Lender and borrower must treat the transaction as if:
The borrower paid the lender the difference between the applicable federal interest rate (compounded semiannually) and the actual interest paid (this difference is called imputed interest).
The lender then returned the imputed interest to the borrower.
The deemed “payment” of the imputed interest in these transactions is treated as interest income to the lender and interest expense to the borrower
The deductibility of the interest expense for the borrower depends on how she used the loan proceeds (for business, investment, or personal purposes).
General rule: The relationship between the transacting parties governs the taxability
Discharge of indebtedness
Tax treatment when lender forgives debt à TP includes forgiven debt as income
Exception: insolvent before or after forgiveness
CHAPTER 12 (7), PART 1
Investments Overview (pp. 7-2)
After-tax returns from investments depend on:
Before-tax rate of return (ATR=PTR*(1-TR)).
The timing of tax payments or tax benefits (i.e., when investment income is taxed or when investment losses are deducted). We will discuss this more in Ch. 3.
The tax rate applied to investment income (i.e., the rate at which investment income is taxed or deductible losses generate tax savings).
Chapter 12 (7) outlines: 1) when various forms of investment income/losses are taxed and 2) the rates at which investment income/losses are taxed.
Portfolio Income: Interest and Dividends (pp. 7-2 through 7-7)
If a TP wants a steady stream of cash flows from her investment, what types of investments will she purchase?
Interest from debt
Bonds, savings accounts
Stocks, mutual funds
When do TPs recognize interest income from interest-paying investments?
How would a TP compute a bond’s:
After-tax rate of return =
After-tax future value =
Note: When computing after-tax future value here, r = ATR
Note: For bonds, the formulas assume that the bonds are purchased at face value. Special rules apply for determining the timing and amount of interest from bonds when there is a bond discount or a bond premium (discussed below).
Corporate and U.S. Treasury Bonds
How often do Treasury bonds and Treasury notes pay interest?
How often do corporate bonds pay interest?
What are the two primary differences between Treasury and corporate bonds?
When is interest income from corporate and U.S. Treasury bonds included in income?
When the bond is issued at face value:
When the bond is issued at a discount (subject to OID rules):
TP will include in income:
Note: This is particularly relevant for zero-coupon bonds.
When the bond was issued at a premium:
TP will include in income:
When the bond was purchased in the secondary market at a discount:
Interest payments are included in income as they are received.
When the bond matures, the taxpayer treats the market discount as interest income.
If the bond is sold prior to maturity, a ratable amount of the market discount (based on the number of days the bond is held over the number of days until maturity when the bond is purchased), called the accrued market discount, is treated as interest income on the date of sale.
If the bond was purchased in the secondary market at a premium:
Same as a bond originally issued at a premium.
TP will include in income:
Interest payments actually received during the year and
The current year amortization of the premium (if TP elects to amortize the premium).
Example 13: At the beginning of his current tax year Brienne invests $12,000 in original issue U.S. Treasury bonds with a $10,000 face value that mature in exactly 10 years. Brienne receives $700 in interest (i.e., stated annual interest rate of 7%; $350 every six months) from the Treasury bonds during the current year and the yield to maturity on the bonds is 5 percent.
How much interest income will Brienne report this year if she elects to amortize the bond premium?
How much interest will she report this year if she does not elect to amortize the bond premium?
U.S. Savings Bonds
How often does the bond pay interest?
When is the interest income recognized? What is the amount of interest income?
Recognition occurs à
Interest income =
Exception to recognition of income:
Summary – Timing of Interest Payments and Taxes (Exhibit 7-1)
Interest Received Annually and Taxed Annually
Interest Received at Sale or Maturity and Taxed at Sale or Maturity
Interest Received at Sale or Maturity but Taxed Annually
When are dividends taxed?
What tax rate applies to dividends?
Qualified dividends à
Other dividends à
What requirements must be met for a dividend to be a “qualified dividend?”
Example 14: Sansa invests $10,000 in preferred shares with a dividend rate of 6%. The dividends are qualified dividends and her MTR is 35%.
Assuming Sansa reinvests the after-tax dividend income in additional preferred shares, what is her accumulated balance in preferred shares after 3 years?
What is Sansa’s after-tax return in each year?
Assuming Sansa withdraws the after-tax dividend income each year, how much dividend income will she have earned after 3 years?
Read the Capital Gains Section (pp. 7-7 to 7-9) for additional info on Capital Gains
CONTINUE WITH CH. 5
Exclusion Provisions(pp. 5-28 through 5-37)
Why does Congress allow exclusions and deferrals?
Subsidize or encourage behavior
To be Fair
What are some common exclusions? Discuss each below.
Muni bond interest
Gain on sale of personal residence
Excludes up to $250,000 ($500,000 if MFJ); remaining gain taxed as Long term capital gains at preferential rates
Must meet ownership test and use test
ownership test à must have owned for two of last five years
use test à primary residence for two of the last five years
if married, either can meet ownership, both must meet use
See Exhibit 5-4 for examples.
What are common educational-related exclusions?
To be excluded à must pay for required materials or tuition for courses
If scholarships > tuition, fees, books, etc. àexcess funds taxed as income
If recipient is required to perform services in exchange for scholarship à
Treated as income
Exception for: athletic scholarships, room and board only excluded if scholarship can’t be canceled for not participating
529 plans and Coverdell
Investment savings accounts for college, must be used to pay for school
Interest income earned from Series EE Bonds
Must be spent on qualifying expenses
Can be phased out
What exclusions mitigate double taxation?
Gifts and inheritances
Gifts (definition): wealth transfers during life
Inheritances (definition): after death
Tax treatment: gift and estate tax, not income tax
Life insurance proceeds
Subject to estate tax, not income tax
Foreign earned income
Income earned in a foreign country is generally taxed in that foreign country
To prevent double taxation (by foreign country and the U.S.), the tax law allows:
A maximum exclusion of $101,300
An itemized deduction for foreign taxes paid (see Ch. 7), or
A foreign tax credit for foreign taxes paid (see Ch. 8)
What requirements must be met to qualify for the foreign earned income exclusion?
Considered to be a resident of the foreign country, or
Live in the foreign country for 330 days in a consecutive 12-month period
Exclusion computed on a daily This means that the maximum exclusion is reduced pro rata for each day during the calendar year the taxpayer is not considered a resident of the country or does not actually live in the foreign country
TP can also exclude housing costs provided by the employer that exceed 16% of foreign-earned income exclusion ($16,208 in 2016). Maximum exclusion is 14% of foreign-earned income exclusion ($14,182 in 2016).
Also subject to proration.
What are some common sickness and injury-related exclusions?
Received when unable to work
Payment associated with personal injury or sickness
Compensatory lawsuit payments
Damages paid for emotional distress that are associated with a physical injury are excluded; Other payments due to emotional distress are taxable
Punitive damages (payments made to punish the person doing the harm) are taxable
Health Care Reimbursement
Reimbursed from employer for med bills = non taxable
If TP pays the cost of the insurance, using money that has already been taxed à
Cost of policy and benefits excluded from gross income
If TP’s employer purchases the insurance and:
Premiums paid by employer are treated as nontaxable fringe benefits à
Disability benefits are included in gross income
Noncash benefits provided to employees
Payments on your behalf by employer, usually taxable
Nontaxable Fringe Benefits (Exclusions)
See Exhibit 12-2
Group term life insurance
Employees may exclude:
Premiums on policies up to $50,000 of insurance (Not benefits)
Health and accident insurance benefits
Premium payment by employer: excluded
Reimbursements of covered expenses: excluded
Meals/lodging for convienice of employer
Requirements for exclusion:
On employer premisis
For convenience of employer
Maximum exclusion amount: $5250
Dependent care benefits
Exclude up to $5,000
Generally, child must be < 13
Exclude value of services that generate no substantial additional costs to employer
Example: empty seat on plane for airline employee
Qualified employee discounts (imputed)
No more than 20 percent discount
Additional non-taxable fringe benefits
De Minimis (basically, too small to be worth tracking)
Qualified transportation fringe benefits: cost of transport/parking up to $255
Qualified moving expense reimbursement: if the employer reimburses expenses that are otherwise deductible (we will discuss in Ch. 6)
Flexible Spending Accounts (FSA)
Used to pay for: medical expenses
Employee or employer contributions
May contribute up to:2550
If not used within the plan year: money forfeited, some employers allow use within first 2.5 months of the year
Deferrals (pp 5-38 to 5-42)
Defer income to later period rather than excluding income permanently
Skim these pages, focus on Ch. 13
We will discuss additional deferrals in Chapter 11
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