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Understanding The Trump Individual Income Tax Return From a Forensic Accountants’ Perspective

Posted in Forensic Accounting, on Mar 2017, By: Mark S. Gottlieb

Unless you were buried alive during this week’s snowstorm, you probably heard that Donald Trump’s 2005 individual income tax return has been disclosed.  To date, no one has taken responsibility for its discovery, except for the journalist who found it on his doorstep.  Many of the talking heads and late night comedians have discussed and joked about the return, or more accurately its first two pages.  Few, if any, have discussed what the return partially states or even means in regards to President Trump’s reported income and/or assets.

 

Granted, this information is incomplete and may pose more questions than answers.  However, this exercise is not uncommon for a forensic accountant engaged in analyzing an individual income tax return in a business dispute or matrimonial action.  This discussion is non-partisan.  Truthfully, the subject matter could be about anyone.  But you are reading this blog post because it applies to the current President of the United States.

Let this be a primer for those of you that are commercial or family law litigators.

Form 1040 is the long form federal individual income tax return filed annually by individuals. You can obtain a full copy of this (blank) form and its instructions here. This particular filing is for the year 2005, which is 12 years prior to Mr. Trump becoming President.  It is fair to say that if President Trump voluntarily submitted his returns for public review, he probably would not have provided a return filed so many years ago.

Here is what we can ascertain from the pages made public this week.

Filing Status & Dependents

1.     Donald Trump and Melanija Knavs (hereafter, “The Trumps”) filed as married filing jointly, which is the most favorable filing status available.  Married filing separate is a higher rate, which would have most likely increased the parties’ income tax liability significantly.

2.     Their son, Baron, had not been born.  Mr. Trump’s three oldest children were obviously emancipated by 2005, and his remaining minor child, Tiffany, was not taken as an exemption on his return.  We can assume that his former wife and Tiffany’s mother, Marla Maples, took Tiffany as a personal exemption.

3.     According to the Internal Revenue Code, you generally can take an exemption for each of your dependents. A dependent is your qualifying child or qualifying relative. If you are entitled to claim an exemption for a dependent, that dependent can’t claim a personal exemption on his or her own tax return.

4.     A personal exemption deduction is reduced or phased out if the taxpayer’s adjusted gross income is more than a certain amount.  It is fair to say that Mr. Trump would not have received any tax benefit even if he had taken Tiffany as a dependent.

Total Income

5.     Lines 7 through 21 provide the construction of “Total Income” of the taxpayer(s).  In this instance, Mr. Trump’s total reported income was slightly less than $50 million, comprised of:

a.     Wages

b.     Interest

c.     Dividends

d.     Business income as a sole proprietor

e.     Net capital gains

f.      Net rental real estate income or income from pass-through entities

g.     Losses reported as “other”

Wages

6.     The Trump’s reported wages of slightly less than $1 million.  Wages are paid to employees and subject to withholding taxes of such as FICA, Social Security, Federal, New York State, and New York City.  (New York State and City taxes are assumed since his address has been listed as Trump Tower in Manhattan.) Line 64 of page 2 of the return indicates more than $400 thousand of federal income taxes were withheld from either wages and/or interest or dividends.

7.     It should be noted the Trump’s were credited with excess social security taxes paid from the wages earned.  This indicates that total wages were derived from more than one employer.

8.     It cannot be ascertained from the partial filing which of the Trump’s received income from wages or how many employers they had (other than the determination above).

9.     When this return was filed with the IRS, copies of their W-2’s were attached and/or a summary schedule of wages and withholding were contained within the return.

Interest & Dividends

10. The Trump’s reported almost $9.8 million of taxable interest and dividends and $47 thousand of tax-exempt interest.

11. This incomplete income tax return did not identify the source of this income.  Interest and dividend income is often derived from bank and brokerage accounts; it can also be derived from pass through entities such as Partnerships, Limited Liability Companies and S-Corporations. Interest income can also be earned from loans made by the taxpayer.

12. Due to the large amount of taxable interest income reported we can assume that the principal generating this income is significant.  Assuming a rate of return equivalent to the 20-year Treasury bill rate at December 31, 2005 of 4.61%.  The principal needed to earn $9.8 million of interest/dividend would be $213 million.  If we would consider the return to be equivalent to the 2005 S&P 500 index dividend yield of 1.79%, the principal balance would approximate $547 million.  Hence, we have a range of possible investment asset values.

13. Again, it cannot be determined from what has been exposed which of the Trump’s held title to the accounts that generated this income.

Business Income

14. The Trump’s reported more than $42 million of net business income as a sole proprietor. This net amount is reflected on Line 12, which is derived from Schedule C of Form 1040.  Since the respective Schedule C(‘s) have not been disclosed, it is not determinable if this income was earned by Mr. Trump, his wife or combination of the two.

15. Schedule C (Form 1040) is used to report income or loss from a business or profession you operate as an unincorporated entity, known as a sole proprietorship. An activity qualifies as a business if your primary purpose for engaging in the activity is for income or profit and you are involved in the activity on a regular basis.

16. The actual Schedule C shows the gross income derived from the activity and the business expenses deducted to determine the net profit reported.  The amount on Line 12 represents the net profit, taxed as ordinary income and subject to social security taxes.

17. It is not determinable from the partial return disclosed what the actual business activity is, nor the it’s gross revenues or deducted expenses.

18. Schedule C can also be used to report wages and expenses you had as a statutory employee, income and deductions of certain qualified joint ventures, and certain miscellaneous income.

19. Certainly, the value of a single business or multiple businesses that generate such levels of profit may be worth multiples of the income it generates.

20. According to the pages provided, the Trumps were subject to additional social security taxes of $1.9 million, which may have been in part caused by this net business income reported.  It should be noted that half of this additional social security tax obligation is deducted in the determination of a taxpayers Adjusted Gross Income.

Net Capital Gain

21. The Trump’s reported more than $32 million of net capital gain in 2005.

22. Net capital gain is defined as the net long-term capital gain over the net short term capital losses in a given year.  The gains are realized, meaning they reflect actual gains from the sale of a capital asset.  A capital asset can be a marketable security or an asset like a parcel of real estate.

23. The actual capital gain rate may be less than the ordinary tax rate.  This is usually the case when a taxpayer’s income is more than modest.

24. Capital gains are generally reported on Schedule D, which indicate the dates of purchase and sale as well as the selling price and cost basis.  Assets that are held for a year or more are considered long-term transactions.  Those assets bought and sold within a 12 month period are considered short-term transactions.  If losses exceed gains only an annual loss of $3,000 is allowed.  The remaining losses are carried forward to future years to offset future capital gains.

25. A taxpayer reports capital gains/losses consummated personally and those attributed to them from pass-through entities, such as Partnerships and S-Corporations.  There is not enough information provided on this incomplete tax return to determine the source of the capital gain or the asset(s) sold.

Rental Real Estate, Royalties, Partnerships, S-Corporation, Trusts, etc.

26. Taxpayers may be engaged in a trade or business through an incorporated or organized entity, such as a S-Corporation, Limited Liability Company or Partnership.  In these instances the income from the business activity is attributed to the owners and taxed on their personal income tax return – as opposed to the corporate level.  A taxpayer’s respective income from the activity is listed on Schedule E of Form 1040.  The sum from all these sources is reported on Line 17 on the face of their individual income tax return.

27. In 2005, the Trump’s reported over $67 million of income from such activities.  Schedule E was not provided, so it is not possible to determine from what entities or activity generated this income or from whom.  These entities may be the same or different from those the taxpayer also reports income from wages, interest, dividends and even capital gains.  As you can see, different types of income are reported separately.

Other Income

28. Line 21 of Form 1040 is identified as “Other Income”.  For most taxpayers this line is used for miscellaneous items such as jury duty income, taxable prizes and awards, gambling winnings and non-business credit card debt cancellation.  In the Trump’s 2005 return, Line 21 actually reported a loss of $103 million.  Of course this item has created a lot of talk, since its inclusion has reduced Mr. Trumps’ total income from $153 million to $50 million.  So what could have effectuated such a large deduction?  My best bet is that this loss represents a deficiency in income from prior years, otherwise known as a “Net Operating Loss”.

29. If a taxpayers deductions in a given year are more than their income, they may have a net operating loss that can be used in another year or years.  Net operating losses are discussed in IRS Publication 536.  And as the IRS states, a loss from operating a business is the most common reason for a net operating loss.

30. The two pages disclosed from Mr. Trump’s 2005 return do not provide any detail or explanation for this item.

Taxable Income, Federal Income Tax & the Alternative Minimum Tax

31. After non-specified itemized deductions of $17 million, Mr. Trump’s taxable income was $32 million, creating a federal tax of $5.3 million.  However, the Trump’s found themselves subject to not only the baseline federal income tax but to the alternative minimum tax as well.

32. The alternative minimum tax (a/k/a “AMT”) is a supplemental income tax required for certain individuals that have exemptions or special circumstances allowing for lower payments of the standard/baseline income tax.  A taxpayer may be subject to the AMT if their taxable income, plus certain adjustments, is more than the AMT exemption amount. This exemption is defined by a taxpayers filing status and income.  In 2005, the AMT exemption amount for a taxpayer filing married jointly was $58 thousand.

Foreign Tax Credit

33. The final item to be discussed is the foreign tax credit of $24 thousand provided on Line 47 on page 2 of Form 1040.  If a taxpayer pays foreign taxes to a foreign country (or U.S. possession) and is subject to U.S. tax on the same income, you may be able to take either a credit or an itemized deduction for those taxes.  Since the accompanying Form 1116 has not been disclosed, we cannot determine what foreign country the Trumps earned income from or the value of the asset generating the income.

Other Items

34. The sexy part of this discussion certainly focused on the large sums of interest income, business income and capital gains.  However, there are some other noticeable items that a forensic accountant would observe.

Some of these items are:

a.     Mr. Trump did not pay any tax deductible alimony to his previous wives in 2005.

b.     He made no self-employed pension contribution.

c.     Although he had federal taxes withheld from his employment, made estimated tax payments during the year and a large tax payment with his filing extension, he still was subject to over $158 thousand of federal penalties and interest.

d.     The copy of the return disclosed is stamped as a “Client Copy”.

So here you have it.  A not so brief overview of how a forensic accountant would view a partial federal income tax return.

In these instances our objective is to better understand the parties’ income, assets, and even value of their estate.  Certainly, many questions remain unanswered due to an incomplete file.  As forensic accountants our firm is often provided with incomplete and inaccurate records and tax returns.  It is our job to review and analyze what is provided to us and make sense of it all.

Mark S. Gottlieb, CPA/ABV/CFF, CVA, CBA, MST is an accomplished forensic accounting and business valuation specialist with expertise in record reconstruction and litigation support. He is recognized for the meticulous preparation and comprehensive research he brings to all of his professional engagements. Since forming MSGCPA, Mr. Gottlieb has lead a team of highly qualified professionals in conducting forensic accounting examinations, independent business and professional practice valuations, and a continuum of financial and economic analyses. He is frequently appointed by the court to provide these services and expert testimony. Mark S Gottlieb can be contacted by email at msgcpa@msgcpa.com or by phone at 646-661-3800.