REG

2019 SuperfastCPA Review Notes

Table of Contents
Area I: Ethics, Professional Responsibilities & Federal Tax Procedures 1
Ethics & Responsibilities in Tax Practice 2
Regulations governing practice before the IRS 2
Internal Revenue Code and Regulations related to tax return
preparers 4
Licensing and disciplinary systems 7
State Boards of Accountancy 7
Federal Tax Procedures 9
Audits, appeals, and judicial process 9
Substantiation and disclosure of tax positions 11
Taxpayer penalties 13
Authoritative hierarchy 15
Legal Duties and Responsibilities 17
Common law duties and liabilities to clients and third parties 17
Privileged communications, confidentiality, and privacy acts 19
Area II: Business Law 22
Agency 23
Authority of agents and principals 23
Duties and liabilities of agents and principals
Duties and liabilities of agents and principals 25
Contracts 29
Formation 29
Performance 37
Discharge, breach, and remedies 38
Debtor-Creditor Relationships 42
Rights, duties, and liabilities of debtors, creditors, and guarantors
42
Bankruptcy and insolvency 44
 Secured transactions 49
Government Regulation of Business 52
Federal securities regulation 52
Other federal laws and regulations 58
Business Structure 66
Selection and formation of business entity and related operation
and termination 66
Area III: Federal Taxation of Property Transactions 77
Acquisition and Disposition of Assets 78
Basis and holding period of assets 78
Taxable and nontaxable dispositions 81
Amount and character of gains and losses, and netting process
(including installment sales) 84
Related party transactions (including imputed interest) 87
Cost recovery (depreciation, depletion, and amortization) 91
Estate and Gift Taxation 99
Transfers subject to gift tax 99
Gift tax annual exclusion and gift tax deductions 100
Determination of taxable estate 101
Area IV: Federal Taxation of Individuals 104
Gross Income 104
Reporting of Items from Pass-Through Entities 110
Adjustments and Deductions to Arrive at Adjusted Gross Income and
Taxable Income 112
Passive Activity Losses 122
Loss Limitations 124
Filing Status 127
Computation of Tax and Credits 131
Alternative Minimum Tax 134
Area V: Federal Taxation of Entities 136
Tax Treatment of Formations and Liquidations of Business Entities
136
Differences Between Book and Tax Income 140
C Corporations 142
Computations of taxable income, tax liability and allowable
credits 142
Net operating losses and capital loss limitations 145
Entity/owner transactions, including contributions, loans, and
distributions 146
Consolidated tax returns 151
Multi-jurisdictional tax issues 152
S Corporations 155
Eligibility and election 155
Determination of ordinary business income(loss) and separately
stated items 157
Basis of shareholder's interest 159
Entity/owner transactions 160
Built-in gains tax 161
Partnerships 162
Determination of ordinary business income(loss) and separately
stated items 162
Basis of partner's interest and basis of assets contributed to the
partnership 164
Partnership and partner elections 167
Transactions between a partner and the partnership 168
Impact of partnership liabilities on a partner's interest in a
partnership 169
Distribution of partnership assets 170
Ownership changes 172
Limited Liability Companies (LLCs) 174
Trusts and Estates 175
Types of trusts 175
Income and deductions 176
Determination of beneficiary's share of taxable income 177
Tax Exempt Organizations 178
Types of organizations 178
Obtaining and maintaining tax exempt status 178
Unrelated business income 179
Area I: Ethics, Professional Responsibilities & Federal
Tax Procedures

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Ethics & Responsibilities in Tax Practice

Regulations governing practice before the IRS

The regulations governing an accountant practicing before the IRS
(representing a client before the IRS) are from the Treasury
Department’s Circular 230.

Defining “Practice before the IRS”:

Circular 230 defines this as:
• All matters connected with presenting to or corresponding with
the IRS relating to a taxpayer’s rights, privileges, or liabilities
under the laws or regulations administered by the IRS.
• This includes (but is not limited to):
⁃ Preparing & filing documents with the IRS
⁃ Communicating with the IRS
⁃ Representing a client at IRS hearings or meetings
⁃ Rendering written advice with potential for tax avoidance or
tax evasion

Who can “practice before the IRS”:

In general, it can only be:
• Attorneys
• CPAs
• Enrolled agents

Some key points from Circular 230:

If a client requests their records be returned to them, the CPA must

comply, even if the client still owes the CPA money for their services.

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A CPA should not represent a client if it would create a conflict of
interest, specifically to another client.

If the CPA finds an error made in a previous year, the CPA must advise
the client of the error. However, what to do about it is up to the client.
The CPA is NOT required to notify the IRS of the error, and they are not
required to file an amended return (the client may choose to do this,
but the key is that the only rule in this situation is that the CPA must
notify the client of the error).

A CPA is not required to verify information provided by a client. The

CPA is allowed to rely on good faith regarding the information provided
by the client.

When an authorized officer or employee of the IRS makes a lawful

request for records or information, the CPA is required to submit the
records requested unless the CPA believes in good faith and on
reasonable grounds that the records or information are privileged.

All paid tax return preparers must register with the IRS. Preparers will
not represent a taxpayer before the IRS, this is limited to attorneys,
CPAs, or an enrolled agent.

No practitioner may charge “unconscionable” fees for representing a

client before the IRS.

A CPA can charge a contingent fee under three circumstances:

1) For services rendered dealing with an IRS examination or challenge
to an original return or amended return or claim of refund.
2) When claiming a refund solely for statutory interest or penalties
previously assessed by the IRS.
3) If the CPA is representing the client in judicial proceedings dealing
with the IRS.
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Even though some CPAs become very familiar with tax law, there is
nothing in the regulations that authorizes a CPA to practice law in any
form.

Internal Revenue Code and Regulations related to tax return

preparers
Tax return preparers are required to obtain a preparer tax identification
number (PTIN). Signers and non-signer preparers are subject to this
requirement.

The definition of a tax return preparer (TRP) is:

“Any person who prepares for compensation, or who employs one or
more persons to prepare for compensation, all or substantial portion of
any return of tax or any claim for refund of tax under the Internal
Revenue Code.”

This includes anyone who prepares any federal income tax returns, and
estate and gift tax returns, and is paid to do so. Being compensated is
key. One layperson helping their mom do her taxes in TurboTax is not
considered a preparer.

Keep in mind it includes anyone who prepares a “substantial portion”

of the return as well, not just the signing TRP.

Tax return preparer penalties

If a TRP aids or abets federal tax evasion, then the TRP can be
prohibited from working as a preparer, AND face federal criminal
prosecution.

If a TRP endorses or otherwise negotiates a refund check issued to a

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taxpayer, this is not allowed and the TRP will pay a fine of $510. So, a
TRP cannot endorse and cash a client’s refund check, even if for some
reason the client asked them to.

Understating a taxpayer’s tax liability: If the preparer takes

unreasonable positions which understate a taxpayer’s tax liability, the
penalty is the greater of $1,000 or 50% of the income derived by the
TRP with respect to the return or claim for refund. Also, if there is
understatement due to willful or reckless conduct, the penalty is the
greater of $5,000 or 50% of the income derived by the TRP with respect
to the return or claim for refund.

Failure to furnish a copy to the taxpayer: If the TRP fails to provide the
client with a copy of the return, there is a $50 penalty for each
instance.

Failure to sign a return: A penalty of $50 for each instance of not

properly signing a return.

Failure to provide PTIN: A penalty of $50 for each failure to provide the
TRP’s identification number on a return.

Failure to retain a copy: A penalty of $50 for each instance of not

retaining a copy of the return.

Failure to file correct information return: Any person that employs

other TRPs needs to file an information return that lists the names and
social security numbers of such employees. Failure to file this
information results in a penalty of $50.

Failure to be diligent in determining eligibility for earned income

credit: This results in a penalty of $510 for each failure.

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Promoting abusive tax shelters: Penalty is $1,000 for each case in
which such a shelter was planned or arranged.

Aiding and abetting understatement of tax liability: This results in a

$1,000 fine.

Unauthorized disclosure of information by a TRP: If a TRP discloses or

uses information from preparing a return for any other purpose then
preparing and filing the return, there is a $250 fine for each use of such
information. This can also be a misdemeanor and a fine of up to $1,000
and possibly imprisonment of up to a year.

Fraud and false statements: This is guilty of a felony, and upon

conviction a fine of not more than $100,000 and possibly imprisonment
for not more than 3 years.

Fraudulent returns or statements: This is guilty of a misdemeanor, and

upon conviction a fine of not more than $10,000 and possibly
imprisonment of not more than a year.

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 Licensing and disciplinary systems

State Boards of Accountancy

These are the boards of each state that govern the practice of CPAs
within their jurisdiction. These are bodies that issue licenses to practice
in their jurisdictions, so it is also up to the state board to revoke a CPA’s
license to practice. The AICPA nor the PCAOB can directly revoke a
CPA’s license to practice, this must be done by the CPA’s state board.

Each state board has the same general requirements to become a

licensed CPA:
1) 150 hours of college education. Most states now require a master’s
degree
2) State-specific ethics course
3) Ongoing CPE
4) Passing the CPA exams
5) 2,000 hours of professional experience

There are a number of reasons a state board will revoke a CPA’s license
and possibly impose fines:
• Fraud in obtaining a certificate
• Failing to properly renew the CPA license
• If the CPA’s right to practice is revoked before a federal or state
agency, such as the PCAOB
• Violation of professional standards
• Conviction of a felony or any crime involving dishonesty
• Dishonesty, fraud, or gross negligence while performing services
for clients

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 • Failing to file the CPA’s own tax returns

AICPA
The AICPA works closely with state boards of accountancy, but
implementing and enforcing regulations is up to the individual state
boards

The AICPA can’t directly revoke a CPA’s right to practice, but most state
boards have rules that mirror the rules of the AICPA. This is why it’s
important for CPAs to adhere to the rules of the AICPA. There is also
the Joint Ethics Enforcement Program that involves joint enforcement
of the AICPA’s and the state board’s ethics rules.

The AICPA will suspend or expel members without hearing for:

• Filing a fraudulent tax return
• If a state board revokes that CPA’s license to practice
• If the CPA is convicted of a crime punishable by imprisonment for
5 years (convicted of a felony)
• Failing to file their own tax return

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 Federal Tax Procedures

Audits, appeals, and judicial process

Audit process
The first part of the audit process is matching up returns with W-2s and
1099s. Then returns are assigned a score, and from there the scores are
used to decide which returns will be audited.

The IRS has 3 years from the later of 1) the date the return was filed or
2) the date the return was due to impose additional tax. However, if the
gross income omitted was more than 25% of the gross income claimed
on the return, then the statute of limitations is 6 years. If there was
fraud involved in the return, then there is no time limitation on the IRS
assessing additional taxes and penalties.

Audits can be handled through written correspondence, in the field, or

in an IRS office.

The taxpayer can hire an enrolled agent, a CPA, or an attorney to

represent him/her in the audit.

After the audit is complete, the IRS agent reports their audit findings in
an Income Tax Examination Changes report.

Then there’s a negotiation period about whether the taxpayer agrees

with the findings in the Income Tax Examination Changes report.

If an agreement is reached:
When an agreement is reached, then the agent will issue a “Revenue

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Agent’s Report”, which the taxpayer will sign. If the taxpayer agrees to
the findings and signs this report, then the taxpayer cannot pursue
relief through the appeals process, AND the IRS can’t come back later
with additional judgements regarding the items listed in the report. But
this only applies to the specific items outlined in the agreement.

If an agreement is not reached (the appeals process):

If the taxpayer and the agent can’t come to an agreement during the
negotiation process, then the taxpayer will receive a copy of the agent’s
report and a 30-day letter. The 30-day letter is a notice that the
taxpayer has 30 days to appeal the decision, and it includes instructions
on how to appeal. The taxpayer is NOT required to respond to this
letter, and if they don’t, they will then receive a 90-day letter. The IRS
wants the taxpayer to agree to the “Revenue Agent’s Report”, but
again, the taxpayer is not required to respond to this 30-day letter.

If the taxpayer wants to appeal, they will file a petition to request an

appellate conference. This petition needs to outline the taxpayer’s
position for each item and include support for taking each position. The
IRS doesn’t have to grant an appeal, but they usually will. This process
takes place between the taxpayer and the IRS appeals office, as
opposed to the formal judicial process. If an agreement is reached
during the appeals process, then the audit process is over.

IF the taxpayer:
1) Does not reach an agreement during the appeals process, OR
2) Doesn’t respond to the 30-day letter, THEN
The taxpayer will receive the 90-day letter.

After the 90-day letter is received, the taxpayer now has 90 days to file
a Tax Court petition with the U.S. Tax Court. Once a petition has been
filed with the Tax Court, the IRS can’t enforce its assessment until after
the Court’s decision is finalized.
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If the taxpayer doesn’t file a tax court petition, after 90 days the
findings of the audit are binding, and the IRS will move to collect the
amounts owed. After the 90 days, the taxpayer’s only recourse is
through U.S. District Court or the U.S. Claims Court, but the deficiency
will have to be paid before the court process can begin.

Substantiation and disclosure of tax positions

According to Statements on Standards for Tax Services (SSTSs) #1, the
CPA needs to comply with standards from taxing authorities if possible,
on taking a specific tax position. A CPA/TRP that takes an
“unreasonable position” can be punished.

There are different levels of what a “reasonable position” means

according to SSTS #1:

A “reasonable basis” would be if the CPA did their research and

concluded there is a 20-33% chance the IRS would support the position.
At this level, there needs to be a disclosure of the position so that the
IRS can review it.

A “realistic possibility” of a position being upheld would be 33% or

more.

However, Congress is the overriding authority and there is a provision

that says it needs to be “substantial authority” to take a given tax
position. In this case, “substantial” means at least a 40% chance that
the IRS would accept the position. You don’t need to know how to
judge the percentage, or how a “40% chance” would be calculated, but

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the standard is a 40% chance that the IRS would agree with the
position.

So, the main thing to remember is that in general, there needs to be a

40% or more chance that the IRS would support a position in order to
take any given federal tax position. If it’s not a federal tax issue, then
the AICPA SSTS rule of greater than 33% would apply.

For a “tax shelter”, it is automatically unreasonable unless there is a

“more likely than not” (more than 50%) chance that the IRS would
accept the position.

The CPA needs to inform the client of potential penalties if the position
is rejected, and if applicable, how penalties can be avoided through
proper disclosure of the position.

What is “appropriate disclosure” for a tax position?

The information regarding the position needs to be “appropriately
disclosed”, and this disclosure should include a description of the
position being taken, the amount of tax involved, and the basis for the
position. If the taxing authority has a specific form for such a position,
then that form needs to be used. Or, if there are specific administrative
guidance for a certain position, that needs to be followed as well.

Remember, a CPA doesn’t have to verify every number the client

provides, but the CPA should make a “reasonable inquiry” if something
doesn’t add up, or even just to clarify something with the client. If the
client wants to pursue a tax position that the CPA doesn’t believe
would be upheld, the CPA should decline to prepare or sign the return.
If the client tells the CPA that documentation for a position exists, then
the CPA can take the client at their word and does not need to take
further action.

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If it turns out that the client just lied to their CPA about a deduction,
and is later figured out by the IRS, the CPA is not subject to any
penalties.

Going along with this, the declaration that the CPA signs on a client’s
return is warranting that the information provided by the client was
relied upon in preparing the return unless it appeared incorrect or
incomplete. This does not mean that every figure provided by the client
was fully audited and substantiated by the CPA.

A few random facts related to this that could be seen on questions:

If legislation causes a change to previous advice given to a client, the

CPA is actually NOT required to notify the client of the changes, unless
the exact issue was specifically the reason for the engagement.

If a question on a federal return has not been answered, there needs to

be “reasonable grounds” for not answering the question.

If errors are discovered on a previous return, the CPA’s duty is to inform

the client of the errors and suggest an amended return, but the
decision is up to the client.

If, for example, a CPA does a client’s return, and then the client alters
figures before sending in the return, and then the CPA finds out later,
the CPA is NOT obligated take any action such as contacting the IRS, but
the CPA should obviously evaluate their relationship with the client in
respect to any further engagements.

Taxpayer penalties
There are 4 types of taxpayer penalties imposed by the IRS:
1) Non-filing penalties

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2) Non-payment or late payment penalties
3) Underpayment penalties
4) Accuracy penalties

Non-filing penalties
The penalty for filing late is 5% a month of the tax due, up to 25% of the
tax due. If the return is filed more than 60 days late, then the penalty is
the lesser of $205 or 100% of the unpaid tax. If the taxpayer doesn’t
owe any taxes or is due a refund, no penalties will apply.

Non-payment or late-payment penalties

Taxes are due by the filing date. If they are not paid by the filing date,
interest on late payments starts to accrue immediately.

The late payment penalty is 0.5% (1/2 a percent) per month, up to a

max of 25% of the taxes owed. However, if the non-filing penalty is also
applicable, then that 5% per month accrues and the 0.5% penalty is not
applicable.

Underpayment penalties
For individuals:
Taxes are paid through withholding, or through estimated tax
payments.
If the amount of tax owed total will be more than $1,000, then the
taxpayer must make estimated tax payments on the 15th of April, June,
September, and January. (Again, this is if taxes aren’t being paid
through withholding)
No penalty will be imposed if the tax payments during the year were at
least 90% of the current year’s taxes or 100% of last year’s taxes. If the
taxpayer’s AGI exceeds $150,000, then the tax payments during the
year must be 110% of last year’s taxes.

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Accuracy penalties
A 20% of the tax due penalty for an inaccurate tax position due to
negligence. This is waived if there is a reasonable basis for the position

A 20% of the tax due penalty for substantially understating the tax due.
This is waived if there is substantial authority for taking the position, OR
if the position was appropriately disclosed on the return.

A 20% of the tax due penalty if there is a substantial overstatement or

40% for a gross overstatement of the value or basis of any property.
Substantial is 150% or more of the actual value, gross is 400% or more
of the actual value.

If fraud is involved in the underpayment, then there is a 75% of the tax

due penalty.

Random facts you could see a question on:

If a taxpayer wants to make a claim for a refund on paying too much tax
in a previous year, the form they would use is the 1040X, the
“Amended US Individual Income Tax Return”

To file an amended return, the taxpayer has 3 years after the filing date
of the original return, or 2 years after the payment of tax related to the
return, whichever is later.

Authoritative hierarchy
For federal tax purposes, here’s the hierarchy of authority for
determining tax positions or tax planning:

At the very top, you have the US Constitution, or in other words,

Congress.

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Then you have the IRS’s Internal Revenue Code (IRC) Statutes.

Then you have the US Treasury Regulations.

Then you have Judicial Authority in the following order:

• US Supreme Court
• US Circuit Court of Appeals
• US District Court
• US Tax Court
• US Court of Federal Claims

Then you have IRS Positions such as:

• Revenue Rulings
• Revenue Procedures
• Private Letter Rulings or Determination Letters
• IRS forms, publications, or FAQs

In general, the main source will be the IRS Internal Revenue Code. A
CPA would then try to find support from some source below that if
nothing explicit was found in the IRC.

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 Legal Duties and Responsibilities

Common law duties and liabilities to clients and third parties

Common Law Liability to Clients
CPAs have an obligation to their clients to exercise due professional
care. With an engagement letter, it provides the client and other third
parties with rights of recovery. Therefore, if the CPAs are not
performing within the agreement set forth in the contract this will be
considered a breach of contract. The clients may also claim negligence
against the CPAs if the work was performed but contained errors or
was not done professionally. This is considered a tort action.

In order to recover from an CPA under common law, the client must
prove:
• Duty of care
• Breach of Duty
• Losses
• Causation

CPAs may defend against a breach of contract if they can prove that the
client’s loss occurred because of factors other than negligence by the
auditors. If the CPA proves the loss resulted from causes other than the
CPA’s negligence, a client may be accused of contributory negligence. If
a state follows the doctrine of contributory negligence, the CPA may
eliminate their liability to the client based on contributory negligence
by the client. Many states do not follow this doctrine. Most states
permit a jury to assess the fault and apply the correct percentage of
fault to the parties involved. This is called comparative negligence.

Common Law Liability to Third Parties

If a third party brings a suit against a CPA there are several things the

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third party must prove:
1) They must prove that the CPA had a duty to exercise due care
2) They must prove that the CPA knowingly breached that duty
3) They must prove that the CPA’s breach was the direct cause of the
loss
4) They must prove that they suffered an actual loss

A few examples:

If a CPA recklessly departs from the standards of due care when

performing an audit, the CPA can be held liable to third parties who
relied on the audited financial statements based on gross negligence. A
breach of contract would only be applicable to direct clients of the CPA.
Also, it is a ‘reckless departure’ that results in gross negligence. If it was
failure to comply with some standards of due care, then it would be
negligence, not gross negligence.

A failure to complete an audit on time would result in a breach of

contract (breaching the terms set in the engagement letter), and the
client could sue the CPA firm for breach of contract under common law.

If an audit is performed according to Generally Accepted Auditing

Standards (GAAS), even if a material misstatement is not detected
which later causes injury to users of the statements, the auditor will
have a good defense against being sued.

Understand “privity of contract” or lack of privity: This means that in a

lot of cases a defense for the CPA would be lack of privity of contract,
meaning that a third party can’t sue the CPA if the audit was not for
their express purpose. On the other hand, when a client has a contract
with a CPA, there is privity of contract, and if the CPA fails to fulfill the
requirements of the contract, that is breach of contract. The client can
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sue for damages resulting from the breach of contract.

Going along with “privity”, there was the Ultramares case that specified
in cases of negligence, the CPA will be held liable to the client and also
any third parties that were intended beneficiaries of the contract. But
this doesn’t include all third parties, just intended beneficiaries of the
contract. This would mean users of the financial reports, such as a bank
using the statements to decide whether or not to give the audited
company a loan.

The best description of the relationship between a corporation and the

CPA firm it hires to do its audit is an employer (the corp) and an
independent contractor (the CPA firm).

Knowingly issuing an unqualified opinion when there is a material

misstatement is fraud, not negligence or breach of contract.

“Constructive fraud” occurs when the following elements are present:

1) a false misrepresentation of a material fact 2) reckless disregard for
the truth, 3) reasonable reliance by the injured party, 4) injury, 5) a
fiduciary relationship between the parties. With constructive fraud,
intent(scienter) doesn’t need to be proven as with actual fraud

The term “strict liability” will never be used to determine the liability of
a CPA. This is term specifically for some product liability cases.

Privileged communications, confidentiality, and privacy acts

There are just a few situations where a CPA can legally disclose
confidential information:

1) If GAAP requires disclosure

2) A valid subpoena or summons has been issued. The CPA is not

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required to inform the client that the information has been
subpoenaed.
3) During a peer review of the CPA’s firm
4) Disclosure to another firm member if pertinent to the engagement
5) An ethics review

When it comes to outsourcing work, which may involve confidential

client information, the CPA firm is responsible for maintaining the
confidentiality of clients’ information, but the CPA is NOT required by
law to notify the client when confidential information is shared with an
outsourcing partner.

If the IRS requests confidential client information, the CPA is not

obligated to comply, unless as noted above it involves a valid subpoena.

When it comes to workpapers involved in an audit, the workpapers are

not subject to the same privileged communication rules as the client’s
own source documents and information. The workpapers remain the
property of the CPA firm after the audit, and the workpapers can be
obtained by third parties if they appear to be relevant to issues in
litigation.

If a partner dies, his clients’ workpapers can be assigned to a surviving

partner.

Random facts that could be questions:

Under federal law, there is no “accountant-client” privilege with regard

to confidentiality. However, several states do have an accountant-client
privilege.

Read this one carefully: If a CPA firm is selling their practice, it IS

permitted to let prospective buyers of the practice view confidential
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client information. BUT, if the purchase goes through, before any
confidential records are actually turned over to the buyer of the firm,
they would need the client’s permission.

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Area II: Business Law

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 Agency

Authority of agents and principals

An agency agreement is when one party designates another to act on
his or her behalf

There are two parties in an agency relationship:

Principal: the party who hires the agent
Agent: the party who acts on behalf of the principal

Types of Agency Relationships

General agent: This type of agent has broad authority to carry out
transactions on behalf of the principal, but usually related to specific
business transactions.

Universal agent: An agent with authority to handle all affairs - business

& personal - of the principal. If a couple were going abroad for 3 years,
they could designate an adult child of theirs to be their universal agent
while they’re gone. A person can have only one universal agent. Then
they might have multiple general agents that each handle certain parts
of their business. A universal agent will usually have general power of
attorney regarding the principal.

Power of attorney: This is a type of general agency where the agent is

given authority to act on behalf of the principal in specific matters, or
even to be able to do or sign anything on behalf of the principal as if the
principal were there in person. The principal needs to sign the power of

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attorney, but the agent does not need to sign it to be valid.

Special agent: When the agent has authority only in specific or

designated instances. Example would be hiring a CPA to represent you
before the IRS when they find out about your tax shelter.

Independent contractor: Someone you’ve given authority to act on

your behalf in a limited and specific capacity, and you don’t control
their day-to-day activities. An example would be hiring an attorney to
draft your will. There are specific liabilities regarding independent
contractors that distinguish them from special agents, see the next
section.

Creation of Agency Relationships

To create an express agency relationship:

You can think of “express” as “explicit” or “direct” authority. This is
where a principal specifically gives an agent authority. If any duties are
incidental to the express authority granted, then the agent also has
implied authority for those incidental duties/tasks.

A written agreement is not required, unless the contract being entered

into falls under the Statute of Frauds OR, if the agency relationship will
last more than a year.

Capacity: to form an agency relationship, only the principal needs to be

competent. Note that agency does terminate if either the principal or
agent become incapacitated, but you could see a question on the
distinction to form an agency relationship.
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The agency relationship does not require consideration.

Apparent agency:
An agency relationship may be implied from the facts or circumstances
surrounding a person’s actions on behalf of another. If the principal
acts in a way that makes a third party assume the agent has authority
to act on behalf of the principal, then there could be apparent
authority, and the principal could have contracts entered into by the
agent enforced against them.

Ratification
If an agent acts on behalf of a principal without express or apparent
authority, the principal is required to ratify the contract before it is
binding.

To summarize: Express authority is explicitly given by the principal.

Apparent authority is when the actions of the principal cause a third
party to believe the agent has authority on behalf of the principal.

Duties and liabilities of agents and principals

Duties of Principals and Agents
The main duties of the principal to the agent are to comply with the
terms of the agency contract, and to reimburse reasonable expenses in
carrying out the agency agreement.

The duty of the agent to the principal is a fiduciary duty. A fiduciary

duty is the highest standard of care, and the agent is required to make
known any material facts to the principal in fulfilling the agency
agreement. This extends to the other logical duties such as obedience,

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reasonable care, providing an accounting of all the principal’s funds
involved in fulfilling the agency agreement, disclosure, and a duty of
loyalty.

Termination of Agency
There is termination of agency based on acts by the parties, and then
termination based on operation of law.

Termination based on acts of the parties:

These are things like one of the parties ending the agreement, the
fulfillment of the agreement, if the specified time frame passes, or if
the agent and principal mutually end the agency.

When there is termination by acts of the parties, the principal has a

duty to notify third parties of the termination. It is still possible for the
agent to act with apparent authority after the termination if a third
party is unaware of the termination. When the termination of agency is
due to an operation of law, this doesn’t apply.

Termination based on operation of law:

The death of either the principal or agent terminates the agency.
The insanity of the principal terminates the agency.
Termination due to the bankruptcy of the principal, or the bankruptcy
of the agent if the bankruptcy compromises the agent’s ability to fulfill
the agency agreement.
Termination due the change of a law. If a law changes and makes the
subject matter of the agreement illegal, then the agency is terminated.

Contract Liability of Principals/Agents

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When the agent has actual authority (express or implied) , and there is
a disclosed principal - meaning the third party knows who the principal
is and the agent has made it clear they are working on behalf of said
principal - the contract is between the principal and the third party,
even if the agent has done all the negotiating and working with the
third party. The liability for the contract is between the principal and
the third party.

In the same scenario, except the agent is acting with apparent

authority, then the principal is only liable to the third party, but the
agent is also liable to the principal for acting with apparent authority.

If there is a disclosed principal, but the agent is acting without any

authority from the principal, then the agent is liable to the third party
for any contractual obligations.

If there is an undisclosed or partially disclosed principal, and the agent

is acting with actual authority, then the agent and the principal can be
held liable to the third party. However, because the agent was acting
with actual authority, the principal would be liable to the agent if the
third party sued the agent.

If there is an undisclosed or partially disclosed principal and the agent is

acting without actual authority (if the principal is undisclosed then
there can’t possibly be apparent authority), then the agent is directly
liable to the third party.

Tort Liability
Agents are individuals, and individuals are always liable for their own
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torts. It’s possible that the principal can be liable for the agent’s tort,
but the agent will also be liable.

In an employer/employee relationship (master/servant), the principal

will always be liable for the torts of their agents, if the tort happened
within the scope of employment, or in performing within the scope of
the agreement. If it’s an independent contractor, then it’s less likely the
principal would be held liable for their torts.

If an agent commits a tort acting outside of the agreement, the

principal generally would not be liable, EXCEPT IF:
1) the principal was negligent in hiring that agent (didn’t screen
properly)
2) the principal was negligent in supervising the agent
3) if there was a pattern of the behavior and it wasn’t corrected
previously (implicit approval)

When an extra hazardous activity is involved, the principal has strict

liability in regard to the agent’s actions.

Other key facts or definitions

Agency coupled with an interest: This is an agency agreement in writing

that also gives the agent an interest in the subject matter of the
agreement. This agreement can’t be terminated by the principal,
whereas a normal agency relationship can be terminated at any time by
the principal.

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 Contracts

Formation
To have proper formation of a contract, there needs to be:
• Offer
• Acceptance
• Consideration
• (Lack of) Defenses to formation (legally valid reasons the contract
could be voided)

Offers:
To have a valid contract, the first step is to have an offer, and then have
acceptance of that offer. There is “making an offer”, but there is also
“making an invitation to make an offer”, which is not actually making
an offer.
A commercial on TV for a sale at a car dealership is an invitation to
make an offer… NOT an offer itself.

A valid offer will meet several criteria, such as:

• Genuine intent
• Offer is properly communicated
• Must contain definite terms and conditions

In general, an offer can only be accepted by the party to whom the

offer is made. The offer can’t be assigned to another party unless the
offeror consents to the assignment.

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Acceptance:
Acceptance binds the contract. If the offeror wants to “take back”
(revocation) their offer, they must do so before their offer is accepted.
Once the offer is accepted, there is an enforceable contract.

For unilateral offers, acceptance takes place upon completion

(performance) of the act required by the offer.
Common law contracts use a “mirror image rule” for the language used.
Anything besides agreement to the exact terms made in the offer
become a counteroffer and rejection of the original offer.

For example, in a real estate contract, if everything was agreed on and

then the buyer wanted the seller to throw in the leather recliners in the
movie room, that one request is a rejection of the current offer and
constitutes a new offer.

If acceptance is sent by an authorized medium (such as the mail), as

soon as the acceptance is sent, a contract is formed.
If the offer doesn’t specify a required response medium (such as
overnight mail), then any medium that is the same or faster method of
communication will constitute acceptance. Pay attention to the
question because if an offer does specify a medium for the acceptance,
then the acceptance needs to be sent by that medium to be valid.

So, if acceptance document is dropped off in the mail before the

deadline, then the offer has been accepted. This is the “mailbox rule”.
The mailbox rule is only for acceptance, it doesn’t apply for offers,
counteroffers, or rejection- those have to be received to be effective.
However, an offer can explicitly stipulate that acceptance is not
effective until the acceptance is received, and if this is the case then the
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mailbox rule doesn’t apply.

Consideration:
Consideration is the benefit promised by the offeror and the legal
detriment promised or performed by the offeree. You are offering $20
(benefit) if I mow your lawn (my time and effort is my detriment)

Consideration has to be of legal value, but the values to do not have to

be equal. You could have a contract to trade a Honda Accord for a
Lexus- the court doesn’t try to make contracts “fair”. The key phrase is
“legally sufficient”.

Bargained-for-exchange: This concept means that the contract induces

legal detriment on both sides (both sides are giving something up).

Past actions cannot count as consideration for current promises. If I say,

“I should give you $20 for mowing my lawn last week”, I can’t be held
to that promise because there is no consideration.

Also, consideration cannot be something you were already obligated to

do. A fireman can’t promise to put out a fire for you for $1,000 fee.

Defenses to formation:
Certain circumstances can void a contract later on if they were present
when the contract was formed. Some examples of ‘defenses to
formation’ are:
• Mistakes
• Fraud
• Misrepresentation
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 • Undue influence (duress)
• Illegal acts/subject matter

Note: In the “steps” to have a valid contract at the top of this section,
the 4th item is “lack of defenses to formation”. So, a valid contract
needs to have two parties that won’t have a valid reason down the line
to void the contract. Defenses to formation aren’t key to a contract…
it’s the lack of defenses to formation that is necessary for a valid
contract.

Capacity
Each party to a contract must be of legal age. Any minor entering a
contract has the right to disaffirm (void) the contract up until they
become of legal age.
If the item is “of necessity” (food, shelter, or clothing), and the item is
in value with what the minor is accustomed to, the seller can recover a
“reasonable value” from the minor.

The minor must return any consideration gained in order to disaffirm

the contract.
If the minor ratifies the contract after they become an adult, they are
fully liable to the terms of the contract.

The minor (now an adult) can either explicitly ratify the contract,
OR, if they keep performing on the contract for a reasonable time after
becoming an adult, they are implying ratification, and the contract is
binding.

Mental capacity is required to make or enter into a binding contract.

This includes mentally incompetent persons.
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It also includes intoxicated persons meaning that someone can void a
contract that they entered into while intoxicated to the extent that
they didn’t understand what they were agreeing to.

Mistakes
A unilateral mistake is a mistake by one party to the contract. The
mistake will be binding unless:
the other party knows the mistake or should know the mistake.
OR, the mistake is material and obvious, such as writing $500 instead of
$5,000 on the contract.
OR, the error was due to a mathematical calculation.
A bilateral mistake is when both parties are mistaken as to the subject
matter. If I thought I had a genuine Picasso painting and you agreed to
buy it, then we found out it was a fake, there is no contract.

Innocent Misrepresentation
Know the difference between “statements of fact” and “sales puffing”.
A statement of fact would be “You will lose 20lbs on this diet”. An
example of sales puffing would be “this diet will help you feel better”
For a valid defense to formation, there needs to be a “statement of
fact” that turned out to be false, and it needs to be “material”, meaning
it was enough to influence the buyer’s decision.

Fraud or “fraud in the inducement”

The thing that separates fraud and misrepresentation is intentional
deception. If I unknowingly leave out a key fact, that is
misrepresentation. If I leave out the key fact on purpose, that is fraud.

Undue Influence
This is when someone in a position of trust or authority over someone
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else uses that trust or authority to get a party to enter a contract with
them. Such contracts are voidable.

Duress
Duress is when someone is coerced into a contract by physical force or
threats of physical force, threats to disclose private information, or
economic pressure. Such contracts are voidable.

Illegality
Contracts in violation of laws or statutes are voidable.

Rejection
Any time the offeree rejects an offer in any way, the offer is
terminated.

Counteroffer
If, the offeree says something like, “I won’t pay $100, but I’d pay $80”,
this is a counteroffer, NOT acceptance of the original offer
Termination: Offers can be terminated through lapse of time, or by an
operation of the law.

Death or insanity of the offeror or offeree terminates an offer.

Destruction of the subject matter terminates an offer. If you’re selling

your car and it blows up before the deal is done, there is no more
contract.

If the subject matter of the contract is illegal, there is no valid offer and
a court would terminate the contract.

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Types of contracts:
Express contract: This is a contract made orally and/or written. If I offer
to sell you a laptop for $1,000 and you say that yes, you want it.

Implied contract (implied-in-fact): This is when a contract is formed by

intent and conduct of the parties. When you go take your car to the
mechanic, it’s not clear exactly what the costs will be, but it is implied
that you will pay for the repairs, whatever they may be.

Quasi contract or implied-in-law: When a court imposes a contract

because there was performance by a party. If you ordered catering, the
caterers showed up, you and your guests ate the food, and then you
tried telling the caterers you weren’t going to pay because the chicken
was overcooked… that would be “unjust enrichment” on your part (free
food) and a court would most likely order you to pay the caterer.

Bilateral contract: Both sides make a promise. The bank gives you
$100,000 to buy a home and you promise to pay it back over 30 years.

Unilateral contract: A contract where one party makes a promise in

exchange for some type of performance. I’ll pay you $20 to wash my
car.

Executed contract: A contract that has been fulfilled by both parties.

Executory contract: A contract that has NOT YET been fulfilled by both
parties.

Partially executed contract: Only one side of the contract has been
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fully performed.

Valid contract: A contract that has been legally formed and meets the
necessary requirements for formation.

Void contract: A contract that lacks a legal purpose or involves an illegal

act.

Voidable contract: An otherwise valid contract that can be voided due

to one party having legal protection for various reasons. This would be
if I got you to agree to buy a Rolex for regular price even though it’s a
fake.

Unenforceable contract: A contract that the courts would not enforce

due to some legal reason, but the parties can still execute if they both
choose to.

Statute of Frauds
This law requires that certain types of contracts be in writing. Any
contract involving the sale of real property must be in writing to be
enforceable. Also, if the contract will take more than a year to fulfill,
then the contract must be in writing to be enforceable.

In general, contracts for items (goods, NOT services) less than $500 can
be made orally and are still enforceable. Anything worth $500 or more
should be in writing to be enforceable.

Don’t get tripped up by questions similar to this involving services.

There can be oral contracts worth more than $500 involving services.
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Also, there is an exception to the “in writing” rule if the buyer and seller
cannot be returned to the “status quo” because of partial performance.
An example is if I was selling my house and I took a down payment and
let the buyer move in before the sale was finalized, and then I tried to
refuse to sell the house.

Parol Evidence Rule

This rule applies to complete written contracts, and it means that any
evidence besides what is written in the contract is not admissible. Once
the contract is written and accepted, one party can’t claim that other
things were agreed to orally; the contract is strictly what is written in
the contract. An exception to the parol evidence rule is fraudulent
statements. If fraud occurred, it will be admitted as evidence in court.

Performance
Once a valid contract is formed, the next thing to happen is the
performance of that contract. There some specific conditions that can
affect the performance of a contract:

Precedent conditions: This is something that must happen before a

party has a duty to perform. This could be qualifying for a loan before
purchasing a house, or if you were hired to clean the carpets in a house,
the furniture would have to be moved before you could be expected to
perform your part of the contract.

Subsequent: This is something that must happen after a duty to

perform has arisen. This could be having to return a TV within 30 days
in order to receive a full refund.

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Concurrent: This is each party’s duty to perform under a contract
simultaneously. An example is shopping at the store; you’re there
choosing the food to buy, you take it to the register, the cashier is there
who takes your payment, then the goods are yours. Performance is
happening concurrently.

If the conditions to perform are not present, then the duty to perform
is absent. There is also an implied agreement in every contract that the
parties won’t hinder performance of the other party.

Statute of limitations regarding contracts: Generally 10 years for

written contracts, and 5 years for oral contracts. If the statute of
limitations has run out and one party hasn’t performed but the other
party also hasn’t sued for nonperformance, the duty to perform is
discharged.

Discharge, breach, and remedies

Discharge of duty: There are several ways in which the duty to perform
can be discharged:
• By failure of conditions. If a condition precedent or subsequent
doesn’t occur, there is no duty to perform.
• The parties can agree to release one another, or to mutually
discharge a contract.
• “Novation” is a new party replacing one party in the contract and
assuming their liability in the contract. All parties need to agree,
and a new contract is formed.
• Discharge by accord & satisfaction: When performance is
completed on the original contract, or one party agrees that the

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 contract can be satisfied by completion of a different
performance.

Discharge by operation of law

• Statute of limitations: The time limits vary from state to state
• Bankruptcy
• Discharge by impossibility
• Death or insanity
• Destruction of subject matter: The car you’re trying to sell is
wrecked
• Illegality

Discharge by performance
If both parties have performed under the terms of the contract, then
the contract has been completed.

Substantial performance: When performance of contract is hard to

judge or has a broad spectrum of what could be considered
performance, then substantial performance which was performed in
good faith will be valid performance.

Discharge by material breach: If one side of a contract materially

breaches the contract, the other party is not required to perform.

Personal satisfaction: If the contract stipulates performance to the

personal satisfaction of one party, then that is the requirement for
performance to be completed.

Remedies for Breach

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Damages: This is when monetary damages are awarded.

Punitive damages are when money is awarded to punish a wrongdoer.

Compensatory damages are awarded to compensate for costs or loss

actually suffered.

Mitigation of damages: When a breach happens, the law usually

requires the non-breaching party to take some action to mitigate the
breach, such as finding a new renter if their old renter just took off with
8 months left on their lease.

Specific performance: This is requiring the other party to perform the

contract. This happens when money damages won’t sufficiently
compensate the injured party. An example would be a contract
involving the sale of a rare baseball card. Money damages aren’t the
same as getting the rare card, so the court would likely award specific
performance and enforce the sale of the card.

Rescission: This is when the parties go back and are restored to their
positions before the contract as much as possible.

Reformation: A contract is rewritten to address or solve an issue

between the parties.

Other Contract Matters

An incidental beneficiary cannot sue to enforce contracts. This would
be if I contracted with you to build my new office building, and in the
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contract, I specify that I want you to use ABC plumbing. If you use XYZ
plumbing instead, ABC cannot sue you or me because ABC was an
incidental beneficiary of the contract.

Unless a contract’s terms expressly prohibit a party from assigning their

rights to another party, one party’s rights are generally assignable in
contracts.

If a sales contract is being assigned to a third party, the assignment

cannot materially increase the other party’s risk or duty in doing so or
the assignment is invalid.

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 Debtor-Creditor Relationships

Rights, duties, and liabilities of debtors, creditors, and guarantors

Suretyship
A surety or “guarantor” is someone who agrees to be liable for
someone else’s debt. It’s like ‘co-signing’, and gives creditors another
form of backup for the debt

The creditor loans money to the debtor, and the surety backs up the
debtor.
• The creditor
• The debtor
• The surety or guarantor

The surety is liable only after the original debtor has defaulted, and
there can be more than one surety, or co-sureties.

When two people act as a co-surety, neither can be held liable for an
entire debt. Once the debtor defaults, if one co-surety pays more than
their share of the debt, they can recover the amount paid in excess of
their share from the other co-surety. This is called “contribution”, and
this doesn’t apply to a single surety since they are the last in line for the
obligation.

In general, where there are co-sureties, the amount each one is liable
for will be pro-rata. For example, if ABC is loaning Tom $300,000, and
he has 3 co-sureties: Bill, Cal, and Dave. Bill is responsible for $150,000,
Cal for $75,000, and Dave for $75,000. So, their pro rata amounts are:

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If Tom defaults after paying off $200,000, then there is $100,000 left
that Bill, Cal, and Dave are responsible for. It’s simply each surety’s pro-
rata amount, so Bill would pay $50,000, and Cal and Dave would each
pay $25,000.

But what if Cal went bankrupt before Tom defaulted on the debt? In
this case, Cal is not liable as a surety, and to determine Bill and Dave’s
obligation, you remove Cal’s portion from the denominator to
determine their portions:

Remember to think of it in common sense terms: If one surety has gone

bankrupt, then each of the two remaining sureties will each owe a
larger portion than when there were three sureties.

On the opposite side of this, if the creditor releases one co-surety from
their liability, then the remaining co-surety’s obligation will be reduced
by the pro-rata portion of the surety that was released.

If the creditor releases one co-surety without the consent of the debtor
or the other co-surety, then the remaining co-surety is only liable for

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half of the debt.

On a “guaranty of collection”, the surety is only liable if collection

against the primary debtor fails first.

A creditor is required to disclose any known material facts to a surety

before the surety signs the loan agreement. For example, if the creditor
knows that the debtor’s financial information is leaving out material
facts, but doesn’t disclose this to the surety, the surety can use this
later as a defense to repayment.

A surety CANNOT compel the creditor to either:

• collect from the principal debtor
• OR, proceed against the principal debtor’s collateral
• A surety is primarily liable for the debt upon the debtor’s default.
The creditor can proceed to collect from the surety

If a surety loses capacity, then they won’t be liable for the debt any
longer.
Suretyship contracts must be in writing according to the Statute of
Frauds, or else they are not enforceable.
The death of the principal debtor does NOT release the surety’s
obligation.

Bankruptcy and insolvency

The actual laws on bankruptcy are complicated, and it would be
counter-productive to try and learn all of it for the REG exam. So, here’s
just a list of the facts you’re most likely to see on the exam:

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Chapter 7 bankruptcy: this is a liquidation bankruptcy. It allows
voluntary or involuntary petitions (meaning either you can initiate
bankruptcy, or a creditor can try to take you through bankruptcy
because you haven’t been making your payments). There is a “means”
test for determining whether the debtor can pay back their debts. This
is also used to determine “bankruptcy abuse” (trying to just get out of
paying off debts through declaring bankruptcy). If there is bankruptcy
abuse, the consumer and the consumer’s lawyer can be held liable for
costs. A trustee is appointed in a chapter 7 bankruptcy.

A debtor does NOT need to be insolvent or have a certain number of

creditors to file chapter 7. Almost anyone can file a petition for chapter
7 relief, BUT, there will be the test for “bankruptcy abuse”.

If a business is being petitioned into bankruptcy by a creditor, and the

business challenges the petition, the challenge will fail if the business
has not been paying their bills as they become due.

There is a creditor’s meeting where the party declaring bankruptcy can

be examined under oath by the creditors. If the debtor fails to attend
(unless excused) the creditor’s meeting, it’s considered a failure to co-
operate and grounds for denial of the debtor’s discharge.

Also, if a debtor fails to reasonably explain a loss of assets, the

discharge will be denied.
Corporations and partnerships can go through Chapter 7, but they
don’t qualify for a general discharge of debts like a regular person does.

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The following are not eligible for chapter 7 bankruptcy:
• Credit unions
• Banks
• Insurance companies
• Railroad companies
• Small business investment companies

Chapter 11 bankruptcy: The purpose of a chapter 11 is to “re-

organize”, and for the firm to stay in business. This allows for a
reorganization of a debtor to pay their debts. This results in a court-
supervised reorganization plan that will pay some or all of the
business’s debts or an extended period of time. Chapter 11 also allows
voluntary and involuntary petitions. There is generally no trustee.

Chapter 13: This type allows for the adjustment of debts of an

individual with regular income. Chapter 13 allows only voluntary
petitions. There is always a trustee with Chapter 13. A 3-5-year plan is
made as a result of the bankruptcy.

Artisan’s lien/Mechanic’s lien: Work done to improve or repair

property gives the artisan a security interest in the property. It is a
possessory lien, meaning that the creditor can take possession of the
property and sell it to satisfy the debt. Any amount from the sale above
what was owed is returned to the owner of the property. A possessory
lien has priority over other perfected secured liens in most states. Auto
mechanics are an example of who could place an artisan lien.

When a debtor declares bankruptcy, the debtor cannot prefer one

creditor over another.
The debtor’s estate in bankruptcy is considered to be all tangible and
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intangible property the debtor held at the beginning of the bankruptcy
proceedings. It also includes any income generated from such property
after the beginning of the bankruptcy proceedings.
Not only income from the property, but any appreciation in value of the
property as well.
Also, any gifts received or property via inheritance received within 180
days of the filing of the bankruptcy petition are considered part of the
estate.
“Payments”, such as alimony or social security payments received after
the filing are NOT considered part of the estate.

Distribution of debtor’s estate:

Below is the order in which a debtor’s estate is divided up after a
bankruptcy. This is a topic frequently tested, and you should know the
order of this list. This list is in order of priority:
• Perfected secured parties
• Claims for domestic support: this includes child support AND
alimony
• Administration costs: includes costs and expenses related to the
bankruptcy proceedings. Includes attorney fees, accounting fees,
appraisals, and trustee fees
• Employee wages: employee wages are limited to those earned in
within 180 days of the filing up to a maximum of $12,850.
Anything above the $12,850 is put in the same category as
“general creditors”
• Contributions to employee benefit plans: any claims for
contributions to an employee benefit plan from services
performed within 180 days before the filing up to $12,850 per
employee
• Claims of farm producers and fisherman: up to $6,325 per creditor
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 • Consumer creditors: up to $2,850 per creditor. Any amount above
that is treated as a general creditor claim
• Claims of governmental units for taxes
• Claims for death or personal injury
• All general unsecured creditors
• If anything is left, this goes back to the debtor

Items NOT discharged in bankruptcy:

• Claims arising from alimony or child support
• Student loans
• Federal tax liens (unpaid taxes)
• Debt acquired through false representations (lying about income
or some other fraud in order to get a loan)

Other bankruptcy facts:

• If a debtor is being represented by an attorney, the creditor needs
to communicate with the attorney, not the debtor.
• An involuntary petition, if not contested by the debtor, will result
in an order for relief. If the petition is contested, then the creditor
needs to prove the debtor hasn’t been making payments to get
the order for relief.
• A writ of garnishment is an order that allows a creditor to take a
portion of a debtor’s wages as a means of repayment.

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Secured transactions
A security interest gives a creditor specific collateral the borrower owns
that the creditor will get if the borrower doesn’t pay back their debt.
To create a security interest, the creditor must give value, the debtor
must have rights in the collateral (you can’t offer your friend’s car as
collateral), and the creditor must take possession of the collateral or
obtain an agreement with the debtor. These 3 things CREATE a security
interest, and to PERFECT a security interest, a financing statement must
be filed. Note: The debtor must agree to the creation of the security
interest.

If a security interest does not attach, it is not effective against the

debtor or third parties.

To summarize, a security interest attaches when the following occurs:

• The secured creditor gives value (provides the loan)
• The debtor has rights in the collateral (can’t offer his friend’s car
as collateral)
• A security agreement exists

And for the interest to be PERFECTED, a financing statement must be

filed. A financing statement lasts for 5 years but can be re-filed
indefinitely every five years.

A security interest can be ‘perfected’ without having to file a financing

statement if the sale is made to a consumer. Example is buying a TV on
credit from a store with credit extended from the store itself. The term
you’ll probably see on a question is “purchase money security interest
in consumer goods.”

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When inventory is the collateral, a financing statement must be filed to
perfect the security interest.

A filing statement is valid if it contains the names of the debtor, the

names of the secured party, and a description of the collateral. Leaving
one of these out invalidates the filing.

The point of perfecting a security interest is to take priority over other

creditors in the same collateral. When two creditors both have
perfected interests in the same collateral, the priority goes to the
creditor whose interest was perfected first.

Priority of secured transactions

If a creditor has a perfected security interest in some collateral, then
they will have priority over:
• A creditor with a security interest that is unperfected
• Unsecured creditors
• Lien creditors where the interest was perfected before the lien
attached
• Judgement liens where the interest was perfected before the
judgement lien attached

Another important fact is that even if a creditor has a perfected interest

in some collateral of the debtor, if a buyer purchases the collateral in
the ordinary course of business, the buyer will be unaffected by the
security interest in the collateral. If a creditor has a security interest in
the inventory of a TV store, and you come in a purchase a TV, the
creditor can’t come after you for anything - you own the TV free and
clear.
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Debtor moves to new jurisdiction:
If a debtor moves to another jurisdiction, someone with a security
interest against them has 4 months to file a financing agreement in the
new jurisdiction. Until the 4 months passes, the oldest security interest
has superiority, even against another security interest in the new
jurisdiction. After 4 months, if the oldest security interest has not filed
in the new jurisdiction, then the oldest properly filed security interest
becomes the most superior security interest.

Example
If Abby has a security interest against me and I move to a new
jurisdiction, and immediately purchase some equipment from Barry
and he gets a security interest against me, if I default on both debts
only after 1 month of being in the new jurisdiction, Abby’s interest is
superior to Barry’s even if Abby hasn’t properly filed her interest
against me in this new jurisdiction.

When a debtor defaults, the secured creditor may repossess the

collateral on its own as long as the repossession is performed without
disturbing the peace. The secured party can then sell the goods and
apply the proceeds towards the debt. Or, the secured party can try to
recover through the judicial process.

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 Government Regulation of Business

Federal securities regulation

Definition of a security:
• A “security” as defined by the 1933 Act is an investment that:
• Is an investment of money
• In a common enterprise
• With the expectation of profit
• To be earned primarily by the action of others

These are things like stocks, bonds, notes, and limited partnership
interests. Doesn’t include a general partnership interest, since this
involves participating in the day to day operations of the partnership.

Registration
Any initial offering of securities must be registered with the SEC unless
it meets one of the exemptions, which are covered below
The primary purpose of registration is to adequately and accurately
disclose financial and other information that investors can use to make
investment decisions.

After a prospectus and registration statement have been filed with the
SEC, there is a 20-day waiting period before the stocks can be issued.
During these 20 days, a preliminary or “red herring” prospectus can be
issued to investors.

Also during the 20 days, a “tombstone ad” may be placed which is a

restricted ad that let’s investors know a prospectus on the stock is

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available.

Under the Act of 1933, a non-WKSI securities-registration statement

must disclose (WKSI means Well-Known Seasoned Issuers and they
have less rules to follow):
• a description of the security
• how the corporation will use the proceeds from the sale
• a description of the registrant’s business and management
• and a financial statement
It also must contain a prospectus

Exempt Securities
There are 3 major types of transactions that are exempt from
registering with the SEC:
Small offering exemption. These types of offerings are so small that
they pose a small threat to the public.

Private placement exemption. These transactions only involve

accredited investors, and therefore do not need the protection of the
1933’s Act disclosure rules.

Intrastate offering exemptions. These are transactions that are

contained within one state and therefore are subject only to that
specific state’s regulations.

Specific Exemption Rules (for all below, one general rule is that the
SEC must be notified within 15 days of the first sale of securities)

Rule 504 of Regulation D

• This rule is mostly for small companies
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 • Can only be used to raise $5 million in any 12-month period
without registration
• Securities can be sold to anyone

Rule 506 of Regulation D

• No limit on the amount
• Securities can be sold to an unlimited number of accredited
investors but no more than 35 unaccredited investors

Regulation A
• Can raise$20 million per 12 months if sold to anyone, or $50
million per 12 months if restricted to accredited investors and
unaccredited investors can only invest up to 10% of their annual
income or net worth.
• It’s pursuant to the JOB Act of 2012

Rule 147 Intrastate offering

Issuer must be organized and doing business in the same state which
the offering will be. There’s an 80% test that means 80% of the assets
should be in state, 80% of revenue should be in state, and 80% of the
proceeds of the offering should be in state.

Other rules
The resale of limited partnership interests will generally be limited.
Governmental securities such as municipal bonds are exempt from
registration under the 1933 Act.
Securities issued by a charitable organization are exempt from
registration.

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JOBS Act
This is not really a “jobs” act, it is a securities law. The idea is that it
would make it easier for small companies to raise capital, and therefore
create jobs.

The act did 5 main things:

• Created a new category of businesses called “emerging growth
companies (EGCs)” which can have an IPO to raise capital but can
also avoid most burdens of being a public company for 5 years
• Encouraged crowdfunding (foreign firms CANNOT use the
crowdfunding exemption)
• Increased the Regulation A amount that can be raised from $5 to
$50 million
• Allows firms doing private placements to use general solicitation
and advertising which wasn’t previously allowed
• Changed the definition of a public company so that firms could
grow larger before becoming “public” and thus avoid all the
regulations and red tape involved with being a public company

Other JOBS act elements

A firm can use general solicitation in an offering as long as they take
“reasonable steps” to ensure that they only sell to accredited investors
under Regulation D.

$100,000 is the most an individual can invest in crowdfunded ventures

in one year. If someone invested 100k in company A’s venture, he
cannot invest in any other crowdfunded ventures that year.

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Requirements to be an EGC
• Have less than $1 billion in annual gross revenue during most
recent fiscal year
• Have been publicly traded for less than 5 years
• Have a public float of less than $700 million (shares in the hands
of public investors as opposed to company officers)
• Have not issued $1 billion in non-convertible debt in the prior 3-
year period

Benefits of being an EGC (the following apply to the firm for up to 5

years after its IPO):
• The registration statement is confidentially reviewed by the SEC
• There is reduced requirements regarding audited financial
statements: they only need 2 years of audited financials instead of
3 years
• Don’t need to comply with SOX 404(b) requirements for audit of
internal controls
• Don’t need to comply with new PCAOB rules
• There’s reduced disclosure requirements regarding executive
compensation

Violations of Securities Laws

Liability Provisions of 1933 Act

This mainly deals with Section 11, which remedies misleading
statements and omissions contained in the registration statement.

Elements involved in a Section 11 claim:

A CPA who certifies financial statements included in a registration
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statement will generally not be liable to a purchaser of the security if
the CPA can prove due diligence. This includes if mistakes were made.
As long as the CPA/auditor acted carefully in performing the audit, the
CPA will have a due diligence defense.

The main things that a plaintiff (the party suing) must show to win a
Section 11 claim are:
• That there was a material misstatement in the registration
statement on the effective date
• That they can trace their shares to that registration statement
• And that they suffered damages

These make it fairly easy for a plaintiff to win, because they don’t need
to prove reliance, or that there was fraud.
Basically, as long as it is discovered the registration statement
contained a material misstatement for whatever reason, and that they
plaintiff suffered a loss, the plaintiff will win.

Victims of fraudulent misstatements are entitled to rescind the

transaction OR recover their losses caused by their reliance on the false
statements.

“Scienter” is a “guilty mind”. The key idea is that there was the
intention to do something wrong. If the word “negligence” is used, then
it was a mistake that was unintentional.

If a CPA acts willfully to certify materially misstated financial

statements, they can be punished criminally under the “criminal
provisions” of the 1933 and 1934 acts.

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In insider-trading cases it is common for the SEC to bring civil charges
and then the Department of Justice to bring criminal charges.

Other federal laws and regulations

Anti-Discrimination
The main act was “Title VII” of the 1964 Civil Rights Act
There can be no discrimination in employment based on:
• Race
• Color
• Religion
• Religion limitation: A Lutheran church is allowed to not hire a
Catholic priest, but an HR firm cannot discriminate against any
candidates no matter their religion
• Sex
• National origin: this includes discrimination because of accents

These rules apply to:

• Employers having 15 or more employees
• AND whose business affects interstate commerce
• Federal, State, and local government employees

These rules are enforced by the Equal Employment Opportunity

Commission (EEOC).

Age Discrimination in Employment Act (ADEA)

This was meant to supplement Title VII which didn’t address age
discrimination.
The act protects individuals 40 years and older. The main effect was to

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prohibit mandatory retirement.

Americans with Disabilities Act (ADA)

Applies to employers with 15 or more employees, all state and local
governments, and most private businesses that provide
accommodations, goods, or services to the public.

Employee Welfare
Social Security benefits are meant to partially replace income when a
worker retires.
To be “fully insured”, one must accrue a minimum of 10 years of
contributions.

A “fully insured” worker is entitled to the following benefits:

• Survivor benefits for widow or widower and dependents
• Disability benefits for worker and family
• Old age retirement benefits to worker and dependents

A “currently insured” worker is eligible for:

• Limited survivor benefits
• Benefits for disabled workers and dependents
• Lump-sum death benefits

Investment income and pension income are expected during

retirement, so these will not reduce Social Security benefits. But,
earning salaries, fees, or wages by working in some form can result in
Social Security benefits being reduced.
Medicare cover portions of costs and hospitalization of insured workers
and spouses 65 and older.
Disability benefits cover workers who suffer a severe physical or mental
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impairment that prevents that person from working for a year or more
or is expected to result in the victim’s death.

Employment Taxes

Federal Insurance Contributions Act (FICA)

Imposes social security tax on employers, employees, and the self-
employed.
Under FICA, contingent fees, bonuses, and commissions are all
considered wages. Reimbursed travel expenses are NOT considered
wages for FICA.
If an employer pays both the employer and employee portions of FICA,
but fails to collect the employee portion from the employee, the
employer has the right to be reimbursed by the employees for the
employees’ share.

Federal Unemployment Tax Act (FUTA)

These are taxes paid by employers which go into federal and state
pools to compensate workers who have lost their jobs and can’t find
new employment.
Unemployment benefits are given to people who lose their jobs and are
not fired for a reason. When a business “down sizes”, the laid off
workers will receive unemployment benefits.
An employer can take credits against Federal unemployment taxes if
they have paid into a state unemployment fund first.
Taxes paid to the Federal Unemployment Tax are deductible by the
employer as a business expense for federal income taxes.

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Fair Labor Standards
Non-exempt workers must be paid overtime for all hours over 40 in any
given week. If an employee had weekly hours of 38, 42, 36, and 44, the
employee has to paid overtime for 6 hours (2 hours from 42 and 4 from
44). Employers are not allowed to average weekly hours.
This act regulates minimum wage, overtime, and the number of hours
in the working week.

Affordable Care Act

Some of the biggest impacts of the ACA are:
• People with pre-existing conditions can’t be refused coverage.
• Coverage can’t be canceled for illnesses, only for failing to pay
premiums or fraud.
• Eliminated pricing discrimination based on gender or other
factors.
• Eliminated lifetime limits - insurance companies can’t cap what
they’ll spend on a patient.
• “Applicable large employers” (ALEs) are required to provide
“minimum value” coverage to at least 95% of their full-time
employees. An ALE is a company that employs at least 50 full-time
employees.
• If a required employer does not offer coverage, then the fine
would be $2,260 per uncovered employee (excludes the first 30
employees).
• The TCJA repealed the individual mandate, meaning there’s now
no penalty for not having health insurance.

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Employee Benefits

Employee Retirement Income Security Act (ERISA)

The act protects employees’ rights in existing pension plans.
It preempts state regulation and replaces it with comprehensive federal
regulation.
It also offers tax incentives to employers for setting up employee
benefit plans that meet certain IRS requirements.
ERISA does not apply to government pension plans.
If an employer offers a pension plan, ERISA mandates that the plan be
offered to new employees without undue delay.

Federal Consolidated Budget Reconciliation Act (COBRA)

This mainly provides health insurance in some circumstances after a
worker loses their job.
Usually covers the employee for 18 months after losing their job.
The coverage period is 29 months if the insured was disabled at the
time of the qualifying event.
This includes the employee’s spouse. If an employee is laid off, their
coverage will last 18 months. If the employee’s spouse was disabled at
the time the employee lost their job, then the spouse’s coverage will
last 29 months.

The Family and Medical Leave Act (FMLA)

This was set up to balance an employee’s workplace demands with the
needs of a family.

This provides an employee with up to 12 weeks of unpaid leave without

losing his/her job for:
• Birth of a child
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 • Adoption
• A personal serious health condition
• The care of a child, spouse, or parent with a serious health
condition
• Impending order of active duty of an employee’s spouse, child, or
parent

To be eligible, the employee must have worked for the employer for at
least 12 months, AND at least 1,250 hours during the previous 12
months.

Employers
• FMLA applies to employers with over 50 employees within a 75-
mile radius
• State and local government agencies
• It is not the burden of employers to offer FMLA, employees must
request FMLA leave to be entitled to it

Employee Health and Safety

Workers’ Compensation Act

This provides compensation for employees who have work-related
injuries. The employer has strict liability, the employee doesn’t have to
prove employer negligence or fault by the employer.
If a worker is killed in an accident on the job, then workers comp will
make monthly payments to dependent children.
Workers comp would also pay burial expenses when a worker dies in a
work-related accident.
Workers comp will pay for prosthetic devices if the worker loses a limb
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while working.

The worker will NOT receive workers comp benefits if:

• The injury was self-inflicted
• If the worker was intoxicated while at work and the injury
happened

OSHA
Requires that the employer provides a workplace free from recognized
hazards.
OSHA is authorized to establish standards that protect employees from
exposure to substances that may be harmful to their health.
Under OSHA, a worker can refuse to work if there is a present safety
violation that threatens physical harm or danger. Also, an employer can
fire an employee for failing to comply with OSHA rules
OSHA does not apply to the federal government, state governments, or
industries that are subject to other safety regulations such as mining.

Unions
If an employee wants to bring a union to his workplace, he will need to
get 30% of eligible employees to sign authorization cards to require the
employer to hold elections as to whether a union will be implemented.

During upcoming collective bargaining, a company cannot lock out

unionized employees in order to:
• destroy the union
• punish the workers for organizing
• avoid good-faith bargaining responsibilities

Management must rehire striking workers after an “unfair labor

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practice” strike. If the strike was over wages, the company does not
have to rehire the workers.

Copyright Laws
A copyright lasts for the life of the author, plus 70 years.
A work for hire (if you write a book for me but I have the rights to the
book) is protected for the shorter of:
95 years from the date of publication or 120 years from the date of
creation.

Patent Laws
A patent expires 20 years from the date of filing, NOT the date that the
patent is granted.

Abstract ideas are not patentable.

An invention is patentable if it:

• Is a tangible application of a new idea
• It is useful
• It is novel
• It is non-obvious. This means that you can’t just patent a slightly
different version of a device that has already been patented - the
original device gave you the idea.

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 Business Structure

Selection and formation of business entity and related operation and

termination
Businesses can be structured in several different ways in order to gain
certain benefits.

Types of Business Entities

Sole proprietor
A single owner business where the assets and liabilities belong solely to
the owner.

Formation
No formal requirements or filings to be a sole proprietor. Very simple to
setup, there’s no specific forms to file to create the entity. There might
be required business licenses but nothing specific to form a sole
proprietorship. Disadvantage is the individual has unlimited personal
liability.

Since there is nothing formal to file to “setup” a sole proprietorship,

there is also no formal process for termination - the individual would
simply stop performing the business activities.

General partnership
Two or more persons working as co-owners to earn a profit. The

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partners are personally liable for business debts, and any profits will
“flow through” to the individual partners for tax purposes. There is
nothing formal required to setup a general partnership. There is pass
through taxation, and there is unlimited personal general liability for
the partners.

Note: There is a governing set of provisions for partnerships called the

Uniform Partnership Act (UPA), which was revised in 1994 and is mostly
referred to as the Revised Uniform Partnership Act (RUPA). RUPA
outlines procedures or rules for the formation, operations, and
termination of partnerships. If a partnership agreement doesn’t include
specifics on certain matters, then the partnership would be subject to
the RUPA rules.

Operational features
Unless there is a written partnership agreement that details otherwise,
all partners have equal say in the day to day operations of the business.
A unanimous vote is required for major decisions such as admitting a
new partner, assigning partnership property, or any decision that would
impair the operation of the partnership.

Partnerships operate using capital accounts for each partner that

account for money or property contributed, share of net profits, share
of liabilities, etc. Again, unless specified in the partnership agreement,
all partners share in profits and losses equally. This includes if one
partner has contributed more or works more, if a specific allocation is
NOT outlined in a partnership agreement or profit-sharing agreement,
then the partners share the profits equally.

If a partner retires, they are liable to creditors for existing debts of the
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partnership. They are not liable for partnership liabilities incurred after
their retirement. If a new partner is going to replace the retiring
partner, the existing debts can be transferred to the new partner if
agreed to by the creditors through a novation. This differs from the
partner’s right to their share of the profits, which is freely assignable to
a new partner without the consent of the other partners, unless this is
expressly prohibited in the partnership agreement.

If a partnership has no time duration specified, then it is a “partnership

at will”.

A tort committed by one partner while performing partnership business

can result in all partners of the partnership being held liable.

Termination
If not specified in a partnership agreement, the rules for termination
will follow RUPA. Several things can cause the dissolution of a
partnership according to RUPA such as the death of a partner, one
partner wanting to end the partnership, the bankruptcy of a partner, a
violation of the partnership agreement by one of the partners, or an
event happening that was in the partnership agreement that would
dissolve the partnership.

If a general partnership is dissolved, the liabilities of the partnership still

exist, and the owners or former partners are still liable.

You might see questions regarding one partner “going into

competition” with the partnership. This would be any situation where a
partner performs some act that hurts the partnership. There is a
fiduciary duty of each partner to not “enter competition” with the
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partnership.
If a partner acts with “apparent authority” and enters a contract on
behalf of the partnership, the partnership will be held to the contract.

Limited partnership
Involves at least one general partner and one limited partner but there
can be multiple of each. A general partner is a full partner which
includes working on the day to day operations of the business, as well
as being fully liable for the business debts. A limited partner contributes
capital but doesn’t actively manage the business and has limited
liability for business debts.

Formation
Formation of a limited partnership differs from a general partnership in
that formal documents must be filed with the state. A limited
partnership is designated by a “LP” or “Ltd” at the end of the business
name.

Operational features
A limited partnership has pass through taxation. Liability is limited for
limited partners, but to maintain their “limited” status they can’t be
involved in the management or day to day operations of the business.
There will be one or more general partners that are “running” the
business day to day and making management decisions, and then one
or more limited partners that are essentially investors.

The operations of a limited partnership are the same as a general

partnership, such as each partner having a capital account

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Termination
This is substantially the same as with a general partnership. One
difference is that a limited partner leaving the partnership doesn’t
dissolve the partnership.

Limited liability partnership (LLP)

This form provides more protection from liability specifically for
professionals such as doctors, accountants, and attorneys. The main
idea is to protect partners from the malpractice of other partners. If
partner A is found guilty of malpractice, partner A is personally liable
and not partners B, C, and D. Limited partners do lose their limited
liability status if they start participating in management activities.

Formation
Like a limited partnership, there are formal documents that need to be
filed to form an LLP. The certificate of limited partnership filed with the
state needs to contain the names of any general partners, but it is not
required to contain the names of the limited partners.

Termination
Same as other partnerships.

Corporation
Provides limited liability for the owners - you can buy a share of stock in
Apple, and your liability is limited to the amount you invested. The
corporation is a legal being separate from its owners. A downside of
corporations is the “double taxation”: the corporation is taxed on its
profits, but the shareholders are taxed again on dividend income.
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A corporation is “domestic” in the state in which it is formed and is
“foreign” in other states.

Formation
To form a corporation, “articles of incorporation” are submitted which
must include:
• the name of the corporation
• the number of shares it is authorized to issue, and classes of stock
to be issued
• the street address of its registered office and the name of its
agent at that address
• the name and address of each incorporator

After the articles are filed, there will be the first board of directors’
meeting, and at that meeting the officers will be elected. The
corporation’s bylaws are also drafted and adopted.

There is a “promoter” (can be more than one) that solicits people to

invest money into a corporation, and “sets up” the corporation such as
finding and leasing office space. The promoter has a fiduciary duty to
the shareholders of the corporation. This can be a shareholder in the
corporation.

For example, if you are the one starting the business, and you go out
and find investor money and lease office space, you are the promoter.
You are liable for the debts or contracts entered into until the
corporation is formed and the corporation assumes the debts/contracts
through a novation.

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So remember that the promoter is personally liable for contracts
entered into or debts accumulated until the corporation adopts them
through a novation.

Operational features
The basic operational structure of a corporation is that there are
shareholders who elect directors (board of directors), and then the
board selects officers who will run the day to day operations of the
corporation.

“Piercing the corporate veil” means that a corporation’s shareholders

become personally liable. One of the biggest things that can cause this
is the corporation being “thinly capitalized” which endangers the
legitimate interests of creditors and tort creditors. Another thing that
can cause the corporate veil to be pierced is when the owners
commingle their funds with the funds of the corporations or using
corporate assets for owner’s personal uses.

Shareholder rights:
• Shareholders of a public corporation have the right to a
reasonable inspection of corporate records
• Shareholders have “preemptive rights” when it comes to
purchasing newly-issued shares. This is so that the original owners
of a corporation can maintain control
• The board of directors of a corporation is best described as a
“fiduciary duty”, which is the duty of highest loyalty

Corporate securities
Corporations can issue stock, which can be common stock or preferred
stock. Preferred stock is cumulative and will accrue if they aren’t paid in
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a given year. Preferred stock also holds dividend priority over common
stock shareholders. A corporation can also issue debt securities such as
notes or bonds. The debt securities of a corporation are not equity
securities (involve an ownership interest).

Stock of a corporation can be “purchased” through services performed,

services promised to be performed, or a promissory note to pay cash.
These are obviously in addition to just purchasing stock, but you could
see this in a question.

Termination
Corporations can be dissolved by the vote of the directors and
shareholders, or they can be dissolved by judicial action or by the state
they are incorporated in. This would be for things like failing to pay
taxes or file annual reports, or by breaking laws or regulations. A
shareholder can bring judicial action that could lead to the dissolution
of the corp, for example if the board of directors were abusing or
wasting corporate assets.

When a corporation is terminated, the directors are responsible to take

the corporation’s resources and pay claims/creditors, and the distribute
the rest to shareholders.

If two corporations are going to merge, the board of directors of both

corporations have to approve the merger. Also, the remaining
corporation will be liable for the debts of the acquired corporation.

Other corporation facts

If a corporate officer acts in good faith but makes a mistake that results
in losses or damages to the corporation, then they won’t be liable to
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the corporation. This is the “business judgment rule”. Remember
however that individuals are always liable for their own torts,
regardless of what other circumstances apply. Going along with this,
the doctrine of “respondeat superior” is when a corporation is liable for
the torts of its employees committed within the scope of their
employment.

Remember that agency rules apply to directors of corporations. A

director may have express authority to enter certain contracts on
behalf of the corporation, or even apparent authority.

A corporate promoter can’t profit from the activities of being a

promoter, this is part of being a fiduciary to the shareholders.

A director of a corporation can sell property to the corporation if the

transaction is fair, reasonable, and at fair market value.

A stockholder has the right to inspect the books and records with 5
days’ notice. This request will be denied if the purpose can be shown to
be for an unwarranted purpose not related to the shareholder’s
corporate interest.

There is entity called a “professional corporation” that provides limited

liability for professionals such as doctors, lawyers, and accountants. The
limited liability is mostly for corporate debts, as each professional is still
liable for their professional acts such as negligence when performing in
a professional capacity.

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Subchapter S: An “S-corp”
This entity type limits the effects of double taxation since it’s a flow
through entity. To elect S-corp status, the entity must meet certain
requirements such as having less than 100 shareholders, and all
shareholders must be individuals (some exceptions for estates and
trusts), and no nonresident aliens can be shareholders (must be U.S.
Citizen or resident). S-corps must stay below 100 or fewer shareholders
to retain the S-corp status. S-corps also only have one class of stock.

Professional corporation (PC)

A special type of corporation aimed at professionals like attorneys and
accountants that provides the limited liability and other benefits of the
corporate form. These operate like a corporation.

Limited liability company (LLC)

This form provides limited liability, but the tax benefits of a flow
through entity. The owners are known as “members” in an LLC. As part
of the formation process for an LLC, there should be an “operating
agreement” document. This should be in writing, and it maps out how
things will work and how disputes will be resolved among the members
of the LLC

Formation
LLCs must file registration documents with the state where formed. The
documents include the articles of organization, and an operating
agreement that outlines operations, members’ profits allocations, etc.

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If not specified in the operating agreement, profits are shared
according to capital accounts.

Termination
LLC laws can vary widely state to state, much more than corporation
laws or partnership laws. There can be terminating or dissolving events
specified in the operating agreement that could cause an LLC to
dissolve. Also, the consent of all members will dissolve an LLC, as can a
court order for various reasons.

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Area III: Federal Taxation of Property Transactions

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 Acquisition and Disposition of Assets

Basis and holding period of assets

Assets for tax purposes, can be divided into 3 categories:
• Ordinary assets: Includes inventory, accounts receivable, and
notes receivable
• Section 1231 assets: This includes depreciable property used in a
trade or business that have been owned for more than a year
• Capital assets: Assets other than what is listed as ordinary assets
or 1231 assets, and include property held for investment use or
personal use. The keyword for capital assets is “investment”

The info in this segment is primarily for capital assets. Business assets
(ordinary assets and 1231 assets) will be discussed in following
segments.

The tax basis in an asset at its most simple is what you paid for it. Then,
when it appreciates in value and you sell it, you’d have a gain, because
you made a profit over what you’ve invested in that property.

To calculate the adjusted tax basis in a piece of property, the formula

is:
Original cost of property (includes delivery costs, installation costs, etc)
+ Capital improvements (does not include repairs)
- Depreciation or amortization
= Adjusted basis

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Example:
ABC corporation purchases a building for $100,000. At the time of
purchase they also make capital improvements of $100,000. The basis
in the building is now $200,000. As they depreciate it over 20 years, the
adjusted basis goes down by $10,000 each year. So at the end of year 3,
the adjusted basis is now $170,000. If they sold it for $200,000 at that
point, ABC would have a gain of $30,000.

Holding period
Holding period of an asset begins at acquisition, and determines if a
gain or loss is short-term or long-term. If the asset is held for a year or
less and then sold, the gain or loss is short-term. If the asset is held for
longer than a year and then sold, it’s a long-term gain or loss. There are
situations where the holding period of an asset will transfer to the new
owner, and those will be covered in other sections. But in a standard
transaction where an asset is acquired, the holding period will begin on
the date of acquisition.

Holding period comes into play for gifted assets or assets received via
inheritance.

Gifts
When property is received as a gift, there is a gain basis, and a loss
basis. It’s important to note that in general, property received as a gift
or inheritance will be a capital asset, which is why the holding period
matters… to determine if the gain or loss would be a short or long-term
capital gain or loss.

Gain basis = the adjusted basis the donor had in the property.
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This is also the depreciable basis.

The holding period includes the donor’s holding period if the gain basis
will be used to compute a gain. If the loss basis is used to compute a
loss, then the holding period begins at the date the gift was received.

Loss basis = the lower of the FMV at the date of gift, or the adjusted
basis of the donor.

A gain is only recognized if the property is later sold for more than the
gain basis.
A loss is only recognized if the property is later sold for less than the
loss basis.
If the property is sold for an amount between the gain and loss basis,
there is no gain or loss recognized.

Example:
Ron bought an antique 10 years ago for $10,000. Now the piece is
worth $20,000, and he gifts it to his son Ben. Ben’s gain and loss basis in
this case is $10,000. However, if the piece was worth $5,000 when Ron
gifted it to Ben, then Ben’s gain basis would be $10,000 and his loss
basis would be $5,000(the lower of FMV or the adjusted basis). If Ben
sold the piece for $12,000, he has a gain of $2,000 which is a long-term
capital gain because he takes over Ron’s holding period. If he sells it for
$4,000 3 months after Ron gave it to him, he has a $1,000 loss which is
a short-term capital loss because the holding period began when Ben
received the gift. And, if he sold the item for $7,000, there would be no
gain or loss because it’s in between the gain and loss basis.

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Inheritances
The basis in property received from an inheritance is the FMV at the
date of death.
OR, if the “alternate valuation date” is used, then it is the FMV at 6
months after the date of death. These are the only two options for the
FMV of inherited property.

As far as the holding period, it is always considered long-term for

inherited property.

Taxable and nontaxable dispositions

Realized and Recognized Gains and Losses

Realized gains
When property is sold or disposed of, you compute the realized gain or
loss.

Realized gain formula:

Amount realized - adjusted basis = realized gain or loss

“Amount realized” includes any cash received, plus the fair value of any
property or services received, plus any liabilities assumed by the buyer,
less selling expenses.
“Adjusted basis” is the cost of the property, including other factors such
as improvements or depreciation (see previous section).

A recognized gain or loss is the amount of a realized gain or loss that is

included in the taxable income of the taxpayer. So, a realized gain or

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loss won’t always be recognized - the gain, or part of the gain (or loss),
could be deferred or excluded from taxable income for various reasons.

Example:
If ABC corporation has a piece of property with a basis of $50,000 and
they have a mortgage on it of $30,000, and they sell it for $60,000 cash
and the buyer assumes the mortgage, the amount realized is
$90,000(60,000 in cash and 30,000 of debt they got out of). The gain is
$40,000 (90,000 - their basis of $50,000).

Remember that the recognized gain or loss will never exceed the
realized gain or loss, but the realized gain or loss can be larger than the
recognized gain or loss.

Like Kind Exchanges

The general rule is that when “like kind” property is exchanged, no gain
is recognized unless boot is received. There are never losses with a like-
kind exchange.
(Again, “recognized” means it is included in taxable income, it can be a
realized gain but deferred and isn’t included in taxable income until the
property is sold.)

The only types of property that qualify for like-kind exchanges are
business property and investment property. All realty or real property
(real estate) is considered “like kind” for the purposes of like kind
exchange rules. So if a building is exchanged for bare land, that is still a
like kind exchange.

Inventory, stocks or bonds, CDs, and partnership interests do not

qualify for like-kind exchanges.
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“Boot” is cash or other non-qualifying property. If you exchange a piece
of land for a smaller piece of land, some cash, and a vehicle, the cash
and vehicle are boot. Debt relief is also boot, such as still owing $2,000
on a vehicle- if the vehicle is exchanged and the other party assumes
the $2,000 of debt, that is a $2,000 gain to you.

In a transaction involving boot, the recognized gain will be the lesser of

the realized gain or the boot received.

Example:
ABC exchanges a building with a FMV of $100,000 (basis of $50,000) for
a building worth $75,000 and $25,000 of cash. The realized gain is
$50,000 (ABC is coming out with $50,000 more in equity than before),
but the boot is the cash of $25,000. So the recognized gain is the lesser
of the realized gain and the boot received, so $25,000. There would be a
deferred gain of $25,000.

Alternatively, let’s say that ABC received a building worth $25,000 and
$75,000 in cash. The realized gain is still $50,000, but the boot is the
cash of $75,000. So in this case, the recognized gain is limited to the
realized gain of $50,000. And in this case, there is no deferred gain.

Remember there are no losses with like-kind exchanges. If you

exchange a building worth 200k for a building worth 150k and that’s
the entire transaction, there would be no gain or loss even though the
property values are different.

The holding period of like-kind property received takes the holding

period of the property exchanged.
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Amount and character of gains and losses, and netting process
(including installment sales)

Capital Gains and Losses

Remember that capital assets are assets that are not business assets or
1231 assets (depreciable assets or land used in a business). So this
basically boils down to assets held as investments and personal assets.
These are things like stocks, bonds, and real estate. Also, the goodwill
of a corporation is a capital asset.

When a capital asset is sold, it will trigger either a capital gain or a

capital loss.
A long-term capital gain or loss is for assets held for more than one
year.
All long-term capital gains and losses are netted together.

A short-term capital gain or loss is for assets held for one year or less.
All short-term gains and losses are netted together.

The netting process:

You first net short-term gains and losses together, and long-term gains
or losses together. Then you net the short-term gain or loss against the
long-term gain or loss. The sum takes the character of whatever was
larger.

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Example:
ABC corporation has ordinary income of $50,000. They had short-term
capital gains of $5,000 and short-term capital losses of $2,000. They
had long-term capital gains of $2,000 and long-term capital losses of
$3,000.
So first we net short-term and long-term and we end up with: $3,000 of
short-term gain, and long-term loss of $1,000. We then net these
together and we have: $2,000 of short-term capital gains, since the
short-term was larger. Regardless of whether it’s a corporation or an
individual, short-term capital gains or losses would be added to ordinary
income. So ABC corporation ends up with ordinary income of $52,000.

However, if it was a long-term capital gain, it would still become part of

ordinary income for a corporation, but an individual has a
different(lower) tax rate on long-term capital gains.

If the net-short term and net long-term gains and losses are negative,
then an individual can deduct this net capital loss from ordinary income
up to $3,000.
Net short-term capital gains are taxed as ordinary income for
individuals and corporations.
Net long-term capital gains are taxed as ordinary income to
corporations, but individuals have a separate tax rate for long-term
capital gains.

A corporation’s net capital losses are carried back 3 years and forward 5
years and can only be used to offset capital gains, but it cannot create a
net operating loss, nor can capital losses reduce taxable income to the
corporation. A corporation’s unused net capital loss that is carried back
or forwards is always treated as a short-term capital loss, whether or
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not is was short-term when it was incurred.

So in a year where a corporation has a net capital loss, it cannot offset

any ordinary income. It can only be carried back 3 years and forward 5
to offset capital gains.

Installment Sales
An installment sale is when you sell a capital asset to a buyer, and you
receive at least one payment after the year in which the sale took
place. All that is happening is the income from the sale is being spread
out over two or more years instead of all at once.

If the asset sold was held for more than a year before the sale, then
each payment results in long-term capital gains. But, if the asset was
held for less than a year, then each payment is a short-term capital gain
(ordinary income), even if the payments are spread across multiple
years.

Also, each payment after the initial payment will have some amount of
interest. And of course, it’s not just the amount of each payment… the
adjusted basis in the asset figures into what amount is actually a gain
on each payment.

The formula is:

So in other words, each payment is just multiplied by the gain

percentage of the total sales amount.

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Example:
Ryan sells Ben his personal car that Ryan owned for 5 years previously.
Ben pays Ryan $1,000 upfront, and then payments of $1,000 for 4 years
afterwards, for 5 payments in total. Ryan had an adjusted basis of
$3,000 in the car. So Ryan’s total gain is $2,000, and $2,000 / $5,000 =
40%. So on each subsequent payment, Ryan will have a long-term
capital gain of $400 (40% of each $1,000 payment). This is example
doesn’t include the interest amounts. Any interest received with each
payment is ordinary income to Ryan.

Note: The total gain is the selling price less any selling expenses, and
less the adjusted basis in the asset.
So if Ryan had $1,000 of selling expenses as part of this transaction,
then the total gain would be just $1,000, which would lower the yearly
gain to 20%.

Depreciation: The problem might mention depreciation of the asset

before it was sold, so remember that depreciation decreases basis. If
the problem said that Ryan purchased the car for $3,000 and had
depreciated $500, then his basis in the car is $2,500, and that would
change the solution.

Related party transactions (including imputed interest)

For the items listed below, a related party would be any of the
following:
• Anyone within the direct family line of the taxpayer from
grandparents down to children. Cousins, uncles, aunts, in-laws are
not considered related.

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 • A corporation or partnership where more than 50% of the stock
or capital interests is owned by the taxpayer.

There are several factors that come into play if an asset is sold to a
related party:

Loss of capital gains treatment:

Whether or not you’ve held an asset for a year or more, when it’s sold
to a related party any gain is ordinary income.

Loss of installment sale status:

If the asset was sold to a related party, the installment method can’t be
used. The buyer can make yearly payments, but the taxpayer would
need to report all the payments as a lump sum in the year of the sale
and any applicable gain would be ordinary income and fully taxable.

No losses allowed:
No losses, short-term or long-term, are allowed to be recognized when
an asset is sold to a related party. The buyer’s basis will be the amount
they paid for the asset, regardless of the seller’s basis.

Like-kind exchange treatment:

If a like-kind exchange takes place with a related party, if the related
party disposes of the asset within two years of the exchange, any gain
from the original transaction is now taxable to the taxpayer.

Disposition of an asset to an unrelated third party that was purchased

from a related party:
Let’s say Bob sells stock he purchased for $5,000 to his son Lance for
$4,000, the FMV. Bob can’t recognize a loss. Then Lance goes and sells
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it to an unrelated third party for $4,500. Lance has a realized gain of
$500, but he doesn’t have to recognize a gain on the sale to the extent
of Bob’s loss ($1,000). This pattern is specific to related parties where
the related buyer goes and sells the asset to an unrelated third party. If
Lance sold the asset for less than $4,000 - his basis - he could recognize
the loss. Also, there is no tack-on of the holding period: If Lance sold
the stock to the unrelated third party within a year of purchasing it
from his father, then it would be a short-term capital loss for Lance.

Corporate Stock Ownership Percentages

There are rules for corporate stock ownership to determine if the
parties are related for federal tax purposes. Two corporations would be
related if the same person directly or indirectly owns more than 50% of
the outstanding stock of both corporations. This can also be a
partnership and a corporation, or an S-corp and a partnership… greater
than 50% ownership in both entities would be considered related
parties.

Computing direct ownership in a corporation:

# Of shares owned / # of outstanding shares. If there are 100
outstanding shares and you own 10 of them, you own 10% of the
corporation.

Computing indirect ownership in a corporation:

If a person (or entity) owns a certain percentage of stock in corporation
A, and corporation A owns corporation B, then you multiply the
percentage they own in A by the percentage A owns in B.

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Example:
Ross owns 40% of ABC corp, and ABC corporation owns 50% of DEF
corp. So, multiply Ross’s 40% by ABC’s 50%, which gives you 20%. So
Ross indirectly owns 20% of DEF via his ownership of ABC stock.

Indirect ownership via relation

A person has constructive ownership of a corporation if certain family
members own shares in a corporation. Family members means direct
family: parents, siblings, half-siblings, spouse, children or grandchildren.
Note that this does not include grandparents. If you are the
grandparent and your grandchild owns the stock, it counts, but not the
other way around.

In this case you add up any percentages different family members own.

Example:
If Jim’s father owns 10% of ABC corp, and his wife owns 20% of ABC
corp, then Jim is considered to own 30% of ABC corporation when
determining related parties.

Imputed interest on loans to related parties

When one party makes a loan to a related party, there needs to be a

minimum amount of interest charged. This is usually based on the
applicable federal rate (AFR). If the interest charged in a related party
loan is less than the AFR (or no interest at all), then the IRS treats the
loan as if it had been made at the AFR, and then classifies this amount
to as ordinary income to the lender.

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Example:
Katy loans her son Drake $50,000, interest-free. If the AFR is 2%, then
Katy should be charging Drake at least 2% interest, or $1,000 each year.
The IRS would collect this amount from Katy as ordinary income.

Exception:
Loans less than $10,000 between individuals isn’t subject to these
imputed interest rules.

Cost recovery (depreciation, depletion, and amortization)

Depreciation

Depreciation acts as cost recovery, so there are rules as to what can be

depreciated and how. Any discussion of depreciation is referring to
assets used for business - personal use property is never depreciated.
Any property placed in service after 1987(basically anything at this
point) will be under the Modified Accelerated Cost Recovery System
(MACRS).

Under the umbrella of depreciation, there are currently 3 “types” of

depreciation:
• MACRS
• Section 179
• “Bonus” depreciation

Each of these is discussed in this section.

Also, it will help to understand a few definitions as they relate to rules

regarding depreciation:

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Personal Property
Also called “personalty”, this term can be confusing because it sounds
like it’s referring to the property of an individual. Personal property
means any property that is moveable, so any property besides real
property or realty. This includes both tangible and intangible personal
property. Also, whenever you’re talking about depreciation, it is for
business use. So don’t get confused by the term “personal” if a
depreciation problem refers to personal property. To be “business use”,
the property must be used for business more than 50% of the time.

Under MACRS, the 200% declining balance is used for personalty (see
useful lives section below).

The 200% declining balance depreciation is calculated as double the

straight-line method each year, based on the book value of the asset
(each year the book balance is reduced by the depreciation amount).

Mid-Year Convention
In general, when personal property is placed into service, the asset is
treated as being placed into service at the mid-year point, regardless of
when it is purchased. So when calculating depreciation on a problem,
you’d be calculating 6 months of depreciation for the year the asset is
put into service.

Note:
There is an exception to this when more than 40% of the assets placed
into service that year were put into service in the last quarter of the
year. When this happens, there is a mid-quarter convention that applies
that treats the assets as placed into service at the midpoint of the
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quarter in which the asset is put into service, regardless of which
quarter. To say it another way, in a given year, if more than 40% of the
assets that are put into service during the year happened in the 4th
quarter, then the mid-quarter convention is used for all assets placed
into service that year.

Real Property
Also called “realty”, this includes land, and anything affixed to land such
as buildings, machinery, or crops.

Under MACRS, realty is depreciated using the straight-line method.

Residential realty (houses, apartments) is depreciated over a 27.5-year
period. Nonresidential realty (office building) is depreciated over a 39-
year period.

Mid-Month Convention:
When real property is placed into service, the asset is treated as being
placed into service at the midpoint of the month its placed into service.

Example:
If an office building that cost $46,800 is placed into service on Aug 23,
the depreciation for that first year is $46,800 / 39 = $1,200 per year, or
$100 per month, then you’d multiply it by 4.5 months (Sep, Oct, Nov,
Dec, and half of Aug), which is $450. The fact pattern is: nonresidential
real property = 39-year straight line depreciation, using a mid-month
convention.

MACRS Useful lives (recovery period) for common asset types:

3 years: Special tools for specific manufacturing applications
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5 years: Computers, copy machines, cars & trucks
7 years: Office furniture & equipment, machinery
10 years: Water vessels

(The main ones you’ll see questions on are 5- and 7-year assets. Just
remember that electronics and vehicles are 5 year, and furniture and
equipment are 7 year)

The 200% declining balance method is used for assets with MACRS
recovery periods of 3,5,7, and 10 years. The 150% method is used for
15- and 20-year property.

Section 179
A section 179 election allows a taxpayer to expense a certain amount of
business property instead of depreciating it. The amount allowed under
179 for 2018 is $1,000,000. An important rule to remember is that the
amount expensed cannot exceed business income. If the income rule
limits a 179 expense, that amount can be carried forward.

Also, there is a dollar-for-dollar reduction on the total asset value put

into service above $2,500,000 in 2018.

Example:
If a business purchases a new software system for $500,000, the entire
amount could be expensed under section 179 UNLESS the company’s
income was less than $500,000. Then the company could only expense
the software up to the amount of taxable business income.

If the asset’s value was $2,600,000, then the amount expensed under
179 would be $400,000. (2,600,000 - 2,500,000 = 100,000, and 500,000
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- 100,000 = 400,000)

Bonus Depreciation
Bonus depreciation is in addition to the section 179 deduction. It is for
qualifying property - personalty with a recovery period of 20 years or
less and does not apply to buildings. Bonus depreciation of 100% is
allowed for qualifying property placed in service after September 27,
2017. This applies to new AND used qualifying property.

1231 Assets and 1231, 1245, and 1250 Recapture

There are complicated rules about depreciation recapture when a
business asset is sold or involuntarily disposed of. The basic idea is that
the business has been taking depreciation on the asset, which lowers
the basis in the asset. Then, when the asset is sold, the depreciation is
“recaptured” by classifying all or part of the gain on the sale as income
to the business.

1231 assets are assets used in a business that are also held longer than
one year. They include realty and depreciable property, but it does NOT
include capital assets, inventory, or accounts receivable.

When 1231 assets are sold, the gains and losses are netted together, if
there’s a net gain it’s taxed as a long-term capital gain. If the gains and
losses net to an overall loss, then it’s an ordinary loss.

But, within the 1231 assets there are rules for 1245 assets and 1250
assets. 1245 assets are depreciable personalty. 1250 assets are realty.

Under the umbrella of 1231, there are 2 types of recapture:

Section 1245: this takes gains on personalty (personal property) as
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ordinary income up to the amount of accumulated depreciation.

If you sell a piece of equipment for 200k that you purchased for 150k,
and it has 50k of accumulated depreciation (so your basis is 100k), that
50k of accumulated depreciation would become ordinary income based
on the 1245 rule. The remaining 50k gain would be a 1231 gain.

Section 1250: this is a recapture of accumulated accelerated

depreciation on buildings in excess of straight-line depreciation as
ordinary income.

Netting 1231 Gains & Losses

To the extent that 1231 gains exceed 1231 losses, the net gain is
treated as a long-term capital gain.
If 1231 losses exceed 1231 gains, the loss is deductible as an ordinary
loss.

1231 Lookback provision

There is a 1231 provision that says 1231 gains must be offset by net
1231 losses going back 5 years that have not previously been
recaptured. Any gains that can be “absorbed” by previous 1231 losses
are treated as ordinary income.

Example:
If you have a 50k 1231 gain in the current year, but in the last 5 years
you have 20k of unabsorbed 1231 losses, that 20k is absorbed by the
50k gain this year, and the 20k is ordinary income. The remaining 30k is
a 1231 gain.

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Amortization

Intangible assets are amortized instead of depreciated - though the

concept is the same: expensing the cost over a period of time.

Start-up costs
$5,000 of startup costs or organizational expenses can be expensed
immediately, and the remaining amount is amortized over 15 years.
There is a cap of $50,000, and any startup costs above $50,000 reduces
the allowed $5,000 dollar for dollar. So, if a company has $55,000 in
startup costs, they need to amortize the entire amount and can’t
immediately expense any.

Qualified intangibles
Qualified intangibles are the common types of intangible assets, and
they are amortized over a 15-year period. It’s important to note that
these are intangibles that are acquired. These include acquired goodwill
(created goodwill is a capital asset), patents, copyrights, customer lists,
trademarks, and licenses or permits.

When a patent is created, then it is amortized over its useful life, which
is usually 17 years. It can be deducted early in the year it becomes
obsolete.

Depletion

This is the same idea as depreciation or amortization, but applied to a

natural resource property.

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The formula for calculating yearly depletion is:

The total deductions allowed are limited to the unrecovered capital

investment in the property.

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 Estate and Gift Taxation

Transfers subject to gift tax

When you give away property while you’re alive, that transfer is subject
to the gift tax. The gift tax is placed on the giver of the gift.

When property is transferred as a result of your death, that transfer is

subject to the estate tax (covered in next section).

When a gift is made, the value of the gift is the FMV of the property.
Gift tax is reported using Form 709.

Type of gifts that are subject to the gift tax:

• Cash
• Property
• Debt that is forgiven to a family member or friend

The gift has to be accessible and usable to the recipient. If you put
money in a bank account for your grandson, it’s not a gift until the
grandson takes money out to use for his benefit.

There is a $15,000 exclusion per recipient, so you can give away 10 gifts
of $15,000, or 100 gifts of $15,000 tax free as long as each gift is to
different recipients. Couples can elect gift-splitting, which means a
couple can give gifts of double the annual exclusion, and each gift is
treated as being half from the husband, half from the wife. Electing gift-
splitting requires Form 709 to be filed.

Example:
Ron and Mary gift property worth $40,000 to their son Jon. They elect
gift-splitting and file Form 709. For tax purposes, the gift is first divided

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in half, so treated as a gift of $20,000 each, and they each get to apply
the $15,000 exclusion. This results in a taxable gift of $5,000 each
(20,000 - 15,000 exclusion). Note that if they had not elected gift-
splitting and it was just Ron gifting the property, then Ron would be
paying taxes on $25,000 (40,000 - 15,000).

When is Form 709 required?

Whenever there is a taxable gift made that doesn’t fall within one of
the exclusions, Form 709 needs to be filed:
• Anytime a gift is made that is larger than the annual $15,000
exclusion
• When a couple elects gift-splitting

If no gift is larger than the annual exclusion, or the only gift made was
excluded due to it being a gift for tuition or medical payments, then
filing Form 709 is not required.

The gift tax return is due April 15th following the year in which the gift
was made.

Gift tax annual exclusion and gift tax deductions

Gift Tax Exclusions & Deductions

Annual Exclusion:
The annual gift exclusion is $15,000 for 2018. Remember that a married
couple can elect gift splitting which combines the exclusion to $30,000.
Gifts of less than $15,000 cannot offset gifts of more than $15,000 to
other recipients.

Education Exclusion:
There is an unlimited exclusion for education gifts if the gift is for
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tuition and is paid directly to the school. The educational institution
generally needs to be in the United States. The exclusion does NOT
apply to room and board.

Medical Exclusion:
There is an unlimited exclusion for medical gifts if the gift is paid
directly to the medical provider.

Deductions:
Note that “deduction” means deduction from the amount of gift tax
owed. It is not a deduction from taxable income if you give a gift to
your spouse or a charitable organization.

Marital Deduction:
There is an unlimited exclusion for gifts to spouses, as long as the
couple is married at the time of the gift.

Charitable Contribution Deduction:

There is an unlimited exclusion when property is gifted to a charitable
organization.

Determination of taxable estate

Estate Tax
In general, a person won’t pay estate taxes unless their estate is worth
more than $5.49 million. The estate tax return doesn’t need to be filed
unless the gross estate value is larger than this amount.

The value of property received from an estate will be one of two things:
1) the FMV of the property at the date of death. Or 2) the executor of
an estate can choose the “alternate valuation date”, then the assets in
a decedent’s estate will be valued 6 months from the date of death, on

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the date of disposition. This is instead of being valued at the date of
death. This election is only allowed if it causes the value of the gross
estate and tax payable to decline.

One exception to the FMV rule.

If property is gifted by A to B, and then the property transfers back to A
due to the death of the B, A takes the basis of the property in the hands
of B (which will be the A’s original basis in the property).

Example:
Jon gifts stock to Mary when the FMV of the stock is $10,000. Jon’s
basis in the stock is $7,000. A year later the stock’s value has gone up to
$15,000 and Mary dies and leaves the stock to Jon. Jon’s basis in the
stock isn’t the FMV, it is his original basis of $7,000.

Marital Deduction
If the decedent is married, their estate can pass tax-free to the
surviving spouse. When that spouse dies the estate would become
subject to the estate tax. The surviving spouse must be a US citizen for
this to apply.

Property Jointly Owned at Death

For a married couple that jointly owns their property, when one spouse
dies half of the value of all assets is included in the estate of the first
spouse to die.

If property was held by tenancy in common, then the FMV of the

decedent’s share is included.

If joint tenancy in property was acquired through a gift or inheritance,

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then the decedent’s share is included.

If a decedent had joint ownership in property through a purchase in a

non-spouse relationship, you would take the percentage of the cost
furnished by the decedent to determine what portion of the property’s
value to include in the decedent’s estate.

Example:
Jon and Joyce (friends) own land together in joint tenancy. They
originally bought the land for $20,000, of which Jon paid $15,000 and
Joyce paid $5,000. When Joyce died, the property was worth $100,000.
Since Joyce paid 25% of the cost of the property, $25,000 would be the
amount included in her estate.

Admin expenses and selling expenses can be deducted from a

decedent's gross estate.

Charitable contributions and funeral expenses are also deductible from

the gross estate.

Medical expenses paid within one year of death can either be deducted
on the estate tax return or the final tax return of the decedent.

An estate tax return is due 9 months after the date of death, but only if
the decedent’s gross estate was valued at more than $5.49 million. The
estate tax return is Form 706.

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 Area IV: Federal Taxation of Individuals

Gross Income

Gross income
Gross income is an individual’s total personal income, before taxes and
deductions. The general rule is that any increase to an individual will be
included in taxable income, unless there is a specific exclusion in the tax
law. For example, if a person is unemployed and receives
unemployment compensation from the state, it might seem like that
wouldn’t be taxable income, but it is an increase to the individual and
replaces wages they would earn if working, so it is taxable income.

Income doesn’t just mean receiving cash… again, any increase to a

taxpayer results in income, which - unless there’s a specific rule that
excludes it - will be taxable income.

Example:
Bill is a dentist and Ted is an artist. Bill and Ted agree to trade services:
Bill cleans Ted’s teeth and Ted paints a mural in Bill’s living room. Bill’s
services are valued at $100, and Ted’s services are valued at $200. Bill
would include $200 in his taxable income, even though they “traded”
services - Bill recognizes the fair market value of Ted’s services as
income. Ted would include $100 in his taxable income.

Questions Tip
With questions on what should be included in taxable income - and
these can be asked in a lot of ways, the value to be included will almost
always be equal to the fair market value of whatever has been received.

Constructive receipt: This means a taxpayer is required to include in

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gross income the value of property in the period which they gained the
right to the property, or when the recipient of the income has “control”
over it. So, any income that is actually received or “constructively
received” in a given year should be included in gross income. If an exact
amount of accrued income can’t be determined, then the income
should be included in taxable income in the year in which the exact
amount can be established.

A cash basis tax payer should report income in the year in which
income is actually OR constructively received.

Example:
Tom is attorney and is owed $10,000 by a client. Tom accepts a piece of
art worth $9,000 in full satisfaction of the obligation. Tom would
include $9,000 in his taxable income.

An accrual basis taxpayer includes income when they have the right to
receive the income, or, once it has been earned. If the amount of an
income item is based on an estimate, and the actual amount is more
than was reported for the estimate, the difference would be reported
in the year when the exact amount was determined.

Example:
In 20X8 Ted reported $10,000 of income based on a reasonable
estimate. The actual amount received from the same transaction
actually ended up being $15,000 in 20X9, so Ted included an additional
$5,000 of income on his 20X9 return.

Tax-benefit rule: If a taxpayer deducted an item, such as a casualty loss

in a prior period, and then ends up receiving the money in a later year,
the reimbursement needs to be included in income because the original
expense provided a tax benefit.

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Example:
Brad had part of his home destroyed by a fire. The amount of damage
was $50,000. The insurance company disputed the cause of the fire and
it wasn’t until two years later that Brad received the $50,000
reimbursement. In the year of the fire Brad deducted the $50,000 as a
casualty loss, but two years later when he received the $50,000, he
would need to include the $50,000 in his gross income.

Interest Income
In general, any interest income will be included in taxable income
unless it is specifically excluded (see excluded items below).

Interest received on US Treasury certificates is NOT exempt from

federal income taxes. Also, interest received on a tax refund is taxable
income. The refund itself is not taxable, but any interest received on
the refund is taxable.

Interest income on state obligations or most municipal bonds is tax

exempt, such as state or county bonds.

Interest on redeeming EE savings bonds can be excluded from income if

the bonds were issued after the taxpayer’s 24th birthday, the taxpayer is
the sole owner of the bonds, and the taxpayer incurred higher
education expenses for themselves, a spouse, or a dependent in the
year of redemption.

Interest income on personal injury awards is taxable interest income.

Income from Rental Property

Income from rental property is included in gross income. Note that
even rent received in advance is included in the year received.

A deposit is not included until the landlord is entitled to the funds, such
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as when the tenant moves out and the landlord finds damage that will
use up the deposit. If a renter barters services in exchange for free rent,
the amount of rent would still be included as income to the landlord.

Note: if a personal dwelling is rented out for less than 15 days per year,
then the rental income does not have to be included in gross income.
This also goes the other way: no deductions for rental use are allowed
on a property rented out less than 15 days a year.

If a taxpayer receives a gift/donation of property and then gifts the

same property to a charitable organization, the taxpayer will add the
fair market value of the property received to their gross income AND
deduct the same amount as a charitable contribution.

Unemployment compensation is included in taxable income.

If a taxpayer accepts services instead of a cash payment, the amount

included in gross income would be the FMV of the services.

If an income item is accrued as an estimate, and then a larger amount is

actually received in a following year, the difference is taxable in the
year received.

Debt that is forgiven is considered income to the taxpayer, unless the

debt was forgiven as a gift, then it’s not taxable.

Taxation of Employee Benefits

The value of an employee discount can be excluded from income if:
• The value is up to 20% of services
• OR, no more than the average gross profit percentage for goods

Certain insurance premiums that are paid by the employer for the
employee can be excluded from the employee’s income such as:
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 • Group term life insurance up to $50,000 of coverage (remember
that amounts above 50k of coverage will be taxable)
• Health insurance premiums
• Disability insurance premiums

The following types of fringe benefits can be excluded from an

employee’s income:
• Meals and lodging for the convenience of the employer
• Working condition expenses: These are benefits provided by the
employer that would be deductible if the employee had paid the
expense. Also, if the cost is reimbursed by the employer it is also
excluded from income
• De minimus fringes
• Employee discounts
• Employee gifts under $25
• Safety or achievement awards

Exclusions from Gross Income

Gifts received are excluded from income. However, “gifts” from

employer to employee constitute compensation and are included in
gross income.

Scholarships are not taxable up to the amount of tuition and expenses.

Scholarship money used on room and board is taxable income. The
student cannot be required to work as part of the scholarship, if they
are then the money is taxable.

Child support is NOT taxable to the recipient, and there is NO deduction

for the payer. Also, property settlements as part of a divorce (getting
the house) is not taxable.

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Money received as compensation for physical injuries or sickness
(worker’s comp) are excluded from income.

Stock and Dividend Splits

These are not a taxable event because no new property is received.
But, the taxpayer must adjust their basis in each share. IF there is even
an option to receive cash, such as “you can choose $100 or 10 more
shares”, then the event triggers income to all recipients, regardless of
whether recipients choose cash or more shares.

However, regular dividends received are gross income. Also, if a person

has access to a company stock purchase plan that lets them purchase
stock at a discount, the difference between the FMV of shares
purchased and the discounted amount is included in gross income.

Example:
Tom can purchase discounted shares of stock from the company he
works for. When the market share price of the stock is $100 per share,
Tom buys 10 shares at his discounted price of $90 per share. Tom would
recognize $100 of gross income on this transaction.

If a person receives an award for achievement without any action on

their part, it can be excluded from gross income only if they assign it to
charity. Otherwise, the reward is taxable.

Life Insurance Proceeds

Proceeds from life insurance due to the death of the insured are
excluded from income. Also, dividends received from a life insurance
policy are not taxable up to the amount of premiums paid. You might
see questions that ask about the taxable amount if the policy is sold to
another individual other than the original beneficiary. In this case, the
policy is an investment to the new buyer of the policy and the regular
basis and gains would apply. The proceeds are only non-taxable to the
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original and intended beneficiary.

Example: Tom purchased a $100,000 life insurance policy on one of his

parents, and then sold the policy to Dave for $10,000. And then Dave
ends up paying premiums of $15,000 until the parent dies. Dave would
have a cost basis in the policy of $25,000, so he would include $75,000
from the proceeds in his gross income.

Jury Duty
If an employee is required to give the employer any funds paid to them
for jury duty in exchange for regular payment from the employer, the
jury duty funds given to the employer would be deducted from gross
income to arrive at adjusted gross income.

Reporting of Items from Pass-Through Entities

Dividend’s received by a taxpayer who is a shareholder in the business
will be dividend income as long as the business has earnings & profits. If
there is no E&P for the year, then dividends are considered a return of
capital. After an owner has received all their capital back, then any
dividends received are classified as a capital gain.

Stock dividends on common stock are not taxable, but stock dividends
as part of preferred stock are taxable.

Remember that in a stock dividend, if there is the option to receive

cash instead of shares, that will be a taxable dividend.

Flow Through From Partnerships / S-corps / LLCs

Remember that a partnership/S-corp doesn’t pay any taxes - the
transactions flow through to each partner’s (or shareholder’s)

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individual taxes. Each partner receives their distributive share of
partnership income based on the partnership agreement.

Within a partnership or S-corp, there are transactions that occur in the

ordinary course of business, and these results in ordinary income or
losses. Then, there are “separately stated” transactions such as
charitable contributions, a section 179 write-off, gains and losses on
sale of equipment, rental activities, or tax credits. Then each partner’s
share of the ordinary income is passed through to the individual, but
then also each partner’s share of the separately stated items will pass
through.

A partner’s share of the ordinary income from a partnership is reported

on Form K-1, and is included in his/her gross income. Then, capital
gains/losses or deductions retain their character when they flow
through to the partner (from the separately stated items). A partner
can only deduct partnership losses up to the extent of their basis in the
partnership.

Income example:
ABC partnership has two partners, Mark and Marvin. ABC generated
net income of $100,000. $50,000 is reported on Mark’s K-1, and the
same on Marvin’s K-1. Then, Mark and Marvin each report $50,000 as
gross income on their respective 1040s.

Loss example:
Fred is a 100% shareholder in an S-corp, and he has basis in the S-corp
of $10,000. By December the business has net income of $20,000, but
Fred takes a salary of $60,000 for the year, which results in the business
having a loss of $40,000. On his 1040, Fred reports income of $60,000,
but can only deduct a loss of $10,000, which is his basis in the S-corp.

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Adjustments and Deductions to Arrive at Adjusted Gross Income and
Taxable Income
Deductions can either be deductions FOR AGI or deductions FROM AGI.
Deductions for AGI are items that lower your gross income to arrive at
AGI, and once you know what your AGI is, then there might be some
deductions from AGI that apply. Deductions from AGI are also known as
itemized deductions.

Deductions for AGI

These are the “for AGI” deductions, which are subtracted from gross
income (all income) to arrive at adjusted gross income (AGI). These are
also called “above the line” items:
• Alimony payments: in 2018 it’s a deduction for AGI for the payer,
and taxable to the recipient
• Trade or business expenses
• Rent or royalty expenses
• 50% of self-employment tax
• 100% of medical insurance premiums if self-employed
• Contributions to retirement plans
• Contributions to health savings accounts (HSAs)
• Student loan interest: this is limited to $2,500 of interest on
student loans in one year. Phased out over range of $30,000 for
married taxpayers over with AGI over $135,000
• Moving expenses are no longer deductible. TCJA suspended any
deductions for moving expenses, except for members of the
Armed Forces

Question Tip
Remember the difference between being a “for AGI” deduction vs a
“from AGI” deduction. You might see a question that lists several
deduction items that asks which ones are deductible if the taxpayer is
itemizing, and it will frequently include a portion of the self-employment

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tax. This would not be included in itemizing deductions, since the
deduction for half of the self-employment tax is an above-the-line
deduction to arrive at AGI.

Retirement Plans
Contributions to retirement plans are usually pre-tax, or above the line
deductions, so they reduce income to arrive at AGI. (Unless they are the
ROTH version)

The maximum contribution that can be made to a 401(k) plan to reduce

taxable salary is $18,500 in 2018, plus another $6,000 for ages 50 and
older.

The maximum contribution that can be made to a Traditional or Roth

IRA in 2018 is $5,500. It’s $6,500 for those 50 and older. Note these
amounts are combined - you can contribute $5,500 total among
traditional or Roth IRA accounts.

Traditional IRAs
Contributions to a Traditional IRA are deductible, as long as the
taxpayer has AGI below certain levels.

If the taxpayer is covered by a retirement plan at work, then their AGI

needs to be below $101,000 filing jointly, or $63,000 if single for
traditional IRA contributions to be deductible. Above those amounts
there is a partial deduction, and if AGI is above $121,000 joint or
$73,000 single, then there is no deduction on contributions.

If a taxpayer withdraws funds from a traditional IRA early and no

exceptions apply, then there is a 10% penalty tax on the amount
withdrawn.

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Roth IRAs
Contributions to a Roth IRA are not deductible. Contributions are made
with “after tax” dollars.

There are income limits to contribute to a Roth IRA. A taxpayer can

make a full contribution if they have AGI less than $120,000 filing
single, $189,000 filing jointly in 2018.

“Late” IRA contributions can be made up until the due date of that
year’s tax return (April 15). This means you’re allowed to contribute
towards your $5,500 for 2018 up until April 15th of 2019. Even if an
extension is filed, the original due date of the return is the last day to
make a late contribution.

HSA Contributions
If a taxpayer has HSA-qualified health insurance, they can contribute
pre-tax dollars to a Health Savings Account and deduct the
contributions to arrive at AGI. Money taken out must be used on
qualified medical expenses, or it’s subject to a 20% penalty.

The contribution limits for 2018 are $6,900 for families, and $3,450 for
single taxpayers.

Pensions
Payments on annuities and pensions are excludable from taxable
income to the extent they are a return of capital.

Whatever the employee contributed will be considered to be recovered

pro rata over the life of the payouts.

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Example
Wesley paid in $24,000 to his pension over his time as an employee.
After he retired, his life expectancy was 20 years. As he receives the
payments, he would be able to exclude $100 of each monthly payment
over the 20 years, since his $24,000 divided over 240 months = $100 per
month.

Itemized Deductions, or Deductions “From” AGI

There are several types of personal expenses that qualify as itemized
deductions:

Medical expenses: Only medical expenses in excess of 7.5% of AGI are

allowable as a deduction. These are medical costs that were not
reimbursed or covered by insurance. Costs for doctors, eyeglasses,
dentists, health insurance, prescribed drugs, medical transportation
and travel up to $50 per night per person, and the costs of altering the
home for handicapped persons are deductible.

This includes in the costs are paid with borrowed funds, such as on a
credit card in December and paying the card off in January of the next
year- the deduction is still claimed in the year the cost was incurred.

Deductible medical expenses include medical expenses paid for the

taxpayers, and expenses paid for dependents, and for individuals
qualifying as a dependent, even though a dependency exemption can’t
be claimed based on their income.

Example
Rick and Jan had medical expenses of $7,000 during 20X8. They also
paid $2,000 of medical expenses for Rick’s mother, who lives full-time
with Rick and Jan. Rick’s mother has income of $5,000 for 20X8. In this
situation, Rick’s mother is a qualifying dependent even though they
can’t claim a dependency exemption because she has gross income
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above the limit for a dependent ($4,150) in 2018.

Cosmetic surgeries are not deductible unless the surgery is medically

necessary, such as facial reconstruction resulting from an accident.

Deductible qualified residence interest: For home mortgage interest,

interest paid on debt relating to the principal residence and a second
home is deductible. The deduction is limited to interest on a total
indebtedness of up to $750,000 to purchase, construct, or substantially
improve a residence. Interest on home equity loans is not deductible,
unless it is to substantially improve the home, and fits within the
$750,000 of allowable indebtedness.

If a taxpayer pays a penalty for early repayment of mortgage, the

penalty is also deductible when computing itemized deductions.

Note: The pre-2018 limit of $1 million mortgage will still be deductible

if incurred before Dec 15, 2017.

State Income Tax and Property Taxes

Personal income taxes imposed by state, local, or foreign governments
are deductible, including property taxes for real property. Tax penalties
such as interest on a tax deficiency, or a late filing penalty are not
deductible.

Only $10,000 of state income taxes and/or property taxes are

deductible for 2018.

For state taxes paid during the year, the deduction is equal to what was
actually paid in the calendar year the return if for.

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Example:
In 20X8 Karen made estimated state income tax payments of $300 on
the 15th of April, June, September, and then another $300 on January
15th of 20X9. Her deduction for state income taxes on her 20X8 return
would be the $900 actually paid. The January payment would be
deductible on her 20X9 return.

Question Tip
If you see a question where property is being sold and one party pays all
of the property taxes for the year as part of the sale, the taxpayer in
question can only deduct the portion of the property taxes allocated to
how much of the year they owned the property.

Charitable contributions: Contributions must be made to a qualifying

organization (randomly giving money to a ‘needy family’ doesn’t
count).
Contributions can be cash or property but not services. Written records
of contributions are required. Deduction for contribution of property is
limited to 50% of AGI. Beginning in 2018, cash contributions of up to
60% of AGI can be deducted.

IF the contribution is something containing a long-term gain such as

stock that has appreciated in value, then the deduction is limited to
30% of AGI. If your AGI is 100k, and you donate stock that you bought
for 20k but is now worth 40k, you can only deduct 30k.

Casualty Losses
Casualty losses are for unreimbursed losses from a federally declared
disaster. The deduction is equal to:

The lower of the decline in FMV or the adjusted basis in the property
Less: Insurance reimbursement
Less: $100 floor per casualty
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Less: 10% of AGI
= The casualty loss deduction

Employee Business Travel Expenses

• Business travel expenses that are deductible are limited to trips
that the primary purpose is business
• The amount and purpose must be substantiated
• Meals and lodging “away from home overnight” are deductible
• Only 50% of the meal costs are deductible

Entertainment Deductions
• In 2018, entertainment business expenses are no longer
deductible.

Business Gifts
A business gift of $25 per customer is deductible. If multiple gifts of
varying values are given, gifts less than $25 per customer are counted
at their value, and any gifts above $25 are calculated at just $25 each.
So if you gave 5 gifts worth $5 each and 5 gifts worth $50 each, you can
only deduct $25 total for the $5 gifts, and $125 for the $50 gifts. You
don’t get to “move” the excess value in gifts to the cheaper gifts to
make a larger deduction.

Qualified Business Income Deduction

The TCJA added a new deduction for qualified business income (QBI).
The deduction is generally 20% of a taxpayer’s QBI from a partnership,
S-corp, or sole proprietorship.
QBI is defined as the net amount of income, gain, deduction, or loss
relating to any qualified business or trade of the taxpayer.

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Employee compensation and guaranteed payments to a partner are
excluded.

The QBI deduction is taken AFTER determining AGI but BEFORE any
itemized deductions. So it’s not a deduction FOR AGI, and it’s not an
itemized deduction.

Important:
For these QBI deduction questions, types of businesses the “business
income” comes from is basically divided into two types:
• Qualified business: Any business that is not a “specified service
trades or business”
• Specified service trade or business (SSTB)

Specified Service Trade or Business (SSTB)

Taxpayers in certain service related businesses are eligible for the
deduction, but only up to certain income levels. These service related
businesses include healthcare professionals, attorneys, accountants,
performing artists, consultants, financial service professionals, or any
business where the principal asset is the reputation or skill of one or
more of its employees.

If the business is a SSTB, the deduction is only allowed if taxable income

is less than $415,000 filing joint, or $207,500 filing single. See the
“phase-in” below.

Taxpayers with Income Less Than $315,000 joint, $157,500 single:

Whether the taxpayer has QBI from a SSTB or not, if their taxable
income is below these levels, then the QBI calculation is the lesser of:
• The combined QBI of the taxpayer, or
• 20% of their taxable income, less net capital gains

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Example
Kelly has sole proprietorship selling golf balls. She has one employee
who is paid $50,000 during 20X7. The income from the business is
$200,000, and on her joint return, Kelly has taxable income of $300,000.
Since Kelly’s income is below the $315,000 cutoff, her QBI deduction is
the lesser of:
• 20% of $200,000 = $40,000
• 20% of $300,000 = $60,000

So Kelly’s deduction is $40,000.

The $100,000 Limitation Phase-In:

For taxpayers with income above the $315,000 joint & $157,500 single
levels, there is a limitation phase-in over the next $100,000 of taxable
income for married filing jointly, and the next $50,000 for filing single.
So this means between $315,000 to $415,000 for married filing jointly,
and between $157,500 to $207,500 filing single. This again is whether
or not the income is from a qualified business or a SSTB.

The calculation (which is determining a percentage) is:

Example
Take the example above but say Kelly’s income is $350,000.

The calculation would be:

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Which is:

You then take this 13% and multiply it by her QBI of $200,000 which
makes her deduction = $26,000.

QBI Wage Limitation

Once the taxpayer’s taxable income gets above $415,000 filing jointly
or $207,500 filing single, if the business is a SSTB, there is no QBI
deduction whatsoever.

If the income is from a qualified business, then the deduction is based

on the following wages limitation:

The deduction for each business will be the lesser of:

1) 20% of the QBI with respect to the trade or business
2) The greater of:
• A) 50% of the W2 wages paid by the business
• B) 25% of the W2 wages paid by the business + 2.5% of the
unadjusted basis of qualified property immediately after
acquisition (meaning prior to depreciation)

Example
Let’s use Kelly’s example, but say her taxable income is $450,000, and
the business has $100,000 unadjusted basis in qualified property.
Remember the business paid $50,000 in wages to an employee.

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Her QBI deduction would be the greater of:
• 50% of the wages paid, or $25,000, or
• 25% of the wages paid ($12,500) + 2.5% of unadjusted basis in
$100,000 of qualified property ($2,500) = $15,000

So Kelly’s QBI deduction is $25,000. Also, notice in the 3 examples how

Kelly’s QBI deduction gets smaller as her taxable income increases…
which is the whole point.

Passive Activity Losses

Passive activity losses
A passive activity is rental real estate or a business in which the
taxpayer doesn’t materially participate. The test for “materially
participating” is putting in over 500 hours in the year, or at least 100
hours but is more time than anyone else in the business.

However, don’t get a “passive activity” confused with “portfolio

income”. You’ll often see questions where it lists several sources of
income and/or losses, and you need to know the difference. Portfolio
income is investment income or interest income from stocks, capital
gains, etc. Passive activities are business ventures where the taxpayer
doesn’t materially participate, such as rental real estate or being a
limited partner in a partnership.

Passive activity limitations apply to individuals, estates, trusts, closely

held C corps, and personal service corporations.

In general, passive activity losses will be limited to the income

generated from the activity.

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However, passive losses from one activity can offset income from a
different passive activity. Remember that “portfolio income” doesn’t
offset passive losses. For example, partner’s share of interest income
doesn’t offset their share of a passive loss amount.

If a taxpayer has excess passive activity losses in one year, they can be
carried forward and used in future years when there is passive activity
income, or until the property is disposed of in a taxable transaction.

For passive activity losses, they are only deductible up to the amount of
income from passive activities.

Example:
Amy is a limited partner in a partnership and her interest in the
partnership results in a $5,000 loss for the year. This loss is not
deductible to Amy since there is no income attributable to the passive
activity.

However, suspended losses and current-year losses are fully deductible

in the year in which the taxpayer fully disposes of all interest in the
passive activity.

Example:
If Amy disposes of her partnership interest in the same year as the
$5,000 loss, then the loss would be fully deductible. If she had a loss
carryover of $10,000 in the partnership, then she would be able to
deduct $15,000 from other sources of income for the year.

Rental real estate losses: If a taxpayer has passive losses from rental
real estate, then the deductible amount is limited to $25k of losses in
one year (the person must own at least 10% of the rental activity and
actively participate).

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IF the taxpayer’s AGI is above 100k, then the 25k is reduced by 50% of
the taxpayer’s AGI above 100k. That means that at $150,000 of gross
income, there would be no deduction.

Exception for Real Estate Professionals

The passive activity limitations don’t apply to a rental real estate
activity IF:
1) More than half of the individual’s personal services during the year
were performed in real property trades or businesses in which the
individual materially participates, and 2) the individual spends more
than 750 hours performing real property trades or in businesses in
which the individual materially participates.

Loss Limitations
Casualty & Theft Losses
Casualty and theft losses are disallowed by TCJA unless they are
attributable to federally declared disaster areas.

Losses and Bad Debt

To deduct non-business bad debt:
• It must be an actual loan
• It is deductible as a short-term capital loss in the year it is
determined to be completely worthless
• Partial worthlessness is NOT deductible

To deduct business bad debts:

• Only the direct write off method is allowed
• It is deducted to the extent the loan is partially worthless

Deducting worthless assets:

• The asset must be totally useless

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 • It is treated as sold for no consideration on the last day of the
taxable year
• Worthless securities receive capital loss treatment for individuals,
but they are an ordinary loss if incurred by a corporation when
investing in 80% or more in another corporation (an affiliated
corporation)

Capital Losses
If a taxpayer has net capital losses in a year, up to $3,000 of capital
losses can be deducted against ordinary income, and the rest is carried
forward indefinitely.

Net Operating Losses

NOLs that occur in 2018 and afterwards have no carryback period, and
can now be carried forward indefinitely. When the NOL is applied, it
can only be applied in a given year up to 80% of income, and the rest is
carried forward. Note that NOLs are only associated with conducting a
trade or business, so the amounts are separate from
nonbusiness(personal) income and deduction items.

Example:
Art had business losses of $100,000 in 20X6. In 20X7, Art had taxable
income of $100,000. Art can apply the NOL, but only in the amount of
80% of his current year income. So he’ll have a deduction of $80,000,
and will have a NOL carryforward of $20,000 remaining.

Excess Business Losses

Losses for a non-corporate taxpayer that exceed $500,000 married
filing jointly ($250,000 single) are disallowed in the year they occur, and
they are added to the taxpayer’s NOL carryforward.

At-Risk Loss Limitations

This is a rule that limits losses to the amount that is “at risk” in an
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activity. If you have a passive investment of $20,000 and it loses $5,000
per year, you can only claim that loss for 4 years (4 x $5,000 = $20,000),
when the loss equals your “at risk” amount.

The general rule is that a taxpayer is considered “at risk” for the
amount of cash they’ve contributed to an activity, the adjusted basis of
property they’ve contributed, or any debt they are personally liable for
they’ve taken on as part of the activity. Debt secured by property used
in the activity usually isn’t considered when calculating the “at risk”
amount. Although debt secured by property NOT used in the activity is
considered “at risk”, for example, taking out a loan secured by your
home to start a business - that amount would be “at risk”.

Example:
Max starts a painting business, and contributes $5,000 of cash, $10,000
of equipment he has a basis in of $5,000, and he takes out a personal
loan for $10,000, and then takes out another loan of $10,000 secured
by equipment he uses in the business.
Under these circumstances, Max’s “at risk” amount includes the $5,000
of cash, his $5,000 of basis in the equipment contributed, and the
$10,000 personal loan, for a total of $20,000. Max is not considered “at
risk” for the loan secured by the equipment. Note if the $10,000 loan
would have been secured by Max’s home, then it would be included in
the “at risk” amount.

Gambling Losses
Gambling losses can only be deducted up to the amount of gambling
winnings. If you lost $5,000 during the year gambling, and won $2,000,
you are only allowed to deduct $2,000 of losses. Under TCJA, expenses
related to gambling - such as traveling to and from a casino - can also
be included in your “losses”, but only up to the amount of winnings.
With the previous example, if you spent $100 getting to and from the
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casino, you could deduct $2,100 from your $5,000 of winnings.

Filing Status
Personal Exemptions
Personal exemptions were disallowed by TCJA. However, you still need
to know how to identify dependents because other things apply based
on dependents, such as the head of household filing status (see below)
and tax credits (see Computation of Tax Credits section).

Going along with this, the standard deductions were increased. See
below.

Types of Filing Status

Married filing jointly: Married status is determined on the last day of

the year, or the last day the taxpayer is alive. Note that a husband and
wife can still file jointly even if they have different accounting methods.
A couple can be living separately but still file jointly if they agree. If, on
the last day of the year, they are divorced or legally separated, then
they would each file as single, unless head of household applies.

Married filing separate: There are rules that prevent taxpayers from
benefitting by filing separately, such as that neither spouse filing
separately can claim the earned income credit, an education credit, or
the child credit and/or the credit for other dependents.

Surviving spouse: A surviving spouse can use the joint rates for two
years after the spouse passed away. The surviving spouse must provide
more than 50% of the costs of maintaining the household for a

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dependent child, stepchild, or adopted child. In the year of the death of
the spouse, the surviving taxpayer will file “married filing jointly”, and
then the next two years will be filed as “surviving spouse”, which again
allows them to use the same standard deduction as “married filing
jointly”.

Abandoned Spouse: A married taxpayer can file as if they aren’t

married if their spouse hasn’t lived in the house for at least 6 months
out of the tax year. They can file as head of household if they provide
more than 50% of the cost of maintaining a home for themselves and a
dependent child.

Head of household: The taxpayer alone must provide more than 50% of
the cost of maintaining the household for one or more dependents.

Single: If unmarried and does not qualify for head of household or

surviving spouse.

Definition of a Dependent
A dependent can be either:
• A qualifying child
• Or a qualifying relative

For both types, they must:

• Be a U.S. Citizen, a U.S. National, a U.S. Resident, or a resident of
Canada or Mexico
• Only be claimed as a dependent by one taxpayer (or married
couple filing jointly)
• Not be filing jointly with another taxpayer

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Qualifying child:
• Relationship test: must be a natural, step, adopted or foster child.
Can also be a sibling or step-sibling, or the offspring of any of
these
• Residence test: the child must have the same residence as the
taxpayer for more than one half of the taxable year
• When parents are divorced, the parent with custody (or having
the child more than half the year) gets to claim the exemption.
The custodial parent can waive the exemption and let the other
parent claim the exemption
• Age test: dependent must be under age 19 at end of tax year, or
under 24 if a full-time student for at least 5 months of the tax
year. No age limitation if the dependent is permanently and
totally disabled
• Not self-supporting: the dependent must not have provided more
than 50% of his or her own support during the tax year

Qualifying relative:
If the taxpayer provides more than 50% of the support for a qualifying
relative, the taxpayer can claim the relative as a dependent. If no one
person provides more than 50% of the support for a qualifying relative,
then any individual who provides more than 10% of the support can
claim them as a dependent if the other support-providers consent to
that person claiming them as a dependent. The dependent must have
gross income of less than $4,150 in 2018, or they can’t be claimed as a
dependent.

What constitutes “support”: Food, clothing, lodging, medical costs, and

recreational costs. Life insurance premiums, funeral expenses, and
income taxes paid from the dependent’s own income are not
considered support.

• A qualifying relative is very broad and includes anyone living in

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 the taxpayer’s house for the full tax year.
• There is no age test for a qualifying relative.
• Gross income test: the dependent’s gross income must be less
than the exemption amount for the year, which is $4,150 in 2018.

Filing Status and the Standard Deduction

Instead of itemizing deductions, a taxpayer can claim the “standard
deduction”, which is a set amount that for many taxpayers is a larger
deduction than their itemized deductions added up.

The standard deduction amounts for 2018 are:

• Married filing jointly & surviving spouses: $24,000
• Head of Household: $18,000
• Unmarried (single): $12,000
• Married filing separate: $12,000

If the taxpayer is either blind or over age 65, then there is an additional
standard deduction of $1,600 for unmarried persons and $1,300 for
married persons.

Examples:
If Paul and Mary are legally separated and live in and maintain separate
homes, for the entire year of 20X9, their only option to file is as single
taxpayers. However, if they had a dependent child and the child lived
with Mary through the year, then she could file as head of household,
while Paul would still file as single.

If Frank’s wife died in 20X6, Frank would still file ‘married filing jointly’
in 20X6. In 20X7, as long as Frank was still unmarried and paid over 50%
of the cost of maintaining a home for himself and one dependent child,
Frank would file as a surviving spouse, and could do so again in 20X8. In
20X9 if the circumstances were still the same, then Frank would file as
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head of household. Note that if there was no dependent child, then
Frank would file as single for every year except the year that his wife
died, when he could still file as married filing jointly.

Computation of Tax and Credits

Estimated Tax Payments
Whether an individual is an employee or self-employed, taxes are
supposed to be paid during the year on income received. For
employees that have taxes withheld, this is something they never have
to think about. Everyone else is expected to make estimated tax
payments quarterly. This applies to anyone who expects to owe at least
$1,000 in federal taxes for the year.

The payment dates are:

• April 15th for January to March
• June 15th for April to May
• September 15th for June to August
• January 15th of following year for September to December

Tax Credits

Child credit
This gives a $2,000 credit for each qualifying child under the age of
17(see the qualifying child definition in the Filing Status section). This is
for dependent children, stepchildren, or grandchildren. There is no
credit for married taxpayers with AGI above $400,000, or $200,000 for
all other taxpayers.
The max refundable amount per credit is $1,400.

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Family Tax Credit
This is a $500 nonrefundable credit for certain dependents who don’t
qualify for a full child tax credit (if they are over the age limit, a disabled
child of any age, or certain non-child dependents).

This could be anyone who is a qualifying relative, children between 17-

19, or under 24 if they are a full-time student for at least 5 months of
the year.

American Opportunity Credit

$2,500 per year for each eligible student.
It is for 100% of the first $2,000 and 25% of the next $2,000 of qualified
education expenses, which totals the maximum of $2,500.

The student must be enrolled in at least a half-time basis to claim the

credit. This credit is only for the first 4 years of postsecondary
education. This credit is only applicable if the individual is NOT claiming
the lifetime learning credit for that same tax year.

Lifetime Learning credit

Up to a maximum of $2,000 per taxpayer per year for qualified
education expenses at an eligible institution for one or more students.
It is calculated as 20% of education expenses up to a max of $10,000 of
expenses. The eligible student(s) must be the taxpayer, a spouse, or a
dependent listed on the taxpayer’s return. As the name implies, it can
be claimed for an unlimited number of years.

Dependent care credit

Provides a nonrefundable tax credit for portion of expenses for
caregiving while the taxpayer is working.
The person receiving the care, which must be a child under 13 or a
disabled adult, must live with the taxpayer for more than half the year.

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The care can be given in the home, but it can’t be from a dependent
relative or child. The care can be given by a relative as long as the
relative isn’t a dependent of the taxpayer. The taxpayer must be
employed and make at least as much as the expenses. The costs of
transporting the person or child to the place of care is NOT included in
this credit.

The credit is calculated as up to 35% of $3,000 in qualifying expenses

for one child or dependent, or up to 35% of $6,000 for two or more
children or dependents. The credit percentage is reduced by 1% for
every $2,000 increment of AGI above $15,000, and bottoms out at 20%
if AGI is above $43,000.

Example:
Tara has AGI of $14,000 and incurred childcare expenses of $6,000 for
her two children during the year. Since her AGI is below the $15,000
threshold, she can claim a credit for the full 35% of the childcare
expenses. $6,000 x 35% = a credit of $2,100.

If Tara’s AGI was $45,000, the credit percentage would go down to 20%
of the childcare expenses, for a credit of $1,200.

Adoption credit
Credit is allowed for adoption expenses up to $13,840, if the taxpayer’s
income is less than $207,580 in 2018. This credit is nonrefundable. The
credit applies in the year that the adoption becomes final, and can
include adoption expenses from previous years related to the same
adoption.

Earned Income credit

This is a way of reducing the tax burden of low-income taxpayers. The
% of the credit increases based on the number of qualifying children
the taxpayer has.
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The credit is based on earned income from wages, salaries, tips, or self-
employment income.

A married taxpayer must file as ‘married filing jointly’ to receive the

credit. ‘Married filing separately’ are not eligible for the EIC. This credit
can result in a refund even if the taxpayer has no tax liability. If there is
no qualifying child, then the filer must be between the ages of 25 and
64 and can’t be claimed as a dependent by another taxpayer.

Alternative Minimum Tax

This is a tough topic to master. The most important things to know with
AMT are the AMT adjustments and AMT preferences. With AMT you
take your taxable income, and then you add or subtract “adjustments”,
then you add in any “preferences” (these will always be an increase),
and that puts you at AMT income. Then you subtract the applicable
exemption, apply the applicable rate, subtract any tax credits, and
subtract regular taxable income to see if there’s a difference. If there’s
an amount left, then that is the AMT tax you would pay.

AMT is the excess of the tentative AMT tax over the regular tax which is
meant to prevent taxpayers with a lot of income from paying a smaller
percentage of tax than other taxpayers. If the tentative AMT tax comes
to $1,000 and your regular tax was $800, the AMT tax you would pay is
the $200 difference. It’s not a full $1,000 on top of your regular taxes.

AMT adjustments: these are adjustments that either increase or

decrease taxable income in computing AMT income
• No standard deduction allowed, it is added back if used
• If itemizing, no deduction for state income tax or property taxes,
they must be added back to regular taxable income

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 • If itemizing, home mortgage interest is deductible if used to
acquire or improve the home
• If itemizing, medical expenses in excess of 7.5% of AGI is
deductible

AMT preferences: these always increase AMT income

• Depletion over adjusted basis for certain minerals, the difference
is added back
• Interest on “private activity” bonds
• Qualifying small business stock (QSBS)

The AMT exemption for married filing jointly is $109,400 in 2018.

The AMT exemption for single filers is $70,300 in 2018.

If a taxpayer has to pay AMT in a given year – let’s say the $200 from
the example – that $200 becomes an AMT credit that can be carried
forward indefinitely and offset timing differences in a future year
against regular taxes (when no AMT is due).

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 Area V: Federal Taxation of Entities

Tax Treatment of Formations and Liquidations of Business Entities

When forming a corporation, a person or persons transfer property (or
cash) to the corporation in exchange for the stock of the corporation.
To have control of the corporation, these persons need to own at least
80% of the corporation after formation. “Control” is defined as owning
at least 80% of the voting and nonvoting stock. The 80% doesn’t have
to be one person. It can be two or more individuals as long as together
they own 80% or more of the corporation immediately after formation.
You can see this asked in a number of different ways, so remember that
“control” involving the formation of a corporation is owning 80% of the
stock.

In general, transferring property to a corporation is a tax-free exchange

when the exchange is solely for stock in the corporation, and the
transferor is in control directly after the exchange.

“Boot” is anything received other than stock for contributing property

to the corporation. Such as contributing $100k worth of inventory to
the corporation and receiving $80k worth of stock and $20k of cash-
the $20k is boot and triggers a gain of $20k.

If boot is received, the gain recognized by the shareholder will be the

lower of the:
• realized gain OR
• the fair market value of the boot received

Basis in contributed property and stock received

The corporation’s basis in the property contributed is the basis that the
transferor had, plus any gain recognized by the transferor. Note that

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this is only when the corporation is being formed.

Example:
Mike Honcho is the sole shareholder of ABC corp, and at formation of
ABC he transfers property worth $500,000 into the corp. Mike had basis
in the property of $200,000. A year later, Ricky Bobby transfers property
worth $300,000 to ABC for 10% ownership. Ricky Bobby had basis in the
property of $100,000. In these two transactions, ABC takes Mike’s basis
of $200,000 in Mike’s transferred property, but it takes basis of
$300,000 (FMV) in Ricky Bobby’s property. This is because Ricky Bobby’s
transaction isn’t subject to the 351 exchange rules regarding the
formation of a corporation. So Ricky Bobby would have a gain of
$200,000, because he’s receiving stock worth $300,000, and ABC has
$300,000 of basis in the property.

The shareholder’s basis in the stock he or she receives is the basis of

the transferred property, plus any gain recognized, less any boot
received and less any liabilities assumed by the corp.

Liquidating Distributions

Liquidating distribution from a corporation:

A liquidating distribution is full payment in exchange for a shareholder’s
stock. The shareholder will recognize a gain equal to the difference
between the FMV of cash and/or property received, and the
shareholder’s basis in the stock.

Example:
ABC corporation liquidated and gave each shareholder $1,000 cash and
property with a basis of $5,000 and FMV of 8,000. Each shareholder had
basis of $4,000 in the ABC stock. In this transaction each shareholder
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recognizes a gain of $5,000: $1,000 cash + property with FMV of $8,000
makes $9,000 the amount realized by each shareholder. Then, each
shareholder has a basis in the stock of $4,000, which makes the gain on
the liquidation $5,000 to each shareholder.

In a partial liquidation, then sale or exchange treatment applies, which

is the same as the corporation selling property at FMV to a third party:
The gain or loss would just be the difference between FMV and the
corporation’s basis in the property.

Liquidating distribution from a partnership:

A liquidating distribution occurs when a partner receives a distribution
and it terminates the partner’s interest in the partnership. It can also
terminate an entire partnership.

In general, the liquidating distribution is treated as a return of capital to

the partner, the property received takes the basis of the partner’s basis
in the partnership. The only time there’s a gain on a liquidating
distribution is if cash received is more than the partner’s basis in the
partnership. If a partner has basis in the partnership of $20,000 and he
receives $25,000 cash in a liquidating distribution, he has a $5,000 gain.

When cash and property is received, the partner’s basis is reduced by

the amount of cash, then by any receivables or inventory received, and
then the remaining basis is assigned to the property received.

Example:
Ed received $5,000 cash, inventory with FMV of $3,000 and a basis of
$2,000, and a piece of land worth $35,000 as a liquidating distribution
in the partnership. The partnership had basis of $15,000 in the land.
Ed’s basis in the partnership was $25,000. So, Ed’s basis in the land
received would be the same as his $25,000 basis in the partnership, but
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you have to reduce that by the amount of cash received, which was
$5,000, AND by the $2,000 partnership’s basis in the inventory. So in the
end, Ed has basis of $18,000 in the land received as part of the
liquidating distribution: $25,000 - $5,000 - $2,000 = $18,000. Also, Ed
would have a $2,000 basis in the inventory. When he sells the inventory,
the gain or loss would be ordinary, and when he sells the land, the gain
or loss would be a capital gain or loss.

A liquidating distribution from a partnership can trigger a loss if the

distribution only consists of cash, inventory, or unrealized receivables,
and if the property received is less than the partner’s basis in the
partnership.

Example:
Paul receives a liquidating distribution of $15,000 in cash and inventory
with basis and FMV of $5,000. Paul’s basis in the partnership was
$25,000. Paul would have a recognized loss of $5,000 on this
distribution: His $25,000 is first reduced by $15,000, and then by the
$5,000 of inventory leaving him with a loss of $5,000.

Note that if in the example the inventory was replaced with a piece of
land, then Paul would have no loss and would take basis in the land of
$10,000.

Cash vs. Accrual Basis

Most taxpayers and entities can use the cash basis method of
accounting.

The following entities are required to use accrual accounting:

• Any regular C corporation with gross receipts over $25 million.
This is based on an average of the previous 3 years, and once that
test is failed (an average above $25 million), then the corporation
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 has to use the accrual method going forward
• Same rules as above for a partnership with C corporation partners

Differences Between Book and Tax Income

Corporations use an “schedule M-1” to reconcile book income to
taxable income. Corporations with total assets of $10 million or more
are required to file a schedule M-3, which provides more detail than an
M-1.

To reconcile book income to tax income, both temporary and

permanent differences are considered.

Temporary differences are things like accelerated depreciation for tax

and straight line for book, accrued liabilities, or estimates.

Permanent differences are things like tax exempt interest, penalties &
fines, life insurance proceeds, and 50% of business
meals/entertainment (valid expense for books, 50% allowed for tax
deduction). These are all things that would be included in book income,
but not for taxable income.

Any non-deductible expenses would be added to book income to arrive

at taxable income, such as a long-term capital loss.

Any non-taxable income would be subtracted from book income to

arrive at taxable income.

Example:
ABC corporation reports $800,000 in taxable income on its federal
return. Its book income was $700,000. Here are the transactions that

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create the difference done both ways:

Tax income reconciled to book income:

Taxable income = $800,000
Less: provision for federal income tax (200,000) - this is an expense for
book income
Less: Fines (50,000) - part of book income but not taxable income
Add: life insurance proceeds 100,000 - part of book income but tax
exempt
Add: MACRS depreciation 100,000 - taken for tax income
Less: straight line depreciation (50,000) - subtract since included in book
income
= Book income of $700,000

Book income reconciled to tax income:

Book income = $700,000
Add: provision for federal income tax 200,000 - an expense in getting to
$700,000
Add: fines = 50,000 - reduced book income but not tax income
Less: life insurance proceeds (100,000) - book income but tax exempt
Less: MACRS depreciation (100,000) - what you use for tax income
Add: straight line depreciation 50,000 - to remove, included in book
income
= Taxable income of $800,000

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 C Corporations

Computations of taxable income, tax liability and allowable credits

Corporate Income Tax Formula

A corporation’s tax liability is calculated as:

Business Income
Less: Expenses
Equals: Gross Income
Less: Deductions
Equals: Taxable Income Before Special Deductions
Less: Special Deductions
Equals: Taxable Income

Then “Taxable Income” is multiplied by the tax rate, which is a flat 21%
in 2018, which equals “Gross Tax”.

From Gross Tax, any credits are subtracted, then any other taxes are
added, which results in “Net Tax”.

Tax-Related Items for Corporations

Charitable Contributions
The deduction for charitable contributions is limited to 10% of taxable
income before the contribution.

Example:
ABC corporation has book income of $50,000 that includes a charitable
contribution of $10,000. To get to taxable income for ABC, you would
add back the contribution, so $60,000, and take 10% of that, which is
$6,000, and subtract that from $60,000, which gives ABC taxable
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income of $54,000.

Net Capital Losses

Capital losses can’t offset income: Remember that capital losses cannot
offset taxable income, they can only offset capital gains. A net capital
loss can be carried back 3 years and forward 5 to offset capital gains.

Damages from Patent Infringement

Damages received from patent infringement are deductible, so they will
be included in both book and taxable income.

Insurance Premiums on Key Executives

Premiums paid are not tax deductible, but if said person(s) dies the
proceeds are not taxable. Premiums paid on a key executive are a valid
expense for book income, but they would be added back to get to
taxable income because they are not deductible. Also remember that if
said key person dies, the proceeds from the policy are not taxable.

Organizational and Startup Costs

$5,000 of organizational costs to form a corporation can be deducted
from taxable income. But, the $5k is reduced by the amount of
expenses incurred above $50k. So organizational costs of $53k would
only allow $2k to be expensed. All remaining organizational costs must
be capitalized and amortized over 180 months.
Stock issuance costs are “syndication costs”, and they are not
deductible.

Penalty Taxes

Accumulated Earnings Tax

This is a penalty tax when a corporation accumulates earnings and

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profits for the purpose of avoiding income tax for its shareholders. The
tax is 20% of the corporation’s accumulated taxable income. Any
dividends received deductions are added back to the income number
for the purpose of evaluating “accumulated earnings”.

Accumulated Earnings Credit

This is given to corporations when they are subject to the accumulated
earnings tax.
The credit is the greater of the amount of current earnings and profit
“reasonably needed” for the business, OR
$250k ($150k for service businesses) less than the accumulated
earnings and profits at the end of the preceding year

Personal Holding Company Tax

This tax penalizes a corporation that seems to hold a high level of stock
investments since corporations receive the dividends received
deduction.

If the IRS deems a corporation to be a personal holding company, then

there is a 20% tax imposed
There are two tests to determine if a corporation is a PHC (the
corporation has to “pass” both tests to be considered a PHC:

1) Income test: If passive income is 60% or more of adjusted ordinary

gross income

2) Ownership test: If more than 50% of the corporation’s stock is

owned directly or indirectly by 5 or less people during the last half of
the year. An example of indirect ownership would be something like
one person owning 40% of the stock, and then another 20% through an
estate with the same person being the estate’s beneficiary.

Adjustments that either increase or decrease taxable income when

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assessing a PHC penalty:
• Accrued income tax reduces taxable income
• Excess charitable contributions reduce taxable income
• After tax net capital gain reduces taxable income
• Adding back in any DRDs increases taxable income
• The carryover from NOLs increase taxable income

Also, pro-rata dividends reduce the taxable income of a PHC so that the
penalty is lower. The PHC can also give a “deficiency dividend” which is
a dividend paid within 90 days after a PHC penalty has been imposed,
and this dividend will reduce taxable income.

Net operating losses and capital loss limitations

Net operating loss (NOL)
This is when a corporation has negative taxable income, it creates a net
operating loss that can be carried forward indefinitely to offset future
taxable income. A NOL can only be used to offset up to 80% of taxable
income in a given year.

A charitable contribution can’t add to a NOL. If a corporation had

business income of $100,000 and expenses of $200,000 - which
included a charitable contribution of $10,000, then the corporation’s
NOL for the year is $90,000. The charitable contribution has to be taken
out when computing the NOL for the year.

Dividends Received Deduction

The “dividends received deduction” (DRD) is when a corporation (C-
corps, S-corps do not get the DRD) owns stock in another company and
that company pays dividends. The corporation gets to deduct a portion
of the dividend income based on the percentage of stock it owns in the
other company.

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If the corporation owns less than 20%, the DRD is 50%.
If the corporation owns 20-79%, the DRD is 65%.
If the corporation owns 80% or more, the DRD is 100%.

Example:
ABC corporation has $500,000 in revenue, receives $100,000 in dividend
income from a 40% owned corporation, and has operating expenses of
$200,000. The stock is 40% owned so it falls in the 65% DRD tier. So,
ABC had $500,000 of revenue, but only $35,000 of the dividend income
needs to be included for tax purposes ($100,000 - 65% = $35,000),
resulting in total income of $535,000, less the $200,000 of expenses,
leaving $335,000 of taxable income.

IF the corporation has taxable income of less than the dividend income,
the DRD is limited to the taxable income amount. So if a corporation
has taxable income before the DRD of $50,000 and dividend income
was $100,000 with a 65% DRD, the DRD is only 65% of the $50,000,
NOT the $100,000.

Entity/owner transactions, including contributions, loans, and

distributions

Owner’s Basis
Calculating a shareholder’s basis in a corporation is based on the timing
of transfers of property, distributions, and earnings & profit (E&P).

Let’s start with formation. Again, when an owner transfers property to

a corporation upon formation as part of a 351 exchange, the
corporation take’s the shareholder’s basis in the property, and the
shareholder receives stock and keeps the same basis in the stock
received.

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Example:
Arnold transfers property with a FMV of $100,000 to a new corporation
where Arnold is the sole shareholder. Arnold had basis in the property of
$80,000. Arnold’s basis in the stock of the corporation remains $80,000,
and the corporation takes basis of $80,000 in the property.

If an individual transfers property after formation of the corporation in

exchange for ownership, then the corporation takes basis in the
property equal to its FMV, regardless of the previous basis in the hands
of the owner.

Example:
A year after Arnold’s corporation was formed, Arnold’s friend Pete
transfers property worth $200,000 for 10% ownership. Pete’s basis in
the property is $100,000. The corporation would take basis of $200,000
in the property, and Pete would have a gain of $100,000 on the stock
received and then have basis of $200,000 in the stock.

If the corporation takes over a liability attached to transferred property,

if the liability is greater than the transferor’s basis, the difference
triggers a gain to the transferor.

Also, remember the boot rules discussed in the “Tax Treatment of

Formations” section. While transferring property in a 351 exchange, if
the transferor receives boot in addition to stock, then the corporation
takes basis equal to the transferor’s basis in the property + the value of
the boot received. The transferor will have a recognized gain that is the
lesser of the boot received or the realized gain.

Distributions
When considering the tax effects of distributions, the “accumulated
earnings and profits” is what matters. A distribution is a dividend as
long as it is made from current or accumulated earnings & profit.
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A distribution that is larger than a corporation’s accumulated earnings
is a return of capital (which lowers shareholder’s basis) to the extent of
the shareholder’s basis in the stock and is not taxable.

Example:
ABC corporation had $20,000 in accumulated E&P at the beginning of
the year, and then $10,000 of E&P in the current year. During the year,
ABC corporation paid cash distributions of $35,000 to shareholders. In
this case, only $30,000 of the distributions would be classified as
dividends ($30,000 in E&P), and the remaining $5,000 would be
considered a return of capital. If shareholders had basis of $40,000
before this distribution, their basis would be lowered to $35,000
because of the return of capital portion.

When a corporation distributes appreciated property to shareholders,

the corporation recognizes a gain equal to the difference in basis and
FMV. It’s treated as if the property were sold to an unrelated party at
FMV. If there’s a liability attached to the property that exceeds FMV
and that liability is assumed by the shareholder, then the gain to the
corporation is equal to the liability less basis.

Example:
ABC corporation distributes property worth $40,000 to a shareholder.
ABC has basis in the property of $30,000. ABC recognizes a gain of
$10,000 on this distribution.
Alternatively, let’s say the property had a liability attached for $50,000,
which the shareholder assumes. In this case, the gain to ABC is $20,000:
$50,000 liability less ABC’s basis of $30,000 = $20,000 gain.

The shareholder’s basis in property received via distribution will be the

FMV of the property. If the shareholder assumes a liability in
connection with a distributed property, if the liability is greater than the
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FMV of the property, then the liability amount becomes the
shareholder’s basis in the property.

No losses on non-liquidating distributions to shareholders: If a

corporation distributes property with FMV less than its basis to
shareholders, no loss is recognized.

Constructive dividends: If a corporation sells property to a shareholder

for less than FMV, the shareholder is considered to have received
dividend income equal to the difference.

Example:
ABC corporation sells a piece of land with FMV of $100,000 to a
shareholder for $75,000. The shareholder will report dividend income of
$25,000 on this transaction.

Liquidation
When a corporation is completely liquidated, property distributions are
treated as a sale at FMV, which means the corporation will have a
recognized gain equal to the difference of the FMV and the
corporation’s basis in the property (or a loss). The gain or loss will be a
capital gain or loss. Again, if any liabilities are assumed by the recipient
and the liability is greater than the FMV of the property, the
corporation recognizes a gain equal to the difference of the liability
amount and the corporation’s basis in the property.

To the shareholder, when a redemption terminates their ownership,

the redemption is a capital gain.

On a partial liquidation, the shareholder treats the redemption as a

capital gain.

Expenses related to a liquidation are deductible by the liquidating

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corporation. These include accounting and legal fees, filing fees, and
other expenses related to the liquidation.

To Summarize…
When cash is distributed to shareholders, it is dividend income to the
extent of accumulated + current E&P. Any amount above E&P is a
return of capital (basis), and any amount above that is a capital gain.

In a complete liquidation of a corporation, both the corporation and

the shareholder recognize a gain equal to the difference of basis and
property distributed/received, just as if the property were sold at FMV.

Reorganizations
Corporate reorganizations are generally tax free to both the
shareholders and the corporation
The 4 main types of corporate reorganizations:
• A: Most assets of target firm are exchanged for stock in the
acquiring firm. This can be either an acquisition- where A acquired
B and only A remains- or a consolidation where A & B combine
and become C.
• B: Only stock for stock- the acquiring firm exchanges its stock for
stock of the target and the acquiring firm must own 80% of the
target stock after the acquisition. A acquires B, B remains in
existence but is now 80% or more owned by A. B shareholders
now own stock in A, the parent.
• C: Acquiring firm acquires 90% of net asset value of target’s assets
in exchange for voting stock. Target firm distributes stock to its
shareholders. A acquires B, B dissolves, and B shareholders are
now shareholders in A.
• D: Divisive- a spinoff or split off. One corporation divides by
transferring assets to a sub in exchange for stock in the sub.

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Consolidated tax returns
Affiliated Group and Consolidated Tax Returns
When one C corporation owns at least 80% of the voting power & value
of another C corporation or multiple C corps, this is an “affiliated
group”, and they can file one consolidated tax return. An S-corp is NOT
allowed to be a member of an affiliated group.

When a parent and sub sell each other property, the seller will have a
realized (not recognized) gain, and it will be recognized when the other
party sells the property to an unrelated third party. The buyer in the
original transaction will take basis equal to the purchase price, and if
subsequently sells the property to an unrelated third party, will
recognize a gain if sold for more than their basis.

Example:
ABC corporation is the parent of XYZ corp. XYZ sells ABC a piece of land
for $50,000. XYZ had basis of $30,000 in the land, so XYZ has a realized
gain of $20,000. A year later, ABC sells the land to an unrelated third
party for $70,000. ABC then has a recognized gain of $20,000, and at
this time XYZ will also recognize the $20,000 gain that was previously
deferred. On the consolidated financials the end result is a gain of
$40,000: XYZ originally had basis of $30,000 and the land ends up being
sold to a third party for $70,000.

One advantage of filing a consolidated return is that the net operating

loss of one member can offset income of the other members. If the
NOL absorbs all the income from the other members, it creates a
consolidated NOL that can be used like a regular NOL: carried back two
years and carried forward 20 years.

Dividends between affiliated members are eliminated in the

consolidation process and are not reported in the consolidated tax

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return.

When one corporation has control of subsidiary corporations, there are

3 main advantages to filing a consolidated return:
• Inter-company dividends are excluded from taxable income
• Losses from one-member corporation offset gains of another
member
• Inter-company profits are deferred until realized

Multi-jurisdictional tax issues

“Domestic” corporations are corporations that are incorporated in their
home state. A “foreign” corporation is a corporation that’s
incorporated in another state. A Florida corporation is domestic in
Florida, but foreign in Alabama.

State Taxes and Nexus

When property is purchased in one state but used in a different state,
the state where the use takes place will probably impose a use tax.

Nexus is when a business has a relationship with another state to the

point that the state has the right to impose taxes on the business.
Nexus is referred to as “sufficient physical presence”. Nexus with other
states can be created a number of ways, but most commonly would be
having a temporary or permanent presence of your business people in
a given state. Sales or service agents, or even consigned inventory in a
warehouse can create nexus.

Apportionment
This is an attempt to allocate sales to the different states that a
business operates in. Different states might use different
apportionment factors, or just one factor.

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Factors include:

Sales Factor
When a business has sales among multiple states that they also have
nexus in, the sales factor for each state is determined on a percentage
of sales basis. If you have sales of 10k in state A and sales of 90k in state
B, your sales factor is 10% for state A and 90% for state B.

Formula is: Total sales in that state / Total sales

Property Factor
Average value of property in that state / Total value of all property

Foreign Income and Tax Considerations

Foreign branch vs foreign subsidiary

A U.S. Corporation that has branches in other countries owes federal
tax on the income from a foreign branch, just as it would with its
operations inside the U.S.

A foreign subsidiary on the other hand, the U.S. parent does not owe
federal tax on the sub’s earnings unless the sub sends money to the
U.S. parent in the form of dividends.

Foreign Tax Credit for Corporations

A U.S. corporation that has paid foreign taxes can claim a credit on their
federal taxes. The credit is the lesser of actual foreign taxes paid, or the
foreign tax credit limit. This is a specific calculation, and the foreign tax
credit cannot be more than this fraction multiplied by the U.S. tax
liability. The fraction is: taxable income from sources outside the U.S. /
Total taxable income from U.S. and foreign sources

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Example:
ABC corporation had taxable income from the U.S. of $100,000, and
taxable income from foreign sources of $50,000. ABC has already paid
$10,000 in foreign taxes. The foreign tax credit limit calculation would
be: $50,000 / $150,000, or 33%. 33% of 100,000 is $33,000, so the
foreign tax credit for ABC would be the lesser of the foreign taxes paid
and the foreign tax credit limit, which in this case is the $10,000 of
foreign taxes paid. $10,000 would be ABC’s foreign tax credit.

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 S-corporations

Eligibility and election

Eligible shareholders for an S-corp:
• Individuals - must be U.S. citizen or U.S. resident
• Bankruptcy estates
• Single member LLC can elect to be taxed as an S-corp
• Testamentary trusts
• Revocable trusts as part of an estate

Ineligible shareholders:
• Nonresident aliens
• C corporations
• Partnerships
• Multiple member LLCs
• LLPs
• Foreign trusts

S-corp elements:
• No more than 100 shareholders (this is relaxed if some
shareholders are family members)
• Can only have one class of stock, but it can be voting and
nonvoting
• An S-corp’s election as an S-corp can be revoked by a majority
consensus of shareholders, including non-voting shareholders
• An S-corp election is only effective for the current tax year if the
election is made by the 15th day of the third month of the tax
year. If made after that date, the election is not effective until the
beginning of the next tax year
• An S-corporation’s tax year is usually the calendar year
• Shareholders are not liable for debt

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 • Shareholders can be employees
• Flow through taxation to shareholders
• S-corps can own stock in C corporations
• S-corps can be a partner in a partnership
• An S-corp can own 100% of the stock of an S-corp subsidiary
• A C corporation cannot own 100% of an S-corp

Process for making the S election:

The election to S-corp status must be unanimous by the shareholders.
The election is made by filing Form 2553 with the IRS. If the election is
made before the 15th day of the third month in the company’s fiscal
year, then it will be effective for that year. If the election is made after
the 15th day of the third month, then the election will be effective at
the beginning of the following year. Remember that this is for the fiscal
year of the business.

Termination of S status:
S status can be terminated through a majority vote of the shareholders.
If more than 50% of the owners change, then the new owners must
agree to keep the S-corp status. Also, the S-corp status can be
involuntarily terminated if passive income exceeds 25% of gross
receipts for 3 years in a row.

If any of the eligibility rules are broken, then the IRS can terminate the
S-corp status.

If an S-corp terminates, it must wait 5 years before it can re-elect to be

an S-corp again.

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Determination of ordinary business income(loss) and separately
stated items
With S-corps, ordinary business income is separated from certain items
referred to as “separately stated items”. Ordinary business income is
generated through the primary activities of the business, and then
separately stated items are things like:
• Charitable contributions
• Interest income
• Dividend income from investments
• Rental activities
• Section 179 deductions
• Capital gains and losses
• Tax credits
• Foreign taxes

These separately stated items are passed through to the S-corp owners
‘separately’ so that they retain their specific tax characteristics.

Example:
ABC, an S-corp, reported the following items during the year:
Revenue of $100,000
Operating expenses of $30,000
Long-term capital loss of $10,000
Charitable contributions $5,000
Business interest expense $7,000

From these items, ABC would have ordinary income of $63,000:

$100,000 - $30,000 - $7,000 = $63,000.
The capital loss would be separately stated and passed through, as
would the charitable contributions. This allows for the shareholder to
net other capital gains/losses, same thing with the charitable
contributions.

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Another example:
Bob is a 60% owner in ABC, and S-corp, and a 30% owner in XYZ,
another S-corp. Both companies elected to take the maximum section
179 deduction during the year. The amount of each 179 deduction that
flows through to Bob’s personal return will be ($510,000 x 60%)
$306,000 from ABC, and ($510,000 x 30%) $153,000 from XYZ, for a
total of $459,000. This would reduce Bob’s basis by the respective
amounts, but he could deduct the full $459,000. If the two amounts
added up to more than $510,000, then Bob would carryover the
remainder to a future year.

Accumulated Adjustments Account (AAA)

The AAA tracks previously taxed but undistributed earnings. When
distributions are made from this account, they are tax free since the
earnings have already been taxed. The AAA is adjusted just like
shareholder’s basis: income and separately stated income items
increase it, except for tax exempt interest. It is decreased by negative
separately stated items and any tax-free distributions. Also, the AAA
can be negative, unlike shareholder’s basis.

Note: An S-corp that has never been a C corporation will not use an
AAA. Also, even if it was previously a C corporation, if there was not any
E&P when converting to an S-corp, then the AAA isn’t necessary either.

If an S-corp has an AAA, then distributions are first from AAA (which
reduce basis), then from E&P which will be dividend income, then from
stock basis which is a return of capital, and when basis is absorbed, any
distributions are taxed as a capital gain.

Example:
ABC, a converted S-corp, has AAA of $20,000 and E&P of $10,000. If it
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makes a distribution of $50,000 to its sole shareholder who has basis of
$30,000 in ABC, here’s how it breaks down: The first $20,000 of the
distribution is tax free from the AAA, and it reduces the shareholder’s
basis to $10,000. The next $10,000 of the distribution is dividend income
from the E&P, the next $10,000 is a tax-free return of capital, and the
next $10,000 of the distribution is considered a capital gain to the
shareholder.

Basis of shareholder's interest

A shareholder’s basis in S-corp stock is increased by all the flow through
income (including tax exempt income) items and decreased by
distributions and flow through deductions.

Example:
Bob is the sole shareholder in ABC, an S-corp. Bob’s basis in ABC at the
beginning of the year is $50,000. At the end of year, ABC had ordinary
income of $30,000, tax exempt income of $10,000, and capital gains of
$10,000. ABC made a $40,000 distribution to Bob during the year. At
the end of the year, Bob’s basis is now $60,000: His basis was increased
by each of the income items and decreased by the distribution for
ending basis of $60,000.

Losses and Basis

A loss by the S-corp is deductible by the shareholders to the extent of
their basis. If losses exceed basis, then the remaining loss can be carried
forward indefinitely to another year when the shareholder has basis to
use it.

Example:
Ron is the sole shareholder of ABC, an S-corp. Upon formation, Ron
invests $10,000 for the stock of ABC, and loans ABC $20,000. During the

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first year, ABC reports a loss of $40,000. In the current year, Ron can
claim a loss of $30,000 on his personal return. His basis was the $10,000
paid + the $20,000 loan to ABC, so he only has basis of $30,000
compared to the $40,000 loss. The remaining $10,000 can be carried
forward to a year when Ron has basis again to use the loss.

Entity/owner transactions
Contributing Property to an S-corporation

Allocating Income to Shareholders

In an S-corp, all income is attributed to the shareholders, whether the
income is distributed or not. The income increases the shareholder’s
basis, and when it’s distributed it decreases the shareholder’s basis.

Example:
Bob is the sole shareholder of ABC, an S-corp. ABC reports $30,000 of
ordinary income for the year and distributes $15,000 to Bob. Bob will
report income of $30,000 on his personal tax return. Don’t get confused
with income and basis. Bob’s basis is increased by the $30,000 of
income, but also decreased by the $15,000 distribution. However, Bob
still reports the full $30,000 of income on his tax returns.

Distributions
As long as an S-corp doesn’t have any earnings and profits (which will
only happen if a C corporation had E&P and then converted to an S),
any distribution a shareholder receives is a return of basis to the extent
of the shareholder’s basis, and anything above that is a capital gain.
Note: if an S-corp does have E&P, then a distribution is first classified as
dividend income to the extent of the E&P, just like a C corp.

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Built-in gains tax
When a C corporation converts to an S-corp, appreciated property that
the corporation owns is subject to the “built-in gains tax” if the
property is sold within the recognition period, which is 35% of the built-
in gain at the time of conversion to an S-corp. The recognition period is
5 years. At the same time, any built-in losses can offset built-in gains.

Note that a sole proprietor that converts to an S-corp is not subject to

the built-in gains tax.

Example:
ABC corporation, originally a C corporation, converts to an S-corp. At
conversion, ABC owns equipment with basis of $50,000 and a FMV of
$90,000. A year after converting to an S-corp, ABC sells the equipment
for $100,000. To calculate the built-in gains tax on this transaction, it
would be 35% of the built-in gain at conversion, which was $40,000
(90,000 - 50,000). Notice that it is not calculated on the sale price, but
rather the FMV at the date of conversion. So, the built-in gains tax
would be $40,000 x 35%, which = $14,000.

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 Partnerships

Determination of ordinary business income(loss) and separately

stated items
Like S-corps, business income is separated from “separately stated
items”. Again, this is so that the separately stated items can retain their
tax character as they flow through to the partners’ individual tax
returns.

The items that determine ordinary business income are what you’d
expect: sales, COGS, expenses as part of operating the business,
depreciation, and included in this for partnerships are guaranteed
payments to partners.

Separately stated items are the same as for S-corps. They can include:
• Charitable contributions
• Interest income (including tax exempt interest income)
• Dividend income from investments
• Rental activities
• Section 179 deductions
• Capital gains and losses
• Tax credits
• Foreign taxes

Example:
ABC partnership reported the following:
• Sales of $100,000
• Interest income of $5,000
• Charitable contributions of $10,000
• Guaranteed payment to partners $5,000
• COGS of $40,000

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 • Depreciation of $10,000

Based on these items, ABC’s non-separately stated ordinary income is

$45,000. (100,000 - 5,000 - 40,000 - 10,000). Remember that
guaranteed payments to partners are included in determining ordinary
income.
The separately stated items are the interest income and charitable
contributions.

Partnership Basics
A general partner participates in day-to-day running of the business and
has joint liability for the partnership’s obligations. If there are two
partners and the partnerships liabilities total $100,000, each partner is
on the line for $50,000.

A limited partner has liability up the amount of his/her investment in

the partnership and can’t participate in management activities of the
business, otherwise they become a general partner.

A partnership reports income on form 1065 and the share to each

partner is reported on a schedule K-1.

The $5k of organizational expenses rule applies the same way to

partnerships. Anything above $50k reduces the $5k that can be
expensed.

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Basis of partner's interest and basis of assets contributed to the
partnership

Partner’s Basis in a Partnership

A partner’s basis in the partnership is increased by:

• Contributions of property
• Proportionate share of income
• Proportionate share of increases in liabilities

There is no gain or loss on property contributed to the partnership. A

partner’s basis in the partnership immediately after formation is the
substituted basis of the assets contributed, which means it has the
same basis as it had in the hands of the individual, and the new
partner’s basis in the partnership is equal to the basis they had in the
contributed property.

Example:
Bill and Ted form a partnership. Bill contributes $50,000 in cash. Ted
contributes property he has basis in of $30,000, which has a FMV of
$40,000 and has a $20,000 liability attached that the partnership
assumes. Bill’s initial basis in the partnership is $50,000 + his share of
the liability assumed. So, his basis is $60,000.

If a partner contributes property with an attached liability, the liability

reduces the partner’s basis in the partnership by the proportionate
amount of the liability. For example, if Max contributes a piece of land
to ABC partnership for a 50% ownership interest, and Max has an
adjusted basis of 10k in the land and the FMV of the land is 20k, but it
has a $5k mortgage that ABC will take over, then Max’s basis in ABC

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partnership is just $7,500. (his 10k basis less ½ of the 5k mortgage he is
getting out of).

Continuing the previous example:

To calculate Ted’s basis, his basis in the property he contributed was
$30,000, but he personally is getting out of the $20,000 liability.
However, the partnership is now liable, and he is a 50% partner, so his
share of the liability is $10,000. However you look at it, his basis is the
basis he had in the property reduced by his net decrease in personal
liability. So, it’s the $30,000 basis, and overall Ted is getting out of
$10,000 of the $20,000 liability, which means Ted’s basis in the
partnership is $20,000 (30,000 - 10,000). Also note that even though Bill
and Ted are 50/50 partners, they have different basis in the partnership.

A partner’s basis is decreased by:

• Distributions
• Proportionate share of expenses, losses, and decreases in
liabilities

Example:
Ron is a 50% partner in ABC partners. At the beginning of the year, Ron
has basis in ABC of $10,000. During the year, ABC has ordinary income
of $20,000, interest income of $5,000, made a distribution of $5,000 to
both partners, and took out a loan for $20,000 but paid off $10,000 of it
by the end of the year.
To calculate Ron’s basis at the end of the year, it would be increased by
the 50% of the income and loan and decreased by the distribution and
50% of the loan payoff.

So, Ron’s basis at the end of the year is: Beginning basis of $10,000 +
$12,500 income + $10,000 loan = $32,500. Then the $32,500 is
decreased by the $5,000 distribution, and his share of the loan payoff,
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$5,000. So, Ron’s basis at the end of the year is $22,500.

If a partner contributes services in return for a partnership interest,

whatever the amount of the partnership interest is, that partner has to
recognize that same amount in wage income. When this happens, the
calculation for the amount of income to recognize is the FMV of the
partnership interest the new partner is receiving for the services.

Example:
Peter gains a 10% interest in ABC partnership for services rendered.
ABC’s net assets have a FMV of $50,000. This results in Peter reporting
$5,000 of ordinary income on his tax return.

Partnership’s Basis in Contributed Property

A partnership takes the same basis the contributing partner had in the
contributed property. If there’s a liability attached that would put the
partner’s basis below zero - which can’t happen - then the partner
would recognize a gain to bring their basis back up to zero.

Example with no liability:

Steve contributes property with a FMV of $50,000 to ABC partnership
for a 50% interest in the partnership. Steve had basis of $10,000 in the
property. ABC takes Steve’s basis in the property of $10,000.

Example with liability:

Steve contributes property with a FMV of $50,000 to ABC partnership
for a 50% interest in the partnership. Steve had basis of $10,000 in the
property, and it had a liability attached of $40,000 which the
partnership assumes.
In this example we’ll start with Steve: He contributes property he has
basis in of $10,000, so his basis in ABC starts at $10,000. But, he’s
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getting out of $40,000 of debt, which takes his basis to -$30,000. But as
a 50% partner, he’s re-assuming half of the liability, so add back
$20,000 to his -$30,000 and he’s still at -$10,000. You can’t have
negative basis, so Steve has to recognize a gain of $10,000 to get his
basis up to $0. So, ABC takes basis in the property of Steve’s original
basis of $10,000 + the $10,000 gain recognized by Steve, for basis of
$20,000.

Partnership and partner elections

Accounting Period
A partnership is allowed to elect an annual accounting period. If this
election is not made, then the partnership must adopt the accounting
year of a partner that owns 50% or more of the partnership. This is to
prevent the deferral of reporting income.

General Partnership Elections

Partners can elect a number of things such as accounting method,
inventory method, depreciation method.

Foreign Tax Credit/Deduction

For foreign taxes paid, each partner can decide if they want to take
their share as a deduction or a credit.

Electing Large Partnerships (ELP)

A large partnership that has more than 100 partners can make an ELP
election which makes tax reporting more straightforward. The main
effect is that the ELP can combine more items at the partnership level
and pass through net amounts to partners.

The main items that can be combined with ordinary business income

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for an ELP include deductions, passive activity income/losses, and
charitable contributions.

Also, capital gains are netted at the partnership level instead of being
separately reported.

Transactions between a partner and the partnership

Guaranteed Payments
These are payments agreed to be made to a partner regardless of
whether the partnership makes a profit in a given year. These are for
non-partner services performed, or for contributing capital. The partner
that receives the payment reports it as self-employed income, and the
amount is deductible when calculating ordinary partnership income. A
guaranteed payment does not reduce the basis of the partner it is paid
to.

Example:
John is a 50% partner in ABC partnership. ABC has ordinary income of
$40,000 which includes a guaranteed payment to John of $10,000.
Based on these facts, John will report $30,000 of gross income on his
personal tax return. The guaranteed payment is figured into the
partnership’s ordinary income number, and so the $10,000 guaranteed
payment + John’s share of ABC’s income ($20,000) = $30,000 of income
to John.

Built-in Gains on Contributed Property

When a partner contributes property to a partnership that has a built-in
gain (partner’s basis is less than FMV), if the partnership sells the
property, the gain is allocated back to the contributing partner up to
the FMV at the time of contribution. The remaining gain is distributed
among the partners like any other income or gain.

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Note: This rule has a 5-year limit, so if the partnership doesn’t sell the
property within 5 years of contribution, after that the entire gain is
allocated to the partners according to the partnership’s income
allocations.

Example:
Bill is a 50% partner in ABC partnership. Bill contributed property with
basis of $30,000 and FMV of $50,000. 2 years later, ABC sells the
property for $60,000. Bill’s built-in gain at the time of contribution was
$20,000 (50,000 - 30,000). So, when ABC sells the property, that gain,
which is now recognized, is allocated back to Bill. Since the property was
sold for $60,000, there’s still $10,000 of gain, and since Bill is a 50%
partner, half of that (an additional $5,000) would be allocated to Bill.
This would be a capital gain to Bill.

Impact of partnership liabilities on a partner's interest in a

partnership
Partnership Liabilities
Liabilities in a partnership increase a partner’s basis by their partner
percentage. If a 50% partner’s basis is $10,000 and then the partnership
takes out a loan for $20,000, that partner’s basis will increase by
$10,000.

When a partner contributes property to a partnership, if there was

previously a liability attached to the property, then the contributing
partner’s basis is reduced by the net amount of the liability they are
getting out of.

Example:
Pam contributes property with basis of $20,000 and FMV of $40,000 to
ABC to become a 20% partner. The property has a $10,000 liability that
ABC will assume. To determine Pam’s basis, start with her basis in the

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property of $20,000. Then, she is getting out of $8,000 of the liability
(partnership assumes all $10,000 but she is now a 20% partner so she’s
liable for $2,000 of the liability), so her $20,000 basis is reduced by
$8,000. So, Pam’s beginning basis in ABC is $12,000.

At-Risk Amount
When a partnership has a business loss for the year, each partner can
only deduct their share of the loss to the extent of their basis, or their
at-risk amount if it is less. The at-risk amount is usually the partner’s
basis less their partner percentage of any non-recourse debt. This is
because non-recourse debt by definition makes the partner not
ultimately liable for the debt, so a partner’s share of that debt is not “at
risk”.

Distribution of partnership assets

Liquidating distribution from a partnership:
A liquidating distribution occurs when a partner receives a distribution
and it terminates the partner’s interest in the partnership. It can also
terminate an entire partnership.

In general, the liquidating distribution is treated as a return of capital to

the partner, the property received takes the basis of the partner’s basis
in the partnership. The only time there’s a gain on a liquidating
distribution is if cash received is more than the partner’s basis in the
partnership. If a partner has basis in the partnership of $20,000 and he
receives $25,000 cash in a liquidating distribution, he has a $5,000 gain.

When cash and property is received, the partner’s basis is reduced by

the amount of cash, then by any receivables or inventory received, and
then the remaining basis is assigned to the property received.

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Example:
Ed received $5,000 cash, inventory with FMV of $3,000 and a basis of
$2,000, and a piece of land worth $35,000 as a liquidating distribution
in the partnership. The partnership had basis of $15,000 in the land.
Ed’s basis in the partnership was $25,000. So, Ed’s basis in the land
received would be the same as his $25,000 basis in the partnership, but
you have to reduce that by the amount of cash received, which was
$5,000, AND by the $2,000 partnership’s basis in the inventory. So in the
end, Ed has basis of $18,000 in the land received as part of the
liquidating distribution: $25,000 - $5,000 - $2,000 = $18,000. Also, Ed
would have a $2,000 basis in the inventory. When he sells the inventory,
the gain or loss would be ordinary, and when he sells the land, the gain
or loss would be a capital gain or loss.

A liquidating distribution from a partnership can trigger a loss if the

distribution only consists of cash, inventory, or unrealized receivables,
and the property received is less than the partner’s basis in the
partnership.

Example:
Paul receives a liquidating distribution of $15,000 in cash and inventory
with basis and FMV of $5,000. Paul’s basis in the partnership was
$25,000. Paul would have a recognized loss of $5,000 on this
distribution: His $25,000 is first reduced by $15,000, and then by the
$5,000 of inventory leaving him with a loss of $5,000.

Note that if in the example the inventory was replaced with a piece of
land, then Paul would have no loss and would take basis in the land of
$10,000.

One key difference in liquidating distributions compared to non-

liquidating, is that in a liquidating distribution the partner’s basis must
go to zero. That can mean recognizing a loss if the distribution only
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consists of cash, inventory, or unrealized receivables, or it can mean
taking an increased basis in distributed property to take the partner’s
basis to zero.

Example
Paul receives a liquidating distribution consisting of $5,000 cash and
land with basis to the partnership of $20,000 and FMV of $40,000.
Paul’s basis in the partnership is $30,000. The distribution would lower
his basis first by the $5,000 of cash, but taking the partnership’s basis in
the land of $20,000 still leaves Paul with $5,000 of basis. So, Paul would
take basis in the land of $25,000 to reduce his basis to zero.

Non-Liquidating Distributions (Current Distribution)

Distributions from a partnership are either a liquidating distribution or
a current distribution. In a current distribution (any distribution that is
not liquidating), the rules are generally the same as a liquidating
distribution: basis is reduced first by cash received, and then by the
partnership’s basis in any distributed property.

Again, a partner’s basis can’t go below zero, so the basis taken in

distributed property is limited to the partner’s basis in the partnership.

A recognized gain will only happen if the partner receives more cash
than the partner has basis in the partnership.

A recognized loss won’t happen in a current distribution.

Ownership changes
Termination of a Partnership

In the liquidation of a partnership, there is no gain or loss on property

received unless a partner receives cash in excess of his/her adjusted

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basis.

A partnership is considered terminated if no part of the business

continues to be carried on by any partner within a 12-month period, or
if there is a sale or exchange of at least 50% in both capital and profits
within a 12-month period.

A partnership is also terminated if one or more partners sell their

interests and the sale leaves only one partner, at this point the
partnership is terminated.

If a partnership splits, if the remaining partners’ interests are more than

50% of the original partnership, then they will continue as the original
partnership.

Selling a Partnership Interest

If a partner sells their interest in a partnership, it’s like selling any other
property: A gain or loss will be the difference between cash received
and the partner’s basis in the partnership. If the buyer assumes the
partner’s share of partnership liabilities, that adds to the gain for the
partner.

Example:
Bob sells his interest in ABC partnership. Bob’s basis in ABC was
$20,000, and he sells his interest for $25,000. Also, the buyer will
assume Bob’s share of the partnership liabilities with his share being
$6,000. Based on these facts, Bob’s gain will be $11,000 (the $25,000 +
the $6,000 of liabilities he’s getting out of)

When a partner sells their interest in a partnership, their tax year as far
as the partnership ends on the date of the sale. This is also the case if a
partner dies.
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When a partner sells their interest in a partnership, a partnership
interest is a capital asset, so the gain or loss is a capital gain/loss.
However, if the partnership has appreciated inventory or unrealized
receivables (hot assets), then the partner’s share of the hot assets will
be ordinary income to the selling partner.

Limited Liability Companies (LLCs)

LLCs can be classified in several different ways:

C corporation: LLCs can be treated as a C corporation for tax purposes if

Form 8832 is filed.

S corporation: LLCs can be treated as an S-corp for tax purposes if Form

2553 is filed.

Partnership: LLCs with more than one member are very similar to
partnerships for tax purposes if no election is made to be taxed as an S-
corp or C corporation. The “partners” are referred to as “members” in
an LLC, but each member receives a K-1 and then each member pays
taxes individually.

Single-Member LLC or Disregarded Entity: An LLC with just one member

that doesn’t elect S or C corporation treatment is a “disregarded entity”
to the IRS. It’s just like being a sole proprietor.

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 Trusts and Estates

Types of trusts
Trust Definitions
A trust is a legal entity setup by a grantor to transfer property/income
to a beneficiary.

Living trust: Setup while you’re alive and immediately becomes

effective.

Testamentary trust: Doesn’t become effective until you die.

Revocable trust: You retain ownership and control of the assets in the
trust and can change terms, beneficiaries, and trustees.

Irrevocable trust: You give ownership and control to a trustee and you
no longer are able to make changes.

Simple trust: This a trust that is required to distribute all annual income
to the beneficiaries, which cannot be charitable organizations. The
income from the trust is taxable to the recipient, and the corpus
(principal) must remain in the trust. Capital gains also stay within the
trust and become part of the corpus.

Complex trust: A trust is considered complex if it does any one of the

following: 1) Retains income in the trust, 2) distributes corpus, 3)
distributions go to charitable organizations.

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Income and deductions
When calculating income for a trust, items are separated into income
and corpus. Note that items in either group may be taxable or non-
taxable. There might be tax-exempt interest that is part of income for
the trust accounting, or a capital gain that is allocated to the corpus for
trust accounting but is taxable.

The basic idea with income and deductions for a trust is you take the
income the trust made during the year, subtract deductions, then the
trust makes distributions of the distributable net income (DNI) to the
beneficiaries - this lowers the taxable amount to the trust and the
beneficiaries are taxed on their distributions - then the trust can take a
personal exemption of $300, and that gets you to the trust’s taxable
income. Then the applicable tax rate would apply, then subtract any
credits and you’re left with the trust’s taxable income.

Here’s a breakdown:

Gross income
Less: Interest, expenses, charitable contributions
Less: Distributions of DNI to beneficiaries
Less: Personal deduction ($300 for trusts)
Equals: Taxable income
Taxable income x applicable tax rate
Equals: Gross tax
Less: any credits
Equals: trust tax payable

Other facts you might see as a question:

If the grantor retains control over the trust and can decide who the DNI

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goes to, then the grantor will be taxed on the DNI, not the beneficiary.

Determination of beneficiary's share of taxable income

The beneficiary is taxed on their portion of distributable net income.

Example:
The ABC trust is setup to distribute $50,000 each year to Peter, and
$150,000 each year to Paul. In 2018, the trust had $140,000 of DNI, so
Peter would report income of $35,000, and Paul would report income of
$105,000. Each beneficiary receives their prorated portion of the DNI.
Peter’s is 25%, and Paul’s is 75%.

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 Tax Exempt Organizations

Types of organizations
Tax Exempt Entities
A tax-exempt organization can either be a corporation, a trust, or an
association.

Tax exempt organizations include the following:

• Charitable organizations
• Religious organizations
• Social welfare organizations
• Labor organization
• Employee benefit associations or funds
• Veterans organizations
• Political organizations (but lobbying to influence legislation or
political parties is not an exempt purpose)

An exempt entity must file an information return (Form 990) if gross

receipts exceed $50,000. Churches do NOT have to file a 990.

Obtaining and maintaining tax exempt status

501(c)(3) Organizations
To qualify as a tax-exempt organization, it must operate solely for a tax-
exempt purpose. The organization has to apply for and receive exempt
status.

The organization must be organized and operated exclusively for

exempt purposes. No part of the organization’s net earnings can
benefit the private interests of any shareholder or individual.

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To apply for exempt status, the organization must be a corporation, a
trust, or an association. The application to become a 501(c)(3)
organization is Form 1023.

If the organization’s annual receipts are more than $50,000, then it

needs to file Form 990 each year which is an information return. If the
organization’s receipts are less than $50,000, then it files 990-N which
is an electronic form.

If the organization fails to file the required returns for 3 years in a row,
it automatically loses its exempt status.

If the organization loses its exempt status, it has 15 months to re-apply

and can have its exempt status retroactively reinstated to the date of
revocation.

Unrelated business income

Unrelated Business Taxable Income (UBTI)
If an exempt organization has business income from activities unrelated
to the exempt purpose, then it is taxed on that income. This income is
only taxed if it is more than $1,000, and it is taxed at normal corporate
rates if the organization is setup as a corporation, and at trust rates if
it’s setup as a trust.

Business activities can avoid this treatment if it is substantially related

to the exempt purpose of the organization.

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