred.

Sale of Business Property

Section 1231 Property

Section 1231 property is property used in a trade or business and held for more than one year.

Gains and Losses

Net section 1231 gains are treated as long-term capital gains. Net section 1231 losses are treated as ordinary losses.

Recapture of Net Ordinary Losses

A net section 1231 gain is treated as ordinary income up to non-recaptured net section 1231 losses taken in prior years. Any net gains in excess of recaptured net losses in prior years are treated as long-term capital gains.

Nonrecaptured Section 1231 Losses

Net section 1231 losses deducted for the previous five tax years that have not yet been applied against a net section 1231 gain.

Section 1231 Transactions

The following transactions result in gain or loss subject to section 1231 treatment:

Sales or exchanges of real property or depreciable personal property.

Sales or exchanges of leaseholds.

Sales or exchanges of cattle and horses (held longer than 2 years). Does not include poultry.

Sales or exchanges of other livestock.

Sales or exchanges of unharvested crops.

Cutting of timber or disposal of timber, coal, or iron ore.

Condemnations.

Casualties and thefts.

Section 1245 property

Property that is or has been subject to an allowance for depreciation and that is one of the following:

Personal property (both tangible and intangible).

Other tangible property used as an integral part of manufacturing, production or extraction or furnishing transportation, communication, electricity, gas, water, or sewage disposal services; a research facility in any activity listed above; a facility in any of the activities listed above for bulk storage of fungible commodities.

Real property to the extent that its adjusted basis was reduced by amortization deductions for certified pollution control facilities, reforestation expenditures, on-the-job training and child care facilities, or for which a section 179 deduction was taken.

Single purpose agricultural (livestock) or horticultural structures.

Storage facilities (except buildings and their structural components) used in distributing petroleum or any primary product of petroleum.

Treatment of Gain

The amount of gain treated as ordinary income is limited to the lesser of the following amounts:

The depreciation and amortization allowed or allowable on the property.

The gain on the disposition (amount realized minus adjusted basis).

Section 1250 Property

Section 1250 includes all real property that is subject to an allowance for depreciation and that is not and never has been section 1245 property. It includes a leasehold of land or section 1250 property subject to an allowance for depreciation. A fee simple interest in land is not included because it is not depreciable.

Treatment of Gain

The amount of gain treated as ordinary income is the excess depreciation deducted over depreciation figured using the straight line method.

Installment Sales

If a taxpayer sells property under the installment method, any depreciation recaptured under section 1245 or 1250 is taxable as ordinary income in the year of the sale, even if no payments are received in that year.

Nontaxable Property Transactions

Like-Kind Exchanges between Related Parties

Special rules limit whether certain exchanges made between related parties are nontaxable. Under these rules, if either party disposes of the property within 2 years after the exchange, the exchange is disqualified from nonrecognition treatment. Exceptions to these rules are the following:

Dispositions due to the death of either related party.

Involuntary conversions.

Exchanges or dispositions if it is established that their main purpose is not the avoidance of federal income tax.

Partially Nontaxable Exchange

Any money or unlike property received in a like-kind exchange is taxable, but only to the extent of the gain realized in the transaction.

To figure the amount of the taxable gain, first determine the FMV of any unlike property received and add it to the amount of any money received then subtract any exchange expenses paid along with the adjusted basis of the property transferred. In a like-kind, if a taxpayer paid any money in addition to giving up like property, there is no taxable gain or deductible loss.

Assumption of Liabilities

If the other party to a nontaxable exchange assumes any liabilities on property they receive, treat this transfer of liabilities as cash received in the amount of the liability.

Chapter Seven - Estate and Trust Income Tax

Estate and Trust Income Tax

When a taxpayer dies, a legal entity called an estate is created. The term "estate" refers the money and property owned by the deceased taxpayer, and it may be subject to federal estate tax. A trust is another legal entity subject to federal tax. Estates and Trusts both report income using Form 1041. Chapter seven is designed to give you an understanding of which taxes apply to estates and trusts, which do not apply, and covers the related information likely to be assessed on the Enrolled Agent Exam.

In This Chapter

Estate Income Tax

Final Return for Decedent

Income Tax Return for Estates

Distributions to Beneficiaries

Trust Income Tax

What is a Trust

Types of Trusts

Personal Exemption

Distributive Net Income

Estate Income Tax

Final Return for Decedent (Form 1040 or 1040-SR)

Name and Address on Return

Write the word “DECEASED,” the decedent's name, and the date of death across the top of the tax return. If filing a joint return, write the name and address of the decedent and the surviving spouse in the name and address fields. If a joint return is not being filed, write the decedent's name in the name field and the personal representative's name and address in the address field.

Filing Requirements

Filing requirement are the same as if the decedent had not died.

Return Due Date

The final income tax return is due at the same time the decedent's return would have been due had death not occurred. A final return for a decedent who was a calendar year taxpayer is generally due on April 15 following the year of death, regardless of when during that year death occurred. A tax return for a decedent can be electronically filed.

Income to Include

The decedent's income includible on the final return is generally determined in the same way as if the person was still alive except that the taxable period is usually shorter because it ends on the date of death.

The method of accounting used by the decedent (cash or accrual method) before death also determines the income includible on the final return. If the decedent uses the cash method, only income actually or constructively received before death is included in the final return. If the decedent uses the accrual method, income is reported when earned.

Deductions

Generally, the rules for exemptions and deductions allowed to an individual also apply to the decedent's final income tax return.

Standard Deduction

If the decedent does not itemize deductions, the full amount of the standard deduction is allowed, regardless of the date of death.

Medical Expenses

Medical expenses not paid before death are liabilities of the estate and are shown on the federal estate tax return (Form 706).

However, if medical expenses for the decedent are paid out of the estate during the 1-year period beginning with the day after death, an election can be made to treat all or part of the expenses as paid by the decedent at the time they were incurred. The amount that can be deducted on the income tax return is the amount above 7.5% of adjusted gross income. Amounts not deductible because of this percentage cannot be claimed on the federal estate tax return.

Deduction for Losses

A decedent's net operating loss deduction from a prior year and any capital losses (including capital loss carryovers) can be deducted only on the decedent's final income tax return.

Credits

On the final income tax return, claim any tax credits that applied to the decedent before death.

Payments of Tax

The income tax withheld from the decedent's salary, wages, pensions, or annuities, and the amount paid as estimated tax are advance payments of tax that must be claimed on the final return.

Refund

Form 1310, Statement of Person Claiming a Refund Due a Deceased Taxpayer, does not have to be filed if claiming a refund and the individual filing the return is:

A surviving spouse filing an original or amended joint return with the decedent, or

A court-appointed or certified personal representative filing the decedent’s original return and a copy of the court certificate showing the appointment is attached to the return.

If the personal representative is filing a claim for refund on Form 1040X, Amended U.S. Individual Income Tax Return, or Form 843, Claim for Refund and Request for Abatement, and the court certificate has already been filed with the IRS, attach Form 1310 and write “Certificate Previously Filed” at the bottom of the form.

Signature

If a personal representative has been appointed, that person must sign the return. If it is a joint return, the surviving spouse must also sign it.

If no personal representative has been appointed, the surviving spouse (on a joint return) signs the return and writes in the signature area “Filing as surviving spouse.” If no personal representative has been appointed and if there is no surviving spouse, the person in charge of the decedent's property must file and sign the return as “personal representative.”

Tax Forgiveness for Military, Victims of Terrorism, and Astronauts

Income tax liability may be forgiven for a decedent who dies due to service in a combat zone, due to military or terrorist actions, as a result of a terrorist attack, or while serving in the line of duty as an astronaut.

Income Tax Return of an Estate (Form 1041)

An estate is a separate taxable entity from the decedent, and comes into being with the death of the individual.

The estate exists until the final distribution of its assets to the heirs or other beneficiaries. The income earned by the property during this period must be reported by the estate on Form 1041. The tax generally is figured in the same manner as for individuals with certain differences in the computation of deductions and credits. The estate's income must be reported annually on either a calendar year or fiscal year basis. The personal representative chooses the estate’s accounting period when he or she files the first Form 1041.

Filing Requirements

Every domestic estate with gross income of $600 or more must file Form 1041. If one or more of the beneficiaries of the domestic estate are nonresident alien individuals, Form 1041 must be filed even if gross income is less than $600.

Due Date

Form 1041 is due by the 15th day of the 4th month after the end of the tax year selected by the estate. The estate's first tax year can be any period that ends on the last day of a month, and that does not exceed 12 months.

Extension of Time to File.

The extension of time to file an estate (other than a bankruptcy estate) or trust return is 5½ months.

Estimated Tax

Estates with tax years ending 2 or more years after the date of the decedent's death must pay estimated tax in the same manner as individuals.

Income in Respect of the Decedent

All income that the decedent would have received had death not occurred that was not included on the final return is income in respect of the decedent.

How to Report

Income in respect of a decedent must be included in the gross income of:

The decedent's estate, if the estate receives it,

The beneficiary, if the right to income is passed directly to the beneficiary and the beneficiary receives it, or

Any person to whom the estate properly distributes the right to receive it.

Character of Income

The character of the income received in respect of a decedent is the same as it would have been to the decedent if he or she were alive.

Wages

Wages and other employee compensation earned by the decedent but unpaid at the time of death is income in respect to the decedent.

Capital Gains and Losses

The basis used to figure gain and loss for property the estate receives from the decedent usually is the fair market value.

Life Insurance Proceeds

Proceeds from a decedent’s life insurance policy are nontaxable.

Exemption and Deductions

Exemption Deduction

An estate is allowed an exemption deduction of $600 in computing its taxable income even if the first return covers a period of less than 12 months. No exemption for dependents is allowed.

Charitable Contributions

If the will provides that contributions are to be paid out of the estate's gross income, the contribution is fully deductible by the estate.

Losses

An estate can claim a deduction for a loss from the sale of property even if the sale is to a personal representative or beneficiary of the estate.

Net Operating Loss Deduction

An estate can claim an NOL deduction, computed in the same way as by an individual, except that it cannot deduct any distributions to beneficiaries or a charitable contribution deduction. NOL carryovers of an estate are passed through to the beneficiaries in the last year of the estate.

Carryover Losses

Carryover losses resulting from NOLs or capital losses sustained by the decedent prior to death cannot be deducted on the estate's income tax return.

Casualty and Theft Losses

Losses incurred for casualty and theft during the administration of the estate can be deducted only if they have not been claimed on the federal estate tax return (Form 706).

Administration Expenses

Expenses of administering an estate can be deducted either from the gross estate in figuring the federal estate tax (Form 706) or from the estate's gross income in figuring the estate's income tax (Form 1041). 

However, these expenses cannot be claimed for both estate tax and income tax purposes. The rule preventing double deductions do not apply to deductions for taxes, interest, business expenses, and other items accrued at the date of death. These expenses can be deducted both in figuring the federal estate tax (Form 706) and from the estate's gross income in figuring the estate's income tax (Form 1041).

Depreciation and Depletion

The allowable deductions for depreciation and depletion that accrue after the decedent's death must be apportioned between the estate and the beneficiaries depending upon the income of the estate that is allocable to each.

Income Distribution Deduction

An estate is allowed a deduction for current distributions actually made to beneficiaries out of the estate's income. The deduction is limited to the distributable net income of the estate.

Funeral and Medical Expenses

No deduction can be taken for funeral expenses or medical and dental expenses on the estate's income tax return, Form 1041.

Funeral expenses. Funeral expenses paid by the estate are not deductible in figuring the estate's taxable income on Form 1041. They are deductible only for determining the taxable estate for federal estate tax purposes on Form 706.

Medical and dental expenses of a decedent. The medical and dental expenses of a decedent paid by the estate are not deductible in figuring the estate's taxable income on Form 1041. They can be deducted in figuring the taxable estate for federal estate tax purposes on Form 706.

Credits

Estates generally are allowed some of the same tax credits that are allowed to individuals. The credits generally are allocated between the estate and the beneficiaries. However, estates are not allowed the credit for the elderly or the disabled, the child tax credit, or the earned income credit.

Alternative Minimum Tax (AMT)

An estate may be liable for the alternative minimum tax.

Distributions to Beneficiaries

When to Report Estate Income

A beneficiary of an estate, that must distribute all its income currently, must report his or her share of the distributable net income whether or not it was actually received.

Any other amount paid, credited, or required to be distributed to the beneficiary, must also be included in the beneficiary's gross income. Each item of income keeps the same character in the beneficiaries’ hands as it had in the hands of the estate. The personal representative can elect to treat distributions paid or credited within 65 days after the close of the estate's tax year as having been paid or credited on the last day of that tax year. If this election is made, the beneficiaries must report that distribution on their return for that year. Each beneficiary who receives a distribution from the estate for the tax year or to whom any item is allocated must receive a Schedule K-1. Gifts or bequests that meet certain conditions are not taxable.

Estate Tax Deduction

Income that a decedent had a right to receive is included in the decedent's gross estate and is subject to estate tax.

This income in respect of a decedent is also taxed when received by the recipient (estate or beneficiary). However, an income tax deduction is allowed to the recipient for the estate tax paid on the income. The recipient can take this deduction only as an itemized deduction on Schedule A.

What is a Trust?

A trust is a legal entity created under state law and taxed under federal law. A trust may be created during a person’s lifetime (inter vivos) or at the time of death under will (testamentary).

Types of Trusts

Irrevocable Trust

An irrevocable trust is a trust cannot be modified, amended, or revoked. For tax purposes, an irrevocable trust can be treated as a simple, complex, or grantor trust, depending on the powers listed in the trust instrument.

Revocable Trust

A revocable trust may be revoked and is considered a grantor trust (IRC § 676).

Living Trust

A living person creates an inter vivos trust during that person’s lifetime. An inter vivos trust can be established as revocable or irrevocable. An inter vivos trust can be a simple, complex, or grantor trust depending on the trust instrument.

Simple Trust

A simple trust is a trust that:

Is required to distribute all of its income currently for the tax year.

Does not provide for any amounts to be paid, permanently set aside, or used for charitable contributions.

Does not make any distribution other than current income (i.e. does not make a distribution out of corpus).

Note: If the above requirements are not met, the simple trust becomes a complex trust. Therefore, a trust may be a simple trust for one year and a complex trust another year.

Complex Trust

A complex trust is any trust that is not a simple trust. A complex trust may accumulate income (i.e., when a trust does not pay out all of its income currently).

Grantor Trust

A trust where the grantor retains excessive rights to the trust. It is not a separate legal entity for federal tax law purposes. All income and deductions are reported on the grantor’s own tax return.

Grantor

The person who transfers the trust property to the trust. A trust can be formed during the grantor’s lifetime or become effective only upon his or her death.

Abusive Trusts

Trusts established to reduce or eliminates income taxes or self-employment taxes, pay for personal expenses, and in violations of the Internal Revenue Code are abusive trusts. The penalties for a fraudulent trust can range from 75% of underpayment of tax (fraud penalty) to $250,000 and/or 5 year in prison (tax evasion penalties).

Corpus

The principal of the trust.

Exemption

A simple trust is allowed an exemption of $300. All other trusts are allowed a deduction of $100.

Distributive Net Income (DNI)

Distributive net income is figured the same as taxable income of a trust or estate with the following modifications:

The deduction for amounts paid, credited, or required to be distributed to beneficiaries is not allowed.

The exemption deduction is not allowed.

Capital gains allocated to corpus and not paid, credited, or required to be distributed to any beneficiary or permanently set aside, or to be used for charitable contributions are excluded.

Capital losses are excluded except to the extent that they are used to determine any capital gains that are paid, credited, or required to be distributed to any beneficiary during the tax year.

In the case of a simple trust, extraordinary dividends and taxable stock dividends that the fiduciary, in good faith, allocates to corpus is excluded.

Tax-exempt interest on state and local bonds is included.

Tax-exempt income from a foreign trust that is determined without regard to the provisions of section 894 (relating to income exempt under treaty), is included.

Deduction for Distributions to Beneficiary

A trust can deduct the amount of income that is required to be distributed to the beneficiaries. If the income required to be distributed is more than the trusts DNI, the distributive deduction is limited to the DNI.

Chapter Eight - Tax Exempt Organizations

Tax Exempt Organizations

A tax exempt organization is a non-profit organization that is exempt from certain taxes because it is described under Section 501 of the Internal Revenue Code (IRC). Chapter Eight covers the filing requirements for all tax exempt organizations, how an organization qualifies for tax-exempt status, whether tax exempt status is automatically recognized, or if the organization must apply for the status.

In This Chapter

Qualifying for Exemption (Section 501(c)(3) Organizations)

Application for Recognition of Exemption

Filing Requirements

Qualifying for Exemption (Section 501(c)(3) Organizations)

An organization may qualify for exemption from federal income tax if it is organized and operated exclusively for one or more of the following purposes.

Charitable.

Religious.

Education.

Scientific.

Literary.

Testing for public safety.

Fostering national or international amateur sports competition (but only if none of its activities involve providing athletic facilities or equipment).

The Prevention of Cruelty to Children or Animals.

Qualification of Organization

To be tax-exempt an organization must be one of the following:

A corporation.

Unincorporated association.

A trust.

Note: Sole proprietorships, partnerships, individuals, or loosely associated groups of individuals do not qualify.

Qualifying Organizations

Nonprofit old-age homes.

Parent-teacher associations.

Charitable hospitals or other charitable organizations.

Alumni associations.

Schools.

Chapters of the Red Cross.

Boys' or Girls' Clubs.

Churches.

Application for Recognition of Exemption

Form 1023

Most organizations will not be treated as tax-exempt unless they apply for recognition of exemption by filing Form 1023, Application for Recognition of Exemption. They must file Form 1023 within 27 months from the end of the month they first organized.

Form 1023-EZ

Form 1023–EZ, Streamlined Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code can be used by smaller organizations seeking exemption with the IRS. Generally, these are organizations which have assets of $250,000 or less and annual gross receipts of $50,000 or less. The Form 1023-EZ can only be filed electronically by going to www.irs.gov/form1023-EZ or www.pay.gov.

Required Inclusions

Along with the application (Form 1023), the organization must attach the following information:

Employer identification number (EIN). Every exempt organization must have an EIN.

Organizing documents. Each application for exemption must be accompanied by a conformed copy of the organization's Articles of Incorporation (and the Certificate of Incorporation, if available), Articles of Association, Trust Indenture, Constitution, or other enabling document. A conformed copy is a copy that agrees with the original and all amendments to it. If the organization does not have an organizing document, it will not qualify for exemption.

Bylaws. Bylaws alone are not organizing documents. However, if the organization has adopted bylaws, include a current copy.

Description of activities. The application must include a full description of the proposed activities of the organization, including each of the fund raising activities of a section 501(c)(3) organization and a narrative description of anticipated receipts and contemplated expenditures.

Financial data. The application must include financial statements showing receipts and expenditures and a balance sheet for the current year and the 3 preceding years.

Organizations Not Required to File Form 1023

The following organizations are not required to file Form 1023:

Churches and other religious organizations.

Any organization (other than a private foundation) normally having annual gross receipts of not more than $5,000.

Gross Receipts Test

For purposes of the gross receipts test, an organization normally does not have more than $5,000 annually in gross receipts if:

During its first tax year the organization received gross receipts of $7,500 or less,

During its first 2 years the organization had a total of $12,000 or less in gross receipts, and

In the case of an organization that has been in existence for at least 3 years, the gross receipts received by the organization during the immediately preceding 2 years, plus the current year, are $15,000 or less.

Note: If an organization fails to meet this test, they must file Form 1023 within 90 days.

Filing Requirements

Form 990 or 990-EZ

Tax-exempt organizations, other than private foundations, must file Form 990, Return of Organization Exempt From Income Tax, or Short Form 990-EZ. An organization may file Form 990-EZ instead of Form 990, if it meets both of the following requirements.

Its gross receipts during the year were less than $200,000.

Its total assets at the end of the year were less than $500,000.

Form 990-N

Small tax-exempt organizations with annual gross receipts normally $50,000 or less must submit Form 990-N, Electronic Notice (e-Postcard) for Tax-Exempt Organizations Not Required to File Form 990 or 990-EZ, with the IRS each year, if they choose not to file a Form 990 or 990-EZ.

Form 990-N must be completed and filed electronically. There is no paper form. Form 990-N requires the following information:

The organization's legal name and mailing address.

Any name under which it operates and does business.

Its Internet website address (if any).

Its employer identification number (EIN).

The name and address of a principal officer.

Organization's annual tax year.

Verification that the organization's annual gross receipts are normally $50,000 or less.

Notification if the organization has terminated.

Form 990-N Exceptions

This filing requirement for Form 990-N does not apply to:

Churches, their integrated auxiliaries, and conventions or associations of churches;

Organizations that are included in a group return;

Private foundations required to file Form 990-PF; and

Section 509(a)(3) supporting organizations required to file Form 990  or Form 990-EZ.

Form 990-PF

All tax-exempt private foundations must file Form 990-PF.

Form 990-T

Even though an organization is recognized as tax exempt, it still may be liable for tax on its unrelated business income.

Unrelated business income is income from a trade or business, regularly carried on, that isn't substantially related to the charitable, educational, or other purpose that is the basis for the organization's exemption. If the organization has $1,000 or more of unrelated business income, Form 900-T must be filed in addition to the required annual information return.

Exclusions

The following types of income (and deductions directly connected with the income) are generally excluded when figuring unrelated business taxable income.

Dividends, interest, annuities and other investment income.

Royalties.

Rents. Rents from real property, including elevators and escalators, are excluded in computing unrelated business taxable income. Rents from personal property aren’t excluded. However, special rules apply to “mixed leases” of both real and personal property.

Income from research. A tax-exempt organization may exclude income from research grants or contracts from unrelated business taxable income. However, the extent of the exclusion depends on the nature of the organization and the type of research.

Gains and losses from disposition of property. Also excluded from unrelated business taxable income are gains or losses from the sale, exchange, or other disposition of property other than:

Stock in trade or other property of a kind that would properly be includable in inventory if on hand at the close of the tax year,

Property held primarily for sale to customers in the ordinary course of a trade or business, or

Cutting of timber that an organization has elected to consider as a sale or exchange of the timber.

Estimated Tax

Tax-exempt organizations must make quarterly payments of estimated tax on unrelated business income if it expects its tax for the year to be $500 or more. Use Form 990-W to figure the organization’s estimated tax payments.

Due Date

Form 990, 990-EZ, 990-PF, 990-N or 990-T must be filed by the 15th day of the 5th month after the end the organization's accounting period.

Electronic filing

For tax years beginning after July 1, 2019, organizations are required to file Form 990, Form 990-EZ, Form 990-PF, Form 990-T, and related forms, schedules, and attachments electronically.

Extension of Time to File

Use Form 8868 to request an automatic 6-month extension of time to file Forms 990, 990-EZ, or 990-PF.

Penalties for Failure to File

A tax-exempt organization that fails to file a required return is subject to a penalty of $20 a day for each day the failure continues.

The same penalty will apply if the organization fails to give correct and complete information or required information on its return. The maximum penalty for any return is the lesser of $11,000 or 5 percent of the organization's gross receipts for the year. Organizations with annual gross receipts exceeding $1,129,500 are subject to a penalty of $110 a day with a maximum penalty for any return of $56,000.

Employment Tax Returns

Tax-exempt organizations, which pay wages to employees, are responsible for withholding, depositing, and reporting federal income tax, social security taxes (FICA), and federal unemployment tax (FUTA) for such wage payments, unless that employer is specifically excepted by law from those requirements.

FUTA Tax Exception

Payments for services performed by an employee of a religious, charitable, educational, or other organization described in section 501(c)(3) that are generally subject to FICA taxes if the payments are $100 or more for the year, are not subject to FUTA taxes.

Chapter Nine - Retirement Plans

Retirement Plans

Chapter Nine discusses the tax advantages of retirement plans that a business may set up and maintain. It covers the amounts that employers and employees may contribute to various retirement plans, how much of the contributions are deductible, how to treat distributions, and how to report information about the plans to the IRS.

In This Chapter

Qualified Plans

Simplified Employee Pensions (SEPs)

SIMPLE Plans

Elective Deferrals (401(k) Plans)

Retirement Plan Rules for 2022

Qualified Plans

Definition of a Qualified Plan

A qualified plan is a retirement plan that can only be established by an employer. A sole proprietor is treated as an employer and can set up a plan. A partnership is treated as an employer of each partner. Therefore, a partnership can set up a plan but a partner cannot.

Set-up Deadline

To take a deduction for a contribution for a tax year, the qualified plan must be set up (adopted) by the last day of that year (December 31 for calendar year employers).

Qualified Plan Requirements

For a qualified plan to qualify for special tax benefits, it must meet all of the following:

The plan must be in writing.

Contributions must be for the exclusive benefit of employees or their beneficiaries.

Plan assets may not be used for, or diverted to, the employer.

The plan must allow all employees age 21 or older and at least 1 year of service (2 years if the plan is not a 401(k) plan and provides that after not more than 2 years of service the employee has a nonforfeitable right to all of his or her accrued benefit) to participate. The plan cannot exclude an employee because he or she has reached a specific age.

Certain minimum coverage requirements must be met depending on the plan.

Contributions and benefits to be provided must not discriminate in favor of highly compensated employees.

Kinds of Plans

There are two basic kinds of qualified plans:

Defined contribution plan. Provides an individual account for each participant in the plan. Benefits to be provided to participants are largely based on the amount contributed to each account. A defined contribution plan can be either a profit-sharing or a money-purchase plan.

Profit-sharing plan. Although it is called a “profit-sharing plan,” an employer does not actually have to make a business profit for the year in order to make a contribution (except if the contribution is for the taxpayer and the taxpayer is self-employed). A profit-sharing plan can be set up to allow for discretionary employer contributions, meaning the amount contributed each year to the plan is not fixed. An employer may even make no contribution to the plan for a given year. In general, an employer can be more flexible in making contributions to a profit-sharing plan than to a money purchase pension plan.

Money-purchase plan. Contributions are fixed and not based on the employer's profits.

Defined benefit plan. Any plan that is not a defined contribution plan. Contributions to the plan are based on a computation of what contributions are needed to provide definitely determinable benefits to plan participants.

Minimum Funding Requirements

If the qualified plan is a money-purchase plan or a defined benefit plan, the self-employed individual (employer) must pay enough into the plan to satisfy the minimum funding standard for each year. The minimum funding requirements do not apply to profit-sharing plans.

Quarterly Installments of Required Contributions

If the qualified plan is a defined benefit plan subject to the minimum funding requirement, the self-employed individual (employer) must make quarterly installment payments of the required contributions.

Due Dates

The due dates for the installments are 15 days after the end of each quarter. For a calendar-year plan, the installments are due April 15, July 15, October 15, and January 15 (of the following year).

Installment Percentage

Each quarterly installment must be 25% of the required annual payment.

Extended Period for Making Contributions

Additional contributions required to satisfy the minimum funding requirement for a plan year will be considered timely, if made no later than 8½ months after the end of that year.

Contributions to Qualified Plans

Self-Employed Individuals

Self-employed individuals can make contributions for themselves only if they have net earnings from self-employment.

If there is a net loss from self-employment, the individual cannot make contributions for himself or herself, even if the individual can contribute for common-law employees based on their compensation. Net earnings must be from personal services, not from investments. A self-employed taxpayer making a contribution for himself or herself to a SEP or qualified plan must make special computations to figure his maximum deduction for these contributions. Earning from self-employment are figured by taking net earnings from self-employment (on Schedule C) and subtracting the income tax deduction allowed for one-half of self-employment tax and the deduction for contribution made on behalf of the self-employed person.

Contributions Deadline

Deductible contributions for a tax year can be made up to the due date of the tax return (including extensions) for that year.

Limits on Contributions

Defined Contribution Plan

For 2022, the annual contributions and other additions to the account of a participant cannot exceed the smaller of:

$61,000, or

100% of the participant's compensation.

Defined Benefit Plan

For 2022, the annual benefit for a participant may not be more than the smaller of:

$245,000, or

100% of the participant's average compensation for his or her highest 3 consecutive years.

Employer Deduction

The deduction limits for qualified plans are as follows:

Defined contribution plans. The deduction for contributions to a defined contribution plan (profit-sharing plan or money purchase pension plan) cannot be more than 25% of the compensation paid (or accrued) during the year to eligible employees participating in the plan.

Defined benefit plans. The deduction is based on actuarial assumptions and computations.

Deducting Contributions for Self-Employed Individuals

When figuring the deduction for contributions made for the self-employed taxpayer, compensation is net earnings from self-employment which takes into account both of the following:

The deduction for the deductible part of self-employment tax.

The deduction for contributions on the taxpayer's behalf to the plan.

Note: A self-employed individual must deduct any contributions made for common-law employees from net earnings in figuring his or her contribution.

Carryover of Excess Contributions

If an employer contributes in excess of deduction limits for a year, the employer can carry over and deduct the excess in later years, subject to the same annual limits.

The excess carryover may be subject to a 10% excise tax. The 10% excise tax does not apply to any contribution to meet the minimum funding requirement in a money purchase pension plan or a defined benefit plan even if that contribution is more than the employer’s earned income for his or her trade or business.

Tax Treatment of Distributions

Distributions from a qualified plan minus a prorated part of the cost basis are subject to income tax in the year they are distributed. Since most recipients have no cost basis, a distribution is generally fully taxable. An exception is a distribution that is properly rolled over.

Rollover

A taxpayer can defer the tax on an eligible rollover distribution by rolling it over into an IRA or another eligible retirement plan.

If a taxpayer receives a distribution other than cash from an employer retirement plan, the taxpayer must roll over the same property into an IRA or sell all or part of the property and roll over the proceeds of the sale into an IRA.

Eligible Rollover Distribution

This is a distribution of all (such as a lump-sum distribution) or any part of an employee’s balance in a qualified retirement plan that is not:

A required distribution.

Any of a series of substantially equal payments made at least once a year over any of the following periods:

The employee's life or life expectancy.

The joint lives or life expectancies of the employee and beneficiary.

A period of 10 years or longer.

The portion of a distribution that represents the return of an employee’s nondeductible contributions to the plan.

A hardship distribution.

Loans treated as distributions.

Dividends on employer securities

The cost of life insurance coverage provided under a qualified retirement plan.

Withholding Requirements

If a taxpayer takes an eligible rollover distribution that is $200 or more, the payer is required to withhold (for Federal income tax) 20% of the taxable part of the distribution. If the taxpayer chooses to have the plan pay the distribution directly to an IRA or another eligible retirement plan (i.e. direct rollover), no withholding is required. If the distribution is not eligible for rollover treatment, the 20% withholding requirement does not apply.

Tax on Early Distribution

A distribution from a retirement plan to a taxpayer before he or she reaches age 59½ is a premature distribution subject to a 10% tax on the part of the distribution that is included in gross income.

Exceptions

The 10% tax will not apply if distributions before age 59½ are:

Made to a beneficiary (or to the estate of the employee) after the death of the employee.

Due to the employee having a qualifying disability.

Rolled over to another retirement plan or an IRA within 60 days of the distribution.

Made because of an IRS levy on the plan.

Made as a qualified reservist distribution.

Part of a series of substantially equal periodic payments, beginning after separation from service, made at least annually for the life or life expectancy of the employee or the joint lives or joint life expectancies of the employee and his or her designated beneficiary. (The payments under this exception, except in the case of death or disability, must continue for at least 5 years or until the employee reaches age 59½, whichever is the longer period).

Made to an employee after separation from service, if the separation occurred during or after the calendar year in which the employee reached age 55.

Made to an alternate payee under a qualified domestic relations order (QDRO).

Made to an employee for medical care to the extent that the distribution does not exceed the amount allowable as a medical expense deduction (determined without regard to whether the employee itemizes deductions).

Timely made to reduce excess contributions under a 401(k) plan.

Timely made to reduce excess employee or matching employer contributions (excess aggregate contributions).

Timely made to reduce excess elective deferrals.

Made as a qualified birth or adoption distribution.

Made as a qualified disaster distribution.

Prohibited Transactions

Certain transactions between the plan and a disqualified person are prohibited. An excise tax is charged on these transactions.

Disqualified Person

The following are disqualified persons:

The employer of participants in the plan.

A 10% partner in a partnership having the plan.

A fiduciary of the plan.

Family members.

Corporations, partnerships, trusts, or estates in which the person owns, directly or indirectly, at least 50% or more of the:

Total voting stock or the value of all stock of the corporation,

Capital interest or profit interest of the partnership, or

Beneficial interest of the trust or estate.

Highly compensated employees (earning 10% or more of the employer's yearly wages).

Employee organizations, any of whose members are covered by the plan.

Persons providing services to the plan.

Prohibited Transactions

The following are prohibited transactions:

A transfer of plan income or assets to, or use of them by or for the benefit of, a disqualified person.

Dealing with plan income or assets by a fiduciary in his or her own interest.

The receiving of consideration by a fiduciary for his or her own account from a party that is dealing with the plan in a transaction that involves plan income or assets.

Any of the following acts between the plan and a disqualified person:

Selling, exchanging, or leasing property.

Lending money, extending credit.

Furnishing goods, services, or facilities.

Tax on Prohibited Transaction

The initial tax on a prohibited transaction is 15% of the amount involved for each year (or part of a year) in the taxable period. If the transaction is not corrected within the taxable period, an additional tax of 100% of the amount involved is imposed.

Reporting Requirements

An annual return/report form must be filed by the last day of the 7th month following the end of the plan year. The following forms are used depending on the type of plan:

Form 5500-SF, Short Form Annual Return/Report of Small Employee Benefit Plan. Form 5500-SF is a simplified annual reporting form. Use Form 5500-SF if the plan meets all the following:

The plan is a small plan (fewer than 100 participants at the beginning of the plan year).

The plan meets the conditions for being exempt from the requirements that the plan's books and records be audited by an independent qualified public accountant.

The plan has 100% of its assets invested in certain secure investments with a readily determinable fair value.

The plan holds no employer securities.

The plan is not a multiemployer plan.

Form 5500-EZ, Annual Return of One-Participant (Owners and Their Spouses) Retirement Plan. A plan qualifies to use this form if it covers only:

An individual and his or her spouse who wholly own a business.

Partners in a partnership and their spouses.

Form 5500, Annual Return/Report of Employees Benefit Plan. Anyone who does not meet the requirements for filing Form 5500-EZ must file Form 5500.

Note: Except for the final year, a taxpayer of a one-participant plan does not have to file Form 5500EZ or any other annual report, if the total assets of the plan are $250,000 or less.

Electronic filing of Forms 5500 and 5500-SF

All Forms 5500 and 5500-SF are required to be filed electronically with the Department of Labor through EFAST2.

Simplified Employee Pensions (SEPs)

A SEP is a written plan that allows an employer to make contributions toward his or her own and his or her employees' retirement without getting involved in the more complex qualified plan.

SEP-IRA

Under a SEP, contributions are made to an individual retirement arrangement called a SEP-IRA.

Set up a SEP-IRA

The SEP-IRA must be set up for each qualifying employee and qualified leased employee, but need not be set up for excludable employees.

Deadline for Setting up a SEP

A SEP can be set up for a year as late as the due date (including extensions) of the tax return for that year.

Qualifying Employee

An individual who:

Reached the age of 21 years,

Worked for employer in at least 3 of the immediately preceding 5 years, and

Received at least $650 in compensation from employer.

Note: An employer can use less restrictive requirements but not more restrictive ones.

Leased Employees

If they are treated as employer's employees and meet the above requirements, leased employees must be included in SEP.

Excludable Employees

The following need not be covered under a SEP:

Employees covered by a union agreement and whose retirement benefits were bargained for in good faith by their union and employer, and

Nonresident alien employees who have no U.S. source earned income from employer.

Contributions to Combination of Plans

If an employer contributes to both a defined contribution plan and a SEP-IRA, the rules for the defined contribution plan apply.

Contributions

Contributions are not required to be made every year. If contributions are made, they must be based on a written allocation formula and must not discriminate in favor of any employees. The contribution for a particular year must be made no later than the due date (plus extensions) of the tax return for that year.

Contribution Limits

For 2022, Contributions made for a year to a common-law employee's SEP-IRA cannot exceed the smaller of 25% of the employee's compensation or $61,000.

Annual Contribution Limit

An employer cannot consider an employee’s compensation over $305,000 when figuring the contribution limit for that employee. However, $61,000 is the maximum contribution amount for each eligible employee.

Deducting Contributions

Deduction Limit for Contributions for Participants

The most an employer can deduct for contributions to himself or herself or to his or her employee's SEP-IRA is the lesser of the following amounts:

Employer contributions (including any excess contributions carryover).

25% of the compensation (limited to $305,000 per participant) paid to the participants during 2022 from the business that has the plan, not to exceed $61,000 per participant.

Deduction Limit for Self-Employed Individuals

If a taxpayer contributes to his or her own SEP-IRA, the taxpayer must make a special computation to figure the maximum deduction for these contributions.

When figuring the deduction for contributions made to a taxpayer's own SEP-IRA, compensation is net earnings from self-employment, which takes into account both the following deductions:

The deduction for the deductible part of self-employment tax.

The deduction for contributions to the taxpayer's own SEP-IRA.

Carryover of Excess Contributions

Contributions in excess of deduction limit may be carried over and deducted in later years subject to the deduction limit in those years. A nondeductible (excess) contribution to a SEP may be subject to a 10% excise tax.

SIMPLE Plans

A SIMPLE plan is a written agreement (salary reduction agreement) between an employer and an employee that allows an employee (including self-employed individuals) to choose:

Reduce compensation by a certain percentage each pay period (SIMPLE 401(k) plan), or

Have the employer contribute the salary reduction to a SIMPLE IRA on behalf of the employee.

Deadline for Setting up a SIMPLE IRA

A SIMPLE IRA must be set up for an employee before the first date by which a contribution is required to be deposited into the employees’ IRA.

Setting up a SIMPLE IRA Plan

Employers can set up a SIMPLE IRA plan if they meet both of the following requirements:

The employer has 100 or fewer employees who earn $5,000 or more during the preceding year.

The employer did not maintain another qualified plan unless the other plan is for collective bargaining employees.

Participant in a SIMPLE IRA

Any employee who receives at least $5,000 in compensation during any 2 years preceding the current calendar year and expected to earn at least $5,000 during the current year.

Contribution Limits

Salary Reduction Contribution Limits

The salary reduction contributions (employee-chosen contribution) that an employer can make on behalf of an employee are limited to $14,000 ($17,000 if age 50 or older).

Matching Employer Contributions

Generally the employer must make matching contributions to an employee’s SIMPLE IRA in an amount equal to the employee’s salary reduction contribution. Their matching contributions cannot be more than 3% of the employee’s compensation for the calendar year.

Matching contributions less than 3%. An employer can reduce the 3% limit on matching contribution for a calendar year, but only if:

The limit is not reduced below 1%,

The limit is not reduced for more than 2 years out of the 5-year period that ends with (and includes) the year for which the election is effective, and

Employees are notified of the reduced limit within a reasonable period of time before the 60-day election period during which they can enter into salary reduction agreements.

Nonelective employer contribution. If an employer chooses to make nonelective contributions, instead of matching contributions, to each eligible employee’s SIMPLE IRA, contributions must be 2% of each employee’s compensation for the year. Only $305,000 of an employee’s compensation can be taken into account to figure the contribution limit.

When to Deduct Contributions

Deduct SIMPLE IRA contributions in the tax year within which the calendar year for which contributions were made ends. Deduct contributions for a particular tax year if they are made for that tax year and are made by the due date (including extensions) of the federal income tax return for that year.

Elective Deferrals (401(k) Plans)

A qualified plan can include a cash or deferred arrangement only if the qualified plan is one of the following plans:

A profit-sharing plan, or

A money-purchase plan in existence on June 27, 1974, that included a salary reduction arrangement on that date.

Partnership. A partnership can have a 401(k) plan.

Contributions

Contributions by Employees

Eligible employees can elect to have part of their before-tax pay contributed to a 401(k) plan rather than receive the cash. This amount (and any earnings on it) remains tax free until it is distributed.

Contributions by Employer

An employer’s contributions to a 401(k) plan are deductible by the employer and tax free to participating employees until distribution from the plan. Deferred amounts are included in wages for social security, Medicare, and federal unemployment (FUTA) tax purposes.

Limits on Elective Deferrals

For 2022, the basic limit on elective deferrals is $20,500 ($27,000 for participants age 50 and older).

Retirement Plan Rules for 2022

Type of Plan
Last Date for Contribution
Maximum Contribution
Maximum Deduction
When to Set Up Plan

SEP

Due date of employer’s return (including extensions).

Smaller of $61,000 or 25% of participant compensation.

25% of all participant's compensation

Any time up to due date of employer's return (incl. ext.).

SIMPLE IRA and SIMPLE 401(k) Plan

Salary reduction contributions: 30 days after the end of the month for which the contributions are to be made.

Matching contributions or nonelective contributions: Due date of employer's return (including extensions)

Employee: Salary reduction contribution, up to $14,000 ($17,000 if age 50 or over).

Employer contribution: Either dollar-for-dollar matching contributions, up to 3% of employee's compensation, or fixed nonelective contributions of 2% of compensation.

Same as maximum contribution.

Any time between 1/1 and 10/1 of the calendar year.

For a new employer coming into existence after 10/1, as soon as administratively feasible.

Qualified Plan: Defined Contribution Plan

Elective deferral: Due date of employer’s return (including extension).

Employer contribution: Due date of employer’s return (including extensions)

Employee contribution: Elective deferral up to $20,500 ($27,000 if age 50 or older).

Employer contribution: Smaller of $61,000 or 100% of participant’s compensation

25% of all participant's compensation, plus amount of elective deferrals made.

By the end of the year.

Qualified Plan: Defined Benefit Plan
Contributions generally must be paid in quarterly installments, due 15 days after the end of each quarter.
Amount needed to provide an annual benefit no larger than the smaller of $245,000 or 100% of participant’s compensation for highest 3 consecutive calendar years.
Based on actuarial assumptions and computations.
By the end of the year.

Chapter Ten - Farm Accounting

Farm Accounting

Farming is a unique business and preparing taxes for a farming business offers special challenges. Chapter Ten explains how the federal tax laws apply to farming, including how to figure income, the special income reporting postponements available to businesses engaged in farming, and how to handle the sale and exchange of various farm assets. The information covered is focused specifically on the aspects of publication 225, the Farmer's Tax Guide, that you will need to learn to pass Part 2 of the Enrolled Agent Exam.

In This Chapter

Farm Income

Livestock and Crops

Farm Inventory

Sale of a Farm

Section 1231 Transactions

Farm Income

Gross Income

Gross income from farming is income from cultivating the soil or raising agricultural commodities. It includes the following amounts:

Income from operating a stock, dairy, poultry, bee, fruit, or truck farm.

Income from a plantation, ranch, nursery, range, orchard, or oyster bed.

Crop shares for the use of land.

Gains from sales of draft, breeding, dairy, or sporting livestock.

Gross income from farming is the total of the following amounts from the taxpayer’s tax return:

Gross farm income from Schedule F (Form 1040 or 1040-SR).

Gross farm rental income from Form 4835.

Gross farm income from Schedule E (Form 1040 or 1040-SR), Parts II and III.

Gains from the sale of livestock used for draft, breeding, sport, or dairy purposes reported on Form 4797.

Other Farm Income

The following are also included in farm income.

Sales caused by weather-related conditions.

Agricultural program payments. Include in farm income most government payments.

Crop insurance and crop disaster payments.

Income From Cooperatives (Patronage Dividends).

Not Farm Income

Farm income does not include any of the following:

Wages received as a farm employee.

Income receive from contract grain harvesting and hauling with workers and machines furnished.

Gains from the sale of farm land and depreciable farm equipment.

Estimated Tax for Farmers

If the taxpayer receives at least two-thirds of gross income from farming or fishing for the previous year or the present year, he or she is only required to make one estimated payment. The due date for that payment is January 15th of the next year. If the taxpayer files return by March 1 of the next year and pays all taxes owed, no estimated payment is required.

Income Averaging for Farmers

A taxpayer who is engaged in a farming business may elect to use farm income averaging if the taxpayer is an individual, a partner in a partnership, or a shareholder in an S corporation.

By income averaging, the taxpayer can average all or some of his or her current year’s farm income by shifting it to the 3 prior years (base years). The taxpayer can use the farm income averaging even if he or she were not engaged in a farming business in any of the base years.

Note: Corporations, partnerships, S corporations, estates, and trusts cannot use income averaging.

How to Figure the Tax

If averaging farm income, figure the tax on Schedule J (Form 1040 or 1040-SR).

Livestock and Crops

Livestock

Weather-Related Conditions Sales

If a sale of livestock or poultry is due to weather-related conditions, a taxpayer can elect to report income from a sale the following year.

Amount to be postponed. Postpone the income only on the additional number of livestock sold solely because of weather-related conditions.

Note: The livestock does not have to be raised or sold in the weather-related conditions area to qualify for the postponement. However, the sale must occur solely because of weather-related conditions.

Crops

Crop Insurance and Disaster Payments

Include crop insurance payments in income. A cash method taxpayer may postpone reporting crop insurance proceeds until the year following the year the damage occurred, if it can be proved that the crops would have been sold in the following year.

Farm Inventory

Inventory

Certain small farms with average annual gross receipts of $27 Million or less in the 3 preceding tax years are not required to maintain an inventory.

Items to Include in Inventory

Inventory should include all items held for sale, or for use as feed, seed, etc., whether raised or purchased, that are unsold at the end of the year.

Hatchery Business

If in the hatchery business, and use an accrual method of accounting, include in inventory eggs in the process of incubation.

Products Held for Sale

All harvested and purchased farm products held for sale or for feed or seed, such as grain, hay, silage, concentrates, cotton, tobacco, etc., must be included in inventory.

Supplies

Supplies acquired for sale or that become a physical part of items held for sale must be included in inventory. Deduct the cost of supplies in the year used or consumed in operations. Do not include incidental supplies in inventory as these are deductible in the year of purchase.

Livestock

Livestock held primarily for sale must be included in inventory. Livestock held for draft, breeding, or dairy purposes can either be depreciated or included in inventory.

Growing Crops

Generally, growing crops are not required to be included in inventory. However, if the crop has a preproductive period of more than 2 years, costs associated with the crop may have to be capitalized (include in inventory).

Inventory Valuation Methods

The following methods are those generally available for valuing inventory:

Cost

Lower of cost or market

Farm-price method

Unit-livestock-price method

Sale of a Farm

The sale of a farm will usually involve the sale of both nonbusiness property (personal home) and business property (the land and buildings used in the farm operation and perhaps machinery and livestock).

If there is a gain from the sale, the taxpayer may be allowed to exclude the gain on the home. If a farm is sold that includes a house that the taxpayer occupies, the taxpayer must determine the part of the selling price and the part of the cost or other basis allocable to the home. The home includes the immediate surroundings and outbuildings relating to it that are not used for business purposes.

Disposition of Farm Assets

When disposing of property used in a farm business, taxable gain or loss is usually treated as ordinary income or capital gain under the rules for section 1231 transactions.

Section 1231 Gains and Losses

Section 1231 gains and losses are the taxable gains and losses from section 1231 transactions. Their treatment as ordinary or capital gains depends on whether there is a net gain or a net loss from all section 1231 transactions in the tax year.

Section 1231 Transactions

Gain or loss on the following transactions is subject to section 1231 treatment:

Sale or exchange of cattle and horses. The cattle and horses must be held for draft, breeding, dairy, or sporting purposes and held for 24 months or longer.

Sale or exchange of other livestock. This livestock must be held for draft, breeding, dairy, or sporting purposes and held for 12 months or longer. Other livestock includes hogs, mules, sheep, goats, donkeys, and other fur-bearing animals. Other livestock does not include poultry.

Sale or exchange of depreciable personal property. This property must be used in business and held longer than 1 year. Generally, property held for the production of rents or royalties is considered to be used in a trade or business. Examples of depreciable personal property include farm machinery and trucks. It also includes amortizable section 197 intangibles.

Sale or exchange of real estate. This property must be used in business and held longer than 1 year. Examples are farm or ranch (including barns and sheds).

Sale or exchange of unharvested crops. The crop and land must be sold, exchanged, or involuntarily converted, at the same time and to the same person and the land must have been held longer than 1 year. The taxpayer cannot keep any right or option to reacquire the land directly or indirectly (other than a right customarily incident to a mortgage or other security transaction). Growing crops sold with a leasehold on the land, even if sold to the same person in a single transaction, are not included.

Distributive share of partnership gains and losses. Distributive share must be from the sale or exchange of property listed earlier and held longer than 1 year (or for the required period for certain livestock).

Cutting or disposal of timber. Standing timber held as investment property is a capital asset. Gain or loss from its sale is capital gain or loss reported on Form 8949 and Schedule D (Form 1040 or 1040-SR), as applicable. If held primarily for sale to customers, it is not a capital asset. Gain or loss on its sale is ordinary business income or loss.

Condemnation. The condemned property must have been held longer than 1 year. It must be business property or a capital asset held in connection with a trade or business or a transaction entered into for profit, such as investment property. It cannot be property held for personal use.

Casualty or theft. The casualty or theft must have affected business property, property held for the production of rents or royalties, or investment property (such as notes and bonds). Must have held the property longer than 1 year. However, if casualty or theft losses are more than casualty or theft gains, neither the gains nor the losses are taken into account in the section 1231 computation. Section 1231 does not apply to personal casualty gains and losses.

Not Section 1231 Transaction

If the property is not held for the required holding period, the transaction is not subject to section 1231 treatment. Any gain or loss is ordinary income.

Treatment as Ordinary or Capital

To determine the treatment of section 1231 gains and losses, combine all of section 1231 gains and losses for the year:

A net section 1231 loss is treated as ordinary loss.

A net section 1231 gain is treated as ordinary income up to nonrecaptured section 1231 losses from previous years. The rest, if any, is long-term capital gain.

Nonrecaptured Section 1231 Losses

Nonrecaptured section 1231 losses are net section 1231 losses for the previous 5 years that have not been applied against a net section 1231 gain by treating the gain as ordinary income. These losses are applied against net section 1231 gain beginning with the earliest loss in the 5-year period.

Appendix - Business Forms & Schedules at a Glance

Type of Form

Purpose of Form

Filing Date

Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return

Use Form 706 to figure a decedent’s estate tax imposed on the entire estate valued at more than $12,060,000.

9 months after the date of the decedent’s death unless receiving an automatic
6-month extension.

Form 990, Return of Organization Exempt From Income Tax

Form 990 and Form 990-EZ are used by tax-exempt organizations, nonexempt charitable trusts, and section 527 political organizations to provide the IRS with the information required by section 6033.

15th day of the 5th month after the end of the organization’s accounting period.

Form 900-PF, Return of Private Foundation

All private foundations exempt under section 501(c)(3) must file Form 990-PF.

15th day of the 5th month after the end of the organization’s accounting period.

Form 990-T, Exempt Organization Business Income Tax Return

Tax-exempt organizations with gross income of $1,000 or more from unrelated business must file Form 990-T.

15th day of the 5th month after the end of the organization’s accounting period. Employee trusts must file by the 15th day of the 4th month.

Form 1041, U.S. Income Tax Return for Estates and Trusts

Estates and trusts must file Form 1041 it they have gross income of $600 or more or a beneficiary who is a nonresident alien.

15th day of the 4th month after the tax year.

Form 1065, U.S. Return of Partnership Income

Form 1065 is an information return used to report income, deductions, gains, losses, etc., from operations of a partnership.

15th day of the 3rd month after the tax year.

Form 1099-DIV, Dividends and Distributions

File Form 1099-DIV for each person paid dividends and other distributions of $10 or more, withheld taxes, or paid $600 or more as part of a liquidation.

Furnish Copy B of this form to recipient by January 31. File Copy A with IRS by end of February.

Form 1120, U.S. Corporation Income Tax Return

Use Form 1120 to report the income, gains, deductions, losses, credits, and to figure the tax liability of a corporation.

15th day of the 4th month after the tax year.

Form 1120-H, U.S. Income Tax Return for Homeowners Associations

A homeowners' association elects to take advantage of the tax benefits provided by section 528 by filing Form 1120-H.

15th day of the 4th month after the tax year.

Form 1120S, U.S. Income Tax Return for an S Corporation

Use Form 1120S to report the income, gains, losses deductions, credits, etc., of an S corporation.

15th day of the 3rd month after the tax year.

Form 1128 - Application To Adopt, Change, or Retain a Tax Year
File Form 1128 to request a change in tax year.
By the due date (not including extensions) of the return for the effective year.

Form 2553, Election by a Small Business Corporation

A Corporation uses Form 2553 to elect to be treated as an S corporation.

15th day of the 3rd month after the beginning of the tax year the election is to take effect.

Form 3115 - Application for Change in Accounting Method

File Form 3115 to request a change in accounting method or the accounting treatment of any item.

File Form 3115 with the IRS no earlier than the first day of the year changed and no later than when the return is filed for the year of change.

Form 3800, General Business Credit

To claim any of the general business credits

Attach to tax return.

Form 4797, Sales of Business Property

Used to report sale of business property.

Attached to tax return.

Form 7004, Application for Automatic Extension of Time To File Certain Business Income Tax, Information, and Other Returns

Use Form 7004 to get an automatic
6-month extension for corporations and partnerships, 5½ month extension for estates, and trusts returns.

Before the due date of the return.

Form 8594, Asset Acquisition Statement

To report a sale or purchase of a group of assets if goodwill or going concern attaches to assets.

Attach to tax return

Form 8824 - Like-Kind Exchanges

To report each exchange of business or investment property of a like kind.

Attached to tax return

Form 8995-A -
Qualified Business Income Deduction
Attached to tax return

Schedule F - Profit or Loss From Farming

Report farm income and expenses.

Attach to tax return

Schedule K-1

Report partner’s, shareholder’s, and beneficiaries’ share of items on Forms 1065, 1120S, and 1041.

Attached to tax return.

Phoenix Tax Group Refund Policies

30 Day Refund

If you are not satisfied with any of our products, you can return them for a full refund, excluding shipping and handling charges.

A refund must be requested within 30 days of purchase, and all hardcopy materials must be returned in the original box. No credit will be given for any materials marked on, missing or damaged in any way. To request a refund, fill out the Refund Request form at the link below.

Pass Guarantee Refund

The Pass Guarantee applies only to products designated as "Packages."

To receive a refund, you must have taken and failed a test or exam twice.

You must provide your failed scores for both failed exams by filling out the online Refund Request Form (see link below). This must be done within 30 days of the second failed exam.

Hard copy materials must be returned within 30 days of the second failed exam.

If you purchased Enrolled Agent study materials together in a 3 part package, refunds will be pro-rated for the part being returned.

The refund will only apply to the person who purchased the study materials from The Phoenix Tax Group. The refund policy does not apply to companies purchasing study materials for employees.

Instructions

To ensure proper credit, please fill out our online refund request form.

http://www.phoenixtax.com/about/refunds

Evaluation

Enrolled Agent Exam Study Package Survey

We feel we have the best and most comprehensive enrolled agent exam preparatory materials available. However, we are always looking for ways to improve. We would appreciate it if you would take a moment to complete our online evaluation at:

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