Corp Tax 3

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How do taxpayers dispose of assets?

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Taxpayers can dispose of assets in many ways. For example they could sell an asset, donate it to charity, trade it for a similar asset, take it to the landfill or have it destroyed in a natural disaster.

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What is the amount realized by a taxpayer from the sale or other disposition of an asset?

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The amount realized is everything of value received from the buyer less any selling costs. Although taxpayers typicdally receive cash when they sell property, they may also accept marketable securities, notes receivable, similiar assets, or any combination of these items as payment/

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Equation for amount realized

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Amount realized = cash received +FMV of other property + Buyers assumption of liabilities - Sellers expenses.

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Adjusted basis

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adjusted basis = cost basis - cost recovery deduction

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Gain realized

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Gain realized = amount realized - adjusted basis

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Recognized gains or losses

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Recognized gains or losses are gains (losses) that increase (decrease) a taxpayers gross income. Thus, taxpayers must report recognized gains and losses on their tax returns. Under certain circumstances they may be allowed to defer recognizing gains to subsequent periods, or they may be allowed to permanently exclude the gains from taxable income.

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Character of gains and losses

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Businesses may recognize certain gains or losses on property dispositions that require some intermediary steps, but even the 1231 gains or losses are eventually characterized as ordinary or capital. The character of the gail or loss is important because gains and losses of different characters are treeated differently for tax purposes/ For example, ordinary income (loss is generally taxed at ordinary rates. However, capital gains may be taxed at preferential rates while deductions for capital losses are subject to certain restrictions.

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Ordinary asset

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Inventory is an asset because it is held for sale to customers in the ordinary course of business. ACcounts receivable are ordinary assets because receivables are generated from the sale of inventory or business services. Other assets used in a trade or business such as machinery and equipment are also considered to be ordinary assets if they have been used in a business for one year or less. When taxpayers sell ordinary assets at a gain, they recognize an ordinary gain that is taxed at ordinary rates. When taxpayers sell ordinary assets at a loss, they deduct the loss against ordinary income.

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Capital assets: What are they and how can an asset be considered a capital asset?

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A capital asset is generally something held for investment (stocks and bonds) for the production of income or for personal use. Whether an asset qualifies as a capital asset depends on the purpose for which the taxpayer uses the asset. Thus, the same asset may be considered a capital asset to one taxpayer and an ordinary asset to another taxpayer.

Front 10

Which do taxpayers prefer ordinary gains or capital gains and why?

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Taxyapers generally prefer capital gains to ordinary income because certain capital gains are taxed at lower rates and capital gains may offset capital losses that cannot be deducted against ordinary income. INdividuals also prefer ordinary losses to capital losses because ordinary losses are deductible without limit, while indidivuals may deduct only $3000 of net capital losses aginst ordinary income. Corporate taxpayers may prefer capital gains to ordinary income because capital gains may offset capital losses that they would ot be allowed to offset otherwise. Corporations are not allowed to offset any net capital losses but they are allowed to carry capital losses back three years and forward five years.

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How long are corporations allowed to carry things forward/backward?

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Corporations are not allowed to offset any net capital losses but they are allowed to carry capital losses back three years and forward five years.

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Section 1231 assets what are they?

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Depreciable assets and land used in a trade or business (including rental property) held by taxpayers for more than one year. At a general level when a taxpayer sells a 1231 asset, the taxpayer recognizes a 1231 gain or loss. Ultimately 1231 gains are characterized as ordinary or capital on a taxpayers return.

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What type of gains do 1231 assets incur?

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Ultimately 1231 gains are characterized as ordinary or capital on a taxpayers return.

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Land what are gains and losses on land characterized as?

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BEcause land is not depreciable, when taxpayers sell or otherwise dispose of land that qualifies as 1231 property, the gain or loss from the sale is always characterized as 1231 gains or losses. Thus we refer to land as a pure 1231 asset.

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How could 1231 assets other than land be sold at a gain?

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It is possible that a 1231 asset other than land could be sold at a gain in situations when the asset has not appreciated in value and even in situations when the asset has declined in value since it was placed in service. It happens because depreciation deductions relating to the asset could reduce the adjusted basis of the asset by more than the actual economic decline in the asset's value. Taxpayers selling these assets would recognize 1231 gains even though the gain was created by depreciation deductions that reduced the basis of the asset being sold.

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Depreciation recapture applies to what?

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Depreciation recapture potentailly applies to gains (but not losses) on the sale of depreciable or amortizable business property. When depreciation recapture applies, it changes the character of the gain on the sale of a 1231 asset from a 1231 gain into ordinary income. Note, however, that depreciation recapture does not affect 1231 losses. Depreciation recapture changes only the character but not the amount of the gain.

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1245 property what is it? What are gains characterized as? How is the 1245 gain calculated and how is the remainder of the gain classified?

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Tangible personal property (machinery, equipment, and automobiles) and amortizable intangible property (patents, copyrights, and goodwill) are all a subset of 1231 property known as 1245 property. The gain from the sale of 1245 property is characterized as ordinary income to the extent the gain was created by depreciation or amortization deductions. The amount of ordinary income taxpayers recognize when they sell 1245 property is the lesser of 1, recognized gain on the sale or 2. total accumulated depreciation on the asset. The remainder of any recognized gain is characterized as a 1231 gain.

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Gain created solely through cost recovery deductions

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When a taxpayer sells these types of assets at a gain, the gain is usually created because the taxpayers depreciation deductions associated with the asset reduced the asset's adjusted basis faster tahn the real decline in the asset's economic value. That is, absent depreciation deductions the taxpayer would recognize a loss on the sale of the asset. The entier gain on the disposition is recaptured as oridnary income under 1245.

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Gain due to both cost recovery deductions and asset appreciation

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Assets subject to cost recovery deductions may actually appreciate in value over time. When these assets are sold, the recognized gain must be divided into ordinary gain from depreciation recapture and 1231 gain. the portion of the gain created through cost recovery deductions is recaptured as ordinary income. The remaining tain (the gain due to economic appreciation is 1231 gain.

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Asset sold at a loss

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Many 1231 assets, such as computer equipment or automobiles, tend to decline in value faster than the corresponding depreciation deductions reduce the asset's adjusted basis. When taxpayers sell or dispose of these assets before the assets are fully depreciaed they recognize a loss on the disposition. Because the depreciation recapture rules don't apply to losses, taxpayers selling 1245 property at a loss recognize at 1231 loss.

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1250 property what is covered as 1250 depreciation recapture

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Depreciable real property is requently referred to as 1250 property. Under 1250 when depreciable property is sold at a gain, the amount of gain recaptured as ordinary income is limited to the excess of accelerated depreciation deductions on the property over the amount that would have been deducted if the taxpayer had used the straight line method of depreciation to depreciate the asset However, under current law, all real property depreciated using the straight line method so the 1250 recapture rules no longer apply.

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291 depreciation recapture

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Applies only to corporations. Under 291, corporations selling depreciable real property recapture as ordinary income 20% of the lesser of 1 recognized gain or loss or 2 the accumulated depreciation.

Front 23

Unrecaptured 1250 gain for individuals

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When individual taxpayers sell 1250 property, they are not required to recapture any of the gain as ordinary income under the depreciation recapture rules. Consequently, a gain resulting from the disposition of 1250 property is a 1231 gain and is netted with other 1231 gains and losses to determine whether the taxpayer has a net 1231 gain for the year or a net 1231 loss for th eyear. If, after the 1231 netting process the gain is ultimately determined to be a long term capital gain, the taxpayer must determine the rate at which the gian will be taxed. Tax policy makers determied that the portion of the gain caused by depreciation deductions reducing the basis (called unrecaptured 1250 gain) should be taxed at a maximum rate of 25% and not the 15% rate that normally applies to other types of long term capital gains. The amount of the gain taxed at a maximum rate of 25% is the lower of the 1 recognized gain or 2 the accumulated depreciation on the asset. The remainder of the gain is taxed at a maximum rate of 15%.

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When an individual sells a 1250 asset how do they determine the deduction and what rate it should be taxed at?

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Tax policy makers determied that the portion of the gain caused by depreciation deductions reducing the basis (called unrecaptured 1250 gain) should be taxed at a maximum rate of 25% and not the 15% rate that normally applies to other types of long term capital gains. The amount of the gain taxed at a maximum rate of 25% is the lower of the 1 recognized gain or 2 the accumulated depreciation on the asset. The remainder of the gain is taxed at a maximum rate of 15%.

Front 25

Under 1239 how is the sale treated? Who is the sale made to?

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The sale is to a related party and the property is depreciable property to the buyer, the entire gain on the sale is characterized as ordinary income to the seller. In these situations, the tax laws essentially treat related parties (the buyer and the seller) as the same person. Because the buyer will be offsetting ordinary income with future depreciation deductions associated with the property, the tax laws require the seller to currently recognize ordinary income.

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How is 1239 recapture different than depreciation recapture?

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1239 recapture provision is different from depreciation recapture in the sense that the seller is required to recognize ordinary income for depreciation deductions the buyer will receive in the future, while depreciation recapture requires payers to recognize ordinary income for depreciation deductions they have received in the past. When depreciation recpature and 1239 recapture provision apply to the same gain, the depreciaiont recapture rule applies first.

Front 27

How could a taxpayer gain significant tax benefits regarding 1231 assets? How does the government prevent this from occurring?

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A taxpayer could gain significant tax benefits by discovering a way to have al 1231 gains treated as long term capital gains and all 1231 losses treated as ordinary losses. The annual netting process makes thistask impossible for a particular year. However, a taxpayer who owns multiple 1231 assets could sell the 1231 loss assets at the end of year 1 and the 1231 gain assets at the beginning of year 2. The tazpayer could benefit from this strategy in three ways, 1. accellerating losses into year 1, 2. deferring gains until year 2, and 3. changing the character of the gains and losses due to the 1231 netting process. The 1231 lookback rule prevents this strategy.

Front 28

How could the taxpayer benefit from selling off their 1231 loss assets at the end of the year and their 1231 gain assets at the beginning of the year?

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The tazpayer could benefit from this strategy in three ways, 1. accellerating losses into year 1, 2. deferring gains until year 2, and 3. changing the character of the gains and losses due to the 1231 netting process. The 1231 lookback rule prevents this strategy.

Front 29

What does the 1231 look back rule require tax payers to do?

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The rule affects the character, but not amount of gains on which a taxpayer is taxed. In general terms, the 1231 lookback rule is designed to require taxpayers who recognize net 1231 gains in the current year to recapture current year gains as ordinary to the extent the taxpayer recognized ordinary net 1231 gains in prior years. The 1231 lookback rule indicates that when a taxpayer recognizes a net 1231 gain for a year, the taxpayer must look back to the five year period preceding the current tax year to determine if, during that period, the taxpayer recognized any unrecaptured net 1231 losses. If the taxpayer recognized a net 1231 loss in that period, and did not previously recapture the loss (by causing a subsequent 1231 gain to be recharacterized as ordinary) in a subsequent year, the taxpayer must recharacterize the current year net 1231 gain as ordinary income to the extent of that prior year nonrecaptured net 1231 loss. If the current net 1231 gain exceeds the nonrecaptured net 1231 loss from the year five years prior, the taxpayer repeats the process for the year four years prior and then three years prior and so on.

Front 30

What are the steps for the 1231 lookback rule?

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1. Apply the depreciation recapture rules and the 1239 recapture rules to 1231 assets sold at a gain (any recaptured amounts become ordinary).
2. Net the remaining 1231 gains with the 1231 losses. If the netting process yields a 1231 loss, the net 1231 loss becomes an ordinary loss.
3. If the netting process produces a net 1231 gain, the taxpayer applies the 1231 look back rule to determine if any of the remaining 1231 gain shuld be recharacterized as ordinary gain. Any gain remaining after applying the look back rule is treated as long term capital gains.

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What are Nonrecogition transactions

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Nonrecognitions transactions are like-kind exchanges, involuntary conversions, installment sasles, and other business related transactions such as business formations and reorganizations. Taxpayers realising gains and losses when they sell or exchange property must immediately recognize the gian for tax purposes unless a specific provision of the tax code says otherwise.

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What are like kind exchanges

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Taxpayers exchanging property realize gains (or losses) on exchanges just as taxpayers do by seling property for cash. However, taxpayers exchanging property for property are in a different situation than taxpayers selling the same property for cash. Taxpayers exchanging one piece of business property for another haven't changed their relative economic position in the sense that both before and after the exchange they hold an asset for use in their business.

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What is true of persons after a like kind exchange?

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Taxpayers exchanging one piece of business property for another haven't changed their relative economic position in the sense that both before and after the exchange they hold an asset for use in their business.

Front 34

When do taxpayers exchanging property for assets other than cash recognize gains?

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they must defer recognition on the gain or loss realized on the exchange until they meet certain requirements. These are referred to as like kind exchanges or 1031 exchanges.

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1031 exchanges deal with

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like kind exchanges

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For an exchange to qualify as a like kind exchange it must meet 3 criteria

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1. The property is exchanged "solely for like kind property"
2. Both the property given up and the property received in the exchange by the taxpayer are either "held for investment by the taxpayer" or "used in a trade or business"
3. The "exchange" must meet certain time criteria.

Front 37

How do we determine what qualifies as like kind property for tangible personal property

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The Treasury regulations explain that tangible personal property qualifies as "like kind" if the property transferreda nd the property received in the exchange are in the same general asset class in rev proc 87-56. To put it simply, for personal property to qualify as like kind property the property given in the exchange and the property received in the exchange must have the same general use to the taxpayer.

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What type of real property is considered to be like kind property?

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All real property is considered to be like kind property with any other typeof real property as long as the real property is used in a trade or business or held for investment.

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Property inelligible for like kind treatment

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Certain types of property are, by definition, excluded from the definition of like-kind property and, thus, are not eligible for like kind treatment. This property includes inventory held for resale (including and held by a developer), most financial instruments (such as stocks, bonds, or notes) domestic property exchanged for foreign property, and partnership interests.

Front 40

Even when property meets the def. of like kind property what other qualifications must it meet to be considered a like kind exchange?

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Taxpayers can only exchange the property in a qualifying like kind exchange if the taxpayer used the transferred property in a trade or business or for investment AND the taxpayer will use the property received in the exchange in a trade or business or for an investment. One party to an exchange may qualify for like kind treatment and the other party may not. Each party to the exchange must individually determine whether or not the exchange qualifies as a like kind exchange to her.

Front 41

Timing for like kind exchanges

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A simultaneous exchange may not be practical or even possible. TAxpayers often use third party intermediaries to facilitate like kind exchanges. When a third party is involved, the taxpayer transfers the like kind property to the intermediary and the intermediary sells the property and uses the proceeds to acquire the new property for the taxpayer. The tax laws do not require a simultaneous exhcnage of assets, but thye do impose some timing requirements to ensure that a transaction is completed within a reasonable time in order to qualify as a deferred like kind exchange.

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What are the 2 timing rules for a like kind exchange

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1. The taxpayer must identify the like kind replacement property within 45 days after transferring the property given upin the exchange and
2. The taxpayer must receive the replacement like-kind property within 180 days ((or the date of the tax return including extensions) after the taxpayre initially transfers property in the exchange.

Front 43

What happens as far as basis when a like kind exhcnage occurs?

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After a like kind exchange they also receive an exchanged basis in the like kind property they reveive that is they exchange the basis they had in the property given up and transfer it to the basis of the property received.

Front 44

Tax consequences of involving boot

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When additional property or boot (non like-kind property) is transferred, the party receiving it apparently fails the first like kind exchange requirement that like kind property be exchanged solely for like kind property. Nevertheless, if a taxpayer receives boot in addition to a like kind exchange propety, the transaction can still qualify for like kind exchange treatment, but the taxpayer is required to recognize realized gain to the extent of the boot received. As a practical matter, this means the taxpayre[s recognized gain is the lesser of 1. the gain realized, or 2. the boot received

Front 45

Equation for basis in like kind property

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basis in like kind property = FMV of like kind property received - deferred gain + deferred loss

Front 46

Involuntary conversion

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Occur when the property is partially or wholly destroyed by a natural disaster or accidnet, stolen, condemned, or siezed via eminent domain by a govt. agency.

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How are involuntary conversions taxed and what is the rational behind it?

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For example, consider a bus that acquired a building for $100,000. The building appreciates in value and when the building is worth $150,000 it is destroyed by fire. The building is uflly insured at its replacement cost, so the business receives a check from the insurance company for 150,000. The problem for the business is that it realizes a $50,000 gain on this involuntary conversion. Assuming the business's income is taxed at 30% marginal rate, it must pay $15,000 tax on the money it receives leaving it with only $135,000 to replace a $150,000 dollar property. Congress provides special tax lawas to allow taxpayers to defer the gains on such involuntary conversions.

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Direct conversion

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involves taxpayers receiving a direct property replaceent for the involuntarily converted property.

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Indirect conversions Can a taxpayer defer these gains/losses? What are the stipulations regarding replacement property?

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involve taxpayers receiving money for this involuntary converted property through insurance reimbursement or some other type of settlement. TAxpayers meeting the requirements may elect to either recognize or defer realized gain in the conversions. Taxpayers can defer realized gains on individual conversions if they acquire qualified replacement property wihin a prescribed limit which is generally 2 years. For both personal and real property, qualified replacement property for an involuntary conversion is defined more narrowly than is like kind property in a like kind exchange. The property must be similar and related in service or use to qualify. For example, bowling alley isn't qualifed replacement prop for a pool hall.

Front 50

What do you recognize when you have a gain on involuntary conversion

Back 50

recognize the lesser of:
1. the gain realized on the conversion
2. the amount of reimbursemtne the taxpayer does not reinvest in qualified property.

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Installment sales

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When taxpayers sell property for cash and collect the entire sale proceeds in one limp sum payment, they immediately recognize gain or loss for tax purposes. The buyer may make a down payment in the year of sale and then agree to pay the remainder of the sale proceeds over a period of time this is an installment sale.

Front 52

What happens when installment sales are made?

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When an installment sale is made the taxpayer selling the property realizes gains to the extent the selling price exceeds their adjusted basis in the property sold. They allow taxpayers selling property in this manner to use installment method of recognizing gain on the sale over tme. Installment method doesn't apply to property sold at a loss. Taxpayers determine the amount of realized gain on the transaction and recognize the gain pro rata as they receive the installment payments. By the time they receiva all payments they will have recognized all gains.

Front 53

gross profit percentage equation

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Gain realized / amount realized

Front 54

Gains ineligible for installment reporting

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Not all gains are eligible. Taxpayers selling marketable securities or inventory on an installment basis may not use the installment method to report gain on the sales. Similarly, any 1245 depreciation recapture is not eligible for installment reporting and must be recognized in the year of sale. Immediately taxable recapture related gains are added to the adjusted basis of the property sold to determine the gross profit percentage.

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Other nonrecognition provisons

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There are several tax law provisons that allow businesse sto change the form or organization of their business while deferring the realized gains for tax purposes. Without the nonrecognizion provisoon, the tax cost of forming a corporation may be large enough to deter taxpayers from doing so. Nonrecognition rules also aply to taxpayers forming partnerships or contributing assets to partnerships.

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RElated party loss disallowance rules

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Taxpayers selling business or investment property at a loss to unrelated parties are generally allowed to deduct the loss. This makes sense in most situations because tax payers are selling the property for less than their remaining investment in the property. In contrast, when they sell to a third party they retain some control so the taxlaw treats them as they are the same taxpayer and disallow recognition of losses on sales to related parties

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Rules for losses to related parties

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1. if the related buyer sells the property at a gain greater than the disallowed loss, the enture loss that was disallowed for the related party seller is deductible by the buyer
2. If the related party buyer subsequently sells the property adn the related party seller's disallowed loss exceeds the related party's gain on the subsequent sale, the related party buyer may only deduct or offset to previously disallowed loss to the extent of the gain on the sale to the unrelated third party--the remaining disallowed loss expires unused.
3. If the related party buyer sells the property for less than her purchase price from the related seller, the disallowed loss expires unused.

Front 58

291 gain what type of property is 291 property? What type of gain does it create? How is the gain calculated?

Back 58

A 291 gain occurs on real property.
It creates an ordinary gain
The ordinary part of the gain is calculated by taking the lesser of the gain and accumulated depreciation and multiplying it by 20%.

Front 59

For individual how does unrecaptured 1250 gain work? How is it taxed?

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For unrecaptured 1250, companies use the lesser of depreciation or recognized gain. This part becomes the unrecaptured 1250 gain. The unrecaptured part of the 1250 gain is taxed at 25%. The excess of the recognized gain is considered 1231 and is taxed at 15%.

Front 60

1239 recapture what type of transaction is that and how is the gain characterized?

Back 60

This transaction takes place when a taxpayer sells property to a related party and the property is depreciable property to the buyer, the entire gain is characterized as ordinary income to the seller.