Part I: Federal income taxation.
7543. What credits may be taken against the tax?
After rates have been applied to compute the tax, certain payments and credits may be subtracted from the tax to arrive at the amount of tax payable. Refundable credits are recoverable regardless of the amount of the taxpayer's tax liability for the taxable year. The refundable credits include:
... Taxes withheld from salaries and wages. (6ch)
... Overpayments of tax. (7ch)
... The excess of Social Security withheld (two or more employers). (8ch)
... The earned income credit. (1ci)
... The 65% health care tax credit for uninsured workers displaced by trade competition. (2ci)
For 2009 and 2010, a making work pay credit is available equal to the lesser of (1) 6.2% of earned income or (2) $800 for a joint return and $400 for all others. The credit is reduced by 2% of the taxpayer's modified adjusted gross income in excess of $150,000 for a joint return and $75,000 for all others. The credit is also reduced by certain other benefits provided by ARRA 2009. The credit is not available for nonresident aliens, for persons for whom a personal exemption is claimed on another person's return, or an estate or trust. (3ci)
There is a first-time homebuyer credit available for a home purchased after April 8, 2008 and through April 2010. (4a) The credit is available for 10% of the purchase price, up to certain limits. For homes purchased in 2009 and 2010, the dollar limits is $8,000 ($4,000 for a married individual filing separate). However, for a home purchased after November 6, 2009 by a long-time resident treated as a first-time homebuyer, the dollar limit is only $6,500 ($3,250 for a married individual filing separate). For a home purchased before November 7, 2009, the credit was phased out based on AGI of $75,000 to $95,000 ($150,000 to $170,000 for a joint return). For a home purchased after November 6, 2009, the credit is phased out based on AGI of $125,000 to $145,000 ($225,000 to $245,000 for a joint return). For a home purchased after November 6, 2009, the credit is not available to a person for whom a personal exemption is allowable to another person. The credit is not available for a home purchased after November 6, 2009 if the purchase price exceeds $800,000. For a home purchased in 2008, the credit must generally be recaptured over a 15-year period beginning with the second year after the home is purchased. The recapture generally must be accelerated if the home is sold or is no longer the taxpayer's principal residence. Credit recapture does not apply to a home purchased in 2009 or 2010 unless the home is disposed of or ceases to be used as a primary residence within three years of purchase. For a first-time homebuyer's credit that can be properly claimed in a year after 2008, the taxpayer can elect to claim the credit as of December 31 of the previous year.
The nonrefundable credits are as follows:
... The personal credits--which consist of the child and dependent care credit (5ci); the credit for the elderly and the permanently and totally disabled (6ci); the qualified adoption credit; (7ci); the nonrefundable portion of the child tax credit (8ci); the Hope Scholarship and Lifetime Learning credits (9ci) (see Q 7546); the credit for elective deferrals and IRA contributions (the "saver's credit," which became permanent under PPA 2006 (10ci));
... The nonbusiness energy property credit (1cj); and the residential energy efficient property credit (2cj).
... Other nonbusiness credits. (3cj)
... The general business credit (see Q 7855) is the sum of the following credits determined for the taxable year: (1) the investment credit determined under IRC Section 46 (see Q 7861) (including the rehabilitation credit; see Q 7821); (2) the work opportunity credit determined under IRC Section 51(a); (3) the alcohol fuels credit determined under IRC Section 40(a); (4) the research credit determined under IRC Section 41(a); (5) the low-income housing credit (see Q 7820) determined under IRC Section 42(a); (6) the enhanced oil recovery credit (see Q 7855) under IRC Section 43(a); (7) in the case of an eligible small business, the disabled access credit determined under IRC Section 44(a); (8) the renewable electricity production credit under IRC Section 45(a) (extended through 2009 under EIEA 2008); (9) the empowerment zone employment credit determined under IRC Section 1396(a); (10) the Indian employment credit as determined under IRC Section 45A(a); (11) the employer Social Security credit determined under IRC Section 45B(a); (12) the orphan drug credit determined under IRC Section 45C(a); (13) the new markets tax credit determined under IRC Section 45D(a); (14) in the case of an eligible employer (as defined in IRC Section 45E(c)); the small employer pension plan startup cost credit determined under IRC Section 45E(a); (15) the employer-provided child care credit determined under IRC Section 45F(a); (16) the railroad track maintenance credit determined under IRC Section 45G(a); (17) the biodiesel fuels credit determined under IRC Section 40A(a); (18) the low sulfur diesel fuel production credit determined under IRC Section 45H(a); (19) the marginal oil and gas well production credit determined under IRC Section 45I(a); (20) for tax years beginning after September 20, 2005, the distilled spirits credit determined under IRC Section 5011(a); (21) for tax year beginning after August 8, 2005, the advanced nuclear power facility production credit determined under IRC Section 45J(a); (22) for property placed in service after December 31, 2005, the nonconventional source production credit determined under IRC Section 45K(a); (23) the energy efficient home credit determined under IRC Section 45L(a); (24) the energy efficient appliance credit determined under IRC Section 45M(a); (25) the portion of the alternative motor vehicle credit to which IRC Section 30B(g)(1) applies; and (26) the portion of the alternative fuel vehicle refueling property credit to which IRC Section 30C(d)(1) applies. (4cj)
ETIA 2005 provides an alternative motor vehicle credit for qualified fuel cell vehicles, advanced lean-burn technology vehicles, qualified hybrid vehicles, and qualified alternative fuel vehicles. (5cj) (This credit replaced the prior deduction for qualified clean-fuel vehicle property, which expired on December 31, 2005. (6cj)) The portion of the credit attributable to vehicles of a character subject to an allowance for depreciation is treated as a portion of the general business credit; the remainder of the credit is a personal credit allowable to the extent of the excess of the regular tax (reduced by certain other credits) over the alternative minimum tax for the taxable year. (7cj)
For new qualified plug-in electric drive motor vehicles acquired and placed in service after 2009, a new credit is available. The credit can vary from $2,500 to $5,000 depending on battery capacity (and subject to phaseout based on number of vehicles sold by the manufacturer). The portion of the credit attributable to property of a character subject to an allowance for depreciation is treated as part of the general business credit. The balance of the credit is generally treated as a nonrefundable personal credit. (1ck) An alternative credit is available for certain plug-in electric cars placed in service after February 17, 2009 and before 2011. This credit is equal to 10% of cost, up to $2,500. (2ck)
Beginning in 2010, the only nonrefundable personal credits available for offset against the regular income tax and the alternative minimum tax are the: (1) nonrefundable adoption credit; (2) nonrefundable child tax credit; and (3) saver's credit (see above). (For tax years beginning in 2000 through 2009, all of the nonrefundable personal credits are available for offset against the regular income tax and the alternative minimum tax. (3ck)) A credit may also be allowed for prior years' alternative minimum tax liability (see Q 7538).
7544. Who qualifies for the tax credit for the elderly and the permanently and totally disabled and how is the credit computed?
The credit is available to taxpayers age 65 or older, or who are under age 65, retired on disability and were considered permanently and totally disabled when they retired. (4ck)
"An individual is permanently and totally disabled if he is unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or which has lasted or can be expected to last for a continuous period of not less than 12 months. An individual shall not be considered to be permanently and totally disabled unless he furnishes proof of the existence thereof in such form and manner, and at such times, as the Secretary may require." (5ck)
The credit equals 15% of an individual's IRC Section 22 amount for the taxable year, but may not exceed the amount of tax. This IRC Section 22 base amount is $5,000 for a single taxpayer or married taxpayers filing jointly if only one spouse qualifies for the credit; $7,500 for married taxpayers filing jointly if both qualify; and $3,750 for a married taxpayer filing separately. (6ck) Married taxpayers must file a joint return to claim the credit, unless they lived apart for the entire taxable year. (7ck)
This base figure is limited for individuals under age 65 to the amount of the disability income (taxable amount an individual receives under an employer plan as wages or payments in lieu of wages for the period he is absent from work on account of permanent and total disability) received during the taxable year. (8ck) (Proof of continuing permanent and total disability may be required. (9ck)) For married taxpayers who are both qualified and who file jointly, the base figure cannot exceed the total of both spouses' disability income if both are under age 65 or if only one is under age 65, the sum of $5,000 plus the disability income of the spouse who is under 65. (1cl)
The base figure (or the amount of disability income in the case of individuals under age 65, if lower) is reduced dollar-for-dollar by one-half of adjusted gross income in excess of $7,500 (single taxpayers), $10,000 (joint return), or $5,000 (married filing separately). (2cl) A reduction is also made for Social Security and railroad retirement benefits that are excluded from gross income, and certain other tax-exempt income. (3cl)
7545. Who qualifies for the child tax credit?
A child tax credit is available for each "qualifying child" (defined below) of eligible taxpayers who meet certain income requirements. The child tax credit is $1,000 through 2010. (4cl) The increased child tax credit will "sunset" (expire) for tax years beginning after December 31, 2010, at which time the child tax credit will return to its pre-EGTRRA level (i.e., $500). (5cl)
The term qualifying child means a "qualifying child" of the taxpayer (as defined under IRC Section 152(c)--see below) who has not attained the age of 17. (6cl)
"Qualifying child" means, with respect to any taxpayer for any taxable year, an individual:
(1) who is the taxpayer's "child" (see below) or a descendant of such a child, or the taxpayer's brother, sister, stepbrother, or stepsister or a descendant of any such relative;
(2) who has the same principal place of abode as the taxpayer for more than one-half of the taxable year; and
(3) who has not provided over one-half of such individual's own support for the calendar year in which the taxpayer's taxable year begins. (7cl)
Additionally, a qualifying child must be either a citizen or a resident of the United States. (8cl)
The term "child" means an individual who is: (1) a son, daughter, stepson, or stepdaughter of the taxpayer; or (2) an "eligible foster child" of the taxpayer. (9cl) An "eligible foster child" means an individual who is placed with the taxpayer by an authorized placement agency or by judgment decree, or other order of any court of competent jurisdiction. (10cl) Any adopted children of the taxpayer are treated the same as natural born children. (11cl)
The amount of the credit is reduced for taxpayers whose modified adjusted gross income (MAGI) exceeds certain levels. A taxpayer's MAGI is his adjusted gross income without regard to the exclusions for income derived from certain foreign sources or sources within United States possessions. The credit amount is reduced by $50 for every $1000 or fraction thereof, by which the taxpayer's MAGI exceeds the following threshold amounts: $110,000 for married taxpayers filing jointly, $75,000 for unmarried individuals, and $55,000 for married taxpayers filing separately. (1cm)
The child tax credit is refundable to the extent of 15% of the taxpayer's earned income in excess of $10,000 (as indexed--see below). (2cm) For example, if the taxpayer's earned income is $16,000, the excess amount would be $6,000 ($16,000 - $10,000 = $6,000), and the taxpayer's refundable credit for one qualifying child would be $900 ($6,000 x 15% = $900). For families with three or more qualifying children, the credit is refundable to the extent that the taxpayer's Social Security taxes exceed the taxpayer's earned income credit if that amount is greater than the refundable credit based on the taxpayer's earned income in excess of $10,000 (as indexed--see below). (3cm) The $10,000 amount is indexed for inflation. But ARRA 2009 reduces the dollar amount to $3,000 for 2009 and 2010. (4d) (Prior to 2001, the child tax credit was refundable only for individuals with three or more qualifying children. (5cm))
The nonrefundable child tax credit can be claimed against the individual's regular income tax and alternative minimum tax (see Q 7543). The nonrefundable child tax credit cannot exceed the excess of (i) the sum of the taxpayer's regular tax plus the alternative minimum tax over (ii) the sum of the taxpayer's nonrefundable personal credits (other than the child tax credit, adoption credit, and saver's credit) and the foreign tax credit for the taxable year. (6cm) For tax years beginning after 2001, the refundable child tax credit is not required to be reduced by the amount of the taxpayer's alternative minimum tax. (7cm) The nonrefundable credit must be reduced by the amount of the refundable credit. (8cm)
Some additional restrictions applying to the child tax credit include: (1) an individual's tax return must identify the name and taxpayer identification number (Social Security number) of the child for whom the credit is claimed; and (2) the credit may be claimed only for a full taxable year, unless the taxable year is cut short by the death of the taxpayer. (9cm) For purposes of applying a uniform method of determining when a child attains a specific age, the Service has ruled that a child attains a given age on the anniversary of the date that the child was born (e.g., a child born on January 1, 1987, attains the age of 17 on January 1, 2004). (10cm) The IRS stated that it would apply Revenue Ruling 2003-72 retroactively and would notify those taxpayers entitled to a refund for 2002 as a result of Revenue Ruling 2003-72. (11cm)
The supplemental child tax credit, which was available before 2002 to certain lower income taxpayers, has been repealed. (1cn)
7546. What are the Hope Scholarship and Lifetime Learning Credits?
The Hope Scholarship Credit and the Lifetime Learning Credit are available to certain eligible taxpayers who pay qualified tuition and related expenses. (2cn)
Hope Scholarship Credit
The Hope Scholarship Credit provides a credit for each eligible student equal to the sum of: (1) 100% of qualified tuition and related expenses up to $2,000 (in 2009 and 2010); plus (2) 25% of qualified tuition and related expenses in excess of $2,000, up to the applicable limit. The applicable limit ($4,000 in 2009 and 2010) is two times the $2,000 amount. (3cn) AARA 2009 increased the credit amounts for 2009 and 2010. In other years, the amounts used to calculate the credit are adjusted for inflation and rounded to the next lowest multiple of $100. (4e) The maximum credit for 2010 is $2,500 ($2,000 + (25% x $2,000).
The Hope Scholarship Credit is available only for the first two years (AARA 2009 expands to four years for 2009 and 2010) of postsecondary education, and can be used in only two (four) taxable years. (5cn) To qualify for the credit, the student must carry at least half of a full-time academic workload for an academic period during the taxable year. (6cn)
An eligible student generally means a student who: (1) for at least one academic period beginning in the calendar year, is enrolled at least half-time in a program leading to a degree, certificate, or other recognized educational credential and is enrolled in one of the first two (four years for 2009 and 2010) years of postsecondary education, and (2) is free of any conviction for federal or state felony offenses consisting of the possession of a controlled substance. (7cn)
Qualified tuition and related expenses are tuition and fees required for the enrollment or attendance of the taxpayer, the taxpayer's spouse, or any dependent of the taxpayer (for whom he is allowed a dependency exemption) at an "eligible education institution." (8cn) Qualified tuition and related expenses do not include nonacademic fees such as room and board, medical expenses (including required student health fees), transportation, student activity fees, athletic fees, insurance expenses, and similar personal, living or family expenses unrelated to a student's academic course of instruction. (9cn) Additionally, qualified tuition and related expenses do not include expenses for a course involving sports, games or hobbies, unless it is part of the student's degree program. (10cn) AARA 2009 expands qualified tuition and related expenses to include required course materials for 2009 and 2010.
An eligible educational institution generally means a postsecondary educational institution that: (a) provides an educational program for which it awards a bachelor's degree, or a 2-year program that would be accepted for credit towards a bachelor's degree; (b) has at least a one year program that trains students for gainful employment in a recognized profession; (c) participates in a federal financial aid program under Title IV of the Higher Education Act of 1965 or is certified by the Department of Education as eligible to participate in such a program; or (d) meets requirements for certain postsecondary vocational, proprietary institutions of higher learning and certain institutions outside the United States. In any event, the institution must also be accredited or have been granted pre-accreditation status. (1co)
An academic period means a quarter, semester, trimester or other period of study (such as summer school session) as reasonably determined by an eligible educational institution. (2co)
Lifetime Learning Credit
The Lifetime Learning Credit is available in an amount equal to 20% of "qualified tuition and related expenses" (defined above) paid by the taxpayer during the taxable year for any course of instruction at an "eligible educational institution" (defined above) taken to acquire or improve the job skills of the taxpayer, his spouse or dependents. The Lifetime Learning Credit is a per taxpayer credit and the maximum credit available does not vary with the number of students in the family. The maximum amount of the credit in 2010 is $2,000 (20% of up to $10,000 of qualified tuition and related expenses). (3co)
Qualified tuition and related expenses, for the purposes of the Lifetime Learning Credit, include expenses for graduate as well as undergraduate courses. The Lifetime Learning Credit applies regardless of whether the individual is enrolled on a full-time, half-time, or less than half-time basis. Additionally, the Lifetime Learning Credit is available for an unlimited number of taxable years. (4co)
Where taxpayers had pre-paid their child's tuition in November 2001 for the academic period that began during the first three months of the following taxable year (i.e., the spring semester of 2002), the prepayment amount was properly includable in the calculation of the taxpayers' Lifetime Learning Credit for the 2001 taxable year, not the 2002 taxable year. (5co)
Limitations and Phaseouts
The Code sets forth special rules coordinating the interaction of these credits. The Lifetime Learning Credit is not available with respect to a student for whom an election is made to take the Hope Scholarship Credit during the same taxable year. (6co) However, the taxpayer may use the Hope Scholarship Credit for one student and the Lifetime Learning Credit for other students in the same taxable year.
Both credits are subject to the same phaseout rules based on the taxpayer's modified adjusted gross income (MAGI). MAGI is the taxpayer's adjusted gross income without regard to the exclusions for income derived from certain foreign sources or sources within United States possessions. The maximum credit in each case is reduced by the credit multiplied by a ratio. For single taxpayers, the ratio equals the excess of (i) the taxpayers' MAGI over $40,000 to (ii) $10,000. For married taxpayers filing jointly, the ratio equals (a) the excess of the taxpayer's MAGI over $80,000 to (b) $20,000. (1cp) The $40,000 and $80,000 amounts are adjusted for inflation and rounded to the next lowest multiple of $1,000. (2cp) For 2010, the threshold amounts are $50,000 for single taxpayers and $100,000 for married taxpayers filing jointly for the Lifetime Learning Credit. (3cp) AARA 2009 increases the threshold amounts in 2009 and 2010 for the Hope Scholarship Credit to $160,000 for married taxpayers filing jointly and $80,000 for single taxpayers.
The amount of qualified tuition and related expenses for both credits is limited by the sum of the amounts paid for the benefit of the student, such as scholarships, education assistance advances, and payments (other than a gift, bequest, devise, or inheritance) received by an individual for educational expenses attributable to enrollment. (4cp) The IRS has determined that qualified tuition and related expenses paid with distributions of educational benefits from a trust could be used to compute Hope Scholarship and Lifetime Learning Credits if the distributions were included in the taxable income of the beneficiaries. (5cp)
Neither credit is allowed unless a taxpayer elects to claim it on a timely filed (including extensions) federal income tax return for the taxable year in which the credit is claimed. The election is made by completing and attaching Form 8863, Education Credits (Hope and Lifetime Learning Credits), to the return. (6cp) Neither credit is allowed unless the taxpayer provides the name and the taxpayer identification (i.e., Social Security) number of the student for whom the credit is claimed. (7cp)
If the student is claimed as a dependent on another individual's tax return (e.g., parents) he cannot claim either credit for himself, even if he paid the expenses himself. (8cp) (The Service has privately ruled that a student was entitled to claim a Hope Scholarship Credit on his own return even though his parents were eligible to claim him as a dependent, but chose not to do so. (9cp)) However, if another individual is eligible to claim the student as a dependent, but does not do so, only the student may claim the Hope or Lifetime Learning Credit for his own qualified tuition and related expenses. (10cp) Both credits are unavailable to married taxpayers filing separately. (11cp) Neither of these credits is allowed for any expenses for which there is a deduction available. (12cp) Taxpayers are not eligible to claim a Hope or Lifetime Learning Credit and the deduction for qualified higher education expenses in the same year with respect to the same student. (13cp)
A taxpayer may claim a Hope Scholarship or Lifetime Learning Credit and exclude distributions from a qualified tuition program on behalf of the same student in the same taxable year if the distribution is not used to pay the same educational expenses for which the credit was claimed. (1cq) See Q 7517.
A taxpayer can claim a Hope Scholarship or Lifetime Learning Credit and exclude distributions from a Coverdell Education Savings Account (ESA--see Q 7516) on behalf of the same student in the same taxable year if the distribution is not used to pay the same educational expenses for which the credit was claimed. (2cq) A taxpayer may elect not to have the Hope Scholarship or Lifetime Learning Credit apply with respect to the qualified higher education expenses of an individual for any taxable year. (3cq)
For 2009 and 2010, AARA 2009 makes the Hope Scholarship Credit allowable against the alternative minimum tax and a portion of the tax is made refundable.
Reporting. For the reporting requirements for higher education tuition and related expenses, see IRC Sec. 6050S, as amended by P.L. 107-131 (1-16-2002). For the reporting requirements for qualified tuition and related expenses, see Treas. Reg. [section]1.6050S-1; TD 9029. (4cq)
7547. What energy credits may be taken against the tax?
Credit for Nonbusiness Energy Property
Editor's Note: The credit for nonbusiness energy property expired on December 31, 2007. Congress later revived it for 2009 and 2010. (5cq)
An individual taxpayer may claim as a credit an amount equal to the sum of: (1) 10% of the amount paid or incurred by the taxpayer for "qualified energy efficiency improvements" (see below) installed during the taxable year; and (2) the amount of the "residential energy property expenditures" (see below) paid or incurred by the taxpayer during the
taxable year. (6cq)
Qualified energy efficiency improvements means any energy efficient "building envelope component" (see below) that meets certain energy conservation criteria, if: (1) the component is installed in or on a dwelling located in the United States that is owned and used by the taxpayer as his principal residence;
(2) original use of the component commences with the taxpayer; and (3) the component reasonably can be expected to remain in use for at least five years. (7cq) The term "building envelope component" means: (1) any insulation material or system specifically and primarily designed to reduce the heat loss or gain of a dwelling when installed in or on the dwelling; (2) exterior windows, including skylights;
(3) exterior doors; and (4) metal roofs if the roof has appropriate coatings specifically and primarily designed to reduce the heat gain of the dwelling. (8cq)
In guidance, the Service clarified that a component will be treated as reasonably expected to remain in use for at least five years if the manufacturer offers, at no extra charge, at least a two-year warranty providing for repair or replacement of the component in the event of a defect in materials or workmanship. However, if the manufacturer does not offer such a warranty, all relevant facts and circumstances are taken into account in determining whether the component reasonably can be expected to remain in use for at least five years. The Service also confirmed that a taxpayer may rely on a manufacturer's certification that a building envelope component is an "eligible building envelope component." A taxpayer is not required to attach the certification to the tax return on which the credit is claimed, but should retain the certification statement as part of his records. In addition, the Service stated that a credit is allowed only for amounts paid or incurred to purchase the components, not for the onsite preparation, assembly, or original installation of the components. (1cr)
Residential energy property expenditures means expenditures made by the taxpayer for "qualified energy property" that is: (1) installed on or in connection with a dwelling unit located in the United States and owned and used by the taxpayer as the taxpayer's principal residence; and (2) originally placed in service by the taxpayer. (2cr) The term "qualified energy property" means: (1) "energy-efficient building property" (see below); (2) a qualified natural gas, propane, oil furnace or hot water boiler; or (3) an advanced main air circulating fan. All of the types of property listed in the preceding sentence must meet certain performance and quality standards. (3cr) "Energy efficient building property" means: (1) electric heat pump water heaters; (2) electric heat pumps; (3) geothermal heat pumps; (4) central air conditioners; and (5) natural gas, propane, or oil water heaters. (4cr)
The Service has confirmed that a taxpayer may rely on a manufacturer's certification that a product is "qualified energy property." A taxpayer is not required to attach the certification to the tax return on which the credit is claimed, but should retain the certification statement as part of his records. In addition, the Service stated that a credit is allowed for amounts paid or incurred to purchase qualified energy property and for expenditures for labor costs allocable to the onsite preparation, assembly, or original installation of the property. (5cr) The Service has issued additional guidance regarding the credit. (6cr)
The lifetime limitation with respect to any taxpayer for any taxable year is $500. (7cr) An additional limit of $200 applies to windows. (8cr) Other limits are as follows: advanced main air circulating fans--$50; qualified natural gas, propane, oil furnace or hot water boilers--$150; and energy-efficient building property--$300. (9cr)
The credit is available for property placed in service after December 31, 2005 and before January 1, 2008, and in 2009 and 2010 (see Editor's Note, above). (10cr)
Residential Energy Efficient Property Credit
An individual taxpayer may claim as a credit an amount equal to the sum of 30% of the following expenditures made by the taxpayer during the taxable year: (1) "qualified solar electric property" (see below); (2) "qualified solar water heating property" (see below); (3) "qualified fuel cell property" (see below); (4) qualified small wind energy property (see below); and (5) qualified geothermal heat pump property (see below). (1cs) Solar water heating property must be certified in order for the credit to be claimed. (2cs)
"Qualified solar water heating property expenditure" means an expenditure for property to heat water for use in a dwelling unit located in the United States and used as a residence by the taxpayer if at least half of the energy used by such property for such purpose is derived from the sun. The term "qualified solar electric property expenditure" means an expenditure for property which uses solar energy to generate electricity for use in a dwelling unit located in the United States and used as a residence by the taxpayer. "Qualified fuel cell property expenditure" means an expenditure for qualified fuel cell property (as defined in IRC Section 48(c)(1)) installed on or in connection with a dwelling unit located in the United States and used as a principal residence by the taxpayer. "Qualified small wind energy property expenditure" means an expenditure for property which uses a wind turbine to generate electricity for use in connection with a dwelling unit located in the United States and used as a residence by the taxpayer. "Qualified geothermal heat pump property expenditure" means an expenditure for qualified geothermal heat pump property installed on or in connection with a dwelling unit located in the United States and used as a residence by the taxpayer. (3cs)
A special rule provides that expenditures allocable to a swimming pool, hot tub, or any other energy storage medium that has a function other than the function of storage cannot be taken into account for these purposes. (4cs)
The maximum credit allowed for any taxable year cannot exceed $2,000 with respect to qualified solar water heating property expenditures, $500 with respect to each half kilowatt of capacity of qualified fuel cell property (as defined in section 48(c)(1)) for which qualified fuel cell property expenditures are made, $500 with respect to each half kilowatt of capacity (not to exceed $4,000) of wind turbines for which qualified small wind energy property expenditures are made, and $2,000 with respect to any qualified geothermal heat pump property expenditures. (5cs) The unused portion of the credit can be carried forward to the succeeding taxable year. (6cs)
The credit is available for property placed in service after December 31, 2005 and before January 1, 2017. (7cs)
Alternative Motor Vehicle Credit
The alternative motor vehicle credit is equal to the sum of: (A) the new qualified fuel cell motor vehicle credit; (B) the new advanced lean burn technology motor vehicle credit; (C) the new qualified hybrid vehicle credit; and (D) the new qualified alternative motor vehicle credit. (1ct) (This credit replaces the prior deduction for qualified clean-fuel vehicle property, which sunset on December 31, 2005. (2ct))
(A) The new qualified fuel cell motor vehicle credit is based on the weight of the vehicle, and ranges from $8,000 (8,500 pound maximum) to $40,000 (26,000 pound maximum). (3ct) The amount determined above with respect to a passenger automobile or light truck is increased if the vehicle achieves certain fuel efficiencies (based on the 2002 model year city fuel economy), ranging from $1,000 to $4,000. (4ct) The credit for passenger automobiles and light trucks can be as much as $12,000.
The term "new qualified fuel cell motor vehicle" means a motor vehicle: (1) propelled by power derived from one or more fuel cells that convert chemical energy directly into electricity by combining oxygen with hydrogen fuel that is stored on board the vehicle in any form and may or may not require reformation prior to use; (2) that, in the case of a passenger vehicle or light truck, has received a certificate that the vehicle meets certain emission levels; (3) the original use of which begins with the taxpayer; (4) that is acquired for use or lease by the taxpayer and not for resale; and (5) that is made by a manufacturer. (5ct)
(B) The amount of the new advanced lean burn technology motor vehicle credit is based on fuel economy, and ranges from $400 to $2,400. The amount of the credit is increased by the conservation credit (based on lifetime fuel savings), and ranges from $250 to $1,000. (6ct) The credit for passenger automobiles and light trucks can be as much as $3,400.
The term "advanced lean burn technology motor vehicle" means a passenger automobile or light truck: (1) with an internal combustion engine that (i) is designed to operate primarily using more air than is necessary for complete combustion of the fuel, (ii) incorporates direct injection, (iii) achieves at least 125% of the 2002 model year city fuel economy, and (iv) for 2004 and later model vehicles, has received a certificate that the vehicle meets or exceeds certain emission standards; (2) the original use of which begins with the taxpayer; (3) is acquired for use or lease by the taxpayer and not for resale; and (4) is made by a manufacturer. (7ct)
(C) The new qualified hybrid motor vehicle credit amount is determined as follows: (1) If the new qualified hybrid motor vehicle is a passenger automobile or light truck weighing no more than 8,500 pounds, the credit amount is the sum of the fuel economy amount and the conservation credit (see (B), above). (8ct) (2) For other motor vehicles, the credit amount is equal to the applicable percentage of the "qualified incremental hybrid cost" (i.e., the excess of the manufacturer's suggested retail price for such vehicle over the price for a comparable gas or diesel powered vehicle) of the vehicle as certified. (1cu) The credit for passenger automobiles and light trucks can be as much as $3,400.
A "new qualified hybrid motor vehicle" means a motor vehicle that: (1) draws propulsion energy from onboard sources of stored energy that are both (i) an internal combustion or heat engine using consumable fuel, and (ii) a rechargeable energy storage system; (2) has been certified as meeting specified emission standards; (3) has maximum available power meeting certain percentages based on weight; (4) the original use of which begins with the taxpayer; (5) is acquired for use or lease by the taxpayer; and (6) is made by a manufacturer. (2cu)
(D) The new qualified alternative fuel motor vehicle credit is an amount equal to the applicable percentage of the incremental cost of any new qualified alternative fuel motor vehicle. (3cu) The "applicable percentage" is 50%, plus 30% if the vehicle has been certified as meeting certain emission standards. (4cu) The "incremental cost" (i.e., the excess of the manufacturer's suggested retail price for the vehicle over the price for a gas or diesel powered vehicle of the same model) cannot exceed between $4,000 to $32,000 based on the weight of the vehicle. (5cu)
"New qualified alternative fuel motor vehicle" means any motor vehicle: (1) that is only capable of operating on an alternative fuel; (2) the original use begins with the taxpayer; (3) is acquired by the taxpayer for use or lease but not for resale; and (4) is made by a manufacturer. (6cu) "Alternative fuel" means compressed natural gas, liquefied natural gas, liquefied petroleum gas, hydrogen, and any liquid at least 85% of the volume of which consists of methanol. (7cu)
Certifications and Limitations for Hybrid Vehicles
Certifications. The tax credit for hybrid vehicles may be as much as $3,400 for those who purchase the most fuel-efficient vehicles. (For the guidance used by manufacturers in certifying credit amounts, see Notice 2006-9. (8cu)) The Service cautions that even though a manufacturer has certified a vehicle, taxpayers must meet the following requirements to qualify for the credit:
(1) The vehicle must be placed in service after December 31, 2005, and purchased on or before December 31, 2010.
(2) The original use of the vehicle must begin with the taxpayer claiming the credit.
(a) The credit may only be claimed by the original owner of a new, qualifying, hybrid vehicle and does not apply to a used hybrid vehicle.
(3) The vehicle must be acquired for use or lease by the taxpayer claiming the credit.
(a) The credit is only available to the original purchaser of a qualifying hybrid vehicle. If a qualifying vehicle is leased to a consumer, the leasing company may claim the credit.
(b) For qualifying vehicles used by a tax-exempt entity, the person who sold the qualifying vehicle to the person or entity using the vehicle is eligible to claim the credit, but only if the seller clearly discloses in a document to the tax-exempt entity the amount of credit.
(4) The vehicle must be used predominantly within the United States.
Limitations. There is a limit on the number of new qualified hybrid and advanced lean burn technology vehicles eligible for the credit. The phaseout period begins with the second calendar quarter following the calendar quarter that includes the first date on which the number of qualified vehicles manufactured by the manufacturer is at least 60,000. (1cv) The Service publishes notices providing the adjusted credit amount based on the actual number of vehicles sold for the applicable quarter.
Effective dates. The credits are in effect as follows: new qualified fuel cell motor vehicle credit (2006-2014); (B) new advanced lean burn technology motor vehicle credit (2006-2010); (C) new qualified hybrid vehicle credit (2006-2010); and (D) new qualified alternative fuel motor vehicle credit (2006-2010).
Plug-in Electric Vehicle Credits
The American Recovery and Reinvestment Act modifies the credit for qualified plug-in electric drive vehicles purchased after Dec. 31, 2009. To qualify, vehicles must be newly purchased, have four or more wheels, have a gross vehicle weight rating of less than 14,000 pounds, and draw propulsion using a battery with at least four kilowatt hours that can be recharged from an external source of electricity. The minimum amount of the credit for qualified plug-in electric drive vehicles is $2,500 and the credit tops out at $7,500, depending on the battery capacity. The full amount of the credit will be reduced with respect to a manufacturer's vehicles after the manufacturer has sold at least 200,000 vehicles. Footnote--Section 30D.
The American Recovery and Reinvestment Act also creates a special tax credit for two types of plug-in vehicles--certain low-speed electric vehicles and two- or three-wheeled vehicles. The amount of the credit is 10 percent of the cost of the vehicle, up to a maximum credit of $2,500 for purchases made after Feb. 17, 2009, and before Jan. 1, 2012. To qualify, a vehicle must be either a low speed vehicle propelled by an electric motor that draws electricity from a battery with a capacity of 4 kilowatt hours or more or be a two- or three-wheeled vehicle propelled by an electric motor that draws electricity from a battery with the capacity of 2.5 kilowatt hours. A taxpayer may not claim this credit if the plug-in electric drive vehicle credit is allowable.
Alternative minimum tax
7548. How is the alternative minimum tax calculated?
In addition to the tax calculated under the normal rates, it is sometimes necessary for a taxpayer to pay the alternative minimum tax (AMT). The AMT is calculated by first determining the alternative minimum taxable income (AMTI), reducing this amount by the allowable exemption to determine taxable excess, and then applying a two-tier tax rate schedule to the amount of the taxable excess. The two-tier rate schedule applies a 26% rate to taxable excess that does not exceed $175,000 ($87,500 for married taxpayers filing separately), and a 28% rate to taxable excess over that amount. The resulting amount is the taxpayer's tentative minimum tax. The preferential tax rates on certain capital gains held for more than twelve months and certain dividends are also used when determining the taxpayer's tentative minimum tax (see Q 7524). (1cw)
If the tentative minimum tax reduced by the AMT foreign tax credit exceeds the regularly calculated tax (with adjustments) for the tax year, the excess is the AMT. Regularly calculated tax for AMT purposes excludes certain taxes including: (1) the alternative minimum tax; (2) the tax on benefits paid from a qualified retirement plan in excess of the plan formula to a 5% owner; (3) the 10% penalty tax for certain premature distributions from annuity contracts; (4) the 10% additional tax on certain early distributions from qualified retirement plans; (5) the 10% additional tax for certain taxable distributions from modified endowment contracts; (6) taxes relating to the recapture of the federal subsidy from use of qualified mortgage bonds and mortgage credit certificates; (7) the additional tax on certain distributions from education IRAs; and (8) the 15% additional tax on medical savings account distributions not used for qualified medical expenses. Regularly calculated tax is reduced by the foreign tax credit, the Puerto Rico and possession tax credit, and the Puerto Rico economic activity credit. (2cw)
For tax years from 2000 through 2009, certain nonrefundable personal credits (see Q 7543) may be used to reduce the sum of a taxpayer's regular tax liability and AMT liability. (3cw)
For tax years beginning after 2009, certain nonrefundable personal credits (except for the adoption expenses credit, the child tax credit, and the credit for elective deferrals and IRA contributions) may not reduce a taxpayer's regular tax liability to less than the taxpayer's tentative minimum tax. (4cw)
Alternative Minimum Taxable Income
Alternative minimum taxable income is taxable income, with adjustments made in the way certain items are treated for AMT purposes, and increased by any items of tax preference. (5cw)
Except as otherwise provided below, the provisions that apply in determining the regular taxable income of a taxpayer also generally apply in determining the AMTI of the taxpayer. (6cw) In addition, references to a noncorporate taxpayer's adjusted gross income (AGI) or modified AGI in determining the amount of items of income, exclusion, or deduction must be treated as references to the taxpayer's AGI or modified AGI as determined for regular tax purposes. (7cw)
Exemption amounts of $70,950 (in 2009; $45,000 after 2009) on a joint return (or for a surviving spouse), $46,700 (in 2009; $33,750 after 2009) on a single return, $35,475 (in 2009; $22,500 after 2009) on a married filing separate return, and $22,500 on an estate or trust return, are available in calculating the taxable excess. These exemption amounts are reduced by 25% of the amount by which the AMTI exceeds $150,000 on a joint return, $112,500 on a single return and $75,000 on a separate return or in the case of an estate or trust. (1cx) In 2008, a married individual filing a separate return must increase AMTI by the lesser of (a) 25% of the excess of the AMTI over $214,900, or (b) $34,975. After 2008, a married individual filing a separate return must increase AMTI by the lesser of (a) 25% of the excess of the AMTI over $165,000, or (b) $22,500. (2cx) For children subject to the "kiddie tax" (Q 7515) the exemption is the lesser of the above amounts or the child's earned income plus $6,700 (as indexed for 2010). (3cx)
In general, the following adjustments are made to taxable income in computing alternative minimum taxable income: (1) generally, property must be depreciated using a less accelerated method or the straight line method over a period which is longer than that used for regular tax purposes, except that a longer period is not required for property placed in service after 1998; (2) the AMT net operating loss is deductible only up to 90% of AMTI determined without regard to such net operating loss; (3) no deduction is allowed for miscellaneous itemized deductions; (4) generally, no deduction is allowed for state and local taxes unless attributable to a trade or business, or property held for the production of income (recovery of state tax disallowed for AMT purposes in a previous year is not added to AMTI in the year recovered); (5) medical expenses are allowed as a deduction only to the extent such expenses exceed 10% of adjusted gross income; (6) interest on indebtedness secured by a primary or second residence is generally deductible (within dollar limitations) if incurred in acquiring, constructing, or substantially improving the residence; however, the amount of refinanced indebtedness with regard to which interest is deductible is limited to the amount of indebtedness immediately prior to refinancing; (7) no standard deduction is allowed; (8) no deduction for personal exemptions is allowed; (9) the limitation on itemized deductions for upper-income taxpayers does not apply; (10) the taxpayer will include any amount realized due to a transfer of stock pursuant to the exercise of an incentive stock option; (11) AMTI is determined using losses from any tax shelter farm activity (determined by taking into account the AMTI adjustments and tax preferences) only to the extent that the taxpayer is insolvent or when the tax shelter farm activity is disposed of; and (12) passive activity losses (determined by taking into account the adjustments to AMTI and tax preferences) are not allowed in determining AMTI except to the extent that the taxpayer is insolvent. (4cx)
Items of tax preference which must be added to AMTI include: (1) the excess of depletion over the adjusted basis of property (except in the case of certain independent producers and royalty owners); (2) the excess of intangible drilling costs expensed (other than drilling costs of a nonproductive well) over the amount allowable for the year if the intangible drilling costs had been amortized over a 10 year period to the extent the excess is greater than 65% of the net income from oil, gas, and geothermal properties (with an exception for certain independent producers); (3) tax-exempt interest on specified private activity bonds (but reduced by any deduction not allowed in computing the regular tax if the deduction would have been allowable if the tax-exempt interest were includable in gross income) (ARRA 2009 provides that tax-exempt interest from private activity bonds issued during 2009 and 2010 is not a tax preference); (4) accelerated depreciation or amortization on certain property placed in service before 1987; and (5) seven percent of the amount excluded under IRC Section 1202 (gain on sales of certain small business stock). (1cy)
Credit for Prior Year Minimum Tax Liability
A taxpayer subject to the AMT in one year may be allowed a minimum tax credit against regular tax liability in subsequent years. The credit is equal to the total of the adjusted minimum taxes imposed in prior years reduced by the amount of minimum tax credits allowable in prior years. However, the amount of the credit cannot be greater than the excess of the taxpayer's regular tax liability (reduced by certain credits such as certain business related credits and certain investment credits) over the tentative minimum tax. The adjusted net minimum tax for any year is the AMT for that year reduced by the amount that would be the AMT if: (1) the only adjustments were those concerning the limitations on certain deductions (such as state taxes, certain itemized deductions, the standard deduction and personal exemptions); (2) the only preferences were those dealing with depletion, tax exempt interest, and small business stock; and (3) the limit on the foreign minimum tax credit did not apply. The adjusted net minimum tax is increased by the amount of any nonconventional fuel source credit and qualified electric vehicles credit that was not allowed for that year due to the AMT. For tax years after 2006 and before 2013, if an individual has minimum tax credits that have not been usable for three years, those long-term unused credits may be treated as a refundable credit. (2cy)
Social Security Taxes
7549. What are the Social Security tax rates?
The rates for 2010, as adjusted by an automatic cost-of-living increase in the earnings base, are:
Self-employment tax: 15.30% (12.40% OASDI and 2.90% hospital insurance). In 2010, the OASDI tax is imposed on up to $106,800 of self-employment income for a maximum tax of $13,243.20. The hospital insurance tax is imposed on all of a taxpayer's self-employment income. However, an above-the-line deduction is permitted for one-half of self-employment taxes paid by an individual and attributable to a trade or business carried on by the individual (not as an employee) (see Q 7934. (3cy) For compensation received in taxable years beginning after 2012, the hospital insurance tax is increased by 0.9% for wages above $250,000 for married taxpayers filing jointly and surviving spouses, $125,000 for married taxpayers filing separate, and $200,000 for single taxpayers and heads of households. The dollar thresholds for the 0.9% tax on the self-employment income of high wage earners are reduced (but not below zero) by wages subject to the FICA tax. The deduction for one-half of self-employment tax is not available for the additional 0.9% tax.
FICA tax (on employer and employee, each): 7.65% (6.20% OASDI and 1.45% hospital insurance). In 2010, the OASDI tax is imposed on up to $106,800 of wages for a maximum tax of $6,621.60 for the employer and $6,621.60 for the employee, or $13,243.20 for employer and employee together. The hospital insurance tax is imposed on all of a taxpayer's wages. (1cz) For compensation received in taxable years beginning after 2012, the employee's portion of the hospital insurance tax is increased to 2.35% for wages above $250,000 for married taxpayers filing jointly (tax applies to combined wages of taxpayer and taxpayer's spouse) and surviving spouses, $125,000 for married taxpayers filing separate, and $200,000 for single taxpayers and heads of households.
Back wages paid as the result of a settlement agreement are subject to FICA and FUTA taxes in the year the wages are actually paid, not in the year the wages were earned or should have been paid. (2cz)
Payroll tax forgiveness for new hires in 2010. An employer who hires certain persons in 2010 does not have to pay the 6.2% OASDI tax on such person for employment after March 18, 2010 and before 2011. (3cz)
In general, the new employee must be hired after February 3, 2010 and before 2010, must not have been employed for more than 40 hours during the 60-day period ending on the day the person begins the employment, must not be hired to replace another employee unless the employee separated from service voluntarily or for cause, and must not be related to the employer. The payroll tax relief is not available for federal, state, or local governments and their instrumentalities, except for institutions of higher learning.
The employer can elect to have the payroll tax forgiveness provision not apply. The Work Opportunity Credit is not available for wages of an employee for which the payroll tax forgiveness provision applies for the one-year period beginning on the date such person was hired. (4cz)
Business Credit for New Hires in 2010. In the case of taxable years beginning after March 18, 2010, the business credit under IRC Section 38 is increased by the lesser of $1,000 or 6.2% of wages paid during a 52 week period for certain new hires. The employee must be employed on any date during the year, the employee must be hired for a period of not less than 52 consecutive weeks, and the employee's wages during the last 26 weeks of such period must equal at least 80% of the employee's wages during the first 26 weeks of such period.
Tax on Investment Income. For investment income (excludes distributions from qualified plans and IRAs) received in taxable years beginning after 2012, an additional tax is imposed at 3.8% on the lesser of (1) net investment income, or (2) the excess of modified adjusted gross income over $250,000 for married taxpayers filing jointly and surviving spouses, $125,000 for married taxpayers filing separate, and $200,000 for single taxpayers and heads of households. For trusts and estates, the 3.8% additional tax is imposed on the lesser of (1) undistributed net investment income, or (2) the excess of adjusted gross income over the dollar amount for which the highest income tax bracket begins. (1da)
7550. Who must pay the self-employment tax?
An individual whose net earnings from self-employment are $400 or more for the taxable year must pay the self-employment tax. (2da) In 2010, such an individual must file a Schedule SE and pay Social Security taxes on up to $106,800 of self-employment income. (The hospital insurance tax is imposed on all of a taxpayer's self-employment income.) However, an above-the-line deduction is permitted for one-half of the self-employment tax paid by an individual and attributable to a trade or business carried on by the individual (not as an employee). (3da) If the individual also works in covered employment as an employee, his self-employment income (subject to the self-employment tax) is only the difference, if any, between his "wages" as an employee and the maximum Social Security earnings base.
7551. How can community property law affect the federal income tax treatment of investment income?
Community property law applies in determining whether property and the income it produces is community property or separate property if (1) in the case of income from personal property the spouses or either of them is domiciled in a community property state; or (2) in the case of income from real property the property is located in a community property state, regardless of the spouses' domicile(s). (4da)
In the states of Arizona, California, Nevada, New Mexico, and Washington, income from separate property is separate property of the spouse who owns the property. In the states of Idaho, Louisiana, and Texas, income from separate property is community property. (In Wisconsin, under the Marital Property Act, income from individual (separate) property is marital (community) property. For federal income tax purposes, the IRS has recognized that spouses' rights under the Wisconsin Marital Property Act are community property rights. (5da)) In May, 1998 Alaska adopted a wholly consensual community property statute, which allows married couples to select which assets are community property and which assets are to be held in some other form of ownership. Both resident and non-resident married couples may classify property as community property by transferring it to a community property trust which has been established under the provisions of the statute.
In all community property states, the income from community property is, of course, community property. And in all states, spouses can have community property converted to separate property by partitioning or by making gifts or sales of their community interests in property. For federal income tax purposes, the distinctions between separate property and community property are important when the spouses file separate returns.
The rules in all community property states for determining whether property is separate or community are quite similar. In general, separate property is property owned by a spouse before marriage and brought into the marriage as such, property acquired by a spouse by gift, will or inheritance during marriage, and property exchanged for separate property or bought with separate funds during marriage. Once property is identified as separate property, it remains separate property as long as it can be traced. All other property is community property (i.e., property owned one-half by each spouse). Earnings of the spouses while domiciled in a community property state are community property. Property acquired during marriage with community funds is presumed to be community property even if title to the property is taken in the name of one spouse only. The presumption can be rebutted only by clear and convincing evidence that the spouses intended the property to be the separate property of the spouse who has title.
The Tax Court held that a married couple's marriage contract had the effect of stopping the application of Louisiana's community property laws for federal income tax purposes, noting that, shortly before marrying, the couple "filed for registry" (in the parish where both of them resided) a marriage contract stating that "the intended husband and wife shall be separate in property." (1db)
In general, if property is bought partly with community funds and partly with separate funds, the property is partly community and partly separate in proportion to the source of the funds. If the property is bought with separate and community funds that have been so commingled that it is not known what part is separate and what part is community, the whole will probably be considered community, and consequently the property purchased will likewise be community. But see Q 7554 for a different effect of commingling when spouses move to a noncommunity property state.
The IRS may disallow the benefits of any community property law to any taxpayer who acts as if he or she were solely entitled to certain income and failed to notify his or her spouse before the due date (including extensions) for filing the return for the taxable year in which the income was derived of the nature and amount of such income. (2db) In Service Center Advice, the Service stated that taxpayers domiciled in community property states have an undivided one-half interest in the entire community so that their filing status must be married filing jointly or, if married filing separately, their returns must each reflect one-half of the total community income and expenses. The Service must establish facts and evidence to demonstrate that IRC Section 66(b) applies (i.e., it may disregard community property laws where the spouse is not notified of community income). (3db)
A California appeals court held that a spouse's early retirement benefit must be characterized as community property where (1) the benefit is payable pursuant to a contract entered into during the marriage, and (2) the years of qualifying employment occurred before the parties' separation. (4db)
The Tax Court held that in a community property jurisdiction, the spouse of a distributee who did not receive a distribution from an IRA should not be treated as a distributee (under IRC Section 408(d)) despite whatever his or her community property interest in the IRA may have been under state law. Thus, under these circumstances, distributions are taxable to the distributee and the penalty tax (under IRC Section 72(t)) applies to the distributee spouse, only. (1dc)
The Tax Court also held that a taxpayer's gross income from his continued employment--which he received in lieu of retirement benefits--did not include the amount of payments to which his former spouse was entitled under California community property law on the basis of the pension earned by the taxpayer. But the appeals court reversed the Tax Court's decision, holding the fact that the taxpayer owed money to a creditor--in this case his former spouse--did not justify excluding any amount of his wages from income. (2dc)
For guidance on the classification for federal tax purposes of a qualified entity that is owned by a husband and wife as community property under the laws of a state, foreign country, or possession of the United States, see Rev. Rul. 2002-69. (3dc)
For more information, see IRS Publication 555, "Federal Tax Information on Community Property."
7552. How is community income reported if spouses are living apart from one another?
Special rules apply in reporting certain community income of two individuals who are married to one another at any time during the calendar year, if all the following conditions exist:
(1) The spouses live apart all year.
(2) The spouses do not file a joint return with each other for a tax year beginning or ending within the calendar year.
(3) Either or both spouses have earned income for the calendar year that is community income.
(4) The spouses have not transferred, directly or indirectly, any of their earned income between themselves before the end of the year.
If all these conditions exist, the spouses must report their community income as explained below. (4dc)
Earned income. Earned income that is not trade or business or partnership income is treated as the income of the spouse who performed the personal services.
Trade or business income. Trade or business income and deductions attributable to such trade or business are treated as the gross income and deductions of the husband unless the wife exercises substantially all of the management and control of such trade or business, in which case all of such gross income and deductions are treated as the gross income and deductions of the wife.
Partnership income or loss. A partner's distributive share of partnership income or loss from a trade or business carried on by a partnership is the income or loss of the partner, and no part of it is his spouse's.
Income from separate property. Community income derived from a spouse's separate property (see Q 7551) is treated as that spouse's income.
All other community income. All other community income, such as dividends, interest, rents, royalties, or gains, is treated as provided in the applicable community property law. (1dd)
If an individual subject to the foregoing special rules (1) does not include in gross income an item of community income properly includable under the above rules in the other spouse's gross income, and (2) establishes that he or she did not know of, and had no reason to know of, such item of community income, and the IRS determines that under the facts and circumstances it would be inequitable to include such item of community income in that individual's income, then the income item will be includable in the other spouse's gross income (rather than in the individual's gross income). (2dd) The Service has released guidance for taxpayers seeking equitable innocent spouse relief under IRC Section 66(c). (3dd)
The Tax court held that it has authority to review the Service's determination that a spouse is not entitled to equitable relief under IRC Section 66(c). (4dd) The Tax Court also held that unlike IRC Section 6015(e) (which provides for equitable relief from liability for the understatement of tax), IRC Section 66 does not provide for jurisdiction permitting a taxpayer to file a "stand alone" petition in response to a denial of a request for relief made pursuant to IRC Sec. 66(c). (5dd)
For the treatment of community income in general, see Treas. Reg. [section]1.66-1. For the treatment of community income where spouses live apart, see Treas. Reg. [section]1.66-2. With respect to the denial of benefits of community property law where the spouse is not notified, see Treas. Reg. [section]1.66-3. For the rules governing the request for relief from the operation of community property law, see Treas. Reg. [section]1.66-4.
7553. How does community property law affect the federal income tax treatment of dividends received from corporate stock?
If local law characterizes the income as community income (see Q 7551, the dividends are treated as having been received one-half by each spouse. This rule has been held to apply to dividend income received by a spouse as marital property under the Wisconsin Marital Property Act. (6dd) If the dividends are characterized as separate property and the spouses file separate returns, each spouse reports his or her own separate income. (7dd)
7554. If spouses move from a community property state to a common law state, will their community property rights in the property they take with them be recognized and protected by the law of their new domicile?
Yes. (1de) Thus, if the spouses report their incomes separately, the income from the community property or from property into which the community property is traceable is reported by the spouses as belonging one-half to each. (2de) If income is community income, the deductions applicable to it must be taken one-half from each spouse's portion if they file separately. (3de) But if community property is commingled with one spouse's separate property so that the original community property cannot be traced, the income from the property must be reported as that spouse's separate income, if the spouses file separately. (4de)
7555. Do transfers of property between spouses, or between former spouses incident to a divorce, result in taxable gains and losses?
Property transferred between spouses or former spouses incident to a divorce generally will not result in recognition of gain or loss (unless the transfer is by trust, under certain circumstances, or pursuant to an instrument in effect on or before July 18, 1984, and the spouses or former spouses have not elected otherwise). (5de) The property transferred will be treated as if it were acquired by gift, and the transferor's basis in the property will be carried over to the transferee, whether the fair market value of the property is more or less than the transferor's basis. (6de) Ordinarily, if the fair market value of property transferred as a gift is less than the donor's basis, the fair market value is the donee's basis for determining loss (see Q 7519.
This nonrecognition rule means that the transfer of property between divorcing spouses in exchange for the release of marital claims generally will not result in a gain or loss to the transferor spouse. A transfer is considered made "incident to a divorce" if it is made within one year after the date the marriage ceases, or if the transfer is related to the cessation of the marriage. (7de) A transfer is related to the cessation of a marriage if: (1) the transfer is pursuant to a divorce or separation instrument; and (2) the transfer occurs not more than six years after the date on which the marriage ceases.
Transfers not meeting the above two requirements are presumed not to be related to the cessation of a marriage, but taxpayers may overcome this presumption by showing that the transfer was made to effect the division of property owned by the former spouses at the time of the cessation of the marriage. Taxpayers may show this by establishing certain factors, such as legal impediments, hampered an earlier transfer of the property, provided that the transfer occurs promptly after any cause for the delay is resolved. (8de) For example, a transfer of a business interest between former spouses that did not occur within six years of their divorce was considered incident to divorce since there existed a legal dispute between the former spouses concerning the value of the property and the terms of payment. (9de) See also Young v. Comm., (10de) in which a transfer within four years of the divorce was considered to have been made "incident to divorce," thus making all gain on the transaction taxable to the transferee spouse. (1df)
While the nonrecognition rule shields from recognition gain that would ordinarily be recognized on a sale or exchange of property, it does not shield from recognition interest income that is ordinarily recognized upon the assignment of that property to another taxpayer. Where a husband transferred Series E and EE bonds to his wife pursuant to a divorce settlement, the IRS determined that he must include as income the unrecognized interest accrued from the date of original issuance to the date of transfer. This income does not constitute gain, for purposes of the nonrecognition rule, but rather is interest income subject to the general rule that deferred, accrued interest on United States savings bonds be included as income in the year of transfer. The wife's basis in the bonds became the amount of the husband's basis plus the amount of deferred, accrued interest recognized by him upon transfer. (2df)
The Tax Court held that the nonrecognition provided in IRC Section 1041 does not apply to interest income received by a spouse through monthly installment payments made on a promissory note executed to effect a division of marital property. The court reasoned that the principal and interest portions of an installment payment constitute two distinct items that give rise to separate federal income tax consequences. Thus, the portions of the monthly installment payments that were allocated to principal under the terms of the separation agreement were not taxable to the payee spouse, but the portions allocated to interest were taxable to her. (3df)
Where property is transferred by trust, either between spouses, or between former spouses incident to divorce, gain will be recognized by the transferor to the extent that the sum of the liabilities assumed by the transferee plus the amount of liabilities to which the property is subject exceeds the total of the adjusted basis of all the property transferred. The transferee's basis will be adjusted to reflect the amount of gain recognized by the transferor. (4df)
In addition, the transfer of an installment obligation generally will not trigger gain, and transfer of investment credit property will not result in recapture if the property continues to be used in a trade or business. (5df) However, where installment obligations are transferred in trust, gain will be recognized by the transferor to the extent that the obligation's fair market value at the time of transfer exceeds its basis. (6df)
The transfer of an interest in an individual retirement account or an individual retirement annuity to a spouse pursuant to a divorce or separation instrument will not be considered a taxable event. The individual retirement account will be treated as owned by the transferee at the time of transfer, and the transfer does not result in taxable gain or loss. (7df) However, the statutory requirements for this nonrecognition treatment must be strictly observed. (8df) The Service privately ruled that a husband's payment of a lump-sum in exchange for his ex-wife's community property interest in a nonqualified deferred compensation plan payable to the husband by his employer constituted nontaxable transfers between former spouses related to the cessation of their marriage. Furthermore, the assignment of income doctrine did not cause the wife to be taxed when her former husband received payment of that deferred compensation from his employer. (1dg)
The IRS has determined that the division of one charitable remainder unitrust (CRUT--see Q 7952 into two CRUTs to effectuate a property settlement in a divorce proceeding does not cause the original or resultant trusts to fail to qualify under IRC Section 664. (2dg)
The Service has ruled that when nonstatutory stock options and nonqualified deferred compensation are transferred incident to divorce, the nonstatutory stock options will be taxed at the time that the receiving spouse exercises the options, and the deferred compensation will be taxed when paid (or made available) to the receiving spouse. (3dg) In addition, the Service has ruled that the transfer of interests in nonstatutory stock options and nonqualified deferred compensation from the employee spouse to the nonemployee spouse incident to divorce does not result in a payment of wages for FICA and FUTA tax purposes. The nonstatutory stock options are subject to FICA and FUTA taxes at the time of exercise by the nonemployee spouse to the same extent as if the options had been retained and exercised by the employee spouse. The nonqualified deferred compensation also remains subject to FICA and FUTA taxes to the same extent as if the rights to the compensation had been retained by the employee spouse. To the extent FICA and FUTA taxation apply, the wages are those of the employee spouse. The employee portion of the FICA taxes is deducted from the wages as, and when, the wages are taken into account for FICA tax purposes. The employee portion of the FICA taxes is deducted from the payment to the nonemployee spouse. The revenue ruling also contains reporting requirements with respect to such transferred interests. (4dg)
Stock redemptions. If a corporation redeems stock owned by a wife, and the wife's receipt of property with respect to the stock is treated, under applicable tax law, as a constructive distribution to the husband (i.e., where the nonredeeming shareholder has a primary and unconditional obligation to purchase the redeeming shareholder's stock), the final regulations treat the redemption as (1) a transfer of the stock by the wife to the husband, followed by (2) a transfer of the stock by the husband to the redeeming corporation. (5dg) Nonrecognition treatment would apply to the deemed transfer of stock by the wife to the husband (assuming IRC Section 1041 requirements are otherwise satisfied), so that no gain or loss would be included on account of that portion of the transaction. However, nonrecognition treatment would not apply to the deemed transfer of stock from the husband to the redeeming corporation. (6dg)
The receipt of any property by the wife from the redeeming corporation with respect to the stock would be recharacterized as (1) a transfer of such property to the husband by the redeeming corporation in exchange for the stock, in a transaction to which nonrecognition treatment would not apply, followed by (2) a transfer by the husband to the wife in a transaction, to which nonrecognition treatment would apply (assuming the requirements of IRC Section 1041 are otherwise satisfied). (7dg) For details of the rules applicable to constructive transfers between spouses and former spouses, see Treas. Reg. [section]1.1041-2; TD 9035. (1dh)
A divided Tax Court held that a stock redemption incident to divorce qualified for nonrecognition treatment where the ex-wife was considered to have transferred property to a third party on behalf of her ex-husband. The court further held that the primary and unconditional obligation standard is not an appropriate standard to apply in a case involving a corporate redemption in a divorce setting. (2dh) See also Craven v. U.S. (3dh) (stock redemption incident to divorce qualified for nonrecognition treatment). But see FSA 200222008 (where the Service ruled that based on the language in the settlement agreement, the redemption should be treated as a complete termination of the wife's interest; thus, the wife was taxable on the stock redemption. The Service reasoned that the intent of IRC Section 1041 and the parties involved was best served by respecting the form of the redemption transaction.) For the tax treatment of stock options transferred incident to a divorce, generally, see FSA 200005006.
Where a husband transferred his 25% interest in real property to his former wife, in consideration for a settlement agreement that provided to her a credit against the $500,000 equalizing money judgment that he owed to her, and the former wife then sold her undivided 50% interest in the same property to an unrelated third party, the Tax Court held as follows: (1) The first transaction, which occurred within one year after the date of the divorce, took place incident to divorce and, therefore, qualified for nonrecognition treatment under IRC Section 1041(a)(2). (2)The second transaction did not fall within IRC Section 1041(a)(2) because it was not a transfer to, or on behalf of, the taxpayer's former husband and incident to divorce. The Tax Court reasoned that the wife's sale of the property to the unrelated third party did not satisfy any legal obligation or liability that the taxpayer's former husband owed to her (or anyone else). Accordingly, the Tax Court concluded that the wife would have to recognize gain resulting from the sale in her interest in the property. (4dh)
Transfers occurring before July 19, 1984 were subject to substantially different rules, which sometimes resulted in a taxable gain to the transferor spouse. For application of the gift tax to property settlements, see Q 7584.
7556. Are alimony payments included in the gross income of the recipient? May the payor spouse take a deduction for these payments?
Alimony and separate maintenance payments generally are taxable to the recipient and deductible from gross income by the payor (even if the payor does not itemize). (5dh) Payments of arrearages from prior years are taxed to a cash basis taxpayer in the year of receipt. (6dh) Furthermore, the Tenth Circuit Court of Appeals has held that an alimony arrearage paid to the estate of a former spouse was taxable as income in respect of a decedent (see Q 7536. (7dh)
A payment received by (or on behalf of) a recipient spouse pursuant to a divorce or separation instrument executed after 1984 is an alimony or separate maintenance payment if: (1) the payment is made in cash; (2) the divorce or separation instrument does not designate the payment as not includable or deductible as alimony; (1di) (3) there is no liability to make the payments after the death of the recipient, (2di) where the Tax Court held that "substitute" payments--i.e., post-death payments that would begin as a result of the death of the taxpayer's ex-wife, and would substitute for a continuation of the payments that terminated on her death, and that otherwise qualified as alimony--were not deductible alimony payments); and (4) if the individuals are legally separated under a decree of divorce or separate maintenance, the spouses are not members of the same household at the time the payment is made. (3di)
A divorce or separation instrument includes any decree of divorce or separate maintenance or a written instrument incident to such, a written separation agreement, or other decree requiring spousal support or maintenance payments. (4di) The failure of the divorce or separation instrument to provide for termination of payments at the death of the recipient will not disqualify payments from alimony treatment. (5di) However, if both the divorce or separation instrument and state law fail to unambiguously provide for the termination of payments upon death, such payments may be disqualified from receiving alimony treatment. (6di)
It has been held that an attorney's letter detailing a settlement agreement constituted a separation instrument for purposes of determining whether payments made thereunder were alimony. (7di) However, a list of expenses by the former wife, negotiation letters between attorneys, notations on the husband's check to his former wife indicating support, and the fact that the husband actually provided support did not constitute a written separation agreement for purposes of IRC Sections 71(b)(2) and 215. (8di) A husband's payments to his wife during the couple's separation under a later invalidated separation agreement and subsequent payments made pursuant to a circuit court's orders were held to be alimony or separate maintenance payments. (9di)
The deduction for alimony paid is limited to the amount required under the divorce or separation instrument. (10di) Payments made voluntarily by a husband to his spouse, which were not mandated by a qualifying divorce decree or separation instrument, were not deductible to the husband. (11di) Where the husband made his initial payment too early because he wanted to "get it over with," and because it was convenient for him to schedule his alimony payments on or immediately after his paydays, the Tax Court concluded that the husband's premature payment was voluntary because it fell outside the scope of the qualified divorce instrument. Accordingly, the payment was not deductible by the husband as alimony. (12di)
According to the General Explanation of TRA '84, where a beneficial interest in a trust is transferred or created incident to a divorce or separation, the payments by the trust will be treated the same as payments to a trust beneficiary under IRC Section 682, disregarding that the payments may qualify as alimony. Thus, instead of including payments entirely as ordinary income, the transferee, as beneficiary, may be entitled to the flow-through of tax-exempt income.
The Tax Court held that interest income, which arose from annual payments made to the taxpayer by her former husband under their divorce settlement, was taxable to the wife. The court further held that because the wife was not able to differentiate between the costs incurred in connection with the divorce, and the amounts paid to obtain the interest income, the taxpayer was therefore not entitled to deduct the interest income under IRC Section 212 (i.e., as an ordinary and necessary expense paid or incurred for the production or collection of income). (1dj)
The Tax Court held that a contract for deed is a third-party debt instrument; consequently, the taxpayer could not deduct the value of the contract for deed transferred to his former spouse as alimony because it did not constitute a cash payment. (2dj)
In deciding whether the transfer of ownership of an annuity contract itself constituted alimony, the Service determined that because IRC Section 71 and the Treasury regulations make it clear that in order to constitute alimony a payment must be in cash, the transfer of ownership of the annuity contract to the taxpayer in this instance did not constitute alimony includable in the taxpayer's gross income. (3dj)
For the types of payments that can constitute alimony payments, see Mozley v. Comm. (4dj) (military retirement payments); Zinsmeister v. Comm. (5dj) (payments on first mortgage, real estate taxes, and miscellaneous expenses); Marten v. Comm. (6dj) (life insurance premiums paid on former wife's life insurance policy insuring the couple's paraplegic child); but cf. Berry v. Comm. (7dj) (former wife's attorney's fees not deductible). Alimony can include rental payments paid to a former spouse. Israel v. Comm. (8dj) Lump sum payments made by a husband to his former wife under a consent judgment were not deductible under IRC Section 215(a) except to the extent the lump sum constituted past due alimony. (9dj)
Recapture. Alimony recapture rules generally require recapture in the third post-separation year of "excess" payments (i.e., disproportionately large payments made in either the first or second years--or both--that are deemed to represent nondeductible property settlements previously deducted as alimony). The first post-separation year is the first calendar year in which alimony or separate maintenance payments are made; the second and third years are the next two calendar years thereafter.
The amount recaptured is included in the income of the payor spouse and deducted from the gross income of the recipient. The amount recaptured is determined by first comparing the alimony payments made for the second and third post-separation years. If payments during the second year exceed the payments during the third year by more than $15,000, the excess is "recaptured." Next, the payments during the first year are compared with the average of the payments made during the second year (as reduced by any recaptured excess) and the payments made during the third year. If the payments made during the first year exceed the average of the amounts paid during the second (as reduced) and third years by more than $15,000, the excess is also recaptured. (1dk)
There are limited exceptions to the recapture rule: if payments cease because of the marriage of the recipient or the death of either spouse before the close of the third separation year, or to the extent payments required over at least a 3-year period are tied to a fixed portion of income from a business or property or compensation, the payments will not come within these rules. Furthermore, payments under temporary support orders do not come within the recapture rules. (2dk)
Payments made under instruments executed before 1985 are taxed under different rules, (i.e., IRC Section 71 prior to TRA '84, unless the instrument is modified after 1984). Depending on the date of modification after 1984, either the TRA '84 rules and a 3-year recapture period will apply, or the recapture rules for instruments executed after 1986 (described above) will apply.
Child support. Any portion of an alimony payment specified in the divorce or separation instrument as payable for child support is not treated as alimony. (3dk) In Freyre v. U.S., (4dk) the appeals court held that because the divorce court order did not specifically designate or fix the disputed monthly payments as child support, as required in the statute (5dk) and the treasury regulations, (6dk) the payments had to be considered as alimony and, thus, were deductible by the taxpayer. (7dk)
Even portions not specified as child support may be treated as child support to the extent that the amount of the alimony payment provided for in the divorce or separation instrument is to be reduced on the occurrence of a contingency relating to a child or at a time clearly associated with such a contingency (e.g., the year a child would turn 18 years old). (8dk) If the divorce or separation instrument provides for alimony and child support payments, any payment of less than the amount specified in the instrument will be applied first as child support, to the extent of the amount specified in the instrument. (9dk) The Tax Court determined that an agreement between former spouses, absent a court modification of their divorce decree, would not alter the tax consequences of this provision. (10dk) A parent was required to include in his gross income the portion of a distribution from his pension plan that was used to satisfy a back child support obligation. (11dk)
The Service has privately ruled that interest paid on past due child support is taxable income to the recipient parent. According to the Service, interest income is not excludable income in the same manner as amounts designated for child support are excludible. The Service reasoned that for child support to be excludable from gross income, the decree, instrument or agreement must specifically designate the sum as child support; interest that is assessed later does not come under an amount specifically designated as child support. (1dl)
When a payor spouse claims alimony payments as a deduction, he is required to furnish the recipient spouse's Social Security number on his tax return for each taxable year the payments are made. (2dl) Alimony paid by a U.S. citizen spouse to a foreign spouse is deductible by the payor spouse even though the recipient is not taxable on the income under a treaty; however, the penalty for failing to include the recipient's Taxpayer Identification Number (TIN) on the payor's tax return may still apply. (3dl)
Trusts and Estates
7557. How is the federal income tax computed for trusts and estates?
Taxable income is computed by subtracting the following from gross income: allowable deductions; amounts distributable to beneficiaries; and the exemption. Estates are allowed a $600 exemption. For trusts that are required to distribute all their income currently, the exemption is $300; for all other trusts, $100. Certain trusts that benefit disabled persons may use the personal exemptions available to individuals. (4dl) A standard deduction is not available. (5dl) Rates are determined from a table for estates and trusts (see Appendix A).
For estates of decedents dying after August 5, 1997, an election may be made to treat a qualified revocable trust as part of the decedent's estate for income tax purposes. The election must be made by both the executor of the estate and the trustee of the qualified revocable trust. A qualified revocable trust is a trust that was treated as a grantor trust during the life of the decedent due to his power to revoke the trust (see Q 7558). If such an election is made, the trust will be treated as part of the decedent's estate for tax years ending after the date of the decedent's death and before the date that is two years after his death (if no estate tax return is required) or the date that is six months after the final determination of estate tax liability (if an estate tax return is required). (6dl)
Generally, income that is accumulated by a trust is taxable to the trust, and income that is distributable to beneficiaries is taxable to the beneficiaries. (7dl) A beneficiary who may be claimed as a dependent by another taxpayer may not use a personal exemption, and his standard deduction may not exceed the greater of (1) $500 as indexed ($950 for 2010); or (2) $250 as indexed ($300 for 2010) plus earned income. (8dl) The amount of trust income which can be offset by the basic standard deduction will be reduced if the beneficiary has other income (see Q 7529 Q 7538). Also, trust income taxable to a beneficiary under 19 years of age (24 for certain students) may be taxed at his parents' marginal tax rate (see Q 7515). (9dl)
A charitable remainder trust is generally not subject to income tax (see Q 7957). However, beneficiaries of a charitable remainder trust are taxable on distributions (see Q 7956). A charitable lead trust is generally taxable as a grantor trust (see Q 7558) if an upfront charitable deduction is claimed (see Q 7959). Otherwise, a charitable lead trust is generally taxed as described here. Proposed regulations would treat annuity distributions from charitable lead annuity trusts (CLATs) and unitrust distributions from charitable lead unitrusts (CLUTs) as made proportionately from all categories of trust income. State law or trust provisions providing otherwise would be ignored. The regulations would prevent such a provision from being used, for example, to allocate all taxable income to the charitable distribution with capital gain and tax-exempt income retained by the trust. (1dm)
Deductions available to an estate or trust are generally subject to the 2% floor on miscellaneous itemized deductions. (2dm) However, deductions for costs incurred in connection with the administration of an estate or trust that would not have been incurred if the property were not held by the estate or trust are fully deductible from gross income. (3dm)
Deductions excepted from the 2% floor include only those costs that would not have been incurred if held by an individual, those costs that would be uncommon for a hypothetical investor. Investment advisory fees incurred by a trust were subject to the 2% floor. (4dm) Proposed regulations have been issued on the proper treatment of costs incurred by trusts and estates. The proposed regulations provide that if a cost is unique to a trust or estate, it is not subject to the 2% floor, but if the cost is not unique to a trust or estate, it is subject to the 2% floor. (5dm) For taxable years beginning before 2009, taxpayers can deduct the full amount of bundled fiduciary fees without regard to the 2% floor. (6dm)
For distributions in taxable years beginning after August 5, 1997, the throwback rule for accumulation distributions from trusts in IRC Sections 665-667 has been eliminated for domestic trusts, except for domestic trusts that were once foreign trusts, and except in the case of trusts created before March 1, 1984, which would be aggregated with other trusts under the multiple trust rules. (7dm) Generally, for those trusts subject to the throwback rule, if a trust distributes income which it has accumulated after 1968, all of the income is taxed to the beneficiary upon distribution. The amounts distributed are treated as if they had been distributed in the preceding years in which the income was accumulated, but are includable in the income of the beneficiary for the current year. The "throwback" method of computing the tax in effect averages the tax attributable to the distribution over three of the five preceding taxable years of the beneficiary, excluding the year with the highest and the year with the lowest taxable income. (8dm)
Excess taxes paid by the trust may not be refunded, but the beneficiary may take a credit to offset any taxes (other than the alternative minimum tax) paid by the trust. However, a beneficiary who receives accumulation distributions from more than two trusts may not take such an offset for taxes paid by the third and any additional trusts. But if distributions to a beneficiary from a trust total less than $1,000 for the year, this penalty will not apply to distributions from that trust. (1dn)
Distributions of income accumulated by a trust before the beneficiary is born or before he attains age 21 are not considered accumulation distributions and thus are not generally subject to the throwback rules. (2dn)
Estates are required to file estimated tax for taxable years ending two years or more after the date of the decedent's death. (3dn) Trusts generally are required to pay estimated tax (see Q 7502). However, there are two exceptions to this rule: (1) with respect to any taxable year ending before the date that is two years after the decedent's death, trusts owned by the decedent (under the grantor trust rules) and to which the residue of the decedent's estate will pass under his will need not file estimated tax (if no will is admitted to probate, this rule will apply to a trust which is primarily responsible for paying taxes, debts and administration expenses); and (2) charitable trusts (as defined in IRC Section 511) and private foundations are not required to file estimated tax. (4dn) A trustee may elect to treat any portion of a payment of estimated tax made by the trust for any taxable year as a payment made by a beneficiary of the trust. Any amount so treated is treated as paid or credited to the beneficiary on the last day of the taxable year. (5dn)
7558. What is a grantor trust? How is a grantor trust taxed?
A grantor who retains certain interests in a trust he creates may be treated as the "owner" of all or part of the trust and thus taxed on the income of the trust in proportion to his ownership. There are five categories of interests for which the IRC gives detailed limits as to the amount of control the grantor may have without being taxed on the trust income. These categories are: reversionary interests, power to control beneficial enjoyment, administrative powers, power to revoke, and income for benefit of grantor. (6dn) With respect to any taxable year ending within two years after a grantor/decedent's death, any trust, all of which was treated under these grantor trust rules as owned by the decedent, is not required to file an estimated tax return (see Q 7557). (7dn)
Generally, a grantor will be treated as the owner of any portion of a trust in which he has a reversionary interest in either the corpus or the income, if, as of the date of inception of that portion of the trust, the value of such interest exceeds 5% of the value of the trust. (8dn) There is an exception to this rule where the reversionary interest will take effect at the death before age 21 of a beneficiary who is a lineal descendant of the grantor. (9dn) For transfers in trust made prior to March 2, 1986, the reversionary interest was not limited to a certain percentage, and so long as it took effect after 10 years it did not result in taxation of the grantor. (10dn) Using a 6% valuation table, the value of the reversionary interest of a term trust falls below 5% if the trust runs more than about 51 years. The value of a reversion will depend on the interest rate and the valuation tables required to be used (see Appendix C).
Power to Control Beneficial Enjoyment
If the grantor has any power of disposition over the beneficial enjoyment of any portion of the trust, and such power is exercisable without the approval of an adverse party, he will be treated (i.e., taxed) as the owner of that portion. (1do) A grantor may do any of the following without such action resulting in his being treated as the owner of that portion of the trust: (1) reserve the power to dispose of the trust corpus by will, (2) allocate corpus or income among charitable beneficiaries (so long as it is irrevocably payable to the charities), (3) withhold income temporarily (provided the accumulated income must ultimately be paid to or for the benefit of the beneficiary), (4) allocate receipts and disbursements between corpus and income, and (5) distribute corpus by a "reasonably definite standard." (2do) An example of a "reasonably definite standard" is found in Treasury Regulation [section]1.674(b)-1(b)(5): "for the education, support, maintenance and health of the beneficiary; for his reasonable support and comfort; or to enable him to maintain his accustomed standard of living; or to meet an emergency." A grantor also may retain the power to withhold income during the disability or minority of a beneficiary. (3do) However, if any person has the power to add or change beneficiaries, other than providing for the addition of after-born or after-adopted children, the grantor will be treated as the owner. (4do)
IRC Section 674(c) allows powers, solely exercisable by a trustee or trustees (none of whom is the grantor, and no more than half of whom are related or subordinate parties who are subservient to the wishes of the grantor), to distribute, apportion, or accumulate income to or for beneficiaries or pay out trust corpus to or for a beneficiary without the grantor being considered the owner of the trust. A related or subordinate party is a person who is not an adverse party and who is the grantor's spouse if living with the grantor; the grantor's father, mother, issue, brother or sister; an employee of the grantor; or a corporation or employee of a corporation if the grantor and the trust have significant voting control of the corporation. (5do) An adverse party is any person having a substantial beneficial interest in a trust which would be adversely affected by the exercise or nonexercise of the power the person possesses respecting the trust. (6do)
The grantor will also not be considered the owner of the trust due to a power solely exercisable by a trustee or trustees, none of whom are the grantor or the grantor's spouse living with the grantor, to distribute, apportion, or accumulate income to or for a beneficiary as long as the power is limited to a reasonably definite external standard set forth in the trust instrument. (7do) Regulations treat a reasonably definite external standard as synonymous with a reasonably definite standard, described above. (8do)
Income for Benefit of Grantor
If the trust income is (or, in the discretion of the grantor or a nonadverse party, or both, may be) distributed or held for the benefit of the grantor or his spouse, he will be treated as the owner of it. (1dp) This provision applies to the use of trust income for the payment of premiums for insurance on the life of the grantor or his spouse, although taxation does not result from the mere power of the trustee to purchase life insurance. This provision is also invoked any time trust income is used for the benefit of the grantor, to discharge a legal obligation. Thus, when trust income is used to discharge the grantor's legal support obligations, it is taxable income to the grantor. (2dp) State laws vary as to what constitutes a parent's obligation to support; however, such a determination may be based in part on the background, values and goals of the parents, as well as the children. (3dp)
The mere power of the trustee to use trust income to discharge a legal obligation of the grantor will not result in taxable income to the grantor. Under IRC Section 677(b), there must be an actual distribution of trust income for the grantor's benefit in order for the grantor to be taxable on the amounts expended.
Other Grantor Powers
A grantor's power to revoke the trust will result in his being treated as owner of it. This may happen by operation of law in states requiring that the trust instrument explicitly state that the trust is irrevocable. Such a power will also be inferred where the grantor's powers are so extensive as to be substantially equivalent to a power of revocation, such as a power to invade the corpus. (4dp)
Certain administrative powers retained by the grantor will result in his being treated as owner of the trust; these include the power to deal with trust funds for less than full and adequate consideration, the power to borrow without adequate interest or security, or borrowing from the trust without completely repaying principal and interest before the beginning of the taxable year. (5dp)
Corporations And Other Business Entities
7559. How is a corporation taxed?
Any corporation, including a professional corporation or association, is considered a C corporation, taxable under the following rules, unless an election is made to be treated as an S corporation.
Graduated Tax Rates
A corporation pays tax according to a graduated rate schedule. The rates range from 15% to 35%, with higher effective rates of 38% and 39% applicable to income at certain levels. (6dp) See Appendix A for the rates. A "personal service corporation" is subject to a different income tax rate. See Q 7561).
Taxable income is computed for a corporation in much the same way as for an individual. Generally, a corporation may take the same deductions as an individual, except those of a personal nature (e.g., deductions for medical expenses and the personal exemptions). A corporation also does not receive a standard deduction. There are a few special deductions for corporations, however, including a deduction equal to 70% of dividends received from other domestic corporations, 80% of dividends received from a 20% owned company, and 100% for dividends received from affiliated corporations. (1dq) A corporation may deduct contributions to charitable organizations to the extent of 10% of taxable income (with certain adjustments). (2dq) Generally, charitable contributions in excess of the 10% limit may be carried over for five years. (3dq)
A corporation is also allowed a deduction for production activities. When this deduction is fully phased in (in 2010) it will be equal to nine percent of a taxpayer's qualified production activities income (or, if less, the taxpayer's taxable income). The deduction is limited to 50 percent of the W-2 wages paid by the taxpayer for the year. The definition of "production activities" is broad and includes construction activities, energy production, and the creation of computer software. (4dq)
Capital gains and losses are netted in the same manner as for an individual and net short-term capital gain, to the extent it exceeds net long-term capital loss, if any, is taxed at the corporation's regular tax rates. A corporation reporting a "net capital gain" (i.e., where net long-term capital gain exceeds net short-term capital loss) is taxed under one of two methods, depending upon which produces the lower tax:
1. Regular method. Net capital gain is included in gross income and taxed at the corporation's regular tax rates.
2. Alternative method. First, a tax on the corporation's taxable income, exclusive of "net capital gain," is calculated at the corporation's regular tax rates. Then a second tax on the "net capital gain" (or, if less, taxable income) for the year is calculated at the rate of 35%. The tax on income exclusive of net capital gain and the tax on net capital gain are added to arrive at the corporation's total tax. For certain gains from timber, the maximum rate is 15%. (5dq)
Alternative Minimum Tax
A corporate taxpayer must calculate its liability under the regular tax and a tentative minimum tax, then add to its regular tax so much of the tentative minimum tax as exceeds its regular tax. The amount added is the alternative minimum tax. (6dq)
To calculate its alternative minimum tax (AMT), a corporation first calculates its "alternative minimum taxable income" (AMTI). (7dq) Also, the corporation calculates its "adjusted current earnings" (ACE), increasing its AMTI by 75% of the amount by which ACE exceeds AMTI (or possibly reducing its AMTI by 75% of the amount by which AMTI exceeds ACE). (1dr) The tax itself is a flat 20% of AMTI. (2dr) Each corporation receives a $40,000 exemption; however, the exemption amount is reduced by 25% of the amount by which AMTI exceeds $150,000 (thus phasing out completely at $310,000). (3dr)
AMTI is regular taxable income determined with certain adjustments and increased by tax preferences. (4dr) Tax preferences for corporate taxpayers are the same as for other taxpayers. Adjustments to income include the following: (1) property is generally depreciated under a less accelerated or a straight line method over a longer period, except that a longer period is not required for property placed in service after 1998; (2) mining exploration and development costs are amortized over 10 years; (3) a percentage of completion method is required for long-term contracts; (4) net operating loss deductions are generally limited to 90% of AMTI (although some relief was available in 2001 and 2002); (5) certified pollution control facilities are depreciated under the alternative depreciation system except those that are placed in service after 1998, which will use the straight line method; and (6) the adjustment based on the corporation's adjusted current earnings (ACE). (5dr)
To calculate ACE, a corporation begins with AMTI (determined without regard to ACE or the AMT net operating loss) and makes additional adjustments. These adjustments include adding certain amounts of income that are includable in earnings and profits but not in AMTI (including income on life insurance policies and receipt of key person insurance death proceeds). The amount of any such income added to AMTI is reduced by any deductions that would have been allowed in calculating AMTI had the item been included in gross income. The corporation is generally not allowed a deduction for ACE purposes which are not allowed for earnings and profits purposes. However, certain dividends received by a corporation are allowed to be deducted. Generally, for property placed into service after 1989 but before 1994, the corporation must recalculate depreciation according to specified methods for ACE purposes. For ACE purposes, earnings and profits are adjusted further for certain purposes such as the treatment of intangible drilling costs, amortization of certain expenses, installment sales, and depletion. (6dr)
Application of the adjustments for adjusted current earnings with respect to life insurance is explained in Tax Facts on Insurance & Employee Benefits, volume 1, at Q 238.
A corporation subject to the AMT in one year may be allowed a minimum tax credit against regular tax liability in subsequent years. The credit is equal to the excess of the adjusted net minimum taxes imposed in prior years over the amount of minimum tax credits allowable in prior years. (7dr) However, the amount of the credit cannot be greater than the excess of the corporation's regular tax liability (reduced by certain credits such as certain business related credits and certain investment credits) over its tentative minimum tax. (8dr)
Certain small corporations are deemed to have a tentative minimum tax of zero and thus are exempt from the AMT. To qualify for the exemption, the corporation must meet a gross receipts test for the three previous taxable years. To meet the test, a corporation's average annual gross receipts for the three years must not exceed $7.5 million. For purposes of the gross receipts test, only tax years beginning after 1993 are taken into account. For a corporation not in existence for three full years, those years the corporation was in existence are substituted for the three years (with annualization of any short taxable year). To initially qualify for the exemption, the corporation must meet the three-year gross receipts test but with $5 million substituted for $7.5 million. Generally, a corporation will be exempt from the AMT in its first year of existence. (1ds)
If a corporation fails to maintain its small corporation status, it loses the exemption from the AMT. If that happens, certain adjustments used to determine the corporation's AMTI will be applied for only those transactions entered into or property placed in service in tax years beginning with the tax year in which the corporation ceases to be a small corporation and tax years thereafter. (2ds) A corporation exempt from the AMT because of the small corporation exemption may be limited in the amount of credit it may take for AMT paid in previous years. In computing the AMT credit, the corporation's regular tax liability (reduced by applicable credits) used to calculate the credit is reduced by 25% of the amount that such liability exceeds $25,000. (3ds)
Accumulated Earnings Tax
A corporation is subject to a penalty tax, in addition to the graduated tax, if, for the purpose of preventing the imposition of income tax upon its shareholders, it accumulates earnings instead of distributing them. (4ds) The tax is 15% of the corporation's accumulated taxable income. (5ds) Accumulated taxable income is taxable income for the year (after certain adjustments) less the federal income tax, dividends paid to stockholders (during the taxable year or within 2 1/2 months after the close of the taxable year), and the "accumulated earnings credit." (6ds)
The tax can be imposed only upon amounts accumulated beyond those required to meet the reasonable needs of the business since an accumulated earnings credit, generally equal to this amount, is allowed. A corporation must demonstrate a specific, definite and feasible plan for the use of the accumulated funds in order to avoid the tax. (7ds) The use of accumulated funds for the personal use of a shareholder and his family is evidence that the accumulation was to prevent the imposition of income tax upon its shareholders. (8ds) In deciding whether a family owned bank was subject to the accumulated earnings tax, the IRS took into account the regulatory scheme the bank was operating under to determine its reasonable needs. (9ds) Most corporations are allowed a minimum accumulated earnings credit equal to the amount by which $250,000 ($150,000 in the case of service corporations in health, law, engineering, architecture, accounting, actuarial science, performing arts or consulting) exceeds the accumulated earnings and profits of the corporation at the close of the preceding taxable year. (1dt) Consequently, an aggregate of $250,000 ($150,000 in the case of the above listed service corporations) may be accumulated for any purpose without danger of incurring the penalty tax.
Tax-exempt income is not included in the accumulated taxable income of the corporation but will be included in earnings and profits in determining whether there has been an accumulation beyond the reasonable needs of the business. (2dt) However, a distribution in redemption of stock to pay death taxes which is treated as a dividend does not qualify for the "dividends paid" deduction in computing accumulated taxable income (see Q 225, Q 228). (3dt)
The accumulated earnings tax applies to all C corporations, without regard to the number of shareholders in taxable years beginning after July 18, 1984. (4dt)
Personal Holding Company Tax
The personal holding company (PHC) tax is a second penalty tax designed to keep shareholders from avoiding personal income taxes on securities and other income-producing property placed in a corporation to avoid higher personal income tax rates. The PHC tax is 15% of the corporation's undistributed PHC income (taxable income adjusted to reflect its net economic income for the year, minus dividends distributed to shareholders), if it meets both the "stock ownership" and "PHC income" tests. (5dt)
A corporation meets the "stock ownership" test if more than 50% of the value of its stock is owned, directly or indirectly, by or for not more than 5 shareholders. (6dt) Certain stock owned by families, trusts, estates, partners, partnerships, and corporations may be attributed to individuals for purposes of this rule. (7dt)
A corporation meets the "PHC income" requirement if 60% or more of its adjusted ordinary gross income is PHC income, generally defined to include the following: (1) dividends, interest, royalties, and annuities; (2) rents; (3) mineral, oil, and gas royalties; (4) copyright royalties; (5) produced film rents (amounts derived from film properties acquired before substantial completion of the production); (6) compensation from use of corporate property by shareholders; (7) personal service contracts; and (8) income from estates and trusts. (8dt)
Professional Corporations and Associations
Organizations of physicians, lawyers, and other professional people organized under state professional corporation or association acts are generally treated as corporations for tax purposes. (9dt) However, to be treated as a corporation, a professional service organization must be both organized and operated as a corporation. (1du) Although professional corporations are generally treated as corporations for tax purposes, they are not generally taxed the same as regular C corporations. See Q 7561. Note that if a professional corporation has elected S corporation status, the shareholders will be treated as S corporation shareholders.
Although a professional corporation is recognized as a taxable entity separate and apart from the professional individual or individuals who form it, the IRS may under some circumstances reallocate income, deductions, credits, exclusions, or other allowances between the corporation and its owners in order to prevent evasion or avoidance of tax or to properly reflect the income of the parties. Under IRC Section 482, such reallocation may be made only where the individual owner operates a second business distinct from the business of the professional corporation; reallocation may not be made where the individual works exclusively for the professional corporation. (2du) However, note that the IRS has stated that it will not follow the Foglesong decision to the extent that it held that the two business requirement of IRC Section 482 is not satisfied where a controlling shareholder works exclusively for the controlled corporation. (3du) A professional corporation may also be subject to the special rules applicable to "personal service corporations," see Q 7561.
7560. How is an S corporation taxed?
An S corporation is one that elects to be treated, in general, as a passthrough entity, thus avoiding most tax at the corporate level. (4du) To be eligible to make the election, a corporation must meet certain requirements as to the kind and number of shareholders, classes of stock, and sources of income. An S corporation must be a domestic corporation with only a single class of stock and may have up to 100 shareholders (none of whom are nonresident aliens) who are individuals, estates, and certain trusts. An S corporation may not be an ineligible corporation. An ineligible corporation is one of the following: (1) a financial institution that uses the reserve method of accounting for bad debts; (2) an insurance company; (3) a corporation electing (under IRC Section 936) credits for certain tax attributable to income from Puerto Rico and other U.S. possessions; and (4) a current or former domestic international sales corporation (DISC). Qualified plans and certain charitable organizations may be S corporation shareholders. (5du)
Members of a family are treated as one shareholder. "Members of the family" are defined as "the common ancestor, lineal descendants of the common ancestor, and the spouses (or former spouses) of such lineal descendants or common ancestor." Generally, the common ancestor may not be more than six generations removed from the youngest generation of shareholders who would be considered members of the family. (6du)
Trusts that may be S corporation shareholders include: (1) a trust all of which is treated as owned by an individual who is a citizen or resident of the United States under the grantor trust rules (see Q 7558); (2) a trust that was described in (1) above immediately prior to the deemed owner's death and continues in existence after such death may continue to be an S corporation shareholder for up to two years after the owner's death; (3) a trust to which stock is transferred pursuant to a will may be an S corporation shareholder for up to two years after the date of the stock transfer; (4) a trust created primarily to exercise the voting power of stock transferred to it; (5) a qualified subchapter S trust (QSST); (6) an electing small business trust (ESBT); and (7) in the case of an S corporation that is a bank, an IRA or Roth IRA. (1dv)
A QSST is a trust that has only one current income beneficiary (who must be a citizen or resident of the U.S.), all income must be distributed currently, and corpus may not be distributed to anyone else during the life of such beneficiary. The income interest must terminate upon the earlier of the beneficiary's death or termination of the trust, and if the trust terminates during the lifetime of the income beneficiary, all trust assets must be distributed to that beneficiary. The beneficiary must make an election for the trust to be treated as a QSST. (2dv)
An ESBT is a trust in which all of the beneficiaries are individuals, estates, or charitable organizations. (3dv) Each potential current beneficiary of an ESBT is treated as a shareholder for purposes of the shareholder limitation. (4dv) A potential current beneficiary is generally, with respect to any period, someone who is entitled to, or in the discretion of any person may receive, a distribution of principal or interest of the trust. In addition, a person treated as an owner of a trust under the grantor trust rules (see Q 7558) is a potential current beneficiary. (5dv) If for any period there is no potential current beneficiary of an ESBT, the ESBT itself is treated as an S corporation shareholder. (6dv) Trusts exempt from income tax, QSSTs, charitable remainder annuity trusts, and charitable remainder unitrusts may not be ESBTs. An interest in an ESBT may not be obtained by purchase. IRC Sec. 1361(e). If any portion of a beneficiary's basis in the beneficiary's interest is determined under the cost basis rules, the interest was acquired by purchase. (7dv) An ESBT is taxed at the highest income tax rate under IRC Section 1(e) (35% in 2010). (8dv)
An S corporation may own a qualified subchapter S subsidiary (QSSS). A QSSS is a domestic corporation that is not an ineligible corporation, if 100% of its stock is owned by the parent S corporation and the parent S corporation elects to treat it as a QSSS. Except as provided in regulations, a QSSS is not treated as a separate corporation and its assets, liabilities, and items of income, deduction, and credit are treated as those of the parent S corporation. (9dv) Regulations provide special rules regarding the recognition of a QSSS as a separate entity for tax purposes if an S corporation or its QSSS is a bank. (10dv) A QSSS will also be treated as a separate corporation for purposes of employment taxes and certain excise taxes. (11dv)
If a QSSS ceases to meet the above requirements, it will be treated as a new corporation acquiring all assets and liabilities from the parent S corporation in exchange for its stock. If the corporation's status as a QSSS terminates, the corporation is generally prohibited from being a QSSS or an S corporation for five years. (1dw) Regulations provide that in certain cases following a termination of a corporation's QSSS election, the corporation may be allowed to elect QSSS or S corporation status without waiting five years if, immediately following the termination, the corporation is otherwise eligible to make an S corporation election or QSSS election, and the election is effective immediately following the termination of the QSSS election. Examples where this rule would apply include an S corporation selling all of its QSSS stock to another S corporation, or an S corporation distributing all of its QSSS stock to its shareholders and the former QSSS making an S election. (2dw)
A corporation will be treated as having one class of stock if all of its outstanding shares confer identical rights to distribution and liquidation proceeds. (3dw) However, "bona fide agreements to redeem or purchase stock at the time of death, disability or termination of employment" will be disregarded for purposes of the one-class rule unless a principal purpose of the arrangement is to circumvent the one-class rule. Similarly, bona fide buy-sell agreements will be disregarded unless a principal purpose of the arrangement is to circumvent the one-class rule and they establish a purchase price that is not substantially above or below the fair market value of the stock. Agreements that provide for a purchase price or redemption of stock at book value or a price between book value and fair market value will not be considered to establish a price that is substantially above or below fair market value. (4dw) Regulations provide that agreements triggered by divorce and forfeiture provisions that cause a share of stock to be substantially nonvested will be disregarded in determining whether a corporation's shares confer identical rights to distribution and liquidation proceeds. (5dw)
An S corporation is generally not subject to tax at the corporate level. (6dw) However, a tax is imposed at the corporate level under certain circumstances described below. When an S corporation disposes of property within 10 years after an election has been made, gain attributable to pre-election appreciation of the property (built in gain) is taxed at the corporate level to the extent such gain does not exceed the amount of taxable income imposed on the corporation if it were not an S corporation. (7dw) ARRA 2009 provides that, in the case of a taxable year beginning in 2009 or 2010, no tax is imposed on the built in gain if the 7th taxable year of the 10-year recognition period precedes such taxable year.
For S elections made after December 17, 1987, a corporation switching from a C corporation to an S corporation may also be required to recapture certain amounts at the corporate level in connection with goods previously inventoried under a LIFO method. (8dw)
In addition, a tax is imposed at the corporate level on excess "net passive income" of an S corporation (passive investment income reduced by certain expenses connected with the production of such income) but only if the corporation, at the end of the tax year, has accumulated earnings and profits (either carried over from a year in which it was a nonelecting corporation or due to an acquisition of a C corporation), and if passive investment income exceeds 25% of gross receipts. The rate is the highest corporate rate (currently 35%). (1dx) "Passive investment income" for this purpose is rents, royalties, dividends, interest, and annuities. (2dx) However, passive investment income does not include rents for the use of corporate property if the corporation also provides substantial services or incurs substantial cost in the rental business, (3dx) or interest on obligations acquired from the sale of a capital asset or the performance of services in the ordinary course of a trade or business of selling the property or performing the services. Also, passive investment income does not include gross receipts derived in the ordinary course of a trade or business of lending or financing; dealing in property; purchasing or discounting accounts receivable, notes, or installment obligations; or servicing mortgages. (4dx) Regulations provide that if an S corporation owns 80% or more of a C corporation, passive investment income does not include dividends from the C corporation to the extent the dividends are attributable to the earnings and profits of the C corporation derived from the active conduct of a trade or business. (5dx) If amounts are subject to tax both as built-in gain and as excess net passive income, an adjustment will be made in the amount taxed as passive income. (6dx)
Also, tax is imposed at the corporate level if investment credit attributable to years for which the corporation was not an S corporation is required to be recaptured. (7dx)
Furthermore, an S corporation may be required to make an accelerated tax payment on behalf of its shareholders, if the S corporation elects not to use a required taxable year. (8dx) The corporation is also subject to estimated tax requirements with respect to the tax on built in gain, the tax on excess net passive income and any tax attributable to recapture of investment credit. (9dx)
Like a partnership, an S corporation computes its taxable income similarly to an individual, except that certain personal and other deductions are allowed to a shareholder but not to the S corporation, and the corporation may elect to amortize organizational expenses. (10dx) Each shareholder then reports on his individual return his proportionate share of the corporation's items of income, loss, deductions and credits; these items retain their character on passthrough. (11dx) Certain items of income, loss, deduction or credit must be passed through as separate items because they may have an effect on each individual shareholder's tax liability. For example, net capital gains and losses pass through as such to be included with the shareholder's own net capital gain or loss. Any gains and losses on certain property used in a trade or business are passed through separately to be aggregated with the shareholder's other IRC Section 1231 gains and losses. (Gains passed through are reduced by any tax at the corporate level on gains.) Miscellaneous itemized deductions pass through to be combined with the individual's miscellaneous deductions for purposes of the 2% floor on such deductions. Charitable contributions pass through to shareholders separately subject to the individual shareholder's percentage limitations on deductibility. Tax exempt income passes through as such. Items involving determination of credits pass through separately. (1dy) Before passthrough, each item of passive investment income is reduced by its proportionate share of the tax at the corporate level on excess net passive investment income. (2dy) Items that do not need to be passed through separately are aggregated on the corporation's tax return and each shareholder reports his share of such nonseparately computed net income or loss on his individual return. (3dy) Items of income, deductions, and credits (whether or not separately stated) that flow through to the shareholder are subject to the "passive loss" rule (see Q 7913 through Q 7920) if the activity is passive with respect to the shareholder (see Q 7914). Apparently, items taxed at the corporate level are not subject to the passive loss rule unless the corporation is either closely held or a personal service corporation (see Q 7913).
Thus, whether amounts are distributed to them or not, shareholders are taxed on the corporation's taxable income. Shareholders take into account their shares of income, loss, deduction and credit on a per-share, per-day basis. (4dy) The S corporation income must also be included on a current basis by shareholders for purposes of the estimated tax provisions (see Q 7502). (5dy)
The Tax Court determined that when an S corporation shareholder files for bankruptcy, all the gains and losses for that year flowed through to the bankruptcy estate. The gains and losses should not be divided based on the time before the bankruptcy was filed. (6dy)
The basis of each shareholder's stock is increased by his share of items of separately stated income (including tax-exempt income), by his share of any nonseparately computed income, and by any excess of deductions for depletion over basis in property subject to depletion. (7dy) An S corporation shareholder may not increase his basis due to excluded discharge of indebtedness income. (8dy) The basis of each shareholder's stock is decreased (not below zero) by items of distributions from the corporation that are not includable in the income of the shareholder, separately stated loss and deductions and nonseparately computed loss, any expense of the corporation not deductible in computing taxable income and not properly chargeable to capital account, and any depletion deduction with respect to oil and gas property to the extent that the deduction does not exceed the shareholder's proportionate share of the property's adjusted basis. For tax years beginning after 2005 and before 2009, if an S corporation makes a charitable contribution of property, each shareholder's basis is reduced by the pro-rata share of their basis in the property. (9dy) If the aggregate of these amounts exceeds his basis in his stock, the excess reduces the shareholder's basis in any indebtedness of the corporation to him. (10dy) A shareholder may not take deductions and losses of the S corporation that, aggregated, exceed his basis in his S corporation stock plus his basis in any indebtedness of the corporation to him. (11dy) Such disallowed deductions and losses may be carried over. (12dy) In other words, he may not deduct in any tax year more than he has "at risk" in the corporation.
Generally, earnings of an S corporation are not treated as earnings and profits. A corporation may have accumulated earnings and profits for any year in which a valid election was not in effect or as the result of a corporate acquisition in which there is a carryover of earnings and profits under IRC Section 381. (1dz) Corporations that were S corporations before 1983 but were not S corporations in the first tax year after 1996 are able to eliminate earnings and profits that were accumulated before 1983 in their first tax year beginning after May 25, 2007. (2dz)
A distribution from an S corporation that does not have accumulated earnings and profits lowers the shareholder's basis in the corporation's stock. (3dz) Any excess is generally treated as gain. (4dz)
If the S corporation does have earnings and profits, distributions are treated as distributions by a corporation without earnings and profits, to the extent of the shareholder's share of an accumulated adjustment account (i.e., post-1982 gross receipts less deductible expenses, which have not been distributed). Any excess distribution is treated under the usual corporate rules. That is, it is a dividend up to the amount of the accumulated earnings and profits. Any excess is applied to reduce the shareholder's basis. Finally, any remainder is treated as a gain. (5dz) However, in any tax year, shareholders receiving the distribution may, if all agree, elect to have all distributions in the year treated first as dividends to the extent of earnings and profits and then as return of investment to the extent of adjusted basis and any excess as capital gain. (6dz) If the IRC Section 1368(e)(3) election is made, it will apply to all distributions made in the tax year. (7dz)
Certain distributions from an S corporation in redemption of stock receive sale/exchange treatment. (Generally, only gain or loss, if any, is recognized in a sale.) In general, redemptions that qualify for "exchange" treatment include redemptions not essentially equivalent to a dividend, substantially disproportionate redemptions of stock, complete redemptions of stock, certain partial liquidations, and redemptions of stock to pay estate taxes. (8dz)
If the S corporation distributes appreciated property to a shareholder, gain will be recognized to the corporation as if the property were sold at fair market value; the gain will pass through to shareholders like any other gain. (9dz)
The rules discussed above generally apply in tax years beginning after 1982. Nonetheless, certain casualty insurance companies and certain corporations with oil and gas production will continue to be taxed under the rules applicable to Subchapter S corporations prior to these rules. (10dz)
7561. How is a "personal service corporation" taxed?
Certain personal service corporations are taxed at a flat rate of 35%. (1ea) In effect, this means that the benefit of the graduated corporate income tax rates is not available. (See Appendix A). A personal service corporation for this purpose is a corporation substantially all of the activities of which involve the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting. In addition, substantially all of the stock must be owned directly by employees, retired employees, or their estates or indirectly through partnerships, S corporations, or qualified personal service corporations. (2ea)
IRC Section 269A permits the IRS to reallocate income, deductions, credits, exclusions, and other allowances (to the extent necessary to prevent avoidance or evasion of federal income tax) between a personal service corporation (PSC) and its employee-owners if the corporation is formed for the principal purpose of securing tax benefits for its employee-owners (i.e., more than 10% shareholder-employees after application of attribution rules) and substantially all of its services are performed for a single other entity. For purposes of IRC Section 269A, a personal service corporation is a corporation the principal activity of which is the performance of personal services and such services are substantially performed by the employee-owners. (3ea) A professional basketball player was considered to be an employee of an NBA team, not his personal service corporation, and all compensation from the team was taxable to him individually, even though his PSC had entered into a contract with the team for his personal services. (4ea)
In addition, special rules apply to the tax year that may be used by a personal service corporation (as defined for purposes of IRC Section 269A, except that all owner-employees are included and broader attribution rules apply). (5ea)
7562. What is a limited liability company and how is it taxed?
A limited liability company (LLC) is a statutory business entity that may be formed by at least two members (although one-member LLCs are permitted in some states) by drafting articles of organization and filing them with the appropriate state agency. There are no provisions for LLCs in the Code, but regulations provide rules to determine how a business entity is classified for tax purposes. A business entity is any entity recognized for federal tax purposes that is not a trust. Unlike an S corporation an LLC has no restrictions on the number or types of owners and multiple classes of ownership are generally permitted. If the LLC is treated as a partnership, it combines the liability shield of a corporation with the tax advantages of a partnership.
An LLC may be treated as either a corporation (see Q 7559), partnership (see Q 7563), or sole proprietorship for federal income tax purposes. A sole proprietor and his business are one and the same for tax purposes. An eligible entity (a business entity not subject to automatic classification as a corporation) may elect corporate taxation by filing an entity classification form; otherwise it will be taxed as either a partnership or sole proprietorship depending upon how many owners are involved.
A separate entity must exist for tax purposes, in that its participants must engage in a business for profit. Trusts are not considered business entities. (1eb) Certain entities, such as corporations organized under a federal or state statute, insurance companies, joint stock companies, and organizations engaged in banking activities, are automatically classified as corporations for federal tax purposes. A business entity with only one owner will be considered a corporation or a sole proprietorship. In order to be classified as a partnership, the entity must have at least two owners. (2eb) If a newly-formed domestic eligible entity with more than one owner does not elect to be taxed as a corporation, it will be classified as a partnership. Likewise, if a newly-formed single-member eligible entity does not elect to be taxed as a corporation, it will be taxed as a sole proprietorship. Under most circumstances, a corporation in existence on January 1, 1997 does not need to file an election in order to retain its corporate status. (3eb)
If a business entity elects to change its classification, rules are provided for how the change is treated for tax purposes. (4eb)
Revenue Ruling 95-37 (5eb) provides that a partnership converting to a domestic LLC will be treated as a partnership-to-partnership conversion (and therefore be "tax free") provided that the LLC is classified as a partnership for federal tax purposes. The partnership will not be considered terminated under IRC Section 708(b) upon its conversion to an LLC so long as the business of the partnership is continued after the conversion. Further, there will be no gain or loss recognized on the transfer of assets and liabilities so long as each partner's percentage of profits, losses and capital remains the same after the conversion. The same is true for a limited partnership converting to an LLC. (6eb)
An LLC formed by two S corporations was classified as a partnership for federal tax purposes. (7eb) An S corporation may merge into an LLC without adverse tax consequences provided the LLC would not be treated as an investment company under IRC Section 351 and the S corporation would not realize a net decrease in liabilities exceeding its basis in the transferred assets pursuant to Treasury Regulation Section 1.752 1(f). Neither the S corporation nor the LLC would incur gain or loss upon the contribution of assets by the S corporation to the LLC in exchange for interests therein pursuant to IRC Section 721. (8eb) A corporation will retain its S election when it transfers all assets to an LLC, which is classified as a corporation for federal tax purposes due to a preponderance of corporate characteristics (see below), provided the transfer qualifies as a reorganization under IRC Section 368(a)(1)(F) and the LLC meets the requirements of an S corporation under IRC Section 1361. (9eb)
An LLC that was in existence prior to January 1, 1997, may continue under its previous claimed classification if (1) it had a reasonable basis for the classification; (2) the entity and its members recognized the consequences of any change in classification within the sixty months prior to January 1, 1997; and (3) neither the entity nor its members had been notified that the classification was under examination by the IRS. (10eb)
Prior to January 1, 1997, whether an LLC was treated as a corporation or partnership for federal income tax purposes depended on the existence or nonexistence of a preponderance of six corporate characteristics: (1) associates; (2) an objective to carry on a business and divide the gains from it; (3) limited liability; (4) free transferability of interests; (5) continuity of life; and, (6) centralized management. (1ec) Characteristics (1) and (2) above are common to both corporations and partnerships and were generally discounted when determining whether an organization was treated as a corporation or partnership. (2ec) These former regulations provided an example of a business entity that possessed the characteristics of numbers (1), (2), (4) and (6) above, noting that since numbers (1) and (2) were common to both corporations and partnerships, these did not receive any significant consideration. The business entity did not possess characteristics (3) and (5) above and, accordingly, was labeled a partnership. (3ec)
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|Title Annotation:||TAX FACTS ON INVESTMENTS: Part 3|
|Publication:||Tax Facts on Investments|
|Date:||Jan 1, 2011|
|Previous Article:||Part I: Federal income taxation.|
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