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Lecture 16

ACCT40610 Lecture Notes - Lecture 16: Ordinary Income, Tax Bracket, Mutual FundPremium

5 pages65 viewsFall 2017

Department
Accountancy
Course Code
ACCT40610
Professor
O' Brien
Lecture
16

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Chapter 16
Business activity.
o Taxpayer commits time and talent on regular basis.
o Profit is partially attributable to personal involvement.
Investment activity.
o Taxpayer is owner of income-producing property.
o Profit is primarily due to invested capital.
o Taxpayer who devotes substantial time to managing income-
producing property is still engaging in an investment activity.
Securities include:
o Common and preferred stock.
o Savings accounts, CDs, notes, and bonds.
Individuals can own financial assets directly or indirectly through a mutual
fund.
Mutual fund diversified portfolio of securities managed by regulated
investment company (RIC).
o Most popular investment vehicle on the market.
Return on investment in financial assets includes:
o Dividends.
Qualified dividends taxed at preferential rates.
0%, 15%, or 20%.
0% for bottom two tax brackets
20% for top tax bracket
15% for all other brackets
o Interest.
o Capital gain on sale of investment assets.
Distributions from mutual funds are often described as dividends.
o Distributions are a flow through of income generated by fund’s
investment portfolio.
Qualified dividends.
Interest.
Net long-term capital gain.
Interest on savings accounts, CDs, and corporate bonds is ordinary income.
Municipal bond interest income is exempt from federal tax.
o If bond is a private activity bond, interest is an AMT preference.
Interest on U.S. debt (Treasury bills, notes, bonds) is subject to federal tax
but exempt from state tax.
Cash basis investors who purchase bonds at a market discount recognize the
discount as ordinary income when the bond is redeemed or sold.
Cash basis investors who purchase newly issued corporate bonds with
original issue discount (OID) must amortize the discount over the life of the
bond.
o Amortized discount is recognized as ordinary income.
Life insurance proceeds are excluded from beneficiary’s gross income.
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o Certain life insurance policies build up cash surrender value (CSV)
over time.
Annual increase in value (inside buildup) is not recognized as
income by owner.
If owner liquidates the policy, excess of CSV over premiums
paid is ordinary income.
Owners of annuity contracts don’t recognize annual increase in value (inside
buildup) as income.
Periodic annuity payment.
o Portion representing return of investment is excluded from gross
income.
Excluded portion is based on exclusion ratio.
Exclusion ratio = owner’s investment/expected return.
o Portion representing distribution of accumulated earnings
is taxed as ordinary income.
Gain or loss is realized on disposition of security.
Basis issues.
o Reinvested dividends increase basis; nontaxable distributions reduce
basis.
o Basis of shares sold determined under:
specific identification method.
FIFO method.
average basis method.
Worthless securities are treated as sold on the last day of the year for $0.
o Loss is capital loss.
Nonbusiness bad debts (e.g., personal loans) are treated as short-term capital
loss.
General rule: exchanges of securities
are taxable events (e.g. Intel for Nike).
Nontaxable if:
o Exchange of stocks issued by the same corporation.
o Exchange pursuant to corporate reorganization.
Basis of original stock becomes basis of new stock.
Sale or exchange of capital asset held for one year or less results in short-
term gain or loss.
o Short-term gains and losses are netted to one number.
Sale or exchange of capital asset held for more than one year results in long-
term gain or loss.
o Separate 28% rate category for long-term gain or loss on sale of
collectibles and qualified small business stock.
o Long-term gains and losses netted to one number.
Net capital gain may consist of short-term gain, long-term gain, or both.
o Short-term capital gain taxed at ordinary rate.
o Long-term gain taxed at preferential rate.
28% rate gain taxed at a maximum 28% rate.
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