Final Exam Review Notes

Stock Options

• Incentive Stock Options (ISOs) and Non-Qualified Stock Options
  • Grant Date: Important for both types.
  • Definitions: Referenced in notes from 04/21 and 04/22.
• Incentive Stock Options (ISOs)
  • No corporate deduction is available either at the grant date or the exercise date.
  • No compensation income is recognized by the employee.
  • For financial reporting purposes, the corporation recognizes expense over the vesting period (from grant date to vesting).
  • Valuation of options often involves the Black-Scholes formula, used to determine the option's value.
  • Schedule M-1 Adjustment: Arises because the compensation expense is debited for financial statement purposes (e.g., 1 million each year), but there's no corresponding tax deduction.
    • Debit Schedule M-1 and credit compensation expense.
    • This is an unfavorable difference.
• Non-Qualified Stock Options
  • The corporation receives a tax deduction.
  • The employee recognizes compensation income.
  • The market price is likely 10 per share, resulting in a zero event on the grant date.
  • Difference between market price and exercise price is taxable income to the employee.

Schedule M Differences

• Book charge recognition as options vest.
  • Unfavorable schedule M.
• Tax deduction on the exercise of a non-qual.
  • Favorable schedule M.

Popularity of Stock Options

• Encourages employee retention.
• Aligns employee interests with shareholder interests.

Exam Preparation Strategy

• Step-by-Step Approach: Vital for exam success.
  • Avoid skipping steps to prevent mistakes.
• IRAC Method: Issue, Rule, Application, Conclusion.
  • Issue: Composed of facts and circumstances (what you know) and the question (what you need to find out).
  • Rules: Identify rules related to the facts, circumstances, and questions from the study guide.
• Discipline: Critical for smart individuals to carefully go through each step.

Importance of Step-by-Step in the Profession

• Essential skill for accountants.
• Accountants must be detail-oriented (in the weeds) and understand the big picture.
• Mastery of step-by-step enables accountants to see the big picture over time.

Exam Details

• Non-programmable calculators are allowed.
• Communication devices are prohibited.
• Ask questions if needed; clarifications may be announced to the class.

Scantron Instructions

• Fill out Scantrons carefully, including the ID number.
• Avoid multiple answers per question.
• Mark answers on the test paper in small letters for personal comparison, but avoid misleading others.

Cheating

• Disserves the individual due to curving.
• Honor code is in effect.

Exam Coverage

• Cumulative exam.
• Expect 40 to 50 questions.
• Duration: 110 minutes.
• Big Picture Questions: Possible questions from exams one and two.
  • Examples: IRAC, do the right thing, clear reflection of income, invasion vs. avoidance.
• Module Coverage: Primarily covers modules from 10 onwards, with some building blocks from earlier modules.

Key Topics and Concepts

• Section 197: Amortization.
• Module 13: Differences between book taxes, tax expense, and the income statement for financial statement purposes.
• Balance Sheet: Deferred tax assets and liabilities (current vs. non-current based on related asset).
• ASC 740: More likely than not (50+%) standard for financial reporting; substantial authority standard for tax returns.
• Tax Return Positions: All positions must have substantial authority.
• Substantial Authority: Found in Treasury Regulations under section 6662-4(d)(3).
• Realistic Possibility: 3% chance of prevailing if challenged, per the Statements on Standards for Tax Services (SSTSs) if no other standard applies.
• Reasonable Basis: 15-20% chance of surviving audit to the highest level of appeal, often used with disclosure.
• Uncertain Tax Return Positions: Differences between standards create these, requiring reconciliation and disclosure.
• ASC 740 Disclosures: Effective rate calculations, sources of temporary and permanent differences, and the effect of state taxes on deferred taxes and effective rate.
• Module 11 Model: Amount realized - adjusted basis = gain realized +/ - deferrals/suspensions/exclusions = gain recognized.
• Home Sale Exclusion: Important to remember.
• Gain or Loss on Disposition: A reoccurring topic in multiple problems.
• Amount Realized: You can expect multiple problems.
• Holding Period: Short term and long term.
• Tax Treatment: Capital gains and capital losses for corporate and non-corporate taxpayers (Section 291, 20% rule).
• Recapture: Sections 1245 and 1250.
• Installment Sales: Section 453, including mixing with 1245/1250 recapture.
• Planning Tips: Be prepared to evaluate planning opportunities.
• Section 1231: Applies to Businesses.
• Section 1221: Used in trading businesses.
  • Accounts receivable, Inventories, supplies and depreciable property.
• Ordinary Income: Depreciation recapture at ordinary rates.
  • If gain is less than accumulated depreciation, it will be recaptured at ordinary rates.
• Section 1250 Property: Three pieces to it.
  • Placed in service between 1980 and 1987: Accelerated depreciation on real estate recaptured at ordinary rates.
  • Remaining depreciation is unrecaptured 1250 depreciation, typically taxed at a maximum rate of 25%.
    • The lecture example shows there is a case where it was at 24%, the income bracket reached 32%, but then it was capped at 25% instead.
• Nonrecognition Transactions
  • Like Kind Exchanges: Treatment of liabilities.
  • Section 351 Transactions: Tax deferred exchange of property for stock (taxed to the extent liabilities exceed adjusted basis).
  • Involuntary Conversions: Section 1033, tax deferred if property is replaced within two years.
  • Sale of principal Residence

Other Key Topics (Module 12)

• Entity Choice: Four drivers for each entity.
• Entity Types
  • Sole Proprietorship.
  • Partnerships: General, limited, and limited liability (LLP).
  • Corporations: Separate legal person.
  • S Corporations: Taxed like a partnership but still a separate legal person.
  • Limited Liability Companies (LLC): Separate person that chooses its tax treatment (sole prop, corp., s-corp).
• Piercing the Corporate Veil: Occurs when separate entities like LLCs and corporations are not set up/operated correctly, negating liability limits.
• While not legally required, you must have a partnership agreement.
• You must know basis in the courts.
• Three fifty one transactions (problems with boot or liabilities transferred)
• Book tax differences between ASC seven forty and schedule m one (conceptually, schedule m one extends the income statement).
• Schedule m one provides differences between taxable income and net income from ASC 740.
• Section 179: Getting most of your depreciation expense in year one, this makes for a bit of a financing tool.

Additional Tips

• Economic benefit of bonus depreciation.
• Capital formation.
• Job Creation.
• Reelection.
• Always study your section 162.