Complete Bisk CPA Review REG Course

28 Jan 2015

Bisk CPA Review

cpa review reg

The popular Bisk CPA Review REG course is back – and free.

Backstory: NINJA CPA Review acquired the Bisk CPA Review intellectual property from Thomson Reuters in 2016.

Many of these videos feature Bob Monette, who passed away in 2015, and is regarded by many as one of the best CPA Review instructors ever.

I personally passed AUD in 2.5 weeks using Bisk CPA Review videos.

I have put these videos on YouTube so that Mr. Monette's teaching legacy can live on.

Note: Some content is obviously outdated, so be sure to only use it with an updated REG CPA Review course.

See Also: Bisk CPA Review Complete Course (129+ Hours)

REG CPA Exam Review Course

I'm Jack Norman and we're discussing contract types for the Regulation section of the CPA Exam. A contract is an express or implied legally binding agreement between two or more persons to perform, or perhaps not perform some specific undertaking. A contract is a meeting of the minds. The result of both an offer and an acceptance. Now there's seven elements of a valid contract, and we'll review these in greater detail a bit later, but first let's talk about types of contracts.

There may be a bilateral contract. Which is a promise for a promise. One person promises to do something. The other party promises to do something in exchange. A unilateral contract. On the other hand is a promise for an act. And it's very often it's something like a reward. A good example would be a person asks for the return of their lost cat and we'll pay reward of $50.

That is a unilateral. Contract now contracts may be either executed or executors. An executed contract means that both parties have fully performed the terms of the contract and execratory contract in con in contrast is one word is not fully, fully performed. And you could have a contract, which is a bit of both assume that one party has fulfilled their obligation.

I have found and returned the cat to the owner, but I have not yet been paid my reward. I've executed my side of the bargain, but the other side is still execratory. It has not been fully performed. Contracts may be valid void or avoidable, and let's take a look at those three terms. A valid contract is fully enforceable.

In contrast a void contract has no legal effect and a party cannot be compelled to perform nor can code under a void contract in between. These two is a voidable contract. This is a contract that is valid, but one of the parties can disaffirm or set it aside. And we'll discuss some of the ways that that may occur a bit later.

A contract may be either expressed or implied. An express contract is either a verbal or written expression of the terms. Now note that it can be verbal and that will still give rise to an express contract, verbal or written expression of the terms agreed upon by the parties, an implied contract. Does not exist in any form, but as suggested by the acts and circumstances of the parties.

So that's an implied contract and there is a third characterization called a I contract, which is not really a contract, but it's really a legal obligation. Imposed by the courts. And it's created by law to imply a contract as a matter of equity and justice. So there's a queasy contract, which is sort of a modified judicially created principles to do equity.

As we continue looking at contract types, a contract may be characterized as unenforceable, which means it cannot be enforced by legal proceedings. For instance, a contract to sell illegal drugs is an unenforceable contract. The legal system will not hear about trying to enforce a contract to sell illegal drugs.

As you study for the exam, you're going to run across a number of cases where you have ease and oars. And by that, I mean, obligations and obligor's debtors and daddies executors that executives here, we're going to talk about obligor's obligations. First, a joint obligation is two or more persons.

Who are owed performance as a single group. So these are the people who are going to be the beneficiaries of a particular performance under a contract. And they will receive the benefit as a single group, several obligations or two or more persons who are owed individual performance under a particular contract.

That's the obligate, those who are receiving the benefit of the contract joint or several. If we turn to the other side of the contract, we will see that there are joint obligor's that's two or more persons who have a duty to perform under the contract. And there are several obligor's two or more persons who owe separate performance under the contract.

Let's see if we can kind of sort this out a little bit, assume a impresario wants to put together a musical show at a particular venue. So he goes out and he contracts with a number of different groups to perform at this particular venue. Well, first of all, who's going to be receiving the benefit of this particular contract.

These sound like obligations and. The joint obligations are all the people who buy the tickets, two or more persons who were owed performance as a single group, they're going to a single concert and they're going to be the beneficiaries of this concert. Well, what about the various acts who are performing?

Well, there are going to be several obligor's, two or more persons who owe separate performances. So perhaps we have five or six different acts, which will be appearing at this country. Yes, sir. They are the several obligor's, but it might be. For instance that one of the performance groups consists of two or more persons who have a joint duty to perform.

So the arranger of the concert has said, well, I want Simon and Garfunkel to perform as an act. They then have an obligation, a joint duty to perform together. They are not performing as individuals here. They are jointly performing. They are joined all the Gores on the other hand. An act, another act on the program would simply be one of several obligor's.

So as you go through studying for the exam, make sure you understand whether you're looking at joint obligations or several obligations who are the obligations and who are the obligor's. As we continue to look at contracts, we're also going to see that there may be concepts of third party beneficiaries.

Now, these are not the ones who directly contracted, but these are beneficiaries of that contract. One type of beneficiary might be a Doni. And this is someone who receives consideration by way of gift. This donate can enforce the contract as if a party to it. And perhaps it example here, I'd like to make a contribution to my university to carry out.

Specific activities in a department. So I might make a contract with, let's just say the university of Alabama, I'm going to give $10,000 to the university of Alabama. But it's conditioned upon that money being used by the accounting department for research in greater transparency in accounting. Well, that department then becomes sort of a Doni type of third-party beneficiary.

My obligation is to make a contribution to the university, but the department is specifically my designated donate there. Another type of third-party beneficiary is a creditor. This is a party who receives the money from a party with whom the debtor contracts and such a creditor can Sue either of the contracting parties.

Another type of third-party beneficiary is the incidental. This is someone who the contracting parties did not intend as part of the contract. And as a consequence, an incidental third party beneficiary has no right to fruit, forced performance under the country. Correct.

This is contract elements and I'm Jack Norman. I've told you that there are seven key elements that are required to have a valid and enforceable contract. And here I've got a pneumonic for you that is going to become impressed upon your brain. You study contract law, the exam, a cold sip of Cola, a cold sip of Cola.

Now this stands for a, the agreement. The parties must come to an agreement. C consideration consideration is required to have a valid and binding contract. As the statute of frauds, certain contracts must be in writing in order to be valid. Not all contracts must be in writing, but some must comply with the statute of frauds.

C stands for the capacity. This is the ability of each of the parties to actually enter into a binding and enforceable contract. The O stands for offer where one party offers to do or not do an act that is the subject matter of the contract. L the subject matter, it must be legal. So the L stands for legal subject matter and finally, a.

Acceptance, the party must accept the offer from the other side, in order to have a binding contract. Now, we're going to talk about all of these elements, but not necessarily in this order, because I want to make you understand how the contract process unfolds. Nevertheless, everything will tie back to a cold sip of Cola.

The O item is the first one I'd like to discuss the offer the offer, or makes an offer to the offeree. See, I want you to be a lot of ORs and EES in this, in this discussion, the offer, or makes an offer to the offeree. The offeree may accept or reject the offer, or the offeree may make a counter offer. The offer or may also revoke the offer before it is accepted.

So let's take a look at a couple of these and walk through exactly how the awful works. The young man makes an offer to the young lady said, would you be willing to marry me? She now has a choice. She may accept or reject the offer. That's the first two points we talked about. I doubt she's going to make a counter offer, but she has the option of either accepting or rejecting the offer.

Let's change the context, the offeree, the offer, or says, I'd like to buy this particular product. What can I purchase it for? The seller says, well, if you buy this product, I will sell it to you for $35. The other party takes a look at the product wants to haggle a little bit. And then now 35 seems a little bit too much.

Will you take 30 for it? The other party now has another choice. Do they accept or reject the $30 offer? And if they accept the $30 offer, we've now come to an agreement. Finally. The offer or does have an opportunity to revoke the offer before it is accepted. I suppose the, the person is selling a piece of merchandise that he believes is silver plate.

So his enlisted at the $35, the potential buyer was examining the merchandise. I said, well, you know, It's got a few dents in it. I think maybe I'll offer 30 for it. The offer is mulling the $30 over at which point the potential buyer turns the piece over and looks at it and I's kind of laid up and realize it's that silver plate it's Sterling silver.

The seller catches the. The Pacific to buyers, I'd said, Oh now I, I, even 35 is not right. I w I'm revoking my, my sales price. It's going to be $350. Perfectly acceptable. If the offer has revoked the offer before the offer re accepted it. Now, what elements must there be in an offer? First, the offer must be seriously intended.

The offer must be communicated. Now only the offer re can accept an offer. He cannot turn around and say, Oh, I'm going to assign that opportunity to somebody else. So the offer must be intended seriously by the offer or the offer must be communicated only the offer. You can accept it. And the office, the offer must be definite in term.

It must include the basic deal. Now it doesn't have to have every element in it, but it must include the basic deal. And if the offer is missing an important term, and this issue is litigated, a court may create the missing item in order to make the deal complete. You can also have an invitation to make an offer.

It doesn't have to be an offer, but it says, I like you, I'm making an opportunity here for you to make an offer like an RSVP. I I'm, I'm sorry, not an RSVP, a, a RFP, a request for proposal here. We're coming out. Make us an offer as to what you would do for this project. There are occasions where something may appear to be an offer, but it's not really an offer.

So the items like this, or advertisements. Price tags and price quotes. They're not an offer per se. They are an invitation to make an offer. However, as in everything I've probably said in programs over the years, every rule has an exception. An advertisement offering a reward is actually an offer, but now there's an exception to the exception.

If the offer, we did not see the ad. The offer is not required to pay because there was no communication. Therefore there was no offer. So remember, on these terms, we talked about the elements of an offer. It must be seriously intended. It must be communicated and it must be definite in term. Now, in addition, the L in our sip of Cola record, a legal subject matter.

An agreement, maybe unenforceable, if the performance would be illegal or if the object of the contract is illegal. I had mentioned previously that a contract to sell drugs is illegal a contract for, to perform any illegal act, certainly is never going to be enforceable. And there's also something which is called an unconscionable contract, which occurs when one party takes unfair advantage of another party.

This also will not be an enforceable contract.

I'm Jack Norman and we're discussing contract elements. As you recall, I gave you a pneumonic to focus on the seven elements of a valid contract, a cold sip of Cola. And one of those A's was acceptance. Acceptance must be unconditional. The offeree must accept the offer just the way it was made. Any change in terms is a counter offer and a counter offer terminates the original offer.

Now you must remember, and it frequently appears on the REG CPA Exam that inquiries are not counter offers. The offer remains open while the question has been placed out and the offeree is awaiting a response to his question, but it has not a counter offer. Now acceptance becomes effective when it meets the specifications of the offer.

And now we need to focus on a concept of early acceptance. Something that you'll frequently see described as the mailbox rule in this case on offeree uses the same method or an equally fast method as the offer. Or if that occurs, the acceptance is legally valid when it's sent now. Only an acceptance could be effective under the mailbox rule revocation counter offer, and rejections are only effective when they're received.

So if you see a question dealing with the mailbox rule, remember it's only effective for acceptances, not for revocations counter offers or rejections. Okay. Well, now that we've introduced the term, what is a counter offer? It's treated as a rejection and a new offer. So the seller makes an offer. The buyer rejects it and makes a new proposal that is a counter offer.

It's considered a rejection of the original and a new offer. The offer becomes the offer of war and counter offers. As we said before, must be received by the other party to be effective. A rejection is simply that the other party rejects the proposal has been put forward to them, whether an offer or a counter offer, and it must be received and it's effective upon receipt.

Now, let me illustrate these couple of concepts with some negotiations, my wife and I went through in purchasing a second home, the seller who was agreeable to sell the property and had a price. We felt that price was too high. So we made a counter offer. The seller did not like our counter offer and came back with another offer, a counter counter offer.

Of course, now that original offer and our proposal are off the table. And we were looking at this second set of numbers from the buyer. We felt that it was unacceptable. And at that point we rejected the contract. A couple of months passed. We were contacted again by the seller, said he had a new proposal for us and made an offer.

We looked at that and it was much more acceptable, but we wanted to make one change. So we made a counter offer. At this point, the buyer accepted our counter offer and we closed the deal. So as you can see in negotiations, either they could be quite simple and easy. They could may be resolved on the original offer, or they may be protracted and involve counter offers.

Counter counter offers, possibly even rejections, but that's part of the negotiating process. Another term we have to focus on is revocation. And this is when an offer or takes back the offer. In other words, we sends it. Revocation must be received before the offer is accepted by the offeree. Now here's a couple of operative rules that may help you with the exam.

Any offer can be accepted before it rev is revoked and any offer can be revoked before it's accepted. There is also something called an indirect revocation. And in this particular case, it might be with the offeree learns of a sale to a third party. And this frequently happens in real estate transactions.

For instance, some people will put their house on the market. They have an open house and four or five people look at it. Well, somebody, one offeree who's interested in buying it may suddenly find that the offer has already accepted. The proposal from another party. In that case, we have an indirect revocation because the subject matter, the particular house or real estate is no longer available for sale.

It has already been in a concluded contract. Irrevocable offers. Now certain offers may not be revoked. And one of those is an option contract. If there's consideration in exchange for a promise to hold the offer, open the offer war cannot revoke it in effect. There has been a payment there's been consideration to hold that offer open for a period of time.

I can give you an option that says you may buy this particular piece of this. Let's just say, say an automobile. You may buy this automobile. Okay. At any time within the next 10 days, if you'll give me a $250. Option payment, the offer can't revoke during the option period. Even if there's a counter offer or a rejection, another term is a firm offer, and this is made by a merchant who provides a written promise to keep the offer for the sale of goods open.

In this case, we were talking about a merchant and sale of goods. Consideration is not required. But since it's a sale of goods, it's only applicable for personal property, no income tracks, if an offer or specifies a period of time for acceptance that offer automatically lapses or ends at the time, that time period ends.

So there's no need for a revocation. It is automatically terminated. And if there's no time in a, an offer proposal, That offer will lapse after a reasonable period of time. That may be subject to some interpretation, but courts tend to look at a reasonable time. You're not going to hold an offer open for multiple years.

So whether it's 30 days, 60 days, it's going to depend on the specific circumstances. In addition, an offer may terminate. If it specifies that it will terminate upon the occurrence of a specified condition. The bankruptcy or insolvency of either the offer or, or the offeree automatically terminates on offer.

So that's automatic on either side the death or insanity of an offer or, or a specific offeree terminates an offer, but only if it is a personal service contract.

Okay. The destruction of property terminates an offer after all, how easy is it to sell something that no longer exist on offer terminates? If the object of the contract for either party, either the object or the performance becomes an illegal act, let's assume that there was a contract to ship merchandise from the United States.

The seller has agreed to ship it to a purchaser in pick any foreign country. Let's just call it where as an, if the Congress suddenly passes a law that says exports are banned to where we stand, then that contract is going to terminate because to perform would be in violation of federal law. So remember, we can have termination on the bankruptcy or insolvency of either the offer or.

Or the offeree upon the death of the, or insanity of the offer war or a specific offer. If it's a personal service contract for the destruction of property or the illegality of the country.

Now, early on, I have told you that offers cannot be assigned, but contracts can be. Once the contract is consummated and agreed upon it can be assigned. There could be an assignment of rights. For example, to receive payments, there could be a delegation of duties to ship goods or to report form and act.

Now without the permission of the obligation for the contract is not assignable. If it's a personal service contract or a confidential relationship. So to illustrate that one assume that you have the Thursday contract, that Jack Dorman will provide legal services. And it, Sam Jones is the other party.

I cannot say, I'm not interested in fulfilling this contract and I'm going to assign it to Andy Andrews. It's a personal service contract. It also happens with Volvo confidential relationship. So unless my. My client agrees. It is on assignable. Furthermore, a contract may not be assigned if the duty of the Abra Gore is changed materially.

If risk is increased, or if there is a chance of return performance being materially impaired, let's assume that we have been able to assign the contract. The SNE takes whatever the rights, the SNR. Had against the obligor's, but no more. The SME takes subject to any defenses and counterclaims that the obligor's had against the SNR.

And an assignment is effective between the parties without notice to the Abra Gore. You're getting confused by all these parties, go back and review the words obligate for astronauts and acidy, because these are issues that do show up on the exam. Let's continue with assignments for just a bit an acid or Canon revoke an assignment, unless there's something called promissory, estoppel performance or the document embodying the right is assigned.

And this means that you can revoke it unless there is some. Condition out there, which prohibits the assignment, a person can delegate a duty to another. We do that very frequently, particularly in employment relationships, performance by delegatee satisfies the delegate Torres obligation. Delegation does not remove the obligation.

However, that delegatory remains obligated, even though if the delegatee fulfills it. There is a fulfillment of the obligation. So there are many words in here, but let's go back and review a couple of quick elements dealing with the contract terms under acceptance. First, it has to be unconditional. Any change is a counter offer.

It's effective when it meets the specifications. And you will remember the mailbox rule that that only applies to acceptance. Counter offers are treated as a rejection and a new offer. A counter offer must be received and furthermore, a rejection must also be received. There's a concept called revocation where an offer or takes back the offer.

Any offer can be revoked before it's accepted and any offer can be accepted before it is revoked. We have irrevocable offers when there is an option contract. And there are a number of areas where a contract may be terminated, including lapse of time or a specific addition, bankruptcy or insolvency, death, or insanity in a personal service contract, destruction of property or illegal acts.

And finally remember that contracts, but not offers can be assigned

we're discussing contract elements. And I'm Jack Dorman fraud is a false representation of a material fact by one party to the other party, with the intent to deceive and which induces the other party to justifiably rely. On that fact to his or her detriment. Now there are two types of fraud, actual fraud and constructive fraud.

And we want to go through the elements of these very carefully, because you will probably see a fraud problem somewhere in the exam. Let's begin with actual fraud and here you have a little pneumonic called Ms. Ryde. M S R I D. These stand for misrepresentation, there must be a misrepresentation of a material fact as the first element of a fraud case, the S stands for C enter.

This is the Latin phrase that means intent to deceive. So the perpetrator of the fraud actually intends to deceive the other party. Our reliance, the fraudster intends for the defrauded party to rely on the material misrepresentation. So that brings us to the eye, the intent to rely giving rise to D damages.

So Ms. Read misrepresentation C enter reliance intent to rely and damages. Those are the five elements. Of actual fraud. Now, the other type of fraud I mentioned is something called constructive fraud and constructive fraud may give rise to a voidable contract. So let's look at the five elements again, this time of constructive fraud and you pneumonic is not much different.

It's Mr. Ryde. And as you're studying these words, you're going to find that the. First that the M the second R the I and the D are exactly the same as an actual fraud. So we have misrepresentation, but instead of center, we are looking at our four reckless disregard of the truth. It's done at an intent to deceive almost a criminal element there, but it's the reckless disregard of the truth.

The remaining three elements are exactly the same reliance. Intention for the party to rely and resulting damages. So those are the five elements that are inherent in either actual fraud or constructive fraud. Now, there is no fraud in the case of innocent misrepresentation, however, such innocent misrepresentation can still avoid the contract since there is no intent to deceive.

There's no C enter and you cannot Sue for damages. Remember a void contract has no legal effect. And if there's no legal effect of a contract, there is no suit for damages. Let's look at a couple of special title waves of contracts. One of them is a covenant not to compete. Now, this is a promise that a person will not do a particular act.

You're frequently going to find it upon the sale of a business or someone leaving a business. And that covenant not to compete. There is a payment in exchange for a promise, not to let's just say work in a competing business for a period of time. The certain elements that the courts have said cannot be in a covenant not to compete.

You cannot restrain trade. The contract will be deemed to be void. However, if the restraint is reasonable, a court will enforce it. And as an example of this, I had a client once upon a time who was a young doctor. He had been interning and working with an established PR practitioner in the Washington metropolitan area.

And after about four years working in this older doctor's office, the young surgeon determined that he was going to go out. And opened his own practice. Well, the older doctor with whom he'd been working asked for a covenant not to compete, this is fairly common when you've particularly got specialized skills that are in high demand.

So the young surgeon asked me to take a look at the covenant, not to compete. If the restraint remember is reasonable, a court will enforce it. Well, the original. Covenant not to compete put forward by the old surgeon called for the young doctor, not to practice his surgery skills within an area that went from Philadelphia, Pennsylvania to Richmond, Virginia for a ten-year period.

Absolutely unreasonable. And so we carve this down to get to the point that the final covenant not to compete. And the I think this was a clearly enforceable, one confined itself to one County around Washington DC for a one-year period. And so you have to look in each one of these situations as to.

What is the time period? What's the geographic? What is the nature of the work? If it's reasonable, a court will enforce it. If not, it's considered restraining trade. And of course we'll avoid the contract. We also need to focus on something called an exoneration clause. And this is where a clause put in a contract that said if there is a, a violation, a problem with it, that the other party will be exonerated or excused from the error, such clauses are frowned upon.

They're usually void and any court will take the position generally that they are unenforceable. You can also never. Ever completely remove liability from negligence, from a contract. So any such clause, again will be uninformed. Licenses are a form of contract. I'm not sure whether you thought about it, but it is a contract.

Even your driver's license is a contract. These are regulatory contracts and they are designed to protect the public without the license. The contract has no legal effect. So, how about if you hire a contractor to do certain work, the need to have licenses, to do electrical work or plumbing work. And without that license, a supposed contractor, that contract has no legal effect.

You can also have contracts which are revenue contracts designed to raise funds without that license. However, the contract is still a valid. Contract now, while we're talking about elements of a contract, if you remember the cold sip of Cola had an S in it, and that I reminded you stood for statute of frauds.

The statute of frauds is a very old English statute, which has been incorporated into American jurisprudence. And it stipulated those contracts that have to be in writing. The writing must include the major terms of the contract. However, price time place of delivery are not considered essential elements of the contract.

A writing, trying to meet the statute of frauds needs to be signed by only one party. And if it's assigned by only that one party is enforceable only against that party. My advice is always to get the contract signed by both parties, but what contracts do have to be under the statute of frauds and here.

I'm going to give you one more pneumonic. I know you're probably tired of hearing about them, but they do help try and focus your attention and help you remember things for the exam. This one is called gripe plus marriage, and that doesn't mean the two go together at all. They just happened to be the key initials that help remember the statute of frauds G stands for the sale of goods.

Worth more than $500 sale of goods with more than $500. Are all real estate contracts must be in writing to be enforceable. So R is for reality, I is any contract impossible to perform within one year of the date of contract and what it was happening back in the English time. They were trying to make sure that these key.

Types of activities were all covered by documents to make sure that they had something that could be enforced. So we're going through sale of goods, real estate contracts. One, it is impossible to perform within one year of the date of contract that takes care of G R N I P and L stands for the promise to answer for the debt of another.

P promised to answer for the debt of another. And the key one in this particular case is a guarantor or surety is promising to answer for the debt of another. As a consequence, any surety relationship must be in writing and E he stands for the promise of an executor to be personally liable for the debts of an estate.

Now we've just taken care of the G R I P. Part of your pneumonic. The last one, marriage is exactly what it says. Any promise in consideration of marriage must be in writing. So as you go through your cold sip of Cola, keep in mind S stands for the statute of frauds. And you want to be very clear in your mind.

What G R I P plus marriage stands for sale of goods. Really? The contracts. Impossibility to perform within one year, promise to answer for the debt of another promise of an executor and a promise in consideration of marriage.

I'm checked Norman and we're discussing elements of the contract. As you recall, from our mnemonic, a cold sip of Cola, one of the seas was capacity. And here, we're talking about the ability of one of the parties to actually contract. Now in general, a minor is considered not an adult prior to the age of 18.

That's the age of consent in most States, if a party misrepresents their age, they could still disaffirm a contract, but they may be sued for fraud. Here's the general rule a contract is voidable by a minor. That minor can disaffirm a contract while still in minority status or within one year of becoming an adult after becoming an adult, the individual can reaffirm a contract, but a minor generally can never ratify a contract.

One minor exception provides it if a minor receives necessities of life, if he or she must pay the reasonable value for those goods or services. Now in the case of a mistake, a one-sided mistake is called a unilateral mistake and has no effect on the contract. The person who made the mistake is bound by the contract, unless the offer or knows or should have known of the mistake.

In the case of a two-sided or a mutual mistake, there is still, there is no contract. So unilateral mistake, generally the contract prevails, unless there is knowledge on both sides of the transaction in a two-sided or mutual mistake, the contract is void. There is no contract. Let's turn to a concept that arises out of English, common law and carries over into American jurisprudence.

It's called the parole evidence rule. And that rule States that if there is a written contract, it cannot be changed by either an oral or written contract made prior to, or at that same time as that original contract. However, A contract can be modified by a later contract. And you can think about this.

We see all the time amendments to contracts, but you cannot go back and contradict a written contract with something else at the same time made at the same time. Why, what we're trying to do is say at the time you came to that contractual agreement, everything is embodied within the four corners of the written document.

So we can change it later, but we can't change it for something that happened before. We assume that all that pre stuff happened prior to the contract and got incorporated into the contract when it was ratified. Now the parol evidence rule does not apply in the case of trying to clarify ambiguities in the written contract.

So two provisions don't quite tie together. There's ambiguity. You are not bound by the parole evidence rule. In addition, the parol evidence rule does not apply in the case of demonstrating that there is fraud in the contract. So that was capacity. We have a second. See if you remember it, a cold sip of Cola, and that stands for consideration consideration is giving up a legal right while relying on a promise.

And that constitutes consideration for the promise. In contract law, all consideration must be legally sufficient and among other things, a promise for a promise, the mutuality of obligation is valid consideration. No consideration is required for a firm offer or a charitable contribution and buy for a firm offer.

What I'm talking about is a merchant offering to sell. Personal property goods that they are normally in the business of selling. So no consideration is required for that contract nor for charitable contributions, but in all other contracts, you do need to have valid legally sufficient consideration.

Another exception I'm going to have to throw out for you is there is no consideration and there's no obligation to pay on a contract when there's a promise after the act is performed or where there's a preexisting obligation

in contract law, we talk about damages and what are liquidated damages. I don't know whether you're going to see this on the examiner, but you need to be aware that liquidated damages are stipulated in advance in the contract. So for instance, in a sale of merchandise, the clause may say that goods are being shipped from Hong Kong to.

Honolulu for delivery. If there is damage to the goods liquidated, if there is physical damage to the goods, there may be a certain amount stipulated as the damages to be paid under the contract, because obviously the buyer doesn't want to accept damaged goods. So they may say if the container is damaged and we know what's in it, we will stipulate damages, liquidated damages of a hundred thousand dollars.

If the liquidated damages are reasonable, a court will enforce them. If the liquidated damages are unreasonable, a court will say that they are indeed more like a penalty and not damages, and they will not enforce the damage clause. Now we've talked about some of the elements of contracts in various.

Little blocks. We've talked about competence consideration. We've talked about capacity. We've talked about offer. We've talked about acceptance. Let's come back and put it all together as a final CPA review and walk through your pneumonic and the different components that you absolutely have to know for contract sections of the CPA exam, a cold sip of Cola.

We have to have agreement between the parties we have to have consideration. And remember that is legally sufficient consideration. Although a promise for a promise may constitute consideration. In certain cases, we must have a written contract and that's the S the statute of frauds. I also expect you to go back and look at the statute of frauds mnemonic, G R I P E plus marriage, which I gave you the categories of contracts, which must be in writing.

You must know the rules about the statute of frauds, continuing with our list of elements. We have capacity and we've talked about what allows a minor to discharge a contract issues of Insanity. These different components are more fully explored in the text, but you must have capacity in order to contract.

We've talked about the offer that goes forward, which leads to the acceptance. And we've talked about counter offers. Make sure you are clear on those. When you have an offer, when you only have an inquiry, we also have the legal subject matter. So whatever is being done in the contract must be legal. If it is illegal then of course the contract is not going to be enforceable and it is an invalid contract.

And finally there must be a acceptance of the contract by the parties. So a cold sip of Cola is going to get you the seven elements of a contract. I can't leave the program without telling you as well as knowing the statute of frauds. Make sure you are very comfortable with actual versus constructive fraud misery versus Mr.

Ed. The difference between center and reckless disregard keeping all these folk items in focus will help you complete the contract portion of the REG CPA Exam with flying colors.

This is just a discussion of contract terminations and I'm Jack Norman. Most contracts are discharged by performance of the promises and acts by the parties. In other words, they conform to and perform everything that's stipulated in the contract that constitutes complete performance. Each side has done what they said they would do.

However, We can't have substantial compliance or substantial performance. In other words, both parties have, have satisfied the contract in general, but there is a little, little shortfall. This is still a valid contract. It has been validly performed to the extent there is no failure of consideration. So that is a substantial compliance or substantial performance of the contract.

In contrast, if there is a material breach of the contract, it means there's a major defect in performance that constitutes a failure of consideration and failure of consideration excuses. The other party from performance. In contracts, there may be conditions to performance and these conditions, baby, within the control of one party or the other, there are generally three types of conditions and we'll take, take, take each one in turn a condition precedent, such a condition must occur before there is a duty of the other party to perform and let's take a home building contract.

I contract with a builder. He's going to build a residence for me and I obtained construction financing to pay for it before I, my full final mortgage on the house buying contract says that when the builder has gotten the foundation installed, I must pay 15% of the purchase price. When the house is under roof, I must pay further 20% toward the contract.

And so there are various stages to get money to the contractor as he's building my home. Well, that is a condition preceding. And when the condition is fulfilled, in other words, the foundation is in and approved. I must make a 15% payment. There's also a condition subsequent. And if it occurs, it relieves a party of a previously existing duty to perform.

Let's assume I have a contract and I'm going to paint your car. It's it's needs to be repainted. So we've scheduled an appointment. I've made the contract. Actually, they've been given me a deposit on the painting job. The morning you're going to bring it in. There's an automobile accident and the car is totaled.

That's a condition subsequent to my making the contract and excuses me for my duty to perform the painting of your car. The third type of condition is a condition concurrent to promises that are beat to be performed about the same time. Well, when was the contract being performed? If the contract does not specify a time.

Then it must be performed within a reasonable timeframe. Now, reasonable in this particular case is often driven by what are the facts and circumstances surrounding the specific contract, but a reasonable time is what the courts will look to based upon all of the circumstances of the contractual arrangement.

Some contracts call for a specified time of performance. And in that case, the contract must be performed within that specified timeframe. Or there is a breach. Occasionally you'll see a contract, which says time is of the essence. A failure to perform is a failure of a condition. And the other party is relieved of a duty to perform.

It may be either specified by the parties. Or if a failure to perform in time would defeat the purpose of the contract. Now I've often seen these of the essence clauses and something like a merger arrangement where in the merger agreement, it says. Consummation of this merger time is of the essence, which means both parties have an obligation to hurry through the due diligence.

The other legal financial arrangements to assure that the merger is consummated and this include may include getting regulatory approvals. So that is that's the essence. Now performance may occur by payment. It could be either in cash or a negotiable instrument. And if using a negotiable instrument, performance is conditional.

It is not fully performed until that instrument has been satisfied. So sending a note does not necessarily completely terminate the contract because the acceptance, as I said is conditional. The contract is not discharged until the instrument is paid in full now. Suppose the debtor is making. Various payments under this instrument.

First, the debtor may specify the application of the payment to do, how do they want the payment applied? If there's no specification by the debtor, the creditor may choose how to apply the payments. If neither chooses then interest is paid, considered paid. First principle, second older debt is considered paid off before newer debt.

And unsecured debt is paid off before secure debt. And here's a good example. Suppose a taxpayer has a obligation to the IRS and is trying to make payments. They've established a payment plan, which is a contract. And so they are making payments of, let us say $400 every month on overdue taxes. Well, of course the IRS imposes penalties, interest and taxes.

The payment comes into the IRS, a $400. How is it applied? Unless the taxpayer has specified the creditor chooses and the IRS applies it first to interest first to penalty, excuse me, first to penalties, then to interest then the principal, and this has the effect of keeping interest running and keeping the.

The basic tax obligation open on which interest is compounding. So there, the debtor may wish to say, apply at first to interest to cut that interest back or apply it to principal. The rule is debtor specifies first, if it does not the creditor specifies, and if neither specifies, then we haven't ordering rule, which looks to interest first and principle second.

Contracts may also be terminated by the parties, simply agreeing to end it or to modify a contract. Let's talk about ending first. The parties may agree on a release, which is simply a discharge of a contractual, right? The parties may go with a waiver, which is a promise to excuse a breach or promise or the failure of consideration.

The parties may enter into a cancellation and that arises because the physical destruction of a written contract with the intent to destroy legal effect in effect, the parties simply tear up the contract, that's it we're over and done with, or there's something called mutual rescission. And in this case, the parties agreed to unwind or undo the contract to put them back in the position.

The w before they executed the contract and Latin, they call this the status quo auntie or where we were before we started. So these ending termination techniques include a release, a waiver, a cancellation, or a mutual rescission. Now let's look at modifying a contract under the common law. You could not have an enforceable clause in a written contract that prohibits future oral modification or rescission of the contract.

That was a common law rule. A modification required consideration. Now the UCC, the uniform commercial code does not require consideration for a modification, but please remember the UCC of lies only. Two sales. So many contracts are not part of the UCC. As we continue with looking at modifications, there's a concept called accord and satisfaction.

In this case, a party accepts performance in the future. In substitution for performance required under an existing contract. So you may, let's just say you have a home building contract as we've been working with in this discussion. And the builder suddenly says because of certain things, weather problems, I can't.

Begin your con, your building for another three months that we've had such incessant rain this spring, the ground will not allow me to dig the foundation. So rather than starting on March 1st, as I promised, I'm going to have to put that off. I can't start until August 1st. It could be an accord and satisfaction.

You could also have a substituted contract, which is simply a new contract, which supersedes. And replaces the original agreed upon contract. There's a modification called novation. In which case, there is a substitution of the debtor by another party. A modification may also occur when the creditor simply releases the original debtor.

And this could be either in, in re in writing, or it can be oral unless. The release relates to a real property transaction in case, in which case it must be in writing. Remember we're talking statute of frauds again, contract terminations may also occur by operation of law. If the contract is impossible to be performed.

Clearly it's terminated. And his impossibility is determined as an objective failure of consideration. This thus constitutes a rescission. They'd be terminated by operational law. If there is a frustration of purpose, for instance, value is destroyed by super Vening events. Assume I propose to buy a warehouse to store goods in.

That warehouse is destroyed by fire. Well, they're not going to force me to buy a destroyed warehouse, so that frustration of purpose, there is no value left in the warehouse is also impossible to perform. There may be a termination by operation of law because of impracticality. Now it can be excused, but unexpected difficulty or cost is not impractical.

And I can give you a wonderful example of this this home, my wife and I purchased out in the country needed to have a septic system. Dan did not have one. So we contracted with the individual to install the septic system. The contract was for X dollars, but the clause also, the contract also said, but if we hit rock.

And we have to blast, then we can't tell you what the outside cost is going to be. I'd love to have canceled that contract when they hit rock and said, we have to bring it in the medic drill, but that was my problem. Not the contract tour's problem. That was not an inexcusable contract. Finally contracts might be terminated because of the statute of limitations.

It doesn't discharge the party, but does bar bringing judicial action against that party? Under the statute of limitations, a breach of contract makes skews the other parties, performance failure to perform whether or not the breaching party was at fault. So. Just because the other party didn't intend to, or wasn't at fault for the breach.

Nevertheless, it does constitute a breach, which will excuse the other party. There's a concept called renunciation and this is any act making a substantial performance. Impossible. Or a statement that the party will not perform his obligations. I've contracted to do something for you. And I say, not withstanding that I'm simply not going to perform.

I've renounced the contract. And here's a little ethic situation for you. I agreed to represent somebody before the IRS. We signed a contract, it was engaged with letter. I had taken some deposit With respect to this transaction, I subsequently got home, began to make some investigations, found that I'd been lied to by the other party.

They had hidden assets from me when I was supposed to go to the service and represent their financial condition. I simply call the party said, I am not performing. I am returning your payment. I renounced the contract. So a contract termination and an ethics case. There may also be something called an anticipatory breach or an anticipatory repudiation of a contract.

And this is a breach in advance of the due date. In the case of an anticipatory breach, the innocent party may Sue immediately or wait until the due date and Sue at that time, because indeed we have a true breach on the due date. An action to prevent performance. This is where a non-actor is discharged and may Sue for the breach of contract.

Any violation of contract terms may result in nominal damages. If it's a slight breach, if it's a material breach, it may actually avoid the contract. Either a material breach or a failure of an express condition, as I say, discharges, the other party. So you may have a slight breach giving rise to nominal damages or a material breach or failure of condition, which discharges the other party.

What happens if there is a breach of conduct, correct. Under common law, the material breach gave rise to her incision. And you could Sue for restitution or the other party could affirm the contract and Sue for damages or for specific performance. So this is the common law rule material breach. The other party has the right to rescind the contract and Sue for restitution or affirm the contract and Sue for either damages or specific performance.

In the case of the UCC where a sale of goods is involved, the sale may be rescinded and damages recovered frequently. You'll be running across the term. An injunction, an injunction is an equitable remedy and which the court orders a party to do something or prohibits them from doing something. So in this particular case, let's assume.

Somebody feels aggrieved. They go to the court and say, we need an injunction to prevent this particular act from occurring, or we demand that you order the party to do a particular act. That is an injunction.

If you recall, we have talked about substantial performance and it applies only to real estate construction projects. It does not apply to the sale of goods. If performance is not completed, the court will determine the damages. And in this particular case, we could have specific performance. The court will compel you to carry out a contract.

And by the way, there is no requirement for specific performance and personal service contracts. You cannot force somebody to carry out a personal service contract because that's considered involuntary servitude. But you can compel the person to do certain other acts. It's the personal services to the problem.

And specific performance also applies to unique goods as well as to real estate. We've talked a lot about termination and we need to just briefly mention a couple of other words, damages. Even if the breach is not material, the other party can Sue for damages. The non breaching party has a duty to mitigate the losses caused by the breach.

Now let's look at the types of damages compensatory. They make up for the loss, consequential, their damages. The result of the breach, there are special damages which may be paid in unusual circumstances is determined often by the court. There are punitive damages when the breach was willful. And there are nominal damages when there was a breach, but no real loss damages may be stipulated in the contract as liquidated damages.

And this says we are setting up front the amount of damages. If there is a breach, a court will enforce liquidated damages. If they're reasonable. And if damages would be difficult to assess they're permitted under the UCC again, on the sale of goods. If the amount is reasonable in light of the anticipated harm caused by the breach.

Yeah. There's a lot to review in contract terminations, work through each of these various options. We have them in mind, as you bear down on contract law.

I'm Jack Norman and we're going to be discussing sales, and we're going to be discussing specifically sales of goods under the uniform commercial code or the UCC. This discussion focuses exclusively on personal property. And remember consideration is not required to modify a sale of goods contracts.

When we're talking sales of goods under the uniform commercial code from offers, do not repeat, do not require consideration. However, an option contract does require consideration. Let's go through it. A couple of definitions here. As we begin to parse the UCC existing goods, those are goods actually owned by the seller.

Future goods as the name implies are to be acquired or produced by the seller. There cannot be a presence sale of future goods. Indeed. It is simply a contract to sell in the future. Now, occasionally you'll see the phrase fungible goods. These are items that are indistinguishable. One, the other, almost every lemon looks like every other lemon.

So those are fungible goods. A merchant. And here, this is a key definition because many of the provisions we're going to be talking about focus on the word merchant. It is one who either deals in goods similar to that in the transaction, or who represents that he has particular knowledge relating to the goods involved in the transaction.

A cover is the right of a buyer. After a breach by the seller to buy substitute goods. That's a cover. Now, when we're talking about these sales, we have to focus on a couple of things. One is the mailbox rule, and you may remember this concept from some of your other law classes, but basically if the offeree makes an acceptance by the same means or a faster beans, Then the offer was submitted, then the posting of that acceptance is the effective time for it not receipt.

So that's the mailbox rule that applies on acceptances. When we're dealing with a sale of goods terms may be changed. And remember here, the changes in terms are not the counter offers. They simply become part of the contract. Unless the offer specifically States no changes allowed. If the contract is silent, minor changes become part of the contract.

If there are major changes, the contract is deemed rejected.

Now you'll also recall from your contract law classes, something called the statute of frauds. And one of the elements of the statute is that it requires a written contract for the sale of goods in excess of $500. The contract must be signed by one party and that's the party to be charged. Under the CC, the writing must include major terms, but it does not have to include all of the terms of the contract.

If there are missing elements, a court will create for a price. If the price is missing a reasonable price, if the time is missing a reasonable time, if the place the transaction is to occur. Is busy for the contract. The court will apply the seller's place of business. Now, as a practical matter, if you're working with sales contracts, it is best to include all of the terms that you possibly can just so you don't have to have something added later on.

Now, while I said that sale of goods over $500 requires a writing pursuant to the statute of frauds. There are several exceptions. To that rule when we're dealing with sale of goods, your acronym here is spam S P a M. It's not specially processed beets. It's stands for special exceptions to the statute of frauds and they are S special specifically manufactured or specially manufactured goods.

So if there's something unique being made for the purchaser, those do not have to be in writing. P, if there is part payment or partial receipt of the goods. In other words, part performance, there does not have to be a writing for this element. And admission in court does not have to be in writing. And finally, a merchant's confirming confirmation does not have to be in writing.

These are exceptions to the general statute of fraud rules, S P a M. Let's turn now from the elements here to the performance, the seller has a duty and that duty includes tendering conforming goods. What happens if the buyer says, thank you very much. I've received the goods, but they're non-conforming.

Well, the seller does have the possibility of curing or submitting conforming goods before any rejection. But the sellers duty under a sale of merchandise pursuant to the UCC is to tender conforming goods. The buyer has several duties among these are the duty to accept conforming goods. The buyer has a duty to pay for those goods.

The buyer also has a right to inspect the goods and there may be excuses and substitutes for performance.

This is Jack Norman and we're discussing sales. We're specifically focused on the concept of warranties. A warranty is a statement of fact, not opinion made by the seller and relied on by the buyer. So when you're looking at questions, dealing with warranty, remember it's a statement of fact made by the seller and the buyer relies upon that statement of fact, in any contract, the seller warrants title.

And by this, we mean, the seller is saying that the title is good and the transfer is rightful and lawful. And secondly, yes, that the goods will be delivered free of any security, lien or encumbrance of which the buyer had no actual knowledge at the time of contracting with the seller. So that is a warranty of title, which is given in any sale of goods under the UCC.

There may be an express warranty. This must form the basis of the bargain. So in other words, its underlying element of the contract and an express warranty. The buyer has relied on the seller's statement effect. Now the sale may be by sample and in that case, the express warranty is all goods conformed to the sample.

The express warranty may be a sale by description, all goods conform to the description. So here's an express warranty, which is the basis of the bargain. I am purchasing a stock of a wool from a seller. That seller then says, I am expressly telling you that all of this wool is from an gorgeous shape that I've raised on my farm.

And it has all of the quality of this sample, which I am now showing to you. That's an express warranty. It's the basis of the bargain. I know what I'm getting. I'm supposed to be getting all the goods conforming to this sample of Angora wool that I have just seen expressly provided to me by the seller.

Now in addition, there are implied warranties. There is an implied warranty of merchantability and this means that the goods are fit for normal use. Remember, we talked a lone ago about what is a merchant, the implied warranty of merchantability is only made by a merchant, but it does say. Purchaser. If you buy these, these goods are fit for normally use.

There can also be an implied warranty for fitness, for a particular purpose. And in this case, the bikes, it was relying on the seller's skill or judgment to select goods fit for a particular purpose, such a warranty may either be made by a merchant or may actually be made, but in non merchant, Here's an example.

Suppose you are a person who is looking to buy a particular cream because you have got a rash and you know what the rash is. It's a very virulent poison, Ivy rash. So you go into the pharmacy and you ask the pharmacist, what is the best of these five lotions to use for my acute poison Ivy rash. And the judgment of that pharmacist who should be skilled and knowledgeable he'll to tell you this one and let's, whatever it is, maybe it's calamine lotion or something else.

He says, this is the one you need to use. That is an implied warranty of fitness for a particular purpose. In warranties, we have a concept called privity. P R I V I T Y privity is the relationship between two contracting parties and under common law, any person seeking to Sue under a warranty had to be in, privity had to have a relationship, a contractual relationship with a party they wish to Sue.

Now the UCC has taken an expanded that common law concept. So the UCC extends express or implied warranties to. Any natural person in the family or the buyer's home. So we're expecting this good that has been purchased by the buyer in accordance with the UCC to be used by members of the family or somebody living with them.

That warranty covers them. It's also extended to natural persons, reasonably expected to use good the goods, and it was personally injured by a breach of warranty. So now let's take the case of the. Seller of a, let's just take a chainsaw. The chainsaw is sold to an individual, takes it home. Of course, the warranty.

Oh, we already know extends to any person in the family or the buyer's home, but the next door neighbor asked to borrow the chainsaw. Indeed operates it in accordance with the way it should be run, but it kicks back in Hinduism that warranty will extend to them because the next door neighbor might reasonably be expected to use the goods.

The express warranties are also applied to any personal reasons to be expected, to use the goods who was injured by breach of a warranty. So it's any other person remember? The one I just gave you was the neighbor who is a natural person. It can also extend to any person reasonably expected to use the goods or injured by the breach of warranty.

Now, warranties can be disclaimed. In other words, the seller is saying, I will not going to provide this warranty to you. Express warranties and warranties of title and against infringement can either be modified or excluded by specific language or circumstances. So you have to specifically say, I am disclaiming my express warranty of title on this.

In the case of implied warranties, they're excluded by language such as, as, as is. So in that particular case, we're gonna say we're selling this to you and terms of merchantability, which it's normal use. Instead, we're going to say this product is being sold to you as is, which means there may be conditional issues on it.

In the case of the warranty for merchantability it must specifically mention the word merchantability and if it's written in must be conspicuously displayed. If there's the attempt to disclaim a particular purpose, it must be in written form and conspicuous. There is no implied warranty. If a buyer is given the opportunity to inspect.

And is encouraged to inspect by the seller, but declined to do so. Customary usage may also modify or exclude any implied warranties. So we've just wrapped up the rules of express and implied warranties, what you have to do and what ones are given in the sale of goods under the UCC and how you may disclaim warranties.

I'm checked Norman and we're now discussing sales. One of the biggest concerns and headaches of almost any seller or manufacturer of a product is product liability. The sellers and manufacturers may be liable for damages caused by their product. And there are basically three theories of liability, breach of warranty negligence.

And strict liability in tort under any of these three theories, the plaintiff must prove first the defendant's product was defective or unreasonably dangerous before it left the defendant's control. They must also show that the product caused harm and they must show that that harm was caused while the product was being used in a normal or foreseeable manner.

So this is the plaintiff's obligation and notice there's several things kind of buried in those three comments. I made you the product was dangerous or defective before it left the defendant's control. So if it is subsequently modified by somebody else that was going to relieve the manufacturer of the liability because they had no control over what happened after it left their control.

Secondly, the product caused harm. That product must be the proximate cause of the damage. Now, if you take, for instance, an exploding gas kerosene heater or a gas heater, it's pretty obvious what caused the harm the harm was caused while the product was being used in a normal or foreseeable manner.

This means that the product must be used as it was designed. If you decide to take and use a metal ladder to try and take down tree limbs, which are hanging over electrical wires, you have just breached the whole warranty that says, never use a metal ladder around live electrical wires. That is not the way it should normally be used.

Or if you recall a step ladder, you've got a few steps and then you've got the top top rung there, the top of the step ladder. And there's always a little signs has, do not stand on the top of it standing up there. That's been, you've been specifically told not to do that. That's not the normal or foreseeable manner in which it should be used.

So the plaintiff has three. Real test here is defective or dangerous before left the defendants control the product it's caused harm and the harm was caused while it was being used and as normal or foreseeable manner. Now, in the case of a breach of warranty express one, these must comply with the federal consumer warranty act, but you may also have implied warranties as we've discussed.

Warranties may be disclaimed. And warranties may have liquidated damage clauses, but if there is a breach of warranty and the plaintiff is able to show these three conditions of damages, then you may also be able to Sue under the warranty causes consequential damages may be limited. However, for personal injuries, any limitation is considered prima facia or on its face.

Unconscionable. Most of the recoveries tend to be under the negligence approach or later the strict liability. Let's talk about negligence. Negligence is the failure to exercise reasonable care under the relevant circumstances. And it may include the failure to warn of appropriate dangerous. The elements in negligence are a duty, a breach of that duty.

Harm and causality. In other words, the direct relationship between the harm and the other party's negligence, there is no requirement for privity in negligence. Now let's go back to a couple of these elements that we just started with may include failure to warn of appropriate, dangerous. Have you ever purchased a product and pulled out the little card?

It says all of the things do not do. Well that's because the manufacturer is trying to cover themselves in this particular case, because if they don't want an affordable, appropriate danger, they may be found guilty under the negligence standard. So you will see it for instance, on bags, plastic bags do not put over the head, do not allow a, an infant to pick up this plastic bag because obviously they could sputter some things in almost.

Insane. You'd never do them. Do not stick your finger in the electric wall socket, but nevertheless, they're trying to warn you of a possible danger. Once we get past the warnings. Again, the plaintiff must show that the manufacturer or the seller owed a duty to someone, the manufacturer or seller breached that duty by putting out a dangerous product.

Or failing to warn of a dangerous product, the plaintiff or a member of the family suffered harm because of that. And there is a direct correlation between the harm and the other party's negligence, but there is no requirement for contractual privity in negligence. So in the case, I mentioned a little earlier about the neighbor with the chainsaw.

Clearly that individual did not purchase the chainsaw, but simply borrowed it from a neighbor. There is no privity of contract, but nevertheless, the neighbor may recover out of the negligence theory.

In the case of negligence, the manufacturer or seller may have some defenses. They may disclaim. But they may not have use a disclaim it to avoid all liability. They may disclaim certain pieces of it. The manufacturer or seller may say that they had given clear warnings that you are not to do this so that that exculpate, or lets them off the hook they had given clear and appropriate warnings conspicuous to the user of the product.

Probably the two most common defenses for a manufacturer seller are contributory negligence, sometimes comparative negligence. And this means where the other party helped give rise to the accident. For instance, if the product is used, but not used quite appropriately by the party who was injured, they contributed to the negligence.

You could have, for instance let's say that the product requires a certain fuel to use it, the party using it, the buyer of it. Uses a fuel that will work in it, but it is not actually that which is specified it's possible that that might be contributory negligence. They didn't follow the instructions precisely correctly.

And that could be a defense for the manufacturer or seller of the product. Assumption of risk means that the buyer of the merchandise has assumed the risk of injury. For instance, If I am the seller of snow skis and my purchaser goes out one, one weekend and his skiing slips doesn't make a turn properly breaks a leg.

Am I responsible for the breaking of the leg? No, the skier assumed the risk. That's a risk that they assumed. Now if the injury occurred, because for instance, the skid came off the bottom of it, or the the bindings came loose because of malefactor mal manufacturing. Then that is not a good defense. The buyer did not assume the risk of the product disintegrating on them.

In the case that negligence has been proved, then the parties will fight a battle over the amount of damages. Generally, unless there is contributory or comparative negligence damages will be awarded in full to the, to the plaintiff. If there is a level of contributory or comparative negligence, the damages may be mitigated or reduced by the amount of negligence.

Of the, of the suing party, personal damages are allowed, but economic losses are not allowable defenses for a product failure. So we've talked about breach of warranties. We've talked about negligence. Let's also talk about strict liability. In this case, men, most States have adopted strict liability rules, which say that if a product was sold in a defective or reasonably dangerous condition that caused damage, anyone in the chain of selling those goods is liable for damages.

And in that particular case, the plaintiff does not need to show any negligence at all. It's anyone in the chain of selling the merchandise that gives rise to this injury. If the product was sold in a defective or unreasonably dangerous condition, there are rules for privity and rules for damages. The same as in negligence, what defenses may be used a disclaimer may not be used as a defense.

However clear Warren earnings may constituted defense contributory or comparative negligence may be a defense. And S of course, assumption of risk is a defense here. So as we look at product liability, you need to focus on a couple of points. Liability may be found under breach of warranty, negligence, or strict liability in torts.

The plaintiff must show that the product that was sold was defective. That defect caused an caused harm or caused injury that harm or injury gave rise to damages and the damages then need to be paid by the defendant. There are certain defenses available, included, clear warnings, contributory, or comparative negligence and assumption of risk.

I'm Jack Norman and we're discussing sales. In this particular case, we're going to focus on title and risk of loss. Now the title for property has significant legal effect on many issues. Title cannot pass until goods are identified. And if the buyer rejects any goods, title Reavis in the seller.

Generally a buyer can obtain no greater title than the seller had. However, it's a seller had voidable title. A buyer can obtain good solid title by taking for value without notice. Now, normally title and risk of loss stay together. And in this point, we need to talk about shipping terms. We're going to begin with fob shipping point, which means the title and the risk of loss pass at the time the seller takes those goods and passes them over at the shipping point to the common carrier.

In contrast, fob, destination means the title and risk of loss passes at the destination. When those goods. Or delivered to the buyer from the common carrier often. And most often these terms are set forth in the contract. But if the contract is not clear, the presumption is fob shipping point. Now suppose the contract contains notions.

In terms, if it's a murder shouldn't seller, then the buyer bears the risk of loss on physical receipt of the goods. If it's a non-merchant seller, the buyer bears the risk of loss on tender. That is when the seller indicates the goods are available to be picked up. Now as you go through sales documents, you'll run across a number of different terms.

One of the more common ones that you may have seen is Cod or cash on delivery. This means that the buyer cannot inspect the goods until payment is made. And in today's world with a lot of companies, having financial issues, more and more inventory sales are being made. Cod. A sale on approval is one we're title and risks stay with the seller until the buyer approves.

And it's generally for consumer use, you may have seen some of those book clubs where you sign up to get some free books and they say they will send you a book each month on approval. Well, Thailand risk are with the seller until you approve. Or as many of those contract provide, if you don't return the book to the seller within 30 days now a sale or return means the title and risk passed to the buyer receipt for resale purposes free alongside is another shipping term and it means title and risk pass.

When the goods are delivered to the common carrier and finally X ship. Title and the risk pass when the goods are unloaded in today's world, we have many, many international transactions and becoming familiar with all these various shipping terms is important. I'm not sure how well there'll be tested on the exam.

The focal point for title and risk of loss is probably these comments, title, and risk generally stay together. You will need to know some of the shipping terms and. You need to focus on the fact that title has significant legal effect and that a buyer can usually obtain no greater title than the seller head, unless the buyer takes for value without notice.

Jack Norman. And we're talking about sales specifically. We're talking about remedies for buyers and sellers. Now either party can demand some assurance that the other party will perform. If it's the seller who seeks assurance, they can, for example, demand partial payment or payment at advanced cash on delivery, various terms like that to protect themselves.

If that's true, the buyer must provide evidence of good financial standing. If they're not making a payment, they may have to submit certified financial statements to the seller. Anything that will make the seller comfortable that indeed the buyer will perform upon the shipment of goods. There's a concept called anticipatory repudiation, and that is one party suspends, the PR his or her performance awaiting action from the other party.

That's generally a sellers prerogative. If we turn over to remedies for the buyer, the buyer who receives the incorrect goods and non-conforming goods can accept them, can reject them. Or can accept some and reject others completely at the buyer's option. Even a minor defect, let's say that you asked for something to be a toy, to be blue color, and it comes in yellow.

That's a defect and it may be only a minor defect, but it does mean that the goods are non-conforming. However, should the buyer received non-conforming goods, notifies the seller and the seller has the right to cure. If the seller notifies the buyer and send con sends, could forming goods within a reasonable period of time, then the buyer must accept those conforming goods.

However, a buyer has a right to cover. That means that the buyer can purchase similar goods elsewhere. And if they have received the non-conforming goods, A buyer also has a right to get specific performance. Even if the goods are not unique in the situation where he is unable to cover. So let's assume that the seller says, I understand that I'm supposed to be providing this material to you.

There's been a delay. There's a issues in my supply chain. I can't get them to you. Please see if you can find a substitute if the. Purchaser says I've gone out. I've looked, I've tried to find the conforming goods from another seller I'm unable to do so you must perform. And unfortunately, the seller in that particular case is stuck with performance or a breach of trust contract.

Now goods must be identified. Once the seller has identified and set aside the buyer's goods, the buyer has an insurable interest in those goods and has the right to demand the goods from an insolvent seller. So once the seller has identified instead of a side, They don't have to be physically moved.

They can simply be tagged or something else. Often the buyer may want to go ahead and get insurance on it and certainly has the right. If his seller subsequently becomes insolvent to demand those particular, let's turn the situation in a different direction and say, what happens if the buyer becomes insolvent there, the seller has a right to demand cash, and that's where you frequently see.

Cod deliveries of product, either in the story or other product. Let's talk for a moment about some sellers remedies. If the buyer is insolvent or perhaps even bankrupt, the seller may stop delivery of the goods in transit may reclaim any goods received by the buyer on credit and having reclaimed those goods may resell them and recover damages.

From the buyer under the UCC on the sale of goods. There's a statute of limitations, which is four years from the date of the breach of the contract. And by agreement this four year statute can be reduced to one year. However, the UCC provides that the statute of limitations may not be extended for the beyond the four year.

Term. So those are some of the remedies of buyers and sellers under the sales provisions of the uniform partial code.

I'm Jack Norman. And this is bankruptcy law. The bankruptcy law of the United States is basically governed by title 11 of the United States code. And in that title, there are chapters dealing with different aspects of bankruptcy on the exam. You will primarily see chapter seven, which is liquidation chapter 11, reorganizations or chapter 13, adjustment of deaths of an individual with regular income.

There are two other chapters, which are occasionally, but rarely tested chapter nine, dealing with the debts of a municipality and chapter 12, the debts of family, farmers, and fishers. Well, what's the effect. If a person files for bankruptcy first, there is an immediate stop to judicial proceedings. There are a few exceptions to this, but the general rule is no foreclosures, no actions to try and collect on credit card debts, or other notes items like that stops judicial proceedings.

Secondly, the debtor is required to list all of the assets and debts that he has. Before, and after the filing date, I want to put a focus on something about bankruptcy law. There are creditor and debtor rights under both federal and state law, but there is a big difference in emphasis the federal law, particularly in the bankruptcy.

Context focuses on the equal treat, but among creditors within a same class is secured creditor and unsecured creditor. A preferential creditor accreditor cannot improve its position. Vis-a-vis other creditors once a bankruptcy filing as occurred in contrast under state law, the emphasis is on the prompt action by a creditor to enforce their rights against the debtors limited and insufficient assets.

Now, of course the state law area gets preempted. Once the federal bankruptcy law has been triggered, as you were reviewing for bankruptcy, there's some key terminology that you need to keep in mind. First, a claim is any right to payment. A creditor is any entity that has a claim or rising. Or considered to have arisen deemed as the word they use before the filing of the bankruptcy, a debt is a liability on a claim and a debtor is the entity who is liable to a creditor let's focus on the bankruptcy estate.

This consists of all of the debtors legal and equitable interests. In property at the time the bankruptcy is filed. So the bankruptcy estate pulls together. Everything that the debtor had sweeps it in to be administered under the bankruptcy law and the eyes of the court. And while I said everything is swept in there's of course, an exception.

That exception is what's called exempt property. And a debtor may keep certain property under either federal or state law. It's exempt for seizure and sale to settle the payment of the debtors debts. In other words, it's not part of the bankruptcy estate. What happens is the debtor has a choice of using the exemptions provided in federal law.

Or in state law. And so a debtor's advisors will have to look at those two different criteria and decide which properties they are going to keep as exempt from the bankruptcy estate. Nonetheless, the debtor must disclose all products pretty to the court. Okay. And then another key phrase is insolvent and there are two different.

Senses of that word insolvent in the bankruptcy said it means debts exceed non-exempt assets and that's figured at fair value. The other concept is an equity insolvency, which means the debtor is not paying their undisputed obligations as they become due. And as you were reading through and reviewing for bankruptcy, keep these two differences in mind, the bankruptcy sense and the equity sense.

Now let's turn to what happens if a person wants to file under bankruptcy. First, you have to meet the criteria of the various chapters, whether it be chapter seven, 13, 11, for instance, chapter 13 requires an individual with regular income and certain levels of debt. Chapter seven, which is a liquidation is a four individuals is tested for a means test.

And it means that only individuals that meet this Bean's test, or if you want to think about it another way, flunked, the means test can file under chapter seven. In addition, debtors must beat mandatory credit counseling before filing the bankruptcy. There are two ways to get into vein into bankruptcy.

There's the voluntary route and the involuntary route. Now under voluntary, it could be a chapter seven, a chapter 11, a chapter 13. It doesn't make any difference. And the debtor simply files a petition with the bankruptcy court takes in their paperwork and files it with the court that debtor must have at least one debt.

Which may only be a penny, but it has to be a debt, but the individual does not need to be insolvent. So they simply may wish to have some debts eliminated. There's no solvency test at all. One debt will do it. Also a husband and wife may file jointly for bankruptcy, but both parties must be knowledgeable and agree to this fact.

In addition, the court may consider. Consolidated the assets of two estates to see whether one will be paying for the debts of the other. On the other hand, a husband and wife may decide not to file joint bankruptcy and only one party make the filing. But if they do file jointly, both must be aware of, and both must consent.

Now in end voluntary, bankruptcy is under chapter seven or 11. And in this particular case, the debtor does not. Want to go into bankruptcy, but the creditors get together and force the bankruptcy court to take the case. If a debtor has more than 12 creditors, three or more creditors, they filed a petition.

If the aggregate claims exceed the security, they hold in the debtor's property and that's over a minimum threshold. The thresholds are in the text material and are periodically changed. If there are less than 12 creditors, any one creditor may file the involuntary bankruptcy petition. If again, that claim for the, for that creditor exceeds the threshold amount.

Once the filing has taken place, if there is a chapter seven proceeding or a chapter 13 proceeding, the court will appoint a trustee. That happens in seven and 11 on a mandatory basis. It is not necessary in either a nine or an 11 proceeding. Although the court may ultimately decide that a trustee should be appointed.

The trustee is an officer of the court and is responsible for administering the bankruptcy estate. The man or woman appointed to that position may hire professionals to assist him. The trustee will gather all the creditors together. At a meeting. And at that meeting, the debtor must appear and submit to questions under oath from the creditors and the trustee.

And in this particular case, what this meeting is all about, they're trying to understand what the debtor's assets are, what the debt is obligations are and how it might be possible to work out a settlement of the bankruptcy case. A debtor has the obligation to file a list of creditors. A schedule of all assets and liabilities and the statement of financial conditions with the bankruptcy court.

The debtor has to cooperate with the trustee and appear at this creditors meeting. I just discussed the debtor has an obligation to send notices to the creditors of the filings. And if the creditor are not listed by the debtor, those creditor debts may not be excused in the bankruptcy filing. The debtor is obligated to attend the discharge hearing.

And most importantly, surrender all of this state property. Those items that are not exempt assets, which were in the debtor's possession or over which the deter had control within 45 days after filing the bankruptcy proceeding. I remember early on, I said that bankruptcy is an automatic stay against judicial activities, collection activities.

Foreclosures. I want to point out that there are a couple of things that it does not stop. And this is reasonable because remember, we're talking about financial work in the bankruptcy arena. The state does not apply to criminal proceedings. Congress has also determined that it should not stay the collection of either alimony or child support.

It doesn't apply to a notice of tax deficiency, the eviction under a residential lease, and it does not prevent trustee action to perfect an interest in property. Now, the trustee is pretty powerful individual that trustee may assume. Or reject any leases or contracts, including leases on personal property, real property, employment contracts.

All of these can be rejected by the trustee. And as a general proposition, if the trustee doesn't act to approve a contract, they are deemed rejected. Creditors could file claims and those claims are only allowed. To the extent of distribution in the state assets. And we'll talk a little bit later about how those distributions are made.

Generally, a co debtor, surety or guarantor is permitted to file a claim in bankruptcy only if he's already paid the creditor in full. And now he's trying to assert those subrogations rights. Administrative claims are the cost of the. Bankruptcy court, the attorneys, the accountants, the other experts who were brought in to work on the bankruptcy case and administrative claims have a priority in the distribution of bankruptcy assets.

This is Jack Norman and a discussion of bankruptcy law. We're going to focus on the priority of claims. What happens after the trustee has marshaled all the assets of the debtor together and then collected what he can from them, those assets by selling inventory or, or selling other assets. Now, the trustee has got a pot of money which needs to be distributed to all of the creditors.

And there is a priority of claims who gets paid first. Who picks up at the rear of the remaining funds is a mnemonic that you need to review for. The final for the REG CPA Exam is called scam, wed tug S C a M w E D T U G. The first priority goes to secure creditors to the extent that the trustee has managed to extract value from the collateral.

So for instance, if property is. Securing a debt of $75,000. You, the property could only be sold for 70. The secured creditor will get $70,000 of the first proceeds and remain an unsecured creditor for that $5,000 difference. S is first second, the C stands for child support and alimony claims any liabilities for child support and alimony claims have a second priority in the distribution of a debtor's funds.

Third come the administrative claims of the bankruptcy court, the attorneys, accountants, and other experts who were working on the proceeding and M in scam, Stan scam stands for middleman death and what this is our debts advances during the period of time after the filing date of bankruptcy. But before discharge it's so-called gap financing to keep the operations going forward.

The wed, we'll start with w unpaid wages for the employees. And there's a maximum amount, which is periodically adjusted. The E stands for unpaid employee benefits again, to a maximum limit. And the D is deposits that are made with the debtor to purchase consumer goods. There's a maximum on this also. So wed unpaid wages, employee benefits, deposits on consumer goods.

We come down to the last three areas, tea and tug for unpaid taxes. These are unsecured claims on federal and state income sales tax, such liabilities to governmental entities. The you under the influence Congress felt that there should be a priority for payments that arise. When the debtor has caused injury under the influence of alcohol drugs, something like that.

So this has a priority just before the last category of G for general unsecured creditors. So you need to understand for the REG CPA Exam says scam, wed tug for the priority of distributions. Besides these rules, there are a few other special rules dealing with the distributions. Any unsecured claims must be filed timely unsecured claims that are filed untimely come after the G in our tug next in line.

If there are any remaining funds, fines, penalties, or forfeitures arising before the bankruptcy filing. Then there is interest on any paid claim. If creditors are getting paid, they may be entitled to interest if there are any funds leftover and last but not least, of course, if all of the priority distributions have been made, then all of these additional categories are made including interest, any surplus, which is highly unlikely, does go to the debtor.

We have in the bankruptcy law, certain exemptions, and this is what I call the tax. The exempt act, the exempt assets of the debtor. They could choose either federal or state exemptions. In addition, certain debts are not dischargeable. So even after filing bankruptcy and paying off a number of claims, certain.

Obligations that have not been fully paid, cannot be discharged in bankruptcy. This includes federal state and local taxes due within three years, the taxes arising from fraudulent tax returns. As I mentioned previously, any debts that were not scheduled. In other words, the debtor did not advise that there was a creditor out there with debt.

So they never made the schedule to the bankruptcy court. These will not be discharged. Child support and alimony liabilities are not discharged by a bankruptcy filing. Neither are educational loans. So we've talked about distributions. Now we've talked about assets. Let's talk further on what the estate property does include and a couple of very important rules dealing with that property.

The debtor must turn over to the bankruptcy court, all legal and equitable interest in property, whether it be tangible or intangible real or personal property. So it might include insurance policies. It might include a rental property. It might include Tools used it a business. So we have to say we've Marshall, everything together.

Get a complete listing of all of these assets and whether or not they're in the hands of the debtor. So they could be on loan to somebody. Nevertheless, they need to be included. Then we're going to take from that the exempt assets that I said you could select from either the federal or state list. The property may also include certain interests acquired by the estate.

After the bankruptcy is filed. Now, the general rule is assets of the debtor before filing belong to the bankruptcy court after belong to the debtor. But one exception is for such items as inheritances, bequest, insurance, policy, health plan, proceeds, municipal bond interest, which are received by the debtor within 180 days after filing bankruptcy.

Those amounts can be pulled by the trustee back into the bankruptcy estate and are available for distribution to creditors. In addition, there are the trustee has power to bring back any items that the debtor has tried to get out as what we call preference transfers the state property exclusions besides the exempt property includes any earnings that the tax that the debtor has had after filing for bankruptcy.

If that's an, a chapter seven 11 proceeding, this doesn't apply in a 13 or any property held in trust for the debt or is excluded from the estate here's those preferential transfers that are, that the trustee pulls back in. In addition to those ones I mentioned before on inheritance, these are called.

Preferential transfers where the debt, or has been trying to benefit a creditor to the expense of other creditors. And you need to focus on another mnemonic called ban Tim, the stands for the transfer of property for the benefit of a creditor. And there is an antecedent debt. In other words, the creditor had a debt running to the debtor before the date of filing bankruptcy.

The transfer occurred within 90 days of filing, there is a threshold amount which is set forth in the text and which is periodically adjusted. The, I stands for insolvent and there is an assumption that the debtor wasn't solvent at the time of this transfer. And finally the creditor will receive more because of this transfer than he would have through the normal bankruptcy proceeding.

So Ben, Tim is a right of power given to the court, to the trustees to try and prevent one creditor from stepping ahead of its normal position in line.

There are exceptions to ban Tim. If there is a contemporaries contemporaneous exchange of new value given in this transaction, for instance, perhaps one note was given in exchange for a new note was slightly different terms. It did not materially enhance the creditor, standing a sale of inventory in exchange.

For payment I contemporary and it's exchange of value is outside the preferential transfer, even though it would look like it meant the band Tim rules. Okay. Hey payment in the ordinary course of business is accepted. For instance, paying the rent, paying the utility bills, paying for inventory. Those are exceptions to the preferential transfer rule.

In addition, certain transfers of security, interest, and child and alimony, payments and gifts to charity are not subject to the preferential transfer. Here's one. I hope you never see fraudulent transfers. These are transfers made. Of an interest of the debtor within two years before filing bankruptcy and made with the intent to hinder defraud delay, either a creditor or commit a fraud on the court.

In these circumstances, the debtor usually receives less than equivalent value and it's. What are those things that not only is a fraud on the court, a fraud on the creditors? It may lead to the fact that the court will not grant a discharge of the creditor. Finally, it is a criminal act. So as though we go through the bankruptcy, Basic rules here quite quickly.

I want you to make sure that you review the entire text. There are a few items in there that are not been tested often, but you ought to take a look at the consumer credit laws provisions related to default on debt and surety ship. Now that's a phrase that means an agreement where one person secures the debt of another.

By assuring that they will pay in case the debtor default. This may be something like again, tour. So in the material on bankruptcy, you have a great deal in the text. It's dense, but we've tried to put out the highlights, make sure you focus on the. Pneumonics the band, Tim and the scam wed Tim pneumonics to focus on the preferential transfers and on the priorities of distributions.

Make sure you understand the difference between the voluntary and the involuntary. And let me remind you of one thing in bankruptcy in the bankruptcy law. Under federal law, we are focused on the inability. Of the debt or to pay the debts as they become due in the accounting world. We frequently think of somebody as being bankrupt.

If the liabilities exceed the assets and that's a classic definition, we think that's not what we're focusing on in federal bankruptcy law. So keep those insolvency distinctions clear in your own mind. You'll do extraordinarily well on the exam.

One of the areas of the REG CPA Exam is always debtor and creditor relationships. Bankruptcy is part of that, but so also are surety relationships, guarantors assumptions, and. We have a program where we talk about bankruptcy and the bankruptcy act specifically in this program, I want to focus on all of the other debtor creditor relationships.

Let's begin with sureties. A surety ship involves a debtor, a creditor, and a third party called the surety. This is the person who responsible for the debt to the creditor upon the default, by the debtor. Now generally a surety ship contains the elements of a contract there's offer acceptance consideration capacity, all those items you learned in school about the elements of a basic contract, those apply fully and completely to the surety ship.

The area that we need to explore for just a few moments is consideration. If the surety arrangement is established at the time of the main contract. And of course in that main contract, there will be consideration there's no additional consideration required to create the surety ship. However, if the surety comes in after the main contract has already been agreed to then just as in any other additional contract consideration is required for the surety ship.

A surety ship also will require are a writing. If we are subject to the state frauds if we've got a real estate contract dizzy, right? It's going to be beyond a one year or if it's to answer for the debts of another ha statute of fraud. So this means the contract must be in writing. Yeah, the terms guarantor and surety are often used interchangeably, but I don't like this.

I generally think of a surety as having come into the arrangement simultaneous with the execution of the debtor creditor relationship, who is a guarantor may come in separately. Now you could certainly have a. A term used inappropriately, but I think if you look at the exam, most often the surety is going to be simultaneous the guarantor and a separate arrangement in either case, however consideration will be required and the arrangement will need to be in writing.

What happens if the debtor defaults the creditors, you can choose any remedy in any order first, he can Sue the surety saying sure. He used to tell me that I'd get paid, pay me. The creditor can go after the collateral. That's any arrangement the creditor can Sue the debtor. The debtor may put up additional collateral and of course the creditor can also go after this additional collateral.

There is a space. So rule, however that if you were trying to Sue a guarantor, the Cola for collection, you have to exhaust all your remedies against the principal debtor. So this is where I distinguish a little bit between a surety and a guarantor. Normally the guarantor says if the debtor doesn't pay, I will pay the surety says if he doesn't pay, I'm also on the hook.

There's, they're similar. But there's a little bit of a difference. The surety arrangement, you exercise your rights in any order, the guarantor, you must go against the principle first. Now what happens if the surety pays the debtors bill? Something arises called the right of subrogation, the surety steps into the creditor's shoes.

And cool can go after any of the collateral that the creditor could have gone after. Let's take, for instance the debtor has a piece of property, which is securing the creditors loan. There's also a surety arrangement here. The debtor defaults. The creditor could have seized that asset, but decides that's too much trouble to try and go through the foreclosure simply turns and says, surety pay me, which the surety is obligated to do under his contract.

After that has happened, the creditor is whole is out of the picture. The surety now steps into that creditor's position and has the right to seize the collateral to make himself whole. Of course. Is there any point in suing the debtor? Probably not because he's already defaulted

if you're looking at the exam, think about this. If you see the term subrogation, look for collateral, if you see collateral, look for subrogation those two tend to go hand in glove in the CPA exam. So there's just a little clue for you. What happens if the debtor actually performs? Well, we call tendering performance.

Well, the debtor said he would pay the creditor. The surety, his deal was I will pay you creditor if the debtor doesn't. If the debtor performs the shirt, it is released from liability. So if you see tender performance, look for that answer. In the case of assurety infancy or bankruptcy of the debtor does not release the surety from liability.

So if the debtor goes bankrupt, the surety is still on the hook. The bankruptcy or infancy of the surety does release the surety from liability.

Now, suppose a creditor comes and tells the surety, your debtor has not paid me. I'm looking to you to make good. Does the surety have any defenses? The answer to that is yes. One, if the surety did not get consideration, because remember this was a contract. If there is a requirement for consideration and the surety did not receive that contract did not receive that consideration.

Then that is a defense. The statute of frauds applies since we are answering for the debt of another, that Trudy contract must be in writing. The surety has a defense. If the creditor perpetrates fraud, the debtor,

I think I missed, okay. The creditor perpetuates fraud on the surety. The surety is released. If the creditor perpetrates fraud on the debtor, the surety is still liable. So let's try that one more time. The surety's defense is creditor perpetrated fraud on me. I'm released. We all agree there. If however, the creditor perpetrated fraud on the debtor, the surety remains liable because he agreed to answer for the debt.

The surety is also released. If there is a material change in the contract, after all the surety agreed to do a payment on a specific contract, if there's a material change. Sure. It is released. There is absolutely no reason why a debtor couldn't have. Multiple sureties. There can be kosher cities. If one of the kosher cities is compelled to pay because of the debt defaults that surety has a right to be reimbursed or collect funds from all of the other kosher cities, since they all agreed to be liable for the debtors debt there, isn't what we might call a right of contribution from the kosher at ease.

How do those kosher cities get their, make their contribution? It is based on their percentage, their proportion of chair, according to the agreements that were made with the debtor. So that's the right of contribution. A question that sometimes occurs on the REG CPA Exam deals with mortgages. What is the difference between assuming a mortgage and taking property, subject to a mortgage?

Here. I think you need to be very careful if you assume a mortgage, the new mortgage, or becomes personally liable on the debt. However, the original mortgage or remains personally liable can the original mortgage or get off. Certainly the bank can release him and substitute the new Person who has assumed the mortgage, that would be innovation, but the general rule is the new mortgage, or is personally liable the old mortgage or remains personally liable on the debt unless released by the bank.

That original mortgage can be thought of as acting as a surety because the obligation must be paid by the new person who assumed the mortgage. If he doesn't, of course, the original mortgage holder is still on the hook. In light of a lot of the issues dealing with declining values and home mortgages.

This is an area that I expect to be tested on the exam. The question of assuming, or taking project subject to a mortgage. Let's talk about that. Taking subject to a mortgage, the new purchaser may have the property, but does not assume any personal liability. All the purchasers stands to lose is the property.

So who is still liable for it? The original mortgage holder on the REG CPA Exam read very carefully, whether the party is assuming a mortgage, in which case you have a surety arrangement or taking subject to avoid. In which case you do not have a surety arrangement. the REG CPA Exam also tends to focus on remedies when a debtor defaults, what are the remedies of a creditor upon a debtor's default?

And I'm going to give you a simple demonic this time. Sometimes I've told you about very long and complicated pneumonics. This one is easy ices, IC E S the remedies include indemnity contribution, exoneration, or subrogation. I Dem indemnity the right of reimbursement from the principal's debtor for an amount paid by the surety to the creditor.

In other words, I paid the creditor. Mr. Debtor, you defaulted, you owe me reimbursement for what I am out of pocket contribution. As we discussed when there's more than one surety, this is seeking funds from the other sureties. Once you have had to pay the right of contribution. Subrogation the surety pays the debt in full and succeeds to the creditor's rights and may seek recovery from the collateral subrogation.

And exoneration, the surety wants out. And before anything takes place before I need to false before any claims, the surety would like to be out and be exonerated from his contract. Generally, the courts will not release a surety, but it is a fourth remedy. So IRS, you review indemnity contribution, exoneration, subrogation.

As a final reminder in the area of debtor creditor relations, there are three things I want you to remember the surety remedies, IRS indemnity, contribution, exoneration, and subrogation. The difference between assuming a mortgage and taking property, subject to a mortgage and creating the surety arrangement.

It is a contract which must have consideration if given after the original contract. Although no consideration is required. If the surety arrangement is part of the original contract and it must be in writing to conform to the statute of frauds

I'm Jack Norman. And on this program, we're going to discuss the concept of agency. An agency involves three elements, the principal, a third party, and the agent. That is the individual who acts on behalf of the principal. Let's talk about establishing an agency relationship. The general rules are a simple, less than one year agency relationship to do a simple task does not need to be in writing.

If the agency relationship is going to continue for more than a year, it must be in writing. And any agency relationship to sell real estate must be in writing. And for many of you, this may be one of your first exposures to agency is in buying or selling a piece of real estate. Remember always that the agent is controlled by the principal.

In contrast, an independent contractor is never controlled by the principal. So the control is a key factor in defining an agency. Relationship. I talked about how to create a relationship. How about terminating one? A an agency relationship can be terminated at will. Either party can end the relationship.

However, there is always the possibility of a breach of contract, which may lead to a lawsuit for damages. If the relationship is terminated, but the principal and the agent can both terminate an agency relationship. Automatically in addition, the relationship is automatically terminated. Nobody has to do anything upon the death of the principal or the bankruptcy of the principal.

Obviously the death of the agent, and usually the bankruptcy of the agent will also lead to an automatic termination. So let me ask you a question. Bankruptcy of an agent or principal will terminate an agency. And the answer to that is false. It will not necessarily terminate the agency. The bankruptcy of the principal will the bankruptcy of the agent may not.

How about this question? The death or insanity of an agent or a principal will terminate the agency relationship. And here the answer is true. Death or insanity of either party will automatically terminate the agency relationship. While I told you a moment ago that the agent and principle could always terminate an agency relationship.

I have to tell you we're dealing with the law. So there is an exception, an agency coupled with an interest may not be terminated. An agency coupled with an interest may not be terminated. Now, what is such an agency? It's one where a principal owes a debt to an agency. Or principal turns property over to an agent.

The agent sells property and reimburses himself an arrangement such as that. And let's, let me give you an example. Suppose a principal told the agent, I want you to take this property and turn it over to you. If you sell it, you get to keep 20% of the proceeds. And remit 80% of me to me, but you have the property.

That's an agency coupled with an interest in contrast. If the agent is simply a real estate agent selling the property title remains with the principal and the agent receives a 6% or 10% or even 20% fee for handling the transaction. That is not an agency coupled with an interest. So remember it cannot be terminated either at life.

Neither does the death of a principal terminate an agency coupled with an interest. If the relationship is being terminated and the principal should give actual notice to any creditor, who's had actual dealings with the agent. So actual notice if there had been actual dealings. On the other hand, the principal may give constructive notice to creditors who may have had knowledge of the agency relationship, but had no actual dealings with the agent.

So as a review knowledge with actual dealings, they give actual notice knowledge without dealings. Constructive notice is adequate. Now frequently appearing on the REG CPA Exam are questions about the types of agency authority. There may be actual authority. There may be express or implied authority. And the third category is apparent or extensible authority.

These three different types are extensively discussed in the materials, but let's review express authority just quickly to refresh our memories. If you will express authority, the principal says, do it, the agent does it. Well, in this case, the principal is responsible for the acts of the agent. The principal has given express authority to the agent in the case of implied authority, it flows from express authority.

In other words, the agent is given power to do everything that is reasonable necessary, and property carry out express authority. Suppose my principal said, I want you to. Acquire a car for me. And I know that I need a four passenger sedan. I'd like a heavier car, go out and find the right car, purchase it for me.

Well, implied in that is that the agent should have the right ability to research different vehicles, go to dealerships road, test them. Make all proper inquiries and line up the paperwork, potentially even the financing and provide those to the principal so that the printers you all can actually purchase the car.

So all that is reasonable and necessary to carry out that express authority is implied authority. Implied authority means that the agent may make ordinary purchases may take care of any emergency situations. May make repairs again, the key test is everything reasonable to carry out that express authority,

the category of apparent authority. This one's a little bit hazier. The principal has created authority in his agent. The principal is bound by the agent's actions. However, the third party is not liable by secret instructions between the principal. And the agent, the principal is liable for acts of his agent who is acting with apparent authority.

So the third party, the doesn't quite know what authority the principal has. The principal has given to his agent, but it certainly appears because similar people in that position. Who've been agents before have done these acts, that that agent has the authority to act on behalf of the principal, looking at the exam.

If there's a multiple choice question on agency, most often the correct response is going to be apparent authority. You have to read through the question carefully, but that's generally the correct answer. Whenever someone says don't do it and the agent does do it. There may well be. And probably again, the correct answer is apparent authority.

Even though the principal said, don't do it. The agent does it. The agent will be cloaked with the apparent authority to do it. There may be some exceptions to this, but this is the general approach you should take on the exam. If the agent is doing the bidding of the agent of the principal, rather let's talk about the liability of the principal.

The principal is liable for all authorized acts. The principal is not liable for unauthorized acts unless, and here's the keyword, the principal ratifies the contract. So if it's unauthorized, the principal must ratify. The principal agrees to due to an unauthorized act that the agent has performed in the principal's name.

If the agent. The agent remains liable. If the principal says, look, you did something that wasn't authorized and I am not ratifying it. The agent is liable on it, but the principle will not be, there are a couple of very special rules with respect to ratification. And if you see a ratification question, check out these points, the principal must be aware of all of the material facts.

If the agent withholds material facts from him. This will not constitute a binding ratification. The principal must expressly ratify, or the principal may imply ratification. Any of those may enter into the ratification discussion. The best answer is going to be the principal expressly ratifies it's not very often that he may imply a ratification.

So the principal must be aware of all of the material. Facts must agree to the unauthorized facts. And if the principal must agree to all of the material facts, the principal must agree to the unauthorized act. And if the principal does not ratify only the agent is responsible. I can't speak, but you'll get all the answers.

Correct. What about the agent's responsibility? We were just talking about the principal's responsibility. Let's talk about the agent. The agent is liable for any unauthorized acts, which he does, which the principal does not ratify. The agent is not liable for authorized acts unless he's acting for an undisclosed principal.

Now. Let me try that one and put it in perspective a little bit. Generally, the agent is acting for the principals, the principals going to be known. So the agent is not liable, but if there is an undisclosed principal, then if the agent does do an authorized act, he may be liable, will be liable for the undisclosed principal.

What is an undisclosed principal? The agent doesn't tell the third party with whom he's dealing, who he's working for. It's not illegal. The agent makes the contract on behalf of this principle. And as I just said is bound and you're wondering, well, what would be an example of an undisclosed principal?

The classic place that this applies is in real estate developers attempting to assemble property. Let's assume that the contractor wants to build a building on a site and there are three different, smaller building located on different lots in this one area that he would like to build on. If the sellers of those three lots, three separate owners know that this contractor is attempting to assemble the parcel, the price will go up.

So very frequently, the undisclosed principal will hire an agent and says, I want you to buy each of these three lots to put the package together for me, but don't let anyone know that you were working for me. That's a classic case of the undisclosed principal and the agent will be liable. So here's an exam clue when a third-party discovers, there's an undisclosed principal, what happens?

The third party has the option to Sue. The agent or the undisclosed principal, but not both generally. So if the third party discoveries is an undisclosed principal, he may Sue one or the other, but not both. Yeah. The law has two different concepts in it, a civil wrong and a criminal wrong, or a crime against the state.

We call these torts. And criminal acts a crime is a wrong against society. A tort is a private wrong in a crime. The state prosecutes, the person who committed the crime in a tort, the person who is injured, sues the person who caused the injury can an act, be a crime and a tort. Absolutely. When I was in law school, we were frequently told that a mugging is a crime.

And a tort. It is a battery which may be a criminal, which is a criminal offense and is also a tortious event. Many torts, however, are simply towards some crimes are just crimes. So you may have a tort, that's a tort, a crime, that's a crime or a act that can be both a crime and a tort. What happens in the case of principals and agents?

Here we come to the concept. The old Latin term respond to at superior. If an agent commits a tort, when acting within the scope of his authority, the principle is liable, liable for the tort. When the acts are prohibited, let's assume a an agent is driving a company car while work he's involved in an accident.

Is the principal liable the accident during work on company hours within the scope of the authority? Yes. The principal is liable. Suppose the damages occur after the company car yeah. Is taken home and the agent has gone out drinking now. The principal is not liable because the agent is not acting within the scope of his authority.

So the principal is liable. If the agent is acting within the scope of the authority, the principal is not liable. If the agent is acting outside of the scope of his authority, that was the torch situation. What about a crime? The principal is never responsible for the crimes of the agent. So, yes, it can be in the tort case, not in a case of a crime, unless the principal participates in the crime, which is just exactly what you'd expect.

You don't expect principals or agents to be involved in crime. If they are it's the agent who is guilty of the crime. The principal is going to be held absolutely blameless unless he participates in a crime. However, the place, the watch on the REG CPA Exam is with respect to torts. And here what's the rule principal liable.

If agent acting within scope of authority, principle, not liable. If the agent acting outside the scope of authority, what is an agent? An agent is a fiduciary and has an obligation to disclose everything to his principal. Cannot make secret profits owes a duty of loyalty to the client. Obeys the principal's instructor shins and receives compensation.

Remember a principal has an agent, an agent has a principal and in reviewing for the exam, make sure that you focus on a 40 and the crimes and torts issues.

I'm Jack Norman, and we're not discussing partnerships. Now, while we're going to talk about a concept of partnership law, I have to tell you the basic partnership principles are based on agency law. And remember in agency law, the principal is responsible for the agent's expressly authorized acts. It's implied authorized acts.

And finally it's apparently authorized acts. In addition, in the case of a principal agent relationship, there is the doctrine of respond yet superior with respect to torts. So for the exam, even though you're working in the partnership area, keep in mind that there may be a question which talks about authority and often apparent authority is the correct answer.

If the principal says don't do it. And the agent does it. Then there is quite often an apparent authority answer that applies, but now let's move out of the concept and straight into the heart of partnership. Law partners and agents are principles of each other is a partnership and entity. Well, Yes it is, but we're really working much more with that broad concept of agency and principle.

There must be notice in here actual for actual dealing constructive for those who knew, but had no dealings with the agent. All right. I told you that a partnership is an entity. It's also a contract. It's a contract between the partners. Does a partnership have to be in writing or can a partnership be an oral agreement?

Can you and I agree to do something. And the answer is certainly any partnership agreement can be oral unless you knew they were going to be, unless clauses. If the partnership is going to exist for more than a year, it must be in writing under the statute of frauds and the statute of frauds also deals.

With transactions that involve the sale of real estate. So here's a question for you, ABC and D form, an oral partnership to buy and sell real estate. Does that agreement have to be in writing answer? No. They've only agreed to deal in real estate. It must be reduced to a writing. One of the partners sells or purchases real property.

So be careful on this particular point, the statute of frauds does apply when we dealing with real estate, but you may have an oral arrangement to conduct an enterprise. Unless of course, as I said, the partnership is going to extend for more than a year. Now to put your mind at ease. There are some areas that are rarely tested on the exam.

One of them is a joint venture. A joint venture is a partnership for a limited purpose. We're going to have a, a joint venture of two construction companies to put up a shopping center. It's a partnership for limited purpose. Normally each of those construction companies would be conducting various other activities.

They have joined together only for the limited purpose of building this one strip shopping center. Now over the past few years, limited liability companies, LLCs have not been tested very heavily on the exam. I'm not so sure that's going to continue to be true in my practice. I'm seeing more and more limited liability companies.

For newly organized enterprises, LLCs are becoming the entity of choice for many attorneys and advisors. So I wouldn't be at all surprised to see the exams testing of LLCs. Expand later in this program, we're going to explore some more of the concepts of limited liability companies and limited liability partnerships for now.

You remember, they vary by state and although. As I said they haven't been tested in the past. I think you might want to beef up your, your reading about LLC. What is a partnership? I always tell students when I'm talking to them, partnership is created when two or more people agree to do something okay.

To do something means carrying on a business activity in general, a partnership is not truly a legal entity now. I'm going to contradict myself in a few minutes. When we talk about the uniform limited partnership act, these become legal entities, it's an entity. However, that's a strange creature. There is an entity concept and there is a separate concept.

We really look at a partnership as all of the partners. Operating individually, the creditors follow the partner's obligations into any new entity. If they break apart, a partnership is not a taxable entity, it files information return. So even though you hear about a partnership tax return, a partnership doesn't file tax, okay.

The income or loss flows through that information partnership return and becomes the taxable income. Or loss of the individual partners who report that income on their separate personal 10 forties. We have a general partnership concept and a limited partnership concept. Let's talk about a general partnership.

First general partnerships, all partners are equal. No one has limited liability. And as a prime example, let us just say that my brother and I, Jim and Jack decided to form a general partnership. We're going to carry on a fishing charter business. He provides the boat. I provide the capital. That's a general partnership.

We are both equally liable. We agree to be 50 50 partners. We split all the profits. The other type of partnership is a limited partnership. Now, this is formed under state law and generally under the uniform limited partnership act of that particular state. Yes. Yeah. Certificate of business must be filed with the partnership is operating and the beauty of a limited partnership is limited partners have limited liability, just like a shareholder in a corporation.

Their liability is limited to their investment in the partnership. Unfortunately. Not every partner can be limited. A limited partnership must have at least one general partner who can be liable for the debts of the partnership. So a limited partnership is going to be formed with one general partner and a number of limited partners.

A limited partner is an investor. They may not be involved in the day to day management of the partnership. In contrast in a general partnership, all of the partners may well be involved in management, but in a limited partnership. And I must stress this to you. The limited partner is an investor only.

They may not engage in management. Generally. They are liable only up to the amount of their investment in a partnership. Now under the older law, some States still have the uniform limited partnership act or ULPA. The limited partner can only contribute cash or property to the partnership under the revised uniform limited partnership act or rule pot.

Are you LPA? A limited partner may contribute services. Most States have gone to the revised limited partnership act. So you should be aware that in most cases, Limited partners may contribute services. As I've mentioned to you before a limited partner may not be active in the management of the business, supposedly do decide to get involved.

What happens there. They stand there. Good. A very good chance of losing their limited partnership status and will be treated as a general partner. The limited partner also should not allow their name to be used in the partnership in any way, shape or form. Now, under the revised limited partnership act limited partners can make minor decisions.

And I said, they can't be involved in the day-to-day management. They can make some minor decisions. They are allowed to vote on dissolution of the limited partnership. They may act as a surety. And they may do things unrelated to the active management of the business. These are Rupa safe harbors. So just in looking at the partnership questions on the exam, be careful about the roles that limited partners are playing

we're back for part two of partnerships. In the first part of our discussion, we talked about the organization and the partnerships general and limited partnerships and the role of limited partners. Now let's move on to another area that the examiners love to question you on the CPA exam. And it's about assignments.

A partner may assign an interest in a partnership or a partner assigned to an interest in partnership property. They sound very similar, but they are very, very different. If a partner assigns an interest in a partnership. In other words, he assigns his interest in that partnership to someone else. The partner is literally assigning his sheriff profits or potentially losses.

The transfer Reed does not become a partner of the partnership and the partner that transferred or assigned his interest does not stop being a partner. There are no grounds to dissolve the partnership now for such an assignment. All the partners must consent. Here's what I want you to remember that partner cannot assign an interest in partnership property.

No partner owns any part of the partnership property. The partnership owns the property. So a partner can assign his interest in the partnership. A partner cannot assign an interest in partnership property. Now it is possible for partners to own property together. And for example, a tenancy is a form of partnership.

My wife and I own our principal residence. We are tenants by the entirety under Virginia state law. It is a partnership, but that's an exception to a rule. Let's go back and reinforce what the REG CPA Exam question is probably going to try and trick you on. Can a partner assigned his interest in a partnership?

Yes. That assignment transfers the share of partnership property of PRI profits. Yeah. One more time. That assignment transfers the share of partnership profits. However, a partner cannot, cannot assign his share. In partnership property, the assignment of the interest must be done with the consent of all of the partners.

It takes care of one exam question for you. Let's talk for a moment about dissolution. A partnership may be dissolved for changes in the partners. If a partner goes bankrupt or the death of a partner, these may dissolve. A partnership doesn't necessarily do it. A new partner can become a member. A, let me try that one again, a new partner can become a member of a partnership only with the consent of all partners.

And why is it so important? Remember corporate situation, we have something called free transferability of interest. I can sell my stock in a corporation, but all I am is holding an ownership interest. The partners are really a very different type of arrangement. They have banded together in a common interest, but they know each other and they are agents and principles with respect to each other.

So a new partner can't come into that partnership unless all of the other partners consent. It's a matter of trust that new partner is not personally liable for any debts prior to his or her admission to the partnership. However, that partner is liable for obligations made out of his individual contribution and certainly is liable for any of the partnership debts that arise after that partner has been admitted to the partnership.

Well, what about the partner who gets out the retiring partner that retiring partner is liable for all of the existing debts up to the date. Of his or her departure from the partnership, unless the creditors agree to innovation. What we're asking for here is a substitution of the debtors. The old partner has taken off new partners, either the new partner has put on or the remaining partners assume that part of the partnership debt for the retiring partners.

This novation must occur with the consent of the creditors. And this is very important. When you're dealing with partnership arrangements and partners leaving they remain liable on the debts unless there is a novation. This is one of the frequently asked exam questions. Novation is usually the correct answer.

There. Other possibility is rescission and it may be one of the choices. Generally it's novation rescission is a possibility. Now there are certain things that must be done within a partnership and can only be done with the unanimous consent of all of the partners, submit partnership claim to arbitration, assigned partnership property to creditors change the nature of the business.

Confess a judgment or in other words, agree to a legal judgment against the partnership, admit a new partner or sell Goodwill. These are items that go to the heart and soul of why partners agreed to create the partnership and carry on the business. So in the interest of trust, and as we said, at the very beginning of the program, the agency relationship, these require these acts require the unanimous consent of all of the partners.

Well, as we talked about in part one of the partnership program, a partnership is not a taxable entity, profits and losses flow through to the shareholders and re are reported on their individual returns. Here's the general rule profits and losses are shared equally absent agreement to the contrary. So if there are three partners, you would normally expect all profits and losses to be shared one third by each of those three partners, it is entirely possible.

However, for the partners to agree on different profit and loss sharing ratios. While this may occur, it needs to be set forth in the partnership agreement. There are certain very significant tax consequences that may occur and it is not something to be done lightly. So most partnerships will generally start with profits and losses being shared equally based on ownership, interest.

If a partnership mentions only losses, partnership agreement only talks about how losses are going to be shared. Then profits are shared in the same manner as the losses. What we've done now is we've created partnerships. We've operated the partnerships. We've talked about provisions that require the consent of the partners.

We've flowed through income and losses from operations over the years. Let's talk for a moment about dissolution. If we wind up the partnership, dissolve it, clearly payments are going to go out in payment to creditors and partners. There is a payment priority order. First, all creditors must be paid. So the creditors a paid out now what's left.

If there are loans that partners made to the partnership, those loans are repaid to the partners. Next partner, capital contributions are repaid, and finally, any profits and losses are the lowest priority. So creditors. Partner loans, partner, capital profits, and losses. Here's the thing started looking at the REG CPA Exam questions.

When you were looking at, let's say financial statements of a partnership and I'm just reviewing quickly. So the counting that you remember, but on the problem, the left side of those financial statements, they're going to show assets and profits the right side liabilities. Loans to partners, loans to creditors and the capital accounts and the net difference is the potential profit or loss sharing amount.

So take a look carefully at the problem, how it's set up and identify those numbers. Before you begin to try and answer the question, let's turn to something that I mentioned is becoming more and more significant in the. The real world, let's call it the real world of tax, advising of financial planning of legal work for clients.

That's limited liability companies. Although it's been slow to get on the exam, I'm expecting to see a lot more of questions dealing with limited liability companies. LLCs. These really are a creature that grew out of state law beginning in Wyoming. Back in the 1970s. If you recall, from some of your reading, I old enough to remember the law before it changed.

We had C corporations, we had partnerships and then we had a hybrid called a S corporation. That was a corporation that elected flow-through treatment. Each one of these had certain advantages, but none of them had the advantage of providing limited liability to all of the owners. Plus flow-through tax treatment and a great deal of flexibility.

The limited liability company fills this niche. They were originally created, as I said, in Wyoming, every state, the district of Columbia and now have limited liability company acts. They are legal entities, which must be set up under state law. There's an interesting concept to these because they may have either a single member or a multiple member.

So I could have an LLC of which I am the sole owner. I'm not called a shareholder or a partner I'm called a member. And a single member LLC is treated like a sole proprietorship. Or if that single owner is a corporation, it's simply treated as a division of the corporation in effect, even though it's called a limited liability company is a disregarded entity.

On the other hand, an LLC that has multiple owners, multiple members is treated for tax purposes as a partnership. So it's going to follow all of the partnership tax rules and file a partnership tax return. So let's focus on a quick review of the LLC is a creature of state law. Every state has them today.

It provides limited liability to all of the members and members are the name is the name used for an owner and it has flow through tax treatment. A single member LLC that's owned by an individual is treated as a proprietorship for tax purposes. A single member, LLC, that's owned by a corporation is treated as a disregarded entity or a division of the corporation and a multiple member LLC is treated as a partnership.

Besides the limited liability company. You'll also hear about a limited liability partnership or LLP. These LLPs are also established under state law. And they are slightly different from the L L C a partner is not personally liable for the negligent acts of his or her own partners has limited liability from such actions as slips and falls on the property or those types just as we looked for limited liability in the corporate environment, but the partner is liable for his or her own negligent acts.

For partnership contracts and for subordinates. Well, you'll ask me, where will I see an LLP? These are generally the professional partnerships. All of the largest accounting firms in the United States are for are organized. Today is limited liability partnerships. In addition to the limited liability from some aspects and the inability.

To get liability protection for your own and subordinate negligence partners in an LLP are jointly and severally liable for contracts and torts. That little CPA review should help you. If you begin to see LLC or LLP questions on the exam, few final clues. Remember the difference between assigning a partnership interest in partnerships.

Yes, it can be done. And it's an assignment of profits and an assignment of partnership property. If the question is worded that way that cannot be done because a partner does not own partnership property focus on the authority types coming out of the agency rules, implied express or apparent. Remember on what happens on the dissolution of a partnership.

The profits are going to be split. And you have the question of liability. The new partner only takes liabilities after the date of admission to the partnership. The old partner remains on those liabilities is pre-existing liabilities. Unless there is an innovation, a new partner cannot be admitted except with the unanimous consent of all of the partners.

Generally, a partnership agreement can be oral. Unless the partnership is intended to last for more than a year, or it undertakes a real estate activity, which would require it to be in writing under the statute of frauds. And finally, a joint venture is a partnership put together for a limited purpose.

I'm Jack Norman. And in this module, we're going to discuss corporations. This is an area that's a bit hard to pinpoint exactly what you might expect on the exam. There are many ways that the examiners can test your knowledge of corporations, but let's begin with the organization of a corporation. There is a promoter, this is an individual, or perhaps a group of individuals who undertake to form the corporation.

You must remember that they are liable on contracts that they've made during the organization process, unless the promoters are released through a novation. In other words, they are taken off of those contracts. The corporation itself is not liable unless it adopts the promoter's contract. And literally they must adopt that con those contracts, because a corporation was not in existence when they were formed, when the contracts were formed.

In other words, since they weren't in existence, they can only adopt, they cannot ratify the contracts that the promoters may have made. It's an important concept that you may well see on the exam, the promoter is liable on any contracts made, unless, and again, we're reinforcing this concept unless that third party releases the promoter through a innovation that is in effect a substitution of the debtor with the consent of the creditor.

And you remember in some of the other. Legal discussions that we have in reviewing for the exam. We do talk about the concepts of novation. So you might want to take a look at those also in conjunction with the corporate discussion incorporations, they are organized under state law. So, so for instance, I'm an attorney in Virginia and I would file papers with the state corporation commission in Virginia to create a domestic Virginia corporation.

And by domestic, we mean that's a business that operates in the state in which it's incorporated. I have filed and created a Virginia corporation. The alternative concept is something called a foreign corporation. And here we don't mean outside the United States. We mean a corporation that does business in a state other than the state, in which it was incorporated.

For example, Many United States corporations, the larger corporations are incorporated in the state of Delaware. They're Delaware, domestic corporations, but they conduct business in any number of States. And in those other States, they are indeed foreign corporations. Well, what's the significance of being a foreign corporation.

First of all. You must file a fee in the States for the privilege of doing business within that state. Now that's not every transaction. If you had an isolated incident, you'll not have to do file for the privilege, but generally carrying on a business in a state requires your registration with that state.

This means having an office phone service, directory listings, employees, all of those aspects require the. Corporation to register in that foreign jurisdiction. Needless to say the result was going to be that your corporation. And again, let's take my Virginia corporation. I will have to file registration documents, pay annual fees, pay income tax to the state of Virginia.

As a domestic corporation, I will be equally liable for filing similar documents with all those States in which I do business. All of those foreign jurisdictions. Suppose the corporation does not file in those other States. They don't comply with the state laws. They are operating in the state without being registered there.

This may result in them being barred, the corporation being barred from suing on contracts, not being able to use the courts in that foreign jurisdiction. And furthermore, there may be fines or other sanctions for failure to comply with state law. Those are the basic rules. And you must be clear on the distinction between domestic and foreign corporation.

Remember when you see foreign in exam, generally it is not a discussion about outside the United States. It's about outside the state in which the corporation was organized sometimes on the exam. You'll see a mention of the word towards professional corporation. What is a professional corporation? It is indeed an incorporated entity, just like someone carrying on a manufacturing or retail business, but it is composed of individuals generally, who are performing in one of the learned professions.

They may be doctors, lawyers, architects, engineers. And you remember from your law review days that corporations provide limited liability for their shareholders. One of the special rules for professional corporations, which you must bear in mind for. the REG CPA Exam is the professionals who are shareholders of professional corporations cannot be protected for their, from their consequences of any negligent actions.

So they may still be sued and still liable on negligence. Even though the organization is a professional corporation. Let's go to the process of setting up a corporation and something called the certificate of incorporation. This is the key corporate document. And in it, you will find the corporate name, the purpose for which the corporation was organized and many corporations.

That purpose will be. To carry on all legal activities, including, but not limited to dot that dot the dot. And in that case, it's a very wide ranging scope. Any legal activity can be carried on by the corporation. You will also find in the certificate of incorporation, the duration that the charter will last most corporations will now go for perpetual duration.

In other words, Some events will have to terminate the corporation, winding up liquidation at the behest of the directors and shareholders. And it will not expire after a period of years. In addition to the certificate of incorporation, we'll talk about the capital structure, how many shares are authorized?

What is the par value or the stated value of those shares? Whether there are multiple classes of stock. So then entire capital structure will be. At least outlined initially in the certificate of incorporation, the certificate must include the registered office and registered agent of the corporation.

And this is the person to whom legal process is given. I as an attorney in Virginia who have set up some corporations and the registered agent for corporations. So if that corporation is to be sued, I am the person who is served the official documents. In addition, the state corporation commission and Virginia will use me as the point of contact for any governmental inquiries, with respect to the corporation.

Finally, most certificates of the corporation will enlist the incorporators and. In Virginia, only one incorporator is needed. This will vary by state law. You don't need to know all of the particulars, but you should be aware of these general criteria that are included in the certificate of incorporation name, purpose, duration, capital structure, the registered office and agent and the incorporators.

Now let's talk a little bit further about those stock capital structure, stock provisions. Generally the certificate is going to list the number of shares that are authorized. And all that is, is the government saying you've told us you would like to be able to issue. Let's just say a thousand or 10 million shares, whatever the incorporators want.

That is the authorized stock. We also have the number of shares issued. This will not be in the certificate, but this is a. Factor that you will take into consideration in both your accounting work and in the legal discussions in notes that surround the financial statements, how many shares that were authorized have been issued.

And these are actually the shares that have been distributed to shareholders after they've made the payments for the value that's required to obtain a share. Finally, there are outstanding shares now. Generally, you're going to begin with the number of issue. Chairs is the number of outstanding shares.

Those shares in the stockholders hands. However, as you remember from your accounting days, the corporation may require shares from the shareholders. They may buy them back. These become treasury shares. So if you have treasury shares, the number of shares issued may not equal the number of shares.

Outstanding. In the notes to the financial statements, you'll discuss the authorized issued and outstanding shares. There will also be a discussion of treasury stock, which is that required by the corporation. As I just mentioned, there will be no voting preemptive nor dividend rights. With respect to treasury stock.

As a general principle, all shares of common stock each have one vote, one share. One vote. There may be special classes of common stock with that is not true, but for your principles of the exam, start by saying each share of common stock has one vote. Each share of common stock is entitled to a common share dividend.

If the dividend is declared by the board of directors and remember the dividends do not have to be declared. That is a matter of discretion for the board of directors. If they are declared, however, each shareholder receives a dividend for each share of stock held. And finally, with respect to common stock, there is no priority of those dividends either for any shareholder or over any other class of stock.

I think my basic principle is common stock is the residual ownership of the equity in the corporation. So think of the common shareholders as the holders. Of all that is left in the corporation after preferred shareholders are paid their returns. So now let's return. Now let's turn to preferred stock.

It is generally non-voting. You may find provisions in preferred stock certificates that say if dividends haven't been paid for a number of years, preferred stock, shareholders may obtain certain voting rights, but the general principle is preferred stock is non-voting. Often preferred stock has something called cumulative rights.

We'll explain those. After I tell you that preferred stock has a priority with respect to dividends over the common shareholders. So the board of directors declares dividends on preferred stock and common stock and preferred stock. Dividend is paid first. The common shareholders receive what is left now, the cumulative, right, which is one of the key features of preferred stock.

And I see it on most of the preferred stock that I am looking at these days, the cumulative right means that not only does the preferred stock have a dividend for the current year dividend, but if dividends have been declared in the past and not paid those dividends accumulate. Become cumulative over the years and all the prior unpaid dividends on preferred stock must be paid before any common stock shareholder can receive their declared dividends.

So with respect to preferred stock, you're going to see it having a priority in dividends, often having a cumulative, right. And generally non-voting and reviewing for the exam. Make sure you understand. How the cumulative stock cumulative dividend provision works on preferred stock. Another phrase that you may hear from time to time, although it is not very common in light of today's security regulations is watered stock.

What it stock is generally issued for fictitious values. Now on sec, registered securities, the oversight by the securities and exchange commission generally prevents watered stock. It may occur in unregistered as he sees securities that are issued under certain exemptions. Often, however, these problems are caught by state security laws as they review some of these transactions.

If you see the phrase, a blue sky law, blue sky, that's a state security law, which may hold issue is liable for misstatements or for watered stock, something along these lines. It's not terribly common in the exam, but you may see it. And it's just another little area that you should brush up on. Let's talk about stockholder's rights and liabilities.

I said a little while ago in a program that. Generally stockholders are protected from liability suits. What we'd have is something called limited liability in the corporate form. So to translate that over to a shareholder, right, there is no personal liability of a shareholder beyond the amount of their investment in the corporation.

Now, there is one caveat to that. The shareholders may be liable if the corporation was formed to perpetuate a fraud or to perpetrate a fraud shouldn't have say, perpetuate to perpetrate a fraud. The law mail out. Just sort of penetrating this corporate veil and holding the shareholders, liable for it, a very unusual circumstance.

It may happen, but there's a very high burden of proof in trying to get to liability for the shareholders. A shareholder must contribute to capital as mandated by the articles of incorporation. This is the present value. They may not contribute future value to obtain their stock rights. As I mentioned a little earlier, when we talk about common stock, the general rule is one vote for one share of stock.

Now there's a concept that I know you've discussed previously. It's called cumulative voting, and this is a way to give minority shareholders representation on the board of directors. Well, what is cumulative voting? Although you only have one share one vote. You also have the number of shares times the number of directors, which equals a number of votes.

So let's say that we have three shares of stock and there are five directors that are being proposed for the board of directors. This will give you 15 votes for the board. You own three shares, one vote per share five directors that comes up to a total of 15 votes. Now, what would you do if you have this cumulative voting, right?

You could put all of those votes to one, one, the directors. In other words, you could try and wait to make sure that at least one of the directors is supported by the minority shareholders. That's the concept of cumulative voting and it's designed. To protect minority shareholders. This must be allowed by the bylaws of the corporation.

You're not going to seek cumulative, devoting set out in the articles of incorporation. This is a bylaws issue, but in order to have killed with the voting, you must have it in the bylaws. Now, there are a couple of other concepts where shareholder involvement is quite important and one of them is in a merger or a consolidation of the corporation.

Going back to some of your law that you learned as you were going through school, a merger, two corporations come together. And one of those two continues. In other words, a corporation and B corporation get together. The result is either a, is a successor or B as a successor. That is a merger of two corporations.

Contrast that with a consolidation in which two corporations get together and become ineffective. A third corporation taking my example, a and B get together in a consolidation. The result is C corporation in both situations, merger, or consolidation. And majority of the shareholders of both companies must approve the transactions.

In addition to the board of directors of both corporations must approve. So normally when you see the newspaper reports of a takeover, a merger or consolidation, which we'll then see is first, the notice that the companies have agreed management generally has agreed on a merger or consolidation, then the boards of directors will meet to approve.

If they agree, then it will go to shareholders vote. And if a majority of the shareholders vote to approve the merger or consolidation, indeed, it goes through. What about the shareholders who don't agree? They're not happy with the merger or the consolidation. These dissenting shareholders have a right to have their shares appraised.

And if a court so agrees with them, they have the right to be paid that appraised value for their shares. Irrespective. Of what the merger or consolidation terms or another shareholder. Right. All the time I see less and less of it today is something called a preemptive, right? And this is a right of the existing shareholder to subscribe to newly authorized hairs in proportion to their existing holdings.

What's the theory of a preemptive, right? Well, if I own, let's just say 20% of a corporation. Other shareholders, obviously on the remaining 80% and they vote to issue additional stock. If they do, what's going to happen to my 20%. If I don't have a preempt, if right, it's going to go down. So the preemptive right protects the existing shareholders to maintain their proportion of their existing holdings.

In other words, I would be entitled to acquire enough of the new stock. To keep my percentage of the company at 20%, as I said, I don't see a whole lot of it today, but you will find many older corporations which do provide preemptive rights to their shareholders. Now here's a hint in taking the exam. The preemptive right.

Does not apply to treasury stock and it does not apply to any stock that is unissued under a prior. Authorization. So it only applies to existing outstanding stock while we're talking about shareholders' rights. Let's talk about a derivative suit. Derivative suit is an action brought by the shareholders in the name of the corporation against the directors.

So a shareholder is suing some members or all of the board of directors. In the name of the corporation for wrongs done to the corporation? Well, what does, why do we talk about a derivative suit? Well, think about who the owners of a corporation are. They're the shareholders, the board of directors are their agents.

So here the shareholders as owners are taking control of the situation and bringing a suit against their agents for harm done to the corporation. Any recovery. Goes to the corporation and not to the shareholders. So don't confuse a derivative action with an action by a shareholder. A shareholder can bring an action against the director, but it's not a derivative suit.

So shareholders can Sue in two ways, a derivative suit, which gives a return of any recovery to the corporation or shareholder can bring a suit and it's individual, right. Remember those for the exam. Finally, let's talk about shareholder rights. D a V I P. And you can think about this pneumonic this way.

Democrats always vote in Paris. If you remember, Democrats always vote in Paris and this is not a political endorsement. It's a pneumonic shareholders have the right to derivative action to asset chairs on disillusion. That's the a, they have voting rights. They can inspect the books and the records of the corporation.

They have a preemptive, right? Let's mention dividends. Briefly dividends are set by the board of directors. Dividends are binding on a corporation once declared, but there is no inherent right to a dividend directors are elected by the shareholders and they are subject to a business judgment rule. A director acting in good faith is not liable.

However, if they are negligent, they may be liable. And we've already talked about the derivative suits.

So for your exam, bear, these few points in mind, preemptive rights, rights of the shareholders, cumulative preferred stock piercing, the corporate veil foreign versus domestic. And Democrats always vote in Paris.

I'm Jack Norman, and we're going to discuss the government regulation of business. And our emphasis is going to be on the securities acts. Federal government has two major securities acts, which you absolutely must know about for the exam. The 1933 act covers initial offerings of stock. And here a registration statement must be filed with the securities and exchange commission and a prospective supplied to the investor so they can make informed decisions.

These are on initial offerings, the 1934 act on the other hand covers secondary. Offerings. So let's start with the first requirement to who must register with the securities exchange commission or the sec and issuer. That's the corporation who is going to be putting shares of stock out into the marketplace.

So the issuer must register with the sec, the underwriter who represents the corporation and issuing the stock must register a dealer. That's the person who buys or sells securities must register with the sec and any controlling person. Now we're going to find that in just a second, but remember a controlling person must also register with the sec that controlling person is anyone with a significant say in management.

Typically you're looking at a major shareholder when they're selling a substantial block to the public. They must reregister with the sec. And they then become the issuer. So we must have a controlling person registering with the sec. And then so often what happens is those majority shareholders, those people with huge blocks of stock, let's just take a bill Gates in the Microsoft situation.

When they sell substantial blocks of their stock, they reregister with the sec. And in effect, instead of being the corporation, they become the issuer of the stock. What is a security and here the courts have been very generous. The sec started up really defining it and the courts have expanded it.

Almost anything you could think of is a security stocks and bonds, investment contracts, limited partnership interest. The basic definition of a security is a, some form of evidence that someone else's efforts are making money for. You. Now notice one little trick in here. It's someone else's efforts. A partnership interest of a general partnership is not a security.

Why? Because all of the partners are involved in the business operations. Only the limited partnership interest is a security because a limited partner can not participate in management and is relying on the general partner and the others to make money for them. Securities must be registered with the sec before they could be sold.

And a prospectus must be handed to all investors. Now that broad requirements that I just set forth is subject to certain registration exemptions. There are certain types of securities that are exempt from registration, and there are certain types of transactions that are exempt from registration. So let's begin by looking at the intra state offering stocks that are part of an interest rate offering.

Do not have to be registered with the sec. And these are defined as those in which all operations are done in one state. 80% of the income of the corporation is derived from that state. And the stock is only sold to residents of that state. Even though these are exempt from sec registration. Most intrastate offerings must be registered with the state where they are being offered.

So there may be state security requirements that must be complied with an intrastate offering. Must require that the shareholders hold the stock for at least nine months before it is sold. The sec has issued several types of exemptions. One of them is a registration exemption under a regulation that was proposed was initiated by the sec.

Co-regulation a, a as in alpha, it is a simplified registration form. It doesn't require the full-blown prospectus and all the documentation, a regulation, a offering. Include securities of $5 million or less all sold within one year. Now, no perspective needs to be provided to the purchasers. There must be an offering circular, which is greatly simplified document, and it does not require audited financial statements under regulation.

A the issuer may solicit investors. There is also a registration exemption for no sale transactions. You like, I, when I first heard this phrase, no sale transaction, I think transactions that had to be a sale. What we're talking about are when a issuer give stock to existing shareholders. What's this stock options in mergers and consolidation, or when there are no sales to the public, there is an exemption register, registration exemption, an exemption from registration.

There also an exemption for casual sales by ordinary investors. And that one's not terribly Picked up on the exam. So I don't think you need to worry about that one. This one. However, this next one I'm going to mention is often appears in the multiple choice question and exempt security stock of charities and nonprofit organizations, stocks of federal state, local government entities.

So governmental entities and short-term commercial paper, which has that maturity in less than nine months are all exempt securities. So not-for-profits governmental short-term commercial payers.

There is a form of exemption on the under regulation D that the sec has also put out and you really need to know these three exemptions under regulation D they. SCC must be notified. If you intend as an issuer to issue stock and claim a reg D exemption, there are three rules under regulation D and here are a couple of the prerequisites for getting a regulation D exemption.

The stock must be held for long-term investment and it cannot be sold for immediate resale. The exemptions fall under rule five Oh four. Five. Oh five and five Oh six. And so often in studying for the exam, you see lots of numbers. You don't need to memorize most numbers. Most Cate times numbers, tables, rates, all that will be given to you on the exam.

But here is one area where you need to know the difference between rule five Oh four, five Oh five and five Oh six. Rule five Oh four, you can issue a maximum of $1 million of stock within a 12 month period to any type or number of investors. The issuer may not solicit the investors unless permitted by the state.

So any type, any number $1 million rule five Oh four. So rule five Oh five. $5 million, 12 month period. Any number of accredited investors? Notice five Oh four was any type of investors. Five Oh five is accredited investors. So what are accredited investors, banks, savings and loans, corporations. Wealthy investors.

And there are dollar thresholds set forth in the materials, the sec guidelines on it and insiders of the issues. Those are accredited investors. So remember under five Oh five, any number of accredited investors, but all of them must be accredited. There may be 35 unaccredited investors also, and these are ones that do not meet the accreditor definition we just discussed under five Oh five, no soliciting or advertising potential investors rule five Oh six.

There is no maximum dollar amount in an unlimited period of time in which to sell it here. An unlimited number of accredited investors and their Mo. There could be only 35 unaccredited investors who is the sec says must be sophisticated investors in a cell or advertised and five Oh six stock cannot be sold.

Before two years finally under five Oh six. If you have unaccredited investors, they must be given audited financial statements. So quick CPA review. Under regulation D in the sec, within 15 days, if you want to operate under this exemption, their dollar limits. $1 million for five Oh four, $5 million for five Oh five, no limit on five Oh six 3,500 and credited investors is the maximum the time to sell and their five Oh four, 12 months, five Oh five, 12 months, five Oh six, no limits.

So. Essentially what you're looking at under five, under the rules of regulation date is an expedited simplified method. You just have to make sure you touch every base to get the exemption. Okay. So if we summarize registration exemptions, remember the pneumonic I dance, D a N C E interest state exemptions, reg D reg a no sale transactions.

Casual sales or exempt securities, and you will be dancing your way to great grades. Turn now over to the, both the 33 and the 34 act and fraud. Anti-fraud provisions are included in both acts and they apply to all securities, including by the way, exempt transactions and exempt securities. So if you see a question on the REG CPA Exam where they talk about securities issued under reg D and fraud is involved, you can't.

Take an answer that says the penalties don't apply. They do apply even though they are an exempt transaction. There are civil penalties and there are criminal penalties. All right, let's focus now for a moment on the 34 act and sec registration, corporations must be registered. If their securities are traded on a national exchange.

If the corporation has assets greater than $10 million. And they have a class of equity securities on record of 500 or more persons. In addition to corporation exchanges, brokers and dealers must be registered with the sec and sec corporation. Registrants must file several reports with the agency. There is the annual 10 K.

And if you were working for either a corporation or a public accounting firm, and you have. As he see registered clients, undoubtedly, you will be reviewing 10 K's the annual reports, which include audited financial statements. And you'll also be looking at a 10 Q, which is a quarterly report, but that does not require audited financial statements.

The sec also requires a report called an eight K on unusual events. This report must be filed within 10 days of the event occurring proxy, solicitations changes in control, large stock transactions. These type of events. The sec requires a special reporting and those are available to the public. Now, as I hit on fraud a moment ago, I said both the 33 and 34 acts do go after fraud.

And I just want to keep, keep you. Well aware of that fraud provisions are on the exam. Reg D will probably be on the exams of a member five Oh four, five Oh five and five Oh six, the  exemptions, the reporting requirements of 10 K eight K and the 10 Q as well as remembering the 33 actives of the initial market.

Whereas the 34 act deals with the secondary market and registrations. You now have a complete quick overview and that's all it is of securities regulation.

I'm Jack Norman, and we're now going to discuss employment regulation. There are many provisions that we need to talk about and let's start with workers' compensation. This is basically state law, which covers the employees for injuries that they incurred during the S within the scope of their employment.

Now, what you have to understand is employees cannot waive their rights under workers' compensation, law, and they are basically designed. To lessen any litigation over these injuries. Most States have compulsory workers' compensation laws, a few States. It is elective. Although most, most companies do not elect out.

They do go into a workman's compensation rule and every so often you will find a self-insurance fund again, a rare situation. So let's focus on the compulsory state rules and see how a workers' compensation system works. The worker is injured and they do not turn around and Sue the employer unless that injury was intentionally inflicted upon them by the employer.

So the employee instead sues the employee, yours insurance carrier under the workers' compensation arrangement. These rules in the workers' compensation arena are very, very interesting. An employee can recover compensation, even if that employee was grossly negligent the. No, they saw the accident about to happen.

Did nothing grossly negligent, still are entitled the workers compensation. They can collect if a fellow employee causes the harm or the injury they can collect. If they assume the risk of doing something they can collect when they disregard the employer's rules about workplace safety, workers' compensation is.

Really a protective umbrella. If that entry results from a fellow employee from gross negligence assumed risk. In all cases, the worker will collect. There are really only two or three areas where workers' compensation will be denied. If the. Worker were intoxicated or under the influence of a narcotic drugs.

They would not be able to collect if the injury was self-inflicted for some particular reason, or if the injury was the result of a fight even on the employer's premises among coworkers, then they will not be entitled to collect negligence. Just as we said gross negligence, any, any form of dangling does not bar recovery.

Now what happens if you are injured by a third person, it's somebody that has come on to the premises. It's not the employee or work site and the activities going on there, but a third person, then you do have the right to Sue that third person for additional compensation. You can Sue the carrier.

If the carrier pays you, then the, a carrier goes after the third party and has subrogated your rights. So you could go after the third party or you could Sue the carrier and subrogation arises. So that's the workers' compensation regime. A second. Program comes under both federal and state law. And this is the unemployment insurance we have at the U S government level.

The federal unemployment tax act, commonly known as Fooda. Now this is where the employer contributes money into the treasury department. There are no contributions from the employee. There is a companion piece called the state unemployment tax or Suda. Now the federal rate is set. State rates may be adjusted and they very frequently are based on the number and frequency of unemployment claims that are filed from a particular employer.

So while the federal rate is set, the state rates may be adjusted. Remember that even under the state plan, the employer only contributes. The employee does not. How can you, when do you collect unemployment benefits? If you are discharged. Through no fault of your own. In other words, downsizing, the workforce layoffs, those types of things will entitle you to unemployment insurance.

However, if the employees had, I just don't like the job I quit and this happens very frequently, they will quit and then go to the unemployment office to collect on insurance, unemployment insurance benefits. They are not entitled to collect there. This only applies to employees. So unfortunately self-employed individuals cannot collect unemployment insurance.

We've talked about now compensation for injuries and for unemployment. Let's talk for a moment about Cobra, the federal consolidated budget reconciliation act, which provides for medical insurance for a limited period. Probably health insurance is one of the biggest issues in facing many employers today.

If the employer does provide health insurance, And former employees or quit fired or laid off, they can, if they were previously covered under the insurance plan, retain coverage for a period of somewhere between 18 and 36 months. And this is called Cobra insurance. It's a run-on insurance. The employees will be pro paying the premiums with respect.

To the Cobra insurance, but it's an incredibly valuable benefit. If one, they had insurance while they were working there. And two, as a transition piece upon termination of employment known and loved by all of us is something called FICA. The federal insurance contribution act. This is a tax that for employees, you know, is withheld from your paycheck.

Self-employed individuals pay. The amount on their tax returns each year under FICA, both the employee and the employer make payments the employer withholds and transmits the withheld taxes and makes his payments directly upon retirement or potentially even disability. The individual can collect their benefits under.

Two different trust funds that are set up under FICA. One is old age and survivors and disability insurance. The OSDI, the second half of the monies goes into the Medicare trust fund under OSDI. You certainly can collect more than Q contributed. The tax consequences. Started out initially as completely non-taxable today, they are subject to income tax based on a graduated rate schedule a, which is dependent on the taxpayer's income, other than social security.

I did mention that self-employed individuals paid FICA in this particular case while they pay the full amount for both the employer and the employee share, they're entitled to a deduction, which will bring them back to a. Hopefully a parody with the employer employee situation. We talked earlier in the program about.

The injuries. We have another federal agency, which is charged with oversight of the workforce workplace. The occupational safety and health act just set up the OSHA administration within the labor department. Their mission is to ensure a safe working environment and it implies to applies to both employers and businesses engaged in interstate commerce.

OSHA has inspectors. Who go out to work sites, go to businesses to determine if the premises have any conditions which are deemed unsafe now for an inspector to walk in. They need probable cause unless the employer says you are welcome to come in. So generally OSHA is going out based upon either reports of unsafe conditions that have made it into the newspapers, to a whistleblower, something like that.

Or they may have found a pattern in certain industries. And then we'll go to various businesses in that industry to say, can we come in and inspect employees may make complaints and OSHA protects these employees. They you cannot take retaliation against an employee for making an OSHA complaint. OSHA also protects the names of these individuals who are making payments.

The administration requires all employers to keep and make available a record of all accidents on the job.

Shift our focus now from injuries to discrimination. And here we're going to be looking at the civil rights act of 1964. And particularly title seven of that act, the civil rights act established, it established the E O C the equal employment opportunity commission and prohibits sexual harassment and employment discrimination based on race, color, religion, sex, or national origin.

Notice, one thing I did not mention in there. The civil rights act of 1964 has absolutely nothing to do with age suppose a civil rights complaint is brought against the business for a violation of title seven. What defenses does the employer have? Well to bonafide defenses are occupational qualifications.

We did not hire this person because they could not meet the requirements for the job. And these have to be bonafide qualifications, just to say, as there was a case that said fire department would not hire women firefighters because they said, well, they can't do the work. Well, OSHA came in and said, prove it.

Let's have it test and see whether there are women applicants who can do the test that you make the men go through. If they can, you've been discriminating. If it is a bonafide occupational qualification, it's a defense. Another defense is seniority or marriage arrangements. These may be negotiated with unions or simply the company's own seniority or merit plans.

That too is a valid defense to a title seven complaint. Since I mentioned the civil rights act did not protect against age discrimination. We turned to another act, the age discrimination and employment act. Which prohibits discrimination against workers over the age of 40 notice, there is no problem with this guy, anything against people under the age of 40, this is to protect the older workers who are discriminated against on the basis of age.

Another act. This one from 1973 is the rehabilitation act. It applies to federal contractors. And there must be affirmative action in hiring otherwise qualified handicapped individual individuals. In other words, the government is trying through this particular legislation to mainstream or bring people with handicaps further into the workforce.

We also have to look at the equal pay act, which will have its wage discrimination on the basis of sex. We cannot discriminate in pay rates between men and women who have the same qualifications and coupled with the discrimination arrangements are the Americans with disabilities act, which protects disabled individuals from discrimination and guarantees equal access to services.

The civil rights act of 1991 reaffirms the rights of complainants, alleging employment discrimination. So you could see, we have a multitude, a whole panoply of federal legislation dealing with various types of discrimination. All are basically anti-discrimination provisions from. Age sex pay national origin, even handicapped status.

In most cases, the defense that a company may raise is that if there are bonafide reasons, bonafide reasons, or particular seniority or merit arrangements that will protect them against discrimination charges. And while we're talking about discrimination, let's raise the concept of reverse discrimination.

And these are challenges to some of these affirmative action programs that were designed to bring in a protected class. So what has happened is some in the past federal programs would say, because we have an under-representation of a protected class, be they minorities or women. We want to. Make extra special efforts to bring them into the workforce.

This was called affirmative action. Some of these have been challenged as a reverse discrimination type of arrangement, and the courts have been on both sides and addressing some of these issues. It's one for you to take a look at the reading. I do not expect reverse discrimination to be included on the exam.

A big, big act from a few years ago, but has major overarching implications. Even today, the employment retirement income security act of 1974 or ERISA, it provides rules for companies who set up retirement plans, but it does not require an employer to establish a retirement plan. So whether. Pension or profit sharing arrangements are going to be offered by an employer is the employer's decision.

But once the employer decides to offer a plan, ERISA kicks in and it has lengthy lengthy rules, both under a title called the labor title and under a second and parallel title called the internal revenue code, large parts of the internal revenue code deal with qualified plans. It's part of ERISA. The labor department also has rules, which are a different title of ERISA, but have parallel requirements.

And then a third title of Orissa deals with pension benefit guarantee, insurance payments, which guarantee pension plans, but not profit sharing or other types of retirement arrangements. Well, what is the risk to contain? First of all, it has rules about employees. Well, he contributions then must vest immediately.

It has investment standards and it has a myriad of other rules on forms of payment, times of notices. It is constant, totally being amended. So again, you need to review the text to make sure you've picked up on the most recent changes that affect ERISA plans, qualified plans under the internal revenue code and plans governed solely by the labor department.

Well, we're talking about the labor department. We also need to mention the wage and hour law, the fair labor state standards act, which came out of the 1930s, provide standards on overtime, minimum wage and child labor guidelines, lines. All of this leads me to a couple of clues about taking the REG CPA Exam in this area of employee benefits and employment arrangements.

Understand the key points of all these various statutes. The underlying theme of most of them is anti-discrimination fair treatment of the workers, a safe workplace employers. They're given defenses that are predicated upon common sense and bonafide. Restrictions, for instance, bonafide job qualifications, bonafide seniority, or merit plans.

Those type of defenses are available almost across the board on the discrimination statutes. So here's how I would approach it. Have in your mind, a list of these major programs and when addressing a question, use your common sense. Congress enacted these as benefits for the employers, for the employees, with protection, for the employers, benefits for the employees with protection for the employers, use your common sense and YouTube will come to the right end.

Sure. Antitrust regulation, a very interesting topic and brought to you by two antitrust regulators. The primary group to enforce antitrust laws is the federal trade commission or the FTC. But the justice department may also be involved and you will frequently see stories about justice department litigation over antitrust matters.

These two agencies focus on three antitrust laws. Each of which you need to have a little bit of knowledge of for the CPA exam, the Sherman antitrust act. The Clayton act and the Robinson Patman act let's begin with the Sherman antitrust act, the oldest of the three, it prohibits any contract combination or conspiracy to restrain trade.

That is a prohibition. Now in implementing the Sherman antitrust act, the. Agencies, the courts have focused on sort of two different approaches. The first is the rule of reason. And what did we've said is we're going to evaluate particular contracts or combinations or practices under a. Rule of reason reasonable restraint of trade will be allowed in the interest of making the system work.

Remember, we are in a free enterprise competitive environment. Just chaos will not work. We have to have a certain amount of organization within the marketplace. So this is under the rule of reason. And for instance, vertical price fixing. Is tested under the reasonable the rule of reason. We can have either maximum vertical price fixing or minimum vertical price fixing.

At one point, the maximums were allowed under the rule of reason, whereas the minimums were per se, bad, recent changes have put both of these, any vertical price fixing under a rule of reason. However, we also have something called per se violations. This is where the agency has come down and said, if you do these things, we're not testing under a rule of reason.

We're saying these are violations for which you will be prosecuted, horizontal restraints on trade, where you keep somebody out of competing. Now, those indeed are per se violations. Price fixing on a horizontal basis is a purse, a violation, an agreement among sellers to allocate market shares. In other words, I will Mark it in this part of town or this part of the state.

You stay out, but I won't come and compete in the areas. We were dividing up the markets that is a per se violation boycotts. And our violations that are per se as our tying arrangements. Now you probably know horizontal, vertical. What is a tying arrangement? This is where you say you can only buy this product from us.

If you agree to buy this product, you've tied together. Two products. Now I must tell you there, there are certain exceptions, for instance you can have a tying arrangement to maintain a warranty. An auto dealership could say you bought our car. And as long as you want the warranty on this car, you must bring it back here for service and use.

Our parts, that's fine, but in general, tying arrangements are per se violations. And why? Because the purpose of the antitrust laws is to have free and fair competition. Most particularly at the horizontal level. Now you always hear the term monopolies bandied about monopolies themselves are not evil.

Monopolies can come about naturally. If you build the best mouse trap, everybody will want to buy it. That's a natural monopoly with the Sherman and the en and the Clayton antitrust. Ex-co go after his actions to maintain or perpetuate a monopoly. So while a monopoly is market power, that's okay. What's prohibited is action to maintain or enhance that money happily.

And I could give you a hypothetical from the last few years of a very successful software company that became a monopoly or virtually a monopoly where they prosecuted by the justice department for that. No, but when they began to tinker with certain aspects of that software package, in order to prevent other things from being added to it by other parties now, suddenly we had an action to maintain or expand the monopoly, which brought justice and FTC scrutiny.

So be careful of the definition of, of monopoly. The monopoly is market power. The bad monopoly is when you couple that with action to maintain or enhance. The monopoly, the Clayton act particularly focuses on illegal mergers. They are, the Clayton act was designed to actually set aside or prevent any mergers, which lessened competition.

And in this particular case, they look at horizontal mergers, vertical mergers, and conglomerate mergers. And we're not going to get into all of the aspects of merger law today, but you can think of horizontal merger take, for instance, suppose office max and office Depot decided to merge. That would be a horizontal merger.

Would it be so big that it control the marketplace perhaps? And that would be something that would be looked at under the Clayton act, vertical mergers. Now let's take an upstream and a downstream business and pull them all together in one activity. The classic example of this was when John Rockefeller put together the standard oil by going from the fields to the tank cars, to the refineries, to the retail distribution of refined gasoline.

He pulled all of the various pieces in a vertical chain. Into a merger. The result of course, ultimately was the standard oil trust arrangement was broken into a number of different oil companies left the vertical pipelines intact, but forced the pipelines to compete the pipelines to compete against each other.

And by pipelines, I don't mean that we're just carrying the oil. I mean the whole vertical chain and in the conglomerate merger. These were thought at one point to not particularly be under the scrutiny because they would either horizontal or vertical is taking unrelated businesses and putting them together.

But indeed the Clayton act has been used to even prevent certain conglomerate mergers because of the massive power that they would exert in the marketplace. So the focus of the Clayton act remember is always lessening competition, and it's focusing on preventing mergers. That would lessen that competition.

The third act that I mentioned at the beginning of the program was the Robinson-Patman act and it prohibits sellers from giving different prices to different buyers. What they're saying is you can't discriminate. If you're selling a single product, a uniform product, you can't discriminate among your buyers.

Now that sounds like a very good general rule, but listen to the exceptions. If you can justify the exceptions because of cost. And the cost, for instance, may be the cost of shipping it. Your product is the same essential price, but the cost is paid by the, your buyer is going to be different because of cost justifications or that Particular buyer may want special packaging or might want something placed on the product may want their name engraved on a pen.

So those cost justifications do provide a valid exception to re Robinson Patman. You can have a discriminatory pricing. If it is designed solely to meet competition, your competitor reduces the price on a particular airline route. You can reduce your price. To meet that competition or raise the price if they've raised theirs.

So meeting competition is the second exception. And of course, if you were selling perishable goods, you are not prohibited from giving different prices to different sellers in order to clear your inventory, which is going to be perished. If you don't, don't get it out off your shelves. So those are the three statutes.

Let's go back and give you your exam clues for this segment of the CPA exam. No, the three major statutes, the Sherman act, the Clayton act, the Robinson-Patman act and the key points under each one of them. The Sherman act is focused on actions that may lessen competition. We generally operate under a rule of reason.

But there are certain per se violations, particularly in the price fixing arena under the Clayton act, we were looking at breaking yeah. Or preventing mergers, which will lessen competition and Robinson Patman deals with discrimination in pricing those things in mind and using your common sense will help you through any questions you may see on antitrust.

I'm Jack Norman. And we're now discussing ethics for tax practice. A CPA is subject to several ethical regimes and let's run through these very quickly. And I'm going to say that these in my mind are the base rules. This is the requirements of the AICPA and the treasury department. But as you and I all know ethics.

Speaks to a higher standard. Nevertheless, the ethical regimes that automatically covers CPA in tax practice are the code of professional conduct to the AICPA, the CPA statements on standards for tax practice, the regulations of the state board of accountancy circular, two 30 issued by the department of the treasury and the penalty provisions of the internal revenue code.

Let's start this discussion with circular two 30 issued by the treasury department. It is not found in the internal revenue code. It is part of title, one of the U S code and applies to all persons practicing before at the treasury department. If you're going to be doing tax work, you are bound by circular two 30.

It contains both ethical guidelines and disciplinary rules, and let's take the harsh part. First, a practitioner can be barred from practice before the IRS censured or fined. In addition, the firm can also be sanctioned, and this is handled by the office of professional responsibility, which is located in the IRS, but is part of the treasury department.

If there is an OPR action against the practitioner, there is an automatic referral to the state disciplinary body. So now that we've dispensed with all the ugly stuff, you'd never want to see the office of professional responsibility. Now, many of the requirements of circular two-thirty are similar to the ACPA rules.

For instance, due diligence. Client and return confidentiality, disreputable conduct, et cetera. And if you're going to be practicing before the IRS, you really need to have circular two 30 close at hand. In addition, the circular sets forth requirements to sign tax returns, provide a copy to a client and standards for positions taken on tax returns.

Many of these standards that are set forth in the circular. Parallel very closely, either specific provisions in the tax law itself or in AICPA standards. The circular also contains specific requirements related to tax shelter opinions, and to other written advice given to clients of tax practitioners.

Let's talk about what a tax preparer is, and there are several definitions. In internal revenue code, section 67, 13, which is the civil penalty for unauthorized use or disclosure of information. A prepare is a person who is engaged in the business of preparing returns or who provides services in connection with the preparation of returns or who prepares return for compensation.

And by the way, who prepares returns for competition also includes a person who prepares part. A material part of a return, even if they are not signing the return. If we turn over to code section 72 16, the criminal penalty for knowing or reckless user disclosure of tax return information, it's quite similar, but it includes a person who was engaged in the business of preparing or assisting in preparing returns is engaged in providing auxiliary services and connects you with return preparation.

Is paid for preparing or assisting in preparing that return or perform services that assist in any of these activities. I just enumerated. And I think you could see from these two definitions, it is a very broad net of who a tax return prepare is one of the key elements of, sorry, two 30. Now the ICPA standards.

And of the tax code itself is code section 66 94, which is a rule that sets forth a penalty imposed on a taxpayer and only tax prepare on a tax return preparer. Now, the penalty on the. Taxpayer is 66 62. And that's not really the focus of our discussion, but it is the same as the penalty on the preparer, 66 94, which is our focus.

And that apply that penalty applies if there's a substantial understatement of tax and that position is not sustained by the IRS and the penalty may be avoided if. Several things happen. First of all, the taxpayer and the tax return, preparer acted good faith acted in good faith and with a reasonable call, there was a reasonable cause for the understatement.

That's sort of a very subjective test. Now, a more concrete way to avoid the penalty is that the position is based on substantial authority. So you've taken a position you've reviewed. The all the facts you've researched the law, you've applied the law to the facts. And you've concluded that your position that you're taking on the return has substantial authority behind it.

That's the safest way. You may also avoid the penalty if there is a reasonable basis and there is adequate disclosure. So you. Believe that there is a reasonable basis, which has a lower standard of substantial authority. And you make disclosure on the tax return of this position being taken. So three ways to avoid the penalty first and probably easiest.

Meet the substantial authority rule second, have a reasonable basis and adequate disclosure. Or thirdly, and as I said, it's based on the surface accepting your good faith and reasonable cause use that facts and circumstances test. Now you're going to say, I don't quite know what reasonable basis substantial authority, what are we looking at?

Well, substantial authority. Does not mean that the position is more likely than not, which would be a greater than 51% standard, but it's a standard probably have at least 40% and it could be backed up by the research done on the law. And on the weight of authorities found in the regulations under 66, 62.

What is a reasonable basis? Well, that's probably somewhere below 40%, but above 15%. So it's not first. If you looked at the highest standard, you'd say it's more likely than not. That's 51%. We don't have to beat that test under any of the criteria. We do have to have substantial authority, probably 40, maybe as low as 35%.

Reasonable basis, at least 15, I'd like to push close to the 35 to 40% level. Now there's another provision in 66 94 that you need to be acutely aware of. And that's the tax shelters and tax avoidance transactions. Can't meet that substantial authority test. They must meet a more likely than not standard more than 51% or a penalty will be imposed.

The Congress has also taken and codified into the tax law. Something called the economic substance doctrine. This was a principle that has long permeated judicial decisions saying that for a tax position, taken on a tax return by a taxpayer and it's prepare there had to be an economic substance to the transaction.

Congress has codified this into the internal revenue code and impose saying that there are penalties for any transaction that lacks economic substance. You can do a disclosure. As we mentioned with a reasonable basis, you can also do the substantial authority. You can make those arguments, but if the.

Service and the court sustain and economic substance doctrine, the penalties is going to be impossible and there is no way that you can get relief from the facts and circumstances. Test of good faith and reliance on the advice of a tax preparer. Let me turn over to tax shelters, a subject that has been much in the news over the last few years and Congress, the IRS, the treasury department had been working very, very diligently to shut down a tax shelter.

A tax shelter has a material advisor. And each material advisor, which one way, somebody who puts the deal together may help sell it provides opinion on it. A material advisor must file an information return with the IRS. And this includes tax shelters that are reportable transactions and listed transactions.

And the IRS periodically puts out on their website and in administrative pronouncements, a list of reportable transactions and listed transactions. There are a number of them. There are abusive transactions and the text material will tell you that you have to keep constantly looking at the high-risk guidance.

Because it changes periodically. Well, who is one of these material advisers that is required to file an information return it's anyone who provides material aid or advice with respect to organizing, promoting, supporting any reportable transaction. Or any list of transaction and who receives gross income in excess of $50,000.

Now, generally a tax return preparer is not going to be receiving compensation in excess of $50,000 for preparing the return, but very frequently, CPAs who do prepare returns may provide assistance to tax shelters. And in this particular case, they may become one of these material advisers. There is another penalty imposed, dealing with tax shelters, and it's called the 67 Oh seven penalty.

It applies to reportable transactions and to listed transactions and the penalties are $50,000 for a reportable transaction or in the case of a listed transaction, the greater of $200,000. Or 50% of the income derived from that transaction. In this particular case, a taxpayer must file a disclosure statement attached to the return.

And let me assure you while the penalties may be imposed on taxpayers, any taxpayer return preparer who does not assure that the taxpayer files those appropriate disclosures. Is probably going to be hit with a plea from the client for the funds. I've talked about circular two 30 and I've talked about the internal revenue code here.

We're looking at federal statutory and administrative rules that govern the practice before the IRS and treasury department. Let's turn over to the AIC PA. The ACPA has had longstanding state and interpretations on ethics and tax practice. There are currently seven state books and two interpretations.

Many of these are paralleled by the provisions of circular two 30. There is nothing really surprising in the. Statements, except to note that statement. Number one, tax return positions has two interpretations, and this statement has been revised by the IRS to say, we're not going to lay out reasonable basis or substantial authority, or more likely than not.

We're simply going to say that the tax return preparer must take a position on the return that is consistent with the rules. Of the texting authorities in the jurisdiction where the return is being filed in effect froze you under the federal rules for a federal tax return or under an individual state's taxing statutes.

If you're preparing. State or local returns. Some of the other remaining six standards include such things as correction of errors. Use of estimates had returned due diligence, confidentiality, and in combination, anyone engaged in the retreat. Tax practice must understand that they are bound by this hierarchy of rules.

They're interlocking. There is a confluence of ethics. Make sure you understand circular two 30, the AIC PA standards, and be well aware of the sub of the draconian penalties set forth in the internal revenue. The code

I'm Jack Dorman, and we'll be discussing accountants responsibilities. It's always a privilege as an accountant to render services to our client and serve the public interest. But with those privileges come certain responsibilities. And that's what we're going to be talking about. Let's begin with the contractual liability of an accountant.

Okay. The account is an independent contractor with respect to his client and thus any liability stems from a violation of that contractual duty. Now under a contract, you have expressed duties and implied duties. Those express duties are set out by the terms of the contract. For example, you're engaged with letter and here it's critically important that your engagement letters say exactly what you intend to do for you will be held to your commitments.

In addition, their duties implied by either a court or by common practice. These include such things as due diligence, confidentiality, and the communications with your client. Besides the contractual duties, you have a duty to perform, and that cannot be delegated. Remember you contracted for personal services?

The client is looking to the accountant as the contact person to work this particular contract. It doesn't mean you can't delegate some of the work to employees, but ultimately it's the accountant's duty to perform partners and accounting firm may be liable for the wrongful acts of their subordinates.

Which are committed to the course of their unemployment. And remember a professional is still liable, even if they are a member of a LLC or L L P a professional limited liability company, or a professional limited liability partnership with respect to the failure to fulfill contract terms. The accountant is generally liable for its failure to fulfill the terms of the contract specifically, and usually any failure to dissolve constitutes a breach of contract.

Of course, any breach may result in damages. Let's talk about a couple of types of breaches. However, there could be a substantial failure to fulfill the contract, and this is often called a material breach in effect. The client has gotten no benefit from the clients, from the accountants performance or nonperformance of the services.

In contrast, we may have certain inaccuracies, certain shortfalls in fulfilling the contract. These are not a material breach. And in that particular case, the accountant is entitled to be compensated for the services rendered, but you may have to negotiate some type of adjustment. To the fee with a client after all, no client expects to pay the full tab for work that is containing certain shortfalls, even though they did not rise to the level of a material breach.

Every account has a just overwhelming, compelling obligation to comply with all of the professions, generally accepted standards of competence and due care. But when we talk about obligations, does the account have an obligation to discover fraud generally, unless the contract specifically says that it is a contract to review documents in search of fraud, there is no obligation to discover fraud.

There is an obligation, however, to design your procedures so that it can detect fraud. If it has occurred, there is an exception to the rule. I just said, The discovery of fraud will give rise to a liability if the accountant's own negligence prevented the discovery of the fraud. For instance, if there were areas that they simply ruled out to do their work in and fraud occurred in that particular area.

No accountant is liable. If their non-performance was caused by a client's interference. For instance, if a client is requested by the auditor to provide certain documents or access to review a certain location and the client refuses, then the accountant can not be held liable for nonperformance caused by that client's actions.

An accountant who breaches a contract, maybe subject to liability for damages and losses as a result of that breach. And so it's not just the damage. That's directly attributable to it. There may be collateral damages arising from the failure to perform, for instance, suppose the. Accountant is engaged to prepare financial statements and review them for submission to a bank for a loan financing arrangement.

The accountant fails in the obligation. And as a result of that, the client is unable to obtain the loan, which may give rise to certain other damages that accountant may be liable for several types of damages. That particular case, both direct and consequential generally. An accountant will not be liable for punitive damages for a simple breach of contract.

So it would only be compensatory damages. Let's look at a couple of concepts here, both negligence and fraud. You're going to hear these terms a lot, and it's important to understand the difference. Negligence is the failure to exercise that degree of care that a reasonable person would exercise under similar circumstances.

Now let's highlight a couple of keywords in that definition, the degree of care that a reasonable person. So it's not the expert. It's not the highest qualified person. But it's also not a person that takes no interest in the job. What a reasonable person would do that degree of care under similar circumstances.

So each of those is a important component. And looking at the definition of negligence, negligence is measured by the degree of quality. Accuracy and completeness demonstrated by the average accountant performing with reasonable care. So again, let's go back to the average account. We're not saying that an audit, you have to be the top review audit partner with 15 two years of experience.

It's the average accountant who is doing that similar type job and performing that job with reasonable care. There are a couple of interesting words that you hear from time to time due diligence and reasonable care. What do they actually mean? What is the court going after? When they say due diligence and reasonable care in each case, it is the degree of inquiry or the degree of care and performing a job that is appropriate to the circumstances.

You know, very well that there comes times when something just doesn't feel right. You don't have hard evidence on it, but it doesn't feel right. That should be an indication that in that circumstance, you need to take one more step, look a little bit further because something has raised the hair on the back of your neck.

Now, honest and inaccuracies and judgmental areas are not negligence. If the account is used that reasonable care, can we make mistakes? We all do. But what we're looking for as one partner at one time told me, he said, I don't expect you to be right. A hundred percent of the time. I expect you to be right 99 and a half percent of the time.

That's really the test of how effective you are. Negligence maybe based on, on unintentional errors. Intent is not the issue. So you don't have to make a mistake. We intended something to be. Presented the wrong way. Negligence can be based on those unintentional mistakes. Hopefully you'll never have one, but if you're perfect, you'd better than I.

Let me raise two more phrases with you. Contributory negligence. Now that's where. One party's negligence may be reduced or eliminated by the client's own negligence. So in a case that the actions of the client or the client's employees may have contributed to the mistake that's contributory negligence, and the result of that is to reduce any liability of the accountant himself.

It's called contributory negligence. Damages are based on the loss that would have been avoided with reasonable care. And as I said, these may be compensatory or consequential damages. It is even possible to have punitive, but they are rare in negligence cases. While we've been talking about the elegance.

We also need to turn over to another concept and that is fraud. A word you really don't want to see raised anywhere in your professional practice. There are two types of fraud. There is actual fraud and there is constructive fraud. And I'm going to give you a pneumonic to remember the element it's of each of these two types of fraud.

They're very similar. One is miseried and S R I D. And one is Mr. Ryde or ID in each case. And let's start with actual fraud. We have misrepresentation and that is a material. Misrepresentation of fact, that's the M S an actual fraud stands for sight enter. It's a Latin word, meaning the intent to deceive.

This is actual fraud where you set out to deceive somebody. So that asks for say, enter is the S in Ms. Red. The next item is reliance. Somebody must have relied on that. Misrepresentation. The person perpetrating the fraud intended for the party to rely. So that is the I the intent. And as a result of this reliance on the misrepresentation, there are damages.

So M S R I D Ms. Representation. So enter reliance intent to rely and damages that is actual fraud. If we turn over to constructive fraud or implied fraud, I told you the word was Mr. Red. And here you'll notice that we have almost exactly the same five elements. M is misrepresentation, but instead of center, we have reckless disregard of the truth.

It's not an intent to deceive is that the actions were so reckless as to disregard the truth. The Ryde elements, reliance intent to rely and damages are exactly the same. So as you go through the CPA exam and you've run across an issue that deals with fraud, think Ms. Red for actual fraud, Mr. Ed for constructive fraud, misrepresented, and then either say enter or recklessness, reliance, intent and damages.

Four out of the five elements are common to both types.

I'm Jack Norman and we're discussing accountants responsibilities. As we've already discussed. Generally the accountant will sign an engagement letter with a client setting forth all of the. Obligations that the accountant will perform for that client in exchange of course, for compensation. So we have a two-party contract between the accountant and the client, and generally the liability runs between those two parties.

We've discussed some of those issues, including negligence and fraud. As between those two parties, but now let's turn to common law liability to third parties. And in some cases, an accountant may be liable to a third party, not withstanding that that third party is not one of the signatories to the engagement letter in the case of negligence and accountant may be liable to that third party.

If the accountant knew or should have known that that third party would be a user of his work product. And as an example, let's assume that the client retained the accountant to prepare a compilation, right? The report or even an audit on financial statements, it would be used knowing knowingly used according to the client by the bank in order to make a loan.

So the account is on, on notice that the bank is going to be using his work in this case, if there is negligence involved in the engagement. The auditor may well be liable to that third party bank. In the case of fraud, an accountant has a duty to all third parties to make certain that the reports are free from either actual or constructive fraud.

So that's not even a new or knowing test. It's an obligation to make certain that they are fraud free. A third party beneficiary may also enforce a contract. I E the engagement letter, even though not a specific party to the contract. And again, going back to my bank example, if a contract was contingent upon having those reviewed financial statements presented to the bank, and that was a condition of a loan, then the bank may even be able to enforce that engagement even though not an original signatory to it.

So those are some common law liabilities with respect to third parties. For the accountants, let's turn over to some federal statutes, which also have very large implications for the public accountant. I'm going to run through about five of them starting with the securities act of 1933. This legislation sets forth the requirements to register securities that are going to be sold to the public.

And among the requirements in this registration process is the preparation of proof of a prospectus. Included in the registration and the perspectives will be any number of representations, both from management and from outside experts with respect to business plans, but they'll also be included financial statements and those financial statements of course are going to be associated with as an accountant.

There is liability. If there are material false statements in that registration prospectus process. Here's the warning for the accountants. Those documents may be prepared at one date, but the liability for the false statements applies when the registration becomes effective. And there may be a time period between the actual preparation of the documentation and the effective date of that prospectus.

So in that case, the accountant has got an obligation to make certain that the. Statements were not only true at the time the documents were prepared, but in subsequent date, when they go effective, The securities exchange act of 1934 deals with securities after they have been initially issued and governs the stock exchange rules, as well as the trading in these securities, it requires periodic reporting from the registered entity you frequently heard of these is.

Form 10 K's the annual report or 10 QS, quarterly reports. Plus there are special reports that the sec requires all of these various documents, which are filed with the commission and made available to the public must be free of false and misleading statements. And under the securities and exchange commission act, there are powerful tools to the sec to enforce the anti-fraud provisions generally under.

Section 10 B and rule 10, B five, any party associated with false or misleading statements in any of these documents will be held liable and parties that receive misleading documents may Sue any of these individuals. So there's cautious warning for anyone doing work under either the 33 act or the 34 act with publicly traded securities.

The federal government also has a private securities litigation reform act of 1995, which imposes certain obligations. This litigation requires auditors' to set procedures, to detect fraud in their audits. It doesn't say the auditor must go actively seeking fraud, nor does it require the auditor to find fraud effectively exist.

But it does require the auditor to establish procedures in their work to detect fraud, should such fraud be suspect affected. The auditor has an obligation to inform management, extend the range of their work. If fraud is discovered and management will not take steps to deal with it, then the auditor ultimately has an obligation to inform the board of directors.

Remember, however that the CPA may not go public with this information. This has to be handled within the client's corporate environment. I also need to raise with you two other federal laws, one affectionately known as Gramm-Leach-Bliley act. It dealt with the deregulation of the financial institutions back just before 2000 but included in that is a provision that deals with the federal trade commission.

And requirement that those dealing with financial activities establish privacy rules. So a CPA or an accountant is doing financial planning, tax work. Anything dealing with financial matters has to establish privacy regulations that have, that are consistent with the guidance issued by the federal trade commission.

And of course, many people have heard about Sarbanes Oxley the so-called Sox act, which Congress passed shortly after the Enron episodes. This act established the public accounting oversight board established a number of requirements, dealing with independence, auditor, rotation board of directors, and also contains the ability of.

The board to review audit work performed by CPAs on publicly traded firms. Now being away from the federal statutes, let's talk about the accountant's responsibility for nondisclosure now, accountants in their work day to day create Workpapers. Those work papers do belong to the accountants, but it's considered a custodial arrangement they're confidential, but there is no legal  to protect Workpapers.

Now having said that, that that's the general rule, no legal privilege to protect Workpapers however special engagements which are done in anticipation of litigation or other the direction of an attorney. Maybe privileged under the attorney work product doctrine, there are certain exceptions to privilege communications.

Also the AICPA has the ability to review for quality control purposes. The Workpapers of members of the Institute courts may issue subpoenas, which require. The accountant to turn over their work papers. And it's entirely possible that sometimes the accountant can challenge these subpoena and have certain aspects of it reviewed by the judge in chambers without automatically turning them over to the other party.

But an accountant needs to be aware that should they receive a subpoena. The operative rule is generally they're going to have to be turned over. Although there may be ways to keep pieces of them confidential or reviewed in camera. This is an area which needs to be discussed with the accountants. Attorney.

Finally, another exception privilege communication is if the client waives that, right. And occasionally a client will say, well, you know, we're talking about doing a, a merger or an acquisition. And the acquiring company would like to CPA review some of our work. Would you turn over certain aspects of the Workpapers generally they're not going to do a full-blown disclosure, but the client may offer waiver in certain situations.

So as we take a look, okay. Back at the accountant's responsibilities, what can give rise to liability? Well, as I said, Once before the privilege of being an accountant also brings with it grave responsibilities. These are to make sure our work is done to the highest standards of the profession and to the best of our abilities liability may arise in audits.

It may arise in preparing work on unaudited financial statements. It may arise in the context of securities laws, the tax laws, state law. Other federal agencies, such as the federal trade commission. So the rule basically needs to be, we're going to work to the highest standards of our profession and to the best ethics that we could bring to all of our work.

I'm Jack Norman. And this is an overview of federal individual income taxation. Now the federal tax law is basically driven by the internal revenue code of 1986. And in this program, we will briefly mentioned the various forms, which help carry the tax law into that return that we know and love. So well, let's begin with an overview of the actual calculation and the flow of the individual income tax.

We begin with gross income. And from that we deduct. What are called deductions for adjusted gross income. And this leaves us at the bottom of page, one of the form, 10 40 with a line called adjusted gross income. From that amount on page two of the form, we will deduct either the standard or itemized deductions and the peripheral exemptions, which will yield a taxable income number.

Now, bear in mind that the, there are two basic principles of taxation. The first is it all income or accretions to wealth are taxable unless they are specifically excluded by a provision of the tax law. And no expenditure may be deducted unless that deduction is specifically authorized by the law. So all income included, no deductions.

Okay. Loud, unless specifically provided for beginning with the concept of income recognition. Income may be received in the form of either cash or property. And many of these items were quite familiar with salaries and wages are income interest in dividends, capital gains, net profits from business. And of course, retirement income.

Now, one that we may not think about as often is income from the forgiveness of debt, because after all, when debt is forgiven, It is in effect an accretion to wealth. So when a taxpayer's debt is relieved or forgiven by the creditor, that also is an income recognition event, unless a specific provision applies to accept it in income recognition.

We must always remember that we're either working with a cash basis of accounting, the accrual basis of accounting, or very occasionally a hybrid method. In the individual income tax, you'll almost always see only the cash method of accounting. One of the concepts I mentioned a few moments ago was the idea of adjusted gross income.

This is gross income minus only certain deductions. Some deductions are taken in computing, adjusted, gross income. Other deductions are itemized deductions, and we'll explore both these concepts a little bit further. Adjusted gross income is used to limit many deductions, exclusions, and credits often AGI is referred to as the line.

So you'll sometimes hear accountants talk about deductions above the line. Those which come from gross income in computing adjusted gross income or those items that are deducted below the line. So AGI is the line at the bottom of page, one of the tax return. The CPA exam often refers to these allowable items as deductions to arrive at adjusted gross income.

They're the same thing. Now, these deductions for adjusted gross income or deductions above the line include certain contributions to individual retirement accounts. There are a number of deductions for self-employed individuals, such as healthcare and a portion. Of the payroll taxes paid on self-employment income alimony that is paid baby deducted in computing adjusted gross income, moving expenses, and certain educational expenses are also deductions for adjusted gross income.

In contrast, we have deductions from adjusted gross income, and here the taxpayer made a duct personal exemptions. And the greater of now, remember I said the greater of either the standard deduction or itemized deductions, let's step back for a moment and look at personal exemption. There is a basic exemption amount, which is adjusted every year, indexed for inflation.

So refer to the numbers in your materials for the base amount of the exemption. We take that base amount and multiply it by the number of personal exemptions are allowed. So each year that number has been increasing ever so slightly, maybe 50 to a hundred dollars for each exemption each year. Again, check the most recent numbers.

That was the personal exemptions. Now let's move over and look at the concept of a standard deduction. Some taxpayers will not have enough. Individual expenditures come up to itemized deductions that exceed the standard deduction. What the standard deduction is, is a floor amount. The Congress has said this will be allowed as an overall deduction for a taxpayer.

The amount of the standard deduction is based on the taxpayers filing status and like the personal exemptions. It is adjusted annually for an inflation index. That basic amount is also increased for age or blindness of a taxpayer or the taxpayer's spouse. So that's the standard deduction. It's a set blanket amount that can be deducted on the return.

Irrespective of whether the taxpayer is able to itemize many taxpayers, particularly those who own homes will be able to take the itemized deduction approach. Instead of claiming the standard deduction and under itemized deductions, there are broad categories. We'll explore those categories in detail, but let's give you the broad categories.

First medical expenses, certain tax expenditures, certain interest expense payments, the taxpayers' charitable contributions for the year. Casualty and theft losses, any category called miscellaneous itemized deductions. So those amounts are summed up and if it is greater than those itemized deductions in those categories, if they're greater than the standard deduction, then the taxpayer will claim the itemized deductions.

If they are less than the standard deduction, the taxpayer will take, of course, the standard deduction. We went through at the beginning of the formula, coming down to taxable income, gross income minus adjustments to compute, adjusted, gross income, then less the exemptions and either the standard or itemized deductions that gave us taxable income.

Now let's talk about the tax calculation itself. We take the taxable income and look for the applicable tax rate. And in the tax forms that the IRS provides there will be tax tables, or you can actually use a, a rate schedule, either one. It depends upon the taxpayers filing status, the number of exemptions that they're going to have, and that will give you an applicable rate to be applied.

That rate times the taxable income will give rise to tax liability. That's the basic or regular tax liability. The amount then must be increased for any additional taxes that the taxpayer is liable for. These may include self-employment tax alternative, minimum tax and certain other payments are additional taxes added onto that regular tax base from the total taxes we deduct tax credits, and these are amounts that Congress has said, if you make certain payments, A percentage of them will be allowed as a credit against your tax liability.

They're not a deduction. They're a direct offset dollar for dollar against tax liability. Plus you reduce your tax potential liability by any tax payments made during the year. Most of us are familiar with the withholding, which is taken out of our salary, but self-employed individuals will be making estimated tax payments during the year.

Both the withholdings and any estimated payments, reduce the taxpayers potential tax liability. The result of it putting together a tax liability plus additional taxes minus credits and minus any payments already made. It gives rise to either a tax due or a tax refund. Now I had mentioned to you that the additional taxes include the alternative minimum tax and the self-employment tax.

There are a few others, but those are the two key ones that you should focus on for purposes of the CPA exam. The personal tax forms for an individual are always in the 10 40 series. The basic form will be filed as a 10 40 page one and two. It may be backed up by schedule a which will list and detail itemized deductions.

Schedule B. If you have interest in dividends above a threshold amount, $600, those must be itemized on schedule B and attached to the return in gross income. As we mentioned earlier, there is self-employment income from the taxpayers proprietary business that will be reported on schedule C and give all the details to that self-employment income.

The summary number from schedule C will roll forward and be included on page. One of the return capital gains and losses will be reported on schedule D in detail. Those two will roll up into a page one line item schedule E which deals with supplemental income, including such things as rental property distributions from partnerships and trust is one more page that must be attached to the return.

And it also. Is summarized on page one. That's a lot to grasp in this overview, but let me give you a couple of study hints, make a list. And in that list, put down items which are inclusions in gross income exclusions from gross income deductions in computing adjusted gross income. And deductions that are taken from adjusted gross income.

So as you study, pull these four different broad categories into lists and focus your attention on what falls in each category, review the tax ones and the basic supporting schedules for familiarity. You absolutely do not need to memorize the forms, but you should understand how each of these. Four categories.

I gave you income, income, exclusions, income inclusions deductions, for and from AGI fit in with the various forms. With that. You'll have a good scope to begin your review of individual taxation.

I'm Jack Norman and we're discussing individual taxation filing status and standard deduction in beginning. To prepare a tax return. One of the most important decisions to be made is the filing status of the taxpayer. They're essentially five categories. The single filing status is the default status.

Then married couples may be filing either as married, filing, jointly the most common approach, or occasionally when. Husband and wife particularly have very similar income and higher income. There may be a married filing, jointly, married, filing separately status, which is elected in lieu of the married filing jointly.

Another status is the qualifying widow or widower. And this applies in the two years after a spouse has died. Finally, there is a head of household status, which applies when a taxpayer who is single or considered single has a dependent in the household for the year. Let's explore the filing status of married filing jointly.

First, the couple may actually live apart as long as they are not legally separated, they must be married on the last day of the year. So living in separate cities, carrying on their vocations is acceptable. As long as they are not legally separated from each other under a an agreement between them.

Penn tending toward a divorce, a deceased spouse may be filed in joint status with the surviving spouse in the year of death. Now, both parties must either be citizens or resident aliens. If you remember citizens and resident aliens filed tax on a worldwide basis, a non-resident alien will only be reporting income from us business and us sources.

Therefore, if a citizen is decides to marry a non-resident alien, a joint filed return would not be possible unless the couple makes an election to report worldwide income from both spouses. In that case, a joint return will be allowed the filing status of a qualifying widow or widower. This is sometimes called the surviving spouse status.

It allows the taxpayer to use the married filing joint tax rates in the two years following the spouse's death. Now, in order to qualify for this status, the surviving spouse must maintain a household for a dependent child. And they must not be remarried in the year of death. The qualifying widow or widower uses the married filing separately or married filing jointly rates.

And the personal exemption for the deceased spouse is allowed that's in the year of death. In the subsequent two years, the favorable status on rates will be continued, but no personal exemption is allowed for the deceased spouse. If we turn to the head of household filing status here, the taxpayer must be unmarried or considered unmarried, or be a surviving spouse.

They must contribute more than 50% of the cost of maintaining a home for half the year. And in that household, they must support a qualifying individual. Let's talk about those qualifying costs. What is allowed in the computation? Cash payments for home mortgage interest or rent real estate taxes and condominium fees, utilities, repairs, and insurance on the home and food consumed on the premises while the person maintaining the household will have other expenses.

The following do not qualify as costs for maintaining the house, clothing, transportation, or vacations. Education or medical treatment or food consumed off the premises. Now for this status, the qualifying individual must reside with the taxpayer in most cases. And here we're talking about a qualifying child or most other dependent relatives.

However, if the head of household status is because the taxpayer is providing the dependency for a parent. That parent does not need to reside with the taxpayer. So the parent does not a qualifying child or any other dependent relative must live in a household for this status to be maintained.

Unrelated dependence can not qualify the taxpayer for a head of household. Although frequently thought about a friend, a foster parent, or a cousin will not work for head of household status. Now let's talk about the divorce situation, where we have custody of a child. A custodial parent may get the head of household status despite a written declaration, not to claim the child as a dependent.

So let's think about this. Here's the parent maintaining the household with the child, the child, nonetheless, under a written declaration is going to be claimed as a dependent by the non-custodial parent. The custodial parent gets head of household status. However, the non-custodial parent will not get the head of household status, even if entitled to the dependency deduction under a support agreement.

So the custodial parent gets the head of household status. Whether or not, they get to claim the child as a dependent, the non-custodial parent does not get head of household status, even if they are able to claim the child as a dependent. Now, the standard deduction is a, an amount that is claimed on the return by the taxpayer, because it is a set amount that the Congress has enacted based on.

Filing status. Alternatively, if it's higher, a taxpayer may be able to take itemized deductions as they go through the categories and add up those deductions. The standard deduction is reduced for any taxpayer who is a dependent of another person. If a taxpayer is filing a 10 40 Z, which is a shorter form.

Of the basic standard, 10 40, then only the standard deduction may be claimed on that return. The taxpayer may never claim itemized deductions. Another rule for the standard deduction is if the. Married, couple files as separate status, married, filing separately. If one spouse itemizes deductions, the other spouse may not use the standard deduction.

They too must itemize. So here's a place where in discussing whether to file jointly or separately, you have to bear in mind that if one spouse itemizes. Because they have a lot of itemized deductions to the other spouse, even if they don't have very many itemized deductions must also itemize they may not claim the standard deduction,

individual income tax exemptions. I'm Jack Dorman. No, the personal exemptions are basically a statutory amount times. The number of exemptions claimed on the return. The exemption amount is adjusted for inflation annually and is a little bit below $4,000. Currently the exemption is not prorated if the taxpayer is born or died during the year, but as long as they it's a life in existence during the year, the full amount of the exemption is allowable.

The number of exemptions on the return or one personal exemption for the taxpayer. And if buried one for the spouse. Additional exemptions are called dependency, ILEC dependency exemptions, and are allowed one for each dependent. If a taxpayer, however, is claimed as an exemption on another return. The taxpayer cannot claim him or herself on his own return.

For example, a child who perhaps is in college and it has to file a return yet is claimed as a dependent by the parent is only claimed on the parent's return and not on the individual student's return. What is a dependent. Now common test apply to both a qualifying child and it qualifying relative.

There are slightly different. There are slight differences between these two definitions. So let's be very careful about these. A qualifying child must meet a specific four-part test relationship, age residents, and support a qualifying dependent must meet a specific three-part test relationship residents.

Income and support. So let's take a look first at that definition of common components, the individual cannot be the dependent of another taxpayer. The dependent cannot file a joint tax return. Other than in the case to a filing a claim for refund, the dependent must be a citizen of the United States, Mexico or Canada.

Now let's turn over to a specific test for the dependent child. The individual must be either a child or stepchild, a sibling or step sibling, any descendant of these first two, in other words, grandchildren, an adopted child or a foster child. However, the dependent child definition does not include a cousin of the taxpayer.

Now the child must be under the age of 19 at the end of the tax year, or if they are a full time student during at least five calendar months, they must be under age 24 at the end of the year. So 19 is the general rule full-time student under the age of 24, or they could be permanently and totally disabled.

That dependent child must live with the taxpayer for more than half of the year, temporary absences are allowed, of course, for illness, education, or military service. Now, we also said there's a support test. And in this particular case, the child may not have provided. More than half of their own support.

So the taxpayer claiming that dependent child must provide more than half the support for that child. Fortunately, scholarships are excluded from the definition of support. Now, there are some situations where the child may be under the custody of. One parent in a divorce situation may actually share custody in the the separation arrangement.

So let's talk about general rules and then some specific rules that are called tiebreaker rules. When we're trying to define that dependent child, the general rule is that the child is the dependent of the custodial parent. So whomever the child lives with. If there's joint custody, the D the dependent of the parent with the, with whom the child resided most of the year.

So it's a seven month, five month arrangement. The seven month taxpayer gets to claim the child as a dependent. Under the tiebreaker rules, suppose there's joint custody with equal time, six months in each household, then the dependent goes to the parent with the highest adjustable, gross income. So those are the three basic rules.

First, the custodial parent, if it's joint custody, it goes to the one with whom the child resided the most during the year. If the time is equal, then it goes to the highest. Income spouse. Now that's the rules, but any parent who is entitled to the custody and the dependency exemption for the child may sign a written waiver, allowing the other parent to claim the deduction.

So let's assume that the child has been given as a custodian is the divorced mother. That child has lived with the mother for. 11 months of the year spends the summer one month of summer vacation with the father, but the father has higher income. Well, under the general rules, that child would be the dependent of the custodial parent.

The mother, there are no tiebreaker rules involved with the mother could say dead. I will allow you to claim our child as a dependent on your return. And that's done by filing a form. It must be done annually. And we'll allow the non-custodial parent to claim the deduction for the taxpayer, who is able to claim the child as a dependent.

There may be other benefits, head of household filing status, the child tax credit, the child independent care credit, and the earned income tax credit. Now these four components, these four additional benefits each has additional statutory and regulatory requirements that go with them. We're not focused on that right now.

What I want to focus your attention on is you must be able to claim the child as a dependent under either the custody rules or the waiver rule in order to claim these additional four benefits. Head of household, child tax credit child, independent care credit, or earned income credit. Now, if we turn away from the child question to a qualifying relative, what is the relationship residents rule?

One of the three tests for a qualifying relative first, they may be any lineal descendant, straight down the chain, an ancestor, or a sibling by whole or half blood. An adopted foster or stepchild, but not a cousin or a foster parent or a member of the household for the entire year income. The qualifying relative must have a taxable income that is less than the statutory exemption amount.

And that amount is around 37, $3,800, a little less than 4,000 right now not taking into consideration is that non taxable income, including such things as social security, scholarships, or municipal bond interest find relative must meet a support test. The taxpayer provides over half of the individual support for the year.

Now suppose there is a multiple support agreement. For instance, two or three children say we will support dependent mom in a multiple support agreement. If no one person provides more than 50% of the support, but collectively they do so therefore they're meeting the overall test, but no one provides at least 50%.

The dependency exemption goes to the person providing more than 10% of the support. There must be signatures of any other individuals who provide more than 10% agreeing to the arrangement. This may sound confusing, but let's try and set it up with an example, three children to collectively, they provide more than 50% of mom's support.

One child provides 20%. The other two each provide 15%. Well that support could go to any of the three because each one of them provides. More than 10% of the support, whichever one is going to claim the exemption. The other two individuals must sign off on an arrangement, giving it to the third person.

And in this particular case, let's just assume that those two, the brother and sister who each provided 15% say that the eldest daughter who provided 20% gets the exemption. That's the way the multiple support arrangement works now. The total exemptions has been phased out when the adjusted gross income of the taxpayer exceeds a particular threshold, the exemptions are reduced 2% for each $2,500 of income over the threshold.

Now that rule applied up through 2009. It was temporarily removed for 2010 through 12, and is scheduled to return back into the law in 2013. All I can tell you, as we go through some of these income tax rules, Congress keeps changing the rules and you need to check the viewer guide for updates on whether a provision has been repealed or reinstated and check also for how threshold amounts and statutory levels.

For instance, the amount of the exemption change from year to year, that information will be included in the viewer guide. So. On the exemption area, which you need to focus on primarily are the qualifying child four-part part test the qualifying dependent three part test. Those are the two key components of the exemption rules in the personal income tax arena.

I'm Jack Norman. And we're talking about income inclusions. As we CPA review the federal individual income tax, the starting point for all individual tax returns is gross income and the courts, the Congress. The IRS all start with a basic premise that all income is taxable. All accretions to wealth are taxable unless specifically excluded.

Let's talk first about the most obvious, the most common form of income wages and salaries, wages and salaries can be paid in either cash or property and the cash or fair market value of any property received in exchange for services. Is includable in gross income. This includes bonuses, commissions, and tips.

It also includes employer provided fringe benefits. For example, if the employer provides an automobile. To the employee for use that is a taxable fringe benefit and is included on the W2. One of the things that is a little bit beyond our scope today is the special rules that apply for the inclusion of qualified and non-qualified stock options.

Stock options have special characteristics, but they are a form of gross income and in different ways are included in income on the return. A second category of includable income is interest income and that interest income, if it is seed $600 must be separately, itemized on a schedule B, which is attached to the return.

Now, what is interest income? It includes bank deposit, income, corporate bond interest you as treasury obligations, interest paid on state and federal tax refunds. So all of these are different types of interests, all of which must be included on schedule B, what is not included in taxable in taxable income is interest on municipal bonds that is state and local for federal purposes.

That is tax exempt. Nevertheless, it must be reported on the return. Even though it is non-taxable. So the number, the amount that you receive is municipal bond interest is reportable. Although it is excludable for federal purposes, schedule B is also used to report dividend income and dividends may be either the cash or fair value of property distributed from a company's earnings and profits.

Now, this is very important, a distribution from a corporation. Maybe taxed as a dividend, maybe taxes, capital gains, maybe taxable return of basis. So dividends are only determined if they are distributed out of earnings and profits of the corporation. Qualified dividends under current law are taxed at a no greater than 15% tax rate.

The same as long-term capital gains. And for taxpayers to dinner in a tax bracket of below 15%, the 10% bracket, there is no tax zero tax on qualified dividends. Dividend income does not include stock dividends, life insurance dividends, or as I mentioned, distributions, which are not from corporate earnings and profits.

Now one thing that you have to be very careful of is dividends that may arise in below market loan situations. If there is a below market loan, there'll be an imputed transaction here in the loan. And the benefit is treated as dividend income to the shareholder. So he'd be low market loan from a corporation to a shareholder will probably give rise to dividend income.

That should be reported by that. Shareholder employee shareholder on schedule B, let's talk about a couple of special rules for income recognition while we're dealing with the income inclusion. The first is the doctrine of constructive receipt, and this means that a taxpayer must report income when they have the right to receive the property, whether or not it is actually received.

In other words, the individual may not turn the back on income, which is in available to them. This is deemed constructively received and must be included in current income. The tax benefit rule States that a later reimbursement for a previously deducted amount. And let's just take, for example, a medical reimbursement after you've deducted medical costs or a state tax refund.

After you've deducted state income taxes paid, those items will give rise to income under the tax benefit rule alimony and child support. Alimony is taxable income to the recipient child. Support is not taxable. So when there is a payment that is constitutes alimony, it will be taxable and accordingly it will be deductible to the payor child support will not be taxable to the recipient, but it will also not be deductible to the payor.

Well, since we need to make the distinction between the two, what is alimony? The payment must be made in cash. It may not be a property settlement. It's purse paid pursuant to a written divorce instrument. It's not designated as something other than alimony. It terminates at the death of the recipient and is not paid to a member of the same household.

It would be well for you to review the elements that comprise alimony.

Now let's talk about a couple of other lines. The details I. Are carried on schedule C D and E schedule C reports, net business, income or loss, and those details carry over to page. One of the tax return schedule D contains capital gains and losses, and that summary carries over to page one in the income inclusion.

And finally on schedule E you'll have income estates, trust partnerships, S corporations, rental, and royalty income. All of those details are on schedule E and those summary amounts will also come forward to page one. As we wrap up a brief discussion and very brief, it is on includable income. A couple of other items come to mind, unemployment compensation, employer expense reimbursements under a non-accountable plan, jury duty pay punitive damages.

And discharge of indebtedness income. Although in the case of discharge of debt, special rules may allow some portion of this income to be excluded. This last category I want to mention is gambling income, and there's been a lot of confusion about gambling income gambling income is indeed gross income and the gross amount of the earnings are not netted against gambling losses.

The income is reported. On page one, gambling losses may be deducted only to the extent of gambling winnings, but they are an itemized deduction. So they do not carry an offset against the income income is included on page one losses show up as itemized deductions.

This is individual tax income exclusions, and I'm Jack Dorman. We've talked in, preparing a return about including items and gross income or everything is included in less specifically exempted. Well, let's look at some of the things that are specifically exempted and therefore excluded from the gross income category of your tax return.

Life insurance proceeds and death benefits. They are excluded from income tax. Now that sounds great. And it is just to remember, I said from income tax this program has focused on the income tax, but you should be aware that they may be included in the estate tax. Now insurance proceeds will be excepted.

From the exclusion. In other words, they will be taxable income. If the, they are employer provided death benefits and furthermore interest on life insurance proceeds. If they're paid out in installments, the interest component will also be included in gross income. So general rule insurance proceeds are not excluded exception and they are taxable.

If it's employer provided death benefits or interest on installment. Payments. Let me just illustrate that second piece for a moment. Assume that there's a $50,000 policy. It pays an installment benefit of $6,000 per year for 10 years. So the principal amount per installment is $5,000. That's excluded the remainder.

The $1,000, 6,000 less. The five of principle is taxable interest income. Also excluded from gross income, any gifts or inheritances. Now a gift is characterized by disinterested generosity. Gifts from employers are usually considered taxable compensation. The inheritance, when a member of your family or a good friend dies and leaves you something from their state, that inheritance is also non-taxable.

Let's come revisit. The question of alimony and child support. Alimony is taxable. Child support is non-taxable so excluded from your income is any child support payment. If there is a combination payment, which might include alimony and child support, that payment is first considered child support before it's considered alimony.

If the payments are reduced due to a child based contingency, the amount is considered child support, even if it is labeled alimony. So let's give this example, the divorce decreased. The John is to pay Mary $500 per month when their son James, which is 21, Mary or dies, the payment is reduced to $300 a month.

Well under this rule, the $300 is considered alimony, which John made a duct. The $200 contingent reduction is considered child support is non-deductible and of course is therefore excluded from Mary's income. Other excluded income includes interest on state and local government bonds, even though the total amount of that exempt income must be reported on the face of the return.

Divorced property settlements are excluded from income. Medicare benefits are excludable welfare and public assistance. Benefits are not included in income and subject to limitations. The gain on the sale of a personal residence has been occupied for the appropriate amount of time is excluded from income.

Interest earned on series double E federal bonds. If it's used to pay qualified educational expenses is excluded from income. So these are qualified educational expenses for the taxpayer, the spouse, or the dependent. The purchaser must be the sole owner of the bonds unless joint was spouse. And the bond issue date is after the 24th birthday of the owner.

So this is a way to buy federal securities, build up some income, the interest of which will be excluded. If it's used for educational expenses,

the tax bill also provides an exclusion for Exclusion for amounts received related to physical injury or to sickness. These include medical expense, reimbursement workers' compensation, disability payments. And it's important to note that the payments must be received on account of a physical injury.

Just to say that you have some type of mental distress emotional injury will not qualify these payments. It must be a physical injury to be excluded. The tax law also allows an exclusion for scholarships and fellowships. The recipient must be a candidate for a degree, and the proceeds of that scholarship or fellowship must be used for tuition.

And of course, related expenses, the amounts may not be received as payment for services. For example, a teaching position. Will not qualify those payments if you're getting the compensation for being a faculty instructor, but it's fun and used for tuition and course related expenses as a scholarship or, or fellowship.

And besides those items, prizes and awards may be excluded from income. If all three of the following requirements are met, the recipient is selected without any action on his or her part. No future services are required from the recipients and the award is assigned to a charity or government by the recipient.

In other words, that reward is not kept by the recipient. Here's one of the more interesting ones excluded benefits for social security. Now, when social security first came in in the 1930s, there was no exclusion from taxation written into the code. The IRS. Issued rulings, which allowed social security benefits to be exempted.

Subsequently Congress has come back and said, well, we reaffirmed that social security benefits are generally not taxable. There are some exceptions, either 50 or 85% of those social security benefits will be subject to tax to the extent that those amounts are. The taxpayer has a income level over a modified AGI threshold.

So if the taxpayer has a modified AGI amount, it's over a threshold, then a portion of the social security benefits will be taxable and no case. However will social security benefits be fully taxable. Another excluded benefit goes to employer provided benefits. And employer group term life insurance policy up to $50,000 is excluded from the employee's income.

To the extent that the group term insurance is in excess of $50,000, then the premium amount on the excess is includable in taxable compensation. This is group term insurance, not whole life insurance. In addition, certainly employer provided benefits are excluded from income. And these categories include a no additional cost service, a qualified employee discount, working condition, fringe benefits, and diminimous fringe benefits.

These benefits must be provided in a manner that does not discriminate in favor of highly compensated employees, but certain examples include. Just for instance, meals that may be provided during the working day. It could be a jump seat airline flight for a flight attendant. It could be the use of certain copier services.

Diminimous copywriters could be employee discounts or meals at a restaurant. So these fringe benefits are booted from income, the employer contributions to qualify, defined pension plan. Benefit and defined contribution plans are excluded from income. Although, as we will know, once benefits are received from these plans, they will be taxable now distributions from an IRA.

And I'm going to call this distributions with caveats distributions from a Roth IRA or non taxable distributions from a deductible. IRA are taxable. Distributions from a non-deductible IRA are non-taxable to the extent of the contributions made and the accumulated earnings amounts are taxable. So you have three different rules related to distributions from individual retirement accounts,

individual tax, business, and rental income. I'm Jack Dorman. Schedule C reports, business income or loss in detail, and it supports other numbers reported on the front page of the individual form 10 40 numerous supporting schedules may be required to go with a schedule C including such items as form 45 62 on depreciation or form 88, 29.

If you're claiming a home office deduction. The form 10 40 summarizes all income and expenses into a single net income or loss at the bottom of schedule C that number carries over as a single figure to page one of the individual return. Now business income includes all cash or property received from the activity less all ordinary and necessary business expenses.

The result, of course, as you remember from your fundamental accounting classes is net business income or loss. And what's included in business expenses, such items as cost of goods sold. If you're engaged in wholesale or retail business, and this will be supported by a cost of goods, sold calculation, including where appropriate inventory numbers and purchases, deductible expenses also include state and local business taxes and licenses.

Interest expense paid on business loans, depreciation on business assets, which may include either those so-called one 79 expensing depreciation or the modified adjusted cost recovery system meals and entertainment expense may be deducted, but only 50% of those expenditures is allowed. The other half is not an allowable deduction.

Deductible expenses also includes such items as office rent and operating expenses, salaries and wages, but not including the owner's draw. If the business is on the accrual basis, the taxpayer may be able to deduct bad debt expense. Of course, a cash basis. Taxpayer has no bad debts to deduct. Travel expenses may be deductible, but there must be an allocation of those expenditures between business and pleasure time.

And if the time spent on personal activities is, is more than 25%, then no deduction for the travel is allowed.

A net business loss can offset only certain types of income. Business income, wage, income, rental income, but that business may also have what is called a nut operating loss. Now just because the business has a loss for the year, doesn't automatically make it a net operating loss under the individual rules.

Certain adjustments have to be made, but once that calculation has been completed and there is truly a business net operating loss, it can be carried back two years. And forward 20 years while we're on the subject of business, income and loss and schedule C, there are a couple of other items that must be considered an entrepreneur, a sole proprietor must pay self-employment payroll tax.

This is commonly called the seek attacks and is 15.3%. That's the general rule and it's fundamentally equal to the employer and employee share of FICA 7.65 for each, the taxpayer can deduct what is considered to be the employer share. That Sikh attacks roughly 7.65%. When Congress has worked on some of this payroll tax holiday, as they did in the middle of 2010, 2011, timeframe that adjustment has been modified slightly and can be reviewed in the materials.

A taxpayer can also deduct premiums, paid on health insurance for the entrepreneur and family members. And for contributions to the owner's retirement plan, such items is SEPs simple plans. Keogh plans can be deducted in computing, AGI on page one. Let's set aside the screen. We'll see for the moment.

And now turn over to schedule E. The front page to look at rental income and rental expenses, obviously rental income, less rental expenses equals net rental income or loss, same accounting formula. Again, schedule III may require some backup supporting schedules, particularly in such areas as depreciation and potentially passive loss.

Once the rental income is calculated for the rental property. It's reported on page one. Now schedule E does have numerous columns in which you may be reporting several different rental properties. Each one will report it in detail. And then the net numbers will be aggregated for a number that rolls from schedule E up to page.

One of the return rental income includes prepaid rent. Lease cancellation payments and improvements made in lieu of rent. And that means, for example, let's just assume I'm the landlord. And the tenant says I'd really like to replace the wall to wall carpeting in the bedroom. My. Child's spilled grape juice all over the carpet.

I'll replace it. We'll get a, an acceptable grade to you and I'll pay for it in lieu of making the rent payment. If that happens. Nevertheless, the, the cost of that lease that lease payment, which is equal to the road that's installed is includable in the landlord's income. Excludable amounts include refundable, deposits and improvements that are not made in lieu of rent.

Now I happened to have a couple of rental properties and one of the things I've always done is demanded a one-year refundable deposit. If at the end of the lease, there's no damage to the to the unit, just fair wear and tear. I will refund the deposit, but in order not to pick that up as includable income, and then I have to worry about deductions.

I simply take the check, buy a CD, and it is a refundable deposit. So that stays out of income. And it also, of course, is not an expense when I would refund it to the client. Rental expenses includes such things as real estate taxes, mortgage interest utilities, depreciation, condominium fees, leasing commissions, professional fees.

Suppose you have, you need to bring a lawyer into a, to have a tenant removed for some reason, repairs and maintenance management fees. All of these items are deductible expenses reported on separate lines on schedule E. Let's turn to a couple of special rules when we're dealing with rental real estate, something called the vacation home.

If vacation home is a property use, partly as a rental and partly as a personal residence. For instance, my in-laws used to have a home at ocean city, Maryland. Part of the time they would go down before and after what was called high season. So maybe April early may, they'd go down to the place and they come back in October and November.

But during the peak seasons of may, through September, that property was rented out. This would be a vacation home. Now certain expenses are not limited. Real estate taxes, mortgage interest, and casualty losses. Those would be deductible to any taxpayer on any home. But if you have these three types of expenses, they must be allocated and broken down between schedule a, which is the itemized deductions for individuals and schedule E for the rental property.

Here's where it gets a little bit more confusing. Okay. If the property is rented for less than 15 days a year, no deductions are loud. Other than those ones we just mentioned, and no income is reported. So if you were to, as some people do, let's just take the masters golf tournament down in Georgia. Some people down there because of the number of visitors will rent out their home too.

People who are coming to the tournament for about six days in that particular case, no deductions are allowed for the rental, but no income is reported. If the property is rented for more than 14 days, deductions may be claimed again, they're allocated. However, between schedule a and schedule II, here's the real hard rule.

If a taxpayer uses the property more than the greater of. 14 days or 10% of the number of days that the property is rentals rented deductions may not exceed the income from the property. So that's a limitation on the allowable deductions, other than mortgage real estate taxes and casualty loss. That's probably the hardest part of the vacation home rule.

If this property is never used as a personal residence, of course the home, the vacation rules don't apply deductions are not limited. And you're under the regular rental rules. It's important for you to recognize that rental income is passive income rental losses. Are passive losses and such a loss in a rental activity is per se passive and may be limited.

Okay. I'm Jack Norman and this is individual tax passive activity and at-risk rules. Four years, IRS and the Congress has struggled with what are perceived as tax shelters. And in trying to combat tax shelters, the Congress has passed and asked the IRS to enforce several different layers of rules, including passive activity rules and add risk requirements.

Let's begin to take these apart by looking at the passive activity rules and under this provision of the law. All income is divided into three types, three categories, active income, which includes wages, salaries, and self-employment income portfolio income includes royalties, interest dividends, capital gains, and losses, and passive activities, a trader business in which the taxpayer does not materially participate.

So a trader business in which the taxpayer does not materially participate. And it includes a rental activity. Now who do these rules affect a trader business apply means any individual closely held C corporation and personal service corporations. Now, since it includes individual, it also will take into account losses from partnerships.

S corporations and limited liability companies. The passive activity rules do not apply to one of these trades or business. If the taxpayer quote materially participates in the activity. Now that's key wording. What does materially participate mean? And Congress said, what we're thinking about is regular continuous and substantial involvement in the business activity.

Regular continuous and substantial. Now in the regulations that the IRS developed, there are seven separate tests that a taxpayer may be able to use to meet the material participation standard. One test, probably the most common one is if the taxpayer spends more than 500 hours per year. Working in the activity that would constitute material participation.

These tests are, these various tests are outlined in the written materials. Now what happens if you have a passive loss, a loss from one of these activities, the loss may only be recognized to the extent of income from passive activities. Or when the activity is disposed of in a taxable transaction to an unrelated party, let's take the first of those two points.

First assume I have a business it's been running for several years. We've never made any money. We have losses and I don't materially participate in I'm simply one investor in that activity. Those are considered passive losses. I cannot claim a deduction for them on my return. Now, after the couple of years of building up these passive losses, which get carried forward in year four and year five, that activity, even though I'm still not materially participating turns profitable and we are beginning to generate passive income, I could reduce the passive income.

From that activity with my accumulated and carried forward passive losses, I can offset any losses from any activity against any passive income from any activity, with a little bit of twist, a passive loss offsets passive income in each year, and then carries forward in subsequent years. So you track each separate activity.

Now let's assume. Take the second part of my test that we never ever ended up with making money on this activity. And we decided to get rid of it. For some reason, we find a buyer who is willing to purchase this business has been running at a loss because they think they can turn it around. There's a great idea.

So if we sell or if I sell that activity to an unrelated party in a taxable transaction, I will probably have a gain or income from the disposition. If I do, I can take my accumulated losses and offset it against any gain and then claim any excess losses. So the rules are lost, are suspended and carried forward until there's income realized whether from the operation of the business or upon the ultimate disposition of it.

In my previous example, I talked about a trader business in which I did not materially participate. There's a second category of passive activities. These are rental activities and they are considered per se, passive. In other words, the material participation test doesn't apply. If you have a rental activity, it is a passive activity.

Congress recognized that a number of individuals. Might have a small rental activity that they were engaged in and did put in a little carve out exception. It said that an individual who actively participates in managing the rental activity may deduct up to $25,000 of losses against their either active or portfolio income.

Let's take my example again. I said I had a rental property. If I can meet the threshold and we're going to talk about this in a minute about the exemption being phased out, but assume I am actively participating in the real estate activity. I have $15,000 of loss and my AGI is less than a hundred thousand dollars.

I can deduct that $15,000 loss, the exemption. That allows the $25,000 loss deduction is phased out at a 50% rate for AGI over a hundred thousand dollars. And in other words, no deduction under the rental rules is allowed when the taxpayer's AGI exceeds $150,000. Now I told you the material participation test is regular.

Continuous substantial. And there are a guidance for seven tests in the regulations. Active participation is not as stringent as material participation. The taxpayer must participate in the management decisions of the rental property. So in my particular case, when I was trying to get under the active test, do you approve new tenants?

Now you can have a real estate agent go out and advertise it. The unit is for rent. Bring the tenant's application to you. You review it and determine whether you will approve the tenant. You approve the rental terms. You set the repair thresholds and approve repairs to the unit. These are things that will get you active participant patient and allow you to claim losses up to the $25,000.

If you meet the exemption threshold. I'm not going to pursue it very far right now, but there's also a special exemption for individuals who are real estate professionals, and they are not bound by the passive activity rules on rental properties, but they must be fully engaged as a real estate professional, passive loss rules are one test.

A second test that we're talking about in this segment is the at-risk rules. The at-risk rules say that losses from business operations are limited to the amount that a taxpayer can actually lose in the particular activity that's going on. It applies to schedule CS. So we know that's businesses and schedule EAs, which are rental activity.

Well, what is the amount that a taxpayer has at risk? It includes cash that they've invested in the venture. The adjusted basis of any property that they put into the adventure, any recourse debt that they borrowed to put in the venture, because of course that means that the lender has recourse against the debtor who has put it in and non-recourse debt if, and only if it is actually secured by real property.

So those are the at-risk amounts. Cash adjusted basis of property recourse, debt, and real property secured non-recourse debt. That test is also applied to limit losses. If the losses are limited, they're carried forward just as the passive losses are. Now, let's take a look at how things unfold here.

Assume I have a business activity or rental activity losses are limited in the following order. First of all, if there's a partnership or an S-corporation it's limited to the taxpayer's basis. Secondly, the at-risk limitation is triggered. You can think of these as screens. So as you go through the first screen, yes, we have sufficient basis.

Then we come down and we look and say, do we have, are we at risk for the full amount of the loss? The answer is yes. We pass down to the passive activity limitation. And now we test on either a material or an active participation test. If you flunk any one of those screens, you stop. If you can get through all three, then the loss may be allowed.

Most taxpayers that are subject to the passive and at-risk rules are at least going to fail. One of the three, what happens disallows amounts are carried forward until you either have, or you do have sufficient basis, a sufficient amount at risk, and then you either have passive income dispose of the activity or meet the material participation test.

So as you were reviewing for the exam, And this particular segment, two things should leap out at you. First. We do not automatically disallow the losses, so the taxpayer never gets them both the passive activity rules and the at-risk rules allow carryforwards remember the difference. Passive activity applies to trader businesses and rental activities on the.

Passive rules with a business, you have a material participation test, regular continuous, substantial participation in the activity. In the rental environment. It's an active test, which is less stringent and there is a $25,000 potential loss that may flow through. If you meet the exemption under the at-risk rules, none of those tests apply.

It's simply that you must have your investment at risk to the extent of cash adjusted basis in the property recourse debt or non-recourse debt secured by the property last but not least the ordering rule basis at risk passive activity, you'll do well on the exam. If you keep these key points in mind.

Individual tax deductions for adjusted gross income. I'm Jack Dorman. There are a number of deductions which may be taken on the return as adjustments to. Or in computing adjusted gross income. These are actually deductions that are shown on page one of the form, 10 40 and at the bottom half of the page, remember income is reported to the top half of the page and we come down to a total income number.

Then these deductions summarized at the bottom are called either deductions to arrive at adjusted gross income, or sometimes called deductions above the line. We'll look at several of these and let's begin with the individual retirement account or IRA. You all know that there are two types of individual retirement accounts, a traditional and a Roth IRA contributions to a traditional IRA are deductible contributions to a Roth.

IRA are not. The contributions to a traditional IRA must be made by April 15th, following the year to which the contribution relates. In other words, the original due date of the return. This rule does not apply to Roth IRAs because they're not deductible. Now the basic contribution for both types of IRAs is $5,000.

And for a taxpayer over the age of 50, an additional $1,000 may be contributed. The amount of the contribution is limited to the taxpayers earned income that earned income includes alimony, but does not include pensions or any type of investment income. Let's talk about these individually retirement accounts now, which are of the traditional CA yeah.

Or if a taxpayer and a spouse who is not an active participant they're eligible and may claim a deduction for the contributions to the IRA. So neither the taxpayer, nor the spouse is an active participant in any pension plan. In addition, the taxpayer may contribute for a non-working spouse. If there is active participation in the plan, the taxpayer and spouse are subject to a phase out range for eligibility.

So if they, if one of them participates in a plan, then they may be subject to a phase out range. And this range varies for the individual single taxpayer, married, filing, jointly, married, filing separately in general. And the numbers change each year. The single taxpayer is somewhere between about 55 and 70,000.

The buried is between 90 and 115,000. If the spouse is a non-participant, the phase out range also varies again, it's above 150,000, but there is a range and these should be checked periodically to see what the current range numbers are. A second deduction, which may be taken in computing adjusted gross income is education as an education expense.

Student loan interest. This is interest paid on a qualified student loan. It applies only for the first 60 months. Interest is required and it applies right now through 2012. But again, Congress keeps changing these rules. So you need to check whether a particular expenditure is allowable for the year.

That you're, that you're looking at the maximum limit per return is $2,500. The loan must be taken out or incurred for qualified tuition fees, books, room, and board. The loan may be for the taxpayer, the spouse and the dependence, but please don't as again, the limit is a per return limit, not a per taxpayer limit.

Again, this is also subject to an income phase-out, which is indexed. And again, we're in the range between 50 and a hundred thousand for singles and between about 120 and 175,000 in terms of a married couple, but just as an, every other phase out range, check your viewer guide to see how that's been adjusted for inflation by the IRS.

A third deduction in computing adjusted gross income is for tuition and fees. The maximum deduction is either 2000 or $4,000. It's scheduled to expire at the end of 2011. Again, check the viewer guide. This deduction cannot be taken. If that expenditure is rolled up and claimed under one of the other benefit provisions, such as the hope credit, the lifeline lifetime learning credit or the education savings account.

Now I mentioned that two different deductible amounts, either 2000 or 4,000. These are again, pegged to the adjusted gross income of the taxpayer. So please check those phase out ranges to see whether you qualify for the lower or hopefully the higher amount. Another itemize, another deduction that can be itemized in computing adjusted gross income above the line, or from moving expenses and qualified moving expenses include moving goods and transportation and lodging for the taxpayer and family to the new residence.

Certain expenses associated with the move are not deductible and they include house hunting trips, commissions meals. Temporary living expenses and any early lease termination payments that have to be paid. The moving expenses have a couple of special rules associated with them. One is the distance rule.

The new job must be 50 miles farther from the old house than the old job was from the old house. So there's a 50 mile distance rule and there's a time rule. Employees must be in the new job. 39 weeks in a 12 months following the move self-employed individuals must meet 78 weeks in the first 24 months, but also must meet the 39 week, 12 month test rule.

So you've got two rules, distance rule in time rules, as well as what does constitute allowable expenses moving the family goods, furniture and so forth. And the actual travel of the family between the residences.

There are several deductions that are very important for self-employed individuals on the deduction group called adjustments for AGI. The employer portion of the self-employment tax may be deducted here. And generally you can think of this as 50% of the se tax as the taxpayer pays. Although while Congress is making these payroll tax holidays, that is a slightly different calculation.

So it's the employer's share of the se tax may be deducted by the self-employed individual. In addition, contributions to qualified retirement plans, such as ASEP. A simple Akil plan may be deducted and medical insurance premiums for the taxpayer spouse and dependents may be deducted in computing, AGI health savings account, or an HSA is another amount that may be deducted in computing AGI.

And in this particular case, the individual must have a high deductible health plan. Frequently, you'll see this referred to as an HDHP, not be entitled to Medicare benefits or other coverage and not be claimed as a dependent on another return. In this case, contributions are deductible to the lesser of the annual health deduction deductible.

The annual health plan deductible, or a statutory contribution limit. And these coverage amounts again are set by the IRS they're indexed for inflation. The starting point was about $3,000 for single coverage and for family coverage, about $6,000. Again, check the viewer guide for the most recent numbers.

If a taxpayer puts an excess amount. Mount over the limitation in their SSA, H S a that excess contribution must be included in income and is subject to a 6% penalty tax until it is corrected. We've talked previously about alimony and child support. If the taxpayer is paying alimony, the alimony payments out.

Maybe included as an adjusted computing. AGI. Remember alimony is deductible child. Support's not why because the recipient is reporting. The alimony as income does not report child support is income in order to be deductible, alimony must be paid in cash pursuant to a written divorce instrument, not designated as anything other than alimony.

It must terminate on the death of the payee. And it must be paid to that. Ex-spouse not paid to someone in the same household. So we've highlighted some of the major expenditures. In computing, AGI, there are a few others just to briefly mention. They include the penalty on early withdrawal of savings.

Jury duty. That's remitted to the employer in exchange for regular compensation, educator expenses, and business expenses of reservists, and finally the domestic production activities deduction. Although it will be rare for you to see very many taxpayers claiming this domestic production deduction.

That will require some very special circumstances, generally arising from investments in pass through activities. So if you want to wrap up and summarize this particular segment in computing gross income, there are certain expenditures that may be deducted from the total income number on page one in arriving at AGI.

And this will have. The taxpayer will be invited in titled to these benefits, not withstanding whether they claim either the standard or itemized deductions. The biggest of these include IRA deductions, deductions for contributions to traditional individual retirement accounts, certain education expenses for tuition or loans.

We also have the alimony deduction. Amounts contributed to health savings accounts, the three different contributions for self-employment individuals, putting self-employment tax retirement plans and medical insurance moving expenses. And I believe that will, if you could keep those major components in place, you'll understand how we get to AGI two adjusted, gross income.

As I said, in a number of these, there are phase outs. Please check the viewer guide. Go forward and pass the exam

individual tax itemized deductions part one. I'm Jack Norman taxpayers, baby, able to deduct on their return. Itemized deductions. Let's discuss the fundamental principles underlying the concept of itemized deductions. They're subtracted from adjusted gross income and computing taxable income. Itemized deductions are unique to each taxpayer and are not based on filing status.

They're listed on schedule a, but reported in total as an actor. Good number on page two of the form, 10 40 and itemized deductions are claimed if they are greater than the standard deduction, there are roughly six categories of expenditures under the itemized deduction scenario. These are. Medical expenses, taxes, interest, charitable contributions, casualty and theft losses, miscellaneous itemized deductions.

In this segment, we're going to begin with the first of those two items. We'll start with medical and continue on with taxes, but let's add one more principle before we begin. I have to define for you the words, threshold and ceiling. A threshold means that the expenses are deductible. To the extent they exceed either a stated percentage of AGI or a stated amount.

This is sometimes called a floor. A ceiling means that the expenses are deductible up to a stated percentage of AGI. We're going to see this in play with our first category medical expenses. Qualified expenses are those paid for the taxpayer, the spouse and those dependents, which are claimed on the return for the individual.

They are deductible to the extent that the total expenditures exceed seven and a half percent of AGI, that's the floor I'm talking about. So you add up all the medical expenses and they only are claimed as an itemized deduction. To the extent they exceed seven and a half percent of the taxpayers adjusted gross income, the deduction is allowed in the year paid regardless of the service date.

Thus credit card charges are deducted in the year. The amount is charged to the card. What constitutes qualified medical expenses, insurance premiums for medical and dental care premiums for long-term care insurance, inpatient. I didn't care. That's for instance, in a hospital or a nursing home, prescription drugs and insulin.

Okay. Medical AIDS, such as glasses and hearing AIDS. Travel expenses and lodging. For instance, if you travel, let's just take as an example from Tampa, Florida, to Rochester, Minnesota for special work at the Mayo clinic, the cost of going to the clinic for travel and for lodging, there are also qualified medical expenses.

They also include capital expenditures to accommodate handicapped. So for instance, if you have to modify a bathroom to take into account. The, the physical effects of the stroke on the taxpayer, those capital costs are deductible to the extent that cost exceed any increase in the value of the residence, in which the expenditures are placed.

Automobile adaptive devices. Those are all qualified expenses. Now let's turn to some other expenses that you may think of as medical expenses, but they are not deductible under this category. Premiums for the loss of earnings insurance premiums for life insurance policies, funeral expenses may not be deducted on the individual tax return.

Most cosmetic surgery. And items for general nutrition and health, for instance, vitamins or health club membership, deductible qualified expenses are those amounts that are not reimbursed by insurance. So if let's just say I go to the dentist, I pay the fee for my My routine cleaning and my dental insurance will reimburse that if it is reimbursable, I cannot deduct the expense.

And remember, if you decide it, you have a policy that would reimburse, but you don't put in for reimbursement. You may not deduct the amount. So if it's reimbursable, it must be re paid by the insurance company. And only the amounts that are not reimbursed are deductible medical expenses. Again, remember very clearly these are amounts in excess of seven and a half percent, and then have not been reimbursed under any insurance policy tax expenses.

The taxpayer made a duct, either state and local income taxes or state and local sales taxes that provision. For state and local sales taxes was put through in Congress a couple of years ago, scheduled to expire at the end of 2011. Please check the viewer guide to see whether it is in effect in the year that you were reviewing this material.

Taxpayers may deduct real estate taxes, personal property taxes, and foreign income taxes. Now, while I gave you the option about the sales tax. You should be aware of that. You either deduct the amount paid or optional IRS table amounts for most taxpayers. That's going to be the easiest thing. Look at the table.

The IRS has provided rather than yang up all your sales tax expenses for the year on the income tax. You may deduct the amount paid during the year through withholding through any estimated payments or through prior year overpayments that you applied. To the current year. In other words, you overpaid, let's just say, for example, in 2010, did not ask for a refund, but said, apply that to my 2011 liability.

Those three amounts withholding the estimated payments and a prior year overpayment applicable to the current year. All are deductible, state and local taxes. Real estate taxes may are, may only be deducted by the person legally obligated to pay the tax. And that's the property owner real estate taxes do not include any special assessments for local benefits.

For instance, some jurisdictions will say in your neighborhood, we're putting in a special assessment for street improvements or sidewalks. Those special assessments do not qualify as real estate taxes. Real estate taxes are also limited to the first and second residence. If they have one of the taxpayer, if there's actually a third residence that does not qualify.

If there's a home office or the particular residence is a part rental. For instance, the vacation home, the taxes must be apportioned. The personal part is reported on schedule a as an itemized deduction, the rental portion on schedule E as a rental expense. Now I mentioned the personal property taxes are deductible, and these are basically ad valorem taxes or value-based taxes and various jurisdictions imposed them on automobiles, aircraft, boats.

So those that are paid are deductible as itemized deductions. Foreign income taxes may either be deducted on schedule a or the taxpayer may claim a foreign tax credit for them in general, small amounts that might be imposed on a small, a stock portfolio are usually claimed on schedule. A larger amounts.

Taxpayers frequently will go to the trouble of computing, the foreign tax credit, but foreign income taxes may indeed be an itemized deduction under the tax category. Taxes are deductible in the year paid. If the taxes relate to a business, then those are deductible on schedule C. You should be aware that the following taxes are not deductible.

You may never deduct federal income taxes. You may not deduct excise taxes, including for example, some excise taxes that are penalty provisions included in the internal revenue code, like an early distribution from an IRA account. Payroll taxes are not deductible social security in the like estate and gift taxes may not be deducted.

Now let's talk about a concept called a tax benefit rule. Assume that a taxpayer has taken a deduction for an expenditure and subsequently the taxpayer receives a reimbursement or a rebate, then that the taxpayer must report income to the extent of the prior benefit received. Let's take a couple of examples.

Suppose during the year I have paid in my state income taxes. And I get a refund rather than apply it. I asked for a refund in the following year, I have to pick up as income that refund the, to the extent of the benefit I received from deducting it in the preceding year. Some other cases may involve then insurance reimbursement that you receive in a subsequent year, you decided you hadn't gotten the reimbursement so that you went ahead and deducted.

The expenditure reimbursement claim came in. Later than you had going to have to restore that as income that's the tax benefit rule. So in this segment, we've talked about two different types of itemized deductions, and we talked about some underlying principles. First of all, we talked about the medical deductions, these to the extent that they are not burst or reimbursable our deductible, to the extent they exceed seven and a half percent of adjusted gross income.

Most of the things we think about as medical expenses are deductible doctors, dentist, hospitals, insurance premiums, for medical care. There are some areas including such things as life insurance and cosmetic surgery and healthcare health club dues, which are not deductible. The second category we talked about were taxes.

And here you can deduct state and local income taxes, foreign income taxes, real estate taxes, and at least for a certain years, sales taxes. Remember that excise taxes and federal income taxes are not deductible. Yeah,

individual tax itemized deductions part two, I'm Jack Dorman. And in this segment, we're going to discuss interest expense and charitable contributions, mortgage interest on the first or second residence is deductible. Subject to limitations. Now first we have interest on acquisition debt and it's deductible.

If the resident's secures the debt and the amount of the debt does not exceed $1 million interest on home equity debt is deductible. If that debt is not used to buy or remodel, the home is secured by the residence. The equity debt does not exceed $100,000. And the debt does not exceed the net equity in the property, net equity being defined as the fair market value of the house minus the acquisition debt.

Now, if you take out a home equity indebtedness, any use of the proceeds for business purposes is deducted not on schedule a, but as it is deducted on schedule C as a business expense. Now let's talk about a couple of specific rules in here, acquisition or improvement points. So in other words, if when you are borrowing on the original acquisition, then those points are deductible where they're paid by the taxpayer or paid by the seller.

If on the other hand, there are points on a refinancing of a loan. Those points may not be deductible. They must be capitalized and written off over the life of the loan. If however, let's just say we took out acquisition debt. We refinanced it once it had points on the first refinancing now, because interest rates are dropped.

We've refinanced a second time. And again, points are imposed. At that point, the points on the second refinancing must be capitalized written off over the life of that second refinance loan, but the remaining balance of the points on the first loan, maybe expensed than because they're gone debt with points must be secured by either the first or second residence, mortgage insurance premiums.

For contracts written after 2006 have been deductible as interest through 2011. You need to check the viewer guide to see whether Congress continues that provision or allowed it to expire. Also in the interest expense category is something called investment interest. This is debt used to purchase securities.

If the securities pay taxable income, the interest is deductible. To the extent of that investment income. If the investment interest expense exceeds the investment income, the excess may not be deducted, but maybe carried forward into future years. Suppose on the other hand that the securities purchased with that loan generate non-taxable income.

For instance, their state and local bonds. Then since the income is not, includable not taxable, the interest is not deductible, much to many people should grant personal or consumer interest is not deductible. So the interest on credit cards for personal purchases, any type of loan like that is considered consumer interest and is not deductible interest on tax deficiencies.

Is never deductible interest related to a business or a rental activity is deducted either on schedule C or schedule E respectively. Now here, remember, we're talking about itemized deduction, interest expense. You will recall that certain education interests may be deductible as an adjustment to AGI or a deduction in computing, AGI.

That is not subject to this personal consumer interest alone. The second category of deductions we're going to talk about is charitable contributions, a charitable contribution. Made to certain types of organizations are deductible, not all tax exempt organizations received, not all tax exempt organizations receive tax deductible contributions.

The only ones to which the contributions are deductible are educational religious hospital organizations and others of the nature that are described in code section five Oh one C3. Private charities such as fraternal orders and veterans organizations may receive tax deductible contributions. And if you wish to make a charitable contribution, not a tax, but a charitable contribution to a government.

For some reason, that is also a deductible contribution. The allowed amount of the contribution depends on both the type of the tote donate and the type of the property. So let's take a look at some of these rules amounts given to the following organizations are not allowed as charitable organizations, foreign charities, political parties.

You cannot give a quote charitable contribution to needy individuals. They may need the benefit. And it's the can certainly come through an outreach organization like a church like salvation army, but an individual giving to a needy individual is not a charitable contribution for purposes of the tax law contribution to civic, leagues or clubs are not deduction.

Neither are contributions to unions or chambers of commerce. In charitable contributions, the donation may be made either as cash or what's called ordinary income property or long-term capital gain property. And these have an effect on the amount that can be deducted. The donation is deductible in the year.

It's when made. So if it's charged to a credit card, it's deductible, when it's charged to the card, if a check is written, it's when the check is mailed, it's not determined. However, if you make a pledge, the pledge must be paid under some form. So making a pledge is not sufficient. It must actually be a cash transaction or, or a credit card.

Let's take a look now at the AGI limitations, you can have a floor or you can have a ceiling here. The charitable contribution is deducted without regard to AGI. So there is no floor, but there's a ceiling. The taxpayer may not deduct an amount greater than a percentage of their adjusted gross income.

For cash. The contribution amount is the fair market value of the cash. And it's generally considered a 50% limitation if made to a public charity, if may do a public charity and it is short-term capital gain property, then the amount is the lower of the adjusted basis or the fair market value of the property.

Again, the limitation is 60%. If however, it's long-term capital gain property, the limitation is 30% of the fair market value of the property, but, and here's a big, but there's something called a special election and we're going to illustrate that in just a minute, but let's look at the other rule. The one I just gave you was public charities, which is what most, let's say colleges, educational institutions the churches, those types of things.

C3 is, are generally public charities. We look at a private charity. The limitations for cash are 30% of the fair market value, short term capital gain property, 30% of the lower of the adjusted basis. Or fair market value and for long-term capital gain property, 20% of the fair market value. So if you can compare the public charity and the private charity you'll notice the contribution amounts are based on the same thing, fair market value or lower of cost, a lower of adjusted basis of fair market value and fair market value for the three categories.

But the AGI limitation changed

now. This, as I said is a ceiling and not a floor. Any excess contributions over the amount of the limitation may be carried forward for up to five years. Now, let's talk about that. Long-term capital gain property with that special election. I said, we'd get to the special election here's here. The assumed facts, the taxpayer's adjusted gross income is $30,000.

The property's fair market value is 15 and it's adjusted basis is 12. So if we do not make the election, the contribution is limited to fair market value. The AGI limit is 30%. The AGA limit is 30%. So 30% of the AGI would be $9,000. So what is the deduction? It's the 15,000. That contribution is limited to the $9,000.

Ceiling, if you will, on the return, we claim 9,000 and we have a $6,000 carry forward. Now let's turn over and make the election. Instead of claiming the fair market value of that long-term property, we cleaned the adjusted basis, which was only $12,000, but the limitation goes to 50% of AGI, not 30%. And accordingly with a 30% AGI, the limit is $15,000.

When we compare the contribution of 12 against the limitation, we're allowed to claim the full deduction of $12,000. And there is no carry forward now, which should you do clearly in the case of property, where you're going to be able to use that second $6,000 in the next year. You'd probably do not want to make the election and take the full advantage of the $15,000.

But if for some reason you may not be able to claim the charitable contribution and you look at time value of money. You look at the taxpayer circumstance, you may be better with claiming the full 12,000. You're getting 3000 more at the front end. But you're going to lose out on 3000 down the road.

That's an individual decision year by year and asset by asset. So if we summarize the charitable contribution rules, you have properties that have cash short term capital gain property. Long-term capital gain property. You have limitations based on AGI and for public charities, they can be either 50% or 30% with a special election for longterm property in a private charity.

You're looking at 20% and 30%. So bear that in mind, as you're working through problems, dealing with charitable contributions. The other segment that we talked about was on interest. Generally personal interest is not deductible and the way the tax list set up, you start with that premise. What interests can you deduct qualified residence interest that's acquisition indebtedness on first and second homes to the extent of a million dollars and home equity, to the extent of a hundred thousand dollars.

Points may be deductible on acquisition, not on refinancing there. They must be capitalized and amortized over the loan term. We also have investment interest expense. Is it deductible? Yes. To the extent of the investment income that's taxable. To the extent that the investment income is non-taxable, you can't offset it with investment income.

And with those facts in mind, you've wrapped up two more topics under itemized deductions,

individual tax itemized deductions, part three. I'm Jack Dorman. We have two more sections of itemized deductions to look at, we'll begin with personal casualty and theft losses. A casualty is a sudden unexpected and unusual in nature. It is not a deterioration of the property. A theft is a criminal act and not merely misplacing property.

And as a general principle, if covered by insurance, a claim must be timely filed before taking the deduction. Well, what's the amount of a casualty or theft loss is the lower of the adjusted basis of the property or the decline in the fair market value of the property. So the lesser of the adjusted basis of the decline in the fair market value reduced by any insurance reimbursement.

Once you have a loss. There is a hundred dollars floor per event. So let's assume I have a $6,000 casualty loss after I've received my insurance reimbursements. I have to reduce that loss to $5,900. And that's a per event reduction, not a per item reduction. Now those losses are only deductible to the extent that total losses exceed.

10% of adjusted gross income. And that's that floor concept. So you add up all of the unreimbursed unrecovered by insurance losses, reduce each event by a hundred dollars, add them all up. And then to the extent they exceed 10% of AGI, they may be deducted. The casualty loss is deductible in the year. The loss occurs.

The theft loss is deductible in the year. It is discovered. And remember we've discussed in other programs, the tax benefit rule generally applies to any benefit derived from a tax deduction. If the taxpayer receives a reimbursement or rebate. And frequently, this may well be insurance down the road.

Sometimes it takes awhile for the insurance companies to work through the claims and actually make reimbursement to the taxpayer. So if a reimbursement comes after the event has occurred in the casualty claim, the taxpayer must report as income that reimbursement to the extent of any prior benefit received from the deduction.

That takes care of the casualty and theft losses. We turn over to the last category. Miscellaneous itemized expenses, miscellaneous itemized deductions are either subject to a floor of 2% of the adjusted gross income or not subject to 2% floor. And you really have to kind of look. Simply at the categories that the code and the service of put in some subject to the 2%, some not.

So let's begin with the ones subject to the 2% limitation, continuing education expenses. And these are not expenses to beat a minimum entry level into a new job. Those could never be deducted, but continuing education expenses of a taxpayer are subject to the 2% limitation. Any unreimbursed employee, business expenses.

Now remember if the employee is entitled to reimbursement under the employer's reimbursement policy, they Mo the employee must put in for reimbursement and may not deduct the expenses. But if there are certain expenses that the employer will not reimburse that the employee encouraged in the business, I think this is rare, but if it happens, nevertheless, the expense may be deducted, but subject to the 2% limitation.

To the extent that the taxpayer purchases, uniforms and protective clothing safety equipment reduced for professional organizations and unions, they may be deducted subject to the 2% limitation subscriptions to professional journals, travel and transportation. Non-business tax return, preparation fees, appraisals to determine casualty losses are all deductible, but again, subject to the 2% limitation now.

Here's a good one legal fees to collect taxable income, such as alimony. The spousal entitled to alimony is not receiving the payments, retains legal counsel to collect those amounts. Since it's taxable income, legal fees are deductible, but to the extent they exceed 2% of AGI fees for wills are not deductible.

Investment expenses are subject to the 2% limitation. And these include such things as safety deposit, Reynolds, custodial fees, investment council investment taxes. There may be some not income taxes, but invest with taxes, subscriptions to invest with publications. Those that we've just talked about for last couple of minutes are all subject to the 2% limitation.

So you say, well, how much can I get into the nuts subject to 2% limitation? And basically it's gambling losses to the extent of gambling, income and estate tax imposed on income with respect to a decedent. Those are really about the only two. Now we've talked in different segments about six different types of.

Itemized deductions and there is, or has been in law and overall limitation on itemized deductions. So this overall limitation has been phased out for a few years. It's eliminated through 2012. So. I don't think he need to pursue it too far, but just to remember that once upon a time, Congress did phase out the limitation on itemized deductions.

What should you remember about this part three segment and the two particular categories we talked about? Well, first on casualty or theft losses, you need to remember that there is a floor of 10% of adjusted gross income. And there is a hundred dollars specific event for unreimbursed for the expenses that are not reimbursed on the casualty loss, miscellaneous itemized deductions.

There are. Two very narrow exceptions with that. Those expenses are not subject to a 2% floor virtually all miscellaneous itemized deductions are subject to a 2% floor. Many of them relate to either investment activities or unreimbursed business opportunity, op opportunities, business expenses, which are not reimbursed by the employer.

Good luck on the exam. You've got this section docked.

I'm Jack Norman and we're discussing tax credits in the context of the individual income tax. Now, there are a number of tax credits of the taxpayer, maybe a little to claim on their return. The individual credits themselves usually have a supporting schedule. We've will contain the details of the credit and must be attached to the form 10 40.

A summary of all of the tax credits then appears on page two of the tax form itself. These credits reduced the liability of the taxpayer from their initial tax computation. Some of these credits whose excess ex is over the amount of the tax liability are not refundable. There are also tax credits, which are refundable and they're applied against the tax liability.

After adding any additional taxes to which the taxpayer may be liable, we'll explore both refundable and nonrefundable credits. In the course of this discussion, let's begin with the non-refundable credit for foreign taxes paid, and I'm going to take each of these non-refundable credits in the order to which they would be applied on the return.

As you recall, taxpayers may either claim an itemized deduction or a tax credit for foreign taxes that they are paying. The foreign tax credit itself is limited to the lesser of the foreign taxes paid or a formula computed as follows the us tax. Times taxable income from a foreign source is divided by worldwide taxable income.

And this is true, who is sure that the tax credits for foreign taxes paid, never exceed the us tax liability. So that limitation is built in. Although the tax credit foreign taxes paid is not refundable. Any excess credit can be carried back one year and forward 10 years. The second credit we're going to talk about is the credit for child independent care.

It applies for a qualifying child under the age of 13 or a disabled dependent spouse. The allowable expenses, $3,000 for one individual, $6,000 for two or more individuals. Now that credit rate on those expenditures is 35% for a taxpayer with AGI of less than $15,000. That percentage is reduced for, for taxpayers.

With higher AGI, with the rate never drops below 20%. The credit may not exceed the lower of the taxpayer or the spouses earned income for the year. Next, we're going to talk about a couple of education tax credits. The first one is the American opportunity education credit, formerly called the hope credit.

It applies to the first $2,000 of qualified expenses at a rate of a hundred percent. And it's 25% of the second $2,000 of qualified expenses. Therefore, the maximum credit is $2,500 per student per year. And that amount is indexed for inflation. In order to qualify, the student must be carrying at least a 50% of a full academic load in a degree program.

And that. Those expenses must be incurred in the first four years of undergraduate education. It covers tuition fees and course materials. The second tax credit is known as the lifetime earning education credit, and it is 20% of up to $10,000 of qualifying expenses. The maximum deduction is $2,000, but it is limited to a taxpayer, not per student.

So on an individual return, only $2,000 would be allowed. Notice the opportunity credit is $2,500 per student. The lifetime education credit is $2,000 per taxpayer, both credits this credit applies to both undergraduate and graduate courses. Th the student does not need to be a full at least a half-time student, nor does he need to be in a degree program for both credits.

They apply to the taxpayer, the taxpayer spouse and any dependence. However, the credits may not be claimed for amounts received as non-taxable distributions from an educational IRA. And furthermore. No credit may be claimed with respect to tuition fees that are otherwise deducted on page one of the return from adjusted gross income, the allowable expenses that would qualify for the credit must be reduced by any scholarships that the student has received.

The next refund non-refundable credit we want to talk about is the resale retirement savings credit. And this credit is based on a sliding scale from 10 to 50% of the annual retirement savings that are placed in a qualified plan. The amount of the credit is based on the filing status and the adjusted gross income of the taxpayer.

The maximum credit is $1,000 per year. Now there were a couple of restrictions. The taxpayer must be 18 or older and not a full-time student. Furthermore, the taxpayer may not be claimed on another taxpayers return as we continue our list of non-refundable credits, there's a child tax credit, which equals a thousand dollars for each qualifying child.

Under the age of 17. This credit is phased out based on AGI and may be completely lost to the taxpayer. If the full amount of the credit is not used in a particular year. There is no carry over of the excess. Now, while I said it's a non-refundable credit, there is a little bit of a twist on that. The credit may be partially refundable to the extent of 15% of earned income in excess of 3000 of a $3,000 threshold.

So for certain individuals, there may be a refundable piece of this thousand dollar credit. Another non-refundable credit is the credit for elderly that is 65 or older or permanently disabled taxpayers. The amount of the credit is 15% of an initial base, which is determined based on the filing status of the individual.

And that amount is reduced for certain types of income, including social security and pensions. It's also reduced for higher AGI taxpayers. So the practical effect is you will very rarely see this particular card being claimed is a non-refundable credit called the adoption credit. And this credit applies to the adoption fees, attorney's fees and court fees.

It does not apply to any medical expenses for the adopted child. The maximum credit is approximately $13,000. Now there's an interesting twist on this credit. Also, if you are adopting a child with special needs, the maximum credit is allowed without regard to the amount of actual adoption expenses incurred.

For other children that is those who are not special needs children. The allowable amount is the lesser of the credit or the actual expenses paid. This credit is phased out for taxpayers with an AGI of between roughly 180 and $220,000. And perhaps at this point I should kind of stop and say you going to see in the credit arena, an awful lot of.

Numbers that are indexed and vary from year to year and also phase out ranges, which change credit by credit. Those amounts are also frequently indexed in preparing for the exam. Don't try and memorize the exact numbers for either qualifying expenses or phase outrageous. No, roughly the area, for instance, we know that the.

Adoption credit is about $13,000. The credit is phased out for roughly between 180 and $220,000. That will be sufficient for the exam. Now that's a series of refund of non-refundable credits. Let's turn over to the refundable tax credits. The first one I wanted to discuss is the earned income tax credit.

It's computed by applying a percentage to the earned income of the taxpayer up to a maximum amount. It also is subject to a phase out. Now that maximum credit is based on whether there's one child, two children, or no children, and four 2010. For example, that credit for one child ranges from a low of 3000 to a high of about 9,000.

For two or more children, it's from five to $12,000 and even a taxpayer would no children can receive a credit it'll rain somewhere from about $500 to about $6,000. Again, keep in mind the range. Now, if are a whole series of special rules related to the earned income tax credit. If the individual has no children, The taxpayer must be between the ages of 60 64 and 25 or said another way, 25 and 64, and not claimed as a dependent on another.

The return married couples are required to file a joint return. The taxpayer is ineligible. If the investment income exceeds a ceiling amount, which is approximately $3,000 and a few years ago, there were some major. Problems with people claiming the earned income tax credit, where they were not eligible.

Congress reacted to this by putting a provision in the law that States that a fraudulent claim bars, a taxpayer from taking the credit for 10 years. In addition practitioners who are claiming preparing returns to claim the credit do have additional due diligence requirements. Now there's another refundable tax credit in today's environment.

You may see this is excess social security withholding. Multiple employers may each correctly with whole FICA FICA tax from an employee. Without recognizing that there is another employer, who's also withholding FICA tax. This can result in excess withholding. So the wage base for FICA is about $107,000.

The FICA tax rate is 6.2%. To the extent that the total withholding exceeds the 6.2% on $107,000, the excess is a refundable credit notice that this credit does not apply to the Medicare 1.5%. So in reviewing for the exam, focus on both the difference between refundable and nonrefundable credits and have a general idea of the magnitude.

Of the credit, the way it operates and the phase out ranges do not try and memorize specific numbers. Otherwise you'll go crazy with the state of credits that are available.

I'm Jack Dorman and we'll be discussing the individual alternative minimum tax or AMT. The alternative minimum tax has been in the tax law in various forms. Since about 1969, congresses made occasionally an add on tax now as an alternative minimum tax. But throughout the concept of the minimum tax it's been thought of as a method of computing tax liability, to ensure that every taxpayer with income pays a certain minimum level of tax.

The AMT is computed separately from the regular tax liability and is mandatory. If the tentative minimum tax exceeds the regular tax liability. Now from your earlier studies and looking at modules and preparing for the exam, you've learned to recognize the regular tax formula let's review it. We begin with gross income, make certain deductions for the adjustments.

And this gives rise to the adjusted gross income number or AGI on the first page of the tax return from AGI, we subtract either the standard or itemized deductions and personal exemptions. This equals the regular taxable income. When we apply the regular tax rates to the regular taxable income, of course.

It'll yields regular income tax. And that's the calculation we're all familiar with, which ends up with a tax number near the top of the second page of the individual return. The minimum tax has three basic rules. I want you to remember for the REG CPA Exam one. The minimum tax always begins. The calculation with regular taxable income.

You do not start from zero, zero and build to a taxable income number for the minimum decks. You start with regular taxable income too. That taxable income is adjusted for differences between the regular and alternative tax systems and three, the elections that you make for regular tax purposes. Also apply from minimum tax purposes.

So remember you begin with regular taxable income, you adjust for differences between the two systems and all elections made for regular purposes or binding for minimum tax purposes, let's review the minimum tax formula. And as I go through this, there going to be some unfamiliar terms, which we're going to elaborate upon in just a moment.

As I said, we begin with regular taxable income. Two that we either add or subtract something called a M T adjusted splits. Then we add a M T preferences and what those two modifications we've computed alternative minimum tax income. We had take off a deduction for an exemption amount, and this gives rise to the alternative minimum taxable income.

Also sometimes known as AMT. I, the alternative tax rates are applied to AMT, I, which yields a tentative minimum tax sometimes called TMT. We subtract the regular income tax that we previously computed from the tech tentative minimum tax. If it's a positive number that gives us alternative minimum tax and that alternative minimum tax.

Will be added to the regular income tax that we calculated in finalizing our return. Well, as I mentioned, we have a number of terms and words of art that have to be looked at let's begin with the AMT adjustments. AMT adjustments may either increase or decrease taxable income. The standard deduction may not be claimed for AMT purposes.

So there you'll only be left with claiming itemized deductions. Personal exemptions are not allowed for the alternative minimum tax. And some of those itemized deductions are not allowed at all. And some were subject to different floors than under the regular income tax system. Let's take a couple of examples here on itemized deductions, state and local taxes are not deductible.

For AMT purposes, even though they were deductible. If you're itemizing for regular tax purposes, miscellaneous itemized deductions that were subject to the 2% floor are not deductible for the AMT. Now you remember for regular tax purposes, medical expenses must exceed seven and a half percent of adjusted gross income.

However, for AMT purposes, medical expenses must exceed 10% of AGI. So it's entirely possible that a taxpayer might have enough medical expenses to exceed the seven and a half percent floor, but not the 10% thus they would get medical expense deductions for regular tax purposes. They would not for AMT another adjustment mortgage interest it's fully deductible on the first and second homes, both acquisition debt, and home equity, subject to certain limitations for regular tax purposes.

That same mortgage interest for AMT purposes is not deductible. If the loan is not used to buy, build or improve either the first or second residence, another example. You take out a home equity loan subject to the appropriate limitations for regular tax purposes, you use that money for a round. The world cruise.

It was still be deductible for regular tax purposes, but not deductible for AMT AMT preferences. Always increase. EMTI. They're mostly business expense items. It'll many returns. You will not see any preferences. However, one preference item, which may affect certain individuals, particularly higher income individuals is interest income earned on private activity bonds.

I mentioned the AMT exemption and rates, AMT exemptions are based on filing status and they're phased out for higher income taxpayers. For 2011, the exemption was about $75,000. Taxpayers married and filing jointly less than that for single taxpayers. Now, if Congress doesn't enact legislation to correct it, the exemption will drop in 2012 to about $45,000 for married filing jointly.

And again, it will drop for single taxpayers. Congress has consistently over the last few years, made that adjustment. So you need to check to see whether Congress changed the exemption and to what level the AMT tax rate is 26% on the first hundred and $75,000 with alternative minimum taxable income and 28% thereafter.

Now, once you've computed this alternative minimum tax, you have to consider one more item. Some of these preferences that we're taking into account are timing differences. And when the future regular tax exceeds the tentative minimum tax, a credit is allowed for the four prior AMTSS on the timing differences, the AMT credit carries forward indefinitely.

So remember, you're looking to be able to use this credit when you have regular tax in excess of AMT. Congress has also edited a special rule, which has unused AMT credits more than three years old are partially refundable. This partial refundable rule is phased out for higher income individuals. Well, not only do we have the AMT credit on a turnaround, certain credits are allowed to offset.

Certain credits that we know about from the regular tax regime are allowed to offset the alternative minimum tax. These include the foreign tax credit, the adoption credit, the child credit, retirement savings, contribution credit, and the earned income credit. Now through 2011, all non-refundable credits have been allowed against the alternative minimum tax.

But again, some of these are subject to expiration unless Congress renews them in focusing on the alternative minimum tax. I believe there are four things you need to do in studying for the exam. Review the AMT formula compared to the regular tax formula, they look similar, but they're not. So make sure, you know, the difference between the two when calculating the minimum tax always begin with regular taxable income and adjust that amount.

You need to distinguish between adjustments, which could be positive or negative and AMT preferences, which are always going to be positive additions. You need to understand the importance of the minimum tax credit. And finally be aware the Congress constantly is tinkering with the alternative minimum tax.

So make sure you're up to date on the latest changes with those facts in mind. You'll knock off the AMT issues raised on the exam

cost recovery. I'm Jack Norman. Depreciation is the allocation of the cost of an asset over its useful life. Remember, depreciation has nothing to do with whether an asset declines in value. It is an allocation of costs. It's entirely possible. You may have an asset that is going up in value, potentially real estate.

For example, nevertheless, it would still be depreciated. Internal revenue code section one 67 allows a taxpayer to claim a deduction for depreciation and code section one 68 sets forth the details of this depreciation system, commonly called makers or the modified accelerated cost recovery system.

Another code section one 79 allows a special depreciation write-off or immediate expensing. We'll discuss this. After we CPA review the basic depreciation rules of one 68. Now, as I said, our system is called makers, accelerate, modified, accelerated cost recovery. It's contained in section one 68, and this is the focus of the CPA exam.

The banker system applies to assets placed in service after 1986. Now there's a little background, although it will not be. Probably tested on the exam. You might want to be aware of the fact that our depreciation system in 1981 was called the accelerator cost recovery system. And that ACRs system plied between 1981 and 1986.

As I said, we now have a modified system which came in in 1986 prior to the original. ACRs system, there was something called the accelerated depreciation range or ADR in your practice. You may see some assets still handled under these two older depreciation systems, but focus for now for the REG CPA Exam on the modified accelerated cost recovery system makers, which is the subject that we're now going to continue with.

Depreciation applies to tangible personal or real property that is used at a trader business or for the production of income. So notice there may be two tests and two types of property, personal or real property either use it a trade of business or held for the production of income. Depreciable property does not include land.

Y. Because God's not making much more of it. And it is non depreciable, furthermore, personal use property, those things that you use in and around your house, your automobile for daily drives to the grocery store or commuting to school the house itself, your principle residence, those are personal use items and a non depreciable intangible assets such as Goodwill.

Patents copyright or customer list are amortizable. They are handled under separate code sections and are not part of our depreciation discussion at the present time. Furthermore, natural resources are depletable assets, not depreciable assets, and they're handled under a depletable tax regime, which we'll also talk about a little bit later.

Such examples include. Oil natural gas, coal resources, mining assets, and even timber. Let's now turn to our tangible personal property. Under the maker system, it's divided into six classes and those classes are given useful lives of anywhere from three to 20 years. For example, computers and vehicles are in a five-year classification.

The default. In other words, if your item that you're looking for in one category is not listed, it will fall into something called a default category with a seven year useful life. So such items as office furniture, retail, most retail appliances, and so forth will fit in that seven year category in the maker's classification system.

All assets in each class are consistent from year to year. So if you buy 14 vehicles for your fleet in the business, they will all be in that automotive class for, let us just say 2013, and they'll all be depreciated together to all assets are consistent in each class in each year. Real property, however, is kept separate and we track each individual piece of real property.

It is either residential real property used for living accommodations and then has a useful life of 27.5 years. Don't even try and guess where the 27.5 came from. It was a compromise in Congress. Just remember 27.5 for residential and for commercial buildings, there is a 39 year useful life. Now besides establishing the useful life of this property, the maker system sets up certain conventions for personal property.

There is either a half year or a quarter, year convention. What this means is that let's just take the half year convention. We assume that all property acquired during the year is placed in service at the mid point of the year. The quarter year convention applies. If more than 40% of the aggregate basis of that property is placed in service the last quarter of the year.

What Congress was trying to do with this quarter convention is to, for event taxpayers, for backend loading or purchasing all our assets in November and December and depreciating it for us half a year. So the basic rule is a half year convention chin. And then if there is an excess year end or back end loading a quarter year convention, real property, however, this is a mid-month convention.

So in whatever month, That real property is placed in service. It is assumed to be in the midpoint of that month. Let's talk about maker's tables, which are used for the tangible personal property. What I'm telling you now is that you go to a table and you look up how much depreciation you can take on that class of real personal property.

In the year, the maker's tables are set up by class. They assume there is no salvage value and you will have a half year table and in bid quarter convention table, those depreciation percentages. Are computed on the basis of a declining balance, double declining balance. This switches to the straight line depreciation method at the optimum point.

So what the Congress and the IRS had done is built tables. All you have to do is take the amount of your tangible personal property in a particular class. Look up the table and using either the half year or mid-quarter convention, pick the percentage on there to compute that year's depreciation. We'll do an example in a moment.

Real estate is only depreciated on a straight line basis using that mid bunk convention. So this is very simple. You've got 39 year life divide that 39 years. Into the cost of the property using your mid-month convention, that will give you your depreciation for the year. I told you we'd have an example.

This is the basic maker's depreciation, and I'm going to assume a business computer. The system costs a hundred thousand dollars and it was placed in service during the first, second or third quarter of the year. So I want to use the mid-year convention. When I look at the makers table. For this property it's table one five-year class with a half year convention.

That table tells me that in the first year I take $20,000 of depreciation, 20% of the a hundred thousand dollars costs. Remember I said, we do not have to worry about salvage value. So in year two, I take the a hundred thousand and apply the table. Percentage 32%. I claim a $32,000 depreciation deduction in year two.

That's all there is to basic maker's depreciation using the accelerated tables. Now taxpayers may elect not to use the maker's tables and use an alternative depreciation system. This is also set forth in code section one 68. It's subsection G of one 68, and it's called the ads alternative depreciation system.

It is a straight line system. Just straight line depreciation with longer lives than a specified class lives. Why would a taxpayer want to even consider the ads? Well, suppose you have a company that is just starting up. They have first year losses. If he go to the makers to system that will just increase the losses because you'll get accelerated front and unloaded depreciation deductions by electing the ad system, you'll get straight line longer lives, lower depreciation in the earlier years.

And you could stretch out the depreciation. The selection may be made on a year by year basis.

This is cost recovery and I'm Jack Dorman. During the height of the most recent recession, Congress enacted a bonus depreciation regime. It was designed to encourage particularly corporate taxpayers to purchase additional fixed assets and get them in service to try and help boost the economy. During those tough times, the 50% bonus depreciation applies to new property placed in service after 2008.

And generally it is property with a useful life of less than 20 years. The bonus depreciation is claimed after the IRC one 79 deduction, and it applies for the alternative minimum tax. A taxpayer may elect not to claim the bonus depreciation. And why would they want to do this? For the same reason that they might wish to extend the useful life under the alternative depreciation system instead of makers.

In other words, what they're trying to do is stretch out to depreciation as long as possible, and by electing out of bonus depreciation, that will save them to appreciation deductions. In the earlier years, let's turn and look at code section one 79. It allows a current deduction for the purchase of depreciable, tangible personal property.

It may apply to either new or used property. The one 79 deduction is limited to the lesser of a current year ceiling or the taxpayer's taxable income. That ceiling amount is set at $500,000 in 2013. Now a taxpayer elects one 79 on a year by year basis for certain assets purchased during that year. If the purchases exceed $2 million in 2013, then that allowable amount is phased down.

This is called the ceiling cap for the phase out. Now you should check in the text material because Congress frequently alters the ceiling level and the phase out of mounts for the one 79 deduction. Let's turn now and take a look at a couple of examples. In the first case, we're going to claim the one 79 deduction without claiming bonus depreciation.

Assume the business purchases as a single asset during the year, a computer system that costs $900,000. The company's taxable income for the year is 27 and a half million dollars. As I mentioned, the internal revenues, the internal revenue code ceiling for 2013 is $500,000 with a $2 million phase out. So in this case, Because the asset was only $900,000.

We have no phase out reduction. The total IRC deduction under one 79 is $500,000 with the assets. Depreciable basis is 900,000. We subtract the one 79 deduction leaving us with $400,000 of remaining depreciable basis. The maker's tables would tell us that it's a 20% rate for the computer in the first year using the mid-year convention.

So that's $80,000 of depreciation in this case using one 79 and no bonus depreciation. The first year depreciation deduction would be 580,500,000 under one 79 plus 80,000 under makers. Suppose we take that same example. Only this time we will use the bonus depreciation. The one 79 deduction is again, $500,000.

The depreciable basis, 900 minus the 500 is $400,000. At this point, we apply the 50% bonus depreciation, which gives us an additional $200,000 of depreciation in the year. Taking the maker's depreciation basis of the 900,000 minus the one 79 deduction of 500 minus the 200 of the bonus depreciation gives us a remaining makers depreciable basis of $200,000.

Applying that 20% rate is another $40,000. So in this case, by claiming the bonus depreciation coupled with one 79, We'll have a total first year depreciation of $740,000 on an asset we purchased for $900,000.

This is cost recovery and I'm Jacqueline woman. One aspect of the depreciation rules is something called listed property. It's contained in code section two 80 F and applies to property, which is in the eyes of the Congress, potentially subject to abuse as both personal use and business use. So certain items are set out on the list, including computers, automobiles, and entertainment facilities, with respect to these assets.

No depreciation can be claimed unless the business use exceeds 50% and you claim the business use percentage. Although nothing is allowed at less than 50%. There are stringent recordkeeping rules with respect to listed property. And if the business use falls below 50%. The taxpayer must recapture the excess of accelerated depreciation over what depreciation would've been allowed on a straight line basis for all prior periods.

And then you straight line depreciation for future years in the case of automobiles as listed property. There's an annual depreciation limit for what so-called luxury automobiles. So each year the IRS puts out tables saying a purchase price in excess of this amount constitutes a luxury vehicle. And the depreciation is limited to an amount under that scheme.

The limitations apply to makers to bonus depreciation and to the IRR C one 79 deductions. The thresholds that are set out for luxury vehicles are slightly higher for trucks and vans than they are for car for cars. And as I mentioned, the IRS publishes these tables each year. When we look at assets, let's talk about something else called a 1231 asset.

Remember when we're doing depreciation, it is w. Tangible personal property or real property used in a trader business or held for the production of income. Now a 1231 asset is real or depreciate depreciable property used in the trader business and intangible assets, subject to amortization, such as Goodwill.

The interesting part of code section 1231 assets is how we treat the gain or loss on the disposition of those assets. When we dispose of the assets, we net all of the gains and losses on the sale of those assets within the year. If there is a net short-term gain or short-term loss, it's treated as an ordinary gain or loss.

If there is a net long-term gain is treated as capital gain. Subject to recapture rules, which we're going to talk about in a few moments. And if there's a net long-term loss, that loss gets ordinary income treatment. So there are a whole series of tests on the disposition of these assets that are classified as 1231 assets recap, short term gain or loss is treated as ordinary.

Long-term gain is treated as capital gain, but long-term loss is treated as an ordinary loss. I mentioned depreciation recapture. This is to prevent the conversion of ordinary deductions into capital gain. And what do I mean by this? Well, think about depreciation. Depreciation expense is claimed on an annual basis on a tax return and reduces a taxpayer's ordinary taxable income.

Yet when we selling business assets, particularly the 1231 assets, you notice that a lot of that gain will be. Capital gain. This is particularly relevant in appreciating assets, but it will also happen with assets that are severely depreciated. You may have a gain on that. Any gain would be treated as capital gain.

Congress saw this as a conversion opportunity. The taxpayer gets an ordinary loss and the gain is taxed at a preferential capital gains rate. Hence depreciation recapture rules. There were two rules. There are two rules in the code right now, section 1245 is still quite viable. Section 1250, much less. So let's start with section 1245.

This applies to tangible personal property, and it has a full recapture of depreciation previously, previously claimed to the extent of any gain. Let me use this example for you. We have. Piece of property that has been depreciated and there is a claimed depreciation deduction or accumulated depreciation of $20,000.

The gain on the disposition is $25,000. So ordinarily we would have $25,000 of capital gain under the recapture rules that full depreciation previously claimed is treated as ordinary gain and only the remaining difference. 5,000 is the capital gain. So while we account for the total gain of 25,020 is treated as ordinary 5,000 is the capital gain.

Section 1250 was originally designed for real estate. And it said that the recapture rule was the excess of the amount of accelerated depreciation over straight line depreciation, to the extent of gain. If you remember. In an earlier discussion, we talked about accelerated cost recovery systems. And we talked about real estate being depreciated on a straight line basis.

That's been true since 1981, but prior to that time, there could have been accelerated depreciation on real estate. Hence the reason for section 1250, it's limited in today's world. There may be a few properties out there. You should know that there used to be a 1250 gain. It has limited application. Most of the CPA exam problems.

You're going to see talk about 1245 recapture. However. And there's always a however in tax law, since nine, 1886, there are buildings that have been depreciated and on a straight line basis. So Congress did want to raise some revenue and they said, we're going to have a partial recapture rule for corporate owned real estate Realty.

It applies only to C corporations. And the recapture rule is 20% of the prior depreciation that was taken on a straight line basis. Let me give you another example here. We have a building that costs 345, $340,000. The previously claimed depreciation on a straight line basis was $140,000. So we have a sales price now of $400,000.

That real estate that building has appreciated. But the basis at the time of the sale is 200,000. Remember the original cost of three 40 minus the accumulated depreciation. It brings us down to an adjusted basis of $200,000. Therefore upon the sale $400,000 of proceeds, less adjusted basis of 200 leaves us with a $200,000 taxable gain.

This recapture provision says 20% of the depreciation previously claimed, which was $140,000 that works out to $28,000 of depreciation. And if you take the total gain of 200,000 less, the 28,000 of recapture, which is treated as ordinary income, there's $172,000 of what will be capital gain or since it was using the trader business, 1231 gain treated under the capital rules.

Nevertheless, the 28 is treated as recapture at ordinary income rates. That takes care of the recapture rules. And we've talked about basic depreciation. Let's talk about intangible assets. And now we're going to focus on code section one 97, which says intangible assets are not depreciated, but they're amortized.

They're written off on a 15 year basis, straight line. Now one 97, intangible is an asset acquired by the taxpayer. You cannot amortize self-created assets. So for instance, a taxpayer acquires or purchases, patents, trademarks, Goodwill, these items are amortized on a straight line basis. Over 15 years.

Certain non one 97 intangibles may be amortized on the street line basis. Under other provisions. For instance, there are certain things like software, which could be written off over 36 months or organizational costs where the entity as its first set up, pays the lawyers and the other organizers, certain fees.

Those will, they be written off, partly expensed the balance written off over 15 years.

we turned from, from amortization rules to depletion rules. These, I said, apply to natural resources. They're found in code section six, 13, and six 13, a the percentage to police. The police should rules, which primarily applies to oil and gas says that you take the gross income from the property. Time's a statutory rate.

So Congress said in this particular instance, you do not have to worry about the cost that you paid for the property. You're looking at the income times a statutory rate. The deduction for percentage depletion is limited to 50% of taxable income from that resource. Cost depletion on the other hand takes the unrecovered acquisition cost divided by the estimated quantity of the resource.

And that gives you a rate. So in effect, you look at the cost and estimate how much coal is at this particular mine, how much timber is on this piece of property. We're going to cut. And you come up with an estimate, compare that against what you cut to get a rate and use that times. Your current use extraction depletion rates are often established by engineering estimates.

So as we go back and think about cost recovery, fixed assets of real estate are depreciated on a straight line basis over useful life of either 27 and a half years. Or 39 years tangible personal property is depreciated using a maker system based on the class life. In each case, there is a possibility of claiming a bonus depreciation amount at the election of the taxpayer or electing the currently expense under code section one 79.

Upon the disposition of assets used in the trader business. You're going to have to take a look at the netting and characterization rules under code section 1231 and the recapture rules under code section 1245. ReoPro for personal property, 1254 old real property, and two 91 for new real property. You have to focus in the intangible arena on whether they are acquired assets and fall under one 97 for a 15 year amortization schedule or under certain other special amortization provisions that are sprinkled throughout the code.

And finally, when you come to natural reasons, cost recovery, you're looking either. At percentage depletion, primarily oil and gas. And you're looking at cost of pollution, primarily for other natural resource systems. Best of luck with your property tax questions and your depreciation cost recovery issues on the exam.

I'd like to talk to you about several transactions that are unique in the area of property transactions. The first one is referred to as a light kind of exchange addressed under section 10 30, one of the tax code. The second is involuntary conversions under section 10 33. And the third is the sale of primary residence under section one 21.

Now 10 31, like kind of exchanges at 10 33. Involuntary conversions are similar. And that they're tied together, but an underlying concept referred to as the continuity of ownership, interest principle. And that idea is that in order for the provisions of those two code sections to apply, there has to be some continuing ownership interests in a similar economic asset.

Now we would still compute the gain or loss on the transaction, like any other property transaction. We look at the fair market value of everything that's received on the transaction. And we compare that to the adjusted basis of everything that's given up computer gain or loss. And then depending upon the applicable tax code section will either recognize a gain or loss that will then be deferred.

We'll realize it, but not recognize it, or it may be that we eliminate the gain altogether. And so let's take a look first at section 10 31, a little bit more detail. In order for 10 31 to apply, there has to be an exchange of business or investment property for like kind of property. So we're not going to be able to take personal use property and, and generally, and swap that kind of property has gotta be business or investment property for  or a business or investment property.

And most often 10 31 applies to real estate transactions. To qualify, it could be improved real estate for unimproved real estate. For example, maybe you trade an apartment building for some pasture land. As long as it's Realty for Realty, personalty for personalty will also qualify, but it has to be the same general asset class.

And a good example might be maybe you have a delivery truck and a business, and you need a tray that in on a newer delivery truck, that's going to be qualified under as like kind of exchanges under 10 31. Now some things that you cannot apply 10 31, two would be inventory. So you can't take inventory off the shelf and swap it for inventory and have 10 31 apply.

Doesn't apply to stocks, bonds, notes, or partnership interests. Now, as you can imagine, if you had some property and I have some property and we discussed the possibility of applying 10 31 and, and you selling your property to me and me, likewise to you, it may be likely that the property's value might not be exactly the same.

And one of us would be concerned that we're not getting the same value as the property we're giving up. And so one of us is going to have some tickets to two boots, kick in some boots in order to make up the difference. And so one might give additional cash or perhaps one assumes the liability of the other, or maybe there's other property or services that are exchanged in order to make the transaction equitable.

Now that's okay. Is with respect to 10 31, except for the fact that the receipt of boot can trigger recognition again, to the extent that you received boot, that's not like on a property, then 10 31 is not gonna apply. Now a quick word about liabilities because real estate is so often the the, the area that 10 31 applies to that.

Oftentimes there's debt that's attached to the Realty, this exchange. So if I'm relieved of a debt, that means I don't have as many obligations to pay. Then I've received boots. If I assume that that means I've given up boot and only the receipt of boot can trigger recognition again. Now under section 10 31 we still go through the property transactions, like any other transaction.

We're going to look at compute the amount realized the mat realizes the fair market value of like on a property plus the fair market value of any boot that I received. Notice that in computing, the amount realized I always look at the fair market value of the property that I'm receiving. To compete, the realized gain I'm going to subtract from the amount, realized the adjusted basis of all the property that has been given up and the adjusted basis of any boot that might be exchanged.

Okay. So it's just like any other property transaction at this point, the recognized game that is the game that I'm going to have to report his income is the lesser of the gay and realized or the boot received. So I go through the property transaction, like. Any other kinds of transaction, I compute a realized gain the recognized gain.

The portion that I have to report his income is the lesser of the gain realized or the route received 10 31 doesn't apply to loss. So losses won't be recognized even if you receive or pay boots. Losses are not going to be recognized with respect to the light kind of property. Now going back to the notion that I mentioned earlier, what if we swap mortgages?

What if you and I swap property? And the property that you have is it has a mortgage attached to it, which I assume, and the property that you have that you're receiving that I'm giving to you has a mortgage attached to it in order to determine whether I've been relieved, a boot or assumed boot with respect to those mortgages, I have to net them together.

So if I have a net relief of boots, I have. W received boot if I have a net assumption of boot than I've given the, so you net the liabilities together. Okay. Now, in a similar way, what happens if I'm relieved of cash that is on paying you cash and I'm relieved of debt. If that's the case, then the cash is netted with the relief of debt.

Now, let me say that again. I have a relief of debt. In this exchange with you, and I'm also paying you cash in order to make this a fair transaction for both of us. And that case to determine whether I've received boot or paid boot, I'm going to net the relief of debt and the cash. Now, if the reverse is true, this is gets a little bit hairy here.

If the reverse is true, if I'm giving you a rather, if I receive cash and I'm assuming your debt, I don't net those together. Okay. Now the basis of the replacement property is also an important consideration. Now I've got some new property here. The basis of the newly acquired property is the fair market value of the new property minus the unrecognized gain, or plus the re unrecognized loss.

Let me say that again. The basis of the new property is the fair market value of the new minus the unrecognized gain or fair market value of the new. Plus the unrecognized loss. Now, if the exchange is between related parties, both parties are required to retain the property for two years. In order for the provisions that 10 31 to apply 10 31 is non-elective provision.

So no gain Ross is going to be recognized. And the only circumstance that would cause gain to be recognized is when you have a receipt of boots, Now 10 33 for involuntary conversions is, is quite similar to 10 31 in many respects, except for the triggering event, in order for an involuntary conversion to apply, there has to be condemnation of the property to be theft or seizure of the property, or perhaps the government is requisite in requisition, the property so that you're compelled to sell the property.

We're going to go through the computation of the gains and losses, like any other kind of transaction. Fair market value them realized minus the adjusted basis is the gain or loss realize except took 33, doesn't apply to losses. So there's no deferral of loss as a result of an Inbar conversion. Those are going to be recognized.

However, the gain that is recognized is the lesser of the gain realized, or the portion of the proceeds is not reinvested. Okay. Now, let me give an example that will help illustrate that. So bear with me here for a second and follow the numbers here. Let's assume that I own property with a fair market value of a hundred dollars.

And my base is in that property is 60. So if I were to sell the property for a hundred and my base is 60, I have a $40 again. And that particular game would be recognized, but if it qualifies as an involuntary conversion, Then I have a choice here. I could take my a hundred dollars and I could keep it all and pay taxes on the $40 gain.

Or I could take the a hundred dollars and reinvest it in similar type property. Well, if I reinvest in similar type property, that allows me to defer recognition of the gain. Because there is some continuing ownership interests in of our property. So let's say I get nine, a hundred dollars and now you have the property.

And I then decided that I'd like to replace my old property with similar property, but I don't want to spend the whole hundred dollars. So I take $10 and put that in my pocket and take the $90 and reinvest it in a similar type property. So now what happens to my gain recognized why have a hundred dollars received a basis of 60?

So I have a $40 gain realized the gain recognized is the lesser of the gain realized the 40 or the proceeds not reinvested by reinvested 90. I didn't reinvest 10. So the answer to the question, how much gain is recognized would be 10. So if I had a $40 gain realized and 10 was recognized, then I deferred 30.

So the basis of the replacement property is the fair market value minus that deferred gain. So my replacement property, it costs me 90. My deferred gain is 30, so I have a $60 gain or $60 basis in the newly acquired property. And now you want to replay that again and make sure you understand how the numbers work.

There is a limited time period that we have to replace the involuntarily converted property. Generally you have until the second year following the year that the gain is realized to reinvest the proceeds, or if the property is condemned real property, then you have until the end of the third year, Now because of the continuity of interest principle, it requires that the property that I now have to replace the old property that was in development in voluntarily converting has to meet a functional use test.

That is the new property has to perform about the same functions the old property did. For example, if I had rental property that I swapped. For our or changed or converted to other property, generally that other property would have to be rental property for condemned real estate property. Then we'd have to use the light kind of exchange rules.

Now the other topic I want to consider in this segment is the sale of a principal residence. And under the old rules, we used to have the requirement that a new resonance would have to be acquired when an old residence supply was sold, but that no longer is the case under the new, the rules of section 221.

If you sell property a principal resident, again, you can exclude not just the firm, but exclude $250,000 of the game. If you're married, filing shortly, that exclusion is $500,000. So this is a tremendous tax break for individuals that own property. Now, in order to qualify, the property has to be owned and occupied has to meet both criteria owned and occupied as a principal residence, at least two of the five years proceeding the year of the sale.

So you got to meet the two out of the five-year tests in order to be exclude able to exclude the $250,000 or 500,000 or gain in the case of married, filing, jointly, any gain in excess of those dollars amounts, whether or not you reinvest the proceeds and the new house doesn't make any difference.

You're going to report those excess gains and they're going to be taxable income, generally going to be a capital gain. Now, in many cases, taxpayers don't meet the two out of the five-year test. And the reason it might not be mad is because maybe there's a health reasons. Maybe you got sick and weren't able to occupy the residence anymore.

Or maybe you had a change in job location, or maybe there's just some sort of unforeseeable event that has occurred. If those are the case, any of those are the case, then it's not a yes or no matter, you didn't make the two year test. So you don't get any other exclusion. It means you get to pro rate the 250 or $500,000 amount.

So for example, if you were there 18 out of the 24 months than 18, 20 force times, the exclusion amount would still be available to you. Now. And if you look at some of the rulings and some of the cases in this area, what exactly is an unforeseen circumstances will clearly health reasons and some change in jobs would, would qualify, but at least in one case, there are things like taxpayers had bought a house and because of an unexpected pregnancy, it proved that the house was not a Piper appropriate in the circumstances and that qualified to allow the taxpayer to exclude the gain.

An area of the tax code that tends to get a lot of attention is the treatment of capital gains and losses. And the primary reason for that is because capital gains get favored tax treatment. So taxpayers would rather have income characterized as capital gains, rather than as ordinary income to qualify as a capital gain, you are required to have a sale or disposition of a capital asset.

So that means we have to have an understanding about what exactly is a capital asset. Okay. And the way we're going to address that as do I tell you exactly what is not a capital asset. So. A capital asset is anything other than inventory, business receivables, depreciable property used in a trader business or artwork, literature compositions in the hands of an artist or a writer or in someone that has received those items as a gift from the artist or the writer.

Now, no pun intended here, but an additional note is that musical competence is compositions and copyrights of musical works are now listed as capital assets. If they are in the hands of the creator or they are acquired by gift. So the one that stands out in my mind is the most confusing. That's not a capital asset is to appreciable assets or real property that's used in a trader business.

Now, so what exactly would then be leftover as a capital asset? Most personally is property investment property would qualify things like stocks, bonds household furnishings collections like store coin and stamp collections, or even an automobile that's used for pleasure or for community, and would qualify as a capital asset now to get the tax benefits the property has to been held for longer than 12 months.

So. The advantage of having a capital gain is extended to long-term capital gains long-term capital gains become longterm with been held for longer than 12 months. If they're 12 months or less than their short-term gains. Now the reporting of capital gains and losses important here they're reported on schedule D of a form 10 40 short-term gains and losses are netted.

Long-term gains and losses are separately. Debted apart from the short term, we don't combine a net short-term gain and a net long-term gain because net short-term gains are taxed at ordinary rates. Whereas long-term gains are taxed at a maximum rate of 15% and dividends are as well. By the way, dividends are taxed, just like the capital gains are.

The rate is 5% for taxpayers and the 10 or 15% bracket. And the year, this is an area that's subject to a little bit of a fluctuation, a little bit of, of concerns about what's going to happen in the future in 2008 and beyond the a 0% right. Applies to long-term capital gains. If the taxpayer's individual rate is 5%.

So that creates a tremendous advantage for taxpayers that. Have long-term capital gains. So this is an area where tax planning is important. Sometimes just the timing of recognition or guidance. Like for example, if you're an, a tax year, when the 15% is going to apply and you could recognize a gain, it might be worth your while to defer recognition of the gain into a later year when a 5% or a 0%.

Right. My apply. The gains on real property depreciation gains on unrecaptured real property depreciation, or don't get this favor tax treatment. They're taxed at a maximum rate of 25%. Now you should also recognize that annual capital losses are limited that once you go through a net, the long-term and short-term gains the loss together, if you end up with a net gain that capital loss rather.

You can only recognize up to $3,000 of that loss as an offset ordinary income. So this is an annual $3,000 capital loss. Annotation. If you have to be a corporation, by the way, that is zero corporations cannot use capital losses to offset ordinary income. If there's any excess long-term or short-term losses that you can't use in the current year, that would then be carried over to a future year.

Then you can use the short term loss first and then the long-term loss after that. But again, in that subsequent year, you'd have an annual loss limitation of $3,000. Any unused losses can be carried forward, indefinitely and combined with the current year's gains and losses that occurred. However, there's no carryback provisions that might, that are available for individuals.

Corporations might be able to carry back the capital losses, but not individuals. Also reported on schedule D would be gains and losses from the sale of collectables. However, collectibles don't get this advantageous maximum 15% tax rate. They're taxed at a maximum rate of 28%. Now collectibles would include color actions of things like artworks or rugs or antiques or stamp collections, or even alcoholic beverages.

But that probably doesn't include the butter light. You're expected to drink right after you get through this module. So collectible would be things like a alcoholic beverage would be things like vintage wines. Net collectible gains are treated as long-term capital gains for netting purposes. But again, they're subject to a maximum tax rate of 28%, not the 15% available to other kinds of capital gains.

Now, earlier we talked about the list of things that are not capital assets, and one of those things that's on the list is to preschool properties and reorder business or land that's used in a trader business. And held for longer than 12 months, although those are not capital assets, but rather they're described as section 1231 assets.

And by the way, 1231 also includes more than just appreciable assets. There's a variety of farm animals that are included certain crops and timber and coal are also classified as 1231 property items. Now under the rules of section 1231, when those assets are sold at a gain. You got a net, a 1231 game.

When they're sold at a loss, you have a 1231 loss. The 1231 gains and losses are netted together and determining what the ultimate outcome of the 1231 gain is a net 1231 gain is then magically transformed into a long-term capital gain, which gives you the advantageous tax treatment of long-term capital gains.

On the other hand, a net 1231, Ross is treated as an ordinary loss of the business. Which gives you are avoids the disadvantage imposed on capital losses. So we get favorable treatment for net 1231 gains long-term capital gain treatment, and we get favorable treatment for net 1230 and losses, which are recognized in full as ordinary losses of the business.

Now if you anticipate thinking, well, this is the chance to do a little bit of tax planning. Let's just recognize 1231 gains this year at 1231 gain losses next year, and try to separate the two. Well, there are some rules in place that would alter the character of the gain. When you try to exercise those kinds of timing, transactions, or timing plan, the, the planning for recognizing those gains and losses.

So it gets a little bit more complicated. Now businesses are also eligible to deduct a business, bad deaths. Individuals could also deduct business bad deaths, as well as non-business bad debts. Non-business bad debts required that there be a bonafide debt or credit to relationship. And then the debt become wholly worthless in the year in which the debt becomes wholly worthless.

The individual gets a short term capital loss treatment in the year. It becomes. Totally worth us. And then that short term cap loss from the non-business bad debt would be incorporated to net it in to the other capital gains and losses. A couple of other requirements on non-business bad debts for individuals versus you have to have a basis in the debts.

And second of all, you have to have a wholly worthless, bad debt. Sometimes when you have, say, for example, lent money to another party with the expectation being paid back, And that other party informs you, that they can only give you 60% of what they borrowed. That would be a partially worthless, bad debt.

So you have to wait until you get your money. And then anything that ultimately is uncollectable then becomes a Holy worth, was bad debt. Another item that has tax favorite tax treatment for taxpayers is referred to a section 1244 stock section 1244. Stock is stock that's issued. At the startup of a company, and it's limited to the first million dollars of stock that's issued to the investor.

And this was a provision that was designed to encourage investor to take more risks, to encourage the development of startup businesses. Now here's how it works. When you have acquired 1244 stock and you either sell it at a loss or it becomes worthless, that loss is recognized as ordinary income.

A rather ordinary loss is fully deductible up to $50,000 and a hundred thousand if you're married, filing joint. So it converts what would normally be a capital loss into an ordinary loss and avoids the limits that are imposed on capital losses. So it's a great advantage. Now the own, this only applies to the original investor.

If that original investor subsequently sells the stock to an unrelated party or anybody else, it loses its status as 1244 stock. So it only applies to the initial investor. Any additional loss is subject to the regular netting procedure. So if you dispose the 1244 stock and you're entitled to 50,000 or ordinary loss treatment, but you have a $72,000 loss, 50 of it would be ordinary and 22 of it.

Would be a excuse me, 50 of it would be ordinary and 22 of it, a capital loss section two 67 works to limit the ability of related parties to recognize losses. Let's say, for example, that I own some property and I originally paid say $12,000 for it, but now it's only worth $7,000. And I'd like to be able to recognize that loss to offset other income.

So if I sold it for seven, my basis is 12. Then I'd have a $5,000 loss, but maybe I don't want to get rid of the property, but I'd rather somehow continue to control it. So rather than selling it to some unrelated parties that I sell it to my spouse. So I sell it for the fair market value of seven. My basis is 12.

So I have a $5,000 loss. Recognizing losses where that is, then it would be certainly wouldn't take much creativity to lower your tax liability. So section two 67 says that a vibe sell property at a loss to a related party. Like my spouse, then I'm not going to be able to recognize my loss in this case, my $5,000 loss.

But let's say that we.  go ahead and sell it to my spouse. So I sell it for seven. My basis is 12, so I have a $5,000 loss and the spouse has now paid seven for it. So she has a $7,000 basis for it and maybe holds her for awhile and maybe then sells it for nine. So she's realizes seven. She has a seven, a nine.

She has a $7,000 basis giving her a $2,000 gain. Well, she can use my loss to offset her again. So I have a $5,000 loss. She has a $2,000 loss, so she can use 2000 of my loss to eliminate her gain altogether the other $3,000 of loss that I suffered. Ella is eliminated. Nobody gets to use that. So a little tax planning here might go a long way towards maximizing benefits of the tax loss.

Now we need to consider who exactly would be a related party. Clearly spouse must be related party, but it would also include sales, a property to a brother or a sister to ancestors by parents or grandparents or lineal descendants. Light children and, and grandchildren not in-laws were also considered to be related to corporations where we own more than 50% of the stock.

So at the same transaction, I described earlier selling property to my spouse at a $5,000 loss. If I sold that to a corporation and I owned more than 50% of the stock, then the same outcome would occur. I wouldn't be able to recognize the loss on the sale of that property to a related party. One other consideration we need to look at for capital gains and losses is addressed under section 10 90, one of the code referred to as the wash sale rules.

Okay. The wash sale rules say that losses related to the sale of property sale stock or securities that are sold at a loss, cannot be recognized if the same or similar stock of securities is required within. 30 days either before or after the loss. So there's a 30 day window. You need to be real careful on if you sell stock or securities and you need to wait at least 30 days before you reacquire similar stock securities.

Otherwise the loss on the original sale is not going to be recognized. Let me give you a short example. Let's say that a taxpayer sells all of his stock in a particular corporation out a loss, and within 30 days requires 60% of that stock. Under the rules of 10 91, 60% of that loss is going to be disallowed because you've required similar stock or securities within that 30 day window.

Now, the disallowed loss, the 60% of the loss that you can't recognize because the stock was required as added back to the basis of that replacement stock. And then the whole name period of the newly acquired stock or the reacquired stock begins with the acquisition date of the original stock. So we tack on the holding period.

I'm Jack Norman, and we're going to discuss trust and estates. Let's begin with trust. What is a trust? It is a legal entity in which a grand tour transfers legal title to a trustee to hold property for the benefit of specified beneficiaries. Let's look at that definition. There are a lot of words, grantor.

That's the person who creates the trust, transfer his legal title. So we have to be passing something into the trust to a trustee, the fiduciary who will hold the property sometimes called the race where the Corpus of the trust for the benefit of beneficiaries. There are generally two types of trust.

There is an inter vivos trust and a testamentary trust.  the Latin term for between lives are created in a lifetime of a trust of a grand tour. So if I create a trust during my life and transfer property into it, as I have done for my grandchildren, then that is an inter vivos trust. A testamentary trust on the other hand is created by my will.

So if my will reeds upon my death, I transfer. These assets into trust for the benefit of my wife, that is a testamentary trust a will or intestate situation. Let's talk about that as an introduction to this whole topic. If I die with a will, that means I'm dying. Testate generally the will must be in writing the willingness designate an executor.

And the will must be witnessed. Now, wills are generally set up under specific state laws. There must be a certain number of witnesses. The, the person setting it up to the test state tour must be competent at the time they are doing it. These are all provisions of the state requirements for a valid will.

Then there is the situation where a person dies without a will. This is called dying intestate. And in that particular case, a court will appoint an administrator to determine how your assets will be distributed and to administer those assets during a probate situation, I always told my students that upon death, Your assets are going to be distributed to someone in accordance with some situation.

Would you rather die intestate and let the state decide or test date and let yourself designate how that's going to be done. If that second situations how you wanted it, it must be a will in writing. Now, as you have been reviewing material for the exam, you're going to see in the discussion of Will's two phrases.

Per capita and per stir PS. These describe how property is distributed from a will or from a trust per capita means to each head sounds reasonable per capita per stirpes fees. On the other hand means that it is passed through a particular descendant. Let me try and illustrate this. Through an example, if I have six children per capita would mean that each child gets one six of my estate per stir, PS is by representation.

So let's assume that I have three grandchildren. Each one of those three grandchildren would receive one half. Each one of those three grandchildren would receive. Part of their parents half share. So I have three children. One, one of those children has no child, no child at all. One of those children has one child and the third child has two children.

Okay. So three children and of my grandchildren, there are three, but those three. One of my child, children has none. One has one, one has two upon my death, the person, the sister who has no children will receive one third of my estate. Let's assume that my sister who has one child is still is, has not Le outlived me.

Her child will receive her. One-third the third child also has pre-deceased me. That child, the third sister had two children. Each one of those will get one half of my deceased daughter's one-third so they will get one half of one third or one six. This sounds very, very complicated, but it's not the purse.

Derbies is simply tracking through the chain. Now that we've identified terms, let's go back to the elements of a trust. The grand tour or settler general only puts the assets or is the one who puts the assets into the trust. Generally cannot revoke the transfer into the trust unless they reserve the right to do so.

So we make an irrevocable transfer into the trust. I will tell you that the rules. If the settlor reserves the right to pull those assets back out, we did not have any irrevocable trust. We have a revocable trust. If the right is irrevocable, which is, most of them are, then we have created that irrevocable trust.

And it's an irrevocable generally, inter vitals trust property is the race or Corpus. And although we've created the trust, it really doesn't exist until the trustee gets legal title to the property. It's just, we've executed some paperwork, but we haven't had the trust actually arise or come into existence until it owns assets.

All trust me, I have a trustee and that is the person who actually holds title to the property. In the trust that trustee is a fiduciary. It is an agent. Of the grand tour. If you want to think about it that way and must strictly follow the trust agreement. What happens if the trustee dies? If there's no successor appointed under the trust agreement, then the court, which oversees the trust would have to appoint a new trustee.

Any trustee can resign, but in drafting trust agreements, I always make certain that the grantor tells me this is the trustee. I wish. Here is a successor trustee. If something happens to that first trustee or he no longer wishes to serve. And then I go for a second alternate trustee, as I mentioned, the trustee is liable for negligence.

There is duty harm, breach, and causality to those words, sound familiar to you there. The element of negligence, the trustee has a duty to perform. If he fails in that duty and it harms. Another person in effect, it's going to harm here. The beneficiary of the trust, that failure to exercise the duty the breach and the harm that was caused is directly caused by the trustee.

Then the trustee is liable for negligence. A trust may be terminated, and here's why. So the trust is terminated. One, the trust agreement may have a specified term. I could say. I am setting up this trust for a period of 10 years. And at the end of 10 years, the trust will terminate. The property will be distributed to the beneficiary.

If the trustee becomes the sole beneficiary of the trust. Assume, as I mentioned earlier, that I set up a testamentary trust for my wife, she's the sole beneficiary. And I originally set up by son as the trustee, but. Something happens to him. He doesn't want to do it. He resigned and my wife becomes a trustee.

If she is the trustee and the sole beneficiary of the trust, the two are considered to have merged. And the trust terminates a trust automatically terminates. If something in that trust, some action to require the trust is illegal or it becomes impossible to perform. The activities of the trust. Let's just take as an example of that last one.

Suppose I set up a trust that owned property in new Orleans, there was destroyed by hurricane Katrina. The trust was to maintain that property and pay out the rental income to my grandchildren. The house is no longer there. The rental property is no longer there. The trust is terminated because it's become impossible to perform.

I should make a comment here. It may be possible. However, if it were insured that if the insurance proceeds allowed a rebuilding of that property on the site that might work, but if the property was condemned and could not be built on again, the trust would have terminated. Beneficiaries, we must have beneficiaries of trust.

And there are generally two types, maybe the same person, but often they are not the income beneficiary receives all of the income during the life of the trust. So in my example of the rental apartment, the income beneficiary would be receiving the annual or the monthly rental income from the property.

The remainder man. Is the person who receives the property upon the distribution, upon the termination of the trust. So if the trust terminates, it's the remainder man who will receive that property. All right. Here's a good example. And it's very similar to the testamentary trust that might you set up in many husband and wife situations.

Husbands sets up a trust. The wife has to receive the income during her life. She's the income beneficiary. When the wife dies, all of the property goes to the son. The son is the remainder man of that trust.

Now here's an exam question that you may see and it recurs quite frequently, and it deals with the allocation of principal and interest in a trust, the allocation of principal and interest, the income beneficiary is charged with all ordinary expenses and credited with ordinary income. So in my example, where I talked about rent, then.

That income beneficiary does receive the rent, but also is charged with any mortgage or interest or D on the income that is coming out. Suppose there are cash dividends or royalties. That's ordinary income. What about the remainder man? The remainder man is charged with any extraordinary expenses and receives any extraordinary income.

The, this couldn't include insurance proceeds. If we suddenly receive a payoff on mortgages, something along these lines you have to look at the example, that's going to be set up in the REG CPA Exam to determine it, but here's the basic rule. The income beneficiary receives all of the current income and is charged with the expenses related to current income.

The remainder man. Receives any extraordinary items that includes extraordinary income and includes extraordinary expenses. The trustee expenses are charged to both the income beneficiary and the remainder man. So let me remind you of a couple of things. As we wrap up this module. We're talking trust and estates.

We're talking for them. Do Sherry responsibilities of the trustee or the executor of the estate. So they are bound by all the rules of the fiduciary accounting and the fiduciary response, including the potential for negligence. We talk about accounting. The current income beneficiary receives. Income and expenses on an annual or recurring basis and extraordinary items of both income and expense belong to the remainder.

Man, trust have several different classifications. Trust may be inter vivos set up during a lifetime or testamentary set up upon death. The estates may be either. The States that are test state done with a will or intestate done without a will, where the state will determine how the assets are distributed.

This is a gift taxation and I'm Jack Norman. The United States has an integrated transfer tax system. It could, it's comprised of the estate gift and generation skipping tax regime. Why is this important? Well, because there are too many easy ways to get around the tax system. If we don't have it integrated, I'll give you the prime example, assume that we only had a gift tax regime so that there was no estate tax, an individual with large assets.

On his death bed could say, well, if I give these gifts to my children right now, before I die, it's all going to be subject to gift tax. But if I wait until after my death, pass it to the same beneficiaries, there will be no tax. So that's. The reasoning on that side, turn it around the other way. Suppose we had an estate tax and no gift tax, then that same individual would say, if I give it all away, the moment before my death, I get avoid the estate tax.

And there is no gift tax. As a consequence, Congress put together this integrated system that locks together, estate gift and generation skipping into a single tax system. Now the gift tax is an excise tax imposed on transfers of property during the life of the donor, the gift tax applies to real or personal property, whether it's tangible or intangible, whether the gift is made outright or in trust to the extent that that transfer is made without full and adequate consideration.

So if I turn around and give $10,000 to my son, With nothing, but thanks. Thank you for being a great son. That is a gift. If all the other hand, I said, you need $10,000. I will sell you. Or I will give you the $10,000 in exchange for so properly that you own for $10,000. That is not a gift. That's a sale.

We're focusing here on gifts. Now gifts made a death. And during the taxpayers, lifetime are all accumulated and the gift tax applies on a cumulative basis. So the tax rate applies at the highest level on the stacked gifts. There's not double taxation of the gifts. It simply determines which tax bracket is applied to the current year gift.

Generally, the value of the gift is the fair market value on the date of the gift. Now a taxpayer is allowed to make annual gifts, which are called exclusionary or annual exclusion gifts. And these are amounts that are not subject to the gift tax. So during 2013, the current numbers, about $14,000, it changes frequently.

So please check the text. But in this case, I can give up to $14,000 this year to any number of people at $14,000 is a per Doni. Per year limitation. So if I were wealthy enough, I can give for instance, $14,000 to 10 people dispose of $140,000 in non taxable gifts. During 2013, these gifts must be present interest and not future interest.

In other words, the recipient must have that right to that property. Use it as soon as they get it, it can't be held back saying you have access to it in the future. And there's an interesting feature of this annual exclusion. If I'm married, I can make a $28,000 gift. If my wife agrees to quote, split the gift as deemed, as though she's made half of the gift with each of us getting a 14,000 annual exclusion, we could, for instance, give $28,000 to each of our children under the annual gift tax exclusion, there would be no tax liability.

There's also unlimited exclusion for tuition and medical expenses paid directly to a provider on behalf of a donee. I'll give you two examples here. My son is planning on going to college or he's in his junior year, wherever the school's tuition is $22,000. To expensive school. It's a good school for him.

If I write the check directly to the university for that tuition amount, the 22,000 is excludable gift. It doesn't count against my annual exclusion. Okay. I could do the same thing for payments of medical expenses to a provider. For instance, my mother is got huge medical bills. She's in a, a facility that has medical expenses that she's unable to cover.

If I write the check directly to that facility on her behalf, that's again, an excluded gift, not counting against the annual limitation. All gifts to my spouse are excluded from tax, unless my spouse is not a us citizen. So. The case of my wife, I can give her any amount of money or other property over the year that does not count against either my annual exclusion or something.

We'll talk about in a moment called the unified credit for the gift tax. The rate is 40%. And as I said, the gift tax is measured by the fair market value on the date of the gift. Now here's the unified credit I was talking about. And it harks back to the integrated transfer regime. There is a credit allowable to each taxpayer of somewhat in excess of $2 million.

Right now it's going to shield about five and a half, five, and a quarter million dollars in either lifetime or testamentary transfers. So this lifetime unified credit could be applied against either gifts during life or bequest under the estate tax law. Let's set aside the estate tax right now and assume that I just dealing in the gift tax regime.

I can make gifts throughout the year coming under the tuition, exclusion, the. Medical exclusion, the spousal unlimited exclusion, the annual exclusion of about $14,000 to any number of donors. And then for any gifts that don't meet any of those special exclusion rules, I still can shelter another five and a quarter million dollars using the unified credit.

Now the basis of property in the hands of the donee. As I said, they receive the property from me and I am taxed at 40% as the donor. However, the donate takes eight bike carry over basis. In other words, what my basis was in the property. So let's assume I acquired some stock back in the 1960s and I paid $5,000 for the stock.

I'm now giving it. To my grandchildren, the stock is now worth $80,000. I will pay the tax on the $80,000 fair value, assuming that it's also due to tax and we do have the explosions issues to address, but they will take my original cost basis when they received the stock. Thus, when they sell it. All of that appreciation will be taxed to them on an income tax basis.

They will have the same holding period that I had. So in the example, I just gave you the stock, which I purchased in the sixties. They will receive long-term capital gain treatment. Let's talk about the gift tax system in total and how we compute it. It's total gifts minus any gifts I've split with my spouse.

And the annual per Doni exclusion, the unlimited marital deduction, exclusion, and of course, gifts to charity are not subject to gift tax. So we count those out of my, as part of the exclusive amounts. So I now have total gifts for the current year, add to that all of my taxable gifts in prior years. And that equals the total taxable gifts.

Now I compute a tentative tax on those total taxable gifts. Then I subtract from that tenant attacks, the tentative tax on all gifts made in the prior year. So this is where the stacking rule comes in. You could see that the current ones are on top of all the previous ones. I apply a tax there and then I get to deduct the taxes that I would have paid in prior years.

So this gives us the gift tax on the curd year gifts. I then have an opportunity to use any of my remaining unified credit. If I want to, to come up with my final gift tax liability, before we leave this area, let's talk about the generation skipping tax. Another component here. This is imposed on the gift that I make to a Doni more than one generation.

Below myself. So for instance, I have set up trust for the benefit of my grandchildren. These are generation skipping trust because they are it's my generation, my son's generation, my grandchildren's generation. So they can be subject to the generation skipping tax. These could be the tax could apply upon a direct skip.

If I make just an outright donation directly to them, it can be in a trust situation where there's a taxable termination of a generation skipping trust, or a taxable distribution from a generation skipping trust. You're unlikely to see a generation skip a question on the REG CPA Exam is not unheard of. It's much less common than the general gift rules.

So let's quickly CPA review a couple of points. It's a 40% tax on the fair value of gifts made. During the year that are taxable, the donor takes a carrot. The Doni, excuse me, the recipient takes a carry over basis. The taxes implied on a stacking rule, but the most important part of the gift tax is the exclusions.

You have an unlimited exclusion for gifts to your spouse. You have an annual exclusion, which is per donee and is subject to, to the gift splitting rule. He has a special rules for tuition and for medical expenses, if paid directly to the provider and you have the unlimited unified, the live, I'm sorry, you have the unified credit, which is about five and a quarter million dollars, which could be applied either in the gift.

Or the estate context. Good luck with this part of the exam.

This is a state taxation and I'm Jack Norman. Like the gift tax. The estate tax is part of a unified transfer tax system. The estate tax is imposed on the taxable estate of a decedent. Now the gross estate consists of all assets owned or controlled by the deceit stunt at the date of death. And then amount is computed at the fair market value.

The estate is allowed various deductions and exemptions in computing. The taxable estate, the maximum tax rate is 40%. And there is a maximum unified credit, which can shelter up to five and a quarter million dollars. As you will remember, this unified credit can be used either against lifetime gifts or against testamentary transfers the credits a little over $2 million and actually shelters about five and a quarter million dollars.

The estate tax return is filed on a form seven Oh six, which is due within nine and a half months of the date of death. And there's also an option provided in the internal review blue code while generally the estate is valued at fair market value on the date of death. And they in a, an executor can elect an alternate valuation date, which is six months after the date of death.

The reason for this would be a dramatic decline in the value of estate assets. Since fair market value is measured. Is the visual of the taxable estate. The heirs received those assets from the decedent at its fair market value. This is called step-up in basis. So in effect, let's just take a very simple example.

This is not a typical estate at all, but the decedent owned $400,000 of cost basis in assets. And at the time of death, those assets were valued at a million dollars. Well, the estate tax is going to be imposed on that million dollars. However, the heirs will take that million dollars as their cost basis when they received the property.

So if it now appreciates up to a million, two, When the air sell it, they will only be taxed on the difference between the million and a million to not the decedent's original cost basis up to the new fair value. So that is one of the nice features of this estate tax regime, even though that's taxed on the state rules at fair value, there is step up in basis in the hand of the property, in the hands of the beneficiaries.

Now let's look at how estate taxation really works. We begin with a growth state. And as a, you said, that's basically all assets at fair market value subtract from that allowable deductions. And we're going to get into some of these concepts in a few minutes. Then we take from that the marital deduction, and we ended up with a taxable estate.

To the taxable estate. We add certain adjustable taxable gifts. Those made near the time of death. And we're going to put those in to come up with a tentative tax base. We apply the tax rates to that tentative tax base and we get a tentative estate tax. From the tenant of estate tax, we subtract the gifts, the taxes that were paid on the prior taxable gifts.

And that gives us a gross estate tax sounds complicated, but we're getting close. And now from that grossest state tax, we deduct any unified credit that we have left or any other credits to equal our final tax liability. Let's talk about some of the concepts are embedded in that textures regime. If it descendant has transferred property, but still has some control of the asset at the time of his death, let's say he's given it in trust, but has the right to change.

Trust beneficiaries has the right to certain Aspects of use of property in the trust, then that property is going to be pulled back in and included in the estate. So if he has control over the assets, people think life insurance is not taxable. And for income tax purposes, that is true for estate tax purposes.

Life insurance proceeds are includable in the estate. If the decedent had any incidences of ownership of the policy, for instance, the right to change the beneficiaries of the insurance policy to borrow against the policy. It is possible to structure life insurance, proceeds, life insurance policies so that the proceeds are excludable for both income and estate tax purposes.

But as a very careful legal and planning point. In addition, some annuities and retirement benefits may be includable in the estate. Well, what about property? That's jointly held for instance, my wife and I own our principal residence jointly the entire value of jointly held property is pulled into the estate, but.

There is an unlimited marital deduction, which then takes out anything, transferred to the spouse. So this would be included in the estate, but then comes back out. So it's part of the mechanics of this deductions are allowed for funeral medical and reasonable administrative expenses of the estate during perhaps the period of probate and, and winding up all the affairs of the descendant.

And the state may also claim unlimited charitable deduction. And as I mentioned before, there has done a limited marital deduction. One interesting piece of statutory change that Congress enacted just a few short years ago was an option by a surviving spouse to tack a seasons unused unified credit onto her own credit.

And in this case with the Hamsa, what the Congress was thinking about was since many times the husband will die first. All of the property will go to the wife. So his uniform I'd credit. If you will, that shelter a five and a quarter million dollars will never be used. If the estate is large enough, they will allow the surviving spouse to add that 5.2 million effectively to her exclusion.

So they could shelter $10 million upon her return. We'll take a look at that minute and a minute. There's one major drawback to this in that it extends the statute of limitations to the IRS to make adjustments on the first return. Let's walk through a couple of examples here. We're going to take a married couple.

The husband dies on February 1st with net assets at fair market value of $5 million. The basis of those assets is $2 million and the entire estate passes to the surviving spouse. Let's make this nice and simple. The spouse dies later that same year, the assets fair market value on that date is now up to $5.4 million.

And the wife leaves her entire estate to their only child. A daughter. For this example, let's assume no marital trust or other tax plan planning complications. I just want to show the way the estate tax works. So both deaths occurred in 2013, the husband's estate $5 million at fair market value. We're going to shelter about $5 million because of the unlimited marital deduction.

There is no estate tax notice. No unified credit was used. So there is no tax on the husband's death. Although in an estate tax return will have to be filed. The wife takes all of the assets with a new basis of $5 million. Now over there next six months is a great run-up in the stock market. Real estate everything's booming.

And the wife's estate is $5.4 million. At the time of her death, there is no surviving spouse. So we're going to compute a tentative tax on that a little over $2 million to the in one Oh five, 800. And that unlimited credit is 2 million Oh 45 800. In 2013. So there'll be a total remaining tax due of $60,000.

The daughter will collect from the estate $5.4 million. The fair market value of the property at mom's death. Minus $60,000 of estate tax. She'll be left with a little over $5.3 million and the entire unified credit has been used up. And we can show the example of that. This means that there's a marginal tax rate of $150,000 difference between 5.4 million and 5.25 times the 40% tax rate that is the $60,000 liability on the surviving spouses is state at the time of her death.

Now. Suppose that surviving spouse had elected to tack her husbands, her deceased husband's unused credit onto hers. Then there would be no estate tax due upon her death. Change the situation. Again, assume that after the husband's death, the surviving spouse sells all of the assets she inherited and just puts them in a money market fund.

Deaths again, both have occurred in 2013, the husband's estate. There's no estate tax. Why? Because of the unlimited marital deduction, the wife's taken assets with a basis of $5 million on the sale. She immediately sells it for $5 million of proceeds. She has a basis of by million dollars, no capital gains.

Now she retains that $5 million puts it in money market funds. Again. We'll use an outrageous assumption in the remaining six months, it grows to 5.4 million. Now that tentative tax is 2 million, $105,000 again, and a credit of two Oh four five, a total tax of $60,000. Leaving the air with the five, three, four, zero that entire unified credit has been used up.

And you get the same result is in my first scenario. If however. The surviving spouse had used Intacct on her. Husband's unused credit. Then again, we would have come over with no tax liability at all, and the daughter would have taken $5.4 million. So as you can see in the estate tax area, the concept is fairly simple.

And in today's world, it's getting easier to work with. First of all, we accumulate all of the assets at the date of death, and we could either use fair market value on the date of death or on the alternate valuation date, up to the six month time period. After that, once we have all those assets accumulated.

We're going to take off the appropriate deductions for allowable expenses, perhaps charitable deductions. We could take the unlimited marital deduction. And after going through our stacking calculation with gifts, we'll compute a potential tax liability of estate tax. If we have unified credit that has not been used, we will certainly apply that.

And in many cases, in many States today, we will have wiped out the tax liability. It is almost impossible. If a husband and wife leave their estate to each other, to have any tax on the first. The state, there may be some on the second, unless you elect the tacking of unified credit that remains unused in the case of a surviving spouse.

Who dies without having remarried. Then of course, there is always the possibility of a tax liability when that estate is in excess of about 10 and a half million dollars today, I hope this gives you a good overview of the estate tax and will stand you in great stead as you pass the CPA exam.

I'd like for you to consider with me the tax consequences to the Doni for receiving gifts and the tax consequences, the beneficiary, when they receive an inheritance, as well as the wealth transfer tax, that's imposed on a lifetime gifts and property that transfers at time of death. First of all, and the tax that's owed at the the wealth transfer tax is I.

A tax that's based on the cumulative lifetime accumulation of wealth. And so when you compute the. A state tax we're going to include in that tax will gifts that were made during the lifetime of the decision. Now, the state tax or the wealth transferred tax is distinguished from any income that might be earned by the by the estate.

So the income that the estate earns is going to be subject to an income tax, but here we're talking about a wealth transfer tax. Now taxable gifts remember, are subject to a gift tax. When the tax, when the gifts are made and the gifts that are taxable are based the, that the tax is assessed based on the fair market value of the property at the time of the gift.

Okay. On the other hand, an estate tax is imposed on all the accumulated wealth and is subject to an estate tax is paid at time of death. With a credit being made for previously paid gift taxes. So between the estate and the gift tax is ample room to do some planning here to minimize the amount of state taxes.

Now let's talk a little bit about gifts and the consequences to the beneficiary of the gift. Okay. Remember, the gifts are not taxable income. They're not subject to tax to the beneficiary. And you look at the donor or, and evaluate what the donor Orr's intent was and making the gift that the donor had a intent to make a gift.

And it's not taxable income to the donor. Now any income that's earned on the gift or any gain or loss that is incurred on the sale of the property is going to be recognized by the Doni. But that's a separate consideration from the fact that the gift itself is not taxable income. So when you do sell gifted property we have to know that the basis is, and generally the basis of property is what you paid for.

It. But obviously with a gift, you didn't pay anything for it. So we have to have a different set of rules to figure out what the basis is. And for gifted property, we're going to use two sets of rules here, and we're going to use a set of rules for one for gains and the other for losses. So when you sell gifted property to gain, use the game basis, when you sell gifted property and a loss use the loss basis, the gang basis is the donor or spaces on the date of the GAF.

Plus the gift taxes that the donor paid that's attributed to the properties appreciation. Okay. Let me say that again. The gain basis, that is the basis used for determining the amount of income recognized by the donor. You want to give to the property is sold at the game I got. That is the donor's basis on the date of the gift.

Plus the gift taxes imposed on the gift. Associated with the property's appreciation that recall that gift taxes are based upon the fair market value of the date of the gift. And so if you multiply the gift tax rates times the fair market value that a portion of the gift tax is associated with the appreciation and the rest of its approach associated with the donor spaces on the date of the gift.

So the donor spaces then is the donor space at the time of the gift. Plus the portion of the gift tax associated with that appreciation. So if the donor, he sells the property to gain the amount realized minus this gain basis is the gain or loss or gain rather than this recognized by the Doni. On the other hand, property may be sold at a loss and the loss spaces is the lesser of the donors.

A fair market value in the data gift are the donors based on the date of the gift. Okay. Now I've got a little a rather long example that I think will really make this a lot simpler. If you stick with me and listen through the numbers here, let's assume that the Doni receives a gift and on the data, the gift, the fair market value is a $100 and the donor's basis is $60.

So the fair market value of a hundred donors basis is 60 and the donor sells it for awhile and sells it for 110. And that case the Doni will have a $50 gain, 110 minus the $60 basis as a $50 gain. What if the Doni sells it for $90? So it's between the 160, and that case, the Doni has a $30 gain. Well, what if the tax of the Doni sells it for $50, then we'd have a $10 loss, right?

50 is the amount realized 60 was the basis. So it all three of those instances. The donation basis is the same as the donors basis. It was $60 each time. And again, the fair market value was a hundred on the date of the gift and the donor spaces was 60 on the date of the gift. Okay. So in all three of those cases, the donor ease basis was the same as the donors basis.

Now let's reverse those first two numbers. Let's say that the fair market value on the date of the gift was 60. And the donor's basis was a hundred. So that is clearly it's decline in value. And we'd go through the same different possibilities. What if it sold for 110, then the donor's basis is still the $60.

That would be the donors basis, or excuse me, fair market value of the date of the gift if you sold it for 90 and that unusual circumstance. Yes. Again, with a fair market value of 60, the donor's basis is a hundred. Neither gain or loss is going to be recognized. So when the fair market value on the date of the gift is less than the donors based on the date of the gift and you sell it in between the two that no gain or loss is recognized.

And the other possibility is, again, the fair market value is 60 basis is a hundred to the at the time of the gift and you sell it for 50. And that particular case you're going to have a $10 loss. So that. Last example was the only time in which we use the fair market value of the data, the gift as the donor's basis.

Now you might want to CPA review that of time or two to make sure you understand the different combinations of fair market value data gift to donor space of the day of the gift and understand how that relates to the sales price now yeah, if the fair market value and the date of the gift is less than the donors based, so that as a gift and is sold for an amount between the two.

Then neither gain or loss is going to be recognized. That's the one anomaly that occurs in this arrangement here holding periods important. The Holy period starts on the date of the gift. If the Dony use the fair market value and the date of the gift is the basis. On the other hand, the holding period starts on the date of the donors acquisition.

If the donor used the donor spaces on the date of the gift. Okay. That's important that holding period is important, cause it would just perhaps distinguished panel a longterm gain a long-term loss or short-term gain or short-term loss. Now inherited property is a little bit more straightforward than gifted property.

Okay. When you inherit property, we know that the receipt of inherited property is not included in income and the basis to the recipient is the fair market value on data death. Okay. That's a simple rule. When you inherit property, whatever the fair market value is on the date of the death is your basis for the property, unless the executor of the estate of the estate, ALEKS, the alternative valuation date, which is six months after day two death.

If the alternative valuation date is elected, then you use the fair market value on that alternative valuation date in order to make that election. The grossest state and the law has to be lowered and the federal state tax liability would also have to be lower in order to be eligible to make that alternative evaluation date election.

What if property is distributed after day two death, but before the six months, what basis does the beneficiaries at that point? Okay. Fair market value on the date of the distribution.

In addition to the taxes that are imposed on individuals and corporations. You should also know that the is an income tax that's imposed on estates and trusts. These are separate taxable entities. So for example, with an estate prior to the distribution of the assets, to the beneficiary, there may be income that's generated.

So the estate itself is going to have a tax liability and trust also will be taxed on the income that's generated. Now. I think one thing that helps me to sort through this taxation of trusts and estates is the idea that we have to compute taxable income. The trust or estate is then taxed on the undistributed portion.

The beneficiary is taxed on the distributed portion of taxable income. So let's talk about then how do you compete at the income of the gross of the estate or the trust? First of all, the rules that are employed to compute the income earned by the trust or the state are pretty much the same as they are for individuals, typical kind of income that an a trust interstate would generate would be interested in comm or dividends.

Royalties or net rental income. In addition, they may have capital gains and losses. And though those gains are taxable, often trust in the States are set up so that the. Capital gains are allocated to the principal or the Corpus rather than a distributable to the, to the beneficiaries. Also stock dividends might be a source of income to the stock, to the trust or estate.

Now, if the estate or trust is to make a specific bequest of cash, so maybe the entity was set up. So. That the there was some cash that was going to be distributed to the beneficiaries. It may be that the executor of the state chooses to distribute appreciated property instead of the cash. And in that particular event, when the property item is distributed, rather than cash under a specific request, then the gain that's inherent in the property would be reported as income to the estate or trust.

For other property that's distributed that is not distributed under this specific request. It's just part of the notion of the executor and the responsibility executors to distribute property to the beneficiaries. Then the executor can elect to either recognize gains or losses on the distribution of that property or not recognize the gains or losses.

Now, if the executor does not make that election. Then the basis of the property transfers to the beneficiary and then the beneficiary would report, gains and losses upon their disposition of the property. Trust in the States are also entitled to an exemption. A simple trust are $300 exemption complex trusts for a hundred and a States or $600.

A simple trust is one where the trustee is required to make a distribution of all trust income currently. And then a complex trust is any trust. That is not a simple trust. So it's possible that complex for us switches back and forth in one year as a simple trust because it distributes all his income currently.

And another years of complex stress, depending upon the nature of the distributions. Now let's consider some of the deductions that are available to estates and trust. One would be there's an unlimited charitable contribution deduction. So at a state of trust can zero out its income simply by making shareable contributions.

There's the deduction for administrative fees. There's no deduction for expenses directly related to taxes, symptom, column, or an allocable portion of indirect related expenses. So if the trust restates has some exempt income. We're gonna subtract out the direct related expenses and an allocable portion of the indirect related expenses from that exempt income and determined the amount that is deductible and computing, the trust or estate income.

And then we have a deduction for capital losses, limited to $3,000, and then losses that flow through from San S-corporation or partnership interest that is held by the estate or trust are also deducted. And then finally, we also have a deduction for what's referred to as DNI, which is referred to, or divide is distributable net income.

Not now, not all of the DNI is necessarily going to be taxable. We're going to combine taxable and non-taxable in common computing, DNI but DNI is referred to as distributable net income. And it's computed by taking first of all, the taxable income, just as we've computed already, the income, less the exemptions and deductions listed.

That we've already considered before any distribution deductions, we're going to add them back in the exemption amount. And we're going to add net capital losses, and we're going to add back the net tax exempt interest income that is available for distribution. So again, some of DNI may be taxable, some of it's not taxable.

And then we're going to subtract any of the non distributable income allocated to principal. For example. Maybe capital gains are allocated to principle and not distributable. So we're going to subtract those at this point, and that gives us distributable net income. Now, again, D and I may include both taxable and non-taxable income.

So beneficiaries should receive DNI would have a proportionate share of taxable income and proportionate share of not income. So if they're multiple beneficiaries, we're going to have to allocate the taxable DNI and the non taxable and empty. And I. Between all of those beneficiaries now taxable DNI is the maximum income that may be taxed for the beneficiaries and the maximum amount of deductible by the fiduciary competing of the taxable income.

So DNI is the maximum amount of income that the beneficiaries might have to report as income. Again, going back to this notion that DNI may have some taxable and non taxable income. The taxable portion of the DNI is the maximum amount that the beneficiary is going to be attached on. So it's possible that the beneficiary receives some non taxable distribution.

Okay. It's also important to know that the character of the income passes through to the shareholder, to the beneficiary. So the beneficiary may in fact have some taxable income that's capital gains and some that's ordinary income. Now, trust tax one, come before the district, the, the deduction for tax buddy.

And I. Is the beginning point for computing, how much income the trust is going to have to report his taxable income. So we have trust taxable income before the deduction for tax will DNI less. The taxable DNI that's distributed to the beneficiary is equal to trust taxable income. Let me say that one more time.

We want to compute the taxable income of the trust or estate. So we start with having all the trust, taxable income and so trapped out. The taxable portion of the DNI that's being distributed, that results in whatever's left over then is the trust taxable income. Now the trust rather than the tax code also has some complex rules that allocate DNI among.

Different beneficiaries when there are more than one that beneficiary and the amount of the distribution exceeds a DNI. So this two tier system preserves the character, the income and taxability of the income for purposes of competing tax liability for both the estate, as well as the beneficiary.

Now, the tax will year and the due days for the Tax returns. The state return has to be that may elect a, either a calendar or a fiscal year. And the due date of that return is three and a half months. After the end of the year. On the other hand, a trust can elect to have a calendar year, but the tax return is still due three and a half months after the end of that year.

And then fiduciary is, are also required to make estimated tax payments, just like individuals have to make estimated tax payments. Now because the tax rates for a trust in the state are so progressive, it's really important that fiduciary is do some planning here. And as we just illustrated with a tax computation, DNI is an important part that computation.

So, unfortunately though we can't determine what DNI is until the end of the year. So the tax code gives us a, of some Slack here and it allows for distributions that are made within the first 65 days of the new year. To be considered to have been made the last day of the preceding year so that we have some opportunity to determine how much DEI and DNI will be so that you can, some degree control the tasks, consequences of distributions, and therefore the tax consequences to the trust or the state for States with gross income of more than $600, half to file a tax return for trust with gross income, more than $600.

Or any trust with taxable income? Must file a tax return.

I'm Jack Norman and we're talking about tax exempt organizations, the internal revenue code grants, tax exemption under section five Oh one, a two organizations described in code section five Oh one C. There are 28 categories of exempt entities. And Congress has enacted these various exemptions based on public policy.

In other words, they've decided that these 20 categories of organizations serve specific public needs, the most common exempt organization is one described in code section five Oh one C3. These are educational, charitable and religious organizations contributions to these types of organizations are tax deductible.

The organizations may not make any political expenditures. And there are restrictions on the amount of lobbying that such organizations can conduct. Well, how does an organization achieve tax exempt status? One of two forms is filed with the internal revenue service. Form 10 23 is filed for all C3 organizations and form 10 24 is filed for any organization seeking exemption under one of the other various categories.

This application form sets forth the exempt purpose to source of financing, the business plan, and any number of other details as specified on the page form. Regulations issued by the treasury department state an exempt organization must meet both an organizational test and an option test. In other words, in setting up the organization, there must be certain criteria met.

To serve a particular enumerated purpose to have a board of directors to meet certain organizational requirements. The second part, the operational test that organization must then operate over its entire life in accordance with both the organizational. Band-aids and, and rules they've sat down and in conformity with the IRS code and regulations among other aspects of both the organizational and operational test is no inurement for private benefit.

In other words, that organization cannot have goods services, monies from the organization going out to benefit a private. Person associated with the entity. For instance, a classic example of prohibited inurement was you could not provide unreasonable compensation to an employee of an exempt organization.

Reasonable competition is fine, but this is inurement over and above it. If there are such violations. The IRS has a draconian hammer. It can rescind the exemption of the organization. There are more or intermediate sanctions in which penalties and monetary penalties can be imposed on the organization.

But the ultimate club is for egregious violations. The organization may lose its tax exempt status. Now I mentioned primarily five Oh one C3. But we need to focus our attention just briefly that there are a number of other types of organizations. For instance, besides the 28 categories under five Oh one C, there are political organizations which are exempt under five 27.

Pension and profit sharing arrangements are tax exempt under code section four Oh one and some of the other sections associated in the 400 series. And there are special rules in code section five Oh nine, dealing with private foundations, which are a special form of five Oh one C3 organizations. So if you have a test question about exempt organizations while they are generally described in five Oh one, a.

They do appear in the 400 series for pension plans, five 27 for political organizations and five Oh nine for foundations. Once we have our exempt status, then the organization must operate in accordance with, as we said, the organization, the organization documents and the regulations. And this is checked every year because the exempt organization must file a form nine 90.

With the IRS, the form was revised a few years ago, contains multiple supporting schedules. So an organization described in five Oh one C3 may file part of the nine 90 with some supporting schedules, but not all an organization that is a five Oh one C3 that is also a private foundation has additional schedules to file.

And while the nine 90 is the general form to be filed. There are a few short forms. There's a nine 90 E Z and a nine 90 N, which may be filed by certain smaller organizations. This tax return is due by the 15th day of the fifth month of the organizations year, obviously for calendar year, that is May 15th.

We have the organization up and running, but we also have a couple of special criteria that we need to look at for the, for the organization. There is a concept called unrelated business income UBI, and this unrelated business income may give rise to a tax on an organization, even though it is a tax exempt organization.

So you just heard the exception in my. And my voice at the organization is exempt, but if they have UBI, they must pay a corporate tax. And that is gross income derived from a trader business, which is regularly carried on by the organization. Now, does the organization get to deduct its expenses related to that?

Absolutely. So the, what we're looking at is a regular business carried on. Less expenses. And that's taxed at the corporate tax rates on a form called a nine 90 T notice that's trader business regularly carried on. So there are certain income categories which are received by an organization, which do not fall under the UBI rules.

And these exemptions include dividends, interest, annuities, royalties, and generally rents from property. Unless that property is debt financed. So you, he kind of think of UBI as business income is taxable and passive or investment income is generally not taxable. Remember I said that there were intermediate sanctions, which could be opposed on exempt organization for violation of, for instance, the inurement rules.

Let's put those really in perspective here. Now, toward the end of this little discussion, the transactions are found in the code section 49, 58. It's a penalty provision. They apply to C3 organizations and C4 organizations and what they. Penalties are is a 25% first here tax and a 200% second tier tax.

They apply to a transaction in which an economic benefit is provided to a disqualified person. And a disqualified person is anyone who exercise substantial influence over the affairs of the entity. Now notice one thing that's intermediate sanction applies to a C3 or C4, but I told you we had 28 categories of exempt organizations.

They're the only penalty that could be applied is exemption revocation. So in reviewing your exempt organizations, For the exam, go back and review the basic criteria for exempt organizations, public policy purposes that meet both an organizational and an operational test.

The regulation section of the CPA exam has a number of questions that deal with corporate tax issues. So we need to take some time out to consider a variety of issues that come up in determining. The tax liability of a corporation. Now corporations generally determine gross income and exactly the same way that individuals do the same income realization, principles apply.

And so what we've covered or what you've probably previously covered with individual, taxation's gonna apply here. Now to make things a little bit easier. Corporations don't have a gesture, gross income. So there's no for, or from AGI deductions, no itemized deductions. There's no personal and dependency exemptions, and there's no standard deduction.

So it's pretty much gross income minus business expenses. Now the deductions also employ the same sort of principles that individuals employed businesses, whether the entities that are controlled by individuals or whether they're corporations. All of the expenses have to be ordinary necessary, reasonable amount, paid and growth.

The taxable year cannot be capital expenditures cannot be expenses of another, cannot be associated with the zinc income and cannot be against public policy. So those are some criteria that you ought to build into your, your knowledge bank, just so you can readily apply those principles when you need to.

Now, the corporations have three important exceptions that we want to talk a little bit about. One is the dividends received deduction. You know that when a corporation distributes profits to a shareholder that's income, that really will be taxed twice, once to the corporation and wants to the shareholder.

But what happens if a corporation invest in another corporation, it's like corporation, a buy stock and corporation B. Well, when B distributes share dividends to AE and then a distributes its dividends to the shareholder. That effectively would mean that the income's been taxed three times. And so the dividends received deduction is intended as a way to reduce the impact of that triple taxation.

Corporations are also limited and the amount of the charitable deductions they can contribute or can deduct. And then they also are able to deduct net operating losses in a way that differs a little bit from individuals. Organizational costs are either deductible or amortizable. Organizational costs are costs that are incurred to start up the company not to issue stock or not to market the stock.

These would be like accounting fees or legal fees or incorporation fees necessary to start the corporation in order to qualify as organizational costs. They also have to have been incurred before the end of the first taxable year. And that's, regardless of whether it's a cash taxpayer article taxpayer, they have to been incurred prior to the end of the year.

Now the rule allows us to deduct $5,000, right? Those organizational costs immediately and amortize the rest over 15 years. However, if your startup costs exceed $50,000, then the $5,000 deduction amount is phased out dollar for dollar. So for example, if the organizational costs were $55,000, Then you effectively would not be able to deduct any of it.

And all $55,000 then would be amortized over the 50 15 year period. Now corporations like individuals may incur bad debts individuals though, have to distinguish between business versus non-business bad debts. Business bad desk, ordinary deductions, non-business bad debts for short-term capital losses for individuals, but for corporate entities, there's no requirement to distinguish business for non-business bad debts.

They're all considered to be business, bad debts, and they're fully deductible, but rather than using a percentage of sales method or percentage of receivables, like might be used for financial accounting, where you estimate. The bad debt losses, a corporation has to use the direct write-off method. So you'd have to specifically identify which accounts that are being deducted.

Corporations don't get any deduction for key person, life insurance premiums. If the corporation is the beneficiary. And the reason for that is because the proceeds from the life insurance will be tax-free to the corporation, just like they are for individuals. And you can't deduct expenses related to exempt income.

You recall that when individuals incur business entertainment and meal expenses, that you can only deduct 50% of those? Well, when a corporation reimburses its employees for meal and entertainment cost, it's the corporation that's bearing the costs for the meal and entertainment costs. So that 50% limit is imposed on the corporation.

So business meals and entertainment that are paid for by the corporation are limited to 50%. Now charitable contributions are also a deductible by corporations and the amount of the deduction each year is 10% of taxable income computed before any dividends received adoption before any net operating loss or before any capital loss carry forward to carry back.

So we've got kind of a pure number here. We have income before the DRD before NLLs and before capital losses. That number is multiplied by 10%. And that is the limit on what a corporation can deduct the charitable contributions. Now the rules that control that amount of the contribution are the same as they are for individuals.

So if you contribute long-term capital gain property, the amount of the contribution is the fair market value. If you contribute ordinary income, property is usually the lesser of. Fair market value or the adjusted basis of the property, the hands of the corporation. So this 10% limit doesn't impose a limitation on the amount of the contribution.

It opposes a limit on the amount of the deduction. Now, earlier we talked about the dividends received deduction and why that reduces triple taxation. So in when a corporation buys stock in another corporation and receives dividends from that corporation, Then the receiving corporation can exclude 70% of the dividend income.

As long as the corporation owns at a less than 20% of the stock. Let me say that another way. Let's say the corporation, a buy a stock of corporation B and corporation B makes a dividend distribution, the corporation a or if a owns less than 20% of B's stock. Then a, could exclude 70% of the dividend that's received from income.

That's called the dividends received deduction. We report all the dividends income, and then we reduce it by 70% of that dividend. On the other hand, if corporation a owns at least 20%, but less than 80% of the stock in B than a can exclude 80%. And then finally have Aons more 80% or more of the stock could be.

Then a can exclude all of the dividend. That's distributed from B to a, and that's how the dividends received deduction works. Now the tax rate schedule is that is imposed on corporations is more progressive for corporations that for individuals. And so when you think about woman in a business organization, one of the things you have to consider is the overall tax liability.

That is how much do the shareholders pay in taxes? Plus how much does the corporate entity pay in taxes and is the combination of the taxes of the two entities, the shareholders and the entity more than what it would be if you chose an alternative organizational forum. So you got to look at the big picture, particularly with smaller closely held companies now for personal service corporations.

There's a flat tax rate of 35%. Normally corporations have a phased in tax, right? That eventually gets up to a maximum of 35%. But if you're a personal service corporation, then the first and the last dollar taxable income are taxed at 35%. Now, personal service corporation is one where it's providing personal services to individuals.

Typically it has to be like a group of accountants that incorporate their practice or a group of physicians or dentist or architects, any professional organization that's performing personal services. Those are taxed at a flat rate of 25%. So again, considering tax planning is an important part or considering that the tax issues is an important part of the choosing the organizations.

There are a variety of credits that apply against the tax liability of the corporation. For example, the research and experimental tax credit can apply against the corporate tax liability and reduce it. Corporations are required to make estimated tax payments just like individuals are. Corporations that suffer casualty losses are able to deduct these losses as ordinary losses.

And the amount of the loss is the lesser of the drop in fair market value or the adjusted base of the property less than the insurance proceeds. So if there's a casual loss that occurs and inventory is destroyed in a hurricane or buildings are destroyed in a tornado. You look at the fair market value just before the event and the fair market value after the event and compare the two it's to measure the drop in fair market value.

And then compare that to the adjusted basis. Whichever is smaller is the amount of the loss. And then you subtract the insurance proceeds and any unrecovered losses that are treated as ordinary deductions of the business. Now, if the property is completely destroyed, Then the property items is simply deducted in full, but the full basis, less insurance proceeds is the amount of their adoption.

Corporations are able to either expense or capitalize research and experimental expenditures. So if you want to expensive, you get an immediate tax deduction. On the other hand, if you capitalize it. Then you can make an election to amortize that research and experimental expenditure over 60 months or more corporations are also required to provide some information about their executive compensations.

The compensation paid to the highest officers is reported on the tax return. And generally. Publicly held companies can only deduct the first million dollars of non performance-based compensation. That's paid to the top former officers. So it's intended to, I guess, make it appear like corporations are, are paying more taxes and not taking big deductions for highly paid CEOs.

It remains to be saying how effective this particular provision. Isn't actually changing compensation for executives. If the corporation pays bonuses to executives or anybody else in the company, even though they may not pay paid until the due date of the return, they're still deductible for that tax return.

As long as the board authorizes the by tax here in the bonus and the corporation distributes the bonuses by the due date of the tax return, that deduction can still be deducted in the year that the board declares the a bonus to be paid. Now NLLs or net operating losses can be used by a corporate entities to reduce their tax liability.

So if you have a net operating loss in the current year you can use it to offset operating income in a prior year or offset income in a future year. When you do have an NOL, the divot I didn't receive deduction is allowed in full. That is let me state that another way. In the years in which you haven't you have a operating income.

The amount of the dividends received deduction is generally limited amount of income. However, in the years, in which you have a net operating loss, the dividends received deduction can be taken in full, which simply increases the amount of net operating loss. And there's no percentage of income not limited to a percentage of income now for NOL carrybacks and carry forwards.

Currently there's a two year carry back and a 20 year carry forward. That is the few. In the current year, you have a net operating loss. You would be able to realize the tax benefits by carrying it back and using an offset income and a prior year or carry forward. Now this time period. Gets changed by Congress in response to economics situation.

So take a look at your, at your tax materials to see what the current carryovers and carrybacks are. I mentioned earlier about PSEs personal service corporations, their principle activity as a service has generally have to use a calendar year and may use the cash method of accounting. Regular corporations have to use the accrual method.

If the average annual gross receipts are greater than $5 million or for sales and cost of goods sold of inventory has maintained qualified service organizations have an exception here. Their average annual grocery seats, less than $1,000 may use the cash method of accounting for buying and selling inventory.

Again, if they're a qualified service provider and finally, a couple of miscellaneous items, corporations are subject to a corporate alternative minimum tax. Corporations are required to pay estimated tax payments. And usually that's a hundred percent of the current year or a hundred percent of the preceding year.

Now there's an exception here. If you're a large corporation that has more than a million dollars of taxable income, then you have to base estimated tax payments on the current year's tax liability rather than a preceding year.

I'm Jack Dorman. And in this module, we're going to discuss two aspects of corporate taxation, charitable contributions, and the dividend received deduction. You as individuals know all about charitable contributions, and I will tell you the same rules apply to corporate taxation as applied to individual taxation with respect to the definition of contributions.

Now, some of the limitations are going to be a little bit different and we're going to go through them all. But the basic contribution determination is made the same way as you do for your individual tax provisions. Long-term capital gain property. The contribution is equal to the fair market value of the property given away.

And for ordinary income property, the contribution is the lesser of fair market value or basis. Now, while that contribution determination is the same as made for individual texture session, there is one exception and the exception is that the is the increase in the contribution amount. With respect to donated property by the corporation.

So you can increase the contribution by one half of the appreciation for donated inventory scientific property. And what the Congress was trying to do was say, we're going to encourage you to give away these things, which would normally be part of inventory and would only go out at the lower of basis.

So that's an exception. Now Congress frequently modifies these charitable contribution rules. And I can only tell you again, stay up with a text to see what all the special rules are because in here over the last couple of years, there have been special rules added for scientific and intellectual property conservation easements requirements for appraisals and documentation and a real tricky rule, which requires the donut or.

To recapture the contribution. If a charity disposes of the property within three years of receiving the contribution, those special rules are highlighted much more fully in the text. Let's talk about the limitations on a charitable contribution by a corporation. The corporation may only deduct up to 10% of its taxable income through charitable contributions.

Now that 10% is computed without regard to either capital, losses or analytic. Carrybacks the charitable deduction itself, the dividends received deduction, or most recently a modification for the qualified domestic production deduction. So after taking those four items into account, the corporation can take charitable contributions up to 10% of its taxable income.

If there's negative taxable income, there is no charitable contribution. What happens if they make contributions in excess to the limit? The excess contributions may be carried forward for as much as five years. Here's a question it's occurred a couple of times, and it's a little bit tricky. The contribution made by a corporation maybe deducted in the current year, even if not paid by the close of the tax year.

If and two conditions must be met. Make sure if you have this question that both of these conditions are met the election to make the payment must be made by the board of directors by the end of the year. And the corporation must make the contribution within two and a half months after the close of the year, if those two conditions are met, the company may still deduct it in the earlier year.

Let's shift our mind now from charitable contributions, being given away to dividends, being received by the corporation. Very often a corporation will have investments in another corporation. And as we remember from all of our study about law and corporation, we know that there is at least two levels of taxation in the corporate world.

A corporation is a taxable entity. And when dividends are distributed to a shareholder, they're taxed again in the shareholders' hands. Well, what would happen if a corporation receives dividends from another corporation and then passes those on to its shareholders, potentially we could have triple or even Daisy chaining of tax and multiple levels.

The dividends received deduction or DRD is designed to avoid this and what happens. The investing corporation, the recipient may be able to take a portion of those dividends and exclude them from tax or take a deduction for what they've included, how much the answer is. It depends on their ownership, interest in the company that is paying the dividends.

This little. Table. I'm going to give you right now may have no rhyme or reason to it. It's what Congress has said. If the recipient company owns less than 20% of the pane corporation, it'd be take a dividend received deduction for 70% of those dividends received. If the receiving corporation owns between 20%, more than 20% at less than 80%.

It may take a deduction for 80% of the deduction received. And if it owns more than 80%, in other words, it's a member of an affiliated group. It may exclude 100% of those dividends that it receives. These are six numbers that I would encourage you to remember. I'm not sure that this will always be provided to you less than 20, 70%.

20 to 80, 80% over 8100%. Now the students received deduction is limited to the DRD presented times taxable income computed, without regard to the net operating loss or the deduction itself, or a capital loss carry back. So there is a limitation of the DRD deduction. And as usual, there's one more exception to the limitation.

The limit does not apply when there already is a net operating loss in that current year. So how we compute the dividends received deduction, multiply the dividends received by the deduction percentage from that table, multiply the taxable income by that deduction. And then limit the deduction to the lesser of the two steps, unless we have that capital that capital loss or net operating loss.

In which case we have to make an adjustment. There is an example in the text now, as great as that all sounded about DRD, there were a couple of special rules. Number one, DRD is not allowed to the extent that the portfolio generating the dividend. Is debt financed. So you have to do some tracing. You cannot use debt to acquire the stock, which is paying the dividend that you want to take the DRD on special rule portfolio debt.

Not that financed. Secondly, the investor must have held the stock for more than 45 days of its common stock or more than 90 days. If it's preferred stock. What happens is the Congress doesn't want a company. Hey, having a little excess cash, jumping in, buying a stock just before the the declaration date holding it long enough to get the dividend, the DRD, and then immediately selling it.

So you have to have a holding period on this earnings and profits. Let's just talk for a moment about what earnings and profits are. It's the ability to pay dividends. And everybody that I talked to who is just starting out in accounting, says, well, I said, isn't that really retained earnings. We pay dividends out of retained earnings.

Yes. We paid dividends from retained earnings, but the concept of earnings and profits is a tax law concept. And it is slightly different from retained earnings. There's a special internal revenue code provision, section three 12, which tells you how to compute the earnings and profits of a corporation.

Dividends truly to get tax dividend tree. They are paid out of either current earnings and profits or accumulated earnings and profits. If a dividend is paid out of ENP, it's taxable as a dividend and in today's world, we know that those qualifying dividends have a maximum tax rate in the hands of individuals.

It's very, very favorable. If the corporation has no earnings and profits, The dividend, the quilt dividend or the payment is a non-taxable return of capital to the extent of basis in that stock. And of course the dividend reduces stock basis when basis is down to zero, any further dividend becomes capital gain.

So earnings and profits. First of all, the distribution comes out of current EMP first, then out of accumulated earnings and profits. If there are no earnings and profits, then we go and begin to look to the rules of stock basis and then capital gain for that about in excess. This module was fairly short, but do you have two important concepts dealing with corporate taxation?

One charitable contributions. Remember the 10% rule, remember how we value the contributions that were made that are made. By the company. Those are probably the two bigger areas that you may see a question on dividend received, deduction and earnings, profit dividends. The only advice I can give is first, I would remember the table on the percentages for DRD and how it's applied with the taxable income limitation.

And secondly, that when dividends or purported dividends are made, we have to look to ENP payment out of current earnings and profits. Then accumulated earnings and profits, then a reduction to stock basis. Then capital gains if the payment exceeds our zero basis in the stock.

All right, thanks again for joining me for this module here. We're going to consider the. Credits that are available to corporations as well as the number of gains and losses that may be experienced in a corporate setting. Okay. First of all, with tax credits one of the large tax credits is available to us.

Based enterprises is the foreign tax credit. Okay. And as you're probably aware, U S corporations are taxed on worldwide income. So they're going to have us source income and foreign sourced income. Us taxpayers then can get a credit against their us taxes for taxes paid in the foreign countries. And you can imagine that enables the US-based enterprises to be more competitive with other countries.

With other businesses overseas. So the credit is a great thing to allow for us taxpayers to be more competitive. The credit for foreign taxes paid cannot exceed the U S taxes that would have been paid on that foreign sourced income. And so there's a foreign tax credit limit that's computed and is computed by taking the ratio of foreign sourced income divided by worldwide income.

And that ratio is then multiplied by the U S taxes. Based on total income, that then is the maximum amount of foreign tax credit that can be taken. So the credit is the lesser of the actual foreign taxes paid, or the foreign tax credit limit is results from this particular formula. There's also a general business credit.

If you look at the tax code in this area, there are several other. Credits that are available to corporate enterprises, as well as other enterprises. And the general business credit is combined to provide some uniform rules for how those credits are treated in combination and how they're carried back and carried forward.

Now, there are a number of Non-recognition events that occur for corporations. One is with respect to its own stock transactions. A corporation doesn't recognize gains and losses with respect to the issuance of its own stock or the sales security stock. So for example, on a section three 51 transfer, when a corporation transfers, stock and initial.

Incorporation that transfer the stock for the property. It receives from shareholders is not a taxable event to the corporation. It doesn't recognize gain and loss is when it issues the stock. Okay. In addition to that, no deduction is allowed for expenses associated with the purchase of treasury stock, except for any interest incurred in the acquisition of that stock.

Now in an earlier module, we'd consider the involuntary conversions that may occur with respect to individuals on involuntary conversion would occur. If the government, for example, condensed property and takes possessions or requisitions property from a taxpayer, or if there's threat or eminence from a governmental enterprise.

In those cases, the involuntary conversion rules that apply to individuals will apply to corporations and precisely the same way. And those are covered under section 10 33, in addition to the light kind of exchange rules under section 10 31 also applied to corporations and a manner that's very similar to the way they.

Are covered for individuals again on her like kind of exchange there's no gain or loss is recognized as a mandatory provision. The only thing that will trigger recognition of gain is the receipt of boots and boot is any part of the exchange. That's not the light kind of property, like cash, the relief of debt, the provision of services or any other kind of property.

That's not like on a property. Now for, with respect to capital assets those are defined the same way for individuals as they are for corporations. That is any kind of asset. That's not an inventory, not business receivables, not appreciable properties and or trigger resists or land. Or not artistic property than the hands of the artists and the example of a painter or a literature in the hands of a rider or composition, musical composition in the hands of a musician.

Now with respect to worthless stock, when a corporation owns worth of stock or when it disposes of stock and a loss corporations can only use capital losses to offset capital gains and with respect to worthless securities. Capital loss treatment is caused on the R occurs on the last day of the year in which the stock becomes worthless now in a parent subsidiary relationship, which is where a parent owns at least 80% of the subsidiary stock.

And more than 90% of the subsidiaries grocery seats are from active sources. The corporate parent would get ordinary loss treatment from that stock when it becomes worthless. So a parent subsidiary relationship, the parent gets ordinary loss treatment when they subsidiary stock becomes worthless.

Otherwise it's treated as the short term capital loss. Now more generally with capital gains and losses. Capital gains and losses are computed in the same manner for individuals and corporations net capital gain. However is taxed at ordinary rates. There's no favorite treatment. We recall with individuals they may be taxed on net capital gains that are right as, as small, as 15% or as low as 15%.

But corporations would have to report a net capital gain as ordinary and be taxed at ordinary rates. Net capital losses. On the other hand, as I mentioned earlier, are only used to offset capital gains net capital losses can be carried back three years and carried forward five years. Recall with individuals there's no, carryback only a carry forward, but the corporations, a three-year carryback and a five-year carry forward when they're carried forward or when they're carried back a long-term capitalist is treated as a short-term capital loss.

Now another provision that applies to corporations in part is the passive loss could recall that a passive activity as a trader business with a taxpayer does not materially participate. And those rules apply in part to corporations, the passive loss rules that apply the individuals apply to closely held C corporations and personal service corporations.

A closely held C corporation is where you have five or fewer individuals. Own directly or indirectly, more than 50% of the stock, the close the tax per year. And that's a closely held corporation. A personal service corporation is one where the principal activity of a performance is the performance of a professional service performed substantially by the owner employees.

To individually on more than 10% of the stock. So that would be like a group of physicians or accountants or lawyers who practice together. That's a pro a professional service corporation. Hey, pers professional service corporations can use passive losses against active income, or excuse me, cannot use Passive losses to offset active or portfolio incomes.

Again, personal service corporations that have passive losses cannot offer offset either active or portfolio income. Alternatively, with a closely held C corporation, passive losses can offset active income, active income being earnings from earned income, as opposed to income you generate from Pat from the investment activities.

So closely. I'll see corporations. Can you use the passive losses again to offset active income, but not portfolio income. So the rules are slightly different depending upon the type of C corporation and involve. Thanks again for joining me for this segment.

Okay. Hello. During this module on corporate taxes, we're going to consider some of the penalty taxes that are imposed on corporations, as well as related parties involving corporations. Now, this is not a particularly heavily tested portion on the CPA exam, but I think if you spend a little bit of time reviewing it, you'll certainly be ready for anything that's on the CPA exam in these areas.

And just want to make sure there's no surprises for you. First of all, in the corporate penalty taxes, there are two of those taxes. One is the personal holding company tax. Then the second is the accumulated earnings tax and they both have a similar objective in that they penalize the companies for not making distributions.

They, first of all, the personal holding company tax. There's an ownership test than an income test, both of which have to be met in order for you to be ex subjected to the personal holding company tax. First of all, the ownership test for personal holding companies, it requires that five or fewer shareholders or five or fewer individuals at any time during the last half of the taxable year on more than 50% of the value of the stock.

Let me say that again, five or fewer individuals on Northern half the stock. At any time during the last half of the year, that's the ownership test. Naturally, if you fail that test, the personal holding company tax, the tax is not gonna apply. The second test is the income test. And this task requires that 60% of them or the income be from passive sources.

So we've got the ownership tasks and the income chest. Now, if you are classified as a personal and the company, based on those two tests, you have to pay a penalty tax of 15% on undistributed. Personal holding company income. Okay. And distributed personal and current wholly company income in addition to the regular tax.

And that's the, where the penalty comes in at, you will not also be subjected to the accumulating earning stacks. So if the personal only company taxes will pause, you can escape the accumulated earnings tax. This is a self assess tax you file schedule pH to pay the tax and to meet your obligation there.

Now, since the objective is to force the corporation to distribute dividends. There are a variety of dividend paid deductions that are available to reduce the penalty tax. So you can meet both tests, but you can reduce or eliminate the penalty. If you make dividend distributions that qualify the personal holding company tax could be avoided by again, failing either one of those two tasks, the ownership task for the 50% or the passive income test.

And so knowing what those requirements are ahead of time. Would allow the corporation to change ownership, interest, or alter income sources and avoid the tax. The second tax is the accumulated earnings tax. Again, the objective is similar to that, of the personal holding company tax that is to encourage the distributions to shareholders by discouraging the unreasonable accumulation of income.

The tax again is 15%. And addition to the regular taxes, the tax is assessed on the adjusted taxable income and the adjusted taxable income is the regular taxable income reduced by the defendants paid reduced by the federal income tax reduced by the net capital gains and losses. The excess Trevor contributions, and also reduced by the greater of the justifiable accumulated earnings.

Or the available accumulated earnings credit. Now these adjustments serve to a product estimate, the dividend paying capacity of the corporation. They're not the, exactly the same as the computation of earnings and profits, but again, the objective is to measure the capacity to pay dividends and to identify what it is that the corporation.

Could be distributing as opposed to what it has distributed. The accumulated earnings credit is $250,000. That is you can accumulate beyond the reasonable business days up to $250,000. If you're a personal service corporation. That limit is 150,000 and these are not annual credits. These are lifetime credits.

So the total accumulated earnings credit for the, at any one point in time is $250,000 for regular corporation. Now there's no requirement to self-report the accumulated earnings tax. So you should be aware of when it's owed, but there's no report requirement to self self-report. Now, if there is a.

Desire to discourage corporations from accumulating earnings rather than distributing. What are some of the justifiable reasons for accumulating earnings? Well, one of those has been working capital requirements. They different companies and different entities or different industries require different amounts of cash or different amounts of inventory, or they have different terms on their accounts payable.

So different competence at different times in their histories. Required different amounts of working capital. So if you have working recapture requirements, that is a reasonable justification for accumulate earnings. If you have a business plans to expand that, or these are not just pie in the sky, wishful thinking ideas, but if you've got some really tangible.

Reasonable business plans to expand. Then that's a reasonable accumulate, a reasonable need to accumulate, or you might be accumulating earnings to retire and debtedness. So if you've got some debt that's coming through, it's reasonable and smart to accumulate resources ahead of time to pay off those debts or to retain funds for self-insurance or realistic contingencies, the key being they're realistic on the contingencies, you can retain funds to self-insure or provide for those contingencies.

Now a few things that are not justifiable needs. One of those would be loans to shareholders. So where a corporate entity is loaning significant amount of funds to the shareholders that's been found are deemed to be a unreasonable accumulation of resources on the part of the corporation, also loans between brothers and sisters, brothers, sister, corporations, that if you have a common shareholder that qualify the corporations qualify as brother, sister, corporations, and one lends money to the other.

That is also unreasonable or non justifiable reason for accumulating earnings. And then finally accumulations to carry out business activities that are unrelated to the corporation's business. You know, for example, if you're operating the manufacturing industry on the East coast and you find some beachfront property on the coast of California, that you would like to have, right.

That might be unrelated to the corporation's business. And therefore might be reviewed, are regarded as an unreasonable accumulation of, of the corporation's resources. Now the third order. And the next time, when we want to consider the transactions between corporations and shareholders, there are a number of instances where shareholders in corporations have transactions between those two and the unfavorable outcome of those consequence of those transactions may result in a dividend being deemed to have occurred.

From the corporation to the shareholder. So let's go through a short list of those one would be a shareholder, a personal use of corporate property. There's some assets that the corporation has that is used in his ordinary course of business, but the shareholder makes a substantial personal use of that property.

Then it could be that, that. Personal use is viewed to be a corporate dividend or a constructive dividend. Another is bargain purchase of corporation, a corporate property. If you're enabled or allowed to purchase corporate property, I substantially below market rate that might be regarded as a constructive dividend, that extra bonus, that your benefit that you receive the bargain rental of corporate property you're renting corporate property of below market rates could be a constructive dividend.

Bargain sale to a related corporation. You have property, you sell to a corporation at a favorable rate to make you make more money at the corporation's expense or payment for the benefit of a shareholder of the corporations pers making payments to on your behalf. That could be regarded as a constructive dividend unreasonable computation compensation shareholder loans.

And then loans to a related corporation at above market rates or in the case of a a thin capitalization. That is where a corporate's financial structure has a small amount of equity relative to the amount of the debt or the IRS. And the courts may view that. Debt to actually be equity. And so when those interest payments are made, that are really not interest payments, they're really dividend payments because of the thin capitalization.

And finally, the last item is losses on the sale property between I, more than 50% shareholder in a corporation are net recognized. Those are the related party rules under section two 67. You sell property at a loss to a. A corporation where you own more than 50% of the stock or vice versa, then the party that realizes the loss, can't recognize the loss.

And thanks again for joining me on this segment.

During this session, we want to consider a variety of corporate changes. This tends to be a particularly interesting part of the tax code, but it gets rather complex pretty quickly. So. Stay with me as we progress through this. One of the first things we want to consider incorporate changes are reorganizations provided for under section three 68.

This is a provision that allows tax-free reorganizations of corporations. One of the first ones is the type re a reorganization, which is also a merger or consolidation. And the notion here is that when there's a merger or consolidation, that the owners of the stock continue to own stock and And I, and acquire our newly formed corporation.

It's important to remember that this is not just the means by which people sell author interest in a corporation and cash out without any tax consequences, but it's really a change in a form. So in order to effect a type of re a reorganization, at least 50% of the consideration must be stock. And that's to comply with the continuity of interest concept.

Okay. It doesn't have to be local stock, but you still have to use 50, 50% of the consideration paid for the what's acquired has to be a stock. Then up to 50% of the remaining balance, then the consideration paid by the acquirer can be cash or other property. Generally, you've got to get approval of the majority of the shareholders of the target company.

And then in this kind of a merger or consolidation, All of the liabilities of the target have to be assumed. And that sometimes is regarded as one of the disadvantages of this type of reorganization is that you don't get to pick and choose which liabilities you assume with the target. And then finally the original corporation goes out of business.

This liquidates. And you start out with a, with a, a new brand new corporation under a type B reorganization. This is a stock for stock acquisition, only voting stock, or the acquiring acquiring company can be used. And you have to have 80% or more control or the target company. The stock has to be acquired directly from the shareholders, or it may be acquired directly from the shareholders.

And then this is generally a less complex reorganization than a type, a merger or consolidation. But the key point is that you. Can only use voting stock and you have to acquire at least 80% of more control of the target company in a type C reorganization. This is a stock for assets, reorganization, and it to affect a stock or asset type C reorganization.

You have to use cash or property. For up to 20% of the fair market value of the property transferred, the acquiring corporation could assume only the liabilities that chooses this is more advantageous in that respect than a type a reorganization and that the acquiring company can choose among the liabilities that it was just to assume.

In addition, the acquiring company has to get almost all up generally 90% or more of the assets of the target company in order to affect this type C reorganization. The target corporation must distribute the stock and securities and properties. It receives in the reorganization to a shareholder. So ultimately the shareholders of the target corporation becomes shareholders in the acquiring corporation.

A type D reorganization is simply a corporate division and this extends to a spinoff, a split off or a split up. And this permits the corporate division without toxic tax consequences. Assuming no boot is involved. In a type II reorganization. This is simply a recapitalization. It allows for a major change in the makeup of the shareholders' equity section of the balance sheet.

For example, they may capitalize on longterm data and create additional shareholders' equity in a type after reorganization. We simply have a change in identity or form or place or organization. The survivor corporation is treated as the same entity as the predecessor. And any tax attributes held by the predecessor carry over to the successor corporation in a time G reorganization.

This is simply a court approved reorganization of a debtor corporation that is creditors exchange notes for stock on a tax-free basis in order for a reorganization to be deigned, to be tax free. You have to, first of all, have a plan of reorganization. It doesn't have to be especially formal, but you have to have a plan in existence before the reorganization starts.

Also, you have to go meet the continuity of interest and continuity of business enterprise test. And both of these are trying to look at these kinds of transaction is not cashing out of the investment. But simply changing the form of the ownership. So target shareholders have substantially the same investment after transaction, as they had before, and they have to receive an equity interest in the acquiring corporation.

Also the continue, the targets historic business, or at least is a significant portion of the assets and the target business in a continuum enterprise. Now, in addition to that, you have to have a bonafide business purpose, not simply a tax avoidance scheme to make this on a tax-free basis. This again is not merely selling off an interest in a corporation.

And generally the step transaction doctrine does not prevent a reorganization. As long as the reorganization is completed within a year. If you do it longer than a year, then the presumption is, is that. These are unrelated transactions and each will be given tax effect and you'll lose the tax advantage of section three 68.

Now in determining the gain or loss and his non-recognition reorganization rules, excuse me, non taxable reorganization rules. They're very similar to the light kind of exchange rules. First of all, you got to compute a gain or loss realized where you take the fair market value. The assets received. And subtract out the adjusted basis of assets surrendered that determines the gain or loss realized.

And then the gain recognized is the lesser of the gain realized or any boot received. So it may be that in order to make these transactions effective, somebody has to kicks up an end to boot to make an equitable exchange. And that boot. Can trigger recognition of gains, just like it does in a light kind of exchange under section 10 31.

Okay. The postpone gain then is the gain is not recognized. So the gain realized minus the gain recognized as the postpone game and all Aussies are postponed. Okay. Receipt of boot can trigger recognition of gain, but all losses are postpone. The basis of the new asset is the fair market value of the assets received minus any postpone gain or in the event of a loss, the fair market value of the assets received.

Plus the postpone loss, the basis of the property received is the from the target company by the acquiring corporation carries over the same basis. So they retain the basis. And then the carryover basis though might be increased by any gain. That's recognized. By the target corporation on that reorganization.

Now in the event of a liquidation go into a new set of rules. Okay. Another corporate change here, liquidate incorporations recognized gain or losses on the distribution of the assets as if the assets are sold at fair market value. So you've got a corporations going out of business. It's deemed to have sold them all at fair market value.

And therefore we will realize I gained our loss on that deem sale. The shareholders are then deemed to have received the liquidated property in exchange for their stock. And the shareholders that will recognize a gain or loss is that they've sold the stock, the shareholders basis, and the assets received on this corporate liquidation is fair market value.

Yeah. In the event that we're talking about a liquidating of a subsidiary, the rules are a little bit different. First of all, to have a parent subsidiary relationship, the parent has to control 80% or more of the subsidiary stock. And when you have a liquidation of subsidiaries, no gain or loss is going to be recognized by the parent or the subsidiary subsidiary assets are transferred to the parent using a carry over basis.

So the parent takes over the same basis and those assets that were. Held by the subsidiary, along with any other subsidiary attributes, like net operating losses and earnings and profits. It's now on another note, what else? But it's what a corporation makes property distributions that as it's not liquid, it's not going out of business.

It simply simply makes a distribution of property. Okay. Under section three, 11, corporations were recognized a game as if the property was sold at fair market value. Okay. If they're distributing appreciated property to recognize the gain, if they're distributing property, that's declined in value, they don't recognize any losses in that event.

If property is distributed subject to a liability, then the fair market value will not be any less than the debt that is being transferred. Say, for example, that you had a, the corporation owned an asset with a fair market value of a hundred. Dollars and a basis of 80, but it was subject to $120,000 liability.

Okay. The $120,000 liability would be deemed to be the fair market value of the asset. So it would be deemed to have been sold for 120, where the basis of 80 resulting in a $40,000. Yeah. Gain shareholders received property in a receiving property in a distribution from a corporation will recognize dividend income in the same manner as if it had been a cash distribution.

That is the amount of the distribution as a dividend, to the extent of earnings and profits. And then the amount of the distribution is deemed to be a fair market value of the property, less IDI liabilities that the shareholder assumes on the distribution, the basis in the property divide, a dividend is fair market value.

So when you receive a property dividends, You get a fair market value basis in that property. And then it's treated as a dividend again, to the extent of earnings and profits. So if you don't have an occurrence of profits, the distribution would then reduce the stock basis in the corporation. Now, redemptions is a, another type of corporate change and a redemption is a sales stock by a shareholder.

Directly back to the corporation. Now under section three Oh two, there's four ways to accomplish this on I and get capital gain treatment, as opposed to dividend treatment. The first way is to have a meaningful reduction in the ownership. There's gotta be something about the ownership interest that changes that significant.

For example, if you were a 55% shareholder before the redemption, and you're a 45% shareholder after redemption. That would be considered to be meaningful since you went from being a majority shareholder to a. Less than majority shareholder. Alternatively, you can accomplish a redemption treatment and get capital gain.

If you have a substantially disproportionate distribution. And that simply means let's look at the we'll look at the ownership interest before and after the redemption. And if the ownership interest after redemption is less than 50% and the ownership interest has dropped to less than 80% of what it was before the distribution, then you get capital gain treatment.

A third way to accomplish a redemption is to have a complete termination of interest where you simply sell back all of your stock to the corporation and your owners, your pensions to zero, and any family that owns the stock. You waive these family attribution rules so that you would not be deemed own any of the stock of family members.

And finally, the fourth way to get capital gains treatment is to have a partial liquidation where there's a contraction or meaningful contraction and the size of the. Of the liquid and corporate or they not stock is paying redeem. There's a significant or meaningful reduction in the size of that ongoing corporation.

The opera shareholder fails to meet any of these tests. The redemption that really does not significantly change the ownership will result in a distribution, being treated as a dividend. Now that particular outcome is lost some of his significant sense. Capital gains and dividends are both tax would favor tax tax rights.

So individuals that are redeeming their stock may often be indifferent between getting dividend treatment or capital gain treatment. However, if the corporation is a shareholder that if you have a shareholder redeeming its stock, they're entitled to the dividends received deduction. So they would often prefer to characterize this redemption as a dividend, rather than a sale to stock and get redemption treatment.

Now the last corporate change we're going to consider is the formation of a corporation. This is when you're going to start a corporation and section three 51 controls the outcome. And section three 51 says that no gain or loss is recognized by the transfer or by the individual. If property is transferred.

So in exchange for stock and the transfer orders, the be able to given up the property exchange with the stock are in control. Immediately after the exchange in control is defined as 80% of the stock. And it includes not only the stock that you acquired as a result of the transfer, but also the stock that was already owned at the time of the transfer.

So you may have an existing corporation and the shareholder choose to make additional contribution of capital in exchange for stock. And we would consider not only the stock that owned prior to the transfer, but also the newly own stock in determining whether they had 80% control. Now under section three 51, when you don't recognize a gain or loss, but again can be triggered if boot is received.

And the gain is recognized. The gain that is recognized as the lesser of the gain realized, or the boot received pay same rule that applied to 10 31 transactions that we talked about earlier, and then the relief of liabilities. Will not be treated as boot, assuming that these are bonafide liabilities and there wasn't a tax avoidance motive and transferring liabilities to the corporation.

So again you transfer property exchange for stock and you receive some distribution back. That distribution you get back is treated as boot and it can trigger, gain, record, be recognized. However, liabilities that are assumed by the corporation and a three 51 transfer are not treated as boot, as long as they're bonafide and a three 51 transaction.

The shareholder ends up with stock and the basis in that stock is the same as the assets that are transferred. Plus the gain that's recognized by the shareholder on the transfer. Minus any liabilities that are relieved of that is that the corporation assumes and then subtract that any boot received.

So the base of the stock is the base of the asset transferred plus gain recognized minus liability to a minus B receipt. Now the basis of the assets in the hands of the corporation is a carry over basis. That is the corporation takes the same basis in the asset. The shareholder had. Plus any gain that the shareholder recognizes and the three 51 transfer?

Well, that concludes this, uh, short CPA review of, uh, corporate,   changes. And again, this is a rather interesting part of the tax code, but it does get pretty complicated and it's worth taking a little bit of extra time to review, to be prepared. Thank you for joining me.

The corporate tax. The return requires three reconciliation schedules that have to be filed was part of the tax return. Their schedules . Schedule M three, which reconcile book income to taxable income and then schedule M two, which reconciles, beginning and ending retained earnings. So we're going to take a quick look at schedule M one first, again, this reconciles bookend come to corporate taxable income.

Before the taxable income includes any net operating loss or dividends received at auctions differences can be due to both permanent and timing differences. We're not trying to distinguish between those two. We're just trying to identify what some of the differences were and the way we're going to do that.

It's going to start out with a net income per books. Remember net income per books would be after tax has been subtracted. So to get back to bookend or taxable income we're first of all, going to add back the federal tax liability. And then we're going to add to that the excess capital losses over capital gains and recall for tax purposes, corporations can't recognize capital losses, but they can for book purposes.

So we're simply adding those excess capital losses back. And they're going to also add back income, not recognized for book purposes in this year, but recognized for are recognized for tax purposes and expenses that are deducted for book purposes this year, but not permitted for tax purposes. And then another adjustment is to add charitable contributions in excess of the 10% limit.

So recall that for book purposes, we were able to deduct all of the charitable contributions. But for tax purposes, you can only deduct charitable contributions to the  to the extent they up to 10% of taxable income. So we're simply adding back the excess charitable contributions here. And finally, we're going to also make an adjustment for the 50% of tray travel entertainment costs that are not permitted for tax purposes.

We've deducted a hundred percent for book purposes. But we can't can only deduct 50% for tax purposes. Now the negative adjustment would include a reduction for tax exempt income. Any charitable contribution, carryovers, like we've already deducted for book purposes and the year of the contribution, but we weren't able in those prior years until now to deduct for tax purposes.

So now we're subtracting them out. We're going to add back the premiums that were paid for a key person, life insurance. We deduct those expenses for book purposes. But we can't for tax purposes. And then we add the interest expense associated with the exempt income, and that should then allow arrive at taxable income.

And that schedule is sometimes not regarded very highly by tax preparers because it just as another step in the compliance process, but from an IRS viewpoint, it may be considered one of the most important schedules because the IRS has. The responsibility for ensuring that corporations comply with the tax tax rules.

And so the in one schedule might point out possible tax issues, potential avoidance, even fraudulent accounting, where there are significant and wide differences. However, over the years it's been apparent that corporations are smarter and they figured out more easier ways to avoid taxes and sheltering taxes.

And found ways to do so without having to disclose that information on schedule M one. So M one wasn't sufficient for many cases. The starting point for Buddha book income varies so frequently from one corporate corporation to the next, the reporting categories on the M one schedule. In many cases, it's just simply too broad.

And then corporations had just a lot of flexibility and they have the reported differences. So in three was initiated. 2004, and it's required for all corporations with more than $10 million in assets at years in and that $10 million would be on an aggregate basis. So in the case of a consolidated tax return, it would include all of those that are consolidated for financial accounting purposes.

So on the schedule and three is divided into three parts. And the first part discloses, what exactly was the source of book income? That is if one of the problems with them, one was that different corporations at different starting points. Exactly. What is the starting point? And that's disclosed in the  and there's a hierarchy here that the book income has to be from the sec form 10 K.

If that's not available, then you would use a certified income statement. If that's not available, then other financial statements. If there are no financial statements issued. Then the beginning point book income is based upon the company's books and records. Part one also isolates. How much of the us book income is reported on the U S tax return and separates how much would be reported and to foreign entities and not tax.

While in the us part two and three are divided into Over 70 income and expense items. And again, remember that the purpose for this forum is to help identify potential tax avoidance issues, identify tax abuses, identify tax sheltering. So parts two and parts three. Also identify the portion of the book tax income attributed to permanent differences and temporary differences.

Tax shelters will often show up as permanent differences. So that's going to be disclosed on schedule in three. Now you may know that taxpayers, corporate taxpayers are required to disclose certain reportable transactions. And these are transactions that often have tax sheltering implications, and they're supposed to report those on form 88, 86.

However, if the firm, if the corporation is. Required to file in three, then there's no additional requirement to form a file form 88 six. So the objective in three again, is to assist the IRS and helping figure it out. Who ought to be audited. Who's most likely to be failing, to report all their income or using too many evasion methods.

And finally, the M two schedule simply recognizes beginning and ending retained earnings. And here we're going to use a counting rather than tax status. So remember that retained earnings, the beginning balance is increased by net income, and then it's reduced by dividends that are paid. And then the result is any retained earnings and that's what's reported on schedule M two.

Bye during this module, we want to consider a miscellaneous corporate transactions. The first one we will look at are the attributes that carry over in a corporate acquisition. We call it when there's a corporate acquisition, there's some continuation of the business activities. Of the acquired corporation and then consideration that has to be given as to how those attributes are carried over.

For example, on the day of the acquisition corporation, the acquiring corporation takes over net operating losses that is NOL to the acquired corporation that were in existence at the time in which the target corporation was acquired. Okay. And those according to the rules cannot be carried back to a prior year of the acquiring corporation.

They could only use B is prospective, or they can only be used. To carry over in the future. This was intended as a way to, to limit corporate incentives, to buy net operating loss corporations solely for the purpose of using their mols. Also, we got to consider the capital loss carry overs. The acquiring corporation would assume any tax credits that are available to the acquiring corporation.

And then finally, ENP deficits will also carry over to the successor corporation. Now under section three 82, there's a special limit. That limits the amount of NOL carry over that can be used by the successor corporation. And this provision under section three 82, applies that there is a more than 50% change in the ownership of the corporation.

During the three previous years. Now, the white three 82 works is that it creates a hypothetical income stream. By taking the fair market value of the corporation acquired and multiplied it by the federal long-term tax exempt interest rate that would then give you a hypothetical limit. On how much of the NOL the can be used in the future if the year, if in the year, the change over the available NOL carry over is limited by the percentage of days remaining in the tax year after the change date.

So let me say that again. First of all, you got this limit on the nos that the successor corporation can take, and that limit is based upon the hypothetical instrum income stream. Of fair market value multiplied by the federal long-term right. And then in the year in which the changeover occurs, the NOL carry over is limited by the percentage of the days that remain in the year.

Now, estimated tax payments are also required of corporations. Corporations must make these estimated payments for both regular and alternative minimum tax liabilities. Unless the expected tax is less than $500. The payments that are made on an estimated tax spaces are due on the 15th day of the fourth, sixth, ninth, and 12th months.

And then one fourth of the taxes due on each of those four days. There are non-deductible penalties assessed on underpayments. So if a corporation should fail to make it on a timely basis or an insufficient amass, there may be a penalty and interest to, they can avoid the penalty. If the estimated payments are timely and equal to the Pryor's tax liability.

Or by paying at least a hundred percent of the current year's tax liability. Now, large corporations don't have that as much of an advantage there. A large corporations cannot base their installment payments on their previous year's taxes, except for the first installment, large corporations or those with taxable income in excess of a million dollars.

Now the final topic we'll talk about real briefly are consolidated return groups. Okay. There were groups that have common ownership and are considered to be affiliated affiliated groups. They're entitled to file a single tax return. So rather than each individual company and the group filed their own independent return, we'd simply consolidate them all and find follow in return.

In order for this to happen. And affiliated group is you have to meet the definition of an affiliated group, which is one or more chains of includable corporations. So not every corporation to do this, but one or more chains of includable corporations connected through stock ownership to a common parent.

Now some of the ineligible corporations would be those that are exempt from tax. Us possession corporations, certain life and mutual insurance companies, foreign corporations and regular investment regulated investment companies. Now our parents subsidiary group includes one where you have a parent can remember a parent has to have at least 80% control of another corporation.

And then another corporation may be controlled by one or more of the other corporations in the group. And so you have this group of affiliated entities. Now, one of the reasons why a corporation might want to file the solder return. Well foremost is the fact that operating losses and capital losses instead of being carried forward and carried over into future years by individual members can be used by other group members in the same period in which those losses occur.

So you get a more immediate benefit of the capital loss carry overs and the operating loss carry overs. Instead of. Pushing them forward. They can be used immediately on the downside gains and losses on sale or exchange of property between group members or an expenditure that would be capitalized by the acquiring company are deferred until the sale or exchange occurs outside the Cassata group.

So as long as the interchange is between family members and the affiliated group, the gains and losses on those sales exchange, they're not recognized. So that becomes a disadvantage on the other side of a positive benefit as you eliminate. The tax on inter-company dividends. There's a hundred percent dividends received deduction on dividends between members and the affiliate group.

The statute of limitations are the same they're subject to the same statute of limitations as individuals are. So this is a kind of a strange group of miscellaneous corporate tax items, but they're rather important. So be sure to take a good look at them. Thanks for joining me on this segment. I'd like for you to consider for a few moments with me, the corporate alternative minimum tax, and recall that the AMT is a parallel tax system.

That's imposed on entities to frankly, ensure that they're paying a fair amount of tax viability because corporations, as well as individuals are so creative and they tax Syria and often find many ways to avoid paying taxes legitimately. The AMT is a tool designed to make sure that everybody pays a little bit.

So if we can begin with, let's take a look at the formula, the model for computing, the alternative minimum tax. The beginning point is the regular taxable income that's reported on the tax return before any NOL deduction using whatever perf whatever items and whatever tax provisions are available.

You compete the regular tax liability to compute AMT we're. First of all, going to add back a number of our variety of tax preference items, tax preference items, or legitimate deductions that were available for regular tax purposes, but they're simply not available for regular time for alternative minimum tax purposes.

So this adjustment the call preferences is always a positive. Jess was always added back. The second item is a. Positive or negative adjustment called adjustments that are sometimes positive. Sometimes they're negative and the same sort of idea that these are legitimate tax benefits that are available in the tax code.

And they typically are a timing difference. And so in occasion they have a positive adjustment. Sometimes they have a negative adjustment, so that allows us to then arrive at the pre adjusted current earnings, alternative minimum tax, wind comp. The next step is to add a subtract the ACE adjustment. Now the ACE adjustment is an adjustment that's akin to the measurement of earnings and profits.

Now you may recall when you have read and studied about distributions from corporations their dividends to the extent of ENP or earnings and profits earnings and profits represents the economic ability to pay dividends. And so ACE, the ACE adjustment is similar to that idea, represents a. Re computation or the alternative minimum tax, low income using the economic concepts of income and expenses.

So we're going to make a positive or a negative adjustment for it. Nice. And then we're going to subtract out the NOL deduction. The NOL deduction is limited to 90% of the pre NOL AMT. I, a lot of letters in there. So it's helpful to look at the notes as we progress through this and that arrives at the alternative minimum tax.

When cob AMCI is then from that is subtracted allowable exemptions. So certain corporate tax payers that whose AMCI falls below the exemption amount. Are not going to be required to report EMTI at all. And I'm not going to be required to pay the alternative minimum tax. So AMT less, the allowable exemption is the AMT base.

The AMT base is then multiplied by the rate and that then arrives at the tentative alternative minimum tax. Before any foreign tax credit, then we were able to then subtract out the alternative minimum tax foreign tax credit. To arrive at the tentative alternative minimum tax. We compare that to the regular tax liability.

And if the AMT is larger than the AMT tax, the regular tax liability that we have to pay, not only the regular tax liability, but also the alternative minimum tax. Now let's take these components and look at them in a little bit more detail. Okay. Recall that the preferences, they are always positive adjustments.

They're always added back to taxable income and these include some, a variety of things, which in some cases are rather strange, but this what the preferences are excess of the percentage depletion over the property's basis, that'd be excess percentage depletion over whatever you would have been allowed for cost depletion, excess and tangible drawing costs.

Net tax exempt interest on private activity, bonds, and then for AMT purposes for pre 1987 real property, you have to spread the cost on a straight line basis over a 40 year period. And then for pre 1987 personal property, you are limited to the 150% declining balance method rather than the 200% declining balance method.

So the depreciation methods are just a little bit more conservative. And these are again, all preference items and they're only added back when they're positive. Then we have a number of adjustments. And as I said, these are timing differences. These can be either positive or negative. The first one is that for regular tax purposes, we get to use a more accelerated rate for depreciating assets than for AMT purposes.

For AMT purposes, we're limited to 150% declining balance method. On personal property, 40 years straight line method for real property, as opposed to the what's available for makers under regular tax rules, we have to make a positive or negative adjustment for regular tax deduction for pollution control facilities.

Mine aspiration and development costs that are in excess of what's required for AMT purposes. So those items that are in specific industries are fairly unique. And so if you were engaged in those kinds of industries, you'd probably be very pretty. I keep track of what the regular tax deduction is for these items compared to the AMT deductions.

I'll learn time contracts have to be reported on the percentage of completion method. And in the case of installment sales of inventory, you have to report all of the installment gain. And again, these are positive or negative adjustments that are typically going to be different from one time to the next.

And then the regular tax NOL in excess of the alternative minimum tax NOL is also a AMT adjustment item. Now the ACE adjustment. Can again, either be positive or negative. And as I mentioned before, the ACE adjustment is very similar to the other. The concept of ACE is very similar to the concept of earnings and profits earnings and profits represents the economic ability ability to pay dividends.

So, and essentially might say the adjusted current earnings represents economic income. And so we're going to compare a S to the taxable income and S. 75% of that difference. Is there going to be added or subtracted depending on whether it's positive or negative to in computing alternative minimum tax income.

Now let's talk a little bit about some of the adjustments that would be made in computing the ACE. So we take the alternative minimum tax when come before the ACE adjustment and we add back income that's excluded from the calculation for both regular tax and alternative minimum tax purposes.

That would include municipal bond interest, key person, life insurance, proceeds greater than cash surrender value. The attire gain on the sell of inventory of sale of installment items. Other than inventory, we also add deductions disallowed by ACE. So remember that we had a dividends received deduction that was permitted for regular tax purposes and alternative out of tax purposes, but not allowed in computing, the adjusted current earnings.

So. We're going to add back the 70% DRD we're going to add back also the amortization of organizational expenses and the excess of  inventory over life or mentors. So these are some rather complicated obscure adjustment items. That again are attempts to get a better measure on how much economic income has been realized by the company.

And then we subtract out some income some expense items that are attributable to previously excluded income. So we couldn't the key man insurance premiums that we couldn't deduct for regulatory tax purposes. We now deduct for purposes of ice. And then we can deduct interest on debt, occurred to acquire exempt bonds that were not previously deducted, but now are, so that then gives us the adjusted current earnings.

So we look at adjusted, current earnings subtract the alternative minimum tax, bill income. And multiply that difference by 75%. That then is the ACE adjustment, which again, could be positive or negative. And then as, or just retracted from the computation for alternative minimum tax. Now the exception amount that's available for corporations is $40,000 that, that like so many other thresholds is phased out.

And the phase out rate is 25% of AMCI in excess of 150,000. So if you run the numbers here, by the time the AMT BI reaches 310,000, any exemption amount is completely phased out. Now the AMT is compared to the regular tax and you pay the higher of the Tinder AMT or the regular tax. The AMT theoretically is the excess over the regular tax, but you're going to pay the entire amount AMT plus the regular tax.

The. AMT credits in the years in which you do pay an income. Yeah. AMT alternative minimum tax that AMT can be used in future years as a credit against the regular tax liability. But only to the extent of AMC that's been previously paid in prior years. So that AMT that's been paid, it can be used as a credit against the regular tax liability.

But again, only to the extent of previously paid AMT. There's an exemption for small corporations. These are entities that are escaped, the alternative minimum tax. Those corporations that are in the first year, or have average annual grocery seats for three consecutive periods, less than seven, seven and a half million dollars are exempted from this now for entities that are in the first three year period.

The rather than a seven and a half million dollar exemption threshold that exemption says threshold is limited to $5 million

as corporations have been around for a long time. And in this segment, we want to review or give you an overview of the S corporations. First of all, one of the primary advantages of a S-corporation is the liability protection. And it's the same as, as if it was a regular C corporation. Secondly is there's a tax benefit afforded to the shareholders.

And that is the entity itself is not taxable, but rather it's a conduit much the same way. A partnership con co is a conduit and the entity itself is not taxable, but rather the shareholders are taxed on their share, their pro-rata share. So there is no entity level tax at the S-corporation level.

Generally speaking income flows through to the individual shareholders with tax effects, similar to the shares to the partnership. In order to qualify as an S-corporation there's some specific requirements that have to be met, not only at the time at which the S election occurs, but also during the entire life that the corporation is an S-corporation.

If at any time it fails to meet those requirements, the S-corporation is terminated. The first requirement is that have to be no more than a hundred shareholders. Now, this was a change in the tax law that came in 2004, increased it from 75 to a hundred shareholders. And the husband or wife may elect to be treated as a single shareholder.

A second requirement is that there cannot be a Rez, a non-resident alien shareholder. So you can have resident alien shareholders, but not non-resident Haven shareholders. You can have no corporate or partnership shareholders. However, an S-corporation can be a partner in a partnership. And in order to keep the tax tax simple and the, with respect to an S-corporation and the allocation of the income supple, that can only be one class of stock.

Okay. You may have different voting rights with respect to different stock, but it all has to have the same, right. To an equal share of its income now, because a debt can take on a lot of equity characteristics. You have to be careful that any debt that the S-corporation. Oh, this is not recharacterize a stock, which could then.

Cause it to compromise this one class of stock requirement in addition, and S-corporation has to be a domestic corporation. It cannot be a member of an affiliated group. Now it may own a hundred percent of a qualified subchapter S subsidiary. However, the qualified subchapter S subsidiary is just all paper.

That is, there's only a say there's a single tax return. That's filed. By the S-corporation the corporation has to make an election to treat the subsidiary as a qualified subchapter S subsidiary to make the election you'd have to file. 25 53 and the form has to be filed if you want to make it effective for the future years and all shareholders have to consent during the previous taxable year or within 75 days after the beginning of the current year.

So if it's a calendar year taxpayer, which has corporations generally are, you'd have to file the 25 53. By March the 15th and all of the shareholders who are owning stock during the, that year would have to make consent or have to consent to the election. Now, termination and S-corporation can occur either voluntarily or involuntarily, a voluntary termination S-corporation requires the consent of a majority that is more than 50% of the shareholders, not all the shareholders.

So. Unlike the a hundred percent requirement to elect the status. It only takes 50% or more to terminate the status. That's a voluntary termination and involuntary termination would occur when there's a. Ceasing to be a small business corporation that is violated one of those multiple requirements of the shareholders that is you have more than a hundred shareholders, or you have a non-resident alien as a shareholder, or you have a inappropriate shareholder.

Any of those would cause termination of the SLA. In addition, there's another peculiar item here that. Initially, it was thought that it was not a good idea of risks. Corporations have investment income. So they created a rule that said that in the years where there are, when there are three consecutive years of excess passive investment income in excess of 25% of gross receipts.

Okay. At the end of that third year, you had terminated the selection. However that termination or that rule only applies if the S-corporation has earnings and profits. Now remember earnings and profits as a C corporation concept, that is, it represents the undistributed. Economic ability to pay dividends and you can only, yeah.

Accumulate earnings and profits as a C corporation. So here, this threat of that involuntary termination would only occur if the S-corporation had previously been a C corporation and has undistributed earnings or profits at the time of when they make it the election. Now in the event that there's a termination of the S-corporation.

You have to wait five years before there's a filing for a new election, unless the IRS consents to an earlier date. And generally if there's been a more than 50% change in the ownership. The IRS will consent to a re-election of the S status. In addition, if there's in an inadvertent termination as a result of perhaps having the Ronald member of shareholders or an invalid term termination, because of something came up that you didn't expect, if you make a reasonable effort to fix those problems with them shortly after realizing they occurred.

The IRS will generally consent to a continue of the S selection in the years of which the S terminates the one portion of the year would be an S and the remaining of the year would be a C corporation that let's talk a little bit about the taxation of a C Corp, excuse me. An S-corporation the computation of the tax blue is very similar to a partnership.

S-corporation would have to recognize gain on the distribution of appreciated property, just like a C corporation. Now recall that when a partnership distributes appreciated property, the partnership generally doesn't recognize gain on that distribution. However, at C corporation does and an S-corporation does as well.

So if an asset distributed property that's appreciated to its shareholders, then they're going to have to recognize. Gain. And then that guy would be passed through to the individual shareholders now where there are no special S-corporation rules. Then you revert back to the sea rules. For example, there are no particular rules that relate to liquidation of an S-corporation.

So we simply rely upon the C corporation liquidation rules. And in the event of a complete termination of an S corporation, again, we would revert back to the C corporation rules. The S-corporation the due dates are the same as the C corporation. Generally it's a calendar year. However, there are circumstances when a fiscal year for an S-corporation will be permitted I 20 S is the tax return that S corporations file.

There's no S-corporation income tax in general, that income flows for the individual shareholders. And then shareholders would report their income and pay the appropriate taxes on their return for their pro rata share of each of the items of income that the S reports S-corporation reports. Now, there are a couple of exceptions to the rules.

I just mentioned that there's a couple of cases where the S-corporation may in fact be. Subject to attacks. One is under section 1374. That's the built-in gains tax, which we'll talk about a little bit. And then section 1375, which is the access of passive investment income tax. So we've referred to this already.

With respect to the three-year rule. When you have three years of access of passive investment income, and you have earnings and profits that can terminate the selection, but in the years in which you are not terminated, you may still owe a tax on that excess of passive investment income. Now let's consider the stock basis.

That is what is the shareholder's basis in the stock is very seminal partnerships. You start out with whatever the initial basis is based on section three 51 and the rules for Agra C corporations. And then we're going to increase that by the income items, including tax exempt income. That's the same thing that affects through our partnerships outside basis.

Our partner's outside basis. We decrease it by non taxable distributions and we also decrease it by the way losses. Now, if there are years in which they are losses and distributions, if those occur at the same in the same year, The distributions reduced stock basis first before considering the fact of the losses.

And that could be very important because losses at an S-corporation can only be recognized to the extent of stock basis. Now, shareholder income, income and expense items are reported on a pro rata basis. So each share stock has the same rights of each different category of income and losses. The flow-through as is.

So if the S-corporation earned ordinary income or capital losses, that character would flow through to the individual shareholders and then each shareholder reports each pro edge of his share of those items. These a S-corporation is required to report a these individual shareholders items on a schedule K one, and that K one breaks down the amount and the types of income.

For a shareholder now, what has to be separate separately? Hoarded. Okay. This is very similar again, to partnerships. Tax exempt income is separate reported. Short-term long-term capital gains and losses as well as 1231 gains and losses. However 12 are reported separately. However, 1245 is not reported separately.

That's simply ordinary income that's included in with the non separately strated items. Shareable contributions are separate reported so that we can't use the seek the S-corporation entity to get around a charitable contribution limitations at the individual level foreign taxes paid are separate reported.

Dividends interest royalties, investment type income, the basis of new amuse section 38, property investment interest, expense rental, real estate activities, and expenses eligible for tax credits. Generally anything that could have a differing effect at the individual shareholders level would have to be separately stated.

Now, as far as deductability of losses go, there are actually three limitations that apply. One limitation is the shareholder's stock basis. Plus any loans that the shareholder has lent to the corporation. So he has a stock basis and a debt basis. And when the losses flow through the shareholders, the losses first reduce the stock basis and then reduce the S the debt basis.

But neither of those would go below zero as a result of losses. So in the event that you have losses in excess of basis, Those losses would be suspended and have to be recognized in a future period when those dot stock and debt basis have been restored, any excess can be carried forward and deducted if, and when is recovered by positive basis.

Have shareholder loss is not only limited to stock basis, but are also subject to the at-risk rules under section four 65 and the passive activity loss rules under section four 69. So if the taxpayer does not materially participate in the S-corporation. Then they're going to be unable to recognize the losses.

Well, that's just a brief overview of the S-corporation. So take a look at that re review it carefully and particularly pay attention to the similarities and differences between S corporations and partnerships. Thanks for joining me and good luck on this part of the exam

in this segment, we'd like to consider how S-corporation shareholders might be taxed. Now, before we get into the details, we should understand a little bit of background information. First of all, remember the concept of earnings and profits earnings and profits is generally a C corporation concept, but it's possible that an S corporation might have EMP and it would come up in one, two ways.

One is that it was a C corporation before and elected that status. And it had earnings and profits at the time the S election occurred and had not yet distributed. It is also possible that a C corporation has earnings and profits elects S status, and then chooses to distribute all earnings, all of its earnings and profits.

So it may have had earnings or profits previously, but it no longer has that. Now you should also be aware of a concept referred to as PTI previously, taxed income, a PTI. This is taxed S-corporation income that was earned prior to 1983. So it goes quite a long ways back. This is income has been taxed, but not previously distributed to shareholders.

Yeah, another concept is called the accumulated adjustments account. This is an account that's tracked at the corporate level and it's the balance of undistributed S-corporation earnings. So ENP related to the seniors, but triple I accumulated adjustments, accounts relates to the S-corporation earnings that have not yet been distributed.

This particular account can be going at negative as a result of corporate losses. But it can't become negative as a result of distributions. Okay. Nor if it's negative already. And there's a distribution, that distribution is not going to cause AAA to get even more negative. Okay. And this particular account, the AAA account is used to compute the tax effect of a distribution made by an S-corporation that has earnings and profits.

Okay. Generally, there's no distinction made between cash and non-cash distributions. However, remember the rules for S corporations distributing appreciated property that when an S distributes appreciated property game, but not losses are recognized just in the same way it would have been if it was a C corporation.

And then that gain will generally pass through to the individual shareholders who then reported on their own tax returns. There isn't an exception, a pretty important exception under section 1374. For built-in gains, which we'll cover in a moment. Now what about S-corp or other shareholder distribution treatment?

What happens on the distribution as corporations, without earnings and profits? So let's look at the simplest case. So we've got an. An S-corporation with no ENP because we don't have any MP. We're not required to track the accumulated adjustments account. So any distributions that occurred by the S to the individual shareholders is considered to be non tax per return of capital to the extent of the shareholder's basis in the stock.

And then any excess amount that is any distribution and access to the shareholder stock basis would be treated as a capital gain. Now, again, with a S-corporation without England P. There's no EMP that to keep track of. Okay. But there are reasons to keep track of that. Nevertheless, in the event that you have undistributed income and your S-corporation is terminated either voluntarily in voluntarily.

There's 121 her other 120 day window to make a tax-free distribution from the S-corporation to the other shareholders after the termination of the S-corporation. So if you don't have any triple I, or if you haven't tracked triple I, you have no way to determine. Whether that cash that's distributed after within that 120 day window is tax-free.

And if you don't are not able to establish that, that then the distribution from the C corporation would in fact, be a taxable dividend to the extent of earnings and profits. Now let's consider what happens to distribution when the S-corporation has earnings or profits, this is a bit more complicated and unless there's a special election made.

The tr the distributions will come in a, in a fairly precise order. Hey, first of all, the distributions come at a triple I, the accumulated adjustments account. And as a consequence, this is whoever AAA is an account that tracks the undistributed earnings. So it represents income has already been taxed. So that distribution at a triple I would be non tax return of capital to the extent of the AAA account.

At the same time it reduces triple. I will also reduce stock basis. Hey, second category once AAA has exhausted any extras, the next distribution would come out of PTI. This is a non-tax return of capital to the extent of the corporations previously taxed income. Thirdly is the distribution is deemed to come out of accumulated earnings and profits.

Okay. Now this is the rules of C corporations come into play. And so when you have distributions of EMP, you have dividend income to the shareholder. So this would be taxable to the individual S-corporation shareholders. It does not reduce stock basis and is simply trade as a dividend, just as if this had been.

A regular C corporation, the next category, the distributions come out of them. It's called the other adjustments account or OAA. And the OAA is a cumulative amount of tax exempt income and less tax related expenses. These distributions will be tax-free and they also reduce stock basis in the same way.

Distributions that a triple Ida now, any remaining shareholder basis in the stock. Is then reduced by any additional distributions and then any extra distributions to the extended exceeds the stock basis is treated as a capital gain now, because there are two certain, because this complexity introduced by having an a and P.

In terms of the need to follow the step by step allocation for the distributions, there is an incentive to get rid of the NP. And so there's a bypass election that taxpayers can make to eliminate EMP altogether. And that does two things. One is you never have to worry about making distributions out of our EMP.

And the second is that you never worried about that penalty that could cause termination of. The S selection when you have three years of excess of passive investment income. Okay. In addition to that, if you don't have any IP, you're not required to track the AAA account. However, as I've already mentioned, that may be a good idea to do anyway.

Now, as corporations are not subject to the federal corporate income tax, so they don't pay corporate income taxes. They're not subject to the accumulated earnings tax and they're not subject to the personal holding company tax. Now one exception. That is an important exception under section 1374. This is the tax on built-in gains.

In 1986, the C corporation rules were changed to cause corporations to have to report income. The gains on the distribution of appreciated property. That's under section three 11. And because there was concern about individual corporations electing as status to avoid that corporate level tax.

Section 1374 was implemented. And this prevents the benefit of nor corporate level tax on built-in gains on assets that were held by the C corporation when it converts to S status. So it's important to recognize 1374 only applies to what are referred to as built-in gains. That is the net gains that are in existence on the day in which the S-corporation was elected.

Now that game, really, if that property happened to be distributed is within 10 years of electing, the S-corporation status is subject to tax at the highest corporate tax rate. And that is a corporate level tax. That is one of the two cases when an S-corporation is going to have to pay taxes when they distribute this.

Property within the 10 years after making the selection. And by the way, this is a good reason why you might want to have an appraisal done when an S selection is made. So you can clearly establish and objectively establish what the built-in gain is. And the built-in gain potential is again, the built-in gains is taxed, the highest corporate tax, right?

Any current years recognized built-in gain or taxable income, whichever is less. That is you had. Compute the tax owed on that built-in gain, but then you would compare at the tax that would be owed if this S-corporation had really been a C corporation. So you compute the taxable income and applying any nos or tax credit, carryovers and assess whatever the corporate level tax would have been if it was a C corporation.

And whichever one of those, the smallest, the tax on the built-in gains or the regular corporate tax is the tax that's owed in that year. Now the other tax that you need to be concerned with is under section 1375. This is the tax on excess of net passive income. Okay. This is a tax that's imposed on excess of passive investment income and access to 25% of grocery seats.

Not only can you potentially lose the status. If you have three consecutive years of this. As well as have EMP at the same time, but you also would owe this penalty tax on top of that. And so you want to it may be a, an incentive to make that bypass selection to get rid of EMP. So you're never faced with this possible termination of the S status, the excess of passive investment income.

Again, that the income earned on the excess of 25% of passive investment income is taxed at the highest corporate tax rate. And you can avoid the tax or the involuntary termination again by distributing accumulated earnings, your profits as corporations tax will year. Most commonly those are that's a calendar year.

Although you may elect the fiscal year, if it's the same as the majority of shareholders. And if you have a valid business purpose and the deferral won't be more than three months, then you might be able to elect a different tax year. Well, that concludes our discussion of S corporations. And again, as, as as corporations are a pretty common area that's taxed on.

So you wanna make sure you're pretty familiar with the rules, particularly the built-in gains tax. Thank you for joining me. Welcome to CPA review. I am Gary Larson. Today, we're going to talk about partnership, taxation and how tax items are reported by the partners in a partnership. First thing you need to know is that a partnership is not a taxable entity.

The partnership itself pays no income tax. It's sometimes called a conduit or a flow through entity. It is summer to an S corporation, which is covered in separate materials. And as corporation also is generally not a separate taxable entity, although with S corporations sometimes under unusual situations, the S Corp can pay some tax.

Going back to partnerships. A partnership must file an information return called form 10 65. This form shows the various types of income, expense, and credits of the partnership. Now these items retain their character at the partnership level when they flow through to the partners and will be included by the partners in their tax returns.

Each partner will receive a form K one, which shows each partner's share of partnership, ship, income, expense, and credits. Now all items reported on the K one must be reported on the partnership individual income tax return. And here's a key point whether or not any cash or property distributions were made to the partner.

Now partnership, ordinary income flows through to the receiving partner and will be reported as ordinary income by the receiving partner. There's also separately allocated items such as capital gains will flow through his capital gains and would be reported as capital gains by the receiving partner.

Now, if we look at a schedule K one, let's look at the items that might be reported, their first partnership, ordinary income. Or ordinary loss. This is also known as non separately stated income or non separately stated loss. The next thing that's on a partner's K one are our guaranteed payments to the partner.

And this is a heavy CPA exam question area. Guaranteed payments are defined as fixed payments to a partner, either for services rendered or for the use of capital and are made whether or not the partnership itself makes a profit. Also any fringe benefits paid to, or for partner at the partnership level are also considered to be a guaranteed payment.

Now a guaranteed payment is an ordinary deduction to the partnership to compute partnership, ordinary income or ordinary loss ordinary income to the partner who receives it, the guaranteed payment, which is listed on the partner's Q1 again, will report as ordinary income by the partner. Now let's also look at some of the other items on the K one.

These are separately stated items. These are income items. Now, first ordinary income or loss from the partnership trader business. Second net income or loss from rental real estate. Third net income or loss from other rental activities and finally portfolio income or loss. And that includes interest dividends, payments, and other items.

We also have net short-term capital gains or losses. Net long-term capital gains or losses. And then again, guaranteed payments to partners. We would also have net section 1231 gain or loss and other incomes gain or loss. Now, in addition to our separately stated induction and credit items on the K one charitable contributions would be a deduction separately stated section one 79, deduction and deduction separately stated and deductions that are related to portfolio income.

And various other deductions. There are also some credits that would flow through from the partnership. For example, low-income housing, credit, qualified rehabilitation expenditures, and other credits. And I think what we need to do is take a look at a couple of sample problems here off the CPA exam, w off the disclosed exam question number one in computing, the ordinary income of a partnership, a deduction is allowed for and our choices, our contribution to recognize charities.

The first $100 of dividends received shortly and capital losses or guaranteed payments to partners. Of course the correct answer is D guaranteed payments to partners, contributions, dividends received, and short-term capital losses will all be, be separately stated items on the case. The second question.

Yeah. Guaranteed payments made by a partnership to a partner for services rendered to the partnership that our deductible business expenses are. Roman one deductible expenses on the form, 10 65 in order to arrive at partnership, ordinary income or loss, Roman to included on schedule K one to be taxed as ordinary income to the partners receiving the guaranteed payment.

The correct answer is excuse me. Our options are basically when you approach this question, if I may go back it's basically a true false question. So Roman wine. Our deductible expenses on a 10 65, that would be true and are also included on the K one to be taxed as ordinary income to the partners.

That would also be true. So the correct answer would be C both one and two. Okay. Now let's discuss the income and expense reporting between the partnership and partners. Again, we previously commented that partners must report the income from the partnership K one for the partnership tax year ending simultaneously with the partner's tax year.

For example if both the partnership and the partners are December 31st. Year ends, then the partnership K one ending December 31st, all of that income would report it, be reported in the annual report for the partner offer that same year. Now, if the partnership around that year end is different.

The partner reports only the items from the K one for the partnership you're ending within the partners tax year. And again, I think we need to look at an example here. If a partner has a calendar year and the partnership has a June 30 year end then let's take an example. If the partner is filing Hertz.

2004 income tax return. It would include the K one items for the partnership ending June 30th, 2004. All of the partnership items that happen after June 30, 2004, would be included in the partnership fiscal return for the next year and would be included in the partners 2005 income tax return. This concludes my presentation on partnership overview be sure to work problems in this area and you will do well.

Thank you for your time.

Welcome to Bisk CPA review. I'm Gary Larson. Today. We're going to talk about partnership, formation basis cash and other property contributions. This is a very heavy area on the CPA exam. First let's talk about partnership formation. Generally the formation of a partnership does not result in a recognized or reported gain or loss to the contributing partner or to the partnership itself in computing, the outside tax basis for our partners partnership interest here are the items that go into it.

First cash contributed second. You would add the adjusted basis of assets contributed. This basis would be reduced by the amount of the liabilities assumed by the partnership, because this is treated as liability relief, like cash being distributed back. You would also add to the basis, any liabilities assumed that would be an increase in your basis.

Now the basis of the partnership interest to a partner cannot go into the negative. It can not go below zero. An example, if the amount of the liability relief causes the partnership basis to be negative, then what happens is that the contributing partner has to report, gain on the contribution to get the partnership basis back up to zero.

Now a situation that occurs a partner may have a recognized gain on the contribution of property, which has a liability in excess of the adjusted basis of the property. Now, the partnership, the inside basis tax basis to the partnership for the assets contributed to the partnership is the amount of cash.

Plus the adjusted basis of the assets to the contributing partner. Holding periods, generally, the partner's holding period for the partnership interest includes the holding period for the contributing property. The partnerships holding period generally includes the partner's holding period for the contributing property.

And I think what we need to do here is to look at a sample CPA problem. Here's the question Jones and Curry formed major partnership as equal partner by contributing the assets below. And what we have here is Jones has contributed cash. The adjusted tax basis to Jones of the cash is 45,000. The fair market value of the Cassius 45,000 Curry has contributed land.

The land has a $30,000 basis to Curry and a fair market value of $57,000. Now the land was held by Curry as a capital asset. And the land is subject to a $12,000 mortgage, which is being assumed by major partnership. And the question is what is Curry's initial basis in the partnership interest 45, 30, 24 or $18,000?

The correct answer is C 24,000. It is calculated as follows. We start with the initial land adjusted basis of 30. We reduced. The partnership basis by the debt assumed by the partnership, the full amount of debt, which is 12,000. But we add back Curry's portion of the debt assumed, which is 50% times, 12,000 or six, therefore Curry's adjusted basis in the partnership.

Interest is a positive $24,000. The second question is what was Jones's initial basis in the partnership interest. And our choices are a 51,000 B 45,000. Save 39,000 or D 33,000. The correct answer is a 51,000 calculated as follows. First, we have Jones's initial cash adjusted basis of 45,000. And we would add the debt assumed by Jones, 50% times the $12,000 debt or six.

So Jones is adjusted basis in the partnership. Interest is 51,000. Now, what I'd like to do is change this question. If the question has a change in the amount of the liability assumed by the partnership changed that from 12,000 to 80,000, then our answers would change as far let's look at Curry first hurries basis and the partnership interest.

Again, we start with the initial adjusted basis in the land, which is 30. Then we reduce the full amount of the debt assumed by the partnership. So we would have a negative 80. Then we would add back Curry's portion of the debt, which is 50%, times 40, which is a plus 40. At this point Curry's adjusted basis in the partnership is a minus $10,000.

You cannot have a negative partnership basis. Therefore Curry will be forced to recognize probably capital gain of $10,000. And at that point, his partnership basis his basis in the partnership interest would be up to. Zero. Now John's his basis in the partnership interest in the same scenario again, his initial cash adjusted basis of 45,000.

We'd start with that. He would add 50% of the debt assumed which is 50% times 80,000, which is a plus 40. Therefore Jones is adjusted basis in the partnership interest under the modified scenario would be $85,000. Okay, let's talk about what if you purchase a partnership interests, the basis of a purchase partnership interest would include cash paid also would include any loan proceeds that would be part of your basis.

In addition, it w you would add your share of the partnership liabilities, which you assume on the purchase of the partnership. Another area on the CPA exam that is significant is where we have services contributed for a partnership interest. Now the basis of a partnership interest received in exchange for services rendered to the partnership is the fair market value of the partnership interest.

The partner must report the fair market value of the partnership interest on his or her tax return. As ordinary income, the partner would have an adjusted basis in their partnership interest equal to the amount reported as ordinary income, which would be the fair market value of the services. Which is the fair market value of the partnership interest.

The partnership itself has a basis of fair market value for the services received. Now, these services may be either expense or capitalized by the partnership, depending on the nature of the services. Let's take a sample CPA problem on June 1st, Kelly received a 10% interest in rock co-partners Rocco, a partnership for services rendered to the partnership.

Rocks net assets at that date had a basis of 70,000 and a fair market value of 100,000 in Kelly's income tax return. What amount must Kelly include as income from the transfer of the partnership interest and a is 7,000 ordinary income B 7,000 capital gain seek 10,000 ordinary income and D 10,000 capital gain.

The correct answer is C 10,000 ordinary income. Now Kelly's adjusted basis in the partnership interest would be $10,000. If those services were for current management services, the partnership will be able to expense the $10,000. If the services were, for example, for the acquisition of an asset, such as land or building, the partnership would have to capitalize the $10,000.

Now let's take a look at partnership basis, increases and decreases first. Self-sovereign increases to partnership basis in the partnership. Now this is generally done annually and most questions on the CPA exam are going to give you just a year-end situation. First, we would start with our initial basis.

Then you would add the adjusted basis of subsequent asset contributions. Then we would add an in any increase in the share of partnership liabilities, because this is treated like a contribution of cash for purposes of the basis. Now, Now we'd look at the K one. We would now add the distributive share of partnership, ordinary income.

Again, that would be on the K one. Then we would add the distributive share of partnership capital gains again from the K one next we would add the distributive share of partnership separately, allocated income items. Again, that would be found on the K one. And finally, we would add the distributive share of partnership tax exempt, exempt income from the K one.

Now let's talk about decreases in the partnership basis. Again, this is generally done on annual basis. Remember, the partnership basis cannot go below zero. If it does the partnership, the partner, excuse me, must recognize income in an amount to increase the negative balance back up to zero. Okay. And adjusting the basis.

The next thing we would do is we would deduct distributions received from the partnership. Now, this is always done before you allocate other deductions or other minus items from the K one loss flow through. So you always take distributions first. Then we would deduct. Your share of partnership, liabilities, a decrease in the partnership in partnership liabilities, because that's treated as a distribution for purposes of basis.

Okay. Now we'd look at the K one and begin to deduct those items. We would deduct the distributive share of partnership, ordinary loss from the K one. We would deduct the distributive share of partnership capital losses from the K one. And we would deduct the distributor share of partnership separately, allocated expense or loss items from the K one.

Now in looking at losses, there are limitations on the deductibility of losses on the partners tax return, the loss flow through from a K one, a has these limitations as to how much you can take. First, the partnership interest cannot go below zero. Therefore an otherwise deductible loss is limited first to the partner's adjusted basis in the partnership.

Secondly, the deductible loss is further limited by the at-risk rules, which are discussed in other materials in this course. Next, the deductible loss is further limited by the passive activity loss rules, again, discussed in other materials in this course. So basically what we're talking about three hurdles, you have to have enough basis.

You have to meet the risk rules and you have to meet the passive activity rules before you can take a loss on a tax return. Now, what if you can't take the loss because of one of these hurdles? Well, the unused loss may be carried forward, indefinitely and used in later years to offset positive basis.

When you get some or passive income or of course if you receive income in the future, you can offset the loss. Now there are special rules dealing with contributing contributed property. This is property contributed to the partnership by a partner. That has a pre contribution difference between the fair market value and the adjusted basis.

The basic rule is that if the partnership later sells this property, the pre contribution gain or loss is allocated back to the contributing partner. And this will be reflected on the K one. Let's take an example. Here a is a 50% partner in AB partnership. They contributed vacant land with a fair market value of a hundred thousand.

And then an adjusted tax basis of 20,000. So you can see there's a pre contribution built in gain here of $80,000. In the current year, AB partnership earns $400,000 of ordinary income and has a long-term capital gain of a hundred thousand dollars on the sale of aged contributed property. Now, what happened there was the selling price by the partnership was $120,000.

The partnership's basis was the same as the contributing partner's basis of 20. Therefore we have a gain. Now H K one what's going to reflected, there will be first able to get there his share of the ordinary income of 200,000, which is simply the 400,000 ordinary income multiplied times 50% plus a we'll get a capital gain on the K one and it's calculated this way.

The partnership capital gain on the sale of the partnership was 100. The pre contribution capital gain of 80 will be allocated to a, so they will report 80,000 their capital gain. Secondly, the balance remaining of the capital gain of 20,000 will be allocated 50% to a and 50% to be. So in essence, a has been allocated the pre contribution capital gain of 80 plus the 10 of the 20 of the further increase.

Okay. This concludes my presentation on partnership basis and K one items, be sure to work problems in this area and you will do well. Thank you for your time.

Welcome to Bisk CPA review. I'm Gary Larson. Today. We're going to talk about partnership distributions, both non liquidating distributions, and liquidating distributions, and some other miscellaneous partnership items. Partnership, non liquidating and liquidating distributions first and non liquidating distribution in balsa situation where the partnership is continuing and the partner receiving the distribution is still a partner.

And that's the basic thing that you look at and liquidating distributions distribution involves a situation where your partnership has liquidated or where a partner is no longer a partner. Now let's talk about non liquidating distributions for a minute. The general rule is that neither the partner, nor the partnership recognized gain or loss and a proportionate, non liquidating distribution, most CPA exam questions involve proportionate, non liquidating, just distributions.

Now partner will recognize gain if the partner receives cash which exceeds that partner's basis. Now you need to remember. That liability relief is treated as cash paid to the partner is treated as cash received by the partner. Secondly, a partner cannot recognize a realized loss on a non liquidating distribution.

Since the partner still owns the partnership interest. Now I need to look at the outside basis of the partner and the ordering rules when you're dealing with a non liquidating distribution. First you need to take away the cash. So you start with a partnership basis, you would reduce it by cash received by the partner.

Now, remember again, cash received by the partner includes liability relief. Library relief is treated like a cash district next. Okay. We realized receivables which are basically a cash basis. Partners account receivable. Partnership, account receivable and inventory. Now the inventory for purposes of this rule includes all assets except cash, which was deducted first and capital and section 1231 assets will be, which will be deducted later.

Okay. Again, so we start with a partner partners basis. We reduce that basis by cash, which includes liability relief. Then next we would reduce it by unrealized receivables, which is again, basically a cash basis account receivable to the partnership and inventory inventory defined us, not cash, not capital assets and not section 1231 assets.

Then the third item that you would take away or reduced basis would be all other assets. Well, they only, all other assets that are left are section 1231 property and capital assets. Now the assets received by the continuing partner take the adjusted basis to the partnership, but this amount is limited to the available partners adjusted basis in the partnership interest at the time of the distribution, we're ready to look at some numbers here.

Let's take a sample of CPA exam question. The adjusted basis of Jody's partnership interest was $50,000 immediately before Jody received a current distribution of $20,000 cash and section 1231 property with an adjusted basis to the partnership of 40,000 and the fair market value of 35,000. The question is what amount of taxable gain must Jody report as a result of this current distribution and our choices are a.

Zero B $5,000, C $10,000 or D $20,000. The correct answer is a, which is zero let's. Look at the calculation of Jodie's basis. Jody's beginning adjusted basis in the partnership interest. Was $50,000. We would reduce that $50,000 first by the cash distribution of 20. Now, remember if this was a liability reduction of 20, we'd do the same thing that would come first.

Okay. Now jetties balance in the partnership interest after the cash distribution is 30 next, we would reduce the partnership basis by. The basis of the property distributed. However, the basis to the partnership of the property is 40,000. Therefore we can only reduce it by 30,000 to get our partnership interest down to zero.

And I remember this person, person's still a partner. So if the question is what is the basis? And the continuing partnership, interesting answer would be zero and the partner does get an adjusted basis in the distributed property of $30,000. I would point out to you that this was not a very smart distribution under the circumstances.

And some planning should have been done before this distribution was made. Now what if the same problem was a liquidating distribution to Jody? Well, the answer would be the same as far as the number of her concerned. Jody would no longer have a partnership interest, so there would not be a number there, but Jody's interest in the asset distributed to Jody would be the $30,000.

Now let's change the facts. If the facts were changed to a liquidating distribution to journey of section 1231 property, but let's assume that the basis to the partnership of this 1231 property is only $10,000. Well, in a liquidating distribution, that property would have solved the full 30 that. The full $30,000 of the basis to the terminating partner and Jody spaces.

And that property would be 30, even though the basis of the partnership was only 10. And at that point, Jody would no longer be a partner. No gain or loss would be recognized by the terminating partner nor the partnership. Now what if we changed the problem facts again, let's change it to the situation where there's a distribution at lonely cash or library relief, which is treated like cash distributed, distributed, or unrealized receivables or inventory in the amount of $20,000.

At that point Jedi has a basis of, of 50,000 and would recognize a loss in the amount of $30,000. On the sale of a capital asset because of all that Jody received there's 20,000 Jody's basis was originally 50. So that loss would be reported in that particular liquidating distribution. The partnership would not recognize any loss.

Now let's talk about some other areas. Let's talk about transactions between a partner and the partnership. Generally the partners and in dealing with the partnership are treated as unrelated parties for purposes of gain transactions. There are some exceptions to that. We're going to discuss in a minute.

There's also another rule dealing with losses. There's a special rule, which says losses between the partner and the partnership where the partner is a more than 50% partner. That partner's loss will be disallowed. Now, if we're dealing with gains, there's another rule I sell of a capital asset to the partnership will be treated as ordinary income to the partner, selling it.

If the asset is not a capital asset in the hands of the purchasing partner, let's take a look at a sample CPA exam questions. Don and Lisa are equal partners in the capital and profits of Sable and no, but are otherwise unrelated. So therefore they're 50 50 partners. Lisa sold stock held long-term to the partnership with a basis of 8,000 and a selling price of 3000.

So you can see that there's a realized loss of 5,000. The amount of the capital loss Lisa can recognize on the sale of the stock is, and our choices are a 5,000 B 3000 C twenty-five hundred and D nothing. The correct answer is a 5,000 and here's the reasoning. The loss is alive because Lisa does not own more than 50% of the partnership.

The answer would change. If Lisa owned more than 50% of the partnership, the entire loss would be disallowed. Now let's talk about the sale of a partnership and generally, yeah. The sale of a partnership, interest results in a capital gain or a capital loss to the selling partner. Now, remember the purchasing partners, assumption of the selling partner's share of liabilities is treated as cash received.

And therefore it'd be a part of the amount realized in that particular transaction. If the partnership has ordinary income assets, and these are called hot assets of sometimes and include all assets, not cash capital or section 1231. If the partnership has these hard assets than a selling partner is true to selling their proportionate share of these ordinary income type assets.

The result is that if the partner has a recognized capital gain on the sale of the partnership interests, Part of that gain or all of it will be recharacterized as ordinary income to the extent of the partner's proportionate share of the ordinary income. So-called hot assets. These calculations are probably too complex for the CPAs.

Damn. So I'm not going to bore you with any more detail on that another way. Yeah. I wanted to just take a brief look yet, is the partnership tax year? The general rule is that the partnership must use the majority partners tax year. Now if the principal partners, which a principal partner being one who owns 5% or more, do not have the same tax year, then the partnership must use the calendar year.

So what usually results here is if you have a 5% fiscal year corporate partner, which differs with the other partners fiscal year, Then a calendar year must be used. There are also some special rules where a partnership may obtain a fiscal year for a valid business purpose, but the default period may not exceed three months.

This is the tax legislative process and I'm Jack Norman. We're going to focus on a federal document called the internal revenue code. And while the first real current income tax came into being in 1913, it was a series of acts each year. So there was an act of 1913, 14, 15, and so forth. The first formal codification of the tax law came in 1939.

That act was rewritten in 1954. And again, there was a comprehensive revision in 1986 tax practitioners refer to the internal revenue code of 1986 as amended. And we say as amended because every year Congress passes a number of tax acts, which revise that statutory tome called the internal revenue code.

Thousands of pages. The code is supplemented by IRS regulations, other administrative guidance, and finally decisions of the federal courts. Now as a tax practitioner, myself, I have a library of documents that takes up. Oh, roughly a hundred plus feet of my my office space, just the code five volumes of regulations and administrative guidance.

And the courts published over almost the last hundred years. How does this tax process work well, as you think back to the U S constitution in article one, it says all revenue measures must initiate in the house of representatives. So the house work is handled by the house ways and means committee all bills to deal with revenue must originate in the house ways and means committee.

After that committee is finished, considering it, it will report the bill to the floor of the house where the members of that house, all, all 435 members vote upon the act. If it is favorable. The bill moves over to the Senate and in the Senate, the legislation will be considered by the Senate finance committee.

That committee will work it's will it may or may not agree with what the house did rarely does he agree in total? So it will write a tax bill of its own. Still working off of that house, fundamental legislation upon agreement by the finance committee, it will report the legislation to the floor of the Senate.

Where senators will amend the legislation till they reach a consensus. And then the Senate passes the bill out. Now, as I've just described, we have a bill passed by the house and a bill passed by the Senate. They are not identical. If they were, it could immediately go to the president and be signed. But since almost invariably, there are differences.

A conference committee, bus meet. And this conference committee is drawing from members of the ways means committee members of the Senate finance committee, where they sit and look at the two versions and work out a four best, best description and Oleo, a pasted together version to pick some out of each, each the house and Senate versions.

They're assisted by some, by a group of experts called the joint committee on taxation and that joint committee. Is comprised of through one or two senior members for both the house ways and means and finance committee, as well as a cadre of tax experts who serve as the staff, this legislation, once it is finally melded together in the conference committee is now goes back to the house and the Senate, which was passed the.

Conference compromised version, assuming it has passed by both houses. Now the legislation goes to the president, hopefully for his signature, although in occasional Vito will occur. And of course, as you remember, if the president vetoes the legislation, then it goes back to the house and Senate where they may either sustain or override the veto most tax legislation does.

Get the president's signature. Once it has been reconciled and passed by the house and Senate. Now, when we're looking at the legislation, you have statutory language, but that is accompanied by extensive committee reports for both the Senate finance committee, the house ways and means committee and generally also from the conference committee.

And that is a quote layman's language description of the legislation. Let's take a look at a piece of legislation. There is an effective date. So when a bill is signed by the president and only at that point is the legislation effective. That's the date of enactment, but you may have within the statute, various effective dates for particular provisions.

For instance, let's just take a change in depreciation. Supposedly act says we want to make a 50% bonus depreciation provision effective for 2011. Then the statute might very well say this change applies to property placed in service after December 31, 2010. So that would be the effective date of that particular provision.

But the statute itself may have been signed by the president on August 14th, 2010. So you have an effective date of the legislation, and then you have effective dates for individual provisions within that legislation. Generally all legislation is prospective. Sometimes it will have an effective date of a particular provision of the date that let's say the ways and means committee decided to close down a tax shelter.

So that provision will say effective for transactions entered into after March 23rd, 2010. That would be the effective date and it is prospective only, but it starts right at that day. The other provision, as I described was the depreciation would be prospective from a later date. It is virtually unheard of for retroactive legislation for the Congress to act and repeal something retroactively.

It has happened, but it is very rare. So you're going to be looking at prospective or immediately effective legislation. Now, the Congress for years and years always did open-ended statutes, but beginning about 20 years ago, they began to put what are called sunset provisions in the law. So for instance, tax cuts enacted early in the Bush administration ran for 10 years and they sunset at the end.

Of 2010. Those are provisions that will expire at December 31st, 2010. And at that point, the so-called Bush tax cuts will be gone and higher tax rates will apply that's the rule today, but Congress always just changing the law and they might quote, extend the tax cuts. In that case, they would come in pass legislation that says.

Rather than a sunset of December 31st, 2010, we're going to move that statute out and we will sunset it at December 31st, 2015. So when you hear land language about we're waiting for the extenders, that's what they mean. Under house budget rules and Senate budget rules there. Revenue estimates are required for tax legislation.

So the joint committee has a group that actually does revenue estimates about the impact of all the tax legislation. And in the budget acts, we have certain quote PayGo requirements and legislator, legislators are always arguing that if we're going to spend money, we also have to have an offset and you'll sometimes hear that referred to as PayGo requirements.

We will extend for instance, unemployment compensation benefits, but we're going to reduce the foreign tax credit in order to quote, pay for. The provision revenue estimates are a key component in the tax legislative process. Now, what I've been describing is the federal internal revenue code tax system.

And just as we're covering tax legislation, I can't leave behind state tax systems. Virtually every state has an income tax. There are about five exceptions, but many of those States systems piggyback on the internal revenue code. So if you look for instance, at a Virginia or a Minnesota tax statute for the state, they will say, starting with your income is determined under federal tax law.

That's a piggybacking system. Every time the federal government changes the tax law. Consequently, the state tax system changes recently because of budget issues because of the economic situation and because of certain congressional actions, right. States have begun to decouple from the federal piggy-backing.

And in this particular case, they will say we're passing a state law that says while the federal change the internal revenue code here, and we still have a piggyback system, we will not accept this particular provision. That the feds enacted. So as you're reading about things, remember that States often piggyback, but recently they've begun to decouple.


I'm Jack Norman and we will be discussing issues in tax compliance among the issues on this, the agenda for today, filing requirements due dates, penalties to statute of limitations. Refunds and assessments. So let's begin with the general filing requirement. A taxpayer must file a tax return if the gross income exceeds the sum of the personal exemption and the standard deduction for the year.

And I'm going to give you two exceptions to that rule I just gave you. So the first rule was you have to file if your income is equal to or exceeds the sum of the standard deduction and the personal exemption. However, the first exception says if net earnings from self-employment or $400 or more, you must file a tax return.

And if the taxpayer is claimed as a dependent on another's return and has unearned income and gross income in excess of just about a thousand dollars, then they also are required to file a return. When is the tax return due? Everybody should know this one off the top of their head, April 15th for individuals, April 15th.

It's the 15th day of the fourth month. And additional due dates that are very significant are for estimated tax payments. The first estimated payment is due the same day as the tax return, April 15th as the first installment for the following year. The other installments for estimated taxes are due on June 15th, September 15th and January 15th of the following year.

Now it is possible for a taxpayer to get an automatic six month extension to file the tax return. And that is requested by timely filing a 48 68 with the IRS. In other words, the extension must be filed before the return is due. Remember, however that this is an extension of time to file, not the time to pay the tax.

So even though you've got an extension from the IRS to pay to file your return later, you must pay by April 15th or interest and potentially penalties we'll begin to run. That data is also significant because with respect to IRA contributions, they must be made by the due date of the return. Not considering the extension.

Now, when you calculate your tax return, you're going to, in all probability have a tax liability number. As a starting point, we then get credit for various payments that we have made throughout the year. And they are applied against that total tax liability. Of course, we know that after applying those payments, we're going to come down with either hopefully a refund or perhaps a balance due.

So let's talk about ways that tax can be paid. First. Virtually all of us are familiar with withholding. That is when we get a paycheck, either weekly, monthly, every two weeks, whatever it is, our employer has withheld federal and state income tax from our paycheck. And we receive a net check. Those withholdings are part of the credit that's applied on the return.

In addition. Estimated payments may have to be made for somebody who is self-employed. For instance, there is no employer withholding tax. Instead they are required to make estimated payments on a quarterly basis. I previously gave you those dates in addition and in today's world has made me fairly common.

If you work for more than one employer during the year, they will both be taking social security out of your paycheck. If the total earnings from those two employer together exceed the so-called FICA ceiling amount, which is somewhat over a hundred, $120,000 a year. Then any excess social security taxes that have been withheld, maybe applied against your income tax liability for the current year.

And finally some individuals, if they have an overpayment in one year will say, don't send me a refund check, but simply apply that overpayment to the succeeding year. So payment of this of tax could come in the form of withholding, estimated payments, excess social security, withheld, or prior overpayments that have been left with the government.

Now here's a little bit of good news. There is a safe Harbor. If you. Thank you have paid all of your tax liability by April 15th, but you got an extension and you don't file it. Say until June 3rd and you're shortfall, you didn't pay enough. Tax is less than a thousand dollars. There will not be any penalty he's assessed for that.

That's the safe Harbor. In addition, there will be a safe Harbor. If the taxpayer has paid 90% of their current year tax. Or a hundred percent of their prior year tax. This is a penalty for underpayment of estimated tax. So the safest way to do this is make sure on your estimated payments, you have paid in a hundred percent in the current year amount in the current year equal to a hundred percent of what you paid for the prior year warning.

If however, the taxpayer's adjusted gross income is above $150,000 that. Safe Harbor level is set at 110% of the prior year tax. Well, nobody wants to hear about penalties, but let's talk about a couple of them just in case they're actual they're actual, there are accuracy related penalties equal to 20%.

If the taxpayer has a substantial understatement of tax or. The tax is under stable is due to negligence or disregard of the rules and regulations. So in other words, if you have paid in your tax, you've taken positions on the return that the IRS comes back and challenges subsequently wins and you tax your taxpayer ends up with a substantial understatement of tax.

Or there was negligence or disregard of the regulations through baby, a penalty of up to 20% of that underpayment imposed if fraud was involved. And that means willful evasion attacks, the penalty rises to 75%. Now I'm going to give you that reminder again, remember that all taxes are paid on time. Even if the filing deadline was extended.

Suppose now a taxpayer files, a tax return. The original return was at 10 40 and they find out that they've made up a stake on the return. Indeed. They overstated the tax due and they need to get a refund. How could they do it? Well, they've got to file a form 10 40 X, an amended return correcting the prior return.

And can they get the refund? Sure. They can. If. That amended return that 10 40 X was filed within a certain window. It is due by the later of two, three years from the date, the return was filed or two years from the time the tax was paid. If the claim for refund is not filed within that timeframe, it will not be honored and the money will simply be forfeited to the federal government.

If no return was filed, but let's say you had withholding did not file a return. You have no liability. But you had had withholding then that amount, that return is due two years from the time the tax was paid. He returned filed early is treated as if filed on the due date of the return. So you can always look to April 15th, not March 3rd, when you filed or February 12th, that he filed really early,

your return has now been filed. You're happy with it a year is going by two years, have gone by what's the latest, the IRS can look at that return to make possible adjustments. Well, the general answer, the general statute of limitations says three years from the latter of the due date for the return or the actual filing of the return, including amended returns.

So let us say that I filed my return on March 20th. 2011. What is the latest time that the IRS could assess that that's going to be in 2014, the actual due date, however, April 15th, 2014. Suppose however, I extend my return and don't file until October 14th, 2011. Now it's three years from that filing date.

Or the October 2014 date, that's the general period in which the IRS can make assessments to adjust the return. If however, there is a 25% omission of gross income. Then the IRS has six years from the later of the filing of the return or the due date. So six years, if there is a 25%. Omission of income.

Suppose the taxpayer never files a return or files a fraudulent return. Now Congress has said there is no statute of limitation. It runs forever. If you failed to file a return in 2011. In 2012 and 2014, and about 2016, the IRS comes back in that he'd go back as far as they want on those unfiled returns and believe me, they will.

So a failure to file is an unlimited statute of limitations. Here's an interesting question that practitioners often get a client might very well say. I know I have a tax liability. I don't have the money to pay it. I'll file the return late. Well, yeah, most practitioners will advise the client. Let's go ahead and file the return.

Put in a request for some type of payment plan or some type of offer in compromise. Don't not file the return. Once you file the return, you may be subject to penalties. You may be subject to interest, but you will begin to run the statute of limitations. My exam tips to issues in this whole area. First of all, when's the statute of limitations expire at the frequently asked question or secondly, under what conditions might a penalty be imposed upon a taxpayer.

All of this material is important, but those are the two questions I would focus on with the exam. Make sure you understand the due dates and when the statute of limitations run with that, you'll do well. And I look forward to seeing you as a member of the profession after you've passed the exam,

probably the most common questions the taxpayers have this first ball. Whether or not, I have to report it in the case of income. And second of all cannot deduct it in the case of expenditures. We want to take a little bit of time and consider some of the concepts that control recognition of income that is when and how taxpayer might have income to recognize the beginning point that you have to consider as the all-inclusive concept.

And that is that okay. Every economic benefit of the taxpayer receives or realizes is taxable, unless there's some specific authorization to exempt that are not reported. So you began with this position that everything's taxable, and then you look for authority to exclude it. In addition to that, most imputed income is not taxable by.

That I mean, imputed income would be if you're able to work as your own plumber or do your own mechanic work, then those kinds of benefits that you drive from your own work effort are not imputed income. One exception to that is below market loans. If you lend out money at less than market rate of interest, market rates of interest to say a family member it may be that you have the interest income that you've foregone imputed back to.

And so you have to be careful recognizing the possibility that you may have shifted income to another party. Another concept that's important for cash basis. Taxpayer is the constructive receipt of income. In order for cash basis, taxpayers to report income, they have to have constructive receipt of the funds that is the funds have been set aside and made available to the taxpayer.

And they're not subject to a substantial limitation or restriction often where this kind of issue comes up is the. Last tech at the end of the year when perhaps the employer has written a check and made it available to the, to the employee. But for some reason, the employee is not able to access it.

Maybe they're out of town or maybe they, the employer said, well, the check's no good. You're going to have to wait until next week, which happens to be the next year before the checks any good. And those circumstances, the issue becomes whether the taxpayer has constructive receipt. If you have constructive receipt, it's going to be reported as income.

There's another concept. That's very similar. Yeah. Constructive receipt and often confused with constructive receipt called the claim of right doctrine. And then, and is that funds have been received by the taxpayer, but there is some unreal restricted climate, right. But there's some restricted climate right to that.

Is there some. Something that compels the taxpayer, not to be able to spend the money. The best example of that, the clearest example or security deposits of you make a security deposit, allowing you to use property or rent an apartment, for example. And that. Security deposit is, is held until you return the property.

That's not considered to be income because to the, to the recipient because there's a restriction on their use of that deposit loans are not not taxable because of this claim of right. As long as you have an obligation to pay back the loan, you don't have a climate right to the funds. If that climate right was lifted, if you were forgiven, then generally you're going to have taxable income.

Now for cash basis, taxpayers, there's a couple exceptions to the general rule. Normally a cash basis, taxpayer will deduct expenses when they rise to the check-out, but some important exceptions apply to cash basis. Taxpayer, one of those is for inventory. If you're in a trailer business and you're engaged in selling inventory and the ordinary course of business, you can't deduct the cost of the inventory.

Until it's sold. So you'd have to go through the computation to look at beginning inventory plus purchases, minus ending inventory to get the cost of goods sold and all to deduct the cost of goods sold. If you're a cash basis. Taxpayer I, in addition to that capital expenditures are not currently deductible, then they be depreciable, but not currently.

Deductible is under the main rules. There are some exceptions to that as usual, but for example, if you purchased a piece of equipment, The general rule would disallow a deduction for that cost and allow you to depreciate it. But that was spread that expenditure over the life of the equipment deductions for payments, that benefit future accounting periods.

For example, if you prepay a rent or prepay insurance or prepay insurance those are generally not deductible. Until the benefits receive. So you've essentially acquired an asset when you prepay these expenses and you can only then deduct the cost of the asset as you consume that cost. And finally, there's no deduction for bad debts for trader businesses that are on the cash basis of accounting.

And that's because they don't have any basis in the accounts receivable. They may have a cash receivable that are outstanding. There may be a mass that are owed, but because there is no basis in the receivable. When they become non collectible, there's no corresponding debt deduction or a cost deduction for that.

Now for accrual basis. Taxpayers, there's a couple exceptions I want to mention. One is the pre-payment for services. When an accrual basis taxpayer receives a prepayment, generally under the wherewithal to pay concept that prepayment is going to be included as income by the accrual basis. Taxpayer, even though the services haven't yet been performed.

And the reason for that is because the accrual taxpayer now has the capacity or wherewithal to pay their taxes. And so that's when the tax laws strike is when the, when the funds are available. The major exception to that prepayment for services is referred to as the one-year rule and the one-year rule allows the.

Accrual cruel taxpayer to defer recognition of the services income, as long as the services will be completed by the close of the next taxable year. So for example, if you receive a prepayment for services in this year and the contract requires you to perform services next year, but you will complete them before the end of next year, then you can spread the income over the two year period.

On the other hand, if you receive an advanced payment for interest or for rents, then the one year rule doesn't apply. And then finally, if you receive a prepayment for services, but the contract extends beyond the close of next year, then all of the prepayment of income is going to be recognized as income again, by the accrual basis.

Taxpayer. Similar rules apply to the advanced payment for goods. And that is when you receive this advanced payment for goods. The pre-payment is income, unless the prepayment is less than the cost of goods sold. And you defer recognition of income for financial accounting purposes. If those two are, is that if that's the case for the accrual basis, taxpayer, then you can defer recognition of gain for tax purposes as well.

Now there are other items of income that would be included. The most obvious would be salaries and wages. When your employer pays you a paycheck, that gross amount of the wages is taxable boat gross, Savannah, the salaries. Now, you know that when you get a paycheck from the employer, the net amount, the amount that you have in your pocket to spend is less than the gross amount.

But it's that gross amount that's reported before there's any withholding taken place. Now, an area that's not always as obvious to taxpayers is let's say if there was a some land that you wanted to acquire and it was going to cost you $10,000, but you didn't have $10,000 in cash. So rather than using cash to purchase the property, you get the seller to agree with you to allow you to use stock worth $10,000.

Well, the stock basis is say 8,000. So you're going to use the stock to acquire the land and in an arm site, the extraction extension or arms-length transaction, you're going to get a thousand dollars worth of property, $10,000 with a property and the other guy's going to get $10,000 with the stock. Well, that's going to be a taxable event to you because you used appreciated property in the transaction.

It's just as if you had sold the property and use the proceeds then to purchase the land. Okay. And now in addition to that, there are times when employers are. Allow employees a special opportunity to purchase goods and services at a discount and the discounts not a made available to everybody as simply a way to recognize a good performance that you've done in that particular case, that bargain element, the amount of the purchase price reduction that you got as a result of your performance is going to be included in taxable income.

Now there are a couple areas of stock options that I think are worth taking a second to look at. Let's talk about three different kinds of stock options. First of all, would have qualified incentive stock options. Non-qualified stock options. And then non-qualified stock options that have a readily determinable value in the marketplace.

Okay. First of all, the qualified incentive stock options. Those are not taxable until you sell the stock that use the option to acquire. So for example, let's say that you had a stock option. And it allows you to, per that you receive from your employer and it allows you to acquire stock at $12 a share when the market value is $20 a share.

So you exercise the option and you buy the stock. When do you have income when you sell the stock that you, that was had a market value of $20 per share. So it's not until the stock has sold that you recognize the income from the incentive stock options. For non-qualified stock options. These are taxable when the option is exercised.

So if you have an option to purchase some stock at a predetermined rate and then exercise that option at the time in which you exercise the option, that's when you recognize the income based on the market value of the option. And then finally the third category is non-qualified stocks options, which have a readily determinable market value.

In some cases, large companies that I have a marketable or rather a market for their stock options. You can look in the wall street journal and you can identify what the fair market value is in those particular cases. When you get a non-qualified stock option with a readily determinable value.

Then the income is recognized at the time in which she received the option. And in that particular case, she could put a dollar value on the option that's been received. So it's pretty easy to figure out how much income you've realized now on the schedule, 10 40 or other form 10 40. There's also a schedule C where individuals, they have their own trader businesses that are like, self-employed.

Are reporting their revenue from their businesses and their expenditure associated with that business. So now just real briefly, what expenses can you deduct on schedule C? Well, those expenses that are ordinary useful, helpful under the circumstances that are necessary and then a reasonable amount are going to qualify.

However, if the expenditures are primarily personal living expenses, or if they are capital expenditures, Or if there are guests, public policies such as fines or bribes or kickbacks, those kinds of things are not deductible. In addition, you cannot deduct on schedule C any expenses related to exempt income expenses paid on somebody else's behalf, or likewise non-deductible as schedule C trader business expenses.

Now there's another expense that you incur as a self-employed taxpayer, and that is the self-employment tax. Now you owe the regular income tax on self-employment income and that's reported and computed on 10 40, but you're also gonna owe a self appointed tax on net self-employment income. There is an above the line deduction for one half the self-employment tax.

Okay. It's not a schedule C trader business deduction is not on that schedule, but it still gets an above the line. Deduction to the advantage of the taxpayer. Now, for those of you that might not be familiar with self-employment tax, you know that as an employee, you have FICA withheld from your paycheck and your employer matches that well, the self-employment tax is the corresponding tax to fat FICA.

But since you don't have an employer, you have to pay both portions. So the self-employment taxes, the responsibility of the self-employed taxpayer, that rental income is another source of income that might be reported. And that can come in many different forms. The rental income can be cash payments.

It can be lease cancellation payments would include forfeited deposits security deposits that have been applied to rent. Now recall with security deposits normally under the climate right doctrine. Those are not taxable income until the. Landlord applies. Those security deposits towards the rent.

A tentative Provence made in lieu of rent are also going to be included as rental. Now, all the expenses then that relate to that rental income. Those that are ordinary and necessary and reasonable amount, just like with the trader business are then subtracted from rentals com and arriving at net rental income and rental income by definition is not.

Is not self-employment income. And so it's not so subject to self-employment tax installment sales is another category of income that taxpayers may recognize. Sometimes when you have a piece of property to sell the buyer, doesn't have the capacity to pay all the payments all in the current year.

And so there are arrangements made to make a payment this year and payment next year. And maybe beyond that. So an installment sale is any sale where at least one payment comes in some future year. So what we have to do for tax purposes is figure out how much of each payment is a return of the investment return of the basis of the property sold.

And how much of it's profit and to do that, we're going to compute a gross profit percentage. Gross profit percentage is the profit on the sale divided by the sales price. So it's like any other property transaction then out realized minus the base of the property would give you the profit on the sale.

That profit then is divided by the sales price in order to get a gross profit percentage. And then how much of each payment is going to be taxable is could come in by multiplying the gross profit percentage. By each of the payments that are received, that's the amount, then that would be taxed to the taxpayer.

In addition to that, you should know that the nature of the property that's being sold will determine the character of the game. So if the assets is being sold, qualified as a capital asset, then have a capital gain. Now, installing the sales don't normally apply to a sale of stock and securities annuity payments are very similar and the way we separate the.

Payments into taxable portion versus non taxable portion. And as much as I would do for installment sales now for annuity payments, we have to compute an excludable portion. And since 1996, we've used the simplified method and the simplified method is simply a matter of taking the investment and the annuity contract.

And dividing it by the number of expected payments and the treasury regulations will specify the number of payments that you should expect to receive. Once you began to receive an annuity payments and that exclusion port excluded portion then is deterrent tells us how much of each payment is not taxable.

So obviously if you get a check for a thousand dollars and the exclusion scooted portion is $300, then the taxable portion would have to be $700. There are a couple of other items that we want to mention with respect to income. One that always comes up because taxpayers, for some reason, they're always interested in gambling.

Winnings, gambling winnings are all reported as part of gross income, but here only the income portion is reported as gross income. They're not netted against losses. So unfortunately losses are below the line deductions. I'd only taken as deductions in the case of your itemized deductions, as opposed to taking a standard deduction.

So gambling winnings are included in gross income and they're not netted against gambling losses. One final item that's included in this module is the income that's conditionally received from an employer for services. And that's addressed under section 83. Let's say, for example, the employer was trying to increase loyalty among employees.

And so they. Granted stock to the individual employees, but whether or not you got to keep the stock dependent upon whether or not you stuck around for say five years. So if you don't stick around for five years and you leave prior to that, the stock that you were given is forfeited and you have to return it.

So the question becomes when he reported to Zynga, when you get the stock. Or after that risk of forfeiture passes and section 83 says that you can wait until the risk of forfeiture passes. So in my example, if you receive stock today and conditioned upon you sticking around for five years, once the five-year passes, then you have to recognize the value of the stock is gross income.

Now there's an old at, at based upon the fair market value of the stock. At the time when the risk of forfeiture passes, there is an option that's available to taxpayers, and that is you can recognize the value of the stock is income now, but if you should subsequently forfeit the stock. You don't get an offsetting deduction.

So there's kind of a risk that the taxpayer has to address to determine whether you want to wait until the risk of forfeiture passes and presumably the amount of income recognized as much higher. Or do you go ahead and recognize it now when perhaps the amount of income recognized would be fairly small?

I'm Jack Norman and we're going to discuss fairly briefly some concepts of tax planning. This is one of the things your clients love to hear. Please plan my taxes. So I have to pay less taxes, perfectly understandable, but I have to warn you. It's not a simple area. Tax planning is a continuous process.

And as you know, from the tax legislative process, Congress is always changing the rules. So how do we approach tax planning? The first thing we have to do is take a look at current law. Versus what we see down the road. And that may be either existing law for the next year or two or taking into so duration what's going on in Washington, DC, prospective changes.

Current law versus prospective changes is, is a fundamental of effective tax planning. Secondly, you cannot do good tax planning for your clients unless you have an excellent grasp of the time value of money concepts. So current law versus perspective changes time value of money. Those two are the drivers of tax planning.

Here's the basic strategy. If tax rates are going up in the future, you always want to defer income and accelerate deductions push off the income as far as possible and get those deductible expenses in as early as possible. But be careful there's a trap. If your client may be subject to the alternative minimum tax, this strategy is exactly reversed.

You want to accelerate income and defer it. Deductions here comes another point of tax planning. You cannot look at a single item in isolation. You have to take a look at the entire picture, both the regular tax system and the alternative tax system. And you cannot ignore state tax implications of any of your strikes.

Geez. Some of these techniques that we can use for effective planning, our elections, do we want to expense something or do we have the opportunity to capitalize it under the tax law? There are times when some things bang fall into either category and you have to make the decision, which way works best for my client.

If it's capitalized. We all know that you have the basic maker's depreciation system, that accelerated system, and there's some bonus provisions and the law, but would you rather elect out of those and take lower depreciation deductions? You have to consider the use of net operating losses, capital losses, and credit carry overs and carry backs.

It may be that at the point, operating loss expires, you need to do one set of tax planning. It may have an interplay with credit carryovers. So ultimately when I, who was first starting in the tax practice, I had big green spreadsheets today. We could take computer spreadsheets and do lots of variations on all of the multiple year planning with loss, carry overs and carry backs.

We have to plan with our estimated taxes. And I have to caution you that every year Congress seems to change the estimated tax rules. How much has to be paid in this year versus that year. So planning with estimated taxes is another key to minimizing your client's current tax liabilities while protecting them from penalties down the road.

Another area of. Great concern for planners is the passive income, passive loss rules. We all know that in passive losses, those losses are deferred until passive income is generated or the client disposes of the property. How can we properly plan a mix of income and loss to take advantage of those shifting patterns?

We need to be constantly aware of changing tax rates and phase out ranges for. Various deductions and why your client may think that they're in the optimum tax mode and here I'm referring to entities. Let's just say they're in a partnership or they're in an S-corporation maybe as the tax law changes, there are reasons to switch entities.

So there may be need for conversions, liquidations, or creation of new entities. Switching entities is another key insight in tax planning. We cannot ignore the impact of any audit adjustments to both our federal and state returns. So even after we've done all of our planning done all our compliance filing should either the IRS or state returns be audited and changed.

We're going to have to rethink our process. That may mean that our whole tax planning that we'd done before needs to be revised in light of audit adjustments. Which may either be favorable or potentially unfavorable to our clients. One item of tax planning. I have to caution avoid tax shelters. This may sound like a great way to save the client money, but I could tell you in the short run, it may work, but the IRS and treasury and even state auditors are looking very hard at tax shelters.

And in the end, this is not good tax planning. The final advice with respect to tax planning, consider the tax implications in your decision-making, but the tax tail should never wag the dog.

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