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Chpt 11 Income tax Guide

Tax Shelters Problem
Ways to avoid taxes, offset income against deduction from other sources. Taxpayers
intentionally invested in activities that were designated to produce losses
At risk limitation: amount loss is amount invested (the amount of cash and the
adjusted basis of property contributed to the activity by the taxpayer; amounts
borrowed for use in the activity for which the taxpayer is personally liable or has
pledged as security property not used in the activity). Applies to individual and
closely held corporation (S corporation and partnerships). The amount can be
increase each year by the taxpayer’s share of income and is decreased by the
taxpayer share of deductible income.
Passive Loss: Passive losses offset passive income. Requires taxpayers to segregate
income and losses in: active, portfolio and passive.
Active income: Wages, salary, commissions, bonuses, and other payments for
services rendered by the taxpayer; profit from a trade or business in which the
taxpayer is a material participant; gain on the sale or other disposition of assets
used in an active trade or business; income from intangible property if the
taxpayer’s personal efforts significantly contributed to the creation of the property.
Portfolio income: Interest, dividends, annuities, and royalties not derived in the
ordinary course of a trade or business; gain or loss from the disposition of property
that produces portfolio income or is held for investment purposes.
Passive: Any trade or business or income-producing activity in which the taxpayer
does not materially participate; subject to certain exceptions, all rental activities,
whether the taxpayer materially participates or not.
General impact: Losses or expenses generated by passive activities can be
deducted to the extent of income from all of the taxpayer’s passive activities. Any
excess may be carry forward to future years to offset passive income generated in
those years. When taxpayer disposes of his interest in the activity, all current
suspended losses related to the activities may offset active and portfolio income.
Carryover of suspended losses: taxpayers are able to deduct passive losses from
other passive activities and then allocated the net losses among the activities that
had losses.
Suspended losses are carryover indefinably and are offset in the future first against
any passive income, and passive income from other activites.
Passive credits: can be utilize only against regular tax attributable to passive
income. Passive credit arise from comparing the tax on all income (including passive
income) with tax on income excluding passive income

Treated as a personal service corporation if more than 10 percent of the stock value is held by employee owners. one primary purpose is to avoid passive loss limitation. Passive activity Changes to Active If passive becomes active activity. Personal Service Corporation: to prevent taxpayers from sheltering personal services income by creating personal service corporation and acquiring passive activities at the corporate level. subject to certain exceptions pertaining to real estate (discussed later). . such services are substantially performed by employee owners. The suspended loss can be carry over to the next years. When activity is dispose of in taxable transaction and loss is recognized the passive credit is lost forever. a taxpayer can treat one or more trade or business activities or rental activities as a single activity if those activities form an appropriate economic unit for measuring gain or loss. Closely Held C Corporation: if at any time during he taxable year more than 50% if the value of its outstanging stock is owned directly or indirectly by five or fewer individuals. Regrouping of activities: taxpayers can group activities appropriately.Carryover of passive Credits: carry forward indefinitely like suspended passive losses. and. Special grouping rules for rental activities: a rental activity may be grouped with a trade or business activity only if one activity is insubstantial in relation to the other. In general. all rental activities. Taxpayers subject to passive Loss Rules Applies to individuals. They activity must continue to be the same activity. may use passive losses to offset active income but not portfolio income Working with the definition of Passive Activities: Any trade or business or incomeproducing activity in which the taxpayer does not materially participate. if not it me be regrouped. suspended losses are allowed to the extent of income from the now active business. and closely held C Corporation (flows through the owners). To determine if it is a personal service corporation is based on: the principal activity is the performance of personal services. C corp. Credit are allowed on disposition only when there is sufficient tax on passive income to absorb them. personal service corporation. the IRS can regroup when taxpayer’s grouping fail to reflect one or more appropriate economic units. estates. trusts. and . Identification of Activity: Taxpayers who are involved in complex business operations need to determine whether a given segment of their overall business operations constitutes a separate activity or is to be treated as part of a single activity.

test based on prior participation and test based on facts and circumstances. Special Passive activities Rules for Real Estate Activities: allow real estate rental losses to offset active or portfolio income. It does not include work if it is of a type not usually done by owners and if one of its principal purposes is to avoid the passive losses or credit limitations. A general partner may qualify as a material participant by meeting any of the seven tests. It should be done constantly. continuous. any loss from that activity is treated as an active loss that can offset active income or portfolio income. Material Participation: taxpayer actively participated in a no rental trade or business activity. as well as other provisions relating to the measurement of taxable income. Participation Defined: work done in activities that one owes. Material participation is achieved by meeting any one of these tests. own 10 percent or more . 5. must meet: Actively participate in the real estate rental activity. Material participant is one who has “a significant nontax economic profit motive” for taking on activities and selects them for their economic value. Reviewing reports in a non-managerial capacity is not counted in applying the material participation test. or 6. Rental Actives defined: all treated as passive activity. Material Participations in a Real Property Rental Trade or Business: taxpayers must meet: more than half of the personal services that the taxpayer performs in trades or businesses are performed in real property trades or businesses in which the taxpayer materially participates. subject to passive activity loss even if the taxpayer is material participant involved. unless the employee performing services owns more than a 5% interest in the employer. the taxpayer performs more than 750 hours of services in these real property trades or businesses as a material participant. Interaction of at-risk and Passive loss limits: the determination of whether a loss is suspended under the passive loss rules is made after application of the at-risk rules.000 of losses from real estate rental activities against active and portfolio income. S 469 requires a taxpayer to participate on a regular. Real Estate Rental Activities: real estate professionals can deduct up to 25. and substantial basis to be a material participant.and taxpayers generally may not treat an activity involving the rental of real property and an activity involving the rental of personal property as a single activity. Seven Test divided in three categories: Test based on current participation. Limited Partners: limited partner is not considered a material participant unless qualifies under test 1. Exception to the rule is based on the presumption that a person who rents property for is required to provide significant service to the customer—involved in service business. Participation of owners spouse counts as participation by the owner. service provided for employees not count. Hours working for spouse does not count toward 750 hours.

Not materialize if it is given to charity organization Installment sale of a Passive Activity: installment sale of a taxpayer’s entire interest in a passive activity triggers recognition of the suspended sale. No limits in the length of the carryover period. Investment interest Limitation Limited imposed: investment interest interest paid on debt borrowed for the purposed of purchasing or continuing to hold investment property\. and substantial involvement in operations. Suspended losses become nondeductible to both the donor and the done. of the allowed step-up basis (increase because of fair value). deciding on rental terms. if not losses are lost. It is limited to the lesser of the investment interest paid or net investment income. Investment income and expenses: serves as the ceiling on the deductible of investment interest.(in value) of all interests in the activity during the entire taxable year (or shorter period during which the taxpayer held an interest in the activity). The difference between active participation and material participation is that the former can be satisfied without regular. annuities. suspended losses are allowed (to the decendant) to the extendt they exceed the amount. Investment income includes gross income from interest. continuous. Disposition of a Passive activity by a Gift: the suspended losses are added to the bases of the property. excess of investment income over investment expenses. It can be involved in management decision such as approving new tenants. Losses are allowed as payment received each year. and approving capital expenditure. Disposition of Passive interest Disposition of a passive Activity at death: transfer because of taxpayer death. Computation of Allowable deduction: the amount invested interest disallowed is carried over to future years. if any. Grater depreciation deduction result because of the increase on the property’s basis. . and royalties in the ordinary course of he trade or business—not passive activity included.